International Finance: Theory and Policy
Chapter 2: National Income Accounting and the
Balance of Payments
A. Introduction
• International macroeconomics: studies how the interactions of national economies
influence the worldwide pattern of industrial activity
o Savings, inflations
• to get picture of these interactions --> statistical data:
o two (related) tools for economists:
▪ national income accounting
▪ BOP accounting (=balance of payment accounting)
B. National income identity
• 𝑁𝐼 ≡ 𝐺𝑁𝑃 : national income identity (in an open economy)
o National income should equal gross national product
National income accounts
• National income accounts record the value of national income that results from
production and expenditure
o national income is often defined to be the income earned by a nation’s factors of
production.
▪ Factors of production are essentially capital and labour (increasingly also
inflation
▪ .)
• we will analyse national income identity
o producers earn income from buyers who spend money on goods and services
o the amount of expenditure by buyers
▪ = the amount of income for sellers
▪ = the value of production
o Every euro spent by an economic agent ends up in the pockets of somebody else
and constitutes part of the income of that economic agent, this is why
expenditure equals income.
• Gross national product (GNP) is the value of all final goods and services produced
by a nation’s factors of production in a given time period.
o no intermediate goods (!); double counting → we only look at final goods and
services.
o factors of production = workers (labour services), physical capital (like buildings
and equipment), natural resources and others.
o the value of final goods and services produced by US-owned factors of
production are counted as US GNP
Chapter 2: National Income Accounting and the Balance of Payments 1
, o no used goods → used goods were already part of the GNP of a previous period
• GNP is calculated by adding the value of expenditure on final goods and services
produced:
o 1. Consumption: expenditure by domestic consumers
o 2. Investment: expenditure by firms on buildings & equipment
o 3. Government purchases: expenditure by governments on goods and services
o 4. Current account balance (exports minus imports): net expenditure by
foreigners on domestic goods and services
• Example US GNP: (you can see that they import more)
• National Income must equal National Product
o The identity is only correct if GNP is adjusted,
▪ depreciation (reduces income of capital owners)
• NI = GNP - depreciation = NNP
▪ unilateral transfers (gifts from/to foreigners)
• Suppose Belgium were to give €1000000 to Congo. This gift obviously
increases the national income of Congo, so the net transfer from Belgium
increases the NI of income. In Belgium our NI will decrease.
• NI = GNP - depreciation + net transfers
▪ sales taxes (example: VAT or the value added Tax)
• if you go to a shop and you buy a good for 100€ and you hand that over
to the shopkeeper, then the 100€ is an expenditure and will counted in
the GNP. The €100 expenditure is not in full the income for the
shopkeeper, he will have to transfer €21 (VAT= 21% for luxury goods) to
the government. So, his income is 100-21= €79.
• NI = GNP - depreciation + net transfers- indirect business taxes
• ! distinction of little importance for macroeconomic analysis! => two terms are used
interchangeably
• Difference between GNP and GDP
o GNP is value of all final goods and services produced by a country's factors of
production
o GDP is volume of production within a country's borders
o GNP = GDP - 'domestic' income earned by foreigners + 'foreign' income earned
by domestic residents
o GNP = GDP + net receipts of factor income from ROW (= rest of the world)
Chapter 2: National Income Accounting and the Balance of Payments 2
, o different criterion: ‘nationality’ vs. location
▪ Suppose there’s an all-American company based in Brussels; the value added
by this company based in Belgium will be part of Belgium’s GDP because
production happens within the borders of Belgium. However, the value added
by this company will be added to the GNP of the US, because the factors of
production (capital and labour) both happen to be American.
• When do you use GNP and when do you use GDP? → depends on your analysis:
o If you are interested in say the level of economic activity and the level of
unemployment that stems from that, then you use GDP (→ within the borders of
a nation).
o If you are interested in say the extent that a country repays its foreign debt,
then it doesn’t matter where the income is earned and then you should use GNP
(→ simply looks at the nationality of the factors of production).
C. Breaking down GDP
Eurozone
• Ex1: “Vive le shopping” (ci. 2000-04)
o Note: GDP growth rate
o We see that Germany’s GDP is lower than France’s.
o We can see a substantial growth of consumer and
government spending for France. Those two engines are
the domestic engines of economic growth.
o Germany however, we see a high change of the export of
Germany. The growth is entirely driven by foreign demand.
(makes you very vulnerable by what happens on the
international scene)
• The best type of growth for a country is where you have balanced growth. Each
contributing to economic activity in the country.
