Which of the following best explains what happens when a currency is pegged to the U.S. dollar?

• A. The currency is only used for domestic transactions and cannot be exchanged internationally.
• B. The value of the currency is fixed at a specific rate relative to the U.S. dollar, and the central bank intervenes to maintain this rate.
• C. The currency's value is determined by a basket of foreign currencies, including but not limited to the U.S. dollar.
• D. The currency is allowed to fluctuate freely in the foreign exchange market based on supply and demand.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concept of a currency peg. A currency peg means that a country's currency value is fixed or tied to the value of another currency, in this case, the U.S. dollar.
2. Step 2: Recognize that when a currency is pegged, the central bank or monetary authority commits to maintaining the exchange rate at a specific level relative to the U.S. dollar.
3. Step 3: Know that to maintain this fixed exchange rate, the central bank must intervene in the foreign exchange market by buying or selling its own currency or U.S. dollars as needed.
4. Step 4: Contrast this with other exchange rate regimes, such as floating rates where the currency value fluctuates based on market supply and demand, or a basket peg where the currency is tied to multiple currencies.
5. Step 5: Conclude that the best explanation for a currency pegged to the U.S. dollar is that its value is fixed at a specific rate relative to the U.S. dollar, and the central bank actively intervenes to maintain this rate.