Question

Which of the following statements is likely to be true?

A)Everything else equal, an increase in the supply of dollars in exchange for pesos will cause the dollars to depreciate against the pesos and will decrease the quantity of dollars being traded in the foreign exchange market.

B)If a country wants to keep the domestic currency overvalued against a foreign currency, it will buy the domestic currency and sell the foreign currency.

C)If a country wants to keep a foreign currency undervalued against the domestic currency, it will buy the foreign currency and sell the domestic currency.

D)Everything else equal, a decrease in the supply of dollars in exchange for pesos will cause the dollars to depreciate against the pesos and will decrease the quantity of dollars being traded in the foreign exchange market.

Answer 1

Answer

Option B) is correct. If a country wants to keep the domestic currency overvalued against a foreign currency, it will buy the domestic currency and sell the foreign currency.

Reason:

By overvalued we mean that the domestic currency is more in demand and thus makes the exports expensive for other countries. Thus, if the domestic currency is reduced further in the market, its demand will increase further and it will continue to stay overvalued.

Other options are incorrect becuase :

a) Everything else equal, an increase in the supply of dollars in exchange for pesos will cause the dollars to depreciate against the pesos and will INCREASE and not decrease the quantity of dollars being traded in the foreign exchange market.

C) If a country wants to keep a foreign currency undervalued against the domestic currency, it will SELL and not buy the foreign currency and sell the domestic currency.

D) Everything else equal, a decrease in the supply of dollars in exchange for pesos will cause the dollars to APPRECIATE and not depreciate against the pesos and will decrease the quantity of dollars being traded in the foreign exchange market.