National Income Accounting for an Open Economy
In this section we extend to the case of an open economy the closed-economy national
income accounting framework you may have seen in earlier economics courses. We begin
with a discussion of the national income accounts because they highlight the key role of
international trade in open-economy macroeconomic theory. Since a closed economy’s
residents cannot purchase foreign output or sell their own to foreigners, all of national
income must be allocated to domestic consumption, investment, or government purchases.
In an economy open to international trade, however, the closed-economy version of
national income accounting must be modified because some domestic output is exported
to foreigners while some domestic income is spent on imported foreign products.
The main lesson of this section is the relationship among national saving, investment,
and trade imbalances. We will see that in open economies, saving and investment are not
necessarily equal, as they are in a closed economy. This occurs because countries can save
in the form of foreign wealth by exporting more than they import, and they can dissave—
that is, reduce their foreign wealth—by exporting less than they import.
Consumption
The portion of GNP purchased by private households to fulfill current wants is called
consumption. Purchases of movie tickets, food, dental work, and washing machines all
fall into this category. Consumption expenditure is the largest component of GNP in most
economies. In the United States, for example, the fraction of GNP devoted to consumption
has fluctuated in a range from about 62 to 70 percent over the past 60 years.
Investment
The part of output used by private firms to produce future output is called investment.
Investment spending may be viewed as the portion of GNP used to increase the nation’s
stock of capital. Steel and bricks used to build a factory are part of investment spending, as
are services provided by a technician who helps build business computers. Firms’ purchases
of inventories are also counted in investment spending because carrying inventories
is just another way for firms to transfer output from current use to future use.
Investment is usually more variable than consumption. In the United States, (gross) investment
has fluctuated between 11 and 22 percent of GNP in recent years. We often use the word
investment to describe individual households’ purchases of stocks, bonds, or real estate, but
you should be careful not to confuse this everyday meaning of the word with the economic
definition of investment as a part of GNP. When you buy a share of Microsoft stock, you are
buying neither a good nor a service, so your purchase does not show up in GNP.
CHAPTER 13 National Income Accounting and the Balance of Payments 299
Government Purchases
Any goods and services purchased by federal, state, or local governments are classified as
government purchases in the national income accounts. Included in government purchases
are federal military spending, government support of cancer research, and government
funds spent on highway repair and education. Government purchases include investment as
well as consumption purchases. Government transfer payments such as social security and
unemployment benefits do not require the recipient to give the government any goods or services
in return. Thus, transfer payments are not included in government purchases.
Government purchases currently take up about 20 percent of U.S. GNP, and this share has
not changed much since the late 1950s. (The corresponding figure for 1959, for example, was
around 20 percent.) In 1929, however, government purchases accounted for only 8.5 percent
of U.S. GNP.
The National Income Identity for an Open Economy
In a closed economy, any final good or service that is not purchased by households or the
government must be used by firms to produce new plant, equipment, and inventories. If
consumption goods are not sold immediately to consumers or the government, firms
(perhaps reluctantly) add them to existing inventories, thereby increasing their investment.
This information leads to a fundamental identity for closed economies. Let Y stand for GNP,
C for consumption, I for investment, and G for government purchases. Since all of a closed
economy’s output must be consumed, invested, or bought by the government, we can write
We derived the national income identity for a closed economy by assuming that all
output is consumed or invested by the country’s citizens or purchased by its government.
When foreign trade is possible, however, some output is purchased by foreigners while
some domestic spending goes to purchase goods and services produced abroad. The GNP
identity for open economies shows how the national income a country earns by selling its
goods and services is divided between sales to domestic residents and sales to foreign
residents.
Since residents of an open economy may spend some of their income on imports, that
is, goods and services purchased from abroad, only the portion of their spending that is not
devoted to imports is part of domestic GNP. The value of imports, denoted by IM, must be
subtracted from total domestic spending, , to find the portion of domestic
spending that generates domestic national income. Imports from abroad add to foreign
countries’ GNPs but do not add directly to domestic GNP.
Similarly, the goods and services sold to foreigners make up a country’s exports.
Exports, denoted by EX, are the amount foreign residents’ purchases add to the national
income of the domestic economy.
The national income of an open economy is therefore the sum of domestic and foreign
expenditures on the goods and services produced by domestic factors of production. Thus,
the national income identity for an open economy is
(13-1)
An Imaginary Open Economy
To make identity (13-1) concrete, let’s consider an imaginary closed economy, Agraria,
whose only output is wheat. Each citizen of Agraria is a consumer of wheat, but each is
also a farmer and therefore can be viewed as a firm. Farmers invest by putting aside a
Y = C + I + G + EX - IM.
C + I + G
Y = C + I + G.
300 PART THREE Exchange Rates and Open-Economy Macroeconomics
portion of each year’s crop as seed for the next year’s planting. There is also a government
that appropriates part of the crop to feed the Agrarian army. Agraria’s total annual
crop is 100 bushels of wheat. Agraria can import milk from the rest of the world in
exchange for exports of wheat. We cannot draw up the Agrarian national income
accounts without knowing the price of milk in terms of wheat because all the components
in the GNP identity (13-1) must be measured in the same units. If we assume the
price of milk is 0.5 bushel of wheat per gallon, and that at this price, Agrarians want to
consume 40 gallons of milk, then Agraria’s imports are equal in value to 20 bushels
of wheat.
