ECON 1103

Globalization, World Economy

Lecture 01

What is Globalization

- Globalization refers to the growing interdependence of countries

resulting from the increasing integration of trade, finance,
people, and ideas in one global marketplace.
 - International trade and cross-border investment flows are the
main elements of this integration.

Commanding Heights

Part 1:
- At the end of the 20th century, the market economy, the capitalist
system, became the only model for the vast majority of the world.

- John Maynard Keynes and Friedrich von Hayek

- Keynes felt that the market economies would go to excesses and

when things were in difficulty, the market wouldn’t work.
Therefore, the government had to step in.

- Hayek felt that the market would eventually take care of itself.
 Week 2

Don’t Take (Good) Market for Granted

A workable platform for markets has five elements:
1) information flows smoothly;
2) property rights are protected;
3) people can be trusted to live up to their promises;
4) side effects on third parties are curtailed;
5) competition is fostered.
- Property rights and trust are two necessary
conditions for trade to happen in the first place.

- Market failure.

- A monopoly is a market failure.

- 1) Market economies based upon property rights

have a built-in incentive structure to reward
individual initiative:

- Motivation; Efficiency and Economic Growth;

Compared to communism.

- Property rights contribute to innovation and

invention.

- Intellectual property rights.

Information
- Information is the lifeblood of markets.
- Any decision making is based on available
information: What are you really
buying/selling? What is the quality? Any risk
related to the transaction?

- Asymmetric information (between buyer and

seller, before or after transaction) reduces
incentive to trade => potential gains from trade
not maximized: inefficient.

- There may be (less costly) solutions to find out

information. But if it is too expensive to obtain
information, trade will not happen.

Competition

- Competition is essential to good performance of the

market.

- Monopoly, the opposite of competition, will distort

efficiency: it is more exploitive and less innovative.

- Competition policy can remedy anti-competitive behavior

such as price-fixing or collusion.
 No Externalities

- If a transaction affects the third-party, positively or

negatively, but this spill-over effect is not considered by
buyers and sellers => the full benefit/cost (private and
social) is not reflected in the market price (only private) =>
the market outcome is not efficient.

Functions of government

In most mixed economies, government performs four

functions:

1) It establishes the rules of the game.

2) It deals with issues surrounding market failure.
3) It provides goods and services that the market itself
doesn’t provide in sufficient quantity.
 4) It plays a redistributive role.

(1) Protect property rights

- The surest way to destroy a market is to undermine

people’s belief in the security of their own property.

- So, an important role of government is to define and

enforce property rights and therefore secure property
from predators.

- This necessitates an impartial rule of law, police and court,

among other things.

(2) Remedy Market Failure

Governments are often called upon to act when markets fail to

allocate resources efficiently.

1) Externalities: environmental policies to reduce pollution

2) Imperfect competition: competition policies and monopoly
regulations
3) Asymmetric information: certification to establish
credibility, financial market regulations to require
information disclosure.

(3) Provide Public Goods

- Public goods are nonrival (one’s consumption does not

reduce others’ consumption) and nonexcludable (no one
can be excluded from consuming it once it is produced).

- People have incentive to “free-ride” on public goods.

Therefore, private market cannot provide enough of them.

- Solution: Government provide public goods by using

compulsory tax money.

- Examples: national defense, infrastructure and basic

research.

(4) Redistribute Income

- Governments also play a redistributive role by collecting
taxes and financing expenditures for individuals in areas
like health care, education, unemployment relief, and
public pensions (social securities system).

- The idea behind these government initiatives is to reduce

inequality, to create an equality of opportunity for all
members of society, and to provide care to individuals who
are unable to afford it.

What Exactly Are Markets?

- Markets are older than recorded human history.

- Originally, they were places where individuals exchanged
one good for another (barter) by haggling over the terms
of exchange.

Market Participants

- Markets usually bring together three sets of participants:

(1) Consumers of the goods and services
(2) Organizations called “firms” that are responsible for
production (transforming inputs into useful outputs)
– firms can be small or large (the modern
corporations)
(3) Suppliers of factor services who sell to the firms –
these are individuals selling labor services.

Rules of the Market

 - Most of the basic rules of the market are provided by
government (who set the legal framework) but this is not
always the case (e.g. black markets)

- Government also provides a monetary system which sets

the legal unit of account (money) in which contracts are
set.

