Global Economic Imbalances: Crisis, GDP, and Open Economy Dynamics
Financial Globalization and the 2008 Crisis
The 2008 financial crisis was closely linked to global macroeconomic imbalances. Key points include:
- Global Imbalances: Emerging countries (e.g., China, oil exporters) had large current account surpluses, while the US experienced significant deficits.
- Capital Flows: Surplus countries invested their excess savings abroad, leading to substantial net capital outflows.
- US Financing: These capital flows played a role in financing the US housing and financial bubble, contributing to low real interest rates.
- Internal and External Imbalances: Domestic and external imbalances are interconnected, with net external debt reflecting total indebtedness across government, firms, and households.
These imbalances highlight the complex relationships between global economies and the potential risks of financial globalization.
Gross Domestic Product (GDP) Explained
Gross Domestic Product (GDP) is the total monetary value of all final goods and services produced within a country’s borders over a specific period, typically a year. It is a widely used indicator of a country’s economic activity and growth.
The fundamental formula for GDP is:
GDP = C + I + G + (X - M)
GDP is an important indicator of a country’s economic performance and is used to:
- Measure economic growth
- Compare economic performance across countries
- Inform policy decisions
Why is GDP Important?
GDP helps policymakers and economists understand the overall health of an economy and make informed decisions about economic policy. It is also used to calculate GDP per capita, which provides insights into a country’s standard of living.
GDP in an Open Economy: Internal and External Imbalances
Recalling the Keynesian equations on the use of income in consumption and saving, we know that GDP = Y = C + S.
Simplifying the previous formula by considering public expenditure (G) included in consumption (C) and investment (I), we have:
GDP = C + I + EX - IM
Substituting C + S for the first term gives:
C + S = C + I + EX - IM
Rearranging the terms:
S - I = EX - IM (*)
Where:
- C: Consumption
- I: Investments
- G: Public Expenditure
- EX: Exports
- IM: Imports
- Y: Income
- S: Saving
This important result demonstrates that internal imbalances (an excess or deficiency of savings relative to investment) are directly reflected in external imbalances (a current account surplus or deficit, or an external transaction surplus or deficit).
Supply and Demand Dynamics in an Open Economy
Understanding supply and demand in an open economy involves several key concepts:
- Total Supply and Demand: These are calculated a posteriori as realized supply and demand, not potential ex-ante figures.
- Components:
- Total supply comprises domestic supply (products made within the economic territory) and foreign supply (imports).
- Total demand includes domestic demand (consumption + investment) and foreign demand (exports).
- Intermediate Consumption: To accurately represent final supply and demand, intermediate consumption (goods and services used in the production process) must be subtracted to avoid duplication.
- Final Domestic Supply: This is represented by GDP (Gross Domestic Product) or NDP (Net Domestic Product) if depreciation is accounted for.
- Imbalance: Domestic supply and demand may not always be in equilibrium, leading to internal and external imbalances (e.g., when S-I > 0 and EX-IM > 0).
These concepts highlight the intricate relationships between domestic and foreign supply and demand, emphasizing the importance of understanding imbalances within the economy.