Chapter 1 - Monitoring Macroeconomic Performance PDF

26/01/2023, 14:04 Chapter 1: Monitoring Macroeconomic Performance
Nouriel Roubini and David Backus

Lectures in Macroeconomics
Chapter 1: Monitoring Macroeconomic Performance
Growth and Business Cycles
Gross Domestic Product
Accounting Identities
The Current Account
Current Account Deficits and Foreign Debt Accumulation: A preview of the Asian crisis
What Causes Current Account Deficits? Are Such Deficits Bad?
Prices and "Real'' Quantities
Summary
Further Readings
Further Web Links and Readings
Growth and Business Cycles

The two central issues of macroeconomics are evident in Figure 1, time series graph of real GDP (Gross
Domestic Product) in the US over the last forty years. As we'll see shortly, GDP is a measure of total
production of goods and services in an economy, the US being one example. The two obvious features of
postwar GDP are its upward trend (GDP has generally been increasing over the postwar period) and the short-
term fluctuations or "wiggles'' in this generally upward-sloping line. We refer to these two issues as economic
growth and business cycles, respectively. When you look at data over periods this long, the wiggles don't look
very important, and in a sense they aren't: the short-term fluctuations are a small part of the wealth of nations.
But from a personal point of view these cycles can be very important, as businessmen and workers dealing
with the latest 2001 recession could tell you. We'll look at both growth and cycles in this course.
The classical question of economic growth is why some countries are richer and/or grow faster than others.
(The two are clearly related, since countries that grow faster will eventually be richer.) Some examples are
given in Figure 2, which graphs per capita GDP for three countries over the postwar period. [All are
measured in 1980 US dollars.] This figure differs from the previous one, since I've expressed output in per
capita (per person) terms by dividing GDP by population. This produces a more meaningful comparison
between countries, since countries with more people don't automatically have higher numbers.
Figure 2 illustrates a number of differences among three countries: Japan, Argentina, and the US. Perhaps the
most obvious feature is that the US is the richest country: by this measure in 1985, it was 30 percent richer
than Japan and almost three times as rich as Argentina. These are averages so they ignore a lot of differences
at the individual level, but they give you some idea of where these nations stand economically. The
comparison with Argentina gives us an idea of the enormous differences between rich and poor countries. In
fact, Argentineans are relatively well off, roughly five times better off than an average person in India. But
the truly remarkable country is Japan. In 1913 Argentina was about 3 times richer than Japan, now it's the
opposite. Japan's remarkable performance has lasted, thus far, for over a century. Argentina, on the other
hand, has gone from one of the richest countries in the world at the turn of the century to an average Latin
American country economically that experienced a severe economic and financial crisis in 2001.

Figure 3 does the same thing for the US, China, and Korea, where again we see sharp differences between
countries. China used to be one of the poorest of these countries but for the last 20 years China has been
among the most rapidly growing countries in the world. Combined with China's enormous population, some
estimates suggest that China is now the world's third largest market.
These comparisons are so striking I find it hard to leave them, but let's turn our attention to the other aspect of
macroeconomics, business cycles. From a business point of view these short-term movements in the economy
https://pages.stern.nyu.edu/~nroubini/NOTES/CHAP1.HTM 1/29
are of more immediate concern. You may want to know, for example, whether the economy will be in better
shape when you finish your degree or whether your airline stock is going to be worth anything in 12 months
(airlines are notoriously sensitive to recessions). You get a much better picture of the short-term fluctuations
in Figure 4, where we graph annual growth rates of US GDP.
By annual growth rate, I mean the "year-on-year'' growth rate in quarterly data,
(GDPt - GDPt-4) /GDPt-4

where GDPt is GDP in quarter t (for example the third quarter of 2005) and GDPt-4 is GDP four quarters
before (for example the third quarter of 2004). Viewed from this perspective, the short-term movements seem
a lot bigger than they did in Figure 1. For the postwar period as a whole the average growth rate of 3.3
percent per year is swamped by the year-to-year variations. [Statistically, we could say that the mean of 3.3
percent per year is only slightly larger than the standard deviation of 3.0 percent. A plus or minus two
standard deviation interval is thus (-2.7,9.3). If you find this mysterious, review your statistics notes.] The
nine downward spikes, all of which touch or pass the axis, are the nine postwar recessions, defined most
simply as two consecutive quarters of declining GDP. The National Bureau of Economic Research, the de
facto arbiter of business cycles in the US, has decided that the troughs (the bottom point) of these recessions
occurred in November 1949, May 1954, April 1958, February 1961, November 1970, March 1975, July 1980,
November 1982, April 1992 and November 2001.
Note that in Figure 4 the growth rate of GDP is defined as year-on-year growth rate of quarterly GDP. Note
that there is an alternative way to define the growth rate of the economy: this is the way the growth rate of
GDP is usually reported by the US Government and the press. It consists of measuring the growth rate of
GDP in a particular quarter relative to the previous quarter and annualize such quarterly rate of growth by
multiplying by four. Accordingly, the quarterly growth rate of the economy at an annual rate (AR) is:
4 x [(GDPt - GDPt-1) /GDPt-1 ]

Figure 4' shows the growth rate of GDP according to this alternative measure. As a comparison of figures 4
and 4' shows, the second way of expressing the growth rate of the economy implies a greater volatility of
output growth as quarterly changes in the rates of growth are amplified when measured at annualized rates.
As the annualized quarterly growth rate gives a better measure of the very recent performance of the
economy, this is the measure usually reported in the press and most closely analyzed in the business and
financial sector. However, the year-on-year definition gives a better measure of the growth rate of the
economy over a longer period, i.e. how the economy has actually grown over the last 4 quarters. A similar
distinction between year-on-year growth rate and annualized quarterly growth rate holds for the other
macroeconomic variables. To create quick charts of macro variables using these alternative definitions, you
can use the Economic Chart Dispenser available on the Web. Tables with the most recent GDP data is
available from the Bureau of Economic Analysis at the Department of Commerce. For more information on
specific macroeconomic variables see the course homepage on the Hyptertext Glossary of Business Cycle
Indicators.
One question you might ask is why the economy experiences such large short-term fluctuations. We'll return
to this later in the course. For now let me just say that recessions happen: business cycles have been a
property of all economies for as long as we've had data and, despite what politicians tell us, they show no
sign of going away. You can see signs of cycles in other countries in Figure 5. In Figure 5 I report growth
rates of real GNP (total, not per capita) in Germany and Japan, where we see that they, too, have had
substantial fluctuations, despite their higher average growth rates. For Japan, though, there would be only
recessions between World War II and 1990 if we defined a recession, as is typically done in the US, as
negative growth. Note, however, that in the 1990s, Japan experience a period of protracted economic
stagnation. The average growth rate per year was close to zero between 1992 and 1995. Growth recovered in
1996 but such recovery fizzled in 1997 when the economy went again into a slump. The weak economic
performance of Japan in the 1990s and 1997 in particular contributed to exacerbate the 1997 economic crisis
in East Asia: as Japan is a leading export market for many East Asian countries, the stagnation of growth in
Japan in this decade led to a reduction (since 1995) in the export growth rate of many East Asian countries.
Gross Domestic Product

Today we're going to go behind the scenes, as it were, and review some of the measurement issues that lie
behind concepts like GDP and GNP. The goal is to gain some familiarity with the most important
macroeconomic indicators so that we know something about their meanings, strengths, and weaknesses. We'll
start with an accounting system analogous to the income statement used by firms: the National Income and
Product Accounts (NIPA) constructed by the Bureau of Economic Analysis at the Department of Commerce.
In many respects this system is like financial accounting systems for firms and, in fact, relies heavily on
reports made by individual firms to the government. It's also like firm accounting in that one needs to use
some artistry to make sense of the numbers.
Our first goal is a measure of overall production, which we will refer to as Gross Domestic Product, or GDP.
Gross National Product, or GNP, is closely related. Both are measures of the total production of goods and
services of the US economy for a particular time period---say, the year 2004 or the first quarter of 2005
(January through March). We will discuss below the difference between these two measures.
We can think of total production in the US as the sum of production by all the individual firms, but there's a
subtlety here that we can illustrate with a simple example. Consider a firm that assembles PCs from parts
made in Taiwan. Its only other expenses are labor. Let's say that the firm's income statement looks something
like this:
Sales revenue 40,000,000
Expenses 26,000,000
Wages 20,000,000

