Open Economy: International Trade and Finance (10–15%)
Textbook chapter ,35
A. Balance of payments accounts
1. Balance of trade
2. Current account
3. Capital account
B. Foreign exchange market
1. Demand for and supply of foreign exchange
2. Exchange rate determination
3. Currency appreciation and depreciation
C. Net exports and capital flows
D. Links to financial and goods markets


ALL THE PAST EXAM QUESTIONS ON THIS TOPIC
https://sites.google.com/site/mrhopkinssocialstudieshome/international-trade-s-link-to-the-macroeconomy

great site /videos
http://education-portal.com/academy/topic/comparative-advantage-specialization-and-exchange.html

THE BEAUTY OF THE BURGER
http://www.econlife.com/using-the-economists-big-mac-index-to-see-purchasing-power/

FREE TRADE
http://www.econlife.com/defending-free-trade/

ONLINE TEXTBOOK
1) INTERNATIONAL TRADE
http://glencoe.mcgraw-hill.com/sites/0217511447/student_view0/chapter37/

2) COMPARATIVE ADVANTAGE
http://glencoe.mcgraw-hill.com/sites/0217511447/student_view0/chapter37/origin_of_the_idea.html

3) The Balance of Payments, Exchange Rates, and Trade Deficits
http://glencoe.mcgraw-hill.com/sites/0217511447/student_view0/chapter38/


overview from UC Berkley
http://www.youtube.com/watch?v=_KljHF8nn-U


BOP
http://www.youtube.com/watch?v=i6M8jnkdCYk

KAHN ACADEMY
CAPITAL ACCOUNT
http://www.youtube.com/watch?v=AimYG1jYD0A
CURRENT ACCOUNT
http://www.youtube.com/watch?v=dirBYVjDk7A




NOTES

INTERNATIONAL TRADE

Now that we have completed our examination of the United States domestic economy, we turn to the ultimate “big picture” of macroeconomics: international trade. But in doing so, we return to the concepts with which we began our study of economics: factors of production, comparative advantage, and production possibilities. Chapter 37 introduces the reasons for international trade and the controversy between free traders and protectionists who seek limits on trade.
Why do nations trade? The easy answer is that nations possess different natural resources and build their industries based on their available resources. Nations develop land-intensive, labor-intensive, or capital-intensive industries—or a combination of such industries—based on their best available resources. They then trade for those products they cannot profitably produce themselves. But the better answer is that nations specialize in those goods for which they hold a comparative advantage.
Absolute advantage refers to a nation’s ability to produce more than another nation, but comparative advantage focuses on a nation’s ability to produce relatively more efficiently than another nation, as measured by a lower opportunity cost. If nations specialize in producing the goods for which they have the comparative advantage and trade, both nations gain from the trade. The terms of trade then determine the parameters for the price of the product being traded. This relationship can be illustrated in production possibilities curves or determined mathematically. It is critical to be able to determine comparative advantage using both methods.
Using a supply and demand model for a closed economy, compared to an economy open to trade, we can see that domestic prices quickly adjust to world prices in an open economy. If the world price is higher than the domestic price, domestic firms will have an incentive to export products, reducing the domestic supply and increasing domestic prices. If the world price is lower than the domestic price, consumers have an incentive to import products, reducing the domestic demand and lowering domestic prices.
The benefits of international trade include a wider variety of products, greater output, greater efficiency in production, and a higher standard of living. The increased competition with foreign firms helps to deter monopolies and holds prices down in the marketplace. International connections help to promote peaceful solutions to political problems, rather than war.
While consumers and the nation may benefit from trade, less efficient domestic firms and their employees are hurt by the drop in domestic demand. Protectionists argue that trade barriers must be used to limit trade. Tariffs, quotas, non-tariff barriers, voluntary export restraints, and export subsidies can all be used to protect domestic industries from foreign competition. The direct effects of these trade barriers include reduced consumption of goods, increased domestic consumption, a reduction in sales for foreign firms, and increased tariff revenue for the government. Indirect effects include a reduction in exports because of the reduced incomes of foreigners, the resulting cuts in output and employment in U.S. export industries, and a reduction in the efficiency of production. Repeated studies of trade barriers have demonstrated that the increased costs to consumers are greater than the gains for domestic industries and the government.But protectionists argue that trade barriers are important for other reasons beyond protection of American industries and jobs. Protectionists argue that we must remain self-sufficient and protect industries vital to national defense. Free traders agree in principle, but argue such a policy is subject to significant abuse. Protectionists argue that economies must be diversified to maintain economic stability, but free traders note that this argument is irrelevant for an economy as diversified as the United States. Protectionists argue that “infant industries” must be shielded with temporary tariffs from the pressures of international competition until they are mature enough to fully compete with foreign firms. Free traders contend that direct subsidies would more effectively promote the growth of new firms, and that so many new firms emerge each year that directed, temporary tariffs would be impossible to impose. Protectionists also argue what widespread tariffs must be used to prevent dumping of imports below cost. Free traders counter that such low-cost goods may be the result of a strong comparative advantage, rather than dumping, and punishments can be narrowly targeted at those guilty of dumping. While protectionists argue that trade barriers protect jobs, free traders argue that trade also creates jobs in more efficient industries; further, retaliatory trade barriers can lead to trade wars. Finally, protectionists argue that trade will reduce U.S. wages, as firms are forced to compete with low-cost foreign labor. Free traders contend that U.S. wages will remain higher than wages in most countries because of the higher productivity of U.S. workers.
Material from Chapter 37 is likely to appear in a few multiple-choice questions on both the AP Microeconomics and AP Macroeconomics Exams. Questions concerning comparative trade, specialization, terms of trade, gains from trade, supply and demand analysis, and trade barriers can be expected in the multiple-choice and free-response portions of both exams. It is important to be able to calculate the opportunity costs of production for the countries involved in trade, determine the absolute and comparative advantage, calculate the range of the terms of trade, and determine whether both countries would gain if the product is set at a particular price. It is also important to recognize the arguments on each side of the trade issue.



