1. International Trade and Exchange Rates
Chapter 16
International Trade and Exchange Rates
In this chapter we will take a look at some key facts about international trade and then start evaluating international trade using comparative advantage. We will also use demand and supply curves to explain how countries determine which goods they will import, which goods they will export, and the price that is charged for these goods. Lastly we will look at trade barriers and how they impact the outcomes of international trade.
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved

2. Trade Facts U.S. trade deficit in goods $646 billion in 2010
U.S. trade surplus in services
$146 billion in 2010
Canada largest U.S. trade partner
Trade deficit with China
$273 billion in 2010
Dependence on oil
International trade is a key component in most nations’ economies. It is what allows countries to grow. Without it, a nation might not have access to a key resource or a way to exchange its own key resources for other items needed. The U.S. economy has thrived on international trade throughout its history. In one sense, the United States was founded on the very basis of international trade as Christopher Columbus discovered the new world while looking for a new route to engage in international trade.
We can understand why Canada is our largest trading partner given the fact that we share a lengthy border that facilitates trade. The trade deficit with China has been decreasing in recent years as their economy grows, providing the citizens with more disposable income with which to purchase imported items coming from the United States. Our dependence on foreign oil still causes concerns in many sectors because if the supply was disrupted for any reason, it could cause severe supply shocks in the economy.
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3. Trade Facts Principal U.S. exports include Chemicals
Agricultural products
Consumer durables
Semiconductors
Aircraft
United States provides about 8.5 percent of world’s exports
The principal U.S. exports reflect the fact that we have a more skilled workforce and also a thriving agricultural industry. Frequently the United States is referred to as the breadbasket of the world due to our ability to produce crops such as wheat and corn.
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4. Principal U.S. imports include Petroleum Automobiles Metals
Some Key Trade Facts
Principal U.S. imports include
Petroleum
Automobiles
Metals
Household appliances
Computers
It is interesting to note that we import some of the same products we export. In today’s economy, most goods that involve basic manual labor are made in countries that have a less-skilled workforce. Clothing is a prime example.
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5. Global Snapshot
This Global Snapshot illustrates the largest export nations in the world. China has the largest share of world exports, followed by Germany and the United States. These eight countries account for approximately 46 percent of the world exports.
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6. Global Snapshot
This Global Snapshot shows exports of goods and services as a percentage of GDP for selected countries. Although the United States is one of the world’s largest exporters, as a percentage of GDP, its exports are quite low relative to many other countries.
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7. Comparative Advantage
Assumptions
Two nations
Same size labor force
Constant costs in each country
Different costs between countries
United States absolute advantage in both
Opportunity cost ratio
Slope of the curve
Soybeans sacrificed per ton of avocados
Comparative advantage is used to explain the relationship between specialization and international trade. A nation does not have to have an absolute advantage in producing a good to benefit by trading. Absolute advantage exists when one nation is the most efficient producer of a good, meaning it can produce the good at the lowest possible price. Under comparative advantage, the country can produce the good at a lower opportunity cost, which measures what must be given up to produce it. In our initial analysis, we will look at two nations with similarities. We will use the United States and Mexico and assume that the United States has an absolute advantage over Mexico in producing two goods: soybeans and avocados.
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8. Comparative Advantage
Self-sufficiency output mix
Specialization and trade
Produce the good with the lowest domestic opportunity cost
Opportunity cost of one ton of soybeans:
Three tons of avocados in United States
Four tons of avocados in Mexico
If each country is isolated and self-sufficient, each must decide what mix of soybeans and avocados it desires to produce, recognizing the fact that to get more soybeans, the country must produce less avocados. Mexico has a higher opportunity cost as it must give up four tons of avocados, whereas in the United States, it is a three to one ratio.
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9. Comparative Advantage
Mexico’s Production Possibilities
Production Alternatives
Product A B C D E
Avocados 20 24 40 60
Soybeans 15 10 9 5
U.S. Production Possibilities
These tables illustrate production possibilities for both the United States and Mexico with regards to the production of soybeans and avocados. Note that the United States has an absolute advantage in producing both goods; gains from specialization and trade are possible. It will be mutually beneficial to both countries if the comparative costs of producing the two products within the two nations differ. The comparative cost looks at what each country must give up to produce one more unit of the other product.
