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International Trade
3
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Outward Oriented Trade Policies
- Focus on trade and outward relations with other countries as the forefront of the
economy
- E
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the Asian Tigers; Singapore, Taiwan, Hong Kong and South Korea

This diagram represents free trade; the price is set by the world supply which is perfectly
elastic
...
From the domestic
production to where the domestic demand meets world supply represents imports, the area in
yellow represents the consumption of foreign producers in terms of free trade
...
They can be produced more
efficiently if each country focuses on their expertise and doesn’t try to produce enough of
everything
...
This is also an increase in consumer surplus
...

As the global market grows the amount of choice has also
...

The specialization of managers, introduction of technology improve productivity
...
They bring about lower
average costs which drives down prices of goods
...
natural gas for heating
...

- A more efficient allocation of resources
No two countries share the exact same resource base, trade takes advantage of these
differences
...
Benefitting consumers due to lower prices and producers
due to greater international demand
...

Consumers benefit from lowered prices and the market becomes more efficient
...

- Political Benefits
Economists and political thinkers generally agree that trade and integration have consistently
encouraged compromise and resolution over conflict and antagonism
...
This results in a
source of foreign exchange and more efficient allocation of resources which boosts GDP
and allowed more consumption of needed imports
...

Disadvantages
- Can’t earn money from tariffs; tariffs are often an important source of government
revenue as they are a way of taxing the rich in developing countries, those who evade
income tax
...

- Unfair; eg
...

When a country has absolute advantage in many industries, it is unfair for them to be the sole
producer of all of them
...

- David Ricardo à early 1800s
- Countries that specialize produce more efficiently can trade their output with other
countries to enjoy a higher standard of living
...
Selling the good at a price between their own opportunity cots and the opportunity
cost of the other country
...
As can be seen by
the curves, the PPC of good A is higher than B for good X but lower than B for good Y
...

Thus, one must determine the comparative advantage
...

Thus, one must determine the comparative advantage
...


In this diagram the two curves are parallel to each other, meaning that they have the same
opportunity cost
...
This is known as autarky prices
...

- Countries that have little natural resources but a highly skilled workforce can provide
services to the world
...
Singapore à services to the region
Determined by
1
...
Value of good produced from the resource to the world market
They determine the efficiency of production and opportunity cost
...

Limitations:
- Perils of extreme specialization
A country might devote its entire resources to the production of a single good, making
the nation highly dependent on the prosperity of the good
...
Which brings high risk to the population’s well-being
and place the country on a rollercoaster of volatility
...

Eg
...

- Unrealistic assumptions
It is criticized for being an inaccurate representation of the actual world trade;
1
...
Goods are assumed to be identical; goods are often differential, which makes it
difficult to assess true comparative advantage
3
...
Theory assumes relatively constant costs, PPC s with constant slopes; might mask
potential comparative advantage for industries that appear uncompetitive or may
overestimate an advantage that is less extreme than appears
5
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Full employment is a necessary condition of the theory but rarely occurs in practice
7
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WTO

WTO
The World Trade Organisation
Origin:
- After WW2 the belief developed that the extremism, violence and war were a result of
economic failure
...
Thus GATT was
formed with 23 members
...

- Aimed at one thing; free trade
Aims:
- Trade without discrimination: all members must agree to Most Favoured Nation
Status, all goods from WTO member countries should be treated equally
...

- Freer trade through negotiation: changes to trade policy are through direct dealing
and are done gradually, allowing countries to prepare for adjustments
...
Openness also encourages more
trade
...
Rules against dumping and intellectual property theft are aimed
at increasing competition
...

Functions:
- Forum for trade negotiations
- Execute WTO agreements
- Evaluate and rule on trade complaints by member countries
- Provide technical assistance to developing countries on trade issues
- Track changes in member trade policies
- International banking

Trade Protection
Protectionism
- The placement of legal restrictions on international trade and includes tariffs, quotas,
subsidies and other bureaucratic barriers
...


As can be seen from the diagram, the implication of a tariff raises the market price of the
good
...
The
area in red highlights domestic revenue and yellow illustrates import revenue
...

Quota
- A limit/restriction barrier on the physical quantity of a good that can be imported into
the country
...
This results in an increase of domestic production from Q1 to Q3,
and a change in imports from Q1-Q2 to Q3-Q4
...

