relations between the balance of payments and other macroeconomic accounts thorvaldur gylfason...

Relations Between the Balance of Relations Between the Balance of Payments and Other Macroeconomic Payments and Other Macroeconomic

AccountsAccounts

Thorvaldur GylfasonThorvaldur Gylfason

Course on External Vulnerabilities and Policies Tunis, March 2–13, 2009

OutlineOutline

Monetary approach to balance of paymentsbalance of payments Accounting relationships

Trace linkageslinkages amongo Balance of payments accountso National income accountso Fiscal accountso Monetary accounts

Proceed from linkages to financial programmingfinancial programming

Numerical examples of financial programming Flow of funds matrix A little algebra

RemarkRemark

External adjustmentExternal adjustment is more effective if it is framed in the context of a financial program financial program agreed jointly with the authorities to ensure consistency among policies

In practice, a financial program is prepared using an accounting framework accounting framework that summarizes all economic transactions and shows the interrelations among all sectors

Main objective of lectureMain objective of lectureIntroduce the different pieces of the financial financial programming framework 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 flow of fundsfunds

What is money?What is money?

Liabilities of banking system banking system to the public That is, the private sector and public enterprises

M = C + TM = 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 systemOverview of banking system

C entra l Bank C om m ercia l Banks

Banking System(M onetary Survey)

O ther F inancia l Institu tions

Financia l System

Balance sheet of Balance sheet of Central Central BankBank

AssetsAssets LiabilitiesLiabilities

DG = domestic credit to government

DB = domestic credit to commercial banks

RC = foreign reserves in Central Bank

C = currency

B = commercial bank deposits in Central Bank

Balance sheet of Balance sheet of Commercial Commercial BanksBanks

DP = domestic credit to private sector

RB = foreign reserves in commercial banks

B = commercial bank deposits in Central Bank

DB = domestic credit from Central Bank to commercial banks

T = time deposits

DG + DP + DB + RB + RC + B = C + T + B + DB

Adding up Adding up the two balance the two balance sheetssheets

MHence, M = D + R

Balance sheet of Balance sheet of banking banking systemsystem

AssetsAssets LiabilitiesLiabilities

Monetary Survey

D = DG + DP = net domestic credit from banking system (net domestic assets)

R = RC + RB = foreign reserves (net foreign assets)

M = money supply

A fresh view of moneyA fresh view of money

The monetary survey implies the following new definition of money:

M = D + RM = D + Rwhere 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 An alternative derivation of monetary surveymonetary survey

PublicPublic sector G G –– T = T = B + B + DDGG + + DDFF

PrivatePrivate sector I I –– S = S = DDPP - - M - M - BB

ExternalExternal sector X X –– Z = Z = R - R - DDFF

Now, add them up

G – T + I – S + X – Z = 0,

so left-hand sides sum to

PublicPublic sector G G –– T = T = BB + + DDGG + + DDFF

PrivatePrivate sector I I –– S = S = DDPP - - MM - - BB

ExternalExternal sector X X –– Z = Z = RR - - DDFF

So, adding them up, we get: 0 = D - M + R because DDGG + D + DPP = D = D

Hence,

M = D + RM = D + R

Monetary approach to balance of Monetary approach to balance of paymentspayments

The monetary survey (M = D + RM = D + R) has three key implications:

Money is endogenousendogenous If RR increases, then MM increases Important in open economies

Domestic creditDomestic credit affects money If RR increases, may want to reduce DD to

contain MM R = R = M - M - DD

Here R = X – Z + FR = X – Z + F Monetary approach to balance of payments

Monetary approach to balance Monetary approach to balance of paymentsof payments

The monetary approach to the balance of payments (R = R = M - M - DD) has the following implications:

Need to Forecast M

And then Determine D

In order to Meet target for R

DD is determined as a residual given both MM and R*R* R*R* = reserve target, e.g., 3 months of imports

Essence of Essence of

financial financial

programmingprogramming

Monetary approach to balance Monetary approach to balance of paymentsof payments

Domestic credit is a policy variable that involves both monetary and fiscal policy

Can reduce* domestic credit (DD) To private sectorTo public sector

By reducing government spendingBy increasing taxes

Monetary and fiscal policy are closely related through domestic credit

*Or rather slow down*Or rather slow down

Linkages: OverviewLinkages: Overview

22Macroeconomic Sectors

Macroeconomic Accounts

Flow of Funds (Transactions)

Private Sector

Government

Monetary Sector

National Accounts

Fiscal Accounts

Monetary Accounts

Real:Revenue, Expenditure(C, S, I, X, Z)

Rest of the World Balance of Payments

Financial: Changes in financial assets and liabilities

LinkagesLinkages

Balance of paymentsBalance of paymentsR = X – Z + F = X – Z + DF

LinkagesLinkages

National accountsNational accountsY = E + X – Z

LinkagesLinkages

Fiscal accountsFiscal accountsG – T = B + DG + DF

LinkagesLinkages

Monetary accountsMonetary accountsM = D + R= DG + DP + R

Linkages: ReservesLinkages: Reserves

Linkages: Current accountLinkages: Current account

Linkages: Foreign creditLinkages: Foreign credit

Linkages: Credit to governmentLinkages: Credit to government

LinkagesLinkages

Private sector accountsPrivate sector accountsI – S = DP – M – B

Linkages: BondsLinkages: Bonds

Linkages: Linkages: MoneyMoney

Linkages: Linkages: Private creditPrivate credit

Further detailsFurther details

National accountsNonfinancial public sectorMonetary accountsBalance of paymentsMacroeconomic interrelationsFlow of funds matrix

National AccountsNational Accounts

1. Consumption C = Cg+CpPublic (general government) CgPrivate Cp

2. Gross Investment I = Ig+Ip Public (fixed capital formation) Ig Private (includes changes in inventories) Ip

4. Exports of goods and services X5. Imports of goods and services Z

3. Absorption or domestic demand (1+2) A = C+I

6. Gross Domestic Product (1+2+4–5) GDP = C + I + X – Z

7. Net factor income from abroad Yf

9. Current transfers from abroad TRf10. Gross National Disposable Income (8+9) GNDI = GNP + TRf

8. Gross National Product (6+7) GNP = GDP + Yf

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 –

OperationsOperations of the Nonfinancial of the Nonfinancial Public Sector (NFPS)Public Sector (NFPS)1.Total Revenue and Grants RGg

Revenue Rg Current CRg Tax revenue Nontax revenue CapitalGrants

2.Total Expenditure and Net Lending GNLgExpenditure Gg

Current CGgWages and salaries Goods and services Interest Subsidies and other current transfers

Capital CAPGgo/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 + NDFg4.1 External NEFg4.2 Domestic NDFg = NDCg + NBg

Bank NDCgNonbank NBg

Cg: government consumption

ASSETSForeign assetsDomestic assets Credit to public sector Credit to other financial

institutions

Credit to private sector

Other assets

LIABILITIESForeign liabilities

Short termMedium and long term

Deposits of public sectorPrivate sector depositsOther liabilitiesCapital and reserves

Liabilities to private sector(MB, M1, M2, M3)

Monetary Accounts:Monetary Accounts:From Accounting to Analytical Format From Accounting to Analytical Format

Net Foreign Assets (NIR, NFA)Net Domestic Assets (NDA) Net domestic credit (NDC) Credit to public sector (net) (NDCg)

Credit (+) Deposits (-)

Credit to other financial institutions

Credit to private sector (DCp)

Other assets net (OAN)

Accounting Analytical

Monetary Accounts: StocksMonetary Accounts: Stocks

Banking System 1. Net Foreign Assets NFA

Central bank (NIR)Rest of banking system

2. Net Domestic Assets NDANet Domestic Credit

Net credit to the nonfinancial public sectorCredit 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 NIR2. Net Domestic Assets NDA