In Table 13-1 we see that Agraria’s total output is 100 bushels of wheat. Consumption
is divided between wheat and milk, with 55 bushels of wheat and 40 gallons of milk (equal
in value to 20 bushels of wheat) consumed over the year. The value of consumption in
terms of wheat is .
The 100 bushels of wheat produced by Agraria are used as follows: 55 are consumed by
domestic residents, 25 are invested, 10 are purchased by the government, and 10 are exported
abroad. National income equals domestic spending plus
exports less imports .
The Current Account and Foreign Indebtedness
In reality, a country’s foreign trade is exactly balanced only rarely. The difference between
exports of goods and services and imports of goods and services is known as the current
account balance (or current account). If we denote the current account by CA, we can
express this definition in symbols as
When a country’s imports exceed its exports, we say the country has a current account
deficit. A country has a current account surplus when its exports exceed its imports.3
The GNP identity, equation (13-1), shows one reason why the current account is important
in international macroeconomics. Since the right-hand side of (13-1) gives total expenditures
on domestic output, changes in the current account can be associated with changes in output
and, thus, employment.
The current account is also important because it measures the size and direction of
international borrowing. When a country imports more than it exports, it is buying more
CA = EX - IM.
(EX = 10) (IM = 20)
(Y = 100) (C + I + G = 110)
55 + (0.5 * 40) = 55 + 20 = 75
TABLE 13-1 National Income Accounts for Agraria, an Open Economy
(bushels of wheat)
GNP Consumption Investment Government Exports Imports
(total output) purchases
100 = 75a + 25 + 10 + 10 - 20b
a
b0.5 bushel per gallon * 40 gallons of milk.
55 bushels of wheat + 10.5 bushel per gallon2 * 140 gallons of milk2.
3 In addition to net exports of goods and services, the current account balance includes net unilateral transfers of
income, which we discussed briefly above. Following our earlier assumption, we continue to ignore such transfers
for now to simplify the discussion. Later in this chapter, when we analyze the U.S. balance of payments in
detail, we will see how transfers of current income enter the current account.
CHAPTER 13 National Income Accounting and the Balance of Payments 301
from foreigners than it sells to them and must somehow finance this current account
deficit. How does it pay for additional imports once it has spent its export earnings? Since
the country as a whole can import more than it exports only if it can borrow the difference
from foreigners, a country with a current account deficit must be increasing its net foreign
debts by the amount of the deficit. This is currently the position of the United States,
which has a significant current account deficit (and borrowed a sum equal to roughly
3 percent of its GNP in 2009).4
Similarly, a country with a current account surplus is earning more from its exports
than it spends on imports. This country finances the current account deficit of its trading
partners by lending to them. The foreign wealth of a surplus country rises because foreigners
pay for any imports not covered by their exports by issuing IOUs that they will eventually
have to redeem. The preceding reasoning shows that a country’s current account
balance equals the change in its net foreign wealth.
We have defined the current account as the difference between exports and imports.
Equation (13-1) says that the current account is also equal to the difference between
national income and domestic residents’ total spending :
It is only by borrowing abroad that a country can have a current account deficit and use
more output than it is currently producing. If it uses less than its output, it has a current
account surplus and is lending the surplus to foreigners.5 International borrowing and
lending were identified with intertemporal trade in Chapter 6. A country with a current
account deficit is importing present consumption and exporting future consumption.
A country with a current account surplus is exporting present consumption and importing
future consumption.
As an example, consider again the imaginary economy of Agraria described in Table 13-1.
The total value of its consumption, investment, and government purchases, at 110 bushels of
wheat, is greater than its output of 100 bushels. This inequality would be impossible in a
closed economy; it is possible in this open economy because Agraria now imports 40 gallons
of milk, worth 20 bushels of wheat, but exports only 10 bushels of wheat. The current account
deficit of 10 bushels is the value of Agraria’s borrowing from foreigners, which the country
will have to repay in the future.
Figure 13-2 gives a vivid illustration of how a string of current account deficits can add
up to a large foreign debt. The figure plots the U.S. current account balance since the late
1970s along with a measure of the nation’s stock of net foreign wealth. As you can see, the
United States had accumulated substantial foreign wealth by the early 1980s, when a sustained
current account deficit of proportions unprecedented in the 20th century opened up.
In 1987, the country became a net debtor to foreigners for the first time since World War I.
That foreign debt has continued to grow, and at the end of 2009, it stood at just below
20 percent of GNP.
Y - 1C + I + G2 = CA.
C + I + G
4 Alternatively, a country could finance a current account deficit by using previously accumulated foreign wealth
to pay for imports. This country would be running down its net foreign wealth, which is the same as running up
its net foreign debts.
Our discussion here is ignoring the possibility that a country receives gifts of foreign assets (or gives such
gifts), such as when one country agrees to forgive another’s debts. As we will discuss below, such asset transfers
(unlike transfers of current income) are not part of the current account, but they nonetheless do affect net foreign
wealth. They are recorded in the capital account of the balance of payments.
