Part One Notes Part One Test Part Two Notes Part Two Test Part Three Notes Part Three Test Part Four Notes Part Four Test 204 Grades


(home)    (up)

ECO 204--Part Four Notes

The final quarter!  We turn our attention to international economics--international trade, trade barriers, 
the foreign exchange market, and the economics of poor countries. 

IMPORTANT NOTE:  There is NO CLASS on Friday, March 30, 2007.  The classroom has
been confiscated for use in the RISE symposium.  As a result, QUIZ #6 will be on Wednesday,
April 11.  QUIZ #7 will be on Friday, April 20.  The last subject matter is about poor countries. 
You will need to read this material, which is at the end of part four notes.  It's an easy read!


Global macro economics

This begins our inquiry into international economics.  We start with some facts, then move to 
understanding why nations trade and how trade is financed with different currencies.  International 
economics is important because there is increasing activity between the United States and 
foreign interests.  Let's not overstate its importance, however.  Exports in the United States 
are about 10.7 percent of GDP and imports are about 16.3 percent.  That's a smaller international 
sector than a number of other countries, e.g. the United Kingdom.


At the outset, it is important to understand that a very important reason for international 
trade is imports.  We want things we cannot produce, e.g. coffee.  We also want things
which can be produced more efficiently in other countries.  A second reason countries
want to trade is because there are profits to be made from exporting goods and
services to other countries.

What determines the level of our imports?  Imports depend on our domestic level of income 
and on relative prices.  The higher our income, the more we import.  Part of the reason we 
import more than we export is because of our robust economy which gives rise to a demand 
for imports.  Prices are also important.  We import VCRs because they are cheaper than VCRs 
we make ourselves. 

There is also a marginal propensity to import (MPIM).  It is equal to the change in imports 
divided by a change in GDP.


What determines the level of our exports?  They depend on income levels in other countries--not 
on our domestic GDP.  If another country's income increases, they will want more goods and 
services from us--just as we want more from them when our income rises.  Relative prices 
are also a factor in determining the level of our exports.

Equilibrium conditions with the foreign sector

Our last visit to the aggregate demand and aggregate supply model showed aggregate demand as 
consisting of C + I + G.  That is now expanded to include net exports, that is the difference 
between exports (X) and imports (IM).  As seen above, net exports are presently negative 
because imports exceed exports.  That causes total output to be lower than without the 
foreign sector, but not by much.  Net exports are presently negative 5.6 percent of GDP.   
The now familiar equilibrium looks like this:

Because there is a marginal propensity to import, the value of the multiplier is affected.  The 
value will be lower with imports than it was in our earlier "closed economy" multiplier.  The 
formula for the multiplier now is:

        MPS + MPIM

If the MPS is .1 and the MPIM is .05, the multiplier would be 1/0.15 = 6.7.  In our closed 
economy multiplier, with no MPIM, the multiplier would be equal to 10.

Changes in exports and/or imports affect the level of real output.  Look at the diagram 
above and note that an increase in exports would shift AD to the right and increase both 
real output and the price level.  An increase in imports leads, ceteris paribus, to a 
decrease in domestic real output.  But that's not all bad.  Imports permit us to enjoy 
things not included in our measure of GDP.

Trade imbalances

One of the most frightening words in the popular press is "imbalance."  A trade imbalance and a capital imbalance are commonly regarded as evil.  (So are unbalanced diets.)  A trade imbalance is when imports exceed exports--i.e. we spend more dollars on foreign goods than we receive from selling our goods to foreigners.

There is really nothing inherently good or bad about a trade deficit or a trade surplus.  A trade deficit is a bit like the other foreboding deficit, that being a government spending deficit.  When there is a trade deficit, domestic output is lower than it would be absent the deficit.  But we are consuming things we didn't produce--things we really want.  That leads to higher living standards.

What, then, is the problem with a trade deficit?  It causes problems with domestic macro policy and might frustrate our efforts to attain full employment.  (Surpluses can also cause problems for domestic policy.)   Suppose we are fighting recession--with any of the anti-recession policies we have available.  If those policies work (which, as we have seen, they might not), then income increases, imports will increase, and real output is lower.  If we are fighting inflation and the inflation rate falls, then exports increase.  An increase in exports increases aggregate demand which increases the price level.

It can be more confusing, because foreign governments may also be following domestic policies which can affect our imports and exports.  If we have a trade deficit, some other countries will have a surplus. That surplus might cause them inflation problems.  They fight that inflation and, if successful, we may import more which reduces our domestic output.  And on and on.  You get the point, however.

Capital imbalances

Now we change the meaning of "capital."  Here we use the financial meaning of the term--money.  Capital (i.e. money) flows in and out of an economy for a number of reasons:

*    interest rate differentials among countries

*    profit opportunities for business firms

*    people traveling in other countries

Does a capital flow also affect domestic macro economic policy?  Yes it does.  Consider one example.  Suppose we have a restrictive monetary policy to fight either real or imaginary inflation.  This, as we have seen, leads to higher interest rates.  That attracts foreign investment to the U. S.  But the increase in foreign investment increases the supply of investment funds which reduces interest rates.  That makes it harder for the Fed to attain its objectives.

So what do we conclude from all this?  As we have seen, and will see more clearly shortly, there are MANY benefits to international trade and investment.  There is also a cost in the form of constraints on domestic policies which result from international trade and investment.

International trade

As noted earlier, we import things we don't produce very well--coffee, bananas and platinum.  Other countries buy things from us they can't produce-e.g. wheat, soybeans and airplanes.  Why do we import things we also export--e.g. clothing and cars?  So, why do countries trade?  They trade because of the principle of comparative advantage.

Comparative advantage--a simple illustration

The principle of comparative advantage is a little tricky.  We will start with a very simplified
illustration of comparative advantage.  Then, in the next class, will do a more expanded
analysis.  The simple analysis which follows is not very realistic, but it will help you to
think about international trade.

