MGCR 382 (Part 1: International Finance & Economics)

What is international trade? Why does it occur?

The exchange of goods/services and money across different countries with the purpose to form political alliances, have better acquisition to unavailable resources, and expand an economy into the global market.

What are the Classical Country Based Trade Theories?

• Mercantilism

• Absolute Advantage

• Comparative Advantage

• Relative Factor Endowments (Heksher-Onlin Theory)

Mercantilism (Definition + Winners/Losers)

• A country’s wealth is determined by holdings of gold + silver

• Winners: Export Oriented Manufacturers, Domestic Manufacturers

• Losers: Government subsidies, Taxpayers, Government Import Restrictions

Absolute Advantage vs Comparative Advantage

A country should export most productive vs relatively productive goods and services and import less productive

Relative Factor Endowments/Hecksher-Onlin Theory (Definition + Examples)

• Countries trade with comparative advantage in products that intensively use resources and has abundance in

• Saudi Arabia = Oil Production (ARAMCO)

What are the Modern Firm-Based Theories?

• Country Similarity Theory (Interindustry + Intraindustry)

• New Trade Theory

What is the difference between intraindustry and interindustry trade? Examples?

Intraindustry trade refers to the trade of two countries for goods/services from the same industry while interindustry trade refers to goods/services from different industries

• Intraindustry = Japan and Germany trading cars, Toyota and BMW

• Interindustry = Canada and Portugal trading food and supplies, cod (fish) and cork

What is an important note of the Country Similarity Theory?

Trade should happen between countries with similar per-capita incomes

New Trade Theory

The impact of economies of scale on differentiated goods

Economies of Scale

If firm’s average cost of producing a good decreases as output of good increases

Country-Based vs Firm Based Theories of Trade

• Country (unit) → examines characteristics of a country (land, labour capital = FOP) to explain trade

• Firm (unit) → examines differences between firms (ownership advantage) to explain trade

Foreign Portfolio Investment - FPI (Definition + Example)

• Passive holdings of securities, none of which entails active management or control

• Stocks, bonds, assets

Foreign Direct Investment - FDI (Definition + Examples)

• acquisition of foreign assets for purpose of controlling them

• Manhattan Island

Supply Factors → FDI

• Production Costs

• Logistics

• Resource Availability

• Access to Technology

Demand Factors → FDI

• Customer Access

• Marketing Advantages

• Exploitation of Competitive Advantages

• Customer Mobility

Political Factors → FDI

• Avoidance of Trade Barriers

• Economic Development Incentives

Economic Rationales for Government Trade Intervention

• Fighting Unemployment

• Protecting Infant Industries

• Developing Industrial Base

• Economic Relationships with other Countries

Infant Industry Argument

The government should shield new industries from foreign competition by guaranteeing a share of domestic market

Industrialization Argument

The government should shield an established industry from foreign competition

What does it mean to Develop an Industrial Base?

• Import Substitution: restrict imports to boost local production

• Export-Led Development: promotion of developed industries with export potential

Important Aspects to Economic Relationships with other Countries

• Balance of Trade Adjustments

• Comparable Access Argument = Fairness

• Import Restrictions = Bargaining Tool → Trade War

• Export Restrictions → prevent dumping, foreign monopolies

Non-Economic Rationales for Government Trade Intervention (+ Examples)

• Maintaining Essential Industries = US Supply of Rare Earth Minerals

• Promoting Acceptable Practices Abroad = Iran (Nuclear Program), Brazil (Deforestation)

• Maintaining Sphere of Influence = Cotonu Agreement (EU, Africa, Caribbean, Pacific)

• Preserving National Culture (Japan, China, Korea → Rice import ban)

Tariffs (Definition + Types)

• Tax on an imported good (import, export, transit)

• Specific (Duty) = per-unit

• Ad Valorem = %

• Compound = mix of both

Subsidy vs Tied aid/loan

• Assistance by government to boost production + competitiveness

• Government requires foreign aid recipients to spend funds in donor country

Customs Valuation

Assesment of import tariff based on origin, price, and product

Quota (Definition + Types)

• A limit on quantity of production

• Import/Export

• Voluntary Export Restraint (VER) = quota variation asking for reduction

• Embargo = prohibits trade

Spot vs Forward Exchange Rates

• Price of one currency in terms of another delivered today

• Price of one currency in terms of another delivered in the future

Bid vs Ask

• Price (what you’re buying)

• Offer (what you’re selling)

Spread

Difference between selling and buying of rates

Arbitrage

Profit opportunities for simultaneously buying a currency in one market while selling in another

Direct vs Indirect Quotation

• Direct: no. of units of home currency per unit of foreign currency

• Indirect: no,. of units of foreign currency per unit of home currency

Impossible Trinity (Trilemma) with Examples

1. Stable Exchange Rates = Us in early 70s Bretton Woods

2. Full Financial Integration = China → regulation

3. Monetary Independence = Euro (Eurozone) → Greece

Fixed Exchange Rate (Definition + Types)

• Currency pegged to another currency

• Hard Peg = Bretton Woods → USD + Gold

• Soft Peg = Gold Standard

What is a crawling peg? Pros + Cons? Examples?

• Local currency depreciates against reference on regular controlled basis

• Allows to expansionary monetary policy

• Temporary regime choice

• China, Bolivia, Ethiopia

Floating Exchange Rate (Definition + Types)

• Not pegged, driven by the market

• Managed Float = Japan → once a while jump in

• Free Float = Western Economies

Pros of Fixed Exchange Rate

• Stability in international prices

• Anti-inflationary nature of fixed prices

Cons of Fixed Exchange Rates

• Need for central banks to maintain large quantities of hard currencies + gold

• Needs to be maintained at rates that are inconsistent with economic fundamentals

Gold Standard (1876 - 1913)

• Pegged to gold

• Gold reserves necessary to back a currency’s value

• Only works if gold can be moved across countries

Bretton Woods + IMF (1944)

• Fixed Exchange Rate

• $USD is convertible to gold

• Soft Peg = allowed to move ± 1%

• Devaluation (on purpose) NOT ALLOWED up to 10%

What is the IMF?

• International Monetary Fund

• Oversees exchange rate policies and advising on how to turn economies around

Eurocurrencies

Domestic currencies of one country on deposit in a a second country

Balance of Payments: Debit vs Credit

• Debit = outflow of money (negative)

• Credit = inflow of money (positive)

Sub accounts of Balance of Payments (BOP)

• Current Account

• Capital/Financial Account

• Official Reserves

• Net Errors and Omissions

Balance of Payments Formula

(X-M) + (CI-CO) + (FI-FO) + FXB = BOP

Current Account

• Goods Trade = import/export of goods (balance of trade)

• Service Trade = import/export of services

• Income = investments made in previous periods (wages, salaries, current investment income)

• Current Transfers = financial settlements, one-way transfers (gifts, grants), transfer payments (global remittance)

Capital Account

Capital transfers related to the purchase and sale of fixed assets (real estate)

Financial Account

• Net FDI

• Net FPI

• Other asset investment (trade credits, cross border loans, currency bank deposits)

What is Balance of Payments?

The measurement of all international economic transactions that take place between the residents of a country and foreign residents

What are Capital Controls?

Any restriction that limits/alters the rate or direction of capital movement into or out of a country

What are the purposes of Capital Controls?

• General Revenue/Financial War Effort

• Financial Repression/Credit Allocation

• Correct BOP Deficit/Surplus

• Prevent Potentially Volatile Inflows/Financial Destabilization/Real Appreciation

• Restrict Foreign Ownership of Domestic Assets

• Preserve Savings for Domestic Use

• Protect Domestic Financial Firms

Capital Flight

Rapid outflow of capital in opposition to or in fear of domestic political and economic conditions and policies

Currency Arbitrage

Profit opportunities for simultaneously buying a currency in one market while selling in another

Exchange Rate Regime Choice

J-Curve (Adjustment Path)

What are the steps of the J-Curve?

• Currency Contract Period: sudden devaluation of domestic currency

• Exchange Rate Pass Through Period: importers and exporters pass EX through own product prices

• Quantity Adjustment Period: achieves the balance of trade adjustment expected from currency devaluation/depreciation

What are the results of the J-Curve?

• increase in trade deficit

• increase in cost to importers

• revenues to exporters stays the same