1. © 2003 McGraw-Hill Ryerson Limited. Open Economy Macro: Exchange Rate And Trade Policy Chapter 16

2. 16 - 2 © 2003 McGraw-Hill Ryerson Limited. The Balance of Payments u The balance of payments is a country’s record of all transactions between its residents and the residents of all foreign countries.

3. 16 - 3 © 2003 McGraw-Hill Ryerson Limited. The Balance of Payments u The current account is the part of the balance of payments account in which all short-term flows of payments are listed. l It includes exports and imports of both goods and services; net investment income; and net transfers.

4. 16 - 4 © 2003 McGraw-Hill Ryerson Limited. The Balance of Payments u The capital and financial accounts are the part of the balance of payments account in which all long-term flows of payments are listed. l When Canadian citizens buy foreign securities or when foreigners buy Canadian securities, they are listed here as outflows and inflows, respectively.

5. 16 - 5 © 2003 McGraw-Hill Ryerson Limited. The Balance of Payments u The government can influence the exchange rate by buying and selling official reserves—government holdings of foreign currencies.

6. 16 - 6 © 2003 McGraw-Hill Ryerson Limited. The Current Account u The difference between the value of goods exported and the value of goods imported is sometimes called the balance of merchandise trade.

7. 16 - 7 © 2003 McGraw-Hill Ryerson Limited. The Current Account u Although the popular press often uses this measure, the merchandise trade balance is not a good summary because services are an important component of trade.

8. 16 - 8 © 2003 McGraw-Hill Ryerson Limited. The Current Account u Trade in services is just as important as trade in goods. u The key statistic for economists is the balance of goods and services which is the difference between the value of goods and services exported and imported.

9. 16 - 9 © 2003 McGraw-Hill Ryerson Limited. The Current Account u There is no reason that the goods and services sent into a country must equal the goods and services sent out in a particular year. u The current account includes payments from past investments and net transfers.

10. 16 - 10 © 2003 McGraw-Hill Ryerson Limited. The Current Account u The last component of the current account is net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods and services.

11. 16 - 11 © 2003 McGraw-Hill Ryerson Limited. The Capital and Financial Account u The capital and financial account consists of l The capital account l The financial account.

12. 16 - 12 © 2003 McGraw-Hill Ryerson Limited. The Capital and Financial Account u The capital account measures transactions such as international inheritances, federal debt forgiveness and the transfer of intangible assets.

13. 16 - 13 © 2003 McGraw-Hill Ryerson Limited. The Capital and Financial Account u The financial account measures transactions in financial assets and liabilities. u It includes Canadian portfolio investment abroad and foreign investment in Canadian stocks and bonds.

14. 16 - 14 © 2003 McGraw-Hill Ryerson Limited. The Capital and Financial Account u The reason for this are statistical discrepancies – many transactions have to be estimated. u Current account balance is not completely offset by the capital and financial account balance.

15. 16 - 15 © 2003 McGraw-Hill Ryerson Limited. The Capital and Financial Account u In thinking about what determines a currency’s value, it is important to remember both the demand for dollars to buy goods and services and the demand for dollars to buy assets.

16. 16 - 16 © 2003 McGraw-Hill Ryerson Limited. Balance of Payments Equilibrium u Because the balance of payments consists of both the capital account and the current account, if the capital account is in surplus and the trade account is in deficit, there can still be a balance of payments surplus.

17. 16 - 17 © 2003 McGraw-Hill Ryerson Limited. 2001 Balance of Payments Account, Table 16-1, p 383

18. 16 - 18 © 2003 McGraw-Hill Ryerson Limited. 2001 Balance of Payments Accounts, Table 16-1, p 383

19. 16 - 19 © 2003 McGraw-Hill Ryerson Limited. Balance of Payments Equilibrium u By definition, current account and the capital and financial account must sum to zero, because they are an accounting identity.

