Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts does not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is GREATER THAN ZERO, a ________ demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and ________ domestic currency for foreign currencies or gold to bring the BOP back near zero.

Question

BlackTom AI · Accepted Answer

To tackle this question, I’ll walk through what happens when the sum of the current and capital accounts is greater than zero under a fixed exchange rate system.
Option a: surplus; sell. If CA + KA > 0, there is a BOP surplus meaning there is excess demand for domestic currency abroad as the world needs to acquire domestic currency to balance the surplus. In order to restore the fixed rate and push the BOP back toward zero, the government would intervene by selling domestic currency for foreign currency (or gold), increasing the supply of the domestic currency on the foreign exchange market. This aligns with standard logic: a surplus situation exerts upward pressure on the domestic currency, and intervention to prevent appreciation involves selling domestic currency.
Option b: deficit; buy. A deficit in the CA + KA would imply the opposite pressure on the currency, typically requiring buying domestic currency, not selling, to prop up demand. This would be inconsistent with the scenario where CA + KA > 0.
Option c: deficit; sell. Here, the deficit implies the currency might need support to prevent depreciation, which would usually call for selling foreign currency and buying domestic currency, not selling domestic currency. This also contradicts the case of a positive sum.
Option d: surplus; buy. If there is a surplus (CA + KA > 0), buying domestic currency would reduce supply and further push the currency toward appreciation, which would worsen the145 fixed-rate dilemma rather than resolve it. Therefore this is not the appropriate intervention.

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