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Chapter 12:

International
Trade and
Exchange Rates

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

U.S. Trade Facts: 2007


U.S. has a trade deficit in goods:
In 2007, U.S. trade deficit in goods was $816 billion.

U.S. has a trade surplus in services:


In 2007, U.S. trade surplus in services was $107 billion.

Principal U.S. exports: chemicals, agricultural products,


consumer durables, semiconductors, and aircraft.
Principal U.S. imports: petroleum, automobiles, metals,
household appliances, and computers.
Largest trading partner: Canada
A Trade deficit occurs when imports exceed exports.
A Trade surplus occurs when exports exceed imports.
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U.S. Trade Balances on


Goods and Services, 2007
Surplus

Deficit

+10.0

Australia
Belgium

The U.S.
trade deficit
with China
was $257
billion in
2007.

+9.8
Canada -67.0
China

Germany -45.3
Japan

-85.0

Mexico

-77.3

Netherlands
-250
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-256.6

-70 -60 -50 -40 -30 -20 -10

+14.3

10 20
Source: BEA

12-3

U.S. Total Exports are


Second Only to Germany
Percentage Share of World Exports, Selected Nations 2007
0

Germany
United States
China
Japan
France
Netherlands
United Kingdom
Italy

10

12

9.20
8.59
8.02
5.38
4.06
3.83
3.71
3.40
Source: World Trade Organization

LO: 12-1

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Specialization and
Comparative Advantage
Specialization and trade increase the productivity of
a countrys resources and allow for greater total
output and income.
Specialization results in more efficient production.

Comparative advantage allows us to determine


who should produce what.
The terms of trade, or the rate at which units of one
product can be exchanged for units of another
product, can make both countries better off.
Comparative advantage is a lower relative or comparative
opportunity cost than that of another person, producer, or country.
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Trade and Specialization


Increase Total Output
Product

Production alternatives: Mexico


A
B
C
D
E

Avocado

20

24

40

60

Soybeans

15

10

Product

Production alternatives: U.S.


A
B
C
D
E

Avocado

30

33

60

90

Soybeans

30

20

19

10

LO: 12-2

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Absolute and Comparative


Advantage
In the above example, the U.S. has an absolute
advantage in producing both goods:
The U.S. can produce 30 tons of soybeans while Mexico can
produce 15 tons.
Also, the U.S. can produce 90 tons of avocados compared to
Mexicos 60 tons.

The U.S. has a comparative advantage in soybeans.


For the U.S., 1S 3A; for Mexico, 1S 4A
Soybeans are relatively cheaper in the U.S.

Mexico has a comparative advantage in avocados.


1 ton of avocados costs 1/4 ton of soybeans in Mexico, which is
less than the cost in the U.S. (1A 1/3S).
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Gains from Specialization


and Terms of Trade
If the U.S. specializes in soybean production while Mexico
specializes in avocado production and both agree on the
terms of trade, both countries will gain from specialization
and trade.
The United States can shift production between soybeans and
avocados at the rate of 1S for 3A.
Mexico can shift production at the rate of 4A for 1S.
Suppose that, through negotiation, the two nations agree on terms of
trade of 1 ton of soybeans for 3.5 tons of avocados.
These terms of trade are mutually beneficial to both countries, since
each can do better through such trade than through domestic
production alone.

The terms of trade is the rate at which units of one


product can be exchanged for units of another product.
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Specialization and Gains


from Trade

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Trade with Increasing Costs


If resources are no longer perfectly
substitutable between alternative uses,
resources less and less suitable to the
production of one good must be allocated
to the production of the other good in
expanding the other goods output.
The primary effect of increasing
opportunity costs is less-than-complete
specialization.
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Foreign Exchange Market


A foreign exchange market is a market in which
foreign currencies are exchanged and relative currency
prices are established.
An exchange rate is the rate at which one currency
trades for another.
Buyers and sellers interacting in international markets
will exchange currencies through the foreign
exchange market.
In the market for foreign currency, the intersection of
the demand for foreign currency and the supply of
foreign currency determine the exchange rate.
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12-11

Market for Foreign


Currency (Pounds)
P

Dollar Price of 1 Pound

Sl

Depreciation is a

Exchange
Rate: $2 = 1

$3

decrease in the value


of a currency relative
to another currency.

Dollar
Depreciates
(Pound
Appreciates)

$2

Appreciation is an

Dollar
Appreciates
(Pound
Depreciates)

increase in the value


of a currency relative
to another currency.

$1
Dl
0

LO: 12-3

Ql

Quantity of Pounds
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Determinants of Exchange
Rates
Factors that cause a countrys currency to
appreciate or depreciate are:
Tastes

Relative Income
Relative Price Levels
Relative Interest Rates
Speculation
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Protectionism or Free
Trade?
Argument for
protectionism
Save U.S. jobs
restrict imports
Cheap foreign labor
pulls down wages in
the U.S.
Tariffs are needed to
protect against
dumping.

Rebuttal
Import restrictions alter the composition
of employment but dont affect total
employment; they also lead to less
effective resource allocation.
Gains from trade are based on
comparative advantage. Specialization
through trade increases labor
productivity and wages.
Dumping is prohibited by most countries
that impose anti-dumping duties. Cases
of dumping are rare.

Dumping is the sale of products in a foreign country


LO: 12-4

at prices either below cost or below the prices charged


at home.
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Multilateral Trade Agreements


and Trade Blocks
General Agreement on Tariffs and Trade (GATT)
1947, 23 nations
Nations agreed to give equal treatment to one another, to reduce tariffs
through multinational negotiations, and to eliminate import quotas.

World Trade Organization (WTO)


1993, 152 nations (as of 2008)
Oversees the provisions of the current world trade agreement, resolves
disputes stemming from it, and holds rounds of trade negotiations.

European Union (EU) a trade block of 27 European nations


Nations that have eliminated tariffs and quotas among them established
common tariffs for imported goods from outside the member nations,
reduced barriers to the free movement of capital, etc.

North American Free Trade Agreement (NAFTA)


1993, free-trade zone of US, Canada, and Mexico.
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