DANBY     Macro Flows Tutorial     2.2

2.2 Assembling the Picture

A. Big Picture for a Country with a Trade Deficit
Here is a picture of flows for a country with a trade deficit.  Click on it if you prefer a slightly larger picture.

B. Details for the Country with a Trade Deficit
Let's quickly sum up how they fit together.

The trade deficit (M>X) shows up both here,

o1.GIF (19175 bytes)

where we see that the country is able to buy more stuff than it makes (E>Y), and here:

o3.GIF (19175 bytes)

where we see that foreigners are sending us more goods than we send to them.

You should already be able to see that the difference between imports and exports has to be exactly the same as the difference between absorption and output, or, using M for imports and X for exports:

And we can see that Which is a simple statement of the Balance of Payments.  We can squeeze one more thing out of that: Take a moment to see how we got that.

We can define

and

    Net Exports =  Exports - Imports

(Net exports is also what is commonly called the trade balance.)  Therefore,

    Net Exports = Net Foreign Investment

In this case, both are negative.

We can carry this a step further.  Why on earth would foreigners be willing to send us more goods than we send them?  The answer is that they are getting something that is not goods.  They are buying assets from us.  Foreigners, in other words, are selling us their stuff and then turning around and using the money they get from selling us stuff to buy, not our stuff, but our assets.  That's what "gross foreign savings" means -- total foreign purchases of assets from us.  Foreigners are buying more of our assets than we are buying of theirs.  And that difference, in turn, is shown down here:

in which we can see that foreigners are buying more securities in our financial market (Gross Foreign Saving) than they are selling (Gross Foreign Investment).

We have two sides that have to add up:
 
Government deficit (G-T)
Gross Foreign Investment
+  Domestic Capital Investment
___________________________
All Sales of securities
= Gross Foreign Savings
    +         Domestic Savings
________________________
All Purchases of securities

Or:

(We're going to start calling "I" "Id" for domestic investment to help keep concepts straight.)
This same thing can be expressed in about six different ways.  One is: which simply points out that all the saving, on one side, has to end up with one of the three kinds of borrowers.  How about: which says that domestic saving goes to one of three places: domestic firms, government, or net lending abroad.  This makes more intuitive sense when NFI is positive.  Or how about: Which points out the following: Our net purchases of foreign securities muast be equal to total domestic saving minus the two domestic things that suck up saving: investment plus government borrowing.

In the case we're looking at here, GFS > GFI.  Foreigners are buying more of our securities than we are buying of theirs.  So look at what's going on:

The fact that GFS is so much bigger than GFI allows both government and domestic businesses to borrow a lot more than they could get if they could only borrow from domestic savers.  And that brings us back again to:

o1.GIF (19175 bytes)

Why are I + G so much bigger than S + T?  We've just seen the answer: because foreigners lent a lot of money to us to buy their goods.  The money went through the financial sector and ended up with businesses and (indirectly), government, which were able to buy more goods than they would have been able to without all that foreign lending.

C. Big Picture for a Country with a Trade Surplus
(Click on the image to see a slightly larger version.)


 

D. Details for the Country with a Trade Surplus
Let's quickly sum up how they fit together.  The trade surplus (X>M) shows up both here,
os1.GIF (19369 bytes)

where we see that the countrymakes more stuff than it buys (Y>E), and here:
os3.GIF (19369 bytes)

 where we see that foreigners are getting more goods frome us than they are sending to us.

You should already be able to see that the difference between exports and imports has to be exactly the same as the difference between output and absorption, or

which is the same thing as Discussed above. Just as above, In this case, both are positive.

Why on earth would we be willing to send foreigners more goods than they send us?  The answer is that we are getting something that is not goods.  We are buying assets from them.  We are selling us stuff to foreigners and then turning around and using the money we get from selling them stuff to buy their assets, not their stuff.   That difference is shown down here:

os2.GIF (19369 bytes)

where you can see that we save a lot, and use a lot of that saving to buy foreign assets.  We are net purchasers of foreign assets.

We still have two sides that have to add up:
 
Government deficit (G-T)
Gross Foreign Investment
+  Domestic Capital Investment
___________________________
All Sales of securities
= Gross Foreign Savings
+         Domestic Savings
________________________
All Purchases of securities
 Or:

We can still express this a lot of ways; look at which says that domestic saving goes to one of three places: domestic firms, government, or net lending abroad.  NFi is positive here so it does make more intuitive sense in terms of thinking about where all that domestic saving went.

And finally we return to:

Why are I + G so much smaller than S + T?  We've just seen the answer: because we are lending foreigners money to buy our stuff, so that lending is not financing purchases of our stuff by our own government or by our own businesses.

E. Algebra
 Definitions and fundamental balances:

F. Summary and Results
 We can summarize this by saying that four things must be equal:  If this difference is positive, then If this difference is negative, then Therefore international trade, international finance, and the performance of the goods-producing and financial parts of the domestic economy are all intimately inter-related.