I’m a little confused on question 16 on the EOC question for Reading 19. It states that a country wants to fix their exhange rate with that of a target country’s rate, and inflation is currnetly increasing in the domestic contry. The answer states that the country should increase thier interest rate.
Wouldn’t that just cause higher inflation and farther away from the target rate?
I think you mean if a country’s inflation rate rises above the target country’s inflation rate. For example, consider a developing country that maintains a fixed exchange rate relative to the US dollar.
To illustrate the point, let us assume that initially domestic inflation rates are very similar in both the US and the developing country, and that the developing country fixes the exchange rate consistent with relative price levels in the two economies.
In the absence of shocks, as long as inflation in the developing country closely mirrors inflation in the US, the exchange rate should be close to the target.
Now if economic activity in the developing country starts to rise rapidly its inflation rises above the inflation level in the US. So if exchange rates were freely floating, the currency in the developing economy would start to fall against the US dollar.
However, to arrest the above fall, the developing country would sell foreign currency reserves and buy its own currency. This has the effect of reducing the domestic money supply and increasing short-term interest rates.
The short-term increase in interest rates is expected to cause the currency in the developing economy to rise against the US dollar and counter the fall that would occur if no intervention were present, essentially maintaining a close to target exchange rate and inflation rate.
Thanks for the response, that was super helpful.