In an economy, the most important are the relationships of the balance of payments, which includes the main operations of the external sector of the economy, with the corresponding indicators of the domestic sector – items of national income and gross national product, the monetary sector and the public sector. In each of these accounts, there is an international element that is directly related to the balance of payments, reflecting the interaction of the economy with the outside world.
Linkages between the real and external sectors
The starting point of the general equilibrium model on which the SNA is based is the equality of supply of goods and services, on the one hand, and demand for them, on the other. The supply of goods and services in a given year consists of their production within the country and imports from abroad. Demand consists of the total expenditure of residents and the government on consumption and investment plus exports abroad.
This relation, known from the general theory of macroeconomics, can be represented by the following formula:
Y+IM=C+1+X, | (1.1) | ||
where Y | – volume of output/level of income; | ||
IM | – import of goods and non-factor services; | ||
With | consumption (households, businesses and government); | ||
I | – domestic investments (capital investments); | ||
X | – export of goods and non-factor services. |
This equation actually expresses all the major cause-and-effect relationships in economics. Any institutional unit, whether a household, an enterprise, the government or the state as a whole, can consume and export abroad goods or services no more than it was able to produce itself and import from abroad. The value of Y is one of the possible ways to change the total output, which by definition is equal to the amount of income in the economy.
It is also known from the general theory of macroeconomics that there are several key indicators of the functioning of the economy, which are directly related to each other through the SNA.
National income (ND) (national income – N1) is the total income in the economy received by residents from the use of factors of production (labor, capital, labor, technology). If indirect taxes are added to national income, the result is net domestic product (NDP). The increase in net domestic product by the amount of depreciation of fixed capital spent in current production gives an indicator of gross domestic product (Fig. 1).
Gross domestic product (GDP) – value added produced by residents within a country. If we assume that Y is GDP, then by transforming equation (1.1), we get:
GDP=(C+I)+(X-IM) | (1.2) |
Residents can use factors of production both at home (building enterprises and producing products) and abroad (building enterprises abroad or acquiring foreign enterprises and producing products on them). To move now from gross domestic product to gross national product, it is necessary to take into account factor income paid abroad and received from abroad.
Gross national product (GNP) is the sum of the value added produced domestically and the net factor income from abroad. GNP is equal to the sum of GDP and net factor income derived from abroad.
GNP=GDP+NY=(C+I)+(X-IM+NY) | (1.3) |
Net factor income (NY) is the difference between the difference between the use of foreign factors of production owned by residents and payments to non-residents for the use of their factors of production in a given country.
Net factor income from abroad includes:
the difference in income from investment activities, such as profits received from abroad on direct and portfolio investments and interest on deposits in foreign banks, and the cost of paying profits to non-residents on foreign capital invested in this country and interest on deposits of non-residents in local banks; the difference in transfers to and from the country of migrant workers who are considered residents of their own, and not a foreign country. Usually, they are abroad for a time limited by law, which does not allow them to be considered residents of a foreign state; the difference in the amount of rent received for leased real estate abroad owned by residents of this country, royalties received from abroad, etc., and rent paid to non-residents for real estate owned by non-residents, but located in this country, royalties to non-residents, etc.
When imports of factor income exceed their exports, net factor income is positive and GNP is greater than GDP. When imports of factor incomes are less than their exports, then net factor income is negative and GNP is less than GDP. Thus, if net factor income is taken into account, the output/income indicator Y takes the form of GNP. However, residents can go abroad in search of work, as well as residents of other countries can come to this country to engage in production and receive income. Therefore, the concept of output/income can be expanded further.
Gross national disposable income (GDI) – used for the accumulation and consumption of GNP, includes net transfers from abroad (NT). To determine the value of the VID, data on net transfers from abroad (NT) are added to the GNP, that is:
GDI=GNP+NT=(C+I)+(X-IM+NY+NT) | (1.4) |
Net transfers (NT) – the difference between the transfers of migrant workers who are considered residents to and from a given country.
The concept of transfers is important for accounting for the remittances of migrant workers. If they are considered residents of the country in which they work, then their remittances to their homeland are considered transfers. If migrant workers continue to be treated as residents of their own country, their remittances are considered factor payments. Thus, the concept of output/income, catching another component of them, expands to the level of GNI.
To simplify equation (1.4), the following concepts can be introduced:
Current account balance (CAB) – the sum of trade balance indicators (exports of goods and services minus their imports), net factor income and net transfers, i.e. CAB=X-IM+NY+NT; Absorption ( A) – the expenditure of residents, including the government, on domestic and foreign goods and services, i.e. A = C + 1; Savings (S) – that part of the GNI that has not been consumed, that is, S = GDI-C. Or, more generally, S=Y-C.
Having made the appropriate substitutions, equation (1.4) can be rewritten in the following more general form:
CAB=Y-A | (1.5) |
The point of this equation is that any internal imbalance leads to an external imbalance. To ensure the internal and external balance, the value of supply (output/income) should ideally be equal to the value of aggregate demand (removals/expenditures), that is, their difference (current account balance) should be zero. If the total income of residents is greater than their total expenses, then the balance of payments balance is positive. If the total income of residents is less than their total expenses, then the current account balance is negative and there is a deficit.
Note that the absorption rate is always constant (A = C + 1). But depending on which indicator is understood by (Y), the composition of the CAB changes. If GDP is considered as Y, then CAB is a simple difference between exports and imports of goods and non-factor services (X-IM); if Y is understood as GNP, then CAB is the difference between exports and imports of goods and all services – non-factor and factor (NY); if Y means GNI, then CAB is the difference between exports and imports of goods, all services and transfers (NT). However, for analytical purposes, the first, simplified approach is most often used, according to which Y = GDP and SAV = X-1M.
The same concept can be expressed through the concept of the balance of savings and investments. From the definition of savings it follows that:
GDI=S+C | (1.6) |
Substituting equation (1.6) into equation (1.4) and making elementary transformations, we obtain:
SAV=S-I | (1.7) |
Equation (1.7) shows that any imbalance between domestic savings and investment affects the current account with foreign countries. Ideally, savings should equal investment and the current account balance should be zero. Equations (1.5) and (1.7) are identical and show the relationship of the domestic economy with the international one.
In real life, never does output/income equal absorption and, accordingly, savings do not equal investment. Consequently, the current balance is different from zero, which indicates the imbalance of the economy and the need to find sources of its financing. However, without additional information, it is impossible to conclude as to what led the economy to an imbalance – an imbalance in external payments (for example, as a result of deteriorating terms of trade) or internal imbalances (for example, as a result of excessively liberal fiscal policy). If, for whatever reason, the real sector is in a state of imbalance, the resulting current account deficit should be covered, i.e. financed. The source of such financing can be the monetary sector.