International Issues

Trade between Countries Countries engage in international trade for two basic reasons. Countries trade because they are different from each other. Nations can benefit from their differences by reaching an arrangement in which each does the things it does relatively well.

Trade between Countries Countries engage in international trade for two basic reasons. Countries trade in order to achieve economies of scale in production. When a country produces only a limited range of goods, it can produce each of these goods at a larger scale and hence more efficiently than if it tried to produce everything.

Trade between Countries: Theories Economists use theories or models to understand and explain why global trade works. We will consider the following theories: Absolute Advantage Comparative Advantage

Advantage: Absolute and Comparative A country is said to have an absolute advantage when it can produce a good more efficiently than another country. A country is said to have a comparative advantage when it can produce a good relatively more efficiently than another country. Relatively more efficiently means at a lower opportunity cost.

Comparative Advantage Trade does not require that a country have an absolute advantage in the production of a good or service. The principle of comparative advantage states that countries specialize in those goods in which they are relatively more efficient.

Comparative Advantage U.S.A. Japan Labor needed to make a computer 100 120 Labor needed to make a ton of wheat 5 8 Assume that in both the USA and Japan 120,000 worker hours are spent making computers, and 120,000 worker hours are spent growing wheat. This means that Japan will produce 1,000 computers and 15,000 tons of wheat while the USA produces 1,200 computers and 24000 tons of wheat. U.S.A. Japan Computers 1,200 1,000 Wheat 24,000 15,000

Comparative Advantage The USA produces more of both products using the same number of labor hours. The USA has ??????

Comparative Advantage Japan however has a comparative advantage in the production of ??????? Computers Japan is 83% as productive as the USA in the production of computers, but only 62.5% as productive in the production of wheat. 1000/1200=0.833 and 15000/24000=0.625

Comparative Advantage Conclusion If both countries specialize in their areas of comparative advantage and trade, both will be better off.

Comparative Advantage Let the USA devote 200,000 worker hours to producing wheat, and the remaining 40,000 worker hours to computers. Production of wheat increases by 16,000 to 40,000 200,000/5=40,000 Production of computers falls by 800 to 400 40,000/100=400

Comparative Advantage Let Japan devote 220,000 worker hours to producing computers, and the remaining 20,000 worker hours to wheat. Production of computers increases by 833 to 1,833 220,000/120=1,833.33 Production of wheat falls by 12,500 to 2,500 20,000/8=2500

Comparative Advantage The point of the example is that world output has increased! Computers increase from 2,200 to 2,233 Wheat increases from 39,000 to 42,500 The gains from specialization and trade are an extra 33 computers and 3,500 tons of wheat If the countries trade, both will be better off.

Determinants of Comparative Advantage Natural Endowments Countries with soil and climate that are relatively better for grapes than for pasture will produce wine; countries with soil and climate that are relatively better for pasture than for grapes will produce sheep. This idea, called geographical determinism, has been outdated by developments in the modern world.

Determinants of Comparative Advantage Acquired Endowments Countries that save, invest and accumulate capital can acquire a comparative advantage in goods that require large amounts of capital in their production. Countries that devote resources to education can develop a comparative advantage in the production of goods that require a skilled labor force.

Determinants of Comparative Advantage Specialization Specialization can create comparative advantages between countries that are similar in all other respects. Specialization increases productivity. When countries specialize in different but similar products, they can enhance or develop a comparative advantage. One country can specialize in luxury cars while another country specializes in economical cars.

Dynamic Comparative Advantage Comparative advantage can change over time. Dynamic comparative advantage describes changes in comparative advantage which occur because of investment in human capital and in technology. A country may have a comparative advantage in a good it has recently developed, but when technology spreads to other countries, the first country must move on to something else.

Conclusions: Countries trade with each other because they can benefit economically from their differences and because of economies of scale. The principle of comparative advantage states that countries specialize in those goods in which they are relatively more efficient. Trade requires only that a country have a comparative advantage.

The Role of Government Direct Intervention Tariffs Subsidies Quotas Voluntary Exchange Restrictions Local Content Requirements

Instruments of Direct Intervention Tariffs A tariff is a duty or tax placed on an import Subsidies A government payment to a domestic producer Examples: cash grants, low interest loans, tax breaks.

