This document discusses international trade and the balance of payments. It defines domestic and international trade, and explains the benefits of international trade such as increased competition and more affordable products. Absolute advantage and comparative advantage theories of international trade are explained using examples. Factors that can change a country's comparative advantage over time are also discussed. The unrealistic assumptions of the Heckscher-Ohlin model are summarized. The document also outlines the structure of exports and imports for Sri Lanka and explains how they have changed over time. Finally, it provides an overview of the components of a country's balance of payments, including the current account, capital account, and financial account.

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4. Section 01

5.  domestic trade could be defined as any exchange
that can take place within the political
boundaries of a country.
 is the exchange of capital, goods, and services
across international borders or territories. This
type of trade allows for a greater competition
and more competitive pricing in the market. The
competition results in more affordable products
for the consumer.

6.  Increased exports
 Increased product range
 Economies of scale
 Increased competition
 Economic and international relations
 Promotes economic growth
 Encourage foreign investments
 A source of government revenue
 Specialization
 Concentration
 Movement of factors across borders

7. Section 02

9.  This occurs when one country can produce a
good with fewer resources than another or if
that country can produce more goods than
another.

10. cost per output unit
 Here USA can produce cars with lower cost
than the UK. Therefore USA has the absolute
advantage in producing cars. UK has the
absolute advantage for producing computers.
cars computers
UK 8 4
USA 6 8

11. output per resource unit
 In this case UK can produce more computers
compared to that of USA and USA produces
more cars than UK. Therefore UK has the
absolute advantage of producing computers and
USA has the absolute advantage of producing
cars
cars computers
UK 8 10
USA 10 8

12.  According to the absolute advantage theory,
each country should specialize in the product
which has absolute advantage and the excess
supply should be exchanged with the product
which has absolute disadvantage
 However to achieve this, there should be goods
with absolute advantages to both the countries.
That means if one country has absolute
advantages for both products, international
trade can not occur based on this theory.

13. output per resource unit
 Here in this case UK has the absolute
advantage for both the products and hence
trade can not happen between these two
countries. To avoid this problem in international
trade we use the comparative advantage
theory.
tea clothes
UK 8 10
USA 6 8

14.  A country has a comparative advantage over
another in the production of a good if it can
produce it at a lower opportunity cost.
 Law of comparative advantage
 This states that trade can benefit all countries
if they specialize in the goods in which they have
a comparative advantage.

15. output per resource unit
 Here India has the absolute advantage for both the products.
Therefore absolute advantage theory is not suitable to evaluate
the international trade occurrence of these two countries.
 Considering the opportunity cost formula, calculate the opportunity
cost and fill in the table below as shown and then select the
country with the lowest opportunity cost for each product.
Opportunity cost table
 Therefore it is clear that India has a comparative advantage over
Japan in the production of rice whereas Japan has the
comparative advantage of producing televisions.
Rice televisions
India 10 10
Japan 6 8
Rice televisions
India 10/10=1 10/10=1
Japan 8/6=1.33 6/8=0.75

16. cost per unit
 Canada has the absolute advantage for both products
according to the absolute advantage theory. Therefore
comparative advantage theory should be used. Considering
the above formula (reciprocal of opportunity cost formula)
prepare an opportunity cost table as shown below,
Opportunity cost table
 Therefore Kenya can specialize in the production of
cloths and Canada can specialize for sugar.
cloths sugar
Canada 4 3
Kenya 6 6
cloths sugar
Canada 4/3=1.33 3/4=0.75
Kenya 6/6=1 6/6=1

17.  Changes in factor endowment
 Changes in technological advancements
 Changes in tastes
 Specialization
 Differences in the sizes of countries
 Location of the country
 Structure of the market

18.  There are only two trading countries
 Those two countries produce only two goods
 The commodities produced in each country are
identical
 There are no barriers to trade and no
transport costs
 Labour is perfectly mobile

19.  perfect factor mobility
 constant returns to scale
 no externalities relating to production or
consumption
 no transportation costs
 constant opportunity costs

20.  unrealistic nature of the factor immobility
assumption
 increased specialization may lead to diseconomies
of scale
 government may restrict trade
 transport costs may outweigh any comparative
advantage
 use of unrealistic assumptions
 neglects the effects of elasticities of demand and
supply
 labour efficiency differentials are not considered
 nature of the markets changes over time

21.  The internal rate is derived from the output or
cost table.
 Here we assume that international trade does
not happen.

22.  The external rate is derived from the
opportunity cost table.
 Here we assume that countries specialize in the
good they have the comparative advantage.

