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Chapter 1

National Income Accounting

and Balance of Payment

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Introduction
This chapter studies:
- The relationship between national income and
balance of payment.
- Three approaches for BOP:
+ The Elasticity and Absorption approach
investigate the impact of exchange rate changes on
the current account position of a country: will a
devaluation (or depreciation) of the exchange rate
lead to a reduction of a current account deficit?
+ The Monetary approach explain for BOP
movements base on changes in money supply and

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National Income Accounting for an Open

Economy
• The national income identity for an open
economy is
Y = C + I + G + EX – IM
= C + I + G + CA
Expenditure by domestic Net expenditure by foreign
individuals and institutions individuals and institutions

National Income Accounting for an Open Economy (cont.)

CA = EX – IM = Y – (C + I + G )
• When production > domestic expenditure, exports > imports: current
account > 0 and trade balance > 0
– when a country exports more than it imports, it earns more income from
exports than it spends on imports
– net foreign wealth is increasing

• When production < domestic expenditure, exports < imports: current

account < 0 and trade balance < 0
– when a country exports less than it imports, it earns less income from
exports than it spends on imports
– net foreign wealth is decreasing

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Balance of Payments Accounts

• A country’s balance of payments accounts accounts for
its payments to and its receipts from foreigners.
• An international transaction involves two parties, and
each transaction enters the accounts twice: once as a
credit (+) and once as a debit (–).

Balance of Payments Accounts (cont.)

• The balance of payments accounts are

separated into 3 broad accounts:
– current account: accounts for flows of goods and
services (imports and exports).
– financial account: accounts for flows of financial
assets (financial capital).
– capital account: flows of special categories of
assets (capital): typically nonmarket, non-
produced, or intangible assets like debt
forgiveness, copyrights and trademarks.

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Elasticities Approach
• The approach provides an analysis of
what happens to the current account
balance when the country devalues its
currency.
• The approach was pioneered by Alfred
Marshall, Abba Lerner and later extended
by Joan Robinson (1937) and Fritz
Machlup (1955)

Elasticities Approach
• Some simplifying assumption:
It focuses on demand conditions and
assumes that the supply elasticities for the
domestic export good and foreign import
good are perfectly elastic.
The changes in relative prices are caused
by changes in the nominal exchange rate.

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Review of Elasticity
• Price Elasticity of Demand is a measure of the
responsiveness of quantity demanded to a
change in price.
• If quantity demanded is highly responsive to a
change in price, then demand is said to be
relatively elastic.
• If quantity demanded is not very responsive to
a change in price, then demand is said to be
relatively inelastic.

The Marshall-Lerner Condition

• Will a depreciation always improve the current
account balance?
• The Marshall-Lerner condition specifies the
necessary conditions for the current account to
improve.
• According to this condition, the current account
balance will improve if the sum of the elasticity of
import demand and the elasticity of export
supply exceed unity.

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Elasticities Approach

– Assumption
• Capital flows occur only as a means of
financing current account transactions.
• Trade balance exclusively represents the
current account.

Elasticities Approach
– CA in domestic currency:CA  PX  eP * M
dCA dX dM
– Derivate it with e: P  P * M  eP *
de de de
eP * M
– Initial CA in equilibrium: 1
PX
dCA eP * M dX dM
– Then: P  P * M  eP *
de PX de de
– Rearrange it: dCA dX e dM e
 P*M (   1)
de de X de M
– Finally:
dCA
 P * M ( x  m  1) (  x  dX e ,m   dM e )
de de X de M

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Elasticities Approach
dCA
– A depreciation to improve CA: 0
de

– So:  x  m  1

– Marshall-Lerner condition states that a

depreciation of domestic currency can improve a
country’s balance of payments only when the sum
of the demand elasticity of exports and the
demand elasticity of imports exceeds unity.

Elasticities Approach
• There are two effects in play once a
currency is devalued:
(1) The price effect – exports become
cheaper measured in foreign currency and
imports become more expensive measured
in the home currency. The price effect
clearly contributed to a worsening of the
current account.

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Elasticities Approach
(2) The volume effect: the fact that exports become
cheaper should encourage an increased volume of
exports and imports become more expensive
should lead to a decreased volume of imports. The
volume effect clearly contributes to improve the
current account.
=> The net effect depends upon whether the price
or volume effect dominates.

Elasticities Approach
- It was argued that a devaluation may work better
for industrial countries than for developing
countries.
- There are enormous problems involved in
estimating the elasticities.
While the devaluation can improve the
current account during a period of time, it does not
preclude an initial J-curve effect.

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Elasticities Approach
• J-Curve Effect
– A depreciation of the domestic currency is unlikely to
immediately improve a country’s balance-of-payments
deficit. It is even possible that the depreciation could
cause a country’s balance of payments to worsen
before it improves.
BP Surplus

C
0 t0 t1 t2 Time

A
e↑

B
BP Deficit

Elasticities Approach
– Reasons for J-Curve Effect:
• Reaction of producers
• Reaction of consumers

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Absorption Approach
• The absorption approach assumes that prices
remain constant and emphasizes changes in real
domestic income.
• Hence, the absorption approach is a real-income
theory of the balance of payments.

Absorption Approach
• Absorption: A  C  I G
• National income: Y  C  I  G  (X  M )
• Current account: CA  X  M =>
CA  Y  A
• Thus dCA  dY  dA
– It shows whether a currency depreciation can
improve the current account (then the balance of
payments) depends on its effect on national
income and on domestic absorption.

