International Economics

Free Trade and Comparative Advantage

Absolute and Comparative Advantage

A country has an absolute advantage in producing a good if it can produce more output per unit of resources than another country.

A country has a comparative advantage in producing a good if it can produce it at a lower opportunity cost than another country. Comparative advantage is the basis for mutually beneficial trade, even when one country has an absolute advantage in all goods.

Ricardian model example:

Consider two countries, A and B, producing two goods, wine and cloth. Output per worker per day:

	Wine (bottles)	Cloth (metres)
Country A	6	3
Country B	2	4

Opportunity costs:

• Country A: 1 bottle of wine costs $3/6 = 0.5\;\mathrm{m}$ of cloth; 1 metre of cloth costs $6/3 = 2$ bottles of wine
• Country B: 1 bottle of wine costs $4/2 = 2\;\mathrm{m}$ of cloth; 1 metre of cloth costs $2/4 = 0.5$ bottles of wine

Country A has a comparative advantage in wine (lower opportunity cost: $0.5\;\mathrm{m}$ vs. $2\;\mathrm{m}$). Country B has a comparative advantage in cloth (lower opportunity cost: $0.5$ bottles vs. $2$ bottles).

Both countries gain from specialising in the good in which they have a comparative advantage and trading at a mutually beneficial terms of trade between the two opportunity cost ratios (e.g., 1 wine for 0.75 cloth -- between A's cost of 0.5 and B's cost of 2).

Gains from trade with numerical example:

If each country has 100 workers and splits them equally before trade:

• Country A produces: $50 \times 6 = 300$ wine, $50 \times 3 = 150$ cloth. Total: 300 wine, 150 cloth
• Country B produces: $50 \times 2 = 100$ wine, $50 \times 4 = 200$ cloth. Total: 100 wine, 200 cloth
• World total: 400 wine, 350 cloth

After specialisation (A produces only wine, B produces only cloth):

• Country A produces: $100 \times 6 = 600$ wine, 0 cloth
• Country B produces: 0 wine, $100 \times 4 = 400$ cloth
• World total: 600 wine, 400 cloth

Both wine and cloth production have increased. If they trade at 1 wine $= 1$ cloth, both countries can consume more of both goods than before trade.

Assumptions and Limitations of the Ricardian Model

The simple comparative advantage model assumes:

• Only two countries and two goods
• Constant returns to scale
• Perfect factor mobility within countries, immobility between countries
• Zero transport costs
• Perfect competition
• No trade barriers
• Labour is the only factor of production

In reality, transport costs, economies of scale, imperfect competition, and factor immobility complicate the picture.

The Heckscher-Ohlin Model

The Heckscher-Ohlin (H-O) model extends the theory by linking comparative advantage to factor endowments: countries export goods that intensively use their abundant factors and import goods that intensively use their scarce factors.

Key propositions:

• H-O theorem: a country will export the good that uses its abundant factor intensively
• Factor price equalisation: trade in goods leads to equalisation of factor prices (wages, rents) between countries (in practice, factor prices do not fully equalise due to transport costs, trade barriers, and imperfect factor mobility)
• Stolper-Samuelson theorem: an increase in the price of a good benefits the factor used intensively in its production and harms the other factor
• Rybczynski theorem: an increase in one factor endowment (at constant goods prices) increases the output of the good that uses that factor intensively and reduces the output of the other good

New Trade Theory

Paul Krugman's new trade theory (1980s) explains trade between similar countries through:

• Economies of scale: large-scale production reduces average costs, giving countries that specialise in particular industries a cost advantage
• Product differentiation: consumers value variety, creating demand for differentiated products from different countries (intra-industry trade)

This explains why most international trade occurs between developed countries with similar factor endowments (e.g., Germany and France trade cars with each other).

Intra-industry trade refers to the exchange of similar products within the same industry (e.g., the UK exports Jaguar cars to Germany while importing BMW cars from Germany). The Grubel-Lloyd index measures the extent of intra-industry trade:

$\mathrm{GL}_i = 1 - \frac{|X_i - M_i|}{X_i + M_i}$

Where $X_i$ and $M_i$ are exports and imports of industry $i$. GL ranges from 0 (pure inter-industry trade) to 1 (pure intra-industry trade).

Terms of Trade

Measurement

The terms of trade (ToT) measure the ratio of a country's export prices to its import prices:

$\mathrm{ToT} = \frac{\mathrm{Index\ of\ Export\ Prices}}{\mathrm{Index\ of\ Import\ Prices}} \times 100$

• An improvement in the terms of trade (ToT rises) means a country can buy more imports for a given volume of exports -- a favourable change
• A deterioration (ToT falls) means the country must export more to buy the same volume of imports

Interpreting Changes in the Terms of Trade

A ToT improvement is not always beneficial:

• If the improvement is caused by rising export prices due to reduced export volumes (e.g., a crop failure), export revenue and national income may fall despite the "favourable" ToT
• If the improvement is caused by falling import prices (e.g., lower oil prices), it may reflect weakness in the global economy that reduces demand for the country's exports

The income terms of trade adjusts for export volume:

$\mathrm{Income\ ToT} = \mathrm{ToT} \times \text{Volume of exports}$

This provides a better indicator of a country's capacity to import.

The Prebisch-Singer Hypothesis

The Prebisch-Singer hypothesis argues that the terms of trade for primary commodity exporters tend to deteriorate over time relative to manufactured goods exporters. Reasons include:

• Low income elasticity of demand for primary commodities (Engel's Law: as incomes rise, the share of spending on food and raw materials falls)
• Technological advances reduce the demand for raw materials (synthetic substitutes, recycling, miniaturisation)
• Primary commodity markets are more competitive (many producers, homogeneous products), so prices are lower
• Oligopolistic pricing in manufactured goods markets keeps export prices of manufacturers higher

Balance of Payments

The balance of payments is a record of all economic transactions between residents of a country and the rest of the world over a given period. It must balance in an accounting sense (total credits $=$ total debits, with the balancing item being errors and omissions).

Current Account

1. Balance of trade in goods: exports minus imports of physical goods (visible trade)
2. Balance of trade in services: exports minus imports of services (invisible trade) -- tourism, banking, insurance, transport, education, consulting
3. Primary income: earnings from investments abroad minus payments to foreign investors (dividends, interest, profits) plus compensation of employees working abroad
4. Secondary income (current transfers): unilateral transfers such as remittances, foreign aid, and pensions

Capital Account

Records transfers of capital that do not affect national income:

• Debt forgiveness
• Transfers of fixed assets (e.g., migration-related transfers of personal assets)
• Capital transfers associated with the acquisition or disposal of fixed assets

The capital account is typically small relative to the current and financial accounts.

Financial Account

Records transactions in financial assets and liabilities:

• Direct investment: cross-border investment in enterprises where the investor acquires a lasting interest (typically defined as $10\%$ or more of voting power). Includes both greenfield investment (establishing new facilities) and mergers and acquisitions
• Portfolio investment: cross-border purchases of shares and bonds without acquiring control
• Other investment: bank deposits, trade credits, loans
• Reserve assets: changes in a country's official foreign exchange reserves held by the central bank (gold, foreign currency, SDRs, IMF reserve position)

The Balance of Payments Identity

$\mathrm{Current\ Account} + \mathrm{Capital\ Account} + \mathrm{Financial\ Account} + \mathrm{Statistical\ Discrepancy} = 0$

A current account deficit must be financed by a surplus on the capital and financial accounts (net capital inflows). A current account surplus corresponds to net capital outflows.

Current Account Imbalances

Causes of current account deficits:

• Excessive domestic consumption relative to production
• Lack of international competitiveness (high production costs, low productivity)
• Overvalued exchange rate
• High reliance on imported capital goods for development
• Strong domestic currency reducing export competitiveness

Consequences of persistent deficits:

• Growing external debt and debt-servicing costs
• Downward pressure on the exchange rate
• Vulnerability to capital flow reversals ("sudden stop")
• Loss of confidence among foreign investors

When a deficit may not be problematic:

• If the deficit reflects productive investment in capital goods that will generate future export capacity
• If it is financed by stable, long-term FDI rather than short-term portfolio flows
• If the country has a strong institutional framework and credible policy environment

Consequences of persistent surpluses:

• Underconsumption (domestic households forego current consumption)
• May contribute to global imbalances (e.g., China's surplus mirroring the US deficit)
• May provoke trade tensions and accusations of currency manipulation
• Low domestic demand may constrain growth

Exchange Rates

Types of Exchange Rate Systems

• Floating exchange rate: determined by market forces of supply and demand for the currency. The central bank does not intervene (or intervenes only rarely). Examples: USD, AUD, CAD, EUR
• Fixed (pegged) exchange rate: the central bank fixes the currency's value against another currency (or a basket). It maintains the peg by buying or selling foreign reserves. Examples: Hong Kong dollar (pegged to USD), some Gulf currencies
• Managed float (dirty float): the exchange rate is primarily market-determined, but the central bank intervenes occasionally to smooth excessive fluctuations or achieve policy objectives

Determinants of Floating Exchange Rates

The exchange rate is the price of one currency in terms of another. In a floating system, it is determined by supply and demand in the foreign exchange market.

Factors that cause a currency to appreciate:

• Higher interest rates (attracting capital inflows -- the interest rate differential)
• Stronger economic growth (attracting investment)
• Improved current account position (higher demand for exports increases demand for the currency)
• Speculation (expectations of future appreciation lead to buying now)
• Political stability and investor confidence (safe-haven flows)
• Higher returns on domestic assets

Factors that cause a currency to depreciate:

• Lower interest rates relative to other countries
• Current account deficit (excess supply of the currency as importers sell domestic currency)
• Higher inflation (reducing export competitiveness, purchasing power parity)
• Capital outflows (investors selling domestic assets)
• Political instability or economic uncertainty
• Expansionary monetary policy (increasing the money supply)

Effects of Exchange Rate Changes

Depreciation:

• Exports become cheaper for foreign buyers ($X \uparrow$)
• Imports become more expensive ($M \downarrow$)
• Current account may improve (assuming the Marshall-Lerner condition holds)
• Imported inflation (higher cost of imported goods and raw materials)
• Foreign debt denominated in foreign currency becomes more expensive to service
• May improve the trade balance if the country is a net exporter
• Domestic consumers face higher prices for imported goods

Appreciation:

• Exports become more expensive for foreign buyers ($X \downarrow$)
• Imports become cheaper ($M \uparrow$)
• Current account may worsen
• Lower imported inflation (cheaper imported goods help contain price pressures)
• Cheaper foreign travel and imports for domestic consumers
• Foreign debt servicing becomes cheaper
• May reduce cost-push inflation

The Marshall-Lerner Condition and J-Curve

A currency depreciation improves the current account balance only if the sum of the absolute values of PED for exports and PED for imports exceeds 1:

$|\mathrm{PED}_X| + |\mathrm{PED}_M| > 1$

Intuition: if demand for both exports and imports is elastic, the depreciation increases export revenue (more units sold at a lower price per unit) and reduces import expenditure (fewer units bought at a higher price per unit), improving the trade balance. If demand is inelastic, the opposite occurs.

The J-curve effect: in the short run, demand tends to be inelastic because consumers and firms have existing contracts and cannot quickly adjust. After a depreciation:

1. Short run: import costs rise immediately (because imports are priced in foreign currency), but export volumes take time to adjust. The current account initially worsens
2. Medium to long run: consumers substitute away from more expensive imports toward domestic goods, and foreign buyers increase purchases of cheaper exports. The current account improves

The path traces a J-shape when plotted over time.

Purchasing Power Parity (PPP)

The theory of purchasing power parity states that exchange rates should adjust to equalise the purchasing power of different currencies:

Absolute PPP: the exchange rate should equal the ratio of price levels between two countries:

$S = \frac{P_{\text{domestic}}}{P_{\text{foreign}}}$

Relative PPP: changes in the exchange rate should reflect the inflation differential between two countries:

$\%\Delta S \approx \pi_{\text{domestic}} - \pi_{\text{foreign}}$

Where $S$ is the spot exchange rate (domestic currency per unit of foreign currency). If domestic inflation exceeds foreign inflation, the domestic currency should depreciate.

PPP is a long-run theory and is a poor predictor of short-run exchange rate movements. In the short run, exchange rates are influenced by interest rate differentials, capital flows, speculation, and risk sentiment.

Fixed Exchange Rate Management

Under a fixed exchange rate system, the central bank must maintain the peg by:

1. Buying or selling foreign exchange reserves: if the currency is under depreciation pressure (excess supply), the central bank buys its own currency using foreign reserves. If under appreciation pressure, it sells its own currency and buys foreign currency
2. Adjusting interest rates: raising rates attracts capital inflows, supporting the currency; lowering rates has the opposite effect
3. Capital controls: restricting cross-border capital flows to reduce pressure on the exchange rate

Problems with fixed exchange rates:

• Loss of independent monetary policy (the central bank must set interest rates to maintain the peg, not to manage domestic demand)
• Need for large foreign exchange reserves
• Vulnerability to speculative attacks (if speculators believe the peg is unsustainable, they may sell the currency, forcing a devaluation -- self-fulfilling crisis)
• Misalignment: the fixed rate may diverge from the equilibrium rate, causing persistent trade imbalances

Trade Protection

Tariffs

A tariff is a tax on imports. It raises the domestic price of the imported good by the amount of the tariff, reducing import volumes and increasing domestic production.

