Econ 141 Fall 2013 Slide Set 6 National and International Accounts: the Balance of Payments.

Econ 141 Fall 2013

Slide Set 6National and International Accounts: the Balance of Payments

National and International Accounts: Income, Wealth, and the Balance of Payments

• In an open economy, the measurement of economic activity is more complicated because we have to account for cross-border flows. • These additional flows are recorded in a nation’s balance of

payments accounts.• We need to learn an international system of trade and payments to

show international trade in goods and services is complemented and balanced by a parallel trade in assets

explain the international system of trade and payments see how these transactions relate to national income and wealth

• Gross national expenditure (GNE) is the total expenditure on final goods and services by home entities in any given period (C + I + G).

• A country’s gross domestic product (GDP) is the value of all (intermediate and final ) goods and services produced as output by firms, minus the value of all goods and services purchased as inputs by firms.

The Flow of Payments in a Closed Economy:Introducing the National Income and Product Accounts

• GDP is a product measure, in contrast to GNE, which is an income measure.

• In a closed economy, income is paid to domestic entities. It thus equals the total income resources of the economy, also known as gross national income (GNI).

The Flow of Payments in a Closed Economy:Introducing the National Income and Product Accounts

• The difference between payments made for imports and payments received for exports is called the trade balance (TB), and it equals net payments to domestic firms for trade. GNE plus TB equals GDP, the total value of production in the home economy.

The Flow of Payments in an Open Economy: Incorporating the Balance of Payments Accounts

• The value of factor service exports minus factor service imports is known as net factor income from abroad (NFIA), and thus GDP plus NFIA equal GNI, the total income earned by domestic entities from all sources, domestic and foreign.

• Gifts may take the form of income transfers or “in kind” transfers of goods and services. They are considered nonmarket transactions, and are referred to as unilateral transfers.

• Net unilateral transfers (NUT) equals the value of unilateral transfers the country receives from the rest of the world minus those it gives to the rest of the world.

The Flow of Payments in an Open Economy: Transfers in the Balance of Payments

• These net transfers have to be added to GNI to calculate gross national disposable income (GNDI). Thus, GNI plus NUT equals GNDI, which represents the total income resources available to the home country.

Current Account

The current account (CA) is a tally of all international transactions in goods, services, and income (occurring through market transactions or transfers).

U.S Current Account

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-7

-6

-5

-4

-3

-2

-1

0

PercentageOf GDP

• The value of asset exports minus asset imports is called the financial account (FA). These net asset exports are added to home GNDI when calculating the total resources available for expenditure in the home country.

The Flow of Payments in an Open Economy: the Financial Account

• A country may not only buy and sell assets but also transfer assets as gifts. Such asset transfers are measured by the capital account (KA), which is the value of capital transfers from the rest of the world minus those to the rest of the world.

The Flow of Payments in an Open Economy: Capital Account

• The expenditure approach looks at the demand for goods: it examines how much is spent on demand for final goods and services. The key measure is GNE.

• The product approach looks at the supply of goods: it measures the value of all goods and services produced as output minus the value of goods used as inputs in production. The key measure is GDP.

• The income approach focuses on payments to owners of factors: it tracks the amount of income they receive. The key measures are gross national income GNI and gross national disposable income GNDI (which includes net transfers).

Three Approaches to Measuring Economic Activity

• Personal consumption expenditures: total spending by households on final goods and services, including nondurable goods such as food, durable goods, and services.

• Gross private domestic investment: total spending by firms or households on final goods and services to make additions to the stock of capital. Investment includes new construction, the purchase of new equipment, and net increases in inventories.

• Government consumption expenditures: spending by the public sector on final goods and services. It does not include transfer payments, such as Social Security or unemployment.

From GNE to GDP: Accounting for Trade in Goods and Services

• Gross domestic product equals gross national expenditure (GNE) plus the trade balance (TB).• The trade balance, TB, is also often called net exports because it is the

net value of exports minus imports, it may be positive or negative.• If TB > 0, exports are greater than imports and we say a country has a

trade surplus.• If TB < 0, imports are greater than exports and we say a country has a

trade deficit.

From GNE to GDP: Accounting for Trade in Goods and Services

TB

IMEXGICGDPbalance Trade

U.S. Trade Balance

19601962

19641966

19681970

19721974

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

2012

-6

-5

-4

-3

-2

-1

0

1

2

Trade balance, % of GDP

• Gross national income equals gross domestic product (GDP) plus net factor income from abroad (NFIA).

