Tuesday, September 07, 2010 10:59 AM

International Economics
- Trade Theory - Finance Theory Institutional description

Globalization:
A movement in an integrated world economy Mutual interdependence We benefit from knowledge that we do not personally poses International trade theory= market theory The existence of international borders is the only difference Labor cannot cross borders

Movement of Goods Movement of capital >> Movement of labor Across International Borders

Adam Smith: 1776 Wealth of Nations People will be able to take their productive power and labors and be prosperous anywhere International trade acts as a substitute as a movement of factors such as labor (we buy Japanese labor indirectly by buying Japanese vehicles)

Three Waves - 1870-1914: The golden age (british gold standard pound) Late colonial period was very globalized and international Britains were on the gold standard, so the pound was very powerful and influential The gold standard fixes exchange rates and makes international trade easier - 1845-1980: The great depression made a very big impression on the world powers establishment of economic standards for the world After WWII the world powers got together and established the way the international relations are today Winding down of European colonial empires The new mission of the world bank was to develop the economy in colonized locations They wanted to get globalization established again in the new world order World Tariffs on average were brought down - 1980-present Transportation costs get cheaper The internet Success in china, India, etc started to grow when they became involved in international trade
Tariff= tax on imported goods IMF= international monetary fund

Barriers To an integrated world economy Financial Complications Floating exchange rates Legal barriers such as (Tariffs, Quotas) Transportation costs

Trade Theory - Gains from trade How are gains possible? Who gains? - Comparative advantage Vs. absolute advantage Recognizing in a numerical example

Thomas Mun: Official of the East India company Mercantilism Favorable balance of trade

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- Favorable balance of trade Ex>Im

What is the purpose of economic activity: To get people to get more of what they want, to increase utility Improve psychic states

P= value Q= quantity
Balance of Payments Record of a nations transactions with foreigners - Current account + Financial account= 0 - CA= -FA How does a nation gain from trade specifically?

Comparative advantage - Vs absolute advantage - Be able to recognize in numerical eample - Average product of labor - Oportunity cost - Effect of a 1-unit movement toward specialization - Gains from trade
Exchange Creates Wealth - Indirectly (A. Smith) - Increase productivity of labor due to specialization - Directly (Menger) - If you allow that value is subjective Water is good for clenching my thirst Army rations, people can trade to make everyone better off

We are taking an idea that applies to individuals and applying it to nations

APL=Q/L Average product of labor sheep Wine

How productive a country is at a specific labor 70 10

Scotland 40 Spain Absolute Advantage The nations that can produce more with their labor should and not produce the things they are not good at 80

Food
Oc

Machines
3M 4F
2m 5F
oc *

Germany France

80 50

60 3m 20 5f
2m

4F

Opportunity Cost- what did you sacrifice when you did something The value of the best alternative sacrificed when you made a choice

Comparative advantage

F Germany -1 France Total + 15 8 7 8

M +3 4 -3 4 0

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How a particular nation fairs in this depends on the trade

Trade Theory: - Eercise I Identifying comp adv Limiting terms of trade Gains from trade - Trade =alternate means of production - Heckscher-ohlin version of comp adv Relative factor abundance Relating factor intensity

HB Bob Mary
25*

oc
1 p/ab

Pie
25

oc
1 hb/p

30

5/3 p/hb

50*

3/5 hb/p

Bob's limit: terms of trade < 1hb/ p Mary's limit: Terms of trade< 5p/3hb Tt>3/5 hb/p 1hb/p > Tt > 3/5 hb/p <-mary's gain Bob's gain->
Production: Transforming inputs into outputs Inputs Outputs

Less valuable

More valuable

Suppose there is a company (like walmart) xmart came out of no ware and gains power quickly All of their central activities are on an island on the coast of north carolina. No one knows much about what goes on there they just bring in raw materials and produce goods. They are taking out all the competition. An investigator goes in and sees the raw materials are being traded with foreign markets and they are importing goods in. Whats the difference between trade and production? Is there value in work itself?

