International Trade, Comparative Advantage, and Protectionism

PRINCIPLE OF ECONOMIC

6 EDITION

KARL CASE, RAY FAIR

PRENTICE HALL BUSINESS PUBLISHING

COPY RIGHT 2002

International Trade

•         All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders.

•         The “internationalization” or “globalization” of the U.S. economy has occurred in the private and public sectors, in input and output markets, and in business firms and households.

The Economic Basis for Trade:  Comparative Advantage

•         Corn Laws were the tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain.

•         David Ricardo’s theory of comparative advantage , which he used to argue against the corn laws, states that specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

Absolute Advantage Versus Comparative Advantage

•         A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does.

•         A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower cost in terms of other goods.

Gains from Comparative Advantage

•         Even if a country had a considerable absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial.

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

•         The real cost of producing cotton is the wheat that must be sacrificed to produce it.

•         A country has a comparative advantage in cotton production if its opportunity cost, in terms of wheat, is lower than the other country.

Exchange Rates

•         When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms.

•         To understand these patterns we must know something about the factors that determine exchange rates.

•         An exchange rate is the ratio at which two currencies are traded.  The price of one currency in terms of another.

•         For any pair of countries, there is a range of exchange rates that can lead automatically to both countries realizing the gains from specialization and comparative advantage.

•         Exchange rates determine the terms of trade.

•         If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage.

•         Only those products in which a country has a comparative advantage will be competitive in world markets.

The Sources of Comparative Advantage

•         Factor endowments refer to the quantity and quality of labor, land, and natural resources of a country.

•         Factor endowments seem to explain a significant portion of actual world trade patterns.

•         The Heckscher-Ohlin theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments.

•         According to the theorem, 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.

•         Product differentiation is a natural response to diverse preferences within an economy, and across economies.

•         Some economists also distinguish between acquired comparative advantage and natural comparative advantages.

•         Economies of scale may be available when producing for a world market that would not be available when producing for a limited domestic market.

Trade Barriers:  Tariffs, Export Subsidies, and Quotas

•         Protection is the practice of shielding a sector of the economy from foreign competition.

•         A tariff is a tax on imports.

•         Export subsidies are government payments made to domestic firms to encourage exports.  Closely related to subsidies is dumping.  A firm or industry sells products on the world market at prices below the cost of production.

•         A quota is a limit on the quantity of imports.

•         The Smoot-Hawley tariff was the U.S. tariff law of the 1930s, which set the highest tariff in U.S. history (60 percent).  It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s.

•         The General Agreement on Tariffs and Trade (GATT) is an international agreement singed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade.

Economic Integration

•         Economic integration occurs when two or more nations join to form a free-trade zone.

•         The European Union (EU) is 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.

•         The U.S.-Canadian Free-Trade Agreement is an agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1988.

•         The North American Free-Trade Agreement (NAFTA) is an agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all of North America as a free-trade zone.

The North American Free-Trade Agreement (NAFTA)

•         The U.S. Department of Commerce has estimated that as a result of NAFTA trade between the United States and Mexico increased by nearly $16 billion in 1994.

•         In addition, exports from the United States to Mexico outpaced imports from Mexico.

•         By 1998, a general consensus emerged among economists that NAFTA had led to expanded employment opportunities on both sides of the border.

The Case for Free Trade

•         The case for free trade is based on the theory of comparative advantage.  When countries specialize and trade based on comparative advantage, consumers pay less and consume more, and resources are used more efficiently.

•         When tariffs and quotas are imposed, some of the gains from trade are lost.

The Case for Protection

•         Protection saves jobs

•         Some countries engage in unfair trade practices

•         Cheap foreign labor makes competition unfair

•         Protection safeguards national security

•         Protection discourages dependency

•         Protection safeguards infant industries

 

The Money Supply and the Federal Reserve System

PRINCIPLE OF ECONOMIC

6 EDITION

KARL CASE, RAY FAIR

PRENTICE HALL BUSINESS PUBLISHING

COPY RIGHT 2002

 

An Overview of Money

•         Money is anything that is generally accepted as a medium of exchange.

•         Money is not income, and money is not wealth.  Money is:

•         a means of payment,

•         a store of value, and

•         a unit of account.

•         Money as a means of payment, or medium of exchange, is more efficient than barter.

•         Barter is the direct exchange of goods and services for other goods and services.

•         A barter system requires a double coincidence of wants for trade to take place.  Money eliminates this problem.

•         Money is a lubricant in the functioning of a market economy.

An Overview of Money

•         Money as a store of value refers to money as an asset that can be used to transport purchasing power from one time period to another.