Net Domestic CreditNet credit to the nonfinancial public sectorCredit to the rest of the banking systemClaims on private sector

Other Assets Net3. Monetary Base (monetary liabilities of CB) = 1 + 2 (MB = NIR + NDC)

Monetary Accounts:Monetary Accounts:Annual flows at end-of-period exchange rateAnnual 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 + OANNet domestic credit NDC = NDCg + DCp Nonfinancial public sector (net) NDCg Private sector DCpOther assets net OAN

3.Money and Quasi-money (M3) M3Money (M1)Quasi-moneyOther liabilities ∆NFA + ∆NDA = ∆M3 (monetary

liabilities)∆NIR + ∆NDAMA = ∆MB (monetary liabilities)

Balance of Payments: Balance of Payments: Analytical PresentationAnalytical Presentation

1. Current account CAB A. Goods and services X – Z

Goods (trade balance)Services

B. Factor income YfOf which: interest

C. Current transfers TRf 2. Capital and financial account CFAB

A. Capital account CAB. Financial account CF

Direct investment (net)Portfolio investment (net)

Public sectorPrivate sectorBanks

Other investment (net) Public sector

Private sectorBanks

3. Overall balance (1 + 2 = 3 = – 4) CAB + CFAB

4. Reserves and exceptional financing –NIR + ExF

Macroeconomic InterrelationsMacroeconomic InterrelationsNational Accounts

Consumption Public Private Gross domestic investment Public Private Exports of goods and servicesImports of goods and servicesGross Domestic ProductNet factor incomeNet current transfersGross National Disposable Income

Balance of PaymentsCurrent account Exports of goods and servicesImports of goods and servicesNet factor incomeNet current transfersCapital and financial accountCapital accountFinancial account Direct investment Net foreign financing Nonfinancial public sector Nonfinancial private sector BanksChange in net international reservesOperations of the NFPS

Total revenue and grantsTotal expenditure and net lending Current expenditure Wages and salaries Goods and services Interest Capital expenditure o/w fixed capital formation Net lendingOverall balanceFinancingExternalDomestic

Banking Survey (flows)Net foreign assets Central bank Rest of banking systemNet domestic assets Net domestic credit NFPS Private sector Other assets net Medium/long term foreign liabilitiesMoney and quasi-money (M3)

Flow of Funds Matrix FormatFlow of Funds Matrix Format

Sectors

Transactions

Nonfinancial (real)

Financial: changes in

financial assets and liabilities

Internal NFPS Private Banks External Total

S – I Sg –Ig Sp –Ip 0 – CAB 0

Total 0 0 0 0 0

Financing – Financing 0

Dom. Dom. Dom. Foreign Foreign Foreign Foreign – Foreign

Y = C + I + G + X - Z

An alternative derivation of An alternative derivation of monetary survey: Recap, same storymonetary survey: Recap, same story

G – T + I – S + X – Z = 0,

so left-hand sides sum to

Overview 1Overview 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 sectorsFor the economy as a whole, shows how the

savings–investment gap is financed by foreign sources

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 BOPGNDI – C – I = S – I = CABGNDI – C – I = S – I = CAB

Deficit in the CAB must be financed by net capital inflows or drawdown of international reservesCAB + CFA = CAB + CFA = ΔΔNIR (i.e., X – Z + F = NIR (i.e., X – Z + F = ΔΔR)R)

• 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 assetsExcess 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

ModelModel

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 variablesList of variables

M = moneyD = domestic creditR = foreign reservesR = R - R-1 = balance

of paymentsP = price levelY = real incomev = velocity

X = real exportsPx = price of exports

Z = real importsPz = price of imports

F = capital inflowm = propensity to

import

Two behavioral

parameters: m and v

List of relationshipsList 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)

Estimate m and v by

regression analysis

The M scheduleThe M schedule

Reserves (R)

GNP (PY)

M schedule

R = (1/v)PY – D

An increase in reserves increases demand for money, and hence also income

PY = v(R + D)

