Nicola Ferretti, Matthew Susskind, and Alvaro Anspach
Adi Albir, Emily Elkin and Loulou
I. Comparative Advantage/Absolute Advantage/Terms of Trade
II. Free Trade vs. Protectionism
III. Foreign Exchange Markets- Depreciation/Appreciation
IV. Current and Capital Accounts

I. Comparative Advantage/Absolute Advantage/Terms of Trade (Adi Albir)
  • Comparative Advantage Principle- A country has a compartive advantage if it has a lower opportunity cost for producing a product than another country.
  • Absolute Advantage- If two countries do not trade, and each country decides to use its entire labor force to produce one of the two products, the country that can produce a total greater amount of either has the absolute advantage.
  • Terms of Trade - The exchange ratio at which both countries will trade the two products.
  • Trade surplus- when exports exceed imports
  • Trade deficit- when imports exceed exports
  • Opportunity Cost Ratio (Domestic Exchange Ratio)- The amount of a product a country can produce domestically while sacrificing the production of another product.

How to Find Absolute & Comparative Advantage (Matt)


Absolute advantage is simple. Find which country can produce the most of a given good. That country has absolute advantage for that good. In this case, the US has absolute advantage in both goods.

Comparative advantage is a little tougher. The simplest way is the following: First find the opportunity cost.
In Mexico, 50 E-Z-Cheez are given up for 25 cars. In the US, 150 E-Z-Cheez are given up for 50 cars. Now simplify the ratio between the two so one good has the same coefficient in both countries. So, Mexico: 2E=1C; US:3E=1C. This makes it easy to see that in the US, 3 E-Z-Cheez are given up for 1 car, while in Mexico, only 2 E-Z-Cheez are given up for a car. Therefore, Mexico has a comparative advantage in making cars, because it has a lower opportunity cost. That means that the US must have a comparative advantage in E-Z-Cheez production, because for two goods, each country has a comparative advantage in one (unless they both have equal comparative advantage in both goods). For proof, in Mexico: 1E=1/2C, while in the US: 1E=1/3C.

To find the terms of trade, find something that benefits both countries. For instance, 2.5 U.S. E-Z-Cheez for 1 Mexican car would work, because the US, would be using forgoing less E-Z-Cheez per car, and vice versa in Mexico. The easiest way to find a number that benefits both is to take the ratios above (Mexico: 2E=1C; US:3E=1C) and pick a number between the two coefficients that aren't the same. In this case, any number between 2 & 3 E-Z-Cheez would benefit both countries.

Multiple Choice Questions:
1. When determining a country's comparative advantage, one must compare its:
a) terms of trade
b) opportunity costs
c) absolute advantage
d) trade surplus or trade deficit

2. The government does all of the following to the US economy except:
a) Maintain Competition
b) Promote Efficiency
c) Set the Equilibrium Price
d) Income Distribution

3. If Colombia exports more than it imports, then it is safe to say that it is experiencing a:
a) trade deficit
b) trade surplus
c) absolute advantage
d) comparative advantage

4. It is beneficial for countries to trade because of all of the following reasons except:
a) it increases efficiency
b) it is economically profitable for both
c) it takes advantage of international trade technologies
d) it increases unemployment

Use the following information for 5 & 6: (Matt)
Mexico can produce 6 cars for every 4 E-Z Cheez they lose. The US can produce 16 cars for every 8 E-Z Cheez.
5) Which of the following is true?
a) The U.S. must have the absolute advantage in car production.
b) Mexico must have the absolute advantage in car production.
c) The U.S. must have the comparative advantage in car production.
d) Mexico must have the comparative advantage in car production.

6) Which of the following terms of trade is acceptable to both countries?
a) 3.5 Mexican cars for 2 American E-Z Cheez
b) 3.5 American cars for 2 Mexican E-Z Cheez
c) 2 Mexican cars for 3.5 American E-Z Cheez
d) 2 American cars for 3.5 Mexican E-Z Cheez

Free Response Question:




A. What country has the absolute advantage in the production of pencils and erasers?
B. What country has the comparative advantage in the prodution of pencils and erasers?
C. If they specialize and trade, what should be the terms of trade?

