Question

Another explanation for U.S. dollar dominance, is the argument that the U.S. has a comparative advantage in financial assets and investment opportunities, of which the U.S. dollar is but one example. Using any of the trade models we have discussed in class, explain how the U.S. might have a comparative advantage in financial assets and investment opportunities.

Answer 1

Comparative advantage motivates people to trade. Because comparative
advantage comes from differences in relative prices, it means that charac-
teristics of both supply and demand matter. Thus comparative advantage
for a country results from a complex combination of the characteristics
that are difficult to change (such as natural resource endowments), char-
acteristics of the overall country that change relatively slowly (such as the
share of production and consumption of services relative to the share
of manufacturing, agriculture, and mining), characteristics of production
technology that in some cases can change relatively quickly (such as
through turnkey production technology), and characteristics of individ-
ual preferences (such as for a particular kind or quality of products, ser-
vices, or financial assets).
Some easy examples of comparative advantage come from trade in
commodities, where resource endowments are quite important. For ex-
ample, the United States imports coffee and tea because people want to
drink these beverages, but the North American climate is not suitable for
the plants that produce the beans and leaves. Similarly, the United States
buys oil on international markets because it can import it at a price lower
than the cost of extracting it from US oil wells—current production tech-
nology combined with resource endowments and the substantial US use The US current account has been in deficit for nearly 20 years. From an
accounting standpoint, this means that the United States has been a bor-
rower for this whole period. Does this mean that capital flows have run
only in one direction, into the United States? Not at all. Throughout this
period, there have been two-way flows of different kinds of financial
assets. In recent years, even as the trade deficit has widened, the two-way
flows have exploded, and gross flows are simply huge.
Figure 3.5 details the types of financial products and ownership rela-
tionships that characterize US trade in financial assets. Net US investment
abroad (capital outflows) is above the zero line, and net foreign invest-
ment in the United States (capital inflows) by the rest of the world is
below the line. While financial flows have always been two-way, the two
directions of trade expand and contract together, broadly following the
US and global business cycles. That is, when the US economy slows (as it
did in 1982, 1990-91, and 1994) or foreign economies slow (as they did in
1997-98), net cross-border investment flows slow as well. This behavior is
consistent with investment and financial flows within an economy over
the business cycle