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Chapter 1 – IntroductionWhat Is International Economics About?
The subject matter of international economics consists of issues raised by the special problems of economic
interaction between sovereign states. Seven themes recur throughout het study of international economics:
1. The gains from trade;
2. The pattern of trade;
3. Protectionism;
4. The balance of payments;
5. Exchange rate determination;
6. International policy coordination, and;
7. The international capital market.
When countries sell goods and services to each other, this exchange is almost always to their mutual benefit.
Although nations generally gain from international trade, it is quite possible that international trade may hurt
particular groups within nations: international trade will have strong effects on the distribution of income.
International trade can adversely affect the owners of resources that are “specific” to industries that compete
with imports, that is, cannot find alternative employment in other industries.
If the idea of gains from trade is the most important theoretical concept in international economics, the
seemingly eternal debate over how much trade to allow is its most important policy theme. The single most
consistent mission of international economics has been to analyze the effects of these so-called protectionist
policies and to criticize protectionism and show the advantages of freer international trade.
International capital markets differ in important ways from domestic capital markets. They must cope with
special regulations that many countries impose on foreign investment; they also sometimes offer opportunities
to evade regulations placed on domestic markets.
Some special risks are associated with international capital markets:
• Currency fluctuations: if the euro falls against the dollar, U.S. investors who bought euro bond suffer a
capital loss.
• National default: a nation may simply refuse to pay its debts, and there may be no effective way for its
creditors to bring it to court.
International Economics: Trade and Money
International trade analysis focuses primarily on the real transactions in the international economy, that is,
transactions involving a physical movement of goods or a tangible commitment of economic resources.
International monetary analysis focuses on the monetary side of the international economy, that is, on
financial transactions such as foreign purchases of U.S. dollars.
1
,Chapter 13 – National Income Accounting and the Balance of
Payments
The branch of economics called microeconomics studies problems from the perspective of individual firms and
consumers.
Macroeconomics is the branch of economics that studies how economies’ overall levels of employment,
production, and growth are determined.
Macroeconomic analysis emphasizes four aspects of economic life:
1. Unemployment
2. Saving
3. Trade imbalances
4. Money and the price level
The National Income Accounts
Of central concern to macroeconomic analysis is a country’s gross national product (GNP), the value of all final
goods and services produced by the country’s factors of production and sold on the market in a given time
period.
GNP is calculated by adding up the market value of all expenditures of final output. GNP therefore includes the
value of goods sold as well as the value of services provided.
To distinguish among the different types of expenditure that make up a country’s GNP, we divide GNP among
the four possible uses for which a country’s final output is purchased:
• Consumption
• Investment
• Government purchases
• Current account balance
The term national income accounts is used to describe this fourfold classification because a country’s income in
fact equals its output.
The GNP a country generates over some period of time must equal its national income, the income earned in
that period by its factors of production.
Two definitions of GNP must be made before the identification of GNP and national income is entirely correct
in practice:
1. GNP does not take into account the economic loss due to the tendency of machinery and structures to
wear out as they are used. This loss, called depreciation, reduces the income of capital owners. To
calculate national income over a given period, we must therefore subtract from GNP the depreciation
of capital over the period. GNP less depreciation is called net national product (NNP).
2. A country’s income may include gifts from residents of foreign countries, called unilateral transfers.
Net unilateral transfers are part of a country’s income but are not part of its product, and they must
be added to NNP in calculations of national income.
National income equals GNP less depreciation plus net unilateral transfers.
Gross domestic product (GDP) is supposed to measure the volume of production within a country’s borders,
whereas GNP equals GDP plus net receipts of factor income from the rest of the world.
GDP does not correct for the portion of countries; production carried out using services provided by foreign-
owned capital and labor, as GNP does.
2
,Example:
The profits of a Spanish factory with British owners are counted in Spain’s GDP but are part of Britain’s GNP.
→ The services British capital provides in Spain are a service export from Britain; therefore they are
added to British GDP in calculating British GNP. At the same time, to figure Spain’s GNP, we must
subtract from its GDP the corresponding service import from Britain.
Income Accounting for an Open Economy
• Consumption (C): the portion of GNP purchased by private households to fulfill current wants is called
consumption.
• Investment (I): the part of output used by private firms to produce future output is called investment.
