National Income and Product Accounts and the Current Account

1. National Income and Product Accounts and the Current Account Course Webpage: http://www.uwm.edu/~amurshid/finance.html Classes: Mon, Wed 11.00 am – 12.15 pm Office Hours: Wed 2.00 pm – 3.00 pm

2. 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

3. National Income Accounting: GDP and GNP • Gross domestic product is the value of all domestically-producedfinal goodsand services • Gross national product is the value of all final goods and services produced by domestically owned factors of production

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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?

11. 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 What’s Debt Got to Do With It?

12. 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?

13. 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

14. Definition of the Current Account: Trade Deficit + Net Factor Income • Current account = trade deficit + net factor income from abroad: CA = NX+ iNFA

15. 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

16. 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

17. Definition of the Current Account: Savings Gap • We can also right the current account as: CA = SN – I • Here SNis just total national savings, and I is domestic investment

18. 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

19. 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

20. 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.

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. How it Works? = Foreign Borrowing (Current Account Deficit) = 500 Investment Gov. Savings (budget surplus) = 1500 + An example of foreign borrowing would be say when Microsoft issues a bond, which is purchased by foreigners + Private Savings = 7000

29. How it Works? Foreign Borrowing (Current Account Deficit) = 500 Government Savings (budget surplus) = 1500 • In this example investment is greater than the sum of private savings and government savings • The shortfall is being made up by foreign borrowing • This shortfall is the current account deficit Private Savings = 7000

30. A Reduction in Government Savings Foreign Borrowing (Current Account Deficit) = 2200 Government Saving = -200 • Investment and private savings is unchanged however the government is now running a budget deficit • Part of private savings is been used to finance purchases of government bonds • The larger shortfall is being made up by foreign lending Private Savings = 7000 Without the increase in foreign investment in the US, the government deficit would cause private investment to contract (and interest rates to rise)

31. A Reduction in Private Savings Foreign Borrowing (Current Account Deficit) = 2500 • Keeping investment constant, we now assume that private savings falls • Again the shortfall is made up by a rise in foreign borrowing • Consequently the current account deficit rises Private Savings = 5000 Government Savings = 1500

32. A Rise in Investment Foreign Borrowing (Current Account Deficit) = 2500 • In this example investment rises, with no change in private or government savings • The result is again a sharper shortfall, which is made up by an increase in foreign borrowing and a rise in the current account deficit Government Savings = 1500 Private Savings = 7000

33. 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!

34. 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)

35. 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

36. 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

37. 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

38. US Current Account Deficit and Budget Deficit • Until about 1992 the current account deficit is highly correlated with the budget deficit Budget deficit Current account deficit

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. Crises • Current account deficits are not always sustainable • Lenders may stop lending abruptly • May lead to a financial crisis

49. 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)

50. 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