Question

The Pugelovian government is attempting to peg the exchange-rate value of its currency (the pnut) at a rate of three pnuts per U.S. dollar (+ or -2%). Unfortunately, private market supply and demand are putting downward pressure on the pnut’s exchange-rate value. In fact, it appears that, under current market conditions, the exchange rate would be about 3.5 pnuts per dollar if the government did not defend the pegged rate.

1) How could the Pugelovian government use official intervention in the foreign exchange market to defend the pegged exchange rate?
2) How could the Pugelovian government use exchange controls to defend the pegged exchange rate?
3) How could the Pugelovian government use domestic interest rates to defend the pegged exchange rate?

Answer 1

1) The Pugelovian government could use official intervention by actively buying its own currency (pnuts) in the foreign exchange market. This increased demand would help support the pegged exchange rate by counteracting the downward pressure caused by private market forces.

2) To defend the pegged exchange rate using exchange controls, the Pugelovian government could implement restrictions on the movement of capital across borders. By limiting the ability of residents and businesses to buy foreign currency, the government can influence the supply and demand for pnuts, helping to maintain the desired exchange rate.

3) The Pugelovian government could use domestic interest rates to defend the pegged exchange rate by adjusting monetary policy. Increasing interest rates can attract foreign capital seeking higher returns, thereby increasing demand for the pnut and supporting the pegged rate. Conversely, lowering interest rates could discourage capital flows, helping to counteract downward pressure on the exchange rate.