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Unit 2: The Global Economy “Is the world really flat?”

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1 Unit 2: The Global Economy “Is the world really flat?”

2 Chapters 6 The U.S. in the Global Economy Chapter 37 International Trade Chapter 38 Exchange Rates, the Balance of Payments, and Trade Deficits

3 Comparative/Absolute Advantage =>Terms of Trade FOREX Balance of Trade

4 Global Trade Issues Outsourcing jobs Illegal immigration – jobs taken Migration for jobs Balance of trade (trade deficit) Environment vs. economic growth Poverty in third world nations – does trade help or hurt?

5 Outsourcing vs. Insourcing

6 Trade Flows Nations are linked by the exchange of: Trade flows = Goods and services [exports (X) and imports (M)] Resource flows = capital (production facilities) and labor move from nation to nation Information and technology flows = info on prices, products, interest rates & investment opportunities; new technology Financial flows = Money for imports, assets, interest on debts & foreign aid

7 Specialization and trade allows consumption possibilities to exceed production possibilities.

8 Name a few things that might limit our production possibilities and push us to seek goods and services from other nations?

9 Resources we don’t produce ourselves Climate and natural resource limitations Lack of skilled labor Lack of low cost labor Lack of capital resources (factories, equipment, technology, etc.)

10 Why Trade? For political reasons To help allies – strengthen relations EX: U.S. and Taiwan in 1950’s To show disapproval or force a change in political policies through embargo or boycott EX: Boycott of S. Africa due to apartheid No trade with China (1949-1972) and Cuba (1950-present)

11 Why Trade? For economic reasons ABSOLUTE ADVANTAGE – when a nation can produce MORE of a good or service with the same or fewer resources EX: Diamonds from S. Africa COMPARATIVE ADVANTAGE – when a nation can produce a good or service at the lowest opportunity cost EX: wheat from U.S.

12 Comparative Advantage Specialization – allows nations with the lowest opportunity cost to do what they do best, then trade Arbitrage – buy low and sell high All participants in a voluntary exchange will benefit Allows total output to increase Illustrated with PPC

13 To the Dry Erase!

14 Avocados Avocados 90 60 Soybeans 24 33 1530 9 19 MEXICOU.S.

15 Comparative Advantage Graph indicates that when self sufficient…… Mexico produces 24 avocados & 9 soybeans when most efficient U.S. produces 33 avocados & 19 soybeans when most efficient To Find Opportunity cost = take max production #, put in fraction & reduce to show ratio

16 Comparative Advantage To Find Opportunity cost for Mexico = take max production #, put in fraction & reduce 60 avocados/15 soybeans is an opportunity cost of 4 tons of avocados for each additional 1 ton of soybeans (1s=4a) AND 15 soybeans/60 avocados =¼ ton soybeans for each additional 1 ton of avocados (1 a = ¼ s)

17 Now find the OC for the U.S. in terms of soybeans and avocados

18 Comparative Advantage To Find Opportunity cost for U.S. = take max production #, put in fraction & reduce 90 avocados/30 soybeans is an opportunity cost of 3 tons of avocados for each additional 1 ton of soybeans (1s=3 a) AND 30 soybeans/90 avocados = 1/3 ton soybeans for each additional 1 ton of avocados (1 a = 1/3 s)

19 Comparative Advantage After determining opportunity cost for each nation – compare them to find the “lowest op cost” – that shows what they should specialize in & trade Mexico has the advantage in avocados (1/4 is less “cost” than 1/3 tons of soybeans) U.S. has the advantage in soybeans (3 is less “cost” than 4 tons of avocados)

20 Gains from trade When Mexico specializes in avocados, they produce 60 tons When the U.S. specializes in soybeans, they produce 30 tons Without trade, the maximum production (by both nations combined) would be: 24 + 33 = 57 tons of avocados (gain of 3 tons) 9 + 19 = 28 tons of soybeans (gain of 2 tons)

21 Castaways – Tom and Wilson Draw a PPC for both Tom Wilson Coconuts 30 20 Fish 40 10 Consumption Tom Wilson 9898 28 6

22 Coconuts 20 30 Fish 9 8 4010 28 6 TomWilson Tom’s C without trade Hank’s C without trade Coconuts

23 Castaways – Tom and Hank Their respective OC One fish One coconut Tom’s OC ¾ C 4/3 F Wilson’s OC 2 C ½ F

24 What are the gains from trade?

25 Gains from Trade Without TradeWith TradeGains ProductionConsumptionProductionConsumption Tom Fish Coconuts 28 9 28 9 40 0 30 10 +2 +1 Wilson Fish Coconuts 6868 6868 0 20 10 +4 +2

26 If Tom gives Wilson 10 fish, and Wilson gives Tom 10 Coconuts, what is the minimum number of fish and coconuts each should take in trade?

