Exchange Rates and the
International Monetary System
Lecture by
Neven Mates
Outline
• International economic relations
•
•
•
Trade flows (goods and services), income flows, grants
Capital flows
Balance of payments
• Foreign exchange markets and the exchange
rates
•
•
Forex market, supply and demand
Appreciation, depreciation, revaluation, and devaluation
• The international monetary system
•
•
•
•
Golden standard and the fixed exchange rate system
Adjustment of an economy to balance of payments imbalances under the golden
standard
Floating system and the system of managed exchange rate
The International Monetary Fund
International economic relations
• Economics often starts with a model of closed economy:
No foreign trade, no capital flows.
• But such simple models are misleading in the modern
World.
• In closed economy saving is always equal to investment,
demand of equals domestic supply and production,
capital cannot flow in or out of the country, and
government has the option of captive finance.
• Today all economies trade internationally large part of
their output.
• Moreover, countries have liberalized their capital
account transactions and investors trade with financial
assets. As a result, capital flows are much larger than
the trade flows.
Global trade grows faster than output:
Economies are becoming more open - Globalization
Global Trade and GDP 1980-2016
growth rates
20
15
10
%
5
19
80
19
84
19
88
19
92
19
96
20
00
20
04
20
08
20
12
20
16
0
-5
-10
-15
Trade volume of goods and services
Gross domestic product, constant prices
Year
Degree of openness varies across
countries
Figure 7: Exports of Goods and Services 2008, as % GDP
Serbia
Romania
Bosnia and Herzegovina
Poland
Latvia
Croatia
Bulgaria
Lithuania
Slovenia
Estonia
Czech Republic
Hungary
Slovak Republic
Exports of Goods and
Services, % GDP
Croatia
SEE
Baltics
Central Europe
EU periphery
Emerging Asia
Emerging Latin America
0
10
20
30
40
50
60
70
80
90
Source: WB Database, IMF WEO September 2011 Database.
*Data for groups calculated with weights corespondiong to nominal GDP in $ in 2008
Large economies are less open:
Exports of goods and service to GDP
•
USA 2010
Eurozone:
12.6%
24.0%
Export growth is a must for small
open economies
Figure 6: Exports of Goods and Services in 2010, 2000=100.
Croatia
Serbia
Slovenia
Latvia
Bulgaria
Bosnia and
Poland
Slovak Republic
Estonia
Hungary
Romania
Czech Republic
Lithuania
Export of Goods and Services
Volume 2010, 2000=100
Croatia
SEE
Baltics
Central Europe
EU periphery
Emerging Asia
Emerging Latin America
0
50
100
150
200
250
300
Source: IMF WEO September 2011 Database.
*Data for groups calculated with weights corespondiong to nominal GDP in $ in 2010
350
400
Conclusion: International trade
• International trade is the main engine of
global growth.
• Growth of international trade persistently
surpasses growth in global GDP.
• Smaller an economy is, more it is
dependent on international trade.
• Small countries have to specialize.
Capital flows are even larger
• Exporting and importing countries have to
settle their obligations, i.e. to make and
receive payments.
• But residents of various also trade with
assets, i.e. they lend and borrow.
• We will now focus on how these payments
are accomplished.
The balance of payments:
• Presentation of all payments between
residents of one country (households,
financial and non-financial corporations,
government) and the rest of the world
(non-residents).
• There is an important distinction between
payments for current and for capital
transactions.
Balance of payments:
I Current account
• Residents of a country sell goods and services to non-residents and
buy from them (exports and imports)
• Residents also receive income from abroad from their investments
and from labour services provided to non-residents.
• On the other side, residents pay to non-residents for the use of
foreign capital (loans, equity investments) and for their labour
services.
• Residents also receive and extend grants
• All these transactions are called the current account transactions, as
they represent incomes earned and costs incurred abroad.
• The net outcome of all these transactions is called the external
current account balance of a country. It is called deficit if negative.
