10  Macroeconomic Analysis of Trade Balance

Previous lectures have been concerned primarily with the problem of making the best use of the world’s scarce productive resources at a single point in time. The branch of economics called microeconomics studies this problem from the perspective of individual firms and consumers. Microeconomics works “from the bottom up” to show how individual economic actors, by pursuing their own interests, collectively determine how resources are used. In our study of international microeconomics, we have learned how individual production and consumption decisions produce patterns of international trade and specialization. We have also seen that while free trade usually encourages efficient resource use, government intervention or market failailures can cause waste even when all factors of production are fully employed.

We shift our focus and ask: How can economic policy ensure that factors of production are fully employed? And what determines how an economy’s capacity to produce goods and services changes over time? To answer these questions, we must understand macroeconomics, the branch of economics that studies how economies’ overall levels of employment, production, and growth are determined. Like microeconomics, macroeconomics is concerned with the effective use of scarce resources. But while microeconomics focuses on the economic decisions of individuals, macroeconomics analyzes the behavior of an economy as a whole. In our study of international macroeconomics, we will learn how the interactions of national economies influence the worldwide pattern of macroeconomic activity.

Macroeconomic analysis emphasizes four aspects of economic life that, until now, we have usually kept in the background to simplify our discussion of international economics:

1. Unemployment: We know that in the real world, workers may be unemployed and factories may be idle. Macroeconomics studies the factors that cause unemployment and the steps governments can take to prevent it.

2. Saving: In earlier chapters, we usually assumed that every country consumes an amount exactly equal to its income—no more and no less. In reality, though, households can put aside part of their income to provide for the future, or they can borrow temporarily to spend more than they earn.

3. Trade imbalances: As we saw in earlier chapters, the value of a country’s imports equals the value of its exports when spending equals income. This state of balanced trade is seldom attained by actual economies.

4. Money and the price level: The trade theory you have studied so far is a barter theory, one in which goods are exchanged directly for other goods on the basis of their relative prices. In practice, it is more convenient to use money—a widely acceptable medium of exchange—in transactions, and to quote prices in terms of money. Because money changes hands in virtually every transaction that takes place in a modern economy, fluctuations in the supply of money or in the demand for it can affect both output and employment.

To get a complete picture of the macroeconomic linkages among economies that engage in international trade, we have to master two related and essential tools.

• The first of these tools, national income accounting, records all the expenditures that contribute to a country’s income and output.

• The second tool, balance of payments accounting, helps us keep track of both changes in a country’s indebtedness to foreigners and the fortunes of its export- and import-competing industries. The balance of payments accounts also show the connection between foreign transactions and national money supplies.

10.1 The National Income Accounts

10.1.1 Gross National Product (GNP)

A country’s gross national product (GNP), the value of all final goods and services produced by the country’s factors of production and sold on the market in a given time period. To distinguish among the different types of expenditure that make up a country’s GNP, government economists and statisticians who compile national income accounts divide GNP among the four possible uses for which a country’s final output is purchased:

1. Consumption (the amount consumed by private domestic residents)

2. Investment (the amount put aside by private firms to build new plant and equipment for future production)

3. Government purchases (the amount used by the government), and

4. Current account balance (the amount of net exports of goods and services to foreigners)

Figure 10_1 shows how U.S. GNP was divided among its four components in the first quarter of 2016:

Figure 10_1: U.S. GNP and Its Components

Why is it useful to divide GNP into consumption, investment, government purchases, and the current account?

• One major reason is that we cannot hope to understand the cause of a particular recession or boom without knowing how the main categories of spending have changed. And without such an understanding, we cannot recommend a sound policy response.

• In addition, the national income accounts provide information essential for studying why some countries are rich—that is, have a high level of GNP relative to population size—while some are poor.