U.S. National Income and Product Accounting:
Basic Definitions and Concepts

Maintained by: Leigh Tesfatsion
Email: tesfatsi@iastate.edu
Last Updated: 22 August 2015


NOTE: These lecture notes are based in part on materials from R. Hall and J. Taylor (HT), Macroeconomics, W.W. Norton and Company, and from the Economic Report of the President.


A. Aggregate Demand: Rough Definition

The aggregate demand curve for an economy aggregates the planned purchases of consumers, firms, and government. More precisely, the aggregate demand curve for an economy is a schedule that depicts the total planned purchases of final goods and services in an economy during some time period T as a function of the general price level in the economy during T, assuming the economy is in a "product market equilibrium." Roughly defined, an economy is in a product market equilibrium in period T if the planned purchase of final goods and services in T is equal to the planned availability of final goods and services in T.

In graphical terms, the aggregate demand curve is a plot of aggregate demand against the general price level, where the price level is on the vertical axis and the quantity demanded is on the horizontal axis. Since the aggregate demand curve is conditional on product market equilibrium, it is not a straightforward extension of the usual microeconomic demand curve. Nevertheless, under conventional assumptions for consumer, firm and government spending behaviors, it has the usual property that higher prices are associated with smaller aggregate demands, implying that the aggregate demand curve is downward sloping.

Note that the aggregate demand curve measures the purchase plans of consumers, firms, and government at different possible price levels, plans that could potentially fail to be realized. That is, it could happen that people are unable to purchase all they plan to buy at a given price level because the actual availability of final goods and services turns out to be insufficient to meet this demand. For example, an unexpected storm at the beginning of period T could force businesses to halt production during T.

It is important in macroeconomics to distinguish between what people plan to do and what they actually end up doing. We will next take up a brief review of the national income and product accounting measures used by macroeconomists in the U.S. and elsewhere to measure actual levels for output, income, the general price level, inflation, and unemployment.

B. Accounting Measures for Actual Outcomes

B.1 Gross National Product

The gross national product (GNP) for some home (domestic) country HC during a specified time period T is the market value of all final goods and services produced during T using factors of production [capital, labor, and natural resource services] owned by the HC. Here are some points to note about this definition.

Need to Specify a Time Period:
The time period T for measuring GNP is conventionally taken to be either one year (annual GNP) or three months (quarterly GNP). For example, "GNP for 2012" refers to GNP for all of 2012 and "GNP for 2012:Q2" refers to GNP only for the second quarter (April through June) of 2012. More generally, GNP(T) refers to GNP for the time period T, however T is defined.
Only Final Goods and Services are Included:
Intermediate goods and services in period T are goods and services used up in the production of other goods and services during period T. Final goods and services in period T are goods and services which are not intermediate in period T. Thus, the flour sold in supermarkets in 2012 constitutes part of GNP for 2012, but not the wheat that was sold to mills in 2012 in order to make the flour.
Where Production Occurs is Not Considered:
The GNP for a country consists of final goods and services newly produced using factors of production owned by the country without regard for where the production actually takes place.

B.2 Gross Domestic Product

As an alternative to GNP, many countries (including the U.S.) now emphasize a modified measure of national production called "gross domestic product." The gross domestic product (GDP) for a country during a specified time period T is defined to be the market value of all final goods and services produced within the borders of the country during period T, regardless of who owns the factors of production.

Let HC denote a home (domestic) country and ROW denote the rest-of-the-world. By definition, the only difference between GNP and GDP for any given HC concerns the treatment of output produced by HC-owned factors of production outside the borders of the HC and the treatment of output produced by ROW-owned factors of production within the borders of the HC. Let NFP denote the net factor payments to the HC from ROW, that is, the payments received by HC-owned factors of production employed in production activities in ROW minus the payments received by ROW-owned factors of production employed in production activities within the borders of the HC. Then, for any given time period T,

              GDP    =     GNP   -   NFP.

B.3 Three Equivalent Representations for GDP

There are three equivalent ways to measure GDP:

by spending;
by net production (total value added);
by earned income.