Real World Example of Comparative Advantage:

The above link describes the US's comparative advantage in agricultural products. The table provided demonstrates the ratio between the exports in the first three months of 2004 and the imports of that same year (ratio: exports divided by imports). The same ratio is given for 2005. If the ratio is greater than one, then the US had a trade surplus. If the ratio is smaller than one, then the US experienced a trade deficit. As shown, the ratio fell from 2004 to 2005 because the US's imports "grew by more than its exports."

Multiple Choice:1b;2c;3b;4d;5c;6b
Free Response:
A: Thailand has the absolute advantage
B: Japan has comparative advantage in erasers. Thailand has comparative advantage in pencils.
C: The Terms of Trade are 2 pencils for the midpoint of 2.5 and 4.

II. Free Trade vs. Protectionism (Adi Albir/Emily Elkin)
  • Protectionsim- country tries to protect domestic industries by putting tariffs on imported industry to make it more expensive.
  • Free Trade- When government barriers to trade are kept to a minimum.
external image fwk-rittenberg-fig17_001.jpg
The above graph represents an economy in which the country is trading internationally with other countries. They are working at point E, outside the PPC graph.

All Governments use protectionist to some extent and the argument is how many or how few restrictions and such measures should be used to reach the countries long term macroeconomic goals.

Arguments For Protectionism- (Alvaro)

Cheap Labor: Countries that are not as developed have a lower natural cost advantage comparatively to other more industrialized countries. Due to low labor costs in these economies they can produce goods at a much cheaper rate giving other major companies incentives to outsource their production of goods. This allows these underdeveloped countries to become more of a competitive factor in the international market and eliminating domestic jobs in other countries.

New "Infant" Industries: This idea holds that some industries need to be protected from the harsh competitiveness of an international market and once fully "matured" can be competitive and provide future benefits for its country.

Security: Any industry that provides military defense or some national security should be protected in case of a national emergency countries dont have to rely on outside help during political and military crises.

Enforcement: Protectionism can be enforced in a number of ways including tariffs, import quotas, voluntary restraints, subsidies, trade bans, and imposing standards (health, environmental, etc.).

Example of Protectionism- New York Federal Reserve Data; Link-

Suppose there is a U.S. company and a foreign company producing widgets:
US made widget
Foreign-made widget
Cost to produce
The American widget factory will find it difficult to stay competitive under this scenario. Now, if the US were to impose a tariff of 60 percent:
U.S.-made widget
Foreign-made widget
New cost to US consumers
$1.20 = [(0.75x.60)+0.75]
If consumers base their purchases only on price, the demand for the foreign widget would fall and the US widget industry would prosper.
If no tariff were imposed, as under free trade, Americans would have saved money by buying the cheaper foreign widget. The US widget industry would either have to become more efficient in order to compete with the less expensive imported products or face extinction.
Tariffs need not push the price of an import above the price of its domestic counterpart. They should be just high enough to reduce the price differential between the import and the domestic good. Tariffs are usually levied as a percentage of the value of the import, although sometimes a flat rate may be charged.

Arguments For Free Trade- Alvaro

  1. Free Trade forces domestic companies to keep prices lows
  2. Free Trade opens up a larger variety of goods for consumers to choose from. Diversifies the consumption market
  3. Companies must consistently be innovative in order to stay afloat in the competitive international market. This leads to a higher quality of service and goods.
  4. Protectionist measures often evoke hostile responses from foreign governments and in response may enact retaliatory measures such as the banning or restriction of a certain countries good or product in their market. This can result in unemployment and inflation due to the export industries poor performance.
  5. Free trade allows entrepreneurs and investors to thrive whereas in a protectionist system they might fear being cut off from certain areas of the market by the government.
  6. Also generally the trend is that the costs of protectionism often outweigh the benefits making it impractical.

