Chap16

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Copyright © 2001 by The McGraw-Hill Companies, Inc. ll rights reser!e".

International Trade andCapital Flows

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Trade

Trade between nations occurs for

Goods and services

Real and financial assets

Foreign households and firms acquire

domestic stocks and bonds or real estate

Domestic residents may purchase real and

financial assets abroad

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International Capital Flows

International capital flowsPurchases and sales of assets across

international bordersFinance imbalances in trade so that

eports need not equal imports everyperiod

Increase the pool of saving which cantranslate into increased domesticinvestment

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Comparative Advantage

!peciali"ation and trade#ach person concentrates on an activity at

which he is relative most efficient#ach person concentrates on an activity at

which he has a comparative advantage

This allows society to achieve a higher

level of productivity and standard of livingthan a country with self$sufficientindividuals

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Principal and Sources of

Comparative Advantage%omparative advantages arise from%limate

&atural resourcesTechnology

'orker(s skills and education

%ulture

Principle of comparative advantage'e can all en)oy more goods and services when

each country produces according to its comparativeadvantage and trades with other countries

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Closed v. Open Economies

%losed economy*n economy that does not trade with the

rest of the world*utarky+ * situation in which a country is

economically self$sufficient

,pen economy*n economy that trades with other

countries

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Production Possibilities

Production possibilities curve

* graph that shows the maimum amount

of each good that can be produced at everypossible level of production of the other

good

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Calculating

Opportunity Costs%arlos can produce either -.. pounds of coffee

or - computer per week ,pportunity cost of producing - computer is -.. lbs/

coffee0aria can produce either -.. pounds of coffee

or 1 computers per week ,pportunity cost of producing - computer is 2. lbs/ %offee

0aria(s opportunity cost of producingcomputers is lower than %arlos(

0aria should produce computers

%arlos should produce coffee

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Fig. !.Production Possibilities Curve for a Two"

#or$er Economy

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Fig. !.%Production Possibilities Curve for a

T&ree"#or$er Economy

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Fig. !.'Production Possibilities Curve for a

(any"#or$er Economy

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Consumption Possibilities

%onsumption possibilities

%ombination of goods and services that a

country(s citi"ens might feasibly consumeIn a closed economy

%onsumption possibilities are identical to its

production possibilities

In an open economy%onsumption possibilities are typically greater

than its production possibilities

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Fig. !.)*ra+il,s Consumption Possibilities

wit& Trade

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Fig. !.-Consumption Possibilities in a

(any"#or$er Economy

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Supply /emand and Trade

'orld price

The price at which a good or service is

traded in international markets!et by world supply and world demand

In an open economy

The relevant price of a commodity is theworld price

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Fig. !.! T&e (ar$et for Computers in *ra+il

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0et Importer and

0et E1porterIf the price of a good or service in a closed

economy is greater than the world price andthat economy opens itself to tradeThe economy will tend to become a net importer

of that good or service

If the price of a good or service in a closedeconomy is less than the world price and thateconomy opens itself to tradeThe economy will tend to become a net eporter

of that good or service

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Fig. !.2 T&e (ar$et for Co3ee in *ra+il

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#inners and 4osers

If trade is so good why do politicians so

often resist free trade and

3globali"ation45

Free trade benefits the overall economy

6ut specific groups may not benefit

*nd if those groups have significant

political influence they will be able to

persuade politicians to legislate trade

restrictions

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#&o *ene5ts6 #&o 7urts6

%ase of importsDomestic consumers of imported goods benefit

from free trade

Domestic producers of imported goods are hurtby free trade

%ase of eportsDomestic consumers of eported goods are hurt

from free tradeDomestic producers of imported goods benefit

from free trade

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Protectionist Policies

ProtectionismThe view that free trade is in)urious and

should be restrictedTariff * ta imposed on an imported good

7uota* legal limit on the quantity of a good that

may be imported

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Tari3s and 8uotas

TariffsRaise domestic prices to the world price plus the

tariff 8urt domestic consumers

8elp domestic producers

Reduce domestic consumption

Increase domestic production

7uotas'ork like a tariff9 ecept that government does

not collect the ta

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Fig. !.9 T&e (ar$et for Computers After t&e

Imposition of an Import Tari3

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Fig. !.: T&e (ar$et for ComputersAfter t&e Imposition of an

Import 8uota

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Ine;ciency of Protectionism

#fficiency principle

#fficiency is an important social goal

If protectionism is inefficient why do

governments limit free trade5

Those who benefit from the restrictions

are often better organi"ed politically thanthose who lose from the restrictions

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Trade and

Environmentalists0any antitrade proponents citeenvironmental concerns

Restricting trade lowers world income

Reducing the resources available to solveenvironmental problems

8igh levels of economic development areassociated with lower amounts of pollution

0uch of the income lost to barriers isabsorbed by poor nations trying to developtheir economies

