Sectoral Balances, Exchange Rates and Open Economy

1.

EC 224
Intermediate Macroeconomics
Sectoral Balances, Exchange Rates and
Open Economy
Lavoie (2014) Post-Keynesian Economics: New Foundations, Chapter 4 and 7
Rey, H. (2015) “Dilemma not Trilemma: The Global Financial Cycle and
Monetary Policy Independence”, NBER Working Paper No. 21162.
1

2.

The overall structure of the Balance of
Payments
1. The Current Account
A: Goods and services
B: Income
C: Transfers
2. The capital and financial accounts
A: The Capital Account
B: The Financial Account

3.

• Current account balance: CAB represents the balance on FX earnings.
• A current account deficit means that the country is spending more foreign
exchange than it actually earns, implying that FX equal to the amount of the
deficit should have been acquired from somewhere.
• The two possible ways to finance a current account deficit is using central bank
reserves and/or funds from abroad.
• The funds acquired from abroad need not take the form of direct borrowing as
we shall see, the country might acquire the FX it needs to finance the current
account deficit in many different forms apart from directly borrowing from
abroad.
• Corresponding to any current account surplus/deficit must be a capital-financial
account deficit/surplus.

4.

Current Account
A. Goods and Services
• A big part of the current account balance is determined by the balance of trade in
goods and services, as these constitute the main FX earning and spending items for
every country.
B. The income component.
• This corresponds to transactions corresponding to compensations without a good
or service being transferred internationally.
• It refers to income earned by UK residents from non-UK residents and vice versa
(debit and credit)
• It is disaggregated as compensation of employees and investment income.

5.

Compensation of employees comprises wages, salaries and other benefits
earned by individuals from economies other than those in which they are
residents, as well as earnings from extraterritorial bodies such as foreign
embassies.
Investment income comprises income earned from the provision of financial
capital and is classified by direct, portfolio and other investment income.
Transfers: Government and other transfers

6.

UK Current Account (2010)
Balance(£m)
% of GDP
Exports of goods and services
Exports of goods
Exports of services
-98514
61776
-6.7%
4.2%
-36738
-2.5%
Total exports of goods and services
Income
Compensation of employees
Investment income
-389
8972
Total income
8583
Current transfers
Central government
Other sectors
Total current transfers
Total
0.6%
-14796
-5615
-20411
-1.4%
-48566
-3.3%

7.

7

8.

UK Capital Account
Capital transfers
Central government
Debt forgiveness
Other capital transfers
2009
2010
-49
-264
-101
-239
-313
-340
Other sectors
Migrants' transfers
Debt forgiveness
Other capital transfers
2722
0
855
2951
0
1040
Total other sectors
3577
3991
Total capital transfers
3264
3651
Non-produced, non-financial
assets (copyrights)
373
53
Total
3637
3704
Total central government

9.

The financial account
• The financial account comprises transactions associated with changes of
ownership of the UK’s foreign financial assets and liabilities.
• Five major components
Direct Investment
Portfolio Investment
Financial Derivatives
Other Investment
Reserve Assets

10.

• Direct investment capital refers to capital provided to or received from an enterprise,
by an investor in another country who is in a direct investment relationship with that
enterprise. A direct investment relationship exists if the investor has an equity interest in
an enterprise, resident in another country, of 10 per cent or more of the ordinary shares
or voting stock.
• Portfolio investment refers to transactions in equity and debt securities (apart from
those included in direct investment and reserve assets). Debt securities comprise bonds
and notes and money market instruments.
• Financial derivatives cover any financial instrument the price of which is based upon
the value of an underlying asset (typically another financial asset). Financial derivatives
include options (on currencies, interest rates, commodities, indices), traded financial
futures, warrants and currency and interest swaps.
• Other investment covers trade credits, loans (including financial leases), currency and
deposits, and a residual category for any other assets and liabilities.

11.

• Reserve assets refer to those foreign financial assets that are available to, and
controlled by, the monetary authorities such as the Bank of England for financing
or regulating payments imbalances. Reserve assets comprise: monetary gold,
Special Drawing Rights, reserve position in the IMF and foreign exchange held by
the Bank.

12.

UK Financial Account
Net transactions
(net credits less net debits)
Direct investment
Equity capital
Reinvested earnings
Other capital transactions
Total net direct investment
Portfolio investment
Equity securities
Debt securities
Total net portfolio investment
Financial derivatives
Other investment
Reserve assets
Total
2009
2010
28373
-9093
-2603
21469
-17822
9802
16677
13449
43442
-16552
-10325
11463
26890
1138
29104
-42143
-5763
32788
-309
-6070
24765
40996

13.

• In theory, current account, capital account and financial account must sum up to
zero.
• In other words, the deficits in current account must be financed by surpluses in
capital and/or financial accounts.
• Due to measurement problems, this almost never happens.
• Net errors and omissions item balance the sum these three accounts to zero.
• UK has significantly high current account deficits financed by the financial
account. Sustainable in the long run?

14.

