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Marco Bulatovic
Trade and integration
Understand the terms of absolute and comparative advantage and use them to analyse the basis of
international trade and the gains from trade
...

The WTO is an international body  1
...
) Polices the rules of
trade (to which its members sign up to), 3
...


Comparative advantage

Absolute advantage
-

Where one country is able to produce
more of a good or service with the same
amount of resources, such that the unit
cost of production is lower
...


-

Reciprocal absolute advantage: Where, in a
theoretical world of two countries and two
products, each country has an absolute advantage
in one of the two products
...
g
...
)
Factor intensities
...
g
...
advantage in
labour-intensive production
...
)
Factor intensities: the balance between land, labour
and capital required in the production of a good or
service
...
The prices are known as the terms of trade
...

Comparative advantage arises a basis for trade
– it makes sense to specialise in your
comparative advantage

x 100

The price of a country’s exports
relative to the price of its imports
...

Where this type of trade occurs, the countries involved could consume outside their
production possibility curve
...
The TPC lies outside the production
possibility curve (PPC), showing the gains in consumption possible from international trade
...


Marco Bulatovic
Heckscher-Ohlin theory of international trade: a theory that a country will export products produced
using factors of production that are abundant and import products whose production requires the
use of scares factors
...
)

The effect of international trade
Global gap
-

Through international trade, global production is increased
Trade allows countries to specialise
...


Economies of scale
-

By being able to supple global markets, firms and industries can benefit from economies of scale
...


However: - Some industries may lack the economies of scale to compete in global markets
...

Competition
-

Trade increases competition for domestic firms and, as a result, will put downward pressure on prices
...

Incentivises firms to lower AC by seeking efficiencies in production and eliminating waste
...

Overall, net gain from trade  but winners and losers in each country
...
International trade can lead to changes in behaviour over a
period of time that can increase productive and allocative efficiencies
...

E
...
India’s toy industry was expanding by 15-20% / annum
...


Factor prices
-

-

If the source of comparative advantage is differences in factor endowments, then over time trade will equalise the
prices of the factors of production
...
This
will increase the demand for labour in China due to it specialising in the production of labour intensive goods
...
This effect has been seen particularly where
regional trading blocs have been formed
...


Marco Bulatovic

The terms of trade
Index of average export prices
Terms of trade=

Index of average import prices

x 100

The terms of trade tell you the volume of exports needed to purchase any given volume of
imports
...

Rise in terms of trade – ‘improvement’
Depends on the reasons for increase
...

Movements in T
...
T reveal nothing about volume of exports and imports (these determine
the effects on the current account of the balance of payments and AD)
- X prices up, but effect depends on PED
...

 Fall in terms of trade – ‘ deterioration’

-

The terms of trade give an indication of the extent to which an economy will benefit from
international trade
...
o
...

E
...
If reliant on primary commodities (goods produced in the primary sector of an economy,
such as coffee and tin) the trend that commodity prices tend to follow a downward trend
can be bad for economies that earn at least 50% of their export revenue from commodities
...

The pattern of global trade
-

Global trade is unevenly distributed  developed economies dominate world trade (2/3 of
the world trade is dominated by the world’s richest economies
...


Developed economies: Countries with a high income per capita & diversified industrial and tertiary
sectors of the economy
...
g
...

Developing economies: Countries with relatively low income per capita, industrial sector is small/
undeveloped
...


Marco Bulatovic
Liberalisation: Reductions in the barriers to international trade, in order to allow foreign firms to
gain access to the market for goods and services that are traded internationally
...


Case against the theory of comparative advantage
There are some patterns of global trade that do not appear to fit the economists’ theory of international trade
based on comparative advantage
...
Trade should take place where relative opp
...
)
With the exception of transition economies, countries tend to trade within their own group (intra-group
trade) rather than with countries whose income level is different
...

Transition economies: Economies in the process of changing from central planning to the free market
...
Small differences in
opportunity costs may be cancelled by transport costs
...

The world is divided up into trading blocs (e
...
EU, NAFTA, ASEAN)
...
In reality, a high proportion of global trade involves countries
exporting and importing products produced in the same industry (intra-industry trade)
...

Comparative advantage does not take into account the market structure of many manufacturing
industries
...
g
...
Different firms produce different products
to appeal to different segments of the market  encourages intra-industry trade (since variety appeals to
consumers
...
Freely floating XR
2
...
Semi-fixed/semi-floating XR
Foreign exchange (FOREX) market: A term used to describe the coming together of buyers & sellers
of currencies
...

-

There is no government intervention in the FOREX markets
...
TRADE – e
...
UK goods and services sold in USA create demand for the GBP
...

2
...

3
...
g
...
)
Governments are free to set domestic economic
policy to achieve the key policy objectives
...


