Q. Why/How may a drastic fall in the current account lead to a devaluation of a currency under a fixed exchange rate system?
A. A drastic fall in the CA may lead domestic policy makers to move for expansion of domestic output in an attempt to increase exports or have positive affects on the CA.
The domestic nation will announce a depreciation of the currency in an attempt to make domestic products cheaper than foreign counterparts. (The nation maybe forced to devaluate due to continued expectations for a depreciating dollar that could ultimately lead to a loss of all F.R. if defence of fixed E continued.) This will in turn expand output in the domestic economy, however, place pressure for domestic interest rates to rise. Rising interest rates would place pressure on E to appreciate. In order to remain on a fixed E at the new devalued level, the central bank will intervene by purchasing foreign assets and expand the money supply.