2. Trade
Buying and selling goods and services from
other countries
The purchase of goods and services from abroad
that leads to an outflow of currency from the UK –
Imports (M)
The sale of goods and services to buyers from
other countries leading to an inflow of currency to
the UK – Exports (X)
3. Specialisation and Trade
Different factor endowments mean some countries
can produce goods and services more efficiently
than others – specialisation is therefore possible:
Absolute Advantage:
Where one country can produce goods with fewer
resources than another
Comparative Advantage:
Where one country can produce goods at a lower
opportunity cost – it sacrifices less resources in
production
4. David Ricardo was one of those rare people
Biography who achieved tremendous success and lasting
fame. After his family disinherited him for
of David marrying outside his Jewish faith, Ricardo made
a fortune as a stockbroker and a loan broker.
Ricardo When he died, his estate was worth over $100
million in today's dollars.
At age of 27, after reading
The Wealth of Nations, Ricardo got excited
about economics. He wrote his first economics
article at age of 37 and then spent fourteen
years—his last ones—as a professional
economist.
In 1814, at the age of 42, Ricardo retired from
business and took up residence at Gatcombe
Park in Gloucestershire, where he had extensive
landholdings.
In 1819 he became MP for Portarlington.
1772~1823 Illness forced Ricardo to retire from Parliament
in 1823 and he died on 11 September at
Gatcombe Park at the age of 51.
5. Important assumptions of
comparative advantages theory
To simplify analysis the following assumptions should be
held.
There are no transport costs.
Costs are constant and there are no economies of scale.
There are only two economies producing two goods.
The theory assumes that traded goods are homogeneous.
Factors of production are assumed to be perfectly mobile
within a country but no movement internationally.
There are no tariffs or other trade barriers.
6. Typical Ricardian “2×2 Model”
Labor Requirements in Portugal and England
in Production of the Given Amount of Wine and Cloth
Portugal England
Wine 80 men/year 120 men/year
Cloth 90 men/year 100 men/year
Portugal is superior to England in the two trades since she could produce the both products with
less labor input. On the contrary, England is inferior to Portugal in the two industries because
she has to employ more labor to produce the given amount of the products.
In accordance with the absolute advantage theory there would no opportunity for the two
countries to execute the mutual benefit trade since the above model dose not satisfy the
requirement of the “assumption of Adam Smith”.
England in the above model, even has no industry in which it could produce at least one
commodity with the absolutely lower cost of labor it necessarily can obtain its trade benefit
by taking an active part in the free trade. For Portugal that enjoys the absolute advantages
in the both industries, it can also maximize its benefit from the free trade.
7. Key to understand such mutual benefit of trade
Difference in degrees of advantages of Portugal over England and
the difference in degrees of disadvantages of England over
Portugal in the two industries.
In producing wine labor This concludes that
In England, on the
requirement in Portugal Portugal is much greater
contrary, labor
is 2/3 of that in England advantageous over England
requirement in
and in production of in producing wine than in
producing cloth is 1/9
cloth the relevant ratio cloth since 2/3 is smaller
more than that in
is 9/10. That is to say than 9/10 whereas England
Portugal while labor
the advantage of suffers from less
requirement in
Portugal in producing disadvantages in producing
producing wine is 1/2
wine is much larger cloth than in wine since 1/2
more than that in
than in cloth. is larger than 1/9.
Portugal.
Portugal has its comparative advantages in the wine industry while England
could be considered to be comparatively advantageous in the cloth industry.
8. Basic principle of
comparative advantages theory
Forthe country enjoying overall advantages in the
both industries, choose one in which it is
comparatively more advantageous, while for the
other country with overall disadvantages in the
both industries, choose one in which it is
comparatively less disadvantageous.
9. Ricardo’s contribution in trade theory
Based on the co-called comparative advantages illustrated by
Ricardo and actually enjoyed by all the possible trading countries
each of them must have the universal motivation to exchange
with the other countries because of real benefit.
Such real benefit constitutes the practical solid foundation for
rationality of free trade policy argument.
The significant difference between Adam Smith and David
Ricardo is that Ricardo developed free trade philosophy and
made such philosophy very much wider applicable.
