2. Slide 12-1Copyright © 2003 Pearson Education, Inc. Chapter 12  National Income Accounting and the Balance of Payments  Introduction  The National Income Accounts  National Income Accounting for an Open Economy  The Balance of Payment Accounts  Summary

3. Slide 12-2Copyright © 2003 Pearson Education, Inc. Introduction  Macroeconomics It studies how economies’ overall levels of employment, production, and growth are determined. It emphasizes four aspects of economic life: –Unemployment –Saving (national saving: household, corporate, gov’t) –Trade imbalances –Money and the price level (Inflation)

4. Slide 12-3Copyright © 2003 Pearson Education, Inc.  The national income accounts and the balance of payments accounts are essential tools for studying the macroeconomics of open economies.  National income accounting Records all the expenditures that contribute to a country’s income and output –For closed economy –For open economy  Balance of payments accounting Keep track of both its payments to and its receipts from foreigners. Introduction

5. Slide 12-4Copyright © 2003 Pearson Education, Inc. 1. The National Income Accounts  Gross national product (GNP): Total market value of all final products (goods and services) produced by a country’s factors of production and sold on the market in a given time period.  GNP identity: sum of all market expenditures on final output: = C + I + G (for a closed economy)  Consumption Purchase by the private domestic residents to fulfill current wants  Investment Purchase by private firms to produce future output (build new plant & buy equipment for future production, including inventory).  Government Purchases Purchase by governments (including central and local governments).

6. Slide 12-5Copyright © 2003 Pearson Education, Inc. The National Income Accounts  Gross Domestic Product (GDP) It measures the volume of production within a country’s borders. GDP = GNP - net receipts of factor income or GNP = GDP + net receipts of factor income –If the factor income from abroad is larger than the foreign factor income here, then GNP>GDP.

7. Slide 12-6Copyright © 2003 Pearson Education, Inc. The National Income Accounts Figure 12-1: U.S. GNP and Its Components, 2000

8. Slide 12-7Copyright © 2003 Pearson Education, Inc.  National Product and National Income  National Income It is earned over a period by its factors of production. In principle, it must equal to the GNP. –One person’s spending is another’s income (i.e., total production equals total spending & also total income). –In practice, it differs from GNP for the following reasons. The National Income Accounts

9. Slide 12-8Copyright © 2003 Pearson Education, Inc.  Adjustments to the GNP for National Income: –Depreciation of capital –It must be subtracted from GNP (to get the NNP). –Net unilateral transfers of income –They are part of a country’s income but are not part of its product. –They must be added to the net national product (to get NI). –Indirect business taxes –Such tax as sales tax which is not distributed to the factors of production –They must be subtracted from GNP (to get NI). The National Income Accounts

10. Slide 12-9Copyright © 2003 Pearson Education, Inc. 2. National Income Accounting for an Open Economy  Modified the closed-economy’s national income accounting Some domestic output is exported and some domestic income spent on imported foreign products.  Consumption  Investment  Government Purchases  Current Account balance (=Net Export = export - import) The amount net export (of goods and services) to foreigners.  The National Income (GNP) Identity for an Open Economy The sum of domestic and foreigners’ expenditure on the goods and services produced by domestic factors of production: Y = C + I + G + (EX – IM) (12-1) = C d + I d + G d + EX (for IM = C im + I im + G im )

11. Slide 12-10Copyright © 2003 Pearson Education, Inc.  An Imaginary Open Economy Assumptions of the model: –An economy, called Agraria, can only produce wheat. –Each citizen is both a consumer and a producer of wheat. –Farmer put aside a portion of product as seed for next year’s planting. –The Agrarian government appropriates part of the crop to feed its army. –Agraria import milk from the rest of the world in exchange for exports of wheat. –The price of milk (per gallon) is 0.5 bushel of wheat, and at this price Agrarians want to consume 40 gallons of milk. National Income Accounting for an Open Economy

12. Slide 12-11Copyright © 2003 Pearson Education, Inc. Table 12-1: National Income Accounts for Agraria, an Open Economy (bushels of wheat) National Income Accounting for an Open Economy

13. Slide 12-12Copyright © 2003 Pearson Education, Inc.  The Current Account and Foreign Indebtedness Current account (CA) balance: (= EX – IM) –The difference between exports (of goods and services) and imports (of goods and services). –A country has a CA surplus when its CA > 0. –A country has a CA deficit when its CA < 0. GNP identity shows why CA balance is important in open macroeconomics. –Change in CA is associated with changes in output. (See next slide) –Also, CA measures the size and direction of international borrowing. –A country’s current account balance equals the change in its net foreign wealth. National Income Accounting for an Open Economy

14. Slide 12-13Copyright © 2003 Pearson Education, Inc. CA balance is equal to the difference between GNP (national income) and domestic residents’ total spending: Y – (C+ I + G) = CA –CA balance is total production less total spending, which can be associated with changes in Y or employment. –CA deficit (spending beyond national income) can be financed by borrowing abroad (or reducing net foreign assets). –Eg: Agraria imports 20 bushels of wheat (40 gallons of milk) and exports 10 bushels of wheat. CA deficit is 10 bushels of wheat. –It has to borrow this much from foreigners, which have to be repaid in the future. –CA surplus increase net foreign assets (eg. lending abroad). National Income Accounting for an Open Economy