Here comes the simple illustration. Suppose we have two countries, the United States and 
Cleveland.  (Sorry if I offend those of you from that foreign country of Cleveland!)  Assume 
these countries produce exclusively either widgets or gidgets, and that one person working 
one day can produce the following dollar amounts of widgets or gidgets:

  Widgets Gidgets
United States $100 $50
Cleveland $20 $40

The United States is a richer country than Cleveland, and one person working one day can produce more widgets than Cleveland and more gidgets than Cleveland.  In economics jargon, that says that the United States has an absolute advantage in both widgets and gidgets.  Does that mean there is no benefit to trading?  NO!

The United States can produce a larger value of widgets per day than it can gidgets.  Cleveland, 
however, can produce a larger value of gidgets per day than it can widgets. Economists observe 
that the U. S. has a comparative advantage in widgets, while Cleveland has a comparative 
in gidgets.   Here is the surprising thing about this simple illustration--both 
countries will benefit by producing the good in which they have a comparative advantage 
and then trade with the other country.

If we consider two persons working one day, and there is no trade, then the United states can 
enjoy $100 worth of widgets and $50 worth of gidgets.  Cleveland, with two persons working 
one day without trade, can enjoy $20 worth of widgets and $40 worth of gidgets.  What if the 
U. S. uses its two persons working one day and produces only widgets?  That would involve 
an output worth $200.  And what if Cleveland uses its two persons working one day and 
produces only gidgets?  That would involve an output in Cleveland of $80.  The U. S. 
could trade with Cleveland and could use its $200 worth of output to buy $100 in widgets 
domestically and another $100 in gidgets imported from Cleveland.  Cleveland could 
produce a daily output of $80 and buy $40 in widgets domestically and import $40 of 
widgets from the U. S.  So with trade, the U. S. could have $100 worth of widgets and  
$100 worth of gidgets (for two days of labor)--and Cleveland could have $40 worth of 
and $40 worth of gidgets (for two days of labor).  That's a better outcome than 
what happened with no trade. 
.   Producing those goods in which a country has a 
comparative advantage and trading with other countries for goods in which they have 
a comparative advantage benefits both countries--even if one country has an absolute 
advantage in both goods.

As noted, this illustration is very simplified.  It assumes that both countries produce only 
widgets or gidgets.  Next we look at a better example that will help you better understand 
the nature of comparative advantage.


Comparative advantage--extended illustration

Assume the following annual production possibilities for bread and wine in France and in the United States.  This is depicted as linear, for simplification (even though we saw earlier that production possibilities frontiers aren't really linear).  Assume that the numbers represent zillions (or whatever) of loaves of bread and zillions of bottles of wine.  

     United States                                 

  Bread Wine
A 100 0
B 80 10
C 60 20
D 40 30
E 20 40
F 0 50


  Bread Wine
G 15 0
H 12 12
I 9 24
J 6 36
K 3 48
l 0 60

Now we need to draw graphs of these production possibilities.  Here they are:

Suppose there is no trade and that the U. S chooses point D which involves 40 units of bread and 30 units of wine.  These outputs are determined by the usual market conditions.  Also suppose France chooses point I which involves 9 units of bread and 24 units of wine.  Note the total output of both goods.  Total bread output is 49 (40 in the U. S. and 9 in France) and total wine output is 54.  That's okay, but there are points where total output of both is greater. 

Suppose the U. S. produced at point C and France produced at point K.  What would total output be?  Total bread output would be 60 units in the U. S. and 3 units in France.  That's a total output of 63, which is better than 49.  Total output of wine would be 20 units in the U. S. and 48 units in France, for a total world output of 68.  That sounds like a better deal, but how do we get there?  And could both countries benefit?

Suppose the U. S. does produce at point C--60 bread and 20 wine.  Also suppose that France decides to produce at point K--3 bread and 48 wine.  Here's what might happen:

We offer to send France 6 units of bread in exchange for 20 units of wine. (This is an example only, but it will show how both countries can benefit.  Other trade offers would also work.)  

How does this offer benefit both countries?  Look closely--very closely--at this:

BEFORE trade, France enjoyed 9 bread and 24 wine.  With trade, they produce 3 bread and 48 wine.  They send the U. S. 20 wine and the U. S. sends France 6 bread. France now enjoys 9 bread and 28 wine.  That's point M on the diagram.  FRANCE NOW CONSUMES AT A POINT BEYOND THEIR DOMESTIC PRODUCTION POSSIBILITIES!
BEFORE trade, the United States produced 40 bread and 30 wine.  With trade, we produce 60 bread and 20 wine.  We send France 6 bread and France sends the U. S. 20 wine.  Now the U. S. enjoys 54 bread and 40 bread.  THE UNITED STATES NOW CONSUMES AT POINT N--BEYOND OUR DOMESTIC PRODUCTION POSSIBILITIES!

That's the basic case for free trade.  Both countries are better off, and both can consume beyond
their domestic production possibilities.  Is this some slight of hand?  No.  Will it work in all
cases?  Generally yes.  There are some isolated cases in which it might not, but generally it
works as in this illustration.  Let's look a little more at what happened--and why--with the

Opportunity costs and comparative advantage

Let's look at the opportunity costs of the two goods in both countries.  The United States can produce a maximum of 100 bread or 50 wine.  The opportunity cost of 1 loaf of bread is one-half bottle of wine.  We give up one-half a bottle of wine for an additional loaf of bread.  In France, the opportunity cost of 1 loaf of bread is 4 wine.  (Look back at the table or the diagram to make certain you understand that.)  We export bread because the opportunity cost is lower than in France.  In its best form, that's what comparative advantage means--we have a comparative advantage in bread because the opportunity cost of bread is lower (in terms of foregone wine) than in France.

The opportunity cost of wine in the United States is 2 loaves of bread.  In France, the opportunity cost of wine is 1/4 a loaf of bread.  France has a comparative advantage in wine--the opportunity cost of wine is lower than in the U. S.  That's why we export bread to France and import wine from France.

