ubea 1013: economics 1 chapter 13: international trade and exchange rate 13.1 absolute advantage...
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UBEA 1013: ECONOMICS
CHAPTER 13: CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATEINTERNATIONAL TRADE AND EXCHANGE RATE
13.1 Absolute Advantage & Comparative Advantage13.1 Absolute Advantage & Comparative Advantage
13.2 Open Economy: Export – Import13.2 Open Economy: Export – Import
13.3 Exchange Rate13.3 Exchange Rate
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UBEA 1013: ECONOMICS
13.1 Absolute Advantage & Comparative 13.1 Absolute Advantage & Comparative AdvantageAdvantage
• David Ricardo’s theory of comparative advantage, states that specialization and free trade will benefit ALL trading partners, even those that may be absolutely less efficient producers.
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UBEA 1013: ECONOMICS
• A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.
• A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does. More output with same resources
Mean lower opportunity cost
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UBEA 1013: ECONOMICS
Yield Per Acre for Wheat And Cotton
NEW ZEALAND
AUSTRALIA
Wheat 6 units 2 units
Cotton
Total land
2 units
100 acres
6 units
100 acres
• New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton.
• We say that the two countries have mutual absolute advantage.
Absolute Advantage:
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UBEA 1013: ECONOMICS
Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres
NEW ZEALAND AUSTRALIA
Wheat 25 acres x 6 units/acre150 units
75 acres x 2 units/acre150 units
Cotton 75 acres x 2 units/acre150 units
25 acres x 6 units/acre150 units
• Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below:
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UBEA 1013: ECONOMICS
Production Possibility Frontiers for Australia and New Zealand Before Trade
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UBEA 1013: ECONOMICS
Gain from mutual Absolute Advantage:
• Absolute advantage theory urges countries to specialize in the production it has the absolute advantage (higher production per unit of resources).
• Therefore, New Zealand should specialize in production of wheat while Australia in production of cotton.
Yield Per Acre for Wheat And Cotton
NEW ZEALAND AUSTRALIA
Wheat 6 units 2 units
Cotton
Production:
Wheat
Cotton
2 units
600 units
0 unit
6 units
0 unit
600 units
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UBEA 1013: ECONOMICS
Production and Consumption of Wheat and Cotton after Specialization
PRODUCTION CONSUMPTION
New Zealand Australia New Zealand Australia
Wheat 600 units 0 unit 300 units 300 units
Cotton 0 unit 600 units 300 units 300 units
• An agreement to trade 300 units of wheat for 300 units of cotton would double both wheat and cotton consumption in both countries.
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• Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.
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UBEA 1013: ECONOMICS
Yield Per Acre for Wheat And Cotton
CASE 1: NEW ZEALAND
AUSTRALIA
Wheat 6 units 2 units
Cotton 2 units 6 units
Comparative Advantage:
Yield Per Acre for Wheat And Cotton
CASE 2: NEW ZEALAND
AUSTRALIA
Wheat 6 units 1 units
Cotton 6 units 3 units
Mutual Absolute
Advantage
New Zealand has absolute
advantage in both wheat &
cotton production
Can trade benefit BOTH?
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UBEA 1013: ECONOMICS
Opportunity cost (The cost of reducing other products to produce another unit of a particular product)
One additional unit of:
NEW ZEALAND AUSTRALIA
Wheat 6 / 6 = 1 unit of cotton 3 / 1 = 3 units of cotton
Cotton 6 / 6 = 1 unit of wheat 1 / 3 = 0.33 unit of cotton
• New Zealand has lower opportunity cost in producing wheat >> should specialize in producing wheat
• Australia has lower opportunity cost in producing cotton >> should specialize in producing wheat
Comparative AdvantageComparative Advantage
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UBEA 1013: ECONOMICS
Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres
NEW ZEALAND AUSTRALIA
Wheat 50 acres x 6 units/acre300 units
75 acres x 1 units/acre75 units
Cotton 50 acres x 6 units/acre300 units
25 acres x 3 units/acre75 units
• Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below:
Comparative AdvantageComparative Advantage
• The gains from trade in this example can be demonstrated in two stages.
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UBEA 1013: ECONOMICS
Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
Stage 1: Countries specialize
Wheat
STAGE 1
New Zealand Australia75 acres x 6 units/acre
= 450 units0 unit
Cotton 25 acres x 6 units /acre= 150 units
100 acres x 3 bales/acre300 bales
• Australia specialized in cotton production. New Zealand transfers 25 acres out of cotton production into wheat.
• New Zealand cannot completely specialize in wheat production because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat).
Comparative AdvantageComparative Advantage
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Stage 2: Countries trade
STAGE 2
New Zealand Australia100 units (trade)
Wheat 350 units 100 units
(after trade)
200 units (trade)
Cotton 350 units 100 units
(after trade)
Agreed trading price: (Term of Trade)
2 units of cotton for 1 unit of wheat
Comparative AdvantageComparative Advantage
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• Terms of trade: The ratio at which a country can trade domestic products for imported products.
• The terms of trade determine how the gains from trade are distributed among trading partners.
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13.2 Open Economy: Export – Import 13.2 Open Economy: Export – Import
• Export & Import transactions is recorded in the country balance of payment under the “current account”.
National Accounting (extension from Chapter 9):
• The balance of payments is 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.
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UBEA 1013: ECONOMICS
• A country’s current account is the sum of its:– net exports (exports minus imports),– net income received from investments abroad, and – net transfer payments from abroad.
• The balance of trade is the difference between a country’s exports of goods and services and its imports of goods and services.
• A trade deficit occurs when a country’s exports are less than its imports.
• Net exports of goods and services (EX – IM), is the difference between a country’s total exports and total imports.
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Multiplier Effect & Aggregate Expenditure (extension from Chapter 11):
Planned aggregate expenditure (AE) in an open economy:
AE C I G EX IM • In equilibrium:C a bY
I I 0
G G 0
EX EX 0
IM mY
Y C I G EX IM Y a bY I G EX mY Y bY mY a I G EX Y b m a I G EX( )1
Yb m
a I G EX* ( )
1
1multiplierm = marginal propensity
to import (or MPM)
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UBEA 1013: ECONOMICS
• Exports contribute to an increase in autonomous expenditures and cause the planned aggregate expenditure function to shift upward.
• Imports affect the value of the multiplier. After imports are included, the aggregate expenditure function rotates and equilibrium income decreases.
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UBEA 1013: ECONOMICS
13.3 Exchange Rate 13.3 Exchange Rate
• The main difference between an international transaction and a domestic transaction concerns currency exchange.
• The exchange rate is 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 is simply all currencies other than the domestic currency of a given country.
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Three Type of Exchange Rate System:
• Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand.
• (Exchange rate movements have important impacts on imports, exports, and movement of capital between countries).
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UBEA 1013: ECONOMICS
• Fixed exchange rates: governments set a particular fixed rate at which their currencies will exchange for each other.
• (Pegging a currency to another currency is in this fixed exchange rate system).
• Managed floating system: In this system, governments intervene if markets are becoming disorderly.
• (Usually, the currency is allowed to float within a pre-determined ranged)
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Monetary Policy & (Floating) Exchange Rate (extension from Chapter 11):
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
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UBEA 1013: ECONOMICS
• The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied.
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UBEA 1013: ECONOMICS
• The level of a country’s interest rate relative to interest rates in a determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British citizens may be attracted to U.S. securities (relative higher return).
• Increase of British investors to seek better investment in US increases the supply of dollar and decreases the demand for pounds.
• The result is depreciation of the pound against the dollar.
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UBEA 1013: ECONOMICS
• A depreciation of a country’s currency (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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UBEA 1013: ECONOMICS
• Who will benefit if the domestic currency depreciate?
– Export sector (more competitive)
• An interesting case: During Asian financial crisis, Ringgit depreciate sharply. What happen to the domestic crude palm oil (CPO) price?
– UP (Why?) (CPO Futures contracts prices traded in Kuala Lumpur Commodities Exchange shot up continuously).
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UBEA 1013: ECONOMICS
• CPO price are quoted at international currency (the US dollar).
• Thus, depreciation of Ringgit cause the price of CPO relatively higher (in term of the local currency or Ringgit)
• Another question: Now, Malaysia has de-peg the Ringgit against the US$ (now under a managed float system). General opinion think that the Ringgit will appreciate.
• Who will benefit if the Ringgit really appreciate?
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UBEA 1013: ECONOMICS
The beneficiaries:
• Companies that have huge US$-dominated debt: e.g. Telekom Malaysia & Tenaga Nasional. They will benefit from one-off translation gains and lower interest expenses.
• Companies that have high imported input cost: e.g. auto & media industry being the obvious.
The “losers”?
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UBEA 1013: ECONOMICS
The losers:
• Exporters: less competitive due to relative higher price (in term of foreign currency).
• Companies with a large part of their revenue stream in foreign currencies. A stronger Ringgit mean less revenue in the local currency after conversion.
• Therefore, the worst will be those “cost in Ringgit, revenue in Dollar” companies. E.g. plantation, semiconductor and timber sector. Their profit margin will be reduced.
End