Ch.

13 International Trade
Benefits of trade
1. Increases in domestic production and consumption as a result of
specialization countries take advantage of factor endowments to specialize
in goods it can produce efficiently, produce more of these and trade some for
other goods produced more efficiently in other countries
2. Economies of scale in production foreign market larger market
3. Greater choice for consumers
4. Increased competition and greater efficiency in production
5. Lower prices for consumers due to domestic firms efficiency, imports are
goods produced more efficiently in other countries
6. Acquiring needed resources import inputs needed for domestic prodn
7. Free trade and a more efficient allocation of resources
8. Source of foreign exchange
9. Trade makes possible the flow of new ideas and technology
10.Trade makes countries interdependent, reducing the possibility of
hostilities and violence
11.Trade as an engine for growth
WTO an international organization that provides the institutional and legal
framework for the trading system that exists between member nations worldwide,
responsible for liberalizing trade, operating a system of trade rules and providing a
forum for trade negotiations between governments, and for settling trade disputes
WTO functions
1.
2.
3.
4.
5.
6.

Administers WTO trade agreements

Provides a forum for trade negotiations
Handles trade disputes
Monitors national trade policies
Provides technical assistance and training for developing countries
Facilitates co-operation with other international organizations

Trading system promoted by WTO is based on the following principles:

Non-discrimination, Free trade, Predictability, Promotion of fair competition,
Development and economic reform should be encouraged
Trade protection government intervention in international trade through the
imposition of trade restrictions (or barriers) to prevent the free entry of imports into
a country and protect the domestic economy from foreign competition
Free trade the absence of govt intervention of any kind in international trade, so
that trade takes place without any restrictions (or barriers) between individuals or
firms in different countries
Under free trade, when Pw>Pd, good is exported | when Pw<Pd, good is imported
Tariffs taxes on imported goods
protective tariff, revenue tariff

Effects of tariffs
1. Increase in quantity supplied, decrease in quantity demanded and
decrease in imports
2. Domestic consumers are worse off higher price, buy lower quantity
3. Domestic producers are better off higher price, sell larger quantity
4. Domestic employment increases
5. Govt gains tariff revenues
6. Domestic income distribution worsens since tariffs are regressive taxes
7. Increased inefficiency in production increase in domestic output,
increase in production by relatively inefficient domestic producers (with
comparative disadvantage)
8. Foreign producers are worse off imports in importing country decreases
smaller exports for foreign country
9. A global misallocation of resources results
10.Consumer surplus increases, producer surplus decreases, social
surplus decreases (welfare loss)
Import quota a legal limit to the quantity of a good that can be imported over a
particular time period (typically a year)
Effects of quotas
1. Increase in quantity supplied, decrease in quantity demanded and
decrease in imports
2. Domestic consumers are worse off
3. Domestic producers are better off
4. Domestic employment increases
5. Govt neither gains nor loses since the govt gives the import licenses to
foreign govts, govt budget unaffected
6. Domestic income distribution worsens the increase in price is
regressive like tariff
7. Increased inefficiency in production
8. Exporting countries may be worse off or better off depends on
whether loss of export revenue or gain in quota revenue is larger
9. Increased inefficiency in production
10.Consumer surplus increases, producer surplus decreases, greater
welfare losses for the domestic economy than tariffs
Subsidies production subsidy and export subsidy
Effects of subsidies
1.
2.
3.
4.
5.
6.
7.
8.

Increase in the quantity supplied, decrease in imports

Consumption of the good is not affected
Domestic producers are better off
Negative effect on the govt budget
Taxpayers are worse off
Domestic employment increases
Increased inefficiency in production
Exporting countries are worse off

