The Current Account, the Spot Exchange Rate and the Demand for Money

We derive a theoretical balance of payments current account model from a framework that assumes a monetary model of exchange rates as a first state of the world, but then presumes the existence of deviations from purchasing power parity. In such a model there is slow price adjustment where short-run exchange rates deviate from long-run equilibrium exchange rates. Under these conditions there are accumulations of net foreign assets due to current account imbalances. A nonlinear model results where there is dependence between exchange rate deviations from equilibrium and the current account, as well as a concurrent dependence of the current account on exchange rate deviations. Furthermore, the current account is also shown to depend on the demand for money. Thus the theoretical explanation of the current account is concomitant on the short-run exchange rate and the determinants of money demand.