2. BA 187 – International Trade Issues, Definitions & Strategies

3. The Issues in International Trade

4. 3 Issues in International Trade  Gains from Trade mutual gains  Trade is not zero-sum, there are mutual gains to trade. unequally distributed  But gains may be unequally distributed within a country.  Pattern of Trade differences  Trade flows may arise from differences in technology, endowments, tastes, first-mover advantage, random.  Protectionism hurt welfare  Attempts by gov’t to shield economy from trade hurt welfare generally, but may improve welfare of sectors.  Balance of Payments  Trade and capital flows between countries are related.

5. 4 Why Countries Trade Relative Differences in Labor Productivity Differential Technologies Differential Factor endowments Short-run fixity of factors Differential Tastes Increasing Returns to Scale Imperfect Competition F Each factor influences the pattern of trade and determines distribution of gains/losses between & within economies. F We examine each of these factors separately & evaluate their relative importance empirically.

6. Accounting for International Economics

7. 6 International Flows F Interaction between economies involves: Flows of goods and services, Net Exports, NX. Flows of capital, Net Foreign Investment, NFI. F National income identities. Real GDP = Y = C d + I d + G d + X u C d = Consumption of Domestic output, etc. Imports = C f + I f + G f u C f = Consumption of Foreign output, etc. Use C = C d + C f, etc. to rewrite Real GDP as: X - ImNX u Y = C + I + G + X - Im = C + I + G + NX

8. 7 Flows of Goods and Services F Nations buy & sell output from each other. F Net Exports, NX = Exports - Imports Exports: Output produced domestically, sold abroad. Imports: Output produced abroad, sold domestically. Net Exports sometimes termed the Trade Balance. F Many factors affect Net Exports.  Primary factor is the real exchange rate,  ‚ Other factors are tastes & technology, domestic & foreign prices, cost of transport, gov’t trade policies. F Net Exports, NX.

9. 8 Flows of Capital F Nations buy & sell assets from each other. F Net Foreign Investment, NFI. Purchase of foreign assets by domestic residents minus purchase of domestic assets by foreigners. Foreign Direct Investment. Foreign Portfolio Investment. F NFI depends on:  Real interest rates on foreign vs. domestic assets ‚Economic & political risks of foreign assets, gov’t policies affecting foreign ownership of assets.

10. 9 Balance of Payments Accounting F Debit items (-) outward –Reflects transactions that give rise to payments outward from the home country. F Credit items (+) inward –Reflects transactions that give rise to payments inward to the home country. F 5 General Categories of Transactions –Category I: Goods and Services Accounts –Category II: Unilateral Transfers –Category III: Long-Term Capital Account –Category IV: Short-Term Private Capital Account –Category V: Short-Term Official Capital Account

11. 10 Debits (-ve) Credits (+ve) Category I A. Imports of Goods B. Imports of Services A. Exports of Goods B. Exports of Services Category II A. Unilateral transfers madeA. Unilateral transfers received Category III A. Increase in L-T foreign assets owned by home country B. Decrease in L-T home country assets owned by foreign country A. Decrease in L-T foreign assets owned by home country B. Increase in L-T home country assets owned by foreign country Category IV A. Increase in S-T foreign assets owned by private individ. in home country B. Decrease in S-T home country assets owned by private foreigners A. Decrease in S-T foreign assets owned by private individ. in home country B. Increase in S-T home country assets owned by private foreigners Category V A. Increase in S-T foreign assets owned by home country gov’t B. Decrease in S-T home country assets owned by foreign country gov’t A. Decrease in S-T foreign assets owned by home country gov’t B. Increase in S-T home country assets owned by foreign country gov’t

12. 11 Example International Transactions F Transaction 1 F Transaction 1 : Home country exporters send $2,000 of goods in exchange for check in foreign bank for equiv. amt Credit Category I.A. Exports of goods+$2,000 Debit Category IV.A. Increase S-T foreign assets-$2,000 held by home country individ. F Transaction 2 F Transaction 2 : Home country exporters send $2,000 of goods paid by check on importer’s account in home country bank. Credit Category I.A. Exports of goods+$2,000 Debit Category IV.B. Decrease S-T foreign assets-$2,000 held by private foreigners

13. 12 Example International Transactions F Transaction 3 F Transaction 3 : Home country residents send $5,000 of goods as disaster aid to foreign country. Credit Category I.A. Exports of goods+$5,000 Debit Category II.A. Unilateral transfers made-$5,000 F Transaction 4 F Transaction 4 : Home country individual buys L-T foreign corporate bond for $25,000. Pays with $25,000 that foreign co. deposits in its account in home country bank. Debit Category III.A. Increase L-T foreign assets-$25,000 held by home country individ. Credit Category IV.B. Increase S-T home country +$25,000 assets held by private foreigners

