MONEY, BANKING, AND MONETARY POLICY
Chapter 17. The Phillips Curve and Expectations Theory
13. Key Concept: Adaptive Expectations
According to adaptive expectations theory, expansionary monetary andfiscal policies to reduce the unemployment rate are
a. useless in the long run.
b. useless in the short run.
c. ineffective on the price level.
d. None of the above.
14. Key Concept: Rational Expectations
The belief that the government can do absolutely nothing in either the short run or the long run to reduce the unemployment rate, because people will anticipate the government’s actions, is held by the
a. rational expectations school.
b. neo-Keynesian school.
c. classical school.
d. supply-side school.
e. Keynesian school.
Causation Chain Game
The Short-Run and Long-Run Phillips Curve—Exhibit 4
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The International Economy
T he fi nal part of this text is devoted to global topics. The fi rst chapter explains the importance of free trade and the
mechanics of trade bookkeeping and exchange rates. Here you will fi nd a feature on the birth of the euro. The second chapter takes a historical look at the theoretical debate over capitalism and the transition of Cuba, Russia, and China toward this system. The fi nal chapter provides comparisons of advanced and developing coun- tries. The chapter concludes with the fascinating economic success
story of Hong Kong. ©David
Muir/DigitalVision/GettyImages.
6 P A R T
CHAPTER
International Trade and Finance
J ust imagine your life without world trade. For openers, you could not eat bananas from Hon- duras or chocolate from Nigerian cocoa beans. Nor could you sip French wine, Colombian coffee, or Indian tea. Also forget about driving a Japanese motorcycle or automobile.
In addition, you could not buy Italian shoes and most DVDs, televisions, fax machines, and personal computers because they are foreign made. Taking your vacation in London would also be ruled out if there were no world trade. And the list goes on and on, so the point is clear.
World trade is important because it gives consumers more power by expanding their choices. Today, the speed of transportation and communication means producers must compete on a global basis for the favor of consumers.
Trade is often highly controversial. Regardless of whether it is a World Trade Organization (WTO) meeting
or a G-8 summit meeting, trade talks face protesters in the streets complaining that globalization has triggered a crisis in the world economy, such as global warming, poverty, soaring oil prices, or food shortages. And in the United States, outsourcing jobs to lower paid workers overseas continues to be a hotly debated issue.
Thefirst part of this chapter explains the theoretical reason why countries should specialize in producing cer- tain goods and then trade them for imports. Also, you will study arguments for and against the United States pro- tecting itself from“unfair”trade practices by other coun- tries. In the second part of the chapter, you will learn how nations pay each other for world trade. Here you will explore international bookkeeping and discover how supply and demand forces determine that, for example, 1 dollar is worth 100 yen.
© David Muir/Digital Vision/Getty Images.
CHAPTER
18
458
• How does Babe Ruth’s decision not to remain a pitcher illustrate an important principle in global trade?
• Is there a valid argument for trade protectionism?
• Should the United States return to the gold standard?
Why Nations Need Trade
Exhibit 1 reveals which regions are our major trading partners (exports plus imports). Leading the list of nations are Canada, our largest trading partner, fol- lowed by China, Mexico, and Japan. Leading U.S. exports are chemicals, machinery, airplanes, and computers. Major imports include cars, trucks, petroleum, electronics, and clothing. Why does a nation even bother to trade with the rest of the world?
Does it seem strange for the United States to import goods it could produce for itself?
Indeed, why doesn’t the United States become self-sufficient by growing all its own food, including bananas, sugar, and coffee, making all its own cars, and prohibiting sales of all foreign goods? This section explains why specialization and trade are a nation’s keys to a higher standard of living.
The Production Possibilities Curve Revisited
Consider a world with only two countries—the United States and Japan. To keep the illustration simple, also assumebothcountries produce only two goods—grain and steel. Accordingly, we can construct in Exhibit 2 a production possibilities curve for each country. We will also set aside the law of increasing opportunity costs,explained in Chapter 2, and assume workers are equally suited to producing grain or steel. This assumption transforms the bowed-out shape of the production possibilities curve into a straight line.
Comparing Parts (a) and (b) of Exhibit 2 shows that the United States can pro- duce more grain than Japan. If the United States devotes all its resources to this pur- pose, 100 tons of grain are produced per day, represented by pointAin Exhibit 2(a).
The maximum grain production of Japan, on the other hand, is only 40 tons per day because Japan has less labor, land, and other factors of production than the United States. This capability is represented by pointDin Exhibit 2(b).
