international economics for year 3

8/3/2019 International Economics for Year 3

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International EconomicsPrepared and Teaching by:

Lecturer : Duy Chandina

Master in management

DBA candidate

Course: International Economics

Up-date, Academic year 2009-2010

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International Economics

2

Copyright @ 2003 by Paul R. Krugman and

Maurice ObstfeldPrinceton University and University ofCalifornia, BerkeleySixth edition.

Additional reading: Microeconomics(Concepts, Analysis, and applications)



The economics of the

international economyInternational

economics, study of

Internationaltrade

Focuses on thereal transactions

that involve:

A physical movement of goodsor a tangible commitment of

economics resources

Internationalmoney

Focuses on the monetary side,that is on financial transactionssuch as foreign purchase of US

dollars.

3



Topic we have to studied Topic I: How countries gain from international trade

Topic II: Government intervention in trade

Topic III: Exchange rates Topic IV: Money, Interest rates, and Exchange rates

Topic V: The political economy of trade policy

4



*The gains from tradeWe know that some IT is beneficial when countries sell goods andservices to each other.

But there is a common misconception that trade is harmful if thereare large disparities between countries in productivity or wages.

1- productivity and competitivenesslow productivity, low wages, low quality,

Not strong enough to stand up to foreign competition.low wages labor can not compete with high wages labor

5



Countries engage in IT for 2 basic reasons

Countries trade becausethey are different fromeach other:-labor with different skill-technological progress-resources-environment-climate-law, culture

Countries to achieveeconomies of scale inproduction. That isIf each country producedonly a limited range of goods,

it can produce each of thesegoods at a large scale andhence more efficiently than ifit tried to produce everything.

The essential concept in this analysis is that ofcomparative advantage

6



What is specialization?

Jobs that have very narrow scope.

Is the ability to concentrate one‟s efforts and thereby become proficient at that type of work.The advantage of the high specialize job is that theyyield high productivity, low unit cost, and they arelargely responsible for high standard of living.

7



Topic I

How Countries Gain FromInternational Trade

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Topic FocusThis lecture explain how economists think about

international trade. Key points to take away from thislecture are:

-The economic purpose of IT

-Why all countries should gain from IT?

- Where does a country’s comparative advantage come from?

-Why different groups in the community are effecteddifferently by IT

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I- Introduction

Since world war 2 the advanced democracies, led bythe United State have persuaded abroad policy

To remove the Tradebarriers

This policy

reflected-Prosperity

-World peace

10



The patterns of International

EconomicsIT is the exchange of goods across the national

boundaries. The terms used for goods and services thatare traded across the national boundaries are:

Exports: aredomestically

produced goodspurchased by othercountries.

And Imports: aregoods purchased

from othercountries.

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Net Exports are also called the

balance of tradeThe balance of trade is the

relationship between acountry’s exports and

imports.

The balance of trade deficit is when a country imports more

goods and service than itexports and net exports are

negative.

The balance of trade surplus is when a country exports more

goods and services than itimports, and net exports are

positive.

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The Gain from Trade

IT is beneficial, when Countries sell goods andservices to each others.

Common misconception

India often worry their economies to IT will led

to disaster because

their industry won’t be

able to compete.

Advanced nations

where workers earn

high wages often fear

that trading with less

advanced will drag

their standard of

living down

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II- Two ways of meeting demand in the home economy Direct: Local Production

Use nation’s resources to produce the goods and servicesrequired within the home economy.

*Indirect: IT

Use nation’s resources to produce goods and services whichcan be exported to pay for imports of goods and servicesactually required within the home economy.

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Direct: local production Use local resources:

Labor

Technological equipment Resources. To produce goods and services required

within the home economy

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Indirect: international trade Use local resources

Labor

Technological equipment Resources

To produce goods and services which can be exported

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Nation’s Resources

-Labor Natural

resources Technology

How to use them

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Objective:

Obtain the required goods and services at thelowest possible resource costs

Farming

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A- A correct perspective on IT

-Imports make countries better off by allowing somegoods and services to be obtain from overseas at a

lower resource cost than producing them in homecountry

-Exports represent the resource cost of obtaining the

benefit of imports.

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B- An incorrect perspective on IT

(Mercantilism)

Exports are good

Imports are bad

Discussing how to export

goods and services

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Alternative outputs from one year

of labor input

Japan Indonesia

Cars 5 1

Coffee 100kg 400kg

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*Comparative advantage

Based on comparisons between countries of relativeefficiency in producing different goods.

Example:

*How many cars must Japan and Indonesia give upto produce 100kg of coffee?

*How many kgs of coffee must Japan andIndonesia give up to produce one car?

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-Opportunity cost of producing one car or 100kgs of coffee

Japan Indonesia

1 car ----kgs coffee? ----kgs coffee?

100kgs coffee ----- Cars? ----- Cars?

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Conclusion*------------------Has comparative advantage inproduction of cars?

* ------------------Has comparative advantage inproduction of coffee?

Japan

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IV-A basic proposition about comparative advantage Even if one country has absolute advantage (has higher

productivity) in the production of every goods and servicesbut:

The other countries must have comparative advantage (berelatively more efficient) in the production of some goodsand services

Each country will benefit by exporting those goods andservices in which it has comparative advantage

And by importing those goods and services in which it hascomparative disadvantage

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Example

Alternative outputs from one year of labor input

Japan India

Cars 4 1

cloth 1000m 500m

(Japan has absolute advantage in production of bothcars and cloth)

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Conclusion

•Japan has comparative advantage in production of cars

•India has comparative advantage in production of cloth

•If Japan specialized in production of cars, India should

be willing to pay up to 500m of cloth per car, compared toopportunity cost of 250m of cloth per car in Japan

•Or if India specialized in production of cloth, Japanshould be willing to pay up to 4 cars per 1000m of cloth,

compared to opportunity cost of 2 cars per 1000m ofcloth in India.

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***Illustration of how price

is determined, e.g. For cars

India wishes to buy

cars from Japan(India’s import

demand curve for

cars)

Japan wishesto sell cars to

India (Japan’s

supply curve of

cars)

Without trade

-Indian buyers pay

500m of cloth per car

-Japanese sellers

receive 250m of

cloth per car

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V-Limitation of comparative advantage

*Competitive markets (Prices reflect

opportunity costs)

*All resources are fully employed

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Discussion 2

How does an economy change frombeing a low wage economy to become a high

wage economy?

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1- setting up the model

Again, a world of two countries, India and Japan. Each country has onlyone factor of production is labor. These countries consume and to be ableto produce a large number of goods let say:Cloth, Shoes, Rice, TVs, Cars.The technology of each country can be described by its

Unit Labor Requirement (ULR) for each goods, that is the number of hoursof labor it take to produce one unit of each. We label

alc als alr altv alcar

India‟ ULR to produce one unit of each

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a*lc a*ls a*lr a*ltv a*lcar

Japan‟s ULR to produce one unit of each.

We choose one trick to calculate the ratio of India‟s ULR to Japan

alc als alr altv alcar

a*lc a*ls a*lr a*ltv a*lcar

< < < <

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W * alcar > W* * a*lcar

OrW / W* > a*lcar / alcar

Car will be produce in Japan

See the table 1-1Offers a numerical example in which India and Japan bothconsume and are able to produce five goods. The third column isthe ratio of the Japan ULR to the India ULR for each good-orstated differently, the relative India productivity advantage in eachgood. We have labeled the goods in order of India productivityadvantage, with the India advantage greatest for cloth and least of

cars.

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•Ex. W = 5W* lead to W / W* = 5

•If the India wage rates is five times that of Japan ( a ratio ofIndia wage to Japan wage of five to one.We can be rearranged to yield

-Cloth: 5 < 10

-Shoes: 5 < 8

Rice: 5 > 4TVs: 5 > 2Car : 5> 0.75

Cloth and shoes will beproduced in India

These goods will be

produced in Japan

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If the India wage rates is only three times thatJapan

W = 3W* lead to W / W* = 3

India will produce: cloth, shoes, and riceJapan will produce only TVs and cars

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Cont.

The line PF show the maximum amount of

cheese Home can produce given any productionof wine, and vice versa.

Note: when there is only one factor of productionthe PPF of an economy is simply a straight line.

50



Cont.

The PPF is determined by the limits on theeconomy‟s resources in this case, labor The limits on production are defined by theinequality,

(aLC * QC) + (aLW *QW) < L 51



Cont.

Ex. If it take one person hour to make apound of cheese and two hours to produce

a gallon of wine, the opportunity cost ofcheese in terms of wine is

one-half = aLC / aLW = ½ *this opportunity cost is equal to theabsolute value of the slope of the PPF

(see figure 2-1) 53



The opportunity cost of cheese in

terms of wine

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Wine

½ gallon

1 hour Time

Cheese

1 pound

1 pound Cheese1 hour Time

Wine

½ gallon

Note: Lw = Qw * aLw = 1 gallon * 2h = 2 labor

Lc = Qc * aLc = 1 pound * 1h = 1 labor



Cont.

It mean that the economist need to knowthe

Relative price

The price of one good in termsof the other.

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Cont.

And aLw also do the same thing

Ww = Pw / aLw

Wages in the cheese sector will behigher if: Pc / aLc > Pw / aLw

PC / Pw > aLC / aLw Or the economywill specialize inthe production of

cheese 59



Cont.

Or wages in wine sector will be higherif: Pc / aLc < Pw / aLw

PC / Pw < aLC / aLw Or the economywill specialize inproduction of wine.

