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International Trade

An Outline

Social welfare implications of moving from closed to open economy

1. Expansion of consumer surplus.
2. This surplus spreads in 3 areas:
3. Area 1: an increase in consumer surplus at the expense of producer surplus.
4. Area 2: green gain or in other words gain in economic efficiency since domestic inefficient producers exit the market.
5. Area 3: real consumer surplus increase since there is a drop in price due to the cheaper imported goods and as a result domestic consumers demand more.

Social welfare implications from tariff imposition

1. Through tariff imposition we have a loss of consumer surplus initially gained by opening the economy however this isn’t an entire loss for the economy seeing that some of it is redistributed in the economy either positively or negatively.
2. Area 1:an increase of producer surplus at the expense of consumer surplus however this surplus is solely referring to domestic producers.
3. Area 2:loss of economic efficiency because some domestic inefficient producers are coming back.
4. Area 3:government revenue from tariffs.
5. Area 4: real consumer surplus loss.

Absolute advantage: A country has absolute advantage in the production of a good if with an equal amount of resources it produces more of the good than another country. Absolute advantage doesn’t necessarily mean the country has comparative advantage.

Comparative advantage: The principle on which trade is based is comparative advantage, which in turn is based on the concept of opportunity cost. A country has comparative advantage when it produces a good at a lower opportunity cost even if it produces fewer units of that good compared to other countries.

Benefits of free trade:

1. If all resources in countries with comparative advantage are diverted into the production of the goods at which they have the lowest opportunity cost then (assuming constant returns to scale) the production will double.
2. Trade allows countries to benefit from more goods and services by specializing in the production of the goods in which they have comparative advantage.
3. Consumers have a wider range of goods at lower prices than they do without trade.
4. Trade enables countries to consume outside their PPF thus expanding the curve.
5. Economies of scale are achieved because countries by specializing may increase output and gain lower unit costs.
6. Efficiency is gained due to international competition which is a motive for countries to become more competitive seeing that now they have to compete at an international scale.
7. Political, social and cultural gains by bringing countries together.

Disadvantages of free trade:

1. Increasing costs of production due to diseconomies of scale producers have to produce more and if they had economies of scale before their current output exceeds the point of minimum economic efficiency.
2. Transport costs may make it expensive for a country to trade despite lower opportunity costs thus increasing the price it offers at the international market thus reducing its competitiveness.

Terms of trade: the rate of exchange of one good for another between trading partners which depends on opportunity cost ratios. If export prices increase compared to import prices the terms of trade improve (favorable movement of the terms of trade). If export prices fall relative to import prices terms of trade worsen (adverse movement of the terms of trade).

1. Quotas placement of a limit on the number of foreign goods and services allowed in a country.
2. Exchange controls placement of limit on the amount of money which can be changed into foreign currency.
3. Non-tariff barriers imposition of different safety standards e.g. German beer.
4. Voluntary agreements voluntary export restraint e.g. Japanese and UK cars.
5. Embargoes when an embargo is placed on a good no trade is allowed often done for political reasons e.g. there was an embargo imposed on Zimbabwe due to Mugabe`s discrimination against whites and there was an embargo imposed in South Africa during the apartheid regime.
6. Tariffs taxes placed on foreign goods so as to make them more expensive and thus encourage consumers to switch to domestic goods and services. Usually countries impose tariffs when they are within the safe boundaries of a regional trading block.

1. Infant industry argument small firms need to be protected so as to have time to expand and gain economies of scale so as to be able to compete on an international basis later on. However so far this has happened only in big industries such as the steel industry and it gives a motive for firms to remain lazy because they know they don’t have to compete on an international level e.g. steel industry in the USA.
2. Dumping to prevent firms from selling goods at a loss to destroy the domestic industry. By allowing free trade there is guarantee for low prices indefinitely because the moment one firm becomes inefficient more efficient ones will enter the market and take it away.
3. Raise revenue for the government through tariffs.
4. Prevent overspecialization and diseconomies of scale in other words over production in a country due to the need to export goods because this will also lead to misallocation of resources which is what we are trying to prevent by free trade.
5. To remove a balance of payments deficit without however tackling the problem at its root this is inefficiency.

