IME International Monetary

Economics
2018

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What is this course about
International Economics deals with the economic and financial interdependence
among nations – its analyses the flows
•of goods and services,
•payments and currencies
between a nation and the rest of the world, policies directed at regulating these
flows and their effect of the nations welfare.
International trade: focuses on the microeconomics of international economics
In this course we focus on the MACRO ECONOMIC aspects of international
economics
•The focus is on international financial flows and the prices that drive them –
exchange rates and interest rates
•The relationship between the real economy and the international financial flows
•Issues such as global current account imbalances the implications of the UK
leaving the EU, the rise of blockchain technology

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The world economy – year ahead

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Recommended Text (available online)
• International Macroeconomics
• 2015c ISBN 9780170355674 Edition 1 98 Pages
• AU / NZ
• Published: 2014 by Cengage Learning Australia
• https://cengage.com.au/product/title/pp0966---
• international-macroeconomics/isbn/9780170355674

Other useful texts

• Salvatore d “ International Economics” Wiley and sons
• Krugman P. Obstfeld (2009) international Economic.
Theory & Policy. Pearson
• Additional materials will be posted on canvas

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Topics covered sequentially over
12 weeks
• 1. Balance of payments and national income accounting
2. Intertemporal Model of the Current Account
3. Exchange Rate Determination in the Short-Run and Long-Run
• 3b: Exchange Rate Determination in the Short-Run and Long-Run
4. Elasticities and Absorption Approaches to the Current Account
5. The Real Exchange Rate and Non-Tradable Goods
6. Macroeconomic Policy in an Open Economy- IS/LM/BP
• 6b. Macroeconomic Policy in an Open Economy- IS/LM/BP
7. Choice Of Exchange Rate Regime
8. Topics in International Macroeconomics – Optimum Currency Areas and
Crises
• 9. The blockchain and implications for the Macroeconomy

Tutorial Questions are available on canvas under each topic

Do the exercises prior to attending class

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Assessment
1) Assessment A : 10% - Individual
• Online Quiz’s- to be completed via Canvas weeks 4, 5, 7, 11, 12= 10%
•2% each
•The tests will consist of multiple choice and T/F questions.

2) Assessment B : 20% - Group

•Executive summary report – with interim submissions

3) Assessment C: 20% - Group

•In class presentation – 10 minutes

Final examination: 50%

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Topic 1:
Balance of payments and
National income accounting
Contents
Balance of Payments Accounting
Foreign Debt
National Income Accounting and the Open
Economy

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The World Economy
• The world economy has become increasingly interconnected:
Globalization: markets exceed national boundaries; increased
mobility of workers, products, and information.

–Real Sector: production and sale of goods and services.

–Financial Sector: transactions in global, foreign, or domestic
financial assets.
“Because globalisation is nothing but the reflection of the growing
interdependence of national economies, and since Balance of
Payments/International Investment Position Statistics are precisely
designed to record such interdependence in the most faithful
possible way, it follows that the more globalisation progresses, the
more interest there is in such statistics both from the economic and
the policymaking viewpoints” Ref ECB
Reserve Bank of Australia

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Trade deficits - the US case
US and China – Article

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US statistics 2018

• The U.S. current-account deficit increased to

$124.8 billion (preliminary) in the third quarter of
2018 from $101.2 billion (revised) in the second
quarter of 2018.
• As a percentage of U.S. GDP, the deficit
increased to 2.4 percent from 2.0 percent.
• The previously published current-account deficit
for the second quarter was $101.5 billion.

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Learning objectives – Topic 1
• Understand how a country’s international transactions
are recorded - What the balance of payment is and what
it measures
• Understand the meaning of credits and debits, and
double entry bookkeeping
• Explain why the current account balance is economically
important
• Relate the current account balance to changes in a
country’s net foreign wealth
• Utilise national income accounting identities to explore
the relationship between savings, investment and the
current account.

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Can you identify key themes in the
analysis presented in this article?
• The expected Value of the Australian dollar

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NATIONAL INCOME MEASURES AND BOP
National income is often defined to be the income earned by a nation’s
factors of production.
 Gross national product (GNP) is the value of all final goods and services
produced by a nation’s factors of production in a given time period.
 Gross domestic product (GDP) measures the final value of all goods and
services that are produced within a country in a given time period.
GNP = GDP
+ payments from foreign countries for factors of production
– payments to foreign countries for factors of production
Gross National Product (GNP) is the total value of final goods and services
produced during a given period by the citizens of a country no matter where
they live. The goods and services are produced by the “nationals” of the
country.

