International Economics: Trade, Finance, and Globalization

Posted on Dec 20, 2024 in Economy

International economic studies how countries influence each other’s economies through two acts: 1. International trade (exchange of goods and services across borders) 2. International finance (movement of money for loans, investments, and financial assets). Gains from Trade: Countries benefit by specializing in goods having a comparative advantage and trading for what they lack.

Comparative Advantage: A country is more efficient in producing a specific good, it specializes in that product and trades for others.

Benefits of Trade

  1. Expands markets
  2. Increases efficiency through specialization
  3. Provides access to a variety of goods and services
  4. Promotes economic growth and higher living standards

Difference between Trade & Finance: Trade: Focuses on goods and services. Finance: Monetary transactions and investments.

Globalization

Economic interconnection of countries through trade and finance. Benefits

  1. Enhances resource efficiency
  2. Encourages innovation and competition
  3. Fosters economic growth globally

Challenges

  1. Increases inequality and geopolitical tensions
  2. Faces threats from protectionism, trade barriers, and sanctions

Gravity Model: Trade volume is proportional to the economic size of countries and inversely proportional to the distance between them. Tij = A * Yi * Yj / Dij. Degree of Openness: (Exports + Imports) ÷ GDP

Types of Traded Goods

  1. Primary goods: Raw materials (oil)
  2. Intermediate goods: Semi-finished products (components for assembly)
  3. Consumer goods: Final products (electronics, clothing)
  4. Capital goods: Machinery and tools for production

Ricardian Model

  1. Labor as the Sole Factor of Production (Production is measured by unit labor requirements (ALX), representing hours needed to produce one unit)
  2. Fixed Technology (Technology is constant and determines labor requirements for each good)

Production Possibility Frontier (PPF): All possible combinations of two goods (cheese and wine) that a country can produce with its available labor. QW x ALW + QC x ALC = L

Autarky (No Trade): Relative prices of goods are determined by their labor requirements. PC / PW = ALC / ALW

Limitations of Ricardo’s Model

  1. Simplified Assumptions
  2. Modern Adjustments: More complex models have multiple production factors

Heckscher-Ohlin-Samuelson (HOS) Model

Extends Ricardo’s trade theory by introducing two factors of production: labor (L) and capital (K). Explains trade patterns based on a country’s factor endowments (relative abundance of L or K) and the factor intensity of goods (how much L or K they use in production).

Assumptions:

  1. Two countries, two goods, two factors of production
  2. Each country has fixed amounts of L and K
  3. Identical technology across countries allows for flexible combinations of L and K based on relative costs

PPF:

  1. Curved: (Variable factor combinations and increasing opportunity costs)
  2. Full Employment (At equilibrium, all L and K resources are utilized efficiently)

Competitive Equilibrium Equations

  1. Prices = Costs: Prices of goods are determined by costs of L and K: PC=aLC.w + aKC.r
  2. Full Employment: L and K used in production L=aLV.QV + aLC.QCK=aKV.QV + aKC.QC

Labor = w (wage) Capital = r (rental)

Core Theorems of the HOS Model

  1. Heckscher-Ohlin (A country exports goods that use its abundant factor intensively and imports goods requiring its scarce factor)
  2. Rybczynski (If one factor increases, the production of goods using that factor increases, while the production of other goods decreases)
  3. Stolper-Samuelson (A rise in the price of a good increases the real return to the factor used intensively in its production)
  4. Factor Price Equalization (Free trade equalizes wage and rental rates in countries by equalizing the prices of goods)
  5. Magnification Effect (A rise in the price of a good increases the real return to the factor used intensively in its production)

Standard Trade Model (STM)

Shows how markets benefit from trade and the impact of protectionism. Assumptions:

  1. All goods are internationally tradable
  2. Two types of goods: exports and imports

Governments impose tariffs for:

  1. Revenue generation
  2. Addressing income inequality
  3. Political motives

Effects of Tariffs:

  1. Raise domestic prices of imports
  2. Reduce consumption

Tariff: Pt=P* (1+t)

Effects of Tariffs:

  1. Domestic production rises
  2. Consumption of imports decreases

Welfare Impacts:

  1. Consumer welfare loss
  2. Producer welfare gain
  3. Government revenue

Effective Protection: Tariffs on final goods and inputs, EP= (VAD-VA*)/VA*

Free Trade Areas

Eliminate tariffs among members, enhancing trade efficiency. Challenges: Goods from non-member countries can exploit tariff differences. Solutions:

  1. Labeling goods by origin
  2. Harmonizing external tariffs

Customs Union (CU): Adopt a common external tariff, eliminating internal customs checks.

Trade Creation: Efficient CU members replace domestic production.

Trade Diversion: Members replace efficient external suppliers, reducing welfare.

