World Economy Management 321: Module 1c

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Review of Module 1b
§ The distinction between variable that are stocks & those that are flows
§ Main performance metrics: inflation; unemployment; economic growth
§ The relation between deficits and debt
Module 1c: Accounting for international transactions
n The Current Account
 What does the CA measure?
 Exports and Imports of what?
n The Capital (Financial) Account
 What does the FA measure?
 Exports and imports of what?
n How are they related to the rest of
the economy?
 The answer lies in your ability to manipulate the NIA identity!

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 Definitions: CA, FA
n Remember the NIA identity (Y = C + I + G + NX)
n CA ≡ “current account” ≡ NX = EX – IM = exports –
imports (Q: of what?)
n The terms ‘Current account’ & ‘Trade Balance’, & ‘Net
exports’ are used synonymously in the financial
press
q (technically, the trade balance refers only to goods, while
the CA refers to goods and services)
n A country that exports more than it imports has a
current account surplus (NX>0).
n Similarly, a country that exports less than it imports
has a current account deficit (NX<0)
n The Financial account (FA) measures trade in claims
to capital (while the CA measures trade in goods & services)
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 The Balance of Payments identity:
accounting for a country’s transactions w/the rest of the world

n CA + FA ≡ 0
q CA measures goods and services flows
q FA measures flows of claims to capital
q No free lunch!
n Y = C + I + G + NX (NIA identity)
n (Y - T - C) + (T - G) = I + NX (Note: T = ‘Taxes’)

n National Savings = Investment + Net Exports

Or, S – I = CA

n (I – S) ≡ the Financial Account

q - FA = CA, or CA + FA = 0

The Balance of Payments identity

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 Implications
n When National savings > Investment,
the country has a current account
surplus
q By definition! (S – I = CA)
n When National savings < Investment,
the country has a current account
deficit
q By definition
q Example, the U.S.

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 How is it possible for a country to *

run current account deficits?

n From the NIA identity, NX = Y- (C + I + G)
n So, if the CA < 0, Y- (C + I + G) < 0, i.e., we are
consuming more than we are producing as a
nation.
n How can we pay?
n There are only2 possibilities:
q selling some of our assets abroad, or
q borrowing from abroad
q
q
n * note: this question refers to a
country as a whole; it is not
referring to the government
accounts!

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 How are CA deficits financed?
n As we import money, we must export a claim
to capital
q For example, if we run a trade deficit with Japan,
it means that we are importing money from
Japan (or some other group of countries), or
the equivalent, exporting claims to capital –
Japanese (or the ROW)* become owners of
US bonds, real estate, stock, etc.
n The balance of payments identity then implies
that a country that runs a CA <0  FA>0
n If the FA > 0, it means that the nation is
exporting more claims to capital (title, or
promissory notes) than it is importing
n
 *Note: ROW = ‘rest of world’
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 Budget deficits, trade deficits, and
investment – are they related?

n (Y - T - C) + (T - G) = I + NX
n Private Saving + Government Saving = Investment +
Net Exports
n budget deficits occur when G>T  (T-G <0)
q When the federal government spends more than it
collects (G>T, termed “expansionary”), it engages in
deficit spending. To finance this spending, it must
borrow (issue/sell Treasury bills and/or bonds) in the
financial markets
n Thus, Government budget deficits lower national
savings
n In the absence of an increase in private savings,
either investment must fall or NX must fall

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 Suppose “we” (any economy) had an
investment boom
n (Y - T - C) + (T - G) = I + NX
n If the investment boom were notfinanced
domestically (through an increase in private
savings), the current account would
deteriorate (fall).
q This is an extremely counter-intuitive result
n Suppose the local economy looked strong,
and foreigners wanted to get a piece of the
action.
q The NIA accounts imply that the country will
move toward current account deficit -- a
situation most investors think signals a
worsening economic environment!

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 Take Aways
n The balance of payments identity
implies a relationship between
savings and investment flows and
goods and services flows
n CA + FA ≡ 0
q CA measures goods and services flows
q FA measures flows of claims to capital

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 Take Aways
n The NIA identity
q implies:
q The balance of payments identity, which
implies, it is not possible to
simultaneously run CA > 0 & FA >0!
q a relationship between government
budget deficit and CA deficit
q The balance of payments identity:
q describesa relationship between
cross-border savings and investment
flows and goods and services flows

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