•         Money is easily portable, and easily exchanged for goods at all times.  The liquidity property of money makes money a good medium of exchange as well as a store of value.

An Overview of Money

•         Money also serves as a unit of account, or a standard unit that provides a consistent way of quoting prices.

•         Commodity monies are items used as money that also have intrinsic value in some other use.  Gold is one form of commodity money.

•         Fiat, or token, money is money that is intrinsically worthless.

•         Legal tender is money that a government has required to be accepted in settlement of debts.

Measuring the Supply of Money in the United States

•         The two most common measures of money are M1 and M2.

•         M1, or transactions money is money that can be directly used for transactions.  It includes currency held outside banks, plus demand deposits, plus traveler’s checks, plus other checkable deposits

•         M1 is a stock measure—it is measured at a point in time—on a specific day.  On June 26, 2000, M1 was $1,103.3 billion.

•         M2, or broad money, includes near monies, or close substitutes for transactions money.

•         M2 / M1 + savings accounts + money market accounts + other near monies

•         On June 26, 2000, M2 was $4,778.2 billion.

•         The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

The Private Banking System

•         Most of the money in the United States today is “bank money,” or money held in checking accounts rather than currency.

•         Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

How Banks Create Money

•         To see how banks create money, consider the origins of the modern banking system:

•         Goldsmiths functioned as warehouses where people stored gold for safekeeping.

•         Upon receiving the gold, a goldsmith would issue a receipt to the depositor.  After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods.

•         At this point, all the receipts issued were backed 100 percent by gold.

•         Goldsmiths realized that people did not come often to withdraw gold and, as a result, they had a large stock of gold continuously on hand.  They could lend out some of this gold without any fear of running out.

•         There were thus more claims than there were ounces of gold.

•         Knowing there were more receipts outstanding than there were ounces of gold, people might start to demand gold for receipts.

•         A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

The Modern Banking System

•         A brief review of accounting:

Assets – liabilities / Net Worth, or

Assets / Liabilities + Net Worth

•         A bank’s most important assets are its loans.  Other assets include cash on hand (or vault cash) and deposits with the Fed.

•         The Federal Reserve System (the Fed) is the central bank of the United States.

•         A bank’s liabilities are the promises to pay, or IOUs, that it has issued.  A bank’s most important liabilities are its deposits.

The Creation of Money

•         Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

•         When someone deposits $100, and the bank deposits the $100 with the central bank, it has $100 in reserves.

•         If the required reserve ratio is 20%, the bank has excess reserves of $80.  With $80 of excess reserves, the bank can lend $400 and have up to $400 of additional deposits.  The $100 in reserves plus $400 in loans equal $500 in deposits.

The Money Multiplier

•         The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.

The Federal Reserve System

•         The Federal Open Market Committee (FOMC) sets goals regarding the money supply and interest rates and directs the operations of the Open Market Desk in New York.

•         The Open Market Desk is an office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

Functions of the Fed

The Fed performs important functions for banks including:

•         Clearing interbank payments.

•         Regulating the banking system.

•         Assisting banks in a difficult financial position.

•         Managing exchange rates and the nation’s foreign exchange reserves.

The Fed performs important functions for banks including:

•         Control of mergers between banks.

•         Examination of banks to ensure that they are financially sound.

•         Setting of reserve requirements for all financial institutions.

•         Lender of last resort.

The Fed’s Balance Sheet

•         Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its balance sheet.

•         The largest of the Fed’s assets, by far, consists of government securities purchased over the years.

•         A dollar bill is a liability, or IOU, of the Fed

How the Fed Controls the Money Supply

•         The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create.

•         If the Fed wants to increase the money supply, it creates more reserves, thereby freeing banks to create additional deposits by making more loans.  If it wants to decrease the money supply, it reduces reserves.

The Discount Rate

•         Banks may borrow from the Fed.  The interest rate they pay the Fed is the discount rate.

•         Bank borrowing from the Fed leads to an increase in the money supply.  The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

The Discount Rate

•         In practice, the Fed does not often use the discount rate to control the money supply.

•         The discount rate cannot be used to control the money supply with great precision, because its effects on banks’ demand for reserves are uncertain.

•         Moral suasion is the pressure exerted by the Fed on member banks to discourage them from borrowing heavily from the Fed.

Open Market Operations

•         Open market operations is the purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

•         Open market operations is by far the most significant tool of the Fed for controlling the supply of money.

•         An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

•         An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

•         Open market operations are the Fed’s preferred means of controlling the money supply because:

•         they can be used with some precision,

•         are extremely flexible, and

•         are fairly predictable.

The Supply Curve for Money

•         A vertical money supply curve says the Fed sets the money supply independent of the interest rate.