The United States runs a current account deficit of $700 billion in a given year. Which of the following must be true by accounting identity?
AThe US government must reduce spending by $700 billion the following year to restore balance
BForeign entities must have acquired a net $700 billion in US assets during that year
CThe US dollar must depreciate by an equivalent amount to restore balance
DUS exports will automatically increase by $700 billion in the next period
The balance of payments always sums to zero by accounting identity. A $700 billion current account deficit means the US received $700 billion more in goods, services, and income from abroad than it sent out. The other side of every one of those transactions is a financial flow: foreigners acquiring US assets (Treasuries, equity, real estate, etc.). The capital account surplus exactly equals the current account deficit — this is arithmetic, not policy choice. No automatic adjustment in government spending, exchange rates, or future exports is required by the identity itself.
Question 2 Multiple Choice
A developing country's current account deficit doubled last year, driven entirely by a surge of foreign technology companies building factories there. How should an economist interpret this?
AThe country is losing international competitiveness and faces an imminent balance-of-payments crisis
BThe country is consuming beyond its means and must increase domestic saving to close the gap
CThe deficit reflects strong foreign direct investment inflows, which appear as a capital account surplus of equal size
DThe country must be running a fiscal deficit, since trade deficits require government borrowing
The current account deficit here is driven by productive foreign direct investment — foreign companies building real capital assets. This is fundamentally different from a deficit caused by excessive consumption financed by borrowing. The capital account surplus (FDI inflows) exactly offsets the current account deficit by identity. A deficit driven by investment inflows may reflect economic attractiveness, not weakness. The normative question requires knowing what drives the deficit, not just its size.
Question 3 True / False
A country running a current account deficit is necessarily living beyond its means and heading toward a financial crisis.
TTrue
FFalse
Answer: False
The sustainability of a current account deficit depends on what drives it and whether foreign investors continue willing to hold the country's assets. The US has run large, persistent current account deficits for decades without a crisis, partly because the dollar's reserve currency status maintains foreign demand for US assets. A deficit driven by high productive investment is very different from one driven by low saving or excessive consumption. The deficit label alone tells you nothing about sustainability — the source and financing structure matter.
Question 4 True / False
If a country's current account moves from a $200 billion deficit to a $100 billion surplus, its capital account must simultaneously shift from a $200 billion surplus to a $100 billion deficit.
TTrue
FFalse
Answer: True
By accounting identity, the current account balance and the capital account balance sum to zero. A swing of $300 billion in the current account (from −$200B to +$100B) requires an equal and opposite swing in the capital account (from +$200B to −$100B). This is double-entry bookkeeping at the national level: every international transaction is recorded as a credit in one account and a debit in another, so the two accounts must always offset each other exactly.
Question 5 Short Answer
Why does the balance of payments always 'balance,' and what is the economic meaning of that accounting identity?
Think about your answer, then reveal below.
Model answer: The balance of payments always sums to zero because it is a double-entry accounting system: every international transaction creates two entries of equal and opposite sign, one in the current account and one in the capital/financial account. Economically, this means a current account deficit (importing more than you export) must be financed by an equal capital account surplus — foreigners are acquiring your assets in return. You cannot receive more goods and services from abroad than you send out without simultaneously giving foreigners something of equal value.
The identity has a powerful implication: a current account deficit is never 'unfinanced.' It always comes with a capital inflow. The real analytical question is what type of capital is flowing in (productive FDI vs. short-term portfolio flows vs. reserve accumulation), how long it can continue, and whether the country can service the resulting external liabilities through future earnings. The arithmetic balance describes what happened; the economic analysis determines whether it is sustainable and what it means for policy.