International Trade and Finance. 1 of of 40

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1 Survey of of Economics: Principles, Applications, and and Tools Tools O Sullivan, Sheffrin, Perez Perez 4/e. 4/e. 1 of 40 2 of 40 Ever since World War II, the nations of the world have regularly negotiated trade agreements with each other that have successively reduced barriers to global trade. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU 3 of 40 1

2 A P P L Y I N G T H E C O N C E P T S Does the protection of one domestic industry harm another? Candy Cane Makers Move to Mexico for Cheap Sugar Do tariffs (taxes) on imported goods hurt the poor disproportionately? The Impact of Tariffs on the Poor How well has the new European central bank managed Monetary policy? Managing the Euro: The European Central Bank 4 of COMPARATIVE ADVANTAGE AND EXCHANGE Specialization and the Gains from Trade P R I N C I P L E O F O P P O RT U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it. 5 of COMPARATIVE ADVANTAGE AND EXCHANGE FIGURE 18.1 Specialization and the Gains from Trade comparative advantage The ability of one person or nation to produce a good at a lower opportunity cost than another person or nation. Fred has a comparative advantage in producing fish because his opportunity cost of fish is one-third coconut per fish, compared to 1 coconut per fish for Kate. Kate has a comparative advantage in harvesting coconuts because her opportunity cost of coconuts is 1 fish per coconut, compared to 3 fish per coconut for Fred. 6 of 30 2

3 18.1 COMPARATIVE ADVANTAGE AND EXCHANGE P R I N C I P L E O F V O L U N T A R Y E X C H A N G E A voluntary exchange between two people makes both people better off. Comparative Advantage versus Absolute Advantage absolute advantage The ability of one person or nation to produce a product at a lower resource cost than another person or nation. 7 of COMPARATIVE ADVANTAGE AND EXCHANGE The Division of Labor and Exchange In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith noted that specialization actually increased productivity through the division of labor. Smith listed three reasons for productivity to increase with specialization, with each worker performing a single production task: 1 Repetition. The more times a worker performs a particular task, the more proficient the worker becomes at that task. 2 Continuity. A specialized worker doesn t spend time switching from one task to another. This is especially important if switching tasks requires a change in tools or location. 3 Innovation. A specialized worker gains insights into a particular task that lead to better production methods. 8 of COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE import A product produced in a foreign country and purchased by residents of the home country. export A product produced in the home country and sold in another country. 9 of 30 3

4 18.2 COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE Outsourcing When a domestic firm shifts part of its production to a different country, we say the firm is outsourcing or offshoring. Some recent studies of outsourcing have reached a number of conclusions: 1 The loss of domestic jobs resulting from outsourcing is a normal part of a healthy economy, because technology and consumer preferences change over time. 2 The jobs lost to outsourcing are at least partly offset by jobs gained through insourcing, jobs that are shifted from overseas to the United States. 3 The cost savings from outsourcing are substantial, leading to lower prices for consumers and more output for firms. The jobs gained from increased output at least partly offset the jobs lost to outsourcing. 10 of COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE Movie Exports FIGURE 18.2 International Box Office Revenue for U.S. Films, of 30 A P P L I C A T I O N 1 CANDY CANE MAKERS MOVE TO MEXICO FOR CHEAP SUGAR APPLYING THE CONCEPTS #1: Does the protection of one domestic industry harm another? About 90 percent of the world s candy canes are consumed in the United States, and until recently most were produced domestically. Domestic firms used their superior access to consumers to dominate the market. In recent years, the domestic production of candy canes has decreased. In 2003, Spangler Candy Company of Bryan, Ohio, shifted half its production to Mexico because the cost of sugar, the key ingredient in candy, is only $0.06 per pound in Mexico, compared to $0.21 in the United States. Since 1998, the Chicago area, the center of the U.S. confection industry, has lost about 3,000 candy-production jobs. Why is the price of sugar in the United States so high? The government protects the domestic sugar industry from foreign competition by restricting sugar imports. As a result, the supply of sugar in the United States is artificially low and the price is artificially high. In this case, the protection of jobs in one domestic industry reduces jobs in another domestic industry. 12 of 30 4

5 18.3 PROTECTIONIST POLICIES Import Bans FIGURE 18.3 Effects of an Import Ban In the free-trade equilibrium, demand intersects the total supply curve at point c, with a price of $12 and a quantity of 80 shirts. If shirt imports are banned, the equilibrium is shown by the intersection of the demand curve and the domestic supply curve (point a). The price increases to $ of PROTECTIONIST POLICIES Quotas and Voluntary Export Restraints import quota A government-imposed limit on the quantity of a good that can be imported. voluntary export restraint (VER) A scheme under which an exporting country voluntarily decreases its exports. 14 of PROTECTIONIST POLICIES Quotas and Voluntary Export Restraints FIGURE 18.4 Market Effects of a Quota, a VER, or a Tariff An import quota shifts the supply curve to the left. The market moves upward along the demand curve to point d, which is between point c (free trade) and a (an import ban). We can reach the same point with a tariff that shifts the total supply curve to the same position. 15 of 30 5

