Transcript Topic 8: International Trade

Topic 8: International Trade
Comparative Advantage
Exchange Rates
Absolute Advantage
 Someone has an absolute advantage in producing something
when they can do so more efficiently (using fewer factors of
production, e.g., less labor) than someone else.
 The person or group that is “better” at producing a good has
the absolute advantage in doing so.
Comparative Advantage
 Someone has comparative advantage in producing something
when their opportunity costs of doing so are lower than
someone else.
 Compared to someone else, everyone has a comparative
advantage in the production of something.
 Comparative advantage does not imply absolute advantage.
Things I could do:
 Writing Papers and Teaching
 Farm
 Where is my absolute advantage?
 Where is my comparative advantage compared to others?
Things I could do:
 Writing Papers and Teaching
 Landscaping and yard maintenance
 Remodel my kitchen
 Clean my bathroom
 Where is my absolute advantage?
 Where is my comparative advantage compared to others?
Examples
 The French and Irish can make both wine and beer
Beer
Wine
France
500
1000
Ireland
1000
100
 Who has the absolute advantage in each product?
 Who has the comparative advantage in wine?
 Ireland must give up 10 Beer for each wine
 France must give up 1/2 beer for each wine
 France has lower opportunity cost, thus it has comparative
advantage.
Examples
 The French and Irish can make both wine and beer
Beer
Wine
France
500
1000
Ireland
1000
100
 Who has the comparative advantage in beer?
 Ireland must give up 1/10 Wine for each Beer
 France must give up 2 Wine for each Beer
 Ireland has lower opportunity cost, thus it has comparative
advantage.
Examples
 The Scottish and Irish can make both sweaters and beer
Sweaters
Beer
Scotland
1000
900
Ireland
1300
1000
 Who has the absolute advantage in each product?
 Who has the comparative advantage in sweaters?
 Ireland must give up 10/13 Beer for each sweater
 Scotland must give up 9/10 Beer for each sweater
 10/13<9/10, so Ireland has lower opportunity cost, thus it has
comparative advantage.
Examples
 The Scottish and Irish can make both sweaters and beer
Sweaters
Beer
Scotland
1000
900
Ireland
1300
1000
 Who has the comparative advantage in Beer?
 Ireland must give up 13/10 Sweater for each Beer
 Scotland must give up 10/9 Sweater for each Beer
 10/9<13/10, so Scotland has lower opportunity cost, thus it
has comparative advantage.
Examples
 In Class Exercise
Examples
 Abby, Bruce and Carlos can make cheese and bread
Cheese
Bread
Abby
500
600
Bruce
200
700
Carlos
600
300
 As always with comparative advantage problems in this class,
assume linear PPFs for each producer.
 Who has the absolute advantage in each product
 Carlos has it in Cheese
 Bruce has it in Bread
Examples
 Abby, Bruce and Carlos can make cheese and bread
Cheese
Bread
Abby
500
600
Bruce
200
700
Carlos
600
300
 Who has the comparative advantage in Cheese?
 Abby v. Bruce?  Abby
 Abby v. Carlos?  Bruce
 Bruce v. Carlos?  Carlos
 Carlos > Abby > Bruce
Examples
 Abby, Bruce and Carlos can make cheese and bread
Cheese
Bread
Abby
500
600
Bruce
200
700
Carlos
600
300
 Who has the comparative advantage in Bread?
 Graph the PPF for the economy with trade.
Comparative Advantage Summary
 Use the concept of comparative advantage to argue in favor
of companies moving production from US to China or India.
 Who gains?
 On average, US citizens are better off.
 Are all US citizens better off?
 Consider the exchange of “goods” and “services”. Which does
the US have comparative advantage in compared to most
other countries?
Effects of Foreign Trade on Fiscal Policy
 Benefits of expansionary policy are no longer concentrated in
domestic boarders.
 Might need more aggressive policy to see same effects at
home.
 That is, the effective multiplier might be smaller. If the MPC
is 0.8, an increase in G of 1000 might increase domestic Y by
less than 1000 / (1- 0.8) = 5000. This is because some of the
Y increase takes place in other countries.
Effects of Foreign Trade on Monetary Policy
 For this, we need to consider the foreign exchange market.
 Consider a world with only two countries: USA and UK
 Alternatively, think of UK as “rest of the world”
Demand for Pounds (£) by holders of $
1.
2.
3.
4.
5.
Import UK produced goods and services
Travel to UK
Buy UK financial assets (e.g., stocks, bonds, currency)
Buy UK “direct” investments (e.g., property, capital goods,
firms)
Speculation in currency markets (i.e., expect price of £/$
to increase)
Supply of Pounds (£) in exchange for $
1.
2.
3.
4.
5.
Import USA produced goods and services to UK
Travel to USA
Buy USA financial assets (e.g., stocks, bonds, currency)
Buy USA “direct” investments (e.g., property, capital
goods, firms)
Speculation in currency markets (i.e., expect price of £/$
to decrease)
Graphing Demand for £
 The Price of £ is given in terms of US $, or P=$/£
 Graph Demand for £
 to Import UK Goods and Services
 for tourism to UK
 by currency speculators
 for investment or financial assets in UK
Graphing Demand for £
 Demand for £ for investment or financial assets
Exchange
Rate
Investment
in $
Investment
in £
Return
%
Return
in £
Return
converted
to $
$5/£1
$100,000
£20,000
10%
$2,000
$10,000
$2/£1
$100,000
£50,000
10%
$5,000
$10,000
$1/£1
$100,000
£100,000
10%
$10,000
$10,000
$0.50/£1
$100,000
£200,000
10%
$20,000
$10,000
 So, return is the same independent of exchange rate… But, what
if we expect the exchange rate to decrease or increase during the
course of our investment?
Graphing Demand for £
 If buy $100,000 investment at $5/£1 exchange rate, and
expect to cash in on the investment after exchange rate falls
to $2/£1.
Investment in
$
Investment in
£ bought at
$5/£1
Return %
Return in
£
Return
converted to $ at
$2/£1
$100,000
£20,000
10%
$2,000
$4,000
 If buy $100,000 investment at $1/£1 exchange rate, and
expect to cash in on the investment after exchange rate
increases to $2/£1.
Investment in
$
Investment in
£ bought at
$1/£1
Return %
Return in
£
Return
converted to $ at
$2/£1
$100,000
£100,000
10%
$10,000
$20,000
Foreign Exchange Market
 Graph supply and demand together
 What is the equilibrium exchange rate?
Changes to exchange rate
 When we consider changes to exchange rates we do so
assuming that other things including in-country prices for
goods and services do not change.
 Keeping prices fixed, what happens to exports and imports
when the price of the dollar falls? Exports go up, Imports go
down.
 When the price of the dollar rises? Exports go down,
Imports go up.
 Why? A dollar now buys more or less from other countries.
Other country currency now buys more or less from US.
Changing interest rate
 What happens if interest rate in USA decreases, but remains
unchanged in UK?
 Buying US financial assets becomes relatively unattractive, so
demand for £ increases, and supply of £ decreases. (Graph it)
 Price of £ increases.
 US exports increase, UK exports decrease.
 Therefore: Expansionary monetary policy (to decrease i at
home) can be even more effective with trade, since it not
only increases domestic investment but it also increases
exports.
Primary Effects of Monetary Policy
with Trade
+ΔMS  −Δi  +ΔI  +ΔY

