International Economics - First mid-term

Norbi Székely

1 List of keywords
• National Account and National Income indicators: GDP = C + I + G + (X-M)1 (Gross
Domestic Product), GNI = C + I + G + (X-M) + Net Primary Income (Gross National Income),
GNDI = C + I + G + CA (Current Account contains both primary and seconadry incomes) (Gross
National Disposable Income)

• External balance: External balance is attained when a country’s current account is neither so deeply
in deficit that the country may be unable to repay its foreign debts in the future nor so strongly in
surplus that foreigners are put in that position.
• Context between the National Account and National Income indicators and external
balance: Change in external balance affects the the national income or GDP.

• Macroeconomic policy goals: Having both Internal and External balance. Internal balance
requires the full employment of a country’s resources and domestic price level stability.
• Balance of Payments and International Investment Position: Balance of Payment is the differ-
ence in total value between payments into and out of a country over a period. International Investment
Position is a financial statement setting out the value and composition of that country’s external fi-
nancial assets and liabilities.
• The concept of resident: Being a resident of a country (in international economics’ view) depends
on predominant economic interest and economic territory and not on citizenship or nationality.
• Base equation of the Balance of Payments: Current Account + Capital Account = Financial
Account
• Transactions recorded in the Current Account: The transactions of the real economy: trades,
primary income of work and investments, and current transfers.
• Main rows of the Current Account: Goods, Services and the Primary and Secondary Income.

• Transactions recorded in the Capital Account: It includes acquisition and disposal of non-
produced and non-financial assets plus capital transfers receivable and payable between residents and
non-residents.
• Main rows of the Capital Account: Gross acquisitions/disposals of non-produced, non-financial
assets and Capital transfers.

• Transactions recorded in the Financial Account: Purchasing and selling assets and financing.
• Mains rows of the Financial Account: Direct Investment, Portfolio Investment, Financial deriva-
tives (but not reserves), Other Investment (mainly loans) and Reserve Assets (central bank).
• Foreign Direct Investment: Long-term influence or control, it has difference forms such as equity,
debt or other financing form, also reinvestments belong to here.
1 (X-M) where X equals to the exports and M equals to the imports.

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 • Portfolio Investment: Traded shares, mutual fund units (ownership), securitized debt (like bonds).
The relationship is mostly anonymous, it has no control or influence over the operation. Also it has a
high degree of trading liquidity.
• The net financing capacity: The difference between savings and borrowings.

• The three approaches of the net financing capacity:

– Real economy approach investigates the Net External Position of the Current and Capital
Account regarding trade balance, income balance and transfers.
– Savings approach distributes the net lending/net borrowing between the sectors of the economy:
the government, corporations and households.
– Financing approach is based on the Financial Account: how the country is financed and how
it invested abroad the income above its spending.
• Causes behind the external imbalance: Imbalance can appear when a country has more import
than export (external deficit) or more export than import (external surplus). The cause can be that
for example a given country has no beneficial investment opportunity and so it will invest abroad, etc.

• Intertemporal trade: Trade of consumption over time. In the globalised world foreign direct in-
vestments (FDI) are necessary for convergence. Capital flow to countries with higher return causes
temporary deficit because of higher import of capital goods first.
• Asymmetric shocks: Output drops suddenly but borrowings from abroad enable the smoothing of
consumption over time.

• Persistent/excessive deficit of Current Account: Means or indicate a fundamental macroeco-

nomic problem. Also it is unsustainable because of intertemporal budget limit and short-term financial
market constraints.
• Macroeconomic fundamentals behind persistent/excessive deficit of Current Account:

– High consumption
– Non-productive investments
– Expansionary (and also non-productive) fiscal2 policy
• Unsustainability of persistent/excessive external deficit: Intertemporal budget constraint:
the persistent deficit accumulates on International Investment Position and so the payments on the ac-
cumulated foreign liabilities strain3 the Current Account in the future; market constraint: excessive
deficit and/or too high accumulated foreign debt worsen the rating of the country, consequently tighten
the financing supply from abroad and increase its cost and if market confidence is lost, a sudden stop
may occur.

