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INTERNATIONAL TRADE AND FINANCE
IntroductionTheories of international tradeInternational trade of Sri LankaBalance of payment accountExchange rates and systems
Summary
Introduction Section 01
Domestic tradedomestic trade could be defined as any
exchange that can take place within the political boundaries of a country.
International trade is the exchange of capital, goods, and
services across international borders or territories. This type of trade allows for a greater competition and more competitive pricing in the market. The competition results in more affordable products for the consumer.
Increased exportsIncreased product rangeEconomies of scaleIncreased competitionEconomic and international relationsPromotes economic growth Encourage foreign investmentsA source of government revenueSpecializationConcentration Movement of factors across borders
Benefits of international trade
Theories of International TradeSection 02
Absolute advantage Comparative advantageProtectionismCommodity terms of tradeIncome terms of trade
Principles of international trade
This occurs when one country can produce a good with fewer resources than another or if that country can produce more goods than another.
Principle of absolute advantage
Illustration 1; cost per output unit
Here USA can produce cars with lower cost than the UK. Therefore USA has the absolute advantage in producing cars. UK has the absolute advantage for producing computers.
cars computersUK 8 4USA 6 8
Illustration 2; output per resource unit
In this case UK can produce more computers compared to that of USA and USA produces more cars than UK. Therefore UK has the absolute advantage of producing computers and USA has the absolute advantage of producing cars
cars computersUK 8 10USA 10 8
According to the absolute advantage theory, each country should specialize in the product which has absolute advantage and the excess supply should be exchanged with the product which has absolute disadvantage
However to achieve this, there should be goods with absolute advantages to both the countries. That means if one country has absolute advantages for both products, international trade can not occur based on this theory.
Core Of Absolute Advantage Theory
Illustration 3; output per resource unit
Here in this case UK has the absolute advantage for both the products and hence trade can not happen between these two countries. To avoid this problem in international trade we use the comparative advantage theory.
tea clothesUK 8 10USA 6 8
A country has a comparative advantage over another in the production of a good if it can produce it at a lower opportunity cost.
Law of comparative advantageThis states that trade can benefit all
countries if they specialize in the goods in which they have a comparative advantage.
Principle of comparative advantage
Illustration 4; output per resource unit
Opportunity cost (if its output) = sacrificed units/ units produced
Here India has the absolute advantage for both the products. Therefore absolute advantage theory is not suitable to evaluate the international trade occurrence of these two countries.
Considering the opportunity cost formula, calculate the opportunity cost and fill in the table below as shown and then select the country with the lowest opportunity cost for each product.
Opportunity cost table
Therefore it is clear that India has a comparative advantage over Japan in the production of rice whereas Japan has the comparative advantage of producing televisions.
Rice televisionsIndia 10 10Japan 6 8
Rice televisionsIndia 10/10=1 10/10=1Japan 8/6=1.33 6/8=0.75
Illustration 5; cost per unit
Opportunity cost (if its cost) = units produced/ units sacrificed Canada has the absolute advantage for both products
according to the absolute advantage theory. Therefore comparative advantage theory should be used. Considering the above formula (reciprocal of opportunity cost formula) prepare an opportunity cost table as shown below,
Opportunity cost table
Therefore Kenya can specialize in the production of cloths and Canada can specialize for sugar.
cloths sugarCanada 4 3Kenya 6 6
cloths sugarCanada 4/3=1.33 3/4=0.75Kenya 6/6=1 6/6=1
Changes in factor endowmentChanges in technological advancementsChanges in tastesSpecializationDifferences in the sizes of countriesLocation of the countryStructure of the market
Sources of comparative advantage
There are only two trading countriesThose two countries produce only two
goodsThe commodities produced in each
country are identicalThere are no barriers to trade and no
transport costsLabour is perfectly mobile
Basic principles of theory of comparative costs
perfect factor mobilityconstant returns to scaleno externalities relating to production or
consumptionno transportation costsconstant opportunity costs
Assumptions of comparative advantage theory
unrealistic nature of the factor immobility assumption
increased specialization may lead to diseconomies of scale
government may restrict tradetransport costs may outweigh any comparative
advantageuse of unrealistic assumptionsneglects the effects of elasticities of demand and
supplylabour efficiency differentials are not considerednature of the markets changes over time
Limitations of comparative advantage
The internal rate is derived from the output or cost table.
Here we assume that international trade does not happen.
Deriving the internal rate
The external rate is derived from the opportunity cost table.
Here we assume that countries specialize in the good they have the comparative advantage.
Deriving the external rate
Protectionism represents any attempt by a government to impose restrictions on trade in goods and services between countries.
This is the opposite of free trade
Trade protectionism
Tariffs- a tax on importsQuotas- this is a physical limit on the
quantity of importsEmbargoes- this could be identified as a
total banSubsidiesAdministrative barriersImport licensingExchange controls
Forms of trade protectionism
Infant industry argumentProducers of primary products are
discouraged. ex; paddy farmersRaise revenue for the governmentHelp the balance of paymentsProtection against dumpingLimits environmental pollutionPrevent harmful products entering the
market
Arguments against free trade/arguments for protectionism
Hurting consumers- higher prices for consumers
Loss of economic welfareRegressive effect on the distribution of
incomeProduction inefficienciesLittle protection for employmentTrade wars
Arguments for free trade/arguments against protectionism
“Terms of trade” is the rate at which the products of one country are exchanged for the products of another.
