Unit 2: The Global Economy

“Is the world really flat?”

Chapters 6 The U.S. in the Global Economy

Chapter 37 International Trade

Chapter 38 Exchange Rates, the Balance of Payments, and Trade

Deficits

Comparative/Absolute Advantage

=>Terms of Trade

FOREX

Balance of Trade

Global Trade Issues

Outsourcing jobsIllegal immigration – jobs takenMigration for jobsBalance of trade (trade deficit)Environment vs. economic growthPoverty in third world nations – does trade help or hurt?

Outsourcing vs. Insourcing

Trade Flows

Nations are linked by the exchange of:Trade flows = Goods and services

[exports (X) and imports (M)]

Resource flows = capital (production facilities) and labor move from nation to nation

Information and technology flows = info on prices, products, interest rates & investment opportunities; new technology

Financial flows = Money for imports, assets, interest on debts & foreign aid

Specialization and trade allows consumption possibilities to exceed production possibilities.

Name a few things that might limit our production possibilities and push us to seek goods and services from other nations?

• Resources we don’t produce ourselves• Climate and natural resource

limitations• Lack of skilled labor • Lack of low cost labor• Lack of capital resources (factories,

equipment, technology, etc.)

Why Trade?For political reasons

To help allies – strengthen relationsEX: U.S. and Taiwan in 1950’s

To show disapproval or force a change in political policies through embargo or boycott

EX: Boycott of S. Africa due to apartheid

No trade with China (1949-1972) and Cuba (1950-present)

Why Trade?For economic reasons

ABSOLUTE ADVANTAGE – when a nation can produce MORE of a good or service with the same or fewer resources

EX: Diamonds from S. AfricaCOMPARATIVE ADVANTAGE – when a nation can produce a good or service at the lowest opportunity cost

EX: wheat from U.S.

Comparative Advantage

Specialization – allows nations with the lowest opportunity cost to do what they do best, then tradeArbitrage – buy low and sell highAll participants in a voluntary exchange will benefitAllows total output to increaseIllustrated with PPC

To the Dry Erase!

AvocadosAvocados 90

60

Soybeans Soybeans

24 33

15 30 9 19

MEXICO U.S.

Comparative Advantage

Graph indicates that when self sufficient……

Mexico produces 24 avocados & 9 soybeans when most efficientU.S. produces 33 avocados & 19 soybeans when most efficient

To Find Opportunity cost = take max production #, put in fraction & reduce to show ratio

Comparative Advantage

To Find Opportunity cost for Mexico = take max production #, put in fraction & reduce

60 avocados/15 soybeans is an opportunity cost of 4 tons of avocados for each additional 1 ton of soybeans (1s=4a)

AND 15 soybeans/60 avocados =¼ ton soybeans for each additional 1 ton of avocados (1 a = ¼ s)

Now find the OC for the U.S. in terms of soybeans and avocados

Comparative Advantage

To Find Opportunity cost for U.S. = take max production #, put in fraction & reduce

90 avocados/30 soybeans is an opportunity cost of 3 tons of avocados for each additional 1 ton of soybeans (1s=3 a)AND 30 soybeans/90 avocados = 1/3 ton soybeans for each additional 1 ton of avocados (1 a = 1/3 s)

Comparative Advantage

After determining opportunity cost for each nation – compare them to find the “lowest op cost” – that shows what they should specialize in & trade Mexico has the advantage in avocados (1/4 is less “cost” than 1/3 tons of soybeans)U.S. has the advantage in soybeans

(3 is less “cost” than 4 tons of avocados)

Gains from trade

When Mexico specializes in avocados, they produce 60 tonsWhen the U.S. specializes in soybeans, they produce 30 tonsWithout trade, the maximum production (by both nations combined) would be:

24 + 33 = 57 tons of avocados (gain of 3 tons) 9 + 19 = 28 tons of soybeans (gain of 2 tons)

Castaways – Tom and WilsonDraw a PPC for both

Tom

Wilson

Coconuts

30

20

Fish

40

10

Consumption Tom

Wilson

9

8

28

6

Coconuts

20

30

Fish Fish

9 8

40 10

28 6

Tom Wilson

Tom’s C without trade Hank’s C without trade

Coconuts

Castaways – Tom and HankTheir respective OC

One fish

One coconut

Tom’s OC

¾ C

4/3 F

Wilson’s OC

2 C

½ F

What are the gains from trade?

