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The Global Economy
Lesson 5


World Trade

Flows between the U.S. and the rest of the world

1. Goods and services flows (or trade flows)

  • Imports - goods and services flow into the country; money flows outward
  • Exports - goods and services flow out of the country; money flows inward
  • Net Exports (Xn) = Exports - Imports
    • Trade deficit is imports exceed exports
      • Net Exports < 0
      • Money is flowing out of the country
        • Usually foreigners take this money and reinvest in the U.S.
      • Buy government bonds, corporate stocks, real estate, etc.
      • U.S. has had trade deficit for last 40 years
      • -$700.2 billion in 2007
    • Trade surplus is exports exceed imports
      • Net Exports > 0
      • Money is flowing into country
      • They usually invest money in foreign countries
      • Many Asian countries

2. Capital and labor flows

  • Capital - if U.S. exports capital; then that foreign country could produce more products and services
    • The opposite occurs if U.S. imports more capital
  • Labor - foreigners immigrate (legally or illegally) into the U.S.
    • Some Americans move abroad

3. Information and technology flows

  • Technology - know how can leave or enter a country
  • Example -
  • Brain drain - foreign scientist and doctors immigrate to U.S.
    • U.S. was a leader in technology; this know how was exported to many Asian countries that use it to produce goods and services
    • U.S. patent holders allows production in a foreign country
    • Many foreigner students study in the U.S.
      • European and U.S. college degrees have a lot of value in many countries around the world
  • Information
    • Wide range of information is transmitted around world, like stock prices, returns on bonds, interest rates, currency exchange rates, etc.
    • Financial Flows -money leaves or enters the United States
      • Outflow
        • U.S. government provides foreign aid
        • Pay for imports
        • Buy foreign assets
          • Foreigners earn interest and profits
          • U.S. bonds pay interest to foreigners
          • Foreigners earn profits from corporations as dividends
          • Foreigner earn rents and capital gains on properties
          • Foreigners invested $232.8 billion in 2007 in U.S.
Blue Arrow

The United States has the largest exports and imports in the world in absolute terms, but trade comprises a small percentage of the U.S. Economy. The U.S. exported $1.6 trillion of goods and services in 2007, but comprised of 11.9% of GDP. U.S. imports were $2.3 trillion, but comprised of 16 9% of GDP.


Why International Trade is Growing

Reasons why international trade grew quickly after WWII.

  1. Transportation cost - a cost to transport products and services to the market or between markets; a form of transaction costs
    • Transaction costs have been decreasing
      • Use large barges and airplanes to ship cargo
  2. Communication technology - another form of transaction costs
    • Communication cost have decrease
    • Easy to communicate and arrange transactions around the world using telephone, e-mail, computers, and faxes
    • Some state governments and corporations have their information hot lines in India and other places
  3. Many countries have decreased tariffs and other trade barriers
  4. Multinational corporations - corporations that have operations in two or more countries
    • Multinational corporations have been growing
    • Every countries has different laws, rules, and regulation; however corporations can create departments that keep up with a countries legal structure
      • Proprietorships and partnerships may be too small to engage in international trade
    • Examples
      • Netherlands-Unilever
      • Switzerland-Nestle
      • U.S.A.-Coca-Cola
      • Germany-Bayer Corporation
      • Japan-Honda, Toyota, and Sony
      • South Korea-LG, Samsung, and Hyundai
  5. Trade Agreements - two or more countries negotiating on free trade
    • Encourage free trade
    • Organizations
      1. General Agreement on Tariffs and Trade (GATT) - from 1948 to 1995
        • Reduced tariffs from rounds
        • Reduced tariffs to 1/10 the value
        • Countries reduced tariffs but increased nontariff trade barriers
      2. World Trade Organization (WTO) - created from 1995
        • More enforcement power than GATT
        • Review a country's trade policies
        • Protect intellectual property rights
        • Help settle trade disputes
        • WTO can impose trade sanctions
2006 Average Tariffs
Country Agricultural Products Textile Products Clothing Products
Australia 1.2 18.3 41.1
Canada 17.3 10.6 17.2
European Commission 15.1 6 .5 11.5
Japan 24.3 5.4 9.2
New Zealand 1.7 10.5 32.
Norway 61.1 7.1 11.1
Switzerland 43.8 6.5 6.4
USA 5.3 7.7 11.4

Source : Department of Commerce.

