Chapter 13: International Trade and Finance

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Chapter 13 International Trade and Finance
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Trade Restrictions

• Specialization and international trade benefit
  individuals in different countries. But, every
  person may not gain.
• Trade Restrictions
• Tariffs
• Quotas
• Dumping

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Tariffs and Quotas

• Tariff a tax on imports.
• Consumers benefit when tariffs do not exist.
• Producers benefit when tariffs do exist.
• The effects of the tariff is increase in tariff
  revenues for government.
• Quota a legal limit on the amount of a good
  that may be imported.
• A quota reduces the supply of a good and raises
  the price of imported goods to domestic
  consumers.
• Consumers dont benefit from quota and producers
  do benefit from quota.
• The effect of quota is an increase in total
  revenue to the importers who sell the allowed
  number of imported units.

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• Dumping The sale of goods abroad at a price
  below their cost and below the price charged in
  the domestic market.

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Why Nations Restrict Trade

• National Defense Argument certain industries
  should remain based in our country, especially if
  they manufacture items vital to our defense.
• This argument is not always valid, since Items
  this argument has been used for also include
  pens, pottery, peanuts, papers, candles,
  thumbtacks, tuna fishing, and pencils.
• Infant Industry Argument new industries must be
  protected from older, established foreign
  competitors until they are mature enough to
  compete. However, removing protection is almost
  impossible.
• This argument can be abused as well.

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Why Nations Restrict Trade (cont)

• Low Foreign Wages Argument A countrys low wage
  advantage may be offset by its productivity
  disadvantage. High wages means high
  productivity. Low wages mean low productivity.
• Saving Domestic Jobs Argument This argument is
  actually most of the previous arguments but in
  disguise.

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Flexible Exchange Rates

• Exchange Rate the price of one currency in
  terms of another currency.
• Flexible Exchange Rate System A system whereby
  exchange rates are determined by the forces of
  supply and demand for a currency.
• Country As demand for Country Bs goods leads to
  a demand for Bs currency and a supply of As
  currency on the foreign exchange market.
• Bs demand for As goods leads to a demand for
  As currency and a supply of Bs currency on the
  foreign exchange market.

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Exhibit 6 The Demand for Goods and the Supply
of Currencies
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Exhibit 7 Translating U.S. Demand for Pesos
into U.S. Supply of Dollars and Mexican Demand
for Dollars into Mexican Supply of Pesos
1 dollar 10 pesos OR 1 peso 0.1 dollars
(1/10 dollars)
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Exhibit 8 A Flexible Exchange Rate System
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Changes in the Equilibrium Rate

• Appreciation An increase in the value of one
  currency relative to other currencies.
• Depreciation A decrease in the value of one
  currency relative to other currencies.
• Example 1 Previously 1 dollar 10 pesos (1 peso
  0.1 dollar). Now 1 dollar 20 pesos (1 peso
  0.05 dollars)
• ? Dollar appreciated and peso depreciated
  (Dollar became stronger and peso became weaker).
• Example 2 Previously 1 dollar 10 pesos (1
  peso 0.1 dollars). Now 1 dollar 5 pesos (1
  peso 0.2 dollars)
• ? Dollar depreciated and peso appreciated
  (Dollar became weaker and peso became stronger).

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Purchasing Power Parity (PPP)

• PPP theory states that exchange rates between any
  two currencies will adjust to reflect changes in
  the relative price levels of the two countries.
• U.S. price level increases by 10 while Mexicos
  price level stays the same.
• U.S. demand for Mexican goods goes up ? U.S.
  demand for pesos goes up.
• Mexican demand for U.S. goods goes down ? Mexican
  demand for U.S. dollars goes down ? Supply of
  pesos will go down.
• Result Demand for pesos decreases and Supply of
  pesos decreases ? peso appreciates and dollar
  depreciates.
• According to PPP theory, dollar will depreciates
  by the same percentage as the inflation rate in
  the U.S. to restore the original price of the
  U.S. goods in pesos.

