2. Chapter Outline:
1.1.International Trade and Finance
1.2. Purpose of International Trade and Finance
1.3. Current Problems of International Trade and Finance
1.4. The Gains and Causes of Trade
1.4.1. General Equilibrium in Closed Economy
1.4.2. General Equilibrium in Open Economy
1.4.3. The Gains from International Trade
1.4.4. The Causes of International Trade
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3. ❑ International trade and finance deals with the economic
interdependence among nations.
❑ This economic interdependence among nations is affected
by, and in turn influences, the political, social, cultural,
and military relations among nations.
❑ It analyzes the flow of goods, services, and payments
between a nation and the rest of the world, the policies
directed at regulating this flow, and their effects on the
nation’s welfare.
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4. ❑ Specifically, international economics as a subject
matter deals with:
❖international trade theory,
❖international trade policy,
❖the balance of payment, and
❖the foreign exchange markets and open–economy
macroeconomics.
❑ International trade theory analyzes the basis and the
gains from trade.
❑ International trade policy investigates the reasons for
and the effect of trade restrictions and new
protectionism.
❑ Balance of payment is a measure of a nation’s total
receipt from and payments to the rest of the world.
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5. ❑ Foreign exchange market is an institutional
arrangement where currency of one nation is
exchanged for the other.
❑ Finally, open- macroeconomics examines the
adjustment mechanisms in balance of payment
disequilibrium (surplus and deficit) as well as the
effects of the macroeconomic interdependence among
nations under different international monetary systems,
and their effect on a nation’s welfare.
❑ International trade theory and policies are the
microeconomic aspects of international economics
since they deal with individual nations treated as a
single unit and with the relative price of individual
commodities.
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6. ❑ International finance represents macroeconomic aspects
of international economics as they examine total receipt
and payment, and the level of national income and the
general price level respectively.
❑ Therefore, international economics can be divided into
two broad subfields: international trade and
international money (finance).
❑ International trade analysis focuses primarily on the
real transactions, that is, on those transactions that
involve a physical movement of goods or a tangible
commitment of economic resources.
❑ International monetary analysis focuses on the
monetary side, that is, on financial transactions such as
foreign purchases of Ethiopian Birr.
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7. ❑ An example of an international trade issue is the
conflict between developed and developing countries
over developed countries subsidized agricultural
products in international market.
❑ An example of an international monetary issue is the
current dispute between U.S.A and China over whether
the Chinese Yuan should be allowed to float freely or
be stabilized by government action.
❑ In short, International trade and finance is a branch of
economics which deals with international trade theory,
international trade policy, the balance of payment and
the foreign exchange markets and open–economy
macroeconomics.
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8. ❑ The purpose of economic theory in general is to predict
and explain economic events.
❑ That is economic theory abstracts from the details
surrounding an economic event in order to isolate the
few variables and relationships considered most
important in predicting and explaining the event.
❑ Along these lines, international economic theory
usually assumes:
❖ A two–nation, two-commodity and two-factor world [2x2x2 model].
❖ No trade restrictions,
❖ Perfect mobility of factors within the nations but no international
mobility,
❖ Perfect competition in all commodity and factor markets, and
❖ No transportation costs.
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9. ❑ Starting from these simplified assumptions just
mentioned, international economic theory examines:
❖the basis for and the gain from trade,
❖the reasons for and the effects of trade restrictions,
❖policies directed at regulating the flow of international
payments and receipts, and
❖the effects of these policies on a nation’s welfare.
❑ These are referred to as the purposes of international
trade and finance.
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10. ❑ With respect to Ethiopia, the purpose of international
trade and finance can be :
❖to investigate the reasons for disequilibrium in
the balance of payment,
❖the benefits and costs of joining World Trade
Organization for Ethiopia, and
❖how Ethiopia can utilizes its resources properly
by participating in international trade and so on.
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11. ❑ The most serious international trade problem facing the
world today is the rising protectionism in industrial
countries.
❑ The most common international monetary problem is
excessive volatility of exchange rates, and their large
and persistent misalignments.
❑ The other serious international economic problem is
large and persistent structural unemployment problem
in Europe following the Euro crises created by a huge
government debt.