Welfare effects:

• Consumer surplus decreases: consumers pay a higher price and consume less
• Producer surplus increases: domestic producers sell more at a higher price
• Government revenue increases: tariff $\times$ quantity of imports after the tariff
• Deadweight loss: two triangles -- one from reduced consumption (consumers who would have bought at the world price but not at the tariff-inclusive price) and one from inefficient domestic production (domestic firms producing at higher cost than the world price)

$\mathrm{DWL} = \frac{1}{2} \times t \times (\text{reduction in imports}) + \frac{1}{2} \times t \times (\text{additional domestic production at higher cost})$

Quotas

A quota restricts the maximum quantity of a good that can be imported. It raises the domestic price (by restricting supply to below the free-trade quantity) and benefits domestic producers.

Unlike tariffs, the revenue from the higher price may accrue to:

• Foreign producers (if the quota is administered through export licences held by foreign governments or firms)
• The domestic government (if import licences are auctioned)
• Importers (if licences are allocated to favoured importers, creating rents)

Subsidies

A production subsidy to domestic producers lowers their costs, enabling them to compete more effectively against imports. Unlike tariffs, subsidies do not directly raise consumer prices, but they impose a fiscal cost on the government and may provoke retaliation under WTO rules.

Administrative Barriers

Non-tariff barriers include:

• Complex customs procedures and documentation requirements
• Product standards and technical regulations (e.g., EU safety standards)
• Labelling and packaging requirements
• Health and sanitary regulations (phytosanitary measures for agricultural products)
• Rules of origin requirements (determining whether a product qualifies for preferential trade treatment)

While often justified on legitimate grounds (consumer safety, public health), these can act as disguised protectionism by imposing additional costs on foreign suppliers.

Arguments for Protection

• Infant industry argument: new industries need temporary protection until they achieve economies of scale and become competitive. Requires that the industry has a genuine comparative advantage potential, and that protection is time-limited and gradually removed. Difficult to implement because it requires the government to identify which industries will be competitive in the future
• Anti-dumping: preventing foreign firms from selling below cost (or below their domestic price) to drive out domestic competitors and then raise prices
• Strategic industries: protecting industries deemed essential for national security (defence, energy, food supply, critical technology)
• Employment: protecting jobs in industries facing intense foreign competition, particularly where alternative employment is limited
• Balance of payments: reducing imports to correct a persistent current account deficit
• Environmental and labour standards: preventing a "race to the bottom" in regulation by ensuring imports meet domestic standards
• Countervailing duties: offsetting foreign government subsidies that distort competition

Arguments Against Protection

• Higher prices for consumers: tariffs and quotas raise domestic prices, reducing real incomes
• Reduced choice and variety: fewer imported goods available
• Retaliation: trading partners may impose retaliatory tariffs, leading to trade wars that harm all parties (e.g., US-China trade tensions)
• Inefficient allocation of resources: domestic firms face less competitive pressure to innovate or reduce costs
• Higher costs for downstream industries: firms that use protected goods as inputs face higher production costs, reducing their international competitiveness
• Deadweight welfare loss: the gains to producers are smaller than the losses to consumers
• Rent-seeking: firms invest resources in lobbying for protection rather than improving efficiency
• Corruption: trade barriers create opportunities for corruption (e.g., bribery to obtain import licences)

Economic Integration

Levels of Integration

1. Free Trade Area (FTA): member countries remove tariffs and quotas on trade with each other but maintain their own external trade policies towards non-members. Rules of origin are needed to prevent transhipment (goods from non-members entering through the member with the lowest external tariff). Examples: NAFTA/USMCA, ASEAN Free Trade Area
2. Customs Union: FTA plus a common external tariff on imports from non-members. Members negotiate trade policy collectively. Example: Southern African Customs Union (SACU), the Eurasian Economic Union
3. Common Market: customs union plus free movement of factors of production -- labour, capital, and enterprise. Workers can move freely between member countries. Example: the EU single market
4. Economic and Monetary Union: common market plus a common currency and a single central bank (monetary policy). Example: the Eurozone (19 EU member states using the euro)

Trade Creation and Trade Diversion

Trade creation: removal of trade barriers leads to the replacement of higher-cost domestic production with lower-cost imports from a partner country. This improves welfare by allocating resources more efficiently.

Trade diversion: removal of trade barriers leads to the replacement of lower-cost imports from a non-member country with higher-cost imports from a member country. This reduces welfare because resources are allocated to a less efficient producer.

The net welfare effect depends on the relative sizes of trade creation and trade diversion:

$\text{Net welfare effect} = \text{Trade creation gain} - \text{Trade diversion loss}$

A trade bloc is more likely to generate net welfare gains when:

• Members are geographically close (lower transport costs)
• Members' economies are competitive rather than similar (more scope for comparative advantage)
• The bloc covers a large proportion of world trade (reducing the scope for trade diversion)
• External tariffs are low (minimising the distortion from trade diversion)

Major Trade Blocs

European Union (EU): 27 member states. Customs union, single market, and (for 19 members) monetary union. Free movement of goods, services, capital, and labour. Common agricultural policy (CAP). The EU accounts for approximately 15% of global trade in goods.

ASEAN (Association of Southeast Asian Nations): 10 member states. ASEAN Free Trade Area (AFTA) and ASEAN Economic Community. Covers a market of over 650 million people. Complementary agreements with China, Japan, South Korea, Australia, and New Zealand (RCEP).

USMCA (United States-Mexico-Canada Agreement): replaced NAFTA in 2020. Covers North American trade. Includes provisions on labour standards, environmental protection, and digital trade.

Mercosur: South American trade bloc (Argentina, Brazil, Paraguay, Uruguay). Customs union with a common external tariff. The world's fourth-largest trading bloc by GDP.

African Continental Free Trade Area (AfCFTA): 54 of 55 African Union member states. Aims to create the world's largest free trade area by number of countries. Potential to significantly boost intra-African trade, which is currently low (approximately 15% of total African trade).

Globalisation

Definition and Dimensions

Globalisation is the process of increasing economic, social, and cultural interconnection between countries. In economics, it refers primarily to the liberalisation of trade and capital flows, the growth of multinational corporations, and the integration of financial markets.

Dimensions:

• Economic globalisation: growth of international trade, FDI, and financial flows
• Technological globalisation: diffusion of technology and information (internet, smartphones)
• Cultural globalisation: spread of ideas, values, and cultural practices
• Political globalisation: growth of international institutions and governance (UN, WTO, IMF)

Drivers of Globalisation

• Technological advances: containerisation (reducing shipping costs by over 80%), the internet (enabling global communication and e-commerce), air travel
• Trade liberalisation: multilateral (WTO) and bilateral trade agreements reducing tariffs and non-tariff barriers
• Capital account liberalisation: removal of restrictions on cross-border capital flows
• Declining communication and transport costs: enabling firms to coordinate global supply chains
• Institutional framework: international organisations promoting trade and investment

Benefits of Globalisation

• Lower prices and greater consumer choice: access to a wider variety of goods and services at lower prices through comparative advantage and economies of scale
• Economic growth: trade and FDI promote growth by improving resource allocation, technology transfer, and competition
• Poverty reduction: globalisation has contributed to the reduction of extreme poverty, particularly in East and South Asia (China's integration into the global economy lifted hundreds of millions out of poverty)
• Technology transfer: developing countries gain access to advanced technologies through FDI and trade
• Cultural exchange: greater understanding and appreciation of diverse cultures
• Efficiency gains: global supply chains allow firms to source inputs from the most efficient producers worldwide

Costs and Criticisms of Globalisation

• Inequality: globalisation has increased within-country inequality in many advanced economies as manufacturing jobs move to lower-cost countries, benefiting skilled workers and capital owners while harming unskilled workers
• Environmental degradation: increased transportation, industrial production, and resource extraction contribute to pollution, deforestation, and carbon emissions. A "race to the bottom" in environmental regulation may occur as countries compete to attract investment
• Loss of national sovereignty: international institutions and trade agreements may constrain domestic policy choices (e.g., the inability to use industrial policy or capital controls)
• Cultural homogenisation: global brands and media may displace local cultures and languages
• Vulnerability to external shocks: greater integration means that crises (financial, health, supply chain) spread more quickly across borders
• Exploitation: concerns about sweatshop labour, child labour, and poor working conditions in developing countries producing goods for export
• Concentration of economic power: multinational corporations and financial institutions may wield more influence than national governments

Foreign Direct Investment and Multinational Corporations

Types of FDI

• Horizontal FDI: the firm invests in the same industry abroad as it operates at home (e.g., Toyota building car factories in the US). Motivated by market-seeking behaviour (bypassing trade barriers, being closer to consumers)
• Vertical FDI: the firm invests in different stages of the supply chain abroad (e.g., an electronics company establishing component manufacturing in Vietnam). Motivated by efficiency-seeking (lower costs) or resource-seeking (access to raw materials)
• Conglomerate FDI: investment in an unrelated industry abroad

Motives for FDI

• Market-seeking: accessing large or growing consumer markets (e.g., FDI in China, India)
• Resource-seeking: accessing natural resources, raw materials, or low-cost labour
• Efficiency-seeking: exploiting cost differences across countries (e.g., manufacturing in low-wage countries)
• Strategic asset-seeking: acquiring technology, brands, or distribution networks through mergers and acquisitions

Benefits of FDI for Host Countries

• Capital inflows: supplementing domestic savings, particularly important for developing countries
• Technology transfer and knowledge spillovers: local firms and workers gain access to advanced technology, management practices, and production techniques
• Job creation and skill development: FDI creates direct employment and indirect employment through supply chains
• Export development: FDI often targets export-oriented production, improving the host country's trade balance
• Tax revenue: profits generated by foreign-owned firms are subject to local taxation
• Infrastructure development: some FDI projects include investment in roads, ports, and utilities

Costs of FDI for Host Countries

• Profit repatriation: a significant portion of profits may flow back to the home country, reducing the net benefit of capital inflows
• Environmental degradation: firms may exploit weaker environmental regulations in host countries (pollution havens hypothesis)
• Exploitation of labour: low wages, poor working conditions, and weak labour protections
• Crowding out: foreign firms may outcompete domestic firms, leading to consolidation and reduced domestic entrepreneurship
• Cultural disruption: large foreign firms may dominate local markets and undermine traditional economic activities
• Enclave economies: FDI may create isolated zones with few linkages to the domestic economy (limited backward and forward linkages)
• Vulnerability: dependence on FDI creates vulnerability to decisions made by foreign corporations (e.g., sudden divestment)

Factors Attracting FDI

• Large market size and growth potential
• Political stability, rule of law, and effective governance
• Skilled labour force at competitive wages
• Favourable tax regimes and investment incentives (tax holidays, special economic zones)
• Infrastructure quality (transport, energy, communications)
• Trade openness and membership of regional trade agreements
• Intellectual property protection

Multinational Corporations (MNCs)

MNCs are firms that own and control production facilities in more than one country. They account for a significant share of global trade, investment, and employment.

Impact on host countries:

• Can bring capital, technology, jobs, and management expertise
• May dominate key sectors, creating dependency and reducing policy autonomy
• Transfer pricing (setting prices for intra-firm transactions to shift profits to low-tax jurisdictions) can reduce tax revenues in host countries

Impact on home countries:

• MNCs benefit from access to global markets, resources, and talent
• May lead to job losses at home as production is relocated abroad (offshoring)
• Profits earned abroad are repatriated, contributing to the home country's current account and tax base

The World Trade Organisation (WTO)

The WTO is the international body that oversees the rules of global trade. Established in 1995 (replacing the General Agreement on Tariffs and Trade, GATT), it currently has 164 member states.

Key Functions

• Administering WTO trade agreements
• Providing a forum for trade negotiations (e.g., the Doha Development Round, ongoing since 2001)
• Settling trade disputes between member states through the Dispute Settlement Body (DSB)
• Monitoring national trade policies through Trade Policy Reviews
• Providing technical assistance and training to developing countries
• Cooperating with other international organisations (IMF, World Bank, UNCTAD)

Core Principles

• Most Favoured Nation (MFN): any advantage granted to one member must be extended to all WTO members. Exceptions are allowed for FTAs and preferential treatment of developing countries
• National treatment: imported goods must be treated no less favourably than domestically produced goods once they have entered the market (after tariffs have been paid)
• Non-discrimination: equal treatment of all trading partners
• Reciprocity: concessions (tariff reductions) should be mutual
• Transparency: members must publish their trade regulations and notify the WTO of changes
• Binding dispute settlement: rulings of the DSB are binding, though enforcement relies on member compliance

Criticism of the WTO

• Decision-making can be dominated by large economies (US, EU, China)
• The Dispute Settlement Body has been weakened since 2019 by US blockage of Appellate Body appointments
• Environmental and labour standards are not adequately addressed in trade rules
• Developing countries may face asymmetric bargaining power in negotiations
• The Doha Round has stalled over disagreements between developed and developing countries on agriculture, industrial tariffs, and intellectual property
• Trade liberalisation may conflict with other policy objectives (environmental protection, public health)

Common Pitfalls

• Confusing absolute advantage with comparative advantage. A country can have an absolute advantage in all goods but still benefit from trade based on comparative advantage.
• Stating that a current account deficit is always bad. A deficit may reflect productive investment in capital goods that will generate future export capacity.
• Assuming that a currency depreciation automatically improves the current account. The Marshall-Lerner condition and the J-curve effect must be considered.
• Confusing trade creation with trade diversion. Trade creation improves welfare; trade diversion reduces it.
• Describing the WTO as a "world government" or suggesting it has enforcement powers comparable to national governments. It relies on member compliance and the dispute settlement mechanism.
• Confusing the trade balance (exports minus imports of goods and services) with the current account (which also includes primary and secondary income).
• Assuming that globalisation benefits everyone equally. While aggregate gains are positive, the distribution of gains is uneven, and there are both winners and losers within and between countries.
• Confusing FDI with portfolio investment. FDI involves a lasting interest and control; portfolio investment is purely financial and can be volatile.
• Forgetting that under a fixed exchange rate, the central bank loses independent monetary policy. To maintain the peg, it must set interest rates to attract or repel capital flows, even if this conflicts with domestic objectives.

