INTERNATIONAL TRADE Domestic Trade- is commerce within a country; wholesale and retail trade.

International Trade commerce with different countries in the form of exports and imports; it is the exchange of goods and services between countries. All economies regardless of their size depend to some extent on other economies and are affected by events outside their borders. Trade Surpluses and Trade Deficits A trade surplus is a situation that results when a country exports more than it imports. A trade deficit is the result of imports exceeding exports. WHY DO COUNTRIES TRADE WITH EACH OTHER? 1. Differences in Technology Advantageous trade can occur between countries if the countries differ in their technological abilities to provide goods and services. Technology refers to the techniques used to turn resources (land, labour, capital) into outputs. 2. Differences in Resource Endowments. Advantageous trade can occur between countries if the countries differ in their resource endowments. Resource endowments refer to the skills and abilities of a countrys workforce, the natural resources available within its borders (minerals, farmland etc), and the sophistication of its capital stock (machinery, infrastructure, communications systems). Countries tend to exports goods that relatively intensively use their relatively abundant factors of production. 3. Difference in Demand. Advantageous trade can occur between countries if demands or preferences differ between countries. Individual in different countries may have different preferences or demands for various products. The Chinese are likely to demand more rice than

Jamaicans, even if facing the same price. Canadians may demand more beer and the Dutch more wooden shoes etc. 4. Existence of Economies of Scale in Production The existence of economies of scale in production is sufficient to generate advantageous trade between countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as increasing returns to scale. 5. Existence of Government Policies Government tax and subsidy programs can be sufficient to generate advantages in the production of certain products. In these circumstances, advantageous trade may arise solely due to differences in government policies across countries. THE ECONOMIC BASIS FOR TRADE The Law of Comparative Advantage: David Ricardo Countries have different factors of production. They differ in population density, labour, skills, climate, raw materials, capital equipment etc. These differences seem to persist because factors are relatively immobile between countries. Thus the ability to supply goods differs between countries. What this means is that the relative cost of producing goods will vary from country to country. ABSOLUTE VERSUS COMPARATIVE ADVANTAGE Absolute advantage A country is said to enjoy an absolute advantage over another country in the production of a good if it uses fewer resources to produce that good than the other country does. If countries A & B produce wheat, but As climate is more suited to produce wheat and its labour is more productive, then country A will produce more wheat per acre than country

B while using less labour. Country A therefore enjoys an absolute advantage over country B in the production of wheat. A country enjoys a comparative advantage in the production of a good if that good can be produced at lower costs in terms of other goods. Gains from Mutual Absolute Advantage Suppose that Jamaica and Trinidad each have a fixed amount of land and do not trade with the rest of the world. Suppose further that there are only two goods wheat used to produce bread, and cotton used to produce clothing. Assume also that people in both countries have similar preferences with respect to food and clothing We will also assume that preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton Finally we assume that each country has 100 acres of land for planting.

YIELD PER ACRE OF WHEAT AND COTTON JAMAICA WHEAT COTTON 6 bushels 2 bales TRINIDAD 2 bushels 6 bales

If there is no trade and each country divide its land to obtain equal amount of cotton and wheat production, each country produces 150 bushels of wheat and 150 bales of cotton. Jamaica puts 75 acres into cotton and 25 acres into wheat, and Trinidad does the reverse. We can construct separate production possibilities BEFORE TRADE

cotton (bales) JAMAICA

200 150

150 wheat (bushels cotton(bales) 600 TRINIDAD

600

150

150

200

wheat (bushels)

The following table shows production and consumption if both countries specialize and then trade with each other.

PRODUCTION JAMAICA wheat 100 acres x 6 bushels per Acre 600 bushels 0 acres 0

TRINIDAD 0 acres 0 100 acres x 6 bales/acre 600 bales

CONSUMPTION JAMAICA wheat 300 bushels

TRINIDAD 300 bushels

cotton

cotton 300 bales

300 bales

Trade enables both countries to move out beyond their own resource constraints- beyond their individual PPF.
cotton (bales) JAMAICA

300 200 150

300 150 wheat (bushels

600

cotton(bales) 600 TRINIDAD 300 150

150

200

300 wheat (bushels)

Because countries have an absolute advantage in the production of one product, it is reasonable to expect that specialization and trade will benefit both countries. Clearly Trinidad should produce Cotton and Jamaica should produce wheat. Transferring all lands to wheat production in Jamaica yields a total of 600 bushels; transferring all lands to cotton production in Trinidad will yield 600 bales. The advantages and specialization of trade seems most obvious when one country is technologically superior at producing another product. GAINS FROM COMPARATIVE ADVANTAGE wheat Cotton JAMAICA 6 bushels 6 bales TRINIDAD 1 bushel 3 bales