The current account balance
(or deficit)
• The current account balance= 1+2+3+4
• 1. Trade balance
•
Exports of goods minus imports of goods
• 2. Balance of services
Exports of services minus imports of services
• 3. Income balance
Investment income of residents (interest and
dividends received) and received payments for labor
services of residents minus such payments to nonresidents
• 4. Balance of grants (unrequited transfers, remittances)
The current account balance
(or deficit)
• If a country has a positive external current
account balance, this means that its
income is higher than its domestic
absorption (consumption and investment).
• This also means that its saving is higher
than its domestic investment (fixed capital
formation plus increase in inventories).
• The surplus is used to acquire assets
(invest) abroad.
Balance of payments:
II Capital account—Outward investments
• Residents of a country make investments
abroad:
– Make deposits in foreign banks and extend
loans to non-residents
– Buy stocks and shares abroad (portfolio
investments)
– Directly invest in foreign companies (they
invest in and acquire some control over a
foreign company).
Balance of payments:
II Capital account—Inward investments
• Non-residents make investments in the country:
– Increase their deposits with the domestic banking
sector
– Extend loans to domestic banks, firms, household,
government)
– They buy stocks and shares (portfolio investments)
– They directly invest in domestic companies (acquire
controlling equity and extend loans to such
companies).
Balance of payments:
II Capital account - net flows
• Sum of all inflows and outflows of capital from
financial transactions gives the capital account
balance. Simplified: The capital account balance
equals net borrowing abroad (borrowing minus
repayment) minus net investments abroad.
• The positive balance means that the country is
receiving more capital from abroad than it has
invested abroad.
• The following identity holds:
• I + II = 0
Balance of payments:
Change in official reserves
• It is often convenient to separate operations of the
central bank from operations of other domestic residents.
• Then the identity looks as follows:
• I + II + III = 0
• where II is now capital transactions excluding the central
bank, and
• where III is the use of reserves of the central bank. If III
is positive, this means that the central bank has reduced
(i.e. sold) some of its reserves. Decline of reserves will
be presented with a positive sign, and increase will be
shown with a negative sign.
Capital and financial account
• Recently, the IMF introduced a new classification
by splitting the capital account into capital
account and financial account.
• Capital account comprises capital grants and
some other items: It is very small.
• All important transactions are recorded in the
financial account.
• Most people ignore the new terminology, and
just refer to the capital account.
BoP: Errors and omissions
• BoP tables are compiled from various sources:
– Trade data are from custom statistics
– Data on services are usually from banks and surveys
– Capital transactions come from banks and surveys
These data do not add up. The difference is shown as
Errors and Omissions.
In the following table for Croatia, the identity reads as:
A +B1+ B2 + C= 0
where A is current account balance, B1 is capital
account balance excluding movements in official
reserves, B2 is change in official reserves, and C are
errors and omissions.
