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CHAPTER 13: CHAPTER 13: INTERNATIONAL TRADE AND INTERNATIONAL TRADE AND
EXCHANGE RATEEXCHANGE RATE
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CHAPTER OUTLINE13.1 Absolute Advantage & Comparative 13.1 Absolute Advantage & Comparative
AdvantageAdvantage
13.2 The Trade Barriers13.2 The Trade Barriers
13.3 Balance of Payment (BOP)13.3 Balance of Payment (BOP)
13.4 Exchange Rate13.4 Exchange Rate
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13.1 Absolute Advantage & 13.1 Absolute Advantage & Comparative AdvantageComparative Advantage
• Absolute advantage– The advantage in the production of a
product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does.
More output with same resources
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13.1 Absolute Advantage & 13.1 Absolute Advantage & Comparative AdvantageComparative Advantage
• Comparative advantage– The advantage in the production of a
product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country.
Mean lower opportunity cost
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13.1 Absolute Advantage & Comparative Advantage
• To illustrate the theory of comparative advantage, let us consider the case of two countries, country A and Country B, producing just two products wheat and cars.
• Assume:
(i) assume constant unit costs.
(ii) no barriers to trade.
(iii) no transport or trading costs.
(iv) all factors are fully employed.
(v) the level of technology remain constant.
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Absolute Advantage
Car (units) Rice (units)
Country A 600 300
Country B
Total production
300
900
600
900
• Country _______has an absolute advantage in producing car.
• Country _______has an absolute advantage
in producing rice.
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Comparative Advantage
Car (units) Rice (units)
Country A 600 300
Country B
Total production
300
900
600
900
Opportunity Cost???
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Comparative Advantage
Car(units)
Opportunity cost
Rice(units)
Opportunity cost
Country A 600 300
Country B 300 600
Total production
900 900
• Country ______ has lower opportunity cost in producing car >> should specialize in producing car.
• Country ______ has lower opportunity cost in producing rice >> should specialize in producing rice.
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Production after Specialization
Car (units) Rice (units)
Country A
Country B
Total production
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Terms of Trade
• Definition:– The ratio at which a country can trade
domestic products for imported products.– How much of one good exchange for unit
of another good.• The terms of trade determine how the gains
from trade are distributed among trading partners.
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13.2 TRADE BARRIERS
• Protection – The practice of shielding a sector of the
economy from foreign competition.
• Varieties of Trade barriers:– Tariff– Quota– Export Subsidies – Dumping (Anti)– Embargoes
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Tariffs
• Definition:– A tax on imports that governments place on
internationally traded goods to encouraging the consumption of domestic goods.
• Tariffs will increase price and reduce quantity.• Under a tariff, the government collects the
tariff revenue.
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Tariffs
Tariff revenue2.00
2.50
Initialimports
Domestic supply
Domestic demand
3.00
100 125 175 200
Price(RM)
Quantity
World price = 2
World price with tariff = 2.50
t = .50
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Quota
• Definition:– A limit on the quantity of imports.
• Quotas will increase price and reduce quantity.
• With a quota, the domestic price increases, and the importer will gets the revenue.
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Quotas
Price(RM)
Quantity
2.00
2.50
Quota
Domestic supply
Domestic demand
3.00
100 125 175 200
World supply with
quota
World price=RM2=World supply
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Export Subsidies
• Definition:– Government payments made to domestic firms
to encourage exports.
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Dumping (Anti)
• Definition:– A firm or industry’s sale of products on the
world market at prices below the cost of production.
– Selling a product abroad for less than charged in the home market or less than the cost of production.
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Embargoes
• Definition:– An embargo is a total restriction on import
or export of a good.• Embargoes are usually established for
international political reasons rather than for economic reasons.
• The U.S. has imposed embargoes on Iraq, Iran, Libya, and Cuba.
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13.3 THE BALANCE OF 13.3 THE BALANCE OF PAYMENTSPAYMENTS
• Definition:– The record of a country’s transactions in goods,
services, and assets with the rest of the world; – Also the record of a country’s sources (supply)
and uses (demand) of foreign exchange.
• 3 main components in the BOP:– Current account– Capital & financial account– The reserve assets
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Current Account
• Definition:– Records payments for the imports of
goods and services from abroad, receipts from exports of goods and services sold abroad, net income received from investment abroad, and net transfer payments from abroad.
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Current Account
• Goods– Record all import and export of goods.– Example: Malaysia exports Proton cars to Canada
and import wheat from New Zealand.