From GDP to GNI: Accounting for Trade in Factor Services

NFIAabroad from incomefactor Net

)()( FSFS IMEXIMEXGICGNI

U.S. Net Factor Income from Abroad

0

50

100

150

200

250

Billions Chained 2009 Dollars

A Paper Tiger? The chart shows trends in GDP, GNI, and NFIA in Ireland from 1980 to 2008. Irish GNI per capita grew more slowly than GDP per capita during the boom years of the 1980s and 1990s because an ever-larger share of GDP was sent abroad as net factor income to foreign investors. Close to zero in 1980, this share had risen to around 15% of GDP by the year 2000 and has remained there.

• If a country receives transfers UTIN and makes transfers UTOUT , its net unilateral transfers, NUT are NUT = UTIN − UTOUT . This can be positive or negative.• Adding net unilateral transfers to gross national income gives a

complete measure of national income in an open economy. This is gross national disposable income (GNDI), which we denote Y:

From GNI to GNDI: Accounting for Transfers of Income

)transfers

unilateralNet )(

abroad from incomefactor Net

)(balanceTrade

)()()(

(NUTGNI

NFIA

FSFS

TB

GNEGNDI

UTUTIMEXIMEXGICY

U.S. Net Unilateral Transfers

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

Percentage of GDP

From GNI to GNDI: Net Unilateral Transfers, 2000-2008

• Define the current account as the sum of all three external terms in gross national disposable income, GNDI:

What do National Economic Aggregates Tell Us?

)(accountCurrent

)transfers

unilateralNet

)(abroad from

incomefactor Net

)(balanceTrade

})()()({

CA

(NUTNFIA

FSFS

TB

GNEGNDI

UTUTIMEXIMEXGICY

U.S. Current Account Balance

19601963

19661969

19721975

19781981

19841987

19901993

19961999

20022005

20082011

-900-800-700-600-500-400-300-200-100

0100

Billions Current $

U.S. Current Account as a Percentage of GDP

19601962

19641966

19681970

19721974

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

2012

-7

-6

-5

-4

-3

-2

-1

0

1

2

CA in percent of GDP

Data for the National Economic Aggregates

The table shows the computation of GDP, GNI, and GNDI in 2009 in billions of dollars using the components of gross national expenditure, the trade balance, international income payments, and unilateral transfers

The Current Account

• This equation is the open-economy national income identity. • It tells us that the current account represents the difference between

national income Y (or GNDI) and gross national expenditure GNE (or C + I + G ).

Notice that • GNDI is greater than GNE if and only if CA is positive, or in surplus.• GNDI is less than GNE if and only if CA is negative, or in deficit.

Y C I G CA

• The current account is also the difference between national saving (S=Y-C-G) and investment:

• This equation is called the current account identity even though it is just a rearrangement of the national income identity. Thus,• S is greater than I if and only if CA is positive, or in surplus.• S is less than I if and only if CA is negative, or in deficit.

The Current Account

CAIGCYIS

Global Imbalances

Global Imbalances

• Private saving SP is that part of after-tax private sector disposable income Y that is not spent on private consumption C. Hence, private saving SP is

• We define government saving as the difference between tax revenue T received by the government and government purchases G. Hence, government saving Sg equals

• Private saving plus government saving equals total national saving, since

Global Imbalances

Sp Y T C

Sg T G

gp SSGTCTYGCYS saving Governmentsaving Private

)()(

Global Imbalances

Global Imbalances

• Do government deficits cause current account deficits? Sometimes they do go together, but these “twin deficits” are not inextricably linked, as is sometimes believed. The current account identity is

• The theory of Ricardian equivalence asserts that a fall in public saving is fully offset by a contemporaneous rise in private saving. What do we find in the data? The current account balance falls about 1/5 to 2/5 of the amount that government deficits rise. Private saving offsets the effects of tax cuts by more than half.

Global Imbalances

CA Sp Sg I

Global Imbalances

Global Imbalances

Global Imbalances

For the world as a whole,saving equals investment. The sum of all current accounts must balance.

The Balance of Payments

Accounting for Asset Transactions: the Financial Account

• The financial account records transactions between residents and nonresidents that involve financial assets.

• This definition covers all types of assets: real assets such as land or structures, and financial assets such as debt (bonds, loans) or equity, issued by any entity (private or public).

• Subtracting asset imports from asset exports gives the home country’s net overall balance on asset transactions. This is called the financial account, where FA = EXA − IMA.

• The financial account measures how the country accumulates or decumulates assets through international transactions.

Accounting for Asset Transactions: the Capital Account

• The capital account (KA) covers two remaining areas of asset movements of minor quantitative significance.

