Relations Between the Balance of Payments and Other Macroeconomic Accounts

1. Relations Between the Balance of Payments and Other Macroeconomic Accounts Course on External Vulnerabilities and PoliciesTunis, March 2–13, 2009 Thorvaldur Gylfason

2. Outline • Monetary approach to balance of payments • Accounting relationships • Trace linkages among • Balance of payments accounts • National income accounts • Fiscal accounts • Monetary accounts • Proceed from linkages to financial programming • Numerical examples of financial programming • Flow of funds matrix • A little algebra

3. Remark • External adjustmentis more effective if it is framed in the context of a financial program agreed jointly with the authorities to ensure consistency among policies • In practice, a financial program is prepared using an accounting framework that summarizes all economic transactions and shows the interrelations among all sectors • Main objective of lecture Introduce the different pieces of the financial programming framework to illustrate the linkages and show how to build a single table focused on the financing side of the interrelations, i.e., theflow of funds

4. What is money? 1 • Liabilities of banking system to the public • That is, the private sector and public enterprises • M = C + T • C = currency, T = deposits • The broader the definition of deposits ... • Demand deposits, time and savings deposits, etc., • ... the broader the corresponding definition of money • M1, M2, M3, etc.

5. Overview of banking system

6. Balance sheet of Central Bank DG = domestic credit to government DB = domestic credit to commercial banks RC = foreign reserves in Central Bank C = currency B = commercial bank deposits in Central Bank

7. Balance sheet of Commercial Banks DP = domestic credit to private sector RB = foreign reserves in commercial banks B = commercial bank deposits in Central Bank DB = domestic credit from Central Bank to commercial banks T = time deposits

8. Adding up the two balance sheets R D DG + DP+DB +RB+RC + B = C + T + B + DB M Hence, M = D + R

9. Balance sheet of banking system Monetary Survey D = DG + DP = net domestic credit from banking system (net domestic assets) R = RC + RB = foreign reserves (net foreign assets) M = money supply

10. A fresh view of money The monetary survey implies the following new definition of money: M = D + R where M is broad money (M2), which equals narrow money (M1) + quasi-money • One of the most useful equations in economics • Money is, by definition, equal to the sum of domestic credit from the banking system (net domestic assets) and foreign exchange reserves in the banking system (net foreign assets)

11. An alternative derivation of monetary survey • Public sector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF Now, add them up

12. An alternative derivation of monetary survey • Public sector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF G – T + I – S + X – Z = 0, so left-hand sides sum to zero

13. An alternative derivation of monetary survey • Publicsector • G – T = B+ DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

14. An alternative derivation of monetary survey • Publicsector • G – T = B+ DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

15. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

16. An alternative derivation of monetary survey • Publicsector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF

17. An alternative derivation of monetary survey Hence, M = D + R • Publicsector • G – T = B + DG+ DF • Privatesector • I – S = DP- M - B • External sector • X – Z = R - DF So, adding them up, we get: 0 = D - M + R because DG + DP = D

18. Monetary approach to balance of payments The monetary survey (M = D + R) has three key implications: • Money is endogenous • If R increases, then M increases • Important in open economies • Domestic creditaffects money • If R increases, may want to reduce D to contain M • R = M - D • Here R = X – Z + F • Monetary approach to balance of payments

19. Monetary approach to balance of payments The monetary approach to the balance of payments (R = M - D) has the following implications: Need to • Forecast M • And then • Determine D • In order to • Meet target for R • D is determined as a residual given both M and R* • R* = reserve target, e.g., 3 months of imports Essence of financial programming

20. Monetary approach to balance of payments • Domestic credit is a policy variable that involves both monetaryand fiscal policy • Can reduce* domestic credit(D) • To private sector • To public sector • By reducing government spending • By increasing taxes • Monetary and fiscal policy are closely related through domestic credit *Or rather slow down

21. Linkages: Overview 2

22. Linkages Balance of payments DR = X – Z + F = X – Z + DDF

23. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF

24. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Fiscal accounts G – T = DB + DDG + DDF

25. Linkages National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

26. Linkages: Reserves National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

27. Linkages: Current account National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

28. Linkages: Foreign credit National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

29. Linkages: Credit to government National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

30. Linkages Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

31. Linkages: Bonds Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

32. Linkages: Money Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X–Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

