LECTURE 9

CHAPTER 3,9,31
OPEN-ECONOMY
MACROECONOMICS
  The meaning of absolute and
comparative advantage and
their application
 How everyone can benefit from
trade
LECTURE
 Examine the trade restrictions
OBJECTIVES
and the arguments for and
against them
 The International flows
 Nominal and Real exchange
rate
OPEN AND CLOSED ECONOMIES
 A closed economy: one that does not interact
with other economies in the world.
 No exports
 No imports
 No capital flows.
 An open economy: one that interacts freely
with other economies around the world.
 INTERDEPENDENCE AND TRADE

ECONOMICS IS THE STUDY OF HOW SOCIETIES

PRODUCE AND DISTRIBUTE GOODS IN AN
ATTEMPT TO SATISFY THE WANTS AND NEEDS
OF ITS MEMBERS.

5
HOW DO WE SATISFY OUR WANTS AND
NEEDS IN A GLOBAL ECONOMY?

 Economically self-sufficient.
 Specialize and
trade with others,
leading to economic
interdependence.

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 INTERDEPENDENCE AND TRADE

 Individuals and nations rely on specialized

production and exchange as a way to address
problems caused by scarcity.
 This gives rise to two questions:
 Why is interdependence the norm?
 What determines production and trade?

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WHY IS INTERDEPENDENCE THE NORM?

Interdependence occurs because

people are better off when they
specialize and trade with others.

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WHAT DETERMINES THE
PATTERN OF PRODUCTION AND TRADE?

Patterns of production and trade

are based upon differences in
opportunity costs.

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A PARABLE FOR THE MODERN
ECONOMY
 Imagine . . .
only two goods: potatoes and meat
only two people: a potato farmer and a
cattle rancher
 What should each produce?
 Why should they trade?

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 THE PRODUCTION OPPORTUNITIES OF THE
FARMER AND THE RANCHER

Hours Needed to Make 1 lb. of: Amount Produced in 40 Hours

Meat Potatoes Meat Potatoes
Farmer 20 hours/lb 10 hours/lb 2 lbs. 4 lbs.
Rancher 1 hours/lb 8 hours/lb. 40 lbs. 5 lbs.

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 SELF-SUFFICIENCY

 By ignoring each other:

 Each consumes what they each produce.
 The production possibilities frontier is also the
consumption possibilities frontier.
 Without trade, economic gains are diminished.

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PRODUCTION POSSIBILITIES
FRONTIERS
Meat
(pounds) (a) The Farmer’s
Production Possibilities
Frontier

A
1

0 2 4 Potatoes (pounds)
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PRODUCTION POSSIBILITIES
FRONTIERS
Meat 40
(pounds)
(b) The Rancher’s
Production Possibilities
Frontier

20
B

0
Potatoes (pounds)
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THE FARMER AND THE RANCHER
SPECIALIZE AND TRADE

Each would be better off if they specialized in

producing the product they are more suited to
produce, and then trade with each other.

 The farmer should produce potatoes.

 The rancher should produce meat.
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THE GAINS FROM TRADE
A SUMMARY
The Outcome
Without Trade:
What They Produce
and Consume
1 lb meat (A)
Farmer 2 lbs potatoes
20 lbs meat (B)
Rancher 2.5 lbs potatoes
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 THE GAINS FROM TRADE
A SUMMARY

The Outcome
With Trade:
What They What They What They
Produce Trade Consume
0 lbs meat Gets 3 lbs meat 3 lbs meat (A*)
Farmer 4 lbs potatoes for 1 lb potatoes 3 lbs potatoes
24 lbs meat Gives 3 lbs meat 21 lbs meat (B*)
Rancher 2 lbs potatoes for 1 lb potatoes 3 lbs potatoes

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TRADE & EXPANSION OF THE SET
OF CONSUMPTION POSSIBILITIES
Meat (a) How Trade Increases the
(pounds) Farmer’s Consumption

Farmer’s
A* consumption
3 with trade

2 Farmer’s
consumption
A without trade
1

0 2 3 4 Potatoes (pounds)
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 Meat 40 TRADE & EXPANSION OF THE SET
(pounds)
OF CONSUMPTION POSSIBILITIES
(b) How Trade Increases The
Rancher’s Consumption
Rancher’s
21 B* consumption
20 with trade
B
Rancher’s
consumption
without trade

0 2.5 3 5 Potatoes (pounds)

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THE GAINS FROM TRADE
A SUMMARY
The Gains
From Trade:
The Increase in
Consumption
2 lbs meat (A*- A)
Farmer 1 lb potatoes
1 lb meat (B*- B)
Rancher 1/2 lb potatoes

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DIFFERENCES IN
COSTS OF PRODUCTION

Differences in the costs of production determine:

 Who should produce what?

