Chapter 2 : National Income Accounting and the Balance of Payments Study Guide

Core Concepts of National Income Accounting and the Balance of Payments

National Income Accounts Defined: The national income accounts record the value of national income resulting from production and expenditure.
Fundamental Identity of Expenditure and Income: The amount of expenditure by buyers is equal to the amount of income for sellers, which is equal to the value of production.
National Income Definition: This is the income earned by a nation's factors of production.
Factors of Production: These are the inputs used to produce goods and services. Examples include: Labor services: Provided by workers. Physical capital: Including buildings and equipment. Natural resources: And various other productive factors.

Gross National Product (GNP) and Components

GNP Definition: The value of all final goods and services produced by a nation’s factors of production in a given time period. For the United States, the value of final goods and services produced by U.S.-owned factors of production are counted as U.S. GNP.
Calculation of GNP: GNP is calculated by summing the expenditure on final goods and services produced:
Consumption ( $C$ ): Expenditures by domestic consumers.
Investment ( $I$ ): Expenditures by firms on buildings and equipment.
Government Purchases ( $G$ ): Expenditures by governments on goods and services.
Current Account Balance ( $CA$ ): Defined as exports minus imports ( $EX - IM$ ). This represents the net expenditure by foreigners on domestic goods and services.

Precise Measures of National Income and GDP

Adjustments to GNP: For a more precise measure of national income, GNP must be adjusted for:
Depreciation of physical capital: This results in a loss of income to capital owners and must be subtracted from GNP.
Unilateral Transfers: National income is changed by payments of expatriate workers sent to home countries, foreign aid, and pension payments sent to expatriate retirees.
Gross Domestic Product (GDP): Measures the final value of all goods and services produced within a country's borders in a given time period.
Relationship to GNP: $\text{GDP} = \text{GNP} - \text{payments from foreign countries for factors of production} + \text{payments to foreign countries for factors of production}$ .

National Income Accounting for an Open Economy

National Income Identity: The standard identity for an open economy is: $Y = C + I + G + EX - IM = C + I + G + CA$
Domestic Expenditure: Defined as $C + I + G$ .
Current Account Balance Outcomes:
Surplus (CA > 0): Occurs when production ( $Y$ ) is greater than domestic expenditure. This implies exports are greater than imports and the trade balance is greater than zero (TB > 0). In this state, the country earns more from exports than it spends on imports, and net foreign wealth increases.
Deficit (CA < 0): Occurs when production ( $Y$ ) is less than domestic expenditure. This implies exports are less than imports and the trade balance is less than zero (TB < 0). The country earns less from exports than it spends on imports, and net foreign wealth decreases.
Current Account Formula: $CA = Y - (C + I + G)$ .
Agraria Hypothetical Example (Open Economy): Production values for a hypothetical economy named Agraria measured in bushels of wheat:
Total: $55\,\text{bushels of wheat} + (0.5\,\text{bushel per gallon}) \times (40\,\text{gallons of milk})$ .
Import value: $0.5\,\text{bushel per gallon} \times 40\,\text{gallons of milk}$ .

Saving and the Current Account

National Saving ( $S$ ): The portion of national income ( $Y$ ) that is not spent on consumption ( $C$ ) or government purchases ( $G$ ): $S = Y - C - G$
Saving in an Open Economy: An open economy can save by building up its capital stock or by acquiring foreign wealth: $S = I + CA$
Private Saving ( $S_p$ ): Part of disposable income (national income, $Y$ , minus taxes, $T$ ) that is saved rather than consumed: $S_p = Y - T - C$
Government Saving ( $S_g$ ): Net tax revenue ( $T$ ) minus government purchases ( $G$ ): $S_g = T - G$
Total National Saving Identity: $S = S_p + S_g = (Y - T - C) + (T - G) = Y - C - G$ .
Forms of Private Saving: Rewriting the identity $S_p = I + CA + (G - T)$ shows that private saving can take three forms: 1. Investment in domestic capital ( $I$ ). 2. Purchases of wealth from foreigners ( $CA$ ). 3. Purchases of domestic government's newly issued debt ( $G - T$ ).

Balance of Payments (BOP) Accounts

Principles of BOP: Records payments to and receipts from foreigners. International transactions involve two parties, and each enters the accounts twice: once as a credit ( $+$ , money coming in) and once as a debit ( $−$ , money going out).
Account Categorization:
Current Account: Accounts for flows of goods and services (imports and exports).
Financial Account: Accounts for flows of financial assets (financial capital).
Capital Account: Records flows of special categories of assets (typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights, and trademarks).
BOP Balancing Identity: $Current\,account + Financial\,account + Capital\,account = 0$ .
Statistical Discrepancy: Data collected from different sources may differ in coverage, accuracy, and timing. The statistical discrepancy is added to or subtracted from the financial account to ensure the identity balances.

Detailed Breakdown of BOP Accounts

Current Account Categories:
Imports and Exports: Includes merchandise (goods like DVDs) and services (legal services, shipping, tourist meals).
Income Receipts: Interest and dividend payments, earnings of firms and workers operating abroad.
Net Unilateral Transfers: Gifts across countries, such as foreign aid, that do not purchase goods or serve as income for production.
Financial Account Categories:
Financial Inflow: Foreigners loan to domestic citizens by buying domestic assets (Credit, $+$ ).
Financial Outflow: Domestic citizens loan to foreigners by buying foreign assets (Debit, $-$ ).
Categories: Official (international) reserve assets, all other assets, and the statistical discrepancy.

Central Banks and Official Reserve Assets

Central Bank Role: Responsible for managing the money supply (e.g., the Federal Reserve in the U.S.).
Official Foreign Exchange Intervention: Central banks buy or sell international reserves in private asset markets to affect macroeconomic conditions or inject/withdraw money from circulation.
Official International Reserve Assets: Foreign assets held by central banks (government bonds, currency, gold, IMF accounts) to cushion against instability.
Sold to foreign central banks: Credit ( $+$ , increases spending power).
Purchased by domestic central bank: Debit ( $-$ ).
Official Settlements Balance (Balance of Payments): The negative value of the official reserve assets. It is the sum of the current account, capital account, non-reserve portion of the financial account, and the statistical discrepancy.
A negative balance suggests the country is depleting reserves or incurring large debts to foreign central banks.

Globalization and Discrepancies

Missing Deficit Mystery: Theoretically, the world's current account balances must sum to zero. However, between 1980 and 2003, the global sum was negative. Since 2004, it has been positive.
Possible Causes for Discrepancy: Incomplete reporting of international investment income or growing international trade in services.

Case Study: Ireland's GDP and Multinationals

The Ireland Phenomenon: In 2014-2015, Ireland's GDP rose by $26.3\%$ .
Cause: This was not due to an increase in physical factors of production but was an accounting phenomenon for tax avoidance.
Tax Incentive: Ireland’s low corporate tax rate of $12.5\%$ incentivizes multinationals to allocate intellectual property (IP) assets to Ireland.
Takeaway: GDP can be a flawed measure of actual economic welfare.

U.S. Net International Investment Position (NIIP)

Debtor Status: The U.S. is the world's largest debtor nation, with the most negative net foreign wealth globally. As of 2012, its CA deficit was approximately $\$440\,\text{billion}$ .
Asset and Liability Growth: Since 1980, both assets and liabilities have grown, but liabilities have grown significantly faster.
Exchange Rate Influence: About $70\%$ of foreign assets held by the U.S. are denominated in foreign currencies, while almost all liabilities are in dollars.
Appreciation of Foreign Currency: Makes U.S.-held foreign assets more valuable but does not change the dollar-denominated debt value.