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Frank & Bernanke
Ch. 16: International Trade and
Capital Flows
Trade Flows

Buying foreign goods at cheaper prices than
domestically produced.
 Selling domestic goods to foreign countries
at higher prices than sold domestically.
 Trade makes participant countries better off.
 The choices are determined by comparative
advantage.
Capital Flows

Buying and selling of assets across borders.
 Financial assets are bank deposits, bonds,
stocks, foreign currency, etc.
 Real assets are real estate, factories, art, etc.
 Trade flows and capital flows together
cancel each other.
– Trade deficits are financed by capital inflows
and trade surpluses are matched by capital
outflows.
Production Possibilities Curve

Suppose there are two individuals (say a
married couple) who have the following
productivities.
– He can clean house or cook one meal per day.
– She can clean house or cook two meals per day.

Draw PPC for this household per week.
Opportunity Costs

What is her opportunity cost of giving up
cleaning?
– A gain of 2 meals.

What is his opportunity cost of giving up
cleaning?
– A gain of 1 meal.

Who should give up cleaning first?
PPC
24
18
Cooking
Cleaning Cooking
14
0
13
2
12
4
11
6
10
8
9
10
8
12
7
14
6
15
5
16
4
17
3
18
2
19
1
20
0
21
12
6
0
0
5
10
Cleaning
15
PPC for 3-persons

Suppose her mother comes to live with
them.
 She can clean or cook three meals.
 Who should stop cleaning first?
 What would the PPC look like?
PPC
Cooking
45
40
35
30
25
20
15
10
5
0
0
5
10
15
Cleaning
20
25
PPC for Many Workers
A
B
Consumption Possibilities

In a closed economy where there is no trade
(autarky) a country’s consumption
possibilities are limited by its production
possibilities.
 In an open economy where a country can
sell products at higher prices than at home
and buy products at lower prices than at
home, the consumption possibilities are
larger than the production possibilities.
Him and Her Again

Suppose cleaning and cooking can be
exchanged in the marketplace for 1.5 meals
per cleaning.
 Put this information on PPC.
 Determine who is going to do what.
 Show why the couple is better-off.
14
7
She can get 10.5 cleanings
for her 14 meals
He can get 10.5
meals for his 7
cleanings
14
21
1
4
Many Workers
Cheap Labor and Jobs

If two countries are producing the same
products, computers and food, and one
country has lower wages, would free trade
make the higher wage country lose all the
jobs?
 Productivity and wages
 Comparative advantage
Productivity and Wages

Wages are high in the country that has
higher productivity.
 Productivity is measured as Marginal
Product of Labor.
 MPL = Increase in Output/Increase in Labor
 MPL shifts to the right as capital,
technology, and human capital increases.
Comparative Advantage

If rich country (R) can produce 10
computers or 100 food with one unit of
labor and poor country (P) can produce 2
computers and 50 food with one unit of
labor who has the absolute and comparative
advantage in computers and in food?
 What if P can produce 2 computers and 20
food?
Supply Curve
If the “price” of one computer is 10 food in
R, would the people in R make more or less
computers if they could exchange a
computer for 11 food? 12 food? 9 food?
 How does this look in a typical supply
curve?
 How does it relate to PPC?

Increasing Computer Price
Food
Computers
PPC
Food
Computers
Supply Curve
Price of
computers
11
10
9
Computers
Demand Curve

Typically, demand depends on the income
of the people, their tastes and the price of
the product.
 As the computer price goes up, ceteris
paribus, the number of computers
demanded will fall.
Autarky
P
Computers
Computers
Exports
P
Pw
Computers
Computers
Imports
P
Pw
Computers
Computers
Markets With Trade

On a supply-demand diagram, show the
world price, amount produced, amount
exported and amount consumed.
 On a supply-demand diagram, show the
world price, amount produced, amount
imported and amount consumed.
Winners and Losers

Because of the difference between world
and domestic prices some gain and others
lose from free trade.
 Winners are consumers of imported goods
and producers of exported goods.
 Losers are consumers of exported goods
and producers of import-competing goods.
Winners and Losers
Winners and Losers
Import Tariffs
Pw+t
Pw
Import Quota
P
Pw
Quota
Net Capital Inflows

Capital inflows are purchases of our assets
by foreigners (funds flowing in).
 Capital outflows are our purchases of
foreign assets (funds flowing out).
 Net capital inflows (KI) is capital inflows
minus capital outflows.
 KI>0 net capital inflows.
 KI<0 net capital outflows.
NX and KI

Net exports and net capital inflows are
connected.
 NX + KI = 0
 If there is a trade surplus, we have claims
abroad: we can keep the local currency
earned in a bank abroad, buy local stocks,
bonds, real estate.
 If there is a trade deficit, the foreigners can
purchase our assets. If they demand their
money, we borrow (sell bonds = KI).
Real Interest Rates and KI

Net capital inflows respond to changes in
our (domestic) real interest rates.
 Higher real interest rates mean people can
earn higher returns here.
 Lower real interest rates mean people can
earn higher returns abroad.
Real Interest Rates and KI
Real interest rate
KI
Net capital outflows
0
Net capital inflows
Shifts in KI

Riskiness of domestic assets increases =>
KI shifts left.
 Riskiness of foreign assets increases => KI
shifts right.
 Real interest rate abroad increases => KI
shifts left.
Savings and Investment
1.
2.
3.
4.
5.
6.
Y = C + I + G + NX (output = AD)
Y=C+S+T
(output = income)
C + S + T = C + I + G + NX (one and two)
S + (T – G) – NX = I (from three)
KI = - NX (from NX + KI = 0)
Private savings + Government savings +
Capital inflows = Investments (from four)
Saving and Investment
r
r
S+(T-G)
S+(T-G)+KI
S+(T-G) S+(T-G)+KI
0
I
Japan
USA