Question

Under the pure flexible exchange rate system,

1. Is it possible for a country to have positive balances for both of its current account and capital account at the same time? If so, is the situation sustainable or not? Explain.

2. Is it possible for a country to have negative balances for both of its current account and capital account at the same time? If so, is the situation sustainable or not? Explain.

Answer 1

To be able to understand whether a country can have a positive or a negative balance simultaneously in it's Capital and Current Account, and whether the situation would be sustainable, its imperative to understand the meaning of Capital and Current Account of a country and the concept of Balance Of Payments.

Current Account

It represents an account of a country's import and export of goods and services as well as unilateral transactions. It's contents are :-

1. Merchandise transactions (Visible Trade) : The import and export of goods is called visible trade. The payments for import are recorded on debit side and receipts for exports are recorded on credit side of this account.

2. Export and Imports of services : A vast variety of services are exchanged among individuals and corporate houses of a country with those of others, like web development, technical consultancy, shipping etc . Its also called 'invisible trade'. The payment for import of services is recorded on the debit side of current account and receipts are recorded on credit side.

3. Unilateral Transactions ;These are one sided transactions like transfer of gifts, donations etc. The transfers to the rest of the world are recorded on the debit side and transfers from the rest of the world are recorded on redit side.

Some Observations!

1. Clearly, the Current Account is determining the net income generated by the country through foreign trade.

2. Surplus in Current Account arises when Credit side amount exceeds the Debit side, indicating Net Inflow of Foreign Exchange.

3. Deficit in Current Account arises when Debit side exceeds the Credit side, indicating Net Outflow of Foreign Exchange.

Capital Account

It represents a country's account of capital inflow and outflow in the form of investments. These are basically financial transactions, used to finance the Current Account's deficit or absorb it's surplus. It's components are :-

1. Investments to and from foreign countries

2. Borrowings to and from foreign countries

3. Change in the foreign exchange reserves

Borrowings from a foreign country are recorded on the credit side of Capital Account and investments to a foreign country are recorded on the debit side.

Observations!

1. Surplus in capital account arises when the credit side is more than the debit side, indicating net inflow of capital.

2. Deficit in capital account arises when the debit side exceeds the credit side, indicating net outflow of capital.

Now, applying this knowledge to the situations asked i.e.,

* If both Current Account and Capital Account are positive ;

It means the export of goods and services are more than exports, generating foreign exchange reserves for the country, but at the same time the capital borrowings of the country from other countries are more than its own investments abroad. The benefit derived by the economy by a positive Current Account balance is being offset by a positive Capital Account balance.

*If both Current Account and Capitla Account are negative ;

It means the export of goods fall short as compared to imports creating a foreign exchange liability and the investments of the country abroad are more than borrowings. But the two circumstances, if occur together, are offsetting the overall gains.

Conclusion

If one of the Current Account and Capital Account is positive, the other should be negative to strike a Balance of payments.