1. Survey of Economics: Principles, Applications, and Tools
SEVENTH EDITION
Chapter 18
International Trade and Finance

2. Learning Objectives
18.1 Use opportunity cost to explain the rationale for specialization and trade List the common protectionist policies Summarize the history of international trade agreements 18.4 Discuss how the price of foreign exchange is determined by demand and supply List the benefits and costs of a system of fixed exchange rates compared to a system of flexible exchange rates.
Slide 2 is list of textbook LO numbers and statements

3. 18.1 COMPARATIVE ADVANTAGE AND EXCHANGE (1 of 3)
Specialization and the Gains from Trade
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
TABLE 18.1 Productivity and Opportunity Costs
Fred
Kate
Coconuts
Fish
Output per day 2 6 1
Opportunity cost
3 fish
1/3 coconut
1 fish
1 coconut

4. 18.1 COMPARATIVE ADVANTAGE AND EXCHANGE (2 of 3)
The ability of one person or nation to produce a good at a lower opportunity cost than another person or nation.
Fred has a comparative advantage in producing fish.
His opportunity cost of fish is one-third coconut per fish, compared to 1 coconut per fish for Kate
Kate has a comparative advantage in coconuts.
Her opportunity cost of coconuts is 1 fish per coconut, compared to 3 fish per coconut for Fred.

5. 18.1 COMPARATIVE ADVANTAGE AND EXCHANGE (3 of 3)
PRINCIPLE OF VOLUNTARY EXCHANGE
A voluntary exchange between two people makes both people better off.
Comparative Advantage versus Absolute Advantage
Comparative advantage
The ability of one person or nation to produce a good at a lower opportunity cost than another person or nation.
Absolute advantage
The ability of one person or nation to produce a product at a lower resource cost than another person or nation.

6. APPLICATION 1
Absolute Disadvantage and Comparative Advantage in Latvia
APPLYING THE CONCEPTS #1: What is the rationale for specialization and trade?
Latvia in the 1990s was much less productive than nations in the European Community. The question is, Why would a member of the EC, whose workers are more productive than Latvian workers in the production of all goods, buy any products from Latvia?
Although the EC has an absolute advantage in both products, it has a comparative advantage (a lower opportunity cost) in grain: the opportunity cost of one unit of grain is 6 units of saw timber in the EC, compared to 20 units of saw timber in Latvia. Latvia has a comparative advantage in saw timber: the opportunity cost is 1/20 units of grain in Latvia, compared to 1/6 units of grain in the EC.
Based on the notion of comparative advantage, we know that both the EC and Latvia can be made better off if the EC produces grain in exchange for saw timber produced by Latvia.

7. 18.2 PROTECTIONIST POLICIES (1 of 4)
Import Bans
In the free-trade equilibrium, demand intersects the total supply curve at point c, with a price of $12 and a quantity of 80 shirts.
If shirt imports are banned, the equilibrium is shown by the intersection of the demand curve and the domestic supply curve (point a).
The price increases to $23.

8. 18.2 PROTECTIONIST POLICIES (2 of 4)
Quotas and Voluntary Export Restraints
Import quota
A government-imposed limit on the quantity of a good that can be imported.
Voluntary export restraint (VER)
A scheme under which an exporting country voluntarily decreases its exports.

9. 18.2 PROTECTIONIST POLICIES (3 of 4)
Quotas, Voluntary Export Restraints, or a Tariff
An import quota shifts the supply curve to the left.
The market moves upward along the demand curve to point d, which is between point c (free trade) and a (an import ban).
We can reach the same point with a tariff that shifts the total supply curve to the same position.

10. 18.2 PROTECTIONIST POLICIES (4 of 4)
Quotas and Voluntary Export Restraints
Import licenses
Rights, issued by a government, to import goods.
Tariff
A tax on imported goods.
Responses to Protectionist Policies
A restriction on imports is likely to lead to further restrictions on trade.
Many import restrictions have led to retaliatory policies and substantially lessened trade.
The most famous was the Smoot-Hawley Tariff Act of When the United States increased its average tariff on imports to 59 percent, its trading partners retaliated with higher tariffs on U.S. products.
The resulting trade war reduced international trade and deepened the worldwide depression of the 1930s.

11. APPLICATION 2 THE IMPACT OF TARIFFS ON THE POOR
APPLYING THE CONCEPTS #1: Do tariffs (taxes) on imported goods hurt the poor disproportionately?
Economists have found that tariffs in the United States fall most heavily on lower-income consumers.
Footwear accounts for:
1.3 percent of the expenditure of lower-income households.
0.5 percent of the expenditure of higher-income households.
The highest tariffs fall on the cheapest products—precisely those that will be purchased by lower-income consumers.
Low-price sneakers face a 32 percent tariff.
Expensive track shoes face only a 20 percent tariff.
To protect U.S. industries, tariffs are highest on labor-intensive goods. But these goods tend to be lower priced. That is why tariffs do fall disproportionately on the poor.