 How much should be traded for each product?

Who can produce potatoes at a lower cost - the farmer

or the rancher?

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 DIFFERENCES IN
COSTS OF PRODUCTION
Two ways to measure differences in costs of
production:

 The number of hours required to produce

a unit of output. (for example, one pound
of potatoes)
 The opportunity cost of sacrificing one
good for another.
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ABSOLUTE ADVANTAGE

 Comparing productivity

 A smaller quantity of inputs to produce

a good → to have an absolute
advantage in producing that good.

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 COMPARATIVE ADVANTAGE

 Comparing opportunity cost.

 Smaller opportunity cost of producing a good → to have a
comparative advantage in producing that good.

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SPECIALIZATION AND TRADE

 Who has the absolute advantage?

The farmer or the rancher?

 Who has the comparative advantage?

The farmer or the rancher?

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 ABSOLUTE ADVANTAGE

 The Rancher needs only 8 hours to

produce a pound of potatoes, whereas
the Farmer needs 10 hours.
 The Rancher needs only 1 hour to
produce a pound of meat, whereas the
Farmer needs 20 hours.
The Rancher has an absolute advantage in the
production of both meat and
potatoes.
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THE OPPORTUNITY COST OF
MEAT AND POTATOES

Opportunity Cost of:

1 lb of Meat 1 lb of Potatoes
Farmer 2 lb potatoes ½ lb meat
Rancher 1/8 lb potatoes 8 lb meat

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COMPARATIVE ADVANTAGE

 The Rancher’s opportunity cost of a pound

of potatoes is 8 pounds of meat, whereas
the Farmer’s opportunity cost of a pound of
potatoes is 1/2 pound of meat.

 The Rancher’s opportunity cost of a pound

of meat is only 1/8 pound of potatoes,
while the Farmer’s opportunity cost of a
pound of meat is 2 pounds of potatoes...
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 COMPARATIVE ADVANTAGE

The Rancher has a comparative advantage in the

production of meat but the Farmer has a comparative
advantage in the production of potatoes.

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THE PRINCIPLE OF
COMPARATIVE ADVANTAGE

 Comparative advantage and differences

in opportunity costs are the basis for
specialized production and trade.
 Whenever potential trading parties have
differences in opportunity costs, they
can each benefit from trade.

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BENEFITS OF TRADE

 Trade can benefit everyone in a society because it

allows people to specialize in activities in which
they have a comparative advantage.

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TRADE BARRIERS
 Tariffs
 Quota
 Quality standards eg safety regulations
 Quarantine measures to protect agriculture and
fisheries from imported diseases
 Government procurement, such as government
employees traveling on national airlines or
purchasing only domestically produced goods
 Subsidies to protect domestic industries

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 ARGUMENTS FOR TRADE RESTRICTIONS

 The infant industry argument

 The view that industries need time to develop
 Restricting trade: give the industry time to develop under
protectionist policies
 National security
 Certain goods such a steel, oil, and the capability of
producing ships and other goods needed in war time
 At a disadvantage having no industries to produce them
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 ARGUMENTS FOR TRADE RESTRICTIONS
 Retaliation
 Retaliating against countries that impose trade restrictions
on the domestic economy
 Strategic trade policy
 Government actions encouraging large firms to locate in
domestic economy
 Anti-dumping
 Selling products below average costs or the price in
domestic country 34
ARGUMENTS FOR TRADE RESTRICTIONS

 Environmental and labour standards

 Improving their environmental and
labour laws (eg.: child labour laws)
 Unemployment reduction
 Reducing trade barriers would lead to an
increase in unemployment

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 ARGUMENTS AGAINST
TRADE RESTRICTIONS
 The infant industry argument
 Potential for protection to last longer than justified
 Import protection in Latin America in the 1950s
 National security:
 Stockpiling supplies in case of war rather than
protect industries
 Retaliation:
 Potential for a trade war 36
ARGUMENTS AGAINST
TRADE RESTRICTIONS
 Strategic trade policy
 Invited retaliation (trade war)
 Environmental and labour standards
 Trade → promote income growth → promote a
concern for the environment and working
conditions
 Unemployment reduction
 Short term: increase U/E,
 Long term: increase incomes and employment

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REDUCING TRADE BARRIERS
 Unilateral disarmament

