International Finance Revised

8/9/2019 International Finance Revised

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International Finance

by Steve Suranovic

Table of Contents

• About the Author

• Acknowledgments

• Preface

• Chapter 1: Introductory inance Issues: Current Patterns! Past "istory! and

International Institutions

o 1#1: The International $conomy and International $conomics

o 1#%: &'P! (nemployment! Inflation! and &overnment )udget )alances

o 1#*: $+change ,ate ,egimes! Trade )alances! and Investment Positions

o 1#-: )usiness Cycles: $conomic (ps and 'owns

o 1#.: International /acroeconomic Institutions: The I/ and the 0orld )ank

• Chapter %: ational Income and the )alance of Payments Accounts

o %#1: ational Income and Product Accounts

o %#%: ational Income or Product Identity

o %#*: (#S# ational Income Statistics 2%3345%3367

o %#-: )alance of Payments Accounts: 'efinitions

o %#.: ,ecording Transactions on the )alance of Payments

o %#8: (#S# )alance of Payments Statistics 2%3367

o %#4: The Twin5'eficit Identity

o %#6: International Investment Position

• Chapter *: The 0hole Truth about Trade Imbalances

o *#1: 9verview of Trade Imbalances

o *#%: Trade Imbalances and obs

o *#*: The ational 0elfare $ffects of Trade Imbalances

o *#-: Some urther Complications

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o *#.: "ow to $valuate Trade Imbalances

• Chapter -: oreign $+change /arkets and ,ates of ,eturn

o -#1: The ore+: Participants and 9b;ectives

o -#%: $+change ,ate: 'efinitions

o -#*: Calculating ,ate of ,eturns on International Investments

o -#-: Interpretation of the ,ate of ,eturn ormula

o -#.: Applying the ,ate of ,eturn ormulas

• Chapter .: Interest ,ate Parity

o .#1: 9verview of Interest ,ate Parity

o .#%: Comparative Statics in the I,P Theory

o .#*: ore+ $

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o 4#-: /oney Supply /easures

o 4#.: Controlling the /oney Supply

o 4#8: /oney 'emand

o 4#4: /oney unctions and $


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o ?#.: Shifting the AA Curve

o ?#8: Supere


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o 1*#*: Inflationary Conse

About the Author

Steve Suranovic

Steve Suranovic is an associate professor of economics and international affairs at the &eorge0ashington (niversity 2&07 in 0ashington! 'C# "e has a Ph' in economics from Cornell(niversity and a )S in mathematics from the (niversity of Illinois at (rbana5Champaign# "ehas been teaching international trade and finance for more than twenty years at &0 and as anad;unct for Cornell (niversityBs 0ashington! 'C! program# In fall %33%! he taught at Sichuan

(niversity in Chengdu! China! as a visiting ulbright lecturer# "e has taught a &0 class atudan (niversity in Shanghai during the summers of %33? and %313# "e has also spoken to

business! government! and academic audiences in apan! /alaysia! the Philippines! China!and /ongolia as part of the (#S# State 'epartment speakerBs programs#

"is research focuses on two areas: international trade policy and behavioral economics# 0ithrespect to behavior! he e+amines why people choose to do things that many observers view asirrational# $+amples include addiction to cigarettes! cyclical dieting! and anore+ia# "isresearch shows that dangerous behaviors can be e+plained as the outcome of a reasoned andrational optimiation e+ercise# 0ith respect to trade policy! his research seeks to reveal thestrengths and weaknesses of arguments supporting various policy options# The goal is to

answer the /ore generally! heapplies the economic analytical method to identify the policies that can attract the mostwidespread support#

"is book A Moderate Compromise: Economic Policy Choice in an Era of Globalization will be released by Palgrave /acmillan in fall %313# In it he offers a criti


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have been the primary audience for these writings# othing has been more encouraging thanhearing a student e+press how much more intelligible are economics news stories in the Wall Street Journal or Financial imes after taking one of my courses or receiving an e5mail abouthow helpful the freely available online notes have been# I thank all those students and readersfor their encouraging remarks#

I am also indebted to my teachers! going back to the primary school teachers at Assumption)/ in Chicago 2especially Sister /arie7! high school teachers at =incoln50ay in ew=eno+! Illinois 2especially )ill Colgan7! professors at the (niversity of Illinois at (rbana5Champaign! and my economics professors at Cornell (niversity 2especially "enry 0an!&eorge Staller! an Sve;nar! 'avid $asley! /ukul /a;umdar! Tapan /itra! $arl &rinols! &aryields! and ,obert rank7#

or my teaching style! I am grateful to my teachers via te+tbooks! including 0illiam )aumol!Alan )linder! "al arian! Paul @rugman! /aurice 9bstfeld! and especially $ugeneSilberberg! whose graduate5level book he Structure of Economics! offering detailed andlogical e+planations of economic models! was most illuminating and inspiring#

I am also grateful to my colleagues at &0! all of whom have contributed in numerous waysvia countless conversations about economic issues through the years# Particular students whohave contributed to the lat 0orld edition include ,unping Du! iyoung =ee! Andrew @lein!Irina Chepilevskaya! and 9sman Ai# inally I am thankful to the reviewers and productionstaff from lat 0orld @nowledge#

9n a personal note! I remain continually grateful for the loving support of my familyE mychildren! )en and @atelynE and /# ictoria arrales#

I am thankful to the reviewers and production staff from lat 0orld @nowledge#

9n a personal note! I remain continually grateful for the loving support of my familyE mychildren! )en and @atelynE and /# ictoria arrales#

Preface

Traditionally! intermediate5level international economics te+ts seem to fall into one of twocategories# Some are written for students who may one day continue on in an economics Ph'

program# These te+ts develop advanced general e


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do positive economics to help answer the normative The results from models give usinsights that help us answer these


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This first chapter provides an overview of the real world with respect to international finance#It e+plains not only how things look now but also where we have been and why thingschanged along the way# It describes current economic conditions and past trends with respectto the most critical international macroeconomic indicators# In particular! it compares the mostrecent worldwide economic recession with past business cycle activity to put our current

situation into perspective# The chapter also discusses important institutions and e+plains whythey have been created#

0ith this overview about international finance in the real world in mind! a student can better understand why the theories and models in the later chapters are being developed# Thischapter lays the groundwork for everything else that follows#

1.1 The International Economy and International Economics

Learning b!ectives

1. Learn past trends in international trade and foreign investment.

2. Learn the distinction between international trade and international nance.

International economics is growing in importance as a field of study because of the rapidintegration of international economic markets# Increasingly! businesses! consumers! andgovernments realie that their lives are affected not only by what goes on in their own town!state! or country but also by what is happening around the world# Consumers can walk intotheir local shops today and buy goods and services from all over the world# =ocal businessesmust compete with these foreign products# "owever! many of these same businesses also havenew opportunities to e+pand their markets by selling to a multitude of consumers in other countries# The advance of telecommunications is also rapidly reducing the cost of providingservices internationally! while the Internet will assuredly change the nature of many products

and services as it e+pands markets even further#

9ne simple way to see the rising importance of international economics is to look at thegrowth of e+ports in the world during the past fifty or more years# igure 1#1 F0orld $+ports!1?-6H%336 2in )illions of (#S# 'ollars7F shows the overall annual e+ports measured in

billions of (#S# dollars from 1?-6 to %336# ,ecogniing that one countryBs e+ports are another countryBs imports! one can see the e+ponential growth in outflows and inflows during the pastfifty years#

igure 1#1 0orld $+ports! 1?-6H%336 2in )illions of (#S# 'ollars7

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Source: 0orld Trade 9rganiation! International trade and tariff data!http:www#wto#orgenglishresJestatisJestatisJe#htm#