• Problems of excessive surplus: Uncertainties in sustainability of foreign borrowing, protectionism

as a response: other countries may impose barriers to import.
• The importance of the International Investment Position: Assessing external economic and
financial developments and the related risks as well as sustainability, it is no longer sufficient to consider
transactions on their own; it is also necessary to analyse other components of change affecting the size
of positions (revaluation, other changes in stock) as well as the position itself.
• Greenspan - Guidotti rule: The international reserves must cover 100% of short-term debt in order
to withstand a sudden stop in external financing, and to be able to finance the withdrawal of short-term
debt.

2 Fiscal: Relating to financial matters. Financial.

3 Strain: Make severe or excessive demands on something.

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 • Prinples of the gold standard:
1. Money in circulation: both gold coins and banknotes (were legal tender4 ).
2. Official gold price: the central bank fixed the exchange price between its currency and gold and was
obliged to convert its banknotes into gold at this official price for anyone without any restrictions.
3. Free trade of gold coins and bullion5 not only domestically but internationally also.
4. Full convertibility, free capital export and free trade.
• Currency and the Banking theory on money supply:
– Currency theory: An uncontrolled banknote issuance leads to inflation and banking crisis and
full gold coverage of banknotes is needed.
– Banking theory: Banknotes backed by credits provided by banks to corporations having sound
business fundamentals and adequate collateral6 . Therefore money creation is driven by cred-
itworthy demand. The reimbursement of credit will withdraw the banknotes from circulation.
There is never more money in circulation than the quantity of “real bills”, so there will not be an
inflationary effect.

• Price specie flow mechanism: A market mechanism which helped to rebalance the Current Account
automatically. It contributes to restore the external equilibrium, based on the interaction between the
trade balance and price level.
• Rules of the game in the Gold Standard: It covered the measures that the central bank made to
affect the investment flows in the Financial Account, in order to rebuild the reserves (or get rid of the
surplus).
• Drawbacks of the Gold Standard: The gold standard places undesirable constraints on the use of
monetary policy to fight unemployment. Tying currency values to gold ensures a stable overall price
level only if the relative price of gold and other goods and services is stable. The gold standard could
give countries with potentially large gold production, a considerable ability to influence macroeconomic
conditions throughout the world through market sales of gold. Pressure on economy and economic
policy.
• Principles of the Bretton Woods monetary system:
1. Official gold price of USD: the Federal Reserve fixed the price of gold at $35 / ounce.
2. The Fed guaranteed to central banks of other member countries (but only to them) the conversion
of the dollar into gold at fixed official price.
3. The exchange rate of each (member state) currency was fixed to the USD.
4. Convertibility, but mainly for Current Account transactions.

• IMF7 role under the Bretton Woods monetary system:

– Maintaining the fixed exchange rate system.
– To ensure financing and flexibility to countries in handling external balances.
– In the case of external imbalance, to provide financing to use intertemporal trade path.

• Asymmetry of the Bretton Woods monetary system: While US monetary policy affects the
internal balance of other countries, the monetary policy of other countries will be undermined by their
adherence to the fixed exchange rate.

4 Legal tender: Coins or banknotes that must be accepted if offered in payment of a debt
5 Gold bullion: Unit of gold, often called as gold bar.
6 Collateral: Security, surety, guarantee. Something pledged as security for repayment of a loan.
7 IMF: International Monetary Fund

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• Monetary trilemma: It is impossible to achieve all 3 of the following at the same time:
1. Fixed exchange rate.
2. Autonomy of monetary policy.
3. Free capital movement.

Policy makers have to choose 2 out of these 3, above mentioned goals. Further more they can pursue
only one of the following regimes:
1. Fixed exchange rate regime.
2. Floating exchange rate regime.
3. Capital flow controls.
• Confidence problem (Triffin): The more holdings of dollars exceeded the US gold reserves, the
more concerns arose against dollar holdings.