Download global business environment: macroeconomics

THE GLOBAL BUSINESS ENVIRONMENT:
INTERNATIONAL MACROECONOMICS AND FINANCE
Professor Diamond
Class Notes: 1
INTRODUCTION AND MEASURING ECONOMIC
PERFORMANCE IN THE GLOBAL ECONOMY
NOMINAL VS. REAL VALUES
Virtually all prices of goods and services in our economy are measured in terms
of current (nominal) market values. At a given moment of time this enables a
comparison of prices of competing goods as well as a summation of different types of
goods and services.
However, when we need to compare the value of key macroeconomic variables
over time we need to convert the nominal data into real values in order to eliminate the
impact of inflation. Nominal values are measured in current dollars not adjusted for
inflation. Real values are measured in constant dollars adjusted for inflation.
To convert nominal data to real values we utilize a price index. A price index
(deflator) is a measure of the average level of prices of a specified set of goods and
services relative to their prices in a given base period.
THE CONSUMER PRICE INDEX AND THE PRODUCER PRICE INDEX
The most utilized measure of inflation is the Consumer Price Index (CPI). It
measures the cost of living for urban households. The CPI is published monthly by the
U.S. Department of Labor’s Bureau of Labor Statistics (BLS). It provides information
for the nation as a whole and the major metropolitan areas. Utilizing sampling
techniques, data is collected for major categories of goods and services e.g. energy,
housing, food, medical services, etc. Since the 1973 OPEC oil boycott the BLS also
computes a core rate CPI. The core rate is the total for all items minus the volatile areas
of energy and food.
The Producer Price Index (PPI) measures the changes in prices at the producer’s
(wholesale) level. Data is published monthly for finished, intermediate and raw material
goods. Like the CPI, the BLS also provides a core rate PPI. The base periods for the two
indices are roughly the same: CPI 1982-84 = 100 and PPI 1982 = 100. However, the CPI
registers a higher rate of inflation than the PPI. For example, at the end of 1999 the CPI
was 168.3 vs. 135.0 for the PPI. The principle reason for the difference is that the PPI
does not include the cost of services, which has been a major source of the rise in
consumer prices. It is interesting to note that the PPI, for which we have fairly reliable
data back to the U.S. colonial period, shows no increase in trend values from the late
1700’s to 1940. During these 150 years periods of inflation were offset by periods of
deflation due to a boom and bust business cycle. Since 1940, however, the PPI and the
CPI trend values have been rising.
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THE GDP DEFLATOR AND THE CHAIN WEIGHTED GDP PRICE INDEX
Gross Domestic Product (GDP) is usually expressed in real terms. Unless
indicated to the contrary, GDP is stated in real terms in these class notes. Real GDP is
derived by dividing nominal (dollar) GDP by the GDP deflator, which is often referred to
as the Implicit GDP Deflator. Real GDP is a measure of the physical volume of an
economy’s production.
Both the CPI and PPI are fixed weight price indices. Each month the BLS
collects the current prices of a fixed list or market basket of goods and services. The
index is calculated by dividing the current cost of the items by their cost in the base
period.
The GDP deflator until 1995 was determined utilizing a variable weight index. In
any given year the GDP deflator is defined as the value of the final goods and services in
a given base year prices. However, the rapid introduction of a new products in recent
years e.g. computers, VCRs and cell phones made the use of the fixed base year
increasingly irrelevant. To deal with this problem in 1995 the U.S. Department of
Commerce, Bureau of Economic Analysis which publishes GDP and other national
product and income data began to utilize a chain-weighted price index. This index uses a
moving base year, which is always the year prior to the current year.
Although the variable and particularly the chain-weighted indices are
conceptually more accurate than the fixed weighted indices, empirical data indicates that
neither is clearly superior. When the prices of different goods are changing by different
amounts a fixed weighted index tends to overstate the cost of living since it fails to take
into account that consumers can substitute less expensive goods. Conversely, under these
conditions the variable weighted indices tend to understate the increase in the cost of
living since although it allows for the substitution of alternate goods it fails to reflect the
reduction comparison of the original GDP deflator and the new chain weighted GDP
price index also indicates that there is no significant difference between the two
measures.
