Question

Explain why, in any period, a country’s net capital inflows equal its trade deficit? Include examples.

Reference and citation, No plagiarism please (250 words)

Answer 1

Balance of payment keeps track of goods flows, financial payment transfers as well as changes in asset position between countries. The system's two biggest accounts are the capital account and the current account.

In short, a country that is running a trade deficit borrows (over production) from the rest of the world to finance consumption. Since the country that borrows receives funds from the lending countries, there is net inflow of capital. To see this from national income and product (NIPA) accounting

• C + G + I + X - M = Y
• X - M = (Y - C - G - I)

The left is net exports, and national savings on the right. A country with a trade deficit, i.e., X-M < 0, is thus met with negative savings, i.e., borrowing. Since that identity is for the economy as a whole, borrowing from other countries is the only way a country as a whole can borrow.

Two countries to consider: A and B. If suppose A imports $100 of good from B, but exports just $80 of good to B, then A is running a $20 trade deficit. The only way A can cover this deficit is to borrow $20 from B, and hence there is a $20 flow from B to A. In return, A will write B an IOU promising to pay the $20 plus interest in the future. In this scenario, B holding net foreign assets would increase by $20, which reflects a $20 capital account deficit for B, and a $20 capital account surplus for A.

Reference- Book on Balance of Payments: Theory and Economic Policy- Robert M. Stern