Download Principles of Economic Growth

Thorvaldur Gylfason
Outline
1. Balance of payments accounting
– How BOP accounts are put together
and how they relate to monetary,
fiscal, and national income accounts
2. Balance of payments analysis
– Economics of exports, imports,
exchange rates, etc.
3. Current account sustainability
– Foreign debt, and how to keep it in
check
Balance of payments
accounting
Accounting system for macroeconomic
analysis in four parts
1.
2.
3.
4.
Balance of payments
National income accounts
Fiscal accounts
Monetary accounts
First look at balance of payments
accounts, and then look at linkages
External transactions
Goods
Exports
Imports
X
g
g
Z
Services Capital
X
s
Z
Real
transactions
s
x
F
F
z
Financial
transactions
Recording external
transactions
Balance of payments
BOP = Xg + Xs + Fx – Zg – Zs – Fz
=X–Z+F
= current account + capital account
Here
X = Xg + Xs Exports of good and services
Z = Zg + Zs Imports of good and services
F = Fx – Fz Net exports of capital =
Net capital inflow
Recording external
transactions
Balance of payments
BOP = Xg + Xs + Fx – Zg – Zs – Fz
=X–Z+F
= current account + capital account
Here
X = Xg + Xs Exports of good and services
Z = Zg + Zs Imports of good and services
F = Fx – Fz Net exports of capital =
Net capital inflow
Recording external
transactions
Balance of payments
BOP = Xg + Xs + Fx – Zg – Zs – Fz
=X–Z+F
= current account + capital account
Here
X = Xg + Xs Exports of good and services
Z = Zg + Zs Imports of good and services
F = Fx – Fz Net exports of capital =
Net capital inflow
Recording external
transactions
Balance of payments
BOP = Xg + Xs + Fx – Zg – Zs – Fz
=X–Z+F
= current account + capital account
Here
X = Xg + Xs Exports of good and services
Z = Zg + Zs Imports of good and services
F = Fx – Fz Net exports of capital =
Net capital inflow
Balance of payments
and reserves
Again
BOP = X – Z + F = DR
where
R = reserves
Note:
X, Z, and F are flows
R is a stock, DR is a flow
Balance of payments
and reserves
Again
BOP = X – Z + F = DR
where DR = R – R-1
Implications
X
F
Z
DR
DR
DR
In practice
Z
F
or DR
From trade balance
to current account
Trade balance
TB = Xg + Xnfs – Zg – Znfs
Xnfs = Xs – Xfs = exports of nonfactor services
Znfs = Zs – Zfs = imports of nonfactor services
Balance of goods and services
GSB = TB + Yf
Yf = Xfs – Zfs = net factor income
Current account balance
CAB = GSB + TR = TB + Yf + TR
TR = unrequited transfers from abroad
Importance of net
factor income
Net factor income from labor
– Remittances from domestic workers
abroad (e.g., Turks in Germany) minus
those of foreign workers at home
Net factor income from capital
– Interest receipts from domestic assets
held abroad minus interest payments on
foreign loans (e.g., Argentina)
– Includes also profits and dividends
Transfers also matter
Capital account
Also called capital and financial account
Four main items
1. Direct investment
–
Involves control by owners
2. Portfolio investment
–
–
Includes long-term foreign borrowing
Does not involve control by owners
3. Other investment
–
Includes short-term borrowing
4. Errors and omissions
–
Statistical discrepancy
Overall balance of
payments
Four main items below the line
1.
2.
3.
4.
Gold
SDRs
Reserve position in IMF
Foreign exchange
 Convenient to measure gross foreign
reserve holdings in terms of months of
import coverage – e.g., 3 months of
imports
National income
accounts
Y=C+I+G+X–Z
=E+X–Z
where E = C + I +G
CAB = X – Z = Y – E
Ignore Yf and TR for simplicity
S=I+G–T+X–Z
CAB = S – I + T – G
CAD = Z – X = E – Y = I – S + G – T
Links between BOP and
national accounts
Y=C+I+G+X–Z
