Question

(Related to Solved Problem 29.1 on page 1034 ) An editorial in the Wall Street Journal in 2017 made the following observation: "When the U.S. has a current- account deficit it has to have a capital-account surplus of the same amount." Briefly explain whether you agree with this observation.

Short answer

Yes, the statement is accurate. When a country has a current-account deficit, it generally indicates that the country is spending more than it is earning. To balance this, it would need to have a capital-account surplus, thereby attracting foreign capital to fund the deficit. So the two accounts should theoretically balance to zero.

Step-by-step solution

Understand the Current Account

The current account of a country's balance of payments includes transactions in goods, services, income, and current transfers between residents and non-residents. When a country has a current-account deficit, it means that the country is importing more goods, services, and capital than it is exporting.

Understand the Capital Account

The capital account, on the other hand, includes all transactions that involve financial assets and liabilities, and that take place between residents and non-residents. When the account has a surplus, it means the country is gaining more capital from non-residents for a total value higher than it is sending capital abroad.

Relate the Two Accounts

When a country has a current-account deficit, it is essentially spending more resources than it is gaining. To fund this deficit, it will need to have an inflow of foreign capital, i.e., a capital-account surplus. This relationship is referred to as the balance of payments: the sum of the current and capital accounts should theoretically be zero.\[Current Account + Capital Account = 0\] Hence, if a country has a current-account deficit, it should generally have a capital-account surplus of the same amount to balance it out.

Key concepts

Understanding Current Account Deficit

A current account deficit occurs when a country's total imports of goods, services, and transfers exceed its total exports. It indicates that the nation is sending more money overseas compared to the money coming in from sale of its goods and services. This can happen due to high levels of consumer spending on foreign goods or services, and can also include payments made for income from foreign investments.

A current account deficit isn't necessarily a bad thing. Depending on circumstances, it could mean that a country is investing in its economy for future growth. However, long-term deficits might become problematic if they lead to unsustainable levels of foreign debt.

Common causes of a current account deficit include:

• Inflation making products less competitive.
• Strong domestic currency making imports cheaper and exports more expensive.
• Economic growth leading to increased consumption of imported goods.

Explaining Capital Account Surplus

The capital account records all transactions that involve the transfer of ownership of assets between a country and the rest of the world. When a country has a capital account surplus, it means there is more investment coming into the country from foreign investors compared to the money it is investing abroad.

This happens when foreign investors buy domestic assets like stocks, bonds, or real estate. This inflow of capital helps to balance out a current account deficit. Essentially, when a country is importing more than it exports, it needs to compensate by receiving investment to balance its books.

The capital account surplus can result from:

• High interest rates that attract foreign investment.
• Positive economic outlook encouraging more investment.
• Government policies making investments attractive to foreigners.

Role of Foreign Capital Inflow

Foreign capital inflow is crucial to balancing a country's current account deficit. It involves the entrance of money from foreign entities for the purpose of investment and financing. This inflow can be in various forms like foreign direct investment (FDI), or by purchasing government and corporate securities.

A healthy inflow of foreign capital allows a country to fund its deficit without dipping into its reserves or resorting to austerity measures. It enables a nation to maintain liquidity and support its economic activities.

Foreign capital inflows may lead to:

• Increased economic growth by providing needed capital.
• May support currency stability by ensuring plenty of foreign currency reserves.
• Help improve infrastructure and development projects through foreign investment.