Key elements of Monetary Policy

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1 Key elements of Monetary Policy Part II Economic Policy Course for Civil Society June 2004 World Bank Institute

2 Structure of the Presentation Introduction Current account Balance of Payments Debt

3 Current account The national income accounts and the balance of payments accounts are essential tools for studying the macroeconomics of open, interdependent economies. National income accounting Records all the expenditures that contribute to a country s income and output Balance of payments accounting Helps us keep track of both changes in a country s indebtedness to foreigners and the fortunes of its export- and import-competing industries

National income accounting Records all the expenditures that contribute to a country s income and output

4 Current account The National Income Identity for an Open Economy It is the sum of domestic and foreign expenditure on the goods and services produced by domestic factors of production: Y = C + I + G + EX IM where: Y is GNP C is consumption I is investment G is government purchases EX is exports IM is imports In a closed economy, EX = IM = 0.

factors of production: Y = C + I + G + EX IM where: Y is GNP C is consumption I is

5 Current account 2 Current account (CA) balance The difference between exports of goods and services and imports of goods and services (CA = EX IM) A country has a CA surplus when its CA > 0. A country has a CA deficit when its CA < 0. CA measures the size and direction of international borrowing. A country s current account balance equals the change in its net foreign wealth.

> 0. A country has a CA deficit when its CA < 0.

6 Current account 3 CA balance is equal to the difference between national income and domestic residents spending: Y (C+ I + G) = CA CA balance is goods production less domestic demand. CA balance is the excess supply of domestic financing. Example: Uganda imports 20 tons of meat and exports only 10 tons of meat. The current account deficit of 10 tons is the value of Uganda s borrowing from foreigners, which the country will have to repay in the future.

CA balance is the excess supply of domestic financing.

7 Current account 4 Saving and the Current Account National saving (S) The portion of output, Y, that is not devoted to household consumption, C, or government purchases, G. It always equals investment in a closed economy. A closed economy can save only by building up its capital stock (S = I). An open economy can save either by building up its capital stock or by acquiring foreign wealth (S = I + CA). A country s CA surplus is referred to as its net foreign investment.

A closed economy can save only by building up its capital stock (S = I).

8 Current account 5 Private and Government Saving Private saving (S p ) The part of disposable income that is saved rather than consumed S p = I + CA S g = I + CA (T G) = I + CA + (G T) (12-2) T is the government's income (its net tax revenue) S g is government savings (T-G) Government budget deficit (G T) It measures the extent to which the government is borrowing to finance its expenditures.

T is the government's income (its net tax revenue) S g is government savings (T-G) Government

9 Balance of Payments A country s balance of payments accounts keep track of both its payments to and its receipts from foreigners. Every international transaction automatically enters the balance of payments twice: once as a credit (+) and once as a debit (-). Three types of transactions: Exports or imports of goods or services Purchases or sales of financial assets Transfers of wealth between countries They are recorded in the capital account.

Every international transaction automatically enters the balance of payments twice: once as a credit (+) and

10 Balance of Payments 2 The Fundamental Balance of Payments Identity: Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity: Current account + financial account + capital account = 0

offsetting entries in the balance of payments resulting in a

11 Balance of Payments 3 The balance of payments accounts divide exports and imports into three categories: Merchandise trade Exports or imports of goods Services Payments for legal assistance, tourists expenditures, and shipping fees Income International interest and dividend payments and the earnings of domestically owned firms operating abroad

legal assistance, tourists expenditures, and shipping fees Income International

12 The Balance of Payments Accounts The Capital Account It records asset transfers The Financial Account It measures the difference between sales of assets to foreigners and purchases of assets located abroad.

Account It measures the difference between sales of

13 The Balance of Payments Accounts 2 All transactions between a country and the rest of the world are recorded in its balance of payments accounts. The current account equals the country s net lending to foreigners. National saving equals domestic investment plus the current account. Transactions involving goods and services appear in the current account of the balance of payments, while international sales or purchases of assets appear in the financial account.

National saving equals domestic investment plus the current account.

14 The Balance of Payments Accounts 3 Official Reserve Transactions Central bank The institution responsible for managing the supply of money Official international reserves Foreign assets held by central banks as a cushion against national economic misfortune Official foreign exchange intervention Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies.

cushion against national economic misfortune Official foreign exchange intervention Central banks often buy

15 The Balance of Payments Accounts 4 Any current account deficit must be matched by an equal surplus in the other two accounts of the balance of payments, and any current account surplus by a deficit somewhere else. The official settlement balance is the sum of the current account balance, the capital account balance, the non reserve portion of the financial account balance, and the statistical discrepancy. A country with a negative balance of payments may signal that it is running down its international reserve assets or incurring debts to foreign monetary authorities International asset transactions carried out by central banks are included in the financial account

The official settlement balance is the sum of the current account balance, the capital account balance, the non reserve portion of the financial account balance, and

16 National Debt When a government spends more than it collects in taxes, it borrows money to finance the budget deficit. Two different forms of borrowing: Non-market debt (compulsory requirements on banks) Market debt Non-market borrowing is highly inefficient, insofar: Restricts financial development Reduces saving and investment (quasi-fiscal nature) Induces an inefficient use of financial savings Market borrowing crowds out private activity, as it: Reinforces credit rationing, and/or Puts an upward pressure upon interest rates

inefficient, insofar: Restricts financial development Reduces saving and investment (quasi-fiscal nature) Induces an inefficient use

17 External Debt Borrowing abroad is vital for growth when domestic savings is insufficient to finance domestic investment. Risks: Accumulation of debt, to be serviced and repaid Vulnerability to external shocks (interest rate shocks, exchange rate shocks), and particularly so the larger is short-term debt Concessionality is a key factor in the contribution of external debt to efficiency. In effect, it: Provides more room for spending May promote better policies Can prevent fungibility when appropriately designed

shocks), and particularly so the larger is short-term debt Concessionality is a key factor in the contribution of external debt

18 Conclusion

MGEC61 International Economics: Finance

MGEC61 International Economics: Finance Introduction International finance is a study of problems and policies of an open economy. International finance studies the issues like unemployment, savings, trade