ECON102 Study Guide

Unit 6: International Trade and Finance

6a. Explain trade balances and their connection with financial capital flows (and the savings and investment identity)

Why is trade-based comparative rather than absolute advantage?
In a simple model of two countries and two goods, does one country always have a comparative advantage in one good, while the other has a comparative advantage in the other good?
What are some goods and services U.S. businesses specialize in and export?
What are some goods and services Americans import?

Countries have an absolute advantage when they use fewer resources to produce a good than other countries. This advantage may be due to a country's natural endowment (such as its geography or resources).

Countries have a comparative advantage when they can produce a good at a lower opportunity cost in terms of other goods. Be sure to consider the opportunity cost of producing a good to trade. For example, if a country uses its resources to produce wheat, it cannot use those resources to produce soy. A country with a necessary natural resource or location has an absolute advantage in the cost to produce the product for trade. The country with the lowest opportunity cost to produce a good relative to another country will have a comparable advantage.

Production Possibility Frontier for the U.S. and Brazil

Production Possibility Frontier for the United States and Brazil

The U.S. PPF is flatter than the Brazil PPF, implying that the opportunity cost of wheat in terms of sugar cane is lower in the United States than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The United States has a comparative advantage in wheat, and Brazil has a comparative advantage in sugar cane.

International trade is based on the principle of comparative advantage. Countries specialize in producing goods and services where they have a comparative advantage. They export these goods and services to other countries and import the goods and services the other countries produce. The international marketplace has become increasingly robust, as it has become easier and more cost-effective to transport goods and services across great distances.

International trade that operates in a free market benefits all trading partners. Exporting countries are able to sell additional goods and services, increase their economic activity, and promote employment in industries where they enjoy a comparative advantage. Consumers in importing countries have the opportunity to buy a greater variety of goods and services that cost less than what is available in their own country. International trade allows trading partners to buy and sell goods in a marketplace beyond their own limited borders.

To review, see:

6b. Discuss how we use economic indicators to compare global income levels and standard of living

What are the goals a country may have for its standard of living?
As an economic measure, what classifications does the gross national income (GNI) allow the World Bank to update each year?
What are some causes of global unemployment?
What is the difference between a country's level of trade and trade balance?

Economic indicators include unemployment, inflation, and balance of trade and policies across countries. These indicators relate to universal macroeconomic goals that impact a country's standard of living. To gauge a country's quality of life of its citizens, economists look at factors such as low levels of unemployment, price stability (low levels of inflation), and the ability to trade.

The World Bank ranks countries as high-income, middle-income, and low-income to measure and compare where countries stand relative to income and growth.

High-income countries are challenged with creating a more educated workforce that can create, invest in, and apply new technologies.
Challenges in middle-income economies relate to political and governmental controls in banking and financial regulations.
Growth policies for economically challenged (low-income) countries must address the lack of economic and legal stability and market-oriented institutions. These factors make it difficult to foster domestic economic growth and attract foreign investment.

A country's balance of trade is any gap between the dollar value of its exports (what its producers sell abroad) and the dollar value of its imports (the foreign-made products and services households and businesses buy). If exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports equal imports, the economy has a balanced trade.

We measure a nation's trade level by its exports of goods and services as a percentage of its GDP. A high level of trade indicates the country exports a good portion of its production. The level of trade indicates the degree of an economy's globalization.

To review, see:

6c. Explain the effects of net exports on aggregate demand

How do changes in exports and imports affect net exports?
Define the relationship between net exports and aggregate demand.
How does international trade affect the equilibrium levels of real GDP and the price level?

Innovations in communications technologies and transportation have increased international trade and globalization. Exports and imports across the globe have increased. Additional factors contributing to increased trade include income levels, relative prices, the exchange rate, trade policies, consumer preferences, and technology innovation.

Net Exports = Exports – Imports

Remember, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). Any increase in net exports creates a greater amount of total spending at every price level. This would shift aggregate demand to the right. A shift in aggregate demand to the left for net exports means that a lesser amount of total spending occurs at every price level. Two factors can cause shifts in aggregate demand for export and import demand: changes in relative growth rates between countries and changes in relative prices between countries.

Relative to net exports, aggregate demand decreases when there is a decrease in foreign demand or when there is a relative price increase of U.S. goods. Aggregate demand increases with an increase in foreign demand or a relative price drop of U.S. goods.

Note the various arguments for restricting imports, such as unsafe consumer products, national interest, the need for higher environmental standards for low-income countries, etc. Do you agree or disagree with some of the reasons for these types of policies? What benefits or adverse effects do you perceive with unrestricted trade?

To review, see:

6d. Identify the components of the U.S. balance of payments

What are two main sources of supply of financial capital in the U.S. economy?
What are two main sources of demand for financial capital in the U.S. economy?

The U.S. balance of payments reflects transactions between the United States and foreign residents. Three major categories in the balance of payments include the current account, the capital account, and the financial account. The U.S. current account refers to the U.S. transactions trade in goods and services, its net earnings on foreign investments, and its net transfer payments over a defined period of time (i.e., quarterly, yearly).