❑ Deep poverty and widening international inequalities is
also facing many of the poorest developing countries of
the world.
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12. ❑ International trade theory states that the best policy for
the world is free trade.
❑ Under such a policy, each nation will specialize in the
production of the commodity that it can produce most
efficiently and, through exchange, each nation will
gain.
❑ In the real world, however, most nations impose some
restrictions on free flow of trade.
❑ Though protectionism is justified on national welfare
grounds, trade restrictions are usually advocated by and
greatly benefit a small minority of producers in the
nation at the expense of the most silent majority of
consumers.
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13. ❑ Exchange rates have exhibited excessive volatility or
fluctuation and large and persistent misalignments or
disequilibria.
❑ These disrupt the pattern of international trade and
specialization and lead to unstable financial conditions
throughout the world.
❑ The persistence of excessive volatility and disequilibria
in exchange rates has led to:
❖calls for reforms of the present IMS along the lines of
establishing the target zones of allowed fluctuation for the
major currencies, and
❖for more international coordination of macroeconomic
policies among the leading industrial countries.
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14. ❑ Following the 2008 and 2009 global recession and Euro
crises the current unemployment rate in the
industrialized countries of Europe and U.S.A. averaged
above 12 percent and 9 percent respectively.
❑ The highest unemployment rate is experienced in
Europe by Spain, 20 percent.
❑ Apart from the global recession and Euro crises, the
high structural or long term unemployment problem in
Europe is believed to be due to the overgenerous social
security benefits and inflexible labour market,
❑ The attempt to reduce benefits and increase flexibility
in the labour market however is creating social unrest
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15. ❑ Even though many developing countries, especially
China and India, have started to grow very rapidly in
recent years, many of the poorest developing nations,
particularly those of Sub–Saharan Africa, face deep
poverty, unmanageable international debt problems,
economic stagnation, and widening international
inequalities in living standards.
❑ International trade and finance will examine why
international inequalities in standard of living between
the rich and many of the poorest developing countries
of the world so large and widening, and what can be
done to overcome this problem.
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16. ❑ The determination of general equilibrium in the closed
economy involves the use of demand and supply side
of the economy.
❑ The three conditions that determine general equilibrium
in the closed economy are:
❖Consumers consume at a point where the price ratio Px/Py
is equal to the marginal rate of substitution, MRS, that is,
MRS = Px/Py
❖Profit maximizing producers produce at a point where the
price ratio, Px/Py is equal to the marginal rate of
transformation, MRT, that is, MRT = Px/Py
❖The market clears, i.e. the demand and supply in the
market are equal, that is, Xc =Xp and Yc = Yp
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❑ The Figure below shows the general equilibrium that
satisfies these three conditions.
Commodity Y
A
U0
Pa
0 Commodity X
Fig. 1: Closed Economy General Equilibrium
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18. ❑ When a country engage in trade, it will face a fixed
world price ratio, denoted by P*=Px*/Py* which is
generally different from the autarky price, Pa.
❑ The first optimization conditions for the producer and
consumer, however, mentioned in autarky
equilibrium will remain unchanged whatever price
prevail.
❑ With international trade, the economy is not
constrained to consume what it can produce.
❑ A trading nation is able to sell some of one good at
world price and use the proceeds to buy the other
commodity.
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19. ❑ Instead of market clearing, we have what we call a
trade balance condition: the value of what a country
sells on world markets must be equal to what it buys.
❑ The concept of Excess demand
❑ We can define the excess demand for goods X and Y
as (Xc-Xp) and (Yc-Yp) respectively.
❑ If excess demand is positive, the economy is
consuming more than it is producing, which
corresponds to demand for import good.
❑ If excess demand is negative, the reverse is true, i.e.
the economy is consuming less than it is producing
which results in an export good.
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20. ❑ Trade balance condition shows that the value of
positive excess demand for exports should be equal to
the value of the negative excess demand for imports.
Px*(Xc - Xp) = - Py*( Yc - Yp)
Px*(Xc - Xp) + Py*( Yc - Yp) = 0 (1.2)
❑ Rearranging the terms in Eq. (1.2.), we get:
Px* Xp + Py* Yp = Px*Xc + Py*Yc (1.3)
❑ The left hand side of this equation is the value of
production at world price, while the right hand side is
the value of consumption at world price.
