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International Trade and Government
Intervention in International Trade
Chapter 35
Absolute vs. Comparative Advantage
0 Absolute advantage
0 The ability to produce more of a good or service than another OR the ability
to produce a good or service using the least amount of resources
0 Comparative advantage
0 The ability to produce a good or service at a lower opportunity cost than
another producer
Production Possibilities in
One Day of Work
0 Which country has the
comparative advantage in the
production of oranges?
0 US
0 Which country has the
comparative advantage in the
production of avocadoes?
0 Israel
0 What is the range in terms of
trade for the United States?
0 Trade one bushel of oranges
for 2+ bushels of avocados
0 What is the range in terms of
trade for Israel?
0 1 bushel of oranges for <4
bushels of avocados
Oranges
Avocados
United
States
75 Bushels
150 Bushels
Israel
100 Bushels
400 Bushels
United States and Israel
Terms of Trade
0 The terms of trade are expressed in terms of the
commodities to be exchanged.
0 For each country there is a range of acceptable terms
of trade.
0 The United States is willing to trade one bushel of
oranges for two or more bushels of avocadoes.
0 Israel is willing to trade one bushel of oranges for less
than four bushels of avocadoes.
0 Thus, both the United States and Israel would be
willing to trade one bushel of oranges for three
bushels of avocadoes.
0 Both countries gain from the trade.
Specialization and Trade
0 Before specialization and trade, the United States was producing 50
bushels of oranges and 50 bushels of avocadoes: Point A on the PPC.
0 If, after specialization and trade, the United States wants to continue to
have 50 bushels of oranges — and the terms of trade are one bushel of
oranges for three bushels of avocadoes — then the United States could
trade 25 bushels of oranges for 75 bushels of avocadoes.
0 Note that this combination — 50 bushels of oranges and 75 bushels of
avocadoes — puts the United States outside of its production possibilities
curve as indicated as point A' on the PPC.
Specialization and Trade
0 Similarly, Israel would have 25 bushels of oranges and
325 bushels of avocadoes: Point B’ after specialization
and trade on the PPC
0 Note:
0 Had Israel produced 25 bushels of oranges before
specialization and trade, it would have had only 300
bushels of avocadoes (Point B on PPC)
0 The combination of 25 bushels of oranges and 325
bushels of avocadoes (B') puts Israel outside of its
production possibilities curve.
0 Thus, the United States has gained 25 bushels of
avocadoes, and Israel has gained 25 bushels of
avocadoes.
Terms of Trade
0 The terms of trade can be anywhere between one bushel of oranges for
two to four bushels of avocadoes.
0 The actual terms of trade are based on market prices that reflect the
opportunity costs.
0 There is a wide range of solutions depending on the agreed-to terms of
trade and the willingness to trade specific amounts of the commodities.
Tariffs
0 Tax imposed by a nation on an imported good
0 Example: US imposes tariff of more than 10% on imports of textiles and
shoes
Quotas
0 Restriction on the quantity or value of a good or service that can be
imported or exported
0 Example: The voluntary export restraint (VER) Japan agreed to in the
1980s limiting the number of cars it exported to the United States
Other regulations to limit trade…
0 Example: The Federal Drug Administration’s test requirements of
pharmaceuticals imported into the United States.
Domestic and Foreign Supply
Unit 6 : Macroeconomics
National Council on Economic Education
Visual 6.3
http://apeconomics.ncee.net
Argument in Support of Limitations on
Trade
0 National defense argument
0 Infant industry argument
0 Preservation of domestic jobs
0 Maintenance of a diverse and stable economy
0 Prevention of exploitation.
0 Most of these arguments do not stand up to scrutiny.
0 Limitations on trade fundamentally allow domestic producers to be
inefficient and increase the costs to domestic consumers.
History of Tariffs in US
0 With the Smoot-Hawley Act of 1933, tariffs reached a high average rate of
20 percent.