Nations can consume more due to trade Purpose of trade Comparative advantage One factor of production= labor

Heckscher-Ohlin
(2x2x2) Labor Capital

A nation has comparative advantage in producing the good that uses inventively the factor it uses abundantly
Factor Abundance- Nations Factor intensity- Product processes

K L

K=Captal= produced means of production Factories, Equipment requires an investment (saving)

K = $1B = 10 L 100M 1

K = $20M = 2 L 50M 5

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Coparative Advantage: Heckscher- Ohlin-a a nation will have Comparative Adavantage In producing the good that uses intensively the factor that it possesses abundantly - Relative factor abundance - Relative Factor Intensity Factor abundance is a characteristic of nations Factor intensity is a characteristic of production process

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- Relative factor abundance - Relative Factor Intensity Factor abundance is a characteristic of nations Factor intensity is a characteristic of production process
China: K= 600M L= 600M = 1 Japan: K=120M L 60M =2

(K) > (K) L j Lc

Ka Q=3 Kb Factor input Price ratio

Slope Rise = K= Ka-Kb Run L La- Lo Q=2 Q=1

La

Lb ISOQUANT

K TC r TC w ISOCOST -W r TC= rK+ wL rK=Tc-wL K=TC/r- W/r L L r=payment to capitol services as a payment for labor (paying a rental price for equipment)

Relative factor abundance Vs Intensity

Input price ratio= wages rent

Three important theorems: Factor price Comparative Advantage - Heckscher-Ohlin Theorems Factor-Price equalization Stopler/Samuelson Compensation Principle

Heckscher Ohlin- says what about comparative advantage? Labor intensive vs capitol intensive

W/T Tetiles a (world) c b india

Pc/Pt (Pc/Pt) (Pc/Pt)us 0 (K/L)t ind (K/L)t US (K/T)L ind (K/L)L US

Cars

(W/r) US USA

(w/r) ind

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In a movement from autarky to free trade, if there were no barriers. We would move to the establishment of one world price. So we have a movement to factor price equalization.

Stolper Samulson There are winners and losers from trade Laborers lose in the stronger country
Real wage= w/p Wage is decreasing faster than prices are falling

r US: Pc ^ Pt v Pc Tc w

Scarce factor vs. abundant factor -> Abundant factor is winner, scarce factor is the loser Factor price equilization Its a trend that is not observed There should be factor price equilization in a world of free trade What stops this? - We dont have complete free trade - Legal parameters - Transportation cost - Not everything is traded (hair cuts) Purchasing power parody is an issue - Leontief Paradox US is a Net importer Explinations Intra-industrial trade Product differentiation Product life-cycle Other sources of comparative advantage Economics of sale
Hekshier Ohlin: N=land (natural resources) L=labor w= price per unit of labor r= rental price per unit of land

(n/l)t= 100 = 5< (n/l)a= 2000 = 200 60 3 10

W/P

SL

P
W/p*

Demand for oil goes up the price increases

DL

L*

Arbitrage: A process in which the existence of an opportunity for a net gain results in behavior that causes that opportunity to disappear

Factor price equalization: In a world with complete free trade and no transportation cost Compensation Principle: There is a net gain for a nation as a whole Leontief Paradox The united states was without a question the most capitalistic, and as a net importer of capital intensive goods. Countries import and export the same goods Wine is both imported and exported: product differentiation Industry trade The world is changing, around 1980, US started to trade with more labor abundant low income nations Capital Mobility: Capitalists are investing every ware Is the US still a capital abundant nation?

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Is the US still a capital abundant nation? -most investors are investing overseas Economies of Scale: a factor in economic life for observed patterns of trade (outside heckshire ohlin)it is significant for understanding the domestic economy. Something gets cheaper to produce per unit the more you produce $/Q $/Q

AC Q Natural monopoly The way a monopoly becomes profitable is to make their goods more scarce Most governments intervene
Product Life-Cycle Video Rental

AFC Q
AFC= FC/Q= constant/ increasing variable

Explaining Observed Trade Patterns - Leontief Paradox - Intra-Industry Trade Product Differentiation Border Trade - Economies of Scale Definition Reasons For Internal D of L Bargaining Large Fixed Costs Machinery Advertising R+D External Implications Determination of number of firms in an industry How firms get to be "too big to fail" Explanation of trade patterns that does not depend on Factor abundance Possible argument for government intervention What Triggers Specialization? Demand Management decisions Product Life-Cycle

$/Q

AFC= FC Q^

ATC=AFC+AVC

ATC

Minimum Efficient Scale (MES) Q

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Q^

ATC

Minimum Efficient Scale (MES)

