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Question

What would be the effect(s) of the unsterilized Central Bank foreign exchange market intervention of selling foreign reserves? 

Select one or more:

a.

The domestic money supply shrinks.

b.

The domestic money supply increases.

c.

Increased demand for the home currency.

d.

Increased supply of the home currency.

Answer 1

The correct answer is option A: The domestic money supply shrinks.

When a central bank conducts an unsterilized foreign exchange intervention by selling foreign reserves, it reduces the supply of foreign currency in the market, which increases the demand for the home currency. This, in turn, leads to an appreciation of the home currency. However, the sale of foreign reserves also results in a reduction in the domestic money supply, as the central bank is effectively withdrawing money from circulation in exchange for foreign currency. This reduction in the money supply can lead to a tightening of monetary policy, which can have implications for inflation, interest rates, and economic growth.