Cost of Parts 6,000,000
Net Income 14,000,000
The question is how we measure this firm's contribution to US output. The straightforward answer is 40m, the
total value of its sales. But if we think about this a minute we realize that 6m of this was produced
somewhere else, so it shouldn't be counted as part of the firm's---or the US's---output. A better answer is 34m,
the amount of value the firm has added to the imported parts. This principle is applied throughout the NIPA:
we take value-added by everyone in the economy and add it up to get GDP. When we sum across firms, we
only count the value added by each one. US GDP is total value-added for the US economy.
Another way to compute value-added is to sum payments to labor and capital. In this case we add 20m paid
to workers to 14m profit that goes to owners of the firm---capital. That gives us factor payments of 34m, the
same number we found above using a different method, factor being a term used by economists to mean
inputs
The term value-added has the connotation that the prices that underlie the firm's income statement reflect
economic value in some deeper sense. When we compared the GDP's of three countries earlier we presumed
that the country with the larger per capita GDP was richer in some useful sense. But suppose they produce
different goods. Suppose country A produces 10 billion apples and country B produces 10 billion bananas.
Which is richer? We generally assume that if apples are worth more than bananas then country A is richer.
The idea is that market prices tell us which is more valuable, apples or bananas. The same thing underlies our
measurement of value-added. Suppose, to make this concrete, that the 40m sales of our fictitious company
was 20,000 PCs at $2,000 each. Our presumption is that the market price of $2,000 reflects economic value
and we use it as part of our calculation of GDP. In some cases this isn't so easy. In, say, North Korea (or until
recently, China), prices do not generally reflect market forces, so it's not easy to calculate economic values.
There are also some subtle issues in market economies about how to value nonmarket activities like
government spending, housework, pollution, and so on.
I promised a little while ago to mention the difference between GDP and GNP. GDP is, to me, the more
natural concept. It measures total value-added produced by firms operating in the US. GNP, on the other
hand, measures value-added generated by factor inputs, capital and labor, owned by Americans. This is
slightly different because there are foreign factors (labor and capital) producing in the US and American
factors producing abroad. Here's a concrete example. An American working in London for Goldman Sachs
would count in US GNP but not US GDP. She would also count in British GDP, since she's working there.
To clarify the distinction between GDP and GDP take the following example. Suppose that the firm we
considered before is partly owned by Japanese owners. Let us also assume that some of the workers in the
firm are Japanese managers temporarily working in the U.S. Then:
Expenses 26,000,000
Wages 20,000,000

Paid to US workers 18,000,000
Paid to Japanese managers 2,000,000

Paid to American owners 9,000,000
Paid to Japanese owners 5,000,000
In this example:
GDP = 34m = 40m - 6m = 20m + 14m
GNP = GDP - 2m - 5m = 27m = 18m + 9m

GNP = GDP - factors payments to foreigners (dividends, interest, rent to foreign residents owning assets in
the US and wages of foreign residents working in the US) + factor payments from abroad to US residents
(dividends, interest, rent to US residents owning assets abroad and wages of Americans working abroad).
The difference between GDP and GNP is not very large in the U.S but can be very large for countries such
as Mexico that have a large amount of foreign debt on which they pay interest to foreigners and countries
such as Ireland where a large fraction of the factories are owned by foreign multinationals that receive profits
and royalties on their Irish operations.
Examples (1987 data):
GDP + Net Factor Income(+) = GNP % difference

Payments (-) Abroad between the two
US 4540 4 4544 0.08

Mexico 192 -9 183 -4.9
Ireland 19.9 -1.9 18 -10
Let us define the Net Foreign Assets (NFA) of a country, say the U.S, as:
NFA = Net Foreign Assets = Assets owned by Americans abroad - Liabilities of Americans
towards foreigners = US Foreign Assets - US Foreign Debt
Assets (and liabilities) include stocks, bonds, loans from banks and other sources, real estate, firm ownership
and so on.
If NFA > 0, the country is a creditor country.
If NFA < 0, the country is a debtor country.

If we define with i the:
i = average interest rate (rate of return) on net foreign assets (foreign assets - foreign
liabilities)
i NFA = Net factor income from abroad = interest rate times net foreign assets.
Then the GNP is :
GNP = GDP + i NFA = GDP + Net factor income from abroad

Given the above identity, it is easy to see that GNP will be greater (smaller) than GDP if the country is a net
creditor (net debtor).
Some examples of the national accounts at work:
1. GDP at factor cost. You'll note in the PC example that we could calculate value-added in two equivalent
ways. We can take sales and subtract costs of raw materials: 40m - 6m = 34m. Or we could add up the profits
and payments to labor: 20m + 14m = 34m. Double-entry bookkeeping always allows you multiple ways of
deriving any number. Both of these methods are used in constructing the national accounts in the US. When
there are capital costs these are counted, too, as part of value-added and GDP (next section).
2. Government services. Here there is no figure analogous to sales (unless you think of taxes this way). In the
national accounts, value-added is generally computed by adding together payments to labor and (sometimes)
capital. For example, payments to Commerce Department employees count as value-added in government
services.
3. Imported oil. Suppose that the US economy continues to produce the same quantities of output at the same
prices after an increase in the price of oil. The value of this output is, by assumption, the same after oil prices
rise, but with more of this value going to oil producers a smaller share is left for domestic factors, capital and
labor. The price increase thus leads to a decline in value-added. [Think of the PC assembler: if the cost of
parts rises to 8m, what happens to value-added if other costs and revenues stay the same?]
4. Underground economy. By practical necessity only market activity is measured. The old example, not
especially relevant these days, is that maids count in GDP but housewives do not. There's some question
about the entire underground economy, which by its nature is hard to monitor and does not show up in GDP
or GNP. In a curious example, economists recently estimated that Italy had a GDP as large as the UK once
they included an estimate of its underground economy.
5. Clean air. There is no market transaction for clean air and pollution, so this aspect of our quality of life is
not incorporated in GDP. GDP is not, then, a catchall measure of our well-being. What does show up in GDP
is expenditures on pollution control equipment. [Perhaps the EPA's plan to allow firms to trade pollution
rights in open markets will change this.]
Accounting Identities
By the magic of double entry bookkeeping, we can divide GDP up in a number of ways. This will give us
several identities that will reappear in different guises throughout the course.
The first is to think of value-added as payments to labor and capital. The point is that sales revenue shows up
as income to someone. Intermediate goods are income to the firm that makes them, wages are income to
workers, and profits are income to the people who own the firm. As a result, we can think of GDP as
measuring either income or output: the two numbers are the same thing.
Let's go back to our PC assembler to see this in action, adding a few things to make it more realistic.
Expenses 32,000,000
Wages 20,000,000

Interest 2,000,000
Depreciation of capital 4,000,000

Thus we can divide value-added (34m) into payments to labor (20m) and payments to capital
(14m=2m+4m+8m). Since we are including depreciation in our measure of output, we refer to it as gross
output---gross of depreciation. That's why we call our output number GDP---G for gross. Net Domestic
Product (NDP) is GDP minus depreciation:
Net Domestic Product = GDP - Depreciation = 34m - 4m = 30m
The reason we tend to stick with GDP is that economic depreciation (as opposed to what shows up on
financial statements and tax returns) is difficult to measure.
The national income and product accounts do this at the aggregate level, with a couple added complications.
The numbers in 1994 looked like this (in billions of dollars):
1. National Income 5,495.1
2. Compensation of employees 4,008.3
3. Proprietor's income 450.9
4. Corporate Profits 526.2
5. Rents 116.6
6. Net Interest 392.8
This is basically the same thing we did for the firm. Line 2 is labor expenses, lines 4 are corporate profits, line
3 is a combination (for unincorporated businesses, like farmers and doctors, it's not easy to separate labor and
capital expenses). On average, about 60-70 percent of gross output goes to labor, the rest to capital (including
corporate profits, rents, net interest and proprietor's income). The point is that GDP measures both production
of goods and services and income to workers and owners: by the logic of double entry bookkeeping, the two
are inseparable.
Our second look at GDP comes from the perspective of purchases of final goods: who buys them (consumers,
firms, governments, or foreigners). The most common decomposition of this sort is
GDP = consumer expenditures + investment + government purchases of goods and services

+ net exports,
or, in a more compact notation,
GDP = C + I + G + NX.
Net exports is simply exports (X) minus imports (M) or NX = X - M. Net exports are also referred to as the
trade balance. Consumption is expenditures on consumer goods by households. Investment in this course will
always mean accumulation of physical capital: purchases of new buildings and machines, plant and
equipment in the language of national income accountants (a close relative of the beloved PPE of financial
accounting). It also includes accumulation of inventories (that is, the change in stocks of inventories).
Government consumption here consists of purchases of goods and services (mainly wages) and does not
include government outlays for social security, unemployment insurance, or interest on the debt. We think of
these, instead, as transfers, since no goods or services are involved. We'll see more of this when we look at
the government deficit. U.S. data on the various components of GDP are contained in Tables published in the
Economic Report of the President. The data for 1994 are as follows:
% Share of GDP

GDP 6931.4 100%
Consumption 4698.7 67.8%
Durable Goods 580.9
Non-Durable Goods 1429.7
Services 2688.1
Gross Private Domestic Investment 1014.4 14.6%
Non Residential 667.2
Residential 287.7
Change in Bus. Inventories 59.5
Government Consumption 1314.7 18.9%
Net Exports of Goods and Services -96.4 -1.3%
Exports 722.0 10.5%
Imports 818.4 11.8%
.............................................
Net Factor Incomes from abroad -9.0
GNP 6922.4
This gives us the same number for GDP as our previous method of summing value-added across firms.
Although purchases of domestic intermediate goods (steering wheels) do not show up explicitly, they are
incorporated in the value of final goods (cars). For firms as a group, domestically produced intermediate
goods net out: a sale by the steering wheel company, an equivalent purchase by the car company. Purchases
of foreign intermediate goods show up as imports.
Given the definition of net exports as X-M, we can also rewrite the national income identity as:
GDP + M = C + I + G + X
The left hand side of the expression represents the total supply of goods available in the country; such a
supply is the sum domestic supply (GDP or domestically produced goods) and foreign supply of goods
(imports). The right hand side says that the total supply of goods is purchased either by private consumers
(C), firms for investment purposes (I), the government for its own public consumption (G) or foreign agents
in the form of exports (X).
The Current Account

