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1 CHAPTER 8 INTERNATIONAL TRADE AND CAPITAL FLOWS Presenter’s name Presenter’s title dd Month yyyy

2 1. INTRODUCTION International trade enhances economic growth by increasing the efficiency of the allocation of resources, providing larger capital and product markets, assisting specialization based on comparative advantages, and increasing the efficiency of the flow of capital among countries. Copyright © 2014 CFA Institute 2

3 2. INTERNATIONAL TRADE Gross national product (GNP) AddProduction of goods and services by foreigners within the country SubtractProduction of goods and services by the country’s citizens outside the country EqualsGross domestic product (GDP) Copyright © 2014 CFA Institute 3 We can measure aggregate output of a country by using the gross national product (GNP) or the gross domestic product (GDP), which differ with respect to goods and services produced by foreigners and by its citizens abroad:

4 TERMINOLOGY Imports are goods and services that a domestic economy purchases from other countries. Exports are goods and services that a domestic economy sells to other countries. The terms of trade is the ratio of the price of exports to the price of imports. -Increasing terms of trade indicate improvement. -Decreasing terms of trade indicate deterioration. Net exports = Exports – Imports -If positive, there is a trade surplus. -If negative, there is a trade deficit. A country that does not trade with other countries is referred to as a closed economy or being in autarky; the price of goods and services is the autarkic price. An economy that is not closed is an open economy. -If there are no restrictions to trade, the price of goods and services is the world price. Copyright © 2014 CFA Institute 4

5 TERMINOLOGY Free trade is the case in which there are no restrictions on a country’s trade with other countries. -Trade protections are restrictions on trade that prevent pricing based on supply and demand. -Capital restrictions are limits on the flow of funds into or out of a country. Measure of international trade: -Trade as a percentage of GDP -Foreign direct investment (FDI): the amount of the investment by a firm in one country in the assets in another country. A multinational corporation (MNC) is a company that operates in more than one country. A foreign portfolio investment (FPI) is a short-term investment in foreign financial instruments. Copyright © 2014 CFA Institute 5

6 BENEFITS AND COSTS OF INTERNATIONAL TRADE BENEFITS Gain from exchange and specialization Greater economies of scale Greater product variety Increased competition More efficient resource allocation COSTS Greater income inequality Loss of jobs in developed countries Adjustments as resources are reallocated Copyright © 2014 CFA Institute 6

7 COMPARATIVE ADVANTAGE An absolute advantage exists if the country is able to produce a good at a lower cost or use fewer resources. A comparative advantage exists if the country’s opportunity cost of producing a good is less than its trading partner. It is possible to have a comparative advantage while not having an absolute advantage in producing a good. The greater the difference between the world price of a good and its autarkic price, the more potential to gain from trade. A country’s comparative advantage can change over time. Copyright © 2014 CFA Institute 7 Comparative advantage Lowest-cost producer of a good Absolute advantage Best producer of a good Based on productivity in terms of opportunity cost, but not necessarily the lowest-cost producer.

8 ADVANTAGES: EXAMPLE COUNTRY ACOUNTRY B Assume identical feed and labor supply. Can produce 5 cows or 25 hogsCan produce 5 cows or 12 hogs Relative price for a cow: 5 hogs Relative price for a hog: 0.20 cow Relative price for cow: 2.4 hogs Relative price for a hog: 0.42 cow Comparative advantage in hogsComparative advantage in cows Absolute advantage in hogs Specialize in hogsSpecialize in cows Copyright © 2014 CFA Institute 8

9 SOURCES OF COMPARATIVE ADVANTAGE RICARDIAN Countries specialize in the goods and services for which they have a comparative advantage. The source of comparative advantage is labor productivity. -Labor productivity is attributed to differences in technology. Countries trade because of differences in labor productivity. HECKSCHER–OHLIN Comparative advantages arise from different endowments of capital and labor. Capital and labor are variable factors of productivity. Countries trade because of different relative amounts of capital and labor. -Efficiency of production matters. This model allows for income redistribution between owners and capital and labor through trade. Copyright © 2014 CFA Institute 9