9. A global misallocation of resources results

Subsidies preferred to tariffs and quota because whilte they encourage inefficiente
production, they do not have negative effects on consumption.
If subsidy large enough, country becomes exporter, even greater domestic and
global resource misallocation
Administrative barriers trade protection measures taking the form of
administrative procedures that countries may use to prevent the free flow of
imports into a country; these may include customs procedures involving inspections
and valuation, controls on packaging, and others. Often considered to be a kind of
hidden trade protection as they dont involve obvious trade protection measures
such as tariffs and quotas
Arguments against trade protection
1. Producers and workers (through the increase in domestic
employment) are the only groups that gain from all types of trade
protection
2. However, the gain of producers has a cost in terms of higher COP
and reduced efficiency
3. Consumers lose in most cases no effect in subsidies, loss greater than
gain of producers
4. Income distribution in most cases worsens (except subsides and
administrative barriers)
5. Foreign producers are worse off in all cases
6. Society as a whole and global resource allocation lose under all
forms of trade protection
7. Trade protection may have negative effects on a countrs export
competitiveness protected good may be input in export
8. Trade protection may give rise to trade wars
9. Trade protection creates a potential for corruption bribes, smuggling,
tariffs and other revenues going to bureaucrats not govt budget
Arguments for trade protection
Qualified arguments
1. Infant industry argument
Infant industry a new domestic industry that has not had time to establish
itself and achieve efficiencies in prodn, and may therefore be unable to
compete with more mature foreign competitors.
To achieve EOC a new firm with high COP may need protection until it grows
to protection unneeded size
Country may have compadv but cannot specialize unless it first receives
some protection , but protection must be temporary
Difficult for govt to know which industries have potential to achieve EOC,
once protection given mayb no strong incentive to become efficient, govt
may protect long after no longer infant

2. Strategic trade policy

Protection of high tech industries which are very important to future econ
growth to help them acheve eos and create a compadv
mayb involve ssps
Difficulties in identifying industries and selecting appropriate protective
policies, all developed countries try to use policies for same industries at
same time, contradicts comadv, danger of continued protection
3. National security
Certain industries essential for national defense and should be protected so
that a country can produce them itself in times of war or national emergency,
danger in nations specializing in weapons production
can be used by industries with indirect use in defense to try to acquire
protection
4. Health, safely, and environmental standards but may be hidden
protection
5. Efforts of a developing country to diversify
Developing countries specialized in a few primary commodities are better off
diversifying
Countries may have to use trade protection policies to keep out imports of
goods they would like to produce themselves
Only LDCs, based on expectation that long term benefits > short term
inefficiencies
govt may not know which industry to protect that will allow for successful
diversification
Questionable arguments
1. Tariffs as a source of govt revenue
imports easier to tax since they must pass through borders where they can
be monitored
but negative effects on income distribution, allocative efficiency, excuse for
govt to delay tax system reform
2. Means to overcome BoP deficit but danger of retaliaton, short term
measure
3. Anti-dumping
Dumping the practice of selling a good in international markets at a price
that is below the cost of producing it
If a country suspects that a trading partner is dumping, it should have right to
impose tariffs or quotas to limit import of dumped good
Difficulty in proving that dumping is being practiced so govts use as excuse
to offer protection
4. Protection of domestic jobs
but unemp increase in countries that are forced to export less, may retaliate
use dsp or ssp to decrease unemp in economy, subsidy to decrease unemp in
particular industry
Incorrect arguments

1. Wage protection argument

imports from low-wage countries sell at lower prices, so protection necessary
But low-wage resources have compadv precisely because of low wage
.. developing countries should specialize in goods that make use of cheap
labour and developed countries with more expensive labour should not
impose import restrictions on these goods
Ch. 14 Exchange rates and the balance of payment
EXR relates the value of one currency to another
In a freely floating EXR system, the forces of demand and supply cause the EXR
to settle at the point where the quantity of a currency demanded equals quantity
supplied. This is the equi EXR
In a freely floating exr system, appreciation and depreciation of a currency occur as
a result of changes in demand or supply for a currency
Causes of changes in exchange rates
1.
2.
3.
4.
5.
6.
7.

