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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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