Table of Contents
GROWTH
I. Labor Resources and Economic Growth: Important determinants of economic growth are growth of labor and capital and the rate of increase of labor and capital productivity. This section examines the conditions necessary for population growth to be translated into economic growth.
A) Population Growth and Economic Growth: The growth rate of per capita real GDP is equal to the rate of growth of real GDP minus the population growth rate.
1. How Population Growth Can Contribute to Economic Growth: Immigration can increase real GDP faster than population if they increase the labor force participation rate. It is possible for higher birth rates to lead to an increase in the labor force and an increase real GDP per capita.
2. Whether Population Growth Hinders or Contributes to Economic Growth Depends on Where You Live: There are countries such as Saudi Arabia where rapidly increasing population leads to lower per capita real GDP and others such as Hong Kong that have experienced high rates of growth of per capita real GDP.
B) The Role of Economic Freedom: Economic freedom is expressed as the rights to own private property and to exchange goods, services, and financial assets with minimal government interference. In general the higher is the level of economic freedom, the higher is per capita real GDP and growth rates.
C) The Role of Political Freedom: Political freedom is the right to openly support and democratically select national leaders. It seems less important than economic freedom in explaining economic growth. In fact there is some evidence that greater democracy in a nation reduces economic growth rates because of successful attempts to restrict competition by producers. In general though as countries achieve high standards of living through consistent growth they tend to become more democratic over time. This suggests that there is a positive relationship between economic freedom and economic growth.
II. Capital Goods and Economic Growth: In general capital is necessary for economic growth. In many developing countries one of the most significant problems they face that retards economic growth is dead capital, which is any capital resource that lacks clear title of ownership. Because people have difficulties exchanging, insuring, and legally protecting their rights to it, it is not readily allocated to its most productive use.
A) Dead Capital and Inefficient Production: Because people who unofficially own capital goods are commonly constrained in using them efficiently, large amounts of capital goods are used inefficiently.
B) Dead Capital and Economic Growth: In developing countries the existence of dead capital reduces the rate of return on investment thus reducing the incentive to invest in new capital goods. This reduces investment. Since economic growth depends in part on investment, the result is a decrease in the rate of economic growth.
1. Government Inefficiencies, Investment, and Growth: A major factor that contributes to dead capital and resulting lower rates of investment in less developed countries is inefficient government regulation. Economies of countries with less efficient governments tend to grow more slowly. The reason is that capital is difficult to direct to its most efficient uses.
2. Corruption and Growth: The more widespread is corruption, the greater is the problem of dead capital and the higher is the cost of investment. Greater corruption leads to lower economic growth.
III. Private International Financial Flows as a Source of Global Growth: One approach to promoting greater economic growth in developing countries is to rely on private markets to direct capital goods to their best uses.
A) Private Investment in Developing Nations: Net private international flows of funds to developing countries have averaged over $100 billion per year since 1995 (equal to about 10 percent of annual net investment in the U.S.).
1. Source of Foreign Funding for Capital Goods: There are three sources of foreign funds for capital goods. These are bank loans, portfolio investment—the purchase of less than 10% of the shares of ownership in a company in another nation—and direct foreign investment. Direct foreign investment is the acquisition of a more than 10 percent share of a firm’s ownership.
2. How International Financial Flows Can Contribute to Global Growth: International investors live in countries where there are fewer barriers to proof of capital ownership. There is a greater likelihood that international investors will be able to prevent the capital they own from becoming dead capital and thus it will remain productive.
B) Obstacles to International Investment: The major problems of financial markets in developing countries are related to the problem of asymmetric information.
1. Asymmetric Information as a Barrier to Financing Global Growth: The problem here is that institutions that make loans or investors who hold stocks and bonds have less information than those who seek to use the funds. Adverse selection arises when those who wish to obtain funds for the least worthy projects are among those who wish to borrow or issue bonds or stocks. If lenders and investors have trouble identifying these higher-risk persons, they may be less willing to channel funds to even creditworthy borrowers. Moral hazard exists when recipients of funds engage in riskier behavior after getting the funds. These asymmetric information problems are great enough in some countries as to form a significant obstacle to economic growth.