Practice Problems

Problem 1: Comparative Advantage with Gains from Trade

Country X can produce 10 tonnes of wheat or 5 tonnes of steel per worker per day. Country Y can produce 6 tonnes of wheat or 6 tonnes of steel per worker per day.

(a) Determine which country should specialise in which good.

(b) If each country has 100 workers, calculate the total world output before and after complete specialisation.

(c) If they trade at 1 tonne of wheat for 0.75 tonnes of steel, show that both countries gain.

(a) Opportunity costs:

• Country X: 1 wheat costs $5/10 = 0.5$ steel; 1 steel costs $10/5 = 2$ wheat
• Country Y: 1 wheat costs $6/6 = 1$ steel; 1 steel costs $6/6 = 1$ wheat

Country X has a comparative advantage in wheat ($0.5 < 1$). Country Y has a comparative advantage in steel ($1 < 2$).

(b) Before specialisation (assuming 50 workers in each industry):

• Country X: 50 workers $\times$ 10 $= 500$ wheat; 50 $\times$ 5 $= 250$ steel
• Country Y: 50 $\times$ 6 $= 300$ wheat; 50 $\times$ 6 $= 300$ steel
• World total: 800 wheat, 550 steel

After specialisation:

• Country X: 100 $\times$ 10 $= 1000$ wheat, 0 steel
• Country Y: 0 wheat, 100 $\times$ 6 $= 600$ steel
• World total: 1000 wheat, 600 steel

Both goods have increased (200 more wheat, 50 more steel).

(c) Before trade, Country X could produce 1 steel at a cost of 2 wheat. By trading at 1 wheat $=$ 0.75 steel, Country X gives up 1 wheat to get 0.75 steel (better than its domestic cost of 0.5 steel per wheat... wait, let me re-check).

At the trade rate of 1 wheat $= 0.75$ steel:

• Country X (wheat producer): giving up 1 wheat yields 0.75 steel. Domestically, 1 wheat could only produce 0.5 steel. So Country X gains 0.25 steel per unit of wheat traded.
• Country Y (steel producer): giving up 1 steel yields $1/0.75 = 1.33$ wheat. Domestically, 1 steel could only produce 1 wheat. So Country Y gains 0.33 wheat per unit of steel traded.

Both countries gain from trade at this price ratio.

Problem 2: Balance of Payments with Multiple Components

A country has the following data (in billions of USD):

• Exports of goods: 450
• Imports of goods: 520
• Exports of services: 180
• Imports of services: 140
• Primary income receipts: 60
• Primary income payments: 90
• Secondary income: net $-20$ (outflow)
• FDI inflows: 80
• Portfolio investment outflows: 30
• Other investment: net inflow of 15
• Change in reserves: $-10$ (reserves increase)

(a) Calculate the current account balance.

(b) Calculate the financial account balance.

(c) Verify that the balance of payments identity holds.

(a) Current account:

• Trade in goods: $450 - 520 = -70$
• Trade in services: $180 - 140 = +40$
• Primary income: $60 - 90 = -30$
• Secondary income: $-20$

Current account $= -70 + 40 - 30 - 20 = -80$ billion USD (deficit).

(b) Financial account:

• FDI: $+80$ (inflows)
• Portfolio investment: $-30$ (outflows)
• Other investment: $+15$
• Reserve assets: $-10$ (increase in reserves is a debit/outflow)

Financial account $= 80 - 30 + 15 - 10 = +55$ billion USD.

(c) Balance of payments identity: $\text{Current Account} + \text{Capital Account} + \text{Financial Account} + \text{Errors} = 0$

$-80 + 0 + 55 + \text{Errors} = 0 \implies \text{Errors} = +25$ billion USD.

The statistical discrepancy (errors and omissions) is USD 25 billion, reflecting measurement imperfections in the balance of payments data.

Problem 3: Marshall-Lerner Condition and J-Curve

A country's exports have a PED of $0.6$ and its imports have a PED of $0.3$. The country's currency depreciates by $15\%$.

(a) Does the Marshall-Lerner condition hold? What happens to the current account?

(b) Explain the J-curve effect.

(c) How might the result differ in the long run?

(a) $|\mathrm{PED}_X| + |\mathrm{PED}_M| = 0.6 + 0.3 = 0.9 < 1$

The Marshall-Lerner condition is NOT satisfied. The depreciation will worsen the current account in the short run because demand for both exports and imports is inelastic. The increase in export revenue from more units sold is outweighed by the decrease in revenue per unit, and the decrease in import expenditure from fewer units bought is outweighed by the increase in price per unit.

(b) The J-curve describes the short-run deterioration followed by long-run improvement. Immediately after depreciation:

• Import costs rise in domestic currency terms (contracts are in foreign currency)
• Export volumes are slow to adjust (new contracts take time to negotiate)
• The current account initially worsens

(c) In the long run, PED values tend to be higher as consumers and firms adjust:

• Consumers substitute away from more expensive imports toward domestic alternatives
• Foreign buyers increase purchases of cheaper exports
• New contracts are negotiated at the new exchange rate

If long-run PEDs satisfy the condition (e.g., $|\mathrm{PED}_X| = 1.2$ and $|\mathrm{PED}_M| = 0.8$, sum $= 2.0 > 1$), the current account will eventually improve. The J-curve describes the path from short-run deterioration to long-run improvement.

Problem 4: Tariff Welfare Analysis

A small country imports good $X$ at a world price of USD 50 per unit. Domestic demand is $Q_d = 200 - 2P$ and domestic supply is $Q_s = 2P - 40$. The government imposes a tariff of USD 10 per unit.

(a) Calculate the pre-tariff and post-tariff equilibrium quantities.

(b) Calculate the change in consumer surplus, producer surplus, government revenue, and deadweight loss.

(c) Who bears the burden of the tariff?

(a) Pre-tariff (world price $= 50$):

$Q_d = 200 - 2(50) = 100$, $Q_s = 2(50) - 40 = 60$

Imports $= 100 - 60 = 40$

Post-tariff (domestic price $= 50 + 10 = 60$):

$Q_d = 200 - 2(60) = 80$, $Q_s = 2(60) - 40 = 80$

Imports $= 80 - 80 = 0$

The tariff is prohibitive -- it eliminates all imports.

(b) Consumer surplus change:

Pre-tariff CS $= \frac{1}{2}(100 - 50)(100) = 2500$ Post-tariff CS $= \frac{1}{2}(100 - 60)(80) = 1600$ $\Delta\text{CS} = 1600 - 2500 = -900$

Producer surplus change:

Pre-tariff PS $= \frac{1}{2}(50 - 20)(60) = 900$ Post-tariff PS $= \frac{1}{2}(60 - 20)(80) = 1600$ $\Delta\text{PS} = 1600 - 900 = +700$

Government revenue $= 10 \times 0 = 0$ (no imports)

Deadweight loss:

$\mathrm{DWL} = |\Delta\text{CS}| - \Delta\text{PS} - \text{Govt revenue} = 900 - 700 - 0 = 200$

Alternatively, DWL $= \frac{1}{2} \times 10 \times (100 - 80) + \frac{1}{2} \times 10 \times (80 - 60) = 100 + 100 = 200$

(c) Consumers bear the entire burden of the tariff in the form of higher prices (+ \10$ per unit) and reduced consumption (from 100 to 80 units). Domestic producers gain from higher prices and increased output. Since the tariff is prohibitive, there are no imports and no government revenue.

Problem 5: Exchange Rate and Competitiveness

The exchange rate between the euro and the US dollar changes from USD 1.10 per euro to USD 1.25 per euro. A European exporter sells a product for EUR 100 in Europe. The price elasticity of demand for the product in the US market is $-1.5$.

(a) What is the percentage change in the euro's value against the dollar?

(b) Calculate the dollar price of the product before and after the change.

(c) Estimate the percentage change in quantity demanded in the US market.

(d) What happens to the exporter's euro-denominated revenue?

(a) Percentage change $= \frac{1.25 - 1.10}{1.10} \times 100 = 13.64\%$ (euro appreciation).

(b) Before: 100 \times 1.10 = \110$. After:$100 \times 1.25 = $125$.

(c) $\mathrm{PED} = \frac{\%\Delta Q_d}{\%\Delta P}$

$\%\Delta P = \frac{125 - 110}{110} \times 100 = 13.64\%$

$\%\Delta Q_d = \mathrm{PED} \times \%\Delta P = -1.5 \times 13.64\% = -20.45\%$

Quantity demanded falls by approximately $20.45\%$.

(d) Revenue in EUR before: $Q_0 \times 100$. Revenue in EUR after: $Q_0 \times (1 - 0.2045) \times 100 = Q_0 \times 79.55$.

The exporter's euro-denominated revenue falls by approximately $20.45\%$ because the volume decline outweighs the higher per-unit price (since the euro price is unchanged, and only the dollar price increases, but the quantity sold falls).

Problem 6: Trade Creation vs. Trade Diversion with Calculations

Country A forms a customs union with Country B. Before the union:

• Country A produces the good at USD 15 per unit
• Country B (the future partner) produces at USD 12
• Country C (the rest of the world) produces at USD 10
• A's external tariff on both B and C is USD 3 per unit
• A's domestic demand is 100 units

After the union, the tariff is removed on imports from B but retained at USD 3 on imports from C.

(a) Before the union, from whom does A import?

(b) After the union, from whom does A import? At what price?

(c) Calculate the welfare effects (trade creation and trade diversion).

(a) Before the union:

• Price from B with tariff: $12 + 3 = 15$
• Price from C with tariff: $10 + 3 = 13$
• Domestic price: $15$

A imports from C at USD 13 (cheapest source). Domestic production $= 0$ (if supply is perfectly elastic at USD 15; alternatively, if domestic production exists at USD 15, A imports from C at USD 13 and does not produce domestically).

(b) After the union:

• Price from B: USD 12 (no tariff)
• Price from C: $10 + 3 = 13$
• Domestic price: USD 15

A imports from B at USD 12 (cheapest available).

(c) The price falls from USD 13 to USD 12, creating a consumer surplus gain. The price fall of USD 1 on 100 units $=$ USD 100 consumer surplus gain.

However, this is trade diversion: production shifts from the more efficient producer (C at USD 10) to the less efficient partner (B at USD 12). The trade diversion cost is the USD 2 per unit difference between B's cost and C's cost, on the diverted volume (100 units) $=$ USD 200.

Net welfare effect = 100 - 200 = -\100$. The customs union reduces welfare in this case because trade diversion exceeds trade creation.

Comparative Advantage: Advanced Analysis (HL Extension)

Opportunity Cost Ratios and Specialisation

The principle of comparative advantage states that countries should specialise in the production of goods for which they have the lowest opportunity cost. The gains from trade arise from the difference between the autarky (no-trade) opportunity cost ratios and the terms of trade.

Formal framework:

Let $a_1$ and $a_2$ be the unit labour requirements for goods 1 and 2 in Country A, and $b_1$ and $b_2$ in Country B. The opportunity cost of good 1 in terms of good 2 is:

• Country A: $\mathrm{OC}_A = a_1 / a_2$
• Country B: $\mathrm{OC}_B = b_1 / b_2$

Country A has a comparative advantage in good 1 if $\mathrm{OC}_A < \mathrm{OC}_B$.

The terms of trade must lie between the two opportunity cost ratios:

$\mathrm{OC}_A < \text{ToT} < \mathrm{OC}_B$

Any terms of trade within this range makes both countries better off than under autarky.

Numerical Example with Production Possibilities

Two countries, France and Japan, can produce wine and electronics. Labour supply: France = 100 workers, Japan = 100 workers.

	Wine (bottles/worker)	Electronics (units/worker)
France	8	4
Japan	2	10

Opportunity costs:

• France: 1 wine costs $4/8 = 0.5$ electronics; 1 electronic costs $8/4 = 2$ wine
• Japan: 1 wine costs $10/2 = 5$ electronics; 1 electronic costs $2/10 = 0.2$ wine

France has a comparative advantage in wine (0.5 < 5). Japan has a comparative advantage in electronics (0.2 < 2).

Autarky (50 workers in each industry):

• France: $50 \times 8 = 400$ wine, $50 \times 4 = 200$ electronics
• Japan: $50 \times 2 = 100$ wine, $50 \times 10 = 500$ electronics
• World: 500 wine, 700 electronics

After complete specialisation:

• France: $100 \times 8 = 800$ wine, 0 electronics
• Japan: 0 wine, $100 \times 10 = 1000$ electronics
• World: 800 wine, 1000 electronics

Both goods increase: +300 wine, +300 electronics.

With trade at 1 wine = 1 electronic:

If France exports 300 wine to Japan and imports 300 electronics:

• France consumes: 500 wine, 300 electronics (gains: +100 wine, +100 electronics vs. autarky)
• Japan consumes: 300 wine, 700 electronics (gains: +200 wine, +200 electronics vs. autarky)

Both countries are strictly better off.

Limitations of Comparative Advantage in Practice

• Transport costs: if transport costs exceed the difference in opportunity costs, trade is not beneficial
• Factor immobility: workers cannot easily switch industries, especially in the short run. Specialisation may cause structural unemployment
• Diminishing returns: the Ricardian model assumes constant returns; in reality, increasing specialisation may face diminishing returns
• Dynamic comparative advantage: comparative advantage can change over time through investment in human capital, technology, and infrastructure (South Korea's shift from agriculture to electronics)
• Strategic trade policy: governments may subsidise industries to create comparative advantage in sectors with economies of scale (e.g., Airbus vs. Boeing)

Terms of Trade: Calculations and Significance (HL Extension)

Terms of Trade Calculation

The terms of trade index measures the ratio of export prices to import prices:

$\mathrm{ToT} = \frac{P_X}{P_M} \times 100$

Where $P_X$ is the export price index and $P_M$ is the import price index, both with base year = 100.

