Worksheet #3: Trade
#1. In the equation Y = C + I + G + NX, are imports part of C, I, and G? Explain your answer and give some examples if possible.
There are two kinds of goods, domestically produced goods (Y) and imports (IMP). These can be sold to consumers, business, government, and foreigners. That means that imports are in each of C, I, G , and X. There are many examples: cosmetics (C) machines (I) police cars (G) and computers (X).
#2. Often we write NX as net exports, but actually this is the balance on current account. Explain the difference.
The balance on current account is really what we mean when we write NX. The balance on current account is more than just trade in goods. It includes tourism, trade in services, and also the international payment of interest, dividends, rents, and wages. The balance of trade in goods is just exports – imports.
#3. Suppose that NX rises by 100. What will be the short run and long run effect on equilibrium Y? Be general in your answer.
We know that Y = C + I + G + NX. When NX rises we know that Y rises immediately by the same amount. However, this rise in Y causes C to rise also. The rise in C forces an increase in Y again. This continues forever. We can illustrate this by an example. If NX rises by 100, then Y will rise by 100. This causes C to go up by say 80. The rise in C forces Y up by 80, and so on…
In the end we have the total change in Y is
100 + 80 + 64 + … = 100 + 80 {1+0.8+0.64+…} = 100 + 400
The 100 increase in Y is short run, while the 400 increase in Y is long run.
We saythat there is a multiplier that increases the initial 100 increase in NX to 400.
#4. A trade surplus is always better than a trade deficit. Do you agree or disagree? Explain your answer.
This is certainly not true. During the 1960’s Taiwan had a trade deficit, but its economic growth rate was above 8 % per year. The real important variable is the volume of trade. The volume of trade is X + IMP and when this doubles, the economic scale of the economy increases. This raises efficiency and productivity so that with the same labor and capital we can produce more. It is this that raises Y, not the trade surplus. It is also important to realize that Taiwan imported a lot of machinery and producer goods at this time and that also raised the productivity of labor.
#5. How is it possible for the NT$ to rise and yet have an expanding real Taiwanese trade deficit? Be sure to consider all possible answers here.
There are two ways for this to happen: (1) there is a large increase in capital inflow into Taiwan which raises the NT$. (2) the central bank buys a lot of NT$ and this raises the value of the NT$.
#6. What are the benefits of free trade? What are the costs? Are the costs always smaller than the benefits.
Consumers benefit from free trade since they get lower priced goods at better quality. Domestic producers can be hurt though…like the farmers. Actually, the benefit is greater than the cost. But, those that benefit must be taxed to help those that get hurt.
#7. Most people are interested in knowing what will happen to the exchange rate. How can you help them understand the future?
Actually, the foreign exchange market is like a beauty contest. If the country is very attractive to investors abroad, then hot money will flow into the country. The foreign exchange rate will fall and the domestic currency will appreciate. Investors will look for the highest rate of return on their investment and the lowest level of risk. They like low taxes, less regulation, clear laws, high liquidity, and a stable political environment.
#8. Why has monopolistic competition become important in international trade?
In international trade we have many countries that produce the same product…like cars. Germany, Japan, the US, France, England, etc all produce cars. Taiwan also produces cars. It imports cars too. But these cars are very different. Therefore we say there is monopolistic competition between car companies in foreign countries.
#9. Countries relatively rich in labor will export labor-intensive goods, while countries relatively rich in capital will export capital-intensive goods. Is this always true for all countries and all products? Explain.
This is a famous problem in international trade. It is not always true. For example, the US has a lot of capital, but it still exports many labor intensive goods. The labor however, has a lot of skill or human capital. It is called the H-O theory.
#10. A trade surplus always causes an increase in the money supply. Do you agree or not? Explain your answer.
This is not always true. It will be true when there are fixed exchange rates. If exchange rates are flexible, then a trade surplus will only lead to a fall in the domestic currency and a rise in the foreign exchange rate.