International Trade

1) Importing goods that we could not produce ourselves

2) Importing goods that other countries could produce more efficiently (interindustry)
3) Importing varieties of goods that other countries produce better (intraindustry)
Benefits of Specialization:
1) Makes use of natural endowments
2) Reaps economies of scale- provides adequate demand for countries with
small domestic markets
3) Time factor, production becomes better as more of it is done. Learn by
Doing
4) Enjoy a greater variety of goods for consumption (inter-industry) and
greater product differentiation within a category of goods (intra-industry)
5) *Increased competition puts more pressure on firms to be efficient
Absolute Advantage: A country has an absolute advantage over another in the
production of a good if it can produce it with fewer resources than the other
country
It may be reflected in a larger output for a given quantity of inputs or fewer
inputs for a given output. Only a small amount of world trade is based on
absolute advantage including the diamond trade in South Africa or Saudi Arabias
Oil.
Comparative Advantage: A country has a comparative advantage over
another country if the production of a good it can produce it at a lower
opportunity cost.
Assumptions: 2 countries, 2 products, constant returns (i.e. PPC is a straight
line), no transport costs, no government restrictions
Example:

Australia has 125 Workers, China has 500 Workers

In Australia 1 worker can produce 4 kilos of rice or 8 bottles of wine

a day
In China 1 worker can produce 2 kilos of rice or 1 bottle of wine a
day
Australia
China
World Output
Australia
China
World Output

Rice (kg)
250
500
750
Rice (kg)
0
1000
1000

+
+
+
+
+
+

Bottles of Wine
500
250
750
Bottles of Wine
1000
0
1000

Gain from trade is 250 kg of Rice and 250 Bottles of wine. The Rate of exchange
for rice against wine must lie somewhere between the opp. cost ratio of the two
countries. i.e. 1 wine to 0.5 to 2 kilos of rice. If we assume 1 wine trades for 1kg
of rice, then the gain is split equally. However, if the richer and more powerful
country may negotiate a more advantageous rate of exchange
Limitations to Theory:
1) Theory assumes constant returns, i.e. PPC is a straight line. In the real
world most countries face increasing costs (diminishing returns) i.e. PPC
will curve outward. This limits the degree of specialization but does not
underminet he principle
2) Transport costs may wipe out any potential gain from trade
3) Instead of trading goods, factors may move between countries
(globalization)
4) Theory is static, ignoring the dynamic element. Countries may decide
what goods they want to acquire advantages in, rather than focusing on
what they currently do best, e.g. China deciding to go into key sectors.
This is an important criticism. CA is a theory of supply, but ignores the
demand side.
5) Governments may restrict trade
Terms of Trade:
ToT is the amount of exports that must be given up to acquire a given quantity of
imports. Usually expressed in monetary terms, being the ratio of export prices to
import prices.
ToT = Index of Export Prices/Index of Import Prices * 100
Increases in ToT are improvements in the Tot and when ToT decreases it is known
to have worsened.
ToT will alter if there are changes in the :
1) Relative price in imports and exports
2) Forex Rate appreciation causes the ToT to improve, and vice versa
Impacts:
i.

ii.
iii.

iv.

Improvement is good if the worlds demand for your exports is growing

and export prices are rising, especially if world demand for your
exports is inelastic.
Improvement is bad if domestic Aggregate Supply is falling, i.e. high
inflation, and if demand for exports is elastic.
Worsening is good if it arises from an increase in Aggregate Supply,
based on increased efficiency and productivity, especially if demand for
exports is elastic.
Worsening is bad if it arises from a lack of demand for your exports,
especially if demand for those exports is inelastic .e.g Zambia Copper
Piping

*Developed countries have been able to dictate favourable ToT so that gains
from trade flow in their direction. ToT may have actually worsened for developing
countries as they specialize in primary products (commodities), and have a low Yed. Supply grows with improved technology and in some cases they are replaced
with synthetics, so their relative price falls. Moreover, developed countries tend
to also protect their own agricultural sectors
Other Gains from Trade:
1) Decreasing Costs and ability to capitalize on EOS (esp for small domestic
markets), MES
2) Differences in Tastes greater variety in the domestic market
3) Increased Competition AND 4) Non Economic Advantages Social,
Cultural, Political.

