Course : ECON6017 - Economics Theory

Effective Period : September 2015

International Trade and Open-Economy Macroeconomics

Session 13
 Acknowledgement
These slides have been adapted from:

Karl E. Case., Ray C. Fair., & Sharon Oster.

(2014). Principles of Economics. 11/E. Pearson
Education. -. ISBN: ISBN-10: 013302380X • ISBN-
13: 9780133023800

Chapter: 33 & 34
 Learning Objectives
LO 3: Analyze the condition of international trade
and open-economy macroeconomics
 Contents

• International Trade, Comparative Advantage, and Protectionism

- Trade surpluses and deficits
- The sources of comparative advantage
- Trade barriers: Tariffs, export subsidies and quotas
- Free trade or protection?
 
• Open-Economy Macroeconomics
- The balance of payments
- Equilibrium output (income) in an open economy
- The open economy with flexible exchange rates
- An interdependent world economy
- Life in the developing nation: Population and poverty
- Economic development: Sources and strategies
 INTERNATIONAL TRADE

The “internationalization” or “globalization” of the economy

country has occurred in the private and public sectors, in
input and output markets, and in business firms and
households.
All economies, regardless of their size, depend to some extent on
other economies and are affected by events outside their borders.

They have trade each other in good and service. Trade can be
surplus and deficits
trade surplus is the situation when a country exports
more than it imports.
trade deficit is the situastion when a country exports
less than it imports.
 THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

theory of comparative advantage is Ricardo’s theory that specialization and

free trade will benefit all trading partners (real wages will rise), even those
that may be absolutely less efficient producers.
Specialization and free trade will benefit all trading partners (real wages will rise), even those
that may be absolutely less efficient producers.

absolute advantage The advantage in the production of a

product enjoyed by one country over another when it uses fewer
resources to produce that product than the other country does.

comparative advantage The advantage in the production of a

product enjoyed by one country over another when that
product can be produced at lower cost in terms of other
goods than it could be in the other country.
 THE ECONOMIC BASIS FOR TRADE:
OBSOLUT ADVANTAGE
Total Production Yield Per Acre of Wheat and Cotton, comparative
advantage
NEW ZEALAND AUSTRALIA

Wheat 6 bushels 2 bushels

Cotton 2 bales 6 bales

Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute

Advantage, and 100 Available Acres
NEW ZEALAND AUSTRALIA

25 acres x 6 bushels/acre 75 acres x 2 bushels/acre

Wheat 150 bushels 150 bushels
Cotton 75 acres x 2 bales/acre 25 acres x 6 bales/acre
150 bales 150 bales

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Production Possibility Frontiers for Australia and New Zealand before Trade

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE
Production and Consumption of Wheat and Cotton after Specialization
PRODUCTION CONSUMPTION
New
New Zealand Australia Australia
Zealand

Wheat 100 acres x 6 0 acres 300 300 bushels

bushels/acre 0 bushels
600 bushels

Cotton 0 acres 100 acres x 6 bales/acre 300 bales 300 bales

0 600 bales

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

Trade enables both

countries to move
beyond their previous
resource and
productivity
constraints.

Expanded Possibilities after Trade

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.

10 of 29
 Gains from Comparative Advantage
Yield Per Acre of Wheat and Cotton
NEW ZEALAND AUSTRALIA

Wheat 6 bushels 1 bushel

Cotton 6 bales 3 bales

Total Production of Wheat and Cotton Assuming No Trade and 100

Available Acres
NEW ZEALAND AUSTRALIA

50 acres x 6 bushels/acre 75 acres x 1 bushels/acre

Wheat 300 bushels 75 bushels
Cotton 50 acres x 6 bales/acre 25 acres x 3 bales/acre
300 bales 75 bales

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE
Realizing a Gain from Trade When One Country Has a Double Absolute Advantage
STAGE 1 STAGE 2
New Zealand Australia New Zealand Australia

50 acres x 6 bushels/acre 0 acres 75 acres x 6 bushels/acre 0 acres

Wheat 300 bushels 0 450 bushels 0
Cotton 50 acres x 6 bales/acre 100 acres x 3 bales/acre 25 acres x 6 bales/acre 100 acres x 3 bales/acre
300 bales 300 bales 150 bales 300 bales

STAGE 3
New Zealand Australia
100 bushels (trade)
Wheat 350 bushels 100 bushels
(after trade)
200 bales (trade)
Cotton 350 bales 100 bales
(after trade)

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE
Why Does Ricardo’s Plan Work?

When countries
specialize in
producing goods in
which they have a
comparative
advantage,
they maximize their
combined output
and allocate their
resources more
efficiently.

