The Global Economy Guide: How the world economy operates

Overview of the Global Economy
How big is the world economy?
We measure the size of the global economy by the combined GDP of all countries. An increase in the GDP over time means that the world economy is producing more goods and services. On the graph we show the so-called "GDP in constant prices," more specifically using U.S....
The growing importance of emerging markets
In 2015, the U.S. was by far the biggest economy, followed by China, Japan, and Germany. The ten countries on the chart were the ten biggest economies and produced more than the half of the world output. The U.S. alone produced 24 percent of the world output, while China and...
Global exports
Global exports have increased from 2.5 trillion U.S. dollars in 1970 to over 22 trillion in 2015. This is a ten fold increase in only four decades. Have in mind that we calculate the exports using year 2010 prices. In other words, the increase in exports on the chart is the...
Economic development around the world
The level of economic development is measured by the Gross Domestic Product (GDP) per capita, i.e. the total amount of goods and services produced in the economy, divided by its population. Below we see that the average GDP per capita in the world increased from about 8,900...
Economic ties between countries
Different economies are connected by trade and investment. It is through these two channels that recessions and expansions spread internationally. Consider an example with the U.S. and Mexico. When the U.S. economy goes into a recession, U.S. consumers buy less of...
Key Economic Indicators
Gross Domestic Product: How much is produced where
The Gross Domestic Product (GDP) is a measure of the overall production in a country. It is the total market value of all goods and services produced in a country during a period of time, e.g. one year. The GDP has to be distinguished from the Gross National Product (GNP)....
Purchasing power parity (PPP) income
The Purchasing Power Parity (PPP) calculation is used to compare the real incomes of people in different countries. It takes into account two things: 1) how much people make and 2) what prices they face in their country. Consider the example below. The GDP per capita in...
Real and nominal economic growth
Economic growth is defined as the rate of change of the Gross Domestic Product (GDP). Positive economic growth means that the value of all goods and services produced in the economy, i.e. the nominal GDP, is increasing. The nominal GDP could increase for two reasons: 1)...
Inflation: not too little, not too much
Inflation is the rate at which prices in the economy change over time. Inflation could be positive which means that prices are increasing. If it is negative, then prices are decreasing. In that case we say that the economy is experiencing deflation, i.e. falling prices....
The causes of inflation in the long run and in the short run
Over the long-term, several years and longer, prices increase because the supply of money in the economy is expanding, i.e. because central banks print more cash. There may be other reasons for inflation in the short run but over longer stretches of time printing money is the...
Unemployment: structural, frictional, and cyclical
The unemployment rate is the percent of people in the labor force who don't have a job and are actively looking for one. The rate of unemployment differs significantly across countries even when the global economy is booming as it did in 2005.
The Balance of Payments: the current and financial accounts
The Balance of Payments summarizes the international transactions of a country. These transactions can be broadly categorized into two types – international trade and international investment. They are presented in the two components of the Balance of Payments: the Current...
Economic Growth and Development
Economic growth: an overview
Economic growth is defined as the rate of increase of the Gross Domestic Product (GDP) of a country. Positive economic growth is an indication that the economy is producing more goods and services. The chart shows the spectacular increase in China's GDP that exemplifies...
Rule of law and economic development
In countries with strong rule of law: 1. Property rights over land, equipment, and personal items are clear and protected by law. 3. Contracts between people, businesses, and the government are effectively enforced by the legal system. 3. Political accountability is...
Education and economic development
Education contributes to economic development in many ways. An educated labor force can use new technologies raising the productivity and competitiveness of firms. Education is also essential for the creation of new technologies. A better educated labor force is more flexible...
International trade and economic development
International trade benefits the economy in several ways: 1. It allows firms to expand their markets and to increase sales. The greater scale of production lowers their cost and makes them more competitive. 2. International trade exposes firms to international...
Financial development and economic development
The "financial system" includes banks, stock markets, insurance companies, and other financial institutions. "Financial development" means that the financial system is fairly large and performs the important functions described below: 1. It provides financing for large...
Sources of economic growth
Broadly speaking, there are three ingredients to economic growth: Physical capital. These are the machines, equipment, buildings, land, and other tangible inputs into the production process. When companies invest in more equipment, this allows them to expand production over...
Income convergence
If poor countries grow faster than rich countries, over time they will catch up in terms of their level of income. This process is called income convergence. Alternatively, incomes would diverge if the rich countries grow more rapidly than poor countries. If economic growth is...
Why incomes might converge or diverge
There are two main arguments for why incomes across countries should converge over time. Technology spillover. One argument is that innovations and technologies that are developed in the rich countries soon become available in the poor countries. This happens, for example,...
Stages of economic development
Historically, most of the advancements in growth have been associated with increased productivity. That, however, is not true for all countries at all times. Less developed countries grow primarily through investment in capital and incorporating more people into their labor...
Growth accounting
Growth accounting is a method to determine the contribution of each of the three sources of economic growth: physical capital, labor, and productivity. A formal presentation of this is as follows: Economic growth = α * Growth in capital + ( 1- α ) * Growth in labor +...
