This document summarizes key concepts in international trade and exchange rates discussed in Chapter 13. It covers absolute and comparative advantage, types of trade barriers, components of the balance of payments, and exchange rate systems. Country A has an absolute advantage in cars and Country B has an advantage in rice, but Country B has a lower opportunity cost of cars, so it should specialize in car production. The current account records trade in goods, services, income, and transfers. Exchange rates can be fixed, flexible, or managed to balance trade and stability.

1. CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATE

2. CHAPTER OUTLINE 13.1 Absolute Advantage & Comparative Advantage 13.2 The Trade Barriers 13.3 Balance of Payment (BOP) 13.4 Exchange Rate

3. 13.1 Absolute Advantage & Comparative Advantage Absolute advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does. More output with same resources

4. 13.1 Absolute Advantage & Comparative Advantage Comparative advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country. Mean lower opportunity cost

5. 13.1 Absolute Advantage & Comparative Advantage To illustrate the theory of comparative advantage, let us consider the case of two countries, country A and Country B, producing just two products wheat and cars. Assume: (i) assume constant unit costs. (ii) no barriers to trade. (iii) no transport or trading costs. (iv) all factors are fully employed. (v) the level of technology remain constant.

6. Absolute Advantage Country _______has an absolute advantage in producing car. Country _______has an absolute advantage in producing rice. Car (units) Rice (units) Country A 600 300 Country B Total production 300 900 600 900

7. Comparative Advantage Opportunity Cost??? Car (units) Rice (units) Country A 600 300 Country B Total production 300 900 600 900

8. Comparative Advantage Country ______ has lower opportunity cost in producing car >> should specialize in producing car. Country ______ has lower opportunity cost in producing rice >> should specialize in producing rice. Car (units) Opportunity cost Rice (units) Opportunity cost Country A 600 300 Country B 300 600 Total production 900 900

9. Production after Specialization Car (units) Rice (units) Country A Country B Total production

10. Terms of Trade Definition: The ratio at which a country can trade domestic products for imported products. How much of one good exchange for unit of another good. The terms of trade determine how the gains from trade are distributed among trading partners.

11. 13.2 TRADE BARRIERS Protection The practice of shielding a sector of the economy from foreign competition. Varieties of Trade barriers: Tariff Quota Export Subsidies Dumping (Anti) Embargoes

12. Tariffs Definition: A tax on imports that governments place on internationally traded goods to encouraging the consumption of domestic goods. Tariffs will increase price and reduce quantity. Under a tariff, the government collects the tariff revenue.

13. Tariffs Tariff revenue 2.00 2.50 Domestic supply Domestic demand Price (RM) Quantity World price = 2 World price with tariff = 2.50 t = .50 Initial imports 3.00 100 125 175 200

14. Quota Definition: A limit on the quantity of imports. Quotas will increase price and reduce quantity. With a quota, the domestic price increases, and the importer will gets the revenue.

15. Quotas Price (RM) Quantity 2.50 Domestic supply Domestic demand World price=RM2= World supply 2.00 Quota 3.00 100 125 175 200 World supply with quota

16. Export Subsidies Definition: Government payments made to domestic firms to encourage exports.

17. Dumping (Anti) Definition: A firm or industry’s sale of products on the world market at prices below the cost of production. Selling a product abroad for less than charged in the home market or less than the cost of production.

18. Embargoes Definition: An embargo is a total restriction on import or export of a good. Embargoes are usually established for international political reasons rather than for economic reasons. The U.S. has imposed embargoes on Iraq, Iran, Libya, and Cuba.

19. 13.3 THE BALANCE OF PAYMENTS Definition: The record of a country’s transactions in goods, services, and assets with the rest of the world; Also the record of a country’s sources (supply) and uses (demand) of foreign exchange. 3 main components in the BOP: Current account Capital & financial account The reserve assets

20. Current Account Definition: Records payments for the imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net income received from investment abroad, and net transfer payments from abroad.

21. Current Account Goods Record all import and export of goods. Example: Malaysia exports Proton cars to Canada and import wheat from New Zealand. Services Recorded all import and export of services. Example: Payments abroad for education, business and leisure.

