International Economics
Lecture 1 Set-up of the Course and Balance of Payments
What is International Economics?
International economics studies:
- the economic interactions among the different nations that make up the
global economy;
- how inhabitants of different nations interact through the flow of trade in
goods and services and the flow of money and investment
Empirically
- nations are more closely linked than ever before through trade and
financial transactions
- smaller countries are likely to be more open (share of international
transactions) than, for instance, the US
Analysis is often in terms of domestic versus foreign sector
Two Fields in International Economics
International Finance / Open Economy Macroeconomics / International Monetary
Economics:
- Exchange rates, capital flows, current account imbalances
- Currencies (money, foreign exchange) are very important
- International policy coordination
International Trade (Microeconomics)
- Physical movement of goods and services (why trade?)
- Where to locate production? (export or FDI)
- The role of trade policy by governments
Issues in Open Economy Macroeconomics
Monetary developments:
- Widely fluctuating exchange rates since 1973
- Exponential increase in international financial markets and capital flows
(esp after 1990)
Financial crises in the past:
- Currency crises: e.g., European Monetary System 1992; Asia 1997;
Argentina 2002
1
, - US subprime mortgage crisis 2007-2008 (Lehman Brothers collapse 2008;
Icelandic banking crisis 2008)
- Sovereign debt crises: Greece 2009-2018; Europe 2010
National Income Accounts: GNP and GDP
Gross national product (GNP) the value of all final goods and services produced
by a nation’s factors of production in a given time
period
> The value of final goods and services produced by home-owned factors
of production are counted as home country’s GNP
Gross domestic product (GDP) measures the final value of all goods and services
that are produced within a country in a given
time period
GDP = GNP - payments (from foreign countries) for home factors of production,
but produced abroad + payments (to foreign countries) for foreign factors of
production
>> GDP is produced at home, GNP is produced by domestically owned factors of
production
GNP is calculated by adding the value of expenditure on final goods and services
produced. There are four types of expenditure: consumption, investment,
government purchases and current account balance (“exports” minus “imports”)
National income: two interpretations and other issues
Ex post national income identity:
- National income = Y = C + I + G + CA = expenditure on domestic
production
- Final products not purchased by households or governments are counted
as inventory investment by firms
Equilibrium condition in a demand driven model:
- Keynesian Cross
- Supply = domestic production = Y = AD (aggregate demand) = C + I + G
+ CA
Alternative representation of the national income identity:
- National income/production + imports = expenditures at home + abroad
(goods/services in home country)
- Y + IM = C + I + G + EX
2
, EX – IM has two meanings
- In CA (here): net expenditure by foreign individuals and institutions. This
includes for instance interest payments for debt / foreign capital
- In trade balance: it means exports and imports of goods and services
A nation’s net foreign assets
CA = EX – IM = Y – (C + I + G)
When production > domestic expenditure (= domestic absorption = expenditures
by domestic individuals / institutions), then “exports” > “imports”: current
account > 0 (CA surplus) (and probably trade balance > 0):
When a country “exports” more than it “imports”, it earns more income from
exports than it spends on imports -> net foreign assets increase
A CA surplus “produces” net foreign wealth (investment)
When production < domestic expenditure, then “exports” < “imports”: current
account < 0 (CA deficit) -> net foreign assets decrease
Savings and the Current Account
National saving (S) := national income (Y) that is not spent on consumption (C) of
government purchases (G)
S := Y – C – G
= (Y – C – T) + (T – G)
=: Sp + Sg (Sg is also the government budget)
We already know: CA = EX – IM = Y – (C + I + G) = (Y – C – G) – I = S – I
Current account = national saving – investment
Current account = change in net foreign assets = net foreign investment
“EX < IM” (CA < 0) ↔ S < I
CA = S – I or I = S – CA (S := Y – C – G)
Countries can finance investment either by saving or by acquiring foreign funds
equal to the current account deficit: a current account deficit implies a financial
asset inflow (asset export) (= negative net foreign investment)
CA = Sp + S g – I
= Sp + government budget – I
3
, = (Sp – I) + (T – G)
Twin deficit: (<0) (=0) (<0)
A deficit in the budget corresponds to/implies a current account deficit, if the
private sector does not increase savings
Summary: (Sp – I) + (T – G) = (X – M)
Private savings surplus + public (government budget) surplus = external (CA)
surplus
Note: this is an ex post identity -> there is no direct causality: e.g. for solving the
twin deficit problem: (T – G) < 0 and (X – M) < 0 it does not necessarily work to
reduce imports in order to solve the budget problem
Balance of Payments
> flow of all payments for transactions conducted between home country and
RoW
CA (+ capital account) + financial account = ERR (IMF standard)
The BoP is balanced by definition, but there are errors and omissions ERR (should
be 0). Each international transaction enters the accounts twice: once as a credit
item (+) and once as a debit item (-)
Loosely speaking:
- “BoP deficit” = deficit official settlements balance (= surplus in reserve
portion of FA) = losing international reserves
- “Imports > exports” = current account deficit (“BoP deficit” if private
investment in financial accounts more or less balanced)
Balance of Payment versus a balance sheet
A firm’s balance sheet:
- Profit and loss account reports profits and losses from the firm’s activities /
changes in net worth resulting from changes in assets, liabilities.
A country’s balance of payments:
- Provides information on a country’s profit and loss account (current
account) and the resulting change in a country’s net worth (i.e. private net
foreign wealth and public reserves)
The structure of the Balance of
Payments (without KA & ERR):
4
Lecture 1 Set-up of the Course and Balance of Payments
What is International Economics?