60



Cont. We denote:

Home’s labor force by (L)

Home’s ULR in wine aLw

Home’s ULR in cheese aLC

We denote:

Foreign labor force by (L*)

Foreign’s ULR in wine a*Lw

Foreign’s ULR in cheese a*LC

64



Cont. We have in Home

aLc/aLw = Pc/Pw

We do the same thing in Foreign, we get a*Lc/a*Lw = P*c/P*w

We can see the example in the next slide

65



Cont. Ex. Home could be less productive thanForeign in wine but more productive in

cheese, or vice versa.

**We make only one assumption that: If:aLC / aLw < a*LC / a*Lw

Or

aLC / a*LC < aLw / a*Lw 66

Pc /Pw<P*c /P*w

Or

Pc /P*c <Pw /P*w



Cont. ** Given the labor forces and ULRs in the twocountries, we can draw the PPF for eachcountry. For Home we already done.

Foreign wine production(Q*w) in gallon

Foreign cheeseproduction Q*c in pound

L*/a*Lw

L*/ a*LC

F*

P*

Foreign‟s PPF figure 2-2

69



Cont. Since the slope of PPF equals the opportunity cost of

cheese in terms of wine

Foreign’s frontier is steeper than Home’s

70



In the absence of trade The relative price of cheese and wine (RPCW) in each

country would be determine by the relative ULRs

In Home the (RPCW) would be: aLC/aLW = Pc /P w

In foreign the (RPCW) would be: a*LC/a*LW = P*c/P* w

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With trade If the relative price of cheese is higher in foreign than

in Home: aLC/aLW < a*LC/a*LW

it will be profitable to ship cheese from Home toForeign and to ship wine from Foreign to Home.

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Cont. So, Home will export enough cheese and Foreign will

export enough wine to equalize the relative price.

But what determines the level at which that price

settles?

73

i i h l i i ( )



Determining the relative price (RP)after trade Prices are determined by supply and demand.

In discussing comparative advantage we must apply supply and demand analysis carefully.

Some of the trade policy analysis it is acceptable to

focus only on: Supply in a single market, example the sugar

Demand market. 74



Cont. ** For two markets

- cheese market

- wine market

It is to focus not just on the quantities of cheeseand wine supplied and demanded but also on therelative supply and demand, that is, on the # of

pound of cheese supplied and demanded dividedby the # of gallons of wine supplied anddemanded.

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Cont. Let see if:

-Pc /Pw <aLC /aLW :Home will specialize

in the production of wine

-Pc /Pw <a*LC /a*LW :Foreign will specialize

in wine production

-aLC /aLW<a*LC /a*LW :so, at relative prices

of cheese below aLC /aLW there will be no worldcheese production.

76



Cont. **When relative prices of cheese

Pc/Pw = aLC / aLW, we know that workers inHome can earn exactly the same amountmaking either cheese or wine.

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Cont. When Home specializes in cheese production, it

produces L/aLC pounds.

Ex. Total labor L=120 people, they need aLC = 2 hours toproduce 60 pounds of cheese, so, 120 people take only 1hour, it can produce 30 pounds of cheese

(120 people/2 * 2 hours = 30 pounds).

Calculated with the formula:Labor productivity = 60 / (120 * 2) = ¼ pound per labor /

hour

So, 120 people per hour = 120 /4 = 30 pounds

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Cont. Similarly, when foreign specializes in wine production

it produces L*/a*LW gallons

So, for any relative price of cheese between aLC/aLW anda*LC/a*LW the relative supply of cheese is:

(L/aLC)/(L*/a*LW )

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Graph

80

RS

RD

RD‟

1

Pc/Pw=a*Lc / a*Lw

Relative quantity of cheese(Qc+Q*c)/(Qw+Q*w)

RP of cheese(Pc / Pw)

Pc/Pw=aLc / aLw

2

::

::

……………………..

(L / aLc)/(L*/ a*Lw)



Cont.

81

- First: Pc / Pw< aLc / aLw < a*Lc / a*Lw , no supply ofcheese. BecausePc / Pw < aLc / aLw , Home specialize in wine andPc / Pw < a*Lc / a*Lw , Foreign specialize in wine-Second: Pc / Pw = aLc / aLw it producing a flatsection to the supply curve.

- Third: aLc /aLw < Pc / Pw < a*Lc /a*Lw

Home will export cheese to Foreign and Foreignwill export wine to Home.



Cont.

82

+ If Pc / Pw > aLc / aLw , Home specialize incheese production, it produce L / aLc = Qc

pounds+ Pc / Pw < a*Lc / a*Lw , Foreign specialize inwine production, it produce L* / a*Lw = Q*w

gallons

So, aLc / aLw <Pc / Pw < a*Lc / a*Lw , relative supply curve of

cheese is (L / aLc)/(L*/ a*Lw) = Qc /Q*w



Example: home work problem 3

83

Suppose that Home and Foreign have the ULRillustrated in table:

Cheese Wine

Home aLc=1 hour /pound aLw=2 hours / gallonForeign a*Lc=6 hours/pound a*Lw=3 hours/gallon

If the world relative price (PR) Pc/Pw =1Which product Home trade to Foreign? And how muchhe gain from trade?And which product Foreign trade to Home? How muchhe gain?



Ex. Home work problem 4

84

Home has 1200 people. It can produce two goods, apples andbananas. The ULR in apple production is 3, while in bananaproduction it is 2.a- graph Home PPF.b- what is the opportunity cost of apples in terms of bananas?c- with no trade, what would the price of apples in terms of

bananas be? And why?There is now also another country, Foreign, with a labor force of800. Foreign ULR in apple production is 5, while in banana

production it is 1.d- graph Foreign PPFe- construct the world relative supply curve.f- what determines the level at which that price settles?



Solution problem 4

85

Home Qa

Home Qb600

400

b-The opportunity cost of applesin terms of bananas isaLa /aLb = 3/2

c- the price of apples in terms ofbananas is Pa/Pb = aLa /aLb = 3/2



Cont.

86

Q*a

160

800 Q*b

d- Graph Foreign PPF800/5=160 units to800/1=800 units



Solution:

87

………………...

:::

:

Pa/Pb

If Pa/Pb=a*La / a*Lb = 5

(L/ aLa)/(L*/ a*Lb)

=400/800=1/2

Relative quantity ofapple

(Qa+Q*a)/(Qb+Q*b)

If Pa/Pb=aLa / aLb = 3/2

RD

RS

RD‟

2

1



Cont.

88

1- If Pa / Pb < 3/2 there will be no world appleproduction.

Because: Pa / Pb < aLa / aLb=3/2 Home specialize in

bananas production.Similarly Pa / Pb < a*La / a*Lb=5 Foreign specialize in

bananas production.

But, 3/2 < 5, Pa / Pb < aLa / aLb < a*La / a*Lb, no

supply of apple.



Cont.

89

2- if Pa/Pb = aLa / aLb = 3/2 workers in Home canearn exactly amount making either apple or banana.So, Home will be willing to supply any relative amount

of the two goods, producing a flat section to the supplycurve.

3- Pa/Pb > aLa / aLb = 3/2, Home will specialize in

apple production, it produce L / aLa = 1200/3=400 units,

and Pa/Pb < a*La / a*Lb = 5, Foreign will specialize inbanana, it produce L*/ a*Lb = 800/1 = 800 units.



Cont.

90

So, 3/2 < Pa / Pb < 5, the relative supply of apple is

(L / aLa ) / (L*/ a*Lb )= (1200/3)/(800/1)= ½.

If Pa/Pb =a*

La / a*

Lb = 5, foreign have a flat section of

supply curve.

Finally, Pa / Pb > a*La / a*Lb > aLa / aLb, both Home

and Foreign will specialize in apple production, therewill be no bananas production, so relative supply ofapple will become infinite.f- the price will be determine between 3/2<Pa/Pb<5.so, both countries will trade.



Cont.

91

If RD move from 1 to 2, Pa/Pb = aLa / aLb = 3/2, thesame as the opportunity cost of apples in terms ofbananas in Home. Home will produce both some

apples and some bananas.



A model of a two-factor economy

( Heckscher-Olin model)The economy we are analyzing can produce two goods

-cloth and foodProduction of these goods requires two inputs that are

limited supply

-Labor-Land

** The reason for this change from the Recardian model is that in atwo-factor economy there may be some choice in the use of inputs.

92



Ex. A farmer may be able to grow more food per acreif he is willing to use more labor input to prepare thesoil, weed, and so on. Thus the farmer may be ableto choose to use less land and more labor per unit of

output. In each sector, producer will face not fixedinput requirements but trade-offs.

93



Cont. Question:What input choice will producers actually make?

It depends on the relative cost of land and labor.If land rents ( r ) are high ( the cost of acre ofland ) the people will use less land.and wage rate (w) per hour of labor is low, thepeople will employed more laborand vice versa they will save on labor and use alot of land.

94



So, the input choice depends on the ratio ofthese two factor price is W / r and the ratio ofland to labor is T / L (land-labor ratio).

-in food production will always use a higher T / Lthan production of cloth.We say that:Production of food is Land-intensive

Production of cloth is Labor-intensive.

95



Cont. **Note: the definition of intensive dependson the T/L use in production,

not the ratio of land or labor to output (T/outputOr L/output)Thus the good can not be both landand labor intensive.

96



Page 75 in international economic

** Comparative advantage and factors of production( Effects of IT between two-factor economies )

We look at Japan and India

They have the same tastes and have identical relativedemands for food and cloth when faced with the samerelative price of the two goods. They also have the sametechnology.

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Cont. -a given amount of land and labor yieldsthe same output of either cloth or food inthe two countries. The only differencebetween the countries is in theirresources:India has a higher ratio of labor to land

than Japan does.