THE NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA)
The NIPA is the official U.S. government accounting system that collects and
publishes data on the nation’s output of goods and services. Gross Domestic Product
(GDP) is the total expenditure on domestically produced goods and services. It is also
the total income earned domestically form both U.S. and foreign owned factors of
production.
The National Income Accounts Identity is the equation showing that the sum of
consumption, investment, government purchases and net exports equals GDP. These data
are published by the U.S. Department of Commerce’s Bureau of Economic Analysis.
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Thus, if we let Y = GDP
Y = C+I+G+NX
where Y = Gross Domestic Product expressed in real terms
C = Consumption
I = Investment
G = Government Spending
NX = Net exports of goods and services
A statement of the National Income Identity which includes NX is referred to as
an open economy. It is an economy that sells goods and services to other nations, buys
imports form them and has significant financial flows to and from foreign nations. A
closed economy is a nation that has little or no trade in goods, services or financial
(capital) flows with other countries. The United States was viewed as essentially a closed
economy for most of its history despite the fact we have always been a coastal nation
with a sizable foreign trade. However, as late as the immediate post-World War II
decades of the 1940’s and 1950’international trade accounted for only about 5 percent of
GDP, exchange rates were fixed and financial flows to and from other nations were
restricted. This is no longer the case. Changing geopolitical, economic and technology
factors have increasingly transformed the U.S. into a more open economy. Imports now
constitute 13 percent of GDP. The exchange rate of the dollar has been floated since 1973
and international financial flows are massive. No longer can U.S. macroeconomic
policies be viewed solely in terms of their impact on the domestic economy. The Federal
Reserve, for example, in determining its monetary policies must take into account the
impact of interest rate changes on both the domestic and international economies. U.S.
inflation in the 1970’s was primarily a function of the policies of the international oil
cartel, OPEC. The impact of sizable U.S. government budget deficits in the 1980-1995
period on private domestic investment was eased by substantial capital flows from
abroad. The 1997-98 Asian financial crises impacted the U.S. positively by substantially
reducing the price of imports while at the same time threatening the prolonged prosperity
of the 1990’s. Moreover, some economists regard the persistent and growing U.S. trade
deficit as one of the major problems facing the U.S. economy. It should be noted that no
major or minor economy in the world today is totally open or closed. In the case of the
U.S., which is increasingly an open economy and a champion of free trade, it still retains
some tariffs and import quotas as well as restrictions on the flow of foreign labor.
Despite the open economy status of the U.S., for analytical and modeling
purposes we still find it useful to use the closed economy expression of the national
income identity for analytical purposes. Let us restate the national income identity in
terms of a closed economy i.e. no net exports:
Y = C+I+G
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We can also observe that the income generated by GDP can be allocated as follows:
Y = C+S+T
where Y = Gross National Income
C = Consumption
S = Saving (that portion of income which is not allocated to
consumption or taxes)
T = Taxes
Setting the two equations equal yields:
C+I+G = C+S+T
If we cancel C from both sides then:
I+G = S+T
And
I = S+ (T-G)
Investment is equal to savings where S is private saving and T-G (taxes minus
government purchases) is government or public saving. As we shall discover the equality
of saving and investment is critically important to our understanding of long and short
run equilibrium in our economy.
We can also observe that saving equals investment by rearranging our expenditure
expressions of GDP in the closed economy:
Y = C+I+G
Recognizing that all government expenditures are viewed in the NIPA as consumption
spending then:
Y-C-G = I
where Y-C-G is the value of the output that remains after the needs of consumers and
government have been met, and thus is national saving or simple saving. As we have
noted earlier national saving is comprised of private (personal and business) saving and
government (public) saving.
A further simplification of the national income identity is to eliminate the
government sector (G and T) in the national income identity, then:
Y = C+I and
Y = C+S
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Equating total national spending with total national income:
C+I = C+S
and once again S = I
We will find this form of the identity useful in developing our models of economic
growth.
