Chapter 12

C h a p t e r 1 2
National Income
Accounting and the
Balance of Payments
To accompany
International Economics, 3e by Sawyer/Sprinkle Copyright © 2009 Pearson Education, Inc.
PowerPoint slides created by Jeff Heyl Publishing as Prentice Hall
CHAPTER ORGANIZATION
• Introduction
• National Income Accounting
• GDP and the Trade Balance
• The Balance of Payments Accounts
• Summary
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 2

Hall
INTRODUCTION
• The way in which a trade balance is interpreted is
not necessarily an accurate assessment of an
economy’s health
• The trade balance is part of a larger economic picture
which includes imports, exports and the GDP
• The country’s balance of payments also play a role
in the economy
• They are an important component of the GDP and as
trade becomes larger, they become increasingly
important
• A country’s interactions in the world market affect
domestic production and the financial markets
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NATIONAL INCOME ACCOUNTING
• The Measurement of GDP

• National income accounting is the calculation
of GDP for a country and the subdivision of
GDP into various components
• GDP is a measure of a country’s total output
• Calculated in the country’s currency with
goods/services measured at market prices
• Not all transactions are accounted for and
constant changes in prices must be considered

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• Items Excluded from GDP

• Final goods and services means that we count
the value sold only to end-users
• This captures the value added by all inputs
• We do have to count the value of intermediate
goods
• Includes only reported market transactions
• Illegal activities are not reported
• GDP understates and provides a conservative
estimate of total economic activity
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• GDP and Changes in Prices

• Current prices can distort measure of real output
• Real GDP accounts for price level changes
• Nominal GDP is the market value of final output
measured in constant prices
• The market value of goods and services
produced in a year is adjusted to account for
changing prices
• Real GDP= (Nominal GDP/GDP deflator)x100

Hall

Hall
The measurement of GDP
1. Income approach
•GDP= Total national income+ sale taxes+
depreciation+ Net foreign factor income
•Total national income=wages+ rent+ interest+profits
•Net foreign factor income= Total income generated by
the citizens and companies in different countries –
Total income generated by the foreigners and foreign
companies generated in the domestic country ( GNP-
GDP).

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The measurement of GDP
2. Value added approach

GDP=Value added of all industries+taxes-
subsidies
Value added of all industries= total output of the

industry-inputs used to produce output

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• The Components to GDP

• GDP can be calculated by summing the different
types of expenditures that occur within a country
Y = C + I + G + (X – M)
Y = GDP (total production)
C = Public’s consumption of goods and services
I= Represents business firms investments in equipment, software
structures, and changes in business inventories, and residential
investments
G = The purchase of goods and services by state, local, and
federal governments
X = Exports of goods and services
M= Imports of goods and services
Hall
Figure 12.2 U.S. Real GDP and Its Components, 2006
12,000 –
10,000 –
In Billions of 2000 Dollars
8,000 –
6,000 –
4,000 –
2,000 –
0–
–2,000 – GDP Consumption Investment Government Net Exports

Hall
Figure 12.3 Real Exports and Imports as a Percentage of GDP
18 –
16 –
14 –
Percentage of GDP
12 –
10 –
8–
4–
2–
0–
59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
Year
Exports Imports
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• Since 1970, the real volume of trade has grown at

more than twice the rate of output
• This has caused an increase in the share of GDP
devoted to exports and imports
• The “globalization” of the U.S. economy refers to
these growth trends in total imports and exports

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GDP AND THE TRADE BALANCE
• GDP in a Closed Economy

• Firms must use any final good or service that
individuals do not consume or the government
does not purchase to produce new plant and
equipment
• For a closed economy
Y=C+I+G

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• GDP in an Open Economy

• In an open economy, trade is allowed
Y = C + I + G + (X - M)
• When exports are greater than imports there is
a trade surplus
• When imports are greater than exports there is
a trade deficit
• Degree of openness of an economy= (X+M) / GDP