Worked example:

Year	Export Price Index	Import Price Index	ToT
2020	100	100	100.0
2021	110	105	104.8
2022	120	125	96.0

The ToT improved by 4.8% in 2021 (favourable: exports rose faster than imports). The ToT deteriorated by 8.4% in 2022 (unfavourable: import prices rose faster than export prices).

When an Improving ToT Is Not Beneficial

An improving ToT is not always good for the economy:

1. Volume effect: if the ToT improves because export prices rise (due to supply constraints, not quality improvements), export volumes may fall. If the volume decline outweighs the price increase, export revenue falls
2. Income ToT: $\text{Income ToT} = \text{ToT} \times \text{Volume of exports}$. A ToT improvement with a large volume decline may reduce the income ToT
3. Import cost effect: if the ToT improves because import prices fall (e.g., lower oil prices), it may reflect weak global demand that also reduces demand for the country's exports

Significance for Development

Developing countries that export primary commodities often face deteriorating terms of trade:

• Primary commodity prices are volatile and subject to long-term decline (Prebisch-Singer hypothesis)
• Manufactured goods prices tend to rise due to technological improvements and monopoly pricing
• This creates a transfer of real income from commodity-exporting developing countries to manufactured-goods-exporting developed countries

Balance of Payments in Depth (HL Extension)

Detailed Account Structure

Current Account:

Component	Credits (+)	Debits (-)
Trade in goods	Exports of goods	Imports of goods
Trade in services	Exports of services	Imports of services
Primary income	Investment income from abroad, compensation of employees from abroad	Investment income paid abroad, compensation paid to foreign workers
Secondary income	Transfers received (remittances in, aid received)	Transfers paid (remittances out, aid given)

Financial Account:

Component	Credits (+)	Debits (-)
Direct investment	FDI inflows (foreigners investing domestically)	FDI outflows (domestic firms investing abroad)
Portfolio investment	Foreign purchase of domestic securities	Domestic purchase of foreign securities
Other investment	Foreign loans to domestic entities, deposits from abroad	Domestic loans abroad, deposits overseas
Reserve assets	Decrease in reserves (using reserves to support currency)	Increase in reserves (accumulating reserves)

Note: the sign convention for reserve assets is reversed. An increase in reserves (buying foreign currency) is recorded as a debit (-), because it represents a capital outflow from the domestic economy.

The Balance of Payments Identity

$\mathrm{CA} + \mathrm{KA} + \mathrm{FA} + \mathrm{EO} = 0$

Where CA = Current Account, KA = Capital Account, FA = Financial Account, EO = Errors and Omissions.

A current account deficit ($\mathrm{CA} < 0$) must be financed by:

• A capital account surplus ($\mathrm{KA} > 0$)
• A financial account surplus ($\mathrm{FA} > 0$): net capital inflows

The Current Account and the Exchange Rate

Under a floating exchange rate, the current account should self-correct through the exchange rate mechanism:

1. A current account deficit means the supply of domestic currency (from importers selling domestic currency to buy foreign currency) exceeds demand (from exporters converting foreign earnings)
2. The exchange rate depreciates
3. Exports become cheaper, imports become more expensive
4. The trade balance improves (assuming the Marshall-Lerner condition holds)

In practice, self-correction may be slow due to the J-curve effect and inelastic short-run demand.

Sustainability of Current Account Deficits

A current account deficit is sustainable if financed by:

• FDI inflows: long-term, stable, and productive. FDI finances investment that generates future export capacity
• Long-term borrowing: mature debt profiles with manageable repayment schedules
• Reserve drawdowns: using accumulated reserves (temporary)

A current account deficit is unsustainable if financed by:

• Short-term portfolio flows ("hot money"): volatile and subject to sudden reversal
• Excessive borrowing: leading to debt accumulation beyond repayment capacity
• Reserve depletion: reserves are finite and cannot be run down indefinitely

Exchange Rate Determination: Advanced (HL Extension)

Purchasing Power Parity (PPP)

Absolute PPP: the exchange rate should equal the ratio of national price levels:

$S = \frac{P_{\text{domestic}}}{P_{\text{foreign}}}$

Relative PPP: the rate of depreciation should equal the inflation differential:

$\%\Delta S \approx \pi_{\text{domestic}} - \pi_{\text{foreign}}$

Big Mac Index (The Economist): a light-hearted but instructive application of PPP. If a Big Mac costs USD 5.50 in the US and EUR 4.50 in the Eurozone, the PPP-implied exchange rate is $5.50/4.50 = 1.22$ USD/EUR. If the actual exchange rate is 1.10 USD/EUR, the euro is undervalued by approximately 10% relative to PPP.

Limitations of PPP:

• Non-tradable goods (housing, services) are included in price levels but cannot be arbitraged across countries
• Transport costs and trade barriers prevent goods from being perfectly tradable
• Quality differences in goods across countries
• Differences in consumption patterns and preferences
• PPP is a long-run theory; short-run deviations are large and persistent

Interest Rate Parity

Covered Interest Rate Parity (CIRP):

$F = S \times \frac{1 + i_{\text{domestic}}}{1 + i_{\text{foreign}}}$

Where $F$ is the forward exchange rate and $S$ is the spot rate. If CIRP does not hold, risk-free arbitrage is possible (borrow in the low-interest currency, convert at the spot rate, invest in the high-interest currency, and lock in the forward rate).

Uncovered Interest Rate Parity (UIP):

$E(S_{t+1}) = S_t \times \frac{1 + i_{\text{domestic}}}{1 + i_{\text{foreign}}}$

Where $E(S_{t+1})$ is the expected future spot rate. UIP states that the expected return on domestic and foreign assets should be equal when adjusted for expected exchange rate changes.

Implication: a country with higher interest rates should see its currency depreciate (to offset the interest rate advantage). In practice, high-interest-rate currencies often appreciate in the short run (the "forward premium puzzle").

The Marshall-Lerner Condition: Derivation

The trade balance in domestic currency (assuming imports are denominated in foreign currency and then converted):

$\mathrm{TB} = P_X \cdot X(S) - S \cdot P_M^* \cdot M(S)$

Where $S$ is the domestic currency price of foreign currency (an increase in $S$ represents depreciation).

For a depreciation to improve the trade balance, the derivative of TB with respect to $S$ must be positive. This condition simplifies to:

$|\mathrm{PED}_X| + |\mathrm{PED}_M| > 1$

Where $\mathrm{PED}_X = \frac{\%\Delta X}{\%\Delta S}$ and $\mathrm{PED}_M = \frac{\%\Delta M}{\%\Delta S}$.

Empirical estimates: in the short run (within 1 year), PED values are typically low (sum < 1), so the Marshall-Lerner condition is not satisfied. In the medium to long run (2--5 years), PED values increase and the condition is usually satisfied. The J-curve describes this transition.

J-Curve: Detailed Analysis

Phase 1 (short run, 0--6 months):

• Import contracts are denominated in foreign currency and fixed in the short term
• Depreciation raises the domestic currency cost of existing import contracts
• Export volumes cannot adjust immediately (production capacity constraints, new marketing efforts)
• The trade balance worsens

Phase 2 (adjustment, 6--18 months):

• New contracts are negotiated at the new exchange rate
• Domestic consumers substitute away from expensive imports toward domestic alternatives
• Foreign buyers respond to cheaper export prices by increasing orders
• The trade balance begins to improve

Phase 3 (long run, 18+ months):

• Full adjustment of trade flows
• If the Marshall-Lerner condition holds, the trade balance is higher than before depreciation
• The long-run improvement may be partially offset by higher domestic inflation (imported inflation) feeding into wages and other costs

Trade Protection: Detailed Welfare Analysis (HL Extension)

Tariff Revenue Calculation

A tariff of $t$ per unit on a small country importing quantity $Q_{\text{imports}}$ generates revenue:

$\text{Tariff revenue} = t \times Q_{\text{imports}}$

Worked example: A small country imports 50,000 units at a world price of USD 100. A specific tariff of USD 20 per unit is imposed.

Post-tariff domestic price = USD 120.

New import quantity: if domestic demand falls to 80,000 and domestic supply rises to 60,000, imports = $80,000 - 60,000 = 20,000$.

Tariff revenue $= 20 \times 20,000 = \text{USD 400,000}$.

Quota Analysis with Welfare

A quota of $Q_{\text{quota}}$ units raises the domestic price to the level where total domestic demand minus domestic supply equals the quota:

$Q_d(P_{\text{quota}}) - Q_s(P_{\text{quota}}) = Q_{\text{quota}}$

Welfare effects compared to free trade:

• Consumer surplus: decreases (higher price, lower quantity consumed)
• Producer surplus: increases (higher price, higher quantity supplied domestically)
• Quota rent: the difference between the domestic price and the world price, multiplied by the quota quantity. This rent accrues to:
  • Foreign producers (if they hold the export licences)
  • The domestic government (if licences are auctioned)
  • Domestic importers (if licences are allocated administratively)
• Deadweight loss: two triangles (consumption and production DWL), same structure as a tariff

Optimal Tariff Argument

For a large country (one that can influence world prices), a small tariff can improve national welfare by improving the terms of trade. The optimal tariff maximises:

$\text{Welfare gain from ToT improvement} - \text{DWL from reduced trade}$

The optimal tariff rate is approximately:

$t^* \approx \frac{1}{\mathrm{PED}_{\text{foreign export supply}} - 1}$

This argument does not apply to small countries (which are price takers) and ignores retaliation by trading partners.

Economic Integration Stages (HL Extension)

Detailed Comparison of Integration Levels

Feature	FTA	Customs Union	Common Market	Monetary Union
Tariff-free trade among members	Yes	Yes	Yes	Yes
Common external tariff	No	Yes	Yes	Yes
Free movement of labour	No	No	Yes	Yes
Free movement of capital	No	No	Yes	Yes
Common currency	No	No	No	Yes
Common monetary policy	No	No	No	Yes
Common fiscal policy	No	No	No	Partial
Sovereignty implications	Low	Moderate	High	Very high

Costs and Benefits of Each Stage

Free Trade Area:

• Benefits: increased trade, consumer choice, efficiency gains through comparative advantage
• Costs: trade diversion, administrative complexity (rules of origin), adjustment costs for industries exposed to competition

Customs Union:

• Additional benefits: simplified trade administration (single external tariff), stronger bargaining power in negotiations with non-members
• Additional costs: loss of independent trade policy (members cannot set their own tariffs toward non-members)

Common Market:

• Additional benefits: labour mobility reduces structural unemployment, capital flows to most productive uses, economies of scale for firms serving a larger market
• Additional costs: pressure on wages (migration may depress wages in host countries), brain drain from poorer regions, regulatory harmonisation costs

Monetary Union:

• Additional benefits: elimination of exchange rate uncertainty and transaction costs, price transparency, lower interest rates for previously high-inflation members, increased trade and investment within the union
• Additional costs: loss of independent monetary policy and exchange rate as adjustment mechanisms, need for fiscal transfers between members, loss of seigniorage revenue, asymmetric shock absorption (one-size-fits-all monetary policy)

WTO and Trade Disputes (HL Extension)

The Dispute Settlement Process

1. Consultations: the complaining country requests formal consultations with the defendant
2. Panel establishment: if consultations fail, a dispute settlement panel of 3--5 experts is established
3. Panel ruling: the panel issues a report based on WTO agreements and evidence
4. Appellate Body review: either party may appeal to the Appellate Body (7 members), which can uphold, modify, or reverse the panel's legal findings
5. Adoption: the DSB adopts the report unless there is a consensus against adoption
6. Compliance: the losing party must bring its measures into compliance. If it cannot do so immediately, it must negotiate compensation or accept retaliation by the winning party

Notable Trade Disputes

• US -- Steel Tariffs (2002): the US imposed tariffs of up to 30% on steel imports. The WTO ruled the tariffs illegal. The EU, Japan, and other countries threatened retaliatory tariffs. The US removed the tariffs in 2003
• EU -- Bananas: a long-running dispute over EU preferential access for ACP (African, Caribbean, Pacific) banana exporters. The WTO ruled against the EU multiple times
• US -- Boeing vs. EU -- Airbus: mutual complaints about subsidies to their respective aircraft manufacturers. The largest dispute in WTO history
• US -- China (various): disputes over intellectual property, technology transfer, market access, and industrial subsidies

Criticism and Reform Needs

• Appellate Body crisis: since 2019, the US has blocked appointments to the Appellate Body, rendering it inoperative. This undermines the WTO's ability to resolve disputes definitively
• Consensus requirement: decision-making by consensus makes reforms difficult and allows individual members to block progress
• Outdated rules: WTO rules do not adequately cover digital trade, data flows, state-owned enterprises, or environmental standards
• Development dimension: developing countries argue that WTO rules favour advanced economies and constrain their policy space for industrialisation

FDI: Advantages and Disadvantages (HL Extension)

For Host Countries

Advantages:

1. Capital formation: FDI supplements domestic savings, particularly important in developing countries where savings rates are low
2. Technology transfer: MNCs bring advanced production techniques, management practices, and quality standards. Spillovers occur through labour turnover, supply chain linkages, and demonstration effects
3. Employment: direct job creation in the MNC's operations, plus indirect employment through supply chains and multiplier effects
4. Export development: FDI often targets export markets, improving the host country's trade balance and integration into global value chains
5. Human capital development: training programmes raise worker skills, which may diffuse to the broader economy
6. Tax revenue: MNC profits are subject to corporate taxation (subject to transfer pricing concerns)
7. Infrastructure: some FDI projects include investment in roads, ports, power, and telecommunications that benefit the broader economy

Disadvantages:

