Relations Between the Balance of Payments and Other Macroeconomic by dfe20727

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									Course on External Vulnerabilities and Policies
Tunis, March 2–13, 2009
Relations Between the Balance of Payments
       and Other Macroeconomic Accounts




                                                  Thorvaldur Gylfason
Outline


 Monetary approach to balance of payments
 Accounting relationships
  Trace linkages among
     o   Balance of payments accounts
     o   National income accounts
     o   Fiscal accounts
     o   Monetary accounts
    Proceed from linkages to financial programming
 Numerical examples of financial programming
  Flow of funds matrix

  A little algebra
Remark

 External adjustment is more effective if it is framed in the
  context of a financial program agreed jointly with the
  authorities to ensure consistency among policies
 In practice, a financial program is prepared using an
  accounting framework that summarizes all economic
  transactions and shows the interrelations among all sectors
 Main objective of lecture
  Introduce the different pieces of the financial programming
  framework to illustrate the linkages and show how to build
  a single table focused on the financing side of the
  interrelations, i.e., the flow of funds
What is money?


     Liabilities of banking system to the public
         That is, the private sector and public enterprises
     M=C+T
         C = currency, T = deposits
     The broader the definition of deposits ...
         Demand deposits, time and savings deposits, etc.,
     ... the broader the corresponding definition
      of money
         M1, M2, M3, etc.
Overview of banking system


                  Financial System

         Banking System       Other Financial Institutions
        (Monetary Survey)

 Central Bank    Commercial Banks
               Balance sheet of Central Bank

DG = domestic
credit to
government
DB = domestic
                      Assets     Liabilities
credit to
commercial banks
RC = foreign
                        DG           C
reserves in
Central Bank
C = currency
                        DB           B
B = commercial
bank deposits in         RC
Central Bank
     Balance sheet of Commercial Banks

DP = domestic
credit to private
sector
RB = foreign
                      Assets   Liabilities
reserves in
commercial banks
B = commercial
                       DP          DB
bank deposits in
Central Bank
DB = domestic
                       RB          T
credit from Central
Bank to commercial
banks                   B
T = time deposits
Adding up the two balance sheets


     D              R

  DG + DP + DB + R B + RC + B
  = C + T + B + DB
     M
         Balance sheet of banking system


D = DG + DP =
net domestic
credit from        Assets    Liabilities
banking system
(net domestic
assets)
R = RC + RB =        D           M
foreign reserves
(net foreign
assets)
M = money supply     R
A fresh view of money


The monetary survey implies the following new
 definition of money:
              M=D+R
 where M is broad money (M2), which equals narrow
  money (M1) + quasi-money
 One of the most useful equations in economics
 Money is, by definition, equal to the sum of
 domestic credit from the banking system (net
 domestic assets) and foreign exchange reserves in
 the banking system (net foreign assets)
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
An alternative derivation of monetary
survey

       Public sector
           G – T = B + DG + DF
       Private sector
           I – S = DP - M - B
       External sector
           X – Z = R - DF
  So, adding them up, we get: 0 = D - M + R
       because DG + DP = D
Monetary approach to balance of
payments

 The monetary survey (M = D + R) has three key
   implications:
  Money is endogenous
       If R increases, then M increases
       Important in open economies
  Domestic credit affects money
    If R increases, may want to reduce D to contain M
  R = M - D
    Here R = X – Z + F
    Monetary approach to balance of payments
Monetary approach to balance of
payments

 The monetary approach to the balance of payments
  (R = M - D) has the following implications:
 Need to
  Forecast M
     And then
  Determine D
   In order to
  Meet target for R
   D is determined as a residual given both M and R*
   R* = reserve target, e.g., 3 months of imports
Monetary approach to balance of
payments

  Domestic  credit is a policy variable that
   involves both monetary and fiscal policy
  Can reduce* domestic credit (D)
    To private sector
    To public sector
     By reducing government spending
     By increasing taxes

  Monetary   and fiscal policy are closely
   related through domestic credit
Linkages: Overview

Macroeconomic       Macroeconomic      Flow of Funds
Sectors             Accounts           (Transactions)

Private Sector      National Accounts Real:
                                      Revenue,
Government          Fiscal Accounts   Expenditure
Monetary Sector                       (C, S, I, X, Z)
                    Monetary
                    Accounts
Rest of the World   Balance of        Financial:
                    Payments          Changes in
                                      financial assets
                                      and liabilities
Linkages


 Balance of payments
 R = X – Z + F
    = X – Z + DF
Linkages


 Balance of payments   National accounts
 R = X – Z + F        Y=E+X–Z
    = X – Z + DF
Linkages