Example- New York Federal Reserve Data; Link-

Protectionist Measures: The Costs Involved
Suppose the United States placed a tariff on imported wrenches that were less expensive than domestic wrenches. There would be four basic costs to the economy:
  • Wrench-buyers will have to pay more for their protected U.S.-made wrenches than they would have for the imported wrenches
  • Jobs will be lost at retail and shipping companies that import foreign-made wrenches
  • Jobs will be lost in any domestic industries that suffer from retaliatory tariffs; and
  • The extra cost of the wrenches gets passed on to whatever products and services use these wrenches
These costs will have to be weighed against the number of jobs the tariff would save to get a true picture of the impact of the tariff.

Multiple Choice Questions:

1. Which of the following is not a way that government interferes with free trade:
a) Import Quotas
b) Protective Tariffs
c) Non-tariff Barriers
d) Export Subsidies
e) Taxes on its citizens

2. When a tariff is put on an imported good:
a) The supply of the good decreases.
b) The supply of the good increases
c) The demand for the good increases.
d) The price of the good decreases.

3. If the U.S. imposes protective tariffs, all of the following will occur except:
a) Increase in quantity of labor on goods that have tariffs.
b) Increase in U.S. GDP.
c) Decrease in U.S. productivity.
d) Decrease in U.S. exports.

Multiple Choice- 1e, 2a, 3b

III. Foreign Exchange Markets (Emily Elkin)
  • Foreign Exchange Market- market used to exchange national currencies for one another.
  • Exchange Rates- the equilibrium price in the foreign exchange market, the price in which currency A can be exchanged for currency B at an equilibrium price.
  • Depreciation- the international value of a currency decreases, increase in the price of currency A leads to the depreciation of currency B compared to A.
  • Appreciation- the international value of a currency increases, decrease in the price of a currency A leads to the appreciation of currency B compared to A.
  • Remember: High i è more demand for the currency / Low i è less demand for the currency

A. Exchange Rates
. 1. Allow us to link domestic prices with foreign prices
B. Appreciation & Depreciation
. 1. Changes in exchange rates are caused by:
. . a. Shifts in the supply & demand for a particular currency
. . . i. Shifts in a nation's income
. . . ii. Shifts in tastes
. . . iii. Relative price-level changes (Changes in prices of similar goods in other countries)
. . . iv. Relative interest rates (Lead to investments in different countries)
. . . . - High i è more demand for that particular currency è currency's appreciation
. . . . - Low i è less demand for that particular currency è currency's depreciation
. . . v. Changes in relative expected returns on stocks, real estate, and production facilities
. . . vi. Speculation

Key Graphs:

Demand Shifts:

This graph shows the exchange market for Yen. On the Y-axis is the Dollar Price for Yen and on the X-axis is the Quantity of Yen. Where the Demand for Yen (D-Yen) intersects with the Supply of Yen (S-Yen) is the equilibrium price. At equilibrium the $ Price for Yen is $0.01
($1= 100Y). When the D-Yen shifts right, D2-Yen, the equilibrium price increases to $0.10 ($10= 1Y). This shows the appreciation of the Yen. When the D-Yen shifts to the left, D3-Yen, the equilibrium price decreases to $.001 ($1000= 1Y). This shows the depreciation of the Yen.

Supply Shifts:
Foreign Exchange Market (supply shifts) (graph modified from

The graph above illustrates the result of both an increase and a decrease in the supply of a particular foreign currency on the foreign exchange market. As S of $ shifts from its original position to S1, the quantity of $ in the foreign exchange market increases, thus lowering the value of the $ compared to other currencies. On the other hand, when S of $ shifts to S2. the quantity of $ in the foreign exchange market decreases, thus increasing the value of the $ compared to other currencies.

Multiple Choice Questions:

1. China invented a rocket ship that can get anyone up to the moon in under 5 minutes, therefore, every country is now trying to buy replicas of this rocket ship from China, which of the following is false?
a) The exchange rate between China and other countries will increase.
b) The supply of Chinese currency will increase.
c) The Chinese currency will appreciate.
d) The demand for Chinese currency will increase.

2. The U.S. puts a protective tariff on Chinese manufactured computers, this will:
a) Increase the price of computers manufactured in the U.S.
b) Decrease the exchange rate between the U.S. and China.
c) Decrease the supply of U.S. made computers.
d) Decrease the demand for Chinese manufactured computers.

