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Chapter 8 International Trade and Capital FLows

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1 Chapter 8 International Trade and Capital FLows
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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. Notes to the presenter: As an introduction, you could mention what happens when countries pull back from international trade, as was the case during the 1930s and early 1940s. The unintended effect was to reduce the standard of living. Comparative advantage is discussed later in the text, but a quick definition is that it is the production of a good or service that can be produced at a lower cost than in any other country. Copyright © 2014 CFA Institute

3 2. International trade 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: Gross national product (GNP) Add Production of goods and services by foreigners within the country Subtract Production of goods and services by the country’s citizens outside the country Equals Gross domestic product (GDP) LOS: Compare gross domestic product and gross national product. Pages 404–405 Notes to the presenter: Definitions of GNP and GDP: Gross national product is the total value of all goods and services provided by a country during a specific period of time. Gross domestic product is the total value of all goods and services consumed, government outlays, investments, and exports less imports. From Chapter 5 (Equation 5-1 on p. 208): GDP = C + G + I + (X – M) The difference between the two measures of performance relates to international trade. Copyright © 2014 CFA Institute

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. LOS: Describe the benefits and costs of international trade. Pages 404–407 Notes to presenter: The purpose of this slide is to establish some of the terminology with respect to imports and exports. Terms of trade ratios for individual nations for 2010 (latest available) from the World Bank: United States = 80% China = 120% Germany = 1.13% Copyright © 2014 CFA Institute

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. LOS: Describe the benefits and costs of international trade. Pages 406–411 Notes to the presenter: Trade as a percentage of GDP for 2010 (latest available) from the World Bank: United States = 80% China = 120% Germany = 1.13% Capital restrictions are also referred to as capital controls. Copyright © 2014 CFA Institute

6 Benefits and costs of International trade
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 LOS: Describe the benefits and costs of international trade. Pages 411–412 Copyright © 2014 CFA Institute

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. LOS: Distinguish between comparative advantage and absolute advantage. Pages 415–422 An absolute advantage is the ability to produce a good or service at a lower cost per unit or use fewer resources than any other producer, whereas a comparative advantage is the ability to produce a good or service at a lower opportunity cost than any other producer. The distinction between the two types of advantages has to do with the lowest cost of production in terms of resources or costs (absolute advantage) versus the lowest opportunity cost (comparative advantage). Notes to the presenter: The distinction between absolute and comparative advantage is challenging. An example, such as that on the next slide, may help clarify the distinction. Example 8-3 is also useful in illustrating the difference, especially when the output is restated in terms of the machinery–cloth opportunity cost. 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. Copyright © 2014 CFA Institute

8 Assume identical feed and labor supply.
Advantages: Example Country A Country B Assume identical feed and labor supply. Can produce 5 cows or 25 hogs Can 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 hogs Comparative advantage in cows Absolute advantage in hogs Specialize in hogs Specialize in cows LOS: Distinguish between comparative advantage and absolute advantage. Pages 415–422 Note to the presenter: Neither Country A nor Country B has an absolute advantage in cows, but Country A has an absolute advantage in hogs. In the graph, note that the slopes are different between the two countries, which indicates that their production efficiency differs. Copyright © 2014 CFA Institute

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. LOS: Explain the Ricardian and Heckscher–Olin models of trade and the source(s) of comparative advantage in each model. Pages 422–424 The Ricardian model of comparative advantage focuses on labor as the source of comparative advantage, whereas the Heckscher–Ohlin model focuses on both labor and capital as sources of comparative advantage. Copyright © 2014 CFA Institute

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 LOS: Compare the types of trade and capital restrictions and their economic implications. Pages 424–428 A tariff is a tax on imported goods. An import quota is a restriction on the quantity that can be imported. An export subsidy is a payment by a government for exporting a specified good. A voluntary export restraint is a voluntary limit on an exported good. Copyright © 2014 CFA Institute

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. LOS: Compare the types of trade and capital restrictions and their economic implications. Pages 424–428 Note to the presenter: The definition of the small country and large country is not a function of the size of the country (population, square mileage, etc.), but rather whether it is a price taker. Copyright © 2014 CFA Institute

