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Economics 101 Multiple Choice Questions for Final Examination Miller PLEASE DO NOT WRITE ON THIS EXAMINATION FORM 1 Which of the following statements is correct a Real GDP is the total market value of the final goods and services produced in America for sale in a year valued in the prices of 1992 Your buying stock in the stock market is an example of investment spending Potentgll Real GDP is always greater than Equilibrium Real GDP Social security and welfare are examples of spending on infrastructure All of the above 9900 2 The period of the business cycle in which GDP is increasing is called the a expansion b peak c recession d trough e stag ation 3 Assume that in the population 95 million people worked for pay last week 5 million people did not work for pay but had been seeking a job 5 million people did not work for pay and had not been seeking a job for the past several months and 45 million were under age 16 The unemployment rate given these numbers is a 5 b 8 c 10 d 20 e 45 4 A type of unemployment in which workers are inbetween jobs or are searching for new and better jobs is called unemployment a frictional b cyclical c structural d turnover 5 Consider three consumer goods 100 of Good A 100 of Good B and 100 of Good C In the base year Good A sold at a price of 1 Good B sold at a price of 1 and Good C sold at a price of 1 In the current year Good A sold at a price of 3 Good B sold at a price of 5 and Good C sold at a price of 10 The Consumer Price Index CPI for the current year is a 100 b 300 c 500 d 600 e 1000 6 Which of the following is a quotloserquot from unexpected in ation a workers with COLAs c people who own Treasury Bills b the middle class d people who own homes and have fixedrate mortgages 7 If the nominal interest rate on a checking account is 2 and the in ation rate is 3 this year the real interest rate is a 5 b 2 c 23 d 1 e 3 8 Which of the following would cause the demand curve for automobiles to m to the E a an increase in the price of the automobiles b an increase in the interest rate paid to borrow money to pay for the automobile c an increase in buyers39 incomes d an increase in the cost of production of automobiles Please Turn Over Page 2 9 Suppose it is announced that industry analysts are predicting that decreased oil supplies from Iraq will cause gasoline prices to rise beginning next month Inthe current weel the announcement would a shift the supply of gasoline right c shift the demand for gasoline left b shift the demand for gasoline right d have no effect on the demand or supply of gasoline 10 quotAt the price of 500 tickets for the Super Bowl are expensive Yet the are long lines of people who wish to buy them Many people who desire tickets will not be able to find themquot From this quote we know that the price of Super Bowl tickets must be a below equilibrium b above equilibrium c equal to equilibrium 11 Assume that the market for computers begins in equilibrium Then there is a decrease in a price of Pentium processors used in the productjon of computers When the new equilibrium is reached a the price and quantity of computers will both have risen b the price and quantity of computers will both have fallen c the price of computers will have risen and the quantity will have fallen d the price of computers will have fallen and the quantity will have risen 12 Assume that the market for the stock of Microsoft begins in equilibrium Then both buyers and sellers expect mm new Linux a competjtor of Microsoft Windows will be a large success reduing Microsoft sali When the new equilibrium is reached a the price and quantity of the stock will both have risen the price and quantity of the stock will both have fallen the quantity of the stock will fall and the price will rise the quantity of the stock will fall but the effect on price cannot be determined the price of the stock will fall but the effect on quantity cannot be determined 9909 13 Assume that the market for Mexican pesos begin in equilibrium Then the Mexican economy experiences a severe recession Because of the recession the Mexican companies lower their prices As a result of the recession and lower prices in Mexico a the dollar depreciates and the peso appreciates c the dollar and the peso both appreciate b the dollar appreciates and the peso depreciates d the dollar and the peso both depreciate 14 Which of the following is an example of quotportfolio investmentquot a An American places funds in a savings account in Canada b Tokyo Bank of Japan buys Union Bank of the United States c Saturn Corp owned by General Motors builds a new factory in Tennessee d An American puts 10000 into a money market fund e All of the above Continued Page 3 PLEASE DO NOT WRITE ON THIS EXAMINATION FORM 15 Which of the following would cause the aggregate demand curve to shift to the right a an increase in purchases by the federal government b an increase in real interest rates c an appreciation of the American dollar d a decrease in the money supply 16 Assume that an economy begins in macroeconomic equilibrium Then taxes are significantly decreased As a result of this change a there is expansion and in ation in the US c there is stag ation in the US b there is recession and de ation in the US d there is expansion and de ation in the US 17 A large increase in oil prices such as the ones occurring in 1973 and 1979 will cause a in ation and expansion c in ation and recession b recession and disin ation d expansion and de ation 18 Assume that production in the United States is valued at 10000 National income is therefore 10000 Of their income workers pay 1000 in taxes save 500 spend 8000 on consumer goods and spend 500 on imports Businesses spend 1000 in new investment spending And foreigners spend 500 on exports In order to avoid any problems of in ation or unemployment the government should have a budget de cit or surplus of a 0 b 500 surplus c 500 deficit d 1000 deficit e 2000 deficit 19 From 1990 to 1995 the US economy was in a recessionary gap According to the classical economists which of the following should have occurred a wages should have fallen which would cause more workers to be hired b prices should have fallen which would increase consumer spending c interest rates should have fallen which would increase consumer and investment spending d all of the above should have occurred 20 Which of the following statements isare true about the classical quantity theory of money a The equation of exchange is MV PQ b The classical economists assumed that V would rise when real interest rates rise c The classical economists concluded that increases in the money supply cause increases in real GDP and nothing else d all of the above Please Turn Over Page 4 21 Assume that the United States and Great Britain are both on the Gold Standard There is in ation in the United States but not in Great Britain As a result of the in ation in the United States a Gold would leave the United States and go to Great Britain b Gold would leave Great Britain and go to the United States c The American dollar would depreciate d The American money supply would increase 22 At an income of 100000 I spent 90000 on consumer goods When my income rose to 200000 I spent 160000 on consumer goods My marginal propensity to consume is a 09 b 08 c 07 d 1 e 70000 23 National Disposable Income Taxes Income Consumpti Investment Government 100 100 0 50 25 100 200 100 100 125 25 100 300 100 200 200 25 100 400 100 300 275 25 100 500 100 400 350 25 100 600 100 500 425 25 100 700 100 600 500 25 100 800 100 700 575 25 100 Using these numbers the equilibrium real GDP equal to National Income is a 300 b 400 c 500 d 600 e 700 24 Which of the following would cause consumption to Iii a the GDP De ator rises b a greater proportion of the population is between age 20 and 30 c transitory income increases d income is taken from poor people and given to rich people 25 Which of the following would cause business investment spending to rise an increase in real interest rates from 5 to 8 a decrease in the corporate profits tax rate from 48 to 34 a reduction of the investment tax credit from 10 to 2 sales falling in relation to capacity from 90 to 60 999 CONTINUED Page 5 PLEASE DO NOT WRITE ON THIS EXAMINATION FORM 26 Assume that net exports increase by 1 billion Equilibrium Real GDP Will rise by m than 1 billion Explain Why ie Whv isthere a multjplier a an increase in net exports appreciates the dollar causing a further increase in net exports b an increase in net exports causes an increase in tax revenues Which increases government spending c an increase in net exports increases income causing an increase in induced consumption d an increase in net exports causes an increase in the money supply 27 The largest transfer in the federal budget is a defense b education c social security d welfare e police 28 The largest tax collected at the federal government level is the a income tax b sales tax c property tax d social security tax 29 A person had an income of 20000 last year and paid 10000 in tax This year the person had an income of 100000 and paid 30000 in tax The person s marginal tax rate is a 25 b 30 c 50 d 100 30 The tax in question 29 is a progressive b regressive c proportional 31 Assume that Equilibrium GDP is 4000 billion Potential GDP is 5000 billion The marginal propensity to consume is 45 08 By how much and in What direction should government purch be changed a increase by 1000 billion c increase by 100 billion b decrease by 1000 billion d increase by 200 billion 32 Using the numbers in question 31 by how much should taxes be changed a increased by 1000 billion c decreased by 200 billion b decreased by 1000 billion d decreased by 250 billion 33 Assume that Equilibrium Real GDP is 20000 while Potential Real GDP is 15000 The marginal propensity to consume is 910 Assume that government decides to lower taxes by 1000 To pay for this it lowers government purchases by 1000 As a result of these two changes what is the new Equilibrium Real GDP a 19000 b 20000 c 21000 d 14000 e 1000 PLEASE TURN OVER Page 6 34 Which of the following statements is true about the national debt a In total it is higher now than it has ever been b Most of it is owed by the federal government to foreigners It means that a tremendous burden is being passed to our children Because of it the United States is on the verge of bankruptcy All of the above 990 35 If the of cial federal budget shows a deficit of 200 billion while the structural budget is has a surplus of 200 billion it can be concluded that a the intent of fiscal policy is very expansionary there is hyperin ation the unemployment rate is well above the natural rate state and local governments have large surpluses offbudget spending is counted in the official deficit but not in the structural deficit 0900 36 The Phillips curve describes the relationship between the federal budget deficit and the trade deficit savings and investment the unemployment rate and the in ation rate marginal tax rates and tax revenues 999 37 Several adjustments have been suggested to the official budget deficit to be able to measure the effects of the budget deficit on the economy For which of the following would the adjusted deficit be larger than the official budget deficit a state and local budget surpluses need to be added to the official budget deficit b the effects of unemployment need to be taken out of the official budget deficit c the effects of in ation need to be taken out of the official budget deficit d offbudget spending needs to be added to the official budget deficit 38 Which of the following is included in Ml a gold c checkable deposits e stock b credit cards d money market mutual funds 39 Which of the following is true about the Federal Reserve System its seven Board members are appointed by the President of the United States its main policymaking body is called the CBO it insures checking accounts against bank failure it accepts deposits from individuals and makes loans for mortgages All of the above 9999 CONTINUED Page 7 PLEASE DO NOT WRITE ON THIS EXAMINATION FORM 40 Assume that the Fed increases the monetary b by 1 billion when the reserve requirement is 17 As a result the money supply will a increase by 1 billion c increase by 7 billion b decrease by 1 billion d increase by 143 million 41 If the m wishes to decrease gtightenz the money supply it should a buy Treasury securities in the open market b raise the discount rate c lower the reserve requirements d raise marginal tax rates 42 The demand for money will fall if a Real GDP rises c the GDP De ator rises b real interest rates rise d people expect de ation soon 43 An increase in the money supply causes a interest rates to fall investment spending to rise and aggregate demand to rise b interest rates to rise investment spending to rise and aggregate demand to rise c interest rates to rise investment spending to fall and aggregate demand to fall d interest rates to fall investment spending to fall and aggregate demand to fall 44 If individuals forecast future prices by examining the rates of in ation of the present and recent past they are using a adaptive expectations c in ationary expectations b rational expectations d structural expectations 45 If the actual unemployment rate is below the natural rate of unemployment it would be expected that a the rate of in ation would increase 0 the Phillips curve would shift to the left b wages would fall d the natural rate of unemployment would fall 46 According to the monetarist acceleration theory in the longrun a the actual unemployment rate will be below the natural rate of unemployment b the actual unemployment rate will be equal to the natural rate of unemployment c the actual in ation rate will be equal to the natural in ation rate d the budget deficit will be equal to zero 6 the money supply will be growing at a constant rate per year PLEASE TURN OVER Page 8 47 According to the monetarists in the longrun the Phillips Curve is a vertical 0 downwardsloping b horizontal d upwardsloping 48 Which of the following statements is true about suDDlVside economics at The main change made by the tax laws of 1981 and 1986 was to increase marginal tax rates in order to balance the budget b The Laffer Curve says that if marginal tax rates fall tax revenues will rise and the budget deficit will decrease c If the tax laws of 1981 and 1986 had had their intended effect consumption would have risen causing an increase in both real GDP and in the price level d All of the above 49 Those who oppose a Constitutional amendment to require a balanced federal budget would make which of the following arguments a Deficits are bad because they can cause crowding out b Such an amendment could force the government to undertake policies that would increase a recessionary gap 0 Deficits can cause in ation by increasing aggregate demand d Budget deficits can cause an increase in the trade deficit by appreciating the dollar 50 If the monev suDDlv is The interest rate is 100 billion 10 120 billion 8 140 billion 6 160 billion 4 120 billion 2 If the interest rate is Investment spending is 10 10 billion 8 20 billion 6 30 billion 4 40 billion 2 50 billion Assume that equilibrium GDP is 400 billion potential GDP is 500 billion the marginal propensity to consume is 910 the interest rate is 8 investment spending is 20 billion the money supply is 120 billion and the reserve requirement is 1 10 By how much and in what direction should the Fed change the monetary base a increase it by 20 billion d increase it by 2 billion b decrease it by 100 billion e decrease it by 10 billion c increase it by 90 billion END OF EXAMINATION Answers 1 A 2 A 3 A 4 A 5 D 6 C 7 D 8 B 9 B 10 A 11 D 12 E 13 A 14 A 15 A 16 A 17 C 18 B 19 D 20 A 21 A 22 C 23 B 24 B 25 B 26 C 27 C 28 A 29 A 30 B 31 D 32 D 33 A 34 A 35 C 36 C 37 D 38 C 39 A 40 C 41 B 42 B 43 A 44 A 45 A 46 B 47 A 48 B 49 B 50 D Economics 101 Final Examination Name This course has involved a macroeconomic history of the 20th century This century has seen major economic problems including in ation recessions and a Great Depression slow economic growth budget deficits and trade deficits 1 Let us consider first the problem of in ation The United States has experienced persistent in ation in ationary gaps during the 1960s and especially throughout the 1970s But there has been some in ation every year since 1954 a In ation is measured by both the Consumer Price Index CPI and GDP De ator Explain how each of these is calculated What arguments have been made to support the assertion that the Consumer Price Index overstates the rise in the cost of living b Then explain why in ation is a problem for the United States In particular consider the effects of unexpected in ation on the distribution of wealth who gains and who loses and its effects on the growth of real GDP over time Explain the causes of the in ation of the 1960s and of the 1970s Name as many causes as you can Illustrate your answer using the aggregate demand aggregate supply potential real GDP graph Be sure to include in your answer the causes of the stag ation of the 197 OS Explain Why the in ation rates were reduced so dramatically in the 1980s and 1990s What fiscal and monetary policies were used to reduce the in ation rates Again illustrate your answer using the aggregate demand aggregate supply potential real GDP graph 20 points for Question 1 2 Second let us consider the problem of recessions and depression There was a Great Depression in the 1930s And since 1961 there have been four main recessions a b Third Explain how the unemployment rate is measured What criticisms can be made of the official unemployment rate measure Explain why recessions and recessionary gaps are problems for the United States Be sure to define each term That is What are the bad effects that result from them Explain the causes of the Great Depression of the 1930s and the causes of the recessions since World War 11 Name as many causes as you can Illustrate your answer using the aggregate demand aggregate supply potential real GDP graph Explain Why the Great Depression and these recessions eventually ended First What arguments are given by Classical economists that these would end automatically if the government just did nothing Second What fiscal and monetary policies have been used to end the recessions Again illustrate your answer using the aggregate demand aggregate supply potential real GDP graph 20 points for Question 2 after 1973 the United States experienced a problem of very slow economic growth Especially productivity grew slower than in the past and slowly in comparison to other countries a b C a b How do we measure economic growth How do we measure productivity What are the problems that have resulted from the slow period of economic growth What monetary and fiscal policies were undertaken to increase economic growth To What extent were they successful 10 points for Question 3 Page 2 Fourth from 1981 to 1998 the United States had very high budget deficits Define quotbudget deficitquot and quotnational debtquot highlighting the difference How is the official budget deficit measured To properly measure the effects of these budget deficits on the economy what changes are needed to the official budget deficit calculation WHY When these changes are made What does the data show about the adjusted budget deficits What are the effects of budget deficits on the American economy Consider ways by which budget deficits may be good for the American economy and ways by Which budget deficits may be harmful to the American economy d Is the national debt of over 5 12 trillion an economic problem for the United States Explain why or why not 15 points for Question 4 5 Since the early 1980s the United States has also experienced high trade deficits a Define trade deficit How is it measured b Explain the three systems for international economic relations that existed in the 20th century the Gold Standard the Bretton Woods System and the system of oating exchange rates c One of the main changes in the world in the 20th century was the growth of international trade First explain why this occurred Then state why this has contributed to economic growth d Based on the material covered in the course explain why the trade deficits of the 1980s and 1990s may have occurred Consider as many reasons as you can 15 points for Question 5 6 This course has explored different economic philosophies as to how the American economy operates and what should be done to correct economic problems The course has considered the Classical Keynesian Monetarist and SupplySide philosophies the philosophies that have been most important in the 20th century At the time of the examination you will be given a situation The information you will be given will include real GDP the growth of real GDP potential real GDP real interest rates consumer spending business investment spending government spending tax revenues the money supply the in ation rate and the unemployment rate and the natural rate of unemployment a Given the situation what would a Classical economist recommend be done Explain why 6 Given this situation what would a Keynesian economist recommend be done Explain why f Given this situation what would a Monetarist economist recommend be done Explain why g Given this situation what would a Supplyside economist recommend be done Explain why In your answer to these questions show the differences between these views of the American economy 20 points for Question 6 International Economics Sample exam questions 1 Multiple choice questions 2 points for correct answer 0 for blank answer 1 for wrong answer 1 In the Ricardian framework the unit labor requirement for good X is aX4 hoursliter and that of good Y is ay2 hoursKg The marginal productivity of labor in industries X and Y is respectively a MPLX4 litershour and MPLY2 Kghour b MPL X214 litershour and MPLYzlz Kghour c MPLX121itershour and MPLY12 Kghour 2 Consider the BranderSpencer framework of strategic trade policy If there is cooperation among the two governments a there will be a subsidy paid to firms uugt0 b there will be a tarifftax paid by firms uult0 0 there will not be either a subsidy or a tariff uu0 3 In the Ricardian framework with two countries Home and Foreign and labor as factor of production consider the following unit labor requirements for the Cheese and Wine industries Cheese Wine Home 1 hourpound 3 hoursgallon Foreign 5 hourspound 4 hoursgallon If in the freetrade equilibrium the relative price of cheese and wine is equal to 1 the wage in Home relative to the wage in Foreign is a 4 b 03 c 1 4 When a big country levies a tariff on imports a the terms of trade change so that imports become relatively cheaper b the terms of trade change so that imports becomes relatively more expensive 0 the terms of trade do not change Traditional trade theories Let us consider the general traditional model In autarchy in country H two goods are produced X and Y whose prices arer and py respectively Two factors of production are employed capital K and labor L whose prices are r and w respectively i Represent graphically the production possibility frontier transformation curve Given a relative autarchy price pXpy show graphically the quantity produced of X and Y in the economy What is the necessary analytic condition that has to be satisfied when firms maximize profits ii If consumers total income is I write the analytic expression of the budget constraint and represent it graphically Given the aggregate utility function UX Y and given the budget constraint show graphically the quantities demand of X and Y What is the necessary analytic condition that has to be satisfied when consumers maximize utility iii At the relative equilibrium autarchy price p XApyA the quantities demanded of X and Y are exactly equal to the quantities supplied by domestic firms market clearing Show graphically the autarchy equilibrium employing the transformation curve and the aggregate indifference curve Let us suppose now that county H opens up to international trade The equilibrium relative price in international markets is p XTpyT being greater than p XApyA iv Show graphically what are the quantities produced and demanded of X and Y at the new price pXTpyT Is country H an importer of good X And what about good Y Let us now consider the HeckscherOhlin framework Let us suppose a two country world where at the international level only one other big country F exists We also know that good Y is relatively intensive in the use of labor in the production process of both countries Cl Cl KYltKX aLY aLX As before after trade is opened up the equilibrium price on international markets is 9 p p being greater than p XA HpyA H autarchy equilibrium relative price of country H v Is country H relatively abundant in capital or labor with respect to country F What was the line of reasoning that you followed New trade theories Consider the variety effect framework Suppose that fixed costs for a firm in the automobile industry startup costs of factories capital equipment and so on are 5000000 and that variable costs are equal to 18000 per finished automobile The market elasticity of demand is assumed to be equal to 2 Assume that the size of the US and the European labor forces are 250 million and 360 million people respectively i Calculate the equilibrium number of firms in the US and European automobile markets Without trade hintz nA L0 a ii What is the equilibrium price operating margin and quantityperfirm of automobiles in the United States and Europe if the automobile industry is closed to foreign trade hintsz 190001 qf01c iii Now suppose that the United States decides on free trade in automobiles With Europe How many automobiles firms Will there be in the United States and Europe combined What Will be the new equilibrium price operating margin and quantityperfirm of automobiles Econ 4401 International Economics University of Minnesota Deniz Cicek Fall 2009 Name Instructions 1 There are three sections multiple choice questions essay questions and computation questions 2 This is a closed book closed notes exam 3 Simple calculator is allowed 4 Please show all your work except for the multiple choice questions If you need more space use the back of the page 5 Fully label all graphs Part 1 Multiple Choice Questions Choose the best answer Explanation is not required 1 The ratio of a country39s exports to its total output GNP or GDP a is known as the index of openness b provides a rough measure of the importance of international trade to that economy 0 if calculated for the United States would be quite low d All of the above Which of the following is true a Much of the trade of the European Union EU countries is with EU countries b Industrialized countries tend to trade relatively little and largely with developing countries 0 Developing countries in Africa and South America tend to trade the most and largely with themselves d All of the above are true If the autarky price of T in terms of S were lower in country A than in country B a A has a comparative advantage in T b B has a comparative disadvantage in S c A has a comparative advantage in S d All of the above The classical theory predicts that a countries will completely specialize in the production of export goods b considerable trade will occur between countries with different levels of technology 0 small countries could obtain all of the gains from trade when trading with large countries d All of the above According to the classical theory of international trade a only countries with low wages will export b only countries with high wages will import 0 countries with high wages will have higher relative prices of all goods d All the above are false According to the HO model a everyone automatically gains from trade b the gainers from trade outnumber the losers from trade 0 the scarce factor necessarily gains from trade d None of the above According to the factor price equalization theorem if country A is labor abundant then once trade opens a wages and rents should fall in A b wages and rents should rise in A c wages should rise and rents should fall in A d wages should fall and rents should rise in A Answer questions 810 based on the following diagrams of an international trade equilibrium between Australia and India TeaIii lee J L lkxmes 10 a Wheat V AUSTRAUA Australia has comparative advantage in a Textiles b Wheat c Both textiles and wheat d Can39t tell without more information India39s exports equal a on units of wheat b op units of textiles c cd units of wheat d Can39t tell without more information If wheat is land intensive and relative to textiles then according to the HO theory Australia is abundant a land b labor c both land and labor d Can39t tell without more information 11 According to the Rybczynski theorem at constant world prices if a country experiences a gain in its 12 capital stock it will produce a more of the capital intensive good and less of the labor intensive good b more of both goods c less of the capital intensive good and more of the labor intensive good d less of both goods According to the factor price equalization theorem the factor should oppose free trade policies in any given country a abundant b scarce c neither d Can39t tell without more information 13 14 15 16 17 18 Suppose that there are two factors capital and land and that the United States is relatively capital abundant while Canada is relatively land abundant According to the HO model a Canadian landowners should support CanadaUS free trade b Canadian capitalists should oppose CanadaUS free trade c US capitalists should support CanadaUS free trade d All of the above According to the human skills theory a trade patterns depend upon a country39s relative endowment of skilled workers b countries with large endowments of skilled labor will have comparative advantage in skilled labor intensive products c the Leontief paradox is explained by the fact that the United States is relatively skilled labor abundant d All of the above A tariff can a never b sometimes c always raise a country s welfare Like tariffs quotas tend to lead to a higher prices and reduced imports b increased government revenue c increased consumer surplus d All of the above are profits that accrue to whomever has the right to import the quota restricted good a Quota licenses b Quota rents c Quota prices d None of the above Tariffs and quotas tend to be similar in their domestic welfare effects a if quota licenses are given to foreigners b if quota license are auctioned c if quota licenses are given to domestic firms d Both b and c Answer questions l920 based on the following diagram P It 50 39 I 39 v I II 39 I I l I I m l I 39 I I ll I 7 I I m I quot I 39 3 I I I m I I 39 I I Quota I I ll h 50039 1 EDDIE 1 EDD 11 500 19 The quota restricts trade by the same amount as a tariff of a 20 b 30 c 50 d Cannot answer without more information 20 Quota rents equal a 2000 b 5000 c 6000 d 10000 Answer questions 2124 based on the following diagram which depicts country A39s market for its importable P 3 jg J 15 L L Tariff 10 SE I Tariff 15 E 11 5E 10 30 40 5E 60 0 100 110 21 22 23 24 If A imposes a per unit tariff of 10 on imports from both B and C it will import a 40 units from B b 10 units from C c 40 units from each d 40 units from B and 10 units from C If A forms a customs union with B the quantity of trade creation will be a 100 units b 60 units c 40 units d 30 units Domestic producers of this product in A would most prefer a a customs union with C b a customs union with B c a free trade agreement with both B and C d no agreement with either country Domestic consumers of this product in A would most prefer a a customs union with C b a customs union with B c a free trade agreement with C d no agreement with either country Part II Essav Questions 1 Some have argued that the factor price equalization theorem implies that US wages must fall to the level of those found in the least developed countries of the world Comment on the validity of this statement The factor price equalization theorem holds in the HO model because of certain assumptions Speci cally the assumption of identical production techniques leads to the result that workers everywhere will have the exactly the same productivity and hence trade guarantees that they earn the same wage In fact workers in different countries have very different productivities and receive different wages according to those productivities Labor in the United States is more productive than labor in say Mexico and receives a correspondingly higher wage However even though there are differences in factor prices due to differences in productivities even with free trade one can expect these differences to be larger in the absence of trade Hence factor prices tend to be more equal across countries under free trade The significance of the FPE theorem is its prediction of this tendency of factor prices to be equalized following a trade liberalization 2 a Why were Leontiefs findings considered to be paradoxical Leontief assumed that the US was the most capital abundant country in the world after World War II and expected his test of the HO model to confirm that US exports were relatively capital intensive while US imports were relatively labor intensive Instead he found that US imports were more capital intensive than its exports hence Leontief39s Paradox b Discuss one of the attempted reconciliations of Leontief s findings Here are a few reconciliations Leontief American workers were so productive relative to workers in the rest of the world the US should more properly be viewed as being relatively labor abundant J aroslav Vanek argued that an important third factor natural resources had been omitted from the analysis Natural resources such as minerals tend to be produced using capitalintensive techniques Thus on a twofactor basis US imports appeared to be relatively capital intensive US imports were actually intensive in a third factor natural resources Prevailing US tariff structure US tariffs on laborintensive products tended to be high Assumption 17 international equality of tastes is violated Comparisons of expenditure patterns across countries indicate that differences in tastes and preferences could be signi cant in overturning HO predictions Assumption 14 identical technology A14 is violated In his test he used the US inputoutput table to construct the factor requirements for both US exports and US importcompeting goods The assumption he then made was that foreign goods would be produced using technologies identical with those found in US importcompeting industries If factor prices are not equalized internationally and if labor is relatively more expensive in the US than in the rest of the world then Leontief s procedure would estimate that US imports are relatively more capital intensive than the techniques actually used to produce these goods in the rest of the world Part III Computation Questions Please show all the formulas and calculations 1 Suppose that the United States and Mexico are the only countries in the world and that labor is the only productive input In the Mexico it requires 6 hours of labor to produce a television X and 4 hours of labor to produce a computer Y In the United States it requires 3 hours of labor to produce a television X and 3 hours of labor to produce a computer Y In other words we have the following input requirement table a television X hours of Labor required to produce a computer Y Mexico 6 US 3 a Which country has absolute advantage in X in Y Explain The US has absolute advantage in both goods because it requires fewer resources to produce the same amount of goods P b Determine the pretrade relative prices FX ie the price of a television X in units of computer Y in each country In Mexico In the US X PY Wages W Y P Wages gtlt hours MexicoX E 1 5 Mexico X hours Mexico Y 4 Mexico ie the price of a television is 15 computers PX WUS gtlt hoursUSX 1 US gtlt hoursUSY 3 Y ie the price of a television is 1 computers 0 Com lete the following table Units of Labor required to produce Opportunity Cost of producing 1 unit of a television X a computer Y X Y Mexico 6 4 6415 4623 US 3 3 1 1 d Which country has comparative advantage in X in Y Explain The US has comparative advantage in X because as can be seen from b the autarky pretrade relative price of X is lower in the US Similary it can also be seen from c the US can produce X with lower opportunity cost Mexico has comparative advantage in Y because it can produce Y with lower opportunity cost e If each country is endowed with 60 hours of labor how much X and Y will each country produce after trade begins Explain Mexico will completely specialize in the production of good Y It will produce 604 15 units of Y none of X The US will completely specialize in the production of good X It will produce 603 20 units of X none of Y i If Mexico and the US sign a free trade agreement What is the allowable range on the terms of trade that is the price of a television X in units of computerY under free trade if trade is owing