BoP Table for Croatia 2008-2010
Table H7: Balance of Payments - Summary
in millions of EUR
2008
A. CURRENT ACCOUNT (1+6)
1. Goods, services, and income (2+5)
1.1. Credit
1.2. Debit
2. Goods and services (3+4)
2.1. Credit
2.2. Debit
3. Goods
3.1. Credit
3.2. Debit
4. Services
4.1. Credit
4.2. Debit
5. Income
5.1. Credit
5.2. Debit
6. Current transfers
6.1. Credit
6.2..Debit
-4.196,7
-5.267,1
21.298,5
-26.565,7
-3.719,2
19.904,6
-23.623,8
-10.793,8
9.814,0
-20.607,8
7.074,6
10.090,6
-3.016,0
-1.548,0
1.393,9
-2.941,9
1.070,5
1.684,4
-613,9
2009**
2010**
-2.379,7
-3.416,0
16.956,4
-20.372,4
-1.617,0
16.157,1
-17.774,1
-7.386,9
7.703,2
-15.090,1
5.769,9
8.453,9
-2.684,1
-1.798,9
799,4
-2.598,3
1.036,3
1.607,8
-571,5
-535,0
-1.622,9
18.487,3
-20.110,3
-65,5
17.591,8
-17.657,4
-5.952,0
9.102,3
-15.054,3
5.886,5
8.489,5
-2.603,0
-1.557,4
895,5
-2.452,9
1.088,0
1.684,6
-596,6
BoP Table for Croatia 2008-2010
B. CAPITAL AND FINANCIAL ACCOUNT
B1. Capital account
B2. Financial account, excl. reserves
1. Direct investment
1.1. Abroad
1.2. In Croatia
2. Portfolio investment
2.1. Assets
2.2. Liabilities
3. Financial derivatives
4. Other investment
4.1. Assets
4.2. Liabilities
B3. Reserve Assets
C. NET ERRORS AND OMISSIONS
5.772,4
14,9
5.427,1
3.246,0
-972,7
4.218,6
-810,1
-380,8
-429,2
0,0
2.991,2
-1.621,6
4.612,8
330,4
-1.575,7
3.431,0
43,1
4.284,3
1.491,7
-888,2
2.379,8
420,9
-558,1
979,1
0,0
2.371,7
748,0
1.623,8
-896,4
-1.051,3
1.264,2
34,5
1.313,5
393,1
112,3
280,9
397,1
-368,3
765,4
-252,7
776,0
697,5
78,5
-83,8
-729,3
The BoP Table for Croatia 20082010: Comments and questions
• How important are services for Croatia’s
BoP?
• What happened to Croatia’s current
account 2007-2010?
• To the capital account?
• To official reserves?
• How large are the errors and omissions?
Phases in the development of
current account balances
•
•
•
•
•
•
•
Traditionally, it was assumed that developing countries would be importing
capital, i.e. they would run current account deficits. Their investments
would be higher than their savings.
Mature, or advanced economies on the other hand would be running
surpluses, i.e. have larger savings than investments.
However, in the modern world this has changed. Germany, Japan and some
other advanced economies indeed run current account surpluses as
expected. So do oil producers.
However, China and other emerging market economies in Asia have very
high saving rates and run current account surpluses.
On the other hand, advanced economies like US have low saving rates and
run current account deficits.
Southern eurozone countries, after euro was established, have cut down
their saving rates, while some of them also increased unproductive
investments. As a result, they started accumulating large foreign debts and
are now in trouble.
Their currencies appreciated in real terms and these countries became noncompetitive.
CA imbalances
Credit boom in Non-core eurozone
How to make payments in the
world of national currencies?
• So far we have focused on transactions,
but not how the corresponding payments
are made.
• Residents from different countries use
different currencies.
• How are these currencies exchanged?
Exchange rates: Some definitions
• Appreciation: Domestic currency gets stronger
relative to a foreign currency. For example, one
needs less kunas to buy euro. Depreciation is
the opposite.
• Be careful: “The exchange rate got higher”
usually means that you need more domestic
currency to buy foreign currency. This means
that domestic currency has depreciated.
• Revaluation: In fixed exchange rates systems,
decisions to set the rate at a more appreciated
level. The opposite is devaluation.
Foreign exchange market-Selling
side
• Every day exporters sell their proceeds.
• Those who borrow abroad and want to use
these resources domestically, sell their $
and euros in the market
• Foreigners who want to invest in Croatia
sell $ or euros to buy kunas.
•
Foreign exchange market-Buying
side
• Importers
• Residents who want to repay their debts in
$ and euros, increase their deposits
abroad, lend to non-residents, or acquire
assets abroad.
• Non-residents who want to repatriate their
incomes and investments.
Foreign exchange marketEquilibrium
• In a fixed exchange rate system, the equilibrium is
established by central bank interventions, i.e. by central
bank purchases or sales in the forex market.
• In a flexible exchange rate system, the equilibrium is
established by price, i.e. by adjustment in the exchange
rate. When supply of euros in the foreign exchange
market is lower than demand, the price for euro gets
higher, i.e. kuna depreciates. And vice versa.