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts
G – T = B + DG + DF
Linkages


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts          Monetary accounts
G – T = B + DG + DF   M = D + R
                         = DG + DP + R
Linkages: Reserves


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts          Monetary accounts
G – T = B + DG + DF   M = D + R
                         = DG + DP + R
Linkages: Current account


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts          Monetary accounts
G – T = B + DG + DF   M = D + R
                         = DG + DP + R
Linkages: Foreign credit


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts          Monetary accounts
G – T = B + DG + DF   M = D + R
                         = DG + DP + R
Linkages: Credit to government


 Balance of payments     National accounts
 R = X – Z + F          Y=E+X–Z
    = X – Z + DF



Fiscal accounts          Monetary accounts
G – T = B + DG + DF   M = D + R
                         = DG + DP + R
Linkages                 Private sector accounts
                         I – S = DP – M – B


 Balance of payments           National accounts
 R = X – Z + F                Y=E+X–Z
    = X – Z + DF



Fiscal accounts                Monetary accounts
G – T = B + DG + DF         M = D + R
                               = DG + DP + R
Linkages: Bonds        Private sector accounts
                       I – S = DP – M – B


 Balance of payments         National accounts
 R = X – Z + F              Y=E+X–Z
    = X – Z + DF



Fiscal accounts              Monetary accounts
G – T = B + DG + DF       M = D + R
                             = DG + DP + R
Linkages: Money          Private sector accounts
                         I – S = DP – M – B


 Balance of payments           National accounts
 R = X – Z + F                Y=E+X–Z
    = X – Z + DF



Fiscal accounts                Monetary accounts
G – T = B + DG + DF         M = D + R
                               = DG + DP + R
Linkages: Private        Private sector accounts
credit                   I – S = DP – M – B


 Balance of payments           National accounts
 R = X – Z + F                Y=E+X–Z
    = X – Z + DF



Fiscal accounts                Monetary accounts
G – T = B + DG + DF         M = D + R
                               = DG + DP + R
Further details

 National accounts
 Nonfinancial public sector
 Monetary accounts
 Balance of payments
 Macroeconomic interrelations
 Flow of funds matrix
National Accounts
1. Consumption                                        C = Cg+Cp
        Public (general government)                   Cg
        Private                                       Cp
2. Gross Investment                                   I = Ig+Ip
          Public (fixed capital formation)            Ig
          Private (includes changes in inventories)   Ip
3. Absorption or domestic demand (1+2)                A = C+I
4. Exports of goods and services                      X
5. Imports of goods and services                      Z
6. Gross Domestic Product (1+2+4–5)                   GDP = C + I + X – Z
7. Net factor income from abroad                      Yf
8. Gross National Product (6+7)                       GNP = GDP + Yf
9. Current transfers from abroad                      TRf
10. Gross National Disposable Income (8+9)            GNDI = GNP + TRf
11.National Savings (10 – 1)                          Sn=(GNDI – C)
         Public                                       Sg = (GDIg – Cg)
         Private                                      Sp = (GDIp – Cp)
12. External Savings (1+2–10)                         Se= (C + I – GNDI)
Operations of the Nonfinancial Public
Sector (NFPS)
1.Total Revenue and Grants                        RGg
   Revenue                                        Rg
     Current                                      CRg
       Tax revenue
       Nontax revenue
     Capital
   Grants
2.Total Expenditure and Net Lending               GNLg
   Expenditure                                    Gg
      Current                                     CGg
          Wages and salaries
          Goods and services                       Cg: government consumption
          Interest
          Subsidies and other current transfers
      Capital                                     CAPGg
          o/w: fixed capital formation            Ig
      Net Lending                                 NLg
3. Overall Balance (1 - 2 )                       OBg = RGg - GNLg
4. Financing (4.1 + 4.2 = – 3)                    Fg = NEFg + NDFg
   4.1 External                                   NEFg
   4.2 Domestic                                   NDFg = NDCg + NBg
       Bank                                       NDCg
       Nonbank                                    NBg
Monetary Accounts:
From Accounting to Analytical Format
     Accounting                 Analytical
ASSETS                       Net Foreign Assets (NIR, NFA)
Foreign assets               Net Domestic Assets (NDA)
Domestic assets                   Net domestic credit (NDC)
 Credit to public sector               Credit to public sector (net) (NDCg)
 Credit to other financial                Credit (+)
       institutions                       Deposits (-)
 Credit to private sector              Credit to other financial institutions
Other assets
                                       Credit to private sector (DCp)
LIABILITIES
Foreign liabilities                Other assets net (OAN)
   Short term
   Medium and long term
Deposits of public sector
Private sector deposits      Liabilities to private sector
                             (MB, M1, M2, M3)
Other liabilities
Capital and reserves
Monetary Accounts: Stocks
Banking System
1. Net Foreign Assets                                           NFA
   Central bank (NIR)
   Rest of banking system
2. Net Domestic Assets                                          NDA
    Net Domestic Credit
       Net credit to the nonfinancial public sector
       Credit to the private sector
    Other Assets Net
3. Money Supply (monetary liabilities to private sector) = 1 + 2 (M3 = NFA + NDA)
Central Bank
1. Net International Reserves                                   NIR
2. Net Domestic Assets                                          NDA
    Net Domestic Credit
        Net credit to the nonfinancial public sector
        Credit to the rest of the banking system
        Claims on private sector
    Other Assets Net
3. Monetary Base (monetary liabilities of CB) = 1 + 2 (MB = NIR + NDC)
Monetary Accounts:
Annual flows at end-of-period exchange rate

