National Income Accounting and the Balance of Payments

National Income Accounting and the Balance of Payments

Ch. 13: National Income Accounting and the Balance of Payments Udayan Roy ECO41 International Economics International Macroeconomics International Trade studies the effects of globalization on how the resources of a country are allocated among different productive activities International Macroeconomics studies the effects of

globalization on how the aggregate spending of a country is allocated among different types of spending International Macroeconomics International macroeconomics introduces four aspects of economic life that are ignored in international trade: Unemployment Saving Trade imbalances Money, the price level, and exchange rates

International Macroeconomics International macroeconomics tries to explain the behavior across countries at any given time, or across time for a given countryof economic variables that are ignored in international trade These variables are measured according to the rules of National income accounting, and Balance of payments accounting

THE NATIONAL INCOME ACCOUNTS The National Income Accounts: GNP A countrys gross national product (GNP) is the value of all final goods and services produced by the countrys factors of production and sold on the market in a given time period The National Income Accounts: GNP A countrys gross national product (GNP) is the value of all final goods and services produced by the countrys factors of

production and sold on the market in a given time period Factors of production are the resources used in production (such as labor, capital, and natural resources) The National Income Accounts : GNP A countrys gross national product (GNP) is the value of all final goods and services produced by the countrys factors of production and sold on the market in a given time period Final goods and services are goods and services that have been or will be sold to their final users

These goods will not be used to produce other goods for sale The National Income Accounts : GNP A countrys gross national product (GNP) is the value of all final goods and services produced by the countrys factors of production and sold on the market in a given time period Why are only final goods counted? Why are intermediate goods not counted? To avoid counting the same productive activity multiple times

The National Income Accounts : GNP A countrys gross national product (GNP) is the value of all final goods and services produced by the countrys factors of production and sold on the market in a given time period Why are only final goods counted? We need to measure national income. It is the expenditure of the buyers of final goods and services that trickles down into peoples pockets and becomes income The National Income Accounts : GNP

The value of the production of all final goods and services (GNP) = value of total expenditure on those goods and services = income earned by the factors of production So, there are three equivalent approaches to GNP measurement: production, expenditure, and income The National Income Accounts : GNP Of the production, expenditure and income approaches to GNP measurement, the expenditure approach is the most useful in

international macroeconomic theory The National Income Accounts Government economists and statisticians divide total expenditure (GNP) into four types of expenditure: consumption (expenditure by private domestic residents), investment (expenditure by private firms to build new plant and equipment for future production), government purchases (expenditure by the government), and the current account (net exports of goods and services)

Figure 13.1 U.S. GNP and Its Components Americas gross national product for the first quarter of 2016 can be broken down into the four components shown. Source: U.S. Department of Commerce, Bureau of Economic Analysis. The figure shows 2016:QI GNP and its components at an annual rate, seasonally adjusted. From GNP to National Income National Income = GNP Depreciation + Net Unilateral

Transfers Depreciation is the economic loss due to the wearing out of machinery and structures as they are used Gross National Product Depreciation = Net National Product From GNP to National Income National Income = GNP Depreciation + Net Unilateral Transfers Unilateral transfers are payments made without getting something in return

Net Unilateral Transfers = Unilateral Transfers received from foreigners Unilateral Transfers paid to foreigners From GNP to National Income National Income = GNP Depreciation + Net Unilateral Transfers Examples of unilateral transfers are pension payments to retired citizens living abroad, reparation payments, and foreign aid. For the United States in 2012, the balance of such payments amounted to around $129.7 billion, representing a

0.8 percent of GNP net transfer to foreigners. From GNP to GDP GNP = GDP + net receipts of factor income from the rest of the world. Gross Domestic Product (GDP) is the market value of all final goods and services produced within the countrys borders Recall that GNP is the value of all final goods and services produced by the countrys factors of production anywhere in the world

From GNP to GDP GNP = GDP + net receipts of factor income from the rest of the world. For the United States, net receipts of factor income are primarily the income residents of the US earn on wealth they hold in other countries less the payments residents of the US make to foreign owners of wealth located in the US. From GNP to GDP GNP = GDP + net receipts of factor income from the rest of

the world. As a practical matter, movements in GDP and GNP usually do not differ greatly. GNP tracks national income more closely than GDP does, and national welfare depends more directly on national income than on GDP. See next slide GDP: https://fred.stlouisfed.org/series/GDPCA; GNP: https://fred.stlouisfed.org/series/GNPCA

