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APOLLO ENGINEERING COLLEGE

INTERNATIONAL TRADE FINANCE
Department of Management Studies
Lecture 1 - Why Do Nations Trade?
administrative stuff
importance of trade to the U.S. economy
impact of globalization on the U.S. economy
why does trade occur?
comparative advantage and trade
an international example
increasing opportunity costs and trade
Heckscher-Olin Theory
trade with demand and supply
measuring the gains from trade
different tastes as a basis for trade

Importance of Trade to the U.S. Economy
How important are exports (American goods purchased by foreigners) and imports (foreign products purchased by
Americans) to the U.S. economy? Many goods and services are nontrade able, e.g. most buildings and most personal
and governmental services. So, what proportion of the nation's output that is potentially exportable is, in fact,
exported?
In 1994, U.S. exports of goods were equal to 24% of the domestic output of goods. This is up from 8% in 1960 and
16% in 1980.

What change has occurred in the relation of goods imported to goods consumed?
In 1994, imports accounted for 28% of total goods consumed compared to just 7% in 1960.

Impact of Globalization on U.S. Economy
foreign economic conditions impact on the U.S. economy
U.S. more dependent on foreign suppliers
more competition in domestic markets: price of imported products falls, benefiting consumers but hurting
U.S. producers of the goods


Why Does Trade Occur?
In some ways the Japanese are our competitors in the world economy since American and Japanese firms do
produce many of the same goods. Ford and Toyota compete for the same customers in the automobile market.
Compaq and Toshiba compete for the same customers in the personal computer market.
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But, trade between the United States and Japan is not like a sports contest, where one side wins and the other side
loses. In fact, trade between countries can make each country better off.
Think about how trade affects your family. When a member of your family looks for a job, she competes against
members of other families who are looking for jobs. Families also compete against each other when they are
shopping because each family wants to buy the best goods at the lowest price. So, each family is competing with all
the other families in the economy.
But, your family would not be better off isolating itself from all other families. If it did, your family would need to
grow all of its own food, make its own clothes, and build its own house and car. Your family gains from its ability to
trade with others. Trade allows each person to specialize in the activities he or she does best. By trading with others,
people can buy a greater variety of goods and services at a lower cost than if they tried to produce each good by
themselves.
Countries also benefit from the ability to trade with one another. Trade allows countries to specialize in what they do
best and to enjoy a greater variety of goods and services. The Japanese are as much our partners in the world
economy as they are our competitors.

Comparative Advantage and Trade
Michael Jordan can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does
this mean he should? Let's say Jordan can mow his lawn in 2 hours while Debbie, the girl next door, can mow
Jordan's lawn in 4 hours. Because he can mow the lawn in less time, Michael Jordan has an absolute advantage in
mowing lawns.
However, is mowing his lawn the best use of Jordan's time? Suppose that in the same 2 hours it takes him to mow
his lawn, he could film a Nike commercial and earn $10,000. Jordan's opportunity cost (the value of his next best
alternative) of mowing the lawn is $10,000.
In contrast, Debbie's next best alternative is to wrap meat at Wegman's where she earns $8 an hour. So, in the 4
hours it would take her to mow Jordan's lawn, she could have earned $32. Debbie's opportunity cost of mowing his
lawn is $32.
Jordan has an absolute advantage in mowing lawns because he can do the work in less time. But, Debbie has
a comparative advantage in mowing lawns because she has the lower opportunity cost. A person or a country has a
comparative advantage when they can produce a good at a lower opportunity cost compared to someone else.
The gains from trade are enormous. Rather than mowing his lawn, Jordan should make the commercial and hire
Debbie to mow the lawn. As long as he pays her more than $32 and less than $10,000, both of them are better off.
Countries can benefit from specialization and trade with one another in the same way individuals can. The gains
from trade do not disappear at national borders.

An International Example
assumptions:
2 countries with the same population and capital stocks (Ghana and Peru)
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2 products: wheat and cloth
perfect competition
full employment of resources
ignore demand side
production possibilities under autarky

Ghana Peru

wheat cloth wheat cloth
(bushels) (bolts) (bushels) (bolts)

150 0 240 0
120 15 180 20
90 30 120 40
60 45 60 60
30 60 30 70
0 75 0 80

Because the same amount of resources can produce more in Peru than in Ghana, Peru can make either a bushel of
wheat or a bolt of cloth with fewer resources than Ghana. So, Peru has an absolute advantage in both products.
Ghana can get 15 more bolts of cloth by decreasing wheat production by 30 bushels. So, the price of 30 bushels of
wheat in Ghana is 15 bolts of cloth. So, 1 bushel of wheat costs 1/2 bolt of cloth or 1 bolt of cloth costs 2 bushels of
wheat.
In Peru, 1 bushel of wheat costs 1/3 bolt of cloth or 1 bolt of cloth costs 3 bushels of wheat.
Ghana can buy its wheat for only 1/3 bolt of cloth in Peru. Peru can buy one bolt of cloth in Ghana for just 2 bushels
of wheat. So, there are gains from trade. These gains and the direction of trade are determined by comparative
advantage.
Ghana has the comparative advantage in cloth production since its opportunity costs are smaller. Peru has the
comparative advantage in wheat production. (Suppose there are 2 countries, A and B, and 2 goods, X and Y. If
country A has a comparative advantage in good X, country B must have the comparative advantage in good Y.)
Ghana should specialize in cloth production and Peru in wheat production and then they trade. World production is
240 bushels of wheat and 75 bolts of cloth. No other combination will give so high a total world output.
deriving the trade line

Increasing Opportunity Costs and Trade
The Ghana/Peru example assumes constant costs which should result in total specialization. The world fails to show
total specialization. This would result if there were increasing opportunity costs so that the PPC is concave.
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In the absence of trade, each country consumes at their point A. Slope of tangent line gives the cost ratio. As long as
the slopes are different there is an incentive to trade.
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Each country produces where the world price ratio line is tangent to its PPC (point B). At point B, the world price
equals the domestic opportunity cost. Then, they trade to end up consuming at point C. The consumption point
depends on preferences, but we'll bring those in later.

Heckscher-Olin Theory
International trade occurs because of differences in opportunity costs, that is, from different shaped PPC's.
International differences in the shape of PPC's result from
1. different goods use factors of production in different ratios
2. nations differ in their relative factor endowments
The Heckscher-Olin Theory argues that factor proportions explain a nation's trade patterns.
Countries export the products that use their abundant factors intensively and import the products that use their
scarce factors intensively.
A country is labor abundant if it has a higher ratio of labor to other factors of production than does the rest of the
world.
A product is labor intensive if labor costs are a greater share of its value than they are of the value of other
products.
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Suppose 2 bushels of wheat = 1 bolt of cloth in the U.S. and 1 bushel of wheat = 1 bolt of cloth in the rest of the
world. Wheat is relatively cheap in the U.S. H-O presumes that factor proportions account for comparative cost
differentials.
So, the U.S. has relatively more of the factors that wheat uses intensively and relatively less of the factors that cloth
uses intensively than does the rest of the world. Suppose land is the factor wheat uses intensively and labor is the
factor cloth uses intensively. In other words, the U.S. must be land abundant.
U.S. land supply R.O.W. land supply
---------------- > ------------------
U.S. labor supply R.O.W. labor supply

implications:
1. U.S. should export wheat and import cloth
2. land should be relatively cheap in the U.S. and labor should receive a relatively higher wage in the U.S.
than elsewhere
H-O theory explains general trade patterns relatively well, but recent trends indicate that the industrial countries are
becoming more similar in their factor endowments. So, the H-O theory may become less relevant.

Trade with Demand and Supply
Consider a consumer with given money income, all of which she spends on only two goods: pizza and beer. The
combinations of pizza and beer are called bundles.
e.g. X = (2 slices of pizza, 3 bottles of beer)
Y = (3 slices of pizza, 1 bottle of beer)

Assume that the consumer can tell us whether
1. X is preferred to Y
2. Y is preferred to X
3. she is indifferent between X and Y
Suppose she is indifferent between X and Y. Connecting the points gives an indifference curve. An
indifference curve shows all combinations of pizza and beer that the consumer is indifferent among.

This is an indifference map:

There are an infinite number of indifference curves. Consumers want to be on the highest possible indifference
curve.
Community indifference curves purport to show the preferences of the entire nation.
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Of all the
points at
which the
country
can
produce,
point E
gives the
highest
utility.
The line
drawn
through
point E
gives the
equilibriu
m price
ratio
which
brings
producers
and
consumers
into
equilibriu
m.

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The country produces at point A and consumes at point B. So, they end up on a higher indifference curve.

Measuring the Gains from Trade
The demand curve measures the value an individual places on each unit of the good. The height of the demand curve
shows the amount she is willing to pay for that unit of the good.

The consumer pays less than she would be willing to for the good. Consumers surplus is the difference between
what a consumer is willing to pay and the market price of the good. Consumer surplus is the area below the demand
curve above the market price.
Producer surplus is the difference between the price firms would have been willing to accept and the price they
actually receive. Graphically, producer surplus is the area above the supply curve below the market price.

The sum of consumer surplus and producer surplus is called net national welfare. When net national welfare
increases, society is better off.

