First we learned that in order to achieve productive efficiency (i.e. in order to produce at a lower cost and therefore produce MORE) we need to "use resources where they are best suited". This means that secretaries should type letters and truck drivers should drive trucks. It also means that farmers in Honduras should grow sugar and farmers in North Dakota should grow potatoes. This way, MORE sugar and potatoes will be grown. THEN, we can trade with Honduras giving them our potatoes for their sugar. the result will be that we can both have more sugar and more potatoes.
Second, we learned that freer trade (i.e. "Joining the World Economy") is one of the Structural Adjustment Policies that countries are undertaking all around the world.
Structural Adjustment Policies:1. Privatization
2. Promotion of Competition
3. Limited and Reoriented Role for Government
4. Price Reform: Removing Controls
5. Joining the World Economy (free trade)
6. Macroeconomic Stability
Third, we learned that the production possibilities curve represents the maximum amount of two products that can be produced by a country -- by itself, WITHOUT TRADE (any point on the blue line below). But, with trade a country can consume quantities beyond what they can produce by themselves like point A on the graph below.
Here we will add to our understand of trade by introducing the very important concept of COMPARATIVE ADVANTAGE.
From our chapter 2 online lecture:
Major economic changes have been occurring in the last few decades. Countries all around the world, including the United States are currently engaged in a process of globalization, or structural adjustment. This includes, among other things, moving toward free trade. Globalization and the removal of trade barriers is occurring now and it will continue to occur. In the previous lecture it was mentioned that much of what we hear in the popular press is contrary to what we are going to learn in this course. This is very true when discussing globalization. For example, read the following quotes from the CNN news article: Dobbs: New Congress must show courage [http://www.cnn.com/2006/US/11/28/Dobbs.Nov29/index.html].
Lou Dobbs, CNN News commentator and best-selling author, says:
- "But the consequences of faith-based free-trade will be eye-popping in the disaster it wreaks on our economy and working Americans."
- "I hope they (the new Democratic congressional leadership) can acknowledge that so-called free trade has come at an inordinate cost to working men and women in this country. "
- "We've lost three million manufacturing jobs as a result of these so-called free trade agreements that enable corporate America to export plants, production and jobs to cheap foreign labor markets."
- "And yet we persist with our historical ignorance, and we continue to enter poorly negotiated agreements that pose great threats to the U.S. economy and the middle class."
Then read the following quotes taken from our textbook:
- p.90 "Nations specialize and trade for the same reasons as individuals: specialization and exchange results in a greater overall output and income."
- p. 92 "Specialization (i.e. trade) . . . improves global resource allocation. The same total inputs of world resources and technology result in a larger global output."
- p. 354 "Import restrictions alter the composition of employment, but they have little or no effect on the volume of employment."
- p. 95 - "Actually the true benefit created by international trade is the overall increase in output obtained through specialization and exchange.
- p. 352 - "the gains that US trade barriers create for protected industries come at the expense of much greater losses for the entire economy. (emphasis added)"
- p. 351 - Study after study finds that the costs to consumers (of trade restrictions) substantially exceed the gains to producers and government."
- "Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." (McConnell and Brue 2005, p. 361)
Many people who favor trade restrictions (those who oppose free trade) use anecdotal evidence to show that trade can be harmful. An example is the book "America: Who Stole the Dream?" by Donald L. Barlett and James B. Steele With chapter titles like: "How US Policies Are Costing American Jobs", "Importing Goods, Exporting Jobs", and "Endangered Label: "Made in the U.S.A." it is clear they feel that free trade results in a loss of jobs and is harmful to our economy. Yet, further investigation will show that they support their case only with anecdotal evidence rather than scientific research They interview people who have lost their jobs when their factory moved overseas and state that this is evidence that free trade is harmful. But they ignore much. Trade does cost us jobs, but it also creates jobs. Trade also results in lower prices, more output, economic growth and a higher standard of living.
Most economists believe that the benefits of free trade far outweigh the costs. Read the following: http://www.ncpa.org/pd/trade/pdtrade/pdtrade10.html.
Why do the arguments of people who oppose free trade (like Lou Dobbs, and Barlett and Steele) sound so good when economists clearly support free trade?
The following CNN online news article provides a good explanation:
The mystical power of free trade
Now let's examine the economic basis for trade - or what I prefer to call "specialization and exchange".
The Economic Basis for Specialization and Exchange -- Trade
To better understand why most economists support free trade I had you take this little SURVEY that was printed in the Wall Street Journal. (If you didn't do the survey, in the future please do all the surveys listed on our WEEKLY ASSIGNMENTS Blackboard site BEFORE you begin your study of a chapter.)
If you think like an economist, then you would have answered "A" to all five questions. Yes, "A" to all questions.
As we studied in our 5Es lecture, the goal of economic activity is to reduce scarcity and satisfy human wants. The purpose of economic activity then is to reduce scarcity (or "to improve consumer well being". Work then is seen as a cost - something that people would avoid if they could. We don't want work, we want bigger boats. An economy where everybody has to work 18 hours a day just to stay alive is not a success. Imports, where more goods are coming into a country, are seen as a benefit - remember the goal is to get more goods. Exports, where we send our goods to someone else, are seen as a cost - or a loss. And finally, the objective of trade is to reduce scarcity or "get goods cheaply".
Even though there are no "correct" answers to this quiz it should remind us that we are studying how to best reduce scarcity.
Why we specialize and exchange?
Adam Smith observed in 1776 that specialization and trade increase the productivity of a nation's resources. His observation related to the principle of absolute advantage whereby a country should buy a good from other countries if they can supply it cheaper than we can.
Trade, either international trade or trade between Illinois and Alabama, or trade between you and Walmart, is based on the productive efficiency (i.e. more output or more boats) gained by specialization, or using resources where they are best suited.
One way to understand the benefits of specialization and exchange (i.e. trade) is to answer this question:
What would life be like if YOU were self-sufficient?
What would your life be like if you produced all your own food, clothes, energy, your house, your car, your computer . . .? What if you didn't buy anything (i.e. what if you didn't trade) and you produced everything for yourself?
ANSWER: You would have very little.
But if you specialize (for example, I teach economics) and then buy what you want (exchange), you will have a much higher standard of living. This is the advantage of specializing and exchanging -- or trade.
Advantages of trade:
Disadvantages of trade:
So we have a choice to make. Either we can join the world economy, become more dependent on other countries, and enjoy a higher standard of living. Or we can restrict trade and try to "go it alone". We will be more independent, but much poorer.