Terms of trade = price index of exports/price index of imports x 100
Terms of trade/ commodity terms of trade
Importance of terms of tradeIt is important to identify the terms of
trade to take national economic decisions. When the country’s goods are in high demand from abroad i.e., when its terms of trade are favorable, the level of money income increases. Conversely, when the terms of trade are unfavorable, the level of money income falls.
Reasons for increase in the terms of tradeExport price index increase while import
price index remains unchanged.Export price index remain unchanged while
import price index decrease.Export price index increases while import
price index decreases.Export price index increases at a greater
percentage while import price index increases at a lower percentage.
Export price index decreases at a lower percentage while import price index decreases at a greater percentage.
Reasons for decrease in the terms of tradeVice versa of the above
Factors that affect commodity terms of tradeRatio of import prices to export pricesThe volume and value of exports and
importsThe conditions attached to exports and
imports.
Income terms of trade can be measured to find the quantity of imports that can be imported to the country, using the income generated from the commodity exports.
Income terms of trade = value of commodity exports/imports price index x 100
Income terms of trade = exports value index / imports price index x 100
Income terms of trade = (exports price index x exports quantity index) / imports price index x 100
Income terms of trade
Consequences of changes in income terms of tradeIncrease/decrease in the real national
incomeFavorable/unfavorable effects to the
balance of payment due to the changes in trade balance.
International trade in SLSection 03
Export structure of Sri LankaImport structure of Sri Lanka
International trade in Sri Lanka
Agricultural exports Tea Rubber Coconut Kernel products Other Other agricultural products Industrial exports Food, beverage and tobacco Textiles and garments Petroleum products Rubber products Ceramic products Leather, travel goods and footwear Machinery and equipment Other industrial exports Mineral exports Gems Other mineral exports Unclassified exports
Exports of Sri Lanka
Trends in exports of Sri LankaAgricultural exports have decreased over
timeImportance if industrial exports have been
increased.The most important export category in
agricultural sector is teaMost important export category in the
industrial sector is textiles and garmentsMineral exports have decreased greatly
over time
Consumer goods Food and beverages Rice Sugar Wheat Other Other consumer goods Intermediate goods Petroleum Fertilizer Chemicals Textiles and clothing Other intermediate goods Investment goods Machinery and equipment Transport equipment Building materials Other investment goods Unclassified imports
Imports of Sri Lanka
Trends in imports of Sri LankaConsumer goods have decreased over timeIntermediate good have increased over
timeFood and beverages are the most
important import in the consumer good category
Petroleum is the most important intermediate import
Machinery and equipments are the most important investment import
Balance of Payments Section 05
The balance of payments is the place where countries record their monetary transactions with the rest of the world. Within the BOP there are two separate categories under which different transactions are categorized;Current accountCapital and financial account
Balance of payment account
Current account-this is a record of all payments for trade in goods and services plus income flow. It is divided into 4 parts; Trade account(visible) Service account(invisibles) Income account Current transfer account
Capital account-this refers to the transfer of funds associated with buying assets such as land. The major components of capital account are; Capital transfers Acquisitions/disposal of non produced, non financial assets
Financial account-the financial account shows the transactions related to foreign financial assets and liabilities. The major components of financial account are; Direct investments Portfolio investments Other investments Reserve assets
Direct investments-investments made in foreign production organizations could be simply referred to direct investments. This includes receipts from privatization too.
Portfolio investments-acquiring financial assets and liabilities related to company shares, bonds, debentures and financial derivatives.
Reserve assets-foreign financial assets used by the CBSL to finance the deficits of balance of payment. These are called “: monetary movements”. Following assets are included in the reserve assets;Gold reservesSpecial drawing rights(SDR)of IMFReserve tranche of IMFBalances of foreign currency
Current accountTrade balance Exports Imports Services(net) Receipts Payments Income(net) Receipts Payments Goods, services and income(net)Current transfers(net) Private transfers(net) Receipts Payments Other transfers(net)Current account balance Capital accountCapital transfers(net) Receipts Payments
Financial accountLong term Direct investments Foreign direct investments(net) Private long term(net) Inflow Outflow Government long term(net) Inflows Outflows Short term Portfolio investments(net) Private short term(net) Commercial bank assets(net) Commercial bank liabilities(net) Government short term(net)Balance of capital and financial accountAllocation of SDR’sValuation adjustmentsErrors and omissions Overall balance
Balance of payments equilibriumBalance of payment equilibrium refers to a
situation where manageable deficits are cancelled out by modest surpluses over a period of time. So, on short term basis it does not necessarily mean that a deficit is bad and a surplus is good.
