International Economics

BBA 2401, Principles of Macroeconomics 1

Learning Objectives Upon completion of this unit, students should be able to:

1. Describe the gains that trade brings. 2. Discuss the arguments in favor of trade restrictions. 3. Explain how the balance of payments works. 4. Discuss foreign exchange rates and markets. 5. Describe the development of the international monetary system. 6. Describe the worldwide variation in economic vitality. 7. Discuss international trade and development. 8. Describe the role of foreign aid in economic development.

Written Lecture The Gains from Trade People exchange goods with those in other nations for the same reasons they exchange goods with other people in their own nation—because they believe they will be better off as a result. Individuals gain by specializing in the production of one thing, selling their output for money, and using the money to buy the goods and services they want. Similarly, nations specialize in production and sell the goods they specialize in for goods in which they do not specialize. There is one difference between individuals who specialize and nations that specialize. Individuals often specialize completely and produce none of the goods they buy; nations often produce some of almost all goods but not enough to satisfy domestic demand for some goods. Suppose a worker in the United States can produce either ten units of wheat or five units of cloth per day, and a worker in Britain can produce either five units of wheat or three units of cloth per day. The U.S. worker is more productive than the British worker in either case, so the United States has an absolute advantage in producing both commodities. However, trade is based on comparative, not absolute, advantage. The opportunity cost of a unit of wheat in the United States is 1/2 unit of cloth, and the opportunity cost of a unit of cloth is two units of wheat. In Britain, the opportunity cost of a unit of wheat is 3/5 unit of cloth, and the opportunity cost of a unit of cloth is 5/3 units of wheat. Hence, the opportunity cost of wheat is lower in the United States than in Britain (1/2 < 3/5), and the opportunity cost of cloth is lower in Britain than in the United States (5/3 < 2). The United States has a comparative advantage in wheat and Britain has a comparative advantage in cloth. The different opportunity costs in the two countries mean that world production of wheat and cloth can increase if each country specializes in the commodity that it can produce more cheaply. If the United States produces 1 less unit of cloth, it can produce two additional units of wheat. If Britain produces one less unit of wheat, it can produce 5/3 additional units of cloth. So the United States produces 1 less unit of cloth, Britain produces an additional 5/3 units of cloth, and, on net, there is 2/3 unit of cloth more than before. Similarly, Britain

Reading Assignments Chapter 18: International Trade Chapter 19: International Finance Chapter 20: Economic Development Supplemental Reading See information below. Learning Activities (Non-Graded) See information below. Key Terms 1. Balance on goods

and services 2. Developing countries 3. Dumping 4. Exchange rate 5. Fixed exchange rates 6. Flexible exchange

rates 7. Foreign aid 8. General Agreement

on Tariffs and Trade (GATT)

9. International Monetary Fund (IMF)

10. Managed float system

11. Net investment income from abroad

UNIT VIII STUDY GUIDE International Economics

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produces one less unit of wheat, but the United States has produced two additional units of wheat. On net, the world now has one additional unit of wheat and 2/3 additional unit of cloth. Since world production is greater when each country specializes, it is possible for residents of each country to consume more with trade than without. Suppose each country has 100 workers (and consumers). Exhibit 1 presents the production possibilities schedule for each country, and Exhibit 2 illustrates the production possibilities frontier (PPF) of each. The PPF for the United States is line AB, with a slope equal to the opportunity cost of cloth in the United States, and the PPF for Britain is line CD, with a slope equal to the opportunity cost of cloth in Britain. The price of a unit of cloth in the United States is two units of wheat, but the price of cloth in England is 5/3 units of wheat. Trade is beneficial to both as long as they trade cloth at a price that is between the domestic prices without trade. That is, both can benefit if wheat can be exchanged for cloth at a rate that is more than one. 67 (5/3) but less than two. Suppose the exchange ratio, or terms of trade, is 1.8 units of wheat per unit of cloth. Without trade, in the United States two units of wheat had to be given up to get a unit of cloth. Now the United States can completely specialize and

(McEachern, W. A., 2012)

(McEachern, W. A., 2012)

12. Net unilateral transfers abroad

13. Privatization 14. Purchasing power

parity (PPP) theory 15. World Trade

Organization (WTO)