Different Tastes as a Basis for Trade
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Assume identical PPC's but different tastes. There are gains from trade even in this case.
Allowing more products and more countries makes the analysis more difficult but doesn't alter the basic gains from
trade


Problem Set #1 - Comparative Advantage
Due by the end of class on January 19.

1. Suppose that the U.S. has an endowment of 30 units of labor and 20 units of capital whereas the rest of the world
has 100 units of labor and 60 units of capital. Is the U.S. labor abundant? Is the U.S. capital abundant?
2. Assume that the tables below give combinations of the number of bottles of Kahlua and bottles of champagne that
France and Mexico would be able to produce in one week using equivalent amounts of resources.
Mexico France

champagne Kahlua champagne Kahlua

10 0 50 0
8 2 40 5
6 4 30 10
4 6 20 15
2 8 10 20
0 10 0 25



a. Which country has an absolute advantage in the production of champagne?
b. Which country has an absolute advantage in the production of Kahlua?
c. Which country has a comparative advantage in the production of champagne?
d. Which country has a comparative advantage in the production of Kahlua?
3. Consider the following domestic supply and demand schedules for desk calendars:
demand supply

price quantity price quantity

$5 0 $5 15
4 2 4 12
3 4 3 9
2 6 2 6
1 8 1 3
0 10 0 0


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Suppose that the country opens up to free trade and that the world price of desk calendars is $1. Calculate the net
effects on consumers surplus, producers surplus, and national welfare of this move to free trade in desk calendars.
4. Using the production possibilities curve/indifference curve diagram, illustrate and explain why it is beneficial for
a country to move from autarky (no international trade) to free trade. Be sure to indicate and discuss the old and new
production and consumption points on your diagram


Lecture 2 - Winners and Losers from International Trade
from last time
immiserizing growth
Rybczynski theorem
winners and losers within a country
Stolper-Samuelson theorem
factor price equalization theorem
trade and income inequality
Leontief paradox
trade and jobs
trade and technology

From Last Time
How is the world price determined? By supply and demand in the international trade market.

The world price equates the demand for imports with the supply of exports.

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Immiserizing Growth
Specializing more in producing goods for export can make the whole nation worse off. Why? Exporting more of a
good lowers its price on world markets, so revenues from exports may fall.

Suppose Brazil expands its
capacity to grow coffee
beans. The supply of
coffee will increase and the
price will fall. Production
moves from A to C and
consumption from B to D.
Brazil is now on a lower
indifference curve.
growth must be biased towards export sector
demand for the exports must be price inelastic so that the increase in supply causes a large fall in price
country must be already heavily exporting the good so that the fall in price offsets the gains from the
increase in supply


Rybczynski Theorem
If the terms of trade are fixed, the growth of one factor of production reduces the output of one good.
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The growth of one factor
relative to others raises the
output of the sectors using
it intensively and reduces
the outputs of the other
sectors. The expanding
sector out-competes the
other sectors for factors of
production. This outcome
is referred to as Dutch
disease where the
development of the natural
gas industry limited the
development of the
manufacturing sector.



Winners and Losers within a Country
Trade does hurt large groups within an economy. We can use the Heckscher-Olin theory to examine the effects of
trade on factor prices. Suppose that wheat is cheap and cloth is expensive in the U.S. and that trade opens up with
the rest of the world.
U.S. exports wheat and imports cloth
the price of wheat rises and cloth prices fall in the U.S.
the U.S. produces more wheat and less cloth
shifts in the demand for factors of production
o wheat: big increase in the demand for land and an increase in the demand for labor
o cloth: decrease in the demand for land and a big decrease in the demand for labor
3. in the short run, factors are unable to move between sectors
rise in rents on wheat-growing land; rise in wages for farm workers
fall in rents on cotton-growing land; fall in wages for textile workers
4. in the long run, factors are mobile between sectors
rise in rents on all land (compared to pre-trade levels)
fall in wages for all workers (compared to pre-trade levels)
in the rest of the world, opposite changes happen so that rents fall and wages rise in the rest of the world in
the long run
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So, some are absolutely better off and some worse off as a result of free trade.

Stolper-Samuelson Theorem
assumptions:
1. 2 goods (wheat and cloth)
2. 2 factors of production (land and labor)
3. perfect competition
4. full-employment
5. wheat is land-intensive and cloth is labor-intensive
6. factors are mobile between sectors but not countries
7. trade raises the relative price of wheat
Under assumptions (1)-(7), moving from no trade to free trade unambiguously raises the returns to the factor used
intensively in the rising-price industry (land) and lowers the return to the factor used intensively in the falling-price
industry (labor), regardless of which goods the sellers of the two factors prefer to consume.
The more a factor is specialized into the production of exports the more it gains from trade; the more a factor is
specialized in the production of importable goods, the more it stands to lose from trade.

Factor Price Equalization Theorem
assumptions:
1. 2 factors of production (land & labor), 2 commodities, and 2 countries
2. competition
3. factor supplies are fixed and immobile between countries
4. full employment
5. no transportation costs
6. no tariffs or other barriers to trade
7. production functions for each industry are the same between countries
8. no economies of scale
9. factor-intensities are the same at all factor-price ratios
10. both countries always produce both goods
Under assumptions (1)-(10), free trade will equalize factor prices so that all laborers will earn the same wage rate
and all units of land will earn the same rent in both countries.
Suppose that labor is scarce. The country will import labor-intensive products. The demand for labor in labor-
intensive industries falls. So, wages fall in the scarce labor country.
Where labor is cheap, the country will export labor-intensive products. The demand for labor there rises, so wages
go up in the cheap labor country.
Trade is a substitute for the migration of labor.

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Trade and Income Inequality
Trade has been blamed for the growing gap between the wages of skilled and unskilled workers in the U.S. The
rising wage differential should lead employers to decrease the proportion of skilled workers and increase the
proportion of unskilled workers. In reality, nearly all industries have employed an increasing proportion of skilled
workers.

Leontief Paradox
If the U.S. is capital abundant, it should be exporting capital-intensive goods and importing labor-intensive goods.
Leontief found that the U.S. was exporting labor-intensive goods and importing capital-intensive goods. The U.S. is
actually abundant in skilled labor and farmland. This is consistent with the U.S. pattern of trade.

Trade and Jobs
U.S. export industries involve more jobs than do U.S. import-competing industries.
Cutting imports will lead to a fall in exports.
1. exports use importable inputs
2. foreigners who lose our business cannot buy so much from us
3. foreign governments may retaliate
Therefore, raising trade barriers will bring a net loss of U.S. jobs.
Lowering existing trade barriers will bring a net job loss because current barriers are concentrated in the most labor-
intensive import competing industries such as textiles and footwear.

Trade and Technology
When a product is invented it needs to be perfected and requires advanced technological inputs. Production is best
done in the country where the product was invented. Once a product becomes standardized and knowledge plays
less of a role and production moves overseas eventually to cheap labor LDC's.


Lecture 3 - Trade and Economies of Scale
from last time
trade facts
shifts in demand
external economies
monopolistic competition
gains and losses from opening up trade
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From Last Time
The Stolper-Samuelson theorem simply says that a move to free trade benefits resources used intensively in
the export sector and hurts the resources used intensively in the import-competing sector.
The Factor Price Equalization theorem says that, under certain assumptions, resources prices will be the
same everywhere under free trade. For example, NAFTA ought to encourage the importation of unskilled
labor-intensive products from Mexico into the United States. The demand for unskilled labor in Mexico
will rise, causing wages to go up there. The demand for unskilled labor in the U.S. will fall due to the
competition from imports. So, the demand for unskilled labor in this country will fall along with wages.
Under certain assumptions, wages in the U.S. and Mexico will eventually be the same.
There is a relationship between government budget deficits and the trade deficit. The budget deficit raises
interest rates. Higher interest rates attract foreign investors, but to invest here they need dollars. The
resulting higher demand for dollars raises the exchange rate value of the dollar. A stronger dollar makes
U.S. products more expensive for foreign buyers and foreign products cheaper to American buyers. So, we
export less and import more. The result is a bigger trade deficit.
The idea behind immiserizing growth is that if a country experiences growth in its export sector, the
resulting increase in supply will push down the price of its exports. Even though it is exporting a larger
quantity, the price might fall so much that its revenues for exports will be smaller than before.

Trade Facts
1. Over the last 30 years, a rising share of world trade has been in knowledge intensive products.
2. Comparative advantage in knowledge intensive products shifts rapidly.
3. Trade between industrial countries rose from 45% to 55% of world trade.
4. Intra-industry trade has grown fastest.


Shifts in Demand
Income growth shifts demand toward luxuries, and knowledge-intensive goods and product variety are both
luxuries.

External Economies
If demand were the whole story, the relative price of luxuries should have risen, but it hasn't.
Economies of scale exist when an x% increase in all inputs leads to a more than x% increase in output. With
economies of scale, average costs drop as output increases. Therefore, when demand increases, price can actually
fall.
One source of economies of scale is external economies. These are the productivity gains and cost reductions that an
individual firm reaps from the expansion of other firms in the same industry. In a knowledge-intensive industry, new
knowledge is available to every firm either as direct information or as knowledge carried by skilled workers
changing firms, e.g. New York's garment district, Silicon Valley.
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With external economies, the more an industry expands its scale of production, the lower each firm's costs fall.
When industry output rises, average costs for all firms fall.

