Question

Consider a country that has foreign assets and liabilities denominated in different currencies. In particular, assume that all the country's assets are denominated in the foreign currency while all its liabilities are denominated in the domestic currency. Derive the country's flow budget constraint. What would be the effect of a depreciation of the domestic currency on the country's current account?

Answer 1

For General discussion, Asset and liabilities denominated in different currencies refers to the holding of the Asset in the form of Foreign exchange reserves. Such reserves consists of bank deposits, treasury bills and bonds which ensures the Federal Bank of USA for backing up the fund. For example China is the country which have large volume of foreign currency. The rate of Balance of payments has shoots to very high level in China's Market. Nearly $3 million value of foreign exchange reserves are kept as asset denomination of US Dollar. Like wise Russia and Dubai has huge volume of foreign exchange reserves of US Dollar. Let us discuss the country;s flow budget constraint in US country (for example) briefly.

Depreciation of the value of the local currency decreases the quantity of quantity of imports and increases the quantity of exports. Thus Import products will be expensive in nature. But there will be considerable fall in the price of export products. It will improve the current deficit. But in contrary, when the appreciation of the value of the local currency increases the quantity of imports and decreases the quantity of Exports. The price level of the exports products increases and which will be the strong reason for earning foreign reserves for their own country.  Budget Constraints will begin only when such Balance of payments crisis occurs. When the consumer spending decreases due to the increase in the import products, then again the account deficit gap will widen further.

Effects of Depreciation of the domestic currency occupies the critical position when the price of the import products which are inelastic in nature. This is due to expensive rate of import products. This will turn reduce the purchasing parity of the consumers. This will not bridge the gap between the Devaluation of the foreign exchange reserves. Profit Margins will be reduce by exchanging through deficit in the current account of the balance of payments. Finally current account of the local domestic import market situation can improve when the appreciation is followed.