Economics Quiz: National Income Identity

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What does the national income identity for an open economy express?

National income is equal to domestic expenditure plus net foreign expenditures. (correct)

National income is equal to C plus I plus G.

National income is equal to the sum of exports and imports.

National income is equal to the sum of production and investment.

If a country exports more than it imports, which of the following outcomes is true?

The current account is greater than zero. (correct)

Net foreign wealth is decreasing.

The current account is less than zero.

The trade balance is zero.

What happens to the current account when production is less than domestic expenditure?

It becomes positive.

It remains constant.

It decreases. (correct)

It increases.

In Agraria, if it imports 40 units of milk at a price of 0.5 per unit, what is the total expenditure on imports?

$20 Signup and view all the answers

Which component is NOT included in the calculation of Gross National Product (GNP)?

Interest payments on foreign loans Signup and view all the answers

What is the relationship between Gross Domestic Product (GDP) and Gross National Product (GNP)?

GDP measures value of production within a country, while GNP measures value produced by a country's factors Signup and view all the answers

Which of the following correctly describes the method of adjusting GNP for depreciation?

Depreciation is subtracted from GNP to represent loss of income to capital owners Signup and view all the answers

A factor that is subtracted from GNP to determine national income due to its effect on outflows is:

Unilateral transfers to other countries Signup and view all the answers

What is the formula used to differentiate GDP from GNP?

GDP = GNP - payments from foreign countries for factors of production + payments to foreign countries for factors of production Signup and view all the answers

What differentiates financial globalization from trade globalization?

Financial globalization involves cross-border financial flows. Signup and view all the answers

Which measure is NOT used to assess trade globalization?

Net portfolio investment changes Signup and view all the answers

What does De Jure measure focus on in the context of financial globalization?

The legal restrictions and policies on capital movements Signup and view all the answers

Which financial asset type is defined as having greater than 10% ownership?

Foreign direct investment Signup and view all the answers

What does the Chinn-Ito Index measure in relation to financial globalization?

Legal restrictions on capital account movements Signup and view all the answers

Which of these is considered an indicator of financial globalization?

The volume of trade credit Signup and view all the answers

How does De Facto measure financial globalization?

By evaluating actual trade in financial assets Signup and view all the answers

What captures the real-world outcomes of financial liberalization?

De Facto financial globalization measures Signup and view all the answers

What was a significant characteristic of international capital flows between 1970 and 2015?

They showed more volatility compared to international stocks. Signup and view all the answers

Which event marked a total collapse of international capital flows?

The Global Financial Crisis in 2008 Signup and view all the answers

During the Gold Standard era, what was a major reason for financial globalization?

Increased transportation and communication technologies. Signup and view all the answers

What type of investment was predominantly sought after during the first financial globalization?

Portfolio investment in foreign natural resources. Signup and view all the answers

Which region received the largest portion of capital outflows from the UK in the 19th century?

The New World Signup and view all the answers

What characterized the financial integration of world capital markets at the end of the 19th century?

High levels of overseas investment by Britain and other countries. Signup and view all the answers

What economic theory supported the idea that capital scarce countries would see high returns to capital during the first financial globalization?

Solow growth model. Signup and view all the answers

Which period is known for its establishment of the Bretton Woods system?

1945-1971 Signup and view all the answers

What primarily contributed to Ireland's significant GDP growth between 2014 and 2015?

Tax avoidance by large multinationals Signup and view all the answers

Which component is NOT included in the balance of payments accounts?

Income account Signup and view all the answers

What does the current account in the balance of payments mainly track?

Flows of goods and services Signup and view all the answers

How is an international transaction recorded in the balance of payments?

Twice, once as a credit and once as a debit Signup and view all the answers

Why has GDP been criticized as a measure of economic welfare?

It ignores the distribution of income. Signup and view all the answers

What is one example of a transaction entering the financial account in the balance of payments?

Receiving dividends from overseas investments Signup and view all the answers

What is primarily accounted for in the capital account?

Intangible asset transactions Signup and view all the answers

What best explains the current account deficit in Spain's context?

Excessive imports of goods and services Signup and view all the answers

What are official foreign exchange interventions primarily used for?

To alter macroeconomic conditions Signup and view all the answers

What constitutes the official settlements balance?

