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Economics: International Flow of Goods & Services


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About this Lesson

  • Type: Video Tutorial
  • Length: 15:14
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 163 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Exports, Imports, and Accounting (4 lessons, $8.91)

In this video lesson on economics, you'll learn about the International Flow of Goods and Services. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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I was about to eat this orange and it occurred to me to wonder where it had come from. Did this orange grow in Florida? Workers from Florida tended the trees, picked the orange, boxed the oranges and sent them to the supermarket? If so, my purchase of this orange provided jobs for people in Florida in the US economy. What if this orange came from Mexico, on the other hand? The workers in Mexico tended the trees, picked the oranges and boxed them. My purchase of this orange created employment for workers in Mexico. Now, the difference is that if this orange was produced in the US economy, my purchase of it stimulated the US economy by creating demand for a product that's produced here. And if wages are sticky, that is, if they don't tend to adjust downward very quickly, then if I move my consumption of products from oranges produced in Florida to oranges produced in Mexico, I may have created unemployment in Florida by causing workers who originally tended trees in Florida to no longer have jobs. This is a concern. Now, of course, as a consumer, I want to buy my oranges from wherever the oranges are least expensively produced; that is, I'm looking for the country that produces oranges with comparative advantage, where the sun shines a lot, where the workers are industrious and where they know something about orange production, because those are the workers that are going to be able to get the oranges on my table at lowest price. However, if my microeconomic sense leads me to buy oranges where the price is lowest and the cost of production is lowest, then, on the other hand, I've got the macroeconomic concern of unemploying workers in the US, who were previously producing oranges and who can't compete with foreign competition.
Now, in a microeconomic classic view of the world, wages and prices would all adjust and the workers who previously made oranges would find new jobs, maybe in the software industry or producing automobiles or something like that. But if we're in a macroeconomic world, where wages and prices don't adjust instantly, then my shift of consumption from domestically produced products to imports creates a period of adjustment that is unemployment and cost to the domestic economy. This is a question that is answered in open economy macroeconomics, the approach to macroeconomics that focuses on our country embedded in a larger world economy, where we import goods from abroad and export goods to foreigners.
We're now going to begin a series of discussions about open economy macroeconomics and see what difference it makes when your conscious of the fact that your economy, your country is only one part of a larger world, a larger world with which your economy interacts.
Now, we've already had a taste of open economy macroeconomics when we considered net exports. Let's begin with the notion of exports. Exports are goods and services that are produced in our economy that are purchased by people in other countries. So the good thing about exports is they provide employment for local resources and they create income for local resources, which ends up being spent and re-spent in your economy through the multiplier effect. So exports are good, because they are demand for local production, they create income for local resources, and they have a multiplier effect in the domestic economy.
Imports, on the other hand, are good because they provide goods and services for people in your economy. They are good and services that are purchased from abroad. So if I import an orange, the good thing about that is I get to enjoy an orange; that is, my standard of living goes up if I can buy an orange inexpensively from Mexico. On the other hand, the more of my income I spend on imported goods and services, the more I'm creating jobs for people in Mexico, which is great for them, but is not so good for the people in Florida, who might otherwise have produced this orange. So imports are good because they increase your satisfaction from goods and services, but they're costly in a macroeconomic sense, because it's income that's leaking out of your domestic economy, and therefore it's reducing the multiplier effect, because you're creating multiplier consequences in some other country, not in your own.
Now, the difference between exports and imports is what we call in macroeconomics net exports. Net exports is the difference between what you're selling to foreigners and what you're buying from them. Net exports is adding to the domestic demand. Net exports is the net addition to domestic demand from your foreign trade. So international trade then has a macroeconomic consequence through net exports. The difference between what you're sending foreigners and what you're buying from them is demand for your locally produced products. This is creating income in your economy and, through the multiplier effect, creating more consumption, more income and so forth, leading your domestic economy to grow.
Now, let's look at how we show net exports in the diagram that represents aggregate spending. This is the diagram we used when we were building Keynes' model of the economy, but you can see that it applies generally to - even in the more sophisticated aggregate demand/aggregate supply model, there's some notion of spending somewhere. We start with consumer spending. It's an upward-sloping line that has here an intersect representing autonomous spending, and the slope of this consumption function is the marginal propensity to consume. Remember the marginal propensity to consume is the amount of each additional dollar of income that a household spends on consumer goods and services. So, for example, if the marginal propensity to consume is 90% or .9, then out of every additional dollar of income that the household gets, a horizontal movement, that household will spend 0.90, the vertical movement or the rise. So rise over run, the slope of this line is the marginal propensity to consume.
Now, lets add on to this consumption function some other autonomous components of spending that are not influenced by income; that is, we're going to shift the line upward in a parallel fashion, but we're not going to change its slope. So if we add on investment spending and government spending, we shift the aggregate expenditure line upward. We've added some more components of autonomous spending and we get this line right here. Now, this is how things would look in a closed economy. This is all the spending that's done as a function of income if business and government and consumers are all registering their demand in the economy. Notice, I haven't added foreigners yet. I haven't added any foreign spending. This is our spending line, aggregate expenditure, in a closed economy.
Now, let's look at what a difference an open economy makes. The first component of the open economy is going to be exports, and we're going to imagine that exports are autonomous; that is, they don't depend on income. Why would that be? Because exports are the demand of foreigners, people in other countries, who want to buy goods from our economy. They don't care what our income is in this country. Our income doesn't influence their demand. Their demand depends on their income. And since their income isn't in this picture, then showing exports is just another upward parallel shift in the line. The line shifts upward, parallel again, and we just added on another autonomous component of spending, exports.