Ricardo developed classical trade theory from what that merely
analyzed some special cases, for instances trade of England and
such countries, into the theory which might function as the
guidance of trade of almost all countries.
That must be a great theoretical contribution of David Ricardo in
development of the pure theory of international trade.
10. Trade benefit based on comparative
advantages theory
Trade benefit based on comparative advantages theory also
derived from comparing domestic exchange ratios between the
two commodities in the two countries with the exchange rate in
international market.
Because the same rule which regulates the relative value of
commodities in one country dose not regulate the relative value
of the commodities exchanged between two or more countries
domestic exchange ratio between the two goods in one country
must be different from that in another country.
Such difference prepares possibility for the two countries to
initiate bargaining for determining an exchange ratio between the
two goods prevailing in international market which represents
real benefit for the both countries.
11. Exchange ratios in an autarky economy
Labor Requirements in Portugal and England
in Production of the Given Amount of Wine and Cloth
Portugal England
Wine 80 men/year 120 men/year
Cloth 90 men/year 100 men/year
Domestic exchange ratio between wine and cloth in Portugal is 1W ： 8/9C or
1C ： 9/8W.
That exchange ratio in domestic market in England is 1W ： 6/5C or 1C ：
5/6W.
The relative price of wine in terms of cloth is lower in Portugal than in
England. 8/9C﹤6/5C.
The relative price of cloth in terms of wine is lower in England than in
Portugal. 5/6W﹤9/8W.
12. Requirements of the two countries and
bargaining between them
The exporter of wine, Portugal requires to exchange
1W for more than 8/9C. The importer of wine,
England is only willing to give up less than 6/5C
for importing 1W from Portugal.
The exporter of cloth, England wants to exchange
1C for more than 5/6W. The importer of cloth,
Portugal, is only willing to pay 1C with less than
9/8W.
13. Exchange ratio in an opening world
There must be an obvious range between the subjective requirements of the two
countries toward the relative prices of the two goods in international market.
For wine, its international 8 6
exchange ratio would fall into the C 〈1W 〈 C
range between 8/9C till 6/5C. 9 5
For cloth, its international exchange 5 9
ratio would fall into the range W 〈1C 〈 W
between 5/6W till 9/8W.
6 8
No matter any point in the respective range at
which the international exchanges would be
actually executed there must be some gains from
trade for the both countries.
14. Figure 8.2 The Gains from lower world price,
At
Trade
(b) Free Trade consumer surplus increases
Price to a+b+d an increase of
b+d from no-trade
S At lower world price,
producer surplus falls to c
a a decrease of b from
no-trade
PA
b
d Gain in trade is triangle d
with area equal to ½(M1)(PA-
c
PW PW )
D
S1 D1 Quantity
Imports, M1
16. The Gains from Trade
Home Import Demand Curve
We can derive the import demand curve, shown in figure 8.3
The relationship between the world price of a good and the
quantity of imports demanded by Home consumers.
At the no-trade equilibrium, there are zero imports
This is shown as point A′ in panel (b).
At the world price of PW, the quantity demanded is greater than
quantity supplied, and we import M1.
This is point B in panel (b).
Joining A′ and B gives import demand curve M.
17. Protectionism
Barriers to international
trade adopted by the
government to protect
the domestic industry.
Protectionist measures
include tariff and non-
tariff barriers.
18. Barriers to trade
Tariffs
A tariff is a tax on imports.
Non-Tariff Barriers (NTB)
Non-tariff barriers, unlike tariffs are less
direct protectionist measures, which are
used to reduce the volume of imports.
19. Import Tariffs for a Small Country
Free Trade for a Small Country
Since Home is a small country, the tariff does not affect world prices.
The Foreign export supply curve X* is horizontal at the world price P W.
Effect of the Tariff
The new export supply curve shifts up to PW+tariff
Quantity demanded falls while quantity supplied rises
However, as firms increase the quantity produced, the marginal costs of production rise.
The domestic price will equal the import price.
22. Figure 8.4
Home price rises by the amount
of the tariff.