between these two countries according to comparative advantage Why The terms of trade must lie between the two autarky relative prices ie the rate of exchange for a television must be between 1 computer and 15 computers If one television can be exchanged for less than 1 computer the US will not engage in trade with Mexico If one television can be exchanged for more than 15 computers Mexico will not engage in trade with the US g Denote the wage rate in Mexico and the wage rate in the US by WM and WUS respectively Denote the exchange rate that translate units of Mexican peso into by E What is the allowable range on the relative wage rate US if trade is ow1ng between these two countries according to comparative M advantage For the US to export its comparativeadvantage good X it must be that W W 3WUS lt E6WM or USlt or USlt2 EWM 3 EWM For Mexico to export its comparativeadvantage good Y it must be that W E4WM lt 3WUS or lt US 3 EWM US lt2 EWM 4 Combining the two conditions it must be the case that E lt 2 Suppose that a small tropical country produces mangoes for domestic consumption and possibly for export The national demand and supply curves for mangoes in this country are given by the following P 50 Q national demand P 25 Q national supply where P denotes the relative price of mangoes and Q denotes the quantity of mangoes in metric tons a What is the autarky price and quantity exchanged Illustrate them on the demand and supply diagram for mangoes To find the autarky prices and quantities the demand and supply equations must be solved simultaneously To nd M set the right hand sides equal to each other So doing yields Q 125 Using this result insert it into either equation to nd P 375 Make sure to label your graphs b Suppose that the world price of mangoes is 45 What are the level of domestic production and consumption Will this small country export or import mangoes If so how many tons Domestic production 45 25 Q Qs 20 Domestic consumption 45 50 Q Qd 5 Since the world price is higher than autarky price of mangoes this country would be an exporter of mangoes Then this country will export 205 15 10 3 Answer the questions based upon the following diagram assume the small country case F Jr a 5 Pwmnd Tariff I 39 u 2 10 1 world I1 I I I i D H l V I 111an mum gaunt 42am 500013 Q a What is the autarky price and quantity exchanged Autarky price 25 Quantity exchanged 25000 units b Suppose the world price of this good is 10 With free trade calculate the total quantity of imports 6000010000 50000 units c With the tariff of 5 per unit calculate quantity of imports 42000 12000 30000 units d With the above tariff how much will the government be able to collect as tariff revenue 5 30000 150000 e Illustrate the deadweight loss on the above diagram f If instead of a tariff the government restricts trade by imposing a quota What is the amount of quota that would produce the same effects on the amount of imports as the above tariff The Quota of 30000 units 11 UNIVERSITY INTERNATIONAL OF LONDON PROGRAM M ES International economics R Versteeg EC3016 2015 Undergraduate study in Economics Management Finance and the Social Sciences This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics Management Finance and the Social Sciences Materials for these programmes are developed by academics at the London School of Economics and Political Science LSE For more information see wwwondoninternationaacuk THE LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE I ISE This guide was prepared for the University of London International Programmes by Dr R Versteeg Department of Economics Mathematics and Statistics Birkbeck College University of London The previous edition of International economics was written by Dr D Petropoulou Stipendiary Lecturer in Economics Hertford College University of Oxford wwweconomicsacukindexphpstaffpetropoulou and A Vanags Director of the Baltic International Centre for Economic Policy Studies BICEPS Latvia and Lecturer in International economics at the Stockholm School of Economics Riga Latvia Some material in this subject guide has been adapted from the subject guide for course EC31 IS Ionetary economics 201 1 written by Ryan Love formerly of the London School of Economics and Political Science This is one of a series of subject guides published by the University We regret that due to pressure of work the authors are unable to enter into any correspondence relating to or arising from the guide If you have any comments on this subject guide favourable or unfavourable please use the form at the back of this guide University of London International Programmes Publications Office Stewart House 32 Russell Square London WCIB SDN United Kingdom wwwlondoninternationalacuk Published by University of London University of London 2015 The University of London asserts copyright over all material in this subject guide except where otherwise indicated All rights reserved No part of this work may be reproduced in any form or by any means without permission in writing from the publisher We make every effort to respect copyright If you think we have inadvertently used your copyright material please let us know Contents Contents 1 Introduction to the subject guide 1 11 Introduction 1 12 Route map to the course 1 13 Introduction to the subject area 1 14 Syllabus 2 141 Prerequisites 3 15 Aims of this course 3 16 Learning outcomes for the course 4 17 Overview of learning resources 4 171 The subject guide 4 172 Essential reading 4 173 Further reading 5 174 Online study resources 6 175 VLE 6 176 Making use of the Online Library 7 18 Study time 7 19 Examination advice 7 191 The examination 7 192 Examination technique 8 Part 1 International trade 11 2 The Ricardian model of international trade 15 21 Introduction 15 211 Aims of the chapter 15 212 Learning outcomes 15 213 Essential reading 16 214 Further reading 16 215 References cited 16 216 Synopsis of chapter content 16 Contents 22 Chapter content 17 221 The Ricardian model 17 222 Techniques and some formal results 17 223 Empirical evidence and application 24 23 Overview of chapter 25 24 Reminder of learning outcomes 25 25 Test your knowledge and understanding 26 251 Sample examination questions 26 252 Guidance on answering Sample examination questions 27 253 Feedback to selected activities 27 3 The Heckscher Ohlin model 33 31 Introduction 33 311 Aims of the chapter 33 312 Learning outcomes 33 313 Essential reading 34 314 Further reading 34 315 References cited 34 316 Synopsis of chapter content 34 32 Chapter content 34 321 Assumptions 34 322 Tools and results for a closed economy 36 323 Trade income distribution and factor price equalisation 44 324 Empirical evidence 46 33 Overview of chapter 46 34 Reminder of learning outcomes 47 35 Test your knowledge and understanding 47 351 Sample examination questions 47 352 Guidance on answering Sample examination questions 48 4 The speci c factors model 49 41 Introduction 49 411 Aims of the chapter 49 412 Learning outcomes 49 413 Essential reading 50 414 Further reading 50 Contents 415 References cited 50 416 Synopsis of chapter content 50 42 Chapter content 50 421 Assumptions 50 422 Tools and results 51 423 Effects of trade 51 424 The pattern of trade 53 43 Overview of chapter 54 44 Reminder of learning outcomes 54 45 Test your knowledge and understanding 54 451 Sample examination questions 54 452 Guidance on answering Sample examination questions 55 The standard trade model 57 51 Introduction 57 511 Aims of the chapter 57 512 Learning outcomes 57 513 Essential reading 58 514 Further reading 58 515 References cited 58 516 Synopsis of chapter content 58 52 Chapter content 58 521 Techniques of the standard trade model 58 522 The gains from trade 59 523 International borrowing and lending as intertemporal trade 62 53 Overview of chapter 62 54 Reminder of learning outcomes 62 55 Test your knowledge and understanding 63 551 Sample examination questions 63 552 Guidance on answering Sample examination questions 63 Factor movements 65 61 Introduction 65 611 Aims of the chapter 65 612 Learning outcomes 65 613 Essential reading 65 Contents iv 614 Further reading 66 615 References cited 66 616 Synopsis of chapter content 66 62 Chapter content 66 621 International mobility of labour 67 622 International mobility of capital 67 623 International borrowing and lending as intertemporal trade 68 63 Overview of chapter 69 64 Reminder of learning outcomes 69 65 Test your knowledge and understanding 69 651 Sample examination questions 69 652 Guidance on answering Sample examination questions 69 7 Imperfect competition and other alternative trade models 71 71 Introduction 71 711 Aims of the chapter 71 712 Learning outcomes 71 713 Essential reading 72 714 Further reading 72 715 References cited 72 716 Synopsis of chapter content 72 72 Chapter content 72 721 Alternative models 72 722 The Krugman monopolistic competition model of trade 73 723 Other models 77 724 Reciprocal dumping 78 725 Control and multinational enterprises 79 73 Overview of chapter 80 74 Reminder of learning outcomes 81 75 Test your knowledge and understanding 81 751 Sample examination questions 81 752 Guidance on answering Sample examination questions 81 8 Instruments of trade policy 83 81 Introduction 83 811 Aims of the chapter 83 Contents 812 Learning outcomes 83 813 Essential reading 84 814 Further reading 84 815 References cited 84 816 Synopsis of chapter content 84 82 Chapter content 84 821 A taxonomy of trade policy instruments 84 822 Trade policy issues 85 823 Partial equilibrium analysis 86 824 General equilibrium analysis 90 825 Equivalence of a tariff and an export tax 93 826 Analysis of a tariff and quota with a domestic monopolist 94 827 Effective protection 95 83 Overview of chapter 96 84 Reminder of learning outcomes 96 85 Test your knowledge and understanding 96 851 Sample examination questions 96 852 Guidance on answering Sample examination questions 97 Economic arguments for protection and the political economy of trade policy 101 91 Introduction 101 911 Aims of the chapter 101 912 Learning outcomes 101 913 Essential reading 102 914 Further reading 102 915 References cited 102 916 Synopsis of chapter content 102 92 Chapter content 103 921 Economic arguments for protection 103 922 The political economy of protection 107 923 The antiglobalisation movement the globalisation backlash 109 93 Overview of chapter 110 94 Reminder of learning outcomes 110 95 Test your knowledge and understanding 110 951 Sample examination questions 110 952 Guidance on answering Sample examination questions 110 Contents 10 Preferential trading arrangements customs unions and economic integration 113 101 Introduction 113 1011 Aims of the chapter 113 1012 Learning outcomes 114 1013 Essential reading 114 1014 Further reading 114 1015 References cited 114 1016 Synopsis of chapter content 115 102 Chapter content 115 1021 Basic theory 115 1022 Trade creation and trade diversion 115 1023 Terms of trade effects 117 1024 Other effects 118 1025 Other levels of integration 118 103 Overview of chapter 119 104 Reminder of learning outcomes 119 105 Test your knowledge and understanding 119 1051 Sample examination questions 119 1052 Guidance on answering Sample examination questions 120 1053 Feedback to selected activities 121 11 Trade policy in developing economies 123 111 Introduction 123 1111 Aims of the chapter 123 1112 Learning outcomes 123 1113 Essential reading 124 1114 Further reading 124 1115 References cited 124 1116 Synopsis of chapter content 124 112 Chapter content 124 1121 The dual economy trade policy and the HarrisTodaro model 124 1122 Importsubstitution as a development policy 126 1123 Exportoriented development 126 113 Overview of chapter 127 114 Reminder of learning outcomes 127 115 Test your knowledge and understanding 127 vi Contents 1151 Sample examination questions 127 1152 Guidance on answering Sample examination questions 128 Part 2 International finance 129 12 National income accounting and the balance of payments 133 121 Introduction 133 1211 Aims of the chapter 133 1212 Learning outcomes 133 1213 Essential reading 134 1214 Further reading 134 1215 References cited 134 1216 Synopsis of chapter content 134 122 Chapter content 134 1221 National income account 134 1222 The balance of payments 137 123 Overview of chapter 138 124 Reminder of learning outcomes 138 125 Test your knowledge and understanding 139 1251 Sample examination questions 139 1252 Guidance on answering Sample examination questions 139 13 An Introduction to foreign exchange markets 141 131 Introduction 141 1311 Aims of the chapter 141 1312 Learning outcomes 141 1313 Essential reading 142 1314 Further reading 142 1315 References cited 142 1316 Synopsis of chapter content 142 132 Chapter content 142 1321 Foreign exchange markets 142 1322 Parity conditions 145 1323 The asset approach to exchange rates 147 1324 The demand for money 148 1325 Exchange rate overshooting Dombusch model 149 vii Contents 133 Overview of chapter 149 134 Reminder of learning outcomes 149 135 Test your knowledge and understanding 150 1351 Sample examination questions 150 1352 Guidance on answering Sample examination questions 150 1353 Feedback to selected actiVities 151 14 Prices and the exchange rate 153 141 Introduction 153 1411 Aims ofthe chapter 153 1412 Learning outcomes 153 1413 Essential reading 153 1414 Further reading 154 1415 References cited 154 1416 Synopsis of chapter content 154 142 Chapter content 154 1421 The law ofone price 154 1422 Purchasing power parity 155 1423 BalassaSamuelson effect 158 1424 The exible price monetary model 159 1425 The real exchange rate 162 143 Overview of chapter 163 144 Reminder of learning outcomes 163 145 Test your knowledge and understanding 164 1451 Sample examination questions 164 1452 Guidance on answering Sample examination questions 164 1453 Feedback to selected actiVities 166 15 Output and the exchange rate 167 151 Introduction 167 1511 Aims of the chapter 167 1512 Learning outcomes 167 1513 Essential reading 168 1514 Further reading 168 1515 References cited 168 1516 Synopsis of chapter content 168 viii Contents 152 Chapter content 168 1521 The AA DD paradigm 168 1522 Short and longrun equilibria for an open economy 172 1523 Further issues in the AA DD framework 174 1524 Competitive devaluations 176 1525 The MundellFleming model 178 153 Overview of chapter 180 154 Reminder of learning outcomes 180 155 Test your knowledge and understanding 181 1551 Sample examination questions 181 1552 Guidance on answering Sample examination questions 181 1553 Feedback to selected activities 181 16 Fixed exchange rates 183 161 Introduction 183 1611 Aims of the chapter 183 1612 Learning outcomes 183 1613 Essential reading 184 1614 Further reading 184 1615 References cited 184 1616 Synopsis of chapter content 184 162 Chapter content 184 1621 Different exchange rate regimes 184 1622 Intervention the money supply and sterilisation 186 1623 Stabilisation policies under a xed exchange rate 188 163 Overview of chapter 191 164 Reminder of learning outcomes 191 165 Test your knowledge and understanding 193 1651 Sample examination questions 193 1652 Guidance on answering Sample examination questions 193 17 Currency crises 195 171 Introduction 195 1711 Aims of the chapter 195 1712 Learning outcomes 195 1713 Essential reading 195 ix Contents 172 173 174 175 18 Monetary systems 181 182 1714 Further reading 196 1715 References cited 196 1716 Synopsis of chapter content 196 Chapter content 196 1721 First generation inconsistent policies 196 1722 Second generation contingent policies 199 1723 Third generation nancial fragilities 199 Overview of chapter 200 Reminder of learning outcomes 200 Test your knowledge and understanding 200 1751 Sample examination questions 200 1752 Guidance on answering Sample examination questions 200 1753 Feedback to selected activities 201 203 Introduction 203 1811 Aims of the chapter 203 1812 Learning outcomes 204 1813 Essential reading 204 1814 Further reading 204 1815 References cited 204 1816 Synopsis of chapter content 204 Chapter content 204 1821 The impossible trinity 204 1822 The Gold standard circa 1870 to 1914 205 1823 Bretton Woods 1944 to 1971 207 183 Overview of chapter 209 184 Reminder of learning outcomes 209 185 Test your knowledge and understanding 209 1851 Sample examination questions 209 1852 Guidance on answering Sample examination questions 210 1853 Feedback to selected activities 210 19 Optimum currency areas 213 191 Introduction 213 1911 Aims of the chapter 213 Contents 1912 Learning outcomes 213 1913 Essential reading 213 1914 Further reading 213 1915 References cited 214 1916 Synopsis of chapter content 214 192 Chapter content 214 1921 European Monetary Union 214 1922 The costs of a common currency 215 1923 Bene ts of a common currency 217 193 Overview of chapter 218 194 Reminder of learning outcomes 218 195 Test your knowledge and understanding 218 1951 Sample examination questions 218 1952 Guidance on answering Sample examination questions 219 20 International capital markets 221 201 Introduction 221 2011 Aims of the chapter 221 2012 Learning outcomes 221 2013 Essential reading 222 2014 Further reading 222 2015 References cited 222 2016 Synopsis of chapter content 222 202 Chapter content 222 2021 Growth of the international capital market 222 2022 Capital market performance 224 203 Overview of chapter 226 204 Reminder of learning outcomes 226 205 Test your knowledge and understanding 226 2051 Sample examination questions 226 2052 Guidance on answering Sample examination questions 227 A Sample examination paper 229 B Examiners Commentary 233 C Bibliography 243 xi Contents Chapter 1 Introduction to the subject guide 11 Introduction Welcome to this course in International economics which is divided into two parts international trade and international nance In this introductory chapter we will look at the overall structure of the subject guide we will introduce you to the subject area to the aims and learning outcomes for the course and to the learning resources available Finally we will offer you some Examination advice We hope you enjoy this course and we wish you every success in your studies 12 Route map to the course The subject of International economics falls rather neatly into two distinct parts One part deals with international trade and the other part deals with international nance An undergraduate economics programme typically takes one term or semester to cover each part Accordingly the guide has been structured to provide you with two separate work programmes one for international trade and one for international nance The subject guide consists of one introductory chapter 10 chapters on international trade nine chapters on international nance and one Sample examination paper with the associated Examiners commentary You are advised to work through the introductory chapter and the 10 chapters of international trade in the Autumn term in the Spring term you are advised to work through the chapters on international nance and at the end to attempt the Sample examination paper under examination conditions that is with closed books limiting yourself to three hours You are advised to progress at a rate of one chapter per week about 20 weeks in total 13 Introduction to the subject area All countries are involved in economic relationships with other countries they trade goods and services with each other they buy and sell each other s assets often they engage in the direct transfer of factors of production between one another in the form of foreign direct investment or migration The nature of these relationships experiences constant change Over time a variety of formal and informal regional trading blocs and monetary unions has evolved Increasing liberalisation and integration of the world economy has led to an explosion of international trade and movement of capital In April 1998 average daily global foreign exchange trading was already a staggering 15 billion but by April 2013 daily turnover 1 Introduction to the subject guide exceeded 53 trillion Source Bank of International Settlements making foreign exchange markets the largest nancial markets in the world With the liberalisation of trade and capital movements the importance of international economic relationships has increased as have the links through which economic shocks are transmitted across countries The extent of these links can be witnessed in the global effects of the 2007 US subprime crisis The above all highlights issues in the sphere of international economics International economics addresses questions such as I Why do countries trade and what determines the pattern of international trade I What are the sources of gains from trade and who might the losers be International economics is at the core of many important policy issues for example I Problems surrounding bilateral trade have for years dominated ChinaU S economic relationships I The Asian nancial crisis of 1997 was a consequence of the development of complicated international nancial linkages I As the nancial crisis emanating from the US subprime crisis continues to unfold important issues regarding the causes consequences and policy responses to nancial crises are reevaluated I The Euro which may yet challenge the US dollar as a world currency is a direct product of the drive to European integration Considering the importance of international economics it is not surprising that our understanding of international economics is subject to constant change and development Within the context of your degree international economics represents an important application of the basic principles and methods that you have learned in your microeconomics and macroeconomics modules 14 Syllabus The module international economics is divided into two parts international trade and international nance sometimes referred to as international macroeconomics or international monetary economics This split essentially coincides with the distinction between the microeconomics and the macroeconomics of the open economy International trade covers the reasons for trade and explanation of trade patterns and the gains accruing from trade or from restricting trade These are core areas and call for extensive coverage Linked to this core are a number of speci c issues which must also be studied I increasing returns and trade I international factor movements I growth and trade 2 15 Aims of this course I income distribution and trade I economic integration I multinational enterprises I Northsouth issues Empirical evidence supplements the theoretical treatment The European Union EU World Trade Organization WTO and the United Nations Conference on Trade and Development UNCTAD are institutionally involved in trade policy issues and their major concerns are included in the subjects to be studied International nance covers the balance of payments exchange rates and openeconomy macroeconomics Linked to this core are a number of speci c issues which must also be studied national income accounting spot and forward markets parity conditions exchange rate determination exchange rate regimes exchange rate stability and currency crises and currency unions Empirical evidence though often inadequate and con icting is relevant in many areas Issues associated with the European Monetary System EMS the International Monetary Fund IMF and in general with international monetary relations are also included in the syllabus 141 Prerequisites If you are studying for this course as part of a University of London International Programmes BSc degree you must have already passed EC2065 Macroeconomics and either MN3028 Managerial economics or EC2066 Microeconomics Students should refer to the degree structures in the Regulations when choosing which prerequisite to select 15 Aims of this course The course aims to enable you to I acquire the analytical methods needed and understanding of how and when to apply different models and approaches to events in the world economy I provide an understanding of the intellectual and practical problems that arise from the economic interaction between countries I offer explanations of the international pattern of trade and specialisation and of the reasons why similar economies often trade more with each other than with dissimilar ones I provide an account of the sources of the gains from trade I offer explanations in the monetary sphere of the determinants of exchange rates of the timing and causes of nancial crises and an analysis of the channels of international economic interdependence 1 Introduction to the subject guide 16 Learning outcomes for the course At the end of the course and having completed the Essential reading and activities you should be able to I discuss and explain speci c policy issues such as environmentalism as protectionism international dumping the choice of exchange rate regime the desirability of free capital ows I apply a speci c framework to illustrate the connection between a variety of models and approaches Explain the connections between Ricardian Heckscher Ohlin and the speci c factors models in trade theory or between the monetary approach and the asset approach in exchange rate theory I explain how international economic theory has been shaped by real world events 17 Overview of learning resources 171 The subject guide The subject guide is intended for you to use in conjunction with the suggested textbooks Therefore it is important that you understand that the subject guide is not itself a textbook or a substitute for a textbook Each chapter of the guide roughly corresponds to one week s work if you were studying as a student on campus and covers a distinct topic or set of topics Each chapter begins with a list of Essential reading and Further reading As the name suggests Essential reading is required reading in order for you to fully understand the concepts introduced in the particular chapter The items listed under Further reading will give you greater insight into the topics covered in the chapter They are meant to both provide alternate textbook sources if you still feel uncomfortable with the material and advanced references if you want to read more on a particular topic Each chapter also provides you with a set of activities together with some Sample examination questions that will enable you to test your understanding of the basic ideas and concepts It is vital that you attempt all the suggested activities since actively doing is a better way of learning than passively absorbing material by reading 172 Essential reading This course is built predominantly around the following textbook Krugman P M Obstfeld and M Melitz International Economics Theory and Policy Boston Mass London PearsonAddisonWesley 2014 Pearson global edition tenth edition ISBN 9781292019550 referred to as KOM in the subject guide International economics has a vast literature including a large number of very good textbooks the book by Paul Krugman Maurice Obstfeld and Marc Melitz in 2014 in its tenth edition is one of the very best It is written by three economists who have been at the forefront of recent 4 17 Overview of learning resources advances in international economics and contains some of the latest developments At the same time the textbook remains very userfriendly is grounded in realworld experience and is widely used throughout the world The main body of the text is nontechnical and more advanced material is contained in appendices and mathematical appendices References in this subject guide are to the ninth edition which has the advantage of including more recent case studies as well as an uptodate discussion on international economic issues Earlier editions of the textbook are suf cient for much of the material but do not address recent debates such as those surrounding the global nancial crisis and issues surrounding the use of unconventional monetary policy in the wake of the crisis Detailed reading references in this subject guide refer to the editions of the set textbooks listed above and below New editions of one or more of these textbooks may have been published by the time you study this course You can use a more recent edition of any of the books use the detailed chapter and section headings and the index to identify relevant readings Also check the virtual learning environment VLE regularly for updated guidance on readings It is essential that you access the textbook and we advise you to purchase it if at all possible Note that references to book chapters diagrams etc are for the editions of the books indicated above Earlier editions of the textbook may be available second hand at more favourable prices but you should weigh this against the fact that the references in this guide will not match exactly Some of the chapters of this syllabus refer to the Online Appendices of KOM These Online Appendices can be found at http wps aw combpkrgmnobstfinterecon10 In the second part of the syllabus on international nance there are a couple of instances where KOM is supplemented with required readings from one other textbook Copeland L Exchange Rates and International Finance Harlow Prentice Hall 2014 sixth edition ISBN 9780273786047 referred to as C in the guide 173 Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text paper or online resource You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world To help you read extensively you have free access to the VLE and University of London Online Library see below There are many textbooks that cover the topics discussed in this subject guide one textbook that can be used as a complement to KOM is Feenstra R and M Taylor International Economics New York Worth Publishers 2014 third revised edition ISBN 9781429278423 referred to as FT in the guide You may also nd Copeland 2014 mentioned under Essential reading useful as Further reading for many chapters of Part 2 of the subject guide There are two free online textbooks available on international trade and international nance written by Suranovic These are excellent online resources that are very easy to access Suranovic SM International Trade Theory and Policy referred to as SIT in the subject guide 1 Introduction to the subject guide httpinternationaleconcomTradetradehomephp Suranovic SM International Finance Theory and Policy referred to as SIF in the subject guide httpinternationaleconcomFinancefinancehomephp However good a book might be it is nevertheless essential that you read more widely Many of the chapters of the subject guide provide several additional references under Further reading which contain seminal contributions to the academic literature survey papers or in some instances relevant policy reports Unless otherwise stated all websites in this subject guide were accessed in February 2015 We cannot guarantee however that they will stay current and you may need to perform an intemet search to nd the relevant pages 174 Online study resources In addition to the subject guide and the Essential reading it is crucial that you take advantage of the study resources that are available online for this course including the VLE and the Online Library You can access the VLE the Online Library and your University of London email account via the Student Portal at http my londoninternational ac uk You should have received your login details for the Student Portal with your of cial offer which was emailed to the address that you gave on your application form You have probably already logged in to the Student Portal in order to register As soon as you registered you will automatically have been granted access to the VLE Online Library and your fully functional University of London email account If you have forgotten your login details please click on the Forgotten your password link on the login page 175 VLE The VLE which complements this subject guide has been designed to enhance your learning experience providing additional support and a sense of community It forms an important part of your study experience with the University of London and you should access it regularly The VLE provides a range of resources for EMFSS courses I Selftesting activities Doing these allows you to test your own understanding of subject material I Electronic study materials The printed materials that you receive from the University of London are available to download including updated reading lists and references I Past examination papers and Examiners commentaries These provide advice on how each examination question might best be answered I A student discussion forum This is an open space for you to discuss interests and experiences seek support from your peers work collaboratively to solve problems and discuss subject material 18 Study time I Videos There are recorded academic introductions to the subject interviews and debates and for some courses audiovisual tutorials and conclusions I Recorded lectures For some courses where appropriate the sessions from previous years Study Weekends have been recorded and made available I Study skills Expert advice on preparing for examinations and developing your digital literacy skills I Feedback forms Some of these resources are available for certain courses only but we are expanding our provision all the time and you should check the VLE regularly for updates 176 Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details or you will be required to register and use an Athens login http tinyurl comollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine If you are having trouble nding an article listed in a reading list try removing any punctuation from the title such as single quotation marks question marks and colons For further advice please see the online help pages wwwexternalshllonacuksummonaboutphp 18 Study time Study time is very much an individual matter However a student following an internal degree programme would normally have three to four hours of contact time per week on an international economics subject at this level Normally an internal student would be expected to back this up by at least the same amount of time devoted to individual study This implies a minimum of say eight hours per week If you are studying this subject over one year you would be advised to devote at least as much time to the subject but you can break this up into three or four sessions over the week 19 Examination advice 191 The examination Important The information and advice given here are based on the examination structure used at the time this guide was written Please note that subject guides may be used for several years Because of this we strongly advise you to always check both the current Regulations for 7 1 Introduction to the subject guide relevant information about the examination and the VLE where you should be advised of any forthcoming changes You should also carefully check the rubricinstructions on the paper you actually sit and follow those instructions Assessment is by a threehour unseen examination From 2014 the examination will have two sections I Section A requires candidates to answer one compulsory question worth 40 marks Question 1 Answers must be supported with a brief justi cation or explanation which may include diagrams or equations where appropriate Unsupported answers will receive no marks I Section B contains 10 predominantly essaystyle questions Candidates are required to choose any three questions from this section each carrying 20 marks These questions are designed to test candidates analytical understanding of the course and require application of knowledge to details provided in the question Candidates should refer to the VLE and read the Examiners commentaries on the Zone A and Zone B examinations of recent years These contain guidelines regarding what constitutes a poorgoodexcellent answer to past examination questions and general advice on how to approach the examination areas where candidates have exhibited weakness etc 192 Examination technique Good examination technique can signi cantly improve your examination performance and poor technique may result in serious underachievement relative to your ability and understanding Some aspects of good technique are elementary and require only awareness and selfdiscipline while others are more subtle You should regard the examination as an opportunity for you to demonstrate to the Examiners that you have covered the material of the subject that you understand the material and that you can use and apply it in different situations You should bear in mind that your examination script is the only evidence available to the Examiners on which to base their judgement about what you have achieved They cannot read your mind or ask you what you mean Accordingly it is important that what you write clearly and unambiguously demonstrates your mastery of the subject This suggests a number of rules that you should follow You should read carefully the instructions at the beginning of the question paper and follow them In particular if you are asked to answer say three questions you should answer three If you answer only two questions you will receive zero marks for the missing third question