Central Bank Role in Fixed Regimes Quiz: Intervention Policy

In a fixed exchange rate regime, the central bank's primary responsibility is to maintain the pegged exchange rate by actively buying and selling foreign currency. When the domestic currency faces downward pressure, the central bank buys it using foreign reserves. When it faces upward pressure, the central bank sells domestic currency. This ongoing market intervention is what keeps the rate fixed rather than allowing it to move with market forces.

The answer is True. This is the central operational responsibility of a central bank managing a fixed exchange rate. When market forces push the domestic currency above or below the target, the central bank must intervene immediately. It buys domestic currency when it falls below the peg and sells domestic currency when it rises above. This continuous readiness to intervene is what gives the fixed rate its stability and distinguishes it from a floating system.

When selling pressure pushes the domestic currency below its fixed target, the central bank must intervene by offering to buy the domestic currency at the fixed rate using foreign exchange reserves. By selling foreign currency and buying domestic currency, the central bank reduces the domestic currency's market supply, increasing its value and restoring the target exchange rate. This operation directly draws down foreign exchange reserves.

A central bank defending a peg can raise interest rates to attract capital and bolster demand for the domestic currency, implement capital controls to reduce outflows, and seek foreign currency support through central bank swap lines or international assistance. Selling domestic bonds to other central banks for revenue purposes is not a standard mechanism for exchange rate defense. Reserve management and capital flow measures are the primary supplementary tools.

The answer is False. Under a fixed exchange rate regime, especially a strict currency board, the central bank's capacity to act as lender of last resort is constrained. Because the money supply is tied to foreign reserve holdings, the central bank cannot freely inject liquidity into the banking system during a financial crisis. If reserves are limited, the central bank may be unable to provide the emergency lending that domestic banks need, amplifying financial instability.

When a fixed rate faces downward pressure, raising domestic interest rates above the anchor country's rates makes domestic assets more attractive to foreign investors. Capital flows in seeking higher returns, increasing demand for the domestic currency. This capital inflow helps offset the selling pressure and supports the exchange rate at its target level, though the higher interest rates also raise borrowing costs across the domestic economy.

The monetary policy trilemma states that a country can achieve at most two of the following three goals simultaneously: a fixed exchange rate, free capital movement, and independent monetary policy. A central bank that fixes the exchange rate and allows free capital flows must surrender monetary independence. Interest rates must follow the anchor country's rates or else capital flows will undermine the peg, leaving no room for domestic-oriented monetary decisions.

The answer is False. A currency board requires full reserve backing of domestic currency at all times, not just when conditions are weak. The arrangement demands that foreign reserves equal at least 100 percent of the monetary base continuously, not variably based on economic conditions. This rigid requirement is fundamental to the currency board's credibility. Allowing partial backing would undermine the institutional guarantee that is the source of its strength.

When a central bank defends a peg by buying domestic currency, its foreign reserves decline and the domestic money supply contracts. When it accumulates reserves by purchasing foreign currency, its foreign asset holdings grow. These balance sheet effects are central to understanding how fixed exchange rate management interacts with domestic monetary conditions. The claim about domestic bond holdings automatically rising is incorrect. Bond changes depend on sterilization decisions, not the intervention itself.

Credibility in a fixed exchange rate regime is critical because markets will test a peg they doubt. A simple political promise to maintain the peg can be reversed when economic conditions deteriorate or political pressures mount. In contrast, a currency board or other institutional arrangement embeds the peg in legal rules, reserve requirements, and operational structures that make abandonment much more costly and difficult, providing the market with stronger assurance that the rate will be defended.

The answer is True. With a fixed nominal exchange rate, a country experiencing higher inflation than its anchor partner sees the real value of its currency rise relative to the anchor. This makes its exports more expensive in foreign markets, gradually eroding international price competitiveness. Unless productivity improves to offset the higher costs, this real appreciation leads to declining export performance and widening trade deficits, putting increasing pressure on the peg.

When a central bank sells foreign reserves and buys domestic currency to defend the peg, it removes domestic currency from circulation. This contraction of the money supply can raise interest rates and slow domestic economic activity. The deflationary pressure created by defending a weak peg can therefore compound economic difficulties if the country is already facing slow growth or recession, adding to the social and political costs of maintaining the fixed rate.

Defending a peg under sustained pressure depletes reserves, forces the central bank to maintain tight monetary policy even during downturns, and creates the risk of sudden disorderly devaluation if reserves are exhausted. The claim about automatic inflation elimination is incorrect. A fixed rate can reduce imported inflation through exchange rate stability but does not automatically eliminate all domestic inflation, which can also arise from fiscal policy, wages, and domestic demand pressures.

When reserve depletion makes the central bank's own capacity to defend the peg insufficient, broader policy coordination becomes necessary. The government may implement fiscal austerity to reduce import demand and improve confidence, capital controls may be introduced to limit outflows, or the country may seek emergency financing from the IMF or bilateral partners. These coordinated measures supplement the central bank's dwindling resources and may allow the peg to be sustained or guide an orderly exit.

The answer is False. A central bank in a fixed exchange rate regime cannot freely expand the money supply. If it creates more domestic currency than demand supports at the fixed rate, the excess supply of domestic currency creates downward pressure on the exchange rate. To defend the peg, the central bank must then absorb the excess currency by selling foreign reserves. Unconstrained monetary expansion is therefore directly incompatible with maintaining a credible fixed exchange rate.