- Individual firms, consumers and factor suppliers are free

to negotiate the terms of exchange – i.e. what price, how
much exchanged, and what to buy or sell.

Modern Market Economies

- The modern market economy is arguably the most

amazing form of social organization ever conceived.

- Literally millions of voluntary transactions occur every

day

Qd: “Quantity Demanded”

P: “Price”
D: “Demand”
Change demand: A shift in the line (curve) to right or to
the left
1. Price of substitutes: If P , D (a rightward shift)
2. Price of complements: If Pc , D (a leftward shift)
3. Income: Normal Goods vs. Inferior Goods
- Normal: If income , D (a rightward shift)
- Inferior: If income , D (a leftward shift)

4. Tastes: Preference changes will shift demand curve

5. Number of Consumers: The larger the potential
market for the good, the greater the demand (a
rightward shift)
6. Expectations: Expect future price => D today (a
rightward shift)

Supply
- Firms supply most goods and services which come from
applying ideas, organization, technology together with
factor inputs like labor to produce goods to sell into the
market.

- Supply in a market comes by adding up what all the firms

in a market would be willing to bring to the market at a
particular price.

- Each firm is limited in what they can bring to the market

by the cost of doing so. The cost of producing a firm’s
output therefore indicates the minimum amount the seller
must receive to make their output available in the market.

- If prices goes up, firms have some ability and desire to

increase quantity supplied. Why? Firms are motivated by
higher prices to make more profit.

- Higher prices cover the additional costs that must be

covered if more output is brought to the markets –
therefore, supply curves slope upward.

Goal: Efficiency
- Efficiency is MB=MC
- Competitive market equilibrium leads to D=S
 Gains from trade
- From trade consumers obtain net benefit: Consumer
surplus (CS) = Total benefit – Total expenditure
- From trade producers obtain net benefit: Producer surplus
(PS) = Total revenue – Total (variable) cost
- The society realizes total gains from trade = CS+PS
- All gains from trade are exploited (maximized) when
competitive market is at equilibrium = Efficiency is
achieved!

The Key: Competition

- Competition is an important characteristic of many, if not,

most markets

- We say markets are competitive if there are lots of buyers

and sellers

- Competition is why the law of supply and demand holds

most of the time

- Competition amongst sellers in particular gives

consumers (buyers) a choice from whom to purchase.
- The existence of this choice is one characteristic of what
are sometimes referred to as FREE markets.

Examining World Trade

- World trade is a key element of economic globalization.

- This is a complex subject riddled with political

controversy, poor logic and substantial public
misperception as to the facts.

- The controversy is largely due to the role of trade as a

source of competition for local jobs

History of International Trade

- Mercantilists (18th century) believed a country should
export for the sole purpose of acquiring gold.

- Early 19th century conflict over Corn Laws in England, led

to the first great Free Trade debate.

- In the last 50 years we have seen a great deal of trade

liberalization (reduction in barriers to trade) but few
instances of free trade (i.e., NO government barriers).
- Trade liberalization has been widely opposed by many
political and social groups.

- Historically, the most important critiques of trade are

based on the argument that it costs jobs and lower wages.

- Trade wars have been an important instance of

international conflict at various times in history.

- Trump wanted to block international trade, by creating

tariff (tax on an imported good) barriers.

- MAGA (Make America Great Again)

Resurgence of Protectionism

- The United States is engaged in numerous trade disputes

including the re-negotiation of NAFTA, concerns about
the WTO (World Trade Organization), and the trade war
with China.

- Protectionism tariff tools have been employed by the US

to extract concessions from trading partners during
current negotiations.

- ROW (Rest of the World) exports.

- Protectionism: Raising or putting tariffs on another
countries exports.

Trade and GDP

- Opening of trade affects the national economy:

1- Import: People spend money on foreign goods – an

outflow of money expenditure from the economy.

2- Export: Sales of exports to foreigners bring money income

into the economy and create employment.

- GDP = (total expenditure on domestic products) is affected

by net export = (export sales less import expenditures, also
called trade balance).

GDP= C+I+G+(X-M)

- Countries are consuming more of their GDP.

- CPP (Canada Pension Plan)

- EI (Employment Insurance)
Why countries trade?

A: Comparative advantage – Economies of Scale

Exporting: The producers/sellers win = Receive higher price

Sell higher quantity

- With imports, consumers win; pay lower world price and

receive a higher quantity than in the absence of trade.

