Final answer:
The government must buy its own currency and sell foreign currency to fix the exchange rate above the market equilibrium. This increases the demand for the domestic currency and decreases its supply, raising its value. Such interventions are limited by foreign reserve availability.
Step-by-step explanation:
To fix the exchange rate (foreign currency price of domestic currency) above the free market equilibrium exchange value, a government must employ specific monetary actions. If a government wishes to fix the exchange rate at a value higher than the free market equilibrium, it must increase the demand for its currency while reducing the supply. The main answer to the student's question is that the government must buy its own currency and sell foreign currency. This action will decrease the amount of domestic currency available in the market, hence raising its price, while increasing the supply of foreign currency, hence lowering its price. This aligns with the fact that no central bank has unlimited foreign currency reserves; hence, this action cannot be sustained indefinitely without adequate reserves.The conclusion is that to establish the domestic currency's exchange rate above its free market equilibrium, a government engages in market intervention, specifically by buying its own currency and selling foreign currency in order to decrease the domestic currency's supply, increase its demand, and thus elevate its relative value on the foreign exchange market.