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• Imports, Exports, and GDP

• We can rearrange the open economy equation
as
X–M=Y–C–I–G
• A country’s trade deficit is the difference
between what is produced in a country and
what is consumed

Hall
Table 12.1 GDP for Alpha and Beta in Billions of Dollars
Country GDP C I G X–M
Alpha $11,319 $8,044 $1,920 $1,981 $–626
Beta 4,269 2,423 1,028 764 53

Hall
• When domestic output (Y) is smaller than the sum

of C, I, and G, then a country is consuming more
goods and services than it has produced
• The country must have a trade deficit
• A country must borrow the difference from other
countries increasing its indebtedness
• The trade balance, X – M, is a flow variable
• It occurs over a period of time
• The amount of debt a country has is a stock
variable
• It can be added to or subtracted from
Hall
• If total domestic output (Y) is larger than the sum

of C, I, and G (domestic spending), then
X–M=Y–C–I–G
• The country must have a trade surplus the extra
production shows up as a trade surplus
• A country with a trade surplus will be reducing its
indebtedness or accumulating more claims on
foreign countries
• Surpluses are not necessarily good and deficits are
not necessarily bad

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• Intertemporal Trade
• When a country has a trade deficit in a given
year, it has consumed more that it produced
during that year
• Production and consumption should balance
over the long run, but they do not need to
balance every year
• If a country has a trade deficit it is importing
present consumption
• At some point in time, it will have to pay for the
deficit
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• Producing more output than it is consuming will

produce a trade surplus
• The country is exporting future consumption
• Trading consumption and production over long
periods of time is known as intertemporal trade
• A country with a trade surplus is producing more
output than it is consuming and is exporting
present consumption to other countries

Hall
• Saving, Investment, the Government

Budget, and the Trade Balance
• GDP measures a country’s total income and
goes to the factors of production in the form of
wages, rent, interest, and profits
• Public spends this income on goods and services
• Money moves in a circular flow from businesses
to the public and back again

Hall
• Not all of a society’s total income is

immediately spent on goods and services
• This is referred to as leakages from the circular
flow
• There are three sources of leakage
• Residents may save a portion of their current
income
• Government taxes use part of current income
• Imports represent reduced spending on
domestically produced goods and services

Hall
• The outflows do not disappear from the economy

• Business, government, and foreigners engage in
activities that inject spending back into the
curricular flow
• These are called injections into the circular flow
• Injections take the form of investment to
businesses and housing, government spending on
final goods and services, and foreigners purchase
domestically produced goods and services—
exports

Hall
• Sum of leakages from the circular flow must

equal sum of injections into the circular flow
S+T+M=G+I+X
• This does not mean that S = I, T = G, or X = M
• The equation can be rearranged as
X–M=S–I+T–G
• Trade balance becomes mismatch between private
saving (S), government saving (T – G) and
business saving (I)

Hall
• In a country with a trade deficit, the economy has

an excess of domestic spending compared to
domestic production
• To reduce this, the country could produce more
goods and services than it consumes
• This is not easy to do in the short run as the
maximum level of production is difficult to alter in
the short run
• Reducing a trade deficit in the short run requires
that a country reduce domestic spending

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• Adjustments to Trade Imbalances

• A country with a trade deficit has four potential
adjustments to reduce trade imbalance
• Increasing the level of savings would tend to
reduce the trade deficit
• It is a difficult policy for a government to
implement as how to do this is not completely
clear
• Increasing savings would reduce consumption
and, this, the trade deficit

Hall
Table 12.2 Potential Adjustment to Reduce Trade Imbalances
Country Has a Trade

Deficit Surplus
Increase Private Savings Decrease Private Savings
Or Or
Increase Government Taxes Decrease Government Taxes
Or Or
Decrease Business Investment Increase Business Investment
Or Or
Decrease Government Spending Increase Government Spending

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• A second adjustment would be to change the

level of investment
• If investment spending falls with no change in
savings or government budget, the trade
imbalance would tend to become smaller
• However, reducing the level of investment may
reduce the real GDP
• Increasing investment may worsen the trade
deficit but may also improve the country’s
economic growth