We will now define a very important concept, the current account of the balance of payments, that is quite
related to the trade balance (net exports, NX).
Given the definition of GNP, we also get:
GNPt = GDPt + it NFAt = Ct + It + Gt + (NXt + it NFAt ) =
= Ct + It + Gt + CAt
where:
CAt = NXt + it NFAt
Current Account = Trade Balance + Net Factor Income from abroad

The subscript t refers to a period t variable. If we take data ar a yearly frequency, GNPt would be GNP in year
t, say 1997. The difference between the trade balance and the CA can be very large if a country is a large
creditor or debtor.
Example: Brazil in 1986.
NX = + $ 8.3b
CA = - $ 5.3b
i NFA = -$ 13.6b
In this example, Brazil had in 1986 a large current account deficit in spite of a trade surplus. In fact, Brazil
was a heavy foreign debtor, having borrowed a lot in the 1970s and 1980s. By 1986 the total foreign debt of
Brazil was above $100b and the net foreign interest payments on that debt (and profit repatriations of foreign
firms owning assets in Brazil) equaled $13.6b.
As the table below shows, in Asia large current account deficits (as a share of the country GDP) were
prevalent in the 1990s. They resulted from very large trade deficits (NX<0) and, in some countries, large
interest payments on foreign debt (i NFA <0) ; such large current account imblances eventually led to the
currency and debt crisis of 1997.
Current Account Balance (% of GDP)

1990 1991 1992 1993 1994 1995 1996
Korea -1.24 -3.16 -1.70 -0.16 -1.45 -1.91 -4.89

Indonesia -4.40 -4.40 -2.46 -0.82 -1.54 -4.25 -3.41
Malaysia -2.27 -9.08 -4.06 -10.11 -11.51 -13.45 -5.99
Philippines -6.30 -2.46 -3.17 -6.69 -3.74 -5.06 -5.86
Singapore 9.45 12.36 12.38 8.48 18.12 17.93 16.26
Thailand -8.74 -8.61 -6.28 -6.50 -7.16 -9.00 -9.18
Hong Kong 8.40 6.58 5.26 8.14 1.98 -2.21 0.58
China 3.02 3.07 1.09 -2.17 1.17 1.02 -0.34

To understand better why a country may be running a current account deficit or surplus, one should notice
that the current account is the difference between what a country produces (GNP) and what the country
spends (total consumption plus investment). In fact:
CA = GNP - (C + G + I)
where GNP is income and (C +G +I) is domestic spending for consumption and investment purposes
(formally called "absorption"). If a country produces more than it spends, the excess of goods produced over
those bought at home for consumption and investment purposes must be on net exported to the rest of the
world (a positive external balance). So, if GNP > Absorption, the external balance is positive or, equivalently,
the current account is in surplus. Viceversa, if If a country produces less than it spends, the excess demand of
goods for consumption and investment purposes over income/production must be on net imported from the
rest of the world (a negative external balance). So, if GNP < Absorption, the external balance is negative or,
equivalently, the current account is in deficit.
Another way to understand the current account is to see that it is the difference between national savings and
national investment. In fact, as for an individual, we can define savings as the difference between income and
spending for consumption purposes. If I consume more (less) than my income my savings are negative
(positive). In the case of a country consumption is made both by the private (C) and public sector (G). So, by
definition, national savings are equal to:
S = GNP - C - G
Substituting this definition of savings in the expression for the current account, we get:
CA = S - I

To see why the current account is equal to the difference between savings and investment, consider the
similarity of a country with an individual. For simplicity, suppose initially that the investment of the
individual is zero and that G=0. If an individual consumes (C) more than his/her income (GNP), the savings
(S=GNP-C) of the individual will be negative (S<0). Since the individual investment is zero, the current
account of the individual will be equal to his/her savings (CA=S<0). So, an individual with negative savings
has a deficit in its current account. In a similar way, if I=0, a country running a current account deficit is
consuming (including both public and private consumption) more than it is producing as CA = S = GNP-C-G.
Consider now how positive investment (I>0) changes things. Take again the case of an individual who has
now positive savings (S=GNP-C >0). Suppose now that the individual makes real investments; for example,
he/she may buy a new home (residential investment). Suppose that the investment in the new home is greater
than the savings of the individual (I > S) as it is usually the case. In this case the current account of the
individual is in deficit as CA = S - I <0. Since the income of the individual (GNP) is less than his/her total
spending (for consumption and investment), the individual current account is in deficit, or the individual's
savings are below the individual's investment. The same story holds for a country. If a country invests more
than its saves, the country is producing an amount of output/income (GNP) that smaller than the total
spending on goods for consumption and investment purposes (C+G+I). Therefore, the excess of spending
(absorption) over income or, equivalently, the excess of investment over savings implies that the country is
running a current account deficit.

Insight in the Asian economic crisis: Why current account deficits

lead to the accumulation of a large stock of foreign debt.
It is very important to understand that if a country runs a current account deficit (CA<0), as it is the case in
many developing countries such as those currently in crisis in Asia , this means that the country is borrowing
from the rest of the world and its foreign debt will increase over time. Thus, flows (items on income and cash
flow statements) translate into changes in stocks (balance sheet items, like household wealth, the stock of
capital, government debt, and net foreign debt).
To understand this important point, we need to be more specific about the distinction between stocks and
flows. A stock is measured at a particular point in time such as the stock of capital at the end of 1997. A flow
instead represents the change in the stock over a particular period of time: for example net investment in
capital in the year 1997 is equal to the difference between the stock of capital between the end of 1997 and
the end of 1996. So, if we define with K the stock of physical capital, this stock is related to the flow of net
investment (I - depreciation) by:
Kt+1 = Kt+ It - Depreciationt
or:
Stock of K at time t+1 = Stock of K at time t + (Net Investment in new capital in period t)
Then, the flow of new investment is equal to the change in the stock of capital
It - Depreciationt = Kt+1 - Kt
Note that macroeconomists typically measure K at replacement cost rather than book value.
Similarly, the current account in the year 1997 is equal to the difference in the stock of net foreign assets of
the country between the end of 1997 and the end of 1996. A current account surplus results in an increase in
the net foreign assets of a country while a current account deficit results in a decrease of these assets or, if the
country is already a net debtor, it results in an increase in the net foreign debt of the country.
To understand why a current account deficit leads to an increase in the stock of foreign debt of a country,
consider the similarity of a country with the budget constraint of an individual. For simplicity, suppose
initially that the investment of the individual is zero (I=0). If an individual consumes (C) more than his/her
income (GNP), the savings (S=GNP-C) of the individual will be negative (S<0). Since the individual
investment is zero, the current account of the individual will be equal to his/her savings (CA=S<0). So, an
individual with negative savings has a deficit in its current account. If the individual has an initial positive
wealth (NFA=(Assets-Liabilities)>0), then these negative savings (current account deficit) will lead to a fall
of his/her net wealth (assets minus liabilities) as he/she will run down his/her assets or, for given gross assets,
he/she will borrow to pay for the excess of the consumption over income. In either case (regardless whether
gross assets are run down or new gross borrowing are made) his/her net wealth will fall as personal assets fall
and/or personal debt goes up. If savings are negative year after year, at some point net assets will fall to zero
and the individual will become a net debtor (assets-liabilities < 0). In this case negative savings will lead over
time to a growing net debt of the individual.
In a similar way, if I=0, a country running a current account deficit is consuming (including both public
and private consumption) more than it is producing as CA = S = GNP - C- G. Therefore, to finance such a
deficit the country needs to run down its assets and/or borrow to pay for the excess of consumption (C+G)
over income/output (GNP). In either case (regardless whether gross assets are run down or new gross foreign
borrowing are made) the country's net foreign wealth (NFA = Foreign Assets - Foreign Liabilities) will fall as
foreign assets fall and/or foreign debt goes up. If the country is initially a net creditor (NFA>0), over time
current account deficits will lead the country to become a net debtor (NFA<0) as net assets fall and eventually
become negative; to finance the deficit, each year the country will borrow from the rest of the world an
amount of funds that is equal to the excess of income over consumption. So the new borrowing (the increase
in foreign debt) is equal each year to the current account deficit. So, if a country is already a net debtor,
further current account deficits will lead this country to increase its stock of net foreign debt.
Consider now how investment changes things. Take again the case of an individual who has now positive
savings (S=GNP-C >0). Suppose now that the individual makes real investments; for example, he may buy a
new home (residential investment). Suppose that the investment in the new home is greater than the savings
of the individual (I > S) as it is usually the case. In this case the current account of the individual is in deficit
as CA = S - I <0. To finance the excess of his/her investment over savings, the individual can do two things:
either run down his/her financial assets (if there are enough assets to be run down) and/or borrow to finance
the new investment. In either case, the excess of I over S leads to a reduction of the net assets (assets-
liabilities) of the individual. If such current account deficits occur over time net assets will fall to zero and the
individual will become a net debtor; the increase in stock of debt will be each year equal to the current
account deficit.
The same holds for a country that has a current account deficit. If a country invests more than its saves, it
has to borrow from the rest of the world to finance this deficit. In fact, a CA deficit means that the country is
producing an amount of output/income (GNP) that falls short of the total spending on the goods of the
country ( the sum of consumption and investment):
CA = GNP - C - G - I
To finance the excess of investment over savings, the country can do two things: either run down its financial
foreign assets (if there are enough foreign assets to be run down) and/or borrow from the rest of the world to
finance the new investment. In either case, the excess of I over S leads to a reduction of the net foreign assets
(foreign assets - foreign liabilities) of the individual. If such current account deficits continue year after year
net foreign assets will fall to zero and the country will become a net debtor; in each year the increase in stock
of foreign debt will be equal to the current account deficit. More formally, the change in the net foreign asset
of a country (a change in stocks) will therefore be equal to the current account (a flow) or:
NFAt+1 - NFAt = CAt
If CA>0 net foreign assets will increase (or net foreign debt will become smaller if the country was starting
with net foreign debt, NFA<0); if CA<0 net foreign assets will decrease (or net foreign debt will become
bigger if the country was starting with net foreign debt, NFA<0). In each period net foreign borrowing will be
equal to the current account deficit (or net accumulation of foreign assets will be equal to the current account
surplus).
Another way to see that the previous equation holds is to notice that the net foreign assets at the beginning of
next period (t+1) must be equal to those in period t plus total national income (GNP) minus the part of
national income that is consumed (C and G) or invested (I):
NFAt+1 = NFAt + GDPt + it NFAt - Ct - Gt - It = NFAt + CAt
Therefore:
NFAt+1 = NFAt + CAt = NFAt + NXt + it NFAt