23.  Protectionism represents any attempt by a
government to impose restrictions on trade in
goods and services between countries.
 This is the opposite of free trade

24.  Tariffs- a tax on imports
 Quotas- this is a physical limit on the quantity
of imports
 Embargoes- this could be identified as a total
ban
 Subsidies
 Administrative barriers
 Import licensing
 Exchange controls

25.  Infant industry argument
 Producers of primary products are discouraged.
ex; paddy farmers
 Raise revenue for the government
 Help the balance of payments
 Protection against dumping
 Limits environmental pollution
 Prevent harmful products entering the market

26.  Hurting consumers- higher prices for consumers
 Loss of economic welfare
 Regressive effect on the distribution of income
 Production inefficiencies
 Little protection for employment
 Trade wars

27.  “Terms of trade” is the rate at which the
products of one country are exchanged for the
products of another.
 Terms of trade = price index of exports/price
index of imports x 100

28.  It is important to identify the terms of trade to
take national economic decisions. When the
country’s goods are in high demand from abroad
i.e., when its terms of trade are favorable, the
level of money income increases. Conversely,
when the terms of trade are unfavorable, the
level of money income falls.

29.  Export price index increase while import price
index remains unchanged.
 Export price index remain unchanged while import
price index decrease.
 Export price index increases while import price
index decreases.
 Export price index increases at a greater
percentage while import price index increases at
a lower percentage.
 Export price index decreases at a lower
percentage while import price index decreases at
a greater percentage.
 Vice versa of the above

30.  Ratio of import prices to export prices
 The volume and value of exports and imports
 The conditions attached to exports and imports.

31.  Income terms of trade can be measured to find
the quantity of imports that can be imported to
the country, using the income generated from the
commodity exports.
 Income terms of trade = value of commodity
exports/imports price index x 100
 Income terms of trade = exports value index /
imports price index x 100
 Income terms of trade = (exports price index x
exports quantity index) / imports price index x 100

32.  Increase/decrease in the real national income
 Favorable/unfavorable effects to the balance of
payment due to the changes in trade balance.

33. Section 03

34.  Export structure of Sri Lanka
 Import structure of Sri Lanka

35.  Agricultural exports
 Tea
 Rubber
 Coconut
 Kernel products
 Other
 Other agricultural products
 Industrial exports
 Food, beverage and tobacco
 Textiles and garments
 Petroleum products
 Rubber products
 Ceramic products
 Leather, travel goods and footwear
 Machinery and equipment
 Other industrial exports
 Mineral exports
 Gems
 Other mineral exports
 Unclassified exports

36.  Agricultural exports have decreased over time
 Importance if industrial exports have been
increased.
 The most important export category in
agricultural sector is tea
 Most important export category in the industrial
sector is textiles and garments
 Mineral exports have decreased greatly over
time

37.  Consumer goods
 Food and beverages
 Rice
 Sugar
 Wheat
 Other
 Other consumer goods
 Intermediate goods
 Petroleum
 Fertilizer
 Chemicals
 Textiles and clothing
 Other intermediate goods
 Investment goods
 Machinery and equipment
 Transport equipment
 Building materials
 Other investment goods
 Unclassified imports

38.  Consumer goods have decreased over time
 Intermediate good have increased over time
 Food and beverages are the most important
import in the consumer good category
 Petroleum is the most important intermediate
import
 Machinery and equipments are the most
important investment import

39. Section 05

40.  The balance of payments is the place where
countries record their monetary transactions
with the rest of the world. Within the BOP
there are two separate categories under which
different transactions are categorized;
 Current account
 Capital and financial account

41.  Current account-this is a record of all payments for
trade in goods and services plus income flow. It is
divided into 4 parts;
 Trade account(visible)
 Service account(invisibles)
 Income account
 Current transfer account
 Capital account-this refers to the transfer of funds
associated with buying assets such as land. The major
components of capital account are;
 Capital transfers
 Acquisitions/disposal of non produced, non financial assets
 Financial account-the financial account shows the
transactions related to foreign financial assets and
liabilities. The major components of financial account
are;
 Direct investments
 Portfolio investments
 Other investments
 Reserve assets

42.  Direct investments-investments made in foreign
production organizations could be simply referred
to direct investments. This includes receipts from
privatization too.
 Portfolio investments-acquiring financial assets and
liabilities related to company shares, bonds,
debentures and financial derivatives.
 Reserve assets-foreign financial assets used by the
CBSL to finance the deficits of balance of
payment. These are called “: monetary
movements”. Following assets are included in the
reserve assets;
 Gold reserves
 Special drawing rights(SDR)of IMF
 Reserve tranche of IMF
 Balances of foreign currency

43. Current account
Trade balance
Exports
Imports
Services(net)
Receipts
Payments
Income(net)
Receipts
Payments
Goods, services and income(net)
Current transfers(net)
Private transfers(net)
Receipts
Payments
Other transfers(net)
Current account balance
Capital account
Capital transfers(net)
Receipts
Payments

44. Financial account
Long term
Direct investments
Foreign direct investments(net)
Private long term(net)
Inflow
Outflow
Government long term(net)
Inflows
Outflows
Short term
Portfolio investments(net)
Private short term(net)
Commercial bank assets(net)
Commercial bank liabilities(net)
Government short term(net)
Balance of capital and financial account
Allocation of SDR’s
Valuation adjustments
Errors and omissions
Overall balance

45.  Balance of payment equilibrium refers to a
situation where manageable deficits are cancelled
out by modest surpluses over a period of time.
So, on short term basis it does not necessarily
mean that a deficit is bad and a surplus is good.
 Balance of payments disequilibrium occurs when,
over a particular period of time a country is
recording persistent deficits or surpluses in its
balance of payments.

