International Economics and the Global Economy

1
International Economics and the Global Economy

• The international trading system...has enhanced
  competition and nurtured what Joseph Schumpeter a
  number of decades ago called creative
  destruction,---- the continuous scrapping of old
  technologies to make way for the new Alan
  Greenspan, 2001

2
The Basic Circular Flow of an Economy --- closed
economy.
FP
Individuals/Households
Producers/Firms
C

• The Circular Flow of an Economy
• An economy is a complex organism whose many
  elements engage in a variety of economic
  transactions.
• The circular flow diagram provides a simplified
  picture of all these economic transactions (An
  Abstraction from a real complex economic system.)
• A simplest version of an economy consists of
  households and producers (ignore foreigners for a
  moment)
• A more complete circular flow diagram adds a
  financial sector and a
• government.
• Note that the circular flow shows the directions
  of the flows of payments, not the direction of
  the flows of the goods, and this will help you
  understand the balance of payments later in the
  chapter.
• FP Factor Payments (rent, wages, interest,
  profit/losses)
• C -- incomes of consumers spent on goods the
  value of consumption goods

3
Incentives, Incentives, and Incentives!

• Note that it is incentives that drive the system.
  Each segment of the economy is motivated by
  different sets of incentives, such as profits for
  producers, welfare for consumers, winning
  elections for government, etc.
• Yet all these sectors all interact to determine
  the flows of payments between them. The idea of
  interdependence can be easily conceptualized
  everyone has choices, but the scope of the
  choices are determined by what everyone else does
  in the rest of the economy.
• Consumption choices are limited by income and
  what producers are able to offer, government
  revenue to carry out government activities is
  limited by what government can tax and borrow,
  and production is limited by what consumers are
  willing to pay for.

4
Adding Investment Goods (Capital Goods)
FP
Individuals/Households
Producers/Firms
I
C
I investment goods/capital goods FP Factor
Payments (rent, wages, interest, profit/losses)
5
Adding Intermediate Goods Supplied Among Producers
FP
Individuals/Households
Producers/ Firms
I
IG
C
I flow of capital goods investment flows
from producers of capital to producers of other
goods that use capital. IG intermediate goods-
produced by producers and used by other producers.
6
Adding Transfers among Individuals
FP
Tr
Individuals/Households
Producers/ Firms
IG
I
C
Tr the value of transfers from individuals to
individuals
7
Adding the Government (G) to the Economy
FP
Tr
TXI
TXP
Individuals/Households
Producers/ Firms
Government
TRI
TRP
IG
G
I
C
TXP government tax receipts from producers
corporate taxes TRP - government transfer
payments to producers corporate welfare TXI
government tax receipts from individuals
personal income tax TRI government transfers to
households welfare other forms G government
expenditure on TRp and TRI from income derived
from TXp and TXI
8
Adding the Financial Sector to the Economy
Sp
Financial Sector/Banks
SI
rI
rp
rG
SG
FP
Tr
TXI
TXP
Individuals/Households
Producers/ Firms
Government
TRI
TRP
IG
G
I
C

• Savings can flow between the FS and individuals
  (net flows SI with
• ri as net Earnings or interest income) and
  between FS and producers (Net flowsSp with rp as
• net Earnings or interest income)
• FS and the Government
• if ggtt, then SG lt 0, i.e. government borrows from
  the FS and makes interest payments (rC) to
• the FS US at this time.
• if gltt, then SG gt 0, i.e. government lends the
  FS and receives interest payments (rC) from
• the FS Japan at this time

9
The Closed Economy
Sp
Financial Sector/Banks
SI
rI
rp
rG
SG
FP
Tr
TXI
TXP
Individuals/Households
Producers/Firms
Government
TRI
TRP
IG
G
I
C
Border

• Opening the Closed Economy
• The closed economy circular flow diagram can be
  opened up.
• By adding a foreign economy to the circular flow
  diagram, a countrys foreign transactions can be
  illustrated
• In an open economy, all four sectors of the
  domestic economy transact with foreigners

Note Since EX IM 0, the economy is closed.
10
What Links Could a Single Economy Form with the
Rest of the World?
Sp
Financial Sector/Banks
SI
rI
rp
rG
SG
FP
Tr
TXI
TXP
Individuals/Households
Producers/Firms
Government
TRI
TRP
IG
G
I
C
Border
Abroad or ROW
11
Figure 2.7The Complete Set of International
Links for an Open Economy 14 links
Sp
Financial Sector/Banks
SI
rF
SF
rI
rp
rG
SG
FP
Tr
TXI
TXP
Individuals/Households
Producers/Firms
Government
TRI
TRP
IG
G
I
C
TrF
Border
Transfers TrF
Financial Flows SF, rF
Imports IM
Exports X
Abroad/Foreigners
The open-economy diagram in Figure 2.7 helps your
understanding of the rationale behind the balance
of payments The balance of payments is an
accounting of the payments between the domestic
economy and the rest of the world as shown in
Figure 2.7.
SF
rF
12
Outsourcing, Vertical Specialization, and
International Trade

• Outsourcing explains a large part of the
  international trade in intermediate goods IM.
• Increasingly, international outsourcing is driven
  by vertical specialization.
• Vertical specialization occurs when producers in
  one country import foreign materials, parts,
  components, etc., in order to produce goods that
  may then be exported to yet another country.

