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Chapter 28International Trade

and Finance

©2000 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

Should the United States return to the

gold standard?Is there a valid argument for trade protectionism?

How does Babe Ruth’s decision not to become a

pitcher illustrate an important principle in international trade?

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Why do countries trade?International trade allows

a country to consume a combination of goods and services that exceeds its production possibilities curve

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U.S. Trading Partners, 1998

11%

21%

22%11%

24%

2%

7%

1%1%

MexicoCanadaWestern EuropeAustraliaEastern EuropeJapanAsiaAfricaLatin America

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0 20 30 40 5010

B´ (with trade)B (without trade)

U.S.

A

C

PPC

Steel (tons per day)

U.S. Production and Consumption

Gra

in (t

ons p

er y

ear)

6

80

60

40

20

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30

0 20 30 40 5010

JapanF

DE´ (with trade)

PPC

E (without trade)

Steel (tons per day)

Japanese Production and Consumption

Gra

in (t

ons p

er y

ear)

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Why should countries Specialize and Trade?

Total world output increases, and therefore, the potential for greater total world consumption also increases

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If countries should Specialize, in what should

they Specialize?They should produce those

goods and services in which they have a comparative advantage

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What isComparative Advantage?

The ability of a country to produce a good at a lower opportunity cost than another country

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What isAbsolute Advantage?The ability of a country to

produce a good using fewer resources than another country

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What is Free Trade?The flow of goods between

countries without restrictions or special taxes

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What is Protectionism?The government’s use of

embargoes, tariffs, quotas, and other restrictions to protect domestic producers from foreign competition

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What is an Embargo?A law that bars trade

with another country

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What is a Tariff?A tax on an import

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What is a Quota?A limit on the quantity

of a good that may be imported in a given time period

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What are the Arguments for Protectionism?

• Infant industry argument• National security argument• Employment argument• Cheap foreign labor argument• Free trade agreements

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What is a Recent Free Trade Agreement?

North America Free Trade Agreement (NAFTA)

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What is NAFTA? A 1993 free trade

agreement between the U.S., Canada, and Mexico

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What is theBalance of Payments?

A bookkeeping record of all the international transactions between a country and other countries during a given period of time

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What is the Current Account?

The first section of the balance of payments, which includes trade in currently produced goods and services

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What is the Balance of Trade?

The most widely reported and largest part of the current account defined as the value of a nation’s merchandise imports subtracted from its merchandise exports

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How is a Current Account Deficit

Financed?By a capital account surplus

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What is theCapital Account?

The second section of the balance of payments, which records payment flows for financial capital

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77 79 8381 85 87 89 91 93 95 97 99

Year

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Bal

ance

of T

rade

(b

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lars

)

U. S. Balance of Trade, 1977-1998

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What does the Balance of Payments always equal?Zero; the current account

deficit should equal the capital account surplus

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How could the US have a Balance of

Payments Problem? The problem is with the

composition of the balance of payments

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What is an Exchange Rate?

The number of one nation’s currency that equals one unit of another nation’s currency

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If 1.81 Dollars is exchangeable for 1

British Pound, what is the Exchange Rate?

1 / 1.81 = .552 pounds per dollar

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How is the Exchange Rate determined?

Supply and demand for foreign exchange

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Pric

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Quantity of dollars (millions per day)

Supply and Demand for Dollars

S of $ (U.S. citizens)

D for $ (Japanese citizens)

E

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120100

140160180200220240

82 84 86 88 90 92 94 96

Changes in the Yen-per-Dollar Rate, 1980-1998

Pric

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98

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What happens when a Currency Depreciates?The price of the currency

falls in relation to another currency

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What happens when a Currency Appreciates?The price of the currency

rises in relation to another currency

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What can cause a Currency to

change Value?The demand and/or supply

of the currency can change

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What can cause a change in Demand of a Currency?