98



** Relative prices and the pattern of trade

India is labor-abundantJapan is land-abundant

Note: abundant is defined in term of ratio not inabsolute quantities

99



Ex. America has 80 million workers and 200 million

hecta ( so, labor to land ratio of one-to-two and a half )mean that: one worker work in 2.5 hecta.Britain has 20 million workers and 20 million hecta ofland ( a labor to land ratio of one to one).

American is land-abundantBritain is labor-abundant

100



** India tends to produce a higher ratio of cloth to

food (cloth/food)India will have a larger relative supply curve of cloth( RS )

** Japan tends to produce a lower ratio of cloth tofood (cloth/food)Japan will have a larger relative supply curve of food( R*S)RD is the relative demand for both countries

Figure 4-8 trade lead to a convergence of relativeprice

101



Relative price of cloth ( Pc /Pf )

Relative quantity ofcloth( Qc + Q*c) / (Qf + Q*f)

3

3

1

2

**If there were no tradeThe equilibrium for India would

be at point 1, the equilibrium forJapan at point 3. the RP of clothwould be lower in India than inJapan.

**with tradeTheir relative price converge-the relative price of cloth rises inIndia and declines in Japan.-the new world relative price (RP)of cloth is at a point 2.

R*S

RS

RD

102



In India the rise in RP of cloth leads to a rise inthe production of cloth, India becomes anexporter of cloth and an importer of food.

Conversely, the decline in the RP of cloth in

Japan leads it to become an importer of clothand an exporter of food.

103



Cont. **India has a higher of L / T than in JapanLead to India is abundant in laborSo, cloth production uses a higher ratio of L / T in its

production than food.

Cloth is labor-intensive and food is land-intensiveIndia export cloth Japan export food

Labor-intensive good land-intensive good

104

Economic Growth and International Trade



Economic Growth and International Trade

As real income increases

Producers

They need to decide how toalter production.

–increase in resources or -change in technology

Consumers

They are faced with how tospend the additional real

income

105

It affects both



Cont.

Both of these decisionshave implications for thecountry’s participation in

International trade

And determining whether

countries become more orless open to trade aseconomic growth occurs.

106



Trade effects of production growth

107

A

electronics

wine0

Return to point A,point lying to theleft of the vertical

line reflect caseswhere the newproduction of wineis less than atpoint A and vs.when it move to

the right.

Production points lying on the straight line passing through the origin and point Areflect outputs of electronics and wine that are proportionally the same as at A;that is, the ratio of electronics to wine production is a constant.

Production effects ofgrowthPPF graphFigure 1



Trade effects of consumption growth

108

B

electronics

0 wine

Figure 2, point lying to the left ofthe dashed vertical axis reflectless consumption of wine, while

point to the right indicate greaterconsumption of wine, if realincome increases reflect arelatively larger increase in theconsumption of wine than in thatof electronics. Because wine is

the export good, a change inconsumption is suggested that thecountry will reduce the export ofwine.

Consumption effectsof growth



The growth Growth can result from changes in

Technology

Technology change alters the manner in which inputs are

used to generate output, and it results in a larger amount of output being generated from a fixed amount of inputs.

The accumulation of factors such as:

capital

Labor.

109



Mid-term Questions

1- We have to compared two situations

One in which countries do not trade at all,

Another in which they have free trade.

What are the results from these situations?

2- what are the factor prices and goods price dependson?It take only 45 minutes.

110



Solution 1

111

1- Countries with no trade:

- Real income have fallen, because of increasing the price of goods.- No economy of scale lead to higher average cost.

- Increasing unemployment rate.- inefficient used of local resources.- People go to the poor



Cont.

112

2- Countries with free trade:- They can mutual benefit from free trade. Ex. We have twogoods cheese and wine. If Cambodia specialized in wineproduction, it should produce wine as much as they can and then

trading the wine for cheese.- another way to see the mutual gain from trade is to examinehow trade affects each country‟s possibilities for consumption. Inthe absence of trade, consumption possibilities are the same asproduction possibilities. If trade is allowed, however, each

economy can consume a different mix of cheese and wine fromthe mix it produces.



Solution

113

-we‟ll also see that trade provides benefits by allowing countries toexport goods whose production makes relatively heavy use ofresources that are locally abundant while importing goods whoseproduction makes heavy use of resources that are scare.

- International trade allows countries to specialize in producingnarrower ranges of goods, giving them greater efficiencies of large-scale production.



Solution 2

114

- Suppose that the economy of a country produces both cloth andfood.Then competition among producers in each sector will ensure thatthe price of each good equals each cost of production. The cost ofproducing a good depends factor prices: if the rental rate on land ishigher, then other things equal the price of any good whoseproduction involves land input will also have to be higher.



Cont.

115

- The importance of particular factor price to the cost ofproducing a good depends, however, on how much of thatfactor the good‟s production involves. If cloth productionmakes use of very little land, then arise in the price of land

will not have much effect on the price of cloth; whereas iffood production uses a great deal of land, a rise in landprices will have a large effect on the price of food.

-Fertilizers

also effect to factor price and the price of goods-insecticide



Final exam 1 Suppose we have two countries (A and B) willing to

engage in the exchange of good. The domestic demandand supply schedules are given the following

equations. Da,b is the quantity demanded for eachcountry and Sa,b is the quantity supplied at price Pa,b

(Hint: Solve this problem by graphing the demand andsupply curves.) see the table at the next slide.

116



TableCountry A Country B

Pa = 100 – 5 Da Pb = 200 – 5 Db

Pa = 0 + 5 Sa Pb = 0 + 20 Sb

117

a. If there is no trade between the two countries, what is theequilibrium price and quantity in each?

b. Which country will import the good and which will export?c. What is the equilibrium price and quantity imported/exported

in the international market? (Hint: construct the excessdemand and supply curves.)



Final exam 2 If a tariff is imposed on Japanese automobiles

imported into the Cambodia, who is helped and who ishurt? Why? How?

118



Answer 1

119

200

150

100

50 50

100

150

200

15 20 5 10 15 20 25 30 35 40105

PbPa

Qa Qb

a. In country A the equilibrium price is 50 and the equilibrium quantity is 10.in country B the equilibrium price is 160 and the equilibrium quantity is 8.

b. Since country A has a lower price than country B, country B will importsthe goods and country A will exports the good.



Answer 1 (cont.)

120

10 15 20 25 30 35 4050

50

100

150

200

Excess supply from A

Excess demand from B

Quantity

Price

c. The equilibrium price is approximately 92 (92.3 to be exact) and theequilibrium quantity imported/exported is approximately 17 (16.92 to beexact). S‟a = - 20 + 0.4 Pc, D‟a = 40 – 0.25Pc.



Cont.

122

P*

2

1.5

1

0 20 40 Q*

P* = b* + a*Q*a* = slope of the linea* = (2 – 1.5)/(0 – 20)

= - 0.5/20b* = 2 (Q* = 0), P* = b*

P* = 2 – (0.5/20)Q*



Answer 2

123

A tariff on imported Japanese automobiles helps domesticautomobiles producers because they can charge a higher priceand sell more output. It also helps Japanese consumersbecause Japanese automobiles manufacturers are forced to sellmore output at home at a lower price. However, this tariff hurtsdomestic consumers because they have to pay a higher price fora smaller quantity of the good. It also hurts Japaneseautomobiles manufacturers because they sell less output.



She work hard

Thank

124



Topic 2: Government intervention in trade

Prepared and Teaching by

Lecturer Duy Chandina(DBA candidate)

Course International Economic

125



Topic focusThis lecture explains how government

interfere in trade, and how this

interference affects the economy

126



Cont. Key points to take away from this lecture*the different ways in which governmentcan interfere in trade (tariffs, quotas etc..)*how tariffs and other types of protectionaffect the economy*how to analysis the effect of protectionwhen domestic producers use imported

input

127

I-Some common forms of trade intervention



I Some common forms of trade intervention

1- Import restrictions

To help the

domestic

producers

Allow the

price to rise

in the

domesticmarket

Domestic

producers

will increase

their

production

128

2- Tariffs



Definition:

Tariff = Tax on imports

Example:

Import price of car: $10,000

20% tariff $2,000

Domestic selling price $12,000

Note: Consumers must pay a higher price because of the tariff and if the higherthe tariff, the consumers will buy less

129

-Imports will reduced because:



Imports will reduced because:

*Domestic producers are producingmore

*Consumers are buying less importgoods when the price is higher

-Tariffs also produce revenue for thegovernment

130

Types of Tariff:



Ad Valorem

(percentageof value)

Specific duty (perunit e.g. per litre)

Prohibitive tariff is a tariff which is set so high thatimports are setout of the domestic market.

131



Basic tariff analysis

132

-The effect of the tariff is to raise the cost of shippinggoods to a country.

-Tariffs have been used as a source of governmentincome and to protect particular domestic sectors.



Cont.

133

•Early 19 century, the UK used tariff to protect its agriculturefrom import competition.*In the late 19th century, both Germany and US protected

their new industrial sectors by imposing tariffs on imports ofmanufactured goods. Later on•The modern governments usually prefer to protectdomestic industries through a varieties of non-tariffbarriers such as

•Import quotas (limitations on the quantity of imports)•Export restrictions (limitations on the quantity ofexports)



The effects of a tariff

134

From the point view of SO shipping goods, atariff is just like a cost of transportation.

* If Cambodia impose a tax of $2 on everybushel of wheat imported, shipper will beunwilling to move the wheat unless the pricedifferent between the two markets at least $2.



Figure 2-1

135

India market World market Japan marketexcess demand in India,

The price below equilibrium

P

D

t

P*T=PT - t

Pw

PT

Q QQ

PP S*xsS

MD D*

3

1

2

QT Qw



Cont.

