Fixed Exchange Rate Pressure from Lost Confidence

Steps:

• Fixed exchange rate means the central bank maintains the currency value by intervening in forex markets.
• Fall in international confidence signals potential devaluation, prompting capital outflows as investors sell the currency.
• To defend the peg, the central bank sells foreign reserves to buy domestic currency and stabilize the rate.
• This depletes reserves, as outflows exceed inflows without policy changes.

Why A is correct:

• Under the balance of payments, reserve loss occurs when capital account deficits force intervention to uphold the fixed rate (Mundell-Fleming model).

Why the others are wrong:

• B: Confidence fall reduces capital inflows, causing outflows instead.
• C: Terms of trade (export/import price ratio) unaffected by confidence; relates to trade balances.
• D: Fixed rate prevents exchange rate fall; central bank acts to keep it stable.

Final answer: A