Discussion Paper Details

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Title: How Expected Inflation Distorts the Current Account and the Valuation Effect

Author(s): Philipp Herkenhoff and Philip Sauré

Publication Date: November 2020

Keyword(s): current account, inflation and Valuation effects

Programme Area(s): International Macroeconomics and Finance

Abstract: We show that the current account balance (CA) is systematically distorted by an inflation effect, which arises because income on foreign-issued debt is recorded as nominal interest in the currency of denomination. Since nominal interest includes compensations for expected inflation, increases in the latter must impact the CA. Guided by the relevant international accounting rules, we impute the inflation effect for 50 economies between 1991 and 2017. When adjusting for the inflation effect, the absolute value of yearly CAs drops by 0.13% of GDP on average. Over the full period, the reduction is sizable 22.85% of initial GDP for the average country (26.4% for the U.S.). As the flip-side of the CA distortions, the inflation effect contributes systematically to the well-known valuation effect of net foreign assets, of which about a twelfth is accounted for between 1991 and 2017 for the average country and well over half for the U.S.

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Bibliographic Reference

Herkenhoff, P and Sauré, P. 2020. 'How Expected Inflation Distorts the Current Account and the Valuation Effect'. London, Centre for Economic Policy Research.