1. Profit repatriation: a significant share of MNC profits flows back to the home country, reducing the net benefit of capital inflows. In some cases, profit outflows exceed new FDI inflows
2. Crowding out: MNCs may outcompete domestic firms through superior technology, scale, and marketing, leading to consolidation and reduced domestic entrepreneurship
3. Environmental degradation: weak environmental regulations in host countries may attract "pollution haven" FDI, where MNCs relocate polluting activities
4. Exploitation: low wages, poor working conditions, and weak labour protections in export processing zones
5. Limited linkages: if MNCs import inputs and export finished goods with minimal domestic sourcing, backward and forward linkages are weak, limiting spillovers
6. Vulnerability: dependence on a few large MNCs creates vulnerability to decisions made abroad (divestment, relocation)
7. Tax avoidance: transfer pricing and profit shifting can significantly reduce tax revenues

For Home Countries

Advantages:

1. Repatriated profits: income from foreign operations contributes to the current account
2. Market access: FDI provides access to growing foreign markets that may be difficult to serve through exports alone (bypassing trade barriers)
3. Lower costs: offshoring production to lower-cost countries reduces costs, increasing profitability and potentially lowering consumer prices at home
4. Competitiveness: global operations allow firms to exploit comparative advantages across locations, enhancing overall efficiency

Disadvantages:

1. Job losses: offshoring production destroys jobs at home, particularly in manufacturing. Workers displaced may face long-term unemployment or wage depression
2. Technology transfer abroad: investing abroad may create future competitors (e.g., Western firms transferring technology to Chinese partners who later compete globally)
3. Tax base erosion: profit shifting to low-tax jurisdictions reduces home-country tax revenues
4. Dependency: reliance on foreign production creates supply chain vulnerability (as demonstrated by COVID-19 disruptions)

Development Economics: Growth Models (HL Extension)

Harrod-Domar Model

The Harrod-Domar model (1939, 1946) was one of the first formal models of economic growth. It relates the growth rate to the savings rate and the capital-output ratio:

$g = \frac{s}{v}$

Where $g$ is the growth rate of output, $s$ is the savings rate ($S/Y$), and $v$ is the incremental capital-output ratio (ICOR), defined as $v = \Delta K / \Delta Y = I / \Delta Y$.

Derivation: in equilibrium, saving equals investment ($S = I$). Saving is $sY$. Investment is $I = v \cdot \Delta Y$ (each unit of additional output requires $v$ units of additional capital).

$sY = v \cdot \Delta Y$

$\frac{\Delta Y}{Y} = \frac{s}{v}$

Implications:

• Higher savings rate $\implies$ higher growth
• Lower capital-output ratio (more efficient use of capital) $\implies$ higher growth
• Growth is proportional to the savings rate: there are no diminishing returns to capital

Limitations:

• Assumes a fixed capital-output ratio (no factor substitution)
• No role for labour or technological progress
• Implies that growth is unstable: if the actual growth rate deviates from the warranted rate ($g_w = s/v$), the economy diverges rather than converging (the "knife-edge" problem)
• The model ignores demand-side constraints: saving may not automatically translate into productive investment

Lewis Dual-Sector Model

Arthur Lewis (1954) proposed a model of structural change in developing economies based on the coexistence of two sectors:

1. Traditional (subsistence) sector: characterised by surplus labour (low marginal productivity of labour, near-zero), low wages at subsistence level, and informal production
2. Modern (industrial) sector: characterised by higher productivity, profit-maximising firms, and wages above the subsistence level

The process of development:

1. The modern sector offers a wage slightly above the subsistence level, attracting surplus labour from the traditional sector
2. Since the marginal product of labour in the traditional sector is near zero, transferring workers to the modern sector does not reduce traditional sector output
3. Profits in the modern sector are reinvested, expanding the capital stock and absorbing more labour
4. This process continues until the surplus labour is exhausted (the Lewis turning point)
5. After the turning point, further labour transfer requires offering higher wages, and the economy enters the neoclassical growth phase

Key insights:

• The source of growth is capital accumulation in the modern sector, financed by profits
• The availability of surplus labour keeps wages low, maintaining high profits and investment
• Development involves structural change: shifting resources from low-productivity agriculture to high-productivity industry
• The model helps explain why some developing countries have grown rapidly (e.g., East Asian "tiger economies") through labour-intensive manufacturing export

Limitations:

• Assumes surplus labour exists in the traditional sector (not always the case)
• Assumes profits are reinvested (capital flight and conspicuous consumption may reduce reinvestment)
• Ignores urban unemployment and informal sector growth in cities
• Assumes constant returns to scale in the modern sector
• Does not account for technological progress or human capital

Structural Change and Industrialisation

Chenery's patterns of development: as countries develop, the share of agriculture in GDP and employment falls, while the shares of manufacturing and services rise. This structural change is driven by:

1. Engel's Law: as incomes rise, the share of spending on food falls (reducing agriculture's share)
2. Productivity growth: manufacturing and services experience faster productivity growth than agriculture
3. Demand shifts: demand shifts toward manufactured goods and services with higher income elasticity

Import substitution industrialisation (ISI): a strategy of replacing imported manufactured goods with domestically produced ones, using tariffs and subsidies. Common in Latin America and South Asia from the 1950s to 1970s.

• Initial success in building domestic industries
• Eventually led to inefficiency, lack of competition, and balance of payments problems (imported capital goods required for industrialisation)
• Largely abandoned in favour of export-oriented industrialisation

Export-oriented industrialisation (EOI): a strategy of promoting exports of manufactured goods, using incentives for export-oriented FDI and investment. Common in East Asia from the 1960s onward.

• Achieved remarkable growth in South Korea, Taiwan, Singapore, and Hong Kong
• Forced domestic firms to compete internationally, driving efficiency and innovation
• Integrated into global value chains, facilitating technology transfer

Measuring Development: Composite Indicators (HL Extension)

HDI Calculation: Comprehensive Walkthrough

The HDI uses a geometric mean to combine three dimension indices:

$\text{HDI} = (I_{\text{health}} \times I_{\text{education}} \times I_{\text{income}})^{1/3}$

Dimension indices:

$I = \frac{\text{Actual} - \text{Minimum}}{\text{Maximum} - \text{Minimum}}$

Goalposts:

Dimension	Indicator	Min	Max
Health	Life expectancy at birth	20	85
Education (mean years)	Mean years of schooling	0	15
Education (expected years)	Expected years of schooling	0	18
Income	GNI per capita (PPP, USD)	100	75,000

The GNI index uses logarithms to reflect diminishing marginal utility of income:

$I_{\text{income}} = \frac{\ln(\text{GNI per capita}) - \ln(100)}{\ln(75\,000) - \ln(100)}$

Why geometric mean? Since 2010, the UNDP has used the geometric mean (instead of the arithmetic mean) to ensure that a very low score in one dimension cannot be fully compensated by high scores in others. This reflects the principle that each dimension is essential for human development.

Gender-Related Development Index (GDI)

The GDI adjusts the HDI for gender inequality:

$\text{GDI} = \frac{\text{Female HDI}}{\text{Male HDI}}$

It is calculated as the ratio of female HDI to male HDI, adjusted for the overall level of HDI. A GDI of 1 indicates perfect gender parity. A GDI below 1 indicates that female achievement is lower than male achievement.

Gender Inequality Index (GII)

The GII measures gender inequality across three dimensions:

1. Reproductive health: maternal mortality ratio and adolescent birth rate
2. Empowerment: parliamentary representation and educational attainment at secondary and higher levels
3. Labour market: female participation in the labour force relative to male participation

GII ranges from 0 (no inequality) to 1 (maximum inequality). Lower values indicate less gender inequality.

Multidimensional Poverty Index (MPI)

The MPI, developed by UNDP and OPHI, measures poverty across three dimensions with ten indicators:

Dimension	Indicators (weights)
Health (1/3)	Nutrition (1/6), Child mortality (1/6)
Education (1/3)	Years of schooling (1/6), School attendance (1/6)
Living standards (1/3)	Electricity (1/18), Sanitation (1/18), Drinking water (1/18), Flooring (1/18), Cooking fuel (1/18), Assets (1/18)

Calculation:

1. For each household, determine the number of weighted indicators in which the household is deprived
2. A household is "multidimensionally poor" if deprived in at least one-third of the weighted indicators (threshold $\geq 33.3\%$)
3. $H$ = headcount ratio (proportion of population that is multidimensionally poor)
4. $A$ = average deprivation share among the poor (average proportion of indicators in which poor households are deprived)
5. $\text{MPI} = H \times A$

Advantages over income-based measures:

• Captures non-income dimensions of poverty
• Reveals the composition of poverty (which deprivations are most prevalent)
• Identifies overlaps between deprivations (households that are deprived in multiple dimensions simultaneously)

Additional Practice Problems

Problem 7: Terms of Trade with Export and Import Volumes

A country has the following data:

Year	Export Price Index	Import Price Index	Export Volume Index	Import Volume Index
2020	100	100	100	100
2021	115	110	95	105
2022	130	140	90	100

(a) Calculate the terms of trade for each year.

(b) Calculate the income terms of trade for each year.

(c) In which year was the country's purchasing power of exports highest?

(a) $\text{ToT} = \frac{P_X}{P_M} \times 100$

2020: $\text{ToT} = 100.0$ 2021: $\text{ToT} = 115/110 \times 100 = 104.5$ 2022: $\text{ToT} = 130/140 \times 100 = 92.9$

(b) Income ToT $= \text{ToT} \times \text{Export Volume Index} / 100$

2020: $100.0 \times 100/100 = 100.0$ 2021: $104.5 \times 95/100 = 99.3$ 2022: $92.9 \times 90/100 = 83.6$

(c) The purchasing power of exports (income ToT) was highest in 2020 (100.0). Despite the ToT improving in 2021, the decline in export volume more than offset the price improvement. By 2022, both the ToT and export volumes had deteriorated, significantly reducing the country's capacity to import.

Problem 8: Exchange Rate with Interest Rate Parity

The spot exchange rate is USD 1.20 per euro. The one-year interest rate in the Eurozone is $1\%$ and in the US is $3\%$.

(a) Calculate the forward exchange rate implied by covered interest rate parity.

(b) Does UIP predict the euro will appreciate or depreciate over the next year?

(c) If the actual forward rate is USD 1.18 per euro, is there an arbitrage opportunity?

(a) CIRP: $F = S \times \frac{1 + i_{\text{USD}}}{1 + i_{\text{EUR}}} = 1.20 \times \frac{1.03}{1.01} = 1.20 \times 1.0198 = 1.2238$

The forward rate is USD 1.2238 per euro.

(b) UIP predicts that the euro will depreciate against the dollar because US interest rates are higher. The expected future spot rate is:

$E(S) = 1.20 \times 1.03/1.01 = 1.2238$

Wait -- the US rate is higher, so $F > S$, meaning fewer dollars per euro, which means the euro is expected to depreciate. Actually, in our notation, $S$ is USD per EUR, so $F = 1.2238 > S = 1.20$, meaning the euro is expected to appreciate. This is because the US dollar has the higher interest rate, and UIP says the higher-yielding currency should depreciate. Let me reconsider.

If $S$ = domestic currency per foreign currency, and the domestic (US) rate is higher, then:

$F = S \times (1 + i_d)/(1 + i_f) = 1.20 \times 1.03/1.01 = 1.2238$

The forward rate is higher (more USD per EUR), which means the EUR is expected to appreciate. This contradicts the standard UIP prediction because the formula shows the higher-interest currency (USD) should have a forward discount.

The issue is the quotation convention. In standard notation, if $S$ is quoted as USD/EUR, then the euro is the "foreign" currency and the US rate is the "domestic" rate. With $i_d > i_f$, $F > S$, meaning the foreign currency (EUR) is expected to appreciate. This is incorrect according to UIP, which says the higher-interest currency should depreciate.

The correct interpretation: since $i_{\text{USD}} = 3\% > i_{\text{EUR}} = 1\%$, UIP predicts the USD should depreciate against the EUR. So the forward rate of 1.2238 USD/EUR means the EUR is stronger (USD depreciated), which is consistent with UIP.

(c) Actual forward rate $F_{\text{actual}} = 1.18$ USD/EUR vs. CIRP-implied $F = 1.2238$ USD/EUR.

The euro is cheaper in the forward market than CIRP predicts. An arbitrageur can:

1. Borrow euros at 1%
2. Convert to USD at spot: $1 \text{ EUR} \to 1.20 \text{ USD}$
3. Invest USD at 3%: $1.20 \times 1.03 = 1.236 \text{ USD after 1 year}$
4. Sell USD forward at 1.18: $1.236 / 1.18 = 1.0475 \text{ EUR}$
5. Repay euro loan: $1 \times 1.01 = 1.01 \text{ EUR}$

Risk-free profit: $1.0475 - 1.01 = 0.0375 \text{ EUR}$ per euro borrowed. This is an arbitrage opportunity.

Problem 9: Harrod-Domar and Lewis Model Application

Country Z has a savings rate of 15%, an incremental capital-output ratio (ICOR) of 4, and a population growth rate of 2% per year.

(a) Using the Harrod-Domar model, calculate the required savings rate to achieve 7% GDP growth.

(b) How does the Lewis dual-sector model explain the growth of Country Z if it has a large agricultural sector with surplus labour?

(c) Evaluate the limitations of both models for policy analysis.

(a) Harrod-Domar: $g = s / v$

Required savings rate: $s = g \times v = 0.07 \times 4 = 0.28$ (28%)

Current savings rate is 15%, which yields $g = 0.15/4 = 3.75\%$. With population growing at 2%, GDP per capita grows at only $3.75\% - 2\% = 1.75\%$.