Policy Trilemma

A country cannot simultaneously maintain:

  1. Free capital mobility
  2. Fixed exchange rate
  3. Independent monetary policy

Exchange Rate Regimes

  1. Fixed Rates
  2. Floating Rates

Spectrum of Exchange Rate Systems

  1. Complete Dollarization
  2. Currency Board
  3. Fixed Peg
  4. Crawling Peg
  5. Currency Band
  6. Dirty Float
  7. Inflation Targeting
  8. Free Float

Markets for Foreign Exchange

  1. Spot Market (Immediate (T+1) currency exchange at the current rate)
  2. Futures Market: (Contracts specify future currency exchange at predetermined rates)

Forex Derivatives

  1. Swaps: Combine spot and future transactions to hedge or provide liquidity
  2. Futures Contracts: Standardized exchange-traded contracts
  3. Options: Provide the right, not the obligation, to trade currencies at specific rates

Interest Rate Parity (IRPT): (1+RUSD)= (1+REUR) x (ERUSD/EUR / EREUSD/EUR)

Expected Return= R + ( (ERE – ER) / ER)

Balance of Payments (BOP)

Accounting registry of all economic transactions between residents and non-residents during a specific period. Purpose: Tracks how international transactions influence the domestic economy. Structure: Double-Entry Accounting.

Two Components:

  1. Current Account: (Records trade in goods and services and income flows)
  2. Capital & Financial Account: Tracks investments, loans, and asset purchases

Law of One Price: Traded goods: Domestic price = World price x Exchange Rate.

Financing a Deficit. Options:

  1. Central Bank Reserves
  2. Borrowing

Money and Interest Rates

Closed Economy: Money demand is entirely local, the Central Bank sets the money supply, directly influencing interest rates.

Open Economy: Interest rates are influenced by global factors:

  1. Capital Flows: Money moves across borders to seek higher returns, driven by international interest rate differentials
  2. Capital Controls: Some countries regulate capital flows to mitigate their impact on the domestic economy

Functions of Money:

  1. Means of Payment
  2. Unit of Account
  3. Store of Value

Characteristics of Money:

  1. No Return
  2. Inflation Risk
  3. Liquidity

Factors Affecting Money Demand:

  1. Interest Rate
  2. Price Level
  3. Economic Activity

Nominal Money Demand: Md= P . Lf (R,Y)

Real Money Demand: Md/P = Lf (R,Y)

Purchasing Power Parity (PPP) Principle: Exchange rates adjust to equalize purchasing power across currencies.

Forms of PPP:

  1. Absolute PPP: Based on the direct cost comparison of a basket of goods: ER = Price of Basket in Foreign Country / Price of Basket in Home Country
  2. Relative PPP: Explains exchange rate changes based on inflation differences: %ΔER = Foreign Inflation Rate − Home Inflation Rate

Capital flows—money moving across borders for investments—are essential to:

  1. Fund real investments (factories, infrastructure)
  2. Support financial investments (stocks, bonds)
  3. Create jobs and drive demand by seeking higher returns

Types of Capital Flows:

  1. Foreign Direct Investment (FDI): Long-term investments in infrastructure, factories, etc. Benefits: Boosts exports, technology transfer, and job creation. Challenges: Regulatory, environmental, labor, and cultural issues
  2. Portfolio Investment: Short-term investments in financial markets (stocks, bonds). Benefits: Deepens local capital markets, enhancing access to foreign savings. Challenges: Highly volatile

Key Components of International Financial Architecture

  1. Rules of the Game: Frameworks governing global trade and finance
  2. Enforcement Mechanisms: Institutions ensuring compliance (WTO, IMF, World Bank)
  3. Decision-Making Power: Distribution of influence over global economic policies among nations

Key Institutions

  1. IMF: Stabilizes exchange rates and provides financial support during crises
  2. World Bank: Reduces poverty and promotes development by offering loans and grants for infrastructure, health, education, etc.
  3. WTO: Oversees global trade rules and resolves disputes through consultations and adjudication
  4. Basel Organizations:
    • Bank for International Settlements (BIS): Coordinates central bank policies and provides data insights
    • Basel Committee: Sets global banking standards to ensure financial stability
  5. Ad-Hoc Committees (G7, G20): Informal groups address economic issues and influence global priorities but lack binding authority

World Trade Organization (WTO)

The principal global body regulating international trade. It sets trade rules, monitors compliance, and resolves disputes to ensure stable and predictable trade flows.

Core Functions:

  1. Negotiation Platform: Forum for trade agreements
  2. Monitoring Compliance: Ensures adherence to trade rules
  3. Dispute Resolution: Manages conflicts between nations

Organizational Structure:

  1. Ministerial Conference: Meets every 2 years; highest decision-making body
  2. General Council: Handles day-to-day operations and trade negotiations
  3. Dispute Settlement Body (DSB): Resolves trade disputes
  4. General Secretariat: Administrative body based in Geneva

Trade Dispute Mechanisms

  1. Bilateral Consultations: Initial attempt to resolve disputes through direct negotiations
  2. Panel Appointment: If unresolved, a panel of 3–5 experts investigates and reports within six months
  3. Binding Decisions: Panel rulings are binding unless rejected by consensus
  4. Appellate Body: Reviews and can uphold, modify, or overturn decisions

WTO’s Future Challenges:

  1. Address inefficiencies in dispute resolution
  2. Rebuild the Appellate Body
  3. Adapt to shifting global trade dynamics, including regional agreements and unilateral policies

Globalization Trilemma

Nations can only achieve two of three goals:

  1. National Sovereignty
  2. Democracy
  3. Hyperglobalization