National Income Identity for an Open Economy We will denote GNP by the symbol Y. We have seen before that government statisticians break down total expenditure (GNP) into four categories of expenditure: Consumption (C) Investment (I) Government Purchases (G) Current Account (CA) = Exports (EX) Imports (IM) Y = C + I + G + EX IM

National Income Identity for an Open Economy Y = C + I + G + EX IM An economy goes into a recession and suffers high unemployment when total expenditure (GNP or Y) is too low In such a situation, we need to use this equation and figure out policies that can raise C or I or G or EX IM CA and International Borrowing CA = EX IM

When EX > IM, CA > 0. The country has a current account surplus When EX < IM, CA < 0. The country has a current account deficit CA Surplus = International Lending CA = EX IM When EX > IM, CA > 0. The country has a current account surplus This requires domestic residents to lend the amount of the

current account balance (CA) to foreign residents Suppose there are only two countries, Anne and Bob. Annes exports to Bob equal $100 and Annes imports from Bob equal $75. This is possible only if Bob borrows $25 from Anne. CA Deficit = International Borrowing CA = EX IM When EX < IM, CA < 0. The country has a current account deficit This requires domestic residents to borrow the amount of the

current account balance (CA) from foreign residents Suppose there are only two countries, Anne and Bob. Annes exports to Bob equal $100 and Annes imports from Bob equal $125. This is possible only if Anne borrows $25 from Bob. International Lending/Borrowing = International Asset Purchases/Sales Borrowing money is the same as selling a financial asset When a corporation borrows money it does so by selling corporate bonds, which are financial assets

Lending money is the same as buying a financial asset When you buy US Treasury bonds, you are lending money to the US government Net Foreign Wealth Net Foreign Wealth of a country = Value of domestic residents assets that were bought from foreign residents Value of foreign residents assets that were bought from domestic residents

CA > 0 means Net Foreign Wealth CA = EX IM. So, when EX > IM, CA > 0 and the country has a current account surplus. We saw that this requires domestic residents to lend the amount of the current account balance (CA) to foreign residents This lending is the same as domestic residents buying assets from foreign residents Therefore, the countrys net foreign wealth increases by the

amount equal to CA CA < 0 means Net Foreign Wealth CA = EX IM. So, when EX < IM, CA < 0 and the country has a current account deficit. We saw that this requires domestic residents to borrow the amount of the current account balance (CA) from foreign residents This borrowing is the same as domestic residents selling assets to foreign residents

Therefore, the countrys net foreign wealth decreases by the amount equal to CA CA and International Borrowing Therefore, the current account balance is a rough measure of the increase in net foreign wealth So a string of current account deficits (surpluses) can lead to a dramatic decrease (increase) in a countrys net foreign wealth Net Foreign Wealth is also called Net International Investment

Position Figure 13.2 The U.S. Current Account and Net International Investment Position, 19762015 A string of current account deficits starting in the early 1980s reduced Americas net foreign wealth until, by the early 21st century, the country had accumulated a substantial net foreign debt. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

CA: https://fred.stlouisfed.org/series/BPBLTT01USA637S. IIP: https://fred.stlouisfed.org/series/IIPUSNETIA. Expenditure and Production in an Open Economy Y = C + I + G +CA CA = Y (C + I + G ) When domestic production (Y) > domestic expenditure (C + I + G), current account = trade balance > 0, exports > imports when a country exports more than it imports, it earns more income from exports than it spends on imports. So,

net foreign wealth increases When domestic production < domestic expenditure, exports < imports, current account = trade balance < 0 when a country exports less than it imports, it earns less income from exports than it spends on imports. So, net foreign wealth decreases 12-34

Saving and the Current Account National saving (S) = national income (Y) that is not spent on consumption (C) or on government purchases (G). S=YCG 12-35 National Saving = Private Saving + Public Saving S=YCG

S=YCGT+T S=YTC+TG The governments net tax revenues are denoted T. T = tax revenues transfer payments Y T is total after-tax income or disposable income Private Saving: Public Saving:

Sp = Y T C Sg = T G National Saving = Private Saving + Public Saving S = Sp + Sg 13-36 S = Sp + Sg 13-37

The Meaning of Saving and Investment Budget Surplus and Budget Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. T G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue. Fun fact: In the 2010 fiscal year, the US federal government ran a budget

deficit of $1.3 trillion 13-38 S = S p + Sg 12-39 How Is the Current Account Related to National Saving? Y = C + I + G + CA

