AP_Krugman_Textbook

that the sum of the red and green arrows going into the United States is equal to the

sum of the red and green arrows going out of the United States. That is,

(41-2) Positive entries on the current account (lower green arrow) +Positive

entries on the financial account (lower red arrow) =Negative entries

on the current account (upper green arrow) +Negative entries on the

financial account (upper red arrow)

Equation 41-2 can be rearranged as follows:

(41-3) Positive entries on the current account −Negative entries on the current

account+Positive entries on the financial account −Negative entries on

the financial account = 0

414 section 8 The Open Economy: International Trade and Finance

figure 41.1

The Balance of Payments

The green arrows represent payments that are

counted in the current account. The red arrows

represent payments that are counted in the fi-

nancial account. Because the total flow into

the United States must equal the total flow out

of the United States, the sum of the current ac-

count plus the financial account is zero.

Payments to the rest of the world for assets

Payments to the United States for assets

Payments to the rest of the world for goods

and services, factor income, and transfers

Payments to the United States for goods

and services, factor income, and transfers

United

States

Rest of

world

GDP, GNP, and the Current Account

When we discussed national income account-

ing, we derived the basic equation relating GDP

to the components of spending:

Y=C+I+G+X−IM

whereXandIMare exports and imports, respec-

tively, of goods and services. But as we’ve

learned, the balance of payments on goods and

services is only one component of the current ac-

count balance. Why doesn’t the national income

equation use the current account as a whole?

The answer is that gross domestic product,

which is the value of goods and services pro-

duced in a country, doesn’t include two sources of

income that are included in calculating the current

account balance: international factor income and

international transfers. The profits of Ford Motors

U.K. aren’t included in America’s GDP, and the

funds Latin American immigrants send home to

their families aren’t subtracted from GDP.

Shouldn’t we have a broader measure that

does include these sources of income? Actually,

gross national product—GNP—does include in-

ternational factor income. Estimates of U.S. GNP

differ slightly from estimates of GDP because

GNP adds in items such as the earnings of U.S.

companies abroad and subtracts items such as

the interest payments on bonds owned by resi-

dents of China and Japan. There isn’t, however,

any regularly calculated measure that includes

transfer payments.

Why do economists use GDP rather than a

broader measure? Two reasons. First, the original

purpose of the national accounts was to track

fyi

The funds Latin American immigrants send home

through Western Union wires, as advertised on

this billboard, aren’t subtracted from GDP.

production rather than income. Second, data on

international factor income and transfer payments

are generally considered somewhat unreliable. So

if you’re trying to keep track of movements in the

economy, it makes sense to focus on GDP, which

doesn’t rely on these unreliable data.

Michael Newman/Photo Edit