INTERNATIONAL FINANCE LESSON 1

National Income and Product Accounts and the Current Account Course Webpage: http://www.uwm.edu/~amurshid/finance.html Classes: Mon, Wed 11.00 am – 12.15 pm Office Hours: Wed 2.00 pm – 3.00 pm Today’s Agenda  National Income and Product Accounts       Definition of GDP Definition of GNP Net factor income from abroad Current account What causes large current account deficits? Current account deficits and crises  The Asian and Latin American crises National Income Accounting: GDP and GNP   Gross domestic product is the value of all domestically-produced final goods and services Gross national product is the value of all final goods and services produced by domestically owned factors of production Final Goods and Intermediate Goods  What is a “final good”?   A good used for final consumption, e.g a loaf of bread that you consume Intermediate goods are inputs in the production process, e.g steel used in the manufacture of a car Double Counting  Why are only “final goods and services” counted?   Because otherwise you would count the same good more than once This is called double counting How Do We Measure GDP?  There are three equivalent methods of estimating GDP  Expenditure approach   Income approach   Total expenditure on all final goods and services produced Total income received by all factors of production Output approach  Sum of value added at each stage of production Components of GDP   Economists often split aggregate expenditure into four components— consumption (C), investment (I), government spending (G), next exports (NX) Hence we can write GDP = C + I + G + NX What’s the Difference Between GDP and GNP?   GDP is the value of all output produced @ home GNP is the value of all output produced using domestically-owned factors of production    Some output produced @ home is produced by foreigners (this should not count in GNP) Some output produced abroad is produced by domesticallyowned factors (this should count in GNP) Hence GNP = GDP + net factor income from abroad How Big is the Difference?   For the US the difference is small (0.08%) For Mexico (-4.9%) and Ireland the difference is substantial (-10%)    The numbers in brackets are (GNP-GDP)/GDP in 1987 Mexico has a large foreign debt on which it has to pay interest to foreigners Due to heavy foreign investment in Ireland, many firms in Ireland are foreign owned What’s Debt Got to Do With It?  In other words what has net factor income got to with debt?    Net foreign assets (NFA) = US assets– US debt Define i as the average interest on NFA Then net factor income from abroad is just iNFA Two Ways of Saying the Same Thing   A rise in consumption and government spending of course corresponds to a fall in national savings Essentially then whether we think about the CA as the savings-investment gap or as the difference between income and domestic absorption does not matter Although one approach emphasizes expenditures, while the other approach emphasizes savings behavior So What Has Driven the US Current Account Deficit?   Different things The US started running current account deficits in 1982  The cause was without a doubt a rise in government spending and a fall in tax revenues, that is a rise in the Federal government budget deficit US Current Account Deficit and Budget Deficit Budget deficit Current account deficit  Until about 1992 the current account deficit is highly correlated with the budget deficit What Has Driven the Current Account Deficit from 1992?    From about 1992 onwards, the US budget deficit has declined but the current account deficit has continued to rise This trend can be explained by the sharp rise in US investment In addition to the rise in US investment a spending binge by US consumers also implied a sharp fall in national savings Robust Climate for Investment No More   The CA deficit in the 1990s can be attributed largely to a robust climate for investment and the immense US expansion However in the last two years the budget surplus has turned into a deficit, consumer spending and investment are at depressed levels, thus the driving force behind the CA deficit are again Federal and local government deficits Is the Trade/Current Account Deficit Bad?   The US Today article suggests that current account deficits are bad, that they are associated with a loss of jobs and lower wages In fact a deficit may or may not be a bad thing The Current Account and Jobs    First it is important to dispel a myth that the current account deficit is somehow related to joblessness During the 1990s, US services and also manufacturing grew, as the economy went through the longest period of expansion in history and unemployment fell to its lowest levels Often we find that current account deficits rise during periods of expansion, its unclear therefore what leads critics of the CA deficit to link it to joblessness When a Deficit Finances Investment   Sometimes a deficit arises because of rise in investment Thus in the US a robust climate for investment in the 90s caused the current account deficit to increase This should be viewed as a good thing, since investment will contribute to future growth Tradable and Export Goods  When the investment is in the tradable and export sectors, there is greater justification for running a current account deficit, since growth in these sectors will eventually help narrow the trade deficit Sustainability   If increases in investment are inducing a current account deficit, it should be viewed as more sustainable However some investments can turn out to be bad and this can have implications for the terms at which foreigners are willing to lend to the deficit country Bad Investments    Not all investments are good investments however Some investments are just speculative and fuel asset price bubbles Other investments are in non-tradables, which not necessarily help lower future deficits The extent to which deficits finance bad investments will depend on the extent of development of the financial sector Cheap Imports and Low Inflation  Another often overlooked reason as to why a deficit may not be a bad thing is that an inflow of cheaper imports limits inflation and allows manufacturers to benefit from these cheaper imports by keeping costs of production low Crises    Current account deficits are not always sustainable Lenders may stop lending abruptly May lead to a financial crisis Recent Experience Asia 1997    In 1997 prior to the Asian crisis several Asian countries ran large CA deficits Many investments were in real estate Real estate price bubble burst   Bankruptcy and bank failures Many investments turned out to be non-profitable   Government tried to always encourage investment Not enough scrutiny by banks on who they were lending too (moral hazard arising from government loan guarantees) Recent Experience Debt Crisis and Mexico 1994/95  1970s many developing-country governments borrowed to finance spending   Then in 1982 US raised interest rates, which triggered a debt crisis Mexico 1995   Optimistic outlook caused C↑ and S↓ Unsustainable CA deficit and a crisis in 1994/95 ... Crisis and Mexico 19 94/95  19 70s many developing-country governments borrowed to finance spending   Then in 19 82 US raised interest rates, which triggered a debt crisis Mexico 19 95   Optimistic... deficit  Until about 19 92 the current account deficit is highly correlated with the budget deficit What Has Driven the Current Account Deficit from 19 92?    From about 19 92 onwards, the US... trade surplus but still have a current account deficit E.g Brazil (19 86)  CA = NX + iNFA = +$8.3bn – $13 .6bn = $5.3bn  In 19 86 Brazil had a large foreign debt  Definition of the Current Account: