University of Papua New Guinea International Economics Lecture 14: National Income Accounting and the Balance of Payments

The University of Papua New Guinea Slide 1 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Overview Review: National income accounting The balance of payments accounts Review: Saving More on the current account… The twin deficits hypothesis Managing the accounts

The University of Papua New Guinea Slide 2 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Review: National income accounting GDP measured by the expenditure method: Y = C + I + G + (X-M) –Y = Income –C = Consumption –I = Investment –G = Government spending –X = Exports –M = Imports Note: (X – M) is sometimes written as NX, meaning ‘net exports’

The University of Papua New Guinea Slide 3 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The balance of payments accounts Current Account + Capital Account = Financial Account

The University of Papua New Guinea Slide 4 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The balance of payments accounts Current account: –X, M –Interest/dividends coming in from overseas investments and going out from FDI (but not the FDI itself!!) –Remittances, transfers… +ve: Money coming in –ve: Money going out

The University of Papua New Guinea Slide 5 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The balance of payments accounts Capital account: Tracks transfers of assets into or out of a country +ve: FDI, foreign loans, foreign aid (when goods or services are attached) –ve: ‘capital flight’

The University of Papua New Guinea Slide 6 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The balance of payments accounts Financial account: Sometimes called the cash account, or the international reserves account –Foreign cash reserves –Gold –Deposits with the IMF –Finance from the IMF –Acts as balancing item in balance of payments IMF = International Monetary Fund; Acts like the world’s reserve bank!

The University of Papua New Guinea Slide 7 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Credits and debits in the Balance of Payments Accounts Note: Everything entering the balance of payments accounts gets entered twice – once as a debit, once as a credit

The University of Papua New Guinea Slide 8 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Review: Saving Closed economy: S = Y – C – G = I Can only build up wealth through developing its own capital stock –I.e., domestic I

The University of Papua New Guinea Slide 9 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Review: Saving Open economy: S = I + CA (‘Current Account’) –Can build up wealth through domestic I, or through acquiring foreign wealth I.e., purchasing foreign assets –Because a country’s savings can be borrowed by another, a current account surplus is often called net foreign investment

The University of Papua New Guinea Slide 10 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Review: Saving Open economy (cont.) The current account is thus intertemporal trade in consumption –I.e., a current account deficit is where a country borrows money – importing consumption now – and pays off the money later – exporting consumption in the future It’s the opposite with a current account surplus!

The University of Papua New Guinea Slide 11 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Review: Saving Private saving: S P = Y – T – C [T = Tax] It is simply income that is saved and not consumed! Public saving: S G = T – G In any given year, if T > G, it a budget surplus If T < G, it is a budget deficit

The University of Papua New Guinea Slide 12 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Why care about the current account? Current account balance = X – M = NX [‘Net Exports’] When X > M: current account surplus When X < M: current account deficit Note: Technically, the current account also includes net income (this is the ingoings and outgoings of dividends, interest, transfers, and foreign aid when it is given as cash with no good or service attached) So we are oversimplifying things when we think of CA = NX!

The University of Papua New Guinea Slide 13 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Why care about the current account? 1.Employment The equation Y = C + I + G + NX tells us that the current account (NX) contributes to output… –…and thus employment!

The University of Papua New Guinea Slide 14 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Why care about the current account? 2.International borrowing It shows the size and direction of international borrowing –E.g. if the current account is –PGK 300million, per month, then it is spending its export earnings, and then borrowing 300million per month to finance these extra imports

The University of Papua New Guinea Slide 15 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Why care about the current account? Thus, the current account balance is equal to the change in its net foreign wealth –Current account is a flow variable –Net foreign wealth is the stock variable Tracking the current account over time helps to identify if a country’s public and private debt is sustainable or not!

The University of Papua New Guinea Slide 16 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Why care about the current account? An analogy that may help: Think about the current account as the withdrawals / deposits, and net foreign wealth as the bank balance (which includes international reserves – the rainy day fund that can help prop up the currency!) If you keep withdrawing, you get into debt …and at some point, no-one will lend to you any more!

The University of Papua New Guinea Slide 17 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish United States

The University of Papua New Guinea Slide 18 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish

The University of Papua New Guinea Slide 19 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Australia

The University of Papua New Guinea Slide 20 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Papua New Guinea

The University of Papua New Guinea Slide 21 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish PNG: Balance of payments balance Source: Paul Flanagan, ANU

The University of Papua New Guinea Slide 22 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish PNG: Balance of payments and international reserves Source: Paul Flanagan, ANU

The University of Papua New Guinea Slide 23 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish PNG: Effect of oil price fall on balance of payments Source: Paul Flanagan, ANU

The University of Papua New Guinea Slide 24 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Source: Paul Flanagan, ANU PNG: Effect of oil price fall on balance of payments and international reserves

The University of Papua New Guinea Slide 25 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The twin deficits hypothesis Argues that there is a strong link between current account deficits, and government budget deficits Some, tentative empirical evidence supports the hypothesis

The University of Papua New Guinea Slide 26 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish The twin deficits hypothesis If we rearrange our savings and output identities, we can get to: If there is a budget deficit, then (T – G) is negative …and this means either investment is crowded out (  I), or there must be a  (NX) => i.e., a worsening of the current account

The University of Papua New Guinea Slide 27 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Managing the accounts International reserves can finance deficits (i.e., the rainy day fund!) –But this is not a long-term solution! Improving the capital account: –FDI, foreign aid, remittances –Sound monetary and fiscal policy

The University of Papua New Guinea Slide 28 Lecture 14: National Income Accounting and the Balance of Payments Michael Cornish Managing the accounts Improving the current account: –Increase X earnings –Decrease interest/dividend payments going overseas –Devaluation! =>  M,  X (but keep imported production inputs in mind!) –Sound monetary and fiscal policy