Question

Country A follows a fixed exchange rate policy that pegs its currency to the currency of country B, which is its main trading partner in a world where international capital is fully mobile. However, due to unresolved structural inefficiencies (for example, excessive bureaucracy), prices in country A tend to increase more than prices in country B. Over time, if nothing else changes, and provided that country A is committed to its current exchange rate policy, which of the following problems is not anticipated for country A? a. Economic recession. O b. Growing deficit in international trade balance. c. Worsening inflation. Od. Decreasing reserve assets. Oe. Growing external indebtedness.

Answer 1

Country A's higher inflation rates relative to country B under a fixed exchange rate policy will likely lead to a trade deficit, decreased reserve assets, and increased external indebtedness, but not worsening inflation, since the fixed exchange rate tends to contain inflation.

Step-by-step explanation:

Country A, which follows a fixed exchange rate policy pegged to the currency of country B, will likely face a set of economic challenges due to its higher inflation rates relative to country B. The higher inflation rate in country A leads to higher prices for its goods and services, making them less competitive internationally. As a result, it can be anticipated that country A may experience a growing deficit in international trade balance due to decreased export competitiveness and increased imports, which are relatively cheaper.

In this scenario, country A's commitment to a fixed exchange rate means it cannot devalue its currency to make exports more competitive. This could lead to a decrease in reserve assets as the country may have to use its reserves to maintain the fixed exchange rate. Additionally, a continued trade deficit could lead to growing external indebtedness as the country borrows to finance its trade deficits.

However, the issue that is not anticipated for country A under these circumstances is worsening inflation. This is because a fixed exchange rate regime, especially when the currency is pegged to a country with lower inflation, typically acts to contain inflationary pressures within the pegged economy. Therefore, the correct answer is option (c) Worsening inflation.