136

Figure 2-1 illustrates the effect of a specific tariff of$t per unit of wheat.

*In the absent of a tariff the Pw in both India

and Japan at point 1 (world market).*With the tariff in place, shipper are not

willing to move wheat from Japan to India unlessIndia price exceeds the Japan price by at least t$. If

no wheat is being shipped, however, there will bean excess demand in India and an excess supply inJapan. Thus the price in India will rise and that inJapan will fall until the price difference is t$.



Cont.

137

** introduce a tariff: the tariff raise the price in Indiato PT and lower the price in Japan to P*T=PT-t.

In India producers supply more at the higher price,while customers demand less, so that fewer importsare demanded (as you can see in the move frompoint 1 to point 2 on the MD curve).In Japan the lower price, decrease supply and

increase demand and thus a small export supply (asseen in the move from point 1 to 3 on the xs curve).



Cont.

138

Thus the volume of traded declines from Qw, thefree trade volume, to QT, the volume with tariff.At a trade volume QT,

India import demand equals Japan exportssupply when PT – P*T = t

PT – P*T> t (Japan happy to export)PT – P*T< t (no import)



Cont.

139

The increase in price in India from Pw to PT is lessthan the amount of the tariff, because part of thetariff is reflected in a decline in Japan‟s export

price and thus is not passed on to Indiaconsumers.



Cont.

140

For small countries that impose a tariff hasvery little effect on the world price. In thiscase a tariff raise the price of the import

goods in the country imposing the tariff bythe full amount of the tariff from Pw to Pw+t



Non-tariff Barriers to free trade

141

Besides the use of tariffs to distort the free tradeallocation of resources, government policy makers

have become very adept at using other forms tradebarriers. These are usually called non-tariff barriers totrade.

* import Quotas* “voluntary” export restraints (VERs)

3- Import Quotas



3 Import Quotas

-A Quota sometimes called a quantitative restriction

-The quota is usually controlled by an import licensingsystem

-The quotas also cause the price to rise in the domesticmarket

142



Cont.

143

* The import quotas differs from an import tariff inthat the interference with prices that can be chargedon the domestic market for an import goods isindirect. It is indirect because the quotas itselfoperates directly on the quantity of the importinstead of on the price.



4- Voluntary export restraints

144

The country may choose to negotiate anadministrative agreement with a foreign supplierwhereby that supplier agrees “voluntarily” to refrain

from sending some exports to the importingcountry.

5-Anti-Dumping duties



5 Anti Dumping duties

-Anti-Dumping duties is that dumping it mean

“Unfair”.

-It used to protect the domestic producer

145

II-Consumer surplus and Producer surplus



Consumer surplusP

D

S

Q

CS= Amounts they are willing to pay - Amounts paid to the market price

146

P

Producer surplus



Producersurplus

P

Q

S

D

PS= The price – the price that producer willing to accept

147

III- Price and quantity effects of a tariff



(Small country case)

t

Sw+t

Sw

Sd

Dd

P

0 QA B C D

148

IV-Who gains and who loses from the tariff



Small country case

P

QA B C D

t

Pf

Pt

Sd

Dd

Sw+t

Swb d

g h k ll

f j

149

V-How tariffs affect the economy



•Production and price of the protected goodsincreases.

•Producer‟s income increase

•Consumers buy less at a higher price•The Government receives revenue from the tariff

150



Discussion:

Does protection increase totalproduction and employment in theeconomy?

How do you think

151

** Tariffs and Quotas may have similar effects



Sd

Sd+q

Sw

P

QA B C DO

Pf

Pr

Dd

152

B f



Before quota Price

Consumption

Domestic production

Imports

Pf

OD

OA

AD

153



With quota limiting imports to BC At price of Pf and the quota may be added to domestic

supply, giving a “total supply curve”, Sd+q

Price rises to Pr

Consumption falls to OC Domestic productions rises to OB

154

VI-Who captures the quota rent?

**Thi d d h th im t li



**This depends on how the import licenses are

allocated1- If licenses are sold by open tender

-Quota rent is collected by government asrevenue (i.e. same situation as tariff)

2- If licenses allocated on historical share basic

-Quota rent is captured by license holders

-License holders import at Pf, sell at Pr

155

Vii- Effective rates of protection



1-Value added and nominal vs. effective rates of protection

In many countries, the manufacturing sector relies heavilyon imported inputs.

The differencebetween the

imported inputsand the finished

The valueadded

is

156

** The value added



e.g. Shirt (output)

Cloth (input)

$0.60

$1.00

Input (cloth)

=60 cents

Value added

=40 cents

Price of shirt

Price of cloth

157



** Nominal rate of protection

Measures amount by which protection increasesdomestic price above world price (e.g. a tariff of 20%raises domestic price 20% above world price)

Important for evaluating impact of protection onconsumers

N.R.P=

Domestic price – World price

World price

158



**Effective rate of protection

Measures difference between value added in domesticindustry and value added at world prices

This difference is caused by protective barriers in theimporting country

Extent of the difference is influenced by tariff on bothimported inputs and finished goods

Important for evaluating impact of protection onproducers’ incomes and on efficiency of resource use in

production.

159

Example A: Tariff on final good > Tariff on input

e.g. tariff on shirt = 20%



g

tariff on cloth= 10%

World prices

Domestic prices

Value added

40 cents

Input (cloth)

60 cents

$0.60

$1.00

10%Tariff

Input (cloth)

60 cents

20%tariff

$0.66

$1.20

Value added

1.20 – 0.66 =$0.54

160

We can see

V l dd d ld i 40



Value added at world price = 40 cents

Value added at domestic price = 54 cents

E.R.P =

54 - 40

40

= 35%

N.R.P =

120 - 100

100

= 20%

Tariff on final good > Tariff on input

Lead to value added increases

E.R.P > N.R.P

161



Example B

World price Tariff

TV set $400 10%

ImportedComponents 360 0

162

World prices Domestic prices



p Domestic prices

Components

= $360Components

= $360

$360 $360

VA = $40

$440

$400

10% tariff

163

Value added at domestic prices = $80



Value added at world prices = $40

E.R.P =80 - 40

40= 100%

N.R.P =440 - 400

400

= 10%

164

Conclusion:

If * t iff fi l d d t iff i t



If * tariff on final good exceeds tariff on input

* import content is high

Then E.R.P can be very high even if N.R.Pappears low

Interpretation of 100% effective rate of protection

Resources use in domestic production $2

Value of domestic production at world prices $1

165



Thank

166

Topic 3 : Exchange Rates



p g(international Finance)

Course International Economic

Academic Year: 2011-2012

167

Exchange rates



Exchange rates Play a central role in international trade. Because

They allow us to compare the prices of goods andservices produced in different countries.

Ex. American car cost $39,000 and Japanese car cost 3,000,000 yen. To make this comparison, we must know the relativeprice of dollars and yen.

168

Cont ex



Cont. ex. Ex. How many dollars would it cost to buy sweater

costing £50? We know an exchange rate of $1.50 perpound.

A change in the $/£ exchange rate would alter thesweater’s dollar price. At an exchange rate of $1.25 perpound, how many dollar would it cost?

Or at an exchange rate of $1.75 per pound. The

sweater’s dollar price would be higher, how much itcost?

169

I- What is an exchange rate?



An exchange rate is the

price at which a foreigncurrency is converted to

domestic currency.e.g. US$1=4000 Riels

170

**Devalue or depreciate



The domestic currencyis said to devalue or

depreciate when itsvalue falls.

e.g. US$1=4500 Riels

Note that inthis case the

price offoreigncurrency is

rising

171

** Appreciate or Revalue



The domestic currencyis said to appreciate orrevalue when its value

rises.e.g. US$1=3500 Riels

Note that in thiscase the price of

the foreigncurrency is falling

172

**A l i i t f G d d A t



**Analysis in term of Goods and Assets

1-When the domestic currency depreciates,goods and assets whose prices are expressed indomestic currency become cheaper in foreign

currency.Conversely, goods and assets whose prices areexpressed in foreign currency become more

expensive in domestic currency.

173

2-When the domestic currency



2 When the domestic currency

appreciate, goods and assets whoseprices are expressed in domesticcurrency become more expensive inforeign currency.

Conversely, goods and assets whoseprices are expressed in foreign currencybecome more cheaper in domestic

currency.

174

Flexible exchange rates



Flexible exchange rates

175

Suppose that, US exports goods to French forfuture delivery in 30 days and that the exporterrequires a price of $1,000 per unit to be willing tomake the sale. If French buyer is willing to pay5,000 francs per unit.

1-What is an exchange rate between US$and Francs?

2- and when exchange rate changes to 5.25francs = $1 by the end of 30 days. How much $ theUS will be received?

Fixed & flexible exchange rates



Fixed & flexible exchange rates The flexible rates are less conducive to the expansion

of world trade and FDI than are fixed rates.

With a flexible rates instead of a fixed rates, the

exporting firm will require some insurance against theexchange rate change.

This insurance can take the form of holding out forslightly higher expected price than $1,000.

A smaller volume of trade will occur under flexiblerates than under fixed rates. Would fixed or flexible exchange rates provide for greater

growth in international trade and investement?

176

Would Fixed or Flexible exchange rates provide for

t ffi i i ll ti ?



greater efficiency in resource allocation?

177

Forward for fixed exchange rates is that the wastefulresource movements associated with flexible exchange

rates are avoided.If the exchange rates can vary substantially, there can beconstantly changing incentives for the trade-able goodssectors.

Cont



Cont. If the country’s currency depreciates in the exchange

markets.