5 The sum is often called domestic absorption in the literature on international macroeconomics.
Using this terminology, we can describe the current account surplus as the difference between income and absorption,
Y - A.
A = C + I + G
302 PART THREE Exchange Rates and Open-Economy Macroeconomics
–3000
–3200
–3600
–2400
–2600
–2800
–2200
–2000
–1800
–1600
–1400
–1200
–1000
–800
–600
–400
–200
0
200
400
Net foreign wealth
Current account
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Current account,
net foreign wealth (billions of dollars)
–3400
Figure 13-2
The U.S. Current Account and Net Foreign Wealth Position, 1976–2009
A string of current account deficits starting in the 1980s reduced America’s net foreign wealth until, by the
early 21st century, the country had accumulated a substantial net foreign debt.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Saving and the Current Account
Simple as it is, the GNP identity has many illuminating implications. To explain the most
important of these implications, we define the concept of national saving, that is, the portion
of output, Y, that is not devoted to household consumption, C, or government purchases, G.6
In a closed economy, national saving always equals investment. This tells us that the closed
economy as a whole can increase its wealth only by accumulating new capital.
Let S stand for national saving. Our definition of S tells us that
S = Y - C - G.
6 The U.S. national income accounts assume that government purchases are not used to enlarge the nation’s capital
stock. We follow this convention here by subtracting all government purchases from output to calculate national
saving. Most other countries’ national accounts distinguish between government consumption and government
investment (for example, investment by publicly owned enterprises) and include the latter as part of national
saving. Often, however, government investment figures include purchases of military equipment.
CHAPTER 13 National Income Accounting and the Balance of Payments 303
Since the closed-economy GNP identity, , may also be written as
, then
and national saving must equal investment in a closed economy. Whereas in a closed economy,
saving and investment must always be equal, in an open economy they can differ.
Remembering that national saving, S, equals and that , we
can rewrite the GNP identity (13-1) as
The equation highlights an important difference between open and closed economies:
An open economy can save either by building up its capital stock or by acquiring foreign
wealth, but a closed economy can save only by building up its capital stock.
Unlike a closed economy, an open economy with profitable investment opportunities does
not have to increase its saving in order to exploit them. The preceding expression shows that it
is possible simultaneously to raise investment and foreign borrowing without changing saving.
For example, if New Zealand decides to build a new hydroelectric plant, it can import the
materials it needs from the United States and borrow American funds to pay for them. This
transaction raises New Zealand’s domestic investment because the imported materials
contribute to expanding the country’s capital stock. The transaction also raises New Zealand’s
current account deficit by an amount equal to the increase in investment. New Zealand’s saving
does not have to change, even though investment rises. For this to be possible, however,
U.S. residents must be willing to save more so that the resources needed to build the plant are
freed for New Zealand’s use. The result is another example of intertemporal trade, in which
New Zealand imports present consumption (when it borrows from the United States) and
exports future consumption (when it pays off the loan).
Because one country’s savings can be borrowed by a second country in order to
increase the second country’s stock of capital, a country’s current account surplus is often
referred to as its net foreign investment. Of course, when one country lends to another to
finance investment, part of the income generated by the investment in future years must be
used to pay back the lender. Domestic investment and foreign investment are two different
ways in which a country can use current savings to increase its future income.
Private and Government Saving
So far our discussion of saving has not stressed the distinction between saving decisions
made by the private sector and saving decisions made by the government. Unlike private
saving decisions, however, government saving decisions are often made with an eye
toward their effect on output and employment. The national income identity can help us to
analyze the channels through which government saving decisions influence macroeconomic
conditions. To use the national income identity in this way, we first have to divide
national saving into its private and government components.
Private saving is defined as the part of disposable income that is saved rather than consumed.
Disposable income is national income, Y, less the net taxes collected from households
and firms by the government, T.7 Private saving, denoted , can therefore be
expressed as
Sp = Y - T - C.
Sp
S = I + CA.
Y - C - G CA = EX - IM
S = I,
I = Y - C - G
Y = C + I + G
7 Net taxes are taxes less government transfer payments. The term government refers to the federal, state, and
local governments considered as a single unit.
304 PART THREE Exchange Rates and Open-Economy Macroeconomics
Government saving is defined similarly to private saving. The government’s “income”
is its net tax revenue, T, while its “consumption” is government purchases, G. If we let
stand for government saving, then
The two types of saving we have defined, private and government, add up to national
saving. To see why, recall the definition of national saving, S, as . Then
We can use the definitions of private and government saving to rewrite the national
income identity in a form that is useful for analyzing the effects of government saving
decisions on open economies. Because ,
(13-2)
Equation (13-2) relates private saving to domestic investment, the current account surplus,
and government saving. To interpret equation (13-2), we define the government
budget deficit as , that is, as government saving preceded by a minus sign. The
government budget deficit measures the extent to which the government is borrowing to
finance its expenditures. Equation (13-2) then states that a country’s private saving can take
three forms: investment in domestic capital (I), purchases of wealth from foreigners ,
and purchases of the domestic government’s newly issued debt .8 The usefulness
of equation (13-2) is illustrated by the following Case Study.
