2 Open-economy Macroeconomic Accounting 2.1. The Balance of Payments Accounts 2.2 Sub-accounts in the Balance of Payments 23 Basic BOP Facts for the United States 24. The NIPA in an Open Economy: Aggregate Identities 2.5 Sectoral Identities 2.6 Summary In order to analyze the macroeconomics of open economies, you will need to become familiar with a wide variety of concepts used by international macroeconomists. The next two chapters are intended to help you do so. This chapter defines some of these concepts and explores the identities (definitional relationships) that link them to each other. By classify ing international transactions into different types and showing how they are linked to each other, these identities provide a foundation for clarifying and disciplining our thinking about international macroeconomic issues. In Chapter 4 we will begin to explore the economic motivations that underlie each of these types of wransactions. Together, therefore, these two ‘chapters provide fundamental building blocks for the general analytical framework that we will construct in Chapter 4. ‘Our point of departure in this chaprer is a country’s balance of payments (BOP) accounts, Recall from the last chapter that macroeconomic openness involves trade between domestic and foreign residents in goods and services as well as in financial assets. “The balance of payments accounts are the record of all such trades. In this chapter we will explore the balance of payments accounts and examine how they are linked with the national income and product accounts. While the basic purpose of doing this is to acquaint you with some fundamental concepts in international macroeconomics, it tums out that we can actually extract some very useful and very powerful economics from the basic relationships that we will be examining in this chapter. Iti hard to resist the urge to take advantage of this ‘opportunity, so we will indeed pause to explore some of these economic applications as we 0 along,18 Foundations 2.1 The Balance of Payments Accounts ‘The term “balance of payments (BOP) accounts" refers to the system of accounts kept by each country that tracks payments to and receipts from nonresidents by residents of the country. The entries in the balance of payments accounts, like those in the national income and product accounts, represent economic flows (which are quantities measured in units of currency or goods per init af tine), rather than stacks (which ain qvantities magsuted at fixed points in time). In this section we will go over the basic rules that govern how these flows are recorded in the balance of payments accounts and will identify the different types, of transactions that are tracked in these aecounts. Rules of Balance of Payments Accounting Since the balance of payments accounts Keep track of economic transactions between residents of the domestic economy and those of other economies, we need to first define who is considered a resident and who is not. Residents are economic agents (such as thouseholds, firms, or governments) who sormally reside in a country, even if they are temporarily abroad, such as tourists, diplomats, military personnel, migrant workers, or students. In the balance of payments accounts of the United States, for example, the term “resident’” does not include branches or subsidiaries of US companies that happen to be located in foreign countries (subsidiaries ace legally incorporated there, branches are not). ‘These are assumed to be residents of the foreign country, because they normally conduct their business (and therefore “reside” there, regardless of their legal status. Under this definition of residence, international transactions are transactions between residents and nonresidents. ‘The balance of payments accounts that track these transactions obey the basic rule of double-entry bookkeeping: because every transaction involves an exchange of equal values, every international iasaction gives rise toro entries In the BOP accounts, one recording, the value of what is received by the domeste resident, as well as one recording the value of what the domestic resident gives up. One exception to the “exchange of equal values" principle might immediately occur to you: gifts exchanged between residents and nonresi- dents. But even in this case, to maintain the double-entty principle, itis assured dat dhe transaction actually involves an exchange — what is exchanged for the item given away is ‘conventionally assumed to consist of “goocwill” that is equal in monetary value to the gif. Under this convention, there are no exceptions fo the rule that every transaction involves an exchange of equal values. "The basic rule for recording internationa: transactions is that any transaction resulting in the receipt of something of value from foreigners (thus creating an obligation to foreigners, ‘of an “account payable” to foreigners by domestic residents) is classified as a debit, and is entered with a negative sign, while any transaction resulting in a transfer of something. of value fo foreigners (creating an “‘acccunt receivable” from foreigners by domestic residents) is classified as a eredit, and is entered with a positive sign. Notice that, because every transaction in the balance of payments accounts thus generates a debit as well as a credit that exactly offsets it in value, the sum of all transactions recorded in the BOP accounts must be equal to zeroOpen-esonomy Macroeconomic Accounting 19 ‘Table 2.1 US international transactions, 2007 Sbn Exports of goods 1149 Imports of goods 1965 Exports of services, 479 Imports of services, -372 Tianae soups 7782 Income payments 708 Unilateral curseat transfers, net = 104 US Government grants =33 US Government pensions and other transfers 7 Private remittances and other transfers 65 Unilateral capital transfers, net -2 US-owned assets abroad, net (increase/financial outflow (—)) 1206 US official reserve assets, net =1 US Government assets, other than official reserve assets, net 23 US private assets, net 1183 Foreign-owned assets inthe United States, net (inerease/financial inflow (+ )) 1868 Foreign official asets in the United States, net 413 ‘Other foreign assets in the United States, net 1451 Statistical discrepancy (sum of above items with sign reversed) 84 Source: US Department of Commerce ‘Types of Transactions ‘Table 2.1 summarizes the external transactions af the United States for the year 2007. You can see that transactions in the accounts are classified into several (six) types: 2 Exports and imports of goods. Sates of goods to foreigners, reterted {0 as exports oF ‘g0ods, transfer something of value to foreigners, so they give rise to credit entries, while purchases of goods from foreigners (imports of goods) involve the receipt of value by domestic residents, so they are recorded as debits. Note that what is recorded here is the actual transfer of the good, whether from domestic (o foreign residents (exports) or vice versa (imports). The payment for the good is typically entered somewhere else in the accounts. In 2007, the United States exported $1149 billion worth of goods to the rest of the world, but imported much more, $1965 billion, b_ Exports and imports of services. Services that are traded between domestic and foreign residents include tourism, transportation (both passenger and freight) royalties and licenses, and insurance and financial services. The same accounting principle applies as for ‘goods in classifying entries as debits or credits. You can see from Table 2.1 that, in contrast ‘with goods, the United States was a net exporter of services to the rest of the world. Receipts and payments of investment income (interest and