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Chapter 14: Problem 8

Why do small nations adopt currency baskets against which they peg their exchange rates?

Short Answer

Expert verified
Small nations adopt currency baskets against which they peg their exchange rates to avoid potential drastic fluctuations or instabilities in trade and economic conditions. This is due to diversification, increased stability, and facilitation of trade, thus ensuring a balanced reliance on the global economy.

Step by step solution

01

Understanding Exchange Rates

An exchange rate is the value of one country's currency in relation to another currency. Countries can either allow their currency to float in international markets, setting its value, or they can peg it, usually to a basket of other currencies.
02

Understanding Currency Baskets

A currency basket is a collection of different currencies with distinct weightings. Typically, larger economies that are significant to the specific smaller nation are included in this basket, such as the U.S. Dollar, the Euro, and the Chinese Yuan.
03

Reasons for Adapting Currency Baskets

Small nations adopt currency baskets for a variety of reasons. 1. Diversification: Currency baskets help avoid being influenced too heavily by the volatility of a single currency, ensuring stability. 2. Increased Stability: It helps in mitigating the risks related to exchange rates, contributing to the economic stability of the nation. 3. Trade Facilitation: Many small countries trade with multiple nations, making a basket peg useful as it moderates the exchange rate volatility against multiple trading partners, thus promoting trade.

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