The Global Economy
Lesson 5

World Trade

Flows between the U.S. and the rest of the world

1. Goods and services flows (or trade flows)

• Imports - goods and services flow into the country; money flows outward
• Exports - goods and services flow out of the country; money flows inward
• Net Exports (Xn) = Exports - Imports
  • Trade deficit is imports exceed exports
    • Net Exports < 0
    • Money is flowing out of the country
      • Usually foreigners take this money and reinvest in the U.S.
    • Buy government bonds, corporate stocks, real estate, etc.
    • U.S. has had trade deficit for last 40 years
    • -$700.2 billion in 2007
  • Trade surplus is exports exceed imports
    • Net Exports > 0
    • Money is flowing into country
    • They usually invest money in foreign countries
    • Many Asian countries

2. Capital and labor flows

• Capital - if U.S. exports capital; then that foreign country could produce more products and services
  • The opposite occurs if U.S. imports more capital
• Labor - foreigners immigrate (legally or illegally) into the U.S.
  • Some Americans move abroad

3. Information and technology flows

• Technology - know how can leave or enter a country
• Example -
• Brain drain - foreign scientist and doctors immigrate to U.S.
  • U.S. was a leader in technology; this know how was exported to many Asian countries that use it to produce goods and services
  • U.S. patent holders allows production in a foreign country
  • Many foreigner students study in the U.S.
    • European and U.S. college degrees have a lot of value in many countries around the world
• Information
  • Wide range of information is transmitted around world, like stock prices, returns on bonds, interest rates, currency exchange rates, etc.
  • Financial Flows -money leaves or enters the United States
    • Outflow
      • U.S. government provides foreign aid
      • Pay for imports
      • Buy foreign assets
        • Foreigners earn interest and profits
        • U.S. bonds pay interest to foreigners
        • Foreigners earn profits from corporations as dividends
        • Foreigner earn rents and capital gains on properties
        • Foreigners invested $232.8 billion in 2007 in U.S.

The United States has the largest exports and imports in the world in absolute terms, but trade comprises a small percentage of the U.S. Economy. The U.S. exported $1.6 trillion of goods and services in 2007, but comprised of 11.9% of GDP. U.S. imports were $2.3 trillion, but comprised of 16 9% of GDP.

Why International Trade is Growing

Reasons why international trade grew quickly after WWII.

1. Transportation cost - a cost to transport products and services to the market or between markets; a form of transaction costs
   • Transaction costs have been decreasing
     • Use large barges and airplanes to ship cargo
2. Communication technology - another form of transaction costs
   • Communication cost have decrease
   • Easy to communicate and arrange transactions around the world using telephone, e-mail, computers, and faxes
   • Some state governments and corporations have their information hot lines in India and other places
3. Many countries have decreased tariffs and other trade barriers
4. Multinational corporations - corporations that have operations in two or more countries
   • Multinational corporations have been growing
   • Every countries has different laws, rules, and regulation; however corporations can create departments that keep up with a countries legal structure
     • Proprietorships and partnerships may be too small to engage in international trade
   • Examples
     • Netherlands-Unilever
     • Switzerland-Nestle
     • U.S.A.-Coca-Cola
     • Germany-Bayer Corporation
     • Japan-Honda, Toyota, and Sony
     • South Korea-LG, Samsung, and Hyundai
5. Trade Agreements - two or more countries negotiating on free trade
   • Encourage free trade
   • Organizations
     1. General Agreement on Tariffs and Trade (GATT) - from 1948 to 1995
        • Reduced tariffs from rounds
        • Reduced tariffs to 1/10 the value
        • Countries reduced tariffs but increased nontariff trade barriers
     2. World Trade Organization (WTO) - created from 1995
        • More enforcement power than GATT
        • Review a country's trade policies
        • Protect intellectual property rights
        • Help settle trade disputes
        • WTO can impose trade sanctions

Source : Department of Commerce.

