ECON20032 Macroeconomics - Topic 1: National Accounts and the Balance of Payments

National Accounts and the Balance of Payments

Background

• The first System of National Accounts (SNA) was published in 1958 by the United Nations.
• It was revised and extended in 1968.
• Subsequent SNAs were released in 1993 and 2008, jointly published by the UN, IMF, World Bank, Eurostat, and OECD.
• The 2008 SNA is still being implemented, while the 1993 SNA remains in use in several countries.

Production, Income, and Expenditure

• Three basic accounting concepts:
  • Production: Goods and services produced by domestic agents (firms, self-employed workers, financial institutions, and the government).
  • Income: Wages and salaries, firms’ operating surpluses, property income, and imputed compensation (fringe benefits and non-cash compensation).
  • Expenditure: Outlays on durable and nondurable final consumption goods and investment.
• Circular Flow of Income and Spending (Closed Economy):
  • Households receive incomes (wages, dividends, interest, profits, and rent) from firms.
  • Households use this income to purchase goods and services, pay taxes, and receive social transfers from the government.
  • The government purchases goods and services and collects taxes.
  • Firms receive payments from households and the government for goods and services.
• Three macroeconomic relationships:
  • Production and income: The total value of production must equal the value of income generated domestically. National income equals the gross domestic product (GDP) plus net factor income from abroad.
  • Income, expenditure, and savings: For any economic agent, income earned plus transfers must equal expenditure plus savings.
  • Savings and asset accumulation: Savings plus borrowing must equal asset acquisition for any economic agent. Assets include physical (capital goods, real estate) and financial (cash, bank deposits, government bonds).

National Income Identities and Budget Constraints in an Open Economy

• Circular Flow of Income and Spending (Open Economy):
  • Includes the rest of the world through imports and exports.
  • Households, firms, the government, and the financial sector interact with the rest of the world.
• GDP and absorption:
  • Two approaches to estimate GDP: expenditure and value added.
  • GDP at market prices in an open economy, denoted as $Y$, is calculated as: $Y = C + I + X - J$, where:
    • $C$: Sum of private consumption ($C<em>P$) and public consumption ($C</em>G$), thus $C = C<em>P + C</em>G$
    • $I$: Sum of private investment ($I<em>P$) and public investment ($I</em>G$), thus $I = I<em>P + I</em>G$
    • $X$: Exports of goods and services.
    • $J$: Imports of goods and services.
  • GDP is also the sum of value added by all firms in the economy (sum of gross sales minus spending on intermediate goods used in production).
  • GDP is also the sum of payments to labor (workers) and profits (capital holders).
    Note: Sometimes the GDP identity is represented as $Y = C + I + G + X - M$, where G is G = $C<em>G + I</em>G$, and $M = J$.
• Absorption (domestic spending): $DA = C + I$
  • Combining with the GDP identity yields: $Y - DA = X - J$
  • $X - J$: Net exports; a negative value corresponds to a trade deficit.
  • $Y - DA$: Excess of production over absorption.
  • If $X - J < 0$ (deficit), then $Y - DA < 0$, or $DA > Y$. To lower the trade deficit, absorption (public or private) must fall relative to domestic production.
• Private sector budget constraint:
  • Private saving ($S<em>P$): Difference between household income ($Y</em>P$), direct taxes net of government transfers ($T<em>D$), and household consumption ($C</em>P$): $Y<em>P - T</em>D - C<em>P = S</em>P$
  • Household income ($Y_P$) depends on factor income (GDP), interest income, foreign transfers, and net factor income from abroad.
  • $Y<em>P - T</em>D$: Disposable (after-tax) income.
  • Household financing constraint: $S<em>P + \Delta L</em>{PB} + \Delta F<em>{BP} = I</em>P + \Delta B_P + \Delta M$, where:
    • $\Delta L_{PB}$: Change in (flow) borrowing from banks.
    • $\Delta F_{BP}$: Change in (flow) net foreign borrowing.
    • $\Delta B_P$: Change in (flow) holdings of government bonds.
    • $\Delta M$: Change in (flow) domestic cash balances.
    • $\Delta B_P$: Equivalent to a loan from the private sector to the government.
      Note: The exchange rate is fixed and normalized to 1.
• Government budget constraint:
  • Gap between total government revenue ($T<em>G = T</em>D + T<em>O$, with $T</em>O$: other revenues) and current public expenditure ($G$) gives public saving ($S<em>G$): $T</em>G - G = S_G$
  • $G$: Sum of consumption spending ($C_G$) and interest payments on public debt.
  • Public investment ($I<em>G$) is financed by public saving and domestic and foreign borrowing: $S</em>G + \Delta L<em>{GB} + \Delta B</em>P + \Delta F<em>{BG} = I</em>G$
    • $\Delta L_{GB}$: Change in (flow) net borrowing from banks.
    • $\Delta F_{BG}$: Change in (flow) net foreign borrowing.
  • Substituting $T<em>G - G$ for $S</em>G$ gives: $G + I<em>G - T</em>G = \Delta L<em>{GB} + \Delta B</em>P + \Delta F<em>{BG}$, where $G + I</em>G - T<em>G$ is the conventional budget balance (with $G + I</em>G$ denoting total public expenditure) and $\Delta L<em>{GB} + \Delta B</em>P + \Delta F_{BG}$ represents financing sources.
• External constraint:
  • Current account, conventional definition: $CA = X - J + NFI + NUT - INT$, where:
    • NFI: Net factor income from abroad (payments on domestic labor and capital used abroad).
    • NUT: Net unilateral transfers from abroad (foreign aid, remittances).
    • INT: Net interest paid on foreign liabilities.
  • Define $\overline{X} = X + NFI + NUT$ as total resources from the rest of the world and $\overline{J} = J + INT$ as total payments to the rest of the world. The equation becomes $CA = \overline{X} - \overline{J}$.

