Macroeconomics Unit 17 Global Macroeconomic Issues

Introduction This unit exposes you to the basic macro economic issues of world trade. What are the advantages and disadvantages of world trade? The marginal propensity to import is discussed as a new leakage to the circular flow. A continuing discussion of specialization and comparative advantage occurs as we examine the positive and negative aspects of world trade on individual economies.

The Global View The U.S. economy is not immune or isolated from other economies in the world. As international trade increases, our economy, along with other economies, become more dependent upon each other. Economic policy decisions in other countries can impact U.S. exports and imports.

International Trade If an economy does not have any foreign trade (imports/exports) it is called a closed economy. GDP in a closed economy = Consumption + Investment + Government Spending (C + I + G). In a closed economy there are no leakages from the circular flow from imports. In a closed economy there are no injections into the circular flow from exports.

International Trade In an open economy, exports (X) and imports (IM) affect the circular flow. GDP or Y = C + I + G + (X-IM). Often this equation is restated as: C + I + G + X = Y + IM. The restated equation illustrates the effects of imports and exports. In an open economy, total spending may not equal total output because of the effect of imports and exports.

International Trade Changes in income will affect the amount of spending in our economy. A portion of any increase in income will be spent on imports which results in a leakage to the circular flow of the economy. The marginal propensity to import (MPM) is used to determine the fraction of each additional dollar in income that is spent on imports. MPM reduces the economic impact of changes in income to an economy.

International Trade MPM also reduces the size of the multiplier. Remember the multiplier = 1/(1-MPC) or 1/MPS. In a closed economy, the value of the multiplier is not affected by imports. In an open economy, the value of the multiplier is affected by MPM. Open economy multiplier = 1 / (MPS + MPM)

International Trade The open economy multiplier includes the leakages associated with savings and imports. Since the amount of leakages is greater in an open economy, any fiscal stimulus package will be reduced by the amount of savings (MPS) and the amount spent on imports (MPM). Simply stated the total effect of the multiplier is reduced when a portion of all income is spent on imports. If consumers receive an additional dollar in income, a portion of that dollar is spent on imports which does not help the domestic economy.

International Trade ActionClosed Econ.Open Econ. Gov’t spends $10 billion more + $10 billion Consumer: MPC =.9 MPS =.1 MPM =.1 Save $1 billionSave $1 billion, spend $1 billion on imports Multiplier1/MPS = 101/(MPS + MPM) = 5 Total Change$100 billion increase$50 billion increase

International Trade The preceding table points out the difference between a closed economy and an open economy where imports occur. Spending on imports reduced the multiplier from 10 to 5, and reduced the economic impact of an increase in government spending from $100 billion to $50 billion. The effect the MPM has on an economy is based upon its value. As its value increases, more spending is occurring on imports which can significantly reduce the value of the multiplier and any fiscal policy decision to increase economic activity.

International Trade Changes in income within the U.S. do not have an impact on exports. Exports are dependent upon foreign income and spending patterns. A change in the demand for exports will cause aggregate demand to shift. If more exports are demanded AD will shift to the right. Once again, exports are dependent upon economic conditions in other countries.

Trade Imbalances The difference between what we export and import is called net exports (X-IM). If exports exceed imports, we have a trade surplus. If imports exceed exports, we have a trade deficit. A trade deficit indicates that we are consuming more than we produce. Currently, the United States has a trade deficit.

Trade Imbalances Trade deficits tend to lessen the chance for inflation. Imported products and services are usually less expensive than domestically produced products and services. Trade deficits can make it more difficult to achieve full employment as domestic companies must compete against possibly lower priced products being imported. Any fiscal stimulus program designed to boost domestic spending will make trade deficits worse as consumers continue to spend additional income on imports.

Trade Imbalances A trade surplus may cause an increase in inflation. Policies designed to reduce inflation domestically may not affect foreign purchases. A trade surplus may exist only because of a reduction in domestic spending. If spending increases, the surplus may disappear. Currently the U.S. has a trade deficit, not a trade surplus. When a country has a trade deficit, other countries must have a trade surplus.

International Finance Money moves from country to country in exchange for goods and services. When U.S. exports are purchased, or investments are made in the U.S. stock or bond markets by foreign investors, capital inflows of money increase. Money that is spent on imports, or U.S. citizens or companies investing in foreign markets, produce capital outflows of money.

Capital Imbalances Similar to trade deficits and surpluses, capital inflows and outflows may not be in balance. A capital deficit exists when the capital outflow exceeds the capital inflow in a given time period. Funds are being invested in other countries at a greater rate then domestic investment. A capital surplus exists when the capital inflow exceeds the capital outflow in a given time period. Funds are being invested domestically at a higher rate than foreign investment.

Capital Imbalances Capital imbalances are directly related to trade imbalances. A trade deficit indicates that more money is being sent overseas. Foreign investors, eager to invest in the U.S. return the money into our economy. This creates a capital surplus. A trade surplus indicates greater foreign purchases of exports than imports. More foreign money is being used to purchases goods and services compared to U.S. dollars being spent overseas on products. This creates a capital deficit.

Capital Imbalances One factor that has an impact on capital flows is the exchange rate. The exchange rate is the price of one country’s currency expressed in terms of another country’s currency. For example, the U.S. dollar may be worth 2 Canadian dollars; the Canadian dollar may be worth $0.50 US.

Capital Imbalances If the value of the U.S. dollar rises, it indicates that the dollar is worth more relative to another country’s currency. A higher valued U.S. dollar enables you to purchase more foreign goods and services. A higher valued dollar also makes our exports more expensive in world markets. Exchange rates change daily in response to fiscal and monetary policy changes.

Productivity and Competitiveness Many of the items we import could be produced here in the U.S. Oil, coffee, toys, etc. could all be produced here. Some of these items would be costly to produce here, or may have a negative impact on the environment. As a result we import items that other countries can produce at a lower cost or more efficiently.

Productivity and Competitiveness When a country is able to produce and good or service for a lower opportunity cost, that country has a comparative advantage. Specialization occurs when countries produce goods and services more efficiently and for lower opportunity costs than other countries. Foreign trade ensures competing domestic producers remain efficient. The competition from foreign imports increases domestic productivity and efficiency.

Productivity and Competitiveness Improvements in productivity (output per unit of input) are necessary in order to compete against lower international labor costs. U.S. companies have higher labor costs than most foreign competitors. To remain competitive, U.S. companies must have higher levels of productivity than their competing foreign companies.

International Organizations The International Monetary Fund (IMF) is essentially a bank that assists countries in economic trouble. Its primary function is to lend funds obtained from member countries to assist other countries with economic stabilization. The loans help a country’s currency become more stable and assists with economic development and growth.

International Organizations The European Union (EU) was originally a group of 11 (and rising) European countries who joined together to establish a common currency, financial system and eliminate trade barriers. A common currency enables easier trading between member countries. Each country adopts a common monetary policy in terms of interest rates and the supply of money. The governments continue to operate as separate entities.

Summary Closed economy and an open economy. Marginal propensity to import. Impact of imports on fiscal stimulus. Trade surplus, trade deficit. Impact of a trade deficit on the economy. Capital deficit, capital surplus. Exchange rate. Effect of exchange rates on imports and exports. Specialization, comparative advantage. International Money Fund. European Union.