The basis for specialization and exchange
There are four reasons why trade (specialization and exchange) increase our standard of living:
a. differences in resource endowments
b. differences in preferences
c. differences in productivity
d. differences in opportunity costs
Differences in Resource Endowments
The US has much good farmland and Saudi Arabia has much oil and little good farmland. Therefore we can both gain if we sell them wheat and they sell us oil. This reduces scarcity by giving us more satisfaction from the same amount of resources.
Differences in Preferences
Even if two countries have identical resources they my benefit from trade if they have different preferences, Let's assume that the US and Great Britain have identical resources for the production of coffee an tea. So both countries can produce both products. But in the US we prefer coffee and in Great Britain they prefer tea. So we can both achieve more satisfaction from the same amount of resources if we sell them our excess tea and they sell us their excess coffee.
Differences in Productivity
First a few definitions. What is the difference between:
Often the word PRODUCTION means the "quantity produced". For example "the production of cars last year increase 10%".
PRODUCTIVITY is output per unit of resource, usually output per person. If Joe can produce 10 bikes a day and if Jane can produce 20 bikes a day, Jane is more productive than Joe.
PRODUCTIVE EFFICIENCY is producing at a minimum cost (one of the 5Es). So, if Joe can produce 10 bikes a day and if Jane can produce 20 bikes a day, Jane is more productive than Joe. But if Joe gets $10 a day and if Jane gets $40 a day, Who would you hire? Joe is more productively efficient producing bikes at a cost of $1 a bike, whereas Jane produces bikes at a cost of $2 a bike.
Differences in PRODUCTIVITY is a reason that countries benefit from trade. If a country is more productive in producing a product we say that they have an ABSOLUTE ADVANTAGE in producing that product.
A country has an ABSOLUTE ADVANTAGE in the production of a product if it can produce it with fewer resources than another country. Absolute Advantage is the ability to produce a good or service with fewer resources because of greater productivity.
Let's see how differences in productivity (absolute advantage) results in specialization and exchange (trade).
Let's say there are two people. One is an attorney, the other a mechanic. Let's assume that the lawyer is more productive at doing law than is the mechanic since he or she can do it in less time. And the mechanic is more productive at fixing cars. So the lawyer has an absolute advantage in law and the mechanic has an absolute advantage in fixing cars. So it doesn't surprise us that if the lawyer's car breaks down he or she will bring it to the mechanic to get it fixed. The lawyer trades with the mechanic.
Now let's do a numerical example like you will find on the exams.
Below are the production possibilities curves for two countries: the US and France. Notice that we have assumed constant costs so that the curves are straight lines. In a previous lecture we said that PPCs are concave to the origin because all resources within a country are not the same (the law of increasing costs). Here, we assume that all resources in the US are the same so there are constant costs and the PPC is a straight line. The resources in France are also all identical to each other (but different than those in the US) so France also has constant costs and a straight PPC.
Lets begin by assuming that initially there is no trade and each country is self-sufficient - producing all of its own bread and wine. Let's assume that the US choses to produce 40 bread and 30 wine and France produces 9 bread and 24 wine. These amounts are shown on the tables and graphs below.
Total production by both countries then is show in the table below: 49 breads and 54 wines. This is just one possible level of total production but it will help us understand how both countries can benefit from trade.
Now, lets assume that each country specializes and produces more of the product in which they have an absolute advantage. This means they produce more of the product in which their resources are more productive. In which product will each country specialize? Looking at the production possibilities tables we can answer this question if we assume that each country has the same amount of resources so the data could represent output per worker. So which country has resources tat are more productive in producing bread? If the US ONLY PRODUCES BREAD it could produce 100 bread and no wine. If France only produces bread it can only produce 15. So the US has an absolute advantage in the production of bread. France can produce a maximum of 60 wines whereas the US can only produce 50. so France's resources are more productive in the production of wine- they have an absolute advantage in the production of wine.
If both countries specialize and produce only those products in which they have an absolute advantage we will get a total production of 100 bread (all produced by the US) and 60 wine (all produced by France). See tables and graphs below.
Now compare total production with specialization according to their absolute advantage with total production before, when they were self sufficient (see table below). You can see that with the SAME AMOUNT OF RESOURCES (remember the assumptions behind the production possibilities curve) MORE IS BEING PRODUCED. Before, when self-sufficient, total production was 49 bread and 54 wine. With 100% specialization we can now produce 100 bread and 60 wines. With the same amount of resources 51 MORE bread is being produced (100 - 49) and 6 MORE wine (60 - 54). This reduces scarcity by producing more output from the same amount of resources.
So specialization results in more output from the same amount of resources, but is each country better off now than before? Probably not. In the US they have plenty of bread to eat but no wine. And in France they are starving (no bread) but they are happy (lots of wine) :-).
Let's see if both countries can gain from exchanging (trade). Let's assume that the US offers the starving French 1 brad for all of their wine. France would probably say no, but they offer the thirsty American's 1 wine for all 100 bread. the US would probably refuse. so they begin to bargain until they find a "trade" that is acceptable to both sides. Let's assume they agree to trade 20 bread for 32 wine.
The graphs below show the results of this exchange. Each country is still PRODUCING as they were before, but now after the trade they are CONSUMING more. In the US after trading 20 breads to France still have 80 left and they received 32 wines leaving France with 28.
Looking at the graphs above and the table below we can see the gains from trade. The US is now consuming 80 bread and 32 wine. This combination is OUTSIDE their production possibilities curve. In an earlier lecture we said that this was impossible or unattainable. But with trade more can be consumed than if they were self-sufficient. The same is true for France. Both countries then benefit from specializing and exchanging. Both countries can consume quantities that are impossible for them to produce by themselves
Differences in Opportunity Costs: Comparative Advantage
The main argument in favor of trade is the principle of COMPARATIVE ADVANTAGE. The principle of comparative advantage was first observed and explained in early 1800s by David Ricardo. This principle says that it pays for a person or a country to specialize and exchange even if that person or nation is more productive than potential trading partners in all economic activities. Specialization should take place if there are relative cost differences in production of different items.
Comparative advantage is the ability to produce a product at a lower opportunity cost. We defined opportunity cost in an earlier lecture and the value of the next best alternative that is not chosen as the result of a decision.
Let's look at two examples of how this supports trade;
Assume there is an attorney who is also an excellent auto mechanic and his/her car needs repair. The attorney could fix it in one hour. An auto mechanic could fix it in two hours. (Note: the attorney is better at BOTH fixing cars and doing law.)
Let's say the auto mechanic charges $50 an hour for repairing cars and the attorney charges $200 per hour for doing law.
SHOULD THE ATTORNEY FIX THE CAR OR HAVE THE MECHANIC DO IT? WHY?
If the attorney fixes the car himself/herself it will cost him one hour of lost work in which he could have made $200, but it the mechanic fixes the attorney's car it will only cost the attorney $100 (2 hours x $50). THEREFORE, even if the attorney is better at BOTH fixing cars and doing law, he/she can benefit from specializing in doing law and exchanging with the auto mechanic. This is due to the principle of comparative advantage. To the mechanic the cost of fixing the car himself/herself is greater than the cost of having the mechanic fix it. Since the mechanic can fix the car at a lower opportunity cost, he/she has a comparative advantage in fixing cars and the attorney has a comparative advantage in doing law. Even though the attorney is better, more productive, at both jobs, both the attorney and the auto mechanic can gain from specializing and exchanging (trade).
Now let's do a numerical example like those you will find on the quizzes and exams.
Look at the production possibilities tables and graphs below for the US and France producing bread and radios. Who has an absolute advantage in producing bread? Since the US can produce 100 loaves if they only produce bread and France can produce only 15, assuming that they have the same amount of resources, the US is more productive in producing bread. the US has an absolute advantage in bread production. Who has an absolute advantage in producing radios? Again it is the US. The US (like the attorney above) is more productive at producing both products.
So will they benefit from trading with France? YES! - but which products should they specialize in and trade to the other country? They should specialize according to their COMPARATIVE ADVANTAGES. They should produce more of the product which they can produce for a lower opportunity cost.
So the first thing we have to do is calculate the opportunity costs. This is similar to what we did in a previous lecture.
In the US, when they produce 1 radio, how many breads do they have to give up? Well, if they produce no radios, they can produce 100 bread. but if they produce 25 radios they can't produce any bread. So for 25 radios they have to give up 100 bread OR 4 bread for every 1 radio. In France what is the cost of 1 radios in terms of bread given up? if they produce no radios they can produce 15 bread. If they produce 10 radios they can't produce any bread. So for 10 radios they gave up 15 bread OR 1 and 1/2 bread for 1 radio.
US: 1 radio costs 4 bread
France: 1 radio costs 1 and 1/2 bread
So, who has a comparative advantage in the production of radios? Who can produce radios at a smaller cost? Who can produce radios and give up less bread? The answer is FRANCE. the US has an absolute advantage (more productive) in the production of radios, but France has a comparative advantage. France can produce radios at a lower opportunity cost.
Who has a comparative advantage in the production of bread? Who can produce bread at a lower opportunity cost? Which country gives up fewer radios for each bread produced?
In the US, when they produce 1 bread, how many radios do they have to give up? Well, if they produce no bread, they can produce 25 radios. but if they produce 100 bread they can't produce any radios. So for 100 bread they have to give up 25 radios OR 1/4 radio for every 1 bread. In France what is the cost of 1 bread in terms of radios given up? If they produce no bread they can produce 10 radios. If they produce 15 bread they can't produce any radios. So for 15 bread they gave up 10 radios OR 2/3 (10/15 ) radios for 1 bread.
US: 1 bread costs 1/4 radio
France: 1 bread costs 2/3 radio
So, who has a comparative advantage in the production of bread? Who can produce bread at a smaller cost? Who can produce bread and give up fewer radios? The answer is the US. The US can produce radios at a lower opportunity cost so they have a comparative advantage in the production of bread.
Self Sufficiency Before Specialization
Let's assume that before specialization and trade both countries produce the quantities shown below. I selected these quantities as our starting point so that I can show that the countries both gain from trade.
So, total production without trade is 72 bread and 12 radios. See table below.
Now, lets assume that each country specializes and produces more of the product in which they have an comparative advantage. We just calculated the opportunity costs and we concluded that the US has a comparative advantage in the production of bread and France has a comparative advantage in the production of radios.
On our exams we'll assume that they specialize 100%, which means each country will only produced one products, but here (as in the real world) we'll have them produce MORE of that product in which they have a comparative advantage but not only that product.
So, the tables and graphs below show the results of this specialization according to the principle of comparative advantage. Notice that the US now is producing more bread than when they were self-sufficient and France is producing more radios than before.
So, total output is now 83 bread and 13 radios. See table below.
Now compare total production with specialization with total production before keeping in mind the assumptions behind the productions possibilities model. These assumptions include "fixed resources", the quantity of resources does not change, but what happens to the amount produced? The amount increases by 11 bread (83 - 72) and 1 radio (13 - 12). So from the same amount of resources we are now producing 11 more bread and 1 more radio. This reduces scarcity.
But are the US and France better off now than before? We can't tell yet, but let's assume they decide to trade. The US produces a lot of bread and few radios and France has a lot of radios and little bread. So the US may offer to trade 1 bread to France for all their radios -- and France will probably decline the offer. France may then offer to trade 1 radio for all of the bread produced in the US -- and the US will most likely refuse.
If they continue bargaining, they may find a trade that is beneficial to each country. Let's say they decide to trade 12 bread for 6 radios.
The US which is producing 80 bread 5 radios (see below) and trading 12 bread to France for 6 radios remains with 68 bread (80 - 12) and 11 radios (5 + 6).
France which is producing 8 radios and 3 bread trades 6 radios to the US in return for 12 bread. They end up with 2 radios (8 - 6) and 15 bread (3 + 12).
If we plot these quantities on the production possibilities graphs of each country (see above) we see that they lie outside the production possibilities curves of each country. In an earlier lesson we said that these quantities are impossible -- but we should have said "impossible without trade". Both countries are consuming more with trade than they could without trade. This reduces scarcity.
Trade with increasing costs
We have been assuming that there are constant costs in the production process which gives us a straight line PPC and makes it easier to calculate opportunity costs and to find who has the comparative advantage. But in an earlier lesson we learned about the Law of Increasing Costs. What would happen to our analysis if we used a more realistic concave PPC?
The result would be that trade is still beneficial to both countries, but there would not be 100% specialization. This is because as production of a product increases so does the opportunity costs of producing that product and the country will not retain its comparative advantage. Remember that comparative advantage is the ability to produce a LOWER opportunity cost, so as costs increase with production, the comparative advantage is lost.
But trade is still beneficial.
Terms of Trade
In the example above we said that after bargaining the US and France decided to trade 12 bread for 6 radios. This is called the "terms of trade" - the prices of goods involved in international trade expressed in real terms (rather than in money terms).
How did I know that if I used these terms of trade that both countries would gain from trade?