Remark 1/3:

• Gross national income, GNI (formerly gross national product, GNP):GDP plus net factor income from abroad, NFI.
• Represents the value produced by a country’s economy in a given year – regardless of whether the source of the value created is domestic production or receipts from abroad.
• Gross national disposable income, GNDI: GNI plus net unilateral transfers, NUT, minus direct income taxes.
• Alternative CA definition (based on the balance of payments (BoP, fixed exchange rates)): $CA + \Delta FB = \Delta R^*$, where:
  • $FB = FBP + FBG$ is net foreign borrowing, and $\Delta FB$ is the change in net foreign liabilities.
  • Current account plus capital account, $\Delta FB$, must be equal to the change in official foreign reserves, $\Delta R^*$.
    *CA = $\Delta R^*$ - $\Delta FB$
• A current account deficit (CA < 0) can be financed either by:
  • A rise in foreign borrowing (capital inflow), \Delta FB > 0
  • A reduction in official foreign reserves, \Delta R^* < 0
  • Flexible exchange rates: $\Delta R^* = 0$ and $CA = -$\Delta FB$. Movements in the current account and capital account mirror each other.</li></ul></li> </ul> <p><em>Remark 2/3:</em></p> <ul> <li>The term “capital account” is used with a more narrow meaning in the IMF BoP Manual.</li> <li>It splits what others call the capital account into 2 components:<ul> <li>Financial account: Records changes in international ownership of assets (FDI, portfolio flows, etc.).</li> <li>Capital account: Includes capital transfers between residents and nonresidents, and acquisition and disposal of nonproduced, nonfinancial assets between them (IMF (2009)).</li></ul></li> <li>In practice, the bulk of financial transactions are recorded in the financial account, which corresponds to the “old”/more common definition of the capital account.</li> <li>The lecture focuses on the old/more common definition of the capital account, as changes in net foreign liabilities.</li> </ul> <p><em>Remark 3/3:</em></p> <ul> <li><p>Net international investment position (NIIP): Difference between the external financial assets and liabilities of a country.</p></li> <li><p>Stock concept; a positive (negative) value means the country is a net creditor (net debtor).<br /> <em>Example:</em> The United States was initially a net creditor but is now the world’s biggest net debtor due to persistent CA deficits and foreign borrowing.</p></li> <li><p><strong>Balance sheet of the financial system:</strong></p> <ul> <li>Financial system: pure intermediary (no profits).</li> <li>No need to worry about savings and its allocation.</li> <li>Consolidated balance sheet:$\Delta L + \Delta R^* = \Delta M$, with$\Delta L = \Delta L{GB} + \Delta L{PB}$.</li></ul></li> <li><p><strong>Saving, investment, and the current account:</strong></p> <ul> <li>The balance of payments equation can be written as:$\Delta FB = \Delta R^* - CA$</li> <li>Adding financing constraints of the private sector and government yields:<br />$SP + \Delta L{PB} + \Delta F{BP} + SG + \Delta L{GB} + \Delta BP + \Delta F{BG} = IP + \Delta BP + \Delta M + IG$</li> <li>$\Delta BP$cancels out. With$S = SP + S_G$denoting domestic saving and given earlier definitions of aggregates$\Delta L$,$\Delta FB$, and I:$S + \Delta L + \Delta FB = I + \Delta M$</li> <li>Substituting for$\Delta FB$gives:$S + \Delta L + \Delta R^* - CA = I + \Delta M$</li> <li>Using the balance sheet of the financial system to substitute out for$\Delta M$:$S - CA = I$or$CA = S - I$</li></ul></li> <li><p>The current account is the difference between domestic saving ($S$) and domestic investment ($I$).</p></li> <li><p>Equivalently, domestic investment is financed by either domestic saving or foreign saving, i.e., a current account deficit ($CA < 0$).</p></li> <li><p>Since$CA = -$\Delta FB$ (assuming $\Delta R^* = 0$), if $CA < 0$, then $\Delta FB > 0$. A current account deficit is matched by an increase in foreign borrowing.

