Download Principles of Macroeconomics

BA 187 – International Trade
Issues, Definitions & Strategies
The Issues in International Trade
Issues in International Trade

Gains from Trade
 Trade is not zero-sum, there are mutual gains to trade.
 But gains may be unequally distributed within a country.

Pattern of Trade
 Trade flows may arise from differences in technology,
endowments, tastes, first-mover advantage, random.

Protectionism
 Attempts by gov’t to shield economy from trade hurt
welfare generally, but may improve welfare of sectors.

Balance of Payments
 Trade and capital flows between countries are related.
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Why Countries Trade
 Relative Differences in Labor Productivity
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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.
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Accounting for International
Economics
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 - Im = C + I + G + NX
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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, e.
 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
outward from the home country.

Credit items (+)
– Reflects transactions that give rise to payments inward
to the home country.

5 General Categories of Transactions
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–
–
–
–
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)
Credits (+ve)
Category I
A. Imports of Goods
B. Imports of Services
A. Exports of Goods
B. Exports of Services
Category II
A. Unilateral transfers made
A. Unilateral transfers received
Category III
A. 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 IV
A. 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 V
A. 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 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
Debit Category IV.A. Increase S-T foreign assets
held by home country individ.

+$2,000
-$2,000
Transaction 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
Debit Category IV.B. Decrease S-T foreign assets
held by private foreigners
+$2,000
-$2,000
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Example International Transactions

Transaction 3: Home country residents send $5,000 of goods
as disaster aid to foreign country.
Credit Category I.A. Exports of goods
Debit Category II.A. Unilateral transfers made

+$5,000
-$5,000
Transaction 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 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
assets of private foreigner
Credit Category V.B. Increase S-T home country
assets held by foreign gov’t
-$25,000
+$25,000
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International Relationships

Savings & 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) = NX
• If NFI negative, then inflow of foreign saving into domestic
economy and trade deficit simultaneously.

Balance of Payments
= 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: Rate increases so domestic currency buys
more foreign currency. (Domestic strengthens)
• 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, e.
• Rate at which can exchange output of one country for
output of another country.
e = [Nominal Exchange Rate x Domestic Price Level]
Foreign Price Level
or
e = [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
e = P*/P
 PPP limited as exchange rate theory:

thus in long run should have:
• Many goods & services are not tradable.
• PPP good basis for understanding large moves in
nominal exchange rate.
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Strategies for Understanding
Trade
Historical Background of Trade
Theory
Mercantilism (1500-1750)
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Nat’l wealth = country’s holdings of bullion (specie).
Economic activity viewed as zero-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 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-correcting.
– Essentially Quantity Theory combined with gold
standard (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-interest & invisible hand of market leads
to specialization & higher productivity.
– Thus countries should also specialize.
– Export goods for which they have an absolute
advantage, import where absolute disadvantage.
– Argument shows trade is positive sum game with
mutual 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
No Trade
Relative Price of Cloth is:
– England
– 1 yard cloth for ¼
gallon of wine
– Portugal
– 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.
Labor Requirements &
Absolute Advantage
Cloth
Wine
England
1 hour/ yard
4 hours/ gallon
Portugal
2 hours/ yard 3 hours/ gallon
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