Notes: International Economics
Chapter 37:International Trade
- One country has an absolute advantage over another in the production of a particular good if it can produce that good using smaller quantities of resources than the other country.
- According to the law of comparative advantage, one country has a comparative advantage over another in the production of a particular good relative to other goods if it produces that good least inefficiently as compared with the other country. If each country specializes in producing the good it does comparatively best (i.e. with the lowest opportunity cost), total output will be greatest overall.
Output Question:Number of Apples and Oranges Produced
GoodsCountry ACountry B
Apples5010
Oranges10040
Country A has an absolute advantage in both apples and oranges, but a comparative advantage in apples. The opportunity cost of producing 1 apple for Country A is 2 oranges whereas the opportunity cost of producing 1 apple for Country B is 4 oranges. The opportunity cost of producing 1 orange for Country A is ½ apple whereas the opportunity cost of producing 1 orange for Country B is 1/4th apple. Thus, Country A should produce apples and Country B should produce oranges and each trade for the other.
Input Question:Days to Produce Two Goods
GoodsCountry ACountry B
Cars8 days15 days
Airplanes10 days12 days
Country A has an absolute advantage in both car and plane production, but a comparative advantage in car production. The opportunity cost of producing 1 car for Country A apple is 4/5th plane whereas the opportunity cost of producing 1 car for Country B is 5/4th plane. The opportunity cost of producing 1 plane for country A is 5/4th car whereas the opportunity cost of producing 1 plane for Country B is 4/5th car. Thus, Country A should produce cars and Country B should produce planes.
- Through free trade and the principle of comparative advantage, the world economy can achieve a more productively and allocatively efficient allocation of resources and a higher level of material well being.
4. Equilibrium world price is determined by interaction of world supply and demand, it is the price that equates the quantities supplied and demanded globally.
5. Two common trade barriers are tariffs, which are excise taxes on imported goods. A protective tariff is intended to protect domestic producers from foreign competition. An import quota is a legal limit on the amount of a good that may be imported. The effect of tariffs or quotas on free trade is exhibited in the graph below:
A tariff that increases the price of a good from Pw to Pt will reduce domestic consumption from d to c. Domestic producers will be able to sell more output (b rather than a) at a higher price (Pt rather than Pw). Foreign exporters are injured because they sell less output (bc rather than ad). The brown area indicates the amount of tariff paid by domestic consumers. An import quota of bc units has the same effect as the tariff except the amount represented by the brown area will go to foreign producers rather than to the domestic government.
6. Who wins and who loses from tariffs and quotas?
a)Consumers in the importing country lose other way as both impose tariffs/quotas result in higher prices for products than before on both foreign and domestic production.
b)Domestic producers not subject to the tariff or quotas are winners as they receive higher prices and expanded sales than before.
c)All foreign producers are hurt by tariffs as the tax raises prices, but not profits (usurped by the importing country’s government) and reduce sales. With quotas, the exporters who manage to enter the market benefit from higher prices in the foreign market; however, all the exporting country’s firms are hurt at home as prices fall and output is restricted.
d)The importing country’s government gains from the tariff revenue, which is a transfer payment that may reduce taxes or pay for other social programs.
e)In theory, the world is hurt as foreign countries earn fewer dollars due to trade barriers and will buy fewer U.S. exports, reducing free trade and distorting comparative advantages that countries enjoy. Note that under free trade, world prices were lower and world production greater.
f)Finally, the importer may be hurt when the exporter retaliates and imposes its own tariffs. Trade wars may result in an inefficient use of resources and sacrifice of comparative advantage of specialization and free trade.
Chapter 38:Exchange Rates, the Balance of Payments, and Trade Deficits
- A nation’s balance of payments shows all the payments a nation receives from foreign countries and all the payments it makes to them.
U.S. Balance of Payments, 2009 (in Billions)
Current account
1. U.S. goods exports$+1046
2. U.S. goods imports-1563
3. Balance on goods$-517
4. U.S. exports of services+509
5. U.S. imports of services-371
6. Balance on services+138
7. Balance on goods and services-379
8. Net investment income+89
9. Net transfers-130
10. Balance on current account-420
Capital and financial account
Capital account
11. Balance on capital account-3
Financial account
12. Foreign purchases of assets in the U.S.+435
13. U.S. purchases of assets abroad-237
14. Balance on financial account+198
15. Balance on capital and financial account+195
$-225
- U.S. trade in currently produced goods/services is called the current account.
a)U.S. exports have a plus (+) sign because they are a credit; they create a foreign demand for dollars, and the fulfillment of this demand increases the supply of foreign currencies owned by U.S. banks and available to U.S. buyers.
b)U.S. imports have a minus (-) sign because they are a debit; they create a domestic demand for foreign currencies and the fulfillment demand reduces the supplies of foreign currencies held by U.S. banks and available for U.S. consumers.
c)The balance on the current account shows all debits and credits in the current account. Within this larger category is the trade balance (item 3) and balance on goods and services (item 6)
d)
- The capital account summarizes the flows of payments (financial capital) from the purchase or sale of real or financial assets.
a)Foreign purchases of asset in the U.S. represent an impayment of foreign currencies and have a (+) sign.
b)U.S. purchases of assets abroad represent an outpayment of foreign currencies from the U.S. and have a (-) sign.
c)The balance on the capital account shows all debits and credits in the capital account.
