Trade, Capital Flows and Exchange Rates Flashcards

Macroeconomics

• Last lecture(s):
  • Supply-side policies.
  • Types and effects of supply-side policies.
  • Laissez-faire vs. government involvement.
  • Diagrams.
  • Potential for “4-0 wins”.
  • Pluses and minuses of supply-side vs. demand side.

Trade

• Reasons for trade.
• Absolute and comparative advantage.
• Critical assumptions and limits to trade.

Importance of Trade

• Exports of goods and services as a % of GDP (2020 Data):
  • Netherlands, Canada, Germany, Italy, UK, Japan, USA, China.
• Trade is becoming more important to the US.
  • Nominal trade as % Nominal GDP: Total Trade, Exports, Imports (1992-2020).
• US Imports and Exports of goods and services ($ Billions, Year 2020).
  • Exports: Goods, Services.
  • Imports: Goods, Services.

Why Trade?

• What is traded?
• Where does it come from?
• Where do we send our goods?
• Why trade at all?
• How much of the goods and services that you need were produced by the family?

Production Possibilities without Trade

• Pakistan can produce 4,000 yards of textile per day or 1 ton of chocolate per day.
• Belgium can produce 1,000 yards of textile a day or 4 tons of chocolate per day.
• Without trade:
  • Pakistan has chosen to produce 2,000 yards of textiles and 0.5 tons of chocolate.
  • Belgium has chosen to produce 500 yards of textile and 2 tons of chocolate.
• Pakistan’s and Belgium’s Individual Choices of Production and Consumption:
  • Pakistan: 2,000 yards of textile per day, 0.5 ton of chocolate per day.
  • Belgium: 500 yards of textile per day, 2 tons of chocolate per day.
  • Total: 2,500 yards of textile per day, 2.5 tons of chocolate per day.
• Visual representation of production possibilities frontier (PPF) for both countries.
• Point A: Combination of textile and chocolate chosen by Pakistan.
• Point B: Combination of textile and chocolate chosen by Belgium.
• Point C: Joint combination without trade.
• The two extreme combinations show both countries producing and consuming only textiles (point D) and both producing only chocolate (point E).
• If these were the only two countries in the world, they could produce and consume combinations like A + B with a total world output like C.

Production Possibilities with Trade

• Combined Production Possibilities:

• Pakistan can produce 4,000 yards of textile per day or 1 ton of chocolate per day.
• Belgium can produce 1,000 yards of textile a day or 4 tons of chocolate per day.
• Now imagine visiting Pakistan, what is the price of fabric in terms of chocolate?
• What is the price in Belgium?
• If you were a trader what would you do?
• Who would be the busiest producers in Pakistan?

Comparative Advantage

• Point F: Each nation focuses on the activity for which it has a comparative advantage.
  • Pakistan produces 4,000 yards of textile.
  • Belgium produces 4 tons of chocolate.
• The combined PPC is bowed out because of Point F – comparative advantage and specialization.
• There is an increase of consumption possibilities.
• With specialization and trade, both countries are better off.

Gains from Trade

• Specialization as the basis for trade:
  • Countries benefit if they specialize and produce goods at which they can exploit the skills they have, the resources they have, and where volume production brings them economies of scale.
  • They gain if they produce more of those goods than they need domestically, then they export the surplus and import goods where they have less of an advantage.
• Absolute advantage:
  • A country may be able to produce a particular good using fewer resources than another country.
  • If two countries each have an absolute advantage producing one of two goods, France in A and the UK in B, then France should produce A and the UK B, and they should trade to meet the demand needs they each have.
• Note on the terms of trade:
  • The trader is unlikely to keep the economic gain; prices in each country will change as goods flow between the countries.
  • Economists keep track of these changing prices.
  • These are defined as The average price of exports divided by the average price of imports (PX/PM) (base year index of 100).
  • If the terms of trade change (say from 100 to 120), then they are said to have improved.

Pre-trade Production and Consumption Possibilities

• Less developed country (LDC) vs. Developed country (DC) producing wheat and cloth.
• Graphical representation of production and consumption possibilities for both countries before trade.
• Effect of trade on consumption possibilities.