profits). Investment income is the compensation that the owner of capital receives for the use by someone else of the services of that capital. These are recarded as ‘‘income receipts"” and “‘income payments” in Table 2.1. An entitlement to the receipt of investment income, in the form of profits or interest, is entered as a credit, because it arises as the result of the transfer to20 Foundations foreigners of the services of capital that is owned by domestic residents, while the obligation to make a payment for investment income is entered as a debit (because domestic residents are using capital services that are produced by foreign-owned capital). Again, i is important to remember that what is entered here isthe value of the services provided (which gives rise to the entitlement to receive payment or the obligation to make payment), not the form in ‘whitch those services are paid for." d_ Unilateral transfers. As mentioneé above, a gift from a domestic resident to a foreign resident is considered an import of something of value (goodwill), so transfers, (gitis) given to foreigners are entered as debits, while transfers received are credits. Thus, this item records the transfer of goodwill, not of the commodity that generates that goodwill. In Table 2.1, unilateral transfers are reported on a net basis (credits minus debits), As you can see, in 2007 the United States provided more transfers than it received in that year. Thus, according to the ROP accounts, at any rate, he conntry was a net importer of goodwill from the rest of the world!” € Purchases and sales of physical or finaneial assets. Sales of physical assets or financial claims by domestic residents to foreign residents, whether those financial claims are themselves on domestic o” on foreign residents, involve giving up something of value and are therefore entered as credits. Corespondingly, purchases of physical assets or financial claims by domestic residents from foreign residents are debits. In the BOP accounts, domestic and foreign residents cre classified into central banks, governments, and private agents. Financial assets held by central banks are called “official assets."* These are treated in the same way as the corresponding asset transactions by other agents (private and government), but are simply tracked separately, for reasons to be explained later in this chapter. Thus, the acquisition of financial c aims by the domestic central bank on residents, of the rest of the world is entered as a debit, while the sale of such claims by the domestic, central bank is entered as a credit. Similarly, the acquisition of a claim on a domestic resident by a foreign central bank is a creditin the domestic balance of payments, while the sale of such a claim is a debit, Statistical discrepancy. Since every transaction recorded in the balance of payments accounts gives rise to equal and offsetting credit and debit entries, the sum of all of the transactions recorded in the accounts should in principle be zero, as we noted previously, However, because the data in the accounts are collected from different sources, measure- ment errors (including unrecorded transactions) and timing problems prevent this from literally bemg true in the recorded data, ‘The “statistical discrepancy’” (also called "errors and omissions”) line in Table 2.1 captures the net effects of these errors, so that the sum of all entries will indeed add to zero when this line is included It is worth pausing for a moment fo define some terms that are frequently used in discussing the financial transactions in the BOP accounts. Sales of financial claims (assets) to foreign residents by domestic residents are called capital inflows, and as mentioned ‘The United States received move payments forthe services of capital in 2007 than it pid to the rest ofthe ‘world. This is something ofa puzzi, Becauso the United States ik etally borrowed more from the ret of ‘the world thanithas loaned fo the rest of the world, 35 we wil se latrin this chapter. We will consider then how this can be reconciled with the dat in Table 2. * Foran extended discussion of the role of unilateral transfers in dhe balance of payments of the United States and other counties, see Fieleke (1996)Open-economy Macroeconomic Accowmting 24 above, these are entered with a positive sign, since something of value (the claim) has been exported. Similarly, purchases of financial assets by domestic residents from foreign residents are called eapital outflows and are ertered with a negative sign, since something of value has been imported. A special term is often used for capital inflows that take the form of the sale by a domestic resident of a financial claim on a foreign resident to either the same or another foreign resident. This type of transaction is refered to as capital repatriation, since it entails returning resources to the domestic economy that were at some point in the past made available to the foreign economy. ‘As discussed in Chapter 1, globalization has involved increased trade not just in goods ‘and services, but also in financial assets. An important dimension of such trade is the scale of capital inflows to developing countries. “hese capital inflows represent additional resources that these countries can use to mest in msereasing their productive capacities or to consume more than they could do. based just on their own resources. But fluctuations in such capital inflows have been large, and have at times been associated with episodes of severe macroeconomic instability in such countries, as we will see at various times in this, book. Figure 2.1 shows both the increasing scale of these inflows in recent years, as well as their volatility. Note in particular the drop-off in capital inflows dung the early 1980s and late 1990s, We will come back to these episodes at various places in this book. International financial transactions come in a variety of forms. A fundamental distinction is between financial claims that take the form o” equity and those that take the form of debi. Debt claims contractually stipulate specific payments that debtors have to make to their creditors, and they do not convey ownership rights that entitle the creditor to an equal say ‘over the affairs ofa firm as its shareholders, Debt claims can take the form of bonds, which 800 500 ; cman ll oananuall SESELILIPEP IRIEL LIS 1 Total (bitons of USS) ire 2.1. Developing countries: total capital inflows Source: World Bank, World Development Indicators22 Foundations are marketable securities, or loans, which are typically not marketable and are usually provided by banks. Equity claims, by contrast, are ownership shares. They entitle the buyer ‘of the claim (o @ voice in appointing the firm’s board of directors (which in turn appoints the firm's management) and of a share tothe fitm’s profits after the servicing of debt. Since debt holders get paid from a firm’s revenues before equity holders do, the latter are often described as having a “residual claim” on the firm’s income. In the balance of payments accounts, daia sources such as the International Monetary Fund (IMF) and World Bank typically classily financial transactions into three types: 1 When purchases of equity by foreigners transfer direct control over an enterprise to the buyers ofthat equity, this type of capital flow is referred to as foreign direct investment (FD into the country where the enterprise is located, Sales of equity to foreign residents by enterprises already controlled by foreign residents are also FDI. What “control” means is afuzzy concept. Conventionally, purchases of equity associated with ownership of at least 10 percent of the market capitalization (value) ofa firm are treated as FDI. 2. The purchase or sale of marketable financial assets across countries is called a portfolio flow. Purchases and sales of equity that do not entail control of domestic firms by foreigners or of foreign firms by domestic residents are referred to as portfolio equity flows, while international purchases and sales of bonds are called portfolio bond flows. ‘The sale of equity (stocks) and bonds by domestic to foreign residents constitutes @ portfolio capital inflow, while the purchase of such assets by domestic from foreign residents represents a portfolio capital outflow 3. The final type of financial transaction is lending. As indicated above, this consists of nonmarketable loans, typically extended by banks, but also by other lenders such as governments and intemationai financial institutions In addition to this three-way classification, financial transactions ate also occasionally classified by the maturity of the financial instrument that is traced.’ When financial claims (bonds or loans) have an original maturity ofless than a year, they are considered short term, and trading in such claims is referred to as short-term capital flows. When claims have ‘original maturities of more than a year, or when they have no specified maturity (for example, FDI or portfolio equity claims), they are dubbed long-term capital flows, 2.2 Sub-accounts in the Balance of Payments ‘The balance of payments accounts are organized into several sub-accounts, which include selected categories of transactions. Notice that, unlike the overall balance, the balance in these sub-accounts need not be zero: since they only contain a subset ofall transactions, the balancing transaction may lie outside the included subset. For example, suppose that a US resident imports a foreign good and pays for it by writing a check to the foreign exporter. ‘The import ofthe good gives rise to a debit in the US balance of payments, but the transfer of the ownership of a claim on the US importer’s bank from @ domestic to a forcign resident szives rise to an exactly offsetting credit. However, if these two sides of the transaction are 2A Financial instrument is jst a promise to make payments inthe fur. The maturity ofthe instrument is he length of time during which those payments are to he ade.Open-economyy Macroeconomic Accounting recorded in different sub-accounts, then there is no reason for the entries in the sub-account to sum fo zero, even though in total all the entries in the balance of payments will do so. ‘AS we shall See, itis these sub-accounts of the overall balance of payments accounts that actually have important economic implications. As you will see below, an important distinetion among the sub-accounts is between those that contain only current transactions (transactions in currently produced goods and services, factor income, and transfers) and those that contain only financial transactions ‘transactions in existing physical assets or financial claims). Definitions "Table 2.2 lists the varions sub-accounts of the Falance of payments for the United States in 2007. They consist of the following: a The balance on merchandise trade. This is the narrowest of the sub-accounts that contain only current transactions. It consists of exports of goods minus imports of goods. ‘This account recorded a deficit (an excess of debits over credits) of $816 billion in the United States in 2007, However, economists don’t usually draw strong distinctions between trade in goods and in services, which makes this very narrow sub-account of limited practical relevance. b The balance on goods and services. This is a more inclusive concept that consists of the balance on merchandise trade plus net service exports (exports of services minus imports ‘Table 2.2 Sub-accounts ofthe US balance of payrvents, 2007 Sin ‘Gurrent account (CA) “79 Balance on goods, services, and investment income 635 Balance on goods and services (N) 109 Balance on merchandise trade 816 Exports of goods 1149) Imports of goods 1965 Balance on services 107 Exports of services a Imports of services -172 [Net investment income (NIV) 4 Income receipts 782 Income payments = 108 ‘Unilateral ransfes, net (NUT) 104 ‘Capital and financial account 656 Capital account -2 [Nonressive financial account (FA) 245 Othiial reserves settlements balance (OWS) 43 US official reserve assets, net 0 Foreign official asses in the United States, net 43 Statistical diseropaney24 Foundations of services). As we will see, this is more meaningful concept. In fact, since we will actually Use it in building our open-economy macroeconomic models, this is a good time to begin to introduce some notation. Since itis the difference between exports and imports of goods and services, we will often refer to the balance or goods and services in this book as net exports. Let X denote the dollar value of exports of goods and services, and [M the corresponding dollar value of imports. Then the dollar value of the balance on goods and services, which ‘we will call W (for net exports), is given by: N=X-M In 2007 exports of goods and services from the United States amounted to $1628 billion, while imports of goods and services were $2337 billion, so the balance of goods and services recorded a deficit of $709 billion. This is not unusual. While the United States has not always run deficits in the balance on goods and services, it has tended to do so for many ‘years, This sub-account receives substantial attention in the press, where positive values of ‘or increases in N are considered to be good economic news, while negative values or decreases are treated as cause for concem.* © The balance on goods, services, and investment income. Adding net investment income (the difference between income receipts and income payments in Table 2.2, which wwe can denote NINV) to N yields the balance on good, services, and investment income. The current account, This is the most inclusive ~ and most important ~ of the BOP sub-accounts relating to current transactions (hence the name). It consists of the balance fon goods, services, and investment income plus net unrequited transfers (NUT). Using the symbol CA to denote its US dollar value, the current account is defined as: cA +NINV + NUT As you can see from Table 2.2, in 2007 the United States recorded a current account deficit of $739 billion, dominated by a large deficit in the balance on goods and services. We will explore the economic significance of the current account later in this chapter. ‘There are also a variety of sub-accounts on the asset (capital) side of the BOP ledger. This side of the BOP accounts is referred to as the capital and financial account, consisting of the capital account and the financial account, ‘The capital account is a relatively minor item. It records unrequited transfers of existing assets (rather than of currently produced goods and services) as well as transactions involving the purchase or sale of nonproduced, nonfinancial assets such as patents, franchises, or leases that are not accounted for elsewhere in the BOP accounts. To keep things as simple as possible, we will omit separate consideration of the capital account in the rest of this book by just assuming (realistically) that itis approximately zero, ‘The financial account is much larger and more important. It records transactions in the different types of financial claims mentioned above (that is, FDI, portfolio flows, and + As we will soon vee, there is some justification feral of this attention. Not only does this particular BOP concep play an important macroeconomic role, bur because a large pat oF the information on these transactions is Grav from customs