CURRENT ACCOUNT DYNAMICS
I. Balance of Payments (Flows , not stocks)
(1) Current Account
( exports / imports of goods and services).
Balance:
CABt  IX t  IM t
(2) Capital Account
( exports / imports of securities and financial assets)
balance:
capital imports or exports
BF ,t 1  BF ,t  IX t  IM t
exports of securities = ( financial ) capital imports
import of securities = ( financial ) capital exports
(3) International Reserves
Account:
R F , t

0

Current Account and National Income Account
C = consumption
Q = Gross Domestic Product
G = government consumption
I = investment
B = External Debt
Y = Gross National Product
Qt  Ct  I t  Gt  X t  IM t
Yt  Qt  i * Bt 1
GNP
domestic absorption

current account balance
Yt  Ct  I t  Gt   X t  IM t  i * Bt 1

T= tax revenue
(Y  T  C )  (G  T )  I  CAB
National Saving
CAB  ( S p  S g )  I
Consumption Smoothing
Budget constraints (period by period):
C1  S  Q1
C2  Q2  (1  r )S
Consumption - possibilities constraint:
C2
Q2
C1 
 Q1 
1 r
1 r
Permanent Income
Yp
Q2
YP 
 Q1 
1 r
1 r
Q2 
1 r 
YP 
 Q1 

2r
1 r 
Consumption smoothing 
C1  C2  YP
consumption
in period 2
W
c
C2  YP
q
Q2
45
1+r
C1  YP Q
1
S = CAB
W
consumption
in period 1
1. Temporary productivity shock
consumption
in period 2
c’
c
q
Q2
45
1+r
C1
MPC 
q’

C1 Q 1 Q 1  
C1  C1
1

consumption
in period 1
2. Permanent Productivity Shock
consumption
in period 2
c’
c
Q 2 (1   )
q’
q
Q2
45
1+r
Q 1 Q (1   )
1

C1  C1 (1  )

C1  C 1  C1
consumption
in period 1

C1  C 1 C1 C1
MPC 



Q1  Q1 Q1 Q1
A Permanent Productivity Shock
consumption
in period 2
Q 2 (1   )
MPC = 1
Q 2  C2
45
1+r
Q1  C1 Q (1   )
1

C1  C1 (1  )

Q1  Q1 (1   )
consumption
in period 1
3. Personal Savings are the market-forecast
of future decline in GDP
(assume : r = 0)
S  Q1  YP  Q1 
Q1  Q2
2
Q1  Q2
2
Q
S
2
S
assume : r  0
S  Q1  YP  Q1 
Q2  Q1  Q1 (1  r ) 1  r 
Q2 
1 r 
Q



Q

 1

 1

2r
1 r 
2r
2r
1 r 
1
1
S
(Q1  Q2 ) 
Q
2r
2r
Diagram Useful to Analyze Dynamics
of the Current Account Balance
S
r
CAB
r*
I
I,S
1. r* S, I
2. Temporary productivity increase
3. Permanent productivity increase
4. Budget deficit through (1) tax reduction (2) rise in G
5. A stock market crash by 10%
Consumers
C1  S  Q1  T1
C2  Q2  T2  S (1  r )
There is not taxes on interest rate payments
C1 
C2
Q
T 

 Q1  2   T1  2 
1 r
1 r 
1 r 
Government
D1  T1  G1
D2  T2  G2  (1  r ) D1
D2  0
G2
T2
G1 
 T1 
1 r
1 r
(1) Emerging markets current account deficits driven by
excessive investments
(2) Reversal of current account deficits achieved through
(1) Real depreciation
(2) Output contraction
(3) Japan’s current account surplus  high saving rates
(4) Sustainability of current account deficit depend on debt,
equity and FDI finance
Resource Constraint

 1 



s t  1  r 
s t

 1 
Cs  I s   (1  r ) Bt    
s t  1  r 
~
Permanent income = C t

r
 1 
rBt 



1  r s t  1  r 
s t
Ys  Gs  I s 
Current Account Balance
CAt  Yt  Ct  I t  Gt
s t
Ys  Gs 
s t

~
X
For every variable X define
its corresponding “permanent” variable
s t

 1  ~
 1 

 Xt  
 Xs

s t  1  r 
s t  1  r 
s t

r
~
 1 
Xt 

 Xs

1  r s t  1  r 
if
C t  permanent income t

 
 
~
~
~
CAt  Yt  Yt  I t  I t  Gt  Gt

Intertemporal Budget Constraint
and
Consumption-Smoothing Current Account Balance
(1) Definition
CAt  Ft  Ft 1  Yt  rFt 1  Ct  I t  Gt  S p ,t  S g ,t  I t
X
p
r   1 




1  r s t  1  r 
s t
Xs
“permanent” X
(2) Deviations from “permanent”
CAt  Yt  Yt p   Ct  Ctp   I t  I tp   Gt  Gtp 
r
p
(3) Gt 
1 r
s t



1


 Ts 
(1  r ) Fg ,t 1   
s t  1  r 


Consumption Smoothing
Ct  Ctp  rFt 


r
 1 



1  r s t  1  r 
 1 
CAt    

s t 1 1  r 
s t
s t
Ys  I s  Gs 
 t  Ys  I s  Gs 
 current account deficits reflect expected increases
in future net output