To achieve 7% growth, the country needs to nearly double its savings rate to 28%. This could be achieved through:

• Increasing domestic saving (tax incentives, financial development)
• Attracting foreign saving (FDI, external borrowing, aid)
• Reducing the ICOR to 2.14 ($s = 0.15 / v$, for $g = 0.07$: $v = 0.15/0.07 = 2.14$) through more efficient investment

(b) Lewis model: Country Z's surplus agricultural labour provides a pool of workers who can be absorbed by the industrial sector at wages slightly above subsistence. The modern sector reinvests profits, expanding capital and employment. Growth continues until the surplus labour is exhausted (Lewis turning point), after which wages rise and the economy transitions to neoclassical growth.

Key conditions for the Lewis mechanism to work:

• Industrial profits must be reinvested (not consumed or sent abroad)
• The modern sector must be able to expand (access to capital, technology, markets)
• Surplus labour must exist in agriculture (marginal product of labour $\approx 0$)
• Institutions must support the transfer (property rights, contract enforcement, infrastructure)

(c) Harrod-Domar limitations:

• Fixed ICOR assumption: no factor substitution or technological progress
• Ignores the quality of investment (some investment is more productive than others)
• Knife-edge instability: the model does not have a stable equilibrium
• No role for labour force growth or human capital
• Savings may not translate into productive investment (capital flight, corruption)

Lewis model limitations:

• Surplus labour may not exist in all developing countries
• Urban unemployment may coexist with rural surplus labour (Harris-Todaro model)
• Profits may not be reinvested (capital flight, elite consumption)
• Ignores agricultural productivity growth (which is important for feeding growing urban populations)
• Assumes constant wage premium in the modern sector

Problem 10: Comprehensive Balance of Payments Analysis

A small open economy has the following data for 2025 (in billions of USD):

Item	Amount
Exports of goods	280
Imports of goods	350
Exports of services	120
Imports of services	90
Investment income received	45
Investment income paid	80
Workers' remittances received	15
Workers' remittances sent abroad	5
Foreign aid received	10
FDI inflows	60
FDI outflows	20
Portfolio investment inflows	30
Portfolio investment outflows	45
Other investment (net)	+15
Change in reserves	-12 (reserves increase)

(a) Calculate the current account balance and its main components.

(b) Calculate the financial account balance.

(c) Does the balance of payments identity hold? If not, calculate errors and omissions.

(d) Assess the sustainability of the external position.

(a) Trade in goods: $280 - 350 = -70$

Trade in services: $120 - 90 = +30$

Primary income: $45 - 80 = -35$

Secondary income: $15 - 5 + 10 = +20$ (remittances received minus sent, plus aid received)

Current account: $-70 + 30 - 35 + 20 = -55$ billion USD (deficit)

The main driver is the goods trade deficit (-70), partially offset by services surplus (+30) and secondary income (+20).

(b) Financial account:

• FDI: $60 - 20 = +40$
• Portfolio investment: $30 - 45 = -15$
• Other investment: $+15$
• Reserve assets: $-12$ (increase in reserves is a debit)

Financial account: $40 - 15 + 15 - 12 = +28$ billion USD

(c) $\text{CA} + \text{KA} + \text{FA} + \text{EO} = 0$

$-55 + 0 + 28 + \text{EO} = 0 \implies \text{EO} = +27$ billion USD

The statistical discrepancy is +27 billion, which is large (suggesting significant measurement issues, possibly unrecorded capital flows or trade misinvoicing).

(d) Sustainability assessment:

• Current account deficit of 55 billion is significant
• The deficit is financed by FDI inflows (+40), which are stable and productive
• However, portfolio investment is a net outflow (-15), suggesting domestic investors are seeking better returns abroad
• The large errors and omissions (27 billion) raise concerns about data quality and possible unrecorded flows
• Reserves are increasing (12 billion), which provides a buffer but is unusual for a deficit country (suggests possible intervention to prevent depreciation)

Overall, the external position is moderately sustainable if FDI inflows continue and the goods trade deficit narrows over time. However, the large statistical discrepancy warrants caution.

Purchasing Power Parity: Calculations (HL Extension)

Absolute PPP: Numerical Application

The Big Mac Index (The Economist) provides an accessible application of absolute PPP.

Example calculation:

Country	Big Mac price (local currency)	Big Mac price (USD)	Exchange rate (LCU/USD)	PPP-implied rate	Over/undervaluation
USA	5.50	5.50	1.00	1.00	--
UK	3.79	5.50	0.79	0.69	Overvalued by 14%
Japan	450	5.50	149	81.8	Undervalued by 45%
China	22	5.50	7.24	4.00	Undervalued by 45%
Switzerland	7.02	5.50	0.89	1.28	Overvalued by 44%

PPP-implied exchange rate $= P_{\text{domestic}} / P_{\text{USA}}$

For Japan: PPP rate $= 450 / 5.50 = 81.8$ JPY/USD. Actual rate $= 149$. Japan is undervalued by $(149 - 81.8) / 81.8 \times 100 = 82\%$.

Wait, let me recalculate more carefully:

Over/undervaluation $= \frac{\text{PPP rate} - \text{Actual rate}}{\text{PPP rate}} \times 100$

For Japan: $(81.8 - 149) / 81.8 \times 100 = -82\%$ (undervalued by 82%).

Limitations of the Big Mac Index:

• Non-tradable inputs (labour, rent, local ingredients) make up a significant share of the Big Mac price, violating the assumption of identical goods
• The Big Mac is a single product and not representative of overall price levels
• Tax differences, trade barriers, and local market power distort the comparison
• Non-tradable sectors (housing, services) are a growing share of GDP in advanced economies
• The index assumes identical quality across countries

Relative PPP: Inflation Differential Calculations

Worked example:

The exchange rate between the euro and the US dollar is EUR/USD $= 1.20$. Eurozone inflation is $3\%$ and US inflation is $2\%$.

Predicted change in EUR/USD:

$\%\Delta S \approx \pi_{\text{EUR}} - \pi_{\text{US}} = 3\% - 2\% = 1\%$

The euro is expected to depreciate by approximately 1% against the dollar. New rate $= 1.20 \times 1.01 = 1.212$ USD/EUR.

Verification with exact formula:

$\frac{S_1}{S_0} = \frac{1 + \pi_{\text{EUR}}}{1 + \pi_{\text{US}}} = \frac{1.03}{1.02} = 1.0098$

New rate $= 1.20 \times 1.0098 = 1.212$ USD/EUR.

The euro depreciates because higher inflation in the Eurozone erodes its purchasing power relative to the dollar.

Real Exchange Rate

The real exchange rate adjusts the nominal exchange rate for relative price levels:

$q = \frac{S \cdot P_{\text{domestic}}}{P_{\text{foreign}}}$

An increase in $q$ represents a real depreciation (the domestic currency loses purchasing power).

If PPP holds exactly, $q = 1$ at all times. Deviations from PPP indicate competitiveness changes:

$q > 1 \implies \text{domestic goods are more expensive relative to foreign (real appreciation)}$ $q < 1 \implies \text{domestic goods are cheaper (real depreciation)}$

Transfer Pricing (HL Extension)

Definition and Mechanism

Transfer pricing refers to the prices at which goods, services, and intangible assets are traded between related entities within a multinational corporation.

MNCs can manipulate transfer prices to shift profits to low-tax jurisdictions:

$\text{Revenue in high-tax country} \downarrow \implies \text{Tax liability} \downarrow$ $\text{Revenue in low-tax country} \uparrow \implies \text{After-tax profit} \uparrow$

Example: A pharmaceutical company manufactures a drug at cost of USD 2 per unit in Ireland (corporate tax rate 12.5%) and sells it to its subsidiary in Germany (corporate tax rate 30%) at a transfer price of USD 8 per unit. The drug retails in Germany for USD 15.

Profit in Ireland $= 8 - 2 =$6 per unit. Tax $= 6 \times 0.125 =$0.75$ per unit.

Profit in Germany $= 15 - 8 =$7 per unit. Tax $= 7 \times 0.30 =$2.10$ per unit.

Total profit $= 6 + 7 = 13$. Total tax $= 0.75 + 2.10 =$2.85$.

If the transfer price were USD 12:

Profit in Ireland $= 12 - 2 =$10. Tax $= 10 \times 0.125 =$1.25$.

Profit in Germany $= 15 - 12 =$3$. Tax$= 3 \times 0.30 = $0.90$.

Total tax $= 1.25 + 0.90 = 2.15$. Total profit unchanged at $13.

By raising the transfer price, the MNC shifts $2$ of profit from Germany (30% tax) to Ireland (12.5% tax), saving $0.70$ per unit in tax.

Regulatory responses:

1. Arm's length principle: transfer prices should be set as if the transaction were between independent (unrelated) parties
2. Country-by-country reporting: requiring MNCs to report revenue, profit, taxes, and employees in each jurisdiction
3. Base erosion and profit shifting (BEPS): OECD/G20 project to address tax avoidance strategies that exploit gaps in tax rules
4. Global minimum corporate tax: the OECD/G20 agreement on a 15% minimum corporate tax rate, reducing the incentive for profit shifting

Optimum Currency Areas and the Euro Crisis (HL Extension)

Mundell's Criteria (1961)

An optimum currency area (OCA) is a region where the benefits of sharing a common currency outweigh the costs of losing monetary independence.

Mundell identified the key criterion: labour mobility. If workers can move freely between regions, asymmetric shocks (a recession in one region) can be addressed through migration rather than monetary policy.

Other OCA criteria:

1. Labour mobility: workers move from depressed regions to booming regions, restoring equilibrium without exchange rate adjustment
2. Wage and price flexibility: if wages can fall in depressed regions, competitiveness is restored without exchange rate depreciation
3. Fiscal transfers: automatic fiscal transfers from booming to depressed regions (e.g., unemployment insurance, federal tax systems)
4. Similar business cycles: synchronised cycles reduce the need for independent monetary policy
5. Product diversification: diversified economies are less vulnerable to sector-specific shocks
6. Financial integration: integrated capital markets can smooth consumption across regions

The Eurozone: A Suboptimal Currency Area?

The Eurozone has been criticised as failing to meet several OCA criteria:

1. Limited labour mobility: linguistic, cultural, and institutional barriers restrict movement between Eurozone countries. Unlike the US, Europe lacks a common language, and pension and qualification recognition remain imperfect

2. Wage rigidity: European labour markets are less flexible than the US, particularly in southern European countries (Greece, Italy, Spain, Portugal). Wages do not adjust downward sufficiently to restore competitiveness

3. Insufficient fiscal transfers: the EU budget is approximately 1% of EU GDP, far below the 10--20% of federal budgets in countries like the US. Automatic stabilisers between Eurozone countries are weak

4. Divergent business cycles: Germany's export-oriented economy experienced a boom while southern European countries faced recession after 2008, requiring different monetary policies that a single currency cannot provide

5. Asymmetric shocks: the 2008 financial crisis and the subsequent sovereign debt crisis hit Greece, Ireland, Portugal, Spain, and Italy much harder than Germany and the Netherlands, yet all shared the same monetary policy

The Eurozone Sovereign Debt Crisis (2010--2012)

Causes:

1. After adopting the euro, peripheral countries (Greece, Portugal, Spain, Ireland) enjoyed lower interest rates due to perceived elimination of exchange rate risk (convergence trade)
2. Lower rates fuelled credit booms and asset price bubbles (particularly in Ireland and Spain)
3. When the 2008 financial crisis hit, revenues fell while debt obligations remained, revealing that the "convergence" was illusory
4. Markets questioned the solvency of Greece, leading to a spike in bond yields and a self-fulfilling crisis

Policy responses:

1. Austerity: the ECB and EU required fiscal consolidation (spending cuts, tax increases) as a condition for bailouts, which deepened recessions
2. Outright Monetary Transactions (OMT): the ECB's programme to purchase sovereign bonds of distressed countries in the secondary market, which calmed markets
3. European Stability Mechanism (ESM): a permanent rescue fund for Eurozone members

Evaluation:

• The ECB's eventual intervention (OMT) was effective at calming markets but came late
• Austerity policies caused deep recessions and social costs in peripheral countries
• The crisis revealed the need for banking union, fiscal union, and capital markets union alongside monetary union -- the "incomplete OCA" argument
• Greece's GDP fell by 25% between 2008 and 2016, with unemployment reaching 27.5%
• Ireland recovered relatively quickly, partly because its export-oriented economy benefited from the euro's depreciation

Commodity Super-Cycles and Terms of Trade Volatility (HL Extension)

Commodity Super-Cycles

A commodity super-cycle is a prolonged period (typically 20--40 years) of abnormally high or low commodity prices, driven by structural shifts in global demand.

