CHAPTER 21: EXCHANGE RATES, THE BALANCE OF PAYMENTS, AND TRADE DEFICITS

FINANCING INTERNATIONAL TRADE

ü  U.S. Export Transaction

U.S. exports create a foreign demand for dollars, and the fulfillment of that demand increases and the supply of foreign currencies and by U.S. ranks and available to U.S. buyers.

ü  U.S. Import Transaction

U.S. imports create a domestic demand for foreign currencies and the fulfillment of that demand reduces the supplies of foreign currencies held by U.S. banks and available to U.S. consumers.

THE BALANCE OF PAYMENTS

-          Is the sum of all the transactions that take place between the residents and residents of all foreign nations. The statement shows all the payments a nation receives from foreign countries and all the payments it makes to them.

ü  Current Account

ü  Balance on Goods

-          Is the difference between its exports and its imports of goods.

ü  Balance on Services

-          Is the difference between U.S. exports of goods and services and U.S. imports of goods and services.

Trade deficit – unfavorable balance of trade

Trade surplus – favorable balance of trade

ü  Balance on Current Account

-          Is the sum of all the transactions of current account.

Net investment income – represents the difference between (1) the interest and dividend payments foreigners paid the United States for the U.S. exported capital and (2) the interest and dividends the United States paid for the use of foreign capital invested in the United States.

ü  Capital Account

-          Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments that accompany them.

ü  Official Reserves Account

-          These reserves can be drawn on to make up any net deficit in the combined current and capital accounts.

ü  Payments Deficits and Surpluses

Balance-of-payments deficits and surpluses – they are referring to imbalances between the current and capital accounts that cause a drawing down or building up of foreign currencies.

FLEXIBLE EXCHANGE RATES

2 Types of Exchange-rate Systems:

·         Flexible/Floating exchange-rate system – through which demand and supply determine exchange rates in which no government intervention occurs.

·         Fixed-exchange rate system – through which government determine exchange rates and make necessary adjustments in their economies to maintain these rates.

Demand-for-pounds curve – is downward-sloping because all British goods and services will be cheaper to the United States if pounds become less expensive to the United States.

Supply-of-pounds curve – is upward-sloping because the British will purchase more U.S. goods when the dollar price of pounds rises.

ü  Depreciation and Appreciation

Depreciation – an estimate of the amount of capital worn out or used up in producing the gross domestic product.

Appreciation – an increase in the value of the dollar relative to the currency of other nation, so a dollar buys a larger amount of the foreign currency and thus of foreign goods.

ü  Determinants of Exchange Rates

·         Changes in Rates

·         Relative Income Changes

·         Relative Price-Level Changes

Purchasing-power-parity theory – holds that exchange rates equate the purchasing power of various currencies.

·         Relative Interest Rates

·         Speculation

ü  Flexible Rates and the Balance of Payments

Proponents of flexible exchange rates say that they have an important feature: They automatically adjust and eventually eliminate balance-of-payments deficits and surpluses.

ü  Disadvantages of Flexible Exchange Rates

·         Uncertainty and Diminished Trade

·         Terms-of-Trade Changes

·         Instability

FIXED EXCAHNGE RATES

ü  Use of Reserves

Currency Interventions – manipulations of market through the use of official reserves.

ü  Trade Policies

The fundamental problem is that these policies reduce the volume of the world trade and change its makeup from what is economically desirable.

ü  Exchange Controls and Rationing

There are major objections to exchange controls:

·         Distorted Trade

·         Favoritism

·         Restricted Choice

·         Black Markets

INTERNATIONAL EXCAHNGE-RATE SYSTEMS

3 exchange-rate systems:

ü  Fixed-rate system

ü  Modified fixed-rate system

ü  Modified flexible-rate system

Ø  The Gold Standard: Fixed Exchange Rates

Under this system, each nation must

·         Define its currency in terms of quantity of gold

·         Maintain a fixed relationship between its stock of gold and its money supply

·         Allow gold to be freely exported and imported

·         Gold Flows

Under the gold standard, the potential free flow of gold between nations resulted in fixed exchange rates.

·         Domestic Macroeconomic Adjustments

When currency demand or supply changes, the gold standard requires domestic macroeconomic adjustments to maintain the fixed exchange rate.

·         Collapse of the Gold Standard

Devaluation – deliberate action by government to reduce the international value of its currency.

