chapters 37 and 38 world economy. international trade: the exchange of goods and services between...

Chapters 37 and 38World Economy

International Trade:• the exchange of goods and services between countries.

US’ s customers

(so be nice to Canadians)

International Trade vs Domestic Trade

• International trade is typically more costly than domestic trade.

• Factors of production less mobile internationally than domestically

• Need for exchanging currencies

• Political issues can block trade.

1973 oil embargo b/c US supports Israel

The volume of world trade

In most countries, it represents a significant share of Gross Domestic Product (GDP).

The volume of world trade• Without international

trade, nations would be limited to the goods and services produced within their own borders.

• International trade = More goods & services for consumers.

The volume of world trade

• multinational corporations and outsourcing are all having a major impact on the international trade system.

1. Microsoft

2. Nokia

3. Toyota Motor

4. Intel

5. Coca-Cola

6. Sony

7. IBM

8. General Electric

9. Nike

10. Citigroup

Top 10 Multinational Corporations

http://www.microsoft.com/

http://www.Nokia.com/

http://www.Toyota.com/

http://www.Intel.com/

http://www.Coca-Cola.com/

http://www.Sony.com/

http://www.IBM.com/

http://www.ge.com/

http://www.Nike.com/

http://www.Citigroup.com/

The volume of world trade grew b/c of

• Industrialization, • advanced

transportation,• globalization,

Economic Basis for Trade

Why do nations trade?

1. Distribution of resources: human*, natural & capital is uneven

* Human capital: education and skill set


2. Efficient production of goods requires different technology or combo of resources

Mercedes Factory


3. Products are differentiated as to quality & other non price attributes

Why Trade?

• David Ricardo: realized the benefits of trading via specialization; states could acquire more than their labor alone would permit them to produce. The Law of Comparative Advantage: each trading partner should specialize in and produce the goods in which they possess lowest opportunity cost.

Why Trade

• The conclusion drawn is that each country can gain by specializing in the good where it has comparative advantage, and trading that good for the other.

Absolute advantage

• The ability of a country* to produce more of a good or service than competitors, using the same amount of resources.

* or firm or individual

.

Absolute advantage

According to the theory of Absolute advantage, no trade will occur with the other party

Country C has the absolute advantage

Assumptions underlying the concept of comparative advantage

Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency


Constant returns to scale (i.e. doubling the inputs in each country - leads to a doubling of total output)


･ No externalities* arising from production and/or consumption

*Externalities are transaction spillover, a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit


Transportation costs are ignored

Comparative Advantage:

the ability of a party (an individual, a firm, or a country) to produce a particular good or service at a lower opportunity cost than another party.

Comparative Advantage

• It is the ability to produce a product with the highest relative efficiency given all the other products that could be produced.

How trade will take place under the theory of comparative advantage

A nation will be better off when it produces goods and services for which it has a comparative advantage.

Example of Gt. Britain & Portugal

• Both countries consume two goods: wine and wool.

• They rely on just one resource: labor.

• However, the productivity of labor in these agricultural industries depends upon the climate of the country.

Portugal = warm and sunny

• labor is relatively productive.

• A barrel of wine requires 1 man-day

• A bale of wool requires 3 man-days of labor.

• 1 Bale of Wool = 3 Barrels of Wine

Britain = cold, damp climate

• Labor is generally less productive.

• A barrel of wine requires 5 man-days

• A bale of wool requires 10 man-days of labor.

• 1 bale of wool = 2 barrels of wine.

the “Labor Theory of Value”

• Both Ricardo and Marx say that the value of every commodity is (in perfect equilibrium and perfect competition) proportionally to the quantity of labor contained in the commodity

Labor Required Per Unit of Product

• 1/3 Portugal (wool/wine)• 1/2 Britain (wool/wine)

Portugal Britain

bale of wool

3 10

barrel of wine

1 5

Britain begins to export wool to Portugal in return for Portuguese wine.

• If the wool sells at Portuguese prices, then each bale of wool will fetch 3 barrels of wine, rather than two as they would at home.

