Notes

B is correct. The mechanism referred to by Brannigan is the portfolio balance channel. Current account imbalances shift financial wealth from deficit nations to surplus nations. Over time, this may lead to shifts in global asset preferences, which, in turn, could affect the path of exchange rates and hence optimal portfolio holdings. Attempts by the Trundool Republic to reduce USD holdings to desired levels could then have a profound negative impact on the USD’s value.

A is incorrect. According to the debt sustainability channel, there should be a limit on the ability of countries to run persistently wide current account deficits. For deficit countries, rising net external debt levels as a percentage of GDP should result in downward revisions of the currency’s long-run equilibrium value. For surplus countries, rising net external asset levels as a percentage of GDP should give rise to upward revisions of the currency’s long-run equilibrium value.

C is incorrect. The flow supply/demand channel is based on a model whereby purchases and sales of internationally traded goods and services require the exchange of domestic and foreign currencies in order to arrange payment for the goods and services. We would expect that countries with persistent current account surpluses would see their currencies appreciate over time and vice versa.