GLOBAL BUSINESS ENVIRONMENT: MACROECONOMICS



THE GLOBAL BUSINESS ENVIRONMENT: INTERNATIONAL MACROECONOMICS AND FINANCE

Professor Diamond Class Notes: 1

INTRODUCTION AND MEASURING ECONOMIC PERFORMANCE IN THE GLOBAL ECONOMY

NOMINAL VS. REAL VALUES

Virtually all prices of goods and services in our economy are measured in terms of current (nominal) market values. At a given moment of time this enables a comparison of prices of competing goods as well as a summation of different types of goods and services.

However, when we need to compare the value of key macroeconomic variables over time we need to convert the nominal data into real values in order to eliminate the impact of inflation. Nominal values are measured in current dollars not adjusted for inflation. Real values are measured in constant dollars adjusted for inflation.

To convert nominal data to real values we utilize a price index. A price index (deflator) is a measure of the average level of prices of a specified set of goods and services relative to their prices in a given base period.

THE CONSUMER PRICE INDEX AND THE PRODUCER PRICE INDEX

The most utilized measure of inflation is the Consumer Price Index (CPI). It measures the cost of living for urban households. The CPI is published monthly by the U.S. Department of Labor’s Bureau of Labor Statistics (BLS). It provides information for the nation as a whole and the major metropolitan areas. Utilizing sampling techniques, data is collected for major categories of goods and services e.g. energy, housing, food, medical services, etc. Since the 1973 OPEC oil boycott the BLS also computes a core rate CPI. The core rate is the total for all items minus the volatile areas of energy and food.

The Producer Price Index (PPI) measures the changes in prices at the producer’s (wholesale) level. Data is published monthly for finished, intermediate and raw material goods. Like the CPI, the BLS also provides a core rate PPI. The base periods for the two indices are roughly the same: CPI 1982-84 = 100 and PPI 1982 = 100. However, the CPI registers a higher rate of inflation than the PPI. For example, at the end of 1999 the CPI was 168.3 vs. 135.0 for the PPI. The principle reason for the difference is that the PPI does not include the cost of services, which has been a major source of the rise in consumer prices. It is interesting to note that the PPI, for which we have fairly reliable data back to the U.S. colonial period, shows no increase in trend values from the late 1700’s to 1940. During these 150 years periods of inflation were offset by periods of deflation due to a boom and bust business cycle. Since 1940, however, the PPI and the CPI trend values have been rising.

THE GDP DEFLATOR AND THE CHAIN WEIGHTED GDP PRICE INDEX

Gross Domestic Product (GDP) is usually expressed in real terms. Unless indicated to the contrary, GDP is stated in real terms in these class notes. Real GDP is derived by dividing nominal (dollar) GDP by the GDP deflator, which is often referred to as the Implicit GDP Deflator. Real GDP is a measure of the physical volume of an economy’s production.

Both the CPI and PPI are fixed weight price indices. Each month the BLS collects the current prices of a fixed list or market basket of goods and services. The index is calculated by dividing the current cost of the items by their cost in the base period.

The GDP deflator until 1995 was determined utilizing a variable weight index. In any given year the GDP deflator is defined as the value of the final goods and services in a given base year prices. However, the rapid introduction of a new products in recent years e.g. computers, VCRs and cell phones made the use of the fixed base year increasingly irrelevant. To deal with this problem in 1995 the U.S. Department of Commerce, Bureau of Economic Analysis which publishes GDP and other national product and income data began to utilize a chain-weighted price index. This index uses a moving base year, which is always the year prior to the current year.

Although the variable and particularly the chain-weighted indices are conceptually more accurate than the fixed weighted indices, empirical data indicates that neither is clearly superior. When the prices of different goods are changing by different amounts a fixed weighted index tends to overstate the cost of living since it fails to take into account that consumers can substitute less expensive goods. Conversely, under these conditions the variable weighted indices tend to understate the increase in the cost of living since although it allows for the substitution of alternate goods it fails to reflect the reduction comparison of the original GDP deflator and the new chain weighted GDP price index also indicates that there is no significant difference between the two measures.