"owever! rapid growth in the value of e+ports does not necessarily indicate that trade is becoming more important# A better method is to look at the share of traded goods in relation

to the sie of the world economy# igure 1#% F0orld $+ports! 1?43H%336 2Percentage of 0orld &'P7F shows world e+ports as a percentage of the world gross domestic product2&'P7 for the years 1?43 to %336# It shows a steady increase in trade as a share of the sie of the world economy# 0orld e+ports grew from ;ust over 13 percent of the &'P in 1?43 to over *3 percent by %336# Thus trade is not only rising rapidly in absolute termsE it is becomingrelatively more important too#

igure 1#% 0orld $+ports! 1?43H%336 2Percentage of 0orld &'P7

igure 1#% 0orld $+ports! 1?43H%336 2Percentage of 0orld &'P7

Source: I/ 0orld $conomic 9utlook 'atabase!http:www#imf#orge+ternalpubsftweo%33?3%weodatainde+#asp+#

9ne other indicator of world interconnectedness can be seen in changes in the amount of foreign direct investment 2'I7# 'I is foreign ownership of productive activities and thus isanother way in which foreign economic influence can affect a country# igure 1#* F0orldInward 'I Stocks! 1?63H%334 2Percentage of 0orld &'P7F shows the stock! or the sum totalvalue! of 'I around the world taken as a percentage of the world &'P between 1?63 and

%334# It gives an indication of the importance of foreign ownership and influence around the

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world# As can be seen! the share of 'I has grown dramatically from around . percent of theworld &'P in 1?63 to over %. percent of the &'P ;ust twenty5five years later#

igure 1#* 0orld Inward 'I Stocks! 1?63H%334 2Percentage of 0orld &'P7

Source: I/ 0orld $conomic 9utlook 'atabase!http:www#imf#orge+ternalpubsftweo%33?3%weodatainde+#asp+E (CTA'! 'IStatistics:

'ivision on Investment and $nterprise! http:www#unctad#orgTemplatesPage#asp>intItemI'K-?4?LlangK1#

The growth of international trade and investment has been stimulated partly by the steadydecline of trade barriers since the &reat 'epression of the 1?*3s# In the postH0orld 0ar IIera! the &eneral Agreement on Tariffs and Trade! or &ATT! prompted regular negotiations

among a growing body of members to reciprocally reduce tariffs 2import ta+es7 on importedgoods# 'uring each of these regular negotiations 2eight of these rounds were completed

between 1?-6 and 1??-7! countries promised to reduce their tariffs on imports in e+change for concessionsGthat means tariff reductionsGby other &ATT members# 0hen the (ruguay,oundThe eighth and last round of &ATT trade liberaliation negotiations that substantiallye+panded the number and scope of trade liberaliation agreements and established the 0T9#!the most recently completed round! was finalied in 1??-! the member countries succeeded ine+tending the agreement to include liberaliation promises in a much larger sphere of influence# ow countries not only would lower tariffs on goods trade but also would begin toliberalie the agriculture and services markets# They would eliminate the many


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Another international push for trade liberaliation has come in the form of regional free tradeagreements# 9ver two hundred regional trade agreements around the world have beennotified! or announced! to the 0T9# /any countries have negotiated these agreements withneighboring countries or ma;or trading partners to promote even faster trade liberaliation# In

part! these have arisen because of the slow! plodding pace of liberaliation under the

&ATT0T9# In part! the regional trade agreements have occurred because countries havewished to promote interdependence and connectedness with important economic or strategictrade partners# In any case! the phenomenon serves to open international markets even further than achieved in the 0T9#

These changes in economic patterns and the trend toward ever5increasing openness are animportant aspect of the more e+haustive phenomenon known as globaliation# &lobaliationmore formally refers to the economic! social! cultural! or environmental changes that tend tointerconnect peoples around the world# Since the economic aspects of globaliation arecertainly the most pervasive of these changes! it is increasingly important to understand theimplications of a global marketplace on consumers! businesses! and governments# That is

where the study of international economics begins#

"hat Is International Economics#

International economics is a field of study that assesses the implications of international trade!international investment! and international borrowing and lending# There are two broadsubfields within the discipline: international trade and international finance#

International trade is a field in economics that applies microeconomic models to helpunderstand the international economy# Its content includes basic supply5and5demand analysis

of international marketsE firm and consumer behaviorE perfectly competitive! oligopolistic!and monopolistic market structuresE and the effects of market distortions# The typical coursedescribes economic relationships among consumers! firms! factory owners! and thegovernment#

The ob;ective of an international trade course is to understand the effects of international tradeon individuals and businesses and the effects of changes in trade policies and other economicconditions# The course develops arguments that support a free trade policy as well asarguments that support various types of protectionist policies# )y the end of the course!students should better understand the centuries5old controversy between free trade and

protectionism#

International finance applies macroeconomic models to help understand the internationaleconomy# Its focus is on the interrelationships among aggregate economic variables such as&'P! unemployment rates! inflation rates! trade balances! e+change rates! interest rates! andso on# This field e+pands basic macroeconomics to include international e+changes# Its focusis on the significance of trade imbalances! the determinants of e+change rates! and theaggregate effects of government monetary and fiscal policies# The pros and cons of fi+edversus floating e+change rate systems are among the important issues addressed#

This international trade te+tbook begins in this chapter by discussing current and past issuesand controversies relating to microeconomic trends and policies# 0e will highlight past trends

both in implementing policies that restrict trade and in forging agreements to reduce trade


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barriers# It is these real5world issues that make the theory of international trade worthstudying#

$ey Takeaways

• International trade and investment ows have grown dramatically and

consistently during the past half century.• International trade is a eld in economics that applies microeconomic

models to help understand the international economy.

• International nance focuses on the interrelationships among aggregateeconomic variables such as GD! unemployment! ination! trade balances!e"change rates! and so on.

• ote that the 'oha ,ound of discussions was begun in %331 and remains uncompleted

as of %33?#

1.% &'P( )nem*loyment( In+ation( and &overnment ,udget

,alances

Learning b!ective

1. Learn current values for several important macroeconomic indicators froma selected set of countries! including GD! GD per capita! unemploymentrates! ination rates! national budget balances! and national debts.

0hen someone reads the business and economics news it is common to see numerous values

and figures used to describe the economic situation somewhere# or e+ample! if you read astory about the Philippines you might read that the gross domestic product 2&'P7 is Q184

billion or that the &'P per person is Q*!.33 per person! or that its unemployment rate is 4#1 percent and its inflation rate is now %#6 percent# Rou might read that it has a government budget deficit of *#4 percent of the &'P and a trade deficit of .#% percent of the &'P# )utwhat does this all mean> "ow is someone supposed to interpret and understand whether thenumbers indicate something good! bad! or neutral about the country>

9ne way to make ;udgments is to compare these numbers with other countries# To this end!the ne+t few sections will present some recent data for a selected set of countries# Althoughmemoriing these numbers is not so important! especially since they will all soon change! it ishelpful to have an idea about what the values are for a few countriesE or if not that! to knowthe appro+imate normal average for a particular variable# Thus it is useful to know that &'P

per person ranges from about Q.33 per year at the low end to about Q.3!333 to Q4.!333 per person at the high end# It is also useful to know that unemployment rates are normally lessthan 13 percent# So when you read that imbabwe recently had unemployment of 4. percent!a reader will know how unusually large that is# 9nce you also recognie that inflation ratesare normally less than 13 percent! a rate of 13!333 percent will strike you as e+traordinary#

Thus the values for some of these numbers will be helpful to make comparisons acrosscountries today and to make comparisons over time for a particular country# Therefore! it can

be very helpful to know the numbers for at least a few countries! or what may be deemed a setof reference countries# The countries in Table 1#1 F&'P and &'P per Capita 2PPP in )illions

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Country/Region (Rank)GP (Percentage in the !orld) GP per Capita (Rank)

India 2.7 *!%66 2-#67 %!463 21*37

,ussia 247 %!%83 2*#*7 1.!?-6 2.%7

)rail 2137 1!?61 2%#?7 13!-88 2447

South @orea 21-7 1!*-% 21#?7 %4!8?% 2**7

Indonesia 2147 ?36 21#*7 *!?63 21%17

@enya 26%7 83 2nil7 1!41% 21-67

&hana 2?87 *- 2nil7 1!.16 21.%7

)urundi 21.67 * 2nil7 *?3 21467

Table 1#1 F&'P and &'P per Capita 2PPP in )illions of 'ollars7! %33?F displays severalthings that are worth knowing# irst! note that the (nited States and $uropean (nion eachmake up about one5fifth of the world economyE together the two are -% percent# Throw apaninto the mi+ with the $uropean (nion and the (nited States and together they make up lessthan one5si+th of the worldBs population# "owever! these three developed nations producealmost one5half of the total world production# This is a testament to the high productivity inthe developed regions of the world# It is also a testament to the low productivity in much of

the rest of the world! where it takes another five billion people to produce the remaining half of the &'P#

