1 Chapter 21 International Trade and Finance ©2004 Thomson/South-Western Key Concepts Key Concepts Summary Summary Practice Quiz

2 Why do countries trade? International trade allows a country to consume a combination of goods and services that exceeds its production possibilities curve

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B´ (with trade) B (without trade) U.S. A C PPC Steel (tons per day) U.S. Production and Consumption Grain (tons per year)

Japan F E´ (with trade) PPC E (without trade) Steel (tons per day) Japanese Production and Consumption Grain (tons per year) D

6 Why should countries specialize and trade? Total world output increases, and therefore, the potential for greater total world consumption also increases

7 If countries should specialize, in what should they specialize? They should produce those goods and services in which they have a comparative advantage

8 What is comparative advantage? The ability of a country to produce a good at a lower opportunity cost than another country

9 What is absolute advantage? The ability of a country to produce a good using fewer resources than another country

10 What is free trade? The flow of goods between countries without restrictions or special taxes

11 What is protectionism? The government’s use of embargoes, tariffs, quotas, and other restrictions to protect domestic producers from foreign competition

12 What is an embargo? A law that bars trade with another country

13 What is a tariff? A tax on an import

14 What is a quota? A limit on the quantity of a good that may be imported in a given time period

15 What are the arguments for protectionism? Infant industry argument National security argument Employment argument Cheap foreign labor argument Free trade agreements

16 What is the General Agreement on Tariffs and Trade? Formed in 1947 by most of the worlds industrialized nations, GATT agreed to end tariff wars

17 What is the World Trade Organization? Formed in 1995 from GATT, the WTO enforces rulings in global trade disputes

18 What is a recent free trade agreement? North America Free Trade Agreement (NAFTA)

19 What is NAFTA? A 1993 free trade agreement between the U.S., Canada, and Mexico

20 What is the balance of payments? A bookkeeping record of all the international transactions between a country and other countries during a given period of time

21 What is the current account? The first section of the balance of payments, which includes trade in currently produced goods and services

22 What is the balance of trade? The most widely reported and largest part of the current account defined as the value of a nation’s merchandise imports subtracted from its merchandise exports

23 How is a current account deficit financed? By a capital account surplus

24 What is the capital account? The second section of the balance of payments, which records payment flows for financial capital

Year U. S. Balance of Trade, Balance of Trade (billions of dollars)

26 What does the balance of payments always equal? Zero; the current account deficit should equal the capital account surplus

27 How could the US have a balance of payments problem? The problem is with the composition of the balance of payments

28 What is an exchange rate? The number of one nation’s currency that equals one unit of another nation’s currency

29 If 1.81 dollars is exchangeable for 1 British pound, what is the exchange rate? 1 / 1.81 =.552 pounds per dollar

30 How is the exchange rate determined? Supply and demand for foreign exchange

Price (yen per dollar) Quantity of dollars (millions per day) Supply and Demand for Dollars S of $ (U.S. citizens) D for $ (Japanese citizens) E

32 What happens when a currency depreciates? The price of the currency falls in relation to another currency

33 What happens when a currency appreciates? The price of the currency rises in relation to another currency

34 What can cause a currency to change value? The demand and/or supply of the currency can change

35 What can cause a change in demand of a currency? There can be a change in - tastes and preferences relative price levels relative interest rates

Quantity of Dollars (millions per day Decrease in Demand S D1D1 D2D2 Price (yen per dollar E2E2 E1E1

37 U.S. exports less popular Decrease in the demand for dollars Value of the dollar falls (dollar depreciates)

38 What can cause a change in supply of a currency? There can be a change in - relative incomes relative price levels relative interest rates

Quantity of Dollars (millions per day) Price (yen per dollar Decrease in Supply S2S2 S1S1 E2E2 E2E2 D

40 Value of the dollar rises (dollar appreciates) Decrease in the supply of dollars Japanese imports less popular

41 What happens when demand and/or supply changes? The currency seeks a new equilibrium; the value changes

42 Japanese price level rises Japanese buy more U.S. exports Increase the demand for dollars Value of the dollar rises (dollar appreciates Decrease in the supply of dollars U.S. citizens buy fewer Japanese imports Impact on relative price changes on Exchange Rates

The Effects of Shift in Supply on Market Equilibrium S2S2 S1S1 D2D2 D1D1 200 E1E1 E2E2 Quantity of dollars Yen / Dollars

44 Key Concepts

45 Key Concepts Why do countries trade? Why should countries specialize and trade? If countries should specialize, in what should they specialize?If countries should specialize, in what should they specialize? What is comparative advantage? What is absolute advantage? What is free trade? What is protectionism?

46 Key Concepts cont. What is an embargo? What is a tariff? What is a quota? What is Nafta? What is the balance of payments? What is the balance of trade? What is an exchange rate? What can cause a currency to change value? What if demand - supply changes?

47 Summary

48 Comparative advantage is a principle that allows nations to gain from trade. Comparative advantage means that each nation specializes in a product for which its opportunity cost is lower in terms of the production of another product and then nations trade.

49 When nations follow the principle of comparative advantage, they gain. The reason is that world output increases and each nation ends up with a higher standard of living by consuming more goods and services than possible without specialization and trade.

B´ (with trade) B (without trade) U.S. A C PPC Steel (tons per day) U.S. Production and Consumption Grain (tons per year)

51 Free trade benefits a nation as a whole, but individuals may lose jobs and incomes from the competition from foreign goods and services.

52 Protectionism is a government’s use of embargoes, tariffs, quotas, and other methods t impose barriers intended to both reduce imports and protect particular domestic industries.

53 Embargoes prohibit the import of export of particular goods. Tariffs discourage imports by making them more expensive. Quotas limit the quantity of imports or exports of certain goods. These trade barriers often result primarily from domestic groups that exert political pressure to gain from these barriers.

54 The balance of payments is a summary bookkeeping record of all the international transactions a country makes during a year. It is divided into different accounts, including the current account, the capital account and the statistical discrepancy.

55 The current account summarizes all transactions in currently produced goods and services. The overall balance of payments is always zero after an adjustment for the statistical discrepancy.

56 The balance of trade measures only goods (not services) that a nation exports and imports. A balance of trade can be in deficit or in surplus. The balance of trade is the most widely reported and largest part of the current account. Since 1975, the U.S. has experienced balance of trade deficits.

Year U. S. Balance of Trade, Balance of Trade (billions of dollars)

58 An exchange rate is the price of one nation’s currency in terms of another nation’s currency. Foreigners who wish to purchase U.S. goods, services, and financial assets demand dollars. The supply of dollars reflects the desire of U.S. citizens to purchase foreign goods, services and financial assets.

59 The intersection of the supply and demand curves for dollars determines the number of units of a foreign currency per dollar.

Price (yen per dollar) Quantity of dollars (millions per day) Supply and Demand for Dollars S of $ (U.S. citizens) D for $ (Japanese citizens) E

61 Shifts in supply and demand for foreign exchange result from changes in such factors as tastes, relative price levels, relative real interest rates, and relative income levels.

62 Depreciation of currency occurs when one currency becomes worth fewer units of another currency. If a currency depreciates, it becomes weaker. Depreciation of a nation’s currency increases its exports and decreases its imports.

63 Appreciation of currency occurs when one currency becomes worth more units of another currency. If a currency appreciates, it becomes stronger. Appreciation of a nation’s currency decreases its exports and increases its imports.

64 END