UK BALANCE OF PAYMENTS
2009
2010
Trade in goods and services
-25637
-36738
Income
20397
8583
Total current transfers
-15076
-20411
Current account balance
-20316
-48566
Capital account balance
3637
3704
Direct investment
Portfolio investment
Financial derivatives (net)
Other investment
Reserve assets
16677
26890
29104
-42143
-5763
13449
1138
32788
-309
-6070
(Accounting) Financial account balance
24765
40996
Net errors and omissions
-8086
3866

15.

Sectoral Balances and Fundamental Identity
• The sectoral balances approach was developed by Wynne Godley in 1974.
• Using national accounts, it is possible to derive a relationship between the deficits
of the private sector, government deficits and the current account balance.
• In order to do this, let’s start with the definition of gross domestic product in an
open economy
GDP = C + I + G + X – M
where X = Exports and M = Imports
15

16.

GDP = C + I + G + X – M
• If we add net foreign income earned by nationals (FY) to both sides of the
equation, we get
GDP + FY = C + I + G + X – M +FY
which can be written as
GNP = C + I + G + X – M +FY
where GNP = Gross National Product
• Subtracting taxes (T) from both sides of the equation and rearranging, we get
(GNP – C – T) = I + (G – T) + (X – M +FY)
16

17.

(GNP – C – T) = I + (G – T) + (X – M +FY)
• Note that GNP – C – T is equal to private savings.
• On the other hand, X – M +FY is the sum of trade balance and the income
component of the current account. Therefore X – M +FY = Current Account
Balance.
• So the equation can now be written as
S = I + (G – T) + CAB
or more intuitively
(S – I) + (T – G) = CAB
17

18.

(S – I) + (T – G) = CAB
• The current account balance is the sum of private deficit and public deficits.
• S – I = Net financial saving of the private sector as it is the net of what is saved
and not spent on tangible investment goods. These savings should have been used
to acquire financial assets (deposits, bonds, equities, etc.) and therefore S – I is
also the net financial investment of the private sector.
• When current account is in balance, CAB = 0 and private surplus (deficit) is the
mirror image of public deficit (surplus)
• Keep in mind that IMF’s insistence on primary fiscal surpluses in order to
eliminate external deficits focuses on reducing (T – G)
• The literature on twin deficits (public and current account deficits)
18

19.

19

20.

21.

22.

(S – I) + (T – G) = CAB
• Remember from our earlier discussion that current account balance represents
whether or not the country is in an FX deficit or a surplus.
• In here, we combine the current account and the capital account shown at the
beginning.
• Therefore, by definition,
CAB + AFAB = 0
where AFAB = Accounting financial balance (as it includes changes in central bank
reserves).
• Ignoring net errors and omissions, this equation must hold at all times
regardless of the exchange rate system in operation
22

23.

UK Balance of Payments
2009
2010
Current Account
Trade in goods and services
Income
Total current transfers
-25637
20397
-15076
-36738
8583
-20411
A. Current account balance
-20316
-48566
B. Capital account balance
3637
3704
Financial Account
Direct investment
Portfolio investment
Financial derivatives (net)
Other investment
Reserve assets
16677
26890
29104
-42143
-5763
13449
1138
32788
-309
-6070
C. (Accounting) Financial account balance
24765
40996
Net errors and omissions 1
-8086
3866

24.

• We can also write
CAB + FAB = Change in Central Bank Reserves
• In a pure floating exchange rate system, the central bank does not intervene in the
markets and change in central bank reserves must be zero, In such a case by
definition
CAB + FAB =0
• In a fixed exchange rate regime or a managed flowing regime, the central bank
intervenes in the FX markets and buys/sells foreign exchange. In such a case,
both CAB and FAB might be negative if the deficit is being financed by central
bank reserves. (or there is a surplus in both accounts and the central bank is
accumulating reserves)
24

25.

(S – I) + (T – G) = CAB
• The current account balance is the sum of private deficit and public deficits.
• S – I = Net financial saving of the private sector as it is the net of what is saved
and not spent on tangible investment goods. These savings should have been used
to acquire financial assets (deposits, bonds, equities, etc.) and therefore S – I is
also the net financial investment of the private sector.
• When current account is in balance, CAB = 0 and private surplus (deficit) is the
mirror image of public deficit (surplus)
• Keep in mind that IMF’s insistence on primary fiscal surpluses in order to
eliminate external deficits focuses on reducing (T – G)
• The literature on twin deficits (public and current account deficits)
25

26.

• Therefore if a country is running current account deficits structurally, meaning that
CAB<0, either the private sector or the government sector (or both) must go into
deficit.
If CAB < 0 then (T – G) < 0 and/or (S – I) < 0.
• This is possible only if either government debt or private debt increases.
• None of these processes are sustainable in the long run and end up either in banking
crisis as private sector defaults on debt or fiscal crisis as government debt explodes
unless the debt is monetized.
• This happens when private capital inflows, which enable the current account deficits to
be run reverse (sudden stop)
• The currency depreciates rapidly, economy shrinks and current account deficit falls as
imports collapse, until a new episode begins with high growth and current account
deficits.
26

27.

Interest parity conditions
Real interest rate parity
• This is the essence of all mainstream exchange rate models.
• In a nutshell, real interest rate parity states that expected real interest rates
should be equalized across the countries.
• This can be written as