NATURAL GDP
Before leaving the subject of the NIPA we need to introduce the concept of the
natural level of GDP. It is the level of national output/income towards which ht economy
gravitates in the long run. It is the level of GDP which results from the full utilization of
the available factors of production in a given time period. It is also sometimes referred to
as the full employment GDP or the non-accelerating inflation rate of unemployment
(NAIRU) GDP. We let Y equal natural GDP. As a result of economic growth
Y changes over time.
THE OPEN ECONOMY
Let us return to the open economy expression of the national income identity and
examine it in more detail.
We begin by observing that some output is sold domestically and some abroad,
thus:
Y = C d  I d  G d  EX
where C d  I d  G d are consumption, investment and government spending on domestic
goods and services and EX is foreign spending on domestic goods and services.
Furthermore:
C = Cd  C f
I =Id I f
G = Gd  G f
Where total consumption, investment and government expenditures are respectively the
sums of domestic and foreign purchases of goods and services, we can substitute this into
the open economy equation as follows:
Y = (C  C f )  ( I  I f )  (G  G g )  EX
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Rearranging we find:
Y = C+I+G+EX- (C f  I f  G f )
We observe that (C f  I f  G f ) is expenditures on imports (IM) and thus the national
income identity is now:
Y = C+I+G+EX-IM
and if we let (EX-IM) equal net exports (NX) we arrive at:
Y = C+I+G+NX
This statement of the national income identity states that expenditures on domestic output
is the sum of consumption, investments, governments purchases and net exports, and:
NX = Y-(C+I+G)
Net exports equals output minus domestic spending on domestic and foreign goods and
investments. If output exceeds domestic spending, net exports are positive and the nation
has a trade surplus. If output is less than domestic spending, net exports are negative and
the nation ahs a trade deficit. Now we again express the national income identity in
terms of saving and investment.
Since
Y = C+I+G+NX
Then
Y-C-G = I-NX
And since Y-C-G is national saving S, then:
S = I+NX or
S-I = NX
Furthermore, as in the case of the closed economy, we can divide national saving into
private and public saving by setting the national income identity equal to the alternative
ways hat national income may be allocated:
C+I+G+NX = C+S+T
Eliminating C from both sides of the equation yields:
I+G+NX = S+T
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Combining government purchases and taxes we arrive at:
I+NX = S+(T-G)
when S is private saving and the difference between taxes and government spending is
public saving. If tax revenues exceed government expenditures, a surplus is generated
and there is positive public saving. If taxes are less than government spending there is a
budget deficit and negative public saving. Rewriting the equation:
S+(T-G)-I = NX
where private plus public saving (national saving) minus domestic investment equals net
exports.
As in the closed economy model the relationship between saving and investment
is important S-I is net foreign investment. It is the excess of domestic saving over
domestic investment. It is equal to the amount that domestic residents are lending abroad
minus the amount that foreigners are lending to the domestic economy. NX is the trade
balance. It can be positive and the nation has a trade surplus or negative and the nation
has a trade deficit. As we shall discern the positive or negative nature of the trade
account largely determines the nature of the current account in the balance of payments.
Net foreign investment always equals the trade balance. Any nation that
generates a trade deficit must cover this difference by being a net borrower in world
financial markets. Nations that experience a trade surplus are net lenders to the rest of
the world. Thus, this form of the national income identity shows that the international
flow of goods and services (trade) and the international flow of funds to finance capital
accumulations are two sides of the same equation. If a nation’s investments exceeds its
saving, the extra investment funds must be secured by borrowing from abroad. These
funds are necessary so that the trade deficit nation can cover the difference between the
value of its imports and exports. Conversely, if a nation’s saving exceeds its investments,
the saving that is not invested domestically is lent to foreigners so that they can pay for
the difference between the value of their imports and exports.