Thus you should pace yourself to allow time to answer all the required questions as even a moderatelyanswered question will score more than zero If a question is compulsory then you must answer it Also there is no advantage in answering more than the required number of questions you will receive credit only for what you are asked to do It is important that what you write is legible The Examiners can only give credit for what they can read If you have problem handwriting you would be advised to write more slowly to ensure legibility You might ask a friend or teacher to advise you on the legibility of your handwriting If you use diagrams or equations it is important that you label them and explain them clearly 8 19 Examination advice and that you refer to them in the text narrative of your answer An isolated and unexplained diagram is useless You should read each question carefully and attempt to identify the nuances that the Examiners may have included Questions are rarely of the form Write all you know about comparative advantage Usually a question requires you to show how a concept or theory might be used or interpreted You need to identify the particular angle the Examiner has decided to emphasise and address that particular angle Often it is helpful to use the opening paragraph of your answer to discuss your interpretation of the question This serves the purpose of informing the Examiners of how you are thinking and may also help you to structure your answer Remember it is important to check the VLE for l uptodate information on examination and assessment arrangements for this course I where available past examination papers and Examiners commentaries for the course which give advice on how each question might best be answered 1 Introduction to the subject guide 10 International trade 11 Introduction to international trade The subject matter of international economics divides rather neatly into what are referred to as international trade and international nance These areas form the two Parts of this subject guide The body of thought that comes under the title of international trade is concerned with real aspects of international economics where the term real is to be understood as contrasting with monetary or nancial Alternatively you might wish to think of international trade as the application of microeconomics to the international economy and international monetary economics as the application of macroeconomics The starting point for studying international trade concerns questions such as I Why do countries trade with each other I How do countries gain from international trade I What determines the international pattern of specialisation and the commodity and composition of trade These are issues addressed in Chapters 2 to 7 which together form a conceptual unit Each chapter deals with different international trade models and offers a model that provides alternative theoretical explanations of international trade Chapters 2 to 4 relate to models of international trade based on comparative advantage Chapter 5 provides a synthesis of the common features of the comparative advantage models dicussed in Chapters 2 to 4 Chapter 6 considers the movement of factors Chapter 7 examines models of trade based on economies of scale and imperfect competition The different modelsexplanations for international trade are in part complementary and in part competing and the intention of these chapters is to highlight these features Chapters 8 to 11 form another block that deals with trade policy or commercial policy Trade or commercial policy is to be understood as intervention by governments of international agencies in the trading process Chapter 8 deals with the fundamentals of trade policy what are the instruments of trade policy intervention How do they work How can they be compared Economists are typically in favour of the absence of trade policy intervention that is in favour of what is sometimes known as free trade In practice very few countries operate free trade regimes and Chapter 9 is devoted to exploring the reasons for this Regional trading arrangements have proliferated in recent years and Chapter 10 is devoted to exploring the reasons for this Chapter 11 nishes up with some of the special trade issues faced by developing countries 13 14 Chapter 2 The Ricardian model of international trade 21 Introduction International trade theory seeks to explain or answer some of the following questions Why do countries trade with each other What are the gains from trade What explains the pattern of international specialisation What explains the commodity composition of trade How is it possible for low productivity countries to trade with high productivity ones How are international prices determined How are the gains from trade distributed Answers to most of these questions are offered by the principle of comparative advantage 211 Aims of the chapter At the end of this chapter and having completed the Essential readings and activities you should be able to I summarise the theory of comparative advantage in particular with reference to the Ricardian model and apply this theory in the real world 212 Learning outcomes By the end of this chapter and having completed the Essential readings and activities you should be able to I explain the concept of comparative advantage and distinguish it from the idea of absolute advantage I explain how comparative advantage based on technological differences is the determinant of the pattern of trade and specialisation in the Ricardian model I explain how the gains from trade arise in this model I explain the relationship between relative international productivity and relative wages I manipulate the RDRS diagram to illustrate different possible equilibria in the Ricardian model I explain how comparative advantage might be interpreted in a real world situation 15 2 The Ricardian model of international trade 213 Essential reading KOM Chapter 3 Labour Productivity and Comparative Advantage The Ricardian Model 214 Further reading FT Chapter 2 Trade and Technology The Ricardian Model SIT Chapter 40 httpinternationaleconcomTradeTch4 Tch4 php Balassa B An Empirical demonstration of classical comparative cost theory The Review of economics and statistics 45 1963 The MIT Press pp231 238 Stable URL httpwwwjstororgstable1923892 Krugman P Growing world trade causes and consequences Brookings papers on economic activity 1 1995 pp327 77 Leamer E and J Levinsohn International trade theory the evidence Chapter 26 Handbook of international economics 3 1995 ppl339 1394 MacDougall G British and American exports a study suggested by the theory of comparative costs the economic journal 61 1951 pp697 724 Ricardo D The principles of political economy and taxation Mineola NY Dover publications Inc 2004 ISBN 9780486434612 215 References cited No further references cited in the text 216 Synopsis of chapter content This chapter like the other main chapters of this subject guide follows a fairly standard structure It begins with an Introduction in this case on the Ricardian model considers this model in more detail before moving on to an Overview of the key content The chapter contains several activities for you to perform and we recommend that you do these in order to facilitate your learning and we recommend that you consider these an integral part of each and every chapter The chapter ends with a Reminder of your Learning outcomes for the chapter along with a Test your knowledge and understanding section with sample examination questions that directly relate to the content of the chapter There will also be some guidance on answering sample questions and there may be some guidance on approaching selected activities 16 22 Chapter content 22 Chapter content 221 The Ricardian model Adam Smith had previously shown the gains of trade in the presence of absolute advantage that is the situation in which a country is more ef cient in producing a good than another country Ricardo s model shows that mutual gains from trade and specialisation arise even when one of the countries say the poor country is less ef cient in the production of both goods Although the poor country may be less ef cient overall and thus not have an absolute advantage it may still have a relative ef ciency giving it a comparative advantage Developed by David Ricardo in the early nineteenth century to provide intellectual support for the abolition of Corn Laws in Great Britain that is to promote the bene ts of free trade in grain the principle of comparative advantage remains one of the enduring insights of economic theory Many textbooks continue to use Ricardo s original numerical example The example uses two countries Portugal and England and the production and trade of two products namely wine and cloth The further development of Ricardo s numerical example as a twogoodtwocountry model has come to be known as the Ricardian model also known as the classical model The Ricardian model remains the starting point of the theory of international trade theory even now nearly 200 years after Ricardo originally developed it The basis for comparative advantage in the Ricardian model which drives the pattern of specialisation and trade lies in crosscountry technological differences as summarised by differences in the opportunity cost of the production of goods The advantages of the Ricardian model Here are some of the advantages of the model I it is a particularly clear account of the principle of comparative advantage and how trade and specialisation according to comparative advantage will generate mutual gains from trade I it demonstrates that a regime of free trade will actually generate a trade and specialisation pattern in accordance with comparative advantage I it provides an understanding of the roles of wages and productivity in international competitiveness I it gives an introduction to a methodology which is used in the development of many other propositions in trade theory I it is a working example of a simple general equilibrium model 222 Techniques and some formal results The usual assumptions of the Ricardian model may be summarised as follows 1 There are two countries which we shall refer to as Home H and Foreign F 17 2 The Ricardian model of international trade 2 There are two goods which we shall refer to as wine w and cloth c 3 Each good is produced with the aid of one factor of production usually thought of as labour You might imagine that labour actually works with land andor capital but these other factors are suppressed in this model and formally you can assume that one unit of labour works with a xed bundle of other inputs 4 Production of both goods is subject to constant returns to scale and hence the technology for each good may be summed up by its unit labour requirement The unit labour requirement in wine is given by the number of units hours of labour needed to produce one unit of output in this case a litre of wine In cloth production it is the amount of labour needed to produce a bale of cloth The inverse of the unit labour requirement is the average and marginal product of labour 5 All markets are assumed to be competitive This means that all markets clear that is supply 2 demand and that in both sectors price 2 average cost marginal cost Note It is not necessary for you to reproduce these assumptions in an essay or in an examination answer unless they are speci cally asked for but you should understand why the assumptions are needed You may nd it helpful to approach the main properties and results of the model in two alternative but complementary ways i comparing the equilibrium under autarky with the free trade equilibrium and ii the relative supply RS relative demand RD analysis Equilibrium under autarky and the free trade equilibrium One route to show the advantages of trade is to assume that initially there is no trade between Home and Foreign perhaps because transport costs are prohibitively high This is known as autarky that is both countries are selfsuf cient in both goods and consume what they produce Thus under autarky each country can be regarded as a closed economy and hence equilibrium in each is simply the closed economy equilibrium With two goods constant returns to scale and one factor of production the production possibility frontier PPF can be depicted as a straight line For each country the area on and below the PPF represents feasible production of that country if there is full employment the actual production should lie on the PPF The slope of the PPF re ects the opportunity cost of cloth in terms of wine and in equilibrium also the autarky relative price of cloth in terms of wine Here we assume that in the autarky equilibrium cloth and wine are both produced and consumed The coincidence of the price ratio and the opportunity cost ratio follows from the fact that in competitive equilibrium prices must equal costs Autarky equilibrium in Foreign can also be represented in this way with the difference being that the slope of the production possibility frontierrelative price line will be different if relative costs are different from what they are in Home Activity 21 Check for yourself that in equilibrium the price ratio the cost ratio Hint for the price of each good note that price 2 marginal cost 2 unit labour requirement gtlt wage rate 18 22 Chapter content International Relative Prices Opportunity Cost and Autarky Relative Prices PCPWFT CPF Cloth Figure 21 Autarky and free trade equilibrium in Home Let us assume for the sake of argument that Home has a higher opportunity cost of cloth in terms of wine relative to Foreign That is more wine needs to be sacri ced in Home to produce one more unit of cloth than in Foreign This is re ected in Figures 21 and 22 where Home s PPF is drawn steeper than the PPF of Foreign Hence cloth is more expensive in the Home autarky equilibrium than it is in Foreign The autarky equilibrium in Home and Foreign is denoted by A and A in Figures 21 and 22 respectively where consumers choose consumption to maximise utility indifference curves I A given the range of feasible production possibilities Hence the PPF is also the consumers budget set in the autarky equilibrium Note that the consumption side of these two economies is assumed to be identical that is consumers in Home and Foreign have the same preferences over wine and cloth Suppose that trade between Home and Foreign becomes possible because of say a transport revolution that slashes international transport costs Economic agents observe that cloth is relatively cheap in Foreign but wine is relatively cheap in Home so Home buyers will switch to Foreign as their source for cloth and Foreign consumers realistically specialised importers who are not modelled here will switch to Home for wine This will have two effects 1 The demand switch will tend to lower the relative price of cloth at Home and the relative price of wine in Foreign Clearly relative prices in the two countries will tend to converge and given free trade and negligible transport costs there will be just one uni ed international relative price Transport costs can be rather important for some internationally traded goods and of course shipping and other forms of international transport are important sectors in their own right However incorporation of transport costs into trade models creates much complexity without changing the basic results Because of this transport costs are conventionally assumed to be zero in trade models 2 These price developments will cause Home to specialise in wine production and Foreign in cloth production and exchange goods in order to consume a mix of the two It is the ability to separate production and consumption through trade that generates gains in the 19 2 The Ricardian model of international trade Wine A PPF International Relative Prices Opportunity Cost and Autarky Relative Prices Cloth Figure 22 Autarky and free trade equilibrium in Foreign Ricardian model Specialisation in Home and Foreign is depicted by production points B and B in Figures 21 and 22 respectively Home can export wine in exchange for cloth at world prices re ected by the shallower dotted relative price line in Figure 21 This Consumption Possibilities Frontier CPF re ects consumers budget line under free trade which is now higher than the PPF Similarly the higher relative price for cloth in Foreign resulting from free trade expands consumers consumption possibilities as re ected by the CPF Consumers in each economy maximise their utility given their consumption possibilities so consumption under free trade is at C and C respectively for the moment we assume that trade is balanced that is the value of exports will be equal to the value of imports The gains from trade In Ricardo s numerical example the gains from trade are established by showing that if specialisation is according to comparative advantage the total world production of both goods can be greater than under autarky Thus both countries can be made better off More generally it can be shown that free trade and hence specialisation according to comparative advantage will expand consumption possibilities in both countries This is shown in Figure 23 which is constructed by combining Figures 21 and 22 The dimensions of the box in Figure 23 show total world production of wine and cloth when both countries are specialised according to comparative advantage Under autarky consumption must be identical with production in both countries Hence Home consumption and production would occur at a point like A and Foreign production and consumption would be at a point like A When free trade is possible both will specialise and be able to trade at international prices the arrowed line in Figure 23 Thus a consumption point such as C is attainable The consumption point C is clearly superior to both A and A This is because at C Home consumers can consume more of both goods than at point A and Foreign consumers can consume more of both goods than at A The gains from trade are also re ected in Figures 21 and 22 directly as consumers are able to 20 22 Chapter content 4 Cloth A39 x Forelgn l I A PCPWF Wlne H me PCPW PC PWH International Relative Prices Figure 23 The gains from trade reach a higher indifference curve and thus welfare level than under free trade Relative Supply RS Relative Demand RD analysis The relative world price of cloth to wine in the free trade equilibrium was argued to lie in between the autarky relative prices of the two countries The next issue we need to address is exactly how relative world prices are determined To do so we need to use a piece of technical apparatus emphasised in KOM the world Relative Supply RS world Relative Demand RD analysis The RS curve is derived from the production possibility curves of the two countries and the condition that producers maximise pro ts The RS curve is stepshaped see KOM Figure 33 World Relative Supply and Demand because the technology assumes xed labour requirements The intersection of world RS and RD curves illustrates world trading equilibrium Two types of equilibria are possible 1 An equilibrium in which both countries specialise Equilibrium 1 in KOM Figure 33 2 An equilibrium in which one of the countries is incompletely specialised such as Equilibrium 2 in KOM Figure 33 Consider Figure 24 which illustrates RS and RD for the Ricardian model RD is quite straightforward to grasp as the relative price of cloth falls there is more demand for cloth relative to wine in the world The RS is a piecewise function and needs careful construction Consider the incentives for production for different relative prices of cloth to wine If PC Pw lt PCPWF then rms cannot cover the costs of cloth production so there will be no production of cloth in either country Hence the RS is vertical at 0 for all relative prices up to PCPWF If PcPw PCPWF only country F can produce cloth and can choose anywhere along its PPF giving a range of possible relative supplies of cloth to wine For relative prices in the range PCPWF lt PcPw lt PCPWH Foreign will produce only cloth while Home will produce only wine This gives the vertical segment of the RS stepfunction Finally for prices 21 2 The Ricardian model of international trade PC PW RS PCpWH PCPW PCPWF RD 0 RS RD ClothWine Figure 24 Determination of world relative prices using RD RS PcPw gt PC PWH there is no incentive for either country to produce any wine so the relative supply of cloth to wine tends to in nity at PCPWH Combining the steps in this reasoning yields the RS schedule in Figure 24 The free trade equilibrium relative prices are determined where RS and RD meet such as point E in Figure 24 Advantages of RS RD approach I It shows the simultaneous determination of prices specialisation and trade I One can use the diagram to do simple comparative statics for example analyse the effects of changes in input requirements productivity of changes in size of country of demand changes I The analysis can be extended to more than one country Consider how world relative prices might be different if the Foreign economy were very large in size large labour force relative to Home This could also re ect the case of an ef ciency gain in labour productivity whereby the same labour force becomes uniformly more productive The PPF of the Foreign economy is further out than that depicted in Figure 22 so there is more scope for the production of cloth and wine than before It follows that the stepfunction changes with a deeper step re ecting larger Foreign production if PcPw PCPWF This is illustrated in Figure 25 Country size and world relative prices where an overall gain in labour productivity in Foreign results in a change from free trade equilibrium E to equilibrium E The interesting result is that the free trade relative price coincides with the autarky relative price of Foreign Without a change in relative prices there is no CPF expansion in Foreign which implies Foreign does not gain from trade by its sheer scale Foreign s autarky prices prevail for the world once trade is liberalised between Home and Foreign with all the gains accruing to Home 22 22 Chapter content PCPW PCPWH RS39 PCPWFT PCPWF Ev PCFwy RD 0 RS RD ClothWine Figure 25 Country size and world relative prices Activity 22 Home has 1200 units of labour available It can produce wine w and cloth 6 the unit labour requirement of wine production is 4 while the labour requirement of cloth is 3 a Graph Home s production possibility frontier b What is the opportunity cost of wine in terms of cloth c Explain what the price of wine in terms of cloth would be in autarky that is in the absence of trade Now consider Foreign with a labour force of 900 Foreign s unit labour requirements are 5 for a unit of wine and 1 for a unit of cloth d Graph Foreign s production possibility frontier e Construct the world relative supply curve Now suppose that the world relative demand takes the following form DcDWW PcPwW where Dc and DW are the demand for cloth and wine respectively f Graph the relative demand curve along with the relative supply curve g What is the equilibrium relative price of wine h Describe the pattern of trade i Show that both Home and Foreign gain from trade Add a third country Moon with labour force 2000 and unit labour requirements of 4 for both wine and cloth 23 2 The Ricardian model of international trade 0 Graph the relative demand curve along with the relative supply curve for the three country case k What is the new equilibrium relative price of wine Relative wages The Ricardian model offers a clear insight into the way in which international relative wages are in uenced by relative productivity This can be seen most clearly in the case of complete specialisation Assume that Home specialises in wine and Foreign in cloth so that the price 2 cost conditions imply m xw an m x am where an and aFC are the labour input coef cients in Home for wine production and in Foreign for cloth production respectively wH and wF are wages at Home and in Foreign Taking the ratio of equation 21 to 22 and rearranging to solve for relative wages yields H F Pw wx m F H w aw PC Thus equation 23 shows that in equilibrium relative wages are linked to relative productivities through the ratio of input requirements and to product demand through the price ratio Other things being equal higher productivity at Home a lower unit labour requirement implies higher relative Home wages and a lower productivity implies lower wages Thus wages adjust to compensate for productivity in the Ricardian model This adjustment in wages ensures that the country will have a labour cost advantage in at least one sector Activity 23 1 Reading KOM Chapter 3 section Misconceptions about Comparative Advantage list three common arguments against free trade and provide reasons against these arguments 2 Reading KOM Chapter 3 section Comparative Advantage with Many Goods show how the two goods two country model described in this chapter can be extended to a multigoods model Verify the results given in KOM Table 32 and KOM Figure 35 223 Empirical evidence and application As with all economic models it is important to ask yourself the question does this model desribe reality well For the Ricardian model the answer is a heavily quali ed yes For instance MacDougall 1951 shows that postSecond World War Britain had lower productivity than the US in almost every sector Still Britain was exporting about as much as the United States As the trade could not have been the result of an absolute advantage on the side of Britain this is indicative of a comparative advantage of some sort Balassa 1963 provides further support to the concept of comparative advantage by looking at the trade of 24 23 Overview of chapter individual industries within the US and Britain KOM Figure 36 Productivity and Exports shows that sectoral exports from the US were positively related to the comparative advantage of that sector It is dif cult to directly test the Ricardian model because its predictions depend on properties of unobservable autarky equilibria or equivalently upon the relative supply curve that is also unobservable Attempts to test the model have accordingly examined the way in which productivity differences have in uenced trade shares in third country markets On the whole such indirect evidence is supportive of the model Of course we need to be careful when applying the Ricardian model or any other trade model Leamer and Levinsohn 1995 provide the following two pieces of sobering advice 1 Don t take trade theory too seriously 2 Don t take trade theory too casually The Ricardian model like all economic theory is not meant to be taken literally It is a simpli ed version of reality meant to elucidate certain key points not to describe it exhaustively As such you should not take it too seriously This also means that nding a piece of evidence against the Ricardian model is not necessarily useful it is much more useful to establish how important comparative advantage is rather than showing that it is not always exactly true However this does not mean that one should ignore the Ricardian model and trade theory in general To make sense of the data it is important to try and connect it to a good theoretical model The theory provides predictions on what patterns to look for in the data and how to interpret these patterns In particular Leamer and Levinsohn 1995 conclude based on the economic literature up to that point that the empirical evidence validates the predictions of the Ricardian model that 1 Except when labour inputs are equal across countries there exist gains from trade 2 A country exports the commodity in which it has a comparative labour cost advantage and imports the commodity in which it has a comparative disadvantage 23 Overview of chapter In this chapter we have discussed the theory of comparative advantage and in particular how the Ricardian model relates to this We have considered the advantages of this model and how it can be applied in terms of estimating comparative advantage from a country s trade data This model is important within international trade and is therefore signi cant for the chapters that follow 24 Reminder of learning outcomes Having completed this chapter and the Essential readings and activities you should be able to 25 2 The Ricardian model of international trade explain the concept of comparative advantage and distinguish it from the idea of absolute advantage explain how comparative advantage based on technological differences is the determinant of the pattern of trade and specialisation in the Ricardian model explain how the gains from trade arise in this model explain the relationship between relative international productivity and relative wages manipulate the RDRS diagram to illustrate different possible equilibria in the Ricardian model explain how comparative advantage might be interpreted in a real world situation 25 Test your knowledge and understanding 251 1 26 Sample examination questions Hardware H and Software S are perfect substitutes Consumers combine a unit of hardware with a unit of software to obtain a laptop so that consumers have a Leontief utility function of the form UH S minH S Hardware and Software are produced both in England and in Portugal using labour as the only production factor England is endowed with 800 units of labour while Portugal is endowed with 400 units of labour Labour productivity is described in the following matrix Hardware Software 110 130 140 120 England Portugal Namely one unit of labour in England produces one tenth of Hardware etc a Does either of the two countries have an absolute competitive advantage Does England have a comparative advantage In which sector What about Portugal b How many laptops are produced in England under autarky How many laptops are produced in Portugal under autarky How many units of labour are employed in the production of Hardware in the two countries What are the relative autarky prices c Suppose free trade is now allowed between England and Portugal Is either of the two countries fully specialising What is the number of Hardware and Software units produced in Portugal and in England What is the free trade equilibrium relative price Show how the relative supplyrelative demand RS RD curve diagram may be used to illustrate international equilibrium in the Ricardian model How would equilibrium change if the size of one of the countries doubled but labour productivity halved 252 a b C 25 Test your knowledge and understanding Guidance on answering Sample examination questions Neither country has an absolute competitive advantage but England has a comparative advantage in making Hardware and Portugal has a comparative advantage in making Software As consumers have a Leontief utility function the quantity of Hardware produced in each country will be equal to the quantity of Software For example in England it will take 40 hours of labour to produce one laptop 10 hours to produce a piece of hardware and 30 hours to produce a piece of Software I So Portugal will produce six laptops 400 40 20 667 round down to the nearest integer I England will use 200 hours of labour in the production of Hardware 1040 x 800 Portugal 26667 hours 2 40 60 X 400 I The relative price of Hardware is 1030 033 in England and 4020 2 in Portugal A good answer would conduct an analysis similar to that provided in KOM Figure 33 World Relative Supply and Demand From a we know that England will produce mainly Hardware and Portugal mainly Software In equilibrium the number of Hardware produced equals the number of Software produced a total of 35 units of each I Portugal will specialise completely in Software I Portugal will produce 20 units of Software and no Hardware England will produce 35 pieces of Hardware and 15 pieces of Software As Portugal specialises completely the relative price of Hardware is determined by the productivity in England the relative price of Hardware will be 033 see b 2 See KOM and the subject guide Figure 24 and surrounding text for details on the RS RD diagram 253 Feedback to selected activities Activity 22 a The Home production possibility frontier is given in Figure 26 it is a straight line that intercepts the Y axis at l 2004 300 and at the Xaxis at 1 200 3 400 b C d The opportunity cost of wine in terms of cloth is 43 133 For each wine produced 133 units of cloths could have been produced instead Labour mobility between the two sectors ensures that wages are equal in both sector and in ef cient markets the price of each good re ects the marginal price so the relative price of wine will be equal to the opportunity cost of wine at 133 units of cloth per unit of wine The Foreign production possibility frontier is given in Figure 27 it is a straight line that intercepts the Y axis at 9005 2 180 and at the Xaxis at 9001 2 900 27 2 The Ricardian model of international trade A E B 300 400 Cloth Figure 26 Home production possibility frontier A Q S B 1 00 900 Cloth Figure 27 Foreign production possibility frontier 28 Relative price of Wine P P 6 f g h i 0 UI W C 25 Test your knowledge and understanding RS1 RD 3 I I I I I I I 1 Relative quantity of wine Q QSV Q2 Q2 Figure 28 World relative supply and demand curve The World relative supply curve is constructed by determining the supply of wine relative to the supply of cloth at each relative price The lowest relative price at which wine is produced is 133 units of cloth per unit of wine The relative supply curve is at at this price The maximum number of wine supplied at the price of 133 is 300 supplied by Home At this price Foreign produces 900 units of cloth and no wine This implies that the relative supply of wine is 300900 2 13 This relative supply holds for any price between 133 and 3 the autarky price in Foreign At the price of 3 both countries would produce only wine and no cloth and the relative supply of wine goes to in nity Thus the relative supply curve is step shaped as seen in Figure 28 See Figure 28 The equilibrium price and supply can be found where the supply and demand intersect In this case the equilibrium price would be three units of cloth per unit of wine At the equilibrium Home produces only wine and exports some of it to Foreign while importing some of the cloth from Foreign In particular Home will export 150 units of wine and import 450 units of cloth Home now consumes 150 units of wine and 450 units of cloth a consumption bundle that lies well outside its autarky production possibility frontier Likewise the consumption bundle of Foreign 150 wine 450 cloth also lies outside its autarky possibility frontier Figure 29 compares the PPF before and after trade See Figure 210 for the diagram Note that the autarky price in Moon is 1 wine per cloth and Moon can produce either 500 wine or 500 cloth or a linear combination between the two So for a relative price less than 1 all three countries produce cloth 400 900 29 2 The Ricardian model of international trade Wine 300 150 i 400 480 900 Cloth Figure 29 Home PPF Autarky versus trade 30 k 25 Test your knowledge and understanding RS39 I I I I I RD I I I 39 i W 038 34 1 QwQW Figure 210 World relative supply and demand curve with three countries 500 so the relative supply of wine is 0 For relative prices between 1 and 133 Moon produces wine 500 and Home and Foreign produce cloth 400 900 for a relative supply of wine of 500 400 900 z 038 When the relative price is between 133 and 5 Moon and Home produce wine 500 400 and Foreign produces cloth 900 for a relative supply of 1 Once the price rises above 5 the relative supply of wine goes to in nity as all three countries supply wine but no cloth The new equilibrium is reached at a relative price of 43 133 and a relative supply of l 133 075 This implies that Moon fully specializes in wine producing 500 Foreign fully specializes in cloth producing 900 units and Home produces both wine and cloth 238 wine and 83 cloth to be precise In terms of trade this implies that Moon will export wine for cloth Foreign will export cloth for wine The trade patterns of Home are a bit more tricky as it produces both goods but as the relative demand in Home and in the rest of the world is 075 it also has an excess supply of wine and will like Moon trade wine for cloth 31 2 The Ricardian model of international trade 32 Chapter 3 The Heckscher Ohlin model 31 Introduction The Heckscher Ohlin HO model of international trade was originally developed by two Swedish economists Eli Heckscher and Bertil Ohlin in the early part of the twentieth century Like the Ricardian model it is a comparative advantage model of international trade where differences between countries are the basis for trade Unlike the Ricardian model where comparative advantage originates in differences in technology between countries technology is assumed to be the same across countries in the HO model with the emphasis instead placed on differences in factor endowments as the origin of comparative advantage The model is explicitly general equilibrium in character and this feature is emphasised through the linkages between factor prices and choice of inputs and factor prices and product