UBEA 1013: ECONOMICS 1 CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATE 13.1 Absolute Advantage &...

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UBEA 1013: ECONOMICS

CHAPTER 13: CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATEINTERNATIONAL TRADE AND EXCHANGE RATE

13.1 Absolute Advantage & Comparative Advantage13.1 Absolute Advantage & Comparative Advantage

13.2 Open Economy: Export – Import13.2 Open Economy: Export – Import

13.3 Exchange Rate13.3 Exchange Rate

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13.1 Absolute Advantage & Comparative 13.1 Absolute Advantage & Comparative AdvantageAdvantage

• David Ricardo’s theory of comparative advantage, states that specialization and free trade will benefit ALL trading partners, even those that may be absolutely less efficient producers.

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• A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.

• A country enjoys an absolute advantage over another country in the production of a product when it uses fewer resources to produce that product than the other country does. More output with same resources

Mean lower opportunity cost

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Yield Per Acre for Wheat And Cotton

NEW ZEALAND

AUSTRALIA

Wheat 6 units 2 units

Cotton

Total land

2 units

100 acres

6 units

100 acres

• New Zealand can produce three times the wheat that Australia can on one acre of land, and Australia can produce three times the cotton.

• We say that the two countries have mutual absolute advantage.

Absolute Advantage:

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Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres

NEW ZEALAND AUSTRALIA

Wheat 25 acres x 6 units/acre150 units

75 acres x 2 units/acre150 units

Cotton 75 acres x 2 units/acre150 units


• Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below:

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Production Possibility Frontiers for Australia and New Zealand Before Trade

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Gain from mutual Absolute Advantage:

• Absolute advantage theory urges countries to specialize in the production it has the absolute advantage (higher production per unit of resources).

• Therefore, New Zealand should specialize in production of wheat while Australia in production of cotton.




Cotton

Production:

Wheat

Cotton

2 units

600 units

0 unit

6 units

0 unit

600 units

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Production and Consumption of Wheat and Cotton after Specialization

PRODUCTION CONSUMPTION

New Zealand Australia New Zealand Australia

Wheat 600 units 0 unit 300 units 300 units

Cotton 0 unit 600 units 300 units 300 units

• An agreement to trade 300 units of wheat for 300 units of cotton would double both wheat and cotton consumption in both countries.

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• Because both countries have an absolute advantage in the production of one product, specialization and trade will benefit both.

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CASE 1: NEW ZEALAND

AUSTRALIA


Cotton 2 units 6 units

Comparative Advantage:


CASE 2: NEW ZEALAND

AUSTRALIA



Mutual Absolute

Advantage

New Zealand has absolute

advantage in both wheat &

cotton production

Can trade benefit BOTH?

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Opportunity cost (The cost of reducing other products to produce another unit of a particular product)

One additional unit of:


Wheat 6 / 6 = 1 unit of cotton 3 / 1 = 3 units of cotton

Cotton 6 / 6 = 1 unit of wheat 1 / 3 = 0.33 unit of cotton

• New Zealand has lower opportunity cost in producing wheat >> should specialize in producing wheat

• Australia has lower opportunity cost in producing cotton >> should specialize in producing wheat

Comparative AdvantageComparative Advantage

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Total Production Of Wheat And Cotton Assuming No Trade, Mutual Absolute Advantage, And 100 Available Acres


Wheat 50 acres x 6 units/acre300 units


Cotton 50 acres x 6 units/acre300 units


• Assume that each country wish to consume equal units of cotton and wheat. Thus, the production is as shown below:


• The gains from trade in this example can be demonstrated in two stages.

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Realizing a Gain from Trade When One Country Has a Double Absolute Advantage

Stage 1: Countries specialize

Wheat

STAGE 1

New Zealand Australia75 acres x 6 units/acre

= 450 units0 unit

Cotton 25 acres x 6 units /acre= 150 units

100 acres x 3 bales/acre300 bales

• Australia specialized in cotton production. New Zealand transfers 25 acres out of cotton production into wheat.

• New Zealand cannot completely specialize in wheat production because it needs 300 bales of cotton and will not be able to get enough cotton from Australia (if countries are to consume equal amounts of cotton and wheat).


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Stage 2: Countries trade

STAGE 2

New Zealand Australia100 units (trade)


(after trade)

200 units (trade)


(after trade)

Agreed trading price: (Term of Trade)

2 units of cotton for 1 unit of wheat


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• Terms of trade: The ratio at which a country can trade domestic products for imported products.