There is no need to set interest rates to achieve an
exchange rate target, for example
...
g
...
Appreciation
lowers import prices  inflationary pressure
reduced
...
Export prices raised  demand
for exports falls
...


The central bank is, therefore, free to use the
interest rate to achieve price stability and the
exchange rate ceases to be a constraint on
economic policy
...

B
...
P deficit must mean more money
leaving the economy than entering it
...

The XR will automatically depreciate 
reduces price of X and increases price of
M
...
B
...
P deficit will be
eliminated
...


Merits of freely
floating XR

XR of currency
er

S (value of
imports +
capital
outflows)

Er1

Reduced speculation over the value of a currency when FF
...
Currency speculators
have little to gain and therefore greater stability encouraged over time
...

This would reduce demand
for GBP on FOREX markets,
causing the pound to
depreciate
...


Q Currency traded

Marco Bulatovic
The merits of a FFXR can be overstated, however:
- The freedom to set domestic economic policy does not necessarily guarantee that
governments will choose to prioritise price stability over other objectives
...

- The reliance on exchange rate to offset domestic inflation is likely to be unsustainable in the
long run
...

- There is a danger that a lack of control over inflation could create a run on the currency 
could result in economic crises? E
...
Argentina 1999-2002 – crises of confidence lead to
massive withdrawals from banking system, conversion of peso’s into dollars (due to panic)
caused value of currency to fall dramatically
...

- Depreciation of the XR does not always improve B
...
P problems, especially in the short run
...

- If the PED for exports is also inelastic, falling export prices would reduce the value of exports
sold (export revenue), further reinforcing the tendency for the trade and current account to
worsen
...

A fall in the exchange rate(at point t1) causes an
initial worsening of the balance of trade, as
higher import prices raise the value of imports
and lower export prices reduce the value of
exports due to short run price inelasticity of
demand for exports and imports
...
An
appreciation of the currency causes an inverted
J-curve effect
...
This is
captured in the Marshall-Lerner condition:

Marshall-Lerner condition states that for a depreciation of the currency to improve the balance of trade
the sum of the PEDs for imports and exports must me greater than 1
...
e
...


Marco Bulatovic

Fixed exchange rate
In a fixed exchange rate system, the value of the currency has a fixed value against another currency
or a basket of other currencies
...

(E
...
Argentina might choose to fix the Peso against the Dollar because the majority of its trade is
with the USA)  sometimes known as a currency peg
...

If the exchange rate is fixed at er but the demand and
the supply of the currency is DS there will be an excess
supply of the currency
...

To maintain the exchange rate at er, either the demand
of the currency must be raised to D1 or its supply must
be reduced to S1
...

Alternatively, it may have to limit the amount of
currency that leaves the country
...


Merits of a fixed XR:

Reduced exchange rate uncertainty – Fixed XR reduces the risks of trade and
investment by reducing XR uncertainty
...
Countries operating fixed XR will enjoy higher levels of trade and
investment
...
As an insurance against movements in XR, firms
engaging in international trade hedge their risks by buying currencies in futures
markets
...

Imposes discipline on domestic firms – If XR cannot depreciate, domestic firms will
need to make sure that they match the productivity improvements of their foreign
competitors and do not allow unit labour costs (ULC) to increase
...

Futures markets: markets where people and businesses can buy and sell contracts to buy
commodities or currencies at a fixed price at a fixed date in the future
...
Such reserves have an
opportunity cost
...
This may put a constraint on the kinds of economic
policies that would contribute to economic growth in the long run
...

-

The loss of control over domestic monetary policy – under a fixed XR system, interest rates
have to be set to maintain the XR
...
When the IR needs to be increased to prevent the XR from depreciating, there is a
conflict with the objective of maintaining economic growth
...
In the event of persistent over- or undervaluation, currency
speculators are likely to sell or buy the currency, causing volatility in the exchange rate
...
For example East Asian economies were forced to
increase interest rates following a massive depreciation of currencies, but these interest rates
did massive damage to the economies affected, and, in the end did not halt the depreciation
of the currencies affected
...


-

International retaliation – countries have much to gain in the short run from fixing their
exchange rate below the market rate, deliberately
...
In the longer term, however, this may cause a rise in protectionist measures against
their exports
...
g
...


In summary:
Drawbacks
Benefits

-

-

-

Reduced exchange rate uncertainty
Reduced cost of trade
Imposes discipline on domestic firms

-

The need to maintain high levels of
foreign currency reserves
The loss of control over monetary
policy
Speculative ‘attacks’ on the currency
International retaliation

Marco Bulatovic

Semi fixed/ semi-floating exchange rates
-

Hybrid systems  include a range of exchange rate systems somewhere between floating
and fixed exchange rates
...

They are either:
1
...

2
...


