Economics note: International trade IV: BOP and national income identity

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BoP is a statistical statement on economic transaction of an economy with the rest of the world in a specified period, usually a quarter or a year. Inflow of money is called credit (+) which improve BoP, outflow of money is called debit (-) which worsens the situation of BoP.

BoP is divided into two parts: the current account(CA) records the inflows and outflows of goods, services, factor incomes and current transfers which won’t generate further external returns; capital and financial account(KA) records the external inflows and outflows of assts or liabilities which are likely to generate future external returns like profits/dividends.

Current account

1)       Visible trade/ goods

It includes the transaction on visible physical goods, including [domestic] export, imports and re-export. We have total export of goods = export value + re-export value

Retained imports (imported goods that for own consumption) = import – ex-export

Balance of [visible] trade = total export of goods – total imports of goods

2)       Invisible trade/services

It includes the transactions on exports and imports of invisible services, including services, royalties and licences. We have invisible trade balance = export of services – import of services

3)       External factor income flows

It includes the income earned by resident aboard or the income earned by non-residents domestically. For example, when a local resident receives profits from foreign firms, it counted as the factor income from abroad. We have net income from abroad (NIFA) = factor income from abroad – factor income paid abroad. Note that GNP = GDP + NIFA.

4)       Current transfers

It includes the economy provides real, financial gifts/donations/remittance/aid, etc, in which are immediately/shortly consumed, which do not gives output in return. These transactions are unidirectional in nature. Net current transfers = inflow – outflow of current transfers.

Reserve assets are foreign assts and gold held by the central bank as foreign exchange reserve/official reserves. It can be used to settle BoP imbalance, supporting the currency or for emergency use.

Since the market BoP excludes the transactions made by the central banks, and the transactions are made by different economic agents, imbalance BoP may result.

[Marketing] BoP balance = CA + KA – net change in reserve assets = CA + net change in capital and financial non-reserve assets; When BoP > 0, it’s a BoP surplus, in opposite it’s a BoP deficit.

Accounting BoP must be balanced (Since the assets conserves and it includes transaction of the central bank) = CA + KA = 0 i.e., CA = -KA

Principle of reserve assets: the amount of imbalance is complemented by transactions between central bank and the market.

1)       BoP surplus

The central bank buys an equivalent amount of foreign currency [debit to market] to offset the surplus make by market. If the BoP = +X, then the net change in reserve assets = +X. Then accounting BoP = CA + KA in non-reserve assets – X = (+X) – X = 0

2)       BoP deficit

The central bank sell an equivalent amount of foreign currency [credit to market] to offset the deficit made by the market. Then there’s a net decrease in reserve assets.

3)       BoP balanced

Central bank need not to do anything to balance the BoP.

National income identity

1)       The current account: CA = NX (net exports) = X – M

2)       The accounting BoP: CA + KA ≡ 0

3)       National income Y ≡ C + I + G + NX

4)       National income by consumption approach Y = C + S_p + T where S_p is private saving and T is the tax revenue for government.

5)       Government expenditure G = T - S_g where S_g is the public saving. The unused tax is saved by the government.

6)       National saving identity: national saving S = S_p + S_g

Implication:

Equating (3) and (4), NX = S_p + T – G – I = S_P + S_G – I = S – I.

It implies that in autarky (NX=0), saving = investment; when net export being constant, increase in saving also increase investment. This can be verified by the banking system: banks keep the minimum reserve and then lend out/invest the rest of the money.

We will have two more part for international trade:

V: Trading and PPF

VI: Trading, economic development and cost of economic development