GDP
GNP
GNP
GNP
= C + I + G + TB
= C + I + G + CAB
– GDP = CAB – TB = Yf (if TR = 0)
= GDP + Yf
 GNP > GDP in Turkey
 GNP < GDP in Argentina
GNDI = GNP + TR = GDP + Yf + TR
Links between BOP and
national accounts
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
Links between BOP and
national accounts
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
GNP
Current
Goods and
account excl. services
transfers
Links between BOP and
national accounts
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
GNP
Current
account excl.
transfers
Current
account incl.
transfers
Goods and
services
GNDI
Goods and
services plus
transfers
Fiscal accounts and
links to BOP
 Public sector
G – T = DB + DDG + DDF
 Private sector
I – S = DDP – DM – DB
Now, add them up
G–T+I–S=
DB + DDG + DDF + DDP – DM – DB =
DDG + DDF + DDP – DM =
DD – DM + DDF = -DR + DDF = Z - X
 External sector
X – Z = DR - DDF
Monetary accounts
and links to BOP
Monetary survey
M=D+R
From stocks to flows
DM = DD + DR
Solve for DR
DR = DM – DD
Monetary approach to balance of
payments
Still holds that DR = X – Z + F
Real exchange rate
Balance of payments
analysis
Payments for imports
of goods, services,
and capital
Imports
Earnings from exports
of goods, services,
and capital
Exports
Foreign exchange
Real exchange rate
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Real exchange rate
eP
Q
P*
Devaluation or
depreciation of e
makes Q also
depreciate unless P
rises so as to leave
R unchanged
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Overvaluation
Real exchange rate
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Overvaluation, again
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Welfare
Price
A
B
C
Consumer
surplus
E
Producer
surplus
Supply
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Demand
Quantity
Welfare, again
Price
Welfare
loss
A
J
F
B
E
Total surplus = AFGC
Supply
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
Price ceiling
H
G
C
Consumer surplus = AFGH
Producer surplus = CGH
Demand
Quantity
Welfare, again
Price
Welfare
loss
A
J
F
B
E
Price ceiling imposes a
welfare loss that results
from shortage (e.g., deficit)
Price ceiling
H
G
C
Supply
Shortage
Demand
Quantity
Causes and costs of
overvaluation
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce foreign
exchange
To make GNP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls
Inflation and
overvaluation
Inflation can result in an overvaluation
of the national currency
Remember: R = eP/P*
Suppose e adjusts to P with a lag
Then R is directly proportional to
inflation
Numerical example
Inflation and
overvaluation
Real exchange rate
Suppose inflation is
10 percent per year
110
105
100
Average
Time
Inflation and
overvaluation
Real exchange rate
Suppose inflation rises
to 20 percent per year
Hence, increased
inflation increases
the real exchange
rate as long as
the nominal
exchange rate
adjusts with a lag
120
110
Average
100
Time
How to correct
overvaluation
Under a floating exchange rate regime
Adjustment is automatic: e moves
Under a fixed exchange rate regime
Devaluation will lower e and thereby also
Q – provided inflation is kept under
control
Does devaluation improve the current
account?
The Marshall-Lerner condition
The Marshall-Lerner
condition: Theory
Valuation
effect
arises
from the
ability to
affect
foreign
prices
T = eX – Z
= eX(e) – Z(e)
Not obvious that a lower e helps T
Let’s do the arithmetic
Bottom line is:
Devaluation improves the current
account as long as
a  b 1
a = elasticity of exports
b = elasticity of imports
The Marshall-Lerner
+
condition
B  eX  Z B  eX (e)  Z (e)
dB
 dX  dZ
 X  e

