The figure given below depicts the foreign exchange market for British pounds traded for U.S.dollars. Figure 22.2 Refer to Figure 22.2.Suppose the British central bank is committed to maintaining an exchange rate of £1 = $1.50, but there is a permanent shift in supply from S₁ to S₃.According to the Bretton Woods agreement: A)the pound should be devalued. B)the dollar should be devalued. C)the British central bank should buy pounds in exchange for dollars. D)the British central bank should encourage speculation. E)the Fed should intervene to maintain the exchange rate of £1 = $1.

Question

Quizplus · Accepted Answer

With a permanent shift in supply from S₁ to S₃ in the foreign exchange market, the equilibrium exchange rate will shift from point E1 to point E2, where the pound depreciates to $1.40, which is below the fixed exchange rate of £1 = $1.50. To maintain the fixed exchange rate, the British central bank will have to buy pounds in exchange for dollars, which will lead to a depletion of its foreign currency reserves. Therefore, the best choice is A as the pound should be devalued to match the new equilibrium exchange rate. However, this would require a departure from the fixed exchange rate system of the Bretton Woods agreement.

The Figure Given Below Depicts the Foreign Exchange Market for British