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The Global
Economy

LEARNING OUTCOMES

• Identify the global pattern of wealth

and inequality;
• Analyse the pattern of international
trade and investment;
• Explain why countries trade with
each other;
• Identify the controls and
impediments to trade; and
• Assess the significance of exchange
rates for the business environment.

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Measuring the Size of the Global Economy

• The most common method of measuring the size of an economy is by
calculating GDP. This is the market value of total output of goods and
services produced within a nation, by both residents and non-
residents, over a period of time, usually a year.
• In comparing the relative size of different economies, one obvious
problem is that the calculation of GDP is in a country’s national
currency. A common currency is required, and this is normally the
USD
• This way of measuring GDP may indicate a country’s international
purchasing power, but does not reflect living standards adequately

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Measuring the size cont.;

• A better indicator of living standards can be achieved by calculating
GDP using what is known as the purchasing power parity (PPP)
method.
• This calculates GDP on the basis of purchasing power within the
respective domestic market—that is, what you can buy with a unit of
a country’s currency.
• The International Comparison Program, established by University of
Pennsylvania and UN in 1968, carried out periodically by the World
Bank, collects information from 199 countries to establish PPP
estimates
https://www.investopedia.com/updates/purchasing-power-parity-ppp/

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GDP as an Indicator of
the Standard of Living

• GDP and PPP values do not indicate the real

standard of living
• GDP also only measures activity that takes
place in the formal, officially recorded,
economy.
• ‘shadow economy’ - all activities (legal and
illegal)that produce an output but do not get
recorded in official statistics
• GDP figures do not take into account
environmental degradation and the depletion
of natural resources

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Economic Growth

• Despite concerns about how it is

measured, growth in national output
(economic growth) is seen as a key
objective for all national
governments, as they believe it is
fundamental to raising standards of
living.
• It is measured by the annual
percentage change in a nation’s gross
domestic product at constant prices,
as GDP can grow through the effects
of inflation

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https://www.imf.org/en/Countries/LKA

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The Changing World Economy

• PwC suggests that the world economy will roughly double in size by
2042, growing at an annual average rate of around 2.6% between
2016 and 2050 due largely to continued technology driven
improvements in productivity.
• The growth is expected to be driven largely by emerging market and
developing countries, with the E7 economies of Brazil, China, India,
Indonesia, Mexico, Russia, and Turkey growing at an annual average
rate of almost 3.5 per cent over the next 34 years, compared to just
1.6 per cent for the advanced G7 nations of Canada, France,
Germany, Italy, Japan, the UK, and the USA

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International
Trade
• One of the key drivers of
globalization is international trade,
the exchange of goods and services
between nations.
• We shall look in more detail at;
• The pattern of global trade and
theories to answer the question
of why countries trade.
• The regulation of trade through
the WTO.

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The pattern of trade

• International trade grew very quickly in the second half of the
twentieth century and more quickly than global output, which had
been rising at 3 per cent per annum.
• In the second half of the twentieth century, merchandise trade grew
almost 20-fold while world merchandise output only increased six-
fold
• The main contributors to this growth are the reduction of trade
barriers, and continuing liberalization of markets following the
adoption by many countries of free trade ideology as the dominant
economic philosophy since the late 1970s

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The pattern of trade cont.;

• The continuing reduction in transport and communications costs,
and, not least, the growth in vertical specialization in production and
the establishment of MNC global supply chains, are also major
drivers.
• Merchandise trade comprises three categories: manufactured goods,
mining, and agricultural products

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Why do Countries Trade?

• Mercantilism
• The earliest theory (seventeenth and eighteenth centuries) in relation to
international trade was that of mercantilism, which held that countries
should maximize exports and try to limit imports as much as possible
• Generating a trade surplus (when the value of exports exceeds the value of
imports) was the aim of governments, as this would result in an inflow of gold
and silver.
• Mercantilists viewed exports as a good thing, as they stimulated industry and
increased the number of jobs at home, and considered imports as bad, since
these meant a loss of demand and jobs.
• Mercantilists viewed trade as a zero-sum game (i.e. one country could only
gain if another lost),

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Why do Countries Trade? Cont.;

• Absolute Advantage
• Adam Smith (1776) set out to prove that all could gain by engaging in free
trade. Smith demonstrated that if countries specialized in producing the
goods in which they were most efficient (i.e. in which they had an absolute
advantage), then world output would be increased and the surpluses could be
traded.
• Comparative Advantage
• David Ricardo (1817) extended this theory to show that even when a country
had an absolute advantage in the production of all goods, total output could
still be increased if countries specialized in the production of a good in which
they had a comparative advantage. A country has a comparative advantage
over another country if it can produce at a lower opportunity cost

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Why do Countries Trade? Cont.;

• Heckscher–Ohlin Theory
• Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put
forward a different explanation of comparative advantage. They argued that
comparative advantage arises from differences in national factor
endowments.
• By factor endowments, they meant the extent to which a country is endowed
with such resources as land, labor, and capital.
• Nations have varying factor endowments, and different factor endowments
explain differences in factor costs; specifically, the more abundant a factor,
the lower its cost.
• The Heckscher–Ohlin theory predicts that countries will export those goods
that make intensive use of factors that are locally abundant, while importing
goods that make intensive use of factors that are locally scarce

