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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

A country on a managed float experiences a large current account deficit financed by short-term foreign portfolio inflows. Investors suddenly withdraw. Which sequence best describes the likely outcome if the central bank does NOT intervene?

Demand for the domestic currency falls as capital leaves, so with no intervention it depreciates. Imports become dearer in domestic terms and exports cheaper for foreigners, which gradually helps correct the deficit, though import price inflation tends to rise.

  1. ADemand for domestic currency falls, the currency depreciates, and imports become dearer while exports become cheaper to foreignersCorrect
  2. BDemand for domestic currency rises, the currency appreciates, and the deficit widens
  3. CThe exchange rate stays unchanged because it is managed
  4. DForeign reserves rise automatically as the currency weakens
  5. Domestic inflation falls because import prices rise

Explanation

Withdrawal of capital reduces demand for the domestic currency, so with no intervention it depreciates. Imports cost more in domestic currency and exports are cheaper abroad, which helps the deficit adjust over time. Higher import prices tend to raise, not lower, inflation, and reserves do not rise without intervention.

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