Now consider the capacities of the two countries for producing steel. If all their respective resources are devoted to this output, the United States produces 50 tons per day (point C), and Japan produces only 40 tons per day (point F). Again, the greater potential maximum steel output of the United States reflects its greater resources. Both countries are also capable of producing other combinations of grain and steel along their respective production possibilities curves, such as pointBfor the United States and pointEfor Japan.
459
Specialization without Trade
Assuming no world trade, the production possibilities curve for each country also defines its consumption possibilities. Stated another way, we assume that both countries are self-sufficient because without imports they must consume only the combination chosen along their production possibilities curve. Under the assump- tion of self-sufficiency, suppose the United States prefers to produce and consume 60 tons of grain and 20 tons of steel per day (pointB). Also assume Japan chooses to produce and consume 30 tons of grain and 10 tons of steel (pointE). Exhibit 3 lists data corresponding to pointsBandEand shows that the total world output is 90 tons of grain and 30 tons of steel.
Now suppose the United States specializes by producing and consuming at pointA,rather than pointB.Suppose also that Japan specializes by producing and consuming at pointF,rather than pointE.As shown in Exhibit 3, specialization in each country increases total world output per day by 10 tons of grain and 10 tons of steel. Because this extra world output has the potential for making both countries better off, why wouldn’t the United States and Japan specialize and produce at pointsAandF,respectively? The reason is that although production at these points
EXHIBIT 1 U.S. Trading Partners, 2007
In 2007, Canada, China, Mexico, and Japan accounted for 43 percent of U.S. trade (exports plus imports).
Latin America (Except Mexico)
9%
Africa 3%
Japan 7%
Middle East 4%
Europe 27%
Canada 16%
Mexico 10%
Asia (Except China, Japan)
14%
China 10%
SOURCE: Bureau of Economic Analysis,U.S. International Transactions by Area, http://www.bea/gov/international/index.htm, Table 12.
460 PA RT 6 THE INTERNATIONAL ECONOMY
EXHIBIT 2 The Benefits of Trade
As shown in Part (a), assume the United States chooses pointBon its production possibilities curve,PPCU.S.. Without trade, the United States produces and consumes 60 tons of grain and 20 tons of steel. In Part (b), assume Japan also operates along its production possibilities curve,PPCJapan, at pointE.Without trade, Japan produces and consumes 30 tons of grain and 10 tons of steel.
Now assume the United States specializes in producing grain at pointAand imports 20 tons of Japanese steel in exchange for 30 tons of grain. Through specialization and trade, the United States moves to consumption possibility pointB,outside its production possibilities curve. Japan also moves to a higher standard of living at consumption pos- sibility pointE0, outside its production possibilities curve.
(a) U.S. production and consumption
Grain (tons per
day)
Steel (tons per day) 100
80 60 70
40 20
0 10 20 30 40 50
B (without trade)
PPCU.S.
A
B´ (with trade)
(b) Japanese production and consumption
Grain (tons per
day)
Steel (tons per day) 100
80 60 40 30 20
0 10 20 30 40 50
PPCJapan D
F C
E (without trade) E´ (with trade)
EXHIBIT 3 Effect of Specialization on World Output Grain Production
(tons per day)
Steel Production (tons per day) Before specialization
United States (at pointB) 60 20
Japan (at pointE) 30 10
Total world output 90 30
After specialization
United States (at pointA) 100 0
Japan (at pointF) 0 40
Total world output 100 40
is clearly possible, neither country wants to consume these combinations of output.
The United States prefers to consume less grain and more steel at pointBcompared to pointA.Japan, on the other hand, prefers to consume more grain and less steel at pointE,rather than pointF.
Conclusion When countries specialize, total world output increases, and, therefore, the potential for greater total world consumption also increases.
Specialization with Trade
Now let’s return to Exhibit 2 and demonstrate how world trade benefits countries.
Suppose the United States agrees to specialize in grain production at pointAand to import 20 tons of Japanese steel in exchange for 30 tons of its grain output. Does the United States gain from trade? The answer is Yes. At pointA,the United States produces 100 tons of grain per day. Subtracting the 30 tons of grain traded to Japan leaves the United States with 70 tons of its own grain production to consume.
In return for grain, Japan unloads 20 tons of steel on U.S. shores. Hence, specializa- tion and trade allow the United States to move from pointAto pointB0,which is a consumption possibilityoutsideits production possibilities curve in Exhibit 2(a). At pointB0, the United States consumes the same amount of steel and 10 more tons of grain compared to pointB(without trade).