• The terms of trade determine how the gains from trade are distributed among trading partners.

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13.2 Open Economy: Export – Import 13.2 Open Economy: Export – Import

• Export & Import transactions is recorded in the country balance of payment under the “current account”.

National Accounting (extension from Chapter 9):

• The balance of payments is the record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange.

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• A country’s current account is the sum of its:– net exports (exports minus imports),– net income received from investments abroad, and – net transfer payments from abroad.

• The balance of trade is the difference between a country’s exports of goods and services and its imports of goods and services.

• A trade deficit occurs when a country’s exports are less than its imports.

• Net exports of goods and services (EX – IM), is the difference between a country’s total exports and total imports.

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Multiplier Effect & Aggregate Expenditure (extension from Chapter 11):

Planned aggregate expenditure (AE) in an open economy:

AE C I G EX IM • In equilibrium:C a bY

I I 0

G G 0

EX EX 0

IM mY

Y C I G EX IM Y a bY I G EX mY Y bY mY a I G EX Y b m a I G EX( )1

Yb m

a I G EX* ( )

1

1multiplierm = marginal propensity

to import (or MPM)

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• Exports contribute to an increase in autonomous expenditures and cause the planned aggregate expenditure function to shift upward.

• Imports affect the value of the multiplier. After imports are included, the aggregate expenditure function rotates and equilibrium income decreases.

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13.3 Exchange Rate 13.3 Exchange Rate

• The main difference between an international transaction and a domestic transaction concerns currency exchange.

• The exchange rate is the price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.

• Foreign exchange is simply all currencies other than the domestic currency of a given country.

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Three Type of Exchange Rate System:

• Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand.

• (Exchange rate movements have important impacts on imports, exports, and movement of capital between countries).

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• Fixed exchange rates: governments set a particular fixed rate at which their currencies will exchange for each other.

• (Pegging a currency to another currency is in this fixed exchange rate system).

• Managed floating system: In this system, governments intervene if markets are becoming disorderly.

• (Usually, the currency is allowed to float within a pre-determined ranged)

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Monetary Policy & (Floating) Exchange Rate (extension from Chapter 11):

Increase in M Interest rate fall Investor earning lower IR

Seek better investment abroad

Sell local currency Buy foreign currency

Exchange rate fall (depreciate)

Local (foreign) product cheaper (more expensive)

Net export increase

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• The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied.

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• The level of a country’s interest rate relative to interest rates in a determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British citizens may be attracted to U.S. securities (relative higher return).

• Increase of British investors to seek better investment in US increases the supply of dollar and decreases the demand for pounds.

• The result is depreciation of the pound against the dollar.

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• A depreciation of a country’s currency (e.g Malaysia) can serve as a stimulus to the economy:

– Foreign buyers are likely to increase their spending on Malaysian goods (relatively cheaper)

– Buyers substitute domestically made goods for imports (as import will costs more)

– Aggregate expenditure on domestic output will rise

– GDP (Y) will increase

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• Who will benefit if the domestic currency depreciate?

– Export sector (more competitive)

• An interesting case: During Asian financial crisis, Ringgit depreciate sharply. What happen to the domestic crude palm oil (CPO) price?

– UP (Why?) (CPO Futures contracts prices traded in Kuala Lumpur Commodities Exchange shot up continuously).

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• CPO price are quoted at international currency (the US dollar).

• Thus, depreciation of Ringgit cause the price of CPO relatively higher (in term of the local currency or Ringgit)

• Another question: Now, Malaysia has de-peg the Ringgit against the US$ (now under a managed float system). General opinion think that the Ringgit will appreciate.

• Who will benefit if the Ringgit really appreciate?

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The beneficiaries:

• Companies that have huge US$-dominated debt: e.g. Telekom Malaysia & Tenaga Nasional. They will benefit from one-off translation gains and lower interest expenses.

• Companies that have high imported input cost: e.g. auto & media industry being the obvious.

The “losers”?

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The losers:

• Exporters: less competitive due to relative higher price (in term of foreign currency).

• Companies with a large part of their revenue stream in foreign currencies. A stronger Ringgit mean less revenue in the local currency after conversion.

• Therefore, the worst will be those “cost in Ringgit, revenue in Dollar” companies. E.g. plantation, semiconductor and timber sector. Their profit margin will be reduced.

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UBEA 1013: ECONOMICS 1 CHAPTER 13: INTERNATIONAL TRADE AND EXCHANGE RATE 13.1 Absolute Advantage &...

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