0 Over time, the United States has attempted to reduce tariffs using trade
agreements such as the North American Free Trade Agreement.
0 In the Uruguay Round (1986 to 1994) of World Trade Organization
negotiations, the United States negotiated its lowest rate ever.
International Finance and
Balance of Payments
Accounts
Why does International Finance Matter?
Balance of Payments
0 Balance of payments: annual record of all of a
nation’s transactions with other nations
0 Records all payments received from and paid to rest of
the world
Balance of Payments
0 Current account: section of a nation’s balance of
payments that records its trade in currently produced
goods and services
0 Balance on goods = exports of goods minus imports of
goods
0 Balance on goods and services = exports of goods &
services minus imports of goods & services
0 Balance on the current account = balance on goods
and services plus the net investment income (dividends
and interest) from other nations and the net private and
public transfers to other nations
0 Balance may produce trade deficit or trade surplus
Balance of Payments
0 Capital and financial account of a nation’s balance of
payments records consists of two accounts: capital
accounts and financial accounts
0 Capital account: measures debt forgiveness, is a “net”
account
0 If Americans forgave more debt that was owed to them
by foreigners than foreigners forgave debt that was
owed to them by Americans, the capital account would
be entered as a negative (-)
Balance of Payments
0 Financial account: shows foreign purchases of real and financial assets
in the US
0 This earns the US some foreign currencies, so it’s entered as a plus (+) in the
capital account
0 US purchases of real and financial assets abroad draw down US holdings, so
this is entered as a minus (-)
0 There’s a surplus in the financial account if foreign purchases of US assets >
US purchases of assets abroad
0 Balance on the capital and financial account = value of capital account
minus value of financial account
Financial Accounts
0 Financial accounts record the flows money from the purchase and sale of
assets domestically and abroad.
0 Let’s say U.S. investors buy a hotel building in Tokyo, or, shares of stock in a
Swedish company while foreign investors buy a factory in the United States,
or, stock in a U.S. company
0 Foreign assets are bought and sold using currencies purchased on foreign
exchange markets.
Balance of Payments and the Market for
Loanable Funds
0 The balance of payments is related to changes in the market for loanable
funds.
0 The financial flows recorded in the financial account are part of the
loanable funds market.
0 Foreign investors provide funds that are used to purchase assets, which
means they supply loanable funds.
0 Changes in the supply of loanable funds affect the equilibrium real
interest rate in the loanable funds market, which then affects a country’s
investment, aggregate demand, output, employment, and price level.
Balance of Payments and the Market for
Loanable Funds
0 Net capital outflows (NCOs, also called
net foreign investment) refer to the
difference between the acquisition of
foreign assets by domestic residents and
the acquisition of domestic assets by
non-residents.
Payments Deficits and
Surpluses
0 A drawing down of official reserves measures a nation’s
payments deficits; a building up of official reserves
measures a nation’s surpluses
0 Adding to foreign reserves would occur if there’s a surplus
0 A balance of payments deficit isn’t necessarily bad, nor is a
balance of payments surplus necessarily good.
0 HOWEVER, persistent payment deficits ultimately deplete the
foreign exchange reserves
0 To correct its balance of payments deficits, a nation might
implement a major depreciation of its currency or other
policies to encourage exports
0 The US has persistently large current account deficits that
must be offset by capital and financial account surpluses,
which of growing concern…
Payments Deficits and Surpluses
Foreign Exchange Markets
Financing International Trade
0 Foreign exchange markets (also known as currency markets) enable
international transactions to take place by providing markets for the exchange
of national currencies
0 Exchange rate – the price of the domestic currency in terms of another currency
0 Generally expressed in terms of one unit of the domestic currency
0 For example, an exchange rate of 80 means that $1 is exchanged for 80 yen.
0 If the exchange rate increases, the quantity demanded falls and the quantity supplied
increases.
