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

Under a managed floating exchange rate system, when a country's currency experiences severe downward pressure due to an increased market supply of the domestic currency, which of the following measures can the central bank take to stabilize its value?

  1. Sell foreign reserves to purchase the domestic currency in the foreign exchange marketAnswer
  2. B
    Buy foreign currencies in the open market using newly issued domestic currency
  3. C
    Reduce commercial bank reserve ratios to lower domestic interest rates
  4. D
    Impose a statutory price ceiling below market equilibrium on foreign exchange transactions

Answer

The central bank stabilizes the currency by selling foreign reserves to purchase domestic currency in the foreign exchange market.
In a managed floating foreign exchange system, monetary authorities actively intervene during periods of currency weakness by selling foreign exchange reserves to buy back their own currency. This intervention increases demand for the domestic currency and shifts the demand curve to the right, stabilizing its value.

Step-by-Step Solution

1
Analyze the exchange rate system and market condition
Under a managed float system, exchange rates fluctuate based on market forces, but central banks step in when excessive currency depreciation or appreciation occurs.
Downward pressure on foreign exchange value is caused by excess supply of domestic currency or insufficient market demand.
2
Identify the central bank intervention technique
To boost the exchange rate, the monetary authority must absorb excess domestic currency from the market.
Using official foreign reserves to buy back domestic currency directly increases demand for the home currency.
3
Evaluate the market shift
The rightward shift in the demand curve for the domestic currency restores equilibrium at a higher exchange rate level.
Direct market purchasing offsets depreciation pressures.

Key Concept

Central Bank Foreign Exchange Market Intervention under Managed Float
Estimated Time:1m 15s
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Topics

Foreign Exchange Market, Systems, and Exchange Rate Determination

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