Speculative Attacks Quiz: Currency Crisis Dynamics

The answer is B. Speculative attacks often occur when a nation's internal economic policies, such as high money supply growth, conflict with its commitment to a fixed exchange rate. Investors recognize this inconsistency and begin selling the currency before an inevitable devaluation, forcing the central bank to intervene until its reserves are depleted.

The answer is True. While reserves provide a buffer, they are finite. If market participants believe that the economic fundamentals are unsustainable, the sheer volume of selling can overwhelm even large reserve holdings. Investors focus on the rate of reserve depletion rather than the total amount, triggering a self-fulfilling prophecy of collapse.

The answer is B. The shadow exchange rate is the theoretical value of a currency if it were allowed to float freely. When this rate falls significantly below the fixed rate, it creates a profit opportunity for speculators. Investors attack the currency once the shadow rate crosses the fixed rate threshold, anticipating a gain.

The answer is A, B, and D. To support the currency, the bank must reduce its supply or increase its demand. Raising interest rates makes holding the currency more attractive, while selling foreign reserves directly supports the price. Capital controls are used to restrict the exit of funds, though they often signal desperation to the markets.

The answer is C. The trilemma states that a country can only choose two of three: a fixed exchange rate, free capital movement, and an independent monetary policy. If a country chooses a fixed rate and open capital markets, it must give up control over its interest rates to maintain the peg.

The answer is False. Defensive interest rate hikes increase the cost of borrowing for businesses and households. This typically leads to a reduction in investment and consumer spending, which can slow economic growth and lead to higher unemployment. This internal economic pain often makes the defense of a fixed regime politically unsustainable.

The answer is B. Capital flight occurs when investors move their wealth into foreign assets to avoid the loss of purchasing power associated with a currency devaluation. As more people convert their local currency into foreign denominations, the pressure on the fixed regime intensifies, accelerating the exhaustion of the central bank's foreign reserves.

The answer is A, B, and D. Unlike first-generation models that focus on reserve exhaustion, second-generation models suggest that attacks occur when the market believes the government will abandon the peg to satisfy other goals, like reducing unemployment. This creates a situation where market sentiment alone can trigger a crisis regardless of reserve levels.

The answer is B. When a central bank sells reserves to support a currency, the domestic money supply shrinks. Sterilization is the process of using open market operations, like buying government bonds, to inject money back into the economy. This prevents interest rates from rising but can inadvertently make the currency harder to defend.

The answer is True. In a fixed regime under pressure, the currency will either stay at the peg or be devalued. Since there is almost no chance the currency will increase in value, speculators can short the currency with minimal risk of loss. If the peg holds, they lose little; if it breaks, they profit immensely.

The answer is C. Once the central bank stops defending the peg due to reserve exhaustion or political pressure, the currency value drops to its market clearing level. This sharp devaluation restores balance to the trade account but can cause immediate spikes in inflation and the cost of imported goods for the population.

The answer is A, B, and D. Original sin refers to a country's inability to borrow internationally in its own currency. When a speculative attack forces a devaluation, the value of the country's foreign-denominated debt increases in local terms, often leading to widespread bankruptcy and a deeper financial crisis than the devaluation alone.

The answer is B. A fixed-but-adjustable system provides the government with the flexibility to reset the exchange rate to a new level if economic conditions change. While this can provide an "exit" during an attack, it can also encourage speculation if the market believes a realignment is imminent due to persistent trade deficits.

The answer is True. A currency board is a strict regime where the domestic money supply is 100% backed by foreign reserves. Because the board cannot print money without increasing its reserves, it creates a much stronger commitment to the peg. This transparency often discourages speculators, though it removes all flexibility for domestic monetary policy.

The answer is C. A persistent current account deficit suggests that a country is spending more abroad than it is earning, often because the fixed exchange rate has made domestic goods too expensive. This imbalance requires a constant drain on reserves to maintain the peg, signaling to speculators that a devaluation is necessary.