International Trade
Free trade: Absence of government intervention or restriction on trading between firms or individuals
Gains from trade
- Specialization
- Differences in factor endowments
- Greater division of labor
- Dynamic gains - innovation/learning curve
- Economies of scale: production
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decreasing average costs of production by increasing size and quantity of output produced
- The size of the market increases when exporting to another country which increases output, lowering costs
- Greater consumer choice
- Greater productive efficiency due to competition
- Lower prices for consumers
- Acquiring necessary resources
- Allocative efficiency
- Source of foreign exchange
- Countries can acquire foreign currency to make payments abroad
- Flow of ideas
- Peace dividend
Theory of absolute advantage
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If countries specialize in a good for which they produce with fewer resources, production and consumption increases in both countries
Theory of comparative advantage
- Even if one country has absolute advantage in both goods trade is advantageous
- It is only necessary that both countries have different opportunity costs for their goods.
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Comparative advantage: situation where one country has lower opportunity cost in production of a good than another country
- the country that has the flatter PPC has a comparative advantage in the good measured on the horizontal axis
- Know the calculations of opportunity cost
- Evaluation points for comparative advantage
- The theory assumes many unrealistic assumptions:
- Factors of production are not immobile/fixed
- technology is not fixed
- Perfect competition doesn't always exist
- Full employment of all resources
- Free trade
- Transport costs
- Complete specialization doesn't exist
- Consumers demand variety
- Opportunity costs are not constant (bowed out ppc)
- Risks of specialization
WTO
- Non discrimination - all member countries get equal treatment
- Called the most favored nation clause
- No country can impose a higher tariff on imports from one country and a lower one on another country
- Exception made for regional blocs
- Attempts to free trade through negotiation/mediation
- non-tariff barriers reduced
- Goal of predictability
- Mediates trade conflicts
- Developing countries offered flexibility in lowering trade barriers to adjust
- Allows injured parties to impost penalties
- Ability to enforce verdicts?
- Handles trade disputes
- Monitors trade policies
- Stable trade environment
- Anti-dumping may be allowed
Trade Protection
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Methods used by governments to restrict international trade flows
- In order to...
- Prevent free entry of imports into a country
- or protect the domestic economy from foreign competition
- Diagram:
- Assumption that world supply curve is perfectly elastic (domestic market is small relative to overall world market)
- Here, in part c, comparative disadvantage because world price is lower than domestic
Tariffs
- Taxes on imported goods
- Raise tax revenue
- Ad valorem - % or Specific - tons/number of good
Impacts of a tariff
- Domestic consumers - worse off
- Price - must pay a higher price - Pw + t
- Quantity - they buy a lower quantity, Q3 instead of Q4
- Consumer surplus - declines by c+d+e+f
- Domestic producers - better off
+ Price - higher (Pw + t)
+ Quantity - higher (Q2 instead of Q1)
+ Producer surplus - increases by c
- Government - better off
+ Revenue - increases (multiply tariff per unit by the quantity of imports)
- Foreign producers - worse off
+ Price received - Pw
+ Quantity - lower
+ Revenue - ??
+ Windfall gain - ??
- Society
+ Deadweight losses
- area d - resulting from increased production by inefficient producers
- area f - resulting from decreased consumption of consumers
- Increased inefficiency of production - inefficient domestic producers produce more
- Global misallocation of resources - decrease in consumption, shift of production to less efficient producers
Quotas
Limit on the quantity of a good which can be imported. Effects similar to tariffs, but no government revenue.
