Basics of Foreign Trade and Exchange, The

Adam Gonnelli
Grade Levels: 9,10,11,12
Document Type: Supplementary Materials
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Provides an elementary discussion on interest rates and their effect on production, employment,
income, and prices.
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THE BASICS OF FOREIGN TRADE AND
EXCHANGE

by

Adam Gonnelli

Federal Reserve Bank of New York • Public Information Department

 ACKNOWLEDGMENTS

The Public Information Department of the

Federal Reserve Bank of New York wishes to
thank the following people for their guidance in
preparing the text:

Peter Crawford, Citibank, N.A, New York

Steven S. Roach, Morgan Stanley & Co. Inc., New York

Lawrence A. Veit, Brown Brothers Harriman & Co., New York

William McDonough, Willene Johnson, Bruce Kasman and David Laster,

Federal Reserve Bank of New York.

Suzanne Lorge, Federal Reserve Bank of New York, proofread the text.

Carol Perlmutter and Phylise Banner, Federal Reserve Bank of New York,
assisted in the preparation of charts.

Design: Robert Silverman Design

Printed 1993

CREDITS
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courtesy of NASA. CIO
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GOODS AND SERVICES FLOW AROUND
1990 MERCHANDICE EXPORTS
THE WORLD IN COMPLEX PATTERNS
IN BILLIONS OF U.S. DOLLARS
 GROWING TRADE,
INTERNATIONAL TRADE
SHAPES OUR EVERYDAY LIVES AND THE
WORLD IN WHICH WE LIVE. WHETHER WE REALIZE IT
OR NOT, NEARLY EVERY TIME WE MAKE A PURCHASE WE ARE
PARTICIPATING IN THE GLOBAL ECONOMY. PRODUCTS AND PARTS OF
PRODUCTS COME TO OUR STORE SHELVES FROM ALL OVER THE
WORLD.

International trade is the system by which countries exchange

goods and services. Countries trade with each other to obtain
things that are better quality, less expensive or simply different
from goods and services produced at home. The goods and
services that a country buys from other countries are called
imports, and goods and services that are sold to other countries
are called exports.

While trade takes place mostly between companies, governments and

individuals frequently buy and sell goods internationally, too. Most
international trade consists of the purchase and sale of industrial equipment,
consumer goods, oil and agricultural products. In addition, services such as
banking, insurance, transportation, telecommunications, engineering and
tourism accounted for one-fifth of world exports in 1990.
One of the most significant trends in the world economy since the end of World
War II has been the rapid increase in international trade. In 1950, total world
merchandise exports amounted to $58 billion. In 1990, exports were $3.5
trillion, over 60 times as much. This rate of increase was roughly three times as
fast as overall world economic growth.
IMPORTANCE OF TRADE
As its volume has increased, trade has become more important to the
economic well-being of many countries. For example, in the early 1960s, the
United States bought less than $1 billion of foreign cars and parts. By the late
1980s, this figure had increased to more than $85 billion. During the same
period, financial ties between the United States and the rest of the world also
increased significantly. The number of foreign banking offices operating in the
United States rose from fewer than 40 to more than 800, and the amount of
money foreigners invested in U.S. companies, assets and real estate––called
direct foreign investment––was 20 times greater in 1990 than in 1970. Gross
transactions of long-term U.S. government securities by foreigners rose from
$144 billion in 1978 to $5.6 trillion in 1991. Since 1950, the costs of
international transportation and communication have been drastically reduced,
making it easier to conduct business across borders. The economies of many
countries have become more closely tied together than ever before.
 SHRINKING WORLD

AMERICANS DRIVE CARS

MADE IN GERMANY, USE VCR’S MADE IN CHINA.
JAPAN AND WEAR CLOTHING MADE IN CHINA.
JAPANESE WATCH AMERICAN MOVIES, EGYPTIANS DRINK
AMERICAN COLA AND SWEDES JOG IN AMERICAN RUNNING SHOES
THE WORLD ECONOMY IS MORE INTEGRATED THAN EVER BEFORE.

Because countries are so

closely linked, economic
trends and conditions in
one country can strongly
affect prices, wages,
employment and production
in other countries. This
condition is referred to as
interdependence. Events
in Tokyo, London and
Mexico City have a direct
effect on the everyday lives
of Americans, just as the
impact of events taking
place in New York,
Washington and Chicago is
felt around the globe. If
stocks on the New York
Stock Exchange plummet in
value, the effects are not
limited only to the United
States; news is transmitted
worldwide almost instantly,
and stock prices all over
the world might change. If
factory workers in Taiwan
go on strike, prices of
Taiwanese toys may be
forced up in Europe, Asia
and North America.
Interdependence means
that countries have to work
together more closely, and,
to a certain extent, rely on
each other for prosperity.
Let's take a closer look at
how this works.
 WHY NATIONS TRADE
International trade occurs because there are things that are produced in a
particular country that individuals, businesses and governments in other
countries want to buy. Trade provides people with a greater selection of goods
and services to choose from, often at lower costs than at home. But what makes
trade profitable and productive for both trading partners?
In order to become wealthier, countries want to use their resources––labor,
land and capital––as efficiently as possible. However, there are large
differences in the quantity, quality and cost of different countries' resources.
Some countries have natural advantages, such as abundant minerals or a
climate suited to agriculture. Others have a well-trained workforce or highly
developed infrastructure, like good roads, advanced telecommunications
systems and reliable electric utilities, that help the production and distribution
of goods and services.

BENEFITS OF SPECIALIZATION
Instead of trying to produce everything by themselves, which would be
inefficient, countries often concentrate on producing those things that they can
produce best, and then trade for other goods and services. By doing so, both
the country and the world become wealthier.
Suppose the mythical nation of Cottonland is very efficient at producing cloth,
but not at making furniture. By dividing its resources evenly between its cotton
and furniture industries, Cottonland is able to produce eight bales of cloth and
four pieces of furniture each day. The economy of its neighbor, Woodland, is
just the opposite; it produces eight pieces of furniture in a day, but only four
bales of cloth.
Further, suppose a piece of furniture is the same price as a bale of cloth. In
Cottonland, where a bale of cloth can be produced in an hour, but a piece of
furniture takes two hours, it makes sense to make a lot of cloth and trade the
surplus for furniture. Conversely, for greater productivity, Woodland should
direct all of its resources to making furniture.
If Cottonland can produce eight bales of cloth using half of its resources, it
will double its cloth production to 16 bales a day by transferring all of its
resources to its cloth industry. By doing so, however, Cottonland would
eliminate its furniture industry. Nevertheless, Cottonland would become
wealthier; it would have as much cloth as before, plus more cloth to trade for
other things that it wants, such as Woodland's furniture. (More accurately,
people in Cottonland will buy some of Woodland's currency on the foreign
exchange market and use it to buy furniture; Woodland will do the opposite to
buy cloth. But more on that later.)

COTTONLAND AND WOODLAND BENEFIT FROM

SPECIALIZATION AND TRADE

Cottonland Woodland
Without trade Without trade
Cottonland can Woodland can
produce: produce:
8 4 4 8
bales of cloth pieces of furniture bales of cloth pieces of furniture
Total Production: Total Production:
12 12
UNITS UNITS

If Cottonland puts all of its If Woodland puts all of its

resources into the resources into the
production of cloth: production of furniture:
16 0 0 16
bales of cloth pieces of furniture bales of cloth pieces of furniture
Total Total
Production: Production:
16 16
UNITS UNITS

Cottonland can now trade its Woodland can now trade its
surplus cloth for furniture. surplus furniture for cloth

Before the two countries directed their resources into their most productive
enterprises, total production for both countries stood at 12 pieces of furniture
and 12 bales of cloth. After the shift in resources, production increased to 16
bales and 16 pieces. Each country can now trade its surplus goods.
Through specialization and trade, the supply of goods in both Cottonland and
Woodland increases; more supply tends to bring prices down, making the
goods more affordable. In addition, trade provides a wider variety of goods to
consumers: salmon from Scandinavia, bananas from South America and
cameras from South Korea, to name just a few of the many thousands of
products that trade makes available. If countries did not engage in trade and
instead limited their consumption to what they produced at home, consumers
would not live nearly as well.
Today, most industrialized nations could produce almost any product they
chose. For instance, the United States could conceivably devote all of its
resources to the production of tropical fruits. The United States could
compensate for an unsuitable climate in certain areas by clearing and fertilizing
land, building hothouses, developing new irrigation techniques and retraining
workers––no tropical fruit would ever need to be imported and there would
plenty left over to export.
However, this does not make good economic sense. Much of the labor, land
and capital that would have to be directed toward the tropical fruit industry
could be used more efficiently in other industries. Countries achieve greater
total wealth by devoting more resources to their most productive industries.

