International Trade & Finance

1. International Trade & Finance This part of the lecture focus on international trade and the finance market. Some basic terminology and important aspects of international trade will be addressed. OBJECTIVES 1. Describe the benefits of international trade. 2. Explain various types of trade restrictions. 3. Recognize the three basic types of exchange rate. 4. Understand the components in the balance of payment accounts.

2. International Trade The distribution of economic resources and technological levels among nations are different. International trade is a method which enables nations to specialize and increases the productivity of their resources. Therefore, nations’ production capacities can be increased, their production possibility frontier will move rightward. The international economy is very complex. Each country has a unique pattern of trade. But every one of them must benefit from the trading in order for them to do that. The following example presents a hypothetical example of two countries: Japan and China both producing fish and cloth, and assuming labor is the only input.

3. Comparative Advantage ---- Output per worker per day in either fish or cloth---- ------------------- Japan----------China----------------------- fish------------------8-------------4---------------------------- Cloth----------------4 -------------3--------------------------- Japan has absolute advantage in producing both fish and cloth because one worker can produce more of either goods in Japan. Absolute advantage is determined by comparing the absolute productivity in different countries of producing each good.It seems that there is no need for Japan to trade because Japan can produce both more of both goods. However, absolute advantage is not the critical consideration. What matters is comparative advantage. Comparative advantage is determined by comparing the opportunity cost of each good in different countries. It is measured by what must be given up in producing one good using the same resource, like one worker per day. For our example: Japan’s opportunity cost of producing 1 unit of fish (in terms of cloth given up) = 4/8=0.50 China’s opportunity cost of producing 1 unit of fish (in terms of cloth given up) = ¾ = 0.75 Since Japan’s opportunity cost is lower, Japan has comparative advantage on fish production and will export fish. The comparative advantage of cloth is found the same way. Japan’s opportunity cost of producing 1 unit of cloth (in terms of fish given up) = 8/4 = 2 China’s opportunity cost of producing 1 unit of cloth (in terms of fish given up) = 4/3 = 1.33 China’s comparative advantage is on cloth production because China has a lower opportunity cost. China should export cloth and import fish from Japan instead of fishing itself. Opportunity cost, which is reflected in the comparative advantage, is the key to international trading. We benefit from trade if we are able to obtain a good from a foreign country by giving up less than we would have to give up to obtain the good at home.

4. Trade Restrictions Governments restrict foreign trade to protect domestic producers from foreign competition. There are several kinds of trade barriers: 1. Tariffs are excise taxes on imports and may be used for revenue purposes, or more commonly today as protective tariffs. 2. Import quotas specify the maximum amounts of imports allowed in a certain period of time. Low import quotas may be a more effective protective device than tariffs, which do not limit the amount of goods entering a country. 3. Non-tariff barriers refer to licensing requirements, unreasonable standards, or bureaucratic red tape in customs procedures. 4. Voluntary export restrictions are agreements by foreign firms to voluntarily limit their exports to a particular country. The economic impacts of tariffs are as follows: 1. When a tariff is imposed, domestic consumption declines due to higher prices. 2. Domestic production will rise because of the higher price. 3. Imports will fall. 4. Government tariff revenue will represent a transfer of income from consumers to government. 5. Indirect effects also may occur in that relatively inefficient industries are expanding and relatively efficient industries abroad have been made to contract. The economic impact of quotas is similar to tariffs, but no revenue is generated by the government, the higher price results in more revenue per unit for the foreign and domestic producers.

5. Exchange Rate Foreign exchange markets enable international trade to take place by providing markets for the exchange of national currencies. A U.S. firm which sells goods to a British firm needs to exchange the check (in pounds) sent by the British company into dollars. U.S. exports create a demand for dollars and a supply of foreign money, pounds in this case. On the other hand, imports create a supply for dollars and a demand of foreign money. Variable Exchange Rate The freely floating exchange rates are determined by the forces of demand and supply. The intersection of supply and demand curves for a currency will determine the price or exchange rate. Theoretically, variable rates have the virtue of automatically correcting any imbalance in the balance of payments. Balance of payments is the sum of all transactions, which take place between a nation’s residents and the residents of all foreign nations. If there is a deficit in the balance of payments, this means that there will be a surplus of that currency and its value will depreciate. As depreciation occurs, prices for goods and services from that country become more attractive and the demand for them will rise. At the same time, imports become more costly as it takes more currency to buy foreign goods and services. With rising exports and falling imports, the deficit is eventually corrected. In addition, flexible exchange rates allow policy makers to be flexible in conducting domestic monetary and fiscal policies. However, unstable exchange rates can destabilize a nation’s economy. This is especially true for nations whose exports and imports are a substantial part of their GDPs. Fixed Exchange Rate If the government offers to buy and sell its currencies at a set price, it is imposing a fixed exchange rate. A nation’s reserves are used to alleviate imbalance in the balance of payments, since exchange rates cannot fluctuate to bring about automatic balance. Domestic macroeconomic adjustments may be more difficult under fixed rates. For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce price, which raises exports and reduces imports. However, such contractionary policies can also cause recessions and unemployment. Managed Floating Exchange Rate The current system is a managed floating exchange rate system in which governments attempt to prevent rates from changing too rapidly in the short term. Since 1987, the G-7 nations ( U.S., Germany, Japan, Britain, France, Italy and Canada) have periodically intervened in foreign exchange markets to stabilize currency values.

6. The Balance of Payments The balance of payment is a periodic statement of money value of all transactions between residents and government of one country and residents and governments of all other countries.   Transactions that involves an outlay of domestic currency is recorded as a debit, any transactions that involves the receipt of foreign currency is recorded as credit. They are usually categorized into three accounts: the current account (export and import), the capital account (purchase of US assets by foreigners and foreign assets purchased by US residence), and official reserve account ( US holding of foreign currencies and US currency held by foreign governments) The current account is the difference between the value of goods exported and the value of goods imported. Exports are products that a country sells to other countries and imports are products that a country buys form other countries. A country will have a trade surplus if its exports exceed imports. On the other hand, a country will have a trade deficit if its imports exceed its exports. U.S. currently has a trade deficit. Countries keep track of the flow of their international exchange by calculating their balance of payments. In addition to the accounts listed above, the balance of payment also includes a statistical discrepancy to account for reported transactions.