20. 16 - 20 © 2003 McGraw-Hill Ryerson Limited. Balance of Payments Equilibrium u If the currencies are freely exchangeable, the quantity of currency demanded must equal the quantity supplied. u Any deficit in the balance of payments, then, must be offset by an equal surplus in official reserve transactions.

21. 16 - 21 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates u Exchange rate is the rate at which one currency can be traded for another. u When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.

22. 16 - 22 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates u In order to demand one currency, you must supply another. u Equilibrium is where the quantity supplied equals the quantity demanded.

23. 16 - 23 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates and the Balance of Payments u A deficit in the balance of payments means that the quantity supplied of a currency exceeds the quantity demanded. u A surplus in the balance of payments means the opposite.

24. 16 - 24 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates and the Balance of Payments u Equilibrium is where the quantity supplied a currency equals the quantity demanded.

25. 16 - 25 © 2003 McGraw-Hill Ryerson Limited. The Supply of and Demand for Euros, Fig. 16-1, p 387 Supply Demand QSQS QDQD $1.30 1.20 1.15 1.10 Quantity of Euros Price of Euros (in dollars)

26. 16 - 26 © 2003 McGraw-Hill Ryerson Limited. Fundamental Forces Determining Exchange Rates u Exchange rate analysis is usually broken down into fundamental analysis and short-run analysis.

27. 16 - 27 © 2003 McGraw-Hill Ryerson Limited. Fundamental Forces Determining Exchange Rates u Fundamental analysis is a consideration of the fundamental forces that determine the supply of and demand for currencies.

28. 16 - 28 © 2003 McGraw-Hill Ryerson Limited. Fundamental Forces Determining Exchange Rates u These fundamental forces include a country’s income, changes in a country’s prices, and the interest rate in a country.

29. 16 - 29 © 2003 McGraw-Hill Ryerson Limited. Changes in a Country’s Income u When a country’s income falls, the demand for imports falls. u Then demand for foreign currency to buy those imports falls.

30. 16 - 30 © 2003 McGraw-Hill Ryerson Limited. Changes in a Country’s Income u This means that the supply of the country’s currency to buy the foreign currency falls. u This finally leads to an increase in the price of that country’s currency relative to foreign currency.

31. 16 - 31 © 2003 McGraw-Hill Ryerson Limited. Changes in a Country’s Prices u If the Canada has more inflation than other countries, foreign goods will become cheaper. u Canadian demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.

32. 16 - 32 © 2003 McGraw-Hill Ryerson Limited. Changes in a Country’s Prices u This rise in Canadian inflation will shift the dollar supply to the right and the dollar demand to the left.

33. 16 - 33 © 2003 McGraw-Hill Ryerson Limited. Changes in Interest Rates u A rise in Canadian interest rates relative to those abroad will increase demand for Canadian assets.

34. 16 - 34 © 2003 McGraw-Hill Ryerson Limited. Changes in Interest Rates u Demand for dollars will increase, while simultaneously the supply of dollars will decrease as fewer Canadians sell their dollars to buy foreign assets.

35. 16 - 35 © 2003 McGraw-Hill Ryerson Limited. Changes in Interest Rates u A fall in Canadian interest rates or a rise in foreign interest rates will have the opposite effect.

36. 16 - 36 © 2003 McGraw-Hill Ryerson Limited. Exchange Rate Determination Is More Complicated Than It Seems u Large exchange rate fluctuations in response to changing expectations make trading difficult and have significant real effect on economic activity.

37. 16 - 37 © 2003 McGraw-Hill Ryerson Limited. Exchange Rate Determination Is More Complicated Than It Seems u If the market expects exchange rates to change, it will become a self-fulfilling prophesy.

38. 16 - 38 © 2003 McGraw-Hill Ryerson Limited. Exchange Rate Determination Is More Complicated Than It Seems u The resulting fluctuations serve no real purpose, and cause problems for international trade and the country’s economy.

