economics 2 part

ECO 2302, Principles of Macroeconomics 1

Course Learning Outcomes for Unit VIII Upon completion of this unit, students should be able to:

1. Recognize the sources of the central economic problem.

2. Define the role of supply and demand in determining prices and quantities of goods and services.

4. Discuss the effects of unemployment and inflation on the economy.

6. Discuss the interaction of the federal government and the Federal Reserve Bank in controlling the U.S. economy.

7. Illustrate monetary theory using the supply and demand model.

8. Interpret the international economy through trade interdependences and financial interactions.

8.1 Explain international trade gains and why nations still trade when no country has a comparative advantage.

8.2 Describe how trade restrictions can harm an economy and why they are still used. 8.3 Discuss how the foreign exchange rate is determined using demand and supply curves.

Course/Unit Learning Outcomes

Learning Activity

1 Unit VIII Final Project

2 Unit VIII Final Project

4 Unit VIII Final Project

6 Unit VIII Final Project

7 Unit VIII Final Project

8.1

Unit Lesson Chapter 17 Article: “The Effects of Tariffs and Trade Barriers in CBO’s Projections” Unit VIII Final Project

8.2

Unit Lesson Chapter 17 Article: “The Effects of Tariffs and Trade Barriers in CBO’s Projections” Unit VIII Final Project

8.3 Unit Lesson Chapter 18 Unit VIII Final Project

Required Unit Resources Chapter 17: International Trade Chapter 18: International Finance

UNIT VIII STUDY GUIDE

International Trade and Finance

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In order to access the following resource, click the link below. Fried, D. (2019, August 22). The effects of tariffs and trade barriers in CBO’s projections. Congressional

Budget Office. https://www.cbo.gov/publication/55576

Unit Lesson As you begin Unit VIII, look at the goods around you. You might be reading this lesson on a computer made in China. The carpet beneath your feet may have been made in the United States. The shoes on your feet may have been made in Vietnam. The ability for consumers to purchase such a wide variety of goods at cheaper prices is due to international trade. In Chapter 2, you learned about the gains that can be made when nations are allowed to specialize. The economies of individual nations gain when allowed to specialize, as do all other economies. Recall that the law of comparative advantage suggests that the individual, firm, or nation with the lowest opportunity cost of producing a good should specialize in that production (McEachern, 2019). This means that comparative advantage—one nation, region, or firm producing a good at a lower opportunity cost—is the basis for international trade. To explain why comparative advantage is the basis for international trade as well as how nations benefit from specialization, an examination of the production possibilities frontier is required. Let’s assume that two nations (the Republic of Ruby and the Kingdom of Luna) can produce two goods, food and automobiles. The Republic to Ruby has 100,000 workers. The Kingdom of Luna has 500,000 workers. The production possibilities frontier for both nations are provided below. The information presented is per year, with no trade occurring between the two countries.

The production possibilities frontier for the Republic of Ruby suggests that workers can produce 7,000 units of food per year or 3,500 automobiles per year. If the Republic of Ruby wanted to produce both food and automobiles, workers could be allocated between the two goods to produce at any level on the production possibilities frontier. For the Kingdom of Luna, workers can produce 3,000 units of food each year if all the workers are allocated to food production. Alternatively, the Kingdom of Luna could produce 6,000 automobiles each year if all the workers were allocated to producing automobiles. Finally, a combination of food and automobiles could be produced if workers were allocated between the two, but the maximum amount of production would be the level represented by the production possibilities frontier for the Kingdom of Luna.

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The slope of the respective production possibilities frontier represents the opportunity cost of production. The opportunity cost of producing one more automobile in the Republic of Ruby is 2 units of food (7,000 / 3,500 = 2). The opportunity cost of producing one more automobile in the Kingdom of Luna is 0.5 (3,000 / 6,000 = 0.5). Because the opportunity cost of producing one more automobile in the Kingdom of Luna is lower, the Kingdom of Luna should specialize in producing automobiles. Calculating the opportunity cost of producing one more unit of food is done in the same way. For the Republic of Ruby, the opportunity cost of producing one more unit of food is 0.5 automobiles (3,500 / 7,000 = 0.5). The opportunity cost of producing one more unit of food for the Kingdom of Luna is 2 automobiles (6,000 / 3,000 = 2). Comparing the two opportunity costs suggests that the Republic of Ruby should specialize in producing food. When determining how much each nation should trade, we again have to refer to the opportunity costs. As long as the Republic of Ruby can get 0.5 automobiles for one unit of food, and the Kingdom of Luna can get 0.5 units of food for each automobile, the two nations would be better off specializing.

