Question

Describe the components of the Balance of Payments.

a. Why do the Current Account and Financial Accounts must balance? Use the case of China and the United State to make your case.

Answer 1

Current account basically deals with the export and import of goods and services and the deficit or surplus from the trade account is moved to the financial account where it is either borrowed to meet the deficit or the surplus is invested. Let’s take the example of the US and China, it is normally that the US has current account deficit with China because China export a significant amount of goods to the US market so China has surplus in the current account. When US has deficit in the current account, that deficit will be moved to the financial account and it will have to borrow to meet the deficit, in a theoretical world where there are only two countries US will borrow from China to meet its financial account deficit and since China has current account surplus, that surplus will be moved to the financial account and china will invest that surplus, so at the end the total current account and financial account of the world will balance out.