Question

Please explain in detail and show work where applicable. Please show any formulas or calculations and explain them.

- perhaps you would Soft Peg the small coutry to a basket of Germany and France's currencies?

- please explain?

Practice # 10

You have been hired as a consultant to the central bank for a small country that, for many years, has suffered from repeated currency crises and rampant inflation. The country depends heavily on both the German and French financial and product markets. What type of exchange rate policy would have the greatest impact and reduce currency volatility between the client country and both Germany and France?

Answer 1

The small country has suffered from currency crisis and inflation. It depends on both Germany and France for financial and product markets.

Germany and France both have Euro as their currency thus the small country can opt to Hard peg their currency to the Euro as the exchange rate volatility will reduce because the domestic money supply will not increase rapidly. Hard pegging it will reduce the currency volatility to a great extent.

If a soft peg is used there will be some sort of volatility as there has to be a band which will leave room for volatility.

The hard peg will allow the domestic currency to be backed 100% by the Euro and the smaller country can also opt to use Euro as the legal tender. This will reduce the transactional expenses to a great extent and the financial sector will be strong because of the backing. Interest rates will be in line and exhange rate risk will be at minimal.

Because of pegging the currency, there is more reliability on the currency and people hold onto the currency more which reduces inflationary expectations when money supply increases. The control of the small domestic nation would also reduce as they have not been able to reduce volatility historically.