IAI Actuarial Core Principles · Business Economics · Globalisation and multinational business
India runs a persistent current account deficit financed mainly by volatile portfolio inflows. Global risk aversion suddenly rises and foreign investors withdraw funds rapidly. Assuming a floating exchange rate and no central bank action, which outcome is most consistent with economic theory?
The rupee depreciates, raising import prices and possibly domestic inflation. Portfolio outflows increase demand for foreign currency and reduce demand for rupees, so under a floating rate the currency weakens, making imports costlier while exports become cheaper.
- AThe rupee depreciates, raising import prices and potentially domestic inflationCorrect
- BThe rupee appreciates, because the deficit shrinks automatically
- CThe rupee is unchanged, because floating rates ignore capital flows
- DThe current account deficit widens immediately because exports become dearer
- Domestic interest rates fall as foreign capital leaves, attracting new inflows at once
Explanation
Capital outflows raise demand for foreign currency and reduce demand for rupees, so the rupee depreciates. Dearer imports can feed domestic inflation. Exports become cheaper in foreign terms, not dearer, so the deficit option D is wrong. Outflows tend to raise, not lower, domestic yields.
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