International Economics Notes

Introduction to International Economics

• The study of international trade and finance is fundamental to economics.
• David Hume's essay “Of the Balance of Trade” (1758) is considered an early economic model.
• British trade policy debates in the 19th century shaped economics into a model-oriented subject.
• International economics is highly relevant in the modern era due to increasing global interconnectedness.
• Nations are linked through trade, money flows, and investment.
• The global economy is turbulent, requiring policymakers and business leaders to monitor international economic changes.
• Figure 1-1 shows U.S. exports and imports as a share of GDP from 1960 to 2015.
  • There has been a long-term upward trend in both exports and imports.
  • International trade has tripled in importance relative to the overall economy.
  • Imports have grown more than exports, leading to a trade deficit.
  • The U.S. pays for imports through capital inflows from foreign investments.
  • The import-export gap indicates growing linkages between national capital markets.
  • Both imports and exports declined during the 2008 global economic crisis.

The Importance of International Economic Relations

• International economic relations are crucial for the United States and even more so for other nations.
• Figure 1-2 shows the average of imports and exports as a share of GDP for various countries.
• The United States relies less on international trade due to its size and diverse resources.
• This text introduces concepts and methods of international economics using real-world applications.
• Old ideas, such as those of David Ricardo and David Hume, remain relevant.
• The economic crisis that began in 2007 presented new challenges.
• Economists have applied existing analyses and developed new approaches to address these challenges.

Learning Goals of International Economics

• Distinguish between international and domestic economic issues.
• Explain recurring themes in international economics and their significance.
• Differentiate between trade and monetary aspects of international economics.

Core Principles of International Economics

• International economics uses the same analytical methods as other branches of economics.
• Individuals' motives and behavior are consistent across domestic and international transactions.
• International trade involves sovereign states, which creates unique concerns.
• Events like quotas on imports or currency devaluation can significantly impact international trade.

Seven Themes in International Economics

1. Gains from trade.
2. Patterns of trade.
3. Protectionism.
4. Balance of payments.
5. Exchange rate determination.
6. International policy coordination.
7. International capital market.

Gains from Trade

• International trade is generally beneficial for all countries involved.
• Skepticism exists regarding trade of goods that a country could produce itself.
• There are gains from trade under a wide range of circumstances.
• Concerns about disparities in productivity or wages are common misconceptions.
• Countries can mutually benefit from trade even with large differences in efficiency.
• Trade allows countries to export goods using abundant resources and import goods using scarce resources.
• International trade enables specialization and large-scale production efficiencies.
• International migration and borrowing/lending are mutually beneficial forms of trade.
• Exchange of risky assets diversifies wealth and reduces income variability.
• Trade can affect income distribution within nations, harming specific groups.

Effects on Income Distribution

• Trade can negatively impact owners of resources specific to import-competing industries.
• Examples include specialized machinery or workers with specific skills.
• Trade can alter income distribution between workers and capital owners.
• Declining real wages for less-skilled workers in the U.S. are attributed to growing international trade.
• Assessing this claim is a task for international economists.

Patterns of Trade

• Explaining observed international trade patterns is crucial for economists.
• Some trade patterns are easily explained by climate and resources.
• More subtle patterns require theories, such as those based on labor productivity (Ricardo) or relative supplies of resources.
• Some theories suggest a random component and economies of scale in trade patterns.

Protectionism

• Governments worry about the impact of international competition on domestic industries.
• They use protectionist policies (limits on imports, export subsidies) to shield or help industries.
• A consistent mission of international economics is to analyze the effects of protectionist policies.
• Economists generally criticize protectionism and advocate for freer trade.
• Post-World War II, advanced democracies pursued removing barriers to international trade.
• Agreements like NAFTA and the establishment of the World Trade Organization (WTO) reflect this.
• A backlash against “globalization” has emerged, with events like Brexit and concerns over job losses.
• Free trade advocates are under pressure to explain their views.

