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External economy considerations – Part 5

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to publish the text sometime in 2013. Our (very incomplete) textbook homepage – Modern Monetary Theory and Practice – has draft chapters and contents etc in varying states of completion. Comments are always welcome. Note also that the text I post here is not intended to be a blog-style narrative but constitutes the drafting work I am doing – that is, the material posted will not represent the complete text. Further it will change as the drafting process evolves.

Chapter 21 Policy in an Open Economy: Exchange Rates, Balance of Payments, and Competitiveness

This material updates the work already done on Chapter 21 that appeared in the following blogs:

The earlier draft had some gaps and some sections to complete which is what I am doing today. The sections I am working on today are not in any particular sequential order.

21.6 The relationship between the Current Account and the Capital Account of the Balance of Payments

Economists have long debated the relationship between the current account and the capital account. From a purely accounting perspective, we know that the current account balance equals the capital and financial account balance (ignoring the statistical discrepancy that the national statisticians report to indicate measurement error).

But this leaves a number of questions unanswered. Two questions that have dominated the public policy debates since the collapse of the Bretton Woods currency arrangements are:

  • Is the current account a problem that policy makers should address? Can the current account be too large?
  • Does the current account cause the capital account or vice versa?

Both questions have relevance for Modern Monetary Theory (MMT) policy prescriptions and are worth exploring in some depth.

A nation that is running a current account deficit will be accumulate financial liabilities to the rest of the world. See the Advanced Material Box – The link between the Current Account and Capital Flows – for a formal derivation of this result.

The current account deficit arises in an accounting sense because the saving of the nation are less than the sum of its investment expenditure and net public spending and it offsets the difference by becoming a net borrower from the rest of the world.

Thus a current account deficit is equivalent to a net inflow of foreign investment, which is recorded in the capital account. This accounting perspective provides no insights into causality – that is, whether the behaviour captured by the current account is responsible for or a reflection of the behaviour measured in the capital account.

The popular debate about the desirability of current account deficits often begins with an observation that domestic jobs are lost if a nation if running large trade deficits (for example, reflecting a preference for foreign-produced automobiles over locally-produces vehicles). However, the debate often ignores where the net capital inflow, which matches $-for-$, the current account deficit goes. Does it manifest as increased productive capacity and employment or not? We will return to this issue later.

The mainstream macroeconomics debate is dominated by two broad positions on the issue of whether a current account deficit should be the focus of policy or not.

One side of the debate is popularly known as the “Lawson Doctrine”, so-called after a famous speech the British Chancellor of the Exchequer in the Thatcher Government, Nigel Lawson presented to the IMF in September 1988 about the concerns that had been raised about the state of the British balance of payments at the time.

Lawson captured the views that had previous made by Australian economist Max Corden, among others, who argued that, in the absence of “government distortions” (for example, tariffs etc), the current account deficit is largely the result of rational spending and saving decisions taken by private households and firms in pursuit of their own interests. Thus, there is no reason for the government to intervene. This view was also strongly put by another Australian economist John Pitchford (1989a and b).

The alternative view expressed by mainstream economists is that, notwithstanding that current account deficits may reflect private saving and investment choices, there are significant distortions that can lead to excessive current account positions, which can undermine the financial stability of a nation and create so-called global imbalances that should be resolved.

This has been a particularly prominent argument during the global financial crisis.

Some of the arguments raised to counter the view that current accounts do not matter include the following. First, while on the surface these maximising private sector choices might be optimal, closer examination reveals that there remains significant public sector exposure, which should be taken into account.

For example, consider the case of domestic banks accumulating ever-increasing foreign liabilities after financial deregulation occurred in the 1980s and 1990s. Who is responsible for those liabilities? Clearly, in the first instance it is the private banks and their shareholders. But as we learned in the global financial crisis, the “too big to fail” doctrine meant that the private losses were shifted onto government and placed stress on fiscal policy and accelerated the move to fiscal austerity.

Second, the global financial crisis also taught us that the risk assessment capacity of the private sector is imperfect and this led to excess borrowing in foreign financial markets by banks and corporations. The resulting collapse of many financial assets spilled over into the real economy with substantial job and income losses being incurred by the economy in general. The capacity of the private sector to act in the best interests of society is limited (that is, private benefits and costs diverge significantly from social benefits and costs).

Advanced Material: The link between the Current Account and Capital Flows

In Chapter 5, we introduced the Sectoral Balances View of the National Accounts, which extended our understanding of the relationship between the government and the non-government sector.

The framework can also help us understand why the Current Account balance is equivalent to net capital inflows recorded in the Capital Account of the Balance of Payments.

We know that Gross national product (GNP) is the market value of all the products and services produced in a period by productive inputs supplied by the residents of a particular country. It is the sum of income accruing to these local productive inputs.

It differs from Gross domestic product (GDP), which is the total market value of output produced in a period within a country. This measure ignores the question of ownership of the productive inputs (foreign or local).

To see the difference, take an Australian resident who incomes from an investment they have overseas. This income will not be recorded in Australia’s GDP measure but will add to the GNP figure.

Conversely, the production for an American-owned firm in Australia will add to Australia’s GDP but not its GNP.

