Download Chapter 26 - McGraw Hill Higher Education

Chapter 26: International
Trade and Capital Flows
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Learning Objectives
1. Understand how trade balances and net capital flows
are related
2. Show how international trade affects a country's
consumption possibilities
3. Explain who wins and who loses with free trade
4. Describe the effects of tariffs and quotas on domestic
prices, production, and consumption
5. Analyze the factors that determine international capital
flows and how these flows affect domestic savings and
interest rates
6. Use the relationship between domestic saving and the
trade balance to understand how domestic saving, the
trade balance, and net capital inflows are related
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International Trade
 National economies do not exist in isolation
but are increasingly interdependent
 Trade is important even to a large economies.
However, international flows of goods and
services become sometimes a matter of
political and economic concern
 Trade

and capital flows are easily politicized
Free trade can be seen to cost local jobs
• U.S.-Morocco Free Trade Agreement

Foreign control of "essential" assets such as ports or
telecommunications infrastructure
• Dubai Ports World
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The Trade Balance and Net Capital Inflows
Trade balance is another name for net
exports (NX)
 Value
of a country's exports minus the value of
its imports
A trade surplus is a positive trade balance
 Exports
> imports
A trade deficit is a negative trade balance

Imports > exports
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The Egyptian Trade Balance, 1960–2009
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The Moroccan Trade Balance, 1960–2009
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The UAE Trade Balance, 1973–2007
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The Turkish Trade Balance, 1960–2009
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Capital Flows
 International capital flows are transactions of
real estate and financial assets across international
borders
Capital inflows are purchases of domestic assets by
foreign households and firms
 Capital outflows are purchases of foreign assets by
domestic households and firms
 Net capital inflows (KI) are capital inflows minus
capital outflows

 Capital flows are not counted as imports or
exports since the funds are used to purchase assets

Imports and exports are goods and services produced
in the current year
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Trade Balance (NX) and Net Capital Inflows
(KI)
NX + KI = 0
 UAE resident purchases Japanese car for $20,000
 Imports
= $20,000
 Manufacturer holds $20,000 in a UAE bank
account
 Option
1: purchase $20,000 of UAE goods and
services so exports = $20,000
 Option 2: purchase UAE bonds or UAE real estate

NX = – $20,000, KI = $20,000
 Option

3: sell dollars for yen
Follow the dollars and see what the purchaser does with
them to determine NX and KI
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The Principle of Comparative Advantage
The Principle of Comparative Advantage
Everyone does best when each concentrates
on the activity with the lowest opportunity cost
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Comparative Advantage
Comparative advantage is determined by
factors such as



■
Climate
Human capital
Natural resources ■
Financial systems
Technology ■
Culture
A closed economy is an economy that
does not trade with the rest of the world
An open economy is an economy that
trades with other countries
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Production Possibilities Curve
A
C
100,000
Coffee (kg/year)
 Economy with two goods
 If 1,000 computers are
produced, the maximum
amount of coffee is 100,000
pound
 Moving from C to D, the
economy
 Gives up 60,000 kg of coffee
 Gains 1,000 computers per
year
 Curvature results from the
Principle of Increasing Opportunity
Cost
D
40,000
B
1,000
2,000
Computers (number/year)
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Production and Consumption Possibilities
 Production possibilities curve shows the
quantities of different goods that an economy can
produce
 Consumption possibilities curve shows the
quantities of different goods that a country could
consume
 Production and consumption possibilities are the
same if a country does not trade

Autarky is a situation where a country does not trade
 In an open economy, a society's consumption
possibilities are greater than its production
possibilities
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Buying and Selling in World Markets
E
Egypt Starts at D
A
Trade
C options
150
Coffee (000s kg/year)
 Egypt begins at point D, 2,000
computers and 50,000 kg of
coffee
 World prices are $10/kg of
coffee and $500/computer
 Sell 2,000 computers for $1
million and buy 100,000 kg of
coffee
 Moves the economy to E,
beyond its PPC
 Sell 50,000 kg of coffee for $0.5
million and buy 1,000
computers
 Moves the economy to F
120
100
PPC
50
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D
Z
F
B
1
2 2.4
Computers( 000s/year)
3
15
Buying and Selling in World Markets
E
Egypt Starts at D
A
Trade
C options
150
Coffee (000s kg/year)
 Operating at D is not Egypt's
best choice
 Trade options between C and
D are inefficient
 Egypt could have more coffee
and more computers than X
without trade
 Egypt is in the best position if it
chooses a point where the trade
options are entirely on or
outside the PPC
120
100
PPC
X
50
D
Z
F
B
1
2 2.4
Computers( 000s/year)
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16
Optimal Production Mix for an Open
Economy
160
L
Egypt Works at G
150
Coffee (000s kg/year)
 The trade options line, LM, is
tangent to the production
possibilities frontier at G
 G is the optimal production
level
 Slope of LM is determined by
prices: 160,000 coffee / 3,200
computers = 50 kg of coffee /
computer
 By producing at G, Egypt can
consume at any point on LM
 LM is the consumption
possibilities curve
CPC
E
120
A
100
C
50
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G
PPC
D
B
1
F
M
2 2.4 3 3.2
Computers (000s/year)
17
Optimal Production Mix for an Open
Economy
160
L
Egypt Works at G
CPC
Coffee (000s kg/year)
At G
 The opportunity cost of
producing one more computer
EQUALS
 The opportunity cost of
purchasing one more computer
AND
 The opportunity cost of
producing one more pound of
coffee
EQUALS
 The opportunity cost of
purchasing an extra pound of
coffee
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G
PPC
F
M
3.2
Computers (000s/year)
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A Simple Economy
Islandia produces coffee and tea
 100
workers are equally productive in both
products
 One work-day produces 8 kg of coffee or tea
Islandia's goal is to produce the highest
value of total output
 Value



