BA 187 – International Trade

Issues, Definitions & Strategies

The Issues in International Trade

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Issues in International Trade Gains from TradeGains from Trade

Trade is not zero-sum, there are mutual gainsmutual gains to trade. But gains may be unequally distributedunequally distributed within a country.

Pattern of TradePattern of Trade Trade flows may arise from differencesdifferences in technology,

endowments, tastes, first-mover advantage, random. ProtectionismProtectionism

Attempts by gov’t to shield economy from trade hurt hurt welfarewelfare generally, but may improve welfare of sectors.

Balance of PaymentsBalance of Payments Trade and capital flows between countries are related.

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Why Countries Trade Relative Differences in Labor Productivity Differential Technologies Differential Factor endowments Short-run fixity of factors Differential Tastes Increasing Returns to Scale Imperfect Competition

Each factor influences the pattern of trade and determines distribution of gains/losses between & within economies.

We examine each of these factors separately & evaluate their relative importance empirically.

Accounting for International Economics

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International Flows Interaction between economies involves:

• Flows of goods and services, Net Exports, NX. • Flows of capital, Net Foreign Investment, NFI.

National income identities.• Real GDP = Y = Cd + Id + Gd + X

Cd = Consumption of Domestic output, etc.

• Imports = Cf + If + Gf

Cf = Consumption of Foreign output, etc.

• Use C = Cd + Cf, etc. to rewrite Real GDP as: Y = C + I + G + X - ImX - Im = C + I + G + NXNX

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Flows of Goods and Services Nations buy & sell output from each other.

Net Exports, NX = Exports - Imports • Exports: Output produced domestically, sold abroad.• Imports: Output produced abroad, sold domestically.

• Net Exports sometimes termed the Trade Balance.

Many factors affect Net Exports. Primary factor is the real exchange rate, Other factors are tastes & technology, domestic &

foreign prices, cost of transport, gov’t trade policies.

Net Exports, NX.

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Flows of Capital Nations buy & sell assets from each other. Net Foreign Investment, NFI.

• Purchase of foreign assets by domestic residents minus purchase of domestic assets by foreigners.

• Foreign Direct Investment.• Foreign Portfolio Investment.

NFI depends on:Real interest rates on foreign vs. domestic assets Economic & political risks of foreign assets, gov’t

policies affecting foreign ownership of assets.

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Balance of Payments Accounting Debit items (-)

– Reflects transactions that give rise to payments outwardoutward from the home country.

Credit items (+)– Reflects transactions that give rise to payments inwardinward

to the home country.

5 General Categories of Transactions– Category I: Goods and Services Accounts

– Category II: Unilateral Transfers

– Category III: Long-Term Capital Account

– Category IV: Short-Term Private Capital Account

– Category V: Short-Term Official Capital Account

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Debits (-ve)Debits (-ve) Credits (+ve)Credits (+ve)

Category ICategory IA. Imports of Goods

B. Imports of Services

A. Exports of Goods

B. Exports of Services

Category IICategory IIA. Unilateral transfers made A. Unilateral transfers received

Category IIICategory IIIA. Increase in L-T foreign assets owned by home country

B. Decrease in L-T home country assets owned by foreign country

A. Decrease in L-T foreign assets owned by home country

B. Increase in L-T home country assets owned by foreign country

Category IVCategory IVA. Increase in S-T foreign assets owned by private individ. in home country

B. Decrease in S-T home country assets owned by private foreigners

A. Decrease in S-T foreign assets owned by private individ. in home country

B. Increase in S-T home country assets owned by private foreigners

Category VCategory VA. Increase in S-T foreign assets owned by home country gov’t

B. Decrease in S-T home country assets owned by foreign country gov’t

A. Decrease in S-T foreign assets owned by home country gov’t

B. Increase in S-T home country assets owned by foreign country gov’t

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Example International Transactions Transaction 1Transaction 1: Home country exporters send $2,000 of

goods in exchange for check in foreign bank for equiv. amt

Credit Category I.A. Exports of goods +$2,000

Debit Category IV.A. Increase S-T foreign assets -$2,000

held by home country individ.

Transaction 2Transaction 2: Home country exporters send $2,000 of goods paid by check on importer’s account in home country bank.

Credit Category I.A. Exports of goods +$2,000

Debit Category IV.B. Decrease S-T foreign assets -$2,000

held by private foreigners

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Example International Transactions Transaction 3Transaction 3: Home country residents send $5,000 of goods

as disaster aid to foreign country.

Credit Category I.A. Exports of goods +$5,000

Debit Category II.A. Unilateral transfers made -$5,000

Transaction 4Transaction 4: Home country individual buys L-T foreign corporate bond for $25,000. Pays with $25,000 that foreign co. deposits in its account in home country bank.

Debit Category III.A. Increase L-T foreign assets -$25,000

held by home country individ.

