CFA Level II Exam · Currency Exchange Rates: Understanding Equilibrium Value

Exchange Rate Crises and Central Bank Intervention

Updated 7 October 2026 · Fact-checked

A currency crisis is a sharp, disorderly fall in a currency, often after a fixed or managed rate becomes unsustainable. To solve questions, scan the vignette for warning signs (falling reserves, large deficits, short-term foreign debt, credit booms), then judge which policy tools the central bank has and how effective they are.

Understand Exchange Rate Crises and Central Bank Intervention

A currency crisis happens when investors lose confidence that a country can defend its exchange rate. Money leaves, the currency falls quickly, and the central bank or government is forced to act. Crises are most common when a country uses a fixed or tightly managed rate and its economy does not support that rate.

The CFA curriculum lists warning signs. Look for these:

Foreign exchange reserves falling, or too low relative to imports or short-term external debt.
The real value of the domestic currency has risen well above its long-run level (a real appreciation), so the currency is overvalued.
Large and growing current account deficits financed by volatile capital inflows.
A boom in bank credit, rising asset prices and a banking system that is weak or lent heavily in foreign currency.
Heavy short-term foreign-currency borrowing, which must be rolled over and can leave suddenly.
Growing government deficits and debt, or slowing exports and weak growth.

Crisis models help you organise this. In first-generation models, a government runs persistent deficits financed by money creation while pegging the rate. Reserves drain steadily until speculators attack and the peg collapses. In second-generation models, the government weighs the cost of defending the peg (high interest rates, weak growth, unemployment) against the benefit. Expectations of devaluation can raise the cost of defence and become self-fulfilling. Contagion is the spread of stress from one country to others with similar weaknesses or linked investors.

Central banks can respond in several ways. Sterilised intervention buys or sells foreign currency and offsets the effect on domestic money supply with open market operations. Unsterilised intervention lets the money supply change. Raising policy rates makes holding the currency more attractive but hurts growth and weak banks. Intervention is more effective for small or emerging markets with thin markets, and when it signals a credible change in policy. It usually fails against a large, sustained flow when fundamentals are bad. Intervention also needs enough reserves.

Capital controls restrict flows. Controls on inflows (taxes, limits on short-term borrowing) aim to curb hot money and credit booms. Controls on outflows try to stop a run, but they can damage credibility, and investors may find ways around them. Controls tend to buy time; they do not fix poor fundamentals.

Key formulas to remember

Sterilised intervention: Change in FX reserves offset by an opposite change in domestic securities, so monetary base is unchanged; Sterilisation does not change the money supply. Its effect works mainly through signalling and portfolio balance, and is usually weaker.
Unsterilised intervention: Selling FX reserves → domestic money supply falls → interest rates rise → currency is supported; Buying FX does the reverse: it raises the money supply and puts downward pressure on the currency. It conflicts with domestic monetary goals.
Reserve adequacy check: Reserves ÷ short-term external debt (or months of imports covered); A low ratio signals vulnerability. Compare with the thresholds the vignette gives; do not assume a universal cut-off.
Real exchange rate: Real rate = nominal rate (domestic per foreign) × foreign price level ÷ domestic price level; Under the domestic-per-foreign quote, a fall in the real rate is a real appreciation of the domestic currency, and a rise is a real depreciation. A persistent fall means the domestic currency is appreciating in real terms and may be overvalued.

How to solve Exchange Rate Crises and Central Bank Intervention questions

Use this method for any vignette on crises, intervention or capital controls.

1Identify the exchange rate regime in the vignette: fixed, managed or floating. Crisis risk is highest for pegs.
2Scan the exhibits for warning signs: reserves, current account balance, short-term external debt, credit growth, real exchange rate, budget deficit.
3Classify each sign as a vulnerability (pushes towards crisis) or a buffer (reserves, surplus, low foreign debt).
4Decide which crisis model fits: steady reserve drain from deficits (first generation) or a policy trade-off with self-fulfilling expectations (second generation).
5Identify the policy response: sterilised or unsterilised intervention, rate increase, or capital controls on inflows or outflows.
6Judge effectiveness: reserves available, market size, credibility, and whether fundamentals support the rate.
7Check the direction and the side effects, such as growth, banks, or credibility.
8Pick the option that matches the vignette facts, not general theory.

