Question

Imagine the world has three countries: country A, B and C. They all have their own currencies. Country A and B both have a flexible regime while country C has pegged its currency against country B.

1. Using a demand and supply analysis, what would you expect to happen to the nominal exchange rate between country A and B if country A make some technological innovations and attracted investors from country B?
2. There has been some bad economic news about country C and foreign investors are taking their money out of the country. What does country C need to do if it wants to defend the pegged rate?
3. What happens to its nominal exchange rate if country C fails to defend the pegged rate in part (b)? How might this lead to future recovery in country C’s GDP?

Answer 1

1. When country A attracts investment from country B then nominal exchange rate of country A will rise because investors will invest in the country capital accumulation will be there. therefore, exchange rate also rises.

For country A, exchange rate will fall because fall in investments lead to low capital formation.

This can be explained with the help of a graph.

DD is the initial demand curve and SS is the initial supply curve. Price level initially is P and quantity is Q. Demand curve shifts rightward due to increase in investments leading to rise in price P1 and quantity Q1.

2. If investors withdraw money from the country, having flexible regime then exchange rate will fall. But if country has pegged exchange rate then it has to keep large amount of reserves in order to maintain the fixed rate. Exchange rate will therefore be fixed even after investors withdraw the money.

3. If country C is not able to defend the pegged exchange rate then as a result the exchange rate will fall and country will be forced to adopt floating exchange rate. For example: During 1997-98 Thai baht (Thailand) fell so much because country was unable to maintain its fixed regime so it has to forcefully adopt floating exchange rate.

If the country adopts floating exchange rate meaning exchange rate will now be determined by forces of demand and supply. Exchange rate being lower will increase exports and recover GDP.