39. 16 - 39 © 2003 McGraw-Hill Ryerson Limited. International Trade Problems From Shifting Values of Currencies u Large fluctuations make real trade difficult, and cause serious real consequences. u It is these consequences that have led to calls for government to fix or stabilize their exchange rates.

40. 16 - 40 © 2003 McGraw-Hill Ryerson Limited. How a Fixed Exchange Rate System Works u One way the government can set the exchange rate is to make its currency nonconvertible. u Most western economies have agreed not to use this approach.

41. 16 - 41 © 2003 McGraw-Hill Ryerson Limited. How a Fixed Exchange Rate System Works u A second way is for government to adopt a fixed exchange rate policy. u A fixed exchange rate policy is one in which the government commits to holding the exchange rate at a specified rate through direct intervention.

42. 16 - 42 © 2003 McGraw-Hill Ryerson Limited. Fixing the Exchange Rate u The government can fix its exchange rate by exchange rate intervention. u Exchange rate intervention – buying or selling a currency to affect its price.

43. 16 - 43 © 2003 McGraw-Hill Ryerson Limited. Direct Exchange Rate Intervention u Currency support is the buying of a currency by a government to maintain its value at above its long-run equilibrium value.

44. 16 - 44 © 2003 McGraw-Hill Ryerson Limited. Direct Exchange Rate Intervention u A country can maintain a fixed exchange rate only as long as it has the official reserves (foreign currencies) to maintain this constant rate.

45. 16 - 45 © 2003 McGraw-Hill Ryerson Limited. Direct Exchange Rate Intervention u Once it runs out of official reserves, it will be unable to intervene, and then must either borrow or devalue its currency.

46. 16 - 46 © 2003 McGraw-Hill Ryerson Limited. Direct Exchange Policy, Fig.16-2, p 392 $1.30 1.20 1.10 Supply Q1Q1 D1D1 D0D0 Quantity of euros QEQE Q2Q2 Excess supply Price of euros (in dollars)

47. 16 - 47 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u A more practical long-run exchange rate policy is currency stabilization. u Currency stabilization – the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies.

48. 16 - 48 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u In currency stabilization, the government is not trying to change the long-run equilibrium. u It is simply trying to keep the exchange rate at that long-run equilibrium.

49. 16 - 49 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u Currency stabilization minimizes the possibility that the government will run out of official reserves.

50. 16 - 50 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u If a country runs out of official reserves, it must adjust its economy if it wants to maintain a fixed exchange rate.

51. 16 - 51 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u Given the small level of official reserves relative to the enormous level of private trading, significant amounts of stabilization are impossible.

52. 16 - 52 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u Strategic currency stabilization is often used when a government has a small level of official reserves.

53. 16 - 53 © 2003 McGraw-Hill Ryerson Limited. Currency Stabilization u Strategic currency stabilization is the process of buying and selling at strategic moments to affect the expectations of traders, and hence to affect their supply and demand.

54. 16 - 54 © 2003 McGraw-Hill Ryerson Limited. Stabilizing Fluctuations Versus Deviating From Long- Run Equilibrium u In theory, it is important to distinguish whether the problem is long- or short- run equilibrium. u In practice, it is difficult to do so.

55. 16 - 55 © 2003 McGraw-Hill Ryerson Limited. Stabilizing Fluctuations Versus Deviating From Long- Run Equilibrium u The long-run equilibrium rate can only be guessed, since no definitive empirical measure of this rate exists.

56. 16 - 56 © 2003 McGraw-Hill Ryerson Limited. Estimating Long-Run Equilibrium Exchange Rates u Purchasing power parity is one way economists have of estimating the long- run equilibrium rate.

57. 16 - 57 © 2003 McGraw-Hill Ryerson Limited. Estimating Long-Run Equilibrium Exchange Rates u Purchasing power parity (PPP) is a method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods. u Those exchange rates may or may not be appropriate long-run exchange rates.

