Answer to Question #102582 in Microeconomics for prashodhan Dhakal

Question

A deficit on the balance on current account will impose severe constraints upon domestic economic policies.explain and illustrate this

Answer 1

The current account deficit reflects an increase in a country's debt to other countries. When a country is faced with a current account deficit, it is obliged to pay it.

The current account deficit of the balance of payments can be financed:

• by selling part of the assets to foreigners, that is, by investing foreign capital in the economy of a given country in the form of direct or portfolio investments;

• using foreign loans from foreign banks, governments or international organizations;

• by reducing official foreign exchange reserves held by the Central Bank.

If the balance of official settlements is reduced in deficit, debt is repaid by the Central Bank by reducing official reserves of foreign currency (if the Central Bank refrains from adjusting the exchange rate).