❑ Thus, equivalent to the trade balance condition is the
requirement that the value of production must equal
the value of consumption.
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21. ❑ Assuming that the value of production at world prices
is equal to the income of the country, we drive the
national budget line at world price ratio P*.
❑ This budget line defines the national income by
evaluating domestic output at world price.
❑ Consumers are free to choose any point on this
budget line, because the value of consumption will be
equal to the value of production as shown in the
forthcoming figure where the world price ratio is
given by P*.
❑ Producers optimize by choosing production at point
Q. Consumers optimize by choosing consumption at
point C.
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❑ The following figure shows a case where a country imports X
(Xc-Xp) and exports Y(Yc-Yp). Trade will balance as far as
the value of production is equal to the value of consumption.
Commodity Y
Yp Q
Yc C
P*
0 Xp Xc Commodity X
Fig. 2: Open Economy General Equilibrium
❑ NB: general equilibrium in open economy occurs when
the above three conditions are satisfied.
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23. ❑ Let us see how the world price and international
equilibrium are determined by using the following
figure.
❑ In the figure, the autarky price ratio is Pa and price
ratio P*1 < Pa, the country produces at Q1 and
consumes at C1.
❑ In this situation, the price of X at the world price is
less than its domestic price, making the relative price
of X lower on the world markets.
❑ Therefore, excess demand for good X is positive; i.e.,
X is imported.
❑ If Y is more expensive in the world market than the
domestic market it will be exported. 23
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❑ At the price ratio P2* > Pa, producers produce at point Q2 and
consumers will consume at point C2.
❑ With the price ratio greater than the autarky price ratio, the
home country exports X (the relatively expensive good on the
world markets and imports Y (the relatively cheaper good on
the world market).
Commodity Y P2*
Q1 C2
A C1
Q2 P1*
P2* Pa
0 Commodity X
Fig.3: Different Equilibrium of Trade
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25. ❑ In general if the world price ratio exceeds the
domestic price ratio (P* > Pa), then X is exported and
there is a negative excess demand for X.
❑ If the world price ratio is less than the autarky price
ratio (P* < Pa), then X is imported and there is a
positive excess demand for X and vice versa for
commodity Y.
❑ The figure below shows the excess demand for good
X, labelled Ex, for the home country.
❑ At the autarky price ratio, Pa, there is zero excess
demand.
❑ Price ratios P1* and P2* are similarly labelled as the
price ratios in the above figure.
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P*
x P2*
Pa
P1* m Ex
-(Xc-Xp) (Xc-Xp)
Fig.4: Excess Demand Curve for commodity X
❑ So far we have seen the excess demand curve for good
X for the home country, say Country H.
❑ If the world economy is characterized by the existence
of two countries, we consider two countries: the home
country and the foreign country.
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27. ❑ Excess demand for X becomes increasingly negative
(export of X becomes increasingly positive) as the
world price ratio increases above Pa.
❑ Excess demand becomes increasingly positive
(imports of X become increasingly positive) as the
world price ratio falls below Pa.
❑ Excess demand curve for X, Ex is similar to the
conventional demand curve, except that the quantity
demanded may be either positive or negative.
❑ A positive demand curve indicates a desire to import
the good at the world price and the reverse is also
true.
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❑ Let us say the foreign country is country F. In the following
figure, the excess demand curve for Country F, Ex*, is placed
arbitrarily above the excess demand curve of County H, Ex.
❑ The autarky price ratio in Country F, Pa* is greater than
Country H’s autarky price ratio, Pa.
P*
Pa*
P* Ex*
Pa
Ex
-(Xc-Xp) (Xc-Xp)
Fig.5: International General Equilibrium
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29. ❑ International equilibrium in the world economy is
then determined at an international price ratio where
the positive excess demand for X in one country (in
our case imports of foreign country) is equal to the
negative excess demand for X (in our case export of
the home country).
❑ This equalization occur at a price ratio P*, which is
the world price ratio.
❑ The market for X clears, which is the combination for
international equilibrium: Ex + Ex* = 0
❑ In a competitive market, the equilibrium price lies
between the autarky prices of the two countries.
