Suppose the country that pegs its currency has an overvalued real exchange rate and that output is currently above the natural level of output. Which of the following will occur as the economy adjusts to this situation?
A) The interest rate falls as the economy adjusts by itself.
B) Net exports will increase as the economy adjusts to this situation.
C) Domestic goods will become less competitive as the economy adjusts by itself.
D) Prices will decrease over time until Y = Yn.
E) A decrease in the pegged value of the domestic currency will cause a leftward shift of the AD curve.

Question

Quizplus · Accepted Answer

EWhen a country has an overvalued real exchange rate, its domestic goods become less competitive on the international market because they are relatively more expensive than foreign goods. This situation leads to a decrease in net exports, which is consistent with choice C. As for choice E, a decrease in the pegged value of the domestic currency (a devaluation) would make domestic goods cheaper relative to foreign goods, potentially decreasing demand for domestic goods as the currency's value is adjusted downward. This could lead to a leftward shift of the Aggregate Demand (AD) curve as domestic and foreign consumers adjust their spending in response to the new exchange rate, affecting the overall demand for the country's goods and services.

Suppose the Country That Pegs Its Currency Has an Overvalued