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produce 1,000 units of wheat, and exchange wheat for cloth at a rate of 1.8 instead of 2. Exhibit 3 presents the consumption possibilities schedules when the rate of exchange is 1.8 units of wheat for one unit of cloth and the United States produces wheat while Britain produces cloth. Exhibit 2 also shows the consumption possibilities frontiers: AB´ in the United States and C´D in Britain. Each country is able to consume more of both commodities than it could when it did not trade. Exchange among nations can be beneficial when the nations involved differ in resource endowments. Resources are not equally distributed among countries. Some countries have more oil than others; other countries have more skilled labor. Countries with a relatively large supply of skilled labor have a comparative advantage in producing goods that require skilled labor. Exchange can also be beneficial if there are differences in tastes among nations. Further, exchange can occur if there are economies of scale so that specialization generates lower production costs. Trade Restrictions When demand curves slope down consumers receive a surplus since some units of the good are purchased at a price lower than the maximum consumers were willing to pay. Similarly, when supply curves slope up producers receive a surplus since some units of the good are sold at a prices above the minimum suppliers had to receive to produce the units. Both producers and consumers usually obtain surpluses in market exchange. Even though the gains from trade exceed the losses from trade, restrictions on trade are ubiquitous. The two major types of trade restrictions are import tariffs and import quotas. Both have the effect of raising price in the domestic economy above the world price. A tariff raises price directly, since an import tariff is a tax on imports. Import quotas raise prices indirectly by restricting the quantity of imports. Their effects are almost identical to those of a tariff. Exhibit 4 illustrates the effects on imports of tariffs and effective quotas. Domestic demand and supply of cloth are represented by D and S, respectively. The world price, $5.00, is below the domestic equilibrium price, so in the absence of trade restrictions the relevant supply curve is mnSw. It intersects the demand curve at point v, so domestic quantity demanded is 6,000 units, and 2,000 units is the quantity supplied by U.S. cloth producers.

(McEachern, W. A., 2012)

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The United States imports 4,000 units of cloth. A specific tariff adds $1.00 to the world price, so the new domestic price is $6.00, and the new supply curve is mn´S´w. Quantity demanded falls to 5,000 units, the amount of cloth produced by domestic firms increases to 3,000 units, and imports fall to 2,000 units. Instead of a tariff, the government could have imposed a quota and achieved the same result. A quota equal to 2,000 units of cloth causes the supply curve to shift to mnrS´. In other words, the supply curve shifts out by the quota limit at the world price of $5.00. It intersects domestic demand at f, which implies a price of $6.00. Domestic production increases from 2,000 to 3,000 units, and domestic consumption falls from 6,000 to 5,000 units. The increase in price due to the tariff (or quota) makes consumers worse off. Consumer surplus falls by areas a, b, c, d, and e. Some of the loss to consumers is transferred to other members of society, but the rest of the loss to consumers represents a deadweight loss to society. In Exhibit 5, area a represents a transfer of surplus from consumers to domestic producers and areas c and d represent revenue received by the government as the result of a tariff. (In the case of a quota, areas c and d represent a transfer from domestic consumers to those who obtain the right to import cloth.) The remaining areas, b and e, represent deadweight losses to society of the tariff (or quota). Clearly, the losses from the trade restrictions exceed the gains from the restrictions. Arguments for Trade Restrictions Arguments for trade restrictions are generally expressed in terms of national welfare. Proponents of trade restrictions justify them by using national defense, infant industry, and antidumping arguments. In recent years, proponents in the United States have argued that restrictions are needed to protect U.S. labor from cheap foreign labor. Wages in the United States are considerably higher than wages in many less developed nations, and those in favor of trade restrictions fear that U.S. labor cannot compete with the foreign labor. However, this argument ignores the reason for the higher U.S. wages: labor in the United States is more productive than labor in less developed nations. Thus, many goods can still be produced at lower cost in the United States.