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Why do Countries Trade? Cont.;

• New Trade Theory
• The new trade theory began to emerge in the 1970s when a number of
economists pointed out that the ability of firms to attain economies of scale
might have important implications for international trade
• New trade theory explained that there were gains to be made from
specialization and economies of scale and that those who were first to enter
the market could erect entry barriers to other firms and become the
dominant firm.
• As output increases, the unit costs of production fall and new entrants are
forced to produce at similar levels. Without a large domestic market to justify
producing on that scale, cost then becomes a major barrier to entry.
• The end result can be a global market supporting very few competitors, and
thus new trade theory becomes a major factor in explaining the growth of
globalization.

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Trade Intervention

• All of the theories and models

make the assumption that trade
takes place freely between
nations. However, every nation
imposes trade restrictions of some
description.
• Generally, their purpose is to limit
imports by imposing;
• tariff
• non-tariff barriers
• subsidizing exporting firms.
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Trade Intervention cont.;

• A tariff is a tax or duty placed on an imported good by a domestic
government. Tariffs are usually levied as a percentage of the declared value
of the good
• Non-tariff barriers can take a number of forms: quotas, licences, rules of
origin, product requirements (standards, packaging, labelling and markings,
product specifications), customs procedures and documentation
requirements, local content rules, and exchange rate manipulation.
• Subsidies can take many forms, and can be difficult to identify and
calculate. Financial assistance of any sort, including cash payments, low
interest loans, tax breaks, export credits and export guarantees, export
promotion agencies, and free trade and export processing zones, all distort
trade in favour of domestic producers

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Why Intervene?

• National defense
• To protect fledgling domestic industries from foreign
competition
• To protect domestic industries from foreign
competition and thereby save jobs
• To protect against over dependence on a narrow
base of products
• Political motives
• To protect domestic producers from dumping by
foreign companies or governments
• To prevent the import of undesirable products
• To resist cultural imperialism and/or maintain a
particular lifestyle

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Control of Trade
• The World Trade Organization (WTO), an
intergovernmental organization that seeks
to regulate world trade, officially came
into being on 1 January 1995 with 123
member nations
• This organization was the successor to the
GATT established in 1947 with just 23
members
• Different to GATT, WTO has a dispute
resolution process and is able to take
sanctions against offenders
• The GATT was a fairly loose arrangement,
but the WTO is a permanent organization
dealing with a much wider range of issues

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WTO Principles
• Non-discrimination: a country should not discriminate between trading
parties.Under the ‘most favoured nation’ rule, a member has to grant to all
members the most favourable conditions it allows trade in a particular product.
Once goods have entered a country, the ‘national treatment rule applies’ in that
they should be treated exactly the same as domestic goods.
• Reciprocity: if a member benefits from access and tariff reductions made by
another member, it must reciprocate by making similar access and tariff
reductions to that member.
• Transparency: members’ trade regulations have to be published so all restrictions
can be identified.
• Predictability and stability: members cannot raise existing tariffs without
negotiation,so everyone can be confident there will be no sudden changes.
• Freeing of trade: general reduction of all barriers.
• Special assistance and trade concessions for developing countries.

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Criticism against WTO

• The major criticism is that it is a club favouring the developed
countries, at the expense of the less developed countries
• Many of the less developed countries are excluded from the decision-
making process.
• Market access in industry is still a problem for less developed
countries;
• Anti-dumping measures have increased
• There are still enormous agricultural subsidies in the developed world
• Labour standards and the environment are ignored.

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Exchange Rates
• An exchange rate is the price of one currency as expressed in another
or, to put it another way, the rate at which one currency is exchanged
for another. There are several ways to manage the exchange rate.
• Floating exchange system - In a floating exchange rate system, the market
value of a currency is determined by the demand for and the supply of a
currency.
• Fixed exchange rate policy where they peg the value of their currency against
another. Fixed rates give a degree of stability to business whether it is an
importer, exporter, or investor wishing to move capital in or out of the
country

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Exchange rate cont.;

• There are also a number of systems which try to capture the benefits
of both systems by allowing currencies to float within a pre-set band
and/or where governments actively manage the exchange rate.
• According to the IMF (2014), 13 countries, including El Salvador and
Panama, use the US dollar as their domestic currency
• Movements in exchange rates can be an important influence on the
business environment—good news for some, bad for others. A rise in
the exchange rate can make imports cheaper, which is good news for
those firms buying a lot of goods and services from abroad. On the
other hand, it is likely to be bad news for exporters as it could make
them less competitive in foreign markets

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Exchange rate cont.;

• Adverse long-lasting realignments of exchange rates can have a major
impact on business strategy. They may cause firms to:
o relocate production;
o change the source of supply;
o look for new product markets or strong currency markets;
o make products having a more global appeal to facilitate the switch from weak
to strong currency markets; and
o look for ways of increasing productivity.

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