Impacts of a quota
Subsidy
Impacts of a subsidy
TODO
Other trade barriers
Other ways to advantage domestic producers
- Administrative Obstacles
- Content documentation and licensing
- Ex:
- Restriction on foreign ownership
- Licensing
- Extensive testing
- Translation
- Health/Safety standards
- increases cost of product modification and delays foreign producers from getting goods to market
- Ex:
- Speed limits
- Emissions
- Bans on sin advertising
- Content labelling
- Environmental Standards
- Line between environmentalism and contrived trade barrier intended to boost domestic producers
- Developed countries outsource to developing countries, causing a race to the bottom of environmental standards
- Currencies and exchange rates
- fluxuations in exchange rate can cause uncertainty for exporters/importers deterring trade
- Commissions on foreign exchange transactions thus create barriers
- Any government control on currency exchange
- Government favoritism in procurement
- Nationalism
Arguments for and against trade protection
Arguments for protectionism
- Infant industry argument
- However:
- Difficulty determining which industries will achieve economies of scale
- All developed countries might use it at the same time, contradicting the idea of creating comparative advantage
- Government might use it long after protection is no longer necessary
- National Security
- Industries are essential to national defence should be protected
- However:
- Can be used to apply to industries with only an indirect use in defence (steel)
- Protection of Employment
- Targetted barriers
- Overcome balance of payment disequilibrium
- Anti-Dumping
- Tariff governement revenue
Arguments against protectionism
- Efficiency losses, allocative/welfare loss
- Admin costs
- Dynamic efficiency costs in the long run
- Export competitiveness
- Shielding of domestic producers (they get lazy, can't compete globally)
- Forward Linkage effect
Exchange rates
The price of one currency in terms of another currency
Perfectly competitive (or close to it)
- Free information
- Low barriers to entry
- Many buyers/sellers
- Homogenous
Demand for a currency is based on:
- Demand for other countries' goods
- FDI and portfolio investment
- Speculative demand
- Relative rates of inflation
- Investment from abroad
- Domestic demand for imports
- Relative interest rate change
- Change in income
- Use of foreign currency reserves
There may be commissions
Measurement:
- Bilateral (relative to the value of another currency)
- Index-trade weighted (compared to a basket of other currencies, weighted based on the amount of trade done with that country)
Effects of changing exchange rate on the macroeconomy
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Effect on economic growth
- Currency depreciation makes exports cheaper and imports more expensive, thus increasing net exports (X-M), thus increasing national income, AD, and GDP.
- Currency depreciation increases GDP, but this increase in AD might be short term because of the inflation caused by depreciation
- Appreciation ostensibly decreases rGDP, but it might have a postive indirect effect on GDP by making imports cheaper, meaning factors of production can be used easier, increasing investment spending and thus GDP.
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Effect on Inflation:
- Cost-push inflation
- Currency depreciation makes imports more expensive. If said imports are important (as factors of production), costs of production increase, shifting SRAS leftward, causing inflation
- Demand pull inflation
- Net exports increase as a result of depreciation, shifting the aggregate demand curve right. Thus, the effect on inflation depends on where along the Keynesian AD/AS curve the economy is operating (recession will mean little impact, etc)
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Effect on Unemployment:
- Currency depreciation increases exports, increasing AD, causing cyclical unemployment to fall if the economy is in a recessionary gap.
- If economy is at or close to potential GDP, increasing AD (due to depreciation) could cause temporary decrease in natural unemployment, but this will come with strong demand-pull inflationary pressures
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Effect on Current Account:
- Depreciation causes imports to fall and exports to increase. If a country has a trade deficit (excess imports relative to exports), depreciation decreases this deficit. If it has a trade surplus, said surplus gets larger.
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Effect on Government Debt:
- Depreciation causes the value of foreign debt to increase by lowering the value of the domestic currency
Types of exchange rates
Fixed
Exchange rates are set by the central bank of a country
Requires constant intervention (buying and selling currency) to eliminate disequilibrium in the foreign exchange market.
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Explain using a diagram how a fixed exchange rate is maintained
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Countries use official reserves to maintain exchange rate.
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Countries increase interest rates, attracting foreign investment, increasing demand for domestic currency
- However, this involves contractionary monetary policy, whcih can lead to recession
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Countries can borrow from abroad to maintain the rate
- Loans come in the form of foreign exchange which is converted into domestic currency, increasing demand
- Has a number of cons
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Limit imports
- In order to reduce supply of domestic currency
- Contractionary policy might lead to a recession
- Trade protection
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Exchange controls
- Restricting the outflows of funds from a country by restricting quantity of foreign money that can be bought
- Causes resource misallocation
Devaluation: Change in the target fixed exchange rate by reducing it
Revaluation: Change in the target fixed exchange rate by increasing it
RWE: Movement from fixed exchange rates to more free floating ones increased growth
Floating
- Market based
Determinants of a floating exchange rate:
Appreciation is an increase in the price of a currency in terms of another currency, caused by increasing demand or decreasing supply for said currency
Depreciation is an decrease in the price of a currency in terms of another currency, caused by decreasing demand or increasing supply for said currency
- Change in Demand/supply of currency
- Speculation - based on future expectations
- Trade flows
- As imports/tourism increase in foreign countries, there is depreciation
- Increased domestic exports appreciate a domestic currency
- Relative inflation
- Domestic rate of inflation increases (relative to other countries), domestic goods demand decreases, thus supply of domestic currency increases, thus domestic currency depreciates
- Relative interest rates
- High relative interest rates cause people to start saving in the domestic economy, causing currency to appreciate
- Relative inflation rates
- If a country has a higher rate of inflation than other countries, demand for domestic exports falls becaue other countries are able to purchase less (they are more expensive relatively), causing demand for domestic currency to decrease
- Higher inflation relative to other countries leads to currency depreciation
- FDI and portfolio investment
- Foreigners investing in a domestic industry need domestic currency, so demand goes up, resulting in currency appreciation
- Changes in domestic demand for imports
- As a country's imports increase, currency depreciates
- Changes in foreign demand for domestic exports
- As demand for exports increases, currency appreciates
- Changing income
- Income levels increasing causes demand for foreign imports to increase
- Foreign currency reserves use
Purchasing power parity theory
- Exchange rates will (in the Long Run) adjust to different inflation rates, leading to equilibrium of purchasing power
- Big Mac index
- Limitations: Some goods are not exportable (restaurant meal)
- Non-homogenous goods
- Price discrimination by producers
- Different expenditure taxes
Dirty float
Managed float
Pegging exchange rates
- Developing countries peg their currencies to another one such as USD.
