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Chapter 8 - International trade and capital flows. This chapter compare gross domestic product and gross national product, describe the benefits and costs of international trade, distinguish between comparative advantage and absolute advantage, explain the Ricardian and Heckscher–Olin models of trade and the source(s) of comparative advantage in each model,...
Chapter International Trade and Capital FLows Presenter’s name Presenter’s title dd Month yyyy Introduction International trade enhances economic growth by • increasing the efficiency of the allocation of resources, • providing larger capital and product markets, • assisting specialization based on comparative advantages, and • increasing the efficiency of the flow of capital among countries Copyright © 2014 CFA 2 International trade We can measure aggregate output of a country by using the gross national product (GNP) or the gross domestic product (GDP), which differ with respect to goods and services produced by foreigners and by its citizens abroad: Gross national product (GNP) Add Production of goods and services by foreigners within the country Subtract Production of goods and services by the country’s citizens outside the country Equals Gross domestic product (GDP) Copyright © 2014 CFA TErminology • • • • Imports are goods and services that a domestic economy purchases from other countries Exports are goods and services that a domestic economy sells to other countries The terms of trade is the ratio of the price of exports to the price of imports - Increasing terms of trade indicate improvement - Decreasing terms of trade indicate deterioration Net exports = Exports – Imports - If positive, there is a trade surplus - If negative, there is a trade deficit A country that does not trade with other countries is referred to as a closed economy or being in autarky; the price of goods and services is the autarkic price Copyright â 2014 CFA • Terminology • • • • Free trade is the case in which there are no restrictions on a country’s trade with other countries - Trade protections are restrictions on trade that prevent pricing based on supply and demand - Capital restrictions are limits on the flow of funds into or out of a country Measure of international trade: - Trade as a percentage of GDP - Foreign direct investment (FDI): the amount of the investment by a firm in one country in the assets in another country A multinational corporation (MNC) is a company that operates in more than one country A foreign portfolio investment (FPI) is a short-term investment in foreign financial instruments Copyright © 2014 CFA Benefits and costs of International trade BENEFITS • • Gain from exchange and specialization Greater economies of scale • Greater product variety • Increased competition • More efficient resource allocation Copyright â 2014 CFA COSTS Greater income inequality Loss of jobs in developed countries • Adjustments as resources are reallocated Comparative advantage • • • • • An absolute advantage exists if the country is able to produce a good at a lower cost or use fewer resources A comparative advantage exists if the country’s opportunity cost of producing a good is less than its trading partner It is possible to have a comparative advantage while not having an absolute advantage in producing a good The greater the difference between the world price of a good and its autarkic price, the more potential to gain from trade A country’s comparative advantage can change over time Copyright © 2014 CFA Advantages: Example Country A Country B Assume identical feed and labor supply Can produce cows or 25 hogs Can produce cows or 12 hogs • • Relative price for a cow: hogs Relative price for cow: 2.4 hogs • • Relative price for a hog: 0.20 cow Relative price for a hog: 0.42 cow • • Comparative advantage in hogs Comparative advantage in cows • Absolute advantage in hogs • • Specialize in hogs Specialize in cows Hogs 15 10 Cows Copyright © 2014 CFA Sources of comparative advantage RICARDIAN • • Countries specialize in the goods and services for which they have a comparative advantage The source of comparative advantage is labor productivity - • Labor productivity is attributed to differences in technology Countries trade because of differences in labor productivity Copyright â 2014 CFA HECKSCHEROHLIN Comparative advantages arise from different endowments of capital and labor Capital and labor are variable factors of productivity Countries trade because of different relative amounts of capital and labor - • Efficiency of production matters This model allows for income redistribution between owners and capital and labor through trade Trade and capital flows: restrictions and agreements • • • A tariff is a tax levied by a government on imported goods - Intended to protect domestic industries - Increases welfare of domestic country if (1) there is no retaliation, and (2) the deadweight loss is less than the benefit from improving trade An import quota is a restriction on the quantity of a good that can be imported - Controlled through import licenses - Importers earn quota