I mentioned that capital inflows could cause a currency crisis, leaving fund managers with significant losses. In the period leading up to a currency crisis, I would predict that an affected country’s:
|Prediction 1|foreign exchange reserves will increase.|
|Prediction 2|broad money growth will increase.|
|Prediction 3|the exchange rate will be substantially higher than its mean level during tranquil periods.|
Question: Which of McFadden’s predictions in Statement 5 is least likely to be correct ?
Answer: Prediction 1 is least likely to be correct. Foreign exchange reserves tend to decline precipitously, not increase, as a currency crisis approaches. Broad money growth tends to rise in the period leading up to a currency crisis and the exchange rate is substantially higher than its mean level during tranquil periods
Shouldn’t the Reserve rate increase if capital is coming in? Investors would have to trade in foreign currency for domestic which would mean the domestic country would have way more foreign currencies?