• The British can get their wine for 3.33 man-days of labor per barrel, while domestic wine would cost them 5 man-days per barrel. By importing wine they are getting it at a lower cost.

=

Portugal exports wine to Britain in return for British Wool.

• Two barrels of wine will fetch a bale of wool. • But, if the Portuguese produce wool at home, they will

have to divert labor sufficient to produce three barrels of wine.

• The Portuguese get their wool cheaper by producing wine to trade for it than by producing wool at home -- despite the fact that they can produce more wool per unit of labor than the British can.

=

Trade is beneficial to both countries

• Both countries get their goods more cheaply through trade, despite the fact that both industries are more productive in Portugal.


Britain has a comparative advantage in wool, even though Portugal has the absolute advantage in both goods.


• Every country has a comparative advantage in some goods.

• When a country trades according to its comparative advantage, it is making the best advantage of its own resources in production for export and for domestic production.

Free Trade

• System of trade policy that allows traders to act and or transact without interference from government.

The basic logic for the case for Free Trade

• According to the law of comparative advantage the policy permits trading partners mutual gains from trade of goods and services.

• So, world resources are used more efficiently

The basic logic for the case for Free Trade

• prices are a reflection of true supply and demand, and are the sole determinant of resource allocation.

• Increases competition

Free Trade

• Consumers get more choices

Current free trade areas with more than three member countries.

Trade Barriers

• any government policy or regulation that restricts international trade.

Trade Barriers: A) Tariffs:

• Tax levied on imports (& rarely exports).

• Raise revenues (revenue tariff) for government

• Types:

ad valorem tax:

sales Tax

value added (VAT)

Uncle Sam: Baby Industry needs “protection medicine” again?

A) Tariffs: ad valorem tax:

• Sales Tax: consumption tax @ pt. of purchase

• VAT: levied on the added value that results from each exchange.

• Property Tax: based on the value of the real property being taxed.

Trade Barriers: B) Import Quotas:

• protectionist trade restriction

• sets a physical limit on the quantity of a good that can be imported into a country in a given period of time.


• trade restriction used to benefit the producers of domestic goods at the expense of consumers of the good.


• Critics say quotas lead to corruption:

bribes (to get a quota allocation),

smuggling (circumventing a quota),

higher prices for consumers.

• less economically efficient than tarrifs

Trade Barriers: C) Non-tariff Barriers (NTBs):

• Are trade barriers that restrict imports but are not in the usual form of a tariff (i.e. tax).

Six Types of Non-Tariff Barriers to Trade

1. Specific Limitations on Trade:

1. Quotas2. Import Licensing

requirements 3. Proportion

restrictions of foreign to domestic goods (local content requirements)

4. Minimum import price limits

5. Embargos

Nixon rejected oil import quotas underthe guise of ensuring sufficient oil for defense.


2. Customs and Administrative Entry Procedures:

1.Valuation systems

2.Antidumping practices

3.Tariff classifications

4.Documentation requirements

5.Fees


3.Standards:1.Standard disparities in goods2.Intergovernmental acceptances of testing methods and standards3.Packaging, labeling, and marking


4.Government Participation in Trade:

1.Government procurement policies

2.Export subsidies3.Countervailing duties*4.Domestic assistance

programs

* duties imposed to neutralize the negative effects of subsidies.


5.Charges on imports:1.Prior import deposit subsidies2.Administrative fees3.Special supplementary duties4.Import credit discriminations5.Variable levies6.Border taxes


6. Others:

1.Voluntary export restraints: diplomatic, to build alliance

2.Orderly marketing agreements

Trade Barriers: D) Voluntary Export Restrictions (VERs):

• a government imposed limit on the quantity of goods that can be exported out of a country during a specified period of time.

a 1981 voluntary restraint agreement limited the Japanese to exporting 1.68 million cars to the U.S. annually.

Economic Effects of a Tariff :

• In almost all instances the tariff causes a net loss to the economies of both the country imposing the tariff and the country the tariff is imposed on.

Figure 1. Price without the influence of a tariff

Figure 2. Price under the effects of a tariff

Economic Effects of a Tariff Costs to Tariffs :

• The price of the good with the tariff has increased, the consumer is forced to either buy less of this good or less of some other good.

