<p>In this reading, we will study economics in the context of global trade. We will start with an understanding of how a country’s Gross Domestic Product (GDP) and Gross National Product (GNP) is calculated. </p>



<p>We will learn about how goods and services move across borders and how trade partners benefit from exporting and importing goods and services. We will also learn about various trade and capital restrictions and how they impact economies. We will then learn about how a country calculates its balance of payments. Finally, we will review the role of international organizations in facilitating international trade.</p>

International Trade and Capital Flows

International trade clearly has more benefits than the costs for the economies as a whole.

The key idea is that as different global economies specialize, nations can gain from trading with one another by creating abundances of those products and services that they do best.&nbsp; The excess of one nation’s product can then be traded to another nation holding an abundance of its own specialty under mutually acceptable terms of trade.

Let’s take the example of China, which has been the exporter of a variety of goods ranging form textiles to electronics to the United States and other countries. There are benefits for both the exporting countries and the importing countries. The importing countries such as the US benefit from the lower cost of goods while the exporting countries benefit from more employment, increase in wages, and profits.

Along with the benefits, international trade also has its associated costs. With increase in imports, the domestic industries will have to compete with the imported goods. For example, as the textile imports in the US grew, many people lost their jobs. While textiles production went down, other industries such as healthcare picked up and people had to be retrained for these new jobs. Even some of the US textile firms used technology and capital to expand and grow.

This way each country starts specializing in some goods and services so that it become beneficial to produce of those goods and services and import the rest.

Overall, the benefits of international trade far outweigh the costs for overall economies in the long run.

Benefits and Costs of International Trade

<p>In international trade, companies can have absolute and comparative advantage in producing goods and services over other countries.</p>



<p>A country has absolute advantage in producing goods if it is able to produce goods at a lower cost in terms of resources compared to other countries.</p>



<p>On the other hand, the country that can produce a product at the lowest opportunity cost, compared to producing other products, has a comparative advantage in that specific product.</p>



<p>As long as different countries have different opportunity costs of producing different goods, there are gains to be made in international trade.</p>



<p>Let’s take an example to understand the concept of comparative advantage and absolute advantage and how two parties can get better outcomes by specializing in their comparative advantage and trading.</p>



<p>The following table shows the labour cost of producing per unit of cloth and wine in England and Portugal.</p>



<figure class="wp-block-table"><table><tbody><tr><td><strong>&nbsp;</strong></td><td><strong>Cloth</strong></td><td><strong>Wine</strong></td></tr><tr><td><strong>England</strong></td><td>100</td><td>110</td></tr><tr><td><strong>Portugal</strong></td><td>90</td><td>80</td></tr></tbody></table></figure>



<p>From the&nbsp;table, you can see that Portugal has absolute advantage in producing both wine and cloth as it is able to produce both the goods at a lower cost compared to England.</p>



<p>Portugal has a comparative advantage in producing wine. We find this out by calculating which country has lesser opportunity cost for producing one unit of wine. For Portugal, the opportunity cost of producing one unit of wine = 80/90 = 0.89 units of cloth. For England, the opportunity cost of producing one unit of wine = 110/100 = 1.1 units of cloth. Since Portugal has less opportunity cost for producing one unit of wine, it has comparative advantage over England to produce wine.</p>



<p>England has comparative advantage in producing cloth. For Portugal, the opportunity cost of producing one unit of cloth = 90/80 = 1.125. For England, the opportunity cost of producing one unit of cloth = 100/110 = 0.91. Therefore, England has comparative advantage in producing cloth.</p>



<p>In this case, Portugal should focus on producing wine, and England should focus on producing cloth and trade with each other. England would produce cloth and trade it with Portugal for wine. This way it will get wine for 100 instead of 110. Similarly, Portugal can get cloth for 80 instead of 90.</p>



<p>The following two videos from Khan Academy explain the concept of comparative advantage and absolute advantage with the help of examples.</p>



<p>The first video explains how two parties can get better outcomes by specializing in their comparative advantage and trading.</p>



<figure class="wp-block-embed aligncenter is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio"><div class="wp-block-embed__wrapper">
https://www.youtube.com/watch?v=xx9xNJlPOJo
</div></figure>



<p>The second video explains that a party benefits from trade as long as there is a comparative advantage and not necessarily an absolute advantage.</p>



<figure class="wp-block-embed is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio"><div class="wp-block-embed__wrapper">
https://www.youtube.com/watch?v=xN3UV5FsBkU
</div></figure>

Comparative Advantage Vs. Absolute Advantage

There are several models that are used to analyze the dynamics of international trade.