Notice that we have not said anything about the absolute costs of production.  It doesn't matter.  Even if France could produce both bread and wine at a lower dollar (or euro) cost, we would still export bread and import wine.  If we can get a bottle of wine for less bread by trading than by producing more bread, we'll do it. 

Terms of trade

One final piece will improve your understanding of what's going on here.  The terms of trade refers to the rate at which goods are exchanged.  In the illustration above, the terms of trade for the U. S. were that 6 bread were exchanged for 20 wine, (or 3.33  wine for each 1 bread).  If we wanted 20 more bottles of wine, and we got that wine internally, we would have to give up 40 loaves of bread.  But with trade, we give up only 6 bread to get 20 more wine.  Trade occurs when the international terms of trade are superior to domestic opportunity cost.


Trade barriers

Comparative advantage presents the basic case for free trade, and the reason why economists typically 
favor free trade.  Nevertheless, there are strong voices to impose trade barriers for a variety of reasons.  
There are generally four types of trade barriers which nations may erect:

  Protective tariffs--designed to keep foreign goods out; not primarily as a revenue source

  Import quotas

  Non-tariff barriers--e.g. licensing, unreasonable standards

  Voluntary export restrictions

We will focus primarily on protective tariffs, with a note later on about voluntary export restrictions.  
Import quotas and non-tariff barriers have the same general effects as protective tariffs.

General effects of a protective tariff

The following diagram illustrates the general effect of a protective tariff on a specific good 
or service:

In the diagram, SF represents the supply schedule for foreign producers--the amounts they will supply at various prices.  The SD represents the domestic supply schedule and ST represents the total of foreign and domestic supplies.  Notice that below price "a" there is no foreign supply.  The ST curve is the horizontal sum of the SF and SD curve.  So at any price less than "a," total supply is the same as domestic supply.  Above price "a" the total supply curve juts outward reflecting the sum of foreign and domestic supply.  The demand curve (D) is domestic demand and assumes that domestic customers don't care if the good is produced domestically or by foreigners (an assumption that doesn't always hold).

Assuming free trade, equilibrium is where total supply equals demand.  That involves an output of QT and a price of PT.  (The T subscripts stand for free trade conditions.)  With free trade, Q* shows the domestic output.  The rest of it, the amount from Q* to QT is the amount supplied by foreign producers. 

Now suppose the United States erects a tariff barrier high enough to drive out all of the foreign supply.  Take the SF curve away and equilibrium will be where demand intersects SD.  That involves an output of QP and a price of PP (where the subscripts stand for protective tariff).  So, compared to free trade, a tariff reduces domestic consumption and increases the price of the good.  That obviously imposes a burden on domestic consumers.

Domestic production does increase with the tariff, from Q* to QP.  That's why protection is popular with domestic producers.  That gain, however, is illusory.  Remember our discussion about comparative advantage.  If we keep foreign goods out, we are no longer able to consume more than our domestic production levels and the increased domestic output involves a higher opportunity cost than if we imported some of the good.  This general case shows why economists almost always prefer free trade.

Specific arguments for trade barriers

We next examine a number of popular arguments as to why trade barriers are desirable, in spite of comparative advantage and the general outcomes we just looked at.

1.  Buy at home argument

This is a popular, but relatively meaningless argument.  Many argue that you should buy what America builds just because it was built in America.  You hear the same argument from local chambers of commerce--e.g. everyone is somehow better off if we buy what Dayton builds.  Abraham Lincoln picked up on this noting that he would not by an overcoat from England.  Why not?  England would end up with the money, he said.  The argument simply ignores the consumption possibilities we saw when we looked at comparative advantage.

2.  Full employment argument

This, to many, is a very compelling argument.  As we saw in the diagram of the general case of protection above, a tariff does increase domestic output--and therefore expands employment for workers producing the protected good.  In the United States, auto workers have always argued for measures to keep Japanese automobiles out of the U. S. so as to promote greater employment for domestic auto workers.

What it really does, however, is preserve visible jobs at the expense of invisible ones.  Suppose, for example, we keep shrimp from Taiwan out of the U. S.  If we do that, we will not be able to export phones to Taiwan.  The shrimp we buy from them gives them the funds to buy U. S. phones.  So, someone who makes phones in the United States loses his or her job because we can't sell them to Taiwan.  We preserve shrimp fishermens' jobs at the expense of phone workers jobs.  That's an invisible effect and certainly neither the employed shrimp fisherman nor the unemployed phone worker see what really happened.  As we noted earlier, keeping out shrimp from Taiwan (or anything else) reduces our total consumption possibilities.

3.  Cheap foreign labor argument

Another popular argument is that American producers cannot be expected to compete with firms in countries that pay much lower wage rates to workers than we do.  That's a half truth, however,  One must compare wage rates to labor productivity.  If our wage rate is ten times higher than in some other country, there isn't a problem if our labor productivity is more than ten times greater.  If our higher wages are not accompanied by higher productivity, then perhaps we don't have comparative advantage in that product and should be producing something else instead.  Comparative advantage just keeps on working to our benefit!

4.  Diversification argument

This argument is not pertinent to the United States but it is for countries which rely heavily on one (or a few) products.  A so-called banana republic is a good example.

(Those are bananas.)

The concern in such a country is that it would be better off if it had more diversified outputs.  A lack of diversification can lead to instability if, e.g., poor weather dramatically reduces output or if world wide demand falls.  How can a country diversify?  Keep out foreign goods with a tariff on goods other than bananas to encourage domestic production.  Diversification may lead to greater stability, but it will also lead to lower output through time if done with a tariff.  There are other, and better, ways to deal with diversification and instability.  Comparative advantage . . . you know the rest.

5.  Infant industries argument

The infant industries argument is not as relevant for the United States as it is for lesser developed countries.  The argument is that protection is needed for a new industry so that it has time to grow, become efficient and achieve economies of scale, and then compete effectively in global markets.  If, for example, some country wants to become competitive in the production of paper, it erects a high tariff to keep foreign produced paper out.  That permits its domestic production of paper to increase and, eventually, become competitive.