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30. ❑ With autarky price of X higher in Country F, the
direction of trade will be that F will import X and H
will export X in international equilibrium as already
indicated in the figure above.
❑ That is the differences in autarky prices are the major
determinant of the direction of trade, i.e., which
country to import and export, and which product.
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31. ❑ Static gains arise from the optimum use of the
country’s factor endowments or human and physical
resources so that the national output is maximized
resulting in increase in social welfare.
❑ The Gain from –Trade theorem states that given that
the value of production is maximized at free trade
prices, the value of free trade consumption at free
trade prices exceeds the value of autarky
consumption at free trade prices.
❑ Therefore, the free trade consumption bundle must
thus be preferred to the autarky bundle.
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32. ❑ It is widely believed by the general public that
imports and trade are harmful for the national
economy; and if one country gains from trade, the
other country should lose i.e., trade is a zero-sum
game: the gains to one player equals the loss of the
other player.
❑ Trade, however, is a “positive sum – game” because
there are a wide range of situations in which all
countries gain mutually from trade.
❑ But all individual within a nation will not necessarily
benefit from trade.
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33. 33
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Case 1) Consider two countries with identical production
possibility curves and identical preferences:
Commodity Y
C2
Q1 C1
A Uf Ua
Q2 P1*
P2*
0 Commodity X
Fig.6: Gain from trade
❑ If the world price ratio happens to be P1* the country will
produce at point Q1 and consume at point C1 by exporting Y
and importing X.
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34. ❑ On the other hand, if the price ratio is P2* the country
will produce at point Q2 and consume at point C2 by
exporting X and importing Y.
❑ The free trade utility, point C2, is the same in the
presence of two different price ratios.
❑ The result requires just the tangency condition
between the price ratio and the production frontier.
❑ The only condition is that the world price ratio must
differ from the autarky price ratio.
❑ Given such difference, the country gains by exporting
what is more valuable (expensive) on the world
markets and by importing what is more costly to
produce at home than abroad. 34
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35. 35
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❑ Case 2) Consider two countries with different
production possibility curves and identical preferences:
Y* P*
Q*
A* C=C*
Y
A IC1 IC2
Q
0 X* X
Fig.7: Mutual gains from trade
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36. ❑ YX and Y*X* represents the PPCs of the home and
foreign economies respectively.
❑ The two economies share IC1 and achieve equilibrium
on their own PPC (at A and A* respectively before
trade).
❑ Following the introduction of new price line P*,
welfare is improved in both nation as shown by a
shift of IC1 to IC2.
❑ Both nations achieve equilibrium of consumption at
C=C*.
❑ Their equilibrium of production will be Q and Q*
respectively.
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37. ❑ These imply that the home economy reduces the
production of commodity Y (to be imported) and
increases the production of commodity X (to be
exported) where as the foreign economy increases the
production of commodity Y (to be exported) and
reduces the production of commodity X (to be
imported).
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38. 38
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Case 3) Consider two countries with different production
possibility curves and different preferences:
Y Y*
A EA’ B
EA’ QB
QA EB’
EB
P* PA PB IC1 P*
0 A’ X 0 B’ X*
Fig.8: Mutual gains from trade
❑ AA’ and BB’ represents the PPCs of the country A and country
B, respectively.
❑ The two economies achieve equilibrium on their own PPC (at
EA and EB, respectively before trade).
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39. ❑ Following the introduction of new price line P*,
welfare is improved in both nation as shown by a
shift of EA to EA’ and EB to EB’.
❑ The nations achieve equilibrium of production at QA
and QB respectively.
❑ These imply that country A reduces the production of
commodity Y (to be imported) and increases the
production of commodity X (to be exported) where as
country B increases the production of commodity Y
(to be exported) and reduces the production of
commodity X (to be imported).
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40. ❑ Dynamic gains refer to those benefits which promote
economic growth and development of the
participating countries.
❑ International trade increases national income and
facilitates saving and opens out new channels of
investment.
❑ Increase in saving and investment is found to
promote economic growth.
❑ Exports earn foreign exchange which can be utilized
in buying capital goods and know-how from abroad
that can serve as instruments of economic growth.
