The correct policy response for aligning the ﬁxed exchange rate with the long-term market rate for the currency is to devalue the currency.

Question

Quizplus · Accepted Answer

If the fixed exchange rate is above the long-term market rate, then devaluation of the currency is necessary to align it with the market rate. This is because devaluation makes exports cheaper and imports more expensive, thus increasing demand for domestic goods and reducing demand for foreign goods, which ultimately leads to an increase in the demand for domestic currency and a decrease in its supply, leading to a currency appreciation. Conversely, if the fixed exchange rate is below the long-term market rate, then revaluation is necessary to align it with the market rate.

The Correct Policy Response for Aligning the ﬁXed Exchange Rate