Topic 3: Aggregate Demand and Supply and the Balance of Payments

We now explore the important relationship between the current and capital accounts and aggregate demand and supply. This relationship is both a definitional one that follows from the principles of double-entry bookkeeping and an equilibrium one that results from the forces that bring desired and actual magnitudes into equality.

We can view purchases of domestic output by the domestic and foreign private sectors and government combined as having three components---domestic consumption, domestic investment and exports to foreign residents for consumption and investment abroad. Thus we can write

  1.   X = C' + Ig' + E'

where  C'  is real domestic consumption of domestically produced goods,  Ig'  is real gross domestic investment of domestically produced goods and  E'  is domestically produced goods and services purchased by foreign residents.

The domestic private and government sectors also import goods and services for consumption and investment and goods are often imported and subsequently re-exported. Denoting foreign variables by the superscript ˆ , total imports can thus be expressed as

  2.   Ê = ÊC + ÊI + ÊE

where Ê is total domestic imports (= foreign exports) and the three terms to the right of the equal sign are, respectively, imports of consumption, investment, and re-exported goods and services.

We now add and subtract Equation 2 on the right-side of Equation 1 and consolidate the terms to obtain

  3.   X = C + Ig + E - Ê

where  C  is real domestic consumption of domestically produced and imported goods and services,  Ig  is gross real domestic investment inclusive of imported goods and services and  E  is domestic exports inclusive of imported goods that are later re-exported. Here,

     C = C' + ÊC

     Ig = Ig' + ÊI


     E = E' + ÊE.

Now we can subtract depreciation denoted by  D  from both sides of Equation 3 to obtain

  4.   Y' = X - D = C + I + E - Ê

where  Y'  is total income generated in the domestic economy, called net domestic product, and  I  ( = Ig - D)  is net investment, the net addition to the stock of domestically employed capital. Note that we have consolidated private and government transactions so that consumption, investment, and net exports are the combined private and public expenditures on these goods and services.

This can be further refined by noting that the total net income of domestic residents---net national product---is equal to income produced in the domestic economy minus interest and dividends paid to foreign residents plus interest and dividends earned abroad by domestic residents---that is,  Y = Y' + DSB  where  DSB  is the debt service balance. Equation 4 then becomes

  5.   Y = C + I + BT + DSB

where  BT  (= E - Ê)  denotes net domestic exports of goods and services---that is, the balance of trade.

Now subtract C + I from both sides of Equation 5 to obtain

  6.   Y - C - I = BT + DSB

or, since income minus consumption equals savings,

  7.   S - I = BT + DSB

where  S (= Y - C)  is the level of domestic savings.

Domestic savings represents the total purchases of new asset holdings by domestic residents on both private and government account. Government held assets are owned by private residents indirectly since the income flows on those assets are rebated to the private sector either directly or through lower taxes than would otherwise be levied. And domestic investment represents the total sales of new assets by private firms and government to finance the purchase and installation of new capital goods. The excess of savings over investment thus equals the net purchase of assets by domestic residents, on private and government account, from foreign residents---if this is positive, domestic residents are purchasing more new assets than are being issued in the domestic economy. Savings minus investment thus equals the net capital outflow, so Equation 7 can be written as

  8.   NCO = BT + DSB

where  NCO  (= S - I)  is the net capital outflow. This equation says that the net capital outflow (or deficit on capital account) equals the balance of trade plus the debt service balance (or surplus on current account).

The balance of payments is thus a component of the balance in the national accounts. This follows from the fact that total expenditure on goods produced in the domestic economy must equal the value of those goods produced. Any domestically produced goods not bought by domestic residents must be bought by foreign residents and any surplus or deficit of purchases by domestic residents over domestic production must be financed by borrowing or lending abroad.

The relationship between income and balance of payments determination becomes crystal clear when we juxtapose the three equations 1, 5, and 8:

  1.   X = C' + Ig' + E'

  5.   Y = C + I + BT + DSB
  8.   NCO = BT + DSB

The above three equations follow logically from each other. All of them can be viewed as accounting identities---everything received must be spent or saved and everything spent must be earned as income or borrowed. And these three equations can also be interpreted as equilibrium conditions. If  C ,  I    and  BT  are interpreted as desired magnitudes, and  X  is the level of output firms choose to produce, then economic variables must adjust to ensure that equilibrium occurs---that desired expenditure (or aggregate demand) equals the value of desired output (or aggregate supply)---and correspondingly, that the net capital flow that arises from desired savings and investment is willingly financed by an appropriate discrepancy between desired receipts and payments on current account. The nature of these equilibrating adjustments is the subject of the next Topic.

It should be noted here that the net capital flow above and the corresponding current account balance includes all transactions, both autonomous and induced. Government accumulations of official reserves of foreign exchange are a component of national savings and must be financed by the incomes domestic residents earn from their labour and from their earnings from capital employed both at home and abroad. What matters is that the aggregate demand for domestic output (total desired expenditure on domestically produced goods) equal the aggregate supply (total value of domestic goods produced), regardless of whether the components of these aggregates originate in the private or public sectors.

It is time for a test. Again, be sure to think up your own answers before looking at the ones provided.

Question 1
Question 2

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