We refer to NFAt as the initial balance and NFAt+1 as the ending balance.
The above discussion clarifies why some countries have a very large stock of foreign debt: like in the case of
an individual, if you consume and invest more than you produce (earn income) year after year, you must
borrow over time to finance this current account deficit (excess of consumption and investment over income
or excess of investment over savings). Therefore, your individual's or country's net foreign debt must increase
over time. So countries with a large stock of foreign debt have had in the past large current account deficits
that have led to an accumulation of this debt. This is very important to understand what happened in Asia in
1997. During the 1990s, all the Asian "crisis countries" run very large and increasing current account deficits
as their national income (GNP) was below their domestic absorption (C+G+I) (or as their investment rates I
were above their savings rates); this led to a large accumulation of foreign debt that eventually became
unsustainable.
What Causes Current Account Deficits? Are Such Deficits Bad?

Now that we have understood the meaning of the current account and how it relates to the foreign debt of the
country, we want to analyze in more detail the link between the current account, private savings and
government budget deficits. This will help us to understand whether current account deficits are caused by
budget deficits (the "twin deficits" hypothesis).
We take our earlier national income account identity (GNP = C + I + G + CA) and do a little algebra to get:
(GNPt -Tt -Ct ) = It + (Gt -Tt ) + CAt ,
where
GNPt - Tt - Ct = Stp= Private Savings
and Tt are taxes collected by the government (TXt ) net of transfer payments (TRt ) and interest payments on
the public debt (it Debtt ). So:
Tt = TXt - TR t - it Debtt .
T is intended to measure all revenues and expenses of the government not included in G, so G-T is the
government deficit, NIPA version, a close relative of the number bandied about in the business press. It's only
a relative because (i) the press generally focuses only on the federal government and (ii) the Administration
and Congress typically have more imaginative measures of the deficit. Note the sign convention: unlike what
you generally do in accounting, a deficit is a positive value of G-T. Continuing with the identity: GNP-T
measures the amount of income households have on hand once we take into account things like taxes paid to
the government, social security payments, and interest on the government debt. GNP-T-C is thus the amount
of income households do not spend on goods and services, namely private saving Sp. Conversely, we can
define public (government savings) Sg as the difference between government revenues and spending. So:
Deft = (Gt - Tt ) = Gt - TXt + TRt + it Debtt = - Stg
or
Stg = - Deft = Tt - Gt
Thus we can write the identity
Stp = It+ Deft + CAt (1)
where Def = G-T is the government deficit as measured by the NIPA. This connects private saving,
investment, the government deficit (negative public savings) and the trade balance. Sometimes we combine S
and Def, as in
St = Stp - Deft = Stp+ Stg = It + CAt
or
St = It + CAt (2)
that implies our earlier definition of the current account:
CAt = St - It(3)
where S is a comprehensive measure of national savings, the sum of private and public savings or, if the
government is running a deficit, it is total savings net of government dissavings.
The first identity (1), which is based on flows of goods, suggests our earlier interpretation of how current
accounts lead to a change in the stock of assets. Private savings, under this interpretation, are a source of new
financial capital, since saving leads to purchases of assets. Savers can purchase either corporate securities
(which finance new investment by firms in plant and equipment, I), government securities (which go to
finance the government deficit, Def), or foreign securities (which finance a current account surplus if CA is
positive); the latter purchase of foreign assets leads to an accumulation of net foreign assets. If the CA is
negative, this means that private savings are not enough to finance both investment and the budget deficit;
therefore foreign savings (borrowing from the rest of the world in the form of an accumulation of foreign
debt) is required to finance the excess demand of funds by firms (for investment) or government (for deficit
financing purposes) relative to the quantity of private savings . This also tells us, for example, that the
government and private industry may be competitors in capital markets for the pool of private savings: if the
government takes more, there is less to support private investment. The second identity expresses national
savings (S) as equal to national investment (I) plus the current account (CA). The third identity expresses the
current account (CA) as the difference between national savings (S) and national investment (I).
There are a couple of connections here that get one thinking about the operation of the economy. One is the
connection between the government deficit (Def = G-T) and the current account deficit (-CA ). A government
deficit must be matched by some combination of higher saving, lower investment, or a trade deficit. To the
extent it's the latter, a large government deficit will be associated with a large trade (current account) deficit.
One of the questions we want to keep in mind for the future is whether the trade deficit is largely the result of
the government deficit, rather than more fundamental problems with US competitiveness. Another issue is the
relation between saving and growth. Two of the things we know are (i) countries that save a lot are also
countries that invest a lot and (ii) countries that invest a lot grow faster. We'll return to (ii) in a week or two.
For now, let me say simply it's not clear what the direction of causality here: whether higher investment leads
countries to grow faster, or countries that grow fast for other reasons (technology?) invest a lot. It's clear,
though, that growth and investment are closely related in the data. As for (i), I've computed ratios of S, I, and
CA to real GNP (defined with the variable Y) for a number of major countries, and reported them in Table 1.
The definition of saving is here total national savings
S=Y-C-G
We then have the identity S = I + CA . You see in Table 1 that the US saves and invests much less, as a
fraction of national output, than most other developed countries. Japan, on the other hand, saves and invests
substantially more. You might plot the growth rates vs saving and investment rates to see how they are
related.
Finally, note that, given our definition of budget deficits, and our previous discussion of how flows lead to
changes in stocks, we can show that a government deficit results in an increase in the stock of government
debt or:
Debtt+1 = Debtt+ Gt - Tt = Debtt+ (Gt + TRt - TXt) + it Debtt
We refer to Debtt as the beginning balance and Debtt+1 as the ending balance.
Another detail. You might be asking yourself (if not, don't) why all taxes are paid by households: what about
the corporate income tax? The answer is that firms are owned (for the most part) by households and we are
consolidating their books. We attribute to households all the before-tax profits of firms (in value added). We
then have them pay the firms' taxes. This is equivalent to just giving them after-tax profits in the first place.
The only fudging arises with firms not owned by Americans. In the real accounts the rest of the world (i.e.,
foreigners) can own some US firms, pay taxes, collect interest on US government debt, and so on, which
would complicate the international part of the accounts. For most of this course we'll ignore that to make
things simpler. Life is complicated enough as it is.

Are Current Account Deficits Good or Bad? Are Large Deficits Sustainable?
The recent experience in Asia shows that large current account deficits led to an accumulation of foreign debt
that eventualy became unsustainable and led to a currency crisis. This leads to the following question: is it a
bad idea to run a current account deficit? The answer is actually quite complex because running a current
account deficit may me a good or bad, sustainable or not sustainable, depending on the cause of the current
account deficit.
To specify a definition of sustainability, consider a situation where current macroeconomic conditions

continue (i.e. there are no exogenous shocks) and that there are no changes in macroeconomic policy. In this
instance the current account deficit can be argued to be sustainable as long as no external sector crisis occurs.
An external sector crisis could come in the form of an exchange rate crisis or a foreign debt crisis. An
exchange rate crisis could be a panic that leads to the rapid depreciation of the currency or a run on the
central bank’s foreign exchange reserves. A debt crisis could be the inability to obtain further international
financing or to meet repayments or an actual default on debt obligations. A sustainable current account deficit
is one that can be maintained without any of these crises occurring. Of course, sustainability can only be
judged after the fact, but we will be examining the characteristics of the economy that are indicative of crises
occurring.
If we rewrite our definition of the current account, we can see that there are three main causes of current
account deficits:
CAt = Stp - It - Deft
A current account deficit may be caused by:
1. An increase in national investment
2. A fall in national savings; specifically:
2a. A fall in private savings and/or

2b. An increase in budget deficits (a fall in public savings).
We want to show that a current account deficit may be bad or good depending on its source.
1. A boom in domestic investment.