(McEachern, W. A., 2012)

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Balance of Payments A country's balance of payments is a summary statement that reflects all economic transactions between residents of that country and residents of the rest of the world. Balance of payments accounts use double-entry bookkeeping, which means that one side of the ledger reflects assets and the other liabilities. Further, the total of all liabilities must equal the total of all assets. Thus, the balance of payments is always in balance. An outflow of payments is entered as a debit, and an inflow of payments is entered as a credit. Exhibit 1 provides balance of payments data for the United States for 2006. Total debits equal total credits, so the overall balance is zero. However, the total of debits at any point above the "bottom line" may exceed or be less than the total of credits. That is, it is likely that segments of the balance of payments will be in deficit and other segments in surplus. In 2006, the merchandise trade balance was in deficit, but the service account was in surplus. The balance on goods and services ran a deficit of $121.6 billion. The balance on current account was also in deficit. Given the nature of double-entry bookkeeping, a deficit in the current account plus a debit entry in the statistical discrepancy implies that the financial account must be in surplus. In 2006, this was the case, because the change in foreign-owned assets in the U.S. exceeded the change in U.S.-owned assets abroad by over $800 billion. Foreign Exchange Rates and Markets Foreign exchange is the currency of another country needed to carry out international transactions. Foreign exchange can be bought in foreign exchange markets. The price is called the exchange rate and can be expressed in two ways. First, the exchange rate can be expressed as the domestic currency price for a unit of the foreign currency. Second, the

(McEachern, W. A., 2012)

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exchange rate can be expressed as the foreign currency price for a unit of the domestic currency. The two exchange rates are reciprocals. That is, if the U.S. dollar price of one British pound is $1.50, then the British pound price of a dollar is 1/1.50, or 0.67 pounds. The foreign exchange market includes the whole world. It consists of a network of telephone and other communication systems that connect large banks in all the major cities. If the exchange rate between the dollar and the franc in Tokyo differs from the exchange rate between the two currencies in New York, then arbitrageurs will buy the currency that is relatively cheap in Tokyo and sell it in New York. Because of arbitrage, exchange rates tend to be the same all over the world. Consider the market for Japanese yen in terms of U.S. dollars. Americans do not desire yens, or other foreign exchange, for the currencies themselves. Instead, they demand foreign exchange because they wish to buy goods or services from foreign countries. Residents of a foreign country want to be paid in their own currency rather than in dollars. Thus, Americans wishing to buy products from Japan must obtain Japanese yen, and Japanese who wish to buy U.S. products must obtain dollars. An increase in demand for foreign goods and services causes a greater demand for foreign exchange. The demand curve for foreign exchange slopes down because at lower exchange rates, other things constant, the dollar price of foreign goods and services falls, Americans buy more goods and services from foreigners, and the quantity of foreign exchange demanded rises. When Americans are demanding foreign exchange, they are also supplying dollars to foreign exchange markets. Hence, in general, the supply of foreign exchange is determined by foreigners wishing to buy dollars. The quantity of foreign exchange supplied to foreign exchange markets usually increases as the exchange rate (defined in dollars) increases. The exchange rate is determined by the intersection of the demand curve for foreign exchange and the supply curve of foreign exchange. The curves are drawn holding other things constant, including domestic and foreign income levels, price levels, interest rates, and expected inflation rates. Exchange rates are flexible when the exchange rate is determined by supply and demand in the marketplace. Exchange rates are fixed when they are set by the government, and central banks intervene in markets to keep rates fixed. Central banks must have a supply of other currencies, especially reserve currencies, to sell in order to keep the exchange rate fixed when the quantity demanded of the foreign currency exceeds the quantity supplied at the fixed rate. Development of the International Monetary System The international monetary system operated on a gold standard from 1879 to 1914. The currencies of all countries were defined in terms of gold, and each country agreed to buy or sell gold at fixed rates. The gold system meant that exchange rates were fixed, but each country's money supply was determined by the flow of gold between countries. World War I and the Great Depression brought about the end of the gold standard. After World War II, the international monetary system operated under the Bretton Woods Agreement. The U.S. dollar was defined in terms of gold, and all other currencies were defined in terms of the dollar. The United States agreed to buy or sell gold at the predetermined rate; countries in the rest of the world used dollars as their reserve currency. For example, under the Bretton Woods system, the French central bank could send British pounds to the Bank of England and receive dollars. In the late 1960s, the dollar became overvalued, and many countries were turning dollars in for gold. The United States stopped converting dollars to gold in 1971. The Bretton Woods system

