6.1 The reasons for international trade
International trade is the exchange of goods and services between countries. It allows specialisation, larger markets, lower prices, greater choice and economies of scale.
Absolute and comparative advantage
- Absolute advantage: a country can produce a good with fewer resources than another.
- Comparative advantage: a country can produce a good at a lower opportunity cost than another.
Benefits: higher world output, lower prices, more choice, economies of scale, more competition and efficiency. Assumptions and limits: no transport costs, constant opportunity cost, no trade barriers, mobile factors. In practice, over-specialisation (risk), structural unemployment, dependence on imports, dumping and environmental costs can arise.
Terms of trade = export price index ÷ import price index × 100. A rise (more imports per unit of exports) is an improvement.
The trading possibility curve shows the combinations of two goods a country can consume after specialising and trading, lying outside its PPC when trade takes place at a favourable terms of trade. Trade liberalisation (cutting trade barriers) allows more specialisation and free trade, raising output and consumption.
6.2 Protectionism
Protectionism is government action to restrict imports to protect domestic industries.
| Method | Effect |
|---|---|
| Tariff (tax on imports) | raises price, cuts imports, raises revenue |
| Quota (limit on quantity) | restricts supply, raises price; no revenue for the government |
| Subsidies to domestic producers | lower costs; distort trade |
| Embargo (ban) | stops trade |
| Administrative barriers | regulations, standards, delays |
Arguments for: protect infant industries, protect jobs and strategic industries, prevent dumping, improve the balance of payments, raise revenue, diversify. Arguments against: higher prices for consumers, less choice, inefficiency (less competition), retaliation (trade wars), losses to exporters and reduced world output.
6.3 Current account of the balance of payments
The balance of payments records all transactions between a country and the rest of the world. The current account has:
| Component | Content |
|---|---|
| Trade in goods | visible exports minus imports (the balance of trade in goods) |
| Trade in services | invisibles: tourism, banking, shipping |
| Primary income | profits, interest, wages from abroad |
| Secondary income | transfers: remittances, foreign aid |
Causes of a deficit: high consumer demand for imports, strong currency, lack of competitiveness, low productivity, inflation higher than trading partners, recession abroad (falling exports). Causes of a surplus: the reverse; export-led growth.
Consequences of a persistent deficit: borrowing or selling assets to fund it, a falling currency, debt, loss of confidence, lower AD in the long run. A surplus may bring currency appreciation and inflation, and political tension.
Consequences of current account imbalances: a persistent deficit means net borrowing or sales of assets, pressure on the exchange rate, a higher external debt and lower confidence, and (through the injections–leakages model) a leakage that depresses AD; a surplus means net lending abroad, upward pressure on the currency and possible inflation, but also lower consumption at home. The domestic effect depends on size, duration and how the deficit is financed.
6.4 Exchange rates
An exchange rate is the price of one currency in terms of another.
- Floating: determined by demand and supply of the currency in the foreign exchange market.
- Fixed: the central bank sets and defends a rate (it buys or sells currency or changes interest rates).
- Managed float: floats but with intervention.
Demand for a currency comes from exports (foreigners buy the currency to pay), foreign investment in the country, speculation and higher interest rates. Supply comes from imports and investment abroad.
A rise in value (appreciation) makes exports dearer and imports cheaper; a fall (depreciation) does the reverse. Appreciation reduces inflationary pressure but harms exporters.
Competitiveness depends on price (relative costs and exchange rate) and non-price factors (quality, innovation, delivery).
Exchange rate: the price of one currency in terms of another (for example $1.25 per pound). Using AD/AS, a depreciation raises net exports, so AD shifts right, increasing real output and employment but also the price level (dearer imports raise costs, SRAS shifts left); an appreciation does the reverse.
6.5 Policies to correct imbalances in the current account of the balance of payments
| Policy | How it works | Limits |
|---|---|---|
| Expenditure-reducing (contractionary fiscal or monetary) | cuts AD and so imports | lower growth, higher unemployment |
| Expenditure-switching (devaluation or depreciation, tariffs) | makes domestic goods relatively cheaper | elasticities, retaliation, inflation |
| Supply-side (productivity, innovation) | raises competitiveness long term | slow, costly |
| Protection | cuts imports | retaliation, less efficiency |
Policies are chosen according to the cause and size of the problem. Trade-offs with growth, inflation and unemployment must be weighed.
Stability of the current account is a government policy objective because large persistent deficits are costly to finance and can weaken the currency; governments aim for a sustainable balance rather than exactly zero.
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