Question

The country of Cerfenia has pegged its currency to the currency of Garlandia. If the Garlandia central bank decreases interest rates in an effort to combat a recession, Cerfenia has to_______ if it wants to maintain the exchange rate fixed.

a. increase interest rates by the same amount
b. increase interest rates more
c. decrease interest rates by the same amount
d. decrease interest rates less

Answer 1

Cerfenia must decrease its interest rates by the same amount as Garlandia to maintain the fixed exchange rate because differences in interest rates affect capital flows and exchange rates. Option c is the correct answer.

Step-by-step explanation:

When the central bank of Garlandia decreases interest rates to combat a recession, Cerfenia, which has pegged its currency to that of Garlandia, must adjust its monetary policy accordingly to maintain the fixed exchange rate.

If Cerfenia wants to keep the exchange rate unchanged, it must effectively match the monetary policy change made by Garlandia. In this case, since Garlandia has lowered interest rates, Cerfenia must decrease its interest rates by the same amount to maintain parity.

This is because differences in interest rates between countries can lead to capital flows that affect the exchange rate. If Cerfenia does not adjust its interest rates accordingly, capital might flow out of Cerfenia in search of higher returns in Garlandia, and this would put pressure on Cerfenia's currency to depreciate against Garlandia's currency.

The correct answer to the question is: c. decrease interest rates by the same amount.