ECON 205 2nd Edition Lecture 16 Outline of Last Lecture I Student Lecture Healthcare Spending Publications and GIC G by Jessica Greenhalgh II Paper Publishing III Introduction to International Trade IV Domestic Accounting and Currency Exchange V The European Monetary Union Outline of Current Lecture I International Trade and GDP modeling II Comparative and Absolute Advantage III The Federal Reserve Tactics Review IV Currency manipulation Trade Balance Current Lecture I International Trade and GDP modeling The value of the international trade is larger than the combined GDP of all nations The conventional macroeconomic model states that investment is very important for a country s growth and investment is domestic savings GDP in basic form is equivalent to aggregate consumption added to aggregate savings The savings goes into investment making GDP equal to consumption plus investment Investment used to be a function of domestic savings but now is a function of both domestic savings and international finance In the absence of international conflict investment will seek the highest yield anywhere in the world regardless of nationality In the United States for instance during these past few decades we have been boring money from abroad Much investment is now international and our savings rate therefore has decreased Over the past century our savings rate average has been 7 but in the past few years savings rate has gone to 2 or below II Comparative and Absolute Advantage Comparative advantage is when it is possible for country A and country B to trade Ricardo comparative advantage when country A can specialize in one good while country B can specialize in the other Conversely absolute advantage is when country A can produce a good for cheaper than country B Adam Smith created modern economics while David Ricardo was the first to describe comparative advantage The theory of international trade states that all countries can benefit from international trade It is therefore not a zero sum game III The Federal Reserve Tactics Review The Federal Reserve Board manipulates the economy by changing the reserve requirement By rising requirements they combat inflation and contract the monetary supply Conversely by lowering requirements they are combating recession and expand the monetary supply The Fed on a constant basis implements open market operations By selling government bonds they can trade billions of dollars on the open market When they sell bonds they take money from people and contract the monetary supply When they buy bonds they give money and fight a recession The third tool of the Fed is by changing the interest rates The Federal Fund Rate is the rate banks charge each other for borrowing money from each other to meet reserve requirements The second rate is the discount rate the rate that the Fed Reserve Bank charges commercial banks for borrowing from the Fed IV Currency manipulation The value of currency is determined by appreciation when the currency s value increases and depreciation when it decreases Both are decided by market forces in the exchange rate market based on the demand and supply of currencies Countries that do not allow their currency to float can announce the rate they are willing to exchange at For instance the Chinese renminbi is pegged to the United States dollar The government in a fixed rate system can devalue currency announcing the exchange rate to be pegged at a lower rate Depreciation takes place by market forces of demand and supply while devaluation takes place by governmental action V Trade Balance Favorable trade balance means exports are greater than imports and unfavorable trade balance is the reverse Countries engage in international trade to get resources lower production costs and differences in taste e g fads Inflation rate can shift the trade balance in unexpected ways For instance if the inflation rate of country A is lower than country B it will create a favorable balance of trade for country A because production costs will be lower Lastly trade is defined by two quantities imports products or services produced abroad that are consumed domestically and exports are products or services produced domestically that are consumed abroad