2. In this chapter, you will
learn to solve these
economic puzzles:
How does Babe Ruth’s
Should the United
decision not to become a
Is there a valid argument
pitcherreturn to the
States illustrate an
for trade protectionism?
important principle in
gold standard?
international trade?
2
3. Why do countries trade?
International trade allows
a country to consume a
combination of goods
and services that exceeds
its production
possibilities curve
3
4. U.S. Trading Partners, 1998
7%
11%
2% Mexico
Canada
Western Europe
24% 21% Australia
Eastern Europe
Japan
Asia
Africa
Latin America
11%
1% 1% 22%
4
5. U.S. Production and Consumption
100 A
80 Grain (tons per year) B´ (with trade)
70 B (without trade)
60
40
PPC
20 U.S.
Steel (tons per day)
C
0 10 20 30 40 50
5
6. Japanese Production
Grain (tons per year)
100 and Consumption
80
60
40
D E (without trade)
30 E´ (with trade)
20 PPC
Japan
Steel (tons per day) F
0 10 20 30 40 50
6
7. Why should countries
Specialize and Trade?
Total world output
increases, and therefore,
the potential for greater
total world consumption
also increases
7
8. If countries should
Specialize, in what should
they Specialize?
They should produce those
goods and services in
which they have a
comparative advantage
8
9. What is
Comparative Advantage?
The ability of a country to
produce a good at a lower
opportunity cost than
another country
9
11. What is Free Trade?
The flow of goods between
countries without
restrictions or special taxes
11
12. What is Protectionism?
The government’s use of
embargoes, tariffs,
quotas, and other
restrictions to protect
domestic producers from
foreign competition
12
13. What is an Embargo?
A law that bars trade
with another country
13
15. What is a Quota?
A limit on the quantity
of a good that may be
imported in a given
time period
15
16. What are the Arguments
for Protectionism?
• Infant industry argument
• National security argument
• Employment argument
• Cheap foreign labor argument
• Free trade agreements
16
17. What is a Recent Free
Trade Agreement?
North America Free Trade
Agreement (NAFTA)
17
18. What is NAFTA?
A 1993 free trade
agreement between
the U.S., Canada,
and Mexico
18
19. What is the
Balance of Payments?
A bookkeeping record of all
the international transactions
between a country and other
countries during a given
period of time
19
20. What is the
Current Account?
The first section of the
balance of payments,
which includes trade in
currently produced
goods and services
20
21. What is the
Balance of Trade?
The most widely reported
and largest part of the
current account defined
as the value of a nation’s
merchandise imports
subtracted from its
merchandise exports
21
22. How is a Current
Account Deficit
Financed?
By a capital account surplus
22
23. What is the
Capital Account?
The second section of the
balance of payments,
which records payment
flows for financial capital
23
24. 50
U. S. Balance of Trade, 1977-1998
0
-50
(billions of dollars)
Balance of Trade
-100
-150
-200
-250 Year
77 79 81 83 85 87 89 91 93 95 97 99
24
25. What does the Balance of
Payments always equal?
Zero; the current account
deficit should equal the
capital account surplus
25
26. How could the US
have a Balance of
Payments Problem?
The problem is with the
composition of the
balance of payments
26
27. What is an
Exchange Rate?
The number of one
nation’s currency that
equals one unit of
another nation’s currency
27
28. If 1.81 Dollars is
exchangeable for 1
British Pound, what is
the Exchange Rate?
1 / 1.81 = .552
pounds per dollar
28
29. How is the Exchange
Rate determined?
Supply and demand for
foreign exchange
29
30. Supply and Demand for Dollars
200 S of $ (U.S. citizens)
Price (yen per dollar)
150
E
100
50 D for $ (Japanese citizens)
0 100 200 300 400 500
Quantity of dollars (millions per day)
30
31. 240 Changes in the Yen-per-
Dollar Rate, 1980-1998
220
200
180
Price (yen per
160
140
120
dollar
100
80
82 84 86 88 90 92 94 96 98
31
32. What happens when a
Currency Depreciates?
The price of the currency
falls in relation to
another currency
32
33. What happens when a
Currency Appreciates?
The price of the currency
rises in relation to
another currency
33
34. What can cause a
Currency to
change Value?
The demand and/or supply
of the currency can change
34
35. What can cause a change
in Demand of a Currency?
