Chapter 12 National Income Accounting and the Balance

Chapter 12 National Income Accounting and the Balance of Payments November 2009

From Trade to Finance, From Microeconomics to Macroeconomics: What’s New? • Unemployment • Saving • Trade imbalances • Money and the price level 12 -2

What’s in this chapter? • National income accounts ¨ National saving, investment and the current account • Balance of payments accounts 12 -3

National Income Accounts • A country’s national income accounts record how income is earned and spent. ¨ Producers earn income by selling their goods and services to buyers. ¨ Buyers spend what they earn from production. ¨ The amount of expenditure by buyers = the income earned by sellers = the value of production. ¨ National income is the total income earned by a nation’s factors of production. 12 -4

Factors of Production • What are factors of production? ¨ labor (workers), ¨ physical ¨ natural capital (like factories and equipment), resources, and ¨ other 12 -5

National Income Accounts: GDP • Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given time period. ¨ This is the expenditure definition of GDP; there are others ¨ Intermediate goods are goods that are used in the production of other for-sale goods. • They disappear inside other goods, as grapes disappear inside wine, or milk inside ice cream, or flour inside bread ¨ All other goods are called final goods. • These are goods sold to their final users, rather than to producers of other for-sale goods ¨ Intermediate goods are not counted separately. • The market value of a final good already includes the value of the intermediate goods used in its production. • GDP counts only final goods in order to avoid counting intermediate goods more than once 12 -6

National Income Accounts: GDP • GDP = total value added by producers located in the country ¨ This is the production definition of GDP ¨ Value added (by a producer) = market value of goods and services produced – market value of goods and services bought from other producers • GDP = total income generated by domestic production ¨ This is the income definition of GDP ¨ Gross domestic income (GDI) is the name given to GDP when calculated by statisticians using the income definition ¨ In theory GDP = GDI. ¨ But in practice the numbers usually differ. This difference is called statistical discrepancy. • GDP = GDI + statistical discrepancy 12 -7

National Income Accounts: GNP • Gross national product (GNP) is the total income earned by the resources owned by the legal residents of a country in a given time period. • GNP = GDP + income earned from foreign residents – income paid to foreign residents • GNP = GDP + net income from foreign residents (NIF) ¨ Gross national income: GNI = GDI + NIF = GNP, in theory ¨ GNP = GNI + statistical discrepancy, in practice 12 -8

National Income Accounts: Components of GDP • GDP is the market value of expenditure on all final goods and services produced within the country. • This expenditure consists of 4 categories : 1. Consumption (C): expenditure by domestic residents 2. Investment (I): expenditure by firms on plants & equipment 3. Government purchases (G): expenditure by governments on goods and services 4. Net exports = exports – imports – NX = EX – IM – net expenditure by foreigners on domestic goods and services • GDP = C + I + G + EX – IM = C + I + G + NX • GNP = C + I + G + NX + NIF 12 -9

GDP = Expenditure on final goods and services produced domestically GDP = Cd + Id + Gd + EX = (C – Cf) + (I – If) + (G – Gf) + EX = C + I + G + EX – (Cf + If +Gf) Cd is consumption spending on domestic goods. Cf is consumption spending on foreign goods. = C + I + G + EX – IM = C + I + G + NX Domestic expenditure Net expenditure by foreigners 12 -10

Fig. 12 -1: U. S. GNP and Its Components America’s $13. 2 trillion 2006 GNP and its components Source: US Dept of Commerce, Bureau of Economic Analysis. 12 -11

Gross National Disposable Income • Gross National Disposable Income (GNDI) is the total disposable income of a country’s residents • GNDI = GNI + gifts received from foreign residents – gifts given to foreign residents • NUT = gifts received from foreign residents – gifts given to foreign residents is called net unilateral transfers • GNDI = C + I + G + NX + NIF + NUT • CA = NX + NIF + NUT is called the current account balance • GNDI = C + I + G + CA ¨ GNDI is denoted by the symbol Y. • Y = C + I + G + CA 12 -12

GDP, GNDI: Recap • GNDI is denoted Y • Y = GNP + NUT = GDP + NIF + NUT = C + I + G + NX + NIF + NUT = C + I + G + CA • In practice, net income from foreign residents (NIF) and net unilateral transfers from foreign residents (NUT) are usually very small in magnitude • Therefore, GNDI, GNP and GDP are usually very similar in magnitude • Therefore, often they will all be denoted by the symbol Y. 12 -13