No-trade Home supply increases and
equilibrium Home demand decreases
Price Price Imports fall to M2
S
A
C
PW +t X*+t
B Foreign export
PW
supply, X*
D M
S1 S2 D 2 D1 Quantity M2 M1 Imports
M2
23. Import (a.1)
Figure 8.5
Tariffs for a Small Country
No-trade
equilibrium Lost consumer surplus due
to the higher price with the
Price tariff is equal to the shaded
S area (a+b+c+d)
A
b d
PW +t
a c
PW
D
S1 S2 D2 D1 Quantity
M2
24. Effect of the Tariff on Producer Surplus
With the tariff, producer surplus is the area above the supply and below the
higher price, PW+t.
Since the tariff increases Home price, firms can sell more goods, and
producer surplus increases
This area, a in figure 8.5 (a.2), is the amount that Home firms gain due to
the higher price caused by the tariff.
Increases in producer surplus can benefit Home workers but at the
expense of consumers.
26. The effect of a tariff on imports
The imposition of the
P S tariff reduced imports
from Qs1-Qd1 to Qs2-
Qd2
Pw + tariff
Pw Sw
D
Q
Qs1 Qs2 Qd2 Qd1
imports
27. Consumer surplus
Theconsumer surplus is the difference
between the maximum price that consumers
are willing to pay and the price that they
actually pay.
P
S
Pe
D
Q
28. Producer surplus
The producer surplus is the difference
between the minimum price that
producers are willing to charge and the
price that they actually charge.
P
S
Pe
D
Q
29. The effect of a tariff on welfare
P S
Consumer
surplus
Pw Sw
D
Q
Qs1 Qs2 Qd2 Qd1
imports
30. The effect of a tariff on welfare
P S The imposition
of the tariff
reduces the
consumer
Consumer surplus
surplus
Pw + tariff
Pw Sw
D
Q
Qs2 Qd2
imports
31. The effect of a tariff on welfare
Area a: increase in
producer surplus
While producers
P S due to tariff
and the government
gain from the tariff,
Area c: government
their combined gain
tariff revenue
is smaller than the
Consumer Areas bthe d: dead-
loss to and
surplus weight loss to
consumer.
Pw + tariff society due to tariff
a c d
b
Pw Sw
D
Q
Qs2 Qd2
imports
32. The Flow of Currencies:
Oil from Russia
Oil
£ changed into Roubles Export earnings for Russia
Import expenditure for the UK
(Debit on balance of payments)
Map courtesy of http://www.theodora.com
33. Exchange Rates
The rate at which one currency can be
exchanged for another e.g.
$1 = 48 Rs
£1 = €1.50
Important in trade
34. Exchange Rates
Converting currencies:
To convert £ into (e.g.) $
Multiply the sterling amount by the $ rate
To convert $ into £ - divide by the $ rate: e.g.
To convert £5.70 to $ at a rate of £1 = $1.90, multiply
5.70 x 1.90 = $10.83
To convert $3.45 to £ at the same rate, divide 3.45 by
1.90 = £1.82
35. Exchange Rates
Determinants of Exchange Rates:
Exchange rates are determined by the demand for
and the supply of currencies on the foreign
exchange market
The demand and supply of currencies is in turn
determined by:
36. Exchange Rates
Relative interest rates
The demand for imports (D£)
The demand for exports (S£)
Investment opportunities
Speculative sentiments
Global trading patterns
Changes in relative inflation rates
37. Exchange Rates
Appreciation of the exchange rate:
A rise in the value of $ in relation to other
currencies – each $ buys more of the other
currency e.g.
$1 = Rs 48 $1=52
India exports appear to be more expensive
( Xp)
Imports to the India appear to be cheaper (
Mp)
38. Exchange Rates
Depreciation of the Exchange Rate
A fall in the value of the £ in relation to other
currencies - each £ buys less of the foreign
currency e.g.
£1 = € 1.50 £1 = € 1.45
UK exports appear to be cheaper
( Xp)
Imports to the UK appear more expensive
( Mp)
39. Exchange Rates
A depreciation in exchange rate should lead to a
rise in D for exports, a fall in demand for imports –
the balance of payments should ‘improve’
An appreciation of the exchange rate should lead
to a fall in demand for exports and a rise in
demand for imports – the balance of payments
should get ‘worse’ BUT
40. Exchange Rates
The volumes and the actual amount of
income and expenditure will depend on the
relative price elasticity of demand for
imports and exports.
