Question

If a government fixes the exchange rate at a value that creates a surplus of the domestic currency, there will be a tendency for the exchange rate (U.S. dollars per unit of the domestic currency) to ________. To maintain the fixed exchange rate, the government must ________.

Answer 1

Answer: Fall; rise foreign demand for domestic currency.

Step-by-step explanation:

The exchange rate must be fall to create a domestic currency surplus in an economy. For example:

Suppose, the ongoing exchange rate of India is $1 = Rs.70

So, if a person wants to buy a good worth of $2, then he have to pay Rs.140 for this good. When the exchange rate falls to $1 = Rs.60, now he have to pay only Rs.120 for this good. Hence, domestic currency surplus of Rs.20 created in an economy.

To maintain this level of fixed exchange rate, which created a domestic currency surplus, so government must increase the foreign demand for their domestic currency, to wipe out all the created domestic currency surplus in this economy.