We consider first the case where the current account deficit is caused by a boom in investment. In this case
running a current account deficit is a good idea and the accumulation of foreign debt associated with the
deficits should not be viewed with concern. To see why, notice that a country is like a firm. Suppose that a
firm has identified good profitable investment projects but that the savings of the firm (i.e. the firm's retained
earnings) are below the value of profitable investment projects. Then, it makes sense for the firm to go to
capital markets external to the firm and borrow funds equal to the difference between the value of the new
investment projects and the firm's savings (retained earnings). This firm borrowing can take various forms: it
could borrow funds from banks; it could issue corporate bonds or it could issue new equity that is purchased
by agents in the economy. Such borrowing by the firms is optimal as long as the financed investment projects
are profitable (i.e. as long as the return on the investment is as high as the cost of borrowed funds). In fact,
over time, the earnings generated by the capital created by the new investment will be sufficient to pay back
the principal and interest on the borrowed funds.
Now, note that a country is like a firm as in a country thousands of firms make individual investment
decisions. Suppose that the country experiences an investment boom. The reasons for such investment boom
can be several: new natural resources are found in the country (oil, minerals); technological progress leads to
new products that can be profitably developed and produced; structural economic reforms (like trade
liberalization or capital market liberalization) or macroeconomic stabilization policies (such as a reduction in
inflation, a cut in budget deficits and reduction in distortionary taxes on income and capital) lead to
expectation of high future economic growth and high profitability of new investments.
In all these cases, the country will have an investment boom that has to be financed with some savings. If the
national savings of the country (the sum of private and public savings) are not sufficient to finance all new
profitable investment projects, then it is optimal for the country (like it was for a firm) to run a current
account deficit, i.e. rely on foreign savings to finance the excess of investment over national savings. Such a
current account deficit will imply the accumulation of new foreign debt, i.e. a capital inflow as foreign funds
will be borrowed to finance domestic investment. The forms of such a capital inflow are similar to those of a
firm. First, the country (or better the country's firms) could directly borrow from foreign banks; second, the
domestic firms could borrow from domestic banks but these in turn borrow from foreign banks; third, the firm
could issue new bonds that are bought by foreign investors; fourth, the firm can issue new equity that is
purchased by foreign investors. Finally, if the new investment is originally made by a foreign firm that has
decided to build a new plant in the domestic economy, the flow of foreign capital that finances this
investment project is called Foreign Direct Investment (FDI). In all these cases, a current account deficit
(CA= S-I <0) is financed by some form of foreign saving (foreign capital). And, as in the case of a domestic
firm, it is optimal for the country to borrow funds from the rest of the world and accumulate foreign debt as
long as the new investment projects are profitable. Over time, the goods produced by the new capital will lead
to increased country exports that will generate the trade and current account surpluses that are necessary to
eventually repay the foreign debt and interest on it.
So, in general a persistent current account deficit and foreign debt accumulation generated by a boom in
investment should not be considered with too much concern and it might actually increase the rate of growth
of an economy where domestic savings are not sufficient to finance all profitable investment projects. There
are however several caveats to be made to this argument.
First, borrowing form the rest of the world to finance investment that produces new goods is especially
good if the new investments are in the traded sector of the economy (i.e. the sectors of the economy that
produce goods that can be sold in foreign markets). In fact, at some point in time the foreign debt has to be
repaid back and, for a country, the only way to pay back foreign debt it to run at some point trade and current
account surpluses. If the new investments are instead in the non-traded sector of the economy (such as
commercial and residential investment), they create goods (housing services) that cannot be sold abroad. So,
in this case the long run ability of the country to repay its debts through trade surpluses may be limited and
this can create a problem. For example, many Asian countries in the 1990s were running large and increasing
current account deficits that were financing new and excessive investments in the non-traded real estate sector
(residential and commercial building). Such investments went bust in 1996-97 because of a glut of real estate
and the collapse of the real estate asset price bubble that lead to a rapid fall in the price of land and real estate
values; then, the firms and individuals that had borrowed foreign funds (and/or the banks that had borrowed
the foreign funds and in turn lent these funds to domestic firms and households) to finance real estate
investments went all into a financial crisis. They had borrowed too much in foreign currency to finance
investments that had a low or negative returns. Moreover, the exchange rate depreciation associated with this
crisis made things worse as the value in domestic currency of funds borrowed in foreign currencies (Dollars,
Yen, Marks) increased enormously once the currencies depreciated rapidly. This real increase in the burden of
foreign debt caused a financial crisis for the banks, firms and individuals heavily exposed in non-traded
sectors (such as real estate) and led to widespread bankruptcies. So the first caveat is that is is dangerous to
run a current account deficit to finance excessive investments in non-traded sectors of the economy.
The second caveat is relevant both for traded sector firms and non-traded sector firms. Every firm knows
that it is optimal to borrow funds to finance investments only as long as the return on these investments are at
least as high as the cost of the borrowed funds; otherwise, a firm that borrowed too much and invested in bad
projects will eventually experience losses, a financial crisis and potentially go bankrupt if most investments
turn out to be bad. The story of the Asian crisis is in part one of a current account deficit and foreign debt
accumulation caused by a boom of investment that turned out to be excessive. In Asia, there were too many
investments (both in traded and non-traded sectors) that turned out to be not very profitable.
How can one rationally explain such overinvestment in wrong projects? Why did the firms make such
investments and borrow the funds? Why did the domestic banks lend them the funds and did not monitor the
quality of the investments? To see understand this we need to introduce some politics and the behavior of
governments. Many governments in Asia were trying to maximize the rate of economic growth; since growth
and the production of goods requires a lot of labor and capital, a necessary condition for high economic
growth is a very high rate of national investment. It appears that many governments in the region were
pursuing economic growth targets that were excessive. Governments gave incentives (such as subsidies) to
firms to invest too much and incentives to the domestic banks to borrow too much from abroad to finance
dubious investment projects by the firms.
Banks, in turn, borrowed too much from abroad for many reasons, mostly related to the implicit promise
of a government bail-out in case things went wrong: first, their risk capital was usually small and owners of
banks risked relatively little if the banks went bankrupt; second, several banks were public or controlled
indirectly by the government that was directing credit to politically favored firms, sectors and investment
projects; third, depositors of the banks were offered implicit or explicit deposit insurance and therefore did
not monitor the lending decisions of banks; fourth, the banks themselves were given implicit guarantees of a
government bail-out if their financial conditions went sour because of excessive foreign borrowing; fifth,
international banks (Japanese, American and European ones) lent vast sums of money to the domestic banks
of the Asian countries because they knew that governments would bail-out the domestic banks if things went
wrong. The outcome of all this was twofold: first, banks borrowed too much from abroad and lent too much
to domestic firms; second, because of all these implicit public guarantees of bail-out, the interest rate at which
domestic banks could borrow abroad and lend at home was low (relative to the riskiness of the projects being
financed) so that domestic firms invested too much in projects that were marginal if not outright not
profitable. Once these investment projects turned out not to be profitable, the firms (and the banks that lent
them large sum) found themselves with a huge amount of foreign debt (mostly in foreign currencies) that
could not be repaid. The exchange rate crisis that ensued made things only worse as the currency depreciation
dramatically increased real burden in domestic currencies of the debt that was denominated in foreign
currencies.
2. A current account deficit caused by a fall in national savings: a fall in private savings or an increase
in budget deficits (a fall in public savings).
Apart form the previous case of an investment boom, a current account deficits may also be caused by a fall
in national savings. A current account imbalance caused by a fall in the national savings rates can be due to
either a fall in private savings or in public savings (higher budget deficits). A fall in national savings caused
by lower public savings (higher budget deficit) is potentially more dangerous than a fall in private savings.
The reason for this is that a fall in private savings is more likely to be a transitory phenomenon while
structural public sector deficits are often hard to get rid of. The private savings rate will recover when future
income increases occur. On the other hand, large and persistent structural budget deficits may result in an
unsustainable build-up of foreign debt. For example, in the late 1970s many developing countries were
running very large budget deficits to finance large and growing government spending; to finance these
deficits, the governments borrowed heavily in the world capital markets (either directly from international
banks or indirectly by issuing bonds purchased by foreign investors). In this case, the large and growing
budget deficits led to large current account deficits and the accumulation of a very large stock of foreign debt.
By 1982, the size of this public foreign debt was so large (often close to or above 100% of GDP) that many
governments began having difficulties in repaying interest and/or principal on their foreign liabilities;
therefore, a severe Debt Crisis emerged in the 1980s with many countries risking default on their foreign
debt and having to negotiate a rescheduling of their foreign liabilities. So the lesson is that running current
account deficits and borrowing from abroad to finance budget deficits is a dangerous game that will
eventually lead to a debt crisis. Unlike firms that borrow to finance investment projects that will be eventually
self-financing (as they generate trade surpluses that will be used to repay the original foreign debt), fiscal
deficits are rarely self-financing, especially if such deficits are chronic, the result of excessive spending and
structural lack of tax revenues.
Unlike the case of a current account caused by a fall in public savings (a larger budget deficit), a current
account caused by a fall in private savings is usually considered with less concern. A fall in private savings
rate may be transitory and occur when expectations of higher future GDP growth result in an increase in
current consumption above current income. For example, an MBA student in school will usually have zero or
close to zero income in the two years he/she is in school. Since consumption is positive while in school (you
got to eat and cloth to live!), the student has negative savings (S=GNP-C < 0 as GNP=0 and C>0) and a
current account deficit. [Note also that the student is borrowing money not only to finance its negative
savings but also to finance its MBA tuition: this is an Investment in human capital that will eventually lead to
higher income; so it is also optimal to borrow to finance that tuition investment]. In this case, negative
savings lead to a current account deficit and accumulation of personal debt; however, this borrowing is
optimal since the student is consuming today not on the basis of his/her current low income but on the basis
of its permanent income that is high because of the expected higher income after school. So, this transitory
fall in savings and accumulation of debt is optimal since the higher income after school will be above
consumption and lead to the repayment of the debt incurred while in school. The same happens for a country:
an economic reform or stabilization may lead to a consumption boom (especially purchases of durable goods)
even if current incomes have not increased yet so much because households in the economy expect high
future incomes because of the expectations of future high economic growth. In this case, current consumption
(C) goes up a lot today while income (GNP) grows only over time; this consumption boom leads to a fall in
private savings; the ensuing current account deficit is financed (at the aggregate country level) through an
inflow of capital from abroad. This accumulation of foreign debt is not worrisome as long as future income
growth is realized and individuals are able to repay their debts (foreign liabilities).
Needless to say, many episodes of unsustainable current account deficits do not fit the patterns described. For
example, the deterioration of the current account balance in the years preceding the 1994 Mexican peso crisis
was largely due to a fall in private savings. In the Mexican episode, the boom in private consumption and the
sharp fall in private savings rates was fueled by the combined forces of overly optimistic expectations about
future growth and permanent income increase together with the loosening of liquidity constraints on
consumption deriving from the liberalization of domestic capital markets. Under such conditions, the fall in
private savings rates led to a rapid and eventually unsustainable current account deterioration. Moreover,
while the 1980s foreign debt crisis was caused by very large budget deficits, more recent episodes of debt
crisis do not seem to have their source in a fiscal imbalance. For example, the 1990-94 Mexican episode and
the 1997 Asian crises occurred in spite of the fact that the fiscal balances were in surplus; the large and
increasing current account deficits and foreign debt accumulation were caused by the private sector behavior,
a fall in private savings and an increase in investment. This suggests that current account deficits that are
driven by structurally low and falling private sector saving rates may be a matter of concern even if they are
the results of the "optimal" consumption and savings decisions of private agents. This is especially the case
when the private consumption boom, like in Asia in the 1990s, is in part the consequence of an excessively
rapid liberalization of domestic financial markets that gives access to credit to households that were
previously borrowing-constrained.
Whether a large current account deficit is sustainable or not also depends on a number of other
macroeconomic factors: 1. the country's growth rate; 2. the composition of the current account deficit; 3. the
degree of openess of the economy (as measured by the ratio of exports to GDP); 4. the size of the current
account deficit (relative to GDP).
1. Large current account deficits may be more sustainable if economic growth is higher. High GDP growth
tends to lead to higher investment rates as expected profitability increases. At the same time, high growth
might lead to higher expected future income and (as noted above) transitory declines in private savings rates.
Generally, higher growth rates are related to more sustainability of the current account deficit because,
everything else equal, higher growth will lead to a smaller increase in the foreign debt to GDP ratio and make
the country more able to service its external debt. However,, many episodes of unsustainable current account
deficits do not fit the patterns described. In particular, the examples of Chile in 1979-81, Mexico in 1977-81
and the Asian countries in 1997 come to mind. In all these instances the average real GDP growth rate in the
years preceding the crisis was above 7%: what happened was that excessively optimistic expectations that the
high economic growth would persist for the long-term led to an excessive investment boom and a boom in
private consumption (a fall in private savings) that resulted in current account deficits and growth of foreign
debt; the latter eventually became unsustainable and caused a currency and debt crisis (as in Asia in 1997-98).
2. The composition of the current account balance which is approximately equal to the sum of the trade
balance and the net factor income from abroad will affect the sustainability of any given imbalance. A
current account imbalance may be less sustainable if it is derived from a large trade deficit rather than a large
negative net factor income from abroad component. In fact, for a given current account deficit, large and
persistent trade deficits may indicate structural competitiveness problems while large and negative net foreign
factor incomes may be the historical remnant of foreign debt incurred in the past.
3. Since a country's ability to service its external debt in the future depends on its ability to generate foreign
currency receipts, the size of its exports as a share of GDP (the country's openness) is another important
indicator of sustainability.
4. Most episodes of unsustainable current account imbalances that have led to a crisis have occurred when the
current account deficit was large relative to GDP. Lawrence Summers, the U.S. deputy Treasury secretary,
wrote in The Economist on the anniversary of the Mexican financial crisis (Dec. 23, 1995-Jan. 5, 1996, pp.
46-48) “that close attention should be paid to any current-account deficit in excess of 5% of GDP,
particularly if it is financed in a way that could lead to rapid reversals.” By this standard, many of the Asian
economies provided ample source for concern in the 1990s as they had very large and increasing deficits,
well above the 5% red flag.
The above analysis suggest that there is not anything inherently good or bad about a current account deficit.
Like and individual or a firm that borrows funds, a country may be borrowing funds from the rest of the
world for good or bad reasons. So a current account deficit and the ensuing accumulation of foreign debt may
be good, sustainable and lead to higher long-run growth or may be eventually unsustainable and lead to a
currency and debt crisis depending on what drives the current account deficit. We will return to the discussion
of current account and foreign debt sustainability in Chapter 3.
Prices and Real Quantities

