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Difficulty: HardForeign Exchange Market, Systems, and Exchange Rate Determination

Under a managed float exchange rate system, when a country's monetary authority actively intervenes in the foreign exchange market to prevent severe depreciation of the domestic currency by selling foreign currencies, what is the immediate impact on its foreign reserves and the domestic monetary base?

  1. Foreign reserves decrease while the domestic monetary base contractsAnswer
  2. B
    Foreign reserves increase while the domestic monetary base expands
  3. C
    Foreign reserves decrease while the domestic monetary base expands
  4. D
    Foreign reserves remain unchanged because the currency experiences official devaluation

Answer

Foreign reserves decrease while the domestic monetary base contracts.
To defend the domestic currency against depreciation under a managed float exchange rate system, the central bank sells foreign currencies out of its external reserves to meet excess market demand. In exchange for this foreign currency, commercial banks pay the central bank with domestic currency. Consequently, the central bank's foreign reserves decline, and the domestic money supply (monetary base) contracts as domestic currency is absorbed from circulation.

Step-by-Step Solution

1
Analyze the Central Bank intervention mechanics
To defend a depreciating currency under a managed float, the Central Bank sells foreign currency (e.g., US Dollars) from its external reserves into the foreign exchange market.
Selling foreign exchange increases the market supply of foreign currency relative to domestic currency, counteracting downward pressure on the exchange rate.
2
Determine the effect on foreign exchange reserves
Foreign reserves decline because the Central Bank depletes its stock of foreign currency assets during the intervention.
Foreign reserves consist of holdings of foreign currencies, so outright sales directly reduce reserve levels.
3
Determine the effect on domestic monetary base
The domestic monetary base contracts as domestic currency is paid by commercial banks to the central bank to purchase foreign currency.
The central bank withdraws domestic currency from private banking circulation when receiving payment for foreign exchange, reducing high-powered money unless sterilised.

Key Concept

Central Bank Foreign Exchange Intervention and Monetary Base Dynamics
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Topics

Foreign Exchange Market, Systems, and Exchange Rate Determination

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