Now, this is only half the story. This is what foreigners are buying from us. Now what we have to subtract from this picture is what we're buying from them. Why are we subtracting it? We're subtracting it, because our imports are already written in this picture; that is, our imports are either purchase by consumers when they import oranges from Mexico, or by businesses when they import computers from Canada, or by the government whenever it imports concrete from Columbia. So what we do is we look at the fact that imported goods are already registering in consumer spending, business spending and government spending. So if we want to find the total demand for domestically produced products, we have to subtract imports from this total spending in our economy.
Now, we're going to make an assumption about imports, and that is that imports depend on the level of income; that is, every time your income goes up by a dollar, consumers spend part of that extra dollar on imported goods. So let's suppose that that number is 10%. So for every dollar's worth of additional income that a household gets, they're going to spend 0.10 of it on imported goods. Now, what that does is, if we want to now look at this line as representing the demand for domestically produced goods and services, we have to reduce the slope of this line by 10%. So we reduce the slope. Previously, the slope of this line was 90%, now it's 90% minus 10%, or 80%. What we've done is we've subtracted imports, because of every dollar that households get in income, they're going to spend 0.90, but they're only spending 0.80 of it on domestically produced goods and services. The remaining 0.10 is going outside our economy as spending on imports and that has to be subtracted, because imports are goods that are not produced in our economy, not creating income for local factors of production.
So there you have it. The curve gets a flatter slope and the intersection point with the spending equals income line. The intersection point with the equilibrium line is now going to be at a point closer to the origin, because we moved right here from an economy with no imports to an economy with imports. And the spending abroad, the fact that some of our goods and services are purchased from abroad, reduces the amount of production that domestic factories have to do to keep up with demand. Remember what we're looking for here is the amount of local production and income that is needed to support the spending plans of the economy. And the more people are importing, the less has to be produced domestically to give us an equilibrium.
So in an open economy what you get is a flatter aggregate expenditure line, because the more people are inclined to import, the less domestic production needs to be done to keep up with demand. This then raises the question of the multiplier. What is the multiplier like in an economy with imports? Well, remember the multiplier says that whenever I buy an orange from Florida, I'm creating income from Florida orange workers. They then spend the money on compact discs and haircuts and T-shirts and those merchants, in turn, go out and spend this new income on other consumer goods and services. But if I imported this orange from Mexico, there is no multiplier effect in the US economy. There's a multiplier effect in Mexico, but we're not studying Mexico's economy, so we can ignore that. The multiplier effect in the US economy is lost when the good is imported rather than produced domestically. So think about then the effect that imports have on the multiplier. It's a kind of leakage. Every dime that's spent on imported goods is a dime that's lost to the multiplier process in this economy. It's a dime that doesn't become local income and therefore isn't passed on in local spending. To see how imports affect the multiplier, let's start with a closed economy multiplier. Remember that it comes from a geometric sequence. When you spend a dollar, you create a dollar's worth of income for someone else, who spends a fraction of that, and the fraction is equal to the marginal propensity to consume. Then the person who gets his money spends a fraction if it. So you get 1 plus the marginal propensity to consume plus MPC^2, and so forth. And when you add up all of this infinite sequence, you get a number that converges to 1 over 1 minus the marginal propensity to consume. So if the marginal propensity to consume is 90% of each additional dollar, then the multiplier is 1 over 1 minus 90%, or 1 over 10%, which is 10.
Now, in an open economy, you get an additional leakage at each step in this story. So, for instance, if I go to the store to buy some flowers, the flower merchant gets a dollar from me. The flower merchant then is inclined to spend 90% of the dollar's worth of income, but he's only inclined to spend some of it on locally produced goods. Suppose the marginal propensity to import, or MPM, is 10%. That means that the flower merchant wants to spend 90% of the money that I gave him. We have to subtract 10% of that amount, which is the amount that he's going to spend on imported goods. The multiplier is the money that he spends that goes to someone locally. So here we have MPC minus MPM. He's only spending 0.80 of my original dollar that I gave him on locally produced goods. So 0.80 goes to someone else, say the ice cream merchant that the flower merchant buys ice cream from. Then he gets 0.80, of which he spends 90%, but only 80% on locally produced goods. Maybe he buys a T-shirt from the merchant next door, as well as spending some of the money on imported oranges. So what you get then is a geometric sequence with 1 plus 80% plus 80%^2 and so forth. It's just like the previous story only the number is smaller. It's reduced by the amount of money that flows out of the economy in the form of imports. So the new multiplier for the open economy is 1 over 1 minus this sum, and the sum is the marginal propensity to consume minus the amount that's spent on imported goods, the marginal propensity to import. Exactly the same idea, a geometric sequence, a chain reaction, everybody playing their role a step in the story, only this time we're reducing the amount passed on at each stage by the amount that's spent on at each stage by the amount that's spent on imported goods. So the multiplier is smaller in this case; 1 over 1 minus 90% minus 10%, or 80%. 1 minus 80% is 20%. The multiplier was just reduced down to 5, 1 over 20% is 5, so our open economy multiplier is smaller than the closed economy multiplier, because when people spend money outside of your economy, they are reducing the multiplier effect. They're reducing the amount of income that's created for local factors of production at each stage, and that reduces local demand for goods and services
So there you have it. In an open economy, the multiplier is smaller, because imported goods, while they're good for your standard of living, will shrink domestic income, because they reduce the multiplier effect. More income goes abroad to foreign countries and that's great for the foreign countries. However, from a macroeconomist point of view, you get a smaller punch now from increased government spending whenever people in your economy are inclined to spend a chunk of their extra income on imported goods.
Now, we're going to consider foreign trade more broadly and look at how economists do the accounting of imports and exports and what this means for measuring economic activity.
International Focus
Exports, Imports, and Accounting
International Flow of Goods and Services Page [3 of 3]

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