ECA001 - Principles of Macroeconomics

I.1 Measuring the Macroeconomy

Lecture 5: Sectoral Analysis and the

Flow of Funds
 Overview

 So far we have discussed the circular flow of income,

how to measure GDP and how to use and interpret
GDP statistics
 This lecture addresses the relationship between the the
sectoral distribution of income and the financial flow of
funds
 You will not find this in the textbooks, but this aspect of
the social accounts is essential to understanding global
imbalances – David Cameron’s ‘re-balancing the
economy’ and financial crises
 Indeed economists failure to use this financial data
indirectly lead to the crash of 2008-09 not being
anticipated
 Contributions Analysis
 A technique to show what each component of GDP is
contributing to the short-run growth of GDP.
 From the national income identity:
GDP = Ca + Ia + Ga + Xa - IMa
Take first differences, denoted by Δ;
i.e. ΔZ = Z(t) - Z(t-1) and divide by GDP(t-1) to get:
ΔGDP/GDP(t-1) = ΔCa/GDP(t-1) + ΔIa/GDP(t-1)
+ ΔGa/GDP(t-1) + ΔXa/GDP(t-1)
- ΔIMa/GDP(t-1)
This divides the growth of GDP into the sum of its
component parts
 UK Data Example

£bn
 The data GDP C I G X
for the UK (£bn) in current 2011 prices give the following numbers for four
IM
successive
2008 years 1518.6 973.5 274.2 315.9 420.9 456.8
2009 1482.1 958.3 221.9 330.0 400.3 428.4
2010 1558.4 1004.7 254.7 336.6 447.1 484.1
2011 1617.7 1039.1 265.1 337.3 499.5 523.3

 The calculations give:

 Results

Annual Annual Annual Annual Annual Annual

% ΔCa as ΔIa as % ΔGa as ΔXa as ΔIMa as
change % of of GDP % of % of % of
in GDP GDP GDP GDP GDP
2008 - 9 -2.4 -1.0 -3.4 0.9 -1.4 1.9
2009-10 5.1 3.1 2.2 0.4 3.2 -3.8
2010-
11 3.8 2.2 0.7 0.0 3.4 -2.5
 Interpretation of Results

 We can see that the %Δ in GDP was negative (-2.4%)

in 2008-09 showing the recession
 The principal reason for this was the fall in
investment. Thus the Great Recession of 2008-09
was largely due to a collapse of private investment
 The subsequent recovery has been in consumption
and in exports with government spending having little
positive impact on GDP due to the policy of austerity
 Much of the growth in consumption has been matched
by a growth in imports, suggesting a slow supply-side
response to higher home demand
 National Income and Saving

 So far we have written the national income or GDP

(Y) identity as the sum of consumption, investment,
government spending and net exports:
i.e. Ya = Ca + Ia + Ga + Xa – IMa
where the superscripts a’s denote that these are
respectively the ex post measured values
 Next we need to define private savings (S).
Households savings are defined as the residual
income remaining after income taxes (T) and
consumption expenditures(C); that is
Sa = Ya – Ta – Ca
 Sector balances

 Substituting for Ya into the saving equation gives:

Sa = Ca + Ia + Ga + Xa – IMa –Ta – Ca
 Noting that the two terms in Ca cancel out gives:
Sa = Ia + Ga + Xa – IMa –Ta
 Then rearranging the remaining elements gives:
(Sa – Ia) = (Ga – Ta) + (Xa – IMa)
non-bank private = public sector + overseas sector
sector surplus deficit deficit
These are the sector balances and they must always
sum to zero due to the fact they are accounting
identities derived from a closed form system
 Interpretation

 If Sa = Ia and Ta = Ga then, by definition, Xa = IMa and

each sector would be in balance with no sector
borrowing or lending to the others.
 The identity can also be rearranged to explicitly show
that the sector balances must sum to zero:
(Ia – Sa) + (Ga – Ta ) + (Xa – IMa) = 0
 The flow of funds between the sectors ensures that
this zero balance always holds by each sector
borrowing or lending to the other sectors
 Such funds are acquired or sold through the financial
system
 Example of an excess of nbps saving

 If there is a non-bank private sector (nbps) surplus so that

Sa > Ia then this additional saving (called the net acquisition
of financial assets, NAFAp) is explicitly made up as follows:
Sa – Ia = financial surplus
= increase in financial assets
– increase in financial liabilities
= net acquisition of financial assets (NAFAp)
 Suppose a company has savings of £100,000 and
investment of £200,000 in a year and its financial assets
and liabilities consist of bank deposits and loans
respectively. Then there are 2 financing options A or B
where Δ denotes a change in:
 Table for example

£’000s £‘000s
Saving 100
- Investment -200
Financial surplus -100
Scenarios A B
Δ bank deposits +50 -50
- Δ loans -150 -50
NAFA -100 -100
 The Flow of Funds