Limits to Specialization and Trade

• Increasing opportunity costs from increasing specialization.
• Diminishing marginal productivity of factors.
• Mobility of factors of production.

Other Reasons for Gains from Trade

• Decreasing costs:
  • Small countries may improve their comparative advantage if they trade because of economies of scale.
• Differences in demand:
  • Even without cost differences or economies of scale, countries may benefit by changing the mix of their production.
  • For example, the LDC changes its mix until it produces the mix most suited to its resources and then importing the one they like better and want more of and exporting the one the DC likes best and wants more of.
• Increased competition:
  • Foreign firms may introduce more competition, benefiting consumers, breaking domestic monopolies, providing more choice.
• Trade as an ‘engine of growth’:
  • When a country is exporting, the growth of the country now has an injection that depends on the demand in other countries.
  • If these countries are growing then as long as the good being exported has reasonable income elasticity of demand, and the exporting country’s PPF is moving outward, then the exporting country will grow also.

Knowledge Drivers

• The importation of technology to be used in other domestic industries, or good practice, knowledge, and know-how.

Non-economic Advantages

• Political advantage (good relations between trading partners).
• Social (mixing of cultures of trading nations).
• Cultural advantage.

Critical Assumptions

• No transport costs (unrealistic).
• No economies/diseconomies of scale (unrealistic, but scale economies reinforce trade).
• Factors of production assumed perfectly mobile:
  • If one country gives up producing a product to specialize in another, the free factors may not be able to migrate to producing the other good. If this is the case, then the country may be left with unemployed resources and reduced living standards.
• No tariffs or trade barriers.
• Perfect knowledge so buyers can be found for the goods anywhere, and new producers know more of the good with comparative advantage should be produced.

Review Questions

• Which country has the comparative advantage in which good? (Given units of resources required to produce one unit of good X and good Y).
• In this example, country A has 300 units of resource, country B 600 units.
• The table shows units of resources to produce one unit of each good.
• Without trade, the second table shows how they choose to produce and consume.
• Can you check that they are on the edges of their PPFs?
• Assume they now specialize in the good for which they have a comparative advantage.
• How much does each produce?
• Can you find a trading ratio?
• Imagine A is willing to trade 1/3 of what he specializes in for the other good. Where might they both end up?
• Who is better off after trade?

Arguments for Restricting Trade

• Methods of restricting trade:
  • Tariffs (effective if demand is reasonably elastic).
  • Quotas.
  • Administrative barriers.
  • Other: Import licenses, Embargoes, Subsidies to domestic producers, Government procurement processes that favor domestic producers, Exchange controls (locals may not buy foreign currency to pay for imports).

Micro Effect of a Tariff

• A world price of p1 will result in domestic demand of Q1 and domestic production of Qd with Q1 – Qd imported.
• Imposing a tariff will result in domestic demand of Q2 and domestic supply of Qdt with Q2 – Qdt imported.
• A domestic market with no imports allowed would result in domestic equilibrium at Pd.

Restricting Trade Arguments

• Infant industry argument:
  • Infant industries can have potential comparative advantage in the future but need scale.
  • Senile industries that have run down could perhaps be revived if protected for a while.
• Changing comparative advantage.
• To prevent dumping:
  • Dumping reduces world welfare because goods are not being sold at prices that reflect resource cost.
• To prevent other trade that is going on using unfair practices.
• To create self-sufficiency and not be at total supply risk from a trading partner.
• To prevent the costs of structural unemployment.

More Arguments for Restricting Trade

• To prevent establishment of a foreign-based monopoly:
  • If another country with comparative advantage is allowed to produce all of the good then it may become a monopoly and mis-allocate resources.
• To spread risks:
  • For example a country specializing in only primary goods will be at risk since these goods are income-inelastic.
  • A country that is highly specialized in a few goods of whatever type risks volatility.
• Externalities:
  • Imported goods reflect only private costs and not social costs.
  • Importing harmful goods.
• Pursuing national interests (but against world interests):
  • Exploiting monopoly power.
  • Protecting declining industries.
• Non-economic arguments:
  • Imported goods may have harmful cultural effects.
  • Loss of diversity due to specialization.
  • Trading with “bad” countries signals tacit support for their policies.

