International Economics: Trade and Finance Lecture Notes

Foundations and Importance of International Economics

International economics is concerned with the complex interactions between nations through the trade of goods and services, the flow of money, and international investment. Although it is an old subject, its importance continues to grow in the 21st century as nations have never been as closely linked as they are today. Increased globalization has heightened market volatility, which requires decision-makers to closely monitor international economic shifts. In the United States, exports and imports as shares of the gross domestic product ($\text{GDP}$) have been on a significant upward trend, with international trade roughly tripling in importance compared to the economy as a whole over the past 60 years. However, both imports and exports saw substantial declines during the 2009 recession and again in 2020 due to the COVID-19 pandemic. Compared to the United States, other countries are even more tied to international trade, with their trade shares of $\text{GDP}$ being substantially higher. The United States relies less on international trade than almost any other country due to its sheer size and broad diversity of resources.

The Gains from Trade and Trade Patterns

The most important insight in all of international economics is that there are gains from trade. When countries sell goods and services to each other, mutual benefits are almost always generated. In a voluntary transaction between a buyer and a seller, both parties can be made better off. Even a country that is the most efficient producer of everything can gain from trade by specializing in goods made with relatively abundant resources and importing those made with relatively scarce resources. Specialization allows for greater efficiency due to large-scale production. Nations also gain by trading current resources for future resources and through international migration. However, trade may also harm specific groups within a country, particularly the owners of resources used intensively in industries that compete with imports. This can affect the distribution of domestic income. The pattern of trade describes who sells what to whom and stems from differences in labor productivity as well as relative supplies of capital, labor, and land.

Government Policies and International Finance

Policy makers influence the amount of trade through various instruments including tariffs, which are taxes on imports or exports, and quotas, which are quantity restrictions. Other measures include export subsidies, which are payments to producers to encourage trade, and regulations that exclude foreign products. Governments often choose trade policies to cater to specific interest groups rather than to maximize national welfare, typically adopting tariffs and then negotiating them down for reciprocal reductions in trade barriers. International finance involves the exchange of risky assets to reduce income variability through diversification. Governments track these interactions through the balance of payments, which measures the value of imports, exports, and financial asset flows. Trade deficits occur when the value of imports exceeds exports. Central banks use these accounts to manage official international payments, with all values recorded in national income accounts.

Exchange Rates and Capital Markets

Exchange rates are a critical financial issue for governments as they determine how much domestic currency can be exchanged for foreign currency. This affects the cost of imports denominated in foreign currency and the price of exports in foreign markets. Some exchange rates fluctuate continually while others remain fixed. In an integrated global economy, economic policies in one country affect others, necessitating policy coordination depending on the exchange rate regime. International capital markets are arrangements where individuals and firms exchange money now for promises of future payment. These markets must cope with special regulations, risks of currency fluctuations, and the possibility of national default, though they sometimes offer opportunities to evade domestic market regulations. International trade primarily focuses on the movement of goods and services, while international finance focuses on monetary and financial transactions.

World Trade and the Gravity Model

More than 30% of world output is currently sold across national borders, with world trade in goods and services exceeding $25 \times 10^{12}\,\text{USD}$ in 2019. The top 15 trading partners of the United States account for 75% of its trade value, with Mexico, Canada, China, Japan, and Germany being the five largest in 2019. The gravity model assumes that the volume of trade between two countries is determined by their economic size and the distance between them. The general formula is $T_{ij} = A \times \frac{Y_i^{a} \times Y_j^{b}}{D_{ij}^{c}}$, where $T_{ij}$ is the trade value, $A$ is a constant, $Y_i$ and $Y_j$ are the respective GDPs, and $D_{ij}$ is the distance. Larger economies produce more to sell and generate more income to buy imports. While the model fits U.S. trade with Europe well, countries like the Netherlands, Belgium, and Ireland trade more than predicted. Ireland's trade is bolstered by cultural affinity and U.S. multinational corporations, while the Netherlands and Belgium benefit from strategic locations and transport cost advantages.

