Question

Fixed/pegged exchange rates, as used in Canada and Brazil, respond quickly to economic conditions and therefore increase exchange-rate risk. TRUE OR FALSE?

If Country A’s trade and budget deficits are increasing relative to those of Country B, the currency of Country B would be expected to strengthen relative to that of Country A, all other things being equal. TRUE OR FALSE?

Answer 1

True. Having a pegged exchange rate means that the country has to shoulder the burden of changes in demand and supply of the currency. This means that this strategy can only work if the country has a large amount of reserve in order to protect against movement in exchange rates. Therefore, there is risk involved in the strategy because countries can't afford to have a large amount of reserves always.

2. True because since the trade and budget deficits are increasing in country A, they would be required to borrow and import from other countries. This means that the demand for country A's currency would go down and that of others would go up. Hence, country A's currency would depreciate relative to other countries.