Where the central bank intervenes in foreign currency markets and alters the level of currency demand and supply to maintain the exchange rate at a specific level. It does this by buying and selling up foreign currency reserves.
Below is a diagram to show how a central bank prevents the exchange rate from moving above its target level to a higher free floating equilibrium. There is upward pressure brought about by an increase in the demand for the domestic currency due to an increase in demand for exports, this creates an excess demand for the currency as shown below. To prevent the exchange rate from rising above the fixed rate the central bank prints more money to increase the supply of money and devalue the currency to offset the upward pressure. This new money is sold to acquire new foreign reserves, so that the foreign currency gets stronger and the domestic currency gets weaker. This downward pressure is enough to offset the upward pressure to maintain the fixed rate.
Below is a diagram to show how a central bank prevents the exchange rate fom moving below its target level to a lower free floating equilibrium. There is downward pressure brought about by an increase in the demand for the foreign currency due to an increae in demand for imports, this creates an excess supply for the domestic currency because when consumers buy foreign imports, they sell domestic currency to buy up foreign currency as the foreign imports are priced in terms of foreign currency. To prevent the exchange rate from falling below the fixed rate the central bank sells foreign currency reserves to buy up domestic currency, which increases the demand for domestic currency and creates upward pressure. By strengthening the domestic currency and weakening the foreign currency the downward pressure is offset and as a result the exchange rate remains at its fixed value.
