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National Income Accounting and the Balance of Payments

Unlike in previous chapters, Chapter 12 focuses on macroeconomics the branch of economics

that analyzes the behavior of the economy as a whole. This analysis stresses four aspects of economic

life that has been ignored before for the sake of discussion simplification. These four are unemployment,

saving, trade imbalances, and money and the price level.

In order to fully grasp the idea of economics and to get a complete picture of the macroeconomic

linkages, there are two related and important tools you can use and have to master. The first one is

national income accounting,and it records all the expenditures that contribute to the countrys income

and output. The next one is balance of payments accountingwhich helps us keep track of both changes

in a country's indebtedness to foreigners and the fortunes of its export- and import-competing industries.

It also shows the connection between foreign transactions and national money supplies.

One of the main concerns in macroeconomic analysis is a countrys gross national product (GNP),

which is the basic measure of a country's output. GNP is the value of all final goods and services

produced by the countrys factors of production and sold on the market in a given period. Since the

output cannot be produced without the aid of factor inputs, the expenditure that make up GNP are

closely linked to the employment of labor, capital, and other factors of production.

GNP is divided into four possible uses: consumption, investment, government purchases, and the

current account balance. This fourfold classification, which will be discussed later, is known as nationalincome accounts. It is useful to divide GNP into these four uses in order to not only understand the cause

of a recession or a boom, but also recommend a sound policy response to such economic activity. In

addition, the national income accounts provide information essential for studying why some countries are

rich (high level of GNP relative to population) while some are poor.

National Product and National Income

Over some time, a countrys GNP must equal its national income. Why?

The answer is that every dollar spent to buy goods or services automatically ends up as

someones income. However, if the good is produced with the help of many factors of production, only

the value of the finished product enters the GNP in order to avoid double counting. Same thing can be

said with the sale of used goods; it was counted in the GNP the first time it was sold, so its sale does not

enter the GNP the next time it is sold.

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Capital Depreciation and International Transfers

Earlier, we have defined GNP and national income as equals. This equality is actually an identity;

however, adjustments must be made so that this identity is entirely correct in practice. We will discuss

the two assumptions to get a better understanding of the previously mentioned identity.

First of all, we have to note that GNP does not take into account depreciation, the economic loss

due to the tendency of machinery and structures to wear out as they are used. This loss reduces the

income of capital owner, and should be subtracted from the GNP. GNP less depreciation is called net

national product (NNP).

Another noteworthy aspect is the unilateral transfers, an economic transaction between residents

of two nations over a stipulated period. Typically, these transactions consist of pension payments to

retired citizens living abroad, reparation payments, and foreign aid. Net unilateral transfers are part of a

countrys income but are not part of its product, and they must be added to NNP to compute the national

income.

In summary, national income equals GNP less depreciation plusnet unilateral transfers.

Gross Domestic Product

Instead of GNP, most countries use GDP in measuring the national economic activity. The gross

domestic product (GDP)measures the volume of production within a countrys borders, while GNP is GDPplusnet receipts of factor income from the rest of the world. Unlike GNP, GDP does not correct for the

portion of the countries production that used foreign-owned capital.

Although movements in GNP and GDP usually do not greatly differ, we will focus more on GNP

because it tracks national income more closely than GDP does, and national welfare depends more

directly on national income than on domestic product.

National Income Accounting for an Open Economy

Earlier, we mentioned national income accounts the fourfold classification of GNP (Y). This

classification includes consumption, investment, government purchases, and the current account balance.

Consumption (C)is the portion of GNP purchased by private households to fulfill current wants.

This portion is the largest component of GNP in most economies. Investment (I) is the part of output

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used by private firms to produce future output. It can also be viewed as a way to increase the nations

stock of capital. The everyday meaning of the word is different from its economic definition, so you

should be careful. For example, when you buy a share of Microsoft stock, you are buying neither a good

nor a service, so your purchase does not show up in GNP. Any goods and services purchased by federal,

state, or local governments are classified as government purchases (G). Government purchases includeinvestment as well as consumption purchases. On the other hand, transfer payments such as social

security and unemployment benefits are not included in G because the recipients do not give the

government any goods or services in return.