There can be a change in -• tastes and preferences• relative price levels• relative interest rates

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Quantity of Dollars (millions per day

Decrease in DemandS

D1

D2

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E2

E1

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U.S. exports

less popular

Decrease in the

demand for

dollars

Value of the dollar falls

(dollar depreciates)

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What can cause a change in Supply of a Currency?There can be a change in -• relative incomes• relative price levels• relative interest rates

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Quantity of Dollars (millions per day)

Pric

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Decrease in Supply

S2S1E2

E2

D

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Value of the dollar rises

(dollar appreciates)

Decrease in the

supply of dollars

Japanese imports

less popular

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What happens when Demand and/or Supply

changes?The currency seeks a new equilibrium; the value changes

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Japanese price level rises

Japanese buy more

U.S. exports

Increase the demand for

dollars

Value of the dollar rises

(dollar appreciates

Decrease in the

supply of dollars

U.S. citizens

buy fewer Japanese imports

Impact on relative price changes on Exchange Rates

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The Effects of Shift in Supply on Market Equilibrium

S2 S1

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Quantity of dollars

Yen

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rs

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Key Concepts

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Key Concepts• Why do countries trade?• Why should countries Specialize and Trade?• If countries should Specialize, in what should t

hey Specialize?• What is Comparative Advantage?• What is Absolute Advantage?• What is Free Trade?• What is Protectionism?

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Key Concepts cont.• What is an Embargo?• What is a Tariff?• What is a Quota?• What is NAFTA?• What is the Balance of Payments?• What is the Balance of Trade?• What is an Exchange Rate?• What can cause a Currency to change Value?• What if Demand - Supply changes?

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Summary

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Comparative advantage is a principle that allows nations to gain from trade. Comparative advantage means that each nation specializes in a product for which its opportunity cost is lower in terms of the production of another product and then nations trade.

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When nations follow the principle of comparative advantage, they gain. The reason is that world output increases and each nation ends up with a higher standard of living by consuming more goods and services than possible without specialization and trade.

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80

60

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100

70

0 20 30 40 5010

B´ (with trade)B (without trade)

U.S.

A

C

PPC

Steel (tons per day)

U.S. Production and Consumption

Gra

in (t

ons p

er y

ear)

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80

60

40

20

100

30

0 20 30 40 5010

JapanF

DE´ (with trade)

PPC

E (without trade)

Steel (tons per day)

Japanese Production and Consumption

Gra

in (t

ons p

er y

ear)

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Free trade benefits a nation as a whole, but individuals may lose jobs and incomes from the competition from foreign goods and services.

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Protectionism is a government’s use of embargoes, tariffs, quotas, and other methods t impose barriers intended to both reduce imports and protect particular domestic industries.

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Embargoes prohibit the import of export of particular goods. Tariffs discourage imports by making them more expensive. Quotas limit the quantity of imports or exports of certain goods. These trade barriers often result primarily from domestic groups that exert political pressure to gain from these barriers.

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The balance of payments is a summary bookkeeping record of all the international transactions a country makes during a year. It is divided into different accounts, including the current account, the capital account and the statistical discrepancy.

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The current account summarizes all transactions in currently produced goods and services. The overall balance of payments is always zero after an adjustment for the statistical discrepancy.

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The balance of trade measures only goods (not services) that a nation exports and imports. A balance of trade can be in deficit or in surplus. The balance of trade is the most widely reported and largest part of the current account. Since 1975, the U.S. has experienced balance of trade deficits.

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77 79 8381 85 87 89 91 93 95 97 99

Year

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-50

0

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Bal

ance

of T

rade

(b

illio

ns o

f dol

lars

)

U. S. Balance of Trade, 1977-1998

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An exchange rate is the price of one nation’s currency in terms of another nation’s currency. Foreigners who wish to purchase U.S. goods, services, and financial assets demand dollars. The supply of dollars reflects the desire of U.S. citizens to purchase foreign goods, services and financial assets. The intersection of the supply and demand curves for dollars determines the number of units of a foreign currency per dollar.

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Pric

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Quantity of dollars (millions per day)

Supply and Demand for Dollars

S of $ (U.S. citizens)

D for $ (Japanese citizens)

E

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Shifts in supply and demand for foreign exchange result from changes in such factors as tastes, relative price levels, relative real interest rates, and relative income levels.

