Theoretical approaches explaining factors affecting the current account: An application for countries with different income level

Current account is a significant macroeconomic indicator, which depends on various economic factors as a result of the portfolio and stock adjustment processes through goods, services and currency market. The total income and expenditures balance, the savings and investment expenditures balance and the cash supply and demand balance, which ensure the internal balance alongside the imports and exports balance, which ensure the external balance, play an active role in shaping the general balance depending on such factors. There are two theoretical approaches based on fundamental economic views, namely, the traditional and the modern, which explain the economic factor causing an imbalance in the current account. The traditional approaches include the flexibility approach, the income-expenditure approach and the monetary approach while the modern approaches include the intertemporal approach. Of the traditional approaches, the flexibility approach maintains that the current account is affected by the changes in the foreign trade balance. The income-expenditure approach, however, suggests that the current account is affected by the disruptions in the total income and expenditures balance, and the monetary approach holds that the factors disrupting the fiscal balance dependent on the cash supply and demand affect the current account through interest and domestic income. Being dynamic beyond the traditional models, the intertemporal approach maintains that the disruption in the current account is due to the changes in the investment and savings balance. The financial literature consisting of these four approaches have been shaped by studies analyzing which approach offers better factors or theories to accurately explain current account movements. This thesis offers a comparative analysis of theoretical approaches, which deal with the current account. This analysis uses the panel analysis method with a data set of the two country groups, the developed countries and the developing countries, for the period from 1986 till 2017. The study uses three different estimators to test the two static and dynamic models, which are established separately for each country group. The static models are estimated with the AMG (Augmented Mean Group) estimator and the CCE (Common Correlated Effects) estimator while the dynamic models are estimated with the FEGMM (Fixed Effects Generalized Method of Moments) estimator. The results from the AMG estimator applied on the static panel data regression model for the developed countries show that the current account can only be explained with the income-expenditure approach while the results from the CCE estimator show that all traditional methods can explain the current account. The results from the FEGMM estimator show that the current account can be explained with the intertemporal approach. The results from the static panel data regression model for the developing countries, however, show that the AMG estimator and the CCE estimator yield consistent results. Accordingly, the income-expenditure approach and the flexibility approach can explain the current account in developing countries and the results from the FEGMM estimator show that the intertemporal approach explains the changes in the current account. These empirical findings show that different approaches can successfully explain the current account in both the developed and developing countries rather than a theoretical approach alone. Therefore, it is evident that one single approach does not suffice to fully understand the current account, and that the variables representing different approaches should factor in the analyses depending on the economic, political, institutional and natural characteristics of each individual country. In addition, the estimators based on different approaches offering different results indicates that selection of methods to be applied in the analysis affects the results.