Note that the international flow of capital can take a variety of forms. For
example, a trade deficit nation like the U.S. can borrow abroad by selling bonds issued by
the U.S. government or private corporations. Alternatively it can take the form of a direct
investment when a foreign corporation constructs a plant or other physical facilities in the
U.S. It can also take the form of foreign purchases of existing U.S. capital stock such as
factories, office buildings, hotels, and recreational properties such as golf courses. In all
of the above, foreigners end up with either a claim to the future returns to domestic
capital or ownership of a portion of the domestic capital stock. The net foreign
investment of the domestic economy is reduced. Moreover, if a domestic economy like
the U.S. experiences sizeable trade deficits over an extended period of time foreign
claims on its capital stock may grow to a level where foreign lenders are no longer
willing to purchase additional claims at the current interest rate level, or in reaction to a
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negative shock to either their own economy or that of the deficit nation may decide to
cash in a sizeable proportion of their claims. This could cause serious financial and
economic problems for the borrowing (debtor) nation.
THE LONG AND SHORT RUN: ECONOMIC GROWTH, BUSINESS CYCLE,
UNEMPLOYMENT AND INFLATION
We have already used the term “long run” in our discussion of GDP. The distinction
between the long and short run is critical to the understanding of macroeconomic theory.
It is also important to make this distinction in analyzing macroeconomic problems. The
long run is an extended time period usually lasting at least a decade thus allowing for
significant changes in key economic variables. The short run is a limited time period
where there is insufficient time for economic variables to fully adjust to changes.
Most macroeconomic theories can be divided into long run and short run
theories. The former focuses on economic growth and the latter on economic stability the business cycle. Moreover long run theories postulate prices to be flexible and thus
respond to changes in supply and demand. In contrast short run theories view most prices
as sticky at some predetermined level.
Classic economic theory focuses on the long run. In so doing it has developed
the concept of the classical dichotomy. This concept enables economists to simplify
economic theory by ignoring nominal variables and concentrate on real variables. For
example, in discussing economic growth we can ignore changes in the money supply
since they do not influence real variables. In contrast, neo-Keynesian theories focus on
the short run. A frequently quoted Keynesian observation is – why worry about the long
run since we will all be dead.
It should also be noted that the impact of a given economic factor may vary in the
long vs. the short run. For example, a high national saving rate is a most positive element
promoting economic growth. However, a high saving rate during the contraction phase
of a business cycle can be a significant negative force in preventing an economy from
returning to prosperity.
ECONOMIC GROWTH
As indicated economic growth theories focus on the long run. They seek to
explain why some countries grow while others do not. At the same time economic
growth is reported in a short run context. The U.S. Department of Commerce Bureau of
Economic Analysis publishes annual rates of changes in real GDP as well as quarterly
data expressed as an annual rate.
In the long run context the measurement of economic growth needs to take
population growth into account. The goal of economic growth is to increase the standard
of living for all individuals. For example, if a nation during a 25 year period were to
double both the size of its population and its annual real GDP, it would have experienced
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significant growth in the total output of goods and services. However, the average
citizen’s level of living would be unchanged. Thus, the appropriate measure of long-term
economic growth is real GDP divided by the size of the population - per capita GDP.
Table 1.1 shows GDP per capita for OECD member countries. OECD is the
Organization for Economic Cooperation and Development. Its members are the nations
with the largesse economies and highest standards of living. You will note GDP per
capita is presented on two bases. One utilizes the current (nominal) exchange rate and
the other the purchasing power parity exchange rate. We will distinguish between the
two measures when we discuss exchange rates later on in the course. We will also want
to explore the major economic models utilized to explain economic growth.
BUSINESS CYCLES
Business cycles are a short run phenomenon. Since the onset of the industrial
revolution many nations, including the United States, have experienced sustained and
substantial economic growth. At the same time, long-term growth has not been smooth.