22. Current Account Net exports of goods and services (EX-IM) The difference between a country’s total exports and total imports. Also known as balance of trade. Trade surplus The situation when a country exports more than it imports. Trade deficit The situation when a country imports more than it exports.

23. Current Account Income – cover two type of transactions: Income received on investments Income payments on investments Income received on investment: The external financial assets and liabilities made by Malaysian at oversea. Example: Dividends and interest arising from direct investment abroad by Malaysian companies. Income payments on investment The investment by foreigner in Malaysia.

24. Current Account Net transfer payments/ current transfer: The unilateral transfers that involve a one-way payment. Example: When Malaysian government donates to foreign country in form of charities.

25. Current Account Balance on current account : The sum of the net exports of goods and services, net investment income and net transfer payment.

26. Capital Account Capital account: Records relatively minor transactions such as capital transfer and acquisition of non-financial assets such as patents, copyright, etc.

27. Capital Account Balance on capital account In the United States, the sum of the following (measured in a given period): the change in private U.S. assets abroad, the change in foreign private assets in the United States, the change in U.S. government assets abroad, and the change in foreign government assets in the United States.

28. Financial account Financial account: Records purchase of assets a country made abroad and foreign purchases of assets in country. Classified such as direct investment, portfolio investment and other investment. Malaysia Case

29. Error and Omissions Error and omissions: Account for missing information.

30. Balance of Payment (BOP) Overall balance of payment: The sum of current account, capital account, net capital account transaction and error and omissions.

31. THE BALANCE OF PAYMENTS – 1.5 (11) Net capital account transactions 0 (12) Balance of payments (5 + 10 + 11) 51.9 (11) Statistical discrepancy 615.5 (10) Balance on capital account (6 + 7 + 8 + 9) 355.3 (9) Change in foreign government assets in the United States 4.1 (8) Change in U.S. government assets abroad (increase is –) 1077.9 (7) Change in foreign private assets in the United States – 821.8 (6) Change in private U.S. assets abroad (increase is –) CAPITAL ACCOUNT ?????? (5) Balance on current account (1 + 2 + 3 + 4) – 72.9 (4) Net transfer payments ????? (3) Net investment income – 344.9 Income payments on investments 369.0 Income received on investments ????? (2) Net export of services – 291.2 Import of services 339.6 Export of services ?????? (1) Net export of goods – 1,473.1 Goods imports 807.6 Goods exports CURRENT ACCOUNT TABLE 21.1 United States Balance of Payments, 2004

32. Multiplier Effect & Aggregate Expenditure (extension from Chapter 11): Planned aggregate expenditure ( AE ) in an open economy: In equilibrium: m = marginal propensity to import (or MPM) multiplier

33. Exports Exports contribute to an increase in autonomous expenditures and cause the planned aggregate expenditure function to shift upward.

34. Imports Imports affect the value of the multiplier. After imports are included, the aggregate expenditure function rotates and equilibrium income decreases.

35. 13.4 Exchange Rate The main difference between an international transaction and a domestic transaction concerns currency exchange. Exchange rate: The price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other. Foreign exchange: The price at which one currency exchanges for another currency.

36. Exchange Rate 3 types of exchange rate system: Fixed exchange rate Flexible exchange rate Managed floating system/ semi-fixed exchange rate

37. Fixed Exchange Rate Definition: Government set a particular fixed rate at which their currencies will exchange for each other. Example: Pegging (RM3.80 = $1.00) Appropriate for developing countries with limited links to global financial production and export structure.

38. Fixed Exchange Rate Advantage: Provide greater certainty for exporters and importers. Disadvantage: Encourages foreign debt.

39. Flexible Exchange Rate Definition: Exchange rates determined by the unregulated force of supply and demand. The exchange rate movements have important impacts on imports, exports, and movement of capital between countries. Appropriate for medium and large industrialized countries and some emerging market economies.

40. Flexible Exchange Rate Advantage: Can provide an automatic adjustment for countries with a large balance of payments deficit. Disadvantage: Increase foreign exchange volatility and this may cause serious problems, especially in emerging economies.

