Current Account - Explained
What is a Current Account?
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Table of ContentsWhat is a Current Account?How is the Current Account Used?Balance of Accounts International TradingSub-balances of the current account Academic Research for Current Account
What is a Current Account?
Current account refers to the summary of all transactions (including imports and exports) involving goods and services which are related to income generation.
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How is the Current Account Used?
A current account balance refers to an accounting document which forms part of the payment balance structure. It is generally seen as an economic indicator of how a country economically associates with other countries or regions. Unlike the balance of capital and financial balances that outline financial assets and investment accounts, current account balance breaks down the purchase and sales that a country makes on goods and services with other countries. In other words, the current account balance provides a summary of all imports and exports of goods and services that a country makes, thus, relating to national income generation.
Balance of Accounts International Trading
Current account balance refers to the country's balance of trade and reflects the level of imports and exports of goods and services of a nation and whether there is an equilibrium between the two. A current account is also concerned with measuring the movement of money in the international arena.
The current account is termed to be well balanced if those living in the country have enough money to engage in buying activities in the country. By those, we mean all businesses, government, and the people. The source of such capital consists of all the savings and income. Purchases entail all that is spent by final consumers, government expenditure on infrastructure and for the growth of businessesOne major objective of most countries is to engage in more exports that they import so that they can accumulate a lot of money. This is commonly referred to as surplus in trading to mean the country will earn more money. In some cases, governments, individuals and businesses may experience trade deficit when they import more products as opposed to those that they export.
The implication of this is that they receive less money from these foreign trade partners and give them more money.The current account forms part and parcel of the nation's balance of payments. The other two components are the financial accounts and capital accounts.
The Four Current Account Components
The Bureau of Economic Analysis classifies the current account into four parts namely net income, asset income, trade and direct transfers of capital.
Trade: Trading in various products and commodities are the major aspects of the current account. As a result, the trade deficit has the capacity to result in a current account deficit. This is true due to the fact that a deficit in products and services has the capacity to offset surplus in direct transfers, asset income and net income.
Net Income: This is the money received by those residing in a country less the money paid to foreigners. This money is mostly gotten from two origins. The first income emanates from foreign assets belonging to the businesses and the residents in a country. These entail dividends and interests earned from foreign investments. The second origin is from citizens working abroadMoney paid to foreigners is usually the same as the first level of payment being dividends and interests earned by foreign internationals who have assets in the nation. Another category is the wages earned by foreigners who are employees in that nation.The net income is said to be positive if the money earned by the country's businesses, government and individuals from foreign entities exceeds the amount of money paid to them. On the other hand, a deficit is brought about if the sum received is less than the amount paid out.
Direct Transfers: This is composed of all the contributions from foreign workers to their home nation, for instance, Mexico earns up to the tune 25 billion dollars from overseas. As far as there are no specific figures, there is a possibility that most of the amount comes from immigrants staying in the United States of America. The current head of state Mr. Donald Trump during his campaigns had alleged that he was going to cancel those payments in case Mexico did not remit the money for the construction of the border wall that he had proposed. He was going to achieve this by the use of the Patriot Act to do away with the payments in the Western Union. This was going to decline Mexicos economic output by 1% and double its current account deficit of 29$ billion.Direct Transfers entails foreign direct investments too. An example is the 22 billion dollars that the United States channels towards annual foreign aid. This in result increases America's current account deficit from the present $502 billion which is the largest globally.The third avenue of direct transfer is foreign direct investments. This occurs when businesses of a country of or residents open investment in other countries. For it to qualify as a Foreign Direct Investment, it must contain at least 10 percent of the foreign firms capital.The fourth means of direct transfer are loans given to foreigners by banks.
Asset Income: This consists of growth or decline in bank deposits, government and central bank reserves, real estate and securities. For instance, if the assets of a nation perform well, the earnings from the assets will be more. Normally, the assets belonging to the United States foreigners get deducted from the asset earning. They entail the following:
- A nations obligation to foreigners like deposits belonging to overseas residents at the banks in the country.
- Loans given to local banks by overseas banks.
- Overseas private buying of a nations government bonds, like the U.S. Treasury securities.
- Disposing of such securities like bonds and stocks through selling to foreigners by the country.
- A foreign direct investment like equities, debt and reinvested earnings.
- Debts belonging to foreigners.
- Assets retained by governments abroad.
- Net shipments of the country's currency to foreign governments
Sub-balances of the current account
According to the VI Manual of the Balance of Payments and the International Investment Position of the IMF, current account balance constitutes four sub-scales: Commercial balance: This balance includes both imports and exports of merchandise. If exports exceed imports, a country is considered to be in a surplus situation. On the other hand, if imports exceed exports, then the country is considered to have a trade deficit. Services balance: This includes operations that are conducted using intangible products such as services offered to other companies, travel services, transport services, and insurance services. Income balance: This balance includes all operations that relate to work remuneration. For instance, wages for work done for a foreign company. Additionally, the income from foreign investment is included including loan interests and dividends. Current transfers balance: This balance entails current transactions which do not need counterparts. The balance includes personal foreign remittances for individuals who have their residence in another country, donations, and aids from the public or private sector.
Academic Research for Current Account
- The global saving glut and the US current account deficit, Bernanke, B. (2005). (No. 77). Board of Governors of the Federal Reserve System (US). This is a speech delivered on March, 10, 2005 at Sandridge Lecture, Virginia Association of Economics, Richmond Virginia and on April 14, 2005 at the Homer Jones Lecture, St, Louis, Missouri.
