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Chapter Two
The Global
Economy
The Global Economy
I started the day early having set my alarm clock
(MADE IN JAPAN) for 6 a.m. While my coffeepot (MADE
IN CHINA) was perking, I shaved with my electric razor
(MADE IN HONG KONG). I put on a dress shirt (MADE IN
SRI LANKA), designer jeans (MADE IN SINGAPORE) and
tennis shoes (MADE IN KOREA). After cooking my
breakfast in my new electric skillet (MADE IN INDIA) I sat
down with my calculator (MADE IN MEXICO) to see how
much I could spend today.
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Chapter 2 | Slide 2
The Global Economy (cont.)
After setting my watch (MADE IN TAIWAN) to the radio
(MADE IN INDIA) I got in my car (MADE IN JAPAN) and
continued my search for a good paying (!) American
job. At the end of yet another discouraging and
fruitless day, I decided to relax for a while. I put on my
sandals (MADE IN BRAZIL) poured myself a glass of
wine (MADE IN FRANCE) and turned on my TV (MADE IN
INDONESIA), and then wondered why I can't find a good
paying job in.....AMERICA!
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Chapter 2 | Slide 3
Imports and Exports as a Percentage of
GDP (in Billions of Dollars)
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Chapter 2 | Slide 4
Historical Development
Stock Market Crash 1929
US Isolationism, Protectionism
Other Countries Retaliate with Similar Measures
Global Depression – Germany and Japan Hit Particularly Hard
World War II
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Chapter 2 | Slide 5
Historical Development (cont’d)
Bretton Woods Conference
GATT, WTO

Import Tariffs Decrease from 40% in 1947 to 4% Today
 World Trade Increases 22-fold Since 1950

Foreign Direct Investment Increased Over 100% in a Single Decade!
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Chapter 2 | Slide 6
Basic Theories of World Trade
Absolute advantage
• Trade is based on each country selling
what it is best at producing
Comparative advantage
• Trade can occur between two countries
even if one of the countries has no
absolute advantage in any product
• Make the product you have a comparative
advantage in
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Chapter 2 | Slide 7
Vietnam
Germany
Yearly output
per worker
Machinery
200 machines 500 machines
Tomatoes
800 tons
1000 tons
Opportunity
cost of
production
1 machine
costs 4 tons
of tomatoes
or 1 ton
tomatoes cost
0.25
machines
1 machine
costs 2 tons
of tomatoes
or 1 ton
tomatoes
costs 0.5
machines
Absolute
advantage
None
Machinery,
tomatoes
Comparative
advantage
Tomatoes
Machinery
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Chapter 2 | Slide 8
1 (Vietnamese) machine =
4 tons (Vietnamese) tomatoes
1 (German) machine =
2 tons (German) tomatoes
If Germany trades 1 machine to
Vietnamese for 3 tons of
tomatoes…both countries win!
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Chapter 2 | Slide 9
Any trading ratio between:
1 machine = 2 tons of tomatoes and
1 machine = 4 tons of tomatoes
will be a mutually advantageous trading ratio
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Chapter 2 | Slide 10
Competitive Advantage (Adam Smith)
Comparative advantage is limited by its focus on
the elements of production, including:
1. Land
2. Labor
3. Natural resources
4. Capital
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Chapter 2 | Slide 11
Porter’s Revised Theory of Competitive
Advantage
• Elements of production
• Nature of domestic demand
• Presence of appropriate suppliers or
related industries
• The conditions in the country that
govern how companies are created,
organized, and managed
• Nature of domestic rivalry
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Chapter 2 | Slide 12
Exchange Rates
An exchange rate measures the value of one
currency in terms of another currency
1 US $ = 0.5 £
One currency can appreciate
or depreciate against another
1 US $ = 0.75 £
1 US $ = 0.30 £
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Chapter 2 | Slide 13
Balance of Payments
An accounting record of the transactions
between one country’s economy and the rest
of the world’s collective economy at a point
in time.
Functions like a statement of cash flows.