0 Two types of foreign exchange rates:
0 Flexible exchange rates
0 Fixed exchange rates
Financing International Trade
0 Let’s look at an American export transaction:
0 US firms sells $300,000 worth of computers to British firm
0 Let’s say the current exchange rate is $2 = £1, so British firm
will pay £150,000
0 The British firm will draw a check on its deposits at a London
bank for £150,000, then send it to the US exporter
0 Exporter sells the British check to an American bank for
$300,000 in exchange for the British check, and the exporter’s
account is credited
0 The American bank will deposit the £150,000 in a
correspondent London bank for future sales
Financing International Trade
0 Major points to note:
0 Exports create a demand for dollars and a supply of foreign money, in this
case British pounds
0 The financing of an American export reduces the supply of money (demand
deposits) in the UK and increases it in the US
Flexible Exchange Rates
0 Determined by the forces of supply and demand
0 Demand for any currency is downward sloping because
as the currency becomes less expensive, people will be
able to buy more of that nation’s goods and, therefore,
want larger quantities of the currency
0 Supply of any currency is upward sloping because as its
prices rise, holders of that currency can obtain other
currencies more cheaply and will want to buy more
imported goods and, therefore, will give up more of
their currency to obtain other currencies
0 As with other commodities, the intersection of supply
and demand determines the equilibrium price (the
exchange rate)
Flexible Exchange Rates
Dollar Price of £1.00
Market for British Pounds
4
3.5
3
2.5
2
1.5
1
0.5
0
S
Exchange rate:
$2.00 = £1.00
D
0.5
1
1.5
Quantity of British Pounds
• The supply of British
pounds is determined by
British demand for foreign
goods, services and
investments
• Demand for British pounds
is determined by foreign
demand for British goods,
services and investments
Currency Appreciation
0 An increase in the exchange rate for a currency (which can be caused by
an increase in demand or a decrease in supply) is called appreciation of
that currency.
0 When a currency appreciates, it is said to have strengthened.
0 For example, if the exchange rate increases in the market for dollars, it means
that it takes more of the foreign currency to purchase a dollar.
0 This means that a dollar can buy more of the foreign currency.
Currency Depreciation
0 A decrease in the exchange rate for a currency (which can be caused by a
decrease in demand or an increase in supply) is called depreciation of
that currency.
0 When a currency depreciates, it is said to have weakened.
0 For example, if the exchange rate decreases in the market for dollars, it
means that it takes less of the foreign currency to purchase a dollar.
0 This means it takes more dollars to buy the foreign currency.
Currency Appreciation/Depreciation and Imports and
Exports
0 Appreciation or depreciation of a currency changes the price of imports
and exports.
0 When a country’s currency appreciates, it is more expensive for
foreigners to buy the country’s exports and it is cheaper for the country
to buy imports.
0 When a country’s currency depreciates, it is cheaper for foreigners to buy
the country’s exports and it is more expensive for the country to buy
imports.
0 Appreciation and depreciation of a currency will affect the economy
because they affect net exports.
Factors that shift the curves…
0 If the exchange rate increases, the quantity demanded
falls and the quantity supplied increases.
0 A change in any factor other than the exchange rate
will cause the demand curve or the supply curve to
shift.
0 For example, if the UK’s income increases, then the
British demand for US dollars will increase because the
British will want to buy more American goods.
0 If interest rates in the UK change relative to interest
rates in other countries or if the expected future
exchange rate changes, then the demand curve will
shift.
Fixed Exchange Rates
0 Fixed exchange rates are pegged to some set value, like the US dollar or
gold
0 Official reserves are used to correct an imbalance in the balance of
payments, since exchange rates cannot fluctuate to bring about automatic
balance
0 This is called currency intervention
0 Trade policies directly controlling the amount of trade and finance might
be used to avoid imbalance in trade and payments
Fixed Exchange Rates
0 Exchange controls and rationing of currency have been used in the past
but are disagreeable for several reasons:
1. Controls distort efficient patterns of trade
2. Rationing involves favoritism among importers
3. Rationing reduces freedom of consumer choice
4. Enforcement problems are likely as “black market” rates develop
Fixed Exchange Rates
0 Domestic macroeconomic adjustments may be more difficult under fixed
rates
0 For example, a persistent deficit of trade may call for tight monetary and
fiscal policies to reduce prices, which raises exports and reduces imports
0 THESE CONTRACTIONARY POLICIES COULD LEAD TO RECESSIONS AND
UNEMPLOYMENT!!!