National Income Accounts • GNP is not the only measure of a nation’s income: National Income and GDP are two other measures. Net National Product = GNP – Depreciation • • • Depreciation of capital is the wear and tear of capital. This results in a loss of income to capital owners. So the amount of depreciation is subtracted from GNP. National Income = NNP – statistical discrepancy ¨ ¨ ¨ In theory, NNP and national income are the same NNP is measured using the expenditure approach and national income (or Net National Income, NNI) is measured using the income approach, but they both measure the same thing The different measuring techniques lead to the statistical discrepancy 12 -14

Expenditure and Production in an Open Economy Y = C + I + G +CA CA = Y – (C + I + G ) • When domestic production (Y) > domestic expenditure (C+I+G), current account = trade balance > 0, exports > imports when a country exports more than it imports, it earns more income from exports than it spends on imports. So, ¨ net foreign wealth increases ¨ • When domestic production < domestic expenditure, exports < imports, current account = trade balance < 0 when a country exports less than it imports, it earns less income from exports than it spends on imports. So, ¨ net foreign wealth decreases ¨ 12 -16

deficit surplus US Current Account As a Percentage of GDP, 1960– 2004 12 -17

US Current Account, 1960– 2004 12 -18

Net Foreign Wealth • US Net Foreign Wealth = foreign assets owned by US residents – US assets owned by foreign residents • The change in net foreign wealth during a year depends on ¨ the current account balance for that year ¨ Changes in worldwide asset prices ¨ Changes in exchange rates (that are used to convert wealth measured in various currencies into a common currency) 12 -19

Fig. 12 -2: U. S. Current Account and Net Foreign Wealth, 1976– 2006 US Net Foreign Wealth = foreign assets owned by US residents – US assets owned by foreign residents Source: U. S. Department of Commerce, Bureau of Economic Analysis, June 2007 release 12 -20

Saving and the Current Account • National saving (S) = national income (Y) that is not spent on consumption (C) or on government purchases (G). • S=Y–C–G • S=Y–T–C+T–G • S = (Y – T – C) + (T – G) • S = Sp + Sg 12 -21

How Is the Current Account Related to National Saving? Y = C + I + G + CA Y – C – I – G = CA CA = (Y – C – G ) – 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. 12 -22

How Is the Current Account Related to National Saving? (cont. ) CA = S – I or I = S – CA • Countries can pay for investment either by using domestic saving or by borrowing foreign funds equal to the current account deficit. ¨ 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. 12 -23

How Is the Current Account Related to National Saving? (cont. ) CA = Sp + Sg – I = Sp – government deficit – I • Government deficit is negative government saving ¨ equal to G – T • A high government deficit causes a negative current account balance, all other things equal. 12 -24

Inverse Relationship Between Public Saving and Current Account? Source: Congressional Budget Office, US Department of Commerce 12 -25

BALANCE OF PAYMENTS ACCOUNTS 12 -26

Balance of Payments Accounts • A country’s balance of payments accounts records its payments to and its receipts from foreigners. • Each international transaction enters the accounts twice: ¨ once as a credit (+) and ¨ once as a debit (-). 12 -27

Balance of Payments Accounts (cont. ) • The balance of payment accounts are separated into 3 broad accounts: ¨ current account: accounts for flows of goods and services (imports and exports). ¨ 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. 12 -28

Example of Balance of Payment Accounting • 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. DVD purchase –$30 (current account) Credit (“sale”) of bank account by bank +$30 (financial account) 12 -29

Example of Balance of Payment Accounting (cont. ) • 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. Purchase of stock –$500 (financial account) Credit (“sale”) of bank account by bank +$500 (financial account) 12 -30

Example of Balance of Payment Accounting (cont. ) • 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. Debt forgiveness: non-market transfer –$100 M (capital account) Credit (“sale”) of bank account by bank +$100 M (financial account) 12 -31

“Balance” • Balance = total credits – total debits ¨ When understood to be a numerical value, • current account stands for balance of the current account, • capital account stands for balance of the capital account, and • financial account stands for balance of the financial account. 12 -32

How Do the Balance of Payments Accounts Balance? • Due to the double entry of each transaction, the overall balance must be zero: current account + financial account + capital account = 0 • For U. S. data, see this Web site of the Bureau of Economic Analysis, U. S. Department of Commerce 12 -33