Periodically increases in GDP have been interrupted by swings in the level of economics
activity -business cycles. Business cycles are economy wide fluctuations in output,
income and employment characterized by alternating waves of expansion and contraction
occurring in a familiar but irregular manner. Prior to World War II U.S. business cycles
often manifested four distinct phases – recovery, prosperity, crisis and depression. The
crisis phase was caused by a severe shock to the economy, such as a financial panic or a
stock market crash. Since 1945 the business cycles has been moderated to exhibit only
two phases prosperity and recession. A recession is commonly described as two
consecutive quarters of negative GDP. The definition of a recession, recognized by the
U.S. government, is the one utilized by the National Bureau of Economic Research: a
period of decline in total output, income, employment, and trade usually lasting
from six months to a year and marked by widespread contraction in many sectors of
the economy.
Given what we have observed concerning the theoretical differences between the
classical and Keynesian schools of thought, it is not surprising to learn they have
differing views of the business cycle. Classical theorists advocate real business cycle
theory. They postulate that the origin of the business cycles lies in real changes in the
economy such as new production techniques or products (technology), bad weather
conditions, new sources of raw materials or real change in government expenditures.
Furthermore, consistent with their long run perspective of the flexibility of prices and
wages they believe the economy will rapidly adjust to the real shocks and return to the
natural level of GDP. There is no need for government intervention (stabilization
policies). Indeed, in virtually all instances government stabilization policies do more
harm than good. In contrast Keynesians believe that nominal variables, particularly
changes in the money supply play a major role by influencing the demand for goods and
services. Given their view that prices and wages are sticky in the short run they theorize
that when shocks destabilize the economy it may take some time before GDP returns to
its natural (full employment) equilibrium. Accordingly they advocate the government
should intervene with appropriate stabilization policies to smooth out the business cycles.
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A substantial majority of U.S. economists agree with the Keynesian school. We will
explore these subjects in some detail.
BUSINESS CYCLE INDICATORS
Not surprisingly the Great Depression of 1929-33 sparked considerable research
as to the possible causes and cures of the business cycle. This was clearly one of the
stimuli leading to Keynes’ publication of the General Theory of Employment, Interest
and Money. The leading students of the business cycles were Wesley Mitchell, Arthur
Burns and others at the National Bureau of Economic Research (NBER). They studied
literally hundreds of business and economic statistical series. These series have been
classified as to direction and timing. Those that move in the same direction as aggregate
economic activity (GDP) such as consumption, industrial production and employment are
termed pro-cyclical. Those that move in the opposite direction are counter-cyclical e.g.
unemployment and bankruptcies. Still others appear to be insensitive to business cycles
and are termed acyclical such as real interest rates. Timing refers to when the turning
points (peaks, troughs) of a statistical series occur relative to the turning points of the
business cycles. Here we can identify three classes of business cycle indicators –
“leading” which tend to turn in advance of aggregate economic activity; “coincident”
whose peaks and troughs occur at about the same time as those of the business cycles’
and “lagging” whose turning points tend to occur after those of the business cycle.
Since the business cycle, particularly in its recession phase importantly impacts
all segments of the economy, any advance information would be most helpful.
Accordingly economic forecasting has become an important activity particularly in
business and government sectors. Of the many statistical series used to forecast business
conditions, the Index of Leading Indicators is one of the most important. This Index
along with the companion Leading and Lagging Indexes is published monthly by The
Conference Board, a leading not for profit business research and service organization.
Based on the work of the NBER the Index of Leading Economic Indicators is
composed of 10 variables, such as average weekly initial claims for unemployment
insurance, contracts and orders for plant and equipment in real dollars, the index of stock
prices and the index of consumer expectations. Each of the components of the leading
indicators has a tendency to predict (lead) economic activity and are frequently and
promptly available. This latter characteristic is essential if the index is to be available in
a timely manner. On the whole the index is a valuable forecasting device, correctly
predicting a large majority of business cycle turning points since World War II.
However, it is by no means perfect. Like all measures of economic activity it has its
limitations.
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UNEMPLOYMENT
During the expansion and contraction phases of the business cycle there are
changes in key economic variables. The most important are GDP, unemployment and
inflation. We have already discussed GDP. Let us now examine unemployment and
inflation.
To understand unemployment we begin with some basic definitions. The labor
force is the number of persons 16 years of age or over who are either working or
unemployed. For analytical purposes we usually exclude those in the armed forces.