 A picture of all the financial activities of each sector is

obtained by listing its transactions in all financial assets and
liabilities, which taken together must be consistent with the
sector’s financial surplus or deficit
 A table in which the rows show different categories of
financial assets (instruments) and the columns show the
sectors financial transactions in each instrument is called a
flow of funds table
 The flow of funds table then presents a complete consistent
statement of the financial transactions between the sectors of
the economy
 Flow of Funds Data

 Because financial assets are stocks (measured at a

single point in time, such as 31st December 2011)
rather than flows (measured over time, such as a
year) to make the income –expenditure accounts
match the flow of funds the asset stocks are always
recorded as “changes in” denoted by Δ
 The flow of funds is therefore a matrix of changes in
assets and liabilities of the sectors
 A minus sign (-) denotes a liability of that sector and a
plus sign (+) an asset to that sector
 It is important to note that a fall in a liability is
anaytically equivalent to an increase in an asset
 Assets and Sector Notation

 In the highly simplified matrix that follows I am going to

assume that there are just 5 assets:
Cash (N – for notes and coin)
Bank Deposits (D – for deposits)
Loans (L – for banks loans)
Government Debt (bonds) (B for bonds)
Foreign government bonds (F for foreign bonds)
 These assets are held by the non-bank private sector
(nbps, denoted by a subscript p; the overseas sector
denoted by a subscript o; the commercial banking
sector denoted by a subscript B or the central bank
denoted by a subscript CB ).
 Non-bank private sector?

 The private sector of the economy consists of

households and privately owned firms (i.e.
firms whose equity is held by households)
 Commercial banks are private companies and
are part of the private sector, but their
liabilities are assets of firms and households
also in the private sector.
 Since banks balance sheets always balance -
they do not take net positions - the relevant
measure of the private sector is to exclude
commercial banks – hence the term nbps
 Now to the Matrix -

 Each row denotes a financial instrument and each

column a sector of the economy
 A minus sign in any cell denotes that for that sector
the financial instrument is a liability; e.g. a bond
issued by the government will appear as a liability to
the government sector, but an asset to all other
sectors
 A plus sign in any cell denotes that for that sector the
financial instrument is an asset; e.g. a government
bond is an asset to the nbps.
 Every row sums to zero since all liabilities must be
held by someone
 nbps Public Overseas Bank Central Row
sector sector sector bank totals
Cash +ΔNP +ΔNB -ΔN 0

Deposits +ΔDP -ΔD 0

Loans -ΔLp +ΔLB 0

Bonds +ΔBP -ΔB +ΔBO +ΔBCB 0

$- +ΔFP -ΔF +ΔFCB 0

Bonds
Column I-S G-T X – IM 0 0
totals
 Interpretation

 The banking sector columns sum to zero because

banks in total can not take an open position
 Reading down any column gives that sector’s
balance. So the overseas column gives the balance of
payments identity as: (X – IM) = ΔF - ΔBo the current
balance surplus equals the net acquisition of foreign
bonds less the net change in the overseas sectors
holdings of domestic bonds
 Similarly any public sector deficit must be financed by
the sale of bonds: G –T = ΔB from column 3 and the
nbps can be held in any of the 5 assets: i.e.
S – I = ΔNp + ΔDp - ΔLp + ΔBp + ΔFp
 Financing the Public Sector

 An interesting use of the matrix is to make transparent the

relationship between the government budget deficit and the money
supply – and to destroy the media myth perpetuated by Neo-classical
economists – that there is a one-to-one relationship between
(G –T) and the change in the money supply (ΔMs)
 From the banking columns we have:
ΔN= ΔBCB+ΔFCB and ΔD= ΔNB+ΔLB
 Defining the money supply as:
ΔMs = ΔD + ΔN – ΔNB
= ΔLB + ΔBCB + ΔFCB
 Cont’d

 If there are no change in foreign currency reserves

(as there will not be under freely floating exchange
rate, ΔFCB =0) and noting that ΔLB =ΔL (from row 4 of
the matrix) then substituting for ΔBCB from the bond
row (row 5 gives:
ΔMs = ΔB - (ΔBp + ΔBo) +ΔL
ΔMs = (G - T) - (ΔBp +ΔBo) +ΔL
So a higher budget deficit need not increase the
money supply providing the government is able to sell
its bonds to either the nbps or the overseas sector.
 Conclusions

 The national income accounts are the main source of

macroeconomic data on the real side of the economy
and the flow of funds for the financial side
 Like all data they need to be used with great care: in
particular they are ex post; i.e. they capture flows that
have already taken place and these may differ greatly
from planned (or ex ante) future flows which are the
concern of macroeconomic theory
 They do, however, capture the intrinsic dynamic
nature of the macroeconomy by virtue of the fact that
all sectors can be in financial deficit or surplus in any
period as they invest or disinvest in a future period
 Cont’d

 it is borrowing and the investment in physical capital

that gives rise to more efficient machines and to
higher productivity
 In turn this generates economic growth and rising
incomes and wealth
 Economic growth will be the next topic