Question

The net inflow of foreign currency into a country on current account and capital account combined is negative in a particular year. The country could be following a fixed or a flexible exchange rate regime. Which of the following scenarios is/are possible for the country’s economy in that year?

• A. The country’s foreign exchange reserves may increase
• B. The country’s exchange rate may appreciate
• C. The country’s foreign exchange reserves may decrease
• D. The country’s exchange rate may depreciate

Hint:

Balance of payments deficits lead to reserve depletion under fixed exchange rates and currency depreciation under flexible exchange rates.

Answer 1

The Correct Option is C, D

Step 1: Interpret the situation.
A negative combined inflow means that outflows of foreign currency exceed inflows — i.e., there is a balance of payments deficit.
Step 2: Analyze by exchange rate regime.
- Under a **fixed exchange rate**, the central bank must sell foreign reserves to maintain the exchange rate ⇒ reserves fall. - Under a **flexible exchange rate**, market forces will cause the domestic currency to **depreciate** as supply of domestic currency rises in the forex market.
Step 3: Conclusion.
Hence, (C) and (D) are possible outcomes.