The Balance of Payments, Exchange Rates, and Trade Deficits

We now understand why nations trade, but how do they trade? How do they manage to exchange goods using a variety of currencies of different values, especially when the currency values themselves constantly change? Chapter 38 concludes this study of the international economy by exploring the movement of money and products between nations, as well as balances in payments, currency values, and net exports.
International trade refers to the sales of goods and services to other countries. International asset transactions refer to exchanges of financial assets between countries, such as sales of stock and real estate. In order for a buyer in one country to make a purchase from another country, he must first buy the currency of that country in a foreign exchange market. The exchange rate, the value of one currency in terms of another currency, is determined by supply and demand.
The balance of payments is the sum of all of the financial transactions between two countries. The balance of payments includes two primary categories: the current account and the capital/financial account. The current account includes the trade of goods and services with other countries. Funds flowing in from the sale of exports and investment income count as a credit (+), while funds flowing out from the purchase of imports and transfers of funds to foreigners count as a debit (-). A trade deficit occurs when a nation imports more than it exports. The capital/financial account primarily compares the foreign purchases of domestic assets (+) with our purchase of foreign assets (-), though a small amount of the total recognizes debt forgiveness between the countries. What is important to note is that no matter how large or small the size of the accounts, the current account and the capital/financial account must balance over time. While a short-run balance of payments surplus or deficit may develop, assets will eventually be transferred to balance the payments.
Exchange rates are determined by supply and demand. While the key graph for this chapter shows the market for only one currency, it is helpful to draw the markets for both currencies side by side, to see the relative changes in the value of currencies. If Americans increase imports of British products, the Americans must increase their demand for British pounds to pay for those products. The increase in demand pushes up the value of the British pound, causing it to appreciate. In order to pay for those pounds, consumers must spend dollars in the international currency market. As the supply of dollars increases (in the dollar market graph), the value of the dollar decreases, or depreciates. All currency values are relative, so if the pound appreciates against the dollar, the dollar must depreciate against the pound.
Demand for a currency can shift as a result of a change in tastes, a change in relative incomes, a change in relative inflation rates, a change in relative interest rates, changes in expected returns on financial investments, and speculation. When incomes increase or domestic inflation rates are high, consumers buy more imports, and as a result, demand for foreign currency increases. In the same way, if households expect to earn higher returns on bonds or other investments in another country, or if they expect the value of the currency itself to increase as an investment, they will increase demand for the currency.
Changes in domestic economic policies can also affect exchange rates. If the Federal Reserve reduces the money supply to counteract inflation, the increase ininterest rates can attract investment from foreigners. As those foreigners increase their demand for dollars in order to buy bonds, the international value of the dollar increases.
The flexibility of exchange rates is important because it can work to eliminate balance of payments surpluses and deficits. Consumers may purchase more imports, but their increased demand for British pounds eventually causes the pound to appreciate (and the dollar to depreciate), resulting in a decrease in the demand for British products over time. While supply and demand primarily determine exchange rates, the system is called a “managed float” because in times of crisis, the International Monetary Fund or nations themselves may take actions to manipulate currency values.
Material from Chapter 38 consistently appears in several multiple-choice questions on the AP Macroeconomics Exam. Free-response questions, in whole or in part, frequently focus on relative currency values, as well as capital and current accounts. It is most important to focus on the graphs that illustrate changes in currency values and the factors that can cause changes in demand for currencies. It is also important to recognize the factors that are included in capital and current accounts, as well as the requirement that they balance.