The National Income Identity for an Open Economy

Y = C + I + G (Equation 1)

Y = C + I + G + EX - IM (Equation 2)

Equation 2 is the national income identity for an open economy. The only difference of it from

Equation 1, which is the national identity for a closed economy, is that the second equation shows trade

among countries. It can be seen in this equation that the national income a country earns by selling its

goods and services is divided between sales to domestic residents and sales to foreign residents.

In an open economy, some residents may spend some of their income on imports (IM), the good

and services purchased from abroad. This means that this portion of their spending is not included in the

domestic GNP, and therefore should be subtracted from Y. Similarly, exports (EX) are added to the

national income of the domestic economy since they are the domestic goods and services sold to

foreigners.

The Current Account and Foreign Indebtedness

A countrys foreign trade is rarely balanced, and the difference between exports and imports is

called current account balance (or current account). In symbols, with current account denoted by CA, we

can define current account as

CA = EX IM (Equation 3)

A current account deficitoccurs when a countrys imports exceed its exports. Alternatively, when

a countrys exports exceed its imports, a current account surplus occurs. Changes in current account can

be associated with changes in output, and thus, employment. Current account is also notable since it

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measures the size and direction of international borrowing. When a country has a deficit, it has to finance

this difference through borrowing from foreigners; by extent, its net foreign debts will increase by the

amount of deficit. Correspondingly, a country with a current account surplus can finance the current

account deficit of its trading partners by lending to them. Through this, the foreign wealth of the surplus

country increases because borrowers issue IOUs that they will eventually have to redeem. This event iscalled an intertemporal trade; a country with current account deficit is importing present consumption

and exporting future consumption, and a country with a current account surplus is exporting present

consumption and importing future consumption. Therefore, we can say that a countrys current account

balance is equal to the change in its net foreign wealth.

Based on Equations 2 and 3, we can now say that the current account is also equal to the

difference between national income and domestic residents' spending:

Y ( C + I + G ) = CA (Equation 4)

Saving and the Current Account

National saving (S) is the portion of output (Y) that is not devoted to household consumption (C),

or government purchases (G). Symbolically, we can express it as

S = Y C G (Equation 5)

We can rewrite Equation 1 as I = Y

C

G, and with this in mind, we can say that S = I. Thismeans that in a closed economy, the national saving must equal investment. In an open economy,

national saving and investment can differ. Recall Equations 3 and 5. With these equations, we can rewrite

the GNP identity as S = I + CA.

This equation emphasizes the difference between an open and closed economy. An open

economy can save either by building up its capital stock or by acquiring foreign wealth, but a closed

economy can only do the former. The preceding equation also shows that it is possible to simultaneously

raise investment and foreign borrowing without changing saving through an intertemporal trade. Since

one country can borrow the savings of another to increase its stock of capital, the second countrys

current account surplus can then be referred to as its net foreign investment.

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Private and Government Saving

The portion of the disposable income that is saved rather than consumed is called private saving

(Sp). Disposable income is national income (Y) minus the net taxes collected by the government (T).

Therefore,

Sp= Y T C. (Equation 6)

Government spending (Sg)is very similar to private saving. The governments income is its net

taxes (T) and its consumption is government purchases (G). Therefore,

Sg= T G. (Equation 7)

The national saving consists of these two types of spending. To see why:

S = Y

C

G = (Y

T

C) + (T

G) = S

p

+ S

g

.

Since S = Sp + Sg= I + CA,

Sp = I + CA Sg = I + CA (T G) = I + CA + (G T). (Equation 8)

To interpret Equation 8, we define (G T) as government deficit or when the government's total

expenditures exceed the revenue that it generates. This equation shows that a countrys private saving

can take three forms: investment in domestic capital (I), purchases of wealth from foreigners (CA), and

purchases of the domestic governmentsnewly issued debt (GT).

The Balance of Payments

The current account has been defined as the difference between exports and imports. It is

important for a country to know the state of its current account since it covers the aspects of foreign

debt. The transactions that occur between countries have to be recorded in order for exports and imports

to be monitored. This is where the balance of payments account comes in.

When two countries engage in trade, the exchanges between them are listed down in the BOPAccount. It keeps a detailed record of the composition of the current account balance and of the many

transactions that finance it. A countrys exchanges are classified into debits and credits. A transaction that

results in a receipt from foreigners is entered into the accounts as a credit, while one that results in a

payment to foreigners is classified as a debit. There are three types of transactions that the balance of

payments recognizes:

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1. Transactions that arise from the export or import of goods or services and are therefore

entered directly into the current account. When a French consumer imports blue jeans, the

transaction is recorded in the US balance of payments as a credit on the current account.