The second thing worth recogniing is the wide dispersion of &'Ps per capita acrosscountries# The (nited States ranks si+th in the world at Q-4!--3 and is surpassed by severalsmall countries like Singapore and =u+embourg andor those with substantial oil and gasresources such as )runei! orway! and Uatar 2not shown in Table 1#1 F&'P and &'P per Capita 2PPP in )illions of 'ollars7! %33?F7# Average &'P per capita in the world is ;ust over Q13!333! and it is ;ust as remarkable how far above the average some countries like the (nitedStates! apan! and South @orea are as it is how far below the average other countries likeChina! India! Indonesia! and @enya are# Perhaps most distressing is the situation of some

countries like )urundi that has a &'P of only Q*43 per person# 29ther countries in a similar situation include imbabwe! Congo! =iberia! Sierra =eone! iger! and Afghanistan#7

)nem*loyment and In+ation around the "orld

"#o other key $acroecono$ic %aria&les that are used as an indicator o' the health o' a

national econo$y are the une$ploy$ent rate 5the percentage of the labor force that iscurrently not employed! and the in'lation rate the rate of change in the general level of

prices in an economy# Alternatively! the percentage change in the consumer price inde+ over a period# The unemployment rate measures the percentage of the working population in a

country who would like to be working but are currently unemployed# The lower the rate! thehealthier the economy and vice versa# The inflation rate measures the annual rate of increase

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of the consumer price inde+ 2CPI7# The CPI is a ratio that measures how much a set of goodscosts this period relative to the cost of the same set of goods in some initial year# Thus if theCPI registers 134! it would cost Q134 2euros or whatever is the national currency7 to buy thegoods today! while it would have cost ;ust Q133 to purchase the same goods in the initial

period# This represents a 4 percent increase in average prices over the period! and if that

period were a year! it would correspond to the annual inflation rate# In general! a relativelymoderate inflation rate 2about 3H- percent7 is deemed acceptableE however! if inflation is toohigh it usually contributes to a less effective functioning of an economy# Also! if inflation isnegative! it is called deflation! and that can also contribute to an economic slowdown#

Table 1#% (nemployment and Inflation ,ates

-ountry/egion)nem*loyment /ate

02In+ation /ate 02

#uropean $nion %.& '(ct. 2))%* +)., '-ov. 2))%*

$nited tates 1).) '-ov. 2))%* +1.& '-ov. 2))%*

/hina %.2 '2))&* +).0 '-ov. 2))%*

apan ,.1 '(ct. 2))%* 2., '(ct. 2))%*

India %.1 '2))&* +11., '(ct. 2))%*

3ussia 4.4 '(ct. 2))%* +%.1 '-ov. 2))%*

5ra6il 4., '(ct. 2))%* +7.2 '-ov. 2))%*

outh 8orea 9., '-ov. 2))%* +2.7 '-ov. 2))%*

Indonesia &.1 ':eb. 2))%* +2.7 '(ct. 2))%*

pain 1%.9 '(ct. 2))%* +).9 '-ov. 2))%*

outh ;frica 27., 'ep. 2))%* +,.& '-ov. 2))%*

#stonia 1,.2 'ul. 2))%* 2.1 '-ov. 2))%*

Source: Economist ! 0eekly Indicators! 'ecember 14! %33?#

The unemployment rates and inflation rates in most countries are unusual in the reported period because of the economic crisis that hit the world in %336# The immediate effect of thecrisis was a drop in demand for many goods and services! a contraction in &'P! and the lossof ;obs for workers in many industries# In addition! prices were either stable or fell in manyinstances# 0hen most economies of the world were booming several years earlier! a normalunemployment rate would have been * to . percent! while a normal inflation rate would standat about * to 8 percent#

As Table 1#% F(nemployment and Inflation ,atesF shows! though! unemployment rates in

most countries in %33? are much higher than that! while inflation rates tend to be lower withseveral e+ceptions# In the (nited States! the unemployment rate has more than doubled! but in

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the $uropean (nion! unemployment was at a higher rate than the (nited States before thecrisis hit! and so it has not risen


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higher perceived risk# To prevent that risk! governments sometimes revert to the printing of money to reduce borrowing needs# "owever! e+cessive money e+pansion is invariablyinflationary and can cause long5term damage to the economy#

In Table 1#* F)udget )alance and ational 'ebt 2Percentage of &'P7! %33?F ! we present

budget balances for a selected set of countries# $ach is shown as a percentage of &'P! whichgives a more accurate portrayal of the relative sie# Although there is no absolute number above which a budget deficit or a national debt is unsustainable! budget deficits greater than .

percent per year! those that are persistent over a long period! or a national debt greater than .3 percent of &'P tends to raise concerns among investors#

Table 1#* )udget )alance and ational 'ebt 2Percentage of &'P7! %33?

-ountry/egion ,udget ,alance 02 3ational 'ebt 02

#uropean $nion 0., <

$nited tates 11.% 94.,

/hina 9.7 1,.0

apan 4.4 142.1

India &.) ,0.7

3ussia &.) 0.,

5ra6il 9.2 9&.&

outh 8orea 7., 27.7

Indonesia 2.0 2%.9

pain 1).& 7).4

outh ;frica ,.) 91.0

#stonia 7.) 7.&

Source: Economist ! 0eekly Indicators! 'ecember 14! %33?! and the CIA 0orld actbook#

ote that all the budget balances for this selected set of countries are in deficit# or manycountries! the deficits are very large! e+ceeding 13 percent in the (#S# and Spain# Althoughdeficits for most countries are common! usually they are below . percent of the &'P# Thereason for the higher deficits now is because most countries have increased their governmentspending to counteract the economic recession! while at the same time suffering a reduction inta+ revenues also because of the recession# Thus budget deficits have ballooned around theworld! though to differing degrees#

As budget deficits rise and as &'P falls due to the recession! national debts as a percent of &'P are also on the rise in most countries# In the (nited States! the national debt is still at a

modest *4#. percent! but recent pro;ections suggest that in a few years it may


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the government and purchased by another branch of the government# or e+ample! in the(nited States for the past decade or more! the Social Security system has collected more in

payroll ta+es than it pays out in benefits# The surplus! known as the Social Security Mtrustfund!N is good because in the ne+t few decades as the baby boom generation retires! thenumbers of Social Security recipients is e+pected to balloon# )ut for now the surplus is used

to purchase government Treasury bonds# In other words! the Social Security administrationlends money to the rest of the government# Those loans currently sum to about *3 percent of &'P or somewhat over Q- trillion# If we include these loans as a part of the national debt! the(nited States debt is now! according to the online national debt clock! more than Q1% trillionor about 6. percent of &'P# 2This is larger than *4#. V *3 percent because the debt clock is anestimate of more recent figures and reflects the e+tremely large government budget deficit runin the previous year#7

/ost other countriesB debts are on a par with that of the (#S# with two notable e+ceptions#irst! China and ,ussiaBs debts are fairly modest at only 1.#8 percent and 8#. percent of &'P!respectively# Second! apanBs national debt is an astounding 14% percent of &'P# It has arisen

because the apanese government has tried to e+tricate its economy from an economic funk by spending and borrowing over the past two decades#

$ey Takeaways

• GD and GD per capita are two of the most widely trac=ed indicators of both the si6e of national economies and an economy>s capacity to providefor its citi6ens.

• In general! we consider an economy more successful if its GD per capitais high! unemployment rate is low '9?, percent*! ination rate is low andnonnegative ')?0 percent*! government budget decit is low 'less than ,percent of GD* or in surplus! and its national debt is low 'less than 2,

percent*.