1. Strategic interests some industries such as the defense industry are better to be kept domestic. For example a country can’t depend on others for it weapons industry because in the case of war it would be left unarmed.
2. Political reasons lack of willingness to trade due to political differences. For example China and Japan don’t trade due to political disputes.
3. Prevention of the import of demerit goods such as tobacco and alcohol.
4. Way of life and maintenance of traditional way of living.
5. Protection against low wage economiessome countries gain comparative advantage by offering lower wages. For example people are imposing trade restrictions on China because it underpays its workers and thus no other economy has the ability to compete with her.

1. Offering subsidies to producers, which is an unpopular alternative because the money will have to be raised through taxes.
2. Free trade area free trade between member countries; members charge whatever tariffs they wish towards non-member countries. Examples of these are CAFTA, LAFTA, NAFTA etc.
3. Customs union free trade between member countries; members must charge a common external tariff against non-member countries. The EU is the only existing such example.

1. Internal economies of scale firms operate in larger markets and thus are able to increase output and reduce costs.
2. Greater competition motive for improving efficiency.
3. The union has more bargaining power and gets better terms of trade.

1. The cost of administering the union is very high.
2. There is great possibility of diseconomies of scale.

1. Imposition of tariff.
2. Trade diversion.
3. Determination of the price of an internationally traded good.
4. Social welfare implications of moving from open to closed economy.
5. Quota imposition.
6. Subsidies as an indirect method of protectionism.
7. Voluntary export restraint.
8. Trade creation

Exchange rate: the price of a currency in terms of another. In a floating exchange rate system this price is determined by market forces of supply and demand. In a fixed system the government intervenes to maintain the external value of the currency.

External VS. Internal value of currency: external value of a currency is the exchange rate whereas internal value of a currency is how much it can buy in its own country.

Fixed VS. Floating exchange rate: in floating exchange rate systems an increase in the exchange rate is an appreciation; a fall is depreciation. In a fixed exchange rate system if the rate at which it is fixed is increased we have a revaluation, if it is decreased we have devaluation.

Types of exchange rates:
1. Trade weighted index measures the value of a currency against a basket of currencies which are rated according to their relative importance in a countries trade.
2. Real exchange rate takes inflation into account when measuring changes in exchange rate.
3. Effective exchange rate takes into account how much trade the country does with other countries. It also considers the extent to which the country competes with these countries internationally.

The demand for a currency: this refers to the desire and ability of people to convert their money into some other currency in order to:

1. Spend on goods or services in that country (associated with tourism).
2. Spend in banks or other financial institutions (long term capital movements).
3. Speculate on the currency in hope that the currency will become more valuable in the future (short term capital movements or “hot money”).

The demand for a currency will increase if:

1. There is an increase in demand for goods and services in that country (associated to tourism).
2. There is an increase in interest rates in that country because that will increase desire to save money in that country to earn higher rates of return when putting your money in a bank account in that country.
3. People think the value of the currency will rise in the future so they buy now.

The elasticity of demand for a currency: if the exchange rate of a currency falls the price of the goods and services in foreign currency also falls and thus demand for the goods and services from that country will increase. The extent of the increase and thus the extent for increase in the quantity demanded of that countries currency depends on the price elasticity of demand for that countries goods and services. The more elastic the demand for these goods the more elastic the demand for the currency.

The supply of a currency: refers to a desire to exchange this currency for another in order to:

1. Buy overseas goods and services or travel abroad.
2. Save in overseas financial institutions.
3. Speculate on foreign currency in hope that it will increase in value.

The slope of the supply of a currency: if the exchange rate of a currency falls the price of imports in that country’s currency will increase thus the amount of imports bought is reduced. If demand for imports is inelastic the total amount spent on imports will increase and the supply of the currency will be downward sloping. If demand for imports is elastic then when their price rises in the domestic currency the total amount spent on them falls. This means the supply of the currency is upward sloping. The supply of a currency will increase if:

1. Overseas interest rates increase so saving abroad becomes more attractive.
2. Overseas goods are demanded more possibly due to increased tourism abroad.
3. People think the currency will fall in the future so they sell now.

