Foreign Reserves Depletion in Fixed Exchange Rate Regimes

Steps:

• Identify balance of payments (BOP) deficit: Imports exceed exports, creating excess demand for foreign currency.
• Recall fixed exchange rate mechanics: Central bank intervenes to keep currency value stable by selling foreign reserves.
• Link deficit to reserves: Persistent deficit drains reserves as bank supplies foreign currency to meet demand.
• Conclude problem: Low reserves risk inability to maintain peg, potentially causing devaluation or crisis.

Why C is correct:

• In fixed exchange rate systems, BOP deficits force the central bank to sell foreign reserves to defend the currency peg, directly reducing reserve holdings per the balance of payments identity (current + capital account = change in reserves).

Why the others are wrong:

• A: Defending the peg typically contracts domestic money supply via reserve sales, not increases it.
• B: Trade protection is a possible retaliation but not inherent to fixed rates or BOP deficits.
• D: Short-run living standards depend on adjustment policies, not directly on the deficit itself.

Final answer: C