To counteract the depreciation of the national currency against the U.S. dollar, the central bank of a country can intervene in the foreign exchange market. Which of the following imposes a restriction on this ability of the central banks to maintain a fixed exchange rate?
A) The central banks have a limited amount of international reserve.
B) The central banks have a limited amount of domestic currency.
C) Unrestricted sale of foreign currency will cause inflation in the domestic economy.
D) The supply of dollars is perfectly elastic in the foreign exchange market.
E) The central banks need to maintain a certain amount of its assets in the form of gold.

Question

Quizplus · Accepted Answer

If the central bank's international reserves are limited, it may not have sufficient resources to continue buying its national currency on the foreign exchange market to maintain a fixed exchange rate. Eventually, it may be forced to let the currency float, leading to depreciation. The other options, such as B, C, D, and E, do not directly restrict the central bank's ability to intervene in the foreign exchange market but may have other implications for monetary policy.

To Counteract the Depreciation of the National Currency Against the U.S