prices Accordingly the model provides a particularly rich account of the mechanisms by which trade in uences the economy A notable insight of the model is that trade in goods can be regarded as a substitute for the international movement of factors that is trade in goods is indirectly trade in factors of production This is seen most clearly in the factor price equalisation Theorem 311 Aims of the chapter At the end of this chapter and having completed the Essential readings and activities you should be able to I describe the Hecksher Ohlin model its advantages and limitations and its applications to problems in international economics 312 Learning outcomes By the end of this chapter and having completed the Essential readings and activities you should be able to I explain the shape of the production possibility frontier with two factors of production I explain how differences in factor endowments can provide a basis for international trade I explain why trade can have profound effects on income distribution I explain the direction of income distribution effects namely that trade bene ts a country s abundant factor and worsens the real income of the scarce factor I explain the effect of changed factor endowments on sectoral outputs 33 3 The Heckscher Ohlin model I explain the limitations of the HeckscherOhlin HO model as an empirical hypothesis about the commodity composition of trade 313 Essential reading KOM Chapter 5 Resources and Trade The Heckser Ohlin Model There is an interactive webpage through Which you can practise building and manipulating the Lerner diagram httpwww personalumichedualandearglossaryfigsLernerldhtml 314 Further reading FT Chapter 4 Trade and Resources The Heckscher Ohlin Model SIT Chapter 60 httpinternationaleconcomTradeTch6 Tch6 php Freeman R Are your wages set in Beijing Journal of Economic Perspectives 93 1995 pp15 32 Jones RW and J P Neary The positive theory of international trade in Jones RW and RB Kenen eds Handbook of International Economics Vol 1 International trade Amsterdam ElseVier Science BV 1998 ISBN 9780444704221 Leontief W Domestic production and foreign trade the American capital position reexamined Proceedings of the American philosophical society 97 1953 pp331 349 Romalis J Factor proportions and the structure of commodity trade American economic review 94 2004 pp67 97 Tre er D The case of the missing trade and other mysteries American economic review 85 1995 pp1029 46 315 References cited No further references cited in the text 316 Synopsis of chapter content This chapter describes the Heckscher Ohlin model of trade 32 Chapter content 321 Assumptions A limitation of the Ricardian model is that it assumes a single factor of production usually taken to be labour or a dose of labour combined With other factors in xed proportions This is 34 32 Chapter content wr Food Manufactures KLi Figure 31 No factor intensity reversals rstly unrealistic and secondly it does not permit the analysis of the impact of trade and trade policy on income distribution In contrast the HO model is what is known as a 2 X 2 X 2 model That is it is characterised by the assumptions of two goods two factors of production and two countries Let us also assume that there are I two goods say food F and manufactures M I two factors of production labour L and capital K I two countries say Home H and Foreign F Further assume that technologies are identical across countries but different across sectors In particular let manufactures be the relative capital intensive sector and food the relative labour intensive sector That is for all possible relative factor prices the ratio of capital to labour employed in the production of manufactures exceeds the ratio of capital to labour employed in the food sector see Figure 31 While the sectors use factors of production with different intensities it is assumed in contrast to the Ricardian model that both countries have access to the same technology that is they have the same production functions in both sectors This is to concentrate attention on differences in resource endowments as the potential origin of comparative advantage Figure 31 illustrates the relationship between relative price of labour to capital w r where w is the wage rate and r is the rental price of capital and the capital labour ratio employed in each sector As labour becomes more expensive relative to capital Figure 31 shows the production process of both sectors becomes more capital intensive but the capital labour ratio in manufacturing is always higher than that in food production In other words we assume there are no factor intensity reversals The phenomenon in which relative factorintensities change at different factor prices is known as factorintensity reversal Although in theory there can be many factorintensity reversals it is debatable whether they are important empirically The often convenient assumption of no factorintensity reversal is sometimes known as the strong factor intensity condition 35 3 The Heckscher Ohlin model Here we impose both the strong factor intensity condition as well as assuming that perfect competition prevails in both goods and factor markets and that production functions satisfy constant returns to scale The assumption of constant returns to scale is crucial in deriving a number of results The two countries are assumed to differ in their endowments of factors In particular assume Home is relatively more capital abundant than Foreign Hence K LH gt K LF Finally consumers of the two countries are assumed to have identical preferences The assumptions of the HO model imply that countries are effectively identical in every respect except their endowment of factors of production It is the interaction of different factor abundances across countries and different factor intensities across sectors that gives rise to a pattern of comparative advantage and thus a basis for international trade 322 Tools and results for a closed economy The procedure for understanding the workings of the model is similar to that employed in the Ricardian model Firstly we describe the characteristics of an economy that does not trade and then we consider what happens when two such economies trade with each other From goods prices to input choices The key analytic concepts of the HO model concern the way in which resources that is labour and capital are allocated between the two sectors food and manufactures as well as the backward linkage to factor prices and the forward linkage to product prices The most important single tool of the HO model is the diagram expressing these linkages In KOM it is Figure 57 From Goods Prices to Input Choices A version of this diagram is reproduced as Figure 32 This gure is based on two assumptions of the model These are I cost minimisation I price equals average cost Thus in each sector producers are assumed to minimise costs This means that at each factor price ratio w r they choose the factor input ratios KiLi which minimises costs The assumption of constant returns to scale means that the costminimising input ratio is independent of the scale of production For further details see KOM Chapter 5 as well as KOM Appendix to Chapter 5 Factor Prices Goods Prices and Production Decisions To understand the mechanisms behind Figure 32 we examine the cost minimisation decision more carefully Figure 32 illustrates unitvalue isoquants for food and manufactures These are isoquants one for each sector along which the value of output revenue is equal to 1 That is PMQM 1 holds along the M isoquant which implies the quantity of manufactures associated with this isoquant is QM 1 PM the inverse of the price of manufactures Similarly PF Q F 1 holds along the F isoquant which implies the quantity of food associated with this isoquant is QF 2 1 PF the inverse of the price of food Notice the M isoquant is positioned towards the K axis as it is relatively capital intensive while F is positioned towards the L axis as it is relatively labour intensive Firms will choose the factor input ratios KiL01 and KiLap that minimises the cost of producing a given value of output The assumption of perfect competition implies there are zero pro ts in equilibrium so cost is equal to revenue in the production of each sector Hence 36 32 Chapter content 1 PM 1 PF L Figure 32 Unit value isoquants PMQM 1 wLM rKM implies zero pro t in the M sector and PFQF 1 wLF rKF implies zero pro t in the F sector Figure 33 depicts the Lerner diagram which illustrates cost minimisation in both sectors There is a unique isocost line wL rK 1 that is tangent to both isoquants This determines the unique equilibrium factor price ratio w r which re ects the slope of the isocost line at which both goods are produced with zero pro ts The prices of the two goods determine the position of the isoquants and cost minimisation pins down the equilibrium factor price ratio and factor input ratios in the two sectors The rays through the origin through points M and F in Figure 33 describe the equilibrium techniques of production for the two sectors The area enclosed by these two rays is called the cone of diversi cation If the endowment point of the economy lies within this cone then there is incomplete specialisation both goods are produced in positive amounts The Stolper Samuelson SS Theorem We can use the Lerner diagram to examine the implications of price changes on factor prices This gives a diagrammatic demonstration of the Stolper Samuelson SS Theorem one of the most important results of the HO model The Stolper Samuelson Theorem states that if both goods continue to be produced incomplete specialisation an increase in the relative price of a good will increase the real return of the factor used intensively in the production of that good and a decrease in the real return to the other factor of production To demonstrate the SS Theorem of the HO model consider the implications of an increase in the price of manufactures from PM to PM as illustrated in Figure 34 When the price of manufactures rises the quantity of output needed to generate one unit of revenue falls shifting in the M sector unitvalue isoquant inwards Cost minimisation implies a lower equilibrium factor price ratio that is w r falls lowering the relative cost of labour to capital so both food and manufactures are produced using a less capital intensive technique of production than before the prices change this corresponds with the shape of the curves in Figure 31 To nd the effect of the price change on w and r independently consider the intercepts of the isocost line on the L axis and K aXis respectively Recall that the equation for the isocost schedule is 37 3 The Heckscher Ohlin model L r KMLM Cone of Diversi cation wr 1 PF L Figure 33 Lerner diagram cost minimisation wL rK 1 Along the K axis L 0 so r l K The change in the intercept from y to x in Figure 34 therefore corresponds to a fall in K intercept and hence a rise in r Similarly examination of the intercept along the Laxis yields a fall in w Hence a rise in the price of manufactures has been shown to raise the nominal price of capital the factor used intensively in manufacturing and lowers the nominal price of labour the factor used intensively in the food sector To establish that the real wage falls and the real rental rate rises thereby completing the proof of the SS Theorem we need to consider prices Since the price of food is unchanged the real wage and real rental rate have obviously fallen and risen respectively in terms of food Additionally the price of manufactures has risen so the real wage in terms of manufactures has unambiguously fallen The con ict arises in the case of rental rates in terms of manufactures since r has risen but so has the price of manufactures To resolve this we appeal to the magni cation effect which is that the change in r is more than proportional to the change in PM This can be seen in Figure 34 since xyOy gt vzOz where the former re ects the proportional change in r and the latter the proportional change in PM Goods prices factor prices and factor intensity linkages We can combine the analysis of Figures 31 34 to construct Figure 35 which shows the way in which resources that is labour and capital are allocated between the two sectors food and manufactures as well as the backward linkage to factor prices and the forward linkage to product prices The factor intensity curves in the righthand half of Figure 35 re ect the choice of costminimising technique In both sectors as wages rise relative to rental rates producers substitute capital for labour that is KiLi rises but the capitallabour ratio of food is always lower than that of manufactures re ecting the fact that food is the relatively labourintensive sector In the lefthand half of Figure 35 the SS curve which shows the relationship between goods prices and factor prices re ects the Stolper Samuelson Theorem Here it is shown that the relative wageland rent ratio rises when the relative food price in terms of manufacturing rises The SS curve is drawn as a straight line in Figure 35 This need not be the case and in 38 32 Chapter content KMLM I I I 39 KM 39 I II I l I I I I I II I I l I I I I Figure 34 The Stolper Samuelson Theorem VYr S Food Manufactures Wr0 S PF PM 4 K PFPM0 KPL190 KMLM0 Figure 35 Goods prices factor prices and factor intensity linkages 39 3 The Heckscher Ohlin model general it will be nonlinear as in KOM Figures 56 Factor Prices and Goods Prices and 57 From Goods Prices to Input Choices As it stands Figure 35 says nothing about the direction of causality between its components The relationships illustrated are simply necessary consequences of the twin assumptions of cost minimisation and price equals average cost However if one of the elements is xed say the goods price ratio then the mechanism of the SS curve and the sectoral factorintensity curves determine the wagerental ratio and the choice of technique in the two sectors If instead we held xed the relative factor price ratio then the SS curve determines the relative goods price ratio consistent with the assumptions of the model The intuition for this follows from the fact that food is always more labourintensive than manufacture and hence as the cost of labour rises relative to the cost of capital the unit cost of the labourintensive good food must rise relative to the landintensive good food Activity 31 As an exercise in the use of Figure 31 assume that at low w r food is relatively labourintensive but that at high w r this is reversed and food is relatively capitalintensive Redraw Figure 31 to re ect this and consider the implications for Figure 35 In particular what does the SS curve look like What happens to the abovementioned linkage between goods prices and factor prices Factor endowments and production possibilities A second important tool of the HO model is the Edgeworth Box diagram or boxdiagram see for example Figure 36 The boxdiagram shows how a given endowment of resources labour and capital is allocated between sectors when the wagerental ratio and implicitly also the goodsprice ratio is given An interesting and famous result employing the boxdiagram concerns what happens to resource allocation and sectoral outputs when the factorendowment changes Figure 37 illustrates the case where the supply of land the factors of production are land and labour in this example instead of labour and capital is taken to increase If goods prices and hence factor prices also are taken to be xed then Figure 37 shows that an increase in the endowment of land will lead to an increase in the output of the landintensive good and a decrease in the output of the capital intensive good More generally it can be shown that if the endowment of a factor increases or decreases then at unchanged goods prices the output of good which uses that factor intensively will increase or decrease and the output of the other good will decrease or increase This result is known as the Rybczynski Theorem The Lerner diagram can be used to construct the Edgeworth box Consider Figure 38 where E denotes the endowment point of this country within the cone of diversi cation Employment of labour and capital in the two sectors must sum to the total endowment in the economy if there is to be full employment The factor input ratios determined by cost minimisation through points M and F facilitate the construction of the employment vectors in the two sectors by completing the parallelogram to E Vector 0A employment in the manufacturing sector plus vector AE employment in the food sector must equal OE that is must exhaust resource endowments in the economy The employment vectors from factor input ratios can be transferred to the Edgeworth box whose dimensions re ect the endowment of labour and capital in the economy as illustrated in Figure 39 The Edgeworth box can be used to demonstrate the Rybczynski Theorem Holding relative goods prices 40 Land used in cloth production Land used in cloth production Labour used in food production 32 Chapter content Lf 1 Tc39 F oc LC Labour used in cloth production Figure 36 The allocation of resources Labour used in food production sz Lfl 0f2 Of gr I a a 1 C a 1 1 To 24 Tf 5 Tcz Isza I I 3 8 I I 3 F2 I 8 0 1 c gt L02 LC Labour used in cloth production Figure 37 An increase in the supply of land uoponpoxd poo ur posn pueq 41 3 The Heckscher Ohlin model lPF L Figure 38 The Lerner diagram revisited L gt Figure 39 From Lerner diagram to Edgeworth box 32 Chapter content KPLP AV KMLM L AL Figure 310 The Rybczynski Theorem constant implies that relative factor prices and the factor input ratios are also xed from Figure 35 An increase in the endowment of say labour expands the width of the box as illustrated in Figure 310 With constant factor input ratios it is straightforward to nd the new allocation of labour and capital between the two sectors by extending employment vectors from the origin and the new endowment point E Comparing A with A shows that there is more employment of both factors in the food sector causing an expansion of the food sector and less employment of both factors in the manufacturing sector which causes the manufacturing sector to shrink This demonstrates the Rybczynski Theorem The boxdiagram can also be used to derive a country s production possibility curve It is then possible to see that if the endowment of a factor grows its production possibility curve will be shifted outward in a manner that is biased towards the good which uses the growing factor intensively This is of interest in its own right but can also be used to compare production possibilities of different countries with different factor endowments Thus a country which is overall relatively wellendowed with labour as compared with another country will possess a production possibility curve which is biased towards food the labourintensive good This is illustrated in Figure 311 below where two production possibility curves are depicted As Home is capitalabundant relative to Foreign its PPF is biased towards manufactures while the Foreign PPF is biased towards cloth Activity 32 Using Figure 311 show that at the same relative goods prices the labourabundant country will produce a larger quantity of food relative to manufactures Hence show that the labourabundant country s relative supply curve of food lies below the relative supply curve of the capitalabundant country Hint see the example in KOM with food and cloth and examine KOM Figures 58 Resources and Production Possibilities and 59 Trade Leads to a Convergence of Relative Prices 43 3 The Heckscher Ohlin model Food A Foreign PPF Home PPF L 0 Manufactures Figure 311 Biased production probabilities 323 Trade income distribution and factor price equalisation The pattern of trade The impact of trade in the HO model may be analysed by rst considering what prices would be in the two countries in the absence of trade that is pretrade or autarky prices For this we need to make some assumptions about demand conditions in the two countries Usually it is assumed that demand conditions are similar in the two countries but for easy exposition it is convenient to assume that they are identical This may be represented in the KOM framework as identical relative demand curves and the same pattern of indifference curves in the PPF diagram It is then easy to see from Figure 312 below that the autarky relative price of manufactures will be low in the capitalabundant Home country while the relative price of food will be low in the labourabundant Foreign country Accordingly the labourabundant country will nd it pro table to export food while the capitalabundant country will nd it advantageous to export manufactures Trade will tend to equalise goods prices in the two countries thereby raising the price of food in the labour abundant country and raising the relative price of manufactures in the capitalabundant country As a consequence in the trading equilibrium Home will be more specialised in manufactures than in autarky production moves from A to B with trade and similarly Foreign will be more specialised in food than in autarky production moves from A to B with trade These arguments can be summarised thus a country will tend to specialise and export those goods that intensively use the factor with which it is abundantly endowed This proposition is sometimes known as the Heckscher Ohlin Theorem and represents a core insight of the HO model namely that when technology is internationally identical it is differences in relative resource endowments that are the origin of differences in relative costs and hence of comparative advantage 44 32 Chapter content Food Food A A Home Foreign PMPFF L r 0 Manufactures 0 Manufactures Figure 312 Autarky and free trade equilibrium PM PF s PFPMH PFPm PFPMF Wr 0 wrF wrW wrH gt 4 Figure 313 Goods and factor price equalisation Income distribution and factor price equalisation Figure 313 below reproduces the SS curve from the lefthand segment of Figure 35 If Home and Foreign have access to the same technology then they will have the same SScurve but capitalabundant Home has a higher autarky relative wage and a higher relative price of food than Foreign Activity 33 Explain why identical technology for both goods in both countries implies that the SScurve is the same in both countries Free trade in goods will equalise goods prices in the two countries at say P F PMW which from Figure 313 we see must also equalise factor prices at wrW This is a remarkable result and is known as the Factor Price Equalisation Theorem It shows that trade in goods can act as a complete substitute for the international mobility of factors that trade in goods represents an 45 3 The Heckscher Ohlin model implicit trade in factors of production Activity 34 In the real world factor prices are clearly not internationally equalised What are the empirical and the theoretical reasons why factor price equalisation might fail Hint when considering theoretical reasons investigate what happens to the SS curve when the strong factorintensity condition fails to hold From Figure 313 you can also see that in the labourabundant country trade has the effect of raising the wagerental rate ratio and in the capitalabundant country trade has the effect of lowering the wagerental rate ratio This links back to the StolperSamuelson Theorem discussed earlier in the chapter 324 Empirical evidence The hypothesis of the Heckscher Ohlin Theorem that countries tend to export goods that use their abundant factors intensively has been one of the most tested hypotheses in the whole of economics In the most famous result Leontief 1953 found that US exports appeared to be more labourintensive than US imports This result appeared to contradict the intuition that the US was a capitalabundant country relative to the rest of the world a nding that quickly became known as the Leontief paradox Subsequently the Leontief tests and other variants have been widely repeated and a number of explanations have been put forward to explain the nding Studies that looked at an international sample found results broadly similar to Leontief 1953 Furthermore Tre er 1995 shows that the actual volume of trade between countries is considerably less than that predicted by the HO Theorem Thus relative factor endowments represent a weak or partial explanation of the observed commodity composition of international trade One key explanation in the literature for the Leontief paradox lies in the assumption by the HO Theorem that production technologies are the same across countries This is clearly not true empirically the US and western countries in general have much higher levels of production technology than developing economies This is re ected in the fact that the US exports are made with much more skilled labour than its imports All this does not mean that the HO Theorem is useless For instance the HO Theorem correctly predicts the pattern of trade between the industrialised and developing countries with developing countries trading their mainly labourintensive products against capitalintensive products from industrialised countries Activity 35 Consider KOM Figure 513 Changing Patterns of Comparative Advantage How can you explain the shift in US imports from Japan and the four miracles between 1960 and 1998 How does this shift t with the predictions made by the HO model 33 Overview of chapter In this chapter we have discussed the Heckscher Ohlin model including its limitations This model is important and signi cant for the chapters that follow 46 34 Reminder of learning outcomes 34 Reminder of learning outcomes Having completed this chapter and the Essential readings and activities you should be able to explain the shape of the production possibility frontier with two factors of production explain how differences in factor endowments can provide a basis for international trade explain why trade can have profound effects on income distribution explain the direction of income distribution effects namely that trade bene ts a country s abundant factor and worsens the real income of the scarce factor explain the effect of changed factor endowments on sectoral outputs explain the limitations of the Heckscher Ohlin HO model as an empirical hypothesis about the commodity composition of trade 35 Test your knowledge and understanding 351 1 Sample examination questions Consider a stande Hecksher Ohlin world with the following endowment of production factors Home Foreign Labour 45 20 Capital 15 10 There are two goods Computers which are capital intensive and T shirts which are labour intensive a Based on the table above explain what are the expected patterns of trade in this world Based on your answer above explain who in this example stands to gain from free trade and who stands to lose 1 Assume for a moment that the relative price of computers is xed at say PCPt and there is a sudden increase in the available Labour in Home Explain what will happen to the production possibility frontier and Home s production of Computers and T shirts 0 Suppose the world is made of two countries Home and Foreign Home is a small labourabundant country while Foreign is capitalabundant Both Home and Foreign produce two goods food and cloth Food production is labourintensive and cloth production is capitalintensive What is the effect of the introduction of an export subsidy in the Home country on the return to each factor of production in the Home country 47 3 The Heckscher Ohlin model 352 Guidance on answering Sample examination questions 1 48 Approaching the question a Note that Home is more labour abundant than Foreign Therefore we expect labour to export T shirts labour intensive to Foreign and import Computers from Foreign b In an HO world factor prices will equalise due to free trade Thus owners of the abundant factor gain from trade owners of the scarce factor lose In this case that means that Home workers and Foreign capitalists bene t from trade and Home Capitalists and Foreign workers will lose from trade c The PPI will shift outwards Home will shift production towards the factor that has increased leading to an increase in the production of T shirts and a decrease in the production of Computers See also KOM Figure 58 Resources and Production Possibilities and the discussion about biased expansion of production possibilities Let Good 1 be relatively labour intensive and Good 2 be relatively capital intensive The HeckscherOhlin Theorem states that a country will export the good that uses relatively intensively its relatively abundant factor of production Since H is assumed to be labour abundant it will export the labourintensive good Good 1 and import the relatively capitalintensive good Good 2 World prices are xed at P1 P2W Calling t the subsidy P lll and P the domestic prices of Good 1 and 2 in country H gives 19341 0103 31 P f P3 32 divide equation 32 by equation 31 to get d w P PW P 1 1 gt 1 33 P2 1 0P P2 Hence an import subsidy increases the relative domestic price of Good 1 The StolperSamuelson Theorem states that an increase in the price of a good will result in an increase in the price of the factor used intensively in its production in relative nominal and real terms and a decrease in the price of the other factor assuming both goods continue to be produced Furthermore the increase in the price of the factor used relatively intensively will be more than proportional to the original increase in the price of the good magni cation effect Thus an import subsidy which increases the domestic relative price of the exported labourintensive Good 1 will increase the relative nominal and real wage and will decrease the relative nominal and real rental rate Chapter 4 The specific factors model 41 Introduction In contrast to the Ricardian and Heckscher Ohlin HO models the speci c factors model assumes that some factors are not all fully mobile between sectors One factor of production say labour is assumed to be mobile while other factors of production are assumed Speci c to a sector because it is embodied in say a form of equipment such as a machine the speci c factors have no use in other sectors and are thus not mobile However in the longrun as the equipment is amortised the capital it embodies can be switched to other sectors Once speci c factors are considered analysis of the shortterm effects of trade and endowment changes is made possible The model also takes into account diminishing returns to a factor This then gives rise to the familiar production possibility setfrontier with the usual curved shape re ecting a diminishing marginal rate of transformation such as in the HO model and in contrast to the constant marginal rate of transformation assumed by the Ricardian model of Chapter 2 of the subject guide 411 Aims of the chapter At the end of this chapter and having completed the Essential readings and activities you should be able to I discuss the speci c factors model and how it relates to the Ricardian and the HO model 412 Learning outcomes By the end of this chapter and having completed the Essential readings and activities you should be able to I explain the mobile factor market diagram I use the mobile factor market diagram to illustrate the effects of trade on labour allocation outputs and on income distribution I use the mobile factor market diagram to illustrate the effects of simple trade policy instruments on labour allocation outputs and on income distribution l contrast the effects of trade liberalisation on factor incomes in the Heckscher Ohlin and speci c factors model I de ne and explain the distributional effects of international migration 49 4 The specific factors model 413 Essential reading KOM Chapter 4 Speci c Factors and Income Distribution 414 Further reading FT Chapter 3 Gains and Losses from Trade in the Speci cFactors Model SIF Chapter 7020 to 7030 httpinternationaleconcomTradeTch7 Tch7 php Borjas G The economics of immigration Journal of Economic Literature Vol 324 December 1994 pp1667 1717 Burtless G International trade and the rise in earnings inequality Journal of Economic Literature 32 1995 pp800 16 Neary P ShortRun Capital Speci city and the Pure Theory of International Trade Economic Journal 88351 1978 pp488 5 10 415 References cited No further references cited in the text 416 Synopsis of chapter content This chapter discusses the speci c factors model to trade 42 Chapter content 421 Assumptions The model assumes two goods and three factors of production One factor of production is assumed to be fully mobile between the two goods sectors The other two factors are each regarded as speci c to each of the two goods sectors and can only be employed in that sector There are xed endowments of each factor One can interpret the model in several ways The most common interpretation is that the mobile factor is homogeneous labour and the speci c factors are capital and land or two different types of capital two different machines each speci c to a sector Suppose the labour market is assumed to be competitive and hence wages in the two sectors are equalised Thus if the two goods are food and manufacturing then capital might be the factor speci c to manufacturing and land might be the factor speci c to food By de nition a speci c factor is immobile between sectors Thus in the example above capital cannot be employed in the food sector and land cannot be employed in the manufacturing sector An alternative interpretation is to assume capital K is the mobile factor of production used in both sectors and the two speci c factors are skilled labour LU and unskilled labour LS 50 42 Chapter content Suppose the two sectors are textiles T and software S Textiles are manufactured using capital and unskilled labour and software is developed using capital and skilled labour With a competitive capital market the rental rate equalises between the two sectors Skilled workers receive the skilled wage wS while unskilled workers receive the unskilled wage wU For the rest of the chapter we will consider this case It is of particular interest as it can shed light on how international trade can affect the wage gap between skilled and unskilled workers in the shortrun In the longrun workers can train to become skilled workers so they can become mobile between sectors as is assumed in the HO model Contrasting the results of the speci c factors model and the HO model sheds light on the short and longrun effects of trade on factor prices and can inform the debate on the phenomenon of rising wage inequality experienced in the US and other countries 422 Tools and results Under the assumptions of the model production in each sector can be represented as depending on the amount of the variable mobile factor capital Given a xed amount of the speci c factor this implies diminishing returns to capital As already noted this implies a standard textbook concave production possibility curve However the most important theoretical construct or tool of the speci c factors model is the mobile factor market diagram which shows how capital is allocated between sectors for given technology and international prices note that when labour is assumed to be the mobile factor the diagram re ects labour market equilibrium and shows wage equalisation This is given in Figure 41 below The two curves in the diagram represent the marginal revenue product of capital in the textile sector PT gtlt MPKT and in the software sector PS X MPKS These curves also represent the demand curves for capital in each sector The total xed supply of capital in the economy is represented by the length of the horizontal axis in Figure 41 Capital market equilibrium occurs when the rental rate r equates supply and demand for capital and this is represented by the point of intersection of the two marginal revenue product curves The equilibrium rental rate is r the amount of capital allocated to the textile sector is KT and the amount of capital allocated to software is K 5 423 Effects of trade Figure 41 can be thought of as representing in the rst instance a closed economy or autarky equilibrium Suppose trade is now possible Trade will take place provided world prices are different from autarky prices and the country will export the good which is expensive abroad cheap at home and import the other good expensive at home but cheap abroad In a trading equilibrium world prices replace autarky prices in other words the relative price of the export good will tend to rise and the relative price of the import good will tend to fall as compared with the autarky equilibrium Figure 42 analyses the effects of a rise in the price of software This exercise can be interpreted as analysing the effects of a rise in the relative price of software with the price of textiles held constant numeraire or unit of account If software happens to be the export good then this exercise can also be interpreted as analysing the effects of trade where the opening up of trade leads to a rise in the price of the export good relative to the price of the import good This could re ect the US for example trading with China With relatively more skilled to unskilled workers the US has a comparative advantage in software