• price increase = reduction in consumer income.

10. Arguments for protectionism

The "Comparative Advantage" argument has lost its legitimacy

The "Comparative Advantage" argument assumes capital (and other factors) being immobile between nations.

Under the new global economy, capital tends simply to flow to wherever costs are lowest-that is, to pursue absolute advantage Ford Hermosillo Mexico plant

Employment Protection Argument Fallacy

• Tariffs and quotas to protect American employment reduce our standard of living as we engage in lines of production that are not efficient to provide jobs for ourselves

Employment Protection Argument Fallacy

The move to free trade would reconfigure employment patterns in the U.S.

• The loss of employment in certain lines of work with free trade are b/c of the current absence of free trade.

• These jobs would not have been created in the U.S. under free trade in the first place.

10. Arguments for protectionism B) Domestic tax policies can favor foreign goods

This reverse protectionism is most detrimental to those countries (like the US) that do not participate in the VAT system. (Value Added Tax on the sale of goods and services) b/c it is a double tax.

10. Arguments for protectionism

C) Infant industry argument must be protected in order to allow them to grow to a point where they can fairly compete with the larger mature industries established in foreign countries.

Other ways to protect/encourage Domestic Industry

Direct subsidies: Government subsidies (in the form of lump-sum payments or cheap loans) given to domestic so they can compete against foreign imports.

Export subsidies: used to increase exports (the opposite of tariffs)

Arguments for protectionism Infant industry argument

• Dumping: the practice of selling goods in a foreign market at less than cost

Divide the

$ Billions

# farmers

Protection of Domestic Industry Fallacy

• the protection of any U.S. industry is to that same extent a detriment to other U.S. industries.

Example: protectionism against steel imports harms American firms which use steel process (auto, appliances, construction, transportation)

Protection of Domestic Industry Fallacy

• It is most difficult for the government to identify an industry that deserves infant industry protection.

• One example is the US wool worsted industry.

Protection of Infant Domestic Industry: Not Valid Argument

• Direct subsidies are better policy tools than import restriction because they are more precise in their effects and less costly to the nation. Tariffs, quotas tend to stay in place past their usefulness (Brazil & computers)

Arguments for protectionism

Unrestricted trade undercuts domestic policies for social good.

Child labor, pollution, safety, living wage etc.Children picking cotton in Uzbekistan

Another Argument for protectionism: Military Self Sufficiency Argument

• Vital military goods may be unavailable from other countries in time of war and therefore a viable domestic industry is necessary for defense.

Military Self Sufficiency Argument Fallacy

• such a scenario can be dealt with by means of stockpiling the needed goods.

Military Self Sufficiency Argument has some merit

• Henry George: "What protection teaches us, is to do to ourselves in time of peace what enemies seek to do to us in time of war."

B-24 Liberators on the production line at the Ford Willow Run plant in Detroit

Protectionism Argument: Diversity - for - Stability

• (Has little application to the U.S. economy),

• In small countries that are heavily dependent on one resource that they export. Ex. Chile & copper

Protectionism Argument: Diversity - for - Stability

• The fallacy of the ‘Diversity - for – Stability’ in the example of Chile is that Chile has a strong advantage in copper production and to forcibly diversify would be to pay dearly in opportunity costs.

Domestic SupplySupply and Demand: Quota

• Sd and Dd: domestic supply and demand for a product.

• Pa , x equilibrium of Domestic Supply

• Pc is the world price of that product.

Country would supply v @ Pc

World produces z @ Pc (b/c supply meets demand)

• Sd + Q: government imposes a quota supply. Country supplies y @ Pt

Effects of Quotas & Tariffs on Domestic Supply

A tariff of PcPt will: have the same effect on domestic price as the quota.

Quota: domestic producers increase production from v to w

FDR’s Reciprocal Trade Agreements Act of 1934

11. Part of the Good Neighbor Policy (1933)

Provided for the negotiation of tariff agreements between the U.S. and separate nations, particularly Latin America countries.