Y C I G = CA CA = (Y C G ) I = S I current account = national saving investment current account = net foreign investment A country that imports more than it exports has low national saving relative to investment. 12-40

CA = S I 12-41 How Is the Current Account Related to National Saving? (cont.) CA = S I or I = S CA

Countries can pay for investment either by using domestic saving or by borrowing foreign funds equal to the current account deficit. a current account deficit implies a financial capital inflow or negative net foreign investment. When S > I, then CA > 0 and net foreign investment and financial capital outflows for the domestic economy are positive. 12-42

How Is the Current Account Related to National Saving? (cont.) CA = Sp + Sg I = Sp government deficit I Government deficit is negative government saving equal to G T A high government deficit causes a negative current account balance, all other things equal.

12-43 BALANCE OF PAYMENTS ACCOUNTS 12-44 Balance of Payments Accounts A countrys balance of payments accounts summarizes all economic transactions between domestic residents and foreign residents. Each international transaction enters the accounts twice:

once as a credit, and once as a debit 12-45 Credits and Debits A countrys balance of payments accounts keep track of both its payments to and its receipts from foreigners. Any transaction resulting in a receipt from foreigners is entered in the balance of payments accounts as a credit.

Any transaction resulting in a payment to foreigners is entered as a debit. Credits: examples Sale of goods, services, and assets to foreign residents Receipt of income from assets bought from foreign residents Dividends received on foreign firms shares, interest paid on bonds sold by foreign firms and governments, rent received on foreign real estate

Unilateral transfers received from foreign residents Debits: examples Purchase of goods, services, and assets from foreign residents Payment of income for domestic assets sold to foreign residents Dividends paid on domestic firms shares, interest paid on bonds sold by domestic firms and government, rent paid on domestic real estate Unilateral transfers given to foreign residents

The Boomerang Principle Why does each cross-border transaction appear twice in the balance of payments accounts, once as a credit and again as a debit? Suppose you pay a foreigner in dollars (debit) Those dollars will one way or the other return to the US (credit), because nobody uses dollars in the foreign country The Boomerang Principle

Suppose you pay Johan in Berlin in dollars for some purchase (debit) Johan uses euros, not dollars So he may deposit the dollars in a US bank, as savings for his future Or, he may sell the dollarsin return for eurosto, say, Heidi, who wants dollars to buy something from some American Either way, the dollars you paid Johan will return to the US (credit)

Balance of Payments Accounts (cont.) The balance of payment accounts are separated into 3 broad accounts: current account: purchases and sales of goods and services (imports and exports). financial account: purchases and sales of financial assets (cross-border borrowing and lending). capital account: transfers of special categories of assets (capital), typically nonmarket, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks. 12-51

Example of Balance of Payment Accounting You buy a fax machine from the Italian company Olivetti and pay with a $1,000 check. Olivetti deposits the funds in its bank account in Citibank, New York. Olivetti considers the money in its bank account a financial asset worth $1,000 that it has just bought. Credits

Fax machine purchase (Current account, US import of a good) Sale of bank deposit by Citibank (Financial account, US sale of an asset) $1,000 Debits $1,000

Example of Balance of Payment Accounting You buy lunch in France and pay by credit card. French restaurant receives payment from your credit card company Credits Meal purchase (current account, U.S. service import)

Sale of credit card claim (financial account, U.S. asset sale) $200 Debits $200 Example of Balance of Payment Accounting

You buy a share of BP, a British firm. BP deposits the money in a U.S. bank. Credits Stock purchase (financial account, U.S. asset purchase) Bank deposit (financial account, U.S. asset sale)

$95 Debits $95 Example of Balance of Payment Accounting U.S. banks forgive a $5,000 debt owed by the government of Bygonia through debt restructuring. U.S. banks who hold the debt thereby reduce the debt by crediting Bygonias bank

accounts. Credits Debt forgiveness (capital account, U.S. transfer payment) Reduction in banks claims (financial account, U.S. asset sale) $5,000

Debits $5,000 Total Credits = Total Debits We saw earlier that for every transaction that is recorded in the balance of payments accounts as a credit there is another transaction of equal value that is recorded as a debit Therefore, Total Credits = Total Debits Total Credits = Total Debits

Total Credits = Total Debits Credits in Current Account + Credits in Capital Account + Credits in Financial Account = Debits in Current Account + Debits in Capital Account + Debits in Financial Account (Credits in Current Account Debits in Current Account) + (Credits in Capital Account Debits in Capital Account) = Debits in Financial Account Credits in Financial Account Balance

