UBEA 1013: ECONOMICS 1 CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATE 13.1 Absolute Advantage & Comparative Advantage 13.2 Open Economy: Export – Import 13.3 Exchange Rate

UBEA 1013: ECONOMICS Absolute Advantage & Comparative Advantage David Ricardo’s theory of comparative advantage, states that specialization and free trade will benefit ALL trading partners, even those that may be absolutely less efficient producers.

UBEA 1013: ECONOMICS 3 A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods. A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does. More output with same resources Mean lower opportunity cost

UBEA 1013: ECONOMICS 4 Yield Per Acre for Wheat And Cotton NEW ZEALAND AUSTRALIA Wheat6 units2 units Cotton Total land 2 units 100 acres 6 units 100 acres New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton. We say that the two countries have mutual absolute advantage. Absolute Advantage:

UBEA 1013: ECONOMICS 5 Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres NEW ZEALANDAUSTRALIA Wheat 25 acres x 6 units/acre 150 units 75 acres x 2 units/acre 150 units Cotton 75 acres x 2 units/acre 150 units 25 acres x 6 units/acre 150 units Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below:

UBEA 1013: ECONOMICS 6 Production Possibility Frontiers for Australia and New Zealand Before Trade

UBEA 1013: ECONOMICS 7 Gain from mutual Absolute Advantage: Absolute advantage theory urges countries to specialize in the production it has the absolute advantage (higher production per unit of resources). Therefore, New Zealand should specialize in production of wheat while Australia in production of cotton. Yield Per Acre for Wheat And Cotton NEW ZEALANDAUSTRALIA Wheat6 units2 units Cotton Production: Wheat Cotton 2 units 600 units 0 unit 6 units 0 unit 600 units

UBEA 1013: ECONOMICS 8 Production and Consumption of Wheat and Cotton after Specialization PRODUCTIONCONSUMPTION New ZealandAustraliaNew ZealandAustralia Wheat600 units0 unit300 units Cotton0 unit600 units300 units An agreement to trade 300 units of wheat for 300 units of cotton would double both wheat and cotton consumption in both countries.

UBEA 1013: ECONOMICS 9 Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.

UBEA 1013: ECONOMICS 10 Yield Per Acre for Wheat And Cotton CASE 1:NEW ZEALAND AUSTRALIA Wheat6 units2 units Cotton2 units6 units Comparative Advantage: Yield Per Acre for Wheat And Cotton CASE 2:NEW ZEALAND AUSTRALIA Wheat6 units1 units Cotton6 units3 units Mutual Absolute Advantage New Zealand has absolute advantage in both wheat & cotton production Can trade benefit BOTH?

UBEA 1013: ECONOMICS 11 Opportunity cost (The cost of reducing other products to produce another unit of a particular product) One additional unit of: NEW ZEALANDAUSTRALIA Wheat 6 / 6 = 1 unit of cotton3 / 1 = 3 units of cotton Cotton 6 / 6 = 1 unit of wheat1 / 3 = 0.33 unit of cotton New Zealand has lower opportunity cost in producing wheat >> should specialize in producing wheat Australia has lower opportunity cost in producing cotton >> should specialize in producing wheat Comparative Advantage

UBEA 1013: ECONOMICS 12 Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres NEW ZEALANDAUSTRALIA Wheat 50 acres x 6 units/acre 300 units 75 acres x 1 units/acre 75 units Cotton 50 acres x 6 units/acre 300 units 25 acres x 3 units/acre 75 units Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below: Comparative Advantage The gains from trade in this example can be demonstrated in two stages.

UBEA 1013: ECONOMICS 13 Realizing a Gain from Trade When One Country Has a Double Absolute Advantage Stage 1: Countries specialize Wheat STAGE 1 New ZealandAustralia 75 acres x 6 units/acre = 450 units 0 unit Cotton 25 acres x 6 units /acre = 150 units 100 acres x 3 bales/acre 300 bales Australia specialized in cotton production. New Zealand transfers 25 acres out of cotton production into wheat. New Zealand cannot completely specialize in wheat production because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat). Comparative Advantage

UBEA 1013: ECONOMICS 14 Stage 2: Countries trade STAGE 2 New ZealandAustralia 100 units (trade) Wheat 350 units100 units (after trade) 200 units (trade) Cotton 350 units100 units (after trade) Agreed trading price: (Term of Trade) 2 units of cotton for 1 unit of wheat Comparative Advantage

UBEA 1013: ECONOMICS 15 Terms of trade: The ratio at which a country can trade domestic products for imported products. The terms of trade determine how the gains from trade are distributed among trading partners.

