Question

Figure 2.3: The Market for British Pounds S (£) D2(£) *D(£) D3(L) Q3 Quantities of pound Q5 Qu Q1 Q2 Refer to Figure 2.3. Suppose that the spot exchange rate of British pound is $2.00 per pound. Suppose that the U.S. decreases its taste for imports from the U.K. Under a flexible exchange rate system, the Bank of England will: Let the British pound depreciate Let the British pound appreciate Sell pounds and buy dollars in foreign exchange market Sell dollars and buy pounds in foreign exchange market

Answer 1

Last option is correct

Sell dollars and buy pounds in the foreign exchange market

Reason/rational:

The condition imposed: U.S. decreases its taste for imports from the U.K.

This will cause the demand for pounds to fall as the U.S. now requires less amount of pounds to import from the U.K. and hence the demand curve will fall down/shift left to D3 and the spot rate will fall from 2.0 to 1.9, to prevent this depreciation of British pound the Bank of England will have no other option but to create a false demand in the market by buying pounds and selling dollars in the foreign exchange market.