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.