Two such models are Ricardian and Heckscher-Ohlin models. Let's look at each of them in detail.
<h2>Ricardian Model</h2>
<ul>
 	<li>The focus is on comparative advantage. The model suggests that the countries specialize in producing goods and services that they can do best.</li>
 	<li>The model assumes that there is only one factor of production, that is, labor.</li>
 	<li>The model suggests that the trade occurs between countries because of the differences in labor productivity that occurs because of technological differences.</li>
 	<li>The model applies in the short-run because the technology can change internationally over time.</li>
</ul>
<h2>Heckscher-Ohlin Model</h2>
<ul>
 	<li>Unlike Ricardian Model, the model suggested by Heckscher-Ohlin assumes that there are two factors of production, namely, labor and capital.</li>
 	<li>One country has comparative advantage over the other because of the differences in relative amounts of each factor.</li>
 	<li>The model suggests that countries should produce and export goods using the resources that they have in abundance. Similarly, the countries should import goods that require resources that they have in short supply.</li>
 	<li>Note that this model differs from the comparative advantage theory that focuses on the efficiency of the production process. Because the country produces goods based on the resources that they have in abundance, it will be cheapest to produce these goods. Very broadly, countries that have more capital will specialize in capital-intensive goods and countries that countries with more labor will specialize in labor-intensive goods. These countries will trade these goods with each other.</li>
 	<li>This model assumes that labor and capital can flow freely between sectors and that the amount of these two factors differs among countries.</li>
 	<li>The model also assumes that in the long-run countries have same technology.</li>
</ul>
The Heckscher-Ohlin model suggests that there will be a redistribution of wealth between the labor and owners of capital.

The price of the resource that's abundant in each country will increase. This is because the goods that a country exports will rise in price and the goods that a country imports will fall in price. For example, for a capital-intensive industry, when they start exporting the goods, the demand for capital will rise, and the owners of capital will receive more income at the cost of labor in that country. Similarly, for a labor-intensive country, increase in production of the labor-intensive good increases the demand for labor and the workers receive more income at the cost of the capital owners.

Ricardian and Heckscher-Ohlin Models of International Trade

<h2>Trade Restrictions</h2>
In many countries governments will impose trade restrictions that will restrict foreign companies from supplying goods to these countries. Below are the main reasons for imposition of trade restrictions.
<ol>
 	<li><strong>Protect new industries:</strong> The government may want to protect any new industry from competition till it grows to a certain level.</li>
 	<li><strong>National security:</strong> The government may want to protect industries that produce goods required for national security. It's crucial that such goods can be procured locally during crisis.</li>
 	<li><strong>Protect jobs:</strong> When you allow foreign players to enter in your country, it will lead to job loss. The government may want to protect its labor. However, economists do not support this reason because there will be more job creation in other industries and also the prices of the imported products will be cheaper.</li>
 	<li><strong>Protect domestic industries:</strong> Many domestic industries may use their political influence to protect themselves from foreign competition.</li>
 	<li><strong>Anti-dumping</strong>: Domestic producers may argue that foreign firms are exporting products below their cost in order to drive competitors to bankruptcy, with the intention of later raising prices.</li>
</ol>
<strong>Methods of Trade Restriction</strong>

Country may attempt to limit trade through the following policies:
<ul>
 	<li><strong>Tariffs</strong> – Government levies taxes on imported products.</li>
 	<li><strong>Quotas</strong> – Government imposes limitations on the amount of a product that can be imported</li>
 	<li><strong>Voluntary Export Restraints</strong> – This is a case where trading partners mutually agree to limit the amount of a product that will be exported</li>
 	<li><strong>Export subsidies</strong>: The governments may provide subsidies to companies that export certain goods.</li>
 	<li><strong>Minimum domestic production:</strong> Government may impose requirement that certain percentage of goods must be domestic.</li>
</ul>
<strong>Effects of Trade Restriction</strong>