33. Linkages: Private credit Private sector accounts I – S = DDP – DM – DB National accounts Y = E + X – Z Balance of payments DR = X – Z + F = X – Z + DDF Monetary accounts DM = DD + DR = DDG + DDP + DR Fiscal accounts G – T = DB + DDG + DDF

34. Further details • National accounts • Nonfinancial public sector • Monetary accounts • Balance of payments • Macroeconomic interrelations • Flow of funds matrix

35. National Accounts 1. Consumption C = Cg+Cp Public (general government) Cg Private Cp 2. Gross Investment I = Ig+Ip Public (fixed capital formation) Ig Private (includes changes in inventories) Ip 3. Absorption or domestic demand (1+2) A = C+I 4. Exports of goods and services X 5. Imports of goods and services Z 6. Gross Domestic Product (1+2+4–5) GDP = C + I + X – Z 7. Net factor income from abroad Yf 8. Gross National Product (6+7) GNP = GDP + Yf 9. Current transfers from abroad TRf 10. Gross National Disposable Income (8+9) GNDI = GNP + TRf 11.National Savings (10 – 1) Sn=(GNDI – C) Public Sg = (GDIg – Cg) Private Sp = (GDIp – Cp) 12. External Savings (1+2–10) Se= (C + I – GNDI)

36. Operations of the Nonfinancial Public Sector (NFPS) 1.Total Revenue and Grants RGg Revenue Rg Current CRg Tax revenue Nontax revenue Capital Grants 2.Total Expenditure and Net Lending GNLg Expenditure Gg Current CGg Wages and salaries Goods and services Interest Subsidies and other current transfers Capital CAPGg o/w: fixed capital formationIg Net Lending NLg Cg: government consumption 3. Overall Balance (1 - 2 ) OBg = RGg - GNLg 4. Financing (4.1 + 4.2 = – 3) Fg = NEFg + NDFg 4.1 External NEFg 4.2 Domestic NDFg = NDCg + NBg Bank NDCg Nonbank NBg

37. Monetary Accounts:From Accounting to Analytical Format Accounting Analytical ASSETS Foreign assets Domestic assets Credit to public sector Credit to other financial institutions Credit to private sector Other assets LIABILITIES Foreign liabilities Short term Medium and long term Deposits of public sector Private sector deposits Other liabilities Capital and reserves Net Foreign Assets (NIR, NFA) Net Domestic Assets (NDA) Net domestic credit (NDC) Credit to public sector (net) (NDCg) Credit (+) Deposits (-) Credit to other financial institutions Credit to private sector (DCp) Other assets net (OAN) Liabilities to private sector (MB, M1, M2, M3)

38. Monetary Accounts: Stocks Banking System 1. Net Foreign Assets NFA Central bank (NIR) Rest of banking system 2. Net Domestic Assets NDA Net Domestic Credit Net credit to the nonfinancial public sector Credit to the private sector Other Assets Net 3. Money Supply (monetary liabilities to private sector) = 1 + 2 (M3 = NFA + NDA) Central Bank 1. Net International Reserves NIR 2. Net Domestic Assets NDA Net Domestic Credit Net credit to the nonfinancial public sector Credit to the rest of the banking system Claims on private sector Other Assets Net 3. Monetary Base (monetary liabilities of CB) = 1 + 2 (MB = NIR + NDC)

39. Monetary Accounts:Annual flows at end-of-period exchange rate 1.Net Foreign AssetsNFA = NIR + NFAb Central Bank NIR Rest of banking system NFAb 2.Net Domestic Assets NDA = NDC + OAN Net domestic credit NDC = NDCg + DCp Nonfinancial public sector (net) NDCg Private sector DCp Other assets netOAN 3.Money and Quasi-money (M3) M3 Money (M1) Quasi-money Other liabilities ∆NFA + ∆NDA = ∆M3 (monetary liabilities) ∆NIR + ∆NDAMA = ∆MB (monetary liabilities)