Because the net change in inventory holdings (positive or negative) is counted as part of investment spending, total spending must necessarily be equal to the value of total net production (total value added). And, because profits are counted as owner-earned income, the value of total net production must necessarily be equal to the value of total earned income. That is,


   GDP = TOTAL SPENDING = TOTAL VALUE ADDED = TOTAL EARNED INCOME,

where

TOTAL VALUE ADDED = FIRM REVENUES FROM  -   FIRM PAYMENTS TO OTHER
                    THE SALE OF PRODUCED    FIRMS FOR GOODS AND SERVICES
                    GOODS AND SERVICES      USED UP IN INTERMEDIATE STAGES
and

TOTAL EARNED INCOME  =    PRE-TAX WAGES     +   PRE-TAX PROFITS

                        + PRE-TAX INTEREST  +   PRE-TAX RENT


                     =    AFTER-TAX WAGES, PROFITS, INTEREST, AND RENT

                        + GOVERNMENT TAX REVENUES.

We will concentrate below on the spending definition of GDP. This spending definition, referred to as the National Income Accounting Identity, is expressed as follows:


GDP =   C      +         I         +       G       +     [EX - IM]  ,

    Realized        Realized gross      Realized        Realized net exports
    consumption     investment spend.   spending by     (exports - imports)
    spending by     by HC firms         the HC gov't
    HC households   in period T         in period T
    in period T     (including          (including
    (including      spending on         spending on
    spending on     imports)            imports)
    imports)


In this identity, exports (EX) denotes the total spending by ROW on final goods and services produced within the borders of the HC in period T plus ROW purchases of HC inventoried final goods previously produced within the borders of the HC but not yet sold. Also, imports (IM) denotes the total spending by the HC on final goods and services produced within the borders of ROW in period T plus HC purchases of ROW inventoried final goods previously produced within the borders of the ROW but not yet sold.

Note that any positive spending in period T on HC inventoried final goods produced within the borders of the HC in periods prior to T is just cancelled out by the correspondingly negative change in HC inventoried final goods included in I. Also, -IM cancels out any spending by HC consumers, firms, and government on final goods and services produced within the borders of the ROW. Consequently, in net terms, the right-hand side of the national income accounting identity represents total spending in period T on HC final goods and services produced within the borders of the HC in period T.

Finally, suppose that HC exports EX in period T consist entirely of final goods and services produced in period T, i.e., suppose EX does not include ROW expenditures on inventoried HC final goods produced in previous periods. Then, rearranging terms, the national income accounting identity can be expressed in the following interesting alternative form:


    GDP             =     [ C + I + G - IM]     +         [ EX ]

Value of all final      Spending by HC private        Spending by ROW
goods and services      and government sectors on     on final goods and
produced within the     final goods and services      services produced
borders of the HC       produced within the borders   within the borders
in period T             of the HC in period T         of the HC in period T


Comparing this national income accounting identity with the previous definition for aggregate demand, one might wonder whether GDP necessarily coincides with the value of aggregate demand. The answer is no. The crucial difference between aggregate demand and GDP is that aggregate demand measures planned purchases of final goods and services corresponding to some possibly hypothetical price level whereas GDP measures realized purchases of final goods and services for the actual price level. As previously stressed, planned purchases of final goods and services can fail for various reasons to be realized in actuality.

REMARKS ON AGGREGATE CONSUMPTION C:

REMARKS ON AGGREGATE INVESTMENT I:

REMARKS ON GOVERNMENT EXPENDITURE G:

REMARKS ON NET EXPORTS:

REMARKS ON GDP VERSUS INCOME:

C. Nominal and Real Gross Domestic Product

Nominal GDP for any particular country is simply the value of its GDP measured in terms of its current money prices.

Ideally, real GDP should then be a measure of GDP in physical terms rather than in money terms. However, apples cannot simply be added to oranges. Something is needed to transform the various heterogeneous types of goods and services into a common unit so that addition can take place.

Prior to 1996, to undertake the computation of annual real GDP, a commonly agreed upon "base year" (e.g., 1987) was first designated. Real GDP for year T was then simply defined to be the value of final goods and services produced in year T measured in these base year prices.


