Module 4: International Economics Mrs. Dannie G. McKee Sevenstar Academy dmckee@educatoronline.net July 2013 Resource: Paul Krugman and Robin Wells, Microeconomics, 2nd Edition - Teacher © 2008 Worth Publishers.

The Growing Importance of International Trade

Comparative Advantage and the Production Possibility Frontier

The Gains from International Trade 4

Consumer and Producer Surplus in Autarky

The Domestic Market with Imports

The Effects of Imports on Surplus

The Domestic Market with Exports

The Effect of Exports on Surplus

Effects of Trade Protection An economy has free trade when the government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand. Policies that limit imports are known as trade protection or simply as protection. The two most common protectionist policies are tariffs and import quotas. In rare instances, governments subsidize export industries.

The Effect of a Tariff

The Effect of a Tariff Reduces Total Surplus

Effects of an Import Quota An import quota is a legal quantity limit on imports. Its effect is like that of a tariff, except that revenues—the quota rents—accrue to the license-holder, not to the government.

The Political Economy of Trade Protection Arguments for Trade Protection Advocates of tariffs and import quotas offer a variety of arguments. Three common arguments are: national security job creation the infant industry argument For Trade liberalization countries engage in international trade agreements.

The Balance of Payments The green arrows represent payments that are counted in the balance of payments on current account. The red arrows represent payments that are counted in the balance of payments on financial account. Because the total flow into the United States must equal the total flow out of the United States, the sum of the balance of payments on current account plus the balance of payments on financial account is zero.

The Loanable Funds Model According to the loanable funds model of the interest rate, the equilibrium interest rate is determined by the intersection of the supply of loanable funds, S, and the demand for loanable funds, D. At point E, the equilibrium interest rate is 4%.

Loanable Funds Markets in Two Countries Here we show two countries, the United States and Britain, each with its own loanable funds market. The equilibrium interest rate is 6% in the U.S. market but only 2% in the British market. This creates an incentive for capital to flow from Britain to the United States.

International Capital Flows British lenders lend to borrowers in the United States, leading to equalization of interest rates at 4% in both countries. At that rate, American borrowing exceeds American lending; the difference is made up by capital inflows from Britain. Meanwhile, British lending exceeds British borrowing; the excess is a capital outflow to the United States.

The Foreign Exchange Market The foreign exchange market matches up the demand for a currency from foreigners who want to buy domestic goods, services, and assets with the supply of a currency from domestic residents who want to buy foreign goods, services, and assets. Here the equilibrium in the market for dollars is at point E, corresponding to an equilibrium exchange rate of † 0.95 per $1.00. The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied.

An Increase in the Demand for U.S. Dollars An increase in the demand for U.S. dollars might result from a higher rate of return available in the United States. The demand curve for U.S. dollars shifts from D1 to D2. So the equilibrium number of euros per U.S. dollar rises—the dollar appreciates. As a result, the balance of payments on current account falls as the balance of payments on financial account rises.

Exchange Rate Policy An exchange rate regime is a rule governing policy toward the exchange rate. A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target. A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it.

Monetary Policy and the Exchange Rate Here we show what happens in the foreign exchange market if Genovia cuts its interest rate. Residents of Genovia have a reduced incentive to keep their funds at home, so they invest more abroad. As a result, the supply of genos shifts rightward from S1 to S2. Meanwhile, foreigners have less incentive to put funds into Genovia, so the demand for genos shifts leftward from D1 to D2. The geno depreciates: the equilibrium exchange rate falls from X1 to X2.