41. Exchange Rates
Rs per $ S$ The rise in
Investing in
Assume an
demand creates a
initial exchange
the UK would
shortage in the
rate of £1 =
now be more
relationship
$1.85. There
attractive
are rumours
between demand
52 for $and UK is –
and the supply
that
demand
going to
the price
for £ would
increase
(exchange rate)
rise
interest rates
48 would rise
D$
Shortage
D$
Quantity on
Q1 Q3 Q2 ForEx Markets
42. Exchange Rates
Floating Exchange Rates:
Price determined only by demand and supply of
the currency – no government intervention
Fixed Exchange Rates:
The value of a currency fixed in relation to an
anchor currency – not allowed to fluctuate
Dirty Floating or Managed Exchange Rate:
– rate influenced by government via central bank
around a preferred rate
43. Exchange Rate Regimes
What is a “clean” float? A “dirty” one?
- With a dirty float the government doesn’t
peg the currency, but tries from time to
time to influence the rate by buying or
selling in the currency markets.
44. Fixed Exchange Rates
How can the government keep a
currency at a certain value if
international commerce becomes
unwilling to pay that price?
It can’t maintain the value for long. If
the demand for the currency falls, it’s
price would fall as well.
45. Fixed Exchange Rates
The only way the price can be kept up
is for the government promising to
maintain the original level to enter the
foreign exchange market and bid the
price of the currency back up by
purchasing it.
46. Fixed Exchange Rates
The government must buy the
amount that will bring the quantity
demanded back to the original level.
$ Price of Rs
Supply of dollars
Demand for dollars
Quantity of exchange
47. Fixed Exchange Rates
To what does the government fix the
value of its currency?
When or how often does the country
change the value of its fixed rate?
48. Fixed Exchange Rates
How does the government defend the
fixed value against any market
pressures pushing toward higher or
lower exchange rate value?
49. Fix to what?
In the past, all currencies were
fixed to gold.
Today, a country can fix its value to
another country’s currency.
50. Fix to what?
A country can fix its currency to a
“basket” of other currencies.
-Same as diversifying a portfolio (Not
putting all your eggs in one basket)
-Special Drawing Right (SDR)…A
basket of four major world currencies.
51. Defending a Fixed Exchange Rate
1. To buy or sell foreign currencies (in order to
influence the prevailing exchange rate), a
government must have foreign exchange
reserves.
2. It is not likely to have enough reserves to defend
against a massive and sustained attack on the
currency. What is an attack on a country’s
currency?
52. Defending a Fixed Exchange Rate
How can higher i rates keep the currency
value up?
(Answer: Foreigners will purchase the
nation’s currency, bidding its value
upward, to make short-term investments
in the country.)
53. Defending a Fixed Exchange Rate
3. The government can also make long-
term adjustments of its
macroeconomic (monetary and/or
fiscal policy).
Budget austerity avoids inflation and
takes downward pressure off
currency.
54. Defending a Fixed Exchange Rate
3. Why does inflation put downward
pressure on a country’s exchange
rate?
Non-inflating countries are unwilling to pay more
and more to buy an inflating country’s goods
and services. Reduced demand for the inflating
currency will make it depreciate.
55. When to Change the Rate?
What is a pegged exchange rate?
The term pegged exchange rate refers to
setting a targeted value for a country’s
foreign exchange, and it indicates the govt.
has some ability to move the peg.
56. When to Change the Rate?
Governments attempt to keep the value
fixed for relatively long periods of time to
reduce trade uncertainties.
What is an adjustable peg?
The government may change the pegged
rate if a substantial disequilibrium in the
country’s international position develops
(e.g., demand for the currency is too weak
to maintain the desired value).
57. When to Change the Rate?
A crawling peg can be changed often
(monthly, say) according to a set of
indicators or the judgment of the
country’s monetary authority.
Indicators:
The difference of inflation rates
Interest Rates
International reserve assets
Growth of the money supply
Growth of Economies
58. The Floating Exchange Rate
Clean Float
Supply and Demand are solely
private activities
Complete flexibility
59. When to Change the Rate?
Governments attempt to keep the value
fixed for relatively long periods of time to
reduce trade uncertainties.