• The (nited States! as the largest national economy in the world! is a good reference

point for comparing macroeconomic data#

o @he $.. GD in 2))& stood at Aust over B17 trillion while per capitaGD stood at B74!))). $.. GD made up Aust over 2) percent of world GD in 2))&.

o @he $.. unemployment rate was unusually high at 1) percent in-ovember 2))% while its ination rate was very low at 1.& percent.

o @he $.. government budget decit was at an unusually high level of 11.% percent of GD in 2))% while its international indebtednessmade it a debtor nation in the amount of 94 percent of its GD.

• Several noteworthy statistics are presented in this section:

o ;verage world GD per person stands at around B1)!))) per person.

o @he GD in the $.. and most developed countries rises as high asB,)!))) per person.

o @he GD in the poorest countries li=e 8enya! Ghana! and 5urundi is

less than B2!))) per person per year.


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o $.. unemployment has risen to a very high level of 1) percentChowever! in pain it sits over 1% percent! while in outh ;frica it isover 27 percent.

o Ination is relatively low in most countries but stands at over %percent in 3ussia and over 11 percent in India. In several countries

li=e apan and #stonia! deation is occurring.

o Due to the world recession! budget decits have grown larger inmost countries! reaching almost 12 percent of GD in the $nitedtates.

o @he national debts of countries are also growing larger! and apan>shas grown to over 14) percent of GD.

1.4 E5change /ate /egimes( Trade ,alances( and Investment

Positions

Learning b!ective

1. Learn current values for several important international macroeconomicindicators from a selected set of countries! including the trade balance! theinternational investment position! and e"change rate systems.

Countries interact #ith each other in t#o i$portant #ays: trade and in%est$ent+ Tradeencompasses the e+port and import of goods and services# Investment involves the borrowingand lending of money and the foreign ownership of property and stock within a country# Themost important international macroeconomic variables! then! are the trade balance! whichmeasures the difference between the total value of e+ports and the total value of imports! and

the e+change rate! which measures the number of units of one currency that e+changes for oneunit of another currency#

E5change /ate /egimes

)ecause countries use different national currencies! international trade and investmentre


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5An e+change rate system in which the rate is fi+ed at a specified value by the government5have been the norm! especially because of the long period that countries maintained a goldstandard 2with currency fi!ed to gold7 and because of the fi+ed e+change rate system 2calledthe )retton 0oods system7 after 0orld 0ar II# "owever! since 1?4*! when the )retton 0oodssystem collapsed! countries have pursued a variety of different e+change rate mechanisms#

The International /onetary und 2I/7! created to monitor and assist countries withinternational payments problems! maintains a list of country currency regimes# The listdisplays a wide variety of systems currently being used# The continuing e+istence of so muchvariety demonstrates that the key Nremains largely unanswered# 'ifferent countries have chosen differently# =ater! this coursewill e+plain what is necessary to maintain a fi+ed e+change rate or floating e+change rate 5Ane+change rate system in which the rate fluctuates! or floats! because it is determined by supplyand demand in the private market5 system and what are some of the pros and cons of eachregime# or now! though! it is useful to recognie the varieties of regimes around the world#

Table 1#- $+change ,ate ,egimes

-ountry/egion /egime

#uro ;rea ingle currency within oating e"ternally

$nited tates :loat

/hina /rawling peg

apan :loat

India Eanaged oat

3ussia :i"ed to composite

5ra6il :loat

outh 8orea :loat

Indonesia Eanaged oat

pain #uro 6oneC "ed in the #uropean $nionC oat e"ternally

outh ;frica :loat

#stonia /urrency board

Source: International /onetary und! 'e acto Classification of $+change ,ate ,egimes and/onetary Policy ramework! %336#

Table 1#- F$+change ,ate ,egimesF shows the selected set of countries followed by acurrency regime# otice that many currenciesGincluding the (#S# dollar! the apanese yen!the )railian real! the South @orean won! and the South African randGare independentlyfloating! meaning that their e+change values are determined in the private market on the basis

of supply and demand# )ecause supply and demand for currencies fluctuate over time! so dothe e+change values! which is why the system is called floatin" #

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ote that India and Indonesia are classified as Mmanaged floating#N This means that thecountriesB central banks will sometimes allow the currency to float freely! but at other timeswill nudge the e+change rate in one direction or another#

China is listed and maintaining a crawling peg! which means that the currency is essentially

fi+ed e+cept that the Chinese central bank is allowing its currency to appreciate slowly withrespect to the (#S# dollar# In other words! the fi+ed rate itself is gradually but unpredictablyad;usted#

$stonia is listed as having a currency board# This is a method of maintaining a fi+ed e+changerate by essentially eliminating the central bank in favor of a currency board that is mandated

by law to follow procedures that will automatically keep its currency fi+ed in value#

,ussia is listed as fi+ing to a composite currency# This means that instead of fi+ing to oneother currency! such as the (#S# dollar or the euro! ,ussia fi+es to a basket of currencies! alsocalled a composite currency# The most common currency basket to fi+ to is the Special

'rawing ,ights 2S',7! a composite currency issued by the I/ used for central bank transactions#

inally! si+teen countries in the $uropean (nion are currently members of the euro area#0ithin this area! the countries have retired their own national currencies in favor of using asingle currency! the euro# 0hen all countries circulate the same currency! it is the ultimate infi+ity! meaning they have fi+ed e+change rates among themselves because there is no need toe+change# "owever! with respect to other e+ternal currencies! like the (#S# dollar or theapanese yen! the euro is allowed to float freely#

Trade ,alances and International Investment Positions

9ne of the most widely monitored international statistics is a countryBs trade balance# If thevalue of total e+ports from a country e+ceeds total imports! we say a country has atrade surplus 59ccurs when the value of e+ports e+ceeds the value of imports during a year#"owever! if total imports e+ceed total e+ports! then the country has a trade deficit 59ccurswhen the value of imports e+ceeds the value of e+ports during a year# 9f course! if e+portse


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It is important to recognie that when a country runs a trade deficit! residents of the country purchase a larger amount of foreign products than foreign residents purchase from them#Those e+tra purchases are financed by the sale of domestic assets to foreigners# The assetsales may consist of property or businesses 2a#k#a# investment7! or it may involve the sale of I9(s 2borrowing7# In the former case! foreign investments entitle foreign owners to a stream

of profits in the future# In the latter case! foreign loans entitle foreigners to a future repaymentof principal and interest# In this way! trade and international investment are linked#

)ecause of these future profit takings and loan repayments! we say that a country with adeficit is becoming a debtor country# 9n the other hand! anytime a country runs a tradesurplus! it is the domestic country that receives future profit and is owed repayments# In thiscase! we say a country running trade surpluses is becoming a creditor country# onetheless!trade deficits or surpluses only represent the debts or credits e+tended over a one5year period#If trade deficits continue year after year! then the total e+ternal debt to foreigners continues togrow larger# =ikewise! if trade surpluses are run continually! then credits build up# "owever! if a deficit is run one year followed by an e


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-ountry/egion Trade ,alance 02 'ebtor 062-reditor 072 Position 02

/hina +0.1 +9,.1

apan +2.4 +,).7

India ).9 0.&

3ussia +2.2 +1,.1

5ra6il ).& 20.0

outh 8orea +9.& ,4.%

Indonesia +1.2 91.7

pain ,.4 &9.0

outh ;frica ,.7 7.1

#stonia +,.& &9.1

Sources: Economist ! the I/! and the China State Administration of oreign $+change# See Economist ! 0eekly Indicators! 'ecember *3! %33?E I/ 'issemination Standards )ulletin)oard at http:dsbb#imf#orgApplicationswebdsbbhome E I/ &'P data from 0ikipedia athttp:en#wikipedia#orgwiki=istJofJcountriesJbyJ&'PJ%6nominal%? E and China StateAdministration of oreign $+change at

http:www#safe#gov#cnmodelJsafeJent;s;Jent;s;JdetailJen#;sp>I'K*3*3*333333333333!16LidK-#

Table 1#. FTrade )alances and International Investment Positions &'P! %33?F shows the mostrecent trade balances and international investment positions! both as a percentage of &'P! for a selected set of countries# 9ne thing to note is that some of the selected countries are runningtrade deficits while others are running trade surpluses# 9verall! the value of all e+ports in theworld must e