The factors of production will be induce to move into

the trade-able goods sectors and out of the non-trade-able goods sectors. Because the production of exportsand import substitutes is now more profitable.

If the country’s currency appreciates.

The incentive reverse themselves and resource move outof trade-able goods sectors and move into non-trade-able goods sectors

178

Effect of dollar depreciation on

exports and imports



exports and importsR=y/$ Domestic

priceFeb 02R=134

May 02R=124

Effects

US exportscomputers

$10,000 Y 1,340,000 Y 1,240,000 X increases

US imports Japanese cars

Y 2,000,000 =$ 14,900 $ 16,100 M decreases

179

Effect of dollar appreciation on

exports and imports



exports and importsR =y /$ Domestic

price Jan 01R=116

Jan 02R=132

Effect

Us .exportcomputers

$ 10,000 Y 1,160,000 Y 1,320,000 X decreases

US. Imports Japanese cars

Y 2,000,000 $ 17,200 $ 15,200 M increases

180

Exchange rates and relative prices



Exchange rates and relative prices Import and export demands, like the demand for all

goods and services, are influenced by relative prices,such as the price of sweaters in terms of designer jeans.

We compute the relative prices of goods and services whose money prices are quoted in different currencies.

An exchange rate $1.50 per pound. If a sweater priced at£50 in Britain. How much an American trying to decide

to spend on British sweater?

181



Cont. compute $/£ exchange rates and relative price

f A i j d B iti h t



of American jeans and British sweaters

183

Exchange rate ($/£) 1.25 1.75

Relative price (pairs of jeans /sweater)

1.39 1.94

Note: the price of a pair of jeans is $45 and the price of a sweater is £50

The foreign exchange market



The foreign exchange market Just as other prices in the economy are determine by

the interaction of buyers and sellers.

Exchange rates are determined by the interaction of

the households, firms, and financial institutions thatbuy and sell foreign currencies to make internationalpayments.

The market in which international currencies trades

take place is called the foreign exchange market.

184

The actors



The actors The major participants in the foreign exchange market

are:

Commercial banks

Corporations that engage in international trade Nonbank financial institutions such as:

Assets management firms

Insurance companies

Individuals like tourist who buys foreign currency at ahotel front desk. (insignificant)

185

Commercial banks



Commercial banks Are the center of foreign exchange market because:

Every international transaction involves

The debiting and

The crediting of accounts at commercial banks.

186

Cont



Cont.

187

Example: Exxon corporation wishes to pay € 160,000 to a Germansupplier.First: Exxon gets an exchange rate quotation from its owncommercial bank by the Third National Bank.

Then it instructs to debits Exxon’s dollar account and pay € 160,000 into the supplier’s account at a German bank. If theexchange rate $1.2 per euro, how much $ is debited from Exxon’saccount?***Note: foreign currency trading among banks-called interbank trading.The rates banks charge to each other called interbank rates. The rates available tocorporate customers, called “retail rates” are usually less than interbank rates. The difference between the retail and interbank rates is the bank compensation for doingthe business.

Corporations



Corporations Corporations with corporations in several countries

frequently make and receive payments in currencies.

To pay workers in a plant in Cambodia, for ex. Thecompany may need the Cambodia Riels. If company hasonly dollar earned by selling his products in the UnitedStates, it can acquire the Riels it needs by buying them

with its dollars in the foreign exchange market.

188

Exchange rates and Asset returns



Exchange rates and Asset returns to see which deposit, euro or dollar, offers a higher

expected rate of return, you must ask the question: if Iuse dollars to buy a euro deposit, how many dollars will I get back after a year? To answer this question letsee the ex.

Today’s exchange rate is $1.10 per euro, but that youexpect the rate to be $1.165 per euro in a year (Perhaps

because you expect unfavorable developments in theUS. Economy).

189

Cont.



Cont. Suppose also that the dollar interest rate is 10% per

year while the euro interest rate is 5% per year. Thismeans :

A deposit of $1.00 pays $1.10 after a year. A deposit of €1.00 pays €1.05 after a year.

Question: which of these deposits offers the higherrate of return?

190

The answer can be found 3 steps



The answer can be found 3 steps Step 1: If the exchange rate today is $1.10 per euro, the

dollar price of a euro is just $1.10.

Step 2: since you expected the dollar to depreciate

against the euro over the coming year so that theexchange rate 12 months from today is $1.165 per euro,then you expect the dollar value of your euro depositafter a year to be $1.165 per euro × €1.05 = $1.223

191

Cont.



Cont. Step 3: now that you know the dollar price of a €1.00

deposit today ($1.10) and can forecast its value in a year($1.223), you can calculate the expected dollar rate of return on a euro deposit as (1.223 – 1.10)/1.10 = 0.11 or11% per year.

Conclusion: the dollar interest rate exceeds the eurointerest rate by 5% per year, the euro’s expected

appreciation against dollar gives euro holders aprospective capital gain that is large enough to makeeuro deposits the higher-yield asset.

192

A simple rule



A simple rule First, define the rate of depreciation. In example:

dollar’s expected depreciation rate is (1.165 – 1.10)/1.10=0.059, or roughly 6% per year.

So, the expected dollar rate of return on a euro depositis the euro interest rate plus the rate of depreciation of dollar against the euro.

193

Cont. some notation:



Cont. some notation: R € = today’s interest rate on one-year euro deposits,

E$∕€ = today’s dollar/euro exchange rate

E®$∕€= dollar/euro exchange rate expected to prevail a

year from today (or the expected future dollar/euroexchange rate)

Expected rate of return on a euro deposit, measured in

terms of dollars =R € + (E®$∕€ - E$∕€)/E$∕€

194

Cont.



The expected rate of return difference between dollarand euro deposits = R$ - [R € + (E®$∕€ - E$∕€)/E$∕€]

Or = R$ - R € - (E®$∕€ - E$∕€)/E$∕€

Note:

When the difference above is positive, dollar deposits yield the higher expected rate of return.

When it is negative, euro deposits yield the higherexpected rate of return.

195

Cont.



Cont. The expected rates of return on a dollar deposit,

measured in terms of euro = R$ - (E®$∕€ - E$∕€)/E$∕€

Example: today’s exchange rate (Riels/$) is 1$=4,000 rielsbut that you expect rate to be 1$= 4,500 riels in a year.Suppose also:

The riels interest rate is 10% per year

While the $ interest rate is 5% per year.

196



Cont.



In the case you expect rate to be $1 = 3,500 riels

Question:

What is the expected rate of return on dollar deposits,

measure in term of riels? And What is the expected rate of return on riels deposits,

measure in term of dollar?

In each case, which of these deposits give a higher rate of

return? Work in class!

198

Comparing dollar rates of return on

dollar and euro deposits (table 13.3)



dollar and euro deposits (table 13.3)

Dollarinterest rate

Euro interestrate

Expected rateof dollardepreciationagainst euro

Rate of returndifferencebetweendollar and

euro deposits

case R$ R € (E®$∕€ - E$∕€)E$∕€

R$-R €- (E®$∕€-E$∕€)/E$∕€

12

34

0.100.10

0.100.10

0.060.06

0.060.12

0.000.04

0.08- 0.04

0.040.00

-0.040.02

199

Cont.



Case 1: the interest difference in favor of dollar depositsis (R$ - R € = 0.10 – 0.06 = 0.04) and no change in theexchange rate is expected (E®$∕€ - E$∕€) = 0.00

E$∕€ This means that the expected annual real rate of return

on dollar deposits is 4% higher than that on euro, sothat, other things equal, you would prefer to hold your

wealth as dollar rather than euro deposits.

200

Cont.



Case 2: the interest difference is the same (4%), but itis just offset by an expected depreciation rate of thedollar of 4%. The two assets therefore have the sameexpected rate of return.

Case 3: is similar to the one discussed earlier: a 4%interest difference in favor for dollar deposits is morethan offset by an 8% expected depreciation rate of the

dollar, so euro deposits are preferred by marketparticipants.

201

Cont.



Case 4: there is a 2% interest difference in favor of eurodeposits, but the dollar is expected to appreciateagainst the euro by 4% over the year. The expectedrate of return on dollar deposits is therefore 2% per year higher than that on euro.

202

Practice



Suppose that today’s exchange rate is $1.20 per euro,but that you expect the rate to be $1.30 per euro in a year. Suppose also that the dollar interest rate is 10%per year while the euro interest rate is 5% per year

Questions:

1- Use today’s dollar/euro exchange rate to find out thedollar price of a euro deposit, (answer $1.20)

2- Use the euro interest rate to find the amount of euro you will have a year from now if you purchase €1 deposittoday. (Ans. At the end of a year, your €1 deposit will be

worth €1.05)203

Cont.



3- use the exchange rate you expect to prevail a year fromtoday to calculate the expected dollar value of the euroamount determined in question 2? (answer: you expectthe dollar value of your euro deposit after a year to be

$1.30 per euro × €1.05 = $1.365) 4- calculate the expected dollar rate of return on a euro

deposit? (answer: 0.10 + (1.365 – 1.32)/1.32 = 13.340%).1.32=1.20 + 1.20 * 0.10, (answer: R € + (E®$∕€ - E$∕€)/E$∕€ =

0.05 + (1.30 – 1.20)/1.20 = 13.333%) (the same answer)

204

Cont.



5- calculate the expected rate of return differencebetween dollar and euro deposits? (answer: R$ - [R € +(E®$∕€ -E$∕€)/E$∕€] = 0.10 – 13.33% = -3.33%. Which of these deposits offers higher rate of return? Answer is

euro deposits yield the higher expected rate of return. Note: when the difference above is positive, dollar

deposits yield the higher expected rate return,

when it is negative, euro deposits yield the higherexpected rate of return.

