Ch. 10: National and International Accounts: Income, Wealth and the Balance of Payments

Based on Feenstra and Taylor, Chapter 16 (KOM chapter 13). There are no lecture slides for this topic on the site yet; check against the lecture when it is given.

Exchange rates, interest rates and prices so far were treated without reference to the rest of the economy. This chapter supplies the accounting framework for the open macroeconomy: how a country's income, spending, saving and investment are measured, how its transactions with the rest of the world are recorded in the balance of payments, and how these flows change the country's stock of external wealth. Accounting identities hold by definition, so they do not explain behavior, but they discipline every model in the rest of the course and they are a favorite source of multiple-choice questions.

1. Measuring macroeconomic activity: the flow of payments

FT trace the flow of payments around an open economy in steps. Think of a circle: spending creates production, production creates income, income is spent.

Step 1: Gross national expenditure (GNE)

Total spending by residents on final goods and services, whether produced at home or abroad:

Step 2: Gross domestic product (GDP)

GDP is the value of all final goods and services produced within the borders of the country (value added by domestic factors of production). Part of GNE is spent on imports (IM), which are produced abroad, and part of domestic production is bought by foreigners as exports (EX). So:

Step 3: Gross national income (GNI)

GDP is paid out as income to the factors of production. But some domestic factors are owned by foreigners (a foreign-owned factory, foreign holders of domestic bonds), and some residents own factors abroad. Net factor income from abroad (NFIA) is factor income received from abroad minus factor income paid to foreigners. It includes investment income (interest, dividends, profits, rent) and compensation of employees (wages of cross-border workers).

Step 4: Gross national disposable income (GNDI)

Residents also receive and make unilateral transfers: gifts that are not payment for goods, services or factor services. Examples: foreign aid, remittances of migrants to their families at home, private charity, nonmilitary grants. Net unilateral transfers (NUT) = transfers received minus transfers given.

The current account

The sum of the three international terms is the current account:

Worked numerical example

A country has C = 600, I = 200, G = 150, EX = 250, IM = 300, factor income received from abroad 40, factor income paid abroad 70, unilateral transfers received 20 and given 10.

• GNE = 600 + 200 + 150 = 950.
• TB = 250 minus 300 = minus 50, so GDP = 950 minus 50 = 900.
• NFIA = 40 minus 70 = minus 30, so GNI = 900 minus 30 = 870.
• NUT = 20 minus 10 = +10, so GNDI = Y = 880.
• CA = minus 50 minus 30 + 10 = minus 70. Check: Y minus GNE = 880 minus 950 = minus 70.

What is excluded

National accounts count only final goods and services and current production. Not counted in GDP: intermediate goods (to avoid double counting), purchases of existing assets such as used houses or shares (asset trades do not create new output), and transfers. Depreciation of capital is ignored by FT (GDP rather than net domestic product). Asset trades with foreigners do appear, but in the financial account of the balance of payments, not the current account.

Application: GDP versus GNI (Ireland, and the poorest countries)

For most countries GDP and GNI are close, but not always. FT's application "Celtic Tiger or Tortoise?": Ireland attracted massive foreign direct investment by multinationals (low corporate tax). Much of the output produced in Ireland generates profits that flow to foreign owners, so NFIA is strongly negative and Irish GNI is well below GDP (in the 2000s by around 15 to 20%; since 2015 the gap is even larger). Ireland's GDP growth therefore overstates the growth of income available to Irish residents. The opposite case: countries whose residents own large assets abroad or receive large remittances have GNI or GNDI above GDP. FT also show that for many poor countries, foreign aid and remittances (NUT) are large relative to GDP (for example in Lesotho, Tajikistan or Haiti remittances are a large share of GNI), and for heavily indebted countries interest payments make NFIA negative.

2. Saving, investment and the current account

National saving S is income not spent on consumption by households or the government:

In a closed economy S = I. An open economy can break this link: it can invest more than it saves (by borrowing abroad) or save more than it invests (by lending abroad). This is the essence of financial globalization.

Private and government saving: the twin deficits

Split national saving into private and public parts. Let T be taxes net of transfers. Private saving S_p = Y minus T minus C; government saving S_g = T minus G (the government budget surplus).

In practice the link is not one for one. FT's application on the US shows that the US budget deficits of the 1980s ("Reagan twin deficits") and of the 2000s coincided with growing current account deficits, but in the late 1990s the US current account deficit widened while the budget moved to surplus, because investment boomed (the dot-com era) and private saving fell. Changes in private saving (Ricardian equivalence: households may save more when the government borrows) and investment can offset or amplify budget changes. The identity holds always; the twin-deficit hypothesis is a behavioral claim about S_p and I staying constant.

Global imbalances

FT's application on global imbalances: since the late 1990s the United States has run large current account deficits (about 6% of GDP at the peak in 2006), financed by surpluses in China and other emerging Asian economies, oil exporters, Japan and Germany. Explanations include the "saving glut" in emerging markets (high saving, low investment after the Asian crisis, reserve accumulation by central banks) and low US saving. In the identity CA = S minus I: US saving fell while investment did not; China's saving rose even faster than its very high investment.