LAW OF COMPARATIVE ADVANTAGE

But what happens when everything a country produces can be produced
more efficiently somewhere else? Does this mean that there is no possibility for
profitable trade with other countries?
The answer is no. According to the Law of Comparative Advantage a
country can profit from international trade even when everything it produces
can be produced more efficiently by other countries. A country maximizes its
wealth by putting its resources into its most competitive industries, regardless of
whether other countries are more competitive in those industries.
Suppose Cottonland produced both cloth and furniture better than Woodland:

Cotton- Wood-
land land

Bales of cloth per day 10 2

Pieces of furniture per 5 3
day

Cottonland has an absolute advantage––it is more efficient––in the

production of both products. However, to achieve greater wealth, each country
should specialize in producing that item in which it has a comparative
advantage, or greatest advantage among the products it produces.

Cottonland should continue to make cloth and trade for Woodland's furniture.
Woodland should concentrate on producing furniture and trade for cloth. If
resources are channeled into the most productive enterprises in each country,
there will be more products to trade.

Let's look at it in terms of opportunity cost, or the cost of not transferring

resources. Cottonland is twice as efficient at producing cloth as furniture, so
each time it produces a piece of furniture, it could have produced two bales of
cloth instead. In contrast, Woodland is one-and-a-half times as efficient at
producing furniture as cloth (three pieces and two bales each day). Each time
Woodland produces a piece of furniture, it misses out on the production of only
two-thirds of a bale of cloth. Since its missed opportunity for production is less
than Cottonland's, it makes sense for Woodland to make the furniture.
SOME COUNTRIES DEPEND VERY HEAVILY ON OIL EXPORTS
1990 EXPORTS

BENEFITS OF DIVERSITY
While it makes good economic sense to put resources into the most productive
industries, no country wants to rely on only one product. Specialization in the
production of one, or too few, goods makes a country more vulnerable to
changes in the world economy, such as recessions, new trade laws and
treaties, and new technologies. If a country relies heavily on producing a
single product and demand for that product suddenly drops because another
country produces a less expensive alternative, or if trade is restricted, the
economy could be devastated. For example, several Middle Eastern countries
rely on oil for more than 90 percent of their exports; to a large extent the
economic fortunes of these countries rise and fall with the oil market.
In addition, the degree to which countries specialize is influenced by that
country's terms of trade. A country's terms of trade reflect the relative prices
of a country's imports and exports. In general, it is most advantageous to a
country to have declining import prices compared with the prices of its exports.
Exchange rates and productivity differences affect the terms of trade more than
any other factors.
By developing a diverse economy, a country can make sure that even if
some industries are suffering, other, more prosperous industries will keep the
economy relatively healthy. Larger, more developed economies, like those of
the United States, Japan, Germany and Great Britain, have many
internationally competitive industries. Among many other fields, the United
States is competitive in finance, entertainment, aerospace, industrial
equipment, pharmaceuticals and communications.

COMPETITIVENESS
Competitiveness is a broad term used to describe the relative productivity of
companies and industries. If one company can produce better products at
lower prices than another, it is said to be more competitive. If, overall, the steel
mills of Germany are more efficient and productive than the steel mills of France
or Belgium, it would be said that the German steel industry is more competitive
than the French and Belgian steel industries. Governments are always
concerned about the competitiveness of their countries' different industries,
since it is difficult for uncompetitive industries to survive.
 In the long run, competitiveness depends on a country's natural resources,
its stock of machinery and equipment, and the skill of its workers in creating
goods and services that people want to buy.

Natural resources are already there and must be used efficiently, but a
country's infrastructure and its workers' skills have to be built up over time. The
ability of a society to use natural resources wisely, develop new technologies,
improve the skills and efficiency of its workforce, and invest in its infrastructure
are key factors in trying to remain competitive.

KNOWLEDGE INTENSICE PRODUCTS CONTRIBUTED TO A U.S.

EXPORT BOOM

From 1986 to 1991, there was an enormous boom in U.S. exports, especially in
manufactured goods. Exports almost doubled, going from $227 billion to $422
billion. One of the driving forces behind the increases in exports was the
success of U.S. companies in selling “knowledge-intensive” manufactured
goods to other industrialized countries.
The value of knowledge-intensive products depends mainly on the skills that
went into them, rather than the costs of the physical components. For example,
when producing a new compact disc, the expenses of paying the artist and the
advertising, marketing, legal and accounting fees far outweigh the cost of
physically producing the disc; or, a custom-made chemical for a new drug
might be expensive because of the years of research, development and testing
that went into it.
The production of these
knowledge-intensive goods relies
more on a skills, well-educated work
force than on natural resources.
many different types of products fit
this description, from software to
custom-built aircraft engine parts.
The most successful exports during
the boom were produced for a very
specific market niches and
substitute products were not easy to
come by. These knowledge-
intensive products are becoming a
major force in international trade
and a source of much wealth to
countries whose economies are
well-positioned to compete in those
markets.
ECONOMIES OF SCALE
The Law of Comparative Advantage says that a country can become more
competitive by putting its resources, through investment in training and
production facilities, into its most efficient industries. Using its resources in this
manner may enable a country to achieve economies of scale––increasing its
output in a particular industry so that its costs per unit decrease. Lower-cost
goods become more competitive in international markets.
Having access to international markets may help countries to achieve
economies of scale in different industries. For example, it would not be
profitable for a small country to produce expensive, sophisticated weapons
systems unless it could spread the enormous research and development costs
over many units. To do this, it may need to export. If nations know that they
have access to foreign markets and can export, it is possible to increase the
scale of their manufacturing operations far beyond what they need for their own
use, and as a result the nations become more efficient and competitive.
Of course, in reality, the factors affecting a country's trade competitiveness
are more complicated. Greater specialization improves competitiveness, but
sometimes resources are difficult to transfer from one industry to another. An
insurance agent cannot be moved to an architectural company without
retraining, and it would cost a great deal of money to turn a car factory into a
shoe factory.
To further complicate matters, governments often attempt to restrict or
encourage international trade to achieve domestic economic goals, such as
increasing employment in certain industries, developing new sources of
wealth, or maintaining economic independence.

FREE TRADE VS. PROTECTIONISM

All governments regulate foreign trade. The extent to which they do so is a

topic of lively debate and is a source of great controversy. The news is full of
reports of different groups demanding to be protected from foreign competition,
new trade agreements, and problems with imports and exports. Some call for
more government action, others for less.
Although the amount of government involvement in trade varies from country
to country and from product to product, overall barriers to trade have been
reduced since World War II.
Those who favor free trade think that an open trading system with few
limitations and little government involvement is best. Advocates of
protectionism believe that governments must take action to regulate trade and
subsidize industries to protect the domestic economy. All governments practice
protectionism to some extent. The debate is over how much or how little
protectionism to use to reach a country's economic goals.
We've seen how trade can raise people's living standards, so why is there a
debate at all about restricting it? If the goal of trade is to provide people with as
many different goods as possible at the lowest prices, then shouldn't all barriers
to trade be eliminated?
 In theory, completely free trade would provide the most goods and services at
the lowest possible cost, as consumers everywhere are allowed to buy goods
and services from whomever in the world produces them most efficiently.
However, the competition that free trade brings to domestic industries may
result in unemployment and slower growth. For example, if cars can be
produced much more efficiently in another country and consumers are free to
buy them, the domestic auto industry will lose business. In this case, a
government might seek to protect its auto industry from competition by
discouraging imports of lower-cost cars.
Indeed, industries and organizations that stand to suffer from free trade
usually want the government to protect them from foreign competition. Our
fictional furniture makers in Cottonland would no doubt favor limiting or taxing
furniture imports from more competitive Woodland. In the real world, political
interest groups often push for legislation to restrict trade.

ARGUMENTS FOR PROTECTIONISM

Sometimes, because of much lower labor costs, less-developed countries can
produce goods less expensively than can developed nations. These goods
tend to be more competitive on international markets, which is a source of great
concern to producers of similar goods in industrialized nations. Therefore, the
argument that protectionism is desirable because it protects domestic jobs by
compensating for foreign firms' use of inexpensive labor is very powerful in
developed nations.

Protectionists also argue that new or infant industries often must be

protected to give them time to grow and become strong enough to compete
internationally. Governments of developing countries may want their
economies to become competitive in industries that can provide a firm
foundation for future growth, such as computers and telecommunications.
Rather than have new companies put out of business by well-established
foreign firms, the government may shield its domestic companies from foreign
competition until they develop sufficiently. Critics of this philosophy correctly
point out that some of these infant industries never "grow up," meaning that
they come to rely on protection and never become competitive.
In addition, traditional protectionist arguments hold that any industry crucial to
national security, such as the producers of military hardware, should be
protected. This way, the nation will not have to depend on outside suppliers
during political or military crises.
Protectionism also may promote diversification of the economy. If a country
channels all of its resources into a few products, no matter how internationally
competitive those products are, it runs the risk of becoming too dependent on
them. However, if other, weaker, industries are kept competitive through
protectionism, it may help the nation's economy to diversify.