     Year-T Real GDP       =   Value of final goods and services
    (Traditional measure)      produced in year T within the 
                               borders of the HC, measured
                               in base year prices                        


This traditional measure for real output is referred to as a fixed-weight measure because it uses fixed base year prices to value output.

In 1996, the U.S. Commerce Department changed to a new measure for real GDP -- a "Fisher ideal index" usually simply referred to as a "chain-weighted measure." Using the chain-weighted measure, real GDP is essentially calculated by deflating nominal GDP by an inflation rate yardstick that is updated every year. The difference between the traditional fixed-weight measure for real GDP and the new chain-weighted measure for real GDP can be rather substantial.

Although the chain-weighted measure for real GDP corrects for inflation effects in a more timely up-to-date fashion than the traditional measure, the chain-weighted measure is more complicated to present, motivate, and manipulate, and it has not yet been incorporated routinely into economic texts. We will therefore use the more traditional fixed-weight measure of real GDP for the duration of these notes.

Let Y denote the traditionally measured real GDP for period T; and let GDP denote nominal GDP for period T. Then the GDP implicit price deflator for period T, denoted by P, is defined to be the ratio of these two values:

             Period-T Nominal GDP           GDP
     P  =   ---------------------    =    -------    .
              Period-T Real GDP              Y


Note, in analogy to micro, that one has the identity

        P       x       Y       =            GDP

     "price"        "quantity"       "total money expenditure"



The price index P provides one useful way to measure the real purchasing power of money in period T, i.e., the amount of goods and services in physical terms that a unit of money can buy in period T. Alternative purchasing power measures will be discussed later on.

D. Saving and Investment

To avoid substantial confusion in the discussion of saving and investment, it is essential to distinguish between what is planned and what is actually realized, as follows:

Realized Saving     =   Planned Saving     +   Unintended Saving
                                                (positive or negative)


Realized Investment =   Planned Investment  +   Unintended Inventory
                                                Build-Up or Take-Down

Planned saving can and typically does differ from planned investment. Indeed, it can be shown that the equality of planned saving and planned investment is equivalent to the product market equilibrium condition that aggregate demand equals aggregate supply.

On the other hand, realized saving S is defined to be realized GDP (income) minus realized consumption C. Given this definition for realized saving, it follows from the National Income Accounting Identity that realized saving S must coincide with realized investment I.

To see the latter point, consider first an economy without a foreign sector (i.e., a closed economy) and without a government sector. In this case one has:

  GDP (realized total income) = C (realized consumption expenditure)
                                + I (realized investment expenditure)
together with

  S (realized saving)  =  GDP (realized total income)
                          - C (realized consumption expenditure),
which implies

  S  =  I  .


Consequently, S = I for a closed economy without a government sector.

Now consider the generalization of this result to an economy HC that is open and that has a government sector. The following terms and abbreviations will be used.

  HC Private Sector = HC Household Sector plus HC Business Sector;

  F   = Government transfers to the HC private sector;

  N   = Interest paid by HC government to HC private sector holders
        of HC government debt instruments (e.g., bonds);

  T   = HC tax revenues;

  V   = Net factor income and transfer payments to the HC from ROW;

  S_p = HC private saving (savings of the HC household sector
        plus savings of the HC business sector);

  S_g = HC government saving (the negative of the HC government deficit);

  S_r = ROW saving vis-a-vis the HC (net HC borrowing from ROW);

  Y   = real GDP for the HC;

  C   = HC consumption expenditure;

  I   = HC gross investment expenditure;

  G   = HC government expenditure;

  NE  = HC net exports.

Then, by accounting definition,

  S_p   =   [Y + V + F +  N - T]   -       C

             Private Sector            Private Sector
             Disposable Income         Consumption


  S_g  =     [T  -  F  -  N]      -     G       =  -1 x Government Deficit

          Govt Income (Tax Rev's     Government
          Net of Transfer and       "Consumption"
          Interest Payments)


  S_r  =  IM - V        -       EX         =     - V  +  [HC trade deficit]

        Income received     ROW Consumption      |                        |
        by ROW from HC      of HC goods and      |                        |
                            and services          ------------------------
                                                 HC current account deficit
                                                 ( -1  x  HC current account)

Summing the three sources of savings, and letting net exports EX-IM be denoted by NE, one obtains

  S  =  S_p + S_g + S_r  =  ([Y+V+F+N - T] - C) + (T-F-N-G) + (IM - V - EX)

                         =   Y  -  C  -  G  -  NE

                         =   I  .