Foreign demand for a countrys exports

Domestic demand for imports
Relative interest rate changes
Relative rates of inflation
Investment from abroad
Changes in income (affects imports)
Speculation A widespread expectation that a currency will appreciate
leads to currency bring that contributes to bringing about the appreciation.
Expectation that a currency will depreciate leads to selling that contributes to
bringing about the depreciation.
8. Use of foreign currency reserves central bank buys/sells foreign
currency to influence value of domestic currency
Evaluating effects of exchange rate changes
1. Effects on the rate of inflation
a. Cost-push inflation depreciation imports more expensive. If
domestic produces heavily dependent on imported FOP, COP increases,
SRAS shifts leftward, cost-push infl
The more inelastic the demand for imported input, the greater the
cost-push inflation
b. Demand-pull inflation depreciation ex increase, im decrease
NX increase AD shifts right inflation if economy producing at or
close to potential output
2. Effects on employment depreciation NX increase fall in cyclical
unemp or temp decrease in natural unemp
Appreciation NX decrease cyclical unemp, increase In cyclical unemp
3. Effects on economic growth Depreciation NX increase AD increase
real ouput increase, but may be temp benefit because of infl effects of
depreciation
growth of ex industries increased inv spending LRAS/KAS shifts right

Appreciation reduce NX, dampen growth. BUT imports cheaper

increased imports of FOPs that can be used to increase inv spending
4. Effects on current account balance
5. Effects on foreign debt depreciation foreign debt increases,
appreciation fd decreases
Fixed exchange rate system exrs are fixed by the central bank and are not
permitted to change in response to changes in currency supply and demand
Intervention to maintain fixed exchange rates
Using official reserves to maintain the exr
If excess supply for domestic currency, sell foreign currency reserves to shift
demand curve back right
If excess demand, sell domestic currency
If excess demand of domestic currency over long time (upward pressure) cb can
keep on selling dom. currency and buying foreign exchange but if excess supply of
domestic currency (downward pressure on exr) cb will eventually run out of foreign
exchange additional methods to maintain fixed exr
1. Increases in interest rate (but contractionary monetary policy maybe
recession)
2. Borrowing from abroad loans come in the form of forex, convert it to
domestic currency
3. Efforts to limit imports reduce supply of domestic currency, use cont
fp,mp or trade protectn
4. Imposing exchange controls restrictions imposed by the govt on the qty
of forex that can be bought by domestic residents of a country
Devaluation a decrease in the value of a currency in the context of a fixed exr
rystem revaluation
Under the managed float, exrs are determined mainly through market forcesm but
with periodic intervention by central banks aiming to smooth out abrupt
fluctuations. Intervention takes mainly the form of the buying and selling of official
reserves Some developing and transition economies peg their currencies to the US
dollar or euro; pegged currencies are fixed in relation to the US dollar or euro, and
float in relation to all other currencies
Over/undervalued currency one that has a value that is too high/low relative to
its equi free market value. Its exr has been set at a higher/lower level than that equi
market exr.
Overvalued currency developing countries want cheap import of capital goods,
r/ms, other inputs for ue in manufacturing industries, to speed up industrialization
Disadv exp expensive so domestic exporters lose
worsening current A/C balance so payment difficulties
domestic producers compete with artificially low-price imports so domestic emp n
res allo negatively affected

