Question

Suppose that a country follows a managed-float policy but that its exchange rate is currently floating freely. In addition, suppose that it has a massive current account deficit.

a. Other things equal, are its official reserves increasing, decreasing, or staying the same?
b. If it decides to engage in a currency intervention to reduce the size of its current account deficit, will it buy or sell its own currency?
c. As it does so, will its official reserves of foreign currencies get larger or smaller?

Answer 1

Find the explanation and answer below

Step-by-step explanation:

A - Its official reserves staying the same. Why? - Currency is expected to depreciate if the current account is in deficit under a floating exchange rates system because current account deficit tells us that there is a small demand for the country’s exports and its currency. The government does not intervene in the foreign exchange market under this system, thus the official reserve does not change

B - Sell its own currency. Why? - Because of the above reason, it needs to sell its currency to reduce the deficit.

C - Its official reserves of foreign currency get larger if it sells its currency because it will receive foreign-denominated currency.