Absolute Advantage vs. Comparative Advantage

Absolute Advantage

• Individual- exists when a person can produce more of a certain good/service than someone else in the same amount of time
• National- exists when a country can produce more a good/service than another country can in the same time period

Comparative Advantage

• Individual/National- exists when a n individual or nation can produce a good/service at a lower opportunity cost than another individual or nation

Absolute Advantage = faster, more, more efficient

Comparative Advantage = lower opportunity cost

Foreign Exchange

• Foreign Exchange- the buying and selling of currency
• Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.
• The exchange rate (e) is determined in the foreign currencies markets
• Ex. The current exchange rate is approximately 77 Japanese Yen to 1 U.S. dollar
• The exchange rate is a price of a currency
• Do not try to calculate the exact exchange rate

Tips:

• Always change the D line on one currency graph, the S line on the other currency's graph
• Move the lines of the two currency's graphs in the same direction (right or left) and you will have the correct answer
• If D on one graph increases, S on the other will also increase
• If D moves to the left, S will move to the left on the other graph

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand currency
• An increase in the supply of a currency will make it cheaper to buy one unit of that currency
• A decrease in supply of a currency will make it more expensive  to buy one unit of that currency
• An increase in demand for currency will make it more expensive to buy one unit of that currency
• A decrease in demand for a currency will make it cheaper to buy one unit of that currency.

Appreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Hypothetical: 100 Yen used to buy one dollar. Now 200 Yen buy one U.S. dollar
• The dollar is stronger because one buys more Yen than it used to.

Depreciation

• Depreciation of a currency occurs when the exchange rate of that currency decreases
• 100 Yen used to buy one dollar. Now 50 yen buys one dollar.
• The dollar is weaker because it takes fewer Yen to buy one dollar.

Dollar Appreciation

• Each dollar gets you more of the other currency
• U.S. exports gets more expensive for foreigners
• U.S. imports gets cheaper for the U.S.
• Exports decrease
• Imports increase
• Money is leaving the U.S.
• Xn decreases
• GDP decreases
• Increase in demand for the dollar
• Decrease in supply of the dollar

Dollar Depreciation

• Each dollar gets you less of the other currency
• Less of the foreign currency is needed to buy each dollar
• Exports increase
• Imports decrease
• Money is entering the U.S.
• Xn increases
• GDP increases
• Demand for the dollar decreases
• Supply of the dollar increases

Supply of the Dollar

• Sources:
1. US citizens
2. Banks
3. Industries wanting to purchase our goods, investments, and assets

Making transferred payments to foreigners --> (Supply)

Foreigners are making transfer payments to us --> (Demand)

Purchasing Power Parity- when the currency rates are set by international markets; changes will be made based on the actual purchasing power of the currencies

Why do we exchange currencies?

1. To sell exports and buy imports
2. To invest in another country's stocks and bonds
3. Build stores or factories in another country
4. To speculate on currency values
5. To hold currencies in bank accounts for future exports, imports, and business loans
6. To control excessive imbalances

Unit 7-Balance of Payments and Trade

The Balance of Payments

• Measure of money inflows and outflows between the United Sates and the rest of the world.
• A system of accounting used for international trade
• Inflows are referred to a credits
• Outflows are referred to as debits

The Balance of Payment is divided into three accounts

1. Current Account
2. Capital/Financial Account
3. Official Reserves Account

Double-entry Bookkeeping

• Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice

Current Account

• Balance of Trade or Net Exports
• Exports of Goods/services - imports of Goods/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments
• Net foreign income
• Income earned by U.S. owned foreign assets- Income paid to foreign-held U.S. assets
• Ex. Interest payments on U.S. owned Brazilian bonds - Interest payments on German-owned U.S. treasury bonds
• Net Transfers (tend to be unilateral)
• Foreign aid --> a debit to the current account
• Ex. Mexican migrant workers send money to family in Mexico

Capital/Financial Account

• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account
• The Toyota Factory in San Antonio
• Direct investments by U.S. firms/individuals in a foreign country are debits to the capital account
• The Intel factory in San Jose, Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Warren Buffet buys stock in Petrochina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current and Capital Account

• The current account and the Capital Account should zero each other out.
• That is...the current account has a negative balance (deficit), then the capital account should then have a positive balance (surplus).
• Ex.The constant net inflow of foreign financial capital to the united States (capital account surplus) is what enables us to import more than we export (current account deficit).

Official Reserves

• The foreign currency holdings of the United States Federal reserve System
• When there is a balance of payment  surplus the FED accumulates foreign currency and debits the balance of payments
• When there is a balance of payment  deficit the FED accumulates foreign currency and credits the balance of payments

Active vs. Passive Official Reserves

• The U.S. is passive in its use of official reserves.  It does not seek to manipulate the dollar exchange rate.
• The peoples Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the U.S.

