Question

Explain the relationship between a current account deficit or surplus and the flow of funds.

Short answer

Flow of funds is a part of current account surplus/deficit.

Step-by-step solution

Step1. Introduction

Imports refer to the buying of goods/services from foreign countries.

Exports refer to the selling of goods/services to foreign countries.

The international flow of funds refers to the flow of financial investments.

Current account balance refers to the trade surplus/deficit.

Step2. Explanation

The current account balance refers to the trade balance which is the net exports (exports minus imports). When a country runs a trade deficit, it imports more goods and services than it exports. Think of the US as an example--it pays USD for foreign imports, and this excess amount of USD comes back to the US in the form of investment in US financial assets (bonds, stocks, real estate, etc.).

A trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad; a trade deficit is exactly equal to the overall or net inflow of foreign investment capital from abroad.