National Income and
Product Accounts and the
Current Account
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Classes: Mon, Wed 11.00 am – 12.15 pm
Office Hours: Wed 2.00 pm – 3.00 pm
Today’s Agenda
National Income and Product Accounts
Definition of GDP
Definition of GNP
Net factor income from abroad
Current account
What causes large current account deficits?
Current account deficits and crises
The Asian and Latin American crises
National Income Accounting:
GDP and GNP
Gross domestic product is the value of
all domestically-produced final goods
and services
Gross national product is the value of
all final goods and services produced
by domestically owned factors of
production
Final Goods and Intermediate
Goods
What is a “final good”?
A good used for final consumption,
e.g. a loaf of bread that you consume
Intermediate goods are inputs in the
production process, e.g. steel used in
the manufacture of a car
Double Counting
Why are only “final goods and
services” counted?
Because otherwise you would count the
same good more than once
This is called double counting
How Do We Measure GDP?
There are three equivalent methods of
estimating GDP
Expenditure approach
Total expenditure on all final goods and services
produced
Income approach
Total income received by all factors of production
Output approach
Sum of value added at each stage of production
Components of GDP
Economists often split aggregate
expenditure into four components—
consumption (C), investment (I),
government spending (G), next
exports (NX)
Hence we can write GDP = C + I + G +
NX
What’s the Difference Between
GDP and GNP?
GDP is the value of all output produced @
home
GNP is the value of all output produced using
domestically-owned factors of production
Some output produced @ home is produced by foreigners
(this should not count in GNP)
Some output produced abroad is produced by domestically-
owned factors (this should count in GNP)
Hence GNP = GDP + net factor income from
abroad
How Big is the Difference?
For the US the difference is small (0.08%)
For Mexico (-4.9%) and Ireland the
difference is substantial (-10%)
The numbers in brackets are (GNP-GDP)/GDP
in 1987
Mexico has a large foreign debt on which it has
to pay interest to foreigners
Due to heavy foreign investment in Ireland,
many firms in Ireland are foreign owned
What’s Debt Got to Do With It?
In other words what has net factor
income got to with debt?
Net foreign assets (NFA) = US assets–
US debt
Define i as the average interest on
NFA
Then net factor income from abroad is
just iNFA
What’s Debt Got to Do With It?
Hence the difference between GDP
and GNP is proportional to NFA
If a country is a debtor nation NFA<0
If a country is a creditor nation NFA>0
The Trade Deficit and the
Current Account
What is a trade deficit?
A country runs a trade deficit when it
imports more than it exports, i.e. NX<0
Is the trade deficit synonymous with a
current account deficit?
No
The current account deficit measures a
country’s total (current-period) deficit to
the world?
What’s the Difference Between
the Two
What’s missing in the trade deficit?
Interest payments on your accumulated
debt
Alternatively if you are net creditor you
receive interest on your accumulated
assets
The current account balance essentially
measures your total (current-period)
deficit/surplus to the world
Definition of the Current Account:
Trade Deficit + Net Factor Income
Current account = trade deficit + net
factor income from abroad: CA = NX+
iNFA
Examples
A country may run a trade surplus but
still have a current account deficit
E.g. Brazil (1986)
CA = NX + iNFA = +$8.3bn – $13.6bn = -
$5.3bn
In 1986 Brazil had a large foreign debt
Definition of the Current
Account: Income - Expenditure
We can write the current account as:
CA = GNP – (C + I + G)
GNP is simply a country’s income
(C + I + G) (called “domestic absorption)
is simply what a country spends
So countries run CA deficits when they
spend more than they produce
Definition of the Current
Account: Savings Gap
We can also right the current account
as: CA = SN – I
Here SN is just total national savings, and
I is domestic investment
Definition of the Current
Account: Savings Gap
How do we derive this identity?
GNP = C + I + G +NX + iNFA
GNP-T+T = C + I + G + NX+ iNFA
[(GNP-T-C)+(T-G)] = I +CA
SN - I = CA
Note that (GNP-T-C) = private savings
(T-G) = government savings
Private savings + government savings = national
savings
Talking Points About the
Current Account
Why do countries run current account
deficits?