There can be a change in -
• tastes and preferences
• relative price levels
• relative interest rates
35
36. 250 Decrease in Demand
S
200 Price (yen per dollar E1
150
E2
100 D1
50 D2
Quantity of Dollars (millions per day
100 200 300 400 500
36
37. Decrease
U.S. Value of the
in the
exports dollar falls
demand
less (dollar
for
popular depreciates)
dollars
37
38. What can cause a change
in Supply of a Currency?
There can be a change in -
• relative incomes
• relative price levels
• relative interest rates
38
39. 250 Decrease in Supply
S2
200 Price (yen per dollar S1
E2
150
E2
100
D
50
Quantity of Dollars (millions per day)
100 200 300 400 500
39
40. Japanese Decrease Value of the
imports in the dollar rises
less supply of (dollar
popular dollars appreciates
)
40
41. What happens when
Demand and/or Supply
changes?
The currency seeks a
new equilibrium;
the value changes
41
42. Japanese
Increase the
buy more
demand for
U.S.
dollars
exports
Japanese Impact on relative Value of the
price price changes on dollar rises
level Exchange Rates (dollar
rises appreciates
U.S.
Decrease
citizens
in the
buy fewer
supply of
Japanese
dollars
imports
42
43. The Effects of Shift in Supply
on Market Equilibrium
300 S2
S1
Yen / Dollars
250 E2
200
150 E1 D2
100
50
Quantity of dollars
D1
100 200 300 400 500 600 700
43
45. Key Concepts
• Why do countries trade?
• Why should countries Specialize and Trade?
• If countries should Specialize, in what should the
• What is Comparative Advantage?
• What is Absolute Advantage?
• What is Free Trade?
• What is Protectionism?
45
46. Key Concepts cont.
• What is an Embargo?
• What is a Tariff?
• What is a Quota?
• What is NAFTA?
• What is the Balance of Payments?
• What is the Balance of Trade?
• What is an Exchange Rate?
• What can cause a Currency to change Value?
• What if Demand - Supply changes?
46
48. Comparative advantage is a
principle that allows nations to gain
from trade. Comparative advantage
means that each nation specializes
in a product for which its
opportunity cost is lower in terms of
the production of another product
and then nations trade.
48
49. When nations follow the
principle of comparative advantage,
they gain. The reason is that world
output increases and each nation
ends up with a higher standard of
living by consuming more goods and
services than possible without
specialization and trade.
49
50. U.S. Production and Consumption
100 A
80 Grain (tons per year) B´ (with trade)
70 B (without trade)
60
40
PPC
20 U.S.
Steel (tons per day)
C
0 10 20 30 40 50
50
51. Japanese Production
Grain (tons per year)
100 and Consumption
80
60
40
D E (without trade)
30 E´ (with trade)
20 PPC
Japan
Steel (tons per day) F
0 10 20 30 40 50
51
52. Free trade benefits a nation as a
whole, but individuals may lose jobs
and incomes from the competition
from foreign goods and services.
52
53. Protectionism is a government’s
use of embargoes, tariffs, quotas,
and other methods t impose barriers
intended to both reduce imports and
protect particular domestic
industries.
53
54. Embargoes prohibit the import of
export of particular goods. Tariffs
discourage imports by making them
more expensive. Quotas limit the
quantity of imports or exports of
certain goods. These trade barriers
often result primarily from domestic
groups that exert political pressure to
gain from these barriers.
54
55. The balance of payments is a
summary bookkeeping record of all
the international transactions a country
makes during a year. It is divided into
different accounts, including the
current account, the capital account
and the statistical discrepancy.
55
56. The current account summarizes
all transactions in currently produced
goods and services. The overall
balance of payments is always zero
after an adjustment for the statistical
discrepancy.
56
57. The balance of trade measures
only goods (not services) that a nation
exports and imports. A balance of
trade can be in deficit or in surplus.
The balance of trade is the most
widely reported and largest part of the
current account. Since 1975, the U.S.
has experienced balance of trade
deficits.
57
58. 50
U. S. Balance of Trade, 1977-1998
0
-50
(billions of dollars)
Balance of Trade
-100
-150
-200
-250 Year
77 79 81 83 85 87 89 91 93 95 97 99
58
59. An exchange rate is the price of
one nation’s currency in terms of
another nation’s currency. Foreigners
who wish to purchase U.S. goods,
services, and financial assets demand
dollars. The supply of dollars reflects
the desire of U.S. citizens to purchase
foreign goods, services and financial
assets. The intersection of the supply
and demand curves for dollars
determines the number of units of a
foreign currency per dollar.
