The demand for the Franconian franc in the foreign exchange market equals 11,000 - 25,000e and the supply of francs in the foreign exchange market equals 9,000 + 25,000 e, where e is the nominal exchange rate expressed in U.S. dollars per franc. If the franc is fixed at 0.15 U.S. dollars per franc, then the franc is ________ and Franconia has a balance-of-payments ________.
A)overvalued; surplus of 5,500 francs
B)undervalued; surplus of 5,500 dollars
C)overvalued; deficit of 5,500 francs
D)undervalued; deficit of 5,500 francs

Question

Quizplus · Accepted Answer

At the official fixed exchange rate of 0.15 U.S. dollars per franc, the demand for the franc is 11,000 - 25,000(0.15)= 7,250 and the supply of francs is 9,000 + 25,000(0.15)= 12,750. In other words, the franc is overvalued as too much is being supplied and not enough is being demanded at this exchange rate. To maintain this fixed rate, the Franconian government must purchase the excess 5,500 (12,750 - 5,250)franc by spending down its international reserves. This will cause a balance-of-payments deficit of 5,500 francs.

The Demand for the Franconian Franc in the Foreign Exchange