Investment spending may be viewed as the portion of GNP used to increase the nation’s stock of
capital.
• Government Purchases (G): any goods and services purchased by federal, state, or local governments
are classified as government purchases in the national income accounts.
We can write for a closed economy:
13.1 𝑌 =𝐶+𝐼+𝐺
The national income identity for an open economy is:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝐸𝑋 − 𝐼𝑀
The difference between exports of goods and services and imports of goods and services is known as the
current account balance. If we denote the current account by CA, we can express this definition in symbols as:
𝐶𝐴 = 𝐸𝑋 − 𝐼𝑀
When a country’s imports exceed its exports, we say the country has a current account deficit. A country has a
current account surplus when its exports exceeds its imports.
Why is the current account so important in international economics?
• Changes in the current account can be associated with changes in output, and thus, employment.
• It measures the size and direction of international borrowing.
A country’s current account balance equals the change in its net foreign wealth.
Equation 13.1 says that the current account is also equal to the difference between national income and
domestic residents’ total spending 𝐶 + 𝐼 + 𝐺:
𝑌 − (𝐶 + 𝐼 + 𝐺) = 𝐶𝐴
It is only by borrowing abroad that a country can have a current account deficit and use more output than it is
currently producing. If it uses less than its output, it has a current account surplus and is lending the surplus to
foreigners. International borrowing and lending were identified with intertemporal trade.
→ A country with a current account deficit is importing present consumption and exporting future
consumption. A country with a current account surplus is exporting present consumption and
importing future consumption.
The net international investment position (or IIP) is the difference between a country’s claims on foreigners
and its liabilities to them.
National saving is the portion of output, Y, that is not devoted to household consumption, C or government
purchases, G. In a closed economy, national saving always equals investment.
3
, Let S stand for national saving:
𝑆 =𝑌−𝐶−𝐺
May also be rewritten as:
𝐼 = 𝑌−𝐶−𝐺
Then:
𝑆=𝐼
For an open economy, remember that national saving, S, equals 𝑌 − 𝐶 − 𝐺 and that 𝐶𝐴 = 𝐸𝑋 − 𝐼𝑀, we can
rewrite the GNP identity as:
𝑆 = 𝐼 + 𝐶𝐴
Important difference: an open economy can save either by building up its capital stock or by acquiring foreign
wealth, but a closed economy can save only by building up its capital stock.
Because one country’s savings can be borrowed by a second country in order to increase the second country’s
stock of capital, a country’s current account surplus is often referred to as its net foreign investment.
Private saving is defined as the part of disposable income that is saved rather than consumed. Disposable
income is national income, Y, less the net taxes collected from households and firms by the government, Tg.
Private savings, Sp, can therefore be expressed as:
𝑆𝑝 = 𝑌 − 𝑇 − 𝐶
Government saving is defined similarly to private saving. The government’s “income” is its net tax revenue, T,
while its “consumption” is government purchases, G. if we let Sg stand for government saving, then:
𝑆𝑔 = 𝑇 − 𝐺
Private and government saving added up to national saving. We rewrite the national income identity in a form
that is useful for analyzing the effects of government saving decisions on open economies:
13.2 𝑆 𝑝 = 𝐼 + 𝐶𝐴 − 𝑆 𝑔 = 𝐼 + 𝐶𝐴 − (𝑇 − 𝐺) = 𝐼 + 𝐶𝐴 + (𝐺 − 𝑇)
The Balance of Payments Accounts
A country’s balance of payments accounts keep track of both its payments to and its receipts from foreigners.
Any transaction resulting in a receipt from foreigners is entered in the balance of payments as a credit. Any
transaction resulting in a payment to foreigners is entered as a debit.
Three types of international transaction are recorded in the balance of payments:
1. Transactions that arise from the export or import of goods or services and therefore enter directly into
the current account.
2. Transactions that arise from the purchase or sale of financial assets. An asset is any one of the forms
in which wealth can be held. The financial account of the balance of payments records all
international purchases or sales of financial assets. The difference between a country’s purchases and
sales of foreign assets is called its financial account balance.
3. Certain other activities resulting in transfers of wealth between countries are recorded in the capital
account. These international asset movements differ from those recorded in the financial account.
Every international transaction automatically enters the balance of payments twice, once as a credit and once
as a debit.
4
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