Question

Starting from a position where the nation's money demand equals the money supply and its balance of payments is in equilibrium, economic theory suggests that the nation's balance of payments would move into a surplus position if there occurred in the nation:

a. A decrease in the money demand

b. An increase in the money supply

c. An increase in the money demand

d. None of the above

Starting from a position where the nation's money demand equals the money supply, and its balance of payments is in equilibrium, economic theory suggests that the nation's balance of payments would move into a deficit position if there occurred in the nation a:

a. Increase in the money demand

b. Decrease in the money supply

c. Decrease in the money demand

d. None of the above

Answer 1

Answer to the first one: c) An increase in money demand

If money demand increases, while money supply remains unchanged, interest rates will increase. As interest rates increase, capital inflow from abroad would increase. As capital inflow from abroad increases capital account surplus increases. Because of this, the Balance of Payment surplus increases.

Answer to the second one: c) Decrease in money demand

The effect will be the exact opposite to that in the previous question. If money demand decreases, interest rates will fall. This will result in capital outflow from the country (to another one where interest rates are higher). This will worsen the capital account balance and increase the capital account deficit. As a result the Balance of Payment deficit would increase.