Gains from TradeWithout Trade

With Trade

Gains

Production Consumption

Production Consumption

Tom

FishCoconuts

289

289

400

3010

+2+1

WilsonFishCoconuts

68

68

020

1010

+4+2

If Tom gives Wilson 10 fish, and Wilson gives Tom 10 Coconuts, what is the minimum number of fish and coconuts each should take in trade?

Wilsons OC of one fish is 2 coconuts. So, he should not accept any trade with Tom where he would give up more than 2 coconuts per fish. (he wants to pay < 2 coconuts per fish.)

Tom will reject any deal that requires him to give up more than 4/3 of a fish per coconut.

So Voluntary exchange only happens if the “price” is right.

Trade Barriers

Tariff – tax on imports (revenue & protective)

Quota – limit on number of imports Informal barriers – licenses, fees, health inspections, & regulations on transportation

Cultural and language differences

Protectionism vs. Free Trade

Pro Protectionism – National defense (keep tech safe)Avoid dependency on other nations (ex:oil)Protect jobs (keep $$ & jobs at home)Infant industries need time to developKeep balance of trade (exports = imports)

Protectionism vs. Free Trade

Pro Free TradeCompetition forces producers to lower prices & provide higher quality Trade raises the standard of living for all partiesMore efficiency when businesses specialize & trade = higher profits for owners Lost jobs are replaced with others Barriers lead to retaliation

Balance of Trade

Difference between exports and imports

(ideal is to have equal amounts; more exports = trade surplus; more imports = trade deficit)Surplus sounds good; deficit sounds bad; but this is not always trueU.S. has had a negative trade balance since 1981 – economists do not agree on how serious this is!

U.S. Trade Deficit for over 20 yrs

Balance of Trade

Balance of payments is based on:Credits (value of things sold abroad):

Goods & servicesU.S. securities (Treasury bonds or stocks)Factories or businesses in the U.S.Interest owed to U.S. citizens for investments abroad

Balance of Trade

Debits (value of things bought from firms abroad)

Goods and servicesForeign securities (stocks in foreign businesses)

Factories or businesses abroadInterest paid to foreign citizens on their investments here

Balance of Payments Account

There are two main accounts – Current Accounts (CA) & Financial Accounts (FA) previous“Capital Account”

If an account is positive it is said to have a surplus; if negative = a deficitThe overall account must be balanced (or total zero) CA + FA = zero

Balance of Payments AccountCurrent Account (CA) trade in goods & services:

Exports of goods & services + (plus)Imports of goods & services - (minus)

Financial Account (FA) summarizes trade in assets

U.S. assets owned by foreigners + (plus)Foreign assets owned by U.S. - (minus)

1999 Changes to BOT Categories

Old Current Account became 2 accounts:

the “New Current Account” –G & S; Income pmts & receiptsand the “New Capital Account” –account to record capital transfers

(ex: assets a migrant brings when moving here or debt forgiveness);

It is a small account for U.S., but more impt for other nations

1999 Changes to BOT Categories

Old Capital Account is now the “New Financial account” – trade in assets2008 Macro AP Exam had question using the terms: “Capital & Current Accounts” which was confusing to students (because they had not learned BOT or learned the new terms & didn’t know the old ones!)

Foreign Exchange Rates

Exchange rate – price of one currency in terms of another (multiply foreign price by exchange rate to get U.S. price)

Fixed rate – rate of exchange stays the same; in past basis was goldFlexible rate (floating) – based on supply and demand for each currency

Current Rates of Exchange 1 USD = 0.74 EUR Euro1 EUR = 1.36 USD

• 1 USD = 76.75 JPY Yen• 1 JPY = 0.01 USD

• 1 USD = 6.38 CNY “wren” or renminbi RMB

• 1 CNY = ?

Foreign Exchange Rates

Flexible rates – began in 1971 when U.S. went off the gold standard U.S. imports increased and foreigners were gaining U.S. dollars & exchanging them for U.S. goldForeign exchange market - wherever one currency is exchanged for another

Foreign Exchange

Appreciation (strong dollar) – dollar buys more of another currency & results in less expensive imports and more expensive exports (SID)Depreciation (weak dollar) – dollar buys less of another currency & results in more expensive imports and less expensive exports (WES)

“Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005

The Market for Yen

Quantity of Yen

Dol

lar

Pri

ce o

f 1

Yen

0

P

QQe

Sy

Dy

THE FOREIGN EXCHANGE MARKET

“Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005

P

Q

Dy

SyD

ollar

pri

ce o

f on

e Y

en

Quantity of Yen

3

2

1

Dollardepreciates

Dollarappreciates

The Market for Yen

THE FOREIGN EXCHANGE MARKET

The supply of U.S. dollars is determined by U.S. demand for foreign goods, services and investments.

Demand for U.S. dollars is determined by foreign demand for U.S. goods, services and investments.

Other countries want U. S. goods when:

-Ours are cheaper-Our inflation is less that theirs-Our interest rate is higher-The other country is growing faster

These cause the dollar to APPRECIATE

The $dollar depreciates when the opposite events occur.

I have no idea why I made this purple

The supply and demand of FOREXThink of dollars as a commodity with a simple supply/demand curve.

Remember—Set the Y axis up like a fraction. The currency that is the denominator is the currency on the X axis.

The exchange rate is the cost of the other country’s currency to one for the country in the graph. The quantity is the number that will be demanded and supplied in the world market at that “price”.

Foreign Exchange $ price for yen

$/Y

Yen price for $

Y/$

Qty of yen

Qty of $

S

D

S

D

Supply of yen from Japanese importers who must exchange them for $$ to buy U.S. goods

Demand for yen by U.S. importers who need them to buy Japanese goods

Foreign ExchangeCauses of S & D change - shifts (leads to exchange rate change):

Incomes go up or down (can buy more or less of foreign goods)

TastesRelative price level (inflation in one nation makes foreign goods cheaper)Real Interest Rates (want to earn on financial assets abroad if rates are higher)

Foreign Exchange

Must practice the supply and demand graphs for exchange rates PRACTICE – PRACTICE – PRACTICE!!!

AP Problem Areas – Increasing Questions on the Exam

Comparative Advantage problems in FRQ’sFOREX graphs & resulting changes in currency values, export/imports BOT questions

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BALANCE OF PAYMENTSChapter 38

Balance of Payments• A nation’s balance of payments is a measure

of money inflows and outflows between the United States and the Rest of the World (ROW)

-- Inflows are referred to as CREDITS -- Outflows are referred to as DEBITS• Transactions include –exports and imports of

services, tourist expenditures, interest and dividends received or paid abroad, and purchases and sales of financial or real assets abroad.

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The Balance of Payments is divided into 3 accounts

Current Account

Capital/Financial Account

Official Reserves Account

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Double Entry Bookkeeping• Every transaction in the balance of payments is

recorded twice in accordance with standard accounting practice

-- Ex. U.S. manufacture, John Deere, exports $50 million worth of farm equipment to Ireland. A credit of 50 million to the current account

( - 50 million worth of farm equipment or physical assets) A debt of $50 million to the capital/financial account

(+ $50 million worth of Euros or financial assets) Notice that the two transactions offset each other.

Theoretically, the balance of payments should always equal zero.

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Current Account• Balance of Trade or Net Exports -- Exports of Goods/Services –import of Goods/Services -- Exports create a credit to the balance of payments -- Imports create a debit to the balance of payments

Net Foreign Income -- Income earned by U.S. owned foreign assets –

Income paid to foreign held U.S. assets -- Ex. Interest payments on U.S. owned Brazilian

bonds - Interest payments n German owned U.S. Treasury bonds.Net Transfers (tend to be unilateral)

-- Foreign aid > a debit to the current account -- Ex. Mexican migrant workers send money to family

in Mexico.

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Capital/Financial Account• The balance of capital ownership• Capital account records the flows of money from the

purchase and sale of real and financial assets domestically and abroad.

• Definitions: real assets = a building or land financial assets = shares of stock

Direct investment in the U.S. is a credit to the capital account.

-- Ex. The Toyota Factory in San AntonioDirect investment by U.S. firms/individuals in a foreign country are debits to the capital account

-- Ex. The Intel Factory in Costa Rica58

Capital/Financial Account

Purchase of foreign financial assets represents a debit to the capital account

--Ex. Donald Trump buys stock in Petrochina.

Purchase of domestic financial assets by foreigners represents a credit to the capital account.

-- Ex. China buys stock in NASDAQ

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Official Reserves Account

The Federal Reserves holds quantities of foreign currency called official reserves. When adding current account and the capital account, if the U.S. has sent more dollars out than foreign currency has come in, there exists a balance of payments deficit. In this case the Fed credits the account so that it balances.

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