Can someone please explain these three approaches to me? I got confused while answering this question ….
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The flow supply/demand channel is based on a fairly simple model that focuses on the fact that purchases and sales of internationally traded goods and services require the exchange of domestic and foreign currencies in order to arrange payment for those goods and services. Hence, countries with persistent current account surpluses should see their currencies appreciate over time, and countries with persistent current account deficits should see their currencies depreciate over time.
Under the Portfolio Balance Approach, Current account imbalances shift financial wealth from deficit nations to surplus nations. Countries with trade deficits will finance their trade with increased borrowing. This behaviour may lead to shifts in global asset preferences, which in turn could influence the path of exchange rates. This is what happened in the case study.
According to the Debt Sustainability mechanism, there should be some upper limit on the ability of countries to run persistently large current account deficits. If a country runs a large and persistent current account deficit over time, eventually it will experience an untenable rise in debt owed to foreign investors. If such investors believe that the deficit country’s external debt is rising to unsustainable levels, they are likely to reason that a major depreciation of the deficit country’s currency will be required at some point to ensure that the current account deficit narrows significantly and that the external debt stabilizes at a level deemed sustainable