International Finance Theory EXAM I (CH 2-4)

GDP (Gross Domestic Product)

The market value of all final goods and services produced within a country over a period of time.

What are 3 identical angles of GDP

• Total expenditure (spending) by buyers (on final good)

• Total Value of goods and services produced

• Total Income earned by sellers

What is main idea or concept of identical angles of GDP?

They are methods of finding GDP, so the final amount should equal each other.

GNP (Gross National Product)

The value of all final goods and services produced by a nation’s factors of production in a given time period

Factors of Production

Factors used to produce goods and services

What are the four parts that have to be true to be counted as GNP?

• Measured in Value

• Final goods and services ONLY

• Produced by the nation’s factors of production

• Within the given time frame (Usually the year/current)

What should you exclude from final goods and services when calculating GNP

Intermediate Goods

Intermediate Goods

Inputs (goods and services) used to make a other product

Goods excluded from current GNP calculations to avoid double counting prior production

Used Goods

Difference between GNP and GDP

GDP is goods and services produced within a country (where), while GNP is goods and services produced with the country’s factors of production (who owns it).

Formula for calculating GNP using GDP

GNP = GDP + Net income from abroad

How do find Net income from abroad?

Payments from foreign countries for the factor of production - payments to foreign countries for factor of production

National Income Account

Bookkeeping system that records the value of national income that results from production and expenditure (spending)

3 way to measure National Income

1. Value of Production

2. Amount of Income from sellers

3. Amount of expenditures from buyers

National Accounting Equality

Total Expenditure = Total Output = Total Income

Formula for Calculating GNP (Expenditure Approach)

Y = C + I + G + CA

What is Y mean in GNP Formula

GNP/National Income/Production/Output

What is C mean in GNP Formula

Consumption

What is I mean in GNP Formula

Investment

What is G mean in GNP Formula

Government Purchase

What is CA mean in GNP Formula

Current Account

Consumption

expenditure by domestic consumers

Investment

expenditure by firms that are not consumed today, but are used instead to create future goods and services (buildings, equipment, machinery, inventory)

Why is inventory an investment?

It is goods a firm owns that are not yet bought (cannot go into investment), produced, so it counts as GNP. It represents current economic output.

2 categories of consumer goods?

• Durable

• Nondurable

Durable Goods

long lived goods (> 3 years)

Non-Durable Goods

Short Lived Goods (< 3 years)

Government Purchases

Expenditure by the government on goods and services.

What does Government purchases include?

• Government Consumption

• Government Investment

What does Government purchases exclude?

Transfer payments

Government Consumption

Spending on goods and services for immediate public needs (less than year)

Government Investment

Spending on fixed Capital Assets that expand productive capacity (More than a year)

Transfer Payments

Money given by the government to people or organizations without expecting any goods or services back.

Current Account Balance

net expenditures by foreigners on domestic goods and services

Why do we adjust for CA?

Purchasing or selling imported goods does not directly change a country’s GNP because the change in domestic spending is offset by an equal and opposite change in the current account balance. Leaving GNP unchanged.

2 meanings/interpretations of CA?

1. Export - Import

2. Size and direction of international borrowing

Negative CA means what

Country is borrowing more than they producing/exporting (debt).

Net National Product (NNP)

GNP - depreciation, a different way to measure economic activity, argued to be more accurate.

National Income Identity

Core economic equation showing that total national income equals total national output and total national spending

National Income Identity Equation (Referring to GNP)

Y = C + I + G + CA

What does Y, C, I, G, CA mean in National Income Identity

• Y = GNP/National Income/Production/Output

• C = Consumption

• I = Domestic Investment

• G = Government purchases

• CA = Current Account Balance

What other equation does National Income equal to?

• Supply = Demand

• Production = Expenditure

In the National Income Identity equation, what does (C + I + G) mean?

Domestic Expenditure

In the National Income Identity equation, what does (CA) mean?

Foreign Expenditure

In words, what is National Income Equation?

GNP (production/output) = Domestic Expenditure + Net Foreign Expenditure

Current Account Equation (NI)

CA = Y - (C + I+ G)

Current Account Equation in words

What we make (Production) - what we spent (Domestic expenditure)

Two scenarios of account balances

• Current Account Surplus

• Current Account Deficit

Current Account Surplus

The country is making more goods than its own people can buy. Therefore, selling extra to foreigners (EXP > IMP)

CA Surplus Equation

Production (Y) > Domestic Expenditure (C+I+G)

Current Account Deficit

The Country’s own people are spending more than they are making. Therefore buying from other countries (EXP < IMP).

CA deficit equation

Production (Y) < Domestic Expenditure (C+I+G)

Because Y>C+I+G, how does affect foreign expenditure? Money wise does mean for us?

