Micro versus Macro PP542. National Income Accounts. Micro versus Macro (cont.) National Income Accounts: GNP. National Income Accounts: GNP (cont.

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1 PP542 Accounting Issues the Balance of Payments (BOP) Micro versus Macro MICROECONOMICS examines how individuals, by pursuing their own interests, collectively determine how resources are used. The key issues from a microeconomic perspective are: how do we best use the world s scarce productive resources? How do we best allocate scare resources? 1 2 Micro versus Macro (cont.) MACROECONOMICS (which is the focus in this course) examines how an economy can ensure that its factors of production are always employed? The key issue from a macroeconomic perspective is: how do the interactions ti of national economies influence the worldwide patterns of employment and economic growth? Before we begin our foray into there issues, we need to get familiar with some basic vocabulary and accounting principles which economists use to describe a country's level of production and international transactions. 3 National Income Accounts Records the value of national income that results from production and expenditure. Producers earn income from buyers who spend money on goods and services. The amount of expenditure by buyers = the amount of income for sellers = the value of production. National income is often defined to be the income earned by a nation s factors of production. 4 National Income Accounts: GNP National Income Accounts: GNP (cont.) Gross national product (GNP) is the value of all final goods and services produced by a nation s factors of production in a given time period. What are factors of production? workers (labor), physical capital (e.g. factories and equipment), natural resources and other factors that are used to produce goods and services. The value of final goods and services produced by US labor, capital and natural resources are counted as US GNP. GNP is calculated by adding the value of expenditure on final goods and services produced. There are 4 types of expenditure: 1. Consumption (C): expenditure by domestic residents 2. Investment (I): expenditure by firms on plants & equipment 3. Government purchases (G): expenditure by (federal, state and local) governments on goods and services 4. Current account balance (CA) (exports (EX) minus imports (IM)): net expenditure by foreigners on domestic goods and services Y = C + I + G + (EX-IM) Y = C + I + G + CA 5 6 1

2 Components of GNP US: C + I + CA In percentage terms (over the past 20 years for the U.S.) C makes up 62-66% of GNP I makes up 12-20% of GNP G makes up 18-20% of GNP CA makes up 10-15% of GNP In most countries investment (I) is the most variable component of GNP. 7 8 US: C + I + G+ CA Japan: C + I + CA Source: B. Bosworth and S. Collins, The U.S. External Deficit: A Soft Landing, Doomed or Delayed?, working paper, China: C + I + CA National Income Accounts GNP is one measure of national income, but a more precise measure of national income is GNP adjusted for following: 1. Depreciation of capital results in a loss of income to capital owners, so the amount of depreciation is subtracted from GNP. 2. Indirect business taxes reduce income to businesses, so the amount of these taxes is subtracted from GNP. 3. Unilateral transfers to and from other countries can change national income: payments of expatriate workers sent to their home countries, foreign aid and pension payments sent to expatriate retirees

3 National Income Accounts (cont.) Another approximate measure of national income is gross domestic product (GDP): Gross domestic product measures the final value of all goods and services that are produced d within a country in a given time period. GDP = GNP factor payments from foreign countries + factor payments to foreign countries GNP versus GDP For the U.S. GNP and GDP are fairly similar: Example: in the 3rd quarter of 2006 GDP = $13,322.6b Plus: Income receipts from the rest of the world ($682.3b) Minus: Income payments to the rest of the world ($665.7b) Equals: GNP = $13,339.2b For up-to-date U.S. data from the BEA see: GNP versus GDP GDP: China, Japan and US GNP will be lower than GDP if much of the income from a country's production flows to foreign persons or firms. For example, in 1994 Chile's GNP was 5 percent smaller than its GDP. If a country's citizens or firms hold large amounts of the stocks and bonds of other countries' firms or governments, and receive income from them, GNP will be greater than GDP. In Saudi Arabia, for instance, GNP exceeded GDP by 7 percent in The Penn World Tables at have a variable called "RATIO OF GNP TO GDP" for various countries World GDP

