Question 1 – Foreign Exchange
Once, all currencies were backed by gold, and so currencies were fixed in value in relation to each other. Then, you could always calculate exactly how many Pounds Sterling, for example, you could buy with a given amount of dollars, as both were denominated in gold. But as currencies became worth more or less than each other, they were exchanged for the underlying gold, and gold began to flow between counties to make up for the difference in currency purchasing power.
The gold standard was abandoned (in steps) in this country for a number of reasons, not the least of which being that it made monetary policy practically impossible to implement. Without a clear definition in gold, however, currencies no longer had a fixed relationship to each other, and had to trade freely, as they do today. The cost of a euro, for example, or a yen, changes on a daily, sometimes hourly basis, in terms of dollars, and currencies are openly traded on organized exchanges today.
If the dollar is â€œcheapâ€, that means foreigners can buy dollars at relatively low cost, in units of their own currency. This is good for US firms which make products for export, as these products become â€œlow costâ€ in foreign counties and so sales are higher. This helps increases US exports and eventually stimulates demand for dollars to pay for these exports, raising the price of the dollar. In that sense, cheap currency is, in theory, self correcting.
When the dollar is â€œdearâ€ (expensive), then our exports are no longer cheap, but products imported from other countries to the US appear cheaper, and so demand for US made substitutes decreases and quantity demanded for imports goes up. We need the foreign currency to pay for these imports, so we buy it in open markets. The process of buying the foreign currency causes its price to rise in relation to the US dollar, and so the dollar will eventually decline in value.
As mentioned in TCO 8, NAFTA has made Mexico and Canada the chief trading partners of the US. What changes have occurred in the relative values of the Mexican Peso and Canadian Dollar since NAFTA? What changes in trade patterns have resulted from NAFTA? Has this helped, or hurt, the US? Read the attachment to this post before you make up your mind for sure.
Question 2 – Free Trade
One country is said to have comparative advantage over another if it can product a product at lower opportunity cost than the other. Even if one country can produce all products at a lower absolute price, if there is a difference in opportunity costs between the two countries, the one with the lowest opportunity cost tradeoff should produce what it can do best.
We donâ€™t need international trade; we certainly could produce everything we need within the borders of the US. It might be very expensive to produce some things that are not suited to this county, for example, bananas or coffee, but it could be done. If we chose to do this, we would operate on our PPC for the country.
But we can expand the PPC by simply producing what we do best, and trading our excess income for different products produced in other places where they can be made at lower opportunity cost. This enhances the PPC of both countries without any change at all, we just work smart, not hard. Why try to grow, say, coffee in the US, when it grows so much better in Brazil?
At present low-labor-cost places like China have a comparative advantage over the US in producing low-skill, labor intensive products, because the opportunity cost of the labor is so low there. This is not likely to change. We need to produce products for which we have comparative advantage and trade for the labor intensive products that we need.
NAFTA (the North American answer to the European Union) has united the US, Mexico and Canada for a number of years, with at least modest or better success. At the time of itâ€™s inception, it was feared that it would cost the US jobs, but since NAFTA has been in place, employment in the US has grown by over 30 million.
A trade deficit occurs when a country imports more than it exports in dollar terms. The US has been running a trade deficit for thirty years or more, due mainly to imports of oil and automobiles. As a result, the value of the US dollar vs. currency of other countries has fallen. This is not all bad, as it results in lower prices (to foreigners) for US products, and so, at least in theory, promotes US exports. The purchasers of these exports must buy dollars to pay for them, and this process actually raises the value of the dollar!
In what ways can the US regain or attain comparative advantage against counties with lower labor costs than we can have domestically? How can the US rectify its balance of payments and increase the relative value of the US dollar? Do we even want the dollar to be higher relative to other currencies?