development 51 4 The specific factors model KdT PTMPKT de PsMPKs 0S 0T V A Ks KT Figure 41 Capital market equilibrium mobile factor relative to China whose relatively large number of unskilled workers gives a comparative advantage in textile production When the two open to trade the US exports software and imports textiles from China Figure 42 shows that a rise in the price of software increases the marginal revenue product of capital in the software sector and thus shifts the demand for capital in the software sector rightwards Equilibrium in the capital market moves from A to B This leads to a reallocation of capital from textiles to software and with xed amounts of speci c factors implies an increase in the output of software and a decrease in the output of textiles The increase in the supply of the mobile factor in one sector raises the marginal product of the speci c factor in that sector here the increase in capital in the software sector makes skilled workers better off the decrease in capital in the textiles sector makes unskilled workers worse off The nominal rental rate increases as a result of a higher price of software but what about the real rental rate of capital As the price of textiles is constant the real rental rate rises with respect to textile price rPT In contrast the real rental rate falls with respect to the price of software rPS which itself has risen This can be seen in Figure 42 where the proportional change in the price of software re ected by yBzB is less than the proportional change in the rental rate re ected by xBzB The effect on the real rental rate on capital is thus ambiguous because the real rental rate falls in terms of the export good but rises in terms of the import good Hence the effect on real rental rates depends on the consumption pattern of capitalists Rising wage inequality Figure 42 shows that if a country trades and exports the good in which skilled labour is the speci c factor then the return to skilled labour rises and unskilled labour falls in the shortrun the long run effects are re ected by the Stolper Samuelson Theorem of the HO as described in Chapter 3 of the subject guide The implication is that trade expands the wage gap between skilled and unskilled labour This is of interest because it offers a possible explanation for the 52 42 Chapter content de 39 PS39MPKS de PSMPKS OS gt CT Figure 42 The effects of trade widening income gap between skilled and unskilled workers experienced by the United States during the 1980s However empirical evidence points to skillbiased technological change as the primary factor behind the increase in US wage inequality over the past thirty years and trade as a secondary rather than a primary factor Activity 41 1 In Figure 42 the opening up of trade has been depicted in terms of a rise in the price of software the export good while keeping the price of textiles constant numeraire Since free trade will raise the relative price of the export good to the import good we could instead keep the price of software xed and lower the price of textiles the import good Use the capital market clearing diagram to show that a fall in the price of textiles has the same effects on capital allocation outputs and income distribution as a rise in the price of software 2 Compare and contrast the income distribution effects of trade in the speci c factors and H0 models 424 The pattern of trade The speci c factors model does not offer any very sharp predictions about the pattern of trade However loosely speaking comparative advantage depends on either relative endowments of factors or on differences in technology Thus the speci c factors model can be interpreted as a hybrid of the Ricardian model differences in technology and the HeckscherOhlin model differences in factor endowments Since explaining the pattern of trade is not the major aim of the speci c factors model it has not attracted empirical testing 53 4 The specific factors model Activity 42 1 Undertake a variety of exercises involving manipulation of Figure 41 in response to different parameter changes In particular a the effects of changes in factor endowments on capital allocation on outputs and on income distribution b the effects of an import tariff on capital allocation outputs and income distribution 0 the effects of an export tax on capital allocation outputs and income distribution 1 a comparison of the effects of an import tariff and an export tax 2 Identify two realworld examples where you believe the speci c factors model provides insights 43 Overview of chapter This chapter has discussed the speci c factors trade model and how it relates to the Ricardian and H0 model 44 Reminder of learning outcomes Having completed this chapter and the Essential readings and activities you should be able to I explain the mobile factor market diagram I use the mobile factor market diagram to illustrate the effects of trade on labour allocation outputs and on income distribution I use the mobile factor market diagram to illustrate the effects of simple trade policy instruments on labour allocation outputs and on income distribution l contrast the effects of trade liberalisation on factor incomes in the HeckscherOhlin and speci c factors model I de ne and explain the distributional effects of international migration 45 Test your knowledge and understanding 451 Sample examination questions 1 Consider the case of Thailand a small open economy that faces constant goods prices Assume that there are two sectors manufacturing and farming There are three productive factors Labour is employed in both sectors and is freely mobile between 54 45 Test your knowledge and understanding W W m f VPMLlf Wage in the manufacturing sector Wage in the farming sector Figure 43 The effect of a ood them Capital is used only in manufacturing and land only in farming After the recent oods a relevant part of arable land has been destroyed discuss the effect on wages and the incomes of capital and land owners 2 Compare and contrast the Ricardian and speci c factors models 452 Guidance on answering Sample examination questions 1 In a small open economy factor prices and labour allocation are determined as follows I In each sector 139 E m f labour is demanded up to the point where the value marginal product of labour equals the wage rate plan K E iMPLi E p 0L I Labour is mobile so the wage must be the same in both sectors pMPLm w prLPf I Labour is fully employed Lm Lf L Graphically the equilibrium is at point E in Figure 43 below where for each sector I the area under the VM PL schedule is the value of total output I the return to the speci c factor is the value of total output minus the wage bill Because of the oods the land endowment of the economy decreases The fall in T decreases the marginal product of labour in the farming sector The new equilibrium wage is lower and labour moves to the manufacturing sector Under the small open economy assumption the price of both sectors remains constant Given that labour moves 55 4 The specific factors model 56 to manufacturing the marginal product of capital increases hence r rises thus the income of capital owners erzpmePKme increases As labour in farming decreases the value marginal product of land 12 goes down but the reduction in land has a positive effect on V so that the overall effect on the value marginal product of land is ambiguous However under reasonable assumptions given that T diminishes the overall effect on the income of landowners v x T is negative Comparing different models is the sort of question that Examiners often ask Models may be compared in terms of any or all of the following I assumptions I purposes I results A list of assumptions is usually not interesting but here we have a question where it is relevant at least insofar as the assumptions of the two models are different So you should spell out the differences The purposes of the two models are different The Ricardian model focuses on determinants of the pattern of trade while the speci c factors model focuses on how trade affects income distribution Differences in assumptions and purposes lead to differences in the kind of results which the models generate and these should be outlined Finally note that you could also be asked for instance to compare the model with the Heckscher Ohlin model covered in Chapter 3 of the subject guide INTERNATIONAL ECONOMICS STUDY MATERIAL VI SEM ESTER BA ECONOMICS CORE COURSE 2011 ADMISSION UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION THENJIPALAM CALICUT UNIVERSITY PO MALAPPURAM KERALA 693 635 i231 School of Distance Education UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION STUDY IVIATERIAL VI Semester BA ECONOMICS CORE COURSE INTERNATIONAL ECONOMICS Prepared by Modules Anil Varma R 3 amp 5 Asst Professor Department of Economics Zamorin39s Guruvayurappan College Calicut Kerala Anooja Chacko 1 2 amp 4 Asst Professor Department of Economics Zamorin39s Guruvayurappan College Calicut Kerala Edited and Scrutinised by Dr C Krishnan Associate Professor PG Department Of Economics Government College Kodanchery Kozhikode 673 580 e mailckcalicut edy fmail com Type settings amp Lay out Computer Section SDE Reserved International Economics Page 2 School of Distance Education Semester VI International Economics EC6 B13 a Introduction International economics deals with the economic relations among nations both trade and financial A good understanding of international economics is necessary of student of Economics and those who wish to work in these areas or governmental organizations b Objectives The basic aim of this introductory course on international economics is to present before the students the questions and answers related to international economic relations c Learning Outcome The students are expected to acquire skill that will help them to take rational decisions in Issues related international economics d Syllabus Module 1 Introduction to International Economics Importance of International Trade Internal Trade and International Trade Module 2 Theories of International Trade Classical Theory Absolute and Comparative cost Advantage theories Hecksher Ohlin Theory and Leontief Paradox Module 3 Theory of Commercial Policy Arguments for and against Free Trade Arguments for and Against Protection Methods of Trade Restriction Tariff NonTariff trade barriers Dumping export subsidy and Countervailing duties Concept only Economic Integration EU NAFTA ASEAN SAARC WTO Module 4 Foreign Exchange Defining foreign exchange and exchange rate Components of foreign exchange reserve Different systems of exchange rate determination gold standard Mint Parity PPP Floating exchange rateFixed and Flexible Exchange rate Concepts only Devaluation revaluation depreciation and appreciation Module 5 Balance of Payments Defining Balance of Trade and Balance of Payment Equilibrium and disequilibrium in BOP Measures to correct BOP disequilibrium BOP in India Reference 1 Salvatore Dominick International Economics Weily India New Delhi 2 CR Kindle Berger International Economics 3 Bo Soderstein and Geoffrey Reed International Economics Macmilon 4 Francis Cherumilam International Economics 5 Mannur HG International Economics 6 Errol D Souza Macro Economics Pearson Education 2008 For BOP in India 7 RBI bulletin various issues International Economics Page 3 School of Distance Education International Economics Page 4 School of Distance Education MODULE I INTRODUCTION TO INTERNATIONAL ECONOMICS International Economics is a specialized branch of Economics focusing on the external trading relations of nations Generally external trade involves the exchange of goods and services among nations crossing the national territories Trade not only strengthens the economic interdependence among nations but promotes consumer welfare also by providing a variety of commodities Since it involves several countries a different set of rules and regulations are necessary for the smooth functioning of the system This is why international economics is treated as a separate branch of study Broadly the subject matter in International Economics can be categorized into five broad groups 1 International Trade Theory It concentrates on the theoretical aspects of trade like reasons of trade gains of trade etc Different schools of theories are discussed in this section 2 International Trade Policy This area deals with the international rules and regulations regarding the ow of transactions It includes various trade restrictions like tariffs quotas changes in exchange rates etc The regulatory mechanisms and various international institutions for monitoring it are also come under this section 3 Balance of Payment With the progress of trade nations have to make and receive payments All these economic transactions of a nation with the rest of the world are systematically recorded in this account The uctuations in BOP and the associated policy regulations are also included in this section 4 Balance of Payment Adjustments or Open Economy Macroeconomics With the progress of transactions sometimes either the credit or the debit may outweigh the other side It will lead to imbalances in BOP This situation is normally coined BOP disequilibrium which demands correction either automatically or externally imposed by the governments The external repercussions are also brought into the study 5 International Organizations International trade is a complex activity involving multiple countries and currencies Commodities and capital ow across countries Hence it requires separate rules and regulations It should be monitored by international level organizations also All these aspects are monitored under the head global economic organizations International Economics Page 5 School of Distance Education TRADE AND DEVELOPMENT International trade is closely linked to development Most fast growing economies also have a dynamic trade sector When a firm or an individual buys a good or a service produced more cheaply abroad living standards in both countries increase There are other reasons consumers and firms buy abroad that also make them better off the product may better fit their needs than similar domestic offerings or it may not be available domestically In any case the foreign producer also benefits by making more sales than it could selling solely in its own market and by earning foreign exchange currency that can be used by itself or others in the country to purchase foreignmade productsThe gainsimportance of trade is generally re ected in the following manner Acquisition of Capital Goods Industries The underdeveloped countries UDCs are enabled by foreign trade to obtain in exchange for their goods capital equipment and heavy engineering machines to foster their countries economic development For example India exports spices cotton and cotton textiles marine products germs and jewellery and in exchange we import heavy machienery defence equipments and other capital equipment from the developed countries Market Extension The foreign trade can extend the scope of the business to the international market The domestic market is limited the foreign trade sector opens new vistas new marketing channels and new markets When the markets are extended the economies of scale are reaped the efficiency and productivity will increase Accordingly the forces of development will set themselves in motion Foreign Investment The foreign trade is also helpful in attracting foreign investment The foreign investors are attracted towards active trading countries and invest in the form of capital goods and technical expertise In this way the assembling plants the manufacturing plants and the latest technology will come into the country Foreign Direct Investments and off shoring will stimulate the economic climate of a nation National Income When there is imports and exports of goods and services the government can earn the revenue in form of tariffs custom duty import licence fees etc Employment Opportunities Moreover the external sector also opens the employment opportunities for the countrymen in the foreign countries Hundreds of thousands of Indians are working abroad India is earning billions of dollars through foreign exchange remittances and stands in the second position just behind China Therefore such remittances are proved to be a major source of foreign exchange earnings International Economics Page 6 School of Distance Education MODULE 2 THEORIES OF INTERNATIONAL TRADE INTRODUCTION International trade theories postulate different aspects of trading practices like basis for trade reasons for trade terms of trade exchange ratio between products and the gains from trade It also helps to predict the size content and direction of trade ows Depending on the differences of arguments various economists put forward different models of trade pattern The three phases of the trade theories are pre classical classical and modern schools Mercantilism represents the pre classical version Adam Smith David Ricardo and John Stuart Mill are associated with the classical theory The modern version is linked with two Swedish economists Eli Heckscher and Bertil Ohlin MERCANTILISM The trade theory that states that nations should accumulate financial wealth usually in the form of gold by encouraging exports and discouraging imports is called mercantilism Rather than a full edged trade theory it was actually an economic policy of wealth accumulation According to this theory other measures of countries39 well being such as living standards or human development are irrelevant They simply focused on the accumulation of gold Mainly Great Britain France the Netherlands Portugal and Spain used mercantilism during the 1500s to the late 1700s Mercantilism proposed that a country should try to export more than its imports in order to receive gold For this they advocated strict controls on trade in the form of tariffs and quotas Mercantilist countries practiced the zerosum game which meant that world wealth was limited and that countries could increase their share only at the expense of other countries This protectionist policy decelerated the long term growth Features gt Restrictive trade aiming at the acceleration of exports and reduction of imports gt Strict focus on the wealth accumulation than welfare promotion gt No simultaneous gains or sharing of gains among countries are possible One country can benefit only at the cost of other countries gt Adoption of trade protectionism Owing to these unrealistic practices it faded in the following era Later by the publication of Wealth of Nations by Adam Smith this doctrine completely lost its relevance But in recent times it is slowly emerging with slight variations Neo mercantilism is the modern version of mercantilist practices through the formation of local trading blocks and promotion of trade with imposition of tariffs and quotas International Economics Page 7 School of Distance Education LABOUR THEORY OF VALUE It is the foundation stone of classical trade theories It states that the value of a commodity is solely depended on the amount of labour hours utilized for its production It assumes that there are no other factor inputs are used for production Commodities are exchanged also on this basis of labour content For example if a jeans is made out of 8 hours of labour and a toy of 4 hours then 2 toys are required to exchange for one jeans Nowadays it seems to be meaningless but at that time technology was less developed and barter system was prevalent THEORY OFABSOLUTE ADVANTAGE ADAM SMITH The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776 through his legendary book An Enquiry into the Nature and Causes of Wealth of Nations He developed the theory as an attack against the then prevailing mercantilist view of restrictive trade with the slogan free trade Smith39s argument was that the wealth of nations depends upon the goods and services available to their citizens rather than the gold reserves held by the nation Maximizing this availability depends primarily on fuller utilization of resources and then on the ability 0 to obtain goods and services from where they are produced most cheaply because of natural or acquired advantages and o to pay for them by production of the goods and services produced most cheaply in the country Human skill up gradation division of labour and specialization and the economies of scale are the sources of acquired advantage for cheaper production Natural advantages may emerge out of natural factors As the name indicates this theory proposes that a country should engage in the production and exchange of those commodities where it has an absolute advantage Such a country produces greater output of a good or service than other countries using the same amount of resources Absolute advantage is defined as the ability to produce more of a good or service than competitors using the same amount of resources Smith stated that tariffs and quotas should not restrict international trade it should be allowed to ow according to market forces Contrary to mercantilism Smith argued that a country should concentrate on production of goods in which it holds an absolute advantage No country would then need to produce all the goods it consumed The theory of absolute advantage destroys the mercantilist idea that international trade is a zero sum game According to the absolute advantage theory international trade is a positivesum game because there are gains for both countries to an exchange International Economics Page 8 School of Distance Education Assumptions There are two countries and two commodities One country has absolute advantage in one commodity and the second country has advantage in another commodity Technology is assumed to be constant Labour is the only factor of production labour is homogeneous that means each unit of labour produces same level of output value of a commodity is measured in terms of its labour content There is no technological improvement Labour is perfectly mobile within the country but perfectly immobile between the countries It means that workers are free to move between industries within the nation but gt gt VVVVVV migration to other countries is impossible gt A system of barter prevails gt Zero transportation cost Based on these assumptions the theory can be explained with an example Suppose there are two countries India and Cuba producing tea and sugar By employing a worker for one hour India can produce either lOkilograms of tea or 5 kilograms of sugar Similarly if a Cuban worker is employed she is capable of producing 10 kilograms of sugar or 5 kilograms of tea Table 1 Output per hour kg Country Sugar Tea India 5 10 Cuba 10 5 From the table it is clear that by spending an hour s labour India is capable of producing twofold of tea than Cuba similarly in the case of sugar Cuba is able to generate double the production in India In short Cuba has absolute advantage in sugar and India in tea In this situation by concentrating on the respective absolute advantageous areas both nations can benefit by fully channelizing their resources to absolutely advantageous commodity Since there is perfect factor mobility within a country India can channelize labourers into tea sector and Cuba into sugar industry If India transfer one labour from sugar to tea sector sugar production may fall by 5 kilograms but can produce 10 more kilograms of tea By exchanging this one unit effort India is capable of purchasing 10 kilograms of sugar from Cuba So it is beneficial for India If India goes for domestic exchange due to the increased cost it will not benefit India The same is true for Cuba in the case of sugar There is a potential problem with absolute advantage If there is one country that does not have an absolute advantage in the production of any product will there still be benefit to trade and will trade even occur The answer may be found in the extension of absolute advantage the theory of comparative advantage International Economics Page 9 School of Distance Education COMPARATIVE ADVANTAGE DAVID RICARDO The most basic concept in the whole of international trade theory is the principle of comparative advantage first introduced by David Ricardo in 1817 It remains a major in uence on much international trade policy and is therefore important in understanding the modern global economy Comparative advantage is the ability of a firm or individual to produce goods andor services at a lower opportunity cost than other firms or individuals A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins David Ricardo stated in his theory of comparative advantage that a country should specialize in producing and exporting products in which it has a comparative advantage and it should import goods in which it has a comparative disadvantage Out of such specialization it will accrue greater benefit for all Assumptions gt There are two countries and two commodities gt One country has absolute advantage in both commodities and the second country has in another commodity Technology is assumed to be constant Labour is the only factor of production labour is homogeneous that means each unit of labour produces same level of output Technology is assumed to be constant value of a commodity is measured in terms of its labour content There is no technological improvement VVVVVVV Labour is perfectly mobile within the country but perfectly immobile between the countries It means that workers are free to move between industries within the nation but migration to other countries is impossible gt A system of barter prevails gt Zero transportation cost Example Table 2 Output per hour kg Country Wheat Tea India 10 10 Burma 4 5 In this example Indian labourers are capable of producing both wheat and tea in absolute advantage Burma is disadvantageous in both cases But still there is a possibility for trade Burma has fewer disadvantages in tea than wheat So it is its comparative advantage If India concentrates in wheat it is capable of producing more than two fold wheat but in tea it can produce only two fold than Burma Although India has an absolute advantage in the production of both tea and wheat India has a comparative advantage only in the production of wheat This is because its advantage in wheat is comparatively greater than its advantage in tea In this situation India can concentrate on wheat and Burma on tea and both can benefit from trade International Economics Page 10 School of Distance Education In this theory there are several assumptions that limit the realworld application The assumption that countries are driven only by the maximization of production and consumption and not by issues out of concern for workers or consumers is a mistake RECIPROCAL DEMAND THEORY J S MILL Comparative advantage explains the pattern of trade It also furnishes a strong argument for trade gains and tells much about readjustment of production and the basic laws that determine the real rate of exchanges between the exportable and importable goods But to explain the actual pattern of production or the exact terms at which one country s products exchange for those of another we also need detailed knowledge of demand and supply This was firstly verbalized by John Stuart Mill through the reciprocal demand theory and then put into graphic form by Alfred Marshall and FY Edgeworth using the offer curves Mill firstly revealed the mechanism of how to determine the rate of exchange in international market and how to distribute the total gains from trade between the two traders by detailing specific relationship between them That is the two participants of trade in Ricardian model must establish a specific relationship with each other this is the reciprocal demand relationship It is this reciprocal demand that actually determines the prevailing terms of trade and how much gains obtained by a particular country The reciprocal demand can be defined as the demand for imports in terms of the export of the country In other words John Stuart Mill had resolved the problem of how to exactly reach the rate of exchange in international market Comparative advantage and law of reciprocal demand by John Stuart Mill constitute the two basic building blocks of the classical theory of international trade Mill argued acquisition of imports from abroad is the purpose of trade while exports are just means of payment for imports In order to import some useful commodities from abroad exports of a country should have a real demand in the other countries So a country should produce both for itself and for consumers in the other countries Otherwise its exports could not be sold in international market and consequently the country could not import any commodities at all Reciprocal demand and terms of trade The value then in any country of a foreign commodity depend upon the quantity of home produce which must be given to the foreign country in exchange for it In other words the values of foreign commodities depend upon the terms of international exchange It is not their cost of production rather the law of supply and demand that determines the terms of international exchanges International Economics Page 1 1 School of Distance Education HECKSCHER OHLIN THEORY In the early 20th century Swedish economists Eli Heckscher and Bertil Ohlin identified the role of labor and capital socalled factor endowments as a determinant of advantage In 1979 Ohlin was awarded Nobel Prize jointly with James Meade for his work in international trade theory The HeckscherOhlin proposition maintains that countries tend to export goods whose production uses intensively the factor of production that is relatively abundant in the country Countries well endowed with capital such as factories and machinery should export capital intensive products while those well endowed with labor should export laborintensive products According to Bertil Ohlin trade arises due to the differences in the relative prices of different goods in different countries The difference in commodity price is due to the difference in factor prices ie costs Factor prices differ because endowments ie capital and labour differ in countries Hence trade occurs because different countries have different factor endowments The Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive goods and countries which are rich in capital will export capital intensive goodsHeckscherOhlin39s theory explains the modern approach to international trade on the basis of following assumptions There are two countries involved Each country has two factors labour and capital Each country produce two commodities or goods labour intensive and capital intensive There is perfect competition in both commodity and factor markets U PP Ni All production functions are homogeneous of the first degree ie production function is subject to constant returns to scale Factors are freely mobile within a country but immobile between countries Two countries differ in factor supply Each commodity differs in factor intensity 99 89 The production function remains the same in different countries for the same commodity For e g If commodity A requires more capital in one country then same is the case in other country 10 There is full employment of resources in both countries and demand are identical in both countries 11 Trade is free ie there are no trade restrictions in the form of tariffs or nontariff barriers 12 There are no transportation costs Given these assumption Ohlin39s thesis contends that a country export goods which use relatively a greater proportion of its abundant and cheap factor While same country imports goods whose production requires the intensive use of the nation39s relatively scarce and expensive factor International Economics Page 12 School of Distance Education Understanding The Concept of Factor Abundance In the two countries two commodities amp two factor model implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity But the concept of country being rich in one factor or other is not very clear Economists quite often define factor abundance in terms of factor prices Ohlin himself has followed this approach Alternatively factor abundance can be defined in physical terms In this case physical amounts of capital and Labour are to be compared Price Criterion for de ning Factor Abundance A country where capital is relatively cheaper and labour is relatively costly is said to be capital rich country Whereas a country where labour is relatively cheaper and capital is relatively costly is said to be labour rich country Explaining Heckscher Ohlin39s HO Theory Let us take an example of same two countries viz England and India where England is a capital rich country while India is a labour abundant nation In the above diagram XX is the isoquant equal product curve for the commodity X produced in England YY is the isoquant representing commodity Y produced in India It is very clear that XX is relatively capital intensive while YY is relatively labour incentive The factor capital is represented on Yaxis while the factor labour is represented on the horizontal Xaxis PA is the price line or budget line of the country England The price line PA is tangent to XX at E The price line PA is also tangent to YY isoquant at K The point K will help us to find out how much of capital and labour is required to produce one unit of Y in England P1B is the price line of the country India The price line P1B is tangent to YY at I The price line RS which is drawn parallel to P1B is tangent to XX at M This will help us to find out how much of capital and labour is required to produce one unit of commodity X in India Under the given situations the country England will choose the combination E Which means more specialisation on capital goods It will not choose the combination K because it is more labour intensive and less capital intensive Thus according to Ohlin England will specialise on production of goods X by using the cheap factor capital extensively while India specialises on commodity Y by using the cheap factor labour available in the country International Economics Page 13 School of Distance Education The Ohlin39s theory concludes that l The basis of internal trade is the difference in commodity prices in the two countries 2 Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries 3 A capital rich country specialises in capital intensive goods amp exports them While a Labour abundant country specialises in labour intensive goods amp exports them Limitations of Heckscher Ohlin39s HO Theory Heckscher Ohlin39s Theory has been criticised on basis of following grounds 1 Unrealistic Assumptions Besides the usual assumptions of two countries two commodities no transport cost etc Ohlin39s theory also assumes no qualitative difference in factors of production identical production function constant return to scale etc All these assumptions makes the theory unrealistic one 2 Restrictive Ohlin39s theory is not free from constrains His theory includes only two commodities two countries and two factors Thus it is a restrictive one 3 OneSided Theory According to Ohlin39s theory supply plays a significant role than demand in determining factor prices But if demand forces are more significant a capital abundant country will export labour intensive good as the price of capital will be high due to high demand for capital 4 Static in Nature Like Ricardian Theory the H0 Model is also static in nature The theory is based on a given state of economy and with a given production function and does not accept any change 5 Wijnholds39s Criticism According to Wijnholds it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices 6 Consumers39 Demand ignored Ohlin forgot an important fact that commodity prices are also in uenced by the consumers39 demand 7 Haberler39s Criticism According to Haberler Ohlin39s theory is based on partial equilibrium It fails to give a complete comprehensive and general equilibrium analysis 8 Leontief Paradox American economist Dr Wassily Leontief tested HO theory under USA conditions He found out that USA exports labour intensive goods and imports capital intensive goods but USA being a capital abundant country must export capital intensive goods and import labour intensive goods than to produce them at home This situation is called Leontief Paradox which negates HO Theory 9 Other Factors Neglected Factor endowment is not the sole factor in uencing commodity price and international trade The HO Theory neglects other factors like technology technique of production natural factors different qualities of labour etc which can also in uence the international trade International Economics Page 14 School of Distance Education There are four major components of the HO model 1 Factor Price Equalization Theorem 2 StolperSamuelson Theorem 3 Rybczynski Theorem and 4 HeckscherOhlin Trade Theorem Factor Price Equalization Theorem Among the four main results of the HO theory FPE is the most fragile theorem If any of the eight assumptions is violated it will not hold However perhaps this is the single most important finding in trade theory it shows how trade affects income distribution of the global economy It