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International Economics

U.S. exports of goods and services

14% of GDP in 2011

Services: transportation, insurance, banking, education and tourism

Capital goods: aircraft

Industrial supplies: chemicals and plastics

Consumer goods: pharmaceuticals and entertainment products

Food and automobiles

The Growth in World Trade

U.S. imports of goods and services

18% of GDP in 2011

Industrial supplies: crude oil and refined petroleum products

Consumer goods: pharmaceuticals

Capital goods: computers

Services, autos, and food

The Growth in World Trade

Major U.S. Trading Partners

EXHIBIT 18.1

David Ricardo, comparative advantage

A country or a region should specialize in producing and selling

Those items that it can produce at a lower opportunity cost than other regions or countries

Comparative Advantage & Gains from Trade

Wendy

In one day, can produce:

10 pounds of food

Or 5 yards of cloth

Or any linear combination of the two goods

Opportunity cost of producing 1 yard of cloth:

2 pounds of food

Opportunity cost of producing 1 pound of food:

1/2 yard of cloth

Comparative Advantage & Gains from Trade

Wendy’s Production Possibilities Curve

EXHIBIT 18.2

Cloth (yards per day)

Food (pounds per day)

Calvin

In one day, can produce:

3 pounds of food

Or 4 yards of cloth

Or any linear combination of the two goods

Opportunity cost of producing 1 yard of cloth:

3/4 pound of food

Opportunity cost of producing 1 pound of food:

4/3 yards of cloth

Comparative Advantage & Gains from Trade

Calvin’s Production Possibilities Curve

EXHIBIT 18.3

Cloth (yards per day)

Food (pounds per day)

Absolute advantage

One producer can perform a task using fewer inputs than the other producer

Wendy has an absolute advantage over Calvin in the production of food

Wendy has an absolute advantage over Calvin in the production of cloth

Comparative Advantage & Gains from Trade

Comparative advantage

One person can produce a good at a lower opportunity cost than can another person

Wendy has comparative advantage in the production of food

Calvin has a comparative advantage in producing cloth

Comparative Advantage & Gains from Trade

Absolute and Comparative Advantage

EXHIBIT 18.4

Cloth (yards per day)

Food (pounds per day)

Wendy’s

PPC

Calvin’s

PPC

Specialization according to comparative advantage

Wendy: produce food

Calvin: produce of cloth

Trade

Exchange “price” of 1 pound of food for 1 yard of cloth

Both Wendy and Calvin consume more of the two goods

Comparative Advantage & Gains from Trade

The Gains from Specialization and Trade

EXHIBIT 18.5

Cloth (yards per day)

Food (pounds per day)

Cloth (yards per day)

Food (pounds per day)

Wendy’s PPC

Calvin’s PPC

B′

C′

Nations trade with nations

Both nations can be better off

The greater the difference in opportunity cost between the two trading partners

The greater the benefits from specialization and exchange

Comparative Advantage & Gains from Trade

Consumer surplus

The most a consumer is willing to pay minus what a consumer actually pays

Producer surplus

The lowest price for which a supplier would be willing to supply minus the revenues a supplier actually receives

Supply and Demand in International Trade

An economy with no trade

Equilibrium: PBT and QBT

Determined by the supply and demand

Decides to engage in free trade

If world price > PBT, export

Domestic producers gain more than domestic consumers lose

If world price < PBT, import

Domestic consumers gain more than domestic producers lose

Supply and Demand in International Trade

Free Trade and Exports

EXHIBIT 18.6

Price of Wheat (world)

Quantity of Wheat (world)

SWORLD

DWORLD

PWORLD

World Market

Domestic Market

Price of Wheat (domestic)

Quantity of Wheat (domestic)

SDOMESTIC

DDOMESTIC

PAT

World Price

PBT

QBT

QDAT

QSBT

Net domestic

gain from trade

Exports

QBT

Free Trade and Imports

EXHIBIT 18.7

Price of Wheat (world)

Quantity of Wheat (world)

SWORLD

DWORLD

PWORLD

World Market

Domestic Market

Price of Wheat (domestic)

Quantity of Wheat (domestic)

