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

An emerging economy maintains a fixed exchange rate while its inflation is persistently higher than that of its anchor country, and its reserves are falling steadily. Which outcome is most likely?

Speculative pressure is most likely to build, making devaluation or abandonment of the peg more probable. Higher inflation under a fixed nominal rate appreciates the real exchange rate, worsens competitiveness and drains reserves, so markets expect the central bank to be unable to defend the peg.

  1. AThe real exchange rate depreciates, improving competitiveness and strengthening reserves
  2. BSpeculative pressure builds, raising the likelihood of a forced devaluation or abandonment of the pegCorrect
  3. CHigher domestic inflation lowers import demand, which restores the current account balance automatically

Explanation

With the nominal rate fixed and domestic inflation higher, the real exchange rate appreciates, hurting competitiveness and widening the current account deficit. Reserves fall as the central bank defends the peg. Speculators anticipate that reserves will run out, so pressure rises and devaluation or abandonment becomes likely. The other options reverse the direction of the real exchange rate effect.

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