It is possible to calculate the minimum and maximum terms of trade. We begin by looking at the opportunity costs:
US: 1 radio costs 4 bread
France: 1 radio costs 1 and 1/2 bread
US: 1 bread costs 1/4 radio
France: 1 bread costs 2/3 radio
We know that since the US has a comparative advantage in the production of bread they will specialize in bread, produce more of it, and trade it to France. What is the minimum amount that the US would accept for 1 bread. Well, in the US itself it costs 1/4 radio to produce each bread so they will not accept anything less than this. France is buying bread from the US. It costs France 2/3 radios to produce 1 bread so they will not pay the US any more than this.
The minimum the US will accept for one bread is 1/4 radio and the maximum that France will pay for 1 bread is 2/3 radio. We say that the minimum and maximum terms of trade for 1 bread that is acceptable to both countries is 1/4 to 2/3 radios.
The ACTUAL terms of trade was 12 bread for 6 radios (see above) or 1 bread for every 1/2 radio. this is between the minimum and maximum terms of trade (1/2 is between 1/4 and 2/3).
We can do the same for radios. France sells radios to the US. It costs France 1 and 1/2 bread to produce 1 radio so they will not accept anything less than this. The US is buying radios. It costs the US 4 bread to produce 1 radio itself, so they will not pay France anything more than 4 bread for 1 radio. Therefore, the minimum and maximum terms of trade for 1 radio is 1 and 1/2 to 4 bread.
The ACTUAL terms of trade was 12 bread for 6 radios (see above) or 1 radio for every 2 bread. this is between the minimum and maximum terms of trade (2 is between 1 and 1/2 and 4).
Above we studied the economic basis for specialization and exchange - or TRADE. People trade because they gain from trade. Remember: free trade is not forced trade. We don't have to trade with anyone if we don't want to. We learned that specialization and exchange occurs because of the principle of comparative advantage and we used this principle and production possibilities curves to show how both sides gain from trade. Everything discussed in that lesson applies to trade between me and Walmart, between Illinois and Alabama, or between the United States and other countries. If you go to a store to buy something rather than produce it yourself, you support trade.
Here we will concentrate on international trade. The reason why we trade with other countries is the same reason why we trade with other states, counties, cities, or with each other - both sides gain.
Unique Aspects of International Trade
Even though the fundamentals that support trade apply to both trade between Illinois and Alabama and to trade between the US and other countries, there are a few differences.
1. mobility differences
Distance does tend to make international trade more costly and therefore less likely than internal trade. But modern transportation has reduced these costs significantly.
2. currency differences
When we buy something from Alabama we pay for it using US dollars, but when we buy something from Japan, they want to be paid with Japan Yen. There is a cost and risk involved with exchanging currency and this makes international trade more costly than internal trade. In Europe they have decided to use the same currency (the Euro) to avoid these costs. Yet in developed economies with well-functioning foreign exchange markets this is not a major impediment to trade, but it can be in some developing countries.
This is the main difference between domestic trade and international trade. The US constitution prohibits restrictions on trade between states. Therefore we in Illinois can't tax Wisconsin cheese to help Illinois dairy farmers. But we can tax cheese imported from other countries. This is one reason that we have political disagreements about trade with Mexico, but not about trade with Montana.
The Facts of International Trade
US Trading Partners
INTRODUCTION: From which countries does the US buy the most and to which countries do we sell the most? Who are the most important trading partners of the US? Please try guessing before scrolling down? China? Japan? Germany? . . . . .
From whom we buy the most? CANADA. See chapter 5 for more facts about the "US and World Trade".
As you study this section of chapter 5 keep the following questions in mind:
- From whom we buy the most?
- To whom do we sell the most?
- What do we trade?
- International Comparisons: Exports as a Percentage of GDP
Outline from textbook:
U.S. and World TradeA. Volume:1. Table 5.1 gives an index of the importance of world trade to several countries, based on their exports relative to total output.
2. Figure 5.2 reveals the growth in U.S. imports and exports over past decades. Currently, exports and imports are 11 percent and 16 percent of GDP, which is more than double their importance of twenty-five years ago.
3. The U.S. is world's leading trading nation measured in total volume of trade, but not relative to its GDP. The U.S. share of total world trade has diminished from a post- World War II level of one-third of total trade to one-eighth today.
B. Dependence:1. U.S. depends on imports for many food items (bananas, coffee, tea, spices); raw silk, diamonds, natural rubber, much petroleum.
2. On the export side, agriculture relies on foreign markets for one-fourth to one-half of sales; chemical, aircraft, auto, machine tool, coal, and computer industries also sell major portions of output in international markets (see Table 5.2).
C. Trade pattern:
- The U.S. has a trade deficit in goods (exports exceed imports); in 2005 the trade deficit in goods was $782 billion.
- The U.S. has a trade surplus in services ($58 billion in 2005).
- The principal exports of the U.S. include computers, chemicals, semiconductors, consumer durables, and agricultural products. Its main imports are petroleum, automobiles, computers, and metals.
- The U.S. exports many of the "same" goods it imports. (Intra-industry trade). Specifically, automobiles, computers, chemicals, and semiconductors. (See Table 5.2)
- Slightly more than half of U.S. trade is with industrially advanced countries. (See Table 5.3)
- Canada is the United States' quantitatively most important trading partner (24% of U.S. exports; 17% of U.S. imports).
- The U.S. has sizable trade deficits with Japan and China. In 2005, the U.S. trade deficit with Japan was $85 billion. The trade deficit with China is now larger than with Japan, at $202 billion in 2005. (See Table 5.3)
- U.S. dependence on foreign oil is reflected in its $94 billion trade deficit with OPEC nations in 2005. In 2005, the U.S. imported $125 billion of goods (mainly oil) from OPEC nations, while exporting $31 billion to those countries.
- The U.S. leads the world in the volume of exports and imports. Germany is the world's top exporter; U.S. exports of goods make up about 9% of the world's exports.
- U.S. exports of goods and services (on a national income account basis) comprise 11% of total U.S. output.
- Although the U.S., Japan, and western Europe dominate world trade, there are emerging nations around the world that collectively generate substantial international trade such as South Korea, Taiwan, Singapore and China. China exported an estimated $762 billion in 2005, making it a major player in international trade.
- International trade and finance link economies. Economic change in one part of the world has repercussions for countries around the globe.
- International trade and finance is often at the center of U.S. economic policy.
D. Financial Linkages: (International trade implies complex financial linkages among nations.) Trade deficits must be financed by borrowing or earning foreign exchange, which is accomplished by selling U.S. assets through foreign investment in the U.S. The U.S. borrows from citizens of other nations; the U.S. is the world's largest debtor nation.