Analytical Framework for Trade Policies

• Economists have developed a framework for determining the effects of government policies on trade.
• This framework predicts the effects of trade policies and allows for cost-benefit analysis.
• It helps define criteria for when government intervention is beneficial.
• Governments do not always follow economists' recommendations.
• Economic analysis helps understand the politics of trade policy by showing who benefits and who loses.

Conflicts of Interest

• Conflicts within nations are often more important than conflicts between nations in determining trade policy.
• Trade has strong effects on income distribution within countries.
• The relative power of interest groups is a key factor in government policies.

Balance of Payments

• A country's balance of payments must be analyzed in an economic context.
• Trade surpluses and deficits have different implications depending on the circumstances.
• The balance of payments is relevant in discussions of foreign direct investment, national income accounting, and international monetary policy.
• This has become a central issue for the U.S. due to large trade deficits since 1982.

Exchange Rate Determination

• Exchange rates can change drastically over time.
• The study of exchange rate determination is a relatively new area of international economics.
• Historically, exchange rates were fixed by government action (e.g., the gold standard).
• The analysis of fixed exchange rate systems remains important.
• Fluctuating exchange rates play a central role in international economics.

International Policy Coordination

• In an integrated world economy, one country’s economic policies affect others.
• Differences in goals among countries can lead to conflicts.
• Coordination of international trade and monetary policies is needed.
• The General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO) govern international trade policies.
• Macroeconomic policy coordination is a newer and more uncertain area.

International Capital Market

• Sophisticated economies have extensive capital markets.
• The international capital market links the capital markets of individual countries.
• Oil-rich nations invest in banks, which then lend to governments and corporations.
• Japan invested export earnings in the U.S. during the 1980s.
• China is now investing export earnings in foreign assets.

Differences between Domestic and International Capital Markets

• International capital markets face special regulations and offer opportunities to evade domestic regulations.
• Currency fluctuations pose a risk to investors.
• National default is a risk, with limited recourse for creditors.
• Global asset markets and foreign borrowing by developing countries are key issues.

Trade and Money

• The economics of the international economy can be divided into international trade and international money.
• International trade focuses on real transactions involving physical goods or economic resources.
• International monetary analysis focuses on financial transactions.
• There is no simple dividing line between trade and monetary issues.

World Trade Statistics

• In 2015, world production totaled approximately $74 trillion.
• World trade in goods and services exceeded $21 trillion, about 30% of total production.
• Later chapters will analyze why countries trade, the benefits and costs of trade, and government policies.
• This chapter begins by describing who trades with whom.

The Gravity Model of Trade

• The gravity model helps explain the value of trade between countries.
• It sheds light on impediments that limit international trade.
• Recent decades have seen an increase in the share of world output sold internationally.
• There has been a shift in the world’s economic center towards Asia.
• Major changes have occurred in the types of goods traded.

Who Trades with Whom?

• Figure 2-1 shows total U.S. trade with its top 15 trading partners in 2015.
• These 15 countries accounted for 75% of U.S. trade.
• Factors determining trade patterns include size, distance, barriers, and borders.

Size Matters: The Gravity Model

• Trade is heavier with larger European economies (Germany, UK,France).
  *Gross Domestic Product (GDP) measures total value of goods and services produced in an economy.

• There is a strong relationship between a country’s economy size and its import/export volume.

• T{ij} = A * Yi * Yj / D{ij}

• Where:

  • T_{ij} is the value of trade between country i and country j.
  • Y_i is country i’s GDP.
  • Y_j is country j’s GDP.
  • D_{ij} is the distance between the two countries
  • A is a constant term

• The value of trade is proportional to the product of GDPs and diminishes with distance. This is analogous to Newton’s law of gravity.

• A more general form of the gravity model:

  • T{ij} = A * Yi^a * Yj^b / D{ij}^c
  • Where a, b, and c are chosen to fit data.

• Large economies import and attract large shares of other countries’ spending.

Limitations

• Countries spend much of their income at home.
• The U.S. and EU account for 25% of world GDP but attract only 2% of each other’s spending.
• To understand actual trade flows, we must consider factors limiting international trade.

Using the Gravity Model: Looking for Anomalies

• Gravity models help identify anomalies in trade, where trade is more or less than predicted.
• Netherlands, Belgium, and Ireland trade more with the U.S. than predicted.

Ireland’s Case

• Cultural affinity with the U.S. (language, ancestry).
• Host to many U.S.-based corporations.

Netherlands and Belgium’s Case

• Geography and transport costs.
• Located near the mouth of the Rhine River, a major European waterway.
• Rotterdam (Netherlands) and Antwerp (Belgium) are major European ports.
• Transport costs and geography significantly affect trade volume.

Impediments to Trade: Distance, Barriers, and Borders

• Canada and Mexico trade more with the U.S. than European economies of equal size.
• Canada, with a similar economy size to Spain, trades as much with the U.S. as all of Europe does.

Distance

• Estimated gravity models show a negative effect of distance on international trade.
• A 1% increase in distance is associated with a 0.7% to 1% fall in trade.
• Increased costs of transporting goods and services.
• Less tangible factors: diminished personal contact.

Barriers and Borders

• Canada and Mexico are part of NAFTA, ensuring few trade barriers with the U.S.
• Trade agreements increase trade among partners.
• National borders still matter, even with free trade agreements.
• There is more trade between regions of the same country than between equivalently situated regions in different countries.
• The Canadian-U.S. border deters trade as if the countries were 1,500 to 2,500 miles apart.

The Changing Pattern of World Trade

• World has not always become smaller due to transportation and communications progress.
• Political forces can outweigh technology effects.
• There have been two great waves of globalization.
  • The first wave relied on railroads, steamships, and the telegraph.
  • The second wave relies on jets and the Internet.

Globalization

• Global economy with strong linkages between distant nations is not new.
• John Maynard Keynes described globalization surge ending in 1914.
• World wars, the Great Depression, and protectionism depressed world trade.
• Globalization returned to pre-World War I levels in the early 1970s.
• Since then, world trade as share of world production has risen to unprecedented heights

Vertical Disintegration of Production

• Cross-shipping of components increases trade flows.
• A $100 product can lead to $200 or $300 of international trade flows.

What Do We Trade?

• Main trade is manufactured goods (automobiles, computers, clothing).
• Mineral products (oil) and agricultural products also key.
• Services play an important role and are expected to grow.

Types of Service Exports

• Traditional transportation fees, insurance fees, and spending by foreign tourists.
• New services made possible by telecommunications (overseas call and help centers).

Service Offshoring and Outsourcing

• Shifting a service previously done within a country to a foreign location.
• Firms decide whether to set up a foreign subsidiary or outsource those services to another firm.
• The key distinction will be between services that can be delivered electronically and those that cannot.

Service Sector Examples

• The worker who restocks shelves at your local grocery has to be on site, but the accountant who keeps the grocery’s books could be in another country, keeping in touch over the Internet.
• The nurse who takes your pulse has to be nearby, but the radiologist who reads your X-ray could receive the images electronically anywhere that has a high-speed connection.

Tradable Industries

• 60% of total U.S. employment consists of jobs that must be done close to the customer, making them nontradable.
• 40% of employment that is in tradable activities includes more service than manufacturing jobs.
• Trade in services, delivered electronically, may become the most important component of world trade.

Historical Perspective

• Current picture of manufactured goods dominating trade is new.
• Historically, primary products (agricultural and mining goods) were more important.
• The share of manufactured goods in trade has increased significantly.

Developing-Country Exports

• Developing countries have shifted from primary products to manufactured goods exports.
• Over 90% of China’s exports are manufactured goods.