58. 16 - 58 © 2003 McGraw-Hill Ryerson Limited. Criticisms of the Purchasing Power Parity Method u The difficulty with purchasing power parity is the complex nature of trade and consumption. u The purchasing power parity will change as the basket of goods changes. u Because of this there is no single measure of purchasing power parity.

59. 16 - 59 © 2003 McGraw-Hill Ryerson Limited. Criticisms of the Purchasing Power Parity Method u Purchasing power parity measures leave out asset demand for a currency, an important element of demand for currencies.

60. 16 - 60 © 2003 McGraw-Hill Ryerson Limited. Criticisms of the Purchasing Power Parity Method u The critics contend that the current exchange rate is the best estimate of the long-run equilibrium exchange rate.

61. 16 - 61 © 2003 McGraw-Hill Ryerson Limited. Alternative Exchange Rate Systems u There are three exchange rate regimes: l Fixed exchange rate – the government chooses an exchange rate and offers to buy and sell currencies at that rate. l Flexible exchange rate – determination of exchange rates is left totally up to the market.

62. 16 - 62 © 2003 McGraw-Hill Ryerson Limited. Alternative Exchange Rate Systems u There are three exchange rate regimes: l Partially flexible exchange rate – the government sometimes affects the exchange rate and sometimes leaves it to the market.

63. 16 - 63 © 2003 McGraw-Hill Ryerson Limited. Advantages of Fixed Exchange Rates u They provide international monetary stability. u They force governments to make adjustments to meet their international problems.

64. 16 - 64 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of Fixed Exchange Rates u They can become unfixed. u When they are expected to become unfixed, they create enormous monetary instability.

65. 16 - 65 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of Fixed Exchange Rates u They force governments to make adjustments to meet their international problems. u Notice that this is an advantage as well as a disadvantage.

66. 16 - 66 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Monetary Stability u If the government picks an exchange rate that is too high, its exports lag and the country loses official reserves.

67. 16 - 67 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Monetary Stability u If the government picks an exchange rate that is too low, it is paying more for its imports than it needs to and is building up official reserves. u Some other country is losing official reserves.

68. 16 - 68 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Monetary Stability u At times fixed exchange rates can become highly unstable because expectations of a change in the exchange rate can force the change to occur.

69. 16 - 69 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Policy Independence u Fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems. u If they become unfixed, they create monetary instability.

70. 16 - 70 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Policy Independence u Because most countries’ official reserves are limited, a country with fixed exchange rates is limited in its ability to conduct expansionary monetary and fiscal policies.

71. 16 - 71 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates and Policy Independence u Many countries run out of official reserves when a recession hits. u They choose expansionary monetary policy to achieve their domestic goals rather than contractionary monetary policy to maintain fixed exchange rates.

72. 16 - 72 © 2003 McGraw-Hill Ryerson Limited. Advantages of Flexible Exchange Rates u They provide for orderly incremental adjustment of exchange rates, rather than large, sudden jumps. u They help government in conducting domestic monetary and fiscal policies.

73. 16 - 73 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of Flexible Exchange Rates u They allow speculation to cause large jumps in exchange rates, which do not reflect market fundamentals.

74. 16 - 74 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of Flexible Exchange Rates u They allow government to be flexible in conducting domestic monetary and fiscal policies. u Notice that this is an advantage as well as a disadvantage.

75. 16 - 75 © 2003 McGraw-Hill Ryerson Limited. Flexible Exchange Rates and Monetary Stability u Proponents argue: why not treat currency markets like any other market and let private market forces determine a currency’s value?

76. 16 - 76 © 2003 McGraw-Hill Ryerson Limited. Flexible Exchange Rates and Monetary Stability u Opponents argue that flexible exchange rates allow far too much fluctuation in exchange rates, making trade difficult.

77. 16 - 77 © 2003 McGraw-Hill Ryerson Limited. Flexible Exchange Rates and Policy Independence u Flexible exchange rate regimes allow governments to be flexible in conducting domestic monetary and fiscal policy.