- When a trade dispute is looming the exporting country can offer to limit their amount of
exports
...

- May prevent a worse outcome for the exporter and satisfies the protectionist desires of
the importer
...


law, easier to change and move as well as apply in the future
...

- Can be in two forms; lump sum or per-unit

The implication of a subsidy causes an outward shift in supply and a rise in price
...
Thus now
domestic producer revenue increases and foreign imports decrease
...

Consumers: No impact due to no price rise and no consumer surplus loss
Domestic Producers: Price received increases and consumption increase; higher revenue
Foreign Producers: Lower revenue
Dead Weight Loss: Increased production by inefficient domestic producers (area B)

Advantages of Protectionism
- Protection of domestic jobs
Keep local jobs safe from foreign competition
...

- Protection of infant industries
Infant Industries
- Those that are newly developed and have not had an opportunity to develop the
economies of scale and low costs that are achieved by selling to a large market
...
Thus they
should be protected until they are large enough to compete
...

Eg
...

- Maintenance of health and safety
Enforcing product standards is important to protect consumers from health and safety
hazards
...
Eg
...
AS well as hormone injected beef from the US which the
EU and Japan have restricted imports of
...

When a country exports goods at a price lower than their production costs they are losing
money but stealing away domestic consumers with their low prices
...
After destroying
competition the dumping firms then raise prices as they now don’t have much competition
...
They severely hurt
domestic producers who cannot compete with the prices and lose customers
...

Some firms do it to sell off surplus goods
...

- Means of overcoming a balance of payments deficit
Balance of payments measures the flow of money into and out of a country, by restricting
imports one is restricting the flow of money out of a country and therefore correcting the
balance of payments deficit
...

- Source of government revenue
Governments can gain tax revenue by implementing a tariff
...

This is particularly beneficially when counteracting relative domestic tax differences
...

- Protecting production base in developing nations
It is suggested that protecting the industries in developing nations can make them less
vulnerable to the volatility of global markets
...
Chinese town Datang à sock city 1970s due to labour cost advantage
...
Moreover, the industries that do have comparative
advantage are hindered
...

- Danger of retaliation and trade wars
Minor disputes can often escalate, causing trade to cease and economic growth to be
hindered
...

- The potential for corruption
Higher tariffs lead to more government revenue which can be used by corrupt government
officials
...

- Increased costs of production due to lack of competition
Domestic complacency can lead to lower incentive to modernize or innovate for greater
efficiency
...

- Higher prices for domestic consumers
Countries that don’t trade have to try to produce enough of everything which is highly
inefficient
...
Less trade
leads to higher real prices of goods and services
- Increased costs of imported factors of production
Businesses that must import factors of production which aren’t readily available domestically
must now import them at higher costs protectionism
...


3
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2 Exchange Rates
Exchange Rate
- The value of one country’s currency expressed in terms of the amount of another
country’s currency needed to buy it
...

- Currency floats freely, the government does not intervene
...

Advantages of a floating rate
- Domestic policy freedom
Allowing exchange rate to float freely means that the government is free to manipulate
monetary policy, specifically interest rates, to manage the balance between domestic growth
rates and inflation
...

- No surplus currency reserves
They do not require stockpiling of currency reserves to devalue or revalue a currency to
financial resources are allocated more efficiently
...

buying capital goods or imported resources
...

Disadvantages
- Uncertainty for investors
Investors need to environment to be as stable and predictable as possible
...
Fluctuations in the currency
may deter investors
...


Not all events can be solved by exchange rate self-adjustment, severe situations can depress
markets and limit growth regardless
...

- Volatility
Wide swings in the currency can make doing business much more difficult particularly for
those heavily involved in trade
...


Depreciation can be caused by a decrease in demand of the currency or an increase in supply,
due to the fact that they cause the equilibrium price to fall
...


Effects
Advantages
- Expansion of domestic industries
Exports are cheap so demand increases, raising revenue and increasing employment; relative
prices of import goods make domestic products more competitive
...

Major economic goals
- Increased inflation can stunt economic growth, though the increased demand for exports
is likely to increase GDP
...

Appreciation
- An increase in the free market value of a currency
...
Meaning that the Euro buys less US$
now
...
Particularly beneficial to firms that import raw materials for production
...

Disadvantages
- Export levels reduced
High export prices reduces their demand causing a fall in revenue for consumers
...