• Fluctuations are reduced by speculators (those who take
short or long positions). They sell foreign currency when
they consider that the kuna exchange rate has
depreciated below equilibrium, and buy foreign currency
when they see the kuna exchange rate as too low (to
much appreciated).
Exchange rates: Where do they
settle in the long-run?
• In the system of flexible exchange rate, the
bilateral nominal exchange rates (for example
$/yen) fluctuate a lot.
• There are many factors driving the nominal ERs.
For example:
– Cyclical position of two countries: If Japan is in
recession, it imports less, which should reduce
demand for $, and lead to appreciation of yen.
– However, since interest rates in Japan are low when
its economy is in recession, and in the USA they are
high if its economy is booming, this will increase
demand for $, and lead to depreciation of yen. The
second effect is in practice much stronger.
Purchasing power parity (PPP):
A theory on the equilibrium exchange rates
•
•
•
•
•
•
PPP theory expects that the exchange rates will settle, or converge toward
levels at which prices of tradable goods in two countries are equal.
The rationale: Given the fact such goods can be traded across borders,
disparities in prices can be eliminated by trade.
If tradable goods at the current exchange rate were cheaper in Mexico than
in USA, Mexico would export them to the USA.
In a system of flexible exchange rates, this would lead to the appreciation
of pesos until the parity is established.
In a fixed exchange rate system, Mexican prices of exported goods will
increase until the parity is established. This means that peso would
appreciate in real terms, although nominal exchange rate would remain
stable.
However: Transportation costs and custom duties impose wedge between
prices of the same good in different countries. Customers might also have
domestic bias.
Purchasing power parity—Two
Implications
•
1. If a country is experiencing high inflation, then its currency will depreciate relative
to the country with a stable price level. However, with the disappearance of inflation
as a global problem, this factor has lost on importance.
•
2. How to compare GDP in different countries? Take note that the equality of prices
under PPP theory applies only to tradable goods. This has interesting implications for
measuring GDP.
Assuming that USA has much higher level of productivity in production of tradable
goods and services. Other things equal, this will imply that wages in those sectors are
much higher in the USA than in China.
Let us also assume that wages in non-tradable sectors in both China and USA are
equal to wages in their tradable sectors.
As a result, wages in China-s non-tradable sector are much lower than in the USA,
regardless of productivity in non-tradable sectors. China prices for non-tradable
services and goods will therefore be much lower in China.
One $ will therefore buy a larger consumer basket in China than in the USA.
This means that China’s GDP calculated at nominal exchange rate in $ would be
underestimated as a measure of well-being.
When nominal GDP is corrected for purchasing power, one gets GDP at PPP.
•
•
•
•
•
•
GDP PPP Adjusted,
in billion $
Table: GDP at nominal and PPP adjusted echange rates, 2010
GDP GDP PPP
Ratio
China
5878
10120
1,7
Germany
3286
2944
0,9
India
1632
4058
2,5
Japan
5459
4324
0,8
United Kingdom
2250
2181
1,0
United States
14527
14527
1,0
Source: IMF WEO, 2011.
GDP and GDP PPP Adjusted
2010
16000
14000
12000
10000
GDP
GDP PPP
8000
6000
4000
2000
0
China
Germany
India
Japan
United Kingdom
United States
Summary on exchange rates:
• In today’s world, movements in the
exchange rates are difficult to predict.
• Interest rates and expectations about their
movements do affect exchange rates.
• But it was not always so.
Global monetary system
• System of fixed exchange rates: Global
golden standard
• System of flexible exchange rates
• System of managed exchange rates
Golden standard
• Between early 18th century and 1930s, with
some interruptions, monetary system of all major
global economies was based on gold: Gold
(coins and bullion) were the main medium of
exchange in international trade. Domestically,
banknotes were exchangable for gold.