UBEA 1013: ECONOMICS Open Economy: Export – Import Export & Import transactions is recorded in the country balance of payment under the “current account”. National Accounting (extension from Chapter 9): The balance of payments is the record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange.

UBEA 1013: ECONOMICS 17 A country’s current account is the sum of its: –net exports (exports minus imports), –net income received from investments abroad, and –net transfer payments from abroad. The balance of trade is the difference between a country’s exports of goods and services and its imports of goods and services. A trade deficit occurs when a country’s exports are less than its imports. Net exports of goods and services (EX – IM), is the difference between a country’s total exports and total imports.

UBEA 1013: ECONOMICS 18 Multiplier Effect & Aggregate Expenditure (extension from Chapter 11): Planned aggregate expenditure (AE) in an open economy: In equilibrium: multiplier m = marginal propensity to import (or MPM)

UBEA 1013: ECONOMICS 19 Exports contribute to an increase in autonomous expenditures and cause the planned aggregate expenditure function to shift upward. Imports affect the value of the multiplier. After imports are included, the aggregate expenditure function rotates and equilibrium income decreases.

UBEA 1013: ECONOMICS Exchange Rate The main difference between an international transaction and a domestic transaction concerns currency exchange. The exchange rate is the price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other. Foreign exchange is simply all currencies other than the domestic currency of a given country.

UBEA 1013: ECONOMICS 21 Three Type of Exchange Rate System: Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand. (Exchange rate movements have important impacts on imports, exports, and movement of capital between countries).

UBEA 1013: ECONOMICS 22 Fixed exchange rates: governments set a particular fixed rate at which their currencies will exchange for each other. (Pegging a currency to another currency is in this fixed exchange rate system). Managed floating system: In this system, governments intervene if markets are becoming disorderly. (Usually, the currency is allowed to float within a pre-determined ranged)

UBEA 1013: ECONOMICS 23 Monetary Policy & (Floating) Exchange Rate (extension from Chapter 11): Increase in MInterest rate fall Investor earning lower IR Seek better investment abroad Sell local currency Buy foreign currency Exchange rate fall (depreciate) Local (foreign) product cheaper (more expensive) Net export increase

UBEA 1013: ECONOMICS 24 The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied.

UBEA 1013: ECONOMICS 25 The level of a country’s interest rate relative to interest rates in a determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British citizens may be attracted to U.S. securities (relative higher return). Increase of British investors to seek better investment in US increases the supply of dollar and decreases the demand for pounds. The result is depreciation of the pound against the dollar.

UBEA 1013: ECONOMICS 26 A depreciation of a country’s currency (e.g Malaysia) can serve as a stimulus to the economy: –Foreign buyers are likely to increase their spending on Malaysian goods (relatively cheaper) –Buyers substitute domestically made goods for imports (as import will costs more) –Aggregate expenditure on domestic output will rise –GDP (Y) will increase

UBEA 1013: ECONOMICS 27 Who will benefit if the domestic currency depreciate? –Export sector (more competitive) An interesting case: During Asian financial crisis, Ringgit depreciate sharply. What happen to the domestic crude palm oil (CPO) price? –UP (Why?) (CPO Futures contracts prices traded in Kuala Lumpur Commodities Exchange shot up continuously).

UBEA 1013: ECONOMICS 28 CPO price are quoted at international currency (the US dollar). Thus, depreciation of Ringgit cause the price of CPO relatively higher (in term of the local currency or Ringgit) Another question: Now, Malaysia has de-peg the Ringgit against the US$ (now under a managed float system). General opinion think that the Ringgit will appreciate. Who will benefit if the Ringgit really appreciate?

UBEA 1013: ECONOMICS 29 The beneficiaries: Companies that have huge US$-dominated debt: e.g. Telekom Malaysia & Tenaga Nasional. They will benefit from one-off translation gains and lower interest expenses. Companies that have high imported input cost: e.g. auto & media industry being the obvious. The “losers”?

UBEA 1013: ECONOMICS 30 The losers: Exporters: less competitive due to relative higher price (in term of foreign currency). Companies with a large part of their revenue stream in foreign currencies. A stronger Ringgit mean less revenue in the local currency after conversion. Therefore, the worst will be those “cost in Ringgit, revenue in Dollar” companies. E.g. plantation, semiconductor and timber sector. Their profit margin will be reduced. End