Explain how it is possible for the nominal exchange rate to remain fixed and the real exchange rate to depreciate in a country with exchange controls and a nontrivial amount of inflation.

Question

Quizplus · Accepted Answer

The Answer is When a country fixes an exchange rate, the exchange rate is expressed in nominal terms. So long as the nominal exchange rate is close to its purchasing power parity value, then a nominal peg may be sustainable over time. However, the real exchange rate may change even if the nominal exchange rate does not. A common problem in this regard is that a country's domestic inflation may not be equal to the foreign rate of inflation. Controlling the money supply in developing countries is difficult due to the lack of open market operations and changes in the government budget deficit can easily translate into large changes in the monetary base and the money supply. This may lead to an increase in the domestic price level relative to the foreign price level. In such a case, the country's real exchange rate is appreciating and the nominal exchange rate is becoming overvalued.

Explain How It Is Possible for the Nominal Exchange Rate