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• Governments may also increase taxes

• This would either reduce budget deficits or
produce a surplus
• Increasing taxes would either reduce government
borrowing or reduced previous debt
• This has the same effect as an increase in savings

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• Government’s may also change their spending

• Reducing government spending would tend to
reduce the trade deficit and, when used in
conjunction with raising taxes, it has the potential
to reduce the trade deficit to a greater extent than
either policy used in isolation

Hall
Table 12.3 Relationship Between Savings, Investment, and

Government Balance, and Trade Balance
Country Time Period S I (G – T) (X – M)

U.S. 1978 – 1980 17.6 17.1 0.4 –0.1
1988 – 1990 16.6 14.8 3.2 –1.4
2000 – 2002 18.4 21.6 0.7 –4.0
Japan 1978 – 1980 36.5 31.7 4.9 –0.1
1988 – 1990 33.6 33.1 –1.6 2.1
2000 – 2002 26.7 17.4 6.9 2.5
EU 1978 – 1980 26.6 22.1 4.2 0.3
1988 – 1990 22.7 17.6 4.2 –0.2
2000 – 2002 23.6 20.9 2.2 0.5

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• Balance of payments accounts keep track of a
county’s international transactions
• The account is composed of a number of different
accounts
• The balance on current account is a record of
transactions that include payments for good,
service, and other items
• The balance on financial account is a record of
transactions that include payments on related to
financial assets

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• The balance on capital account is a record of other
activities resulting in transfers of wealth between
countries
• At the most basic level, the balance of payments is
a record of all economic transactions derived from
the exchange of goods, services, income, and
assets between residents of one country and the
rest of the world
• It records the total inflows and outflows of money
to and from foreign countries

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• The Balance on Current Account
• Merchandise exports are recorded as a positive
number and imports are recorded as a negative
number
• This convention applies to all other items in the
balance of payments
• The difference between merchandise exports
and imports yields the merchandise trade
balance

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
Table 12.4(a) U.S. International Transactions, 2006 ($ billions)
Current Account transactions

Exports of Merchandise $1,023.1
Imports of Merchandise –1,861.4
Balance of Trade (Goods) –838.3
Exports of Services 422.6
Imports of Services –342.8
Balance on Services 79.7
Balance on Goods & Services –758.5
Income Receipts on U.S. Assets Abroad 650.5
Income Payments on Foreign Assets in the U.S. –613.8
Balance on Investment Income 36.6
Balance on Goods, Service, and Income –721.9
Unilateral Transfers, Net –89.6
Balance of Current Account –811.5

Hall
Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
Table 12.5(a) Summary of U.S. International Transactions,
1964-2006 ($ billions)
Year Merchandise Service Goods and Investment Unilateral Current
Trade Balance Balance Service Income Transfers Account
Balance Balance Balance Balance
1964 6.8 –.8 6.0 5.0 –4.2 6.8
1966 3.8 –.9 2.9 5.0 –5.0 3.0
1968 .6 –.4 .3 6.0 –5.6 .6
1970 2.6 –.3 2.3 6.2 –6.2 2.3
1972 –6.4 1.0 –5.4 8.2 –8.5 –5.8
1974 –5.5 1.2 –4.3 15.5 –9.2 2.0
1976 –9.5 3.4 –6.1 16.5 –5.7 4.3
1978 –33.9 4.2 –29.8 20.1 –5.8 –15.1
1980 –25.5 6.1 –19.4 30.4 –8.3 2.3
1982 –36.5 12.3 –24.2 35.2 –16.5 –5.5
1984 –112.5 3.4 –109.1 35.1 –20.3 –94.3

