1. Ch. 13: National Income Accounting and the Balance of Payments Udayan Roy ECO41 International Economics

2. 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

3. International Macroeconomics International macroeconomics introduces four aspects of economic life that are ignored in international trade: – Unemployment – Saving – Trade imbalances – Money and the price level

4. International Macroeconomics International macroeconomics tries to explain the behavior—across countries at any given time, or across time for a given country—of economic variables that are ignored in international trade These variables are measured by the tools of – National income accounting, and – Balance of payments accounting

5. THE NATIONAL INCOME ACCOUNTS

6. The National Income Accounts A country’s gross national product (GNP) is the value of all final goods and services produced by the country’s factors of production and sold on the market in a given time period

7. The National Income Accounts A country’s gross national product (GNP) is the value of all final goods and services produced by the country’s 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)

8. The National Income Accounts A country’s gross national product (GNP) is the value of all final goods and services produced by the country’s 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

9. The National Income Accounts A country’s gross national product (GNP) is the value of all final goods and services produced by the country’s 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

10. The National Income Accounts A country’s gross national product (GNP) is the value of all final goods and services produced by the country’s 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 people’s pockets

11. The National Income Accounts 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

12. The National Income Accounts Of the production, expenditure and income approaches to GNP measurement, the expenditure approach is the most useful in international macroeconomic theory

13. 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)

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15. 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

16. 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

17. 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.

18. 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 country’s borders – Recall that GNP is the value of all final goods and services produced by the country’s factors of production anywhere in the world

19. 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.

20. 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.

21. 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

22. 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

23. 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

24. CA and International Borrowing 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. Anne’s exports to Bob equal $100 and Anne’s imports from Bob equal $75. This is possible only if Bob borrows $25 from Anne.

25. CA and 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. Anne’s exports to Bob equal $100 and Anne’s imports from Bob equal $125. This is possible only if Anne borrows $25 from Bob.

26. CA and International Borrowing CA = EX – IM Net Foreign Wealth of a country = Value of assets bought by domestic residents from foreign residents – Value of assets bought by foreign residents from domestic residents

27. CA and International Borrowing CA = EX – IM 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

28. CA and International Borrowing 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 country’s net foreign wealth increases by the amount equal to CA

29. CA and International Borrowing 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 country’s net foreign wealth decreases by the amount equal to CA

30. CA and International Borrowing Therefore, the current account balance = change in net foreign wealth – So a string of current account deficits (surpluses) can lead to a dramatic decrease (increase) in a country’s net foreign wealth Net Foreign Wealth is also called Net International Investment Position

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32. 12-32 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

33. 12-33 Saving and the Current Account National saving (S) = national income (Y) that is not spent on consumption (C) or on government purchases (G). S = Y – C – G

34. National Saving = Private Saving + Public Saving S = Y – C – G S = Y – C – G – T + T S = Y – T – C + T – G The government’s net tax revenues are denoted T. T = tax revenues – transfer payments Y – T is total after-tax income or disposable income Private Saving: S p = Y – T – C Public Saving: S g = T – G National Saving = Private Saving + Public Saving S = S p + S g 13-34

35. S = S p + S g 13-35

36. 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 13-36

37. S = S p + S g 12-37

38. 12-38 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.

39. CA = S – I 12-39

40. 12-40 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.

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

42. 12-42 Inverse Relationship Between Public Saving and Current Account? Source: Congressional Budget Office, US Department of Commerce

43. BALANCE OF PAYMENTS ACCOUNTS 12-43

44. 12-44 Balance of Payments Accounts A country’s 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

45. Credits and Debits A country’s 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.

46. 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

47. 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

48. 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

49. 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 dollars—in return for euros—to, say, Heidi, who wants dollars to buy something from some American Either way, the dollars you paid Johan will return to the US (credit)

50. 12-50 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 non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks.

