INTERNATIONAL FINANCE

ECON 171, Ch.13 1

Ch.13 National Income and Balance of Payments

I. The National Income Accounts

1. What is national income account?

• Measures national income that results from production and expenditure.

• The amount of expenditure by buyers

= the amount of income for sellers

= the value of production

• Thus, at the national level, income = output.

ECON 171, Ch.13 2

2. Measures of national income: GNP vs. GDP

• Gross National Product (GNP): the value of all final goods and services produced by a

nation’s factors of production (such as workers, physical capital, natural resources, etc.)

in a given time period

• Can we say “National income is the income earned by a nation’s factors of production”?

• Another widely used economic statistic GDP (Gross Domestic Product) measures the

final value of all goods and services produced within a country in a given time period.

• GNP excludes economic activity that occurs in the U.S. but is owned by foreigners and

includes American economic activity that occurs in other countries.

ECON 171, Ch.13 3

3. Compositions of GNP

• Since GNP measures national income which is equal to aggregate expenditure on final

goods and services,

Y = C + I + G + (EX – IM)

where Y = GNP

C = consumption

G = government purchases

EX = exports

IM = imports

(EX – IM) = current account balance (CA) or net exports

ECON 171, Ch.13 4

Fig.1: U.S. GNP and its Components

ECON 171, Ch.13 5

• To precisely measure national income using GNP, we would need to make the

following adjustments:

National Income = GNP – Depreciation + Net Unilateral Transfers

4. National Income Identity for an Open Economy

• In an open economy,

Y = C + I + G + CA

where C + I + G measures “expenditure by domestic individuals and institutions” and

CA (= EX – IM) measures “net expenditure by foreign individuals and institutions”

ECON 171, Ch.13 6

• Rearranging the above identity gives

CA = (EX – IM) = Y – (C + I + G)

Interpretation: When production > domestic expenditure, exports > imports

→ Net foreign wealth is increasing!

Example 1: An open economy producing wheat (100 bushels) only

ECON 171, Ch.13 7

• Saving and the Current Account

National saving (S) is defined as the portion of national income (Y) that is not spent on

consumption (C) or government spending (G):

S = Y – C – G

Note that S = I in a closed economy. In an open economy, S = I + CA. (Why?)

In other words, an open economy can save by building up its capital stock or by

acquiring foreign wealth.

Private saving (Sp) is defined as the part of disposable income (Y – T) that is not

consumed:

Sp = Y – T – C

ECON 171, Ch.13 8

Government saving (Sg) is net tax revenue (T) minus government spending (G):

Sg = T – G

Thus, national saving S = Y – C – G = (Y – T – C) + (T – G) = Sp + Sg

• Because S = Sp + Sg = I + CA,

Sp = I + CA + (G – T)

Interpretation: Private saving can be used to finance i) domestic capital investment (I),

ii) purchases of wealth from foreigners (CA), and iii) government budget deficit (G –

T).

ECON 171, Ch.13 9

II. Balance of Payments (BoP) Accounts

5. What is BoP?

• Records a country’s payments to and its receipts from foreigners

• Any transaction resulting in a receipt from foreigners is entered as a credit (+) and in a

payment to foreigners is entered as a debit (–) in BoP.

• BoP accounts are separated into:

i) Current Account: exports or imports of goods and services

(plus, income receipts such as interest and dividend payments, earnings of firms and

workers operating abroad, and net unilateral transfers)

ECON 171, Ch.13 10

ii) Financial Account: international purchases or sales of financial assets (e.g., stocks),

including official international reserves which are foreign assets held by the central

bank in the form of government bonds, currency, gold, and accounts at the IMF

Note: Official reserve assets sold to foreign central banks are a credit because the

Federal Reserve can spend more money to cushion against instability.

iii) Capital Account: special transfers of assets, typically non-market activities

(e.g., debt forgiveness) or acquisition or disposal of non-produced and intangible assets such as copyrights and trademarks

ECON 171, Ch.13 11

• Double-entry bookkeeping:

Every international transaction automatically enters the BoP twice, once as a credit and

once as a debit.

Example 2

• You import a fax machine from Italian company Olivetti. Olivetti deposits your check in a U.S. bank.

Credit Debit Fax machine purchase (current account, U.S. good import) $1,000 Sale of U.S. bank deposit (financial account, U.S. asset sale) $1,000

ECON 171, Ch.13 12

• You buy lunch in France and pay $200 by credit card. French restaurant receives

payment from your credit card company.

Credit Debit Meal purchase ( ) ( ) Sale of credit card claim ( ) ( )

• You buy a share of British Petroleum (BP) stock at $90. BP deposits the money in a

U.S. bank.

Credit Debit BP stock purchase ( ) ( ) BP’s deposit ( ) ( )

ECON 171, Ch.13 13

• You receive $100 in interest from German bonds you own. The $100 is deposited in a

German bank.

Credit Debit Interest income ( ) ( ) Purchase of German deposit ( ) ( )

• U.S. banks forgive a $5 million debt owed by the government of Argentina. U.S. banks who hold the debt thereby reduce the debt by crediting Argentina’s bank accounts.

Credit Debit Debt forgiveness ( ) ( ) Reduction in banks’ claims ( ) ( )

ECON 171, Ch.13 14

• Fundamental balance of payments identity:

Current Account + capital account = Financial Account

ECON 171, Ch.13 15

Table 1: U.S. BoP Account for 2012 (billions of dollars)

ECON 171, Ch.13 16

• The U.S. has the most negative net foreign wealth in the world, and so is the world’s

largest debtor nation. Its foreign debt continues to grow because its current account continues to be negative.

Fig. 2: U.S. Gross Foreign Assets and Liabilities, 1976-2012