Historical super-cycles:

1. Late 1800s--early 1900s: industrialisation drove demand for raw materials and energy. Prices of metals, rubber, and oil rose
2. 1950s--1970s: post-war reconstruction and the rapid industrialisation of Japan and Europe sustained high commodity demand
3. 2000s: China's industrialisation drove the most recent super-cycle, with oil peaking at USD 147 per barrel in 2008 and metals reaching record highs

Implications for commodity-exporting developing countries:

During a super-cycle upswing:

savings{'\}'} \implies \text{Higher investment}$$ During a super-cycle downswing: $$\text{ToT deteriorate} \implies \text{Lower export revenue} \implies \text{Fiscal deficits} \implies \text{Debt accumulation}$$ The volatility of commodity prices makes fiscal planning extremely difficult for commodity-dependent developing countries. ### Managing Commodity Price Volatility 1. **Sovereign wealth funds**: save resource revenues during boom periods to stabilise spending during busts (e.g., Norway's Government Pension Fund Global) 2. **Hedging**: commodity futures and options can lock in prices, but this is expensive and requires sophisticated financial infrastructure 3. **Diversification**: reducing dependence on a narrow range of commodity exports 4. **Stabilisation funds**: Chile's Structural Balance Rule and Copper Stabilisation Fund provide a model for counter-cyclical fiscal policy ## Worked Examples: International Economics (HL Extension) <details> <summary>Problem 11: PPP Calculation and Exchange Rate Forecast</summary> The following data are available: | Country | CPI (local currency, base 2020 = 100) | |---------|--------------------------------------| | USA | 120 | | UK | 108 | | Japan | 95 | | India | 130 | The exchange rate in 2020 was GBP/USD $= 0.75$ and JPY/USD $= 110$ and INR/USD $= 75$. (a) Calculate the PPP-implied exchange rate for each currency against the USD. (b) Determine whether each currency is overvalued or undervalued against the USD. (c) Forecast the exchange rate in one year if US inflation is 2.5%, UK inflation is 4%, and Japan inflation is 1%. (a) PPP-implied GBP/USD $= 108/120 = 0.90$ PPP-implied JPY/USD $= 95/120 = 0.792$ For India: if CPI $= 130$, PPP-implied INR/USD $= 130/120 = 1.083$ (b) UK: actual $= 0.75$, PPP $= 0.90$. Overvalued by $(0.90 - 0.75)/0.90 \times 100 = 16.7\%$ Japan: actual $= 110$, PPP $= 0.792$. Undervalued by $(0.792 - 110)/0.792 \times 100 = -13\,888\%$ More precisely, the actual rate is 110 JPY/USD while PPP implies 0.792 USD/JPY, or $1/0.792 = 126.3$ JPY/USD. The yen is overvalued (too few yen per dollar), not undervalued. Correction: actual $= 110$ JPY/USD, PPP $= 126.3$ JPY/USD. Since $110 < 126.3$, the yen is overvalued (stronger than PPP predicts). India: actual $= 75$ INR/USD, PPP $= 1.083$ USD/INR, or $92.3$ INR/USD. Since $75 < 92.3$, the rupee is overvalued. (c) Relative PPP: $\%\Delta S \approx \pi_{\text{domestic}} - \pi_{\text{US}}$ GBP/USD: $\%\Delta = 4.0\% - 2.5\% = 1.5\%$. New rate $= 0.75 \times 1.015 = 0.761$ JPY/USD: $\%\Delta = 1.0\% - 2.5\% = -1.5\%$. New rate $= 110 \times (1 - 0.015) = 108.35$ INR/USD: $\%\Delta \approx \pi_{\text{India}} - \pi_{\text{US}}$. If India's inflation is 6%: New rate $= 75 \times (1 + 0.06 - 0.025) = 75 \times 1.035 = 77.63$ </details> <details> <summary>Problem 12: Eurozone Crisis Analysis</summary> In 2010, Greece's government debt was 130% of GDP, its budget deficit was 15% of GDP, and its 10-year bond yield was 10%. Germany's government debt was 80% of GDP, its deficit was 4% of GDP, and its bond yield was 3%. (a) Why were bond yields so much higher in Greece than Germany despite both using the euro? (b) Explain why the euro may have contributed to Greece's problems. (c) Evaluate the effectiveness of the policy response to the crisis. (a) Bond yields reflect the perceived risk of default. Even though both countries use the euro, investors demanded much higher yields on Greek bonds because: - Greece's debt was far higher (130% vs. 80% of GDP), increasing default risk - Greece's deficit was nearly four times larger (15% vs. 4%), indicating unsustainable fiscal dynamics - Greece had a history of fiscal misreporting (it revised its deficit figures upward in 2009) - Greece's tax collection was weak, with a large informal economy reducing revenue - Germany had stronger institutions, a more diversified economy, and greater fiscal credibility Under a common currency, investors cannot be compensated for country-specific risk through currency depreciation (the "original sin" problem for emerging markets), so they demand higher interest rates instead. (b) The euro contributed to Greece's problems because: 1. **Lower borrowing costs**: before joining the euro, Greece paid high interest rates (partly reflecting drachma depreciation risk). Euro adoption eliminated this risk premium, leading to a credit-fuelled consumption and investment boom 2. **Loss of exchange rate adjustment**: when competitiveness declined, Greece could not devalue. In a flexible exchange rate regime, drachma depreciation would have restored competitiveness gradually; under the euro, the only adjustment mechanisms are internal devaluation (wage cuts, price cuts), which are slow and painful 3. **Capital market integration**: low interest rates encouraged borrowing from core European banks, which accumulated large exposures to Greek sovereign debt 4. **No lender of last resort**: the ECB was not initially designed to act as a lender of last resort for sovereign governments (c) **Austerity**: fiscal consolidation deepened Greece's recession. GDP fell by 25% (2008--2016). Unemployment rose to 27.5%. Social spending cuts reduced health and education outcomes. The fiscal multiplier in a depressed economy is high, so austerity was particularly self-defeating **ECB intervention (OMT, 2012)**: Mario Draghi's commitment to "do whatever it takes" and the OMT programme calmed bond markets and reduced sovereign spreads. This was effective but came too late to prevent deep recessions **Structural reforms**: labour market and product market reforms were implemented, but short-term social costs were severe **Long-term lesson**: the crisis demonstrated that monetary union without fiscal union, banking union, and political union is unstable. Subsequent reforms (banking union, European Stability Mechanism, Capital Markets Union) address some gaps but progress is incomplete. </details> <details> <summary>Problem 13: Terms of Trade and Development Policy</summary> Country X is a copper exporter. The following data show its terms of trade and income terms of trade: | Year | Export Price Index | Import Price Index | ToT | Export Volume Index | Income ToT | |------|-------------------|-------------------|-----|--------------------|-----------| | 2018 | 100 | 100 | 100.0 | 100 | 100.0 | | 2019 | 110 | 105 | 104.8 | 95 | 99.6 | | 2020 | 125 | 140 | 89.3 | 80 | 71.4 | | 2021 | 105 | 120 | 87.5 | 90 | 78.8 | | 2022 | 115 | 115 | 100.0 | 105 | 105.0 | (a) Calculate the annual percentage change in the ToT for each year. (b) Explain the Income ToT result in 2020. What happened? (c) What policies could Country X implement to reduce ToT volatility? (a) 2019: $(104.8 - 100.0)/100.0 \times 100 = 4.8\%$ (improvement) 2020: $(89.3 - 104.8)/104.8 \times 100 = -14.8\%$ (sharp deterioration) 2021: $(87.5 - 89.3)/89.3 \times 100 = -2.0\%$ (further deterioration) 2022: $(100.0 - 87.5)/87.5 \times 100 = 14.3\%$ (strong improvement) (b) In 2020, the ToT deteriorated by 14.8% due to the COVID-19 pandemic reducing demand for copper (export prices fell) while import prices rose (supply chain disruptions). However, the Income ToT fell even more dramatically (from 99.6 to 71.4, a 28.3% decline) because export volumes also fell sharply. The ToT improvement in 2022 was driven by post-pandemic recovery in demand for copper, with both prices and volumes recovering. (c) Policies to reduce ToT volatility: 1. **Sovereign wealth fund**: save copper revenue during price booms (2022) to stabilise government spending during busts (2020) 2. **Economic diversification**: develop manufacturing and services to reduce dependence on copper, which is subject to super-cycle volatility 3. **Forward contracts**: hedging copper sales on futures markets to lock in prices 4. **Value-added processing**: refine copper domestically rather than exporting raw ore, capturing more of the value chain 5. **Counter-cyclical fiscal policy**: save during booms, spend during recessions 6. **Stabilisation fund**: similar to Chile's ESSF, create a fund that accumulates resources when copper prices are high and disburses when they are low </details> ## Common Pitfalls: International Economics (Comprehensive) - Assuming that a current account deficit always requires devaluation. The deficit may reflect productive investment that generates future export capacity - Confusing absolute and relative PPP. Absolute PPP is a poor short-run predictor; relative PPP is more useful but still imprecise - Applying the Marshall-Lerner condition without considering the J-curve. A depreciation worsens the current account in the short run, even when the condition holds in the long run - Assuming that the Big Mac Index accurately measures PPP. Non-tradable inputs and local market conditions make it an imprecise indicator - Confusing the optimum currency area criteria with the Eurozone reality. The OCA framework is useful for analysis even if the Eurozone fails to meet several criteria - Ignoring transfer pricing when evaluating FDI. Reported profits may significantly understate the true profitability of MNC operations in host countries - Assuming that the Eurozone crisis proves monetary union is impossible. The crisis revealed the need for complementary institutions (fiscal union, banking union), not the abandonment of monetary union ## Exchange Rate Regimes: Comparative Analysis (HL Extension) ### Types of Exchange Rate Regimes 1. **Currency union:** countries share a common currency and a common central bank (e.g., Eurozone, CFA franc zone) 2. **Currency board:** domestic currency is fully backed by foreign reserves and convertible at a fixed rate (e.g., Hong Kong dollar pegged to USD) 3. **Fixed (pegged) exchange rate:** the central bank intervenes to maintain a target rate, with some flexibility (e.g., Saudi riyal pegged to USD) 4. **Crawling peg:** the exchange rate is adjusted periodically in small, pre-announced amounts (e.g., Nicaragua's crawling peg against USD) 5. **Managed float:** the exchange rate is determined by market forces, but the central bank intervenes occasionally to smooth volatility (e.g., India, Singapore) 6. **Free float:** the exchange rate is determined entirely by market forces without government intervention (e.g., USD, AUD, NZD) ### The Impossible Trinity (Trilemma) A country cannot simultaneously maintain: 1. A fixed exchange rate 2. Free capital mobility 3. An independent monetary policy It must choose two of the three: | Regime | Fixed exchange rate | Free capital mobility | Independent monetary policy | |---|---|---|---| | Currency board | Yes | Yes | No | | Bretton Woods (1950s--60s) | Yes | No | Yes | | Free float (e.g., USA) | No | Yes | Yes | | Capital controls (e.g., China, pre-2005) | Yes | No | Yes | ### Advantages and Disadvantages of Each Regime **Fixed exchange rates:** *Advantages:* - Reduces exchange rate uncertainty, promoting trade and investment - Disciplines monetary policy (prevents inflationary finance) - Reduces transaction costs for international trade *Disadvantages:* - Requires large foreign exchange reserves to defend the peg - Loss of independent monetary policy (the interest rate must match the anchor currency) - Vulnerable to speculative attacks (as in the 1997 Asian financial crisis) - Requires fiscal discipline (fiscal deficits put pressure on the peg) **Floating exchange rates:** *Advantages:* - Automatic adjustment to external shocks (the exchange rate absorbs the shock) - Independent monetary policy (the central bank can set interest rates for domestic objectives) - No need for large foreign exchange reserves *Disadvantages:* - Exchange rate volatility creates uncertainty for trade and investment - Potential for excessive volatility (speculative bubbles, overshooting) - May lead to misalignment (persistently overvalued or undervalued exchange rates) ### The Asian Financial Crisis (1997--1998): A Case Study **Causes:** 1. **Fixed exchange rates with free capital mobility:** Thailand, Indonesia, and South Korea maintained fixed or semi-fixed exchange rates while liberalising capital accounts, creating the impossible trinity problem 2. **Short-term foreign currency debt:** firms and banks borrowed in USD at low interest rates, creating currency mismatches (revenues in local currency, debts in USD) 3. **Speculative attack:** when investors lost confidence, capital outflows forced central banks to deplete reserves defending the peg 4. **Contagion:** the crisis spread from Thailand to Indonesia, South Korea, Malaysia, and the Philippines **Sequence of events:** $$\text{Capital inflows} \implies \text{Credit boom} \implies \text{Asset price bubble}$$ $$\implies \text{Loss of confidence} \implies \text{Capital outflows}$$ $$\implies \text{Reserve depletion} \implies \text{Forced devaluation}$$ $$\implies \text{Currency crisis} \implies \text{Banking crisis} \implies \text{Recession}$$ **Impact:** - Thai baht: lost 50% of its value against USD - Indonesian rupiah: lost 80% - South Korean won: lost 50% - GDP declines: Thailand -10.5%, Indonesia -13.1%, South Korea -5.1% (1998) - Poverty increased dramatically: Indonesian poverty rate rose from 11% to 20% **Lessons:** 1. The impossible trinity matters: fixed rates + free capital flows + independent monetary policy is unsustainable 2. Short-term foreign currency debt is dangerous for emerging markets 3. Capital account liberalisation should be sequenced carefully (domestic financial reform before capital account opening) 4. International financial architecture needs a better mechanism for resolving sovereign debt crises (the IMF's role was controversial) ## Trade Creation and Trade Diversion: Formal Treatment (HL Extension) ### Customs Unions and Welfare Effects A **customs union** eliminates tariffs between member countries and establishes a common external tariff against non-members. The welfare effects depend on whether the union creates or diverts trade. **Trade creation:** the union causes a member country to import a good from a lower-cost producer within the union instead of producing it domestically at higher cost. This improves welfare. **Trade diversion:** the union causes a member country to import a good from a higher-cost producer within the union instead of from a lower-cost producer outside the union. This reduces welfare. ### Numerical Example Country A imports good X. The domestic cost of production is USD 100 per unit. - Country B (potential union partner): cost USD 80 per unit - Country C (outside the union): cost USD 60 per unit Before the customs union, Country A has a 50% tariff on all imports: - Cost of importing from B: $80 \times 1.50 = 120$ (more expensive than domestic, so A produces) - Cost of importing from C: $60 \times 1.50 = 90$ (cheaper than domestic, so A imports from C) A imports from C at a landed cost of USD 90. After forming a customs union with B (tariff-free between A and B; 50% tariff on C): - Cost of importing from