A country follows a fixed exchange rate system and has a large deficit in its BoP. People come to know that its foreign exchange reserves are inadequate. Which of the following chains of events is most likely?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → People doubt that the rate can be held → they expect a devaluation → they buy foreign currency aggressively → the government is forced to devalue
With low reserves, people expect a devaluation and rush to buy foreign currency. This speculative attack forces the devaluation.
Option (1) People doubt that the rate can be held → market forces lower the exchange rate → the domestic currency appreciates — Incorrect. Under a fixed rate, market forces do not set the rate, and doubt pushes the currency down, not up.
Option (2) People doubt that the rate can be held → they expect a revaluation → they buy the domestic currency aggressively → the government is forced to revalue — Incorrect. Inadequate reserves lead people to expect a devaluation, not a revaluation.
Option (3) People expect the domestic currency to gain value → they sell foreign currency → reserves rise → the BoP deficit is removed — Incorrect. Nobody expects a currency with thin reserves to gain value.
Option (4) People doubt that the rate can be held → they expect a devaluation → they buy foreign currency aggressively → the government is forced to devalue — Correct. Doubt, an expected devaluation and aggressive buying of foreign currency make up a speculative attack.
NCERT (2026-27): “6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems The main feature of the fixed exchange rate system is that there must be credibility that the government will be able to maintain the exchange rate at the level specified. Often, if there is a deficit in the BoP, in a fixed exchange rate system, governments will have to intervene to take care of the gap by use of its official reserves. If people know that the amount of reserves is inadequate, they would begin to doubt the ability of the government to maintain the fixed rate. This may give rise to speculation of devaluation. When this belief translates into aggressive buying of one currency thereby forcing the government to devalue, it is said to constitute a speculative attack on a currency.” |