Thus, a nation such as Ireland, which encouraged a substantial foreign presence via lower corporate tax rates, will typically finds that its GDP growth is higher than its GNP, because significant income flows are repatriated to foreign owners of productive capital.

So GNP includes net income received from assets abroad.

Total GDP is defined as:

(21.16)      GDP = C + I + G + (X – M)

(see Chapters 3 and 5 for definition of terms).

Total GNP (or Gross National Income) is defined:

(21.17)      GNP = GDP + NFI

where NFI is net factor income received from abroad, It is the difference between income payments received by domestically-owned productive inputs located abroad and the income payments to foreign-owned productive inputs located domestically.

NFI is comprised of:

  • Net dividends paid to owners of capital, interest paid on debt liabilities, rent to residents owning assets abroad.
  • Net wages to residents working abroad.

GNP (or GNI) thus represents the total income earned by a nation over a particular period. Augmenting this earned income are net unilateral transfers (NFT), comprising remittances and foreign aid, which, if positive, expand the available total income available for a nation.

The Current Account balance (CA) is thus equal to net exports plus net factor income plus net unilateral transfers:

(21.18)      CA = (X – M) + NFI + NFT

The Current Account will be in surplus if CA > 0 and deficit if CA < 0. For example, the Current Account will be in deficit if a deficit on the balance of trade in goods and services (X < M) is not offset by (NFI + NFT) > 0.

The GNI received by the productive inputs can be used for:

(21.19)      GNP = C + S + T + NFI + NFT

Noting the equivalence of GNI (as defined) and GNP, we can equate the two perspectives of the national accounting expression for GNP to get (after simplifying and re-arranging):

(21.20)      (X – M) – NFI – NFT = (S – I) + (T – G)


(21.20a)      CA = (S – I) + (T – G)

which says that the Current Account balance equals the surplus of private saving over investment (S – I) and the government balance (T – G).

The flow of saving in each period (S) can be offset by private investment (I), used to purchase government debt (that is, a budget deficit (G – T), given that under current institutional governments match their net spending with debt-issuance) or purchase foreign assets (FA).

The net foreign assets owned by a nation are the difference between its foreign assets (share, bonds, real productive assets) and foreign liabilities (real and financial domestic assets owned by foreign interests).


(21.21)      S = I + (G – T) + FA

Thus, when domestic saving is greater than domestic investment and the budget deficit, the nation is able to accumulate foreign assets, and vice versa.

Bringing the information in Equations (21.20a) and (21.21) together we get:

(21.22)      FA = (S – I) – (G – T) = (S – I) + (T – G) = CA

Thus the net purchase of foreign assets (FA) is equal to the Current Account balance (CA). If the Current Account is in deficit, then the nation has negative purchases of FA, which means it is increasing its foreign liabilities (that is, drawing on foreign saving).

If the Current Account is in surplus, then the nation has positive purchases of FA, which means it is using is accumulating foreign assets and increasings its national wealth.



Corden, W.M. (1977) Inflation, Exchange Rates and the International System, Oxford University Press, Oxford.

Corden, W.M. (1994) Economic Policy, Exchange Rates and the International System, Clarendon Press, Oxford.

International Monetary Fund (1988) Summary Proceedings of the Forty-Third Annual Meeting of the Board of Governors International Monetary Fund, Washington, particulary pages 78-85.

Pitchford, J. (1989a) ‘A Sceptical View of Australia’s Current Account and Debt Problem’, The Australian Economic Review, 86, 5–14.

Pitchford, J. (1989b) ‘Does Australia Really Have a Current Account Problem?, Policy Magazine, June 6, 1989 –



Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2012 Bill Mitchell. All Rights Reserved.

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    This Post Has 5 Comments
    1. Dear Bill

      It seems to me that the balance of payments doesn’t always balance. This was clear when gold was the currency. It was possible for a country to have a net inflow or outflow of gold. It is still possible today because people can hoard money. Suppose that Argentinian exports are 140 billion US dollars. Its imports are only 100 billion. The other 40 billion US dollars are hoarded by Argentinian households as a reserve because they have apprehensions about the future. If Argentinians used this trade surplus of 40 billion to buy American T Bills, then the balance of payments would balance. By hoarding the 40 billion, they are creating a net inflow of US dollars, not different from a net inflow of gold in former times, with the difference, however, that a net inflow of gold would be inflationary while the hoarding of US dollars is not. Hoarding of US dollars is, or was, quite common in Latin America.

      Shouldn’t the balance of payment have 3 accounts. a current account, a capital account and a hoarding account? Hoarding could also be done by the Central Bank. if the Argentinian Central Bank had bought up the 40 billion trade surplus and then kept the money in a big vault in Buenos Aires, wouldn’t that be hoarding too, something different from the purchase of US T Bills?

      Regards. James

    2. Bill
      i just caught the video of your presentation on age discrimination from the website.
      Superb. Don’t know how I missed it first time round.

    3. Prof, can’t wait for your textbook despite being an IT professional and not an economics student. I’m patiently, persistently, and politely (3Ps) trying to get the Kenyan government to maximize spending on labour-intensive construction and farming.

    4. The Bretton Woods system collapsed over forty years ago. Unfortunately, a few people never received the memo.

      “The Hoarding Account” aka Monetarism Version 9

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