Undervalued currency exp cheaper so developing countries use to expand export

industries, expand their economies and .. increase emp level
But unfair competitive adv compared to other countries, they suffer conseq of
higher imp and lower exp
The balance of payments of a country is a record (usually for a year) of all
transactions between the residents of a country and the residents of all other
countries. Its role is to show all payments received from other countries, credits,
and all payments made to other countries, debits.
In the course of a year, all inflows of payments (credits) must equal the outflow of
payments (debits); the sum of all credits is equal to the sum of all debits.
In the balance of payments accounts of country, all credits (inflow of money) create
a foreign demand for the countrys currency; and all debits (outflows of money)
create a supply of the countrys currency.
The current account of the BOP is the sum of 1) the balance of trade in goods;
2)the balance of trade in services; 3) income inflows minus outflows; 4)current
transfer inflows minus outflows.(gifts, foreign aid,pensions) Most important is the
balance of trade in goods and services 1+2
The capital account of the BOP is composed of inflows minus outflows of funds for
capital transfers and transactions in non-produced, non-financial assets. The capital
account is relatively small compared to the current account and financial account.
The financial account of the BOP consists of inflows minus outflows of funds for
1)direct investment, 2)portfolio investment and 3) reserve assets.
A current account deficit means a country consumes more than it produces; and it
pays for extra output through a financial account surplus.
A current account surplus means a country consumes less than it produces, and
part of the income generated from the sale of extra output produced corresponds to
a financial account deficit.
Under freely floating exchange rates, when there is a deficit in the current account,
market forces create a downward pressure on the currency exchange rate.
When there is a surplus in the current account, market forces create an upward
pressure on the currency exchange rate.
As a result, exchange rate changes automatically eliminate current account deficits
and surplus, and create a balance in the BOP.
In a managed exchange rate system, the BOP is made to balance by a combination
of central bank buying and selling of currencies and market forces.
In a fixed exchange rate system, the BOP is made to balance by policies that keep
the exr fixed.
Everything that is recorded in the BOP creates a demand for or supply of a domestic
currency. Since value of domestic currency determined by currency D and S,
balance in BOP means there is a balance between the D for and S of a currency.

Comparing and contrasting exchange rate systems

1. Degree of certainty for stakeholders
Fixed EXR
high degree of certainty for firms, consumers and gov
easier for firms to plan future inv, exports, costs of imported inputs, other
activities
consumers can better plan travel abroad, purchases of imported GNS,
financial inv in other ctry
govt can plan activities involving foreign transactions
favor intl trade coz absence of exr possible to calculate accurately price of
gns in diff countries
speculation is limited, remove cause of currency instability due to speculation
(except when people believe country may devalue of revalue is currency)
Floating EXR
uncertainty negative effects on trade and inv flows due to inability to plan
accurately for future
large abrupt exr changes can cause serious problems for countries that
depend heavily on exp, financial crises due to large current acc deficits (may
require intervention by imf)
currency speculation can be destabilizing
2. The role of foreign currency reserves
Fixed EXR CB intervention to maintain fixed exr requires sufficient supplies
of foreign currency reserves, problems can arise if not enough reserves to
offset deficits
Floating EXR no need for cb to hold foreign currency reserves since no
need for intervention
3. Ease of adjustment
Fixed EXR no easy methods to correct imbalances in BOP. In external
shocks, if large FCRs or access to foreign borrowing not available, country
must resort to cont policies, trade protection or exchange controls
Floating EXR market forces automatically bring about balance in bop
easy adjustment to external shocks, economy shielded against effects of
negative external developments
4. Flexibility offered to policy-makers
Fixed EXR no flexibility to policy-makers. The need to maintain EXR at a
fixed level forces govt and cb to purse policies with certain disadvs.
- I increase attract financial inv but have cont effects in dom eco
- borrowing from abroad increases inflows of finds but extensive borrowing
high level of debt
- cont fp and mp to limit imports may create recession and unemp
-trade protection to limi imports increased inefficiency in prodn, increased
dom and global misallocation of resources, retaliation
- exchange controls limit currency outflows but result in major resource
misallocation
Floating EXR
greater flexibility to policy-makers, policies can be carried out in accordance