❑ The larger the national income and output the higher
the rate of growth. 40
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41. ❑ The higher level of output will enable a country to
avoid the vicious circle of poverty and put the
country in the take off or self-sustaining growth.
❑ Production possibilities and cost of production in
different countries differ so widely that foreign trade
brings to the participating countries tremendous gains
in terms of national output and income.
❑ International trade promotes economic development
in the following ways:
❖Developing countries can import capital goods in
exchange for their exports that are mostly agricultural
products. The capital goods then will increase the
productive capacity of these countries and promote the
process of industrial development. 41
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42. ❖A country can also import technical know-how technical skills,
managerial talent and entrepreneurship through foreign trade
and collaboration.
❖International trade has brought about a tremendous movement
of FDI from developed countries to developing countries. Thus,
foreign trade facilitates the payment of interest or repatriation
of capital. The existence of large volume of foreign trade serves
as guarantee for the payment of interest and the principal for
lenders.
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43. ❑ So as to understand the causes of trade assume that
there is no trade in the world.
❑ As per our simple model discussed earlier, this means
that the autarky price ratios are identical.
❑ There are no scale economies (note that economies of
scale can give rise to trade).
❑ That means all countries have identical, convex
production frontier and the same type of community
indifference curve prevails in all countries as
presented in the following figure.
❑ If there is no trade, the demand and supply conditions
in all countries will be the same.
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Commodity Y
T
A U
P
0 T’ Commodity X
Fig. 9: Two identical countries
❑ That means there is identical and homogenous taste
throughout the world and the production possibility curve is
the same for all countries.
❑ The position and shape of production possibility frontier is
determined by three factors viz.
❑degree of homogeneity,
❑factor endowments, and
❑production function. fbaylie@yahoo.com
45. ❑ That means if countries have identical production
curve, they have constant returns production function
and the same factor endowments.
❑ The conditions that together guarantee no trade are
thus:
Identical production functions among countries
The same relative endowments in all countries
No division of labour (specialization)
No price differential
Constant returns to scale
Identical and homogenous taste in all countries
The absence of distortions (eg. Taxes, subsidies, imperfect
competition)
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46. ❑ These sets of assumptions are not the only set of
assumptions that will guarantee no trade.
❑ The real importance of these assumptions is not that
they describe a world in which there will be no trade,
rather they describe the different causes of trade.
❑ That is, if any one of the assumptions is relaxed, the
situation will give rise in which trade is possible.
❑ Therefore, the above conditions are the causes of, or
bases of trade.
❑ Let us relax the assumption of no price differential
and see how trade can be created.
❑ Price is a signal that shows the deviation between
demand and supply. 46
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47. 47
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❑ Thus, the existence of price differential implies that
there are differences in demand and/or supply
conditions across countries.
❑ Case 1) Assume that home (H) and foreign (F)
economies have similar demand conditions but
different supply conditions as shown below.
Foreign Home
SF SH
PH
x P* m
PF
DF DH
Commodity X 0 Commodity X
Fig.10: Similar Demand Conditions
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❑ Case 2) Assume that home (H) and foreign (F)
economies have similar supply conditions but different
demand conditions as shown below.
Foreign Home
SF SH
PH
x P* m
PH
DF DH
Commodity X Commodity X
Fig.11: Similar Supply Conditions
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❑ Case 3) Assume that home (H) and foreign (F)
economies have different demand supply conditions as
shown below.
Foreign Home
SF SH
PH
x P* m
PF
DF DH
Commodity X 0 Commodity X
Fig.12: Different Demand and Supply Conditions
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50. ❑ The price of commodity X is PH in the home
economy and PF in the foreign economy.
❑ PH>PF implies that the home economy can import
commodity X more cheaply from the foreign
economy than producing the same commodity at
home.
❑ Conversely, the foreign economy will be interested to
export commodity X to the home economy at a
higher price. Therefore, at any price between PH and
PF (such as P*), trade can be created.
❑ If so, the foreign economy can export commodity X
to the home economy (or the home economy imports
commodity X from the foreign economy.
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❑ Case 4) Assume that home (H) and foreign (F)
economies have similar demand conditions and supply
conditions as shown below.
