The demand for euros in the foreign exchange market equals 8,000 - 2,000 e and the supply of euros in the foreign exchange market equals 3,000 + 3,000 e, where e is the nominal exchange rate expressed in U.S. dollars per euro. If the euro is fixed at 1.25 U.S. dollars per euro, then the euro is ________ and Euroland has a balance-of-payments ________.

Question

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At the official fixed exchange rate of 1.25 U.S. dollars per euro, the demand for the euro is 8,000 - 2,000(1.25)= 5,500 and the supply of euro is 3,000 + 3,000(1.25)= 6,750. In other words, the euro is overvalued as too much is being supplied and not enough is being demanded at this exchange rate. To maintain this fixed rate, the European governments must purchase the excess 1,250 (6,750 - 5,500)euro by spending down their international reserves. This will cause a balance-of-payments deficit of 1,250 euro.

The Demand for Euros in the Foreign Exchange Market Equals