The sum of the current account and the non-reserve portion of the financial account Signup and view all the answers

What does a negative official settlements balance indicate?

A depletion of official international reserve assets Signup and view all the answers

What type of assets do official international reserve assets include?

Foreign assets and government bonds Signup and view all the answers

What was the U.S. current account deficit in 2012?

$440 billion Signup and view all the answers

What characterizes the United States' position in terms of net foreign wealth?

It has the most negative net foreign wealth Signup and view all the answers

What has been the trend of U.S. foreign assets and liabilities since 1976?

Both have increased sharply, but liabilities have risen more quickly Signup and view all the answers

What effect does the purchase of official reserve assets by the domestic central bank have?

Decreases the financial resources available to the central bank Signup and view all the answers

Study Notes

Economic Environment Analysis - Lecture 5

Lecture 5 covers the economic environment, focusing on financial globalization.
Previous lectures discussed globalization facts, productivity/resource impacts on trade patterns, and trade policies.
This week's lecture focuses on financial globalization, the current account's transition to an open economy, and the balance of payments.

Financial Globalization

Financial globalization is a process of rising global linkages through cross-border financial flows.
It is distinct from trade globalization.
Measures of trade openness include integration and economic vulnerability (exports + imports)/GDP.
Important restrictions to trade are also considered.
A measure of financial globalization examines the openness of cross-border financial transactions.

Financial Globalization: Assets

Financial assets transfer purchasing power across time periods.
Portfolio investment involves equity or debt holdings.
Foreign direct investment (FDI) represents ownership exceeding 10%.
Other investments include bank loans and trade credit.
Derivatives, like futures and options, are also included.
Central bank reserves are considered a type of financial asset.

Financial Globalization: De Jure vs. De Facto

De Jure measures assess the legal/regulatory openness to international capital movements.
These measures focus on official policies governing capital accounts, forex regulations, and restrictions.
De Facto measures quantify the actual flow of capital across borders, disregarding regulations.
They prioritize observed trade in financial assets (like FDI and portfolio investments).
De Facto measures also include both legal and illegal transactions.

Financial Globalization: The Chinn-Ito Index

The Chinn-Ito index is a de jure measure of capital account openness, created by Menzie Chinn and Hiro Ito.
It uses IMF data on legal restrictions from the Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).
The index covers data for over 180 countries since 1970.
The Chinn-Ito index compresses complex regulatory data into a single index, facilitating comparisons across countries and over time.

Financial Globalization: How to Measure Financial Assets

Flows represent the value of assets traded in a given year.
Stocks represent the value of assets held in a given year, which is cumulative flows.

Financial Globalization: Examples

Equity bonds: a company issuing €100 million in bonds represents the flow of financial assets in 2023.
Sovereign debt: examples use Spain's 2023 debt issuance which was around €70 billion.

Financial Globalization: De Facto Measures

International Financial Integration (IFI) equals (domestic assets held by foreigners + foreign assets held by domestic investors) / GDP.
IFI and flows are often expressed as a ratio to GDP.
Inflows are net purchases of domestic assets by foreign investors (e.g., bank loans from a foreign bank to a domestic firm).
Outflows are net purchases of foreign assets by domestic investors (e.g., bonds issued by a foreign government to domestic households).

Financial Globalization (De Facto) - 1970-2015

International Financial Integration (IFI) showed a large increase from 1970 to 2015.
IFI increased significantly for both developed and developing/emerging countries.
IFI grew considerably more for developed countries compared to developing countries.

Financial Globalization: International Capital Flows (De Facto)

International Capital Flows (% of world GDP) have risen from the 1990s.
These flows are more volatile than stock market investments.

Financial Globalization: History

World capital markets were integrated in the late 19th century.
The share of British wealth invested abroad was high (17% in 1870; 33% in 1913).
Capital outflows from the UK went predominantly to countries with natural resources.

Financial Globalization: History (Eras)

Four eras of financial globalization are highlighted:
- Gold Standard era (1880-1914)
- World Wars (1915-1945)
- Bretton Woods era (1945-1971)
- Floating-rate era (1971-2000's)

Financial Globalization: The Beginning (Causes)

Transportation and communication (like the telegraph) facilitated information transmission.
Global banking institutions (especially those in the UK) played a crucial role.
The Solow growth model provides the theoretical basis for explaining capital flows.
Capital scarcity in countries led to high returns on capital.

