The Theory of International Trade

Globalization versus Inter-Regional IntegrationEconomic AlliancesNAFTAUSA, Canada, MexicoEuropean UnionCurrently 25 members10 new members joined in May of 20043 more countries are being consideredAssociation of Southeast Asian Nations10 member countriesOngoing negotiations between ASEAN, China, Japan, India 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

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 MERCOSURSouthern Common MarketOriginal members: Argentina, Brazil, Uruguay, ParaguayAndean CommunityBolivia, Colombia,Ecuador, Peru, Venezuela

Growth in International Trade

Trade Specialization. The TheoryAbsolute advantage principleWhy specialize in the production of something that is cheaper to purchase from abroad?Comparative advantage principleSpecialize in the production of those products in which you have the lowest relative (opportunity) cost of production

SpecializationSources for Comparative AdvantageResource EndowmentHeckscher-Ohlin TheoremPast economic development/planning is responsible for current comparative advantageLeontief ParadoxFactor Price equalizationStopler-Samuelson Theorem and H-O theoremIncrease in the earnings of relatively abandoned factor, decrease in the earnings of relatively scarce factor

US exampleUS trade balance (available on BEA website)http://www.bea.gov/bea/di/home/trade.htmHow does the US afford to run this large trade deficit continuously?Demand for the US dollarBoP (available through the BEA website)http://www.bea.gov/bea/di/home/bop.htm

Current Account Balance (~Trade balance) as % of GDP, 2001Less than 8.2-8.2 < . < - 4.8-4.8 < /

Forms of Common Trade RestrictionsQuotaTariff

Arguments against free trade-strategic industry-infant industry-cultural or social values-job preservation

Forms of Trade AgreementsPreferential trade arrangement (one sided or reciprocal)Free trade area (reciprocal)Customs UnionCommon market factors mobilityEconomic union policy coordination

International ArrangementsGATT General Agreement on Tariffs and Trade. Instituted in 1947. In 1945, the USpresented 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 Actwas 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 aretwo exceptions to Article 1: customs unions and free-trade areas, and countries arePermitted 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.

WTOMonitors 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 forDeveloping countries.Established January 1, 1995Located in Geneva SwitzerlandCurrently 146 member nations

EU1948 Benelux the custom union of Belgium, Luxemburg, the Netherlands1950 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 established1973Denmark, Ireland, United Kingdom join the European Community1979 Establishment of European Monetary System1981 Greece becomes a member1986 Spain and Portugal enter1995 Austria, Sweden and Finland1993 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 launchedMay 2004 Massive expansion into Eastern EuropePerspective members: Bulgaria, Romania, Turkey

Can Euro be a problem for the Dollar?Price of oilInternational reserve currencyCompetition 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 significantrole. 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.

Sheet1

Myanmar0

French Polynesia5

Rwanda6

Marshall Islands8

Sudan8

Burundi9

Palau9

Argentina10

Eritrea10

Japan10

Brazil11

Central African Republic11

Mozambique11

Uganda11

United States11

Burkina Faso12

India12

Lebanon12

Bangladesh13

Haiti13

New Caledonia13

Ethiopia14

Sierra Leone14

Tanzania14

Chad15

Egypt, Arab Rep.15

Pakistan15

Peru15

West Bank and Gaza15

Albania16

Cuba16

Niger16

Benin17

Bolivia17

Suriname18

Uruguay18

Cape Verde19

Colombia19

Guatemala19

Australia20

Greece20

Armenia21

Guinea21

China22

Venezuela, RB22

Comoros23

Iran, Islamic Rep.23

Nepal23

Paraguay23

Turkey23

Zambia23

Cameroon24

Lesotho24

El Salvador25

Guinea-Bissau25

Madagascar25

Mali25

Bosnia and Herzegovina26

France26

Georgia26

Italy26

Kenya26

Poland26

South Africa26

United Kingdom26

Malawi27

Spain27

Algeria28

Azerbaijan28

Botswana28

Bhutan29

Chile29

Germany29

Romania29

Dominican Republic30

Morocco30

Portugal30

Senegal30

Mexico31

Ghana32

New Zealand32

Syrian Arab Republic32

Togo32

Panama33

Iceland34

Samoa34

Indonesia35

Nicaragua35

Sao Tome and Principe35

Israel36

Sri Lanka36

Uzbekistan36

Yemen, Rep.36

Cambodia37

Denmark37

Ecuador37

Nigeria37

Finland38

Mauritania39

Norway39

Lithuania40

Croatia41

Saudi Arabia41

Jamaica42

Kazakhstan42

Korea, Rep.42

Kyrgyz Republic42

Macedonia, FYR42

Switzerland42

Tunisia42

Turkmenistan42

Honduras43

Bulgaria44

Canada44

Cote d'Ivoire44

Jordan44

Latvia44

Russian Federation44

Sweden44

Austria45

Cyprus45

Gabon45

Papua New Guinea45

Gambia, The46

Kuwait46

Zimbabwe46

Djibouti47

St. Kitts and Nevis48

Namibia49

Barbados50

Belize51

Philippines51

Trinidad and Tobago51

Costa Rica52

Moldova52

St. Vincent and the Grenadines52

Hungary53

Slovenia53

Ukraine54

St. Lucia56

Dominica58

Thailand58

Belarus59

Czech Republic61

Mongolia61

Netherlands61

Grenada62

Slovak Republic62

Tajikistan62

Mauritius65

Fiji68

Congo, Rep.72

Bahrain74

Seychelles74

Swaziland74

Antigua and Barbuda76Exports as % of GDP in 1999

Belgium77Singapore166Estonia77

Estonia77Hong Kong, China133United States11

Macao, China80Malaysia122Slovak Republic62

Angola86Luxembourg113Czech Republic61

Ireland88Ireland88Austria45

Malta91Malta91Russian Federation44

Maldives93Angola86Netherlands61

Equatorial Guinea94Belgium77Sweden44

Guyana99

Luxembourg113

Malaysia122

Hong Kong, China133

Singapore166

American Samoa..

Andorra..

Aruba..

Bahamas, The..

Bermuda..

Brunei..

Cayman Islands..

Channel Islands..

Congo, Dem. Rep...

Faeroe Islands..

Greenland..

Guam..

Iraq..

Isle of Man..

Kiribati..

Korea, Dem. Rep...

Lao PDR..

Liberia..

Libya..

Liechtenstein..

Mayotte..

Micronesia, Fed. Sts...

Monaco..

Netherlands Antilles..

Northern Mariana Islands..

Oman..

Puerto Rico..

Qatar..

San Marino..

Solomon Islands..

Somalia..

Tonga..

United Arab Emirates..

Vanuatu..

Vietnam..

Virgin Islands (U.S.)..

Yugoslavia, Fed. Rep...

Sheet2

Sheet3

Hedging works like an insurance against currency fluctuations:there are several mechanisms that exist in currency markets for thispurpose: futures, forwards, options, swaps. Perhaps options should bemost 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 regimeFLOATstrong open economy effect, thus weak fiscal policy. Monetary expansion causes depreciation in the value of the currency, thus strong monetary policy

FIXEDno open economy effect, weak indirect crowding out effect, thus strong fiscal policyno currency depreciation, inability to change domestic interest rate due to international capital mobility

Economic DevelopmentEstablishment of World Bank/Bank for Reconstruction and DevelopmentCapital growth and productionTargeted developmentDebt

Role of Human Capital

Institutions and their development

Political Stability and Economic Prosperity

Multinational firmExchange rate and translation impactPolitical and institutional changesTransfer pricingwindow dressingProfit transfer