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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A central bank under a managed float intervenes by selling foreign currency reserves and buying its own currency. Without sterilization, what is the effect on the domestic money supply and the intent of the action?

Unsterilized selling of foreign reserves to buy the domestic currency withdraws domestic money from circulation, so the money supply contracts. Together with the direct demand for the currency and upward pressure on interest rates, this supports the currency's value.

  1. AMoney supply contracts, supporting the domestic currencyCorrect
  2. BMoney supply expands, supporting the domestic currency
  3. CMoney supply expands, weakening the domestic currency
  4. DMoney supply is unchanged, weakening the domestic currency

Explanation

Buying domestic currency with foreign reserves withdraws domestic currency from circulation, so the money supply falls and interest rates tend to rise, both supporting the currency. Sterilization would offset this through domestic open market purchases, but the question specifies none.

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