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International Trade and Exchange Rates

Subject: Economics
Topic: 6
Cambridge Code: 0455 / 2281

Basis for International Trade​

Comparative Advantage​

Comparative advantage - Lower opportunity cost

Example:

  • UK: 10 cars OR 20 wheat per year
  • China: 8 cars OR 40 wheat per year

Opportunity costs:

  • UK: 1 car = 2 wheat
  • China: 1 car = 5 wheat

China has comparative advantage in wheat (lower opportunity cost)

Gains from Trade​

Specialization and trade:

  1. Each specializes in comparative advantage
  2. Total output increases
  3. Trade at mutually beneficial rate
  4. Both countries better off

Example:

  • Before: UK makes 5 cars + 10 wheat, China makes 4 cars + 20 wheat
  • After: UK makes 10 cars, China makes 40 wheat
  • Trade at 1 car = 3 wheat
  • Both get more than before!

Protection from Trade​

Protectionism - Limiting imports to protect domestic industry

Methods​

Tariffs (Import tax):

  • Tax on imported goods
  • Makes imports more expensive
  • Domestic producers benefit
  • Consumers pay more
  • Government gets revenue

Quotas (Quantitative restriction):

  • Limit quantity of imports allowed
  • No revenue but controls supply
  • More direct than tariff
  • Often evaded

Subsidies to domestic producers:

  • Government support to local firms
  • Makes them more competitive
  • Foreign firms lose sales
  • Can trigger retaliation

Standards and regulations:

  • Technical requirements
  • Safety/health standards
  • Limit imports indirectly

Arguments for Protection​

Infant industries:

  • New industries need protection
  • Allow time to develop
  • Gain economies of scale
  • Then remove protection

Fairness:

  • Prevent dumping (selling below cost)
  • Protect against unfair competition
  • Fair trade arguments

Employment:

  • Protect domestic jobs
  • Avoid unemployment

National security:

  • Keep key industries viable
  • Not dependent on others

Problems with Protection​

Reduces economic efficiency:

  • Prevents specialization
  • Higher costs, lower output

Increases prices:

  • Consumers pay more
  • Reduces living standards

Retaliation:

  • Other countries retaliate
  • Trade wars harmful
  • Everyone loses

Inefficiency:

  • Protected industries become lazy
  • No incentive to improve
  • Other industries may need imports

Exchange Rates​

Exchange rate - Price of one currency in terms of another

Example: 1 GBP = 1.3 USD

Determining Exchange Rates​

Supply and demand:

  • Demand for currency: Buy goods, invest, tourism
  • Supply of currency: Buy foreign goods, invest abroad
  • Price (exchange rate) balances supply and demand

Appreciation and Depreciation​

Appreciation (Strengthening):

  • Currency worth more (e.g., 1 GBP = 1.4 USD, was 1.3)
  • Takes more foreign currency to buy UK pound

Depreciation (Weakening):

  • Currency worth less (e.g., 1 GBP = 1.2 USD, was 1.3)
  • Takes less foreign currency to buy UK pound

Factors Affecting Exchange Rate​

Demand for currency ↑ (appreciation):

  • More people want to buy, invest
  • Higher interest rates
  • Better investment returns
  • Economic growth

Supply of currency ↑ (depreciation):

  • Exports more competitive (automatically adjust)
  • Capital flight (money leaving country)
  • Lower interest rates

Effects of Exchange Rate Changes​

Appreciation (Stronger pound)​

Advantages:

  • Imports cheaper (lower inflation)
  • Foreign holidays cheaper
  • Debt repayment easier

Disadvantages:

  • Exports more expensive (less competitive)
  • Imports more competitive (domestic firms suffer)
  • Unemployment may rise in export/import-substitute sectors
  • Tourist visits decline

Depreciation (Weaker pound)​

Advantages:

  • Exports cheaper (more competitive)
  • Domestic industries protected
  • May boost output and employment
  • Attracts tourists

Disadvantages:

  • Imports more expensive (inflation)
  • Foreign debt costs more to repay
  • Foreign holidays expensive
  • Purchasing power reduced (lower real income)

J-curve Effect​

Short run:

  • Depreciation makes exports cheaper
  • But quantity takes time to respond
  • Revenue falls initially (price ↓, quantity unchanged)

Long run:

  • Export quantity increases
  • Import quantity decreases
  • Revenue recovers and exceeds original

Balance of Payments​

Balance of Payments - Record of all international transactions

Current Account​

Goods and services:

  • Exports: Selling goods/services abroad
  • Imports: Buying goods/services from abroad

Balance of trade = Exports - Imports

Positive (surplus): Exports > Imports Negative (deficit): Imports > Exports

Investment income:

  • Dividends and interest from abroad

Capital Account​

Investment flows:

  • Foreign direct investment (FDI)
  • Portfolio investment (stocks, bonds)
  • Capital movements

Overall Balance​

Balance of payments must balance:

  • Current surplus = Capital outflow
  • Current deficit = Capital inflow

Sustainability: Large persistent deficit problematic

  • Accumulates foreign debt
  • Future interest payments burden
  • May lose confidence

Trading Blocs​

Trade bloc - Group of countries with preferential trade

Types​

Free trade area:

  • Remove barriers between members
  • Each keeps own barriers to outsiders
  • Example: AFTA

Customs union:

  • Free trade between members
  • Common external tariff
  • Example: SADC

Common market:

  • Free trade + free movement of labor/capital
  • Example: EU (formerly)

Economic union:

  • Plus coordination of economic policies
  • Example: Eurozone

Advantages​

  • Increased trade among members
  • Greater specialization
  • Larger market (economies of scale)
  • Increased bargaining power

Disadvantages​

  • Trade diversion (inefficient trade)
  • High-cost members may suffer
  • Loss of independence
  • Bureaucracy

Key Points​

  1. Comparative advantage basis for beneficial trade
  2. Specialization increases total output
  3. Tariffs and quotas protect but reduce efficiency
  4. Exchange rate reflects currency supply and demand
  5. Appreciation: Stronger currency, exports less competitive
  6. Depreciation: Weaker currency, exports more competitive
  7. J-curve: Long-run adjustment lag
  8. BoP: Current account vs capital account
  9. Deficits must be financed by capital inflow
  10. Trading blocs increase trade among members

Practice Questions​

  1. Calculate comparative advantage
  2. Determine trade gains
  3. Analyze protectionism effects
  4. Predict exchange rate changes
  5. Analyze import/export effects
  6. Calculate exchange rate problems
  7. Analyze BoP position
  8. Compare trading blocs

Revision Tips​

  • Know comparative advantage clearly
  • Understand gains from trade
  • Know protection arguments and problems
  • Understand exchange rate determination
  • Know appreciation/depreciation effects
  • Understand J-curve concept
  • Know BoP structure
  • Practice calculations and analysis