Balance of Trade 

• Goods and Services Exports - Goods and Services Imports
• Trade Deficit- when the balance of trade is negative (more imports then exports)
• Trade Surplus- when the balance of trade is positive (more exports then imports)

Current Account

• Balance on Trade + Net Investment + Net Transfer

Capital Account

• Foreign purchases of your country's assets + your country's purchases of assets abroad

Official Reserve

• Current Account + Capital Account

Balance on Goods and Services

• Goods Imports + service imports
• Goods exports + goods imports

Unit 6

Economic Growth

• Sustained increase in Real GDP over time
• Sustained increase in  Real GDP per Capita over time

Why Grow?

• Growth leads top greater prosperity for society
• Lessens the burden of scarcity
• Increases the general level of well-being

Conditions for growth

• Rule of Law
• Sound legal and economic institutions
• Economic Freedom
• Respect for Private Property
• Political and Economic Stability
• Low inflationary expectations
• Willingness to sacrifice current consumption
• Saving 
• Trade

Physical capital

• Tools, machinery, factories, infrastructure
• Physical capital is the product of investment
• Investment is sensitive to interest rates and expected rates of return
• It takes capital to make Capital
• Capital must be maintained

Technology and Productivity

• Research and development, innovation and invention yield increases in available technology
• More technology in the hands of workers increases productivity
• Productivity is output per worker
• More productivity = Economic Growth

Human Capital

• People are a country's most important resource.  Therefore human capital must be developed.
• Education
• Economic Freedom
• The right to acquire private property
• Incentives
• Clean water
• Stable food supply
• Access to technology

Hindrances of Growth

• Economic and Political Instability
• High inflationary expectations
• Absence of the Rule of Law
• Diminished Private Property rights
• Negative Incentives
• The welfare state
• Lack of savings
• Excess current consumption
• Failure to maintain existing capital
• Crowding out of investment
• Government deficits and debt increasing long-term interest rates
• Increased income inequality --> Populist policies
• Restrictions on Free International Trade

Laffer Curve

• It is a trade-off between tax rates and government revenue
• Used to support the supply side argument
• As tax rates increase from 0, tax revenues increase from 0 to some maximum level, then decline.

Criticisms of the Laffer Curve

• Research suggests that the impact of the tax rates on incentives to work, save and invest are small.
• Tax cuts also increase demand, which can fuel inflation, which will cause demand to exceed supply
• Where the economy is actually located on the curve is difficult to determine

Supply-Side Economics

Supply-side economists tend to believe that the AS curve will determine levels  of inflation, unemployment, and economic growth

To increase the economy you take actions to shift the AS curve to the right, always benefiting the company first.

They focus on marginal tax rates (the amount paid on the last dollar earned or on each additional dollar).

If they reduced the marginal tax rates you encourage more people to work longer in which they will forgo their leisure time for extra income.

Lower taxes are an incentive for businesses to invest in our economy.

Lower taxes are incentives for people to increase savings and therefore create lower interest rates for increases in business investment.

They believe only in AS, not AD

Reaganomics

• Lowered the marginal tax rate to get the U.S. out of a recession --> led to a deficit

Phillips Curve

Phillips Curve- it is the relationship between unemployment and inflation (only occurs in the short run)


LRPC (Long Run Phillips Curve)- it occurs at the natural rate of unemployment; it is represented by a vertical line and there is no trade-off between unemployment or inflation in the long run.

• The major LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits create lower natural rates.

SRPC- have relevance to Okun's Law

• Inverse relationship between unemployment rates and inflation rates

High Inflation=Low unemployment

Low Inflation=High unemployment

Aggregate supply shocks can cause the rate of inflation and the rate of unemployment to increase.

Supply shocks are rapid and significant increases in resource cost which causes the SRAS curve to shift.

Since wages are sticky, inflation changes (move the points on the SRPC)

If inflation persists and the expected rate of inflation rises, then the entire SRPC moves upward which creates a situation called Stagflation.

If inflation expectations drop due to new technology, then the SRPC will move downward.

Stagflation-high unemployment + high inflation at the same time
The Misery Index- it is a combination of inflation and unemployment in a given year. Single digit misery index is good.

The Long-Run Phillips Curve

• Because the long-run Phillips curve exists at the natural rate of unemployment, the structural changes in the economy that affect unemployment will also cause the LRPC to shift
• Increases in Unemployment will shift LRPC -->
• Decreases in unemployment will shift LRPC <--

Relating Phillips Curve to AS/AD

• Changes in the AS/AD model can also be seen in the Phillips curves
• An easy way to understand how changes in the AS/AD model affect the Phillips curve is to think of the two sets of graphs as mirror images.
• The two models are not equivalent. The AS/AD model is static, but the Phillips curve includes changes over time.  Whereas AS/AD shows one time changes in the price level as inflation or deflation; the Phillips curve illustrates continuous change in the price level as either increased inflation or disinflation.

Disinflation- reduction in the inflation rate from year to year, which is usually displayed in the long-run Phillips curve.

• Also occurs when aggregate demand declines
• In the short-run, profits fall and the unemployment rate increases
• Decrease in inflation rates

Deflation- it is an actual drop in the price level

*Cost-push inflation causes supply shocks*