Production Alternatives
Product A B C D E
Avocados 30 33 60 90
Soybeans 20 19 10
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10. Comparative Advantage
Terms of trade
United States: 1S = 3A
United States will sell 1S for more than 3A
Mexico: 4A = 1S
Mexico will pay less than 4A for 1S
Settle between the two
Depends on supply/demand factors
Assume 1S = 3.5A
Since the United States can produce soybeans for less than Mexico, it makes sense for the United States to produce soybeans and trade with Mexico for avocados. Mexico has a comparative advantage in avocados as the country would only have to sacrifice ¼ ton of soybeans to gain a ton of avocados, whereas the United States would have to give up ⅓ ton of soybeans to gain a ton of avocados. By doing so, both nations will benefit as they work out the terms of trade. The U.S. will end up getting more than 3½tons of avocados for one ton of soybeans, and Mexico will get 1 ton of soybeans for 3½tons of avocados, which is more that it would get without trade.
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11. Comparative Advantage
Specialization According to Comparative Advantage and the Gains from Trade (in Tons)
Country
(1)
Outputs before Specialization
(2)
Outputs after Specialization
(3)
Amounts Traded
(4)
Outputs Available after Trade
(5)
Gains from Specialization and Trade
(4) – (1)
Mexico
24 avocados
60 avocados
-35 avocados
25 avocados
1 avocados
9 soybeans
0 soybeans
+10 soybeans
10 soybeans
1 soybeans
United States
33 avocados
0 avocados
+35 avocados
35 avocados
2 avocados
19 soybeans
30 soybeans
-10 soybeans
20 soybeans
This table lists the international specialization according to comparative advantage and the gains from trade for the United States and Mexico.
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12. The Foreign Exchange Market
$1 Will Buy…
44.49 Indian rupees
0.62 British pounds
0.96 Canadian dollars
11.72 Mexican pesos
0.82 Swiss francs
0.71 European euros
79.2 Japanese yen
1058 South Korean won
6.5 Swedish kronor
4.3 Venezuelan bolivares fuertes
In international trade, sellers set their prices in their domestic currencies, but buyers frequently possess different currencies. In order to obtain the needed currency, a foreign exchange market can be used. A foreign exchange market is a market in which various currencies are exchanged for one another. The equilibrium prices in such currency markets are called exchange rates. This chart illustrates different exchange rates per U.S. dollar as of July 2011.
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13. Exchange Rates Demand for pounds Supply of pounds Market equilibrium
Increase in dollar price of pounds
Dollar depreciates
Pound appreciates
Decrease in dollar price of pounds
Dollar appreciates
Pound depreciates
The exchange rate frequently determines the size and persistence of a nation’s balance of payments deficits and surpluses and what it must do to correct the situation. We will be looking at a system of flexible exchange rates, which is one in which the demand and supply for the currency determine the exchange rate, as opposed to a fixed exchange rate system through which the government takes actions to determine the exchange rate. In our example, we will be comparing the dollar with the British pound. If it takes more dollars to buy a pound, we would say the dollar has depreciated relative to the pound and if it takes fewer dollars to buy a pound, the dollar would have appreciated relative to the pound.
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14. Flexible Exchange Rates
The Market for Foreign Currency
(Pounds) Q
Dollar price of 1 pound
Quantity of pounds P S1
Exchange
rate: $2 = £1 $2 $3 $1 Q1
Dollar
depreciates
(pound
appreciates)
Dollar
appreciates
(pound
depreciates)
The demand for pounds is downward-sloping, meaning that as the pound becomes less expensive in terms of dollars, more British goods and services will be purchased since they will be cheaper. The supply for pounds curve is upsloping because the British will purchase more U.S. goods when the dollar price of pounds rises. When that happens, the British will buy more U.S. goods and services because they will become less expensive. D1
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15. Flexible Exchange Rates
Determinants of exchange rates
Factors that shift demand/supply
Changes in tastes
Relative income changes
Relative inflation rate changes
Relative interest rates
Relative expected returns on assets
Speculation
There are many factors that can cause a nation’s currency to appreciate or depreciate, but the basic laws of supply-demand apply. If the demand for a nation’s currency increases, that nation’s currency will appreciate, and vice versa if the demand drops. If the supply of currency increases, it will depreciate, and if one country’s currency appreciates, some other country’s currency will depreciate relative to it. So, what causes supply or demand to shift? Any change in consumer’s tastes will, of course, cause the demand for the currency to change. The change in income relative to the income in other nations will also shift demand, as will relative inflation rate changes.
Another factor is speculation. Speculators are people who buy and sell currency solely to make money in the classic “buy low, sell high” process. These speculators can cause shifts in supply and demand.
