1. International Trade: Benefits
 Exchange and specialization
 Greater economies of scale
 Greater product variety
 Increased competition
 Efficient allocation of resources
 Liberalization can lead to increased real GDP
Study Session 6, Reading 19

2. International Trade: Costs
 Greater income inequality
 Loss of jobs in some economies which specialise in low
intensity of labour production.
 Import competition may reduce the profitability of local
producers.
 Less efficient firms may need to exit the market and reallocate
resources to other more efficient areas of the economy.
Study Session 6, Reading 19

3. International Trade: Comparative
Advantage
 A country will have a comparative advantage if it has a lower
opportunity cost of production of a particular product.
 Comparative advantage can still provide trade benefits in the
absence of absolute advantage.
 The benefits of trading driven by comparative advantage are a
key argument for increased trade.
Study Session 6, Reading 20

4. International Trade: Absolute
Advantage
 A country will have an absolute advantage if it can produce a
greater quantity of output products with the same factor
inputs.
 An absolute advantage may be driven by a comparison
between labour productivity.
 A country with an absolute advantage will have a lower cost of
production.
Study Session 6, Reading 20

5. Ricardian Model
 The Ricardian Model suggests that differences in labour
productivity reflect difference in technology.
 It assumes:
 Firms cannot effect the market individually
 Firms choose output to maximize profits
 Homogenous outputs
 Labour only variable
 Differences in labour productivity underline the differences
in technology
Study Session 6, Reading 20

6. Heckscher–Ohlin Model
 Heckscher and Ohlin argues that countries have different
factor endowments of labour, land and capital inputs.
 It suggests that countries will specialise in and export those
products which intensively use the factors of production which
they are most endowed.
 Capital and labour are variable factors of production.
Study Session 6, Reading 20

7. Trade and Capital Restrictions
 A Trade Restriction is a policy measure designed to limit
exports or imports.
 Tariffs are taxes which are imposed on goods imported into
the country.
 Import quotas restrict the quantity of goods that can be
imported into the country.
 Export subsidies given by the government for export of a good.
 A Voluntary Export Restraint is a a trade restriction on the
quantity of a good that an exporting country is allowed to
export to another country.
Study Session 6, Reading 20

8. Economic Implications of Trade and
Capital Restrictions
 Tariffs create deadweight loss as they give rise to
inefficiencies.
 The following chart highlights the deadweight loss caused by
tariffs and import quotas.
Study Session 6, Reading 20

9. Characteristics, Motivations and
Advantages of Trading Blocs
 Members typically share common trade restrictions for non-
member nations and have lower/no barriers among the
members of trading blocs.
 They allow for the free movement of resources towards the
most economic efficient uses.
 Economic unions have a greater degree of integration in that it
incorporates the aspects of a common market and economic
institutions.
 Regional integration through blocs and economic unions
promotes trade, and hence the benefits of comparative
advantage.
Study Session 6, Reading 20

10. Components of the Balance of
Payments
 The Balance of Payments (BOP) compares the dollar difference
of the amount of exports and imports in an economy.
 It includes all financial exports and imports.
 The Current Account includes all transactions which give rise
to or use national income.
 The Capital Account consists of short- terms and long-term
capital transactions.
Study Session 6, Reading 20

11. Impacts of Consumers, Firms, and
Governments Influence
 Firms exporting more can create a positive balance of
payments and vice versa.
 Firms importing capital equipment can negatively affect the
balance of payments.
 National savings is a sum of private saving and public saving. If
national savings is less than domestic investment, a country
will borrow from abroad.
 An increase in foreign debt increases the current account
deficit as the interest costs are recorded in the current
account.
Study Session 6, Reading 20

12. World Bank
 The original purpose of the World Bank was to lend money to
Western European governments to help them rebuild their
countries after WW2.
 By imposing terms on these loans, it encourages developing
countries to:
 Fight corruption
 Develop its financial system which can help microfinance as
well as mega capital ventures
 Protect individual and property rights
 Improve the legal and judicial system
Study Session 6, Reading 20

13. International Monetary Fund
 The initial focus of the IMF was to regulate currency exchange
rates to facilitate orderly international trade.
 It is a lender of last resort when a member country
experiences balance of payments difficulties and is unable to
borrow money from other sources.
 ‘Structural Adjustment Programs’ (SAPs) are designed to
increase money flow into the country by promoting exports so
that the country can pay its debts.
 Provides a forum for cooperation in international monetary
problems.
Study Session 6, Reading 20

14. World Trade Organization
 The World Trade Organization (WTO) deals with the rules of
trade between nations.
 WTO agreements are negotiated and signed by the bulk of the
world’s trading nations and ratified in their parliaments.
 The goal is to help producers of goods and
services, exporters, and importers conduct their business.
Study Session 6, Reading 20

15. Nominal & Real Exchange Rates
 Nominal exchange rates are established on currency financial
markets called "forex markets".
 The relationship between nominal and real exchange rates can
be described as:
e .Pi=Pi*
 where:
e denotes the nominal exchange rate of the domestic currency
in terms of the foreign currency
pi denotes the price of good i in domestic in domestic currency
pi* denotes the price of the same good in the foreign in
foreign currency
Study Session 6, Reading 21

