Foldvary, Econ 11

Mankiw, Chapter 9, International Trade.

Note: some of the text was not covered during class and will not be on the exams.

In Chapter 3, we covered the theory of exchange, comparative advantage, and the gains from trade.

Chapter 9 continues this theme, applying supply and demand to international trade.

See also some definitions

The effect of international trade on the economy

A trade barrier is an intervention that restricts trade, including by imposing costs.

"Protectionism" means trade limitation, the doctrine of having trade barriers.

The three basic types of trade barriers: tariffs, quotas, arbitrary regulation (rules for which costs exceed benefits).

Free trade is the exchange of goods without any trade barriers.

Example in the textbook: steel. Steel is manufactured in many countries.

Without trade, there is supply, demand, and the social surplus.

If the world price is lower, the domestic economy would be better off importing steel.

If the world price is higher, then the economy should export steel.

With free trade, in equilibrium, the domestic price equals the world price.

If the domestic price was lower than the world price, trade raises the domestic price.

Consumers have to pay more for products made of steel, like cars and knives.

Is society better off with free trade?

The gain in the producer surplus is greater than the loss of consumer surplus.

Total economic well-being rises.

But the producers as such, i.e. the owners of just the enterprise, do not get the gain.

The gain goes to landowners.

If the corporation owns the land, the shareholders gain the rent as dividends and capital gains,

unless the top executives and board of directors loot the company, taking higher than market-based income, at the expense of shareholders.

Non-landowners do not gain unless the rent is shared by everyone.

What if the world price before trade is lower than the domestic price.

That is how it is in the US with sugar.

The supply curve is infinitely elastic at the world price.

Consumers get a higher consumer surplus.

Producers, and thus landowners, get a lower producer surplus.

Again, the social surplus increases, the gain being greater than the loss.

In this case, the gain in consumer surplus is at the expense of rent.

Both importing and exporting increase the social surplus.

With free trade, an economy imports and exports and raises the social surplus and well being.

Temporarily, during the transition, workers can lose their jobs and firms lose profits and assets.

So, often, policy does not go to the long-run advantage because those such as labor unions who have transition losses have the political clout to prevent the better policy from being enacted.

Many free-trade agreements, such as NAFTA, have exceptions such as for agriculture.

If rent were fully taxed, there would be less political opposition, because the landowners would not lose any land value.

There is also a transition cost in switching from one industry to another.

Even if the costs of transition were compensated for, the economy would be better off.

But compensation is usually politically difficult because the losers are still better off with the trade barrier.

Tariffs. (Note spelling).

A tariff or import duty is a trade barrier consisting of a sales tax on imported goods.

Tariffs raise the price of the good, like any sales tax, reducing the quantity demanded and thus reducing the amount imported and making domestic production more profitable.

Sellers and their landowners are better off, consumers worse off.

The government gains revenue, but that is neutral for the economy, since it removes resources from the taxpayers.

There is a deadweight loss or excess burden as with the sales tax.

An import quota is a limit on the quantity of an import.

Quotas enable domestic producers to raise their prices.

An example is import licenses.

Whoever owns a licence gets the created surplus, which acts like land rent.

If the government charges a fee for the license, then in effect it is a tariff.

The deadweight loss is even greater when resources are spent to get the license or tariff.

There are also non-tariff barriers such as regulations,

such as requiring products to meet certain standards,

which often don't have anything to do with consumer protection.

Other benefits of free trade:

More variety of goods.

Greater productivity from economies of scale.

Increased competition and therefore less monopoly power and lower prices.

The spread of technology.

Trade barriers bring retaliation - other countries put up barriers.

In a trade war, all economies suffer.

The Smoot-Hawley tariff of 1930 raised tariffs 60%.

Other countries retaliated. International trade dropped by more than half.

Made the Great Depression worse than it would have been.

The ultimate quota is zero - an embargo or prohibition on the import and export of goods. For example, the United States has had an embargo on trade with Cuba.

Arguments in favor of trade barriers.

1) National security and the environment.

We don't want to export nuclear bombs or import dangerous species.

