Academic journal article International Journal of Business and Society

Current and Capital Account Interdependence: An Empirical Test

Academic journal article International Journal of Business and Society

Current and Capital Account Interdependence: An Empirical Test

Article excerpt


The interrelation between the current and capital accounts of the balance of payments is widely recognised in the literature, but the nature of that interdependence is not well understood. This study uses two empirical specifications to test the interdependence between the current and capital accounts of the balance of payments. The alternative specifications, derived from the balance of payments constraint and from national income accounting relationships, respectively, yield consistent support for the interdependence hypothesis. The balance of payments specification returns positive findings for nine of the ten sample countries. These are corroborated by the general equilibrium specification in three instances. The relatively weak support obtained from the general equilibrium specification may be attributable to the rudimentary nature of that specification, in particular to the failure to model the lag structure of the underlying model.

Keywords: Current account; Capital account; Developing countries; G-5; Interdependence

(ProQuest: ... denotes formulae omitted.)


The interrelation between the current account (CA) and capital account (KA), more recently known as the financial accounts, of the balance of payments is a fundamental relation in open economy macroeconomics. The "interdependence" between these component accounts captures the reactions of the financial and real sectors to systemic disturbances and their interaction during the adjustment process (Fausten, 1989-90). These reactions constitute channels for the intersectoral transmission of disturbances, and expose the susceptibility of the domestic nonfinancial sector to developments in international asset markets. Prominent intermediate variables which play a role in this process include income, foreign direct investment, exchange rates, interest rates, and so on. The interrelation between these component accounts of the balance of payments is well known in both the theoretical and empirical literature. But the nature of that interdependent has not been examined intensively.

One issue of particular interest is the simultaneity of the CA and KA. In the limiting case of freely floating exchange rates, CA deficits are financed entirely by KA surpluses and, conversely, net capital flows are "financed", or transferred, through commensurate imbalances on current account. Formally, the simultaneity of the two component external accounts is captured in the double-entry bookkeeping practice of balance of payments accounting. The economic substance of this phenomenon derives from the fact that voluntary transactions involve exchanges of equivalents - i.e., any sale or purchase involves a quid pro quo. Both equivalents are determined simultaneously and, in the case of cross-border transactions, are recorded in the external accounts.

The requirement that net flows on the two component accounts of the balance of payments must be mutually consistent implies that at any point in time the flow balances of the two accounts are mirror images of each other (CAB = -KAB). The resulting "redundancy" problem", viz. that in a closed system with n variables only n-1 variables are independent while the nth variable must be determined residually, is captured in the balance of payments constraint. However, the constraint itself does not identify which variable (or component account) is the residual element, i.e., should be written on the lefthand side. The alternative options have inspired alternative "views" of the balance of payments that assign primacy to different sectors of the economy in the determination of balance of payments outcomes (Johnson, 1966). Emphasis on either the CA or the KA as the autonomous driver of crossborder transactions flows has been invoked as a rationale for selecting either the real or the financial sector of the economy for explicit analysis of external balance issues. These alternative structural and analytical perspectives are reflected, respectively, in the traditional "commodity" approach and the more modern "monetary" and "assets" approaches to the balance of payments and exchange rates. …

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