METHODS OF PROTECTIONISM
Governments use a variety of tools to manage their countries' international
trade positions. One of the most important of these tools, the tariff, is a tax on
an import. It has the effect of making the item more expensive to consumers,
thereby reducing demand. For example, if it costs $1 to produce a widget in an
American factory and only $.75 in a foreign factory, the American factory will
have a difficult time staying competitive. If the U.S. government were to impose
a tariff of 60 percent, the cost to Americans would jump $.45 to $1.20 ($.75 x .6 =
$.45). If consumers base their purchases only on price, people would probably
buy the less expensive American widgets; by doing so, they would help the
U.S. widget industry to prosper.
However, if the tariff had not been imposed, Americans could have saved
money by purchasing the imported widgets for less than the cost of the
domestically produced widgets. Under a pure free trade policy, which would
not have tariffs, the U.S. widget industry would either have to change in order to
compete with the less expensive imported products or face extinction.
Tariffs do not have to push the price of a foreign import above the price of its
domestically produced counterpart to be effective. In the example above, a
tariff of 20 percent instead of 60 percent on the $.75 foreign product would
increase the price of the widget to $.90, but would not make the $1 American
product a less-expensive alternative. Such a tariff would have three effects,
though:
• it might reduce the consumption of the foreign product, simply by making it
more expensive and reducing the price difference between the foreign and
domestic products;
• domestic companies still would have to become more efficient and reduce
prices to compete, but they wouldn't have as far to go; and
• it could be used as a political bargaining chip during trade negotiations.
Tariffs usually are calculated in terms of a percentage of the value of the
imported goods, although sometimes a flat rate is charged (one dollar per item
or pound, for example).
Governments sometimes restrict sales of foreign goods by imposing import
quotas. These limit the quantity of a foreign good that can be imported annually
and help domestic producers by limiting the share of the market that can be
taken by foreigners. Sometimes governments negotiate voluntary restraint
agreements by which the exporting country agrees to limit voluntarily its
exports of a certain product. For example, in 1992, Japan began limiting its
auto exports to the United States to 1.65 million cars per year, a significant
decrease from the limits of previous years. It is important to note, however, that
sometimes sales may not even reach these limits.
These types of limits have problems of their own. The free market is not
allowed to function since the quantity of goods remains constant while the price
changes, instead of supply and demand influencing both price and quantity. In
addition, if the price of a restricted good rises, the exporting country profits; if a
tariff causes the price of a good to rise, it is the importing country's government
that gains revenue.
Another way to achieve the goals of protectionism is to make the domestic
industry more competitive, rather than limiting or taxing imports to make foreign
goods less competitive. This can be done through subsidies, which are
payments by the government to an industry. A direct subsidy is an outright
payment; indirect subsidies include special tax breaks or incentives, buying up
surplus goods, providing low-interest loans or guaranteeing private loans.
In addition to using tariffs and quotas to manage international trade,
governments sometimes ban trade with certain countries for political reasons––
during times of war or political crises––or ban imports of a certain product to
protect domestic industries. The Japanese government, for example, in order to
protect its rice industry from competition, allows almost no imported rice into
Japan.
The United States offers most-favored-nation (MFN) status to many of its
trading partners. MFN status assures a country that no other country will get
lower tariffs when exporting to the United States. Of course, this status can be
revoked at the discretion of the U.S. government.
Health, environmental and safety standards, which often vary from country to
country, can function as a form of protectionism. Forcing imported goods to
meet certain standards before they are allowed into the country can add to their
cost. For example, the United States has strict auto emission standards, which
foreign car manufacturers must meet to gain access to the U.S. market. Meeting
these standards can be expensive and adds to the cost of the imported car.
 INTERNATIONAL ORGANIZATIONS SEEK COOPERATION
ON TRADE ISSUES
As trade has become more and more important to nations' economic well-
being, countries have attempted to manage it to achieve greater wealth and
stability. International organizations have been formed to facilitate cooperation
on trade issues.
The General Agreement on Tariffs and Trade (GATT) is essentially a treaty
among many different nations to help manage global trade. Over 80 percent of
world trade occurs between GATT signatories. The basic principles of the
treaty are that:
• national origin of an import should not be a factor in considering trade
barriers;
• tariffs and not quotas should be used to protect domestic industries;
• countries should consult on trade matters; and • GATT meetings should
provide a forum to discuss trade issues and a legal instrument to codify
agreements.
Representatives from the countries that have signed the treaty meet
periodically at what are called "rounds" of GATT talks, to negotiate trade
agreements and settle disputes. Since World War II, the GATT has played a
major role in the reduction of obstacles to international trade.

Another organization, the International Monetary Fund (IMF), was founded

at the United Nations Monetary and Financial Conference at Bretton Woods in
1944. It was set up to promote monetary and exchange rate cooperation and to
facilitate international trade. The IMF provides assistance to nations suffering
from short-term financial problems. While a related organization, the World
Bank, loans only to poor countries in order to help them develop, the IMF
loans to any member country that needs foreign currency to meet its
obligations. This was especially useful when exchange rates were fixed,
because the IMF helped countries to avoid devaluing their currencies.
The Bank for International Settlements (BIS) in Basle, Switzerland,
functions as a bank for central banks, helping them invest their reserves in
financial markets all over the world. The BIS also provides a forum where
central bank officials from around the world meet to discuss financial and
economic issues. The Basle Committee on International Banking Supervision, a
committee of the BIS that consists of representatives of some of the world's
largest countries, meets to establish uniform financial and performance
guidelines for commercial banks around the world.
The Group of Seven, or G-7, consists of the leaders of the United States,
Germany, Japan, Great Britain, Canada, Italy and France, who meet semi-
annually to discuss a myriad of global economic issues. First held in 1975,
these economic "summit meetings" involve discussions on economic growth,
trade relations, aid to developing countries and foreign exchange markets.
While economic issues still dominate these meetings, discussions on
environmental issues and arms control have been included in recent years.
Another "G," the Group of Thirty (G-30), is a private, independent
organization dedicated to studying the international economy. Top financial
experts, economists and government officials from the 30 member nations
participate in smaller groups that address current issues in international
economics.
A major development in world trade was the formation of the European
Community, or EC, in 1957. The EC attempts to bind European nations
together into a common market, with no trade obstacles among member nations.
In 1990, European nations took a step toward complete financial and economic
unification. At a meeting in Maastricht, Holland, plans were made to form one
currency and one central bank for member nations by the year 2000.
Other nations have moved to build free-trade zones and common markets as
well. The United States, Canada and Mexico have very few trade barriers
between them. Many smaller "trade blocs" are developing all over the world, in
North Africa, Southeast Asia, different parts of Latin America, Eastern Europe
and the Middle East.
A possible problem is that competing trade blocs will adopt protectionist
policies and slow worldwide economic growth by restricting trade among
groups of nations. However, the rapid proliferation of trade blocs and free-trade
zones has occurred because many countries want the benefits of increased
trade that accompany lower trade barriers.
Over the past few decades, tariffs have been lowered, but non-tariff barriers
like voluntary restraint agreements and quotas have increased. The GATT
provides a multinational forum to deal with tariff issues, but other forms of
protectionism usually are negotiated between pairs of countries. In the future,
organizations may have to facilitate multinational negotiations to deal with non-
tariff trade restrictions.
Besides legal restrictions, sometimes there are less formal obstacles to
international trade. Cultural factors may play a significant role in the way
companies do business with foreigners. In some countries, it is common for
businesses to establish long-term relationships with one another. While this
practice tends to preserve the stability of the market, it also makes it difficult for
foreign companies entering the market to establish new business relationships.
In other countries, companies do business with whoever offers the best terms,
often changing business partners frequently. This practice strengthens
competition, but sometimes at the cost of more stable, mutually beneficial
business relationships.
ARGUMENTS FOR FREE TRADE
The debate about how free a trading system should be is an old one, with
positions and arguments evolving over time. Free-trade advocate Frederic
Bastiat presented the French Chamber of Deputies with a devastating satire of
protectionists' arguments in 1845. His petition asked that a law be passed
requiring people to shut all windows, doors, skylights and shades during the
day, so that the candle industry would be protected from the "unfair"
competition of the sun. He argued that this would be a great benefit to the
French candle industry, creating many new jobs and enriching suppliers.
While it is undoubtedly true that the candle industry would benefit from a lack
of sunlight, consumers would obviously not be happy about being forced to
pay for light that they could get for free were there no government intervention.
U.S. free-trade advocates typically argue that consumers benefit from freer
trade because foreign competition forces U.S. companies to keep prices low
and provides a greater selection of goods and services. Foreign trade also
forces U.S. companies to modernize plants, production techniques and
technology, which keeps them competitive.
Free-traders argue that imposing protectionist measures, like tariffs, often
brings about retaliation by foreign governments, which might seek to restrict
sales of U.S. products in their countries. This may increase both inflation and
unemployment, as U.S. export industries suffer and prices of imported goods
rise. The Smoot-Hawley Tariffs of 1930, which placed high tariffs on both
agricultural and manufactured imports, provoked a wave of retaliatory actions
by overseas trading partners of the United States. World trade dropped by more
than 60 percent, a reduction that deepened the Great Depression of the 1930s.
Another argument for free trade is that the costs of protectionism outweigh the
benefits. For example, suppose the United States placed a tariff on imported
wrenches that were less expensive than domestic wrenches. The tariff would
have four basic costs to the economy:
• wrench-buyers would have to pay more for their protected U.S.-made
wrenches than they would have for imported wrenches;
• jobs would be lost at retail and shipping companies that import foreign
wrenches;
• jobs would be lost in any domestic industries that suffer from retaliatory tariffs;
and
• the extra costs of the wrenches will be passed on to whatever goods and
services the wrenches are used on. For example, if these particular
wrenches are used to tighten bolts in a photocopy machine factory, the
prices of those machines will have to include the extra cost of the wrenches.
These costs must be weighed against the number of jobs that the tariff would
save.
Finally, an open trading system may create a better climate for investment
and entrepreneurship than one in which the fear of governments cutting off
access to markets is present.
MEASURES OF TRADE
In order to examine a country's position in international trade, it is useful to
consult two of the most frequently used statistics, the balance of trade and the
balance of payments. When you hear on the news about the U.S. "trade
balance," what you are usually hearing about is the merchandise trade
balance, which is the difference between a nation's exports and imports of
merchandise. A "favorable" merchandise balance of trade, or trade surplus,
occurs when a country's exports exceed its imports. A "negative" balance of
trade, or trade deficit, occurs when a country's imports exceed its exports.
From the mid-1970s, throughout the 1980s and into the 1990s, the United
States has run persistent trade deficits. Economists disagree as to the effects
this has had on the economy, but it is certain that these deficits allowed
foreigners to accumulate U.S. dollars earned in payment for products that
Americans imported. Many of these dollars were then used to purchase U.S.
goods, services and assets, such as real estate and companies.
 The balance of trade, however, is not the whole picture; it includes only
purchases and sales of merchandise. The complete summary of all economic
transactions between a country and the rest of the world––involving transfers
of merchandise, services, financial assets and tourism––is called the balance
of payments.
Simply, any transaction that results in money flowing into the country is a
balance of payments credit, and anything that draws money out of the country
is a balance of payments debit.
Balance of payments deficits, where the amount of money leaving the country
is greater than the amount flowing in, need to be financed; extra money has to
come from somewhere. Usually, payments deficits are financed by borrowing
money from overseas.
The balance of payments for a country is separated into two main accounts:
the current account and the capital account. The current account records
sales and purchases of goods, services and interest payments. The entire
merchandise trade balance is contained in the current account. The capital
account deals with investment items, like whole companies, stocks, bonds,
bank accounts, real estate and factories. Thus, if you bought a parachute from
a factory in Germany, your purchase would be recorded in the current
account. But if you bought the entire parachute factory, your purchase would
be in the capital account.
The balance of payments is influenced by many factors, including the
financial and economic climate of other countries. For example, if other
countries want the services of U.S. doctors, bankers, lawyers, accountants,
engineers, entertainers and other service-providers, that demand will play a
significant role in the U.S. balance of payments. Large amounts of money flow
between nations in payment for such services, even if no merchandise is
exchanged. In 1991, service exports accounted for over one-quarter of total
U.S. exports. Financial conditions also have an effect. If U.S. banks are offering
higher interest rates for deposits than banks abroad, foreign deposits will flow to
the United States, which improves the U.S. capital account. Conversely, if
interest rates are higher abroad, U.S. investors might choose to invest their
money in other countries. This would weaken the U.S. capital account.

