# Global economy

 Topics:

## Global Connections

An economy that has no international linkages is called a closed economy, while one that participates in the global economy is called an open economy. The economic linkages among countries can take many forms, including:

• international trade flows, when goods and services that have been created in one country are sold in another.
• international income flows, when capital incomes (profit, rent, and interest), labor incomes, or transfer payments go from one country to another.
• international transactions in assets, when people trade in financial assets such as foreign bonds or currencies, or make investments in real foreign assets such as businesses or real estate.
• international flows of people, as people migrate from one country to another, either temporarily or permanently.
• international flows of technological knowledge, cultural products, and other intangibles, which can profoundly influence patterns of production and consumption, as well as tastes and life-styles.
• international sharing of common environmental resources, such as deep-sea fisheries and global climate patterns.
• the institutional environment created by international monetary institutions, international trade agreements, international military and aid arrangements, and banks, corporations, and other private entities that operate at an international scale.

Any one of these forms of interaction may be crucially important for understanding the macroeconomic experience of specific countries at specific times. Mexico and Turkey, for example, receive significant flows of income from remittances sent home by citizens working abroad. Biological hazards, such as diseases or insects that threaten human health or agriculture, can travel along with people and goods. Trade in “intellectual property” such as technology patents and music copyrights is currently an issue of hot dispute.

This article will lay out some basics of international trade and international finance, looking briefly at selected international institutions and the question of how global linkages can affect living standards and macroeconomic stabilization.

## Major Policy Tools

Governments can try to control the degree of “openness” or “closedness” of their economies through a variety of policy tools. The most drastic way to “close” an economy is to institute a trade ban. In theory a country could prohibit all international trade, but this hardly ever happens. More often countries make trade in selected goods illegal, or ban trade with particular countries (such as the United States ban on trade with Cuba). Inspections at the country’s borders, or at hubs of transportation such as airports, are used to enforce a ban.

A less drastic measure is a trade quota, which does not eliminate trade, but sets limits on the quantity of a good that can be imported or exported. A quota on imports, by restricting supply, generally raises the price that can be charged for the good within the country. An import quota helps domestic producers by shielding them from lower-price competition. It hurts foreign producers because it limits what they can sell in the domestic market. Foreign producers may, however, get some benefit in the form of extra revenues from the artificially higher price.

A third sort of policy—which has been used very often throughout history—is a tariff (or “duty”). Tariffs are taxes charged on imports or exports. Tariffs, like quotas, may serve to reduce trade since they make internationally traded goods more costly to buy or sell. Like quotas, import tariffs benefit domestic producers while raising prices to consumers. Unlike quotas, however, import tariffs provide monetary benefit to the government. Also unlike quotas, tariffs do not give foreign producers an opportunity to increase prices – in fact, foreign producers may be forced to lower prices in order to remain competitive with domestic producers who do not pay the tariff.

The last important major category of trade-related policies—trade-related subsidies—may be used to either expand or contract trade. Export subsidies, paid to domestic producers when they market their products abroad, are motivated by a desire to increase the flow of exports. Countries can also use subsidies to promote a policy of import substitution, by giving domestic producers extra payments to encourage the production of certain goods for domestic markets, with a goal of reducing the quantity of imports.

Government policies can also influence international capital transactions. Central banks often participate in foreign exchange markets with policy goals in mind (as will be discussed below). Countries sometimes institute capital controls, which are restrictions or taxes on transactions in financial assets such as currency, stocks, or bonds, and/or on foreign ownership of domestic assets such as businesses or land. Restrictions on how much currency a person can take out of a country, for example, are one type of capital control. Such controls are usually instituted to try to prevent sudden, destabilizing swings in the movement of financial capital.

Countries may also regulate the form that foreign business investments can take. Some have required that all business ventures be at least partially owned by domestic investors. Some have required that all traded manufactured goods include at least a given percentage of parts produced by domestically-owned companies. Sometimes such controls are related to a development strategy, while in other cases they simply reflect a desire to avoid excessive foreign control of domestic economic affairs.

Some trade polices are enacted to try to attract foreign investment, for example by giving foreign companies tax breaks and other incentives. A popular form of this is the foreign trade zone, a designated area of the country within which many tax, tariff, and perhaps regulatory policies that usually apply to manufacturing are not enforced. By attracting foreign investment, countries may hope to increase employment or gain access to important technologies. A well known example is the maquiladora policy in Mexico under which manufacturing plants can import components and produce goods for export free of tariffs.

