Question

21.   If a small country fixes its exchange rate against a large country’s currency, and the small country initially has a higher inflation rate than the large country, the two inflation rates will be equalized because

A.   the higher inflation in the small country appreciates its real exchange rate, reducing net exports and output, and reducing the inflation rate to the same rate as in the large country.
B.   the higher inflation in the small country depreciates its real exchange rate, reducing net exports and output, and reducing the inflation rate to the same rate as in the large country.
C.   the higher inflation in the small country appreciates its real exchange rate, increasing net exports and output, and increasing the inflation rate to the same rate as in the large country.
D.   the higher inflation in the small country depreciates its real exchange rate, reducing net exports and output, and increasing the inflation rate to the same rate as in the large country.

Answer 1

Inflation cause changes in the quantity of import and export of the small country. A high inflation leads to reduction in export from the small country. The reason is that the goods and services of the small country are more costly in the international market due to inflation. Thus the demand for small country’s currency in the forex market decreases.

Due to inflation the foreign goods become cheaper in the domestic market of the small country. This will lead to an increase in import of the country. Thus the country’s demand for foreign currency increases.

The increased demand for foreign currency and decreased demand for domestic currency in the small country depreciate its national currency.

The increased demand for import and less demand for export reduce the volume of net export. In other words the increased import over export in the small country reduces the price level and the volume of output. The price level decreases because more cheap goods are imported. The output decreases because the import competing industries find it difficult to compete with the low priced imported goods. The export sector also produce less because the less demand in foreign market. Thus the output and factor prices decrease. The fall in factor price reduce the inflation rate. In short the reduction in net export and output depreciate the real exchange rate and reduce the inflation in the small country which gradually become equal to the large country.

Answer: B. the higher inflation in the small country depreciates its real exchange rate, reducing net exports and output and reducing the inflation rate to the same rate as in the large country.