Questions: The Current Account Balance

Question 1

A developing country runs a large current account deficit, financed mainly by foreign investment in new manufacturing facilities and infrastructure. An economist argues this is not cause for alarm. Which reasoning best supports this view?

• A. Current account deficits are always healthy because they indicate strong consumer demand
• B. The deficit reflects excess investment over saving — if foreign funds are financing productive capital formation, future growth may more than offset the accumulated liability
• C. Since the current and capital accounts sum to zero, the deficit will automatically reverse without policy intervention
• D. Developing countries are not subject to normal balance-of-payments constraints

Answer: (B)

The current account balance equals S − I (saving minus investment). A deficit means investment exceeds saving — the country is borrowing to invest. Whether this is sustainable depends on what the borrowing finances: productive capital that generates future returns can service foreign liabilities; consumption-financed borrowing is harder to sustain. Deficits are not inherently dangerous — context determines the risk.

Question 2

If the United States runs a current account deficit of $800 billion in a given year, what must be true about its balance of payments?

• A. The U.S. government must have a federal budget deficit of at least $800 billion
• B. The U.S. capital and financial account must show a surplus of approximately $800 billion — foreigners are accumulating $800 billion in net claims on U.S. assets
• C. U.S. GDP must have declined by $800 billion that year
• D. The Federal Reserve must have intervened to purchase $800 billion in foreign currency

Answer: (B)

The balance-of-payments identity requires the current account and the capital and financial account to sum to zero. A current account deficit must be exactly matched by a capital account surplus — foreigners are lending to, investing in, or otherwise acquiring claims on the U.S. The deficit is literally financed by these capital inflows; it doesn't arise from nowhere.

Question 3

A persistent current account deficit reliably indicates that a country is living beyond its means and will inevitably face a balance-of-payments crisis.

• T. True
• F. False

Answer: False

The U.S. has run current account deficits for decades without crisis because foreigners value the liquidity and safety of dollar-denominated assets — the 'exorbitant privilege' of reserve currency status. Whether a deficit is sustainable depends on what it finances, the country's productivity growth, and the confidence of foreign creditors. Persistent deficits are a risk factor, not a verdict.

Question 4

A country's current account deficit equals the excess of domestic investment over domestic saving — it represents the share of investment financed by borrowing from abroad.

• T. True
• F. False

Answer: True

This is the national income accounting identity: CA = S − I. When domestic investment exceeds domestic saving, the gap must be filled by net borrowing from abroad — which shows up as a current account deficit. This reframes the question 'Is the deficit a problem?' as 'Is the excess of investment over saving a problem?' — which depends on whether the investment is productive.

Question 5

Why does a U.S. current account deficit necessarily mean that foreigners are accumulating claims on U.S. assets?

Model answer: The balance-of-payments identity requires the current account and capital and financial account to sum to zero. When Americans buy more from the rest of the world than they sell (current account deficit), the dollar difference flows back as foreign investment in U.S. assets — Treasury bonds, real estate, equities, bank deposits. Running a deficit is equivalent to saying: the rest of the world is net lending to or investing in the U.S.

This accounting identity is exact, not approximate. Every dollar of current account deficit is matched by a dollar of capital account surplus. The question isn't whether foreigners accumulate claims — they must — but whether the assets they're accumulating are productive enough to sustain the liability over time. The U.S.'s reserve currency status makes this easier; countries without it face harder constraints.