10 3. TRADE AND CAPITAL FLOWS: RESTRICTIONS AND AGREEMENTS A tariff is a tax levied by a government on imported goods. -Intended to protect domestic industries -Increases welfare of domestic country if (1) there is no retaliation, and (2) the deadweight loss is less than the benefit from improving trade An import quota is a restriction on the quantity of a good that can be imported. -Controlled through import licenses -Importers earn quota rents if they charge a higher price with a quota An export subsidy is a payment by a government to a firm when it exports a specified good. -Encourages firms to shift to export goods, increases the domestic price -A voluntary export restraint (VER) is a voluntary limit on goods exported to a specific country. -Allows exporter to earn quota rents Copyright © 2014 CFA Institute 10

11 TRADE AND CAPITAL RESTRICTIONS Domestic content provisions are requirements that a specific portion of value-added or components be produced domestically. Capital restrictions are controls placed on ownership of assets, either of foreign assets or of ownership of domestic assets by foreign persons or firms. The effect of restrictions on trade and capital depends on whether the country is a price taker or can affect price: -A small country in the context of international trade is a price taker. -A large country in this context can influence the price. Copyright © 2014 CFA Institute 11

12 SUMMARY OF EFFECTS TariffImport Quota Export Subsidy Voluntary Export Restraint (VER) Impact on Importing country Exporting country Importing country Producer surplus ++++ Consumer surplus  Government revenue + Mixed  0 National welfare Small country  Large country ++  Price ++++ Domestic consumption  Domestic production ++++ Trade Imports  Exports + Copyright © 2014 CFA Institute 12

13 TRADING BLOCS A trading bloc is an agreement among countries to work toward eliminating trade barriers. Trading blocs may be regional (e.g., NAFTA, EU), yet there are different degrees of integration possible. Copyright © 2014 CFA Institute 13 Economic union Common market Customs union Free trade area (FTA) Coordination of economic policies among members Allows free movement of factors of production Common trade policy regarding nonmembers Trading block with no trade barriers

14 WHY TRADING BLOCS? 1.Increased competition -Lowers prices and increases quantity 2.Cost of production declines -Easier access to natural resources and technology 3.Increased access to technology and knowledge 4.Increased specialization 5.Greater opportunity for economies of scale 6.Increased employment 7.Increased income 8.Increased interdependence among members -Less chance of conflicts Copyright © 2014 CFA Institute 14

15 TRADING BLOCS AND CAPITAL RESTRICTIONS Copyright © 2014 CFA Institute 15 Possible results of trading blocs: -Trade creation: Replacement of higher-cost domestic production by lower- cost imports -Trade diversion: Replacement of lower-cost imports from nonmembers by higher-cost imports from members Impediments to effectiveness of trading blocs: -National sovereignty concerns -Differences in tastes, culture, and competitive conditions among members Capital restrictions may affect inflows, outflows, or both: -May be in the form of taxes, price or quantity controls, or prohibitions -Difficult to distinguish effects of these restrictions from the effects of other policies

16 4. BALANCE OF PAYMENTS The balance of payments is the accounting of the flow of funds into and out of a country. Copyright © 2014 CFA Institute 16 DEBITS Increase in Assets, Decrease in Liabilities CREDITS Decrease in Assets, Increase in Liabilities  Value of imported goods and services  Purchases of foreign financial assets  Receipt of payments from foreigners  Increase in debt owed by foreigners  Payment of debt owed to foreigners  Payments for imports of goods and services  Payments for foreign financial assets  Value of exported goods and services  Payment of debt by foreigners  Increase in debt owed to foreigners

17 BALANCE OF TRADE COMPONENTS Current Account Merchandise trade Services Income receipts Unilateral transfers Capital Account Capital transfers Sales and purchases of nonproduced, nonfinancial assets Financial Account Financial assets abroad Foreign-owned financial assets Copyright © 2014 CFA Institute 17

18 5. TRADE ORGANIZATIONS As a result of countries building barriers to international trade in the 1930s and 1940s, international trade fell, along with the standard of living in many countries. International trade organizations were created to encourage international trade and development. Copyright © 2014 CFA Institute 18 International Monetary Fund (IMF) Ensuring stability of the exchange rate system Ensuring stability of the international payments system The World Bank Group Fighting poverty in developing countries Encouraging environmentally sound economic growth The World Trade Organization (WTO) Providing legal and institutional foundation for the multinational trading system

19 INTERNATIONAL MONETARY FUND The purpose of the International Monetary Fund is to stabilize exchange rates and the system of international payments. -Provides a forum for cooperation -Facilitates growth in international trade -Promotes employment, economic growth, and poverty reduction -Lends foreign currencies to member countries that are experiencing trade deficits In response to the global financial crisis, the IMF has expanded its scope to include monitoring of economies, risk, capital market developments, and financial sector vulnerabilities. Copyright © 2014 CFA Institute 19

