Chapter 30: Problem 6

When the government fixes the exchange rate above market exchange rates, a. international trade falls. b. the infrastructure improves. c. real GDP per capita rises. d. the vicious circle of poverty is broken.

Short Answer

Expert verified

a. international trade falls.

Step by step solution

Understand the Concept of Fixed Exchange Rates

A fixed exchange rate, also referred to as a pegged exchange rate, is a type of exchange rate regime where a currency's value is fixed or pegged by the government to the value of another single currency, a basket of other currencies, or to another measure of value, such as gold. Fixed exchange rate regimes are set to maintain the country's currency value within a very narrow band. Also, these regimes are often used to stabilize the value of a currency, vis-à-vis the currency it is pegged to. It can also help to prevent inflation, and this is often the reason for its implementation.

Analyze the Implication on International Trade

(a) When a government fixes the exchange rate above market rates, the local currency becomes overvalued. This means that the local goods become more expensive for foreign buyers. As a consequence, an overvalued currency can reduce the competitiveness of a country's goods and services in the global markets, leading to a fall in exports. Simultaneously it would increase imports since foreign goods would become cheaper, disturbing the balance of trade. Therefore, international trade can fall in such conditions.

Evaluate the Effect on Infrastructure

(b) The fixed exchange rate itself doesn't directly result in the improvement of infrastructure. Improved infrastructure would require substantial investments, which are typically a result of economic growth, government policy, and available resources rather than an overvalued currency. Therefore, it's not accurate to say that fixing the exchange rates above the market levels would result in infrastructure development.

Discern the Impact on Real GDP per Capita

(c) Real GDP per capita can be influenced by a multitude of factors and not just the exchange rate policy. An inflated exchange rate can initially lead to increased consumption (due to cheap imports) which could inflate GDP. However, this effect might be short-lived as the decreased competitiveness in international trade can harm domestic industries, leading to unemployment. Thus, it's not necessarily right that an above-market fixed exchange rate leads to rising Real GDP per capita.

Consider If It Can Break Poverty Circle

(d) Fixing the exchange rate above the market levels doesn't guarantee that the vicious circle of poverty will be broken. While it could lead to increased consumption of cheaper imported goods in the short term, in the long term it could negatively impact domestic industries as they may not be able to compete with cheaper foreign goods, leading to unemployment. This could potentially exacerbate poverty rather than alleviate it. To break the vicious circle of poverty, comprehensive and multifaceted efforts in areas like education, healthcare, infrastructure, and employment generation are needed.