Ø  The Bretton Woods System/ Adjustable-peg System

The conference that produced a commitment to a modified fixed-exchange-rate system.

·         IMF and Pegged Exchange Rates

Under the Bretton Woods system there were three main source of the needed pounds:

·         Official Reserves

·         Gold Sales

·         IMF borrowing

·         Fundamental Imbalances: Adjusting the Peg

The Bretton Woods remedy was correction by devaluation, that is, by an “orderly” reduction of the nation’s pegged exchange rate.

·         Demise of the Bretton Woods System

The problem culminated in 1971 when the United States ended its 37-year-old policy of exchanging gold for dollars at $35 per ounce. It severed the link between gold and the international value of the dollar, thereby “floating” the dollar and letting market forces determine its value. The floating of the dollar withdrew U.S. support from the Bretton Woods System of fixed exchange rates, and, in effect, ended the system.

·         The Current System: The Managed Float

Managed floating exchange rates – the current international exchange-rate system is an “almost” flexible system. The system permits nations to buy and sell foreign currency to stabilize short-term changes in exchange rates or to correct exchange-rate imbalances that are negatively affecting the world economy.

RECENT U.S. TRADE DEFICITS

ü  Implications of U.S. Trade Deficits

·         Increased Current Consumption

Increased U.S. Indebtedness

CHAPTER 20: INTERNATIONAL TRADE

THE ECONOMIC BASIS FOR TRADE

“Why do nations trade?” hinges on three facts:

·         The distribution of natural, human and capital resources among nations is uneven; nations differ in their endowments of economic resources.

·         Efficient production of various goods requires different technologies or combinations of resources.

·         Products are differentiated as to quality and other nonprice attributes.

Labor-intensive goods – products requiring a relatively large amount of labor to be produced.

Land-intensive goods – products requiring a relatively large amount of land to be produced.

Capital-intensive goods – products that require a relatively large amount of capital to be produced.

COMPARATIVE ADVANTAGE: GRAPHICAL ANALYSIS

• Two isolated nations

2 characteristics of theses production possibilities curves:

·         Constant costs

·         Different costs

• United States

• Brazil

Brazil’s production possibilities curve represents a different full-employment opportunity-cost ratio.

• Self-Sufficiency Output Mix

If the United States and Brazil are isolated and are to be self-sufficient, then each country must choose some output mix on its production possibilities curve. It will choose the mix that provides the greatest utility, or satisfaction.

•  Specializing based on Comparative Advantage

·         Principle of Comparative Advantage

Total output will be greatest when each good is produced by the nation that has the lowest domestic opportunity cost for that good.

• Terms of Trade

The international exchange ratio or terms of trade:

1W = 1C (United States’ cost conditions

And

1W =2C (Brazil’s cost conditions)

• Gains from Trade

Trading possibilities line – shows the amounts of two products a nation can obtain by specializing in one product and trading for the other.

• Improved Options

• Added Output

Specialization according to comparative advantage results in a more efficient allocation of world resources, and larger outputs of both products are therefore available to both nations.

As a result of specialization and trade, both countries have more of both products.

A nation can expand its production possibilities boundary by (1) expanding the quantity and improving the quality of its resources or (2) realizing technological progress.

• Trade With Increasing Costs

• The Case For Free Trade

Through free trade based on the principle of comparative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material well-being than it can without a free trade.

SUPPLY AND DEMAND ANALYSIS OF ExPORTS AND IMPORTS

World Price – price that equates the quantities supplied and demanded globally.

Domestic Price – price that would prevail in a closed economy that does not engage in international trade.

• Supply and Demand in the United States

·         U.S. Export Supply

U.S. export supply curve slopes upward, indicating a direct or positive relationship between the world price and the amount of U.S. exports. As world prices increase relative to domestic prices, U.S. exports rise.

·         U.S. Import Demand

It reveals that as world prices falls relative to U.S. domestic prices, U.S. imports increase.

TRADE BARRIERS

Tariffs – excise taxes on imported goods.

Revenue Tariff – usually applied to a product that is not being produced domestically.

Protective Tariff – is designed to shield domestic producers from foreign competition.

Import Quota – specifies the maximum amount a commodity that may be imported in any period.

Nontariff Barrier – is a licensing requirement that specifies unreasonable standards pertaining to product quality and safety, or unnecessary bureaucratic red tape that is used to restrict imports.

Voluntary Export Restriction – is a trade barrier by which foreign firms “voluntarily” limit the amount of other exports to a particular country.

