BGIE Review: Balance of Payments Fiscal Policy

1. Ted Berk James Ratcliffe January 28-29, 2001 BGIE Review: Balance of PaymentsFiscal Policy

2. Introduction • Who we are: • Ted Berk (OD), eberk@mba2001.hbs.edu, 868-8577 • James Ratcliffe (OC), jratcliffe@mba2001.hbs.edu, 492-2974 • What these reviews are for: • Focus on the basic tools • i.e. what you need to know for BGIE as it’s taught at HBS • Geared towards people who feel like they aren’t “getting it” • NOT for folks with macroeconomics courses in their past • NOT for debating the arcane details of macroeconomic theory • Slides are on the web at: www.mba2001.hbs.edu/jratcliffe/bgie.html

3. Agenda • Last time: • BGIE math (CAGRs, real vs. nominal) • National income and product accounting • Today’s agenda • Balance of payments accounting • Fiscal policy overview • Future sessions: • Exchange rates • Monetary policy / interest rates

4. Balance of payments accounting • Why does it matter? • Balance of payments provides critical data for diagnosing a country’s economic relationships with the rest of the world • Analogous to using national income and product accounts for diagnosing the domestic situation • What does it tell you? • Quantifies international transactions, i.e. transactions between the residents of one country and the rest of the world, including: • Goods and services • Income and dividends • Investments (assets and liabilities) • Doesn’t necessarily tell you “good” or “bad” but rather provides information you can use as a basis for policy recommendations • Examples: • The U.S. has run an increasingly large trade deficit for quite some time. Good or bad? • The U.S. has borrowed significantly from foreign investors. Good or bad?

5. Principles of BoP statements • The balance of payments is essentially an accounting statement that captures a country’s international transactions • Like with NIPA, the minutiae of how the statements are created are less important than interpreting them • Transactions are divided into 2 broad categories • Current account: transactions in goods and services • Capital account: transactions in financial assets • Financial transactions by government institutions (especially the central bank) are broken out separately as “reserves” • The balance of payments always adds to 0. “+” = sources of foreign exchange, “–” = uses of foreign exchange • As accounting necessarily involves some error and estimation, the plug in the BoP is called “errors and omissions” Current account + Capital account + Errors and omissions + Δ in reserves = 0

6. Current account Exports are a source of foreign exchange and therefore a “+” in the BoP, and vice versa for imports Includes dividends and interest on securities, and income on direct investment (i.e. overseas assets that are owned and controlled by domestic residents) Includes foreign aid programs, military aid, etc.

7. Capital account Includes foreign direct investment, purchases of foreign securities Capital account Always equal to the opposite of the overall balance, therefore a “+” change in reserves is actually a USE of foreign exchange (a decrease in reserves)

8. BoP examples Where do the following transactions show up in the balance of payments? • Toyota builds a new plant in the US… …and finances by raising debt from US investors. …and finances by selling its holdings of US securities. …and pays with a fleet of new cars. • U.S. government sends much-needed humanitarian aid to Canada… …and finances by selling them a bunch of computers. …and finances with a new issue of Treasury bills sold to foreigners. …and finances from its cash reserves.

9. BoP issues to think about • When faced with a balance of payments statement (or any other BGIE exhibit, for that matter), look for big or sudden changes in the numbers • What might explain / what are the implications of: • current account deficits • shift from capital inflows to capital outflows • large changes in reserves • high errors and omissions • shift from long-term to short-term capital flows

10. Fiscal policy overview • What is it? • Fiscal policy includes all government programs that impact national output either directly or indirectly, such as: • Government purchases and investment (G) • Taxes (Ta) • Transfer payments (Tr) • Why should I care? • Keynes says you should. It seems to matter for the economic health of the country. • A hotly debated issue among policymakers, as this is one of the critical ways the government tries to influence economic activity • e.g. 2000 debates in U.S. election over tax cuts, military spending, welfare, education…

11. Keynes’s theories • Key concept: aggregate demand (AD) • The total demand for goods and services in the economy • Assumes that if people want more stuff, and can pay for it, then more will be produced. • Pre-Keynes view: if AD slows, then prices will fall, and AD will pick up again • This assumes flexible prices, but in the real world, prices tend to be “sticky” and adjust slowly. • Keynes’s view: when AD slows, a vicious circle can ensue. • Consumer spending is down  sales are down  businesses slow production and don’t invest  people earn less  consumer spending is down. • If prices don’t adjust (i.e. they are “sticky”), then the cycle will not turn up again. • This was his explanation for the Great Depression. • OK, so what do we do about it?

12. The income multiplier • Key tool is the income multiplier effect • If the government puts $100 in the pockets of consumers, output increases by more than $100 • as the first recipient spends the money she causes a secondary effect, which in turn drives a tertiary effect, etc. • otherwise, it’s just moving money from one bucket into another, with no net gain • Leakages: imports, taxes, savings… so the entire $100 does not go towards boosting national output • i.e. anything that prevents this new income from being spent on domestically-produced stuff • Overall effect of income multiplier is 1 / ( 1 – Marginal Propensity to Consume ) • The multiplier means that government action can actually have an effect on the economy – you get more bang for your buck • Government can also slow the economy by taking money out of consumers’ pockets, i.e. the multiplier works the same way with contractionary policies.

13. Questions?