3. The balance of payments

The current account records flows of goods, services, income and transfers. Every one of these transactions has a counterpart: something is paid for. The balance of payments (BOP) records all transactions between residents and the rest of the world, using double-entry bookkeeping: every transaction is entered twice, once as a credit (+) and once as a debit (minus).

The three accounts

• Current account (CA): exports and imports of goods and services (TB), factor income (NFIA) and unilateral transfers (NUT).
• Financial account (FA): trade in financial assets (bonds, shares, bank deposits, real estate, direct investment, central bank reserves). FA = EX_A minus IM_A: exports of assets (sales of home assets to foreigners, capital inflows) minus imports of assets (purchases of foreign assets by residents, capital outflows).
• Capital account (KA): capital transfers and transactions in nonproduced, nonfinancial assets. Examples: debt forgiveness, migrants' transfers of assets when they move, sale of rights to natural resources, patents and copyrights when sold outright, embassy land. Usually small: KA = KA_IN minus KA_OUT.

Warning on signs. The IMF's current manual (BPM6) and some newer textbook editions define the financial account as net acquisition of foreign assets minus net incurrence of liabilities, the opposite sign of FT. With that convention the identity reads CA + KA = FA. Always check which convention a question uses; this chapter follows FT.

Official reserve transactions by the central bank are part of the financial account. Some presentations separate them: the official settlements balance (balance of payments in the narrow sense) is the change in reserves. If a central bank sells foreign reserves to support its currency, this is a sale of foreign assets, a credit in the FA. In practice the BOP does not add up exactly to zero, so statisticians add a statistical discrepancy (errors and omissions).

Double-entry examples (FT style)

Each row sums to zero, which is why the whole BOP sums to zero. Note that a pure asset swap (row 2) changes only the FA.

The BOP and saving

Combining CA = S minus I with the BOP identity gives S = I + CA = I minus FA minus KA. A country can finance investment with domestic saving, or by net exports of assets (borrowing abroad). In the US BOP table FT discuss, a CA deficit of hundreds of billions of dollars a year is matched by large financial inflows: foreign purchases of US Treasury bonds, shares and direct investment exceed US purchases of foreign assets.

4. External wealth

The balance of payments records flows. The stock counterpart is external wealth (the net international investment position, NIIP):

Changes in external wealth

External wealth changes for two reasons: financial flows (buying and selling assets) and valuation effects (capital gains and losses on existing assets and liabilities).

Without valuation effects and with a negligible KA, a current account deficit reduces external wealth one for one: a CA deficit means the country is borrowing or selling off assets, so its external wealth falls. Cumulated over time, external wealth is the sum of past current accounts plus capital gains.

Valuation effects through the exchange rate

Exchange rate changes create capital gains or losses when assets and liabilities are in different currencies. The US is special: most US external liabilities are denominated in dollars (Treasury bonds, dollar deposits), while a large share of US external assets are in foreign currencies (foreign shares, direct investment abroad). When the dollar depreciates, the dollar value of US foreign assets rises while the value of liabilities is unchanged: a dollar depreciation raises US external wealth. Many emerging markets are in the opposite position: their liabilities are in dollars (the "original sin" of being unable to borrow in their own currency), so a depreciation of their currency raises the home-currency value of their debt and lowers external wealth.

Example: the US holds foreign assets worth €1,000 billion and has dollar liabilities of $2,000 billion. E $/€ rises from 1.00 to 1.10 (dollar depreciation). Assets rise from $1,000 billion to $1,100 billion; liabilities stay $2,000 billion. W rises from minus $1,000 billion to minus $900 billion: a valuation gain of $100 billion.

Application: the US as the world's largest debtor and "exorbitant privilege"

The US has run current account deficits almost every year since the early 1980s and changed from a net creditor to the world's largest net debtor in the late 1980s. Its NIIP is large and negative (in recent years well over 10 trillion dollars). Yet two features slowed this decline. First, valuation effects were often favorable (dollar depreciation, strong returns on US equity and FDI abroad), so W fell by less than the sum of current account deficits in many years. Second, despite being a net debtor, the US for a long time earned positive net factor income (NFIA > 0): it earns higher returns on its assets (risky equity and FDI) than it pays on its liabilities (safe Treasury bonds at low interest). French finance minister Valéry Giscard d'Estaing called this the US "exorbitant privilege", and the combination of a positive return differential and valuation gains is sometimes called "dark matter". During the 2008 crisis, the US also received a temporary "exorbitant duty": as investors fled to safety, the dollar appreciated and foreign assets fell in value, so US external wealth dropped sharply.

FT also show that some emerging and developing countries face the opposite situation: they pay high interest on their debts, so NFIA is negative and their wealth position worsens even without trade deficits, and they suffer valuation losses when their currency depreciates.

Gross versus net

Gross external assets and liabilities have grown far faster than net positions since the 1990s (financial globalization). Many advanced countries have gross assets and liabilities of several times GDP while the net position is moderate. Large gross positions make valuation effects potentially much bigger than current account flows.