Suppose foreign exchange markets anticipate a devaluation for country A.Further assume that policy makers in country A will continue to fix its nominal exchange rate.In order to peg the currency at its original level,which of the following must occur?
A)increase the domestic interest rate
B)increase the domestic price level
C)convince trading partners to raise their interest rates
D)all of the above
E) none of the above

Question

Quizplus · Accepted Answer

When the foreign exchange markets anticipate a devaluation, foreign investors will try to sell off their holdings of the country's currency in anticipation of earning less return from their investments due to the expected decline in the currency's value. To prevent the currency from depreciating, the policymakers must increase the demand for their currency by increasing its interest rates. This increase in interest rates makes the domestic assets more attractive, drawing in investors to invest in the country and thereby increasing the demand for the country's currency. Therefore, the policymakers must increase the domestic interest rate to peg the currency at its original level. Increasing the price level and convincing trading partners to raise their interest rates may have some impact, but the primary and essential response would be increasing the domestic interest rate.

Suppose Foreign Exchange Markets Anticipate a Devaluation for Country A Assume