A country's balance of trade is the difference between the monetary value of its exports minus its imports (X-M). More about this component is discussed in Learning Outcomes 2g and 6b above. As mentioned in Learning Outcome 6b, a nation's level of trade is measured by its exports of goods and services as its share of GDP.

While the balance of trade tracks imports and exports, the current account also includes income from investments and transfers. Unilateral transfers are payments from governments, charities, and individuals when they send money abroad without receiving any direct good or service.

There are two primary sources for the supply of financial capital in the U.S. economy: individual and business savings (S) and the inflow of financial capital from foreign investors (this inflow is the trade deficit or imports minus exports M – X).

Two primary sources of demand for financial capital in the U.S. economy are private sector investment (I) and government borrowing. The government must borrow when government spending, G, is higher than the taxes collected, T.

Supply of financial capital = Demand for financial capital

S + (M – X) = I + (G – T)

There are times when various components of the national savings and investment identity can switch roles. For example, when the government needs to borrow funds to offset deficits, it can become a borrower (G – T > 0) and a demander of financial capital on the right side of the equation. However, the government would appear on the left side of the equation as a supplier of financial capital if the government is experiencing a surplus (T – G > 0).

To review, see:

6e. Analyze the pros and cons of having a large trade deficit and financial account surplus

How can borrowing money or running a trade deficit result in a healthy economy?
How can borrowing money or running a trade deficit result in a weaker economy?
When does it make economic sense for a national economy to borrow from abroad?

When a country's imports exceed its exports, its economy has a trade deficit. It receives a net inflow of foreign capital from abroad. Much of that foreign capital is invested in railroads and public infrastructure (roads, water systems, schools). These invested funds help the U.S. economy to grow. In this way, the trade deficit and the accompanying investment of funds help the U.S. economy. This inflow of foreign money can also cause harm if investing countries withdraw it quickly when they are concerned about the economic health of the recipient country. A rapid departure of foreign capital can negatively impact the country's economy and banking system and lead to a recession.

A trade surplus can create robust economic health. It can also negatively impact economic growth. For example, Japan has faced recessionary fears since 1990 due to slow GDP growth and increasing unemployment rates. Japan's trade surplus reflects a high rate of domestic savings (more than it can invest domestically). Therefore, Japan invests its extra funds abroad. Their consumption of imports is low, and the growth of consumption is slow. Exports continually exceed imports and result in a high trade surplus in most years. In Japan's case, a trade surplus, with slow GDP growth and an increasing unemployment rate, does not guarantee good economic health.

To review, see Pros and Cons of Trade Deficits and Surpluses and The Difference between the Level of Trade and the Trade Balance.

6f. Define and compare the main types of exchange rate systems

What changes in the foreign exchange market will bring about currency appreciation?
What about changes that depreciate the currency?
How does a change in the value of a currency affect the country's exports and imports and, therefore, its net exports?

Businesses and consumers who want to import goods and services from foreign countries must buy sufficient foreign currency to buy the goods or services they want to import. For example, a Japanese consumer who wants to buy American toys and games must buy enough U.S. dollars to cover the purchase costs.

Businesses, investors, banks, and consumers buy currencies on the foreign exchange market. Like other types of markets, the foreign exchange market is subject to the laws of supply and demand. When Japanese consumers exhibit a strong demand to buy American products and services, the price of the U.S. dollar increases.

An exchange rate is the rate at which one currency can be exchanged for another. It represents the value of one country's currency in relation to another currency. Exchange rates can be either fixed or floating. A fixed or pegged rate is determined by the government or the central bank of a country, while a floating rate is determined by market forces, specifically by the supply and demand dynamics in the foreign exchange market.

The Market for Dollars

A shift in demand and/or supply of dollars will affect the value of the U.S. dollar. For example, a shift of the demand for dollars to the right raises the equilibrium value of the dollar (the dollar will appreciate) and vice versa.

To review, see Exchange Rate Policies.

6g. Identify the main arguments in support of international trade and link this with comparative advantage

How do tariffs and quotas restrict free trade?
How do trade restrictions affect each trading partner (importer and exporter) in terms of the price level for the goods subject to the tariff or quota, job availability, and the value of its currency?
How do trade restrictions affect final goods and services when intermediate goods and services are subject to a tariff or quota?
How do trade restrictions affect market efficiency?

Free trade generally increases the well-being of both trading partners since it allows countries to specialize in producing the goods and services where they enjoy a comparative advantage. Nevertheless, policymakers frequently argue against free trade policies and impose trade restrictions, such as tariffs and quotas.

Consumers may suffer when governments impose tariffs and quotas; foreign businesses pass along any additional fees they must pay for the tariff to consumers by increasing prices. Businesses may feel less pressure to make needed improvements to gain a competitive advantage in the global marketplace – since they no longer face competition from foreign companies.

To review, see:

Unit 6 Vocabulary

absolute advantage
balanced trade
balance of trade
comparable advantage
comparative advantage
current account
economic indicators
exchange rate
free trade
high-income countries
international trade
low-income countries
middle-income countries
quota
tariff
trade deficit
trade surplus
U.S. balance of payments