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

A country with a fixed exchange rate has a large current account deficit and falling foreign reserves. Investors begin to expect a devaluation. The central bank is most likely to be pressured to:

The central bank would most likely sell foreign reserves and raise domestic interest rates. Both actions support demand for the domestic currency and help defend the peg, although the rate increase hurts growth and falling reserves limit how long the defense can last.

  1. Asell its foreign reserves and raise domestic interest rates to defend the peg.Correct
  2. Bbuy foreign currency in the market and cut domestic interest rates to defend the peg.
  3. Crelax capital controls and reduce the interest rate to attract inflows.

Explanation

To defend a peg under selling pressure, the central bank sells foreign reserves to buy domestic currency and raises interest rates to attract capital. Buying foreign currency and cutting rates would weaken the domestic currency further.

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