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Depreciation of currency occurs when one currency becomes worth fewer units of another currency. If a currency depreciates, it becomes weaker. Depreciation of a nation’s currency increases its exports and decreases its imports.

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Appreciation of currency occurs when one currency becomes worth more units of another currency. If a currency appreciates, it becomes stronger. Appreciation of a nation’s currency decreases its exports and increases its imports.

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Chapter 28 Quiz

©2000 South-Western College Publishing

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1. With trade, the production possibilities for two nations lie a. outside their consumption possibilities.b. inside their consumption possibilities.c. at a point equal to the world production

possibilities curve.d. none of the above.

B. When countries specialize and trade, total world output increases and potential total total world consumption also increases.

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2. Free trade theory suggests that when trade takes placea. both nations will be worse off.b. one nation must gain at the other nation’s

expense.c. both nations are better off.d. one nation will gain and the other nation will

be neither better nor worse off.

C. Free trade allows a country to consume a combination of goods that exceeds its production possibilities curve.

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3. Which of the following is true when two countries specialize according to their comparative advantage? a. It is possible to increase their total output of

all goods.b. It is possible to increase their total output of

some goods only if both countries are industrialized.

c. One country is likely to gain from trade while the other loses.

d. None of the above.A. Comparative advantage is the ability of a

country to produce a good at a lower opportunity cost than another country.

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4. According to the theory of comparative advantage, a country should produce and a. import goods in which it has an absolute

advantage.b. export goods in which it has an absolute

advantage.c. import goods in which it has a comparative

advantage.d. export goods in which it has a comparative

advantage.D. Don’t confuse comparative advantage and

absolute advantage. Absolute advantage is the ability of a country to produce a good using fewer resources than another country.

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COUNTRY POTATOES WHEAT

U.S. 1 3

Ireland 1 2

Exhibit 11 Potatoes and Wheat Output (tons per hour)

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5. In Exhibit 11, which country has the comparative advantage in the production of potatoes?a. The United States because it requires fewer

resources to produce potatoes.b. The United States because it has the lower

opportunity cost of potatoes.c. Ireland because it requires fewer resources to

produce potatoes.d. Ireland because it has the lower opportunity

cost of potatoes.D. To produce 1 ton of potatoes, the

opportunity cost for the U.S. is 3 tons of wheat. To produce 1 ton of potatoes, the opportunity cost for Ireland is 2 tons of wheat.

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6. In Exhibit 11, the opportunity cost of wheat is a. 1/3 ton of potatoes in the United States and

1/2 ton of potatoes in Ireland.b. 2 tons of potatoes in the United States and 1

1/2 tons of potatoes in Ireland.c. 8 tons of potatoes in the United States and 4

tons of potatoes in Ireland.d. 1/2 ton of potatoes in the United State and

2/3 ton of potatoes in Ireland.A. U.S. 1 ton potatoes = 3 tons of wheat 1/3 ton of potatoes = 1 ton of wheat Ireland 1 ton potatoes = 2 tons of wheat 1/2 ton potatoes = 1 ton of wheat

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7. In Exhibit 11, the opportunity cost of potatoes is a. 1/2 ton of wheat in the United States and 2/3

ton of wheat in Ireland.b. 2 tons of wheat in the United States and 1 1/2

tons of wheat in Ireland.c. 16 tons of wheat in the United States and 6

tons of wheat in Ireland.d. 3 tons of wheat in the United States and 2

tons of wheat in Ireland.D. U.S. 1 ton potatoes = 3 tons of wheat Ireland 1 ton potatoes = 2 tons of wheat

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8. If the countries In Exhibit 11 follow the principle of comparative advantage, the United States shoulda. buy all of its potatoes from Ireland.b. buy all of its wheat from Ireland.c. buy all of its potatoes and wheat from

Ireland.d. produce both potatoes and wheat and not

trade with Ireland.A. The U.S. should specialize in the

production of wheat when it has a comparative advantage (see question 6 for opportunity cost calculations).

