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A)	Running a deficit in the current account balance simply means a country imports more than it exports, but a country can do this only for a short time.

B)	A nation's current account surplus or deficit is a good measure of the health of its economy.

C)	Capital inflows from foreigners are not bad even if the foreigners buy up domestic real estate, domestic industries and own other productive assets.

All statements except for the capital inflows statement are incorrect. Current account deficits are neither good nor bad and countries can run such deficits for long periods of time. Current account deficits are usually accompanied by financial account surpluses that can sustain current account deficits for long periods.

A)	the result of a country importing less than it exports.

B)	not an indication of a nation's economic health.

C)	an indication that the economy is growing rapidly.

A current account deficit occurs when a country imports more than it exports, and it is not an indication of economic health. There is no requirement that the current account balance be zero, in surplus or in deficit.

A)	occurs when a country exports less than it imports.

B)	is not an indication of a nation's economic health.

C)	is an indication of significant foreign investment in the domestic market.

A current account surplus occurs when a country exports more than it imports, and it is not an indication of economic health. There is no requirement that the current account balance be zero, in surplus, or in deficit.

Under a flexible exchange rate system, a nation that offers more attractive investment opportunities than its trading partners will be likely to experience a:

A)	surplus on current account transactions.

B)	deficit on its capital account transactions.

C)	deficit on current account transactions.

Higher interest rates attract foreign investment and discourage domestic investment from leaving the country. Thus, the increased aggregate demand encourages imports, which moves the current account towards deficit.

The primary reason why the balance of payments method is difficult to implement in determining exchange rates is that:

A)	the timeliness of trade flow data tends to affect the current account more dramatically than the capital account and thus gives rise to volatility in the foreign exchange markets.

B)	foreign exchange markets affect trade flows and help determine the values of the balance of payments and not the other way around.

C)	data on trade flow elasticity is difficult to obtain and the sensitivity of such trade flows to the movement of exchange rates is not determinable.

The traditional approach to foreign exchange rate determination suggests that exchange rate adjustments are required to restore balance of payments equilibrium. This is a difficult model to implement, however. An analysis of these potential adjustments requires an estimate of trade flow elasticity in response to movements in exchange rates. Further, the model must be dynamic and complex enough to handle the impact of capital flows and the effect on the balance of payment components. Ultimately, small changes in current account flows cannot substantiate the dramatic points of inflection and volatility in the exchange rate markets, meaning an analysis of the elements of the balance of payments is not useful in explaining how exchange rates are determined.

Larry Goren, CFA, is an economist for the Federal Reserve Bank. He is interested in using a country’s balance of payments as a forecasting tool in determining exchange rates. He notices that China has a high current account balance resulting in a large surplus in its balance payments. It can be implied that:

A)	China received a great deal of income flows from the sale of trade merchandise and services and payments on its existing investments.

B)	China provided a great deal of financial assistance to other nations.

C)	China’s international currency reserve holdings have increased.

A large increase in China’s current account can only mean that it has received income from the sale of its trade merchandise (exports) and payments on its existing investments. Both remaining transactions affect the other elements of the balance of payment accounts. If China lends financial assistance to other nations, it shows up in its capital account and if its foreign currency reserves increase, it shows up in its official reserve account.