Consequently, realized saving S must equal realized investment I even for an open economy with a government sector.

It is useful to reexpress this S=I accounting identity in the following informative way:

      S_p   +   S_g       +         S_r        =           I
   |                  |
   |                  |
 HC national saving S_N           ROW saving        HC gross investment
        |                            |
        |                            |
         --- Total saving -----------
             at the disposal
             of the HC

This relation reveals that the government budget deficit and the current account deficit comprising the "twin deficit problem" for the U.S. are closely interrelated quantities. The sum of S_p and S_g gives HC national saving S_N. If private saving S_p is low (such as in the U.S. in recent years), the HC will have to finance I either with government saving S_g or with ROW saving S_r. In particular, if the HC government is running a budget deficit, so that S_g is actually negative, then the only way to finance a high level of I will be to maintain a high level of S_r, i.e., to run a persistently large HC current account deficit.

The difficulty with financing I through ROW saving rather than through HC national saving is that the HC government ends up selling ever more financial assets to ROW, including ownership claims to HC productive physical assets such as corporations and commercial real estate. In addition to losing control over its productive assets, the HC runs the risk that ROW may decide at some future time to reduce or even discontinue lending to the HC.

E. Balance of Payments Accounts

A foreign exchange market is an international currency market. Many countries, use "balance of payments" accounts to keep track of their cross-border currency flows resulting from currency transfers and foreign exchange market transactions. These accounts keep track of the flow of currency into or out of a country over a specified period of time.

For expositional clarity, balance of payments accounts are defined and discussed below under the simplifying assumption that the world consists of only two countries: a home country (HC); and the rest-of-the-world (ROW). Consequently, from the vantage point of the HC, there is only one foreign exchange market: the market for HC currency, where the price of HC currency is measured in terms of ROW currency units. As will be clarified in Section G, below, this price E is called the exchange rate for the HC.

As diagrammed below, the currency flows for the HC can be divided into two main categories: (i) the "Current Account (CA)"; and (ii) the "Capital and Financial Account (KFA)":


               ----(i)CURRENT ACCOUNT (CA): Keeps track of 
              |       payment transfers (e.g., gifts) and trades 
              |       in final goods and services (including 
              |       income received from financial asset
              |       holdings) between HC and ROW
Balance of ---|       
Payments      |      
Accounts      |
              |
              |
              |
              |___(ii)CAPITAL AND FINANCIAL ACCOUNT (KFA): Keeps
                      track of unilateral asset transfers, 
                      financial asset trades, and secondary 
                      physical asset trades between HC and ROW                 

A more detailed description of these accounts will now be given.


Definition of the Current Account (CA)

The definition given below for the HC current account in any given time period T follows standard U.S. national income and product accounting principles as used, for example, in the Economic Report of the President. It is assumed that all elements of the current account are consistently valued in HC currency units in order to be able to add and subtract them meaningfully. For expositional simplicity, all time period variables are supressed.

The HC Current Account CA in Any Period T:


(1) CA  =  HC Net Exports

           +  Net Factor Payments by ROW to the HC
              (for real/financial asset services)

           +  Net Transfer Inflow from ROW to the HC

        =  NE  +  NFP  +  TRr

Technical Remarks:

Recall from earlier discussion, above, that gross national product GNP and gross domestic product GDP satisfy GNP = GDP + NFP. Recall, also, that net factor payments NFP includes all net payments received by U.S. owners of financial assets issued by foreign countries, as well as all net payments received by U.S. owners of real assets for services rendered by these real assets within foreign countries. In particular, then, in U.S. national income and product accounts, all net payments to the U.S. on foreign-issued financial assets are treated as if they were payments for services of factors of production even if these financial assets are issued by agencies other than firms.