41. Managed Floating System Definition: The government sometimes buys or sells currencies to influence the exchange rate, while at other times letting private market forces operate. Central bank may have to intervene to maintain the value of the currency within the target.

42. Managed Floating System Appropriate for emerging market economies and some other developing countries with relatively stronger financial sector and track record for disciplined macroeconomic policy. Advantage: Can maintain stability and competiveness. Disadvantage: Lead to uncertainty.

43. Fixed ER System vs. Flexible ER System Fixed ER ER fixed by the government through Central Bank intervention Currency is pegged to one key currency Country needs to purchase @ sell foreign currency to ensure that the ER does not move above @ below the official ER Country must hold international reserves (foreign currency) to maintain the ER Flexible ER ER determined by the unregulated forces of SS & DD Currency can appreciate @ depreciate – fluctuation in ER Country do not need to purchase @ sell foreign currency to ensure that the ER does not move above @ below the official ER Country do not need to hold international reserves (foreign currency) to maintain the ER

44. The Open Economy With Flexible Exchange Rates Currency depreciation: The rise in value of one currency relative to another in a flexible rate system. Currency appreciation: The fall in value of one currency relative to another in a flexible rate system.

45. The Equilibrium Exchange Rate 3.49 0 D S Foreign exchange (millions of dollars) 800 820 Exchange rate (RM per dollar) Initial equilibrium exchange rate is RM3.49 If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually 3.50 3.48

46. Figure: Effect on the Foreign Exchange Market of an Increased Demand for Dollars 3.49 0 D S Foreign exchange (millions of dollars) 800 3.50 820 Suppose an increase in Malaysia incomes causes Malaysian to increase their demand for all normal goods, including those from the U.S area: demand curve shifts from D to D ' The shift of the demand curve leads to an increase in the exchange rate from RM3.49 to RM3.50 per dollar. The dollar appreciates and the RM depreciates: U.S people purchase more Malaysian products. Exchange rate (RM per dollar) D'

47. The Open Economy With Flexible Exchange Rates Fundamental forces determine the demand and supply for currencies and can cause them to shift: A country’s income Changes in a country’s prices The interest rate in a country A country’s trade policy

48. Changes in a Country’s Income Income increases in the Malaysia Imports increase Demand for foreign currency to buy imports increase which means the supply of the RM increases The increase in supply of the RM causes the price of the RM to decrease

49. Changes in a Country’s Income

50. Changes in a Country’s Prices Inflation in the Malaysia increases Imports increase because foreign goods are cheaper Demand for foreign currency to buy imports increases which means the supply of the RM increases The increase in supply of RM causes the price of RM to decrease

51. Changes in a Country’s Prices

52. Changes in Interest Rates Interest rates in the Malaysia increase Demand for Malaysia interest-bearing assets increases Demand for RM to buy Malaysia assets increases The increase in the demand for RM causes the price of RM to increase

53. Changes in Interest Rates

54. Changes in Trade Policy Malaysia trade restrictions on imports increase Demand for imports to the Malaysia decreases The demand for foreign currencies decreases, which means the supply of RM decreases If foreign countries retaliate with restrictions on Malaysia exports, the demand for RM decreases

55. Changes in Trade Policy

56. The Effects of Exchange Rate on the Economy The level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports will change. Changes in exports and imports can in turn affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy.

57. Exchange Rate Effects on Imports, Exports, and Real GDP A depreciation of a country’s currency is likely to increase its GDP (e.g Malaysia) can serve as a stimulus to the economy: Foreign buyers are likely to increase their spending on Malaysian goods (relatively cheaper) Buyers substitute domestically made goods for imports (as import will costs more) Aggregate expenditure on domestic output will rise GDP ( Y ) will increase

58. Monetary Policy with Flexible Exchange Rate Increase in M Interest rate fall Investor earning lower IR Seek better investment abroad Sell local currency Buy foreign currency Exchange rate fall (depreciate) Local (foreign) product cheaper (more expensive) Net export increase

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