A country with a fixed exchange rate experiences downward pressure on the exchange rate value of its currency. The central bank chooses to intervene in the market to maintain its fixed exchange rate. How would the central bank go about intervening? If the downward pressure on the currency persists for a long period, even after successive interventions in the foreign exchange market, would it be difficult to maintain the fixed exchange rate? Why or why not? Give an example of a country that attempted to maintain its exchange rate in the face of downward pressure. What was the result?

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Downward pressure means pressure on the country's currency to depreciate. The central bank would have to buy domestic currency and sell foreign currency in the foreign exchange market. Since the central bank has a limited supply of foreign currency, it would be difficult to maintain the fixed exchange rate if there is persistent downward pressure. Sooner or later the central bank would have to worry about depleting its foreign exchange reserves. An example would be Mexico in 1994. After its foreign exchange reserves were nearly gone, Mexico had to allow a large depreciation of its currency.