Question

Suppose that a country follows a managed-float policy but that its exchange rate is currently floating freely. In addition, suppose that it has a massive current account deficit. Other things equal, are its official reserves increasing, decreasing, or staying the same? If it decides to engage in a currency intervention to reduce the size of its current account deficit, will it buy or sell its own currency? As it does so, will its official reserves of foreign currencies get larger or smaller?

Short answer

The official reserves are part of the capital account and stay the same with a current account deficit.

The currency intervention will lead to buying its own currency to correct the current account deficit.

The official reserve becomes smaller.

Step-by-step solution

Managed floating exchange rate and current account deficit

The exchange rate system, which has a mixed system of flexible exchange rate and currency intervention, is called managed floating exchange rates.

Since 1971, most nations have mixed exchange rates where the government buys or sells foreign exchange through currency intervention to stabilize short-term changes in exchange rates or correct exchange rate imbalances.

A current account deficit implies that imports of goods or services or investment incomes are more significant than exports.

Effects of the trade deficit on the exchange rate

The country running a large current account deficit is always at risk of seeing the currency's value fall. If there are insufficient capital flows to finance the deficit, the exchange rate will fall to reflect the imbalance of foreign flows of funds.

The official reserve is a part of the capital account, and official reserve transactions are relevant under fixed exchange rate than when exchange rates are floating. Thus, the official reserves remain the same; however, there is a massive current account deficit.

Through currency intervention, the government will buy its own currency to correct the current account deficit. To achieve this, the nation uses its foreign exchange reserves to balance any shortfall in the BOP.When the central bank sells foreign exchange to meet the deficit, it is known as the official reserve sale.

Due to the selling of foreign exchange, the official reserve of the country will become smaller.