ECON 11 LE4 PDF - International Trade

Lec 1-2 : Trade and Development CH. 18 - INTERNATIONAL TRADE Why Trade? ➔ Trade disciplines domestic firms that wield market power (contestability). ➔ In intermediate goods (machinery and other forms of capital), trade often embodies new technologies that raise pro...

Lec 1-2 : Trade and Development CH. 18 - INTERNATIONAL TRADE Why Trade? ➔ Trade disciplines domestic firms that wield market power (contestability). ➔ In intermediate goods (machinery and other forms of capital), trade often embodies new technologies that raise productivity. ➔ Trade increases not only the amount of goods a nation can consume, but also the quality and variety of goods available. ➔ In trading, there are higher returns with cheaper costs than if a country would only rely on itself or be “self-sufficient”. This is due to the law of comparative advantage. Law of Comparative Advantage ★ This is when the opportunity cost of producing a commodity is less than that in another country. ○ For example, it is cheaper to produce cars in Japan than in the UK. ○ The former (ex. Japan) then, is considered to have a comparative advantage in the production of that commodity (ex. Cars) ★ It is comparative advantage that should dictate trade patterns, not absolute advantage. ★ This says that a nation should specialize in producing and exporting those commodities that it can produce with lower costs and import the goods that it produces at a higher cost. Ricardian Analysis of Comparative Advantage Looking at a hypothetical example: Pre-Trade Situation: ★ America is more efficient in producing both F and C, but it is more efficient in food ★ Opportunity cost of producing 1 food in America is ½ clothing (1 FAM = ½ CAM) ○ To produce 1F and 1C, it will take 3 hrs. ★ Opportunity cost of producing 1 food in Europe is ¾ clothing (1 FEU = ¾ CEU) ○ To produce 1F and 1C, it will take 7 hrs. Post-Trade Situation: ★ With trading, the price the commodities shall take on will fall between the price of the 2 producing countries: 1F will take on a price between ½ CAM and ¾ CEU. Assuming such, the price will be at 1F = ⅔ C. TRADING PRICE POST TRADE : [1F = ⅔ C] or [1C = 3/2F] AMERICA EUROPE Specialized : 1F = 1hr of labor Specialized : 1C = 4hrs of labor 1C = 1 x 3/2 = 1 ½ hrs of labor 1F = 4 x ⅔ = 8/3 hrs = 2 ⅔ hrs of labor Total = 1 + 1 ½ = 2 ½ hrs of labor Total = 4 + 2 ⅔ = 6 ⅔ hrs of labor (from 3 hrs Pre-Trade) (from 7 hrs Pre-Trade) 3 ℎ𝑟𝑠 7 ℎ𝑟𝑠 2 1/2 ℎ𝑟𝑠 = 1.20 - 1 = 20% increase in real wage 6 2/3 ℎ𝑟𝑠 = 1.05 - 1 = 5% increase in real wage Modern Analysis of Comparative Advantage Take this Production Possibility Schedule for example: AMERICA EUROPE Choice # Food Clothing Choice # Food Clothing A 100 0 A 150 0 B 50 15 B 100 40 C 30 21 C 50 80 D 0 30 D 0 120 ★ With the different possible combinations of production, we assume that the 2 countries went with choice C, being that it is the most optimal. Pre-Trade Situation AMERICA EUROPE WORLD PRICE (PC / PF) 10/3 10/8 – FOOD Production 30 50 80 Consumption 30 50 80 X+/M- 0 0 0  CLOTHING Production 21 80 101 Consumption 21 80 101 X+/M- 0 0 0 ★ Without trade, what a country consumes is limited to what it produces. ★ The price of the commodity differs between countries depending on the behavior of the market within each country. They do not affect each other. Post-Trade Situation AMERICA EUROPE WORLD PRICE (PC / PF) 10/6 10/6 10/6 FOOD Production 100 0 100 Consumption 40 60 100 X(+) /M(-) +60 -60 – CLOTHING Production 0 120 120 Consumption 36 84 120 X(+) /M(-) -36 +36 – ★ With trade, the price is then determined by the individual prices of the countries (it settles in between the two countries’ prices). ★ With the law of comparative advantage, America would specialize production in food leaving Europe with producing clothing. ★ Not all produced are consumed and not all consumed are produced by one and the same country as trade gives way for imports and exports. ★ The country which the price settles closer to is at an advantage because it exchanges fewer of its goods for the other country’s goods, and it enjoys a better deal since it is trading at a rate closer to what it would have cost to produce the goods domestically. Supply & Demand Analysis of Trade Trading of Clothing in America: - The no-trade equilibrium price is at $8, and trade lowered the price to $4. - To achieve the demand at $4 (300 units), America only needs to produce M to E (100 units) and simply import E to F (200 units). Trade Strategies : Import Substitution ★ For sustained economic development, countries need to shift from primary production (e.g. agriculture) to manufacturing (e.g. industries) to prevent prolonged specialization in low-value added activities, i.e. less import, more production. This cannot be done immediately and needs government assistance. 