1.Net Foreign Assets                    NFA = NIR + NFAb
  Central Bank                          NIR
  Rest of banking system                NFAb
2.Net Domestic Assets                   NDA = NDC + OAN
   Net domestic credit                  NDC = NDCg + DCp
     Nonfinancial public sector (net)   NDCg
     Private sector                     DCp
   Other assets net                     OAN
3.Money and Quasi-money (M3)       M3
   Money (M1)
   Quasi-money
   Other liabilities
                     ∆NFA + ∆NDA = ∆M3 (monetary liabilities)

                     ∆NIR + ∆NDAMA = ∆MB (monetary liabilities)
Balance of Payments:
Analytical Presentation
1. Current account                      CAB
   A. Goods and services                X–Z
      Goods (trade balance)
      Services
   B. Factor income                     Yf
         Of which: interest
   C. Current transfers                 TRf
 2. Capital and financial account       CFAB
    A. Capital account                  CA
    B. Financial account                CF
          Direct investment (net)
          Portfolio investment (net)
                   Public sector
                   Private sector
                   Banks
          Other investment (net)
                   Public sector
                   Private sector
                   Banks
3. Overall balance (1 + 2 = 3 = – 4)    CAB + CFAB

4. Reserves and exceptional financing   –NIR + ExF
Macroeconomic Interrelations
       National Accounts                    Balance of Payments
Consumption                         Current account
 Public                             Exports of goods and services
 Private                            Imports of goods and services
Gross domestic investment           Net factor income
 Public                             Net current transfers
 Private                            Capital and financial account
Exports of goods and services       Capital account
Imports of goods and services       Financial account
Gross Domestic Product               Direct investment
Net factor income                    Net foreign financing
Net current transfers                 Nonfinancial public sector
Gross National Disposable Income      Nonfinancial private sector
                                      Banks
       Operations of the NFPS       Change in net international reserves
Total revenue and grants
Total expenditure and net lending          Banking Survey (flows)
 Current expenditure                Net foreign assets
  Wages and salaries                 Central bank
  Goods and services                 Rest of banking system
  Interest                          Net domestic assets
 Capital expenditure                 Net domestic credit
  o/w fixed capital formation         NFPS
 Net lending                          Private sector
Overall balance                      Other assets net
Financing                             Medium/long term foreign liabilities
External                            Money and quasi-money (M3)
Domestic
Flow of Funds Matrix Format

        Sectors
Transactions       Internal NFPS Private        Banks   External      Total


 Nonfinancial
    (real)                 Y=C+I+G+X-Z
                    S–I     Sg –Ig Sp –Ip        0      – CAB           0
                                    Financing           – Financing     0
   Financial:
   changes in                Dom. Dom.         Dom.
financial assets    Foreign Foreign Foreign   Foreign   – Foreign
 and liabilities

Total                  0               0          0        0           0
An alternative derivation of monetary
survey: Recap, same story

       Public sector
          G – T = B + DG + DF
       Private sector
          I – S = DP - M - B
       External sector
          X – Z = R - DF
Overview 1

 Presents real transactions and their financing
 For each sector, shows the gap in all nonfinancial
  transactions (income – expenditure =>
  gap = savings – investment = deficit/surplus) and
  how it is financed
 Shows financing flows among different sectors
 For the economy as a whole, shows how the
  savings–investment gap is financed by foreign
  sources
Overview 2