13
In an Open Economy, Incentives Still Matter

• In an open economy choices are expanded, but the
  range of choices now depends on what everyone
  else does in the rest of the world (ROW.) The
  extension from the closed-economy circular flow
  diagram into the open-economy circular flow
  diagram (Figure 2.7) highlights the links between
  a national economy and the rest of the world
  (ROW.)
• The key point with this extension is that total
  payments to the rest of the world must be equal
  to the total receipts from the rest of the world.
  
• Specifically, the sum of the net inflows of
  payments for goods and services, asset purchases
  (SF), returns on accumulated foreign assets (rF),
  and transfers (TrF) must be equal to zero, as
  equation (2.2) from the text shows
• (X IM) SF rF TrF 0

14
A Countrys International Transactions

• An open economy exports goods and services, X.
• It also imports goods and services, IM.
• It sends savings abroad (US Assets Abroad) and
  receives an inflow of foreign savings (Foreign
  Assets in the US) the net inflow is SF.
• Past inflows and outflows of savings generate a
  net inflow of returns on assets, rF.
• There is also a net inflow of international
  transfers, TrF.

That is, (X IM) SF rF TrF 0
15
The Logic of the Balance of Payments 1

• The current account contains all transactions
  related to the trade of goods and services
• The current account also contains payments to
  factors of production and earnings on assets.
• Finally, the current account contains transfers
  between people and organizations in different
  countries.
• In terms of the notation used earlier, the
  current account balance CA (X- IM) TrF rF
• Alternatively,
• CA sp ip (g t) FA

16
The Logic of the Balance of Payments 2

• The financial account contains all payments
  related to the sale and purchase of assets.
• In terms of the notation above, the financial
  account balance SF
• Since foreign payments must be exactly offset by
  foreign receipts, the current account and the
  financial account must sum to zero
• That is, (X - IM) TrF rF SF
• How Long Can the U.S. Continue to Run Large
  Current Account Deficits?
• For the past 20 years, the U.S. has imported more
  products than it has exported.
• As a country, it has paid for those extra imports
  by selling assets (IOUs) to foreigners.
• That is, it has covered the deficit on the
  current account with a surplus on the financial
  account.
• How much longer will foreigners be willing to
  accumulate large amounts of U.S. assets?

17
The Net International Investment Position1

• The International Investment Position is the net
  sum of the value of (1) foreign assets that are
  owned by a countrys own citizens, firms, and
  government agencies and (2) domestic assets that
  are owned by foreign citizens, firms, and
  governments.
• The balance of payments measures flows of
  payments over the course of a year, the net
  investment position measures the accumulated
  stocks of assets at a point in time.
• The U.S.s recent financial account surpluses are
  reflected in its large negative net international
  investment position.

18
Table 2-22 The International Investment
Position of the United States(US billions,
current cost basis)

• U.S.-owned Foreign-owned U.S. Net
  International
• assets abroad assets in U.S.
  Investment Position
• 1988 2,008.4 1,997.9 10.5
• 1989 2,350.2 2,397.2 -47.0
• 1990 2,294.1 2,458.6 -164.5
• 1991 2,470.6 2,731.5 -260.8
• 1992 2,466.5 2,918.8 -452.3
• 1993 3,081.4 3,235.7 -144.3
• 1994 3,326.7 3,450.4 -123.7
• 1995 3,930.3 4,273.6 -343.3
• 1996 4,631.3 5,017.8 -386.5
• 1997 5,379.1 6,214.3 -835.2
• 1998 6,174.5 7,268.6 -1,094.2
• 1999 7,386.9 8,440.5 -1,053.6
• 2000 7,350.9 8,934.0 -1,583.2
• 2001 6,862.9 9,172.1 -2,309.1
• Source Table 2 in Elena L. Nguyen (2002), The
  International Investment Position of the United
  States at Yearend 2001, Survey of Current
  Business, July, 2002, pp. 18-19.

19
The Foreign Exchange Market

• The foreign exchange market is the set of markets
  where the worlds many different national
  currencies are exchanged.
• It is operated by large private international
  banking firms.
• The foreign exchange market can be represented by
  the familiar supply and demand curves.
• The foreign exchange rate is determined by the
  forces of supply and demand. In equilibrium, the
  supply of a currency equals the quantity
  demanded.
• Note the similarity between the balance of
  payments net zero sum of international payments
  and the foreign exchange markets equilibrium
  where the supply and demand of a currency is
  equal.

20
An Example An Increase in Demand for Pesos (FX
to USresidents) US Perspective
e/peso number of required to get 1 Peso
0.10

• If holders of dollars want to engage in more
  foreign transactions that require Mexican pesos,
  the demand for pesos will increase.
• Such an increase in demand for pesos will cause
  the dollar to depreciate and the exchange rate e
  to rise, all other things equal.
• In the example shown, e rises from .10 to .125
  ( depreciation, peso appreciation).

21
The Foreign Exchange Market The Mexican
Perspective
1/ePeso/ number of pesos required to get 1
1/0.1010Pesos

• The supply curve for dollars from the U.S.
  perspective is seen as the demand curve for pesos
  from Mexico
• Similarly, the U.S. demand curve for dollars is
  the supply curve of pesos.
• Thus, the equilibrium exchange rate from the
  Mexican perspective is 1/e 1/.10 10 pesos.

22
The Foreign Exchange Market A Shift in the
Supply of Pesos

• The shift (increase) in demand for dollars from
  the U.S. perspective is a shift in supply of
  pesos from the Mexican perspective.
• The shift in supply causes the exchange rate to
  decline from 10 pesos, or 1/e 1/.10, to 1/e
  1/.125 8 pesos (Peso appreciation,
  depreciation)
• 37.5 million dollars are exchanged for 300
  million (8x37.5) pesos