with domestic priorities, current account automatically balanced

but domestic policy may have undesirable/unintended effects on foreign
sector of economy
Evaluating the managed float (managed exrs)
Superior to fixed exr because offers flexibility to pursue policies according to needs
of domestic eco, adjust more easily to shocks
govt can prevent very sudden and large exr fluctuations
speculation difficult because speculators do not know if and when cb will intervene
Cannot do enough to prevent large currency fluctuations which are esp damaging to
economies highly dependent on exports, sharp drops in exr brought about severe
financial crisis in some Asian countries in late 1990s
not successful in eliminating large trade imbalances as experience of US indicates
countries can cheat by undervaluing currency and gaining unfair competitive adv
(dirty float)
Sup
Ch. 15 Economic intergration and the terms of trade
Economic integration economic integration between countries and coordination of their economic policies, leading to increased economic links between
them
occurs because of numerous benefits that may be derived by the co-operating
countries
Preferential trade agreement an agreement between two or more countries to
lower trade barriers between each other on particular products
Bilateral trade agreement an agreement between two countries
Multilateral trade agreement an agreement between many countries
Regional trade agreement agreement between a group of countries that are
within a geographical region
trade liberalization free(r) trade by reducing or eliminating trade barriers between
members
Trading bloc a group a of countries that have agreed to reduce tariff and other
barriers to trade for the purpose of encouraging free or freer trade and co-operation
between them
Free trade area consists of a group of countries that agree to gradually eliminate
trade barriers between themselves
Each member country retains right to impose its own trade policy towards nonmembers
Prob low trade barrier country may sell imports from non-members to high trade
barrier country, they end up importing more than they would like FTAs make
rules of origin to prevent imports in low barrier country e.g. NAFTA, ASEAN

Customs union a group of countries that fulfils the requirements of a FTA

(elimination of trade barriers between members) and in addition adopts a common
policy towards all non-member countries
no need to create rules of origin but possibility of disagreements on trade policies
e.g. CEFTA, SACU
Common market a type of trading bloc in which countries that have formed a
customs union proceed further to eliminate an remaining tariffs in trade between
them; they continue to have a common external policy, and in addition agree to
eliminate all restrictions on movement of any factors of production within them;
factors affected are mainly labor and capital which are free to cross all borders and
move, travel and find employment freely within all member countries e.g. EEC,
CARICOM
Advantages of trading blocs
1. Increase competition imports increase, domestic producers face foreign
competition, production by more efficient producers, lower prices, improve
resource allocation
2. Expansion into other markets
3. EOS
4. Lower price for consumers and greater consumer choice
5. Increased investment firms attracted by larger market size.
Multinationals attracted by escape tariff or other protection imposed by
trading bloc on imports from outside
6. Better use of factors of production: improved resource allocation
unemployed workers in one country may seek a job elsewhere where there
are more emp opportunities, capital can also move freely in search of greater
profits
7. Improved efficiency in production and greater economic growth
8. Political advantages reduced likelihood of hostilities between countries
whose economies become more interdependent
Possible disadvantages of trading blocs
1. Trading blocs may not be the best way to achieve trade liberalization
inferior to WTOs multilateral approach of reducing trade barriers towards all
countries, involve increasing amount of discrimination, violating WTOs nondiscrimination principle
2. Trading blocs may create obstacles to the achievement of free trade
on a global scale
conflicts between different blocs may slow down global trade liberalization
free trade benefits within bloc but barriers on non-members can limit trade
on global scale
worse global res allo, lower global output, weakened role of WTO, risk of
breaking up global economy into many regional trading blocs
3. Unequal distribution of gains and losses
countries forming trading bloc, stakeholders within countries unlikely to gain
equally from operation of trading bloc conflicts

Monetary union a high form of economic integration, involving the adoption by a

group of countries of a single currency. Monetary integration in addition involves the
adoption of a common monetary policy carried out by a single central bank, which is
necessitated by the use of a single currency
Advantages of monetary union
1. A single currency eliminates exchange rate risk and uncertainty
benefits importers and exporters, consumers and investors, encourages trade
and inv across boundaries more efficient res allo
2. A single currency eliminates transaction costs
significant savings that encourage trade, inv, intl financial flows of all kinds
3. A single currency encourages price transparency
consumers and firms able to compare prices without having to make exr
conversions economic decision makers see price differences quickly
accuratelypromote comp and effi
4. A single currency promotes a higher level of inward investment
because of absence of currency risk within an expanded market eco
growth
5. Low rates of inflation give rise to low interest rates, more
investment and increased output
Disadvantages of monetary union
1. A single currency involves loss of exchange rates as a mechanism for
adjustment
2. A single currency involves loss of monetary policy as an instrument
of economic policy
3. Fiscal policy is constrained by the convergence requirements
e.g. limits in govt debt or budget deficit
4. Monetary policy pursued by the single cb impacts differently on each
member country, depending on its own particular circumstances