• Services– Recorded all import and export of services.– Example: Payments abroad for education, business
and leisure.
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Current Account
• Net exports of goods and services (EX-IM)– The difference between a country’s total
exports and total imports.– Also known as balance of trade.
• Trade surplus– The situation when a country exports more
than it imports.
• Trade deficit– The situation when a country imports more
than it exports.
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Current Account
• Income – cover two type of transactions:– Income received on investments– Income payments on investments
• Income received on investment:– The external financial assets and liabilities made
by Malaysian at oversea.– Example: Dividends and interest arising from direct
investment abroad by Malaysian companies.
• Income payments on investment– The investment by foreigner in Malaysia.
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Current Account
• Net transfer payments/ current transfer:– The unilateral transfers that involve a one-way
payment.– Example: When Malaysian government donates to
foreign country in form of charities.
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Current Account
• Balance on current account :– The sum of the net exports of goods and services, net
investment income and net transfer payment.
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Capital Account
• Capital account:– Records relatively minor transactions such as capital
transfer and acquisition of non-financial assets such as patents, copyright, etc.
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Capital Account
• Balance on capital account – In the United States, the sum of the following
(measured in a given period): the change in private U.S. assets abroad, the change in foreign private assets in the United States, the change in U.S. government assets abroad, and the change in foreign government assets in the United States.
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Financial account
• Financial account:– Records purchase of assets a country made abroad
and foreign purchases of assets in country.– Classified such as direct investment, portfolio
investment and other investment.
Malaysia Case
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Error and Omissions
• Error and omissions:– Account for missing information.
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Balance of Payment (BOP)
• Overall balance of payment:– The sum of current account, capital
account, net capital account transaction and error and omissions.
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THE BALANCE OF PAYMENTS
– 1.5(11) Net capital account transactions
0(12) Balance of payments (5 + 10 + 11) 51.9
(11) Statistical discrepancy
615.5(10) Balance on capital account (6 + 7 + 8 + 9)
355.3(9) Change in foreign government assets in the United States
4.1 (8) Change in U.S. government assets abroad (increase is –)1077.9 (7) Change in foreign private assets in the United States
– 821.8 (6) Change in private U.S. assets abroad (increase is –)CAPITAL ACCOUNT
??????(5) Balance on current account (1 + 2 + 3 + 4)– 72.9(4) Net transfer payments????? (3) Net investment income
– 344.9Income payments on investments369.0Income received on investments
????? (2) Net export of services– 291.2Import of services
339.6Export of services
?????? (1) Net export of goods– 1,473.1Goods imports
807.6Goods exportsCURRENT ACCOUNT
TABLE 21.1 United States Balance of Payments, 2004
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Multiplier Effect & Aggregate Expenditure (extension from Chapter 11):
Planned aggregate expenditure (AE) in an open economy:
A E C I G E X IM
In equilibrium:C a bY I I 0
G G 0
E X E X 0
IM m Y
Y C I G E X IM Y a bY I G E X m Y Y bY m Y a I G E X Y b m a I G E X( )1
Yb m
a I G E X* ( )
1
1multiplierm = marginal propensity to
import (or MPM)
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Exports
• Exports contribute to an increase in autonomous expenditures and cause the planned aggregate expenditure function to shift upward.
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Imports
• Imports affect the value of the multiplier.
• After imports are included, the aggregate expenditure function rotates and equilibrium income decreases.
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13.4 Exchange Rate
• The main difference between an international transaction and a domestic transaction concerns currency exchange.
• Exchange rate:– The price of one country’s currency in terms of
another country’s currency; the ratio at which two currencies are traded for each other.
• Foreign exchange: – The price at which one currency exchanges
for another currency.
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Exchange Rate
• 3 types of exchange rate system:– Fixed exchange rate– Flexible exchange rate– Managed floating system/ semi-fixed
exchange rate
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Fixed Exchange Rate
• Definition:– Government set a particular fixed rate at which their
currencies will exchange for each other.– Example: Pegging (RM3.80 = $1.00)
• Appropriate for developing countries with limited links to global financial production and export structure.
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Fixed Exchange Rate
• Advantage:– Provide greater certainty for exporters and
importers.• Disadvantage:
– Encourages foreign debt.
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Flexible Exchange Rate
• Definition:– Exchange rates determined by the unregulated
force of supply and demand.
• The exchange rate movements have important impacts on imports, exports, and movement of capital between countries.
• Appropriate for medium and large industrialized countries and some emerging market economies.
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Flexible Exchange Rate
• Advantage:– Can provide an automatic adjustment for
countries with a large balance of payments deficit.