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
Table 12.5(b) Summary of U.S. International Transactions,
1964-2006 ($ billions)
Year Merchandise Service Goods and Investment Unilateral Current
Trade Balance Balance Service Income Transfers Account
Balance Balance Balance Balance
1986 –145.1 6.6 –138.5 15.5 –24.1 –147.2
1988 –127.0 12.4 –114.6 18.7 –25.3 –121.2
1990 –111.0 30.1 –80.9 28.6 –26.7 –79.0
1992 –96.9 57.7 –39.2 24.2 –35.1 –50.1
1994 –165.8 67.3 –98.5 17.1 –40.3 –121.6
1996 –191.0 86.9 –104.1 22.3 –43.0 –124.8
1998 –248.2 82.1 –166.1 4.3 –53.2 –215.1
2000 –454.7 74.9 –379.8 21.1 –58.6 –417.4
2002 –485.0 61.2 –423.7 27.7 –63.6 –459.6
2004 –669.6 57.5 –612.1 56.4 –84.4 –640.1
2006 –838.3 79.7 –758.5 36.6 –89.6 –811.5

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THE BALANCE OF
PAYMENTS ACCOUNTS
• The balance on services is the difference between
exports and imports of services
• The balance on goods and services is the
combination of the surplus of the service balance
with the merchandise trade deficit
• The balance on investment income is the
difference between income earned on foreign
assets and payments to foreign residents on their
assets

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• Combining the surplus of the balance on
investment income with the deficit on the balance
on goods and service yields the balance on goods,
services, and income
• Unilateral transfers are the inflows and outflows
from the U.S. where there are no services rendered
• For all countries the balance is the most
comprehensive view of a country’s total trade
flows

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• In the U.S., the balance on goods and services
monthly
• However, the current account balance is reported
quarterly with the GDP
• The focus is generally on the GDP data so the
current account balance doesn’t receive much
publicity
• While the monthly data is interesting, the
quarterly report of the current balance is a much
better indicator of the country’s trade position

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• The Balance on Capital and Financial
Accounts
• When foreigners purchase U.S. assets the
transactions are recorded in the financial account
• Government purchases of foreign assets are
recorded in the capital account
• The change in assets abroad totals all of the
purchases of foreign assets that U.S. citizens and
the U.S. government made during a year

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• The U.S. official reserve assets are assets the
government uses to buy and sell foreign currencies
or foreign assets and include government holdings
of gold or foreign currency
• Special Drawing Rights (SDRs) are official reserve
assets that are traded among the world’s central
banks
• These are distributed by the International
Monetary Fund (IMF), a multilateral agency
created to promote international monetary stability
and cooperation
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THE BALANCE OF
PAYMENTS ACCOUNTS
• The change in foreign assets item records all the
purchases of U.S. assets by foreigners and foreign
central banks
• The final entry in the balance of payments account
is the statistical discrepancy
• This captures any net inflows or outflows that the
U.S. government failed to record
• It is impossible to identify which flows were
actually missed, so this account forces the inflows
and outflows to be equal

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THE BALANCE OF
PAYMENTS ACCOUNTS
• The Current Account and the Capital and
Financial Account
• Total inflows and outflows must equal
• Current account and capital and financial
account must balance out
• A country running a deficit on trade in goods
and services must “finance” this deficit by
borrowing from foreigners

Hall
Hall
The International Investment Position of the
United States
 A nation’s BOP measures international flow

of goods, services and capital during a one-
year period (flow concept).
 A nation’s international investment position

measures total amount and distribution of
assets abroad and foreign assets in the nation
at the end of the year (stock concept).
THE BALANCE OF
PAYMENTS ACCOUNTS
Figure 12.4 The Net International Investment Position of the U.S.,
1976-2006
500 –
0–
In Billions of Dollars
–500 –
–1,000 –
–1,500 –
–2,000 –
–2,500 –
–3,000 –
1976 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
Year

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THE BALANCE OF
PAYMENTS ACCOUNTS
• Until the late 1990s, U.S. investments overseas
were generally larger than foreign investment in the
U.S.
• However, since 1983 the U.S. has invested less
overseas than foreigners have invested in the U.S.
• The U.S. has been financing its current account
deficit by borrowing from the rest of the world and
by selling U.S. assets
• This is neither good or bad as a deficit in goods and
services has to be offset somewhere

