1 Ch. 12: National Income Accounting and the Balance of Payments

2 GDP vs. GNP Gross domestic product is the final output of a geographic area in a year, like US GDP. Gross domestic product is the final output of a geographic area in a year, like US GDP. Gross national product is the final product of the citizens of a country in a year. Gross national product is the final product of the citizens of a country in a year. Because international payments include gifts, aid (unilateral transfers) and earnings from overseas, it is better to concentrate on GNP. Because international payments include gifts, aid (unilateral transfers) and earnings from overseas, it is better to concentrate on GNP.

3 GDP vs. GNP In both cases, the output produced has to equal to the income generated: circular flow concept. In both cases, the output produced has to equal to the income generated: circular flow concept. The output=income total will be equal to the total expenditures. The output=income total will be equal to the total expenditures. GDP = C + I + G + EX - IM GDP = C + I + G + EX - IM GNP = C + I + G + CA GNP = C + I + G + CA

4 GDP vs. GNP EX is exports of goods and services. EX is exports of goods and services. IM is imports of goods and services. IM is imports of goods and services. CA is current account balance. CA is current account balance. CA = EX - IM + Net unilateral transfers + Net transfers of factor income CA = EX - IM + Net unilateral transfers + Net transfers of factor income

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6 Adjustment of Income and Output Although we say output = income, in real life there needs to be adjustments to go from GNP to NI. Although we say output = income, in real life there needs to be adjustments to go from GNP to NI. GNP - depreciation = NNP GNP - depreciation = NNP NNP - Indirect business taxes = NI NNP - Indirect business taxes = NI GDP - depreciation = NDP GDP - depreciation = NDP NDP – depreciation + Net unilateral transfers + Net transfers of factor income = NI NDP – depreciation + Net unilateral transfers + Net transfers of factor income = NI

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9 National Income Accounts: GNP

10 Balance on Current Account, 2006 (Millions of USD)

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12 Imports and Exports As a Fraction of GDP Imports and exports as a percentage of GDP by country, Source: OECD

13 Current Account and Macroeconomy Y = C + I + G + CA If CA>0, a nation increases its net foreign wealth by consuming less than its output. The savings are used to acquire foreign assets. If CA<0, a nation’s net foreign wealth is reduced to allow more consumption than production.

14 Current Account ( )

15 US Current Account As a Percentage of GDP, 1960–2004 deficit surplus

16 US Current Account and Net Foreign Wealth, 1977–2003

17 Saving and Current Account Y = C + I + G + CA Y = C + T + S p T + S p = I + G + CA T - G + S p = I + CA S g + S p = I + CA National saving finances domestic investments and accumulation of assets abroad. Government deficits and low private savings, unless financed from abroad, will lower growth.

18 Saving and the Current Account (S) = national income (Y) that is not spent on consumption (C) or government purchases (G). National saving (S) = national income (Y) that is not spent on consumption (C) or government purchases (G). Y – C – G Y – C – G (Y – C – T) + (T – G) (Y – C – T) + (T – G) S p + S g = S S p + S g = S Total Saving includes saving from abroad.

19 How Is the Current Account Related to National Saving? CA = Y – (C + I + G ) implies CA = (Y – C – G ) – I CA = (Y – C – G ) – I = S – 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. A country that imports more than it exports has low national saving relative to investment.

20 How Is the Current Account Related to National Saving? CA = S – I or I = S – CA Countries can finance investment either by saving or by acquiring foreign funds equal to the current account deficit. Countries can finance investment either by saving or by acquiring foreign funds equal to the current account deficit. a current account deficit implies a financial capital inflow or negative net foreign investment. 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. When S > I, then CA > 0 and net foreign investment and financial capital outflows for the domestic economy are positive.

21 How Is the Current Account Related to National Saving? CA = S p + S g – I = S p – government deficit – I Government deficit is negative government saving Government deficit is negative government saving equal to G – T equal to G – T A high government deficit causes a negative current account balance, all other things equal. A high government deficit causes a negative current account balance, all other things equal.

22 Source: Congressional Budget Office, US Department of Commerce

23 Balance of Payments Accounts A country’s balance of payments accounts accounts for its payments to and its receipts from foreigners. A country’s balance of payments accounts accounts for its payments to and its receipts from foreigners. Each international transaction enters the accounts twice: once as a credit (+) and once as a debit (-). Each international transaction enters the accounts twice: once as a credit (+) and once as a debit (-).