59
60. Supply and Demand for Dollars
200 S of $ (U.S. citizens)
Price (yen per dollar)
150
E
100
50 D for $ (Japanese citizens)
0 100 200 300 400 500
Quantity of dollars (millions per day)
60
61. Shifts in supply and demand for
foreign exchange result from changes
in such factors as tastes, relative price
levels, relative real interest rates, and
relative income levels.
61
62. Depreciation of currency occurs
when one currency becomes worth
fewer units of another currency. If a
currency depreciates, it becomes
weaker. Depreciation of a nation’s
currency increases its exports and
decreases its imports.
62
63. Appreciation of currency occurs
when one currency becomes worth
more units of another currency. If a
currency appreciates, it becomes
stronger. Appreciation of a nation’s
currency decreases its exports and
increases its imports.
63
65. 1. With trade, the production possibilities for two
nations lie
a. outside their consumption possibilities.
b. inside their consumption possibilities.
c. at a point equal to the world production
possibilities curve.
d. none of the above.
B. When countries specialize and trade, total
world output increases and potential total
total world consumption also increases.
65
66. 2. Free trade theory suggests that when trade
takes place
a. both nations will be worse off.
b. one nation must gain at the other nation’s
expense.
c. both nations are better off.
d. one nation will gain and the other nation
will be neither better nor worse off.
C. Free trade allows a country to consume a
combination of goods that exceeds its
production possibilities curve.
66
67. 3. Which of the following is true when two
countries specialize according to their
comparative advantage?
a. It is possible to increase their total output of
all goods.
b. It is possible to increase their total output of
some goods only if both countries are
industrialized.
c. One country is likely to gain from trade
while the other loses.
d. None of the above.
A. Comparative advantage is the ability of a
country to produce a good at a lower
opportunity cost than another country.
67
68. 4. According to the theory of comparative
advantage, a country should produce and
a. import goods in which it has an absolute
advantage.
b. export goods in which it has an absolute
advantage.
c. import goods in which it has a comparative
advantage.
d. export goods in which it has a comparative
advantage.
D. Don’t confuse comparative advantage and
absolute advantage. Absolute advantage is
the ability of a country to produce a good
using fewer resources than another country.
68
69. Exhibit 11 Potatoes and Wheat Output
(tons per hour)
COUNTRY POTATOES WHEAT
U.S. 1 3
Ireland 1 2
69
70. 5. In Exhibit 11, which country has the
comparative advantage in the production of
potatoes?
a. The United States because it requires fewer
resources to produce potatoes.
b. The United States because it has the lower
opportunity cost of potatoes.
c. Ireland because it requires fewer resources
to produce potatoes.
d. Ireland because it has the lower opportunity
cost of potatoes.
D. To produce 1 ton of potatoes, the
opportunity cost for the U.S. is 3 tons of
wheat. To produce 1 ton of potatoes, the
opportunity cost for Ireland is 2 tons of wheat.
70
71. 6. In Exhibit 11, the opportunity cost of wheat is
a. 1/3 ton of potatoes in the United States and
1/2 ton of potatoes in Ireland.
b. 2 tons of potatoes in the United States and 1
1/2 tons of potatoes in Ireland.
c. 8 tons of potatoes in the United States and 4
tons of potatoes in Ireland.
d. 1/2 ton of potatoes in the United State and
2/3 ton of potatoes in Ireland.
A. U.S. 1 ton potatoes = 3 tons of wheat
1/3 ton of potatoes = 1 ton of wheat
Ireland 1 ton potatoes = 2 tons of wheat
1/2 ton potatoes = 1 ton of wheat
71
72. 7. In Exhibit 11, the opportunity cost of potatoes
is
a. 1/2 ton of wheat in the United States and 2/3
ton of wheat in Ireland.
b. 2 tons of wheat in the United States and 1
1/2 tons of wheat in Ireland.
c. 16 tons of wheat in the United States and 6
tons of wheat in Ireland.
d. 3 tons of wheat in the United States and 2
tons of wheat in Ireland.
D. U.S. 1 ton potatoes = 3 tons of wheat
Ireland 1 ton potatoes = 2 tons of wheat
72
73. 8. If the countries In Exhibit 11 follow the
principle of comparative advantage, the United
States should
a. buy all of its potatoes from Ireland.
b. buy all of its wheat from Ireland.
c. buy all of its potatoes and wheat from
Ireland.
d. produce both potatoes and wheat and not
trade with Ireland.
A. The U.S. should specialize in the
production of wheat when it has a
comparative advantage (see question 6 for
opportunity cost calculations).