depends on world prices
Produce the good with the highest price
Sell some
Buy the other, lower-priced good
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 Islandia's production
possibilities curve is a
straight line
 If only coffee is
produced, output is 800
kg per day
 If only tea is produced,
output is 800 kg per day
 Any combination
between these is possible
Coffee (kg/year)
A Simple Economy
800
Islandia Production
Possibilities Curve
A
600
B
C
200
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D
200
600 800
Tea (kg/year)
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Two Consumption Possibilities Curves
600
A
1,600
Produce at A
Coffee (kg/year)
Coffee (kg/year)
800
Price of Tea Twice
Price of Coffee
B
CPC
C
200
800
600
D
200 600 800
Produce at D
A
B
CPC
200
PPC
Price of Coffee Twice
A' Price of Tea
D'
1,600
Tea (kg/year)
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PPC
C
D
200
600 800
Tea (kg/year)
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Production and Consumption Possibilities
 If the price of coffee and tea are the same,
there are no gains from trade for Islandia
 Produce
what you want and consume it
 Suppose the production possibilities curve is
convex
 Produce
where the opportunity cost of
production equals the opportunity cost in trade
 Pick a point on the consumption possibilities curve
 Trade to reach that point
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Trade for Egypt


80,000 kg of coffee
1,600 computers
 Consumption is at N
Export 20,000 kg of coffee
for $200,000
 Import 400 computers for
$200,000
 N is outside the production
possibilities curve

160
L
Egypt Works at G
CPC
Coffee (000s kg/year)
 World prices are $10 per
kg of coffee and $500 per
computer (shown by LM)
 Egypt produces at G
120
100
C
G
80
N
60
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PPC
M
1
1.6 2
3.2
Computers (000s/year)
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Benefits of Free Trade
 Free trade produces net benefits
 Some
gain; some lose
Gains
Losses
Domestic consumers of
imported goods
Domestic producers of
imported goods
Domestic producers of
exported goods
Domestic consumers of
exported goods
 Free trade is efficient
 Increases
total economic surplus in the economy
 Equilibrium Principle
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Protectionism and Tariffs
 Protectionism is the view that free trade is
injurious and should be restricted
 Tariff
is a tax imposed on an imported good
 Egypt imposes a tariff on imported computers
 Same
as an increase in the world price of
computers
 Domestic price increases to world price plus tariff

Consumers pay more for computers than with free
trade and business profits increase
 Quantity
demanded decreases and quantity
supplied increases

Imports decrease and government revenues go up
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Honda Civic in Egypt versus the UAE
Egyptian residents pay more than $30,000
for a 1.6-liter Civic.
UAE residents pay about $20,000 for a 1.8liter Civic.
Egypt imposes a 40 percent tariff and 15
percent value-added tax on all imported
cars not exceeding 1.6 liters.
The UAE imposes a flat 5 percent tax on all
imported goods exceeding a value of $300.
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Protectionism and Quotas
 Quota is a legal limit on the quantity or value
of a good that may be imported
 Usually
administered by permits issued to
importers
 Economic effects are similar to a tariff
 Domestic
price increases to the benefit of
domestic producers
 Domestic consumers pay higher prices
 Foreign manufacturers sell fewer units
 The key difference between tariffs and quotas
is the gains captured by permit holders
 Buy
at world prices and sell at a higher price
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Voluntary Export Restrictions (VER)
 Higher gas prices of the 1970s caused consumers'
preferences for fuel-efficient Japanese cars to
increase

Demand for US cars decreased
 In 1981, US negotiated an agreement with Japan to
limit their exports to the US voluntarily

System lasted until 1994
 US and European car manufacturers benefited from
lower competition

