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 = Ê_{C}
+ Ê_{I} + Ê_{E}

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' + Ê_{C}

Ig = Ig' + Ê_{I}

and

E = E' + Ê_{E}.

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 + B_{T} + DSB

where B_{T} (= 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 = B_{T} + DSB

or, since income minus consumption equals savings,

7. S - I = B_{T} + 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 = B_{T} + 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 + B_{T} + DSB

8. NCO = B_{T} + 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 B_{T} 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.

Choose Another Topic in the Lesson