de
 de  de
a
dB
 dX
 X  e
de
 de
b
 e  X   dZ   e  Z 
    
   
 X  e   de   Z  e 
1
1
The Marshall-Lerner
condition
dB
 dX  e  X   dZ   e  Z 
 X  e
    
   
de
 de  X  e   de   Z  e 
dB
 X  aX  bX  1  a  b X
de
dB
0
de
if
a  b 1
X
The Marshall-Lerner
condition: Evidence
Econometric studies indicate that the
Marshall-Lerner condition is almost
invariably satisfied
Industrial countries: a = 1, b = 1
Developing countries: a = 1, b = 1.5
Hence,
a  b 1
Empirical evidence from
developing countries
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
1.4
Elasticity of
exports
0.6
0.4
0.5
1.0
2.5
0.7
1.8
0.9
2.7
1.1
Elasticity of
imports
0.9
1.7
2.2
0.8
0.8
1.0
0.8
2.7
1.5
Small countries:
A special case
Small countries are price takers abroad
Devaluation has no effect on the foreign
currency price of exports and imports
So, the valuation effect does not arise
Devaluation will, at worst, if exports and
imports are insensitive to exchange
rates (a = b = 0), leave the current
account unchanged
Hence, if a > 0 or b > 0, devaluation
improves the current account
The importance of
appropriate side measures
Remember:
eP
Q
P*
It is crucial to accompany devaluation
by fiscal and monetary restraint in
order to prevent prices from rising
and thus eating up the benefits of
devaluation
To work, nominal devaluation must
result in real devaluation
Balance of payments
equilibrium
Equilibrium between demand and
supply in foreign exchange market
establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Current account
sustainability and debt
There are two ways to finance a deficit
on current account
1. Run down foreign reserves
 But there is a limit
 Rule of thumb: Do not bring reserves
below three months of imports
2. Run up debts abroad
 Where is the limit?
Is foreign debt bad?
Not necessarily if the borrowed funds are
used for profitable investments
Conceptual framework
If the world interest rate is lower than
the domestic interest rate, the
country will be a borrower in world
financial markets
Domestic firms will want to borrow at
the lower world interest rate
Domestic households will reduce their
saving because the domestic interest
rate moves down to the level of the
world interest rate
Conceptual framework
Real interest rate
Saving
Domestic
equilibrium
World
equilibrium
Borrowing
0
Domestic
saving
Domestic
investment
World
interest
rate
Investment
Saving, investment
Conceptual framework
Real interest rate
Saving
A
Domestic
equilibrium
World
equilibrium
B
C
D
Borrowing
World
interest
rate
Investment
0
Saving, investment
Conceptual framework
Real interest rate
Consumer surplus
before borrowing
Saving
A
Domestic
equilibrium
World
equilibrium
0
B
C
Producer surplus
before borrowing
Investment
Saving, investment
Conceptual framework
Real interest rate
Consumer surplus
after borrowing
A
Domestic
equilibrium
World
equilibrium
B
C
D
Borrowing
Producer surplus
after borrowing
0
Saving
World
interest
rate
Investment
Saving, investment
Conceptual framework
Before trade
After trade
Change
Consumer surplus
A
A+B+D
+ (B + D)
Producer surplus
B+C
C
-B
A+B+C
A+B+C+D
+D
Total surplus
The area D shows the increase in total surplus
and represents the gains from borrowing
Gains from trade:
Three main conclusions
 Borrowers are better off and savers
are worse off
 Borrowing raises the economic wellbeing of the nation as a whole
because the gains of borrowers
exceed the losses of savers
 If world interest rate is above
domestic interest rate, savers are
better off and borrowers are worse
off, and nation as a whole still gains
External debt:
Key concepts
Debt stock
Usually measured in dollars or other
international currencies
because debt needs to be serviced in foreign
currency
Debt ratio
Ratio of external debt to GDP
Ratio of external debt to exports
More useful for some purposes, because
export earnings reflect the ability to service
the debt
External debt:
Key concepts
Debt burden
Also called debt service ratio
Equals the ratio of amortization and
interest payments to exports
A  rD
q
X
F
q = debt service ratio
A = amortization
r = interest rate
DF = foreign debt
X = exports
External debt:
Key concepts
Interest burden
Ratio of interest payments to exports
Amortization burden
Also called repayment burden
Ratio of amortization to exports
F
rD
b
X
A
a
X
q=a+b
External debt: Magnitude
and composition
Magnitude of the debt
Debt should not become too large
How large is too large?
Measurement of the debt
Gross or net?
May subtract foreign reserves in excess of
three months of imports
Composition of the debt
FDI, portfolio equity, long-term loans,
short-term loans
External debt: Magnitude
and composition
Composition of the debt
Foreign direct investment
Least likely to flee, most desirable
Portfolio equity
Long-term loans
Short-term loans
Most volatile, least desirable
As a rule, outstanding short-term debt
should not exceed foreign reserves
External debt: Numbers
How can we figure out a country’s
debt burden?
Divide through definition of q by
income
F
A
D
r
Y
Y
q
X
Y
Now we have expressed the
debt service ratio in terms
of familiar quantities: the
interest rate r, the debt ratio
DF/Y, and the export ratio
X/Y as well as the
repayment ratio A/Y
Numerical example
Suppose that
r = 0.06
DF/Y = 0.50
A/Y = 0.05
X/Y = 0.20
Here we have a country
that has to use 40% of
its export earnings to
service its external debt
F
A
D
r
Y
q Y
X
Y
0.05  0.06  0.5 0.08
q