Are current account deficits
necessarily bad?
When do deficits become
unsustainable?
We will organize answers primarily by
considering US recent experience
The US Trade Deficit
“The United States recorded a $435.2 billion trade
deficit for 2002, the largest imbalance in history...
huge trade deficits represent the loss of millions of
manufacturing jobs as U.S. companies have been
battered by what the critics say is unfair competition
from low-wage countries that stifle labor rights and
have lax environmental protections…the
administration contends that it is pursuing the
correct procedure in trying to cut global trade deals
that will lower high [tariff] barriers in other countries
in a way that boosts American exports.” Source:
USA Today.
Thrust of the USA Today
Article
Current accounts are bad
Associated with job losses
Caused by tariff barriers and unfair
competition
Solution is freer trade and a level
playing field
Root Causes of the US Deficit
High tariff barriers and unfair
competition?
Is this what causes a current account
deficit?
Perhaps the removal of trade barriers
may mitigate the deficit, however the
underlying reasons for the deficit has to
do with consumption, investment and
savings patterns
Why Do Countries Run
Current Account Deficits?
To start with write down the different
definitions of the current account
CA = (X – M) + iNFA
CA = SN - I = SP + SG - I
CA = Y - (C + I + G)
Below we consider each in turn
A Role for Tariffs?
The current account is the trade deficit
plus net factor income from abroad
For the US net factor income is relatively
small
What causes trade imbalances
High tariff barriers abroad
Unfair practices and a level playing field
Solutions to the Deficit
Remove tariff barriers
Introduce similar production practices
But labor is cheap in some countries,
so will free trade work
Structural adjustment in the US
necessary in increasingly global world
Emphasis on Prices
The current administrations places
emphasis on the relative prices of
imports and exports
Several factors drive imports and
exports not just relative prices
US demand
Foreign demand
The Savings Gap
One way of thinking about the current
account is as the difference between
investment and (national) savings
If the US is investing more than it is saving,
these investments need to be financed by
foreign investors
If we think about the current account in this
way, it helps emphasize that a fall in
national savings or a rise in investment can
cause a current account deficit
How it Works?
Foreign Borrowing
Gov. Savings
(budget surplus) =
(Current Account
Deficit) = 500 = Investment
1500
+ An example of
foreign borrowing
would be say when
+
Private Savings Microsoft issues a
= 7000
bond, which is
purchased by
foreigners
How it Works?
Foreign Borrowing
Government (Current Account Deficit)
Savings (budget = 500
surplus) = 1500 In this example
investment is greater
than the sum of private
savings and
government savings
Private Savings
= 7000
The shortfall is being
made up by foreign
borrowing
This shortfall is the
current account deficit
A Reduction in Government
Savings
Foreign Borrowing
Government (Current Account Deficit)
Saving = -200 = 2200 Investment and private
savings is unchanged
however the
government is now
running a budget
deficit
Private Savings Part of private savings
= 7000 is been used to
finance purchases of
government bonds
The larger shortfall is
Without the increase in foreign investment in the
US, the government deficit would cause private
being made up by
investment to contract (and interest rates to rise)
foreign lending
A Reduction in Private Savings
Foreign Borrowing
(Current Account Deficit)
= 2500
Keeping investment
constant, we now
assume that private
savings falls
Private Savings
= 5000
Again the shortfall is
made up by a rise in
foreign borrowing
Consequently the
Government current account deficit
Savings = 1500
rises
A Rise in Investment
Foreign Borrowing
(Current Account Deficit)
= 2500 In this example
Government investment rises, with
Savings no change in private or
= 1500 government savings
The result is again a
Private Savings sharper shortfall,
= 7000 which is made up by
an increase in foreign
borrowing and a rise in
the current account
deficit
Is Investment Driving the US
Current Account Deficit?
Some have argued (e.g. William Poole
President of the Federal Reserve Bank
of St. Louis) that the US current
account deficit increased in the 90s
because of a rise in investment. This
may be true, but the latest US CA
figures surely cannot be attributed to
rising investment!
