Collated by Marc Jefferson B.

Obeles (XS ‘19)

Unit 1: International Trade

International Trade
● buying and selling of goods and services across country borders
● imports & exports

Benefits of International Trade

1. Lower Prices
○ when countries can specialize in their area of expertise
○ there will be global division of labor
○ there will be more output for less resources
○ this drives down the real prices of goods
2. Factor Endowments
○ countries can ​take advantage of their resources
○ premise is that no two countries share exactly the same resource base
○ trade takes advantage of these differences between countries
3. Economies of Scale (the more you produce, average cost of each product goes down)
○ large scale production to meet international demand
○ gains come from large scale production and would not likely occur if it were
limited to the domestic market
○ the benefits of extreme specialization bring lower and lower average cost
4. Increased Variety
○ you can have same goods made by different countries thus providing different
levels of satisfaction brought to consumers
○ gives the consumers power to make decisions about their own purchases
5. Acquisition of Needed Resources
○ some countries lack critical goods to improve their standard of living; sometimes
to trade is the only way to get it
○ imported goods can improve production and standards of living
6. Competitions Improves Efficiency
○ COMPETITIVE INCENTIVE
○ when domestic markets are opened to foreign competition, companies are
pressed into lowering prices and improving service, or they will suffer from
competition with the foreign firms
7. Political Benefits
○ trade requires relationships and attachments
○ trade and integration have consistently encouraged compromise and resolution
over conflict and antagonism
8. Efficiency and Growth = Economic Growth and Development
○ more exports (better foreign exchange)

Absolute Advantage
 ● one country can produce more of a given product with the same or less resources than
another country 
 
Comparative Advantage
● lower opportunity cost = higher comparative advantage
● when a country gives up more to produce something that other countries produce

● Factors
○ abundance of resources
○ value of the good produced

● Calculate the domestic opportunity for the output problem

○ Opportunity Cost of product X = Output Y / Output X
● Calculate the domestic opportunity for the input problem
○ Opportunity Cost of product X = Input X / Input Y

● Limitations
○ Perils of Extreme Specialization
■ this concerns countries that specialize in agricultural products (volatile
products)
○ Unrealistic Assumptions
■ it is difficult to assess true comparative advantage when the goods are
not the same
● more often, goods are assumed to be identical even if they have
some sort of differentiation
■ transport cost cannot be ignored in practice
● can raise costs enough to eliminate a comparative advantage
■ perfect information about the availability and prices of goods is
IMPOSSIBLE
■ theory assumes relative constant cost
■ two-country model is unrealistic
■ full employment rarely occurs in practice
■ countries do not practice complete free trade

World Trade Organization

● Functions
○ administer WTO trade agreements
○ be a forum for trade negotiations
○ handle trade disputes among member countries
○ monitor national trade policies
○ provide technical assistance and training for developing countries
○ cooperate with other international organizations
 Unit 2: Exchange Rates
Exchange Rates
● the value of one’s currency ​expressed in terms of another currency

Foreign Exchange Market

● forex or currency market
● close to a perfectly competitive market
○ huge market (millions of buyers and sellers)
○ perfect information on prices
○ homogenous product

● Actors
○ speculation/hedge funds
○ remittance companies
○ retail/individual
○ central banks
○ investment banks and other banks

Demand for Currency

● Demand = buy
○ foreign consumers
○ foreign investors
○ foreign tourists

Supply for Currency

● Supply = sell
○ domestic importers
○ domestic tourists going abroad
○ domestic residents who want to acquire foreign currencies

Currency Appreciation
● an increase in the value of a currency
● an increase in the demand or a decrease in supply of a currency

Currency Depreciation
● a decrease in value of a currency
● a decrease in demand or an increase in supply of a currency

Determinants of Exchange Rate

● Foreign Demand for Exports
 ○ an increase in foreign demand for a country’s exports require foreigners to
demand another country’s currency
● Domestic Demand for Imports
○ an increase in domestic demand for imports requires local importers to demand
foreign currency
● Relative Inflation Rate
○ higher domestic inflation rate seems to make a country’s exports more expensive
in the international market

Floating Exchange Rate

● equilibrium exchange rate is determined by the forces of demand and supply
● no government intervention in the foreign exchange market to influence the value of a
currency

How do countries PEG/Fix their exchange rates?​ (government intervention; fixed

exchange rates)
● Official Reserves (affects AS)
○ government may buy or sell domestic currency in the foreign exchange market
○ may pose problems on a country’s level of foreign reserves
● Interest Rates (affects AS)
○ involves monetary policy to either increase or decrease interest rates
● Exchange Controls (affects AD)
○ limits imposed by a country on
■ the amount of foreign currency by domestic residents
■ the amount of domestic currency held by foreign enterprises
● Import/Export Policies (affects AD)
○ depends if a country is export-oriented or import-oriented