Case Study
Government Deficit Reduction May Not Increase the Current Account Surplus
The linkage among the current account balance, investment, and private and government
saving given by equation (13-2) is very useful for thinking about the results of economic
policies and events. Our predictions about such outcomes cannot possibly be correct unless
the current account, investment, and saving rates are assumed to adjust in line with (13-2).
Because that equation is an identity, however, and is not based on any theory of economic
behavior, we cannot forecast the results of policies without some model of the economy.
Equation (13-2) is an identity because it must be included in any valid economic model,
but there are any number of models consistent with identity (13-2).
A good example of how hard it can be to forecast policies’ effects comes from thinking
about the effects of government deficits on the current account. During the administration
of President Ronald Reagan in the early 1980s, the United States slashed taxes and
raised some government expenditures, which generated both a big government deficit and
a sharply increased current account deficit. Those events gave rise to the argument that
the government and the current account deficits were “twin deficits,” both generated primarily
by the Reagan policies. If you rewrite identity (13-2) in the form
CA = Sp - I - 1G - T2,
(G - T)
(CA)
G - T
Sp = I + CA - Sg = I + CA - 1T - G2 = I + CA + 1G - T2.
S = Sp + Sg = I + CA
S = Y - C - G = 1Y - T - C2 + 1T - G2 = Sp + Sg.
Y - C - G
Sg = T - G.
Sg
8 In a closed economy, the current account is always zero, so equation (13-2) is simply Sp = I + (G - T).
CHAPTER 13 National Income Accounting and the Balance of Payments 305
you can see how that outcome could have occurred. If the government deficit rises
( goes up) and private saving and investment don’t change much, the current
account surplus must fall by roughly the same amount as the increase in the fiscal
deficit. In the United States between 1981 and 1985, the government deficit increased
by a bit more than 2 percent of GNP, while fell by about half a percent of GNP,
so the current account fell from an approximately balanced position to about –3 percent
of GNP. (The variables in identity (13-2) are expressed as percentages of GNP for easy
comparison.) Thus, the twin deficits prediction is not too far off the mark.
The twin deficits theory can lead us seriously astray, however, when changes in government
deficits lead to bigger changes in private saving and investment behavior. A good
example of these effects comes from European countries’ efforts to cut their government
budget deficits prior to the launch of their new common currency, the euro, in January
1999. As we will discuss in Chapter 20, the European Union (EU) had agreed that no
member country with a large government deficit would be allowed to adopt the new currency
along with the initial wave of euro zone members. As 1999 approached, therefore,
EU governments made frantic efforts to cut government spending and raise taxes.
Under the twin deficits theory, we would have expected the EU’s current account
surplus to increase sharply as a result of the fiscal change. As the table below shows,
however, nothing of the sort actually happened. For the EU as a whole, government
deficits fell by about 4.5 percent of output, yet the current account surplus remained
about the same.
The table reveals the main reason the current account didn’t change much: a sharp
fall in the private saving rate, which declined by about 4 percent of output, almost as
much as the increase in government saving. (Investment rose slightly at the same time.)
In this case, the behavior of private savers just about neutralized governments’ efforts
to raise national saving!
It is difficult to know why this offset occurred, but there are a number of possible
explanations. One is based on an economic theory known as the Ricardian equivalence
of taxes and government deficits. (The theory is named after the same David Ricardo
who discovered the theory of comparative advantage—recall Chapter 3—although he
himself did not believe in Ricardian equivalence.) Ricardian equivalence argues that
when the government cuts taxes and raises its deficit, consumers anticipate that they
will face higher taxes later to pay off the resulting government debt. In anticipation,
they raise their own (private) saving to offset the fall in government saving. Conversely,
governments that lower their deficits through higher taxes (thereby increasing government
saving) will induce the private sector to lower its own saving. Qualitatively, this is
the kind of behavior we saw in Europe in the late 1990s.
Sp - I
G - T
European Union (percentage of GNP)
Year CA SP I G - T
1995 0.6 25.9 19.9 -5.4
1996 1.0 24.6 19.3 -4.3
1997 1.5 23.4 19.4 -2.5
1998 1.0 22.6 20.0 -1.6
1999 0.2 21.8 20.8 -0.8
Source: Organization for Economic Cooperation and Development, OECD Economic Outlook 68
(December 2000), annex tables 27, 30, and 52 (with investment calculated as the residual).
306 PART THREE Exchange Rates and Open-Economy Macroeconomics
Economists’ statistical studies suggest, however, that Ricardian equivalence doesn’t
hold exactly in practice. Most economists would attribute no more than half the decline
in European private saving to Ricardian effects. What explains the rest of the decline?
The values of European financial assets were generally rising in the late 1990s, a development
fueled in part by optimism over the beneficial economic effects of the planned
common currency. It is likely that increased household wealth was a second factor lowering
the private saving rate in Europe.
Because private saving, investment, the current account, and the government deficit
are jointly determined variables, we can never fully determine the cause of a current
account change using identity (13-2) alone. Nonetheless, the identity provides an
essential framework for thinking about the current account and can furnish useful clues.