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Exhibit 10 Inflation, Exchange Rates, and
Purchasing Power Parity (PPP) Higher US Inflation
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Self-Test

• In the foreign exchange market, how is the demand
  for dollars linked to the supply of pesos?
• What could cause the U.S. dollar to appreciate
  against the Mexican peso on the foreign exchange
  market?
• Suppose the U.S. economy grows while the Swiss
  economy does not. How will this affect the
  exchange rate between the dollar and the Swiss
  franc? Why?
• What does the Purchasing Power Parity Theory say?
  Give an example to illustrate your answer.

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Fixed Exchange Rates

• Fixed Exchange Rate System the system where a
  nations currency is set at a fixed rate relative
  to all other currencies, and central banks
  intervene in the foreign exchange market to
  maintain the fixed rate.
• Overvaluation when a currencys current price,
  in terms of other currencies, is above the
  equilibrium price.
• Overvalued peso ? Undervalued dollar
• Undervaluation when a currencys current price,
  in terms of other currencies, is below the
  equilibrium price.
• Undervalued peso ? Overvalued dollar

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Exhibit 11 A Fixed Exchange Rate System
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Exhibit 12 Fixed Exchange Rates and an
Overvalued Dollar
At equilibrium 2 1 peso 0.12 dollars, but 1
peso is fixed to 0.1 dollars ? peso is
undervalued ? dollar is overvalued Dollar side
of the story At equilibrium 2, 1 dollar 0.83
pesos, but 1 dollar is fixed to 10 pesos ? dollar
is overvalued ? peso is undervalued
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Problem with Overvalued Currency

• When Country As currency is overvalued it makes
  exports of Country A more expensive for
  foreigners to buy.
• When Country Bs currency is undervalued it makes
  imports from Country B cheaper.
• U.S Mexico example
• U.S. currency is overvalued ? U.S. goods are more
  expensive ? U.S. exports will decline
• Mexicos currency is undervalued ? Mexican goods
  are cheaper ? imports from Mexico will rise
• U.S. Trade Balance
• ? U.S. will have Trade deficit (negative trade
  balance), since Exports? Imports?

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Government Involvement in a Fixed Exchange System

• Suppose there is a surplus of pesos.
• The Fed might buy pesos with dollars, causing the
  demand for pesos will increase and its demand
  curve will shift to the right.
• The Banco de Mexico might buy the peso with its
  reserve dollars, increasing the demand for pesos
  and the equilibrium rate.
• Or, the Fed and the Banco de Mexico might both
  buy pesos.

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Options Under a Fixed Exchange Rate System

• Devaluation and Revaluation
• Devaluation occurs when the official price of a
  currency is lowered.
• Revaluation occurs when the official price of a
  currency is raised.
• Protectionist Trade Policy
• Tariff a tax on imports.
• Quota a legal limit on the amount of a good
  that may be imported.
• Changes in Monetary Policy

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The Gold StandardFixed Exchange Rate System

• Under Gold Standard countries automatically fix
  their exchange rate.
• Example 1 ounce of gold could be bought with
  either 10 dollars or 100 pesos. Fixes
  dollar/peso exchange rate 1 dollar to 10 pesos.
• Define their currencies in terms of gold.
• Stand ready and willing to convert gold into
  paper money and paper money into gold.
• Link their money supplies to their holdings of
  gold.

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Fixed Exchange Rates Versus Flexible Exchange
Rates

• Fixed Exchange Rates provide certainty, and that
  certainty of price exchange promotes
  international trade. Persistent balance of trade
  problems could develop.
• Trade Balance the difference between the value
  of merchandise exports and the value of
  merchandise imports.
• Flexible Exchange Rates allow a country to adopt
  policies to meet domestic economic goals. But,
  flexible exchange rates can dampen international
  trade.

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Self-Test

• Under a fixed exchange rate system, if one
  currency is overvalued then another currency must
  be undervalued. Explain why this is true.
• How does an overvalued dollar affect U.S. exports
  and imports?