One of the things you may have noticed is that the national accounts have been measured, so far, in dollars.
The problem (unlike physics, where, generally, a meter is a meter and a second is a second) is that the value
of a dollar isn't constant. Sometimes a dollar buys a lot of goods, sometimes not so many. It seems ridiculous
to argue that GDP in Brazil in the early 1990s was rising at more than 1000 percent a year, when almost all
of that increase reflects increases in cruzeiro (the local currency) prices of goods, not increases in quantities
of the goods produced. This issue is not simply an academic one; it shows up as well in accounting standards
for foreign subsidiaries of US companies operating in high-inflation countries, who are generally required to
translate profits of subsidiaries into US dollars (or other more stable currency).
As a result, a great deal of effort goes into measuring "real'' (as opposed to "money'' or "nominal'') GDP and
related quantities and constructing indexes of "average'' dollar prices. For GDP we would generally like to
compare quantities of output produced in different periods, so that an increase in GDP means we are
producing more of something.
How to measure correctly the real value of GDP and the correct level of the inflation rate is a difficult issue.
Until the end of 1995, the U.S. followed a "fixed-weight" approach to the measurement of real GDP but has
since moved to a "chain-weight" method. This move was. however, somewhat controversial and object of a
serious debate. For what concerns the inflation rate, we can measure it by using the price deflator series
derived from the calculation of real and nominal GDP or we can measure it by calculating the CPI (Consumer
Price Index) inflation rate. Recently, however, it has been argues that the CPI inflation rate overstates the true
inflation rate. In December 1996, the Boskin Commission appointed by the Senate Finance Committee,
reached the conclusion that the CPI overstates the annual inflation rate by 1% to 2% per year. To understand
these recent debates on the correct measurement of GDP and inflation, we need to consider in more detail
these issue. In particular, we need to start by understanding why the US switched from a fixed-weight to a
chain-weight method to measure real GDP and why the CPI inflation rate might be overestimated. Let us start
with the fixed-weight GDP measure.
Suppose, for example, we want to compare GDP in 1993 to GDP in 1992. The (fixed-weight) measures of
nominal and real GDP using 1987 as the base year (the method used until the end of 1995) were:

Nominal GDP Real GDP
1987 4539.9 4539.9
1992 6020.2 4979.3
1993 6343.3 5134.5

The growth rate of nominal GDP in 1993 was:
5.3% = 100 x (6343.3 - 6020.2)/6020.2
But how much of that reflects a decline in the value of the dollar? What we might do is measure the 1992 and
1993 quantities and value them at the same prices to get a "constant'' price comparison. The NIPA, for
example, used to measure everything in 1987 prices; 1987 is referred to as the base year. This was a "fixed-
weight" method since it implied measuring quantities of goods in different years at the prices prevailing in a
base year. Using this method, GDP in 1987 prices was 4979.3 in 1992 and 5134.5 in 1993, implying a grow
rate of real GDP of
3.1% = 100 x (5134.5 - 4979.3)/4979.3
Thus it appears that 2.2 percent (5.3% - 3.1%) of the growth in current dollar GDP was simply a general
increase in dollar prices of goods.
This general increase in prices is implicit in the real and nominal measures of GDP. One measure of the
average price is the ratio of GDP in current prices to GDP in 1987 prices. We call this measure of prices the
GDP implicit price deflator:
GDP Price Deflator = GDP in current prices (Nominal GDP) / GDP in base year prices (Real GDP)
Nominal GDP (NY) = Real GDP (Y) x GDP deflator (P)
Or:
NYt = Yt x Pt
where the subscript refers to the year t value of the the corresponding variable. We typically report this price
deflator as an index, with 1987 = 100. The index was