Floating exchange rate system: the exchange rate is determined by demand and supply of the currency in the foreign exchange market and involves no government intervention./p> Advantages:

1. The exchange rate automatically adjusts so that supply of the currency equals demand which can automatically eliminate balance of payments deficits or surpluses.
2. There is no need for the central bank to keep foreign reserves.
3. The Government can pursue its own domestic policies.
4. It prevents imported inflation.
5. It possibly reduces speculation because speculators might lose and so fewer speculators take the risk.
Disadvantages:
1. It causes instability which deters investment and trade.
2. It can lead to inflation, if a country has inflation which makes its goods uncompetitive this will lead to a fall in demand for its currency and a fall in the exchange rate. This makes its goods competitive again but makes imports more expensive, which in the long run leads to more inflation (cost push). This happens due to the increase of imported factors of production.
3. Speculation on future movements can lead to major changes in the rate.
4. Governments aren’t forced to control their economies.
Government and exchange rate: Ways in which the government can influence exchange rate:
1. Buying and selling currency.
2. Changing the interest rate to influence capital inflows and outflows from the economy.

To increase demand for the currency a government may:

1. Buy the currency.
2. Raise interest rates to attract investors.

Fixed exchange rate: the government intervenes to maintain the exchange rate. If the price of the currency is about to fall the government may increase demand by buying its own currency or increasing interest rates. If the price of the currency is about to increase the government may sell its own currency or lower interest rates.

Advantages:
1. Provides stability to firms and households, which encourages trade and investment.
2. Constraint on domestic inflation. If a country has higher inflation than its trading partners it will become uncompetitive thus now firms will have to control costs to compete.
3. They prevent speculation seeing that there is no point since exchange rate is fixed.
Disadvantages:
1. A government must have sufficient reserves to intervene to maintain the price of its currency.
2. A country’s firms may be uncompetitive if the exchange rate is fixed at too high a rate.
3. The government must make intervention a priority which means that it might undertake policies that are going to damage the domestic economy.

Managed exchange rate system: government intervenes on occasions to influence the price without fixing it though.

Purchasing power parity: the theory that in a floating system exchange rates adjust until a unit of currency can buy exactly the same amount of goods and services as a unit of another currency.

Exchange rate mechanism: a union in which each member country has to agree to stabilize its currency against a central rate. The central bank intervenes to keep the currency within this band. If the central rate needs to be realigned it can be only if all members agree.

Reasons for joining an exchange rate mechanism:

1. It may lead to less inflation because firms know that prices won’t be offset by low exchange rates and thus they have pressure to control costs and prices.
2. It creates stability which encourages trade and investment.

Fiscal and monetary policy and exchange rate systems:

1. Under fixed exchange rate systems it is difficult o pursue monetary policies because any change in the interest rate is liable to lead to inflows or outflows of currency and increase pressure on it. If the government tries to control the money supply which leads to higher interest rates encourage inflows on the capital account and thus they will increase the money supply again.
2. A fiscal policy is more effective, the government could deflate the economy through higher taxes and less spending. This reduces aggregate demand and spending on imports will reduce demand for money and interest rateslead to capital outflow reinforces the contractionary fiscal policy.
3. Under floating exchange rate systems monetary policies are more effective. An expansion of the money supply will reduce interest rates spending within the economy is boosted and outflows of currency of the capital account fall in the value of the currency exports are boosted leading to a further increase in aggregate demand.
4. A contractionary monetary policy increases interest rates and reduces aggregate demand. Higher interest rates lead to capital inflows and an appreciation of the currency which further reduces aggregate demand.
5. Fiscal policy is less effective (reduction of income and demand for money). This reduces interest rates and leads to outflows on the capital account depreciation of the exchange rate which raise aggregate demand.

Balance of payments: a record of a country’s transactions with the rest of the world. It shows the countries payments and receipts from its trade and it is split into the capital and current account. There is inflow of money in the country because of exports or export related activities represent credit and outflow of money.

