Study Notes on Trade and Finance

INTRODUCTION TO TRADE AND FINANCE

Trade refers to the process of buying, selling, or exchanging goods and services.
Trade is categorized into two broad types:
  - Domestic Trade:
    - Also known as “home trade”.
    - Involves the flow of commodities within a country or territory via water, air, and rail transport systems.
  - International Trade:
    - Involves the exchange of goods and services between two or more countries.
Differences between domestic and international trade:
  - Commercial Policies: Movement of goods between nations is subject to tariffs and quotas, while domestic movements have minimal regulations.
  - Factor Inputs: Labor and capital move freely within a country, but not between countries.
  - Governance: International trade is governed by different national policies, political units, and monetary systems.

ROLE AND GAINS FROM TRADE

Both domestic and international trade play important roles in the modern economy.
Key themes to be discussed in this unit include:
  - Potential role and gains from trade.
  - Theories of domestic and international trade.
  - Reasons and effects of different trade and commercial policies governing the movement of goods, services, and factors of production.

WORLD TRADE ORGANIZATION (WTO)

WTO was created on January 1, 1995.
Replaces the General Agreement on Tariffs and Trade (GATT), which had governed world trade from 1948 to 1994.
WTO administers international trade rules and facilitates dispute resolution among member countries.

KEY CONCEPTS IN TRADE

Import and Export
Trade Balance: Difference between a country's exports and imports.
Trade Surplus: Occurs when a country's exports exceed its imports.
Absolute Advantage: Ability of a person or nation to produce a greater quantity of a good or service than competitors using the same amount of resources.
Comparative Advantage: Ability to produce a good at a lower opportunity cost than another producer.
Tariffs: Taxes imposed on imported goods to increase their price in the domestic market.
Non-Tariff Measures: Regulations other than tariffs that countries use to control the amount of trade across their borders.
Balance of Payment (BOP): A statement that summarizes all economic transactions between residents of a country and the rest of the world in a specific period.
Foreign Exchange Rate: The price at which one currency can be exchanged for another.
Regional Integration: The process by which two or more countries work together to achieve common economic goals.

5.1 OVERVIEW OF DOMESTIC TRADE

Definition of Domestic Trade

Domestic Trade: The exchange of goods or services within a single country, also referred to as “local trade” or “internal trade”.

Characteristics of Domestic Trade

Market constrained by country borders.
Goods must be bought/sold by individuals within the domestic market.
Divided into:
- Retail Trade: Selling goods and services for direct consumption.
- Wholesale Trade: Involves transactions between wholesalers and retailers, serves as the backbone of the domestic market.

Importance of Domestic Trade

Historically, countries relied on domestic trade due to:
- Lack of skills, transportation, and information.
Domestic trade contributes to economic growth by:
  - Improving standard of living.
  - Increasing employment rates.
  - Efficient resource distribution.
Domestic trade diminishes dependence on foreign goods, strengthening the economy against political issues and international conflicts.

Advantages of Domestic Trade

Lower transaction costs due to no tariffs/customs duties.
Lower transportation costs due to shorter distances.
Better resource distribution leading to economic performance.

Limitations of Domestic Trade

Limited selection of available products.
Pure domestic trade markets can struggle to meet demand due to limited production capacity.
Necessity of international trade to benefit from global specializations.

5.2 BASIS OF INTERNATIONAL TRADE

Definition and Importance of International Trade

International Trade: The exchange of goods and services across international borders.
Immediate cause for international trade is differences in prices among countries, influenced by:
- Resource endowments.
- Technology and skills.
Example:
- Ethiopia imports computers due to lack of production capacity; producing domestically incurs higher costs.
Major benefits of international trade include:
  - Efficient global resource use.
  - Enhanced output and quality of goods.
  - Political relations stability through trade relations.
  - Encouragement of economic efficiency and domestic firm competitiveness.
  - Promotion of cultural exchange and technological learning.

5.3 BASIC THEORIES OF INTERNATIONAL TRADE

Overview of Trade Theories

Mercantilism

Developed in Europe from 1500-1800.
Focuses on nation-building and accumulating precious metals for wealth.
Advocates for exports to generate revenue while limiting imports to conserve wealth.