16. Spot & Forward Exchange Rates
 The spot exchange rate is the rate of a foreign-exchange
contract for immediate delivery. It is also known as
"benchmark rates", "straightforward rates" or "outright rates".
 Spot rates represent the price that a buyer expects to pay for a
foreign currency in another currency at time 0.
 The globally accepted settlement cycle for foreign-exchange
contracts is two days.
Forward Rate = Spot Rate of FC x (1 + Interest Rate of FC)
(1+ Interest Rate of DC)
Study Session 6, Reading 21

17. Participants in Foreign Exchange
Markets
 Retail clients
 Commercial banks
 Foreign exchange brokers
 Central banks
 Corporations
 Speculators and arbitragers
Study Session 6, Reading 21

18. Functions of Foreign Exchange
Markets
 Transfer of purchasing power
 Provision of credit instruments and credit
 Coverage of risk
Study Session 6, Reading 21

19. Direct Quotes
 A Direct Quotes expresses the domestic currency per unit of
the foreign currency.
 In the US, a direct quote for Canadian dollar will be .
 It involves quoting in fixed units of foreign currency against
variable amounts of the domestic currency.
 In a direct quote, the domestic currency is always listed as the
base currency .
Study Session 6, Reading 21
.

20. Indirect Quotes
 An Indirect Quotes expresses the foreign currency per unit of
the domestic currency.
 Under an indirect quote, the foreign currency is a variable
amount and the domestic currency is fixed at one unit.
 Indirect quotes indicate how many units of foreign currency
are needed to purchase one unit of domestic currency.
 In an indirect quote, the foreign currency is the base currency
and the domestic currency is the counter or quote currency.
Study Session 6, Reading 21

21. Currency Cross Rates
 Currency cross rates measure the currency exchange rate
between two currencies.
 Both of currencies may not be the official currencies of the
country in which the exchange rate quote is given in. That is, it
can be expressed in terms of a third currency.
Study Session 6, Reading 21

22. Calculate and Interpret
 Originating Currency, Amount, Target Currency and Market Maker
 AUD/EUR (Australian Dollar, Euro) with USD as the Cross Rate
Currency:
 Originating Currency = EUR
 Target Currency = AUD
 Amount = 100000 AUD
 USD/EUR Exchange = 1.2474 Bid; 1.2478 Offer
 USD/AUD Exchange = 0.7296 Bid; 0.7299 Offer
 Denom = .7299 / 1.2474 = 0.585137
 Result = 100000 / 0.585137 = 170900.1 AU
Study Session 6, Reading 21

23. Forward Discount and Premium
 The Forward Premium or Discount is measured as the
difference between the current spot rate and the forward
rate.
 A Forward Premium is when the forward price is higher than
the spot price.
 A Forward Discount is when the forward price is lower than
the spot price.
Forward Rate = Spot Rate of FC x (1 + Interest Rate of FC)
(1+ Interest Rate of DC)
Study Session 6, Reading 21

24. Point Basis or Percentage Terms
 Forward rates usually quoted in terms of points, where
positive points are quoted when the forward rate is greater
than the spot rate.
 Forward rates are based on arbitrage relationship, considering
the interest rate differential between two economies.
Study Session 6, Reading 21

25. Forward Rates Based on Spot Rates
and Interest Rates
 The relationship between forward rates and spot rates can be
described as:
Ff/d=Sf/d(1+if)/(1+id)
 Effectively, forward rates are just spot rates adjusted for the
interest rate differential between the two countries.
 This formula is based on the premise that two alternative
investments should have equal returns. That is, there is no
arbitrage opportunity.
Study Session 6, Reading 21

26. Exchange Rate Regimes
 An exchange rate regime is a policy framework to counter
exchange rate volatility.
 There are three properties of an ideal currency regime:
 Fixed exchange rate between two countries
 All currencies would be fully convertible
 Each country will be able to have a fully independent
monetary policy
Study Session 6, Reading 21

27. Exchange Rate Regimes
 There are three types of pegged floats:
 Crawling Bands: the rate is permitted to fluctuate within a
particular band or limit and the movements are based on a
particular central value
 Crawling Pegs: exchange stay fixed
 Pegging with Horizontal Bands: the rate would be allowed
to move within a specified limit or band.
Study Session 6, Reading 21

28. Impact on International Trade and
Capital Flows
 The impact of the exchange rates and other factors on the
trade balances must be mirrored by their impact on the capital
flows.
 A country with a trade deficit will have to borrow funds.
 A country with a trade surplus will need to lend funds.
 any factor that effects the trade balance must have an equal
and opposite effect on the capital account (and vice versa).
Study Session 6, Reading 21

29. The Elasticity Approach
 The effectiveness of devaluation for reducing the trade deficit
depends on the demand and supply curves for goods and
services.
 Elasticity is measured by:
 An increase in price decreases expenditure if (ie if demand is
elastic).
 An increase in price decreases expenditure if (ie if demand is
inelastic).
Study Session 6, Reading 21

30. The Elasticity Approach
 Demand for imports and exports should be sufficiently price
sensitive.
WxEx + WM(EM – 1)>0
Study Session 6, Reading 21

31. The Absorption Approach
 Trade balances cannot improve in the case of full employment.
 The absorption approach only works if there is excess capacity
in the economy.
 Increasing demand will increase income.
 If expenditure does not decline, devaluation will put upward
pressure on domestic prices.
 Trade balances can only improve if expenditures decline.
Study Session 6, Reading 21