SDOMESTIC

DDOMESTIC

PAT

World Price

PBT

QSAT

QDBT

Net domestic

gain from trade

Imports

Tariff: a tax on imported goods

Leads to

Smaller total quantity sold

Higher price for domestic consumers

More sales at higher prices for domestic producers

Lower foreign sales

Gains to producers are more than offset by the losses to consumers

Tariffs

Free Trade and Tariffs

EXHIBIT 18.8

Price of Shoes (world)

Quantity of Shoes (world)

SWORLD

DWORLD

World Market

Domestic Market

Price of Shoes (domestic)

Quantity of Shoes (domestic)

SDOMESTIC

DDOMESTIC

SWORLD

PW+T

SWORLD + TARIFF

Q′S

Q′D

Imports before tariff

Imports after tariff

Temporary trade restrictions help infant industries grow

Identifying infant industries

The goal of allowing the industry to reach its efficient size can be reached without protection

The tariffs often linger long after the industry is mature and no longer in need of protection

Arguments for Tariffs

Tariffs can reduce domestic unemployment

The overall employment effects of a tariff imposition are not likely to be positive

Retaliation

Reduce our exports

Thus creating unemployment in the export industries

Arguments for Tariffs

Tariffs are necessary for reasons of national security

Hasten depletion of domestic reserves

Are tariffs necessary to protect against dumping?

Difficult to prove dumping

Foreign countries may simply have comparative advantage

Arguments for Tariffs

Import quota

Legal limit on the imported quantity of a good

Higher prices, Loss in consumer surplus

Loss in government revenue

Rent seeking

Efforts by producers to gain profits from government protections

Tariffs and import quotas

Import Quotas

Free Trade and Import Quotas

EXHIBIT 18.9

Price of Sugar (world)

Quantity of Sugar (world)

SWORLD

DWORLD

World Market

Domestic Market

Price of Sugar (domestic)

Quantity of Sugar (domestic)

SDOMESTIC

DDOMESTIC

SWORLD

PW+Q

SWORLD + QUOTA

Q′S

Q′D

Imports before Quota

Imports after Quota

Free Trade and Import Quotas

EXHIBIT 18.9

Subsidy, to encourage exports

Revenue is given to producers for each exported unit of output

Can distort trade patterns and lead to inefficiencies

Export goods because costs have been artificially reduced by government action

Transfers income from taxpayers to the exporter

Subsidies

Some countries might use methods other than tariffs and import quotes to restrict trade. For example, France might impose quality standards on certain products such as imported wine.

Tariffs, Import Quotas, and Subsidies

Balance of payments

The record of international transactions in which a nation has engaged over a year

The current account

The financial account

Statistical discrepancy

The Balance of Payments

Current account

A record of a country’s imports and exports of goods and services, net investment income, and net transfers

Exports of goods, credit (+)

Imports of goods, debit (-)

Exports of services, credit (+)

Imports of services, debit (-)

The Balance of Payments

Current account

Net transfer payments

U.S. gives foreign aid, debt (-)

Private gifts to foreigners, debt (-)

U.S. humanitarian and military aid, debt (-)

U.S. receives aid or private gifts, credit (+)

Net investment income

U.S. investors hold foreign assets, credit (+)

Foreign investors hold U.S. assets, debit (-)

The Balance of Payments

Current account balance

The net amount of credits or debits after adding up all transactions of goods, services, and transfer payments

If credits exceeds debits

Balance-of-payments surplus on the current account

If debits exceed credits

Balance-of-payments deficit on the current account

The Balance of Payments

U.S. Balance of Payments, 2011 (billions of dollars)

EXHIBIT 18.10

Total deficit on the current account: $466 billion

Balance-of-trade deficit, $739 billion

Surplus in services, $179

Balance of goods and services: $560 billion deficit

Net unilateral transfers, $133 billion

Net investment income, $227 billion

Balance of trade

Net surplus or deficit resulting from the level of export and import of merchandise

The Balance of Payments

U.S. Balance of Trade on Goods, 1975–2011

EXHIBIT 18.11

The financial account

Foreign purchases or assets in the domestic economy (a monetary inflow)