2. Transactions that arise from the purchase or sale of financial assets. All international

purchases or sales of financial assets are entered in the financial accountof the balance ofpayments. When an American company buys a French factory for $1 billion, the transaction

enters the US balance of payments as a $1 billion debit in the financial account. It enters as

a debit because the transaction requires payment from the US to foreigners. The difference

between a countrys purchases and sales of foreign assets is called itsfinancial account

balance, or its net financial flows.

3. Other activities resulting in transfers of wealth between countries. These activities are

recorded in the capital accountand usually result in nonmarket activities and associated

nonproduced, nonfinancial, and possibly tangible assets. For example, if the US cannot pay

for the factory and recognizes it as debt, France can choose to forgive the $1 billion debt and

its recorded in Frances capital account as a debit.

Balance of payments accounting holds the same rule as double-entry bookkeeping: Every international

transaction automatically enters the balance of payments twice, once as a credit, and once as a debit.

Examples of Paired Transactions:

A U.S. citizen buys a $1000 typewriter from an Italian company, and the Italian company deposits

the $1000 in its account at Citibank in New York.

The U.S. trades assets for goods, and the transaction enters the US balance of payments in

the current account as a $1000 debit, and the US financial account as a $1000 credit.

A U.S. citizen pays $200 for dinner at a French restaurant in France by charging his Visa credit card.

The U.S. trades assets for services, and the transaction enters the US balance of payments in

the current account as a $200 debit, and the US financial account as a $200 credit.

A U.S. citizen buys a $95 newly issued share of stock in the United Kingdom oil giant British

Petroleum (BP) by using a check drawn on his stockbroker money market account. BP deposits the

$95 in its own U.S. bank account at Second Bank of Chicago.

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The U.S. trades assets for assets, and the transaction creates a $95 debit in the US financial

account and a $95 credit in the US financial account.

A U.S. bank forgives $5000 in debt owed to it by the government of Bygonia.

This transaction creates a $5000 debit in the US capital account and a $5000 credit in the USfinancial account.

THE FUNDAMENTAL BALANCE OF PAYMENTS IDENTITY:

Since all international transactions automatically give rise to two offsetting entries in the balance

of payments, the current account balance, the financial account balance, and the capital account balance

automatically add up to zero:

Current account + financial account + capital account = O

This relationship is because the sum of the current and capital accounts equals the total change

in a countrys net foreign assets and that sum equals the financial account (preceded by a minus sign),

which is the difference between a countrys foreign purchases and sales.

The Current Account, Once Again

The balance of payments accounts divide exports and imports into three categories: merchandise

trade(exports or imports of goods), services(payments for legal assistance, tourists expenditures, and

shipping fees), and income(international interest and dividend payments and the earnings of

domestically owned firms operating abroad).

The Capital Account

It records asset transfers and tends to be small for the United States.

The Financial Account

It measures the difference between sales of assets to foreigners and purchases of assets located

abroad. A transaction that enters the financial account can either be a financial inflow (capital inflow),

which is a loan from the foreigners with a promise that they will be repaid or a financial outflow (capital

outflow), a transaction involving the purchase of an asset from foreigners.

The Statistical Discrepancy

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More often than not, data associated with a given transaction may come from different sources

that differ in coverage, accuracy, and timing. This causes the balance of payments accounts to be

unbalanced, and the account keepers fix the problem by adding a statistical discrepancy to the accounts.

This discrepancy is difficult to allocate among the current, capital, and financial accounts.

Official Reserve Transactions

The central bankis the institution responsible for managing the supply of money. They hold

official international reserves, foreign that serve as cushions against national economic misfortune. These

reserves are bought or sold in private market assets to regulate macroeconomic conditions. These

transactions are called Official foreign exchange intervention.in their economies. The book-keeping offset

to the balance of official reserve transactions is called the Official settlements balance (balance of

payments). It is the sum of the current account balance, the capital account balance, the nonreserve

portion of the financial account balance, and the statistical discrepancy.

Vitug, Camille Joie C.

2012-62476

Luna, Patricia Marie D.

2012-58536