Japanese companies benefited from higher prices for
their products
 Consumers paid higher prices for cars
 Cost of VERs estimated at $3 billion per year
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Other Trade Barriers
 There are bureaucratic ways to decrease
imports
 Strict



application of rules for health and safety
Refusal to accept drug trial results conducted outside
the US, for example
Testing and certification procedures for compliance to a
technology standard
Bans on genetically modified foods in Europe
 Use
of the Imperial system instead of metric
system increases the cost of doing business in the
US

Different electricity characteristics have same effect
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The Inefficiency Of Protectionism
 Free trade is efficient; protectionism reduces total
surplus

Protectionism confers benefits on favored groups
 If trade barriers are removed, total surplus
increases

Divert some of the increase to compensate those hurt
by trade

Reduces resistance to free trade in those who bear the costs
 Environmental concerns are better addressed
under a free trade system

Restrictions impose costs on poor countries
(polluters), reducing the resources for clean-up
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International Capital Flows
 Highly developed financial markets allow
borrowing and lending across borders
 Transactions are subject to laws in the
originating country and the target country
 Size
of international flows for a country depend on
its regulations and laws
 Also depend on economic integration and political
stability
 Lending is acquiring a real of financial asset
 Buying
a share of stock or a government bond or a
parcel of land
 Borrowing is selling a real or financial asset
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Two Roles of International Capital Flows
Trade Imbalances
• International capital flows compensate for trade
imbalances
• Trade surplus means net capital outflows
• Trade deficit means net capital inflows
Efficient Allocation of Savings
• International capital flows allow savers to invest in the
most profitable opportunities
• Independent of location
• Fills savings gap in destination country
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International Capital Flows
 Capital inflows to the home country include foreign
purchases of
Stocks and bonds of local companies
Local government bonds
Real assets such as land
and buildings owned by
local residents
 Capital flows respond to real
interest rates

Higher domestic interest
rates mean greater capital
inflows
Domestic Real
Interest Rate (r)



KI
KI < 0
Net capital
outflows
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KI > 0
Net capital
inflows
0
Net Capital Inflows (KI)
33
Risk and Capital Inflows
 Shifts
the capital inflow
curve to the left
 Foreigners are less willing
to buy domestic assets
 Domestic savers are more
willing to buy foreign
assets
Domestic Real
Interest Rate (r)
For a given real interest
rate, increase in riskiness
in of domestic assets
decreases capital inflows
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KI' KI
0
Net Capital Inflows (KI)
34
Savings, Investment, Capital Inflows
 Definition of output
Y = C + I + G + NX
 Solve for I
Y – C – G – NX = I
 National savings, S, is (Y – C – G)
S – NX = I
 Also
NX + KI = 0 OR KI = – NX
 So
S + KI = I
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S + KI = I
 Savings plus net capital inflows equals
investment in new capital goods
savings can supplement domestic savings
to create capital goods to
support economic growth
S + KI
 In a closed economy,
S=I
 In
an open economy,
S + KI = I
 Capital inflows mean more
investment and lower
interest rates
Real interest rate (%)
 Foreign
r*
I
S, I
Saving and investment
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Capital Flows and Debt Crises
Developing countries fund their growth
with capital inflows
 Incomes
are too low for large domestic savings
 High rates of return on infrastructure and
early investments
Interest on foreign loans and eventually, the
principle, must be paid
 If
investments are not productive, there are
insufficient funds to pay interest and repay the
loan: a debt crisis
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Argentina, 2001 - 2002
Argentina has natural resources and human
capital
 Good
potential for economic growth
 Low national savings rate
 Large capital inflows


Invest more and grow quickly
Large debt to foreigners
 Foreigners
loaned willingly provided there was
a good return
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Argentina, 2001 – 2002
 1995 – 1997 was a high growth period
 The Argentine economy slowed in 1998
 Tax
receipts decreased and demand for
government services increased
 Government at all levels ran large deficits
 The need for foreign funds grew rapidly
 Perceived
risk increased and capital inflows slowed
 Interest rates increased, domestic investment
decreased and the economy continued to weaken
 Argentina was eventually forced into default
 Worked
economy
with IMF and others to restart the
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The Savings Rate and the Trade Deficit
 Trade deficits result from low domestic
savings
S – I = NX
 Holding investment constant, a high rate of
savings results in high net exports
 If
S < I, the country is a net importer and NX < 0
 Suppose a country has a low national savings
rate
G


and C are large relative to Y
Strong demand for imports
Few goods available for export
 The
country will have a trade deficit
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The Savings Rate and the Trade Deficit
If national savings rate is low, the savings
will not be sufficient to finance domestic
investment
 Many
good investments available for foreign
funds
 Capital flows in
Low levels of savings increases interest
rates and attracts foreign capital inflows
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