National accounting in an open economy

Gianni VaggiApril 2014

The components of GDP: closed and open economy

Closed economy

GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government expenditures (G)

Y = C + I + G

Open Economy

plus Net Exports (NX) Y = C + I + G + NX

Saving, Investments and Trade National saving S (private and public) is the

income of the nation that is left after paying for current consumption and government purchases:

S = Y - C - G = I + NX

S = I + NX

NX = (X – M) = Trade Balance or Balance of Goods

and services

For the moment suppose that NX is the only component of the Current Account of the BoP

Saving, Investments and Trade

S – I = X – M

(Sp – Ip) + (T – G) = (X – M)

Sp private savings Ip private investments T taxes G government expenditures

The Current Account Balance

In the BoP the Current account balance (CA) is the sum of three items:

Trade balance (X-M), Net income transfers (interest

payments, dividends, etc.;)= Net Primary Income = NPI

Net unilateral transfers (gifts, donations, remittances, international aid, etc.)= Net Secondary Income = NSI

The Current Account Balance

CA = [(X-M) + NPI + NSI]

Sometimes(NPI + NSI) are called Net Factor Income =

NFIand NPI is called Net Incomesand NSI is called Net transfers

The Financial and the Capital Account

The Financial Account , FA, has largely absorbed The Financial Account , FA, has largely absorbed what was formerly called the Capital account!!what was formerly called the Capital account!!

In the BoP CA + FA = 0Current Account Balance + Financial Account Balance = 0

Net of Changes in reserves, R. The overall balance of payments also includes movements of Official reserves, if private transactions do not match exactly. Suppose: ∆R = 0.

FA = NCF = Net Capital Flows

NCF = (Inflows – Outflows)

The Current and Capital Accounts NCF can be +/- depending on CA

If CA = +10 then FA = -10 Which means: Outflows >Inflows Therefore: NCF = -10

And CA = - NCF

The Equality of Current Account and Net Capital Flows

For an economy as a whole CA, and NCF must balance:

CA= [(X-M) +NPI+NSI] = FA (+/-) = NCF(+/-)

This holds true because every transaction that affects one side of the BoP must also affect the other side by the same amount.

In principle the sign of FA (+/-) depends on that of CA

Saving, Investment, and International Flows

Y = C + I +G+[(X-M) + NPI + NSI]

(S – I) = [(X-M) + NPI + NSI]= CA = FA= NCF

Saving = Domestic Investment + Net Capital FlowsS = I + NCF

Saving, Investment, and International Flows

Investments may be financed either by national saving (S) or by foreign saving (NCF):

I = S – NCF

Remember that in general the sign of FA (+/-) and NCF depends on the Current Account Balance, CA,…BUT… with large international flows…

National accounting in an indebted open

economy

Gianni VaggiApril 2014

The national accounting in an indebted open economy

Suppose D0 = 100 to be repaid in 10 years and i = 5%,

each year:

iD interest payments = 5 ΔD principal repayment = 10

iD + ΔD = DS Debt Service

The national accounting in an indebted open economy

Remember: FA = NCF = Net Capital Flows = (Inflows – Outflows)

FA = [(Inflows - Other Outflows) -ΔD] = dD/dt• ΔD<0 in an indebted economy ΔD is an

outflow because debt must be repaid• dD/dt is the change of the debt stock

during the year, which depends also on inflows and other outflows in the FA.

CA = [(X-M) + (NPI – iD) + NSI]

The national accounting in an indebted open economy

CA+FA = 0

Suppose an indebted economy where there are only foreign debt related flows:

(Inflows - Other Outflows) = 0

and no other item in NPI and NSI other than –iD

[(X-M) - iD] - ΔD = 0

(X-M) = iD + ΔD = DS

Take the example: DS = 5 +10 = 15

(X-M) - iD = ΔD

The national accounting in an indebted open economy

IF IF the trade balance is 15 and exactly covers the debt service, thenthen the overall debt decreases by ΔD = D0 - D1 , according to the original scheduled payments or:

-ΔD = 90 -100 = -10 = -dD/dt

IF IF the trade balance is 5 and covers interests only, thenthen ΔD = 0 and the overall debt does not change:

dD/dt=0

IF IF the trade balance is less than 5 and, thenthen the overall debt increases:

dD/dt=>0

The Current Account BalanceNow suppose there are other financial flows in the

CA

In the BoP the Current account balance (CA) is the sum of three items:

Trade balance (X-M) Net income transfers (interest payments,

dividends, etc.;)= Net Primary Income = NPI Net unilateral transfers (remittances,

international aid, etc.)= Net Secondary Income = NSI

The national accounting in an indebted open economy

Net primary income: Net primary income: Interests on foreign debt Dividends (on portfolio investments); Earnings of FDIs, profit repatriation Rents on land and natural resources; Compensation of employees (cross-border

workers).

Net secondary income:Net secondary income:

Personal transfers (i.e. remittances); Current) International cooperation,ODA

The national accounting in an indebted open economy

Consider the following flows:

-iD are outflows in NPI = -5

Compensation of employees are often included in remittances

NSI includes -remittances

-international aid , ODA

The national accounting in an indebted open economy

Remember:

[(X-M) + NPI + NSI] = CA Current Account Balance

and CA + FA = 0

[(X-M) - iD + NSI] + (-ΔD) = 0

[(X-M) + NSI] = iD + ΔD = DS = 15

Debt sustainability - 1 D = overall foreign debt Y = GDP gn = (dY/dt)/Y is the nominal growth rate

Thresholds d(D/Y)/dt < 0< 0

The latter: Domar 1944

Debt sustainability - 2

By total differentiation of D/Y:

d(D/Y)/dt = [ (dD/dt)*Y - (dY/dt)*D ]/ Y2

= (dD/dt)Y - [ (dY/dt)/Y ] * (D/Y)

= (1/Y) [dD/dt - gn * D ]

But dD/dt = [inD - (X – M)]

Debt sustainability - 3

i = (in - dp/dt) and g = (gn - dp/dt)

dp/dt inflation rate on debt

d(D/Y)/dt = (i - g)D/Y - (X - M)/Yd(D/Y)/dt = (i - g)D/Y - (X - M)/Y

i, g are the real interest rate and the GDP growth rate

d(D/Y)/dt = inD/Y - gnD/Y - (X - M)/Y

Debt sustainability - 4But there are also other financial flows:Current Account (CA)= [(X-M) + NPI + NSI ]

NICA = [CA – iD] = Non-Interest Current Account

NICA = [CA – iD] = [(X-M) + NPI + NSI] - iD

NICA largely depends on the trade balance, but not only.

Debt sustainability - 5

The correct sustainability formula is

d(D/Y)/dt = (i - g)D/Y - d(D/Y)/dt = (i - g)D/Y - NICANICA/Y/Y

Debt sustainability – 6- and national public debt

NICA is the equivalent for foreign debt of the concept of Primary surplus (net of interests) for domestic(public) debt

(T – G) = Primary surplus

[(T – G) – iD] (<0) = overall Fiscal Deficit = FD

FD/Y must not exceed 3%