How expected inflation distorts the current account and the valuation effect

Abstract

We show that the current account balance (CA) is systematically distorted by an inflation effect, which arises because income on 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 a 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. For the average country, the inflation effect accounts for a twelfth of the valuation effect, for the U.S., it accounts for well over a half.