Exam Review Notes: International Economics

Protectionism

• Infant Industry Argument: Protecting new industries until they are strong enough to compete.
• Diversification: Protecting multiple industries to buffer against downturns in specific sectors.
• Job Protection: Shielding domestic industries to preserve jobs from cheaper foreign labor.
• Wage Fairness: Protecting domestic industries due to differences in minimum wage compared to low foreign wages.
• Military Self-Sufficiency: Maintaining domestic production of essential military goods for national security reasons, even if other countries can produce them more cheaply.
• Currency Manipulation: Governments may intervene in currency markets to influence exchange rates.
  • Buying currency to increase its value.
  • Selling currency to decrease its value.

Consequences of Protectionism

• Higher Prices: Trade barriers can increase the cost of goods for consumers.
• Inefficiency: Protected industries may become less efficient due to lack of competition.
• Reduced Competition: Protectionism limits competition, which can stifle innovation and efficiency.
• Lower Standard of Living: Consumers may have limited access to goods and services, potentially decreasing the overall standard of living.
• Retaliation: Countries may retaliate with their own trade barriers, leading to trade wars that harm export industries.
• Job Losses: While some jobs may be created in protected industries, others may be lost in export industries due to retaliation.

Exchange Rates

• Currency Conversion: Basic currency conversion calculations (e.g., 1 = 10 \text{ pesos}, an item costing 20 \text{ pesos} costs 2 \text{ dollars}).
• Appreciation and Depreciation: Understanding the impact of currency appreciation and depreciation on exports, imports, aggregate demand, and the balance of trade.

Determinants of Exchange Rates

• Relative Prices:
  • Lower prices in a country lead to currency appreciation as foreigners demand more of that currency to buy cheaper goods.
  • Example: If prices are lower in the U.S., the dollar will appreciate.
• Income:
  • Increased domestic income can lead to currency depreciation if it results in higher demand for foreign goods.
  • Example: If U.S. income increases and Americans buy more foreign goods, the foreign currency will appreciate.
• Consumer Taste:
  • Increased demand for a country's goods leads to currency appreciation.
  • Example: If there is more demand for US goods, the dollar will appreciate.
• Expectations:
  • Expectations about future economic conditions or policies (e.g., tariffs) can influence currency values.
  • Example: Anticipation of tariffs can cause currency depreciation as people buy foreign goods now.
• Interest Rates:
  • Higher interest rates attract foreign investment, leading to currency appreciation.
  • Key Consideration: This refers to investing money in a country and collecting interest, not borrowing money.
  • Example: High interest rates in Japan would make the yen more attractive to investors.

Exchange Rate Mechanics

• If prices are lower in the U.S.:
  • Increased demand for dollars.
  • Increased supply of other currencies (e.g., yen).
• Understanding that changes in one currency market affect the other.
  • Example: Lower prices in the U.S. increase the international demand for dollars, but also decrease the international supply of yen.
• Appreciation/Depreciation:
  • If a dollar buys more yen, the dollar has appreciated, and the yen has depreciated.
• Impact on Exports and Imports:
  • If the dollar appreciates, U.S. exports fall (more expensive for foreigners), and U.S. imports rise (cheaper for Americans).
  • Net exports (Xn) decrease: X_n \downarrow

Connecting Currency Value to Prices

• If the dollar appreciates, the yen price of U.S. goods increases (making them less competitive).
• The graph serves as a cheat sheet.

Fiscal and Monetary Policy & International Trade

• The link between fiscal and monetary policy in the international sector is interest rates.
• Expansionary Monetary Policy -> Lower interest rates.
• Contractionary Monetary Policy -> Higher interest rates.
• Fiscal policy is often the opposite.

Fiscal Policy

• Contractionary Fiscal Policy (to combat inflation):
  • Increase taxes.
    • T \uparrow
  • Decrease government spending.
    • G \downarrow
  • Decrease transfers.
    • Tr \downarrow
  • Results in surplus spending.
• Impact on Money Demand & Interest Rates:
  • Decreased demand for money.
    • M_d \downarrow
  • Real interest rates fall.
    • r \downarrow
• Impact on Investment (I) and Consumption (C):
  • Lower interest rates stimulate investment and consumption.
    • I \uparrow, C \uparrow
• International Effects:
  • Decreased international demand for dollars.
    • Dollar Demand \downarrow
  • Decreased supply of euros.
    • Euro Supply \downarrow
  • The euro price of the dollar falls (dollar depreciates).
    • Dollar \downarrow
  • U.S. exports increase.
    • X \uparrow
  • Imports decrease.
    • M \downarrow
  • Net exports increase.
    • X_n \uparrow
• Overall Effect: Net result is a decrease in aggregate demand, but the key international component is the change in interest rates.

Monetary Policy

• Contractionary Monetary Policy (to combat inflation):
  • Goal: Increase interest rates to decrease aggregate demand.
    • r \uparrow, AD \downarrow
• Methods:
  • Limited Reserve System:
    • Increase the discount rate.
      • Discount Rate \uparrow
    • Increase the reserve requirement.
      • Reserve Requirement \uparrow
    • Sell bonds (open market operations).
      • Sell Bonds
  • Ample Reserve System:
    • Increase administered interest rates.
    • Increase interest on reserves.
      • Interest on Reserves \uparrow
      • (Which raises policy rate, discount rate, and all rates).
• International Effects:
  • Increased demand for dollars.
    • Dollar Demand \uparrow
  • Increased supply of euros.
    • Supply of Euros \uparrow
  • The euro price of the dollar increases (dollar appreciates).
    • Dollar \uparrow
  • The dollar price of the euro decreases (euro depreciates).
    • Euro \downarrow

Balance of Payments

• Two main accounts:
  • Current account.
  • Capital/Financial account (they are the same).

Current Account

• Primarily deals with exports and imports of goods and services.
• Also includes money transfers and investment income.
• Balance of Trade:
  • Exports > Imports = Trade Surplus
    • (X > M)
  • Exports < Imports = Trade Deficit
    • (X < M)

Capital (Financial) Account

• Trading of stocks and bonds.
• U.S. buying foreign stocks and bonds, and foreigners buying U.S. stocks and bonds.

Relationship Between Accounts

• The current and capital accounts reflect the same transactions from different perspectives.
• Outflows and Inflows:
  • Think of money flowing in and out of a country.
• Deficit in Current Account:
  • More money flows out of the country than flows in because we're importing more than we're exporting
  • Example: If the U.S. has a deficit in its current account (buying more from China), money flows to China.
    • Outflows > Inflows
• Surplus in Capital:
  • The surplus in the capital account occurs when the other nation invests in the country with the current account deficit.
  • Example: China invests dollars back into the U.S.
    • Inflows > Outflows
• If you know one account balance (e.g., U.S. current account deficit), you can infer the others (e.g., U.S. capital account surplus, China's balances).
• If the US has a deficit in its current account:
  • It has a surplus in its capital account.
  • In its capital account, its inflows are greater than its outflows.