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    Question

    In a flexible exchange rate system, if domestic interest

    rate increases, then which of the following is true:
    A Current account worsens, capital account improves Correct Answer Incorrect Answer
    B Current account improves, capital account improves Correct Answer Incorrect Answer
    C Current account worsens, capital account worsens Correct Answer Incorrect Answer
    D Current account improves, capital account worsens Correct Answer Incorrect Answer
    E None of these Correct Answer Incorrect Answer

    Solution

    In a flexible exchange rate system, if domestic interest rate increases, it is going to lead to capital inflow in the country because rate of return has increased. As a result, there is capital account surplus. Also, this will increase AD and output which means import demand increases. Therefore, current account worsens.  

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