Question

Explain how balance of payment crises and currency crises might arise under fixed exchange rate regime.

Answer 1

A bank of payment crisis or currency crisis arises when a country is running persistent deficits in the balance of payments while trying to maintain its fixed exchange rate and is about to deplete its foreign reserves. A crisis may force a country to devalue its currency or move to a floating rate of exchange. Countries can borrow money from organizations such as the International Monetary Fund (IMF) sometimes to postpone the crisis. A central bank will often increase currency issuance to compensate for the damage resulting from a banking or default crisis, which can decrease reserves to a point where a fixed exchange rate breaks.