Instruments of Direct Intervention Quotas A quota is an administrative device to limit trade Voluntary Export Restraint Quota on trade imposed by the exporting country. Local Content Requirements Rules that specify that some specific fraction of the good be produced domestically.

Tariffs and Subsidies Tariffs Subsidies Price Supply 2 Price Supply 1 Subsidy P1 P1 P2 Demand Demand Q2 Q1 Quantity Q1 Q2 Quantity Tariffs Subsidies

Quotas Price Quota P2 Supply Demand 2 P1 Demand 1 Quantity Q1 Q2

Exchange Rates An exchange rate is the price of one currency in terms of another. Exchange rates are important because exports, imports and all international financial transactions are affected by the prices at which currencies exchange for one another.

Explaining Exchange Rates with Purchasing Power Parity Purchasing power parity explains how price differentials between countries affect exchange rates Purchasing power parity says that when the prices charged for essentially the same goods in different countries diverge, exchange rates will move in the opposite direction and equalize the effective prices between the two countries.

Purchasing Power Parity: Example Assume that the U.S. and Canada produce identical bushels of wheat and that the exchange rate is $1.00 Canadian for $1.00 USA. Let the price of wheat in Canada be $3/bushel and the price of wheat in the USA be $2.50/bushel. What will happen?

Purchasing Power Parity: Example Canadians will buy U.S. wheat. In order to do this, they must first buy U.S. dollars. Supply of Canadian dollars in the global marketplace increases. Demand for U.S. dollars in the global marketplace increases The Canadian dollar depreciates and the U.S dollar appreciates.

Purchasing Power Parity: Example The price of U.S. wheat increases for Canadians for two reasons. The dollar has appreciated. The increase in demand for U.S. wheat pushes up its price. The decrease in demand for Canadian wheat pushes down its price. Over time these effects combine to bring about a single price for U.S. and Canadian wheat.

Explaining Exchange Rates with Interest Rate Parity Interest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

Interest Rate Parity: Example Assume that U.S. real interest rates are higher than those in other countries. The high rates of return on U.S. financial assets attract foreign buyers. In order to buy U.S. financial assets, foreigners must first buy dollars. The demand for dollars increases in the global marketplace and the dollar appreciates. The supply of the foreign currency increases in the global marketplace and it depreciates.

Other Exchange Rate Determinants Productivity Technical innovations that increase productive efficiency increase the demand for that country’s currency, pushing up its value. Preferences for domestic vs. foreign goods If we favor foreign goods over domestic, the supply of our currency increases, pushing down its value.

Other Exchange Rate Determinants USA Income or GDP Higher GDP raises the demand for imports; thus, increasing the supply of dollars available in the world. As the availability of dollars increases, other things remaining the same, the exchange rate falls.

Other Exchange Rate Determinants Rest of the World Income Higher ROW income raises the demand for USA exports; thus, increasing the demand for dollars in the world. As the demand for dollars increases, other things remaining the same, the exchange rate rises. Monetary Policy

Monetary Policy Monetary policy is conducted by the Federal Reserve. The Federal Reserve is our central bank. It is an independent agency, created by Congress in 1913 when they passed the Federal Reserve Act. Monetary policy is the attempt by the Federal Reserve to influence economic activity by changing the rate of growth of the money supply. Interest rates are often targets of monetary policy.

The Money Supply and Trade Deficits When the Fed decreases the rate of growth in the money supply, interest rates tend to rise. If the increase in interest rates causes our rates to be more attractive than the rates prevailing in other countries, funds will tend to move to the USA.

The Money Supply and Trade Deficits The increase in demand for U.S. securities causes the demand for the U.S. dollar to increase. As the dollar appreciates, net exports fall

The Money Supply and Trade Surpluses When the Fed increases the rate of growth in the money supply, interest rates tend to fall. If the decrease in interest rates causes our rates to be less attractive than those in other nations, funds will move out of the U.S.A. The decrease in demand for U.S. securities leads to a decrease in demand for the dollar. As the dollar depreciates, net exports rise. Expansionary monetary policy can be associated with a positive change in the trade balance.

Conclusion Exchange rates are important determinants of the balance of trade. Exchange rates are determined in the long run by price differentials between countries as well as changes in tastes and preferences and productivity. Exchange rates are determined in the short run by interest rate differentials between countries. Monetary policy changes interest rates and as a result has an impact on exchange rates and trade between nations.