For expositional simplicity, suppose the world consists of only two countries: a home country (HC); and the rest-of-the-world (ROW).
As discussed in the Appendix for Mishkin Chapter 1, (nominal) gross national product (GNP) for the HC in any period T is defined to be the total value of all final goods and services produced using HC-owned factors of production in period T, without regard for where the production takes place. In contrast, (nominal) gross domestic product (GDP) for the HC in any period T is defined to be the total value of all final goods and services produced within the borders of the HC in period T.
Consequently, GNP and GDP differ by a term called net factor payments (NFP), defined as follows for any period T:
NFP(T) = the payments received by HC-owned factors of production for services rendered within the borders of ROW in period T MINUS the payments received by ROW-owned factors of production for services rendered within the borders of the HC during period T.
The relationship between gross national product GNP(T) and gross domestic product GDP(T) can then be expressed as follows:
In GDP national income accounting, exports in period T, hereafter denoted by EX(T), are expenditures by ROW in period T on goods and services produced within the borders of the HC. Also, imports in period T, hereafter denoted by IM(T), are expenditures by the HC in period T on goods and services produced within the borders of ROW. Note that exports EX(T) and imports IM(T) do not include any exchanges of financial assets.
Given EX(T) and IM(T), the net exports of the HC in period T, hereafter denoted by NE(T), are defined as the difference between exports and imports as follows:
Let C(T) denote expenditures by the HC in period T on consumption goods and services, and let G(T) denote HC government expenditures in period T on final goods and services.
Finally, let I(T) denote gross private investment expenditures by the HC in period T. More precisely, I(T) consists of business fixed investment (new buildings and equipment), residential investment (new houses and apartment buildings), and inventory investment (defined as the change in inventories over period T).
The GDP for the HC during period T then satisfies the following National Income Accounting Identity, a relationship that always holds by accounting definition of its various components.
National Income Accounting Identity:
(1) GDP(T) = C(T) + I(T) + G(T) + NE(T)
Finally, suppose that HC exports EX(T) in period T consist entirely of goods and services produced in period T, i.e., EX(T) does not include ROW expenditures on inventoried HC goods produced in previous periods. Then the accounting identity (1) can be expressed in the following alternative form:
(2) GDP(T) = [ C(T)+I(T)+G(T) - IM(T)] + [ EX(T) ] Value of final Total HC expenditures Total ROW expenditures goods and services on final goods and on final goods and produced within services produced within services produced within the borders of the borders of the HC the borders of the HC the HC in in period T in period T period T
ROW saving in relation to the HC is given by the income received by ROW from the HC less the consumption by ROW of HC goods and services.
Let PayOut(T) denote the sum of the following two payment outflows from the HC to ROW: (a) period T net factor payments from the HC to ROW, including the period T net income paid by the HC to ROW arising from the ROW ownership of HC-issued financial assets [i.e., - NFP(T)]; and (b) period T net transfer payments from the HC to ROW [i.e., -TRr(T)].
ROW saving relative to the HC in period T, denoted by Sr(T), is then defined as follows:
(3) Sr(T) = [IM(T) + PayOut(T)] - EX(T) | | | | ROW saving Total Income received Consumption by by ROW from HC ROW of HC goods and services
As will be seen below, the payment stream in the opposite direction to Sr(T) --- that is, [- Sr(T)] --- is what is meant by the HC current account. In particular, if ROW saving is positive (so that the current account is in deficit), the HC is a net borrower from ROW.
It will now be shown that the standard national income accounting identity GDP=C+I+G+NE can equivalently be expressed in saving=investment form. As will be seem below, this equivalence permits a deeper understanding of the basic accounting relationship between the current account and HC national saving, where the latter is defined as the sum of private plus government saving. This, in turn, will permit a deeper understanding of the twin deficit problem, i.e., the simultaneous occurrence of a current account deficit and a government budget deficit, that has plagued the U.S. for much of the time since the early nineteen eighties.
In order to derive the desired saving=investment relation, various symbols need to be introduced to represent different types of expenditure flows in the national income accounts, as follows:
For any agent (whether a person or an institutional entity), the saving of that agent in a given period T is defined to be the net income of the agent in period T minus the consumption expenditures of the agent in period T. The conventional accounting definition for the gross saving Sp of the HC private sector in any period T is defined as follows:
HC Gross Private Saving Sp in Any Period T:
(4) Sp = HC private sector - HC private sector after-tax income consumption = [1-t]Y + NFPrp + INp + TRp - C .
