Country Z buys far more goods from abroad than it sells. Its imports of oil and machinery keep rising, while its exports grow slowly. Its citizens working abroad send money home to their families, but this covers only a small part of the gap. Foreign firms have set up new plants in Z, and Z’s companies have borrowed from banks abroad. Even so, the money coming into Z during the year is less than the money going out. Z follows a fixed exchange rate, and its central bank has stepped in to meet the shortfall.
When Country Z’s central bank meets the shortfall, which of the following is correct?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Its official reserves fall, and Z has an overall balance of payments deficit.
To meet the shortfall, the central bank sells foreign exchange from its reserves. This is an official reserve sale, so the reserves fall.
A fall in official reserves is itself the measure of a BoP deficit. The sale covers the gap, but the deficit is still there; the sale is an accommodating transaction.
NCERT (2026-27): “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). …” |