For the Current Account and the Capital Account, Balance = Total Credits Total Debits But for the Financial Account, its the reverse: Balance = Total Debits Total Credits = Lending Borrowing = Net Lending = Financial outflows financial inflows = Net Financial Flows

Fundamental Balance of Payments Identity (Credits in Current Account Debits in Current Account) + (Credits in Capital Account Debits in Capital Account) = Debits in Financial Account Credits in Financial Account Current Account Balance + Capital Account Balance = Financial Account Balance Recall that the financial account balance is also called net financial flows or net lending Fundamental Balance of Payments Identity

Anne and Bob are the only two countries Anne exports $100 of goods and services to Bob. In return Bob exports $75 of goods and services to Anne plus $25 of financial assets. The capital account has no Annes current account balance = +$25 role in this example. Annes financial account balance = +$25

Note that the Bobs current account balance = $25 balances must be the same in Bobs financial account balance = $25 each country. Fundamental Balance of Payments Identity Note that Annes (Bobs) net foreign wealth increases by the amount of Annes (Bobs) current account balance

That is, the current account balance is the increase in a nations net foreign wealth (or, International Investment Position) We will see later that a nations IIP can change for other reasons as well Current Account Balance Current Account Balance = Credits Debits Current Account Credits Exports of goods Exports of services

E.g., Payment received for legal work, tourists spending Income receipts (primary income) E.g., interest and dividends received, profits received from businesses located abroad but owned by domestic residents Unilateral transfers (gifts) received Current Account Balance Current Account Balance = Credits Debits

Current Account Debits imports of goods imports of services Income payments (primary income) Unilateral transfers (gifts) given Roughly speaking, a nations current account balance equals its net exports of goods and services Table 13.2 U.S. Balance of

Payments Accounts for 2015 (billions of dollars) Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 16, 2016, release. Totals may differ from sums because of rounding. NUT = gifts received gifts given. Gifts given

exceeded gifts received by $129.7 billion Credits Debits Income is made up mostly of international interest and dividend payments and the earnings of

domestically owned firms operating abroad. A negative current account is called a deficit: $440.4 billion has to be made up by borrowing. 12-65 NUT = gifts

received gifts given. Gifts given exceeded gifts received by $129.7 billion Credits Debits Income is made up mostly of international interest

and dividend payments and the earnings of domestically owned firms operating abroad. A negative current account is called a deficit: $440.4 billion has to be made up by borrowing. This is credits debits. It is a positive amount, which

indicates that $7.0 billion was received. But that still leaves $433.4 that must have been borrowed. 12-66 Financial Account Balance Financial account balance = net purchases of foreign assets by domestic residents

net purchases of domestic assets by foreign residents = lending borrowing = net lending = outflow inflow = net financial flows Financial inflow (borrowing) When foreign residents give loans to domestic residents, they acquire/purchase financial assets from domestic residents These financial inflows are credits in the financial account They represent an increase in the indebtedness of domestic residents Financial outflow (lending)

When domestic residents give loans to foreign residents, they acquire/purchase financial assets from foreign residents These financial inflows are debits in the financial account They represent an increase in the wealth of domestic residents Balance of Payments Accounts (cont.) Roughly speaking, a nations net financial flows equals the increase in its net foreign wealth In 2012, US net financial flows was -$439.4 billion. As a negative

increase amounts to a decrease, this means US net foreign wealth actually decreased in 2012 Net foreign wealth is also called International Investment Position Net Errors and Omissions In theory, Current Account Balance + Capital Account Balance = Financial Account Balance In reality, the two sides dont match, because of imperfections in the data This mismatch is called Net Errors and Omissions or Statistical

Discrepancy Statistically, Current Account Balance + Capital Account Balance + Net Errors and Omissions = Financial Account Balance Official Reserve Transactions Official (international) reserve assets: foreign assets held by central banks to cushion against instability in international markets. Assets include government bonds, currency, gold and accounts at the International Monetary Fund.

