27. Suppose Canada operates under a fixed exchange rate system and the Canadian

Question

27.    Suppose Canada operates under a fixed exchange rate system and the Canadian dollar is fixed or pegged against the US dollar. If Canada’s current account has a value of -US$50 and capital account has a value of $40, then the BOC will have to _____ US dollars. The BOC will ____ US dollar reserves.

         A) Buy; accumulate

         B) Buy; deplete

         C) Sell; accumulate

         D) Sell; deplete

E) None of the answers is correct.

Why the answer is D? Can you show me the step ,please?Thank you.

Explanation / Answer

Canada runs a bop deficit of $10 and a trade deficit if $50. This implies that domestic demand for foreign currency (to buy imports) exceeds foreign demand for domestic currency (to buy our exports). Now in order to keep the exchange rate fixed, the central bank would need to intervene by selling foreign currency in exchange for domestic currency. This would lead to a reduction of foreign reserves and hence a balance in balance of payments. Thus the answer is d.

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