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Chapter 21International Trade
and Finance
©2004 Thomson/South-Western
• Key Concepts• Summary• Practice Quiz
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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, 2001
MexicoCanadaWestern EuropeAustraliaEastern EuropeJapanAsiaAfricaLatin AmericaChina
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80
60
40
20
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 (
ton
s p
er y
ear)
5
80
60
40
20
100
30
0 20 30 40 5010
JapanF
E´ (with trade)PPC
E (without trade)
Steel (tons per day)
Japanese Production and Consumption
Gra
in (
ton
s p
er y
ear)
D
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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 the General Agreement on Tariffs
and Trade?Formed in 1947 by most of the worlds industrialized nations, GATT agreed to end tariff wars
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What is the World Trade Organization?
Formed in 1995 from GATT, the WTO enforces rulings in global trade disputes
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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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0179 8381 85 87 89 91 93 95 97 99
Year
-350
-250
-150
-50
50
-450
U. S. Balance of Trade, 1979-2001B
alan
ce o
f T
rad
e (b
illi
on
s o
f d
oll
ars)
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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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200
150
100
50
0 200 300 400 500100
Pri
ce (
yen
per
do
llar)
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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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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100 200 300 400 500
50
150
200
250
100
Quantity of Dollars (millions per day
Decrease in Demand
S
D1
D2
Pri
ce (
yen
per
do
llar
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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100 200 300 400 500
50
150
200
250
100
Quantity of Dollars (millions per day)
Pri
ce (
yen
per
do
llar
Decrease in Supply
S2S1E2
E2
D
40
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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50
100 200 300 400
150
100
250
300
500 600 700
The Effects of Shift in Supply on Market Equilibrium
S2 S
1
D2
D1
200
E1
E2
Quantity of dollars
Yen
/ D
olla
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 they
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
40
20
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 (
ton
s 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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0179 8381 85 87 89 91 93 95 97 99
Year
-350
-250
-150
-50
50
-450
U. S. Balance of Trade, 1979-2001B
alan
ce o
f T
rad
e (b
illi
on
s o
f d
oll
ars)
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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.
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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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200
150
100
50
0 200 300 400 500100
Pri
ce (
yen
per
do
llar)
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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END