Why International Specialization Occurs International trade occurs because each nation believes it will be better off by trading with other nations. The information above shows how to calculate the opportunity cost of producing one good over another and how to determine if specialization should occur. The reasons why the opportunity cost is different for different goods within a nation or between nations are many and are addressed below.

Differences in Available Resources The availability of resources causes differences in the opportunity cost of production (McEachern, 2019). For instance, the United States has an abundance of fertile land for growing wheat; whereas, Saudi Arabia has significantly less such land. Specifically, total acreage planted in wheat in the United States in 2019 was 45.2 million acres (National Agricultural Statistics Service, 2019). Saudi Arabia planted only 215,673.6 acres of wheat in 2019 (Mousa, 2019). On the other hand, proven oil reserves in the United States as of the end of 2018 was 43.8 billion barrels (U.S. Energy Information Administration, 2019). Saudi Arabia had significantly more oil in reserve with 267.03 billion barrels at the end of 2018 (Organization of the Petroleum Exporting Countries, 2019). The abundance of land suitable for wheat production in the United States suggests that specialization in wheat production is occurring in the United States. The abundance of oil reserves in Saudi Arabia suggests specialization in oil production is occurring in Saudi Arabia. Much of this specialization is due to climate and the concentration of oil resources. If the United States produces more wheat than it consumes, the remainder can be made available for export. If Saudi Arabia produces more oil than can be consumed domestically, it can export the remainder of the oil.

Economies of Scale When the long-run average cost of production falls as a firm expands operations, economies of scale are achieved (McEachern, 2019). When nations can achieve economies of scale, specialization occurs within that nation. When specialization occurs, nations will begin to produce more of a particular good. When countries are producing at the lowest opportunity cost, they are the most competitive in world markets and can engage more successfully in international trade.

Taste Differences Consumer tastes differ from one region to the next within a country. For example, in Texas, bar-b-que usually refers to beef. In Tennessee, bar-b-que refers to pork.

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Once you begin looking at consumer tastes between nations, we find even more differences. Bird’s nest soup is considered to be a delicacy in China, and fried tarantulas are consumed in Cambodia. Different tastes of consumers lead to specialization of production. As the world’s population continues to migrate from one nation to another, the tastes of consumers travel with them. The demand for goods that are customary in a person’s native country can lead to international trade for those goods.

Variety Think about an economy where you were limited to only the goods that were produced locally. If this were the case, you would not be able to purchase coffee in Maine, lobster in New Mexico, or rice in North Dakota. Today, we have a wide variety of goods to purchase in every area because of trade. Domestic trade increases the selection of goods that are available to purchase by a great amount. Once a nation begins engaging in international trade, the selection grows even more.

Trade Restrictions When trade restrictions are discussed, the impacts of these policies are evaluated in terms of consumer and producer surplus. Producer surplus is defined as the area above the supply curve but below equilibrium price. Consumer surplus is defined as the area below the demand curve but above equilibrium price (McEachern, 2019).

Tariffs

A tariff is a tax on goods being sold. While tariffs can be applied to exports, the discussion of tariffs in this section is focused on imports. McEachern (2019) explains that tariffs can be specific, such as a dollar amount per unit or ad valorem (a percentage of the import price). When a specific tariff is used, the price of the good is increased by the amount of the tariff. For example, let’s assume the supply and demand for wheat in the United States is as shown below.

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The world price for wheat is $5 per bushel. This world price is below the equilibrium price for wheat in the United States. If wheat producers in the United States attempted to sell wheat above the world price, consumers in the United States would just purchase wheat from another nation that was willing to accept $5 per bushel. Where the world price for wheat intersects the supply curve for wheat on a graph indicates the amount of wheat that producers in the United States are willing and able to produce. The amount of wheat produced in the United States is represented by Point a. Where the world price intersects the demand curve indicates the quantity of wheat demanded in the United States (represented by Point b). A specific tariff of $0.10 per bushel being imposed on wheat imports into the United States would raise the world price by $0.10 per bushel in the United States.