15. Slide 12-14Copyright © 2003 Pearson Education, Inc. Figure 12-2: The U.S. Current Account and Net Foreign Wealth Position, 1977-2000 National Income Accounting for an Open Economy

16. Slide 12-15Copyright © 2003 Pearson Education, Inc.  Saving and the Current Account The GNP identity has many important implications. National saving (S) –(Def.) The portion of output (Y) that is not devoted to household consumption (C) or government purchases (G). (S= Y – C – G). –In closed economy, national saving always equals investment (S = I ). –This can be derived from GNP identity. –A closed economy can save only by building up its capital stock –An open economy can save either by building up its capital stock or by acquiring foreign wealth (S = I + CA, derived from GNP identity). –Investment can increase not just based on domestic saving, also based upon imported goods financed by foreign borrowing. –Some foreign country save for this country’s investment. –A country’s CA surplus is referred to as its net foreign investment. National Income Accounting for an Open Economy

17. Slide 12-16Copyright © 2003 Pearson Education, Inc.  Private and Government Saving Private saving (S p ) –Part of disposable income that is saved rather than consumed ( S p = Y – T – C ) Government savings S g = (T-G) National Saving (S) defined by (Y-C-G) is the sum of S p and S g. –S = (Y-C-G) = (Y-T-C) + (T-G) = S p + S g (= I + CA). (Rewrite national income identity to analyze the effect of S g ). S p = I + CA – S g = I + CA – (T – G) = I + CA + (G – T) (12-2) –Government budget deficit (G – T) (– of government saving) is the extent of government borrowing to finance its expenditure. Equation (12-2), an identity, is useful in many analysis. –Private saving can take three forms: investment, purchase of foreign asset, and government’s newly issued debt. National Income Accounting for an Open Economy

18. Slide 12-17Copyright © 2003 Pearson Education, Inc. 3. The Balance of Payments Accounts  A country’s balance of payments accounts keep track of both its payments to and its receipts from foreigners. A payment is recorded as debit(-), while receipt as credit(+).  Three types of int’l transactions recorded (3 sub-accounts). Exports or imports of goods or services –Recorded in current account, as a credit(+) or a debit(-). Purchases or sales of financial assets (money, stocks, bond, factory, etc) recorded in financial account. –When a country buy foreign asset, recorded as a debit (-) in financial account, while sales of asset recorded as a credit (+). * Transfers of wealth between countries (usually non-market). –Recorded in the capital account (debt forgiveness recorded as -) –(In some countries) included in current account as current transfer.

19. Slide 12-18Copyright © 2003 Pearson Education, Inc.  Any international transaction automatically enters the balance of payments twice: once as a credit (+) and once as a debit (-) Among the three sub-accounts.  Examples of Paired Transactions A U.S. citizen buys a $1000 typewriter from an Italian company, and the Italian company deposits the $1000 in its account at Citibank in New York. –This transaction creates the following two offsetting entries in the U.S. balance of payments (bookkeeping): –It enters the U.S. CA with a negative sign (-$1000) or $1000 debit (as a goods import). –It enters as a $1000 credit in the U.S. financial account (as sale of bank deposit, which is a US asset).. The Balance of Payments Accounts

20. Slide 12-19Copyright © 2003 Pearson Education, Inc. (Examples: cont’d) A U.S. citizen pays $200 for dinner at a French restaurant in France by charging his Visa credit card. –This transaction creates the following two offsetting entries in the U.S. balance of payments: –It enters the U.S. CA with a negative sign (-$200) (as a service import). –It shows up as a $200 credit in the U.S. financial account (as sale of claim on US asset). The Balance of Payments Accounts

21. Slide 12-20Copyright © 2003 Pearson Education, Inc. (Examples: cont’d) A U.S. citizen buys a $95 newly issued share of stock of a UK company by issuing a check drawn on his account, while the UK company deposits the $95 in its own U.S. bank account. –That is, the U.S. trades assets for assets. –This transaction creates the following two offsetting entries in the U.S. balance of payments: –It enters the U.S. financial account with a negative sign (-$95)- as purchase of a share of a UK company. –It shows up as a $95 credit in the U.S. financial account, as a sale of claim (deposit by the UK company on US bank). The Balance of Payments Accounts

22. Slide 12-21Copyright © 2003 Pearson Education, Inc. (Examples: cont’d) A U.S. bank forgives $5000 in debt owed to it by the government of (imaginary) Bygonia. –This transaction creates the following two offsetting entries in the U.S. balance of payments: –It enters the U.S. capital account with a negative sign (-$5000), as a capital transfer (that is, debit in capital account). –It shows up as a $5000 credit (+) in the U.S. financial account (as an ‘export’ of US asset, with reduction in the bank’s claim on Bygonia) ). The Balance of Payments Accounts