data, itis available and publish relatively frequently (on a monthly bass) compared to some ofthe other data inthe BOP accounts, which are compiled quaeOpes-cconomy Macroeconomic Accounting 25 lending). ‘These transactions can be undertaken by the private sector, by governments, and by central banks. As shown in ‘Table 2.2, the BOP accounts track these individually. For analytical purposes, it is useful to consider separately those transactions involving the private sector and governments, on the one hand, and those involving central banks, on the other. Financial claims on nonresidents held by central banks are called official for exchange reserves, or just “reserves” for short? Accordingly, the purchase or sale of financial assets by the private sector or governments is entered in the nonreserve financial account, while those involving central banks are entered in the official reserves settle- ‘ments accounts. This gives us our ast two subaccounts, € The nonreserve financial account balance (NFA). As we saw previously, sales of physical assets and financial claims by domestic (non-central bank) residents t0 foreign (non-centeal bank) residents are called enpital inflows (KD), while purchases. af physical assets or financial claims by domestic (non-ceniral bank) residents from foreign (non- central bank) residents are called capital outflows (KO). The former are entered as credits, and the latter as debits, in the balance of paymerts accounts. The difference between the (wo is the nonreserve financial account balance (VF4):° NFA =KI~ KO ‘Table 2.2 shows that the United States ran a nonrescrve financial account surplus of $245, billion in 2007. This means that nonofficial US residents in the aggregate borrowed this ‘much more than they loaned to the rest of the werld. This isin part how the country managed. to pay for the excess of the goods and services that it bought from the rest of the world over the goods and services that it sold to the rest of the world, plus its net payment of investment income and unilateral transfers to the rest of th world, £ Official reserve settlements balance (ORS). Purchases and sales of foreign financial assets by central banks are called official foreign exchange intervention. The net change in official reserve assets (net increase in financial claims on domestic residents held by foreign central banks minus the net increase in claims on foreign residents held by the domestic central bank) is called the official reserve settlement balance, We will refer to this sub- account as ORS. Is important to note that the United States sin a somewhat nnnsual position regarding ORS, because of the role of the US dollar as the dominant intemational “vehicle” These consis of gold, foreign interest bearing assets, special drawing rights (SDR, and other claims on the International Monetary Fund (IMF), all oF which can be exchanged fr foreign curency, The IMF s described in ‘Chapter 6, and SDRs in Chapter 7 "Tete semantic issue thats important to mention a this point. The terminology used inthis chapter for the ‘nd financial account and its subaccounts is telatively new. It is the product ofa revision to the IMF's ‘official Balance of Payments Manual adopted in 1999, Belore then, the term “capital account” was applied to ‘what was called above the ""nonreserve financial account,” snd most ofthe ems erent ineuded in the capital account Were included under transfers in the current account. The reason this is imporant is because many ‘economists continue to refer to the nonreserve financial aecount as the “eapital account” of the balance of ‘payments, and you will oflen encounter this usage in boh the press as well as inthe policy and professional Tiertue26 Foundations currency.” Generally, central banks hold foreign exchange reserves in order to have the option to engage in foreign exchange market infervention (to buy or sell their own currencies in the foreign exchange market). Such reserves are usually maintained in the form of vehicke currencies, such as the US dollar.® That means that the central banks of other countries typically hold financial claims on US residents (usually these take the form of ‘Treasury bills issued by the US government)” Thus, in calculating the country’s net international reserve position, the international reserves held by the United States have to be netted out against the claims on US resicents held by foreign central banks. Indeed, as ‘you can see from Table 2.2, in 2007 the offical reserves settlements balance for the United ‘States was driven entirely by the accumulatien of claims on the US by foreign central banks. But because a very small number of currenc es serve as vehicle currencies, this situation is the exception rather than the rule, Generally, international reserves of other central banks consist only of the net foreign assets held by those central banks themselves. Interpreting the Sub-accounts Since the current account, the nonreserve financial account, and the official reserve settle- ‘ment balance together exhaust all of the transactions that comprise the balance of payments, in the absence of statistical discrepancies these three sub-accounis should sum to zero."° That is: CA-+NFA+ ORS =0 ‘This is referred (0 as the balance of payments identity. However, remember that the ompouents of this suin Uo not individually irave to be equal (© zero, Should we care what values these sub-accounts take? The answer is yes, and our next task is to explain why. Why the current account matters From the identity above, a current account surplus must be offset by a deficit on the sum of the uomeserve finaucial avccunt aint ORS, aunl a vunsent account deficit must be offset by a surplus on the sum of the nonfinancial capital account and ORS: CA = (SFA | ORS) erin he Foreign exchange market te to quae pices in terms of «sal numberof eurencies end © use those currencies ap common meas of excharge ai asthe eration “moneys fx which other cures are bought and sod. Te euencies that play his role are elle vehicle curencies. According 9 the Bank for tnermatnatSeements (200), 9 206 uly 89 perce of all ein exchange ansactons ‘wound the word ivalved US dolar While most intemational reserves ane eld in the frm of US dolla, some counts lo hold reserves the form of euros, Japanese yn, or Bish pou. Accorting fo the IMF, in 2005 stout 66 pce ofthe wor toa eserves were i US dollars, 25 prec inca, percent in en and preet in pounds. The counties tha sue these cuenta ha Siar pst oto he Une States "nose yea, sever countas that have accumulated large amounts of reserves have created special insitons to vest hese reserves in wider array ef asst, hoping for higher returns than ae sible on goverment sects, These isiutions ate called sovereign weath und, Recall ht we are assuming hat the capital account bance is 2.Open-economy Macroeconomic Accounting — 2 ‘Thus, if CA is positive, NFA + ORS must be negative and equal in magnitude. In other words, a current account surplus represents an exactly equal accumulation of net financial claims by domestic residents on the rest of the world. This explains why the current account surplus is often referred to as the economy's net foreign investment. It is one way that the domestic economy can accumulate wealth, On the other hand, ifthe current account balance is negative, there is an equal accumulation of net financial claims by the rest of the world on the domestic economy. ‘Thus, @ cu/rent account deficit corresponds to an exactly equal ‘accumulation of net financial liabilities to the rest of the world, and is referred to as net foreign borrowing, ‘The net financial claims that all the residents of country inthe aggregate have on the