1. Relations Between the Balance of Payments and Other Macroeconomic Accounts Thorvaldur Gylfason Course on External Vulnerabilities and Policies Tunis, March 2–13, 2009

2. Outline balance of payments  Monetary approach to balance of payments  Accounting relationships linkages Trace linkages among o Balance of payments accounts o National income accounts o Fiscal accounts o Monetary accounts financial programming Proceed from linkages to financial programming  Numerical examples of financial programming  Flow of funds matrix  A little algebra

3. Remark External adjustment financial program External adjustment is more effective if it is framed in the context of a financial program agreed jointly with the authorities to ensure consistency among policies accounting framework In practice, a financial program is prepared using an accounting framework that summarizes all economic transactions and shows the interrelations among all sectors Main objective of lecture Main objective of lecture financial programming framework flow of funds Introduce the different pieces of the financial programming framework to illustrate the linkages and show how to build a single table focused on the financing side of the interrelations, i.e., the flow of funds

4. What is money? banking system  Liabilities of banking system to the public That is, the private sector and public enterprises M = C + T  M = C + T C = currency, T = deposits  The broader the definition of deposits... Demand deposits, time and savings deposits, etc., ... the broader the corresponding definition of money M 1, M 2, M 3, etc. 1

5. Overview of banking system

6. Balance sheet of Central Bank AssetsLiabilities DGDG C DBDB B RCRC D G = domestic credit to government D B = domestic credit to commercial banks R C = foreign reserves in Central Bank C = currency B = commercial bank deposits in Central Bank

7. Balance sheet of Commercial Banks D P = domestic credit to private sector R B = foreign reserves in commercial banks B = commercial bank deposits in Central Bank D B = domestic credit from Central Bank to commercial banks T = time deposits

8. D G + D P + D B + R B + R C + B = C + T + B + D B Adding up the two balance sheets D R M Hence, M = D + R

9. Balance sheet of banking system AssetsLiabilities DM R Monetary Survey D = D G + D P = net domestic credit from banking system (net domestic assets) R = R C + R B = foreign reserves (net foreign assets) M = money supply

10. A fresh view of money The monetary survey implies the following new definition of money: M = D + R where M is broad money (M 2 ), which equals narrow money (M 1 ) + quasi-money  One of the most useful equations in economics  Money is, by definition, equal to the sum of domestic credit from the banking system (net domestic assets) and foreign exchange reserves in the banking system (net foreign assets)

11. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F Now, add them up

12. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F G – T + I – S + X – Z = 0, so left-hand sides sum to zero

13. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

14. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

15. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

16. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F

17. An alternative derivation of monetary survey  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F So, adding them up, we get: 0 =  D -  M +  R D G + D P = D because D G + D P = D Hence, M = D + R

18. Monetary approach to balance of payments M = D + R The monetary survey (M = D + R) has three key implications: endogenous  Money is endogenous RM If R increases, then M increases Important in open economies  Domestic credit  Domestic credit affects money RDM If R increases, may want to reduce D to contain M   R =  M -  D  R = X – Z + F Here  R = X – Z + F Monetary approach to balance of payments

19.  R =  M -  D The monetary approach to the balance of payments (  R =  M -  D) has the following implications: Need to  Forecast M And then  Determine D In order to  Meet target for R DMR* D is determined as a residual given both M and R* R* R* = reserve target, e.g., 3 months of imports Essence of financial programming

20. Monetary approach to balance of payments  Domestic credit is a policy variable that involves both monetary and fiscal policy D  Can reduce* domestic credit (D) To private sector To public sector By reducing government spending By increasing taxes  Monetary and fiscal policy are closely related through domestic credit *Or rather slow down

21. Linkages: Overview 2 Macroeconomic Sectors Macroeconomic Accounts Flow of Funds (Transactions) Private Sector Government Monetary Sector National Accounts Fiscal Accounts Monetary Accounts Real: Revenue, Expenditure (C, S, I, X, Z) Rest of the WorldBalance of Payments Financial: Changes in financial assets and liabilities