Japan also has an incentive to specialize by moving its production mix from pointEto pointF.With trade, Japan’s consumption will be at pointE0. At pointE0, Japan has as much grain to consume as it had at pointE,plus 10 more tons of steel.
After trading 20 tons of the 40 tons of steel produced at pointFfor grain, Japan can still consume 20 tons of steel from its production, rather than only 10 tons of steel at point E. Thus, point E0 is a consumption possibility that lies outside Japan’s production possibilities curve.
Conclusion Global trade allows a country to consume a combination of goods that exceeds its production possibilities curve.
Comparative and Absolute Advantage
Why did the United States decide to produce and export grain instead of steel? Why did Japan choose to produce steel, rather than grain? Here you study the economic principle that determines specialization and trade.
Comparative Advantage
Engaging in world trade permits countries to escape the prison of their own produc- tion possibilities curves by producing bread, cars, or whatever goods they make best. The decision of the United States to specialize in and export grain and the deci- sion of Japan to specialize in and export steel are based oncomparative advantage.
Comparative advantage is the ability of a country to produce a good at a lower opportunity cost than another country. Continuing our earlier example, we can cal- culate opportunity costs for the two countries and use comparative advantage to determine which country should specialize in grain and which in steel. For the Comparative advantage
The ability of a country to produce a good at a lower opportunity cost than another country.
462 PA RT 6 THE INTERNATIONAL ECONOMY
United States, the opportunity cost of producing 50 tons of steel is 100 tons of grain not produced, so 1 ton of steel costs 2 tons of grain. For Japan, the opportunity cost of producing 40 tons of steel is 40 tons of grain, so 1 ton of steel costs 1 ton of grain. Japan’s steel is therefore cheaper in terms of grain forgone. This means Japan has a comparative advantage in steel production because it must give up less grain to produce steel than the United States. Stated differently, the opportunity cost of steel production is lower in Japan than in the United States.
The other side of the coin is to measure the cost of grain in terms of steel. For the United States, 1 ton of grain costs 1/2 ton of steel. For Japan, 1 ton of grain costs 1 ton of steel. The United States has a comparative advantage in grain because its opportunity cost in terms of steel forgone is lower. Thus, the United States should specialize in grain because it is more efficient in grain production. Japan, on the other hand, is relatively more efficient at producing steel and should specialize in this product.
Conclusion Comparative advantage refers to the relative opportunity costs between different countries of producing the same goods. World output and consumption are maximized when each country specializes in producing and trading goods for which it has a comparative advantage.
Absolute Advantage
So far, a country’s production and global trade decisions depend on comparing what a country gives up to produce more of a good. It is important to note that comparative advantage is based on opportunity costs, regardless of the absolute costs of resources used in production. We have not considered how much labor, land, or capital either the United States or Japan uses to produce a ton of grain or steel. For example, Japan might have an absolute advantage in producing both grain and steel. Absolute advantage is the ability of a country to produce a good using fewer resources than another country. In our example, Japan might use fewer resources per ton to produce grain and steel than the United States. Maybe the Japa- nese work harder or are more skilled. In short, the Japanese may be more produc- tive producers, but their absolute advantage does not matter in specialization and world trade decisions. If the United States has a comparative advantage in grain, it should specialize in grain even if Japan can produce both grain and steel with fewer resources.
Perhaps another example will clarify the difference between absolute advantage and comparative advantage. When Babe Ruth played for the New York Yankees, he was the best hitter and the best pitcher, not only on the team, but in all of major league baseball. In fact, before Ruth was traded to the Yankees and switched to the outfield, he was the best left-handed pitcher in the American League for a few sea- sons with the Boston Red Sox. Hisfinal record was 99–46. In other words, he had anabsolute advantagein both hitting and throwing the baseball. Stated differently, Babe Ruth could produce the same home runs as any other teammate with fewer times at bat. The problem was that if he pitched, he would bat fewer times because pitchers need rest after pitching. The coaches decided that the Babe had acompara- tive advantagein hitting. A few pitchers on the team could pitch almost as well as the Babe, but no one could touch his hitting. In terms of opportunity costs, the Yan- kees would lose fewer games if the Babe specialized in hitting.
Absolute advantage The ability of a country to produce a good using fewer resources than another country.
CHECKPOINT
Do Nations with an Advantage Always Trade?
Comparing labor productivity, suppose the United States has an absolute advantage over Costa Rica in the production of calculators and towels. In the United States, a worker can produce 4 calculators or 400 towels in 10 hours.