20 THE WORLD BANK GROUP The objective of the World Bank is to help developing countries fight poverty and enhance environmentally sound economic growth. Economic development in developing nations requires strong governmental system, developed legal and judicial systems, individual and property rights, support of contracts, financial systems robust enough for all sizes of business, and willingness and ability to fight corruption. It provides funds, as well as technical and financial expertise, to developing nations. -It helps to create the basic economic infrastructure for a developing nation. Nonprofit affiliates: -International Bank for Reconstruction and Development (IBRD) -International Development Association (IDA) Copyright © 2014 CFA Institute 20

21 THE WORLD TRADE ORGANIZATION The purpose of the World Trade Organization is to provide the legal and institutional foundation for the multinational trading system. It addresses barriers to trade and subsidies that inhibit trade. The WTO implements and administers individual agreements, which encourages trade by providing a platform for negotiations and settling of disputes. Copyright © 2014 CFA Institute 21

22 CONCLUSIONS AND SUMMARY The benefits of trade include gains from exchange and specialization, gains from economies of scale, a greater variety of products available to households and firms, increased competition, and more efficient allocation of resources. A country has an absolute advantage in producing a good (or service) if it is able to produce that good at a lower absolute cost or use fewer resources in its production than its trading partner. A country has a comparative advantage in producing a good if its opportunity cost of producing that good is less than that of its trading partner. -In the Ricardian model of trade, comparative advantage and the pattern of trade are determined by differences in technology between countries. -In the Heckscher–Ohlin model of trade, comparative advantage and the pattern of trade are determined by differences in factor endowments between countries. Trade barriers prevent the free flow of goods and services among countries. Governments impose trade barriers for various reasons, including to promote specific developmental objectives, to counteract certain imperfections in the functioning of markets, or to respond to problems facing their economies. Copyright © 2014 CFA Institute 22

23 CONCLUSIONS AND SUMMARY In a small country, trade barriers generate a net welfare loss arising from distortion of production and consumption decisions and the associated inefficient allocation of resources. Trade barriers can generate a net welfare gain in a large country if the gain from improving its terms of trade (higher export prices and lower import prices) more than offsets the loss from the distortion of resource allocations. But the large country can only gain if it imposes an even larger welfare loss on its trading partner(s). An import tariff and an import quota have the same effect on price, production, and trade. With a quota, however, some or all of the revenue that would be raised by the equivalent tariff is instead captured by foreign producers (or the foreign government) as quota rents. Thus, the welfare loss suffered by the importing country is generally greater with a quota. A voluntary export restraint is imposed by the exporting country. It has the same impact on the importing country as an import quota from which foreigners capture all of the quota rents. Copyright © 2014 CFA Institute 23

24 CONCLUSIONS AND SUMMARY An export subsidy encourages firms to export their product rather than sell it in the domestic market. The distortion of production, consumption, and trade decisions generates a welfare loss. The welfare loss is greater for a large country because increased production and export of the subsidized product reduces its global price—that is, worsens the country’s terms of trade. Capital restrictions are defined as controls placed on foreigners’ ability to own domestic assets and/or domestic residents’ ability to own foreign assets. In contrast to trade restrictions, which limit the openness of goods markets, capital restrictions limit the openness of financial markets. A regional trading bloc is a group of countries that have signed an agreement to reduce and progressively eliminate barriers to trade and movement of factors of production among the members of the bloc. From an investment perspective, it is important to understand the complex and dynamic nature of trading relationships because they can help identify potential profitable investment opportunities as well as provide some advance warning signals regarding when to disinvest in a market or industry. Copyright © 2014 CFA Institute 24

25 CONCLUSIONS AND SUMMARY The major components of the balance of payments are the current account balance, capital account balance, and the financial account. Created after WWII, the International Monetary Fund, the World Bank, and the World Trade Organization are the three major international organizations that provide necessary stability to the international monetary system and facilitate international trade and development. -The IMF’s mission is to ensure the stability of the international monetary system. -The World Bank helps to create the basic economic infrastructure essential for creation and maintenance of domestic financial markets and a well- functioning financial industry in developing countries. -The World Trade Organization’s mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules. Copyright © 2014 CFA Institute 25

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