STATISTICS CAN HAVE DIFFERENT INTERPRETATIONS

Whether it was the tariffs imposed by the North that were a prelude to the U.S.
Civil War, the Smoot-Hawley tariffs that contributed to the Great Depression, or
the international trade disputes we face today, conflicts over trade issues have
played an important role in history.
Trade statistics are often used to support arguments in these conflicts.
However, trade statistics, like all statistics, sometimes can be misleading. By
themselves, statistics don't mean much at all; their interpretation depends on
the questions that are being asked. The U.S. trade deficit, for example, has at
different times been viewed as bad, good, irrelevant, overstated, understated
and illusory. To a company that exports goods to the United States, the deficit
may be viewed as a sign of a healthy U.S. market. To a U.S. trade union, the
deficit may be viewed as a sign that companies in the United States are having
difficulty competing in world markets.
 It is important to know something about the data that is being gathered in order
to draw conclusions from them. In a global economy that is measured in trillions
of dollars, not every transaction is going to be reported accurately. Statistics for
many types of transactions rely heavily on estimates made by statisticians, and
even the best estimates are sometimes incorrect. This can produce a skewed
measurement of what is actually taking place in the economy.
Each month, U.S. importers file over one million tax documents with the U.S.
Customs Service describing the type and value of imported goods. These
reports are processed and tabulated to determine the overall level of U.S.
imports. Inaccurate reports, delays in processing data and smuggling can
affect their validity.
There is no U.S. tax on exports, so to collect information, the U.S. Department
of Commerce developed a form called the Shippers' Export Declaration (SED)
form, which exporters fill out when they send goods overseas. These forms are
tallied to arrive at export totals.
The Bretton Woods Agreements Act of 1945 requires the publication of
complete balance of payments information, and statistics are generally reliable.
However, the collection process is often difficult; for example, data on travel,
services, direct foreign investment and financial transactions is gathered
largely through quarterly or annual mail surveys, many of which are only
voluntary.
Sometimes, even classifying goods as imports or exports can be difficult. For
example, trade usually is tabulated on the basis of national origin rather than
national ownership. If a product is shipped from the United States to Germany, it
is considered to be a U.S. export and a German import. It makes no difference
whether a foreign company owns the U.S. factory that produced the item, or if it
is a U.S. company in Germany that buys it. Conversely, if a U.S. company has a
plant in Brazil and sells a product to a Japanese company in Great Britain, the
transaction is recorded as a British import and a Brazilian export.
It is often also difficult to assign a value to goods. To compare the exports of
two countries in a given year, it is necessary to convert the figures into the
same currency. However, the exchange rate may distort the significance of the
numbers. It may appear that one country is exporting more goods than another,
when, in fact, the difference can be attributed to variations in exchange rates,
not to the quantity or quality of exports. In addition, real estate values must be
adjusted to current market prices, equipment must be depreciated with age,
and inflation must be taken into account. If these and many other factors are not
considered, the value of an import or export might be misleading.
For example, at first glance it would appear that Germany's exports leaped
dramatically from $269 billion in 1989 to $346 billion in 1990––nearly a 30
percent increase. Do these figures indicate a weakening of the German mark
on foreign exchange markets? A new free-trade agreement? Neither one––after
East and West Germany were reunited, East German exports were added into
the German total, which made total exports seem significantly larger than they
would have been otherwise.
Changes in trade statistics do not necessarily signify changes in a nation's
trade patterns; the changes may be merely a result of putting data together in
new ways.
 FOREIGN CURRENCY EXCHANGE

In order to buy foreign products or services, or to invest in other countries,

companies and individuals may first have to buy the currency of the country
with which they are doing business. Generally, exporters prefer to be paid for
their goods and services either in their own currency (Japanese in yen and
Germans in marks, for example) or in U.S. dollars, which are accepted all over
the world. For example, when the French buy oil from Saudi Arabia, they may
pay in U.S. dollars, not French francs or Saudi dinars, even though the United
States is not involved in the transaction. The foreign exchange market, or
"FX" market, is where the buying and selling of different currencies takes
place. The price of one currency in terms of another country's currency is
called an exchange rate.
The market itself is actually a worldwide network of traders, connected by
telephone lines and computer screens––there is no central headquarters. The
three major centers of trading, which handle more than half of all FX
transactions, are Great Britain, the United States and Japan. Transactions in
Singapore, Switzerland, Hong Kong, Germany, France and Australia account
for most of the rest of the market. Trading goes on 24 hours a day; at 8 a.m. in
London, the trading day is ending in Tokyo, Singapore and Hong Kong. At 1
p.m. in London, the New York market opens for business. In the afternoon,
traders in San Francisco can do business with their colleagues in the Far East.
The FX market is fast paced, volatile and enormous––in fact, it is the largest
market in the world. In 1992, an estimated $880 billion was traded every day––
roughly equivalent to every person in the world trading $176 each day.

MARKET PARTICIPANTS
Of course, not everyone in the world participates in the foreign exchange
market. There are four types of market participants––banks, brokers, customers
and central banks.
 • Banks and other financial institutions are the
biggest participants. They earn profits by
buying currencies from, and selling
currencies to, customers and to each other.
Roughly two-thirds of FX transactions
involve banks dealing directly with each
other.
• Brokers act as intermediaries between
banks. Dealers sometimes call them to find
out where they can get the best prices for
their currencies. Dealing through brokers
has the added advantage of anonymity;
sometimes banks wish to keep their FX
transactions confidential, and by dealing
through a broker, this can be easily done.
Brokers earn profits by charging
commissions on the transactions they
arrange.