In Costa Rica, a worker can produce 1 calculator or 100 towels in the same time. Under these conditions, are specialization and trade advantageous?
Free Trade Versus Protectionism
In theory, global trade should be based on comparative advantage and free trade.
Free trade is the flow of goods between countries without restrictions or special taxes. In practice, despite the advice of economists, every nation protects its own domestic producers to some degree from foreign competition. Behind these barriers to trade are special interest groups whose jobs and incomes are threatened, so they clamor to the government forprotectionism. Protectionism is the government’s use of embargoes, tariffs, quotas, and other restrictions to protect domestic producers from foreign competition.
Embargo
Embargoes are the strongest limit on trade. An embargo is a law that bars trade with another country. For example, the United States and other nations in the world imposed an arms embargo on Iraq in response to its invasion of Kuwait in 1990.
The United States also maintains embargoes against Cuba, Iran, and North Korea.
Tariff
Tariffsare the most popular and visible measures used to discourage trade. A tariff is a tax on an import. Tariffs are also called customs duties. Suppose the United States imposes a tariff of 2.9 percent on autos. If a foreign car costs $40,000, the amount of the tariff equals $1,160 ($40,000 × 0.029), and the U.S. price, including the tariff, is $41,160. The current U.S. tariff code specifies tariffs on nearly 70 percent of U.S. imports. A tariff can be based on weight, volume, or number of units, or it can bead valorem(figured as a percentage of the price). The average U.S. tariff is less than 5 percent, but individual tariffs vary widely. Tariffs are imposed to reduce imports by raising import prices and to generate revenues for the U.S. Treasury.
Exhibit 4 shows the trend of the average tariff rate since 1930.
During the worldwide depression of the 1930s, when one nation raised its tar- iffs to protect its industries, other nations retaliated by raising their tariffs. Under the Smoot-Hawley tariffs of the 1930s, the average tariff in the United States reached a peak of 20 percent. Durable imports, which were one-third of imports, were subject to an unbelievable tariff rate of 60 percent. In 1947, most of the world’s industrialized nations mutually agreed to end the tariff wars by signing the General Agreement on Tariffs and Trade(GATT). Since then, GATT nations have met periodically to negotiate lower tariff rates. GATT agreements have significantly reduced tariffs over the years among member nations. In the 1994Uruguay round, member nations signed a GATT agreement that decreased tariffs and reduced other Free trade
Theflow of goods between countries without restrictions or special taxes.
Protectionism The government’s use of embargoes, tariffs, quotas, and other restrictions to protect domestic producers from foreign competition.
Embargo A law that bars trade with another country.
Tariff A tax on an import.
464 PA RT 6 THE INTERNATIONAL ECONOMY
trade barriers. The most divisive element of this agreement was the creation in 1995 of the Geneva-basedWorld Trade Organization (WTO)to enforce rulings in global trade disputes. The WTO has 150 members and a standing appellate body to renderfinal decisions regarding disputes between WTO members. Critics fear that the WTO might be far more likely to rule in favor of other countries in their trade disputes with the United States. Some people argue that the WTO is unaccountable, and these critics reject free trade and globalization.
To illustrate an interesting case, the United States imposed tariffs in 2002 on steel imports to protect jobs in the struggling U.S. steel industry against foreign competition. The WTO ruled these tariffs were illegal, and countries in Europe and Asia prepared a list of retaliatory tariffs. These levies targeted products such as citrus fruit grown in Florida and apparel produced in southern states crucial to President Bush’s reelection. Meanwhile, U.S. automakers and other steel-consum- ing industries complained because the tariffs increased their costs. Facing these threats, the United States removed the tariffs on steel imports in 2003. It is inter- esting to compare this case to the You’re the Economist titled World Trade Slips on Banana Peel.
EXHIBIT 4 The United States Average Tariff Rate, 1930--2007
Under the Smoot-Hawley Act of 1930, the average tariff rate peaked at 20 percent. Since the GATT in 1947 and other trade agreements, tariffs have declined to less than 5 percent.
5
0 10 15 20
1930 1940 1950 1960 1970 1980 1990 2000 2010
Average tariff
rate (percent)
Year
SOURCES: Economic Report of the President 1989,http://www.gpoaccess.gov/eop/, p. 151; United States International Trade Commission,The Economic Effect of Significant U.S. Import Restraints, June 2002, p. 146, http://www.USITC.gov/; andTrade Profiles, http://stat.wto.org/CountryProfiles/US_e.htm.
World Trade Organization (WTO) An international organization of member countries that oversees international trade agreements and rules on trade disputes.