Under fixed exchange rate, which one of the following statements is the most accurate?
A) Devaluation causes a decrease in output, a decrease in official reserves, and a contraction of the money supply.
B) Devaluation causes a rise in output, a rise in official reserves, and an expansion of the money supply.
C) Devaluation causes a rise in output and a rise in official reserves.
D) Devaluation causes a rise in output and an expansion of the money supply.
E) Devaluation causes a rise in official reserves, and an expansion of the money supply.

Question

Quizplus · Accepted Answer

Under a fixed exchange rate system, devaluation leads to an increase in the domestic currency price of imports and a decrease in the foreign currency price of exports. This stimulates domestic production and exports, leading to an increase in output. Moreover, devaluation increases the value of domestic currency in terms of foreign currency, which means an increase in official reserves. To prevent the exchange rate from appreciating excessively, the central bank usually expands the money supply, leading to an increase in liquidity in the economy. Therefore, option B is the most accurate as it encompasses all the effects of devaluation under a fixed exchange rate system.

Under Fixed Exchange Rate, Which One of the Following Statements