6. Suppose a country wants to fix the exchange rate of its domestic currency higher than...

6. Suppose a country wants to fix the exchange rate of its domestic currency higher than what markets alone would bring about.

(a) Suppose the central bank officially sets the higher-than-market exchange rate for the domestic currency, but otherwise undertakes no action. Which would result, a surplus of the currency or a shortage of the currency?

(b) Suppose the central bank does undertake an action to achieve its desired fixed exchange rate. Which would the central bank do, buy the domestic currency or sell the domestic currency?

(c) Which does the country have, a reserve transaction outflow or a reserve transaction inflow?

(d) Which does the country have, a narrow Balance of Payments deficit or a narrow balance of Payments surplus?

Expert Solution

(a) Suppose the central bank officially sets the higher-than-market exchange rate for the domestic currency, but otherwise undertakes no action. Which would result, a surplus of the currency or a shortage of the currency?

Since central bank is keeping the exchange rate artificially higher than one that might be prevailing in free market. Thus, country currency value will witness rise and import will become cheaper. Export will be relatively expensive.

Thus, Shortage of currency is likely to be witnessed.

(b) Suppose the central bank does undertake an action to achieve its desired fixed exchange rate. Which would the central bank do, buy the domestic currency or sell the domestic currency?

Domestic currency value is higher, now central bank will release the domestic currency in market and rise in supply of domestic currency will invariably lead to fall in its exchange rate.

Domestic currency shall be sold.

(c) Which does the country have, a reserve transaction outflow or a reserve transaction inflow?

There will be reserve inflow of foreign currency. When central bank sells domestic currency, it will receive foreign currency in return.

(d) Which does the country have, a narrow Balance of Payments deficit or a narrow balance of Payments surplus?

When country exchange rate is artificially higher, it would witness rise in import and fall in export. Hence, there will be balance of payment deficit.

Rahul Sunny answered 2 years ago

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