Also, letting NII denote (net) investment income paid by ROW to the HC, and letting NWP denote net wage and salary payments from ROW to the HC, one has NFP = NII + NWP. NWP for the U.S. is quantitatively small, so that for most practical purposes NFP and NII can be treated as equivalent concepts. This practice is followed, for example, when the current account is reported in the Economic Report of the President.


Relation Between the Current Account and National Saving

By conventional accounting definition, national saving for the HC is given by the sum S_N = S_p+S_g of HC private and government saving. It follows from this definition for SN, from the national income accounting identity in saving = investment form, and from definition (1) for the HC current account CA, that CA satisfies the following sequence of accounting identities:

(2) HC CURRENT ACCOUNT CA =   - S_r

                      
                          =     S_p  +  S_g   -   I


                          =         S_N      -   I


                          =  HC NATIONAL SAVING - HC TOTAL GROSS INVESTMENT
                             

If the HC current account CA is in deficit -- i.e., if CA < 0 -- then the HC is borrowing from ROW to finance the gap between its gross investment expenditures I and its domestically generated savings SN.

(3) CA < 0  --> S_N < I  --> HC is borrowing [I - S_N] from ROW

Equivalently, ROW is lending to the HC to finance the HC's current account deficit, and the amount of this lending equals ROW saving Sr:

(4)       Sr  =   [I - S_N]   =     - CA     >   0

Conversely, if the HC current account CA is in surplus -- i.e., if CA > 0 -- then the HC is lending the excess of SN over ITot to ROW. Equivalently, ROW is borrowing this amount from the HC.

(5) CA > 0  --> S_N > I  ---> HC is lending [S_N - I] to ROW .


Definition of the Capital and Financial Account (KFA)

The Capital and Financial Account (KFA) consists of the sum of two sub-accounts. The Capital Account (KA) is a category newly defined in 1999 by the U.S. Department of Commerce that keeps track of all unilateral transfers of assets between HC and ROW (e.g., forgiveness of ROW debts by the HC). The Financial Account (FA) keeps track of all financial asset transactions and secondary physical asset transactions between the HC and ROW.

The Financial Account (FA) can, in turn, can be broken down into two subcategories: (a) Financial and secondary physical asset transactions between HC and ROW that do not involve the HC central bank; and (b) the net change in HC official reserve assets, defined to be those assets held by the HC central bank, other than domestic money or securities, that can be used to make payments to ROW.

For expositional simplicity, it is assumed below that the only official reserve asset available to the HC central bank is ROW currency, and that the only official reserve asset available to ROW is HC currency. Moreover, it is assumed that all reserves of ROW currency and HC currency for international payments are held by the HC central bank; the ROW central bank does not hold currency reserves. [Note: In actuality, the U.S. holds its international currency reserves in two main forms: gold; and reserve positions at the International Monetary Fund.] Also, all time period variables are supressed.

Finally, all elements of the HC Capital and Financial Account (KFA) are assumed to be consistently valued in HC currency units in order to be able to add and subtract them meaningfully.

The HC Financial Account in Any Period T:


(6)  FA   =   Net ROW lending to the HC resulting
              from financial and secondary physical asset
              transactions other than those conducted
              by the HC central bank

                            less

              Net change in HC official reserve assets
              (ROW currency reserves held by HC central bank)


          =   The Non-Official Financial Account NFA

                            less

              The Balance of Payments BOP (or the "official
              reserve transactions balance")

          =   NFA  -  BOP  .


Important Remarks:

The above definition (6) for the HC Financial Account FA is in accordance with post-1999 U.S. national income and product account conventions.

In the above definition (6) for the HC Financial Account FA, "lending" must be interpreted in broad terms. More precisely, net ROW lending to the HC (or equivalently, net HC borrowing from ROW) includes the sale to ROW of HC-owned financial assets (e.g., stocks and bonds), whether newly issued or not, as well as the secondary sale by the HC to ROW of existing physical assets, such as real estate and capital equipment. Net primary (original) sales of physical assets by the HC to ROW are included in HC exports to ROW, hence in the current account.

