Transcript A Note on The Current Account

A Note on The Current Account:
Why the large current account
deficit of the United States is not
a bad thing.
The Current Account (CA)

All the things exchanged between nations
include goods, services, income, gifts and
financial assets. If all credits = all debits, then
the balance on goods, services, income and
gifts, i.e., the CA surplus must = net foreign
investment.
The Current Account (CA)

The CA balance = If, net foreign investment,
or, CA = If

With national savings, S, we can invest in
domestic capital formation, invest abroad, If
So, S = Id + If
The Current Account (CA)

So the CA balance = If, net foreign investment
S = I d + If
If = S - Id, or
CA = S – Id
Also, CA = the domestic production of goods
and services – total expenditures on goods and
services.
Starting from Basic Macro
Y = C + Id + G + X – M
 E (Expenditures or “Absorption”)
E = C + Id + G,
These three categories all include purchases of
imports, but still reflect demand for domestic
goods.

Y = E + (X – M)
CA = X – M = Y – E

In Summary,
Y – E = S – Id = X – M = If
The Implications
So what does a current account deficit
mean, going from these three basic identities?
1. The country has negative net foreign
investment and is a net borrower from the rest
of the world.
2. The country is saving less than it is
investing domestically.
3. The country is producing less than it is
spending on goods and services.
The Implications
One can think differently about causation.
Some think that our extravagant consumption
has to be financed by inflows of funds for
foreign investment into the US economy.
We can also think that our strong domestic
economy provides a safe and profitable haven
for foreign investment funds. That surplus in
the capital account has to be offset (in terms of
accounting relationships) by a deficit in the
current account.
The Implications
When foreigners invest here, they gain profits
and their assets are secure. Those investment
need merely to continue to generate a positive
yield. We should therefore avoid inflation and
keep our economy strong, which it currently is.
The surplus in the capital account permits the
world to find export markets in the US. We
have the foreign exchange coming in to
purchase an excess of imports, which benefits
our consumers and foreign exporters.
The Key Accounting Definitions

Current-Account Balance + Capital-Account
Balance + Official Settlements Balance ≡ 0

The Official Settlements Balance reports net
changes in foreign exchange reserves and
official government borrowing.


Through their autonomous transactions,
businesses and private parties can produce a
balance of payments deficit (an excess of
autonomous debits over autonomous credits)
or surplus.
The government balances the accounts (in the
non-trivial sense) through compensatory
transactions.

We started with
Current-Account Balance + Capital-Account
Balance + Official Settlements Balance ≡ 0,
which can be rewritten as
CA + KA = - Official Settlements Balance
The government must assure a balance because a
country’s total receipts from foreigners must
equal its total payments to foreigners (in the
double=entry bookkeeping sense).

We can rewrite the last equation as the explicit
relationship between autonomous and
accomodating transactions:
Balance on autonomous transactions +
Balance on accomodating transactions = 0
If we have fixed exchange rates, the government
must take care of a deficit from its foreign
exchange reserves, get IMF help, or incur debt
to keep the value of its currency from falling.

We can rewrite the last equation as the explicit
relationship between autonomous and
accomodating transactions:
Balance on autonomous transactions +
Balance on accomodating transactions = 0
If we have a flexible exchange rate, the
adjustment can occur automatically. In foreign
exchange markets the currency would
depreciate to eliminate a deficit.