HOMEWORK

1) READ AND DO A 1/4 PAGE RESPONSE ON THE ARTICLES BELOW
15 points each

A) http://www.nytimes.com/2007/12/02/business/02view.html?_r=2&oref=slogin
B) http://www.nytimes.com/2008/03/16/business/16view.html?_r=1&ex=1363320000&en=87bab26528ec03d0&ei=5090&partner=rssuserland&emc=rss&pagewanted=all&oref=slogin
C) http://www.nytimes.com/2008/04/05/business/05money.html?_r=1&ref=business&oref=slogin



2) APE ECONOMIC GROWTH & INERNATIONAL TRADE 30 points
Economic development is a sustained increase in the standard of living of a country's population. Broadly understood, the standard of living includes a rise in the average incomes of the population as measured by real per capita GDP, and also improvements in health and education, some social protection from poverty, freedom, a rule of law and other social goals. Thus, although economic development does focus on the material standard of living, it is a broader term than just economic growth. Economic development is facilitated by high investment levels in physical and human capital, higher productivity, competitive markets, low inflation, political stability and free trade. Incentives that increase factors contributing to economic development are greater economic freedom, protection of property rights and sound monetary policies.Web resource; http://tutor2u.net/economics/revision-notes/a2-macro-theories-of-economic-growth.html

INTRO TO INTERNATIONAL TRADE
WEB resource; http://tutor2u.net/economics/revision-notes/a2-macro-trade-development-introduction.html
World trade in goods- RANK TOP 7
IMPORT
EXPORT















World trade in services- RANK TOP 7
IMPORT
EXPORT















Trade and Economic Development – Import Substitution and Export Promotion One of the main aims of developing countries is to pursue industrialisation by expanding their industrial sector. And trade provides a means by which this development strategy can be pursued. There are two main strategies that countries can follow with regards this problem.
Import substitution:The idea is to domestically produce what was previously imported from elsewhere. There are some economically sound reasons for doing this; producing rather than importing will save valuable foreign exchange and ease the balance of payments deficit that most poor countries have. Moreover, there is obviously a ready-made market for the product, because people are already buying it from abroad.In theory, new firms would start by importing ‘capital goods’ - plant and machinery and the latest technology - ‘intermediate goods’ [raw materials and other components], and technical expertise. Once off the ground, the industry would be able to import capital goods to make all the necessary machinery themselves. The government would remove the tariffs once the industry was ready to compete with producers from around the world .In reality, firms have rarely got beyond the first stage. Import tariffs have remained in place, since producers were unprepared to face global competition – and so they had no incentive to become efficient and competitive.
Export PromotionThis was the approach adopted by the ‘East Asian Tiger’ economies in their expansion of hi-tech manufacturing industries. Countries try to find markets in which they can successfully exploit their comparative advantages and sell their products to buyers elsewhere in the world.Production centred on labour-intensive technologies (for the comparative advantage!) – I.e. production has been based on much lower unit labour costs.Industry made up of private-sector firms driven by the profit motive.Government provides incentives for firms to export.Many of the Asian Tiger economies have been incredibly successful in implementing export promotion strategies and for them the process of globalisation has been a huge stimulus to their economic growth and development over the last ten – twenty years.
The New GlobalizersMany developing countries—sometimes known as the ‘new globalizers’— have made huge progress in building and sustaining a strong position in world markets for manufactured goods and services. For example there has been a sharp rise in the share of manufactured goods in the exports of developing countries: from about 25 percent in 1980 to more than 80 percent today and a decline in the dependency of some countries on exporting primary commodities.These ‘new globalizers’ have managed to exploit their competitive advantage in manufacturing based on a fast growth of labour productivity, much lower unit labour costs, high levels of capital investment, (much of it linked to inward investment) and crucially a reduction in the tariff levels imposed by industrialised economies.Technological progress has also speeded up the expansion of trade in manufactured goods from developing economies with improvements in containerisation and airfreight reducing the costs of transportation.Developing countries have become important exporters of manufacturesMany developing countries have successfully exploited the rapid growth in demand for transistors, valves, semi-conductors, telecommunications equipment, electrical power machinery, office machines, computer parts and other electrical apparatus. These are all fast-growing industries, although in many cases, price levels are falling as production shifts across the globe to lower cost production centres. The huge increase in out-sourcing of manufacturing production has been a major factor behind the speedy growth of export industries in many developing countries, not least the emerging market economies of south East Asia and more recently in eastern Europe. Relatively low-income countries such as China, Bangladesh, and Sri Lanka have manufactures shares in their exports that are above the world average of 81 percent. Others, such as India, Turkey, Morocco, and Indonesia, have shares that are nearly as high as the world average.
Trade and the law of Comparative Advantage WEB http://tutor2u.net/economics/revision-notes/a2-macro-trade-comparative-advantage.htmlA country's place in the global economy seems neither predestined nor predictable. Comparative advantage is almost impossible to spot in advance. Source: The Economist, April 2004 Trade's virtuous effects are of two distinct kinds. First, trade helps countries make the most of what they already have. It frees countries to allocate their resources—whether they be cheap labour, fertile land or educated minds—as efficiently as possible. But, secondly, trade can also allow countries to accumulate resources more quickly. Indeed, the biggest prizes lie in faster growth, not heightened efficiency; in accumulation and innovation, not allocation.”
Source: Adapted from the Economist, July 20th 2006. MAKE NOTES ON THE FOLLOWING
.1) Comparative advantage is often a self-reinforcing process-


