Chapter 7: International Trade and Finance

The Importance and Scope of International Economics

We are all living within a global economy which embraces a lot of international transactions. Due to the tremendous increase in international transactions, international economics have acquired a broader part and an increased importance within economics. Thus, we have to understand at least the basic of international economics.

Why do the participants of the international economics involve with the international transactions? The answer is related with the economic gains. They are seeking to increase their economic benefits.

International economics constitute a separate study area within the science of economics. This is due to the interactions between national and international variables.

An example for this interaction could be given from international trade. Suppose that, under the simplifying assumptions, a tariff restriction whose main purpose is to restrict the imports would affect the domestic market of this imported commodity by increasing the domestic price.

Moreover, international economic transactions affect the general equilibrium of an economy. The main purpose of the economic activities is to attain,

• Internal equilibrium and
• External equilibrium at the same time.

General equilibrium is determined by the implementation of two economic policies, namely;

• Expenditure changing policies,
• Expenditure switching policies.

Expenditure changing policies are the fiscal and monetary policies which change the volume of the total expenditure. On the other hand, expenditure switching policies are the policies which switch the total expenditure from imported commodities to domestic commodities or vice versa.

Regarding the scope of international economics, it consists of two main parts:

• International trade
• International finance.

International trade refers to the real side of international economics. In other words, the analysis within its scope is performed without taking into account the effects of money, exchange rates and interest rates. On the other hand, international finance refers to the monetary side of international economics.

International Trade Theory

International trade has a comprehensive theory dating back to the seventeenth century. The theory starts with the economic philosophy called mercantilism. Before analyzing the international trade theory, the fundamentals and basic assumptions should be given. In order provide the simplicity of the trade analysis, it is assumed that there are only two countries, two commodities and two factors of production on all over the world. The analysis begins with autarky equilibrium. Then, the gains of the countries from international trade are examined. In this analysis;

• Production possibilities frontier,
• Consumption possibilities frontier of the countries are used.

Production possibilities frontier is the boundary between those combinations of commodities and services that can be produced and those cannot.

Consumption possibilities frontier or in other words, budget line gives the limits to the consumption choices of a household. In international economics, it defines the consumption choices of a country under the given relative prices.

Terms of trade is another fundamental phenomenon within the international trade theory. It refers the ratio of the price of the exported commodity of a country to the price of its imported commodity.

In a world of many traded commodities, the terms of trade of a country are given by the ratio of the price index of its exports to the price index of its imports.

International trade is presumed as the precursor of economics. The philosophy of mercantilism acknowledged international trade as a zero-sum game, meaning that a country can gain in the expense of the other country with international trade.

The earliest international trade theory that proves a mutually beneficial trade is the theory of absolute advantage of Adam Smith.

Theories starting with the Adam Smith’s theory are referred to early trade theories. Thus, early trade theories are:

• Theory of absolute advantage,
• Theory of comparative advantage,
• Standard theory of international trade,
• Heckscher-Ohlin theory.

Theories which were developed after the Heckscher-Ohlin theory are called new trade theories. They compensate the weaknesses of the early trade theories.

New trade theories are mostly based on:

• Differences in the development and spread of new technologies among the countries,
• Economies of scale,
• Imperfect competition.

International Trade Policy

Despite the negative economic effects of the restrictive instruments, countries continue to restrict their trade. There are two traditional restriction aims of the countries in restricting their trade:

• To protect domestic producers,
• To collect revenue.

Restrictive trade instruments are classified into two groups:

• Tariffs,
• Non-tariff restrictions.

A tariff is a tax or duty levied on the traded commodity as it crosses a national boundary. On the other hand, a nontariff restriction is any action other than a tariff that restricts international trade.

Non-tariff restrictions are clustered into three different groups:

• Non-tariff restrictions imposed on imports,
• Non-tariff restrictions imposed on exports,
• Non-tariff restrictions imposed in national economy.

