University of Warwick

International Economics (EC312)

Topic 1

National Income Accounting in Open Economy

The Balance of Payments

Lecturer: Natalie Chen

International Macroeconomics

² Unemployment: the problem of ensuring full employment in economies

open to international trade

² Saving: a country’s saving or borrowing behaviour a¤ects domestic em-

ployment and future levels of national wealth (savings are equal to invest-
ment in a closed economy, but can be di¤erent in an open economy)

² Trade Imbalances (the value of exports di¤ers from the value of imports):
they redistribute wealth among countries

² Money and the Price Level: the supply or demand for money a¤ect
both output and employment
National Income Accounting

It records all expenditures that contribute to a country’s income and output

² GNP: the value of all …nal goods and services produced by the factors of
production of a country in a given time period. It is calculated by adding
up the market value of all expenditures on …nal output (in what follows,
GNP is identi…ed with national income)

² GDP: the value of all …nal goods and services produced within a country’s
borders
Example: a Spanish …rm in the UK: Spain’s GNP but UK’s GDP

GNP = GDP + net receipts of factor income from the rest of the world

GNP = GDP + output of UK …rm in Spain – output of Spanish …rm in UK

Expenditure view: divides GNP among its four possible uses

1. Consumption C (the amount consumed by private domestic residents)

2. Investment I (the amount put aside by …rms to build new plants and
equipment)

3. Government purchases G (the amount used by the government)

4. Current account balance CA = X ¡ M (the amount of net exports of

goods and services to foreigners)
Figure 13.1 U.S. GNP and Its
Components

America’s gross national product for the first quarter of 2016 can be broken down
into the four components shown.
Source: U.S. Department of Commerce, Bureau of Economic Analysis. The figure
shows 2016:QI GNP and its components at an annual rate, seasonally adjusted.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
National Income Identities

² Closed economy
Y =C+I +G
so all output produced is consumed or invested (or added to inventories)
by the country’s citizens or purchased by its government

² Open economy
Y =C +I +G+X ¡M

– X is the value of goods and services exported (sold to the rest of the
world)

– M is the value of goods and services imported (purchased from the

rest of the world)
The Current Account

It represents the value of exports minus the value of imports

CA = X ¡ M

² If CA > 0 (X > M), current account surplus: the country lends to the
rest of the world (accumulates foreign credit)

² If CA < 0 (X < M), current account de…cit: the country is borrowing

from the rest of the world (accumulates foreign debt)
Figure 13.2 The U.S. Current Account and Net
International Investment Position, 1976–2015

A string of current account deficits starting in the early 1980s reduced America’s
net foreign wealth until, by the early 21st century, the country had accumulated a
substantial net foreign debt.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
National Saving and the Current Account

National saving S is the proportion of output that is not devoted to private C

or public consumption G: S = Y ¡ C ¡ G

² A closed economy can only build its capital stock by saving

Y =C +I +G)S =I
² An open economy can build its capital stock by saving or by acquiring
foreign wealth
Y = C + I + G + CA ) S = I + CA

1. In an open economy, it is possible to increase investment without increas-

ing savings
2. An open economy’s current account surplus is often referred to as net
foreign investment because a country’s savings can be borrowed by a
second country to increase its stock of capital
Three De…nitions of the Current Account

² Di¤erence between the value of exports and of imports CA = X ¡ M

² Borrowing (CA < 0) or lending (CA > 0) to the rest of the world

² Di¤erence between saving and investment CA = S ¡ I

Private and Government Saving

² Private saving (part of disposable income saved rather than consumed)

Sp = Y ¡ T ¡ C

² Government saving (T is net tax revenue)

Sg = T ¡ G

² National saving S p + S g

S = Sp + Sg = Y ¡ T ¡ C + T ¡ G
= Y ¡C ¡G
= I + CA
It can be shown that
S p = I + CA + (G ¡ T )
S p = I + CA ¡ S g
A Case Study

In the early 1980s, the US decreased taxes and raised government expenditures,
generating both a big government AND current account de…cits, i.e. “twin
de…cits”