• The first is the acquisition and disposal of nonfinancial, nonproduced assets (e.g., patents, copyrights, trademarks, franchises, etc.).

• The second important item in the capital account is capital transfers (i.e., gifts of assets), an example of which is the forgiveness of debts.

• Capital transfers received by the home country are KAIN and capital transfers given by the home country as KAOUT. The capital account, KA = KAIN − KAOUT, records net capital transfers received.

Accounting for Home and Foreign Assets

• From the home perspective, a foreign asset is a claim on a foreign country. When a home entity holds such an asset, it is called an external asset of the home country.

• When a foreign entity holds such an asset, it is called an external liability of the home country because it represents an obligation owed by the home country to the rest of the world.

The Double-Entry Principle in the Balance of Payments

1. CA: Espresso along the Champs-Elysees −IM −$110

FA: Cafe’s claim on AMEX +EXH +$110

2. CA: Oregon pinot noir wine exported to Ireland

EX +$36

CA: Guiness imported to United States −IM −$36

3. FA: American Purchase of UK stocks

IMF

−$10,000

FA: London bank claim against +EXH

at Wells Fargo

−IM +$10,000

4. CA: Relief supplies exportedto South Sudan

−IM +$5,000

CA: U.S. citizen’s charitable gift −UTOUT −$5,000

5. KA: U.S. grant of debt relief −KAOUT −$1,000,000,000

FA: Decline in U.S. external assets −EXF

−$1,000,000,000

The Double-Entry Principle in the Balance of Payments, continued

Accounting for Home and Foreign Assets

• Using superscripts “H” and “F” to denote home and foreign assets, we can break down the financial account as the sum of the net exports of each type of asset:

• FA equals the additions to external liabilities (the home-owned assets moving into foreign ownership, net) minus the additions to external assets (the foreign-owned assets moving into home ownership, net).

assets external

toadditionsNet sliabilitie external

toadditionsNet assetsforeign ofexport Net assets home ofexport Net

)()()()( FA

FA

HA

HA

FA

FA

HA

HA EXIMIMEXIMEXIMEXFA

How the Balance of Payments Accounts Work

• Recall that gross national disposable income is

In addition, the home economy can free up (or use up) resources in another way: by engaging in net sales (or purchases) of assets. We can calculate these extra resources using our previous definitions:

income fromcountry home to

available Resources

CAGNENUTNFIATBGNEGNDIY

esasset trad toduecountry home theto

available resources Extra

purchases viaimported assets allof Value

gifts asimported

assets allof Value

importedassets all

of Value

sales viaexported assets allof Value

gifts asexported

assets allof Value

exportedassets all

of Value

][][ KAFAKAKAIMEXKAIMKAEX OUTINAAINAOUTA

• Adding the last two expressions, we arrive at the value of the total resources available to the home country for expenditure purposes. This total value must equal the total value of home expenditure on final goods and services, GNE:

• We can cancel GNE from both sides of this expression to obtain the important result known as the balance of payments identity or BOP identity:

How the Balance of Payments Accounts Work

GNEKAFACAGNE

esasset trad toduecountry home theto

available resources Extraincome toduecountry home to

available Resources

0=++account Financialaccount CapitalaccountCurrent

FAKACA

• The components of the BOP identity let us see the details behind why the accounts must balance.

• If an item has a plus sign, it is called a balance of payments credit or BOP credit.

• If an item has a minus sign, it is called a balance of payments debit or BOP debit.

How the Balance of Payments Accounts Work

CA(EX IM ) (EXFS IM FS ) (UT UT )

KA(KA KA )

FA (EXAH IM A

H ) (EXAF IM A

F )

We have to understand one simple principle: every market transaction (whether for goods, services, factor services, or assets) has two parts. If party A engages in a transaction with a counterparty B, then A receives from B an item of a given value, and in return B receives from A an item of equal value.

How the Balance of Payments Accounts Work

What the Balance of Payments account tells us

• A country that has a current account surplus is called a (net) lender. By the BOP identity, we know that it must have a deficit in its asset accounts, so like any lender, it is, on net, buying assets (acquiring IOUs from borrowers). For example, China is a large net lender.

• A country that has a current account deficit is called a (net) borrower. By the BOP identity, we know that it must have a surplus in its asset accounts, so like any borrower, it is, on net, selling assets (issuing IOUs to lenders). As we can see, the United States is a large net borrower.

• The current account measures external imbalances in goods, services, factor services, and unilateral transfers. The financial and capital accounts measure asset trades.

• Surpluses on the current account side must be offset by deficits on the asset side. Similarly, deficits on the current account must be offset by surpluses on the asset side.

