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Chapter 8 Aggregate Accounts, Budget Constraints, and Model Consistency

The World Bank. Chapter 8 Aggregate Accounts, Budget Constraints, and Model Consistency. © Pierre-Richard Agénor. Production, Income, and Expenditure A Consistency Accounting Matrix National Income Identities and Budget Constraints A Three-Good Model with Banks An Intertemporal Framework.

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Chapter 8 Aggregate Accounts, Budget Constraints, and Model Consistency

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  1. The World Bank Chapter 8Aggregate Accounts, Budget Constraints, and Model Consistency © Pierre-Richard Agénor

  2. Production, Income, and Expenditure • A Consistency Accounting Matrix • National Income Identities and Budget Constraints • A Three-Good Model with Banks • An Intertemporal Framework

  3. Production, Income, and Expenditure

  4. Production: Goods, services carried out by domestic agents; firms, self-employed workers, financial institutions, and the government. • Income: Wages and salaries, firms' operating surpluses, property income, and imputed compensation. • Expenditure: Outlays on durable and nondurable final consumption goods and investment.

  5. Linked by three macroeconomic relationships: • Production and income: total value of production must equal the value of income (excluding transfers) generated domestically. • Income, expenditure, and savings: for any economic agent, income earned plus transfers must be equal to expenditure plus savings. • Savings and asset accumulation: savings plus borrowing must equal asset acquisition for any economic agent.

  6. A Consistency Accounting Matrix • Current account transactions • Capital account transactions

  7. Five sets of accounts incorporated in the consistency framework: • The national accounts. • The accounts of the nonfinancial private sector. • The government accounts. • The balance sheets of the financial sector. • The balance of payments.

  8. Current Account Transactions

  9. See Table 8.1 • Rows: sources of finance for each sector. • Columns: uses of finance for each sector. • Ex Post: each sector’s deficit must be financed,  sum of rows = sum of columns. • Ex Ante: sectoral balances areconstraints.

  10. National Accounts • Row 1 & Column A, National Accounts: consolidated current-period activities of all production units; • incorporated enterprises (financial and nonfinancial); • informal sector firms; • producers of government services; • production by households for own consumption.

  11. National Accounts • Row 1, allocation of goods, services produced domestically, Y, or imported, J, between: • government consumption, Cg; • private consumption, Cp; • exports, X; • government and private sector investment, Ig and Ip, with I = Ig + Ip.

  12. National Accounts • Column A, GDP at current market prices, Y, decomposed into types of income generated through sale (plus own consumption) of domestic output; • net indirect taxes: indirect taxes, TI, less subsidies, SUB; • operating surplus of government enterprises, OSg; • wages and salaries, W, and profits, ; • incomes of the self-employed and own-account producers, Ys.

  13. National Accounts • GDP at factor costs,Yfc: sum of employee compensation (wages, salaries and incomes of own-account producers) and operating surpluses of all enterprises. • Value added at factor cost, Vfc: by convention, accrues to households or government. • Value added at Market Price:Vfc + net indirect taxes. • Total amount of goods and services available for final use: sum of value added at market prices and imports.

  14. Current Government Transactions Row 2 & Column B: • Government savings, Sg, given by, Sg = Tg - G, Tg = TI - SUB + OSg + TD + NTgf, G = Cg + NTpg + INTpg + INTfg .

  15. Row 2: Sources of government revenues, Tg, as, • net indirect taxes, TI- SUB; • operating surpluses of government-owned enterprises, OSg; • direct taxes on the nonfinancial private sector, TD; • net transfers to government from external sector, NTgf.

  16. Current Government Transactions Row 2 & Column B: • Column B: government expenditures, G, as • government consumption of goods and services, Cg; • net transfers to the nonfinancial private sector, NTpg; • interest paid to the private sector on domestic public debt, INTpg; • interest payments on public foreign debt, INTfg.

  17. Financial Sector Row 3 & Column C: • Financial system: pure intermediary. There is no independent revenues, expenditure accounts.

  18. Nonfinancial Private Sector Row 4 & Column D: • Private saving, Sp: total private sector income, Yp, minus total current expenditures of the private sector, CCp: Sp = Yp - CCp with Yp = W +  + s + NTp + INTpg + NTpf + NFPpf, CCp = Cp + TD + INTfp + Sp.