In this section we extend to the case of an open economy the closed-economy national
income accounting framework you may have seen in earlier economics courses. We begin
with a discussion of the national income accounts because they highlight the key role of
international trade in open-economy macroeconomic theory. Since a closed economy’s
residents cannot purchase foreign output or sell their own to foreigners, all of national
income must be allocated to domestic consumption, investment, or government purchases.
In an economy open to international trade, however, the closed-economy version of
national income accounting must be modified because some domestic output is exported
to foreigners while some domestic income is spent on imported foreign products.
The main lesson of this section is the relationship among national saving, investment,
and trade imbalances. We will see that in open economies, saving and investment are not
necessarily equal, as they are in a closed economy. This occurs because countries can save
in the form of foreign wealth by exporting more than they import, and they can dissave—
that is, reduce their foreign wealth—by exporting less than they import.
Consumption
The portion of GNP purchased by private households to fulfill current wants is called
consumption. Purchases of movie tickets, food, dental work, and washing machines all
fall into this category. Consumption expenditure is the largest component of GNP in most
economies. In the United States, for example, the fraction of GNP devoted to consumption
has fluctuated in a range from about 62 to 70 percent over the past 60 years.
Investment
The part of output used by private firms to produce future output is called investment.
Investment spending may be viewed as the portion of GNP used to increase the nation’s
stock of capital. Steel and bricks used to build a factory are part of investment spending, as
are services provided by a technician who helps build business computers. Firms’ purchases
of inventories are also counted in investment spending because carrying inventories
is just another way for firms to transfer output from current use to future use.
Investment is usually more variable than consumption. In the United States, (gross) investment
has fluctuated between 11 and 22 percent of GNP in recent years. We often use the word
investment to describe individual households’ purchases of stocks, bonds, or real estate, but
you should be careful not to confuse this everyday meaning of the word with the economic
definition of investment as a part of GNP. When you buy a share of Microsoft stock, you are
buying neither a good nor a service, so your purchase does not show up in GNP.
CHAPTER 13 National Income Accounting and the Balance of Payments 299
Government Purchases
Any goods and services purchased by federal, state, or local governments are classified as
government purchases in the national income accounts. Included in government purchases
are federal military spending, government support of cancer research, and government
funds spent on highway repair and education. Government purchases include investment as
well as consumption purchases. Government transfer payments such as social security and
unemployment benefits do not require the recipient to give the government any goods or services
in return. Thus, transfer payments are not included in government purchases.
Government purchases currently take up about 20 percent of U.S. GNP, and this share has
not changed much since the late 1950s. (The corresponding figure for 1959, for example, was
around 20 percent.) In 1929, however, government purchases accounted for only 8.5 percent
of U.S. GNP.
The National Income Identity for an Open Economy
In a closed economy, any final good or service that is not purchased by households or the
government must be used by firms to produce new plant, equipment, and inventories. If
consumption goods are not sold immediately to consumers or the government, firms
(perhaps reluctantly) add them to existing inventories, thereby increasing their investment.
This information leads to a fundamental identity for closed economies. Let Y stand for GNP,
C for consumption, I for investment, and G for government purchases. Since all of a closed
economy’s output must be consumed, invested, or bought by the government, we can write
We derived the national income identity for a closed economy by assuming that all
output is consumed or invested by the country’s citizens or purchased by its government.
When foreign trade is possible, however, some output is purchased by foreigners while
some domestic spending goes to purchase goods and services produced abroad. The GNP
identity for open economies shows how the national income a country earns by selling its
goods and services is divided between sales to domestic residents and sales to foreign
residents.
Since residents of an open economy may spend some of their income on imports, that
is, goods and services purchased from abroad, only the portion of their spending that is not
devoted to imports is part of domestic GNP. The value of imports, denoted by IM, must be
subtracted from total domestic spending, , to find the portion of domestic
spending that generates domestic national income. Imports from abroad add to foreign
countries’ GNPs but do not add directly to domestic GNP.
Similarly, the goods and services sold to foreigners make up a country’s exports.
Exports, denoted by EX, are the amount foreign residents’ purchases add to the national
income of the domestic economy.
The national income of an open economy is therefore the sum of domestic and foreign
expenditures on the goods and services produced by domestic factors of production. Thus,
the national income identity for an open economy is
(13-1)
An Imaginary Open Economy
To make identity (13-1) concrete, let’s consider an imaginary closed economy, Agraria,
whose only output is wheat. Each citizen of Agraria is a consumer of wheat, but each is
also a farmer and therefore can be viewed as a firm. Farmers invest by putting aside a
Y = C + I + G + EX - IM.
C + I + G
Y = C + I + G.
300 PART THREE Exchange Rates and Open-Economy Macroeconomics
portion of each year’s crop as seed for the next year’s planting. There is also a government
that appropriates part of the crop to feed the Agrarian army. Agraria’s total annual
crop is 100 bushels of wheat. Agraria can import milk from the rest of the world in
exchange for exports of wheat. We cannot draw up the Agrarian national income
accounts without knowing the price of milk in terms of wheat because all the components
in the GNP identity (13-1) must be measured in the same units. If we assume the
price of milk is 0.5 bushel of wheat per gallon, and that at this price, Agrarians want to
consume 40 gallons of milk, then Agraria’s imports are equal in value to 20 bushels
of wheat.
