The capital account and current accounts are believed to be the two elements or components of balance of payments. Now, what is the balance of payments? It is nothing but database/recorded information of monetary transactions between a country with other countries.
These two concepts can help students of economics understand the economic conditions of nations and write research reports based on their observations. Since both these type of accounts are related to the balance of payments, let us know this concept first before we understand current accounts vs. capital accounts in the macroeconomic context.
Balance of Payments
Balance of payments is a sheet which consists of records of financial dealings between a country and other nations. Every nation has to make some imports from other countries to satisfy its domestic need and make some exports to earn foreign exchange.
Both these import and export details are entered into the balance of payments sheet in such a way that there is no surplus or deficit in trade. So, the amount of goods imported should be equal to the amount of goods exported by the country.
If this does not happen and in case the import are more than the exports, then the deficit is balanced by reducing reserves and getting loans from other nations. In this way, the current account deficit and capital account deficit are dealt with by economic policy makers.
A current account is a sum of three things - net factor income, balance of trade and net transfer payments. Net factor income is nothing but the income which comes from the sources like interest and dividends. On the other hand, the balance of trade denotes the difference in the exports of a country and its imports.
Net transfer of payments could be related to the foreign aid which is received by many nations. A current account, in simple words is a sign of the net income of a nation. A surplus shows that the country's net foreign assets have risen over a fixed period while a deficit is an indicator of decreased net foreign assets of the country.
Current accounts are known as the balance of international dealings of currently produced goods and services. Its deficits are possible in times when exports are less than the imports. At this time, these deficits can be balanced with the surplus on capital accounts.
Merchandise trade, service such as tourism, labor, transportation, engineering, management consulting, software services, income receipts and unilateral transfers which are one way transfer of assets are all included in current accounts.
Capital account has been defined by economists as the net balance of the international investment transactions. With such an account, we can understand the flow of money in and out of the nation. Any surplus is an indicator of money coming inside a country while deficit reveals that money is going out of the country.
Calculation of capital account can be done by the summation of foreign direct investment (FDI), portfolio investments, reserve account and other investments. While FDI is the long-term capital investment with a lot of money, portfolio investments are the acquiring of shares and bonds.
The reserve account is a source of capital flows and are managed by central bank of the nation and the other investments basically include capital flows in banks and capital flows advanced as loans.
The International Monetary Fund (IMF) has split capital account into two sub-divisions - financial account and capital account. The financial account involves investments and instruments like the USA owned assets in foreign countries and foreign-owned assets in the USA.
Having capital account convertibility helps nations convert local assets into foreign assets and vice versa. The rate of exchange will be based on the current market rats at that point of time.
Like capital account convertibility, current account convertibility can be beneficial as it allows conversion of currency. Finally, we conclude that for ensuring rapid economic progress of a nation, many reforms must be introduced to improve the current state of financial system.