Question

Suppose that country A pegs its currency to country B’s currency, and A has excessively high inflation. Country B is only likely to help A if:

a. both are members of the International Monetary Fund.

b. country B has a free trade agreement with country A.

c. country B’s output is above its preferred level.

d. country B does not trade at all with country A.

e. country B’s output is below its preferred level.

Answer 1

Given that country A pegs its currency to country B's currency, and that country A is not witnessing high inflation. In order to correct this inflation, country A will need cooperation from Country B such that country B will reduce its money supply. This will lead to an increase in interest rates in country B, causing a fall in consumption and investment and hence a leftward shift in the AD curve and a fall in equilibrium GDP.

Decreasing the money supply in country B will lead to a revaluation of exchange rate. Since country A's currency is pegged to country B's. it will also lead to a revaluation of the currency of country A, thus solving the inflation problem.

Country B will be willing to cooperate with country A only if country B's output is above its preferred level.

Ans. (C)