Barriers to Trade and Globalization

Beyond size and distance, factors such as cultural affinity, geography, multinational corporations, and borders influence trade. Common languages and history lead to strong economic ties, while ocean harbors facilitate easier transport. Crossing borders involves formalities, different currencies, and monetary costs like tariffs. The gravity model predicts that a 1% increase in distance is associated with a 0.7% to 1% decrease in trade volume. Trade agreements like NAFTA (1994), replaced by the USMCA in 2020, aim to reduce these barriers. Despite free trade agreements, physical borders remain significant; Canadian provinces trade much more with each other than with U.S. states of equal distance. The U.S.-Canada border effect is estimated to be equivalent to adding an extra $1,500$ to $2,500$ miles of physical distance. Globalization has occurred in two waves: the first relied on railroads, steamships, and the telegraph, while the modern wave relies on jets and the internet. Trade grew from 1870 to 1913, declined during the world wars and the Great Depression, and reached unprecedented heights after 1970.

The Changing Composition of International Trade

The composition of world trade has shifted significantly. Today, approximately 70% of trade volume is in manufactured products (such as automobiles and computers), while fuels and mining products make up 15%, and agricultural products account for 10%. In the past, such as in 1910, Britain and the U.S. primarily imported agricultural and mineral products. Low and middle-income countries have also seen a shift; in 1960, 58% of their exports were agricultural, but by 2001, 65% were manufactured. China now sees more than 90% of its exports as manufactured goods. Service outsourcing or offshoring occurs when firms move service operations to foreign locations via electronic transmission. While some jobs are tradable, approximately 60% of services must be performed near the customer and are thus nontradable. Modern trade is increasingly driven by human-created resources rather than natural resources, leading to political battles regarding workers whose skills are devalued by imports.

The Ricardian Model of Comparative Advantage

The Ricardian model is based on the concept of opportunity cost, which measures the cost of not being able to produce one good because resources are used for another. In a one-factor economy where labor is the only factor of production, labor productivity varies across countries due to technology but remains constant within each country. For a two-good economy (wine and cheese), the unit labor requirement ($a_{Li}$) indicates the hours of labor required to produce one unit of output. A high unit labor requirement implies low labor productivity. The Production Possibility Frontier ($\text{PPF}$) is defined by the equation $a_{Lc} \times Q_{c} + a_{Lw} \times Q_{w} \le L$, where $L$ is the total labor supply. If $L = 1000$, $a_{Lc} = 1$, and $a_{Lw} = 2$, the maximum cheese production ($Q_{c,max}$) is $1000$ and maximum wine production ($Q_{w,max}$) is $500$. The opportunity cost of cheese in terms of wine is given by the ratio $\frac{a_{Lc}}{a_{Lw}}$, which is the absolute value of the slope of the $\text{PPF}$.

Relative Prices, Wages, and Specialization

In the Ricardian model, hourly wages in the cheese industry ($W_{c}$) and wine industry ($W_{w}$) are determined by the price of the good and the unit labor requirement: $W_{c} = \frac{P_{c}}{a_{Lc}}$ and $W_{w} = \frac{P_{w}}{a_{Lw}}$. Workers will migrate to the industry paying the higher wage. If \frac{P_{c}}{P_{w}} > \frac{a_{Lc}}{a_{Lw}}, the economy specializes entirely in cheese. If \frac{P_{c}}{P_{w}} < \frac{a_{Lc}}{a_{Lw}}, it specializes in wine. If $\frac{P_{c}}{P_{w}} = \frac{a_{Lc}}{a_{Lw}}$, workers are indifferent and both goods are produced. In the absence of trade, the relative price of a good must equal its opportunity cost. Comparative advantage occurs when one country has a lower opportunity cost for a good than another country. Even if a country has an absolute advantage (produces more efficiently in all sectors), it still benefits from specializing according to comparative advantage and trading. World relative supply ($RS$) is calculated to determine the relative price after trade. If the world relative price falls between the two countries' opportunity costs, both countries specialize and benefit.

Heckscher-Ohlin Model of Resource Endowment

The Heckscher-Ohlin theory argues that trade patterns are determined by differences in labor, skills, capital, and other factors of production. Different production processes use these factors with varying relative intensities. As the wage ($w$) increases relative to the rental rate of capital ($r$), producers substitute labor for capital. The Stolper-Samuelson theorem suggests that an increase in the relative price of a good will raise the real income of the factor used intensively in its production and lower the real income of the other factor. For example, if cloth is labor-intensive, an increase in the relative price of cloth raises real wages for workers and lowers returns for capital owners. The Rybczynski effect states that if an economy's labor force grows, the expansion of production possibilities is biased toward the labor-intensive good (cloth), potentially leading to a contraction in the capital-intensive good (food). The Heckscher-Ohlin theorem concludes that countries export goods that intensively use the factors they possess in abundance.

The Standard Model of Trade and Welfare

The standard trade model combines production possibilities with relative supply and demand. An economy maximizes output value by producing where the $\text{PPF}$ is tangent to the isovalue line, where the slope equals $-\frac{P_{c}}{P_{f}}$. An increase in the relative price of cloth ($\frac{P_{c}}{P_{f}}$) makes the isovalue line steeper, shifting production toward cloth and increasing relative supply. Consumption is determined by indifference curves, which represent combinations of goods that provide equal satisfaction. A higher relative price for exports improves a country's terms of trade, which is the price of exports relative to the price of imports. An increase in the terms of trade increases national welfare. Growth can be export-biased (expanding the export sector) or import-biased (expanding the import sector). Export-biased growth tends to worsen a country's terms of trade, while import-biased growth improves them. Intertemporal trade treats current and future consumption as two different goods, where the price of future consumption relative to current consumption is $\frac{1}{1+r}$, with $r$ being the real interest rate.

Economies of Scale and Market Structure

Economies of scale occur when larger production volumes lead to lower average costs. External economies of scale depend on the size of the industry and typically result in many small competitive firms. Internal economies of scale depend on the size of the firm and result in imperfectly competitive markets. External economies are driven by specialized equipment, labor pooling, and knowledge spillovers. This can lead to a forward-falling supply curve, where higher output reduces prices. Trade based on external economies can be influenced by historical accidents; an established producer may remain competitive even if another country could potentially produce more cheaply. Dynamic increasing returns to scale arise when costs fall as cumulative output increases over time, represented by a learning curve. This is sometimes used as a justification for the infant industry argument, though temporary protection can be hard to remove. In internal economies, integration allows better-performing firms to expand while others exit, improving overall industry efficiency.

Monopolistic Competition and Firm Responses to Trade

In monopolistically competitive industries, firms differentiate their products and treat rivals' prices as given. A firm's sales ($Q$) are modeled as $Q = S \times [\frac{1}{n} - b \times (P - \bar{P})]$, where $S$ is total industry sales, $n$ is the number of firms, $b$ is a responsiveness constant, $P$ is the firm's price, and $\bar{P}$ is the average price. Equilibrium occurs where the price-setting curve ($PP$) intersects the average cost curve ($CC$). As $n$ increases, competition lowers prices but increases average costs because each firm produces less. Trade increases the market size ($S$), which decreases average costs and increases product variety, benefiting consumers. Intra-industry trade refers to the two-way exchange of similar goods. Trade costs, like a transport cost $t$, mean that only the most productive firms (those with the lowest marginal costs) will export. Dumping is the practice of charging lower prices for exports than for domestic sales. Foreign Direct Investment ($\text{FDI}$) involves a firm owning at least 10% of a subsidiary in another country, classified as either Horizontal $\text{FDI}$ (replicating production) or Vertical $\text{FDI}$ (breaking up the production chain).

Instruments of Trade Policy and Their Effects

Trade policy tools include tariffs, which create a wedge between national and international prices. For a large country, a tariff lowers the foreign price and raises the domestic price, leading to a domestic supply increase and a demand decrease. The welfare change is calculated as $e - (b + d)$, where $b$ and $d$ are efficiency losses (distortions) and $e$ is the terms of trade gain. For a small country, the terms of trade gain ($e$) is zero, and the tariff always reduces welfare. The Trump administration's tariffs (2018\u20132019) on Chinese goods increased costs for U.S. households by $300\,\text{USD}$ to $900\,\text{USD}$ annually. Export subsidies always damage national welfare by worsening terms of trade and creating efficiency losses. Import quotas restrict quantity and generate quota rents for license holders rather than government revenue. For instance, the U.S. sugar quota costs consumers roughly $3.5\,\text{billion}\,\text{USD}$ annually ($11\,\text{USD}$ per person) and benefits producers by $3.9\,\text{billion}\,\text{USD}$; eliminating it would create $17,000$ to $20,000$ jobs in food production at the cost of only $500$ to $2,000$ sugar industry jobs.

Exchange Rates and the Foreign Exchange Market

Depreciation is a decrease in a currency's value, making its exports cheaper and imports more expensive. Appreciation is an increase in value, making exports more expensive and imports cheaper. The foreign exchange ($\text{FX}$) market is dominated by commercial banks, with transactions often exceeding $1\,\text{million}\,\text{USD}$. Other participants include corporations, non-bank financial institutions, and central banks. Spot rates are for current exchanges, while forward rates are for future dates (e.g., 30, 90, 180 days). The demand for currency deposits depends on the expected rate of return. The dollar rate of return on euro deposits is approximately $R_{\text{\u20ac}} + \frac{E^e_{\$/\text{\u20ac}} - E_{\$/\text{\u20ac}}}{E_{\$/\text{\u20ac}}}$. Equilibrium in the $\text{FX}$ market occurs at interest parity: $R_{\$} = R_{\text{\u20ac}} + \frac{E^e_{\$/\text{\u20ac}} - E_{\$/\text{\u20ac}}}{E_{\$/\text{\u20ac}}}$. Covered Interest Parity ($\text{CIP}$) uses forward rates ($F_{\$/\text{\u20ac}}$) to remove exchange rate risk: $R_{\$} = R_{\text{\u20ac}} + \frac{F_{\$/\text{\u20ac}} - E_{\$/\text{\u20ac}}}{E_{\$/\text{\u20ac}}}$. Deviations from $\text{CIP}$ became significant during the 2007\u20132008 banking crisis and have persisted.

Price Levels and the Long-Run Exchange Rate

The Law of One Price states that identical goods in competitive markets must sell for the same price. Purchasing Power Parity ($\text{PPP}$) applies this to baskets of goods. Absolute $\text{PPP}$ states the exchange rate equals the ratio of average price levels, while Relative $\text{PPP}$ states that changes in exchange rates equal the difference in inflation rates ($\pi \approx \frac{\Delta P}{P}$). The Fisher effect suggests that in the long run, a rise in the domestic inflation rate leads to an equal rise in the nominal interest rate: $R_{\$} - R_{\text{\u20ac}} = \pi^e_{\text{US}} - \pi^e_{\text{E}}$. $\text{PPP}$ often fails due to trade barriers, nontradable services (like haircuts), imperfect competition, and differing price measurement baskets. Price levels are typically lower in poorer countries because non-tradables (which are labor-intensive) are cheaper due to lower wages. Balassa-Samuelson attributes this to productivity differences, while Bhagwati-Kravis-Lipsey attributes it to capital-labor ratios. Real interest rates are inflation-adjusted: $r^e = R - \pi^e$. Real interest parity says that differences in real interest rates between countries equal the expected change in the real exchange rate.