dec. Demand
Fall in
exports go up
inc. Supply  value of  imports down
of US $
US $
−Δ MS  +Δi  −ΔI  −ΔY

inc. Demand
rise in
imports go up
dec. Supply  value of  exports down
of US $
US $
Example 1
 Change in tastes in the USA. Now people like foreign goods
more.
 Supply of $ increases, which decreases the price of $
 This decrease in the price of $ will cause some “2nd order”
increases to US exports & decreases to US imports, but these
will not be as much as the initial changes due to changes in
tastes
Example 2
 Income in US goes up, but not elsewhere.
 Now US has more $ and will buy more including more imports.
 Increased income in the US may also increase prices for US
goods.
 Increased demand for imports will cause supply of $ to increase,
which decreases the price of $
 This decrease in the price of $ will cause some “2nd order”
increases to US exports & decreases to US imports. These may
or may not be enough to overcome initial price increases at
home.
Example 3
 There is an increase in inflation in the US, relative to rest of
world
 Fewer people want to buy US produced goods. Demand for $
decreases, supply of $ increases. Price of $ falls.
 The cheaper $ makes buying US produced goods more
attractive (a 2nd order effect), but not by enough to offset the
initial impact of inflation (a 1st order effect).
Circular Flow
 Draw a circular flow diagram for both the US and UK with
trade between the countries.
Some questions:
 Why do investors care about foreign exchange markets?
 Speculation
 Changes in currency prices effects the expected return on investment
in different locations.
 How could the Federal Reserve increase the “strength” of the
dollar (make the price of dollars go up)?
 Are you personally made better off when the dollar is stronger?
 If you are from abroad and must convert currency to $ to pay tuition?
 If you live in the US and like to travel abroad?
 If you own a consulting company that typically does 75% of its
business in other countries?