Just the Facts
How do countries decide what to export?
Most economists argue that countries produce and export goods in which they have an absolute or comparative advantage
What is an absolute advantage? What is a comparative advantage?
A country enjoys an absolute advantage when it can produce a certain good more efficiently and/or at less cost than another country. A country enjoys a comparative advantage when it can produce a certain good with a lower opportunity cost than another country.
What does the term “opportunity cost” mean?
An opportunity cost is what you sacrifice in making an economic choice. In terms of foreign trade, it refers to the commercial profits accruing to product X that are sacrificed in deciding to produce and export product Y instead of X.
What currency is used in completing an international exchange?
Generally, buyers have to complete their purchase in the currency of the selling nation. In other words, before buying a foreign product they must secure some foreign currency.
Does that mean that people and businesses must go the bank and exchange their money before buying a foreign product through the mail or online?
No. It’s both more complicated and easier than that. When you buy something from a foreign vendor the transaction will most likely be routed through your bank and the bank of the vendor. These banks will secure the currency they need to complete the transaction from the foreign currency market. This market is not an actual place; it is a web of currency traders connected electronically.
Who or what determines the exchange rates in the foreign currency market?
Currently exchange rates are determined by laws of supply and demand. The amount you pay for foreign currency is determined by the broader demand for that currency and the amount available. If there is a great deal of interest in buying a nation’s products, investing in its industries, or buying its government’s bond then demand for the currency will be high.
What is a “strong“ or “weak” currency?
If demand for a currency is high and foreigners must pay a lot of their nation’s currency to obtain it, we say that the currency is strong. If demand for a currency is low and foreigners need to spend comparatively little of their nation’s currency to obtain it, we say that the currency is weak.
Have international exchange rates always been set by supply and demand?
No. The current system of flexible exchange rates is relatively new. For the first part of the twentieth century many nations were on the gold standard—that is, they backed their currency with gold and uniformly tied the value of their currency to a specific quantity of gold. But during the Great Depression the United States weakened the link between their currencies and gold. After World War II, the United States and many other nations adopted a fixed rate of exchange at a conference held at Bretton Woods, New Hampshire. The value of the dollar was pegged to a certain quantity of gold ($35 per ounce) and foreign currencies were pegged to the dollar (i.e. one American dollar equaled four German marks, 360 Japanese yen, 625 Italian lira, .357 British pounds, etc).
What happened to the system of fixed exchange rates adopted at Bretton Woods?
America’s growing trade deficits and spiraling expenditures in Vietnam led many to lose confidence in the American economy and the American dollar on which the Bretton Woods agreements hinged. In 1971, President Richard Nixon announced that the United States would no longer convert its dollars to gold, essentially eliminating the dollar’s value as the basis of international finance.
Do all international currencies currently “float freely”—that is, do all nations allow the market to establish the exchange rate for their currencies?
Not exactly. Governments can influence the value of their currencies by buying and selling currencies in the foreign exchange market. For example, a country can aggressively buy foreign currency, and dump their currency into the foreign currency market in the process, thereby weakening their currency—since the supply of their currency on the foreign exchange market has been increased, the price for it will drop. Nations generally do this in order to boost their exports—if their currency is weak, foreigners can more easily acquire their currency and therefore their nation’s products. Most international trade agreements discourage this, but some nations periodically do this.
Do governments adopt any other measures in regards to international trade?
Yes. Nations often adopt measures aimed at preserving a trade surplus and a positive balance of payments. As part of these efforts, some nations provide protection for their domestic industries from foreign competition.
What is a trade surplus?
A trade surplus occurs when a country exports more than it imports. A trade deficit, on the other hand, occurs when a country imports more than it is exports.
What is a positive balance of payments?
The balance of payments measures not just the net exchange of goods between countries, but also the amount of money other countries spend on services, such as a banking and insurance, and the amount of money foreigners invest in your country’s economy. The United States could have a trade deficit, but a positive balance of payments if much of the money spent on foreign goods returned when foreigners consumed American services and invested in American industries.
What is protectionism?
Protectionism is a set of policies aimed at protecting a nation’s industries from foreign competition. Common protectionist measures include tariffs, quotas, and embargos.
What is a tariff?
A tariff is a tax on an imported good thus raising its price and diminishing its attraction.
What is a quota?
A quota is a limit placed on the quantity of a specific good allowed into the country.
What is an embargo?
An embargo is a complete prohibition of a certain good or lists of goods allowed into a country.
What is free trade?
Free trade is a trade philosophy and policy that emphasizes unrestricted commerce between nations. “Free traders” oppose the use of tariffs, quotas, and embargos.
What are the basic arguments in favor of free trade?
By insulating domestic producers from foreign competition protectionism discourages modernization and improvement. Domestic consumers are also forced to pay higher prices since the price of foreign imports that might bring down retail prices are artificially elevated by government intervention. Also, protectionism invites retaliation from other nations. A protectionist measure that benefits one domestic industry might trigger a retaliatory measure injuring a different, more vulnerable industry.
What are the basic arguments in favor of protectionism?
Protectionism protects domestic industries and therefore domestic jobs. The money spent by consumers fuels job creation and business expansion at home. In addition, foreign industries can afford to pay lower wages, are not forced to meet similar safety and environmental standards, and are often subsidized by their governments making it difficult for domestic industries to compete without some degree of protection.