The current account has a different relationship to the different types of exchange rate systems, impacting how the exchange rate itself shifts.
We will bring up the balance of payments example table for Country A from 4.6.2 Components of Balance of Payments.
| Line | Components | Figures (Millions of dollars) |
|---|---|---|
| 1 | Current Account | |
| 2 | Exports of Goods | +25 |
| 3 | Imports of Goods | -40 |
| 4 | Balance of Trade in Goods (Line 2 - 3) | -25 |
| 5 | Exports of Services | +15 |
| 6 | Imports of Services | -5 |
| 7 | Balance of Trade in Services (Line 5 - 6) | +10 |
| 8 | Balance of Trade in Goods & Services (Line 4 + 7) | -15 |
| 9 | Income (inflows - outflows) | -4 |
| 10 | Current Transfers (inflows - outflows) | +1 |
| 11 | Balance on Current Account (Line 8 + 9 + 10) | -18 |
| 12 | Capital Account | |
| 13 | Capital Transfers (inflows - outflows) | +1.1 |
| 14 | Transactions non-financial assets (inflows - outflows) | +0.9 |
| 15 | Balance on Capital Account (Line 13 + 14) | +2 |
| 16 | Financial Account | |
| 17 | Foreign Direct Investment (inflows - outflows) (FDI; inflows - outflows) | +18 |
| 18 | Portfolio Investment (inflows - outflows) | -3 |
| 19 | Reserve Assets (official reserves) | +2 |
| 20 | Official Borrowing | -1 |
| 21 | Balance of Financial Account (Line 17 + 18 + 19 + 20) | +16 |
| 22 | Balance (Line 11 + 15 + 21) | 0 |
The current account and exchange rates
Floating Exchange Rate System
At equilibrium
- Recall, under a floating exchanging rate system, the market forces (demand and supply) solely determines the equilibrium exchange rate, where there is no intervention from the government or central bank.
- For our example with Country A, this would mean the reserve assets would be 0, as there would be no buying or selling of currencies.
- Observing the Figure A above, the initial exchange rate is at $0.34 \text{ ecocoins } = 1 \text{ dollar}$, where the supply and demand of dollars are equal (equilibrium).
- Hence, the sum of credits is equal to the sum of debits in US balance of payments.
- Meanwhile observing Figure B, there is equilibrium at the same exchange rate of $3 \text{ dollars } = 1 \text{ ecocoin}$, where sum of credits is equal to the sum of debits.
Change in equilibrium
- The demand for the dollar increases from $D_1$ to $D_2$ if Econland's demand for imports from the US increases.
- Looking back at the initial equilibrium, now there is an excess demand for dollars, which can be calculated by the horizontal distance between the initial equilibrium exchange rate A and point B.
- Therefore, the US has a surplus in its current account or excess credits in its balance of payments, leading to an imbalance.
- For Econland, the increased demand for imports from US, causes the supply of ecocoins to increase from $S_1$ to $S_2$. At the initial equilibrium rate, there is an excess supply of ecocoins, which can be calculated by the distance between A and B.
- Therefore, Econland has a current account deficit.
The current account surplus in the US correlates with the current account deficit in Econland.
Return to equilibrium
- For floating exchange rates, the market forces cause the exchange rate to change.
- When there is a deficit in the current account as with Econland, which lead to the depreciation of the econcoins, a downward pressure is applied on the currency exchange rate.