205

The equilibrium in the foreign

exchange market



g We have learned about the demand for and supplies of

foreign currency assets to determine the

Equilibrium in the foreign exchange market

The foreign exchange market is in equilibrium whendeposits of all currencies offer the same expected rate of return

206

Interest parity: the basic

equilibrium condition



q The condition that the expected returns on deposits of

any two currencies are equal when measured in thesame currency is called the interest parity condition

Let’s see why the foreign exchange market is inequilibrium only when the interest parity conditionholds?

207

Cont.



Ex. Suppose the dollar interest rate is 10% and the eurointerest rate is 6%, but that the dollar is expected todepreciate against the euro at an 8% rate over the year.(this is case 3 in table 13.3, slide 183). This means that

The expected return on euro deposit is 4% greater thanthat on dollar deposits: the results

- no one will be willing to continue holding dollardeposits.

- the holders of dollar deposits will be trying to sell themfor euro deposits.

208

Cont.



- so, there will be an excess supply of dollar deposits

and an excess demand for euro deposits in the foreignexchange market.

209

Cont.



As a contrasting example,

Suppose dollar deposits again offer a 10% interest ratebut euro deposits offer 12% rate.

The dollar is expected to appreciate against euro by 4%over the coming year.(this is case 4 in table 13.3)

Now the return on dollar deposits is 2% higher. Results

No one would demand euro deposits

So, they would be an excess supply and $ deposits wouldbe in excess demand.

210

Cont.



When $ interest rate is 10%

Euro interest rate is 6%

$ expected depreciation rate against the euro is 4%

$ and € deposits offer the same rate of return andparticipants in the foreign exchange market are willingto holder either. (this is case 2 in table 13.3, side 183).

In this point: the foreign exchange market is in

equilibrium when no type of deposits is in excessdemand and excess supply. Or when the interest parity condition holds.

211

Cont.



The expected of return measured in dollar equal

212

R$ = R € + [(Eª$/ € - E$/ €)/E$/ €]

Cont.

Like all markets, the market for foreign



Like all markets, the market for foreign

exchange can be analyses in term of:

1- Demand forforeignexchange

2- Supply offoreignexchange

213

*To pay for importsAs the price of foreign exchangefalls(domestic currencyappreciation) , the price ofimports in domestic currency



1- Demand forforeignexchange

Foreign exchange isneeded for thefollowing purpose

p y

become cheaper, the demandfor them will rise, and so willincrease demand for foreignexchange to pay for them

**To pay for overseas investments being made by localinvestors, and to satisfy the needs of overseas investorswithdrawing their capital or repatriating dividends from the localeconomy.As the price of foreign exchange falls, the price of foreignassets becomes cheaper relative to the price of assets in the

domestic economy, and so there will be a flow of investmentfunds out of the domestic economy, creating an increaseddemand for foreign exchange.

214

2- Supply of foreignexchange

2- foreign investors wishing toinvest in domestic economy

-as the price of foreignexchange rises



1- receiving payment from exports

- As the price of foreign exchangerises.

Mean that Riel

depreciation The foreign currency

price of exportsbecomes lower

-Export sale will increase-Receipts of foreign exchange

will rise, lead to an increasedsupply of foreign exchange.

g

The price of assets in the domesticeconomy became cheaper relative tothe price of foreign assets and so there

will be a flow of investment intodomestic economy, bringing with anincreased supply of foreign exchange.

215

III- The equilibrium exchange rate

P (Riel per $)



Q

D

S

P*

We have two reason:

1-Under a freely floatingexchange rate system

2- Under a fixed exchangeRate system

216



We can prevent the exchange rate

by controlling at.



Domestic currency depreciation or

Domestic currency appreciation

Ex. If it is appreciation lead to demand for import

increased then demand for foreign exchange alsoincreased. Mean that an excess demand for foreignexchange, $ f low out. So the Gov. should consider aboutthis problem in order to keep the exchange rate at a fixedlevel.

218

** Changes in the equilibrium exchange rate

The shifts in the demand and supply curves



for foreign exchange may be cause by thefollowing:

P*

P**

P

Q

D*

D**

S

1- Changes inimport demand

219

Change in import demand



If the demand for imports rises, import payment willincrease. This means the demand curve for foreignexchange will shift outwards and the equilibriumexchange rate will rise.

Similarly, if the demand for imports falls, the demandcurve for foreign exchange shift inwards and theequilibrium exchange rate falls.

220

Increases in import payments may

be caused by



A sudden rise in the price of essential imports, such asoil

Faster growth in the domestic economy

Imports technologies Imports resources

And other goods relative to production

Higher inflation in the domestic economy, making

domestic production less competitive with imports.

221

S*

S**



P*

P**2- Changes inexports

222

Change In exports



If exports fall, the supply of foreign exchange isreduced, the supply curve for foreign exchange shiftsinward, and the equilibrium exchange rate rises.

If exports rise, the supply of for foreign exchangeincreases, the supply curve for foreign exchange shiftsoutward, and the equilibrium exchange rate falls.

223

A fall in exports may be caused by



-A fall in export prices

-slower growth in overseas export markets

-higher inflation in the domestic economy, makingexports less competitive.

224

3- Interest rate differentials

R



-domestic interest rate > oversea interest rate

-If domestic interest rates < oversea interest rate

225

R

QQ

Interest rate differentials



If capital is able to move in and out of the economy, thesupply and demand for foreign exchange will also beaffected by changes in the difference between domestic andoverseas interest rate.

226

Cont.



* If domestic interest rates rise relative tooversea rate, capital will be attracted intothe domestic economy. The increasedsupply of foreign exchange shifts thesupply curve outward and the equilibriumexchange rate falls.

227

Cont.



* If domestic interest rate fall relative tooversea rates, capital will be attractedaway from the domestic economy,

creating an increased demand for foreignexchange.The demand curve for foreign exchangeshifts outward and the equilibrium exchange

rate rises.

228

Interest Rates



To compare returns on different deposit, we need twopieces of information

First: they need to know how the money values of thedeposits will change

Second: they need to know how the exchange rates willchange.

Interest rates play an important role in the foreignexchange market because the large deposits traded pay interest. Ex. When the interest rate on dollars is 10%per year, a $100,000 deposit is worth $110,000 after a year.

229

IV- The effects of changing in the exchange rate



1- Devaluation or Depreciation of the domestic currency

* When the domestic currency is depreciated

-Goods priced in foreign currency become

more expensive in domestic currency (the price of Importsgoods become more expensive in the domestic marketand local goods therefore become more competitive withimport, so imports fall).

-Goods priced in domestic currency becomecheaper in foreign currency (Exports become morecompetitive in overseas markets, so exports increase)

230

-The trade balance will improve

-National production will increase (Sincethere will be increases in production by both Export



p y pindustries and industries which compete with imports)

-Because the price of tradable goodsrises, inflation will increase (Since imports and exportsmake up only part of national production, inflationshould rise by a smaller percentage than the exchangerate change, unless other costs, especially wages alsorise as a result. In the latter case, the rise inflationcould cancel out the effect of the exchange rate change

on imports and exports.

231

2-Revaluation or appreciation of the domestic currency

**When the domestic currency is appreciated



-Goods priced in foreign currency becomecheaper in domestic currency (Imports become morecheaper in the domestic market and therefore becomemore competitive with local goods, so imports rise)

-Goods priced in domestic currencybecome more expensive in foreign currency (Exportsbecome less competitive in overseas market, so exportsfall).

-The trade balance will deteriorate

232

-National production will slow down orfall (Since there will be falls in production by both



exports industries and the industries which competewith imports).

Because the price of tradable goods falls, inflationwill decrease.

233

The effect of changing: expectations on

the current exchange rate



Figure A, may also be used to study the effect ontoday’s exchange rate of a rise in the expected futuredollar/euro exchange rate (E®$∕€.)

Given today’s exchange rate, a rise in the expectedfuture price of euro in terms of dollars raised the dollarexpected depreciation rate.

234

Example



If today’s exchange rate is $1 per euro and the rateexpected to prevail in a year is $1.05 per euro theexpected depreciation rate of the dollar against theeuro is (1.05 – 1.00)/1.00 = 0.05; if the expected future

exchange rate now rise to $1.06 per euro, the expecteddepreciation rate also rises, to 0.06. because

A rise in the expected depreciation rate of the dollarraises the expected dollar return on euro deposits, thedownward-sloping schedule shifts to the right, as infigure A.

235

Figure A: effect of a rise in the euro interest rate



236

E²$ ∕€

E$∕€

Exchange rateE$ ∕€

R$ rates of return(in dollar terms)

Dollar return

Rise in eurointerest rate

Expected euroreturn

2

1

A rise in theinterest ratepaid by eurodeposits causesthe $ to

depreciate frompoint 1 to 2.(this figure alsodescribes theeffect of the risein the expectedfuture $ ∕€ exchange rate)

Page 348

Cont.



At the initial exchange rate E$/€ there is now an excesssupply of dollar deposits: euro deposits offer a higherexpected rate of return (measured in dollar terms)than do dollar deposits.

The $ therefore depreciates against the euro untilequilibrium is reached at point 2.

We conclude that, all else equal, a rise in the expected

future exchange rate cause a rise in the currentexchange rate and vice versa.

237

Question for study and analysis 1



Suppose the exchange rate between $ U.S and Swedishkronor is $1 in US currency can buy 8 kronor.

a. if the price of a U.S. computer is $2,000, according to thepurchasing power parity, what should be the price, in kronor,

of a Swedish computer? b. if the interest rate in the United States is 10% but it increases

from 10 to 15% in Sweden, what is likely to happen to theexchange rate?

c. if the growth rate of output is 5% in Sweden but the United

Stated is in a recession and a growth rate is -2%, what is likely to happen to the exchange rate?

d. if the exchange rate increases to 15 cents per kronor, whichcurrency appreciates and which depreciates?

