"A developing country that maintains a fixed value for its currency relative to the Canadian dollar is experiencing a decline in its economic activity, and its inflation rate falls below the level of inflation in the Canada. The most likely result of the developing country’s actions to maintain the fixed exchange rate target is that its:
- foreign exchange reserves will decrease.
- short-term interest rates will fall.
- money supply will contract.
Solution
B is correct. With a decline in economic activity and domestic inflation, the currency of the developing country would start to rise against the dollar. To protect the exchange rate target, the developing country’s monetary authority will purchase foreign exchange reserves and sell its own currency. This will increase the domestic money supply, decrease short-term interest rates, and increase foreign exchange reserves. " CFAI MOCK
Why would the currency start to rise with the decline in activity.? if CAN/D *( CPI_D/CPI_CAN) …the decline in inflation of country D would result in country D being able to buy less of Canadian dollar.
What am I missing here?