Question

Under the fixed exchange regime, if the country begins with a deficit in its overall balance of payments, to maintain the fixed exchange rate, explain the following

a)   How does the central bank intervene through monetary policy to affect the balance of payment?
b)   How does the central bank intervene through fiscal policy to affect the balance of payment?

Answer 1

When there is a deficit, it means that the country is needs to pay more to other countries than it gets from other countries. When this happens, there is a depreciationary pressure on the currency.

A. To maintain the fixed exchange rate, the central bank can use monetary policy and reduce the local currency supply in the market. That will result in an appreciationary pressure on the currency and will counteract the depreciationary problem. Tha central bank achieves this by open market operations.

B. On the other hand, fiscal policy can also be used to tighten. This means the central bank will need to reduce spending and investment. That can be done by increasing taxes or reducing government spending. This will result in lower money supply and appreciation of the local currency.