4 National Income Accounts The purchase of a foreign good or service counts as consumption (C) but it is then subtracted via imports (IM) so it enters twice in GNP. The profits of foreign subsidiaries of domestic firms are counted in GNP based on the percent domestic ownership of the subsidiary. Note: no workers need to be domestic, just a percentage of the owners. If 10% or more of the foreign subsidiary is domestically owned (rule used to be 20%) this enters under the FDI (Foreign Direct Investment) category. If less than 10% of the foreign subsidiary is domestically owned this enters as portfolio investment. For up-to-date data from the BEA see: =N What is the difference between the trade balance and the current account? The trade balance is the amount a country receives for the export of goods and services minus the amount it pays for its import of goods and services. The current account is the trade balance plus the net amount received for domestically-owned factors of production used abroad An Example: If an American owns an apartment building in London, the rent she receives is part of the current account but not part of the trade balance. In essence, the current account is a very broad measure of the trade balance where the income from domestically-owned factors used abroad are considered an export of factor services and the payments for foreign-owned factors used here are considered an import of factor services. To continue our example, the current account treats our American landlord as if she were an exporter of housing services. Example (cont.) If a Brit owns an apartment building in Boston, the treatment of the rent she receives is similar, but with the opposite sign for the U.S. current account balance. When an American buys an apartment building in London (or a Brit in Boston), that purchase appears neither in the trade balance nor in the current account. It is a financial account transaction (to be discussed later in today s lecture) Is the foreign sector measured differently depending on whether Y is GDP or GNP? US Current Account Components If Y is Gross Domestic Product, then the foreign sector is measured by the trade balance. If Y is Gross National Product, then the foreign sector is measured with the current account. These two measures are similar for many countries, and so economists sometimes use the terms interchangeably (even though they are not precisely the same). But for countries with large net foreign assets or debts, the difference can be large

5 GNP = Expenditure on a Country s Goods and Services National income = value of domestic production Y = C d + I d + G d + EX Expenditure on domestic production = (C-C f ) + (I-I f ) + (G-G f ) + EX = C + I + G + EX (C f + I f +G f ) = C + I + G + EX IM = C + I + G + CA Expenditure by domestic individuals and institutions Net expenditure by foreign individuals and institutions Expenditure and Production in an Open Economy CA = EX IM = Y (C + I + G ) When production > domestic expenditure, exports > imports: current account > 0, trade balance > 0 when a country exports more than it imports, it earns more income from exports than it spends on imports net foreign wealth is increasing When production < domestic expenditure, exports < imports: current account < 0, trade balance < 0 when a country exports less than it imports, it earns less income from exports than it spends on imports net foreign wealth is decreasing US Current Account (% GDP) US Current Account Deficits and Developing Country Surpluses More Current Account Balance Data CA as a Share of World GDP Source: B. Bosworth and S. Collins, The U.S. External Deficit: A Soft Landing, Doomed or Delayed?, working paper,

6 Saving For the moment we will ignore the foreign sector and think about a closed economy with no trade. National saving g( (S) = national income (Y) that is not spent on consumption (C) or government purchases (G). S = Y C G S = (Y C T) + (T G) S = S p + S g 31 Savings and Investment Recall that (in a closed economy): Y = C + I + G And the saving is: S = Y C G Substituting: S = [C + I + G] C G S = I National saving must equal investment in a closed economy and savings can take place in the aggregate only through enlarging the stock of capital. This is not a causal relationship, it is an ACCOUNTING IDENTITY 32 What happens to this relationship when we open the economy to trade? How Is the Current Account Related to National Saving? Investment no longer equals savings because countries can save by exporting more than they import, of dissave by importing more than they export. Recall that the current account (CA) measures the difference between exports and imports on goods and services. Y = C + I + G + CA CA = Y (C + I + G) implies CA = Y (C + I + G ) CA = (Y C G ) I = S I current account = national saving investment current account = net foreign investment A country with a CA deficit is importing present consumption and exporting (by borrowing) future consumption So that a country that imports more than it exports has low national saving relative to investment How Is the Current Account Related to National Saving? (cont.) How Is the Current Account Related to National Saving? (cont.) CA = S I or I = S CA Countries can finance investment either by saving or by acquiring 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. 35 An open economy can save by either investing in new capital stock (as in a closed economy) or by acquiring foreign wealth (by running a current account surplus). Because one country's savings can be borrowed by a second country to increase the second country's stock of capital - a country's current account surplus is often referred to as its NET FOREIGN INVESTMENT. 36 6

7 How Is the Current Account Related to National Saving? (cont.) So far we have lumped private and government saving together government saving (or dissaving) can be used to increase (or decrease) output and employment. Government saving (or dissaving) is a policy variable. S = S p + S g = I + CA Rearranging: CA = S p + S g I 37 How Is the Current Account Related to National Saving? (cont.) CA = S p + S g I = S p government deficit I Government deficit is negative government saving equal to G T Do government deficits worsen the current account? Remember, this is not a causal relationship, it is an ACCOUNTING IDENTITY 38 Inverse Relationship Between Public Saving and Current Account? G DP Percent of G 4% 2% 0% -2% -4% -6% US current account and public saving relative to GDP, % current account public saving Source: Congressional Budget Office, US Department of Commerce US Net Savings and Investment 41 Source: B. Bosworth and S. Collins, The U.S. External Deficit: A Soft Landing, Doomed or Delayed?, working paper,

