Question

Suppose foreigners lose confidence in the U.S. economy and therefore move to decrease their investments in the United States. Also suppose that the U.S. currently runs a current account deficit.

True or False: The change in the interest earned by foreigners on these investments would decrease the current account deficit.

True

False

True or False: This decrease of foreign investments in the U.S. would decrease demand for dollars and cause the dollar to depreciate.

True

False

Answer 1

Answer 1. The change in the interest earned by foreigners on these investments would decrease the current account deficit.

False

Reason: The impact of an increase in interest rates on the current account balance of payments is uncertain. There are a few different implications. Interest rates affect both consumer spending (imports) and have an affect on the exchange rate (which affects the price of exports/imports) The effect of interest rates on the current account depends on which factor proves the most powerful. It is not possible to say definitely whether the current account will improve or worsen.

Answer 2. This decrease of foreign investments in the U.S. would decrease demand for dollars and cause the dollar to depreciate.

True

Lower real interest rates tend to lead to an depreciation of the currency. This is because low-interest rates mean saving in U.S. gives a lower return. Therefore investors often move funds to countries with higher interest rates and remove them from U.S.