22. Linkages Balance of payments  R = X – Z + F = X – Z +  D F

23. Linkages Balance of payments  R = X – Z + F = X – Z +  D F National accounts Y = E + X – Z

24. Linkages Balance of payments  R = X – Z + F = X – Z +  D F National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

25. Linkages Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

26. Linkages: Reserves Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

27. Linkages: Current account Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

28. Linkages: Foreign credit Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

29. Linkages: Credit to government Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F

30. Linkages Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

31. Linkages: Bonds Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

32. Linkages: Money Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

33. Linkages: Private credit Balance of payments  R = X – Z + F = X – Z +  D F Monetary accounts  M =  D +  R =  D G +  D P +  R National accounts Y = E + X – Z Fiscal accounts G – T =  B +  D G +  D F Private sector accounts I – S =  D P –  M –  B

34. Further details National accounts Nonfinancial public sector Monetary accounts Balance of payments Macroeconomic interrelations Flow of funds matrix

35. National Accounts 1. Consumption C = Cg+Cp Public (general government) Cg Private Cp 2. Gross Investment I = Ig+Ip Public (fixed capital formation) Ig Private (includes changes in inventories) Ip 4. Exports of goods and servicesX 5. Imports of goods and services Z 3. Absorption or domestic demand (1+2) A = C+I 6. Gross Domestic Product (1+2+4–5) GDP = C + I + X – Z 7. Net factor income from abroad Yf 9. Current transfers from abroad TRf 10. Gross National Disposable Income (8+9) GNDI = GNP + TRf 8. Gross National Product (6+7) GNP = GDP + Yf 11.National Savings (10 – 1) Sn=(GNDI – C) Public Sg = (GDIg – Cg) Private Sp = (GDIp – Cp) 12. External Savings (1+2–10) Se= (C + I – GNDI)

36. Operations of the Nonfinancial Public Sector (NFPS) 1.Total Revenue and GrantsRGg Revenue Rg Current CRg Tax revenue Nontax revenue Capital Grants 2.Total Expenditure and Net LendingGNLg ExpenditureGg CurrentCGg Wages and salaries Goods and services Interest Subsidies and other current transfers CapitalCAPGg o/w: fixed capital formationIg Net LendingNLg 3. Overall Balance (1 - 2 ) OBg = RGg - GNLg 4. Financing (4.1 + 4.2 = – 3)Fg = NEFg + NDFg 4.1 ExternalNEFg 4.2 Domestic NDFg = NDCg + NBg BankNDCg NonbankNBg Cg: government consumption

37. ASSETS Foreign assets Domestic assets Credit to public sector Credit to other financial institutions Credit to private sector Other assets LIABILITIES Foreign liabilities Short term Medium and long term Deposits of public sector Private sector deposits Other liabilities Capital and reserves Liabilities to private sector (MB, M1, M2, M3) Monetary Accounts: From Accounting to Analytical Format Net Foreign Assets (NIR, NFA) Net Domestic Assets (NDA) Net domestic credit (NDC) Credit to public sector (net) (NDCg) Credit (+) Deposits (-) Credit to other financial institutions Credit to private sector (DCp) Other assets net (OAN) AccountingAnalytical

38. Monetary Accounts: Stocks Banking System 1. Net Foreign AssetsNFA Central bank (NIR) Rest of banking system 2. Net Domestic AssetsNDA Net Domestic Credit Net credit to the nonfinancial public sector Credit to the private sector Other Assets Net 3. Money Supply (monetary liabilities to private sector) = 1 + 2 (M3 = NFA + NDA) Central Bank 1. Net International ReservesNIR 2. Net Domestic AssetsNDA Net Domestic Credit Net credit to the nonfinancial public sector Credit to the rest of the banking system Claims on private sector Other Assets Net 3. Monetary Base (monetary liabilities of CB) = 1 + 2 (MB = NIR + NDC)