International Trade
Domestic vs. international trade
International trade occurs when products produced in one country are consumed in another country. The existence of a border between the producing and the consuming country creates a number of issues. There could be restrictions on imports and exports in the form of tariffs,...
Comparative advantage, specialization
The theory of comparative advantage explains why, for example, Argentina specializes in raising cattle whereas Germany makes cars. An example might be the easiest way to explain the logic. Let’s say that in Germany it takes $90,000 worth of resources (wages, capital,...
The benefits and costs of free trade
Without tariffs, quotas and other restrictions on international trade, products will be produced at the best possible locations around the world. Then, they will be shipped to wherever they are in demand. As a result, consumers are able to enjoy a greater variety of goods and...
The World Trade Organization
The World Trade Organization (WTO) is an organization that commenced in 1995 with the goal to supervise and liberalize international trade. The WTO is a replacement for the General Agreement of Tariffs and Trade (GATT) which was established in 1948. The WTO deals with the...
Are trade deficits bad for the economy?
The short answer is "no", unless the trade deficits are greater than about 3 percent of GDP for several years. Let's see why but, first, let's recall the terminology: an economy runs a trade deficit if the volume of its exports of goods and services is less than the volume of...
Why do countries run trade deficits?
A country could run a trade deficit for two reasons: - its firms are not competitive internationally and cannot export their goods and services - the country is very attractive to foreign investors In the first case, firms may not be using the latest know-how or the...
International Investment
Foreign Direct Investment
Foreign direct investment (FDI) is the ownership of production facilities in a foreign country. To be classified as FDI, a foreign investor has to own at least 10 percent of a local company. Otherwise, if the ownership is less than 10 percent of the value of the local company,...
Sudden stops in international finance
The term 'sudden stop' refers to a sudden reversal of capital flows into a country. A country may be attracting large volumes of international capital for many years. Then, at some point, the inflow of international investment goes in reverse. An example is the portfolio...
Currency values and investment returns
We'll use an example to illustrate how international investment is affected by currency values. The example uses deposit interest rates but the same logic applies to any asset or production facility that generates returns. Consider two deposit accounts: one in a U.S. bank...
The puzzle of international lending and sovereign debt
International sovereign debt is the credit extended to governments (the sovereign) by lenders in other countries. For example, the government of Brazil has taken credits from banks from the U.S., Britain, Spain, Japan, and many other countries. These banks want to lend to...
How foreign money funds capital investments
By capital investment (also known as fixed capital formation) we mean the purchase of machines, land, real estate, and other production items by firms. Capital investment is important as it expands the capacity of firms to produce and grow over time. Greater investment also...
Exchange Rates
What factors determine the exchange rates?
The exchange rate is the price of one currency expressed in units of another currency. For example, at the beginning of 2017, 1 U.S. dollar exchanged for about 21 Mexican Peso, 1 euro exchanged for 4.4 Polish Zloty, and one Brazilian Real exchanged for 0.41 Canadian Dollars....
Fear of floating: fixed vs. flexible exchange rates
Countries have multiple choices when it comes to exchange rate policy. At one end are the floating exchange rate regimes where the price of the local currency is determined only by market forces. If travelers, importers, exporters, and international investors demand more (or...
Is currency depreciation good or bad for the economy?
When a currency depreciates, the prices of domestically-produced goods decline relative to international prices. The exporting firms become more competitive and exports increase. If the growth of exports is significant, then production and employment also expand and the entire...
The unholy trinity of international finance
The unholy trinity states that a country cannot have all of the following at the same time: free capital mobility, a fixed exchange rate, and independent monetary policy. It can have any two of these three but not all three. Let’s first explain what these three policies are:...
Currency substitution and financial dollarization
Currency substitution is the case when foreign currencies are used in domestic transactions. For example, many people in Latin America use dollars to buy real estate and cars. In Eastern Europe, people use the dollar and the euro for the same purposes. Why are dollars used...
Currency unions, monetary unions
A currency union (also known as a monetary union) is a group of countries that use the same currency. They also have the same central bank that issues the common currency. The most prominent example of this arrangement is the European Monetary Union where close to 20 European...
Dollarization, euroization
Dollarization refers to the case when a country decides to abandon its own currency and to substitute it with a foreign currency. As the foreign currency is usually the dollar, the policy has been termed "dollarization." However, the country may adopt the euro or another...
Gold standard
Under the gold standard, the government authorities commit to exchange local money for gold at a certain price. In essence, the domestic currency is backed by gold. The same is required of the government authorities of the other countries participating in the gold standard...
Currency boards
Currency boards are fixed exchange rate regimes with an additional feature: the central bank has to keep large foreign exchange reserves. Specifically, the reserves have to be large enough to cover all the money in circulation and the deposits that commercial banks keep at the...
Currency Crises
What is a currency crisis
A currency crisis, also called a devaluation crisis or an international financial crisis, is a sharp depreciation of the currency of a country. The depreciation usually comes after a period during which the exchange rate has been very stable, even fixed. Notice on the...
