The Open Economy

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The Open Economy

• Sushi and demand for Blue Tuna
• The circular flow
• Balance of payments accounts
• Foreign exchange markets
• Trends in globalization U.S. balance of
  payments
  
• Net investment position and balance of payments

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The Circular Flow
Sourcewww.washingtonpolicy.org/images/STAMPfig1Ci
rcularFlow
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Adam Smith Theory of Absolute Advantage

• Smith examined the case of absolute advantage, in
  which labor productivity in producing one product
  is higher in one country and labor productivity
  in producing the other product is higher in the
  other country.
• With no trade each country must produce both
  products to meet national demands. The discussion
  of the Smith case focuses on the increase in
  global production efficiency achieved by shifting
  production in each country toward the product in
  which it has the higher labor productivity.
• The increase in total world production is the
  evidence of gains from international trade.

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• Smith's approach does not indicate what would
  happen if the same country had absolute advantage
  in both products.

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Adam Smiths ExampleAbsolute Advantage
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Ricardos Theory of Trade

• Ricardo demonstrated the principle of
  comparative advantagea country will export
  products that it can produce at low opportunity
  cost and import products that it would otherwise
  produce at high opportunity cost.  
• Comparative advantage
•  A country will export products that it can
  produce at a low opportunity cost (in terms of
  other goods that could be produced within the
  country).
•  A country will import products that it would
  otherwise produce at a high opportunity cost.
  
•  
• Basis for trade
• Relative differences in labor (resource)
  productivity.

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Ricardos ExampleComparative Advantage
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Ricardos ExampleNo-Trade Relative Prices
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The Gains from Trade, Shown for Ricardos
Constant-Cost Case
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Production Possibilities under Increasing Costs
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Indifference Curves Relating an Individuals
Utility Levels to Consumption of Two Goods
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Indifference Curves and Production Possibilities
without Trade
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Two Views of Free Trade and Its Effects
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Heckscher-Ohlin Theory of Trade

• A country will export products that use
  relatively intensively those production factors
  found relatively abundantly in the country, and
  import products that use relatively intensively
  those production factors that are relatively
  scarce in the country.
• H-O comparative advantage is actually a triple
  comparison
  
• -across countries
• -across products
• -across factors of production