Trade-Offs and Comparative Advantage (chapter 2)

1. Trade-Offs and Comparative Advantage(chapter 2) TOPIK 10: PERDAGANGAN ANTARABANGSA & EKONOMI TERBUKA

2. Trade • The act of buying and selling. • It makes it possible for people to become better off by increasing both their production and their consumption.

3. 2 - 4 Production Possibilities for You and Your Neighbor, Without Trade Trade Specialization and Gains from Trade TradeThe act of buying or selling.

4. Specialization and Gains from Trade If you picking all apples = 20 pounds. If you picking all cherries = 20 pounds If your neighbour picking all apples = 30 pounds. If your neighbour picking all cherries = 60 pounds Without trade Suppose that when you don’t trade with your neighbour, you pick 8 pounds apples and 12 pounds cherries (point A). Your neighbour picks 9 pounds apples and 42 pounds cherries (point B). Without trade

5. With Trade • Suppose your neighbour offers a trade; 15 pounds cherries for your 10 pounds apples. • You will specialize in picking apples • You can trade 10 apples with 15 cherries. • You now consume extra 2 apples and 3 cherries • Your neighbour will get 10 apples and 45 cherries and consume extra 1 apples and 3 cherries.

6. 2 - 5 Gains from Trade Trade • Specialization and Gains from Trade

7. 2 – 1 A Summary of the Gains from Trade Trade • Specialization and Gains from Trade

8. Trade • Absolute Advantage Versus Comparative Advantage Absolute advantage The ability of an individual, firm, or country to produce more of a good or service than competitors using the same amount of resources. Comparative advantage The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers.

9. Trade • Comparative Advantage and the Gains from Trade The basis for trade is comparative advantage, not absolute advantage. A country has a comparative advantage in the production of the good for which it has a lower opportunity cost. To enjoy the gains from trade, a country should specialize in the production of the good for which it has a comparative advantage. Even if one party has an absolute advantage in producing both goods but comparative advantage will show which party should specialize in what so they could trade.

10. TOPIK 10: PERDAGANGAN ANTARABANGSA & EKONOMI TERBUKA Macroeconomics inan Open Economy(chapter 29)

11. The Balance of Payments: Linking the U.S. to the International Economy • Open economy An economy that has interactions in trade or finance with other economies. • Closed economy An economy that has no interactions in trade or finance with other economies. • Balance of payments The record of a country’s trade with other countries in goods, services, and assets. • It contains three accounts • Current account • Financial account • Capital account

12. The Balance of Payments: Linking the U.S. to the International Economy • The Current Account • Current accountThe part of the balance of payments that records a country’s net exports, net investment income, and net transfers. • THE BALANCE OF TRADE • Balance of trade The difference between the value of the goods a country exports and the value of the goods a country imports. • If a country exports more than it imports – trade surplus • If it export less than it imports – trade deficit

13. The Balance of Payments of the United States, 2004 (billions of dollars) 29 – 1 The Balance of Payments: Linking the U.S. to the International Economy

14. 29 – 1 cont. The Balance of Payments of the United States, 2004 (billions of dollars) The Balance of Payments: Linking the U.S. to the International Economy

15. The Balance of Payments: Linking the U.S. to the International Economy • The Current Account • NET EXPORTS EQUALS THE SUM OF THE BALANCE OF TRADE AND THE BALANCE OF SERVICES • Balance of services is the difference between the value of the services a country exports and the value of the services a country import. • Net exports is not equal to the current account balance because current account balance also includes net investment income and transfers.

16. 29 - 1 Trade Flows for the United States and Japan, 2004 The Balance of Payments: Linking the U.S. to the International Economy • The Financial Account

17. The Balance of Payments: Linking the U.S. to the International Economy • The Financial Account • Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. • Records long-term flows of funds into and out of a country. • Capital outflow – when investor in US buys a bond by foreign company or US firms build factory in another country. • Capital inflow – when foreign investor buys a bond by US firm (foreign portfolio investment -FDI) or foreign firm builds a factory in US (foreign direct investment -FPI). • Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

18. The Balance of Payments: Linking the U.S. to the International Economy • The Capital Account • Capital Account The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers, and sales and purchases of nonproduced, nonfinancial assets.

