4.6.5 (HL)—Financial account and exchange rate

An inward financial flow—such as foreign direct investment, portfolio investment or official borrowing—normally requires purchase of the domestic currency, shifting its demand right and supporting appreciation. An outward investment flow requires residents to supply domestic currency for foreign currency, shifting supply right and supporting depreciation. Reserve transactions can offset market pressure: a central bank selling foreign reserves buys domestic currency, while accumulating reserves supplies domestic currency. Interest-rate differentials, expected asset returns, risk and exchange-rate expectations determine the size and reversibility of flows. A financial-account surplus may finance a current-account deficit, but volatile portfolio inflows are less stable than long-term productive FDI; always identify direction, asset type and currency transaction before predicting the rate.