2. Incomplete Information and International Financial Crises: An international financial crisis exists when there is a rapid withdrawal of foreign investments and loans from a nation. These happen because less sophisticated investors and banks follow the example of larger, more sophisticated investors and institutions in withdrawing funds when risks in a foreign country or group of foreign countries exist.
IV. International Institutions and Policies for Global Growth: Since 1945 the world’s governments have taken an active role in supplementing private markets through the World Bank and the International monetary Fund.
A) The World Bank: A multinational agency that specializes in making loans to about 100 developing nations in an effort to promote their long-term growth and development. The bank mainly finances projects such as irrigation systems and road improvements.
B) The International Monetary Fund: The IMF is an international organization that aims to promote world economic growth through more financial stability. Each nation that joins the IMF deposits funds to an account called its quota subscription and these are measured in special drawing rights from a pool of funds held by the IMF. The IMF currently makes both short-term and long-term loans to help finance growth or to provide assistance to countries that are having trouble paying off their debts.
C) The World Bank and the IMF: Part of the Solution or Part of the Problem? In recent years economists have questioned IMF and World Bank policy making.
1. Does the World Bank Really Have a Mission Anymore?: While the World Bank’s mission is to make loans to developing nations that fund projects incapable of attracting private investors for funding, it makes many of its loans to countries that have little trouble attracting private investment. Some countries such as China are inappropriate recipients for World Bank loans.
2. Asymmetric Information and the World Bank and the IMF: Lending policies of both organizations can make the adverse selection problem worse.
3. Rethinking Long-Term Development Lending: Many economists argue that promoting market reforms by governments in developing countries would have much higher payoffs in promoting development. The major issue is whether the lending should be for specific projects or more for financing the market reforms by government.
4. Alternative Institutional Structures for Limiting Financial Crises: Proposals range from eliminating the IMF and the World Bank and replacing them with alternative organizational forms to simply having the IMF and World Bank more carefully monitor borrowers. Almost all economists agree that improved accounting standards for international borrowers are needed.
TRADE
I. Why We Trade
A) The Output Gains from Specialization: If specialization and trade occurs along lines of comparative advantage, then production increases above what would be possible without specialization and trade.
B) Specialization Among Nations: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than can other producers. Comparative advantage always exists as long as the opportunity cost of doing the same job varies for different individuals or countries. Absolute advantage is the ability to produce more output from given inputs of resources than another can.
C) Transmission of Ideas: Ideas are transmitted through international trade. These ideas may be in the form of intellectual property, new goods and services, and new processes.
II. The Relationship Between Imports and Exports: In the long run, imports are paid for by exports. This is because foreigners want something in exchange for the goods that are shipped to the US. Any restriction of imports ultimately reduces exports, because restrictions on imports lead to a reduction in employment in the export industries.
III. International Competitiveness: This term is hard to define precisely because countries do not compete. Businesses within each country compete with businesses in other countries. Based on an international study, the US leads the world in measures of competitiveness.
IV. Arguments Against Free Trade: The arguments against free trade do not consider the benefits of the possible alternatives for reducing costs while still reaping benefits.
A) The Infant Industry Argument: The argument that tariffs should be imposed to protect an industry that is trying to get started from import competition. After the industry becomes technologically efficient, the tariff can be lifted.
B) Foreign Subsidies and Dumping: When a foreign government subsidizes its producers, ours claim they cannot compete fairly with subsidized foreigners. To the extent that such subsidies fluctuate, one can argue that unrestricted free trade will seriously disrupt domestic producers. Occasionally, dumping takes place — selling a good or service abroad at a price below its cost of production or below the price charged in the home market. This disrupts international trade and may impair commercial well being at home.
C) Protecting Domestic Jobs: The most often used argument against free trade is that unrestrained competition from other countries will eliminate U.S. jobs because other countries have lower-cost labor and less restrictive environmental standards.
