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Class 26 Basic Notes on Capital Account and Current Account

# Class 26 Basic Notes on Capital Account and Current Account...

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Class 26 Trade and the Balance on Current Account & Capital Account Notes on current account and capital account. 8-12-2011 Robert G. Crawford Consider the following basic relations from national income accounting: (1) , defines the expenditure form of aggregate demand. Notice that imports seem to reduce GDP and Exports increase GDP. Be sure you can explain why (1) is defined as it is. Imports are subtracted to avoid overstating GDP in an accounting sense because imports are already included in C, I & G. To see this observe: a. C = C d + C f => C d = C - C f b. I = I d + I f => I d = I - I f c. G = G d + G f => G d = G - G f So, since GDP is just counting domestic production, but since total C, I & G includes imports, they must be subtracted from Exports to avoid double counting and overstating GDP. (2) , defines Net Exports, so (2) into (1) and rearranging defines (3) , which shows that net exports are the ‘surplus’ of what is produced in the domestic country minus the total quantity consumed by the domestic country—including domestic country consumption of goods produced in other countries. Notice that since total income = total product, [C+I+G]—total domestic spending—can exceed total domestic income [output] only by dis-saving—that is the spending is financed by funds from the sale of assets—essentially decreasing previous years savings from previous income held in ‘storage’ as assets. Also note that N X is defined as the CAB [ C urrent A ccount B alance] in the National Income and Product Account [NIPA] Statistics. To understand the significance of these definitions, note the following definitions of private and public saving: (4) (5) = the Government budget deficit or surplus. Combining these gives (6) Rewriting (3) above as & Noting , we can write (7) as (7) Note that (6) defines total saving in the economy as the sum of private and public saving. Also note that for a closed economy—one that does not engage in trade outside its borders—total saving equals total investment—I—as seen from definition (1) with Nx equal to zero. Finally, (7) can be rearranged as (8) , which states that (-Nx) [which defines the C apital A ccount B alance = KAB] makes up the difference between saving and investment in the domestic economy. Nx < 0 means a country has a deficit on current account. Therefore it can have total domestic investment greater than its domestic saving will finance. Nx < 0 means that there is net foreign investment flowing into the country from the ROW—a positive inflow of capital from the rest of the world. It is useful at this point to examine a particular meaning of net exports—Nx—for the economy. A country that has Nx > 0 ‘saves’ an amount of ‘income’ produced in the economy equal to net exports—that is, its ‘saving’ equals the ‘value’ of goods and services produced but not consumed in the economy because they were shipped to other countries for consumption. Also, the sum of (i)—the trade balance; (ii)—the income produced by services provided and (iii)—the income produced by assets held in other countries is called the current account balance [CAB]. Although

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