Download Lecture 13 - Har Wai Mun

UBEA 1013: ECONOMICS
CHAPTER 13:
INTERNATIONAL TRADE AND EXCHANGE RATE
13.1 Absolute Advantage & Comparative Advantage
13.2 Open Economy: Export – Import
13.3 Exchange Rate
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UBEA 1013: ECONOMICS
13.1 Absolute Advantage & Comparative
Advantage
• David Ricardo’s theory of comparative
advantage, states that specialization and
free trade will benefit ALL trading partners,
even those that may be absolutely less
efficient producers.
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UBEA 1013: ECONOMICS
• A country enjoys an absolute advantage
over another country in the production of a
product when it uses fewer resources to
produce that product than the other country
does.
More output with same resources
• A country enjoys a comparative advantage
in the production of a good when that good
can be produced at a lower cost in terms of
other goods.
Mean lower opportunity cost
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UBEA 1013: ECONOMICS
Absolute Advantage:
Yield Per Acre for Wheat And Cotton
NEW
AUSTRALIA
ZEALAND
Wheat
Cotton
Total land
6 units
2 units
100 acres
2 units
6 units
100 acres
• New Zealand can produce three times the wheat
that Australia can on one acre of land, and
Australia can produce three times the cotton.
• We say that the two countries have mutual
absolute advantage.
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UBEA 1013: ECONOMICS
• Assume that each country wish to
consume equal units of cotton and wheat.
Thus, the production is as shown below:
Total Production Of Wheat And Cotton Assuming No Trade, Mutual
Absolute Advantage, And 100 Available Acres
NEW ZEALAND
AUSTRALIA
Wheat
25 acres x 6 units/acre
150 units
75 acres x 2 units/acre
150 units
Cotton
75 acres x 2 units/acre
150 units
25 acres x 6 units/acre
150 units
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UBEA 1013: ECONOMICS
Production Possibility Frontiers for
Australia and New Zealand Before Trade
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UBEA 1013: ECONOMICS
Gain from mutual Absolute Advantage:
Yield Per Acre for Wheat And Cotton
NEW ZEALAND
AUSTRALIA
Wheat
6 units
2 units
Cotton
Production:
Wheat
Cotton
2 units
6 units
600 units
0 unit
0 unit
600 units
• Absolute advantage theory urges countries to specialize
in the production it has the absolute advantage (higher
production per unit of resources).
• Therefore, New Zealand should specialize in production
of wheat while Australia in production of cotton.
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UBEA 1013: ECONOMICS
• An agreement to trade 300 units of wheat for 300 units of
cotton would double both wheat and cotton consumption
in both countries.
Production and Consumption of Wheat and Cotton after Specialization
PRODUCTION
New Zealand
Wheat
600 units
Cotton
0 unit
CONSUMPTION
Australia
New Zealand
Australia
0 unit
300 units
300 units
600 units
300 units
300 units
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UBEA 1013: ECONOMICS
• Because both countries have an absolute
advantage in the production of one product,
specialization and trade will benefit both.
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UBEA 1013: ECONOMICS
Comparative Advantage:
Yield Per Acre for Wheat And Cotton
CASE 1:
NEW
AUSTRALIA
ZEALAND
Wheat
6 units
2 units
Cotton
2 units
6 units
Yield Per Acre for Wheat And Cotton
CASE 2:
NEW
AUSTRALIA
ZEALAND
Wheat
6 units
1 units
Cotton
6 units
3 units
Mutual
Absolute
Advantage
New Zealand has
absolute
advantage in
both wheat &
cotton production
Can trade
benefit BOTH?
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UBEA 1013: ECONOMICS
Comparative Advantage
Opportunity cost (The cost of reducing other products to produce
another unit of a particular product)
One additional
unit of:
NEW ZEALAND
AUSTRALIA
Wheat
6 / 6 = 1 unit of cotton
3 / 1 = 3 units of cotton
Cotton
6 / 6 = 1 unit of wheat
1 / 3 = 0.33 unit of cotton
• New Zealand has lower opportunity cost in producing
wheat >> should specialize in producing wheat
• Australia has lower opportunity cost in producing
cotton >> should specialize in producing wheat
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UBEA 1013: ECONOMICS
Comparative Advantage
• Assume that each country wish to consume
equal units of cotton and wheat. Thus, the
production is as shown below:
Total Production Of Wheat And Cotton Assuming No Trade, Mutual
Absolute Advantage, And 100 Available Acres
NEW ZEALAND
AUSTRALIA
Wheat
50 acres x 6 units/acre
300 units
75 acres x 1 units/acre
75 units
Cotton
50 acres x 6 units/acre
300 units
25 acres x 3 units/acre
75 units
• The gains from trade in this example can be
demonstrated in two stages.
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UBEA 1013: ECONOMICS
Comparative Advantage
Realizing a Gain from Trade When One Country Has a
Double Absolute Advantage
Stage 1: Countries specialize
STAGE 1
New Zealand
Australia
Wheat
75 acres x 6 units/acre
= 450 units
0 unit
Cotton
25 acres x 6 units /acre
= 150 units
100 acres x 3 bales/acre
300 bales
• Australia specialized in cotton production. New Zealand
transfers 25 acres out of cotton production into wheat.
• New Zealand cannot completely specialize in wheat production
because it needs 300 bales of cotton and will not be able to get
enough cotton from Australia (if countries are to consume equal
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amounts of cotton and wheat).
