International economics are increasingly turning out to be an important sphere of research as global markets become highly assimilated. As matters of fact, governments, businesses and consumers have come realize that their existences depend on what is taking place within the international market.
International economics is defined as a sphere of study that explores the outcomes of lending, borrowing, investment and trade on an international scale. Conversely, international trade looks at how macroeconomic models can be used to comprehend international economics.
Some of the salient features of international trade include consumer behaviour, firm behaviour, perfectly competitive monopolistic and oligopolistic market structures, and consequences of market distortions.
The gross domestic product (GDP) is an important economic variable that measures the economic conditions of an individual/country. The gross national product reflects the output of economic activities within a specified period of time. For instance, the GDP/capita depicts the economic condition of a person in a country.
It is important to mention that the GDP per capita differs significantly across countries. Table 1 provides up-to-date data on GDP and GDP per capita for a selected cluster of countries. Inflation and unemployment rates are used to measure the economic well-being of a country. Inflation is an economic variable that compares consumer price indices between two different periods. For instance, a lower inflation rate means that the economy is doing well and vice versa.
The latter (unemployment rate) is used to measure the percentage of the unemployed people within a country. Table 2 depicts inflation rates and unemployment rates for some selected countries. It is worth mentioning that some data in table 2 are abnormal as a result of the economic meltdown that occurred in 2008.
Some economists employ a government budget to gauge the performance of economic activities. Tax revenues are commonly used to fund public projects such as the construction of highways. Generally, a surplus in the government budget occurs when the amount spent by the government on public projects is less than the total amount of tax revenue.
Conversely, a deficit in the government budget occurs when the tax collected is inadequate to finance public expenditure. It deserves merit to note that a Forex market is needed to facilitate transaction among different currencies in international trade. Many countries face the dilemma of whether to fix the exchange rate of their respective currencies or allow the rates to fluctuate according to the market dynamics.
It is against this backdrop that the International Monetary Fund (IMF) was established to monitor and help countries solve their international currency dilemma. The IMF has created a list of currency regimes in all countries participating in international trade. The exchange rate systems adopted by some countries are depicted in table 3.
The trade balance of a country is another key international statistics that indicate the economic well-being of a country. A country is deemed to have a trade surplus if the value of total goods exported surpasses the value of the total goods imported. On the other hand, a nation is considered to be experiencing trade deficits if the aggregate quantity of goods imported surpass the aggregate quantity of goods exported.
This information is critical because it enables economists to describe the international investment position (IIP) of a country. It is worth mentioning that the IIP is an economic indicator that measures the aggregate value of foreign properties owned by local inhabitants minus the aggregate value of domestic properties owned by foreign persons.
The world has experienced several economic crises since the last century. The most recent one occurred in 2008 when world output declined and unemployment rate increased. What is more, there was a substantial decline in international trade as both domestic and international investments shrank.
An economic recession usually occurs when the real gross domestic product of a country declines in addition to a rise in the aggregate rate of unemployment over a specified period of time. Thus, the International Monetary Fund (IMF) and the World Bank were established in order to curb economic crises.
For instance, the main goal of the World Bank is to offer grants and loans to foster economic development among poor countries. On the other hand, the IMF is mainly tasked with monitoring the international exchange rate systems as well as offering short-term loans to countries experiencing balance of payments (BOP) problems.
National Income and Product Accounts
The national income depicts the aggregate amount of money generated by factors of production within a year. Some components of the national income include profits, rents and wages. The national product (national output) depicts the market value of all final goods and services generated within an economy during a given year.
Figure 1 depicts the circular flow of money within an economy. It deserves merit to mention that the national income (value of total income) should be equivalent to the national product (value of total output). As noted earlier, the gross domestic product reflects the output of economic activities within a country in a specific period of time.
On the other hand, the gross national product (GNP) measures the total amount of goods and services produced using domestic factors of production. The GNP includes all production activities that occur within and outside the country.
The national income defines the manner in which the GDP is computed. The equation below shows that the gross domestic product is an aggregation of the consumption (C), investment (I), government spending (G), and expenses on exports (XE) less expenses for imported goods (ME):
GDP = C + I + G + XE − ME
The consumption variable of the equation (C) represents domestic and/or foreign products and services procured by residents. Investments (I) denote the costs incurred while undertaking fixed investments. XE denotes the total amount of goods exported to other countries. ME denotes the total goods procured from another country.