1. Identify products with large domestic markets (as indicated by substantial imports) and relatively simple production technologies that can be mastered quickly. 2. Government introduces protective barriers to forcibly increase the price of competing imports. They do this through: a. Tariffs - taxes imposed on imports at the border b. Quotas - quantitative limits on specified categories of imports c. Production subsidies - Financial assistance to local producers to encourage increase in local supply and discourage importing. d. Exchange Rate Management - manipulation of the foreign exchange rates. TARIFFS ★ Raises price of the covered good ★ Lowers the quantity consumed and imported of the covered good ★ Raises domestic production of the covered good Diagrammatic Analysis - Price raised from $4 to $6 with the addition of a $2 tariff on the good. - Demand decreased from F (300 units) to J (250 units). - Imports decreased from EF (200 units) to HJ (100 units). - Production increased from LE (100 units) to MH (150 units) = effective! Although it is effective in increasing local production, there are still inefficiencies to consider: ➔ Area A = excess cost of production ➔ Area C = net loss in consumer surplus ★ Area B = increased government revenue from tariff (not an inefficiency) QUOTAS ★ Same as tariff but government revenue goes to quota-holder SUBSIDIES ★ Subsidy = Producer surplus + Resource cost ★ Funds come from government, not from consumer  ★ No loss of consumer surplus. EXCHANGE RATE MANAGEMENT AN UNDERVALUED EXCHANGE RATE: ★ Makes imports more expensive, exports more profitable. ★ Tends to damp overall consumption as imports are more expensive, increasing saving ★ Allows countries to build up foreign exchange reserves. ○ Reserves are, by definition, resources that a society puts aside and does not use for consumption or investment. ★ Not popular with consumers because, again, of expensive prices.  Lec 3-4 : Ex Rates and Int’l Financial Sys. CH. 27 - INTERNATIONAL TRADE Balance of International Payments (BOP) ★ Provides a systematic system of all economic transactions between a country and the rest of the world. Features of BOP ★ Every transaction is recorded either as a debit (-) or a credit (+). How do we know which is which? Rule: If a transaction earns foreign currencies for the nation, it is recorded as a credit (+). If a transaction spends foreign currency, it is a debit (-). ★ It has two fundamental parts: Current Account and Financial Account. ○ CA and FA must always = 0. Double entry system of accounting. Current Account ★ Represents the spending and receipts on goods and services, along with transfers. ★ There are: ○ Balance of Trade - exports and imports of goods and services ○ Primary Income - arising from factor incomes like interest and dividends ○ Secondary Income - transfer payments Financial Account ★ Includes purchases and sales of financial assets and liabilities. ★ There are: ○ Direct Investment ○ Portfolio Investment ○ Financial Investment ○ Other Investments ★ Formal rule in debiting and crediting FA: ○ Debit increases assets, decreases liabilities. (-) ○ Credit decreases assets, increases liabilities. (+) ○ Think of the country as exporting and importing stocks, bonds, and other securities. When we borrow abroad, we export IOUs so it is credit (+). When we lend and import IOUs, this is debit (-). Determination of Foreign Exchange Rates ★ ForEx rate - the price of one currency in terms of another currency ★ e = the amount of foreign currency that can be bought with 1 unit domestic currency. ★ ε = reciprocal exchange rate  𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 ○ e= 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 ○ ε= 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 Supply and Demand Analysis With Philippine Peso and US Dollars - Demand : Filipino desire for American goods; buying dollars - Supply : American desire for Filipino goods; buying pesos - Equilibrium is at E. It is where the exchange rate settles. - Above E = Surplus (Supply > Demand) - Below E = Shortage (Demand > Supply) Shifts of the Demand Curve ★ When the D curve shifts left, it depreciates the dollar. Shifting left could be due to recession or deflation where people tend to