Consider an economy with a fixed exchange rate and money supply equal to 2 billion pesos. The country has 1 billion in reserves and 1 billion in domestic credit. If as a result of some exogenous events, foreign interest rate increases, then the central bank in the home country:
A) will have to decrease the reserves to maintain the peg.
B) will have to decrease the domestic assets.
C) will have to increase the reserves to maintain the peg.
D) will do nothing.

Question

Quizplus · Accepted Answer

When foreign interest rates increase, investors will likely move their capital to foreign assets to take advantage of the higher returns. To maintain the fixed exchange rate (or the peg), the central bank will need to sell foreign currency (from its reserves) in exchange for domestic currency to support the domestic currency's value. This action will decrease the reserves.

Consider an Economy with a Fixed Exchange Rate and Money