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BALANCE OF PAYMENTS ACCOUNTING
• Definition: The balance of payments (BOP) accounts measures all
international economic transactions between the residents of a
country and foreign residents in a given period of time.

• The BOP is constructed on the basis of double entry book keeping

• Each transaction is recorded twice: once as a credit and once as a

debit.
– If you have to pay a foreign resident, (e.g – Imports)
normally in exchange for something that you bring into the country,
then that something counts as a debit.
– If a foreign resident has to pay you (e.g exports)
for something, then the something counts as a credit.

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Simple example
Credit Debit
Import a car from Japan
Debit on BOP (pay foreign resident) Import Car -
Export JPY
Export currency in exchange in
Credit on BOP
exchange
for car
But which sub accounts?

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AAPSep 4th, 2018

• Australia's current account deficit has widened to

$13.5 billion in the three months to June, missing
market expectations of a fall to $11 billion. The
current account deficit widened from the March quarter's
revised $11.7 billion, according to seasonally adjusted
figures released on Tuesday from the Australian Bureau
of Statistics. The balance on goods and services fell
16 per cent to a surplus of $2.81 billion, as commodity
price rises and an improvement in the services balance
failed to offset an increase in goods imports and a fall in
international income from employment and investment.

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Balance of payments accounting
• Composed of two primary sub accounts, the Current
Account and the (Capital) Financial Account:

– Current account: CA records flows of goods, services,

income on assets and unilateral transfers
– (Capital)Financial account: FA records flows of assets
– In addition, the Official Reserves account (ΔIR) tracks
government currency transactions
– A fourth account, the Net Errors and Omissions account is
produced to preserve the balance of the BOP.

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 Current Account (CA)
• Measures a country's net exports of goods and services (NX) and net
international income receipts (NI = income earned on foreign assets
owned by domestic citizens minus income paid on domestic assets owned
by foreigners -including interest payments, dividends and profits).
• It also includes unilateral transfers

- Exports are recorded as a credit (+) on the current account.

- Imports are recorded as a debit (-) on the current account.

• An entitlement to the receipt of income from abroad is recorded as a

credit. The obligation to make a payment of income to a foreign resident
is recorded as a debit.
• A current account surplus is where credits exceed debits, that is when
exports and income received from abroad are greater than imports and
income paid to foreign residents.
• A current account deficit is where debits exceed credits.
• CA = (NX + NI)

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Current Account vs Financial Account

• Link to ABS balance of payments data

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Components of CA
Current Account Balance (a),
Main aggregates

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CA : Note:-– Income on foreign assets – iFA
• What is Investment Income?
Payment to holders of foreign financial assets, including:
– Interest on bonds and loans
– Dividends and other claims on profits by owners of foreign
businesses
– Payments made to temporary (nonresident) workers

What are unilateral transfers?

• Official government grants in aid to foreign governments

• Charitable giving (e.g., famine relief)
• Migrant workers transfers to families in their home countries

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Financial Account (FA)

• Net change in foreign ownership of investment assets

• Measures the difference between sales of assets to
foreigners and purchases of foreign owned assets.
• Sales of assets to foreigners be it direct, portfolio,
investment in financial derivatives or other investment
(including currency and deposits) is recorded as a credit
entry on the financial account.
• Purchases of assets located abroad are recorded as a
debit entry on the financial account. (import the asset)
• FA = – ΔNFA = Change in Net Foreign Assets

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Inverse Relationship Between
CA and FA

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Fundamentals of BOP
Accounting
Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Primary income (iNFA) Received Paid
Secondary income (remittances, Received Paid
transfers)
Financial Account (= – ΔNFA) Decrease Increase (Buy)
Foreign assets owned by domestic Increase Decrease
(FA)
Domestic assets owned by Decrease in R Increase in R
foreigners (FL)

Change
Errors &inOmissions
Official Reserves
(Statistical Discrepancy)
(= – ΔIR) = Sum of credits minus sum of
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Example 1
• Suppose an Australian resident wants to purchase something in Japan and
thus needs Japanese currency to make the purchase.