Unemployment is the number of persons in the labor force who are jobless and actively
seeking work. The natural rate of unemployment U is the rate of unemployment
toward which the economy gravitates in the long run. It is the unemployment rate
accompanying natural GDP, Y .
The major components of natural unemployment are frictional, structural,
seasonal and wait unemployment. Frictional unemployment occurs as workers move
from job to job in the search for suitable employment and as firms seek suitable
employees. Structural unemployment results from an imbalance between the skill,
training, education and location of workers and the requirements of available jobs.
Seasonal unemployment is due to the seasonal character of some work situations caused
by weather conditions and the customs of the society such as major national holidays or
vacation periods. Wait unemployment is due to inefficiency in the job market due to
factors such as wage rigidity, job rationing and insufficient information about job
opportunities.
Empirically the natural rate of unemployment for any given year can be estimated
by averaging all unemployment rates for 10 years later. Changes in one or more of the
types of unemployment that comprise U can cause the natural rate to change. As figure
6-1 indicates for the U.S. the natural rate was below 5% from the end of World War II
until the mid 1960’s. Thereafter it rose to 6% by the mid 1970’s and remained generally
at that level until the mid 1990’s. During the latter half of the 1990’s, it has been
estimated to have fallen to between 5.5 and 5%. Some of the possible reasons for these
changes include:
1. The changing composition of the labor force – large numbers of teenagers
(baby boomers) entering and women returning to the work force.
2. The increase in female labor force participation – which has increased the
number of two-income families apparently causing the unemployment rate of
men to rise.
3. Sectoral shifts in the economy such as the OPEC oil shock which forced
workers to relocate from more energy intensive to less energy intensive
industries.
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OKUN’S LAW
During the contraction phases of the business cycle (recession or depression) the
nation’s unemployment rate may rise substantially. The difference the between the total
unemployment rate and the natural rate (cyclical unemployment) and the change in the
annual growth rate of GDP is described by Okun’s Law.
Arthur Okun, an economics professor at Yale, was asked in 1961 by President
Kennedy’s Council of Economic Advisors (CEA) to serve as a consultant. The CEA
wanted to convince the President, Congress and the public that a reduction of the current
unemployed rate of almost 7% in 1961 to 4% would yield economy-wide benefits. Okun
was asked to estimate the gains of GDP associated in the unemployment reduction. The
answer became known as Okun’s Law.
The law describes the relationship between cyclical unemployment and GDP. For
each percentage point that the cyclical unemployment rate was above the natural rate,
Okun found the GDP was 3% below natural GDP (Y). The percentage departure of
actual GDP from Y is called the GDP gap. Current calculations estimate that for every
percentage point of unemployment above natural unemployment there is a loss of 2% in
GDP. Another way of expressing Okun’s law is to say that a decrease in cyclical
unemployment of 1% is associated with additional growth in GDP of approximately 2%/
More formally Okun’s Law may be expressed as:
Y / Y  Y / Y  2U
The equation states the percentage growth rate of GDP Y / Y is equal to the percentage
growth rate of natural GDP minus two times the change in cyclical unemployment (U).
For example, assuming that natural GDP grows by 3% annually, public policy that
reduced unemployment from 7% to 6% during a recession would result in increasing
GDP by 5%.
Figure 1.1 entitled “The U.S. Job Machine” shows unemployment rates and yearto-year changes (increases and decreases) in non-farm payrolls from 1976 to 1998. Note
that the 6% unemployment level as shown by the dark horizontal line drawn at the 6%
unemployment rate. In the period 1978 to the mid 1990’s the unemployment rate was
generally at or above the 6% level. Significant cyclical unemployment (above 6%)
occurred during the 1981-82 and 1990-91 recessions and the immediate years following
these contractions. Since 1994 to 2000 there has been a steady decline in the
unemployment rate to below the 4% level. These are the lowest levels of unemployment
in some 40 years. It is one of the remarkable signs of the longest and most robust
expansion in U.S. business cycle history.