- The domestic producers produce lower Qs and receive a

lower world price.

- Overall society will gain, but the gains are going to be

evenly distributed.

Protectionism: When the government creates barriers to trade

One barrier to trade

A tariff: A tax on the imported good.

Ex: Apples produced in Canada do not face a tariff in Canada,

but apples produced in New Zealand do face a tariff.
Types of Trade Regulation

- Tariffs: These are taxes or “duties” applied to imports –

historically the most common government restriction on
trade.

- Quotas: Specific limits to the quantity of imports that can

enter the domestic market (very common in shoes and
clothing, for example)

- Government procurement targeted at domestic suppliers

(“discriminatory sourcing”). For example, “Buy American”.

- Health and safety product regulations which are applied to

foreign suppliers but not domestic suppliers.

- Export subsidies --- less common but applied by

governments to some sectors: very common in some
agricultural markets like wheat, where subsidies to export
are prevalent.

Trade Liberalization
- Historically there have been periods of intense and
widespread trade wars. In fact, during the first half of the
 20th century, governments shut down international
economic interdependence – especially during the Great
Depression.

- Since WWII, there has been a tremendous liberalization

and expansion of trade throughout the world.

- This reduction in trade barriers has been achieved

through:

- A reduction in trade barriers because of multilateral trade

talks sponsored by GATT.

- Negotiated trade agreements known as Regional Trade

Agreements (or Preferential Trade Arrangements).

GATT
- After WWII, several new international organizations and
agreements were instituted – one of these was the General
Agreement on Tariffs and Trade (GATT).

- The GATT served two main purposes in the international

community.
Can’t compete with cheap foreign labour?

- Free trade would cause our jobs to flow to low-wage

countries (“a giant sucking sound”)?
- NO!
- Why?

a) Firstly, low wage doesn’t mean low cost!

Low wage different from Low cost

- Low wage is mainly because of low productivity

b) Second, wages and productivity tell us nothing about the

source of gains from trade, which is comparative
advantage.

High-income countries should specialize in producing products

that they have comparative

- For a country, the gains from trade exceed losses. It is

ideal that those who gain compensate those who lose so
that everyone is in favor of free trade.
 - The government should use redistribution policies to help
those workers who lose jobs due to import competition.

- It is simple in theory, but hard to do in practice.

- The way to ease globalization is the same as the way to

ease other sorts of economic change, including the impact
of technology.

- The aim is to help people to move jobs as comparative

advantage shifts rapidly from one activity to the next.

- This requires:

- a flexible and dynamic labor market to facilitate displaced

workers to find new jobs;

- an education system and retraining programs that equip

people with general skills that make them adaptable and
mobile;

- a reliable social safety net that provides unemployment

insurance with health care and pensions detached from
employment.

Two Location Problems

Where to sell? A firm can sell in domestic market or foreign
market – an issue of international trade

Where to produce? A firm can obtain goods and services in any

of four ways

1) Vertical integration = Within the firm and within the

country (onshore)

2) Offshoring (FDI) = Within the firm and outside the

country (offshore)

3) Domestic outsourcing = Outside the firm (Outsourcing)

and within the country (onshore)

4) Offshore outsourcing = Outside the firm (Outsourcing)

and outside the country (Offshore)

FDI= Foreign Direct Investment

 Financial Markets

- One person (the borrower) needs current real resources

from the economy beyond those she already has claim to,
for example, to consume more than she earns, or to invest
in some activity (say, drill for oil or start up a coffee shop)

- An interest rate on the IOU is just the additional amount

paid back expressed as an annual percent of the amount
borrowed.

- Potentially this intertemporal transaction is mutually

beneficial; Borrower gets positive net return on productive
investment opportunities after paying interest; lender gets
interest income. Both can gain from this intertemporal
transaction (which involves two periods)

- The financial market (also called credit market or capital

market) is where such intertemporal transactions occur. A
functioning financial market is essential to promote
intertemporal efficiency – resources are invested in
productive opportunities, and intertemporal gains from
trade are maximized.

- The IOU is simply a piece of paper or a verbal statement

in which the details of the promise are laid out; the IOU is
a form of contract – credit contract.
- From the lender’s point of view, trust in the borrower is
essential – because the IOU is a promise about the future
there are lots of opportunity for fraudulent behavior or
outright theft – the borrower may simply take the lender’s
resources and run away.

