Suppose a country that has been pegging its currency is faced with a situation where financial market participants now expect some future devaluation. In such a situation, we would generally expect which of the following to occur?
A) An increase in investment.
B) An increase in domestic stock prices.
C) An increase in demand for the country's currency.
D) An increase in interest rates.
E) An announcement by the central bank that a large devaluation will occur in the near future.

Question

Quizplus · Accepted Answer

In a situation where financial market participants expect a devaluation of the country's currency, the central bank may need to increase interest rates to prevent capital outflows and maintain the value of the currency. This is because higher interest rates would make the country's assets more attractive to foreign investors, leading to an increase in demand for the currency. A) and B) are unlikely as investors and traders may be wary of investing in stocks or making new investments until the situation stabilizes. C) is unlikely as the expectation of devaluation would lead to a decrease in demand for the currency. E) is unlikely as such an announcement would only worsen the situation and potentially lead to a currency crisis.

Suppose a Country That Has Been Pegging Its Currency Is