Unit 6- Foreign Sector

International Trade, Balance of Payments, and Exchange Rates

Why Trade?

• Specialization and trade based on comparative advantage benefits both trading partners

• Even if one country has an absolute advantage in all production

Free Trade

For example, many of us have our shirts laundered at professional cleaners rather than wash and iron them ourselves. Anyone who advised us to “protect” ourselves from the “unfair competition” of low-paid laundry workers by doing our own wash would be thought looney. Common sense tells us to make use of companies that specialize in such work, paying them with money we earn doing something we do better. -Library of Economics

Free Trade

For example, many of us have our shirts laundered at professional cleaners rather than wash and iron them ourselves. Anyone who advised us to “protect” ourselves from the “unfair competition” of low-paid laundry workers by doing our own wash would be thought looney. Common sense tells us to make use of companies that specialize in such work, paying them with money we earn doing something we do better.

Free Trade

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy.. . . If a foreign country can SUPPLY us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. – Adam Smith

Current Account

• Balance of Trade (net exports)– Exports – Imports– US has a balance of trade deficit– Goods-visible trade– Services- invisible trade*Largest component of current account

Current Account

• Balance of Trade (net exports)– Exports – Imports*Largest component of current account

• Net Investment Income– Examples • Dividends (profit from stock)• Interest (return on bonds)• Rent (from real estate holdings)

– Payments out of US are a debit– Receipts from foreign countries are a credit

Current Account

• Balance of Trade (net exports)– Exports – Imports*Largest component of current account

• Net Investment Income

• Net (unilateral) Transfers– Foreign Aid– Migrant income sent home

Capital Financial Accounts

• Capital Account– Debt Forgiveness

• Financial Account– Purchase and sale of real or financial assets– Real Assets: Real Estate, Factory– Financial Asset: Stocks and bonds– Foreigner purchases US Asset- credit– American purchases foreign asset- debit

Trade Barriers• Tariffs– Revenue- What type of goods?– Protective

• Subsidy- ?

• Import Quotas

• Embargo

• Sanctions

Arguments for Trade Limitations

• National Defense• Anti-Dumping• Save Jobs• Infant Industry Protection

*Bottom Line: Limitations on trade create inefficiencies and increase domestic prices

Trade Agreements

• NAFTA

• World Trade Organization (WTO)

• European Union

Financial Account and Loanable Funds

• Capital Inflows (credits to Financial Account)– Increase the supply of loanable funds

• Capital Outflows (debits to Financial Account)– Decrease the supply of loanable funds

Foreign Exchange and Exports

Foreign Exchange and Trade Balance

• 1 US Dollar = 2 Yuan (depreciated US dollar)• 1 US Dollar = 6.2 Yuan (current)• 1 US Dollar = 8 Yuan (appreciated US dollar)

• If the US dollar appreciates will the US import more or less from China?

• If the US dollar depreciates will the US import more or less from China?

Foreign Exchange Market• Dollar Appreciation– Dollar becomes more expensive– Foreign goods become relatively cheaper (In. imports)– US goods become relatively more expensive (D Exports)– Current Account• Toward deficit

Foreign Exchange Market• Dollar Depreciation– Dollar becomes less expensive– Foreign goods become relatively expensive (D imports)– US goods become relatively cheaper (Increase Exports)– Current Account• Toward surplus

Shifters (Big Four)- Foreign Exchange

• Change in Taste– Popular country experiences appreciation

• Change in Relative Income– Slower growing income country experiences

appreciation• Change in Relative Inflation Rates• Relative Interest Rates

Shifters (Big Four)- Foreign Exchange

• Change in Taste– Popular country experiences appreciation

• Change in Relative Income– Slower growing income country experiences

appreciation• Change in Relative Inflation Rates– Lower inflation rate country experiences appreciation

• Relative Interest Rates

Shifters (Big Four)- Foreign Exchange

• Change in Taste– Popular country experiences appreciation

• Change in Relative Income– Slower growing income country experiences

appreciation• Change in Relative Inflation Rates– Lower inflation rate country experiences appreciation

• Relative Interest Rates– Higher interest rate country experiences appreciation

Shifters (other)- Foreign Exchange

• Expected Returns on Investment

• Currency Speculation

F. Based on 5 year data, what are 2 things that could have caused the change in exchange rate?

Use each shifter once

Draw the FOREX market for each country

Market or Command

• North Korea• free enterprise• capitalism• consumer sovereignty• competition• more efficient• better quality

• profit motive• government control• government ownership• no motivation• no private property

rights• prices determined by s

and d• lack economic freedom• United States?