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Lesson M21.L01: The Intertemporal Approach to the Current Account

Module: M21: Open Economy Macroeconomics Part II Level: intermediate Duration: 30 minutes Learning Objective: Apply the intertemporal budget constraint to explain current account determination in a small open economy. Data as of: 2024 Provenance: RBA Balance of Payments Statistics | ABS International Trade Statistics

Explanation

The current account (CA) measures the net flow of goods, services, and income between a country and the rest of the world. A fundamental identity links the CA to domestic saving and investment:

CA = S āˆ’ I

where S = national saving = Y āˆ’ C āˆ’ G and I = private investment. This identity follows from the national income identity: Y = C + I + G + NX, so NX = Y āˆ’ C āˆ’ I āˆ’ G = S āˆ’ I. In an open economy, NX ā‰ˆ CA (ignoring net transfers).

A small open economy ā€” like Australia ā€” takes the world interest rate r* as given. Households can borrow or lend internationally at r*. This creates the key insight: households will smooth consumption across time in response to income shocks.

Temporary vs Permanent income shocks:

  • A temporary fall in income (e.g., a drought reducing farm output) leads rational households to borrow abroad to maintain consumption ā†’ CA deficit.
  • A permanent fall in income leads households to reduce consumption proportionally ā†’ no CA deficit needed.

Australia's CA history: Australia ran persistent CA deficits of approximately 4ā€“5% of GDP through the 1990s and 2000s, driven by high investment demand and relatively low domestic saving. Australia attracted foreign capital because domestic investment opportunities (mining, infrastructure) exceeded domestic saving. From 2019ā€“2023, commodity export prices surged during the commodity boom, driving Australia's CA into surplus for the first time in decades ā€” reaching approximately +2.5% of GDP in 2021ā€“22.

Sustainability: Not all CA deficits are equal. A deficit that funds productive investment (e.g., new mines, infrastructure) generates future export earnings to repay borrowing ā€” this is sustainable. A deficit that funds excess consumption does not generate future repayment capacity ā€” this is unsustainable.

The intertemporal budget constraint states that the present value of future CA surpluses must equal current net foreign debt. Countries cannot run deficits forever; eventually the external account must balance in present-value terms.

Worked Example

Given: Australia's national accounts (simplified, $bn):

Variable Value
Output Y 2,000
Consumption C 1,800
Investment I 300
Government spending G 100

Step 1: Calculate national saving S.

\[S = Y - C - G = 2{,}000 - 1{,}800 - 100 = 100\]

Step 2: Calculate the current account using CA = S āˆ’ I.

\[CA = S - I = 100 - 300 = -200\]

Step 3: Express as a share of GDP.

\[\frac{CA}{Y} = \frac{-200}{2{,}000} = -0.10 = -10\%\]

Step 4: Verify using the expenditure side. NX = Y āˆ’ C āˆ’ I āˆ’ G:

\[NX = 2{,}000 - 1{,}800 - 300 - 100 = -200 \checkmark\]

Interpretation: Australia has a CA deficit of $200bn (10% of GDP). Saving of $100bn falls well short of investment of $300bn, so Australia must borrow $200bn from abroad. This is a large deficit (historically Australia ran 4ā€“5%), so this example is stylised for pedagogical clarity.

Common Misconception

Misconception: A current account deficit always means the country is living beyond its means and is heading for a crisis.

Correction: A CA deficit simply means domestic investment exceeds domestic saving. If the deficit finances productive investment ā€” as Australia's mining-driven deficits did in the 2000s ā€” it can be entirely rational and sustainable. The deficit attracts foreign capital that earns returns sufficient to service the debt. A CA deficit only becomes problematic when it finances excess consumption rather than investment, or when the debt-to-GDP ratio grows faster than the economy (see Lesson M21.L02).

Practice Prompts

  1. Conceptual: Why does a temporary negative income shock cause a larger CA deficit than a permanent negative income shock of the same size? ā†’ Answer: With a temporary shock, rational households borrow internationally to smooth consumption ā€” they reduce saving sharply relative to investment, widening the CA deficit. With a permanent shock, households revise their permanent income downward and reduce consumption permanently, so saving does not fall as dramatically. The key is the consumption-smoothing motive: only when shocks are temporary do households borrow internationally to maintain consumption.

  2. Numerical: Suppose Y = 3,000, C = 2,400, I = 500, G = 200. Calculate national saving S, the current account CA, and CA as a percentage of GDP. Show all steps. ā†’ Answer: Step 1: S = Y āˆ’ C āˆ’ G = 3,000 āˆ’ 2,400 āˆ’ 200 = 400 Step 2: CA = S āˆ’ I = 400 āˆ’ 500 = āˆ’100 Step 3: CA/Y = āˆ’100/3,000 = āˆ’3.33% Interpretation: This economy runs a CA deficit of $100bn (3.33% of GDP), consistent with historical Australian averages in the 2000s.

  3. Application: Australia shifted from persistent CA deficits (~āˆ’4% to āˆ’5% GDP) to a CA surplus (~+2% GDP) during 2021ā€“22. Using the Sāˆ’I framework, explain what drove this shift. ā†’ Answer: The commodity price boom of 2021ā€“22 (driven by China's post-COVID infrastructure demand and the Ukraine war energy shock) significantly raised Australian export income, particularly from iron ore, coal, and LNG. This increased Y without a proportional increase in C or I (COVID and supply-chain disruptions constrained investment). National saving S = Y āˆ’ C āˆ’ G rose sharply because income rose faster than absorption. The surplus was primarily saving-driven (via higher export income) rather than investment-compression. This illustrates how a terms-of-trade improvement shifts CA = S āˆ’ I upward even without deliberate policy action.

Further Resources