Question

In order to maintain a pegged exchange rate in China:

	a.	at least one foreign country must also maintain a pegged exchange rate.
	b.	no other country that China shares a geographical border with can maintain a pegged exchange rate.
	c.	the Chinese government must prevent Chinese citizens from trading goods or services with other countries.
	d.	the Chinese government must prevent Chinese citizens from purchasing assets denominated in foreign currencies.
	e.	the Chinese government must adjust the supply of the yuan in world markets.

Answer 1

The central bank is committed to buy or sell the domestic currency for foreign currency at a price in pegged exchange rate (fixed exchange rate) system. In order to have equality between equilibrium exchange rate and announced exchange rate, the central bank adjusts money supply to the required level.

Let's assume that China fixes the exchange rate as 10 CNY = 1 USD

The following two situations explain how a pegged exchange rate system decides the currency supply.

(I) When equilibrium exchange rate is more than pegged exchange rate:

In this situation, arbitrageur will earn profit by buying Yuan in foreign exchange market and selling to China.This will raise the currency supply shown by rightward shift of LM₁ to LM₂ curve. The rightward shift is to the extent (till point E₁) such that the exhange rate reduces to level 10 CNY = 1 USD.

(II) When equilibrium exchange rate is less than pegged exchange rate:

In this situation, arbitrageur will earn profit by buying dollars in foreign exchange market and selling to China. This reduces the currency supply shown by leftward shift of LM₁ to LM₂ Curve. The leftward shift is to the extent ( till point E₁) such that exchange rate rises to level 10 CNY = 1 USD.

Hence, the correct option is e.