- The official reserves are quantities of foreign currencies held by central banks and which can be drawn on to make up any net deficit in the combined current and capital account. Through the mechanism of official reserves, the balance of payments will be zero.
a)A drawing down of official reserves (which is shown as a positive official reserves entry in the balance of payments) measures a nation’s balance of payments deficit.
b)A building up of official reserves (which is shown as a negative official reserves entry in the balance of payments) measures a nation’s balance of payments surplus.
5. Flexible or floating exchange rates are determined by supply and demand without government intervention.
a)A nation’s currency is said to appreciate when exchange rates change so that a unit of its own currency can buy more units of foreign currency.
Example: in March of 2008, $1 = £0.50 or £1= $2.00
if in March of 2008$1 = £0.65 or £1= $1.53
Then the pound has depreciated relative to the dollar i.e. the pound can buy less dollar.
b)A nation’s currency is said to depreciate when exchange rates change so that a unit of its own currency can buy fewer units of foreign currency.
Note: if the dollar appreciates relative to the pound the pound must depreciate relative to the dollar.
- Market Determines of Exchange Rates
In general, in the supply and demand graph, a currency will appreciate if the demand for the currency increases or the supply of the currency decreases. A currency will depreciate if the demand for the currency decreases or the supply of the currency increases. The following are specific market determinants that will cause a currency to appreciate or depreciate.
a) changes in product preferences: if consumers desire goods from a foreign country (e.g. avocados from Mexico) then exports will increase, demand for that country’s currency will increase and the foreign currency – pound – would appreciate.
b) change in relative income (output effect): if the growth of a nation’s income exceeds that of another nation, then its currency depreciates. If the U.S. RGDP > Britain’s RGDP => imports will increase => demand for foreign currency (pound) will increase => U.S. dollar depreciates
c)relative price levels (price level effect):
i)if U.S. prices rise faster than foreign prices => imports are relatively cheaper => imports will rise => demand for foreign currency (pound) will rise => U.S. dollar depreciates
ii)if U.S. prices rise faster than foreign prices => U.S. exports are relatively expensive => exports will fall => demand for U.S. dollar will fall => U.S. dollar depreciates
d)relative real interest rates (interest rate effect): If U.S. real interest rates increase, international investors seeking the highest rate of return for their investment will increase their demand for dollar-denominated assets, thereby increasing the demand for dollars in foreign exchange markets. Thus, the U.S. dollar will appreciate. If U.S. interest rates are relatively lower, the dollar will depreciate as foreigners demand fewer U.S. bonds.
e)Speculation: Currency speculators will buy and sell currencies in the hope of reselling/repurchasing at a profit. If speculators feel a currency (e.g. pound) will depreciate (due to an unstable economy, forecast of a recession, etc.) those holding pound will begin to convert them to dollars before they lose value increasing the supply of pound and demand for dollars, thus depreciating the pound before the market forces begin. In many ways this is akin to a bank run or a stock market crash.
- Flexible Exchange Rates and Balance of Payments
See graph below: If the demand for pound increases, but the exchange rates are fixed at $2.00 = £1.00, a balance of payment deficit (ab) will occur. U.S. consumers demand Q2 pound, but the supply is fixed at Q1. Thus, a shortage of pound exists. With flexible exchange rates, the dollar would depreciate to the new equilibrium where $3.00 = £1.00, imports would be more expensive and quantity demanded for British imports would fall, resulting in less demand for pound.
British TV at £100 would be $200 with an exchange rate of $2.00 = £1.00.
British TV at £100 would be $300 with an exchange rate of $3.00 = £1.00.
At the same time, U.S. exports to Britain would become cheaper if the dollar depreciated and quantity demanded for U.S. exports would rise, resulting in more supply of pound.
U.S. wine at $10 bottle would be £5 with an exchange rate of $2.00 = £1.00.
U.S. wine at $10 bottle would be £3.33 with an exchange rate of $3.00 = £1.00.
- Fixed Exchange Rates: a predetermined rate set by the government at which currencies are exchanged. In the above example, if the dollar were fixed at £1.00 = $2.00 or $1.00 = £0.50 after the demand for the pound increased, how could the U.S. maintain this over currency deficit?
1)use of official reserves of foreign currency (pound) accumulated over time or sell gold to Britain in exchange for pound in order to increase the supply of pound to meet the higher demand. The problem is that if persistent deficits exist, a nation cannot maintain a fixed exchange rate as reserves become exhausted (especially, if speculators, sensing this inevitable depreciation of the dollar in this case, begin selling dollars for pound).
2) The U.S. could respond to the shortage of dollars by discouraging imports (thereby reducing the demand for pound) with trade barriers (tariffs/quotas) or encouraging exports (thereby increasing supply of pound).
3)The U.S. could implement contractionary fiscal/monetary policies that would do the following:
i)reduce income/RGDP => imports would fall => demand for pound falls
ii)reduce U.S. prices => British imports would be more expensive => imports would fall => demand for pound would fall => while exports to Britain would be cheaper => exports would rise => supply of pound would increase
iii)higher interest rates => supply of pound would increase as British investors buy U.S. bonds
4)A devaluation is a reduction in the official value of a currency whereas a depreciation reflects the interaction of supply and demand. In this case, the U.S. government could officially devalue the dollar so that $3.00 = £1.00.
Note: a revaluation is an increase in the official value of a currency (contrast with appreciation)