The Act reduced tariffs and increased trade between the US and Latin America.


• The Act was a response to the Hawley - Smoot bill

http://www.youtube.com/watch?v=LKfrg6oIjh0

http://www.youtube.com/watch?v=LKfrg6oIjh0

Most Favored Nation status: MFN

• a country enjoys all the lowered tariffs and reductions of trade barriers that all other members receive.

• Used in The Jay Treaty, 1794 between UK & US

China granted MFN status after decades ofdebate during Clinton & Bush presidencies.

12. Why protectionism resurfaced in the 1980’s

• Governments around the world have again bailed out companies seen as strategic for ‘economic reasons’

1. Fannie Mae

2. AIG

3. Freddie Mac

4. GM

5. Bank of America

6. Citigroup

7. JPMorgan Chase

8. Wells Fargo

9. GMAC (now Ally Financial)

10. Chrysler

11. Goldman Sachs

12. Morgan Stanley

12. Why protectionism resurfaced in the 1980’s

• Bailed-out companies and sectors have been instructed not to move production abroad or to employ foreign workers.

• Bailed-out banks have been told to lend at home, not abroad.

• Antidumping measures are increasing.

(dumping: predatory pricing: when an imported good is sold at less than the good's domestic fair market value.)

Problem with Tariffs: Keeping score builds resentments

• Retaliatory Tariff: country impose tariff on another in response to protective measure(s) taken by the latter

International Trade: Why Bother?

• The economic interaction among different nations involving the exchange of goods and services, that is, exports and imports. The guiding principle of international trade is comparative advantage, which indicates that every country, no matter their level of development, can find something that it can produce cheaper than another country.

The Problem with Financing International Trade

1. What currency will the trade be done in?

2. How do uneven balance of payments affect the economies of trading nations?

3. Why do some countries fix the value of their currency?

4. How does this effect balance of payments?

5. How do U.S. trade deficits impact the economy?

How an Export/Import Transaction Operates:

The exchange rate between two currencies is a kind of price.

Example: How much 1 € costs in $US or 1 € = $US

What consumers and businesses that import want in the US? Strong dollar & weak Euro

What exporters want in US? Weak dollar strong Euro

http://www.xe.com/ucc/convert/?Amount=1&From=EUR&To=USD



Export/Import transactions create demand for

currencies depends on 1. demand of that country's goods

abroad. Foreigners need $US to buy American exports. Americans need foreign currencies to buy imported goods.

ex: If a Scotland buys a Corvettes, Bank of Scotland buys $US with Scottish Pounds from US Banks.

Demand for $US increasesSupply of Scottish pounds increases in

US BanksWhat happens when US buys Mini

Coopers?

Export/Import transactions create demand for currencies depends on

2. demand for domestic investment by foreigners.

3. the belief in the value of the currency in the future. (Speculative)

4. a central banking wanting holdings in that currency.

International Balance of Payments (BOP)

• an accounting record of all monetary transactions between a country and the rest of the world.


Includes:• payments for the

country's exports/imports,

• financial capital (holding currency as speculation or by national bank),

• financial transfers(foreign investment).


The BOP summarizes international transactions for a specific period (usually a year).

BOP = current account - capital account + balancing item

Current Account

current account = (net earnings on exports - payments for imports) + (earnings from foreign investments - payments to foreign investors) + cash transfers

Capital Account

capital account = the net change in ownership of foreign assets, (loans and investments)

Main recipients of foreign investment (2007)

Balancing Item

balancing item = amount that accounts for any statistical errors and make sure the current and capital accounts sum to zero

Debit or Credit

Balance of Trade = exports - imports

• The largest component of a country's Balance of Payments

Official Reserves

• In a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities.

The Currency Composition of Reserve Holdings

Source: International Monetary Fund,

Official Reserves

• However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights (SDRs are international foreign exchange reserve assets.) and International Monetary Fund (IMF) reserve positions.

What currency is the most popular in

countries’ reserves?

European Union

• The EU began in the 1950s as the ‘European Communities‘ with six member states.

