BS1609 Economic Framework

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October 29, 2013

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October 29, 2013

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Balance of Payments (BoP) Accounts

There are three major BoP accounts: Current Account
Records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments).

Financial Account
Records foreign investment in a country minus domestic investments abroad. (This account also has a statistic discrepancy that arises from errors and omissions in measuring capital transactions.)

Ocial Settlements Account

Records the change in a countrys reserves. Essentially, this account keeps track of transactions related to international assets including gold, foreign exchange reserves and bank deposits.

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Balance of Payments (BoP) Accounts

There are also two minor components of the BoP: Capital Account
Transfers of capital due to migration, debt pardons etc.

Net Errors and omissions

Constitute a residual category and derived as the balance on the nancial account minus the balances on the current and capital accounts.

The ve components of the BoP of a country must sum to zero.

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Balance of Payments Identity (BoPI)

When the BoP accounts are recorded correctly, the combined balance of the current account (CA), the nancial account (FA), and the reserves account (RA) must be zero, that is, CA + FA + RA = 0. This equation suggests that a country can run a balance of payments surplus or decit by increasing or decreasing its ocial reserves. For example, if a country runs a decit on the overall balance, that is, CA + FA is negative, the central bank of the country can supply foreign exchanges out of its reserve holdings. But if the decit persists, the central bank will eventually run out of its reserves, and the country may be forced to devalue its currency. This is roughly what happened to the Mexican Peso in Dec. 1994.

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Balance of Payments Identity (BoPI)

But generally, central banks will not intervene in foreign exchange markets. Thus the BoPI is represented by CA = FA. That is, a current account surplus or decit must be matched by a nancial account decit or surplus, respectively, and vice versa.

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Current Account and National Income

Recall the basic macroeconomic equality: GDP = Y = C + I + G + (X M ) National income can also be written as Y = C + S + T ; where S and T represent private savings and government taxes, respectively. Combining these two equations and rearranging gives: (X M ) = (S I ) + (T G ) The trade balance in goods and services (X M ) is the dominant component of the CA. Thus, this shows that a positive CA balance means a country is saving more than it is investing. A negative balance implies a country is investing more than it is saving, meaning the countrys (net) investment is partly being nanced abroad.

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Decit vs Surplus
Current Account:
Theoretically the balance should be zero but in the real world this is very unlikely - whether the current account has a decit or surplus tells us something about the government and state of the economy in question. Surplus:

Indicative of an economy that is a net creditor to the rest of the world and shows how much a country is saving over investing. This means a country is providing an abundance of resources to other economies and is owed money in return - a country with a CA surplus gives other countries the chance to improve productivity while running a decit. Indicative of an economy that is a net debtor to the rest of the world and shows it is investing more than it is saving and is using resources from other economies to meets its domestic consumption and investment requirements. Example: an economy decides that it must invest for the future. Instead of saving it sends money abroad into a project that will provide investment income in the long run. This would be marked as a debit in the FA now but the investment income would be a credit in the CA later.
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Decit:

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Decit vs Surplus
Current Account Decit: With the long-term in mind, a country may run a decit by importing more than its exporting, with the ultimate goal of producing nished goods for export.
Balance of trade decit: A trade decit could mean that the country is importing more in order to increase its productivity and subsequently produce more exports, alleviating the long run decit. Investing for the future: Instead of saving money now, a country could also choose to invest abroad in order to reap the rewards in the future. Foreign investors: A decit could be the result of increased claims by foreign investors, whose money is used to increase local productivity and stimulate the economy. Overspending without enough income: Sometimes governments spend more than they earn, simply due to ill-advised economic planning. Key Point: A CA decit is not necessarily a bad thing! - The current account highlights what is traded with other countries, and it is a good reection of each nations comparative advantage in the global economy, but when analyzing a current account decit or surplus, it is vital to understand the economic foundations of the extra credit or debit.
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Decit vs Surplus

Financing a CA decit:
Public and private foreign funds: Funding channeled into the capital and nancial accounts (remember, these accounts nance the decits in the current account) can come from both public (ocial) and private sources. Balanced nancing: To avoid unnecessary extra risks associated with investing money abroad, the nancing of the decit should ideally rely on a combination of long-term and short-term funds rather than one or the other.

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Factors Aecting International Trade Flows

Historically:
Ination - A relative increase in a countrys ination rate will decrease its current account, as imports increase relative to exports. National income - A relative increase in a countrys income level will decrease its current account, as imports increase relative to exports. Government restrictions - A government may reduce its countrys imports by imposing trade restrictions such as a tari on imported goods or by enforcing a quota. Exchange rates - If a countrys currency begins to rise in value, its current account balance will decrease as imports increase relative to exports.