Trade restrictions have the following common impact:
<ul>
 	<li>Domestic price of the good increases</li>
 	<li>Quantity imported decreases</li>
 	<li>Quantity supplied domestically increases.</li>
 	<li>Domestic producers gain</li>
 	<li>Foreign exporters lose</li>
 	<li>Government gains (tariff revenue, import licenses, etc.)</li>
</ul>
All methods except quotas and tariffs will decrease national welfare. In a large country, tariffs and quotas can increase welfare under certain conditions.
<h2>Capital Restrictions</h2>
Some countries may restrict the flow of capital across borders. This can come in the form of:
<ul>
 	<li>Prohibiting or restricting foreign investment in a country or specific industries</li>
 	<li>Prohibiting or taxing income earned on foreign investments</li>
 	<li>Restrictions on repatriation of earnings of foreign entities</li>
</ul>
Capital restrictions decrease economic welfare, however they tend to help developing countries in the short-term.

Trade and Capital Restrictions

Countries often enter into different types of agreements with respect to their trade policies. The objective of such agreements is to reduce the trade barriers among countries.

These types of agreements are generally referred to as trade blocs or regional trading agreements (RTA), under which a group of countries agree to reduce or eliminate trade barriers.

These agreements will have internal rules that the members of the group follow for behavior among themselves. They will also have external rules that the members follow for dealing with non-members.
<h2>Types of Trade Blocs</h2>
There are different types of trade blocs depending on the levels of commitments and arrangement between the members.
<p style="text-align: center;"><a href="https://financetrain.com/wp-content/uploads/trade-blocs.gif"><img class="wp-image-7304 aligncenter" title="trade-blocs" src="https://financetrain.com/wp-content/uploads/trade-blocs.gif" alt="" width="600" height="395"></a></p>

<h3>Preferential Trade Areas</h3>
Preferential trade areas have the lowest level of commitment to the reduction of trade barriers. Here the members lower the trade barriers but do not eliminate the barriers among themselves. Such an agreement does not address how individual members will deal with the non-members.
<h3>Free Trade Area</h3>
The next level of commitment is the free trade area where all the trade barriers among the members are removed. So, all members are free to import and export goods and services among themselves. These members will continue to maintain independent trade policies with non-member countries. An example of a free trade agreement is NAFTA (North American Free Trade Agreement) under which Canada, Mexico and the US have agreed to eliminate the barriers among themselves. However, each member maintains independent policy while dealing with other countries.
<h3>Customs Union</h3>
This is the third type of trade bloc, under which the member countries not only eliminate internal trade barriers, but also adopt common policies on how to deal with non-member countries. An example is Customs union of Russia, Belarus and Kazakhstan, which was formed in 2010. These countries are eliminating trade barriers among themselves but have also agreed to some common set of policies for dealing with nonmember countries.

The above three types of trade blocs only addressed trade barriers related to goods and services. The following trade blocs, apart from these trade barriers, also address other factors such as flow of resources.
<h3>Common Market</h3>
In a common market, the members eliminate internal trade barriers, adopt common external trade barriers and allow free movement of resources, for example labor, among member countries. Examples include Mercosur (Southern Cone Market), East African Common Market, and West African Common market.
<h3>Economic Union</h3>
In an economic union, members eliminate internal barriers, adopt common external barriers, allow free movement of resources, and adopt a uniform set of economic policies. The European Union is an example of an economic union. With one currency, they adopted one monetary policy.
<h3>Full Integration</h3>
The final level is the full integration of the member states. The example is the United States.

<em>[Image Map: www.pbs.org]</em>

Trading Blocs, Common Markets, and Economic Unions

To buy foreign goods and services, the firms and individuals need to buy the currencies of the foreign countries. Similarly they need to purchase the currency of domestic country while paying for goods and services to foreigners.