 The flow of funds matrix can be seen as the
  representation of the budget constraint faced by all
  sectors of the economy because it shows real
  transactions and how they are financed
 The domestic economy is subject to the amount of
  resources the rest of the world is willing to
  provide: financing of the balance of payments
  Excess of domestic demand (absorption) over supply 
   deficit in current account of the BOP
   GNDI – C – I = S – I = CAB
  Deficit in the CAB must be financed by net capital inflows
   or drawdown of international reserves
   CAB + CFA = ΔNIR (i.e., X – Z + F = ΔR)
Overview 3

• Each sector of the economy has a budget constraint
 The overall balance of the public sector must be
  equal to the change in its net financial assets
   Excess of expenditure over revenues  deficit that must
    be financed either by increasing liabilities (domestic or
    foreign) or by reducing assets.

    RGg – GNLg = DIg – Cg – Ig = Sg – Ig = ΔNAFg


 The private sector also has a budget constraint
    If expenditures exceed revenues, it must either reduce
     assets or acquire more debt (domestic or foreign)
     Sp – Ip = ΔNAFp
Model


 Express accounting linkages in terms of
 simple algebra
 Use model to describe how nominal income
 and reserves depend on domestic credit
  Demonstrate how BOP target translates into
   prescription for fiscal and monetary policy
  Financial programming in action
List of variables

M = money                   X = real exports
D = domestic credit         Px = price of exports
R = foreign reserves        Z = real imports
R = R - R-1 = balance of   Pz = price of imports
  payments                  F = capital inflow
P = price level             m = propensity to import
Y = real income
v = velocity
List of relationships


M=D+R                   (monetary survey)
M = (1/v)PY             (money demand)
R = (1/v)PY – D         (M schedule)
R = PxX – PzZ + F      (balance of payments)
PzZ = mPY               (import demand)
R = PxX – mPY + F + R-1 (B schedule)
The M schedule
Reserves (R)

                          M schedule
                            R = (1/v)PY – D
                     1
                            PY = v(R + D)
                             An increase in reserves
               v             increases demand for money,
                             and hence also income
                   D up
                             PY is nominal income
                                         GNP (PY)
The B schedule
Reserves (R)

               R = PxX – mPY + F + R-1
                      An increase in income encourages
       m              imports, so that reserves decline

               1
                              F up, e down

                            B schedule
                                         GNP (PY)
Solution to model


Two equations in two unknowns
1) R = (1/v)PY – D
2) R = PxX – mPY + F + R-1
Solution for R and PY
          v 
    PY          D  R1  PxX  F 
          1  mv 
       1                          mv 
    R        R1  PxX  F           D
       1  mv                     1  mv 
Multipliers: Algebra



   dPY    v            dPY     v
                          
    dD 1  mv          dPxX 1  mv


   dR      mv           dR     1
                         
   dD    1  mv        dPxX 1  mv
Multipliers: Numbers

Suppose m = ¼ and v = 4
  dPY      4       4
                  2
   dD 1  (1 / 4)4 2


   dR      (1 / 4)4      1
                    
   dD    1  (1 / 4)4    2
Macroeconomic equilibrium

Reserves (R)

                      M schedule


                             D up

               Equilibrium
                             F up, e down


                         B schedule
                                            GNP (PY)
Economic models




 Exogenous                       Endogenous
                    Model
  variables                       variables


 Change in       Financial     Foreign reserves
 domestic        programming   and nominal
 credit or the   model         income
 exchange rate
Experiment: Export boom

 Reserves (R)

                      M schedule



                A




                    B schedule
                                   GNP (PY)
Export boom

 Reserves (R)

                            M
                    C


                A
                            Exports increase

                                   B’
                        B
                                               GNP (PY)
Export boom

 Reserves (R)

                            M
                    C
                                An increase in exports
                A               increases both reserves
                                and nominal income


                                B’
                        B
                                        GNP (PY)
An interpretation




 Exogenous                        Endogenous
                     Model
  variables                        variables


 Export boom or   Financial     Foreign reserves
 capital inflow   programming   and nominal
                  model         income increase
Another experiment: Domestic
credit expansion
Reserves (R)
                                    An increase in D
                           M        increases PY, but
                                    reduces R.
                               M’
                   D up             D up         M up
                                         PY up
               A                    PzZ up     R down

