CAD and financial account question (1 Viewer)

[malcolm21]

(c) Briefly explain the relationship between the current account and the capital and
financial account under a floating exchange rate system.

How would you approach this

 

[aanthnnyyy]

- define each component
- draw relationship and elaborate relationship I.e. Curr + cap and fin = 0 and so fourth

 

[genodeg]

Depends how many marks but I'd define the two sections (if it's only a 'briefly' question I can't imagine a great deal of merit defining every individual component) then make sure to explicitly outline the fact that inflow of FDI and portfolio investment (KAFA surplus) results in dividend payments (Primary income deficit) which leads to a CAD then that (only under a floated exchange rate) CA+KAFA=0

 

[malcolm21]

Depends how many marks but I'd define the two sections (if it's only a 'briefly' question I can't imagine a great deal of merit defining every individual component) then make sure to explicitly outline the fact that inflow of FDI and portfolio investment (KAFA surplus) results in dividend payments (Primary income deficit) which leads to a CAD then that (only under a floated exchange rate) CA+KAFA=0

thnks, but can you explain why this is only the case in floated ehange rate?

 

[genodeg]

Not 100% sure it's part of the syllabus they just assume we know we do our BOP work under floating exchange rate.

BUT I imagine it's due to the fact that in a fixed/pegged exchange rate the central monetary organisation purchases and sells domestic currency on the FOREX market independent of the goods, services or income account therefore there are currency inflows or outflows that can't be evaluated on the BOP. With a floating exchange rate, the central monetary organisation sort of pulls the strings and leads others to do the financial flows (always under a category of the BOP)

 

[YouCantMakeMe]

thnks, but can you explain why this is only the case in floated ehange rate?

"The distinguishing characteristic of a floating exchange rate system is that the price of a currency adjusts automatically to whatever level is required to equate the supply of and demand for that currency, thereby clearing the market. The logic of the relationship between our international transactions and the supply and demand for currencies implies that this market-clearing, or 'equilibrium', price also produces automatic equilibrium in the balance of payments. That is, the balance of current account (whether positive, negative, or zero) must be precisely offset by the balance (negative, positive, or zero) of the capital account. Under floating exchange rates these outcomes are achieved automatically without the need for government intervention. By contrast, under fixed exchange rates balance of payments equilibrium is not the normal condition." -http://www.abc.net.au/money/currency/features/feat10.htm

Basically just cos supply = demand in free market system (which the floating exchange rate system emulates)