Economists have distinguished between these different systems as follows:
Adjustable peg systems
Where the exchange rate is fixed in the short term but is adjusted upwards or downwards in the
long term in order to avoid sustained under- or overvaluation
...

Crawling peg systems
Where the exchange rate is fixed but large revaluations or devaluations are avoided by frequent but
small changes to the fixed exchange rate
...
Intervention only
occurs when the exchange rate reaches its upper or lower limit (ceiling or floor)
...

Bilateral exchange rates show greater fluctuation than measures of effective exchange
rates based on averages of a basket of currencies
...

Effective exchange rate: The exchange rate of one currency against a basket of currencies of other
currencies, often weighted according to the amount of trade done with each country
...


When

demand > supply for a currency  Exchange rate will appreciate

(rise in value)
...


-

-

In the longer term changes in demand and supply of a currency are related to changes in the
value of EXPORTS and IMPORTS and LONG-TERM CAPITAL FLOWS Flows of money related to buying
The determinants of changes in X, M and LT capital flows
change slowly over time
...


and selling of assets, such as land or
property or production facilities
(direct investment) or shares in
companies (portfolio investment)
...


In short term: XR changes owe much to speculation  depends on confidence
...


Marco Bulatovic
Consequences of XR fluctuations
Benefits
- Lower import prices are a benefit for
consumers and for those producers that
import raw materials, components and
machinery
...
Producers benefit
from lower input costs and higher profit
margins, or are able to reduce prices to
raise demand (An appreciation of XR can
also lead to reduced inflationary
pressures
...
E
...
paying for contracts up
front
...

- Another option is the use of futures
markets
...

- Despite risks and uncertainties created by
fluctuating exchange rates, world trade
volumes are remarkably stable
...


Problems
- Appreciation of XR  raises price of
exports and reduces the price of imports
...
The
extent to which this is a problem depends
on PED for exports
...

Lower import prices will amplify
these effects if price elastic
...

-

-

Fluctuating exchange rates create
uncertainty and risk through regular
movements up and down in the value of
the currency
...
The more a country’s
exchange rate fluctuates, the more risky
trade is with that country and the lower
the volume of trade is likely to be
...


A trade deficit in goods or services may come about by:
-

High levels of consumption causing excessive spending on foreign-produced G+S
...

A change in comparative advantage  cheaper G+S being imported rather than produced
domestically
...

Structural weaknesses in the economy resulting from domestic firms losing competitiveness
against imported goods due to a lack of investment, high labour costs or low productivity
...
of
...
Do nothing
-

-

Current account deficit must be matched by a capital account surplus  i
...
If more money
is flowing out of the economy on the current account, then more money must flow in on the
capital account (otherwise there will be downward pressure on the XR)
...
As a result they have attracted FDI,
which counts as a credit in the capital account of the B
...
P
...

There are two reasons for this:



The economy is living beyond its means (spending more than earning from abroad
...

2
...

This requires the relative price of imports to rise and the relative price of exports to fall
...
A fall in the exchange rate
2
...
Subsidising exports
Main problems with this type of policy are related to their impact on the domestic economy
...
Raising the price of imports may
have little impact on the volume of imports demanded if the PED for imports is inelastic
...
) then
expenditure-switching policies will be ineffective
...
Increase in price combined with a less than proportionate
reduction in demand  raise the value of imports
...

Subsidising exports and placing tariffs on imports risks retaliation from the countries affected and
would be against the rules of the WTO
...
of
...


Marco Bulatovic

3
...

This can be achieved by:
1
...

2
...

3
...

Problems:
There is a large cost to domestic industry from reducing AD and output  May have to suffer from a
sustained period of recession to correct current account position
...
of
...
g
...
)
Economic integration
Economic integration refers to the process of blurring the boundaries that separate economic activity
in one nation state from that in another
...

-

Tariff and NTB’s reduce the free movement of goods, services and the factors of production
between economies
...

Customs union (CU) – an agreement
- Economic integration seeks to remove these barriers to trade
...

countries to abolish tariffs on trade
between them
...

Monetary union – The deepest form of
economic integration from a
integration in which countries share
customs union by eliminating nonthe same currency and have a
tariff barriers to trade, promoting
common monetary policy as a result
...


Marco Bulatovic
Stages of economic integration:
1
...

3
...

5
...
This is often restricted to a limited
range of G+S
...

Trade deflection: Where one country in a FTA imposes high tariffs on another to reduce imports but the imports
come from elsewhere in the free trade area
...
g
...

Customs union (CUs)
The problem of trade deflection is avoided by strengthening economic integration by agreeing a common
external trade policy
...

This involves a loss of economic sovereignity
...

Single Markets (SMs)
Removes restrictions on the free movement of labour and capital between countries, removes NTB’s through
agreeing a common approach to product standards, employment laws, taxation policies, completion policies
and state aid to industry
...
Flows of goods, services, labour and capital
between the members of CU become significant and price disparities between the member states narrow
...
Economic policy making becomes more
central, there is no agreed definition, however
...

