Paf Is a Country with a Fixed Exchange Rate with the U.S

question 12

Essay

Paf is a country with a fixed exchange rate with the U.S. dollar, set at 0.9 pifs per dollar. The Paf government intends to defend this central parity but has no exchange controls; it can only use an interest rate policy to defend its national currency, the pif. The pif comes under severe speculative devaluation pressures because of a drop in the official reserves of Paf. The current (annualized)
one-month interest rates are 18% for the pif and 6% for the dollar.
a. What type of borrowing/lending action could you take to try to take advantage of a devaluation of the pif?
b. How much would you stand to lose if Paf is successful in defending its currency?
c. How much would you stand to gain if the pif is devalued to 1 pif per dollar within the next month?

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