Under a fixed exchange rate regime, how can the central bank prevent appreciation when faced with capital inflows?

• A. The central bank buys domestic currency and lowers reserves
• B. The central bank sells foreign exchange to reduce the money supply
• C. The central bank buys foreign exchange and expands the money supply using reserves
• D. The central bank imposes capital controls and raises interest rates

Answer: (C)

When a fixed exchange rate peg is in place, capital inflows raise the demand for the domestic currency and would push the currency toward appreciation. To keep the peg, the central bank must counteract that pressure by supplying more domestic currency to the market. The way to do this is to use its foreign exchange reserves to buy foreign currency, paying with domestic money. That purchase injects domestic currency into the economy, expanding the money supply. The extra domestic currency offsets the upward pressure on the domestic currency, helping to keep the exchange rate fixed.

Other moves either remove domestic currency from circulation or don’t directly address the peg: buying domestic currency or selling foreign exchange would tend to tighten money, pushing the currency toward appreciation or depreciating it differently than needed to maintain the fixed rate; and capital controls or higher interest rates are slower, less direct tools for sustaining the fixed rate in the face of sustained inflows.