• Coins of different nations contained different
quantity (weight) of gold.
• Their exchange rates were determined by the
ratio of quantity of gold they contained.
Golden standard: Macroeconomic
adjustment
• English philosopher Hume described how prices and
incomes adjust under the golden standard (1752)
• He assumed that the level of prices depends on supply
of money in the country.
• If US wages and prices increase above equilibrium, US
would import more from UK than it would export.
• Therefore, it would be losing gold.
• The reduced quantity of gold would push prices and
wages in the US down. The increased quantity of gold in
UK would push the prices up. This would correct prices
and the trade flows.
• If gold is found in California, this would trigger inflation in
the USA and the UK.
In the early 20th century, the golden standard came under
pressure
• Some countries during the WW I de-linked their currencies from
gold.
• After the war, some tried to re-establish the old parity: The result
was a long depression. This suggested that the golden standard
was too inflexible.
• Then, during the 1930s depression, some countries again de-linked
their currencies from gold and devalued them.
• This was seen by others as unfair competition (“beggar your
neighbour policy”).
• In response, they strengthened protectionist policies: higher custom
protection, and restrictions on payments for imports.
• The result was a further drop in global trade, which exacerbated the
recession.
• After the WW II, these issues tried to be addressed by establishing
the IMF.
The fixed but adjustable system under the Bretton-Woods
agreement 1945
• Post WW II global monetary system was designed by victorious
coalition at the conference in Bretton Woods USA in 1944.
• To facilitate global trade but also to prevent competitive
devaluations, the international monetary system it was decided to
base global monetary system on fixed but adjustable exchange
rates.
• The anchor to the system was still provided by gold, or by $ which
was fixed to gold.
• The exchange rates could however be adjusted only with the
approval of the International Monetary Fund (IMF).
• At the same time, to reduce the need and magnitude of adjustments
in the exchange rates, the IMF would provide loans to countries that
have run out of their golden reserves.
• These countries would have to reduce their consumption so as to
bring their balance of payments into equilibrium.
The breakdown of the Bretton-Woods System
• The fixed but adjustable system of exchange rates was designed at
the time when capital flows were small.
• The balance of payment pressures were driven primarily by external
current account flows. This means they were limited in scope and
not developing fast.
• However, with growing liberalization of capital flows, the system of
the fixed exchange rates became unsustainable.
• Imbalances started to become larger, and grew faster.
• When the US in late 1960s followed expansionary fiscal and
monetary policies (printing too much $), US started losing gold
reserves, and eventually had to abandon the convertibility of $ into
gold in 1971. The system fell apart.
• Since then, major economies float their currencies (US, UK, Euro
zone, Canada, Australia, Sweden, Japan), some of them with
occasional interventions by their central banks).
Small countries with fixed exchange rates after
1972
• After large countries let their currencies float, some small
countries continued to fix their exchange rates to
currencies of their major trading partners.
• Under the currency board arrangement, the central
bank creates domestic currency only by buying foreign
currency at fixed exchange rate. It is always willing to
sell or buy foreign currency at the same rate. No
domestic central bank money is created by credit. As a
result, all primary money is fully covered by official
reserves of the central bank.
• Other countries fix their exchange by announcements,
or practice of their central banks. Their central banks
continue to extend credit, but usually do not have much
scope to do it.
Small countries with floated or managed
exchange rates after 1972
• Other countries have flexible exchange rates with
occasional interventions (interventions are purchases
and sales of foreign currency by the central bank).
• Interventions are used only to smooth large fluctuations,
or to keep the exchange rate within some band, which
may or not be announced.
• Interest rates of central bank might also be adjusted with
a view of keeping the exchange rate within some range.
Such systems are called managed exchange rate
systems.
• Some countries operate in inflation targeting framework.
They use only interest rate policy so as to target low
inflation, but usually abstain from foreign exchange rate
interventions.