THE NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA)

The NIPA is the official U.S. government accounting system that collects and publishes data on the nation’s output of goods and services. Gross Domestic Product (GDP) is the total expenditure on domestically produced goods and services. It is also the total income earned domestically form both U.S. and foreign owned factors of production.

The National Income Accounts Identity is the equation showing that the sum of consumption, investment, government purchases and net exports equals GDP. These data are published by the U.S. Department of Commerce’s Bureau of Economic Analysis.

Thus, if we let Y = GDP

Y = C+I+G+NX

where Y = Gross Domestic Product expressed in real terms

C = Consumption

I = Investment

G = Government Spending

NX = Net exports of goods and services

A statement of the National Income Identity which includes NX is referred to as an open economy. It is an economy that sells goods and services to other nations, buys imports form them and has significant financial flows to and from foreign nations. A closed economy is a nation that has little or no trade in goods, services or financial (capital) flows with other countries. The United States was viewed as essentially a closed economy for most of its history despite the fact we have always been a coastal nation with a sizable foreign trade. However, as late as the immediate post-World War II decades of the 1940’s and 1950’international trade accounted for only about 5 percent of GDP, exchange rates were fixed and financial flows to and from other nations were restricted. This is no longer the case. Changing geopolitical, economic and technology factors have increasingly transformed the U.S. into a more open economy. Imports now constitute 13 percent of GDP. The exchange rate of the dollar has been floated since 1973 and international financial flows are massive. No longer can U.S. macroeconomic policies be viewed solely in terms of their impact on the domestic economy. The Federal Reserve, for example, in determining its monetary policies must take into account the impact of interest rate changes on both the domestic and international economies. U.S. inflation in the 1970’s was primarily a function of the policies of the international oil cartel, OPEC. The impact of sizable U.S. government budget deficits in the 1980-1995 period on private domestic investment was eased by substantial capital flows from abroad. The 1997-98 Asian financial crises impacted the U.S. positively by substantially reducing the price of imports while at the same time threatening the prolonged prosperity of the 1990’s. Moreover, some economists regard the persistent and growing U.S. trade deficit as one of the major problems facing the U.S. economy. It should be noted that no major or minor economy in the world today is totally open or closed. In the case of the U.S., which is increasingly an open economy and a champion of free trade, it still retains some tariffs and import quotas as well as restrictions on the flow of foreign labor.

Despite the open economy status of the U.S., for analytical and modeling purposes we still find it useful to use the closed economy expression of the national income identity for analytical purposes. Let us restate the national income identity in terms of a closed economy i.e. no net exports:

Y = C+I+G

We can also observe that the income generated by GDP can be allocated as follows:

Y = C+S+T

where Y = Gross National Income

C = Consumption

S = Saving (that portion of income which is not allocated to consumption or taxes)

T = Taxes

Setting the two equations equal yields:

C+I+G = C+S+T

If we cancel C from both sides then:

I+G = S+T

And I = S+ (T-G)

Investment is equal to savings where S is private saving and T-G (taxes minus government purchases) is government or public saving. As we shall discover the equality of saving and investment is critically important to our understanding of long and short run equilibrium in our economy.

We can also observe that saving equals investment by rearranging our expenditure expressions of GDP in the closed economy:

Y = C+I+G

Recognizing that all government expenditures are viewed in the NIPA as consumption spending then:

Y-C-G = I

where Y-C-G is the value of the output that remains after the needs of consumers and government have been met, and thus is national saving or simple saving. As we have noted earlier national saving is comprised of private (personal and business) saving and government (public) saving.

