Global events and how they reach the domestic economy

Overview

Tariffs imposed by other countries affect a domestic economy, same global event affect different economies to very different degrees and second-round effects.

What you need to know

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Questions from this subtopic

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1. 1

   Through which channels does an event in the world economy reach a domestic economy?

   Model answer

   There are several distinct channels and most large events use more than one. Trade in goods and services transmits changes in foreign demand to domestic exporters and changes in foreign supply to domestic buyers. Commodity and energy prices, set in world markets, feed directly into domestic costs. Financial markets transmit changes in interest rates, asset prices and the availability of credit, since capital moves across borders instantly. The exchange rate moves in response to all of these and then changes the domestic price of everything traded. Supply chains transmit physical disruption, so a factory closure abroad stops production at home. Migration flows respond to conditions in both countries. And confidence spreads, so bad news abroad can cause domestic firms and households to postpone spending even before any measurable effect arrives.

2. 2

   A country imports 500 million barrels of oil a year and the world price rises from 60 to 100 dollars a barrel. Calculate the increase in the import bill and express it as a share of a GDP of 500 billion dollars.

   Model answer

   The price has risen by 40 dollars a barrel, so on 500 million barrels the additional cost is 500 million multiplied by 40, which is 20 billion dollars a year. As a share of GDP that is 20 divided by 500, which is 4%. Four per cent of national income is therefore transferred abroad to oil producers, assuming the quantity imported does not change. That transfer is the essential nature of the shock: it is a loss of real income to the importing country, not merely a rise in one price, which is why demand-side policy cannot undo it and why the domestic argument shifts to who bears the loss.

3. 3

   Analyse the effect of a sharp rise in world energy prices on a net energy importer's prices, output, employment and balance of payments.

   Model answer

   Prices rise immediately, because energy enters household bills directly and enters the cost of almost everything else indirectly through transport, heating and manufacturing, so both the headline rate and the underlying rate climb. Output falls, for two reasons operating together: firms face higher costs, so at any given price level they supply less, and households face higher bills, so their real disposable income falls and they cut spending on everything else. Employment falls with output, and the loss is concentrated in energy-intensive industries and in sectors selling discretionary goods and services. The balance of payments deteriorates on the current account, because the same quantity of imported energy costs more, and the deterioration is larger the less able the country is to reduce the quantity in the short run, since demand for energy is highly inelastic. The exchange rate often falls as well, which raises import costs further. The economy therefore experiences rising inflation and falling output together, which is precisely the combination that demand-management policy cannot correct.

4. 4

   Analyse the effect on a domestic economy of a recession in a major trading partner.

   Model answer

   The partner's households and firms buy less, including less from abroad, so domestic exporters lose orders and the current account worsens. Exporting firms cut production and employment, and because they buy from domestic suppliers the loss spreads through the supply chain; regions specialised in exporting are hit hardest. Investment falls, both in exporting firms with idle capacity and more widely as confidence weakens. Falling export earnings reduce incomes and therefore domestic spending, so the contraction spreads to firms with no direct export exposure. There are partial offsets: the partner's currency may weaken, the world price of commodities usually falls in a global slowdown, which lowers domestic costs, and the domestic central bank can cut interest rates. The severity depends on how large a share of exports goes to that partner and how concentrated they are.

5. 5

   Analyse how a financial crisis abroad reaches an economy that had no part in causing it.

   Model answer

   Losses in one country's financial system are transmitted directly to institutions elsewhere that hold claims on it or on the same assets, so foreign banks suffer losses without having made the original bad loans. Confidence collapses generally, so banks everywhere become reluctant to lend to one another and funding markets close, which reduces credit even to sound borrowers. Investors sell risky assets worldwide and move into safe ones, so asset prices fall, the cost of finance rises and currencies of smaller economies depreciate. Trade credit becomes scarce, which reduces trade even where demand is unchanged. And as the crisis countries fall into recession, their demand for imports collapses. An economy with a well-run banking system can therefore experience a severe contraction in credit, in asset prices and in exports without any domestic cause at all.

6. 6

   Why does a disruption to global supply chains affect both prices and output at the same time?

   Model answer

   A supply chain delivers physical inputs, and if a component cannot be obtained the final good cannot be made regardless of how much demand exists or how cheap finance is. Output therefore falls for a reason unconnected with demand. At the same time the scarcity of the input raises its price, buyers bid against one another for whatever is available, and transport costs rise as capacity is rationed, so costs and prices rise. The two effects are the same event seen from different sides: a reduction in supply raises price and reduces quantity simultaneously. This is why such disruptions produce the uncomfortable combination of shortages, rising prices and falling production, and why they cannot be cured by managing demand.

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