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CFA Level I · CFA Level I Exam · Capital Flows and the FX Market

A central bank pegs its currency within a band of ±1% around a central parity against the euro. The market rate has weakened to the bottom of the band, and the central bank wants to defend the peg. The action most likely consistent with defending the peg is to:

The central bank should buy its own currency using foreign exchange reserves. This raises demand for the domestic currency and pushes the rate back from the band's floor. Selling domestic currency or cutting interest rates would add depreciation pressure and undermine the peg.

  1. Abuy domestic currency using foreign exchange reservesCorrect
  2. Bsell domestic currency and buy euros in the market
  3. Clower the domestic policy interest rate

Explanation

To support a weak domestic currency, the central bank buys it with foreign reserves, raising demand. Selling domestic currency would weaken it further. Lowering the policy rate reduces the yield on domestic assets, encouraging capital outflow and more depreciation pressure.

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