Quickest way: Vulnerability checklist

When to use it: When time is short and the question asks which country is most at risk or whether intervention will work.

Count vulnerabilities: low reserves, big deficit, short-term foreign debt, credit boom, overvalued real rate.
Check if the regime is a peg. If so, risk goes up.
For intervention, ask: sterilised? Then expect a weak, signalling effect.
For capital controls, ask: inflow or outflow? Inflow controls curb booms; outflow controls buy time but harm credibility.
Eliminate options that claim controls or intervention fix fundamentals.

Common mistakes in Exchange Rate Crises and Central Bank Intervention

Saying sterilised intervention changes the money supply.
Students mix it up with unsterilised intervention.
Fix: Sterilised means offset. The monetary base stays unchanged.
Treating a current account deficit as a crisis signal by itself.
The deficit is a well-known warning sign.
Fix: Look at how it is financed. A deficit financed by stable long-term investment is less risky than one financed by short-term borrowing.
Assuming capital controls solve a crisis.
Controls look decisive.
Fix: Controls buy time and can hurt credibility. They do not fix weak fundamentals.
Reading a high real value of the domestic currency as strength.
A strong currency sounds good.
Fix: A currency whose real value has risen well above its long-run level (a real appreciation) is overvalued and vulnerable to a sharp fall. Under the domestic-per-foreign quote, this shows up as a fall in the real exchange rate, not a rise.
Ignoring reserves relative to short-term debt.
Students look at the reserve level in isolation.
Fix: Compare reserves with the claims that can leave quickly, such as short-term external debt.

Worked examples

Example 1

Vignette: Country X pegs its currency to the US dollar. Over three years, its foreign exchange reserves fell by half. Its current account deficit widened, and short-term foreign-currency debt now exceeds reserves. Bank credit grew rapidly and the real value of the domestic currency has appreciated well above its long-run average. Q1: Is Country X vulnerable to a currency crisis? Q2: Which crisis model best fits the reserve decline?

Show the solution

Regime: a peg, so defence is needed and risk is higher.
Warning signs: falling reserves, widening deficit, short-term debt above reserves, credit boom, a real value of the currency well above its long-run average (overvaluation).
No buffers are listed, so vulnerability is high.
Falling reserves over time with a peg match the first-generation model: persistent imbalances drain reserves until speculators attack.

Answer: Q1: Yes, highly vulnerable. Q2: The first-generation model fits best, because reserves have drained steadily under a peg.

Example 2

Vignette: The central bank of Country Y sells foreign currency to support its currency. It then buys government bonds to keep the domestic money supply unchanged. Q1: What type of intervention is this? Q2: What is its likely effect compared with unsterilised intervention?

Show the solution

Selling foreign currency would normally reduce the money supply.
Buying bonds adds money back, offsetting the effect, so the monetary base is unchanged.
That is sterilised intervention.
Because interest rates do not move, the effect works mainly through signalling and portfolio balance, so it is usually weaker and shorter-lived.

Answer: Q1: Sterilised intervention. Q2: Likely weaker, because it does not change interest rates or the money supply.

Exam tips

The vignette usually gives the data. Quote the specific exhibit figure in your reasoning before you pick an option.
Always separate sterilised from unsterilised intervention before judging effectiveness.
When asked about capital controls, decide first whether they target inflows or outflows.
Compare countries by counting vulnerabilities and buffers rather than relying on one indicator.

Exchange Rate Crises and Central Bank Intervention: frequently asked questions

What are the main warning signs of a currency crisis?

Falling reserves, a large current account deficit, heavy short-term foreign debt, a credit boom, an overvalued real exchange rate and weak banks. No single sign is enough on its own. The vignette will usually present several together.

What is the difference between sterilised and unsterilised intervention?

Sterilised intervention offsets the effect on the domestic money supply through open market operations, so the monetary base is unchanged. Unsterilised intervention lets the money supply change. The unsterilised version has a stronger effect but conflicts with domestic monetary goals.

Do capital controls prevent currency crises?

Not on their own. Inflow controls can reduce hot money and credit booms. Outflow controls may slow a run but can damage credibility, and they do not fix weak fundamentals.

What is the difference between first- and second-generation crisis models?

First-generation models blame persistent deficits financed by money creation that drain reserves under a peg. Second-generation models focus on the government's trade-off between defending the peg and domestic costs, where expectations can be self-fulfilling.