Prof. Bryson Marriott School

1. A Note on The Current Account:Why the large current account deficit of the United States is not a bad thing. Prof. Bryson Marriott School

2. 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.

3. 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

4. The Current Account (CA) • So the CA balance = If, net foreign investment S = Id + If If = S - Id, or CA = S – Id Also, CA = the domestic production of goods and services – total expenditures on goods and services.

5. 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.

6. Y = E + (X – M) CA = X – M = Y – E • In Summary, Y – E = S – Id = X – M = If

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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).

13. 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.

14. 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.