24 Balance of Payments Accounts Payments enter as minus. Payments enter as minus. Receipts enter as plus. Receipts enter as plus. Transactions that enter into current account are exports, imports, transfers and factor incomes. Transactions that enter into current account are exports, imports, transfers and factor incomes. Transactions that match the above enter into financial account - as acquiring and reducing assets. Transactions that match the above enter into financial account - as acquiring and reducing assets. Nonmarket activities are recorded in capital account. Nonmarket activities are recorded in capital account.

25 Balance of Payments Accounts The balance of payment accounts are separated into 3 broad accounts: The balance of payment accounts are separated into 3 broad accounts: current account: accounts for flows of goods and services (imports and exports). current account: accounts for flows of goods and services (imports and exports). financial account: accounts for flows of financial assets (financial capital). financial account: accounts for flows of financial assets (financial capital). capital account: flows of special categories of assets (capital), typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks. capital account: flows of special categories of assets (capital), typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks.

26 Financial Account An increase in US assets abroad will enter as a minus: it is a payment. An increase in US assets abroad will enter as a minus: it is a payment. An increase of foreign assets in the US will enter as a plus: it is a receipt. An increase of foreign assets in the US will enter as a plus: it is a receipt. A decrease of US assets abroad will enter as a plus. A decrease of US assets abroad will enter as a plus. A decrease of foreign assets in the US will enter as a minus. A decrease of foreign assets in the US will enter as a minus.

27 Example of Balance of Payment Accounting You import a DVD of Japanese anime by using your debit card. 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. 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 Increase of Japanese assets in US (financial account) +$30

28 Example of Balance of Payment Accounting You invest in the Japanese stock market by buying $500 in Sony stock. 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. 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 Increase of Japanese assets in USA (financial account) +$500

29 Example of Balance of Payment Accounting US banks forgive a $100 M debt owed by the government of Argentina through debt restructuring. 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. 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 Decrease of American ownership abroad (financial account) +$100 M

30 Exercises How do the following affect the US Balance of Payments? How do the following affect the US Balance of Payments? An American buys a share of German stock, paying by writing a check on an account with a Swiss bank. An American buys a share of German stock, paying by writing a check on an account with a Swiss bank. An American buys a share of German stock, paying by transfer of funds within an American bank. An American buys a share of German stock, paying by transfer of funds within an American bank. A tourist from Detroit buys a meal in France and pays with a traveler’s check. A tourist from Detroit buys a meal in France and pays with a traveler’s check. An Italian buys a Dell computer and pays by a credit card issued by an Italian bank. An Italian buys a Dell computer and pays by a credit card issued by an Italian bank.

31 How Do the Balance of Payments Accounts Balance? Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: current account + financial account + capital account = 0

32 BOP Entries Current Account Current Account Exports (+) Exports (+) Imports (-) Imports (-) Income earned (+) Income earned (+) Income paid (-) Income paid (-) Unilateral transfers (+/-) Unilateral transfers (+/-) Financial Account Financial Account Increase in US assets abroad (-) Increase in US assets abroad (-) Decrease in US assets abroad (+) Decrease in US assets abroad (+) Increase in foreign assets in US (+) Increase in foreign assets in US (+) Decrease in foreign assets in US (-) Decrease in foreign assets in US (-)

33 Balance of Payments Accounts Each of the 3 broad accounts are more finely divided: Each of the 3 broad accounts are more finely divided: Current account: imports and exports Current account: imports and exports 1. merchandise (goods like DVDs) 2. services (payments for legal services, shipping services, tourist meals,…) 3. income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries) Current account: net unilateral transfers Current account: net unilateral transfers gifts (transfers) across countries that do not purchase a good or service nor serve as income gifts (transfers) across countries that do not purchase a good or service nor serve as income

34 Balance of Payments Accounts Capital account: records special asset transfers, but this is a minor account for the US. Capital account: records special asset transfers, but this is a minor account for the US.

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

36 Balance of Payments The meaning of balance of payments is that the balance sheet should always balance. The meaning of balance of payments is that the balance sheet should always balance. If it doesn’t, there is a statistical discrepancy from not collecting the data accurately or timely. If it doesn’t, there is a statistical discrepancy from not collecting the data accurately or timely. If private transactions don’t match because foreigners do not want to own our assets, governments will get involved. If private transactions don’t match because foreigners do not want to own our assets, governments will get involved.

37 Balance of Payments Accounts Statistical discrepancy Statistical discrepancy Data from a transaction may come from different sources that differ in coverage, accuracy, and timing. 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 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. 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.