Also, HC gross government saving in period T (including Federal, state, and local government gross saving) is defined as follows:
HC Gross Government Saving Sg in Any Period T:
(5) Sg = HC government tax revenues - HC government plus net factor, transfer, consumption and interest payments TO gov't expenditures = tY + NFPrg + TRg - IN - Gc .
Recall that the government deficit is defined to be -Sg, i.e., the excess of government consumption expenditures over government net revenues.
Finally, gross ROW saving in relation to the HC in period T is defined as follows:
ROW Gross Saving Sr in Relation to the HC in Any Period T:
(6) Sr = Income received by - ROW consumption of ROW from the HC HC goods and services = IM - NFP - TRr - EX = - NE - NFP - TRr = - [HC Current Account] .
The following saving=investment relation then follows from the national income accounting identity Y=C+I+G+NE given in (1) together with the savings definitions (4)-(6):
Period T National Income Accounting Identity in Saving=Investment Form:
(7) Total Saving Available to the HC in period T = Sp + Sg + Sr = ([1-t]Y + NFPrp + INp + TRp - C) + (tY + NFPrg + TRg - IN - Gc) + (- NE - NFP - TRr) = Y - C - Gc - NE = I + Gi = ITot = HC Total Gross Investment in Period T.
If is interesting to examine the relative sizes of the various saving and investment quantities in (7) as estimated for the U.S. economy.
Empirical Illustration of (7) for the U.S. Economy:
As a concrete example of the accounting identity (7), empirical data are given below for the U.S. economy for 1997:Q3 (i.e., for the third quarter of 1997), at the height of the dot.com stock market "bubble" in the late 1990s. These data were obtained from the Economic Report of the President (February 1998, pages 280 and 318). Note that all data are reported as a percentage of Y = U.S. GDP(1997:Q3) by dividing through by Y.
Sp/Y = (Pers. Sav.)/Y + (Bus. Sav.)/Y = 2.6% + 11.7% = 14.3% ; Sg/Y = (Fed Govt Sav.)/Y + (State+Local Govt Sav.)/Y = 0.8% + 2.4% = 3.2% ; Sr/Y = 2.0% ; ITot/Y = I/Y + Gi/Y = 15.4% + 2.8% = 18.2% ; Statistical Discrepancy in Measurement of I/Y = 1.3%. Thus, for the U.S. in 1997:Q3, [Sp/Y + Sg/Y + Sr/Y] = 19.5% = ITot/Y + (Stat Discrepancy) .
Many countries, including the U.S., keep track of their currency flows on the foreign exchange market in the form of "balance of payments accounts." These accounts keep track of the flow of currency into or out of a country over a specified period of time. For expositional clarity, these 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).
As diagrammed below, the currency flows for the HC can be divided into two main categories: (1) the "Current Account"; and (2) the "Capital and Financial Account:"
----(1)CURRENT ACCOUNT: Keeps track of payment | transfers (e.g., gifts) and trades in | final goods and services (including income | received from financial asset holdings) Balance of ----| between HC and ROW Payments | Accounts | | | | |___ (2)CAPITAL AND FINANCIAL ACCOUNT: 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.
III.B 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. NIPA 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:
(8) 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
III.C Relation Between the Current Account and National Saving
By conventional accounting definition, national saving for the HC is given by the sum SN = Sp+Sg of HC private and government saving. It follows from this definition for SN, from the accounting identity (7) for saving and investment, and from definition (8) for the HC current account CA, that CA satisfies the following sequence of accounting identities:
(9) HC CURRENT ACCOUNT CA = - Sr = Sp + Sg - ITot = SN - ITot = 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 investment expenditures ITot and its domestically generated savings SN.
CA < 0 --> SN < ITot --> HC is borrowing [ITot - SN] 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:
Sr = [ITot - SN] = - 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.
CA > 0 --> SN > ITot ---> HC is lending [SN - ITot] to ROW .
III.D 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:
(10) 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 .
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.