39. Monetary Accounts: Annual flows at end-of-period exchange rate 1.Net Foreign Assets NFA = NIR + NFAb Central Bank NIR Rest of banking system NFAb 2.Net Domestic Assets NDA = NDC + OAN Net domestic credit NDC = NDCg + DCp Nonfinancial public sector (net) NDCg Private sector DCp Other assets net OAN 3.Money and Quasi-money (M3) M3 Money (M1) Quasi-money Other liabilities ∆NFA + ∆ NDA = ∆ M3 (monetary liabilities) ∆NIR + ∆ NDA MA = ∆ MB (monetary liabilities)

40. Balance of Payments: Analytical Presentation 1. Current account CAB A. Goods and services X – Z Goods (trade balance) Services B. Factor income Yf Of which: interest C. Current transfers TRf 2. Capital and financial accountCFAB A. Capital accountCA B. Financial accountCF Direct investment (net) Portfolio investment (net) Public sector Private sector Banks Other investment (net) Public sector Private sector Banks 3. Overall balance (1 + 2 = 3 = – 4)CAB + CFAB 4. Reserves and exceptional financing –  NIR + ExF

41. Macroeconomic Interrelations National Accounts Consumption Public Private Gross domestic investment Public Private Exports of goods and services Imports of goods and services Gross Domestic Product Net factor income Net current transfers Gross National Disposable Income Balance of Payments Current account Exports of goods and services Imports of goods and services Net factor income Net current transfers Capital and financial account Capital account Financial account Direct investment Net foreign financing Nonfinancial public sector Nonfinancial private sector Banks Change in net international reserves Operations of the NFPS Total revenue and grants Total expenditure and net lending Current expenditure Wages and salaries Goods and services Interest Capital expenditure o/w fixed capital formation Net lending Overall balance Financing External Domestic Banking Survey (flows) Net foreign assets Central bank Rest of banking system Net domestic assets Net domestic credit NFPS Private sector Other assets net Medium/long term foreign liabilities Money and quasi-money (M3)

42. Flow of Funds Matrix Format Sectors Transactions Nonfinancial (real) Financial: changes in financial assets and liabilities Internal NFPS Private Banks External Total S – I Sg –Ig Sp –Ip 0 – CAB 0 Total 00 0 0 0 Financing – Financing 0 Dom. Dom. Dom. Foreign Foreign Foreign Foreign – Foreign Y = C + I + G + X - Z

43. An alternative derivation of monetary survey: Recap, same story  Public  Public sector G – T =  B +  D G +  D F  Private  Private sector I – S =  D P -  M -  B  External  External sector X – Z =  R -  D F G – T + I – S + X – Z = 0, so left-hand sides sum to zero

44. Overview 1 Presents real transactions and their financing For each sector, shows the gap in all nonfinancial transactions (income – expenditure => gap = savings – investment = deficit/surplus) and how it is financed Shows financing flows among different sectors For the economy as a whole, shows how the savings–investment gap is financed by foreign sources

45. Overview 2 The flow of funds matrix can be seen as the representation of the budget constraint faced by all sectors of the economy because it shows real transactions and how they are financed The domestic economy is subject to the amount of resources the rest of the world is willing to provide: financing of the balance of payments  Excess of domestic demand (absorption) over supply  deficit in current account of the BOP GNDI – C – I = S – I = CAB  Deficit in the CAB must be financed by net capital inflows or drawdown of international reserves CAB + CFA = ΔNIR (i.e., X – Z + F = ΔR)

46. Overview 3 Each sector of the economy has a budget constraint The overall balance of the public sector must be equal to the change in its net financial assets  Excess of expenditure over revenues  deficit that must be financed either by increasing liabilities (domestic or foreign) or by reducing assets. RGg – GNLg = DIg – Cg – Ig = Sg – Ig = ΔNA F g The private sector also has a budget constraint  If expenditures exceed revenues, it must either reduce assets or acquire more debt (domestic or foreign) Sp – Ip = ΔNA F p

