How do developing countries typically manage to keep currencies pegged at values that are too high? Who benefits from such an overvalued currency? Who is hurt by an overvalued currency?

Question

What will be an ideal response?

Answer 1

Such a situation is difficult to maintain, because if the exchange rate overvalues the local currency on the foreign exchange markets, there will be an excess supply of the local currency—everybody will want to turn in local currency to the central bank, receive foreign currencies, and invest them abroad. If this situation persists, the central bank's foreign reserves will dwindle quite fast. The only way to sustain such a system is to impose exchange controls. The central bank of the developing country must ration the use of foreign exchange, manage who gets access to it, and restrict capital flows; in short, it must strictly control financial transactions involving foreign currencies. That currencies of developing countries are primarily traded by the central bank of the country or by a number of financial institutions with strict controls on their use of foreign currency (i.e. the currencies are inconvertible), is helpful to maintain such a system.
It is clear who benefits and who loses from this situation. The fixed exchange rate undervalues the foreign currency and overvalues the domestic currency, thereby subsidizing buyers of foreign currency (such as importers and those investing abroad) and taxing sellers of foreign exchange (such as exporters and foreign buyers of domestic assets). Not surprisingly, one main reason for the popularity of over-valued exchange rates is that such situations increase the external purchasing power of the political elite.