rest of the world (that is, their claims on the rest of the world minus the rest of the world's claims on them) are referred (0 as the country’s international investment position, which we wll call MP. Because these net financial claims generate income for domestic residents (in the form of interest, dividends, capital gains, and so on), the esuntry’s international investment position isa component ofits national wealth in exactly the seme sense that its stock of productive physical capital is. What we have shown is that, ust as the country’s stock of physical capital isthe stm of its past net investment, its net international investment position is the sum of its past curent account surpluses and deficits. As a component of a country’s wealth at a moment of time, the intemational investment position is a stock, rather than a flow. Table 2.3 shows the international investment position, as a fraction of the country’s GDP, for a group of industrial and developing counities in 2004, The investment position was estimated by accumulating each country’s cument account surpluses and deficits, Notive that it varies substantially among countries. Most industrial countries are net creditors to the ‘Table 23. Net ms of selected countries, 2004 (ratio to GDP) Indusivial countries mPIGDP Developing countries PIGDP Australia 0.64 Argentina 0.48) Austria 017 reat 09) Belgium 031 Chile 037 Canada 0.13 China 0.08, Finland 0.12 Colombia 035 France 0.05 India -o.l Germany 0.08 Indonesia =0.52 Italy ons, Korwa —0.04 Spat 038) Kuwait 243 Netherlands 0.06 Mexico 0.43 New Zealand 092 Pera 0.53 Norway 0.065, Philippines 059) Sweden 0.10 Saudi Arabia ot Switzerland 130 Singapore 175 United Kingdom 0.13 South Africa 005 United States 0.23 Syria 054 Thailand 029 Venezuela oT Zimbabwe 061 Sowee: Lane and Mi28 Foundations rest of the world, though there are some exceptions. The United States, as the world’s largest debtor, is an important one.'' But sparsely populated industrial countries with substantial natural resources such as Australia, Cantsla, New Zealand, and several Scandinavian ‘countries are also net intemational debtors. We will discuss later on in the chapter why this might be so (see Box 2.5). Similarly, developing countries tend to be net intemational borrowers, but thete are also exceptions te this pattern — in particular, several sparsely populated oil-producing countries in the Middle East. We will Jook at one such example, Kuwait, in Box 2.2 We have just seen thatthe current account matters because it determines the change in the ‘economy's international investment position. Does that mean that current account deficits ~ ‘which increase the country’s net debt to the rest of the world — are always bad? We will see in the following section that this depends an what is financed with the borrowing that is associated with current acconnt deficits Why the ‘balance of payments” masters Beonomists often use the term “overall” balance ‘of payments (or just balance of payments for short to refer to a particular sub-account: the sum of the current and nonreserve financial accounts, Thus: BOP CA +NFA From the balance of payments identity, we can see that: BOP = —ORS Thus the overall balance of payment balance. Why should we care about this particular sub-account? As already mentioned, central banks often decide to intervene in foreign exchange markets by buying or selling their own currencies in exchange for foreign currencies, typically US dollars (we will see wy they do this in the next chapter). While they can always sell their own currencies in exchange for foreign currencies, however (since they can print it in amounts that are unlimited in principle), they can only buy their own currency if they have the foreign exchange with which to do so, Since they can not print foreign exchange (only foreign central banks can do that) they often maintain a stock of foreign exchange reserves for this purpose, as we Saw previonsly. These reserves take the form of financial assets that can quickly be tured into foreign currency, such as gold, liquid financial assets issued by foreign governments, the country’s reserve position at the IMF, and its stock of special drawing rights (SDRs). We will discuss the role of gold in Chapter 5 and of reserve positions at the IMF as well as of SDRs in Chapters 7 and 8. just the negative of the official reserves settlement "Remember tha we previously noted thatthe Unita States had a surplus on nat investment income in 2007 How can this be, if the rest ofthe world owas moe franca elim on the United States than the United States does on the rest of the world? One part ofthe answers that the infematinal investment poston ofthe United ‘States calculated by summing US current account defictsfsurpluss over tine probably understates the tre vale of UP for the United States, hocause many of these assets are relatively ol, and have probably increased substantially in market value over tine. Another pur: is that a larger share of US claims on the rest of the ‘woe than ofthe rest ofthe world's clams on the Unie States ae inthe form of high-yielding ase ike FDI rather than lower yielding ones ike Treasury billsOpen-cconomy Macroeconomic Accounting 29 ‘This means that the stock of foreign exctange reserves that a central bank holds determines its ability (0 buy its curreney in the foreign exchange market. The importance of the overall balance of payments, which we denoted BOP above, emerges from this fact. ‘Assuming that foreign central banks do not Fold claims on the domestic economy, the relationship above indicates that BOP surpluses/deficits correspond to increases/decreases in the central bank's liquid foreign assets. A BOP surplus means that ORS must be negative, so the domestic central bank must be acquiring net claims on the rest of the world and thus accumulating net foreign exchange reserves. Conversely, a BOP deficit means that ORS is, positive, so the central bank must be selling clcims to the rest of the world and thus losing reserves. BOP deficits are thus worrisome because they signify decreases in the central bank's stock of foreign exchange reserves, which would imply a reduced ability by the central bank to buy its own currency with foreign currency. 2.3 Basic BOP Facts for the United States We saw in the previous chapter that macroeconomic openness is likely to alter the way an ‘economy works, and we have learned in this chapter that the current account ofthe balance of payments accounts is important because it serves as an indicator of the change in a country’s net international creditor position. Hew open is the US economy, and how has its current account balance been behaving over tine? ‘A good indicator of the degree of an economy's openness in the market for goods and serviees is the ratio of the sum of its exports andl imports of goods and serviees to its GDP. The larger that exports are as a share of GDP, the larger the share of domestic production that is purchased by foreigners, and the larger that imports are as a share of GDP, the larger the share of domestic spending that is devoted to buying foreign goods, and services. As Figure 2.2 shows, this ratio has more than doubled in the United States over the past four decades, from less than 10 percent of GDP in the early 1960s, to nearly 30 percent of GDP by the year 2007. By this measure, the US ecoromy is clearly becoming significantly more open over time, 0.35 7——_———— oss 02 percent 018 on 0.05 PP FPEEEEPEPPPISE year Figure 2.2. United States: Sum of exports and imports of goods and services relative to GDP.30 Foundations 250 2o0 150 1.00 oso a "SOS EPPS F PPP PP Hes ses With regard to financial openness, a widely used