238

Problem 2



In terms of United States economics, as discuss intopic 3, which is more likely to increase nationaloutput, depreciation or appreciation of domesticcurrency? Explain.

239

Answer 1



240

a. According to purchasing power parity a computer that has theprice of $2,000 should has a price of 16,000 kronor in Sweden.If the price is less than 16,000 kronor, then someone in theUnited States can take $2,000, trade for16,000 kronor at a

exchange rate of $1 = 8 kronor and have money left over.b. If the interest rate in Sweden increases from 10 to 15%, this islikely to attract investment dollars from United States. That thedemand for Swedish kronor will increase, leading to anincrease in the exchange rate between dollars and kronor. Theprice of a kronor will be greater than 0.40 Kronor, meaning the

kronor appreciates relative to dollar.

Cont.



241

c. If Sweden economy grows relative faster than the US economy,$ depreciation. Kronor/$ exchange rate is 7.44 Kronor (8 – 8*7%)=$1d. If the exchange rate between dollars and kronor increases to 15

cents per kronor, this mean $1 can buy fewer kronor (6.8 kronorper dollar) and 1 kronor can buy more dollars. As such the kronorappreciates relative to the dollars and the dollar depreciatesrelative to the kronor.

Answer 2



242

Since appreciation of US currency encourages imports anddiscourages exports, it will lead to a reduction in national output.However, depreciation of currency will have a opposite effect. Itencourages exports because it makes the price of exported

goods relatively cheaper and discourages imports because itmakes the price of imports goods relatively higher. As such,depreciation of currency will lead to an increase in nationaloutput.

Mid-term



We have dollar and euro, you want to deposit them in abank, how do you think which on give you a higherrate of return, if exchange is fixed?

243



End of topic 3

Good Luck to you

244



Money, Interest Rates, and Exchange

Rates

245

Introductiond d f ll h d f h



To understand fully the determination of ERs, we haveto learn how interest rates (Rs) themselves aredetermined and how expectation of future ERs areformed.

246

I- Money defined d f h ( h



Money as a medium of exchange (is the mostimportance function of money)

Money as a unit of account (second importance role)

Money as a store of value What is money

How the money supply is determined

247

Money as a medium of exchange d f



Money accepted means of payment People purchase goods and services

Trade of goods or services for other goods or services

248

Money as a unit of account A id l i d f l E P i f



A widely recognized measure of value. Ex. Prices of goods, services, and assets are typically expressed interm of money

Exchange rates (ERs) allow us to translate differentcountries’ money prices into comparable terms.

The convention of quoting prices in money termssimplifies economic calculations by making it easy tocompare the prices of different commodities. (Ex. The

international prices comparisons in chapter 3, which ERs to comparethe prices of different country’s output)

249

Money as a store of value B b d f h i



Because money can be used to transfer purchasingpower from the present to future.

Automatically makes it the most liquid of all assets (anasset is said to be liquid, when it can be transformedinto goods or services rapidly and without hightransaction costs, such as brokers’ fees.

250

What is money? C d Ch ki b i i l



Currency and Checking may be written certainly quality as money.

Assets such as real estate do not qualify as money,because, unlike currency and checking deposits, they lack the essential property of liquidity.

251

How the money supply isdetermined M l f h l f



Money supply refer to the total amount of currency and checking deposits held by household and firms.

The large deposits traded by participants in the FEmarket are not considered part of the money supply,because they are not used to finance routinetransactions.

252

Cont. A ’ l i l d b i l



An economy’s money supply is controled by its centralbank

The central bank directly regulates the amount of currency in existence and also has indirect control overthe amount of checking deposits issued by privatesbanks.

253

II- the demand for money byindividuals Th d t i t f i di id l d d b



The determinants of individual money demand can bederived from the theory of asset demand in lastchapter individuals base their demand for an asset onthree characteristics

The expected return the asset offers compared with thereturns offers by other assets

The riskiness of the asset’s expected return

The asset’s liquidity

254

Expected return Wh h ld d d t b th



When you hold money and you do not buy thegovernment bond, you will sacrifice the higher interestrate you could earn by holding your wealth in agovernment bond.

The higher the interest rate, the more you sacrifice by holding wealth in form of money.

255

Cont. E St k t i th f f di id d d



Ex. Stocks pay return in the form of dividends andcapital gains

The family spend their time at the beach pays a returnin the form of pleasure of vacations at the beach.

The money you lent pays a return in the form of interest

256

Cont. S f l th t th i t t t ld



Suppose, for example, that the interest rate you couldearn from a Cambodian Treasury bill is 10% per year. If you use $10,000 of your wealth to buy a treasury bill, you will be paid $11,000 at the end of the year. But you

keep the $10,000 as cash in safe-deposit box, you giveup the $1,000 interest you could have earn by buyingthe treasury bill.

257

Cont. W l d th t ll l l i i th i t t



We conclude that, all else equal, a rise in the interestrate causes the demand for money to fall.

Risk is not important factor in money demand, but itis risky to hold money. Because an unexpected

increase in the price of goods and services couldreduce the value of your money in terms of thecommodities you consume.

(note: interest-paying assets such as government bond)

258

Liquidity: being able to changeassets into cash Th i b fit f h ldi f it



The main benefit of holding money come from itsliquidity.

Household, and firms hold money because it is easiest way of financing their everyday purchases.

259

III- aggregate money demand



260

Aggregate money demand (the total demand for money by households andfirms in the economy)

Individualhouseholds

demand formoney

Firms demand

for money

Three main factors determineaggregate money demand



Three main factors

The interest rate (Rs):a rise in the Rs causeseach individual in theeconomy to reduce

her demand formoney. All else equal,

lead to aggregatemoney demand falls

The price level: if theprice level rises,

individual householdsand firms must spend

more money thanbefore to purchase

their usual weekly baskets of goods and

services

Real National Income(GNP): when GNP

rises, more goods andservices are being sold

in the economy, raisesthe demand for money

261

Cont. If P is the price level



If P is the price level R is the interest rate

Y is the real GNP or real income

Md is the aggregate demand for money can beexpress as Md = P * L(R,Y) (1),(L= liquidity)

Note: naturally L(R,Y) rises when R falls and falls when

Y falls.

262

Cont. From (1) we can write: Md/P L(R Y) (2)



From (1) we can write: Md/P = L(R,Y) (2)

263

The ratio Md/P that is,designed money holdingmeasure in terms of a typicalreference basket ofcommodities equal the amountof purchasing power peoplewould like to hold in liquid form

Call aggregate realmoney demand

Cont. ex. If people wish to hold $1 000 in cash at a price level of



If people wish to hold $1,000 in cash at a price level of $100 per commodity basket, their real money holding would be equivalent to $1,000/$100 per basket = 10basket.

If the price level double (to $200 per basket) thepurchasing power of their $1,000 in cash would behalved, $1,000/$200 per basket = 5 basket

264

Figure 1.1: aggregate realmoney demand and the R

Interest rate (R)



265

Interest rate (R)

The downward-sloping real moneydemand schedule

show that for agiven real incomelevel ,Y, realmoney demandrises as the ,R,

falls. Aggregate real moneydemand

L(R,Y)

Figure 1.2: effect on the aggregate realmoney demand schedule of a rise in real

income



266

Increase inreal income

Interest rate( R )

Aggregate realmoney demand

L(R, Y²)

L(R, Y¹)

An increase in realincome from Y¹ to Y²raises the demand forreal money balances atevery level of the Rand causes the wholedemand schedule to

shift upward.

Cont. For a given level of real GNP changes in R cause



For a given level of real GNP, changes in R causemovement along the L(R,Y) schedule.

Changes in real GNP cause the schedule itself to shift.So, figure 1.2 show a rise in real GNP from Y¹ to Y²

affects the position of the aggregate real money demand schedule. Because a rise in Y raises aggregatereal money demand for a given R, L(R,Y²) lies to theright of L(R,Y¹) when Y²>Y¹.

267

IV- The equilibrium interest rate: theinteraction of money supply and

demand

Th k t i i th ilib i h



In this section we see how the interest rate isdetermined by money market equilibrium

The money market is in the equilibrium when

The money supply set by the central bank

Equals aggregate money demand

268

Equilibrium in the moneymarket If Ms is money supply



If Ms is money supply And Md aggregate

So the condition for equilibrium is:

Ms = Md (3)

269

Figure 1.3 determination of theequilibrium interest rate (R)

Interest rate (R)



270

Interest rate (R)

Q² Ms/p=Q¹ Q³ real moneyholding

R²

R¹

R³

real moneysupply

2

1

3

Aggregate realmoneydemand L(R,Y)

With p and Y givenand a real moneysupply of Ms/p,

money marketequilibrium is atpoint 1. at this pointaggregate realmoney demand andthe real money

supply are equaland the equilibriumR is R¹.

Cont. We can express the money market equilibrium



We can express the money market equilibriumcondition in terms of aggregate money demand as

Ms/p = L(R,Y) (4)

Given the price level, p, and output, Y, the equilibriuminterest rate is the one at which aggregate real money demand equal real money supply.

271

Cont.



At point 2 the demand for real money holding falls short

of the supply by Q¹-Q², so there is an excess supply ofmoney. Individuals will attempt to get rid of their excessmoney by lending it to the others.