• Economic Impact of Tariffs

·         Direct Effects

-Decline in consumption

-Increased domestic production

-Decline in imports

-Tariff revenues

• Indirect Effect

Tariffs directly promote the expansion of inefficient industries that do not have a comparative advantage; they also indirectly cause the contraction of relatively efficient industries that do not have a comparative advantage.

• Economic Impact of Quotas

While tariffs generate revenues for the domestic government, a quota transfers that revenue to foreign produces.

• Net Cost of Tariffs and Quotas

Protection raises the price of a product in three ways:

1)      The price of the imported product goes up

2)      The higher price of imports causes some consumers to shift their purchases to higher-priced domestically produced goods.

3)      The prices of domestically produced goods rise because import competition has declined.

• Import on Income Distribution

Tariffs and quotas affect low-income families proportionately more than high-income families. Because they are much like sales or excise taxes, these trade restrictions are highly regressive. That is, the “overcharge” associated with trade protection falls as a percentage of income as income increases.

THE CASE FOR PROTECTION: ACRITICAL VIEW

• Military Self-Sufficiency Argument

The argument here is not economic but political-military. Protective tariffs are needed to preserve or strengthen industries that produce the materials essential for national defense. In an uncertain world, the political-military objectives sometimes must take precedence over economic goals.

• Increased Domestic Employment Argument

This argument has several shortcomings:

·         Job creation from imports

·         Fallacy of composition

·         Possibility of retaliation

•  Diversification-for-Stability Agreement

There are also two serious shortcomings:

·         The argument has a little or no relevance to the United States and other advanced economics.

·         The economic costs of diversification may be great; for example, on-crop economics may be highly inefficient at manufacturing.

• Infant industry Argument

·         Counterarguments. There are some logical problems with the infant industry argument.

·         In the developing nations it is difficult to determine which industries are the infants that are capable of achieving economic maturity and therefore deserving protection.

·         Protective tariffs may persist even after industrial maturity has been realized.

·         Most economists feel that if infant industries are to be subsidized, there are better means of them tariffs for doing so.

• Strategic Trade Policy

The problem with this strategy and therefore with this argument for tariffs is that the nations put at a disadvantage by strategic trade policies tend to retaliate with tariffs of their own. The outcome may be tariffs worldwide, reduction of world trade, and the loss of potential gains from technological advances.

•  Protection-against-Dumping Argument

Dumping – is the selling of excess goods in a foreign market at a price below costs.

2 plausible reasons for this behavior:

1)      Firms may use dumping ahead to drive out domestic competitors there, thus obtaining monopoly prices and profits for the importing firm.

2)      Dumping may be a form of price discrimination, which is charging different prices to different customers even though costs are the same.

• Cheap Foreign Labor Argument

The cheap foreign labor argument says that domestic firms and workers must be shielded from the ruinous competitions of countries where wages are low.

CHAPTER 19: DISPUTES OVER MACRO THEORY AND POLICY

SOME HISTORY: CLASSICAL ECONOMICS AND KEYNES

• The Classical View

The aggregate supply curve is vertical and is the sole determinant of the level of real output.

·         Vertical Aggregate Supply Curve

The economy will operate at its potential output because of (1) Say’s Law, and (2) responsive, flexible prices and wages.

·         Stable Aggregate Demand

The amount of real output that can be purchased depends on (1) the quantity of money households and business process and (2) the quantity of purchasing power of that money as determined by the price level.

• The Keynesian View

The macroeconomic generalizations that lead to the conclusion that a capitalistic economy is characterized by the macroeconomic instability and that fiscal policy and monetary policy can be used to promote full employment, price level stability and economic growth.

·         Horizontal Aggregate Supply Curve

The downward inflexibility of prices and wages presumed by the Keynesian translates to the horizontal aggregate supply curve.

·         Unstable Aggregate Demand

• Keynesian economics view aggregate demand as unstable from one period to the next, even WHAT CAUSES MACRO INSTABILITY?

• Mainstream View

Macro instability is caused by the volatility of investment spending, which shifts the aggregate demand curve. If aggregate demand increases too rapidly, demand-pull inflation may occur, if aggregate demand decreases, recession may occur.

2 main sources:

(1) Significant changes in investment spending, which change aggregate demand and (2) adverse aggregate supply shocks, which change aggregate supply.