But this is often an excuse for trade limits.

2) Infant industries.

Those advocating trade barriers argue that these encourage economic development in the long run by protecting "infant industries" until they can mature and obtain more experience and a lower cost. But another way to protect such industries is with subsidies, which leave fewer distortions in the relative price structure and make the cost more explicit.

There is no guarantee that the protected industry will become more efficient; just the opposite can occur, as the firms rely on artificially high prices to remain inefficient.

Also, trade limitation subjects the process to political influences.

It is also not clear why the initial time when the industry is getting started should not be paid for by the investors rather than the taxpayers.

The infant-industry argument is therefore weak at best and subject to the problem of the lack of knowledge as to whether it will succeed and to manipulation by special interests.

Once an industry is given a privileged position, it becomes a special interest that will seek to preserve its privilege.

Many trade limitations, involving both subsidies and quotas, do not involve infant industries at all, but are an attempt to preserve the economic condition of an industry such as agriculture which cannot be sustained at current market prices.

Note: the lecture went to this point. The rest will not be on exams.

International Agreements

To counter trade barriers, prevent trade wars, and promote international trade, especially in manufactured goods, the General Agreement on Tariffs and Trade (GATT) was signed in 1947.

Since GATT was founded, significant reductions in tariffs have been achieved by the member states. GATT rules are enforced by the World Trade Organization, WTO.

Many developing countries which maintained protectionist policies are now liberalizing their trading policies.

Regional trading blocks such as the European Community and the North American Free Trade Agreement (NAFTA) are reducing trade barriers in continental regions.

A major problem with international trade is the unequal environmental policy among countries.

Some of those protesting at WTO meetings say that the environment is not being protected.

The problem in free trade is then to equalize such pollution charges, otherwise some countries will have an unjust advantage.

Foreign money and trade.

Expanding money makes the trade deficit worse.

Contracting money reduces trade deficits but cause recessions.

Expanding government spending increases income and consumption in the short run but also increases the trade deficit.

Increasing taxes reduces the trade deficit but reduces investment.

Decreasing government spending and at the same time decreasing borrowing and taxation decreases the trade deficit and decreases government debt, which benefits the economy unless the spending is vital.

Another long-term policy: reduce restrictions on enterprise, reducing the costs of business without reducing spending or increasing taxes.

And shift taxes from production to the use of natural resources, which increases both income and exports by making production less expensive. Fiscal policy would consist of collecting revenue without trying to manipulate the economy.

A change to commodity-based money would stabilize it and leave the price level to the market, with no need for monetary policy.

These changes won't take place until the public is educated about these options. Many economists aren't aware of options such as free banking.

Competitiveness is the ability of a country to produce goods at a lower cost than other countries.

Competitiveness depends on productivity, which is a function of technology and costs. Taxes on enterprise reduce productivity. Better training and technology increases productivity.

The price of foreign currency can affect competitiveness.

If $1 buys fewer Japanese Yen, US exports become cheaper.

But US assets also cheaper, and US export profits are lower.

Imported capital goods become more expensive.

Currency values reflect many variables, so high or low exchange rates can affect exports.

We can increase competitiveness by decreasing the cost of US goods.

How? One way, reducing taxes and regulations.

Chapter discusses Germany and Japan as successful economies.

One reason: educational systems, including vocational training.

Second: low-cost government, though Germany has become less so.

Third, fewer strikes and labor problems. Fewer legal costs.

So high-quality labor and capital, lower costs of government.

Germany had natural resources: coal, iron.

Japan grew in later 1800s with land reform and high land taxes.

But trade barriers make imports expensive, and land is expensive,

so the Japanese standard of living is only 2/3 that of US.

US products costly because of artificial costs: taxes, restrictions,

forms, litigation, medical.

International Dimensions of Monetary & Fiscal Policies.

Foreign trade different due to different currencies.

Not always so: gold was an international currency.

Today: fiat money with floating exchange rates.

Exchange rate: the ratio of the units of account of two currencies.

Or: the price of one currency in terms of another currency.

e.g. British pound = $1.50. German mark = 60c.

