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Why must balance of CAD + Financial & Capital AC = 0 under a floating exchange rate? (1 Viewer)
- Thread starter Lucas_
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deswa1
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Re: Why must balance of CAD + Financial & Capital AC = 0 under a floating exchange ra
Basically, under a floating exchange rate system:
Demand for $A=Supply for $A
Exports+Financial inflows+Income inflows=Imports+Financial outflows+Income outflows
(Exports-imports)+(Income inflows-income outflows)=(Financial outflows-financial inflows)
Current account deficit (surplus)= Financial account surplus (deficit)
Basically, under a floating exchange rate system:
Demand for $A=Supply for $A
Exports+Financial inflows+Income inflows=Imports+Financial outflows+Income outflows
(Exports-imports)+(Income inflows-income outflows)=(Financial outflows-financial inflows)
Current account deficit (surplus)= Financial account surplus (deficit)
gnrlies
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Re: Why must balance of CAD + Financial & Capital AC = 0 under a floating exchange ra
Deswa1 gives a good and simple answer.
An alternative way of thinking about it, which is essentially the same as the above answer, is that one account must pay for the other. I.e. if a country has a huge trade deficit for a given period, this must be paid for somehow (perhaps through a foreign loan or investment). It is a bit like if you spend more than you earn in a given week. It means that you must be borrowing that money from somewhere. Inflows and outflows must add to zero because money doesn't grow on trees so to speak, which is synonymous with $S=$D as given by Deswa1.
Even under fixed exchange rates the same principle applies as the Government needs to engage in sterilization to ensure that inflation does not result (hence reserve assets listed in the Capital and Financial account).
Deswa1 gives a good and simple answer.
An alternative way of thinking about it, which is essentially the same as the above answer, is that one account must pay for the other. I.e. if a country has a huge trade deficit for a given period, this must be paid for somehow (perhaps through a foreign loan or investment). It is a bit like if you spend more than you earn in a given week. It means that you must be borrowing that money from somewhere. Inflows and outflows must add to zero because money doesn't grow on trees so to speak, which is synonymous with $S=$D as given by Deswa1.
Even under fixed exchange rates the same principle applies as the Government needs to engage in sterilization to ensure that inflation does not result (hence reserve assets listed in the Capital and Financial account).