Comparative and Absolute Advantage

Specialization

• Individuals and Countries can be made better off if they will produce in what they have a comparative advantage and then trade with others for whatever else they want/need. 

Absolute Advantage: The producer that can produce the most output OR requires the least amount of inputs (resources)

Comparative Advantage: The producer with the lowest opportunity cost.

Countries should trade if they have a relatively lower opportunity cost. 

• An output problem presents the data as products produced given a set of resources. (ex. Number of pens produced)
• An input problem presents the data as amount of resources needed to produce a fixed amount of output. (ex. Number of labor hours to produce 1 bushel)
• When identifying absolute advantage, input problems change the scenario from who can produce the most to who can produce a given product with the least amount of resources. as

Foreign Exchange (FOREX)

• The buying and selling of currency
• Ex: in order to purchase souvenirs in France, it is first necessary for Americans to sell 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 
• Ex: the current exchange rate is approximately 8 Yuan to 1 dollar
• Simply put, the exchange rate is the price of a currency 

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand for currency. 
• An increase in the supply of a currency will decrease the exchange rate of a currency 
• A decrease in supply of a currency will increase the exchange rate of a currency 
• An increase in demand for a currency will increase the exchange rate of currency
• A decrease in demand for a currency will decrease the exchange rate of a currency 

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases 
• Depreciation of a currency occurs when the exchange rate of that currency decreases 
• Ex: If German tourists flock to America to go shopping, then the supply of euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate. '

To understand Appreciation and Depreciation more, please visit this website: Appreciation and Depreciation

Exchange Rate Determinants

• Consumer Tastes
• Relative Income 
• Relative Price Level
• Speculation 

Balance of Payments

Measure  of money inflows and outflows between the United States and the Rest of the World

• Inflows are referred to as CREDITS
• Outflows are referred to as DEBITS 

The Balance of Payments is divided into 3 accounts

• Current Account
• Capital/Financial Account
• Official Reserves Account 

Current Account

• Balance of Trade or Net Exports
• Exports of Goods/Services - Import of Goods/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 U.S. owned foreign assets -Income paid to foreign held U.S. assets
• Ex. Interest payments on U.S. owned Brazilian bonds - Interest payments on German-owned U.S. 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 United States is a credit to the capital account
• Ex. The Toyota Factory in San Antonio
• Direct Investment by U.S. firms/individuals in a foreign country are debts to the capital account 
• Ex. The Intel Factory in San Jose, Costa Rica 
• Purchase of foreign financial assets represents a debt 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 
• The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Current Account with Financial Account = 0 

Official Reserves 

• The foreign currency holdings of the United States Federal Reserve System 
• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments 
• When there is balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments 
• The Official Reserves zero out the balance of payments

Balance of Trade: Exports - Imports 

Balance of Goods and Services: (Goods Exports + Services Exports) - (Goods Imports + Services Imports)

Balance on Current Account: Balance of goods and services + Net investments  + Net transfer

Balance of Capital Account: Direct investment and purchase of stocks and bonds 

Official Reserves: Current Account + Capital Account = 0