Note that the official reserve transactions balance BOP is included in the definition of the Financial Account FA, i.e., FA = NFA - BOP.

Important Textbook Note: Some textbooks present balance of payments accounting discussions that deviate from standard U.S. reporting conventions. For example, Frederic Mishkin (The Economics of Money, Banking, and Financial Markets, 2009 edition) uses an older pre-1999 conception of the capital account and breaks out official reserve transactions as a third separate item within the balance of payments accounts.

To avoid confusion, whatever source one reads for a discussion of balance of payments accounting, care must always be taken to see whether the author includes official reserve asset transactions in the definition of the Financial Account or lists these transactions as a separate category. As will be seen below, the sum of the Current Account CA, the Capital Account KA, and the Financial Account FA must equal zero as an accounting identity if and only if official reserve asset transactions are included in the definition of the Financial Account FA.

F. Balance of Payments: Accounting Identity vs. Equilibrium

Conceptual Distinction Between Accounting Identity and Equilibrium Conditions

HC purchases of goods and services from ROW must be paid for with ROW currency; and conversely, ROW purchases of goods and services from the HC must be paid for with HC currency. Under our simplifying assumption on currency reserve holding, any transaction that gives rise to a payment by HC citizens to ROW citizens implies an outflow of ROW currency from the HC central bank, and any transaction that gives rise to a payment by ROW citizens to HC citizens implies an inflow of ROW currency to the HC central bank.


         ROW currency inflow implies an addition
     to ROW currency reserves held by HC central bank


        -------- ROW CURRENCY INFLOW <---------
       |                                       |
       \/                                      |
       HC                                     ROW
       |                                      / \
       |                                       |
       |                                       |
        -------> ROW CURRENCY OUTFLOW ---------


         ROW currency outflow implies a contraction
     of ROW currency reserves held by HC central bank

In order to support its planned purchases of ROW goods and services, the HC must obtain ROW currency from one or more of the following sources: (a) the sale of newly produced goods and services to ROW; (b) ROW currency transfers to the HC; (c) ROW "lending" (i.e., ROW purchase of HC financial assets and/or pre-existing HC physical assets); or (d) existing ROW currency reserves held by the HC central bank.

In short, all purchases by the HC from ROW must be matched by an equal amount of payments by the HC to ROW. Consequently, apart from statistical discrepancies (i.e., errors due to problems of measurement), the following purchases=payments accounting identity must hold in each period T:

(7) HC imports +  HC purchase of ROW factor services in HC

       =   HC Exports

           +  ROW purchase of HC factor services in ROW

           +  net transfer payments from ROW to HC

           +  net unilateral asset transfers from ROW to HC

           +  net ROW lending to HC (private sector)

           +  payments to ROW out of existing
              ROW currency reserves (central bank)

or equivalently:

(8)   0 =    HC Net Exports +  Net Factor Payments by ROW to the HC

          +  Net Transfer Inflow from ROW to the HC

          +  Net unilateral asset transfers from ROW to HC

          +  net ROW lending to HC (private)

          -  Net change in ROW currency
             reserves held by HC (central bank)

From previous definitions for CA, KA, NFA, and BOP, relation (8) can equivalently be re-expressed as

(9)  0  =  CA + KA + NFA - BOP  

Thus, the balance of payments BOP must satisfy the following accounting identity:

Balance of Payments Accounting Identity:

(10)  BOP   =   CA  +  KA  +  NFA  .

Using earlier notation, however, note that the accounting identity (10) can be expressed in a variety of equivalent ways:
 
         BOP  =  CA + KA + NFA ;

         0  =  CA  +  KA  +  [NFA - BOP];

         0  =  CA  +  KA  +  FA ;

         0  =  CA + KFA . 

It is important to note that the accounting identity (10) does not require that BOP be equal to zero. By construction, the BOP for the HC can alternatively be expressed as


(11) BOP  =   ROW Currency Inflow to HC
            (Due to Non-Central Bank Transactions)

            - ROW Currency Outflow from HC
              (Due to Non-Central Bank Transactions)

One then has:


          ROW CURRENCY INFLOW          ROW CURRENCY OUTFLOW
          Increase in ROW reserves     Contraction of ROW reserves
          (More Supply of ROW curr.)   (More Demand for ROW curr.)