There are at least two problems with this argument.  One is that government, which obviously enacts the tariff, doesn't really  know if the paper industry is likely to achieve success or not.  Governments can't anticipate future market conditions.  The second is that the infant frequently never grows up.  Once the tariff is in place, it's politically very hard to get rid of it.  If a government really thinks this is compelling, a better way is to give the infant a direct subsidy for a time.  That, too, is suspect because it suggests that government is better at resource allocation than private markets.

6.  Declining industry argument

This is sort of the reverse of the previous argument.  If an industry is declining
--for whatever reason--some argue it should be give protection to halt the decline.  It's 
sort of a jobs argument.  An example is the U. S. textiles industry.  But if textiles (or 
anything else) can be made more efficiently elsewhere, then so be it.  A country's 
comparative advantage changes through time and, when that happens, resources 
need to be reallocated.  We have a long history of resource reallocation for various 
reasons.  How could we be doing so well in computer technology if resources had 
not been attracted away from declining industries into computer technology 

7.  Dumping argument

Dumping occurs when a foreign firm or a foreign government overproduces something and then, to get rid of the surplus, temporarily sells the good in another country below cost.  Domestic producers howl that this is not fair because they can't meet the lower price.  There are short term benefits to consumers, obviously--the lower prices.  There is no real evidence that temporary dumping does a lot of harm to domestic producers in the long run.  Sometimes it isn't clear when a sale is really below cost.  If there is any validity to this argument, it is an argument for a very temporary tariff. 

8.  Foreign subsidy argument

Sometimes a foreign government subsidizes one or more of its industries making it more difficult for producers in other countries to compete.  This has a curious effect.  If, for example, Taiwan subsidizes its clothing industry then clothing will be cheaper in the United States than it would be absent the subsidy.  The effect is that Taiwanese people are subsidizing U. S. citizens.  That's not all bad--if that's what they want to do.  Providing protection in such a case could encourage U. S. producers to be less efficient.  Perhaps our resources would be better used for something else.  The Trade Act of 1988, however, requires the U. S. to retaliate when other governments subsidize their domestic industries.  

9.  Critical self sufficiency argument

A final argument is that we should provide protection for some things that are critical to our well being.  This argument often centers around things which are critical during a potential war.  We would not, for example, want to import a missile guidance system from North Korea--even if they had a comparative advantage in such systems!  But there are many other critical things--e.g. steel, plastic, etc.  In the event of war, the U. S. government would have no problem suspending trading relationships where necessary.

Answers to Quiz #6--April 11, 2007--10:00 section

1.  false           6.  B
2.  false           7.  B
3.  A                8.  A
4.  D                9.  B
5.  E              10.  C

Answers to Quiz #6--April 11, 2007--
1:00 section

1.  true           6.  A
2.  false          7.  D
3.  C               8.  A
4.  B               9.  B
5.  B              10. B


FRIDAY, APRIL 13, 2007

We continue with some other international trade topics and then begin a discussion of international
finance--how payments are made between countries with different currencies.

Voluntary restrictions

Rather than enact a protective tariff, sometimes the U. S. (or other countries as well) persuades a foreign government to voluntarily limit shipments of some good to the U. S.  We have done this with Japan's automobiles.  There aren't zero imports, just fewer than the free market quantity.  This sounds good, but it's actually worse than a tariff!

If we use a tariff, we will likely get some revenue from it--if it's not high enough to keep all foreign goods out.  With a voluntary restriction, the U. S. doesn't get any revenue, but the foreign government does.  Why?  No foreign producer voluntarily limits exports to the U. S.  So the foreign government establishes export licenses or taxes to keep exports within the agreed limit.  When the foreign government does that, it gets the revenue--either the fee for an export license or the tax revenue.  That's what makes voluntary restrictions worse than a tariff.

Tariff reduction efforts

Currently there are over 9,000 tariffs involving an annual cost of at least $20 billion.  In 1790, there was one page of tariffs.  Even so, there have been significant tariff reductions in recent years, even if we still have over 9,000 of them.

World Trade Organization (WTO)

In 1947, 23 countries set up an international agreement to reduce tariffs--called the General Agreement on Tariffs and Trade (GATT). GATT in turn set up the WTO in 1995.  There are currently over 140 member countries. The group meets periodically and negotiates tariff reductions among members.  When GATT first started, tariff rates averaged 40 percent in developed countries.  Now average tariffs are less than 4 percent. 

Part of the purpose pf the WTO is to enforce free trade rules.  It can cite and impose remedial action on countries violating trade agreements.  Why do sovereign nations buy in to this?  Partially because most are committed to free trade.  When the WTO meets, there are often huge demonstrations on the part of those opposed to free trade--unions, environmentalists and others. 

3rd WTO Ministerial Conference, Seattle 1999



That's the logo of the WTO for its 1999 meeting in Seattle.  At that meeting, the demonstrations were so intense that little was accomplished during the meeting.  For more information about GATT and the WTO--and a ton of information about free trade and related topics--go to:

Regional trading blocs

European Union

The European Union (EU) is an agreement among 37 European countries to provide free trade among member nations.   Not all of these countries participate in the common currency, called the Euro--e.g. the United Kingdom has not given up its British pound.  There are also a number of countries who are candidates for membership in the EU; some will likely be admitted at some point.

The Euro currency phased in in three steps.  The first step, which started in January of 1999, provided for major corporations, financial institution and governments to begin using Euros electronically.  Exchange rates between the Euro and local currencies were set up.  Beginning in January, 2002, Euro coins and currency were issued.  For six months, EMU members could use either Euros or local currencies.  Beginning June 1, 2002, old currencies were no longer used--everything is now exchanged using the Euro.

