Full Money Market

I understand that it has something to do with governments trying to fix exchange rates, but my textbook isn’t making the rest of it clear.

Here’s how:

Assume that some government has fixed their exchange rate 1-1 with the US Dollar.

Now, assume that the "market" exchange rate, based on money supply, demand, whatever, is 1.2 -> 1 dollar.

Since the country’s central bank is committed to a fixed exchange rate of 1 dollar for 1 local, people will give the central bank 1 local currency and receive 1 dollar.

Then they’ll turn around and sell the dollar on the market for 1.20 of their local currency.

They just made a free 0.20 in their local currency.

What happens if a bunch of people do this, multiple times? Eventually, more dollars are in the market, and less local currency is in the market (since the central bank is giving out dollars and receiving local currency). This will eventually force the exchange rate to the fixed 1-1 ratio.

This is why governments with fixed exchanged rates have trouble controlling interest rates in their economy, since they cannot control the money supply.

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