• Ex2: navy blues (ci. 2012-15)→contributions of economic growth in the euro-area
o “consumption has only grown relatively modestly, and investment scarcely at all,
in Germany and the rest of the core. Instead, core and periphery alike have
relied on international demand for their exports (see chart). Between 2011 and
2015 the euro area’s trade surplus rose from just 0.1% of euro-zone GDP to
3.7%.”
o “Europe’s addiction to exports leaves it vulnerable to any deceleration in
global growth. Were China’s economy to slow more sharply, or America’s to
return to recession, Europe, too, would see growth wane.”
Chapter 2: National Income Accounting and the Balance of Payments 3
,• Ex3: German consumer expenditures
o “After years of near-stagnation, private
consumption is growing at about 2 per cent — a
rate Germany has not seen since the dotcom boom of
the late 1990s.
o For economists, the shift is significant. Germany has
long relied on exports, which make up almost
40 per cent of GDP, to drive growth. The wage
restraint showed by German workers helped underpin
that by maintaining competitiveness. ...
o There are signs that model could be changing.
The slowdown in emerging markets has tamed
demand for German exports. As a result,
companies are investing less but German
domestic demand is kicking in and taking up the
slack, creating a more balanced economy.
o “The [economic] upswing we’re seeing now is
consumption-driven,” said Jörg Krämer, chief
economist at Commerzbank. “It’s a paradigm
shift in the German growth model.”
China
• China: 2007
o incredible growth rates ...
o ! - "China's economy is driven not by exports but by investment,
which accounts for over 40% of GDP".
o "since 2005, net exports have contributed more than 20%of
growth”
o contribution of household consumption lower than in West
o in short: unbalanced!
o Growth rates like these can be quite dangerous for later inflation
▪ Notice in 2007: export isn’t the only factor that helps with
economic growth. However, household consumption is lower than here in the
west.
• China: 2009 (Martin Wolf)
o "In the longer term, China needs to rebalance its economy, by increasing
consumption.”
o "It is important to understand how distorted China's economy now is: in 2007,
personal consumption was just 35 per cent of GDP. Meanwhile, China was
investing 11 per cent of GDP in low-yielding foreign assets, via its current
account surplus. Remember how poor hundreds of millions of Chinese still are.
Then consider that the net transfer of resources abroad [will be explained later! ;
lvh] was equal to a third of personal consumption”.
Chapter 2: National Income Accounting and the Balance of Payments 4
,• China: 2010 (again) (Martin Wolf)
o Michael Pettis of Peking University’s Guanghua School of
Management: Chinese growth is .. ‘unbalanced’, ...: it
is highly dependent on investment as a source of
demand and driver of supply (see charts). It is, in a
sense, the most ‘capitalist’ economy ever.
o Thus, between 1997 and 2009, gross investment rose
from 32 per cent to 46 per cent of GDP, while household
consumption fell from 45 per cent of GDP to a mere 36
per cent. This must be the lowest share of
consumption in any significant economy ever. In a
country with hundreds of millions of poor people, it is even shocking
• China: 2012
o China took one step forward over the past year in rebalancing its economy
towards a more sustainable growth model. ...
o Building on a trend that began last year, consumption was a bigger
contributor than investment to growth in the first three quarters of this
year [2012; lvh], a crucial shift for an economy which has long been excessively
reliant on investment”
• China: 2013
o China “has a highly unbalanced economy whose most
striking feature is the extraordinarily low share of
consumption, public and private, and extraordinarily high
share of investment (both close to half of GDP). Until last
year, in which there was a small reversal, the rise in the
investment share had been rapid”
o “At present, private consumption is about 35 per cent of
GDP, roughly half the share in the US.”
• China: 2016
o China exported $1.65tn of goods and services in the first
three quarters of 2016, a 7.2 per cent fall from the same
period a year before. During the same period the country’s
ratio of exports to gross domestic product fell to just
20.2 per cent, compared with a 2006 per cent peak of
38.6 per cent, according to FT calculations.
o Its export intensity is now a fraction above that of India,
[...]
o Mark Williams, chief Asia economist at Capital Economics,
..., added: “It’s not so much that China has done so much
worse than other parts of the world, but its GDP has
grown very fast so its share of exports to GDP has gone down a lot.”[...]
China’s government has been attempting to reorient the country away from
export-led growth and towards domestic consumption.
