The correct option is Excess supply of dollars.
Explanation
In a fixed exchange rate system, the monetary authority pegs the value of the domestic currency against a foreign currency. The exchange rate is typically expressed as the price of foreign currency in terms of domestic currency (e.g., ₹ per $). Setting this rate hig than the market equilibrium implies that the government has officially undervalued the domestic currency (devaluation), making the foreign currency artificially expensive.Analysis of the Outcome
- Price Mechanism: When the exchange rate is fixed above the equilibrium level (e.g., fixing the rate at ₹80/$1 when the market equilibrium is ₹70/$1), the price of the dollar is higher than what the market forces of demand and supply would determine.
- Effect on Supply of Dollars: A higher exchange rate makes domestic goods cheaper for foreigners and increases the returns for exporters (they get more rupees per dollar). This incentivizes exports and capital inflows, leading to an increase in the supply of dollars.
- Effect on Demand for Dollars: Simultaneously, foreign goods become more expensive for domestic buyers. This discourages imports and outflows, leading to a contraction in the demand for dollars.
- Conclusion: Since the supply of dollars exceeds the demand at this higher price point, the market experiences an excess supply of dollars. To maintain the fixed rate, the Central Bank must intervene by purchasing this excess supply, thereby accumulating foreign exchange reserves.
Note on other options:
- Excess demand Excess demand for dollars. and Black markets Emergence of a black market for dollars. typically occur when the exchange rate is set below the equilibrium (overvaluation), making dollars artificially cheap and causing a shortage.
Key Takeaway: In a fixed regime, undervaluation (rate > equilibrium) leads to an excess supply of foreign currency, while overvaluation (rate < equilibrium) leads to an excess demand for foreign currency.