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• Current account surpluses have to be balanced as
well
• A capital account surplus means that there will be
less capital for investors to invest in their own
country since capital will be moving to other
countries
• Rates of economic growth are sensitive to capital
investment so the growth of productivity and real
wages may slow
• However, exporting capital may lead to rising
investment income
Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• There is a myth that deficits are bad and surpluses
are good, but this is not always true
• A poor country usually has abundant labor and
scare capital
• Raising the GDP per capita requires increasing
capital per worker and this is difficult to do as
capital is scare and rising populations make
increasing capital per worker even more difficult
• The solution is to import foreign capital

Hall
THE BALANCE OF
PAYMENTS ACCOUNTS
• This creates a capital and financial account
surplus and a current account deficit
• The FDI may lead to an increase in exports which
creates a trade surplus
• Investment income may be negative as debts are
repaid
• Repayment of debts shifts the country to a current
account surplus and a capital and financial
account deficit
• Deficits change over time and are typical for
economies at different stages of development
Hall
SUMMARY
1. A nations GDP is equal to the total output of

final goods and services a nation produces in a
year
2. GDP can be divided into several different types
of spending: consumption, investment,
government purchases, and the trade balance
3. In an economy closed to international trade, GDP
must be consumed, invested, or purchased by the
government

Hall
SUMMARY
4. In an open economy, international trade does not

have to balance
5. Trade imbalance equals a change in a country’s
borrowing or lending to foreigners
6. The trade imbalance also equals the country’s
outflows and inflows of income—savings or
taxes—and its injections of income—investment
or government purchases
7. The trade balance is a way for a country to
balance its production and consumption over
periods of time longer than a year
Hall
SUMMARY
8. The balance of payments is a record of a

country’s economic transactions with all other
countries
9. The balance of payments identifies economic
transactions as current account transactions,
capital account transactions, or financial account
transactions

Hall
SUMMARY
10. Since total inflows and outflows of dollars

will be equal, a current account deficit will be
matched by an equal capital and financial
account surplus or a current account surplus
will be matched by a capital and financial
account deficit
11. In many cases deficits are typical for
economies at different stages of development

Hall

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C h a p t e r 1 2

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 2

• The Measurement of GDP

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 4

• Items Excluded from GDP

• GDP and Changes in Prices

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 6

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 7

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 8

2. Value added approach

Value added of all industries= total output of the

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 9

• The Components to GDP

Figure 12.2 U.S. Real GDP and Its Components, 2006

–2,000 – GDP Consumption Investment Government Net Exports

Figure 12.3 Real Exports and Imports as a Percentage of GDP

• Since 1970, the real volume of trade has grown at

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 13

• GDP in a Closed Economy

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• GDP in an Open Economy

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• Imports, Exports, and GDP

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Table 12.1 GDP for Alpha and Beta in Billions of Dollars

Country GDP C I G X–M

Alpha $11,319 $8,044 $1,920 $1,981 $–626

Beta 4,269 2,423 1,028 764 53

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 17

• When domestic output (Y) is smaller than the sum

• If total domestic output (Y) is larger than the sum

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 19

• Producing more output than it is consuming will

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 21

• Saving, Investment, the Government

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• Not all of a society’s total income is

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 23

• The outflows do not disappear from the economy

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 24

• Sum of leakages from the circular flow must

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 25

• In a country with a trade deficit, the economy has

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 26

• Adjustments to Trade Imbalances

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 27

Table 12.2 Potential Adjustment to Reduce Trade Imbalances

Country Has a Trade

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 28

• A second adjustment would be to change the

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 29

• Governments may also increase taxes

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• Government’s may also change their spending

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 31

Table 12.3 Relationship Between Savings, Investment, and

Country Time Period S I (G – T) (X – M)

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Current Account transactions

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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice 12 – 38