23. Slide 12-22Copyright © 2003 Pearson Education, Inc.  The Fundamental Balance of Payments Identity Any international transaction automatically gives rise to two offsetting entries in the balance of payments, resulting in a fundamental identity: Current account + financial account + capital account = 0 (12-3) The sum of current and capital account balance (current account balance until 1999 in US) is the change in country’s net receipt, therefore it should be matched by the financial account balance (i.e., net change in financial asset) with opposite sign. –Recall the relationship linking the current account to international lending (or borrowing). The Balance of Payments Accounts

24. Slide 12-23Copyright © 2003 Pearson Education, Inc. The Balance of Payments Accounts

25. Slide 12-24Copyright © 2003 Pearson Education, Inc. The Balance of Payments Accounts

26. Slide 12-25Copyright © 2003 Pearson Education, Inc.  The Current Account, Once Again The balance of payments accounts divide exports and imports into three categories: –Merchandise (goods) trade: exports or imports of goods –Services trade: –Payments for legal assistance, tourists’ expenditures, and shipping fees, etc. –Income payment –International interest/dividend payments, earnings of domestic firms operating abroad or individuals working abroad, etc (kind of service trade- compensation for services) Unilateral transfer between countries, such as gifts. –Not correspond to the purchase (or sale). The Balance of Payments Accounts

27. Slide 12-26Copyright © 2003 Pearson Education, Inc.  The Capital Account It records asset transfers (not transactions) and tends to be small for most countries.  The Financial Account It measures the difference between sales (export) of assets to foreigner and purchases (import) of assets from foreigner. –Financial (capital) inflow (+) –Borrowing from foreigners is selling them an asset (a promise to be repaid). –Financial (capital) outflow (-) –Lending to foreigners is purchasing an asset from them. The Balance of Payments Accounts

28. Slide 12-27Copyright © 2003 Pearson Education, Inc.  The Statistical Discrepancy Data associated with a given transaction may come from different sources that differ in coverage, accuracy, and timing. –This makes the balance of payments accounts seldom balance in practice. (‘fundamental identity’ not held). –Account keepers force the two sides to balance by adding an item called ‘statistical discrepancy’ to the accounts. –It is very difficult to allocate this discrepancy among the current, capital, and financial accounts. –The financial account is the most likely. The Balance of Payments Accounts

29. Slide 12-28Copyright © 2003 Pearson Education, Inc.  Official Reserve Transactions (skip) One type of financial account transaction is important enough for separate discussion: –Sale or purchase of official reserve assets by central bank. Central bank –The institution responsible for managing the supply of money Official international reserves –Foreign assets held by central banks as a cushion against national economic misfortune Official foreign exchange intervention –Central banks buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies. The Balance of Payments Accounts

30. Slide 12-29Copyright © 2003 Pearson Education, Inc. The Balance of Payments Accounts  Official foreign exchange intervention It is recorded in financial account as if the same transaction by a private citizen. Eg. US import of German car (Volkswagen) for $15,000, where Volkswagen sell the dollar revenue to the Bundesbank (German central bank). –Bundesbank’s official dollar reserve increases. –US BOP account: +$15,000 in financial account, with -$15,000 in current account. –German BOP account: -$15,000 in financial account, with +$15,000 in current account

31. Slide 12-30Copyright © 2003 Pearson Education, Inc. Official settlements balance –The book-keeping offset to the balance of official reserve transactions is called Official settlements balance (or balance of payment). –It is the sum of the current account balance, the capital account balance, the nonreserve portion of the financial account balance, and the statistical discrepancy. –Example: The U.S. balance of payments in 2000 was -$35.6 billion, that is, the balance of official reserve transactions with its sign reversed. –A country with a negative balance of payments may signal that it is running down its international reserve assets or incurring debts to foreign monetary authorities. The Balance of Payments Accounts

32. Slide 12-31Copyright © 2003 Pearson Education, Inc. The Balance of Payments Accounts Table 12-3: Calculating the U.S. Official Settlements Balance for 2000 (billions of dollars)

33. Slide 12-32Copyright © 2003 Pearson Education, Inc. The Balance of Payments Accounts Table 12-3: Continued

34. Slide 12-33Copyright © 2003 Pearson Education, Inc. Summary  A country’s GNP is equal to the income received by its factors of production. GDP is equal to GNP less net receipts of factor income from abroad, measures the output produced within a country’s territorial borders.  In a closed economy, GNP must be consumed, invested, or purchased by the government. In an open economy, GNP equals the sum of consumption, investment, government purchases, and net exports of goods and services.

35. Slide 12-34Copyright © 2003 Pearson Education, Inc. Summary  All transactions between a country and the rest of the world are recorded in its balance of payments accounts.  The current account equals the country’s net lending to foreigners. National saving equals domestic investment plus the current account. Transactions involving goods and services appear in the current account of the balance of payments, while international sales or purchases of assets appear in the financial account.

36. Slide 12-35Copyright © 2003 Pearson Education, Inc. Summary  The capital account records asset transfers and tends to be small in the United States.  Any current account deficit must be matched by an equal surplus in the other two accounts of the balance of payments, and any current account surplus by a deficit somewhere else.  International asset transactions carried out by central banks are included in the financial account.