Comparative Advantage Means Lower Opportunity Cost

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE:
COMPARATIVE ADVANTAGE

terms of trade The ratio at which a country can trade domestic

products for imported products.
exchange rate The ratio at which two currencies are traded. The
price of one currency in terms of another. When people in different
countries buy from and sell to each other, an exchange of currencies
must also take place. The price of one country’s currency in terms of
another country’s currency; the ratio at which two currencies are
traded for each other.
 Trade and Exchange Rates in a Two-Country/Two-Good
World
Domestic Prices of Timber (Per Foot) and Rolled Steel (Per Meter) in
the United States and Brazil
UNITED STATES BRAZIL

Timber $1 3 Reals
Rolled steel $2 4 Reals

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE
Trade Flows Determined by Exchange Rates
EXCHANGE PRICE
If exchange rates end RATE OF REAL RESULT
up in the right
ranges, the free
market will drive each $1 = 1 R $1.00 Brazil imports timber and steel
country to shift
$1 = 2 R .50 Brazil imports timber
resources into those
sectors in which it $1 = 2.1 R .48 Brazil imports timber; United States
enjoys a comparative imports steel
advantage. Only
those products in
$1 = 2.9 R .34 Brazil imports timber; United States
which a country has imports steel
a comparative $1 = 3 R .33 United States imports steel
advantage will be
competitive in world
$1 = 4 R .25 United States imports timber and
markets. steel

Exchange Rates and Comparative Advantage

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE SOURCES OF COMPARATIVE ADVANTAGE

factor endowments The quantity and quality of

labor, land, and natural resources of a country.
THE HECKSCHER-OHLIN THEOREM
Heckscher-Ohlin theorem A theory that explains the existence
of a country’s comparative advantage by its factor
endowments: A country has a comparative advantage in the
production of a product if that country is relatively well
endowed with inputs used intensively in the production of
that product.
A country has a comparative advantage in the production of a product if
that country is relatively well endowed with inputs used intensively in the
production of that product.
 TRADE BARRIERS: TARIFFS,
EXPORT SUBSIDIES, AND QUOTAS

protection The practice of shielding a sector of

the economy from foreign competition.
tariff A tax on imports.

export subsidies Government payments made to

domestic firms to encourage exports.
dumping A firm or industry’s sale of products on the
world market at prices below the cost of production.

quota A limit on the quantity of imports.

 TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

economic integration Occurs when two or more

nations join to form a free-trade zone.
European Union (EU) The European trading bloc
composed of Austria, Belgium, Denmark, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg,
the Netherlands, Portugal, Spain, Sweden, and the
United Kingdom.
General Agreement on Tariffs and Trade (GATT) An
international agreement signed by the United States
and 22 other countries in 1947 to promote the
liberalization of foreign trade.
 TRADE BARRIERS: TARIFFS, EXPORT
SUBSIDIES, AND QUOTAS

U.S.-Canadian Free Trade Agreement An agreement in

which the United States and Canada agreed to eliminate
all barriers to trade between the two countries by 1998.

North American Free Trade Agreement

(NAFTA) An agreement signed by the United
States, Mexico, and Canada in which the three
countries agreed to establish all
North America as a free-trade zone.
 THE CASE FOR FREE TRADE

The Gains from

Trade and
Losses from
the Imposition
of a Tariff

Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively
inefficient production techniques, and force consumers to pay higher prices for protected products
than they would otherwise pay.
Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 THE CASE FOR PROTECTION

Protection Saves Jobs

Some Countries Engage in Unfair Trade Practices

Cheap Foreign Labor Makes Competition Unfair

Protection Safeguards National Security
infant industry A young industry that may need temporary protection
from competition from the established industries of other countries to
develop an acquired comparative advantage.
Protection Discourages Dependency
 THE BALANCE OF PAYMENTS
foreign exchange All currencies other than the
domestic currency of a given country.
balance of payments The record of a country’s
transactions in goods, services, and assets with the rest of
the world; also the record of a country’s sources (supply)
and uses (demand) of foreign exchange.
balance of trade A country’s exports of goods and services
minus its imports of goods and services.
 EQUILIBRIUM OUTPUT (INCOME)
IN AN OPEN ECONOMY

THE INTERNATIONAL SECTOR AND PLANNED AGGREGATE

EXPENDITURE
Planned aggregate expenditure in an open economy:
AE  C + I + G + EX - IM

net exports of goods and services (EX - IM)

The difference between a country’s total
exports and total imports.
Determining the Level of Imports
marginal propensity to import (MPM) The change in
imports caused by a $1 change in income.
 EQUILIBRIUM OUTPUT (INCOME)
IN AN OPEN ECONOMY