• Today the European Union has 27 members, but not all use Euro. Who doesn’t?

http://ec.europa.eu/news/external_relations/101111_en.htm




deficits and surpluses

• trade deficit: when a nation imports more than it exports;

(a negative or unfavorable balance)

Okay if small. American consumers benefit from deficit in the period it occurs.

deficits and surpluses

• trade surplus: when a nation exports more than it imports; positive or favorable balance of trade.

•China- Balance of Trade 2000-07

Terms of trade: ratio at which nations exchange goods

• TOT is (Exports)/(Imports),

or • (Price Exports)/(Price

Imports). • In layman's terms it

means how much is exported per import, used as a proxy for the relative social welfare of a country,

Type of Exchange Rate Systems

1) Flexible exchange rate (aka Floating exchange rate): is one where governments neither announce an exchange rate nor take steps to enforce one.

2nd Type of Exchange Rate Systems:

• Fixed exchange rates: where governments specify the rate at which their currency will be converted into other currencies.

Free Floating exchange rate determined

• Determined by supply and demand.

• Is "self-correcting", as any differences in supply and demand will automatically be corrected in the market.

Currency Traders

The Determinants of Exchange Rates:

1. Differentials in Inflation: countries with higher inflation typically see depreciation in their currency in relation to the currencies of their - trading partners.


2. Differentials in Interest Rates: higher interest rates attract foreign capital and cause the exchange rate to rise.


3. Current-Account Deficits = (net earnings on exports - payments for imports) + (earnings from foreign investments - payments to foreign investors) + cash transfers


4. Public Debt: debt encourages inflation, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations.


5. Terms of Trade: A ratio comparing export prices to import prices; is related to current accounts and the balance of payments.

If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.


6. Political Stability and Economic Performance: Political turmoil can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

advantage of a flexible rate

• Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit.

Advantage of a Flexible Rate

Gives the government / monetary authorities flexibility in determining interest rates.

Because interest rates do not have to be set to an agreed upon exchange rate (within pre-determined bands).

Advantage/Disadvantage of a Flexible Rate

Terms of trade changes: A nation’s terms of trade will be worsen by a decline in the international value of its currency.

For example, if a country’s currency loses value, they have to spend more on imports.

TOT = Exports Imports

Disadvantage of a Flexible Rate

• Instability: Flexible exchange rates may have destabilizing effects on the domestic economy because wide fluctuations stimulate then contract industries producing exported goods.

Disadvantages of a Flexible Rate

• Uncertainty and diminished trade: If an individual in a domestic economy contracts to buy the exports of another country, a sudden fall in the exchange rate will increase the price of the goods.

Fixed Exchange Rate

• A country's exchange rate regime under which the government-or central bank ties the official exchange rate to another country's currency (or the price of gold).

Fixed Exchange Rate

• The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band.

• Also known as pegged exchange rate.

Policies to maintain a Fixed Exchange Rate

the government sets the official exchange rate.

The Argentine peso was fixed one-to-one against USDJanuary 2002, the "New Economic Policy" included the devaluation (and floating) of the peso


by either buying or selling its own currency on the open market.


by simply making it illegal to trade currency at any other rate. (black market)

Men Exchange Currency; Black MarketOriginal caption: 2/22/1949-Berlin, Germany


If a government fixes its currency to country A’s currency, it controls exchange rate by holding country A’s reserves.

Importers want their currency to be strong against the country they buy from.

Exporters want the opposite (weak currency)The UAE keeps its dirham pegged to the US dollar,

Types of Exchange Rate Systems

A) Floating

B) Fixed

or Pegged

C) Managed

Float

Gold Standard:

• A monetary standard (an economic system’s measure of value &

wealth) in which the standard economic unit of account (measurement of value/cost of

goods, services, or assets) is a fixed weight of gold.

Thomas Nast in 1876, comments on one debate that raged in the years following the Civil War: should the currency of the United States be based on gold (the "gold standard") or on paper (known as "greenbacks")?

3 conditions must be met for a nation to use the gold standard

1) a country's money supply is determined by its “stock of gold” (quantity of gold).