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been running a trade deficit for more than the past thirty years and as a result has amassed adebt to the rest of the world larger than any other country! totaling about Q*#- trillion or almost %. percent of (#S# &'P# As such! the (#S# is referred to as the largest debtor nation inthe world#

In stark contrast! during the past twenty5five or more years apan has been running persistenttrade surpluses# As a result! it has amassed over Q%#- trillion of credits to the rest of the worldor ;ust over .3 percent of its &'P# It is by far the largest creditor country in the world# Close

behind apan is China! running trade surpluses for more than the past ten years and amassingover Q1#. trillion of credits to other countries# That makes up *. percent of its &'P and makesChina a close second to apan as a ma;or creditor country# 9ne other important creditor country is ,ussia! with over Q%.3 billion in credits outstanding or about 1. percent of its&'P#

ote that all three creditor nations are also running trade surpluses! meaning they aree+pending their creditor position by becoming even bigger lenders#

=ike the (nited States! many other countries have been running persistent deficits over timeand have amassed large international debts# The most sieable are for Spain and $stonia! bothover 63 percent of their &'Ps# ote that Spain continues to run a trade deficit that will add toit international debt whereas $stonia is now running a trade surplus that means it is in the

process of repaying its debt# South @orea and Indonesia are following a similar path as$stonia# In contrast! the $uro area! South Africa! and to a lesser degree )rail and India arefollowing the same path as the (nited StatesGrunning trade deficits that will add to their international debt#

$ey Takeaways

• #"change rates and trade balances are two of the most widely trac=edinternational macroeconomic indicators used to discern the health of aneconomy.

• DiFerent countries pursue diFerent e"change rate regimes! choosingvariations of oating and "ed systems.

• The (nited States! as the largest national economy in the world! is a good reference

point for comparing international macroeconomic data#

o @he $nited tates maintains an independently oating e"changerate! meaning that its value is determined on the private mar=et.

o @he $nited tates trade decit is currently at 9.1 percent of GD. @his is down from 0 percent recently but is one of a string of decitsspanning over thirty years.

o @he $.. international investment position stands at almost 2,percent of GD! which by virtue of the $.. economy si6e! ma=es the$nited tates the largest debtor nation in the world.

• Several other noteworthy statistics are presented in this section:

o /hina maintains a crawling peg "ed e"change rate.


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o 3ussia "es its currency to a composite currency while #stonia usesa currency board to maintain a "ed e"change rate.

o apan is the largest creditor country in the world! followed closely by/hina and more distantly by 3ussia.

o pain and #stonia are e"amples of countries that have seriousinternational debt concerns! with e"ternal debts greater than &)percent of their GDs.

1.8 ,usiness -ycles9 Economic )*s and 'owns

Learning b!ectives

1. $nderstand the distinctions between an economic recession and adepression.

2. /ompare and contrast the current recession in the $nited tates withprevious economic downturns.

9. 3ecogni6e why the economic downturn in the 1%9)s is called the GreatDepression.

In %33? the world was in the midst of the largest economic downturn since the early 1?63s#$conomic production was falling and unemployment rising# International trade fellsubstantially everywhere in the world! while investment both domestically and internationallydried up#

The source of these problems was the bursting of a real estate bubble # )ubbles are fairlycommon in both real estate and stock markets# A bubble is described as a steady and persistent

increase in prices in a market! in this case! in the real estate markets in the (nited States andabroad# 0hen bubbles are developing! many market observers argue that the prices arereflective of true values despite a sharp and une+pected increase# These ;ustifications foolmany people into buying the products in the hope that the prices will continue to rise andgenerate a profit#

0hen the bubble bursts! the demand driving the price increases ceases and a large number of participants begin to sell off their product to realie their profit# 0hen these occur! prices

To understand whether it is or not! it is useful to look at the kind of data used to measurerecessions or depressions and to compare what has happened recently with what happened inthe past# irst! here are some definitions#

n econo$ic recession 2,efers to a decline in a countryBs measured real gross domestic

product 2&'P7 over a period usually coupled with an increasing aggregate unemploymentrate7 refers to a decline in a countryBs measured real gross domestic product 2&'P7 over a


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period usually coupled with an increasing aggregate unemployment rate# In other words! itrefers to a decline in economic productive activity# "ow much of a decline is necessary beforeobservers will begin to call it a recession is almost always arguable! although there are a fewguidelines one can follow#

In the (nited States! it is typical to define a recession as two successive


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The /ecession of %::;


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>ear.?uarter &rowth /ate 02 )nem*loyment /ate 02

2))%.9 2.2 %.4

2))%.7 < 1).)

Sources: (#S# )ureau of $conomic and Analysis and (#S# 'epartment of =abor#

The /ecession of 1=;:


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>ear.?uarter &rowth /ate 02 )nem*loyment /ate 02

1%&1.7 7.% &.9

1%&2.1 0.7 &.%

1%&2.2 +2.2 %.7

1%&2.9 1., %.&

1%&2.7 +).9 1).&

1%&9.1 +,.1 1).7

1%&9.2 +%.9 1).1

1%&9.9 +&.1 %.,

1%&9.7 +&., &.,

Sources: (#S# )ureau of $conomics and Analysis 2http:www#bea#gov7 and (#S# 'epartmentof =abor 2http:www#dol#gov7#

If indeed the current recession turns out like the 1?63 to 1?6* episode! we might e+pect to seesubstantial swings in the &'P growth rates in future


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It is worth comparing numbers between the current period and the 'epression years if only tolearn how bad things really were during the 1?*3s# The &reat 'epression was a time thattransformed attitudes and opinions around the world and can surely be credited with havingestablished the necessary preconditions for the Second 0orld 0ar#

So letBs take a look at how bad it really was# 9nce again! weBll consider the (#S# e+periencelargely because the data are more readily available# "owever! it is worth remembering that allthree of the economic downturns described here are notable in that they were worldwide inscope#

irst of all! there is no ear &rowth /ate 02 )nem*loyment /ate 02

1%9) &.0 &.%

1%91 0., 1,.%

1%92 19.1 29.0

1%99 1.9 27.%

1%97 +1).% 21.4

1%9, +&.% 2).1

1%90 +19.) 14.)


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>ear &rowth /ate 02 )nem*loyment /ate 02

1%94 +,.1 17.9

1%9& 9.7 1%.)

1%9% +&.1 14.2

1%7) +&.& 17.0

Sources: (#S# )ureau of $conomics and Analysis and (#S# 'epartment of =abor#

The )$, dated the first part of the 'epression as having started in August 1?%? and endingin /arch 1?**# )ut a second wave came! another recession beginning in /ay 1?*4 andending in une 1?*6# This caused &'P to fall by another *#- percent in 1?*6 whileunemployment rose back above 1. percent for another two years#

The &reat 'epression is commonly used to refer to the economic crisis 2or crises7 that persisted for the entire decade of the 1?*3s! only truly coming to an end at the start of 0orld0ar II# $ven then it is worth mentioning that although &'P began to grow rapidly during0orld 0ar II! with &'P growth from 1?-1 to 1?-* at 14#1 percent! 16#. percent! and 18#-

percent! respectively! and with (#S# unemployment falling to 1#% percent in 1?--! these datamask the fact that most of the e+tra production was for bullets and bombs and much of themost able part of the workforce was engaged in battle in the Atlantic and Pacific war theaters#In other words! the movement out of the &reat 'epression was associated with a nationalemergency rather than a more secure and rising standard of living#

Although the data presented only cover the (nited States! the &reat 'epression was aworldwide phenomenon# 0ithout digging too deeply into the data or ;ust by taking a


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• @he Great Depression of the 1%9)s displayed much greater decreases inGD! showed much larger increases in unemployment! and lasted for alonger period than any economic downturn in the $nited tates since then.

• @he largest annual decrease in the $.. GD during the Great Depressionwas 19.1 percent while the highest unemployment rate was 27.% percent.

• @he largest uarterly decrease in the $.. GD during the current recessionwas 0.7 percent while the highest unemployment rate was 1).1 percent.