·         Changes in Investment Spending

Investment spending in particular, is subject to wide “booms” and “busts”. Increases in investment spending are multiplied into even greater increases in aggregate demand and thus can produce demand-pull inflation. In contrast, significant declines in investment spending are multiplied into even greater decreases in aggregate demand and thus can cause recessions.

·         Adverse Aggregate Supply Shocks

• Monetary View

(1) Focuses on the money supply, (2) holds that markets are highly competitive, and (3) says that a competitive market gives the economy a high degree of macroeconomic stability.

·         Equation of Exchange

MV =PQ

M is the supply of money

V is the velocity of money, that is, the average number of times per year a dollar is spent on final goods and services

P is the price level

Q is the physical volume of goods and services produced

·         Stable velocity

When monetarists say that velocity is stable, they mean that the factors altering velocity change gradually and predictably that changes in velocity from one year to the next can be readily anticipated. Moreover, they told that velocity does not change in response to changes in the money supply itself.

• Monetary Causes of Instability

Inappropriate monetary policy – an increase in the money supply directly increases aggregate demand.

• Real-Business Cycle View

Views changes in resource availability and technology, which alter productivity, as the main causes of macroeconomic instability. In this theory, shifts of the economy’s long-run aggregate supply curve change real output. In turn, money demanded and money supply change, changing the aggregate demand curve in the same direction as the initial change in long-run aggregate supply. Real output thus can change without a change in the price level.

• Coordination Failures

Is said to occur when people lack away to coordinate their actions in order to achieve a mutually beneficial equilibrium. Depending on people’s expectations, the economy can come to rest either a good equilibrium or a bad equilibrium.

·         Noneconomic Example

·         Macroeconomic Example

DOES THE ECONOMY “SELF-CORRECT”?

• New Classical View of Self-Correction

Rational Expectations Theory – the idea that businesses, consumers and workers expect charges in policies or circumstances to have certain effects on the economy, and in pursuing their own self-interest, take actions to make sure those changes affect them as little as possible.

New Classical Economics – holds that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy will automatically move it back to that output.

• Graphical Analysis

• Speed of Adjustment

RET is based on two assumptions:

·         People behave rationally, gathering and intelligently processing information to form expectations about things that an economically important to them.

·         Like classical economists, RET economists assume that all product and resource markets are highly competitive and that prices and wages are flexible both upward and downward.

• Unanticipated Price-Level Changes

Price-level surprises – unanticipated changes in the price level cause temporary changes in real output.

• Fully Anticipated Price-Level Changes

Do not change real output, even for shorter periods

• Mainstream View of Self-Correction

• Graphical Analysis

• Downward Wage Inflexibility

• Efficiency Wage Theory

Efficiency Wage – is a wage that minimizes the firm’s labor cost per unit of output.

How can higher wage result in greater efficiency?

·         Greater work effect

·         Lower supervision costs

·         Reduced job turnover

• Insider-Outsider Relationships

Insider-Outsider Theory – outsiders may not be able to underbid existing wages because employers may view the nonwage cost of hiring them to be prohibitive.

RULES OR DISCRETION?

• In Support of Policy Rules

Such rules would prevent government from trying to “manage” aggregate demand. That would be a desirable trend, because in their view, such management is misguided and thus is likely to cause more instability.

• Monetary Rule

One such rule would be a requirement that the Fed expand the money supply each year, at the same annual rate as the typical growth of the economy’s production capacity.

• Balanced Budget

• In Defense of Discretionary Stabilization Policy

·         Discretionary Monetary Policy – Annual rate of increase in the money supply might not eliminate fluctuations in aggregate demand.

• ·         Discretionary Fiscal Policy – Deliberate changes in taxes and government spending by Increased Macro Stability

Moreover, mainstream economists point out several specific policy successes in the past two decades.

·         A tight money policy dropped inflation from 13.5% in 1980 to 3.2% in 1983.

·         An expansionary fiscal policy reduced the unemployment rate from 9.7% in 1982 to 5.5% in 1988.

·         An easy money policy helped the economy recover from the 1990-1991 recession.

·         Judicious tightening of monetary policy in the mid-1990s, and then again in the late 1990s, helped the economy remain on a noninflationary, full-employment growth output.

·         In late 2001 to 2002, expansionary fiscal and monetary policy helped the economy slowly recover from a series of economic blows, including the collapse of numerous Internet start-up firms, a severe decline in investment spending, the impacts of the terrorist attacks of September 11, 2001, and a precipitous decline in stock values.