1. A Frugal Governed OPEN Economy Lecture 23
Dr. Jennifer P. Wissink
©2017 Jennifer P. Wissink, all rights reserved.
November 14, 2017 1

2. The Economic Basis for Trade: Recall Comparative Advantage
David Ricardo’s theory of comparative advantage: “specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely more efficient producers.”
Recall England and Portugal
Wine
Cloth
i>clicker question: Given the table, suppose Portugal and England are going to trade wine and cloth with each other. Suppose Portugal is making wine and England cloth. What is the lowest price (in terms of cloth) we would expect to see barrels of wine selling for?
1/10 a yard of cloth
1/20 a yard of cloth
10 yards of cloth
20 yards of cloth
10 barrels of wine
LABOR (L) HOURS REQUIRED
ENGLAND
PORTUGAL
1 yd. cloth
2 hours
1 hour
1 barrel wine
40 hours
10 hours

3. From Terms of Trade to Exchange Rates
The ratio at which a country can trade domestic products for imported products is the terms of trade.
Was easy with only two goods like guns & butter.
We looked at internal MOC versus terms of trade.
When we have more than two goods and two countries and lots of trade  money  currencies  currencies need to be exchanged  foreign exchange rates.
An exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another.
For any pair of countries, there is a range of exchange rates that can lead to both countries realizing the gains from specialization and comparative advantage.

4. Exchange Rates and Comparative Advantage
If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage.
Only those products in which a country has a comparative advantage will be competitive in world markets.

5. Sources of Comparative Advantage
The Heckscher-Ohlin (H-O) Theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments.
Factor endowments: the quantity and quality of labor, land, and natural resources of a country.
Eli Heckscher and Bertil Ohlin: economists from Sweden, circa 1933.
According to the H-O theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

6. Sources of Comparative Advantage
A country with a great deal of good fertile land…
California & Iowa in agriculture
Brazil and coffee beans
A country with a large amount of accumulated capital…
New Jersey in oil refining
South Korea and passenger cars
A country well-endowed with human capital…
New York in highly technical financial services
US and advanced education
Check out this site! Very interesting and oddly fun.

9. Other Suggested Explanations for Observed Trade Flows
Product differentiation and competitive markets
Acquired comparative advantage
Economies of scale and scope
However, because evidence suggests that economies of scale are exhausted at relatively small size in most industries, it seems unlikely that they constitute a valid explanation of world trade patterns.
Trading Environments, Openness of Economy
Free Trade Policy
Protectionist Policy

10. Keeping Track of Trade: Foreign Exchange & The Balance of Payments
Foreign exchange is simply all currencies other than the domestic currency of a given country.
The balance of payments: it’s the record of a country’s transactions in goods, services, and assets with the rest of the world.
It’s a record of the country’s sources (supply) and uses (demand) of foreign exchange.
Note: it’s not a “balance sheet”.
But: the overall account always balances.
It’s broken into two pieces
the Current Account
the Capital Account

11. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

12. In the Current Account…
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account
In the Current Account…
Debit items: any transaction that causes the US to loose foreign exchange.
Imports use up foreign exchange and are a debit (–) item.
Credit items: any transaction that provides the US with foreign exchange.
Exports generate foreign exchange and are a credit (+) item on the current account.

13. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

14. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

15. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

16. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

17. TABLE 20.1 United States Balance of Payments, 2011
37.7
(11) Net capital account transactions and financial derivatives
(13) Balance of payments ( )
−89.2
(12) Statistical discrepancy
517.4
(10) Balance on capital account ( )
211.8
(9) Change in foreign government assets in the United States
−119.5
(8) Change in U.S. government assets abroad (increase is −)
789.2
(7) Change in foreign private assets in the United States
−364.1
(6) Change in private U.S. assets abroad (increase is −)
Capital Account
−465.9
(5) Balance on current account ( )
−133.1
(4) Net transfer payments
227.0
(3) Net investment income
−517.6
Income payments on investments
744.6
Income received on investments
178.6
(2) Net export of services
−427.4
Imports of services
606.0
Exports of services
−738.4
(1) Net export of goods
−2,235.8
Goods imports
1,497.4
Goods exports
Current Account Billions of dollars
TABLE United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

18. Example 1: The Wissinks go to France.
Hotel/food/train/gifts costs €5,000 Euros
The Wissinks need to buy Euros
€ 1 Euro = $1.33 USD OR $1 USD = € 0.75 Euro
So... it all costs $6,650 USD
Cool currency converter site:
The Wissinks are importing goods and services.
There will be 2 entries in the Balance of Payments.

19. Example 1: The Wissinks go to France.
In the Current Account, “Imports of goods and services” (lines 1&2) shows a - $6,650. (Note: a debit item, since we use up foreign exchange!)
I take $6,650 US dollars and purchase € 5,000 Euros from a French private bank to pay the hotel/tour bill.
In the Capital Account, (line 7) “Change in foreign private assets in the United States” (in this case, French holdings of US dollars) are increased by +$6,650. (Note: this is a credit item!)
The net wealth position of the US vis-à-vis the rest of the world has decreased by $6,650.