● Maintaining a High Exchange Rate

○ Official Reserves - government buying domestic currency using foreign currency
○ Interest Rates - increasing domestic interest rates may attract foreign depositors
which increases demand for the local currency
○ Exchange Controls - restricting the supply of domestic currency to reduce
downward pressure on its exchange rate
○ Export/Import Policies - cutting back demand on imports and slowing demand for
foreign currency

● Maintaining a Low Exchange Rate

Managed Exchange Rate Systems

● also called as the managed float
● periodical government intervention to keep the rate within an acceptable range of values
 ● Why do central banks intervene?
○ Stability of Exchange Rates
■ avoiding large, abrupt fluctuations in exchange rates which may cause
disruptions in international trade
■ Overvalued Currency
● currency has been valued too high relative to the equilibrium value
● (+) cheaper imports (consumer & capital goods)
● (-) more expensive exports
● (-) endangers domestic industries and employment
● (-) endangers export industry and their workers
● (-) inefficient resource allocation
■ Undervalued Currency
● currency has been valued too low relative to the equilibrium value
● (+) improves export competitiveness and trade balance
● (-) may be viewed as unfair trade promotion
● (-) risks inflationary pressures

Evaluation: Exchange Rate Systems

● Fixed Exchange Rates
○ Advantages
■ Stability (of value)
● simplifies business plans and reduces cost of potential foreign
companies
● may also help domestic companies with significant foreign sales or
imported cost components
■ Inflation Control
● helps government control inflation and maintain export
competitiveness in the world market
■ Protection Against Speculation
● the currency’s fixed value gives speculators less incentives to
make speculative actions against the currency
○ Disadvantages
■ Limitations on Policy
● addressing recession, imported inflation, and trade deficit may be
harder since traditional policies may not necessarily work
● responding on external shocks may also be limited
■ Need to Have Large Foreign Reserves
● protects against speculators and eventually defends the currency
● could have been used to buy or sell needed resources
■ Risks of Speculation
● speculators betting against the currency prompts the government
to defend it through spending more reserves
■ Setting the Rate
 ● determining fixed rate is a complex process/decision
● too high or too low rates may affect stakeholders
■ Charges of Unfair Competition
● countries with an undervalued currency may face resentment from
competitor nations, which may lead to poor trade relations

● Floating Exchange Rates

○ Advantages
■ Domestic Policy Freedom
● monetary policy (and interest rates) can be easily manipulated to
manage the balance between domestic growth rates and inflation
■ No Surplus Currency Reserves
● foreign exchange are allocated more efficiently and productively
on capital goods and imported resources
● no need to buy excess currency reserves
■ Flexible Response to External Shocks
● disruptions in the economy can be addressed using various
means
○ Disadvantages
■ Uncertainty for Investors
● exchange rate fluctuations and administrative cost, making costs
and prices unpredictable
■ Influence of Random Events
● not all shocks can be solved by exchange rate adjustment
■ Risk of Imported Inflation
● some countries with a persistently weak currency and high level of
imports may experience cost-push inflation
■ Volatility
● wide swings in exchange rate make doing business much more
difficult, particularly for regular exporters or importers
 Unit 3: Balance of Payments
Fixed assets​ - long term tangible property (e.g. building, vehicles, machineries, etc.)

Definition
● is a simply a ​record​ of the value of all transactions between one economy and another
within a period of time (usually a year)
● it is, in essence, a mere ​balance sheet​; and should not be confused with the balance of
trade

Transactions
● inflows are credited​ to the relevant account
● outflows are debited​ to the relevant account

Components
1. Current Account
○ Balance of Trade in Goods (tangible)
○ Balance of Trade in Services (intangible)
○ Income (interest from investments included)
○ Current Transfers (Unilateral Net Transfers; private)
■ no exchange of goods & services is involved (unilateral)
■ transfer payments

2. Capital Account
○ Capital Transfers (produced)
■ Transfer of ownership of fixed assets
● e.g. assets transferred by migrants
● properties of migrants technically become the domestic country’s
assets
■ Transfers of funds linked to the acquisition of disposal of fixed assets
● e.g. property taxes in a migrant‘s home country paid by using
domestic income
■ Cancellation of liabilities
● i.e. cancellation of debt/loan
● e.g. Country A asks Country B to not pay them anymore,
assuming that the Country B borrowed money from Country A
■ Intergovernmental investment grants
● used for production of capital