Q

D
$/Q

Natural Monopoly Fulfill the worlds Demand with possible decrease in cost - Once in this position they can keep off competitors AFC
Q

What causes economies of scale? Division of labor The bigger the company the more specialization within the company Branding is important (Advertising) People trust a good name Research and development

Protective Instruments - Tariffs Definition Specific Advalorem Average Tariff Effective Rate of Protection Tarriff Escalation Welfare Effects Small country - Quotas Definition Comparison to tariff - Subsidy

Protectionism Tariff- tax on an imported good Specific tariff: example- $1 a bottle per wine Tariffs on specific goods in every country $20 specific tariff $40 -> $20 pretax $22 -> $2 pretax Average Tariff: Total Tariff Revenue Total Imports Smoot Howley Tariff- lead the world to a great depression http://en.wikipedia.org/wiki/Smoot%E2%80%93Hawley_Tariff_Act Laffer Curve: Tax Revenue Optimal rate

0%

100% Tax rate

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0%

100% Tax rate

At a real high rate its possible to cut Government deficit by raising taxes (50%)

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Protection: - Tariffs Finish history Effectove rate of protection Tariff escalation Gains and lossers from tariffs Small nation Large nation Quotas Definition Comparison with tariff e=n-ab (1-a)

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(1-a) - e=effective rate n=nomnal tariff rate a= value of imported inputs/ total value of product b= nominal tariff on imported inputs

Ch6. history of Tariffs

World trade collapse in 1930's - Polly Tariff - Average rate of 61% which essentially stopped world trade

After WWII the allies created a new world order - United nations - World bank Formed in order to rebuild Europe Now is used to rebuild 3rd world countries
GAT - Formed world trade organization (WTO) - It allows multi lateral negotiations Reduces transaction cost

Effective Rate of Protection e=n-ab (1-a) - e=effective rate n=nomnal tariff rate a= value of imported inputs/ total value of product b= nominal tariff on imported inputs
The nationality of products are ambiguous - In the making and designing of products are multi national

Nominal tariff: 10% tariff is a 10% rate of protection But What if a domestic manufacture is using a portion of imported inputs? Pcar=$10,000 Value steel= $5,000 a=.50 b=0 n=10% on imported cars .10-0/.50=0.1 P S E PA Pn+t (a) Tariff ^ Pn < Imports > Qd Qft D Q (b) (c) (d) Sw +t Sw
Free Trade World price

a)Transfer from consumer to producer (from tariff) a+c= transfers b+d= deadweight losses

C.S.

Pa

Producer vs consumer

P.S.

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Gains + Losers from Tariffs: Deadweight losses > pass-through effects Exchange rate - Lobbying costs

$/E Weak $ ^ v Strong $

SE

DE Euros
Strong Dollar hurts exporters Bc US goods are more expensive to foreigners

Protection: - Tariff - Large Nation - Quota Definition Comparison with tariff - Voluntary export restraints - Other protective devices Subsidy

Large vs. Small nation Large countries have the ability to drive up world prices

D
p

Pb Pa t

The burden of tax depends on the elasticity of the demand in the market for a particular good being taxed

If you raise the tax too high people buy less then the government doesnt get the revenue

Q
The total tax revenue is equal to the tariff times quantity b

tax paid by consumer D

p sb

Tax rev= (Pb-Pbt)Qb= tQb t Tax paid by seller sa

Pb Pa Pbt t

Q Tariff Model
P

Price restriction Pw + t A Pw D Quota Q b c d e

a) Transfer of consumer surplus to prooducer surplus b) Dead weight c) Profit to foreign seller d) Dead weight less

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Voluntary Export restraints Japanese Automobiles in the 1980's The Japanese agreed to limit the amount of cars sent to the US It caused the Japanese to shift their focus to higher profit per car instead of high volume All protection (Stolper Samuelson) there is no question that protection can protect some jobs. But the gains and losses from Autarky to free trade are at a smaller cost then the other way

Subsidy - P
Sa

Sb
D Q Sw

Subsidy is a payment to a producer (as aposed to a tariff which is a tax on foreign producers - Generally economist like subsidies better than tariffs because there is no deadweight costs - Secondly it is a cost on the government so the have an incentive to drop it bc its a cost on their budget Modern protectionism Is it protection or something else?