A further simplification of the national income identity is to eliminate the government sector (G and T) in the national income identity, then:

Y = C+I and

Y = C+S

Equating total national spending with total national income:

C+I = C+S

and once again S = I

We will find this form of the identity useful in developing our models of economic growth.

NATURAL GDP

Before leaving the subject of the NIPA we need to introduce the concept of the natural level of GDP. It is the level of national output/income towards which ht economy gravitates in the long run. It is the level of GDP which results from the full utilization of the available factors of production in a given time period. It is also sometimes referred to as the full employment GDP or the non-accelerating inflation rate of unemployment (NAIRU) GDP. We let [pic] equal natural GDP. As a result of economic growth [pic]changes over time.

THE OPEN ECONOMY

Let us return to the open economy expression of the national income identity and examine it in more detail.

We begin by observing that some output is sold domestically and some abroad, thus:

Y = [pic]

where [pic]are consumption, investment and government spending on domestic goods and services and EX is foreign spending on domestic goods and services.

Furthermore:

C = [pic]

I =[pic]

G = [pic]

Where total consumption, investment and government expenditures are respectively the sums of domestic and foreign purchases of goods and services, we can substitute this into the open economy equation as follows:

Y = [pic]

Rearranging we find:

Y = C+I+G+EX-[pic]

We observe that [pic]is expenditures on imports (IM) and thus the national income identity is now:

Y = C+I+G+EX-IM

and if we let (EX-IM) equal net exports (NX) we arrive at:

Y = C+I+G+NX

This statement of the national income identity states that expenditures on domestic output is the sum of consumption, investments, governments purchases and net exports, and:

NX = Y-(C+I+G)

Net exports equals output minus domestic spending on domestic and foreign goods and investments. If output exceeds domestic spending, net exports are positive and the nation has a trade surplus. If output is less than domestic spending, net exports are negative and the nation ahs a trade deficit. Now we again express the national income identity in terms of saving and investment.

Since Y = C+I+G+NX

Then Y-C-G = I-NX

And since Y-C-G is national saving S, then:

S = I+NX or

S-I = NX

Furthermore, as in the case of the closed economy, we can divide national saving into private and public saving by setting the national income identity equal to the alternative ways hat national income may be allocated:

C+I+G+NX = C+S+T

Eliminating C from both sides of the equation yields:

I+G+NX = S+T

Combining government purchases and taxes we arrive at:

I+NX = S+(T-G)

when S is private saving and the difference between taxes and government spending is public saving. If tax revenues exceed government expenditures, a surplus is generated and there is positive public saving. If taxes are less than government spending there is a budget deficit and negative public saving. Rewriting the equation:

S+(T-G)-I = NX

where private plus public saving (national saving) minus domestic investment equals net exports.

As in the closed economy model the relationship between saving and investment is important S-I is net foreign investment. It is the excess of domestic saving over domestic investment. It is equal to the amount that domestic residents are lending abroad minus the amount that foreigners are lending to the domestic economy. NX is the trade balance. It can be positive and the nation has a trade surplus or negative and the nation has a trade deficit. As we shall discern the positive or negative nature of the trade account largely determines the nature of the current account in the balance of payments.

Net foreign investment always equals the trade balance. Any nation that generates a trade deficit must cover this difference by being a net borrower in world financial markets. Nations that experience a trade surplus are net lenders to the rest of the world. Thus, this form of the national income identity shows that the international flow of goods and services (trade) and the international flow of funds to finance capital accumulations are two sides of the same equation. If a nation’s investments exceeds its saving, the extra investment funds must be secured by borrowing from abroad. These funds are necessary so that the trade deficit nation can cover the difference between the value of its imports and exports. Conversely, if a nation’s saving exceeds its investments, the saving that is not invested domestically is lent to foreigners so that they can pay for the difference between the value of their imports and exports.