78. 16 - 78 © 2003 McGraw-Hill Ryerson Limited. Flexible Exchange Rates and Policy Independence u Some argue that flexible exchange rates do not provide sufficient discipline for macro policy. u They are, however, open to private speculation.

79. 16 - 79 © 2003 McGraw-Hill Ryerson Limited. Partially Flexible Exchange Rates u Most nations have opted for a policy, partially flexible exchange rates, that stands between these two extremes. u Sometimes, these are referred to as “managed” exchange rates or a “dirty” float.

80. 16 - 80 © 2003 McGraw-Hill Ryerson Limited. Partially Flexible Exchange Rates u If policy makers believe there is a fundamental misalignment in a country’s exchange rate, they allow market forces to determine it.

81. 16 - 81 © 2003 McGraw-Hill Ryerson Limited. Partially Flexible Exchange Rates u If they believe the currency’s value is falling because of speculation, they step in and fix the exchange rate, either supporting or pushing down their currency’s value.

82. 16 - 82 © 2003 McGraw-Hill Ryerson Limited. Partially Flexible Exchange Rates u Partially flexible exchange rate regimes combine the advantages and disadvantages of fixed and flexible exchange rates.

83. 16 - 83 © 2003 McGraw-Hill Ryerson Limited. Which View Is Right? u Which view is correct is much in debate. u In order to decide, it is necessary to go beyond the arguments and look at the history of the various regimes.

84. 16 - 84 © 2003 McGraw-Hill Ryerson Limited. The View of Foreign Exchange Traders u Most foreign-exchange traders feel their take on the market is better than that of governments’.

85. 16 - 85 © 2003 McGraw-Hill Ryerson Limited. The View of Foreign Exchange Traders u When these traders know that government might enter the market, they stop focusing on fundamentals and switch to trying to guess what the regulators will do. u Such guessing-games tend to destabilize the market, not stabilize it.

86. 16 - 86 © 2003 McGraw-Hill Ryerson Limited. The View of Central Banks Economists u Economists at central banks maintain that government intervention helps to stabilize currency markets.

87. 16 - 87 © 2003 McGraw-Hill Ryerson Limited. Monetary Union in North America u Should Canada and the United States adopt a common currency? u Twelve members of the European Union replaced their national currencies by euro – a common currency in Europe.

88. 16 - 88 © 2003 McGraw-Hill Ryerson Limited. Monetary Union in North America u Possible options for North America: l Moving back to fixed exchange rates. l Creating a new North American currency (the amero). l Adopting the U.S. dollar.

89. 16 - 89 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates u Fixing the value of the Canadian dollar to the U.S. dollar makes sense from a practical stand-point. u There are potential benefits and costs of such an action.

90. 16 - 90 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates u Benefits: l A fixed exchange rate would force Canadian firms to be competitive - Steady decline in the value of the Canadian dollar has postponed cost-cutting decisions of firms, as Canadian products became relatively cheap.

91. 16 - 91 © 2003 McGraw-Hill Ryerson Limited. Fixed Exchange Rates u Costs: l Any advantages of a flexible rate vis-à-vis other nations would be lost.

92. 16 - 92 © 2003 McGraw-Hill Ryerson Limited. A New Currency u If a common currency could be agreed, we have to decide the rate at which the two economies would enter the monetary union. u Which central bank gets to determine monetary policy?

93. 16 - 93 © 2003 McGraw-Hill Ryerson Limited. A New Currency u A common currency is beneficial when l states respond in similar fashion to disturbances l An economy is relatively open.

94. 16 - 94 © 2003 McGraw-Hill Ryerson Limited. Adopting the U.S. Dollar u As long as Canada benefits from a separate currency and floating exchange rate, it is not feasible to consider either the adoption of a common currency, nor adoption of the U.S. dollar.