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Absorption Approach
• The effect of depreciation on absorption can be divided
into two parts:
– dA  a  dY  dAd
• The induced effect of income changes resulting from
depreciation on absorption: a  dY
(a: MPC: Marginal Propensity to Consume: the proportion of
a raise that is spent on the consumption of goods and
services, as opposed to being saved)
• The direct effect of depreciation on absorption: dAd
dCA  (1  a )  dY  dAd
• Therefore, the effects of depreciation on the current
account: the income effect: (1  a)  dY
the absorption effect: dAd

Absorption Approach
• Effects of Depreciation on National Income
– On the supply side, an effective depreciation
requires idle resources in the economy.
– On the demand side, an effective depreciation
requires the Marshall-Lerner condition to be
met.
– From the perspective of government’s
macroeconomic regulation, an effective
depreciation requires loosening protective or
restrictive trade polices.

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Absorption Approach
• Direct Effects of Depreciation on Absorption
– Real cash balance effect
require Ms↓to guarantee

e↑ P↑ cash balance↓

expenditure↓ C↓

withdraw Price of financial r↑ C↓,

financial assets assets↓ I↓

dAd 

Absorption Approach
– Income redistribution
effect
e↑ P↑ Income redistribution from
wage earners to profit earners
W
profit earners have lower MPC

C↓ dAd 

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Absorption Approach
• In conclusion, the absorption approach proposes
that depreciation can be effective in improving
the balance of payments when
– the economy has idle resources;
– the economy meets the Marshall-Lerner
condition;
– the government fulfills contractionary fiscal or
monetary policy along with depreciation.

Monetary Approach
• The Introduction
Monetary Approach focuses on the
supply and demand of money and the
money supply process.
• The monetary approach hypothesizes that
BOP and exchange-rate movements result
from changes in money supply and
demand.

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The Monetary Base

• A nation’s monetary base can be measured by
viewing either the assets or liabilities of the
central bank.
• The assets are domestic credit (DC) and foreign
exchange reserves (FER).
• The liabilities are currency in circulation (C) and
total reserves of member banks (TR).

Simplified Balance Sheet of

the Central Bank
Assets Liabilities

Domestic Credit Currency

(DC) (C)

Foreign Exchange Total Reserves

Reserves (FER) (TR)

Monetary Base Monetary Base

(MB) (MB)

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Money Stock
• There are a number of measures of a
nation’s money stock (M).
• The narrowest measure is the sum of
currency in circulation and the amount of
transactions deposits (TD) in the banking
system.

Money Multiplier
• Most nations require that a fraction of
transactions deposits be held as reserves.
• The required fraction is determined by the
reserve requirement (rr).
• This fraction determines the maximum
change in the money stock that can result
from a change in total reserves.

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Money Multiplier
• Under the assumption that the monetary
base is comprised of transactions deposits
only, the multiplier is determined by the
reserve requirement only.
• In this case, the money multiplier (m) is
equal to 1 divided by the reserve
requirement,
m = 1/rr.

Relating the Monetary Base and the

Money Stock
• Under the assumptions above, we can
write the money stock as the monetary
base times the money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
• Focusing only on the asset measure of the
monetary base, the change in the money
stock is expressed as
M = m(DC + FER).

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Example - BOJ Intervention

• Suppose the Bank of Japan (BOJ)
intervenes to strengthen the yen by selling
¥1 million of US dollar reserves to the
private banking system.
• This action reduces the foreign exchange
reserves and total reserves component of
the BOJ’s balance sheet.

BOJ Balance Sheet

Assets Liabilities

DC C

FER TR
-¥1 million -¥1 million

MB MB
-¥1 million -¥1 million

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BOJ Intervention
• Because the monetary base declined, so
will the money stock.
• Suppose the reserve requirement is 10
percent. The change in the money stock
is
M = m(DC + FER),
M = (1/.10)(-¥1 million) = -¥10 million.

Monetary Approach
Small Country Example
A small country is modeled as:
(1) Md = kPy
(2) M = m(DC + FER)
(3) P = SP*
and, in equilibrium,
(4) Md = M.

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Monetary Approach
Small
The balance Countryis Model
of payments defined as:
(5) CA + KA = FER.

For example, if FER< 0, then CA + KA < 0,

and the nation is running a balance of
payments deficit.

Monetary Approach
Small Country Model
(4) and (3) into (1) yields,

M = kP*Sy.

Sub in (2),
(6) m(DC + FER) = kP*Sy.

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Monetary Approach
Small Country Model
• Fixed Exchange Rate Regime
• Under fixed exchange rates, the spot rate,
S, is not allowed to vary.
• FER must vary to maintain the parity value
of the spot rate.
• Hence, the BOP must adjust to any
monetary disequilibrium.

Monetary Approach
• Small
Consider what Country Model
happens if the central bank
raises DC. Money supply exceeds money
demand.
m(DC + FER) > kP*Sy
• There is pressure for the domestic
currency to depreciate. The central bank
must sell FER until M = Md.
m(DC + FER) = KP*Sy

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Monetary Approach
• Small
There has beenCountry Model
no net impact on the
monetary base and money supply as the
change in FER offset the change in DC.
• There results, however, a balance of
payments deficit as FER < 0.

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Monetary Approach
•
Small Country Example
Flexible exchange rate regime:
• Under a flexible exchange rate regime, the
FER component of the monetary base
does not change.
• The spot exchange rate, S, will adjust to
eliminate any monetary disequilibrium.

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Monetary Approach
• Small
Consider Country
the impact of an Model
increase in DC.
• Again money supply will exceed money
demand
m(DC + FER) > kP*Sy.
• Now the domestic currency must
depreciate to balance money supply and
money demand
m(DC + FER) = kP*Sy.

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Monetary Approach
• Small approach
The monetary Countrypostulates
Model that
changes in a nation’s balance of payments
or exchange rate are a monetary
phenomenon.
• The small country illustrates the impact of
changes in domestic credit, foreign price
shocks, and changes in domestic real
income.

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