The expectation of future devaluation causes a balance of payments crisis marked by
A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate.
B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world interest rate.
C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate.
D) a sharp rise in reserves and an even greater rise in the home interest rate above the world interest.
E) a sharp rise in reserves and a rise in the home interest rate to the level of the world interest.

Question

Quizplus · Accepted Answer

An expectation of future devaluation causes investors to anticipate a depreciation in the value of the domestic currency. This, in turn, prompts them to shift their investments to other countries with stronger currencies. This leads to a net outflow of capital, which results in a fall in the foreign exchange reserves of the country. To stem the outflow of capital, the central bank may raise the domestic interest rate above the world interest rate. This can lead to a recessionary pressure on the economy. Thus, a sharp fall in reserves and a rise in the home interest rate above the world interest rate are the typical features of a balance of payments crisis caused by the expectation of future devaluation.

The Expectation of Future Devaluation Causes a Balance of Payments