Monetary and Fiscal Policy in the Global
Economy
Chapter 36
Domestic Economic Policies and
International Trade
0 A country’s domestic monetary and fiscal policy and its balance of trade
and exchange rates.
0 Changes in a nation’s monetary and fiscal policies affect its exchange
rates and its balance of trade through their effect on the real interest rate,
income, and the price level.
0 Domestic policies influence currency values, and currency values
influence domestic policies.
0 Policy makers cannot ignore the international effects of changes in
monetary and fiscal policies.
Review
0 How would changes in the value of a country’s currency affect that
country’s balance of trade?
0 Aggregate demand would be affected.
0 Changes in aggregate demand then affect real output and the price level.
Review
0 What are the short-run effects of expansionary monetary and fiscal policy
on domestic interest rates?
0 Expansionary monetary policy decreases interest rates in the short run.
0 Expansionary fiscal policy increases interest rates if deficit financing is
required.
Effects of Fiscal Policy
0 If the U.S. government raises spending to stimulate the economy,
borrowing increases and U.S. interest rates increase.
0 Higher interest rates attract investment from abroad and the dollar
appreciates.
0 As a result of the appreciated dollar, exports decrease and imports
increase.
0 The result is a smaller stimulative effect.
Effects of Monetary Policy
0 If the Federal Reserve stimulates the economy by causing interest rates to
decline, investment from abroad will decline.
0 The dollar will decrease in value.
0 As a result, exports increase and imports will decrease.
0 The outcome is a larger stimulative effect.
Net Exports and Capital Flows
Capital Flow
0 The term capital flow refers to the movement of financial capital (money)
between economies.
0 Capital inflows are foreign funds moving into an economy from another
country.
0 Capital outflows are the opposite—they are domestic funds moving out of
an economy to another country.
Capital Flow
0 For example:
0 From the perspective of the U.S. economy, the construction of a new plant by
a Japanese automobile manufacturer within the United States is an example
of capital inflow.
0 When an American manufacturer finances the construction of a plant outside
of the United States, it is an example of capital outflow.
A Macroeconomic Theory of the
Open Economy
Macroeconomic Variables in an Open
Economy
0 An open economy is one that interacts freely with other economies
around the world.
0 The important macroeconomic variables of an open economy include:
0
0
0
0
0
0
net exports (NX)
net capital outflow (NCO)
nominal exchange rates (e)
real exchange rates (eP/P*)
real interest rates (r)
Loanable funds (LF=I=S)
0 Theory helps us to link these variables together; however, to simplify the
analysis we will make some assumptions.
Basic Assumptions
0 The model takes the economy’s GDP as given. Y = Y-bar (like the quantity
theory)
0 The model takes the economy’s price level as given. P = P-bar (unlike the
quantity theory)
The Theory of the Open Economy: A Complete Logical
Flow
0 The theory relates and determines r, NCO, eP/P*, and NX
0 It begins with conditions in the loanable funds market and then the
foreign exchange market.
0 In each market, the demand and supply are used, put together to
determine equilibrium, and then the effects of shifts in demand and
supply are analyzed.
0 The two markets are linked together and r, NCO, eP/P*, and NX are jointly
determined.
0 Different policies and situations are then analyzed and their affect on r,
NCO, eP/P*, and NX identified.