states that international trade will bring about equalization in the returns to homogeneous factors across countries StolperSamuelson Theorem The theorem intends to show that the change in commodity prices change the distribution of real incomes between capital and labor It states that the international trade will reduce the income of the scarce factor of production and increase the income of the abundant factor of the country This is because when trade promotes nations will export commodities which are intensive in its abundant and cheap factor This will earn more income to that factor Since imports are on the scarce factor the income will ow to abroad leading to a net decline in its earnings Rybczynski Theorem It states that at constant commodity prices an increase in the quantity of one factor increases the production of the commodity intensive in this factor and reduces the output of the other commodity which is intensive in the constant factor For example if labour force increase in a country and it turns to be more profitable to employ them then naturally the country intensify the production of labour intensive commodities at the cost of capital intensive commodity HeckscherOhlin Trade Theorem It maintains a country will produce and export those commodities in which its abundant factor is intensively used and import those commodities in which the relatively scarce factor is immensely used LEONTIEF S PARADOX In 1953 Wassily Leontief published a study named quotDomestic production and foreign trade the American capital position reexaminedquot where he tested the validity of the Heckscher Ohlin theory Using data available from the 1947 inputoutput I O model of the US economy Leontief calculated the K and L requirements for the production of 1 million of US exports and 1 million of US production in importcompeting industries He found that the former required a higher proportion of L than the latter The study showed that the US was more abundant in capital compared to other countries therefore the US would export capital intensive goods and import labourintensive goods Leontief found out that the US39s export was less capital intensive than import HecksherOhlin39s theory of factor endowments stressed that a country should produce and export goods that require resources factors that are abundant in the home country Leontief tested the HecksherOhlin theory in the US and found that it was not applicable in the US International Economics Page 15 School of Distance Education Possible explanations of the Leontief paradox 1 US demand for Kintensive products outstripped its capacity to provide them domestically So there was no other alternative than imports 2 quotFactorintensity reversalquot Leontief had no idea of the input mix for manufacturing in other countries he measured the Kintensity of US production in importcompeting industries not of US imports If L is expensive in the US then US industries facing import competition would have to reduce their use of L by substituting K However this would mean that production functions ie input mix technology vary for the same products in different places which renders the HeckscherOhlin theorem nearly useless 3 Perhaps international trade ows were not rationalized according to comparative advantage in 1947 immediately after the destruction and disruption of World War 2 After all comparative advantage is a normative concept 4 The US imported naturalresource commodities whose extraction is Kintensive but in which other nations have an absolute advantage 4 quotHumanskills theoryquot L is a heterogeneous factor and should be analyzed as separate factors according to skills levels Perhaps the US is actually skilled and technicalL rich and therefore has a comparative advantage in production that requires much skilled or technical L H O formulations should be expanded to allow for more than one L factor Difficult to test but can be added to the H0 theorem Related to this is the recognition of international differences in factor productivity US labor is more productive than the labor of most countries because of skills work organization capitalworker and technology and is paid more per hour this helps explain why US labor looms larger as a cost in US exports 5 Technology itself is a nationspecific factor of production rather than being a universal attribute of production Furthermore technology is a factor that is produced within a given nation much like a commodity but is not perfectly mobile or tradable This kind of thinking has led to quotneotechnology theories of tradequot 6 The US Government and private companies lent or otherwise invested so much capital in particular sectors of particular foreign economies that these enclaves became essentially capital rich Thanks Mike for this suggestion Empirically it probably doesn39t play an important role in Leontief39s 1947 data but it a does conceptual damage to the factorproportions theory because it implies that capital a factor is mobile and b it presages the model of the international product life cycle below International Economics Page 1 6 School of Distance Education TERMS OF TRADE It is the ratio of export prices to import prices of the country It is a measure of the exchange of exports and imports or how much a nation can import in terms of its exports If export prices exceed the import prices it will be favorable to the home country and Vice versa It can be stated as Terms of Trade Export prices Import prices PxPm Net barter Terms of Trade N This is the ratio of price index of exports to the price index of imports N PxPm X 100 Gross Barter Terms of Trade G It is the ratio of quantity of imports to quantity of exports G QmQx X 100 Income Terms of Trade 1 It is the product of net barter terms of trade and the quantity of exports It is a yardstick of a country s capability to import based on its export earnings I PxPm X Qx International Economics Page 1 7 School of Distance Education MODULE 3 THEORY OF COMMERCIAL POLICY But in general the protective system of our day is conservative while the free trade system is destructive It breaks up old nationalities and pushes the antagonism of the proletariat and the bourgeoisie to the extreme point In a word the free trade system hastens the social revolution It is in this revolutionary sense alone gentlemen that I vote in favor of free trade Karl Marx FREE TRADE Free trade may be defined as a policy of a government which does not discriminate against imports or interfere with trade by applying tariffs to imports or subsidies to exports In other words it is the unrestricted purchase and sale of goods and services between countries without the imposition of constraints such as tariffs duties and quotas Free trade enables nations to focus on their core competitive advantages thereby maximizing economic output and fostering income growth for their citizens The idea that free trade is welfare enhancing is one of the most fundamental doctrines in modern economics dating back at least to Adam Smith 1776 and David Ricardo 1816 But the policy of free trade has been in controversy all the time because the countries were not taking choice between free trade and autarky no trade They always choose one policy from among a spectrum of free trade regimes with varying degrees of liberalization Here are some arguments which are placed in favour of the free trade regime 1 The theory of comparative advantage This explains that by specializing and trading goods in which countries have a lower opportunity cost or greater comparative advantage there can be an increase in economic welfare for all countries Free trade enables countries to specialize in those goods where they have a comparative advantage Free trade in lines of comparative advantage is expected to mutually benefit the countries engaged in free trade 2 Trade as a vent for surplus Trade is identified as a vent for surplus output of an economy The dictum is related to Adam smith who identified the importance of division of labour Smith also maintained that the division of labour is limited by the size of the market Hence division of labour is expected to raise the domestic production A deficiency in Aggregate demand may reduce the domestic prices Here trade can act as a vent for surplus production brought forth through technology and division of labour Free trade is expected to smoothen this process International Economics Page 18 School of Distance Education 3 Reducing Tariff barriers leads to trade creation Trade creation occurs when consumption switches from high cost producers to low cost producers Reducing the tariff barriers with an objective to bring about free trade in an economy may help countries for trade creation The following diagram explains the above idea 5 World e TarEFF P1 5 World Qquot E132 Q3 Q4 wrwemnomiesheMfg o The removal of tariffs leads to lower prices for consumers and an increase in consumer surplus of areas 1 2 3 4 0 Imports will increase from Q3Q2 to Q4Q1 o The government will lose tax revenue of area 3 0 Domestic firms producing this good will sell less and lose producer surplus equal to area 1 0 However overall there will be an increase in economic welfare of 24 1234 13 0 The magnitude of this increase depends upon the elasticity of supply and demand If demand elastic consumers will have a big increase in welfare 4 Economies of Scale If countries can specialize in certain goods they can benefit from economies of scale and lower average costs Economies of scale refer to the capacity of firms to change their output more than proportionately to changes in inputs This is especially true in industries with high fixed costs or that require high levels of investment The benefits of economies of scale will ultimately lead to lower prices for consumers Lowering of trade restrictions enhances this outcome 5 Increased Competition With more trade domestic firms will face more competition from abroad As a result of this there will be more incentives to cut costs and increase efficiency It may prevent domestic monopolies from charging too high prices International Economics Page 1 9 School of Distance Education 6 Trade is an engine of growth World trade has increased by an average of 7 since the 1945 causing this to be one of the big contributors to economic growth 7 Make use of surplus raw materials Middle Eastern counties such as Qatar are very rich in reserves of oil but without trade there would be not much benefit in having so much oil Japan on the other hand has very few raw material without trade it would be very poor 8 Tariffs encourage inefficiency If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs Trade liberalization is often justified in terms of the efficient market outcome and efficient price fixation through a competitive price fixing mechanism Arguments against Free Trade 1 Infant Industry Argument Governments are sometimes urged to support the development of infant industries protecting home industries in their early stages usually through subsidies or tariffs Subsidies may be indirect as in when import duties are imposed or some prohibition against the import of a raw or finished material is imposed If developing countries have industries that are relatively new then at the moment these industries would struggle against international competition However if they invested in the industry then in the future they may be able to gain Comparative Advantage 2 The Senile industry argument If industries are declining and inefficient they may require large investment to make them efficient again Protection for these industries would act as an incentive to for firms to invest and reinvent themselves However protectionism could also be an excuse for protecting inefficient firms 3 To diversify the economy Many developing countries rely on producing primary products in which they currently have a comparative advantage However relying on agricultural products has several disadvantages One of the most important determinants of Agricultural Prices is the environmental factors Hence they can uctuate with climatic changes Agricultural commodities have a low income and price elasticity of demand Therefore with proportionate rise in economic growth will lead to less than proportionate rise in demand Agricultural commodities have relatively low price elasticity of supply A proportionate rise in prices will lead to less than proportionate rise in supply of agricultural commodities This is because of the time lag involved in the production of agricultural goods This is given by the fact that the production of agricultural goods at time t is determined by the prices prevailing in time tI 4 Raise revenue for the govt Import taxes and tariffs can be used to raise money for the government International Economics Page 20 School of Distance Education 5 Help the Balance of Payments Reducing imports can help the current account However in the long term this is likely to lead to retaliation 6 Cultural Identity This is not really an economic argument but more political and cultural Many countries wish to protect their countries from what they see as an Americanization or commercialization of their countries 7 Protection against dumping The EU sold a lot of its food surplus from the CAP at very low prices on the world market This caused problems for world farmers because they saw a big fall in their market prices 8 Environmental It is argued that free trade can harm the environment because Developing countries may use up natural reserves of raw materials to produce exportable commodities Also countries with strict pollution controls may find consumers import the goods from other countries where legislation is lax and pollution allowed Trade Restrictions Restrictions on international movement of goods and services can be divided into tariff barriers and non tariff barriers A tariff is a tax put on goods imported from abroad The effect of a tariff is to raise the price of the imported product It helps domestic producers of similar products to sell them at higher prices The money received from the tariff is collected by the domestic government An import tariff is a duty on Import commodities and an export tariff is a duty on export commodities Tariffs can be ad valoram specific or compound An ad valorem tariff is expressed as a fixed percentage of the value of the traded commodity For example if the US government decides to levy a 10 ad valoram duty on the 100 worth bicycles that the US imports from India the imported will have to pay 10 for each bicycle that he imports from India The specific tariff is expressed as a fixed sum per physical unit of the traded commodity Here if the specific duty is specified as 5 then the customs officials have to collect 5 for each bicycle that is imported to us from India irrespective of its price A compound tariff is the combination of the ad valorem and specific tariffs Finally a compound duty of 15 on the bicycle imported to US will lead the customs officials to collect 5 as the specific part of the compound duty and 10 that ile if each 100 worth bicycle as the ad valorem part of the compound duty Besides these classifications tariffs can be classified as protective and revenue tariffs Protective tariffs are put in place specifically to make foreign good more expensive to protect domestic industries from competition Revenue tariffs are put in place to raise money for the government It all depends on the intention of the government that implements the tariff International Economics Page 21 School of Distance Education NonTariff Trade Barriers Nontariff barriers to trade NTBs are trade barriers that restrict imports but are not in the usual form of a tariff Some common examples of NTB39s are antidumping measures and countervailing duties which although called nontariff barriers have the effect of tariffs once they are enacted Nontariff barriers to trade include import quotas special licenses unreasonable standards for the quality of goods bureaucratic delays at customs export restrictions limiting the activities of state trading export subsidies countervailing duties technical barriers to trade sanitary and phytosanitary measures rules of origin etc Their use has risen sharply after the WTO rules led to a very significant reduction in tariff use Some nontariff trade barriers are expressly permitted in very limited circumstances when they are deemed necessary to protect health safety sanitation or natural resources In other forms they are criticized as a means to evade free trade rules such as those of the World Trade Organization WTO the European Union EU or North American Free Trade Agreement NAFTA that restrict the use of tariffs A quota is a quantitative limit on the amount of goods that can be imported Putting a quota on a good creates a shortage which causes the price of the good to rise and allows domestic producers to raise their prices and to expand their production An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically It is a type of protectionist trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time If a quota is put on a good less of it is imported Quotas like other trade restrictions are used to benefit the producers of a good in a domestic economy at the expense of all consumers of the good in that economy Dumping Dumping is international price discrimination Price discrimination is usually practiced by a monopolist and refers to charging different prices to same commodity for different people A firm may charge higher price for domestic consumers and a lower price for foreign consumers This may be considered as a trade barrier Two necessary conditions for price discrimination and dumping are i The markets should be subdivided and the division should be so effective that the goods sold in one market needs to be resold in another market ii The price elasticity demand should be different in each market Dumping is of different types The following are the important types of dumping i Persistent dumping ii Predatory dumping iii Sporadic dumping International Economics Page 22 School of Distance Education i Persistent Dumping It is a continuous tenancy of a domestic monopolist to maximize total profits by selling the commodity at a higher price in the domestic markets than foreign market ii Predatory Dumping It is the temporary sale of a commodity at a lower price may be low cost in abroad in order to drive foreign producers out of business iii Sporadic Dumping Sporadic Dumping is the occasional sale of a commodity at below cost at a lower price abroad than domestically in order to unload an unforeseen and temporary surplus of the commodity without having to reduce domestic prices Trade restrictions to counteract predatory dumping are justified and allowed to protect domestic industries from unfair competition from abroad These restrictions usually take the form of antidumping duties to offset price differentials or the threat to impose such duties Through the trade restriction they discourage imports and promote their own products Export Subsidies These are direct payments to nation s exporters Export subsidies are of different types They include the practice of granting tax relief and subsidized loans to the nation s exporters or potential exporters providing low interest loan to foreign buyers so as to stimulate the nation exports etc Export subsidies as such may be regarded as a form of dumping All the major industrial nations give low interest loans to foreign buyers of the nation s export to finance the purchases This is undertaken through agencies such as Export import Bank These low interest credits are financing about 2 of US exports as compared with Japan s 32 France s 18 and Germany s 9 indeed This is the one of the most serious trade complaints that US has against many other industrial countries The amount of subsidies can be measured by the difference between the interest that would have been paid on a commercial loan and what is in fact gained at the subsidize rate In 1996 US provided about 1 billion as such subsidies and Japan France and Germany two or three times that amount Countervailing Duties CVDs CVDs is often imposed on imports to offset export subsidies by foreign Government Duties that are imposed in order to counter the negative impact of import subsidies to protect domestic producers are called countervailing duties In cases foreign producers attempt to subsidize the goods being exported by them so that it causes domestic production to suffer because of a shift in domestic demand towards cheaper imported goods the government makes mandatory the payment of a countervailing duty on the import of such goods to the domestic economy This raises the price of these goods leading to domestic goods again being equally competitive and attractive Thus domestic businesses are cushioned These duties can be imposed under the specifications given by the WTO World Trade Organization after the investigation finds that exporters are engaged in dumping These are also known as antidumping duties International Economics Page 23 School of Distance Education Countervailing duties CVD are meant to level the playing field between domestic producers of a product and foreign producers of the same product who can afford to sell it at a lower price because of the subsidy they receive from their government If left unchecked such subsidized imports can have a severe effect on domestic industry forcing factory closures and causing huge job losses As export subsidies are considered to be an unfair trade practice the World Trade Organization WTO which deals with the global rules of trade between nations has detailed procedures in place to establish the circumstances under which countervailing duties can be imposed by an importing nation The WTO s Agreement on Subsidies and Countervailing Measures which is contained in the General Agreement on Tariffs and Trade GATT 1994 defines when and how export subsidies can be used and regulates the measures that nations can take to offset the effect of such subsidies These measures include the affected nation using the WTO s dispute settlement procedure to seek withdrawal of the subsidy or imposing countervailing duties on subsidized imports that are hurting domestic producers The WTO only permits countervailing duties to be charged after the importing nation has conducted an indepth investigation into the subsidized exports The agreement contains detailed rules for determining whether a product is being subsidized and calculating the amount of such subsidy criteria for establishing whether these subsidized imports are affecting domestic industry and rules for the implementation and duration of countervailing duties which is typically five years Economic Integration A free trade area is a form of economic integration where in all barriers on trade among members are removed but each nation retains its own barriers on trade with the nonmembers In a free trade area the group of countries will invoke little or no price control in the form of tariffs or quotas between each other Free trade areas allow the agreeing nations to focus on their competitive advantage and to freely trade for the goods they lack the experience at making thus increasing the efficiency and profitability of each country Eg European Free Trade Association EFTA in 1960 North American Free Trade Agreement NAFTA in 1993 European Union EU formed in 1957 General Agreement on Tariff and Trade GATT GATT an international organization created in 1947 It s Head Quarters in Geneva Switzerland for the promotion of Free Trade through multilateral trade negotiations Originally it was thought that GATT would become part of the International Trade Organization ITO GATT was vested on three basic principles i Non discrimination ii Elimination of NonTariff Trade iii Consultation among nations in solving trade disputes within the GATT frame work International Economics Page 24 School of Distance Education European Union EU The EU is also known as European common market The European Union EU is an economic and political union of 28 member states that are located primarily in Europe It was founded by the Treaty of Rome signed in March 1957 by West Germany France Italy and Belgium In the intervening years the community and its successors have grown in size by the accession of new member states and in power by the addition of policy areas to its remit The Maastricht Treaty established the European Union under its current name in 1993 The latest major amendment to the constitutional basis of the EU the Treaty of Lisbon came into force in 2009 The EU has developed a single market through a standardized system of laws that apply in all member states Within the Schengen Area which includes 22 EU and 4 non EU states passport controls have been abolished EU policies aim to ensure the free movement of people goods services and capital enact legislation in justice and home affairs and maintain common policies on trade agriculture fisheries and regional development The euro zone a monetary union was established in 1999 and came into full force in 2002 It is currently composed of 18 member states Through the Common Foreign and Security Policy the EU has developed a role in external relations and defence Permanent diplomatic missions have been established around the world The EU is represented at the United Nations the WTO the G8 and the G 20 With a combined population of over 500 million inhabitants or 73 of the world population the EU in 2012 generated a nominal gross domestic product GDP of 16584 trillion US dollars constituting approximately 23 of global nominal GDP and 20 when measured in terms of purchasing power parity which is the largest nominal GDP and GDP PPP in the world The North American Free Trade Agreement NAFTA NAFTA is an agreement signed by Canada Mexico and the United States creating a trilateral rules based trade bloc in North America The agreement came into force on January 1 1994 The creation resulted in the formation of one of the world s largest free trade zones thereby laying the foundations for strong economic growth and rising prosperity for Canada the United States and Mexico Since then NAFTA has demonstrated how free trade increases wealth and competitiveness delivering real benefits to families farmers workers manufacturers and consumers In terms of combined purchasing power parity GDP of its members as of 2007 the trade bloc is the largest in the world and second largest by nominal GDP comparison All remaining duties and quantitative restrictions were eliminated as scheduled on January 1 2008 NAFTA now links 450 million people producing 17 trillion worth of goods and services The Association of Southeast Asian Nations ASEAN The Association of Southeast Asian Nations or ASEAN was established on 8 August 1967 in Bangkok Thailand with the signing of the ASEAN Declaration Bangkok Declaration by the Founding Fathers of ASEAN namely Indonesia Malaysia Philippines Singapore and International Economics Page 25 School of Distance Education Thailand Brunei Darussalam then joined on 7 January 1984 Viet Nam on 28 July 1995 Lao PDR and Myanmar on 23 July 1997 and Cambodia on 30 April 1999 making up what is today the ten Member States of ASEAN Main objectives of the Association was to accelerate the economic growth social progress and cultural development in the region through joint endeavors in the spirit of equality and partnership in order to strengthen the foundation for a prosperous and peaceful community of Southeast Asian Nations The association aims to promote active collaboration and mutual assistance on matters of common interest in the economic social cultural technical scientific and administrative fields Also it intends to collaborate more effectively for the greater utilization of their agriculture and industries the eXpansion of their trade including the study of the problems of international commodity trade the improvement of their transportation and communications facilities and the raising of the living standards of their subjects The South Asian Association for Regional Cooperation SAARC The South Asian Association for Regional Cooperation SAARC is an economic and geopolitical union of eight member nations that are primarily located in South Asia contingent Its secretariat is headquartered in Kathmandu Nepal The idea of regional political and economical cooperation in South Asia was first coined in 1980 and the first summit held in Dhaka on 8 December in 1985 led to its official establishment by the governments of Bangladesh Bhutan India Maldives Nepal Pakistan and Sri Lanka In the intervening years its successors have grown in size by the accession of new member states Afghanistan was the first to have been accessed in the physical enlargement of the SAARC in 2007 The SAARC policies aim to promote welfare economics collective self reliance among the countries of South Asia and to accelerate socio cultural development in the region The SAARC has developed a role in external relations around with world Permanent diplomatic relations have been established with the EU the UN as an observer and other multilateral entities On annual scheduled basis the official meetings of leaders of each nation are held meetings of foreign secretaries twice annually The next summit is eXpected to be held in Kathmandu in 2013 but the official dates for the summit is yet to be determined World Trade Organization WTO Internationally coordinated tariff reduction as a trade policy dates back to the 1930s In 1930 the United States passed a tariff law known as the Smooth Hawley Law Under the act the tariffs rose sharply US Trade volume fell sharply It is argued by many economists that the Act is the reason behind the great depression of 1930 s US administration argued that the tariff should be reduced But the reductions were not possible due to the pressure from the interested groups in Us states The only possible way is to go for bilateral negotiations Such bilateral negotiations helped US to reduce their average level of tariffs from 59 in 1932 to 25 percent in the II world war period Multinational negotiations started immediately after the II world War It was imagined that an international organisation called the International Trade Organisation ITO would be established along with the IMF and the World Bank But International Economics Page 26 School of Distance Education a group of 23 countries began the trade negotiations to establish the General Agreement on Tariff and Trade GATT GATT was an official Agreement and not an organisation The countries participated in the agreement were known as the contracting parties GATT maintained a permanent secretariat in Geneva In 1995 the World Trade Organisation WTO was established The basic logic and the rules remains the same The World Trade Organization WTO deals with the global rules of trade between nations Its main function is to ensure that trade ows as smoothly predictably and freely as possible The World Trade Organization WTO is the only global international organization dealing with the rules of trade between nations At its heart are the WTO agreements negotiated and signed by the bulk of the world s trading nations and ratified in their parliaments The following are the main methods in which the WTO system works More open Lowering trade barriers is one of the most obvious ways of encouraging trade these barriers include customs duties or tariffs and measure such as import bans or quotas that restrict quantities selectively Predictable and transparent Foreign companies investors and governments should be confident that trade barriers should not be raised arbitrarily With stability and predictability investment is encouraged jobs are created and consumers can fully enjoy the benefits of competition choice and lower prices More competitive Discouraging unfair practices such as export subsidies and dumping products at below cost to gain market share the issues are complex and the rules try to establish what is fair or unfair and how governments can respond in particular by charging additional import duties calculated to compensate for damage caused by unfair trade More beneficial for less developed countries Giving them more time to adjust greater exibility and special privileges over threequarters of WTO members are developing countries and countries in transition to market economies The WTO agreements give them transition periods to adjust to the more unfamiliar and perhaps difficult WTO provisions Protect the environment The WTO s agreements permit members to take measures to protect not only the environment but also public health animal health and plant health However these measures must be applied in the same way to both national and foreign businesses In other words members must not use environmental protection measures as a means of disguising protectionist policies Trade negotiations The WTO agreements cover goods services and intellectual property They spell out the principles of liberalization and the permitted exceptions They include individual countries commitments to lower customs tariffs and other trade barriers and to open and keep open services International Economics Page 27 School of Distance Education markets They set procedures for settling disputes These agreements are not static they are renegotiated from time to time and new agreements can be added to the package Many are now being negotiated under the Doha Development Agenda launched by WTO trade ministers in Doha Qatar in November 2001 Implementation and monitoring WTO agreements require governments to make their trade policies transparent by notifying the WTO about laws in force and measures adopted Various WTO councils and committees seek to ensure that these requirements are being followed and that WTO agreements are being properly implemented All WTO members must undergo periodic scrutiny of their trade policies and practices each review containing reports by the country concerned and the WTO Secretariat Dispute settlement The WTO s procedure for resolving trade quarrels under the Dispute Settlement Understanding is vital for enforcing the rules and therefore for ensuring that trade ows smoothly Countries bring disputes to the WTO if they think their rights under the agreements are being infringed Judgements by specially appointed independent experts are based on interpretations of the agreements and individual countries commitments Building trade capacity WTO agreements contain special provision for developing countries including longer time periods to implement agreements and commitments measures to increase their trading opportunities and support to help them build their trade capacity to handle disputes and to implement technical standards The WTO organizes hundreds of technical cooperation missions to developing countries annually It also holds numerous courses each year in Geneva for government officials Aid for Trade aims to help developing countries develop the skills and infrastructure needed to expand their trade Outreach The WTO maintains regular dialogue with nongovemmental organizations parliamentarians other international organizations the media and the general public on various aspects of the WTO and the ongoing Doha negotiations with the aim of enhancing cooperation and increasing awareness of WTO activities Trade Rounds These methods are used to improve the trade system through different Trade Rounds In each Trade rounds groups of countries get together to negotiate a set of tariff reductions and other measures to liberalize trade Eight trade rounds have been completed since 1947 The last round was the Uruguay round of trade negotiations in 1994 In 2001 there was the ninth round which is known as the Doha Round The eighth round of trade negotiations started in the year 1986 at Punta de Este in Uruguay After Eight long years of negotiations the participants could finally produce a document which is signed at Marrakesh in Morrocco International Economics Page 28 School of Distance Education MODULE 4 FOREIGN EXCHANGE MARKET Most countries have their own currencies and when people in different countries do business with each other an exchange of currencies must take place Foreign Exchange market is the market for the purchase and sale of currencies It is a global market which operates in all times 24x7 market The price prevailing in this market is called foreign exchange rate An exchange rate is the rate at which one currency can be exchanged for another In other words it is the price of foreign currency in terms of the domestic currency Just like the price of any asset the exchange rate is the price at which one can buy another currency Exchange rates are determined in the foreign exchange market Thus economists predict that movements in exchange rates should re ect changes in the relative demand for and supply of the two currencies Functions 1 Fund Transfer It convenes the transfer of funds and purchasing power from one nation and currency to another as foreign exchange is demanded to exchange commodities between nations It is realized through the in ow and out ow of