The real cost of producing cotton is the wheat that must be sacrificed to produce it. When we think of costs this way, it is less costly to produce cotton in Trinidad than in Jamaica, even though an acre of land produces more cotton in Jamaica. Trinidad has a comparative advantage in cotton production and Jamaica has a comparative advantage in wheat production. Terms of Trade the ratio at which a country can trade domestic products for imported P products is called the terms of trade. Terms of trade is referred to as x where Px is the Py price of exports and Py is the price of imports.

ARGUMENTS FOR FREE TRADE In one sense, the theory of comparative advantage is the case for free trade. Trade has potential benefits for all nations. A good is not imported unless its net price to buyers is below that of domestically produced alternatives. The argument for free trade holds that each country should specialize in producing the good and services in which it enjoys a comparative advantage. trade enriches culture war is less likely enhances national security competition variety lower prices to consumers

Methods of restricting Trade Tariffs (Custom Duties) these are taxes on imports and are usually advalorem; i.e. a percentage of the price of import. Tariffs that are used to restrict imports will be most effective if demand is elastic. Quotas this is where a limit is imposed on the quantity of a good that can be imported Exchange Controls these include limits on the amount of foreign exchange made available to importers or to citizens travelling abroad. Import Licensing the imposition of exchange controls or quotas will often involve importers obtaining licenses so that the govt. can better enforce its restrictions. Embargoes where the government completely bans certain imports Export Taxes these can be used to increase the price of exports when the country has monopoly power in their supply Subsidies these can be given to domestic producers to prevent competition from other wise lower priced imports. These can also be given to exports in a process known as dumping. These goods are dumped at artificially low prices in the foreign market. Administrative Barriers Regulations may be designed in such a way as to exclude exports. Eg. Purity Standards Procurement Policies- this is where the government favors domestic producers when purchasing equipment.

ARGUMENTS AGAINST FREE TRADE 1. Infant Industry There may be industries in a country that are in their infancy, but which have potential comparative advantage. Without protection, these infant industries will not survive competition from abroad. 2. To prevent the establishment of foreign-based monopoly competition from abroad could drive domestic producers out of business. The foreign company, now having monopoly of the market, could charge high prices with a resulting misallocation of resources 3. Protection saves jobs- as foreign competitors cost domestic residents their jobs. 4. Anti-Dumping argument Dumping is the sale of goods by foreign suppliers in another country at a price below that charged by the supplier in its home market. Dumping generally benefits the domestic consumers and imposes costs on domestic producers of goods for which the imports are good substitutes. The lower prices of the dumped goods permit consumers to obtain the goods at cheaper prices. 5. Protection against unfair trade practices

BALANCE OF PAYMENTS
An open economy will have a balance of payment account. This records all the flows of money between residents of that country and the rest of the world. Receipts of money from abroad are regarded as credits and are entered with a positive sign. Outflows of money from the country are regarded as debits and are entered with a negative sign.

THE STRUCTURE OF THE BOP ACCOUNT There are three main parts of the balance of payments account 1. The current account 2. The capital account 3. The financial account The Current Account

The current account records payments for imports and exports of goods and services, plus incomes flowing into and out of the country, plus net transfers of money into and out of the country. It is normally divided into four subdivisions. The trade in goods account This records imports and exports of physical goods (visible). Exports result in an inflow of money (credit item), imports result in an outflow of money (debit item). The balance of these is called the balance of trade in goods. A surplus is when exports exceed imports. A deficit is when imports exceed exports. The trade in services account This records imports and exports of services such as transport, tourism and insurance. Thus the purchase of a foreign holiday would be a debit, since it represents an outflow of money, whereas the purchase by overseas resident of a Jamaican insurance policy would be a credit to Jamaicas services account. The balance of both the goods and services accounts together is known as the balance on trade in goods and services or simply the balance of trade. Income Flows These consist of wages, interests and profits into and out of the country. For example, dividends earned by a foreign resident from shares in a Jamaican company would be an outflow of money (debit). Current transfers of Money These include government contributions to and receipts from international organizations, and international transfers of money by private individuals and firms. Transfers out of the country are debits. Transfers into the country (eg. Money sent from US to an American studying in Jamaica) would be a credit item. The current account balance is the overall balance of all the above four subdivisions. A current account surplus is where credits exceed debits, and a deficit is where debits exceed credits.

