The net inflow of foreign currency on current and capital accounts combined is negative in a year. The country could be on a fixed or a flexible exchange rate regime. Which scenarios is/are possible?
Select all that apply.
IIT JAM 2021 Question 37: Balance of payments and exchange rates
Answer and worked solution
Answer: (C) and (D)
A negative combined current-plus-capital balance is an overall deficit. Under a fixed exchange rate the central bank sells reserves to defend the peg, so reserves fall, giving (C).
Under a flexible exchange rate the excess demand for foreign currency weakens the home currency, so it depreciates, giving (D). Reserves would not rise and the currency would not appreciate under a deficit, so (A) and (B) are ruled out. The correct statements are (C) and (D).
The trap: (A) The country's foreign exchange reserves may increase
A payments deficit drains reserves or weakens the currency; rising reserves or an appreciation would accompany a surplus, not the deficit described.
Balance of payments and exchange rates has come up 120 times in 7 exams since 2007.
What this question tests
This question is on Balance of payments disequilibrium and adjustment, part of Balance of payments and exchange rates in International Economics.
What causes a deficit or surplus and how it is corrected.
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Question from the IIT JAM 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.