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The Balance of Payment The Balance of Payment

National Income Account and BOP n Y = C + I + G + National Income Account and BOP n Y = C + I + G + CA n n Y = GDP C = consumption G = government spending CA = current account balance This is called National Income Identity

Current Account n CA = X – M = net export of goods and Current Account n CA = X – M = net export of goods and services X = export; M = import n n Strictly speaking CA = X – M +UT but, for a while, we ignore UT = unilateral transfer In a closed economy, we do not have CA. (because X = M = 0)

National Income Account Consumption = spending by households, including consumer spending on durable goods National Income Account Consumption = spending by households, including consumer spending on durable goods n Investment = Business sector’s adding to the physical stock of capital, including inventories. (individual household’s purchases of stocks, bonds or real estates are not included) n Government purchases = spending by federal, state, or local governments n

National Income Account n n n 1999 C I G CA 67. 6% 17. National Income Account n n n 1999 C I G CA 67. 6% 17. 5% 17. 6% -2. 7% $6. 3 trillion $1. 6 -$0. 25

Current account balance n n (Domestic spending on goods and services produced domestically) =C+I+G–M Current account balance n n (Domestic spending on goods and services produced domestically) =C+I+G–M (Foreign spending on goods and services produced domestically) =X

Current account balance (cont’d) CA = X – M n When X > M Current account balance (cont’d) CA = X – M n When X > M or CA > 0, we say current account surplus. n When X < M or CA < 0, we say current account deficit. n CA = Y – (C + I + G) = Y – A where A = domestic absorption n

Current account balance (cont’d) A country with current account deficit is buying more from Current account balance (cont’d) A country with current account deficit is buying more from foreigners than it sells to them It has to increase net foreign debts. CA = net foreign wealth n US has been a net debtor since 1985. In 1998, debt = $5. 5 trillion n

Saving and Investment Let S = national saving = Y – C – G. Saving and Investment Let S = national saving = Y – C – G. n Then S = I + CA (In a closed economy S = I) where I = domestic investment = capital stock accumulation CA = foreign wealth acquisition = net foreign investment n An open economy can increase investment by borrowing abroad. n

Saving S = SP + SG where SP = Yd – C = Y Saving S = SP + SG where SP = Yd – C = Y – T – C SG = T – G SP = private saving; SG = government saving; Yd = disposable income; T = net tax. n Then SP = (C + I + G + CA) – T – C = I + CA + (G - T) where G – T = government budget deficit. n So CA = SP – I – (G – T) A large gov’t budget deficit leads to a large current n

Balance of Payment Accounts n n n Double-entry bookkeeping each entry is recorded twice. Balance of Payment Accounts n n n Double-entry bookkeeping each entry is recorded twice. A debit entry a payment to foreigners A credit entry a receipt from foreigners

Current Account (CA) the record of commodity and services transaction n n A. Exports Current Account (CA) the record of commodity and services transaction n n A. Exports (credit) B. Imports (debit) n n n 1. Merchandise: commodity transaction 2. Services: travel, tourism, royalties, transportation costs, insurance premiums. 3. Income n n Income receipts on US assets abroad (credit) Income payments on foreign assets in US (debit) Direct investment receipts and payments Interest, dividends.

Current Account (cont’d) n C. Unilateral Transfers (debit) n n n US foreign aid, Current Account (cont’d) n C. Unilateral Transfers (debit) n n n US foreign aid, gifts, retirement pensions, interest payments to foreigners on their US gov’t debt, workers’ remittances. CA > 0: current account surplus the country is a net lender to the rest of world CA < 0: current account deficit the country is a net borrower from the rest of world

Capital Account (KA) the record of financial assets transaction n A. US assets abroad Capital Account (KA) the record of financial assets transaction n A. US assets abroad n n 1. US official reserve assets (Gold, SDR, reserve in IMF, foreign currencies) 2. US gov’t assets 3. US private assets (direct investment, foreign securities) B. Foreign assets in US n n 1. Foreign official assets in US (US gov’t securities, …) 2. Other foreign assets in US (direct investment, US treasury securities)

Example (a) n An American buys a share of German stock, paying by writing Example (a) n An American buys a share of German stock, paying by writing a $10, 000 check on his account with a Swiss Bank. n n Debit: US asset held abroad $10, 000 Credit: US asset held abroad $10, 000. For Germany n n Credit: Foreign asset held in Germany Debit: German asset held abroad

Example (b) n An American buys a share of German stock, paying the seller Example (b) n An American buys a share of German stock, paying the seller with a $10, 000 check on an American bank. n n Debit: US asset held abroad $10, 000 Credit: Foreign asset held in US $10, 000

Example (c) n The French government carries out an official foreign exchange intervention in Example (c) n The French government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens. n n Debit: Foreign asset held in US $1 million Credit: Foreign asset held in US $1 million (US official reserve asset)

Example (d) n A tourist from Detroit buys a meal at an expensive restaurant Example (d) n A tourist from Detroit buys a meal at an expensive restaurant in Lyons, France, paying with a VISA credit card. VISA uses a checking account in France to make payments. n n Debit: Import, Services Credit: US assets held abroad $300

Example (e) n A California winegrower contributes a case of his best cabernet sauvignon Example (e) n A California winegrower contributes a case of his best cabernet sauvignon for a London wine tasting. n No market transaction!

Statistical Discrepancy n Theoretically, current account and capital account should add up to zero. Statistical Discrepancy n Theoretically, current account and capital account should add up to zero. But in reality, there is a discrepancy due to errors, time lags, and so on.

Official Reserve Assets n Official reserve assets: n n n purchase or sale of Official Reserve Assets n Official reserve assets: n n n purchase or sale of foreign assets held by the central bank Official international reserves: gold, SDR, foreign currencies, etc. (current account) + (non-reserve capital account) + (statistical discrepancy) = Balance of Payment (official settlement)

Balance of Payment n n Balance of Payment (official settlement) = current account deficit Balance of Payment n n Balance of Payment (official settlement) = current account deficit needed to be covered by the central bank’s official reserve transactions. BOP deficit the country is running down its official reserves.