• Customers are market participants, mostly large companies, who require

foreign currency in the course of doing business or making investments.
Companies with large foreign exchange needs will sometimes have their own
trading desks to manage their currencies. This category also includes
individuals, who may need foreign currency for tourism or purchases abroad.
• Central banks, which act on behalf of their governments, sometimes
participate in the FX market to influence the value of their currencies.
With almost a trillion dollars changing hands every day, the activity of these
participants greatly affects the value of every dollar, pound, yen, mark or
guilder in our pockets.
The players in the foreign exchange market participate for a variety of
reasons: to make short-term profits from fluctuations in exchange rates, to
protect themselves from loss due to changes in exchange rates, and to acquire
the foreign currency necessary to buy goods and services from other
countries.

FOREIGN EXCHANGE RATES

Many people's contact with the world of foreign exchange is limited to
changing money for use when traveling in, or buying things from, other
countries. Suppose a U.S. tourist traveling in France wants to buy a sweater.
The price tag says 500 francs. Before going shopping, the tourist visits a bank
and converts, or exchanges, U.S. dollars for French francs. At the bank, he is
told the exchange rate at the time is 5.5 francs to $1. The tourist determines that
the 500 franc cost of the sweater is the equivalent of paying $90.91.
 However, exchange rates can
change at any time, so whenever we
engage in FX transactions, we take a
risk. There's always a chance that our
purchases could actually be less
expensive––or, unhappily, more
expensive––if we wait to buy them. For
example, if the exchange rate changes
from 5.5 to 5.6 on the next day (a huge
change by market standards) the 500
franc sweater will cost the tourist only
$89.29 instead of $90.91. The franc is
said to have "fallen" or lost value
against the dollar, because $1 will buy
more francs than before. The dollar is
said to have "risen" against the franc.

However, if the rate is 5.4, the franc is said to be stronger, or to have "risen"
against the dollar, while the dollar has "weakened" against the franc. At 5.4, $1
will buy fewer francs, and our tourist's sweater will cost $92.60. These price
changes may not seem very significant, but when billions of dollars are
involved, even a hundredth of a percentage point change in the exchange rate
becomes important.
What effects do exchange rate fluctuations have on a country and the world
economy? If one currency can buy an increasing amount of another currency
it is said to be "strong." However, just because a currency is strong does not
mean that everyone in that country is better off. A stronger dollar means that
Americans can buy foreign goods more cheaply, but foreigners will find U.S.
goods more expensive. If you work in a company that relies on the sale of
exports, a stronger dollar probably is not going to help your firm's business. The
goods you produce will be more expensive to foreigners, who therefore may
not buy as many. If you are an importer, by contrast, your cost of purchasing
foreign goods will drop.
Therefore, it would be logical to assume that if the dollar were weaker, the
U.S. trade balance would improve, as foreigners bought more American goods.
However, after the dollar depreciates, the U.S. trade balance usually worsens
for a few months. A phenomenon called the J-curve explains why: most
import/export orders are taken months in advance. Just after a currency’s value
drops, the volume of imports remains about the same, but the price of the
ordered imports rises in terms of the home nation's currency. In the meantime,
the value of domestically produced exports tends to remain constant. The
difference in value worsens the country's trade balance, until the volumes of
imports and exports fully adjust to the new exchange rate.
Exchange rates also are a very important factor to consider when making
international investment decisions. Just as our tourist's sweater may increase
or decrease in price based on changes in exchange rates, money invested
overseas incurs the same risk. When the investor decides to "cash out," or
bring his money back home, any gains could be magnified or wiped out,
depending on the changes in exchange rates. Companies that do a great deal
of international business must watch exchange rates carefully to try to protect
and increase their profits.

In short, changes in foreign exchange rates affect prices of imported goods

and the overall level of price and wage inflation in an economy. Tourism
patterns may change depending on where currencies can buy the most.
Confidence in a currency's strength also may encourage consumers to buy
and investors to make long-term commitments.

DETERMINATION OF FOREIGN EXCHANGE RATES

Exchange rates respond quickly to all sorts of events, both tangible and
psychological: business cycles, balance of payments statistics, political
developments, new tax laws, stock market news, expectations for inflation,
international investment patterns, government and central bank policies, and
many other things.
At the heart of all this complexity, though, are the same forces of supply and
demand that determine the prices of goods and services in any free market. If,
at current exchange rates, the demand for a currency is greater than the
supply, its price tends to rise; if supply exceeds demand, the price tends to fall.
 The supply of a given currency is heavily influenced by the country's
monetary authorities (usually the country's central bank), consistent with the
amount of spending taking place in the economy. Governments and central
banks must closely monitor economic activity to keep the money supply at a
level appropriate to achieve their economic goals. Too much money in the
economy can lead to inflation, with the value of money declining and prices
rising; too little money can lead to sluggish economic growth and rising
unemployment. Monetary authorities must decide whether economic conditions
call for a larger or smaller supply of money.
The condition of a country's economy plays a big role in the demand for its
currency on the FX market. The currency of a country with a growing
economy, relative price stability and a wide variety of competitive goods and
services for sale would be more in demand than that of a country in political
turmoil, with high inflation and only a few marketable exports.
But it is not only the demand for a nation's tangible goods that influences
exchange rates. Money will flow to wherever it can get the highest return with
the least risk. If a nation's financial instruments, such as stocks and bonds, offer
high rates of return at relatively low risks, foreigners may buy currency to
invest in them. In addition, FX traders' speculation within the market about the
likelihood of different events will also move exchange rates. For example:
• News of political instability in different parts of the world often causes the U.S.
dollar to rise as investors buy dollars, seeking a "safe haven" for their money
in the world's largest economy.
• A country's interest rates rise and its currency appreciates, as foreign
investors seek a higher return than they can get in their own countries.
• A developing nation implements a low-inflation program of economic growth
widely believed to have good prospects for success; its currency rises as
 foreign investors seek new opportunities. However, if the government is
suddenly replaced and economic plans are changed radically, the
currency's value in foreign exchange markets may plummet as foreigners
seek to withdraw their money.

FOREIGN CURRENCY TRADING

"Yoshi, it's Maria in New York. May I have a price on twenty cable?"

"Sure. One seventy-five, twenty-thirty."

"Mine twenty."

"All right. At 1.7530, I sell you twenty million pounds."

"Done."

"What do you think about the Swiss franc? It's up 100 pips."

"I saw that. A few German banks have been buying steadily all day..."

"Yoshi, it's Maria in New York. I am interested in either buying or selling 20

million British pounds."

"Sure. I will buy them from you at 1.7520 dollars to each pound or sell them to
you at 1.7530 dollars to each pound."

"I'd like to buy them from you at 1.7530 dollars to each pound."

"All right. I sell you 20 million pounds at 1.7530 dollars per pound."

"The deal is confirmed at 1.7530."

"Is there any information you can share with me about the fact that the Swiss
franc has risen one-one hundredth of a franc against the U.S. dollar in the past
hour?"

"Yes, German banks have been buying Swiss francs all day, causing the
price to rise a little..."

Conversations like this one occur thousands of times every day in the foreign
exchange market, as traders buy and sell currencies, talk about the markets
and exchange information. Of the estimated $880 billion that is traded every
day, less than 20 percent is traded for the import and export needs of
companies and individuals or for direct foreign investment. The majority of
trading is done to try to profit from short term fluctuations in exchange rates, to
manage existing positions or to purchase foreign financial instruments.
 In the volatile FX market, traders constantly try to predict the behavior of
other market participants. If they can correctly anticipate other traders'
strategies, they can act first and beat the competition. FX traders make money
for their firms by buying currency and selling it later at a higher price, or,
anticipating that the market is heading down, by selling at a high price first and
buying back at a lower price later. If a trader purchases a lot of a currency, he
is said to be long that currency (long dollars, long yen, etc.); conversely, if a
trader sells a currency, he is said to be short (short sterling, short francs, etc.).
In order to predict movements in exchange rates, traders often try to
determine if a particular currency's price reflects a realistic value in terms of
current economic conditions. Analysts attempt to determine a currency's actual
value by examining inflation, interest rates and the relative strength of the
country's economy. They assume that the price will move up if the currency is
under priced, and down if overpriced.