2) Broad gains from free trade


3) Terms of Trade-


4) What determines comparative advantage-


5) Wider benefits of International Trade-





3) FILL IN THE TERMS 21 points
APE INTERNATIONAL TRADE TERMS
1)Appreciation……………………………………………………………………………………………………………………………………
2)Balance of payments……………………………………………………………………………..................................
3) Balance of trade…………………………………………………………………………………………….................
4) Capital account……………………………………………………………………………………………...............
5) Closed economy……………………………………………………………………………………………………….
6) Current account……………………………………………………………………………………………………….
7) Depreciation…………………………………………………………………………………………………………
8) Dumping……………………………………………………………………………………………………………..
9) Exchange Rate…………………………………………………………………………………………………………
10) Gold standard…………………………………………………………………………………………………………
11)Import quota………………………………………………………………………………………………………….
12) Import tariff…………………………………………………………………………………………………………….
13) Infant industries…………………………………………………………………………………………………….
14) Intervention……………………………………………………………………………………………………….
15) Managed float……………………………………………………………………………………………………….
16) Net investment income……………………………………………………………………………………………
17)Net transfers………………………………………………………………………………………………………….
18)Official reserves……………………………………………………………………………………………………….
19) Open economy………………………………………………………………………………………………………
20) Trade Deficit…………………………………………………………………………………………………………
21) Trade Surplus………………………………………………………………………………………………………………………………








ASSIGNMENT 4 groups of two
POWER POINT PRESENTATION 150 POINTS
Clearly explain each of the following
——REASONS WHY WE TRADE- COMPARATIVE/ABSOLUTE ADVANTAGE
----- THE BALANCE OF PAYMENTS
———BALANCE OF TRADE
———BARRIERS TO TRADE
———THE CASE FOR PEOTECTION
---- CAPITAL ACCOUNT
----- CURRENT ACCOUNT
——IMPACT OF CURRENCY ON TRADE


ASSIGNMENT 5 IN CLASS
Respond to the following blog
http://www.econlife.com/the-dow-jones-average-and-inflation/
Your insights in the following conversation
On my birthday I treated myself to watching Jeremy Grantham be interveiwed by Charlie Rose. What an eye opener. I have met Jeremy Grantham and have had several opportunities to talk to him. He has been a habitual stock market bear. Well, at one point, in his mind the US stock market had been over valued for nearly 20 years. Here is what he had to say about GDP. Most all of what follows is long-term, not a year by year prediction. For example: What will oil cost per barrel? It wil be more than $80/bbl. Long-term. Not tomorrow. Not next year. again, here is how GDP is found.
% change in real GDP = work force hour growth increase rate + productivity increase rate. Historically we had our labor force grow at about 1.5% per year and productivity has grown at about a 1.9 to 1.5% per year. Add that together and you have a 3% plus maybe a bit more for GDP growth (RGDP) in the USA. I think we and our textbooks all assumed that 3% was a 'normal' growth rate for the USA.
I have heard the term 'new normal' from all sorts of guru type investment advisors. I haven't been clever enough to ask why 2% should be the new normal, and they have not been forth coming enough to provide the justification for such.
Well, Jeremy says the work hours are growing at about 0.2 or 0.3% per year. The work force has been growing a bit faster, maybe 0.5% but we want to work fewer hours and are working fewer hours so teh hours of growth per year is less than the number of additional bodies. And productivity, according to Mr Grantham, has been a long slow decline since the end of WWII and now is about 1.3 to 1.2% per year. When you add these two together, well hang on...that doesn't equal 3%!! It is less than 2%!
So what?, you say. Well the national debt and structural budget deficit is just about fine right now if we grow at 3% per year. Grow at 2% and we need some tax increases to make things work. Increased taxes might reduce consumption and we know what that does.
So what?, you say. Even the most funded major pension plan in the USA (Wisconsin that is) has an assumed rate of return that needs 3% GDP growth to be met. Larger contribution would be needed, Once again, less consumption and we know....
So what?, you say. Stock market returns...are estimated tobe 9, 10 mayne 11% per year over the long haul. That assumes a GDP long-term growth rate of 3%. To have a retirement fund a person will have to save more per year...oh oh.
The list could go on and on.
Bloomberg news has the video (54 minutes) of Jeremy Gratham with Charlie Rose (who gets in the way some of the time). It is an intersting hour. I suggest you have a pen and pad available because the numbers come fast and furious.










