Transcript International Issues

International Issues
Trade between Countries
• Countries engage in international trade for
two basic reasons.
– Countries trade because they are different from
each other.
• Nations can benefit from their differences by
reaching an arrangement in which each does the
things it does relatively well.
Trade between Countries
• Countries engage in international trade for
two basic reasons.
– Countries trade in order to achieve economies
of scale in production.
• When a country produces only a limited range of
goods, it can produce each of these goods at a larger
scale and hence more efficiently than if it tried to
produce everything.
Trade between Countries:
Theories
• Economists use theories or models to
understand and explain why global trade
works.
• We will consider the following theories:
– Absolute Advantage
– Comparative Advantage
Advantage: Absolute and
Comparative
• A country is said to have an absolute
advantage when it can produce a good more
efficiently than another country.
• A country is said to have a comparative
advantage when it can produce a good
relatively more efficiently than another
country.
– Relatively more efficiently means at a lower
opportunity cost.
Comparative Advantage
• Trade does not require that a country have
an absolute advantage in the production of a
good or service.
• The principle of comparative advantage
states that countries specialize in those
goods in which they are relatively more
efficient.
Comparative Advantage
U.S.A.
Labor needed to make a computer
Labor needed to make a ton of wheat
Japan
100
120
5
8
Assume that in both the USA and Japan 120,000 worker hours are spent
making computers, and 120,000 worker hours are spent growing wheat.
This means that Japan will produce 1,000 computers and 15,000 tons of
wheat while the USA produces 1,200 computers and 24000 tons of wheat.
U.S.A.
Japan
Computers
1,200
1,000
Wheat
24,000
15,000
Comparative Advantage
• The USA produces more of both products
using the same number of labor hours. The
USA has ??????
Comparative Advantage
• Japan however has a comparative advantage
in the production of ???????
• Computers
– Japan is 83% as productive as the USA in the
production of computers, but only 62.5% as
productive in the production of wheat.
• 1000/1200=0.833 and 15000/24000=0.625
Comparative Advantage
Conclusion
• If both countries specialize in their areas of
comparative advantage and trade, both will
be better off.
Comparative Advantage
• Let the USA devote 200,000 worker hours
to producing wheat, and the remaining
40,000 worker hours to computers.
– Production of wheat increases by 16,000 to
40,000
• 200,000/5=40,000
– Production of computers falls by 800 to 400
• 40,000/100=400
Comparative Advantage
• Let Japan devote 220,000 worker hours to
producing computers, and the remaining
20,000 worker hours to wheat.
– Production of computers increases by 833 to
1,833
• 220,000/120=1,833.33
– Production of wheat falls by 12,500 to 2,500
• 20,000/8=2500
Comparative Advantage
• The point of the example is that world
output has increased!
• Computers increase from 2,200 to 2,233
• Wheat increases from 39,000 to 42,500
• The gains from specialization and trade are
an extra 33 computers and 3,500 tons of
wheat
• If the countries trade, both will be better off.
Determinants of Comparative
Advantage
• Natural Endowments
– Countries with soil and climate that are
relatively better for grapes than for pasture will
produce wine; countries with soil and climate
that are relatively better for pasture than for
grapes will produce sheep.
– This idea, called geographical determinism,
has been outdated by developments in the
modern world.
Determinants of Comparative
Advantage
• Acquired Endowments
– Countries that save, invest and accumulate
capital can acquire a comparative advantage in
goods that require large amounts of capital in
their production.
– Countries that devote resources to education
can develop a comparative advantage in the
production of goods that require a skilled labor
force.
Determinants of Comparative
Advantage
• Specialization
– Specialization can create comparative
advantages between countries that are similar in
all other respects.
• Specialization increases productivity. When
countries specialize in different but similar products,
they can enhance or develop a comparative
advantage.
– One country can specialize in luxury cars while another
country specializes in economical cars.
Dynamic Comparative
Advantage
• Comparative advantage can change over
time.
– Dynamic comparative advantage describes
changes in comparative advantage which occur
because of investment in human capital and in
technology.
• A country may have a comparative advantage in a
good it has recently developed, but when
technology spreads to other countries, the first
country must move on to something else.
Conclusions:
• Countries trade with each other because they
can benefit economically from their
differences and because of economies of scale.
• The principle of comparative advantage states
that countries specialize in those goods in
which they are relatively more efficient.
• Trade requires only that a country have a
comparative advantage.
The Role of Government
• Direct Intervention
–
–
–
–
–
Tariffs
Subsidies
Quotas
Voluntary Exchange Restrictions
Local Content Requirements
Instruments of Direct
Intervention
• Tariffs
– A tariff is a duty or tax placed on an import
• Subsidies
– A government payment to a domestic producer
– Examples: cash grants, low interest loans, tax
breaks.
Instruments of Direct
Intervention
• Quotas
– A quota is an administrative device to limit
trade
• Voluntary Export Restraint
– Quota on trade imposed by the exporting
country.