The Loanable Funds Market
0 The supply and demand in the loanable funds market determines the real
interest rate {r}
0 Closed Economy: S=I only domestic borrowing and lending are allowed.
0 Open Economy: S=I+NCO this allows trade and borrowing and lending from
the ROW (rest of the world)
SUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN
ECONOMY
0 The Market for Loanable Funds
S = I + NCO
0 At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of investment and net capital outflows.
0 The supply of loanable funds comes from
national saving (S).
0 The demand for loanable funds comes from
domestic investment (I) and net capital outflows
(NCO).
0 The supply and demand for loanable funds depend on the real
interest rate.
0 A higher real interest rate encourages people to save and raises
the quantity of loanable funds supplied.
0 The interest rate adjusts to bring the supply and demand for
loanable funds into balance
0 At the equilibrium interest rate, the amount that people want
to save exactly balances the desired quantities of domestic
investment and net foreign investment.
0 National Saving: S → SLF is positively related to r↓(↑) → SLF ↓(↑)
0 Investment and Net Capital Flow:
I+NCO → DLF is negatively related to
r ↓(↑) → DLF ↑(↓)
0 r ↓(↑) I ↑(↓)
0 r↓(↑) PV ↑(↓) of future returns
0 r ↓(↑) NCO ↑(↓)
0 rUS ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases
(increases) demand for US assets
Figure 3 How Net Capital Outflow Depends on the
Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
Copyright©2003 Southwestern/Thomson Learning
0 The equilibrium r in the LF market brings national saving = investment
+net capital outflow or S=I+NCO.
0 Supply-side shocks to LF
0 S↓ (income taxes↑ or budget →deficit), then r↑→LF↓
0 S↑ (income taxes↓ or budget →surplus), then r↓→LF↑
0 Demand-side shocks to LF
0 I↑ (tax credits↑ or expected Y↑), then r↑→LF↑
0 I↓ (tax credits↓ or expected Y↓), then r↓→LF↓
0 NCO↓ (political instability abroad↑), then r↓→LF↓ [US holds
fewer ROW assets and ROW holds more US assets]
0 NCO↑ (political stability abroad ↓), then r↑→LF↑ [US holds
more ROW assets and ROW holds less US assets]
0 We have now fully described the LF market and the determination of r
Figure 1 The Market for Loanable Fund
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning
The Market for Foreign-Currency Exchange
0 The two sides of the foreign-currency exchange market are represented
by NCO and NX.
0 NCO represents the imbalance between the purchases and sales of capital
assets.
0 NX represents the imbalance between exports and imports of goods and
services.
0 In the market for foreign-currency exchange, U.S. dollars are traded for
foreign currencies.
0 For an economy as a whole, NCO and NX must balance each other out, or:
NCO = NX
The Market for Foreign-Currency Exchange
0 The price that balances the supply and demand for foreign-
currency is the real exchange rate.
0 The demand curve for dollars is downward sloping because a
higher exchange rate makes domestic goods more expensive.
0 The supply curve is vertical because the quantity of dollars
supplied for net capital outflow is unrelated to the real
exchange rate. It is related to the real interest rate and comes
from the loanable funds market.
0 The real exchange rate adjusts to balance the supply
and demand for dollars.
0 At the equilibrium real exchange rate, the demand
for dollars to buy net exports exactly balances the
supply of dollars to be exchanged into foreign
currency to buy assets abroad.
0 For example, if the US has a trade surplus,
foreigners are demanding US dollars to buy the net
exports. At the same time, US dollars are being
supplied to buy the foreign assets from the resulting
net capital outflow (US receipt of foreign assets).
The Foreign Exchange Market
0 The supply and demand in the foreign exchange market determines the
real exchange rate eP/P*
0 Closed Economy: no trading, NX, or eP/P*.
0 Open Economy: NX=NCO this allows trade and borrowing and lending from
the ROW (rest of the world)
0 Net Capital Outflow - NCO → S$
0 If NCO↑, US is supplying more dollars, on net, to purchase foreign assets
0 If NCO↓, US is supplying fewer dollars, on net, to purchase fewer foreign
assets
0 NCO is determined by r in the loanable funds markets and is not related to
eP/P*.