Rewrite

S p = I + CA + (G ¡ T )
CA = S p ¡ I ¡ (G ¡ T )

With I and S p remaining more or less constant, the increase in G and decrease
in T were associated with the increased de…cit in the current account CA

Note that this is an identity. No relation of causality can be determined from

a theoretical viewpoint
Balance of Payments Accounting

It records all transactions between a country and the rest of the world during a
time period (payment to foreigners in debit of the BP (< 0) and receipt from
foreigners in credit (> 0))

Three types of transactions are recorded

1. Transactions that involve goods and services (e.g., jeans exported from
the UK to France: credit in UK BP): current account CA

2. Transactions that involve …nancial assets (any form in which wealth can
be held, e.g., money, factories): …nancial account F A

3. Transfers of wealth between countries (non-market activities, e.g., copy-

rights): capital account KA
Every transaction enters the balance of payments twice, once as a credit and
once as a debit

Note: In an older classi…cation, there were only the current and capital ac-
counts

New classi…cation Old classi…cation

CA+KA CA
FA KA
The Fundamental Balance of Payments Identity

Given that any transaction gives rise to two di¤erent o¤setting entries in the
balance of payments, it must be that

CA + F A + KA = 0

1. You buy a car abroad paying £10,000. Your payment enters the current
account in debit with a negative sign. Then the car company deposits your
check in a bank, so purchases a UK asset (a “promise” to be paid), and
the transaction shows up as £10,000 credit in the UK …nancial account
CA ¡$10, 000
F A $10, 000

2. You buy a factory abroad for £50,000. This is not a good nor a service,
but a …nancial asset: the transaction is recorded in the …nancial account
F A $50, 000
F A ¡$50, 000
The Financial Account

The …nancial account measures the di¤erence between sales of assets to for-
eigners and purchases of assets bought abroad

² Nonreserve …nancial account: “private” transactions (non-Central Banks)

² O¢cial reserve transactions (Central Bank transactions)

O¢cial international reserves are held by Central Banks to a¤ect macroeco-

nomic conditions (“o¢cial foreign exchange intervention”) through the injec-
tion or withdrawal of money in circulation
 Balance of Payments for the US in 2000 (bn)
Credits Debits
Current account CA -435.4
Capital account KA +0.7
Nonreserve …nancial account NRF A +399.1
Sum -35.6
O¢cial reserve transactions
Foreign o¢cial reserve assets +35.9
US o¢cial reserve assets -0.3
Sum +35.6

² Foreign o¢cial reserves increased by $35.9 bn (foreign Central Banks in-

creased their reserves, “export”)
² US o¢cial reserves (international reserves held by the Central Bank) rose
by $0.3 bn (“import”)
² Variation in o¢cial reserves is $35.6 bn, and covers the US current de…cit
BP ¡ ¢reserves = CA + KA + NRF A = ¡¢reserves
Money Supply in an Open Economy

The banking system consists of the Central Bank and of Commercial Banks
Central Bank’s balance sheet
Assets Liabilities
FX MB
LG

where F X are Gold and Foreign currency reserves, LG is Lending to the

government and MB is currency issued (“monetary base”)
Commercial Banks’ balance sheet
Assets Liabilities
MB b D
L

where MB b is Currency plus deposits with the Central Bank, L are Loans to
personal and corporate sector, and D are the Deposits by the public
Consolidated Banking Sector
F X + LG ´ MB
MB b + L ´ D
) F X + M B b + (LG + L) ´ MB + D

² LG + L is the total consolidated banking sector’s lending, i.e., domestic

credit DC

² MB ¡ MB b is total monetary base net of that part which is in the co¤ers

of the banks themselves, i.e., MB p (currency in circulation)

² MB p + D is total currency in circulation plus deposits in the banks, i.e.,

money stock M s
F X + DC ´ M s
Money supply is the sum of domestic credit and the value of the country’s
reserves of gold and foreign currency held by the Central Bank