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chap 16 - Chapter 16 Trade and Foreign Exchange Rate...

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11/8/2010 1 Chapter 16 Trade and Foreign Exchange Rate Determination Learning objectives ` 1. Explain how specialization according to comparative advantage and trade can lead to gains for each of two countries involved in trade, although not everyone necessarily gains gains. ` 2. Understand how exports, imports, capital inflows, and capital outflows enter into an economy’s balance of payments. ` 3. Explain the link between exchange rate changes and the quantity of dollars demanded and supplied in the foreign exchange markets. ` 4. Show how exchange rates are determined by the interaction of supply and demand in the foreign exchange markets . ` 5. Explain the potential role speculation plays in exchange rate movements
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11/8/2010 2 Why do countries trade? ` Countries trade because sometimes it is cheaper to buy goods from other countries than it is to produce them domestically ` Example: U S Mexico U.S. Tomatoes per day 1/2 ton 1/4 ton Wheat per day 1/3 ton 1/8 ton Costs and comparative advantage ` U.S. can produce ½ of a ton of tomatoes or 1/3 of a ton of wheat 1 f 2/3 f f h ` 1 ton of tomatoes costs 2/3 of a ton of wheat ` 1 ton of wheat costs 3/2 tons of tomatoes ` Mexico can produce ¼ of a ton of tomatoes or 1/8 of a ton of wheat ` 1 ton of tomatoes costs 1/2 of a ton of wheat ` 1 ton of wheat costs 2 tons of tomatoes ` U.S. has comparative advantage in wheat, and Mexico has comparative advantage in tomatoes
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11/8/2010 3 Mutually beneficial trade ` Mexico will buy wheat from U.S. for anything less than 2 tons of tomatoes less than 2 tons of tomatoes ` U.S. will sell wheat to Mexico for anything more than 1 ½ tons of tomatoes ` T d ill b fit b th t i if th i Trade will benefit both countries if the price of one ton of wheat is somewhere between tons of tomatoes and 2 tons of tomatoes Terms of trade ` 1 ½ tons of tomatoes < price of 1 ton of wheat < 2 tons of tomatoes ` Terms of trade express the price of one country’s goods in terms of how much of a second country’s goods must be given up ` The terms of trade are also referred to as the real exchange rate ` Real exchange rate (e) = the relative price of a country’s goods in terms of a second country’s goods
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11/8/2010 4 Terms of trade, continued ` Mexico will sell tomatoes to U.S. if the price of 1 ton of tomatoes is at least ½ a ton of wheat ` U.S. will buy tomatoes from Mexico if the price of 1 ton of tomatoes is anything below 2/3 of a ton of wheat ` Terms of trade are between ½ and 2/3 of a ton of wheat Mutually beneficial exchange ` Specialization and trade can make both countries better off
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11/8/2010 5 Arguments against free trade ` 1)Fear that international competition will destroy jobs. ` BUT if we produce goods for which we have comparative advantage, new jobs can be created Arguments against free trade, continued ` 2)National security ` BUT what is really a "necessity”?
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