1 International Trade and Finance ©2006 South-Western College Publishing

2 Interdependence and Trade Consider your typical day: uYou wake up to an alarm clock made in Korea. uYou pour yourself some orange juice made from oranges grown in Florida. uYou put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. uYou watch the morning news broadcast from New York on your TV made in Japan. uYou drive to class in a car made of parts manufactured in a half-dozen different countries. …and you haven’t been up for more than two hours yet!

How do we satisfy our wants and needs in a global economy? uWe can be economically self- sufficient. uWe can specialize and trade with others, leading to economic interdependence.

Why is interdependence the norm? Interdependence occurs because people are better off when they specialize and trade with others.

What determines the pattern of production and trade? Patterns of production and trade are based upon differences in opportunity costs.

6 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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u Imagine...  only two goods: potatoes and meat  only two people: a potato farmer and a cattle rancher u What should each produce? u Why should they trade? A Parable for the Modern Economy

Self-Sufficiency By ignoring each other: uEach consumes what they each produce. uThe production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished.

The Farmer and the Rancher Specialize and Trade Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other. u The farmer should produce potatoes. u The rancher should produce meat.

Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) (a) How Trade Increases the Farmer’s Consumption 0 A 3 3 A* Farmer’s consumption without trade Farmer’s consumption with trade

Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) (b) How Trade Increases The Rancher’s Consumption 0 B 21 3 B* Rancher’s consumption without trade Rancher’s consumption with trade

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

14 What conclusion can we draw from this? International trade allows a country to consume a combination of goods that exceeds its production possibilities curve

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

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

17 What advantage comparative advantage? World output and consumption are maximized when each country specializes in producing and trading goods for which it has a comparative advantage

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

19 Should Tiger Woods Mow His Own Lawn? ? ??

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

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

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

23 What is a tariff? A tax on an import

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

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

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

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

28 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

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

30 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

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

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

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

34 TaiwanJapanCanadaItalyGermanyMexicoFranceChina Ireland

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

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

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

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

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

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

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

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

43 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

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

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