International Economics

Law of comparative advantage – Nations can mutually benefit from trade so long as relative production costs differ. Comparative advantage – Producing at a lower opportunity cost.

INDIANAOREGON Oregon: Opportunity cost of timber is 1 soybean. Opportunity cost of soybeans is 1 timber Indiana: Opportunity cost of timber is 3 soybeans Opportunity cost of soybeans in 1/3 timber Soybeans (tons)Timber (tons)Soybeans (tons)Timber (tons)

soybeans timber Oregon without trade 10 Consuming 5 of each specialize soybeans timber Indiana without trade 18 6 Consuming 9 soybeans, 3 timber specialize

soybeans timber Oregon with trade 10 Consuming 5 timber, 9 soybeans soybeans timber Indiana with trade 18 6 Consuming 9 soybeans, 5 timber

If the costs of production are different, 2 economies both find benefit to specialize and trade. Specialization and trade allow nations to consume beyond the PPC. Free trade based on comparative advantage allows for a more efficient allocation of resources and greater prosperity. soybeans timber Indiana’s PPC 18 6 Oregon’s PPC 10 PPC with trade

Read pages Answer questions 1-4 on page 694

If Japanese citizens wish to purchase US soybeans, they must pay in dollars. Before goods can be exchanged between foreign trading partners, the currency of importing nations must first be converted to the currency of the exporting nation.

When US citizens and firms exchange goods and services with foreign consumers and firms, payments are sent back and forth through major banks around the world. This is tracked by the balance of payments statement which summarizes the payments made to and from every country in the world.

The current account on the statement shows current import and export payments for goods and services. A deficit balance such as this tells us that the US sent more US dollars abroad than foreign currency received in current transactions. Current Account Good exports$30 Goods imports-$50 Balance on goods (merchandise) -$20 Service exports$18 Service imports-$12 Balance on services$6 Balance on goods and services -$14 Net investment income-$5 Net transfers-$7 Balance on current account -$26

When a citizen or firm of one nation buys a foreign firm, real estate or financial assets of another nation, it appears in the capital account. A German buys a factory in Ohio or a US bond, it is an inflow of foreign capital assets into the US. An American firm buys a company in Turkey, it is an outflow of assets to foreign nations. Capital Account Inflow of foreign assets$35 Outflow of US assets-$20 Balance on capital account $15 Balance on current account -$26 Official Reserves Account Official reserves$11 $0

The Fed holds foreign currency called official reserves. When a balance of payments deficit exists, the Fed credits the account so that it balances. When there is a balance of payments surplus, the Fed transfers currency back to official reserves.

Apart from statistic discrepancies US dollars sent to foreigners are equal to US dollars from foreigners. When you buy an imported item from Brazil, the US current account is negative. Those US dollars will come back to the US from a foreign purchase of a US export or financial assets. The Fed makes short-term adjustments to insure the accounts balance. In the long-term, dollars that leave will eventually come back.

Read pages and answer questions 2 and 3 on page 715.

1.Production Possibilities Curve 2.Supply and Demand 3.Aggregate Supply and Aggregate Demand 4.Money Market 5.Market for Loanable Funds 6.Foreign Currency Market 7.The Phillips Curve

When nations trade goods they are also trading currency. The rate of exchange between two currencies is determined in the foreign currency market. Some nations fix their exchange rates while others allow theirs to “float” with supply and demand. The exchange rate between two currencies tells you how much of one currency you must give up to get one unit of the 2 nd currency If $2 = 1 euro, $1 =. 5 Euro. If $1 = 10 pesos, $.10 = 1 peso

If the US economy is strong, Americans increase D for European products. The increased demand for the euro also increases the S of dollars in the foreign exchange market. The dollar price of euros rises, and the euro price of a dollar falls. The euro as an asset is appreciating and the dollar as an asset is depreciating in value.

$ price of a euro Quantity of € D D1D1 S $0$0 $1$1 Market for Euros Euro price of a $ Quantity of $ D S €0€0 €1€1 Market for Dollars S1S1

Consumer Tastes – When US consumers prefer foreign produced goods, foreign currencies appreciate and the dollar depreciates. Relative Incomes – When a nation’s economy is strong and incomes are rising, they increase their demand for all goods, including those produced abroad. D for foreign currency increases.

