Capital Account

Definition

The capital account is a record of a country's net investment and financial transactions with the rest of the world. It tracks the flow of capital, both physical and financial, between a country and its foreign counterparts over a given period of time.

5 Must Know Facts For Your Next Test

1. The capital account records the net change in ownership of national assets, such as stocks, bonds, real estate, and other financial instruments.
2. A surplus in the capital account indicates a net inflow of foreign investment, while a deficit indicates a net outflow of investment.
3. The capital account is closely linked to the current account, as a country's current account deficit is typically financed by a surplus in the capital account.
4. Exchange rate policies can significantly impact the capital account, as changes in the relative value of a currency can affect the flow of foreign investment.
5. Fiscal policy, such as government spending and taxation, can also influence the capital account by affecting the attractiveness of a country's assets to foreign investors.

Review Questions

• Explain how the capital account is connected to the trade balance and flows of financial capital between countries.
  • The capital account records the net flow of investment and financial capital between a country and the rest of the world. A country with a trade deficit in its current account will typically finance that deficit by attracting foreign investment, which is reflected as a surplus in the capital account. Conversely, a country with a trade surplus may see an outflow of capital, resulting in a deficit in the capital account. The relationship between the current account and the capital account is known as the fundamental balance of payments identity, where the sum of the current account and the capital account must equal zero.
• Describe how exchange rate policies can impact the capital account and a country's overall balance of payments.
  • Exchange rate policies can have a significant impact on the capital account. For example, a country that maintains a fixed or pegged exchange rate may attract more foreign investment, as investors perceive the currency as more stable. This would result in a surplus in the capital account. Conversely, a country with a floating exchange rate may experience more volatility in the capital account, as investors respond to changes in the relative value of the currency. Exchange rate policies can also affect the current account, as they influence the price competitiveness of a country's exports and imports, which in turn affects the trade balance and the overall balance of payments.
• Analyze how a country's fiscal policy, such as government spending and taxation, can influence the capital account and the overall balance of payments.
  • A country's fiscal policy can have a significant impact on its capital account and balance of payments. Expansionary fiscal policies, such as increased government spending or tax cuts, can lead to a larger budget deficit, which may need to be financed by borrowing from foreign investors. This would result in a surplus in the capital account as foreign capital flows into the country. Conversely, contractionary fiscal policies, such as spending cuts or tax increases, may reduce the need for foreign financing, leading to a deficit in the capital account as domestic savings are used to fund investment. The impact of fiscal policy on the capital account can also affect the exchange rate, as changes in the demand for a country's currency can influence the overall balance of payments.

Related terms

Current Account: The current account is a record of a country's international trade in goods and services, as well as income and transfer payments.

Balance of Payments: The balance of payments is a statement that summarizes a country's economic transactions with the rest of the world, including the current account and the capital account.

Exchange Rate: The exchange rate is the price of one currency in terms of another, which determines the value of a country's currency relative to other currencies and affects the flow of capital and trade.