Note that the international flow of capital can take a variety of forms. For example, a trade deficit nation like the U.S. can borrow abroad by selling bonds issued by the U.S. government or private corporations. Alternatively it can take the form of a direct investment when a foreign corporation constructs a plant or other physical facilities in the U.S. It can also take the form of foreign purchases of existing U.S. capital stock such as factories, office buildings, hotels, and recreational properties such as golf courses. In all of the above, foreigners end up with either a claim to the future returns to domestic capital or ownership of a portion of the domestic capital stock. The net foreign investment of the domestic economy is reduced. Moreover, if a domestic economy like the U.S. experiences sizeable trade deficits over an extended period of time foreign claims on its capital stock may grow to a level where foreign lenders are no longer willing to purchase additional claims at the current interest rate level, or in reaction to a negative shock to either their own economy or that of the deficit nation may decide to cash in a sizeable proportion of their claims. This could cause serious financial and economic problems for the borrowing (debtor) nation.

THE LONG AND SHORT RUN: ECONOMIC GROWTH, BUSINESS CYCLE, UNEMPLOYMENT AND INFLATION

We have already used the term “long run” in our discussion of GDP. The distinction between the long and short run is critical to the understanding of macroeconomic theory. It is also important to make this distinction in analyzing macroeconomic problems. The long run is an extended time period usually lasting at least a decade thus allowing for significant changes in key economic variables. The short run is a limited time period where there is insufficient time for economic variables to fully adjust to changes.

Most macroeconomic theories can be divided into long run and short run theories. The former focuses on economic growth and the latter on economic stability - the business cycle. Moreover long run theories postulate prices to be flexible and thus respond to changes in supply and demand. In contrast short run theories view most prices as sticky at some predetermined level.

Classic economic theory focuses on the long run. In so doing it has developed the concept of the classical dichotomy. This concept enables economists to simplify economic theory by ignoring nominal variables and concentrate on real variables. For example, in discussing economic growth we can ignore changes in the money supply since they do not influence real variables. In contrast, neo-Keynesian theories focus on the short run. A frequently quoted Keynesian observation is – why worry about the long run since we will all be dead.

It should also be noted that the impact of a given economic factor may vary in the long vs. the short run. For example, a high national saving rate is a most positive element promoting economic growth. However, a high saving rate during the contraction phase of a business cycle can be a significant negative force in preventing an economy from returning to prosperity.

ECONOMIC GROWTH

As indicated economic growth theories focus on the long run. They seek to explain why some countries grow while others do not. At the same time economic growth is reported in a short run context. The U.S. Department of Commerce Bureau of Economic Analysis publishes annual rates of changes in real GDP as well as quarterly data expressed as an annual rate.

In the long run context the measurement of economic growth needs to take population growth into account. The goal of economic growth is to increase the standard of living for all individuals. For example, if a nation during a 25 year period were to double both the size of its population and its annual real GDP, it would have experienced significant growth in the total output of goods and services. However, the average citizen’s level of living would be unchanged. Thus, the appropriate measure of long-term economic growth is real GDP divided by the size of the population - per capita GDP.

Table 1.1 shows GDP per capita for OECD member countries. OECD is the Organization for Economic Cooperation and Development. Its members are the nations with the largesse economies and highest standards of living. You will note GDP per capita is presented on two bases. One utilizes the current (nominal) exchange rate and the other the purchasing power parity exchange rate. We will distinguish between the two measures when we discuss exchange rates later on in the course. We will also want to explore the major economic models utilized to explain economic growth.

BUSINESS CYCLES

Business cycles are a short run phenomenon. Since the onset of the industrial revolution many nations, including the United States, have experienced sustained and substantial economic growth. At the same time, long-term growth has not been smooth. Periodically increases in GDP have been interrupted by swings in the level of economics activity -business cycles. Business cycles are economy wide fluctuations in output, income and employment characterized by alternating waves of expansion and contraction occurring in a familiar but irregular manner. Prior to World War II U.S. business cycles often manifested four distinct phases – recovery, prosperity, crisis and depression. The crisis phase was caused by a severe shock to the economy, such as a financial panic or a stock market crash. Since 1945 the business cycles has been moderated to exhibit only two phases prosperity and recession. A recession is commonly described as two consecutive quarters of negative GDP. The definition of a recession, recognized by the U.S. government, is the one utilized by the National Bureau of Economic Research: a period of decline in total output, income, employment, and trade usually lasting from six months to a year and marked by widespread contraction in many sectors of the economy.