- For this reason, most credit market relationships in

primitive economies and even many today involve people
who have close personal relationships.

- In modern economy, trust is based on information

provided by financial institutions and reinforced by legal
protection of property rights.

- The history of capitalism parallels the development of

more formal market-like relationships for dealing with the
problem of creating and then trading IOU’s amongst
unrelated individuals

- Today we call the problem of matching borrowers and

lenders, financial intermediation, and the markets where
most of this occurs financial markets.

- Financial intermediation began with the local Shylock

(money lender), extended to the emergence of banks, then
regional and national financial markets, and most recently
have extended to global finance.
- What makes financial markets different than most other
markets, is the important role of information.

- Because the underlying contract (IOU) involves

uncertainty about the future, information pertaining to
that future and the parties involved in the contract is
extremely important and very unevenly distributed – some
know more than others.

- Most financial markets are characterized by asymmetric

information – the borrower typically knows more about
what they will do with the money than the lender.

- Because of this, there is a long history of governments

providing legal frameworks, which govern relationships
between the borrowers, lenders and intermediaries (like
banks).

- Modern financial markets are just more sophisticated

versions of creating and then trading IOUs.

1) They produce information to better match borrowers and

lenders. Financial intermediaries specialize in collecting
and analyzing information. By screening and monitoring
they can reduce problems caused by asymmetric
information, ensuring creditworthy borrowers and
productive projects get funded.
 2) They facilitate more efficient allocation of risk by
spreading large risks (e.g. drilling for oil), across
thousands of people. All savers’ money is pooled to make
risky investment on many projects. Individuals face lower
risk due to diversification and risk-sharing. This
encourages more savers to participate in financial market
and promotes efficient use of resources.

3) They also provide liquidity. If a particular lender wants to

get his money back quickly, it is usually possible to do so
in a modern financial market; if you want to get back
money lent to your brother today, that might not be so
easy – we say that loan is illiquid. Financial markets create
liquid instruments and trade opportunities to facilitate
quick conversion back to cash. Even money itself can be
easily created by commercial banks through loan-making.

4) The prices of intertemporal transactions are determined in

financial markets. The most important price is interest
rate, which plays the central role in decision-making on
intertemporal resource allocation.

All in all, financial markets direct economic resources (savings)

for investment purposes; they are essential to efficient
allocation of resources over time, which is necessary for
sustained long-run growth.
- Many developing countries experience low rates of
economic growth, perhaps due to their underdeveloped
financial system – a situation referred to as financial
repression.

- Several difficulties keep their financial systems from

operating efficiently:

- Poorly functioning system of property rights (lack of

collateral to deal with asymmetric information problem)

- Poorly developed legal systems (no enforcement of

financial contract)

- Government allocation of credit (less incentive to solve

asymmetric information problems)

- Inefficient state-owned banks.

Financial Institutions

Commercial banks: Take deposits from people who want to save

and turn around to lend this money for borrowers.

Pay one interest rate to depositors and charge another (higher)

interest rate to borrower – the difference is profit.

- Banks “borrow short, lend long”; transform short-term, low

risk, liquid demand deposits to long-term, high risk,
illiquid loans.

- Banks have been around forever --- banks are now heavily
regulated and depositors are protected by deposit
insurance (CDIC in Canada, FDIC in US), which was
established after the Great Depression – a lot of banks
went broke, and the depositors lost all their savings.

Investment banks: They help sell new bonds and new stock
issues, called “underwrite” securities – e.g., Lehman Brothers.

Pension funds: They are very important in the financial markets

as they are representative of the largest pools of savings in most
industrial economies
Insurance companies: They provide insurance service and are
large holders of other financial securities.

Mutual funds: They sell units to raise funds from investors, for
the purposes of investing in securities such as bonds and stocks.

Mortgage companies: Issue mortgage loans on real estate,

mostly homes, to individuals and raise capital by issuing bonds
or other debt instruments.

Credit rating agencies: Grade debt instruments by probability of

default (investment grade to junk bond) – S&P, Moody’s, Fitch.

Venture capital funds: A form of private equity that specializes

in providing funds to small, early-stage. Emerging firms
(startups) that are deemed to have high growth potential, or
which have demonstrated high growth.