14. 13 Example International Transactions F Transaction 5 F Transaction 5 : Foreign country bank (private) wishes to convert $ to own currency by selling to its own central bank. Transaction transfers $account in home country bank to $account of Foreign central bank (held in home country). Debit Category IV.B. Decrease S-T home country-$25,000 assets of private foreigner Credit Category V.B. Increase S-T home country+$25,000 assets held by foreign gov’t

15. 14 International Relationships F Savings & Investment F Savings & Investment in an open economy. Output Equilibrium: Y = C + I + G + NX Rewrite as: Y - C - G = S = I + NX NFI = S - I(r) = NXRe-arrange as: NFI = S - I(r) = NX If NFI negative, then inflow of foreign saving into domestic economy and trade deficit simultaneously. F Balance of Payments = Current Account + Capital Account = 0 Current Account approx. equal NX. Capital Account approx. equal -NFI Need to understand why NX = NFI due to paired transactions feature of int’l flows

16. 15 Prices for Int’l Transactions I F Nominal Exchange Rate, e. Rate at which can exchange one currency for another. Always express here as # units of foreign currency per unit of domestic currency. Appreciation:Appreciation: Rate increases so domestic currency buys more foreign currency. (Domestic strengthens) Depreciation:Depreciation: Rate decreases so that domestic currency buys less foreign currency. (Domestic weakens) F There is an exchange rate for each foreign country’s currency versus the domestic currency.

17. 16 Prices for Int’l Transactions II  Real Exchange Rate, . output outputRate at which can exchange output of one country for output of another country.  = [Nominal Exchange Rate x Domestic Price Level] Foreign Price Level or  = [e x P]/P * Real exchange rate gives cost of output, both foreign and domestic, in common terms. Depreciation of Real Exchange Rate increases NX. u makes U.S. output cheaper, increasing U.S. exports while decreasing U.S. imports.

18. 17 Purchasing Power Parity, PPP F Purchasing Power Parity the simplest theory of how real exchange rates are determined. “Law of One Price”: A good cannot sell for different prices in different places at same time. Implies real exchange rate roughly constant e = P * /P u thus in long run should have: e = P * /P F PPP limited as exchange rate theory: Many goods & services are not tradable. PPP good basis for understanding large moves in nominal exchange rate.

19. Strategies for Understanding Trade

20. Historical Background of Trade Theory

21. 20 Mercantilism (1500-1750) (specie). F Nat’l wealth = country’s holdings of bullion (specie). zero-sum game F Economic activity viewed as zero-sum game. F Strong state power critical to economic success. F Economic system consist of 3 sectors: –Manufacturing, rural, & foreign colonies. –Merchants for trade, Labor for production. –Commodities priced by relative labor content. F Need for state to regulate economic activity to ensure favorable (positive) trade balance. –Positive trade balance means inflows of precious metal (specie) –Increase national wealth, financing for military capability. F Implicitly assuming that economy below full employment, no effects on inflation.

22. 21 Hume & Price-Specie Mechanism F David Hume (1752) attacks mercantilist views. price-specie flow F Focuses on price-specie flow mechanism –Trade surplus leads to inflows of specie to country. –This will increase the country’s money supply –This in turn will result in higher prices, reducing competitiveness of country’s goods. –This will result in falling trade surplus. –Exact opposite occurs in trading partner. self-correcting –Trade surplus/deficit is thus self-correcting. Quantity Theorygold standard –Essentially Quantity Theory combined with gold standard (fixed exchange rate).

23. 22 Adam Smith & Absolute Advantage F Smith (1776): Nation’s wealth arises from its labor productivity not its store of precious metal. self-interestmarket specializationproductivity –Individual self-interest & invisible hand of market leads to specialization & higher productivity. –Thus countries should also specialize. absolute advantage –Export goods for which they have an absolute advantage, import where absolute disadvantage. positive sum game mutual benefits –Argument shows trade is positive sum game with mutual benefits. Powerful argument for expanding trade, used against mercantilist thought. –Saw absolute advantage as deriving from a country’s unique endowments of factors of production.

24. 23 Example of Absolute Advantage ClothWine England 1 hour/ yard4 hours/ gallon Portugal 2 hours/ yard3 hours/ gallon Labor Requirements & Absolute Advantage No Trade Relative Price of Cloth is: –England –1 yard cloth for ¼ gallon of wine –Portugal –1 yard cloth for 2/3 gallon of wine –England has absolute advantage in cloth, Portugal in wine. –Show if can trade at 1 cloth per 1/3 gallon wine then both nations are better off.