 0.4
0.2
0.2
External debt dynamics
Debt accumulation is, by its nature, a
dynamic phenomenon
A large stock of debt involves high
interest payments which, in turn, add to
the external deficit, which calls for
further borrowing, and so on
Debt accumulation can develop into a vicious
circle
How do we know whether a given debt
strategy will spin out of control or not?
To answer this, we need a little arithmetic
External debt dynamics
Recall balance of payments equation:
BOP = X – Z + F
where
F = capital inflow = DDF
where
DF = foreign debt
Capital inflow, F, thus involves an increase
in the stock of foreign debt, DF, or a
decrease in the stock of foreign claims
(assets)
So, F is a flow and DF is a stock
External debt dynamics
Now assume
Then, it follows that
BOP = X – Z + DDF = 0
so that
DDF = rDF
Z = ZN + rDF
Z = total imports
ZN = non-interest imports
rDF = interest payments
Further, assume
X = ZN
BOP = 0
In other words:
ΔD
r
F
D
F
A flexible exchange rate ensures
equilibrium in balance of payments at all times
External debt dynamics
So, now we have:
ΔD
r
F
D
F
Now subtract growth rate of output from
both sides:
ΔD
ΔY

 r-g
F
D
Y
F
DY
g
Y
External debt dynamics
But what is
ΔD F ΔY

F
D
Y
?
This is proportional change in debt ratio:
 DF 

Δ
F
Y 
ΔD
ΔY



F
DF
D
Y
Y
This is an application of a
simple rule of arithmetic:
%D(x/y) = %Dx - %Dy
Proof
z = x/y
log(z) = log(x) – log(y)
Dlog(z) = Dlog(x) - Dlog(y)
But what is Dlog(z) ?
dlog(z) dz 1 Δz
Δlog(z) 
  
dt
dt z z
So, we obtain
Δz Δx Δy


z
x
y
Q.E.D.
Debt, interest, and growth
We have shown that

Δd
rg
d
Debt
ratio
rg
where
F
D
d
Y
r=g
rg
Time
What can we learn
from this?
It is important to keep economic growth at
home above – or at least not far below –
the world rate of interest
Otherwise, the debt ratio keeps rising over time
External deficits can be OK, even over long
periods, as long as external debt does
not increase faster than output and the
debt burden is manageable to begin with
A rising debt ratio may also be OK as long as
the borrowed funds are used efficiently
Once again, high-quality investment is key
Debt dynamics:
Another look
Let us now study the interaction
between trade deficits, debt, and
growth
Two simplifying assumptions:
DDt = aYt (omit the superscript F, so D = DF)
Y Exponential
growth
Trade deficit is constant fraction a of output
Yt = Y0egt
Output grows at constant rate g per year
t
Pictures of growth
Y
log(Y)
g
1
time
time
Exponential growth implies a linear
logarithmic growth path whose
slope equals the growth rate
Debt as the sum of
past deficits
T
DT   ΔD t dt
0
at time T
Debt as the sum of
past deficits
T
DT   ΔD t dt
at time T
0
T
T
0
0
DT   ΔD t dt   aY0egt dt
Debt as the sum of
past deficits
T
DT   ΔD t dt
at time T
0
T
T
0
0
DT   ΔD t dt   aY0egt dt
 1  gt
DT   ΔD t dt   aY0e dt  aY0  e
g
0
0
T
T
gt
Evaluate this
integral between
0 and T
Debt as the sum of
past deficits
T
DT   ΔD t dt
at time T
0
T
T
0
0
DT   ΔD t dt   aY0egt dt
So, as T goes to infinity, Dt
becomes infinitely large.
But that may be quite OK
in a growing economy!
 1  gt
DT   ΔD t dt   aY0e dt  aY0  e
g
0
0
T
T
gt
Evaluate this
integral between
0 and T