Initially
the
industry
is at point
A when
new
export
business
increases
demand.
The price
initially
rises
causing
firms to
produce
more
output.
This is
when the
external
economie
s kick in.
The
expansio
n of
output
lowers
costs and
shifts the
industry
supply
curve to
the right.
Producer
s surplus
has risen
so
domestic
producers
gain. The
price falls
so
consumer
s benefit
and
foreign
producers
lose.
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The idea is that the country gained access to export markets and external economies magnified its success. The first
country to gain access to new markets and supply them captures a big expansion of exports and lowers its costs.
Comparative advantage can be acquired from historical luck or government policy.

Monopolistic Competition
Internal economies occur when expanding the firm's own scale of operation cuts only its average costs. Internal
economies tend to lead to imperfect competition.
characteristics of monopolistic competition
1. many buyers and sellers
2. different products
3. free entry and exit
4. perfect information
In a monopolistically competitive market, firms use product differentiation more than price to compete. Toothpaste
is basically toothpaste, but consumers are convinced that Crest is different than Aim. So, the makers of Crest have a
monopoly in the market for Crest while the makers of Aim have a monopoly in the market for Aim. In the short run,
monopolistic competitors can earn economic profits. They produce the quantity of output at which MR = MC.

Entry into the market causes the demand curve for all other competitor's products to decrease. New products
are introduced as long as economic profits are positive. In the long run, free entry and exit allows only for
normal profits.


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Suppose
an export
market
opens up
so that
the
demand
curve
shifts up
to the
right.
The firm
is able to
earn
above-
normal
profits
which
attract
new
firms.
The
demand
curve
shifts
down to
the left
and the
firm ends
up at
point B.
The price
has fallen
so
consume
rs gain
and
foreign
producer
s lose.
There is
no long
run
change in
profits so
there is
only a
temporar
y gain
for
domestic
producer
s.

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Economies of scale do not determine comparative advantage but do translate any comparative advantage into lower
prices and a greater expansion of output and trade.

Gains and Losses from Opening Up Trade

competition external economies monopolistic competition
Exporting Country gain gain gain
producers gain gain temporary gain
consumers lose gain gain
Importing Country gain gain gain
producers lose lose lose
consumers gain gain gain
Whole World gain gain gain



Lecture 4 - Protectionism
from last time
tariffs
effective rate of protection
indifference curve analysis of a tariff
quotas
other barriers to trade
costs of trade barriers
arguments for protection

From Last Time
Firms that lose profits due to imports may indeed shut down.
Imperfect competition is a generic term encompassing monopoly, monopolistic competition, and oligopoly
Exporters gain from trade while import-competing firms lose profits. So, those hurt by imports often seek
trade protection.
Trade, whether with perfect competition or economies of scale, benefits the nation as a whole. The impact
on particular groups differs under the 3 cases.
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The important thing about trade with external economies is that an expansion of output due, say, to the
opening of an export market, lowers average costs. This, in turn, lowers the price. Consumers in both the
exporting and importing country gain from the lower price.
In the short run, the wages, interest, rent, and profits paid to the resources in the export sector do rise
following a move to free trade. The payments to factors in the import-competing sector fall in the short run.
In the long run, the payments to factors of production used intensively in the export sector rise and
payments to the factors used intensively in the import-competing sector fall. This is the Stolper-Samuelson
theorem.
Total demand is equal to home demand, the demand of domestic consumers, plus foreign demand, demand
from foreign consumers.
The assumption of free entry drives economic profits for monopolistic competitors to zero. As long as there
are economic profits available, firms will enter the market and steal existing firms' customers.

tariffs
A tariff is a tax on imports.

The tariff raises the domestic price above the world price. Consumers are losers because they pay a higher
price and buy less of the product. Since the domestic price rises, domestic firms increase output and see
their profits rise.

Effective Rate of Protection
Tariffs also have an effect on industries that sell material inputs to the protected industry, and firms in the protected
industry are affected by tariffs on their inputs. This complicates looking at who is being protected by a set of tariffs.
The effective rate of protection is the percentage by which the entire set of a nation's trade barriers raises the
industry's value added per unit of output.
Suppose that under free trade, the input costs of a bicycle are $220 and the world price is $300. Value added equals
$80.
Suppose a 10% tariff is imposed on bicycle imports so the domestic bicycle price rises to $330 and a 5% tariff is
placed on its inputs so that input costs rise to $231. Value added now equals $99.
The effective rate of protection for the bicycle industry equals (99-80)/80 or 23.8%, not the 10% nominal tariff. This
tells us that income rises by 23.8% in the bicycle industry.

Indifference Curve Analysis of a Tariff
A tariff distorts consumption so we end up on a lower indifference curve. Production of the import good rises and
that of the export good falls.

quotas
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A quota is a limit on the amount of imports. For example, the U.S. allows 1 million tons of sugar to be imported but
no more than that.

The tariff has the same effects on producers and consumers as a tariff. The domestic price rises above the
world price.

Other Barriers to Trade
regulatory barriers: health & safety standards; government procurement policies
export barriers: quotas & duties
exchange controls

Costs of Trade Barriers
industry consumer losses per job saved
orange juice $240,000
textiles 42,000
color TV's 420,000
automobiles 105,000
specialty steel 1,000,000
sugar 60,000


Arguments for Protection
1. optimal tariff
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2. spillover effects
3. creation of domestic jobs
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4. infant industries
5. infant government
6. national pride
7. income redistribution
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8. national defense
9. balancing the balance of trade
10. creation of a "level playing field"
11. strategic trade policy


Lecture 5 - Strategic Trade Policy and Trade Blocs
from last time
strategic trade policy
export subsidies
countervailing duties
dumping
manufacturing leadership
trade blocs
NAFTA
trade embargoes

From Last Time
Anything a tariff can do to encourage domestic production a subsidy can do at a smaller net national loss
because, unlike the tariff, a subsidy does not raise the price to domestic consumers.
The world price is set by the supply and demand for imports. With an optimal tariff, the world price falls
because the higher domestic price due to the tariff causes consumers to purchase less. So, even though
consumers are paying a higher price because of the tariff, the nation gains because it is able to purchase the
product from other countries at a lower world price.
Import quotas would cut imports first. The decrease in supply would raise the price causing domestic firms
to increase production.
We are going to discuss the politics of trade after the exam. Political influence determines which industries
receive trade protection.
The spillover argument for trade protection is based on the idea that an industry generates benefits for other
industries for which the industry is not compensated. Maybe certain industries are not fully compensated
for their research and development expenditures. The argument is typically made for technologically
progressive industries where firms can capture the results of other firms' research by simply taking apart a
product to see how it works. Trade protection can both compensate this industry for the spillover benefits it
generates and encourage more production and more spillover benefits.
Indifference Curve Analysis of a Tariff
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Under free
trade, the
country
produces at
point A and
consumes at
point B on
indifference
curve I
1
. A tariff
raises the
domestic price
of the import
good. The slope
of the price ratio
line is the price
of the export
good divided by
the price of the
import good. So,
the tariff flattens
out the price
ratio line. The
economy now
produces at
point C and
consumes at
point D on
a lower indiffer
ence curve, I
2
.
The level of
imports falls as
domestic
production of
the import good
rises. The fall in
welfare is due to
the distorting
effects of the
tariff on
consumption.


Strategic Trade Policy
Strategic trade policy refers to the aggressive support by a nation's government of the international competitive
position of home firms.
Imagine that a new technology will soon be available to produce a new kind of passenger aircraft and that there are
two firms (Boeing and Airbus) in a position to develop that technology. The economics are such that only one firm
can enter the market profitably: profits are 100 if only one firm enters; if both enter, they each lose 10.
26


What will happen? Suppose Boeing enters first, Airbus will stay out and Boeing reaps the profits.
Suppose that a group of European governments promise Airbus a subsidy of 20 if it enters the market, regardless of
what Boeing does.

27

Whatever Boeing does, Airbus finds it profitable to enter. But, this means that if Boeing enters it will lose money.
So, Boeing doesn't enter and Airbus does.
problems with strategic trade policy
government must estimate the potential payoff of each course of action
the behavior of rival governments must be anticipated
many interest groups will compete for the governmental assistance although only a small number of
industries can be considered potentially strategic
subsidizing one domestic industry takes resources away from others

Export Subsidies

An export
subsidy
raises the
domestic
price above
the world
price by the
amount of
the subsidy
because
domestic
firms would
be unwilling
to sell at
home for
less than
they would
receive if the
product was
exported. As
a result,
consumers
lose areas A
and B.
Producer
surplus rises
by areas
A+B+C+D+
E. The cost
of the
subsidy to
the
government
equals areas
B+C+D+E+
F. Overall,
there is a net
national loss
equal to
28

areas B+F.

Countervailing Duties
GATT's rules hold that export subsidies on manufactured goods are illegal for developed countries and an importing
country can retaliate by imposing countervailing import duties.

The
export
subsidy
increases
the
supply of
imports
to
S
2imports.
The subsidy
lowers the
price in the
importing
country.


importers exports world
with export subsidy gain X+Y lose X+Y+Z lose Z
with countervailing duty lose Y gain Y+Z gain Z
both together gain X lose X 0
A countervailing duty big enough to offset the export subsidy shifts the supply curve back to S
1
imports
. The
countervailing duty hurts the importing country while it is beneficial for the world as a whole.

