Suppose a sudden deterioration in the current account, for example, leads the foreign exchange market to expect the government to devalue in the future and adopt a new fixed exchange rate
The correct answer and explanation is:
Answer:
If the foreign exchange market expects a future devaluation of a fixed exchange rate due to a sudden deterioration in the current account, this expectation will lead to immediate pressure on the domestic currency. Investors and speculators will try to sell the domestic currency in anticipation of its future lower value, causing a depreciation pressure. The central bank will have to use its foreign reserves to defend the fixed exchange rate. If reserves run low, the fixed exchange rate becomes unsustainable, eventually forcing the government to devalue the currency to a new, lower fixed rate.
Explanation:
When a country experiences a sudden deterioration in its current account—meaning it imports more than it exports, or faces increased external payments—there is a higher demand for foreign currency relative to domestic currency. Under a fixed exchange rate regime, the government or central bank commits to maintaining the domestic currency at a certain rate against a foreign currency (e.g., USD).
If the market perceives that this current account imbalance is large and persistent, investors will start to expect the government to devalue the currency to restore competitiveness. Devaluation makes exports cheaper and imports more expensive, which helps to correct the current account deficit.
Expectations and speculative behavior:
The expectation of a future devaluation triggers immediate market reactions. Speculators and investors begin to sell the domestic currency to avoid losses from holding a currency that will soon be worth less. This selling pressure causes a depreciation tendency on the currency in the foreign exchange market.
Central bank intervention:
To maintain the fixed rate, the central bank must intervene by selling foreign reserves and buying domestic currency. This action reduces the supply of the domestic currency, supporting its value. However, foreign reserves are finite, so defending a fixed exchange rate under pressure can deplete reserves rapidly.
Unsustainability and forced devaluation:
If the government continues to defend the fixed exchange rate without addressing the underlying current account problem, the reserves eventually run out. Once reserves are exhausted or too low, the fixed rate peg becomes unsustainable, and the government is forced to devalue the currency to a new, lower fixed rate or allow the currency to float.
Policy implications:
A credible fixed exchange rate requires consistent economic fundamentals. Large current account deficits can undermine confidence, making a devaluation expected and, ultimately, inevitable unless corrective fiscal, monetary, or structural policies are implemented.
In summary, expectation of future devaluation due to current account deterioration causes immediate pressure on the currency, leading to reserve depletion and eventual forced devaluation to a new fixed exchange rate.