Financial Globalization: History (Theory Sketch)

Output (yt) is produced efficiently using inputs like capital (kt), which are influenced by technology (At).
The relationship is typically described as yt = Atkα (production function)
a is a technological parameter (0 < a < 1) representing the diminishing return to capital, meaning marginal productivity of capital decreases as more capital is used.

Financial Globalization: The Beginning (MPK)

Marginal productivity of capital (MPK) measures the amount of output produced with an additional unit of capital.
MPK is directly linked to the return on capital.
With increased capital, MPK decreases.
The difference in MPK between capital-rich and capital-poor countries drives capital flows.

Financial Globalization: The Washington Consensus

The Washington Consensus is a set of loosely articulated ideas from the 1990s aiming to modernize, reform, and deregulate economies.
Emerging markets often opened their capital markets during the early 1990s, while developed markets were already open since the 1980s.

Financial Globalization: Expected Gains

Intertemporal trade gains arise from moving capital from rich (lower return due to decreasing returns) to poor countries (higher return).
This leads to increased investment and potentially faster growth in capital-poor countries.
This approach promotes a more steady state.
It also allows risk sharing by spreading risk.

Financial Globalization: The Lucas Puzzle

Despite low capital/labor ratios, substantial capital flows to developing countries are relatively small.
Many emerging markets lend to rich countries rather than vice-versa, though the flow of capital is there, it does not flow in the opposite direction.

Financial Globalization: Uphill Capital Flows

Capital inflows often go to poorer, less developed countries despite their low productivity (this is not always true).
This phenomenon can be due to factors like domestic distortions or low total factor productivity (TFP).

International risk sharing, often associated with risk diversification, lets investors reduce the risk of their portfolios by investing internationally.
Diversification reduces the risk associated with specific countries.

Are Global Financial Markets Integrated?

International asset holdings are growing rapidly and substantially.
A "portfolio home bias" is observed: investors tend to invest more in assets close to their home market or country.

National Income Accounts

National income accounts track the value of national income from goods/services production and expenditure.
Producers earn income from consumers' expenditures on goods/services.
National income is often defined as the income earned from factors of production in a nation, e.g. labor, capital.

National Income Accounts: Gross National Product (GNP)

Gross national product (GNP) values all final goods and services by domestic factors of production in a given time period.
It considers workers, physical capital, natural resources, etc. as factors of production.
U.S. GNP includes the output of foreign factors of production owned by U.S. residents.

National Income Accounts: Calculating GNP

GNP is calculated by adding up expenditures on final goods/services.
The four components of GNP are consumption, investment, government purchases, and the current account balance (exports - imports).

US GNP and its Components (2020 Q1)

Graphs illustrate the composition of the US GNP for 2020 Q1
Values are expressed in billions of dollars, seasonally adjusted.

National Income Accounts: Depreciation

Depreciation of physical capital is subtracted from GNP to get a more precise value for national income.
It accounts for the wear and tear on capital goods that affects national income.

National Income Accounts: Unilateral Transfers

Unilateral transfers (e.g., foreign aid, remittances, and pension payments) affect national income.
These transfers are part of the current account balance.

National Income Accounts: Gross Domestic Product (GDP)

GDP is another measure of national income.
GDP measures goods/services produced within a country during a given period
GDP differs from GNP because it includes only production in the country.

National Income Accounts: Open Economy Identity

The national income identity for an open economy is Y = C + I + G + (EX-IM) = C + I + G + CA.
(EX-IM) = current account balance (CA).
C + I + G are domestic expenditures.
CA represents the net expenditures from foreigners.

National Income Accounts: Current Account Balance (CA)

A positive current account balance indicates the country has more exports than imports, leading to higher income, and increasing net foreign wealth.
A negative current account balance (deficit) means the country imports more than it exports, meaning the country is borrowing from other countries and causing net foreign wealth to fall.

National Income Accounts: Saving and Current Account

National saving (S) is the part of national income (Y) that is not consumed (C) or spent by the government (G).
S = Y - C - G
In an open economy, saving can be used to build up capital stock or acquire foreign wealth. In this case, S = I + CA (I for investment in capital stock).