Protective Devices - Tariffs - Quotas - Subsides - Other Domestic content required Red Tape Government Procurement plicies Environmental and safety Cabotage Laws Export Credit subsidies - Free Trade Debate Economic arguments Protect jobs/wages Infant industry argument Strategic trade policy Level playing field Non economic National defense Cultural protection Foreign policy objectives

Trade is an alternate means of production - You do it because you can produce a thing with less comparative advantage - Exchange creates wealth
Jobs and Wages: You can always protect a job at a cost

Free Trade Arguments - Economic Protect Jobs/wages Possible to protect some jobs; not all jobs (cost?, to whom?) - Depends on gdp, which depends on demand - People take different jobs and new jobs are created - The jobs created by exports, Low wage labor not always cheap (productivity) - High wage American labor cannot compete with low wage foreign labor APL=Q/L TC=rK+wL AC= rK/6- wL/Q Unit labor cost =W/APL

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=W/APL Cheap labor doesnt always mean the best because the quality is not as good and the workers not as productive Education Infrastructure Availability of capital/ investment Labor not always the decisive factor - Some jobs do not demand very much labor (oil) Number of jobs not fixed ("lump of labor fallacy") - There is no reason to believe the number of jobs is fixed - People higher people to make more money A nation cannot have comparative advantage in everything - Comparative advantage in things that you can do at a lower cost to yourself - But it is possible to have absolute advantage due to monetary imbalance Economic (count'd) Infant industry argument Strategic trade policy The ability of the government to know what should and should not be Manufacturing is something special encouraged. Level playing field Non-economic National defense Cultural protection French farming is French culture Foreign policy strategy (e.g. sanctions) Check out Blackboard

International Finance - Balance of Payments Definition Structure Meaning - Exchange Rates

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Does this look like it was a part of the handout? Because its NOT!

The GDP is an attempt to measure the Nations income: GNP= market value of the goods produced by the citizens of a nation in one year Now they measure all goods produced within the nation.
GOV

I F.I. C T Sp ROW

C+I+G+[XX-M] GDP G+S

HH BUS

ROW

Y=C+I+G+[X-M] balance of trade A=C+I+G A(absorption-domestically) Y=A+(X-M) [X-M]=Y-A Household Outlays: Firm's Revenues

Prod Serv.

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ROW

Serv.
w,r,I, National Income

Y=C+S+T = [Sp-I]+[T-G]=[X-M] Sn-I=[X-M]

C+I+G+[X-M]

Twin Deficit Theory there is a strong link between a national economy's current account balance and its government budget balance.

Balance of payments: The US and the world Two main components: The current account (CA) Exports and imports Financial Account (FA) [capitol account] Net changes in financial transactions
CA+FA=0

Balance of payments - Payments Always Balance - Broad Structure Current account Financial account Debts+Credits

Credits must equal debits - Every transaction needs a payment

Balance of Payments Balance of trade: Fa<=(x-m)=Sn-I CA+FA=0 (floating rates) Ca=-FA Absorption-If a nation absorbs more it produces then it has trade deficit To do this you need to borrow, or be lent money, or be given gifts There is an imminent relationship between exchange rates and balance of payments

Weak$ $/ eF Strong $

How do you fix an exchange rate? Can you just make a law? NO! A gov to fix an exchange rate must have foreign exchange reserves

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Balance of Payments - Payments always Balance - Structure Credits + Debits Current account Financial account - Exchange rate Definition Types of Transaction Spot Forward Future Swap

Twin Deficit Gov deficit - trade deficit Deficit-> deficit to the 1 year planned gov budget National Debt-> accumulation of debt from all Budg deficits => Then government Borrows: FED: print money/monetize the debt Public Domestic or foreign Other Gov's Philips Curve:

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 Swap Option

inflation

Real interest rate= price of using money Nominal interest rate= real interest rate+expected inflation

unemployment

Twin Deficit (Budget Deficit)^ -> inflation (US borrowing)^ => foreign lending ^ => D$^ (demand for dollar)=> Trade deficit ^

Every transaction has a negative & positive

Current Account: 1) Exports of goods & services 18) Imports 29) Income payments Balance of Trade + unilateral transfers Balance of Payments - imports & exports of IOU's
Exchange Rates: - Definition - Types of Transaction Spot Forward Futures Swap Option - Motives Commercial/Financial Hedging Speculation Arbitrage - Institutions Retail level Interbank Market makers Futures market Exchange Rates: In a world of floating rates