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Trade *alance

Trade balance :or &et eports;The value of a country(s eports less the value of its

imports in a particular period* quarter or a year

Trade surplusThe condition when eports eceed importsThe difference between the value of a country(s eports

and the value of its imports in a given period

Trade deficitThe condition when imports eceed eportsThe difference between the value of a country(s imports

and the value of its eports in a given period

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Fig. !.< T&e =.S. Trade *alance :!<":::

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International Capital Flows

International capital flowsPurchases or sales of real and financial assets across

international borders

%apital inflowsPurchases of domestic assets by foreign households

and firms <i/e/9 foreign savers buying domestic assets

%apital outflows

Purchases of foreign assets by domestic householdsand firms <i/e/9 domestic savers buying foreign assets

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4in$ *etween Trade *alance

and Capital FlowsTrade balance NX Represents the difference between the value of

goods and services eported by a country and the

value of goods and services imported by the country

&et capital inflows KI Represent the difference between purchases of

domestic assets by foreigners and purchases of

foreign assets by domestic residentsThe trade balance and net capital inflows sum

to "ero : NX + KI = 0;

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E1ample

* =/!/ resident purchases a >apaneseautomobile priced at ?1.9...

!uppose the =/!/ buyer writes a checkfor ?1.9... to the >apanese carmanufacturer who holds an account ina =/!/ bank

'hat will the >apanese manufacturerdo with the ?1.9...5

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E1ample>*uys ?oods and

ServicesThe >apanese manufacturer can-/ =se the ?1.9... to buy =/!/ produced

goods and services!ome =/!/ car parts or 8awaiian vacations

In this case9&et eports are balanced

&@ A .The ?1.9... of the import good is balanced

with ?1.9... of the eported goods

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E1ample>*uys Assets

,r the >apanese manufacturer can1/ 6uy =/!/ assets=/!/ Treasury bond or some real estate

In this case=/!/ has a trade deficit of ?1.9...

&@ A $?1.9...

The ?1.9... car import is not offset by any eports of goodsor services

6ut there is a capital inflow of ?1.9...BI A ?1.9...

In either case&et eports and net capital inflows equal "ero

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/eterminants of

International Capital Flows6asic factors determining the attractiveness

of any assetRisk or return

Financial investors seek a high rate of return,ther factors held constant

The higher the real interest rate in a homecountryDomestic assets are more attractive

The more capital inflows9 the less capital outflows

,pposite is also holds

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Fig. !.0et Capital In@ows and t&e eal

Interest ate

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Fig. !.%An Increase in is$ educes 0et Capital

In@ows

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Saving Investment and

Capital Flows%apital inflows increase the domestic

saving pool

0ore funds available for investment

Increases economic growth

%apital outflows reduce the amount of

saving available for investmentRestrains economic growth

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Saving Investment

and 0et Capital In@owsY = C + I + G + NX

!ubtract C + G + NX from both sides to get

Y – C – G – NX = I

'e know S = Y – C – G

'e know NX + KI = . or KI = - NX

!ubstituting

S + KI = I The pool of savings available for investment

includes our national saving and funds from saversabroad

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Fig. !.' T&e Saving"Investment /iagram

for an Open Economy

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S + KI Curve

*t high values of the domestic realinterest rate&et capital inflows are positive

S + KI curve is greater than S

*t low values of the domestic realinterest rate

&et capital inflows are negative

S + KI curve is less than S

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is$s of Capital In@ows

%apital inflows also have risks

%ountries that finance domestic investment in

foreign financial capital must also it back

* number of developing countries have

eperienced debt crisis

Due to domestic investments made with foreign

money turned out poorlyThey were unable to pay the interest and

dividends owed to foreign creditors

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(isunderstanding

Trade /e5citsPeople misunderstand the reason for

trade deficits

0edia stories sometimes claim that theyoccur because a country produces inferior

goods or because other countries impose

unfair trade restrictions

These are unsubstantiated claims

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S de


E1plaining Trade /e5cits

#conomist argue that trade deficits primarily

occur because of a low rate of national saving

RecallY = C + I + G + NX

!ubtracting % C I C G from both sides yields

Y – C – G – I = NX

Recall ! A E % E G yields

S – I = NX

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E1plaining Trade /e5cits

8olding investment < I constant

* high rate of national saving S implies a

high level of net eports NX * low rate of national saving ! implies a

low level of net eports NX

If S I 9 then NX will be negative

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4ow Saving S

* country with low national saving < S

8ouseholds and governments have high spending

rates relative to domestic income and production

Part of spending is on imported goods

*n economy with low saving and high

spending will have a high volume of imports

* low$saving economy consumes a largeproportion of its domestic production9

reducing eports

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4ow Saving BS

* country with a trade deficit must bereceiving positive net capital inflows NX . then KI H . if NX + KI A .

* low national saving rate S is consistent withnet capital inflows* low saving economy will not have enough to

finance its domestic investment9 welcoming foreignsavers

* low domestic saving also drives up domesticreal interest rates which also attracts foreignsavers

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Fig. !.)0ational Saving Investment and t&e

Trade *alance in t&e =.S. :!<":::

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