73
74. 9. A tariff increases the
a. quantity of imports.
b. ability of foreign goods to compete with
domestic goods.
c. prices of imports to domestic buyers.
d. all of the above.
C. A tariff is a tax, also called customs
duties, on an import.
74
75. 10. The infant industry argument for
protectionism is based on which of the
following views?
a. foreign buyers will absorb all of the output
of domestic producers in a new industry.
b. the growth of an industry that is new to a
nation will be too rapid unless trade
restrictions are imposed.
c. firms in a newly developing domestic
industry will have difficulty growing if they
face strong competition from established
foreign firms.
d. It is based on none of the above.
C. It is difficult to make this argument because
there is an arbitrary line between an “infant”
and a “grown up” industry.
75
76. 11. The figure that results when merchandise
imports are subtracted from merchandise
exports is
a. the capital account balance.
b. the balance of trade.
c. the current account balance.
d. always less than zero.
B. The capital account records payments for
financial capital, such as stocks and bonds.
The current account includes trade in
currently produced goods and services.
76
77. 12. Which of the following international accounts
records payments for exports and imports of
goods, military transactions, foreign travel,
investment income, and foreign gifts?
a. The capital account.
b. The merchandise account.
c. The current account.
d. The official reserve account.
C. The capital account records payments for
financial capital, such as stocks and bonds.
The merchandise account is the value of a
nation’s merchandise imports subtracted
from its merchandise exports. There is no
official reserve account.
77
78. 13. Which of the following international accounts
records the purchase and sale of financial
assets and real estate between the United
States and other nations?
a. The balance of trade account.
b. The current account.
c. The capital account.
d. The balance of payments account.
C. The balance of trade is the value of a
nation’s merchandise imports subtracted
from its merchandise exports. The current
account includes trade in currently produced
goods and services. Balance of payments in a
bookkeeping record of all international
transactions in a given period of time.
78
79. 14. If a Japanese radio priced at 2,000 yen
can be purchased for $10, the exchange rate
is
a. 200 yen per dollar.
b. 20 yen per dollar.
c. 20 dollars per yen.
d. none of the above.
A. X yen / dollar = 2,000 yen / 10 dollars =
200 yen / dollar.
79
80. 15. The United States
a. was on a fixed exchange rate system prior to
late 1971, but now is on a flexible exchange
rate system.
b. has been on a fixed exchange rate system
since 1945.
c. has been on a flexible exchange rate system
since 1945.
d. was on a flexible exchange rate system prior
to late 1983, but now is on a fixed exchange
rate system.
A. For most years between World War II
and 1971, were based primarily on gold.
80
81. 16. Suppose the exchange rate changes so that
fewer Japanese yen are required to buy a
dollar. We would conclude that
a. the Japanese yen has depreciated in value.
b. U.S. citizens will buy fewer Japanese
imports.
c. Japanese will demand fewer U.S. exports.
d. none of the above.
B. When the dollar is weak or depreciates,
U.S. goods cost foreign consumers less and
they buy more U.S. exports.
81
82. 17. Which of the following would cause a
decrease in the demand for French francs by
those holding U.S. dollars?
a. Inflation in France, but not in the United
States.
b. Inflation in the United States, but not in
France.
c. An increase in the real rate of interest on
investments in France above the real rate of
interest on investments in the United States .
d. None of the above.
A. A rise in the French Franc relative price
level causes the dollar to appreciate and
demand for French Francs decreases.
82
83. 18. An increase in the equilibrium price of a
nation’s money could be caused by a (an)
a. decrease in the supply of the money.
b. decrease in the demand for money.
c. increase in the supply of the money.
d. increase in the demand for money.
A.
83
84. 250 Decrease in Supply
S2
200 Price (yen per dollar S1
E2
150
E2
100
D
50
Quantity of Dollars (millions per day)
100 200 300 400 500
84
85. 19. If the dollar appreciates (becomes stronger),
this causes
a. the relative price of U.S. goods to increase
for foreigners.
b. the relative price of foreign goods to
decrease for Americans.
c. U.S. exports to fall and U.S. imports to rise.
d. a balance of trade deficit for the U.S.
e. all of the above to occur
E.
85
86. 20. Which of the following would cause the U.S.
dollar to depreciate against the Japanese yen?
a. Greater popularity of U.S. exports in Japan.
b. A higher price level in Japan.
c. Higher real interest rates in the U.S.
d. Higher incomes in the U.S.
D. As a result of higher income, U.S. citizens
buy more domestic products and imports.
The supply curve for dollars shifts
rightward and the equilibrium exchange
rate decreases.
86
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87