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

52. 12-52 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 CreditsDebits Meal purchase (current account, U.S. service import) $200 Sale of credit card claim ( financial account, U.S. asset sale ) $200

53. 12-53 Example of Balance of Payment Accounting You buy a share of BP, a British firm. BP deposits the money in a U.S. bank. CreditsDebits Stock purchase (financial account, U.S. asset purchase) $95 Bank deposit (financial account, U.S. asset sale) $95

54. 12-54 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 Bygonia’s bank accounts. CreditsDebits Debt forgiveness (capital account, U.S. transfer payment) $5,000 Reduction in bank’s claims (financial account, U.S. asset sale) $5,000

55. 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

56. 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

57. “Balance” For the Current Account and the Capital Account, – Balance = Total Credits – Total Debits But for the Financial Account, – Balance = Total Debits – Total Credits

58. 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

59. 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. Anne’s current account balance = +$25 Anne’s financial account balance = +$25 Bob’s current account balance = –$25 Bob’s financial account balance = –$25 The capital account has no role in this example. Note that the balances must be the same in each country.

60. Fundamental Balance of Payments Identity Note that Anne’s (Bob’s) net foreign wealth increases by the amount of Anne’s (Bob’s) current account balance That is, the current account balance is the increase in a nation’s net foreign wealth (or, International Investment Position) – We will see later that a nation’s IIP can change for other reasons as well

61. 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

62. 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 nation’s current account balance equals its net exports of goods and services

63. 12-63 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. NUT = gifts received – gifts given. Gifts given exceeded gifts received by $129.7 billion Credits – Debits

64. 12-64 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. NUT = gifts received – gifts given. Gifts given exceeded gifts received by $129.7 billion Credits – Debits This is credits – debits. It is a positive amount, which indicates that $7.0 billion was received. But that still leaves $433.4 to be borrowed.

65. 12-65 Financial Account Balance Financial account balance = purchases of foreign assets by domestic citizens – sales of domestic assets to foreigners. A nation’s financial account balance is also called its net financial flows Financial inflow – 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 – 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

66. Balance of Payments Accounts (cont.) Financial account balance = debits – credits = financial outflow – financial inflow = purchase of financial assets by domestic residents from foreign residents – sale of financial assets by domestic residents to foreign residents = net financial flows Roughly speaking, a nation’s net financial flows equals the net increase in what domestic residents owe foreign residents 12-66

67. 12-67 Balance of Payments Accounts (cont.) Financial account has at least 3 categories: 1.Official (international) reserve assets 2.All other assets 3.Statistical discrepancy

68. 12-68 Balance of Payments Accounts (cont.) 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

69. 12-69 Balance of Payments Accounts (cont.) Statistical discrepancy – Data from a transaction may come from different sources that differ in coverage, accuracy, and timing. – The balance of payments accounts therefore seldom balance in practice. – The statistical discrepancy is the account added to or subtracted from the financial account to make it balance with the current account and capital account.

70. 12-70 Balance of Payments Accounts (cont.) The negative of the balance of official reserve assets is called the official settlements balance or “balance of payments”. – It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statistical discrepancy.

71. 12-71 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 to be borrowed.

72. 12-72 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 theory implies.

73. 12-73 This is the lending to foreigners (or, asset purchases) by the US central bank, the Fed This is US residents’ borrowing from (or, asset sales to) foreign central banks. 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 US’s current account deficit. US residents’ net asset purchases from central banks is 4.5 – 393.9 = – $389.4 billion. This is the official settlements balance of the US. Informally, this too is called balance of payments.

74. 12-74 US Balance of Payments Accounts The US has the highest negative net foreign wealth in the world, and is therefore the world’s 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.

75. Changes in Net Foreign Wealth (IIP) We have seen that a country’s net foreign wealth increases by the amount of its current account balance But net foreign wealth can change for two other reasons as well

76. Changes in Net Foreign Wealth (IIP) Changes in the market price of wealth previously acquired can alter a country’s net foreign wealth. – When Japan’s 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 Japan’s net foreign wealth increased as a result.

77. 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.

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79. 12-79 Recall from Table 13-2 that this was the US current account deficit in 2012.

80. 12-80 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.

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83. 12-83 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.