• The Australian currency sold is recorded as a credit entry in the financial

account. Ownership changes from an Australian resident to a foreign
resident.
• The Japanese yen purchased is recorded as a debit entry on the
financial account, valued at the current exchange value.

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Example 2
Assume that the Australian resident uses his yen to purchase a camera from a
store in Japan and then brings it back to Australia

The item sold in this case is Japanese currency, reflecting a decrease in

holdings of foreign exchange. This is recorded as a credit entry on the financial
account.
The good imported into Australia is recorded as a debit entry on the current
account.

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Example 3
• Assume that the Australian resident uses his yen to purchase a Japanese
government bond.

The transaction is recorded on the financial account as a debit entry

representing the increase in domestic holdings of foreign bonds, and as a
credit entry reflecting a decrease in holdings of foreign exchange.

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Example 4
Assume a Japanese resident who owns bonds issued by a Australian company
receives interest payments.

The transaction is recorded on the current account as a debit entry

representing the payment of income to a foreign resident,
and as a credit entry on the financial account reflecting an increase in
Japanese financial claims against an Australian bank.

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Official Reserve Transactions
• Official international reserves are foreign assets held by the central
bank.
• Governments/ central banks can influence exchange rates by
buying and selling official reserves.
• The buying and selling of official reserves is recorded in the “official
transactions” account.

• Consider the examples above. Private foreigners in Japan might not

wish to retain all of these newly obtained $AUD balances.
• If Japan is receiving more $AUD than it requires for the purchase of
Australian assets and imports from Australia, then there is an
excess supply of AUD dollars.
• The price of the $AUD in terms of Yen will decline, and the
exchange value of the Yen will increase.

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Official Reserve Transactions (– ΔIR)
• If the Central Bank is adding to its stock of Official Reserves it is
recorded in the Balance of Payments statistics as a debit.
(Importing reserves)

(Similar to the treatment of a private citizen purchasing foreign assets,

which is also recorded as a negative in the Financial Account of the
Balance of Payments)

• A reduction in the Central Bank’s Stock of Foreign Exchange

assets is recorded as a credit in the Balance of Payments.
(Exporting reserves)
• Note: Under a pure floating or a flexible exchange rate the
Central Bank does not buy or sell foreign exchange

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Capital Account ( KA)

• A minor account of the Balance of Payments for many

countries.

Covers:

– Migrant transfers (goods and financial assets

accompanying migrants as they enter or leave the
country).
– Debt forgiveness

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Summary on BOP – the BOP must
always balance
(X – M + NI) – ΔNFA – ΔIR =0

Current Account Financial Account Change in Reserves

Change in Net
Foreign Assets

With no Central Bank intervention:

BOP = Current Account + Financial Account = 0
Current Account = – Financial Account = ∆NFA

If there is Central Bank intervention:

If ΔIR < 0 (the Central Bank is increasing its stock of
foreign reserves), then CA + FA > 0.

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Summary: The balance of payments
will always balance
BOP = CA + FA + KA + ΔIR = 0
•Typically the KA is relatively small and can be neglected.

•With no Central Bank intervention:

BOP = CA +FA = 0
CA = -FA

•If there is Central Bank intervention:

BOP = CA + FA + ΔIR = 0
If ΔIR < 0 (the Central Bank is increasing its stock of foreign exchange
reserves), then CA + FA > 0.

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Note
• The CA and FA measure the private and non Australian Government
demand for Australian Dollars

• BOP = CA+FA=0

• If not in balance then it must be paid for by International reserve flows

• BOP = CA+FA+ΔIR = 0

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Meaning of a CAD / CAS

• A current account surplus (CAS) means exports

of goods and services, investment income and
transfers exceed imports and outflows.

• A current account deficit (CAD) means imports

of goods and services, and outflows are greater
than exports and inflows; must be financed by
borrowing (Financial account inflows).

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International Investment Position

• International Investment Position (IIP) is another

related balance sheet. It is a statement of the
stocks of a nation’s international assets and
foreign liabilities at a point in time, usually the
end of a year.

• Any capital flows (related to a current account

imbalance) creates a change in the IIP.

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Financing a Current Account Deficit
The concept of current account balance is economically important in that it
reflects changes in a country’s net foreign assets, international investment
position, or a country’s net foreign wealth (W).
That is, the difference between foreign assets owned by Australian
residents and Australian assets owned by foreigners (foreign liabilities).