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Chapter 2 | Slide 14
Balance of Payments
• Add table 2.5, p. 26 here
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Chapter 2 | Slide 15
Supply and Demand and FOREX
Pounds
• The foreign
exchange market
reflects the
supply and
demand for one
currency versus
another
S
p
D
q
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DM
Chapter 2 | Slide 16
Rates Determining Factors
(besides Supply & Demand)
• Imports/exports drive need for
currencies
• Inflation
• Investors and speculators - ROI
• Government actions
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Chapter 2 | Slide 17
Is a strong currency good or bad?
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Chapter 2 | Slide 18
“Soft” Currencies
• Currencies of smaller, less developed
countries
• Rates can be artificially “determined” by the
governments of these countries
• Pegging of rates to more stable currencies
• Governments must eventually respect
FOREX supply and demand
• Currencies often face significant
devaluations
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Chapter 2 | Slide 19
Dollarization
• Panama adopted the U.S. dollar as its
currency in 1904
• Ecuador adopts U.S. dollar in 2000
• Good idea?
+ Monetary stability
- Lack of flexibility in monetary or foreign exchange
policy to respond to economic downturn or
external shocks (i.e. what if dollar depreciates?)
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Chapter 2 | Slide 20
Agencies Promoting Economic and
Monetary Stability
• International Monetary Fund
– Prevention of economic instability in
emerging markets
• World Bank
– Long-term loans to developing countries
• Group of 7(8)
– Finance ministers/Central Bank governors
of USA, Japan, Germany, France, Britain,
Italy, Canada (Russia)
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Chapter 2 | Slide 21
Protectionism and Trade Restrictions
• Tariffs
• Quotas
• Orderly marketing arrangements
(voluntary export restrictions)
• Non-tariff barriers (regulations,
stringent standards, bribes, etc.)
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Chapter 2 | Slide 22
General Agreement on Tariffs
and Trade (GATT) – Key Principles
• Reciprocity
• Non discrimination
– Most favored nation (MFN) status
• Transparency
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Chapter 2 | Slide 23
World Trade Organization
• Created as final act of GATT
• Unlike GATT, WTO decisions can only be
overturned by consensus and not by
unilateral veto
• Challenges
– Continued liberalization of trade
– Establish trade policy for foreign investment,
competition and labor standards
– Promote regional trade agreements
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Chapter 2 | Slide 24
Opposition to WTO Agendas
• Unfair to developing countries?
• Threat to national sovereignty and culture?
• Protectionist agendas still remain in some
countries
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Chapter 2 | Slide 25
Different Types of Regional
Economic Integration
– Free Trade Area (i.e. NAFTA)
•
Liberal external trading policy
– Customs Union
•
•
supranational trade policy-making body
Common external trade barrier adopted by all member
nations
– Common Market
•
Customs Union characteristics + mobile labor and
capital among member nations
– Monetary Unions (example: European Union
and the “Euro”)
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Chapter 2 | Slide 26
Geographic Proximity Often
Contributes to Economic Integration
• Distances are short – lower cost of
trading
• Similar consumer tastes
• Common history or interests
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Chapter 2 | Slide 27
The Effects of Economic Integration
• Benefits
 Trade Creation
 Bigger Markets
 Greater
Consensus
 Political
Cooperation &
Good Will
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• Drawbacks
 Trade Diversion
 Shifts in Employment
and Loss of Jobs
 Loss of National
Sovereignty
Chapter 2 | Slide 28
European Integration….
''When I need to get in touch with the
Kremlin, I know who to call. When I
need to get in touch with Europe, who
do I call?''
--Henry Kissinger
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Chapter 2 | Slide 29
European Union - Characteristics
• Founded on International Treaties
among sovereign nations rather than a
Supra-national Constitution
• Power to enact laws that are binding
on all EU citizens throughout EU
territory
• Common Currency established – the
“Euro”
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Chapter 2 | Slide 30
EU Objectives
1. Promote economic and social
progress
2. Assert the identity of the European
Union on the international scene
3. Introduce European citizenship
4. Develop an area of freedom
5. Maintain and build an established EU
law
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Chapter 2 | Slide 31
History of the EU
• 1951 - European Coal
and Steel Community
• 1957 – Treaties of
Rome: EEC (later EC)
• 1992 – European Union
Signed in Maastricht
• 1999 – Most Countries Adopt
the Euro
• 1960 - European Free
Trade Association
• 1967 – Internal Tariffs
Eliminated in EC;
Common External Tariff
Imposed
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Chapter 2 | Slide 32