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Accounting Framework
CHAPTER 12
Reinert/Windows on the World Economy, 2005
Introduction
International trade refers to the exchange of
merchandise and services among the
countries of the world
 International finance refers to the exchange
of assets among the countries of the world
 Global exchange of assets in the world economy

has at times been nearly 100 times larger than
the exchange of merchandise and services
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Open-Economy Accounts

View an economy as being aggregated into one giant sector
 For example, we’ll treat the Mexican economy as being composed of
• Firm account
• Household account
 Relationships between these two accounts are summarized as a
circular flow diagram of a simple, closed economy
• “Closed” means the absence of any trade and financial interactions with
the world economy
• Production process of the Firm generates income that accrues to the
Household



Income (Y) consists of wages, salaries, and payments for the use of
property assets
Given the simple assumptions of this chapter, Y is also equal to both the
nominal gross national product (GNP) and the nominal gross domestic
product (GDP) of Mexico
Consumption process of the household generates consumption
expenditures that accrue to the Firm (C)
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Figure 12.1 A Circular Flow Diagram
for a Simple, Closed Economy
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Open-Economy Accounts

To inject more realism we need to add three new
accounts
 Capital
• Income not consumed, which is available for use in investment
• Financial intermediary in the savings-investment process

Banks, mutual funds, and brokers that receive funds from savers
and use these funds to make loans or buy assets
 Government
 Rest of the World
• Captures the interactions of the Mexican economy with the other
countries of the world

Results in a circular flow diagram for an open
economy with government, savings, and
investment
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Figure 12.2 An Open Economy with
Government, Savings, and Investment
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Expenditures in Open-Economy
Accounts



Production process of the Firm generates income that
accrues to the Household
Household has three types of expenditures
 Consumption of goods and services (C)
 Household savings (SH) accrues as income to the Capital account
 Taxes paid to the government (T)
Government makes two alternative expenditures
 Government spending (G)
 Government savings (SG)
• In many cases SG are negative


Flow is reversed—from Capital to Government
Capital has a single expenditure (I)
 Funds provided to firms for investment purposes
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Open-Economy Accounts

The Rest of the World interacts with the
Mexican economy
 Makes an expenditure that accrues to the Firm
account in the form of its purchases of Mexico's
exports (E)
 Receives income in the form of Mexico's
purchases of imports (Z)
 Makes an expenditure that accrues to Capital in
the form of foreign savings (SF)
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Capital Account


Capital account has one expenditure—domestic investment
Capital account has three types of receipts (savings flows)
 Domestic savings
• Household
• Government
 Foreign savings

Expenditures must equal receipts for the Capital account, or

Helpful to rearrange this equation by subtracting domestic savings from
both sides
 Expenditure = Receipts or
 I = (SH + SG) + SF or
 Domestic Investment = Domestic Savings + Foreign Savings
 Domestic Investment – Domestic Savings = Foreign Savings

Any gap between domestic investment and domestic savings is made
up for by an inflow of foreign savings
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Rest of the World Account



Has two expenditures
 Mexico’s exports
 Foreign savings
Single receipt in the form of Mexico’s imports
Equation expressing the equality between expenditures and
receipts for the Rest of the World account
 E + SF = Z or
 Exports + Foreign Savings = Imports
 Helpful to rearrange this equation by subtracting exports from both
sides
• Foreign Savings = Imports – Exports or
• Foreign Savings = Trade Deficit

Gap between imports and exports (any trade deficit) has a
counterpart in and inflow of foreign savings
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Capital Account and Rest of
World Equations
Both have foreign savings on one side
 Can combine into a single relationship
 Fundamental accounting equation for open

economies
• Domestic Investment – Domestic Savings = Foreign
Savings = Trade Deficit

Can also be written as
 Domestic Savings – Domestic Investment = Foreign
Investment = Trade Balance
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Table 12.1. Domestic Savings, Domestic
Investment, Foreign Savings, and the Trade
Balance
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Fundamental Accounting
Equations


What do the fundamental accounting equations tell us?
Suppose that Mexico’s domestic investment exceeds its
domestic savings
 Shortfall in domestic savings is made up for by a positive inflow of
foreign savings
 According to the first equation, there must be a trade deficit
• Mexican economy is importing more merchandise and services in value
•
terms than it is exporting
Therefore, Mexico must sell something else other than merchandise and
services to the rest of the world to make up the difference

Assets: government and corporate bonds, corporate equities, and even real
estate
 Purchase of Mexican assets by the Rest of the World generates the
inflow of foreign savings into Mexico
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Fundamental Accounting
Equations

Suppose that Mexico’s domestic savings exceeds
its domestic investment
 Generates a positive outflow of foreign investment by
Mexico

According to the second equation, there must be a
trade surplus
 Mexican economy is exporting more merchandise and

services in value terms than it is importing
Therefore Mexico must buy something else other than
merchandise and services from the rest of the world to
make up the difference
• Assets—purchase of foreign assets by Mexico generates the
outflow of foreign investment to the Rest of the World
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Fundamental Accounting
Equations—Summary

Relate domestic investment, domestic savings, and the
trade deficit or surplus
 Trade deficit will be associated with an excess of domestic
investment over domestic savings
 Trade surplus will be associated with an excess of domestic savings
over domestic investment
 Fundamental equation provides a link between Mexico’s interactions
with the Rest of the World (the trade balance) and Mexico’s
economic aggregates of domestic investment and domestic savings
• Link is foreign savings


