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International Trade & Finance

This part of the lecture focus on international trade and the finance market.
Some basic terminology and important aspects of international trade will be

1. Describe the benefits of international trade.
2. Explain various types of trade restrictions.
3. Recognize the three basic types of exchange rate.
4. Understand the components in the balance of payment accounts.
International Trade
The distribution of economic resources and technological levels among nations
are different. International trade is a method which enables nations to specialize
and increases the productivity of their resources. Therefore, nations production
capacities can be increased, their production possibility frontier will move

The international economy is very complex. Each country has a unique pattern of
trade. But every one of them must benefit from the trading in order for them to
do that. The following example presents a hypothetical example of two
countries: Japan and China both producing fish and cloth, and assuming labor is
the only input.
Comparative Advantage
---- Output per worker per day in either fish or cloth----
------------------- Japan----------China-----------------------
Cloth----------------4 -------------3---------------------------

Japan has absolute advantage in producing both fish and cloth because one worker can produce more of
either goods in Japan. Absolute advantage is determined by comparing the absolute productivity in different
countries of producing each good. It seems that there is no need for Japan to trade because Japan can
produce both more of both goods. However, absolute advantage is not the critical consideration. What
matters is comparative advantage. Comparative advantage is determined by comparing the opportunity cost
of each good in different countries. It is measured by what must be given up in producing one good using the
same resource, like one worker per day. For our example:

Japans opportunity cost of producing 1 unit of fish (in terms of cloth given up) = 4/8=0.50
Chinas opportunity cost of producing 1 unit of fish (in terms of cloth given up) = = 0.75

Since Japans opportunity cost is lower, Japan has comparative advantage on fish production and will export
fish. The comparative advantage of cloth is found the same way.

Japans opportunity cost of producing 1 unit of cloth (in terms of fish given up) = 8/4 = 2
Chinas opportunity cost of producing 1 unit of cloth (in terms of fish given up) = 4/3 = 1.33
Chinas comparative advantage is on cloth production because China has a lower opportunity cost. China
should export cloth and import fish from Japan instead of fishing itself. Opportunity cost, which is reflected in
the comparative advantage, is the key to international trading. We benefit from trade if we are able to obtain
a good from a foreign country by giving up less than we would have to give up to obtain the good at home.
Trade Restrictions
Governments restrict foreign trade to protect domestic producers from foreign competition. There are
several kinds of trade barriers:

1. Tariffs are excise taxes on imports and may be used for revenue purposes, or more commonly today as
protective tariffs.
2. Import quotas specify the maximum amounts of imports allowed in a certain period of time. Low
import quotas may be a more effective protective device than tariffs, which do not limit the amount of
goods entering a country.
3. Non-tariff barriers refer to licensing requirements, unreasonable standards, or bureaucratic red tape in
customs procedures.
4. Voluntary export restrictions are agreements by foreign firms to voluntarily limit their exports to a
particular country.

The economic impacts of tariffs are as follows:

1. When a tariff is imposed, domestic consumption declines due to higher prices.
2. Domestic production will rise because of the higher price.
3. Imports will fall.
4. Government tariff revenue will represent a transfer of income from consumers to government.
5. Indirect effects also may occur in that relatively inefficient industries are expanding and relatively
efficient industries abroad have been made to contract.

The economic impact of quotas is similar to tariffs, but no revenue is generated by the government, the
higher price results in more revenue per unit for the foreign and domestic producers.
Exchange Rate
Foreign exchange markets enable international trade to take place by providing markets for the exchange of national
currencies. A U.S. firm which sells goods to a British firm needs to exchange the check (in pounds) sent by the British
company into dollars. U.S. exports create a demand for dollars and a supply of foreign money, pounds in this case. On
the other hand, imports create a supply for dollars and a demand of foreign money.

Variable Exchange Rate

The freely floating exchange rates are determined by the forces of demand and supply. The intersection of supply and
demand curves for a currency will determine the price or exchange rate. Theoretically, variable rates have the virtue of
automatically correcting any imbalance in the balance of payments. Balance of payments is the sum of all transactions,
which take place between a nations residents and the residents of all foreign nations. If there is a deficit in the balance
of payments, this means that there will be a surplus of that currency and its value will depreciate. As depreciation
occurs, prices for goods and services from that country become more attractive and the demand for them will rise. At
the same time, imports become more costly as it takes more currency to buy foreign goods and services. With rising
exports and falling imports, the deficit is eventually corrected. In addition, flexible exchange rates allow policy makers to
be flexible in conducting domestic monetary and fiscal policies. However, unstable exchange rates can destabilize a
nations economy. This is especially true for nations whose exports and imports are a substantial part of their GDPs.

Fixed Exchange Rate

If the government offers to buy and sell its currencies at a set price, it is imposing a fixed exchange rate. A nations
reserves are used to alleviate imbalance in the balance of payments, since exchange rates cannot fluctuate to bring
about automatic balance. Domestic macroeconomic adjustments may be more difficult under fixed rates. For example, a
persistent deficit of trade may call for tight monetary and fiscal policies to reduce price, which raises exports and reduces
imports. However, such contractionary policies can also cause recessions and unemployment.

Managed Floating Exchange Rate

The current system is a managed floating exchange rate system in which governments attempt to prevent rates from
changing too rapidly in the short term. Since 1987, the G-7 nations ( U.S., Germany, Japan, Britain, France, Italy and
Canada) have periodically intervened in foreign exchange markets to stabilize currency values.
The Balance of Payments
The balance of payment is a periodic statement of money value of all transactions between
residents and government of one country and residents and governments of all other
Transactions that involves an outlay of domestic currency is recorded as a debit, any
transactions that involves the receipt of foreign currency is recorded as credit.

They are usually categorized into three accounts: the current account (export and import),
the capital account (purchase of US assets by foreigners and foreign assets purchased by US
residence), and official reserve account ( US holding of foreign currencies and US currency
held by foreign governments)

The current account is the difference between the value of goods exported and the value of
goods imported. Exports are products that a country sells to other countries and imports are
products that a country buys form other countries. A country will have a trade surplus if its
exports exceed imports. On the other hand, a country will have a trade deficit if its imports
exceed its exports. U.S. currently has a trade deficit.

Countries keep track of the flow of their international exchange by calculating their balance
of payments. In addition to the accounts listed above, the balance of payment also includes
a statistical discrepancy to account for reported transactions.