- Then currency is allowed to fluctuate up to a maximum relative to USD.
Overvalued/Undervalued currencies
Overvalued currency: value is too high relative to equilibrium free market value
Undervalued currency: value is too low relative to equilibrium free market value
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Don't exist in free floating system
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Many developing countries overvalue in order to get cheap imports to speed up industrialization
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Undervaluing currency can cause expansion of export industries
Know the calculations for Exchange rates
Economic integration
Group of countries move progressively toward removing restrictions on trade
- Bilateral/Multilateral trade agreement
- Intended to increase trade by decreasing trade barriers
Trade creation (SR) - higher cost imports replaced by lower cost imports after trade integration
- Increased consumer welfare
Trade diversion (SR) - Lower cost imports replaced by higher cost imports after trade integration
- Means that free trade area might not improve allocation of resources
- Trade bloc
- Regional trade agreements
- Preferential trade agreement
- Preferential access to certain products by reducing tariffs
- Free trade area - remove tariffs/quotas between themselves
- retains barriers towards non-members
- Loss of tariff revenues, ability to set trade barriers
- Customs union - common barriers applied to non-members
- Avoids reexports
- Need for greater convergence (tax rate harmonisation)
- Politically uncomplex, administratively complex
- Common market - custom union with freedom of movement of all goods and services.
- Needs increased legislative cooperation in taxes, labor laws, invisible trade barriers
- Complete freedom of movement of factors of production
- 4 freedoms: people (work/study/live), G&S, Capital (tranferred without restriction)
- Cooperation in health and safety standards required
- Mutual recognition rule
- Costs
- increased harmonisation
- central decision making
- possibility of monopoly due to larger market
- purely domestic social policies difficult to enact
- environmental standards might lower
- Benefits
- less market distortion
- consumer welfare
- competition
- resource allocation
- Economies of scale
- trade creation
- spread of ideas
- labor mobility
- Monetary union - common market but with common currency and common central bank
- EMU (european central bank) on the euro
- Needs the same rate of interest
- Member countries forego domestic monetary policy
- Members keep budget deficits, growth, debt, stability in line
- Costs
- Loss of monetary policy freedom
- Inflation asymmetry
- fiscal policy restrictions
- Regional unemployment due to language barriers
- Benefits
- Trade creation
- competition
- EoS
- Lower transaction costs due to commission fees decreasing
- predictability/reliability of the same currency increases investment
- investment from non-members due to growth and stability
Balance of Payments
A record of all transactions between residents and foreign residents (money inflows and outflows)
Mercantilist view: limit imports, increase exports
- Fallacious - exports are payments for imports
Current Account
Monetary flows to and from a country arising from:
- Balance of trade in goods
- Balance of trade in services
- Income
- Repatriated profits, interest, dividends
- Current transfers
- Gifts, foreign aid/pensions, - transfers to other countries
Consequences of current account deficit/surplus
- Current account deficit = capital account surplus
- Not necessarily bad
- Import expenditure is more than export revenue in a deficit, thus a downward pressure on exchange rate
- Any deficit must be financed by the financial account, which, if done with FDI, might harm sovereignty
- You may need to borrow money to finance said deficit
- Disadvantages of a deficit
- Borrowing from abroad needs to be repayed with interest
- International credit rating
- Investor confidence
- Debt servicing more costly due to depreciation
- International business cycle prone
- Increased interest rates to attract foreign loans might have contractionary effect
- Speculative inflows cause domestic unemployment
- Foreign ownership of domestic assets might be bad
- Advantages of deficit
- More consumption than production
- Might not have a lot of impact, seen in the light of a country's fundamental ability to pay back the money (US)
- If deficit is financed through investments, AD rises
- Current account surplus:
- Net outflow in capital account, net foreign assets have increased, net creditor
- Net purchaser of assets abroad net lender to other countries
- Upward pressure on currency/exchange rate
- Advantages:
- Foreign assets - form of saving for the country
- Capital will flow to countries with higher rate of return, enhancing resource allocation
- Interest received from foreign holdings
- Disadvantages
- Consumption possibility decreases (resources going abroad)
- Low domestic consumption - low standard of living
- Insufficient domestic investment
- Appreciation of the domestic currency
- Reduced export competitiveness
- Diverting investment from domestic to foreign market
- Tax loss - portion of tax bases are taxed outside of the country
