introducing the foreign trade sector most

Question

Introducing the Foreign Trade Sector 

Most economies in the real world are open economies. They engage in trade with other economies. Goods and services are exported and imported. Residents of one country might earn incomes in another country by hiring out their labor or capital. Gifts and other transfers are made between governments and private citizens of different countries.

On the expenditure side, a part of the output produced at home is bought by foreign nationals. These are exports of goods and services. A part of expenditure by domestic residents is on goods produced abroad rather than at home. These are imports of goods and services. Thus GNP has to be defined as the value at market prices of expenditure on domestic output.

GDP at market prices = C + I + G + E - M

Here E denotes value of exports and M the value of imports of goods and services.

On the factor incomes side, some of the incomes generated in domestic productive activity accrue to foreigners - e.g. repatriated profits, payments to consultants, etc. - while some domestic residents earn incomes abroad. Thus we have to take separately Gross Domestic Product (GDP) and Gross National Product (GNP).

GNP at factor cost = GDP at Factor Cost + Income received from abroad - Income paid abroad 

Another complication is internation transfers. Persons and governments make and receive transfer payments to and from foreign persons and governments. These can be treated as part of the current account in the foreign trade accounts.

Still another complication is capital transfers. A foreign government may give a donation to finance the purchase of capital equipment or may directly donate equipment. The former may be treated as part of current account. The latter should be separated out. In either case GNP figures are not affected. 

A. Complete System of Accounts 

i.	The Production Account
	Factor Incomes	85		Sales to Households	78
	a. Paid to Domestic Residents	(80)		Sales to Government	4
	b. Paid to Foreign Residents	(5)		Domestic Investment	12
	Retained Profits	3		a. Fixed Investment	(10)
	Corporate Profit Tax	1		b. Inventory Investment	(2)
	Indirect Taxes	6		Exports	8
	Imports	5		Subsidies from Government	3
	Depreciation	5
		105			105

ii.	The Household Sector Account
	Consumption	78		Incomes from Domestic Production	86
	Personal Income Tax	10		Income from Abroad	4
	Transfers to Foreigners	5		Transfers from Government	2
	Personal Savings	2		Transfers from Foreigners	3
		95			95

iii.	The Government Account
	Wages and Salaries	6		Corporate Profit Tax	1
	Purchases of Goods and Services	4		Indirect Taxes	6
	Transfers to Foreigners	1		Personal Income Tax	10
	Transfers to Households	2
	Subsidies to Producers	3
	Surplus	1
		17			17

iv.	The External Account
	Exports	8		Imports	5
	Transfers from Foreigners	3		Transfers to Foreigners	6
	Incomes from Abroad	4		Incomes paid to Foreigners	5
	Deficit on Current Account	1
		16			16
v.	The Savings-Investment Account
	Personal Savings	2		Fixed Investment	10
	Business Savings	8		Net Change in Stocks	2
	Government Savings	1
	Deficit on Current Account	1
		12			12

Note that the production account is a consolidated account of the entire productive sector and shows only sales of final goods and services. All transactions in intermediate inputs have been netted out.

Using the above hypothetical accounts we can illustrate all the national accounts aggregates discussed in the text. 

All factor incomes paid out to suppliers of factor services, i.e. 

 GDP at Factor Cost       =    wages, salaries, dividends, interest and rent + Retained profits +

                                       Corporate profit tax + Depreciation  

=85 + 6 + 3 + 1 + 5 = 100 

NDP at Factor Cost = GDP at factor cost - Depreciation 

=100 - 5 = 95 

Since we have not separated out factor incomes accruing to the Government, we will assume that there is no such item. Hence

NDP at Factor Cost =Income from domestic production accruing to the private sector

 In reality some factor incomes do accrue to the government e.g. surpluses of public enterprises. These have to be deducted from NDP at factor cost to get income from domestic production accruing to the private sector.

Income from Domestic Production accruing to the Private Sector +

Private Income = Net Factor Income from Abroad + Current Transfers from

                        Government + Net Transfers from RoW to the Private Sector

                    =95 + (4 - 5) + 2 + (3 - 5) = 94

Personal Income =Private Income - Retained Profits - Corporate Profits Tax

                       =94 - 3 - 1 = 90

Personal Disposable Income  = Personal Income - Personal Income Tax = 90 - 10 = 80

This must equal private consumption plus household saving. The former is 78, the latter is 2.

GDP at Market Prices =GDP at Factor Cost + Indirect Taxes - Subsidies

                               =100 + 6 - 3 = 103

                                =C + I + G + X - M

                               =78 + 12 + 10 + 8 - 5 = 103

at in G we include only the first two items shown on the debit side of the Government account. Only these items represent expenditure on current goods and services. The rest are transfers.

GNP at Market Prices =GDP at Market Prices + Net Factor Income from Abroad (NFIA)

                              =103 + (4 - 5) = 102

Alternatively,.

GNP at Factor Cost =GDP at Factor Cost + NFIA

                          =100 - 1 = 99

GNP at Market Prices = GNP at Factor Cost + Indirect Taxes - Subsidies

=99 + 6 - 3 = 102 as above.

Gross Domestic Saving =Household Saving + Gross Business Saving + Government Saving

                                 =2 + 8 + 1 = 11

Gross business saving includes retained profits and depreciation provisions.

Gross Domestic Capital Formation = Gross Fixed Investment + Inventory Investment = 10 + 2 = 12

The excess of gross domestic capital formation over gross domestic saving is financed by borrowing from the Rest of the World (RoW). This shows up as current account deficit in the balance of payments. Thus, 

GDCF = 12 = GDS + Deficit on Current Account = 11 + 1 = 12

Alternatively, we can use the term 'foreign investment' to denote surplus on current account. Then,

GDCF + Foreign Investment = GDS (Note that surplus = - Deficit)

This is mere common sense. Domestic saving can be used for capital formation at home and acquisition of foreign assets by running a current account surplus. To put it another way, domestic capital formation can be financed by domestic saving and by borrowing from foreigners by running a current account deficit (or by decumulating foreign assets built up in the past).

Even after adding many complications the accounts exhibited in this appendix are far too simple compared to real-life national accounts. There are several other complications which we have left out, e.g.

a. Treatment of services derived from assets owned by households e.g. owner-occupied houses. Some method of imputing rent must be adopted.

b. Treatment of services derived from publicly owned capital.

c. Treatment of consumer durables like cars and refrigerators.

d. Adjustments for inventory valuation and capital consumption.

These details, while important in practice are not essential to an understanding of the principles of national accounting.