3. Discuss why countries with undervalued fixed exchange rates tend to experience inflationary expectations?

Expert Solution

An undevalued currency means that a country would have to pay more for imports. For example $1 = 100 Indian rupees and India keeps its currency undervalued to export more then $1= 120.

India will earn more with every addional $ export to USA. However, Indian importers will suffer more and will have to pay more for every $ good/service imported.

India is dependent on Gulf countries for oil imports but if India keeps its currency undervalued then each imported barrel of oil make India pay more. This additional cost of crude oil will be passed on to consumers by raising prices of goods/service in India. This will also increase costs of production in India and Indian goods will become expensive in world markets and exports will also go down and many people may lose jobs. Indian goods becoming expensive will take price index up in India causing inflation. This is a clear case how inflation goes up. Hence an undervaluation. decision should be taken depending on elasticty of imports.

Undervalued currency helps to export more and produce more jobs. Example- China is accused of keeping yuan value low to increase exports. This also leads to more exports and more income to its people. This will again shift aggregate demand up and average prices will go up.

Rahul Sunny answered 2 years ago

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