1987 100
1992 120.9 = 100 x 6020.2/4979.3
1993 123.5 = 100 x 6343.3/5134.5
for an inflation rate of 2.2 percent (= 126.3/121.3 -1).
Here, we are defining the inflation rate p as the % rate of change of the price level (the GDP deflator)
between period t-1 and period t, or:
pt = (Pt - Pt-1)/Pt-1 = inflation rate in year t.
More formally, the rate of growth of nominal GDP (nyt) is equal to the rate of growth of real GDP (yt ) plus
the rate of inflation. In fact:
(ny)t = (NYt - NYt-1)/NYt-1 = (NYt / NYt-1) -1 = (Yt x Pt) / (Yt-1 x Pt-1) - 1 =
(Yt / Yt-1) x (Pt / Pt-1) - 1
Therefore:
ny = ( 1 + y) x (1 + p) - 1 = y + p + yp (*)
Since yp is a small number, the expression (*) is approximately equal to:
nyt = yt + pt
Or:
(NYt - NYt-1)/NYt-1 = (Yt - Yt-1)/Yt-1 + (Pt - Pt-1)/Pt-1.
Figure 6 shows the levels of nominal and real GDP for the U.S. economy; note that since the base year for the
comparison is 1992, nominal and real GDP are equal to each other in that year as the deflator is equal to 1 by
choice of the base period. Figure 7 presents a graph of the rate of growth of nominal and real GDP for the
U.S. economy. As inflation is positive, nominal GDP growth is above real GDP growth.
This is simply one example of a price measure. There are also price deflators for components of GDP:
consumption, investment, government spending, exports and imports. The most common measure of price
movements, though, has nothing to do with the national income accounts.
The Consumer Price Index measures the dollar price of a "fixed basket'' of goods rather than the constant
price of a changing basket of goods used to compute the "fixed-weight" GDP and its nominal price deflator.
The idea is to calculate the price of a constant list of goods at different points in time. Eg, consider 5 gallons
of gas, one haircut, 2 pounds of chicken, 3 bottles of soda, and so on. The Bureau of Labor Statistics at the
Department of Labor sends people to stores every month to collect prices of the various goods, and then
computes prices of various "baskets.'' The Consumer Price Index (CPI) is the total price of all of these goods
at different dates, normalized to equal 100 at some date. Same idea, really, as the Dow Jones Industrial
Average or the S&P 500. The CPI takes its basket of goods from the typical spending patterns of an American
family.
The conceptual problem for both price indexes---the fixed-weight GDP deflator and the fixed basket CPI
deflator ---is that it's not clear how to measure the purchasing power of the dollar when the dollar prices of
different goods are changing at different rates. Conversely, it's not clear how to combine quantities of
different goods when their relative prices are changing. As usual, this is easier to see with an example.
Example (made-up numbers).
Our economy produces two goods, fish and and chips (computer chips, not potato ones). At date 1 we
produce ten fish and and ten chips. Fish cost 0.25 cents and chips 50 cents. At date 2 the price of fish has risen
to 50 cents and of chips to 75 cents and the quantities have changed to 8 and 12.

Price of Chips Quantity of Chips Price of Fish Quantity of Fish
Date 1 0.5 10 0.25 10
Date 2 0.75 12 0.50 8
Note that the two prices have not gone up by the same amount: fish inflation is 100 percent but chip inflation
is 50 percent. Another way to say the same thing is that the relative price of chips to fish has fallen from 2
(=.50/.25) to 1.5 (=.75/.50). What is the change in the price level?
Example continued (fixed-weight GDP deflator and fixed-weight real GDP). We construct GDP at both
dates in current prices and in date 1 prices.
Date 1 Nominal GDP = $7.50 (= .50x10 + .25x10)
At date 2
Date 2 Nominal GDP = 13.00 (= .75x12 + .50x8).
In date 1 prices ("real'') GDP is:
Date 1 prices ("real'') GDP = 8.00 (= .50x12 + .25x8).
The GDP deflator (the ratio of current price GDP to GDP in base year prices, here date 1) rises from 1.0 in the
base year date 1 to 1.625 (= 13/8) at date 2, an inflation rate of 62.5 percent.
The the, real GDP growth measured with fixed weights is:
6.66% = 100 x (8-7.5)/7.5
In fact, since we know from (*) above that::
(1 + ny) = ( 1 + y) x (1 + p)
real growth y is:
y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.625)] -1 = 0.066
Consider now what happens to our measure of real GDP growth when we use a "fixed-basket" based measure
of inflation (the CPI index).
Example continued ("fixed-basket" CPI deflator and real GDP). The consumer price index uses quantities
in a base year to compute the costs of the same basket of goods at 2 different dates. Let's say here that the
basket of goods is 10 fish and 10 chips (the same composition as GDP). Then:
CPI at date 1 = 7.50 (= .50x10 + .25x10).
CPI at date 2 = 12.50 (= .75x10 + .50x10).
The implied CPI inflation rate is 66.6 (= 100 x (12.50-7.50)/7.50) percent.
Note the difference between the two indexes: the CPI uses date 1 quantities while the GDP deflator uses date
2 quantities to compute the date 2 price index. (Check out the CPI Calculation Machine at the Minneapolis
Fed home page to get, say, the price of a cup of coffee in 1963).
Since nominal GDP growth is again 73.3% and the fixed-basket (CPI based) measure of inflation is 66.6%,
now the fixed basket measure of real GDP is 4% rather than the higher 6.66% obtained by using the fixed-
weight method. In fact:
y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.666)] -1 = 0.04
How can we compute directly the real GDP growth if we use the CPI deflator ? Simple: compute real GDP in
the second period by taking period 2 as the base year (rather than period 1 as in the fixed-weight method).
Then:
Period 2 Real GDP using date 2 as the base year: 13 = 0.75x12+0.5x8
Period 1 Real GDP using date 2 as the base year: 12.5 =0.75x10+0.5x10
Implied Real (fixed-basket) GDP growth using period 2 as base year: 4% =(100 x (13-12.5)/12.5)
You see that, depending on which deflator we use, our estimate of real GDP growth will be different (6.66%
versus 4%).
So which method is better ?
The point is this: there is no unique or best way to separate relative price movements from general
movements in the price level, even in theory. This problem involves some subtle issues about price
measurement, like what quantities to use, date 1 or date 2. How much difference does this make in practice?
Some, but in high inflation periods, especially, the movements in different prices indexes are similar. You can
see this from the graphs of the CPI and GDP deflator in levels and rates of change (Figure 8 and Figure 9).
Note also that, the fixed-weight method used by the US until 1995 had the disadvantage that it was giving too
much weight in the calculation of real GDP to the good whose relative price had fallen over time (in this
example chips). Because of this bias, the value of the real output of chips was overestimated and led to an
overestimation (6.66%) of the value of the growth rate of the economy.
To see this issue in more detail consider the following example:

Price of Chips Quantity of Chips Price of Fish Quantity of Fish
Date 1 1 10 1 10
Date 2 0.5 20 2 5
In this example:
Date 1 Nominal GDP = 20 (= 1x10+1x10)
Date 2 Nominal GDP = 20 (= 0.5x20+2x5)
Note intuitively that, in this example, real GDP has not changed in period 2 relative to period 1. In fact the
share of the 2 goods in nominal output is 50% and the quantity produced of one good (chips) doubled while
the quantity of the other was cut by half.
So, what happens when we estimate real growth of GDP using the fixed-weight and CPI methods ?
Fixed-weight approach:
Date 2 Real GDP (in date 1 prices) = $ 25 (= 1x20 + 1x5)
Real 'fixed weight' GDP growth: 25% = (25/20)-1
GDP deflator inflation: -20%
Nominal GDP growth = 0 = (20-20/20) = (1 - 0.2)(1 + 0.25) -1
CPI (fixed basket) approach:
CPI inflation: 25% = [( 0.5x10 + 2x10) / 20] -1
Period 1 Real GDP using date 2 as the base year: 25
Period 2 Real GDP using date 2 as the base year: 20
Real GDP growth using date 2 as the base year: -20%
Nominal GDP growth = 0 = (20-20/20) = (1 + 0.25)(1 - 0.20) -1
The problem is that in fixed-weight approach, too much weight is given to production of the good (chip)
whose price has fallen over time. If we use a fixed-weight method, the output level and growth rate is biased
upward (we get an estimate of 25% real growth) because we are overestimating the value of the output of the
good whose price has fallen.
It is like computing the real output of a PC computers in 1997 by taking the 1987 price of an equivalent
machine (approximately $6,000) as the base for valuing the real value added of a PC that is priced only at
$2,000 today. It does not make sense to value the quantity of computers produced today at prices that were
prevailing 10 years ago. So, the fixed-weight method led to an overestimation of the value added of the
computer industry.
When the U.S. relied on the fixed-weight method, it was giving too much weight in the calculation of real
GDP to the good whose relative price had fallen over time (in this example chips and in reality computers,
semiconductors and other high tech sectors of the economy). Because of this bias, the value of the real output
of chips was overestimated and led to an overestimation of the growth rate of the economy. This issue
became serious over the 1980's as the price of computers was falling in absolute and relative terms while the
fixed-weight, by using the high prices of computers prevailing in the base year, was leading to an
overestimate of the real GDP created by computers. In order to eliminate such a bias, the Department of
Commerce switched at the end of 1995 to a chain-weight method of measuring real GDP. The chain weight
method is a combination of the fixed-weight method and the fixed-basket method. Real GDP is estimated
twice, first using the previous year prices as the base (fixed-weight) and the second time using the current
year prices as the base and the previous year quantities to compute real GDP in the previous year. Then, a
(geometric) average of the two is taken. Using this method:
Growth rate of chained GDP = [(1 + 0.25)(1- 0.2)-1]/2 = 0

