Suppose that a nation has adopted a fixed exchange rate with another country, and has a persistent trade deficit.What is most likely to happen?

Question

Quizplus · Accepted Answer

A persistent trade deficit under a fixed exchange rate system puts pressure on the nation's currency because it implies that the demand for foreign currency (to pay for imports) exceeds the supply of foreign currency coming in from exports. This imbalance can lead to a depletion of the nation's foreign currency reserves as it tries to maintain the fixed exchange rate. Eventually, if the situation is not corrected, it can lead to a lack of confidence among investors and currency holders, resulting in a "run" on the currency as they try to exchange it for more stable foreign currencies before the value drops. This scenario typically results in a sudden devaluation of the currency when the government can no longer maintain the fixed rate and is forced to devalue or float its currency.

Suppose That a Nation Has Adopted a Fixed Exchange Rate