27 Wilsons OC of one fish is 2 coconuts. So, he should not accept any trade with Tom where he would give up more than 2 coconuts per fish. (he wants to pay < 2 coconuts per fish.) Tom will reject any deal that requires him to give up more than 4/3 of a fish per coconut. So Voluntary exchange only happens if the “price” is right.

28 Trade Barriers Tariff – tax on imports (revenue & protective) Quota – limit on number of imports Informal barriers – licenses, fees, health inspections, & regulations on transportation Cultural and language differences

29 Protectionism vs. Free Trade Pro Protectionism – National defense (keep tech safe) Avoid dependency on other nations (ex:oil) Protect jobs (keep $$ & jobs at home) Infant industries need time to develop Keep balance of trade (exports = imports)

30 Protectionism vs. Free Trade Pro Free Trade Competition forces producers to lower prices & provide higher quality Trade raises the standard of living for all parties More efficiency when businesses specialize & trade = higher profits for owners Lost jobs are replaced with others Barriers lead to retaliation

31 Balance of Trade Difference between exports and imports (ideal is to have equal amounts; more exports = trade surplus; more imports = trade deficit) Surplus sounds good; deficit sounds bad; but this is not always true U.S. has had a negative trade balance since 1981 – economists do not agree on how serious this is!

32 U.S. Trade Deficit for over 20 yrs

33 Balance of Trade Balance of payments is based on: Credits (value of things sold abroad): Goods & services U.S. securities (Treasury bonds or stocks) Factories or businesses in the U.S. Interest owed to U.S. citizens for investments abroad

34 Balance of Trade Debits (value of things bought from firms abroad) Goods and services Foreign securities (stocks in foreign businesses) Factories or businesses abroad Interest paid to foreign citizens on their investments here

35 Balance of Payments Account There are two main accounts – Current Accounts (CA) & Financial Accounts (FA) previous“Capital Account” If an account is positive it is said to have a surplus; if negative = a deficit The overall account must be balanced (or total zero) CA + FA = zero

36 Balance of Payments Account Current Account (CA) trade in goods & services: Exports of goods & services + (plus) Imports of goods & services - (minus) Financial Account (FA) summarizes trade in assets U.S. assets owned by foreigners + (plus) Foreign assets owned by U.S. - (minus)

37 1999 Changes to BOT Categories Old Current Account became 2 accounts: the “New Current Account” –G & S; Income pmts & receipts and the “New Capital Account” – account to record capital transfers (ex: assets a migrant brings when moving here or debt forgiveness); It is a small account for U.S., but more impt for other nations

38 1999 Changes to BOT Categories Old Capital Account is now the “New Financial account” – trade in assets 2008 Macro AP Exam had question using the terms: “Capital & Current Accounts” which was confusing to students (because they had not learned BOT or learned the new terms & didn’t know the old ones!)


40 Foreign Exchange Rates Exchange rate – price of one currency in terms of another (multiply foreign price by exchange rate to get U.S. price) Fixed rate – rate of exchange stays the same; in past basis was gold Flexible rate (floating) – based on supply and demand for each currency

41 Current Rates of Exchange 1 USD = 0.74 EUREuro 1 EUR = 1.36 USD 1 USD = 76.75 JPY Yen 1 JPY = 0.01 USD 1 USD = 6.38 CNY “wren” or renminbi RMB 1 CNY = ?