Domestic purchases of assets abroad (a monetary outflow)

A current account deficit

Is financed by a financial account surplus

The Balance of Payments

Statistical discrepancy

Errors and omissions

The balance of payments does balance

The number of U.S. dollars demanded equals the number of U.S. dollars supplied

When the balance of payments is zero

The Balance of Payments

Exchange rate

The price of one unit of a country’s currency in terms of another country’s currency

Demand for foreign currencies

Derived demand - from the demand for foreign goods and services or for foreign investment

Downward-sloping

Exchange Rates

Supply of foreign currency

Provided by foreigners who want to buy the exports of a particular nation

Upward-sloping

Equilibrium exchange rate

Intersection of the supply of and demand for a foreign currency

Exchange Rates

Equilibrium in the Foreign Exchange Market

EXHIBIT 18.12

Dollar Price of Euros

Quantity of Euros

Supply of euros

(U.S. sales

of goods

and services

to Europeans)

Demand for euros

(U.S. purchases of

European goods

and services)

$1.50

$1.25

$1.00

Excess demand

for euros

Excess supply

of euros

Changes in the equilibrium in the foreign exchange market

Any force that shifts either the demand for or supply of a currency

Changes in consumer tastes for goods

Income levels

Relative real interest rates

Relative inflation rates

Speculation

Changes in the Foreign Exchange Market

Increase the demand for euros

Because of an increase in the demand for European goods

And a higher exchange rate for the euro

Increased tastes for European goods

Higher incomes in the United States

Decrease in U.S. tariffs on European goods

Changes in the Foreign Exchange Market

Impact on the Foreign Exchange Market of a U.S. Change in Taste, Income Increase, or Tariff Decrease

EXHIBIT 18.13

Dollar Price of Euros

Quantity of Euros

Supply of euros

$1.00

$1.25

Increase the supply of euros in the euro foreign exchange market

Because Europeans demand more U.S. goods and U.S. dollars

Lower exchange rate for the euro

Increases in European incomes

Reductions in European tariffs

Changes in European tastes

Changes in the Foreign Exchange Market

Impact on the Foreign Exchange Market of a European Change in Taste, Income Increase, or Tariff Decrease

EXHIBIT 18.14

Dollar Price of Euros

Quantity of Euros

Demand

for euros

$1.25

$1.00

Increase in the interest rates in the U.S.

Increase in the supply for euros

Higher rate of return on U.S. investments

European investors increase their demand for U.S. investments

Decrease in the demand of euros

U.S. investors shift their investments away from Europe

Relative appreciation of the dollar

Relative depreciation of the euro

Changes in the Foreign Exchange Market

Impact on the Foreign Exchange Market from an Increase in the U.S. Interest Rate

EXHIBIT 18.15

Dollar Price of Euros

Quantity of Euros

$1.50

$1.25

Europe – higher inflation rate than U.S.

Decrease in the demand for euros

European products - more expensive

Americans: decrease the quantity of European goods demanded

Increase supply of euros

U.S. goods - cheaper to Europeans

Europeans: increase the quantity of U.S. goods demanded

Demand more U.S. dollars

Changes in the Foreign Exchange Market

Impact on the Foreign Exchange Market from an Increase in the European Inflation Rate

EXHIBIT 18.16

Dollar Price of Euros

Quantity of Euros

$1.50

$1.25

Expectations and speculation

If speculators believe that the price of a country’s currency is going to rise

Buy more of that currency

Pushing up the price

Causing the country’s currency to appreciate

Changes in the Foreign Exchange Market

A strong dollar (dollar appreciates)

Good for U.S. consumers

Pay less for foreign currencies

Good for foreign producers

Their sales rise

Bad for domestic producers

Consumers buy more imports and fewer domestic goods

Foreigners buy fewer U.S. exports

Increase in imports, decrease in exports

Changes in the Foreign Exchange Market

A weak dollar (dollar depreciates)

Good for U.S. producers

U.S. goods - relatively less expensive to foreign buyers

Bad for domestic consumers

Bad for foreign producers

Increase in exports and a decrease in imports

Changes in the Foreign Exchange Market