rents if they charge a higher price with a quota An export subsidy is a payment by a government to a firm when it exports a specified good - Encourages firms to shift to export goods, increases the domestic price - A voluntary export restraint (VER) is a voluntary limit on goods exported to a specific country - Allows exporter to earn quota rents Copyright © 2014 CFA 10 Trade and capital restrictions • • • Domestic content provisions are requirements that a specific portion of value-added or components be produced domestically Capital restrictions are controls placed on ownership of assets, either of foreign assets or of ownership of domestic assets by foreign persons or firms The effect of restrictions on trade and capital depends on whether the country is a price taker or can affect price: - A small country in the context of international trade is a price taker - A large country in this context can influence the price Copyright © 2014 CFA 11 Summary of effects Impact on Producer surplus Consumer surplus Government revenue Tariff Import Quota Export Subsidy Importing country Importing country Exporting country Voluntary Export Restraint (VER) Importing country + + + + + Mixed + + + + + + + + + + National welfare Small country Large country Price Domestic consumption Domestic production Trade Imports Exports Copyright © 2014 CFA + 12 Trading blocs A trading bloc is an agreement among countries to work toward eliminating trade barriers Trading blocs may be regional (e.g., NAFTA, EU), yet there are different degrees of integration possible Copyright © 2014 CFA 13 Why trading blocs? Increased competition - Lowers prices and increases quantity Cost of production declines - Easier access to natural resources and technology Increased access to technology and knowledge Increased specialization Greater opportunity for economies of scale Increased employment Increased income Increased interdependence among members - Less chance of conflicts Copyright © 2014 CFA 14 Trading blocs and capital restrictions • • • Possible results of trading blocs: - Trade creation: Replacement of higher-cost domestic production by lowercost imports - Trade diversion: Replacement of lower-cost imports from nonmembers by higher-cost imports from members Impediments to effectiveness of trading blocs: - National sovereignty concerns - Differences in tastes, culture, and competitive conditions among members Capital restrictions may affect inflows, outflows, or both: - May be in the form of taxes, price or quantity controls, or prohibitions - Difficult to distinguish effects of these restrictions from the effects of other policies Copyright © 2014 CFA 15 Balance of payments The balance of payments is the accounting of the flow of funds into and out of a country DEBITS Increase in Assets, Decrease in Liabilities Value of imported goods and services Purchases of foreign financial assets Receipt of payments from foreigners Increase in debt owed by foreigners Payment of debt owed to foreigners Copyright © 2014 CFA CREDITS Decrease in Assets, Increase in Liabilities Payments for imports of goods and services Payments for foreign financial assets Value of exported goods and services Payment of debt by foreigners Increase in debt owed to foreigners 16 Balance of trade components Copyright â 2014 CFA 17 Trade organizations • As a result of countries building barriers to international trade in the 1930s and 1940s, international trade fell, along with the standard of living in many countries International trade organizations were created to encourage international trade and development Copyright © 2014 CFA 18 International monetary fund • • The purpose of the International Monetary Fund is to stabilize exchange rates and the system of international payments - Provides a forum for cooperation - Facilitates growth in international trade - Promotes employment, economic growth, and poverty reduction - Lends foreign currencies to member countries that are experiencing trade deficits In response to the global financial crisis, the IMF has expanded its scope to include monitoring of economies, risk, capital market developments, and financial sector vulnerabilities Copyright © 2014 CFA 19 The World Bank Group • • • The objective of the World Bank is to help developing countries fight poverty and enhance environmentally sound economic growth Economic development in developing nations requires strong governmental system, developed legal and judicial systems, individual and property rights, support of contracts, financial systems robust enough for all sizes of business, and willingness and ability to fight corruption It provides funds, as well as technical and financial expertise, to developing nations - • It helps to create the basic economic infrastructure for a developing nation Nonprofit affiliates: - International Bank for Reconstruction and Development (IBRD) - International Development Association (IDA) Copyright © 2014 CFA 20 The World Trade Organization • • • The purpose of the World Trade Organization is to provide the legal and institutional foundation for the multinational trading system It addresses barriers