Dumping
Dumping is a form of price discrimination. It occurs when an exporting firm sells at a lower price in a foreign
market than it charges in its home-country market. Predatory dumping has the purpose of eliminating competitors so
as to later raise prices.
29

A firm will maximize profits by charging a lower price to foreign buyers if it has greater monopoly power in its
home market than abroad and if buyers in the home market cannot import the good cheaply.

A price discriminating monopolist maximizes profits by setting marginal revenue in each market equal to marginal
cost. The price will be higher in the market with the less elastic demand.
U.S. firms may bring dumping charges against foreign competitors. If the Commerce Department finds that
dumping has occurred and the U.S. International Trade Commission finds that U.S. firms have been injured, an extra
import tax equal to the proven price discrepancy is levied.

Manufacturing Leadership
The purpose of strategic trade policy is to gain international leadership. Manufacturing is the usual focus because
manufacturing has more potential for external benefits and economies of scale. We can look at relative prices to
determine leadership.
Japan caught up to the U.S. in the steel industry by the 1970's because of differences in wages rates, productivity,
and the costs of raw materials. Government policies played no role.
In automobiles, high union wages and lagging productivity were the reasons why U.S. auto makers fell behind.
Japanese government policies played a secondary role.
The Japanese government targeted electronics for rapid export growth by underwriting research and development
spending and by protecting the home market.

30

Trade Blocs
An economic bloc consists of two or more countries joined together into a closer economic union than each has with
the rest of the world.
types:
1. free trade area
NAFTA is an example of a free trade area. In a free trade area member countries trade freely among
themselves but have different policies towards non-members.
2. customs union
Members of a customs union adopt common tariff policies towards non-members.
3. common market
Members allow full freedom of labor and capital migration among themselves in addition to having a
customs union.
4. economic union
Members unify all their economic policies as well as policies toward trade and factor migration.

Are preferential trade agreements beneficial? Since they represent a move towards free trade, preferential trade
agreements create trade (which is good). However, since preferential trade agreements discriminate against non-
members, they may divert trade away from the low cost supplier (which is bad). The above diagram represents the
U.S. market for some product on which a tariff is levied. Since China is the low cost supplier, we import the product
from China and pay the Chinese price plus the tariff. NAFTA eliminate tariffs on Mexican imports but leaves the
tariff on imports from China. We now import the product from Mexico. The level of imports rises but trade has been
diverted away from the low cost supplier, China.

NAFTA
NAFTA provides for the elimination of tariff and most non-tariff barriers to trade and investment on trade between
the U.S., Canada, and Mexico. Opponents point to the fact that average hourly compensation in Mexican
manufacturing is only 14% of the U.S. figure and argue that low Mexican wages and poor enforcement of Mexican
labor standards will deprive U.S. workers of jobs and drive down U.S. wages.
But, high U.S. labor productivity pays for high U.S. wages. And, opponents ignore the jobs created by increased
trade with Mexico. NAFTA should stimulate Mexican income growth, so there will be more U.S. exports to Mexico.
Exports to Mexico support 122,000 more jobs today than in 1993. Only a couple of thousand Americans have been
certified as having lost their jobs due to NAFTA.
NAFTA opponents also argue that Mexico has lower environmental standards and that this causes U.S. factories to
move to Mexico. Also, NAFTA gives Mexico the right to challenge the strict U.S. environmental regulations.
31

In reality, Mexican standards are similar to those of the U.S. and rising Mexican incomes will lead to demand for
more environmental protection. And, any challenge to U.S. environmental standards must be based on the absence
of scientific evidence justifying a trade barrier. In the end, NAFTA will probably cause Mexico to produce fewer
chemicals, rubber, and plastics (all dirty items) and more agricultural and labor-intensive products (both relatively
cleaner).
U.S. exports to Mexico grew by 36.5 percent (or $15.2 billion) from 1993 to a record high in 1996, despite a 3.3
percent contraction in Mexican domestic demand over the same period.

Trade Embargoes
A trade embargo is a complete ban on trade. The majority of embargoes fail to alter the policies of the target nations.
Consider a total embargo on exports to Iraq.

Haiti: fall in consumer surplus = B+C
Embargoing countries: loss of profits on exports = A
Non-embargoing countries: gain of producer surplus = B





32



Lecture 6 - Negotiating
from last time
the prisoners' dilemma
the rational pigs
negotiating with a deadline
what are the sources of bargaining strength?
commitment
using information strategically
overcoming an informational disadvantage
using an informational advantage
negotiating international trade agreements

From Last time
The supply curve is imports are horizontal when we assume perfect competition. The nation can buy all the
imports it wants at the world price.
Sony was not guilty of dumping because the Commerce Department decided it wasn't.
Governments use trade embargoes because they are a relatively inexpensive way of trying to get a foreign
government to change its policy and sometimes they do work.

The Prisoners' Dilemma
A pair of transients, Al Fresco and Des J ardins, has been arrested for vagrancy. They are suspected of complicity
in a robbery, but the evidence is inadequate to convict them. The DA interrogates them in separate cells and
offers them each the following deal. "I f you confess and your friend does not, you will be released and your
friend will have the book thrown at him; and the other way around if he confesses and you do not. I f both
confess, both will receive moderately long sentences. I f neither confesses, both will be convicted of a minor
vagrancy charge." What does rationality dictate that our players do?


Define the equilibrium as the outcome of simultaneously rational decisions by both of the players. An outcome is
not efficient if there is another outcome that both players would prefer. The Prisoners' Dilemma shows that people
who fail to cooperate for their own mutual benefit may be acting perfectly rationally.

The Rational Pigs
33

Two pigs, one dominant and the other subordinate, are put in a box. There is a lever at one end of the box which,
when pressed, dispenses food at the other end. Thus the pig that presses the lever must run to the other end; by
the time it gets there, the other pig has eaten most, but not all, of the food. The dominant pig is able to prevent the
subordinate pig from getting any of the food when both are at the food. Assuming the pigs can reason, which pig
will press the level?

Let's attach some numbers to the game:
6 units of food are delivered whenever the lever is pushed
if the subordinate pig pushes the lever, the dominant pig eats all 6 units
if the dominant pig pushes the lever, the subordinate pig eats 5 units before the dominant pig pushes it
away
suppose the subordinate pig can run faster so, if both press, it gets 2 units of food before the dominant pig
arrives
suppose pressing the lever requires 1/2 unit of food of effort
The subordinate pig's bet response is "don't press" so the dominant pig presses the lever. This game shows that
weakness can be strength in bargaining.

Negotiating with a Deadline
Mortimer and Hotspur are to divide $100 between themselves. Each of the bargainers knows that the game has
the following structure:
Stage 1: Mortimer proposes how much of the $100 he gets. Then either Hotspur accepts it, in which case
the game ends and Hotspur receives the remainder of the $100; or Hotspur rejects it, in which case the
game continues.
Stage 2: The sum to be divided has now shrunk to $90. Hotspur makes a proposal for his share of the
$90. Then Mortimer either accepts it and gets the remainder; or rejects it, in which case each receives
nothing and the game ends.
What will Mortimer demand at the first stage?
Mortimer must imagine the game has reached the second stage. Hotspur is now in a strong position and can demand
almost all of the $90, leaving Mortimer just enough so that he doesn't say no because of spite. This game shows that
the last person to make the offer can capture most of the remaining gains from trade. So, get your offer in before the
deadline so that your bargaining partner has no choice but to accept it.

What are the Sources of Bargaining Strength?
What matters is each bargainer's belief about what price his opponent will find acceptable: what does each bargainer
believe about the other's willingness to settle and about the others beliefs.
1. alternative opportunities: the more attractive a bargainer's alternative opportunities are, the better the
negotiated outcome will be for that bargainer
2. relative costs of delay: the more impatient your opponent is to settle, the better is the agreement you can
hold out for
34

Bargaining games usually have many possible agreements that leave both bargainers better off than at the status quo.
Suppose there is something about the bargaining situation that serves to highlight a particular outcome. Then we
have a focal point, e.g. something highlighted by precedent, mathematical symmetry, suggested by an impartial
mediator.

Commitment
A commitment shapes the buyers expectations of what the seller will settle for.
ways of being inflexible during negotiations:
put reputation at stake
hire an agent to follow publicly known procedures
burn bridges

Using Information Strategically
Bargainers typically do not know exactly the other's valuation, alternative opportunities, costs of delay, and
commitment possibilities. These are all private information.
Suppose a seller has cars for sale which cost the seller $1000 each and that there are two kinds of buyers (50 of
each), one values the car at $1040 and the other, $1100 but the seller cannot distinguish between the two. The seller
makes a take-it-or- leave-it offer. What price should he charge?
Private information means that some mutually beneficial sales are not made.
Private information can be a source of bargaining power, resulting in extra gains going to the holder of the
information. Suppose the lower valuation is $1060, then the seller charges $1060 and the high-valuation customers
get a windfall from their private information.