The symbol for the Euro looks like this:

Euro Homepage

And a 20 Euro bill looks like this:

What is the likely impact of the EU?  The elimination of tariffs obviously benefits consumers in all EU countries.  There will be a stronger economic environment--the EU has 290 million people and produces about 20 percent of the world's total output.  Most think growth will be enhanced as a result of mergers and lower prices.  There will of course be greater simplicity for members of the EMU--you don't have to convert francs to lira and so on.  There were some initial disruptions, but most think it a very positive move and a real victory for free trade.

North American Free Trade Agreement (NAFTA)

Signed in 1992, NAFTA eliminates all tariffs over a 15 year period between the United States, Canada and Mexico.  Although it was controversial, most think it has obvious benefits of lower prices for consumers in all three countries.  Of course there will be winners and losers.  The federal government predicted that losers in the U. S. would include construction workers and some apparel makers.  Winners were predicted to include farmers, truckers and those in financial services.

International finance  

A Spanish producer selling goods in the United States wants to be paid in pesos, not in dollars.  And if we ship goods to Germany we want to be paid in dollars, not euros.  The way this happens is through a foreign exchange market, where currencies are valued in terms of one another and exchanged for international goods and services.

The foreign exchange market

Schematically, the foreign exchange market looks something like this:

The top part of the diagram shows goods, services and financial assets moving from the U. S. to France.  The French purchasers take euros to the foreign exchange (FE) market and exchange them for dollars, which are used to pay the U. S. exporters.  The bottom part shows the U. S. receiving goods, services and financial assets from France.  They take dollars to the foreign exchange market and exchange them for euros to pay the French producer.  Where is the foreign exchange market?  Financial institutions or governments make these exchanges; much of it is now done electronically.  The rate at which euros exchange for dollars is determined in the foreign exchange market.  Shortly we will see how exchange rates are determined.

The official balance of payments

In total, all our payments to all other nations must equal our receipts, i.e. they must balance.  The official balance of payments is a summary of all kinds of international transactions between private parties and governments.  Following is the balance of payments for the United States in 2006, where the dollar amounts are in billions of dollars:  

1 Merchandise exports +1023
2 Merchandise Imports - 1860
3 Service exports     413
4 Service imports -   342
  TRADE BALANCE (1-4 above) -   766
5 Income from U.S. foreign investments     622
Income outflow for foreign owned U.S. investments -   629
7 Unilateral transfers (mostly government and private pensions)  -    84
  CURRENT ACCOUNT BALANCE (1-7 above) -   857
8 U.S. capital inflow    1765
9 U.S. capital outflow -  1045
  CAPITAL BALANCE (8-9 above)      720
10  Statistical discrepancy     137    
  NET BALANCE        0

The first thing to note is that the net balance is always zero--by definition!  The statement is divided into two parts: items 1-7 is the current account and items 8-9 is the capital account.  Note that the trade balance was -$766 billion in 2006--a matter of great concern to many resulting in banner headlines in the financial and popular press.  

The capital accounts are straight forward and show that there was more foreign investment in the U. S. than there was U. S. investment in foreign economies. Finally note item 10, a statistical discrepancy.  It's not possible to catch every international transaction.  Participants in the underground economy hide some transactions.  We know that the net balance has to be zero by definition.  So if we add up all the other items, we know that there was a money outflow of $137 billion which was not reported. A deficit in the current account will always be accompanied by a surplus in the capital account. 

MONDAY, APRIL 16, 2007

Exchange rates

Next we look at how exchange rates are determined.  How many dollars does it take to buy a Mexican peso?  Or how many dollars can someone obtain for a euro?  Most exchange rates are determined in free markets.  But it is possible for governments to intervene and fix exchange rates at some level--in much the same way we saw earlier how governments sometimes try to control prices of particular goods or services.  We look first at freely fluctuating exchange rates; then we look at what happens with fixed exchange rates.

Freely fluctuating exchange rates

In order for the U. S. to purchase stuff from the United Kingdom, we have to convert dollars to pounds in the foreign exchange market.  We have a demand for British pounds, derived from our demand for British goods and services.  We supply dollars to the foreign exchange market.  Residents in the U. K. have a demand for dollars, derived from their demand for U. S. goods and services.  And they supply pounds to the foreign exchange market.  We have to look at the foreign exchange market (and the supplies and demands of both currencies) from the perspective of the U. S. and of the U. K.  The following diagrams put this together:

Our demand for British pounds (shown in the left diagram) give rise to our willingness to supply dollars (shown in the right diagram).  Our demand for pounds would be downward sloping--the lower the dollar price of a pound, the more we will demand.  The higher the pound price of dollars, the more we will supply.  The same thing holds true for the U. K.  They will have a demand for dollars (right diagram) which slopes downward.  This gives rise to their willingness to supply pounds (left diagram).  An equilibrium exchange rate arises, such that the price of a pound in the U. S. is $2, i.e. $2 = 1.

In the U. K., the equilibrium price is 0.5 = $1.  There has to be a consistency between these two rates.  If it takes 2 dollars to get 1 pound in the U.S., that same two to one relationship must hold in the U.K. That's why we know that, in the U. K., one-half a pound fetches one U. S. dollar.  With free exchange rates, these "cross rates" are always in the same ratio.  It can't be any other way!

Changes in exchange rates

Example #1

Of course, exchange rates can and will change as the result of changes in the demand or supply of foreign currency.  Suppose, for a first example, the U. S. has an increased demand for British goods and services.  That will mean an increase in the demand for pounds--and a corresponding increase in the supply of dollars to the foreign exchange market.  The diagrams below show what happens:

Look what happened.  The demand for pounds shifted to the right from D to D'.  That produced a new equilibrium at an exchange rate of $3 for one British pound.  Looking at the United Kingdom, our increase in the demand for pounds is accompanied by an increase in the supply of dollars.  That produced a new equilibrium in the U. K. such that the price of one U. S. dollar is now 0.33.  Exchange rate changes have a sometimes confusing lingo.  If the pound price of a dollar falls (as in this example), the dollar is said to have depreciated against the pound--it takes fewer pounds to get a dollar or, put differently, dollars are now cheaper.

