The correct option is Purchase foreign currency to absorb the excess supply..
Explanation
In a fixed exchange rate system, the Central Bank is committed to maintaining the value of the domestic currency at a specific, predetermined level (peg) against a foreign currency. To sustain this peg, the Central Bank must intervene in the foreign exchange market to offset any disequilibrium between the supply of and demand for foreign currency.
Analysis of the Scenario:
- Market Condition: An excess supply of foreign currency (associated with a Balance of Payments surplus) implies that inflows of foreign currency exceed outflows. Under normal market forces, this excess supply would cause the price of the foreign currency to fall, leading to an appreciation of the domestic currency.
- Intervention Requirement: To prevent this appreciation and keep the exchange rate fixed at the official peg, the Central Bank must eliminate the excess supply.
- Action Taken: The Central Bank intervenes by purchasing the excess foreign currency from the market. By buying foreign currency, the Central Bank injects domestic currency into the economy and accumulates foreign exchange reserves.
Why other options are incorrect:
- Sell foreign currency to absorb the excess supply.: Selling foreign currency would increase the supply in the market even further, worsening the imbalance and putting greater pressure on the domestic currency to appreciate.
- Devalue the domestic currency.: Devaluation is a deliberate reduction in the value of the domestic currency. In a situation of BoP surplus (pressure to appreciate), the relevant policy adjustment-if the peg were to be changed-would be revaluation, not devaluation.
- Increase interest rates.: Increasing interest rates typically attracts foreign capital investment (capital account inflows). This would increase the supply of foreign currency further, exacerbating the excess supply problem.
Key Takeaway: In a fixed exchange rate regime, a Balance of Payments surplus creates pressure for the domestic currency to appreciate; the Central Bank must purchase foreign currency to absorb the excess supply and maintain the peg.