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Chapter 2
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)
International
Economics
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.
International
Economics
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.
International
Economics
The Basic Circular Flow of an Economy
FP
Individuals
Producers
C
International
Economics
Adding Investment Goods (Capital Goods)
FP
Individuals
Producers
I
C
International
Economics
Adding Intermediate Goods Supplied Among Producers
FP
Individuals
Producers
C
IG
I
International
Economics
Adding Transfers among Individuals
FP
Tr
Individuals
Producers
IG
I
C
International
Economics
Adding the Government to the Economy
FP
Tr
Individuals
TXI
TRI
TXP
Government
TRP
Producers
IG
G
I
C
International
Economics
Adding the Financial Sector fo the Economy
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
TRP
Producers
IG
G
I
C
International
Economics
The Closed Economy
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
TRP
Producers
IG
G
I
C
Border
International
Economics
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
International
Economics
What Links Could a Single Economy
Form with the Rest of the World?
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
TRP
Producers
IG
G
I
C
Border
Abroad
International
Economics
The Economy Could Import Consumption Goods
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Imports IM
Abroad
International
Economics
It Could Import Intermediate Goods
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Imports IM
Abroad
International
Economics
And Capital Goods
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Imports IM
Abroad
International
Economics
Finally, the Government Could Import Goods
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Imports IM
Abroad
International
Economics
The Open Economy Also Exports Consumption Goods,
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Exports X
Imports IM
Abroad
International
Economics
Intermediate Goods,
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Exports X
Imports IM
Abroad
International
Economics
Investment (Capital) Goods,
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Exports X
Imports IM
Abroad
International
Economics
And Government Goods
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
Border
Exports X
Imports IM
Abroad
International
Economics
There Are International Transfers by Individuals
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
TrF
Border
Exports X
Imports IM
Abroad
International
Economics
And by Governments
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
Individuals
TXI
TRI
TXP
Government
Producers
TRP
IG
G
I
C
TrF
Border
Transfers TrF
Exports X
Imports IM
Abroad
International
Economics
There Are Also International Asset Sales and Purchases,
SF
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
TXI
Individuals
TRI
TXP
Government
Producers
TRP
IG
G
I
C
TrF
Border
Transfers TrF
Exports X
Imports IM
Abroad
SF
International
Economics
And the Returns to Foreign-Owned Assets
rF S
F
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
TXI
Individuals
TRI
TXP
Government
Producers
TRP
IG
G
I
C
TrF
Financial
Flows SF, rF
Border
Transfers TrF
Exports X
Imports IM
Abroad
SF
rF
International
Economics
Figure 2.7
The Complete Set of International Links for an Open Economy
rF S
F
SI
Sp
Financial Sector
rI
rG
SG
rp
FP
Tr
TXI
Individuals
TRI
TXP
Government
Producers
TRP
IG
G
I
C
TrF
Financial
Flows SF, rF
Border
Transfers TrF
Exports X
Imports IM
Abroad
SF
rF
International
Economics
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.
International
Economics
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.
Country 3
Exports
Country 2
Final
Goods
Domestic
Intermediate
Goods
Country 1
Capital and
Labor
Intermediate
Goods
International
Economics
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: (XIM) + 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.
International
Economics
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
International
Economics
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
International
Economics
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?
International
Economics
The Net International Investment Position
• The International Investment Position is 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.
International
Economics
Table 2-2
The International Investment Position of the United States
(US$ billions, current cost basis)
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
U.S.-owned
assets abroad
2,008.4
2,350.2
2,294.1
2,470.6
2,466.5
3,081.4
3,326.7
3,930.3
4,631.3
5,379.1
6,174.5
7,386.9
7,350.9
6,862.9
Foreign-owned
assets in U.S.
1,997.9
2,397.2
2,458.6
2,731.5
2,918.8
3,235.7
3,450.4
4,273.6
5,017.8
6,214.3
7,268.6
8,440.5
8,934.0
9,172.1
U.S. Net International
Investment Position
10.5
!47.0
!164.5
!260.8
452.3
!144.3
!123.7
!343.3
!386.5
!835.2
-1,094.2
!1,053.6
!1,583.2
!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.
International
Economics
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
International
supply and demand of a currency is equal.
Economics
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 = $.10.
e$//peso
S
$.15
$.10
D
$.05
0
100
200
250
350
Millions of Pesos
International
Economics
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 $.125.
e$//peso
S
$.15
$.12.50
$.10
D
D
$.05
0
100
200
250
300
350 Millions of Pesos
International
Economics
The Foreign Exchange Market: The Mexican Perspective
• The supply curve for
dollars from the U.S.
perspective is seen as
the demand curve for
pesos from Mexico
• Similarly, the U.S.
demand curve for
dollars is the supply
curve of pesos
• Thus the equilibrium
exchange rate from
the Mexican
perspective is 1/e =
1/.10 = 10 pesos.
epesos/$
S
10 pesos
D
0
15
25
Millions of Dollars
International
Economics
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
epesos/$
S’
S
10 pesos
8 pesos
D
0
15
25
37.5
Millions of Dollars
International
Economics