Intervention to defend a fixed exchange rate can magnify the transmission of a foreign recession into an economy.

Question

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When a country defends a fixed exchange rate, it may have to use its foreign reserves to buy its own currency. This can lead to a depletion of reserves and a reduction in the money supply, which can exacerbate the negative effects of a foreign recession on the domestic economy. Additionally, intervention to defend a fixed exchange rate can signal to investors that the country's policymakers are unable to maintain the exchange rate without significant intervention, leading to a loss of confidence and further economic problems.

Intervention to Defend a Fixed Exchange Rate Can Magnify the Transmission