NFA = Net Foreign Assets = Net Foreign Wealth = Net

International Investment Position
= FA (Foreign Asset ) – FL (Foreign Liabilities)
Change in net foreign wealth (W) = current account balance = - financial
account balance.
If the current account is in deficit the shortfall must be financed
A current account deficit corresponds to an exactly equal
accumulation of net financial liabilities to the rest of the world.

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 Financing a Current Account Deficit
Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Factor income Received Paid
Transfer Received Paid
Financial Account (= – ΔNFA)
Foreign assets owned by domestic (FA) Decrease Increase
Domestic assets owned by foreigners Increase Decrease
(FL)

Decrease in R Increase in R
Change in Official Reserves
(= – ΔIR)

Increase in Net Foreign Liabilities = Accumulate foreign debt

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Foreign Debt
Net foreign debt = Australian non-equity assets owned by
foreigners - foreign non-equity owned by Australian
residents. Overseas borrowing, by itself, does not add to net
foreign debt.
There will be an increase in foreign holdings of domestic
bonds, recorded as a credit entry on the financial
account,
But,
an offsetting increase in the domestic holding of foreign
currency, recorded as a debit entry on the financial
account. There is therefore no net change in a country’s
financial account and no net change in that country’s net
foreign liabilities.

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Foreign Debt
Foreign loans are “counter balanced”, there are three
possibilities:
1. purchases of foreign goods and services by domestic
residents (including income payments)
2. purchases of claims on foreigners (purchasing foreign
currency assets)
3. financing the acquisition of foreign reserves
Net foreign debt can only increase if borrowing is financing
a current account deficit. Otherwise, borrowing from
overseas will be increasing foreign claims on domestic
assets but at the same time they will be increasing foreign
currency assets.

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There are three ways in which the shortfall
can be financed
• 1. The domestic economy can borrow from the rest of the world by issuing
financial claims (liabilities) on itself which are financial assets for the rest of
the world. This is recorded as a credit entry in the financial account. This
results in a reduction in net foreign assets (increase in net foreign liabilities).

• 2. Rather than add to debt, the domestic economy can sell off its financial
assets, both domestic and foreign, to the rest of the world. This would
appear as a capital inflow and therefore as a credit entry in the financial
account. This results in a reduction in net foreign assets (increase in net
foreign liabilities).

3 The Central Bank can also finance the shortfall by running down its stocks
of foreign exchange reserves which also results in a reduction in net foreign
assets (increase in net foreign liabilities).

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Changes in net foreign wealth reconsidered
Link to world bank data on Net foreign assets
Change in net foreign wealth (W) = Current account balance + Capital gains on
W

Valuation changes arising from asset price and exchange rate movements can
cause net foreign wealth to diverge from the level implied by current account
deficits.
Example: In the US, the period 2002-2007 exhibited the largest current account
deficits since 1976. Nevertheless, US net foreign wealth improved. This
discrepancy is due to increases in the market value of U.S.-owned foreign
assets (most denominated in foreign currency ) relative to foreign-owned U.S.
assets (mostly denominated in US dollars).
•Reduction in the exchange value of the US dollar, increasing the US dollar
value of foreign currency denominated US-owned assets, leave unchanged the
US dollar value of US dollar denominated foreign owned assets.
•Stock market in foreign countries outperformed the US stock market

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• Open – Economy Macroeconomics Identities
• In an open economy, domestic residents can trade both
goods and services as well as financial assets with the
rest of the world.
• Total spending on domestic goods is given by:

GDP = (C + I + G) + (X – IM)
GNP = GDP + NI
where NI is net international income

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• The relationships among the various components of GDP are described in
the national income accounts.

• Closed Economy Macroeconomics Identities

GDP = C + I + G

• Define gross domestic savings as

S = GDP – C – G (where S is the sum of private sector savings and
government sector savings).