purchase more locally. ★ When the D curve shifts right, it appreciates the dollar. Shifting right could be due to monetary policy, specifically Federal Reserve increasing interest rates, where one’s money would have higher returns and therefore would encourage more dollar purchase. Purchasing Power Parity ★ The PPP theory explains an aspect of currency appreciation and depreciation. ○ For example, a good costs $1000 in the US but only P10,000 in the PH. As P100 = $1, it’ll be only $100 when purchased with dollars in the PH. ○ Consumers would then choose to buy the good in the PH, increasing imports from PH, increasing demand for PHP, appreciating its value. ○ This cycle will only end when the cost of the good is at relatively the same level in both countries. With hypothetical $1000 and P10,000, it will be when the exchange rate falls to P10 = $1. ★ PPP compares the value of money in different countries by looking at what it can buy. ○ The idea is simple: The price or cost of a product should be the same in both countries when measured in each currency. If not, the exchange rate between their currencies should adjust to make them equal. Foreign Exchange Rates and BOP ★ Exchange Rates movements serve as a balance wheel to remove BOP disequilibria ○ Ex. Raising interest rates will shift the D curve right and foreigners will move their assets here to take advantage of the higher returns (increases FA).  ○ As the D curve shifts, local currency will appreciate and other currencies will depreciate. Imports in the country increases as they are now cheaper, and exports decrease (decreases CA). ○ In this situation, when FA moves into surplus, exchange rate moves CA into deficit, restoring equilibrium. The International Financial System ★ These are the institutions under which payments are made for transactions that cross national borders. It determines how foreign exchange rates are set and how governments affect exchange rates. ★ 3 Major Exchange Rate Systems: ○ Fixed - not changed; changed through dictation ○ Flexible - ExRates are determined by market forces ○ Managed - ExRates where nations intervene to smooth rate fluctuations or to move their currency toward a target zone. Fixed Exchange Rates The Gold Standard ★ Governments specify the exact rate at which their currency will be converted into others. ★ The Gold Standard was then the most important. ExRates were determined by the amount of gold in their monetary units. ★ Fallen out of favor with large countries as they deemed it better to be either flexible or managed. International Monetary Systems (IMS) Post WW2 ★ The Bretton Woods System also fixed exchange rates but were also adjustable. When one currency got too far out of line, it is adjusted ★ It eventually broke down after functioning for about 25 years when the dollar became overvalued. Today’s Monetary System ★ Today’s IMS is a hybrid system without anybody planning it, each country to its own. ★ Mostly Flexible and Managed. There are still fixed ones but are easily changed by the government.  Lec 5-6 : Economic Growth CH. # Theories of Economic Growth Classical Theories Smith ★ If population doubles, output doubles ★ There is infinite supply of everything (mainly land) ★ Entire national income would go to wages because nothing goes to land Malthus ★ Population growth leads to resource shortages, famine, and poverty unless population control measures are adopted. Neoclassical Theory Solow ★ Introduces the role of capital accumulation and technological change. ★ Single output, two inputs (L and K). Labor growth is given 𝐾 ★ Growth model : 𝑄 = 𝐹(𝐾, 𝐿) or 𝑄 = 𝐹( 𝐿 )? Capital Deepening vs Capital Widening ★ Deepening - when stock of capital grows more rapidly than the labor force ○ K/L > Q/L ○ In the long run, since the growth is diminishing, it will eventually stop rising and will stay in a steady state. ★ Widening - when growth in real capital stock is just equal to the growth of the labor force (or population). So the ratio between total capital and total labor remains unchanged. New Growth Theory ★ Tech change is an output of the economic system ★ They are public goods or “nonrival” ★ Are expensive to produce but inexpensive to reproduce. Sources of Economic Growth Growth Accounting G = (WCAP x GCAP) + (WLAB x GLAB) + Tech Alternative Models of Development 1. Asian managed-market - strong gov’t + powerful market forces 2. Socialism - socialist government operating in a democratic framework 3. Soviet-style centrally planned economy - centrally planned, no hierarchy; failed