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INFLATION
As we have observed it is important in macroeconomic analysis to take account of
changes in the price level. This is certainly the case in studying the business cycle. In pre
World War II U.S. business cycles the economy experienced both inflation and deflation.
With the advent of the moderate business cycles since 1945 we have had to deal only
with inflation.
Figure 1.2 entitled “Waging War on Inflation” depicts the annual rate of inflation
as measured by the CPI from 1960 to 1998. Observe that for the first half of the 1960’s
the inflation rate was below 2%. This was also the case in the 1945-1960 period.
However, in the latter half of the1960’s the inflation rate began to rise due largely to
increased deficit financing associated with the Vietnam conflict. By 1969 the inflation
rate had risen to 6%. At his point a recession occurred due primarily to the negative
effect of rising prices on the economy and the efforts of our central bank, the Federal
Reserve, to slow down the inflation rate. Note that recession periods are shown by the
shaded areas on the chart. Observe that the 1980 and 1990-91 recessions were also
preceded by a rise in the inflation rate. The exception was the 1981-82 recession which
was induced by the Federal Reserve to disinflate the economy i.e. wring out the inflation
that had occurred in the 1970’s and early 1980’s due to the OPEC oil price increases.
During the 1982-85 disinflation period the U.S. inflation rate dropped substantially. The
modest rise in the price level during the last half of the 1980’s was eliminated in the
1990-91 recession. Since that time and particularly in the 1995-2000 period U.S.
inflation has been quite low with the national rate returning to the levels of the immediate
post World War II decades.
THE PHILLIPS CURVE
Based on the longitudinal studies of a New Zealand economist A.W. Phillips, who
observed a predictable trade-off between inflation and unemployment, most economists
accepted the principal known as the Phillips Curve. It showed that as a nation tried to
reduce its unemployment rate below the natural level a negative relationship arose
between the unemployment rate and inflation – as the unemployment rate fell the
inflation rate would rise. The Phillips Curve accurately described the U.S. economy of
the 1960’s. However, with the onset of the OPEC induced inflation of the 1970’s the
empirical evidence deviated from the expected Phillips Curve configuration. This
discrepancy continued in the 1980’s and 1990’s. Indeed another remarkable aspect of the
1990’s expansion is that the U.S. economy experienced lower unemployment
accompanied by lower rates of inflation. See Figure 1.3. Furthermore, the Phillips Curve
was attacked on theoretical grounds because it studied money wages rather than real
wages. While the Phillips Curve is largely discredited, the notion that a nation’s annual
GDP growth rate with its accompanying unemployment rate cannot long exceed its
natural growth rate without generating sizeable increases in its inflation rate still prevails.
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THE BALANCE OF PAYMENTS, THE CURRENT AND CAPITAL ACCOUNTS
AND THE TRADE DEFICIT
THE BALANCE OF PAYMENTS ACCOUNTS
Previously, we derived and examined the open economy expression of the
national income accounts identity. We now want to extend our understanding of the links
between the domestic and international economies.
The balance of payments accounts is a summary record of all transactions in
goods, services and financial assets during a given time period between a country’s
residents and residents of the rest of the country. It records the sources (receipts) and use
(payments) of funds for a country’s external transactions. It is a flow of funds statement
that shows changes in national assets, liabilities and net worth over time. The sources of
funds are exports, investment income, transfer payments received and long term and short
term borrowing abroad. The use of funds are imports, investment income paid abroad,
transfer payments abroad, long term and short term lending and investments abroad and
increases in official reserve assets.
Balance of payments accounts utilize a double entry accounting system. Any
accounting transaction giving rise to a receipt from the rest of the world or which
increases net claims on foreigners is recorded as a credit. Conversely, any transaction
giving rise to a payment to the rest of the world or which increases net indebtedness to
foreigners is recorded as a debit. There is always an equality between credits and debits.
THE CURRENT ACCOUNT
The balance of payments is divided into two major accounts – the current account
and the capital account.