Let see at its equilibrium level at point 2, with R ², that isabove R¹

272

Cont. Similarly if the R is at a level R³ below R¹ it will tend



Similarly, if the R is at a level R below R , it will tendto rise. There is an excess demand for money equalto Q³-Q¹ at point 3.individuals therefore attempt to sell interest bearing

assets such as bonds to increase their moneyholdings (that is, they sell bonds for cash)

273

Cont. At point 3 no every one can succeed in selling enough



At point 3 no every one can succeed in selling enoughinterest bearing assets to satisfy his or her demand formoney. People bid for money by offering to borrow athigher R and push R upward toward R ¹ and then R

stop rising.

274

Interest rates (R) and themoney supply Initially the money market is in equilibrium at point 1



Initially the money market is in equilibrium at point 1, with a money supply M¹ and interest rate R¹. sincewe are holding p constant, a rise in the moneysupply to M² increase the real money supply from

M¹/p to M²/p.

275

Cont. With a M²/p point 2 is the new equilibrium and R² is



With a M /p, point 2 is the new equilibrium and R isthe new, lower R that induce people to hold theincreased available real money supply.

Note

Ms is the money supply issue by the central bank.

M¹/p is the real money supply

With lower R people will hold more money. They use

their surplus funds to bid for assets they pay interest.

276

Cont. We conclude that:



We conclude that: An increase in the money supply, lowers the interest

rate(R), while a fall in the money supply raises the R,given the price level and output (see figure 1.4)

277

Figure 1.4 effect of an increasein the money supply on the R

Interest rate (R) Real moneysupply



( )

278

M¹/p M²/p realmoney holding

ysupplyReal moneysupplyincreases

1

2

R¹

R²L(R,Y)

For a given price level, p,and real income, Y, anincrease in the money

supply from M¹ to M²reduces the R from R¹(point 1) to R² (point 2)

Figure 1.5: output and the R This show us the effect on the R of a rise in the level of



This show us the effect on the R of a rise in the level of output from Y ¹ to Y² , given Ms and p, an increase inY causes the entire aggregate real money demandQ schedule to shift to the right, moving the

equilibrium away from point 1. at the old equilibriuminterest rate R¹, this is an excess demand for moneyequal to Q²-Q¹ (point 1).

279

Figure 1.5 Interest rate (R) Real money supply



( )

280

Increase in realincome

L(R,Y²)

L(R,Y¹)

1‟ 1R¹

Ms/p=Q¹ Q² real moneyholding

Cont. We conclude that an increase in the real output Q



We conclude that an increase in the real output Qraises the R, while a fall in real output, Q, lower the R,given the price level and the money supply.

281

V- the money supply and theexchange rate in the short run We will discover that an increase in a country’s money



We will discover that an increase in a country s money supply causes its currency to depreciate in the Foreignexchange (FE) market, while a reduction in the money supply causes its currency to appreciate.

282

Linking money, R, and the ERs Figure 1.6, we combine two diagrams. We are looking



gu e .6, e co b e t o d ag a s. e a e oo gat the $/€ ER, that is, the price of euro in terms of dollars.

The first diagram, shows the equilibrium in the FE

market and how it is determined given Rs andexpectation about future ERs.

283

Cont. The, R ¹$, which is determined in the money market.



, , y At the intersection of the two schedules (point 1‟),

the expected rates of return on $ and € deposits areequal, and therefore, interest parity holds.

284

Cont. The second diagram we need to examine the relation

b d d d f



gbetween money and ER was introduced as figure 1.3.this figure shows how a country’s equilibrium interestis determined in the money market.

Both assets market are in the equilibrium at the R$¹and the E¹$/€, at these value money supply equalsmoney demand ( point 1) and the interest parity condition holds (point 1’)

285

Two diagrams, figure 1.6

Return on $deposits

$/ € ER

E$/ €

Foreignexchange



286

Rates of return

(in $ terms)L(R$, Yu.s)

Expected returnon € deposits

1‟

R¹$

1‟

E¹$/ €

0

Ms(us)/Pus(increasing)

US real money holding

market

Moneymarket

US money supply and the $/€ ER. We now use our model of asset market linkage (the

li k b h k d FE k )



g (links between the money market and FE market) toask how the $/€ ER changes when the Federal reservechanges the US money supply =[Ms(us)].

287

Figure 1.7: effect on the $/€ ER and R$

of an increase in the US money supply

Given Pus and Yus, when the money supply rise fromM¹ t M² th R$ d li ( k t



, y pp yM¹us to M²us, the R$ declines (as money marketequilibrium is reestablished at point 2) and the $depreciates against the € (as FE market equilibrium

is reestablished at point 2‟)

288

Figure 1.7

2‟

1‟

E$/ €

E²$/ €

$ return



289

2

1

R¹$R²$

E¹$/ €

0

M¹us/Pus

M²us/ Pus

US real moneyholding

L(R$, Yus)

Expected € return

Increase in US realmoney supply

Rates of return(in $ terms)

Cont. At the initial money supply M¹us, the money market

i i ilib i t i t 1 ith R¹$ Gi th R€



y pp y yis in equilibrium at point 1 with an R¹$. Given the R € and the expected future ER, a R¹$ implies that FEmarket equilibrium occurs at point 1‟with an ER

equal to E¹$/ €.

290

Cont. What happens when the Federal reserve raises the US

l f M¹ t M² ?



ppmoney supply from M¹us to M²us?

1- at R¹$ there is an excess supply of money in theUS money market, so the R¹$ falls to R²$ as the

money market reaches its new equilibrium (point 2) 2- given E¹$/ € and the new, lower the R²$, the

expected return on € deposits is greater than that on$ deposits. Holders of $ deposits try to sell them for

€ deposits.

291

Cont. 3- the $ depreciates to E²$/ €, as holders of $ deposits.

Th FE k t i i i ilib i t i t



3 p pThe FE market is once again in equilibrium at point2‟ because the ER‟s move to E²$/€ causes a fall indollar‟s expected future depreciation rate sufficient to

offset the fall in the R$. We conclude that an increase in a country‟s money

supply causes its currency to depreciate in the FEmarket and reverse.

292

Home work R$ = 10%, E$/ € $1.2 = €1



If $ 1200 buy £1800, question = E£/$ ?

R$ = 12%, question = E$/ € ?

In this case, if $1200 buy £ ? Answer: $1.2= €1=£1.8 lead to$1200/$1.2 = €1000=£1800

€1=$1.176=£1.764 lead to $1200/1.176 = €1020.4

€1020.4 - €1000 = €20.4, €20.4 * 1.764 = £36

$1200 buy £1800 +36 =£1836

293

Topic 5: page 218

Th li i l E f



The political Economy ofTrade Policy

Lecturer: Duy Chandina

DBA. Candidate

294

Introduction

In 1981 U.S. asked Japan to limit its exports of autos to theU.S.



- This raised the

price of importedcars and forcedU.S. consumersto buy domestic

autos.

Japan was willing to accommodate the U.SGov. on this point.

But a request that Japan eliminate importquotas on

- beef, and citrus products.

Quotas that forced Japanese consumers to buy

incredibly expensive domestic products insteadof cheap imports form the U.S.

295

Cont. This reason:

F h G f b h i h d i d



Force the Gov. of both countries were thus determinedto pursue policies

Is not base on economists’ cost-benefit calculations

(consumer and producer surplus) Will discuss the characteristic trade policy issues facing

developing and advanced countries, respectively.

296

The case for free trade



No tariff or import quotas -free trade and efficiency.

Efficiency case for free

trade is simply to reverse ofthe

cost-benefit analysis of atariff.

Using the concepts of consumer and producer surplus. 297

Cont. P d ti

P



-Productiondistortion.

-Consumptiondistortion

World price+ tariff

World price

Q **Tariff causes a net loss to the economy measured by the area oftriangles; it does so by distorting the economic incentives of both:producers and consumers.

298

For free trade Eliminates these

Di t ti



Distortions

And increases national welfare.

299

Additional gains from free trade Economies of scale

F t d ff t iti f l i d



Free trade offers more opportunities for learning andinnovation

Increase real income

300

The domestic market failureargument against free trade The domestic market failure because:

S k t i th t i t d i it j b i ht



Some markets in the country is not doing its job right.

Labor market is not clearing

Unemployment

Underemployment

The capital market is not allocating resources efficiently

301

*Shows theconventional cost-benefit analysis of atariff for a smallcountry.

a, b =are the net loss

a b

P If the tariff issmall enough,the area © mustalways exceedthe area a + b,

lead to level ofsocial welfare

S

D

Pw+t

Pw



S‟ S” D” D‟

of social welfare. s‟, s” = increasedproduction.

•Show the marginalbenefit fromproduction.

•Marginal socialbenefit curve.

c s‟ s”

Q Dollars

Q

higher than thatfree trade.

D

302

How convincing is the marketfailure argument? Who would want to argue that the real economies we

live in are free from market failures



live in are free from market failures.

In poorer nation

Market imperfection. Ex.

Unemployment

Massive differences between rural and urban wage rates.

Inability of innovative firms to reap the fall rewards of theirinnovations

303

How can we raise the nationalwelfare? (two things solution) The first argues that domestic market failures should

be corrected by domestic policies aimed directly at the



be corrected by domestic policies aimed directly at theproblem’s sources

The second argues that economists can not diagnose

market failure well enough to prescribe policy.

304



End the course

305

Purchasing Power Parity (PPP) To express the PPP, Pus be the dollar price of a

reference commodity basket sold in the United States



reference commodity basket sold in the United Statesand PE the euro price of the same basket in Europe.Then PPP predicts a E$/€ of E$/€ = Pus/PE

Ex. The reference commodity basket cost $200 inUnited States and €160 in Europe PPP predicts a E$/€

international economics for year 3

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