2.1. Basic Terminology

The aggregate output of a nation over a specified time period is usually measured as its gross domestic product or its gross national product.

Gross domestic product (GDP) measures the market value of all final goods and services produced by factors of production (such as labor and capital) located within a country/economy during a given period of time, generally a year or a quarter.

Gross national product (GNP), however, measures the market value of all final goods and services produced by factors of production (such as labor and capital) supplied by residents of a country, regardless of whether such production takes place within the country or outside of the country.

The difference between a country’s GDP and its GNP is that GDP includes, and GNP excludes, the production of goods and services by foreigners within that country, whereas GNP includes, and GDP excludes, the production of goods and services by its citizens outside of the country.

Countries that have large differences between GDP and GNP generally have a large number of citizens who work abroad (for example, Pakistan and Portugal), and/or pay more for the use of foreign-owned capital in domestic production than they earn on the capital they own abroad (for example, Brazil and Canada).

Therefore, GDP is more widely used as a measure of economic activity occurring within the country, which, in turn, affects employment, growth, and the investment environment.

Imports are goods and services that a domestic economy (i.e., households, firms, and government) purchases from other countries. For example, the US economy imports (purchases) cloth from India and wine from France. Exports are goods and services that a domestic economy sells to other countries. For example, South Africa exports (sells) diamonds to the Netherlands, and China exports clothing to the European Union. So how are services imported or exported? If a Greek shipping company transports the wine that the United States imports from France, the United States would classify the cost of shipping as an import of services from Greece and the wine would be classified as an import of goods from France. Similarly, when a British company provides insurance coverage to a South African diamond exporter, Britain would classify the cost of the insurance as an export of services to South Africa. Other examples of services exported/imported include engineering, consulting, and medical services.

The terms of trade are defined as the ratio of the price of exports to the price of imports, representing those prices by export and import price indices, respectively. The terms of trade capture the relative cost of imports in terms of exports. If the prices of exports increase relative to the prices of imports, the terms of trade have improved because the country will be able to purchase more imports with the same amount of exports.2 For example, when oil prices increased during 2007–2008, major oil exporting countries experienced an improvement in their terms of trade because they had to export less oil in order to purchase the same amount of imported goods. In contrast, if the price of exports decreases relative to the price of imports, the terms of trade have deteriorated because the country will be able to purchase fewer imports with the same amount of exports. Because each country exports and imports a large number of goods and services, the terms of trade of a country are usually measured as an index number (normalized to 100 in some base year) that represents a ratio of the average price of exported goods and services to the average price of imported goods and services. Exhibit 1shows the terms of trade reported in Salvatore (2010). A value over (under) 100 indicates that the country, or group of countries, experienced better (worse) terms of trade relative to the base year of 2000.

Exhibit 1. Data on the Terms of Trade for Industrial and Developing Countries
(Unit Export Value/Unit Import Value)

	1990	1995	2000	2005	2006
Industrial countries	99.8	104.8	100	101.3	99
Developing countries	103	101.9	100	99.4	100.5
Africa	100.4	102.8	100	107.9	105.2
Asia	106.8	106.8	100	91.5	89.2
Europe	68.7	105.5	100	102.1	99.8
Middle East	109	68.4	100	140.4	155.9
Western hemisphere	129.6	107.1	100	104.3	108.7

Source: Salvatore (2010), case study 3–3. Base year 2000 = 100.

As an example, Exhibit 1 indicates that from 1990 to 2006 both of the broader groups, developing and industrial countries, experienced a slight decline in their terms of trade. Looking at the disaggregated data indicates that developing countries in Asia and the Western hemisphere experienced a considerable decline in terms of trade while those in Europe and the Middle East (which benefited from rising prices of their petroleum exports) experienced a substantial increase. Africa also experienced a small improvement in its terms of trade during this period.

Net exports is the difference between the value of a country’s exports and the value of its imports (i.e., value of exports minus imports). If the value of exports equals the value of imports, then trade is balanced. If the value of exports is greater (less) than the value of imports, then there is a trade surplus (deficit). When a country has a trade surplus, it lends to foreigners or buys assets from foreigners reflecting the financing needed by foreigners running trade deficits with that country. Similarly, when a country has a trade deficit, it has to borrow from foreigners or sell some of its assets to foreigners. Section 4 on the balance of payments explains these relationships more fully.

Autarky is a state in which a country does not trade with other countries. This means that all goods and services are produced and consumed domestically. The price of a good or service in such an economy is called its autarkic price. An autarkic economy is also known as a closed economy because it does not trade with other countries. An open economy, in contrast, is an economy that trades with other countries. If there are no restrictions on trade, then members of an open economy can buy and sell goods and services at the price prevailing in the world market, the world price. An open economy can provide domestic households with a larger variety of goods and services, give domestic companies access to global markets and customers, and offer goods and services that are more competitively priced. In addition, it can offer domestic investors access to foreign capital markets, foreign assets, and greater investment opportunities. For capital intensive industries, such as automobiles and aircraft, manufacturers can take advantage of economies of scale because they have access to a much larger market. Free trade occurs when there are no government restrictions on a country’s ability to trade. Under free trade, global aggregate demand and supply determine the equilibrium quantity and price of imports and exports. Government policies that impose restrictions on trade, such as tariffs and quotas (discussed later in the reading), are known as trade protection and prevent market forces (demand and supply) from determining the equilibrium price and quantity for imports and exports. According to Deardorff, globalization refers to the “increasing worldwide integration of markets for goods, services, and capital that began to attract special attention in the late 1990s.”3 It also references “a variety of other changes that were perceived to occur at about the same time, such as an increased role for large corporations (multinational corporations) in the world economy and increased intervention into domestic policies and affairs by international institutions,” such as the International Monetary Fund, the World Trade Organization, and the World Bank.

The levels of aggregate demand and supply and the quantities of imports and exports in an economy are related to the concepts of excess demand and excess supply. Exhibit 2 shows supply and demand curves for cars in the United Kingdom. E is the autarkic equilibrium at price P^A and quantity Q^A, with the quantity of cars demanded equaling the quantity supplied. Now, consider a situation in which the country opens up to trade and the world price is P₁. At this price, the quantity demanded domestically is Q^K while the quantity supplied is Q^J. Hence excess demand is Q^J Q^K. This quantity is satisfied by imports. For example, at a world price of $15,000, the quantity of cars demanded in the United Kingdom might be 2 million and UK production of cars only 1.5 million. As a result, the excess demand of 500,000 would be satisfied by imports. Returning to Exhibit 2, now consider a situation in which the world price is P₂. The quantity demanded is Q^C while the quantity supplied is Q^D. Hence, the domestic excess supply at world price P₂ is Q^CQ^D, which results in exports of Q^C Q^D.

Exhibit 2. Excess Demand, Excess Supply, Imports and Exports