i.e. the growth rate of chained GDP is equal to zero that is the sensible economic answer since real output in
the example above had not changed in a substantial sense.
There are however several potential problems also with the chain-weight method:
1. Quality changes are not correctly measured (examples: computers, light) leading to under-estimate of the
product of industries where such quality changes occur.
2. Major productivity growth in the service industries (ATM's, telecommunications, quality of health care)
not measured by standard GDP measures.
First, an important issue in computing price indexes is how they deal with quality change and new goods.
One of the facts of life in growing economies is that the goods change: candy bars change size, PCs have
ever-increasing capabilities, and some goods simply didn't exist in the base period. Candy bars are the easiest:
we simply regard a five oz bar as half a ten oz bar. But what about PCs? If a 286 sells for $2000 and a 386 for
$4000, has there been inflation or is the 386 machine twice as good as the 286? It's even more difficult if the
commodity has no counterpart in the base period. How do we include VCRs in the calculation when they
didn't exist, for all practical purposes, prior to the 1980s? For this reason, some people think that price
indexes and real GDP do not adequately reflect quality improvements---that real GDP is growing faster than
we think because quality is constantly improving. That's especially true now of new high-tech capital goods.
Second, related issues show up in services. Many authors (including the Fed Chairman Alan Greenspan) have
argued that major productivity growth in the service industries are not measured by standard GDP measures.
Moreover, there are other subtle measurement issues: if the price of one hour of a lawyer's time goes up, does
this represent an improvement in quality or just a rise in the price?
Critics of the switch from fixed-weights to chain-weights have argued that, while the fixed-weight method
overestimated the contribution of computers to real GDP, the chain-weight method fixes one problem but
does nothing to address the two issues above; that, on net, leads to an underestimation of real GDP. So the
new measure might overall tend to underestimate GDP and its growth rate.
At the same time, a number of authors have argued that the use of the CPI inflation rate also tends to
overestimate the true level of inflation rate in the US economy because of a number of biases. In December
1996, the Boskin Commission appointed by the Senate Finance Committee, reached the conclusion that the
CPI overstates the true inflation rate by 1% to 2% per year. Note that, if inflation is overestimated, then our
measure of real GDP growth is underestimated as well as more of the growth of nominal GDP is imputed to
an increase in prices than to an increase in quantities produced. A wide debate on the CPI has followed the
publication of the Boskin Commission recommendations. Fed Chairman Alan Greenspan has expressed his
views on this debate in a testimony in Congress in January 1997 and a recent speech in November 1997.
For more discussion on these issues see the home page on the debate on whether output and CPI inflation are
mismeasured.
Summary
1. GDP measures the total value of production at market prices, the sum of value-added by every
production unit in the economy.
2. Identities.
Output (GDP) = Income (payments to labor and capital, gross of depreciation).
GDP = C + I + G + NX .
GNP = GDP + i NFA = C + I + G + (NX + i NFA) .
GNP = C + I + G + CA .
S = I + CA .
3. Price indexes measure the purchasing power of money. Issues: relative price vs general price level
movements, quality change and new goods.
4. Bottom line: economic indicators clearly contain useful information, but like accounting statements
they must be interpreted with care. [Data are like sausages: if you like them, you shouldn't think too
much about what goes into them.]
Further Readings
For a wealth of WEB-based data and analysis of the U.S. and world economy, check out the WEB sites listed
in the our home pages on Macro Data and Analysis Links and Business Cycle Indicators.
On paper, there are two good (by which I mean informative and readable) books on the uses, sources, and
meaning of economic data: Norman Frumkin's Guide to Economic Indicators (Armonk: Sharpe, 1994, 2nd
edition) or Tracking America's Economy (Armonk: Sharpe, 1992). Not needed for this course, but if you ever
have to look something up it's a good place to start. A slightly more technical introduction to macroeconomic
data is available from the Richmond Fed: Macroeconomic Data: A User's Guide, edited by Roy Webb. Both
of these cover the US, but in many cases the methods are similar to those used in other countries (especially
for national income and product accounts, for which there is a United Nations standard).
Further Web Links and Readings

The course home page on the controversy about whether output and CPI inflation are mismeasured is a useful
source of materials on the chain-weight measure of GDP, on the results of the Boskin Commission and the
debate on these results. The debates on the chain-weight system of measuring GDP and the biases in
measuring the inflation rate are also related to the question of whether we are correctly measuring
productivity growth and whether there has been a resurgence of productivity growth in the 1990s after the
dismal productivity experience in the 1973-1990 period (see also Chapter 4). On this debate and the related
issue of the productivity slowdown see the homepages on the controversies Productivity Growth, Its
Slowdown in the 1973-90 period and its resurgence in the 1990s: Truth or a Statistical Fluke? and the New
Economy.
Table 1
Saving and Investment Rates for Developed Countries.
Entries are percentages, averages of quarterly data over the period 1970:1 to 1989:4. Data are from the
OECD's Quarterly National Accounts, seasonally adjusted, except US, from Citibase. Variables are: Y = GNP
or GDP; S = Y-C-G, where C is consumption and G is government purchases of goods and services; I = gross
fixed capital formation. All variables are measured in current prices. Numbers may not sum to zero because
of rounding, and because my measure of investment does not include the change in business inventories.
Country S/Y I/Y CA/Y Y Growth
Australia 24.1 24.6 1.1 3.33

Austria 26.6 25.2 0.1 2.95
Canada 23.7 22.1 1.2 2.82
France 23.3 22.2 0.2 2.83
Germany 25.1 21.4 3.1 2.51
Italy 22.8 22.7 -0.1 3.06
Japan 33.6 31.2 1.5 4.49
United Kingdom 18.2 18.2 0.0 2.38
United States 16.0 15.5 0.1 2.77
Figure 1. US Real GDP
FIGURE 2. Per Capita GDP: International Comparisons
Figure 3. Per Capita GDP: International Comparison 2
FIGURE 4
FIGURE 4'
Figure 5. GNP Growth in Germany and Japan
Figure 6
Nominal and Real GDP
Figure 7
Nominal and Real Growth Rate of GDP
Figure 8. CPI Level

and its Percentage Annual Rate of Change
Figure 9. GNP Deflator Index

and its Percentage Annual Rate of Change
Copyright: Nouriel Roubini and David Backus, Stern School of Business, New York
University, 1998.

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26/01/2023, 14:04 Chapter 1: Monitoring Macroeconomic Performance

Nouriel Roubini and David Backus

Growth and Business Cycles

(GDPt - GDPt-4) /GDPt-4

4 x [(GDPt - GDPt-1) /GDPt-1 ]

Gross Domestic Product

Wages 20,000,000

Net Income 14,000,000

Sales revenue 40,000,000

Wages 20,000,000

Net Income 14,000,000

GDP = 34m = 40m - 6m = 20m + 14m

GNP = GDP - 2m - 5m = 27m = 18m + 9m

Examples (1987 data):

GDP + Net Factor Income(+) = GNP % difference

US 4540 4 4544 0.08

If NFA > 0, the country is a creditor country.

If NFA < 0, the country is a debtor country.

Then the GNP is :

GNP = GDP + i NFA = GDP + Net factor income from abroad

Some examples of the national accounts at work:

Wages 20,000,000

Net Income 8,000,000

Net Domestic Product = GDP - Depreciation = 34m - 4m = 30m

2. Compensation of employees 4,008.3

3. Proprietor's income 450.9

4. Corporate Profits 526.2

6. Net Interest 392.8

GDP = consumer expenditures + investment + government purchases of goods and services

% Share of GDP

The Current Account

Given the definition of GNP, we also get:

GNPt = GDPt + it NFAt = Ct + It + Gt + (NXt + it NFAt ) =

CAt = NXt + it NFAt

Current Account = Trade Balance + Net Factor Income from abroad

Example: Brazil in 1986.

Current Account Balance (% of GDP)

Korea -1.24 -3.16 -1.70 -0.16 -1.45 -1.91 -4.89

Insight in the Asian economic crisis: Why current account deficits

Kt+1 = Kt+ It - Depreciationt

NFAt+1 - NFAt = CAt

NFAt+1 = NFAt + GDPt + it NFAt - Ct - Gt - It = NFAt + CAt

NFAt+1 = NFAt + CAt = NFAt + NXt + it NFAt

What Causes Current Account Deficits? Are Such Deficits Bad?

(GNPt -Tt -Ct ) = It + (Gt -Tt ) + CAt ,

GNPt - Tt - Ct = Stp= Private Savings

Deft = (Gt - Tt ) = Gt - TXt + TRt + it Debtt = - Stg

Thus we can write the identity

Stp = It+ Deft + CAt (1)

St = Stp - Deft = Stp+ Stg = It + CAt

that implies our earlier definition of the current account:

Debtt+1 = Debtt+ Gt - Tt = Debtt+ (Gt + TRt - TXt) + it Debtt

To specify a definition of sustainability, consider a situation where current macroeconomic conditions

CAt = Stp - It - Deft

A current account deficit may be caused by:

1. An increase in national investment

2. A fall in national savings; specifically:

2a. A fall in private savings and/or

1. A boom in domestic investment.