Given what we have observed concerning the theoretical differences between the classical and Keynesian schools of thought, it is not surprising to learn they have differing views of the business cycle. Classical theorists advocate real business cycle theory. They postulate that the origin of the business cycles lies in real changes in the economy such as new production techniques or products (technology), bad weather conditions, new sources of raw materials or real change in government expenditures. Furthermore, consistent with their long run perspective of the flexibility of prices and wages they believe the economy will rapidly adjust to the real shocks and return to the natural level of GDP. There is no need for government intervention (stabilization policies). Indeed, in virtually all instances government stabilization policies do more harm than good. In contrast Keynesians believe that nominal variables, particularly changes in the money supply play a major role by influencing the demand for goods and services. Given their view that prices and wages are sticky in the short run they theorize that when shocks destabilize the economy it may take some time before GDP returns to its natural (full employment) equilibrium. Accordingly they advocate the government should intervene with appropriate stabilization policies to smooth out the business cycles. A substantial majority of U.S. economists agree with the Keynesian school. We will explore these subjects in some detail.

BUSINESS CYCLE INDICATORS

Not surprisingly the Great Depression of 1929-33 sparked considerable research as to the possible causes and cures of the business cycle. This was clearly one of the stimuli leading to Keynes’ publication of the General Theory of Employment, Interest and Money. The leading students of the business cycles were Wesley Mitchell, Arthur Burns and others at the National Bureau of Economic Research (NBER). They studied literally hundreds of business and economic statistical series. These series have been classified as to direction and timing. Those that move in the same direction as aggregate economic activity (GDP) such as consumption, industrial production and employment are termed pro-cyclical. Those that move in the opposite direction are counter-cyclical e.g. unemployment and bankruptcies. Still others appear to be insensitive to business cycles and are termed acyclical such as real interest rates. Timing refers to when the turning points (peaks, troughs) of a statistical series occur relative to the turning points of the business cycles. Here we can identify three classes of business cycle indicators – “leading” which tend to turn in advance of aggregate economic activity; “coincident” whose peaks and troughs occur at about the same time as those of the business cycles’ and “lagging” whose turning points tend to occur after those of the business cycle.

Since the business cycle, particularly in its recession phase importantly impacts all segments of the economy, any advance information would be most helpful. Accordingly economic forecasting has become an important activity particularly in business and government sectors. Of the many statistical series used to forecast business conditions, the Index of Leading Indicators is one of the most important. This Index along with the companion Leading and Lagging Indexes is published monthly by The Conference Board, a leading not for profit business research and service organization.

Based on the work of the NBER the Index of Leading Economic Indicators is composed of 10 variables, such as average weekly initial claims for unemployment insurance, contracts and orders for plant and equipment in real dollars, the index of stock prices and the index of consumer expectations. Each of the components of the leading indicators has a tendency to predict (lead) economic activity and are frequently and promptly available. This latter characteristic is essential if the index is to be available in a timely manner. On the whole the index is a valuable forecasting device, correctly predicting a large majority of business cycle turning points since World War II. However, it is by no means perfect. Like all measures of economic activity it has its limitations.

UNEMPLOYMENT

During the expansion and contraction phases of the business cycle there are changes in key economic variables. The most important are GDP, unemployment and inflation. We have already discussed GDP. Let us now examine unemployment and inflation.