Current Account and Domestic
Absorption
Alternatively we can think about the
current account as the difference
between earnings and expenditures
This expenditure is referred to as
domestic absorption
CA = Y - (C + I + G)
Current Account and Domestic
Absorption
If we think about the current account in
this way, it helps emphasize that a
deficit is caused by either a rise in
consumption, a rise in government
spending, or a rise in investment
Two Ways of Saying the Same
Thing
A rise in consumption and government
spending of course corresponds to a fall in
national savings
Essentially then whether we think about the
CA as the savings-investment gap or as the
difference between income and domestic
absorption does not matter. Although one
approach emphasizes expenditures, while
the other approach emphasizes savings
behavior
So What Has Driven the US
Current Account Deficit?
Different things
The US started running current
account deficits in 1982
The cause was without a doubt a rise in
government spending and a fall in tax
revenues, that is a rise in the Federal
government budget deficit
US Current Account Deficit
and Budget Deficit
400
Budget deficit Until about
300
Current account deficit 1992 the
current
200
account
100
deficit is
highly
0 correlated
with the
-100 budget
deficit
-200
What Has Driven the Current
Account Deficit from 1992?
From about 1992 onwards, the US budget
deficit has declined but the current account
deficit has continued to rise
This trend can be explained by the sharp
rise in US investment
In addition to the rise in US investment a
spending binge by US consumers also
implied a sharp fall in national savings
Robust Climate for Investment
No More
The CA deficit in the 1990s can be attributed
largely to a robust climate for investment
and the immense US expansion
However in the last two years the budget
surplus has turned into a deficit, consumer
spending and investment are at depressed
levels, thus the driving force behind the CA
deficit are again Federal and local
government deficits
Is the Trade/Current Account
Deficit Bad?
The US Today article suggests that
current account deficits are bad, that
they are associated with a loss of jobs
and lower wages
In fact a deficit may or may not be a
bad thing
The Current Account and Jobs
First it is important to dispel a myth that the current
account deficit is somehow related to joblessness
During the 1990s, US services and also
manufacturing grew, as the economy went through
the longest period of expansion in history and
unemployment fell to its lowest levels
Often we find that current account deficits rise
during periods of expansion, its unclear therefore
what leads critics of the CA deficit to link it to
joblessness
When a Deficit Finances
Investment
Sometimes a deficit arises because of
rise in investment. Thus in the US a
robust climate for investment in the
90s caused the current account deficit
to increase
This should be viewed as a good thing,
since investment will contribute to
future growth
Tradable and Export Goods
When the investment is in the tradable
and export sectors, there is greater
justification for running a current
account deficit, since growth in these
sectors will eventually help narrow the
trade deficit
Sustainability
If increases in investment are inducing
a current account deficit, it should be
viewed as more sustainable
However some investments can turn
out to be bad and this can have
implications for the terms at which
foreigners are willing to lend to the
deficit country
Bad Investments
Not all investments are good investments
however
Some investments are just speculative and
fuel asset price bubbles. Other investments
are in non-tradables, which do not
necessarily help lower future deficits
The extent to which deficits finance bad
investments will depend on the extent of
development of the financial sector
Cheap Imports and Low
Inflation
Another often overlooked reason as to
why a deficit may not be a bad thing is
that an inflow of cheaper imports limits
inflation and allows manufacturers to
benefit from these cheaper imports by
keeping costs of production low
Crises
Current account deficits are not always
sustainable
Lenders may stop lending abruptly
May lead to a financial crisis
Recent Experience Asia 1997
In 1997 prior to the Asian crisis several Asian
countries ran large CA deficits
Many investments were in real estate
Real estate price bubble burst
Bankruptcy and bank failures
Many investments turned out to be non-profitable.
Government tried to always encourage investment
Not enough scrutiny by banks on who they were
lending too (moral hazard arising from government
loan guarantees)
Recent Experience Debt Crisis
and Mexico 1994/95
1970s many developing-country
governments borrowed to finance
spending
Then in 1982 US raised interest rates,
which triggered a debt crisis
Mexico 1995
Optimistic outlook caused C↑ and S↓
Unsustainable CA deficit and a crisis in
1994/95