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collapsed in 1973, and major world economies moved to a managed float system, which allows for occasional central bank intervention to moderate fluctuations in floating exchange rates. Worlds Apart There is a huge disparity in wealth and living standards between the industrial market economies and the economies of developing economies. The World Bank classifies countries as high-income economies, middle-income economies, and low-income economies. The high-income economies are the United States and Canada in North America, the nations in Western Europe, Japan, South Korea, Australia, and New Zealand. The middle-income countries include Russia, Mexico and South America, Eastern Europe, and the Middle East. The low-income countries are most of sub-Saharan Africa, and portions of eastern and southern Asia. A huge part of the world moved from the low- income countries into the middle-income countries as China has had rapid economic growth in recent years. The low-income countries tend to have economies that rely heavily on agriculture. Further, the productivity of the agricultural sector tends to be low. There are a variety of reasons for this—poverty leads to malnutrition and poor education systems. In particular, women often face very limited educational opportunities and are forced to operate on the fringes of the economy. Population growth tends to be high even though infant mortality rates are also high compared to the rest of the world. Productivity: Key to Development A key determinant of economic development is increasing labor productivity. As noted above, labor productivity is low in most poor countries. Labor productivity is enhanced by human and physical capital investments. However, a poor country finds it difficult to set aside the savings necessary in order to make investments in human and physical capital. Children may be involved in labor activities, either on the farm or in factories, which limits their ability to attend school. Unemployment is high in urban areas. Farms are often too small to support even a small family. One result of this is that higher food prices, which normally help farmers, may make farmers in many poor countries worse off because they are net purchasers of food. Some middle-income countries and some countries with high per-capita GNPs are rich in natural resources, especially petroleum. The oil-rich countries still have a difficult time translating the wealth held by the country into an economy that could function well in the absence of oil. Poor countries also are characterized by underdeveloped financial sectors and capital infrastructure. For the latter, investments have to be made and as already noted, the funds for the investments are difficult to obtain. The financial intermediation that people living in the industrial nations take for granted is often lacking in the low-income countries. Additionally, institutions such as the rule of law and well-defined property rights are often lacking. People are less likely to invest if they believe there is a good chance their property will be confiscated by the government or lost in a civil war. International Trade and Development International trade can increase welfare in all countries involved in trade. However, not all citizens benefit from trade, and there usually are some who are harmed by free trade. The low-income countries tend to export primary products—agricultural goods and natural resources. The prices of primary products tend to fluctuate more than the prices of manufactured goods,

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generating substantial risk for the farmers in the poor countries. Further, the industrial countries often protect their farmers from international competition, harming the farmers in the low-income countries. Within the low-income countries, policies are often in place to help people close to the government rather than the poor in the country. Due to the lack of opportunities in many poor countries, educated professionals often emigrate to other countries, depriving the source nation of their services. There have been two main approaches used by low-income countries to try to encourage economic development through trade. The first is known as import substitution. The argument is the country needs to have an industrial sector to develop, and the industrial sector will need protection from the established manufacturing firms in the industrial nations. So, the nations impose tariffs on manufactured goods, trying to give their nascent industries a chance to develop. A serious drawback to this approach is that it does not take advantage of comparative advantage. Shielded from competition, the industries rarely became efficient and able to compete without the aid of the trade protection. The second approach is export promotion, which is a policy of finding comparative advantage and promoting it. Export promotion expands trade rather than constricts trade. A number of nations that have escaped from the low-income classification have followed export promotion policies. Foreign Aid and Economic Development Foreign aid is an international transfer made on favorable terms for the purpose of promoting economic development in the recipient country. Theoretically, foreign aid can provide funds for investing in human and physical capital and in infrastructure, which would enhance the country’s ability to increase labor productivity. Unfortunately, foreign aid in practice often falls short of this ideal. Bilateral aid often has strings attached to the aid, usually in the form of requiring the recipient nation to spend much of the aid in the donor nation. Further, controls on aid have often been weak, with recipient government rulers diverting the funds to themselves instead of to the poor in the nation. One response to these problems is an increase in the involvement of non-governmental organizations involved in development. Transitional Economies The high-income countries in the world primarily rely on markets as the way of organizing the economic order. Resources are owned by individuals and the coordination of economic activity is carried on by market forces—primarily prices and price changes. Many of the nations of Eastern Europe and Western Asia that had either been part of the Soviet Union or one of its satellites are trying to make a transition from a centrally-planned, socialistic economy to a decentralized market economy. The "rules of the game" differ in the two economic systems, which can make the transition difficult. Under socialism, production was carried out by state enterprises. Some of the enterprises made a "profit" and others a "loss." However, the profits and losses were not distributed to the decision-makers of the enterprises. Instead, profits were appropriated by the government and losses were subsidized by the government. That is, socialist enterprises had soft budget constraints. A manager of a steel mill would have a quota to fulfill and would obtain needed resources, such as coal or iron ore, from other enterprises that had quotas. If the manager of the steel mill didn’t receive the necessary coal, he might have to find an alternate source through his personal contacts. Managers often hoarded resources in case of a shortage later on. Production tended to be inefficient when compared to comparable private enterprises in the U.S. or Western Europe.