  • In sum, there are 3 equivalent ways to define the current account balance:

    • As exports of G&S plus income receipts from abroad (net unilateral transfers and net factor payments from abroad) minus imports of G&S plus net income payments: $CA = X - J$.
    • As net capital inflows (net of changes in official reserves under fixed exchange rates): $CA = \Delta R^* -$\Delta FB$.</li> <li>As domestic saving minus domestic investment (private and public):$CA = S - I$.<br /> <em>Notes:</em></li></ul></li> <li><p>If net transfers and net factor payments from abroad and net interest payments are all 0, then$\overline{X} = X$and$\overline{J} = J$. Thus,$CA = X - J$(same as trade balance).</p></li> <li><p>Given the earlier definition of domestic absorption,$DA = C + I$, the current account can then be written as$CA = Y - DA$. A country runs an external deficit ($\overline{X} < \overline{J}$) if absorption exceeds output ($DA > Y$).<br /> Also, in a closed economy:$CA = 0$and$S = I$.</p></li> </ul> <h4 id="twindeficits">Twin Deficits</h4> <ul> <li>The current account definition can be broken down as:$CA = S - I = (SP - IP) + (SG - IG)$</li> <li>A current account imbalance is the counterpart to imbalances between:<ul> <li>Private saving and private investment,$SP - IP$, for a given imbalance between public saving and investment,$SG - IG$.</li> <li>Public saving and public investment,$SG - IG$, for a given imbalance between private saving and investment,$SP - IP$.</li></ul></li> <li>If$SP - IP$is more or less constant, changes in current account imbalances will reflect essentially changes in fiscal imbalances.</li> <li>If$SP ≈ IP$, negative public savings ($SG - IG < 0$) will be associated with external deficits (external borrowing, which translates into capital inflows). This is referred to as twin deficits.</li> <li>However, government deficits may affect private savings.</li> <li><strong>Ricardian equivalence:</strong> An increase in public borrowing (which reflects a higher fiscal deficit or a fall in public saving) is offset by higher private savings so that domestic savings,$S = SP + SG$, is unaffected.<ul> <li>When the budget deficit increases and is financed by borrowing, agents will anticipate that the government will raise taxes in the future to pay back the accumulated debt.</li> <li>To “pay for” the expected future increase in taxes, households begin to save now and build up wealth by spending less today.</li></ul></li> <li>High future taxes reduce the present value of lifetime disposable income.</li> <li>A decrease in$SG$is offset by an increase in$SP$. There is no link between fiscal and current account deficits.</li> <li>However, Ricardian equivalence requires some stringent assumptions to hold, e.g., households look far into the future and are not subject to borrowing constraints (about one-third of borrowers in the euro area).<br /> <em>Example:</em> United States: Late 1980s, 1990s: inverse correlation. Other periods: positive correlation, including following November 2017 tax cuts and increases in military spending (without spending cuts). US budget deficit: went from -3.5<li>Also, as a result of the increase in government borrowing, interest rates may increase. In turn, this may dampen private investment,$I_P$.</li> <li>Even if$SP$does not change, the decline in$IP$may be large enough to offset the decline in$SG$. If the crowding-out effect on$IP$$ is very strong, the current account may even improve rather than deteriorate (negative correlation).

    Practice Questions

    1. Explain the three basic accounting concepts of production, income, and expenditure.
    2. Explain the relationship between income, expenditure, and savings.
    3. Explain the relationship between savings and asset accumulation.
    4. Define the relationship between production, domestic absorption, and net exports.
    5. What is the conventional measure of the current account balance?
    6. Define the net international investment position of a country.
    7. From the identities and budget constraints discussed in class, derive the savings-investment equilibrium.
    8. Is an excess of domestic investment on domestic saving associated with a deficit or a surplus in the current account?
    9. Explain the notion of twin deficits.
    10. Explain Ricardian equivalence. Can it account for the existence of twin deficits?