G denotes the total amount spend by the government on public projects (i.e. Construction of highways). Imports are usually deducted from the GDP equation since imported goods are a subset of the government, investment and consumption expenditures. In other words, the gross domestic product level is not directly affected by imports.
The balance of payment (BOP) accounts is a documentation of the financial transactions between the inhabitants of one country with the rest of the world within a specified fiscal year. The BOP account is composed of several smaller accounts. These include current account (CA), merchandise trade account, services account, goods and services account, and financial account. The following equation represents the CA balance:
CA = XEG,S, IPR, UT-MEG, S, IPR, UT
Where G= includes imports and exports of goods; S= services; IPR= income payments and receipts; and UT= unilateral transfers. A country is deemed to have a surplus current account if current account>0. This means that the value of exports surpasses the value of imports. If the current account<0, then the country has a deficit current account because imports are greater than exports.
The trade balance shows various ways to record the difference between imports and exports. The merchandise trade balance is somewhat constricted in measuring trade between countries dealing with traded products. Finally, the financial account balance measures the aggregate imports and exports.
The international investment position (IIP) of a country can be compared to a balance sheet since it reveals the aggregate foreign assets owned by domestic inhabitants and the aggregate domestic assets held by foreigners within a specified period of time.
Consequently, a nation’s net position with respect to international trade is either surplus or deficit. If the net position is a surplus, then it implies that the aggregate value of foreign assets owned by domestic inhabitants surpasses the aggregate value of domestic assets owned by foreign inhabitants.
Statistics suggest that the United States is arguably the biggest debtor country in the world. In other words, the country’s IIP is in deficit and the monetary value of that shortage is the biggest in the world. For example, in 2008, the amount of money the US owed the rest of the world was estimated at $3.47 trillion. Although some Americans are worried about the numerical size of the debt, it is worth mentioning that this debt is less than 25% of the country’s annual GDP.
Overview of Trade Imbalances
Some people consider a trade surplus to be a good thing and a trade deficit a bad one. However, a trade surplus/deficit can be good or bad subject to the prevailing economic conditions. A trade surplus occurs when exports surpass imports whereas a trade deficit emerges when imports surpass exports. Some people suggest that trade deficits usually results in loss of jobs in the economy.
Nonetheless, when all outcomes of trade imbalances are considered, a trade deficit can only result in short-term job losses. It has been demonstrated that there exists an inverse relationship between trade deficits and the unemployment rate.
For instance, figure 2 shows the trade deficit and unemployment in the United States between 1980 and 2009. According to figure 2, when the trade deficit increases, the unemployment level decreases. This phenomenon contradicts the earlier perception that trade deficits cause job loss in an economy.
In a nutshell, trade deficits, when assessed with respect to their short-term and long-term economic effects, can bring about positive or negative effects depending on the prevailing economic conditions. For example, a trade deficit may indicate extreme borrowing that could result in a significant decline in the living standards since more resources are redirected to service accumulated debt.
In this condition, a trade deficit is clearly disastrous for the economy. On the other hand, a trade deficit can augment domestic investments and eventual stimulate economic growth. In this case, debt repayment can be achieved without compromising the living standards of the households.
What is more, a trade surplus may simply reflect discreet foreign savings as well as procurement of foreign assets in order to finance the pension scheme. In this condition, a trade surplus may prove to be useful for the economy. In addition, a trade surplus can also depict a period of reimbursement of previous debt. This situation may be tolerable if it is accomplished in harmony with the rising standards of living.
Nevertheless, if the trade surplus emerges during a period characterized by a declining gross domestic product, then the trade surplus would occur when the living standards are declining. In this situation, a trade surplus would be a bad thing for the economy. Nonetheless, problems associated with trade deficit can be alleviated via an increase in the gross national product (GNP).
In order to assess the trade imbalance of a country, one should start by establishing the country’s investment status (net international asset). A country’s investment status is comparable to a balance sheet which reveals the aggregate foreign assets held by domestic inhabitants. It also reveals the aggregate domestic assets held by foreigners within a specified period of time.
As a result, a nation will be in a credit position if the value of foreign properties owned by its citizens transcends the value of local propertied owned by foreign inhabitants. Conversely, a country is said to be in a debtor position if the aggregate amount of domestic assets held by foreigners surpasses the aggregate amount of foreign assets held by domestic inhabitants.
