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BS1609 Economic FrameworkWebinar

October 29, 2013

() BS1609 Economic Framework October 29, 2013 1 / 18


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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 andomissions in measuring capital transactions.)

Official Settlements Account Records the change in a countrys reserves. Essentially, this account keeps

track of transactions related to international assets including gold, foreignexchange 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 financialaccount minus the balances on the current and capital accounts.

The five 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 thecurrent account (CA), the financial 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 ordeficit by increasing or decreasing its official reserves.

For example, if a country runs a deficit on the overall balance, that is,CA + FA is negative, the central bank of the country can supply foreignexchanges out of its reserve holdings. But if the deficit persists, the central

bank will eventually run out of its reserves, and the country may be forced todevalue its currency. This is roughly what happened to the Mexican Peso inDec. 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 deficit must be matched by a financialaccount deficit 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 representprivate 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 ofthe 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 morethan it is saving, meaning the countrys (net) investment is partly being financedabroad.



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Deficit 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 deficit or surplus tells ussomething 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 givesother countries the chance to improve productivity while running a deficit.

Deficit: 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 othereconomies to meets its domestic consumption and investment requirements.

Example: an economy decides that it must invest for the future. Instead ofsaving it sends money abroad into a project that will provide investment incomein the long run. This would be marked as a debit in the FA now but theinvestment income would be a credit in the CA later.



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Deficit vs Surplus

Current Account Deficit: With the long-term in mind, a country may run adeficit by importing more than its exporting, with the ultimate goal of

producing finished goods for export. Balance of trade deficit:

A trade deficit could mean that the country is importing more in order toincrease its productivity and subsequently produce more exports, alleviatingthe long run deficit.

Investing for the future: Instead of saving money now, a country could alsochoose to invest abroad in order to reap the rewards in the future.

Foreign investors: A deficit could be the result of increased claims by foreigninvestors, whose money is used to increase local productivity and stimulate theeconomy.

Overspending without enough income: Sometimes governments spend morethan they earn, simply due to ill-advised economic planning.

Key Point: A CA deficit is not necessarily a bad thing! - The currentaccount highlights what is traded with other countries, and it is a goodreflection of each nations comparative advantage in the global economy, butwhen analyzing a current account deficit or surplus, it is vital to understand

the economic foundations of the extra credit or debit.() BS1609 Economic Framework October 29, 2013 8 / 18


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Deficit vs Surplus

Financing a CA deficit:

Public and private foreign funds: Funding channeled into the capital and

financial accounts (remember, these accounts finance the deficits in thecurrent account) can come from both public (official) and private sources.

Balanced financing: To avoid unnecessary extra risks associated withinvesting money abroad, the financing of the deficit should ideally rely on acombination of long-term and short-term funds rather than one or the other.



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Factors Affecting International Trade Flows

Historically:

Inflation- A relative increase in a countrys inflation rate will decrease itscurrent account, as imports increase relative to exports.

National income - A relative increase in a countrys income level will decreaseits current account, as imports increase relative to exports.

Government restrictions - A government may reduce its countrys imports byimposing trade restrictions such as a tariff on imported goods or by enforcinga quota.

Exchange rates - If a countrys currency begins to rise in value, its currentaccount balance will decrease as imports increase relative to exports.



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Factors Affecting International Trade Flows

The Future: Demographic- Demographic changes in a country, such as an ageing

population, migration, educational improvements and womens labourparticipation, will impact on import demand via affects on a countriescomparative advantage.

Physical infrastructure - Better transport infrastructure across neigbouringcountries, such as road connectivity, could strengthen regional trade. ICTinfrastructure could further expand services trade.

Technological progress- Technology spill overs are largely regional andstronger among countries connected by production networks. In addition to

traditionally R&D intensive manufacturing sectors, knowledge-intensivebusiness services are emerging as key drivers of knowledge accumulation.

Energy production - There have been, and will continue to be, dramaticshifts in energy production patterns and therefore international trade flows, asNorth America, via shale gas, becomes self-sufficient.



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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, nottheir development.

Neoclassical theory contains two erroneous assumptions: institutions do not matter;

time does not matter.

Provide analytical foundations for understanding the historical evolution andeconomic performance of economies - retain neoclassical dynamics of scarcity

and competition, modifies the rationality assumption and adds the dimensionof time.



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Institutions and Economic Performance

Institutions define the incentive structure of societies and economies.

The neoclassical result of efficient markets only obtains when it is costless totransact (Coase, 1960).

When it is costly to transact, institutions matter - and it is costly totransact, Wallis and North (1986).

Efficient markets demand informational and institutional requirements.

Informational: Informational feedback process will correct initially incorrectmodels, punish deviant behaviour and lead surviving players to correct models.

Institutional: Institutions are designed to induce informational feedbackprocess in the face of significant transaction costs.

Both of these requirements are very rarely realised! Agents typically act on incomplete information and the information feedback

process is insufficient to correct models.

Institutions are typically not socially efficient.



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The Nature of Institutional Change

If institutions are the rules of the game, organisations and their entrepreneursare the players.

The organisations that come into existence will reflect the incentives andopportunities provided by institutions.

Economic change occurs when individuals believe they could do better byrestructuring political and/or economic exchanges - That is, by alteringinstitutions.

The speedof economic change is a function of the rate of learning but the

directionof that change is a function of the expected payoffs to acquiringdifferent kinds of knowledge.



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The Rationality Assumption

History demonstrates that irrationality - ideas, ideologies, myths, dogmasand prejudices - matter in attempting to understand the nature of humanlearning and societal change.

Rational-choice framework assumes that individuals know what is in theirbest 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 performanceand change, we thus must understand decision-making under uncertainty - acognitive 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 filters the information derived fromexperiences, and;

the different experiences confronting individuals and societies at differenttimes.

Acquiring knowledge is the essential foundation of modern economic growthand as well as being affected by monetary rewards and punishments, isfundamentally influenced by a societys tolerance of creative developments.

A major factor in the development of Western Europe was the gradualperception 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 ofeconomic history;

bysuccessfully characterising the very uneven pattern of economicperformance- the pace of growth has varied greatly over the ages and has

not been unidirectional;

by successfully characterising path dependance - the tendency foreconomies, once on a path of growth or stagnation, to persist, and;

bycontributing to our understanding of the complex interplay betweeninstitutions, technology and demography in the process of economicchange.



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Implications for Development Policy

1. The transfer of formal political and economic rules from successfulWestern market economies to developing economies is not a sufficientcondition for good economic performance.

2. With respect to the form the government takes; Political institutions will be stable only ifsecured 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 takestime, 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 efficiency which is the key to long-runeconomic growth - that is, it is how political/economic institutions adapt andevolve to survive shocks and changes that matters most for successful

economic evolution.() BS1609 Economic Framework October 29, 2013 18 / 18

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