Macroeconomic adjustments in
different exchange rate systems
• In fixed exchange rate systems, the adjustment
is similar to the one described by Hume, except
that countries with the deficits in the BoP now
lose official reserves, instead of gold.
• Loss of reserves results in tightening of domestic
monetary conditions and this reduces domestic
consumption and investment.
• In floating systems, BoP pressures result in
depreciation. To prevent inflation, the central
bank has to increase its interest rate.
Macroeconomics of small open
economies
• Small economy: One that cannot influence
global prices
• Open economy: It is engaged in foreign
trade, and can run current account deficit
or surplus.
• What are the main implications?
Macroeconomics of small open
economies
• Effect on multiplier
• Effect on investment-saving balance
Simple Keynesian model of a closed economy without
income taxes
This mechanism can best be described by the following simple model of a
closed economy. We assume here that government does not collect income or
consumption based taxes, and that there is spare capacity in the economy:
C= a + bY
Y=C+G+I
By combining these two equations, we get  Y = (a+I+G)/(1-b)
If there is no free capacity in the economy, an increase in G would have to
squeeze out investment or private consumption. It is usually assumed that this
would take place via increases in interest rate. As the government tries to borrow
funds to increase its spending, this increases the interest rates, which then
reduces private investment.
If spare capacity is available, an increase in G results in an increase in output Y.
dY/dG = 1 / (1-b)  fiscal multiplier
If the b is equal to 0,80 then the multiplier is 5.
48
Simple Keynesian model of a closed economy without
income taxes
The above results can also be demonstrated with the following figure:
C+I+G’
C, I, G
C+I+G
Y
Y’
Y
Increasing G and assuming spare capacity would therefore increase aggregate
demand, which means that the line C+I+G would be shifted up by the corresponding
amount. Output would then increase from Y to Y'.
49
Simple model with income taxes
Model with income tax:
Yd=Y-tY
C=a+bYd
Y=C+I+G,
Combining equations we get:
dY/dG = 1/(1-b(1-t))
Assuming b=0.8, and t=0.3, results in much lower multiplier of about 2.3 Income
tax would therefore reduce the value of the multiplier, but the multiplier would still
remain larger than 1.
Such simple models suggest that in situation with spare capacity, an increase in
government spending produces substantially larger increase in GDP. On the
basis of such reasoning, the following policy prescription follows: When economy
is in recession, government should increase spending (or reduce taxes) to
provide stimulus to the economy, and smooth the output path. Fiscal policy
appears in such models as a powerful tool.
50
Simple model with income taxes
Model with income tax:
Yd=Y-tY
C=a+bYd
Y=C+I+G,
Combining equations we get:
dY/dG = 1/(1-b(1-t))
Assuming b=0.8, and t=0.3, results in much lower multiplier of about 2.3 Income
tax would therefore reduce the value of the multiplier, but the multiplier would still
remain larger than 1.
Such simple models suggest that in situation with spare capacity, an increase in
government spending produces substantially larger increase in GDP. On the
basis of such reasoning, the following policy prescription follows: When economy
is in recession, government should increase spending (or reduce taxes) to
provide stimulus to the economy, and smooth the output path. Fiscal policy
appears in such models as a powerful tool.
51
Model with imports
Let us assume that the economy also imports, and that demand for imports M is
proportional to income. Exports E are determined exogenously.
M=mY+n
Yd=Y-tY,
C=a+bYd,
Y=C+I+G+E-M, which results in
Y= a+(b(1-t))Y+I+G+E-mY
The multiplier in such situation is given by
dY/dG = 1 / (1-b +bt+m)
Assuming elasticity of imports to income of 0.7 (which is often used for small
open economies), b equal to 0.8 and t equal to 0.3, gives a substantially lower
multiplier of 0.9. Such result follows from the fact that the increased domestic
demand not only affects domestic production, but it also leaks into imports.
52
Limitations of simple models
 The household consumption function in this model is extremely simple, linking
consumption only to the current income. More realistically, consumption is linked
to permanent income (expected income over an extended prospective period). As
a result, the secondary effects of government spending, i.e. the multiplier are
lower.