Balance of payments disequilibriumBalance of payments disequilibrium occurs
when, over a particular period of time a country is recording persistent deficits or surpluses in its balance of payments.
Factors which cause disequilibrium in the balance of paymentsContinuous decrease in the trade balance due
to an increase of imports expenditure.Insufficient inflows of foreign capitalIncreased foreign debt repayments and interest
paymentsRigidity in the imports structure
Policies to reduce balance of payments deficitDevaluation of the currencyEncouraging exports and increase the export
revenueDecreasing import expenditureControlling the domestic inflationEncouraging foreign direct investments
When the government balances a short term BOP deficit using foreign reserves or obtaining loans or when transfers surpluses to the reserve assets, it is called financing the BOP.
When there is a long term deficit in the BOP, adjustments should be made to the economy to correct the problem. When the economy adjusts its exchange rates, fiscal policies and monetary policies to face the problem is called adjustments to BOP.
The difference between financing BOP and adjustments to BOP
This means that the value of exports has increased at a slower rate than the value of imports.
Therefore there could have been an increase in the deficit or the surplus could have changed into a deficit.
Deterioration of the current account
This states that devaluation will improve the balance on the current account on the condition that the combined elasticity’s of demand for imports and exports greater than one.
If (PEDx + PEDm > 1) then a devaluation will improve current account
If (PEDx + PEDm > 1) then an appreciation will worsen current account
The Marshall Learner condition
In short term demand for imports and exports tends to be inelastic.
Therefore current account tends to get worse before it gets better.
Another problem with devaluation is that it can lead to imported inflation.
This is a problem if it leads to cost push inflation.
This means the improvement in the current account might only be temporary
The J curve effect
Exchange rates and systems Section 05
Direct quotation or price quotationWhen the price of foreign currency is
expressed using the domestic currency it is called direct quotation.
U.S Dollar ($) 1 = Sri Lankan Rs. 137Indirect quotation or volume quotation
When the price of local currency is expressed using the foreign currency it is called indirect quotation. It is the reciprocal of the direct quotation. Generally we use 4 or 5 digits to express this.
Sri Lankan Rs. 1 = U.S. Dollar ($) 0.008
Foreign exchange rates
Nominal exchange rateThis is the value of a country’s currency in
relation to other currencies without adjusting for the rate of inflation.
Real exchange rateIt’s the nominal exchange rate adjusted
for inflation
Differentials of exchange ratesDifferentials in interest ratesCurrent account deficitsTerms of tradePolitical stability and economic
performance
Determinants of exchange rates
Fixed exchange rate system
It is a system in which the value of a country’s currency is determined in relation to the value of other currencies through government intervention.
Exchange rate systems
Advantages of fixed exchange ratesPromotes international tradeIs good for small nationsPromotes international investmentsRemoves speculationNecessary for developing countriesEconomic stabilizationIt ensures smooth functioning of the monetary
systemDisadvantages of fixed exchange rate
systemsOut dated systemDiscourage investments due to lack of speculative
profitsHigh Monetary dependence
Floating exchange rate system
This is a system in which a currency’s value is determined solely by the interplay of the market forces of demand and supply instead of government intervention.
Advantages of floating exchange rate systemAutomatic balance of payments adjustmentsAbsence of crisisFlexibilityLower foreign exchange reserves are needed to
manage the systemDisadvantages of floating exchange rate
systemUncertaintyLack of investmentsSpeculationLack of discipline in economic management
Managed floating exchange rate system
It is a system under which a country’s exchange rate is not pegged, but the monetary authorities try to manage it rather than simply leaving it to be set by the market.
The exchange rate falls, this changes the relative prices of imports and exports. Exports will appear to become relatively cheaper in other currencies, and imports will appear to be more expensive. Because we buy imports, they are included as part of the retail price index, and so if the price of imports goes up, this could be inflationary and vice versa.
Effects of changing exchange rates on the economy
Different types of changes in exchange rates
Depreciation-is the loss of value of a country’s currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system.
Appreciation- this is an increase in the value of one currency with respect to another under a floating exchange rate
Overvaluation-an exchange rate is overvalued when it implies that the currency is stronger than it is according to a long run market determined rate under a fixed exchange rate system.
Undervaluation-an exchange rate is undervalued when it implies that the currency is weaker under a fixed exchange rate than it is according to a long run market determined rate.
Devaluation-devaluation is when a country makes a conscious decision to lower its exchange rate in a fixed or semi fixed exchange rate.
$ 1 = Rs. 100$ 1 = Rs. 103
Reasons for devaluationTo increase exports and to decrease importsTo reduce the balance of payments deficitTo devalue the overvalued currencyTo reduce the outflow of foreign currency reserve
Conditions required to a successful devaluationDemand for exports should be elasticDemand for imports should be elasticSupply of exports should be elasticLocal inflation should be lower than other countriesOther countries should not devalue their currencies.
Revaluation- this is an increase in the value of a currency in relation to others under a fixed or semi fixed exchange rate.
$ 1 = Rs. 100$ 1 = Rs. 103