IV.A 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:
(11) 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)
(12) 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 (12) can equivalently be re-expressed as
(13) 0 = CA + KA + NFA - BOP
Thus, the balance of payments BOP must satisfy the following accounting identity:
Balance of Payments Accounting Identity:
(14) BOP = CA + KA + NFA .Using earlier notation, however, note that the accounting identity (14) 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 (14) does not require that BOP be equal to zero. By construction, the BOP for the HC can alternatively be expressed as
(15) 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.
(16) 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.
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.
(17) 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):
(18) 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:
(19) KA + NFA = - CA . ROW net asset transfer to HC current account deficit
If [KA + NKA] is positive, then the HC's debts to ROW are increasing. Unless the borrowed funds are being used for sufficiently productive purposes, i.e., purposes productive enough to support the future servicing (payment of interest obligations) on the added debt, the HC may eventually be in a position where the added interest obligations to ROW become a major burden.
Alternatively, if the HC runs a persistently negative [KA + NFA], and hence a persistently positive current account surplus (CA greater than 0), its ROW trading partner may eventually retaliate by resorting to trade protectionist measures.
Eventually, in the face of a persistent BOP deficit, 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 might move to bring demand for ROW currency in line with the supply of ROW currency, thus avoiding the need for currency reserve transactions.
These possibilities will now be more carefully considered.
IV.B External Balance With A Fixed Nominal Exchange Rate
Suppose that the nominal exchange rate E for the HC is fixed (pegged) at some given level E*.
Suppose, also, that the HC is currently running a balance of payments deficit, i.e., BOP is negatively valued. Then, in net terms, the HC central bank must use its ROW currency reserves to provide ROW currency to HC citizens in exchange for their HC currency in order to allow the HC citizens to meet their payment obligations to ROW.
The total value of the HC central bank's net worth is unchanged by this currency exchange per se. Nevertheless, HC citizens have either run down their holdings of HC currency or withdrawn deposits from HC checking deposit accounts. Consequently, recalling that the narrowest definition of the HC money supply, M1, includes HC currency in circulation plus HC checkable deposits, the HC money supply tends to contract.
On the other hand, suppose the HC is currently running a balance of payments surplus, i.e., BOP is positively valued. Then, in net terms, the HC central bank must use its HC currency reserves to provide HC currency to ROW citizens in exchange for their ROW currency. The ROW citizens then pay out this HC currency to HC citizens to finance their HC purchases, and the HC money supply tends to expand.
The HC government can sterilize the movements in the money supply due to a BOP imbalance by engaging in offsetting domestic open market operations (i.e., buy back of government debt from the HC private sector or sale of additional government debt to the HC private sector).
Suppose, however, that the HC central bank is attempting to support a persistent BOP deficit -- i.e., an excess demand for ROW currency (or equivalently, an excess supply of HC currency) -- by running down its ROW currency reserves. Eventually the HC central bank will run out of ROW currency reserves and will be unable to continue with its intervention. In this case the HC government will eventually need to undertake a devaluation of the HC currency (i.e., a decrease in the pegged value E* for the nominal exchange rate E) in an attempt to decrease the demand for ROW currency and increase the demand for HC currency.
IV.C External Balance With A Flexible Nominal Exchange Rate
Suppose, instead, that the nominal exchange rate E for the HC is flexible, i.e., fully free to move up or down in response to market forces.
In this case, in principle, E should continuously adjust to equate the demand and supply for ROW currency units, and the BOP accounts should thus continuously be in balance with BOP=0. No intervention by the HC central bank in the form of buying or selling of ROW currency should be necessary -- i.e., HC central bank currency reserve transactions should be zero.
In our present post-1973 world financial system, nominal exchange rates are officially supposed to be floating; but central banks do nevertheless frequently intervene in the foreign exchange market by engaging in the purchase and sale of foreign currencies. For this reason our present system is often referred to as a managed float (or dirty float) system.
V.A Origins of the IMF
Before World War I, the world economy largely operated under a gold standard. This means that the currencies of most countries were directly convertible into gold at specified fixed rates. For example, a U.S. dollar bill could be turned in to the U.S. Treasury and exchanged for about one twentieth of an ounce of gold. As long as countries kept their currencies backed by and convertible into gold at fixed rates, exchange rates among currencies also remained fixed.
