Suppose foreign exchange markets anticipate a devaluation for country A. Further

Question

Suppose foreign exchange markets anticipate a devaluation for country A. Further assume that policy makers in country A continue to fix its nominal exchange rate. In order to maintain the peg of the currency at its original level, which of the following must occur?

Select one:

a. increase the domestic interest rate

b. increase the domestic price level

c. convince trading partners to raise their interest rates

d. convince trading partners to raise their taxes

e. decrease the domestic interest rate

Explanation / Answer

Since in the foreign exchange market, its anticipated that country A currency may devaluate in future and policy maker in country A wants to fix nominal exchange rate and continue it. So it may happen only through evaluation of the currency of country A.

So it may be possible only when, there is an increase in the domestic interest rate.

This is because if domestic interest rate increase, so more people around the world would like to invest their money in country A. So the demand of currency of country A increase, so it may evaluate the country A currency and nullify the effect of devaluation of the country A currency.

Hence option A is the correct answer.

Option A is; increase the domestic interest rate.

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