International economics studies:
- the economic interactions among the different nations that make up the
global economy;
- how inhabitants of different nations interact through the flow of trade in
goods and services and the flow of money and investment
Empirically
- nations are more closely linked than ever before through trade and
financial transactions
- smaller countries are likely to be more open (share of international
transactions) than, for instance, the US
Analysis is often in terms of domestic versus foreign sector
Two Fields in International Economics
International Finance / Open Economy Macroeconomics / International Monetary
Economics:
- Exchange rates, capital flows, current account imbalances
- Currencies (money, foreign exchange) are very important
- International policy coordination
International Trade (Microeconomics)
- Physical movement of goods and services (why trade?)
- Where to locate production? (export or FDI)
- The role of trade policy by governments
Issues in Open Economy Macroeconomics
Monetary developments:
- Widely fluctuating exchange rates since 1973
- Exponential increase in international financial markets and capital flows
(esp after 1990)
Financial crises in the past:
- Currency crises: e.g., European Monetary System 1992; Asia 1997;
Argentina 2002
1
, - US subprime mortgage crisis 2007-2008 (Lehman Brothers collapse 2008;
Icelandic banking crisis 2008)
- Sovereign debt crises: Greece 2009-2018; Europe 2010
National Income Accounts: GNP and GDP
Gross national product (GNP) the value of all final goods and services produced
by a nation’s factors of production in a given time
period
> The value of final goods and services produced by home-owned factors
of production are counted as home country’s GNP
Gross domestic product (GDP) measures the final value of all goods and services
that are produced within a country in a given
time period
GDP = GNP - payments (from foreign countries) for home factors of production,
but produced abroad + payments (to foreign countries) for foreign factors of
production
>> GDP is produced at home, GNP is produced by domestically owned factors of
production
GNP is calculated by adding the value of expenditure on final goods and services
produced. There are four types of expenditure: consumption, investment,
government purchases and current account balance (“exports” minus “imports”)
National income: two interpretations and other issues
Ex post national income identity:
- National income = Y = C + I + G + CA = expenditure on domestic
production
- Final products not purchased by households or governments are counted
as inventory investment by firms
Equilibrium condition in a demand driven model:
- Keynesian Cross
- Supply = domestic production = Y = AD (aggregate demand) = C + I + G
+ CA
Alternative representation of the national income identity:
- National income/production + imports = expenditures at home + abroad
(goods/services in home country)
- Y + IM = C + I + G + EX
2
, EX – IM has two meanings
- In CA (here): net expenditure by foreign individuals and institutions. This
includes for instance interest payments for debt / foreign capital
- In trade balance: it means exports and imports of goods and services
A nation’s net foreign assets
CA = EX – IM = Y – (C + I + G)
When production > domestic expenditure (= domestic absorption = expenditures
by domestic individuals / institutions), then “exports” > “imports”: current
account > 0 (CA surplus) (and probably trade balance > 0):
When a country “exports” more than it “imports”, it earns more income from
exports than it spends on imports -> net foreign assets increase
A CA surplus “produces” net foreign wealth (investment)
When production < domestic expenditure, then “exports” < “imports”: current
account < 0 (CA deficit) -> net foreign assets decrease
Savings and the Current Account
National saving (S) := national income (Y) that is not spent on consumption (C) of
government purchases (G)
S := Y – C – G
= (Y – C – T) + (T – G)
=: Sp + Sg (Sg is also the government budget)
We already know: CA = EX – IM = Y – (C + I + G) = (Y – C – G) – I = S – I
Current account = national saving – investment
Current account = change in net foreign assets = net foreign investment
“EX < IM” (CA < 0) ↔ S < I
CA = S – I or I = S – CA (S := Y – C – G)
Countries can finance investment either by saving or by acquiring foreign funds
equal to the current account deficit: a current account deficit implies a financial
asset inflow (asset export) (= negative net foreign investment)
CA = Sp + S g – I
= Sp + government budget – I
3
, = (Sp – I) + (T – G)
Twin deficit: (<0) (=0) (<0)
A deficit in the budget corresponds to/implies a current account deficit, if the
private sector does not increase savings
Summary: (Sp – I) + (T – G) = (X – M)
Private savings surplus + public (government budget) surplus = external (CA)
surplus
Note: this is an ex post identity -> there is no direct causality: e.g. for solving the
twin deficit problem: (T – G) < 0 and (X – M) < 0 it does not necessarily work to
reduce imports in order to solve the budget problem
Balance of Payments
> flow of all payments for transactions conducted between home country and
RoW
CA (+ capital account) + financial account = ERR (IMF standard)
The BoP is balanced by definition, but there are errors and omissions ERR (should
be 0). Each international transaction enters the accounts twice: once as a credit
item (+) and once as a debit item (-)
Loosely speaking:
- “BoP deficit” = deficit official settlements balance (= surplus in reserve
portion of FA) = losing international reserves
- “Imports > exports” = current account deficit (“BoP deficit” if private
investment in financial accounts more or less balanced)
Balance of Payment versus a balance sheet
A firm’s balance sheet:
- Profit and loss account reports profits and losses from the firm’s activities /
changes in net worth resulting from changes in assets, liabilities.
A country’s balance of payments:
- Provides information on a country’s profit and loss account (current
account) and the resulting change in a country’s net worth (i.e. private net
foreign wealth and public reserves)
The structure of the Balance of
Payments (without KA & ERR):
4