E. Facilitating factors that explain the growth of trade:1. Transportation technology has improved over the years.
2. Communications technology allows traders to make deals in trade and global finance very easily.
3. Trade barriers declined dramatically since 1940, and the trend toward free trade continues.
F. Participants in international trade:1. Global Perspective 5.1 shows the major participants in world trade.
2. New participants have become important, especially the Asian countries of China (which now includes Hong Kong), Singapore, South Korea, and Taiwan. The collapse of communism has led to the emergence of former Soviet republics and Eastern bloc countries as world trade participants.
Top Trading Partners - Total Trade, Exports, Imports
Data are goods only, on a Census Basis, in billions of dollars.
Top Ten Countries with which the U.S. Trades
Growth of Trade
International trade as a percent of total output is growing in the US and throughout the world as countries all around the world lower their trade barriers to gain the advantages of of free trade that we have discussed.
Why has trade increased?(1) Improvements in transportation technology ( Costs)
(2) Improved Communications Technology (internet)
(3) General Decline in Tariffs (Structural Adjustment)
THIS QUESTION CAN BE FOUND ON THE DISCUSSION BOARD
Should the US use trade restrictions to protect American jobs?READ:Could your job go to China?
While U.S. employment leaps ...
September 7, 2001 Posted: 12:07 PM EDT (1607 GMT)
By Porter Anderson
(CNN) -- Just as Friday's new Labor Department report shows the United States unemployment rate soaring in August to 4.9 percent from 4.6 percent, a newly released, federally funded study reveals that a significant number of production jobs are shifting from the American workplace to China.
Labor Department statistics suggest that U.S. employers cut far more jobs in August than private economists had anticipated -- 113,000 non-farm positions. And this is after American layoffs passed the 1-million mark in July.
But what concerns Stephanie Luce, Ph.D., about her research data is not just her figure of at least 34,900 jobs -- and maybe twice that -- moving from the States to China in a seven-month period as a result of warming Washington-Beijing trade relations.
"What makes it worse," she says, "is that some of these are higher-wage jobs, the type jobs that U.S. cities have been fighting to win. And now they're leaving. Many of those jobs were held by people who'd been working in them for many years, and in some cases their whole lifetimes."
QUESTIONS:AFTER READING, WHAT DO YOU THINK?
- Should the US use trade restrictions to protect American jobs? What is YOUR answer to this question? YES / NO
- How would most economists answer this question? YES / NO
- According to economic studies which of the following is true for countries that restrict trade?
- The benefits of trade restrictions are much greater than their costs (i.e. countries GAIN from trade)
- The costs of trade restrictions are much greater than the benefits (i.e. countries LOSE when they trade with other countries)
- If YOU answered NO to the first question, how do you reconcile your answer with the news article above? OR what could be done instead of trade restrictions?
Even though there are significant efficiency advantages to free trade, as we have discussed, many people support trade restrictions (or barriers). Here we will discuss the types of trade barriers, look at their costs and benefits, and analyze why they exist.
US trade Barriers: http://www.ncpa.org/pd/trade/pd120998a.html
Types of Trade Restrictions
There are five ways that countries can restrict, or distort, trade:
- import quotas
- nontariff barriers
- voluntary export restrictions
- export subsidies
TariffsTariffs are taxes imposed on imported products. There are two types of tariffs - or two reasons that countries put additional taxes on imported items:1) revenue tariffs - are tariffs that are used for raising revenue for the government. Revenue tariff rates tend to be LOW so that consumers will still buy the product and therefore the government will collect revenue. The tariff on imported cars is 2.5%. This low tariff still results in many car imports and the government then collects the additional revenue.
2) protective tariffs - tariffs that protect domestic producers from foreign competition by raising import prices. Protective tariffs tend to be high. The goal of protective tariffs is to raise the price of the imported item so much that people will not buy the foreign import and will buy the domestically produced product instead. The tariff on imported trucks is 25%. Some protective tariffs are as high as 100%.
Examples of US tariffs: http://internationalecon.com/v1.0/ch10/10c051.html
Import QuotasImport quotas are maximum limits on the number or total value of specific imports. Once quotas are filled, no more imports are allowed into the country. Import quotas specify the maximum amounts of imports allowed in a certain period of time. Low import quotas may be a more effective protective device than tariffs because tariffs do not limit the amount of goods entering a country. If an exporting country can produce a product at a very low cost, it might still be able to sell a lot even if there is a tariff. But with an import quota it doesn't matter how cheaply the product can be produced, once the quota is reached no more of the product can be imported.
Nontariff BarriersThere are many ways that governments restrict and distort world trade. These nontariff barriers include licensing requirements, unreasonable standards, or bureaucratic red tape in customs procedures.
For examples see: http://www.globalpolicy.org/globaliz/econ/2003/0403barriers.htm
Voluntary Export RestrictionsVoluntary export restrictions are agreements by foreign firms to "voluntarily" limit their exports to a particular country. Japan has voluntary limited on its auto exports to the United States. Why? Usually voluntary export restricts are enacted in response to threats of stronger trade restrictions. For example, in the 1980s the growing numbers of automobile imports from Japan resulted in congress considering the imposition of tariffs or quotas on Japanese cars. In response to these discussions, even though no new trade restrictions were enacted, the Japanese auto producers voluntarily reduced their exports to the US and this action persuaded congress NOT to enact any new trade restrictions.
Export Subsidies / Agricultural SubsidiesExport subsidies occur when governments pay firms to export goods. Such subsidy lowers the prices of these exports and the amount exported therefore increases. Export subsidies are really a type of nontariff barrier to trade, but I list it separately here because it is one that is commonly in the news these days. Since they distort international trade, they are seen as a barrier to "free" trade.
The US, Europe, and Japan have many subsidies and price supports on agricultural products. This encourages farmers in these rich countries to produce more. As more is produced, the world prices of these products decreases. These low world prices have a very detrimental affect on poor developing countries who rely more on agriculture for their livelihood. So the result of rich countries trying to help their farmers is to hurt the poorest of the poor around the world. Furthermore, rich countries also tend to have high tariffs on imports of agricultural products from poor countries. These three policies (export subsidies, agricultural subsidies, and agricultural import restrictions) have very negative effects on the poor farmers in the world's poor countries.
Please listen to the following National Public Radio report by clicking on the link below and then click on the button. In it you will learn about a proposal to:
- reduce agricultural tariffs around the world to promote trade and efficiency
- eliminate agricultural export subsidies in the rich countries
- reduce agricultural price supports that pay farmers in the rich countries to produce more
Global Trade Talks Aim to Reduce Agriculture Subsidies
by Kathleen Schalch
All Things Considered, November 22, 2002 · In Doha, Qatar, World Trade Organization talks focus on dramatically reducing or eliminating agriculture subsidies. Some analysts say subsidies make it difficult for developing countries to compete in growing and exporting crops. NPR's Kathleen Schalch reports.
