INTERNATIONAL TRADE & FINANCE AP MACRO UNIT 8 MR. LIPMAN INTERNATIONAL TRADE & FINANCE

International Trade 2 2

Where does our stuff come from? (Check the tags on your clothes, shoes, watch, calculator, etc.) Why have your clothes and personal items traveled all around the world?

Why people trade Without trade what things would you have to go without? Everything you don’t produce yourself! (Clothes, car, cell phone, bananas, heath care, etc) Every country specializes in the production of goods and services and trades it to others for things they cannot produce themselves. Limiting trade reduces people’s choices and makes them worse off. The Point: More access to trade means more choices and a higher standard of living. 4

Closed vs. Open Economies A closed economy focuses only on the domestic price. An open economy trades for the lowest world price. Export Goods & Services are now 16% of Americas GDP. US Exports have doubled as a percent of GDP since 1975. 5

Two-way Capital Flows Capital moves in both directions Differences in individual investor's incentives Financial specialization Countries can be both creditors and debtors simultaneously   6

Balance of Trade Net Exports (XN) = Exports – Imports Trade Surplus = Exporting more than is imported Trade Deficit (aka. trade gap) = Exporting less than is imported

Balance of Trade

Balance of Payments (BOP) Balance of trade includes only goods and service but balance of payments considers ALL international transactions. The BOP summary is done for a given year & Prepared in the domestic country’s currency Ex. If accounting the BOP of the U.S. it would be in the Dollar. The balance of payments is made up of two accounts. The current account and the capital account.

Which countries have the highest account surpluses and account deficits?

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The Loanable Funds Model Revisited 13

Loanable Funds Markets in Two Countries 14

Loanable Funds Markets in Two Countries 15

The Current Account is made up of three parts: Trades in Goods and Services (Net Exports)- Difference between a nation’s exports of goods and services and its imports Ex: Toys imported from China, US cars exported to Mexico Investment Income- $ from factors of production including payments made to foreign investors. Ex: Money earned by Japanese car producers in the US Net Transfers- $ flows from the private & public sectors Ex: donations, aids and grants, official assistance

Capital or (Financial) Account The Capital Account measures the purchase and sale of financial assets abroad. (Purchases of things that stay in the foreign country). Examples: US company buys a hotel in Russia A Korean company sells a factory in Ohio Australian company owns local Mall

Current or Capital Account? Identify if examples are counted in the current or capital account and determine if it is a credit or debit for the US. Bill, an American, invests $20 million in a ski resort in Canada A Korean company sells vests to the US Military A US company, Boeing, sells twenty 747s to France A Chinese company buys a shopping mall in San Diego An illegal immigrant sends a portion of his earning to his family An German investor buys $50,000 US Treasury Bonds Italian tourists spend 5 million in the US while American tourists spend 8 million in Italy.

Current or Capital Account Answers Capital Account (financial asset), Debit Current Account (trade of goods/services), Debit Current Account (trade of goods/services), Credit Capital Account (financial asset), Credit Current Account (net transfer), Debit

Practice Questions & Answers 1. U.S. income increases relative to other countries. Does the BOP move toward a deficit or a surplus? U.S. citizens have more disposable income Americans import more Net exports (Xn) decrease The current account balance decreases and moves toward a deficit. 2. If the U.S. dollar depreciates relative to other countries does the BOP move to a deficit or a surplus? US exports are desirable America exports more Net exports (Xn) increase The current account balance decreases and moves toward a surplus.

Foreign Exchange (aka. FOREX) Module 42 Exchange Rate = Relative Price of Currencies

Exports and Imports US sells cars to Mexico Mexico buys tractors from Canada Canada sells syrup to the U.S. For all these transactions, there are different national currencies. Each country must be paid in their own currency The buyer (importer) must exchange their currency for that of the sellers (exporter).

The turnover in FOREX markets is almost $4 trillion (USD) a day Currency Codes USD = US Dollar EUR = Euro JPY = Japanese Yen GBP = British Pound CHF = Swiss Franc CAD = Canadian Dollar AUD = Australian Dollar NZD = New Zealand Dollar

In the FOREX market only look at two countries/currencies at a time Ex: US Dollars and British Pounds Examine price of one currency in terms of the other currency. Ex:$2 = £1 Exchange Rate will depend on which currency you are converting. The price of one US Dollar in terms of Pounds is 1 Dollar = £1/$2 = £.5 The price of one Pound in terms of Dollars is 1 Pound = $2/£1 = $2

Depreciation The loss of value of a country's currency with respect to a foreign currency If the dollar losses value compared to another country’s currency More units of dollars are needed to buy a single unit of the other currency. The dollar is said to be “Weaker”

Appreciation The increase of value of a country's currency with respect to a foreign currency If the dollar gains value compared to another country’s currency Less units of dollars are needed to buy a single unit of the other currency. The dollar is said to be “Stronger”

This is the Foreign Exchange Market! FOREX is based upon Supply and Demand Imagine a huge table with all the different currencies from every country This is the Foreign Exchange Market! If you demand one currency, you must supply your currency. Ex: If Canadians want Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.

Equilibrium Exchange Rate FOREX follows laws of supply & demand Equilibrium Exchange Rate   Suppose the demand for U.S. dollars increases. Maybe European consumers have more money to spend and some of that additional income is being spent on financial investments in America. The payments from those European citizens will flow into the U.S. financial account As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. It will now cost more eurosto buy one U.S. dollar. Because the U.S. dollar has appreciated against the euro, American consumers will increase purchases of goods and services from Europe. More U.S. dollars will be supplied and will flow out of the U.S. current account. Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied. This tells us that any increase in the U.S. balance of payments on the financial account is exactly offset by a decrease in the U.S. balance of payments on the current account. Summary: An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports. A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports.

S&D for the US Dollars Pound£ Dollar$ Supply by Americans Equilibrium: Price of US Dollars Supply by Americans Pound£ Dollar$ Equilibrium: $1 = £1 2£/1$ 1£/1$ 1£/4$ US Dollar appreciates US Dollar depreciates Demand by British Q Quantity of US Dollars

Inflation and Real Exchange Rates Real Exchange Rates Are Adjusted for Inflation Nominal Exchange Rates Real Exchange Rate and the Current Account

Real versus Nominal Exchange Rates, 1990–2009: Note that Inflation in Mexico causes rise in # of Pesos needed to dollar but actual value stays consistent

Purchasing Power Parity Purchasing Power Parity (PPP) is nominal exchange rate between 2 countries for a given basket of goods and services. Big Mac Index (single item cost nation to nation) Nominal Exchange Rates and PPP If a basket of goods cost $1k in Mexico but only $100 in U.S. then the exchange rate would be 10 pesos to the dollar.   Then the purchasing power parity is 10 pesos per U.S. dollar: at that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries.

America’s big drop in trade balance since 1980s due to decrease in exports

Practice Questions American tourists increase visits to Japan. For each of the following examples, identify what will happen to the value of US Dollars and Japanese Yen. American tourists increase visits to Japan. The US government significantly decreases personal income tax. Inflation in the Japan rises significantly faster than in the US. Japan has a large budget deficit that increases Japanese interest rates. Japan places high tariffs on all US imports. The US suffers a larger recession.

Practice USD depreciates and Yen appreciates For each of the following examples, identify what will happen to the value of US Dollars and Japanese Yen. USD depreciates and Yen appreciates USD appreciates and Yen depreciates USD depreciates (Demand Falls) and Yen appreciates (Supply Falls) USD appreciates (Supply Falls) and Yen depreciates (Demand Falls)

Module 43 Exchange Rate Policy Governments have more power to influence nominal exchange rates than other prices Exchange rates are important to countries where exports and imports are a large fraction of GDP  

Fixed Exchange Rate: When the government keeps the exchange rate against another currency at or near a particular target rate. (provides certainty but must keep large quantities of foreign currency on hand and thus low-return investment) Floating Exchange Rate: Country lets exchange rate go where ever the market takes it. (helps to insulate nation from recessions in other nations) "Managed" & "Target Zone" An exchange rate regime is a rule governing policy toward the exchange rate.   There are two main kinds of exchange rate regimes. A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target. For example, Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1. A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it. This is the policy followed by Britain, Canada, and the United States. But if the exchange rate is determined by market forces of supply and demand, how can it be held fixed?

If using a fixed exchange rate then country must be prepared to “step into the market” to adjust currency rates.

Module 44: Exchange Rates and Policy Devaluation: A reduction in the value of a nation’s currency Revaluation: An increase in a nation’s currency value General Rule: Recessions lead to a fall in imports and an expansion leads to a rise in imports  

Hypothetical country of Genovia lowers interest rates and thus attracts less foreign investors reducing demand for Genos