Notice that the cross rates are appropriate.  A $3 price for one pound means that, across the ocean, the pound price of a dollar will be 0.33--the same three to one ratio in both countries.  Note that an increase in the dollar price of a pound will involve a decrease in the pound price of a dollar.

Example #2

To make sure you understand all this, let's do one more example of a change in exchange rates.  This one is a bit more complicated.  (Sorry!)  Suppose inflation increases in the U. K. relative to the U. S.--i.e., the U. K. experiences a higher rate of inflation than we do in the U. S.  This means U. S. households and businesses will be less eager to do business in the United Kingdom--while the United Kingdom will be more interested in buying things from the United States.  Why?  Our prices are not rising as rapidly so they can get better deals in the United States.

This means the U. S. demand for pounds will fall, and the supply of dollars will fall.  The U. K. will experience an increase in the demand for dollars and an increase in the supply of pounds.

Note the following diagram:

Note carefully the little prime marks.  They are a little hard to see, but they show the shifted demand and supply functions.  In the U. S., there is an increase in the supply of pounds and a decrease in the demand for pounds.  The U. K. wants to offer us more pounds (because our prices are not as high as theirs), while we demand fewer of their pounds.  The result is that the exchange rate falls from $2 for 1 to $1 for 1.  In the U. K., there is a decrease in the supply of dollars and an increase in the demand for dollars.  That causes the exchange rate to rise from 0.5 for $1 to 1 for $1.  This is described by saying the dollar has appreciated.  Make sure you understand what all happened here!

Other examples

Let's take two other examples.  I won't draw diagrams, but it would be a good idea if you did to check your understanding of exchange rate changes.  A simple example would be if income in the U. S. increased relative to that of the U. K.  That means we would want to import more from the U. K.  That's an increase in the demand for pounds, which would lead to a higher dollar price of pounds--and a lower pound price of dollars.

Here is a more complex one.  Suppose interest rates fall in the United States, while they remain unchanged in the United Kingdom.  That makes it more attractive for us to invest in the U. K. and it makes it less attractive for people in the U. K. to invest in the U. S.  Figure out what will happen.  (Hint:  The dollar price of pounds will rise.)  Interest rate fluctuations are largely responsible for day-to-day fluctuations under free exchange rates.

Evaluation of free rates

There are obvious advantages of free rates.  They are the market solution, which always suggests an optimum condition.  We can be certain that rates reflect relative purchasing power.  If it costs $2 for 1, we can be sure that $2 in the United States will buy about the same stack of goods and services as 1 will buy in the U. K.  If that wasn't so, the rates would quickly adjust.

Many, however, are not enamored of free rates.  Some say there is risk associated with rate fluctuations.  Yeah, there is.  There is risk associated with any market activity, for that matter.  Risk is hardly confined to possible adverse effects of changes in exchange rates.  Some are concerned that free rates might encourage speculators.  If you think the price of a Dutch guilder will rise in the future, buy some guilder now and resell it later.  (Of course if a lot of people did that the price of the guilder would rise quickly.)  There are all kinds of speculation in contemporary business.  The New York Stock Exchange which, to some, epitomizes capitalism is a good place to see speculation at work.  That doesn't bother many, so why should speculating in exchange rates bother people either?  

FRIDAY, APRIL 20, 2007

Fixed exchange rates

The United States has had a system of free exchange rates since 1973.  But before that we were on a system of fixed rates--as were most other countries.  The argument for fixed rates is simply to overcome the (alleged) disadvantages of free rates.  There is still a lot of sentiment to return to fixed rates, so we want to look at how they worked and what problems there were.

How did governments fix exchange rates?

Back in the time of fixed rates, most major countries were on a gold standard.  That meant several things.  First, central bank liabilities were partially backed by gold.  Second, gold was often used to settle balance of payments differences between nations.  Third, currencies were defined in terms of gold.  It is that latter feature that gave rise to fixed exchange rates.

(That's a stack of gold bars, which is how countries stored gold under the old gold standard.)

Here's how it worked.  Each country defined its currency in terms of a common standard--gold.  After World War II, the United States officially defined the U. S. dollar as .0294 ounces of gold.  The United Kingdom defined the pound as .0823 ounces of gold.  Hence 1 pound = .0823/.0294 = $2.80.  The pound was defined as consisting of 2.8 times as much gold as the dollar.  In the U. K., the price of one dollar was 0.357.  Hence the exchange rates were determined by the definitions of gold, and could not change unless one or the other country changed the official definition of its currency.

Under the gold standard, countries were not supposed to change official definitions of their currencies.  The United States broke the rules several times before going off the gold standard in 1973.  There has always been, among many, a belief that gold possesses magical qualities and that perhaps the price of gold is determined in heaven.  Many were fearful when we abandoned the gold standard that somehow our whole monetary system would collapse.  It didn't.  Part of the reason we abandoned the gold standard was because our government finally understood that free rates worked better.  There are still some far out groups that want to return to the gold standard, however. 

Disequilibrium possibilities with fixed rates.

With fixed rates, (unlike with free rates), disequilibrium in a country's balance of payments can result--i.e. the balance of payments is not always automatically balanced.  In the diagram below, suppose the demand for pounds is initially at D1.  Suppose that the equilibrium exchange rate of e1 just happens to coincide with legal fixed rate, also e1.  The quantity of pounds exchanged is equal to Q1.

