Question

1. What are some of the measures -and their limitations- that a central bank can take to defend the currency of that country that is coming under sustained downward pressure in the foreign exchange markets?

Answer 1

---> A central bank often intervenes in foreign currency markets and alters the level of currency demand and supply to maintain the exchange rate at a specific level. It does this by buying and selling up foreign currency reserves. There is downward pressure brought about by an increase in the demand for the foreign currency due to an increae in demand for imports, this creates an excess supply for the domestic currency because when consumers buy foreign imports, they sell domestic currency to buy up foreign currency as the foreign imports are priced in terms of foreign currency. To prevent the exchange rate from falling below the fixed rate the central bank sells foreign currency reserves to buy up domestic currency, which increases the demand for domestic currency and creates upward pressure. By strengthening the domestic currency and weakening the foreign currency the downward pressure is offset and as a result the exchange rate remains at its fixed value. The limitation of these measures is that strengthening domestic currency makes exports less competitive.