What is an adjustable peg?
The government may change the pegged
rate if a substantial disequilibrium in the
country’s international position develops
(e.g., demand for the currency is too weak
to maintain the desired value).
60. When to Change the Rate?
A crawling peg can be changed often
(monthly, say) according to a set of
indicators or the judgment of the country’s
monetary authority.
Indicators:
The difference of inflation rates
International reserve assets
Growth of the money supply
The current actual market exchange rate relative to
the central par value of the pegged rate
61. The Floating Exchange Rate
Clean Float
Supply and Demand are solely
private activities
Complete flexibility
62. The Floating Exchange Rate
Dirty Float (Managed Float)
From time to time, the
government tries to impact the
rate through intervention
More popular than clean float
Effectiveness of intervention is
controversial
63. Monetary Policy with Fixed Exchange
Rates
Expanding the Money Supply Worsens the Balance of
Payments
Capital flows
out.
(in the short
run)
To improve a The overall
Interest rate
poor payments
drops
macroeconomic balance
situation, a
“worsens.”
country
increases its
money supply so The Current account
Real spending,
that banks are balance “worsens” as
production, and
more willing to exports fall and
income rise, but
lend. imports increase.
The price
level
increases.
64. Thoughts on Fixed and Floating
Rates
Times have changed since the early 1970s
and Nixon’s destruction of Bretton Woods.
Markets have developed to hedge
exchange risks and we have become
accustomed to the uncertainties associated
with them. Trade flourishes.
65. On
Exchange Rate Choices
Many countries have gone to the float
for their exchange rates, but many still
decide to peg their currency or fix their
exchange rate. The choice is probably
the most important macro-economic
policy decision a country makes.
66. What Changes the Equilibrium Rate?
Inflation rates:
Higher domestic inflation means less demand for local
goods (decreased supply of foreign currency) and more
demand for foreign goods (increased demand for
foreign currency).
Interest rates:
Higher domestic (real) interest rates attract investment
funds causing a decrease in demand for foreign
currency and an increase in supply of foreign currency.
Economic growth:
Stronger economic growth attracts investment funds
causing a decrease in demand for foreign currency and
an increase in supply of foreign currency. 66
67. What Changes the Equilibrium Rate?
Political & economic risk:
Higher political or economic risk in the domestic country
results in increased demand and reduced supply of
foreign currency.
Changes in future expectations:
Any improvement in future expectations regarding the
domestic currency or economy will decrease the
demand for foreign currency and increase the supply of
foreign currency.
Government intervention:
Maintain weak currency to improve export
67
competitiveness.
68. Balance of Payments Accounting
The Balance of Payments is the statistical
record of a country’s international
transactions over a certain period of time
presented in the form of double-entry
bookkeeping.
N.B. when we say “a country’s balance of
payments” we are referring to the
transactions of its citizens and government.
69. Balance of Payments
The BOP is a statistical record of the flow of
all of the payments between the residents of
a country and the rest of the world in a given
year.
Transactions are recorded on the basis of
double entry bookkeeping – by definition it
has to balance.
Every “source” must have a “use”.
The two main components are:
Current Account
Capital/Financial Account 69
71. Current Account (CA)
This is record of a country’s trade in goods and
services in the current period.
CA = Exports (X) – Imports (M)
It is divided into 4 sub-categories:
Goods trade
Services trade
Income
Current transfers
The sum of the four sub-categories = CA balance
71
72. Capital Account (KA)
This includes all short- and long-term
transactions pertaining to financial assets.
KA = Capital Inflow (cr) – Capital outflow
(dr)
The two main components:
Capital account.
Financial account (direct, portfolio, other).
KA balance = Sum of capital account and
financial account. 72
73. Official Reserves
Records the purchase or sale of official reserve assets
by the central bank. These assets include
Commercial paper, Treasury bills and bonds
Foreign currency
Money deposited with the IMF
This account shows the change in foreign exchange
reserves held by the central bank.
The Balance of
Since the BOP must balance Payments
Identity
CA + KA + ∆RFX = 0
CA + KA = – ∆RFX
For floating rate regime countries, such as the U.S.,
official reserves are relatively unimportant. 73
74. Statistical Discrepancy (E&O)
The identity CA + KA = – ∆RFX assumes that all
transactions are measured accurately.