40. Balance of Payments: Analytical Presentation 1. Current accountCAB A. Goods and services X – Z Goods (trade balance) Services B. Factor income Yf Of which: interest C. Current transfers TRf 2. Capital and financial account CFAB A. Capital account CA B. Financial account CF Direct investment (net) Portfolio investment (net) Public sector Private sector Banks Other investment (net) Public sector Private sector Banks 3. Overall balance (1 + 2 = 3 = – 4) CAB + CFAB 4. Reserves and exceptional financing –NIR + ExF

41. Macroeconomic Interrelations Balance of Payments Current account Exports of goods and services Imports of goods and services Net factor income Net current transfers Capital and financial account Capital account Financial account Direct investment Net foreign financing Nonfinancial public sector Nonfinancial private sector Banks Change in net international reserves National Accounts Consumption Public Private Gross domestic investment Public Private Exports of goods and services Imports of goods and services Gross Domestic Product Net factor income Net current transfers Gross National Disposable Income Operations of the NFPS Total revenue and grants Total expenditure and net lending Current expenditure Wages and salaries Goods and services Interest Capital expenditure o/w fixed capital formation Net lending Overall balance Financing External Domestic Banking Survey (flows) Net foreign assets Central bank Rest of banking system Net domestic assets Net domestic credit NFPS Private sector Other assets net Medium/long term foreign liabilities Money and quasi-money (M3)

42. Flow of Funds Matrix Format Sectors Transactions Nonfinancial (real) Financial: changes in financial assets and liabilities Internal NFPS Private Banks External Total Y = C + I + G + X - Z S – I Sg –Ig Sp –Ip 0 – CAB 0 Financing – Financing 0 Dom.Dom. Dom. Foreign Foreign Foreign Foreign – Foreign Total0 0 0 0 0

43. An alternative derivation of monetary survey: Recap, same story • Public sector • G – T = B + DG + DF • Privatesector • I – S = DP - M - B • Externalsector • X – Z = R - DF G – T + I – S + X – Z = 0, so left-hand sides sum to zero

44. Overview 1 • Presents real transactions and their financing • For each sector, shows the gap in all nonfinancial transactions (income – expenditure => gap = savings – investment = deficit/surplus) and how it is financed • Shows financing flows among different sectors • For the economy as a whole, shows how the savings–investment gap is financed by foreign sources

45. Overview 2 • The flow of funds matrix can be seen as the representation of the budget constraint faced by all sectors of the economy because it shows real transactions and how they are financed • The domestic economy is subject to the amount of resources the rest of the world is willing to provide: financing of the balance of payments • Excess of domestic demand (absorption) over supply  deficit in current account of the BOP GNDI – C – I = S – I = CAB • Deficit in the CAB must be financed by net capital inflows or drawdown of international reserves CAB + CFA = ΔNIR (i.e., X – Z + F = ΔR)

46. Overview 3 • Each sector of the economy has a budget constraint • The overall balance of the public sector must be equal to the change in its net financial assets • Excess of expenditure over revenues  deficit that must be financed either by increasing liabilities (domestic or foreign) or by reducing assets. RGg – GNLg = DIg – Cg – Ig = Sg – Ig = ΔNAFg • The private sector also has a budget constraint • If expenditures exceed revenues, it must either reduce assets or acquire more debt (domestic or foreign) Sp – Ip = ΔNAFp

47. Model 3 • Express accounting linkages in terms of simple algebra • Use model to describe how nominal income and reserves depend on domestic credit • Demonstrate how BOP target translates into prescription for fiscal and monetary policy • Financial programming in action

48. List of variables M = money D = domestic credit R = foreign reserves DR = R - R-1 = balance of payments P = price level Y = real income v = velocity X = real exports Px = price of exports Z = real imports Pz = price of imports F = capital inflow m = propensity to import Two behavioral parameters: m and v

49. List of relationships M = D + R (monetary survey) M = (1/v)PY (money demand) R = (1/v)PY – D (M schedule) DR = PxX – PzZ + F (balance of payments) PzZ = mPY (import demand) R = PxX – mPY + F + R-1 (B schedule) Estimate m and v by regression analysis

50. The M schedule Reserves (R) M schedule R = (1/v)PY – D PY = v(R + D) 1 An increase in reserves increases demand for money, and hence also income v D up PY is nominal income GNP (PY)