International Economics: Key Concepts Explained

Posted on Aug 8, 2024 in Economy

Foreign Direct Investment (FDI) and Multinational Corporations (MNCs)

FDI represents long-term investments made by private MNCs in overseas countries. There are two primary methods: Greenfield Investment, where MNCs establish new facilities or expand existing ones in foreign countries, and Mergers and Acquisitions, where MNCs merge with or acquire existing firms.

MNCs are drawn to developing countries for several reasons:

  • Abundant natural resources
  • Large and expanding markets
  • Lower labor costs compared to developed countries
  • Less stringent regulations

Developing countries often face a savings gap that FDI can help bridge, leading to various benefits:

  • Employment opportunities and potential for education and training, enhancing workforce skills and managerial capabilities.
  • Access to research and development (R&D), technology, and marketing expertise, accelerating industrialization.
  • Multiplier effect on the host economy, stimulating growth.
  • Increased tax revenue for the government, which can be used to promote economic development initiatives like education.
  • Injection of foreign capital and increased aggregate demand (AD) when MNCs acquire existing companies.
  • Potential improvements in infrastructure, increased consumer choice, and lower prices.
  • More efficient allocation of global resources.

However, MNCs can also have drawbacks:

  • Potential for pollution and negative externalities in countries with weak environmental regulations.
  • Exploitation of low-skilled labor without providing adequate education, training, or technology transfer.
  • Excessive power and influence, potentially leading to tax incentives that reduce government revenue.
  • Engagement in transfer pricing to minimize tax liabilities.

In conclusion, FDI can be beneficial for economic growth but may have negative consequences for sustainable economic development. The overall impact depends on the type of investment and the host country’s ability to regulate MNC behavior.

Current Account

The current account measures the flow of funds from trade in goods, services, and other income flows. It comprises four main components:

  1. Balance of Trade in Goods (Visible Trade): This measures the difference between revenue from exports and expenditure on imports of tangible goods. A surplus occurs when revenue exceeds expenditure, and a deficit occurs when expenditure exceeds revenue.
  2. Balance of Trade in Services (Invisible Trade): This measures the difference between revenue from exports and expenditure on imports of services, such as tourism.
  3. Income: This measures the net monetary movement of profits, interest, and dividends flowing into and out of the country due to financial investments abroad.
  4. Current Transfers: This measures the net transfer of money between countries without an exchange of goods and services, including foreign aid and remittances.

Therefore, the current account can be summarized as: Current Account = Balance of Trade in Goods + Balance of Trade in Services + Net Income Flows + Net Transfers

Floating Exchange Rates

In a floating exchange rate system, the value of a currency is determined by the forces of demand and supply in the foreign exchange market. There is no government intervention to influence the currency’s value, which appreciates when it rises and depreciates when it falls.

Demand for local currency increases when:

  • Foreign countries experience higher inflation, making local goods and services cheaper.
  • Foreign income rises, allowing individuals to increase demand for local goods and services.
  • Foreign preferences shift in favor of local products.
  • Local investment prospects improve.
  • Local interest rates increase, making it more attractive to save in local banks.
  • Speculation anticipates a rising value of the local currency.

Supply of local currency increases when:

  • Local inflation is higher than in foreign countries.
  • Local income rises.
  • Local preferences shift in favor of foreign products.
  • Foreign investment prospects improve.
  • Foreign interest rates increase.
  • Speculation anticipates a rising value of foreign currencies.

An increase in the supply of local currency shifts the supply curve rightward, leading to depreciation. Conversely, an increase in demand shifts the demand curve rightward, leading to appreciation.

Factors of Production and Economic Growth

The quantity and quality of factors of production (FOP) are directly linked to economic growth. While economic development is a more complex concept, economic growth, if managed effectively, can contribute to economic development.

Natural FOPs like land are challenging to increase in quantity, so improvements in quality through better planning are crucial.

Human capital can be enhanced by encouraging population growth or immigration. However, developed countries often focus on improving the quality of human capital through improved education.

Physical capital includes factories, machinery, and other infrastructure. Social capital encompasses schools, roads, hospitals, and other public goods. The quantity of these FOPs is influenced by savings, domestic and foreign investment, and government intervention. Quality improvements are driven by higher education, R&D, access to foreign technology, and other factors.

Firms can choose between capital widening, where extra capital is used with an increased amount of labor (maintaining productivity), and capital deepening, which involves increasing the amount of capital per worker, leading to productivity gains through technological advancements.

High levels of economic growth can lead to higher GDP per capita, potentially improving standards of living. However, the distribution of income is a critical factor in ensuring that the benefits of economic growth are shared equitably.

Managed Exchange Rates

In a managed exchange rate system, the currency is allowed to float within a specified range set by the government or central bank. Intervention occurs when the exchange rate approaches the upper or lower limits of this range.

Reasons for intervention include:

  • Lowering the exchange rate to boost employment.
  • Increasing the exchange rate to combat inflation.
  • Maintaining a fixed exchange rate.
  • Preventing excessive fluctuations in the floating exchange rate system.
  • Promoting exchange rate stability to enhance business confidence.
  • Addressing a current account deficit.

Methods of intervention include:

  • Using foreign currency reserves to buy or sell foreign currency, influencing the value of the local currency.
  • Adjusting interest rates to attract or deter foreign investment, impacting demand for the local currency.

Financial Account

The financial account tracks net changes in foreign ownership of domestic assets. A surplus occurs when foreign ownership of domestic assets increases faster than domestic ownership of foreign financial assets.

The financial account has three main components:

  1. Direct Investment: This involves the purchase of long-term assets with the aim of gaining profit or control from a foreign company, including property, businesses, or stocks.
  2. Portfolio Investment: This involves the purchase of stocks and bonds, representing a more liquid and less permanent form of investment compared to direct investment.
  3. Reserve Assets: This includes gold and foreign currency reserves held by central banks to manage exchange rates and intervene in the foreign exchange market.

Due to the complexity of international transactions, the balance of payments (BOP) accounts may not always perfectly balance. To address this, a “net errors and omissions” category is included.

Foreign Aid

Foreign aid encompasses any assistance provided to a country that would not have been available through normal market forces.

Reasons for providing foreign aid include:

  • Providing relief in response to natural disasters or conflicts.
  • Supporting economic development in developing countries.
  • Fostering political or strategic alliances.
  • Addressing savings gaps in developing countries.
  • Promoting economic development and improving welfare in developing economies.

Types of foreign aid:

  1. Humanitarian Aid: Aims to alleviate short-term suffering and often takes the form of grant aid, which does not need to be repaid. This includes food aid, medical aid, and emergency aid.
  2. Development Aid: Aims to alleviate poverty in the long run and improve welfare. This includes long-term loans, tied aid, project aid, technical assistance aid, and commodity aid.

Foreign aid can be provided through official development assistance (ODA) channels or through unofficial channels, often organized by non-governmental organizations (NGOs).