Key Terms

appreciation Central American Free Trade Agreement (CAFTA) current account depreciation financial account fixed exchange rate flexible exchange rate General Agreement on Tariffs and Trade (GATT) North American Free Trade Agreement (NAFTA) quotas subsidies tariffs terms of trade trade deficit trade surplus voluntary export restraints (VER) World Trade Organization (WTO)

Comparative Advantage Comparative advantage is and should be one of the reasons for trade. It occurs when a nation can produce a good at a lower opportunity cost than another nation. Relative costs determine comparative advantage. Every nation has a comparative advantage in some good or service. There are two ways to measure productivity that is used to determine comparative advantage. We can calculate output over a given period of time (words per minute, tons per acre, miles per hour, etc.) or we can measure it by the amount of inputs necessary to do an activity (hours to do a job, number of pitches to throw a strike, etc). Use the output method when output is variable and input is fixed. Use the input method when input is variable and output is fixed.
Output Method: DVDs Pizza Country A 8 10 Country B 4 7 Input Method: DVDs Pizza Country A 8 10 Country B 4 7 (Amount of product produced per hour) = 10/8 8/10 = 7/4 4/7 (Hours to produce one of each product) = 10/8 8/10 = 7/4 4/7

Types of protectionism Tariffs Quotas Subsidies to producers to help them compete with foreign producers Voluntary Export Restraints (VERs) Government red tape such as licensing requirements, inspections, health and safety standards or environmental standards

Arguments for protectionism Infant industry argument Efforts of a developing country to diversify Protection of employment Source of government revenue Strategic defense arguments Anti-dumping Arguments against protectionism Inefficiency of resource allocation Costs of long-run reliance on protectionist methods Increased prices of goods and services to consumers Decreased quantity and variety of goods and services to consumers Lower standard of living Determinants of Exchange Rates (TIPSI):

Tastes/preferences: American consumer tastes shift towards foreign goods relative Incomes: Rising income (GDP up is sign of rising income) in US leads to
increased demand for imports relative Price levels: If inflation is higher in the US than foreign nations, Americans will demand foreign money to buy relatively cheap foreign goods

Speculation: If investors expect foreign money to appreciate relative to the $, demand

for foreign money will increase

Interest rates: Higher interest rates in foreign nations mean greater returns on savings,
American will demand more foreign money (High interest rates/ High demand) Determinants of Supply of U.S. Dollar in Foreign Exchange Market A change in demand for foreign goods could be caused by: A change in relative price levels (inflation in the US) A change in income in the US (higher income means more demand for imports, lower income means fall in demand for import) A change in tastes and preferences in the US towards foreign products A change in foreign investment prospects: Foreign stock and bonds become more valuable or real estate markets boom mean Americans will demand foreign assets and supply more USD to market A change in relative interest rates: a rise in foreign interest rates makes it more attractive to save and invest in foreign financial capital so Americans will supply more dollars to the foreign exchange market depreciating USD Speculation on future value of dollar or foreign money: If speculators predict the USD will depreciate, they will supply more now in the hope of buying them back cheaper in the future

Foreign exchange (Forex) markets work in tandem with one another. The exchange rate (price) is determined by the intereaction of foreign and U.S. investors. While USD are demanded by foreign buyer, foreign dollars are demanded by Americans While USD are supplied by Americans, foreign dollars are supplied by Europeans The foreign money exchange rate is always the reciprocal of the USD exchange rate

A change in the USD market coincides with a change in the foreign money market. An increase in DFM by Americans causes SUSD to increase since Americans must supply more foreign money in exchange for USD Increase in SFM causes the USD to depreciate

Increase in DFM causes the foreign money to appreciate New exchange rates are reciprocals of one another

Appreciation: It takes less USD to buy foreign currency. The value or the purchasing power of the currency has risen.

Depreciation: It takes more USD to buy foreign currency. The value or the purchasing power of the currency has fallen.

The Balance of Payments: A nations balance of payments is the sum of all transactions that take place between its residents and the residents of all foreign nations. It is made up of the current account and the financial account. The current account summarizes a nation's trade in currently produced goods and services. "Balance of trade" - measures the difference between a nation's expenditures on imports of goods and services and its income from the export of goods and services Balance on the current account is found by adding all transactions between two nations on net exports (expenditures on imports plus income from exports), investment income, and foreign aid o If a country spends more on imports than it earns from exports, it is said to have a "current account deficit" or a "trade deficit" o If a country earns more from its exports than it spends on imports, it is said to have a "current account surplus" or a "trade surplus" The financial account summarizes the buying and selling of assets between countries, including anything that can be owned and that has value such as land, real estate, companies, bank deposits, stocks and shares, treasury bills, government bonds, foreign currency If foreign ownership of domestic assets increases more quickly than domestic ownership of foreign assets, then there is more money coming into the country than going out... this is a financial account SURPLUS If domestic owenership of foreign assets increases more quickly than foreign ownership of domestic assets, then there is more money leaving the country than coming in... this is a financial account DEFICIT