1. Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Topic 6 National Income Accounting and the Balance of Payments

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-2 Preview Micro vs. Macroeconomics National income accounts  GNP: measure of national income and the value of production  Components of GNP: C, I, G, and EX-IM National saving, investment, and the current account Balance of payments accounts

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-3 Micro vs. Macroeconomics Can economic analysis help us understand both the interdependencies among countries and the reasons why their wealth differs? Country Average GNP growth rate (1998-2007) U.S.3.2% E.U.2.0% Japan1.3% China8.9%

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-4 Micro vs. Macroeconomics (cont.) Trade is a microeconomics topic:  How can countries make the best use of scarce resources at a single point in time? Focused on how the decisions of consumers and firms determined resource allocation and patterns of trade. Free trade encourages efficient resource use. Government policies can create waste.

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-5 Micro vs. Macroeconomics (cont.) Finance is a macroeconomics topic:  How can economic policy ensure that factors of production are fully employed?  What determines how an economy’s capacity to produce goods and services changes over time? Focus on economies’ overall level of employment, production, and growth. Study the behavior of the economy as a whole vs. decisions of individuals. Learn how the interactions of countries influence worldwide patterns of macroeconomic activity.

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-6 Micro vs. Macroeconomics (cont.) Macro emphasizes four aspects of economic life: 1.Unemployment: factors that cause it and steps government can take to prevent it. 2.Savings: previously we assumed that every country consumes an amount equal to its income. However, a country’s savings or borrowing behavior affects domestic employment and future levels of national wealth.

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-7 Micro vs. Macroeconomics (cont.) 3.Trade imbalances: previously we assumed that the value of a country’s imports equals the value of its exports. However, trade imbalances are a main channel through which one country’s macroeconomic policies affect its trading partners. 4.Money and the price level: previously we ignored money. Goods were exchanged directly for goods on the basis of their relative prices. In reality, fluctuations in the supply or demand for money can affect output and employment. And changes in one country’s monetary policy can have impacts on other countries.

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-8 Micro vs. Macroeconomics (cont.) We begin by examining the accounting concepts economists use to describe a country’s level of production and its international transactions.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-9 National Income Accounts Records the value of national income that results from production and expenditure.  Producers earn income from buyers who spend money on goods and services.  The amount of expenditure by buyers = the amount of income for sellers = the value of production.  National income is often defined to be the income earned by a nation’s factors of production.

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-10 National Income Accounts: GNP Gross national product (GNP) is the value of all final goods and services produced by a nation’s factors of production in a given time period.  Factors of production are workers (labor services), physical capital (like buildings and equipment), and natural resources (like land and minerals).  The value of final goods and services produced by US-owned factors of production are counted as US GNP.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-11 National Income Accounts: GNP (cont.) GNP is calculated by adding the value of expenditure on final goods and services produced. There are 4 types of expenditure: 1.Consumption (C): expenditure by domestic consumers. – For the past 50 years in the U.S., C has been roughly two-thirds of GNP.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-12 National Income Accounts: GNP (cont.) 2.Investment (I): expenditure by firms on buildings and equipment. – Portion of GNP (e.g., steel, bricks, and labor) used to increase the nation’s capital stock. – Includes firms’ purchases of inventories. – In U.S., I is more volatile than C. Recently, I has fluctuated between 12% and 22% of GNP. – I does not include the purchase of stocks or bonds as neither is a good or a service.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-13 National Income Accounts: GNP (cont.) 3.Government purchases (G): expenditure by federal, state, or local governments on goods and services. – G does not include transfer payments (e.g., SSI or UI) as the recipients do not provide a good or a service to the government. – Since late 1950s in U.S., G has been roughly 20% of GNP.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-14 National Income Accounts: GNP (cont.) 4.Current account balance (CA): net expenditure by foreigners on domestic goods and services. – CA = Net exports = exports – imports – In 2007, U.S. CA deficit was roughly 6% of GNP.

