Frank Bernanke Ch 16 International Trade and

Frank & Bernanke Ch. 16: International Trade and Capital Flows

Trade Flows l Buying foreign goods at cheaper prices than domestically produced. l Selling domestic goods to foreign countries at higher prices than sold domestically. l Trade makes participant countries better off. l The choices are determined by comparative advantage.

Capital Flows l Buying and selling of assets across borders. l Financial assets are bank deposits, bonds, stocks, foreign currency, etc. l Real assets are real estate, factories, art, etc. l Trade flows and capital flows together cancel each other. – Trade deficits are financed by capital inflows and trade surpluses are matched by capital outflows.

Production Possibilities Curve l Suppose there are two individuals (say a married couple) who have the following productivities. – He can clean house or cook one meal per day. – She can clean house or cook two meals per day. l Draw PPC for this household per week.

Opportunity Costs l What is her opportunity cost of giving up cleaning? – A gain of 2 meals. l What is his opportunity cost of giving up cleaning? – A gain of 1 meal. l Who should give up cleaning first?

PPC for 3 -persons l Suppose her mother comes to live with them. l She can clean or cook three meals. l Who should stop cleaning first? l What would the PPC look like?

PPC for Many Workers A B

Consumption Possibilities l In a closed economy where there is no trade (autarky) a country’s consumption possibilities are limited by its production possibilities. l In an open economy where a country can sell products at higher prices than at home and buy products at lower prices than at home, the consumption possibilities are larger than the production possibilities.

Him and Her Again l Suppose cleaning and cooking can be exchanged in the marketplace for 1. 5 meals per cleaning. l Put this information on PPC. l Determine who is going to do what. l Show why the couple is better-off.

14 7 She can get 10. 5 cleanings for her 14 meals He can get 10. 5 meals for his 7 cleanings 14 21 1 4

Many Workers

Cheap Labor and Jobs l If two countries are producing the same products, computers and food, and one country has lower wages, would free trade make the higher wage country lose all the jobs? l Productivity and wages l Comparative advantage

Productivity and Wages l Wages are high in the country that has higher productivity. l Productivity is measured as Marginal Product of Labor. l MPL = Increase in Output/Increase in Labor l MPL shifts to the right as capital, technology, and human capital increases.

Comparative Advantage l If rich country (R) can produce 10 computers or 100 food with one unit of labor and poor country (P) can produce 2 computers and 50 food with one unit of labor who has the absolute and comparative advantage in computers and in food? l What if P can produce 2 computers and 20 food?

Supply Curve l If the “price” of one computer is 10 food in R, would the people in R make more or less computers if they could exchange a computer for 11 food? 12 food? 9 food? l How does this look in a typical supply curve? l How does it relate to PPC?

Increasing Computer Price Food Computers

PPC Food Computers

Supply Curve Price of computers 11 10 9 Computers

Demand Curve l Typically, demand depends on the income of the people, their tastes and the price of the product. l As the computer price goes up, ceteris paribus, the number of computers demanded will fall.

Autarky P Computers

Exports P Pw Computers

Imports P Pw Computers

Markets With Trade l On a supply-demand diagram, show the world price, amount produced, amount exported and amount consumed. l On a supply-demand diagram, show the world price, amount produced, amount imported and amount consumed.

Winners and Losers l Because of the difference between world and domestic prices some gain and others lose from free trade. l Winners are consumers of imported goods and producers of exported goods. l Losers are consumers of exported goods and producers of import-competing goods.

Winners and Losers

Import Tariffs Pw+t Pw

Import Quota P Pw Quota

Net Capital Inflows l Capital inflows are purchases of our assets by foreigners (funds flowing in). l Capital outflows are our purchases of foreign assets (funds flowing out). l Net capital inflows (KI) is capital inflows minus capital outflows. l KI>0 net capital inflows. l KI<0 net capital outflows.

NX and KI l Net exports and net capital inflows are connected. l NX + KI = 0 l If there is a trade surplus, we have claims abroad: we can keep the local currency earned in a bank abroad, buy local stocks, bonds, real estate. l If there is a trade deficit, the foreigners can purchase our assets. If they demand their money, we borrow (sell bonds = KI).

Real Interest Rates and KI l Net capital inflows respond to changes in our (domestic) real interest rates. l Higher real interest rates mean people can earn higher returns here. l Lower real interest rates mean people can earn higher returns abroad.

Real Interest Rates and KI Real interest rate KI Net capital outflows 0 Net capital inflows

Shifts in KI l Riskiness of domestic assets increases => KI shifts left. l Riskiness of foreign assets increases => KI shifts right. l Real interest rate abroad increases => KI shifts left.

Savings and Investment 1. 2. 3. 4. 5. 6. Y = C + I + G + NX (output = AD) Y=C+S+T (output = income) C + S + T = C + I + G + NX (one and two) S + (T – G) – NX = I (from three) KI = - NX (from NX + KI = 0) Private savings + Government savings + Capital inflows = Investments (from four)

Saving and Investment r r S+(T-G)+KI 0 I Japan USA