PY is nominal income

The B scheduleThe B schedule

Reserves (R)

GNP (PY)

B schedule

R = PxX – mPY + F + R-1

F up, e down

An increase in income encourages imports, so that reserves decline

Solution to modelSolution to model

Two equations in two unknowns1) R = (1/v)PY – D 2) R = PxX – mPY + F + R-1

Solution for R and PY

FXPRDmv

mvFXPR

Multipliers: AlgebraMultipliers: Algebra

1 mvXdP

Multipliers: NumbersMultipliers: Numbers

4)4/1(1

4)4/1(

Suppose m = ¼ and v = 4

Credit multiplier

Half of credit

expansion

leaks abroad

through balance of

payments

Macroeconomic equilibriumMacroeconomic equilibrium

GNP (PY)

M schedule

Equilibrium

B schedule

Reserves (R)

F up, e down

Economic modelsEconomic models

Exogenousvariables

Endogenousvariables

Change in domestic credit or the exchange rate

Financial programming model

Foreign reserves and nominal income

Experiment: Export boomExperiment: Export boom

M schedule

B schedule

Reserves (R)

GNP (PY)

Export boomExport boom

GNP (PY)

Exports increase

Reserves (R)

Export boomExport boom

GNP (PY)

Reserves (R)

An increase in exports increases both reserves and nominal income

An interpretationAn interpretation

Exogenousvariables

Endogenousvariables

Export boom orcapital inflow

Financial programming model

Foreign reserves and nominal income increase

Another experiment: Domestic Another experiment: Domestic credit expansioncredit expansion

D upM’

An increase in D increases PY, but reduces R.

Reserves (R)

D up M up PY up PzZ up R down

Domestic credit contractionDomestic credit contraction

GNP (PY)

D down

When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases. Here, an improvement in the reserve position is accompanied by a decrease in income.

Reserves (R)

Too low reserves

Domestic credit contraction Domestic credit contraction accompanied by devaluationaccompanied by devaluation

GNP (PY)

F up, e down

D down

When D falls, M also falls, so that PY goes down and PzZ also decreases. Therefore, R increases. Further, a devaluation strengthens the reserve position and helps reverse the decline in income.

Reserves (R)

Comparative statics: Comparative statics: An overviewAn overview

D PxX F e

R - + + + -

PY + + + + +

= inflation= inflation

Experiment: Experiment: Inflation goes upInflation goes up

B schedule

Reserves (R)

GNP (PY)

An increase in inflation () increases v, so the M schedule becomes flatter. Hence, R goes down and PY increases in the short run.

Experiment: Experiment: Inflation goes upInflation goes up

B schedule

Reserves (R)

GNP (PY)

An increase in inflation () makes domestic currency appreciate in real terms, so the B schedule shifts left. Hence, R goes farther down and PY can rise or fall in the short run.

up eP/P* up X down B shifts left

History and targetsHistory and targets Record history, establish targetsRecord history, establish targets

ForecastingForecasting Make forecasts for balance of payments, Make forecasts for balance of payments,

output and inflation, moneyoutput and inflation, money

Policy decisionsPolicy decisions Set domestic credit at a level that is Set domestic credit at a level that is

consistent with forecasts as well as consistent with forecasts as well as foreign reserve targetforeign reserve target

Numerical examplesNumerical examples 44

1)1)Make forecasts, set reserve target R*Make forecasts, set reserve target R*– E.g., reserves at 3 months of importsE.g., reserves at 3 months of imports

2)2) Compute permissible imports from BOPCompute permissible imports from BOP– More imports will jeopardize reserve More imports will jeopardize reserve

targettarget

3)3) Infer permissible increase in nominal Infer permissible increase in nominal income from import equationincome from import equation

4)4) Infer monetary expansion consistent with Infer monetary expansion consistent with increase in nominal incomeincrease in nominal income

5)5) Derive domestic credit as a residual: D = M Derive domestic credit as a residual: D = M – R*– R*