47. Overview 4 The financial sector plays the role of financial intermediary, and in that sense, also has a constraint Assets = Liabilities (monetary + nonmonetary) + Net Worth NFA + NDA = M3 An increase in loans must have a counterpart in an increase in liabilities or net worth  Sources of funds include deposits of the private sector (money supply) and of the public sector or increases in liabilities with central bank or foreign creditors  If sources are limited, or are restricted by prudential norms, an increase in credit to the public sector may imply a reduction in credit to the private sector

48. Statistical Issues Sources of data: NA, BOP, NFPS, MA. When figures for the same transaction differ, choose one and include the difference in the statistical discrepancy Banking system No real transactions (for convenience) External sector Treated as the opposite to domestic economy  income (expenditure) becomes expenditure (revenue) Recording of financial assets and liabilities  Increase (reduction) of assets: – (+)  Increase (reduction) of liabilities: + (–)

49. Statistical Issues: Definitions Public Sector Disposable income (DIg) Revenue and grants – rent – transfers – net lending Consumption (Cg) Wages and salaries + goods and services Savings (Sg) DIg – Cg Investment (Ig) Fixed capital formation Public sector balance ( = deficit/surplus) Sg – Ig

50. Statistical Issues: Possible Discrepancies National Accounts (SNA) vs. Fiscal Accounts (FA) when using GFSM 1986 Cash basis (FA) vs. accrual (SNA) Consumption of fixed capital is included in SNA, but not in FA Net lending Expenditure in FA, not in SNA => Disposable income, savings not the same For convenience, overall fiscal balance is taken from the FA

51. Operations of the NFPS: NA Format

52. 52 National Accounts, Fiscal, and Balance of Payments

53. Monetary Accounts

54. Flow of Funds Matrix: Domestic Economy

55. Flow of Funds Matrix: NFPS

56. Flow of Funds Matrix: The Private Sector

57. Flow of Funds Matrix: The Banking Sector

58. Flow of Funds Matrix : All Sectors 1

59. 59 Flow of Funds Matrix: All Sectors 2

60. Model  Express accounting linkages in terms of simple algebra  Use model to describe how nominal income and reserves depend on domestic credit Demonstrate how BOP target translates into prescription for fiscal and monetary policy Financial programming in action 3

61. List of variables M = money D = domestic credit R = foreign reserves  R = R - R -1 = balance of payments P = price level Y = real income v = velocity X = real exports P x = price of exports Z = real imports P z = price of imports F = capital inflow m = propensity to import Two behavioral parameters: m and v

62. List of relationships M = D + R (monetary survey) M = (1/v)PY (money demand) R = (1/v)PY – D (M schedule)  R = P x X – P z Z + F (balance of payments) P z Z = mPY (import demand) R = P x X – mPY + F + R -1 (B schedule) Estimate m and v by regression analysis

63. The M schedule Reserves (R) GNP (PY) M schedule 1 v R = (1/v)PY – D D up An increase in reserves increases demand for money, and hence also income PY = v(R + D) PY is nominal income

64. The B schedule Reserves (R) GNP (PY) B schedule 1 m R = P x X – mPY + F + R -1 F up, e down An increase in income encourages imports, so that reserves decline

65. Solution to model Two equations in two unknowns 1) R = (1/v)PY – D 2) R = P x X – mPY + F + R -1 Solution for R and PY

66. Multipliers: Algebra

67. Multipliers: Numbers Suppose m = ¼ and v = 4 Credit multiplier Half of credit expansion leaks abroad through balance of payments

68. Macroeconomic equilibrium GNP (PY) M schedule Equilibrium B schedule Reserves (R) D up F up, e down

69. Economic models Exogenous variables Endogenous variables Model Change in domestic credit or the exchange rate Financial programming model Foreign reserves and nominal income

70. Experiment: Export boom M schedule B schedule Reserves (R) GNP (PY) A

71. Export boom GNP (PY) M B B’ A C Exports increase Reserves (R)

72. Export boom GNP (PY) M B B’ A C Reserves (R) An increase in exports increases both reserves and nominal income

73. An interpretation Exogenous variables Endogenous variables Model Export boom or capital inflow Financial programming model Foreign reserves and nominal income increase

