1.2. NATIONAL ACCOUNTING RELATIONS

15

can buy the foreign currency in the interbank market because arbitrage will equate the two prices near the maturity date.

(1.14) also tells you the extent to which the futures contract hedges risk. If you have long exposure, an increase in ST −k (a weakening of the home currency) makes you worse o while an increase in the futures price makes you better o . The futures contract provides a perfect hedge if changes in FT −k exactly o set changes in ST −k but this only happens if φT −k = 1. To obtain a perfect hedge when φT −k 6= 1, you need to take out a contract of size 1/φ and because φ changes over time, the hedge will need to be rebalanced periodically.

1.2National Accounting Relations

This section gives an overview of the National Income Accounts and their relation to the Balance of Payments. These accounts form some of the international time—series that we want our theories to explain. The National Income Accounts are a record of expenditures and receipts at various phases in the circular ßow of income, while the Balance of Payments is a record of the economic transactions between domestic residents and residents in the rest of the world.

National Income Accounting

In real (constant dollar) terms, we will use the following notation.

Y Gross domestic product, Q National income,

C Consumption, I Investment,

G Government Þnal goods purchases,

A aggregate expenditures (absorption), A = C + I + G, IM Imports,

EX Exports,

R Net foreign income receipts, T Tax revenues,

16 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND

S Private saving,

NFA Net foreign asset holdings.

Closed economy national income accounting. We’ll begin with a quick review of the national income accounts for a closed economy. Abstracting from capital depreciation, which is that part of total Þnal goods output devoted to replacing worn out capital stock. The value of output is gross domestic product Y . When the goods and services are sold the sales become income Q. If we ignore capital depreciation, then GDP is equal to national income

Y = Q.

(1.15)

In the closed economy, there are only three classes of agents–households, businesses, and the government. Aggregate expenditures on goods and services is the sum of the component spending by these agents

A = C + I + G.

(1.16)

The nation’s output Y has to be purchased by someone A. If there is any excess supply, Þrms are assumed to buy the extra output in the form of inventory accumulation. We therefore have the accounting identity

Y = A = Q.

(1.17)

The Open Economy. To handle an economy that engages in foreign trade, we must account for net factor receipts from abroad R, which includes items such as fees and royalties from direct investment, dividends and interest from portfolio investment, and income for labor services provided abroad by domestic residents. In the open economy national income is called gross national product (GNP) Q = GNP. This is income paid to factors of production owned by domestic residents regardless of where the factors are employed. GNP can di er from GDP since some of this income may be earned from abroad. GDP can be sold either to domestic agents (A − IM) or to the foreign sector

1.2. NATIONAL ACCOUNTING RELATIONS

17

EX. This can be stated equivalently as the sum of domestic aggregate expenditures or absorption and net exports

Y = A + (EX − IM).

(1.18)

National income (GNP) is the sum of gross domestic product and net factor receipts from abroad

Q = Y + R.

(1.19)

Substituting (1.18) into (1.19) yields

Q = A + (EX − IM) + R					(1.20)
|		{z		}

Current Account

A country uses the excess of national income over absorption to Þnance an accumulation of claims against the rest of the world. This is national saving and called the balance on current account. A country with a current account surplus is accumulating claims on the rest of the world. Thus rearranging (1.20) gives

Q − A = ∆(NFA)

=(EX − IM) + R

=Q − (C + I + G)

=[(Q − T ) − C] − I + (T − G)

=(S − I) + (T − G),

which we summarize by

∆(NFA) = EX − IM + R = [S − I] + [T − G] = Q − A. (1.21)

The change in the country’s net foreign asset position ∆NFA in (1.21) is the nation’s accumulation of claims against the foreign sector and includes o cial (central bank) as well as private capital transactions. The distinction between private and o cial changes in net foreign assets is developed further below.

Although (1.21) is an accounting identity and not a theory, it can be used for ‘back of the envelope’ analyses of current account problems. For example, if the home country experiences a current account

18 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND

surplus (EX − IM + R > 0) and the government’s budget is in balance (T = G), you see from (1.21) that the current account surplus arises because there are insu cient investment opportunities at home. To satisfy domestic resident’s desired saving, they accumulate foreign assets so that ∆NFA > 0. If the inequality is reversed, domestic savings would seem to be insu cient to Þnance the desired amount of domestic investment.5 On the other hand, the current account might also depend on net government saving. If net private saving is in balance (S = I), then the current account imbalance is determined by the imbalance in the government’s budget. Some people believed that US current account deÞcits of the 1980s were the result of government budget deÞcits.

Because current account imbalances reßect a nation’s saving decision, the current account is largely a macroeconomic phenomenon as well as an intertemporal problem. The current account will depend on ßuctuations in relative prices of goods such as the real exchange rate or the terms of trade, only to the extent that these prices a ect intertemporal saving decisions.

The Balance of Payments

The balance of payments is a summary record of the transactions between the residents of a country with the rest of the world. These include the exchange of goods and services, capital, unilateral transfer payments, o cial (central bank) and private transactions. A credit transaction arises whenever payment is received from abroad. Credits contribute toward a surplus or improvement of the balance of payments. Examples of credit transactions include the export of goods, Þnancial assets, and foreign direct investment in the home country. The latter two examples are sometimes referred to as inßows of capital. Credits are also generated by income received for factor services rendered abroad, such as interest on foreign bonds, dividends on foreign equities, and receipts for US labor services rendered to foreigners, receipts of foreign aid, and cash remittances from abroad are credit transactions in

5This was a popular argument used to explain Japan’s current account surpluses with the US

1.2. NATIONAL ACCOUNTING RELATIONS

19

the balance of payments. Debit transactions arise whenever payment is made to agents that reside abroad. Debits contribute toward a deÞcit or worsening of the balance of payments.6

Subaccounts

The precise format of balance of payments subaccount reporting differs across countries. For the US, the main subaccounts of the balance of payments that you need to know are the current account, which records transactions involving goods, services, and unilateral transfers, the capital account, which records transactions involving real or Þnancial assets, and the o cial settlements balance, which records foreign exchange transactions undertaken by the central bank.

Credit transactions generate a supply of foreign currency and also a demand for US dollars because US residents involved in credit transactions require foreign currency payments to be converted into dollars. Similarly, debit transactions create a demand for foreign exchange and a supply of dollars. As a result, the combined deÞcits on the current account and the capital account can be thought of as the excess demand for foreign exchange by the private (non central bank) sector. This combined current and capital account balance is commonly called the balance of payments.

Under a system of pure ßoating exchange rates, the exchange rate is determined by equilibrium in the foreign exchange market. Excess demand for foreign exchange in this case is necessarily zero. It follows that it is not possible for a country to have a balance of payments problem under a regime of pure ßoating exchange rates because the balance of payments is always zero and the current account deÞcit always is equal to the capital account surplus.

When central banks intervene in the foreign exchange market either by buying or selling foreign currency, their actions, which are designed to prevent exchange rate adjustment, allow the balance of payments to be non zero. To prevent a depreciation of the home currency, a privately determined excess demand for foreign exchange can be satisÞed by sales of the central bank’s foreign exchange reserves. Alternatively,

6Note the unfortunate terminology: Capital inßows reduce net foreign asset holdings, while capital outßows increase net foreign asset holdings.