Unit 7: Absolute and Comparative Advantage

Absolute Advantage

Individual Absolute Advantage exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources).

National Absolute Advantage exists when a country can produce more a good/service than another country can in the same time period.

Comparative Advantage

A person or a nation has a comparative advantage when it can produce one good and give up less of the other product when comparing to another person or nation.

         Examples of output problems

1.      Words per minute.

2.      Miles per gallons.

3.      Tons per acre

4.      Apples per tree

5.      Televisions produced per hour

         Examples of input problems

1.      Number of hours to do a job.

2.      Number of acres to feed a horse

3.      Number of gallons of paint to paint a house.

 Specialization and trade

 Gains from trade are based on comparative advantage, not absolute advantage. The ratio of trade is established as 1 unit of product 1 : lowest opportunity cost of product 2 to higher opportunity cost of product 2. 

Unit 7: Foreign Exchange Market

Foreign Exchange Market

 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 Euros.

 Any transaction that occurs in the balance of payments necessitates foreign exchange.

 The exchange rate (e) is determined in the foreign currency markets.

 Changes in exchange rates

  Exchange rates (e) are a function of the supply and demand for currency.

  An increase in the supply of a currency will decrease the exchange rate of a currency.

  A decrease in supply of a currency will increase the exchange rate of a currency.

  An increase in demand for a currency will increase the exchange rate of a currency.

  A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and depreciation

       Appreciation of a currency occurs when the exchange rate of that currency increases.

       Depreciation of a currency occurs when the exchange rate of that currency decreases (e decreases)

Note: the more you supply, the value depreciates. The more you demand value appreciates.

Exchange rates determinants

• Consumer tastes (buyers taste)
• Relative income
• Relative price level
• Speculation

Exports and imports

The exchange rate is a determinant of both exports and imports.

Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper, thus reducing exports and increasing imports.

Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive, thus increasing exports and reducing imports.

As two currencies trade:

1.      One supply line will change; the other demand line will change.

2.      They will move in the same direction.

3.      One currency will appreciate, the other will depreciate.

Flexible rate

Based on the supply and demand of that currency versus the other currency. It is very sensitive to the business cycle and it provides options for investment.

Fixed rates

It is based on a countries willingness to distribute currency and to control the amount.

Unit 7: Balance of Payments

Balance of payments

BOP are measures of money inflows and outflows between the United States and the rest of the world (ROW).

Inflows are referred to as 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 book keeping

Every transaction in the balance of payments is recorded twice in accordance

Current account

 Balance of trade or Net exports

Exports of goods/services- import 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 the U.S. owned foreign assets

 Interest payments on U.S. owned foreign assets- Interest payments on German-owned U.S treasury bonds.

 Net transfers (tend to be Unilateral).

 Foreign aid- a debit to the current account.

 Example- Mexican migrant worker sends money to family.

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.

 Direct investment by United States firms/individuals in a foreign country are a debit to the capital account.

 Intel factory construction in Germany

·         Purchase of foreign financial assets represents a Debit to the capital account.

               (Warren buffets buys stock in Petrochina.)

·         Purchase of domestic financial assets by foreigners represents a credit to the capital account.

            (The UAE 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….if the current account has a negative balance (deficit) then the capital account should then have a positive balance (surplus).

 Official reserves

  The foreign currency holdings of the U.S. fed.

  When there is a balance of payments surplus the fed accumulates foreign currency and debits the balance of payments.

  When there is a balance of payments deficit, the fed depletes its reserves of foreign currency and credits the balance of payments.

Active v. 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 People's 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 w/ the United States.

Formulas

Balance of trade:     Good exports + goods imports

Balance on goods & services:        Goods exports + service exports + goods imports + service imports.

Current Account:         Balance on goods and services + net investment + net transfers

Capital account:       Foreign purchases + domestic purchases.

Unit 5: The Philips curve and Inflation

The Philips curve shows an inverse relationship between inflation and unemployment.

 The Long-Run Phillips Curve/LRPS

Measures unemployment and inflation.

NRU, or Natural rate of unemployment, is constant;

Because the Long-Run Phillips Curve exist at the natural rate of unemployment, structural changes in the economy that affect unemployment will also cause the LRPC to shift.

Increases in unemployment will shift LRPC to the right

Decreases in unemployment will shift LRPC to the left.

The Short-Run Phillips Curve

SRPC has a tradeoff between inflation and unemployment (when one increases the other decreases). (inverse relationship)

LRPC: There is no tradeoff between inflation and unemployment.

          1. The economy produces at the full employment output level.

          2.It is represented by a vertical line.

          3. It occurs at the natural rate of unemployment.

Natural unemployment rate (NRU)= Frictional +Structural +Seasonal

Full employment = 4-5%

LRAS shifters also shifts LRPC.

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

The misery index:  A combination of inflation and unemployment in any given year.

Single digit misery is good.

Inflation:

It is the general rise in the price level

Deflation:

A general decline in the price level

Disinflation:

Decrease in the rate of inflation over time

Stagflation:

Unemployment and inflation increasing at the same time.

Laffer Curve

The Laffer Curve demonstrates the relationship between tax rate and government revenue.

Tax rates only raise government revenue to some maximum, then above that maximum, they generate less revenue despite the tax rate being higher.

Unit 5: Analyzing Aggregate Supply

Short Run Aggregate Supply /SRAS

This is the period in which wages (and other input prices) remain fixed as price level increases or decreases.

Long Run Aggregate Supply /LRAS

Period of time in which wages have become fully responsive to changes in price level.

Effects over Short-Run

In the short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant.

In the long run, wages will adjust to the price level and previous output levels will adjust accordingly.

Equilibrium in the Extended Model

The long run AS Curve is represented with a vertical line at full employment level of real GDP.

Demand Pull Inflation

Demand pull- prices increases based on an increase in aggregate demand or AD.

In the short run, demand pull will drive up prices, and increase production.

In the long run, increases in aggregate demand will eventually return to previous levels.

Cost push & the Extended Model

Cost push inflation arises from factors that will increase per unit costs such as increases in the price of a key resource.

Dilemma for the Government

In an effort to fight cost-push, the government can react.

• Action such as spending by the government could begin an inflationary spiral.
• No action however could lead to a recession by keeping production and employment levels declining.