If a country sets a pegged exchange rate that is below the equilibrium exchange rate,how can the country maintain the peg?

Question

Quizplus · Accepted Answer

If a country sets a pegged exchange rate below the equilibrium exchange rate, there will be excess supply of domestic currency in the foreign exchange market, i.e. there will be excess demand for foreign currency. To maintain the peg, the central bank of the country needs to sell the excess domestic currency in exchange for foreign currency at the pegged exchange rate. This will reduce the excess supply of domestic currency and increase the foreign reserves of the central bank, which can be used to defend the peg in the future. Therefore, option B is the correct choice. Option A is incorrect because purchasing surplus domestic currency at the pegged rate will increase the excess supply and put further pressure on the peg. Option C is incorrect because purchasing surplus domestic currency at the equilibrium rate will increase the excess supply and put further pressure on the peg. Option D is incorrect because decreasing the pegged exchange rate will exacerbate the excess supply and lead to a larger deviation from the equilibrium rate.

If a Country Sets a Pegged Exchange Rate That Is