6 18.3 PROTECTIONIST POLICIES Quotas and Voluntary Export Restraints import licenses Rights, issued by a government, to import goods. tariff A tax on imported goods. Responses to Protectionist Policies A restriction on imports is likely to lead to further restrictions on trade. Many import restrictions have led to retaliatory policies and substantially lessened trade. The most famous was the Smoot-Hawley Tariff Act of When the United States increased its average tariff on imports to 59 percent, its trading partners retaliated with higher tariffs on U.S. products. The resulting trade war reduced international trade and deepened the worldwide depression of the 1930s. 16 of 30 A P P L I C A T I O N 1 THE IMPACT OF TARIFFS ON THE POOR APPLYING THE CONCEPTS #1: Do tariffs (taxes) on imported goods hurt the poor disproportionately? Economists have found that tariffs in the United States fall most heavily on lowerincome consumers. Footwear accounts for: 1.3 percent of the expenditure of lower-income households. 0.5 percent of the expenditure of higher-income households. The highest tariffs fall on the cheapest products precisely those that will be purchased by lower-income consumers. Low-price sneakers face a 32 percent tariff. Expensive track shoes face only a 20 percent tariff. To protect U.S. industries, tariffs are highest on labor-intensive goods. But these goods tend to be lower priced. That is why tariffs do fall disproportionately on the poor. 17 of A BRIEF HISTORY OF INTERNATIONAL TARIFF AND TRADE AGREEMENTS General Agreement on Tariffs and Trade (GATT) An international agreement established in 1947 that has lowered trade barriers between the United States and other nations. World Trade Organization (WTO) An organization established in 1995 that oversees GATT and other international trade agreements, resolves trade disputes, and holds forums for further rounds of trade negotiations. In addition to the large group of nations in the WTO, other nations have formed trade associations to lower trade barriers and promote international trade: The North American Free Trade Agreement (NAFTA) The European Union (EU) Asian Pacific Economic Cooperation (APEC) Dominican Republic - Central America Free Trade Agreement (DR-CAFTA) 18 of 30 6

7 18.5 HOW EXCHANGE RATES ARE DETERMINED What Are Exchange Rates? exchange rate The price at which currencies trade for one another in the market. euro The common currency in Europe. An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency. A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency. 19 of HOW EXCHANGE RATES ARE DETERMINED How Demand and Supply Determine Exchange Rates FIGURE 18.5 The Demand for and Supply of U.S. Dollars Market equilibrium occurs where the demand for U.S. dollars equals the supply. 20 of HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply FIGURE 18.6 Shifts in the Demand for U.S. Dollars An increase in the demand for dollars will increase (appreciate) the dollar s exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars. 21 of 30 7

8 18.5 HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply FIGURE 18.7 Shifts in the Supply of U.S. Dollars An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate. Higher European interest rates or lower European prices will increase the supply of dollars. 22 of HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply Let s summarize the key facts about the foreign exchange market, using euros as our example: 1 The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros. 2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros. 3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar. 4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar. 23 of FIXED AND FLEXIBLE EXCHANGE RATES To set the stage for understanding exchange rate systems, let s recall what happens when a country s exchange rate appreciates increases in value. There are two distinct effects: 1 The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated. 2 The increased value of the exchange rate makes U.S. goods more expensive on world markets. 24 of 30 8

9 18.6 FIXED AND FLEXIBLE EXCHANGE RATES Fixing the Exchange Rate foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate. FIGURE 18.8 Government Intervention to Raise the Price of the Dollar To increase the price of dollars, the U.S. government sells euros in exchange for dollars. This shifts the demand curve for dollars to the right. 25 of FIXED AND FLEXIBLE EXCHANGE RATES Fixed versus Flexible Exchange Rates FLEXIBLE EXCHANGE RATE SYSTEM flexible exchange rate system A currency system in which exchange rates are determined by free markets. FIXED EXCHANGE RATES fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating. 26 of FIXED AND FLEXIBLE EXCHANGE RATES Fixed versus Flexible Exchange Rates BALANCE OF PAYMENTS DEFICITS AND SURPLUSES balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country s currency exceeds the demand for the currency at the current exchange rate. balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country s currency exceeds the supply for the currency at the current exchange rate. devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system. revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system. 27 of 30 9

10 18.6 FIXED AND FLEXIBLE EXCHANGE RATES The U.S. Experience with Fixed and Flexible Exchange Rates Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies especially to maintain similar inflation rates and interest rates. Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge. Exchange Rate Systems Today The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods. Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen. 28 of 30 A P P L I C A T I O N 3 MANAGING THE EURO: THE EUROPEAN CENTRAL BANK APPLYING THE CONCEPTS #3: How well has the new European central bank managed monetary policy? The European Central Bank (ECB) was founded in 1998, one year before the euro was launched. The bank was charged with managing monetary policy the money supply, interest rates, and the exchange rate. Monetary policy at the ECB is set by six members of an executive board plus 13 heads of the euro-zones national banks. Inflation is their primary focus. Decisions are made by consensus. How well has the ECB performed? In its early days, the ECB was viewed as somewhat clumsy at managing its communications, and the euro initially fell in value. But in recent years, its reputation has increased. The euro has appreciated against the U.S. dollar. The ECB also demonstrated considerable financial skill as it responded decisively to the global mortgage-related financial crisis in the summer of It had carefully prepared for a financial crisis several years in advance, and its actions to provide liquidity to banks even spurred the Fed to take similar steps to combat the crisis. The ECB has now earned the respect of global financial market participants. 29 of 30 K E Y T E R M S absolute advantage balance of payments deficit balance of payments surplus comparative advantage devaluation exchange rate euro export fixed exchange rate system flexible exchange rate system foreign exchange market intervention General Agreement on Tariffs and Trade (GATT) import import licenses import quota revaluation tariff voluntary export restraint (VER) World Trade Organization (WTO) 30 of 30 10