The Theory of International Trade

The Theory of
International Trade
Globalization versus Inter-Regional Integration

Economic Alliances
European Union
NAFTA
USA, Canada, Mexico
Currently 25 members
10 new members joined in May of 2004
3 more countries are being considered
MERCOSUR
Association of Southeast Asian Nations
Southern Common Market
10 member countries
Original members: Argentina,
Ongoing negotiations between ASEAN, China, Japan, India
Brazil, Uruguay, Paraguay
Andean Community
Bolivia, Colombia,Ecuador, Peru, Venezuela
All members of WTO (previously parties to GATT) are required to notify

WTO of any trade agreement. (See the handout)
1948-1994, GATT received 124 notifications.
1995-2002 WTO (established in 1995) received 130 notifications
WTO provides the following note of caution on Regional Trade Agreements:

RTAs can complement the multilateral trading system, help to build and strengthen it. But by their very
nature RTAs are discriminatory: they are a departure from the MFN principle, a cornerstone of the
multilateral trading system. Their effects on global trade liberalization and economic growth are not clear
given that the regional economic impact of RTAs is ex ante inherently ambiguous. Though RTAs are designed
to the advantage of signatory countries, expected benefits may be undercut if distortions in resource
allocation, as well as trade and investment diversion, potentially present in any RTA process, are not
minimized, if not eliminated altogether. Source: WTO Website: http://www.wto.org
Growth in International Trade
Trade Specialization. The Theory

Absolute advantage principle
Why specialize in the production of something
that is cheaper to purchase from abroad?
Comparative advantage principle

Specialize in the production of those products
in which you have the lowest relative
(opportunity) cost of production
Specialization
Sources for Comparative Advantage
Resource Endowment
Heckscher-Ohlin Theorem
Past economic development/planning is responsible for
current comparative advantage
Leontief Paradox
Factor Price equalization
Stopler-Samuelson Theorem and H-O theorem
Increase in the earnings of relatively abandoned
factor, decrease in the earnings of relatively scarce
factor
US example
US trade balance (available on BEA
website)
http://www.bea.gov/bea/di/home/trade.htm
How does the US afford to run this large

trade deficit continuously?
Demand for the US dollar
BoP (available through the BEA website)
http://www.bea.gov/bea/di/home/bop.htm
Current Account Balance (~Trade balance) as % of GDP, 2001
Less than 8.2

-8.2 < . < - 4.8
-4.8 < / <-2
-2 < . < 2.9

Over 2.9
No data available
Forms of Common Trade

Restrictions
Quota
Tariff
Arguments against free trade

-
strategic industry
infant industry
cultural or social values
job preservation
Forms of Trade Agreements

Preferential trade arrangement (one sided or
reciprocal)
Free trade area (reciprocal)
Customs Union
Common market factors mobility
Economic union policy coordination
International Arrangements
GATT General Agreement on Tariffs and Trade. Instituted in 1947. In 1945, the US
presented the IMF with a draft charter for an International Trade Organization,
but that failed to materialize in part due to the US congress lack of approval.
Instead, an agreement (GATT) under the Reciprocal Trade Agreements Act
was introduced.
GATS General Agreement on Trade in Services.
General Agreement on Trade-Related Aspects of Intellectual Property Rights.
Under GATT (Article 1) all countries signing the treaty must extend the Most-Favored
Status (treat all countries equally) to all other countries that ratified GATT. There are
two exceptions to Article 1: customs unions and free-trade areas, and countries are
Permitted to apply lower import tariffs to goods coming from developing countries.
Movement away from quotas towards tariffs, and subsequent reduction in tariffs
Some famous rounds of negotiations:
The Uruguay Round 1986-1993 lead to the Establishment of WTO in 1995.
The Kyoto Round: The Kyoto Protocol of 1997 set targets for reductions of
greenhouse gas emissions for industrialized countries from the 1990 level by 2012: 8%
in Europe, 7% in US, 6% in Japan, and stabilization of emissions in Russia.
WTO
Established January 1, 1995
Located in Geneva Switzerland
Currently 146 member nations
Monitors and administers all WTO trade agreements (GATT)

Presents a forum for future trade negotiations
Provides arbitrage in trade disputes between nations
(WTO has a nice case study example on their website at:
http://www.wto.org/english/thewto_e/whatis_e/tif_e/disp3_e.htm)
Provides technical assistance, policy recommendations for

Developing countries.
EU
1948 Benelux the custom union of Belgium, Luxemburg, the Netherlands
1950 proposition of forming a larger of six countries: Belgium,
Luxemburg, the Netherlands, France, Germany, and Italy (European
Economic Community, 1957)
1968 Customs union with common external tariffs is established
1973 Denmark, Ireland, United Kingdom join the European Community
1979 Establishment of European Monetary System
1981 Greece becomes a member
1986 Spain and Portugal enter
1995 Austria, Sweden and Finland
1993 Maastricht Treaty is ratified (plans to establish a common
currency in 1999). Three step approach: free capital movement and
close policy coordination, then establishment of central European
banks to control the currencies followed by the establishment of fixed
exchange rate and transfer of monetary authority.
January 1 1999 Euro is launched
May 2004 Massive expansion into Eastern Europe
Perspective members: Bulgaria, Romania, Turkey
Can Euro be a problem for the

Dollar?
Price of oil
International reserve currency
Competition for investment funding
Foreign Exchange
Foreign exchange (Nominal) simply the price of one currency
in terms of
another (1 dollar = 30 roubles , 1 dollar = 0.85 euros)
The currency appreciates when the number of units of foreign
currency required to purchase it increases (1 dollar = 36 roubles
would be an example of a 20% appreciation in the value of the
dollar). Depreciation is just the opposite of appreciation.
Why should we be concerned about the exchange rate of the dollar?

