# Chapter 1: The balance of payments: an account of transactions with the rest of the world

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1 Chapter 1: The balance of payments: an account of transactions with the rest of the world 1. National income accounting for an open economy The nation income identity for an open economy The GDP of an open economy is therefore the sum of domestic and foreign expenditure on the goods and services produced by domestic factors of production. Thus, the macroeconomic identity for an open economy is: GDP = Y = C + I + EX IM (1-1) with, C, consumption, I, investment, EX, exports and IM, imports. The Current Account of balance of payments is defined as: CAB = EX IM + NY + NTC (1-2) with EX, exports of goods and services, IM, imports of goods and services, NY, net income received from the Rest of the World and NTC, net current transfers. For the moment, we ignore such incomes and transfers to simplify the discussion. When a country s imports exceed its exports, we say the country has a current account deficit. A country has a current account surplus when its exports exceed its imports. In addition to net exports of goods and services, the current account balance includes net income received from the Rest of the World (NY) and net current transfers. National Account defines GNDY as follows: GNDY = C + S (1-3) GNDY = GDP + NY + NCT (1-4) The linkages between National Accounts and Balance of Payments appear in the following equality: GNDY = GDP + NY + NCT C + S = C + I + EX IM + NY + NCT (S I) = CAB (1-5) However, we know that: (S I) + KAB = CAB + KAB = NLB where NLB is net lending (+) or borrowing (-) of the total economy. It is equal but of opposite sign to net borrowing (-) or lending (+) of the rest of the world. So, finally: (S I) + KAB = NLB (1-6) -1-

2 Table 1: Relation between Gross Domestic Product (GDP), Gross National Income and Gross National Disposable Income (GNY) Gross Domestic Product (GDP) + Compensation of employees receivable from the rest of the world - Compensation of employees payable to the rest of the world + Property income receivable from the rest of the world - Property income payable to the rest of the world + Subsidies receivable from the rest of the world - Current taxes payable to the rest of the world Gross National Income 1 (GNI) + current transfers 2 receivable from the rest of the world - current transfers payable to the rest of the world Gross National Disposable Income (GNDY) - consumption of fixed capital at constant prices Net National Disposable income (NNDI) 1 Gross national income (GNI) represents total primary income receivable by resident institutional units. GNI (at market price) is conceptually identical with gross national product (GNP) (at market prices). 2 Current transfers include: current taxes on income, wealth etc., social contributions, social benefits and other current transfers Private and government saving We define net tax revenue T as the difference between receipts of public authorities (federal, state, or local governments + Social Security (the National Health Service)) less government transfer payments: T = taxes + social security contributions social transfers subsidies. Private saving, denoted S P, can therefore be expressed as: S P = Y T C (1-7) Government saving is defined similarly to private saving. The government s income is its net tax revenue, T, while its consumption is government purchases, G. In fact, we define net tax revenue T as the difference between receipts of public authorities (federal, state, or local governments + Social Security (the National Health Service)) less government transfer payments: T = taxes + social security contributions social transfers subsidies. If we let S g stand for government saving, then: S g = T G (1-8) Private and government saving add up to national saving. Recall that the definition of national saving, S, as Y C G, then: S = Y C G = (Y T C) + (T G) = S P + S g (1-9) Because S = S P + S g = I + CA, then: S P = I + CA S g = I + CAB (T G) = I + CAB + (G T) (1-10) -2-

3 2. Balance of payments accounts Examples of paired transactions 1- Purchase of a mobile phone to the Swedish company Ericsson paid with a 1,000 check paid. Ericsson s salesperson deposits your check in Ericsson account at Société Générale in Paris. Current Account Import of goods Mobile phone purchase - 1,000 Financial Account France asset export Sale of bank deposit by Société Générale + 1, During a travel in Russia, you pay 100 for a diner in a Restaurant in Moscow. You place the charge on your credit card. Current account German import of services Meal purchase German asset export Sale of claim on the company issuing your credit card You buy a newly issued share of stock in the U.K. company British Petroleum (BP) and you pay with a check of 95 drown on your bank account. BP, in turn, deposits the 95 check on its own German bank account at Deutsche Bank. German asset import Your purchase of a share of BP - 95 German asset export BP s deposit payment at the Deutsche Bank French banks forgive 5,000 in debt owed to them by the government of the imaginary country of Sylvania. Capital account France transfer payment France banks debt forgiveness - 5,000 French asset export Reduction in banks claims on Sylvania + 5,000-3-

4 2.2. Detailed presentation of the balance of payments Table 2: Euro area balance of payments for 2009 (billions of euros) Credits Debits Balance Credits Debits Balance 1. Current account Goods 1, , , , Services Income Current transfers Capital account Net lending (+) or borrowing (-) of the total economy (1 + 2) , Direct investment -189, From the euro area abroad From abroad toward the euro area Portfolio investment From the euro area abroad From abroad toward the euro area Financial derivatives Other investment Reserve assets Base balance ( ) Net errors and omissions (opposite of ) (Source: ECB, Table 3: Euro Area international investment position end of 2007 (billions of euros) Assets Liabilities Balance Assets Liabilities Balance TOTAL 13,907 15,157-1,250 13,312 14,950-1,638 (% of GDP) Direct Investment 3,573 3, ,744 3, Portfolio Investment 4,632 6,557-1,925 3,764 6,079-2,315 Financial Derivatives Other investment 5,381 5, ,466 5, Reserve assets (Source: ECB, Table 4: United States international investment position end of 2007 (billions of dollars) Assets Liabilities Balance Assets Liabilities Balance TOTAL -2,140-3,469 (% of GDP) Direct Investment 3,451 2,450 1,001 3,699 2,647 1,052 Portfolio Investment 6,835 9,370-2,535 4,244 8,817-4,573 Financial Derivatives Other investment 5,156 6, ,027 5, Reserve assets (Source: Bureau of Economic Analysis (BEA), -4-

5 Table 5: United States balance of payments for 2009 (billions of dollars) Credits Debits Balance Credits Debits Balance 1. Current account Goods 1, , , , Services Income Current transfers Capital account Net lending (+) or borrowing (-) of the total economy (1 + 2) Direct investment From the United States abroad From abroad toward the United States Portfolio investment From the United States abroad From abroad toward the United States Financial derivatives n.a Other investment Reserve assets Base balance ( ) 4. Net errors and omissions (opposite of ) (Source: Bureau of Economic Analysis (BEA), Table 6: China balance of payments for 2008 (billions of dollars) 2008 Credits Debits Balance 1. Current account Goods 1,435-1, Services Income Current transfers Capital account 3 Net lending (+) or borrowing (-) of the total economy (1 + 2) Direct investment 94 From China abroad -54 From abroad toward China Portfolio investment 43 From China abroad 33 From abroad toward China Other investment -121 Base balance ( ) Reserve assets Net errors and omissions (opposite of ) -26 (Source: State Administration of Foreign Exchange (SAFE), -5-

6 Figure 1-1: Elasticity of World Trade to World Income by Decade Figure 1-2: Net International Investment Position of the United States at Yearend,

7 Figure 1-3: Global imbalances (Source: World Economic Outlook, IMF, October 2009) -7-

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