• By telling us how current account imbalances are financed, the balance of payments makes the connection between a country’s income and spending decisions and the evolution of that country’s wealth.

What the Balance of Payments account tells us

U.S. Balance of Payments, 1960-2012 (current billion US$)

19601962

19641966

19681970

19721974

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

2012

-1000

-800

-600

-400

-200

0

200

400

600

800

1000

Financial Account Current AccountSum of CA, KA and Statistical Discrepancy Capital Account

• The level of a country’s external wealth (W) equals

• A country’s level of external wealth is also called its net international investment position or net foreign assets. It is a stock measure, not a flow measure.• If W > 0, home is a net creditor country: external assets exceed

external liabilities.• If W < 0, home is a net debtor country: external liabilities exceed

external assets.

The Level of External Wealth

LA

W

ROWby owned

assets Home

homeby owned

assetsROW = wealth External

• There are two reasons a country’s level of external wealth changes over time.1. Financial flows: As a result of asset trades, the country can

increase or decrease its external assets and liabilities.Net exports of home assets cause an equal increase in the level of external liabilities and hence a corresponding decrease in external wealth.

2. Valuation effects: The value of existing external assets and liabilities may change over time because of capital gains or losses. In the case of external wealth, this change in value could be due to price effects or exchange rate effects.

Changes in External Wealth

• Adding up these two contributions to the change in external wealth (ΔW), we find

• Since −FA = CA + KA, substituting into the first equation gives us

Changes in External Wealth

wealthexternal

on gains capitalNet

account

Financial

wealthexternal

in Change

FAW

effectsValuation

wealthexternal

on gains apitalcNet

account

Capital

account

urrentC

wealthexternal

in Change

KACAW

External wealth and total wealth

A country’s total wealth is the sum of its capital stock (K = all nonfinancial assets in the home economy) plus amounts owed to home by foreigners (A) minus amounts owed foreigners by home (L):

Changes in the value of total wealth are given by

wealthExternal

assets alnonfinanci Home

)-(+ = wealthTotal LAK

losses) minus (gains effectsValuation disposals) minus ns(acquisito Additions

–on

gains Capital+

on

gains Capital+

– to

Additions +

to

Additions =

wealthtotal

in Change

LAKLAK

Increases in K are investment, I. Increases in external wealth, A – L, equal net additions to external assets minus net additions to external liabilities

Using the BOP identity, we know that CA + KA + FA = 0 so that minus the financial account –FA must equal CA + KA, so that we can write

External wealth and total wealth, continued

losses) minus (gains effectsValuation

toAdditionsK toAdditions –on

gains Capital+

on

gains Capital+)(

wealthtotal

in Change

LAK

FAILA

losses) minus (gains effectsValuation

–on

gains Capital+

on

gains Capital

wealthtotal

in Change

LAK

KACAI

• The BOP identity connects external asset trade and transactions on the current account. Using the current account identity, S = I + CA, we get the equation

This says that there are three ways to gain more (or less) wealth: save more (or less) (S), receive (or give) gifts of assets (KA), or enjoy the good (bad) fortune of capital gains (losses) on your portfolio.

losses) minus (gains effectsValuation

–on

gains Capital+

on

gains Capital

wealthtotal

in Change

LAK

KAS

External wealth and total wealth, continued

U.S. External Wealth in 2008–2009

U.S. External Wealth in 2008–2009, continued

U.S. External Wealth in 2008–2009, continued

• In the case of the United States, for the past three decades, the financial account has been almost always in surplus, reflecting a net export of assets to the rest of the world to pay for chronic current account deficits.

• If there were no valuation effects, the change in external wealth between two dates would equal the cumulative net import of assets (negative of the financial account) over the intervening period.

• But valuation effects (capital gains and losses) can generate a significant difference in external wealth. From 1988 to 2009 these effects reduced U.S. net external indebtedness in 2009 by more than half what financial flows alone would predict.

U.S. External Wealth

• External wealth data tell us the net credit or debit position of a country with respect to the rest of the world.

• They include data on external assets (foreign assets owned by the home country) and external liabilities (home assets owned by foreigners). A creditor country has positive external wealth, a debtor country has negative external wealth.

• Countries with a current account surplus (deficit) must be net buyers (sellers) of assets.

What External Wealth Tells Us

• An increase in a country’s external wealth results from the net import of assets; conversely, a decrease in external wealth results from the net export of assets.

• In addition, countries can experience capital gains or losses on their external assets and liabilities that cause changes in external wealth.

• All of these changes are summarized in the statement of a country’s net international investment position.

What External Wealth Tells Us