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The intersection of the price of wheat in the United States ($5.10) represents the world price of $5 per bushel plus the specific tariff of $0.10 per bushel. Wheat producers in the United States now see a higher price and increase their level of production to Point c. Consumers in the United States now see a higher price and reduce their demand to Point d. Consumer surplus has now decreased as a result of the tariff being imposed, and producer surplus has increased. To evaluate the changes to consumer and producer surplus, we need only focus on the area between the world price and the price in the United States after the tariff was imposed.

Consumer surplus was decreased by the sum of Areas 1, 2, 4, and 5. Revenues of wheat producers in the United States are increased by the Areas 1, 2, and 3. However, producer surplus is only increased by Area 1. Revenues associated with Areas 2 and 3 only go to offset higher marginal costs faced by wheat producers in the United States. Area 2 is a net welfare (producer surplus plus consumer surplus) loss to the economy of the United States because the additional bushels of wheat could have been imported at $5 per bushel instead of $5.10 per bushel. The federal government gets to keep revenues equal to Area 4. This is a loss to consumers. However, McEachern (2019) points out that the government can fund additional services for consumers or lower taxes. Finally, Area 5 is a loss of consumer surplus and does not get redistributed to any sector. That means Area 5 is a loss to the economy due to the tariff being imposed on wheat.

Import Quotas Import quotas limit the total amount of a good that can be imported into a nation and are usually focused on imports from one particular country (McEachern, 2019). While an import quota targets the quantity of a good, ultimately, consumers end up paying a higher price. Tracing the effects of an import quota requires that we start with the supply and demand for a good in a nation. Assume that we are examining the effects of a quota on the wheat industry in the United States. As with the example for tariffs, the hypothetical supply and demand for wheat is as follows.

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The world price for wheat is $5 per bushel. This world price is below the equilibrium price for wheat in the United States. If wheat producers in the United States attempted to sell wheat above the world price, consumers in the United States would just purchase wheat from another nation that was willing to accept $5 per bushel. Where the world price for wheat intersects the supply curve for wheat indicates the amount of wheat producers in the United States are willing and able to produce. The amount of wheat produced in the United States is equal to Point a. Where the world price intersects the demand curve indicates the quantity of wheat demanded in the United States (represented by Point b).

Remember, Point a represents quantity of wheat supplied in the United States by domestic wheat producers. Point a represents the intersection of the world price of wheat and the domestic supply curve for wheat. The quota puts a limit on the total amount of wheat that can be imported into the United States. This quota is represented by the distance between Points a and c. That means Point c is the total amount of wheat that will be supplied to the United States at the world price.

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Also notice that the supply curve for wheat has shifted with the quota to Supply 2. Supply 2 is horizontal at the world price until it reaches Point c. From Point c and beyond, the new supply curve with the quota is horizontal to the original domestic supply curve for wheat (Supply). The point where Supply 2 intersects the domestic demand curve for wheat (Demand) tells us what the new price for wheat is in the United States with the quota in place: $5.05 per bushel. Consumer and producer surplus obviously changed when the quota was enacted. As with a tariff, producer surplus increases and consumer surplus decreases when a quota is applied.

Focusing on the area between the world price for wheat and the domestic price of wheat tells us what specific changes have been made to consumer and producer surplus.

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With the quota, producer surplus is increased by Areas 1 plus 2. Consumer surplus is decreased by Areas 1 plus 2 plus 3. The loss of welfare is represented by Area 3 as consumer surplus is lost here but is not gained by an increase in producer surplus. Analysis of the use of a quota suggests that consumers end up paying a higher price for goods affected by the quota. Further, consumer surplus is decreased when a quota is used, and producer surplus is increased. However, the increase in producer surplus does not offset the decrease in consumer surplus.