Chapter 2: National Income Accounting and the Balance of Payments 5
,United states of America
• US: 2007-2009: period before vs after financial crisis
o For decades, ... growth has been led by consumer
spending. Thanks to rising asset prices and ever easier
access to credit, Americans went on a seemingly
unstoppable spending binge, .... Consumer spending
and residential investment rose from 67% of GDP in
1980 to 75% in 2007 (see chart). The household saving
rate fell from 10% of disposable income in 1980 to close to
zero in 2007; ..."
o "Americans now save more than 5% of their after-tax
income, still well below the post-war average but hugely
up from only a year ago. ... The collapse in consumption has dramatically
changed the composition of America's economy. A huge increase in
private saving has been offset by a leap in the budget deficit"
• US: 2017: history is repeating itself
o “Gross domestic product grew an annualised 2.6 per cent in the final quarter of
2017, .... Consumers were the key driver of growth in the period, lifting their
spending 3.8 per cent.”
o “Among the drags on growth were inventories and trade; imports climbed at
double the rate of exports. But personal consumption grew 3.8 per cent in the
quarter, the quickest pace since mid-2016, while fixed investment advanced 7.9
per cent. The report also showed an uptick in government spending, which
climbed 3 per cent.”
D. Financial implications of running a CA deficit
• Case that we use is the US.
National income accounting for an open economy
• national income identity for closed economy
o 𝑁𝐼 = 𝐺𝑁𝑃
o 𝑌 = 𝐶 + 𝐼 + 𝐺
▪ In a closed economy the national income must be generated domestically.
Household consumption, investment and government spending are of a
domestic nature.
• national income identity for open economy → there is trade.
o 𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝐸𝑋 − 𝐼𝑀)
o Y = sales to domestic residents + sales to foreign residents
▪ 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴
• CA = current account balance
• C + I + G = expenditure by domestic individuals and institutions
• CA = Net expenditure by foreign individuals and institutions
Chapter 2: National Income Accounting and the Balance of Payments 6
,Current account and Foreign Indebtedness
• current account (balance) is important concept
o ∆ 𝐶𝐴 => ∆ 𝑌 => ∆ 𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡
o The current account measures the size and directions of international borrowing.
▪ 𝐶𝐴 = 𝑌 − (𝐶 + 𝐼 + 𝐺) = 𝑛𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 𝑜𝑓 𝑟𝑒𝑠𝑖𝑑𝑒𝑛𝑡𝑠
o CA deficit: (the left side of the equation above is negative, that means the right
side also has to be negative)
▪ buys more from foreigners than it sells to them; country uses more output
than it produces (spending > income) deficit financed by borrowing abroad
→ foreign indebtedness increases.
▪ A country that runs a CA deficit borrows from the rest of the world.
▪ 𝐶𝐴 = ∆ 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑤𝑒𝑎𝑙𝑡ℎ
• The current accounts measures the change of the foreign wealth of a
country.
• Ex1: US current account and Net International investment position 1976-2015
o ever since the early 1980’s, the US has been running a deficit current account
every year.
o In 1991, there is an exception. This improvement of the CA balance was due to
Saudi-Arabia financially compensating the US for part of the military expenditure
during the Gulf War.
o A country that runs a CA deficit sees a deterioration of its net international
investment position or of its foreign wealth. (red line)
▪ The net foreign wealth gives you:
• The claims that the US has on TRW
• The claims that TRW has on the US
▪ Net foreign wealth is the difference between money that TRW owes to the US
and what the US owes to TRW.
o In the second half the 1970’s the red line was above zero, which means that
TRW owed more money to the US than vice versa. In the early 1980’s you can
see that once the US started running a current accounts deficit its net foreign
wealth was negative, and it continues to go down. (now they owe more to TRW
than vice versa). The US went from being a net creditor to a net debtor.
Chapter 2: National Income Accounting and the Balance of Payments 7
, o Note: if the current accounts balance slightly improves or stabilizes like for
example early 2000’s, that does not mean that the net foreign wealth improves.
We are still talking about a deficit which worsens the foreign wealth. Only with
an international surplus will you be able to pay back your international debt.
o The US is the world’s biggest debtor:
▪ “at the end of 2012, the United States had a negative net foreign wealth
position far greater than that of any other country”
▪ It was USD -3,863.9 billion. That number is so large because the economy of
the US is also large. But in relative terms only 25% of GDP
▪ US trade deficit with China: The difference between the imports and exports
with china is quite high. The trade balance with China has been negative since
the 1980’s.
E. CA deficit and foreign debt: a qualification
• We saw that as soon as the US started running an account deficit, its net
international investment position went down. However, if you look at the figure on
p7, it’s not always the case. For example, look circa 1997 or 2008, their current
balance account was more negative than the year before, but we see a small change
positive change in net foreign wealth.