2. Trade Bloc – promote internal free trade while retaining trade barriers with nonmember nations

1. Free Trade Area - a group of countries remove trade barriers among themselves but keep their separate barriers for outsiders
   • Example: North American Free Trade Agreement (NAFTA) - free trade zone among Canada, Mexico, and United States
     • Completely remove trade barriers by 2008
     • Claims NAFTA created many new jobs in United States
2. Customs Union – a group of countries remove trade barriers among themselves and have a common external barriers to outsiders
   • Russia, Belarus, and Kazakhstan
   • The Southern Common Market (MERCOSUR) – Argentina, Brazil, Paraguay, and Uruguay
3. Common Market – a customs union that allows full freedom of factor flows, like capital and labor
   • European Union
   • Free movement of labor, capital, goods, and services within Europe
   • Euro - common currency for EU members
   • Founded the institutions
     • European Parliment Court of Justice
     • European Central Bank
4. Economic Union – member countries unify all economic policies
   • Monetary, fiscal, and welfare policies
   • United States

• Croatia, Republic of Macedonia, and Turkey are candidates for admission to EU
• Did you noticed that Norway and Switzerland are not members?

Comparative Advantage - David Ricardo

Comparative advantage - how two countries can benefit from trade, even though one country could be large and produce everything

• Show how two countries benefit from trade
• Assumptions
  • Both countries are at full employment (i.e. on production possibilities curve)
  • PPCs are straight line (no losses occur when moving resources from industry to industry
    • Works with curved PPCs
  • U.S.A. and Mexico produce both tomatoes and cars
    • No trade - set production at the half way point

• Autarky - no trade
  • U.S. produces 25 tomatoes and 50 cars
  • Mexico produces 30 tomatoes and 15 cars
  • Total production is 55 tomatoes and 65 cars
• Comparative advantage - countries specialize in production of products which they have low opportunity costs
  • Important because a large country like the U.S. that can produce everything at low cost can still benefit from trade with a small country with higher costs
  • Related to slopes of the PPC
  • U.S.A. produces all cars and Mexico produces all tomatoes
    • PPCs are straight lines
  • Total production is 100 cars and 60 tomatoes
    • Gain in production of 35 cars and 5 tomatoes
• Terms of trade - ratio of imports to exports
  • This is an exchange rate between two goods
  • Have not shown how countries divide up the extra production
• Limitations
  • Capital and technology can easily flow from one country to another
  • Outsourcing - a firm sends out part of its production to another firm (in another country)
    • Communication and transportation costs are decreasing

Why Government Imposes Trade Restrictions

Why do country impose trade restrictions?

• A country specializes in trade
  • Country gains from free trade from the goods and services it exports
  • The industry contracts for the products it imports
    • Temporary higher unemployment
    • Some regions may gain while others lose
      • Example - the Rust Belt
        • Ohio, Indiana, Illinois, and Michigan are seeing declines in manufacturing jobs
• Countries have different levels of labor rights, environmental laws, etc.
  • Under free trade, polluting firms may relocate to countries with weak environmental laws
    • Some U.S. firms relocated to Mexico, because of weaker environmental laws
  • Firms relocated to countries that do not have the generous benefits of the West
    • several Asian countries do not unemployment insurance, workman's compensation, sick days, etc.

Methods a country uses to restrict trade

1. Protective tariffs - a tax (or duty) imposed on imported goods
   • A tariff would cause a higher market price on the market goods
   • Encourages consumers to buy within their country
2. Import quotas - government imposes the maximum number of items that can be imported each year
   • The government does not collect any tax revenue
   • During 1980s, imports quotas on Japanese cars
     • Some Japanese cars are made here now
     • Quotas were voluntary, because Japan did not want U.S. markets shut to Japanese cars
3. Non tariff barriers - government imposes licensing requirements or standards
   • Creating "bureaucratic red tape"
   • Government can cite a potential health problem and not import beef
     • Examples
       • Europe prohibited imports of U.S. beef because of the wide use of hormones
       • U.S. temporary halted imports of British beef becuase of mad cow disease
4. Export subsidies - government subsidizes an industry
   • A subsidy causes a a lower market price
   • Can encourage the expansion of a domestic industry
     • Example - U.S. government subsidize U.S. farmers