• @he largest uarterly decrease in the $.. GD since Horld Har II was1).7 percent in the rst uarter of 1%,&! while the highestunemployment rate was 1).& percent in 1%&2.

• (f the thirtyfour $.. recessions since 1&,7 classied by the -5#3! thelongest was si"tyve months in the 1&4)s! whereas the average lengthwas seventeen months.

• (f all the $.. e"pansions since 1&,7 classied by the -5#3! the longestwas 12) months in the 1%%)s whereas the average length was thirtyeightmonths.

O1 See the ational )ureau of $conomic ,esearch! http:www#nber#orgcycles#html#

1.@ International acroeconomic Institutions9 The IB and

the "orld ,ank

Learning b!ectives

1. Learn about the origins of the Horld 5an= and the International Eonetary:und.

2. $nderstand the purpose of the International Eonetary :und both duringthe "ed e"change rate regime from 1%7, to 1%49 and after 1%49.

After the &reat 'epression! one of the things policymakers thought was important was toreturn the international economy to a system of fi+ed e+change rates# )efore the 'epression2i#e#! in the 1?%3s and before7! the world mostly maintained a gold standard# (nder such asystem! a country establishes two rules: first! it fi+es its currency value to a weight of goldEsecond! it establishes convertibility between the currency and gold# This means that anyindividual holding the national currency is allowed to cash in the currency for its e


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There is much that can be said about how a gold standard operates! but that discussion isreserved for a later chapter# or our purposes here! it is sufficient to e+plain that the goldstandard was a system of fi+ed e+change rates# or e+ample! before the 1?*3s the (nitedStates fi+ed the dollar at Q%3#84 per ounce of gold# 'uring the same period! the (nited@ingdom fi+ed its currency at Y-#%- per ounce# As a result of the gold5currency convertibility

in both countries! this meant the dollar and pound were fi+ed to each other at a rate of Q-#64.Y#

'uring the 'epression years! most countries dropped off the gold standard because the loss of confidence threatened a complete conversion of currency to gold and the depletion of nationalgold reserves# )ut! as 0orld 0ar II drew to a close! e+perts were assembled in )retton0oods! ew "ampshire! in the (nited States in 1?-- to design a set of institutions that wouldhelp establish an effective international monetary system and to prevent some of thead;ustment catastrophes that occurred after 0orld 0ar I# 9ne such catastrophe occurred in&ermany in 1?%% to 1?%* when a floating &erman currency resulted in one of the worsthyperinflations in modern history# Photos from that period show people with wheelbarrows

full of money being used to make basic purchases# 9ne way to prevent a reoccurrence was toestablish a system of fi+ed e+change rates# As will be shown later! an important benefit of fi+ed e+change rates is the potential for such a system to prevent e+cessive inflation#

The )retton 0oods Conference 2A monetary conference held in 1?-- in )retton 0oods! ew"ampshire! that laid the groundwork for the establishment of the 0orld )ank and the I/7!more formally called the (nited ations /onetary and inancial Conference! was held inuly 1?--# The purpose of the conference was to establish a set of institutions that wouldsupport international trade and investment and prevent some of the monetary instabilities thathad plagued the world after 0orld 0ar I# The conference proposed three institutions! only twoof which finally came into being#

The unsuccessful institution was the International Trade 9rganiation 2IT97! which wasintended to promote the reduction of tariff barriers and to coordinate domestic policies so asto encourage a freer flow of goods between countries# Although a charter was drawn up for the IT9! the (nited States refused to sign onto it! fearing that it would subordinate too manyof its domestic policies to international scrutiny# A subagreement of the IT9! the &eneralAgreement on Tariffs and Trade 2&ATT7! designed to promote multilateral tariff reductions!was established independently though#

The two successfully chartered institutions from the )retton 0oods Conference were the

International )ank for ,econstruction and 'evelopment 2I),'7 2The core institution in the0orld )ank whose mission is to provide loans to assist postwar reconstruction and economicdevelopment7 and the International /onetary und 2I/7 2The international organiationcreated after 0orld 0ar II to oversee the )retton 0oods system of fi+ed e+change rates7#

The I),' is one component of a larger organiation called the 0orld )ank # Its purpose wasto provide loans to countries to aid their reconstruction after 0orld 0ar II and to promoteeconomic development# /uch of its early efforts focused on reconstruction of the war5torneconomies! but by the 1?83s! its efforts were redirected to developing countries# The intentwas to get countries back on their feet! economically speaking! as


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not the revival of a gold standard but rather what is known as a gold5e+change standard#(nder this system! the (#S# dollar was singled out as the international reserve currency# orty5four of the forty5five ratifying countries agreed to have their currency fi+ed to the dollar# Thedollar in turn was fi+ed to gold at Q*. per ounce# The countries also agreed not to e+changeofficially held gold deposits for currency as had been the practice under the gold standard#

"owever! countries agreed that officially held gold could be e+changed between central banks#

Another important re


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and many othersGare floating# 0hen a currency is allowed to float! its value is determined bysupply and demand in the private market and there is no longer any need for a countryBscentral bank to intervene# This in turn means that a country can no longer get into a balance of

payments problem since that balance is automatically achieved with the ad;ustment in thee+change rate value# In essence the raison dBZtre of the I/ disappeared with the collapse of

the )retton 0oods system#

Curiously! the I/ did not fall out of e+istence# Instead! it reinvented itself as a kind of lender of last resort to national governments# After 1?4*! the I/ used its MfundN to assist nationalgovernments that had international debt problems# or e+ample! a ma;or debt crisis developedin the early 1?63s when national governments of /e+ico! )rail! eneuela! Argentina! andeventually many other nations were unable to pay the interest on their e+ternal debt! or themoney they borrowed from other countries# /any of these loans were either taken by thenational governments or were guaranteed by the national governments# This crisis! known asthe Third 0orld debt crisis! threatened to bring down the international financial system as anumber of ma;or banks had significant e+posure of foreign loans that were ultimately

defaulted on# The I/ stepped in to provide Mstructural ad;ustment programsN in this instance#So the I/ not only loaned money for countries e+periencing balance of payments crises butalso now provided loans to countries that could not pay back their foreign creditors# And also!

because the I/ wanted to get its money back 2meaning the money contributed by themember nations7! the structural ad;ustment loans came with strings attached:I/ conditionalityConditions that countries must promise to fulfill to receive a loan from theI/# Conditions can include re


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Although controversial! the I/ has played a significant role in maintaining the internationalfinancial system even after the collapse of fi+ed e+change rates# 9ne last issue worthdiscussing in this introduction is the issue of moral haard# In the past thirty years or so!almost every time a country has run into difficulty repaying its e+ternal debt! the I/ hasstepped in to assure continued repayment# That behavior sends a signal to international

investors that the risk of lending abroad is reduced# After all! if the country gets into troublethe I/ will lend the country money and the foreign creditors will still get their money back#The moral haard refers to the fact that lending institutions in the developed countries mayview the I/ like an insurance policy and thus make much riskier loans than they would haveotherwise# In this way! the I/ could be contributing to the problem of international financialcrisis rather than merely being the institution that helps clean up the mess#

$ey Takeaways

• @he Horld 5an= and the IE: were proposed during the 5retton Hoods/onference in 1%77.

• @he main purpose of the Horld 5an= is to provide loans for postwar

reconstruction and economic development for developing countries.

• @he main purpose of the IE: was to monitor the international "ede"change rate system and to provide temporary loans to countriessuFering balance of payments problems.

• ince the brea=up of the 5retton Hoods "ed e"change rate system in1%49! the IE: has mostly assisted countries by ma=ing structuraladAustment loans to those that have diJculty repaying international debts.

• @he IE: conditionalities are the oftencritici6ed conditions that the IE:places on foreign governments accepting their loans. @he freemar=et

orientation of these conditions is =nown as the Hashington /onsensus.