WEB RESOURCES
1) International Trade
http://www.businessbookmall.com/Economics_Appendix_A_International%20Trade.htm
http://welkerswikinomics.wetpaint.com/page/Recent+US+Trade+Deficits

2)Comparative Advantage
http://www.mhhe.com/economics/mcconnell15e/student/olc/chap37graphs.mhtml
http://tutor2u.net/economics/revision-notes/a2-macro-trade-comparative-advantage.html
3) Exchange Rates
http://www.reffonomics.com/TRB/chapter30/currencyexchangemarket12.swf
http://www.mhhe.com/economics/mcconnell15e/student/olc/chap38graphs.mhtml
http://www.reffonomics.com/currencyexchange.html
http://www.reffonomics.com/currencyexchangemarket12.swf
http://www.mhhe.com/economics/mcconnell15e/student/olc/chap37graphs.mhtml
http://www.economist.com/daily/chartgallery/displaystory.cfm?story_id=15210330
http://welkerswikinomics.wetpaint.com/page/Flexible+Exchange+Rates
http://welkerswikinomics.wetpaint.com/page/Fixed+Exchange+Rates
http://www.nytimes.com/interactive/2009/12/06/business/metrics.html
4) overview of the unit
http://www.youtube.com/watch?v=fvWw09nfE2Y

5) Balance of Payments
http://www.reffonomics.com/TRB/chapter26/currentcapitalaccountsinteractive.swf
http://www.youtube.com/watch?v=Pd_qs8ueIWw&feature=related
http://www.investopedia.com/articles/03/060403.asp
http://thismatter.com/money/forex/topics/international_balance_of_payments.htm
http://welkerswikinomics.wetpaint.com/page/The+Balance+of+Payments

6) INTERESTING ARTICE
http://photo.newsweek.com/2010/3/brands-no-longer-made-in-the-usa.html
7)TRADE WITH CHINA
http://www.nytimes.com/2010/06/08/business/global/08wages.html?emc=eta1




LESSON 1 Comparative Advantage
Comparative Advantage is the ability to produce an item at a lower opportunity cost.Resources are scarce, so that one can only produce more of one product by taking the resources away from another.
Chipland and Entertainia are the two nations that currently produce their own Computer Chips and CD Players.
Production without Trade

Product
Chipland
Entertainia
1 Computer Chip
5 hours
24 hours
1 CD Player
10 hours
12 hours
Total
15 hours
36 hours

Note that Chipland uses less time (15 hours) to produce both and Entertainia uses more time (36 hours) to produce both. Chipland enjoys an Absolute Advantage, an ability to produce an item with fewer resources.
Why would Chipland care about trade?

Opportunity Cost of production


Chipland
Entertainia
1 Computer Chip
1/2 CD Player
2 CD Players
1 CD Player
2 Computer Chips
1/2 Computer Chip
The table shows that Chipland has a comparative advantage in Computer Chip production while Entertainia has the comparative advantage in the production of CD Players.

These nations can benefit from trade.