15. Fig. 1: U.S. GNP and Its Components (in 2006) Source: U.S. Department of Commerce, Bureau of Economic Analysis Why examine the components of GNP? Because we cannot understand the cause of a recession or boom without knowing how these spending categories have changed.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-16 National Income Accounts: GNP (cont.) GNP measures the value of national production and national income. Why?  Every dollar used to purchase goods or services automatically ends up in somebody’s pocket.  E.g., a doctor’s visit of $450 is included in national output (GNP) and it is included in national income.  E.g., A firm producing $100 M of output pays most of the proceeds (say $90 M) to its workers, lenders, and landlord. The residual of $10 M is profit that is paid to company owners. All of these payments represent income to someone.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-17 National Income Accounts GNP is one measure of national income, but a more precise measure of national income is GNP adjusted for the following: 1.Depreciation of physical capital results in a loss of income to capital owners, so the amount of depreciation is subtracted from GNP to obtain net national product (NNP). 2.Unilateral transfers to and from other countries can change national income: payments of expatriate workers sent to their home countries, foreign aid, and pension payments sent to expatriate retirees.

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-18 National Income Accounts (cont.) National income = GNP – depreciation + net unilateral transfers The difference between GNP and national income is not insignificant, but macroeconomists are not interested in it. Thus, the textbook and lectures will use the terms GNP and national income interchangeably.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-19 National Income Accounts (cont.) Another approximate measure of national income is gross domestic product (GDP). GDP measures the final value of all goods and services that are produced within a country’s borders in a given time period. GDP = GNP – payments from foreign countries for factors of production + payments to foreign countries for factors of production

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-20 National Income Accounts (cont.) GNP includes the goods and services produced by all Americans regardless of where they work. For consistency, the outputs produced by foreigners working in the U.S., are not included in GNP. In practice, GNP and GDP are very close. But we will focus on GNP because it is a better measure of national income.

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-21 GNP = Expenditure on a Country’s Goods and Services Y = C d + I d + G d + EX = (C-C f ) + (I-I f ) + (G-G f ) + EX = C + I + G + EX – (C f + I f +G f ) = C + I + G + EX – IM = C + I + G + CA Expenditure by domestic individuals and institutions Net expenditure by foreign individuals and institutions Expenditure on domestic production National income = value of domestic production

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-22 Expenditure and Production in an Open Economy Y – (C + I + G ) = CA = EX – IM When production > domestic expenditure → exports > imports: CA surplus  The country is earning more from its exports than it spends on imports.  Net foreign wealth is increasing because foreigners pay for any imports not covered by their exports by issuing IOUs that they will eventually have to redeem.

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-23 Expenditure and Production in an Open Economy (cont.) When production < domestic expenditure → exports < imports: CA deficit  The country is buying more from foreigners than it sells to them and must somehow finance this.  Net foreign wealth is decreasing because the country must borrow to finance its CA deficit. A country’s current account balance equals the change in its net foreign wealth.

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-24 Expenditure and Production in an Open Economy (cont.) Fig. 2 shows how a string of CA deficits can add up to become a large foreign debt. U.S. had accumulated substantial foreign wealth by the early 1980s, when a sustained CA deficit opened up. In 1987, the country became a net debtor for the first time since WWI. Our foreign debt has continued to grow and is now about 20% of GNP.

25. Fig. 2: U.S. Current Account and Net Foreign Wealth, 1976–2006 Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2007 release

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-26 Saving and the Current Account National saving (S) = national income (Y) that is not spent on C or G. In a closed economy, savings (S) must equal investment (I):  Y = C + I + G  Y – C – G = I  S = I Any final good or service that is not purchased by households or government must be used by firms to produce new plant, equipment, and inventories.

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-27 Saving and the Current Account (cont.) In an open economy, savings (S) need not equal investment (I):  Y = C + I + G + EX – IM  Y – (C + I + G) = CA  Y – C – G = S  S = I + CA An open economy can save either by building up its capital stock or by acquiring foreign wealth (via CA surplus), but a closed economy can only save by building up its capital stock.

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-28 Saving and the Current Account (cont.) current account = net foreign investment Because one country’s savings can be borrowed by a second country to increase the second country’s capital stock, a country’s CA surplus is often called “net foreign investment.” Domestic investment and foreign investment are two different ways in which a country can use current savings to increase its future income.

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-29 Saving and the Current Account (cont.) I = S – CA orCA = S - I Countries can finance investment either by saving or by acquiring foreign funds equal to the CA deficit.  a CA deficit implies a financial asset inflow or negative net foreign investment When S > I, then CA > 0, so that net foreign investment and financial capital outflows for the domestic economy are positive.

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-30 Saving and the Current Account (cont.) We should make a distinction between private and government saving decisions. Government saving decisions are made with consideration of their impact on output and employment. S p + S g = S S p = Y –T – C ; where T = taxes - transfers S g = T – G CA = S p + S g – I CA = S p – government deficit – I

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-31 Saving and the Current Account (cont.) CA = S p – government deficit – I (Eq. 1) Government deficit is negative government saving  equal to G – T A high government deficit causes a negative current account balance when other factors remain constant.