Free Trade and Protectionism

Protectionism situations where countries are trying to protect their domestic
industries from competition from overseas, it has expanded to cover any
restriction on imports
1) Tariffs: Customs Duties (ad valorem taxes) on imported goods, designed to
raise the price of imports and thus discouraging them and encouraging
domestic production. Success of this strategy still depends on P-Ed.
2) Quotas: Limit a quantity of a specific good allowed into the country,
restricting entry of goods with an inelastic demand. E.g. Voluntary Export
Restrictions. E.g. Japanese Cars in 1980s. This may result in more
expensive cars flowing into the US (or any other) market
3) Non-Tariff Barriers: anything that make it difficult for goods to flow into the
country. Licenses, Quotas, VERs, Embargoes, Standards, Local Content
Requirements, Health Regulations. E.g. French Skis, British vs German
Beer, Poitiers VCRs.
4) Exchange Controls: a country may limit the amount of foreign currency
that can be purchased
5) Subsidies: Import subsidies makes domestic goods cheaper, or on
exported goods. The latter may be seen as dumping(selling goods at
below cost), with a view to wipe out foreign producer before raising
prices.
6) Procurement Policies: Governments may choose to only buy from domestic
suppliers
7) Others: Import Licencing, Embargoes, Export Taxes, Import Deposit
Schemes
Fallacious Arguments:
1) Cheap Foreign Labour China can produce anything cheaper than the US.
Not true because US has a comparative advantage in capital intensive or
skill intensive goods.

2) Reduce Unemployment might maintain jobs in what you could have

imported cheaper, at the expense of destroying jobs in those goods you
should be exporting. Competitive devaluations
3) Imports are a leakage by buying foreign goods we create the income for
them to buy what we are good at producing
Not So Fallacious Arguments:
1) Infant Industry import substitution as new industries in developing
countries may need some support before they can become internationally
competitive. OR senile industries, which may need protection to die
gracefully. OR ailing industries which can recover
2) Anti-Dumping self explanatory. But how to differentiate between price
differentiation and dumping?
3) Balance of Payments tariff may be used to correct a BoP deficit
4) Revenue Tariffs may generate revenue
5) Diversification Tariffs may allow a country to avoid putting all its eggs in
one basket
6) Demerit Goods
7) Optimum tariffs If you have a monopsony in buying from the world (US),
then applying a tariff may achieve social efficiency, ensuring MSC = MSB,
improve efficiency of resource allocation by eliminating welfare loss.
8) Strategic Trade Theory Lester Thurow, managed trade is preferable to
free trade, as if other countries are cheating, there may be winner takes
all gains.
9) Self Sufficiency Agriculture, Steel, Power, Arms
10)
Politics sanctions
11)
Traditional Way of Life Japanese Rice Farmers
12)
Human Rights protecting fair trade and labour

Burden on Tariff:

Harberger Triangles Welfare Loss Triangles

Other Costs of Protectionism:
1) Second Best are tariffs the best way of addressing the issue, or are there
better alternatives? E.g. retraining for declining industries
2) Retaliation imposing tariffs on your countrys exports
3) Protects inefficiency
4) Bureaucracy and Corruption DUP activity and waste of resources.
Economic Cooperation:
1) Free Trade Area Countries have no tariffs between members. E.g. NAFTA
or proposed AFTA.
2) Customs Union this is a free trade union but involves harmonization of
economic policies such as a Common External Tariff. E.g. EU before
Maastricht Treaty in 1992

3) Common Market/Economic Union harmonisation goes much further,

similar taxes, employment regulation, free movement of labour and
capital, a common currency.
Trade Creation arises where a country joins a union and trades in goods with a
partner, previously these goods were not traded at all, this is good as it
presumably leads to production shifting to a lower cost producer.
Trade Diversion this arises when a country joins a union and now buys from
another member of the union instead of a country that is not part of the union.
This is bad as it diverts trade from the lower cost producer to the higher cost
producer inside the union.
Pattern of Trade:
World trade was virtually destroyed by the great depression, but has grown
enormously since 1950s at around 7.5% p.a. in 1962 Tinbergen suggested a
gravity model of trade, where trade is a function of the mass and distance
between two countries.