Official reserve assets sold to foreign central banks are a credit Official reserve assets purchased by the domestic central bank are a debit 12-70 Official Settlements Balance Official Settlements Balance = net purchase of international reserves by domestic central bank net purchase of domestic assets by foreign central banks

= net lending to foreign residents by domestic central bank net lending to domestic residents by foreign central banks = net lending to foreign residents through interventions by central banks Official Settlements Balance Roughly speaking: Net financial flows is the net new lending by domestic residents to foreign residents This was -$439.4 billion in 2012

Official settlements balance is the net new lending by domestic residents to foreign residents through transactions that involve central banks This was -$389.4 billion in 2012 This is also called net central bank financial flows Income is made up mostly of international interest and dividend payments

and the earnings of domestically owned firms operating abroad. A current account deficit: $440.4 billion has to be made up by borrowing. This is a positive amount, which indicates that $7.0 billion was received. That still leaves $433.4 that

must have been borrowed. 12-73 The net US acquisition of financial assets = acquisition of new assets from foreign residents the sale (back to foreign residents) of assets US residents had bought from foreign residents in the past. So, this is new US lending to foreigners.

New US borrowing from foreigners US net borrowing from foreigners. Should have been $433.4 billion. Measurement is imperfect. It seems we borrowed $6 billion more than what the 12-74 theory implies. All central banks combined gave US residents a loan of $389.4 billion. So a huge

chunk of the $439.4 billion that US residents borrowed to pay for their current account deficit was from foreign central banks. This is not a good sign because it suggests that private-sector lenders would not provide the loans needed to support the USs current account deficit. This is the new lending to foreigners by the US central bank, the Fed

This is US residents new borrowing from foreign central banks. US residents net asset purchases involving central banks is 4.5 393.9 = $389.4 billion. This is the official settlements balance of the US. Informally, this too is 12-75 called balance of payments. US Balance of Payments Accounts

The US has the highest negative net foreign wealth in the world, and is therefore the worlds biggest debtor nation. And its current account continues to be in deficit. So, its net foreign wealth continues to decrease. The value of foreign assets held by the US has grown since 1980, but liabilities of the US (debt held by foreigners) has grown more quickly. Changes in Net Foreign Wealth (IIP)

We have seen that a countrys net foreign wealth increases by the amount of its net financial flows But net foreign wealth can change for two other reasons as well: Changes in asset prices Changes in exchange rates Changes in Net Foreign Wealth (IIP) Changes in the market price of assets previously acquired can alter a countrys net foreign wealth.

When Japans stock market lost three-quarters of its value over the 1990s, for example, American and European owners of Japanese shares saw the value of their claims on Japan plummet, and Japans net foreign wealth increased as a result. Changes in Net Foreign Wealth (IIP) Exchange rate changes have a similar effect. When the dollar depreciates against foreign currencies, for example, foreigners who hold dollar assets see their wealth fall when measured in their home currencies.

12-80 Recall from Table 13-2 that this was the US current account deficit in 2012. These reflect changes in the dollar values of assets bought (sold) by US residents from (to) foreign residents caused by asset price changes and exchange rate changes.

12-83 Figure 13.3 U.S. Gross Foreign Assets and Liabilities, 19762015 Since 1976, both the foreign assets and the liabilities of the United States have increased sharply. But liabilities have risen more quickly, leaving the United States with a substantial net foreign debt. Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2016. Table 13.3 Change in the Yearend U.S. Net

International Investment Position (billions of dollars) (1 of 4) Table 13.3 Change in the Yearend U.S. Net International Investment Position (billions of dollars) (2 of 4) Table 13.3 Change in the Yearend U.S. Net International Investment Position (billions of dollars) (3 of 4)

Table 13.3 Change in the Yearend U.S. Net International Investment Position (billions of dollars) (4 of 4) r Revised n.a. Not available. . . . Not applicable (*) Value between zero and +/ $50 million 1. Represents gains or losses on foreign-currency-denominated assets and liabilities due to their revaluation at current exchange rates. 2. Includes changes due to year-to-year shifts in the composition of reporting panels and to the incorporation of more comprehensive survey results. Also includes capital gains and losses of direct investment affiliates and

changes in positions that cannot be allocated to financial transactions, price changes, or exchange-rate changes. 3. Financial transactions and other changes in financial derivatives positions are available only on a net basis, which is shown on line 3; they are not separately available for gross positive fair values and gross negative fair values of financial derivatives. 4. Data are not separately available for price changes, exchange-rate changes, and changes in volume and valuation not included elsewhere. Note: Details may not add to totals because of rounding. Source: U.S. Bureau of Economic Analysis. US Balance of Payments Accounts (cont.)

About 70% of foreign assets held by the US are denominated in foreign currencies and almost all of US liabilities (debt) are denominated in dollars. Changes in the exchange rate affect the value of net foreign wealth (gross foreign assets minus gross foreign liabilities). A depreciation of the US dollar makes foreign assets held by the US more valuable, but does not change the dollar value of dollar denominated debt. Any Questions? 90

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