0 As eP/P*↓(↑), NCO remains the same
0 Net Exports - NX → D$ is negatively related to eP/P*
0 If eP/P*↓, NX↑, D$↑ - US goods become cheaper, net exports
increase, and ROW needs more US dollars to purchase more
goods and services
0 If eP/P*↑, NX↓, D$↓ - US goods become more expensive, net
exports decrease, and ROW needs fewer US dollars to purchase
fewer goods and services
0 Equilibrium in the foreign exchange market occurs when
the eP/P* equates the D$ with the S$ or NX=NCO .
0 Foreign Exchange Shocks
0 D$↑, S$ is constant from NCO, eP/P*↑, until quantity of D$↓ and
equals the quantity of S$
0 D$↓, S$ is constant from NCO, eP/P*↓, until quantity of D$↑ and
equals the quantity of S$
Figure 2 The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning
EQUILIBRIUM IN THE OPEN ECONOMY
0 In the market for loanable funds, supply comes from national
saving and demand comes from domestic investment and net
capital outflow.
0 In the market for foreign-currency exchange, supply comes
from net capital outflow and demand comes from net exports.
0 Net capital outflow links the loanable funds market and the
foreign-currency exchange market.
0 The key determinant of net capital outflow is the real interest rate.
0 Prices in the loanable funds market and the foreign-currency exchange
market adjust simultaneously to balance supply and demand in these two
markets.
0 As they do, they determine the macroeconomic variables of national
saving, domestic investment, net foreign investment, and net exports.
WOW!
Linking the Loanable Funds and Foreign Exchange
Market
0 NCO link the two markets together
0 Step 1: S=I+NCO or SLF=DLF →r
0 Step 2: r →NCO
0 Step 3: NCO →S$
0 Step 4: NX →D$
0 Step 5: D$=S$ →eP/P* and NX=NCO
Examples of Transmission of LF and
FEM Shocks
0 Loanable Funds Shocks:
0 S↓, SLF↓, r↑,NCO↓,S$↓, eP/P*↑,NX↓
0 S↑, SLF↑, r↓,NCO↑,S$↑, eP/P*↓,NX↑
0 I↑, DLF↑, r↑,NCO↓,S$↓, eP/P*↑,NX↓
0 I↓, DLF↓, r↓,NCO↑,S$↑, eP/P*↓,NX↑
0 Foreign Exchange Shocks
0 D$↑, S$ is constant from NCO, eP/P*↑, until quantity of D$↓, but NX are
constant, r is constant
0 D$↓, S$ is constant from NCO, eP/P*↓, until quantity of D$↑, but NX are
constant, r is constant
Figure 4 The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
Demand
Net capital
outflow, NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
Supply
E
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY
0 The magnitude and variation in important macroeconomic variables
depend on the following:
0 Government budget deficits
0 Trade policies
0 Political and economic stability
Government Budget Deficits
0 In an open economy, government budget deficits . . .
0 reduce the supply of loanable funds,
0 drive up the interest rate,
0 crowd out domestic investment,
0 cause net foreign investment to fall.
Figure 5 The Effects of Government Budget Deficit
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
S
1. A budget deficit reduces
(b) Net Capital Outflow
the supply of loanable funds . . .
Real
Interest
Rate
S
B
r2
A
r
2. . . . which
increases
the real
interest
rate . . .
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
E1
5. . . . which
causes the
real exchange
rate to
appreciate.
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
0 Effect of Budget Deficits on the Loanable Funds
Market
0 A government budget deficit reduces national saving,
which . . .
0 shifts the supply curve for loanable funds to the left, which . . .
0 raises interest rates
0 Effect of Budget Deficits on Net Foreign Investment
0 Higher interest rates reduce net foreign investment.
0 Effect on the Foreign-Currency Exchange Market
0 A decrease in net foreign investment reduces the supply of
dollars to be exchanged into foreign currency.
