International Trade and Finance

Why do countries trade?

Divergent opportunity costs, where countries can focus resources on G+S they have a comparative advantage on, such that they can increase production and GDP

When does a country have a comparative advantage over another country?

When they can produce a good at a lower opportunity cost than any other country

How does international trade create gains for countries?

It’s Cheaper to buy than to produce

• E.g. if the rest of the world buys UK chemicals, which is has a CA on, then countries can decrease their production of chemicals, move along their PPF, and be able to buy more chemicals for the same number of cars

Note: UK can now consume at any point along the trade line

What are some other advantages of international trade?

• Permits exploitation of economies of scale, supporting small countries who may not have a large enough domestic market

• Increases choice, through the proliferation of differentiated products

• Promotes competition by breaking down local monopolies

• Leaning by doing decreases costs due to the large scale of production

Who are the winners and losers of international trade for an importing country

Price decreases after trade

• Consumers gain as the pay less and buy more, increasing CS

• Producers lose as the receive less, produce less and have a smaller PS

• Consumers’ gain exceeds producers’ loss, so total surplus increases

Who are the winners and losers of international trade for an exporting country?

Price increases after trade

• Producers gain as they receive a higher price, produce more and receive a larger PS

• Consumers lose as they pay more and buy less, decreasing CS

• Gain in PS exceeds loss in CS, so total surplus increases

What is a tariff, and how does it work?

• Tax imposed by the importing country when an imported good crosses int’l boundaries

• By imposing a tariff, it increases producer surplus whilst decreasing consumer surplus, reducing imports but creating a DWL in the process

What is a quota, and how does it work?

• It’s a limit of the quantity of a good that can be imported

• By putting a limit on imports, it shifts the domestic supply curve right, meaning new equilibrium is at a higher quantity and lower price, increasing CS and decreasing PS, but imposing a DWL in the process

What are the arguments for protectionist policies?

• National security argument

• Infant-industry argument (e.g. post WW2 Japan)

• Saves jobs

What are the arguments against protectionist policies?

• Consumers pay higher prices

• Resources moved from an efficient to inefficient use

• Can’t export if we don’t import

• Protection could invite retaliation

What is the Balance of Payments, Credit and Debit?

• Balance of Payments = Record of a country’s transactions (Trading, borrowing and lending) with the rest of the world

• Credit = Payments by foreigners

• Debit = Payments to foreigners

What is a current account, and what does it include?

It records transactions in G+S

Includes:

• Payments for imports

• Receipts for exports

• Net interest paid abroad

• Net transfers

Current account balance = X - M + Net interest income + Net Transfers

When is the current account in deficit or surplus, and what must it do to rectify it?

Deficit when X - M < 0

• Must borrow from foreigners or sell assets

Surplus when X - M > 0

• Must make loans to foreigners or buy some of their assets

What does the capital account show, and what happens when a country is a net borrower/lender?

Capital account = S - I (Net capital outflow)

Net borrower (S<I):

• Capital inflow needed: Purchase of domestic assets by foreigners

Net lender (S>I):

• Capital outflow needed: UK purchases foreign assets

What is a key condition of the balance of payments, and what must be done in order to maintain this state?

BOP must always balance

• Sum of current and capital accounts must always equal zero

• Any difference needs to be compensated by a change in foreign currency reserve holdings

  • Countries with current account surplus acquire foreign assets

  • Countries with current account deficit sell assets