Production With Trade
Chipland

Entertainia

1 Computer Chip for Chipland
5 hours
1 CD Player for Entertainia
12 hours
1 Computer Chip for Entertainia
5 hours
1 CD Player for Chipland
12 hours
Total
10 hours

24 hours
















LESSON 2 Protectionism: Barriers to Trade
Restrictive trade practices prevent the free flow of goods and services among trading nations. Trade Barriers create artificially high profits and wages in protected markets. This will draw resources to these industries at the expense of others. This leads to higher price levels for consumers and lower employment in unprotected industries. Trade barriers direct production away from a nation’s most efficient and competitive industries to less efficient ones. Here are seven actions that are deemed barriers to trade.
Tariffs
taxes placed on imported goods
Quotas
quantity restrictions on imported goods
Government Subsidy
payments to domestic companies which allow for production at lower cost
Voluntary Trade Restraint
quotas that an exporting country places on its own products
Product Standards and Regulations
health and safety rules to guarantee minimum standard of quality which are often disguising an import quota
Red Tape
bureaucracy involved in exporting products to a particular country; licensing is an example
Dumping
charging a price for exported good that is below the actual cost of production to undercut the competition

Identify the following examples as one of the list actions above.
_ Various forms of financial assistance have been created for US farmers to protect them against crop damage due to weather, pests and to protect them from foreign competition.
_ During the 1980’s, the Japanese agreed to export only a certain number of cars to the US; most of the cars were top-of-the-line cars loaded with expensive features to give the Japanese exporter the greatest amount of profit
_ The Japanese assist some of their industries by providing low interest loans for capital resources to improve technology to lower cost and boost production.
_ Japanese auto imports are limited to 3% of France’s auto sales. In Italy, Japanese imports are limited to 1% of auto sales. In other countries without imports, Japanese imports are as high as 40% market share.
_ US importers of wool suits have paid a tax of 28¢ per pound plus 21% of the value of the imported suit. An imported suit weighing 6 pounds and having a wholesale price of $200 would bear a price of $243.60 before retail markup.

_ The US boycotted Mexican tuna because the number of dolphins caught in the nets of Mexican tuna fishermen exceeds the number tolerated by US law. The US Marine Mammal Protection Act stipulates that any country that buys tuna from Mexico will not be allowed to sell tuna in the US
_ Stores and warehouses in Japan are limited so that only a small amount of storage space is available. Small wholesalers and many layers of distribution make the Japanese method of distribution very sluggish and expensive for foreign importers.
_ The US filed suit against Sandvik, a Swedish producer of steel tubing used in the chemical and power industries. They captured 15 to 20% of the market and were accused of selling at a price, which does not cover their costs.
_ At one time, Indonesian palm oil refiners were obligated to purchase a stated percentage of the raw oil from domestic producers at prices fixed by the government.
_ In Venezuela, exporters benefited from tax relief when the government issued certificates to companies exporting goods other than coffee, cocoa, iron ore, and oil. Exporting firms could pay any federal tax with these certificates.
_ Auto makers wishing to sell cars in Japan must offer features which appeal to Japanese consumers such as right-hand steering, license plate holders which fit the type and shape of Japanese plates and locally-produced radios. European cars sold in Japan offer these options in addition to lights that warm of overheated anti-pollution devices, which are an important feature in Japan, a traffic-congested nation.















LESSON 3 BALANCE OF PAYMENTS

BOP = Current Account + Capital Account = Credits - Debits 0

The international balance of payments (BOP) is an accounting of the international transactions of a country that has its own currency over a certain time period, typically a calendar quarter or year. It shows the sum of all economic transactions between individuals, businesses, and government agencies in the country and those in the rest of the world.
Every international transaction involving different currencies results in a credit and a debit in the BOP. Credits are transactions that increase the amount of money to domestic residents from foreigners, and debits are transactions that increase the money paid to foreigners. For instance, if someone in England buys a South Korean stereo, the purchase is a debit to the British account and a credit to the South Korean account. If a Brazilian company sends an interest payment on a loan to a bank in the United States, the transaction represents a debit to the Brazilian BOP account and a credit to the United States BOP account.
The BOP for the United States international transactions is divided into 2 accounts: the current account and the capital account. The current account deals with international trade in goods and services and with earnings on investments. The capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets. A subdivision of the capital account, the financial account records transfers of financial capital and non-financial capital. The official reserves account, which is part of the financial account, is the foreign currency held by central banks, and is used to pay balance-of-payment deficits. Each account is further divided into sub-accounts.

