CHAPTER 11

1. CHAPTER 11 National Income Accounting and the Balance of Payments

2. Chapter Organization • National Income Accounting • GDP and the Trade Balance • The Balance of Payments Accounts • Summary

3. National Income Accounting • National income accounting • The process used by governments to keep track of GDP and its components. • The Measurement of GDP • GDP:measure of a country’s total output • Total output measured in country’s currency with goods/services measured at market prices • Not all transactions are accounted for • Constant changes in prices must be considered for comparison across time

4. National Income Accounting • Items Excluded from GDP: • Intermediate goods • Only final goods/services - Value added by all inputs • Example:The final value of cheeseburgers sold at fast-food restaurants not the price of the cheeseburger (intermediate good) • Non-reported market transactions and activities • Homemakers • Tax evasion, illegal goods • GDP is understated and provides a conservative estimate of country’s total economic activity

5. National Income Accounting • GDP and Changes in Prices • Current prices can distort measure of real output. • Doubling prices doubles value of GDP. • Does not mean twice the amount of goods/services were produced • Real GDP: Measure of GDP adjusted for price changes • Nominal GDP:The value of GDP in current dollars. Real GDP in year t = (Nominal GDP in year t) (Price level in year t)

6. National Income Accounting • The Components to GDP • Summation of different types of expenditures that occur within a country: Y = C + I + G + (X - M) Y = GDP (total production) C = Public’s consumption of goods and services I = Represents business firms in equipment, software, structures, and changes in business inventories, and residential investment G = The purchase of goods and services by state, local , and federal governments X = Exports of goods and services M = Imports of goods and services

7. National Income Accounting

8. National Income Accounting Figure 11.2: U.S. Real GDP and Its Components, 2003

9. GDP and the Trade Balance • Closed Economy (no trade): Y = C + I + G • Open Economy (trade): Y = C + I + G + (X - M) • Trade Surplus: X > M  (X - M) > 0 • Trade Deficit: X < M  (X - M) < 0 • Imports, Exports, and GDP • Open Economy: X – M = Y - C - I - G • Imports make up for excess demand (trade deficit) • Exports make up for excess supply (trade surplus)

10. GDP and the Trade Balance • Trade Deficit: • A country is increasing its indebtedness to other countries • Trade balance (X – M) is a flow variable– occurs over a period of time • Stock variable: Amount of debt a country has • Can be added to or subtracted from

11. GDP and the Trade Balance • Trade Surplus: • A country is reducing its indebtedness to other countries • Accumulating more claims on foreign countries • Stock variable: Amount of debt a country has • Can be added to or subtracted from • A country’s trade surplus is not really reflecting anything more profound than a mismatch between domestic production and domestic consumption.

12. GDP and the Trade Balance • Consuming more than producing is having trade deficit-importing present consumption. • Deficits must be paid by producing more than consuming (exporting future consumption). • Trade deficit is the process of importing present consumption and exporting future consumption. • Intertemporal Trade: • Countries trading production for consumption at different points in time.

13. GDP and the Trade Balance • Producing more output than it is consuming is having trade surplus. • Future trade deficits are importing future consumption. • Trade imbalances denote a country’s preference for present versus future consumption • Preferences expressed by choices of consumers, government, and businesses.

14. GDP and the Trade Balance • Leakages of Income: (S + T + M) • Forms of income that are withdrawn from the circular flow of income • Savings (S), taxes (T), and imports (M) • Injections of Income: (G + I + X) • Additions to the circular flow of income that are not derived from current income • Investment (I), government spending (G), and exports (X)

15. GDP and the Trade Balance • Government spending is the way taxes are re-injected into the economy. • Foreigners’ purchases of domestically produced goods and services is another injection of spending into the economy. • The injection of exports replaces the leakage of imports.

16. GDP and the Trade Balance • Sum of outflows must equal sum of inflows: S + T + M = G + I + X • This does not mean that S=I, T=G, or X=M • Rearranging the equation, we get: (X – M) = (T – G) + (S – I) • Twin Deficits: Fiscal Deficit + Savings Deficit = Trade Deficit

17. GDP and the Trade Balance • If (S + T) > (G + I) then (X – M) is positive • If (S + T) < (G + I) then (X – M) is negative • Trade balance is difference between outflows of income and domestic injections of spending X – M = (S + T) - (I + G)

18. GDP and the Trade Balance • Adjustments to Trade Imbalances • 4 strategies to reduce trade imbalance: • Increasing the level of savings to reduce the trade deficit • Change level of investment • Increase taxes • Change government spending

19. GDP and the Trade Balance Table 11.2: Potential Adjustments to Reduce Trade Imbalances

20. GDP and the Trade Balance Relationship Between Savings/Investment Balance, Government Balance, and Trade Balance (All Figures are Percentages of GDP) Source: OECD, Economic Outlook, Paris: OECD, Dec. 1998.