World War I (1914-1918) caused massive disruptions in international trade. Many countries could no longer support the convertibility of their currency into gold, and the gold standard collapsed. Following World War I, attempts were made to revive the gold standard, but the Great Depression (1929-1939) led to its permanent demise.
In 1944, towards the end of World War II (1939-1945), the Allied countries met in Bretton Woods, New Hampshire, to devise a new international monetary system. The resulting Bretton Woods Agreement lasted from 1945 to 1971. The Bretton Woods Agreement ushered in a fixed exchange rate regime. Central banks were to buy and sell their own currencies to keep their exchange rates fixed at certain specified levels. More precisely, the central banks of the participant countries agreed to maintain their exchange rates in fixed relationship to the U.S. dollar, where the convertibility of the U.S. dollar into gold was set at $35 per ounce of gold.
In addition, the Bretton Woods Agreement created the International Monetary Fund (IMF), headquartered in Washington D.C. The IMF was given three basic tasks:
For various reasons outlined by Mishkin, the Bretton Woods Agreement collapsed in 1971. In the next couple of years the IMF member countries reached an agreement to permit their exchange rates to float in response to market pressures. The first task envisioned for the IMF -- maintenance of fixed exchange rates -- was therefore rendered moot, but the second two tasks remained in force.
Despite the general shift to flexible exchange rates after 1971, central banks today still often intervene in the foreign exchange market in an attempt to control exchange rate movements and prevent domestic balance of payments problems. The current international financial system is a mix of fixed and flexible exchange rates.
V.B Organization of the IMF
Note: The following paragraphs are paraphrased from materials available at the About the IMF section of the official IMF website.
The IMF is a cooperative institution consisting of over 180 member countries. (Membership in 2011 = 187 countries.) Membership is open to every country that conducts its own foreign policy and is willing to adhere to the IMF charter of rights and obligations.
Upon joining the IMF, each member country contributes a certain sum of money called a quota subscription, which is a form of credit union deposit. The quota subscription contributed by each country is roughly proportional to the country's size.
These quota subscriptions serve three basic purposes.
The IMF meets its annual expenses mainly by the difference between the interest receipts on its loans and the interest payments on its quota ``deposits." The IMF has no outside revenue stream. Consequently, the IMF is basically run like a for-profit business. In particular, unlike the World Bank, the IMF is not set up as a development agency. This important fact should be kept in mind when evaluating criticisms of the IMF in Part V.D below.
The IMF lends money to IMF member countries who are having trouble meeting their financial obligations to other members, but only on condition that they undertake economic reforms to eliminate these difficulties for their own good and that of the entire membership. The IMF has no effective authority over the domestic economic policies of its members. The IMF can, and often does, advise members regarding how to make the best use of their scarce resources. However, the IMF cannot force a member country to adopt any particular policy.
V.C Functions of the IMF
As noted above, the IMF is no longer charged with maintaining fixed exchange rates. However, it still continues to function as a collector of international economic data and as an adviser to countries experiencing balance of payments problems.
In particular, the role of the IMF as an international lender of last resort has grown in importance in response to the globalization of world financial markets. The IMF makes loans, sometimes very large loans, to IMF member countries experiencing balance of payments problems (e.g., runs on their currencies due to speculative attacks), conditional on the promise by these countries to abide by various IMF rules.
The rationale for having the IMF play a lender-of-last-resort role in global financial markets is similar to the rationale for having the Fed play a lender-of-last-resort function in the domestic U.S. economy.
By providing liquidity to an IMF member country experiencing a run on its currency (panic selling), the IMF may be able to calm investors' fears and reduce or even stop the panic selling. Similarly, by standing ready to provide liquidity to the U.S. banking system, the Fed hopes to be able to prevent "bank runs," i.e., episodes in which depositors --- spooked for some reason about the safety of their deposit accounts --- try all at once to withdraw their funds from their bank deposit accounts.
An added consideration is that the lender-of-last-resort function of the IMF may prevent the spread of financial panics from one country to another. For example, a successful speculative attack on the currency of one country may lead to speculative attacks on the currencies of other countries.
Over the past several years, a variety of different countries have been hit by balance of payments problems, and many have requested (and received) assistance from the IMF.
Why is the role of the IMF in global financial markets so controversial? Some argue that IMF lender-of-last-resort interventions are as likely to exacerbate a financial crisis as to relieve it for the following reasons: