chapter 26: international trade and capital flows

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 26: International Trade and Capital Flows


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Learning Objectives

1.Understand how trade balances and net capital flows are related

2.Show how international trade affects a country's consumption possibilities

3.Explain who wins and who loses with free trade4.Describe the effects of tariffs and quotas on

domestic prices, production, and consumption5.Analyze the factors that determine international

capital flows and how these flows affect domestic savings and interest rates

6.Use the relationship between domestic saving and the trade balance to understand how domestic saving, the trade balance, and net capital inflows are related


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International Trade

National economies do not exist in isolation but are increasingly interdependent

Trade is important even to a large economies. However, international flows of goods and services become sometimes a matter of political and economic concern Trade and capital flows are easily politicized

Free trade can be seen to cost local jobs• U.S.-Morocco Free Trade Agreement

Foreign control of "essential" assets such as ports or telecommunications infrastructure

• Dubai Ports World


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The Trade Balance and Net Capital Inflows

Trade balance is another name for net exports (NX) Value of a country's exports minus the

value of its importsA trade surplus is a positive trade

balance Exports > imports

A trade deficit is a negative trade balance

Imports > exports


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The Egyptian Trade Balance, 1960–2009


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The Moroccan Trade Balance, 1960–2009


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The UAE Trade Balance, 1973–2007


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The Turkish Trade Balance, 1960–2009


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Capital Flows

International capital flows are transactions of real estate and financial assets across international borders Capital inflows are purchases of domestic

assets by foreign households and firms Capital outflows are purchases of foreign

assets by domestic households and firms Net capital inflows (KI) are capital inflows

minus capital outflows Capital flows are not counted as imports

or exports since the funds are used to purchase assets Imports and exports are goods and services

produced in the current year


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Trade Balance (NX) and Net Capital Inflows (KI)

NX + KI = 0UAE resident purchases Japanese car for

$20,000 Imports = $20,000

Manufacturer holds $20,000 in a UAE bank account Option 1: purchase $20,000 of UAE goods

and services so exports = $20,000 Option 2: purchase UAE bonds or UAE real

estate NX = – $20,000, KI = $20,000

Option 3: sell dollars for yen Follow the dollars and see what the purchaser

does with them to determine NX and KI


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The Principle of Comparative Advantage

The Principle of Comparative Advantage

Everyone does best when each

concentrates

on the activity with the lowest

opportunity cost


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Comparative Advantage

Comparative advantage is determined by factors such as

Climate ■ Human capital Natural resources■ Financial systems Technology ■ Culture

A closed economy is an economy that does not trade with the rest of the world

An open economy is an economy that trades with other countries


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Production Possibilities Curve

Economy with two goods If 1,000 computers are

produced, the maximum amount of coffee is 100,000 pound

Moving from C to D, the economy Gives up 60,000 kg of

coffee Gains 1,000 computers

per year Curvature results from the

Principle of Increasing Opportunity Cost Computers (number/year)

Co

ffee

(kg

/yea

r)

B

CA

D

100,000

40,000

1,000 2,000


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Production and Consumption Possibilities

Production possibilities curve shows the quantities of different goods that an economy can produce

Consumption possibilities curve shows the quantities of different goods that a country could consume

Production and consumption possibilities are the same if a country does not trade Autarky is a situation where a country does

not trade In an open economy, a society's

consumption possibilities are greater than its production possibilities


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Buying and Selling in World Markets

Egypt begins at point D, 2,000 computers and 50,000 kg of coffee

World prices are $10/kg of coffee and $500/computer

Sell 2,000 computers for $1 million and buy 100,000 kg of coffee

Moves the economy to E, beyond its PPC

Sell 50,000 kg of coffee for $0.5 million and buy 1,000 computers

Moves the economy to FComputers( 000s/year)

Co

ffee

(00

0s k

g/y

ear)

B

C

A

D

120

100

1

50

2 2.4

Egypt Starts at D150

3

Trade options

Z

PPC

F

E


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Buying and Selling in World Markets

Operating at D is not Egypt's best choice

Trade options between C and D are inefficient

Egypt could have more coffee and more computers than X without trade

Egypt is in the best position if it chooses a point where the trade options are entirely on or outside the PPC Computers( 000s/year)

Co

ffee

(00

0s k

g/y

ear)

B

C

A

D

120

100

1

50

2 2.4

150

3

Egypt Starts at D

PPC

Trade options

E

F

X

Z


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Optimal Production Mix for an Open Economy

The trade options line, LM, is tangent to the production possibilities frontier at G G is the optimal

production level Slope of LM is determined

by prices: 160,000 coffee / 3,200 computers = 50 kg of coffee / computer

By producing at G, Egypt can consume at any point on LM LM is the consumption

possibilities curveComputers (000s/year)

PPC

Cof

fee

(000

s kg

/yea

r)B

C

A

D

F

E150

120

100

1

50

2 2.4 3

160

3.2

G

M

L

CPC

Egypt Works at G


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Optimal Production Mix for an Open Economy

At G The opportunity cost of

producing one more computer

EQUALS The opportunity cost of

purchasing one more computer

AND The opportunity cost of

producing one more pound of coffee

EQUALS The opportunity cost of

purchasing an extra pound of coffee

Computers (000s/year)

PPC

Cof

fee

(000

s kg

/yea

r)F

160

3.2

G

M

L

CPC

Egypt Works at G


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A Simple Economy

Islandia produces coffee and tea 100 workers are equally productive in

both products One work-day produces 8 kg of coffee

or teaIslandia's goal is to produce the

highest value of total output Value depends on world prices

Produce the good with the highest price Sell some Buy the other, lower-priced good


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A Simple Economy

Islandia's production possibilities curve is a straight line

If only coffee is produced, output is 800 kg per day

If only tea is produced, output is 800 kg per day

Any combination between these is possible

Tea (kg/year)

Cof

fee

(kg/

year

)

B

C

A

D

200

200

600

800

600 800

Islandia Production Possibilities Curve


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Two Consumption Possibilities Curves

Cof

fee

(kg/

year

)

Tea (kg/year)

B

C

A

600

200

600

800

800

D

200

Price of Tea Twice Price of Coffee

Produce at A

PPCD'

1,600

CPC

Tea (kg/year)

Cof

fee

(kg/

year

)

B

C

A

600

200

600

800

800

D

200

Price of Coffee Twice Price of TeaProduce at D

PPC

1,600 A'

CPC


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Production and Consumption Possibilities

If the price of coffee and tea are the same, there are no gains from trade for Islandia Produce what you want and consume it

Suppose the production possibilities curve is convex Produce where the opportunity cost of

production equals the opportunity cost in trade

Pick a point on the consumption possibilities curve

Trade to reach that point


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Trade for Egypt

World prices are $10 per kg of coffee and $500 per computer (shown by LM) Egypt produces at G

80,000 kg of coffee 1,600 computers

Consumption is at N Export 20,000 kg of coffee for $200,000 Import 400 computers for $200,000 N is outside the production

possibilities curve

Computers (000s/year)

PPC

Cof

fee

(000

s kg

/yea

r)

C

120

100

1 2

160

3.2

G

M

L

CPC

Egypt Works at G

1.6

80

N60


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Benefits of Free Trade

Free trade produces net benefits Some gain; some lose

Free trade is efficient Increases total economic surplus in the

economy Equilibrium Principle

Gains Losses

Domestic consumers of imported goods

Domestic producers of imported goods

Domestic producers of exported goods

Domestic consumers of exported goods


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Protectionism and Tariffs

Protectionism is the view that free trade is injurious and should be restricted Tariff is a tax imposed on an imported good

Egypt imposes a tariff on imported computers Same as an increase in the world price of

computers Domestic price increases to world price plus

tariff Consumers pay more for computers than with free

trade and business profits increase Quantity demanded decreases and quantity

supplied increases Imports decrease and government revenues go up


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Honda Civic in Egypt versus the UAE

Egyptian residents pay more than $30,000 for a 1.6-liter Civic.

UAE residents pay about $20,000 for a 1.8-liter Civic.

Egypt imposes a 40 percent tariff and 15 percent value-added tax on all imported cars not exceeding 1.6 liters.

The UAE imposes a flat 5 percent tax on all imported goods exceeding a value of $300.


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Protectionism and Quotas

Quota is a legal limit on the quantity or value of a good that may be imported Usually administered by permits issued to

importersEconomic effects are similar to a tariff

Domestic price increases to the benefit of domestic producers

Domestic consumers pay higher prices Foreign manufacturers sell fewer units

The key difference between tariffs and quotas is the gains captured by permit holders Buy at world prices and sell at a higher price


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Voluntary Export Restrictions (VER)

Higher gas prices of the 1970s caused consumers' preferences for fuel-efficient Japanese cars to increase Demand for US cars decreased

In 1981, US negotiated an agreement with Japan to limit their exports to the US voluntarily System lasted until 1994

US and European car manufacturers benefited from lower competition Japanese companies benefited from higher

prices for their products Consumers paid higher prices for cars Cost of VERs estimated at $3 billion per year


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Other Trade Barriers

There are bureaucratic ways to decrease imports Strict application of rules for health and

safety Refusal to accept drug trial results conducted

outside the US, for example Testing and certification procedures for

compliance to a technology standard Bans on genetically modified foods in Europe

Use of the Imperial system instead of metric system increases the cost of doing business in the US

Different electricity characteristics have same effect


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The Inefficiency Of Protectionism

Free trade is efficient; protectionism reduces total surplus Protectionism confers benefits on favored

groups If trade barriers are removed, total surplus

increases Divert some of the increase to compensate

those hurt by trade Reduces resistance to free trade in those who bear

the costs

Environmental concerns are better addressed under a free trade system Restrictions impose costs on poor countries

(polluters), reducing the resources for clean-up


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International Capital Flows

Highly developed financial markets allow borrowing and lending across borders

Transactions are subject to laws in the originating country and the target country Size of international flows for a country depend

on its regulations and laws Also depend on economic integration and

political stabilityLending is acquiring a real of financial

asset Buying a share of stock or a government bond

or a parcel of landBorrowing is selling a real or financial

asset


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Two Roles of International Capital Flows


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International Capital Flows

Capital inflows to the home country include foreign purchases of Stocks and bonds of local companies Local government bonds Real assets such as land and buildings owned by local residents

Capital flows respond to real interest rates Higher domestic interest

rates mean greater capital inflows

Dom

estic

R

eal

Inte

rest

Rat

e (r

)Net Capital Inflows (KI)

0

KI > 0Net capital

inflows

KI < 0Net capitaloutflows

KI


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Risk and Capital Inflows

For a given real interest rate, increase in riskiness in of domestic assets decreases capital inflows Shifts the capital inflow

curve to the left Foreigners are less willing

to buy domestic assets Domestic savers are

more willing to buy foreign assets

Dom

estic

R

eal

Inte

rest

Rat

e (r

)Net Capital Inflows (KI)

0

KIKI'


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Savings, Investment, Capital Inflows

Definition of outputY = C + I + G + NX

Solve for IY – C – G – NX = I

National savings, S, is (Y – C – G)S – NX = I

AlsoNX + KI = 0 OR KI = – NX

SoS + KI = I


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S + KI = I

Savings plus net capital inflows equals investment in new capital goods Foreign savings can supplement domestic

savings to create capital goods to support economic growth

In a closed economy,S = I In an open economy,

S + KI = ICapital inflows mean more

investment and lower interest rates

Saving and investment

Re

al i

nte

rest

rat

e (

%)

I

S + KI

S, I

r*


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Capital Flows and Debt Crises

Developing countries fund their growth with capital inflows Incomes are too low for large domestic

savings High rates of return on infrastructure and

early investmentsInterest on foreign loans and

eventually, the principle, must be paid If investments are not productive, there

are insufficient funds to pay interest and repay the loan: a debt crisis


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Argentina, 2001 - 2002

Argentina has natural resources and human capital Good potential for economic growth Low national savings rate Large capital inflows

Invest more and grow quickly Large debt to foreigners

Foreigners loaned willingly provided there was a good return


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Argentina, 2001 – 2002

1995 – 1997 was a high growth periodThe Argentine economy slowed in 1998

Tax receipts decreased and demand for government services increased

Government at all levels ran large deficitsThe need for foreign funds grew rapidly

Perceived risk increased and capital inflows slowed

Interest rates increased, domestic investment decreased and the economy continued to weaken

Argentina was eventually forced into default Worked with IMF and others to restart the

economy


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The Savings Rate and the Trade Deficit

Trade deficits result from low domestic savings

S – I = NXHolding investment constant, a high rate

of savings results in high net exports If S < I, the country is a net importer and NX

< 0Suppose a country has a low national

savings rate G and C are large relative to Y

Strong demand for imports Few goods available for export

The country will have a trade deficit


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The Savings Rate and the Trade Deficit

If national savings rate is low, the savings will not be sufficient to finance domestic investment Many good investments available for

foreign funds Capital flows in

Low levels of savings increases interest rates and attracts foreign capital inflows

chapter 26: international trade and capital flows

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