Determining Equilibrium Output in an Open Economy

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 The Open-Economy Multiplier

1
open-economy multiplier 
1( 
MPCMPM
)

The effect of a sustained increase in government spending (or investment) on income—

that is, the multiplier—is smaller in an open economy than in a closed economy. The
reason: When government spending (or investment) increases and income and
consumption rise, some of the extra consumption spending that results is on foreign
products and not on domestically produced goods and services.
 IMPORTS AND EXPORTS AND THE TRADE
FEEDBACK EFFECT

The Determinants of Imports

The same factors that affect households’ consumption behavior and firms’
investment behavior are likely to affect the demand for imports.

The Determinants of Exports

The demand for U.S. exports depends on economic activity in the rest of the
world—rest-of-the-world real wages, wealth, nonlabor income, interest rates,
and so on—as well as on the prices of U.S. goods relative to the price of rest-
of-the-world goods. If foreign output increases,
 Feedback
The Trade Feedback Effect
trade feedback effect The tendency for an increase in
the economic activity of one country to lead to a
worldwide increase in economic activity, which then
feeds back to that country.
The Price Feedback Effect
price feedback effect The process by which a domestic
price increase in one country can “feed back” on itself
through export and import prices. An increase in the
price level in one country can drive up prices in other
countries. This in turn further increases the price level in
the first country.
 THE MARKET FOR FOREIGN EXCHANGE
Some Private Buyers and Sellers in International Exchange Markets:
United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1.Firms, households, or governments that import British goods into the United States or wish to buy
British-made goods and services
2.U.S. citizens traveling in Great Britain
3.Holders of dollars who want to buy British stocks, bonds, or other financial instruments
4.U.S. companies that want to invest in Great Britain
5.Speculators who anticipate a decline in the value of the dollar relative to the pound

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

1. Firms, households, or governments that import U.S. goods into Great Britain or wish to buy U.S.-
made goods and services
2. British citizens traveling in the United States
3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United
States
4. British companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the pound

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 floating, or market-determined, exchange rates Exchange rates that
are determined by the unregulated forces of supply and demand.

The Demand for Pounds in the The Supply of Pounds in the Foreign
Foreign Exchange Market Exchange Market

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 The Equilibrium Exchange Rate

The equilibrium exchange rate occurs at the point at which the quantity demanded of
a foreign currency equals the quantity of that currency supplied.

appreciation of a currency
The rise in value of one
The Equilibrium currency relative to another.
Exchange Rate

depreciation of a currency
The fall in value of one
currency relative to another.
Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
 FACTORS THAT AFFECT EXCHANGE RATES

Purchasing Power Parity: The Law of One Price

law of one price If the costs of transportation
are small, the price of the same good in
different countries should be roughly the
same.
purchasing-power-parity theory A theory of
international exchange holding that exchange
rates are set so that the price of similar goods
in different countries is the same.
 Exchange Rates Respond to Changes in Exchange Rates Respond to Changes in
Relative Prices Relative Interest Rates

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of Economics.
33 of 26
 THE EFFECTS OF EXCHANGE RATES ON
THE ECONOMY
The level of imports and exports depends on exchange rates as well as on
income and other factors. When events cause exchange rates to adjust, the
levels of imports and exports will
change. Changes in exports and imports can in turn affect the level of real
GDP and the price level. Further, exchange rates themselves also adjust to
changes in the economy.

Exchange Rate Effects on Imports, Exports, and Real GDP

A depreciation of a country’s currency is likely to increase its GDP.
 THE OPEN ECONOMY WITH FLEXIBLE
EXCHANGE RATES
Exchange Rates and Prices The depreciation of a country’s
currency tends to increase its price level.

Monetary Policy with Flexible Exchange Rates A cheaper

dollar is a good thing if the goal of the monetary expansion is to stimulate
the domestic economy.

Fiscal Policy with Flexible Exchange Rates The openness of

the economy and flexible exchange rates do not always work to the
advantage of policy makers.

Monetary Policy with Fixed Exchange Rates There is no role

monetary policy can play if a country has a fixed exchange rate.
 Appendix

Bretton Woods The site in New

Hampshire where a group of experts
from 44 countries met in 1944 and
agreed to an international monetary
system of fixed exchange rates.
 Referrence
• - Principles of Economics, Case, Fair & Oster
(2014). Chapter 33
• - Principles of Economics, Case, Fair & Oster
(2014). Chapter 34
• http://www2.econ.iastate.edu/classes/econ3
02/alexander/fall2003/openeconmacro/ope
neconomymacroeconomics.pdf
Thank You