Balance of Payments
A record of a countrys transactions with the rest of the world, inflows being
recorded as credit and outflows being recorded as debit.
1. Current Account Visible Trade, Invisible Trade (Services) [BoT] + Factor
Incomes [Dividends, Interest, Profits] and Transfers
2. Capital Account Direct Investment, Portfolio Investment, Financial
Derivatives and Other Investment (loans)
3. Net Errors and Omissions
4. Overall Balance Surplus or Deficit
5. Official Reserves Addition as a negative figure, Subtraction as a positive
figure
Balance of Payments must always balance, hence the Overall Balance and the
Official Reserves must be zero.
BoP Deficit and Surpluses
Can be caused by a deficit/surplus in either the Current A/C or the Financial A/C
or both, an overall surplus or deficit can only apply under a fixed exchange
regime (as it will be eliminated by the appreciation/depreciation of any floating
regime)
a) The Current A/C reflects current trends in demand and supply of goods and
services between countries. A deficit implies a S>D whereas a surplus
implies D>S. Affected by
a. Terms of Trade (overall prices) due to supply or demand side factors
b. Changes in the forex rates
c. Rate of growth of domestic Income relative to the worlds rate of
growth
d. Trends in flows of investment income and transfers
b) The Financial Account can be split into Short Run and Long Run Flows
a. In the short run, hot money flows according to current interest
rates, changes in the i/r can cause an inflow or outflow (given that
currency will remain stable, if it is likely to depreciate then no
amount of i/r increase will attract hot money)
b. In the long run, capital flows depend on political factors,
government policy, global opinion and structural changes e.g. the
cost of labour and availability of resources etc
Effects
Whether a surplus or deficit is negative or positive depends on the stage of
development of a country and the cause of the surplus or deficit. (Typically
developing countries will have a deficit on the Current A/C and a surplus on the
Capital A/C, and the converse is true for developed countries)
Internal Effects:

a) Prices, output and employment: a surplus can create jobs to meet export
orders and boost output, but may lead to inflation if it generates excess
demand
b) Money supply: if there is a fixed exchange rate, then the MS will rise with a
BoP surplus, and fall with a deficit, and hence,
c) A surplus will add to the foreign reserves and a deficit will run down
reserves
External Effects:
a) A surplus/deficit may bring about a revaluation or devaluation, but this is
asymmetric as additions to reserve can be built up indefinitely, but too
many deficits and foreign reserves will be run down.
b) Terms of Trade a surplus will cause the Terms of Trade to improve,
whereas a deficit may cause it to worsen
Circular relationship between Forex rates, the ToT and the BoP. Each affects the
other until equilibrium is restored.
E.g. If Forex rate rises above equilibrium, then the Terms of Trade will improve,
and the BoP will produce a deficit
Policies
Note: External balance occurs when the inflow equals the outflow of currency at
current exchange rates such that there is no change in reserves or exchange
rate. Long term external imbalance is regarded as Fundamental Disequilibria.
Deficits is a larger problem, and may lead to running down of reserves or a
depreciation of the currency, which may undermine confidence in the economy.
The following policies are designed to eliminate a deficit
Expenditure Dampening:
Excess Demand domestically may cause M>X, hence producing a deficits. Thus,
either Monetary or Fiscal policy can be used to dampen domestic demand
through deflationary policy.
a) It allows the government to maintain a fixed exchange rate
b) It avoids the use of import controls, thus avoiding international disapproval
c) It is not prone to retaliation
Domestic policy is hence directed to external policy, deflation might cause
unemployment, fall in growth and bankruptcies, internal economy is subject to
external balance
Expenditure Switching:
Focuses on increasing exports and reducing imports, there are two options:
a) Devaluation/depreciation under a fixed/floating exchange rates. This will
improve BoP as long as the Marshall-Lerner Criterion is satisfied. (Price
Elasticity of Demand for Imports and Exports together is greater than one).