8 US Federal Budget Balance 43 Source: B. Bosworth and S. Collins, The U.S. External Deficit: A Soft Landing, Doomed or Delayed?, working paper, Balance of Payments Accounts A country s balance of payments accounts accounts for its payments to and its receipts from foreigners. An international transaction involves two parties, and each transaction enters the accounts twice: once as a credit (+) and once as a debit (-). The balance of payments 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, nonproduced, or intangible assets like debt forgiveness, copyrights and trademarks Example of Balance of Payments Accounting Example of Balance of Payments Accounting (cont.) You import a DVD of Japanese anime by using your debit card. The Japanese producer of anime deposits the money 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 deposit in account by bank (financial account) +$30 You invest in the Japanese stock market by buying $500 in Sony stock. Sony deposits the money in its Los Angeles bank account. The bank credits the account by the amount of the deposit. Purchase of stock (financial account) Credit ( sale ) of deposit in account by bank (financial account) $500 +$

9 Example of Balance of Payments Accounting (cont.) U.S. banks forgive a $100 M debt owed by the government of Argentina through debt restructuring. U.S. banks who hold the debt thereby reduce the debt by crediting Argentina's bank accounts. Debt forgiveness: non-market transfer $100 M (capital account) How Do the Balance of Payments Accounts Balance? Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: current account + financial account + capital account = 0 Credit ( sale ) of account by bank (financial account) +$100 M Balance of Payments Accounts The 3 broad accounts are more finely divided: Current account: imports and exports 1. merchandise (goods like DVDs) 2. services (payments for legal services, shipping services, tourist meals, ) 3. income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries) Current account: net unilateral transfers gifts (transfers) across countries that do not purchase a good or service nor serve as income for goods and services produced Capital account: records special transfers of assets, but this is a minor account for the U.S Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens. Financial inflow Foreigners loan to domestic citizens by buying domestic assets Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction Financial outflow Domestic citizens loan to foreigners by buying foreign assets Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction Financial account has at least 3 subcategories: 1. Official (international) reserve assets 2. All other assets 3. Statistical discrepancy

10 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. Official (international) reserve assets: foreign assets held by central banks to cushion against financial instability. Assets include government bonds, currency, gold and accounts at the International Monetary Fund. Official reserve assets owned by (sold to) foreign central banks are a credit (+) because the domestic central bank can spend more money to cushion against instability. Official reserve assets owned by (purchased by) the domestic central bank are a debit (-) because the domestic central bank can spend less money to cushion against instability Developing Economies Reserves U.S. Balance of Payments Accounts for 2006 (billions of dollars) The negative value of the 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. A negative official settlements balance may indicate that a country is depleting its official international reserve assets or may be incurring large debts to foreign central banks so that the domestic central bank can spend a lot to protect against financial instability

11 U.S. Balance of Payments Accounts for 2006 (billions of dollars, cont.) U.S. Balance of Payments Accounts The U.S. has the most negative net foreign wealth in the world, and so is therefore the world s largest debtor nation. The U.S. current account deficit in 2007 was $731 billion dollars, so that net foreign wealth continued to decrease. The value of foreign assets held by the U.S. has grown since 1980, but liabilities of the U.S. (debt held by foreigners) has grown more quickly U.S. Gross Foreign Assets and Liabilities, U.S. About 70% of foreign assets held by the U.S. are denominated in foreign currencies and almost all of U.S. liabilities (debt) are denominated in dollars. Changes in the exchange rate influence value of net foreign wealth (gross foreign assets minus gross foreign liabilities). Appreciation of the value of foreign currencies makes foreign assets held by the U.S. more valuable, but does not change the dollar value of dollar-denominated debt for the U.S Net International Investment Position U.S. Net International Investment Position (NIIP) A country's international investment position (IIP) is a financial statement setting out the value and composition of that country's external financial assets and liabilities. The IIP is the all other assets component of the financial i account of a country's balance of payments, (containing for example stock of companies, real estate, financial instruments, and so on). The difference between a country's external financial assets and liabilities is the net international investment position (NIIP). The NIIP measures the accumulation of financial claims against the US held by foreigners, net of the increase in claims held by the US against the rest of the world The change in NIIP each year is equal to: the current account the effect of asset price changes The effect of currency changes The US has benefited in recent years because it holds a riskier portfolio (mostly in equity), and therefore a higher return portfolio, relative to foreign claims against the US (mostly in bonds)

12 U.S. International Investment Position Source: B. Bosworth and S. Collins, The U.S. External Deficit: A Soft Landing, Doomed or Delayed?, working paper,