Balance of Payments Accounts • Current account balance = (exports of goods and services – imports of goods and services) + (factor income received from foreigners – factor income paid to foreigners) + (gifts of current income received from foreigners – gifts of current income paid to foreigners) • CA = NX + NIF + NUTincome 12 -35

Balance of Payments Accounts (cont. ) • Financial account = sales of domestic assets to foreigners – purchases of foreign assets by domestic citizens. • Financial inflow Foreign citizens give loans to domestic citizens by acquiring domestic assets. (+) ¨ Foreigners’ purchase of assets from domestic citizens are a credit (+) ¨ • Financial (capital) outflow Domestic citizens give loans to foreigners by acquiring their assets (foreign assets). (-) ¨ Domestic citizens’ purchase of assets from foreign citizens are a debit (-) ¨ 12 -37

Balance of Payments Accounts (cont. ) • Financial account balance = capital inflow – capital outflow = borrowing from foreign residents – lending to foreign residents 12 -38

Balance of Payments Accounts (cont. ) • Financial account has at least 3 categories: 1. Official (international) reserve assets 2. All other assets 3. Statistical discrepancy 12 -39

Balance of Payments Accounts (cont. ) • Official (international) reserve assets: foreign assets held by central banks to cushion againstability in international markets. ¨ Assets include government bonds, currency, gold and accounts at the International Monetary Fund. ¨ Official reserve assets sold to foreign central banks are a credit (+). ¨ Official reserve assets purchased by the domestic central bank are a debit (-). 12 -40

Balance of Payments Accounts (cont. ) • Statistical discrepancy ¨ 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 statistical discrepancy is the account added to or subtracted from the financial account to make it balance with the current account and capital account. 12 -41

Balance of Payments Accounts (cont. ) • The negative of the balance of official reserve assets 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. 12 -42

Official Settlements Balance • If the official settlements balance is a negative number, the balance of the official reserve transactions account must be a positive number. • In this case the transactions of non-central bank entities has increased our debt. • And so, either foreign central banks must help us out by buying our assets or our central bank must sell its holdings of foreign assets. • Thus, a crisis may be in the offing. 12 -43

Balance of Payments Accounts (cont. ) • 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. ¨ The selling of foreign currency by the domestic central bank and the buying of domestic assets by foreign central banks are credits for official international reserve assets, and therefore reduce the official settlements balance. 12 -44

Table 12 -2: U. S. Balance of Payments Accounts for 2006 (billions of dollars) 12 -45

Table 12 -2: U. S. Balance of Payments Accounts for 2006 (billions of dollars) Balance of Official Reserve Transactions = 2. 4 + 440. 3 = + 442. 7 Official Settlements Balance = - 442. 7. Also called, Balance of Payments. 12 -46

US Balance of Payments Accounts • The US has the highest negative net foreign wealth in the world, and is therefore the world’s biggest debtor nation. • And its current account deficit in 2006 was $812 billion dollars. ¨ So, its 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. 12 -47

Table 12 -3: International Investment Position of the United States at Year End, 2005

Fig. 12 -3: U. S. Gross Foreign Assets and Liabilities, 1976 -2006 Source: U. S. Department of Commerce, Bureau of Economic Analysis, June 2007

US Balance of Payments Accounts (cont. ) • 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 affect the 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. 12 -51

Summary 1. A country’s GNP is roughly equal to the income received by its factors of production. 2. In an open economy, GNP equals the sum of consumption, investment, government purchases, and the current account. 3. GDP is equal to GNP minus net receipts of factor income from abroad. It measures the output produced within a country’s borders. 12 -52

Summary (cont. ) 4. National saving minus domestic investment equals the current account (≈ exports minus imports). 5. The current account equals the country’s net foreign investment (net outflows of financial assets). 6. The balance of payments accounts records flows of goods & services and flows of financial assets across countries. ¨ It has 3 parts: current account, capital account and financial account, which balance each other. ¨ Transactions of goods and services appear in the current account; transactions of financial assets appear in the financial account. 12 -53

Summary (cont. ) 7. Official international reserve assets are a component of the financial account which records official assets held by central banks. 8. The official settlements balance is the negative value of official international reserve assets, and it shows a central bank’s holdings of foreign assets relative to foreign central banks’ holdings of domestic assets. 9. The US is the largest debtor nation, and its foreign debt continues to grow because its current account continues to be negative. 12 -54