National Income Account Identity | The Open Economy

Let us make an in-depth study of the National Income Account Identity for an Open Economy. After reading this article you will learn about: 1. Subject-Matter of International Capital Flows and the Balance of Trade 2. The National Income Accounts Identity for an Open Economy.

Subject-Matter of International Capital Flows and the Balance of Trade:

The main difference between an open economy and a closed economy is that in an open economy, the total value of its consumption may be different from the total value of its GDP.

GDP is divided into four broad categories of spending: consumption (C), investment (I), government purchases (G) and net exports (X – AT), where X stands for exports and M for imports.

So we can express GDP as:

Y = C + I + G + X – M

This identity is called national income accounts identity for an open economy. Consumption refers to household expenditure on various goods and services. Goods are of three types: non-durables (such as food and cloth), durables (such as cars and refrigerators) and services (such as haircut, education and medical care).

Investment refers to capital goods, which are purchased for producing mainly consumer goods in the economy (although, in reality, machines are also used to make machines). It may be noted, at the outset, that investment does not include purchases of shares and bonds, which just reallocate existing assets among different individuals. Investment refers to expenditure on new capital, which can be used in the future.

Investment is of three main types: business fixed investment, residential fixed investment and inventory investment. Business investment is the purchase (acquisition) of new plant, equipment and machinery by firms.

Residential investment is the purchase of new houses by the individuals. Inventory investment is the increase in the firm’s stock of finished goods (although business firms also hold stocks of raw materials). A fall in inventories implies negative investment and vice versa.

Government purchases are the various goods and services purchased by the central, state and local governments (such as municipalities and panchayats) such as food, books, stationery, railway wagons, and medicines as also services of government workers. For example, when an individual is working in a nationalised bank, the government is buying his service by paying him salary.

Government purchases does not include transfer payments made to individuals, such as pensions, interest on government bonds, unemployment benefit, etc. Those who receive such transfer payments do not provide anything to the government in exchange.

This is why they are excluded from GDP. For example, interest on government bonds is not a part of GDP because government pays interest on bonds just by taxing people.

So, there is a transfer of income from taxpayers to bondholders but the total production of goods and services and thus, the flow of income remains constant. There is just reallocation of existing income through such transfers. However, interest paid by a company to its debenture holders is a part of national income because the company pays such interest from its sales revenue.

Net exports are the difference between exports and imports. It is the difference between the value of goods and services exported to the rest of the world and the value of goods and services imported from the rest of the world. They represent the net exports by foreigners on domestically produced goods and services. Such income generates income for domestic producers.

Thus, national income is the sum-total of income earned by the people of a country through their contribution to the production process. It not only includes income earned within the domestic territory of a country but also any income earned abroad.

We may now refer to the macroeconomic identity for an open economy.

The National Income Accounts Identity for an Open Economy:

From the expenditure side, national income = total final expenditure

= C + I + G + X – M

Total final expenditure consists of expenditure that generates income, or it can be thought of as sources of income.

Now let us consider the expression:

Y = C + S + T. The right hand side of this equation indicates the use of the income generated in the economy (for consumption, for saving, and for taxes).

Since uses of income must equal sources of income, we have the following identity:

C + S + T = C + I + G + X – M

or, S + T = I + G + X – M

or, S + T + M = I + G + X

This implies that the sum-total of leakages from the circular flow of income = the sum- total of injections into the circular flow.

Another Interpretation of the above Identity:

The above equation can be expressed as:

I + G + X = S + T + M

or, I = S + (T – G) + (M – X)

Total investment = household saving + budget surplus + trade deficit

or, S = I + (G – T) + (X – M)

or, S – I = (G – T) + (X – M)

or, the difference between S and I = government budget deficit + trade surplus.

The Twin Deficits:

In an open economy, a fiscal deficit shall spread to a current account deficit (CAD). The CAD is the excess of I over S plus the excess of G over T. So as G exceeds T, unless I falls or S rises, the CAD will widen.