__________ account deficit is financed by net capital flows from the rest of the world, thus by a capital account surplus.

The blank in the sentence should be filled with "Current". So, the complete sentence is: "Current account deficit is financed by net capital flows from the rest of the world, thus by a capital account surplus."

Here's the step by step explanation:

1. The current account is a record of a country's trade in goods and services with the rest of the world. It also includes net income, such as interest and dividends, and transfers, like foreign aid, though these components make up a smaller percentage of the current account than exports and imports.

2. When a country has a current account deficit, it means it is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the difference.

3. On the other hand, the capital account is a record of the inflows and outflows of capital that directly affect a nation’s foreign assets and liabilities. It is concerned with all international trade transactions between citizens of one country and those in other countries.

4. So, when a country has a capital account surplus, it means that money is flowing into the country, but unlike a current account surplus, the inflows are in the form of investment capital, not trade.

5. Therefore, a current account deficit is financed by a capital account surplus. The country is borrowing more from foreign countries than it is lending to them, and using this capital to finance its current account deficit.