Current Account = balance of trade + net factor income from abroad + net unilateral transfers from abroad

Capital Account
At high level:
begin{align}mbox{Capital account} & = mbox{Change in foreign ownership of domestic assets} & - mbox{Change of domestic ownership of foreign assets} end{align}
begin{align}mbox{Capital account} & = mbox{Change in foreign ownership of domestic assets} & - mbox{Change of domestic ownership of foreign assets} end{align}

Breaking this down:
begin{align}mbox{Capital account} & = mbox{Foreign direct investment} & + mbox{Portfolio investment} & + mbox{Other investment} & + mbox{Reserve account} end{align}
begin{align}mbox{Capital account} & = mbox{Foreign direct investment} & + mbox{Portfolio investment} & + mbox{Other investment} & + mbox{Reserve account} end{align}










LESSON 4 EXCHANGE RATES


Depreciation—value of currency has fallen; it takes more units of that country’s currency to buy another’s currency. Example: If the Rate had been $2 for 1 £ but now the rate is $3 for 1£, the dollar has depreciated.
Appreciation— value of currency has risen; it takes fewer units of that country’s currency to buy another’s currency. Example: If the Rate had been $2 for 1 £ but now the rate is $1 for 1£, the dollar has appreciated.


Determinants of exchange rates:
Example
Depreciates Appreciates
Changes in tastes
Japanese autos decline in popularity in US
Japanese Yen
Dollar

German tourists flock to US
German mark
Dollar
Changes in relative incomes
England is in recession; its imports decline while the US is growing increasing US imports
Dollar
Br. Pound
Changes in relative prices
Germany experiences a 3% inflation rate compared to US 10% inflation rate
Dollar
German Mark
Changes in relative interest rates
FED raises interest rates while Bank of England does not
Br. Pound
Dollar
Speculation
Currency traders believe France will have more rapid inflation than US
French Franc
Dollar

Currency traders think that German interest rates will plummet relative to US. rates
German mark
Dollar

Flexible rates have the ability to automatically correct the imbalance in the balance of payments. If there is a deficit in the balance of payments, this means that there is 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.

Disadvantages of Fixed Rate Exchange
1. Uncertainty and Diminished trade results if traders cannot count on future prices of exchange rates
2. Terms of trade may be worsened by a decline in the value of a nation’s currency
3. Unstable exchange rates can destabilize an economy especially if exports and imports are a large part of the GDP



Text Box: Fixed Exchange Rates
Text Box: Fixed Exchange Rates




• Rates that are pegged to some set value like gold or the US dollar.
Official reserves are used to alleviate imbalance in balance of payments since exchange rates cannot fluctuate
Trade policies must be used directly to control the amount of trade and finance
• Exchange controls and rationing of currency are bad for four reasons:
1. distorts trade patterns
2. involves discrimination among importers
3. reduces freedom of choice by consumers
4. black market rates develop unless policed.
• Domestic macroeconomic adjustments are more difficult under fixed exchange.
√ A persistent trade deficit may call for tight monetary policy and fiscal policies to reduce prices which raises exports and reduces imports, but this can also cause recession and unemployment.














LESSON 5 OVERVIEW



Interest
Rate

Capital
Flows

Demand for
Currency

Value of Currency

Imports


Exports



In

Appreciates




Out

Depreciates










Most people (including many teachers and economists) truly do not understand the principles of free trade. They think countries specialize in products that they can make the cheapest, which is a fallacy. Countries specialize in the products that they have a "comparative advantage" in which is a totally inward looking (in country) concept. For example, the United States could specialize in producing shoes, clothes, and toys at less cost than China and Germany in many cases, but US entrepreneurs choose not to because there is not as much money in making Barbie dolls or nurses' shoes as there is in say producing medical equipment or consulting. Thus, the US has a comparative advantage in medical technology equipment because the domestic opportunity cost of producing toys is higher in the US than in China which means a loss in US income if U.S. business school graduates choose, via the free market, to produce more toys and less medical equipment. As another example, the US can really produce "hats" less cheaply than Ecuador as our advanced technology could "trump" their lower wages, but which educated entrepreneur would want to pursue hat production and foregoe their pursuit as a video game designer.

In any free trade situation both nations (but not all individuals within the nations) will always win! Of course, the key words are "free trade". We're not talking about currency manipulations, tariffs, or export subsidies. The gains from trade are both quantitative and qualitiative. By definition trade will only occur if each country desires what the other country is producing (which means each side has a comparative advantage in their respective products). Since each country can not use the other country's currency, it is called "trade" (like the cowboys & indians) with currency rates simply determining the ratio that the goods/services will be traded at.

Free trade promotes competition among nations which is always good for both nations as the world's resources are used most effectively, choices & quality increases, and standards of living always rise. Neither NATION can ever lose in a free trade arrangement, as by definition, there is a free market exchange of that which both country's want, although individuals or companies within the nation can "lose" to a better competitor which is a necessary evil for the overall cause of quantitiative and qualitative gains for the nation as a whole.