 The multiplier is much lower in an open economy simply because part of
additional demand leaks into the current account balance.
 Households may react to the increases in government spending by reducing
their own spending in expectations that government will have to increase taxes in
the future. Such behaviour is called Ricardian. To keep their future spending path
unchanged, in response to government's decision to increase spending,
households immediately increase their saving, offsetting the effect of higher
government spending.
.
53
Limitations of simple models
There are, however, also other explanations why households might react
negatively to the increase in government spending. For example, in a country that
has been plagued by large budget deficits and high inflation, government's
decision to further relax budget in a situation when the government is already
facing risk of default, might result in consumers' and investors' loss of confidence,
and reduction in their spending.
In the opposite case, announced cuts in budget spending might improve
consumer and investor confidence, and result in increased private sector
spending and investment. The effects of such changes in the private sector
behavior might be larger than the direct effects of increased budget spending.
Fiscal consolidation might in such circumstances be expansionary, while fiscal
expansion might be contractionary.
54
Empirical results
In a recent study, the IMF staff estimated that the multipliers for government
investment amount to 1-1.5 in large countries, 0.5-1 in middle size countries, and
0.5 in small countries. The multipliers are much smaller for government transfers
and tax cuts. Moreover, they pointed out that the multipliers could indeed be
negative if the country faces problems with fiscal sustainability
Conclusions: While in simple models of closed economy fiscal policy appears to be
a very effective instrument to fight recession, the picture drastically changes when
one considers more complicated models. Moreover, empirical results also suggest
that the power of fiscal policy is much more moderate.
55
Saving-investment balance in a
closed economy
•
•
•
•
Sp = Ip + G + Ig – T
Sg = T – G - Ig
Sp + Sg = Ip + Ig
S=I
• Domestic interest rate establishes equilibrium
between investment and saving
Saving-investment balance in an
open economy
• National savings equal investment plus
current account balance
• S = I + CA
The influence of the budget deficit
on the external current account deficit
Identities below decompose national net savings into private sector net savings (private
savings minus private investment) and government net savings.
GDP=C+I+G+X-M (GDP from the expenditure/absorption side)
Sg = NT-G (Government savings equals net taxes (taxes - transfers) minus government
consumption. It is also equal to the budget operating surplus)
NSg = Sg - Ig=GB (net savings of the government equal government savings minus
government net investment, which is equal to the government balance)
Sp = GDP + NFI - C - NZ (Private sector savings equal income from producing GDP plus
net factor incomes from abroad minus private consumption minus net taxes)
S = Sg+Sp (Total national savings are the sum of private and public savings)
CA = X-M+NFI (Current account balance equals exports of goods and services minus
imports plus net factor incomes from abroad).
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The influence of the budget deficit on the external current
account deficit
Combining all identities, we get:
CA = S - I = Sg + Sp - Ig - Ip = NSg + NSp = GB + NSp (Current account
balance CA equals government balance GB plus private sector net savings NSp)
This identity tells us that the external current account balance is equal to the
budget balance plus private sector saving-investment balance.
This does not mean that the two private S-I balance and the budget
balance move completely independently, so that for example by improving the
budget balances by 1 percent of GDP, the current account automatically
improves by the same amount.
Recent empirical research suggests that the elasticity of the current account
balance to the budget balance in medium-term is about 0.3-0.5, while it is higher
in the longer term.
The budget deficit therefore affects the external current account deficit. Excessive
current account imbalances are these days seen as an important indicator of
external vulnerability of a country.
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The role of interest rates in closed
and open economy
• In a closed economy, equality of I and S is
established via interest rates.
• In an open economy, the global interest rate is
exogenously given.
• The global interest rate (plus country’s risk
spread) will determine, combined with other
factors, I and S. If investment is higher than S,
the country will borrow abroad.
• See charts in Samuelson’s Economics.