Comparing Tariffs and Quotas When either tariffs or quotas are used, domestic consumers pay a higher price. Also, both tariffs and quotas reduce consumer surplus, increase producer surplus, and create a net loss to welfare because the increase in producer surplus does not offset the decrease in consumer surplus. However, there are differences in the outcomes when tariffs are used versus quotas. A tariff can be viewed as a tax on imports. The revenue generated from tariffs is paid to the domestic government, while the revenue generated from the use of a quota goes to the nation that secures the right to sell goods in the domestic market (McEachern, 2019). Because revenues generated from a tariff can be used by the domestic government to fund other services in the domestic market, the domestic economy is worse off with a quota. An example of revenue being redistributed to the economy from the use of tariffs can be found in revenues generated by the trade war between the United States and China. As of February 21, 2019, $12.194 billion had been collected in tariff revenue by the United States (Williams et al., 2019). Because farmers in the United States were economically harmed by this trade war, the federal government of the United States authorized the Market Facilitation Program, Food Purchase and Distribution Program, and the Agricultural Trade Promotion Program to assist these producers (U.S. Department of Agriculture, 2019).

Arguments for Trade Restrictions Trade restrictions are proven to negatively impact total welfare of an economy. McEachern (2019) suggests that it would be more efficient to transfer money from domestic consumers to domestic producers. However, politically, making such a transfer of money would be unpopular. As such, other arguments are made for supporting trade restrictions. These arguments include imposing trade restrictions in the name of things such as national defense, protecting infant industries, antidumping, jobs and income, and protecting declining industries. These arguments are discussed in more detail below.

National Defense Some goods are vital to national defense. Relying on other nations to produce these goods could result in a national security threat. This argument relies on a belief that national defense is more important than efficiency and equity in a market (McEachern, 2019). While the national defense argument can be used, McEachern (2019) points out that the federal government could use trade restrictions and just stockpile the resources. Government subsidies could also be used to promote the production of these goods by domestic firms. Finally, McEachern (2019) acknowledges that technology is ever-changing, and some weapons may quickly become obsolete. Protecting domestic industries that provide resources used in the production of these weapons may be vitally important today but might not be needed in the very near future.

Infant Industries New (infant) industries usually face an average cost curve that falls as output increases (McEachern, 2019). For these industries to expand and become competitive, they may need protection. Trade restrictions can give these new industries time to grow and become efficient enough to compete with international firms.

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The theoretical basis for this argument sounds justified. However, McEachern (2019) asks several thought- provoking questions that can make it difficult to apply that theory. For instance, the question of which new industries are important enough to protect may be difficult to answer. In the not-so-distant past, consumers could drive to a store and rent a movie that was saved on a VCR tape. These consumers would then drive home with the rented movie and watch it on a VCR player that was connected to their television. If the federal government believed that the infant VCR taped movies industry was vital to economic growth in the nation, trade restrictions might have been used to protect this industry. Today, many consumers do not even know what a VCR tape is, much less understand the wide range of emotions experienced when entering a store excited to rent the newest movie on the market only to find that all the copies were already rented. Using trade restrictions would have proven to not be effective as the industry was replaced by streaming videos. The question also is raised regarding when firms are “old enough” to remove the protection (McEachern, 2019). Further, trade restrictions create inefficiencies in a market. After all, the industry is being protected from outside competition, thereby creating less of an incentive to become efficient. As a comparison, with this protection of the infant, the federal government is acting as a helicopter parent to the infant industry. The lower incentive to become efficient could create a situation where the infant industry cannot survive without trade restrictions as a protection.

Antidumping When nations sell a good at a lower price in another country than the price that is charged in the domestic market, the nation is engaging in dumping (McEachern, 2019). Consumers may greatly enjoy the much lower prices they will pay when another nation dumps goods on their nation. However, persistent dumping results in decreases in producer surplus that outweigh the increases in consumer surplus. To ensure that dumping does not occur, the United States enacted the Trade Agreement Act of 1979 (McEachern, 2018). This agreement allows for tariffs to be applied when goods are sold in the United States for less than in the home market or for less than the cost of production. More recently, the World Trade Organization (WTO) allows for tariffs to be used when products are sold for less than their fair market value and when there is material injury to domestic producers (McEachern, 2019).

Jobs and Income Protecting domestic industries in the name of wages and jobs is common. Developed nations can have a much higher wage rate than developing nations. Availability of technology, education levels, laws, and differences in standards of living can account for variations in wage rates. One of the biggest problems with using trade restrictions in the name of protecting jobs and income is that other nations tend to retaliate by restricting imports into their country to save their jobs (McEachern, 2019). As a result, jobs are lost in the export markets and gains from trade do not materialize.