Also read the following BBC report on how subsidies to US cotton farmers affect poor farmers around the world.
The World Trade Organization has ruled that these US subsidies constitute unfair trade and they have asked the US to eliminate them.http://news.bbc.co.uk/1/hi/business/3820875.stm
Why Trade Barriers Exist? -- special-interest effect
We now know that "Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." If this is true, why do countries restrict trade? Can't governments understand the benefits of free trade? To understand why trade barriers exist we will use the example of import quotas on steel and answer the following three questions:a. who gains from trade barriers (who gains from the quotas in steel imported into the US) ?
b. who loses from trade barriers?
c. why do trade barriers "look good"?
Who gains from trade barriers? (Who would support restrictions on the imports of cheaper steel into the US from other countries?)
- US steel producers
- Workers in US steel plants
Who loses from trade barriers? (Who is hurt from these steel import restrictions?)
- Foreign steel companies and their workers
- US companies that use steel because with the import quotas the price of steel will rise - like US automobile producers
- Workers in factories that need to use steel - like US auto workers
- and most importantly, US consumers lose due to higher steel prices and less steel, higher automobile prices and fewer cars, i.e. LESS EFFICIENCY, FEWER PRODUCTS, AND HIGHER PRICES.
Why do trade barriers "look good"? / Why do governments enact trade barriers?They don't understand the benefits from international trade and see only the damage in certain industries that can't compete successfully with imports. Remember, the benefits of free trade far outweigh the costs. Political considerations are important because consumers don't see the effects of a tariff or quota directly, but they do see the impact of import competition on some workers. Also, the benefits of free trade tend to be spread among all consumers, but the benefits of a protective policy are realized almost immediately in the short run by the affected industry may have a large and vocal stake in the outcome.
Therefore, governments enact trade barriers even though they hurt their consumers who must pay higher than world prices. Interference with international trade through protective tariffs and quotas is shown to cost society more than the benefits that are received by the protected firms and workers.
Read the following article, especially the yellow highlighted paragraphs which describe the "special interest effect". The special interest effect says that since a few people benefit A LOT from trade restrictions (like US steel companies and their workers) they have a "special interest " in supporting steel import restrictions. The rest of use are only hurt only A LITTLE from these trade restrictions, therefore we do not object very much. So, even though there are many more of us, and the total of our losses are much greater than what the steel industry gains (see table below), the steel industry lobbies harder for these trade restrictions and we lobby very little against them.
READ: Why do trade barriers "look good" (from http://www.cnn.com/ALLPOLITICS/time/1999/12/06/free.trade.html).
Consumers don't see the negative effects of a tariff or quota directly, but they do see the impact of import competition on some workers.
Also, the benefits of free trade tend to be spread among all consumers, but the benefits of a protective policy are realized almost immediately in the short run by the affected industry may have a large and vocal stake in the outcome.
What are the COSTS of Trade Barriers?
The costs of trade barriers are much higher than the benefits
The costs of trade barriers to society are much higher than the benefits of trade barriers to society. Economists have estimated these benefits and costs and have expressed them in dollar terms. Since the main argument for trade restrictions is to create jobs (we will discuss the fallacy of this argument below), economists then calculate the total cost to society PER JOB SAVED. The results can be seen in the table below.The net costs of trade protection in 8 industries:
From McConnell and Brue, 2002
Annual loss to economy from barriers = Cost
Net employment loss if barrier is removed = jobs "saved"
Annual cost PER JOB SAVED
Textile and apparel
$ 10.04 billion
$ 2.79 billion
$ 1.01 billion
$ 710 million
$ 661 million
$ 185 million
$ 162 million
$ 147 million
Source: compiled from United States International Trade Commission data released December 1995. Data are for 1993.
As you can see, the annual cost to society per job saved is very high - even higher than the salary for those jobs. In other words, we would be better off to have free trade and just pay these former workers for doing nothing! But of course, we wouldn't want to do that, but we will still come out far ahead if we move to freer trade and then HELP people who lose their jobs adjust to the more efficient economy. the important point is:
"The gains which trade barriers create for protected industries come at the expense of much greater losses for the economy as a whole. The result is economic (productive) inefficiency" (McConnell and Brue 2005, p. 368)
Our textbook discusses the changes that occur in dynamic, free trade, economies and what can be done to help workers who are negatively affected by free trade. The point is that society would be better off with free trade (and then help these people adjust), than if we try to restrict trade and prevent the changes.
Outline of the textbook section:Trade Adjustment AssistanceA. A nation's comparative advantage changes over time, changing the goods that are produced. Workers in the declining industries are often hurt by this process.
B. The Trade Adjustment Assistance Act of 2002 was passed to mitigate the hardships caused by changing trade patterns. The law provides:1. Cash assistance (beyond unemployment insurance) for up to 78 weeks for workers displaced by imports or plant reallocations. To receive assistance workers must actively engage in job search or retraining program.
2. Funds to geographically relocate to a new job elsewhere in the U.S.
3. Refundable tax credits for health insurance to maintain coverage during the unemployment period.
4. Wage insurance for workers 50 years of age or older that fills any gap in wages between their old and new jobs.
C. Supporters like that it targets those hurt by foreign trade and still allows reduction of trade barriers.
D. Critics observe that only 3% of job loss is due to foreign trade, many jobs are lost because of a dynamic economy (the same reason foreign trade patterns change), and losing one's job to foreign trade is not deserving of preferential treatment.
Trade barriers have a negative impact on income distribution (i.e. they hurt the poor more than the wealthy)We have discussed above, and will discuss more below, how trade restrictions tend to hurt people in the poorest countries of the world more than those in the wealthier countries. But even within the wealthy countries of the world trade restrictions tend to hurt the poor more than the rich. Skim the following report that makes this point. Actually, the report linked below tends to exaggerate the point a bit by selecting specific and dramatic, examples. what you should remember is: "Tariffs and quotas affect low-income families proportionally more than high-income families . . . . [T]rade restrictions are highly regressive" (McConnell and Brue, 2005, p. 369)
Trade restrictions in the more developed countries have a large negative impact on people in less developed countriesWe will study the less developed countries of the world in the next unit. Here we want to understand how trade restrictions may have a larger negative impact on the world's poorest countries.
The Case FOR Protection (Trade Restrictions)
Now that we know that the overall costs of trade restrictions significantly outweigh the benefits, we should ask, "Why do we have them?" The special-interest effect discussed above partially answers this questions. Here let's examine the arguments used by those who support trade barriers. For each argument make sure you(1) understand the argument,
(2) know whether the argument is economically sound or not, and
(3) if it is economically sound, know whether there are additional problems with the argument.
There are six commonly-used arguments for trade restrictions that we will discuss briefly:a. Military Self-Sufficiency
c. Infant Industry / strategic trade policy
d. Protection from Dumping
e. Create or Protect Jobs
f. Cheap Foreign Labor
Military Self-Sufficiency Argumenta. argument:The argument is that the country cannot be dependent on other countries for its national defense. Therefore, we may want to protect certain industries so that they don't go out of business due to international competition. Military self sufficiency may be a valid political economic argument for protecting industries that are critical to national defense.
b. argument makes some economic sense, BUT:However, the problem with this rationale is that nearly every industry is critical in one way or another. It is difficult to select strategic industries to protect. Also, most goods are produced in many places, so dependence on one nation is not likely.
c. counterargument:(1) It is difficult to measure benefits of such trade restrictions
(2) Very many industries try to make this claim
(3) Are there better ways to assure that we do not become dependent on other countries for our national defense? Subsidies to certain industries could help those industries stay in business with fewer negative effects on society.
Diversification for Stabilitya. argument:(1) protect certain industries to diversify economy
(2) less dependence on one or two products
b. argument makes some economic sense,Diversification for stability may be a legitimate reason for a nation to protect certain industries until they become viable. For example, Saudi Arabia may not always be able to depend on oil exports nor Cuba on sugar exports. They need to develop other industries.
c. BUT: counterargument:(1) This argument does not apply to the U.S. or other diversified economies.
(2) The economic costs (inefficiency) of diversification may be great and not worth the protection.
Infant-Industry Argumenta. argument:The infant industry argument is similar to the diversification argument for protection. New industries allegedly may need "temporary" protection to gain productive efficiency.
(1) temporary protection
(2) while new industries become established
(3) the protection then is removed
b. argument makes some economic sense, BUT:
c. counterarguments(1) which industries should be protected and how do we know that they will be able to compete once the protection is removed? Such questions would need to be answered by the government who do not have expertise in such areas.
(2) Often, such protection is not temporary. Once an industry becomes established the trade restrictions are supposed to be removed with the result being more competition which is good for society. But often the industry gains political clout and lobbies to keep the trade restrictions.
(3) Is it necessary? Many industries become established without government help. It is not clear why certain industries would need such help.
(4) better methods-subsidies?
c. strategic trade policyStrategic trade policy has been successful in Japan and South Korea, but there is still a danger of retaliation by affected nations. Affected nations can implement tariffs in response.
(1) industrialized economies
(2) promotes product development
(3) examples: Japan; South Korea
(4) problems: retaliation
Protection Against "Dumping"a. argument:Protection against "dumping" is another argument for tariffs when nations "dump" excess products onto U.S. markets at below cost. These firms may be trying to drive out U.S. competition.
(1) define dumping: below COST
(2) driving out competitors = monopolization
(3) argument makes some economic sense, BUT:The Federal government has the right to impose antidumping duties (tariffs) on the goods that were "dumped," but it may be difficult to prove the below cost sales in the first place. Dumping is an "unfair trade practice" and is prohibited under U.S. trade law.
b. counterargument:(1) few cases
(2) price discrimination is not dumping - Dumping can be a form of price discrimination
(3) dumping or comparative advantage?
Increase Domestic Employment?a. argument:Increasing domestic employment is the most popular argument for protection, but there are important shortcomings associated with this reasoning.
b. counterargument:(1) job creation from imports also - Imports may eliminate some jobs, but they create others in the sales and service industries for these products.
(2) retaliation - Retaliation is a risk that occurred in the 1930s when high tariffs were imposed by the U.S. Smoot Hawley Tariff Act of 1930. Protectionism against American goods will hurt our export industries. Such trade wars still erupt today although the WTO helps to eliminate the problem.
(3) long-run feedbacks - Long run feedbacks relate to the fact that continued excess of exports over imports leads to a shortage of dollars abroad, which foreigners need to purchase more American goods and services; a nation must import in order to export.
(4) must import to export - The fallacy of composition applies here. The imports of one nation are the exports of another. By achieving short term employment goals at home, the trading partner may be made weaker and less able to buy the protectionist nation's products.
c. The Increase Domestic Employment argument does NOT make economic sense - jobs change, but not increased
Recently "offshoring: of jobs has become an issue in the popular press. Offshoring is the shifting of work previously done by American workers to workers located in other nations. Offshoring has occurred for a long time, usually in manufacturing. In recent years, however, advances in computer and communication technology have allowed service jobs to move offshore. Offshoring reflects changes in comparative advantage, and creates the same problems (job loss) and benefits (lower production costs and goods prices) as other changes in trade patterns.
The U.S. develops and/or maintains a comparative advantage in other sectors; while offshoring causes some job loss, it also creates demand for complementary jobs. While offshoring parts of an operation imposes costs on workers losing their jobs, it is preferable to the entire firm relocating abroad.
Cheap Foreign Labora. argument:Protection is said to be needed against the competition from cheap foreign labor. However, this argument is not valid.
b: counterargumentIt is mutually beneficial for rich and poor to trade with one another.
c. The Cheap Foreign Labor argument does NOT make economic sense - but it is very popularBy not trading, we don't raise our living standards at all, but we will decrease them by shifting labor into inefficient areas where the foreign labor could have produced the items more efficiently.
Summing UpArguments that make some sense, but often abuseda. Military Self-Sufficiency
c. Infant Industry
d. Protection from Dumping
Arguments that do not make sense, but are very populara. increase domestic employment
b. cheap foreign labor
International Trade Policy
Multilateral Agreements and Free-Trade ZonesTrade barriers can cause a "trade war," in which all nations retaliate with trade barriers of their own. The Smoot-Hawley Tariff Act of 1930 was a classic example of this. It prompted other nations to increase tariffs and global trade fell as well as U.S. output. (See Figure 5.5.)
1. Reciprocal Trade Agreements Act of 1934 had the goal of reducing tariffs.1. It gave the President the power to negotiate reductions up to 50 percent if the trading partner also reduced its tariffs.
2. It included "most-favored-nation" clauses in agreements so other nations also benefit when negotiations succeeded with one particular country. For example, if the U.S. negotiated a reduction in tariffs with France, to lower American tariffs on French imports, the imports of other nations having most favored nation status, say, Sweden would also be reduced.