In the short run demand may be fairly inelastic and supply may not be
able to adjust, so a J-curve may emerge before Current A/C gets better.
HOWEVER: it may undermine investor confidence, produce uncertainty
and speculation
b) Direct Controls: tariffs and quotas, either raise the price or reduce the
quantity of imports, but are politically unacceptable, subject to retaliation,
treats the symptoms
If done in tandem, discretionary policy may create the spare capacity to meet
increased export demand due to exp-switching policies, otherwise they may be
simply inflationary. Ultimately a BoP deficit is caused by wrong prices, this
fundamental problem must be addressed.

Foreign Exchange Rate Systems

Exchanging currencies is expensive, a tax on trading, and changeable exchange
rates add to uncertainty. All forex rates are produced by a demand and supply of
currency, which is determined by foreign demand for local goods, services and
willingness to invest capital, and local demand for
foreign goods,
services, and willingness to invest capital.
Fixed Exchange Rates a country can have a fixed
exchange rate such that if supply and demand fluctuate the
Central Bank will buy or sell in the forex market to maintain
the forex rate. If there is excess demand for domestic
currency (BoP surplus), the Central Bank sells, if there is
excess supply (BoP deficit), the Central Bank buys.
Where Q1 to Q2 is a deficit, and the Central Bank needs to
buy local currency
Floating Exchange Rates domestic currency is allowed to find its own level,
adjusting automatically to changes in supply and demand. BoP surpluses will
result in an appreciation, making it less attractive to buy and more attractive to
sell, and the opposite if the BoP is tending towards a deficit. Hence it is
automatically self-correcting.

a) Adjustable Peg changes to fixed rate are made but infrequently,

reviewed consistently
b) Crawling Peg changes made more frequently than adjustable peg
c) Dirty or Managed Float free to fluctuate, but the Central Bank ensures
that the fluctuations are not too wild.
Forward rates allow importers and exporters to remove some uncertainty of fixed
rates, by allowing rates to be fixed for future delivery.
Exchange Rate Bands are bands in which a currency is allowed to fluctuate

A joint float is when a group of countries fix rates to one another, and the whole
band fluctuates against the world the Euro Snake.

Nominal Exchange Rates rate quoted on the forex market for the
currency, the spot rate is the rate for purchases/sales on that day itself
The real exchange rate measures the relative price of goods from different
countries when measured in a common currency
Trade Weighted Exchange rates are currencies measured against the
currencies of all trading partners, given weights, this is the best guide to
the value of a countrys currency.

Fixed Exchange Rates

Strengths
Weaknesses
Certainty importers, exporters and
Long term disequilibrium between
investors are encouraged to do
inflow and outflow of currency a
business
fundamental disequilibria, will not be
resolved
Limited Speculation reduces
Huge reserves of foreign currency
speculation on currency
necessary to defend
External Discipline internal macro
Relinquishment of ability to pursue
policy is subservient to the need of the domestic policy
external value of the currency.
Domestic policy is tied to foreign
country
Floating Exchange Rates
Strengths
Weaknesses
Any Disequilibrium is automatically
Uncertainty may discourage flow of
resolved
goods, services and capital
Central Bank doesnt need to
Exchange rates that move all the time
intervene, hence no need to hold
will encourage currency speculation,
reserves or borrow from IMF
doesnt contribute to economic welfare
A floating exchange rate leaves the
Governments may act irresponsibly
government free to pursue whatever
with domestic policy
domestic policy it likes. Shifts in the
forex rate will act as a shock absorber
and protect the domestic economy
from external shocks