A country with a fixed exchange rate experiences upward 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 upward pressure on the currency persists, would it be difficult to maintain the fixed exchange rate? Why or why not? Would your answers differ if the country carried out sterilized intervention? Why or why not? Give an example of a country that attempted to maintain its exchange rate in the face of upward pressure on its currency value. What was the result?
What will be an ideal response?
POSSIBLE RESPONSE: Upward pressure means pressure on the country's currency to appreciate. The central bank would have to buy foreign currency and sell domestic currency in the foreign exchange market. If there is persistent pressure for appreciation, it could eventually be difficult to maintain the fixed exchange rate. The central bank increases the domestic money supply by selling domestic currency in the foreign exchange market. Sooner or later there would be more inflation. In addition, the country would come under foreign political pressures because of its persistent payments surpluses. Sterilization means offsetting the consequences of foreign exchange intervention on domestic money supply. The central bank would have to carry out contractionary domestic monetary actions to sterilize. Such sterilization could hold off the inflation but would not stop the foreign pressures. One such example was China. China's foreign exchange reserves more than quadrupled from 2000 to 2005. After that, the Chinese government had to allow appreciation of its currency.
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