2. The General Agreement of Tariffs and Trade (GATT):1. In 1947 after WWII, the U.S. signed an agreement to negotiate reductions on a multilateral basis. Twenty-three nations originally signed, but now 128 nations belong to GATT.
2. The latest round of GATT negotiations was the eighth set of negotiations. It began in Uruguay in 1986 and concluded at the end of 1993. The agreement was passed by Congress in the fall of 1994, went into effect in 1995, and was phased in through 2005. Its major provisions include the following.a. Tariff reductions will average 33 percent.
b. Services are included in the treaty's trade rules.
c. Quotas on textiles and apparel imports will be replaced by tariffs and these, too, will be eliminated gradually.
d. Agriculture will also be affected with members agreeing to cut subsidies to agriculture and quotas on agricultural imports.
e. Intellectual property will be protected by international patent, trademark, and copyright agreements.
3. World Trade Organization (WTO)Inefficiencies of protectionism have led nations to seek ways to promote free trade. The Uruguay Round of 1993 established the World Trade Organization. In 2006, the WTO had 149 member nations. The Uruguay Round of the GATT established the WTO as the GATT's successor.
The ninth and latest round of negotiations (the Doha Round) started in Doha, Qatar, in late 2001. This round has targeted further tariff and quota reductions, as well as reductions in agricultural subsidies that distort the pattern of trade. It was named for where the round originated, Doha, Qatar.
The WTO oversees trade agreements and rules on trade disputes.
Critics of the WTO are concerned that the rules crafted to expand trade and investment enables firms to circumvent national laws that protect workers and the environment. The WTO has become a protest target of groups who are against various aspects of globalization.
Proponents argue promotion of free trade will raise output and incomes and that the higher standards of living will likely result in more protections for workers and the environment.
4. European Union (EU):1. In many regions of the world, countries have formed free-trade zones to reduce tariffs.
2. The EU, formed in 1958 as the Common Market, now is comprised of 25 European countries, with the last 10 joining in 2004.
3. The EU is a trade bloc, with member nations having a common identity, economic interests, and trade rules.
5. The Euro:1. The euro is a currency established by the EU that is now being used by twelve of the twenty-five EU nations (as of 2006).
2. Starting in 1999, the euro has been used as electronic payments for credit card purchases and transfer of funds among banks.
3. As of July 2002, only the euro is accepted for payments in the EU countries that have adopted the currency.
6. North American Free Trade Agreement (NAFTA):1. This free-trade zone was established in 1993 among Canada, U.S. and Mexico with about the same combined output as EU, but a larger geographical area.
2. Free trade with Mexico was controversial because critics fear a loss of American jobs as firms can move to Mexico more easily. Also, they fear Japanese and South Korean firms will build plants there and import goods duty-free to U.S.
3. The increased trade has increased domestic employment, reduced unemployment, and increased the standard of living in all three countries.
Recent U.S. Trade Deficits
A trade deficit occurs when the value of goods imported is greater than the value of goods exported.
- merchandise: http://dylee.keel.econ.ship.edu/intntl/ecn321/lecture/images/Trade_m.gif
- services: http://dylee.keel.econ.ship.edu/intntl/ecn321/lecture/images/Trade_s.gif
Recent U.S. Trade DeficitsA. In 2005 the U.S. trade deficit in goods and services was $724 billion, and the trade deficit in goods only was $782 billion. (Figure 19.3) A trade deficit means that the U.S. is receiving more goods and services as imports from abroad than it is sending out as exports.
B. Causes of the trade deficit.1. From 1997 to 2000, and from 2003 to 2005, the U.S. economy grew more rapidly than the economies of several major trading nations. This growth of income has boosted U.S. purchases of foreign goods. In contrast, Japan, some European nations, and Canada suffered recessions or slow income growth during this period.
When our economy grows people buy more things, included imported things. When the economies of other countries are in recession their citizens buy less things included fewer goods exported from the US.
2. Large trade deficits with China have emerged ($202 billion in 2005, larger than the $83 billion U.S. deficit with Japan).
3. Rapidly rising oil prices, because of the large percentage of oil imported by the U.S., have increased the trade deficit with OPEC.
4. A declining savings rate in the U.S. has contributed to U.S. trade deficits and an increase in foreign investment in U.S. As Americans save less, they spend more, including more on imports.
C. Implications of U.S. trade deficits1. INCREASED CURRENT CONSUMPTION A trade deficit means that the U.S. is receiving more goods and services as imports from abroad than it is sending out as exports. The gain in present consumption (increased current consumption allowing the US to consume quantities outside of its production possibilities curve.) may come at the expense of reduced future consumption. Eventually, with high trade deficits the value of the dollar will decline and imports will become more expensive and begin to decline as exports increase. This will reduce the trade deficit, but also decrease future consumption.
2. INCREASED US INDEBTEDNESS A trade deficit is considered "unfavorable" because it must be financed by borrowing from the rest of the world, selling off assets, or dipping into foreign currency reserves. In 2004, foreigners owned $2.5 billion more assets in the U.S. than Americans owned in foreign assets.
3. Therefore, the current consumption gains delivered by U.S. trade deficits could mean permanent debt, permanent foreign ownership, or large sacrifices of future consumption. These sacrifices may be minimized if higher economic growth results as foreign investment expands our capital base.
For details see: http://www.census.gov/indicator/www/ustrade.html
Foreign Exchange Markets
A. In a foreign exchange market, various national currencies are exchanged for one another so that international trade can take place. Germans want euros, Mexicans want pesos, and the Japanese want yen when they sell their products.
B. Exchange rates link domestic (one country's) prices with all foreign prices. They enable you to translate the price of foreign products into dollars. For example, if the dollar/yen exchange rate is 1 cent/per yen, a Sony TV set priced at ¥20,000 will cost an American $200 = (20,000 x .01).
C. The dollar yen exchange market is depicted in Figure 5.3. The demand for yen and the supply of yen curve will establish the equilibrium dollar price of yen.
D. Changing rates: Appreciation and Depreciation.1. If the demand for yen rises, the dollar price of yen rises. That means the dollar depreciates relative to the yen. This could happen for many reasons including an increase in U.S. incomes that enables Americans to buy more Japanese goods, or an increase in preference for Japanese products. The result is that Japanese goods would become more expensive to Americans and U.S. products would become less expensive to us. (See Figure 5.4.)
2. If the opposite occurred and Japanese incomes increased more than U.S. incomes and/or Japanese preferences for U.S. products increased, then the dollar would appreciate relative to the yen as the yen supply increased. Americans will purchase a greater quantity of Japanese products because they have become less expensive in dollar terms.