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 Goals of This Chapter • Review the simple circular flow diagram of a closed economy. • Illustrate how the closed economy circular flow diagram can be extended into an open economy circular flow diagram and all of its linkages with the rest of the world. • Explain the balance of payments accounts, which reflect the logic of the open economy circular flow diagram. • Introduce foreign exchange markets and explain how foreign exchange rates are determined by the supply and demand for currencies, which are fundamentally related to the flows recorded in the balance of payments. • Present the recent changes in the U.S. balance of payments. • Explain the net investment position of a country and how it is related to the balance of payments.

3. 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. • A simplest version of an economy consists of households and producers. • 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 or services paid for.

4. The Basic Circular Flow of an Economy FP Individuals Producers C

5. Adding Investment Goods (Capital Goods) FP Individuals Producers I C

6. Adding Intermediate Goods Supplied Among Producers FP Individuals Producers I IG C

7. Adding Transfers among Individuals FP Tr Individuals Producers IG I C

8. Adding the Government to the Economy FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C

9. Adding the Financial Sector fo the Economy Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C

10. The Closed Economy Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border

11. 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 country’s foreign transactions can be illustrated • In an open economy, all four sectors of the domestic economy transact with foreigners

12. What Links Could a Single Economy Form with the Rest of the World? Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Abroad

13. The Economy Could Import Consumption Goods Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Imports IM Abroad

14. It Could Import Intermediate Goods Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Imports IM Abroad

15. And Capital Goods Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Imports IM Abroad

16. Finally, the Government Could Import Goods Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Imports IM Abroad

17. The Open Economy Also Exports Consumption Goods, Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Exports X Imports IM Abroad

18. Intermediate Goods, Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Exports X Imports IM Abroad

19. Investment (Capital) Goods, Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Exports X Imports IM Abroad

20. And Government Goods Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C Border Exports X Imports IM Abroad

21. There Are International Transfers by Individuals Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C TrF Border Exports X Imports IM Abroad

22. And by Governments Sp SI Financial Sector rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C TrF Border Transfers TrF Exports X Imports IM Abroad

23. There Are Also International Asset Sales and Purchases, Sp SI Financial Sector SF rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C TrF Border Transfers TrF Exports X Imports IM Abroad SF

24. And the Returns to Foreign-Owned Assets Sp rF SI Financial Sector SF rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C TrF Border Transfers TrF Financial Flows SF, rF Exports X Imports IM Abroad SF rF

25. Figure 2.7The Complete Set of International Links for an Open Economy Sp rF SI Financial Sector SF rI rG SG rp FP Tr TXI TXP Individuals Government Producers TRI TRP IG G I C TrF Border Transfers TrF Financial Flows SF, rF Exports X Imports IM Abroad SF rF

26. A Country’s International Transactions • An open economy exports goods and services, X. • It also imports goods and services, IM. • It sends savings abroad and receives an inflow of foreign savings; 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.

27. Outsourcing, Vertical Specialization, and International Trade • Outsourcing explains a large part of the international trade in intermediate goods. • 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.

28. The Logic of the Balance of Payments • The open-economy circular flow diagram shows that the net flows of payments for goods and services, asset purchases, returns on accumulated foreign assets, and transfers across a country’s border must sum to zero: (X-IM) + SF + rF + TrF = 0 • This logical conclusion lies behind the balance of payments accounting. • In the balance of payments, the sum total of outflows of payments across the border for products, assets, and transfers equals the sum total of payment inflows from abroad.

29. The Logic of the Balance of Payments • 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 = (X!IM) + TrF + rF

30. The Logic of the Balance of Payments • 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

31. 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 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?

32. The Net International Investment Position • The International Investment Positionis the net sum of the value of (1) foreign assets that are owned by a country’s 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.

33. Table 2-2The 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.

34. The Foreign Exchange Market • The foreign exchange market is the set of markets where the world’s 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 market’s equilibrium where the supply and demand of a currency is equal.

35. An Example: The Market for Mexican Pesos • The demand curve intersects the supply curve at the price $.10. • That is, one peso costs ten U.S. cents. • We often use the letter e to represent the foreign exchange rate, so that the equilibrium can be written as e = $.10.

36. An Example: An Increase in Demand for Pesos • 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.

37. The Foreign Exchange Market: The Mexican Perspective • 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.

38. The Foreign Exchange Market: A Shift in the Supply of Pesos • The shift 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 • 37.5 million dollars are exchanged for 300 million (8x37.5) pesos