• Local Content Requirements
– Rules that specify that some specific fraction of
the good be produced domestically.
Tariffs and Subsidies
Price
Supply 2
Supply 1
Price
Supply 1
Tariff
Supply 2
P2
P1
Subsidy
P1
P2
Demand
0
Q2 Q1
Tariffs
Quantity
Demand
0
Q1 Q2
Subsidies
Quantity
Quotas
Price
Quota
P2
Supply
Demand 2
P1
Demand 1
0
Q1
Q2
Quantity
Exchange Rates
• An exchange rate is the price of one
currency in terms of another.
• Exchange rates are important because
exports, imports and all international
financial transactions are affected by the
prices at which currencies exchange for one
another.
Explaining Exchange Rates with
Purchasing Power Parity
• Purchasing power parity explains how price
differentials between countries affect
exchange rates
– Purchasing power parity says that when the
prices charged for essentially the same goods
in different countries diverge, exchange rates
will move in the opposite direction and equalize
the effective prices between the two countries.
Purchasing Power Parity:
Example
• Assume that the U.S. and Canada produce
identical bushels of wheat and that the
exchange rate is $1.00 Canadian for $1.00
USA.
• Let the price of wheat in Canada be
$3/bushel and the price of wheat in the USA
be $2.50/bushel.
• What will happen?
Purchasing Power Parity:
Example
• Canadians will buy U.S. wheat. In order to
do this, they must first buy U.S. dollars.
– Supply of Canadian dollars in the global
marketplace increases.
– Demand for U.S. dollars in the global
marketplace increases
• The Canadian dollar depreciates and the U.S dollar
appreciates.
Purchasing Power Parity: Example
• The price of U.S. wheat increases for
Canadians for two reasons.
– The dollar has appreciated.
– The increase in demand for U.S. wheat pushes up
its price.
• The decrease in demand for Canadian wheat
pushes down its price.
• Over time these effects combine to bring about
a single price for U.S. and Canadian wheat.
Explaining Exchange Rates with
Interest Rate Parity
• Interest rate parity says that the higher
domestic real rates of interest are relative to
foreign real interest rates, the higher will be
the value of the domestic currency, other
things remaining the same.
Interest Rate Parity: Example
• Assume that U.S. real interest rates are higher
than those in other countries.
• The high rates of return on U.S. financial
assets attract foreign buyers.
– In order to buy U.S. financial assets, foreigners
must first buy dollars.
• The demand for dollars increases in the global marketplace
and the dollar appreciates.
• The supply of the foreign currency increases in the global
marketplace and it depreciates.
Other Exchange Rate
Determinants
• Productivity
– Technical innovations that increase productive
efficiency increase the demand for that
country’s currency, pushing up its value.
• Preferences for domestic vs. foreign goods
– If we favor foreign goods over domestic, the
supply of our currency increases, pushing down
its value.
Other Exchange Rate
Determinants
• USA Income or GDP
– Higher GDP raises the demand for imports;
thus, increasing the supply of dollars available
in the world.
– As the availability of dollars increases, other
things remaining the same, the exchange rate
falls.
Other Exchange Rate
Determinants
• Rest of the World Income
– Higher ROW income raises the demand for
USA exports; thus, increasing the demand for
dollars in the world.
– As the demand for dollars increases, other
things remaining the same, the exchange rate
rises.
• Monetary Policy
Monetary Policy
• Monetary policy is conducted by the Federal
Reserve.
– The Federal Reserve is our central bank. It is an
independent agency, created by Congress in 1913 when
they passed the Federal Reserve Act.
• Monetary policy is the attempt by the Federal
Reserve to influence economic activity by
changing the rate of growth of the money supply.
– Interest rates are often targets of monetary policy.
The Money Supply and Trade
Deficits
• When the Fed decreases the rate of
growth in the money supply, interest rates
tend to rise.
• If the increase in interest rates causes our
rates to be more attractive than the rates
prevailing in other countries, funds will
tend to move to the USA.
The Money Supply and Trade
Deficits
• The increase in demand for U.S. securities
causes the demand for the U.S. dollar to
increase.
– As the dollar appreciates, net exports fall
The Money Supply and Trade
Surpluses
• When the Fed increases the rate of growth in
the money supply, interest rates tend to fall.
• If the decrease in interest rates causes our rates
to be less attractive than those in other nations,
funds will move out of the U.S.A.
• The decrease in demand for U.S. securities
leads to a decrease in demand for the dollar.
– As the dollar depreciates, net exports rise.
• Expansionary monetary policy can be
associated with a positive change in the trade
balance.
Conclusion
• Exchange rates are important determinants of the
balance of trade.
• Exchange rates are determined in the long run by
price differentials between countries as well as
changes in tastes and preferences and productivity.
• Exchange rates are determined in the short run by
interest rate differentials between countries.
• Monetary policy changes interest rates and as a
result has an impact on exchange rates and trade
between nations.