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Fridays Academy: Basic Accounting Relationships

Ignacio Hernandez's picture

As every Friday we are posting a lecture note prepared by Raj Nallari and Breda Griffith. This week we finish our review of the National Income Accounts.

 

 

Basic Accounting Relationships
This section links four of the macroeconomic sectors – households, enterprises, government, financial sector and rest of the world – with the key macroeconomic concept of GDP.  The relationships derived are accounting relationships and, while providing insights into how policy might be designed, they say nothing about the theory underlying the behavior of the sectors.  We introduce two sets of interrelations between a country’s national accounts and its balance of payments. These interrelationships are basic accounting relationships that lie at the heart of macroeconomic analysis. The first examines the links between aggregate income and demand and the external current account balance. Viewed from a different angle this examines the linkages between aggregate savings and investment and the external current account balance. Second, we look at the resource gap of the non-government (private) sector and its financing.

 

 

Aggregate income, Absorption and the Current Account Balance

Gross domestic product (GDP), or the value of goods and services that are produced by the domestic economy, can be derived from a basic macroeconomic relationship stating that the value of domestic production must be equal to the value of incomes that are domestically generated. Thus:

 

GDP = C + I  + (X-M)
given that:
            A = C + I 
then:
GDP =  A + (X-M) or total income equals domestic demand (absorption) plus net exports
given that:
GNI = GDP + Yf
then:

GNI = A + (X-M+Yf)

given that:

GNDI = GNI + TRf

then:

GNDI = A + X-M+Yf+TRf

and so:

GNDI – A = X-M+Yf+TRf

           

X-M+Yf+TRf  equals the Current Account Balance (CAB)

 

The identity GNDI – A = CAB is the absorption approach to the balance of payments.

 

Basically the identity states that a current account deficit arises whenever an economy spends beyond its means or absorbs more than it produces. Thus to reduce a current account deficit, a country must increase its income and/or reduce absorption. In the short term, increasing income requires unused production capacity, while in the medium and long-term structural policies to help boost capacity are required. Reducing domestic absorption can come from shrinking either private or government consumption of goods and services.

 

We can go one step further by remembering that:

 

GNDI – C = S

thus:

 GNDI = S + C

substituting this for GNDI gives:

S + C – A = X-M+Yf+TRf

given that:

A = C + I

then:

S – I = X-M+Yf+TRf

or:       

S – I = CAB

 

The relationship between the national accounts - as summarized by the savings-investment balance - and the current account balance is another implication of basic national accounts relationships. Thus the current account of the balance of payments is equal to the gap between savings and investment in an economy. Accordingly, the current account balance may be viewed as the country’s use of foreign saving. In a closed economy setting, savings must equal investment but in an open economy framework any excess of investment over savings must be met by recourse to foreign savings. A current account deficit must be covered by increased savings and/or reduced investment. As before, the accounting relationships hold, making the identities true but they provide no theory or explanations of the underlying concepts.

 

The Resource Gap of the Nongovernment Sector and its Financing

The real or private sector is defined as the sum of the household and enterprise sectors. The income-expenditure gap of the private sector needs financing. The relationship can be identified through accounting relationships. Savings by the private sector equals the difference between the private sector’s disposable income and its consumption. The private sector or nongovernment sector is denoted by the subscript p in the following identities.

 

Sp = GNDIp – Cp

 

The private sector’s absorption or aggregate demand can be written as:

Ap = Cp + Ip

 

where:

Ip is private sector gross investment.

 

It therefore follows that

Ap = GNDIp – Sp + Ip

Ap – GNDIp = - (Sp – Ip)

Fp = - (Sp - Ip

 

where:

Fp = financing gap

 

Thus the private sector’s gap between savings and investment reflects an excess of absorption over income. The gap must be financed by the rest of the economy including the rest of the world sector. Examples of financing include foreign direct investment from abroad (FDIp), net borrowing by the private sector from abroad (NFBp), and private sector borrowing from the banking system – identical to net credit from the banking system to the private sector (ΔNDCp). These financial inflows are offset by financial outflows from the private sector, i.e. lending to the banking system in the form of increased currency holdings and deposits (ΔM2) and its lending to the government or nonbank borrowing of the government from the private sector (NB). Therefore

 

Fp=FDIp+NFBp+ΔNDCp-ΔM2-NB

 

It follows that:

Sp-Ip + FDIp+NFBp+ ΔNDCp-ΔM2-NB = 0

 

Conclusion

The second step in measuring how economic policies can impact the poor is in understanding the key relationships between the various economic agents in an economy. (These include households, firms, the financial sector, government, and the rest of the world.) Macroeconomics is the branch of economics that attempts to study the aggregate economy and these important relationships. The measurement of economic activity or economic growth, captured by GDP and its movements, is the central concern of macroeconomics. Three approaches were identified in past postings for measuring GDP, the production, expenditure, and income approaches. An economy’s external position vis-à-vis other countries is measured by the balance of payments.  We have concluded with a number of accounting relationships illustrating the links between the domestic economy and the rest of the world. We are now equipped to analyze the important questions of how various policies influence poverty in developing countries.

 

Next Friday: Economic Growth and Poverty