12. 18.3 A BRIEF HISTORY OF INTERNATIONAL TARIFF AND TRADE AGREEMENTS
General Agreement on Tariffs and Trade (GATT)
An international agreement established in 1947 that has lowered trade barriers between the United States and other nations.
World Trade Organization (WTO)
An organization established in 1995 that oversees GATT and other international trade agreements, resolves trade disputes, and holds forums for further rounds of trade negotiations.
In addition to the large group of nations in the WTO, other nations have formed trade associations to lower trade barriers and promote international trade:
The North American Free Trade Agreement (NAFTA)
The European Union (EU)
Asian Pacific Economic Cooperation (APEC)
Dominican Republic - Central America Free Trade Agreement (DR-CAFTA)

13. 18.4 HOW EXCHANGE RATES ARE DETERMINED (1 of 5)
What Are Exchange Rates?
Exchange rate
The price at which currencies trade for one another in the market.
Euro
The common currency in Europe.
An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.
A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.

14. 18.4 HOW EXCHANGE RATES ARE DETERMINED (2 of 5)
How Demand and Supply Determine Exchange Rates
Market equilibrium occurs where the demand for U.S. dollars equals the supply.

15. 18.4 HOW EXCHANGE RATES ARE DETERMINED (3 of 5)
Changes in Demand or Supply
An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate.
Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.

16. 18.4 HOW EXCHANGE RATES ARE DETERMINED (4 of 5)
Changes in Demand or Supply
An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate.
Higher European interest rates or lower European prices will increase the supply of dollars.

17. 18.4 HOW EXCHANGE RATES ARE DETERMINED (5 of 5)
Changes in Demand or Supply
Let’s summarize the key facts about the foreign exchange market, using euros as our example:
The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros.
The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.
Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.
Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.

18. 18.5 FIXED AND FLEXIBLE EXCHANGE RATES (1 of 5)
To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects:
The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated.
The increased value of the exchange rate makes U.S. goods more expensive on world markets.

19. 18.5 FIXED AND FLEXIBLE EXCHANGE RATES (2 of 5)
Fixing the Exchange Rate
Foreign exchange market intervention
The purchase or sale of currencies by government to influence the market exchange rate.
To increase the price of dollars, the U.S. government sells Euros in exchange for dollars.
This shifts the demand curve for dollars to the right.

20. 18.5 FIXED AND FLEXIBLE EXCHANGE RATES (3 of 5)
Fixed versus Flexible Exchange Rates
FLEXIBLE EXCHANGE RATE SYSTEM
Flexible exchange rate system
A currency system in which exchange rates are determined by free markets.
FIXED EXCHANGE RATES
Fixed exchange rate system
A system in which governments peg exchange rates to prevent their currencies from fluctuating.

21. 18.5 FIXED AND FLEXIBLE EXCHANGE RATES (4 of 5)
Fixed versus Flexible Exchange Rates
BALANCE OF PAYMENTS DEFICITS AND SURPLUSES
Balance of payments deficit
Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate.
Balance of payments surplus
Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.
Devaluation
A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system.
Revaluation
An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.

22. 18.5 FIXED AND FLEXIBLE EXCHANGE RATES (5 of 5)
The U.S. Experience with Fixed and Flexible Exchange Rates
Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.
Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge.
Exchange Rate Systems Today
The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.
Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.

23. APPLICATION 5 A TROUBLED EURO
APPLYING THE CONCEPTS #3: What are the fundamental causes for the problems with the Euro?
When the euro was launched in 1999, the vision of its founders was to use the monetary union to further unify Europe economically and politically. They envisioned a large economic market, comparable to the United States. They believed that by moving to a single currency with agreements on a number of fiscal rules that they could achieve economic stability and growth.
Unfortunately, this vision proved to be naïve. Under the umbrella of the euro, financial investors throughout the world poured funds into Spain and Ireland fueling an unsustainable housing boom and also lending excessive amounts to the governments of Greece, Italy, and Portugal that faced severe budget challenges.
When the housing boom collapsed and the worldwide recession of 2007 increased budgetary pressures, it became clear that the banks and governments of these countries could not easily pay their debts. Moreover, with a single currency for the euro area, countries could not make adjustments through depreciation of their currency. The options facing Europe were bleak: either large-scale financial transfers from Germany and other successful countries, or sharp cutbacks in budgets and prolonged unemployment to reduce wage levels.
What became apparent was that the United States did not just have a single currency; it also had a unified fiscal system that provided transfers to states and regions in economic distress. Monetary union without a corresponding fiscal system cannot be easily sustained.

24. KEY TERMS
Consumption possibilities curve Outsourcing Dumping Predatory pricing General agreement on tariffs Price discrimination and trade (gatt) Import licenses Tariff Import quota Terms of trade Infant industries Voluntary export restraint (VER) Learning by doing World Trade Organization (WTO)