Monetary Unions (MUs)
Agrees a common approach to monetary policy
...
This form of economic integration eliminates XR uncertainty and takes
away the cost of changing currencies (Transaction costs)
...

Competition increased between member states  strengthens a single market  flow of G+S increases
...

Free traders argue that NAFTA has increased trade between the three countries, boosted foreign investment and helped to
raise growth in Mexico in particular
...

Trade agreements such as NAFTA create winners and losers  this is the consequence of resource allocation
...
In 2007 it committed itself to creating a single
market by 2020 with the free movement of G, S, capital and labour
...

ASEAN’s free trade zone involves exemptions for too many G+S and there has been little success in reducing NTBs  whilst
trade between ASEAN members has grown, trade with non-ASEAN countries has grown more rapidly
...

Single European Market (SEM): a process adopted in the EU that promoted the free movement of goods, services and
capital by harmonising product standards and removing non-tariff barriers to trade
...

Monetary policy sovereignty: the ability of a country to pursue an independent monetary policy
...


TRADE CREATION
Trade creation is where economic integration results in high-cost domestic production being replaced by
imports from a more efficient source within the economically integrated area
...
This benefits consumers through lower prices and
higher consumer surplus
...

Overall economic efficiency is raised but there are winners and losers
...

TRADE DIVERSION
Trade diversion is where economic integration results in trade switching from a low-cost supplier outside the
economically integrated area to a less efficient source within the area
...
This arises because tariffs on trade are
eliminated within the economically integrated area but remain on trade from outside
...

In the LR, there are other expected consequences of economic integration  known as the
DYNAMIC EFFECTS because they occur over time
...
A reduction in monopoloy power
Economic integration erodes the power of domestic monopolies, leading to increased choice for
consumers, lower prices and greater allocative efficiency
...
Greater innovation and R&D
Competition between producers in an economically integrated area can lead to more product and
process innovation and expenditure on research and development
...


3
...

Over time there may be regional concentration of industry  cost advantages in terms of access to
specialist suppliers, skilled labour and sharing of knowledge
...

This could result in significant regional and structural unemployment within an economically
integrated area
...

Integration may also, over time, result to the emergence of oligopolies and monopolies
...
(e
...
Price fixing cartels)

Marco Bulatovic
The external impact of integration
Trade diversion represents a potentially significant loss of income for those countries outside free
trade areas and customs unions
...

Poor countries suffer the most from this aspect of economic integration because they are dependent
on agricultural exports
...

Therefore MEDC’s may be winners, whilst LEDC’s may be losers in the process of economic
integration
...
This stimulates trade
...


The benefits might be limited by the ability of consumers to engage in cross-border shopping
...

There are ST costs: Changing over to a new currency (including menu costs)
...

LRAS and AD should increase from the introduction of a monetary union, therefore causing growth
without inflation
...
For
example, ECB sets the euro interest rate
...

In addition, countries cannot offset losses in competitiveness through exchange rate
depreciation
...
Fiscal policy is the only tool left for ST management of the economy and Supply
side policy must be used to bring LT improvements in economic performance
...

If this does not happen, fiscal policy of individual nations might undermine monetary policy
for the whole currency area
...

Depending on where these limits are set, it is possible for membership of a monetary union
to limit the operation of automatic stabilisers in individual economies and to cause the
business cycle in some countries to be more pronounced as a result
...

Automatic stabilisers: Elements of fiscal policy that cushion the impact of the business cycle without
any need for corrective action by the government
...

The need for fiscal transfers
Fiscal transfers: occur where taxation raised in one country is used to fund government
expenditures in another country
...

Without such a mechanism, there is a risk that countries lack the macroeconomic policy
instruments to manage their economy when its performance diverges from the ‘average’ of
the rest of the monetary union
...
Alternatively, interest rate management may be very conservative,
with the central bank slow to adapt to a global slowdown
...
A lack of economic convergence could occur when one country is
in the boom phase of the economic cycle when others are in the recession phase
...
The lack of business cycle convergence
therefore means that one interest rate does not ‘fit all’
...


Marco Bulatovic
-

Countries where borrowing tends to be at variable rates of interest will show much more
response to interest rate changes than countries where borrowing is at fixed rates
...


Economic convergence: the process by which economic conditions in different countries become
similar
...

Membership of the euro area only requires monetary convergence to have taken place
...
These requirements help to soothe out differences in
economic performance that arise from the loss of monetary policy sovereignty
...
Of these
characteristics, some economists argue that the most important are those that impact on
the supply-side performance of the economy
...


Optimal currency area: refers to conditions that need to be met to avoid the costs of monetary
union
...




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