Question

Unambiguous “tell-tale” signs of an undervalued real exchange rate are:

A) Higher domestic inflation and larger current account deficit

B) Higher domestic inflation and larger current account surplus

C) Lower domestic inflation and larger current account deficit

D) Lower domestic inflation and larger current account surplus

E) None of the above

Answer 1

It shall be noted that "telltale sign" means something which has become known.

An undervalued exchange rate implies that a countries currency is too low for the state of the economy. An undervalued exchange rate means that the country's exports will be relatively cheaper and imports expensive. An undervalued exchange rate tends to increase domestic demand and discourage spending on imports.

Thus, this leads to a larger current account surplus.

It shall further be noted that lower domestic inflation means more exports and fewer imports.

Hence, the correct answer is - D) Lower domestic inflation and larger current account surplus