Now suppose the demand for pounds increases to D2.  With free exchange rates, the dollar price of pounds would rise above e1, as we saw earlier.  But the rate is legally fixed at e1 and can't rise.  So what happens?  The quantity of pounds demanded is at Q2 but the quantity supplied remains at Q1.  The result is an excess demand for pounds, shown by the difference between Q2 and Q1.  This excess demand means there is obviously a shortage of pounds, so one thing that often happened is a black market developed in which pounds were illegally sold at a price higher than e1

This situation produces a balance of payments deficit for the United States, because more dollars are flowing out of the U. S. than are flowing in to the U. S.  The U. S. has to cover the resulting deficit in one of two ways.  With the gold standard, countries were required to hold reserves of foreign currencies and also to hold gold reserves.  To settle up the deficit, the U. S. must either sell pounds or ship gold to the U. K.  If we sell pounds, that shifts the supply of pounds to S2:

Prior to abandoning the gold standard in 1973, the United States had a balance of payments deficit for 22 consecutive years.  That caused our foreign exchange reserves to become depleted.  The balance of payments deficits exceeded the gold we held in Fort Knox so that our gold reserves were no longer a credible way to ensure fixed exchange rates.

Setting rates above equilibrium results in the opposite of the above.  A balance of payments surplus results and a country would have to purchase foreign exchange.

Other problems with fixed rates

When exchange rates stay fixed over time, the optimal pattern of trade becomes distorted.  If inflation is high in the U. K. (relative to the U. S.) that would normally reduce the dollar price of pounds.  But with fixed rates, that doesn't happen.  We would then trade less with U. K. than would be suggested by comparative advantage.

The balance of payments problems explained above can also cause domestic fiscal and monetary policies to become distorted.  A country with a payments deficit might have to follow policies that lead to higher unemployment; a country with a payments surplus might end up following domestic policies which aggravate inflation.  With a deficit, a country might seek policies designed to reduce imports.  How can you reduce imports?  Raise taxes or cut government spending.  Countries don't like to do this and that's what sometimes caused countries to change their official price of gold.  But if one country changes its gold price to get rid of balance of payments imbalances, another might retaliate so that the imbalance does not always go away.

"Managed flexibility"

Even with free rates, governments can and do sometimes get involved by trying to alter equilibrium exchange rates.  In the U. S. either the Treasury or the Federal Reserve can influence free rates by buying or selling dollars or buying or selling other foreign currencies.  Both monetary agents hold foreign currencies. 

Why would they do this?  To remedy a "disorderly" market--whatever that is.  My normative opinion is that monetary authorities don't know what a disorderly market is.  Put differently, if there is some disorder I am confident the market will cure it--not the Treasury or Federal Reserve.

How does this process--sometimes called "dirty float"--work?  Suppose either agency decides the dollar price of pounds is "too low."  The authorities can go into the market and buy British pounds.  That's the same as an increase in the demand for pounds which would raise the dollar price of pounds.  In 1992, the Fed bought German marks on two different occasions.  That increased the dollar price of marks and was done to reduce the trade deficit.

Like any intervention in free markets, trying to micro manage exchange rates is suspect.  It certainly doesn't please trading partners when that happens and is often accompanied by political ramifications as well.

Answers to Quiz #7--April 20, 2007-- 10:00 section

1.   true              6.  C
2.   false             7.  D
3.   E                  8.  B
4.   C                  9.  C
5.   D                 10. C

Answers to Quiz #7--April 20, 2007--
 1:00 section

1.   true              6.  C
2.   true              7.  C
3.   E                  8.  B
4.   B                  9.  B
5.   D                 10. E


Here's a tough multiple choice question:

If all the economists in the world were laid end to end,
    A.  it would be a good thing.
    B.  they would be more comfortable.
    C.  they would never reach a conclusion.
    D.  all of the above
    E.  none of the above


NOTE:  The following material is something for you to read on your own.  Because of the earlier
canceled class, I will likely not have time to cover much of this in class.  I will try to hit the
highlights if I can.

 International development


We want to look next at the economics of development.  Specifically we want to look at poor countries.  Now, notice the word I used--poor.  If you go back about forty years, you will find that they used to be called "underdeveloped" countries.  Then, later on, "less developed" countries.  Currently they are often called "third world" countries.  That term is puzzling.

I use the term poor countries, because that's what they are.

The U. S. has a per capita GDP of over $40,000.  Three billion people--over half of the world's population--live in countries where per capita income is less than $700.  Can you imagine what it would be like to live in that kind of environment?  That's why I call them poor countries. 

There are over 200 countries in the world.  Only 24 of those countries have a per capita income of $12,000 or more.  The World Bank refers to these as "rich" countries.

The poorest areas are in Africa, Asia and Latin America.  And, unfortunately, many countries that are poor are getting poorer.  Not all of them.  Some poor countries are beginning to experience income growth.  We want to look at the characteristics of these countries and then offer a few thoughts on how poor countries might advance to higher standards of living.

Common characteristics of poor countries

1.  Very little physical capital

Poor countries have very limited amounts of physical capital.  As we have pointed out several times, capital equipment is a major requirement for prosperity.  There is little or no saving from which to obtain funds for investment because of subsistence incomes.  Consider the following production possibilities curve which shows capital and consumption possibilities:

Suppose a poor country is operating at point A, and suppose that point involves an absolute minimum amount of consumption.  Even with that level, there may be widespread hunger.  But the amount of capital, shown by Y, is not enough to support economic growth.  The economy needs an amount of capital shown by point B, but there's no way to get there.  This is one of the many vicious circles of underdevelopment.

2.  Limited human capital

There is typically a glut of unskilled labor and very little skilled labor.  A further complication is that there is poor health and a lot of disease.  Sometimes when talented people live in poor countries, they move to countries with a higher standard of living.

3.  Limited agricultural development

Aggravating the hunger problem is the lack of agricultural development.  Although some poor countries are not adept at agricultural production, almost all countries have the natural resources to produce some food.  The need for agricultural development is a precondition for industrial development.  This reflects the problem outlined in #1 above of inadequate physical capital.

4.  Noncompetitive industry and agriculture

As if the internal problems weren't enough, poor countries often enact all kinds of protectionist policies--tariffs, quotas, etc.  This denies them access to world markets which further impairs their ability to grow.

5.  Urban unemployment

In many poor countries, there has been a migration of workers from farms to cities.  The trouble is there aren't many jobs in urban areas, so unemployment rises when this migration to cities takes place.