Foreign Home
SF SH
PF=PH
DF DH
Commodity X 0 Commodity X
Fig.12: Similar Demand and Supply Conditions
❑ The price of commodity X is PH in the home economy
and PF in the foreign economy but PH=PF in this case.
This implies that there is no option for trade.
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52. ❑ International trade (external trade or foreign trade)
can be defined as the exchange of goods and services
between the residents of a given country with
residents in the rest of the world.
❑ Domestic trade (internal trade) refers to the exchange
of goods and services among the residents of the
same country.
❑ The difference between domestic and international
trade is explained below.
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53. ❑ The distinction made by classical economists
between domestic and international trade was grounded
on the notion of geographic mobility of factors of
production.
❑ The assumption made was that within the nation,
there is free mobility of factors of production.
❑ If internal mobility were perfect, then all factors of
production notably labour and capital, would move
into areas where they can receive higher rate of return
for their services.
❑ Under idealized perfect mobility there could not exist
inter-regional differences in factor prices.
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54. ❑ The factors would move from the regions where their
prices are relatively lower to regions where their
prices are relatively higher until the price differences
between the regions are completely wiped off.
❑ In such a case, the price of any factor of production
of a given type and quality must be the same
throughout the entire country.
❑ In international trade however the factor mobility is
neither free nor perfect.
❑ First of all, there are restrictive immigration laws
which prevent free mobility of labour from one
country to another.
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55. ❑ In respect of capital also, there are restrictions on the
inflow and outflow of capital and investment across
national frontiers.
❑ In addition to these legal barriers, there are other
social, cultural and political barriers that restrict the
mobility of factors from one country to another.
❑ Differences in language, climate, social customs and
practices, political and educational system etc do
create additional barriers to factor mobility between
nations.
❑ Within the nation, such differences may not exist, or
may not appear too formidable to be overcome by
economic incentive.
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56. ❑ Within the nation, the movement of goods and
services from one region to another is free.
❑ The only internal barriers to free movement of goods
and services are the distance and cost of
transportation what may be termed as natural barriers.
❑ But in the case of international trade, such a
movement is not free, because in addition to natural
barriers, are formidable man-made barriers.
❑ For instance, there are import and export duties and
quotas, exchange controls, non-tariff (hidden)
barriers which put countless obstacles to the free
movement of goods and services between countries.
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57. ❑ Growing protectionism and spirit of nationalism have
been making trade between countries more and more
difficult.
❑ Agricultural protectionism in the western
industrialized countries and the policies of
industrialization through import substitution in
developing countries are some of the examples of
how international trade in commodities is being
deliberately reduced in today’s world.
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58. ❑ Within a nation, the economic environment is more
or less the same in all the regions of the country.
❑ For example, the legal framework or the laws
governing the consumption, production and exchange
of goods and services are the same throughout the
country.
❑ Government policies with regard to interest rates,
taxes, wages or prices are the same within the
country.
❑ Production techniques, factor proportions, factor
prices, infrastructure facilities and production
functions or possibilities are nearly the same in the
country.
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59. ❑ Similarly, market structures- the degree of
competition or monopoly in production and consumer
taste patterns and preferences are more or less the
same throughout of the country.
❑ All of them would add up to create certain economic
environment or investment climate within the nation.
❑ But between nations, they could all differ very
significantly.
❑ This would make the character of international trade
significantly different from that of domestic trade.
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60. ❑ The difference between domestic and foreign trade is
more obvious in international monetary or currency
differences.
❑ Within the nation, monetary laws and the financial
system and arrangements are the same for all regions
in the country.
❑ Most significantly, there is a single currency used as a
medium of exchange or a measure of value which
would make exchange very smooth as far as domestic
trade is concerned.
❑ There are multiple currencies between countries and
not all of them are freely accepted in discharge of
international monetary obligations.
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61. ❑ An Ethiopian importer must first obtain US dollar
before he/she can think of buying goods from the
USA.
❑ But with the domestic trade, one can export or import
goods from one region to another in any quantity.
❑ In respect of foreign trade, however, there are
currency complications, problems of non-
convertibility currencies, exchange controls and
restrictions and many other obstacles.
❑ International monetary differences, therefore,
introduce complications and complexities in
international transactions; and these are absent in
domestic trade and exchange.
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