International Trade
and Finance
©2006 South-Western College Publishing
1
Interdependence and Trade
Consider your typical day:
You wake up to an alarm clock made in Korea.
You pour yourself some orange juice made from
oranges grown in Florida.
You put on some clothes made of cotton grown in
Georgia and sewn in factories in Thailand.
You watch the morning news broadcast from New
York on your TV made in Japan.
You drive to class in a car made of parts
manufactured in a half-dozen different countries.
…and you haven’t been up for more than two hours
yet!
2
How do we satisfy our wants and
needs in a global economy?
We can be economically selfsufficient.
We can specialize and
trade with others,
leading to economic
interdependence.
Why is interdependence the
norm?
Interdependence occurs because
people are better off when they
specialize and trade with others.
What determines the pattern of
production and trade?
Patterns of production and
trade are based upon
differences in opportunity costs.
Why do countries trade?
International trade
allows a country to
consume a
combination of goods
and services that
exceeds its production
possibilities curve
6
U.S. Trading Partners, 2004
Mexico
Canada
Western Europe
Australia
Eastern Europe
Japan
Asia
Africa
Except Mexico
China
7
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?
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.
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.
Trade Expands the Set of
Consumption Possibilities
(a) How Trade Increases the
Farmer’s Consumption
Meat
(pounds)
Farmer’s
consumption
with trade
A*
3
Farmer’s
consumption
without trade
2
1
0
A
2
3
4
Potatoes (pounds)
Meat 40
(pounds)
Trade Expands the Set of
Consumption Possibilities
(b) How Trade Increases The
Rancher’s Consumption
21
20
B*
B
Rancher’s
consumption
with trade
Rancher’s
consumption
without trade
0
2.5 3
5
Potatoes (pounds)
Why should countries
specialize and trade?
Total world output
increases, and therefore,
the potential for greater
total world consumption
also increases
13
What conclusion can
we draw from this?
International trade allows a
country to consume a
combination of goods that
exceeds its production
possibilities curve
14
If countries specialize,
in what should they
specialize?
They should produce
those goods and services
in which they have a
comparative advantage
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What is
comparative advantage?
The ability of a country
to produce a good at a
lower opportunity cost
than another country
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What advantage
comparative advantage?
World output and consumption
are maximized when each
country specializes in
producing and trading goods
for which it has a comparative
advantage
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What is
absolute advantage?
The ability of a country
to produce a good
using fewer resources
than another country
18
Should Tiger Woods Mow His
Own Lawn?
?
?
?
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What is free trade?
The flow of goods between
countries without
restrictions or special taxes
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What is protectionism?
The government’s use of
embargoes, tariffs,
quotas, and other
restrictions to protect
domestic producers from
foreign competition
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What is an embargo?
A law that bars trade
with another country
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What is a tariff?
A tax on an import
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What is a quota?
A limit on the quantity
of a good that may be
imported in a given
time period
24
What are the arguments
for protectionism?
• Infant industry argument
• National security argument
• Employment argument
• Cheap foreign labor argument
• Free trade agreements
25
What is a recent free
trade agreement?
North America Free Trade
Agreement (NAFTA)
26
What is NAFTA?
A 1993 free trade agreement
between the U.S., Canada,
and Mexico
27
What is the
balance of payments?
A bookkeeping record of all
the international
transactions between a
country and other
countries during a given
period of time
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What is the
current account?
The first section of the
balance of payments,
which includes trade in
currently produced
goods and services
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What is the
balance of trade?
The most widely reported
and largest part of the
current account defined
as the value of a
nation’s merchandise
imports subtracted from
its merchandise exports
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How is a current
account deficit
financed?
By a capital account surplus
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What is the
capital account?
The second section of
the balance of
payments, which
records payment flows
for financial capital
32
-350
U. S. Balance of Trade, 1983-2004
-450
-400
-450
-500
Balance of Trade
(billions of dollars)
-400
-550
83
85
87
89
91
93
95
97
99
01
03
33
-124
13
12
11
10
9
8
7
6
5
4
3
2
1
-66
-52
-41
-39
-18
-14
China Japan Canada Mexico Germany Ireland Italy
-14
-12
Taiwan France
34
What does the
balance of payments
always equal?
Zero; the current account
deficit should equal the
capital account surplus
35
How could the US
have a balance of
payments problem?
The problem is with the
composition of the
balance of payments
36
What is an
exchange rate?
The number of one
nation’s currency that
equals one unit of
another nation’s currency
37
If 1.81 dollars is
exchangeable for 1
British pound, what is
the exchange rate?
1 / 1.81 = .552
pounds per dollar
38
How is the exchange
rate determined?
Supply and demand for
foreign exchange
39
What happens when a
currency depreciates?
The price of the currency
falls in relation to
another currency
40
What happens when a
currency appreciates?
The price of the currency
rises in relation to
another currency
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What can cause a
currency to
change value?
The demand and/or
supply of the currency
can change
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What can cause a
change in demand of
a currency?
There can be a change in • tastes and preferences
• relative price levels
• relative interest rates
43
U.S.
exports
less
popular
Decrease
in the
demand
for
dollars
Value of the
dollar falls
(dollar
depreciates)
44
What can cause a
change in supply of
a currency?
There can be a change in • relative incomes
• relative price levels
• relative interest rates
45