Economics: Unit 7

Balance of Payment

Balance of Payment: Sum of all transactions that take place between its residents and the residents of a foreign nation

3 Components:

1. Current account summarizes US trade in currently produced goods and services
2. Balance on goods
• Balance of trade on goods=the difference between its exports and its imports of goods
3. Balance on services

The capital account summarizes the purchase sale of real and financial assets and the corresponding flows of monetary payments that accompany them

The official reserves account

Central banks of nations that hold quantities of foreign currencies called official reserves

Comparative and Absolute Advantage

• The division of labor into specific tasks and roles intended to increase the productivity of workers is called  specialization
• Globalization is the process of increasing the connectivity and interdependence of the world's markets ad businesses
• Absolute advantage refers to a countries ability to produce a certain more of a good or service than another country
• Absolute advantage rule states that 2 countries should specialize and trade when each other partner has an output advantage over the other
• Comparative advantage refers to a country's ability to produce a particular good with lower opportunity cost then another country
• Comparative advantage rule states that 2 countries should specialize and trade, even if one produces more output of both products, as long as each partner has a cost advantage over the other
• Gains from trade are based on comparative advantage, not absolute advantage
• Comparative advantage is the basis for all trade between individuals, regions, and nations. 

Foreign Exchange Market

• A foreign exchange market is a market in which various national currencies are exchanged for one another
• The equilibrium prices in these markets are called exchange rates.
• The rate at which the currency of one nation can be exchanged for the currency of another nation.
• Two things about the foreign exchange market are that it is:
• A Competitive market
• They are competitive markets characterized by large numbers of buyers and sellers dealing in standardized products such as the American dollar, the European euro, the Mexican peso, and the Japanese pound.
• Linkages to all domestic and foreign prices
• To translate prices of foreign goods into their own currency; multiply the foreign product price by the exchange rate
• If the US dollar-yen exchange rate is $.01 per yen, a Sony television set priced at 20,000 yen will cost $200 (=20,000 x $.01) in the US. 
• Dollar Yen Market
• U.S firms exporting goods to japan want payment in dollars, not yen, but the Japanese importers of those U.S goods possess yen. So the Japanese importers supply their yen in exchange for dollars in the foreign exchange market.  
• U.S. firms importing have the same problem and vice versa. 
• We then have a market in which the price is in dollars and the product is in yen. 

• Changing Rates: Depreciation and Appreciation
• An increase in the US demand for Japanese goods will increase the demand for yen and raise the dollar price of yen.
• Suppose the dollar of yen rises from $.01=1 yen to $.02=1 yen.
• When the dollar price of yen increases, we say a depreciation of the dollar relative to the yen has occurred. 
• What might cause the exchange rates to change? 
• Yen’s supply and demand determinants are similar to those of any products supply/demand determinants.
• Us imports from Japan yield a demand (Dy)
• Us exports to Japan create supply (Sy)
• Exchange rate is determined at the intersection of the curves 
• Depreciation of the dollar is a decrease in the value of the dollar relative to another currency, so a dollar buys a smaller amount of the foreign currency and therefore of foreign goods.
• Alternatively stated, the international value of the dollar has declined. 
• Because each yen buys more dollars, US goods become cheaper to people in Japan and US exports to Japan rise.
• If the opposite event occurred-if the Japanese demanded more US goods-then they would supply more yen to pay for these goods. 
• Change from $.01=1 yen to $.005=1 yen
• Appreciation of the dollar is a increase in the value of the dollar relative to another currency, so a dollar buys a larger amount of the foreign currency and therefore of foreign goods.
• The international of the dollar has increased. 
• It takes fewer dollars to buy a single yen; the dollar is worth more because it can purchase more yen.
• US imports rise, and because it takes more yen to get a  dollar, US exports to Japan fall.

	Assets (+) Demand for the $ “Inflows”	Debits/Liabilities (-) Supply of the $ “Outflows”
Current Account (CA)
·        Balance on Goods and Services ·        Net exports ·        Balance of Trade	·        Exports ·        Tourism Here	·        Imports ·        Tourism There
Net Investment	·        Interest/divided payments ·        Foreigners pay to the US for the use of exported capital	·        Interest divided payments ·        The US made for the use of foreign capital invested in the US
Net Transfers	·        Aid to the US ·        Includes our royalties	·        Aid to other countries ·        Includes their royalties
Financial Accounts (K) or (KA)-or- “Financial and Capital Accounts”-or- “Capital Accounts	·        Capital inflows ·        Stock/bonds/realestate ·        Direct investment in the US by foreigners ·        Purchase of stocks/bonds by foreigners	·        Capital outflows ·        Direct investment by US over there ·        Purchase of stocks/bonds by the US
Official Reserves or Official Settlements or Special Drawing Rights	·        Current account + capital account = official reserves	Currencies, gold, IMF