Financial programming step by Financial programming step by stepstep

KnownKnown at beginning of program period: at beginning of program period: MM-1-1 = 70, D = 70, D-1-1 = 60, R = 60, R-1-1 = 10 = 10

Recall: Recall: M = D + RM = D + R

XX-1-1 = 30, Z = 30, Z-1-1 = 50, F = 50, F-1-1 = 15 (all nominal) = 15 (all nominal)

Recall: Recall: R = X – Z + FR = X – Z + F

So,So,RR-1-1 = 30 – 50 + 15 = -5, so R = 30 – 50 + 15 = -5, so R-2-2 = 15 = 15Current account deficit, overall deficitCurrent account deficit, overall deficit

RR-1-1/Z/Z-1-1 = 10/50 = 0.2 = 10/50 = 0.2Equivalent to 2.4 (= 0.2Equivalent to 2.4 (= 0.2••12) months of 12) months of

importsimportsWeak reserve positionWeak reserve position

HistoryHistory

X grows by a third, so X = 40X grows by a third, so X = 40

F grows by 67%, so F = 25F grows by 67%, so F = 25

Suppose R* is set at 15 (Suppose R* is set at 15 (R* = 5)R* = 5)Z = X + F + RZ = X + F + R-1-1 – R* – R*

= 40 + 25 + 10 – 15 = 60= 40 + 25 + 10 – 15 = 60

Level of imports is consistent with R*Level of imports is consistent with R*RR**/Z = 15/60 = 0.25/Z = 15/60 = 0.25Equivalent to 3 (= 0.25Equivalent to 3 (= 0.25••12) months of 12) months of

importsimports

Forecast for balance of Forecast for balance of paymentspayments

BOP BOP fore-fore-castscasts

Increase in Z from 50 to 60, i.e., by Increase in Z from 50 to 60, i.e., by 20%, is consistent with R20%, is consistent with R** equivalent equivalent to 3 months of importsto 3 months of imports

Now, recall that Z depends on PY Now, recall that Z depends on PY where P is price level and Y is outputwhere P is price level and Y is output

Hence, if income elasticity of import Hence, if income elasticity of import demand is 1, PY can increase by demand is 1, PY can increase by 20% 20% E.g., 5% growth and 15% inflationE.g., 5% growth and 15% inflation

Forecast for real sectorForecast for real sector

If PY can increase by 20%, then, if If PY can increase by 20%, then, if income elasticity of money demand is income elasticity of money demand is 2/3, M can increase by 14% 2/3, M can increase by 14%

Hence, M can expand from 70 to 80Hence, M can expand from 70 to 80

Alternatively, by quantity theory of Alternatively, by quantity theory of moneymoneyMV = PYMV = PY

Constant velocity means that Constant velocity means that

%%M = %M = %PY = %PY = %P + %P + %YYIf so, income elasticity of money demand is

Forecast for Forecast for moneymoney

Recall M = D + M = D +

Having set reserve target at R* = 15 Having set reserve target at R* = 15 and forecast M at 80, we can now and forecast M at 80, we can now compute level of credit that is compute level of credit that is consistent with our reserve target, consistent with our reserve target, based on M = D + Rbased on M = D + R

So, D = 80 – 15 = 65, up from 60So, D = 80 – 15 = 65, up from 60D/DD/D-1-1 = 5/60 = 8% = 5/60 = 8%Quite restrictive, given that PY rises by Quite restrictive, given that PY rises by

20%20%Implies substantial reduction in domestic Implies substantial reduction in domestic

credit in real termscredit in real terms

Determination of creditDetermination of credit

Financial programming : RecapFinancial programming : Recap

Sequence of stepsSequence of steps

R*R* ZZ YY MM DD

Z = X + F + RZ = X + F + R-1-1 – R – R**

Z = mPYZ = mPY

MV = PYMV = PY

D = M – RD = M – R**

ConclusionConclusion

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

These slides will be posted on my website: www.hi.is/~gylfason

The EndThe End

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