If a government fixes the exchange rate so as to generate a surplus of the domes

Question

If a government fixes the exchange rate so as to generate a surplus of the domestic currency, the exchange rate (U.S. dollars per unit of the other currency) will tend to _____. To maintain the fixed exchange rate, the government must _____ the domestic currency.

1-

rise; increase the international demand for

2-fall; increase the domestic supply of

3-fall; decrease the international demand for

4-fall; increase the international demand for

If a government fixes the exchange rate so as to generate a surplus of the domestic currency, the exchange rate (U.S. dollars per unit of the other currency) will tend to _____. To maintain the fixed exchange rate, the government must _____ the domestic currency.

1-

rise; increase the international demand for

2-fall; increase the domestic supply of

3-fall; decrease the international demand for

4-fall; increase the international demand for

Explanation / Answer

Option 4 is correct.

Lets understand this with the help of an example, suppose the government fixes the exchange rate at 50 INR = $1.

So to generate a surplus of the domestic currency (dollars), the exchange rate should fall below 50 (say 40 INR), such that less dollars are now needed to buy the same 50 INR, creating a surplus of the domestic currency.

Now in order to maintain the same fixed exchange rate, which has already created a surplus, the government must increase its demand for domestic currency internationally, such that all the surplus generated can be wiped out.

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