Under a fixed exchange rate system, if one currency is overvalued, then another currency must be undervalued. Explain why this statement is true.

Under a fixed exchange rate system, if one currency is overvalued, then another currency must be undervalued. Explain why this statement is true.

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July 16, 2021
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Under a fixed exchange rate system, if one currency is overvalued, then another currency must be undervalued. Explain why this statement is true.

Answer and ExplanationSolution by a verified expert

Explanation
The fixed exchange rate is determined by the authorities as an official price. If the fixed exchange rate exceeds the equilibrium exchange rate in terms of the other currency then this will lead to the overvaluation of one currency and undervaluation of the other currency and vice-versa.

This can be understood with an example of the dollar and peso. If 1 peso is trading for $0.30 at the equilibrium and as per the fixed exchange rate, 1 peso trades for $0.70, then the peso is overvalued. This means that to buy 1 peso, more dollars will be needed. This results in the devaluation of the dollars as it is fetching fewer pesos than it would at the equilibrium.

Verified Answer
If the value of one currency is overvalued, it will fetch more of the other currency than it would be at equilibrium, making the other currency undervalued.

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