Classical economic theories

Absolute Advantage Theory (Adam Smith):
   - Free trade promotes international labor division.
   - Trade should occur when a country can produce a good at lower absolute cost.
   - Example:
     - Tailor exchanges suits for shoes from a shoemaker for mutual benefit.
Comparative Advantage Theory (David Ricardo):
   - Introduced the concept of opportunity cost in international trade.
   - Trade can benefit countries even if one has an absolute advantage in both goods.
   - Example:
     - England and Portugal trading cloth and wine leveraging relative efficiencies.

Applications of Theories

Both theories promote specializations that lead to trade, emphasizing mutual benefits.
Comparative advantage proves to be more inclusive, allowing trade even without absolute advantages.

5.4 BALANCE OF PAYMENT COMPONENTS

Definition and Structure of Balance of Payments

A systematic record of a country’s economic transactions with the rest of the world.
Involves:
  - Visible goods (physical goods).
  - Invisible goods (services).
  - Capital transfers (financial transactions).
Key components:
  - Current Account (CA)
    - Includes trade balance, net services, and net transfers.
  - Capital Account (KA)
    - Involves transactions in financial instruments and reserve movements.

Current Account Details

Trade Balance
   - Difference between exports and imports:
     - Export > Import = Trade Surplus.
     - Import > Export = Trade Deficit.
     - Export = Import = Trade Balance.
Net Services
- Difference between export and import of services such as transport, insurance, and banking.
Net Transfers
- Unrequited transactions like remittances and donations.

Capital Account Details

Transactions regarding financial capital movement.
Recorded as credit (inflow) and debit (outflow) items.
Overall BoP = CA + KA.

5.5 TRADE POLICIES AND STRATEGIES

Definitions

Trade Policies: Actions taken by a country to encourage or restrict international trade.

Types of Trade Restrictions

Tariffs: Taxes on imports to raise prices domestically, reducing demand for foreign goods.
Non-Tariff Measures: Quantitative restrictions like import quotas.

Reasons for Trade Restrictions

Protection of domestic jobs.
Support for infant industries.
Maintaining standard of living.
National security.
Cultural considerations.

Trade Strategies

Import Substitution (IS): Replaces imports with domestic production, protecting young industries and increasing government revenues.
Export Promotion (EP): Supports and incentivizes the export sector to enhance foreign revenue.

5.6 EXCHANGE RATE DETERMINATIONS

Foreign Exchange Market

Marketplace determining currency exchange rates, driven by supply and demand.

Exchange Rate Definitions

Nominal Exchange Rate: The price of one currency in terms of another.
Real Exchange Rate (RER): Reflects purchasing power; adjusts nominal rates for relative price levels. Formula:
$RER = \frac{External Price}{Domestic Price}$

Exchange Rate Systems

Fixed Exchange Rate: Set by government, requiring reserves for currency manipulation.
- Advantages: Stability and predictability for international trade.
Floating Exchange Rate: Set by market forces, with government options for intervention.
- Benefits: Reflect economic conditions better but can be volatile.

5.7 REGIONAL INTEGRATION AND GLOBALIZATION PRACTICES

Definition of Regional Integration

Process where countries collaborate to achieve common economic goals; also called economic integration.

Advantages

Trade benefits, increased employment, and political cooperation.

Disadvantages

Trade diversion, potential unemployment from firm relocations, and sovereignty erosion.

Types of Economic Integration

Free Trade Area: No trade barriers within members.
Customs Union: Common external trade policy.
Common Market: Labor and capital movement across borders.
Economic Union: Harmonized economic policies.

Globalization in Ethiopia

Refers to interdependence of economies and cultures.

Benefits

Access to new markets, exposure to new cultures, technological advancements.

Downsides

Potential loss of cultural identity and exploitation of workers.

UNIT SUMMARY AND REVIEW QUESTIONS

Summary

Trade involves buying and selling goods/services in domestic and international contexts. Domestic trade focuses on local exchanges, while international trade connects different countries.
Important trade theories include Mercantilism, Absolute Advantage, and Comparative Advantage. Balance of Payments records economic transactions and informs trade policies.

Review Questions

Multiple Choice: Answer questions about trade benefits, comparative advantages, and trade dynamics.
Work Out: Solve practical problems based on provided data about trade advantages and outputs.