Global Economics

What is “Global Economics”?

Global economics refers to the global economic system in which countries across the globe – both developed and emerging – are integrated through trade, finance, and supply chain channels. In order to understand global economics, we need to be familiar with trade advantages, the balance of payments (BoP), stages of the economic/business cycle, the impact of monetary and fiscal policy on the business/economic cycles, and interest rates.

The global economic system is becoming increasingly integrated economically and financially, and there is greater synchronicity between the business/economic cycles of countries across the globe.

Global Economics and Trade Advantage

International trade enhances economic growth for all countries because it increases the efficiency of resources and how they are allocated. This provides for a larger capital pool and markets for specific products.

Countries can have two types of advantages in producing specific products. First, there could be an absolute advantage or there can be a comparative advantage. Absolute advantage is the difference in productivity levels between countries and that is related to the cost of production. So, a country has an absolute advantage if it can produce product X at a lower price than other countries. Absolute advantage is always the low-cost producer.

In the case of comparative advantage, it is similar but focuses on the opportunity cost of production. Here, the country has a comparative advantage only if the opportunity cost of producing that product is less than other countries.

The key takeaway here is that a country with an absolute advantage is always the low-cost producer. But in a comparative advantage that is not necessarily the case. In fact, it is quite possible to have a  comparative advantage in producing a product while not having an absolute advantage in producing that product.

Global Economics and Balance of Payments

The balance of payments is an accounting of a country’s international transactions over a particular time period. It is accounting on a country-to-country basis. Just like corporate accounting, we have inflows of money and outflows of money – the former is a credit, while the latter is a debit.

Credits include the value of exports, income of a country on investments abroad, other increases in liabilities, or a decrease in assets.

Whereas the opposite is true of debits. It includes the value of imports, income on foreign investments, and other increases in assets or a decrease in liabilities. Each transaction is recorded in the principles of double-entry book-keeping that there is an equal amount involved on each side of the equation.

The sum of both sides of the balance of payments should always be equal i.e. be the same. There is no bookkeeping requirement or rule that the sums of individual sub-sectors on each side have to be also equal. Therefore, we hear the term surpluses or deficits within the balance of payments. These surpluses or deficits are of large importance to analysts and the government as they evaluate an economy.

The balance of payments is broken down into three components – Current Account, which includes merchandise trade, services, income, and transfers, Capital Account, which includes capital transfers, sales and purchases of non-produced, non-financial assets that are primarily used for production, and the Financial Account, which captures the money flows for financial assets such as stocks and bonds. Now, in theory, these accounts should balance i.e. the sum of the payments for each account should be offset by the other two and vice versa.

Global Economics and Stages of the Business Cycle

Business or economic cycle is essentially the fluctuations found in the aggregate economic activity of countries and they have four phases – economic expansion, contraction i.e. upward and downward movement in economic activity, peaks, and troughs. Peaks represent turning points and inflection points in the cycle. Periods of expansion occur after the trough or lowest point of the business cycle and before the peak – which is the highest point. A contraction comes after the peak and before the trough.

The contraction, often called a recession when the downturn is particularly severe, is a period where aggregate economic activity is declining. Although downturns are commonly observed, the long-term economic trend of most countries is upward.

The full business cycle is essentially the full sequence of events and it has a recurring pattern. One key point is that the duration and severity of business cycles can vary widely.

Monetary and fiscal policy affect the business cycle. These macroeconomic policies are used during various phases of the business cycle to try to moderate or expand economic activity. Once the expansion phase of the business cycle is identified, the central bank enters a tightening/restrictive policy environment by raising interest rates, raising reserve requirements of banks, or selling treasuries or government securities to take out money from the economy.  These measures are taken to moderate the economy.

On the fiscal side, in an expansionary phase, the government raises taxes or decreases spending. If the government is raising taxes, there will be less disposable income to spend, which in turn slows down output (GDP). On the other hand, if the government lowers spending, it decreases infrastructure spending with the aim to slow down output growth.

On the converse, when the economy is in a contractionary phase monetary and fiscal policy turn expansionary.

Global Economics and Interest Rates

Interest rates are essentially the price of money and just like many other markets, it is determined by the forces of demand and supply. Interest rates effectively adjust to bring the supply and demand for money into equilibrium. Money is demanded transactional, precautionary, and speculative motives.

As far as the supply of money is concerned, the central bank of a country effectively dictates it and can choose to either increase or decrease the money supply in the economy by using tools such as open market operations, discount rate, and Reserve Requirement Ratio (RRR). When the money supply is increased (i.e. monetary policy is loosened) or decreased (i.e. monetary policy is tightened) through these policy tools, the economy is stimulated or moderated respectively.

The money supply curve is a vertical curve, while the money demand curve is a downward-sloping curve (i.e. as interest rates increase, the demand for money falls and vice-versa). The equilibrium rate of interest is determined by the intersection of these two curves.

Fiscal Policy – Multiplier, Formula

When a major economy, such as the US, undertakes an expansionary fiscal policy, it tends to positively affect other countries worldwide and the global economy through more demand for their goods (i.e. higher exports) and results in higher global growth.

Expansionary fiscal policy can be undertaken through an increase in government spending, lowering taxes, or some combination of both to stimulate an economy. Here we take the example of the Fiscal Policy Multiplier – which shows how much will output (GDP) change, for a given change in government expenditure or tax revenue. In other words, it is the ratio of change in output to a change in government expenditure or tax revenue.

The formula of Fiscal Multiplier:

Fiscal Multiplier = 1/1-MPC
MPC = Marginal Propensity to Consume

Fiscal Policy – Multiplier, Example

Given below is an example, where policymakers in an economy (for example, the US) undertake a major fiscal stimulus of $1 billion to boost GDP growth (i.e. stimulate the economy) and the MPC is 0.65. Upon calculation, we find that the Fiscal Multiplier is around 2.86. Therefore, for an initial fiscal stimulus of $1 billion, the GDP is predicted to get an overall boost of around $2.9 billion, given an MPC of 0.65.

The total change in GDP for an initial increase in government spending is calculated below.

Conclusion

In an increasingly economically integrated world, an understanding of global economics and its key constituents – international trade, balance of payments, stages of the business cycle, monetary and fiscal policy, and interest rates is pivotal to the analysis of the global economic system and how it operates.