Assume a country is in a fixed exchange rate regime. Now suppose that individuals expect that policy makers will devalue its currency. Explain the various actions that policy makers can choose in response to this expected devaluation.

ANSWER:

Policy makers can attempt to persuade (via official announcements) that they remain committed to pegging the currency at its current rate. Second, they may have to raise domestic interest rates to prevent any depreciation of the currency. Eventually, they may be forced to devalue because of the contractionary effects of the higher i.