Overcoming an Informational Disadvantage
Screening means structuring the negotiations to induce the other party to reveal private information.
Suppose delay is costly to the buyer, e.g. second period gains are valued at 80% of first period gains. The seller can
ask for a relatively high price in the first period and drop the price in the second period to $1060. Purchasing in the
second period yields a high-valuation buyer (0.8) (1100-1060) = $32. So, the best first period price is $1068. Then
all the high valuation buyer purchase the car in the first period yielding the seller profits of $68 a car. The price in
the second period is $1060. The 50 low valuation customers purchase the car at this price. Total profits are $6400.
The seller achieves higher profits with a screening strategy.

Using an Informational Advantage
35

Consider the market for used cars. A potential buyer cannot tell whether a used car is a good car that will run well or
is a lemon that will never run right. After one has owned a car for a while, one learns something about the quality of
the automobile. So, the seller knows more about the quality of a used car than the buyer.
Since the buyer cannot tell the difference between a good and a bad car, both good and bad cars must sell for the
same price somewhere in between the low value of a lemon and the high value of a good car. Suppose that buyers
know that 60% of used cars are lemons. A buyer is willing to pay $2000 for a good car and $1000 for a lemon.
Sellers are willing to accept $1500 for a good car and $500 for a lemon. Since the price will reflect the average car
quality, all used cars will sell for $1400.
Sellers of lemons are more than happy to receive a price higher than the lemon's low quality, but sellers of good cars
will be unwilling to sell at a price below its high value. Therefore, only lemons will be offered for sale.
The seller of a good car must communicate information about the car's quality in a way that the buyer will believe.
The seller of a good car must find a signal. A signal is an action that is more costly if you are lying than if you are
telling the truth.
brand names
guarantees and warranties

Negotiating International Trade Agreements
GATT (General Agreement on Tariffs and Trade) has successfully lowered tariffs but it has not removed other kinds
of trade barriers such as government regulations and subsidies. The U.S. has threatened to restrict entry into the U.S.
market in retaliation against nations that it perceives have unfairly closed their borders to U.S. firms if the offending
barriers are not removed. What determines the success or failure of such aggressive bargaining tactics?
International trade negotiators place a positive value on their nation's trade restrictions. So, setting up trade
restrictions has a Prisoners' Dilemma character with both nations imposing high tariffs.
international agreements must be self-enforcing
repeated game nature of international agreements
Retaliation can be used to enforce agreement in repeated games. If one country pursues its immediate interests,
departing from a pre-existing agreement to maintain low tariffs, then the other country retaliates by increasing its
own tariffs. This is allowed under GATT.
GATT and the World Trade Organization serve to establish focal points, e.g. principle of reciprocity under which
countries trade tariff reductions so as to achieve a perceived balance of concessions. But, nontariff barriers are more
difficult to measure and there is no common definition of how to measure them. No focal points (such as equal
reductions) are available. This explains GATT's inability to remove non-tariff barriers to trade.
Section 301 of the 1974 Trade Act enables the President to retaliate against foreign countries' trade-restricting
policies that reduce U.S. exports. The Super 301 provision of the 1988 Omnibus Trade and Competitiveness Act
strengthened the retaliatory provisions. Super 301 threaten to withhold access to the U.S. market unless our demand
is met. This gives the U.S. bargaining power with countries that are very dependent on sales to us. The ability to
counter-retaliate weakens U.S. bargaining power. For example, the U.S. did not put the EC on the 1989 list of
"unfair" traders while India and Brazil were.
36

Aggressive bargaining actions are likely to be successful if they are addressed at countries
1. with small counter-retaliation ability
2. that would suffer significant harm from having their market access limited


Lecture 7 - Political Economy of Trade
from last time
history of trade policy
politics of trade barriers
Japan's development strategy
effects of trade on the environment
pollution-haven hypothesis
external costs dolphin-safe tuna
global environmental issues

From Last time
When there is a deadline and any kind of deal is better than no deal at all, the last person to make an offer
will be able to capture most of the gains from trade. So, in the class example, Hotspur got to make the take-
it-or-leave it offers on how to divide $90. He could propose an $89/$1 split. Mortimer knows all this so, at
the first stage, he offers Hotspur $90 of the $100 to be divided. Hotspur accepts and both are better off than
with the $89/$1 split.
How will the dominant pig remain dominant if the subordinate pig always gets the better deal? In a one-
time game, this isn't a concern. In a repeated game, the dominant pig and the subordinate pig could
eventually reverse roles or find themselves evenly matched and in a Prisoners' Dilemma.
Do other countries have plans similar to Super 301? I don't know, but I assume they do.

History of Trade Policy
Tariffs were originally designed for revenue. The U.S. used a tariff of 5% as its earliest source of government
revenue. Alexander Hamilton recommended protective tariffs to develop infant industries. The U.S. tariff rate rose
to 25% by 1815. The South depended on imported goods and managed to block the really substantial protective
tariffs favored by the North until the Civil War. The ascendancy of northern manufacturing interests after the Civil
War ushered in a long period of high tariffs. With the Tariff of 1897, tariffs reached an average of 57%. In 1913, the
Democrats lowered tariffs to 29% but Republicans returned to power in 1921 and passed high agricultural and
manufacturing tariffs.
The Smoot-Hawley tariff (1930) placed an average tariff of 59.1% on 800 items in all sectors. 12 large trading
countries retaliated with their own heavy tariffs. Total imports of 75 countries had been $3 billion a month in
January 1929 but just $500 million in March 1933. U.S. exports were only 53% of their 1929 volume in 1932.
37

The Reciprocal Trade Act of 1934 provided for tariff cuts only in return for tariff cuts by our trading partners. It also
set up most favored nation status: if the U.S. cut a tariff to one nation it would cut them to all. Reciprocal tariff
reductions are available on a non-discriminatory basis. The average tariff level fell from 53% in 1934 to 11% in
1962.
The major force for free trade in the post-WWII era has been GATT, the General Agreement on Tariffs and Trade.
Member of GATT agreed to three things: (1) MFN status extended to all members, (2) quotas are prohibited, and (3)
members agree to submit trade disputes to non-binding GATT panels. The most important activity has been its
sponsorship of conferences of multilateral trade negotiation.
The Uruguay round created the World Trade Organization. The WTO is the successor to GATT and is designed to
oversee global trade treaties, to provide a forum in which future trade deals will be discussed, and to resolve
disputes. Under GATT, suppose that the U.S. complains that Japan is blocking imports of U.S. widgets and a GATT
panel agrees. If Japan dissents from that finding, U.S. cannot legally retaliate with trade sanctions. With WTO, a
finding that a country violated a trade accord would stand unless all 132 member nations voted it down.

Politics of Trade Barriers
Trade policy is an outcome of the political process. Any change in policy produces winners and losers who have an
incentive to lobby for a legislative outcome in their own favor. On the other side, politicians need votes and money
to stay in office. These are the sources of supply and demand for trade policy.
Those who gain from free trade are numerous and gain only a little while those who gain from protection are highly
concentrated in well-defined industry groups. It is easier, therefore, for protectionists to organize.

Japan's Development Strategy
high saving and investment rates; high investment in training and education
MITI targeted industries with government-sponsored research, R&D subsidies, preferential access to
capital, and temporary trade protection
long-term transactions based on tradition are more common than those based solely on the market
Keiretsu (the word means system) are affiliations between firms.
1. horizontal
2. vertical
3. distribution
Keiretsu can create entry barriers for newcomers and engage in anti-competitive practices which reduce imports.

Effects of Trade on the Environment
It is sometimes argued that trade is bad for the environment because trade promotes economic growth and economic
growth leads to environmental degradation in the form of pollution, depletion of resources, and degradation of the
scenic environment.
38

In developing countries, rural areas have seen large-scale soil erosion and water quality deterioration, deforestation,
and declining soil productivity. Urban areas have experienced seriously diminished air and water quality.
But, growth enables governments to tax and raise resources to reduce pollution and protect the environment. We see
more environmental protection in rich countries.

Pollution-Haven Hypothesis
Another environmental objection to trade claims that since environmental standards are less strict in developing
countries, these LDC's will become pollution havens: places where firms can move and operate without the strict
environmental controls of the developed countries.
testing the hypothesis:
look at environmental regulations
compare emissions of firms before and after they have moved
look at how "dirty" industries have grown or declined in different countries


External Costs
Economic efficiency occurs at the level of output at which the marginal social benefits (MSB) equal the
marginal social costs (MSC). Demand and supply determine equilibrium prices and quantities in a free
market. A free market will result in efficiency when (1) the demand curve is the same as the MSB curve and
(2) the supply curve is the same as the MSC curve.

Economists make a distinction between private costs and external costs. Private costs are borne by someone
involved in the transaction that created the externality. External costs are borne by someone not involved in the
transaction. The same distinction is made between private and external benefits.
Social costs = private costs + external costs
Social benefits = private benefits + external benefits
When there are external costs or benefits, a free market produces too much or too little of the good.

When there is a harmful production externality, the production of a good imposes external costs. The marginal social
costs exceed marginal private costs by the amount of the external costs. When choosing how much to produce, firms
are only concerned with their own costs, the marginal private costs (MPC). The market supply curve is the MPC
curve. Although the firm is unconcerned with the external costs, society counts these costs as part of the cost of
producing the good. So the free market results in too much of the good being produced.
policies for externalities
1. regulation: allow the externality to the point where MSC = MSB
2. taxes or subsidies: levied on polluting activities to make MPC = MSC
39

3. pollution permits: firms are required to possess permits for each unit of pollution emitted and these permits
can be bought and sold
4. assign property rights: the Coase theorem says that costless bargaining leads to the efficient level of the
externality


Dolphin-Safe Tuna
Mexican fishermen use nets that snare lots of dolphins along with the tuna. The United States attempted to ban
imports of Mexican tuna because the dolphins have mouths that are contorted into nice smiles, making them look
cute. A GATT panel ruled against the U.S. ban. Let's analyze this case as an externality.
The problem is that foreign production of tuna is imposing an external cost on us. The best response to an external
cost is a tax on the producer, but the U.S. lacks the ability to tax Mexican fishermen. The next best response would
be to tax the consumers of Mexican tuna with a tariff on tuna imports.

Global Environmental Issues
ozone depletion
global warming
biological diversity



Lecture 8 - Foreign Exchange
from last time
balance of payments accounts
exchange rates
uses of foreign exchange markets
relationship between spot and forward exchange rates
currency options

From Last time
Are there any cases where the external costs can be good?

40

How much do all tariffs together cost us a year? I haven't seen any figures for all tariffs put together. One
study estimated that trade restrictions on only 3 goods - clothing, sugar, and automobiles - caused increased
consumer expenditures of $14 billion in 1984. That's about $140 a household.
Economists make a distinction between private costs and external costs. Private costs are borne by someone
involved in the transaction that created the externality. External costs are borne by someone not involved in
the transaction. Marginal external costs are the additional external costs resulting from producing one more
unit of output.
Does India produce a lot of CFC's that it matters globally? Yes, because of it large population. India is the
only major CFC-producing country outside the Montreal Protocol.
What is an example of a distribution keiretsu? This type is found in the distribution of automobiles,
consumer electronics, cosmetics, pharmaceuticals, cameras, and newspapers.

Balance of Payments Accounts
An open economy engages in international trade and international borrowing and lending. A country's spending
need not equal its production in every period. By importing more than it exports and borrowing from abroad to make
up the difference, a nation can temporarily spend more than it produces.
The balance of payments is a record of a country's trade in goods, services, and financial assets with the rest of the
world.
Any international transaction involves two opposite flows of equal value:
1. credit - flow for which the country is paid, e.g. exports, sale of assets
2. debit - flow for which the country must pay, e.g. imports, purchase of assets

Each transaction is recorded twice in the balance of payments: once as a credit and once as a debit. This is called
double-entry bookkeeping. As a result, the balance of payments must balance.
The balance of payments consists of two parts: (1) the current account, which measures the country's trade in
currently produced goods and services, and (2) the capital account, which records trade between countries in
existing assets.
Click here to go to the balance of payments accounts for the U.S.
current account
The current account balance = exports of goods, services, and investment income
- imports of goods, services, and investment income
+ net unilateral transfers
Services include transportation, tourism, insurance, education, and financial services. Investment income includes
interest payments and dividends people receive from assets owned outside of their own country. A unilateral transfer
occurs when one party gives something but receives nothing in return, e.g. foreign aid.
capital account
A capital inflow occurs when the home country sells an asset to another country, e.g. Rockefeller Center is sold to a
Japanese company.
41

A capital outflow occurs when the home country buys an asset from abroad, e.g. an American obtains a Swiss bank
account.
The capital account balance = capital inflows - capital outflows
A country has a capital account surplus when its residents sell more assets to foreigners than they buy from
foreigners.
Current Account balance + Capital Account balance = Zero
When a country runs a current account deficit, it means that it received fewer funds from its exports than the funds
paid for imports. To finance this deficit, it must sell its assets to the foreigners. So, a current account deficit must be
accompanied by a capital account surplus. The balance of payments must balance.
Included in the capital account is the official settlements balance. The official settlements balance records
transactions conducted by central banks. It measures the net increase in a country's official reserve assets, assets that
can be used in making international payments. The official settlements balance is called the balance of payments.

Exchange Rates
Foreign exchange is the money of another country. The exchange rate is the price of one country's currency in terms
of another country's money. For example, say, $1 = 5.6415 French francs.
Click here for the 10AM foreign exchange rates

Flexible exchange rates are determined by supply and demand in the foreign exchange market; fixed exchange rates
are officially determined.
system dollar rises in value dollar falls in value
flexible appreciation depreciation
fixed revaluation devaluation


Uses of Foreign Exchange Markets
spot vs. forward markets
1. clearing
Foreign exchange markets allow people to end up holding the national currency they need to purchase
goods and services.
42

foreigners demand dollars to
o buy U.S. goods and services
o buy U.S. assets
Americans sell dollars to
o buy foreign goods and services
o buy foreign assets

2. hedging
Hedging refers to trying to reduce the risk from exchange rate fluctuations. You are fully hedged when you
have neither a net asset nor a net liability position in an asset.
Suppose you receive 1 million lira. You now have an asset position in lira. You want to hold onto this
money for 6 months but you would be exposed to exchange rate risk. You can convert the lira into dollars
and remove that risk. Hedgers avoid gambling on the future of exchange rates.
You can use the forward market to remove risk also. You can hedge your lira risk by entering into a
forward contract to sell 1 million lira in 6 months at an exchange rate agreed to today. The obligation to sell
the lira gives you a liability position to offset your asset position. Now, you are fully hedged.
3. speculation
Speculation is gambling on the future of exchange rates. It refers to the act of taking a net asset or net
liability position in a foreign currency. Speculators attempt to profit from price changes and therefore
provide liquidity for hedgers.
Speculators can use derivatives to outguess the market. Suppose you believe that the Dutch guilder will sell
for 25 cents in 90 days while the 90-day forward rate is 51 cents. You can sign a forward contract giving
you the right to sell, say, 10 million guilders at 51 cents per guilders. If you are right you have a contract
requiring a trader to give you $5,100,000 in exchange for 10 million guilders. On the spot market you will
be able to purchase 10 million guilders for $2,500,000. You'll earn a profit of $2.6 million.

Relationship Between Spot and Forward Exchange Rates
Suppose you have $10,000 to invest and you've narrowed your investment options to (1) a U.S. government bond
with an 8% interest rate or (2) a German government bond with a 6% interest rate. Which bond is the better
investment? It all depends on what you expect to happen to the exchange rate between dollars and German marks.
You are exposed to exchange rate risk if you purchase the German bond.
2 ways of dealing with risk:
1. contract now to convert DM back into $ at the 1 year forward exchange rate - covered (hedged)
2. wait and convert DM into $ at the future spot exchange rate in 1 year - uncovered (speculation)
43

If you invest in the German bond you must turn your dollars into marks now and back again in one year. Suppose
the exchange rate is now $1 = DM 2 or r
s
= $0.50/DM.
$10,000 today = DM 20,000
DM 20,000 + 6% = DM 21,200 after one year
Every $ invested yields (1 + i
for
/r
s
DM in 1 year.
Suppose at the time of investment, you could have contracted to sell DM in the forward market at r
f
= $0.52/DM to
get an assured number of dollars next year. 21,200 DM in one year converted back into $ at the r
f
is $11,024.
Overall, every dollar invested yields (1 + i
for
) (r
f
/r
s
in one year.
If you invest in the U.S. bond, you will have $10,800 after one year.
In general, the choice depends on the sign of the difference between the two returns. Let CD equal the covered
interest differential.
CD = (1 + i
for
) (r
f
/r
s
) - (1 + i)
if CD > 0, invest abroad
if CD < 0, invest in U.S.

So, the German bond is the better investment. This is because the German bond provides two sources of return:
1. interest rate
2. appreciation in the value of the DM
The return on the foreign bond equals the foreign interest rate plus the percentage change in the exchange rate value
of the foreign currency (called the forward premium).
Assets which have identical risk, taxation, and liquidity characteristics ought to have the same return. The U.S. bond
and the German bond should have the same return. Covered interest parity says that CD = 0.
For the bond example, covered interest parity would exist if the percentage change in the value of the DM equaled
the difference in interest rates, 2%. The forward exchange rate would need to appreciate 2% to $0.51/DM.
return on U.S. bond = return on German bond
U.S. interest rate = foreign interest rate + percentage change in the exchange rate value of the foreign currency
r
f
/r
s
= (1 + i)/ (1 + i
for
)
a rise in i causes r
f
to rise (dollar falls in value in forward market)
a rise in i
for
causes r
f
to fall (dollar rises in value in forward market)

Let r
e
s
= expected future spot exchange rate and EUD = expected uncovered interest differential.
44

EUD = (1 + i
for
) (r
e
s
/r
s
) - (1 + i)
if EUD > 0, invest abroad
Uncovered interest parity says that EUD equals 0. A currency is expected to appreciate by as much as its interest is
lower than the interest rate in the other country.
percentage change in the exchange rate = U.S. interest rate - foreign interest rate
if the U.S. interest rate is greater than the foreign interest rate, the dollar is expected to depreciate against
the foreign currency
if the U.S. interest rate is less than the foreign interest rate, the dollar is expected to appreciate
For countries with no capital controls and for comparable short-term financial assets, covered interest parity holds
almost perfectly. It is hard to directly measure r
e
s
, but uncovered interest parity appears to roughly hold.

