You are the head of the central bank of a country with a fix

You are the head of the central bank of a country with a fixed exchange rate and open capital markets. Then there is a bad piece of news which you think will cause the currency to depreciate by 20% if you do nothing. What are 3 possible responses you can make? Draw FX market diagrams to illustrate your choices

Solution

If there is chance of curremcy depreciation it implies the economic or financial conditions could have made the an increase in supply of domestic currency in foreign exchange market.

Now one way could be to purchase the domestic currency by orivate investors bythe central bank to balance supply and demandat the fixed exchange rate.

Trading restrictions could be used such as quotas on the suze of short positions that a bank is allowed to carry. A tobin tax that is tax on all currency trabsaction can also be used.

Increasing interest rates will attract investors abroad which will increase the demand of the domestic currency preventing the depreciation