International Finance Theory and Policy Analysis

Gross Domestic Product (GDP) is a way to assess the strength of an economy. Basically, it is the end value of all the things produced in our country. For example, the end value of a bushel of wheat (i.e. The amount of money, in USD, that a bushel of wheat 'converts to' when purchased as bread, or cereal, etc., by consumers), probably multiplied by how many of bushels of wheat were produced in that year, would be used in factoring GDP. While GDP is certainly a method of assessing the strength of the economy, it is not without its pitfalls.

GDP is calculated by simply adding a number of other calculations together: the value of all the things we have consumed (including foreign goods), the value of all investments by private domestic businesses, the value of government expenditures (i.e. government worker salaries), and exports. Imports are subtracted from this list. This equation is known as the national product identity.

Imports are subtracted from GDP for this reason, and this reason alone: imports come to the U.S. And are then purchased by consumers, businesses, and the government. These expenditures are included in the national product identity. However, they do not in reality represent a product of the U.S., so their total value must be subtracted from GDP, otherwise GDP would appear larger than it actually is.

When the U.S.' GDP is broken down into its component parts, consumption expenditures make up the bulk of it, followed by investment expenditures. A noteworthy aspect of investment expenditures is that they 'should' be a measure of future economic growth. This is because investment expenditures represent money put into the creation of new product, or as the text calls it, capital. Thus, the amount of investment expenditures for one year should give us an idea of how much a country will grow in the upcoming years. However, this formula has been shown unreliable.

The balance of payments accounts is basically exports minus imports. What this really refers to is the net value of transactions between residents of two countries. The balance of payments accounts is divided into four categories (of which exports and imports exist): current account -- international transactions of goods and services; merchandise trade account -- international transactions of goods; services account -- international transactions of services; and financial account -- international transactions of assets.

Recording transactions on the balance of payments is done in a fairly simple way. All exports are treated as 'credit,' and in effect add to the balance of payments, and all imports are treated as 'debit,' and in effect subtract from the balance of payments. Theoretically, recording transactions on the balance of payments should result in zero, with goods and services bought always being canceled by financial assets sold, and the other way around. However, because of gaps in accounting, economists must use a statistical discrepancy figure to balance transactions correctly.

Through a number of diagrams, the text attempts to explain the Twin Deficit Identity, which is the relationship of a government's budget deficit with a nation's current account deficit. The twin deficit identity can be summarized as this: the net of private savings (firms' profits) minus private investments (financial institutions' 'savings') plus the net of value of imports (which private firms purchase) minus exports (which private firms sell) equals the net of government spending (on the goods and services of private firms) plus tax revenue (made to households) minus taxes (paid for by firms).

A country's international investment postion is basically a reading of if the country is 'in debt' (a 'debtor' nation) or 'in the green' (a 'creditor' nation). The U.S. is the biggest 'debtor' nation of them all, but this does not necessarily mean that the country is in the worst position, in terms of international investment, of them all.

Chapter 6

Trade deficits and trade surpluses are not to be used as a general indicator of the strength of an economy. Although they are often reported as such, this type of logic is misguided. There are situations where a trade deficit can be bad for a country, and there are situations where a trade deficit can be good for a country. The same goes for trade surpluses. In either case, to judge the strength of a country's economy based on these two things alone is not sufficient for an accurate analysis. This is not to imply that they do not affect the strength of economy.

Trade deficits can lead to a situation where the standard of living in a country is actually higher. Since standard of living is measured, in the text, by domestic spending, if a country is borrowing more money abroad than it is exporting, standard of living can actually be increased by an increase in consumption made possible by the borrowed foreign funds. However, since the country is borrowing more than it is exporting, it does have a trade deficit. But this situation is not without its pitfalls. While the standard of living was raised, it was raised on the foundation of borrowed money. Thus, it will have to be repaid in the future, with interest, which leads to a potential situation where there is less money for domestic spending and thus a lower standard of living. In this situation there is actually a trade surplus, as less money is being borrowed as is being exported.

A way that a trade deficit can benefit a country in the future is by borrowing foreign money and immediately investing it. By immediately investing it, the country is not allowing its domestic spending to go up. However, the result of investment in the future will translate to more domestic spending, or an increase in the standard of living.

Suranovic's basic point with trade deficit was to say, in essence, that as long as the country makes enough money to pay back its borrowed cash, it is well positioned. Large trade deficits can persist, and even be advantageous to domestic spending and future development, but only as long as the country grows rapidy enough to pay them back.

Similarly, a trade surplus can be beneficial to a country in the long run by creating a situation where a country is paid back loans they had previously given out. The country then has that much extra cash to spend on domestic consumption, which is an increase in standard of living.