○ Transactions in Non-produced, Non-financed Assets

■ Net international sales in non-produced assets
● land use
● rights to fish, drill, mine, etc.
■ Net international sales in intangible assets
● e.g. copyrights, patents, trademarks, branch, franchise

3. Financial Account
 ○ direct investment
■ at least 10% ownership
■ long-term
■ risks involved (income not guaranteed)

■ if any of these 3 are not met, it is a portfolio investment

○ portfolio investment
■ small-scale or less than 10%
■ short-term
■ income is partially/fully guaranteed
○ reserve assets
■ buying and selling of official reserves

■ buying foreign currency = losing domestic currency = debit

■ selling foreign currency = gaining domestic currency = credit

Relationship between Current, Capital & Financial accounts

● Current Account
○ offsets (balances out)
○ the sum of the capital & financial accounts, and statistical discrepancy

○ surplus
■ balanced by a capital & financial account deficit
○ deficit
■ balanced by a capital & financial account surplus

● All current transactions are offset by capital & financial transactions

a. imports increase = debit to the current account
b. foreigners owning more of the local currency = credit to financial account
(because foreigners would invest the same domestic currency)

● Some capital & financial transactions offset each other

a. purchase of foreign bonds = debit to the financial account
b. foreigners own more of the local currency = credit to the financial account (ends
up invested)

● foreign holdings of the local currency fall under foreign ownership of local assets

Typical causes of Current Account Deficits aside from Trade Deficits

1. Interest payments Credited to the Financial Account
○ loans from overseas
○ foreign acquisition of local assets
2. Transactions Debited from the Current Account
○ debt-servicing
○ interest payments
3. Increased Risk of Incurring a Current Account Deficit

Consequences of Persistent Current Account Imbalance

● Current Account Deficit & a ​Fixed XR System​ (assuming a trade deficit)
○ pressure to buy domestic currency is higher (to decrease AS)
■ export & import prices remain constant
● the deficit cannot be addressed
○ lower levels of investor confidence (applicable for all XR systems)
■ lower productivity levels
● greater pressure for the government to increase interest rates
■ greater risk of capital flight
● greater pressure for the government to impose capital controls

● Current Account Surplus & a ​Fixed XR System

○ pressure to sell domestic currency is higher to maintain low currency value (to
increase AS)
■ export & import prices remain constant
● surplus is maintained
○ greater threat of retaliation
○ greater investor confidence (applicable for all XR systems)
■ higher inflow of foreign investors

● Current Account Deficit & a Floating XR System

○ currency depreciates
■ exports become cheaper
● increased export revenues
■ imports become more expensive
● reduced import expenditures
● imported inflation
○ cost-push inflation
○ more pressure to attract investments to decrease the deficit (applicable for all XR
systems)
■ increase interest rates
● government can’t resort to expansionary monetary policy in the
near future
○ government is limited to the use of fiscal policy
 Unit 4: Protectionism
Tarrifs

Quotas
● maximum amount of imported products
Subsidies
Export Promotion Subsidies
Other Protectionist Measures (6)
● bureaucratic barriers
○ hassle paperworks
○ a lot of processes, demotivating for foreign suppliers
● environmental standards
○ harmful chemicals found in products may not be accepted
● product standards
○ goods of low quality may not be accepted
● qualifications
○ services of low quality may not be accepted
○ e.g. inability to speak in a country’s native language
● nationalistic campaigns
○ advertisements that promote domestic products/condemn imported products
● exchange rates
○ manipulation of domestic currency to make domestic products seem cheaper
than imported products
 Unit 5: Economic Integration
Trade Bloc
● free trade area
○ reduced or no trade barriers within the bloc
○ no common external barrier
● customs union
○ reduced/no barriers within the bloc
○ common external barriers
● common market
○ CU + free movement of resources
■ reduced qualifications, less bureaucratic barriers, etc.
● economic & monetary union
○ CM + common currency

Trade Creation

● given that there were trade barriers before the creation of the trade bloc, the market
inefficiency and loss of consumer surplus will eventually be regained due to the removal
of trade barriers within the bloc, bringing the world supply curve back to normal

Trade Diversion
● given three countries, A, B, and C, where C sells a product at a lower price than B, when
country A and B creates a trade bloc together, raising the trade barriers for products
from C, consumers from A will be forced to buy products from country B due to its
relatively​ low price compared to C as an effect of the aforementioned trade barrier. As
such, there will be a market inefficiency within the trade bloc (since more is produced at
a higher price), as well as a loss in consumer surplus (due to the increase in price,
lowering Qd)