Migration controls are another important aspect of policy. Countries generally impose restrictions on people visiting or moving into their territory, and a few also impose tight regulations on people leaving the country. While beliefs about race, national culture, and population size are often the most obvious influences behind the shaping of these controls, economic concerns also play a role. For example, policies may be affected by concerns about the skill composition of the domestic labor force or the desire to get remittances from out-migrants.

Countries do not necessarily choose sets of policies that consistently lead towards “openness” or consistently towards “closedness.” Often there is a mix—policies are chosen for a wide variety of reasons, and can even run at cross-purposes. Nor do countries choose their policies in a vacuum. Policymakers need to take account of the reactions of foreign governments to their policies. Increasingly they also need to pay attention to whether their policies are in compliance with international agreements.

## Patterns of Trade and Finance

Figure 1: Trade Expressed as a Percentage of Production, World and United States, 1965-2003. The worldwide volume of trade, expressed as a percentage of GDP, has been increasing over the past four decades. While the United States remains less “open” than many economies, trade has become more important here as well. (Source: GDAE)

International trade has grown immensely in recent years. Sometimes the sum of a country’s imports and exports of goods and services, measured as a percent of gross domestic product (GDP), is used as a measure of an economy’s “openness.” Growth in trade according to this measure is shown in Figure 1, for the years 1965-2003. While trade still remains relatively less important in the United States than in other countries, its importance has been increasing here as well.

Why has trade grown over time? One reason is improvements in transportation technology. The costs and time lags involved in shipping products by air, for example, are far reduced now from what they were in 1950. Fruit from Chile and flowers from Colombia are now flown into the U.S. every day—and are still fresh when they arrive. A second reason for increased trade is advances in telecommunications. The infrastructure for communication by phone, fax, and computer has improved dramatically, making it much easier for businesses to communicate with potential overseas suppliers and customers. Apparel companies in New York, for example, can communicate details about styles and sizes to their foreign suppliers almost instantaneously. Better telecommunications even make it possible for some kinds of services such as customer support to be directly imported from, for example, call centers in India. Thirdly, many governments have, over time, lowered their tariffs and other barriers to trade.

Figure 2: Top Purchasers of Goods from the United States and Suppliers of Goods to the United States, 2005. The United States' neighbors, Canada and Mexico have long been among its major trading partners. But China has been an increasingly important source of merchandise imports. (Source: GDAE)

Figure 2 shows the volume of exports that the U.S. sells to the top ten buyers of its goods, and the volume of its imports that come from the top ten countries which sell to it. Historically the near neighbors of the U.S.—Canada and Mexico—have been very important trading partners. Various western European economies, and Japan after it industrialized, have also, not surprisingly, played a strong role. For political reasons the U.S. government has historically encouraged trade with certain strategic allies, including South Korea and Taiwan, explaining their presence among the major trading partners.

The biggest development in recent years has been the emergence of The Peoples Republic of China as a major source of U.S. imports. Until about 1980, U.S. trade with China was negligible. Since then, U.S. importation of Chinese products—especially electronics (including computers and televisions), clothing, toys, and furniture—has boomed. While China buys some U.S. goods (including agricultural products and aircraft), the value of U.S. imports from China far exceeds the value of U.S. exports to China.

The volume of global financial transactions has also exploded in recent years. For example, foreign exchange flows in 2004 had average volumes of about $1.9 trillion-per day. This is a daily figure of nearly$300 per person on Earth. The volume in 2004 was over a third higher than it had been only three years earlier.

Is greater openness to international trade and finance a good thing, or a bad thing? You have probably heard arguments in the media about how globalization can “destroy” jobs by causing industries to move overseas. Many people feel that when capital moves too freely, interests of local communities and the environment can suffer. On the other hand, many commentators—with a number of economists often among them—argue that globalization is a good thing. While a few people may end up having to suffer temporary losses, they say, a more integrated global economy will bring greater overall benefits.

Free trade, by creating efficiencies in production and allocation that countries could not achieve on their own, leads to better living standards. Then we will examine the many other issues that may cause countries to maintain trade barriers, at least in regards to some goods and services.