74. Another experiment: Domestic credit expansion GNP M B D up M’ A C An increase in D increases PY, but reduces R. Reserves (R) D up M up PY up P z Z up R down

75. Domestic credit contraction GNP (PY) M B D down M’ A When D falls, M also falls, so that PY goes down and P z Z also decreases. Therefore, R increases. Here, an improvement in the reserve position is accompanied by a decrease in income. R* C Reserves (R) Too low reserves

76. Domestic credit contraction accompanied by devaluation GNP (PY) M B F up, e down D down B’ M’ A C When D falls, M also falls, so that PY goes down and P z Z also decreases. Therefore, R increases. Further, a devaluation strengthens the reserve position and helps reverse the decline in income. R* Reserves (R)

77. Comparative statics: An overview DPxXPxXFe  R -+++- PY +++++  = inflation

78. Experiment: Inflation goes up M B schedule Reserves (R) GNP (PY) M’ A C An increase in inflation (  ) increases v, so the M schedule becomes flatter. Hence, R goes down and PY increases in the short run.  up

79. Experiment: Inflation goes up M B schedule Reserves (R) GNP (PY) M’ A C An increase in inflation (  ) makes domestic currency appreciate in real terms, so the B schedule shifts left. Hence, R goes farther down and PY can rise or fall in the short run.  up B’  up eP/P* up X downB shifts left

80. History and targets  Record history, establish targets Forecasting  Make forecasts for balance of payments, output and inflation, money Policy decisions  Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target Numerical examples 4

81. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step

82. Known at beginning of program period:  M -1 = 70, D -1 = 60, R -1 = 10 Recall: M = D + R  X -1 = 30, Z -1 = 50, F -1 = 15 (all nominal) Recall:  R = X – Z + F So,  R -1 = 30 – 50 + 15 = -5, so R -2 = 15 Current account deficit, overall deficit Current account deficit, overall deficit  R -1 /Z -1 = 10/50 = 0.2 Equivalent to 2.4 (= 0.212) months of imports Equivalent to 2.4 (= 0.212) months of imports Weak reserve position Weak reserve position History

83. X grows by a third, so X = 40 F grows by 67%, so F = 25 Suppose R* is set at 15 (  R* = 5) Z = X + F + R -1 – R* = 40 + 25 + 10 – 15 = 60 Level of imports is consistent with R* R * /Z = 15/60 = 0.25 Equivalent to 3 (= 0.2512) months of imports Equivalent to 3 (= 0.2512) months of imports Forecast for balance of payments BOP fore- casts

84. Increase in Z from 50 to 60, i.e., by 20%, is consistent with R * equivalent to 3 months of imports Now, recall that Z depends on PY where P is price level and Y is output Hence, if income elasticity of import demand is 1, PY can increase by 20% E.g., 5% growth and 15% inflation E.g., 5% growth and 15% inflation Forecast for real sector

85. If PY can increase by 20%, then, if income elasticity of money demand is 2/3, M can increase by 14% Hence, M can expand from 70 to 80 Alternatively, by quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y If so, income elasticity of money demand is 1 Forecast for money ˜ M = D + R Recall M = D + R

86. Having set reserve target at R* = 15 and forecast M at 80, we can now compute level of credit that is consistent with our reserve target, based on M = D + R So, D = 80 – 15 = 65, up from 60  D/D -1 = 5/60 = 8% Quite restrictive, given that PY rises by 20% Quite restrictive, given that PY rises by 20% Implies substantial reduction in domestic credit in real terms Implies substantial reduction in domestic credit in real terms Determination of credit

87. Financial programming : Recap Sequence of steps R* Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R *

88. Conclusion  The four mains sets of macroeconomic accounts are closely intertwined  These interrelations form the analytical basis of financial programming Fund economists understand that countries differ, and they seek to help tailor financial programs to the needs of individual countries Even so, certain fundamental principles and relationships apply everywhere These slides will be posted on my website: www.hi.is/~gylfason The End