UBEA 1013: ECONOMICS
Comparative Advantage
Stage 2: Countries trade
STAGE 2
New Zealand
Australia
100 units (trade)
Wheat
350 units
100 units
(after trade)
200 units (trade)
Cotton
350 units
100 units
(after trade)
Agreed trading price: (Term of Trade)
2 units of cotton for 1 unit of wheat
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UBEA 1013: ECONOMICS
• Terms of trade: The ratio at which a
country can trade domestic products
for imported products.
• The terms of trade determine how
the gains from trade are distributed
among trading partners.
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UBEA 1013: ECONOMICS
13.2 Open Economy: Export – Import
National Accounting (extension from Chapter 9):
• Export & Import transactions is recorded in
the country balance of payment under the
“current account”.
• The balance of payments is 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.
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UBEA 1013: ECONOMICS
• A country’s current account is the sum of its:
– net exports (exports minus imports),
– net income received from investments abroad, and
– net transfer payments from abroad.
• The balance of trade is the difference between a
country’s exports of goods and services and its
imports of goods and services.
• A trade deficit occurs when a country’s exports are
less than its imports.
• Net exports of goods and services (EX – IM), is
the difference between a country’s total exports and
total imports.
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UBEA 1013: ECONOMICS
Multiplier Effect & Aggregate Expenditure
(extension from Chapter 11):
Planned aggregate expenditure (AE) in an
open economy:
AE  C  I  G  EX  IM
• In equilibrium:
C  a  bY
Y  C  I  G  EX  IM
I  I0
G  G0
EX  EX 0
IM  mY
m = marginal propensity
to import (or MPM)
Y  a  bY  I  G  EX  mY
Y  bY  mY  a  I  G  EX
Y (1 b  m)  a  I  G  EX
1
Y* 
(a  I  G  EX )
1 b  m
multiplier
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UBEA 1013: ECONOMICS
• Exports contribute to an
increase in autonomous
expenditures and cause the
planned aggregate expenditure
function to shift upward.
• Imports affect the value of the
multiplier. After imports are
included, the aggregate
expenditure function rotates and
equilibrium income decreases.
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UBEA 1013: ECONOMICS
13.3 Exchange Rate
• The main difference between an
international transaction and a domestic
transaction concerns currency exchange.
• The exchange rate is 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.
• Foreign exchange is simply all currencies
other than the domestic currency of a given
country.
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UBEA 1013: ECONOMICS
Three Type of Exchange Rate System:
• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated forces of
supply and demand.
• (Exchange rate movements have
important impacts on imports, exports,
and movement of capital between
countries).
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UBEA 1013: ECONOMICS
• Fixed exchange rates: governments set
a particular fixed rate at which their
currencies will exchange for each other.
• (Pegging a currency to another currency
is in this fixed exchange rate system).
• Managed floating system: In this
system, governments intervene if
markets are becoming disorderly.
• (Usually, the currency is allowed to float
within a pre-determined ranged)
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UBEA 1013: ECONOMICS
Monetary Policy & (Floating) Exchange Rate
(extension from Chapter 11):
Increase in M
Exchange
rate fall
(depreciate)
Local (foreign)
product cheaper
(more expensive)
Interest rate fall
Sell local
currency
Buy foreign
currency
Investor earning
lower IR
Seek better
investment
abroad
Net export
increase
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UBEA 1013: ECONOMICS
• The equilibrium exchange rate occurs
at the point at which the quantity
demanded of a foreign currency
equals the quantity of that currency
supplied.
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UBEA 1013: ECONOMICS
• The level of a country’s interest rate relative to interest
rates in a determinant of the exchange rate. If U.S.
interest rates rise relative to British interest rates, British
citizens may be attracted to U.S. securities (relative
higher return).
• Increase of British investors
to seek better investment in
US increases the supply of
dollar and decreases the
demand for pounds.
• The result is depreciation of
the pound against the dollar.
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UBEA 1013: ECONOMICS
• A depreciation of a country’s currency (e.g
Malaysia) can serve as a stimulus to the
economy:
– Foreign buyers are likely to increase their
spending on Malaysian goods (relatively
cheaper)
– Buyers substitute domestically made goods
for imports (as import will costs more)
– Aggregate expenditure on domestic output will
rise
– GDP (Y) will increase
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UBEA 1013: ECONOMICS
• Who will benefit if the domestic currency
depreciate?
– Export sector (more competitive)
• An interesting case: During Asian financial crisis,
Ringgit depreciate sharply. What happen to the
domestic crude palm oil (CPO) price?
– UP (Why?) (CPO Futures contracts prices
traded in Kuala Lumpur Commodities
Exchange shot up continuously).
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UBEA 1013: ECONOMICS
• CPO price are quoted at international currency
(the US dollar).
• Thus, depreciation of Ringgit cause the price of
CPO relatively higher (in term of the local
currency or Ringgit)
• Another question: Now, Malaysia has de-peg the
Ringgit against the US$ (now under a managed
float system). General opinion think that the
Ringgit will appreciate.
• Who will benefit if the Ringgit really appreciate?
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UBEA 1013: ECONOMICS
The beneficiaries:
• Companies that have huge US$-dominated debt:
e.g. Telekom Malaysia & Tenaga Nasional. They
will benefit from one-off translation gains and
lower interest expenses.
• Companies that have high imported input cost:
e.g. auto & media industry being the obvious.
The “losers”?
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UBEA 1013: ECONOMICS
The losers:
• Exporters: less competitive due to relative higher
price (in term of foreign currency).
• Companies with a large part of their revenue
stream in foreign currencies. A stronger Ringgit
mean less revenue in the local currency after
conversion.
• Therefore, the worst will be those “cost in Ringgit,
revenue in Dollar” companies. E.g. plantation,
semiconductor and timber sector. Their profit
margin will be reduced.
End
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