 Multilateral negotiations

 Regional free trade zones

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 THE FLOW OF GOODS: EXPORTS,
IMPORTS & NET EXPORTS

 Exports

 Imports

 Net exports (NX) or trade balance

THE FLOW OF GOODS
EXPORTS, IMPORTS & NET EXPORTS
 Trade deficit

Imports > Exports

 Trade surplus

Exports > Imports

 Balanced trade

Exports = Imports
FACTORS AFFECTING NET
EXPORTS
 The tastes of consumers for domestic
and foreign goods.
 The prices of goods at home and
abroad.
 The exchange rates at which people
can use domestic currency to buy
foreign currencies.
FACTORS AFFECTING NET
EXPORTS

 The incomes of consumers at home and

abroad.
 The costs of transporting goods from
country to country.
 The policies of the government toward
international trade.
 THE OPENNESS OF THE
ECONOMIES

https://www.youtube.com/watch?v=q2WeWOoTbag
THE FLOW OF CAPITAL
NET CAPITAL OUTFLOW OR NET FOREIGN INVESTMENT

 NCO: purchase of foreign assets by domestic residents

minus the purchase of domestic assets by foreigners.
A U.S. resident buys stock in the Toyota corporation.
A Mexican buys stock in the Ford Motor corporation.
THE FLOW OF CAPITAL
NCO OR NFI

 When a U.S. resident buys stock in

Telmex, the Mexican phone company,
the purchase raises U.S NCO
 When a Japanese residents buys a
bond issued by the U.S. government,
the purchase reduces the U.S. NCO
THE FLOW OF CAPITAL
NCO OR NFI
 When an Australian resident buys
shares in British Telecom (a British
phone company), the purchase ………..
Australian net foreign investment.
 When a Japanese resident buys a bond
issued by the Australian government,
the purchase ……….. Australian net
foreign investment.
VARIABLES INFLUENCING
NCO OR NFI
 The real interest rates being paid on
foreign assets.
 The real interest rates being paid on
domestic assets.
 The perceived economic and political
risks of holding assets abroad.
 The government policies that affect
foreign ownership of domestic assets.
NX = NCO
 Net exports (NX) and net capital outflow
(NCO) are closely linked.
 For an economy as a whole, NX and
NCO must balance each other so that:
NCO = NX
Every transaction that affects one side
must also affect the other side by the
same amount.
SAVING, INVESTMENT &
INTERNATIONAL FLOWS

 Net exports: a component of GDP

Y = C + I + G + NX
 National saving: the income of the
nation that is left after paying for current
consumption and government
purchases
Y - C - G = I + NX
 SAVING, INVESTMENT &
INTERNATIONAL FLOWS

 National saving (S) equals Y-C-G so:

S = I + NX
or

Saving = Domestic Foreign

+
Investment Investment
REAL AND NOMINAL EXCHANGE
RATES
 International transactions are
influenced by international prices.
 The two most important international
prices are the nominal exchange rate
and the real exchange rate.
NOMINAL EXCHANGE RATES
 The nominal exchange rate: the rate at which a
person can trade the currency of one country
for the currency of another, expressed in two
ways:
In units of foreign currency per one unit of
domestic currency:
 In Australia:USD1 = AUD1.2850
In units of domestic currency per one unit of
the foreign currency.
 In Australia:AUD1 = USD0.7782 (1/1.2850)
NOMINAL EXCHANGE RATES
 Appreciation of a domestic currency

 Depreciation of a domestic currency

REAL EXCHANGE RATES

➢ The real exchange rate:

 The rate at which a person can trade the goods and
services of one country for the goods and services of
another.
 Comparing the prices of domestic goods and foreign
goods in the domestic economy.
REAL EXCHANGE RATES

 Determinants of the real exchange rate:

 the nominal exchange rate
 the prices of goods in the two countries measured in local
currencies.
 REAL EXCHANGE RATES

Real Nominal exchange rate x Domestic price

Exchange =
Foreign price
Rate

The real exchange rate is a key

determinant of how much a
country exports
and imports.
 REAL EXCHANGE RATES

 A depreciation (fall) in the U.S. real exchange rate

→U.S. goods have become cheaper relative to foreign goods.
→Consumers both at home and abroad would buy more U.S.
goods and fewer goods from other countries.
→U.S. exports rise, and U.S. imports fall
→U.S. net exports increase.
 REAL EXCHANGE RATES

 An appreciation in the U.S. real exchange rate

→U.S. goods have become …………………. relative to foreign
goods.
→So consumers both at home and abroad would buy …………
U.S. goods and ………… goods from other countries.
→U.S. exports …………, and U.S. imports ………… U.S. net
exports ………..
  The meaning of absolute and
comparative advantage and
their application
 How everyone can benefit from
trade
LECTURE
 Examine the trade restrictions
REVIEW
and the arguments for and
against them
 The International flows
 Nominal and Real exchange
rate