International Economic Factors

With a solid understanding of how the Fed and the business cycle drive the domestic economy, you can now extend those concepts to the global stage: trade, currency, and how the U.S. economy connects to the rest of the world.

GDP and GNP

Two measures capture the total economic output of a country. The SIE tests the difference between them.

Key points:

• GDP is the more commonly used and tested measure
• Real GDP adjusts for inflation; nominal GDP does not
• A recession is two consecutive quarters of declining real GDP. That is the definition the exam uses; one quarter of decline is not enough
• GDP measures production by location (within borders); GNP measures production by ownership (by citizens)

Think of it this way: GDP asks "where was it made?" while GNP asks "who made it?" A Toyota plant in Kentucky adds to U.S. GDP (made here) but Japanese GNP (made by a Japanese company).

Exam Tip: Gotchas

• GDP = within borders (domestic). GNP = by citizens (national). A Japanese auto factory in Ohio counts toward U.S. GDP but NOT U.S. GNP.
• An American tech company's overseas office counts toward U.S. GNP but NOT U.S. GDP for that production.

U.S. Balance of Payments

The balance of payments is a record of all economic transactions between the U.S. and the rest of the world. It has three accounts:

Current Account

• Tracks trade in goods and services, income, and transfers
• A trade deficit occurs when imports exceed exports (the U.S. buys more than it sells)
• A trade surplus occurs when exports exceed imports (the U.S. sells more than it buys)
• The trade balance is only one part of the current account. Income and transfers can change the overall current-account result.
• The U.S. has run a trade deficit for decades

Capital Account

• Tracks capital transfers, such as debt forgiveness, and transfers of nonproduced, nonfinancial assets

Financial Account

• Tracks investment flows, including foreign purchases of U.S. assets and U.S. purchases of foreign assets
• Foreign purchases of U.S. stocks and bonds are financial-account transactions

The relationship: A trade deficit does not by itself establish a current-account deficit. When the current and capital accounts together show a deficit, financial flows finance the difference. Foreign investment in U.S. assets is recorded in the financial account.

Exam Tip: Gotchas

• A trade deficit means the U.S. imports MORE than it exports (not less). "Deficit" here means the U.S. is spending more abroad than it earns from selling goods overseas.
• A trade deficit alone does not tell you whether the current account has a deficit. Foreign investment flows belong to the financial account, not the capital account.

Exchange Rates

The exchange rate is the price of one currency expressed in terms of another. Exchange rates directly affect trade, investment returns, and the cost of imported goods.

Currency pairs and the spot rate:

• A rate is quoted as a currency pair, such as EUR/USD. The first currency is the base currency; the second is the quote currency (also called the counter currency)
• The rate tells you how much of the quote currency buys one unit of the base currency. EUR/USD at 1.10 means one euro costs $1.10
• A conversion done today is priced in the spot market, at the current spot exchange rate. Sell 1,000 euros at a spot rate of 1.10 and you receive $1,100
• Interest rates, inflation, trade balances, and political stability move the spot rate over time, but the amount you receive on a conversion today is set by the spot rate itself

Strong Dollar (Appreciating)

• Makes U.S. imports cheaper (good for U.S. consumers)
• Makes U.S. exports more expensive (bad for U.S. exporters)
• Makes foreign investments less valuable when converted back to dollars

Weak Dollar (Depreciating)

• Makes U.S. imports more expensive (bad for U.S. consumers)
• Makes U.S. exports cheaper (good for U.S. exporters)
• Makes foreign investments more valuable when converted back to dollars

Think of it this way: A strong dollar is like having a coupon at a foreign store: you get more for your money when buying imports. But it also makes your products look expensive to foreign buyers, which hurts exporters.

Why "more expensive" hurts exporters (not helps them): The U.S. seller still charges the same dollar price. What changes is how much foreign currency the buyer needs to come up with. A U.S. tractor priced at $50,000 costs a European buyer €50,000 when the rate is even. If the dollar strengthens so that $1 buys €1.25, that same $50,000 tractor now costs the European buyer €62,500. The U.S. exporter still receives $50,000 per sale, but European demand drops at the higher local-currency price, so fewer tractors get sold. The hit is lost volume, not lower revenue per unit.

What influences exchange rates:

• Interest rates: Higher U.S. rates attract foreign capital, strengthening the dollar
• Inflation: Higher inflation erodes purchasing power, weakening the currency
• Trade balances: A large trade deficit can weaken the dollar over time
• Political stability: Stable governments attract foreign investment, strengthening the currency

Exam Tip: Gotchas

• A strong dollar HURTS U.S. exporters but HELPS U.S. consumers buying foreign goods. A weak dollar does the opposite.
• Think about it from the buyer's perspective: a strong dollar means your dollar buys more foreign currency, so imports are cheaper.
• "How much counter currency will I get?" is answered by the spot exchange rate. Inflation, the trade balance, and political stability are reasons the rate moves; they are not what prices today's conversion.

Connecting It All

International economic factors tie directly back to the Fed and the business cycle:

• Fed raises interest rates → Dollar strengthens → Imports cheaper, exports more expensive → Trade deficit may widen
• Fed lowers interest rates → Dollar weakens → Imports more expensive, exports cheaper → Trade deficit may narrow
• Strong economic expansion → Rising imports (consumers spending more) → Trade deficit grows
• Recession → Falling imports (consumers cutting back) → Trade deficit shrinks

Why higher U.S. interest rates strengthen the dollar: "Rates" here means U.S. interest rates, not the exchange rate. The Fed sets a target range for the federal funds rate (the rate banks charge each other for overnight loans), and the actual rate is set by supply and demand between banks. When the Fed raises its target range, the actual rate follows it up, and U.S. bonds and bank deposits start paying more. Foreign investors want a piece of those higher yields, so they sell their own currency to buy dollars (which they then use to buy U.S. assets). That extra demand for dollars pushes the exchange rate up. The chain is: U.S. interest rates up → foreign demand for dollars up → dollar strengthens.

What Should You Check on Exam Day?

• Can you explain that GDP counts production within a country's borders, while GNP counts production by its citizens regardless of location?
• Do you know a trade deficit means imports exceed exports, while the current account also includes income and transfers?
• Can you state that a strong dollar makes imports cheaper for consumers but hurts exporters, while a weak dollar does the reverse?
• Do you know higher U.S. interest rates strengthen the dollar, and that a currency conversion done today is priced at the spot exchange rate?
• Can you define a recession as two consecutive quarters of declining real GDP?