indicator is the ratio of the sum of a country’s external assets and liabilitics to GDP. Figure 2.3 shows this ratio for the United States. The picture for financial openness is even more dramatic than that for commercial openness. In this case, the data start only in 1970, and end in 2004. But over this 35-year period, the ratio of the United States’ extemal assets and habits to GDP increased from just over 25 percent to nearly 200 percent, suggesting much more extensive cross-border trade in financial assets over time. ‘Turning to the current account performance of the United States, as Figure 2.4 indicates, Ural performance has been erratic over recent decades, Relative 10 the size of its economy (aS measured by GDP), the United States had ¢ dectining current account surplus during the 19608, had periods of surpluses as well as deficits during the 1970s, and began to record ‘massive deficits during the first half of the 1980s, Overall, current account deicits tended to 0.02 001 ° |1960 1963 1966 1960-4972 197 Hy dora shy" 1904 1967" ypSq 1959 1996 19092002 2005] -001 -002 003 008 005 0108 -007 ae : US current account balance relative to GDP.Open-economy Macroeconomic Accounsing 31 bbe small and temporary until about 1982 oF so, but the situation has changed since then. While current account balance was temporarily restored in the early 1990s, in recent years the deficit has again widened significantly and persistently, amounting to a high over this 40-year period of over 6 percent of GDP by 2006. The upshot is that the United States has been a large net international borrower for more than two decades. Consequently, the US international financial position has evolved from @ net creditor position of about 14 percent of GDP in 1980 to a net debtor position, which, according to Table 2.3, amounted to about 23 percent of GDP by 2004. In short, the United States is becoming ircreasingly open and is also becoming an increasingly larger net international debior. Are these two developments linked in some ‘way? Is the increased openness of the United States somehow causing it to become an ever- larger net intemational debtor? ‘The answer is probably not. ‘There are many countries in Table 2.9 — for example, Germany and Switzerland ~ that are much mote open than the United States but are net international creditors. We will explore the factors driving the large current account deficits that the United States has accumulated since the early 1980s in ‘Chapters 10, 17, and 19. 2.4 The NIPA in an Open Economy: Aggregate Identities ‘The relationships among the various components of GDP are described in a system of accounts called the National Income and Preduet Accounts (NIPA). In this section, we ‘will examine the relationship between the BOP accounts and the more familiar closed- economy NIPA accounts. Closed-economy Macroeconomic Identities Ina closed economy, we can write the basic NIPA identity as GDP =CVIFG where GDP is the dollar (nominal) value of GDP, and all other variables (aggregate private consumption, C, private investment, 1, and government spending, G) are also measured in ‘current dollars. This identity holds because any ouput that is not sold to willing buyers in tite usa ketplace is automatically considered to be *‘sold” to firms inthe form of unintended inventory investment, so private investment is actually defined as 1 = GDP — C ~ G. Defining gross domestic saving asi? S=GDP-C-G ‘The basie NIPA identity also implies the familiar closed-economy identity: I 1 This definition assumes that all of government spending Gis devoted vo consumption. I this is not the case {as it usually is not), we etn simply redefine to include the investment component of government spending, and refer to a domestic (ater than private) investment32 Foundations ‘This identity states that wealth accumulation (saving) in a closed economy must take the form of the accumulation of real productive assets (investment). Now let's see what happens to these relationships in the context of an open economy. Open-economy Macroeconomic Identities, ‘As we have seen, in an open economy, domestic residents cam thas: Luh gunly atl er vives as well as financial assets with the rest of the world. This introduces several changes to the two identities above, First, in an open economy we need to distinguish between rota! spending by domestic residents and rotal spending on domestic goods by both domestic and foreign residents Total spending by domestic residents is called absorption (4), and is given by: A=CHIFG Why is this no longer the same as total spending on domestic goods? First, what domestic residents spend is: not necessarily spent on domestic goods. What they’ actually spend ‘on domestic goods is their total spending, C 1+ G, minus what they spend on foreign ‘goods (imports of goods and services, IM). Second, foreign residents also buy domestic goods (Gn the form of exports of goods and services, X). Thus, total spending on domestic goods is sven by. GDP = ((C+14G)— IM] +X where the frst term ou the sigh-taun side ofthe identity corresponds (o total spending on domestic goods and services by domestic residents, andthe second to spending on domestic z0ods and services by foreign residents. ‘This can equivalently be written as: GDP =(C+1+G)+(X-IM) =AtN Recall that NV denotes net exports (the balance on goods and services). Thus, we have our first link between the BOP and NIPA accourts, GDP must be equal to domestic absorption plus ner exports. The latter is the second of the two BOP sub-accounts we discussed previously, and this identity shows why the balance on goods and services is an important macroeconomic concept: itis one of the key components of aggregate demand. Other links will refer to progressively broader sub-nccounts, as we shall see subsequently." Next, we need to draw a distinction between gross domestic produet (GDP) and gross rational product (GNP). Recall that gross domestic product is defined as the total value of all final goods and services produced in the domestic economy during a given period, valued ‘al market prices. What is the difference between this concept and that of GNP? The answer "What about links involving the marowest sub-account, the balance on merchandise tae? Since the NIPA. oes not aw adistinction between the production of goods and tha of services, there ino link betwoen the trade ‘lance and the NIPA accounts coresponding to the ove described above forthe balance on goals and servicesOpen-eeonomy Macroeconomic Accounting — 33 is that GNP is GDP plus net investment income, to correct for the fact that some of the domestic GDP is produced by foreign capital (that is, by capital owned by foreign residents) and some foreign GDP is produced by domestic capital: GNP = GDP + NINV Using the basic NIPA identity from above and adding net investment income to both sides, wwe have: GNP C+I+G) +N +NINV) Notice that this links the next broader balance of payments sub-account (the balance on goods, services, and investment income) to the national income and product accounts, Finally, adding net unilateral transfers GNP + NUT = (C4146) + (N+ NINV + NUT) (+14 G)4CA While the quantity GNP_-+ NUT corresponds to gross national income."