 1  gt
 1  gT
DT   ΔD t dt   aY0e dt  aY0  e  aY0   e  1
g
g
0
0
T
T
gt
Debt as the sum of
past deficits
DT  a  Y0egt  Y0
  
YT  g 
YT
Debt as the sum of
past deficits
DT  a  Y0egt  Y0
  
YT  g 
YT
DT  a  Y0egt  Y0  a  Y0 
  
  1  
YT  g 
YT
 g  YT 
Debt as the sum of
past deficits
DT  a  Y0egt  Y0
  
YT  g 
YT
DT  a  Y0egt  Y0  a  Y0 
  
  1  
YT  g 
YT
 g  YT 
DT  a  Y0egt  Y0  a  Y0   a 
  
  1      1  e gT
YT  g 
YT
 g  YT   g 


Debt as the sum of
past deficits
DT  a  Y0egt  Y0
  
YT  g 
YT
DT  a  Y0egt  Y0  a  Y0 
  
  1  
YT  g 
YT
 g  YT 
DT  a  Y0egt  Y0  a  Y0   a 
  
  1      1  e gT
YT  g 
YT
 g  YT   g 

So, as T goes to
infinity, DT/YT
approaches the
ratio a/g
lim
T 
DT a

YT g

Numerical
example
Suppose
Debt ratio
3
Trade deficit is 6% of GNP
a = 0.06
Growth rate is 2% per year
Time
g = 0.02
Then the debt ratio approaches
d = a/g = 0.06/0.02 = 3
This point will be reached regardless of
the initial position ...
... as long as a and g remain unchanged
Numerical example, again
Here we have a
Suppose that
country whose
entire export
r = 0.06 (as before)
earnings do not
D/Y = 3 (our new number) suffice to service
its debts
A/Y = 0.05 (as before)
X/Y = 0.20 (as before)
A
DF
r
Y
q Y
X
Y
0.05  0.06  3
q
 1.15
0.2
Numerical example, again
Suppose that
r = 0.06 (as before)
D/Y = 2 (our new number)
A/Y = 0.05 (as before)
X/Y = 0.20 (as before)
A
DF
r
Y
q Y
X
Y
0.05  0.06  2
q
 0.85
0.2
Numerical example, again
Suppose that
r = 0.06 (as before)
D/Y = 1 (new number)
A/Y = 0.05 (as before)
X/Y = 0.20 (as before)
A
DF
r
Y
q Y
X
Y
0.05  0.06 1
q
 0.55
0.2
Numerical example, again
Suppose that
r = 0.06 (as before)
D/Y = 0.4 (new number)
A/Y = 0.05 (as before)
X/Y = 0.20 (as before)
A
DF
r
Y
q Y
X
Y
0.05  0.06  0.4
q
 0.37
0.2
Numerical example, again
Suppose that
r = 0.06 (as before)
D/Y = 0.4 (as before)
A/Y = 0.05 (as before)
X/Y = 0.30 (new number)
A
DF
r
Y
q Y
X
Y
0.05  0.06  0.4
q
 0.25
0.3
What to conclude?
Must adjust policies
Must either
Reduce trade deficit by stimulating exports
or by reducing imports, or
Increase economic growth
Otherwise, the debt ratio will reach
unmanageable levels, automatically
No country can afford an external debt
equivalent to three times annual output
And why not?
Because the debt burden then
becomes unbearable
Recall our earlier numerical example
Where we looked at the relationship between
the debt ratio and the debt burden
Korea is a case in point
Its export-oriented growth strategy reduced the
numerator and increased the denominator of
the debt ratio, thereby quickly reducing the
country’s debt burden
An import-substitution strategy would reduce
both numerator and denominator with an
ambiguous effect on the debt burden
In conclusion
These slides will be posted
on my website:
www.hi.is/~gylfason
External borrowing is a necessary and
natural part of economic development
This requires countries that borrow to invest
the funds borrowed in high-quality capital
This is necessary to be able to service the debt
If debt burden becomes too heavy, must
either reduce deficit or spur growth
It is always desirable anyway to do everything
possible to encourage economic growth
Rapid growth allows more foreign borrowing
without making the debt burden
unmanageable