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Principles of Economics M. Yusof Saari

International Trade and Openness. Principles of Economics M. Yusof Saari. Malaysian trade in figures…. Malaysian trade in figures…. Gains from trade. International trade International trade refers to exchange of goods and services between the people of two countries of the world.

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Principles of Economics M. Yusof Saari

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  1. International Trade and Openness Principles of Economics M. Yusof Saari

  2. Malaysian trade in figures…

  3. Malaysian trade in figures…

  4. Gains from trade International trade International trade refers to exchangeof goods and services between the people of two countries of the world. Internal trade Internal trade refers to exchange of goods and services within the political boundaries of a country.

  5. Natural Resources Monetary Units Immobility of Factors of Production DIFFERENCES BETWEEN INTERNATIONAL TRADE AND DOMESTIC TRADE National Policies Size of Market and Total Transaction Documentation Protectionism

  6. Interdependencies • Consider your typical day: • You wake up to an alarm clock made in Korea. • You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. • You put on some clothes made of cotton grown in China and produces in factories in Thailand. • You watch the morning news broadcast from BBC on your TV made in Japan. • You drive to class in a car made of parts manufactured in a half-dozen different countries.

  7. Interdependencies • . . . and you haven’t been up for more than two hours yet!

  8. Interdependencies • How do we satisfy our wants and needs in a global economy? • We can be economically self-sufficient. • We can specialize and tradewith others, leading to economic interdependence.

  9. Interdependencies • Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. • But this gives rise to two questions: • Why is interdependence the norm? • What determines production and trade?

  10. Interdependencies • Why is interdependence the norm? • Interdependence occurs because people are better off when they specialize and trade with others. • What determines the pattern of production and trade? • Patterns of production and trade are based upon differences in opportunity costs.

  11. Interdependencies • Imagine . . . • only two goods: cotton and rice • only two countries: Malaysia and China • What should each produce? • Why should they trade?

  12. Absolute advantage DEFINITION The ability of a country to produce more efficiently than another country. Assumptions: There are only two countries in the world. Only two goods are produced. Free trade exists between these two countries. No transportation costs are involved. Identical production functions between trading countries.

  13. Absolute advantage Malaysia and China are producing cotton and rice. Production before specialization SPECIALIZATION WILL TAKE PLACE China has an absolute advantage in producing cotton. Malaysia has an absolute advantage in producing rice.

  14. Absolute advantage Malaysia and China will produce rice and cotton respectively. Production after specialization INTERNATIONAL TRADE TAKE PLACE Total world output has increased with specialization.

  15. Absolute advantage Assume that there is an arrangement to trade 1 tonne of cotton for 1 tonne of rice. Production after international trade takes place WHAT HAPPENS IF A COUNTRY HAS AN ABSOLUTE ADVANTAGE OVER BOTH GOODS? SOLUTION : COMPARATIVE ADVANTAGE Both countries are better off with more goods as a result of international trade. Figures in parentheses are before trade

  16. Comparative advantage DEFINITION The ability of a country to produce goods at a lower opportunity cost than another country. Production before specialization NEED TO CALCULATE THE OPPORTUNITY COST SPECIALIZATION WILL NOT TAKE PLACE Malaysia has an absolute advantage in producing cotton. Malaysia has an absolute advantage in producing rice.

  17. Comparative advantage Opportunity cost is defined as desired goods that one has to forgo to obtain other goods. OPPORTUNITY COST SPECIALIZATION WILL TAKE PLACE China has lower opportunity cost in the production of rice. Malaysia has lower opportunity cost in the production of cotton.

  18. Comparative advantage Malaysia and China will produce cotton and rice respectively. Production after specialization INTERNATIONAL TRADE TAKE PLACE

  19. Comparative advantage Terms of trade Refers to the rate at which goods are exchanged. Malaysia agrees to trade 40 tones of cotton in exchange to 10 tonnes of rice. Production after international trade takes place Term of trade: 1 Rice = 4 Cotton

  20. Prices for international trade • International transactions are influenced by international prices. • The two most important international prices are the nominal exchange rate and the real exchange rate.

  21. Nominal exchange rate • The rate at which a person can trade the currency of one country for the currency of another.

  22. Nominal exchange rate • The nominal exchange rate is expressed in two ways: • In units of foreign currency per one MYR. • In units of MYR per one unit of the foreign currency.