• Disadvantage:– Increase foreign exchange volatility and
this may cause serious problems, especially in emerging economies.
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Managed Floating System
• Definition:– The government sometimes buys or
sells currencies to influence the exchange rate, while at other times letting private market forces operate.
• Central bank may have to intervene to maintain the value of the currency within the target.
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Managed Floating System
• Appropriate for emerging market economies and some other developing countries with relatively stronger financial sector and track record for disciplined macroeconomic policy.
• Advantage:– Can maintain stability and competiveness.
• Disadvantage:– Lead to uncertainty.
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Fixed ER System vs. Flexible ER System
Fixed ER• ER fixed by the government
through Central Bank intervention
• Currency is pegged to one key currency
• Country needs to purchase @ sell foreign currency to ensure that the ER does not move above @ below the official ER
• Country must hold international reserves (foreign currency) to maintain the ER
Flexible ER
• ER determined by the unregulated forces of SS & DD
• Currency can appreciate @ depreciate – fluctuation in ER
• Country do not need to purchase @ sell foreign currency to ensure that the ER does not move above @ below the official ER
• Country do not need to hold international reserves (foreign currency) to maintain the ER
The Open Economy With FlexibleExchange Rates
• Currency depreciation: • The rise in value of one currency relative to another
in a flexible rate system.
• Currency appreciation:• The fall in value of one currency relative to another in
a flexible rate system.
The Equilibrium Exchange Rate
3.49
0
D
S
Foreign exchange(millions of dollars)800 820
Exc
han
ge
rate
(R
M p
er d
olla
r)
Initial equilibrium exchange rate is RM3.49If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually
3.50
3.48
Figure: Effect on the Foreign Exchange Market of
an Increased Demand for Dollars
3.49
0
D
S
Foreign exchange(millions of dollars)
800
3.50
820
Suppose an increase in Malaysia incomes causes Malaysian to increase their demand for all normal goods, including those from the U.S area: demand curve shifts from D to D'The shift of the demand curve leads to an increase in the exchange rate from RM3.49 to RM3.50 per dollar.The dollar appreciates and the RM depreciates: U.S people purchase more Malaysian products.
Exc
han
ge
rate
(R
M p
er d
olla
r)
D'
The Open Economy With FlexibleExchange Rates
• Fundamental forces determine the demand and supply for currencies and can cause them to shift:– A country’s income– Changes in a country’s prices– The interest rate in a country– A country’s trade policy
Changes in a Country’s Income
Income increases in the Malaysia
Imports increase
Demand for foreign currency to buy imports increase which means the supply of the RM increases
The increase in supply of the RM causes the price of the RM to decrease
Changes in a Country’s Income
Changes in a Country’s Prices
Inflation in the Malaysia increases
Imports increase because foreign goods are cheaper
Demand for foreign currency to buy imports increases which means the supply of the RM increases
The increase in supply of RM causes the price of RM to decrease
Changes in a Country’s Prices
Changes in Interest Rates
Interest rates in the Malaysia increase
Demand for Malaysia interest-bearing assets increases
Demand for RM to buy Malaysia assets increases
The increase in the demand for RM causes the price of RM to increase
Changes in Interest Rates
Changes in Trade Policy
Malaysia trade restrictions on imports increase
Demand for imports to the Malaysia decreases
The demand for foreign currencies decreases, which means the supply of RM decreases
If foreign countries retaliate with restrictions on Malaysia exports, the demand for RM decreases
Changes in Trade Policy
The Effects of Exchange Rate on the Economy
• The level of imports and exports depends on exchange rates as well as on income and other factors.
• When events cause exchange rates to adjust, the levels of imports and exports will change.
• Changes in exports and imports can in turn affect the level of real GDP and the price level.
• Further, exchange rates themselves also adjust to changes in the economy.
Exchange Rate Effects on Imports, Exports, and Real GDP
• A depreciation of a country’s currency is likely to increase its GDP (e.g Malaysia) can serve as a stimulus to the economy:– Foreign buyers are likely to increase their
spending on Malaysian goods (relatively cheaper)
– Buyers substitute domestically made goods for imports (as import will costs more)
– Aggregate expenditure on domestic output will rise
– GDP (Y) will increase
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Increase in M Interest rate fall Investor earning lower IR
Seek better investment abroad
Sell local currency Buy foreign currency
Exchange rate fall (depreciate)
Local (foreign) product cheaper (more expensive)
Net export increase
Monetary Policy with Flexible Exchange Rate
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