In Table 13-1 we see that Agraria’s total output is 100 bushels of wheat. Consumption
is divided between wheat and milk, with 55 bushels of wheat and 40 gallons of milk (equal
in value to 20 bushels of wheat) consumed over the year. The value of consumption in
terms of wheat is .
The 100 bushels of wheat produced by Agraria are used as follows: 55 are consumed by
domestic residents, 25 are invested, 10 are purchased by the government, and 10 are exported
abroad. National income equals domestic spending plus
exports less imports .
The Current Account and Foreign Indebtedness
In reality, a country’s foreign trade is exactly balanced only rarely. The difference between
exports of goods and services and imports of goods and services is known as the current
account balance (or current account). If we denote the current account by CA, we can
express this definition in symbols as
When a country’s imports exceed its exports, we say the country has a current account
deficit. A country has a current account surplus when its exports exceed its imports.3
The GNP identity, equation (13-1), shows one reason why the current account is important
in international macroeconomics. Since the right-hand side of (13-1) gives total expenditures
on domestic output, changes in the current account can be associated with changes in output
and, thus, employment.
The current account is also important because it measures the size and direction of
international borrowing. When a country imports more than it exports, it is buying more
CA = EX - IM.
(EX = 10) (IM = 20)
(Y = 100) (C + I + G = 110)
55 + (0.5 * 40) = 55 + 20 = 75
TABLE 13-1 National Income Accounts for Agraria, an Open Economy
(bushels of wheat)
GNP Consumption Investment Government Exports Imports
(total output) purchases
100 = 75a + 25 + 10 + 10 - 20b
a
b0.5 bushel per gallon * 40 gallons of milk.
55 bushels of wheat + 10.5 bushel per gallon2 * 140 gallons of milk2.
3 In addition to net exports of goods and services, the current account balance includes net unilateral transfers of
income, which we discussed briefly above. Following our earlier assumption, we continue to ignore such transfers
for now to simplify the discussion. Later in this chapter, when we analyze the U.S. balance of payments in
detail, we will see how transfers of current income enter the current account.
CHAPTER 13 National Income Accounting and the Balance of Payments 301
from foreigners than it sells to them and must somehow finance this current account
deficit. How does it pay for additional imports once it has spent its export earnings? Since
the country as a whole can import more than it exports only if it can borrow the difference
from foreigners, a country with a current account deficit must be increasing its net foreign
debts by the amount of the deficit. This is currently the position of the United States,
which has a significant current account deficit (and borrowed a sum equal to roughly
3 percent of its GNP in 2009).4
Similarly, a country with a current account surplus is earning more from its exports
than it spends on imports. This country finances the current account deficit of its trading
partners by lending to them. The foreign wealth of a surplus country rises because foreigners
pay for any imports not covered by their exports by issuing IOUs that they will eventually
have to redeem. The preceding reasoning shows that a country’s current account
balance equals the change in its net foreign wealth.
We have defined the current account as the difference between exports and imports.
Equation (13-1) says that the current account is also equal to the difference between
national income and domestic residents’ total spending :
It is only by borrowing abroad that a country can have a current account deficit and use
more output than it is currently producing. If it uses less than its output, it has a current
account surplus and is lending the surplus to foreigners.5 International borrowing and
lending were identified with intertemporal trade in Chapter 6. A country with a current
account deficit is importing present consumption and exporting future consumption.
A country with a current account surplus is exporting present consumption and importing
future consumption.
As an example, consider again the imaginary economy of Agraria described in Table 13-1.
The total value of its consumption, investment, and government purchases, at 110 bushels of
wheat, is greater than its output of 100 bushels. This inequality would be impossible in a
closed economy; it is possible in this open economy because Agraria now imports 40 gallons
of milk, worth 20 bushels of wheat, but exports only 10 bushels of wheat. The current account
deficit of 10 bushels is the value of Agraria’s borrowing from foreigners, which the country
will have to repay in the future.
Figure 13-2 gives a vivid illustration of how a string of current account deficits can add
up to a large foreign debt. The figure plots the U.S. current account balance since the late
1970s along with a measure of the nation’s stock of net foreign wealth. As you can see, the
United States had accumulated substantial foreign wealth by the early 1980s, when a sustained
current account deficit of proportions unprecedented in the 20th century opened up.
In 1987, the country became a net debtor to foreigners for the first time since World War I.
That foreign debt has continued to grow, and at the end of 2009, it stood at just below
20 percent of GNP.
Y - 1C + I + G2 = CA.
C + I + G
4 Alternatively, a country could finance a current account deficit by using previously accumulated foreign wealth
to pay for imports. This country would be running down its net foreign wealth, which is the same as running up
its net foreign debts.
Our discussion here is ignoring the possibility that a country receives gifts of foreign assets (or gives such
gifts), such as when one country agrees to forgive another’s debts. As we will discuss below, such asset transfers
(unlike transfers of current income) are not part of the current account, but they nonetheless do affect net foreign
wealth. They are recorded in the capital account of the balance of payments.