19. The Foreign Exchange Market and Exchange Rates • Nominal exchange rate The value of one country’s currency in terms of another country’s currency. • The nominal exchange rate determines how many units of a foreign currency you can purchase with one dollar • RM3.72 = 1 US dollar • RM0.04 = 100 Rupiah • RM3.12 = 100 Yen • Real exchange rate which corrects the nominal exchange rate for changes in prices of goods and services.

20. The market exchange rate is determine by the interaction of demand and supply. • Let’s consider the demand for US dollars in exchange for Japanese yen. • There are three sources of foreign currency demand for the US dollar: • Foreign firm and consumers who want to buy goods and services produced in the US. • Foreign firms and consumers who want to invest in the US either through FDI or FPI. • Currency traders believe that the value of the dollar in the future will be greater than its value today.

21. 29 - 2 Equilibrium in the Foreign Exchange Market The Foreign Exchange Market and Exchange Rates • Equilibrium in the Market for Foreign Exchange

22. The Foreign Exchange Market and Exchange Rates • Equilibrium in the Market for Foreign Exchange Currency appreciation Occurs when the market value of a currency rises relative to another currency. If U.S. real exchange rate appreciates, it means that U.S. goods have become more expensive compared to foreign goods  U.S. net exports fall Currency depreciation Occurs when the market value of a currency falls relative to another currency. If U.S. real exchange rate depreciates, it means that U.S. goods have become cheaperrelative to foreign goods.

23. The Foreign Exchange Market and Exchange Rates • How Do Shifts in Demand and Supply Affect the Exchange Rate? • Three main factors cause the demand and supply curves in the foreign exchange market to shift: • Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services. • Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries. • Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

24. The Foreign Exchange Market and Exchange Rates • How Do Shifts in Demand and Supply Affect the Exchange Rate? • SHIFTS IN THE DEMAND FOR FOREIGN EXCHANGE • Speculators Currencytraders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates. • SHIFTS IN THE SUPPLY OF FOREIGN EXCHANGE • ADJUSTMENT TO A NEW EQUILIBRIUM

25. 29 - 3 Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate The Foreign Exchange Market and Exchange Rates • How Do Shifts in Demand and Supply Affect the Exchange Rate? • ADJUSTMENT TO A NEW EQUILIBRIUM

26. Real exchange rate = Nominal exchange rate x The Foreign Exchange Market and Exchange Rates • The Real Exchange Rate • Real exchange rate The price of domestic goods in terms of foreign goods.

27. Q1.Nominal exchange rate: i. 80 yen per dollar  90 yen per dollar US$ depreciate/appreciate? ii. 80 yen per dollar  70 yen per dollar US$ depreciate/appreciate? • Q2.Change into units of U.S. dollars per one unit of the foreign currency. i. 90 yen per dollar ii. 80 yen per dollar iii. 70 yen per dollar • Q3. American Rice vs Japanese Rice: • Domestic Price = $100, Foreign Price = ¥16,000, • Nominal exchange rate = 80 yen per dollar • Real exchange rate ?

28. The Effect of a Government Budget Deficit on Investment • if federal government runs a budget deficit • the US Treasury must raise an amount to the deficit by selling bonds • the US Treasury must raise the interest rate on its bonds • will attract foreign investors • investors will have to buy US dollars to be able to purchase bonds • the demand for US dollars will increase their relative value to foreign countries • so exports from US will fall and imports to US will rise (nx fall) Budget Deficit - interest rate, appreciation of US net export

29. Monetary Policy and Fiscal Policy in an Open Economy • Monetary Policy in an Open Economy • Expansionary policy • Closed economy • Lower interest rate on domestic investment spending and purchases of consumer durables. • Open economy • Lower interest rate will cause lower exchange rate and net export will increase. • Contractionary policy • Closed economy • Higher interest rate on domestic investment spending and purchases of consumer durables. • Open economy • Higher interest rate will lead to higher foreign exchange and net export will fall. Monetary policy has a greater impact on AD in n open economy than in a closed economy

30. Fiscal Policy in an Open Economy • Expansionary policy • Closed economy • Reduces domestic spending and purchases of consumer durables. • Open economy • Increase in foreign exchange and decrease net export. • Contractionary policy • Closed economy • Increase domestic spending and purchases of consumer durables. • Open economy • Reduce in foreign exchange and increase net export. Fiscal policy has smaller impact on AD in an open economy than in a closed economy.