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16. Trade Barriers and Export Subsidies
Tariffs
Import quota
Nontariff barrier (NTB)
Voluntary export restriction (VER)
Export subsidy
Even though a nation gains from trade as a whole, some domestic industries may be hurt by trade and some industries may need to be maintained even if they are not cost effective for reasons such as national security or defense. Countries use several different techniques to protect industries from the harmful effects of trade.
Tariffs are one of the most common barriers to trade. A tariff is an excise tax on the dollar value or quantity of an imported good. Revenue tariffs are applied to a good that is typically not produced in the domestic country, and they are designed to raise revenue for the domestic government. Revenue tariffs tend to be fairly low.
Protective tariffs are another matter. They are applied to goods that do have a domestic competitor and are designed to make the imported goods cost at least as much as, or more than, the domestic good, so these tariffs can be quite high.
Import quotas are another common barrier countries use. A quota is a limit on the amount of a particular good that could be imported in a given amount of time. By limiting the supply, you drive the price up, thereby making the imported good more expensive than its domestic competitor.
A nontariff barrier can include such things as requiring extensive documentation for imported goods, restricting the location available to receive the imported goods, or having unreasonable standards for imported goods.
A voluntary export restriction is when foreign firms “voluntarily” agree to limit the amount of their exports to a particular country. The catch is that even though it was voluntary, it was done under the threat of mandatory barriers so it really was not done through free will.
Export subsidies consist of government payments to a domestic producer of export goods and are designed to help that producer by reducing its production costs. This should enable the producer to compete more effectively against the imported goods.
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17. Economic Impact of Tariffs
Direct effects
Decline in consumption
Increase in domestic production
Decline in imports
Tariff revenue
Indirect effects
Because tariffs are the most commonly used trade barrier, we will look closer at their effect on the economy. The direct impact of tariffs includes a decline in domestic consumption as the desired goods are now at a higher price than consumers are willing to pay; an increase in domestic production as suppliers will be able to receive a higher price for the goods; a decline in imports, which was the whole point of the tariff; and tariff revenue accruing to the domestic government.
Tariffs also have an indirect effect beyond just basic supply and demand concepts. Since the foreign country supplying the import will sell less, their economy will decline. If they imported any products from the domestic country, those would decline as well. Tariffs also to some extent subsidize inefficient producers, which can be a drain on the economy.
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18. Price of imported product goes up
Net Costs of Tariffs
Price of imported product goes up
Consumers shift purchases to higher-priced domestic goods
Domestically produced goods become more expensive as import competition declines
Tariffs do impose costs on domestic consumers but also provide gains to domestic producers and revenue to the federal government. Study after study finds that the costs to consumers substantially exceed the gains to producers and governments for a net cost to society. This results in economic inefficiency, reduced consumption, and lower standards of living.
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19. Three Arguments for Protection
Increased domestic employment
Cheap foreign labor
Protection against dumping
There are many different arguments used to support the use of trade barriers, but three main themes come up over and over again. The first two arguments both involve labor issues. Saving American jobs is a standard campaign slogan for political candidates. While imports do eliminate some U.S. jobs, they also create new jobs in industries that will be exporting to the foreign country that now has disposable income to spend due to selling their exports. It also creates jobs for individuals involved with importing the good into the country. History has shown that trade barriers often have the reverse effects and can reduce domestic employment, especially if foreign countries retaliate. It is argued that cheap foreign labor will drive the wage rates in the United States down, reducing our standard of living. Again, the saying is “a rising tide lifts all boats.” Everyone benefits from trade. Dumping is also considered a big problem that needs addressing. Dumping occurs when a foreign firm deliberately sells goods below their cost in an attempt to drive the domestic industry out of business. Once the domestic industry is gone, the foreign firm is then free to raise prices to whatever level they desire. This may even be done with the support of the foreign government. Dumping is considered an “unfair trade practice,” and sanctions can be imposed against the countries or firms involved.
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20. Trade Adjustment Assistance
Trade Adjustment Assistance Act
Designed to help individuals hurt by international trade
Offshoring of jobs
Shifting of work previously done by American workers to workers abroad
The Trade Adjustment Assistance Act of 2002 introduced some innovative policies designed to help those workers who had been displaced by international trade. The Act provided financial assistance beyond unemployment benefits, relocation allowances, and retraining services. Critics argue that helping one small section of workers is not fair to other workers who lose jobs for a variety of reasons.
Offshoring of jobs is another major concern to American workers, but it is not necessarily bad for the economy. Offshoring can increase the demand for complementary jobs in the United States and increase the offshored workers’ income to purchase goods produced in the United States.
