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 and the price level

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

The National Income Accounts

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

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)

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

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

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

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

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

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)

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 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

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.

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 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.

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.

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

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

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

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

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

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

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

National Saving = Private Saving + Public Saving S = Y – C – 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 S = Y – C – G – T + T S = Y – T – C + T – G Private Saving: Sp = Y – T – C Public Saving: Sg = T – G National Saving = Private Saving + Public Saving S = Sp + Sg

S = Sp + Sg Figure 4.1 of Macroeconomics: Policy and Practice by Frederic Mishkin

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

S = Sp + Sg Figure 4.1 of Macroeconomics: Policy and Practice by Frederic Mishkin

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.

CA = S – I Figure 4.1 of Macroeconomics: Policy and Practice by Frederic Mishkin

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.

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.

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

Balance of Payments Accounts

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 (-).

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.

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

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.

Example of Balance of Payment Accounting You import a DVD of Japanese anime by using your debit card. The Japanese producer of anime deposits the funds in its bank account in San Francisco. The bank credits the account by the amount of the deposit. DVD purchase (current account) –$30 Credit (“sale”) of bank account by bank (financial account) +$30

Example of Balance of Payment Accounting (cont.) You invest in the Japanese stock market by buying $500 in Sony stock. Sony deposits your funds in its Los Angeles bank account. The bank credits the account by the amount of the deposit. Purchase of stock (financial account) –$500 Credit (“sale”) of bank account by bank (financial account) +$500

Example of Balance of Payment Accounting (cont.) US banks forgive a $100 M debt owed by the government of Argentina through debt restructuring. US banks who hold the debt thereby reduce the debt by crediting Argentina’s bank accounts. Debt forgiveness: non-market transfer (capital account) –$100 M Credit (“sale”) of bank account by bank (financial account) +$100 M

“Balance” Balance = total credits – total debits When understood to be a numerical value, current account stands for balance of the current account, capital account stands for balance of the capital account, and financial account stands for balance of the financial account.

How Do the Balance of Payments Accounts Balance? Due to the double entry of each transaction, the overall balance must be zero: current account + financial account + capital account = 0 This is called the Fundamental Balance of Payments Identity Link: http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3

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 sum to zero for each country.

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 a measure of the change in a nation’s net foreign wealth (or, IIP) We will see later, however, that IIP can change for other reasons as well

Balance of Payments Accounts Each of the 3 broad accounts are more finely divided: Current account merchandise (goods like DVDs) services (payments for legal services, shipping services, tourist meals,…) income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries) gifts (transfers) across countries that do not purchase a good or service nor serve as income

Balance of Payments Accounts Current account balance = (exports of goods and services – imports of goods and services) + (factor income received from foreigners – factor income paid to foreigners) + (gifts of current income received from foreigners – gifts of current income paid to foreigners) CA = NX + NFI + NUTincome

Balance of Payments Accounts (cont.) Capital account: records special asset transfers, but this is a minor account for the US. Capital account balance = gifts of assets received from foreign residents – gifts of assets given to foreign residents KA = NUTassets

Balance of Payments Accounts (cont.) Financial account = sales of domestic assets to foreigners – purchases of foreign assets by domestic citizens. Financial inflow Foreign citizens give loans to domestic citizens by acquiring domestic assets. (+) Foreigners’ purchase of assets from domestic citizens are a credit (+) Financial (capital) outflow Domestic citizens give loans to foreigners by acquiring their assets (foreign assets). (-) Domestic citizens’ purchase of assets from foreign citizens are a debit (-)

Balance of Payments Accounts (cont.) Financial account balance = capital inflow – capital outflow = sale of financial assets by domestic residents to foreign residents – purchase of financial assets by domestic residents from foreign residents = net export of financial assets

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

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 (-).

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.

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.

Official Settlements Balance If the official settlements balance is a negative number, the balance of the official reserve transactions account must be a positive number. In this case the transactions of non-central bank entities has increased our debt. And so, either foreign central banks must help us out by buying our assets or our central bank must sell its holdings of foreign assets. Thus, a crisis may be in the offing.

Balance of Payments Accounts (cont.) A negative official settlements balance may indicate that a country is depleting its official international reserve assets or may be incurring debts to foreign central banks. The selling of foreign currency by the domestic central bank and the buying of domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance.

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.

US lending to foreigners 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.

All central banks combined gave US residents a loan of $389. 4 billion All central banks combined gave US residents a loan of $389.4 billion. So a huge chunk of the borrowing that US residents needed 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. This is the lending to foreigners (asset purchases) by US central bank, the Fed This is US residents’ borrowing from (asset sales to) foreign central banks. US residents’ net asset purchases 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.

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.

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

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.

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.

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.

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.