2. Trade Bloc – promote internal free trade while retaining trade barriers with nonmember nations

  1. Free Trade Area - a group of countries remove trade barriers among themselves but keep their separate barriers for outsiders
    • Example: North American Free Trade Agreement (NAFTA) - free trade zone among Canada, Mexico, and United States
      • Completely remove trade barriers by 2008
      • Claims NAFTA created many new jobs in United States
  2. Customs Union – a group of countries remove trade barriers among themselves and have a common external barriers to outsiders
    • Russia, Belarus, and Kazakhstan
    • The Southern Common Market (MERCOSUR) – Argentina, Brazil, Paraguay, and Uruguay
  3. Common Market – a customs union that allows full freedom of factor flows, like capital and labor
    • European Union
    • Free movement of labor, capital, goods, and services within Europe
    • Euro - common currency for EU members
    • Founded the institutions
      • European Parliment Court of Justice
      • European Central Bank
  4. Economic Union – member countries unify all economic policies
    • Monetary, fiscal, and welfare policies
    • United States
European Union Members
Austria Belgium Bulgaria
Cyprus Czech Republic Denmark
Estonia Finland France
Germany Greece Hungary
Ireland Italy Latvia
Lithuania Luxembourg Malta
Netherlands Poland Portugal
Romania Slovakia Slovenia
Spain Sweden United Kingdom
  • Croatia, Republic of Macedonia, and Turkey are candidates for admission to EU
  • Did you noticed that Norway and Switzerland are not members?


Comparative Advantage - David Ricardo

Comparative advantage - how two countries can benefit from trade, even though one country could be large and produce everything

  • Show how two countries benefit from trade
  • Assumptions
    • Both countries are at full employment (i.e. on production possibilities curve)
    • PPCs are straight line (no losses occur when moving resources from industry to industry
      • Works with curved PPCs
    • U.S.A. and Mexico produce both tomatoes and cars
      • No trade - set production at the half way point

Illustrating trade with PPCs

  • Autarky - no trade
    • U.S. produces 25 tomatoes and 50 cars
    • Mexico produces 30 tomatoes and 15 cars
    • Total production is 55 tomatoes and 65 cars
  • Comparative advantage - countries specialize in production of products which they have low opportunity costs
    • Important because a large country like the U.S. that can produce everything at low cost can still benefit from trade with a small country with higher costs
    • Related to slopes of the PPC
    • U.S.A. produces all cars and Mexico produces all tomatoes
      • PPCs are straight lines
    • Total production is 100 cars and 60 tomatoes
      • Gain in production of 35 cars and 5 tomatoes
  • Terms of trade - ratio of imports to exports
    • This is an exchange rate between two goods
    • Have not shown how countries divide up the extra production
  • Limitations
    • Capital and technology can easily flow from one country to another
    • Outsourcing - a firm sends out part of its production to another firm (in another country)
      • Communication and transportation costs are decreasing


Why Government Imposes Trade Restrictions

Why do country impose trade restrictions?

  • A country specializes in trade
    • Country gains from free trade from the goods and services it exports
    • The industry contracts for the products it imports
      • Temporary higher unemployment
      • Some regions may gain while others lose
        • Example - the Rust Belt
          • Ohio, Indiana, Illinois, and Michigan are seeing declines in manufacturing jobs
  • Countries have different levels of labor rights, environmental laws, etc.
    • Under free trade, polluting firms may relocate to countries with weak environmental laws
      • Some U.S. firms relocated to Mexico, because of weaker environmental laws
    • Firms relocated to countries that do not have the generous benefits of the West
      • several Asian countries do not unemployment insurance, workman's compensation, sick days, etc.

Methods a country uses to restrict trade

  1. Protective tariffs - a tax (or duty) imposed on imported goods
    • A tariff would cause a higher market price on the market goods
    • Encourages consumers to buy within their country
  2. Import quotas - government imposes the maximum number of items that can be imported each year
    • The government does not collect any tax revenue
    • During 1980s, imports quotas on Japanese cars
      • Some Japanese cars are made here now
      • Quotas were voluntary, because Japan did not want U.S. markets shut to Japanese cars
  3. Non tariff barriers - government imposes licensing requirements or standards
    • Creating "bureaucratic red tape"
    • Government can cite a potential health problem and not import beef
      • Examples
        • Europe prohibited imports of U.S. beef because of the wide use of hormones
        • U.S. temporary halted imports of British beef becuase of mad cow disease
  4. Export subsidies - government subsidizes an industry
    • A subsidy causes a a lower market price
    • Can encourage the expansion of a domestic industry
      • Example - U.S. government subsidize U.S. farmers