12 Voluntary Export Restraint (VER)
Summary of effects Tariff Import Quota Export Subsidy Voluntary Export Restraint (VER) Impact on Importing country Exporting country Producer surplus + Consumer surplus Government revenue Mixed National welfare Small country Large country Price Domestic consumption Domestic production Trade Imports Exports LOS: Compare the types of trade and capital restrictions and their economic implications. Pages 424–430 The restrictions on trade and capital have effects on producer surplus, consumer surplus, government revenue, and national welfare, as well as the price, consumption, and production of goods. A tariff, import quota, export subsidy, and voluntary export restraint would increase producer surplus, reduce consumer surplus, and result in higher prices and lower production. These restrictions affect government revenue differently and affect the national welfare depending on whether the country is a price taker (small country) or can affect prices (large country). Notes to the presenter: This slide is a simplified version of Exhibit 8-13. Copyright © 2014 CFA Institute

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. 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 LOS: Explain motivations for and advantages of trading blocs, common markets, and economic unions. Page 430 Copyright © 2014 CFA Institute

14 Why trading blocs? Increased competition
Lowers prices and increases quantity Cost of production declines Easier access to natural resources and technology Increased access to technology and knowledge Increased specialization Greater opportunity for economies of scale Increased employment Increased income Increased interdependence among members Less chance of conflicts LOS: Explain motivations for and advantages of trading blocs, common markets, and economic unions. Pages 430–434 The reasons for forming a trading bloc are many and are intended to benefit the domestic economy: Increased competition Cost of production declines Increased access to technology and knowledge Increased specialization Greater opportunity for economies of scale Increased employment Increased income Increased interdependence among members Copyright © 2014 CFA Institute

15 Trading blocs and capital restrictions
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 LOS: Explain motivations for and advantages of trading blocs, common markets, and economic unions. Pages 435–436 Copyright © 2014 CFA Institute

16 4. Balance of payments The balance of payments is the accounting of the flow of funds into and out of a country. 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 LOS: Describe the balance of payments accounts, including their components. Pages 438–443 The assets of a country are increased and its liabilities decreased when consumers and businesses purchase foreign financial assets, lend funds to foreign entities, and pay off debts to foreigners. The assets of a country are decreased and its liabilities increased when consumers and businesses pay for imported goods and borrow from foreigners. Notes to the presenter: One way to address the effects on the balance of payments is to stress the fact that it is a double-entry bookkeeping system. Example 8-10 is a way to illustrate the additions and subtractions to the current account, capital account, and financial account of a country. Exhibit 8-16 is an example of transactions and how they affect the balance of payments. Copyright © 2014 CFA Institute

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 LOS: Describe the balance of payments accounts including their components. Pages 438–440 The current account is the goods and services into and out of a country: the sum of the exports less imports, net income from other countries, and net current transfers. The capital account captures the flows related to the purchase and sale of nonfinancial assets used in production. The financial account captures the monetary flows for financial assets, such as bonds and stocks. Notes to the reviewer: Unilateral transfers are money that is received or sent as gifts, including transfers to a worker’s home country. These transfers include payments among governments. Copyright © 2014 CFA Institute

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. 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 LOS: Describe functions and objectives of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization. Pages 451–455 Notes to the presenter: The creation of these organizations has in its origin an era of protectionism during the Great Depression. These organizations facilitate trade, hence benefiting countries in general. Copyright © 2014 CFA Institute

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. LOS: Describe the function and objective of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization. Pages 451–453 The purpose of the International Monetary Fund is to stabilize exchange rates and the system of international payments. Copyright © 2014 CFA Institute

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) LOS: Describe the function and objective of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization. Pages 453–454 The objective of the World Bank is to help developing countries fight poverty and enhance environmentally sound economic growth. Copyright © 2014 CFA Institute

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. LOS: Describe the function and objective of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization. Pages 454–455 The purpose of the World Trade Organization is to provide the legal and institutional foundation for the multinational trading system. Copyright © 2014 CFA Institute

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

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

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

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


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