Declining Industries As an established domestic industry ages, it faces the potential of becoming obsolete. Lower-priced imports could hasten the industry being forced out of existence. However, resources in this industry take time to transition to other industries (e.g., workers may need new training or machinery may not be able to be used in another industry). When this occurs, McEachern (2019) suggests that trade restrictions could help the industry stay in operation long enough to transition these resources to other industries. Using trade restrictions can lessen the shock experienced by the economy from losing the industry.

International Finance An important part of a nation’s gross domestic product (GDP) is the value of exports and imports. Due to the importance of this part of the calculation of GDP, accounting for these transactions is crucial. The balance of payments is how economic transactions between a domestic economy and international economies are recorded. These transactions could be for goods and services, real and financial assets, or transfer payments (McEachern, 2019).

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The merchandise trade balance involves subtracting the value of merchandise imports from the value of merchandise exports (McEachern, 2019). Merchandise trade involves only tangible products such as cheese made in France, toys made in China, and wheat grown in the United States. When the United States sells and delivers wheat to another nation, it is considered to be an export. This adds to the merchandise trade balance. The United States importing cheese from France or toys from China would negatively impact the merchandise trade balance. When the value of merchandise that is imported is greater than the value of exported merchandise, the trade balance is in deficit (McEachern, 2019). As of November, 2019, the merchandise trade balance for the United States for 2019 was -$779.251 billion with $1.514 trillion in exports being more than offset by $2.293 trillion in imports (United States Census Bureau, n.d.). Interestingly enough, not all individual industries in the United States show a deficit in the trade balance. For instance, the agricultural sector of the United States economy showed a trade surplus of $4.542 billion for 2019 through the month of November, with $124.835 billion in exports and $120.293 billion in imports (Economic Research Service, 2019). Merchandise trade is only one component of net exports. Remember, net exports are used in the calculation of GDP. Services are also imported and exported. These services could include “transportation, insurance, banking, education, consulting, and tourism” (McEachern, 2019, p. 325). The balance on goods and services is calculated by subtracting the value of goods and services imported from the value of goods and services exported. Investment income can occur for residents of the United States who own foreign assets as well as for residents of foreign nations who own assets in the United States. Income earned from United States residents owning assets in foreign nations adds to the balance of payments. Income earned from foreign residents owning assets in the United States deducts from the balance of payments. The federal government records money that is sent to other nations’ governments or citizens that does not result in the purchase of a good or service as a unilateral transfer. Examples of these unilateral transfers would be the United States federal government providing foreign aid, money sent from workers in the United States to family members in other nations, or donations to foreign charities, just to name a few. Monies sent from the United States to foreign nations are subtracted from the monies received from foreign nations to arrive at the net unilateral transfers (McEachern, 2019).

Foreign Exchange Rates If you have ever traveled outside your home nation, you have experienced foreign exchange rates. For instance, the average currency exchange rate between the United States dollar (USD) and Mexican peso (MXN) was 1 USD to 19.246 MXN in 2019 (Internal Revenue Service, 2020). This means that, on average, when your plane landed in Mexico and you disembarked to begin your vacation, you could exchange 100 USD for 1,924.6 MXN. Then you will go to a vendor to purchase a souvenir and be quoted a price in United States dollars (where you would more than likely take all the Mexican pesos out of your pocket and hold them out to the vendor as if to say you had no idea what they were asking you to pay). Your confusion here was based on not being able to quickly convert the exchange rate between United States dollars and Mexican pesos. Foreign exchange rates show how much a nation’s currency is worth compared to another nation’s currency (McEachern, 2019). These exchange rates are determined by the market participants (households, private financial institutions, and governments, for example) that buy and sell foreign currency based on consideration of the supply and demand for the currencies in question. Foreign exchange rates are constantly changing because the supply and demand for currencies are constantly changing. When residents of the United States travel to Mexico, they must purchase Mexican pesos from the foreign exchange market. The supply of foreign currency is determined by how much foreign residents desire another currency (McEachern, 2019). Residents of Mexico want United States dollars to purchase goods and services in the United States. The Mexican residents will pay for these United States dollars with pesos. Together, the demand and supply for foreign currency determines the exchange rate.

