Net Exports and International Finance Read Chapter 15 pages I The International Sector: An Introduction A)The Case for Trade 1) A country has a comparative advantage in the production of a good if it can produce it at a lower opportunity cost than other countries. If countries specialize in production of what they do best then global production will be increased which can result in more consumption for everyone.

2) Types of restrictions on trade. a) A tariff is a tax imposed on imported goods or services. b) A quota is a ceiling on the quantity of specific goods and services that can be imported. 3) If one were to argue against free trade one would have to argue on normative grounds such as valuing, a) certain sectors of the economy or b) the environment to a greater extent.

B) The Rising Importance of International Trade. 1) In the U.S. international trade has risen from 3.7 % of GDP in 1960 to 11.7% of GDP in ) Trade has risen as: a) Costs associated with transportation and communication have fallen; b) Trade barriers have fallen.

C) Net Exports and the Economy 1) Determinants of Net Exports. a) Income – higher incomes in the world means people will buy more goods and services. b) Relative prices – a higher price level within a country makes one countries goods more expensive and thus reduces its exports.

c) An increase in the exchange rate means that more foreign currency is required to obtain domestic currency (i.e. currency is more expensive) thus reducing exports. d) Trade policies can potentially limit exports or imports. e) Preferences and technology. 2) Net exports affect both the slope and position of aggregate demand. a) Slope is impacted by the international trade effect. b) Other factors change the position.

II International Finance A) International Finance is that field that examines the macroeconomic consequences of the financial flows associated with international trade. B) The balance between spending flowing into a country and spending flowing out is called the balance of payments. C) We will look at the balance of payments with two simplifications, 1) ignore transfer payments, 2) used GNP measurements rather than GDP.

D) Currency demand comes from two sources. 1) Exports. 2) Purchases by foreigners of domestic assets. E) The supply of currency comes from two sources. 1) Imports. 2) Domestic purchases of foreign assets.

F) Currency market equilibrium Exports + (demand by foreigners of domestic assets) = Imports + (domestic demand for foreign assets.) G) Accounting for International Payments. 1) Exports – imports = (domestic demand for foreign assets)- (demand by foreigners of domestic assets). [Note there is a typo in formula (3) on page 317.]

2) The current account is an accounting statement that includes all spending flows across a nation’s borders except those that represent purchases of assets. 3) The balance of current account equals spending flowing into an economy from the rest of the world on current account less spending flowing from the nation to the rest of the world on current account. (This equals net exports.)

4) When the balance on current account is positive, the country runs a current account surplus. 5) When the balance on current account is negative, the economy is in a current account deficit. 6) A country’s capital account is an accounting statement of spending flows into and out of the country during a particular period for purchases of assets.

7) If more foreign money flows into a country for the purchase of domestic assets than flows out for the purchase of foreign assets then there is a capital account surplus. 8) If less foreign money flows into a country for the purchase of domestic assets than flows out for the purchase of foreign assets then there is a capital account deficit. 9) Current account balance= -(capital account balance)

H) Deficits and Surpluses: Good or Bad? The U.S. has run current account deficits and capital account surpluses for the last two decades. Is this good or bad? Common arguments that it is bad: 1) Trade deficits mean a lose of jobs. This is untrue as can be noting that the last twenty years has resulted in increased U.S. job creation. 2) Foreigners now own parts of the U.S. Nothing wrong with this. If anything, it keeps the capital in the U.S. supporting our own jobs.

III Exchange Rate Systems 1)In a free-floating exchange rate system, governments and central banks do not participate in the market for foreign exchange. 2)Government or central bank participation in a floating exchange rate system is called a managed float. 3) A fixed exchange rate system is one in which the exchange rate between two currencies is set by the government.

4) Types of Fixed exchange rate systems. a) In a commodity standard system, countries fix the value of their respective currencies relative to a certain commodity or group of commodities. (e.g. gold) b) Currency board arrangements are systems that fix the exchange rate to a specified foreign currency with a legislative commitment to ensure that this rate will hold up.

c) Fixed exchange rate through intervention.

Some reminders. Homework #3 due Wednesday. Midterm #3 is Friday. The exam will cover chapters The format will be the same as before with 30 multiple choice questions. There is a sample exam as well as powerpoint printouts in Eisenhower. On Wednesday we will review as much as possible.