Effect of the currency on trade: If a US firm sells a product in Russia
that is priced at 300 roubles, then given the exchange rate of
1USD=30R, the US firm receives 10 dollars per unit sold, but what if
during the time between shipping the product to Russia and actually
selling it and converting the proceeds into dollars the value of the dollar
changes to 1USD=40 R, then the US firm will receive only 7.5 dollars
per unit sold => 25% loss in revenues!
Investment is similarly effected by the exchange rate fluctuations.
These fluctuations in the exchange rate create uncertainty for
export/import firms and international investors causing those agents to
hedge against foreign exchange fluctuations.
In addition, currency conversion has a cost, that can play a significant

role. Every time you convert currencies you are charged conversion
fees by the bank. It was estimated that in Europe these fees, because
of large volume of trade ran near 1% point of the GDP a strong
reason for creating a common currency.
Exports as %
Singapore
166
Hong Kong, China
133
Malaysia
122
Luxembourg
113
Ireland
88
Malta
91
Angola
86
Belgium
77
of GDP in 1999
Estonia
United States
Slovak Republic
Czech Republic
Austria
Russian Federation
Netherlands
Sweden
77
11
62
61
45
44
61
44
Hedging works like an insurance against currency fluctuations:

there are several mechanisms that exist in currency markets for this
purpose: futures, forwards, options, swaps. Perhaps options should be
most familiar, since those are also used in the stock market as well.
Options can be of two setups: European (like stock index options),
and American, like stock options. More importantly, options are done
in two types: calls and puts.
Consider the following simple example:
You intend to sell your product in Russia at 300 roubles per unit, but
you are not sure what the exchange rate between the rouble and the
dollar will be when you complete your sale, you can protect yourself
by purchasing a put option on the rouble with a given strike price
today and an expiration period that is sufficient for your sale.
(use stock example here)
Clearly, options like any risk shifting instrument will have premiums,
and hence may be quite expensive, especially on volatile currencies.
What if the demand for the dollar suddenly drops?

Can the government do anything to stop the value of the dollar from
falling?
The preceding discussion concentrated on the floating exchange

rate regime, but that wasnt always the case.
Alternative regimes:
Gold Standard 1880s-1914. Gold standard made the exchange
rates fixed, removing all the complexities of the floating exchange
rate that we previously mentioned. Gold acted as international
money! Humes correction mechanism and the balance of
payments.
1944 Bretton Woods conference and the birth of WB and IMF,
the Gold Exchange Standard.
Fixed exchange rate system under a fixed exchange rate system
the government specifies the exchange rate. In many places this
system lead to parallel markets, as the government regulations
expended in order to protect the government reserves of forex.
Fixed exchange rate continued: many countries fix their

currencies to the currency of their major trading partner to insure
stability in trade (Bulgaria, Estonia and the Deutsche mark in the
late 1990s, Argentina and the USD)
Although, fixing the exchange rate has its benefits, it may also be
quite costly. What if my currency is overvalued, like the Mexican
Peso in 1994, prior to the December crisis, then my economy will
experience growing trade deficit. The currency crisis doesnt need
to come from the trade side, in the case of Russia in 1998, and in
the earlier currency crisis, one of the larger contributors was the
capital flight (Financial account instead of the current account,
know this distinction, as I may put it on the exam)
Relatively recent solution the currency board!
Policy and exchange rate

regime
FLOAT
strong open economy effect, thus weak fiscal policy.
Monetary expansion causes depreciation in the value of the
currency, thus strong monetary policy
FIXED
no open economy effect, weak indirect crowding out effect, thus
strong fiscal policy
no currency depreciation, inability to change domestic interest rate
due to international capital mobility
Economic Development
Establishment of World Bank/Bank for Reconstruction and Development

Capital growth and production
Targeted development
Debt
Role of Human Capital
Institutions and their development
Political Stability and Economic Prosperity
Multinational firm
Exchange rate and translation impact
Political and institutional changes
Transfer pricing
window dressing
Profit transfer

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The Theory of

Globalization versus Inter-Regional Integration

All members of WTO (previously parties to GATT) are required to notify

1995-2002 WTO (established in 1995) received 130 notifications

WTO provides the following note of caution on Regional Trade Agreements:

Growth in International Trade

Trade Specialization. The Theory

Comparative advantage principle

How does the US afford to run this large

Current Account Balance (~Trade balance) as % of GDP, 2001

Less than 8.2

-2 < . < 2.9

Forms of Common Trade

Arguments against free trade

cultural or social values

Forms of Trade Agreements

Monitors and administers all WTO trade agreements (GATT)

Provides technical assistance, policy recommendations for

Can Euro be a problem for the

Why should we be concerned about the exchange rate of the dollar?

In addition, currency conversion has a cost, that can play a significant

Hedging works like an insurance against currency fluctuations:

What if the demand for the dollar suddenly drops?

The preceding discussion concentrated on the floating exchange

Fixed exchange rate continued: many countries fix their

Policy and exchange rate

Establishment of World Bank/Bank for Reconstruction and Development

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