• Ex1: “Last year [=2004; lvh], America had a current-account deficit of $668
billion. In effect, it had to borrow this amount from the rest of the world. However,
the new numbers, published last week by the government's Bureau of Economic
Analysis, show that America's net external liabilities rose by only $170 billion
in 2004, to $2.5 trillion. The mystery goes deeper. Since the end of 2001, America's
cumulative current-account deficit has amounted to $1.7 trillion, yet America's net
external liabilities have increased by only $200 billion, and have fallen as a
percentage of GDP (see chart). What's going on?”
o The net foreign investment position is the difference between claims that TRW
owes to the US and what the US owes to TRW. You have to put a market value
on all the assets that are put into account. The market value of bonds and equity
can fluctuate. → valuation effect
Chapter 2: National Income Accounting and the Balance of Payments 8
,Valuation effect
𝑈𝑆 𝑛𝑒𝑡 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑤𝑒𝑎𝑙𝑡ℎ = 𝑈𝑆_𝑜𝑤𝑛𝑒𝑑 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 – 𝑓𝑜𝑟𝑒𝑖𝑔𝑛_𝑜𝑤𝑛𝑒𝑑 𝑈𝑆 𝑎𝑠𝑠𝑒𝑡𝑠
o The net foreign investment position is the difference between claims that TRW
owes to the US and what the US owes to TRW.
Example:
𝑈𝑆 𝑛𝑒𝑡 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑤𝑒𝑎𝑙𝑡ℎ (↑↑) = 𝑈𝑆_𝑜𝑤𝑛𝑒𝑑 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 (↑⋮↑↑)– 𝑓𝑜𝑟𝑒𝑖𝑔𝑛_𝑜𝑤𝑛𝑒𝑑 𝑈𝑆 𝑎𝑠𝑠𝑒𝑡𝑠 (=⋮↑)
• American portfolio = US-owned foreign assets
o mostly in foreign currencies => decline of USD lifts value of overseas
investments.
▪ The value of these foreign owned assets in dollars will be affected by the
exchange rate. A period when the dollar weakens, this will actually increase
the value of the overseas investments of the US. When the value of those
assets is converted in dollars, you will get more dollars for your Euros. (these
are the arrows)
o riskier assets => ROR >7% over 2002-2004 (=rate of return)
▪ high risk means higher compensation, when the stock market does well it
pushes up the value of the American portfolio adds another positive valuation
effect.
• Foreign portfolio = foreign-owned US assets
o mostly in dollars => not affected by ER
▪ whenever the exchange rate of the dollar fluctuates, the value of this portfolio
is hardly affected.
o low risk assets => ROR only 3.4%. (for example, government bonds)
▪ foreign investments are central banks and are risk averse and invest mostly in
short term government bonds. The lower rate of returns still pushes up the
value of the foreign portfolio when the stock market does well, but not as well
as riskier ROR assets.
• In period when the dollar weakens (↑ 𝑎𝑛𝑑 =) ; you have valuations effects that push
up the value of US net foreign wealth ↑
• In a period where the stock markets are doing well (↑↑ 𝑎𝑛𝑑 ↑) , which means riskier
assets pay off, you have valuations effect that push up the value of the US net
foreign wealth ↑
• In a period where the stock markets are doing less well, the ROR on riskier portfolio
will be lower. In a period when the dollar strengthens, the valuation effects will go in
the opposite direction.
US Balance of payments accounts (cont.)
• About 70% of foreign assets held by the U.S. are denominated in foreign currencies
and almost all of U.S. liabilities (debt) are denominated in dollars.
• Changes in the exchange rate influence value of net foreign wealth (gross foreign
assets minus gross foreign liabilities).
o Appreciation of the value of foreign currencies makes foreign assets held by the
U.S. more valuable, but does not change the dollar value of dollar-denominated
debt for the U.S.
Chapter 2: National Income Accounting and the Balance of Payments 9
, F. Global imbalances
• The US is not the only country that has been running a current accounts deficit. It’s
also important to note that countries like the US run a CA deficit because other
countries choose to run a CA surplus. This is the very essence of trade imbalances;
some countries import more than they export and vice versa.
• 2008:
o CA surplus:
▪ Oil exporters, in 2008 oil prices were very high.
▪ China
▪ Germany
▪ Japan
o CA deficit:
▪ US, note however that the deficit was manageable at the time it was only -
4.6% of the GDP.
▪ Spain → -10%
▪ Greece → largest relative CA deficit (% of GDP) -14%
▪ Portugal → -12%
o This was all prior to the Euro crisis, so you can already see some red flags for
some countries which means it could’ve been predicted.
• 2014:
o Between 2006 and 2014, the CA deficits halved in importance. It was still a
threat to stability. They had to borrow less but they still had to borrow.
• 2015:
o You can see the importance of the imbalances have
gone down.
o You can see that Europe in 2013 has become a
current account surplus. They clearly changed
compared to 2008.
Chapter 2: National Income Accounting and the Balance of Payments 10