Forward contract: Agree today to an exchange rate to be paid in the future Product of a floating rate system People enter into these contracts to hedge against exchange rate risks Individually tailored for specific purposes Over The Counter (custom to particular situation)
Futures: Exchange rated contracts Exchange traded bundles of foreign currency

Swap: Simultaneous purchase and sell a currency at two different maturities

-not credit default swaps (these are insurance policies)

Options: Financial derivative The right to buy/sell foreign currency at a price you agree to today After the closing date expires the option is gone
Hedgers The importer of wine will hedge with a foreign contract to hedge against an unknown future even Speculation Stable Unstable Bubble activity Arbitrage A process in which the existence of opportunity for net gain(profit) results in a behavior that causes that opportunity to disappear (lines in a grocery store) In foreign exchange The exchange is the same from london to new york as london to california

(X-M) us=(Sn-I) us=-(Sn-I)row= -(X-M) row Sp+SG-I (Sp+Tx-G-I) Whats rong with a trade deficit? - Is it sustainable? Quantitative easing:

ROW=rest of the world US Government expenditure: - Social security 20% - Health 20% - Military 20% - Interest 10%

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Quantitative easing: - Injecting cash into the economy - Monetizing the debt by buying US government securities Budget Deficit: Tax revenue - government spending ^I =>^budget deficit => ^national debt

Exchange Rate Determination - Supply + Demand for FX $/F Commercial vs. financial Weaker $ - Market Fundamentals - Expectations - Interest Rate parity Stronger $ Uncovered Covered - Carry Trade Exchange rate movement - Purchasing Power Parity (PPP) Ultimately a currencies value is anchored by the currencies ability to buy goods and services

SE b a c
DE

Financial Flows: $3.2 t/day US imports: $2.8 t/year

Interest rate parity: - With open capital market there is enough flow of foreign capitol to effect the interest rate. RODA (return on domestic assets) Ius ROFA (return on foreign assets) Iuk + % [1/e] E(%1/e) Ef-e s/ e s

If a lot of people move their money to a foreign account the it effects the exchange rate and makes the return make nothing

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 Exchange rates follow supply and demand Uncovered interest rate - No protection - Interest in US = Foreign [return on domestic assets=return on foreign] - The process is interest rate arbitrage Arbitrage The key to understanding micro economics Any equilibrium is the result of an arbitrage process An activity that seems will be profitable wont be profitable RODA=ROFA

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Purchasing Power Parity: The currency's value depends on the currencies ability to buy goods and services
$=100Y tv Pus=$500 tv Ptokyo=Y50,000 Absolute purchasing power parity: goods are exchanged We dont expect to see this all the time because the amount of services that are not traded

BOP Adjustment - Floating Exchange Rate General Idea If your currency weakens then that causes the price of US exports to become cheaper

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 If your currency weakens then that causes the price of US exports to become cheaper and imports become more expensive. The volume of imports should decrease and exports should decrease=> reducing the deficit Weak $ - e=$/ e - e^=> Pex^, PemV=> [Ex^, IMV]=> reducing the deficit Strong $ Complications Imported inputs - Imported inputs increase cost and go against the benefits of decreasing the value of a currency Elasticity - A numerical measure to a change in stimulus - The price elasticity of demand Percentage change in quantity demanded / percentage change in price pED=%Qd/%P Elastic: 40%/-10%=-4 %Qd>%P=>TR^ Inelastic: +1%/-10%=.1 Marshall/Larner condition - The foreign elasticity plus the domestic elasticity of imports must be< 1 - Eex+Eim>1 - Depends on foreign price elasticity of exports and domestic price elasticity for imports J-curve Surplus + 0 Time Deficit Currency Pass through: The effect of the currency change effecting the price of goods

Current account is almost the balance of trade, with unilateral transfers and foreign aid Balance of payments= CA+FA=0 (floating rates) CA=-FA CA= Balance of trade + Unilateral transfers (Fied rate) CA+FA+ORT=0 >Basic balance CA+FA=-ORT

Higher Cost=> Higher prices => Exv, Im^=> Ex-Im=Deficit => Borrowing from Foreigners => Credit Crisis

e=I /DM
Floating Exchange Rate, e^

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