Question

Explain how a central bank can use buying and selling of foreign currencies to keep its currency pegged. What would a country do in the case of an appreciation? What would it do if the currency depreciates? In which scenario is the country at risk of running out of foreign reserves?

Answer 1

Answer

In a fixed exchange rate system/ pegged exchange rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged.

In the case of an anticipated appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate.

The central bank during a time of private sector net demand for the foreign currency (causing depreciation of the domestic currency), sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value.

In case of depreciation of domestic currency, the country is at the risk of running out of foreign reserves because the Central Bnak has to sell foreign currency from its reserves and buys back the domestic money, to keep the exchange rate fixed.