International Economics Topic 10 International Economics

International Economics International trade Microeconomic perspective Comparative advantage Trade barriers vs. free trade International finance Macroeconomic perspective Exchange rate determination

US Trade US trade deficit in goods and surplus in services US exports about 13% of its output Chemicals Agricultural products Consumer durables Semiconductors Aircraft U.S. provides about 8.5% of world’s exports

US Trade Principal U.S. imports include: Petroleum Automobiles Metals Household appliances Computers

Why do countries trade? Nations have different resource endowments Labor intensive Land intensive Capital intensive Comparative advantage A nation has a comparative advantage in good A when it has a lower opportunity cost of producing A,compared with another nation.

Comparative Advantage Vegetables (Tons) 30 25 20 15 10 5 35 40 45 Beef (Tons) (b) Mexico 12 18 8 4 A Z (a) United States

Comparative Advantage

Trade Barriers and Export Subsidies Tariffs, import quota, nontariff barrier (NTB), voluntary export restriction (VER), and export subsidies Effects of trade barriers on prices, consumption, production, etc. Arguments for trade protection

Multilateral Trade Agreements General Agreement on Tariffs and Trade (GATT, 1947-1993) World Trade Organization (WTO, 1995) European Union (EU) North American Free Trade Agreement (NAFTA)

International Finance Lending and borrowing among countries International asset transactions Currency exchange – daily global currency transaction volume is several trillion $.

Exchange Rates The price of a currency in terms of another currency €1=$1.252 Demand vs. supply Appreciation vs. depreciation Revaluation vs. devaluation

Exchange Rate Determination Determinants of exchange rates Factors that change demand/supply Changes in tastes Relative income changes Relative price-level changes Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation

The Demand for British Pounds To analyze demand for pounds, start with a very basic question Who is demanding them? Anyone who has dollars and wants to exchange them for pounds In our model of market for pounds, we assume that American households and businesses are the only buyers Why do Americans want to buy pounds? To buy goods and services from British firms To buy British assets

The Demand For British Pounds

The Demand For Pounds Curve Curve tells us quantity of pounds Americans will want to buy in any given period, at each different exchange rate Curve slopes downward The lower the exchange rate, the greater the quantity of pounds demanded Why does a lower exchange rate—a lower price for the pound—make Americans want to buy more of them? Because the lower the price of the pound, the less expansive British goods are to American buyers As we move rightward along demand for demand for pounds curve, as in the move from point A to point E

Shifts in the Demand for Pounds Curve If any of these variables changes, entire curve will shift Keep in mind that we are assuming that only one of them changes at a time; we suppose the rest to remain constant U.S. real GDP Relative price levels Americans’ tastes for British goods Relative interest rates Expected changes in the exchange rate

The Supply of British Pounds Demand for pounds is one side of market for pounds Other side is supply of pounds In real world, pounds are supplied from many sources In our model of market for pounds, we assume that British households and firms are the only sellers British supply pounds in the dollar—pound market for only one reason They want dollars Thus, to ask why the British supply pounds is to ask why they want dollars To buy goods and services from American firms To buy American assets

The Supply of Pounds Curve Supply curve for foreign currency Curve tells us quantity of pounds British will want to sell in any given period, at each different exchange rate Curve slopes upward The higher the exchange rate, the greater is the quantity of pounds supplied Why does a higher exchange rate—a higher price for the pound—make the British want to sell more of them? Because the higher the price for the pound, the more dollars someone gets for each pound sold As we move rightward along the supply of pounds curve, such as the move from point E to point F

The Supply of British Pounds

Shifts in the Supply of Pounds Curve When exchange rate changes, we move along supply curve for pounds But other variables can affect supply of pounds besides exchange rate Real GDP in British Relative price levels British tastes for U.S. goods Relative interest rates Expected change in the exchange rate

The Equilibrium Exchange Rate Important—and in most cases, realistic—assumption Exchange rate between dollar and pound floats Is freely determined by forces of supply and demand Without government intervention to change it or keep it from changing In come cases, however, governments do not allow exchange rate to float freely Instead manipulate its value by intervening in market, or even fix it at a particular value When exchange rate floats, price will settle at level where quantity supplied and quantity demanded are equal Intersection of demand curve and supply curve

The Equilibrium Exchange Rate

What Happens When Things Change? What would cause price of pound to rise or fall? Simple answer—anything that shifts demand for pounds curve, or supply of pounds curve, or both curves together Appreciation An increase in price of a currency in a floating-rate system Depreciation A decrease in price of a currency in a floating-rate system When a floating exchange rates changes, one country’s currency will appreciate (rise in price) and other country’s currency will depreciate (fall in price)