to trade and subsidies that inhibit trade The WTO implements and administers individual agreements, which encourages trade by providing a platform for negotiations and settling of disputes Copyright © 2014 CFA 21 Conclusions and summary • • • The benefits of trade include gains from exchange and specialization, gains from economies of scale, a greater variety of products available to households and firms, increased competition, and more efficient allocation of resources A country has an absolute advantage in producing a good (or service) if it is able to produce that good at a lower absolute cost or use fewer resources in its production than its trading partner A country has a comparative advantage in producing a good if its opportunity cost of producing that good is less than that of its trading partner - In the Ricardian model of trade, comparative advantage and the pattern of trade are determined by differences in technology between countries - In the Heckscher–Ohlin model of trade, comparative advantage and the pattern of trade are determined by differences in factor endowments between countries Trade barriers prevent the free flow of goods and services among countries Governments impose trade barriers for various reasons, including to promote Copyright © 2014 CFA objectives, to counteract certain imperfections in the 22 specific developmental • Conclusions and summary • • • In a small country, trade barriers generate a net welfare loss arising from distortion of production and consumption decisions and the associated inefficient allocation of resources Trade barriers can generate a net welfare gain in a large country if the gain from improving its terms of trade (higher export prices and lower import prices) more than offsets the loss from the distortion of resource allocations But the large country can only gain if it imposes an even larger welfare loss on its trading partner(s) An import tariff and an import quota have the same effect on price, production, and trade With a quota, however, some or all of the revenue that would be raised by the equivalent tariff is instead captured by foreign producers (or the foreign government) as quota rents Thus, the welfare loss suffered by the importing country is generally greater with a quota A voluntary export restraint is imposed by the exporting country It has the same impact on the importing country as an import quota from which foreigners capture all of the quota rents Copyright © 2014 CFA 23 • Conclusions and summary • • • An export subsidy encourages firms to export their product rather than sell it in the domestic market The distortion of production, consumption, and trade decisions generates a welfare loss The welfare loss is greater for a large country because increased production and export of the subsidized product reduces its global price—that is, worsens the country’s terms of trade Capital restrictions are defined as controls placed on foreigners’ ability to own domestic assets and/or domestic residents’ ability to own foreign assets In contrast to trade restrictions, which limit the openness of goods markets, capital restrictions limit the openness of financial markets A regional trading bloc is a group of countries that have signed an agreement to reduce and progressively eliminate barriers to trade and movement of factors of production among the members of the bloc From an investment perspective, it is important to understand the complex and dynamic nature of trading relationships because they can help identify potential profitable investment opportunities as well as provide some advance warning signals regarding when to disinvest in a market or industry Copyright © 2014 CFA 24 • Conclusions and summary • • The major components of the balance of payments are the current account balance, capital account balance, and the financial account Created after WWII, the International Monetary Fund, the World Bank, and the World Trade Organization are the three major international organizations that provide necessary stability to the international monetary system and facilitate international trade and development - The IMF’s mission is to ensure the stability of the international monetary system - The World Bank helps to create the basic economic infrastructure essential for creation and maintenance of domestic financial markets and a wellfunctioning financial industry in developing countries - The World Trade Organization’s mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules Copyright © 2014 CFA 25 ... that operates in more than one country A foreign portfolio investment (FPI) is a short-term investment in foreign financial instruments Copyright © 2014 CFA Benefits and costs of International... international trade: - Trade as a percentage of GDP - Foreign direct investment (FDI): the amount of the investment by a firm in one country in the assets in another country A multinational corporation... create the basic economic infrastructure essential for creation and maintenance of domestic financial markets and a wellfunctioning financial industry in developing countries - The World Trade Organization’s