Foreign Exchanges Rates

Foreign exchange market - the exchanging of different currencies

• Exchange rates - value of one currency in terms of another
  • Most transactions are electronic transfer and involve the exchange of bank deposits denominated in different currencies
• Example: Value meal in Moscow cost 26,000 rubles (approx. $5)
  • What is the exchange rate?
  • $1 = 5,200 rubles
• Example: $1 - 11 pesos (Mexico)
  • How much does a 1-liter of Coca-Cola costs in dollars if it costs 15 pesos?
  • 15 p ($1 / 11 p) = $1.36
• Exchange rates change
  • Example
    • Exchange rate is $1 = 11 pesos and changes to $1 = 10 pesos
      • Depreciation - value of currency decreases
        • Dollar depreciated because it buys less
      • Appreciation - value of currency increases
        • Peso appreciates because pesos purchase more
      • Cola-cola 's price is 15 pesos
        • Now it is $1.50
    • Exchange rate is $1 = 11 pesos and changes to $1 = 12 pesos
      • Dollar appreciated
      • Peso depreciated
      • Coca-cola's price is 15 pesos
        • Now it is $1.25
• If currency is depreciation
  • Encourages investor to switch out of this currency
  • This country's imports decrease
    • Value of their currency is lower
  • This country's exports increase
    • This country has cheaper prices from the depreciated currency
• Opposite occurs if currency is appreciation
• Inflation rule: If inflation rates are: U.S. 3% and Mexico: 25%.
  • Consumers and businesses prefer to hold U.S. dollars.
  • U.S. dollar retains its value.
  • Investors have higher demand for stable currencies

Supply and Demand for Currencies - Optional Material

• Demand and supply market has the assumptions
  • No government interference
  • Flexible exchange rate
• Trade between Mexico and U.S.
  • Exchange rate - the dollar price of 1 peso.
    • amount of $'s per 1 peso.
  • Import - U.S. residents and firms purchase goods and services from Mexico.
    • U.S. firms buy Mexican goods.
    • U.S. firm needs pesos to pay for it.
    • Demand for pesos increases.
    • Converting dollars to pesos causes supply of dollars to increase on foreign exchange market.
  • Export - U.S. residents and firm sell goods and services to Mexico.
    • U.S. firms sell computers to Mexican firms.
    • Mexican firms need dollars to pay for it.
    • Demand for dollars increases.
    • Converting pesos to dollars causes supply of pesos to increase.

Demand for pesos in one market creates a supply of U.S. dollars in other market, and vice-versa.

Demand for Pesos
Price of Pesos
($'s for 1 peso)
Quantity of Pesos

Point A : $ 1/1,000 = 1 Peso        [$1 = 1,000 Pesos]
Point B: $ 1/2,000 = 1 Peso         [$1 = 2,000 Pesos]

• Moving from Point A to Point B causes exchange rate to go down.
  • The $ appreciated, because $1 buys more pesos.
  • The peso depreciated, because 1 peso buys less dollars.
  • The price of American goods became more expensive, while Mexican goods become cheaper.
    • U.S. imports increase.
    • U.S. exports decrease.

Supply for Pesos
Price of Pesos
($'s for 1 peso)
Quantity of Pesos

• Moving from Point A to Point B causes exchange rate to go up.
  • The $ depreciated in value.
  • The peso appreciated in value.
  • The price of American goods became cheaper, while Mexican goods become more expensive.
    • U.S. imports decrease.
    • U.S. exports increase.
• For Mexicans to buy cheaper U.S. products, they need dollars. They convert pesos into dollars, causing more pesos to be supplied on the market.

• Example - Americans demand more Mexican products, ceteris paribus.
  • The equilibrium exchange rate for pesos is P* and quantity exchanged is Q*.
  • Demand for pesos increases.
  • The dollar depreciates, while peso appreciates.
  • U.S. products become cheaper to Mexicans.
    • U.S. exports rise.
    • U.S. imports decrease.

Market for Pesos
Price of Pesos
($'s for 1 peso)
Quantity of Pesos

Changes in exchange rates alter prices of all goods, services, and assets, which are traded on the international markets.

Terminology