ECONOMICS: MICROECONOMICS AND

MACROECONOMICS

INTERNATIONAL TRADE AND CAPITAL FLOWS

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 GROSS DOMESTIC PRODUCT AND GROSS NATIONAL PRODUCT

READING 19 INTERNATIONAL TRADE AND CAPITAL FLOWS 3

 BENEFITS AND COSTS OF INTERNATIONAL TRADE

 Imports are goods and services that a domestic economy purchases from other
countries
 Exports are goods and services that a domestic economy sells to other countries
 The terms of trade is the ratio of the price of exports to the price of imports
 Increasing terms of trade indicate improvement
 Decreasing terms of trade indicate deterioration
 Net exports = Exports – Imports
 If positive, there is a trade surplus
 If negative, there is a trade deficit
 A country that does not trade with other countries is referred to as a closed
economy or being in autarky; the price of goods and services is the autarkic
price
 In open economy (no restrictions to trade) the price of goods and services is the
world price

READING 19 INTERNATIONAL TRADE AND CAPITAL FLOWS 4

 BENEFITS AND COSTS OF INTERNATIONAL TRADE

 Free trade is the case in which there are no restrictions on a country’s trade
with other countries
 Trade protections are restrictions on trade that prevent pricing based on
supply and demand
 Capital restrictions are limits on the flow of funds into or out of a country
 Measure of international trade:
 Trade as a percentage of GDP
 Foreign direct investment (FDI): the amount of the investment by a firm in
one country in the assets in another country
 A multinational corporation (MNC) is a company that operates in more than one
country
 A foreign portfolio investment (FPI) is a short-term investment in foreign
financial instruments

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 BENEFITS AND COSTS OF INTERNATIONAL TRADE

BENEFITS
 Gain from exchange and
specialization
 Greater economies of scale
 Greater product variety
 Increased competition
 More efficient resource allocation
COSTS
 Greater income inequality
 Loss of jobs in developed countries
 Adjustments as resources are
reallocated

Overall the gains from liberalization of trade policies are thought to exceed the
costs, so that the winners could conceivably compensate the losers and still be
better off

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 COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE

 An absolute advantage exists if the country is able to produce the good at lower
cost in terms of resources relative to another country
 A comparative advantage exists if the country’s opportunity cost in terms of
other goods that could be produced instead is lower than that of another
country

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 COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE

 It is possible to have a comparative advantage while not having an absolute

advantage in producing a good
 The greater the difference between the world price of a good and its autarkic
price, the more potential to gain from trade
 A country’s comparative advantage can change over time

Absolute
• Lowest-cost producer of a good
advantage

• Best producer of a good

Comparative • Based on productivity in terms of
advantage opportunity cost, but not necessarily
the lowest-cost producer.

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 RICARDIAN AND HECKSCHER–OLIN MODELS OF TRADE AND THE SOURCE(S) OF
COMPARATIVE ADVANTAGE

RICARDIAN
 Countries specialize in the goods
and services for which they have a
comparative advantage
 The source of comparative
advantage is labor productivity
 Labor productivity is attributed to
differences in technology
 Countries trade because of
differences in labor productivity
HECKSCHER–OHLIN
 Comparative advantages arise from
different endowments of capital and
labor
 Capital and labor are variable factors
of productivity
 Countries trade because of different
relative amounts of capital and labor
 Efficiency of production matters
 This model allows for income
redistribution between owners and
capital and labor through trade

READING 19 INTERNATIONAL TRADE AND CAPITAL FLOWS 9

TYPES OF TRADE AND CAPITAL RESTRICTIONS AND THEIR ECONOMIC IMPLICATIONS

 A tariff is a tax levied by a government on imported goods

 Intended to protect domestic industries
 Increases welfare of domestic country if (1) there is no retaliation, and (2)
the deadweight loss is less than the benefit from improving trade
 An import quota is a restriction on the quantity of a good that can be imported.
 Controlled through import licenses
 Importers earn quota rents if they charge a higher price with a quota
 An export subsidy is a payment by a government to a firm when it exports a
specified good
 Encourages firms to shift to export goods, increases the domestic price
 Allows exporter to earn quota rents
 A voluntary export restraint (VER) is a voluntary limit on goods exported to a
specific country
 Domestic content provisions are requirements that a specific portion of value-
added or components be produced domestically
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TYPES OF TRADE AND CAPITAL RESTRICTIONS AND THEIR ECONOMIC IMPLICATIONS

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TYPES OF TRADE AND CAPITAL RESTRICTIONS AND THEIR ECONOMIC IMPLICATIONS

 Capital restrictions are controls placed on ownership of assets, either of foreign

assets or of ownership of domestic assets by foreign persons or firms
 The effect of restrictions on trade and capital depends on whether the country
is a price taker or can affect price:
 A small country in the context of international trade is a price taker
 A large country in this context can influence the price