Foreign expenditure increases, and we have more money

If foreign expenditure increases, what does that mean for our Current Account?

CA > 0

When export > Import, what does that mean for trade balance?

Trade Balance > 0

Because Y < C+I+G, how does affect foreign expenditure?

Foreign expenditure decrease

If foreign expenditure decreases, what does that mean for our Current Account?

CA<0

When export < Import, what does that mean for trade balance?

Trade Balance < 0

Global Financial Result for CA Surplus

Because Production > Domestic expenditure, we must sell extra goods to foreigners (Export > Import), Trade Balance > 0, therefore pulling extra cash from foreigners, CA >0.

Global Financial Result for CA Deficit

Because Production < Domestic expenditure, we are buying from foreigners more (Export < Import), Trade Balance < 0, therefore pulling cash from foreigners decreases, CA < 0

Intemporal Trade

The exchange of goods and services, or financial assets, between different time periods to balance current and future consumption.

Intemporal Trade interpretation in CA deficit

The country is importing present consumption & exporting future consumption

Intemporal Trade interpretation in CA surplus

The country is exporting present consumption & importing future consumption

Private Savings

Part of disposable income that is saved rather than consumed

Private Savings Equation

S^p = Y - T - C

Private Savings Equation in words

Private Savings = Disposable Income - Taxes - Consumption

Disposable Income Equation

Y - T (National Income - Taxes)

Government Saving

Net tax revenue, T, minus government (G)

Government Saving Equation

S^g = T - G

National Savings

Totas income in an economy that is not spent on consumption or government purchases

National Savings equation

National Savings (S) = Private Savings (Y-T-C) + Government Savings (T-g)

What other 2 equations to find National savings

• S = Y - C - G

• S = I + CA

What is are the 2 alternative ways to find private savings?

• Private Savings (S^p) = National Savings (I + CA) - Government Savings (T-G)

• Private Savings (S^p) = National saving (I + CA) + Government deficit (G-T)

Government Budget Deficit

Government spends more money than it collects. Financed through debt issuance

3 Forms of Private Savings in a Country

1. Investment in domestic capital (I)

2. Purchases of wealth from foreigners (CA)

3. Purchase of the domestic government-issued debt (G-T)

Balance of Payments

Financial record of the international transactions (Credits & Debits) between one country and rest of the world.

What does BOP track?

• Payment to Foreigners

• Receipts from foreigners

3 categories of BOP

• Current Account

• Financial Account

• Capital Account

Current Account — BOP

accounts for flows of goods and services (Exports & Imports)

Financial Account — BOP

Accounts for flows of financial assets (Financial Capital)

Capital Account —BOP

Accounts for special categories of assets (capital), non-market, produced, or intangible assets transfers.

Credit (BOP)

Result in receipts from foreigners

You credit when…

• Money flowing into the country

• Export

• Creation of liabilities abroad

• Country that owes you money pays off debt

Debit

If results in payment to foreigners

You Debit when…

• Money flowing out of the country

• Import

• Reducing liabilities

• Country now owes you money

The fundamental BOP identity

Because every transaction is recorded twice—once as a credit and once as a debit—the Balance of Payments identity states that the sum off all accounts must = 0

Fundamental BOP Identity Equation

-(Current Account + Capital Account) = Financial Account

What is true when you record credits and Debits in BOP

Must Balance each other out, Credit = Debit

Current Account in BOP tracks what 3 main categories of transactions?

• Goods and services trade

• Primary Income

• Secondary Income

Primary Income

Income earned on investment or labor abroad

What Income receipts in Primary Income

Payments earned by domestic citizens from foreign assets (Inflow)

What outflow in primary income

payments sent to foreigners who own assets inside the country

Secondary Income

Net Unilateral Transfers, One-way money transfers where nothing tangible is given in return

Balance of CA Equation

= Export - Import + net unilateral transfers

Official reserve assets

Foreign financial assets held by a country’s central bank to cushion against financial instability

3 Reasons why Central banks hold reserve assets?

1. Exchange Rate Intervention

2. Economic Defense

3. Liquidity

Explain the Exchange Rate Intervention reasoning for holding reserve assets

Buying or selling foreign currencies to influence or stabilize the exchange value of their own domestic currency.

Explain the Economic Defense reasoning for holding reserve assets

Maintaining an annual cushion to protect against sudden global market panics or economic crises.

Explain the Liquidity reasoning for holding reserve assets

Ensuring the country has enough convertible foreign funds available to make international payments if foreign borrowing suddenly dries up

Selling Foreign Reserves transaction process in BOP

Official reserve assets sold to foreign central bank (we sell foreign asset & buy back our currency, money flows in), we credit, & domestic central bank can spend more money to cushion against instability