Capital account: records investments and financial flows (movements in money capital by firms, households and the government). In the case of government intervention in the exchange rate market aimed at influencing the value of the currency there will be a third element in the balance of payments called official financing which expresses the extent of this intervention. If at the given exchange rate there is excess demand for currency the government will have to sell some of its currency to keep the value constant. This type of government intervention is entered as a negative number under official financing on the balance of payments account. If at the given exchange rate there is an excess supply of the currency the government will have to buy the currency to keep the value constant. This type of government intervention is entered as a positive number under official financing. If there is no official financing then the supply of currency will always equal the demand and the balance of payments i s 0. A surplus in the current account means a deficit on the capital account and vice versa.

Current account:

1. Visible trade account which is the difference between the export revenue and the import spending on physical goods.
2. Invisible trade account which measures the difference between export revenue and import spending on:
1. Services.
2. Interest, profit and dividends flowing in and out of the country.
3. Transfer payments.

Current account balance= balance of both visible and invisibles.

Balance of payments and floating exchange rates: in a free floating exchange rate system the balance of payments will automatically balance. The exchange rate automatically changes until the supply of the currency equals to the demand for the currency. This doesn’t mean however that each element of the balance of payment account balances.

Balance of payments and fixed exchange rates: If the exchange rate is fixed above the equilibrium rate there will be excess supply of currency. This means that excluding government intervention there is a balance of payments deficit. If the price is fixed below the equilibrium rate there will be excess demand for the currency. This means that excluding government intervention there is a balance of payments surplus.

Current account deficit: the country is spending more on foreign goods and services thus money is leaving the country.

Problems of current account deficit: in the long run this creates problems with the competitiveness of a country’s industries. This usually occurs with a fixed exchange rate system. However the deficit may be offset by inflows on the capital account or the government will have to intervene to buy up excess currency. In the floating exchange rate systems the external value of the currency will fall making exports competitive again

Policies to reduce a balance of payments deficit:

1. Expenditure switching policies: attempts to make imports relatively expensive compared to exports:
   1. Import controls such as tariffs.
   2. Bringing about a reduction in the exchange rate such as devaluation.
2. Expenditure reducing policies: the government attempts to reduce spending throughout the economy. This is likely to reduce the amount spent on imports. To reduce spending the government could increase taxation rates while minimizing its own spending or increasing interest rates.

Policy packages: it may be necessary to use a combination of policies to cure a balance of payments deficit because the use of one might lead to several negative side effects which will need the imposition of yet another policy to be eliminated. Expenditure reducing and expenditure switching policies are complementary and not substitutes.



The J curve effect when the exchange rate for a currency falls in the short run demand for imports will be inelastic because consumers and firms already have their resources of supply and thus may not be willing to change.

Marshall Lerner condition the necessary minimum condition in order for a devaluation to improve the balance of payments account is that the sum of price elasticity of exports and price elasticity of imports is greater than one. However the bigger the sum the bigger the improvement of the balance of payments account.

Income effect if depreciation leads to a fall in imports, the country that produced these goods will suffer a fall in their income.

Why a Balance of Payments surplus is a problem:

In order to reduce it we could use the following policies:

1. Reflate so as to boost demand and thus increase imports.
2. Remove import controls i.e. methods of protectionism.
3. Revalue the currency.

A balance of payments surplus is a problem for the following reasons:

1. One country’s surplus is another country’s deficit and thus the country with the deficit may introduce methods of protectionism.
2. An increase in the demand for products of a country leads to an increase in exchange rate thus making the country uncompetitive.
3. In the case of a fixed exchange rate a balance of payments surplus will increase the domestic money supply which may lead to inflation.

International competitiveness depends on:

1. Productivity.
2. Cost of a single unit.
3. State of technology.
4. Investment in machinery.
5. Quality of design and production.
6. Research, development and innovation.
7. Entrepreneurship.
8. Exchange rate.

Government intervention to improve international competitiveness:

1. Lower interest which will stimulate investment in the country because loans will be cheaper.
2. Decrease in tax to increase investment.
3. Help entrepreneurs start up and survive by reducing bureaucracy and regulation for example.
4. Reduce protectionist barriers to stimulate competition.
5. Increase in tourism through advertisement.
6. Increase advertisement.