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-32 Case Study: Government Deficits and Current Accounts Linkage between CA, I, private S, and government deficit given by equation 1 is useful for thinking about the impact of economic policies and events. In early 1980s, U.S. experienced a government deficit and a CA deficit, giving rise to the phrase “twin deficits.” CA = S P – I – (G – T) Equation shows that ↑(G-T) → ↓CA if private S and I don’t change much.

33. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-33 Case Study: Government Deficits and Current Accounts (cont.) But twin deficits theory is misleading if changes in government deficits lead to bigger changes in private S and I behavior. E.g., European countries were forced to cut their government budget deficits (by raising taxes and slashing G) prior to the launch of the euro in 1999. Twin deficits theory predicts that EU’s CA surplus should rise sharply in response to the fiscal change. However, data shows that government deficits fell by 4.5% of GNP while CA surpluses remained the same.

34. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-34 Case Study: Government Deficits and Current Accounts (cont.) Why? A sharp fall in private S (4% of GNP) and a slight increase in I. So private savers just about neutralized the governments efforts to raise national savings! Difficult to know why this occurred.  Ricardian equivalence predicts that the private sector will lower its own saving when governments raise taxes.  Values of EU financial assets were rising in late 1990s because of anticipated benefits of the euro. Thus, rising household wealth may have reduced private S rate.

35. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-35 Case Study: Government Deficits and Current Accounts (cont.) CA = S P – I – (G – T) Because the four variables are jointly determined in equation 1, we can never fully determine the cause of a CA change by only looking at the equation.

36. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-36 Balance of Payments Accounts Balance of payments (BOP) accounts are a detailed record of the composition of the CA balance and the many transactions that finance it. An international transaction involves two parties, and each transaction enters the accounts twice: once as a credit (+) and once as a debit (-).

37. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-37 Balance of Payments Accounts (cont.) Any transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit (-). Any transaction resulting in a receipt from foreigners is entered as a credit (+).

38. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-38 Balance of Payments Accounts (cont.) BOP accounts are separated into 3 broad accounts: 1.current account: accounts for flows of goods and services (imports and exports). 2.financial account: accounts for flows of financial assets (financial capital). Its balance is the difference between a country’s exports and imports of assets. An asset is any one of the forms in which wealth can be held (e.g., money, stocks, factories, or gov. debt).

39. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-39 Balance of Payments Accounts (cont.) 3.capital account: flows of special categories of assets (capital): typically non-market, non- produced, or intangible assets like debt forgiveness, copyrights, and trademarks. These international asset movements are generally very small for the U.S.

40. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-40 Example of Balance of Payments Accounting You import a DVD of Japanese anime by using your debit card. The Japanese producer of anime deposits the money 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 deposit in account by bank (financial account) +$30

41. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-41 Example of Balance of Payments Accounting (cont.) You invest in the Japanese stock market by buying $500 in Sony stock. Sony deposits the money 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 deposit in account by bank (financial account) +$500

42. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-42 Debt forgiveness: non-market transfer (capital account) –$100 M Credit (“sale”) of account by bank (financial account) +$100 M Example of Balance of Payments Accounting (cont.) U.S. banks forgive a $100 M debt owed by the government of Argentina through debt restructuring. U.S. banks who hold the debt thereby reduce the debt by crediting Argentina's bank accounts.

43. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-43 How Do the Balance of Payments Accounts Balance? Due to the double entry of each transaction, the BOP accounts will balance by the following equation: current account + capital account + financial account = 0

44. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-44 How Do the Balance of Payments Accounts Balance? (cont.) Recall that the CA measures the size and direction of international borrowing. CA + capital account = ∆net foreign assets CA + capital account = -financial account  E.g., a country must finance its CA deficit by borrowing from foreigners (i.e., selling financial or intangible assets).

45. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-45 Balance of Payments Accounts The 3 broad accounts are more finely divided: Current account: imports and exports a.goods (like consumer electronics or cars) b.services (payments for legal services, shipping services, tourists’ expenditures, etc.) c.income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries) Current account: net unilateral transfers  gifts (transfers) across countries; payments that do not correspond to the purchase of any good, service, or asset.

46. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-46 Balance of Payments Accounts (cont.) Capital account: records special transfers of assets (typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights, and trademarks), but this is a minor account for the U.S.  In 2006, U.S. capital account = -$3.9 billion. Why are “net unilateral transfers” placed in the current account instead of the capital account?  Distinguish between “net unilateral transfers” (gifts) which impact a country’s income and “non-market transfers” (like debt forgiveness) which impact a country’s balance sheet.

47. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-47 Balance of Payments Accounts (cont.) Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. Financial inflow (or capital inflow)  Foreigners loan to domestic citizens by buying domestic assets  Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction Financial outflow (or capital outflow)  Domestic citizens loan to foreigners by buying foreign assets  Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction

48. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-48 Balance of Payments Accounts (cont.) Financial account has at least 3 subcategories: 1.Official (international) reserve assets 2.All other assets 3.Statistical discrepancy

49. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-49 Balance of Payments Accounts (cont.) Statistical discrepancy  Data from a transaction may come from different sources that differ in coverage, accuracy, and timing.  The BOP 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 CA and capital account.

50. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-50 Balance of Payments Accounts (cont.) Official (international) reserve assets: foreign assets held by central banks to cushion against financial instability.  Assets include gov. bonds, currency, gold, and accounts at the IMF.  Official reserve assets sold to foreign central banks are a credit (+) because the domestic central bank can spend more money to cushion against instability.  Official reserve assets purchased by the domestic central bank are a debit (-) because the domestic central bank can spend less money to cushion against instability.

51. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-51 Balance of Payments Accounts (cont.) Balance of official reserve transactions = net increase in foreign official reserve claims on domestic assets – net increase in official reserves held by the domestic central bank. The negative value of the balance of official reserve transactions 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.  It indicates the payments gap that official reserve transactions need to cover.

52. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-52 Balance of Payments Accounts (cont.) A negative “balance of payments” (a deficit) may indicate that a country:  is depleting its international reserve assets or  incurring large debts to foreign central banks. If a country faces the risk of being suddenly cut off from foreign loans, it will want to maintain a “war chest” of international reserves as a precaution.  Developing countries are sometimes in this position.

53. Table 1: U.S. Balance of Payments Accounts for 2006 (billions of $) U.S. must cover its current + capital account deficit with a net financial inflow (via net borrowing or sales of assets to foreigners) of $815.4 billion.

54. Table 1 (cont): U.S. Balance of Payments Accounts for 2006 (billions of $) Reserves sold by the Fed Reserves purchased by foreign central banks U.S. “balance of payments” = -$442.7 billion = - [$440.3 billion + $2.4 billion] Roughly half of the U.S. current + capital account deficit was financed by foreign central banks.

55. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-55 U.S. Balance of Payments Accounts U.S. has the most negative net foreign wealth in the world, and is therefore the world’s largest debtor nation. In 2006, U.S. net foreign wealth was estimated at -$2,539.6 billion.  By contrast, total foreign debt owed by all Central and Eastern European countries was about $750 billion in 2006.  U.S. debt is just under 20% of GDP. And its CA deficit in 2006 was $812 billion, so net foreign wealth continued to decrease.

56. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-56 U.S. Balance of Payments Accounts (cont.) The value of foreign assets held by the U.S. has grown since 1980, but liabilities of the U.S. (debt held by foreigners) has grown more quickly. U.S.19762006 Foreign assets 25%104% Liabilities16%123% Note: figures expressed as a percentage of GDP.

57. Fig. 3: U.S. Gross Foreign Assets and Liabilities, 1976-2006 Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2007

58. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-58 U.S. Balance of Payments Accounts (cont.) About 70% of foreign assets held by the U.S. are denominated in foreign currencies and almost all of U.S. liabilities (debt) are denominated in dollars. Changes in the exchange rate influence the value of net foreign wealth (gross foreign assets minus gross foreign liabilities).  Appreciation of the value of foreign currencies makes foreign assets held by the U.S. more valuable, but does not change the dollar value of dollar-denominated debt for the U.S.

59. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-59 U.S. Balance of Payments Accounts (cont.) E.g., a 10% depreciation in the dollar would leave U.S. liabilities unchanged but would increase U.S. assets (measured in dollars) by $964 billion (or 7.3% of GDP). So should policy makers ignore their CA deficits and try to devalue their currency and thereby reduce foreign debt?  No, such efforts would reduce foreign demand for domestic- currency assets.