Currency Options
An options contract gives the rights to buy or sell an asset at a pre-determined price by a predetermined time.
buy a call option
you have a right to purchase an asset at a specified price
buy a put option
you have the right to sell an asset at a specified price
write (sell) a call option
you have an obligation to sell an asset at a specified price
write (sell) a put option
you have an obligation to buy an asset at a specified price
strike price
the predetermined, specified price
expiration date
when the option expires
option premium
fee charged by the option writer

45



Lecture 9 - What Determines Exchange Rates?
from last time
prices and exchange rates
purchasing power parity
factors affecting exchange rates
exchange rate overshooting
foreign exchange policies
European monetary union

From Last time
Can a normal person buy call options in DM? Yes, although the minimum amount may be quite large.
If the spot exchange rate goes up or down, what happens to the forward exchange rate? If the interest rate
parity condition holds, if the spot rate goes up, the forward rate will also have to go up, everything else the
same.
Uncovered interest parity says that a currency is expected to appreciate by the percentage point difference
between the foreign interest rate and the domestic interest rate. Suppose the U.S. interest rate is 6% and the
interest rate on a comparable Japanese security is 8%, then the dollar is expected to rise 2% against the yen.
This makes the return from holding the two bonds equal. Covered interest parity applies the same idea to
the forward and spot rates. For the previous example, covered into rest parity would say that the dollar's
value against the yen in the forward market is 2% higher than the value in the spot market.

Prices and Exchange Rates
The U.S. economy is linked to the rest of the world through exchange rates. An exchange rate is the price of one
national currency in terms of another.
Suppose an American buys a bottle of Kahlua for 85 pesos and that the exchange rate is $1 = 7.9060 pesos. Then,
that bottle of Kahlua costs $10.75.
If the exchange rate goes to $1 = 8.0230 pesos, the dollar appreciates and a bottle of Kahlua now costs
$10.59. Therefore, when the dollar appreciates, foreign goods become less expensive to American
buyers.
If the exchange rate went instead to $1 = 7.5015 pesos, the dollar depreciates and a bottle of Kahlua now
costs $11.33. So, when the dollar depreciates, foreign goods become more expensive to American
buyers.
Suppose A Mexican buys a 6-pack if Yuengling Black and Tan for $5.75. At $1 = 7.9060 pesos, the beer costs 45.46
pesos.
46

When the dollar appreciates to 8.0230 pesos, the beer costs 46.13 pesos. Therefore, when the dollar
appreciates, American goods become more expensive to foreign buyers.
If the dollar depreciates to 7.5015 pesos, the beer costs 43.13 pesos. So, when the dollar depreciates,
American goods become less expensive to foreign buyers.

Purchasing Power Parity
The law of one price says that identical goods should cost the same in all countries. Profit opportunities ensure that
the price of a good is the same all over the world. For example, suppose a yard of cloth costs $10 in the U.S. and the
same yard of cloth produced by a French firm sells for 50 francs. The exchange rate between dollars and francs
should be 50 francs = $10 or 5 francs = $1. If, at the going exchange rate, U.S. cloth is cheaper, the demand for
dollars would go up, raising the value of the dollar.
Purchasing power parity generalizes the law of one price to a group of goods. A basket of goods and services should
cost the same in all countries after converting prices into the same currency.
absolute PPP: r = P/P
for

relative PPP: % change in r = domestic inflation rate - foreign inflation rate
Big Mac PPP
The Big Mac is a collection of ingredients sold all over the world. Hence, it provides a good test of purchasing
power parity. Big Mac PPP is the exchange rate that would leave burgers costing the same in America as abroad. Let
Big Mac PPP be equal to the foreign price in foreign currency divided by the American price in dollars. The foreign
currency is overvalued if Big Mac PPP is greater than the actual exchange rate.
Why does PPP fail?
1. transportation costs
2. barriers to trade
3. non-traded goods - price of a Big Mac reflects more than just the price of its ingredients
4. imperfect competition - able to engage in price discrimination
5. current account imbalances - trade in assets affects supply and demand for currencies


Factors Affecting Exchange Rates
foreigners demand dollars to
buy U.S. goods and services
buy U.S. assets
Americans sell dollars to
buy foreign goods and services
buy foreign assets
47

1. changes in real GDP
2. expected future inflation
3. interest rates
4. shifts in demand
5. change in U.S. money supply
6. change in foreign money supply
7. expected future spot exchange rate


Exchange Rate Overshooting
Exchange rate overshooting occurs when speculators rationally react to news of a change in economic policy by
driving the exchange rate past what they know will be its ultimate equilibrium.
Suppose there is a 10% increase in the U.S. money supply. The value of the dollar will fall by 10% in the long run as
the domestic price level rises by 10%. However, prices are sticky, so it takes time for prices to rise 10%.


r
f
/r
s
= (1 + i)/ (1 + i
for
)
48

A rise in the money supply will cause domestic interest rates to fall, making foreign investment more attractive.
Now, covered interest parity does not hold. The left-hand side of the equation must also fall. If correct speculation
makes r
f
go up by 10%, then r
s
must go up by more than 10% to keep CD = 0.
Speculators must have the prospect of seeing the value of the dollar rise in order to keep them invested in the U.S.
This can only happen if the value of the dollar is bid below its ultimate value.

Foreign Exchange Policies
1. intervene in the foreign exchange market
2. impose direct restrictions on international transactions
3. adopt tighter aggregate demand policies
4. allow the exchange rate to adjust

exchange rate regimes
1. gold standard
2. Bretton Woods
3. flexible exchange rates


European Monetary Union
A monetary union occurs when two or more independent countries agree to fix their exchange rates or to employ
only one currency to carry out all transactions.
advantages:
1. reduces uncertainty
2. promotes stability
3. eliminates exchange rate management as a trade barrier
4. saves resources that would have been employed in foreign exchange transactions
The European Currency Unit serves as the basis for determining exchange rate parities. It is a basket made up of
fixed amount of all EC currencies. Each currency has an official rate against other EC currencies and against the
ECU. Deviations of +/- 2.25% are permitted.
The European Central Bank comes into existence this summer. On January 1, 1999, the EMU will begin the move to
a single currency, the euro. The European Central Bank will operate only in Euros, as will the financial markets. At
the retail level, national currencies will continue to circulate and remain sole legal tender until July 2002. The euro
will be introduced for retail transactions in January 2002. Thereafter, national currencies will be redeemed for Euros
for periods set by national legislation.
European governments are giving up the ability to have an independent monetary policy. This would not be a
problem if Europe is an optimal currency area (share the same currency without any adverse consequences).
optimal currency area:
49

homogeneity
flexibility of wages and prices
mobility
fiscal transfers


Lecture 10 - Open Economy Macroeconomics with Fixed Exchange Rates
from last time
macroeconomic equilibrium
the multiplier
effects of AD and AS on the trade balance
effect of devaluation on national income
fixed exchange rates and economic policy
perfect capital mobility
shocks to the economy
assignment rule

From Last Time
What was Nixon's explanation for our gold shortage? By the 1960's, the U.S. had begun to run large
balance of payments deficits. More and more dollars ended up in the hands of foreign central banks. With
so many dollars out there, foreign central banks became concerned about whether the dollar was really
worth $35 = 1 ounce of gold. So, they began to redeem their dollars. The U.S. gold supply shrunk. Nixon
could have contracted the American economy to reduce imports. This would have reversed the gold flow.
He could have devalued the dollar, say by changing the price to $50 = 1 ounce of gold. He could have
imposed restrictions on international transactions. The easiest thing to do, however, was just to break the
link between gold and the dollar.
PPP is not good in the short run but how does it do in the long run? Studies have found that it takes at least
5 years for PPP to reestablish itself after a disturbance to the exchange rate.
Does/Should PPP work across states in the U.S.? Yes it should. There are profit opportunities if goods are
priced differently across the country. It doesn't primarily because of transportation costs.
Suppose a currency is expected to appreciate in value over the coming year. Assets denominated in that
currency will rise in value, making them more attractive to investors. The demand for the currency will
increase now so the current spot exchange rate appreciates.
Exchange Rate Overshooting: A rise in the money supply will cause domestic interest rates to fall, making
foreign investment more attractive. In order to keep people invested in the U.S. at the lower interest rate,
the dollar must be expected to rise in value. This can only happen if the value of the dollar is bid below its
ultimate equilibrium value. Then, the dollar will rise in value to reach its new equilibrium.
Under the Bretton Woods system, exchange rate was fixed. Countries were supposed to maintain exchange
rates within a 1% band around the par value. If the deviation from the par value was due to something
permanent, the exchange rate could be change d.

50

Macroeconomic Equilibrium
Assume that the price level is fixed so that the level of output is determined by just the level of aggregate
expenditures.
AD = C + I + G + X
Equilibrium is a situation in which there is no tendency for change. The economy will be in equilibrium when there
is no reason for the level of income to change. Unplanned changes in inventory, equal to the difference between real
GDP (Y) and aggregate demand will cause firms to alter the level of production:
When AD > Y, firms see that their inventories have dropped below the desired level, so production
increases to bring inventories up to desired levels. Real GDP rises so that economy cannot have been in
equilibrium.
When AD < Y, firms are unable to find buyers for all the goods they have produced. These unsold goods
pile up in firms' inventories. Firms will cut back on production in order to sell off the excess inventories.
Real GDP falls, so this cannot be the equilibrium either.
When AD = Y, firms are able to sell all of the goods they have produced. Inventories are at the desired
levels. Firms have no reason to increase or decrease production. Real GDP will not change. The economy
is in equilibrium.

