Macro Review Day 5

International Trade Policy, Comparative Advantage, and Outsourcing 9 Balance of Trade Trade deficit = exports < imports Trade surplus = exports > imports The U.S. has a significant trade deficit of approximately $820 billion which is 5.5% of GDP The balance of trade is the difference between the value of exports and the value of imports The U.S. is financing its trade deficit by selling off financial assets, stocks and bonds, and real assets, corporations and real estate 9-2

International Trade Policy, Comparative Advantage, and Outsourcing 9 Debtor and Creditor Nations The U.S. is currently financing its trade deficit by selling off assets The U.S. has gone from a large creditor nation to being a large debtor nation, international considerations have been forced on the nation The U.S. has not always had a trade deficit, following WWII, it had trade surpluses Running a deficit isn’t necessarily bad 9-3

International Trade Policy, Comparative Advantage, and Outsourcing 9 The Principle of Comparative Advantage Opportunity cost is what must be given up in one good in order to get another good The principle of comparative advantage is that as long as the relative opportunity costs of producing goods differ among countries, then there are potential gains from trade 9-4

International Trade Policy, Comparative Advantage, and Outsourcing 9 Output Method If you are trying to calculate the opportunity cost of apples, apples are the denominator unit, and oranges are the numerator (#oranges/#apples). McGraw-Hill/Irwin Colander, Economics 5

International Trade Policy, Comparative Advantage, and Outsourcing 9 Input Method When you are using the input method, the thought process is flipped. When you are trying to calculate the opportunity cost of apples, apples will be the numerator and oranges will be the denominator (apple hours/ orange hours). McGraw-Hill/Irwin Colander, Economics 6

International Trade Policy, Comparative Advantage, and Outsourcing 9 Some Concerns about the Future Transferable comparative advantages are based on factors that can change relatively easily, such as capital, technology, and types of labor Whether a country can maintain a much higher standard of living in the long run depends in part on whether its comparative advantage is inherent or transferable Inherent comparative advantages are based on factors that are relatively unchangeable, such as resources and climate Inherent and transferable comparative advantage 9-7

International Trade Policy, Comparative Advantage, and Outsourcing 9 Varieties of Trade Restrictions Quotas are quantity limits placed on imports Voluntary restraint agreements are when countries voluntarily restrict their exports Tariffs are taxes governments place on internationally traded goods (generally imports) An embargo is a total restriction on the import or export of a good Regulatory trade restrictions are government-imposed procedural rules that limit imports Nationalistic appeals, such as “Buy American” can help to restrict international trade 9-8

International Trade Policy, Comparative Advantage, and Outsourcing 9 S Domestic P Q $2.50 Imports Application: Tariffs when the domestic country is small Tariffs decrease imports, increase domestic production, and generate tariff revenue $3.00 D Domestic P World = S World $2.00 P World + $0.50Tariff = S’ World Imports’ Tariff revenue 9-9

International Trade Policy, Comparative Advantage, and Outsourcing 9 S Domestic P Q $2.50 Imports w/o quota Application: Quotas when the domestic country is small Quotas decrease imports and increase domestic production $3.00 D Domestic P World = S World $2.00 Quota = S’ World Quota =

International Trade Policy, Comparative Advantage, and Outsourcing 9 Why Economists Generally Oppose Trade Restrictions International trade provides competition for domestic companies Restrictions based on national security are often abused or evaded From a global perspective, free trade increases total output Trade restrictions are addictive 9-11

International Financial Policy 36 The Balance of Payments Balance of payments is a country’s record of all transactions between its residents and the residents of all foreign nations These include a country’s buying and selling of goods and services (imports and exports) and interest and profit payments from previous investments, together with all the capital inflows and outflows These accounts record all payments made by foreigners to U.S. citizens and all payments made by U.S. citizens to foreigners in those years 36-12

International Financial Policy 36 The Current Account The current account (lines 1–14) is the part of the balance of payments account in which all short-term flows of payments are listed The balance of merchandise trade is the difference between the value of goods exported and the value of goods imported The balance of trade is the difference between the value of goods and services exported and imported 36-13

International Financial Policy 36 The Financial and Capital Account The financial and capital account (lines 15–25) is the part of the balance of payments account in which all long-term flows of payments are listed 1.The capital account includes debt forgiveness, migrant’s transfers, and transfers related to the sale of fixed assets 2.The financial account includes trade in assets such as business firms, bonds, stocks, and ownership right to real estate Official reserves are government holdings of foreign currencies 36-14

International Financial Policy 36 Exchange Rates An exchange rate is the rate at which one country’s currency can be traded for another country’s currency The exchange rate is determined by demand and supply in the forex market (foreign exchange market) where traders buy and sell currencies The forex markets are very busy with nearly $2 trillion traded every day 36-15

International Financial Policy 36 The Supply and Demand for Euros Price of euros (in $) Euros Supply Demand $1.50 QDQD QSQS $1.30 In the supply of and demand for euros, Price is measured in $ Quantity is in euros QEQE If the price increases to $1.50, the quantity supplied (Q S ) of euros is greater than the quantity demanded (Q D ) 36-16

