Question of the Week

Under a pegged exchange rate system which of the following measures can be undertaken by a home country in order to devalue its currency back to its original peg?

I. Decrease the growth of the money supply in the home market relative to the country to which the home currency is pegged.
II. Reduce the real level of interest rates.
III. Implement measures to stimulate economic growth at home.
IV. Sell some of the foreign currencies in its reserves in exchange for the domestic currency.

a) II and III only.
b) I and IV only.
c) I, II, and IV only.
d) I and II only.

Answer:

The correct answer is: a)

By reducing the level of real interest rates at home, foreign and domestic investors will invest in some other nation, where they can get a higher real rate of return. However, this process would involve the selling of the home currency, which will result in its devaluation. Similarly, by increasing income levels in the domestic economy, imports will naturally increase. This process too, will involve the selling of the home currency in order to buy the currency of the nation from where the imports are being bought.



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