3. Using the Market for Yen graph above, if the Demand for Yen is at D2-Yen and the S-Yen is as shown, a Sony laptop that costs 45,000 Yen will cost:
a) $4.50
b) $45
c) $450
d) $4,500

Free Response Question:

The following questions refer to the graph above.
a. What would happen to the value of the Dollar relative to the Euro if the price of German-made cars rose relative to those made in the United States, ceteris paribus? (illustrate the changes on the graph)
b. Given the changes from 'part a', explain what effects this would have on the German economy.
c. What kind of measures should be taken by the German government in order to induce more foreign spending in the German car industry?

Multiple Choice- 1b, 2d, 3c

IV. Current and Capital Accounts (LouLou, Emily Elkin)
​ Terms:
  • Balance of Payment- the total of all the financial transactions (exports/imports of goods and services, international purchases of financial and real assets) that take place between a country's residents and foreign countries, the way flows in and out of a country are measured.
  • Current Account- shows the net income of a nation, a sum of the difference between exports and imports + net income + transfer payments.
  • Capital Account- measures debt forgiveness, therefore measures the transaction of assets between people.
  • Financial Account- measures international asset transactions, international sale and purchase of real/financial assets.
  • Imports- outflow of money, inflow of goods.
  • Exports- inflow of money, outflow of goods.

Balance of payments- always balances

Current Account:
  1. goods exports (+)
  2. goods imports (-)
  3. balance on goods: difference between exports and imports of goods
  4. services exports (+)
  5. services imports (-)
  6. balance on services: difference between exports and imports of services
  7. balance on goods and services
  8. net investment income- difference between (a) interest and dividend payments by foreigners to US for US services by exported capital and (b) interest and dividends US citizens and companies paid for services by foreign, imported capital
  9. net transfers- public and private transfers between countries
  10. balance on current account: adding all transactions of current account (deficit or surplus)
Capital account
  1. balance on capital account: measures debt forgiveness (+ or -)
Financial Account
  1. foreign purchases of assets in US (+)
  2. US purchases of assets abroad (-)
  3. balance on financial assets

Balance of payments deficit: when foreign currency receipts are less than foreign currency payments
  • nation must reduce its official reserves of its central bank to balance its payments
Balance of payments surplus: when foreign currency receipts are greater than foreign currency payments
  • nation must expand its official reserves to balance its payments

Adjustments depend on the exchange-rate systems:
  1. flexible/floating exchange rate system- exchange rates set by demand and supply of each nation's currency
  2. fixed exchange rate system- used to peg or fix a specific amount of one nation's currency that must be exchanged for another's

Balance of Payments (Matt)
Plain and simple, the Balance of Payments is always even. If the Financial account is negative, the Current Account is positive, and vice versa. When they don't equal each other, this means that the Capital Account is making up the difference. Logically, this makes sense. When we import from other countries (Current Account -), we have to pay for it in currency, which they use to buy assets in the US (Financial Account +).

Multiple choice questions:

1. The United States forgives $35,000 of Mexico's debt. Where does this appear on the United States' balance of payments and is it positive or negative? (lou)
a) capital account, negative
b) current account, positive
c) financial account, negative
d) capital account, positive
e) current account, negative

2. If a country has a positive value for it's Current Account, assuming the Capital Account is 0, all of the following are true EXCEPT: (Matt)
a) It's Financial Account is negative
b) Net Exports is negative
c) The Balance of Goods and Services is positive
d) Balance of Payments is 0

Discussion Questions:

1. (lou) Country X exports $50,000 of goods and services to country Y. Country Y exports $17,000 of goods and services to country X. Country Y then purchases 3 factories in country X, each worth $11,000. Country X makes no notable purchases. No debts are forgiven and no net investments or transfers are made between the two countries.
a. show a balance account for country Y
b. identify whether there is a balance of payments deficit or a balance of payments surplus, or neither
c. identify the two possible methods to adjust a deficit or surplus, if necessary

Answers: 2b
Example: South Korea's current account surplus: