Question

1. A country has a fixed exchange rate. If world interest rates rise, what will the country have to do to maintain its fixed exchange rate? Has the fixed exchange rate become relatively more undervalued or overvalued?

Answer 1

If World interest rates rise, then rest of the countries would become more attractive financially and thus attract more Investment. Thus, supply of investment in home country would fall, depreciating the value of home currency.

In order to fix this, the central bank will have to intervene and sell its reserves of foreign currency and buy more of domestic currency in the forex market, in order to increase its value to the rest of the world's.

The exchange rate has become relatively undervalued and needs to be increased, for it to become competitive.