  19. Nonfinancial Private Sector Row 4 & Column D: • Row4: private sector revenues, Yp, as, • factor income, including wages and salaries, W, profits, , and incomes of the self-employed, s; • net transfers received from the government, NTp; • interest payments received on government debt holdings, INTpg; • net transfers, NTpf, plus net factor payments from abroad, NFPpf.

  20. Nonfinancial private sector Row 4 & Column D: • Column D: private sector expenditures, CCp, as, • private consumption, Cp; • payment of direct taxes, TD; • interest payments on private external debt, INTfp.

  21. External Sector Row 5 & Column E: • Current Account Balance, CA: - (savings by foreign residents); CA = X + (NTgf + NTpf) + NFPpf - J - INTfg - INTfp

  22. External Sector Row 5 & Column E: • Row 5: sources of income to foreign residents; • value of imports of goods and services, J; • public and private sector interest payments on their respective external debts, INTfg and INTfp. • Column E: sources of income from foreign residents; • exports of goods and services, X; • net current transfers to the government and private sectors, NTgf and NTpf; • net factor payments to the private sector, NFPpf.

  23. Capital Account Transactions

  24. Financing of asset acquisition by government, private nonfinancial sector, and external sector. Government Row 6 & Column F: • Row 6: sources of financing: • government savings, Sg; • net borrowing from the financial system,Lgb; • net borrowing from the private sector, Bp; • net foreign borrowing, FBg. • Column F: gross fixed capital investment by the government, Ig.

  25. Financial Sector Row 7 & Column G: • Row 7: financial system liabilities, M; • new domestic currency issues, • demand deposits, • time deposits. • Column G: financial system assets; • loans to the government, Lgb, • loans to the private sector, Lpb, • net foreign assets, R*.

  26. Nonfinancial Private Sector Row 8 & Column H: • Row 8: private sector asset acquisition financing; • private sector savings, Sp, • net borrowing from the financial system, Lpb, • net borrowing from abroad, FBp. • Column H: private sector asset acquisitions; • private investment, I p; physical assets, inventories and working capital, plus intangible nonfinancial assets; • net lending to the government, Bp; • increases in holdings of monetary assets, M, that is, liabilities issued by the financial sector.

  27. External Sector Row 9 & Column I: • Row 9: savings by foreign residents, CA (deficit), and acquisition of net foreign exchange reserves by the financial system, R*. • Column I: net foreign borrowing of the government, FBg, and the private sector, FBp. • Rise (fall) in either the current account deficit or foreign exchange reserves must be accompanied by a rise (fall) in foreign savings (borrowing from abroad).

  28. Savings-Investment Balance Row 10 & Column J: Total domestic savings finances total investment; • Row 10: total domestic savings; government saving, Sg, private saving, Sp, plus foreign saving (CA). • Column J: Total investment; government investment, Ig, plus private investment, I p.

  29. National Income Identitiesand Budget Constraints • Gross domestic product and absorption • The government budget constraint • The private sector budget constraint • The balance sheet of the financial system • The savings-investment balance

  30. Gross Domestic Product and Absorption • Two approaches for estimating GDP: expenditure approach and value added approach

  31. Set row 1 = column A, Cg + Cp + X + Ig + Ip = W +  +  s + OSg + (TI - SUB) + J (1) • GDP at market prices, Y: Y = C + I + X - J, (2) with, C = Cp + Cg, and I = Ip and Ig. • GDP at factor cost, Yfc: Yfc = W +  +  s + OSg (3)

  32. Y = Yfc + (TI - SUB), • Y: GDP at market price equals Yfc: GDP at factor prices, plus indirect taxes net of subsidies. J - X = A - Y = I - (Y - C) = I - S, • J - X: net imports, equals A-Y: domestic absorption over output, equals I-S: investment over savings. • Reduction in trade deficit requires decrease (increase) in absorption (domestic savings).

  33. The Government Budget Constraint • Government Revenues/Expenditures, • Row 2 = Column B, TI - SUB + OSg + TD + NTgf = Cg + NTpg + (INTpg + INTfg) + Sg (6) or, Tg - G = Sg (7). • Current public revenues equal current expenditures plus current savings.

