Oz fixes the exchange rate of its rupee relative to the Wonderland baht. Demand for Oz rupee declines. What would occur to keep the par value of the Oz rupee at the desired level?

Question

BlackTom AI · Accepted Answer

A fixed exchange rate requires the central bank to offset any market pressure that would move the currency away from the peg. When demand for the Oz rupee falls, there is downward pressure on the rupee (tendency to depreciate). To keep the par value, the central bank must step in by using its foreign reserves.

1) Relevant concepts
- Fixed (pegged) exchange rate: the central bank buys/sells currencies to maintain a set rate.
- Foreign-exchange intervention: to prop up a domestic currency, the central bank buys that domestic currency using foreign currency reserves.
- Market effects: buying rupees increases demand for rupees; selling baht increases the supply of baht in the FX market.

2) Step-by-step reasoning
- Initial shock: private-sector demand for rupees declines → leftward shift in rupee demand → downward pressure on rupee value (would depreciate vs baht).
- Central bank intervention objective: restore equilibrium at the pegged rate by increasing net demand for rupees.
- Mechanism: Oz’s central bank sells baht reserves and uses them to buy rupees from the market.
- Result of that operation: the act of buying rupees increases demand for rupees (directly supporting its value) and the sale of baht increases the supply of baht on foreign-exchange markets.

3) Intermediate/transaction steps (algebraic view)
- Let Qd0 be original rupee demand; demand falls by ΔQ < 0 → new demand Qd1 = Qd0 + ΔQ.
- To maintain the peg, central bank buys quantity |ΔQ| of rupees.
- Central bank sells |ΔQ| of baht → supply_baht increases by |ΔQ|; demand_rupee increases by |ΔQ| due to central-bank purchases.
- Market cleared at original exchange rate.

4) Why the correct answer is correct
Because the central bank must purchase rupees (raising demand for rupees) and finance those purchases by selling baht reserves (raising the supply of baht). Those two moves neutralize the initial drop in private demand for rupees and keep the pegged rate intact.

5) Why other options are incorrect
- Option B (raise demand for baht and supply of rupees): reversed actions; that would further depreciate the rupee.
- Option C (raise demand for rupees and decrease supply of baht): decreasing baht supply would mean the central bank is buying baht, which is the opposite of what’s needed to buy rupees.
- Option D (raise demand for baht and decrease supply of rupees): again increases pressure against the rupee and does not support the peg.

Conclusion: The central bank must raise demand for rupees and increase the supply of baht by selling baht reserves to buy rupees. This matches the provided correct answer: "Oz would raise both demand for rupees and supply of baht."

Oz fixes the exchange rate of its rupee relative to the Wonderland baht. Demand for Oz rupee declines. What would occur to keep the par value of the Oz rupee at the desired level?Single choice

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