95. 16 - 95 © 2003 McGraw-Hill Ryerson Limited. Adopting the U.S. Dollar u Canadian and U.S. economy differ in important aspects - Canada is a net exporter of primary commodities. As such, it benefits from a flexible exchange.

96. 16 - 96 © 2003 McGraw-Hill Ryerson Limited. Trade Policy u Trade policy involves government creating trade restrictions on imports in order to meet the balance of payments constraint without using traditional macro policy or exchange rate policy.

97. 16 - 97 © 2003 McGraw-Hill Ryerson Limited. Trade Policy u Economists generally oppose such trade restrictions. l They prevent competition. l They lower world welfare. l They lead other countries to retaliate.

98. 16 - 98 © 2003 McGraw-Hill Ryerson Limited. Varieties of Trade Restrictions u The most common trade restrictions are tariffs and quotas. u Other trade restrictions are voluntary restraint agreements, embargoes, regulatory trade restrictions, and nationalistic appeals.

99. 16 - 99 © 2003 McGraw-Hill Ryerson Limited. Tariffs u Tariffs, also called customs restrictions, are taxes governments place on internationally traded goods—generally imports.

100. 16 - 100 © 2003 McGraw-Hill Ryerson Limited. Tariffs u Tariffs are the most-used and most- familiar type of trade restriction. u Tariffs operate in the same way a tax does.

101. 16 - 101 © 2003 McGraw-Hill Ryerson Limited. Tariffs u They make imported goods relatively more expensive than they otherwise would have been and thereby encourage the consumption of domestically produced goods.

102. 16 - 102 © 2003 McGraw-Hill Ryerson Limited. The Impact of Tariffs on Imported Goods, Fig. 16-3, p403 P0P0 S1S1 S0S0 Tariff D0D0 Q1Q1 P1P1 Quantity of imported goods Price of imported goods Q0Q0

103. 16 - 103 © 2003 McGraw-Hill Ryerson Limited. Tariffs u International organizations promoting free trade: l The General Agreement on Tariffs and Trade (GATT) – a regular international conference to reduce trade barriers. l World Trade Organization (WTO) - a successor to GATT.

104. 16 - 104 © 2003 McGraw-Hill Ryerson Limited. Quotas u Quotas are quantity limits placed on imports. u Quotas differ from tariffs in the distribution of revenue. u Foreign producers prefer quotas to tariffs.

105. 16 - 105 © 2003 McGraw-Hill Ryerson Limited. Quotas u In a tariff, the government receives the tariff payment. u In a quota, revenues accrue as additional profits to producers of the protected good.

106. 16 - 106 © 2003 McGraw-Hill Ryerson Limited. Quotas u With quotas, an increase in domestic demand will be met by the less-efficient domestic producers. u Under a tariff, part of any increase in domestic demand will be met by more- efficient foreign producers.

107. 16 - 107 © 2003 McGraw-Hill Ryerson Limited. Voluntary Restraint Agreements u To avoid imposing new tariffs on their goods, countries often enter into voluntary restraint agreements. u Voluntary restraint agreements are those in which countries voluntarily restrict their exports.

108. 16 - 108 © 2003 McGraw-Hill Ryerson Limited. Voluntary Restraint Agreements u The effect of voluntary restraint agreements is the same as the effect of quotas.

109. 16 - 109 © 2003 McGraw-Hill Ryerson Limited. Voluntary Restraint Agreements u In the case of the voluntary quotas imposed on Japanese auto manufacturers, consumers lost since they paid higher prices both for domestic and imported cars.

110. 16 - 110 © 2003 McGraw-Hill Ryerson Limited. Embargoes u An embargo is an all-out restriction on import or export of a good. u Embargoes are usually created for international political reasons rather than for primary economic reasons.

111. 16 - 111 © 2003 McGraw-Hill Ryerson Limited. Regulatory Trade Restrictions u Regulatory trade restrictions are indirect methods of imposing governmental procedural rules that limit imports. l An example: limiting or prohibiting foodstuffs to be imported if certain pesticides are used.