To understand unemployment we begin with some basic definitions. The labor force is the number of persons 16 years of age or over who are either working or unemployed. For analytical purposes we usually exclude those in the armed forces. Unemployment is the number of persons in the labor force who are jobless and actively seeking work. The natural rate of unemployment [pic] is the rate of unemployment toward which the economy gravitates in the long run. It is the unemployment rate accompanying natural GDP, [pic].

The major components of natural unemployment are frictional, structural, seasonal and wait unemployment. Frictional unemployment occurs as workers move from job to job in the search for suitable employment and as firms seek suitable employees. Structural unemployment results from an imbalance between the skill, training, education and location of workers and the requirements of available jobs. Seasonal unemployment is due to the seasonal character of some work situations caused by weather conditions and the customs of the society such as major national holidays or vacation periods. Wait unemployment is due to inefficiency in the job market due to factors such as wage rigidity, job rationing and insufficient information about job opportunities.

Empirically the natural rate of unemployment for any given year can be estimated by averaging all unemployment rates for 10 years later. Changes in one or more of the types of unemployment that comprise U can cause the natural rate to change. As figure 6-1 indicates for the U.S. the natural rate was below 5% from the end of World War II until the mid 1960’s. Thereafter it rose to 6% by the mid 1970’s and remained generally at that level until the mid 1990’s. During the latter half of the 1990’s, it has been estimated to have fallen to between 5.5 and 5%. Some of the possible reasons for these changes include:

1. The changing composition of the labor force – large numbers of teenagers (baby boomers) entering and women returning to the work force.

2. The increase in female labor force participation – which has increased the number of two-income families apparently causing the unemployment rate of men to rise.

3. Sectoral shifts in the economy such as the OPEC oil shock which forced workers to relocate from more energy intensive to less energy intensive industries.

OKUN’S LAW

During the contraction phases of the business cycle (recession or depression) the nation’s unemployment rate may rise substantially. The difference the between the total unemployment rate and the natural rate (cyclical unemployment) and the change in the annual growth rate of GDP is described by Okun’s Law.

Arthur Okun, an economics professor at Yale, was asked in 1961 by President Kennedy’s Council of Economic Advisors (CEA) to serve as a consultant. The CEA wanted to convince the President, Congress and the public that a reduction of the current unemployed rate of almost 7% in 1961 to 4% would yield economy-wide benefits. Okun was asked to estimate the gains of GDP associated in the unemployment reduction. The answer became known as Okun’s Law.

The law describes the relationship between cyclical unemployment and GDP. For each percentage point that the cyclical unemployment rate was above the natural rate, Okun found the GDP was 3% below natural GDP (Y). The percentage departure of actual GDP from [pic]is called the GDP gap. Current calculations estimate that for every percentage point of unemployment above natural unemployment there is a loss of 2% in GDP. Another way of expressing Okun’s law is to say that a decrease in cyclical unemployment of 1% is associated with additional growth in GDP of approximately 2%/

More formally Okun’s Law may be expressed as:

[pic]

The equation states the percentage growth rate of GDP [pic]is equal to the percentage growth rate of natural GDP minus two times the change in cyclical unemployment (U). For example, assuming that natural GDP grows by 3% annually, public policy that reduced unemployment from 7% to 6% during a recession would result in increasing GDP by 5%.

Figure 1.1 entitled “The U.S. Job Machine” shows unemployment rates and year-to-year changes (increases and decreases) in non-farm payrolls from 1976 to 1998. Note that the 6% unemployment level as shown by the dark horizontal line drawn at the 6% unemployment rate. In the period 1978 to the mid 1990’s the unemployment rate was generally at or above the 6% level. Significant cyclical unemployment (above 6%) occurred during the 1981-82 and 1990-91 recessions and the immediate years following these contractions. Since 1994 to 2000 there has been a steady decline in the unemployment rate to below the 4% level. These are the lowest levels of unemployment in some 40 years. It is one of the remarkable signs of the longest and most robust expansion in U.S. business cycle history.

