Standard Model of Trade

The standard model of trade (Paul Krugman-Maurice Obsfeld model) implies the existence of the
relative global demand curve resulting from the different preferences for a certain good and relative
global supply curve resulting from the different production possibilities.
According to Paul Krugman and Maurice Obsfeld, the exchange rate, the rapport between the
export prices and the import prices, is determined by the intersection between the two curves,
which is the equilibrium. Relative prices determine the economy’s output. Other factors being
constant, the exchange rate improvement for a country implies a substantial rise in the welfare of
that country.
Global demand or total demand refers to amount of money, which subjects (consumers) of an
economy plan to spend on goods and services at the different size of income or at given prices in
a given period. Total demand consists of personal consumption of households and individuals,
gross private domestic investment by business, gross government spending, and net export.
Net exports are a measure of nation’s total trade. The formula for net exports is a simple one: the
value of a nation’s total export goods and services minus the value of all the goods and services it
imports equal its net exports.
Market equilibrium is the intersection of the global demand curve and the global supply curve.
Market/economy equilibrium means that the national product and level of prices are shaped on the
level on which buyers are willing to buy what enterprises are ready to sell.
The aggregate demand curve shows how many goods and services consumers can and are willing
to buy at different total price levels, other conditions remaining the same. The size of purchases
made by consumers influences prices. The size of global demand changes the level of prices
inversely. The crucial factor is the elasticity of global demand in relation to interest rates or level
of global wealth.
The supply curve represents the relationship between price and quantity supplied, with all other
factors affecting supply held constant. Quantity supplied (supply curve) is a function of price. A
shift in the supply curve happens when a nonprice determinant of supply changes and the overall
relationship between price and quantity supplied is affected.
The standard trade model is a general model that includes the Ricardian model, the Ronald ones
and Paul Samuelson specific factors model, and the Heckscher-Ohlin (H-O) model as special
cases-two goods, food (F) and cloth (C). Each country’s production possibility frontier (PPF) is a
smooth curve.
The standard trade model assumes the following:
a. Each country produces two goods, food (F) and cloth (C).
b. Each country’s production possibility frontier (PPF) is a smooth curve (TT).
c. The point on its PPF, at which an economy actually produces, depends on the price of
cloth relative to food, PC/PF.
d. Isovalue lines are lines along which the market value of output is constant.
A country’s production possibility frontier (PPF) determines its relative supply function because it
shows what the country is capable of producing, which should be maximized. National relative
supply function determines the world relative supply function, which along with world relative
demand determines the equilibrium under international trade.
The slope of an isovalue line (relative price of cloth to food) equals PC/PF. The best point to
produce is where PPF is tangent to the isovalue line, a line of slope equal to the relative prices.
The value of an economy’s consumption equals the value of its production. The economy’s choice
of a point on the isovalue line depends on the tastes of its consumers, which can be represented
graphically by a series of indifference curves.
The standard trade model is built on four key relationships:
a. The relationship between PPF and the world relative supply (RS) curve;
b. The relationship between relative prices (RP) and relative demand (RD);
c. The world equilibrium as determined by world RS and RD; and
d. How changes in the terms of trade affect a nation’s welfare.
The world relative supply curve (RS) is upward slopping because an increase in the price of
cloth/price of food (PC/PF) leads both countries to produce more cloth and less food.
The world relative demand curve (RD) is downward sloping because an increase in PC/PF leads
both countries to shift their consumption mix away from cloth toward food.
Terms of trade (TOT) means the price of a country’s exports divided by a country’s imports.
Generally, a rise in the TOT increases a country’s welfare, while a decline in the TOT reduces its
welfare. Intuitively, TOT falls, price of what a country produces goes down relative to price of
what the country consumes. The relationship between TOT, total price of production, and a
country’s welfare is direct.