- Upward pressure on currency leads to loss of export competitiveness
Correcting a current account/BOP deficit
- Short run:
- Managing the exchange rate
- Protectionism
- Contractionary demand-side policy
- Long run:
- Supply side policy
- Increase productivity
- R&D
- Innovation/quality improvement
- Expenditure switching/expenditure reducing policy
- Diverting domestic expenditure away from imports to domestic goods
- Ex. Trade barriers
- Ex. Lowering the exchange rate (devaluation)
- Risk: retaliatory protectionism
- Overall, reduces AD and expenditure/national income and demand for imports
- Risk: tradeoff of growth and unemployment
- Competitive devaluations
- Countries seek to gain a trade advantage over other countries by causing the exchange rate of their currency to fall
- Read page 406 in textbook
Marshall-Lerner condition
If satisfied, allows depvaluation or depreciation to lead to an improvement in a country's balance of trade (and therefore its current account)
If PED < 1 then demand is inelastic
If PED > 1 then demand is elastic
- If the sum of PEDs for imports and exports is > 1 (PEDm + PEDx > 1), devaluation/depreciation will improve tradde balance (make a trade deficit [imports exceed exports] smaller)
- If the sum of the two PEDs is less than 1, devaluation/depreciation will worsen the trade balance (make a trade deficit bigger)
J-curve effect
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Depreciating country may see worsening trade balance immediately following the devaluation/depreciation. Later, the trade deficit will shrink, provided Marshall-Lerner condition is met.
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This is because of the Marshall-Lerner condition - initially PEDx and PEDm are very inelastic, very low, but after some time they increase up to the point at which their sum is greater than 1.
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Capital account/Financial account
Capital transfers and investments to and from other countries
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Mirrors the current account
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Includes: Portfolio investment, FDI, Reserve assets, loans and deposits, currency flows
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Current account deficit means that there is a net inflow in capital account e.g. a decrease in net foreign assets
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Current account balance + capital account balance = 0
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Includes things like:
- Deposits in foreign banks
- Lending to foreigners
- Short term financial flows (hot money)
- Foreign reserves
Balancing item - Corrects for statistical errors such as time lags in accounting, tax avoidance, parallel markets (markets for goods that aren't necessarily illegal, just not recorded as a business), illegal trade.
Foreign Direct Investment (FDI)
Investments in physical capital such as buildings and factories undertaken by multinationals
Portfolio Investment
Financial investments such as stocks and bonds, parital ownership of companies held by a foreign country
Terms of trade (TOT)
The amount of exports needed to purchase a given amount of imports
- Using a common currency
- Ratio of export prices to import prices
terms of trade = average price of exports/average price of imports * 100
- Improvement in terms of trade:
- increase in the value of the ratio of average export prices to average import prices (fall in the opportunity cost of imports)
- Deterioration in the terms of trade
- decrease in the value of the ratio (increase in opportunity cost of importing)
SR causes of TOT change
- Changes in global demand
- Changes in gloabl supply
- Changes in relative inflation rates
- Changes in exchange rates
- Trade protection
LR causes of TOT change
- World income changes (depends on YED)
- Productivity changes
- Technology
Consequences of changes in TOT
- Improvement:
- Pros:
- Increased consumption of imports
- Easier to get more for domestically produced goods, thus debt servicing is cheaper
- Import cheaper raw materials/capital
- Improve current account if exports are inelastic
- Cons:
- Aggravates a BOP deficit if demand for exports/imports is elastic as export revenues decrease and import expenditures increase
- National income falls as (X-M) decreases
- Deterioration
- Pros:
- Current account improvement if demand is elastic
- As net exports increase, jobs increase, national income increases
- Cons:
- Higher prices for foreign goods, lower consumption possibilities
- Current account deteriorates if demand for imports/exports is inelastic
- Imported inflation if the demand for imports is inelastic
Imported inflation
Currency depreciation leads to higher price of imports, production costs are higher for companies, thus prices of goods increase, causing inflation.
TOT changes affecting Current account
- Changing TOT affects balance of trade
- If a change in TOT may cause an increase in the value of exports or decrease in value of imports it improves the balance of trade (larger trade surplus or smaller deficit)
- However, TOT's effects depend on not just price but also quantity because balance of trade/current account depends on the values of exports and imports (P*Q).
- The role of PED