Question

In a freely floating exchange rate system, if the current account is running a deficit, what are the consequences for the nation’s balance on financial account and its overall balance of payments?

Answer 1

Answer:

If the current account is running in as deficit, the capital account must be running in a surplus equal to the same amount and thus the overall balance of the payments is same as before.

Explanation:

In a freely floating exchange rate system, the nation's balance of payments must always be zero.

So if the current account is running in as deficit, the capital account must be running in a surplus equal to the same amount and thus the overall balance of the payments is same as before.

Answer 2

Answer:

The balance of payments (BOP) must equal 0 in a free floating exchange rate system.

The formula for determining the BOP = current account + financial account + capital account +

• current account = flow of income from one country to another, i.e. net trade between nations, net earnings from foreign investments and transfer payments
• financial account = flow of assets from one country to another, includes foreign direct investment and portfolio investments
• capital account = flow of money between entities in one country to another, e.g. transfer of remittances from the US to Mexico

If the current account is negative (has a deficit) it means more money exits the country though a trade deficit or earnings from foreign investments. In order for the BOP to equal 0, then both the financial account and/or the capital account must have a surplus that offset the deficit from the current account. Usually the capital account is much smaller than the financial account, at least in developed nations. In some developing countries, e.g. Central America that depend on foreign remittances, the capital account is much larger. So most of the surplus generally comes from the financial account in developed countries.