Unit 6 International Sector (Macro)

Unit 6 Overview & Video Lesson: Top 10 things you need to know about international trade, balance of payments, and foreign exchange. This video lecture is geared toward college-level principles of Macro and Micro courses and students enrolled in AP Economics & IB classes. Below the Top 10 video, you will find mini lessons, essential questions, graphs and models on specific topics from this unit. Take notes and pause when necessary.

Top 10 concepts in this video: 

#1. Current Account vs. Financial (Capital) Account

#2. Trade Deficit in Short Run

#3. Benefits of Trade

#4. Barriers to Trade

#5. Causes of Appreciation

#6. Causes of Depreciation

#7. Foreign Exchange Graph

#8. Foreign Exchange – Increased Interest Rates

#9. Foreign Exchange – Decrease in Aggregate Income

#10. Interest Rates Summarized

What is the difference between a current account transaction and a financial account transaction?

The balance of payments system keeps record of all foreign transactions. There are two main accounts in the balance of payments system, the current account and capital account.

The current account consists of imports, exports, and foreign transfer payments.

The financial account (or capital account) consists of real assets and financial assets. A real asset is property or a factory. A financial asset is a stock or bond.

When foreign money flows into our current account as a result of an export, our current account is credited. When our currency leaves the financial account after purchasing a foreign apartment complex, the financial account is debited. If one account shows a surplus, the other will show a deficit. In the end, the two accounts should balance.

What is a trade deficit?

A trade deficit occurs when a country's imports (M) are greater than its exports (X) in the short run. Net exports (Xn) are negative. Imports and exports are current account transactions. A trade deficit often contributes to a current account deficit (or capital account surplus). 

In the long run, a nation's imports (a leakage) will equal its exports (an injection).

How does a trade deficit affect a nation's economy in the short run? 

When a trade deficit increases in the short run, aggregate demand shifts to the left. The price level decreases, real GDP falls, and unemployment rises.

If a nation’s exports are greater than its imports, it has a trade surplus or current account surplus. When net exports increase, aggregate demand will increase.

In the long run, exports and imports will balance out.

What are some barriers to international trade?

In the long run, the gains from international trade are greater than the losses. In the short run, trade can hurt domestic producers and cause domestic unemployment, which can lead to the implementation of trade barriers by policy makers.

One type of trade barrier is a tariff; a protectionist tool that taxes imports. This raises the costs of foreign goods to keep domestic industries alive. However, higher prices hurt consumers.

Other tools of protectionist policy include import quotas (legal limits), complicated licensing procedures, and high quality standards.

A more unfortunate barrier to trade is a global military conflict that cuts off supply lines between trade partners; or perhaps, a war between two trading partners.

How can you determine whether a country benefits from a trade?

If you are deciding whether countries should specialize and trade, then you must use the law of comparative advantage (AKA the Ricardian Model). First establish which country will be exporting what good. To do this, simple look at which country that has the lower opportunity cost in producing the good. The country with the lower opportunity cost will specialize in that good and therefore export the good if the trade terms are beneficial.

To determine if trade terms are beneficial, do the following: 

Imports divided by Exports

If Imports / Exports are > than the opportunity cost of the country's export then it is a good trade for that country.

You must also plug in the imports and exports for the other country since it will be exporting the other good if it has a comparative advantage in the production of the other good.

How do exchange rates work?

An exchange rate is determined by supply and demand in the foreign exchange market. It is how much of one country’s currency it takes to buy one unit of another country’s currency.

For example, it might cost 0.73 euro to buy $1 US this month. If it costs 0.5 euro to buy $1 US next month, the euro has appreciated in value because it takes fewer euros to buy $1 US. This means that the dollar has depreciated against the euro.

With the exchange rates from the example above, $1.37 US will buy 1 euro this month. Next month, it costs $2 US to buy 1 euro. Again, the euro appreciated and the US dollar depreciated. Exchange rates and the value of a currency are all relative.

How do you graph a foreign exchange market?

To graph a foreign exchange market, you need two different currencies to compare. For example, the market for US dollars needs to show how much of a foreign currency is needed to buy 1 US dollar.

In the market for US dollars, the quantity of dollars goes on the x-axis. On the y-axis, you put the foreign currency price of the US dollar.

In the No Bull Review graph below, we see the market for US dollars and how many euros it takes to buy a US dollar. This graph is showing a rightward shift of demand for dollars. This causes the US dollar to appreciate relative to the euro (and the euro depreciates relative to the dollar). It now takes more euro to purchase 1 US dollar, and fewer US dollars to purchase 1 euro. 

The value of a currency will appreciate when its demand shifts to the right or its supply shifts to the left. 

The value of a currency will depreciate when its demand shifts to the left or its supply shifts to the right.

How do you show the effects of a decrease in a nation's aggregate income using the foreign exchange market?

Suppose one economy is in recession while another country’s economy is strong. The country in recession won’t be able to import as many goods since income is low. Therefore, it will supply less of its currency to the foreign exchange market. When this happens, the value of currency will appreciate.

What are the factors that will appreciate the value of a currency?

The international value of currency will appreciate (increase in value) due to the following factors:

1. Interest rates increase - Foreigners will demand more bonds when interest rates rise (because foreigners will make more money). There will be more demand for currency so the currency will appreciate.

2. Tastes and preferences for goods increase - If foreigners demand products produced over here, then there will be more demand for currency and the currency will appreciate.

3. Inflation decreases - If prices are relatively lower here than overseas, then foreigners will demand goods over hear. There will be more demand for currency so the currency will appreciate.

4. Incomes decrease - If this economy is weaker than foreign economies, this economy cannot afford to buy as many foreign goods. This economy will supply fewer units of currency to the foreign exchange market so the currency will appreciate.

What are the factors that will depreciate the value of a currency?

The international value of currency will depreciate (decrease in value relative to another currency) due to the following factors:

1. Interest rates decrease - Foreigners will demand fewer bonds when interest rates fall (because foreigners will make less money off our interest-bearing assets).

2. Tastes and preferences for goods decrease - If foreigners demand fewer products produced over here, then the currency will depreciate.

3. Inflation increases - If prices are relatively higher over here than overseas, then foreigners will not want our goods and we will want cheaper goods overseas.

4. Incomes increase - If this economy is strong and foreign economies are weak, foreign economies cannot afford our goods. However, we can afford to purchase foreign goods.

How do interest rates affect the value of currency?

Interest rates are an important determinant to the international value of a country's currency and net exports.

When interest rates increase, foreigners demand more interest-bearing bonds and more currency to purchase the bonds. This appreciates the value of the currency, which makes the country's goods look more expensive to foreigners. Exports will decrease and imports will increase.

When interest rates decrease, foreigners demand fewer interest-bearing bonds and less currency to purchase the bonds. This depreciates the value of the currency, which makes the country's goods look cheaper to foreigners*. Exports will increase and imports will decrease.

*This also makes imported economic resources to appear more expensive, which raises the costs of production in certain industries. Depending on the scale, this can be detrimental to the short-run aggregate supply curve.