China Renminbi = 11c. Japanese Yen = .9c.

In the very long run, exchange rates are determined by their purchasing power in internationally traded goods.

So the long-run exchange rates change with relative inflation.

In medium run, rates vary with interest rates and national income.

In short run, rates vary with expectations and speculation.

Fixed exchange rates: set either by government fiat or by being tied to a commodity or some other currency. Some are tied to the dollar.

Government pledges to buy and sell currency at a fixed rate.

Exchange rates were fixed during the 1800s until WWI.

Gold was the universal money. World was on a gold coin standard.

A dollar was defined as a certain number of ounces of gold.

Coinage Act of 1792 defined a dollar as 371.25 grains of silver and 24.75 grains of gold.

1879, changed to 23.22 grains of gold, $20.67 an ounce.

Raised to $35 an ounce in 1930s for foreigners.

In Great Britain, the coin called the sovereign was defined as having 123.27 grains of gold = 20 shillings.

Gold and silver coins circulated.

Money wasn't covertible into gold, money WAS gold. And silver.

Paper money - money substitutes - were convertible into gold.

Most money was money substitutes.

The amount of gold did not limit trade since paper and checking accounts could expand the purchasing media.

If exports were greater than imports, a country imported gold.

When gold entered the country, the money supply increased.

With more money, prices rose. Interest rates fell temporarily.

When prices rose, exports fell until they equalled imports.

The gold specie flow mechanism.

Gold flows and price level changes adjust to balance trade.

Depressions were not caused by the gold standard.

But once a depression set in, the balance of payments adjustment could make it more severe, because when gold left a country, the money supply shrank, and it took time for the price level to fall; meanwhile there could be a shortage of money. This could have been avoided with free banking.

There was a free market in gold but not in money substitutes, or bank notes, which were nationalized after the Civil War, War Between the States.

Countries went off the gold stanard during major wars: Civil War,

World War I. Then went back on at pre-war rates, which were no longer realistic, because there had been inflation during the War.

Why? Government leaders did not want to raise taxes too much, to keep up the support for the war. So they went off gold to create money.

In early 1930s, the Federal Reserve allowed the money supply to decrease. This made the depression worse than it needed to be.

In 1933, US government made it illegal to own gold or gold coins, other than jewelry or tooth fillings or for industrial use.

Foreign governments could exchange dollars for gold at $35/oz.

Dollar bills were backed by silver until the 1960s.

After World War II, the Bretton Woods agreement established a fixed exchange system for currencies.

US was a reserve currency - other countries held dollars to back up their currency exchanges.

But because of inflation in the US, $35 per oz became way too cheap.

A lot of gold was leaving the US, especially to France.

1971, US stopped paying gold for dollars.

The world started a new era of fiat money.

Most industrialized countries have a managed float system.

Flexible or floating exchange rates: set by the market.

Partially flexible rates, or managed float, or dirty float:

Set by market but government intervenes to influence the rate.

Managed float can be costly and ineffective.

Problems: knowledge, lags, politics, loss of money.

Intervention increases speculation as speculators try to outguess what government will do.

Most less developed countries have fixed fiat rates.

Some countries such as Hong Kong and Estonia have rates fixed to some other currency.

Some countries have nonconvertible currencies. Cannot be freely exchanged. Can be converted at fixed rates, often different from what free market rate would be. Then an underground illegal market.

E.g. East German, 1 DDR for 1 WG, but black market, 10 DDRs.

Note was no good outside of East Germany.

These countries have capital controls - controls on exchange rates and quantity of money coming in and out.

And limitations on imports and exports.

Often, you can't take dollars out unless you brought them in.

Some countries have high inflation, but want to keep their currency valuable so it can buy imports cheaper or export more expensibly, such as by forcing tourists to spend more dollars and other hard currencies.

These countries often have illegal markets for goods and currencies.

US has controls too but no restrictions.

Over $10K cash must be reported.

Foreign bank accounts must be reported.

Sometimes you have to give a reason if you carry a lot of cash.

Cash is legally subject to confiscation if the police suspect illegal activity.