Frank & BernankeFrank & Bernanke

Ch. 16: International Trade and Capital Flows

Trade FlowsTrade FlowsBuying foreign goods at cheaper prices than

domestically produced.Selling domestic goods to foreign countries

at higher prices than sold domestically.Trade makes participant countries better off.The choices are determined by comparative

advantage.

Capital FlowsCapital FlowsBuying and selling of assets across borders.Financial assets are bank deposits, bonds,

stocks, foreign currency, etc.Real assets are real estate, factories, art, etc.Trade flows and capital flows together

cancel each other.– Trade deficits are financed by capital inflows

and trade surpluses are matched by capital outflows.

Production Possibilities CurveProduction Possibilities CurveSuppose there are two individuals (say a

married couple) who have the following productivities.– He can clean house or cook one meal per day.– She can clean house or cook two meals per day.

Draw PPC for this household per week.

Opportunity CostsOpportunity CostsWhat is her opportunity cost of giving up

cleaning?– A gain of 2 meals.

What is his opportunity cost of giving up cleaning?– A gain of 1 meal.

Who should give up cleaning first?

Cleaning Cooking14 013 212 411 610 89 108 127 146 155 164 173 182 191 200 21

PPC

0

6

12

18

24

0 5 10 15Cleaning

Cooking

PPC for 3-personsPPC for 3-personsSuppose her mother comes to live with

them.She can clean or cook three meals.Who should stop cleaning first?What would the PPC look like?

PPC

0

5

10

15

20

25

30

35

40

45

0 5 10 15 20 25

Cleaning

Cooking

PPC for Many WorkersPPC for Many Workers

A

B

Consumption PossibilitiesConsumption PossibilitiesIn a closed economy where there is no trade

(autarky) a country’s consumption possibilities are limited by its production possibilities.

In an open economy where a country can sell products at higher prices than at home and buy products at lower prices than at home, the consumption possibilities are larger than the production possibilities.

Him and Her AgainHim and Her AgainSuppose cleaning and cooking can be

exchanged in the marketplace for 1.5 meals per cleaning.

Put this information on PPC.Determine who is going to do what.Show why the couple is better-off.

14

21

7

14

14

She can get 10.5 cleaningsfor her 14 meals

He can get 10.5meals for his 7cleanings

Many WorkersMany Workers

Cheap Labor and JobsCheap Labor and JobsIf two countries are producing the same

products, computers and food, and one country has lower wages, would free trade make the higher wage country lose all the jobs?

Productivity and wagesComparative advantage

Productivity and WagesProductivity and WagesWages are high in the country that has

higher productivity.Productivity is measured as Marginal

Product of Labor.MPL = Increase in Output/Increase in

LaborMPL shifts to the right as capital,

technology, and human capital increases.

Comparative AdvantageComparative AdvantageIf rich country (R) can produce 10

computers or 100 food with one unit of labor and poor country (P) can produce 2 computers and 50 food with one unit of labor who has the absolute and comparative advantage in computers and in food?

What if P can produce 2 computers and 20 food?

Supply CurveSupply CurveIf the “price” of one computer is 10 food in

R, would the people in R make more or less computers if they could exchange a computer for 11 food? 12 food? 9 food?

How does this look in a typical supply curve?

How does it relate to PPC?

Increasing Computer PriceIncreasing Computer Price

Computers

Food

PPCPPCFood

Computers

Supply CurveSupply CurvePrice ofcomputers

Computers

9

10

11

Demand CurveDemand CurveTypically, demand depends on the income

of the people, their tastes and the price of the product.

As the computer price goes up, ceteris paribus, the number of computers demanded will fall.

AutarkyAutarkyP

Computers Computers

ExportsExportsP

Computers Computers

Pw

ImportsImportsP

Computers Computers

Pw

Markets With TradeMarkets With Trade

On a supply-demand diagram, show the world price, amount produced, amount exported and amount consumed.

On a supply-demand diagram, show the world price, amount produced, amount imported and amount consumed.

Winners and LosersWinners and LosersBecause of the difference between world

and domestic prices some gain and others lose from free trade.

Winners are consumers of imported goods and producers of exported goods.

Losers are consumers of exported goods and producers of import-competing goods.

Winners and Losers Winners and Losers

Winners and Losers Winners and Losers

Import TariffsImport Tariffs

Pw

Pw+t

Import QuotaImport Quota

Pw

P

Quota

Net Capital InflowsNet Capital InflowsCapital inflows are purchases of our assets

by foreigners (funds flowing in).Capital outflows are our purchases of

foreign assets (funds flowing out).Net capital inflows (KI) is capital inflows

minus capital outflows.KI>0 net capital inflows.KI<0 net capital outflows.

NX and KINX and KINet exports and net capital inflows are

connected.NX + KI = 0If there is a trade surplus, we have claims

abroad: we can keep the local currency earned in a bank abroad, buy local stocks, bonds, real estate.

If there is a trade deficit, the foreigners can purchase our assets. If they demand their money, we borrow (sell bonds = KI).

Real Interest Rates and KIReal Interest Rates and KINet capital inflows respond to changes in

our (domestic) real interest rates.Higher real interest rates mean people can

earn higher returns here.Lower real interest rates mean people can

earn higher returns abroad.

Real Interest Rates and KIReal Interest Rates and KIReal interest rate KI

0 Net capital inflowsNet capital outflows

Shifts in KIShifts in KIRiskiness of domestic assets increases =>

KI shifts left.Riskiness of foreign assets increases => KI

shifts right.Real interest rate abroad increases => KI

shifts left.

Savings and InvestmentSavings and Investment

1. Y = C + I + G + NX (output = AD)

2. Y = C + S + T (output = income)

3. C + S + T = C + I + G + NX (one and two)

4. S + (T – G) – NX = I (from three)

5. KI = - NX (from NX + KI = 0)

6. Private savings + Government savings + Capital inflows = Investments (from four)

Saving and InvestmentSaving and Investmentr r

Japan USA

0

S+(T-G)S+(T-G)+KI

I

S+(T-G)+KIS+(T-G)