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INTERNATIONAL TRADE
AND FINANCE
LECTURE 2: Introduction:
World Trade, An
Overview
Recall: What is International
Economics about?
• International economics deals with economic interactions that
occur between independent nations.
– The role of governments in regulating international trade and
investment is substantial.
• There are several issues that recur throughout
the study of international economics.
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The Gains from Trade
The Pattern of Trade
How Much Trade?
The Balance of Payments
Exchange Rate Determination
International Policy Coordination
The International Capital Market
Outline
• What determines the direction of trade (The largest
trading partners of the U.S.)
• Gravity model:
– influence of an economy’s size on trade
– distance and other factors that influence trade
• Borders and trade agreements
• Globalization: then and now
• Changing composition of trade
• Service outsourcing
Who Trades with Whom?
• The 5 largest trading partners with the
U.S. in 2005 were Canada, China,
Mexico Japan and Germany.
• The total value imports from and exports
to Canada in 2005 was about $500
billion dollars.
• The largest 10 trading partners with the
U.S. accounted for 56% of the value of
U.S. trade in 2005.
Fig. 2-1: Total U.S. Trade with
Major Partners, 2006
Source: U.S. Department of Commerce
Size Matters: The Gravity Model
• 3 of the top 10 trading partners with the U.S.
in 2005 were also the 3 largest European economies:
Germany, UK, and France.
• These countries have the largest gross domestic
product (GDP) in Europe.
– GDP measures the value of goods and services
produced in an economy.
• Why does the U.S. trade most with these European
countries and not other European countries?
Size Matters: The Gravity Model
(cont.)
• In fact, the size of an economy is directly related
to the volume of imports and exports.
– Larger economies produce more goods and services,
so they have more to sell in the
export market.
– Larger economies generate more income from
the goods and services sold, so people are able
to buy more imports.
Fig. 2-2: The Size of European
Economies, and the Value of Their
Trade with the United States
Source: U.S. Department of Commerce, European Commission
The Gravity Model
Other things besides size matter for trade:
1. Distance between markets influences transportation
costs and therefore the cost of imports and exports.
–
Distance may also influence personal contact and
communication, which may influence trade.
2. Cultural affinity: if two countries have cultural ties, it is
likely that they also have strong economic ties.
3. Geography: ocean harbors and a lack of mountain
barriers make transportation and trade easier.
The Gravity Model (cont.)
4. Multinational corporations: corporations spread across
different nations import and export many goods
between their divisions.
5. Borders: crossing borders involves formalities that take
time and perhaps monetary costs like tariffs.
–
–
These implicit and explicit costs reduce trade.
The existence of borders may also indicate the existence of
different languages (see 2) or different currencies, either of
which may impede trade more.
The Gravity Model (cont.)
• In its basic form, the gravity model assumes that only
size and distance are important for trade in the following
way:
Tij = A x Yi x Yj /Dij
• where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country j
– Perhaps surprisingly, the gravity model works fairly well in
predicting actual trade flows
Distance and Borders
• Estimates of the effect of distance from the
gravity model predict that a 1% increase in
the distance between countries is associated
with a decrease in the volume of trade of
0.7% to 1%.
Distance and Borders (cont.)
• Besides distance, borders increase the cost and time
needed to trade.
• Trade agreements between countries are intended to
reduce the formalities and tariffs needed to cross
borders, and therefore to increase trade.
• The gravity model can assess the effect of trade
agreements on trade: does a trade agreement lead to
significantly more trade among its partners than one
would otherwise predict given their GDPs and distances
from one another?
Distance and Borders (cont.)
• The U.S. signed a free trade agreement with
Mexico and Canada in 1994, the North American
Free Trade Agreement (NAFTA).
• Because of NAFTA and because Mexico
and Canada are close to the U.S., the
amount of trade between the U.S. and its
northern and southern neighbors as a fraction of
GDP is larger than between the U.S. and
European countries.
Fig. 2-3: Economic Size and Trade
with the United States
Source: U.S. Deparment of Commerce, European Commission
Distance and Borders (cont.)
• Yet even with a free trade agreement between
the U.S. and Canada, which use a common
language, the border between these countries
still seems to be associated with a reduction in
trade.
• E.g. Due to the use of different national currencies
Geographic Trade Patterns
• Developed countries account for the bulk of world
trade (largest exporters and importers).
• Developed countries trade primarily with each
other.
• Developing countries rely on developed countries
for their export markets.
• Countries trade mainly with neighbors.
• (What can explain why sub-Sahara Africa
countries does less trading amongst
themselves?
Geographic Trade Patterns ctd
The Issues:
• Similar commodities
• Trade barriers: Did you know until recently,
if you wanted to go to say Tunisia, you
may have had to go to Germany?
Globalization
• Globalization is the term used to
convey the idea that international
factors are becoming a more
important part of the world economy
• The simplest measure of globalization
is the ratio of exports to GDP
– Countries with a high ratio of exports to
GDP are generally more open to the
world economy than countries with a low
ratio
GLOBALIZATION
• Globalization or the increasing
openness of an economy, means
changes that are not universally
positive
• Globalization involves not only the
goods and service but the movement
of people and money as well
• International transactions occur
because both parties expect the
transaction to improve their welfare
Index of Openness
• Index of Openness—a measure of how
much a country participates in international
trade; defined as the ratio of a country’s
exports to its GDP (or GNP).
• Open Economy—a country with a high
value of the index of openness.
• Closed Economy—a country with a
relatively low index of openness.
The Growth of Globalization
• Since the end of WWII, world trade has
grown much faster than world output.
 (exp orts  imports) 
Openness _ Index  

GDP


FIGURE 1.1 Openness Index for
Selected Nations (1913–2000)
International Trade
• Exports—goods and services produced in
one country and sold to other countries.
• Imports—goods and services consumed
in a country but which have been
purchased from other countries.
• Trade Deficit (Surplus)—a country has a
trade deficit (surplus) if its imports
(exports) exceeds its exports (imports).
Growth of World Exports
• What has caused the explosion
of world trade?
• Refer to Figure 1.1 (next slide)
FIGURE 1.1 World Exports and Output in
Real Terms: 1950–2007
Growth of World Exports
• What has caused the explosion of
world trade?
– Reduction in trade barriers
– Advances in transportation,
communication and technology
– Proliferation of trade agreements
Commodity composition – What goods do
countries trade?
But Manufactured
product exports is a
relatively new
phenomenon (table
below):
Source: Krugman and Obstfeld
Commodity composition – What goods do
countries trade?
Commodity composition – What goods do
countries trade?
Changing composition of Developing-Country Exports
Service outsourcing
• One of the current areas of considerable debate
• It is a situation in which a service that was previously done within
a country is shifted to a foreign location (also called service
offshoring)
– Blinder (2006) argues “in the future, and to a great extent already in
the present, the key distinction for international trade will no longer be
between things that can be put in a box and things that cannot. It will,
instead, be between services that can be delivered electronically over
long distances with little or no degradation of quality, and those that
cannot.” E.g: Shop Accounts keeping; radiologist who reads X-ray.
• Source: Krugman
END OF WEEK 1