Country needs to be able to buy/sell gold in global market


2) The credibility of the monetary-authority (Fed) to maintain a fixed relationship between its stock of gold and its money supply.


3. Ability of country to insulate its economy from external monetary shocks: discovery of new gold mines.

The distribution of gold production in 2006.

Advantages to the Gold Standard

• money is backed by a fixed asset. It provides a self-regulating and stabilizing effect on the economy.


• more productive nations are directly rewarded. As they export more goods, they can accumulate more gold.


• discourages government debt and budget deficits, as well as trade deficits

Disadvantages to the gold standard

A gold standard leads to deflation/inflation whenever an economy using the gold standard grows faster/slower than the gold supply.

McKinley’s Gold Standard Campaign

Disadvantages to the gold standard

• Monetary policy would essentially be determined by the rate of gold production provoking speculation & instability.

The Bretton Woods System 1944

• Created an international basis for exchanging one currency for another.

• Led to the creation of the International Monetary Fund (IMF) and the World Bank (International Bank for Reconstruction and Development).

(The United Nations Monetary and Financial Conference)

Bretton Woods System

• made each country adopt a monetary policy that maintained their exchange rates within a fixed value in terms of gold.

1.pegged the value of $US to 1/35th of a troy ounce of gold.

2. Other currencies were pegged to the $US dollar at fixed rates.

Mount Washington Hotel

http://www.newhampshire.com/historical-markers/mount-washington-hotel-bretton-woods.aspx

http://www.newhampshire.com/historical-markers/mount-washington-hotel-bretton-woods.aspx

Reason for the failure of the Bretton Woods System

• On August 15, 1971, the U.S. went fiat. The Nixon Shock: $US became the sole backing of currencies and a reserve currency for the member states.

Current Monetary System for International Trade

• Managed Float (aka Dirty Float) currency exchange rate system is not controlled entirely by the market forces of demand and supply.

• Instead, it is controlled (at least partially) by government intervention that limits appreciation or depreciation of the currency within a range.

The Chinese have "managed" to keep about a 60 degree slope in the chart of gradual Yuan

appreciation.

US dollar / Chinese yuan

This “Managed” currency results in Undervaluing

• By how much is the yuan still undervalued?

• Using the Big Mac Index, a simple application of the PPP approach, suggests this may be over 50%.

Blue Line = yuan needed to buy $US in floating exchangeRed Line = yuan needed to buy $US in ‘managed’ exchange

Implications of Undervalued Yuan

• China’s Currency Policy Gives it a Distinct Advantage:

• Makes Chinese made goods cheaper and US T Bills’ interests rates higher for Chinese investors.

Remember: GDP = C + I + G +(Export - Imports)

General Agreement on Tariffs and Trade (GATT)

1947 multilateral agreement regulating trade among about 150 countries.

The purpose of GATT is the "substantial reduction of tariffs and other trade barriers and to increase trade.

North American Free Trade Agreement (NAFTA) 1994

• Goal of NAFTA was to eliminate trade barriers and investment between the US, Canada and Mexico.

• Free trade zone with the US, Canada and Mexico

The World Trade Organization (WTO) 1995

• Replaced GATT; has153 nations, 97% total world trade.

• Provides a framework for negotiating and formalizing trade agreements, and a dispute resolution process.

Central American Free Trade Agreement CAFTA 2006

Cut tariffs on commerce among the United States, Costa Rica, Nicaragua, El Salvador, Honduras, Guatemala & Dominican Republic

Central American Free Trade Agreement CAFTA

• Critics say it will increase poverty b/c it opens markets to US agricultural goods which are subsidized, making local farmers unable to compete with imports.

Central American Free Trade Agreement CAFTA

• Days before the January 1 2006 deadline for CAFTA was to go into effect, several of the CAFTA countries' parliaments were unwilling to ratify the controversial agreement at all. They had grave misgivings about the legislation required to implement the deal. It went into effect 2009 after concessions .

chapters 37 and 38 world economy. international trade: the exchange of goods and services between...

Documents

trade slide

nations trade

absolute advantage slide

benefit slide

international trade

loss of efficiency slide

doubling of total output

law of comparative advantage