The balance of payments is the method used by countries to monitor all their international transactions.

The Federal Reserve Board (FRB) defines a country's balance of payments as the record of transactions between its residents and foreign residents over a specified period. Any transaction that causes money to flow into a country is a credit to its BOP account, and any transaction that causes money to flow out is a debit.

The accounts are grouped into three major categories: current account, capital account, and financial account. The current account measures the flow of goods and services, the capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets; and the financial account records investment flows.

Let’s look at the components of each of these accounts.
<h2>Current Account</h2>
The current account is composed of four sub-accounts:

<strong>Merchandise and Services: </strong>Merchandise consists of all raw materials and manufactured goods bought, sold or given away. <strong>Services</strong> include tourism, transportation, engineering and business services, such as law, management consulting and accounting, fees from patents and copyrights on new technology, software, books and movies.

<strong>Income receipts:</strong> Foreign income derived from ownership of assets, such as dividends on holdings of stock and interest on securities.

<strong>Unilateral transfers:</strong> One-way transfers of assets, such as worker remittances from abroad and direct foreign aid. In the case of aid or gifts, the capital account of the donor nation is debited.
<h2>Capital Account</h2>
The capital account has two sub-accounts:

<strong>Capital transfers</strong> include debt forgiveness and goods and financial assets accompanying migrants as they leave or enter the country. It also includes the transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets and legacies.

<strong>Acquisition and disposal non-financial assets: </strong>This includes the sales and purchases of non-produced assets, such as the rights to natural resources, and the sales and purchases of intangible assets, such as patents, copyrights, trademarks, franchises and leases.
<h2>Financial Account</h2>
The financial account is made up of two sub-accounts:

<strong>U.S.-owned assets abroad: </strong>Include official reserve assets, government assets and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets, direct foreign investment and U.S. claims reported by U.S. banks.

<strong>Foreign-owned assets</strong> <strong>in the United States:</strong> Include foreign official assets and other foreign assets in the United States. These assets include U.S. government, agency, and corporate securities; direct investment; U.S. currency; and U.S. liabilities reported by U.S. banks.
<h2>Deficit and Surplus</h2>
The current account should balance with the capital plus the financial accounts, and the sum of the balance of payments statements should be zero. In each account, there can be surplus or deficit. For example, when the United States imports more goods and services than it exports, there will be a current account deficit. The difference must be financed by borrowing, or by selling more capital assets than it buys, which will lead to a capital account surplus.

If a country has a persistent current account deficit, it is, in effect, exchanging capital assets for goods and services. A large trade deficit means that the country is borrowing from abroad.

Balance of Payments Accounts

This article explains the role of the three important international organizations, namely, World Bank, the International Monetary Fund, and the World Trade Organization in facilitating trade.

The excerpts of the functions and objectives are taken from their respective websites.
<h2>International Monetary Fund (IMF)</h2>
The purposes of the IMF are clearly expressed in Article I of its constitution, the Articles of Agreement:
<ul>
 	<li>To promote international monetary cooperation</li>
 	<li>To facilitate the expansion and balanced growth of international trade</li>
 	<li>To promote exchange stability</li>
 	<li>To assist in the establishment of a multilateral system of payments</li>
 	<li>To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards</li>
 	<li>To shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members</li>
</ul>
<h2>World Bank</h2>
The World Bank is a vital source of financial and technical assistance to developing countries around the world.

We are not a bank in the ordinary sense but a unique partnership to reduce poverty and support development. We comprise two institutions managed by 188 member countries: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while IDA focuses exclusively on the world’s poorest countries. These institutions are part of a larger body known as the World Bank Group.

Together these two institutions provide low-interest loans, interest-free credits and grants to developing countries for a wide array of purposes that include investments in education, health, public administration, infrastructure, financial and private sector development, agriculture, and environmental and natural resource management.
<h2>World Trade Organization (WTO)</h2>
The World Trade Organization (WTO) is the only international organization dealing with the global rules of trade between nations. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible.