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Economic coordination was accomplished by central planning. There were prices, but prices usually were not determined by supply and demand. Instead, they were set by committees, often for political reasons. For example, the prices of necessities were kept low to keep people happy. However, the quantities supplied tended to be insufficient for the quantities demanded at those prices and shortages were common. Retail stores often had empty shelves and consumers often waited in long lines for necessities. A person of influence in the Communist Party or a manager of a retail outlet might help friends obtain goods they wanted. When prices are not used to align demand and supply other methods are found such as knowing influential people. Central planning proved to be very inefficient and most of the former socialist economies are trying to develop market systems. This has proven to be more difficult than many people thought it would be. Markets and Institutions Institutions are important in determining whether economic development will take place or not. The right institutions aid and encourage development, but there are institutions that retard development. For example, a system of private property helps development because the incentives provided by private ownership promote a more efficient use of resources. The rule of law encourages development because a person can make investments without fear of government expropriation. On the other hand, a system that relies on knowing people of influence often ends with an inefficient use of resources. In the extreme this system ends with corruption and bribery, raising the costs of any endeavor. The institutions developed in socialist economies do not promote efficiency. A country trying to convert their socialist economy into a market economy has to alter their institutions. Those who prospered under the old institutions resist the change. Custom and convention are harder for a government to change than formal institutions over which it may have direct control. In some of the former socialist countries bribery and corruption are major problems that retard economic development. A movement from socialism to capitalism requires privatization of the state enterprises. Agricultural land that was state owned also has to be privatized. In many places, privatization would include much of the housing stock as well. Two approaches have been advocated and attempted. The big-bang theory is an approach that calls for a swift and broad switch from socialism to markets. The alternate approach is gradualism which argues that the transition from central planning to markets must be gradual and grow from the bottom up. In some situations, privatization happened quickly and favored the people who were the leaders of the government or industry under the former socialist regime. Privatization and the development of efficient markets require certain types of institutions. As noted above, these include private property rights and the rule of law. Other necessary institutions include accounting and information systems, bankruptcy laws, securities markets, a stable currency, political stability, and tax systems that are perceived as fair along with the means to prevent tax evasion. Supplemental Reading Click here to access a PDF of the Chapter 18 Presentation. Click here to access a PDF of the Chapter 19 Presentation.

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Click here to access a PDF of the Chapter 20 Presentation. Learning Activities (Non-Graded) Click on the following link to watch a video on Outsourcing: http://www.swlearning.com/economics/abcvideos/TWB04021501.html Click on the following link to watch a video on The Trade Deficit Hits Main Street: http://www.swlearning.com/economics/abcvideos/WNT05031101.html Click on the following link to watch a video on America and the World Economy: http://www.swlearning.com/economics/abcvideos/TMG03011501.html Click on the following link to watch a video on China as a Superpower: http://www.swlearning.com/economics/abcvideos/GMA05062301.html Non-graded learning activities are provided to aid students in their course of study. This is a non-graded activity, so you do not have to submit it.