TRADING BETWEEN BANKS

Many banks are major forces in the FX market and employ large numbers of
traders. Trading between banks is done in two ways. If a U.S. bank trades with
another bank, a foreign exchange broker is sometimes used as an intermediary.
The broker arranges the transaction, matching buyer with seller without ever
taking a position. The brokerage firm receives a commission for its services,
half of which is paid by the buyer and half by the seller. About one-third of FX
transactions are arranged in this manner.
Most of the time, banks deal directly with each other. The fictional dialogue at
the start of this section is an example of direct dealing. Yoshi "makes a market"
for Maria by quoting her a two-way price. This means that Yoshi's firm
provides prices for both buying and selling and is prepared to do either one.
For most currencies, the difference in the two price quotes (the spread) is
usually no more than 10 pips, or hundredths of a currency unit.
Most prices of currencies are quoted by saying how many units of that
currency would equal $1. However, the British pound, New Zealand dollar,
Australian dollar, Irish punt and European Currency Unit (ECU) are all quoted
in terms of how many dollars would equal one unit of foreign currency.
The currencies of the world's large, industrial economies, or hard
currencies, are always in demand and are traded actively. In terms of volume,
trading in the foreign exchange market is dominated by four currencies: the U.S.
dollar, the German mark, the Japanese yen and the British pound. Together,
they account for approximately 80 percent of market activity.
However, it is not always easy to find markets for all currencies. There is a lot
less demand for the currencies of less-developed countries (soft
currencies). This lack of demand along with exchange controls may make
these currencies very difficult to convert.
TYPES OF TRANSACTIONS
The most common type of transaction (comprising almost half of the foreign
exchange market) is called a spot transaction. The spot market is the heart of
the foreign currency market. Two parties agree on an exchange rate and one
sells the other a certain amount of currency. Here's how it's done: A trader will
call a trader from another company and ask for the price of a currency, say,
British pounds. This expresses only a potential interest in dealing, without the
caller saying whether he or she wants to buy or sell at that point. The other
trader provides the first trader with prices for both buying and selling (a two-
way price). If the traders agree to do business, one trader will send pounds and
the other will send dollars. By convention, payment actually is made two days
later, but next day settlements are used as well.
Although spot transactions are the most common FX transaction, they leave
the currency buyer exposed to some potentially dangerous financial risks. Our
earlier example of a tourist in France demonstrated how exchange rate
fluctuations can effectively raise or lower prices. This can be a financial
planning nightmare for companies and individuals. For example, suppose a
U.S. company orders machine tools from a company in Switzerland. The tools
will be ready in six months and will cost 15 million Swiss francs. At the time of
the order, Swiss francs are trading at 1.5 to the dollar, so the U.S. company
budgets for $10 million in Swiss francs to be paid when they receive the tools
(that is 15,000,000 francs ÷ 1.5 francs per dollar = $10,000,000).
Of course, there is no guarantee that the exchange rate will still be at 1.5 in
six months. If the rate drops to 1.4 francs to the dollar, the cost of the tools in
dollars would increase from $10 million to $10,714,285 (15,000,000 Swiss
francs ÷ 1.4 francs to the dollar = $10.714,285). The U.S. company would lose
over $700,000 because of a change in exchange rates.

One alternative for the company

would be to pay the Swiss right away,
when they know what the exchange
rate is. Still, no one wants to part with
money any sooner than necessary––if
the company does pay in advance, it
loses six months worth of interest and
risks losing out on a favorable change
in exchange rates. Thus, businesses
demand foreign currency services to
minimize the effects of the market's
unpredictability.
A common tool to deal with FX risk is to engage in a forward transaction.
This differs from a spot transaction in that the money does not actually change
hands until some agreed-upon future date. A buyer and a seller agree on an
exchange rate for any date in the future and the transaction occurs when the
date arrives, regardless of what the market rates are then. Forward transactions
can be arranged for a few days, months or even years in the future.
Foreign currency futures are forward transactions with standard contract
sizes and maturity dates; for example, 500,000 German marks for next May, or
50 million yen for next November. These contracts are traded on a separate
exchange set up for that purpose.
In both forward and futures transactions, market rates might change, but if the
rates improve for either the buyer or the seller, they still are locked into a
contract at a fixed price. These tools allow market participants to plan more
safely, since they know in advance what the foreign currency will cost. It also
allows them to avoid an immediate outlay of cash. The prices of currencies in
these markets are strongly influenced by the differences in interest rates
between countries.
The most common type of forward transaction is the currency swap. In a
swap, two parties exchange currencies for a certain length of time and agree to
reverse the transaction at a later date. For example, if a U.S. company needs
15 million Japanese yen for a three-month investment in Japan, it might agree
upon a rate of 150 yen to the dollar, and swap $100,000 with a company willing
to swap 15 million yen for three months. At the end of three months, the U.S.
company returns the 15 million yen to the other company and gets its $100,000
back, with adjustments made for interest rate differentials. Since the agreed-
upon rate of 150 does not change, neither company has to deal with the risk of
the rates changing. Once again, though, while neither company needs to
worry about losing money if the rates change, they will not make any money
from a change in rates either.
To address this lack of flexibility, the foreign currency option was developed.
For a price, a market participant can buy the right, but not the obligation, to buy
or sell a currency at a fixed price on or before an agreed-upon future date. This
is similar to a forward transaction, except that the owner of the option does not
have to buy or sell the currency when the date arrives. The option will be
exercised only if market conditions are favorable to the buyer. This allows
much more flexibility than a swap or forward contract, because the owner of the
option can choose between the option rate or current market rates, whichever
is better. An option to buy currency is known as a call, while an option to sell is
known as a put. The agreed upon price is the strike price.
For example, if a trader purchases a six-month call on one million German
marks at 1.65 marks to the dollar, this means that at any time during the six
months the trader can either purchase the marks at 1.65, or purchase them at
the market rate. Options––which can be sold and resold many times before
their expiration date––serve as an insurance policy against the market moving
in an unfavorable direction.
 FLOATING AND FIXED EXCHANGE RATES

The FX market was not always so volatile or quick

to respond to changing events. Today's FX rates
float; they fluctuate according to market value.
However, for most of the 20th century, currency
rates were fixed, or kept at the same level,
according to the amount of gold they could be
exchanged for; they did not change according to
market pressures. This system was called, aptly
enough, the gold-exchange standard. For
example, if one ounce of gold was worth 12 British
pounds or 35 U.S. dollars, the exchange rate
between the dollar and the pound would remain
constant at just under three to one.

In addition to serving as a common measure of value, the gold-exchange

standard helped to keep inflation under control by keeping the money supplies
in the gold-exchange standard economies relatively stable. And, of course,
long-range planning was much easier because exchange rates changed
infrequently.
The gold-exchange standard should not be confused with the gold standard.
The gold standard refers to the system by which U.S. households and
businesses could exchange their dollars for gold. This practice was terminated
in 1933 during the Great Depression, in large part to allow freer expansion of
the money supply. However, foreign governments still were able to exchange
their dollars for gold until 1971 when the United States abandoned the gold-
exchange standard.
This change marked the end of the "Bretton Woods" international economic
system, which had been effective since 1944 when leaders of allied nations
met at Bretton Woods, New Hampshire, to set up a stable economic structure
out of the chaos of World War II. The U.S. dollar was fixed at $35 per ounce of
gold and all other currencies were expressed in terms of dollars.

BEGINNING OF FLOATING EXCHANGE RATES

The Bretton Woods system began to weaken in the 1960s, when Americans
sharply increased their consumption of imported goods. As foreigners
accumulated large amounts of U.S. dollars from sales of exports to the United
States, these exporting countries began to express concern that the United
States did not have enough gold to redeem all of the dollars held overseas. A
look at some data shows why. In 1950, U.S. gold reserves were about $23
billion and the amount of dollars being held by foreign countries was $8 billion.
However, by 1970, gold reserves had fallen to only $11 billion and dollars held
by foreigners stood at $47 billion.
 Clearly, if all the countries that held dollars chose to exchange them, the
United States would quickly run out of gold. This situation could not be
sustained, and in 1971, President Nixon announced that U.S. dollars would no
longer be convertible into gold. By 1973, this action led to the system of
"floating" exchange rates that exists today, where currencies rise and fall in
value according to forces of supply and demand. After the abandonment of the
gold-exchange standard, the foreign exchange market quickly went from a
relatively unimportant financial specialty to the forefront of international
economics.
 THE ROLE OF CENTRAL BANKS