* If we assume that NUT = 0 (as we will do from now on), We can write GNP =(C+1+G)+CA Notice that we can also write: CA=GNP A ‘Thus the current account is the difference between a country's income and the goods and services that it absorbs, This particular identity has played an important role in the devel ‘opment of international macroeconomics (see Box 2.1). The ;position of National Saving in an Open Economy Recall that in the closed-economy NIPA, domestic saving was defined as $= GDP —C ~G. In an open economy, our definition of saving must be modified to: S=GNP-C-G "5 tally, we can daw a second distinction between SIP and national income (N/). Inthe national income and product accounts, national income is defined as GNP minus depreciation (DEP) plus unilateral wansiers received from abyotd e.g, pensions, partion payments, and foreign adh: NI= GNP — DEP + NUT This tells us the amount of income that domestic residents actually have available for consumption and ne34 Foundations Box 2.1 The Absorption Approach to the Balance of Payments The relationship between GDP, domestic absorption, and the balance on goods ancl serviees (net exports) played an important role in the development of open-economy macroeconomics, Inthe early 1960s, an economist atthe International Monetary Fund named Sydnoy Aloxancler formulated what booame lnown aa the abworption approx to the balance of payments (actually, it should have been called the absorption approach to the balance on goods and services, but that woulda’t have been a very elegant nae). Pring to Alovandler’s contribution, most economists had tended to analyse adjuct ‘ment in the balance on goods and services from a partial equilibrium perspective — that is, by looking ar the markets for expons and imports in isolation and disregarding the consequences of developments in these markets forthe rest of the economy. Based fon the identity linking GDP, domestic absorption, and the balance on goods and services, Alexander noted that net exports could only improve (that is, record a larger surplus or smaller deficit) if domestic abyiption declined relative © GDP. This ‘emphasized the point that adjustments in « country’s external trade had an important general-equilibrium (macroeconomic) dimension and could not be analyzed in isol- ation from the rest of the economy. The absorption approach shows that since either GDP or absorption (or both) must charge when net exports change, a credible explanation of what determines changes i net exports must be able 10 also account for the unavoidable associated changes in GDP and/or domestic absorption. ‘As you will sce, we will use the absorption approach quite frequently in the chapters that foltow. Often we will want to know how shocks to the domestic economy affect the equilibrium value of net exports. There will be times when a simple partial- equilibrium examination of the determinants of exports and imports will give an ambiguous answer. But a consideration of the general-equilibrium perspective using the shsorption approach will in many ease: help us pin down what will happen to the equilibrium value of net exports. This early insight into the general-equilibrium implications of macroeconomic openness ‘hus remains quite useful today. Which iscalled gross national (instead of domestic) saving. This definition allows usta derive a very important identity relating national saving, investment, and the current account: S=I+CA As il (ums out, this identity yields a number of important economic insights. First, written in this form, the identity shows that while a closed economy can only accumulate wealth by building real (nonfinancial) capital, an open economy can do so by building real capital at home or by acquiring financial claims on the rest of the world. Domestic investment and ccurrent account surpluses (often appropriately called foreign investment) are two different ‘ways in which a country can use current output to increase future income, Notice that wealth accumulation equals saving, no matter what form wealth accumulation takes, This raises an obvious question: how should an economy accumulate wealth, from a social welfare-maximizing perspective? The answer is that the size of the national “pie” is,Open-zconomy Macroeconomic Accounting 38 maximized if wealth is accumulated in the form that yields the highest social return, whether iL is real investment in the domestic economy or the accumulation of financial claims on the rest of the world. This simple observation can provide some useful economic insights. Boxes 2.2 and 2.3 provide two instances, relating to the disposition of oil revenues in Box 2.2 The Disposition of Oil Revenue in Kuwait (Over the past three decades, Kuwait has pumped oat a substantial amount of ol from its reserves and sold it on the world market, presumably on the view that the oil is more ‘valuable if sold in the present than kept inthe ground and sold inthe future. It is easy to see that, other things being equal, from an NIPA perspective the act of pumping oil from the ground for sale in the world market would tend (0 increase not only the country’s exports, EX, but also the value of its production and income, GNP. Now let’s consider what the country could have done with that oil revenue, and how its decisions regarding the disposition of its oil revenues would have affected its national income accounts. In principle, the revenues from oil exports could have been consumed or saved. If saved, they could have been invested in increasing the domestic capital stock or in ‘acquiring claims on the rest of the world. To see how the country’s national income and product accounts are affected by different decisions about the disposition of the revenues, assume for simplicity that any cianges in absorption by Kuwaitis would hhave been devoted to the purchase of foreign goods. Now consider the following three possibilities, ‘Ifthe oil revenues had been fully devoted -0 consumption, consumption and imports would have risen by the same amount as the inerease in exports, In that case, the increase in oil revenues would have induced no change in national saving, investment, ‘or the current account of the balance of payments. GNP and consumption would have risen by the same amount; exports and imports would also have increased by that ‘amount. On the other hand, saving, investment, and the current aecount would have remained unchanged. If the increase in revenues had been fully devoted to investment, investment and imports would have increased by the same amount as exports. In this case, national saving would also have risen by that amount, but the current account would have remained unchanged. Finally, suppose that consumption and investment remained unchanged, Then both GNP and national saving would have increased by the amount of the increase in exports, as would the country’s current account surplus, ‘What should a country do in such circumstances? We'll investigate this question in Chapter 19. As to what actually happened, while part of the revenue was indeed ‘consumed, much of it was not, so the Kuwaiti national saving rate has tended to be very high. And while domestic investment has also been high, so has the country’s current account surplus, reflecting a diversification of the national wealth portfolio into real capital in Kuwait as well as to the acquisition of financial claims on the rest of the world, Thus, as shown in Table 2.2, Kuwait has become a substantial net creditor to the rest of the world36 Foundations America in the Early 1980s During the decades of the late 1970s and early 1980s, many countries in Latin America experienced massive capital flight, meaning that domestic residents opted to take their savings abroad (often to Miami), rather than invest them at home. How does thie affect the countrieo’ national income accounts, and what are the implications of capital flight for economic welfare? Notice first that the emergence of such a phenomenon would fend to leave saving unchanged (since capital flight does not concem changes in consumption, but rather in the alloratinn af saving). Since domestic residents were choosing to acquire claims on the