Inaccurate recording of transactions (errors & omissions),
results in the above equality not holding. For BOP to
balance,
CA + KA + E&O = – ∆RFX
Assuming changes in official reserves, errors are
approximately zero:
Current Account = (–) Capital Account
This will hold approximately for floating rate countries
74
76. BOP in Total
A surplus in the BOP implies that the demand for
the country’s currency exceeded the supply and
that the government should allow the currency
value to increase – in value – or intervene and
accumulate additional foreign currency reserves
in the Official Reserves Account.
A deficit in the BOP implies an excess supply of
the country’s currency on world markets, and the
government should then either devalue the
currency or expend its official reserves to
support its value.
76
77. Examples of Transactions
An Australian company exports goods worth US$1
million to the United States:
Export of goods is credit for the current account.
Increase in foreign asset (US$1 million) is debit for capital
account.
Australian company then coverts US$ into A$ and buys
government bonds back in Australia:
Decrease in foreign asset is credit for the capital account.
Increase in government liability is debit for official reserves
account.
Australian individual imports a sports car from Europe:
Increase in foreign liabilities is credit for the capital account.
Import of goods is debit for current account.
77
78. BOP & Macroeconomic Variables
A nation’s balance of payments
interacts with nearly all of its key
macroeconomic variables.
Interacts means that the BOP affects
and is affected by such key
macroeconomic factors as:
Gross Domestic Product (GDP)
Exchange rate
Interest rates
Inflation rates
78
79. BOP & Exchange Rates
A country’s BOP can have a significant
impact on the level of its exchange rate
and vice versa.
The relationship between the BOP and
exchange rates can be illustrated by
use of a simplified equation that
summarizes the BOP (see next slide).
79
80. BOP & Exchange Rates
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
Current Account Balance
M = imports of goods and services
CI = capital inflows Capital Account Balance
CO = capital outflows
FI = financial inflows Financial Account Balance
FO = financial outflows
FXB = official monetary reserves
80
81. BOP & Exchange Rates
Fixed Exchange Rate Countries
Under a fixed exchange rate system, the
government bears the responsibility to
ensure that the BOP is near zero.
Floating Exchange Rate Countries
Under a floating exchange rate system,
surpluses/deficits influence exchange rate.
81
Editor's Notes
Figure 8.2 (b) The Gains from Free Trade at Home With Home demand of D and supply of S , the no-trade equilibrium is at point A, at the price P A producing Q 0 . With free trade, the world price is P W , so quantity demanded increases to D 1 and quantity supplied falls to S 1 . Since quantity demanded exceeds quantity supplied, Home imports D 1 − S 1 . Consumer surplus increases by the area (b + d), and producer surplus falls by area b . The gains from trade are measured by area d.
Figure 8.3 Home Import Demand With Home demand of D and supply of S , the no-trade equilibrium is at point A , with the price P A and import quantity Q 0 . Import demand at this price is zero, as shown by the point A ‘ in panel (b). At a lower world price of P W , import demand is M 1 = D 1 − S 1 , as shown by point B . Joining up all points between A ' and B , we obtain the import demand curve, M .
Figure 8.4 Tariff for a Small Country Applying a tariff of t dollars will increase the import price from P W to P W + t . The domestic price of that good also rises to P W + t . This price rise leads to an increase in Home supply from S 1 to S 2 , and a decrease in Home demand from D 1 to D 2 , in panel (a). Imports fall due to the tariff, from M 1 to M 2 in panel (b). As a result, the equilibrium shifts from point B to C .
Figure 8.4 Tariff for a Small Country Applying a tariff of t dollars will increase the import price from P W to P W + t . The domestic price of that good also rises to P W + t . This price rise leads to an increase in Home supply from S 1 to S 2 , and a decrease in Home demand from D 1 to D 2 , in panel (a). Imports fall due to the tariff, from M 1 to M 2 in panel (b). As a result, the equilibrium shifts from point B to C .
Figure 8.5 (a) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t . As a result, consumer surplus falls by (a + b + c + d) . Producer surplus rises by area a , and government revenue increases by the area c . Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d) , which is measured by the two triangles b and d in panel (a).