Financial markets attract a lot more attention than most other

markets --- Why? The key is risk:

a) Risk by nature: Investment always involves uncertainty ---

you are never so sure whether the project will succeed in
the future --- this creates winners and losers
b) Risk of dishonesty: The potential for fraud, theft, scam
artists, etc., seems to be unlimited – consequences of this
are disastrous for people who lose their savings.

c) Magnified risk: A lot of financial market activity uses

leverage or gearing: leverage occurs when you make an
investment of one type which in turn is financed by going
into debt or taking on a loan at the same time – e.g.,
borrow money to buy shares in Nortel --- lose twice ---
Nortel stock worth nothing and still have to pay back the
loan.

- Leverage is very common but it creates additional risks

which at a large enough scale can become a societal
problem.

- Hedge Funds are typically higher levered investment

funds.

- When a leveraged investor makes a big mistake, his

creditors suddenly become involuntary participants in the
original investment --- this happened with hedge fund
Long Term Capital Management who used leveraged to
invest in Russian bonds (which were defaulted on). LTCM
was bailed out by the big US money center banks.
d) Systemic risk: Financial crises – Large-scale financial asset
value loss and financial institution failure seems to be a
familiar part of the free market landscape. One
market/institution’s problem may easily cause panic and
crisis for the whole financial system and domestic, even
global economy.

- In recent years we had the Southeast Asian crisis in 1997,

LTCM and Russian default in 1998, the dot-com bubble
burst in 2000, and 2008 Subprime Mortgage Crisis, plus
numerous banking crises in emerging markets.

- Financial crises can occur because of a loss of confidence

of market participants – if a lender loses confidence that
his borrower can repay, he may choose to call in the loan –
this in turn may trigger a decline in the confidence in
other borrowers – which triggers more loan withdrawals,
etc. – we effectively get a chain event which spirals out of
control.

- Financial markets seem very prone to this type of

contagion – classic case is
a bank run. Run on a bank occurs when depositors worry
about security of
their deposit and withdraw their deposit — as deposits
 withdrawn bank must
call in loans to pay back deposits — other depositors get
wind of this and also
try to withdraw funds; bank cannot meet all depositors’
demands at once and
you get a bank failure – this can happen to both bad and
good banks!

Monetary System

- The world monetary system is probably one of the least

understood aspects of the global economy but nevertheless
is very, very important.

- The current global monetary system has evolved over last

couple of centuries and continues to change decade by
decade --- most recent big changes were in 1973 with the
end of Bretton Woods system and the introduction of the
Euro in 1999.

National money:
- National monetary systems with national money and
banking systems are generally controlled or regulated by
national central banks in all countries
Global banking:
- A global banking system which facilitates payments
between countries is motivated by international trade and
international asset transactions

Main Currencies:
- A system of floating (or flexible) exchange rates between
the three largest currency areas/zones (USD, Euro and
Yen) with transactions occurring in the world’s foreign
exchange market (a bid-ask market located in major world
money centers – New York, London, Tokyo, Hong Kong,
Zurich) --- large banks and governments are major
participants.

Other Currencies
- The bulk of emerging market and developing economies
run pegged or fixed exchange rate regimes.

- A few of the industrial countries run flexible

National Monetary System
- The 20th century saw the nationalization, or government
asserting control over its monetary system --- Central
Banks emerged in early part of the 20th century.
- We live in a monetary economy because money (currency,
deposits) are the means of payment for all transactions –
alternative to monetary system is a barter system – goods
trade for goods.

- Money flows parallel the circular flow of goods and factors

in a market economy. Early monetary theorists often drew
biological analogies – with money being the “blood” of the
economy.

- The banking system is an integral part of any monetary

system because the commercial banks create deposit
money by making loans, so as to flexibly accommodate
the society’s

What do central banks do?

a) Issue money
b) Commercial banks’ bank – hold deposits of commercial
banks (reserves) and lend to these banks as the lender of
last resort.
c) Monetary policy – control money supply or interest rates
to achieve specific policy goals
 d) Foreign exchange market intervention

Monetary policy
- Central banks try to set short term interest rates (the
interbank rate) with a goal of controlling either inflation
or unemployment/or economic growth.

- Typically at any point of time they can only target one of

these objectives

- If inflation is too high, they raise interest rates so people

will borrow less, spend less and thus reduce demand
pressures on prices (to lower inflation)

- If growth is too low they will cut interest rates to try to

stimulate borrowing which raises demand and therefore
increases economic growth.

- Often no conflict between objectives