The costs of currency crises
Devaluations could have a large and prolonged negative impact on the economy. The immediate effect is a jump in the rate of inflation because the imported products become more expensive. For example, a car imported from the U.S. to Indonesia before the devaluation in 1997...
Explaining currency crises
There are three main theories that explain currency crises. They are called the first, second, and third generation models of currency crises due to the timing of their development. The first generation model was developed in the late 1970’s and attributes crises to...
The first generation model of currency crises
According to that explanation, currency crises have a fundamental cause. They are not the result of bad luck or market speculation but of bad policy. Here is how the story goes: The government pursues two policies at the same time: 1) maintain a fixed exchange rate regime...
The second generation model of currency crises
In the second generation model of crises, the economy has a fixed exchange rate regime. However, it does not have fundamental problems such as a large fiscal deficit, a large current account deficit, or high inflation. Then, for no apparent reason, currency traders...
The third generation model of currency crises
In the third generation model of currency crises, the problem is liquidity. The economy is working well without large deficits and high inflation. However, it has accumulated substantial amounts of foreign debt. Even worse, it has accumulated a lot of short-term foreign debt,...
Leading indicators of currency crises
Currency crises are difficult to predict but certain pressures in the economy can tell us if there are conditions for a crisis. A large budget deficit financed by printing money. The creation of money causes inflation and the loss of international competitiveness. The...
International financial contagion
Financial contagion is the spillover of a financial crisis from one country to another. Investors flee from one country and then the capital flight starts in other countries in the region and even globally. There are various reasons for the contagion. If one of the major...
International Parities
The law of one price
The law of one price states that the same product should have the same price across countries. For example, if a T-shirt costs $10 in the U.S. and the exchange rate is 100 Japanese yen = 1 U.S. dollar, then the T-shirt should cost 10*100 = 1000 yen in Japan. Why should the...
Absolute purchasing power parity
The absolute purchasing power parity theory (APPPT) predicts that price levels will be the same across countries. Recall that the law of one price states that the same products will have the same prices everywhere. The APPPT applies the same logic to all prices in the country....
Relative purchasing power parity
The relative purchasing power parity theory (RPPPT) does not predict that price levels are the same across countries. It predicts that the changes in price levels are the same across countries. For example, when we look at most goods and services, Switzerland is about 40%...
Real exchange rate
The real exchange rate (RER) is a very useful measure of the competitiveness of an economy. It tells us whether the prices of goods and services at home are higher or lower than their prices abroad. If domestic prices are lower, then we can expect healthy exports and a trade...
Balassa-Samuelson effect
The Balassa-Samuelson effect explains how a country could become more expensive over time without losing its international competitiveness. Consider two countries: an industrialized economy and an emerging market economy. Each of these countries has two sectors: 1) a...
Interest rate parity
The interest rate parity condition predicts that changes in the exchange rate between two countries equals the difference of the interest rates of the two countries. Let’s take bank deposits in the U.S. and Mexico as an example. An American investor has 100 dollars to put...
Financial Systems
Types of financial institutions
The financial system consists of the following major institutions: Banks are financial intermediaries that collect deposits and give out credits. Some credits are investment-oriented and serve to buy real estate, machines, and equipment. Other credits are short-term...
Financial Structure – stock markets vs. banks
The financial system serves as an intermediary between the population that has savings and the firms and households that need financing. The transfer of funds can happen through two main channels. Savings can accumulate in the banking system in the form of bank deposits and...
Benefits of the financial system for the economy
Collect information about borrowers and allocate capital To appreciate the value of banks for the economy, let’s say that you have $10,000 to invest. To select investment opportunities, you start looking at firms that need financing and at individuals who want to buy a...
Banking crises
Banking crises are periods when many banks in the economy are on the brink of collapsing. Depositors rush to get their money out and, often, the government intervenes to save the banks. It might nationalize, close, or merge banks to contain the problem. It takes about 5 years...
Longer verions of the guide articles
How to find information about foreign economies
A number of international organizations publish information that can be used to understand the economies of various countries. That information is useful to international investors as well as all others who are interested in a particular economy, including their own. This...
Economic growth and development
Robert Lucas, a Nobel Prize winning economist, once said that once you start thinking about economic growth, it is hard to think about anything else. Indeed, rapid economic growth year after year can lift the living standard for large masses of people and can bring more...
Exchange rate definition, determinants, regimes, and crises
The exchange rate is the most important price in any economy. When the currency appreciates, the country becomes more expensive and less competitive internationally. At the same time its citizens enjoy a greater standard of living as they can buy international products at...
International trade and investment
The place of production is often on the other side of the border from the country where the product is consumed. The difference in locations creates challenges and opportunities and gives rise to international trade and investment. Both are the centerpiece of economic...
Finance and the real economy
The financial system is the blood system of the economy. It is essential for the health of the economy as allows the savings of the population to go to various projects and investments. When it performs these functions well, the economy thrives. When it doesn’t, the economy...
Other issues