INFLATION

As we have observed it is important in macroeconomic analysis to take account of changes in the price level. This is certainly the case in studying the business cycle. In pre World War II U.S. business cycles the economy experienced both inflation and deflation. With the advent of the moderate business cycles since 1945 we have had to deal only with inflation.

Figure 1.2 entitled “Waging War on Inflation” depicts the annual rate of inflation as measured by the CPI from 1960 to 1998. Observe that for the first half of the 1960’s the inflation rate was below 2%. This was also the case in the 1945-1960 period. However, in the latter half of the1960’s the inflation rate began to rise due largely to increased deficit financing associated with the Vietnam conflict. By 1969 the inflation rate had risen to 6%. At his point a recession occurred due primarily to the negative effect of rising prices on the economy and the efforts of our central bank, the Federal Reserve, to slow down the inflation rate. Note that recession periods are shown by the shaded areas on the chart. Observe that the 1980 and 1990-91 recessions were also preceded by a rise in the inflation rate. The exception was the 1981-82 recession which was induced by the Federal Reserve to disinflate the economy i.e. wring out the inflation that had occurred in the 1970’s and early 1980’s due to the OPEC oil price increases. During the 1982-85 disinflation period the U.S. inflation rate dropped substantially. The modest rise in the price level during the last half of the 1980’s was eliminated in the 1990-91 recession. Since that time and particularly in the 1995-2000 period U.S. inflation has been quite low with the national rate returning to the levels of the immediate post World War II decades.

THE PHILLIPS CURVE

Based on the longitudinal studies of a New Zealand economist A.W. Phillips, who observed a predictable trade-off between inflation and unemployment, most economists accepted the principal known as the Phillips Curve. It showed that as a nation tried to reduce its unemployment rate below the natural level a negative relationship arose between the unemployment rate and inflation – as the unemployment rate fell the inflation rate would rise. The Phillips Curve accurately described the U.S. economy of the 1960’s. However, with the onset of the OPEC induced inflation of the 1970’s the empirical evidence deviated from the expected Phillips Curve configuration. This discrepancy continued in the 1980’s and 1990’s. Indeed another remarkable aspect of the 1990’s expansion is that the U.S. economy experienced lower unemployment accompanied by lower rates of inflation. See Figure 1.3. Furthermore, the Phillips Curve was attacked on theoretical grounds because it studied money wages rather than real wages. While the Phillips Curve is largely discredited, the notion that a nation’s annual GDP growth rate with its accompanying unemployment rate cannot long exceed its natural growth rate without generating sizeable increases in its inflation rate still prevails.

THE BALANCE OF PAYMENTS, THE CURRENT AND CAPITAL ACCOUNTS

AND THE TRADE DEFICIT

THE BALANCE OF PAYMENTS ACCOUNTS

Previously, we derived and examined the open economy expression of the national income accounts identity. We now want to extend our understanding of the links between the domestic and international economies.

The balance of payments accounts is a summary record of all transactions in goods, services and financial assets during a given time period between a country’s residents and residents of the rest of the country. It records the sources (receipts) and use (payments) of funds for a country’s external transactions. It is a flow of funds statement that shows changes in national assets, liabilities and net worth over time. The sources of funds are exports, investment income, transfer payments received and long term and short term borrowing abroad. The use of funds are imports, investment income paid abroad, transfer payments abroad, long term and short term lending and investments abroad and increases in official reserve assets.

Balance of payments accounts utilize a double entry accounting system. Any accounting transaction giving rise to a receipt from the rest of the world or which increases net claims on foreigners is recorded as a credit. Conversely, any transaction giving rise to a payment to the rest of the world or which increases net indebtedness to foreigners is recorded as a debit. There is always an equality between credits and debits.

THE CURRENT ACCOUNT

The balance of payments is divided into two major accounts – the current account and the capital account.