Despite the size and importance of the foreign exchange market, it remains
largely unregulated. There is no international organization that supervises it,
nor any institution that sets rules. However, since the advent of flexible
exchange rates in 1973, governments and central banks, such as the Federal
Reserve System in the United States, periodically act to maintain stability in
the FX market.
There is no standard definition of instability or a disorderly market––
circumstances must be evaluated on a case-by-case basis. Sharp, rapid
fluctuations of exchange rates and traders' reluctance to be ready to either buy
or sell currencies (maintaining a "two-way" market) may be signs of a
disorderly market. In these cases, central banks often work together to restore
stability. However, a country taking a very conservative view toward market
intervention would act only in response to unusual circumstances that require
immediate action, like political unrest or natural disasters. The monetary
authorities would be less likely to try to counteract the usual fundamental
factors that drive exchange rates, such as trade patterns, interest rate
differentials and capital flows.
INTERVENTION
The U.S. Treasury, which has overall responsibility for managing the U.S.
government's foreign currency holdings, works closely with the Federal
Reserve to regulate the dollar's position in the FX markets. If the monetary
authorities decide that it would be desirable to strengthen or weaken the dollar
against a particular currency, instructions are given to the Federal Reserve
Bank of New York, which intervenes in the FX market as agent for the U.S.
monetary authorities. The Federal Reserve Bank of New York buys dollars and
sells foreign currency to support the value of U.S. dollars, or sells dollars and
buys foreign currency to try to exert downward pressure on the price of the
dollar. Most of the transactions the Fed engages in involve the exchange of
dollars for either German marks or Japanese yen, the most frequently used
currencies in international transactions.
Central banks in other countries have similar concerns about their own
currencies and sometimes intervene in the FX market as well. Usually,
intervention operations are undertaken in coordination with other central
banks. The amount of intervention, from tens of millions to a few billion dollars,
is not a great deal in a market whose size sometimes exceeds $1 trillion per
day. The actual purchase or sale of currency by a central bank has the same
impact on the supply or demand for currency as the actions of any other market
participant. However, the actions of central banks send strong signals to other
market participants about what the country's monetary authorities think about
the value of the currency; the resulting expectation that the country's economic
policy will move in a certain direction can influence trading.
Most of the Federal Reserve Bank of New York's activity in the foreign
exchange market is undertaken for far less dramatic purposes than to influence
exchange rates. The Bank often deals in the foreign exchange market as an
agent for other central banks and international organizations to execute
transactions related to flows of international capital.
Some countries have special arrangements with other countries to help keep
their currencies stable. Many less-developed nations have their soft
currencies pegged to hard currencies, which means their value rises and falls
simultaneously with the stronger currency. Some peg their currencies to a
basket of hard currencies, the average of a group of selected currencies.
Those countries that choose to tie their currency to a single currency usually
use the U.S. dollar or the French franc. Some European countries are part of an
agreement called the European Monetary System (EMS), which requires
them to keep their currencies within a certain price range. When currencies
move too high or too low relative to other currencies in the EMS, central banks
act to try to keep the currency within the range.
Intervention in the FX market is not the only way monetary authorities can
affect the value of their country's currency. Central banks also can affect
foreign exchange rates indirectly by influencing their countries' interest rates.
Relatively high interest rates tend to push the price of a currency up because
investors may want to buy the currency to invest at the higher rates. If
Germany's interest rates rise to eight percent while those of the United States
are at three percent, demand for the German mark will be stimulated. A
reduction in interest rates would lessen demand for the currency and its price
would tend to fall. In addition, if a central bank's policies are viewed by the
market as promoting stable growth without inflation, the currency will be viewed
as a safe investment, and demand for it will increase.

CONCERNS ABOUT EUROCURRENCY

An important side effect of the increase of international economic activity over
the past few decades has been the creation and growth of the Eurocurrency
market. Eurocurrencies are the name given to any bank deposits in any
country held in a different country's currency, like U.S. dollars in a British bank,
or French francs in a bank in Germany. These deposits are most often put there
by other banks. Actually, "Eurocurrency" is a misnomer, because the term has
come to include activity outside Europe, such as U.S. dollars held in a bank in
South east Asia. A great deal of foreign exchange market activity involves the
transfer of Eurocurrency deposits.
Eurocurrency, particularly Eurodollars (approximately two-thirds of
Eurocurrency are U.S. dollars), are a source of concern to central banks and
regulators because they are "stateless money"––subject to very little
regulation. This means that many of a country's rules governing its currency
and bank deposits, such as taxes, restrictions on capital movement and
exchange controls, do not apply to the currency in the Eurocurrency markets.
As a result, banks around the world use the Eurocurrency market to move and
store funds more profitably than they could in many countries. This might pose
problems for countries attempting to regulate capital flows.
International trade and foreign exchange cannot be viewed as two separate
economic processes. They are intimately connected on many different levels.
Increased international trade and investment helped to bring the FX market to
its present size; in turn, what happens on the FX market has a significant
influence on trade and investment patterns. Together, trade and foreign
exchange affect peoples' living standards and livelihoods all over the world.
 WORKING ACROSS BORDERS

Many large companies are "international" in that they have branches and
subsidiaries overseas; by some estimates, intra-firm trade, or trade between
branches of the same company in different countries, accounts for an
astonishing 40 percent of U.S. exports. Many more companies buy and sell
goods all over the world. Companies frequently form partnerships with
companies in other countries so that cooperation sometimes replaces
competition. This has had a profound impact on the way companies operate in
the global marketplace. Instead of merely exchanging goods and services with
other countries, businesses around the world now work side-by-side to
produce and market products. This is partially because it is often difficult for a
single company to bear the economic risks of global production and marketing.

For example, a running shoe

company headquartered in the United
States might be financed by a
Japanese bank, buy rubber from
Indonesia and leather from Spain,
and do its manufacturing in Mexico.
The legal and accounting work might
be handled by Americans, while a
British company might do the
advertising and marketing. The
running shoes might be sold in many
countries all over the world. As a
result, such companies will often shift
resources from country to country to
maximize profits and productivity.

Now, if the final product is shipped to Indonesia from San Francisco, it will be
recorded, simply, as a U.S. export and an Indonesian import. However, if the
Indonesians apply a high tariff to the running shoes, they might harm more than
just the U.S. exporters; all the businesses around the world that were involved
in the process, including the Indonesian rubber manufacturers, might lose
business. With more and more companies operating internationally, it is
increasingly difficult for governments to target trade policies effectively.
These changes also mean changes in the ways people prepare for careers.
Now more than ever, as economic ties between countries grow and strengthen,
it has become very important to a nation's competitiveness to have a workforce
that is able to deal with different languages and cultures. Varied business
practices in different countries require new approaches to making profits.
Doing business in different countries sometimes can be frustrating; practices
that are considered standard procedure in some places may be outrageous in
others. In the United States, a signed contract is considered all but sacrosanct;
in the Far East, Southern Europe and the Middle East, the spirit of the
agreement sometimes can matter more than the letter. The "get down to
business" approach that Americans and Germans usually favor in business
negotiations may be considered brusque or harsh in Japan or Korea. Even the
small details of business behavior––whether or not to look someone in the eye,
tone of voice, the exchange of gifts––vary significantly from country to country.
To remain competitive, individuals, companies, and governments all must
adapt to the changing global marketplace.
 TEACHER'S GUIDE

The Basics of Foreign Trade and Exchange is intended to give students of

economics, business and political science a general overview of international
trade and the foreign currency markets. Its principal educational objectives
include:

• demonstrating the importance of international trade;

• showing how international trade helps both the exporter and the importer;
• presenting the issues in the debate over free trade and protectionism;
• introducing students to the concept of foreign exchange and discussing its
importance to individuals, businesses and the performance of national
economies;
• demonstrating how foreign exchange markets work.

Reading Basics will give students a comprehensive overview of the theory

and practice of international trade and the issues arising from the globalization
of markets and of our lives.
The outline below will help educators use Basics more effectively. In it, you
will find a brief summary of each of the book's sections, several topical
questions and suggested student activities to stimulate further study and
classroom discussion.
 WHY NATIONS TRADE

Trade occurs because people want or need to buy goods and services that
are available from other countries. Perhaps the foreign goods are less
expensive or of higher quality than similar domestic products; perhaps they're
unique and simply not available from domestic sources; or maybe buyers
simply prefer them.

DISCUSSION QUESTIONS

1. Indicate the country of origin of three items in your house.

a. Why did you buy each item?

b. Could you have purchased similar items from a different country? Why
didn't you?

2. Name five items (other than food) in your home that you believe were made
in the United States without any foreign input. Why are such goods becoming
more and more difficult to find?

THE LAW OF COMPARATIVE ADVANTAGE

According to the Law of Comparative Advantage, a country maximizes its
wealth when its resources go into its most productive industries, even if other
nations are more productive in those industries. Yet there are benefits to having
a diverse economy; a country that relies on a single good or service too
heavily risks economic chaos if demand for that good or service drops
suddenly.

DISCUSSION QUESTIONS

1. Which industries and regions would be helped or hurt the most if the United
States truly applied the principle of comparative advantage?

COMPETITIVENESS
Competitiveness refers to a country's ability to produce and market goods
and services that people want to buy. Strong competitiveness typically leads to
job creation and economic growth, while weak competitiveness could result in
fewer jobs and slower economic growth. Nations with advantages such as a
high-quality workforce, a well-developed infrastructure or abundant natural
resources are better able to produce desired goods and services efficiently.

DISCUSSION QUESTIONS

1. Although Canada and the United States have similar cultures, demographics
and a common border, U.S. industry has been generally more competitive
than Canadian industry in global markets. How do you explain this
difference?
2. What steps could business and government take to make the United States
more competitive? Why do you think these steps have not been taken?
 FREE TRADE AND PROTECTIONISM

Despite its many benefits, trade can pose serious short-term and long-term
challenges to a country's economic health. Foreign competition helps to keep
prices low, but it can also lead to lower profits and unemployment in
uncompetitive industries. As a result, some companies and industries try to get
their governments to protect them from foreign competition. All countries
practice some protectionism, but the practice is often highly controversial,
pitting the interests of households, businesses and governments against on
another.