Foreign Exchanges Rates

Foreign exchange market - the exchanging of different currencies

  • Exchange rates - value of one currency in terms of another
    • Most transactions are electronic transfer and involve the exchange of bank deposits denominated in different currencies
  • Example: Value meal in Moscow cost 26,000 rubles (approx. $5)
    • What is the exchange rate?
    • $1 = 5,200 rubles
  • Example: $1 - 11 pesos (Mexico)
    • How much does a 1-liter of Coca-Cola costs in dollars if it costs 15 pesos?
    • 15 p ($1 / 11 p) = $1.36
  • Exchange rates change
    • Example
      • Exchange rate is $1 = 11 pesos and changes to $1 = 10 pesos
        • Depreciation - value of currency decreases
          • Dollar depreciated because it buys less
        • Appreciation - value of currency increases
          • Peso appreciates because pesos purchase more
        • Cola-cola 's price is 15 pesos
          • Now it is $1.50
      • Exchange rate is $1 = 11 pesos and changes to $1 = 12 pesos
        • Dollar appreciated
        • Peso depreciated
        • Coca-cola's price is 15 pesos
          • Now it is $1.25
  • If currency is depreciation
    • Encourages investor to switch out of this currency
    • This country's imports decrease
      • Value of their currency is lower
    • This country's exports increase
      • This country has cheaper prices from the depreciated currency
  • Opposite occurs if currency is appreciation
  • Inflation rule: If inflation rates are: U.S. 3% and Mexico: 25%.
    • Consumers and businesses prefer to hold U.S. dollars.
    • U.S. dollar retains its value.
    • Investors have higher demand for stable currencies


Supply and Demand for Currencies - Optional Material


  • Demand and supply market has the assumptions
    • No government interference
    • Flexible exchange rate
  • Trade between Mexico and U.S.
    • Exchange rate - the dollar price of 1 peso.
      • amount of $'s per 1 peso.
    • Import - U.S. residents and firms purchase goods and services from Mexico.
      • U.S. firms buy Mexican goods.
      • U.S. firm needs pesos to pay for it.
      • Demand for pesos increases.
      • Converting dollars to pesos causes supply of dollars to increase on foreign exchange market.
    • Export - U.S. residents and firm sell goods and services to Mexico.
      • U.S. firms sell computers to Mexican firms.
      • Mexican firms need dollars to pay for it.
      • Demand for dollars increases.
      • Converting pesos to dollars causes supply of pesos to increase.
Bue Arrow Demand for pesos in one market creates a supply of U.S. dollars in other market, and vice-versa.
Demand for Pesos
Price of Pesos
($'s for 1 peso)
A demand curve
Quantity of Pesos

Point A : $ 1/1,000 = 1 Peso        [$1 = 1,000 Pesos]
Point B: $ 1/2,000 = 1 Peso         [$1 = 2,000 Pesos]

  • Moving from Point A to Point B causes exchange rate to go down.
    • The $ appreciated, because $1 buys more pesos.
    • The peso depreciated, because 1 peso buys less dollars.
    • The price of American goods became more expensive, while Mexican goods become cheaper.
      • U.S. imports increase.
      • U.S. exports decrease.
Supply for Pesos
Price of Pesos
($'s for 1 peso)
A supply curve
Quantity of Pesos
  • Moving from Point A to Point B causes exchange rate to go up.
    • The $ depreciated in value.
    • The peso appreciated in value.
    • The price of American goods became cheaper, while Mexican goods become more expensive.
      • U.S. imports decrease.
      • U.S. exports increase.
  • For Mexicans to buy cheaper U.S. products, they need dollars. They convert pesos into dollars, causing more pesos to be supplied on the market.


  • Example - Americans demand more Mexican products, ceteris paribus.
    • The equilibrium exchange rate for pesos is P* and quantity exchanged is Q*.
    • Demand for pesos increases.
    • The dollar depreciates, while peso appreciates.
    • U.S. products become cheaper to Mexicans.
      • U.S. exports rise.
      • U.S. imports decrease.
Market for Pesos
Price of Pesos
($'s for 1 peso)
A demand increase in the exchange market
Quantity of Pesos
A blue arrow Changes in exchange rates alter prices of all goods, services, and assets, which are traded on the international markets.


  • imports
  • exports
  • net exports (Xn)
  • multinational corporations
  • trade agreements
  • free trade area
  • customs union
  • common market
  • Euro
  • economic union
  • comparative advantage
  • autarky
  • terms of trade
  • protective tariffs
  • import quotas
  • nontariff barriers
  • export subsidies
  • foreign exchange market
  • exchange rates
  • depreciation
  • appreciation
  • inflation rule

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