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9. A tariff increases the a. quantity of imports.b. ability of foreign goods to compete with

domestic goods.c. prices of imports to domestic buyers.d. all of the above.

C. A tariff is a tax, also called customs duties, on an import.

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10. The infant industry argument for protectionism is based on which of the following views?a. foreign buyers will absorb all of the output of

domestic producers in a new industry.b. the growth of an industry that is new to a

nation will be too rapid unless trade restrictions are imposed.

c. firms in a newly developing domestic industry will have difficulty growing if they face strong competition from established foreign firms.

d. It is based on none of the above.C. It is difficult to make this argument because

there is an arbitrary line between an “infant” and a “grown up” industry.

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11. The figure that results when merchandise imports are subtracted from merchandise exports is a. the capital account balance.b. the balance of trade.c. the current account balance.d. always less than zero.

B. The capital account records payments for financial capital, such as stocks and bonds. The current account includes trade in currently produced goods and services.

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12. Which of the following international accounts records payments for exports and imports of goods, military transactions, foreign travel, investment income, and foreign gifts?

a. The capital account.b. The merchandise account.c. The current account.d. The official reserve account.

C. The capital account records payments for financial capital, such as stocks and bonds. The merchandise account is the value of a nation’s merchandise imports subtracted from its merchandise exports. There is no official reserve account.

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13. Which of the following international accounts records the purchase and sale of financial assets and real estate between the United States and other nations?a. The balance of trade account.b. The current account.c. The capital account.d. The balance of payments account.

C. The balance of trade is the value of a nation’s merchandise imports subtracted from its merchandise exports. The current account includes trade in currently produced goods and services. Balance of payments in a bookkeeping record of all international transactions in a given period of time.

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14. If a Japanese radio priced at 2,000 yen can be purchased for $10, the exchange rate is a. 200 yen per dollar.b. 20 yen per dollar.c. 20 dollars per yen.d. none of the above.

A. X yen / dollar = 2,000 yen / 10 dollars = 200 yen / dollar.

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15. The United States a. was on a fixed exchange rate system prior to

late 1971, but now is on a flexible exchange rate system.

b. has been on a fixed exchange rate system since 1945.

c. has been on a flexible exchange rate system since 1945.

d. was on a flexible exchange rate system prior to late 1983, but now is on a fixed exchange rate system.

A. For most years between World War II and 1971, were based primarily on gold.

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16. Suppose the exchange rate changes so that fewer Japanese yen are required to buy a dollar. We would conclude that a. the Japanese yen has depreciated in value.b. U.S. citizens will buy fewer Japanese

imports.c. Japanese will demand fewer U.S. exports. d. none of the above.

B. When the dollar is weak or depreciates, U.S. goods cost foreign consumers less and they buy more U.S. exports.

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17. Which of the following would cause a decrease in the demand for French francs by those holding U.S. dollars? a. Inflation in France, but not in the United

States.b. Inflation in the United States, but not in

France.c. An increase in the real rate of interest on

investments in France above the real rate of interest on investments in the United States .

d. None of the above.A. A rise in the French Franc relative price

level causes the dollar to appreciate and demand for French Francs decreases.

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18. An increase in the equilibrium price of a nation’s money could be caused by a (an) a. decrease in the supply of the money.b. decrease in the demand for money.c. increase in the supply of the money.d. increase in the demand for money.

A.

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Quantity of Dollars (millions per day)

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19. If the dollar appreciates (becomes stronger), this causesa. the relative price of U.S. goods to increase for

foreigners.b. the relative price of foreign goods to decrease

for Americans.c. U.S. exports to fall and U.S. imports to rise.d. a balance of trade deficit for the U.S. e. all of the above to occur

E.

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20. Which of the following would cause the U.S. dollar to depreciate against the Japanese yen?a. Greater popularity of U.S. exports in Japan.b. A higher price level in Japan. c. Higher real interest rates in the U.S. d. Higher incomes in the U.S.

D. As a result of higher income, U.S. citizens buy more domestic products and imports. The supply curve for dollars shifts rightward and the equilibrium exchange rate decreases.

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END