National Income Accounts: Private and Government Saving

Private saving (SP) is the part of disposable income (Y - T) not spent on consumption. SP = Y - T - C
Government saving (SG) is net tax revenue (T) minus government spending (G). SG = T - G
National saving is the sum of private and government savings (S = SP + SG).

Current Account and Savings

The current account balance (CA) reflects savings and investment behavior. A country with high savings relative to investment will usually have a current account surplus.
A country with low savings compared to investment will usually have a current account deficit.
A country with a current account deficit is borrowing from the rest of the world, and vice versa for a surplus.

Current Account and Savings in the U.S.

Historical data graphs show the U.S. saving rate, investment rate, and current account balance from roughly the 1970s until about 2020.

Understanding Current Accounts

Consumption smoothing, an intertemporal approach, guides borrowing and lending decisions to address income shocks.
Fast growth often creates current account deficits because investment exceeds savings.
Aging populations typically save more, resulting in current account surpluses.

Understanding Current Accounts: No Obvious Normative Judgment

There's no one way to interpret current account signs and magnitudes.
Capital flows might not reflect an efficient allocation of resources.
Factors like social insurance, financial development, and public borrowing have a major influence on the magnitude of private saving.

Understanding Current Accounts: Systemic Distortions

Large current account imbalances (like those seen in the Asian financial crisis of 1997–1998) and the role of foreign exchange reserves may influence and affect countries' economic stability.
These imbalances can result from imperfect adjustment mechanisms. (i.e., exchange rates that can't fluctuate, as in the Eurozone).

Multinationals' Profit Shifting and Ireland's Volatile GDP

Ireland's GDP growth between 2014 and 2015 was exceptionally high but related more to accounting procedures than economic activity from multinational corporations.
These multinational corporations often exploited Ireland's low corporate tax rate to move their intellectual property overseas, thereby generating accounting gains for gross domestic product (GDP).

Ireland's GDP (1999-2020)

Graph plotting Ireland's real GDP growth between 1999 and 2020 illustrates a sharp increase in 2015 that was mostly due to an accounting technique.

Balance of Payments Accounts

A country's balance-of-payments records its transactions with other countries. Transactions are recorded with a corresponding credit and debit for the same transaction.
International transactions are recorded twice, once as a credit for one party and once as a debit in the same transaction for the other party.
The accounts for (1) current account flows of goods and services (exports-imports), (2) financial account (financial capital flows), and (3) capital account (assets' transfers).

Balance of Payments Accounting: Examples

Importing a fax machine involves a current account debit (import) and a financial account credit (sale of foreign asset).
Purchasing lunch in France involves a current account debit (import) and a financial account credit (sale of foreign asset) through a credit card.
Buying a stock of BP generates a financial account debit (purchase) with a financial account credit (sale of asset) from BP depositing the money in a US bank.
Debt forgiveness reduces the debt in the capital account.

Balance of Payments: Balance Equation

Balance of payments accounts balance due to the double-entry system.
Current account + Financial account + Capital account = 0.

Balance of Payments Accounts: Current Account

The current account records merchandise exports and imports.
It also records services, income receipts, and net unilateral transfers.
Services include payments for legal, shipping, and tourism services, etc.
Income receipts involve interest payments, dividends, and income from firms, etc., operating in foreign countries.

Balance of Payments Accounts: Capital Account

The capital account records special asset transfers (typically non-market, non-produced, or intangible assets) such as debt forgiveness, copyright transfers, etc.
While important, this is often a smaller-scale component in the US and other developed countries.

Balance of Payments Accounts: Financial Account

The financial account records inflows (credits) and outflows (debits) of financial assets, including official reserve assets, other assets and financial derivatives (not including reserve assets).
Foreign buying of domestic assets (i.e., lending to domestic citizens) is a credit.
Domestic buying of foreign assets (i.e., lending to foreigners) is a debit.
The financial account has 3 categories: official reserve assets, other assets and a statistical discrepancy.

Balance of Payments Accounts: Statistical Discrepancy

Data sources for BOP transactions may differ in coverage, accuracy, and timing.
The statistical discrepancy is used to balance the accounts in practice.