• The basic national income accounting identity implies the familiar closed-
economy identity:
S=I

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY

Open – Economy Macroeconomics Identities

Using the basic national income accounting
identity and adding net investment income to both
sides we have:

•GNP = (C + I + G) + (NX + NI)

Therefore:
•GNP = (C + I + G) + CA

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY

• Open – Economy Macroeconomics Identities

• GNP = (C+I+G)+CA
In an open economy, our definition of saving must also be
modified to:
• S = GNP – C – G
• S = C+I+G+CA – C- G
We can therefore derive the following identity:
• S = I + CA
alternatively
• I = S - CA
alternatively
• S - I = CA (note that if NI = 0, S – I = NX)

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY

• Open – Economy Macroeconomics Identities

Insights:
• While a closed economy can only allocate savings to the
purchase of real (nonfinancial) capital, an open economy can
also allocate savings to the acquisition of financial claims on
the rest of the world. S=I+CA
• While a closed economy must finance investment by saving,
an open economy can do so either by saving or reducing its
net foreign wealth (borrowing abroad). I=S-CA
• The current account balance is the difference between
savings and investment. S-I=CA

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
If S >I
•Current Account Surplus
•Net Foreign Wealth Increasing
•Financial Account Deficit
•Lending savings to the Rest of the World

If S <I
•Current Account Deficit
•Net Foreign Wealth Decreasing
•Financial Account Surplus
•Borrowing savings from the Rest of the World

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Net Foreign Wealth - Australia

• It reflects difference between

foreign assets owned by Australian
residents and Australian assets
owned by foreigners
• The value of Australia’s foreign
assets and foreign liabilities have
both been on an increase since late
1980s
• Foreign assets have consistently
been below foreign liabilities and
the difference has been tracking
upwards

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Is a Current account deficit bad
• A trade deficit is not necessarily a bad thing (e.g. when growing
domestic industries attract foreign investments)
– if borrowing is financing investment (which generates economic
growth and income in future) then it is not a problem
• However, if a country persistently runs a trade deficit this is
something to worry about (e.g. vulnerability to loss of foreign
investors’ confidence)
– excessive borrowing on capital account to finance consumption
on current account will incur higher interest payments and
eventually lead to reduction consumption

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On running a CA deficit, Is it a
bad?
• Countries frequently run large bilateral trade deficits. Sometimes you will
hear commentators providing the following incorrect explanation.
• “China protects its markets from US goods while the US allows China to sell
freely into the US. This means US exports to China are small while its
imports from China are big. That’s why we have a trade deficit.”
• This is wrong for several reasons. First, countries typically exhibit “ circular
comparative advantage”, meaning that the US buys from China, China buys
from Japan, Japan buys from US. All have a trade deficit with one partner
and a trade surplus with another. This is not caused by protection, but by the
fact that countries produce and demand different sets of goods.
• To use a simpler example, I have an enormous trade deficit with Taco Bell
(and McDonalds, and about every other fast food restaurant in town). I
“import” low quality food from them, but they have never once bought an
economics lecture from me. Is that because Taco Bell is protecting its
market? No. It just doesn’t need economics lectures. Happily, I can sell my
lectures to undergrads, who then sell their labor to Taco Bell, which sells me
greasy tacos of mediocre quality – circular comparative advantage.

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On running a CA deficit, Is it a
bad? Cont’
• Trade deficits indicate only that a country currently saves less than it
invests.
• Far from indicating a lack of competitiveness, trade balances may be
caused precisely because a country is expecting a surge in productivity
in the near future, and investing to take advantage.
• That does not mean that trade deficits are necessarily good. Its possible
that a country may be saving too little (or investing too much) for some
reason, and this would lead to a trade deficit. But analyzing this point
requires addressing the savings (or investment) behavior directly.

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National “Life Cycles”
• Nations also have life cycles caused by demographics and productivity surges. The
age distribution of a population can differ substantially across populations. Compare
Japan and China.
• Currently, Japan’s population is “middle-aged”, meaning a disproportionate share of
the population is in their peak working years. This necessarily means that in 20 years,
that population will be retirement age, and Japan will be dis-saving (spending more
than it saves) in order to pay for that retirement. China’s population, in contrast, is
very young. In 20 years, it will have a very large working age population.
• Productivity change can also induce cycles. The most obvious example is the case of
post-war economies like Japan and Germany that had to consume more than they
produced during a period in which domestic investment exceeded domestic savings.
• But this kind of a thing can happen in any economy that is expecting a future
productivity surge. If productivity will be greater in the future (due to positive
technological change), I want to invest heavily now to take advantage of that. This
may help explain extremely high investment rates relative to saving in the US in the
last 20 years – an effort to capture the returns to computer-related productivity
increases.

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Summary: National Income Account

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Recent trends

• OECD countries : Current account balances

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International Flow of Income

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Trade Balance and Current
Account

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