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Vilasram Deshmukh is forecasting JPY/USD exchange rates based on balance of payments analysis. He notes that...

Vilasram Deshmukh is forecasting JPY/USD exchange rates based on balance of payments analysis. He notes that the United States is running large current account deficits relative to Japan. Based on this information, he concludes that the JPY/USD rate should decrease. His conclusion is most likely supported by which one of the following reasons.

Please provide explanation to justify your answer.

A. flow mechanism of the current account influences.

B. portfolio composition mechanism of the current account influences.

C. capital account influences.

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Answer #1

The correct answer is A .  The decrease in the JPY/USD rate implies depreciation of the USD. The flow mechanism of current account influences supports the view that current account deficits lead to depreciation of currency.

Under capital account influences, current account deficits imply capital account inflows and, hence, would lead to an appreciation of USD.

The portfolio composition mechanism of current account influences supports the flow mechanism if investors rebalance a portion of their portfolio out of USD assets due to gradual buildup of USD assets over time in their portfolios.The question does not provide information to support this reallocation.

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