money by exports and imports 2 Credit for Trade The ow of goods and services across countries demand sufficient financial support Through various monetary instruments like external commercial borrowing Eurobonds foreign bonds etc foreign exchange market performs this function effectively 3 Hedging and Speculation Exchange rate risk is very fundamental to the foreign exchange market The market itself offers ways to reduce or avoid it Hedging means the measures adopted for avoiding risks But speculation is an open position in the market with an expectation of gains through the uctuations PARTICIPANTS IN THE MARKET It is an organizational framework within which individuals firms and banks buy and sell foreign currencies or foreign exchange This 24x7 hour market is the most liquid market in the world level It has global outreach and the currencies are traded worldwide The different monetary centers are connected by a telephone network Commercial banks brokers and clients are the major participants of this system Exporters and importers are the real clients of the market Now a days speculators also involve in the market with an eye on the profit Brokers intervene between the banks and clients The regulators of the market are the banking system consisting of central banks and commercial banks With the expansion of activities corporate and non banking financial intermediaries also actively take part in it International Economics Page 29 School of Distance Education Fixed Exchange Rates There are two ways the price of a currency can be determined against another A fixed or pegged rate is a rate the government central bank sets and maintains as the official exchange rate A rate will be determined against a major world currency usually the US dollar but also other major currencies such as the euro the yen or a basket of currencies In order to maintain the local exchange rate the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged If for example it is determined that the value of a single unit of local currency is equal to US50 the central bank will have to ensure that it can supply the market with those dollars In order to maintain the rate the central bank must keep a high level of foreign reserves This is a reserved amount of foreign currency held by the central bank that it can use to release or absorb extra funds into or out of the market This ensures an appropriate money supply appropriate uctuations in the market in ationde ation and ultimately the exchange rate Floating Exchange Rates Unlike the fixed rate a oating exchange rate is determined by the private market through supply and demand A oating rate is often termed quotselfcorrectingquot as any differences in supply and demand will automatically be corrected in the market A oating exchange rate is constantly changing In a oating regime the central bank may also intervene when it is necessary to ensure stability and to avoid in ation but the frequency is comparatively low In reality no currency is wholly fixed or oating In a fixed regime market pressures can also in uence changes in the exchange rate Sometimes when a local currency re ects its true value against its pegged currency a quotblack marketquot which is more re ective of actual supply and demand may develop A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one thereby halting the activity of the black market EXCHANGE RATE REGIMES HISTORICAL BACKGROUND Between 1870 and 1914 there was a global fixed exchange rate Currencies were linked to gold meaning that the value of a local currency was fixed at a set exchange rate to gold ounces This was known as the gold standard This allowed for unrestricted capital mobility as well as global stability in currencies and trade However with the start of World War I the gold standard was abandoned At the end of World War II the conference at Bretton Woods an effort to generate global economic stability and increase global trade established the basic rules and regulations governing international exchange As such an international monetary system embodied in the IMF was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy It was agreed that currencies would once again be fixed or pegged but this time to the US dollar which in turn was pegged to gold at US35 per ounce International Economics Page 30 School of Distance Education What this meant was that the value of a currency was directly linked with the value of the US dollar So if you needed to buy German marc the value of the marc would be expressed in US dollars whose value in turn was determined in the value of gold If a country needed to readjust the value of its currency it could approach the IMF to adjust the pegged value of its currency The peg was maintained until 1971 when the US dollar could no longer hold the value of the pegged rate of US35 per ounce of gold From then on major governments adopted a oating system and all attempts to move back to a global peg were eventually abandoned in 1985 Since then no major economies have gone back to a peg and the use of gold as a peg has been completely abandoned Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions The peg is there to help create stability in such an environment It takes a stronger system as well as a mature market to maintain a oat When a country is forced to devalue its currency it is also required to proceed with some form of economic reform like implementing greater transparency in an effort to strengthen its financial institutions Some governments may choose to have a quot oatingquot or crawling peg whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly Usually this causes devaluation but it is controlled to avoid market panic This method is often used in the transition from a peg to a oating regime and it allows the government to quotsave facequot by not being forced to devalue in an uncontrollable crisis Advantages of oating exchange rates Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit If an economy has a large deficit there is a net out ow of currency from the country This puts downward pressure on the exchange rate and if depreciation occurs the relative price of exports in overseas markets falls making exports more competitive whilst the relative price of imports in the home markets goes up making imports appear more expensive This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports are sufficiently high A second key advantage of oating exchange rates is that it gives the government monetary authorities exibility in determining interest rates This is because interest rates do not have to be set to keep the value of the exchange rate within predetermined bands For example when the UK came out of the Exchange Rate Mechanism in September 1992 this allowed a sharp cut in interest rates which helped to drag the economy out of a prolonged recession The third important merit is that since adjustments are done automatically the cost of adjustment will be very low It removes all the bottlenecks associated with frequent adjustments by the monetary authorities International Economics Page 31 School of Distance Education Advantages of Fixed Exchange Rates disadvantages of oating rates Fixed rates provide greater certainty for exporters and importers and under normally circumstances there is less speculative activity although this depends on whether the dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible Sterling came under intensive speculative attack in the autumn of 1992 because the markets perceived it to be overvalued and ripe for devaluation DEVALUATION AND REVALUATION Under a fixed exchange rate system devaluation and revaluation are official changes in the value of a country39s currency relative to other currencies In a fixed exchange rate system both devaluation and revaluation can be conducted by policymakers usually motivated by market pressures Under a fixed exchange rate system only a decision by a country39s government or monetary authority can alter the official value of the currency Governments do occasionally take such measures often in response to unusual market pressures Devaluation the deliberate downward adjustment in the official exchange rate reduces the currency39s value in contrast a revaluation is an upward change in the currency39s value A key effect of devaluation is that it makes the domestic currency cheaper relative to other currencies There are two implications of a devaluation First devaluation makes the country39s exports relatively less expensive for foreigners Second the devaluation makes foreign products relatively more expensive for domestic consumers thus discouraging imports This may help to increase the country39s exports and decrease imports and may therefore help to reduce the current account deficit There are other policy issues that might lead a country to change its fixed exchange rate For example rather than implementing unpopular fiscal spending policies a government might try to use devaluation to boost aggregate demand in the economy in an effort to fight unemployment Revaluation which makes a currency more expensive might be undertaken in an effort to reduce a current account surplus where exports exceed imports or to attempt to contain in ationary pressures Effects of Devaluation A significant danger is that by increasing the price of imports and stimulating greater demand for domestic products devaluation can aggravate in ation If this happens the government may have to raise interest rates to control in ation but at the cost of slower economic growth Another risk of devaluation is psychological To the extent that devaluation is viewed as a sign of economic weakness the creditworthiness of the nation may be jeopardized Thus devaluation may dampen investor confidence in the country39s economy and hurt the country39s ability to secure foreign investment International Economics Page 32 School of Distance Education Another possible consequence is a round of successive devaluations For instance trading partners may become concerned that devaluation might negatively affect their own export industries Neighboring countries might devalue their own currencies to offset the effects of their trading partner39s devaluation Such quotbeggar thy neighborquot policies tend to exacerbate economic difficulties by creating instability in broader financial markets Under a oating exchange rate system market forces generate changes in the value of the currency known as currency depreciation or appreciation Depreciation is the downward trend whereas appreciation is the upward trend in rate of exchange THEORIES OF EXCHANGE RATE There are two prominent theories which determine exchange rate systematically gold standard and purchasing power parity theory Purchasingpower parity theory Purchasing power parity is both a theory about exchange rate determination and a tool to make more accurate comparisons of data between countries It serves as a tool for crosscountry comparisons of income and wages which is used by international organizations like the World Bank in presenting much of their international data The concept of purchasing power parity is quite old It is believed to have been propounded by the sixteenthcentury scholars of the University of Salamanca of Spain It relates the price level in a country to the exchange rate Purchasing power parity PPP is a theory of exchange rate determination which compares the average costs of goods and services between countries The theory states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent PPP indicates that exchange rate between two countries should equal to the ratio of similar goods and services in both countries In short what this means is that a bundle of goods should cost the same in India and Pakistan when we take the exchange rate between them Purchasingpower parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so Since the price for any one good should be equal across markets the price for any combination or basket of goods should be equalized PPP calculated by comparing price of one good across in different currencies is known as Absolute PPP For example if one kg of wheat costs INR 12 in India and similar quality of wheat costs 2 dollars in USA then the PPP exchange rate would be INR 6 per USD This is the absolute version of theory of purchasing power of parity International Economics Page 33 School of Distance Education Another form of less stringent PPP stresses on comparing price index of basket of goods in both countries rather than comparing any one goodservice There is an alternative version of the PPP theory called the relative PPP theory In essence this is a dynamic version of the absolute PPP theory In other words the spot rate between two countries can be determined by comparing the price index of a basket of similar goods and services It is very important to understand at this point is that price index should comprise of similar goods amp services consumed by residents of both country If the actual spot exchange rate equals the rate calculated by PPP then PPP holds true However it is empirically proved that PPP in absolute form based on single product or based on a price index does not hold good Problems with the PPP Theory The main problem with the purchasing power parity PPP theory is that the PPP condition is rarely satisfied within a country Transportation costs and trade restrictions These mean that there can be no tariffs on imports or other types of restrictions on trade Since transport costs and trade restrictions do exist in the real world this would tend to drive prices for similar goods apart Transport costs should make a good cheaper in the exporting market and more expensive in the importing market Similarly an import tariff would drive a wedge between the prices of an identical good in two trading countries markets raising it in the import market relative to the export market price Thus the greater transportation costs and trade restrictions are between countries the less likely for the costs of market baskets to be equalized Costs of non tradable inputs Many items that are homogeneous nevertheless sell for different prices because they require a non tradable input in the production process As an example the same food item will be charged at two different prices at a local hotel and a five star restaurant The increased rate of rent and more comfortable hospitality will be added to the cost of menu causing a higher charge in the restaurant They can t discount this as it is a part of their production At this stage prices would not be equalized Perfect information The law of one price assumes that individuals have good even perfect information about the prices of goods in other markets Only with this knowledge will profit seekers begin to export goods to the high price market and import goods from the lowpriced market Consider a case in which there is imperfect information Perhaps some price deviations are known to traders but other deviations are not known or maybe only a small group of traders know about a price discrepancy and that group is unable to achieve the scale of trade needed to equalize the prices for that product Perhaps they face capital constraints and can t borrow enough money to finance the scale of trade needed to equalize prices In either case traders without information about price differences will not respond to the profit opportunities and thus prices will not be equalized Thus the law of one price may not hold for some products which would imply that PPP would not hold either International Economics Page 34 School of Distance Education Other market participants Notice that in the PPP equilibrium stories it is the behavior of profitseeking importers and exporters that forces the exchange rate to adjust to the PPP level These activities would be recorded on the current account of a country s balance of payments Thus it is reasonable to say that the PPP theory is based on current account transactions This contrasts with the interest rate parity theory in which the behavior of investors seeking the highest rates of return on investments motivates adjustments in the exchange rate Since investors are trading assets these transactions would appear on a country s capital account of its balance of payments Thus the interest rate parity theory is based on capital account transactions It is estimated that there are approximately 1 2 trillion dollars worth of currency exchanged every day on international foreign exchange Forex markets That s oneeighth of US GDP which is the value of production in the United States in an entire year In addition the 1 2 trillion estimate is made by counting only one side of each currency trade Thus that s an enormous amount of trade If one considers the total amount of world trade each year and then divides by 365 one can get the average amount of goods and services traded daily This number is less than 100 billion dollars This means that the amount of daily currency transactions is more than ten times the amount of daily trade This fact would seem to suggest that the primary effect on the daily exchange rate must be caused by the actions of investors rather than importers and exporters Thus the participation of other traders in the Foreign exchange market who are motivated by other concerns may lead the exchange rate to a value that is not consistent with PPP PPP is based on the concept of Law of One Price The LOOP indicates that identical goodservices should sell for the same price in two separate markets when there are no transportation costs and no differential tax rates exists in the two markets If there is a price difference then exchange rate would move in such a manner so that in both markets the product will sell at same price The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets The LOOP holds well only if three conditions are satisfied These three are 0 Transportation costs barriers to trade importexport levies customs duty etc and other transaction costs currency conversion fee are insignificant There must be competitive markets for the goods and services in both countries 0 The LOOP applies only to tradable goods LOOP is not applicable to immobile goods such as houses and many services that are local in nature International Economics Page 35 School of Distance Education Mint Parity Theory Mint parity theory explains the determination of exchange rate between the two countries which are on gold standard In a country which is on gold standard the currency is either made of gold or is convertible into gold at a fixed rate There are also no restrictions on the export or import of gold The central bank of the country was always ready to buy and sell gold at the specified price The rate at which the standard money of the country was convertible into gold was called mint price of gold Determination of Exchange Rate The rate of exchange between the gold standard countries is determined on a weight to weight basis of the gold contents of their currencies In other words the exchange rate is determined by the gold equivalents of the currencies involved For examples before World War 11 1926 1931 England and American currencies were on gold standard The mint par between these two countries was pound one of England486 dollars of America The rate of exchange showed that one pound of England contained as much fine gold as 4866 dollars contained in America The ratio of weights of metal was called the mint parity The mint par was a fixed rate It remained constant so long as the monetary laws of the country remained unchanged The current or the market rate of exchange however uctuated from time to time due to changes in the balance of payments of the respective countries The variations in the exchange rate remained within the well defined limits called gold points or specie points The gold points refer to the limits within which the market rate of exchange between two gold standard countries uctuates from the mint parity equilibrium The upper gold point indicates the upper limit and the lower gold point indicates the lower limit Calculations of gold points But the actual rate of exchange could very above and below the mint parity by the cost of shipping gold between the two countries The gold points are determined by the costs of transporting gold such as shipping packing insurance charges etc from one country to another The upper gold point upper specie point is obtained by adding the cost of shipping gold to the mint parity rate of exchange The lower gold point lower specie point is arrived at by deducting the cost of shipping gold from the mint parity rate of exchange For example the mint parity rate of exchange between England and America is l4866 The shipping cost of gold from America to England worth 4866 dollars of gold is 02 cent In that case the upper gold point 2 l4866 024886 The lower gold point 2 l4866 02 4846 Gold export point and gold import point The upper gold point is also called gold export point It is the rate of exchange above which the gold will be exported The lower gold point is also called the gold import point It is the rate of exchange below which gold will be imported Under the gold standard the exchange rate between the two currencies cannot vary above the upper gold point and below the lower gold point as is illustrated in the figure International Economics Page 36 School of Distance Education 3 1 7 Emu EKPQT FIDINT gt 39 quot quot A quot L E MirIT a an 3 5g 5 Emma liMFIEI HT iHT E 7 r F u deEt li rg dmn a 39 m ningMad F15 Te 39 In the figure the demand curve DD and supply curve DD intersect each other at point R OR is the exchange rate between the dollar and the pound It may here be noted that the exchange rate need not be at the mint parity It can be anywhere between the upper and lower gold points depending on the shape of demand and supply curves An American importer would not pay more than 4886 to obtain one pound of England It is because he can purchase 4866 worth of gold from the US Treasury and ship it to England at a cost of 02 cent per pound The exchange rate therefore cannot rise beyond the gold export point OU The supply curve of pounds becomes perfectly elastic at the US gold export point Similarly the rate of exchange cannot fall between 4846 to a pound The exchange rate of 4846 to a pound is the US gold import point In case of lower rate the Americans would prefer to use the pounds to import gold from England The Americans demand curve for pounds becomes perfectly elastic at the gold import point OL The mint parity theory has long been discarded ever since the gold standard broke down Now no country is on the gold standard So it has an academic curiosity only Drawbacks The gold standard has only limited applicability in the present worldThis will function only under gold base standard It fails to explain the determination of exchange rate in the present day oating system COMPONENTS OF FOREIGN EXCHANGE RESERVES Foreign exchange reserves are the financial hoardings of a country to intervene or support its external economic transactions at times of necessity Since US dollar is the dominant vehicle currency generally foreign exchange reserves are denominated in terms of it At times of foreign exchange risk or BOP crisis central banks and governments intervene and smoothen out the turbulence using this reserve It is an important indicator of external economic health of a country It mainly consists of four components gold reserves held by the central bank stock of foreign currencies reserve tranche position in IMF and the holding of IMF currency Special Drawing Rights In India RBI keeps 55775 tonnes gold as reserve Foreign currency holdings are kept by the central bank in the form of US dollar Euro Pound Sterling and Japanese Yen These are used for open market operations and other intervening activities Reserve tranche position is the borrowal facility offered by the IMF to the member countries Using it a country can borrow upto 25 of its quotawhich is equal to its gold subscription and hence also called gold tranche unconditionally SDR is the reserve asset created by IMF in 1967 and provided to the members proportionate to their quotas This accounting money is also called paper gold and is not used as a circulating currency International Economics Page 37 School of Distance Education MODULE 5 BALANCE OF PAYMENTS The Balance of Payments is a systematic records of all economic transactions between residents of the reporting Country amp residents of foreign countries Kindleberger Introduction Balance of Payment BOP is a summary statement of all economic transactions of the residents of a nation with the residents of Rest of the World ROW during a particular period of time BOP is recorded usually for a Calendar year In other words B O P is a systematic statistical statement or record of the character and dimensions of the country s economic relationship with the rest of the world Balance of payments is integral parts of national accounts for an open economy The main purpose of the Balance of Payment is to inform the Government of the international economic position of the nation and to help in formulating its of monitory fiscal and trade policies The Foreign Governments also use the Balance of Payment accounts for the purpose of formulating trade relation with other countries Other economic agents like Bank firms and individual may also depend upon the Balance of Payment accounts for various purposes The Balance of Payment account serves another purpose The balance of Country s foreign transactions and accompanying issues of the exchange date and reserves whether of Gold or of foreign currencies has long been a focus of interest for policy members Thus the state of BOP plays an essential role in providing information to economic agents and Governments According to Sodersten the BOP is nearly a way of listing receipts and payments in international transactions for a country The Balance of Payment account have significant role in an open economy An open economy is one which has economic relations with the rest of the world An economic transaction is an exchange of value involving a payment or receipts of money in exchange of a good a service or an asset for which payment is made between the resident of a country with resident of the rest of the world In barter trade goods are exchanged for goods and in some cases assets are transacted against assets Some goods are transferred to other as a gift without expecting payment known in economics as the transfer payments or unilateral transfers Each of these transactions occurs between the residents of a country and between the economic agents residing in two different countries If the exchange is happening between the residents of two countries that transaction in an International economic transaction An international economic transaction is systematically recorded in the books of accounts of balance of payments Balance of payments are maintained in a Double entry book keeping principle Under such principle each transaction is the balance of payments is entered as a Credit or a Debit entry A Credit entry in Balance of Payments refers to an in ow or that transaction is the one that shows a receipt of funds from the rest of the world Similarly a Debit entry Balance of Payments refers to an out ow or that International Economics Page 38 School of Distance Education transaction is the one that shows a payment of funds to the rest of the world According to the Double entry book keeping principle for each Debit entry a corresponding Credit entry is made to keep the balance of payment always in balance I In ow or Credit Resident of the ROW Resident of the Domestic Tnnn V IIOut ow or Debit gt In the above ow chart diagrams the 1St ow shows an in ow of value which may appear as a Credit entry in the books of accounts of Balance of payments on the Domestic Country This In ow of value includes the receipts that the Resident of the domestic territory gets in return for the Export of commodities or Services also known as the invisibles unilateral transfers and the Foreign Capital receipts 2nd ow shows an out ow of value This may appear as a Debit entry in the books of accounts of Balance of payments of the Domestic Country This out ow of value includes the payments that the Resident of the domestic territory makes in return for the Imports of commodities or Services also known as the invisibles unilateral transfers and the Investments abroad Balance of payments and balance of trade All countries engaging in International Exchange of value may import some commodities and services from other countries They also export certain other commodities and services which are surplus in their country The difference between the value of goods and services exported out of a country and the value of goods and services imported into the country in known as the Balance of Trade If a country has a balance of trade deficit it imports more than it exports and if it has a balance of trade surplus it exports more than it imports The balance is said to be favorable when the value of the exports exceeded that of the imports ie exports exceed imports and unfavorable when the value of the imports exceeded that of the exports ie imports exceed exports In other words it is the difference between the value of goods and services International Economics Page 39 School of Distance Education exported out of a country and the value of goods and services imported into the country The balance of trade is the official term for net exports that makes up the balance of payments The official balance of trade is separated into the balance of merchandise trade for tangible goods and the balance of services A balance of trade surplus is most favorable to domestic producers responsible for the exports However this is also likely to be unfavorable to domestic consumers of the exports who pay higher prices Alternatively a balance of trade deficit is most unfavorable to domestic producers in competition with the imports but it can also be favorable to domestic consumers of the exports who pay lower prices The difference between the Balance of Payments and Balance of trade can be explained with the help of the below given table Balance of Payment BOP Balance of Trade BOT Balance of Trade is defined as 39difference Balance of Payment includes not only import between export and import of goods and and export of goods and services but also services39 financial capital transfer BOT Net Earning on Exports Net payment BOP BOT Net Eaming on foreign made for imports investment ie payments made to foreign investors Cash Transfer Capital Account or Balancing Item or BOP Current Account Capital Account or Balancing item Errors and omissions If export is more than Balance of Payment will be favorable if the import at that time BOT will be favorable If country has surplus in current account for import is more than export at that time BOT paying your all past loans in her capital will be unfavorable account Balance of payment will be unfavorable if country has current account deficit and it took more loan from foreigners After this it has to pay high interest on extra loan and this will make BOP unfavorable Need not be in balance always Balance of payments to be in balance always Followin are main factors which affect BOT g Followmg are mam factors wh1ch affect BOP a cost of productlon a Condltlons of forelgn lenders b ava11ab111ty of raw materlals b Economlc pollcy of Govt E h t C XC ange m e c all the factors of BOT 1 Prices of goods manufactured at home International Economics Page 40 School of Distance Education Balance of payment Accounting Balance of Payments is essentially maintained in double entry book keeping principle They record all international transactions between the residents of one country with the residents of other countries Here residents refer to the individuals business and governments and their agencies International organizations are also regarded as foreign residents Balance of payment accounts are kept in standard Double entry book keeping principle International transactions are recorded in the balance of payments as a credit and a debit transaction Credit transaction is that transaction which involves the receipt from the residents of the rest of the world A debit transaction on the other hand involves a payment to the foreign residents Under this method each international transaction undertaken by the residents of a country are entered as a debit and credit entry of equal size into the balance of payments For example an export entered as credit in a countries balance of payment is followed by a debit entry of equal size to show the manner in which the transaction is undertaken Import transactions are entered as a debit transaction in the balance of payments and a credit entry of equal size is made in the books of account On the basis of its value 3 possibilities are there They are If Debit balance gt Credit balance it leads to Balance of Payment deficit Here the in ow will be lesser than the out ow Hence the nation experiences a deficit in its Balance of Payment accounts On the other hand if the Debit balance lt Credit balance we have a Balance of Payment Surplus Here the out ow will be lesser than the in ow If Debit balance Credit balance then we can say that the nation s Balance of Payment is in balance Balance of Payment Accounts consists of the two sub accounts They are Current account and Capital Account Current account includes visible items commodities and Invisible items Services Capital account consists of long term and short term capital ows Let us explain them in detail THE CURRENT ACCOUNT The current account includes exports and imports of goods and services amp unilateral transfers Exports weather it is goods or services are by convention entered as a credit items in the account Imports are normally calculated free on board That means that the cost of transportation insurance etc are not included Imports are normally calculated cif cost insurance freight Transportation insurance cost and fright are included Balance of payment accounts usually make differences between trade in goods and trade in services In the current account of Balance of payment accounts we have a visible part of commodities and Invisibles part of Services The net of exports and import of visibles in Balance of payment accounts is called the merchandise trade balance The net of exports and import of invisibles or services in Balance of payment accounts is called the services trade balance Travel Business Process outsourcing Medical Transcription etc are examples for international trade in Services The Capital account on the other hand consists of long term and short term capital ows Let us explain them in detail International Economics Page 41 School of Distance Education Invisible trade is much more hetnogenious them the trade in goods Trade in the latter of which shipping banking and insurance services and payments by residents as tourists abroad are usually the most important Exports and imports of such services are ows of outputs whose values will be determined by the same variable that could affect the demand on supply for goods unilateral transfer or transfer payments Unilateral transfers are receipts which the residents of a country receive for free without making any present or future service transaction in return Unilateral receipts from abroad are entered as positive items and they are credited Unilateral payments abroad are entered as negative items and they are debited Unilateral transfers may be private unrequited transfers which may be in the form of gifts received by domestic residents from foreign residents Secondly official unrequited transfers is the payment of pure aid by governments in developed countries to government in less developed countries LDCs A third form of unilateral transfer has been important reparation payments Typically such payments occurred when a morally and physically superior country came out of war and was in a position to make the foreign country or its former enemy pay indemnities The net value of the balance of visible trade and invisible trade and of unilateral transfers defined the balance on current account It is however services and transfer payments or invisible items of the current account that re ect the true picture of the balance of payments account They along with the visible items determine the actual current account position If export of goods and services exceed import of goods and services the balance of payments is said to be favorable In the opposite case it is unfavorable In the current account the exports of goods and services and the receipts of transfer payments are entered as credit because they represent the receipt from foreigners On the other hand the imports of goods and services and transfer of payments to foreigners are entered as debits because they represent payments to foreigners THE CAPITAL ACCOUNT The capital account records all international financial transactions that involve resident of the country concerned changing either his assets with or his liabilities to a resident of another country Transactions in the capital account re ect change in a stock either assets or liabilities It is often useful to make distinctions between various forms of capital account transactions The basic distinctions are between private and official transaction between portfolio and direct investments Distinction between private and official transaction is fairly transparent and need not concern us too much On the other hand portfolio investments are the acquisition of an asset that does not give the purchaser control over it An example is the purchase of shares in a foreign company or of bonds issued by a foreign government Loans made to foreign firms or governments come into the same broad category Foreign Direct investment FDI is the act of purchasing an asset and at the same time accruing control of it The acquisition of a firm residing in one country by a firm in another country is an example International Economics Page 42 School of Distance Education The purchase of an asset in another country whether it is direct or portfolio investment would appear as a debit item in the capital account for the country of the firm which purchase it and as a negative item in the capital account for the other country The capital account out ows appear as a debit item in country s balance of payments and capital in ows as credit items The net value of the balance of direct and portfolio investment defines the balance on capital account ERRORS AND OMISSIONS The balances of payments accounts are completed by the entering some other minor items that can be identified but do not fall comfortably into one of the standard categories Errors and omissions which re ect transactions that have not been recorded for various reasons and cannot be entered under a standard heading may cause Errors and omissions Balance of payments is constructed as an accounting identity with each transaction theoretically recorded twice the sum total of debits and credits should in theory always be equal That means that if a debit entry is made to record an out ow of value a corresponding credit entry is to be made in some other part of the books of account for theoretically maintaining balance in the books of accounts of the balance of payments However one or other of the parts of transaction takes more than one year discrepancy may arise and the Balance of payment may not balance OFFICIAL RESERVES ACCOUNT The official reserves account measures the changes in the official reserves and changes the foreign official assets in the country during the year Official reserves consist of gold Special Drawing Rights SDRs borrowed from the IMF and holding of foreign convertible currencies The changes in the country s reserves must re ect he net value of all the other recorded items in the balance of payments These changes will of course be recorded accurately and it is the discrepancy between the changes in reserved and the net value of the other recorded items that allows identifying the errors and omissions Increase in official reserves represents capital out ows from the country and are recorded as debits in the official reserves accounts of the books of accounts of Balance of Payments of the country Any decrease in the official reserves is recorded as capital in ows and are credit entries in the reserves accounts of the books accounts of Balance of Payments of the country The entries are similar to that of private capital but we are here dealing with the official capital The items of the balance of payments account of the country can be noted distinguishing credits and debits as shown below International Economics Page 43 School of Distance Education gt Current Account Balance of Payments Export of Goods Export of Services Import of Goods Import of Services Capital Account Capital Receipts Direct Investment Portfolio Investment Capital payments Direct Investment Portfolio Investment amp other capital payments abroad International Economics Page 44 School of Distance Education Official Reserve assets Official Reserve accounts Official Reserve liabilities Autonomous and Accommodating Flow It is useful to distinguish between autonomous and accommodating items in the balance of payments All transactions in the current and capital account are called automatic transactions Transactions are said to be autonomous if their value is determined independently of the balance of payments They take place for business or private motive Accommodating items are transactions that come under the official reserve account and are determined by the net consequences of the autonomous items They are required to balance international transactions Alternatively items are said to be above the line autonomous or below the line accommodating Obviously the sum of the accommodating and autonomous items must be zero since all entries in the balance of payment 3 accounts must come under one of the tw3o headings A deficit in a nation s balance of payments is given by a net debit balance in the nation s autonomous items and a surplus is given by a net credit balance In order to correct the deficit the accommodating ows to be positive in the first case and negative in the second The autonomous capital ow could take many forms It could have been caused for instance by a foreign resident paying back a loan to a firm or it could be that a person or a company took up a loan abroad by issuing bonds for instance In all these cases it is a question of private persons or firms having international capital transaction These transactions have an effect on the country s balance of payments but they are in no way caused by balance of payments considerations In fact they are all examples of autonomous capital movements The accommodating in ow of capital can take various forms Foreign firms might accept short term claims on firms in the country or perhaps a foreign government extends a loan to the country In the case of a less developed country it might even be possible that a foreign government is willing to ease the balance of payments situation of the country by making it a gift amounting to the value of the accommodating in ow Or possibly the county in question has had to deplete its reserves of foreign currency to settle its imbalance in autonomous capital in ow In short the accommodating capital movements are a direct consequence of the balance of payments situation Accommodating capital in ows are unforeseen capital ows which have to be made to bring the balance of payments into equilibrium International Economics Page 45 School of Distance Education EQUILIBRIUM AND DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS Balance of payments should always be in equilibrium Disequilibrium in the balance of payments of a country appears either as a surplus or as a deficit A Surplus in the balance of payments implies receipts from the rest of the world exceed payments made to rest of the world A Deficit in the balance of payments occurs as the payments made to foreigners exceed receipts from the Rest of the world As a BOP is in equilibrium any positive balance in its current accounts in exactly offset by a negative balance on its capital account and vice versa In an accounting sense the balances of payments always balance There is difference of opinion with regard to the primary cause of imbalances in Balance of Payments Conventionally it is beloved that the factors with regard to the current accounts are the primary causes of imbalance They include the appreciation or a depreciation of exchange rate the government39s fiscal deficit business competitiveness and private behavior such as the willingness of consumers take debt to finance extra consumption An alternative view as argued by Ben Bemanke the chairman of the American Federal Reserve in a 2005 paper is that the primary driver of Balance of payment deficit is the capital account He maintained that the cause of Balance of payment disequilibria of US is a global savings glut which caused a runs ahead of savers in surplus countries over the available investment opportunities which resulted in excess consumption and asset price in ation MEASURES TO CORRECT BALANCE OF PAYMENT DISEQUILIBRIUM Persistent disequilibrium in the balance of payments particularly a deficit in balance of payments is undesirable because it a weakens the country39s economic position at the international level and b affects the progress of the economy adversely It must be cured by taking appropriate measures There are many measures to correct disequilibrium in the balance of payments Important among them are discussed below 1 De ation In the wake of Deficit in a nation s Balance of Payments it can resort to tight monetary policy The currency authority may try to lower the prices by reducing the quantity of money in circulation or follow a de ationary monetary policy De ation is the classical medicine for correcting the deficit in the balance of payments De ation refers to the policy of reducing the quantity of money in order to reduce the prices and the money income of the people This is done by the central bank of the country through raising the bank rate by selling the securities in the open market and by other methods can reduce the volume of credit in the economy which will lead to a fall in prices and money income of the people Fall in prices will stimulate exports and reduction in income checks imports Thus de ationary policy restores equilibrium to the balance a by encouraging exports through reduction in their prices and b by discouraging imports through the reduction in incomes at home Moreover a higher interest rate in the domestic market International Economics Page 46 School of Distance Education will attract foreign funds which can be used for correcting disequilibrium However de ation is not considered a suitable method to correct adverse balance of payments because of the following reasons a De ation means reduction in income or wages which is strongly opposed by the trade unions b De ation causes unemployment and suffering to the working class c In a developing economy expansionary monetary policy rather than contractionary de ationary monetary policy is required to meet the developmental needs 2 Depreciation Another method of correcting disequilibrium in the balance of payments is depreciation or appreciation of the exchange rate Deprecation means a fall in the rate of exchange of one currency home currency in terms of another foreign currency A currency will depreciate when its supply in the foreign exchange market is large in relation to its demand In other words a currency is said to depreciate if its value falls in terms of foreign currencies ie if more domestic currency is required to buy a unit of foreign currency An appreciation on the other hand is the rise in the value of a currency relative to the foreign currency Depreciation helps a country to achieve a favorable balance of payments by checking imports and stimulating exports The following are the defects of this method i It is not suitable for a country which follows a fixed exchange rate system ii It makes international trade risky and thus reduces the volume of trade iii The terms of trade go against the country whose currency depreciates because the foreign goods have become costlier than the local goods and the country has to export more to pay for the same volume of imports iv Experience of certain countries has indicated that exchange depreciation may generate in ationary pressure by increasing the domestic price level and money income v The success of the method of exchange depreciation depends upon the cooperation of other countries If other countries also start depreciating their exchange rates then these methods will not benefit any country 3 Devaluation Devaluation refers to the official reduction of the external values of a currency The difference between devaluation and depreciation is that while devaluation means the lowering of external value of a currency by the government depreciation means an automatic fall in the external value of the currency by the market forces the former is arbitrary and the latter is the result of market mechanism Thus devaluation serves only as an alternative method to depreciation Both the methods imply the same thing ie decrease in the value of a currency in terms of foreign currencies International Economics Page 47 School of Distance Education Both the methods can be used to produce the same effects they discourage imports encourage exports and thus lead to a reduction in the balance of payments deficit The success of the method of devaluation depends upon the following conditions i The elasticity of demand for the country39s exports should be greater than unity ii The elasticity of demand for the country39s imports should be greater than unity iii The exports of the country should be nontraditional and the increasingly demanded from other countries iv The domestic price should not rise and should remain stable after devaluation V Other countries should not retaliate by resorting to corresponding devaluation Such a retaliatory measure will offset each other39s gain Devaluation also suffers from certain defects i Devaluation is a clear revelation on the country39s economic weakness ii It reduces the confidence of the people in country39s currency and this may lead to speculative out ow of capital ii It encourages in ationary tendencies in the home country iv It increases the burden of foreign debt v It involves large time lag to produce effects vi It is a temporary device and does not provide a permanent remedy to correct adverse balance of payments 4 Exchange Control Exchange control is the most widely used method for correcting disequilibrium in the balance of payments Exchange control refers to the control over the use of foreign exchange by the central bank Under this method all the exporters are directed by the central bank to surrender their foreign exchange earnings Foreign exchange is rationed among the licensed importers Only essential imports are permitted Exchange control is the most direct method of restricting a country39s imports The major drawback of this method is that it deals with the deficit only and not its causes Rather it may aggravate these causes and thus may create a more basic disequilibrium In short exchange control does not provide a permanent solution for a chronic disequilibrium 5 Tariffs Tariffs are duties taxes imposed on imports When tariffs are imposed the prices of imports would increase to the extent of tariff The increased prices will reduced the demand for imported goods and at the same time induce domestic producers to produce more of import substitutes Nonessential imports can be drastically reduced by imposing a very high rate of tariff International Economics Page 48 School of Distance Education Drawbacks of Tariffs 1 Tariffs bring equilibrium by reducing the volume of trade 2 Tariffs obstruct the expansion of world trade and prosperity 3 Tariffs need not necessarily reduce imports Hence the effects of tariff on the balance of payment position are uncertain 4 Tariffs seek to establish equilibrium without removing the root causes of disequilibrium 5 A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country already having a surplus 6 Tariffs to be successful require an efficient amp honest administration which unfortunately is difficult to have in most of the countries Corruption among the administrative staff will render tariffs ineffective 6 Quotas Under the quota system the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period By restricting imports through the quota system the deficit is reduced and the balance of payments position is improved Types of Quotas 1 the tariff or custom quota 2 the unilateral quota 3 the bilateral quota 4 the mixing quota and 5 import licensing Merits of Quotas l Quotas are more effective than tariffs as they are certain 2 They are easy to implement 3 They are more effective even when demand is inelastic as no imports are possible above the quotas 4 More exible than tariffs as they are subject to administrative decision Tariffs on the other hand are subject to legislative sanction Demerits of Quotas 1 They are not longrun solution as they do not tackle the real cause for disequilibrium 2 Under the WTO quotas are discouraged as they are constraints on free trade We examined the method of correcting a deficit in a nation s current account or balance of payments by depreciation or a devaluation of the nation s currency Depreciation implies a exible exchange rate system Devaluation on the other hand refers to the deliberate policy increase in the exchange rate by the nation s monetary authorities from one fixed or pegged level to another However since both a depreciation and a devaluation operate on prices to bring about adjustment in the nation s current account and the balance of payments they are both referred to as the price adjustment mechanism International Economics Page 49 School of Distance Education Balance Of Payments Adjustments with Exchange Rate Changes Under exible exchange rates the disequilibrium in the balances of payments is automatically solved by the forces of demand and supply for foreign exchange An exchange rate is the price of a currency which is determined like any other commodity by demand and supply The exchange rate varies with varying supply and demand conditions but it is always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium This is automatically achieved by a depreciation or appreciation of a country s currency in case of a deficit or surplus in its balance of payments Depreciation or appreciation of a currency means that its relative value decreases or increasesdepreciation has the effect of encouraging exports and discouraging imports When exchange depreciation takes place foreign prices are translated into domestic prices Suppose the Rupee depreciates in relation to dollar It means that the price of a rupee falls in relations to the dollar in the foreign exchange market For example assume that the value of Indian currency was around Rs 40 1 in 2008 Imagine that there is a deficit in India s BOP Deficit is due to large imports compared to its imports In 2013 depreciation of Indian rupee caused the exchange rate to increase to RS 68 1 This causes exports to increase and imports to fall In 2008 an Indian citizen could purchase 1 worth commodity with Rs 40 but the same dollar worth commodity is worth RS 68 today Hence the Imports fall and exports increases The Balance of payment moves back to equilibrium The effect of depreciation of a currency is to make imports dearer and exports cheaper Thus this leads to the lowering of the prices of Indian exports in US and raising the prices of US imports in the India When import prices are higher in the India Indians will purchase fewer goods from the U S On the other hand lower prices of Indian exports will increase their sales to U S Thus the India exports will increase and imports diminish thereby bringing equilibrium in the balance of payments ASSUMPTIONS The analysis is based on the following assumptions 1 There are only two countries 2 Both are on exible exchange rate system 3 BOP disequilibrium is automatically adjusted by changes in exchange rates 4 Prices are exible in both the countries 5 There is free trade between the two countries Given these assumptions the adjustment process is explained in terms of the following International Economics Page 50 School of Distance Education In the above figure D is the Indian demand curve of U S which id a derived demand from the demand for U S imports and S is the US supply curve of foreign exchange representing its exports to India FIGURE 1 L d 5 E 1 lquot pi iquot a H A E E 5 F J u 51 I E T a 5 Jf Elia5 chl lij39 ff j39 39ig muck GEE At p the demand and supply of the Indian foreign exchange is in equilibrium where the rate of exchange between Indian Rupee and US is 0p and the quantity of exchange is 0dd0ss If the exchange rate is at p1 the demand for U S dollar is greater than its supply This implies that the import from US is greater than exports and hence a deficit in India s BOP This causes the Rupee to depreciate and the exchange rate finally sets at p and BOP reaches back to equilibrium The currency needs t be depreciated by p1p amount for the BOP to be in balance The exact opposite happens when the exchange rate is at p2 a surplus in BOP The above analysis based on the assumptions of relative elasticity of demand and supply of foreign exchange However in order to measure the full effect of depreciation on relative prices in the Balance of payment of the country we have to take the impact of these elasticity also It is not necessary that the demand and supply conditions to be relatively elastic as shown in the above diagram N additional demand and supply curve as illustrated in the below given diagram requires more depreciation to correct the disequilibrium in the BOP International Economics Page 51 School of Distance Education FIGURE 2 d39 3 l39 n 3 E F H P E a l 5 H a E Equot E A 1 LiaI r E d E 1L3 539 iti a an u39 af rming excl agre Where the original less elastic demand and supply curves of foreign exchange are d and s respectively which intersect at p and the equilibrium exchange rate is 0p Here the new sets of demand and supply curves d and s intersects at a higher point ie e and plp depreciation is insufficient to bring about equilibrium in the BOP here we need plp2 depreciation in the domestic currency Hence greater depreciation is needed when the Demand and Supply of foreign currency is relatively inelastic Automatic price adjustment under gold standard Under the international gold standard which operated between 18801914 the currency in use was made of gold or was convertible in to gold at fixed rate The central bank of the country was always ready to buy and sell gold at the specified price The rate at which the standard money of the country was convertible into gold was called the mini price of gold This rate was called the mint parity or mint par of exchange because it was based on the mint parity by the cost of shipping gold between the two countries Suppose the US had a deficit in its balance of payments with Britain The difference between the value of imports and exports would have to be paid in gold by US importers because the demand for pounds exceeded the supply of pounds But the transhipment of gold involved transportation cost and other handling charges insuranceetc Suppose the shipping cost of gold from the US to Britain was 3 cents So the importers would have to spend 6036O3c for getting l This could be the exchange rate which was the US gold export point or upper specie International Economics Page 52 School of Distance Education point No US importer would pay more than 603 to obtain 1 because he could buy 6 worth of gold from the US treasury and ship it to Britain at a cost of 3 cents per ounce Similarly the exchange rate of the pound could not fall below 597 to a pound was the US gold import point or lower specie point The exchange rate under the gold standard was determined by the forces of demand and supply between the gold points and was prevented from moving outside the gold points by shipments of gold The main objective was to keep BOP in equilibrium Deficit or surplus in BOP under the gold standard was automatically adjusted by the pricespecie ow mechanism For instance BOP deficit of a country meant a fall in its foreign exchange reserves due to an out ow of its exports and reduce its imports This adjustments process in BOP was supplemented by a rise in interest rates as a result of reduction in money supply This led to the in ow of shortterm capital from the surplus country Thus the in ow of shortterm capital from the surplus to the deficit country helped in restoring BOP equilibrium Adjustment mechanism of balance of payments under income approach In examining the price adjustment mechanisms we implicitly assumed that national income remained constant However a change in the level of trade affects national income which in turn induces a change in the value of imports For example starting from an equilibrium position in the balance of trade and less than full employment domestically an autonomous increase in the value of exports causes real national income Yto rise by an amount equal to the increase in X times the foreign trade multiplier kif the marginal propensity to save or MPS S 0then k1MPM where is the marginal propensity to import OR M Y In this case the induced increase in M resulting from the increase in Y equals the original autonomous increase in X and so the adjustment in the balance of payments in complete if on the other hand more realisticallyMPSgt0KlMPSMPM and the induced increase in M falls shorts of the increase in X and the adjustment is incomplete TRENDS IN INDIA S BOP The true index of economic prosperity or disparity of a country in relation to the other countries of the world is provided by the balance of payments account A typical problem of the developing countries is that of a chronic BOP deficit India being no exception This mainly due to unequal sharing of gain from trade deterioration in underdeveloped countries Terms of Trade India has been facing BOP disequilibrium right since independence culminating into a disaster in 199091 the year of the acute BOP crisis Indian foreign reserves fell below 1billion barely sufficient to finance a month s import bill India approached the International Bank for Reconstruction and Development IBRD popularly known as World Bank and the International Monetary Fund IMFand received 7billion as loan to manage the crisis For available the loan these international agencies expected India to liberalise and open up the economy by removing restrictions on the private sector reduce the role of the government in many areas and remove trade restrictions International Economics Page 53 School of Distance Education BOP situation prereform period The India s BOP always under pressure and had huge deficits due to high imports of food grains and capital goods the heavy external borrowings and its payment and poor exports India s aim after attaining independence was to attain economic self reliance For this the country had to tap both the internal as well as the external resources Not only was our technology backward then there was food scarcity too Large amounts of food grains had to be imported to feed the huge population Self reliance was to be achieved through import substitution For this basic industries had to be set up which required import of capital goods Heavy capital goods were imported but other imports were severely restricted to shut off competition in order to promote domestic industries All focus was on import substitution with gross neglect of exports Such inward looking protectionist policies did result in some selfreliance in the consumer goods industries but the capital goods industries remained mostly import intensive The high degree of protection to Indian industries led to inefficiency and poor quality products due to lack of competition The high cost of production further eroded our competitive strength These are the some internal factors that causes for the deficit in BOP Rising petroleum products demand the two oil shocks harvest failure all put severe strain on the economy The BOP situation remained weak throughout the 19803 till it reached the crisis situation in 199091When India was on the verge of defaulting due to heavy debt burden and constantly widening trade deficit India had to resort to large scale foreign borrowings for its developmental efforts in the field of basic social and industrial infrastructure The country s resources were very much limited due to low per capita income and savings The situation worsened because Government of India resorted to heavy foreign borrowings to correct the BOP situation in the short run out of panicky By 19851990 India had to resort to large scale foreign borrowings for its developmental efforts in the field of basic social and industrial infrastructure The country s resources were very much limited due to low per capita income and savings The situation worsened because Government of India resorted to heavy foreign borrowings to correct the BOP situation in the short run out of panicky India mainly primary product exporters the price of which uctuated heavily with uctuations in world market demand Primary products exporting countries have an unfavorable term of trade The earnings from primary product exports were low and unstable The quality of Indian products was not up to the world standards due to which we could not sustain markets The instability of the exchange value of the rupee was another problem The constant devaluations to promote exports raised the amount of external debt The value of rupee was managed by the central bank fixed exchange rateThe strict foreign exchange controls also encouraged hawala trade India followed a strongly inward looking policy laying stress on import substitution Ideally imports should be financed by export earnings But because there was export pessimism the deficit was financed either by the invisible earnings or by foreign aid or depletion of valuable foreign exchange reserve India s BOP was thus beset with several problems The process of liberalization began from the mid 19805 Restriction on certain imports were removed particularly those which were used as inputs for export production But by then the situation was already bad and all the mismanagement ultimately led to the 199091 BOP crisis International Economics Page 54 School of Distance Education TRENDS IN INDIA S BOP POST AND PRE REFORM PERIODS It is clear from the Table1 the Balance of Payment situation started improving since 1991 except for the years 199596 and 200809 The reasons for satisfactory performance of BOP are as follows High earnings from invisibles The positive earnings from invisibles covered a subpart of the trade deficit with the result that the account deficit was reduced Significantly Earning invisibles exceeds the deficit on trade account in 2001022002 03and 200304 with the result that there surplus on current account in these years The software exports and private remittances that are the main new contributors to improve in the balance of payment Situation recently Rise in external commercial borrowing External commercial borrowings have been an important source of funds for the government Over the years the net external commercial borrowings have increased In 199192 the external commercial borrowing was1456 million During 200102 to 200304 external commercial borrowing were negative During 200708 the external commercial borrowing were 22609 million which was 210 percent or onefifth of total capital in ownet In 200809 external commercial borrowings were only 7941 million NonResident deposits The nonresident deposits add to the capital account of BOP In 199091 nonresident deposits net were 15 US billion which increased to 29 US billion in 200910 The various schemes of incentives announced by Indian government helped in attracting huge deposits from nonresident Indians Role of Foreign Investment Foreign investment is constituted of 1foreign direct investment and 2 portfolio investment portfolio investment in turn consists of a foreign institutional investment and b euro equities and others which includes Global Depository Receipts GDRS American Depository Receipts ADRS and Offshore funds and othersSince 1991 the govt has been offering various concessions facilities and incentive to the foreign investors with a view to encouraging foreign investment into the country These measures have helped in increasing foreign investment substantially in the recent years In 199394 the foreign was 4235 million which was 43 percent of the total capital in owsnet of 9882 million in the country In 200203 it was 4161 million and rose to 14753 million in 200708 and 3467 million in 200809 because of Global recession investors withdrawal of portfolio investment International Economics Page 55 School of Distance Education Table1 India39s BOP Indicators 19802012 US million Year Trade Net Balance cur Balance cap Overall Reserve Items Balance Invisibles ac ac balance increase 198081 7869 5065 2804 1665 1140 654 198182 7273 4094 3179 657 2523 1812 198283 6978 3572 3407 2087 1319 649 198384 6714 3499 3216 2655 561 750 198485 5654 3238 2417 3147 730 779 198586 7833 2967 4867 4506 361 577 198687 7316 2756 4560 4512 47 573 198788 7168 2316 4852 5047 195 737 198889 9361 1364 7997 8064 68 1001 198990 7456 615 6841 6977 136 740 199091 9437 242 9680 7188 2492 1278 199192 2798 1620 1178 3777 2599 3384 199293 5447 1921 3526 2936 590 698 199394 4056 2897 1159 9694 8535 8723 199495 9049 5680 3369 9156 5787 4644 199596 11360 5447 5912 4690 1222 2937 199697 14815 10196 4619 11412 6793 5818 199798 15507 10008 5499 10010 4511 3893 199899 13246 9208 4038 8260 4222 3829 199900 17841 13143 4698 11100 6402 6142 200001 12460 9794 2666 8535 5868 5842 200102 11574 14974 3400 8357 11757 11757 200203 10690 17035 6345 10640 16985 16985 200304 13718 27801 14083 17338 31421 31421 200405 33702 31232 2470 28629 26159 26159 200506 51904 42002 9902 24954 15052 15052 200607 61782 52217 9565 46171 36606 36606 200708 91467 75731 15737 107901 92164 92164 200809 119519 91605 27915 7835 20079 20080 200910 118202 80022 38180 51622 13441 13441 201011 130593 84648 45945 58996 13050 13050 201112 189759 111604 78155 65324 12832 12831 Source RBI Hand book of statistics on Indian Economy From the table1 it is clear that India s trade balance shows a deficit through out all years which is shown in the figure1The intensity of deficit shows an increasing rate It is because of a continuous and faster increase in import compared to its export After 200405 India s trade balance shows a much more higher International Economics Page 56 School of Distance Education deficit mainly due to increase in crude oil price in international market depreciation of Indian currency which worsen the import bill fall in export earnings due the financial crisistable3 Fig3 India s current account also re ects a continuous deficit in all years except 2001 02 200203 200304It is because of strong capital in ows during that periods It is shown in fig2Current account deficit is comparatively low when we compared to trade deficit it is because higher earnings from invisibles which covers huge part of trade deficit In capital account all years appear with a surplus value There is a low capital in ow during 200809 periods because of high withdrawal of portfolio investment due the financial crisis It also affects overall balance of payment of our country The overall balance of payment of our county shows a uctuating tends In 198081 to 198384 198586 to 198687 199091 199697 200809 and 201112 shows a deficit trend Figl India39s Trade balance amp Net invisibles 19802012 150000 100000 Trade Balance 50000 Net Invisibles 0 50000 100000 150000 200000 250000 Years Trade balance amp Net invisibles Fig2 India39s Current amp Capital ac 19802012 150000 Balance cur ac 100000 Balance cap ac I 50000 Years 50000 100000 curac bal amp cap ac balance International Economics Page 57 School of Distance Education Fig3 India39s Overall balance amp Reserves 9 Overall balance 150000 I Reserveincrease 0 100000 a E a 50000 a a oi 0 a 8 2 50000 B 0 100000 E 0 150000 Years Fig4 India39s BoP indicators in terms of GDP ExportGDP ImportGDP Trade Balance lnvisibles netGDP Cur ac BalanceGDP 0303030303 1 1 1 1 1 20 1 FYea rs lmporGDP ExportGDP Trade balGDPCur ac IGDP CONCLUSION The balance of payment of a country is a systematic record of all economic transactions between the residents of the country and the rest of the world It presents a classified record of all receipts on account of goods exported services rendered and capital received by residents and the payments made by them on account of goods imported and services received and capital transferred to nonresidents or foreigners Balance of Payment manual for India September 2010 The main purpose of the balance of payment is to inform the govt of the international position of the nations and to help it its formulation of monetary fiscal and trade policiesThe transactions are presented in forms of doubleentry book keeping That means the transactions are classified as credit or debit Credit transactions are those that involve the receipts of payments from foreigners The export of goods and services unilateral transfers from foreigners and capital in ows are credited and entered with a positive sign Debit transactions are those that involve the making payments to foreigners The import of goods and services unilateral transfers to foreigners and capital out ows are debited and entered with a negative sign Each transaction is recorded twice once as a credit and once as a debit of an equal amount This is known as doubleentry book keeping If a nation s in ows are greater than its out ows credit gt debit the BOP said to be in surplus If a nation s out ows are greater than its in ows debitgt credit the BOP said to be in deficit International Economics Page 58