BA 187 – International Trade

1. BA 187 – International Trade Issues, Definitions & Strategies

2. The Issues in International Trade

3. 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.

4. 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.

5. Accounting for International Economics

6. 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

7. 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.

8. 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.

9. 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 • 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

11. 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 +$2,000 Debit Category IV.A. Increase S-T foreign assets -$2,000 held by home country individ. 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 +$2,000 Debit Category IV.B. Decrease S-T foreign assets -$2,000 held by private foreigners Example International Transactions

12. 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 +$5,000 • Debit Category II.A. Unilateral transfers made -$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

13. 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 -$25,000 • assets of private foreigner • Credit Category V.B. Increase S-T home country +$25,000 • assets held by foreign gov’t

14. 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

15. 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.

16. 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.

17. 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 = 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.

18. Strategies for Understanding Trade

19. Historical Background of Trade Theory

20. Mercantilism (1500-1750) • 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.

21. 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).

22. 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.

23. Example of Absolute Advantage Labor Requirements & 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.