Question

3.

a. List and explain 2 criteria or factors that countries may use to fix or float their exchange rates.

b. The IMF frequently prescribes devaluation and contractionary fiscal policy for developing countries operating fixed exchange rates and facing problems with excessive deficits in the current account of their balance of payments. These policies are frequently quite controversial. Based on what you learned in this chapter, can you provide a rationale for this particular combination of policies, as opposed to using a single policy to achieve the current account target? Assume the central bank is pursuing monetary targeting. [Hint: what other macroeconomic outcomes might both the country and the Fund care about?]

Answer 1

Two criteria or factors that countries may use to fix or float their exchange rates are:

1. Differentials in inflation: difference in inflation rate affect the exchange rates.lower inflation rate result into appreciation in the value of currency. while higher inflation sees depriciation in its currency.

2. Differentials in Interest rates: Increase in interest rates result into appreciation in currency value because higher rates means higher rates to lenders and more foreign capital and hence result into rise in exchange rates.