Relative inflation – When a nation’s price level is rising, fewer foreigners will want to purchase products from that nation as they will need more of the exporting nation’s currency to buy. Speculation – Foreign currencies can be traded as assets and investors seek to buy low and sell high. If investors believe interest rates in Japan will rise soon, they will demand yen and it will appreciate.

Read pages and answer questions 7 and 10 on page 715.

Relative interest rates between countries can also affect exchange rates between those nations. When the Fed increases MS, interest rates on US financial assets will fall. Foreigners will see US financial assets as less attractive places to put their money. Demand for the $ will ↓, and the $ will depreciate. A depreciating $ makes goods in the US less expensive to foreigners, US net exports will ↑, which shifts AD to the right.

The reverse is true as well, If the Fed ↓ the MS, US interest rates rise and the dollar appreciates. This makes US goods more expensive to foreigners, ↓ net exports and AD to the left. When interest rates rise we see a ↓in capital Investment (business spending) and an ↑ in financial investments (bonds).

Remember: If the Fed ↑ MS, ↓ i %, ↓ D$, depreciates the $, ↑ US net exports, ↑ AD If the Fed ↓ MS, ↑ i %, ↑ D$, appreciates the $, ↓ US net exports, ↓ AD

European tastes for American-made goods is stronger. European relative incomes are rising, increasing D for US goods. The US relative price level is falling, making US goods relatively cheaper. Speculators are betting on the $ to rise in value. The US relative interest rate is higher, making the US a relatively more attractive place for financial investments.

1. Assume the US economy is in a severe recession with no inflation. a.Using a correctly labeled AD/AS graph, show each of the following for the economy. i.Full-employment output ii.Current output level iii.Current price level b.The federal government announces a major decrease in spending. Using your graph in part (a), show how the decrease in spending will affect each of the following i.Level of output ii.Price level c.Explain the mechanism by which the decrease in spending will affect the unemployment rate. d.The Federal Reserve purchases bonds through its open market operations i.Using a correctly labeled graph, show the effect of this purchase on the interest rate. ii.Explain how the change in the interest rate will affect output and the price level. e.Explain how the interest rate you identified in part (d) will affect each of the following. i.International value of the dollar relative to other currencies ii.United States exports iii.United States imports

Many economists would agree that free trade among nations increases the standard of living for all trading nations due to the law of comparative advantage. Some people however feel that trade may reduce the number of jobs available, especially when other countries can offer labor at lower wages. Trade barriers are put in place to prevent a loss of jobs.

A revenue tariff is a tax placed on a good that is not produced domestically and is meant to generate revenue for the importing nation’s government. A protective tariff is set on a good that is produced domestically and is meant to protect domestic industries from global competition by increasing the price of foreign products.

Consumers pay higher prices Consumer surplus is lost. Domestic producers increase output. Jobs are protected Declining imports Tariff revenue is collected. Inefficiency Dead weight loss now exists.

Domestic price of steel = $100/ton Equilibrium quantity of domestic steel = 10 million tons Competitive world market price of steel = $80/ton At $80/ton the US would demand 12M tons but produce 8M tons. 4M tons would be imported. Consumer surplus is the triangle below the D curve and above the world price. IF US steel gets Congress to pass a tariff, the world price rises by $10, increasing Q of domestic steel supplied and reducing imported steel from 4M to 2M tons. Higher price and lower consumption reduces the area of consumer surplus and creates dead weight loss.

$ per ton Q of steel (millions of tons) Pd = $100 Pt = $90 Pw = $80 Sd Dd Imports = 2 Dead weight loss Market for Domestic Steel

An import quota is a maximum amount of a good that can be imported into the domestic market. The impact of quotas with the exception of government revenue is the same as tariffs. Tariffs and quotas both: Hurt consumers with artificially high prices and lower consumer surplus. Protect domestic producers Reallocate economic resources towards domestic producers.

3 questions on comparative advantage 2 questions on balance of payments 3 questions on foreign exchange markets 2 questions on trade barriers 1 QUESTION ON FOREIGN EXCHANGE MARKETS AND INTEREST RATES