By signing the Bretton Woods agreement, countries agreed to protect
their exchange rate from moving up or down from the agreed-upon rate.
This agreement implied that central banks had to take on a more activerole in making sure that market pressure did not change the exchange
rate. The various central banks achieved this goal by buying and selling
their domestic currencies on the foreign exchange market. The central
bank intervention can be illustrated using the trade flow model developed
in Chapter 1. Assume that the U.S. and the U.K. are trading with each
other, and that the U.K. residents start demanding more Fords (a U.S.
good). In the first chapter you learned that this would imply a shift in the
supply curve for pounds. U.K. traders would be more willing to supply
their pounds to banks in exchange for dollars, because the traders want to
buy U.S. goods. Banks see more customers supplying pounds and
demanding dollars, causing banks to want to depreciate the pound.
Figure 2.2 illustrates the shift in the supply curve causing the banks to
want to depreciate the pound from a starting dollar/pound exchange rate
of 2.00 to a new equilibrium exchange rate of 1.80.