A country could use its reserves of foreign exchange in order to balance any deficit in its balance of payments. The reserve bank _________ foreign exchange when there is a deficit. This is called ___________.
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Sells, official reserve sale
When a country pays more abroad than it receives, its balance of payments is in deficit, and the gap has to be paid for. The reserve bank can cover it by selling foreign exchange from its own reserves; this is an official reserve sale. The fall in the reserves measures the deficit, because the monetary authorities are its ultimate financiers.
Why the other options are incorrect
Option (2) Buy, BOP Deficit — Incorrect. A reserve bank that buys foreign exchange adds to its reserves, which happens when there is a surplus. The BoP deficit is the gap itself, not the way of financing it.
Option (3) Borrow, transfer payments — Incorrect. Transfers are gifts, remittances and grants received or paid without anything in return. They are current account items, not the use of the country’s reserves.
Option (4) Buy, net factor income from abroad — Incorrect. Net factor income from abroad is the factor income earned by residents abroad less that earned by foreigners here. It is a part of national income, not a reserve transaction, and buying foreign exchange would raise the reserves, not finance a deficit.
Note: A same/similar question was asked in CUET (UG) in the papers below.
| 2026 | 2025 | 2024 | 2023 | 2022 |
| 13-05 S2* 15-05 S1 06-06 S1* | 31-05 S1* | – | – | – |
* A similar question.
NCERT (2025-26): “6.1.3 Balance of Payments Surplus and Deficit … Alternatively, the country could use its reserves of foreign exchange in order to balance any deficit in its balance of payments. The reserve bank sells foreign exchange when there is a deficit. This is called official reserve sale. The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus). The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus).…” |