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TYPES OF TRADE AND CAPITAL RESTRICTIONS AND THEIR ECONOMIC IMPLICATIONS

Tariff Import Quota Export Subsidy
Importing Importing
Impact on
country country
Producer surplus + +
Consumer surplus  
Government revenue + Mixed
National welfare
Small country  
Large country + +
Price + +
Domestic consumption  
Domestic production + +
Trade
Imports  
Exports
Voluntary Export
Restraint (VER)
Exporting Importing
country country
+ +
 
 0
 
 
+ +
 
+ +

+

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MOTIVATIONS FOR AND ADVANTAGES OF TRADING BLOCS, COMMON MARKETS,
AND ECONOMIC UNIONS
A trading bloc is an agreement among countries to work toward eliminating trade
barriers. Trading blocs may be regional (e.g., NAFTA, EU), yet there are different
degrees of integration possible.

• Member countries adopt single

Monetary union currency

Integration
• Coordination of economic
Economic union
policies among members

• Allows free movement of

Common market
factors of production

• Common trade policy regarding

Customs union
non-members

• Trading block with no trade

Free trade area (FTA)
barriers

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MOTIVATIONS FOR AND ADVANTAGES OF TRADING BLOCS, COMMON MARKETS,
AND ECONOMIC UNIONS

 Increased competition
 Lowers prices and increases quantity
 Cost of production declines
 Easier access to natural resources and technology
 Increased access to technology and knowledge
 Increased specialization
 Greater opportunity for economies of scale
 Increased employment
 Increased income
 Increased interdependence among members
 Less chance of conflicts

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MOTIVATIONS FOR AND ADVANTAGES OF TRADING BLOCS, COMMON MARKETS,
AND ECONOMIC UNIONS

Possible results of trading blocs:

 Trade creation: Replacement of higher-cost domestic production by lower-
cost imports
 Trade diversion: Replacement of lower-cost imports from nonmembers by
higher-cost imports from members
Impediments to effectiveness of trading blocs:
 National sovereignty concerns
 Differences in tastes, culture, and competitive conditions among members
Capital restrictions may affect inflows, outflows, or both:
 May be in the form of taxes, price or quantity controls, or prohibitions
 Difficult to distinguish effects of these restrictions from the effects of other
policies

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 COMMON OBJECTIVES OF CAPITAL RESTRICTIONS IMPOSED BY GOVERNMENTS

 Capital restrictions may affect inflows, outflows, or both. Objectives include:

 Reduce the volatility of asset prices
 Maintain fixed exchange rates
 Keep domestic interest rates low
 Protect strategic industries

Difficult to distinguish effects of capital restrictions from the effects of other

policies

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 THE BALANCE OF PAYMENTS ACCOUNTS

The balance of payments is the accounting of the flow of funds into and out of a
country
DEBITS CREDITS
Increase in Assets, Decrease in Assets,
Decrease in Liabilities Increase in Liabilities
 Value of imported goods and  Payments for imports of goods and
services services
 Purchases of foreign financial  Payments for foreign financial
assets assets
 Receipt of payments from  Value of exported goods and
foreigners services
 Increase in debt owed by  Payment of debt by foreigners
foreigners  Increase in debt owed to foreigners
 Payment of debt owed to
foreigners

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 THE BALANCE OF PAYMENTS ACCOUNTS

 The current account is the goods and services into and out of a country:
 the sum of the exports less imports
 net income from other countries
 net current transfers
 The capital account captures the flows related to
 capital transfers
 the purchase and sale of nonfinancial assets
 The financial account captures the monetary flows for financial assets, such as
bonds and stocks
 Government-owned assets abroad and foreign direct investment
 Foreign-owned assets in the country

READING 19 INTERNATIONAL TRADE AND CAPITAL FLOWS 19

HOW DECISIONS BY CONSUMERS, FIRMS, AND GOVERNMENTS AFFECT THE BALANCE
OF PAYMENTS

 If a country’s net savings (both government and private savings) are less than
the amount of investment in domestic capital, the investment must be faced by
foreign borrowing. Foreign borrowing results in capital account surplus, which
mean there is a trade deficit.
 Exports – Imports = private savings + gov. savings – investments
(Ex – Im) = S + (T – G) – I

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 FUNCTIONS AND OBJECTIVES OF THE INTERNATIONAL ORGANIZATIONS THAT
FACILITATE TRADE, INCLUDING THE WORLD BANK, IMF, AND WTO

 As a result of countries building barriers to international trade in the 1930s and

1940s, international trade fell, along with the standard of living in many
countries
 International trade organizations were created to encourage international trade
and development

International • Ensuring stability of the exchange rate system

Monetary Fund
(IMF) • Ensuring stability of the international payments system

The World Bank • Fighting poverty in developing countries

Group • Encouraging environmentally sound economic growth
The World Trade
• Providing legal and institutional foundation for the
Organization
multinational trading system
(WTO)

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 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume II  Reading 19

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume II  Reading 19  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  Economics #1

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