Where countries have faced trade barriers and wanted them lowered, the negotiations have helped to open markets for trade. But the WTO is not just about opening markets, and in some circumstances its rules support maintaining trade barriers — for example, to protect consumers or prevent the spread of disease.

At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations. These documents provide the legal ground rules for international commerce. They are essentially contracts, binding governments to keep their trade policies within agreed limits. Although negotiated and signed by governments, the goal is to help producers of goods and services, exporters, and importers conduct their business, while allowing governments to meet social and environmental objectives. The system’s overriding purpose is to help trade flow as freely as possible.

Role of International Organizations (IMF, World Bank, and WTO)

<p>Gross Domestic Product (GDP) is the total output of all economic activity in a country over a given period and a country’s GDP will include domestic output by foreign owned firms.</p>



<p>GDP has a mathematical relationship with the measures of gross national income (GNI) and net national income (NNI)</p>



<p>GNI is the sum of all incomes for residents of a country regardless of the location of the assets of these residents.</p>



<div class="wp-block-group has-background" style="background-color:#fffac1"><div class="wp-block-group__inner-container">
<p><strong>NNI = GNI less depreciation of physical capital</strong></p>



<p><strong>GDP + interest, dividend, rent and profit abroad = GNI</strong></p>



<p><strong>GNI – physical capital depreciation = NNI</strong></p>
</div></div>



<p><strong>Expenditure Approach to GDP</strong></p>



<p>GDP can also be calculated using the expenditure approach.</p>



<div class="wp-block-group has-background" style="background-color:#fffac1"><div class="wp-block-group__inner-container">
<p><strong>GDP = Personal Consumption + Investment + Government Consumption + (Exports – Imports)</strong></p>



<p><strong>GDP = C + I + G + (X-M)</strong></p>



<p><strong>GDP at Factor Cost = Expenditure Approach GDP – Indirect Taxes + Subsidies</strong></p>
</div></div>



<p>GDP does not include items such as: government transfer payments, gifts, unpaid household activities, trades, second hand transactions (e.g., selling used goods on Ebay), and transactions involving illegal goods.</p>



<p>Nominal GDP refers to GDP in current prices.</p>



<p>A price deflator must be applied to the current GDP in order to compare current GDP to the GDP of a prior year.</p>

Gross Domestic Product and Gross National Product

<p>The difference between what a country exports and what it imports is called net exports (X-M). If exports exceed imports, then we have a trade surplus. However, if imports exceed exports, then we have a trade deficit.</p>



<p>A trade deficit indicates that we are consuming more than we produce.&nbsp;&nbsp;The United States currently has a trade deficit.</p>



<p>The trade deficit can be expressed in terms of savings and investments as follows:</p>



<p class="has-text-align-center has-background" style="background-color:#fffac1"><strong>(X – M) = (S-I) + (T-G)</strong></p>



<p>In the above equation, S – I is the private saving balance, that is, the difference between private sector savings (S) and investment (I). T – G represents government savings, that is, the difference between tax collected (T) and government spending (G). If government spending is more than tax collected, there will be government deficit. (X – M) is the net exports and is called the current account balance.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p>



<p>Let’s understand the importance of the above equation.</p>



<p>Let’s say at the current level of income and employment, the current account balance is zero.</p>



<p>Also, let say that the private saving balance (S – I) = 100. If we substitute these numbers in the above equaition, then (T-G) must be -100. If private sector savings increase to 200, the government deficit must become -200 inorder to keep the current account balance zero.&nbsp;</p>



<p>We will have a current account deficit if we have a large government deficit, low private savings and high domestic investments. A current account deficit is matched by an inflow of foreign investment.</p>



<p>A current account deficit means that either the private sector or the government (or both) has negative saving. In many cases, it is the government that overspends its budget. Or maybe both sectors have negative savings. To reduce the current account deficit, there are only two ways. Increase net private saving or increase net government saving.Marshall-Lerner condition states that a depreciation of domestic currency can improve a country’s balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds unity.&nbsp;</p>

Factors Affecting Balance of Payments

This quiz is a part of the CFA Level 1 study session 'International Trade and Capital Flows'. 

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