38 Balance of Payments Accounts Official (international) reserve assets: foreign assets held by central banks to cushion against instability in international markets. 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. Assets include government bonds, currency, gold and accounts at the International Monetary Fund. Official reserve assets owned by (sold to) foreign central banks are a credit (+). Official reserve assets owned by (sold to) foreign central banks are a credit (+). Official reserve assets owned by (purchased by) the domestic central bank are a debit (-). Official reserve assets owned by (purchased by) the domestic central bank are a debit (-).

39 Balance of Payments Accounts The Balance of Payments balance is (-1) times the official reserve account. The Balance of Payments balance is (-1) times the official reserve account. It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statistical discrepancy. It is the sum of the current account, the capital account, the non-reserve portion of the financial account, and the statistical discrepancy. 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. 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. selling foreign currency by the domestic central bank and buying domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance. selling foreign currency by the domestic central bank and buying domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance.

40 More Exercises Indicate the changes in US and Canadian BOP. Indicate the changes in US and Canadian BOP. An American buys an hovercraft in Canada. An American buys an hovercraft in Canada. 1. She pays by personal check drawn against an American Bank. 2. She pays with US dollars. 3. She exchanges USD for C$ and pays with C$.

41 Official Reserve Transactions An American buys a Lexus from Japan and pays $50,000. Lexus doesn’t want to hold USD. It exchanges it at a local bank, which in turn exchanges it at Japanese Central Bank. An American buys a Lexus from Japan and pays $50,000. Lexus doesn’t want to hold USD. It exchanges it at a local bank, which in turn exchanges it at Japanese Central Bank. Japanese official assets at US have increased. Japanese official assets at US have increased.

42 Official Reserve Transactions A Turk buys an IBM server and pays with Turkish lira. A Turk buys an IBM server and pays with Turkish lira. With the financial meltdown (2/01), IBM does not want to hold Turkish lira. With the financial meltdown (2/01), IBM does not want to hold Turkish lira. IBM takes the TL to Turkish Central Bank and gets USD. IBM takes the TL to Turkish Central Bank and gets USD. In the Turkish BOP, the official reserve account shows a reduction of foreign assets (+). In the Turkish BOP, the official reserve account shows a reduction of foreign assets (+). In the US BOP, foreign ownership of US assets has fallen (-). In the US BOP, foreign ownership of US assets has fallen (-).

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44 US Balance of Payments Accounts, 2003 in Billions of Dollars

45 US Balance of Payments Accounts, 2003 in Billions of Dollars

46 Using the web site Build a simple BOP account for 2010 the way the previous slide has organized the accounts.

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56 US Balance of Payments Accounts The US has the most negative net foreign wealth in the world, and so is therefore the world’s largest debtor nation. The US has the most negative net foreign wealth in the world, and so is therefore the world’s largest debtor nation. Its current account deficit in 2004 was $670 billion dollars, so that net foreign wealth continued to decrease. Its current account deficit in 2004 was $670 billion dollars, so that net foreign wealth continued 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. 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.

57 US Balance of Payments Accounts

58 US Balance of Payments Accounts 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. 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 influence value of net foreign wealth (gross foreign assets minus gross foreign liabilities). Changes in the exchange rate influence 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. 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.

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65 A NEW REPORT by the American Chamber of Commerce to the European Union offers a useful reminder that behind all the hoopla about China, India and other emerging economies, ties between the rich nations of the western world go very deep indeed.American Chamber of Commerce to the European Union Here are some highlights from the survey, "The Transatlantic Economy 2008", put together by scholars at Johns Hopkins University. American assets in Britain came to a total of $2.3 trillion in 2005, which is more than combined American assets in Asia, South America, Africa and the Middle East. The output of American affiliates in Belgium in 2005 came to $18.4 billion, which is more or less the same as the combined output of American affiliates in China and India the same year (at $18.8 billion). American foreign direct investment in Switzerland in 2006 came to $10.4 billion, or half again as much as total American FDI in Africa and the Middle East. nd_europe_own_eac.cfm

66 europe_own_eac.cfm "Despite stories about European companies moving to cheap labour markets in central Europe or Asia, most foreigners working for European companies outside the EU are American. European majority-owned foreign affiliates directly employed roughly 3.5 million US workers in The top five European employers in the US were firms from the United Kingdom (908,000), Germany (655,000), France (473,000), the Netherlands (442,000) and Switzerland (389,000)."