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Chapter -ational Inco$e and the .alance

o' Pay$ents ccounts

The most important macroeconomic variable tracked by economists and the media is the grossdomestic product 2&'P7# 0hether it ought to be so important is another matter that isdiscussed in this chapter# )ut before that evaluation can occur! the &'P must be defined andinterpreted# This chapter presents the national income identity! which defines the &'P# It also

presents several other important national accounts! including the balance of payments! thetwin5deficit identity! and the international investment position# These are the variables of

prime concern in an international finance course#

%.1 3ational Income and Product Accounts

Learning b!ectives

1. Dene GD and understand how it is used as a measure of economic wellbeing.

2. 3ecogni6e the limitations of GD as a measure of wellbeing.

/any of the key aggregate variables used to describe an economy are presented in a countryBs ational Income and Product Accounts 2IPA7# ational income represents the total amountof money that factors of production earn during the course of a year# This mainly includes

payments of wages! rents! profits! and interest to workers and owners of capital and property#The national product refers to the value of output produced by an economy during the courseof a year# ational product! also called national output! represents the market value of allgoods and services produced by firms in a country#

)ecause of the circular flow of money in e+change for goods and services in an economy! thevalue of aggregate output 2the national product7 should e


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ational product measures the monetary flow along the top part of the diagramGthat is! themonetary value of goods and services produced by firms in the economy# ational incomemeasures the monetary flow along the bottom part of the diagramGthat is! the monetary valueof all factor services used in the production process# As long as there are no monetaryleakages from the system! national income will e


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not be counted as part of the (#S# &P! however! since the production was done by a foreignfactor owner#

&'P is probably the most widely reported and closely monitored aggregate statistic# &'P is ameasure of the sie of an economy# It tells us the total amount of MstuffN the economy

produces# Since most of us! as individuals! prefer to have more stuff rather than less! it isstraightforward to e+tend this to the national economy to argue that the higher the &'P! the

better off the nation# or this simple reason! statisticians track the growth rate of &'P# ,apid&'P growth is a sign of growing prosperity and economic strength# alling &'P indicates arecession! and if &'P falls significantly! we call it an economic depression#

or a variety of reasons! &'P should be used only as a rough indicator of the prosperity or welfare of a nation# Indeed! many people contend that &'P is an inade


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construction activities reuired to rebuild the damaged buildings. @hisillustrates why GD growth may not be indicative of a healthy economy insome circumstances.

4. GD measures the value of production in the economy rather thanconsumption! which is more important for economic wellbeing. ;s will be

shown later! national production and consumption are eual when acountry>s trade balance is 6eroC however! if a country has a trade decit!then its national consumption will e"ceed its production. Ideally! becauseconsumption is pleasurable while production often is not! we should usethe measure of national consumption to measure economic wellbeingrather than GD.

$ey Takeaways

• GD is dened as the value of all nal goods and services produced withinthe borders of a country during some period of time! usually a year.

• The following are several important weaknesses of &'P as a measure of economic

well5being:

o GD measures income! not wealth! and wealth is a better measureof economic wellbeing.

o GD does not account for income distribution eFects that may beimportant to economic wellbeing.

o GD measures badsM li=e pollution as well as goods.M

o GD measures production! not consumption! and consumption ismore important to economic wellbeing.

%.% 3ational Income or Product Identity

Learning b!ectives

1. Identify the components of GD dened in the national income identity.2. $nderstand why imports are subtracted in the national income identity.

The national income or product identity describes the way in which the gross domestic product 2&'P7 is measured! as the sum of e+penditures in various broad spending categories#The identity! shown below! says that &'P is the sum of personal consumption e+penditures2C 7! private investment e+penditures 2 # 7! government consumption e+penditures 2G7! ande+penditures on e+ports 2 E$ 7 minus e+penditures on imports 2 #M 7:

GDP N C + I + G + EX IM.

Personal consumption e+penditures 2C 7! or MconsumptionN for short! include goods andservices purchased by domestic residents# These are further subdivided into durable goods!commodities that can be stored and that have an average life of at least three yearsEnondurable goods! all other commodities that can be storedE and services! commodities thatcannot be stored and are consumed at the place and time of purchase# Consumption alsoincludes foreign goods and services purchased by domestic households#


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Private domestic investment 2 # 7! or MinvestmentN for short! includes e+penditures by businesses on fi+ed investment and any changes in business inventories# i+ed investment! both residential and nonresidential! consists of e+penditures on commodities that will be usedin a production process for more than one year# It covers all investment by private businessesand by nonprofit institutions! regardless of whether the investment is owned by domestic

residents or not# onresidential investment includes new construction! business purchases of new machinery! e


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0hen consumption e+penditures! investment e+penditures! government e+penditures! ande+ports are measured! they are measured without accounting for where the purchased goodswere actually made# Thus consumption e+penditures 2C 7 measures domestic e+penditures on

both domestically produced and foreign5produced goods# or e+ample! if a (#S# resident buysa television imported from @orea! that purchase would be included in domestic consumption

e+penditures# =ikewise! if a business purchases a microscope made in &ermany! that purchasewould be included in domestic investment# 0hen the government buys foreign goods abroadto provide supplies for its foreign embassies! those purchases are included in governmente+penditures# inally! if an intermediate product is imported! used to produce another good!and then e+ported! the value of the original imports will be included in the value of domestice+ports#

This suggests that we could rewrite the national income identity in the following way:

GDP N 'CD + CF * + 'ID + IF * + 'GD + GF * + 'EXD + EXF * IM!

where C% represents consumption e+penditures on domestically produced goods! CF represents consumption e+penditures on foreign5produced goods! #% represents investmente+penditures on domestically produced goods! #F represents investment e+penditures onforeign5produced goods! G% represents government e+penditures on domestically producedgoods! GF represents government e+penditures on foreign5produced goods! E$% representse+port e+penditures on domestically produced goods! and E$F represents e+port e+penditureson previously imported intermediate goods# inally! we note that all imported goods are usedin consumption! investment! or government or are ultimately e+ported! thus

IM N CF + IF + GF + EXF .

Plugging this e+pression into the identity above yields

GDP N CD + ID + GD + EXD

and indicates that &'P does not depend on imports at all#

The reason imports are subtracted in the standard national income identity is because theyhave already been included as part of consumption! investment! government spending! ande+ports# If imports were not subtracted! &'P would be overstated# )ecause of the way thevariables are measured! the national income identity is written such that imports are added and

then subtracted again#

This e+ercise should also clarify why the previously described misinterpretations were indeedwrong# Since imports do not affect the value of &'P in the first place! they cannot representan opportunity cost! nor do they directly or necessarily influence the sie of &'P growth#

$ey Takeaways

• GD can be decomposed into consumption e"penditures! investmente"penditures! government e"penditures! and e"ports of goods and servicesminus imports of goods and services.

• Investment in GD identity measures physical investment! not nancial

investment.


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• Government includes all levels of government and only e"penditures ongoods and services. @ransfer payments are not included in the governmentterm in the national income identity.

• Imports are subtracted in the national income identity because importeditems are already measured as a part of consumption! investment and

government e"penditures! and as a component of e"ports. @his means thatimports have no direct impact on the level of GD. @he national incomeidentity does not imply that rising imports cause falling GD.

%.4 ).S. 3ational Income Statistics 0%::C


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%::C %::;

%::;

0Percentage

of &'P2

ervices ,!4%7.70!)0&.

%

72.,

IGross private domestic

investment

2!197.

)

2!))7.

117.)

-onresidential 1!,)9.&1!,,0.

21).%

tructur

es7&).9 ,,0.9 9.%

#uipme

nt and software 1!)29., %%%.% 4.)

3esidential 09).2 7&4.& 9.7

/hange in

business inventories9.0 9%.% ).)

G

Government consumption

e"penditures and gross

investment

2!047.

&

2!&&9.

22).2

:ederal %4%.91!)41.

2 4.,

-ational

defense002.2 497.9 ,.1

-ondefe

nse914.1 990.% 2.7

tate and local 1!0%,.,1!&12.

112.0

EX #"ports 1!002.7

1!&04.&

19.1

Goods 1!17%.21!2&%.

0%.)

ervices ,19.2 ,4&.2 7.)

IM Imports2!94).

2

2!,99.

)14.4

Goods 1!%&,.2

2!114.