- Exchange rates and the current account, Dornbusch, R., & Fischer, S. (1980). The American Economic Review, 70(5), 960-971. This paper outlines a model of exchange rate determination which integrates roles of expectations, relative prices, and assets market, and emphasizes the existing correlation between the exchange rate behavior and current account. The study draws its arguments from recent studies related to exchange rate theory. To address the objective, the authors departed from the one-commodity model and instead consider the analyzed country to be producing differentiated products whose global price is endogenous. The authors further draw their interpretations from the work of Fischer, Olivier Blanchard, and Wilson in order to understand the effects of anticipated future disturbances.
- The current account in the eacroeconomic adjustment process, Sachs, J. D. (1981). This article provides an analysis of current account balance using a dynamic model. Considering optimizing agents, the authors have stressed on 2 analytical ideas. First, the current account balance of an economy depends on future economic trends as in the case of current economic environment. Secondly, temporary disturbances in the economy results in permanent effects, by changing the whole future path of international indebtedness of the economy.
- Testing intertemporal budget constraints: Theory and applications to US federal budget and current account deficits, Trehan, B., & Walsh, C. E. (1991). Journal of Money, Credit and banking, 23(2), 206-223. This article provides an overview of intertemporal constraints by analyzing the sustainability of the debt/deficit of the Japanese government. The authors first provide an overview of the approaches and findings of sustainable analysis then introduces arguments by Hoshi and Ito that predict the share of foreign investors in JGBs could exceed the domestic ownership. Further, the authors discusses the problem facing the JGB market based on Onji et al.s findings that examine how withdrawal from JGBs by a government could roil the market.
- The unsustainable US current account position revisited, Obstfeld, M., & Rogoff, K. (2007). In G7 current account imbalances: Sustainability and adjustment (pp. 339-376). University of Chicago Press. This article explores the current unsustainable current account position in the US. The authors claim that by considering the global equilibrium ramifications of the current account deficit of the US, the potential collapse of the dollar is considerably larger compared to the previous estimates. Obstfelt and Rogoff also project this situation asserting that the impact would be 30% or even higher. The article reveals that the deepening of the global capital market has accelerated over the past years and this may have helped the US to a record breaking string of deficits. However, the authors note that the global capital market is deepening, and this is the only way to mitigate the dollar decline which would eventually occur after the global current account adjustment. A model is used by the authors to dispel common misconceptions regarding the shifts needed to close the current account imbalance of the US.
- Defaultable debt, interest rates and the current account, Aguiar, M., & Gopinath, G. (2006). Journal of international Economics, 69(1), 64-83. This article discusses the concepts of current account balance, interest rates, and defaultable debt. Aguiar and Gopinath assert that world capital markets have witnessed massive sovereign defaults severally. Thus, they develop a quantitative debt and default model which they use to market 4 empirical regularities in regard to emerging markets. These include defaults occur in equilibrium, net exports being countercyclical, interest rates being countercyclical, and positive correlation between interest rates and current account. The authors further highlight the purpose of a stochastic trend on emerging markets.
- The terms of trade and the current account: The Harberger-Laursen-Metzler effect, Svensson, L. E., & Razin, A. (1983). Journal of political Economy, 91(1), 97-125. This paper investigates the possible impact of terms-of-trade changes on the spending and current account balance of a small country. The authors have assumed that optimizing behavior within an intertemporal framework has perfect international capital mobility. Using the Harberger-Laursen-Metzler effect model, the authors analyze the possible changes in a countrys terms-of-trade. They find that the deterioration of temporary terms-of-trade implies a deteriorating trade balance, and vice versa.
- The intertemporal approach to the current account, Obstfeld, M., & Rogoff, K. (1995). Handbook of international economics, 3, 1731-1799. This paper explores the intertemporal approach to understand current account balance of a capital market. The authors define the current account balance of a country to be an increase in the residents claims on foreign outputs or incomes, less the increase in similar foreign-owned claims on domestic output or income. The paper surveys the empirical work and theory of the intertemporal approach in reference to the current account in the 1980s.
- The US current account and the dollar, Blanchard, O., Giavazzi, F., & Sa, F. (2005). (No. w11137). National Bureau of Economic Research. This paper explores the forces impacting the US current account deficits. The highlighted forces include the increase in foreign goods demand in the US, and an increase in foreign demand of US assets. These forces, according to the authors, have increasingly impacted the current account deficits since the mid-1990s. This trend has been accompanied by an appreciation of the real dollar until 2001 when the real depreciation began. The authors, therefore, attempt to analyze these issues using a simple model of exchange rate as well as a current account determination model based on the imperfect substitutability in the asset and goods market.
- Global current account imbalances and exchange rate adjustments, Obstfeld, M., & Rogoff, K. S. (2005). Brookings papers on economic activity, 2005(1), 67-123. This article explores the imbalances of the global current account and exchange rate adjustments. The problem addressed by the authors is the current account deficit and the potentially shape movements in exchange rates witnessed the US market. Obtfeld and Rogoff explain that the country is running at about 6% deficit in GDP. Incredibly, the deficit soaks up 75% of the combined surpluses of Japan, China, and Germany. It is further argued that the speed at which the current account returns towards balance in the use is allocated across Asia and Europe.
- Current account reversals and currency crises: empirical regularities, Ferretti, G. M. M., & Razin, A. (2000). (pp. 285-323). University of Chicago Press. This paper describes the existing empirical regularities surrounding current account reversals and currency crises. The authors study the sharp reductions in the deficits of current account and large depreciations in the exchange rates of low and middle-income countries. Two factors that help predict the currency crisis and account reversal have been discussed. These include domestic factors such as lower reserves and external factors like unfavorable trade conditions and high interest rates.