The Capital Account The capital account records the flow of funds into and out of the country, associated with the acquisition or disposal of fixed assets (eg. Land), the transfer of funds by migrants, and the

payments of grants by the government for overseas projects and the receipt of US dollars for capital projects. The Financial Account This records the flow of money into and out of the country for the purposes of investments or as deposits in banks and other financial institutions. Direct investments: If a foreign company invests money from abroad in one of its branches or associated companies in Jamaica, this represents an inflow of money when the investment is made. (any subsequent profit from this investment that flows abroad will be recorded as an investment income outflow). Portfolio investments: this includes changes in the holdings of paper assets, such as company shares. If a Jamaican resident buys shares in an overseas company, this is an outflow of funds.

CORRECTING BALANCE OF PAYMENTS DEFICITS AND SURPLUSES If the BOP is in deficit, this will have to be covered by borrowing from abroad or attracting deposits from abroad. If a deficit persists, then a country must adjust in one of three ways: 1) internal deflation of prices, 2) depreciation of its rate of exchange, 3) imposition of exchanges and exchange controls. EXCHANGE RATES An exchange rate is the rate at which one currency trades for another on the foreign exchange market.

Determinants of Demand and Supply of Foreign Exchange/Foreign Currency The amount of foreign exchange in demand will depend on the volume of international transfers that require payments to foreigners. The amount of foreign exchange in demand varies inversely with its price. This means that the amount demanded at a high price is less than the amount demanded at a low price (ceteris paribus). The supply of foreign exchange in the foreign exchange market derives from the international transfers that require money receipts from foreign residents. The amount of foreign exchange supplied in the market varies directly with the foreign exchange rate.

EXCHANGE RATE REGIMES 1. Fixed Exchange rate regime Under a pure fixed exchange rate system, the government set a particular rate at which their currencies will exchange for each other and then commit themselves to maintaining that rate. 2. Floating Exchange rate regime Exchange rates are determined by the unregulated forces of supply and demand. 3. Adjustable Peg The adjustable peg is towards the fixed end of the spectrum. Exchange rates are fixed (or pegged) for a period of time perhaps several years. In the short term, correction is the same as with a totally fixed system. Central banks have to intervene in the foreign exchange market to maintain the rate. In the long term, if a fundamental disequilibrium occurs, the currency can be repegged at a lower or higher rate. Adjusting the peg downwards is known as devaluation. Adjusting it upwards is known as revaluation. 4. Dirty Floating This is a system towards the free floating end of the spectrum. Exchange rates are not pegged, they are allowed to float. But the central bank intervenes from time to time to prevent excessive exchange rate fluctuations. 5. Crawling Peg This system is midway between dirty floating and the adjustable peg system. Instead of making large and infrequent devaluations (or revaluation), the government adjusts the peg by small amounts, but frequently say a month, as the equilibrium exchange rate changes 6. Joint Float Under a joint float a group of countries have a fixed or adjustable peg system between their own currencies, but jointly float against all other currencies. 7. Exchange rate band With an exchange rate band the government sets a lower and an upper limit to the exchange rate. It will then allow the exchange rates to fluctuate freely within these limits. It will intervene however if the rate hits the floor or the ceiling.

CORRECTING BOP DEFICIT UNDER FIXED EXCHANGE RATE SYSTEM Government can use discretionary fiscal and monetary policies for the purpose. Such policies have two main effects on the current account; 1) An income effect (expenditure reducing) and 2) a substitution effect between home and foreign goods (expenditure switching). Expenditure Reducing deflationary policy will reduce national income, which will reduce expenditure including expenditure on imports. Expenditure Switching where deflationary policies lead to a reduction in inflation and cause a switch in expenditure away from imports and towards exports. CORRECTING BOP UNDER FREELY FLOATING Freely floating exchange rates should automatically and immediately correct a balance of payments deficit or surplus: by depreciation or appreciation respectively. Foreign exchange dealers simply adjust the exchange rate, so as to balance their books at the end of the day in line with demand and supply. Depreciation, as well as affecting relative prices will affect national income. This will cause expenditure changing. As the exchange rate falls, more imports will be sold and fewer imports will be purchased. Appreciation, as well as affecting prices will result in fewer exports and more imports.

