Country X holds its currency at a fixed rate but its reserves of fore…

Country X holds its currency at a fixed rate but its reserves of foreign exchange are small, and it often runs BoP deficits. Country Y lets its exchange rate float freely. Which of the following is correct?

Answer & explanation

Correct answer: option 1

The correct answer is Option (1) → Country X is more prone to a speculative attack, while Country Y does not need to keep large stocks of foreign exchange reserves.

A fixed rate with small reserves invites doubt that the rate can be held, which can lead to a speculative attack. A floating rate needs no defence, so large reserves are not needed.

Option (1) Country X is more prone to a speculative attack, while Country Y does not need to keep large stocks of foreign exchange reserves. — Correct. A fixed rate invites speculative attacks, while a flexible rate needs no large reserves.

Option (2) Country X is more prone to a speculative attack, and Country Y must keep large reserves to correct its BoP. — Incorrect. Under a flexible rate the exchange rate itself corrects the BoP.

Option (3) Neither country can face a speculative attack, since both have central banks. — Incorrect. Having a central bank does not help when reserves are inadequate.

Option (4) Country Y is more prone to a speculative attack, while Country X does not need to keep large stocks of foreign exchange reserves. — Incorrect. This reverses the two systems.

NCERT (2026-27): “6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems … 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.”

“6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems … The flexible exchange rate system gives the government more flexibility and they do not need to maintain large stocks of foreign exchange reserves. …”