  34. Government savings and borrowing, • Row 6 = Column F, Sg + Lgb + Bp + FBg = Ig (8) • Government savings plus net domestic and foreign borrowing equals physical assets acquired. • Substitute (Tg – G) for Sg in (8): G + Ig - Tg = Lgb + Bp + FBg (9) with, G + Ig - Tg: overall fiscal deficit, Lgb + Bp + FBg: sources of deficit financing.

  35. The Private Sector Budget Constraint • Private Sector Income/Expenditures • Row 4 = Column D, W + + s + NTpg + INTpg + NTpf + NFPpf = Cp + TD + INTfp + Sp or Yp = CCp + Sp(10) with CCp = Cp + TD + INTfp Yp = W +  + s + NTpg + INTpg + NTpf + NFPpf

  36. Private Sector Saving/Borrowing • Row 8 = Column H: Sp + Lpb + FBp = Ip + Bp + M (11) Substituting (Yp – CCp)for Spin (11)  • Private sector budget constraint: Yp- CCp+ Lpb + FBp = Ip + Bp + M • Private sector income plus borrowing net of expenditures equals asset acquisitions; money, physical investment, and lending to the government.

  37. The External Sector Budget Constraint External sector income/expenditures • Row 5 = Column E, J + INTfg + INTfp = X + NTgf + NTpf + NFPpf + CA .

  38. External sector saving/borrowing • Row 9 = Column I, CAD = FBg + FBp - R* • CA deficit financing via, • increasing net foreign borrowing; • drawing down reserves.

  39. External sector budget constraint: J-X = F - R*, with, J: J + INTfg + INTfp ; X: X + NTgf + NTpf + NFPpf; • gross payments by domestic economy, J; sum of imports and all interest payments on external debt; • gross receipts to the domestic economy, X; exports plus net transfers; • and net factor payments from abroad.

  40. The Balance Sheet of the Financial System • Pure Intermediary: not budget constraint per se, but rather a balance sheet accounting identity. • Row 7 = Column G, L + R* = M, with L = Lgb + Lpb, R* = M - L

  41. Increases (decreases) in domestic credit (L), with money demand unchanged, result in decreases (increases) in foreign reserves.

  42. The Savings-Investment Balance • Add budget constraints of the government and private sectors to yield: S + L + F = I + M. • Given that F = J - X + R*, • Then S + L + (J - X) + R* = I + M

  43. Savings-investment balance: • With L + R* = M, we have, I = S + (J - X) • Domestic investment, I, financed by domestic savings, S, and foreign saving, J - X, (e.g. the current account deficit, CA).

  44. A Three-Good Model with Banks

  45. Open-economy macroeconomic model • Accounting relationships integrated with behavioral equations to analyze transmission process of macroeconomic policy and exogenous shocks. • 5 agents: households, producers, commercial banks, the government, and the central bank. • All households, firms, banks are identical in endowments and behavior. • Exchange rate fixed. • Economy produces two goods: home good and exportable good. • Fixed capital stock and perfect labor mobility.

  46. Households • Supply labor inelasticaly. • Consume both home and importable goods. • Four types of financial assets: domestic money, bank deposits, domestic bonds, and foreign bonds. • Financial assets are imperfect substitutes. • Consumption decisions: two stage process.

  47. Stage 1: Consumption determined by, C = (1 - s)(Y - T), 0 < s < 1, (20) Y: net factor income, T: lump-sum taxes, s: marginal propensity to save.

  48. Stage 2: consumption of imported goods (CI) and home goods (CN) by, CI = (1 - )C, (21) : share of home goods in private expenditures. PNCN = EC (22) • Using (20), (22) rewritten as, CN = zC = z(1 - s)(Y - T) (23) z  E/PN: real exchange rate.

  49. Asset Demand Equations: Money Demand: Md = Md(ib,Y) (24) Demand for Bank Deposits: Dp = Dp(id,ib,Y)(25) - + - + + • Demand for Foreign Bonds: B* = (i* + a - ib ),  > 0, (26) i*: interest rate spread of foreign minus domestic bonds, a : expected nominal exchange rate devaluation,  : degree of substitutability, or capital mobility in fixed income markets.

  50. Uncovered Interest Parity Condition: ib = i* + a holds, when   , e.g. perfect capital mobility. • Using (24), (25), and (26), demand function for domestic bonds, B given by, B = W - Md - Dp - B*.

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