Advantages and Disadvantages of Fixed and Flexible Exchange Rate Regimes Fixed vs. Flexible Fixed advantages A fixed exchange rate should reduce uncertainties for all economic agents in the country. As businesses have the perfect knowledge that the price is fixed and therefore not going to change they can plan ahead in their productions. Inflation may have a harmful effect on the demand for exports and imports. To ensure that inflation is kept as low as possible the government is forced to take measurements, to keep businesses competitive in foreign markets. In theory a fixed exchange rate should also reduce speculations in foreign exchange markets. In reality this is not always the case as countries want to make speculative gains.

Fixed Disadvantages The government is keeping the exchange rate fixed by manipulating the interest rates. If the exchange is in danger of falling the government needs to increase interest rates to increase demand for the currency. As this would have a deflationary effect on the economy the demand might decrease and unemployment might increase. A government has to maintain high levels of foreign reserves to keep the exchange rate fixed as well as to instill confidence on the foreign exchange markets. This makes clear that a country is able to defend its currency by the buying and selling of foreign currencies. Fixing the exchange rate is not easy as there are many variables which are changing over time if the exchange rate is set wrong it might be hard for export companies to be competitive in foreign countries. International disagreement might be created when a country sets its exchange rate on a too low level. This would make a countries export more competitive which might lead to a disagreement between countries as they might see it as an unfair trade advantage. Flexible Advantages As the exchange rate does not have to be kept at a certain level anymore interest rates are free to be employed as domestic management policies (Appleyard 703). The floating exchange rate is adjusting itself to keep the current account balanced, in theory. As the reserves are not used to control the value of the currency it is not necessary to keep high levels of reserves (like gold) of foreign countries.

Flexible Disadvantages Floating exchange rates tend to create uncertainty on the international markets. As businesses try to plan for the future it is not easy for the businesses to handle a floating exchange rate which might vary. Therefore investment is more difficult to assess and there is no doubt that excursive exchange rates will reduce the level of international investment as it is difficult to assess the exact level of return and risk. Floating exchange rates are affected by more factors

than only demand and supply, such as government intervention. Therefore they might not necessarily adjust themselves in order to eliminate current account deficits. The floating exchange rate might worsen existing levels of inflation. If a country has higher inflation rate than others this will make the export of the country less competitive and its imports more expensive. Then the exchange rate will fall which could lead to even higher import prices of goods and because of cost-push inflation which might drive the overall inflation rate even more. While flexible exchange rates can ensure that the country achieves external balance, they do not ensure internal balance. In several situations the exchange rate change that reestablishes external balance can make an internal imbalance worse. If a country has rising inflation and a tendency toward external deficit, the depreciation of the currency can intensify the inflation pressures in the country. If a country has excessive unemployment and a tendency toward surplus, the appreciation of the currency can make the unemployment problem worse. To achieve internal balance, the country's government may need to implement domestic policy changes.

ECONOMIC INTEGRATION When countries form economic coalitions, their efforts represent a partial movement to free trade and an attempt by each participating country to obtain some benefits of a more open economy without sacrificing control over goods and services that cross its borders. There are 4 basic types of formal regional economic arrangements Free Trade Area The most common integration scheme is referred to as a free-trade area, in which each member of the group removes tariffs on each others product, while at the same time each member retain its independence in establishing trade policies with non-members. In other words, the members of a FTA can maintain individual tariffs and other trade barriers on the outside world.

It needs to be noticed that when each member country sets its external tariff, nonmember countries may find it profitable to export a product to the member country with the lowest level of outside protection and then through it to other member countries, whose protection levels against the outside worlds are higher. Without rules of origin by members regarding the source country of a product, there is nothing to preclude nonmember countries from using this transshipment strategy to escape some of the trade restrictions in the more highly protected member countries. Customs Union In this stage, all tariffs are removed between members, and the group adopts a common external commercial policy toward nonmembers. Furthermore, the group acts as one body in the negotiation of all trade agreements with nonmembers. The existence of a common external tariff takes away the possibility of transshipment by nonmembers. The customs union is thus a step closer toward economic integration than the FTA.

Common Market All tariffs are removed between members, a common external trade policy is adopted for nonmembers and all barriers to factor movements among member countries are removed. The free movement of labour and capital between members represent a higher level of economic integration and, at the same, a further reduction in national control of the individual economy. Economic Union This includes all features of the common market but also implies the unification of economic institutions and coordination of economic policy throughout all member countries. While separate political entities are still present, an economic union generally establishes several supranational institutions whose decisions are binding upon all members. When an economic union adopts a common currency, it has become a monetary union as well.