  23. Nominal exchange rate • Assume the exchange rate between the Japanese yen and MYR is 25 yen to one MYR. • One MYR trades for 25 yen. • One yen trades for 1/25 (= 0.04) of a MYR.

  24. Nominal exchange rate • Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy. • Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy. • If local currency is appreciated, then foreign currency is depreciated and vice versa

  25. Nominal exchange rate • If a MYR buys more foreign currency, there is an appreciation of the MYR. • If it buys less there is a depreciation of the MYR. • For example Malaysia: • On Dec 20, 2011: 1 MYR = 0.21 Euro • (1 Euro = 4.76 MYR) • On Dec 21, 2011 : 1 MYR = 0.24 Euro • (1 Euro = 4.16 MYR) • So, MYR is appreciated or depreciated?

  26. Real exchange rate • Therate at which a person can trade the goods and services of one country for the goods and services of another.

  27. Real exchange rate • The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. • If a case of Malaysian rice is twice as expensive as Indonesian rice, the real exchange rate is 1/2 case of Malaysian rice per case of Indonesian rice.

  28. Real exchange rate • The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

  29. Real exchange rate • Hypothetical example: • 1 kg Malaysian rice = MYR 10; 1 kg Japanese rice = 160 yen • Nominal exchange rate: 1 MYR = 8 yen • Then 1 kg Malaysian rice = 80 yen • Therefore the real exchange rate is • 1 kg Malaysian rice = ½ kg Japanese rice • = (8 yen/MYR) x (1 MYR/kg Malaysian rice) • 160 yen/kg Japanese yen • = (80 yen of Malaysian rice) / (160 yen of Japanese yen)

  30. Real exchange rate • In practice: • Price index has been used e.g. CPI • Real exchange rate = (e x P)/P* • e = nominal exchange rate • P = CPI for Malaysia • P* = CPI for foreign

  31. Real exchange rate • The real exchange rate is a key determinant of how much a country exports and imports.

  32. Real exchange rate • A depreciation (fall) in the Malaysian real exchange rate means that Malaysian goods have become cheaper relative to foreign goods. • This encourages consumers both at home and abroad to buy more Malaysian goods and fewer goods from other countries.

  33. Real exchange rate • As a result, Malaysian exports rise, and Malaysian imports fall, and both of these changes raise Malaysian net exports. • Conversely, an appreciation in the Malaysian real exchange rate means that Malaysiangoods have become more expensive compared to foreign goods, so Malaysian net exports fall.

  34. Exchange rate determination: Purchasing power parity (PPP) • The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

  35. Exchange rate determination: Purchasing power parity (PPP) • Purchasing-power parity is a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

  36. Exchange rate determination: Purchasing power parity (PPP) • According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

  37. Exchange rate determination: Purchasing power parity (PPP) • The theory of purchasing-power parity is based on a principle called the law of one price. • According to the law of one price, a good must sell for the same price in all locations.

  38. Exchange rate determination: Purchasing power parity (PPP) • If the law of one price were not true, unexploited profit opportunities would exist. • The process of taking advantage of differences in prices in different markets is called arbitrage. • For example: • Coffee beans in Seattle less expensive than in Boston • So, buy coffee in Seattle $4 and sell $5 in Boston • Make a profit of $1

  39. Exchange rate determination: Purchasing power parity (PPP) • If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. • According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

  40. Exchange rate determination: Purchasing power parity (PPP) • Illustration: • If a dollar could buy more coffee in the US than in Japan • Then international traders could profit by buying coffee in the US and selling it in Japan • Exports coffee from the US to Japan would drive-up US price and drive-down Japanese price • At the end, the law of one price implies a dollar must buy the same amount of coffee in all countries

  41. Exchange rate determination: Purchasing power parity (PPP) • Price of Big Mac across countries • (price in US = $3.57)

  42. Commercial breaks: illegal is everywhere

  43. Implication of PPP • If the purchasing power of the MYR is always the same at home and abroad, then the exchange rate cannot change. • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. • When the relative prices between two countries are equal then, there will be equal inflation rate different

  44. Implication of PPP • When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

  45. Limitation of PPP • Many goods are not easily traded or shipped from one country to another. • Tradable goods are not always perfect substitutes when they are produced in different countries.

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