1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 0 International Trade and Capital Flows

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 1 Trade  Trade between nations occurs for  Goods and services  Real and financial assets  Foreign households and firms acquire domestic stocks and bonds or real estate  Domestic residents may purchase real and financial assets abroad

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 2 International Capital Flows  International capital flows  Purchases and sales of assets across international borders  Finance imbalances in trade so that exports need not equal imports every period  Increase the pool of saving which can translate into increased domestic investment

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 3 Comparative Advantage  Specialization and trade  Each person concentrates on an activity at which he is relative most efficient  Each person concentrates on an activity at which he has a comparative advantage  This allows society to achieve a higher level of productivity and standard of living than a country with self-sufficient individuals

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 4 Principal and Sources of Comparative Advantage  Comparative advantages arise from  Climate  Natural resources  Technology  Worker’s skills and education  Culture  Principle of comparative advantage  We can all enjoy more goods and services when each country produces according to its comparative advantage and trades with other countries

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 5 Closed v. Open Economies  Closed economy  An economy that does not trade with the rest of the world  Autarky: A situation in which a country is economically self-sufficient  Open economy  An economy that trades with other countries

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 6 Production Possibilities  Production possibilities curve  A graph that shows the maximum amount of each good that can be produced at every possible level of production of the other good

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 7 Calculating Opportunity Costs  Carlos can produce either 100 pounds of coffee or 1 computer per week  Opportunity cost of producing 1 computer is 100 lbs. coffee  Maria can produce either 100 pounds of coffee or 2 computers per week  Opportunity cost of producing 1 computer is 50 lbs. Coffee  Maria’s opportunity cost of producing computers is lower than Carlos’  Maria should produce computers  Carlos should produce coffee

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 8 Fig. 16.1 Production Possibilities Curve for a Two-Worker Economy

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 9 Fig. 16.2 Production Possibilities Curve for a Three-Worker Economy

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 10 Fig. 16.3 Production Possibilities Curve for a Many-Worker Economy

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 11 Consumption Possibilities  Consumption possibilities  Combination of goods and services that a country’s citizens might feasibly consume  In a closed economy  Consumption possibilities are identical to its production possibilities  In an open economy  Consumption possibilities are typically greater than its production possibilities

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 12 Fig. 16.4 Brazil’s Consumption Possibilities with Trade

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 13 Fig. 16.5 Consumption Possibilities in a Many-Worker Economy

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 14 Supply, Demand and Trade  World price  The price at which a good or service is traded in international markets  Set by world supply and world demand  In an open economy  The relevant price of a commodity is the world price

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 15 Fig. 16.6 The Market for Computers in Brazil

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 16 Net Importer and Net Exporter  If the price of a good or service in a closed economy is greater than the world price and that economy opens itself to trade  The economy will tend to become a net importer of that good or service  If the price of a good or service in a closed economy is less than the world price and that economy opens itself to trade  The economy will tend to become a net exporter of that good or service

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 17 Fig. 16.7 The Market for Coffee in Brazil

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 18 Winners and Losers  If trade is so good why do politicians so often resist free trade and “globalization”?  Free trade benefits the overall economy  But specific groups may not benefit  And if those groups have significant political influence they will be able to persuade politicians to legislate trade restrictions

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 19 Who Benefits? Who Hurts?  Case of imports  Domestic consumers of imported goods benefit from free trade  Domestic producers of imported goods are hurt by free trade  Case of exports  Domestic consumers of exported goods are hurt from free trade  Domestic producers of imported goods benefit from free trade

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 20 Protectionist Policies  Protectionism  The view that free trade is injurious and should be restricted  Tariff  A tax imposed on an imported good  Quota  A legal limit on the quantity of a good that may be imported

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 21 Tariffs and Quotas  Tariffs  Raise domestic prices to the world price plus the tariff  Hurt domestic consumers  Help domestic producers  Reduce domestic consumption  Increase domestic production  Quotas  Work like a tariff, except that government does not collect the tax

23. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 22 Fig. 16.8 The Market for Computers After the Imposition of an Import Tariff

24. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 23 Fig. 16.9 The Market for Computers After the Imposition of an Import Quota

25. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 24 Inefficiency of Protectionism  Efficiency principle  Efficiency is an important social goal  If protectionism is inefficient why do governments limit free trade?  Those who benefit from the restrictions are often better organized politically than those who lose from the restrictions

26. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 25 Trade and Environmentalists  Many antitrade proponents cite environmental concerns  Restricting trade lowers world income  Reducing the resources available to solve environmental problems  High levels of economic development are associated with lower amounts of pollution  Much of the income lost to barriers is absorbed by poor nations trying to develop their economies

27. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 26 Trade Balance  Trade balance [or Net exports]  The value of a country’s exports less the value of its imports in a particular period  A quarter or a year  Trade surplus  The condition when exports exceed imports  The difference between the value of a country’s exports and the value of its imports in a given period  Trade deficit  The condition when imports exceed exports  The difference between the value of a country’s imports and the value of its exports in a given period

28. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 27 Fig. 16.10 The U.S. Trade Balance, 1960-1999

29. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 28 International Capital Flows  International capital flows  Purchases or sales of real and financial assets across international borders  Capital inflows  Purchases of domestic assets by foreign households and firms (i.e., foreign savers buying domestic assets  Capital outflows  Purchases of foreign assets by domestic households and firms (i.e., domestic savers buying foreign assets

30. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 29 Link Between Trade Balance and Capital Flows  Trade balance NX  Represents the difference between the value of goods and services exported by a country and the value of goods and services imported by the country  Net capital inflows KI  Represent the difference between purchases of domestic assets by foreigners and purchases of foreign assets by domestic residents  The trade balance and net capital inflows sum to zero [ NX + KI = 0 ]

31. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 30 Example  A U.S. resident purchases a Japanese automobile priced at $20,000  Suppose the U.S. buyer writes a check for $20,000 to the Japanese car manufacturer who holds an account in a U.S. bank  What will the Japanese manufacturer do with the $20,000?

32. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 31 Example—Buys Goods and Services  The Japanese manufacturer can  1. Use the $20,000 to buy U.S. produced goods and services  Some U.S. car parts or Hawaiian vacations  In this case,  Net exports are balanced  NX = 0  The $20,000 of the import good is balanced with $20,000 of the exported goods

33. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 32 Example—Buys Assets  Or the Japanese manufacturer can  2. Buy U.S. assets  U.S. Treasury bond or some real estate  In this case  U.S. has a trade deficit of $20,000  NX = -$20,000  The $20,000 car import is not offset by any exports of goods or services  But there is a capital inflow of $20,000  KI = $20,000  In either case  Net exports and net capital inflows equal zero

34. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 33 Determinants of International Capital Flows  Basic factors determining the attractiveness of any asset  Risk or return  Financial investors seek a high rate of return  Other factors held constant  The higher the real interest rate in a home country  Domestic assets are more attractive  The more capital inflows, the less capital outflows  Opposite is also holds

35. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 34 Fig. 16.11 Net Capital Inflows and the Real Interest Rate

36. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 35 Fig. 16.12 An Increase in Risk Reduces Net Capital Inflows

37. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 36 Saving, Investment, and Capital Flows  Capital inflows increase the domestic saving pool  More funds available for investment  Increases economic growth  Capital outflows reduce the amount of saving available for investment  Restrains economic growth

38. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 37 Saving, Investment, and Net Capital Inflows Y = C + I + G + NX  Subtract C + G + NX from both sides to get Y – C – G – NX = I  We know S = Y – C – G  We know NX + KI = 0 or KI = - NX  Substituting S + KI = I  The pool of savings available for investment includes our national saving and funds from savers abroad

39. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 38 Fig. 16.13 The Saving-Investment Diagram for an Open Economy

40. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 39 S + KI Curve  At high values of the domestic real interest rate  Net capital inflows are positive  S + KI curve is greater than S  At low values of the domestic real interest rate  Net capital inflows are negative  S + KI curve is less than S

41. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 40 Benefits of Capital Inflows  A country that attracts significant amounts of foreign capital inflows will have a larger pool of total saving, hence, it will have  A lower real interest rate and higher investment  Capital inflows are very sensitive to risk  Countries that are politically stable and safeguard the rights of foreign investors will attract more foreign capital  These countries will grow quicker

42. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 41 Risks of Capital Inflows  Capital inflows also have risks  Countries that finance domestic investment in foreign financial capital must also it back  A number of developing countries have experienced debt crisis  Due to domestic investments made with foreign money turned out poorly  They were unable to pay the interest and dividends owed to foreign creditors

43. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 42 Misunderstanding Trade Deficits  People misunderstand the reason for trade deficits  Media stories sometimes claim that they occur because a country produces inferior goods or because other countries impose unfair trade restrictions  These are unsubstantiated claims

44. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 43 Explaining Trade Deficits  Economist argue that trade deficits primarily occur because of a low rate of national saving  Recall Y = C + I + G + NX  Subtracting C + I + G from both sides yields Y – C – G – I = NX  Recall S = Y – C – G yields S – I = NX

45. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 44 Explaining Trade Deficits  Holding investment (I) constant  A high rate of national saving S implies a high level of net exports NX  A low rate of national saving S implies a low level of net exports NX  If S < I, then NX will be negative

46. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 45 Low Saving S  A country with low national saving (S)  Households and governments have high spending rates relative to domestic income and production  Part of spending is on imported goods  An economy with low saving and high spending will have a high volume of imports  A low-saving economy consumes a large proportion of its domestic production, reducing exports

47. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 46 Low Saving (S)  A country with a trade deficit must be receiving positive net capital inflows  NX 0 if NX + KI = 0  A low national saving rate S is consistent with net capital inflows  A low saving economy will not have enough to finance its domestic investment, welcoming foreign savers  A low domestic saving also drives up domestic real interest rates which also attracts foreign savers

48. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 16 - 47 Fig. 16.14 National Saving, Investment, and the Trade Balance in the U.S., 1960-1999