D) Emerging Arguments Against Free Trade: environmental concerns, undesirable effects (genetic engineering), certain technologies should not be exported
V. Ways to Restrict Foreign Trade:
A) Quotas: Quotas are government-imposed restrictions on the quantity of a specific good that another country is allowed to sell in the US. Quotas restrict imports. These restrictions are usually applied to a specific country or countries. With a voluntary restraint agreement (VRA) a country agrees to voluntarily restrict its exports to the US. The opposite is a voluntary import expansion agreement (VIE) in which a foreign country agrees to voluntarily increase its imports from the US. Neither a VRA nor a VIE has the force of law.
B) Tariffs: A tariff is a tax on imported goods. A protective tariff is such that no similar tax is applied to identical domestic goods.
1. Tariffs in the US: Tariffs on all imported goods have varied widely. The highest tariff rates in 20th century occurred with passage of the Smoot-Hawley tariff in 1930.
2. Current Tariff Laws: The Trade Expansion Act of 1962 permitted the president to reduce tariffs by up to 50%. The Trade Reform Act of 1974 and the Trade and Tariff Act of 1984 allowed the president to reduce tariffs further and resulted in the lowest tariff rates ever. All of these trade agreement obligations of the US are carried out under General Agreement on Tariffs and Trade (GATT), an international agreement formed in 1947 to further world trade by reducing barriers and tariffs.
VI. International Trade Organizations: Widespread efforts to reduce tariffs around the world have led to a growth of international trade organizations.
A) World Trade Organization (WTO): The successor organization to GATT handles all trade disputes among its 117 member nations. In addition, the WTO agreement will lead to a 40 percent reduction in tariffs worldwide, protection of intellectual property rights, local content laws will be eliminated, and US service suppliers will be subject to the same rules as foreign suppliers in their countries.
B) Regional Trade Agreements: Other international trade organizations such as the EU and NAFTA known as regional trade blocs also exist. These trade blocs are groups of nations that grant members special trade privileges.
VII. The Balance of Payments and International Capital Movements: The balance of payments is a system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and between governments and residents of the rest of the world during a specific time period. Balance of payments transactions are normally grouped into three categories: current transactions, capital account transactions and official reserve account transactions.
A) Accounting Identities: Accounting identities are definitions of equivalent values.
1. Disequilibrium: Disequilibrium exists when the item that brings about a balance in an accounting identity cannot continue indefinitely.
2. Equilibrium: The accounting identity does not contain a balancing item that cannot go on indefinitely.
3. An Accounting Identity Among Nations: If a nation interacts with other nations, an accounting identity insures a balance, but not necessarily an equilibrium.
B) Current Account Transactions: All payments and gifts that are related to the purchase or sale of both goods and services constitute the current account in international trade.
1. Merchandise Trade Exports and Imports: The largest portion of any nation’s balance of payments current accounts is typically the importing and exporting of merchandise goods. The balance of trade is defined as the difference between the value of merchandise exports and the value of merchandise imports.
2. Service Exports and Imports: The services exports and imports have to do with invisible or intangible items that are bought and sold, such as shipping, insurance, tourist expenditures, and banking services. Also, income earned by foreigners on U.S. investments and income earned by Americans on foreign investments is part of service imports and exports.
3. Unilateral Transfers: Americans give gifts to relatives and others abroad. The federal government grants gifts to foreign nations. Foreigners give gifts to Americans and some foreign governments have even granted money to the U.S. government. Net unilateral transfers are the total amount of gifts given by Americans minus the total amount received by Americans from abroad.
4. Balancing the Current Account: If the sum of net exports plus unilateral transfers plus net investment income exceeds zero, a current account surplus is said to exist; if the sum of net exports plus unilateral transfers plus net investment income is negative, there is a current account deficit.
C) Capital Account Transactions: Capital account transactions concern the buying and selling of real and financial assets in international transactions. They occur when foreigners invest in the US or Americans invest in other countries. In the absence of interventions by finance ministries or central banks, the current account and capital account must sum to zero. Thus any nation running a current account deficit must also be running a capital account surplus.
D) Official Reserve Account Transactions: The third type of balance-of-payments transaction concerns official reserve assets:
1. Foreign currencies
2. Gold
3. Special drawing rights (SDRs): These are reserve assets that the International Monetary Fund created to be used by countries to settle international payment obligations.
