Question

Let Y = GDP (national income).  In equilibrium, Y = C + I + G + X - M, with C + I + G represented on a domestic expenditure basis. If Y = C + I + G + X - M, then Y - (C + I + G) = X - M.  If X - M > 0, then Y > C + I + G. How, then, is balance of payments equilibrium achieved?

Answer 1

The balance of payment equilibrium is achieved when the sum of the current account balance and capital account balance is zero. The current account measures the transaction in goods and services of the domestic economy with the rest of the world (ROW). The capital account measures the transaction in assets.

Therefore, a surplus in the current account must be matched by a deficit in the capital account. A deficit in capital account means funds are flowing out of the economy. The funds flow out of the economy if savings is greater than an investment at the world interest rate.  

Savings is over domestic investment if the trade balance is greater than zero or in surplus. To prove the national savings can be written as

Therefore,

This also implies savings is greater than investment in the current situation. Thr=erefore, there is a deficit in the capital account and hence the balance of payment is in equilibrium.