20. Example 2:
Prof. Wissink decides to buy a British bond from a non-government (private) British issuer.
The bond costs £10,000.
£1 GBP = $1.54 USD OR $1 USD = £0.65 GBP
I take $15,400 USD and purchase the £10,000 GBP bond (which has a US dollar value of $15,400).
The Wissinks are dealing with buying a foreign asset.
There will be 2 entries in the Balance of Payments

21. Example 2:
Wissink buys a British bond.
“Change in foreign private assets in the US” (in this case, British holdings of US dollars) show a +$15,400 in the Capital Account.
(Reminder: increases in this item get recorded as a “+” item in line (7) of the Capital Account.)
But now I hold this bond so there is a “change in private U.S. assets abroad”, that is an increase in US assets abroad (the U.S.(me!) now holds more British bonds) and so we show this as a -$15,400 in the Capital Account.
(Reminder: increases in this item get recorded as a “–” item in line (6) of the Capital Account.)
So there is still “balance” in the Balance of Payments accounts.

22. Trade Policy: Free vs. Protection
Free Trade - the practice of leaving the markets alone and letting the invisible hand of the price mechanism do its work.
Protection - the practice of shielding a sector of the economy from foreign competition via various policies.
So…
Should we? (Protectionist Policies)
Should we not? (Free Trade Policies)
Common protectionist policies
A tariff is a tax on imports.
The average tariff on imports into the United States is about 5 percent.
A quota is a limit on the quantity of imports.
Export subsidies are government payments made to domestic firms to encourage exports.
Dumping refers to when a firm or industry sells products on the world market at prices below the cost of production.
The Comprehensive Trade Act of 1988 contains clauses that permit the president to impose trade sanctions when investigations reveal dumping by foreign companies or countries.

23. The Case For Free Trade
The case for free trade is based on the theory of comparative advantage.
When countries specialize and trade based on comparative advantage, consumers pay less and consume more, and resources are used more efficiently.
When tariffs and quotas are imposed, some of the gains from trade are lost.
The Economist’s history and free trade
Sep 6th 2013, 13:55 by C.R. | LONDON
Additional justifications
Trade keeps us all connected
Trade keeps us all at peace with each other

24. The Case For Protection
Protection saves jobs at home.
Some countries engage in unfair trade practices, so we need to protect against that.
Cheap foreign labor makes competition unfair.
Protection safeguards national security.
Protection discourages dependency.
Protection safeguards infant industries.
Often Special Issues emerge with developing economies.

25. U.S. Trade Policies Long and complicated history. Affected by:
economic conditions
political conditions
social conditions
High water mark: the Smoot-Hawley tariff was the U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (average tariff rate reached 60%).
It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s.

26. Global Trade Policies
The General Agreement on Tariffs and Trade (GATT) is an international agreement originally singed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade.
GATT was supposed to be temporary but lasted a long time and in 1995 spawned the WTO through the Uruguay Round negotiations. For all intents and purposes, GATT now lives vicariously through the WTO. [Special Thanks to Barrett Lane (S08) for great detective work provided to me on the history between GATT and the WTO.]
The World Trade Organization (WTO) is the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to help producers of goods and services, exporters, and importers conduct their business.
Location: Geneva, Switzerland
Established: 1 January 1995
Created by: Uruguay Round negotiations ( )
Membership & Observers: 160 countries on 26 June 2014
Membership: Functions: • Administering WTO trade agreements • Forum for trade negotiations • Handling trade disputes • Monitoring national trade policies • Technical assistance and training for developing countries • Cooperation with other international organizations  

27. Economic Integration
Economic integration occurs when two or more nations join to form a free-trade zone.
Two Examples:
The European Union (EU)
Initially, the EU consisted of just six countries: Belgium, Germany, France, Italy, Luxembourg and the Netherlands. (EEC, aka the “common market” in 1957)
Then over time more countries joined!
In 1991 they signed the Maastricht Treaty  the EU was born (1993) and the EURO, which 16 of the EU countries adopted. See:
The North American Free-Trade Agreement (NAFTA)
An agreement signed by the United States, Mexico, and Canada in 1994 in which the 3 countries agreed to establish all North America as a free-trade zone.
President Trump and Trade
NAFTA
Trans-Pacific Partnership

28. The EU Today
The European Union is now composed of 28 independent sovereign countries which are known as member states, they are:
Members: Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.
BREXIT VOTE on June 23, 2016
Candidates: Albania, FYROM, Iceland, Montenegro, Serbia, Turkey

29. Our Model and Simple Policy Prescriptions…?
So... AEd = C + Id + G + EX – IM and to get equilibirum set Y* = AEd(Y*) and solve for Y*
So… it’s good to EX and IM to make your Y* as large as possible…
…however, this implies another country’s exports may go and its imports may go which might not be good for them.
Get beggar thy neighbor policies
Exporting unemployment
Retaliation via tariffs and quotas, etc
Bad for international trade overall
GOOD QUESTION: What really determines EX and IM?

30. Determinants of Exports & Imports
The determinants of imports include the same factors that affect consumption and investment.
i.e., Y or Yd, r, wealth and any other stuff you think belongs in the model
i>clicker question: Do YOU check for where what you consume is produced? A. Yes. B. No.
Imports also depend on the prices of domestically-produced goods relative to foreign-produced goods.
prices at home relative to abroad
exchange rates matter a lot here
The determinants of exports are the same – just from the position of the rest of the world.
US exports depend on economic activity in the rest of the world.
I.e., If foreign output increases, U.S. exports tend to increase.