Graphically, the economy is in equilibrium at the point where the AD function intersects the 45 degree line. At this
level of real GDP, AD equals Y.

Equilibrium Conditions:
1. Y = AD
2. no unplanned changes in inventories
3. leakages = injections
Leakages are income that is not spent on domestic consumption. The leakages are savings, taxes, and imports.
Leakages cause real GDP to fall. Injections are spending on domestic production other than consumption spending.
The injections are investment spending, government spending, and exports. Injections cause real GDP to rise. In
equilibrium, real GDP does not change. So, the leakages must balance out the injections.

The Multiplier
The simple multiplier is equal to 1 divided by the marginal propensity to save or 1/s.
Suppose m is the marginal propensity to import. Then the spending multiplier in a small, open economy equal
1/(s + m).
This formula assumes that our imports have no effect on foreign economies. For a large open economy this is
unlikely to be the case. The spending multiplier with foreign repercussions is
[1 + (m
f
/s
f
)]/[s + m + (m
f
s/s
f
)]
51



Effects of AD and AS on the Trade Balance
1. an increase in C + I + G will likely worsen the trade balance as imports will rise more than exports
2. an increase in exports will improve the trade balance
3. an increase in AS will lower prices and improve the trade balance as we export more and import less


Effects of Devaluation on National I ncome
Suppose the U.S. exports aircraft and imports shoes. U.S. net exports would be equal to
Price in $
aircraft
x Quantity of Aircraft Exported - Price in $
shoes
x Quantity of Shoes Imported
Suppose the dollar depreciates. The dollar price of shoes rises for American buyers while the price of aircraft falls
for foreign buyers. Shoe imports fall and aircraft exports rise.
However, since imports have become more expansive, their real value may rise even though the quantity of imports
falls. If the change in the exchange rate causes a large change in the quantity of imports and exports, then net
exports will rise. Typically, in the short run the quantity of imports and exports does not change much. So, net
exports fall. After consumers and firms have had time to adjust their spending patterns, net exports will rise.

Generally, the exchange rate and the trade balance move in opposite directions.
So, devaluation will cause national income to rise if
1. devaluation actually improve the trade balance
52

2. the terms of trade do not worsen so that import prices rise while export prices fall


The I S/LM/BP Model
The IS curve tells us what value of the real interest rate clears the goods market for any given value of real income.
It shows combinations of Y and r for which the goods market is in equilibrium. S equals I at all points along the IS
curve. The IS curve is downward sloping because higher Y leads to higher S which requires a lower r to bring the
goods market into equilibrium.
The LM curve traces out those combinations of r and y for which the asset market is in equilibrium, holding
everything else constant.
Assume a fixed exchange rate regime. There are two policy problems under fixed exchange rates:
1. external balance - maintaining the BOP so the exchange rate can remain fixed because a BOP deficit puts
downward pressure on the value of the dollar while a BOP surplus puts upward pressure
2. internal balance - control AD to maintain full-employment without inflation
With fixed exchange rates, the BOP reflects private trading between the domestic and foreign currency. A BOP
surplus causes a net inflow of money from abroad while a BOP deficit causes a net outflow.
influences on BOP
1. current account balance = NX(Y, R)
2. financial capital flows = F(r)
The BP line shows combinations of Y and r that allow equilibrium in the foreign exchange market. Point to the left
of the BP line represents a BOP surplus while points to the right of the line represent a BOP deficit.
53


In the short run the economy is in equilibrium at the intersection of the IS and LM curves. Equilibrium can be at any
BOP position: surplus, deficit, or balanced.

Fixed Exchange Rates and Economic Policy
monetary policy

54

An
expansionary
monetary
policy worsens
the balance of
payments. An
increase in the
money supply
has three effects:
1. the real
interest
rate
falls
causing
an
outflow
of
capital,
so the
BOP
worsens
2. real
income
rises, so
imports
go up
and the
BOP
worsens
3. the
price
level
rises
causing
imports
to rise
and
exports
to fall,
so the
BOP
worsens


55

fiscal policy
Expansionary
fiscal policy
worsens the
balance of
payments in the
long run. A rise in
government
spending, for
example, causes
1. Y to rise
so imports
go up,
worsening
the BOP
2. r to rise,
leading to
an inflow
of money
which
improves
the BOP,
but only in
the short
run


Fiscal policy is more effective than monetary policy when exchange rates are fixed.

Perfect Capital Mobility
Perfect capital mobility means that money is free to move between countries in search of the highest interest rate.
So, the interest rate all over the world is fixed at r
w
.
56

monetary policy

An increase in the
money supply pushes
the domestic interest
rate below r
w
. This
causes an outflow of
money and the money
supply shrinks. A
contractionary monetary
policy has the opposite
effect. So, the LM curve
is horizontal at r
w
and
monetary policy has no
effect on the LM
curve. Monetary policy
is ineffective under
fixed exchange rates
and perfect capital
mobility.
57

fiscal policy

A rise in government
spending causes the interest
rate to rise. With r above r
w
,
money flows into the
economy from abroad. The
inflow causes the money
supply to rise until r falls
back to r
w
. Fiscal policy is
effective under fixed
exchange rates and
perfect capital mobility.

Shocks to the Economy
1. domestic monetary shock - e.g. increase in money demand
2. domestic spending shock - flexible rates are procyclical
3. international capital flow shocks - e.g. capital outflow
4. export demand shock
5. import supply shock

Fixed exchange rates stabilize internal shocks but magnify external shocks.

Assignment Rule
In the long run, both expansionary fiscal and monetary policy worsen the BOP through their effects on income.
Which means that in some cases, it is impossible to improve both the level of domestic demand and the BOP?
options:
1. abandon fixed exchange rates (our subject for next week)
2. abandon controlling the domestic economy
3. develop new policy tools
4. use both monetary and fiscal policy
58

An increase in the money supply lowers the interest rate while expansionary fiscal policy raises the interest rate. So,
a combination of expansionary monetary policy and contractionary fiscal policy that kept AD unchanged would
decrease the interest rate and worsen the BOP. Monetary and fiscal policy can be mixed to achieve any combination
of AD and BOP position.
The assignment rule suggests using fiscal policy to control the domestic economy and monetary policy to influence
the BOP.


Lecture 11- Open Economy Macroeconomics with Flexible Exchange Rates
from last time
monetary policy with flexible exchange rates
fiscal policy with flexible exchange rates
shocks to the economy
fixed or flexible exchange rates?

From Last Time
Is our paper supposed to be co-written: 1 group, 1 paper or 1 group, 3 papers? 1 group, 1 paper
Expansionary fiscal policy is more effective than expansionary monetary policy under fixed exchange rates
because, in the short run, expansionary fiscal policy can lead to a balance of payments surplus. The BOP
surplus causes the money supply to increase which reinforces the expansionary nature of your economic
policy.
Why are exports not considered in the calculation for the multiplier in a small open economy? Such an
economy is too small to have an impact on other national economies. So, the multiplier is equal to 1
divided by the sum of the nation's marginal propensity to save and its marginal propensity to import.
Do countries base their exchange rate policy solely on the cause of economic shocks? No, the decision may
be based on any combination of economic and political considerations.

Monetary Policy with Flexible Rates
Assume full-employment and suppose that the supply of dollars in the foreign exchange market increases as the U.S.
runs a balance of payments deficit. The exchange rate drops (the dollar falls in value) so that prices in the U.S. fall
relative to those in the rest of the world. Imports will fall and exports will rise causing the trade balance to improve.
The rise in net exports causes aggregate demand to increase and real GDP to increase by a multiplied amount.
a BOP deficit causes the dollar to depreciate which causes real GDP to rise
a BOP surplus causes the dollar to appreciate which causes real GDP to fall
Consider an expansionary monetary policy. The rise in the money supply causes the interest rate to fall. The lower
interest rate has two effects: (1) it stimulates AD which results in a rise in real GDP; higher income worsens the
59

balance of trade, and (2) the fall in the interest rate causes capital to flow out of the country, thereby worsening the
balance of payments. The result of these two forces is a worsening of the BOP which causes the dollar to depreciate
which causes real GDP to rise. What's going on is that the currency depreciation caused by the increase in the
money supply expands the economy even more.

Fiscal Policy with Flexible Rates
Consider an expansionary fiscal policy. This has two effects as well: (1) AD and real GDP rise, worsening the trade
balance, and (2) the higher interest rates caused by the bigger budget deficit attract capital inflows which improve
the balance of payments (this is a short run phenomenon). These two effects work in opposite directions but the net
result is probably a fall in the value of the dollar which causes real GDP to rise.
Monetary policy is more effective than fiscal policy when exchange rates are flexible.

Shocks to the Economy
1. domestic monetary shock - e.g. increase in money demand
2. domestic spending shock - flexible rates are procyclical
3. international capital flow shocks - e.g. capital outflow
4. export demand shock
5. import supply shock

Flexible exchange rates stabilize external shocks but magnify internal shocks.

Fixed or Flexible Exchange Rates?
1. types of macroeconomic shocks
2. policy tool preferences
3. policy goals
4. controlling inflation
5. variability