There are four potential trade imbalance situations that a country might encounter. These are: (1) a creditor country experiencing a trade surplus, (2) a debtor country experiencing a trade surplus, (3) a creditor country experiencing a trade deficit, and (4) a debtor country facing a trade surplus. Figure 3 shows an assortment of potential investment positions a country might face in an international arena. The left side of the figure implies that the nation is a net debtor while the right side implies that the nation is a net creditor.
There are important observations that can be derived from the situations above. First, trade deficits are harmful to the economy when the prospect for economic growth is low and the country is facing enormous international debt. Second, trade deficits may be less harmful if the nation is in a credit position.
What is more, trade deficits are less harmful if they take place in an environment characterized by increasing investments that spur economic growth. Third, a trade surplus can be harmful to the economy if it increases while the country is in a debt position. Finally, a trade surplus is harmful when the repayments of debts in the future will be lower than projected.
The Forex: Participants and Objectives
The foreign exchange market entails currency trading by key international banks. These international actors (banks) function as mediators between real sellers and buyers of currencies such as individuals, businesses and governments. In many cases, the international banks keep foreign currency reserves and are prepared to swap them for local currency when the demand increases.
Although each bank can set the exchange rate (ER), the market forces of supply and demand will eventually determine the real exchange rate. To put it another way, each bank establishes the ER at each period in order to balance the demand and supply of foreign currency in the Forex market. It is important to make out two different sets of partakers in the foreign exchange market.
The firsts set consists of partakers whose transactions are documented on the current account. The second set comprises of partakers whose transactions are captured on the financial accounts.
An individual who engages in exports or imports of merchandise must swap currencies in order to complete the transaction. For that matter, tourists and investors who travel overseas usually participate in the Forex market to swap their currencies.
Investors usually engage in the Forex market on a daily basis. These investors include commercial banks, insurance firms and investment firms which engage in the Forex market in order to reap maximum profits on their investments or assets. What is more, some of these investors usually manage the assets owned by other parties.
For example, insurance and investment firms handle hefty investment portfolios which represent capital utilized to compensate claims on deaths and accidents. A substantial number of these firms have forayed in international Forex markets in order to maximize the returns on their investments. For instance, the Bank of International Settlement spends approximately $3 trillion worth of currency in the Forex market each day.
There are three main objectives that drive the investment decisions of investors. First, investors are concerned with the rate of return on their investments. Investors are usually attracted by investment portfolios that promise a high rate of return on their investments. Second, investors are concerned with the level of the risk posed by the asset.
It is important to mention that there is a direct relationship between the level of risk and the anticipated rate of return. Therefore, the main issue of concern for investors is how to handle the exchange between investment returns and risk. Liquidity is the third issue of concern for investors. It basically implies the rate at which investment portfolios can be converted to cash.
Insurance firm must hold investment assets that are somewhat easy to convert to cash in order to meet compensation claims that arise suddenly. Commercial banks must also invest in fairly liquid assets that can be easily converted to cash in order to fulfil cash requirements of their depositors.
The exchange rate is defined as the amount of units that a given currency is swapped for one unit of another currency. For instance, the exchange rate between a British pound and a US dollar can be expressed as £/$. In addition, the value/worth of currency can only be ascertained by by comparing it to another currency.
A currency is considered to have appreciated if its value/worth increases in comparison to another. On the other hand, currency depreciation implies that the value of a given currency declines with respect to another currency.
There are several exchange rate terms that are commonly used in the Forex market. For instance, currency arbitrage implies purchasing a currency at a lower rate in one market (i.e. London) and reselling it later at a higher rate in another market (i.e. New York). The spot exchange rate is defined as the exchange rate that facilitates trading to occur right away.
Forward exchange rate reflects the value of the exchange rate on trades that will occur in the future to fulfil a prearranged agreement. Finally, hedging is defined as activities performed to minimize the risks that emanate from currency trading.
Appendix
Figure 1: A Circular Flow Diagram
Figure 2: U.S. Trade Deficits and Unemployment 1980–2009
Figure 3: International Asset Positions
Table 1: GDP and GDP per Capita (PPP in Billions of Dollars), 2009
Table 2: Unemployment and Inflation Rates
Table 3: Exchange Rate Regimes