Problems with Protection

• Protection as ‘second best’.
• World multiplier effects.
• Retaliation.
• Illegality (against GATT, EU, and other treaties that may have been signed).
• Cushions inefficiency.
• Bureaucracy.

FRED Data

• Employed full-time: Wage and salary workers: Pressers, textile, garment, and related materials occupations.
• Full-time and part-time employees: Domestic private industries: Auto repair, services, and parking.

Assignment

• Read McC & B chapter 20 and Ch 21.
• If you need to return to Ch1.
• If you are reading the free textbook:
  • Ch 10 for trade and the Balance of Payments accounts.
  • Ch.16 for foreign exchange markets.
  • Ch 20 for Trade and comparative advantage.
• You should now be seriously reviewing the course so far.
• The final exam will likely have the following format:
  • Section 1: 37 minutes, 15 to 25 questions.
  • Section 2: 37 minutes, one question in the format of the type of material you have been reading for your assignments.
  • Section 3: 2 essay questions, 37 minutes each.

Sample Questions Section 3

• Explain the causes of inflation. (20 marks)
• Explain and assess the contribution that the Federal Reserve and its open market committee makes to the control of inflation in the United States (30 marks)
• Explain how fiscal policy can be used to influence both the level and the pattern of economic activity. (20 marks)
• Explain the problems pitfalls of using Fiscal policy to control short term fluctuations in the economic cycle. (30 marks)

Writing Essay Questions

• Read the question and have it in front of you while writing your essay. WHAT IS THIS QUESTION ABOUT?
• Ask yourself WHAT DO I KNOW?
• WRITE A BULLET POINT PLAN IN PENCIL!
• REVIEW THE PLAN AND ADD/AMEND/RE-ORDER!
• When you write use the content/analysis application/evaluation format.
• Always illustrate your point with examples.
• Use diagrams and LABEL THEM!
• Always define any economic terms (in a part a/part b type question terms defined in a need not be defined again in part b).

International Transactions Accounting

• The sum of all transactions between residents of a country and all foreign nations.
• B.O.P has three parts:
  • Current account,
  • Capital Account,
  • Financial Account and Reserve Balances

The Current Account

• Trade in goods.
• Trade in services.
• Balance of trade in goods and services.
• Income flows (interest and dividend income, net).
• Current transfers (or unilateral transfers) of money (public and private e.g., aid, remittances).
• Balance on current account.

Example

• Trade in goods –
  • Exports $125m
  • Imports $135m
• trade in services
  • Exported services $20m
  • Imported services $5m
• balance of trade in goods and services
  • What is the answer?

US Balance of Payments

• Current account balance, exports, and imports of goods and services.
  *Note: you often read in the newspapers about Balance of Payments deficits and surpluses. In most cases they are actually talking about current account imbalances. A balance of payments surplus or deficit refers to a situation where the sale or purchase of central bank reserves of foreign currency serves to balance the current, capital and financial accounts

The Capital Account

• Payments in and out for past investments.
• Forgiveness of debt.

The Financial Account

• Investment – direct and portfolio, examples:
  • Purchases of US treasury securities by foreigners
  • Investments in US subsidiaries by foreign companies
  • Shares bought in overseas companies by US residents
  • Flows to and from reserves of the central bank
• In the end all the accounts must balance
  • Apart form statistical errors and omissions

US Balance of Payments 2019-2020 ($bn)

• Signs in table: +inflow of funds –outflow of funds

Trade and Macro Relationships

• Y = C + I + G + X – M and Y = C + S + T
• So, rearranging……… S + (M – X) = I + (G – T)
• The supply of funds from domestic saving and foreign capital inflows (lhs) finances domestic investment and the budget deficit (rhs)
• Dynamically, if the budget deficit (G – T) grows, then other things equal, the trade deficit (M – X) will grow.
• In another case, If domestic investment (I) grows and is not financed by domestic private savings from individuals or companies (S) or the government (T rises or G falls) then it must cause the trade deficit to rise and foreign capital to flow in.

