In 1995, the Thai baht is pegged to a basket of currencies. Assume that the baht exchange rate is set
at 25 baht per U.S. dollar. Thailand is experiencing rapid economic growth, with extensive ongoing foreign investment. Consumer price index (CPI) inflation in Thailand is somewhat higher than in the United States, and the current account in Thailand is in deficit. Nevertheless, Thailand has no problem maintaining its fixed exchange rate with the dollar.
a. Explain why the Thai baht does not depreciate as suggested by purchasing power parity (PPP).
b. Two years later, prospects for economic growth are much lower and investors are worried about the political and financial uncertainties in Thailand. Explain why the Thai baht depreciates strongly against the U.S. dollar.

Question

Quizplus · Accepted Answer

The Answer is a. PPP does not take into account Thailand's important growth potential. As suggested by the asset market approach, this growth potential attracts large inflows of capital through foreign investment in the country. This results in an increased demand for the home currency, which is consequently strengthened. The current account deficit is offset by a financial account surplus. Also, productivity gains in Thailand allow it to sustain a real appreciation of the baht. Both reasons explain why the Thai baht does not depreciate as suggested by PPP.
b. Two years later, prospects for economic growth are much lower. Moreover, investors are worried about the political and financial uncertainties in Thailand. As a result, the demand for the home currency falls. Then, the spot exchange rate adjusts to inflation differential between the two countries. This explains why the Thai baht depreciates against the U.S. dollar.

In 1995, the Thai Baht Is Pegged to a Basket