The current account includes four major categories – merchandise, services,
income on investments and unilateral transfer. The difference between a nation’s
merchandise exports and imports is called the merchandise trade balance. Since the
mid 1970’s it has been in deficit. Services include a variety of non material transactions
such as the billeting of U.S. troops abroad, transportation, tourism, financial and legal
services, educational services consulting and the like. It is one of the rare components of
the balance of payments which is currently in a surplus mode. However, its net positive
balance is insufficient to offset the negative merchandise trade balance. Thus the U.S.
balance on goods (merchandise) and services, the trade balance, has registered a deficit
for some 25 years. As we noted earlier this is NX in the national income identity.
Income on investments records receipts from assets abroad, such as interest,
dividends, profits and royalties. They are offset by payments to foreigners for the use by
the domestic economy of their financial and capital assets. As we shall see until recently
this account has generated a net surplus. However, the accumulation by foreigners of
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U.S. financial and capital assets for some 25 years has finally transformed this portion of
the current account into a deficit mode.
Unilateral transfers are payments made from on country to another that do not
involve the purchase of any goods, services or assets. Examples include government
grants for foreign aid or relief assistance, pensions paid to citizens living abroad and
immigrant remittances to family members in their former country. Net unilateral
transfers for the U.S. have consistently been negative due to sizeable immigration
throughout the nation’s history.
The sum of the above four major components yields the current account
balance. For the 30 years between 1970 and 2000, with the exception of the early 1970’s
and the recessions of the first half of the 1980’s and 1990-91, it has been in deficit mode.
During this time period, it was dominated by the trade account which except for two
years in the early 1970’s, registered deficits. In such a case, for analytical purposes, the
current account (CA) may replace net exports (NX) in the national income identity:
NX = Y – (C+G+I)
and since
NX = CA
then
CA = Y – (C+G+I)
If a nation’s output/income exceeds its consumption expenditures on domestic and
foreign goods and services, investments and government spending then it generates a
current account surplus. If, however, the sum of its consumption, investment and
government expenditures is greater than its output a current account deficit results.
In this context note that it is possible for a country to have a trade surplus and a
current account deficit. This occurs when a nation has accumulated a large foreign debt
and the servicing of this debt results in a sizeable deficit in the income of the investment
account. This deficit may exceed the trade account surplus yielding a current account
deficit. This was the case in Brazil in the 1980’s who experienced a large current account
deficit
THE CAPITAL ACCOUNT
The capital account records trade between countries in existing assets either real
or financial. When the home country sells an asset to another country the transaction is
registered as a capital inflow for the home country and thus as a credit item in the capital
account. When the home country buys an asset from abroad the transaction is a capital
outflow from the home country. The capital accounts balance equals the value of capital
inflows minus the value of capital outflows. When the residents of the home country
purchase more assets from abroad than they sell to foreigners the capital accounts balance
is said to be in deficit (negative). The converse is true if more assets are sold abroad than
purchased from foreigners. Since the U.S. current account is in deficit and the sum of the
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current and capital accounts must be zero, the U.S. capital account must be on net in
surplus (positive). The summing of the actual numbers in the current and capital
accounts do not equal zero due to statistical discrepancies – errors and omissions in
reporting a country’s transactions with the rest of the world. This is corrected by
including a statistical discrepancy figure in the balance of payments accounts. This may
often be a substantial sum.
Note that in the capital account the flow of private and government (official)
assets are separated. Indeed, in some cases changes in government assets are placed in a
separate official international reserve account. This account records changes in a
nation’s reserve assets, which include gold convertible currencies of major industrial
nations (hard currency), and special assets created by the International Monetary Fund
(IMF). These reserve assets can be used to make international payments. Increases in
U.S. reserve assets are recorded as debits in the capital account and decreases as credits.
The official settlement balance is the net increase in a country’s official reserve asset.
During our class discussion of this topic we will have the opportunity to examine
the latest annual summary and analysis I of the U.S. Balance of Payments. We will want
to pay particular attention to the growth in the trade balance and current account deficits
particularly as a percentage of GDP.
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