Major Economic Goals
- Appreciation reduces inflationary pressure where import demand is inelastic which may
help with economic growth
...
Likely reducing employment in
exporting industries
...

An increased demand for exports is an increased demand for their currency, causing it to
appreciate
...

- Demand for foreign direct investment (FDI)
Foreign investors may need to purchase the currency of the country that they wish to invest
in
...
Increased FDI appreciates the currency
...
Demand for financial investment
appreciates the currency
...
This is effectively a reduced demand in that currency
...

- Speculation
Holders of foreign currency can speculate on what they believe the value of it will be in the
future
...
Hence they will buy or sell a currency depending on what they think is going to
happen to it
...
Can cause large swings in
exchange rates
...
They can
appreciate the value of their currency by using foreign reserves to buy their currency, or vice
versa
...


Government Intervention
Fixed Exchange Rate
- One that, through government action, is held to a narrow band of possible prices
...

- A commitment to a single fixed rate currency
...

- This can be done by buying/selling the currency or adjusting interest rates
...
if the US wanted to match their economy with that of the EU
...
In response, the US government wants to increase demand and
cause an outward shift back to equilibrium
...
Or by raising interest rates, which encourages people to save their money in US
banks, increasing demand for USD and revaluating the currency
...
Simplifying business plans and reducing FDI costs
...

- Inflation control
Exports are vulnerable to the effects of domestic inflation thus governments have to manage
inflation to keep export prices competitive
...

Disadvantages
- Limitations of domestic policy
Fixed-exchange rate system is managed largely by interest rates meaning that they cannot be
used to manage domestic monetary policy
...

- Limited options with external shock
In economic crisis the fixed system can limit the range of options available to respond to the
crisis
...

- Setting the rate
Setting the fixed rate is a very difficult decision, it has a huge number of unknown factors and
consequences
...

Devaluation
- When a government implements measures to depreciate the value of a currency
...

Managed Exchange Rate
- A system where the government periodically intervenes to keep the rate within a band of
accepted values
...

Currency Evaluation
- When a currency is held above or below equilibrium it causes overvaluation or
undervaluation which can have a significant effect on the economy
...

Advantages
- Enables importation of capital goods or materials at cheaper prices
...

- It hurts exports producing a trade deficit
...


Undervalued:
Advantages
- Cheap exports
- Reduced attractiveness of imported goods
- Improve trade balance
- Used as means to gain access to more foreign exchange
- Accelerate economic growth
Disadvantages
- Create opportunity for imported inflation
Purchasing Power Parity
- The theory that in the long run identical products and services that are sold in different
countries should cost the same
...

Limitations:
- Speculation: in the forex market currency exchange occurs due to speculation not
reflecting the PPP
- Confidence: prospects for future growth and income
- Capital inflows: changes in relative interest rates
- Much trade is not international: % of traded goods is unlikely to make up the entire
GDP for most countries
- Barriers to trade: protectionism limits the free trade and free movement of good causing
higher prices
- Goods not always comparable: differences in product types and quality make further
comparison significantly more problematic

3
...

- Current, capital and financial account
- Important when it comes to the formulation of national and international policy, national
economies are becoming increasingly interdependent
...

Debits are subtracted from the balance of payments because it is spending by consumers on
foreign products
...

- The current account includes the visible (goods) and invisible (services) balance
...

Four components of the current account:
- Balance of trade in goods and services
- Income: factor incomes (wages); NPI
- Current transfers: flows of government money; aids and payments
The Capital Account
- Records the transactions involving ownership of capital between a nation and all other
nations

...

Three main components of the financial account
- Direct investment: abroad and at home

Three main components of the financial account
- Direct investment: abroad and at home
FDI: the buying and selling of a minimum of 10% of a company’s shares by a foreign
investor in the domestic economy or by a domestic investor in another nation’s
economy
...
Reserves consist primarily of foreign and financial assets such as government
bonds and foreign currency
...


Implications of a persistent deficit:
- Foreign ownership of domestic assets
Balance of payments must equal zero so a deficit in the current account means there is a
surplus in the financial/capital accounts
...

- Exchange rates
Puts downward pressure on the currency

As can be seen on the diagrams above, a deficit means that either demand for the currency
has decreased (decrease in exports) or supply has risen (increase in imports), leading to the
devaluation of the currency
...
Depreciation causes inflation due to higher import prices and to prevent the massive
depreciation the government must use monetary policy; tighten money supply and raise
interest rates
...

August 2010 China held $868 billion of US Treasury Securities
...

- International credit ratings

- International credit ratings
Require a nation to run a foreign account surplus over time it reduces the attractiveness of the
deficit country’s government bonds to foreign investors
...

- Increased protectionism
Increased barriers to trade will encourage domestic consumption over imports, either
tariffs, quotas or subsidies
...

Expenditure reducing policies:
- Contractionary fiscal policies
Raising taxes and decreasing spending will reduce AD including for imports
...

- Contractionary Monetary Policy
Raise interest rates to discourage consumption of imported products
...

Consequences
- Unemployment
- Reduced output
- Stunted economic growth
- Improved inflation
Expansionary supply-side policies
- Investments in education and healthcare: educated and healthy workforce increases
productivity, output and competitiveness
- Public funding for scientific research and development:
- Investments in modern transportation and communication infrastructure: to remain
competitive in the world economy
Allocation of scarce economic resources towards economic activities in which it can most
effectively compete in the global economy
...

J-curve effect
- Shows how depreciation of the nation’s currency is likely to affect the current account
balance over time
...
Firstly
worsening the deficit then improving to produce a surplus
...


Effect of current account on the exchange rate

- An increase in demand (more exports) or a fall in supply (less imports) caused by the
current account surplus can cause the currency to appreciate
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3
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- If a group of countries wish to become more open and trade more freely with each other,
they may attempt to remove trade restrictions between themselves but maintain them
with other countries
...


- Economic integration will increase competition among producers within the trading
bloc
...


Free Trade Area
- Member countries remove tariffs and quotas between themselves, but retain whatever
restrictions each member chooses with non-member countries
...


- No internal trade Barriers
Customs Union
- A customs union is like a free trade area, but in addition members must adopt common
external tariffs and quotas with non-member countries
...

- This is believed to be beneficial as cheaper supplies from abroad allows for lower prices
that benefit consumers
...

- This is usually due to the common external tariff that the countries in the trading bloc
may agree to
...

Common (Single) Market
- A customs union with common policies on product regulation, and free movement (no
trade restrictions) of not only goods across borders but also financial flows and labour
...
Germany and Greece
- Countries involved may vary greatly in their language, culture and politics which may
make them very difficult to integrate
- Inefficiency: inefficient firms in the bloc are favoured for more efficient firms outside of
the trading bloc

3
...
’
- Base year = 100
- Increase in value is favourable
- Decrease in value is unfavourable

Factors which effect the terms of trade
- Export and import prices move in opposite directions
- One moves and the other does not
- Both move in the same direction but one further

Causes:
Short Term
1
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Different domestic inflation rates (higher local price levels = more expensive exports =
lower ToT)
3
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Growth in incomes (impact determined by YED)
2
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Technological advances
4
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- A country can purchase a larger quantity of exports with the same quantity of imports
...
Therefore, the result is a
global redistribution of output and income
...


imports
...

- If the good or service is price elastic: a price increase would lead to a decrease in export
revenue and yet an increase in the ToT
- If it is inelastic: a price increase would create an improvement in the terms of trade and
have a positive impact on the economy
...

Domestic Inflation
- If inflation causes ToT improvements and the demand is inelastic then export revenues
grow
...

Exchange Rates
Depreciation
- Causes a decrease in terms of trade
- If goods are elastic then it improves trade balance
- If goods are inelastic then it is negative for the economy
Appreciation
- Causes increase in terms of trade
- If PED is elastic it hurts the balance of trade
- If PED is inelastic then it is good for the economy
How much of GDP is derived from trade
- Indonesia – 6%
- Singapore – 100%
Short-term fluctuations in the terms of trade
- ELDCs tied to primary goods and commodity goods can have volatile markets
...

- Sudden improvements in commodity activity can improve the ToT, this known as
commodity booms
...
This can lead to higher
production costs and a trade deficit
...
It can help them import more, reduce debt and
improve standards of living
...

- Governments often struggle to implement effective policies to handle the situation
...

- ELDCs often gain most of their export revenue from commodities
...

- Thus the terms of trade of developing countries is likely to deteriorate over the long
term
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