The current account includes four major categories – merchandise, services, income on investments and unilateral transfer. The difference between a nation’s merchandise exports and imports is called the merchandise trade balance. Since the mid 1970’s it has been in deficit. Services include a variety of non material transactions such as the billeting of U.S. troops abroad, transportation, tourism, financial and legal services, educational services consulting and the like. It is one of the rare components of the balance of payments which is currently in a surplus mode. However, its net positive balance is insufficient to offset the negative merchandise trade balance. Thus the U.S. balance on goods (merchandise) and services, the trade balance, has registered a deficit for some 25 years. As we noted earlier this is NX in the national income identity.

Income on investments records receipts from assets abroad, such as interest, dividends, profits and royalties. They are offset by payments to foreigners for the use by the domestic economy of their financial and capital assets. As we shall see until recently this account has generated a net surplus. However, the accumulation by foreigners of U.S. financial and capital assets for some 25 years has finally transformed this portion of the current account into a deficit mode.

Unilateral transfers are payments made from on country to another that do not involve the purchase of any goods, services or assets. Examples include government grants for foreign aid or relief assistance, pensions paid to citizens living abroad and immigrant remittances to family members in their former country. Net unilateral transfers for the U.S. have consistently been negative due to sizeable immigration throughout the nation’s history.

The sum of the above four major components yields the current account balance. For the 30 years between 1970 and 2000, with the exception of the early 1970’s and the recessions of the first half of the 1980’s and 1990-91, it has been in deficit mode. During this time period, it was dominated by the trade account which except for two years in the early 1970’s, registered deficits. In such a case, for analytical purposes, the current account (CA) may replace net exports (NX) in the national income identity:

NX = Y – (C+G+I)

and since NX = CA

then CA = Y – (C+G+I)

If a nation’s output/income exceeds its consumption expenditures on domestic and foreign goods and services, investments and government spending then it generates a current account surplus. If, however, the sum of its consumption, investment and government expenditures is greater than its output a current account deficit results.

In this context note that it is possible for a country to have a trade surplus and a current account deficit. This occurs when a nation has accumulated a large foreign debt and the servicing of this debt results in a sizeable deficit in the income of the investment account. This deficit may exceed the trade account surplus yielding a current account deficit. This was the case in Brazil in the 1980’s who experienced a large current account deficit

THE CAPITAL ACCOUNT

The capital account records trade between countries in existing assets either real or financial. When the home country sells an asset to another country the transaction is registered as a capital inflow for the home country and thus as a credit item in the capital account. When the home country buys an asset from abroad the transaction is a capital outflow from the home country. The capital accounts balance equals the value of capital inflows minus the value of capital outflows. When the residents of the home country purchase more assets from abroad than they sell to foreigners the capital accounts balance is said to be in deficit (negative). The converse is true if more assets are sold abroad than purchased from foreigners. Since the U.S. current account is in deficit and the sum of the current and capital accounts must be zero, the U.S. capital account must be on net in surplus (positive). The summing of the actual numbers in the current and capital accounts do not equal zero due to statistical discrepancies – errors and omissions in reporting a country’s transactions with the rest of the world. This is corrected by including a statistical discrepancy figure in the balance of payments accounts. This may often be a substantial sum.

Note that in the capital account the flow of private and government (official) assets are separated. Indeed, in some cases changes in government assets are placed in a separate official international reserve account. This account records changes in a nation’s reserve assets, which include gold convertible currencies of major industrial nations (hard currency), and special assets created by the International Monetary Fund (IMF). These reserve assets can be used to make international payments. Increases in U.S. reserve assets are recorded as debits in the capital account and decreases as credits. The official settlement balance is the net increase in a country’s official reserve asset.

During our class discussion of this topic we will have the opportunity to examine the latest annual summary and analysis I of the U.S. Balance of Payments. We will want to pay particular attention to the growth in the trade balance and current account deficits particularly as a percentage of GDP.

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