DISCUSSION QUESTIONS

1. If the United States completely stopped importing, what do you think would
happen to the economy? What types of businesses and individuals would be
helped or hurt? What would happen if the United States stopped exporting?

ARGUMENTS FOR PROTECTIONISM

• Protectionism saves jobs.
• Some countries have an unfair advantage because their labor costs are
much lower.
• New industries must be protected from competition until they are strong
enough to compete internationally.
• Industries important to national security should be protected so that the
country does not have to rely on outside sources for supplies during war.

METHODS OF PROTECTIONISM
Each of the various tools that countries use to restrict and regulate foreign
trade—such as tariffs and quotas—has its own advantages and disadvantages,
and each affects economic growth and employment in different ways.

DISCUSSION QUESTIONS

1. Try to make a case in favor of government protection of an industry in which

one of your relatives works. What impact would protection in other industries
have on your industry?

2. List the costs and benefits of unrestricted free trade. Which U.S. industries
might favor free trade? Which would oppose it? Why?
ARGUMENTS FOR FREE TRADE
• Free trade provides consumers with a wide variety of goods and services,
sometimes less expensively than would be available under a restricted
trading system.
• Competition that is brought about by free trade helps keep companies
modern and competitive.
• The costs of protectionism outweigh the benefits.

DISCUSSION QUESTIONS

1. You are the president of a U.S. company that makes tape recorders and pays
its workers $10 per hour. A rival company based in Southeast Asia pays its
workers only 60 cents per hour. Its less expensive tape recorders are
shipped to the United States and are attracting all your customers. What can
you do, or try to do, to keep your customers?

2. Countries sometimes enter into economic agreements such as trade blocs in

order to minimize trade-related problems. What would be the advantages and
disadvantages of a trade bloc which included the United States, Canada
and Mexico?

MEASURES OF TRADE
A variety of statistics are used to measure the flows of goods, services and
financial assets between countries. These statistics show which countries are
importing more than exporting, where money is being invested and many other
useful things.
The balance of trade (often reported on the news) measures the difference
between a country's imports and exports of merchandise. The balance of
payments reflects the complete summary of economic transactions between a
country and the rest of the world, including merchandise, raw materials,
financial transactions, tourism and foreign aid. in turn, the balance of payments
statistics are divided into the current account and the capital account, which
separate investment from consumption and interest payments,

DISCUSSION QUESTIONS

1. What are the long-term consequences of a persistent trade deficit?

2. Why can't we conclude that a widening trade deficit is necessarily bad for
the country?
 FOREIGN CURRENCY EXCHANGE

The foreign currency market is the largest market in the world. In order to
engage in trade with other nations, companies and individuals may first have to
buy the currency of the country with which they are doing business. This is
done in the foreign exchange (FX) market, a worldwide network of banks and
brokers where individuals, companies and governments go to buy and sell
currency. The four types of participants in the foreign exchange market are
banks, brokers, customers and central banks. The price of one currency in
terms of another is called the exchange rate. Changes in exchange rates will
result in changes in the costs of imports and exports. If, for example, the U.S.
dollar depreciates in value against the Japanese yen, U.S. exports to Japan
will be less expensive, and Japanese exports to the United States will be more
expensive.

DETERMINATION OF FOREIGN EXCHANGE RATES

Since 1973, the foreign exchange rates of major industrial countries have
been determined by the law of supply and demand. Demand for a currency is
based on how attractive foreigners find the goods, services and investments in
that country. Supply of a currency is regulated by the country's monetary
authorities.
Speculation in the foreign exchange market is largely responsible for the day-
to-day fluctuations of exchange rates. However, long-term trends are a result of
changes in economic fundamentals, such as interest rates, trade balances and
overall economic strength.

DISCUSSION QUESTIONS

1. How would you find out how much $100 is worth today in Japanese yen ?

2. If a weaker dollar helps encourage exports and discourage imports, why

shouldn't the United States encourage a free-fall in the value of the dollar?
How would such a policy affect you?
 FOREIGN CURRENCY TRADING

Of the nearly $1 trillion traded every day on the foreign exchange market,
roughly 80 percent is traded for speculation, 15 percent for investment and 5
percent for foreign trade.

TYPES OF TRANSACTIONS
The basic and most common transaction is the spot transaction: two parties
agree on an exchange rate and one sells the other a certain amount of
currency. Other types of transactions have been developed to help manage
the risk of currency fluctuations.

DISCUSSION QUESTIONS

1. If you were a financial official at a large U.S. company that wanted to buy
German industrial equipment costing DM 1 million, how would you go about
it? What could you do to protect yourself from losses?
 FLOATING AND FIXED EXCHANGE

Exchange rates did not always fluctuate from day to day. For most of the
twentieth century, they were fixed, not flexible. The entire system was based on
gold. The system began to weaken in the 1960s, and rates began to "float" in
1973.

DISCUSSION QUESTIONS

1. What might be the advantages/disadvantages of returning to a fixed

exchange rate system?
 THE ROLE OF THE CENTRAL BANKS

Despite the fact that the foreign exchange market is the largest market in the
world, it remains basically unregulated. However, governments and central
banks sometimes act to maintain stability in the FX market. Some countries
have agreements to keep the value of their currencies within certain ranges. A
group of European nations are part of such an arrangement (the Exchange
Rate Mechanism, or ERM) that requires the central banks to act to keep
currencies at or near certain levels. In addition, central banks can influence
exchange rates by regulating their countries' interest rates. Yet these efforts
sometimes cannot stop market forces from driving the exchange value of a
particular currency up or down.

DISCUSSION QUESTIONS

1. Under what conditions should a central bank intervene in the currency

markets?

2. Under what conditions should a central bank attempt to cause its currency to
depreciate?

3. You are the head of a large industrialized country's central bank. Because of
a sharp decline in your stock market, your currency is dropping like a stone.
Is this necessarily bad, and what can you do about it?
 WORKING ACROSS BORDERS

Many large companies are international in that they have branches and/or
partnerships overseas; many more buy and sell goods and services all over
the world. Global business networks have mostly replaced huge, centrally
located, hierarchical companies. This means workers in any country will have
to prepare to compete with workers all over the world.
The skills needed to compete successfully will increasingly have
international components. Foreign languages, knowledge and experience of
business practices in other countries and the ability to deal with different
cultures will be more and more valuable.

DISCUSSION QUESTIONS

1. How would you put together a curriculum at your school to best prepare
students to live and work in the global economy?

2. Assignment: Interview a foreigner who works in the United States or an

American who has worked overseas and find out what skills the person
found necessary to succeed in a different country.
 MULTIPLE CHOICE QUESTIONS

1. The United States accounts for roughly how much of the world's exports?
a. all of them
b. one-half
c. One-quartet
d. one-eighth

2. The Law of Comparative Advantage says that:

a. consumers tend to look for the best bargains regardless of the products
country of origin
b. if one country can produce something better than all other countries it
should devote as many of its resources to that industry as possible
c. a country should focus its resources on its most efficient industries even if
there are other countries that are more efficient in those industries
d. none of the above.

3. Economies of scale result in:

a. lower per-unit production costs
b. a loss of efficiency
c. a diversified economy
d. the production of tropical fruit .

4. Which of the following is not an argument for free trade ?

a. consumers have more goods and services to choose from
b. protectionism is too expensive
c. the economy should be as diverse as possible
d. foreign competition helps keep prices low.

5. To find data on foreign investment in the United States, one would consult:
a. The Basics of Foreign Trade and Exchange
b. the balance of payments
c. the merchandise trade balance
d. the terms of trade.

6. Today, the DM is at 1.5487. Yesterday, it was at 1.5469. The DM

a. has depreciated against the dollar
b. has appreciated against the British pound
c. has been devalued
d. has strengthened against the dollar.

7. Which of the following can influence foreign exchange rates?

a. the difference in interest rates between countries
b. inflation
c. election results
d. all of the above
8. Two banks agree to let each other use a certain amount of foreign currency
for a fixed amount of time. This is known as
a. a spot transaction
b. an option purchase
c. a call
d. a swap.

9. Which of the following was not characteristic of the "Bretton Woods"

international economic system?
a. floating exchange rates
b. a gold-exchange standard
c. devaluation
d. fixed exchange rates

10. Which of the following is not an organization that helps to coordinate the
economic activities of different nations?
a. GATT
b. IMF
c. SED
d. BIS

11. You are a British citizen traveling with U.S. dollars on a French plane from
Florence, Italy, to Bonn, Germany, to buy a pair of German roller skates. Which
of the following events will directly cause the price of the skates, in marks, to
rise?
a. a rise in the pound against the dollar
b. a decline in the DM against the dollar
c. a rise in the British pound against the DM
d. a rise in the DM against the dollar

Answers: Id 2c 3a 4c 5b 6a 7d 8d 9a 10c 11d