Chap13

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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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