BOP < 0 -> [ROW Currency Inflow]    <   [ROW Currency Outflow]

BOP = 0 -> [ROW Currency Inflow]    =   [ROW Currency Outflow]

BOP > 0 -> [ROW Currency Inflow]    >   [ROW Currency Outflow]

A negative BOP corresponds to an excess demand for ROW currency: The current purchase, sale, and transfer plans of HC and ROW citizens would result in HC citizens having to pay out more ROW currency to ROW than is received back from ROW as the result of currency inflow. An overall contraction in the HC central bank's ROW currency reserves is needed to satisfy this excess demand for ROW currency.


(12)  BOP < 0  ->  ROW currency reserves held by the HC
                  must decrease in order to support the
                  purchase, sale, and transfer plans of
                  HC and ROW citizens.

Eventually, in the face of a persistent BOP deficit (BOP < 0), the HC central bank would run out of ROW currency reserves. Consequently, a persistent BOP deficit is not a tenable long-run situation. Another possibility, however, is that the nominal HC exchange rate E (i.e., the price of HC currency measured in terms of ROW currency) might move to bring demand for ROW currency in line with the supply of ROW currency, thus avoiding the need for currency reserve transactions.

Conversely, a positive BOP corresponds to an excess supply of ROW currency: The current purchase, sale, and transfer plans of HC and ROW citizens would result in HC citizens paying out less ROW currency to ROW than is received back from ROW as the result of currency inflow. An expansion of the HC central bank's ROW currency reserves is needed to sop up this excess supply of ROW currency.


(13)  BOP > 0  ->  ROW currency reserves held by the HC
                  must increase in order to support the
                  purchase, sale, and transfer plans of
                  HC and ROW citizens.

Thus, BOP different from 0 means that there is either an excess demand or an excess supply of ROW currency which results from the current purchase, sale, and transfer plans of HC and ROW citizens, a disequilibrium situation in the market for ROW currency. The value of BOP gives the net change in ROW currency reserves that must be sustained by the HC central bank in order to support these purchase, sale and transfer plans. Consequently, BOP measures the degree to which the HC central bank is intervening in the foreign exchange market.

Balance of Payments Equilibrium Condition (External Balance):


(14)          BOP   =   0  .

Interpretation of BOP=0:

External balance (i.e., BOP=0) holds if and only if the foreign exchange market for ROW and HC currency is in equilibrium in the following sense: the purchase, sale, and transfer plans of ROW and HC citizens can be met without reliance on any currency reserve transactions by the HC central bank.

As intuitively attractive as this concept of equilibrium may be, there are two major difficulties with external balance as a policy objective:

BOTTOM LINE: The HC is said to be in a BOP equilibrium (or in external balance) if the purchase, sale, and transfer plans of ROW and HC nationals are such that BOP = 0, i.e., if the purchase, sale, and transfer plans of ROW and HC nationals can be met without reliance on changes in the ROW currency reserves held by the HC central bank.

G. The Exchange Rate

The HC (nominal) exchange rate, denoted by E, measures the price of HC currency in terms of ROW currency. For example, if the HC is the U.S. and the ROW is China, then

             E    =   number of yuan/ per dollar.


The exchange E rate determines how expensive ROW goods are relative to HC goods. For example, suppose E is measured in terms of the number of yuan per dollar and the value of E increases. Then, all else equal, one dollar now buys more Chinese goods than before.

In principle, if the exchange rate E is flexible in the sense that it is free to increase (decrease) in response to excess supply (demand) for ROW currency relative to HC currency, then E should continuously adjust to equate the demand and supply for ROW currency. In this case the BOP would remain at zero without the need for any HC central bank intervention in the form of official reserve transactions.

From 1944 to 1973, under the Bretton Woods Agreement, exchange rates were officially fixed. This agreement broke down in stages from 1971 to 1973. In our present post-1973 system, exchange rates are officially supposed to be flexible; but central banks do nevertheless frequently intervene in currency markets by engaging in the purchase and sale of currencies.