Question

Assume that a country’s currency is “under speculative attack,” i.e. that forex traders are aggressively seeking to depreciate the currency.

a. Explain how the central bank could intervene in order to prevent the depreciation.

b. Explain what the central bank would need to do to sterilize the action you described in part a.

Answer 1

a) To stop the trend of depreciation, the central bank could sell foreign exchange. In doing so, it would increase the supply of foreign exchange and reduce the supply of domestic currency.

b) The above action would lower money supply thus affecting the interest rate. To sterlize this action, the central bank can purchase government bonds. In doing so, it would increase the money supply back to initial amount.