Question

Use a figure and words to explain the following: What is meant by saying that a country’s exchange rate is overvalued? Also briefly state:

(a) Why should it be surprising to find that a country trying to protect its domestic industries from import competition has an overvalued exchange rate?

(b) Why did countries following import substitute industrialization policies nonetheless often have overvalued exchange rates?

Answer 1

An overvalued exchange rate implies that acountries currency is too high for the state of the economy. An overvalued exchange rate means that the countries exports will be relatively expensive and imports cheaper. An overvalued exchange rate tends to depress domestic demand and encourage spending on imports.

a)The exchange rate is overvalued when the price is below P*, the market-clearing level. ... It's surprising that a country trying to protect domestic industry would have an overvalued exchange rate, since such an exchange rate makes imports cheaper and thus more competitive with locally produced manufactures.

b) Overvalued exchange rates typically resulted from the combination of (i) higher domestic than world inflation rates, with (ii) fixed exchange rates and resistance to frequent devaluations. A major cause of this resistance was the influence of privileged urban consumers of imported goods, and opposition from manufacturers dependent on cheap imported inputs.