5 The sum is often called domestic absorption in the literature on international macroeconomics.
Using this terminology, we can describe the current account surplus as the difference between income and absorption,
Y - A.
A = C + I + G
302 PART THREE Exchange Rates and Open-Economy Macroeconomics
–3000
–3200
–3600
–2400
–2600
–2800
–2200
–2000
–1800
–1600
–1400
–1200
–1000
–800
–600
–400
–200
0
200
400
Net foreign wealth
Current account
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Current account,
net foreign wealth (billions of dollars)
–3400
Figure 13-2
The U.S. Current Account and Net Foreign Wealth Position, 1976–2009
A string of current account deficits starting in the 1980s reduced America’s net foreign wealth until, by the
early 21st century, the country had accumulated a substantial net foreign debt.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Saving and the Current Account
Simple as it is, the GNP identity has many illuminating implications. To explain the most
important of these implications, we define the concept of national saving, that is, the portion
of output, Y, that is not devoted to household consumption, C, or government purchases, G.6
In a closed economy, national saving always equals investment. This tells us that the closed
economy as a whole can increase its wealth only by accumulating new capital.
Let S stand for national saving. Our definition of S tells us that
S = Y - C - G.
6 The U.S. national income accounts assume that government purchases are not used to enlarge the nation’s capital
stock. We follow this convention here by subtracting all government purchases from output to calculate national
saving. Most other countries’ national accounts distinguish between government consumption and government
investment (for example, investment by publicly owned enterprises) and include the latter as part of national
saving. Often, however, government investment figures include purchases of military equipment.
CHAPTER 13 National Income Accounting and the Balance of Payments 303
Since the closed-economy GNP identity, , may also be written as
, then
and national saving must equal investment in a closed economy. Whereas in a closed economy,
saving and investment must always be equal, in an open economy they can differ.
Remembering that national saving, S, equals and that , we
can rewrite the GNP identity (13-1) as
The equation highlights an important difference between open and closed economies:
An open economy can save either by building up its capital stock or by acquiring foreign
wealth, but a closed economy can save only by building up its capital stock.
Unlike a closed economy, an open economy with profitable investment opportunities does
not have to increase its saving in order to exploit them. The preceding expression shows that it
is possible simultaneously to raise investment and foreign borrowing without changing saving.
For example, if New Zealand decides to build a new hydroelectric plant, it can import the
materials it needs from the United States and borrow American funds to pay for them. This
transaction raises New Zealand’s domestic investment because the imported materials
contribute to expanding the country’s capital stock. The transaction also raises New Zealand’s
current account deficit by an amount equal to the increase in investment. New Zealand’s saving
does not have to change, even though investment rises. For this to be possible, however,
U.S. residents must be willing to save more so that the resources needed to build the plant are
freed for New Zealand’s use. The result is another example of intertemporal trade, in which
New Zealand imports present consumption (when it borrows from the United States) and
exports future consumption (when it pays off the loan).
Because one country’s savings can be borrowed by a second country in order to
increase the second country’s stock of capital, a country’s current account surplus is often
referred to as its net foreign investment. Of course, when one country lends to another to
finance investment, part of the income generated by the investment in future years must be
used to pay back the lender. Domestic investment and foreign investment are two different
ways in which a country can use current savings to increase its future income.
Private and Government Saving
So far our discussion of saving has not stressed the distinction between saving decisions
made by the private sector and saving decisions made by the government. Unlike private
saving decisions, however, government saving decisions are often made with an eye
toward their effect on output and employment. The national income identity can help us to
analyze the channels through which government saving decisions influence macroeconomic
conditions. To use the national income identity in this way, we first have to divide
national saving into its private and government components.
Private saving is defined as the part of disposable income that is saved rather than consumed.
Disposable income is national income, Y, less the net taxes collected from households
and firms by the government, T.7 Private saving, denoted , can therefore be
expressed as
Sp = Y - T - C.
Sp
S = I + CA.
Y - C - G CA = EX - IM
S = I,
I = Y - C - G
Y = C + I + G
7 Net taxes are taxes less government transfer payments. The term government refers to the federal, state, and
local governments considered as a single unit.
304 PART THREE Exchange Rates and Open-Economy Macroeconomics
Government saving is defined similarly to private saving. The government’s “income”
is its net tax revenue, T, while its “consumption” is government purchases, G. If we let
stand for government saving, then
The two types of saving we have defined, private and government, add up to national
saving. To see why, recall the definition of national saving, S, as . Then
We can use the definitions of private and government saving to rewrite the national
income identity in a form that is useful for analyzing the effects of government saving
decisions on open economies. Because ,
(13-2)
Equation (13-2) relates private saving to domestic investment, the current account surplus,
and government saving. To interpret equation (13-2), we define the government
budget deficit as , that is, as government saving preceded by a minus sign. The
government budget deficit measures the extent to which the government is borrowing to
finance its expenditures. Equation (13-2) then states that a country’s private saving can take
three forms: investment in domestic capital (I), purchases of wealth from foreigners ,
and purchases of the domestic government’s newly issued debt .8 The usefulness
of equation (13-2) is illustrated by the following Case Study.