Exchange Rates

• The rate of exchange
  • individual rates of exchange
  • The rate at which one currency trades for another
  • A floating exchange rate – rate determined by the market forces – supply and demand
• Exchange Rate:
  • $1 = ¥105
  • Harley Davidson:
    • In US: $20,000
    • In Japan: ¥2,100,000
  • Kawasaki:
    • In US: $19,048
    • In Japan: ¥2,000,000

Determination of Exchange Rates

• the equilibrium exchange rate
• The equilibrium is determined where demand equals supply
• The demand for $ (by foreigners) will be downward sloping, the higher the price of $ (expressed in their currency) the less they will demand
• The supply by the US will be the opposite. The higher the price of $ the more the US will supply.

Determination of Exchange Rates

• See table below to determine how to draw your supply and demand curves for the currencies
• Choose one of the two ways to approach it, for example “Dollars for Yen” then you know the demand curve is set by the Japanese and the supply curve by the US.
• Logic then tells you it is the Japanese demanding $ (in return for Yen) and the US supplying $ (in return for Yen)
• Look at the box below to see how to draw the “price” on the Y-axis. For example to make the demand curve downward-sloping the demand less $ when the $ price is higher – 1$=100Yen is higher than 1$=80Yen

Shifts in Currency Demand and Supply

• Five key reasons:
  1. Differences in interest rates. If US rates fall, There will be a shift INWARD in the $ demand curve as $ rate FALLS
     • foreigners will want to invest in the US less. Thus the demand for $ falls (shifts to left).
     • At the same time more US residents want to invest abroad. Their supply of $ abroad rises.
     • Let’s look at the demand for dollars by residents of, say, the UK
  2. Differences in inflation rates. If the US has a rise in prices, exports become less competitive. Imports become more attractive to US residents.
     • Demand for $ shifts to the left foreigners demand less $ because US exports have become relatively more expensive
     • Supply of $ shifts to the right as US residents seek imported goods which now look relatively cheaper
  3. Rise in domestic incomes relative to those abroad (change in aggregate demand)
     • Demand for imports rises with incomes and the supply of dollars will increase
  4. Relative investment prospects abroad improve.
     • Demand for investment abroad by US residents increases the supply of $.
     • If foreigners also recognize this trend, they will demand less US investments and the demand for dollars will shift to the left
  5. Speculation
     • If businesses think the $ is about to fall they will attempt to sell $ early. Its supply will rise.
     • Those who need $ will attempt to delay their needs and delay purchasing $ because they think that if they wait the dollar will become cheaper. Demand for $ shifts to the left

Exchange Rates & the Balance of Payments

• Exchange rates and the balance of payments: no government intervention
  • If supply and demand for a currency are determined entirely in a free market, then the price of the currency will be determined by the demand and supply of that currency.
  • The exchange rate is said to float freely.
  • There will be automatic balancing of overall balance of payments.
  • Current, capital and financial accounts might not separately balance, but together they must.
• Exchange rates and the balance of payments: government intervention
  • Governments may decide movements in the exchange rate are bad for business.
  • Constant short-term fluctuations:
    • create uncertainty and a poor investment climate
    • make long-term trade agreements difficult to manage
• reducing short-term fluctuations
  • using reserves – shifts the $ demand curve to the right by selling foreign currency reserves to buy $
  • borrowing from abroad in FX – and then using the foreign currency borrowed to buy $ again shifting the D curve to the right
  • changes in interest rates. Raises US interest rates thus shifting the $ supply curve to the left and the demand curve to the right
• maintaining a fixed rate of exchange over the longer term
  • deflation / reflation
    • If the government wants the $ to rise in value it can shift the dollar supply curve to the left by
    • reducing AD (fiscal or monetary policy), this cuts imports directly as AD falls and import demand falls
    • Indirectly as prices fall and inflation falls thus making imported goods seem more expensive.
    • Using supply side policies
    • Actual legal controls on imports or foreign exchange dealing.

Exchange Rate Systems - Fixed vs Floating

*Advantages of Fixed Exchange Rate
1. Certainty helps investment and long-term trade deals
2. With a fixed rate there is not volatility from speculation
3. Takes away a method for the government to behave responsibly. If they create inflation above the levels of the countries with whom they trade, the current account will fall and the country's reserves will fall. There is no way to get out of the problem using a fall in the value of the currency.

