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)P will decrease over time until Y = Yn.
B)A reduction in the pegged value of the domestic currency will cause a leftward shift of the AD curve.
C)Net exports will increase as the economy adjusts to this situation.
D)Domestic goods will become less competitive as the economy adjusts by itself.
E) none of the above

Question

Quizplus · Accepted Answer

If a country's currency is overvalued, it means that its goods are relatively expensive compared to other countries' goods, making them less competitive in international markets. As a result, the country is likely to experience a decrease in exports and potentially an increase in imports, leading to a trade deficit.

If output is currently above the natural level of output, it suggests that the economy is operating above its potential, which could lead to inflationary pressures. To bring the economy back to its natural level, there may be a decrease in aggregate demand, possibly through a reduction in government spending or an increase in interest rates, leading to a decrease in output (choice A).

A reduction in the pegged value of the domestic currency (choice B) would make the currency weaker, which could increase exports by making them cheaper, but it would also increase the prices of imported goods, which could lead to inflationary pressures. It does not necessarily cause a leftward shift of the AD curve.

Net exports tend to decrease when a country's currency is overvalued, as stated above (choice C).

Therefore, the best choice is D - domestic goods will become less competitive as the economy adjusts by itself.

Suppose the Country That Pegs Its Currency Has an Overvalued