If domestic saving falls short of investment, the gap is made up for with
foreign savings, which we know is associated with a trade deficit
If domestic saving exceeds domestic investment, the excess is lent abroad
 This negative foreign savings is associated with a trade surplus
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The Balance of Payments
Accounts

Focus on the relationship of the country with the Rest of the World
Rest of the World equation

• Balance of Payments: Trade Balance + Foreign Savings = 0 or
• Current Account + Capital Account = 0
Capital account

 Foreign Savings = Trade Deficit
 Subtract the trade deficit from both sides of this equation
 Records the net balance of transactions involving the exchange of assets


between Mexico and the Rest of the World
When foreign savings is positive, there is a net positive purchase of Mexican
assets by investors in the Rest of the World
• Means by which the inflow of foreign savings takes place
Current account of the balance of payments
 Records the net balance of transactions between Mexico and the Rest of the
World not involving the exchange of assets
• Only trade transactions and is equal to the trade balance
 Includes more items than exports and imports
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The Balance of Payments
Equations



A current account surplus must be accompanied by
a capital account deficit
A current account deficit must be accompanied by a
capital account surplus
A common allegation about the place of the United
States and Europe in the world economy is that the
future lies in low-wage countries
 Attracting the bulk of world financial capital

• Implies that the countries will have capital account surpluses
Running large trade surpluses
• Implies that the countries will have current account surpluses
• Logical fallacy because this is impossible
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Table 12.2. Mexican Balance of Payments,
1993 (billions of US dollars)
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Analysis of Table 12.2

Table 12.2 gives the approximate balance of
payments accounts for Mexico in the year 1993
 1993 is the last year before the Mexican balance of
payments crisis in 1994

Current account includes items 1 through 6
 Item 1—total Mexican exports


• Reported in gross terms as US$61 billion
Item 2—total Mexican imports
• Reported in gross terms and has a value of $77 billion
Item 3—trade balance
• Reported in net terms—in 1993, Mexico had a trade balance of –
$16 billion or a trade deficit
• First term of the balance of payments equation above
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Analysis of Table 12.2
 Item 4—net factor receipts
• Residents of Mexico, either households or firms, own factors of
production located in the Rest of the World and receives income
or profits from this factory

Known as factor receipts or factor service exports
• Alternatively, residents of foreign countries own factors of
production located in Mexico, and they receive payments from
Mexico

From Mexico’s point of view, these are factor payments or factor
service imports
 Item 5—transfers and is recorded in net terms
• Possible transfer items are foreign aid, remittances of expatriates
and foreign workers from one country to another, and
international pension flows
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Analysis of Table 12.2

The sum of the net items 3 through 5
composes the current account balance and
is entered into the accounts as a major
balance in item 6 of Table 12.2
 In 1993, Mexico had a current account deficit of
$23 billion
 Since the accounts between Mexico and the rest
of the world must balance
• There were other transactions in the balance of
payments offsetting or financing the current account
deficit
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Analysis of Table 12.2

Capital account consists of transactions involving the
exchange of assets
 Type of asset exchanged and who exchanges them determines the
capital account item in which a transaction is recorded
• For example, item 7 is direct investment or direct foreign investment—
consists of money that corporations invest in firms they own in other
countries
 Portfolio investment
• Includes government bonds of various maturities, corporate equities,
corporate bonds, and bank deposits

Unlike direct investment, portfolio investment does not involve an element of
control
• Can be divided further into


Long-term capital
Short-term capital
 More volatile than long-term capital
• There was a net inward flow of portfolio investment in 1993 of $29 billion

Much of this was of a short-term nature and contributed to a crisis in 1994
and 1995
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Analysis of Table 12.2
 Official reserves balance (Item 9)
• Does not show up at all in the open-economy
•
accounts relationship of the balance of payments
equation above
Reflects the actions of the world’s central banks
Central banks need to hold reserves of foreign exchange
 Other countries’ government bonds and accounts at foreign
central banks

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Analysis of Table 12.2

Transaction on the official reserves balance occur in four
instances:
 Mexico’s central bank sells foreign exchange holdings
• Generates an inward flow of funds and income or receipts on Mexico’s
official reserve balance (positive entries)
 Mexico’s central bank buys foreign exchange holdings
• Generates outlays or expenditures on the official reserve balance
(negative entries)
 Foreign central banks sell their reserves of Mexico’s currency
• Generates an outward flow of funds and an outlay or expenditure on
Mexico’s official reserves balance (negative entries)
 Foreign central banks buy reserves of Mexico’s currency
• Generates an income or receipts on Mexico’s official reserve balance
(positive entries)
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Analysis of Table 12.2

Up to this point
 Current account balance is –$23 billion
 Direct investment balance is $4 billion
 Portfolio investment balance is $29 billion
 Official reserves balance is –$7 billion
• Sum is $3 billion, yet the current and capital accounts must sum
to zero

What has gone wrong?
 In most all cases, collecting balance of payments data is a
difficult and imprecise activity
 Many transactions cannot be measured accurately or simply
“slip through the cracks”
 Consequently, there needs to be an honest accounting of errors
and omissions, recorded as a net balance of –$3 billion in item
10
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Balance of Payments Accounts
as a Diagnostic Tool

Help identify patterns of relationships of the
country in question with rest of world that
might not be sustainable
 For example, if a country is financing persistent
current account deficits with short-term portfolio
investment or by selling foreign reserve holdings
• May be cause for alarm
 Economist can turn to the open-economy
accounts to explore how the external imbalance
is associated with domestic (household and
government) savings and investment
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Table 12.3. The Mexican Balance of Payments,
1990-1996 (billions of US dollars)
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