Question

Why is a sustained undervaluation of a currency different from a sustained overvaluation of a currency, in terms of how quickly the policy maker will have to change the fixed rate?

Answer 1

Sustained underevaluation

It increases the profitability of the' tradeables' sector, promotes economic growth, expands the share of tradeables in domestic value added. Developing countries suffer from institutional weaknesses, and, market failures. Undervaluation increases the 'tradeables' sector's profitability, and, compensates for the negative effect of these distortions. The market price is too low.

Sustained overvaluation

Real overvaluation hampers exports. Imports will be cheaper, and, exports relatively expensive. The market price of the currency is too high.

Change the fixed rate

It may be changed once in five years, or a decade. The underlying value comes from an asset, the currency is then pegged against another currency.