US Balance of Payment Accounts (2019)

Table presenting a breakdown of exports, imports, services, and income receipts, plus a net balance on the current account and a capital account in US Dollars.

The Mystery of the Missing Deficit

Global current account balances ideally sum to zero, but they frequently don't sum to zero due to incomplete reporting, or a change in classification of income.

Balance of Payments Accounts: Central Banks

Central banks manage the money supply.
They sometimes intervene in foreign exchange markets to influence macroeconomic conditions.
Official foreign exchange intervention is a way to either inject (or remove) money from the economy.

Balance of Payments Accounts: Official (International) Reserve Assets

Official reserve assets are foreign assets owned by central banks aimed at preserving stability.
Such assets include government securities, currencies, gold, and IMF accounts etc.
Purchases or sales of these assets are important factors in current account balances.

Balance of Payments Accounts: Official Settlements Balance

The balance of the current account, capital account, the non-reserve portion of the financial account, and the statistical discrepancy forms the official settlement balance.
A negative balance means the country is depleting its reserves or accumulating debts with other countries.

U.S. Balance of Payments Accounts and Net Foreign Assets

The U.S. has the most negative net foreign wealth globally.
The country's current account deficits have led to decreasing net foreign wealth since 1980.
While U.S. assets abroad have grown, foreign holdings of U.S. assets have increased faster.

Current Accounts and Net Foreign Assets

Accumulating current account deficits creates negative net foreign assets (NFA) which reflects the differences between foreign assets held by domestic residents in comparison to domestic assets held by foreign residents.
The accounting identity NFA_t = NFA_{t-1}+CA_t captures the evolution of NFA from one time period to another.

Valuation Effects on External Positions

Capital gains/losses on assets (or liabilities) held abroad from exchange rate changes or market valuation changes, affect NFA calculations.
Financial globalization's rise has increased the importance of these valuation effects.

Valuation Effects on External Positions: US Annual Real Returns

Graph showing annual real returns on foreign assets and liabilities for the US.
Volatility in capital gains/loses on net external assets is noted.

Understanding Valuation Effects

Large US current account deficits in the early 2000s did not necessarily result in a major change in the U.S. net foreign asset position.
This may be attributed to valuation effects (i.e., real exchange rates, and market-value gains on both foreign-held and domestic-held assets, etc.)

Understanding Valuation Effects: How Can That Be?

Capital gains on foreign-held U.S. assets, especially in foreign currency, had considerable gains that offset the current account deficits.
U.S. dollar depreciation contributed significantly to some of the valuation increases.

The US Net foreign asset positions

Table illustrating asset and liability valuations for the U.S. at the end of 2019 in terms of dollars and as a percentage of GDP.
The majority of US wealth and assets are denominated in U.S. Dollars.

Exorbitant Privilege

The U.S. has an 'exorbitant privilege' that results from foreign investors having a weak return on U.S. assets compared to their returns on assets elsewhere.
This is related to dollar's role as a reserve currency and the liquidity of the U.S. financial markets.

Exorbitant Privilege and Exorbitant Duty

External constraints on U.S. current account balances have relaxed due to the financial crisis in the early 2000s.
U.S. valuation adjustments from a financial crisis resulted in a dramatic drop in the value of US assets overseas in comparison to assets held by foreigners in the US, with US dollar-denominated debt remaining stable or even growing.

External Adjustment

External adjustment mechanisms such as trade channel (adjusting production and consumption) or financial channel (capital gains and losses) are needed to correct for current account disequilibria.

External Adjustment and Exchange Rates

Exchange rates can support external adjustment measures.
Depreciation of a currency can boost exports and reduce imports, but the effects can vary depending on the structure of holdings of foreign assets and liabilities of affected countries.

External Adjustment and Exchange Rates: Eurozone (Pre-2008)

Prior to the 2008 crisis, the Eurozone experienced current account imbalances with deficits in southern Europe and surpluses in northern Europe.

A Glimpse of the Euroarea Heterogeneity

Graph illustrates the average current account balances across various European countries from 2002-2007.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Test your understanding of national income identity in an open economy. This quiz covers key concepts like GDP, GNP, current accounts, and the impact of trade balances. Challenge yourself with questions that explore the calculation and components of national income.