test of the world rather than to invest in domestic physical capital, however, domestic Investment would have decreased and the current account increased by equal amounts. ‘Was this a bad thing for the countries involved? It does not necessarily have to have been so. For example, it would rot have been a bad thing if it simply reflected a relatively low social return on douestiv capital compared W Ue higher returns available to domestic savers abroad. So why, then, were so many people ‘worried about this phenomenon at the time? There could have been a variety of reasons, some of which are not immediately relevant for us in the present context. Bat one possible reason is worth mentioning. It may have been that, while social rates of return were actually higher at home than abroad, capital flight happened anyway. In that case, capital flight would have made the countries from which capital “*flew’* poorer than if the money had been invested at home. How could such a situation arise? It could have beer due to the perception by those engaged in capital flight that private rates of return to savers were not as high in the domestic economy as the private (and social) rates of return available abroad. This can happen as the result of policies pursted toward the financial system and/or the flake of expropriation by financially strapped governmente. If domestic bank are not permitted to pay savers interest rates that reflect the high retums available on ‘domestic capital investment, or if capitalists have reason to fear that these returns may be appropriated by the government, they may well prefer to take their money {fo Miami. In the presence of such distortions, domestic wealth wonld have indeed been misallocated through capital flight Kuwait and the phenomenon of capital flight in Latin America during the late 1970s and early 1980s. ‘The Financing of Domestic Investment in an Open Economy ‘The identity derived above can be written two other ways, and both of them offer additional economic insights. Finst, it can be written as: =S—CAOpen-sconomy Macroeconomic Accounting — 37 This tells us that, while a closed economy must finance investment by saving, an open economy can do so either by saving or by reducing its net foreign wealth (borrowing, abroad). This is an important form of the identity, It explains, for example, why many developing countries are attracted by macroeconomic openness: by giving them access 10 external funds, it provides them with the means to sustain a higher level of investment ‘and economic growth than they could achieve on the basis solely of their own national saving. This observation fundamentally alters the role of national saving in long-run growth. Rather than saving being required to make a given level of investment possible, what saving by domestic residents actually does is to alter the way that domestic investment is financed, that is, it alters the composition of investment financing between domestic and foreign sources. This change in perspective is not alway’s easy for economists t0 adopt, as Box 24 iMlustrates, ‘The Composition of the Current Account Finally, we can write the same identi This says that the current account deficit (~C) is the difference between investment and saving. For example, we saw previously that a current account deficit represents the use of foreign saving, that is, net borrowing from abroxd that increases a country’s net international indebtedness. Does this mean that a current aczount deficit is bad’? In part the answer depends on whether it reflects increased investment or reduced saving. Ifit reflects an increase in investment with yields exceeding the cost of external borrowing, then it can be a good thing, in the sense that it can inerease the country’s future consumption ‘opportunities, because the returns that domestic residents receive on the funds they have borrowed exceeds the amount that they have to pay for those funds, leaving more resources, available for future consumption. If it reflects low saving resulting from higher current consumption, however (as in Mexico in the early 1990s; see Box 2.4), then repaying the accumulated debt will require a downward correction in future consumption, since there is no increase in future income in this case with which to repay the debt. This is desirable only if an extra unit of current consumption is worth more to the economy than the future ‘consumption that it would have to give up to repay the debs. This is likely to be the case, for ‘example, when the economy’s income is unusually low, such as in the event of a natural «disaster that femporarily impairs a country’s productive capacity, This form of the identity is used frequently by international macroeconomists to discip- Jine our thinking about the likely causes and sustainability of current account deficits in both industrial and developing countries. Three cases are described in Boxes 2.5 to 2.7. 2.5 Sectoral Identities So far, we have been analyzing open-economy macroeconomic ident five of the country as a whole. Next, we will di jes from the perspec ide the country into private and public38 Foundations Box 2.4 Saving and Growth in Post-reform Mexico, 1994 In the early 1990s, the intemational financial institutions (the Intemational Monetary Fund and World Bank) considered Mexico to be a model country. After a period of poor macroeconomic performance during the 1980s, Mexico had reformed many of its poticies in a manner consistent with advice widely proffered by those institutions. Yet by 1994 many observers of the Menican economy had become worried about the low growth registered by the Mexican economy despite its widespread policy reforms. Low growth was blamed in part on the relatively low rates of investment that Mexico had achioved after implomenting thooe roformo. Tho qusation was why investment remained low despite what was widely perceived as a substantial improvement in the policy environment. In answering this question, many observers focused on the low rates of national saving that were also observed in Mexico at the same time. But does it make sense to blame low saving for the unsatisfactory investment performance of the Mexican economy? As We have seen, in an open economy investment need not be constrained by the level of national saving. Mexico was indeed 4 very open economy during this time and had received very substantial capital inflows during the early part of the decade of the 1990s. The identity = 5 — CA suguests thal, since Mesicd isa highly ope reconuruy, if more investment way desired, it could have been financed by additional extemal borrowing, Thus, low saving by domestic residents was not necessarily « constraint on investment in Mexico. Instead, ‘while low investment was indeed a problem for growth, it likely existed for independ ent reasons affecting the demand for investment, not the supply of financing for investment in Mexico. Observers should have been worried about a reduced demand for investment, not a reduced availability of funds for investment. ‘The low saving rate tus out fo have been a problem, bat for other reasons. The low saying rate resulted in a lorge current account deficit in the balance of payments, despite Mexico's low investment rate. This current account deficit resulted in a buildup of extemal debt that contributed fo a severe financial crisis by the end of 1994, Observers were right to have worried about Mexico’s low saving rate, not because of its effect on investment, but rather because of its implications for the country’s current account deficit. sectors, In particular, let NT denote the net taxes paid by the private sector to the govern ‘ment, and suppose that we define: and