Credit Category IV.B. Increase S-T home country +$25,000

assets held by private foreigners

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Example International Transactions Transaction 5Transaction 5: Foreign country bank (private) wishes to

convert $ to own currency by selling to its own central bank. Transaction transfers $account in home country bank to $account of Foreign central bank (held in home country).

Debit Category IV.B. Decrease S-T home country -$25,000

assets of private foreigner

Credit Category V.B. Increase S-T home country +$25,000

assets held by foreign gov’t

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International Relationships Savings & InvestmentSavings & Investment in an open economy.

• Output Equilibrium: Y = C + I + G + NX

• Rewrite as: Y - C - G = S = I + NX

• Re-arrange as: NFI = S - I(r) = NXNFI = S - I(r) = NX• If NFI negative, then inflow of foreign saving into domestic

economy and trade deficit simultaneously.

Balance of Payments Balance of Payments

= Current Account + Capital Account = 0= Current Account + Capital Account = 0• Current Account approx. equal NX.

• Capital Account approx. equal -NFI

• Need to understand why NX = NFI due to paired transactions feature of int’l flows

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Prices for Int’l Transactions I Nominal Exchange Rate, e.

• Rate at which can exchange one currency for another.• Always express here as # units of foreign currency per

unit of domestic currency.• Appreciation:Appreciation: Rate increases so domestic currency buys

more foreign currency. (Domestic strengthens)• Depreciation:Depreciation: Rate decreases so that domestic currency

buys less foreign currency. (Domestic weakens)

There is an exchange rate for each foreign country’s currency versus the domestic currency.

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Prices for Int’l Transactions II Real Exchange Rate, .

• Rate at which can exchange outputoutput of one country for outputoutput of another country.

= [Nominal Exchange Rate x Domestic Price Level]

Foreign Price Level

or or = [e x P]/P = [e x P]/P**

• Real exchange rate gives cost of output, both foreign and domestic, in common terms.

• Depreciation of Real Exchange Rate increases NX. makes U.S. output cheaper, increasing U.S. exports

while decreasing U.S. imports.

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Purchasing Power Parity, PPP

Purchasing Power Parity the simplest theory of how real exchange rates are determined.• “Law of One Price”: A good cannot sell for different

prices in different places at same time.• Implies real exchange rate roughly constant

thus in long run should have: e = Pe = P**/P/P PPP limited as exchange rate theory:

• Many goods & services are not tradable.• PPP good basis for understanding large moves in

nominal exchange rate.

Strategies for Understanding Trade

Historical Background of Trade Theory

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Mercantilism (1500-1750) Nat’l wealth = country’s holdings of bullion (specie).(specie). Economic activity viewed as zero-sum gamezero-sum game. Strong state power critical to economic success. Economic system consist of 3 sectors:

– Manufacturing, rural, & foreign colonies.– Merchants for trade, Labor for production.– Commodities priced by relative labor content.

Need for state to regulate economic activity to ensure favorable (positive) trade balance.– Positive trade balance means inflows of precious metal (specie)– Increase national wealth, financing for military capability.

Implicitly assuming that economy below full employment, no effects on inflation.

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Hume & Price-Specie Mechanism David Hume (1752) attacks mercantilist views. Focuses on price-specie flowprice-specie flow mechanism

– Trade surplus leads to inflows of specie to country.

– This will increase the country’s money supply

– This in turn will result in higher prices, reducing competitiveness of country’s goods.

– This will result in falling trade surplus.

– Exact opposite occurs in trading partner.

– Trade surplus/deficit is thus self-correctingself-correcting.

– Essentially Quantity TheoryQuantity Theory combined with gold gold standardstandard (fixed exchange rate).

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Adam Smith & Absolute Advantage Smith (1776): Nation’s wealth arises from its

labor productivity not its store of precious metal.– Individual self-interestself-interest & invisible hand of marketmarket

leads to specializationspecialization & higher productivityproductivity.– Thus countries should also specialize.– Export goods for which they have an absolute absolute

advantageadvantage, import where absolute disadvantage.– Argument shows trade is positive sum gamepositive sum game with

mutual benefitsmutual benefits. Powerful argument for expanding trade, used against mercantilist thought.

– Saw absolute advantage as deriving from a country’s unique endowments of factors of production.

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Example of Absolute Advantage

Cloth Wine

England 1 hour/ yard 4 hours/ gallon

Portugal 2 hours/ yard 3 hours/ gallon

Labor Requirements & Absolute Advantage

No TradeNo TradeRelative Price of Cloth

is:– EnglandEngland

– 1 yard cloth for ¼ gallon of wine

– PortugalPortugal– 1 yard cloth for

2/3 gallon of wine– England has absolute

advantage in cloth, Portugal in wine.

– Show if can trade at 1 cloth per 1/3 gallon wine then both nations are better off.