112. 16 - 112 © 2003 McGraw-Hill Ryerson Limited. Regulatory Trade Restrictions u A second type of restriction involves making import and customs restrictions so detailed and time consuming that importers simply give up.

113. 16 - 113 © 2003 McGraw-Hill Ryerson Limited. Nationalistic Appeals u Given two products of equal quality and appeal, Canadians prefer to “Buy Canadian.”

114. 16 - 114 © 2003 McGraw-Hill Ryerson Limited. Economist Dislike Trade Restriction Policies u Despite the political popularity of trade restrictions, most economists support free trade. u A free trade policy allows unrestricted trade among countries.

115. 16 - 115 © 2003 McGraw-Hill Ryerson Limited. Economist Dislike Trade Restriction Policies u Trade restrictions lower aggregate output. l One nation benefits while most other nations are hurt. l They work only if there is no retaliation, and retaliation is the rule.

116. 16 - 116 © 2003 McGraw-Hill Ryerson Limited. Economist Dislike Trade Restriction Policies u Trade restrictions lower international competition. l This competition is necessary to keep domestic firms on their toes, keeping costs and prices down. l Domestic companies become less efficient.

117. 16 - 117 © 2003 McGraw-Hill Ryerson Limited. Economist Dislike Trade Restriction Policies u They often result in harmful trade wars that hurt everyone.

118. 16 - 118 © 2003 McGraw-Hill Ryerson Limited. Strategic Trade Policies u Strategic trade policies are threats to implement tariffs to bring about a reduction in tariffs or some other concession from the other country. u The threats must be credible.

119. 16 - 119 © 2003 McGraw-Hill Ryerson Limited. International Trade Agreements Affecting Canada u Those are: l The Canada-U.S. Free Trade Agreement (FTA) l The North American Free Trade Agreement (NAFTA) l Free Trade Areas of the Americas (FTAA)

120. 16 - 120 © 2003 McGraw-Hill Ryerson Limited. The Canada-U.S. Free Trade Agreement (FTA) u FTA was signed in 1987, and it came into effect in 1989. u It set into motion a process that removed most tariff and non-tariff barriers between the two countries over a 10-year period.

121. 16 - 121 © 2003 McGraw-Hill Ryerson Limited. The Canada-U.S. Free Trade Agreement (FTA) u Who are the winners and losers of tariff reduction? l The elimination of tariffs would decrease domestic price, benefiting consumers. l Some high-cost firms will have to leave the industry, and domestic production will decline.

122. 16 - 122 © 2003 McGraw-Hill Ryerson Limited. The Benefits of Tariff Reduction, Fig. 16-4, p 408 PTPT PWPW DS P Q Q1Q1 Q2Q2 Q3Q3 Q4Q4 A B

123. 16 - 123 © 2003 McGraw-Hill Ryerson Limited. The North American Free Trade Agreement (NAFTA) u In 1993 Canada, U.S. and Mexico signed the North American Free Trade Agreement (NAFTA). u It extended the FTA to eliminate other impediments to international trade. u Among other goals, it promoted free trade in services.

124. 16 - 124 © 2003 McGraw-Hill Ryerson Limited. The North American Free Trade Agreement (NAFTA) u NAFTA brought as many critics as the FTA. u The critics believed that Canadian economy will be “Americanized”.

125. 16 - 125 © 2003 McGraw-Hill Ryerson Limited. Free Trade Areas of the Americas (FTAA) u Free Trade Areas of the Americas (FTAA) agreement includes all economies of the Americas. u The problem with free trade is that it is not necessarily a fair trade, so some observers believe that rich nations may be dictating the terms and taking advantage of the small developing nations.

126. © 2003 McGraw-Hill Ryerson Limited. Open Economy Macro: Exchange Rate And Trade Policy End of Chapter 16