Tariffs have been the mostly preferred type of trade restriction within the history of international trade. However, tariffs have been reduced since the signing of the General Agreement on Tariffs and Trade (GATT) since 1947.

GATT had organized a series of trade negotiation rounds since its entering into force. The most well-known trade round is the Uruguay Round because it led to the establishment of the World Trade Organization (WTO) in 1995. WTO is the unique international organization which is responsible for the global trade rules today.

WTO and GATT have succeeded to lower the tariff rates. However, the countries continue to restrict their trade by using nontariff restrictions. The usage of non-tariff restrictions instead of tariffs is generally referred to new protectionism.

Foreign Exchange Rates, Foreign Exchange Market and Foreign Exchange Rate Systems

As we know, each international transaction requires the usage of at least two different national currencies.

The price of one country’s currency expressed in terms of another country’s currency is called foreign exchange rate.

Different national currencies are bought and sold in the foreign exchange market. Thus, foreign exchange market is the market in which economic actors buy and sell foreign currencies.

The economic actors, or in other words, the participants of the foreign exchange market are;

• Individuals,
• Firms,
• International traders,
• Foreign investors,
• Commercial banks,
• Central banks.

Despite some minor similarities, the characteristics of the foreign exchange market are different than the characteristics of the commodity markets. The characteristics of the foreign exchange market are as follows:

• Foreign exchange market is a single market.
• There is no need to meet at the market in order to make a transaction.
• Foreign exchange market resembles to a perfectly competitive market.

Determination of the foreign exchange rate depends on the foreign exchange rate system. Foreign exchange rate is determined by the market demand and supply of the foreign currency if the country has flexible exchange rate system.

On the contrary, foreign exchange rate is determined by the central bank of the country, if the country has a fixed exchange rate system.

The difference between nominal exchange rate and real exchange rate is another important point which should be mentioned.

Nominal exchange rate gives the quantity of the foreign currency that can be bought by the national currency. In other words, nominal exchange rate is the price of one country’s currency expressed in terms of another country’s currency.

On the other hand, real exchange rate is the nominal exchange rate weighted by the consumer price index of the two countries.

Foreign exchange rate can vary depending on the economic transactions. While flexible exchange rate system allows the exchange rate fluctuations, fixed exchange rate system does not.

Currency depreciation is the fall in the value of one currency in terms of another currency in the flexible exchange rate system.

Currency appreciation is the rise in the value of one currency in terms of another currency in the flexible exchange rate system.

As central bank does not allow the exchange rate fluctuations in the fixed exchange rate system, it can decide for a currency devaluation or currency revaluation.

Currency devaluation is the fall in the value of one currency in terms of another currency in the fixed exchange rate system.

Currency revaluation is the rise in the value of one currency in terms of another currency in the fixed exchange rate system.

Balance of Payments

Balance of payments of an economy is the summary statement of all the economic transactions made by the foreign currency.

Main function of the balance of payments is to give information to the government about the international economic situation of the country.

Balance of payments are recorded depending on accounting principles. International economic transactions are classified as;

• Debit international transactions and
• Credit international transactions.

Debit international transactions are the international transactions that embrace the making of payments to foreigners.

Credit international transactions are the international transactions that embrace the receipt of payments from foreigners.

Balance of payments has two main accounts:

• Current Account
• Capital and Financial Account

Current Account is the account that embraces the exports and imports of the commodities and services, net interest and dividend incomes and unilateral transfers.

There is a Current Account deficit if the net result of the Current Account is negative.

On the contrary, there is a Current Account surplus if the net result of the Current Account is positive.

Capital and Financial Account consists of two subaccounts:

• Capital Account
• Financial Account

Patent rights, intellectual property rights and licenses are recorded under the Capital Account.

Foreign direct investments and portfolio investments are recorded under the Financial Account.

Current Account should be equal to the Capital and Financial Account in principle. Official Reserves Account is used to adjust the imbalance.

Errors, omissions and mistakes are recorded under the Statistical Discrepancy Account.