International Financial Policy 36 Changes in Interest Rates Interest rates in the U.S. increase Demand for U.S. interest-bearing assets increases Demand for dollars to buy U.S. assets increases The increase in the demand for dollars causes the price of dollars to increase 36-17

International Financial Policy 36 Changes in a Country’s Income or Prices Income or prices increase in the U.S. Imports increase Demand for foreign currency to buy imports increases which means the supply of the dollar increases The increase in supply of the dollar causes the price of the dollar to decrease 36-18

International Financial Policy 36 The Net Effect of Monetary Policy on Exchange Rates M i Y Exchange Rate P Competitiveness Imports Exchange rate Exchange rate (LR) Expansionary monetary policy lowers exchange rates It decreases the relative value of a country’s currency 36-19

International Financial Policy 36 The Net Effect of Monetary Policy on Exchange Rates M Y i Exchange Rate Exchange rate Exchange rate (LR) Contractionary monetary policy increases exchange rates It increases the relative value of a country’s currency P Imports Competitiveness 36-20

International Financial Policy 36 The Net Effect of Fiscal Policy on Exchange Rates Expansionary Fiscal policy Y ? Exchange Rate ? P Competitiveness Imports Exchange rate Exchange rate (LR) The effect of expansionary fiscal policy on exchange rates is not so clear Exchange rate i 36-21

International Financial Policy 36 The Net Effect of Fiscal Policy on Exchange Rates Y Exchange rate Exchange rate (LR) P Imports Competitiveness The effect of contrationary fiscal policy on exchange rates is not so clear i Exchange rate ? Exchange Rate ? Contractionary Fiscal policy 36-22

International Financial Policy 36 Purchasing Power Parity and Real Exchange Rates Purchasing power parity (PPP) is a method of calculating exchange rates that values currencies at rates such that each currency will buy an equal basket of goods According to PPP, if a basket of goods costs $7 in the U.S. and ¥1000 in Japan, the exchange rate should be $1 = 1000/7 = ¥143 Purchasing power parity exchange rates may or may not be appropriate long-run exchange rates 36-23

International Financial Policy 36 Real Exchange Rates A real exchange rate is an exchange rate adjusted for differential inflation or differential changes in the price level. A nominal exchange rate is the actual exchange rate used when currencies are exchanged %Δ real exchange rate = %Δ nominal exchange rate + (domestic – foreign inflation) 36-24

International Financial Policy 36 Alternative Exchange Rate Systems Three exchange rate regimes are: 1.Fixed exchange rate where the government chooses an exchange rate and offers to buy and sell currencies at that rate 2.Flexible exchange rate where the determination of exchange rates is left totally up to the market 3.Partially flexible exchange rate where the government sometimes buys or sells currencies to influence the exchange rate, while at other times letting private market forces operate 36-25

Macro Policy in a Global Setting 37 The Exchange Rate Goal Depending on the state of the economy, there are arguments for both high and low exchange rates Advantages of high exchange rates: Foreign currencies are cheaper, so imports are cheaper Competition from cheaper imports keeps U.S. inflation low Disadvantages of high exchange rates: Imports increase and exports decrease causing a trade deficit Trade deficits can have a contractionary effect on the economy 37-26

Macro Policy in a Global Setting 37 The Trade Balance Goal The trade balance is the difference between a country’s exports and imports Running a trade deficit is good in the short run but presents problems in the long run In the short run, imports exceed exports, so we’re consuming more than we could if we didn’t run a deficit If a country runs a trade deficit year after year, eventually the long run will arrive and the country will run out of assets to sell 37-27

Macro Policy in a Global Setting 37 Balancing the Exchange Rate Goal with Domestic Goals In principle, the government can control the exchange rate with monetary policy The problem with doing so is that monetary policy also affects the domestic economy Expansionary monetary policy will push the exchange rate down Contractionary monetary policy will push the exchange rate up and may decrease domestic income and jobs In order to achieve a certain exchange rate, a country may have to sacrifice domestic goals 37-28

Macro Policy in a Global Setting 37 Targeting an Exchange Rate with Monetary and Fiscal Policy To increase the exchange rate value of the euro, the European Central Bank (ECB) could: Price of euros (in $) Euros S0S0 D0D0 $1.50 $1.30 D1D1 Run contractionary monetary policy to increase interest rates and increase the private demand for euros Or induce a recession and decrease the private supply of euros S1S

Macro Policy in a Global Setting 37 Monetary Policy’s Effect on the Trade Balance Expansionary monetary policy makes the trade deficit larger Contractionary monetary policy makes the trade deficit smaller M Y Imports Trade deficit M Y Imports Trade deficit 37-30

Macro Policy in a Global Setting 37 Fiscal Policy’s Effect on the Trade Balance Expansionary fiscal policy makes the trade deficit larger Contractionary fiscal policy makes the trade deficit smaller Fiscal Y Imports Trade deficit Fiscal Y Imports Trade deficit 37-31