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21. Multilateral Trade Agreements
General Agreement on Tariffs and Trade (GATT)
World Trade Organization (WTO)
European Union (EU)
North American Free Trade Agreement (NAFTA)
The modern trend is for nations to seek to reduce or eliminate trade barriers as they recognize the fact that trade is a good thing. Each of these trade agreements reflect the trend towards increased free trade.
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22. Equal, nondiscriminatory trade between member nations
GATT
Three principles:
Equal, nondiscriminatory trade between member nations
Reduction in tariffs
Elimination of import quotas
First signed in 1947 by 23 nations, including the United States, GATT’s aim was to provide a forum for multilateral negotiations to reduce trade barriers. Since the enactment of GATT, tariffs on thousands of products have been eliminated or reduced with overall tariffs decreasing by 33 percent. Each round of negotiations added more countries to the agreement and further increased international trade.
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23. Established by Uruguay Round of GATT 153 member nations in 2011
WTO
Established by Uruguay Round of GATT
153 member nations in 2011
Oversees trade agreements and rules on disputes
Critics argue that it may allow nations to circumvent environmental and worker-protection laws
The WTO is the largest organization devoted to promoting international trade. The current round of negotiations began in 2001 in Doha, Qatar, and are aimed at further reducing tariffs and quotas as well as agricultural subsidies that can distort trade.
Critics are concerned that the WTO may supersede the authority of a member nation to protect its own environment and workers by allowing firms to move to countries with less restrictive laws. Proponents respond that these concerns are outside the scope of WTO authority and should be dealt with in other forums. They also feel that as developing nations gain from trade, they will be better equipped to help protect their workers and environment.
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24. Initiated in 1958 as Common Market
European Union
Initiated in 1958 as Common Market
Abolished tariffs and import quotas between member nations
Established common tariff with nations outside the EU
Created euro zone with one currency
Currently at 27 member nations, the EU is one of the most dramatic examples of a free-trade zone. In addition to eliminating almost all tariffs and quotas between the member nations, it has also liberalized the movement of capital and labor within the union and created common policies on matters of joint concern, such as agriculture, transportation, and business practices. The introduction of the euro currency in the early 2000s, which has been adopted by 17 of the member nations, has enabled those nations to improve their standard of living by making it easier to price and sell their products in the euro zone nations.
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25. Agreement between United States, Canada, and Mexico
NAFTA
Agreement between United States, Canada, and Mexico
Established a free trade zone between the countries
Trade has increased in all countries
Enhanced standard of living
So far, time has proven the critics of NAFTA wrong. Since NAFTA was enacted in 1993, over 20 million jobs have been created in the United States, trade among the three nations has increased, and the standard of living in each nation has also increased.
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26. U.S. Trade Deficits Large and persistent Causes of trade deficits
High U.S. growth (relatively)
China
Price of oil
Low U.S. saving rate
Implications of trade deficits
Increased current consumption
Increased indebtedness
In recent years, the United States has experienced record large trade deficits, reaching a record high deficit of $806 billion in 2006, an amount equal to 6 percent of GDP. There are several causes to these deficits. During 2001–2007, the U.S. economy grew at a faster pace than many of its trading partners. This growth enabled Americans to increase their demand for imports. The United States also has an enormous trade deficit with China as it imports more and more goods and services from them. China’s standard of living is still low, relatively speaking, which means they do not yet have a large demand for imported items. China also has a fixed exchange rate, which prevents their currency, the yuan, from appreciating relative to other currencies. This continues to make U.S. imports more expensive in China which further reduces the demand. Another factor in the trade deficit is the United State’s continued dependence on imported oil as it creates a deficit with the OPEC nations. The last piece is the low U.S. savings rate. Remember from the balance of payments that a key component is the financial account, which reflects the savings of a nation. Most of our investment has been financed by foreign investors since there is not enough domestic savings to meet the demand. The implications of the continued trade deficits are serious. It reflects the fact that we continue to consume far more of the world’s resources than we produce and have increased indebtedness to foreign entities. Trade deficits can be a mixed blessing. The long-term impacts are largely unknown, which concerns many people. It remains to be seen in the future if the country can withstand those deficits and return to a more balanced balance of payments.
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27. U.S. Trade Deficits Billions of Dollars
This graph illustrates the annual U.S. trade deficits for the period of 2001– Notice that the deficit did peak in 2006 and since then has declined somewhat, mainly due to the recession of 2008– During the recession, the demand for both domestic and imported goods and services declined dramatically. It remains to be seen what effect the current recovery will have on future trade deficits.
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