E) What Affects the Balance of Payments?: The balance of payments is affected by a country’s domestic rate of inflation relative to that its trading partners and relative political stability. Political instability in other countries causes “capital flight,” moving assets to countries that are stable.
VIII. Determining Foreign Exchange Rates: A foreign exchange rate is the price of foreign currency in terms of domestic currency. If the foreign exchange rate for Japanese yen is 1 cent, one yen costs 1 cent. The exchange rate between yen and dollars is determined by the demand for and supply of yen and dollars in the foreign exchange market.
A) Demand for and Supply of Foreign Currency: Flexible or floating exchange rates fluctuate in the foreign exchange market in response to changes in supply and demand conditions. Every US transaction concerning the importation of foreign goods constitutes a supply of dollars and a demand for some foreign currency in the foreign exchange market and vice versa for export transactions.
B) Market Determinants of Exchange Rates:
1. Changes in Real Interest Rates: If the US interest rate increases relative to the rest of the world, international investors will increase their demand for dollar-denominated assets, thereby, increasing the demand for dollars.
2. Changes in Productivity: When a country’s productivity increases relative to others, the former will become more competitive, demand for its exports will increase, and so will the demand for its currency.
3. Changes in Consumer Preferences: If other countries change their preferences to U.S. goods, this will increase the derived demand for US dollars in foreign exchange markets.
4. Perceptions of Economic Stability: If the US looks economically and politically stable relative to other countries, more foreigners will want to put their savings into US assets. The demand for dollars will increase.
IX. The Gold Standard and the International Monetary Fund
A) The Gold Standard: An international monetary system in which nations fix their exchange rates in terms of gold. Thus, all currencies are fixed in terms of each other. Any balance of payment problems could be made up by shipments of gold. There is a relationship between the balance of payments and changes in domestic money supplies. When a nation had a deficit in its balance of payments, more gold was flowing out than in. Because the domestic money supply was also based on gold, an outflow of gold to foreigners caused an automatic reduction in the domestic money supply. Interest rates rose attracting foreign capital and improving the balance of payments and national output and prices fell. Imports were discouraged and exports were encouraged improving the balance of payments.
B) Bretton Woods and the International Monetary Fund: The Bretton Woods Agreement Act of 1945 set up the International Monetary Fund (IMF) to lend to member countries with a balance-of-payments deficit. Member governments were obligated to maintain the values of their currencies in foreign exchange markets within 1 percent of the declared par value (the legally established value of the monetary unit). The US was obligated to maintain gold prices within 1% of the official value of $35 an ounce. In 1971 President Nixon suspended the convertibility of dollars into gold. In 1973 the finance ministers of the European Economic Community announced they would let their currencies float against the dollar. Since 1973 the US and most other important trading countries have either had flexible exchange rates or managed (dirty) floating exchange rates.
X. Fixed Versus Floating Exchange Rates
A) Fixing the Exchange Rate: Central banks can keep exchange rates fixed as long as they have enough foreign exchange reserves available to deal with potentially long-lasting changes in the demand or supply of their nation’s currency.
B) Pros and Cons of a Fixed Exchange Rate:
1. Foreign Exchange Risk: Limiting foreign exchange risk is one major argument for fixed exchange rates. The possibility that changes in the value of a nation’s currency will result in variations in market values of assets. Hedging can also offset this type of risk.
2. The Exchange Rate as a Shock Absorber: If residents of a country are relatively immobile, then exchange rate movements can reduce the shock of a decrease in demand for a country’s products by having the exchange rate fall thus increasing the quantity demanded along the new demand curve. The unemployment effects of the decrease in demand for the country’s exports will be smaller.
C) Splitting the Difference: Dirty Floats and Target Zones:
1. A Dirty Float: A system of managed exchange rates in between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to “smooth out” rate fluctuations.
2. Crawling Pegs: An exchange rate arrangement in which a country pegs the value of its currency to the exchange rate of another nation’s currency, but allows the par value to change at regular intervals.
3. Target Zones: A range of permitted exchange rate variations between upper and lower exchange rate bands that a central bank defends by buying or selling foreign exchange reserves.
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