International Trade and Finance

Open Economy: International Trade and Finance

A. Balance of payments accounts

1. Balance of trade

2. Current account

3. Capital account

B. Foreign exchange market

1. Demand for and supply of foreign exchange

2. Exchange rate determination

3. Currency appreciation and depreciation

C. Net exports and capital flows

D. Links to financial and goods markets

Macro Unit 5 Summary- International Trade and Foreign Exchange
The Big Ideas of Trade

International Trade

•Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this)

•Trade barriers create more economic loss than benefits.

•Today there is a trend towards free trade and a reduction in trade barriers.

•Strongest arguments for protection are the infant industry and military self-sufficiency arguments.

•WTO oversees trade agreements and disputes, but has become a target of protesters lately.

Comparative Advantage

•A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost.


Cheese Wine

Spain: 2 pounds 2 Cases

France 2 pounds 6 Cases

Spain should produce cheese (1C = 1W)

France should produce wine (1W = 1/3C)

Office Hours: Absolute vs. Comparative Advantage
Comparative Advantage

Exchange Rates and International Markets

The value of a foreign nation’s currency in relation to your own currency is called the exchange rate.

•An increase in the value of a currency is called appreciation.

•A decrease in the value of a currency is called depreciation.

Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions

Foreign Exchange Market

•Let’s say a U.S. citizen travels to Australia. This transaction will provide a supply of the U.S. dollar and result in a demand for Australian dollar. It will become cheaper for the Australia to buy the dollar and more expensive for Americans to buy the Australian dollar. The Australian dollar is Appreciating and the dollar is Depreciating.

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Types of Exchange Rate Systems

Fixed Exchange-Rate Systems

A currency system in which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system

Flexible Exchange-Rate Systems

•Flexible exchange-rate systems allow the exchange rate to be determined by supply and demand.

Squanderville v Thriftville

Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nations

Current Account: Shows U.S. exports and U.S. imports of goods and services.

Capital Account: Shows the U.S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U.S.

Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets)

Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.

•The Current Account and Capital Account must be equal.

•Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts.

•If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.

Macro 5.1- Balance of Payments
Specialization and Trade: Crash Course Economics #2