How does the global economy work?

The global economy has changed significantly over the past few decades, in the way that it is organised and governed by collaborating nations. These changes have repercussions that not only affect the flow of goods and services between countries, but also the movement of people. As we’ve seen on occasions over the last century, too great a fluctuation in this international economic system can lead to a global economic crisis.

So what exactly is the global economy, how does it function, and how does it affect our lives? Here we take a closer look to help you understand the complexities of the force that governs the modern world!

What is a global economy?

The global economy refers to the interconnected worldwide economic activities that take place between multiple countries. These economic activities can have either a positive or negative impact on the countries involved.

The global economy comprises several characteristics, such as:

• Globalisation: Globalisation describes a process by which national and regional economies, societies, and cultures have become integrated through the global network of trade, communication, immigration, and transportation. These developments led to the advent of the global economy. Due to the global economy and globalisation, domestic economies have become cohesive, leading to an improvement in their performances.
• International trade: International trade is considered to be an impact of globalisation. It refers to the exchange of goods and services between different countries, and it has also helped countries to specialise in products which they have a comparative advantage in. This is an economic theory that refers to an economy's ability to produce goods and services at a lower opportunity cost than its trade partners.
• International finance: Money can be transferred at a faster rate between countries compared to goods, services, and people; making international finance one of the primary features of a global economy. International finance consists of topics like currency exchange rates and monetary policy.
• Global investment: This refers to an investment strategy that is not constrained by geographical boundaries. Global investment mainly takes place via foreign direct investment (FDI).

Why is the global economy important?

We can understand the importance of the global economy by looking at it in relation to emerging markets:

• Economic importance at a micro and macro level: The increase in the world’s population has led to emerging markets growing economically, making them one of the primary engines of world economic growth. The growth and resilience shown by emerging markets is a good sign for the world economy. Before delving into the next point, you need to understand the concept of microeconomics. It refers to the study of the behaviour of households, individuals, and firms with respect to the allocation of resources and decision-making. In simpler terms, this branch of economics studies how people make decisions, what factors affect their decisions, and how these decisions affect the price, demand, and supply of goods in the market. Therefore, from the perspective of microeconomics, some of the largest firms with high market value and a few of the richest individuals in the world hail from these emerging markets, which has helped in the higher distribution of income in these countries. However, many of these emerging countries are still plagued by poverty, and work still needs to be done to work towards eradicating it.
• Long-term world economic outlook: According to financial and economic projections based on demographic trends and capital productivity models, the GDP in emerging market economies in 2019 are likely to keep increasing at a positive rate. According to an emerging markets economic forecast for 2019 conducted by Focus Economics, the economy is set to increase by 7.5% in India, 6.6% in Philippines, 6.3% in China, 5.3% in Indonesia, 5.1% in Egypt, 4.9% in Malaysia, 3.8% in Peru and 3.7% in Morocco.

Who controls the global economy?

Many people think that the global economy is controlled by governments of the largest economies in the world, but this a common misconception. Although governments do hold power over countries’ economies, it is the big banks and large corporations that control and essentially fund these governments. This means that the global economy is dominated by large financial institutions. According to world economic news, US banks participate in many traditional government businesses like power production, oil refining and distribution, and also the operating of public assets such as airports and train stations. This was proven when certain members of the US Congress sent a letter to the Federal Reserve Chairman Ben Bernanke. Here’s an excerpt from the letter:

“Here are a few examples. Morgan Stanley imported 4 million barrels of oil and petroleum products into the United States in June, 2012. Goldman Sachs stores aluminium in vast warehouses in Detroit as well as serving as a commodities derivatives dealer. This “bank” is also expanding into the ownership and operation of airports, toll roads, and ports. JP Morgan markets electricity in California.

In other words, Goldman Sachs, JP Morgan and Morgan Stanley are no longer just banks – they have effectively become oil companies, port and airport operators, commodities dealers, and electric utilities as well.”

How does the global economy work?

The functioning of the global economy can be explained through one word —transactions. International transactions taking place between top economies in the world help in the continuance of the global economy. These transactions mainly comprise trade taking place between different countries. International trade includes the exchange of a variety of products between countries. It ranges all the way from fruits and foods, to natural oil and weapons. Such transactions have a number of benefits including:

• Providing a foundation for worldwide economic growth, with the international economy set to grow by 4% in 2019 (source: World Trade Organisation);
• Encouraging competitiveness between countries in various markets;
• Raising productivity and efficiency across countries;
• Helping in the development of underdeveloped countries by allowing them to import capital goods (machinery and industrial raw materials) and export primary goods (natural resources and raw materials).

What are the effects of global economy?

Nearly every country in the world is in some way affected by things that happen in what may seem at times, like unrelated countries - due to the influence of the global economy. A good example of this is the economic impact that the Brexit vote will have other countries, not only in Europe, but across the globe. Brexit was referendum decision for the United Kingdom to withdraw from the European Union (EU).

The main cause of these effects is economics — based on the production and exchange of goods and services. Restrictions on the import and export of goods and services can potentially hamper the economic stability of countries who choose to impose too many.

The purpose of international trade is similar to that of trading within a country. However, international trade differs from domestic trade in two aspects:

• The currencies of at least two countries are involved in international trade, so they must be exchanged before goods and services can be exported or imported;
• Occasionally, countries enforce barriers on the international trade of certain goods or services which can disrupt the relations between two countries.

Countries usually specialise in those products that they can produce efficiently, which helps in reducing overall manufacturing costs. Then, countries trade these products with other countries, whose product specialisation is something else altogether. Having greater specialisation helps countries take advantage of economies of scale. Economies of scale refer to the proportionate saving in costs gained by an increased level of production. Manufacturers in these countries can focus all their efforts on building factories for specialised production, instead of spending additional money on the production of various types of goods.

Occasionally countries add barriers to international trade. Some of these barriers include trade tariffs (taxes on imports) and trade quotas (limitation on the number of products that can be imported into a country). Trade barriers often affect the economies of the trading countries, and in the long run, it becomes difficult to keep employing such barriers.

What are the benefits of global economy?

There are numerous benefits of a global economy, which include:

• Free trade: Free trade is an excellent method for countries to exchange goods and services. It also allows countries to specialise in the production of those goods in which they have a comparative advantage.
• Movement of labour: Increased migration of the labour force is advantageous for the recipient country as well as for the workers. If a country is going through a phase of high unemployment, workers can look for jobs in other countries. This also helps in reducing geographical inequality.
• Increased economies of scale: The specialisation of goods production in most countries has led to advantageous economic factors such as lower average costs and lower prices for customers.
• Increased investment: Due to the presence of global economy, it has become easier for countries to attract short-term and long-term investment. Investments in developing countries go a long way in improving their economies.

Factors affecting global economy

According to the latest economic news, here are some of the key factors that influence and affect how well the global economy works:

• Natural resources;
• Infrastructure;
• Population;
• Labour;
• Human capital;
• Technology;
• Law.

If you are interested in learning more about the global economy and how it works, Edology offers a Certificate Course for Policy Issues in the Global Economy. Find out more here.