Thus, the question posed below on "break even" is not real world...it is a hypothetical use of terms which appear reasonable on the surface, but really cannot be measured in reality. Said another way, any trade in a free trade agreement is a win-win because how could it be otherwise if the trade was made? For example, if the US makes Ford trucks in America and export them to China, by definition, the US had a comparative advantage in Ford trucks as some US company (Ford) felt the domestic opportunity cost was low (didn't want to produce medical equipment or did not have the capability) and apparently Ford was right as our US product was exported. There was a win for both China (tough Ford trucks) and the US (income for workers and profit for owners).

In basic economics we look at opportunity costs on both countries and assume that all externalities are included. That being part of our over-all assumption that everyone of our contrived situations operates in a Perfectly Competitive market, unless we are told other wise.

Real life of course is much more complicated. How can anyone "know" if the trade is mutually beneficial when so many inputs are subsidized. This oil out of the middle-east. It would certainly more more expensive if the US didn't maintain a large naval presence. But these are problems and implcations for much more advanced students than ours. Our problem is to keep the kids on the strraight and narrow of basic economics.

And speaking of the straight and narrow, and international trade. The back pages of The Economist magazine has the estimated trade imbalance for 2009 as a percent of GDP (-3%) and the estimated Federal Budget deficit for 2009 as a percent of GDP (-10%). With those two numbers I would expect my students to be able to calculate the 2009 estimated national savings rate as a percent of GDP.

Our Trade Balance of -3% means the Capital Account is +3%. That means an amount equal to 3% of our GDP is flowing into Financial markets. With the Federal Budget deifict at 10% of GDP, that much must be flowing out of the Financial markets (-10%). For the Financial markets to have sufficient funds to supply this demand from the Federal government, savings from Households and firms must be +7%.

Person savings, household savings is estimated to be in the 4 to 5 percent range. That implies that firms are savings an amount equal to between 2 and 3% of GDP. And yes, firms have seldom been so "cash rich".

Porter came out with the theory of Competitive Advantage in 1990, which is 20 years ago now, to further explain differences in what nations trade. He said why do nations with similar factor endowments of Land, Labour, Capital and Enterprise often specialise and trade in quite different things. Eg France and Germany. Ever heard of German perfume or high fashion? Likewise the French are not best known for high quality precision machinery.

Porter postulated that other factors such as a very high standard of Domestic Demand, (as well as Related and Supporting Industries, Resource Improvement and Legislative and Regulatory Framework) will give a nation a "competitive advantage" which it can use in international trade.


Here's a different view of the textbook scenario for arguments sake only:

The comparative advantage model works well in economic text books but fails to recognize the overpowering motivation for profit creation. Money flows have few borders while labor is landlocked. In addition, U.S. trade models respect the sovereign laws of nations. This allow the U.S. to ignore most human rights, environmental and intellectual property rights issues. Branding, of course, affords American consumers the ability to rationalize this. I suppose this is the Naomi Klein - No Logo argument.

Marx would argue that profits are nothing more than the exploited surplus value of labor. There is certainly more surplus value in poorer countries than in Middle America. American companies do produce toys, shoes and clothes; we just don't do so in this country. Capital finds its highest rewards so production is moved from US factories to those in Viet Nam and Haiti. It is much easier to find profits there since production costs are low, environmental restrictions are few, and barriers to entry don't exist.

So Haiti makes textiles for US companies because it supplies cheap labor with few strings attached. Our Government provides favorable trade agreements for Haitian producers as long as they buy U.S. Government subsidized cotton from Texas and California. In addition, Walmart gets special import treatment for buying finished textiles from those Haitian producers that bought their cotton from subsidized US growers.

What about those the lucky U.S. textile workers that were freed from their low opportunity costs jobs? Those textile workers in North Carolina were not redeployed to make medical equipment. They were redeployed into construction, landscaping, maid service and Walmart greeters. This gets explained away neatly as "service sector employment growth" and "job creation" but says little about aggregate wage losses and credit expansion based standards of living.

So we trade private and public debt for cheap outsourced goods and that model works well until the music stops. The music has stopped and those former unemployed factory workers that migrated to the "service" industry are structurally unemployed for the long run.

Ah, but the solution is to fix a debt solution with more debt (Dems: stimulus & Reps: tax cuts). Some believe you can't solve a debt problem with additional debt and that makes sense to me.

If that is true then the solution is a long period of painful debt de-leveraging, long term wage rate reduction and currency destruction. At some point, US labor & production facilities will become cost effective and we can once again "make" things again.

Can't happen? Think Japan but worse.

Note: Yen remained strong due to high personal savings rates in spite of high debt / GDP and decades of falling asset prices