) 17.&


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%::C %::;

%::;

0Percentage

of &'P2

ervices 9&,.1 71,.% 2.%

Source: )ureau of $conomic Analysis! ational $conomic Accounts! &ross 'omestic Product2&'P7! at http:www#bea#govnationalnipawebInde+#asp#

There are a number of important things to recognie and remember about these numbers#

irst! it is useful to know that (#S# &'P in %336 was ;ust over Q1- trillion 2or Q1-!333 billion7# This is measured in %336 prices and is referred to as nominal &'P# This number isuseful to recall! first because it can be used in to ;udge relative country sies if you happen tocome across another countryBs &'P figure# The number will also be useful in comparison

with (#S# &'P in the future# Thus if in %3%3 you read that (#S# &'P is Q%3 trillion! youBll beable to recall that back in %336 it was ;ust Q1- trillion# Also! note that between %334 and %336!the (nited States added over Q833 billion to &'P#

The ne+t thing to note about the numbers is that consumption e+penditures are the largestcomponent of (#S# &'P! making up about 43 percent of output in %336# That percentage isrelatively constant over time! even as the economy moves between recessions and boom times2although it is up slightly from 86 percent in 1??47# otice also that services is the largestsubcategory in consumption# This category includes health care! insurance! transportation!entertainment! and so on#

&ross private domestic investment! MinvestmentN for short! accounted for ;ust 1- percent of &'P in %336# This figure is down from almost 14 percent ;ust two years before and isreflective of the slide into the economic recession# As &'P began to fall at the end of %336!

prospects for future business opportunities also turned sour! and so investment spending alsofell# As the recession continued into %33?! we can e+pect that number to fall even further thene+t year#

The investment component of &'P is often the target of considerable concern in the (nitedStates# Investment represents how much the country is adding to the capital stock# Sincecapital is an input into production! in general the more capital e


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can e+pect this number will rise considerably ne+t year# ,ecall that this figure includes state!local! and federal spending but e+cludes transfer payments# 0hen transfer payments areincluded! government spending plus transfers as a percentage of &'P e+ceeds *3 percent inthe (nited States#

Two things are worth noting# irst! the state and local spending is almost twice the level of federal spending# Second! most of the federal spending is on defense5related goods andservices#

$+ports in the (nited States accounted for 1* percent of &'P in %336 2up from 13 percent in%33*7 and are closing in on the Q% trillion level# Imports into the (nited States are at Q%#.trillion! amounting to almost 16 percent of &'P# In terms of the dollar value of trade! the(nited States is the largest importer and e+porter of goods and services in the world#"owever! relative to many other countries! the (nited States trades less as a percentage of &'P#

$ey Takeaways• $.. GD stands at Aust over B17 trillion per year in 2))&.• $.. consumption is about 4) percent of GDC investment! 17 percentC

government e"penditures! 2) percentC e"ports! 19 percentC and imports!about 1& percent.

%.8 ,alance of Payments Accounts9 'eDnitions

Learning b!ectives

1. Learn the variety of ways e"ports and imports are classied in the balanceof payments accounts.

2. $nderstand the distinction between GD and G-.

The balance of payments accounts is a record of all international transactions that areundertaken between residents of one country and residents of other countries during the year#The accounts are divided into several subaccounts! the most important being thecurrent accountA record of all international transactions for goods and services! income

payments and receipts! and unilateral transfers# and the financial accountA record of allinternational transactions for assets## The current account is often further subdivided into themerchandise trade account and the service account# These are each briefly defined in Table%#* F)alance of Payments Accounts SummaryF#

Table %#* )alance of Payments Accounts Summary

-urrent Account

3ecord of all international transactions for

goods and services! income *ayments

and recei*ts! and unilateral transfers.

@he current account is used in the national

income identity for G-.

Eerchandise @rade ;ccount; record

of all international transactions for

goods only.


goods only. Goods include physical items

li=e autos! steel! food! clothes! appliances!furniture! etc.

http://catalog.flatworldknowledge.com/bookhub/reader/26?e=suranfin-ch01#suranfin-ch02_s04_t01http://catalog.flatworldknowledge.com/bookhub/reader/26?e=suranfin-ch01#suranfin-ch02_s04_t01http://catalog.flatworldknowledge.com/bookhub/reader/26?e=suranfin-ch01#suranfin-ch02_s04_t01http://catalog.flatworldknowledge.com/bookhub/reader/26?e=suranfin-ch01#suranfin-ch02_s04_t01http://catalog.flatworldknowledge.com/bookhub/reader/26?e=suranfin-ch01#suranfin-ch02_s04_t01


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ervices ;ccount; record of all

international transactions for

services only.


services only. ervices include

transportation! insurance! hotel! restaurant!

legal! consulting! etc.

Goods and ervices ;ccount; record

of all international transactions for

goods and services only.

3ecord of all international transactions forgoods and services only. @he goods and

services account is used in the national

income identity for GD.

Binancial Account


assets. ;ssets include bonds! @reasury bills!

ban= deposits! stoc=s! currency! real estate!

etc.

The balance on each of these accounts is found by taking the difference between e+ports andimports#

-urrent Account

The current account 2CA7 balance is defined as CA K E$G&SP'&( W #MG&SP'&( wherethe G&SP'&( superscript is meant to include e+ports and imports of goods 2G7! services 2S 7!income payments and receipts 2 #P'7! and unilateral transfers 2( 7# If CA [ 3! then e+ports of goods and services e+ceed imports and the country has a current account surplus# If CA \ 3!then imports e+ceed e+ports and the country has a current account deficit#

Income payments represent the money earned 2i#e#! income7 by foreign residents on their investments in the (nited States# or e+ample! if a )ritish company owns an office buildingin the (nited States and brings back to the (nited @ingdom a share of the profit earned thereas a part of its income! then this is classified as an income payment on the current account of the balance of payments#

Income receipts represent the money earned by domestic residents on their investmentsabroad# or e+ample! if a (#S# company owns an assembly plant in Costa ,ica and brings

back to the (nited States a share of the profit earned there as a part of its income! then this isclassified as an income receipt on the current account of the balance of payments#

It may be helpful to think of income payments and receipts as payments for entrepreneurialservices# or e+ample! a )ritish company running an office building is providing themanagement services and taking the risks associated with operating the property# In e+changefor these services! the company is entitled to a stream of the profit that is earned# Thus income

payments are classified as an import! the import of a service# Similarly! the (#S# companyoperating the assembly plant in Costa ,ica is also providing entrepreneurial services for which it receives income# Since in this case the (nited States is e+porting a service! incomereceipts are classified as a (#S# e+port#

(nilateral transfers represent payments that are made or received that do not have an

offsetting product flow in the opposite direction# ormally! when a good is e+ported! for e+ample! the good is e+changed for currency such that the value of the good and the value of


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the currency are e


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call the current account deficit a trade deficit and then define it briefly as a MbroadN measureof trade#

A simple solution would be to call the current account balance the Mtrade balanceN since it is arecord of all trade in goods and services and to call the merchandise trade balance the

Mmerchandise goods balance!N or the Mgoods balanceN for short# I will ascribe to thisconvention throughout this te+t in the hope that it might catch on#

&'P versus &3P

There are two well5known measures of the national income of a country: &'P and &P# )othrepresent the total value of output in a country during a year! only measured in slightlydifferent ways# It is worthwhile to understand the distinction between the two and whatad;ustments must be made to measure one or the other#

Conceptually! the gross domestic product 2&'P7 represents the value of all goods and services produced within the borders of the country# The gross national product 2&P7 represents thevalue of all goods and services produced by domestic factors of production#

Thus production in the (nited States by a foreign5owned company is counted as a part of (#S#&'P since the productive activity took place within the (#S# borders! even though the incomeearned from that activity does not go to a (#S# citien# Similarly! production by a (#S#company abroad will generate income for (#S# citiens! but that production does not count asa part of &'P since the productive activity generating that income occurred abroad# This

production will count as a part of &P though since the income goes to a (#S# citien#

The way &'P versus &P is measured is by including different items in the e+port andimport terms# As noted above! &'P includes only e+ports and imports of goods and services!implying also that &'P e+clu

Documents

International Finance Revised