Specialization and Trade

• Specialization & International trade improve a producer's productivity and allow it to achieve greater output than it could otherwise
• Specialization occurs when productive agents (such as persons or nations) use their available resources to focus on producing one or a few products at which they are best suited
• Economic resources needed to efficiently produce goods are not evenly distributed among producers
• Thus, some producers are better suited to produce certain items than others
• International Trade occurs when buyers & sellers in two nations exchange with one another
• A nation has a closed economy when it neither imports nor exports products (this is the situation represented by the basic market model)
• A nation has a open economy when it both imports and exports products. By trading products they specialize in for those they don't, a nation with an open economy can obtain more of both
• Cost Ratios provide a method of comparing opportunity costs of producing certain items between producers
• The lower a nation's cost ratio, the lower its opportunity cost in producing certain items - in other words, the lower the cost ratio, the greater the cost advantage
• Like per-unit opportunity costs, cost ratios measure how much of one good must be surrendered for every unit of another good gained - opportunity costs compare different production possibilities within a single nation whereas cost ratios compare national production between nations
• Cost ratios can be compared between different nations for the same item OR between different items within the same nation
• Cost ratios can be calculated using output or input data - both approaches lead to the same results if done correctly
• In general, producers should specialize in making a product only when their cost ratio of doing so is less than that of their trading partners

• Output problem approach is based on the most of an item each producer could make if it specializes using a set amount of resources (generally, all its resources) - these problem are stated in terms of output per resource unit (applies per acre, widgets per hour, etc.)
• Determine the maximum amount of each item each producers can make if they use all their resources & arrange the data in a table with the producers as rows & the products as columns
• Divide each producer's output data in the following manner: Divide its output data of the OTHER item OVER the data for one whose cost ratio you wish to find

Cost Ratio	Formula	Interpretation
Item A	Maximum output of item B /Maximum output of item A	How much of item B must be lost for every unit of item A gained by this producer
Item B	Maximum output of item A /Maximum output of item B	How much of item A must be lost for every unit of item B gained by this producer

• Input problem approach is based on the least resources each producer needs to make a certain amount of an item (generally one unit)-these problems are stated in terms of resources per output unit
• Determine the minimum amount of resources each producer needs to make one unit of an item if they specialize and list the data in a table with the producers as rows and the products as columns
• Divide each producers input data in the following manner: Divide the INPUT data of the other item INTO the data of the item whose cost ration you INTENDED to find

Cost Ratio	Formula	Interpretation
Item A	Maximum output of item A /Maximum output of item B	How much of item A must be lost for every unit of item B gained by this producer
Item B	Maximum output of item B /Maximum output of item A	How much of item B must be lost for every unit of item A gained by this producer

• Rules of specialization-these hold true for both input and output problems
• In general, producers should specialize in making a product only when their cost ratio of doing so is less than that of their trading partners
• The no advantage rule states that nations should not specialize or trade if neither trading partner possesses a cost advantage in producing either product
• The absolute advantage rule states that 2 countries should specialize and trade when each partner has an output advantage over the other
• The comparative advantage rule states that 3 countries should specialize and trade, even if one produces more output of both products, as  long as each partner has a cost advantage over the other

• Trade possibilities curve provide an alternative way of solving output problems
• The trade possibilities curve (TPC) shows the amount of 2 items a country can trade-offs must be made in how a nation uses its own resources
• THE PPC assumes a closed economy where trade-offs must be made in how a nation uses its own resources
• The TPC assumes an open economy where a nation is free to specialize its own production and trade with other nations
• Comparing the TPCs of different economies reveals their absolute and comparative advantage
• The slope of the trade possibilities curve, which may be found using the slope formula (y2-y1)/(x2-x1), provides opportunity cost of producing one more unit of a particular good
• The nation with the lower opportunity cost has a comparative advantage in that particular item

Terms of Trade

• Terms of Trade determine the rate at which one country is willing to trade one item for another item on the world market
• Trade terms may be expressed in either monetary or bartering vocabulary 
• As a monetary expression, terms of trade are stated as a world price, the subject of upcoming discussions
• When viewed from a bartering standpoint, trade terms refer tot he amount of certain items 2 countries are willing to exchange with one another
• Trade terms are influenced by economic and non-economic factors and must be negotiated through a political process
• There is no unique set of optimal trade terms between countries
• A range of acceptable trade solution exists from which the countries must select through trade agreements
• Knowing how a country benefits from specializing can help us determine how it may benefit from trade-shits PPC outward
• Solving terms of trade problems
• IF necessary, construct an output table using the data for 2 nations-this represents their production possibilities before trade
• Determine the cost ratios and comparative advantage of each nation
• Select one product as a reference and use its cost ration to determine its per-unit opportunity cost for each nation
• Set a term of trade somewhere between the 2 boundaries
• Calculate the maximum amount of each nation can gain through trade
• Nation whose cost advantage is item A should MULTIPLY its output of that item by the term of trade
• Nation whose cost advantage is item B should DIVIDE its output of that item by the term of trade