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Homework answers / question archive / Which of the following two statements is correct? S1: If a country wants to “prop-up” its currency, i
Which of the following two statements is correct?
S1: If a country wants to “prop-up” its currency, i.e. increase its value, it can do so by buying up its domestic currency. Generally, this leads to an increase in the country’s FX reserves.
S2: If a country wants to weaken its currency, i.e. decrease its value, it can do so by selling its FX reserves and buy its own currency. Generally, this strategy is not sustainable because the country will run out of FX reserves.
A. Both statements are correct
B. Both statements are false
C. S2 is correct but S1 is false
D. S1 is correct but S2 is false
The correct option is (B) i.e. both the above given statements are false.
As a part of the monetory policy, the Central Bank of a country may use the method of currency intervention in order to influence the value of the domestic currency. The process of Currency intervention is also known as currency manipulation or foreign exchange market intervention. Currency intervention is a process in which the country's central bank buys or sells foreign currency in exchange of its domestic currency in order to check inflation, regulate the exchange rate, influence the export & trade policy etc.
When the country's domestic currency is depreciating or decreasing in value, then in order to "prop up" its currency i.e. to increase its value, the central bank may resort to currency intervention for creating an artificial demand for its domestic currency. It can do so by selling some of its forex reserves and buy the local currencies in return. In this manner, the central bank can also affect the domestic money supply, since it is removing some of the nation's currency from circulation as it buys up the domestic currency in exchange of forex. However, this process reduces the Forex reserves of the Central Bank.
When the country's domestic currency is appreciating or increasing in value, then in order to weaken it or to reduce the value of the local currency, the central banks sells its own currency and buys foreign exchange denominated assets thereby building up its forex reserves. Since the central bank releases more domestic currency into circulation, it increases the domestic money supply.
