This is the fourth in a series of notes for a semester-long macroeconomics course. The first note is here. The point of the course is to create a practical and open-ended introduction to macro, with a coherent role for money and without reproducing IS–LM.
Domestic production systems are connected by international trade and financial flows.
Up to now we have been considering a single unified production system, with all production grouped into a single monolithic “business” sector, and all spending grouped into monolithic “household” and “government” sectors. In the abstract, we could interpret this as a way of thinking of all human economic activity together, organized as a single global production system.
That would be a perfectly correct interpretation of what we have done so far, but macroeconomics more frequently focuses on national production systems, the economic activity carried out within some set of national borders. Why is national economy the usual choice of macroeconomic scope? One reason is that macroeconomic policy decisions are generally in the hands of government officials, and the sphere of influence of any particular government extends to its national borders. For example, stimulus spending is directed by government authorities, and monetary policy (for the most part) by national central banks. Similarly, most macroeconomic data is collected by government agencies, whose sphere of interest again extends to national borders and not beyond. (A notable exception is the supranational organization of European institutions, but this doesn’t really change the main point.)
So, if our three-sector model of production is interpreted as applying to a production system within the borders of one country, then we are missing something important: cross-border flows. As a first step toward adding these into our model, we can add a new sector called “rest of world,” the consolidation of all flows among countries other than the one we are interested in. What does this mean? Suppose we take the entire world’s economic activity, pull out one country of interest, China for example. Then we take all countries other than China and consolidate all of their economic flows into a single sector. Following the rules of consolidation, every flow will net out to zero, except those that cross into or out of China’s borders. The result might come out like this:
This four-sector model shows the three-sector model of a single domestic production system, plus one more sector for the rest of the world. Importantly, it doesn’t say anything about what is happening in the rest of the world, only what is crossing the borders of the country we are looking at. What crosses the borders? I’ve added two new kinds of flow, exports and imports. I imagine that the business sector does all of the foreign trade. Products that the domestic business sector buys from abroad, are imports for the business sector, a use of funds. Those same flows are exports for the rest of the world, a source of funds. Flows in the other direction work similarly.
However, I have made a strong assumption. Look at the sectoral account for the rest of the world: the only use of funds is imports, the only source is exports. By the rules of accounting, it must be that exports and imports are equal, so that the two entries balance correctly. But in the real world, this is clearly not the case: the US has run a persistent trade deficit (imports greater than exports) for many years; China has run a persistent trade surplus (exports greater than imports). One way to handle this is to lump imports and exports together as net exports, exports minus imports:
But if we do that, and we recognize that net exports can be something different from zero, then the rules of accounting immediately tell us that we need another entry. The rest of the world must have a source of funds, which must be a use of funds for one of the domestic sectors, and that source of funds must not be exports. Rather than leave you in suspense, I will tell you that this source of funds must be financial in nature, and in the modern world is frequently in the form of bonds. These must be bonds issued by the rest of the world and purchased by a domestic sector, which for now I assume to be the household sector.
How can we be sure that the household sector has the funds to buy these bonds? You can check this by adding numbers to the accounts, and using the rules of accounting to make the accounts balance. What you will see is that the flow of exports generates new incomes, which are paid from businesses to households. These higher incomes to households must be absorbed somewhere, and the shortest path is for households to buy foreign bonds. (There are other possibilities, but all of them end up with a domestic sector buying foreign bonds.)
When a country is a net exporter, exports greater than imports, net exports greater than zero, we say that the country is in current account surplus, and that country must also be a net purchaser of foreign financial assets.
When a country is a net importer, imports greater than exports, net exports less than zero, we say that the country is in current account deficit, and that country must also be a net issuer of financial assets held abroad.