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

A country operates a fixed exchange rate against the US dollar. Market pressure causes its currency to weaken below the official rate. Which action by the central bank is consistent with defending the peg?

The central bank defends a weakening peg by selling foreign currency reserves to buy its own currency and by raising interest rates to attract capital. Buying dollars or cutting rates would increase supply of the domestic currency and worsen the pressure on the peg.

  1. ASell dollar reserves and buy the domestic currency, and/or raise domestic interest ratesCorrect
  2. BBuy dollars with newly created domestic currency to add to reserves
  3. CCut interest rates to stimulate domestic demand
  4. DRemove all controls on capital outflows and leave the rate unchanged
  5. Announce that the currency will now float freely

Explanation

To support a weak currency the bank must increase demand for it: selling foreign reserves to buy domestic currency, and raising interest rates to attract capital inflows. Buying dollars or cutting rates would add to downward pressure. Floating abandons the peg rather than defending it.

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