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Factors Aecting International Trade Flows

The Future:
Demographic - Demographic changes in a country, such as an ageing population, migration, educational improvements and womens labour participation, will impact on import demand via aects on a countries comparative advantage. Physical infrastructure - Better transport infrastructure across neigbouring countries, such as road connectivity, could strengthen regional trade. ICT infrastructure could further expand services trade. Technological progress - Technology spill overs are largely regional and stronger among countries connected by production networks. In addition to traditionally R&D intensive manufacturing sectors, knowledge-intensive business services are emerging as key drivers of knowledge accumulation. Energy production - There have been, and will continue to be, dramatic shifts in energy production patterns and therefore international trade ows, as North America, via shale gas, becomes self-sucient.

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Economic Performance Through Time: D.C. North

Motivation:
Neoclassical theory inappropriate tool to analyse and prescribe policies that will induce development - it is concerned with the operation of markets, not their development. Neoclassical theory contains two erroneous assumptions:

institutions do not matter; time does not matter.

Provide analytical foundations for understanding the historical evolution and economic performance of economies - retain neoclassical dynamics of scarcity and competition, modies the rationality assumption and adds the dimension of time.

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Institutions and Economic Performance

Institutions dene the incentive structure of societies and economies. The neoclassical result of ecient markets only obtains when it is costless to transact (Coase, 1960).
When it is costly to transact, institutions matter - and it is costly to transact, Wallis and North (1986).

Ecient markets demand informational and institutional requirements.

Informational: Informational feedback process will correct initially incorrect models, punish deviant behaviour and lead surviving players to correct models. Institutional: Institutions are designed to induce informational feedback process in the face of signicant transaction costs.

Both of these requirements are very rarely realised!

Agents typically act on incomplete information and the information feedback process is insucient to correct models. Institutions are typically not socially ecient.

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The Nature of Institutional Change

If institutions are the rules of the game, organisations and their entrepreneurs are the players.
The organisations that come into existence will reect the incentives and opportunities provided by institutions.

Economic change occurs when individuals believe they could do better by restructuring political and/or economic exchanges - That is, by altering institutions. The speed of economic change is a function of the rate of learning but the direction of that change is a function of the expected payos to acquiring dierent kinds of knowledge.

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The Rationality Assumption

History demonstrates that irrationality - ideas, ideologies, myths, dogmas and prejudices - matter in attempting to understand the nature of human learning and societal change. Rational-choice framework assumes that individuals know what is in their best interests and act accordingly.
This assumption is unreasonable when describing choices made under uncertainty, that is to say, all political and economic choices!

To construct a viable framework for understanding economic performance and change, we thus must understand decision-making under uncertainty - a cognitive approach.

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An Institutional/Cognitive Approach to Economic History

Collective learning: The cumulative experience of our past generations that is embodied in culture.
The transmission in time of our accumulated stock of knowledge (Hayek, 1960)

The cumulative learning of a society appears to be a function of;

the way in which a given belief structure lters the information derived from experiences, and; the dierent experiences confronting individuals and societies at dierent times.

Acquiring knowledge is the essential foundation of modern economic growth and as well as being aected by monetary rewards and punishments, is fundamentally inuenced by a societys tolerance of creative developments.
A major factor in the development of Western Europe was the gradual perception of the utility of research in pure science.

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An Institutional/Cognitive Approach to Economic History

Institutional/cognitive approach can contribute to our understanding of economic history;

by successfully characterising the very uneven pattern of economic performance - the pace of growth has varied greatly over the ages and has not been unidirectional; by successfully characterising path dependance - the tendency for economies, once on a path of growth or stagnation, to persist, and; by contributing to our understanding of the complex interplay between institutions, technology and demography in the process of economic change.

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Implications for Development Policy

1. The transfer of formal political and economic rules from successful Western market economies to developing economies is not a sucient condition for good economic performance. 2. With respect to the form the government takes;
Political institutions will be stable only if secured by organisations interested in the stability of the political institution. Both institutions and belief systems must change for successful reform. Developing behavioural norms that will support and legitimise new rules takes time, but without such norms political institutions will tend to be unstable. Long run economic growth entails the development of the rule of law. Informal institutions (norms, conventions and codes of conduct) can sometimes produce economic growth even with unstable/adversepolitical rules.

3. It is adaptive, and not allocative eciency which is the key to long-run economic growth - that is, it is how political/economic institutions adapt and evolve to survive shocks and changes that matters most for successful economic evolution.
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