The current account surplus is
A) an increasing function of disposable income and an increasing function of the real exchange rate.
B) a decreasing function of disposable income and a decreasing function of the real exchange rate.
C) a decreasing function of disposable income and an increasing function of the real exchange rate.
D) only a decreasing function of disposable income.
E) only an increasing function of the real exchange rate.

Question

Quizplus · Accepted Answer

The current account surplus is composed of two main components: the trade balance (exports minus imports) and net income from abroad. Disposable income affects both exports and imports, but in opposite directions. An increase in disposable income leads to an increase in imports (because people have more money to spend), while it also leads to an increase in exports (because people are able to afford more foreign goods). Since the effect of income on imports is typically stronger than the effect on exports, an increase in income leads to a decrease in the trade balance and therefore a decrease in the current account surplus.

The real exchange rate affects the trade balance as well. A depreciation of the domestic currency (an increase in the real exchange rate) makes exports cheaper and imports more expensive, which tends to increase the trade balance and therefore increase the current account surplus.

So, the current account surplus is a decreasing function of disposable income and an increasing function of the real exchange rate, which means that the correct answer is C.

The Current Account Surplus Is