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Currently exchange rates and the fluctuations of those rates can have a large impact on international trade. For instance, assume that the current exchange rate between our two fictional nations, the Republic of Ruby and the Kingdom of Luna, is 1 Republic of Ruby dollar equals 20 Kingdom of Luna dollars. At that exchange rate, the Republic of Ruby purchases 200 rowboats for their limited navy at a total cost of 50 Republic of Ruby dollars (which is equal to 1,000 Kingdom of Luna dollars). Now, assume that next year, the economy of the Kingdom of Luna has grown, and the value of the Kingdom of Luna dollars has increased relative to The Republic of Ruby dollars. In the second year, 1 Republic of Ruby dollar is worth 10 Kingdom of Luna dollars. The Republic of Ruby would now have to pay 100 Republic of Ruby Dollars to purchase the same 200 rowboats worth 1,000 Kingdom of Luna dollars. The reason for the increased cost is because the exchange rate between the Republic of Ruby and the Kingdom of Luna changed. Fluctuations in currency exchange rates can occur for many reasons. Exchange rates may change because of financial reasons. However, political events can also affect exchange rates (Mahapatra & Bhaduri, 2019). These political events could be war, elections that could alter the policy stance of a nation, changes to current monetary or fiscal policies, and so on. When it comes to firms engaging in international business, Reynolds (2017) suggests that fluctuations in exchange rates is one of the most challenging aspects.

References Economic Research Service. (2019). U.S. agricultural trade data update: Total value of U.S. agricultural trade

and trade balance, monthly. United States Department of Agriculture. Retrieved December, 2019, from https://www.ers.usda.gov/data-products/foreign-agricultural-trade-of-the-united-states-fatus/us- agricultural-trade-data-update

Internal Revenue Service. (2020, January 10). Yearly average currency exchange rates. Retrieved on

January 30, 2020, from https://www.irs.gov/individuals/international-taxpayers/yearly-average- currency-exchange-rates

Mahapatra, S., & Bhaduri, S. N. (2019, March). Dynamics of the impact of currency fluctuations on stock

markets in India: Assessing the pricing of exchange rate risks. Borsa Istanbul Review, 19(1), 15–23. https://doi.org/10.1016/j.bir.2018.04.004

McEachern, W. A. (2019). Macro ECON6: Principles of macroeconomics (6th ed.). 4LTR Press. Mousa, H. (2019, April 4). Saudi Arabia: Grain and feed annual 2019 (GAIN Report No. SA1902). United

States Department of Agriculture Foreign Agricultural Service. https://apps.fas.usda.gov/newgainapi/api/report/downloadreportbyfilename?filename=Grain%20and% 20Feed%20Annual_Riyadh_Saudi%20Arabia_4-4-2019.pdf

National Agricultural Statistics Service. (2019, September 30). All wheat acres, United States [Graphic].

United States Department of Agriculture. https://www.nass.usda.gov/Charts_and_Maps/graphics/awac.pdf

Organization of the Petroleum Exporting Countries. (2019). OPEC share of world crude oil reserves, 2018.

https://www.opec.org/opec_web/en/data_graphs/330.htm Reynolds, K. (2017, January 6). 11 biggest challenges of international business in 2017. Hult International

Business School. https://www.hult.edu/blog/international-business-challenges/#currency-rates United States Census Bureau. (n.d.). Trade in goods with world, seasonally adjusted. Retrieved January 30,

2020, from https://www.census.gov/foreign-trade/balance/c0004.html U.S. Department of Agriculture. (2019, May 23). USDA announces support for farmers impacted by unjustified

retaliation and trade disruption [Press release]. https://www.usda.gov/media/press- releases/2019/05/23/usda-announces-support-farmers-impacted-unjustified-retaliation-and

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U.S. Energy Information Administration. (2019, December 13). U.S. crude oil and natural gas proved reserves, year-end 2018. https://www.eia.gov/naturalgas/crudeoilreserves/

Williams, B. R., Cimino-Isaacs, C. D., Fefer, R. F., Hammond, K. E., Jones, V. C., Morrison, W. M., &

Schwarzenberg, A. B. (2019, February 22). Trump administration tariff actions (Sections 201, 232, and 301): Frequently asked questions (CRS Report No. R45529). Congressional Research Service. https://crsreports.congress.gov/product/pdf/R/R45529