46.  Continuous decrease in the trade balance due to
an increase of imports expenditure.
 Insufficient inflows of foreign capital
 Increased foreign debt repayments and interest
payments
 Rigidity in the imports structure
 Devaluation of the currency
 Encouraging exports and increase the export
revenue
 Decreasing import expenditure
 Controlling the domestic inflation
 Encouraging foreign direct investments

47.  When the government balances a short term
BOP deficit using foreign reserves or obtaining
loans or when transfers surpluses to the
reserve assets, it is called financing the BOP.
 When there is a long term deficit in the BOP,
adjustments should be made to the economy to
correct the problem. When the economy
adjusts its exchange rates, fiscal policies and
monetary policies to face the problem is called
adjustments to BOP.

48.  This means that the value of exports has
increased at a slower rate than the value of
imports.
 Therefore there could have been an increase in
the deficit or the surplus could have changed
into a deficit.

49.  This states that devaluation will improve the
balance on the current account on the condition
that the combined elasticity’s of demand for
imports and exports greater than one.
 If (PEDx + PEDm > 1) then a devaluation will
improve current account
 If (PEDx + PEDm > 1) then an appreciation will
worsen current account

50.  In short term demand for imports and exports
tends to be inelastic.
 Therefore current account tends to get worse
before it gets better.
 Another problem with devaluation is that it can
lead to imported inflation.
 This is a problem if it leads to cost push
inflation.
 This means the improvement in the current
account might only be temporary

52. Section 05

53.  When the price of foreign currency is expressed
using the domestic currency it is called direct
quotation.
U.S Dollar ($) 1 = Sri Lankan Rs. 137
 When the price of local currency is expressed using
the foreign currency it is called indirect quotation. It
is the reciprocal of the direct quotation. Generally
we use 4 or 5 digits to express this.
Sri Lankan Rs. 1 = U.S. Dollar ($) 0.008

54.  This is the value of a country’s currency in
relation to other currencies without adjusting for
the rate of inflation.
 It’s the nominal exchange rate adjusted for
inflation

56.  Fixed exchange rate system
 It is a system in which the value of a country’s
currency is determined in relation to the value of
other currencies through government
intervention.

57.  Advantages of fixed exchange rates
 Promotes international trade
 Is good for small nations
 Promotes international investments
 Removes speculation
 Necessary for developing countries
 Economic stabilization
 It ensures smooth functioning of the monetary
system
 Disadvantages of fixed exchange rate systems
 Out dated system
 Discourage investments due to lack of speculative
profits
 High Monetary dependence

58.  Floating exchange rate system
 This is a system in which a currency’s value is
determined solely by the interplay of the market
forces of demand and supply instead of
government intervention.

59.  Advantages of floating exchange rate system
 Automatic balance of payments adjustments
 Absence of crisis
 Flexibility
 Lower foreign exchange reserves are needed to
manage the system
 Disadvantages of floating exchange rate system
 Uncertainty
 Lack of investments
 Speculation
 Lack of discipline in economic management

60.  Managed floating exchange rate system
 It is a system under which a country’s exchange
rate is not pegged, but the monetary authorities
try to manage it rather than simply leaving it to
be set by the market.

61.  The exchange rate falls, this changes the relative
prices of imports and exports. Exports will appear
to become relatively cheaper in other currencies,
and imports will appear to be more expensive.
Because we buy imports, they are included as part
of the retail price index, and so if the price of
imports goes up, this could be inflationary and
vice versa.

63.  Depreciation-is the loss of value of a country’s
currency with respect to one or more foreign
reference currencies, typically in a floating
exchange rate system.

64.  Appreciation- this is an increase in the value of
one currency with respect to another under a
floating exchange rate

65.  Overvaluation-an exchange rate is overvalued
when it implies that the currency is stronger than
it is according to a long run market determined
rate under a fixed exchange rate system.

66.  Undervaluation-an exchange rate is undervalued
when it implies that the currency is weaker under
a fixed exchange rate than it is according to a
long run market determined rate.

67.  Devaluation-devaluation is when a country makes
a conscious decision to lower its exchange rate in
a fixed or semi fixed exchange rate.
$ 1 = Rs. 100
$ 1 = Rs. 103

68.  Reasons for devaluation
 To increase exports and to decrease imports
 To reduce the balance of payments deficit
 To devalue the overvalued currency
 To reduce the outflow of foreign currency reserve
 Conditions required to a successful devaluation
 Demand for exports should be elastic
 Demand for imports should be elastic
 Supply of exports should be elastic
 Local inflation should be lower than other countries
 Other countries should not devalue their
currencies.

69.  Revaluation- this is an increase in the value of a
currency in relation to others under a fixed or
semi fixed exchange rate.
$ 1 = Rs. 100
$ 1 = Rs. 103