Question

Suppose a country has fixed exchange rate and no capital controls. The country has kept the value of its currency below its market level. Now, due to a political crisis, projections for economic growth in coming years are revised sharply downwards. As a result of new projections, savers wish to purchase financial assets in other countries.(e)Will the country be able to maintain the exchange rate? (f)Capital flows can cause problems for exchange rate stability. So, why do most countries allow the free movement of capital

Answer 1

No the country will not be able to maintain the exchange rate. This is because firstly the country has no capital controls to maintain the exchange rates for the initial period of time, and even after this, the political crises that have emerged in the country will force its investors to invest their capital I'm foreign assets. This would require them to borrow foreign currency, thereby increasing the demand for foreign exchange exponentially and thus driving down exchange rates. Thus, the country will not be able to maintain its exchange rates.

Countries allow free movement of capital because today countries are very much interrelated to each other when it comes to trade. It is not possible for any one country to produce everything within its borders and not import anything from the foreign country. Thus, the country can do nothing but allow free movement of goods and capital, because putting restrictions of trade and capital would give a wrong signal to the foreign countries that the country is closed minded in its trade policies.