                   C
                       B
                                           GNP
Domestic credit contraction
 Reserves (R)
                     M’           When D falls, M also
                                  falls, so that PY goes
                              M
                                  down and PzZ also
        C                         decreases. Therefore,
                D down            R increases.
R*
                                  Here, an improvement
                                  in the reserve position
                                  is accompanied by a
                A                 decrease in income.
                          B
                                         GNP (PY)
Domestic credit contraction
accompanied by devaluation
 Reserves (R)
                                   When D falls, M also
                                   falls, so that PY goes
                    M’        M
                                   down and PzZ also
                C                  decreases. Therefore,
                                   R increases.
R*
                                   Further, a devaluation
                    F up, e down   strengthens the
                                   reserve position and
                A    B’
                                   helps reverse the
         D down                    decline in income.
                          B
                                          GNP (PY)
Comparative statics:
An overview


        D    PxX       F   e   p

  R     -     +        +   +   -



 PY     +     +        +   +   +
Experiment:
Inflation goes up

 Reserves (R)
                                         An increase in
                           M             inflation (p)
                                         increases v, so the
                        p up          M’ M schedule
                                         becomes flatter.
                A                        Hence, R goes
                                         down and PY
                    C                    increases in the
                                         short run.
                         B schedule
                                            GNP (PY)
Experiment:
Inflation goes up

 Reserves (R)   p up        eP/P* up     X down       B shifts left
                                          An increase in
                              M           inflation (p) makes
                                          domestic currency
            p up                       M’ appreciate in real
                                          terms, so the B
              A                           schedule shifts left.
                                          Hence, R goes
                                          farther down and
                                          PY can rise or fall
                C           B schedule    in the short run.
                       B’
                                             GNP (PY)
Numerical examples

History and targets
   Record history, establish targets
Forecasting
   Make forecasts for balance of payments,
   output and inflation, money
Policy decisions
   Set domestic credit at a level that is consistent
   with forecasts as well as foreign reserve target
Financial programming step by step

1) Make forecasts, set reserve target R*
     – E.g., reserves at 3 months of imports
2)   Compute permissible imports from BOP
     – More imports will jeopardize reserve target
3)   Infer permissible increase in nominal income from
     import equation
4)   Infer monetary expansion consistent with
     increase in nominal income
5)   Derive domestic credit as a residual: D = M – R*
History

Known   at beginning of program period:
          M-1 = 70, D-1 = 60, R-1 = 10
           Recall: M = D + R
          X-1 = 30, Z-1 = 50, F-1 = 15 (all nominal)
           Recall: R = X – Z + F
           So, R-1 = 30 – 50 + 15 = -5, so R-2 = 15
           Current account deficit, overall deficit
          R-1/Z-1 = 10/50 = 0.2
           Equivalent to 2.4 (= 0.2•12) months of imports
           Weak reserve position
Forecast for balance of payments

X grows by a third, so X = 40
F grows by 67%, so F = 25
Suppose R* is set at 15 (R* = 5)
  Z = X + F + R-1 – R*
  = 40 + 25 + 10 – 15 = 60
Level of imports is consistent with R*
  R*/Z = 15/60 = 0.25
  Equivalent to 3 (= 0.25•12) months of imports
Forecast for real sector

Increase in Z from 50 to 60, i.e., by 20%,
  is consistent with R* equivalent to 3
  months of imports
Now, recall that Z depends on PY
  where P is price level and Y is output
Hence, if income elasticity of import
 demand is 1, PY can increase by 20%
  E.g., 5% growth and 15% inflation
Forecast for money

If PY can increase by 20%, then, if income
  elasticity of money demand is 2/3, M can
  increase by 14%
Hence, M can expand from 70 to 80
Alternatively, by quantity theory of money
  MV = PY
  Constant velocity means that
  %M = %PY = %P + %Y
                  ˜
  If so, income elasticity of money demand is 1
Determination of credit

Having set reserve target at R* = 15 and
  forecast M at 80, we can now compute level
  of credit that is consistent with our reserve
  target, based on M = D + R
So, D = 80 – 15 = 65, up from 60
  D/D-1 = 5/60 = 8%
  Quite restrictive, given that PY rises by 20%
  Implies substantial reduction in domestic credit
   in real terms
Financial programming : Recap


         Sequence of steps

 Z = X + F + R-1 – R*   MV = PY

         R*       Z     Y    M      D
                  Z = mPY    D = M – R*
                       These slides will be posted on my website:
Conclusion                                    www.hi.is/~gylfason




 The four mains sets of macroeconomic
 accounts are closely intertwined
 These interrelations form the analytical
 basis of financial programming
  Fund economists understand that countries
   differ, and they seek to help tailor financial
   programs to the needs of individual countries
  Even so, certain fundamental principles and
   relationships apply everywhere

								
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