6.  Limited access to technology

This is similar to some of the items listed earlier, but they are all inter-related.  Poor countries are isolated from other countries and it is difficult for them to transfer technology in from other countries.  Sometimes they are quite unreceptive to technological assistance--for political and, I guess, other reasons.

7.  Unstable macro economies

As noted, there are often high rates of unemployment in poor countries.  They also often have high rates of inflation--stagflation in its worst form.  There is also typically enormous government regulations and controls which further inhibit the prospects for growth.

8.  Excessive population growth

It is simple arithmetic to note that, if population grows faster than output, output per capita will decline.  This is why some poor countries are becoming even poorer--too much population growth.  Although some countries, e.g. China, have established family planning programs, most have not.

Birth rates are high in most poor countries and, historically, as countries have become richer (or at least not as poor) the birth rate falls.  When the birth rate falls, by definition, per capita output rises.  How can we explain this phenomenon?  However strange this may sound, we can look at the benefits and costs of having additional children in poor countries and in rich countries.  This will help us understand what's going on.


What are the benefits of additional children?

There are the usual nonmonetary benefits of enjoyment, companionship, etc.  But there are two additional important monetary benefits.  One is the productive agent benefit.  Children are seen as potential income earners to improve the welfare of the family.  The other is the security benefit.  Children are seen as care providers when parents age or become ill.

What are the costs of additional children?

The direct cost of food, clothing and shelter is minimal.  There is zero opportunity cost of parent's time away from the work force.


Compared to rich countries, the benefits are high and the costs are low.  Hence procreation benefits the family--even if it doesn't benefit the whole country.


What are the benefits?

Only the nonmonetary ones.  In the U. S., for example, parents don't look at children as income earners or as care providers.  The benefits are low relative to poor countries.

What are the costs?

They are high.  The direct cost of food, clothing, shelter, education, vacations--and on and on--are very high compared to poor countries. There is also a very high opportunity cost if one parent withdraws from the labor force to care for children.


Compared to poor countries, the costs are high and the monetary benefits are low.

See what has happened?  As families and nations get richer, the benefits of additional children fall and the costs rise.  Hence the birth rate falls as they get richer.  This is another dilemma for poor countries.  Although the country would be better off if birth rates fell, that is not in the best interests of families in poor countries.

How to acquire funds for developing physical and human capital

Obviously the real key to economic development is acquiring funds to develop both physical and human capital.  How does a poor country do that?  Generally, there are two sources--internal 
saving, and external sources. 

Internal savings

There really isn't much hope here.  The subsistence incomes don't permit much saving to occur.  Some governments have attempted to force savings through taxes and controls.  (The tax receipts can theoretically channeled into investment in capital equipment.)  Some--notably the former Soviet Union--restricted the production of consumer goods which forced saving.  Rapid money creation has also been tried, but that brings serious inflation.  Even where saving has taken place, there is sometimes capital flight to other countries.  So most poor countries must rely on external funding.

External funding sources

There are three types of external funding possibilities: foreign private investment, foreign aid (from foreign governments) and loans.  Looking at these will further illustrate the many serious problems which impede development efforts.

Foreign private investment

How in the world does a poor country entice private investors in rich countries to invest?  Would you invest in a country with an unstable macro economy, an unstable political system--and all those characteristics we listed above?  Although some have done this, the volume of foreign investment is very low.  Sometimes it's done for altruistic reasons.  Until a country establishes some important preconditions (discussed below), foreign investment is not likely to improve the lot of poor countries very much.

Foreign aid

Foreign aid is gifts by foreign governments or various international agencies-e.g. World Bank, International Monetary Fund.  These groups also make loans to poor countries.

The volume of foreign aid is not large.  The average aid from rich countries has been 0.3 percent of GDP--and the U. S. has given only half that much.  Many poor countries don't want foreign aid.   They fear becoming dependent on foreigners and there are a zillion political issues involved as well.   Sometimes foreign aid is used inappropriately.  A country might, for example, use the funds to build a hydroelectric generating plant when what it really needs is an irrigation system.  Sometimes it finds its way into the hands of politicians who use it for their own gain.


Loans may be made to poor countries from private banks or financial institutions, governments and international organizations.  There have been a lot of loans; usually they are tied to the poor country promising to do something to its own benefit.  This has resulted in very serious debt problems for many poor countries.  The Vatican has called on lenders to forgive many of these loans, but that is fraught with all kinds of problems, especially when the lenders are private parties.

So how can development take place?

Most experts think that economic development is most likely to occur in a market based 
environment, with a minimum of four elements:

>  A competitive micro economy

>   A stable macroeconomy

>  Investment in human capital

>   Integration with the global economy

Some other desirable elements would help countries take off into sustainable growth:

> Improved structure of financial institutions

>  Increased agricultural productivity

>  Emergence of an entrepreneurial class

>  Increased domestic saving and investment (obviously)

> Foreign aid

That's a tough agenda and it makes you wonder how the vicious cycle of poverty can ever be broken.  Are there any success stores?  Three very brief examples follow.

Three success stories

Three countries that used to be poor, but aren't any more, are South Korea, Taiwan and Hong Kong.  Each took a different route, but all three found ways to facilitate positive incentives and all three stressed exports.

South Korea.  South Korea went about development by establishing large conglomerates, e.g. Samsung.  They sold these products around the globe and that gave them funds for development.

Taiwan.  Taiwan developed a highly competitive model such that 40,000 firms account for three-fourths of their exports.  These firms produce a huge variety of goods, allowing for the benefits of competition familiar to capitalist economies.

Hong Kong.  Hong Kong, famous for its capitalistic approach, essentially followed a laissez faire model--with very low taxes and very few restrictions.  This worked impressively in Hong Kong.


I hope you have found this web site useful.  If you have comments about the web site, I would like to hear from you.  I am particularly interested in your suggestions for improving the site.  Please send me an e-mail.  If you have questions about the final exam, send me an e-mail about that.  I will respond promptly to any of your comments or questions.  Send stuff to: