MGCR 382 Midterm

Below is a comprehensive, textbook‐style synthesis of the key concepts and details covered in the slides from Sessions 2 through 11 of Winter 2025. This compilation is organized by topic areas, with new or unique information from each session included in its proper section. Repeated material has been consolidated for clarity.

1. Introduction and Overview

The course spans a wide range of topics in international business, with a dual focus on trade theory and international finance. The field map provided in the slides shows interconnected topics including trade theory, trade policy, exchange rate determination, the international monetary system, and the balance of payments. In this synthesis, we cover both classical and modern trade theories, government intervention in trade, and the fundamentals of international financial systems.

2. Trade Theory

2.1 Classical Country-Based Trade Theories

Mercantilism

• Definition: An early economic philosophy (16th century) where a country’s wealth was measured by its holdings of gold and silver.

• Key Principles:

  • Emphasis on achieving a favorable balance of trade by exporting more than importing.

  • Policies often favored domestic industries and protectionism.

  • Modern echoes appear in neomercantilist and protectionist policies.

• Visual Aids: Slides include diagrams illustrating trade flows under mercantilist policies.

Absolute Advantage

• Concept: Introduced by Adam Smith as a critique of mercantilism.

• Key Insight:

  • A country benefits by specializing in the production of goods for which it has an absolute productivity advantage.

  • Encourages free trade to maximize overall wealth and consumer choice.

• Example: Illustrations comparing production capabilities between countries.

Comparative Advantage

• Definition: Introduced by David Ricardo.

• Core Idea:

  • Even if one country has an absolute advantage in producing all goods, trade can still be beneficial if countries specialize based on lower opportunity costs.

• Key Detail:

  • Opportunity cost is the value of the next best alternative forgone.

  • Numerical examples in the slides show how relative differences in opportunity costs lead to beneficial trade.

• Graphical Illustrations: Comparative advantage is often illustrated with production possibility frontiers and trade-off graphs.

Relative Factor Endowments and the Leontief Paradox

• Heckscher-Ohlin Theory: Suggests that a country will export goods that intensively use its abundant factors and import those that use its scarce factors.

• Leontief Paradox:

  • Empirical findings by Wassily Leontief in the post–World War II United States contradicted the theory.

  • Despite being capital-abundant, U.S. imports were found to be more capital intensive than exports.

  • This paradox spurred further research into additional factors (e.g., technology, human capital) affecting trade.

• Charts: Comparative tables and graphs detail the expected versus observed factor intensities.

2.2 Modern Firm-Based Trade Theories

Linder’s Country Similarity Theory

• Concept:

  • Emphasizes that trade in manufactured goods is driven by similarities in consumer preferences between countries at similar stages of development.

  • Explains intraindustry trade, where similar industries in different countries exchange differentiated products.

• Key Detail:

  • Differentiated goods (e.g., automobiles, electronics) benefit from brand reputation and consumer loyalty.

New Trade Theory

• Developed by: Economists such as Helpman, Krugman, and Lancaster.

• Core Idea:

  • Economies of scale and network effects lead to intraindustry trade.

  • Multinational corporations (MNCs) engage in “cat-and-mouse” competitive strategies to exploit scale economies.

• Examples: Rivalries like Caterpillar vs. Komatsu or Airbus vs. Boeing.

• Photographs/Charts: Graphs demonstrating cost curves and scale economies are included in the slides.

3. Trade Policy

3.1 Rationale for Government Intervention

• Economic Motivations:

  • Fighting Unemployment: Import restrictions may protect jobs, though they can have negative side effects (e.g., higher prices, reduced exports).

  • Protecting Infant Industries: Temporary protection helps emerging industries develop a competitive advantage.

  • Developing an Industrial Base: Strategic industries may be nurtured to enhance national economic strength.

  • Economic Relationships: Trade policy can foster stronger bilateral or multilateral ties.

• Noneconomic Motivations:

  • Preservation of national culture and political considerations (e.g., influence or ideological goals).

3.2 Instruments of Trade Control

Tariffs

• Definition: Taxes imposed on imported or exported goods.

• Types:

  • Specific Duty: A fixed fee per unit (e.g., $1 per pen).

  • Ad Valorem: A percentage of the good’s value (e.g., 10% on a $50,000 car yields a $5,000 tariff).

  • Compound Tariff: Combination of both specific and ad valorem tariffs.

• Impact on Trade:

  • Tariffs raise domestic prices, reducing import volumes.

  • Graphs in the slides illustrate how tariff imposition shifts domestic supply and demand curves in both Home and Foreign markets.

Non-Tariff Barriers (NTBs)

• Examples: Quotas, voluntary export restraints (VERs), "buy local" legislations, standards and labels, licensing, administrative delays, and countertrade.

• Visuals: Diagrams showing quantity limitations and price effects.

Subsidies

• Definition: Direct financial assistance to domestic industries to improve competitiveness.

• Purpose: Address market imperfections or overcome valuation problems.

• Charts: Comparative visuals show how subsidies lower effective production costs and affect trade flows.

4. Foreign Exchange Rates

4.1 Basic Terminology

• Exchange Rate: The price of one country’s currency in terms of another’s.

• Direct vs. Indirect Quotes:

  • Direct Quote: Home currency per unit of foreign currency (e.g., 5.04 Danish Krone per US dollar).

  • Indirect Quote: Foreign currency per unit of home currency (e.g., 0.68 EUR per Canadian dollar).

• Bid and Ask Rates:

  • Bid Rate: The price at which an FX dealer is willing to buy a currency.

  • Ask Rate: The price at which an FX dealer is willing to sell.

  • Spread: The difference between the bid and ask rates, representing the dealer’s profit margin.

4.2 Arbitrage and Cross Rates

• Arbitrage: Exploiting price differences across markets to secure a riskless profit.

  • Two-Point Arbitrage: Simple discrepancies between two locations.

  • Triangular Arbitrage: Involves three currencies and uses cross rates to check for inconsistencies.

• Cross Rate Calculation:

  • Example: Given quotes for GBP in terms of YEN and USD, one can calculate the YEN/USD rate.

  • Charts: Flow diagrams and numerical examples in the slides illustrate these computations.

4.3 Spot and Forward Rates

• Spot Rate: The current exchange rate for immediate delivery (usually within two business days).

• Forward Rate: Agreed-upon exchange rate for a transaction set for a future date.

• Forward Premium/Discount:

  • Represents the annualized percentage difference between the forward and spot rates.

  • Example Calculation: A forward premium of 0.7% might be calculated by comparing a 6-month forward rate to the current spot rate.

5. International Monetary System

5.1 Overview and Institutions

• Key Institutions:

  • The International Monetary Fund (IMF) plays a central role in stabilizing currencies, providing financial assistance, and administering the Special Drawing Rights (SDR) as a unit of account.

• Currency Boards and Dollarization:

  • Some emerging markets (e.g., Argentina, Panama, Ecuador) have used currency boards or adopted a foreign currency (often the USD) to ensure stability.

• Visuals: Timelines and photographs from historical currency events (1971–2014) highlight shifts in monetary regimes.

5.2 Fixed vs. Flexible Exchange Rates

• Fixed Exchange Rate Regime:

  • Pros: Provides stability in international prices and tends to be anti-inflationary.

  • Cons: Requires substantial foreign reserves and may limit the central bank’s ability to conduct independent monetary policy.

• Flexible (Floating) Exchange Rate Regime:

  • Pros: Allows for independent monetary policy, letting market forces determine the exchange rate.

  • Cons: Can result in greater volatility.

• The Impossible Trinity:

  • A country cannot simultaneously have a fixed exchange rate, free capital mobility, and an independent monetary policy. Only two of these goals can be achieved at one time.

• Charts: Diagrams illustrate the trade-offs and the potential impacts of different regime choices.

6. Balance of Payments (BOP)

6.1 Structure and Components

• Definition: The BOP records all economic transactions between residents of a country and the rest of the world over a specified period.

• Accounts in the BOP:

  • Current Account: Covers trade in goods and services, income from investments, and unilateral transfers.

  • Capital/Financial Account: Records cross-border investments, portfolio flows, and other financial transactions.

  • Official Reserves Account: Reflects changes in the central bank’s holdings of foreign currency and other reserve assets.

  • Net Errors and Omissions: Adjusts for any statistical discrepancies ensuring the overall balance sums to zero.

• Mathematical Identity:

  • The BOP is represented as:
    Current Account + Capital/Financial Account + Net Errors and Omissions + Official Reserves = 0

  • This identity stems from double-entry bookkeeping, where every transaction is recorded as both a debit and a credit.

6.2 Double-Entry Bookkeeping in the BOP

• Concept: Every international transaction is recorded twice, ensuring that total debits equal total credits.

• Example: An export (a credit in the current account) is matched by a corresponding entry (a debit) in the financial account.

• Adjustment: Any imbalance due to measurement errors is captured in the net errors and omissions account.

7. International Parity Conditions

7.1 Purchasing Power Parity (PPP)

• Absolute PPP:

  • States that the price of an identical basket of goods should be the same across countries when expressed in a common currency.

  • Example: The Big Mac Index compares the price of a Big Mac in different countries to assess if currencies are over- or undervalued.

• Relative PPP:

  • Focuses on the rate of change in prices (inflation) between two countries and predicts that the exchange rate will adjust to offset these differences.

  • Example: If Country A has a 2% inflation rate and Country B a 5% inflation rate, relative PPP predicts that Country A’s currency should appreciate (or Country B’s depreciate) roughly by the inflation differential over time.

7.2 Interest Rate Parity and the Fisher Effect

• Uncovered and Covered Interest Rate Parity:

  • These conditions link interest rate differentials to expected or forward exchange rate changes, ensuring that investors earn comparable returns across countries when adjusted for risk.

• Fisher Effect:

  • States that the nominal interest rate is approximately the sum of the real interest rate and expected inflation.

  • Mathematical Expression:
    1 + nominal rate ≈ (1 + real rate) × (1 + expected inflation)

  • Implication: If expected inflation rises, nominal rates should adjust upward correspondingly.

Conclusion

This comprehensive synthesis encapsulates the critical topics presented in the Winter 2025 sessions. From foundational trade theories and the evolution of firm-based approaches to the intricacies of trade policy instruments, foreign exchange mechanisms, the international monetary system, and balance of payments accounting, the slides provide an integrated view of how countries interact economically on a global scale. Detailed charts, numerical examples, and visual aids enrich these discussions, providing both theoretical frameworks and practical applications.

This compilation should serve as a solid reference to identify areas of strength and topics that may require further review as you prepare for your exams and engage in discussions on international business.