*Disadvantages of Fixed Exchange Rate
1. To control the flows of currencies and keep a fixed exchange rate the government may have to use interest rate policy Therefore interest rate (monetary) policy cannot be used for the management of domestic goals. Only fiscal policy can be used
2. To reduce inflation to keep the flows in line with the fixed exchange rate the government may have to reduce its own growth using fiscal and monetary policy. Other countries may "compete" by trying to reduce their inflation too.
3. If there are sudden shocks the country may have to abandon its domestic policies to keep the exchange rate at the fixed level.
4. If speculators do not believe a country has the reserves to keep its currency fixed, they may attack it and force the currency down.

*Advantages of Floating Exchange Rate
1. Automatic adjustment to a free floating price equilibrium
2. No crises as reserves fall
3. Automatic adjustment to external shocks
4. Governments can use its policies (fiscal and monetary) to control the domestic economic variables

• Disadvantages
  1. The currency is volatile creating uncertainty which may hurt trade and investment
  2. Speculators may drive the currency to great highs and lows.

Test Yourself

1. Inflow or outflow?
   • Spending by US tourists on their holidays in Italy
   • Payment of dividend by UK companies to US residents
   • Germans taking out insurance policies with US companies
   • US government spending some of its reserves of Yen
   • Investment in China by US companies
2. Imagine the US economy is booming. What is likely to be happening to the balance of trade?
3. Does the picture change if the US’s main trading partners are booming too?
4. If the US’s exchange rate depreciates there may be some bad effects on the US economy. Name one.
5. Consider the argument that the governments of individual countries have very little ability to manage their exchange rates

Purchasing Power Parity Theory

• Implies that the NOMINAL exchange rate between two countries will come to rest when the price of a basket of everything, costs the same in both countries when translated at the nominal exchange rate
• Also that if a country has higher relative inflation, its currency will depreciate

Comparing Countries - Purchasing Power Parity

• To compensate for this problem, purchasing power parities (PPPs) can be calculated. Rather than using the exchange rate in the market place, we can use a rate that would buy the same amount of a basket of goods. This is called purchasing power parity.
• Using this simple technique it would then be true that, while the market exchange rates we have discussed move around for a number of reasons (interest rates, speculation, inflation, changes in aggregate demand) the PPP will only change when the relative inflation rates change.
• For example, a “Big Mac” may cost 210 yen or $2, in which case (if the Big Mac were viewed as a representative basket of goods in both Japan and the US), the PPP would be 105:1. If there was 20% inflation in the US and zero in Japan then the next year the Big Mac would cost 210 yen and $2.40. The PPP would adjust to 84:1.

The Big Mac Index

• Take the local price of a big Mac in each of 2 countries this should give PPP exchange rate as the products are the same.
• Compare with the exchange rate.
• The chart shows the difference

Discussion

• International trade – good for a country or bad?
  • What are the benefits
  • What are the costs?
  • What would a developing country do?
• Using AD/AS analysis show what happens to the economy when exchange rates change
• The US has a massive current account deficit – is that good or bad?

Summary

• Measuring the International Economy – Current Account, Capital Account and Balance of Payments
• Exchange Rates
  • Five key influences
  • A theory – purchasing power parity
• Exchange Rates and the Capital Account
• Current Account Deficits – Good or Bad?

Revision

*Thinking like an economist teams produce answer plans on the board

1. The government is trying to “spend its way out of a recession” Will it succeed?
2. There are different views about the effectiveness of ANY kind of demand side policy. Why?
3. Supply-side policy seems the perfect answer to the goals of the 4 key macroeconomic variables. Why is it not always the perfect answer
4. Stimulating the economy is simple – just let your exchange rate depreciate. How true is this statement?
5. Unemployment is easy to cure as long as you are prepared for a little inflation. How true is this statement?

Essay Questions

• Describe the behavior of the 4 key macroeconomic indicators in the US economy over the last 2 years (show in graphs or tables). Do you think Fiscal policy could have improved this performance? Explain your answer. (30 marks max)