Case Study
Government Deficit Reduction May Not Increase the Current Account Surplus
The linkage among the current account balance, investment, and private and government
saving given by equation (13-2) is very useful for thinking about the results of economic
policies and events. Our predictions about such outcomes cannot possibly be correct unless
the current account, investment, and saving rates are assumed to adjust in line with (13-2).
Because that equation is an identity, however, and is not based on any theory of economic
behavior, we cannot forecast the results of policies without some model of the economy.
Equation (13-2) is an identity because it must be included in any valid economic model,
but there are any number of models consistent with identity (13-2).
A good example of how hard it can be to forecast policies’ effects comes from thinking
about the effects of government deficits on the current account. During the administration
of President Ronald Reagan in the early 1980s, the United States slashed taxes and
raised some government expenditures, which generated both a big government deficit and
a sharply increased current account deficit. Those events gave rise to the argument that
the government and the current account deficits were “twin deficits,” both generated primarily
by the Reagan policies. If you rewrite identity (13-2) in the form
CA = Sp - I - 1G - T2,
(G - T)
(CA)
G - T
Sp = I + CA - Sg = I + CA - 1T - G2 = I + CA + 1G - T2.
S = Sp + Sg = I + CA
S = Y - C - G = 1Y - T - C2 + 1T - G2 = Sp + Sg.
Y - C - G
Sg = T - G.
Sg
8 In a closed economy, the current account is always zero, so equation (13-2) is simply Sp = I + (G - T).
CHAPTER 13 National Income Accounting and the Balance of Payments 305
you can see how that outcome could have occurred. If the government deficit rises
( goes up) and private saving and investment don’t change much, the current
account surplus must fall by roughly the same amount as the increase in the fiscal
deficit. In the United States between 1981 and 1985, the government deficit increased
by a bit more than 2 percent of GNP, while fell by about half a percent of GNP,
so the current account fell from an approximately balanced position to about –3 percent
of GNP. (The variables in identity (13-2) are expressed as percentages of GNP for easy
comparison.) Thus, the twin deficits prediction is not too far off the mark.
The twin deficits theory can lead us seriously astray, however, when changes in government
deficits lead to bigger changes in private saving and investment behavior. A good
example of these effects comes from European countries’ efforts to cut their government
budget deficits prior to the launch of their new common currency, the euro, in January
1999. As we will discuss in Chapter 20, the European Union (EU) had agreed that no
member country with a large government deficit would be allowed to adopt the new currency
along with the initial wave of euro zone members. As 1999 approached, therefore,
EU governments made frantic efforts to cut government spending and raise taxes.
Under the twin deficits theory, we would have expected the EU’s current account
surplus to increase sharply as a result of the fiscal change. As the table below shows,
however, nothing of the sort actually happened. For the EU as a whole, government
deficits fell by about 4.5 percent of output, yet the current account surplus remained
about the same.
The table reveals the main reason the current account didn’t change much: a sharp
fall in the private saving rate, which declined by about 4 percent of output, almost as
much as the increase in government saving. (Investment rose slightly at the same time.)
In this case, the behavior of private savers just about neutralized governments’ efforts
to raise national saving!
It is difficult to know why this offset occurred, but there are a number of possible
explanations. One is based on an economic theory known as the Ricardian equivalence
of taxes and government deficits. (The theory is named after the same David Ricardo
who discovered the theory of comparative advantage—recall Chapter 3—although he
himself did not believe in Ricardian equivalence.) Ricardian equivalence argues that
when the government cuts taxes and raises its deficit, consumers anticipate that they
will face higher taxes later to pay off the resulting government debt. In anticipation,
they raise their own (private) saving to offset the fall in government saving. Conversely,
governments that lower their deficits through higher taxes (thereby increasing government
saving) will induce the private sector to lower its own saving. Qualitatively, this is
the kind of behavior we saw in Europe in the late 1990s.
Sp - I
G - T
European Union (percentage of GNP)
Year CA SP I G - T
1995 0.6 25.9 19.9 -5.4
1996 1.0 24.6 19.3 -4.3
1997 1.5 23.4 19.4 -2.5
1998 1.0 22.6 20.0 -1.6
1999 0.2 21.8 20.8 -0.8
Source: Organization for Economic Cooperation and Development, OECD Economic Outlook 68
(December 2000), annex tables 27, 30, and 52 (with investment calculated as the residual).
306 PART THREE Exchange Rates and Open-Economy Macroeconomics
Economists’ statistical studies suggest, however, that Ricardian equivalence doesn’t
hold exactly in practice. Most economists would attribute no more than half the decline
in European private saving to Ricardian effects. What explains the rest of the decline?
The values of European financial assets were generally rising in the late 1990s, a development
fueled in part by optimism over the beneficial economic effects of the planned
common currency. It is likely that increased household wealth was a second factor lowering
the private saving rate in Europe.
Because private saving, investment, the current account, and the government deficit
are jointly determined variables, we can never fully determine the cause of a current
account change using identity (13-2) alone. Nonetheless, the identity provides an
essential framework for thinking about the current account and can furnish useful clues.
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