Absolute Advantage

Balance of Trade
Individual: exists when a person can produce more of a certain good/ service that someone else in the same amount of time (or can produce a good using the least amount of resources)
National: exists when a country can produce more of a good/ service than another country can in the same period of time.

Comparative Advantage
Person or nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than a trading partner

• Input:
• ex. TVs produced per hour, miles per gallon
• Output:
• ex. number of hours to do jobs, number of acres to feed horses

Specialization and Trade
Gains from trade are based on comparative advantage, not absolute advantage.

• countries should trade if they have a lower opportunity cost

Mechanics of Foreign Exchange (FOREX)

FOREX

The buying and selling of currency 

• ex. In order to purchase souvenirs in France, it is first necessary for Americans to seek their dollars and buy euros 
• any transaction that occurs in the balance of payments necessitates foreign exchange 
• The exchange rate (e) is determined in the foreign currency markets 

Changes in e

e are a function of the supply and demand for currency 

• an increase in the supply of a currency will decrease the e of currency 
• A decrease in supply of a currency will increase the e of a currency
• An increase in demand for a currency will increase the e of a currency 
• A decrease in the demand for a currency will decrease the e of a currency 

Appreciation and depreciation

• appreciation of a currency occurred when the e of that currency increases
• Depreciation occurs when the e of that currency decreases 

Exchange rate determinants

• consumer tastes 
• Relative income 
• Relative price level
• Speculation 

Exports and imports

• the e is a determinant of both exports and imports
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods  to be relatively cheaper thus reducing exports and increasing imports 
• Depreciation of the dollar caused American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports 

Floating or flexible rates 

• depends upon supply and demand for that currency vs other currencies 
• Very sensitive to the business cycle
• Provides options for investments 

Fixed rate

• based upon a countries willingness to distribute currency and the ability to control the amounts 

The Balance of Payments

Measure of money inflows and outflows between the US and the Rest of the World (ROW)

• inflows are referred to as CREDITS
• outflows are referred to as DEBITS 

Current Account

balance of trade or net exports

• exports of goods/ services- import of good/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments 

Net Foreign Income

• income earned by US owned foreign assets- income paid to foreign held US assets
• Ex. Interest payments on US owned Brazilian bonds- interest payments on German owned US Treasury bonds

Net Transfers (tend to be unilateral)

• foreign aid ->a debit to the current account 
• Ex. Mexican migrant workers send money to family in Mexico 

Capital/ financial account: the balance of capital ownership

• Includes the purchase of both real and financial assets 
• Direct investment in the US is a credit to the capital account
• ex. The Toyota factory in San Antonio 

• direct investment by US firms/ individuals in a foreign country are debits to the capital account 
• ex. The intel factory in San Jose, Costa Rica 

• purchase of foreign financial assets represent a debit to the capital account 
• ex. Warren Buffet buys stock in Petrochina

• purchase of domestic financial assets by foreigners represents a credit to the capital account 
• ex. the United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

RELATIONSHIP BETWEEN CURRENT AND CAPITAL ACCOUNT

• the current and capital accounts should zero each other out
• If the current has a negative balance (deficit) the capital should have a positive balance (surplus) 

Official reserves 

the foreign currency holdings of the United States Federal Reserve System 

• When there is a balance of payments deficit the fed depletes its reserves of foreign currency and credits the balance of payments 
• When there is a balance of payments surplus the fed accumulates foreign currency and debits the balance of payments 
• The official reserves zero out the balance of payments 

Active v passive official reserves

the US is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate

Supply Side Economics

AKA Reaganomics

Changes in AS, and not AD, are the main active force in determining the level of inflation, unemployment rates, and economic growth

• Supply side economists support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Incentives to save and invest

1. High marginal tax rates reduce the rewards for savings and investments 
2. Consumption might increase but investments depend upon savings
3. Lower marginal tax rates encourage saving and investment

Laffer curve

A theoretical relationship between tax rates and tax revenues 

So as tax rates increase from zero, tax revenue increases from 0 to some maximum level and then declines

Three criticisms of the laffer curve

1. Evidence suggests that the impact of tax rates on incentives to work, save, and invest are small
2. Tax cuts also increase demand which can fuel inflation and demand may exceed supply 
3. Where the economy is actually located on the curve is difficult to determine

Phillips Curve

 

*Note that this graph is missing the Long Run Curve which would show the natural rate of unemployment

Long Run Phillips Curve

The LRPC exists at the NRU, structural changes in the economy the effect the NRU cause the LRPC to shift as well. 

• Increases in the NRU will shift LRPC -->
• Decreases in the NRU will shift LRPC <--

Short Run Phillips Curve

There is a trade-off between inflation and unemployment

• as one increases, the other decreases and vice versa
• determinants are the same as AS: produtivity, input costs, legal institutions

Long Run Phillips Curve

There is no trade-off between inflation and unemployment as the line is always vertical at NRU.

• will only shift is LRAS shifts

Major LRPC Assumption

More worker benefits create higher NR's and fewer worker benefits create lower NR's

Supply Shocks

Rapid and significant increases in resource cost

• causes SRAS to shift
• SRAS shifts downward, SRPC shifts outward

Misery Index

The combination of inflation and unemployment in any given year

• single digit misery is good
• Used to determine what's going on in with the economy

Extending the Analysis of Aggregate Supply

SRAS 

Period when wages and other input prices remain fixed as price level increases or decreases 

Effects over SR

Price level changes allow companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant 

• In the long run wages will adjust to the price level and previous output levels will adjust accordingly 

Equilibrium 

The LRAS curve is represented with a vertical line at full employment level of real GDP 

Demand pull inflation in AS model

Prices increase based on increase in AD

• In the short run, demand pull will drive up prices and increase production 
• In long run increases in AD. Will eventually return to previous levels 

Cost push inflation  

Arises from factors that will increase per unit costs such as increase in the price of a key resource 

Dilemma for the Gov't

In an effort to fight cost-push the gov't can react in two different ways:

1. Action such as spending by the gov't could begin an inflationary spiral 
2. No action however could lead to recession by keeping production and employment levels declining 

Misery Index

A combination of inflation and unemployment in any given year 

• Single digit misery is good

Supply shocks 

Rapid and significant increase in resource cost 

Inflation

A general rise in prices 

Deflation 

General decline in prices

Disinflation 

reduction in inflation from year to year (found in LRPC)

Stagflation 

Unemployment and inflation rise/ increase at same time

What Do Banks Do?

• a bank is a financial intermediary

• uses liquid assets (i.e. Bank deposits) to finance the investments of borrowers

• process is known as Fractional reserve banking

• a system in which depository institutions hold liquid assets less than the amount of deposits 
• Can take the form of:

1. Currency in bank vaults 
2. Bank reserves- deposits held at the federal reserve 

• T-Account (balance sheet)

• statements of assets and liabilities

• assets ( amount owned)

• items to which a bank holds legal claim
• The use of funds by financial intermediaries 

• liabilities( amounts owed)

• the legal claims against a bank
• The sources of fund for financial intermediaries 

Federal reserve bank

• 12 district federal reserve banks
• Each are quasi-owned

• Functions of the fed

• issues paper currency 
• Sets reserve requirements and holds reserves of the bank 
• Lends money to the banks and charged them interest 
• They are a check clearing service for banks 
• Act as a personal bank for the government 
• Supervise member banks
• Control money supply in the economy