42 Foreign Exchange Rates Flexible rates – began in 1971 when U.S. went off the gold standard U.S. imports increased and foreigners were gaining U.S. dollars & exchanging them for U.S. gold Foreign exchange market - wherever one currency is exchanged for another

43 Foreign Exchange Appreciation (strong dollar) – dollar buys more of another currency & results in less expensive imports and more expensive exports (SID) Depreciation (weak dollar) – dollar buys less of another currency & results in more expensive imports and less expensive exports (WES)

44 “Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005 The Market for Yen Quantity of Yen Dollar Price of 1 Yen 0 P QQeQe SySy DyDy THE FOREIGN EXCHANGE MARKET

45 “Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005 P Q Dy Sy Dollar price of one Yen Quantity of Yen 321321 Dollar depreciates Dollar appreciates The Market for Yen THE FOREIGN EXCHANGE MARKET

46 The supply of U.S. dollars is determined by U.S. demand for foreign goods, services and investments. Demand for U.S. dollars is determined by foreign demand for U.S. goods, services and investments.

47 Other countries want U. S. goods when: - Ours are cheaper -Our inflation is less that theirs -Our interest rate is higher -The other country is growing faster These cause the dollar to APPRECIATE The $dollar depreciates when the opposite events occur. I have no idea why I made this purple

48 The supply and demand of FOREX Think of dollars as a commodity with a simple supply/demand curve. Remember—Set the Y axis up like a fraction. The currency that is the denominator is the currency on the X axis. The exchange rate is the cost of the other country’s currency to one for the country in the graph. The quantity is the number that will be demanded and supplied in the world market at that “price”.

49 Foreign Exchange $ price for yen $/Y Yen price for $ Y/$ Qty of yen Qty of $ S D S D Supply of yen from Japanese importers who must exchange them for $$ to buy U.S. goods Demand for yen by U.S. importers who need them to buy Japanese goods

50 Foreign Exchange Causes of S & D change - shifts (leads to exchange rate change): Incomes go up or down (can buy more or less of foreign goods) Tastes Relative price level (inflation in one nation makes foreign goods cheaper) Real Interest Rates (want to earn on financial assets abroad if rates are higher)

51 Foreign Exchange Must practice the supply and demand graphs for exchange rates PRACTICE – PRACTICE – PRACTICE!!!

52 AP Problem Areas – Increasing Questions on the Exam Comparative Advantage problems in FRQ’s FOREX graphs & resulting changes in currency values, export/imports BOT questions

53 53 BALANCE OF PAYMENTS Chapter 38

54 Balance of Payments A nation’s balance of payments is a measure of money inflows and outflows between the United States and the Rest of the World (ROW) -- Inflows are referred to as CREDITS -- Outflows are referred to as DEBITS Transactions include –exports and imports of services, tourist expenditures, interest and dividends received or paid abroad, and purchases and sales of financial or real assets abroad. 54

55 The Balance of Payments is divided into 3 accounts Current Account Capital/Financial Account Official Reserves Account 55

56 Double Entry Bookkeeping Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice -- Ex. U.S. manufacture, John Deere, exports $50 million worth of farm equipment to Ireland.  A credit of 50 million to the current account ( - 50 million worth of farm equipment or physical assets)  A debt of $50 million to the capital/financial account (+ $50 million worth of Euros or financial assets) Notice that the two transactions offset each other. Theoretically, the balance of payments should always equal zero. 56

57 Current Account Balance of Trade or Net Exports -- Exports of Goods/Services –import of Goods/Services -- Exports create a credit to the balance of payments -- Imports create a debit to the balance of payments Net Foreign Income -- Income earned by U.S. owned foreign assets – Income paid to foreign held U.S. assets -- Ex. Interest payments on U.S. owned Brazilian bonds - Interest payments n German owned U.S. Treasury bonds. Net Transfers (tend to be unilateral) -- Foreign aid > a debit to the current account -- Ex. Mexican migrant workers send money to family in Mexico. 57

58 Capital/Financial Account The balance of capital ownership Capital account records the flows of money from the purchase and sale of real and financial assets domestically and abroad. Definitions: real assets = a building or land financial assets = shares of stock Direct investment in the U.S. is a credit to the capital account. -- Ex. The Toyota Factory in San Antonio Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account -- Ex. The Intel Factory in Costa Rica 58

59 Capital/Financial Account Purchase of foreign financial assets represents a debit to the capital account --Ex. Donald Trump buys stock in Petrochina. Purchase of domestic financial assets by foreigners represents a credit to the capital account. -- Ex. China buys stock in NASDAQ 59

60 Official Reserves Account The Federal Reserves holds quantities of foreign currency called official reserves. When adding current account and the capital account, if the U.S. has sent more dollars out than foreign currency has come in, there exists a balance of payments deficit. In this case the Fed credits the account so that it balances. 60

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