Unit 14. International Trade and the Balance of Payments IES Lluís de Requesens (Molins de Rei)‏ Batxillerat Social Economics (CLIL) – Innovació en Llengües Estrangeres Jordi Franch Parella

International Trade and the Balance of Payments A closed economy is one that does not interact with other nations (no exports, no imports, no capital flows)‏ An open economy interacts freely with other nations (both in product and financial markets)‏ Trade Balance = Export – Imports  Exports > Imports --> trade surplus  Exports trade deficit

International Trade and the Balance of Payments Factors that affect net exports:  Prices of goods at home and abroad  Exchange rates  Tastes for domestic and foreign goods  Incomes at home and abroad Capital outflow is the purchase of foreign assets by domestic residents Capital inflow is the purchase of national assets by foreign residents (a mexican that buys Telefonica shares)‏

International Trade and the Balance of Payments Factors that influence net capital outflow:  The real interest rates (foreign and domestic, abroad and at home)‏  The risk of holding assets abroad Net exports = Net capital outflows Y = C + I + G + NX Y – C – G = I + NX Saving = Investment + Net Capital Outflow

International Trade and the Balance of Payments The exchange rate is the price of a currency in terms of another currency Appreciation is the increase in the value of a currency Depreciation is the decrease in the value of a currency The real exchange rate is the rate at which a person can trade the goods and services of one country in terms of another country

International Trade and the Balance of Payments Real exchange rate = Nominal exchange rate x domestic price / foreign price A depreciation in euro real exchange rate means that european goods have become cheaper relative to foreign goods As a result european imports fall and exports rise

International Trade and the Balance of Payments According to the Purchasing-Power Parity Theory, a good must sell for the same price in all nations  If 1 € = 1,3 $, and 1 Burger King costs you 2 € in Spain and 2,5 $ in New York, the € is overvalued and the $ undervalued  You buy $ and sell € --> the $ appreciates and the € deppreciates until 1 € = 1,25 $ Arbitrage is taking advantage of differences in prices in different markets

International Trade and the Balance of Payments If arbitrage occurs, prices that differ in two different markets would converge According to Purchasing-Power Parity, exchange rates have to ensure that the currencies have the same purchasing power in all countries  Nominal exchange rates must change with prices. If 1 € = 1 $ and prices double in Europe, then 1 € = 0,5 $  Limitations of PPP: many goods are not easily traded and are not perfect substitutes

International Trade and the Balance of Payments Net exports = Capital outflow (Net imports = Capital inflow)‏ Domestic Saving = Investment (at home) + Purchase of assets (abroad)‏ The nominal exchange rate is the relative price of the currency of two countries The real exchange rate is the relative price of the goods of two countries

International Trade and the Balance of Payments

According to Power-Purchasing Parity, a unit of currency should buy the same quantity of goods in all countries  The nominal exchange rate between the currencies of two countries should reflect the countries' price levels in those countries At the equilibrium of the (real) interest rate, the amount that people save exactly balances the domestic investment plus the net foreign investment

International Trade and the Balance of Payments In an open economy, government budget deficits:  Reduce the total saving and the supply of loanable funds  Crowd oud private sector  Drive up the interest rate  Cause net foreign investment to fall