Since imports increase with increases in either income or the real exchange rate, we can expect to observe negative correlations between the current account balance and both incomes and real exchange rates.
True or False?
The answer is false . The observed current account balance is an equilibrium level determined by the interaction of desired savings and investment with desired imports and exports---the movements in income and/or the real exchange rate preserve equilibrium, bringing the desired net capital outflow into equality with the desired current account balance. The directions of the observed relationships between the current account balance and the levels of income and the exchange rate will depend on whether the predominant shocks generating the equilibrium movements in output, the real exchange rate and the current account balance are shocks to desired savings minus investment or desired exports minus imports.
If there are big shifts in desired savings and investment and small shifts in desired exports and imports, the equilibrium real exchange and current account balance will be negatively correlated if real exchange rate adjustments bring about equilibrium and the current account balance will be negatively correlated with income and employment if they adjust to bring about equilibrium. On the other hand, if there are big shifts in exports and imports relative to savings and investment, it is possible that the equilibrium real exchange rate and current account, or output and employment and the current account balance, could be positively correlated.
If both the real exchange rate and real income and employment adjust to maintain equilibrium, the correlations between the observed current account balance and the observed levels of real income and the real exchange rate can still be either positive or negative, depending on the nature of the shocks driving the equilibrium.