0 This causes the real exchange rate to appreciate.
Trade Policy
0 A trade policy is a government policy that directly
influences the quantity of goods and services that a
country imports or exports.
0 Tariff: A tax on an imported good.
0 Import quota: A limit on the quantity of a good produced
abroad and sold domestically.
0 Because they do not change national saving or
domestic investment, trade policies do not affect the
trade balance.
0 For a given level of national saving and domestic
investment, the real exchange rate adjusts to keep the
trade balance the same.
0 Trade policies have a greater effect on
microeconomic than on macroeconomic markets.
Trade Policy
0 Effect of an Import Quota
0 Because foreigners need dollars to buy U.S. net exports, there is an
increased demand for dollars in the market for foreign-currency.
0 This leads to an appreciation of the real exchange rate.
0 There is no change in the interest rate because nothing happens in the
loanable funds market.
0 There will be no change in net exports.
0 There is no change in net foreign investment even though an import
quota reduces imports.
0 Effect of an Import Quota
0 An appreciation of the dollar in the foreign exchange market encourages
imports and discourages exports.
0 This offsets the initial increase in net exports due to import quota.
0 Trade policies do not affect the trade balance.
Figure 6 The Effects of an Import Quota
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
2. . . . and
causes the
real exchange
rate to
appreciate.
Supply
1. An import
quota increases
the demand for
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Political Instability and Capital Flight
0 Capital flight is a large and sudden reduction in the demand for
assets located in a country.
0 Capital flight has its largest impact on the country from which
the capital is fleeing, but it also affects other countries.
0 If investors become concerned about the safety of their
investments, capital can quickly leave an economy.
0 Interest rates increase and the domestic currency depreciates.
0 When investors around the world observed political problems
in Mexico in 1994, they sold some of their Mexican assets and
used the proceeds to buy assets of other countries.
0 This increased Mexican net capital outflow.
0 The demand for loanable funds in the loanable funds market
increased, which increased the interest rate.
0 This increased the supply of pesos in the foreign-currency exchange
market.
Figure 7 The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
(b) Mexican Net Capital Outflow
Real
Interest
Rate
Supply
r2
r2
r1
r1
3. . . . which
increases
the interest
rate.
1. An increase
in net capital
outflow. . .
D2
D1
NCO1
Quantity of
2. . . . increases the demand
Loanable Funds
for loanable funds . . .
NCO2
Net Capital
Outflow
Real
Exchange
Rate
E
5. . . . which
causes the
peso to
depreciate.
S
S2
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . .
E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning
Summary
0 To analyze the macroeconomics of open economies, two
markets are central—the market for loanable funds and the
market for foreign-currency exchange.
0 In the market for loanable funds, the interest rate adjusts to
balance supply for loanable funds (from national saving) and
demand for loanable funds (from domestic investment and net
capital outflow).
Summary
0 In the market for foreign-currency exchange, the real exchange rate
adjusts to balance the supply of dollars (for net capital outflow) and the
demand for dollars (for net exports).
0 Net capital outflow is the variable that connects the two markets.
Summary
0 A policy that reduces national saving, such as a government budget
deficit, reduces the supply of loanable funds and drives up the interest
rate.
0 The higher interest rate reduces net capital outflow, reducing the supply
of dollars.
0 The dollar appreciates, and net exports fall.
Summary
0 A trade restriction increases net exports and increases the demand for
dollars in the market for foreign-currency exchange.
0 As a result, the dollar appreciates in value, making domestic goods more
expensive relative to foreign goods.
0 This appreciation offsets the initial impact of the trade restrictions on net
exports.
Summary
0 When investors change their attitudes about holding assets of
a country, the ramifications for the country’s economy can be
profound.
0 Political instability in a country can lead to capital flight.
0 Capital flight tends to increase interest rates and cause the
country’s currency to depreciate.