B: USD 80 (no tariff) - Cost of importing from C: $60 \times 1.50 = 90$ (tariff still applies) A now imports from B at USD 80 instead of from C at USD 90. **Analysis:** - **Trade creation:** A switches from domestic production (USD 100) to importing from B (USD 80). This is a welfare gain of USD 20 per unit on the quantity previously produced domestically - **Trade diversion:** A switches from importing from C (USD 60) to importing from B (USD 80). This is a welfare loss of USD 20 per unit on the quantity previously imported from C **Net welfare effect:** If A imports 100 units, previously all from C at USD 60: New cost $= 100 \times 80 = 8\,000$ Old cost $= 100 \times 90 = 9\,000$ (including tariff revenue) Consumer cost falls by USD 1,000. Government loses tariff revenue of $100 \times 30 = 3\,000$. Producer surplus: domestic production was zero before and remains zero. Net welfare effect $= 1\,000 - 3\,000 = -2\,000$. **Trade diversion dominates:** the customs union reduces welfare because the lower-cost producer (C at USD 60) is replaced by the higher-cost partner (B at USD 80), and the tariff revenue loss exceeds the consumer gain. This illustrates Viner's (1950) key insight: customs unions are not always welfare-improving. The net effect depends on the relative costs of domestic, partner, and world producers. ### Conditions for Net Welfare Gain A customs union is more likely to improve welfare when: 1. The partners' costs are close to world costs (minimising trade diversion) 2. The union covers a large share of world trade (reducing the scope for trade diversion) 3. Demand is elastic (so trade creation is large relative to trade diversion) 4. The pre-union tariff is high (so removing the tariff creates large efficiency gains) 5. The union partners are geographically close (low transport costs increase competitiveness) ## Exam-Style Questions: International Economics (HL Extension) <details> <summary>Question 1: Impossible Trinity Application (10 marks)</summary> Country M currently has a fixed exchange rate against the USD, free capital mobility, and an independent monetary policy. It faces rising inflation (8%) while the US inflation rate is 2%. (a) Explain why Country M's current position is unsustainable. [4 marks] (b) Analyse two policy options: (i) devalue the peg, (ii) impose capital controls. [6 marks] (a) By the impossible trinity, Country M cannot simultaneously maintain all three: a fixed exchange rate, free capital mobility, and independent monetary policy. With free capital mobility and a fixed exchange rate, Country M's interest rate must match the US rate. If Country M tries to raise interest rates to fight inflation while the US keeps rates low, the interest differential attracts capital inflows, putting upward pressure on the exchange rate. The central bank must sell domestic currency (increasing the money supply, which is inflationary) to maintain the peg, undermining its inflation-fighting objective. (b) **(i) Devalue the peg:** A devaluation makes exports cheaper and imports more expensive. The Marshall-Lerner condition must hold for the current account to improve. In the short run, the J-curve effect may worsen the trade balance. Devaluation is also inflationary (import prices rise). However, it restores competitiveness and does not require capital controls. **(ii) Impose capital controls:** Capital controls break the link between domestic and foreign interest rates, restoring monetary policy independence. The central bank can raise interest rates to fight inflation without triggering capital inflows. However, capital controls reduce investor confidence, may discourage FDI, and create opportunities for evasion (capital flight through informal channels). **Evaluation:** devaluation is more market-friendly but may not address the underlying inflation problem. Capital controls restore monetary autonomy but damage financial integration. The best option depends on Country M's specific circumstances: the credibility of its institutions, the elasticity of its exports, and the duration of the inflation problem. </details> <details> <summary>Question 2: Trade Creation and Diversion (10 marks)</summary> Countries A, B, and C produce good Y at costs of USD 50, USD 40, and USD 30 per unit respectively. Country A has a 40% tariff on imports. Country A imports 200 units per year. (a) From which country does A import before any customs union? [2 marks] (b) A and B form a customs union. Calculate the welfare effect. [4 marks] (c) A and C form a customs union instead. Calculate the welfare effect. [4 marks] (a) Landed cost from B: $40 \times 1.40 = 56$. Landed cost from C: $30 \times 1.40 = 42$. A imports from C (42 < 50 < 56). Total cost $= 200 \times 42 = 8\,400$. Tariff revenue $= 200 \times 12 = 2\,400$. (b) A-B customs union: tariff-free with B, 40% tariff on C. Landed cost from B: 40. Landed cost from C: $30 \times 1.40 = 42$. A switches to importing from B at USD 40. New cost $= 200 \times 40 = 8\,000$. Tariff revenue $= 0$. Consumer saving $= 8\,400 - 8\,000 = 400$. Government loses tariff revenue of 2,400. Net welfare $= 400 - 2\,400 = -2\,000$. Trade diversion dominates. A replaces imports from the efficient producer (C at 30) with imports from the less efficient partner (B at 40), and the tariff revenue loss exceeds the consumer gain. (c) A-C customs union: tariff-free with C, 40% tariff on B. Landed cost from C: 30. Landed cost from B: $40 \times 1.40 = 56$. A imports from C at USD 30. New cost $= 200 \times 30 = 6\,000$. Tariff revenue $= 0$. Consumer saving $= 8\,400 - 6\,000 = 2\,400$. Government loses tariff revenue of 2,400. Net welfare $= 2\,400 - 2\,400 = 0$. No trade diversion because C was already the lowest-cost producer. There is pure trade creation: A switches from domestic production to importing from the lowest-cost source. </details> <details> <summary>Question 3: Asian Financial Crisis and the Trilemma (10 marks)</summary> Thailand maintained a fixed exchange rate (baht pegged at 25 to USD) with free capital mobility in the 1990s. In 1996--97, Thai current account deficits reached 8% of GDP, and short-term external debt was USD 70 billion (50% of GDP). (a) Using the impossible trinity, explain Thailand's vulnerability. [4 marks] (b) Explain how the crisis unfolded once speculative pressure began. [3 marks] (c) Evaluate the IMF's response to the crisis. [3 marks] (a) Thailand maintained a fixed exchange rate and free capital mobility, sacrificing independent monetary policy. When the US raised interest rates in 1994--95, Thailand could not follow suit because its economy was slowing. The interest differential (Thai rates < US rates) encouraged capital outflows, putting downward pressure on the baht. To defend the peg, the Bank of Thailand had to sell USD reserves and buy baht, depleting reserves from USD 39 billion (1996) to USD 2 billion (July 1997). Once reserves were exhausted, the peg collapsed. The vulnerability was amplified by currency mismatches: Thai firms and banks had borrowed heavily in USD (short-term external debt = 50% of GDP). When the baht was devalued, the local currency cost of servicing USD debt doubled, triggering a wave of defaults. (b) Once speculative pressure intensified: 1. Hedge funds and investors sold baht short, betting on devaluation 2. The Bank of Thailand spent reserves defending the peg 3. On 2 July 1997, Thailand abandoned the peg; the baht fell from 25 to 56 per USD 4. Thai firms with USD-denominated debt could not service their obligations 5. The banking crisis spread to Indonesia, South Korea, and Malaysia (contagion) 6. GDP fell 10.5% in 1998; the stock market lost 75% of its value (c) **IMF evaluation:** *IMF actions:* provided USD 17 billion in loans, conditioned on fiscal austerity, high interest rates, and structural reforms (bank closures, privatisation). *Criticism:* 1. **Fiscal austerity was contractionary:** the IMF required budget surpluses during a deep recession, worsening the downturn 2. **High interest rates:** the IMF recommended raising interest rates to defend the currency, but this deepened the recession and increased corporate bankruptcies 3. **Bank closures:** the IMF mandated the closure of 56 Thai finance companies, triggering a banking panic and credit crunch 4. **One-size-fits-all:** the same policy package was applied to all affected countries, ignoring different circumstances *Defence:* the IMF argued that restoring confidence required fiscal and monetary discipline, and that the alternative (unconditional lending) would have created moral hazard. **Lesson:** the IMF's response has since been reformed. The 2010 IMF lending framework allows more counter-cyclical policies (deficit spending during recessions) and more flexible conditionality. </details> ## Case Study: Brexit and Trade Policy (HL Extension) ### The Economics of Brexit The UK's decision to leave the EU (2016 referendum, 2020 exit) provides a case study in trade policy, customs unions, and the costs of trade barriers. **Trade effects:** 1. **New trade barriers:** the UK-EU Trade and Cooperation Agreement (TCA) eliminated tariffs on goods but introduced customs checks, rules of origin requirements, and regulatory barriers. Non-tariff barriers (NTBs) are estimated to increase trade costs by 10--15% 2. **Services:** the TCA provides limited access for UK service providers to the EU market. Services account for 80% of the UK economy and were the primary source of Brexit-related economic costs 3. **Trade diversion:** UK imports from the EU fell post-Brexit, partially replaced by imports from other countries (trade diversion away from the most efficient EU producers) 4. **Foreign direct investment:** UK FDI inflows fell relative to comparator countries, as the UK became less attractive as a gateway to the EU single market **Quantitative estimates (various studies, 2020--2024):** - UK GDP is estimated to be 2.5--4.0% lower than it would have been within the EU - UK-EU trade in goods fell by approximately 15% (after accounting for COVID and other factors) - UK services exports to the EU fell by approximately 8% - The UK's share of EU FDI inflows fell from 22% (2016) to 8% (2022) **Evaluation:** Brexit illustrates the economic costs of leaving a customs union: 1. **Trade creation was reversed:** goods that were traded freely within the EU now face barriers, reducing trade and welfare 2. **New trade diversion:** UK firms source from non-EU countries (with higher costs) due to EU rules of origin requirements 3. **Regulatory divergence:** the UK's ability to set independent regulations is a benefit of sovereignty but creates additional trade barriers with the EU 4. **Long-run effects uncertain:** the full impact depends on the UK's ability to negotiate new trade agreements and the extent of regulatory divergence ## FDI and Development: Extended Analysis (HL Extension) ### Types of FDI 1. **Horizontal FDI:** the firm replicates its production process in the host country to serve the local market (market-seeking). Common in manufacturing and services. E.g., Toyota building assembly plants in the US, UK, and Thailand 2. **Vertical FDI:** the firm locates different stages of production in different countries to exploit factor cost differences (efficiency-seeking). Common in labour-intensive manufacturing. E.g., Apple designing in California, assembling in China 3. **Export-platform FDI:** the firm establishes production in a host country to export to third countries. E.g., electronics firms in Singapore exporting to the US and EU ### Determinants of FDI **Pull factors (host country characteristics):** 1. **Market size:** GDP and GDP per capita determine the potential market for goods and services 2. **Labour costs:** lower wages attract labour-intensive manufacturing (but skill levels matter) 3. **Natural resources:** resource-seeking FDI targets countries with mineral, oil, or agricultural endowments 4. **Infrastructure:** transport, energy, and telecommunications infrastructure reduce production and distribution costs 5. **Institutional quality:** rule of law, property rights, and contract enforcement reduce the risk of FDI 6. **Tax incentives:** lower corporate tax rates, tax holidays, and special economic zones attract FDI **Push factors (home country characteristics):** 1. **Saturated domestic markets:** firms seek growth in emerging markets 2. **High production costs:** firms relocate labour-intensive activities to lower-cost countries 3. **Regulatory constraints:** environmental and labour regulations may push firms to relocate ### FDI and Economic Development: Empirical Evidence **Positive effects:** 1. **Capital formation:** FDI contributes to gross fixed capital formation, especially in capital-scarce developing countries 2. **Technology transfer:** MNCs bring advanced technology, management practices, and organisational know-how. Borensztein, De Gregorio, and Lee (1998) find that FDI has a positive effect on growth only when the host country has a minimum threshold of human capital (secondary school enrolment > 0.69 years) 3. **Export competitiveness:** FDI can help host countries integrate into global value chains 4. **Employment:** FDI creates jobs, though often in specific sectors and regions 5. **Productivity spillovers:** domestic firms may benefit from proximity to MNCs through labour mobility, supply chain linkages, and demonstration effects **Negative effects:** 1. **Crowding out:** FDI may displace domestic firms that cannot compete with MNCs 2. **Enclave economies:** FDI in extractive industries may have limited linkages to the domestic economy (low multiplier effects) 3. **Profit repatriation:** MNC profits flow to the home country, reducing the net benefit to the host country 4. **Environmental degradation:** weak environmental regulation may attract polluting industries 5. **Labour exploitation:** FDI in low-wage countries may involve poor working conditions ### FDI Spillovers: Formal Analysis The spillover effect of FDI on domestic firms can be modelled as: $$\text{TFP}_{d,i} = \alpha + \beta \text{FDI}_{s,j} + \gamma X_i + \epsilon_i$$ Where: - $\text{TFP}_{d,i}$ = total factor productivity of domestic firm $i$ - $\text{FDI}_{s,j}$ = FDI presence in sector $j$ (e.g., share of sector employment or output) - $X_i$ = firm characteristics (size, age, export status) - $\beta$ = spillover coefficient Empirical estimates of $\beta$ are mixed: - **Positive spillovers:** Aitken and Harrison (1999) find positive horizontal spillovers in Venezuela, but only for firms with above-average technology - **Negative spillovers (market stealing):** Javorcik (2004) finds negative horizontal spillovers in Lithuania (FDI competes with domestic firms) but positive backward spillovers (domestic suppliers benefit from MNC demand) - **Conditional spillovers:** the magnitude and direction of spillovers depend on the technology gap between MNCs and domestic firms, the absorptive capacity of domestic firms, and the degree of competition ## Exam-Style Questions: International Economics (Additional) <details> <summary>Question 4: FDI and Spillovers (10 marks)</summary> Country X attracts FDI in its manufacturing sector. The FDI share of manufacturing employment is 30%. Research estimates the following spillover effects: - Horizontal spillover: $\beta_H = -0.02$ (FDI competes with domestic firms) - Backward spillover: $\beta_B = +0.05$ (domestic suppliers benefit) - Forward spillover: $\beta_F = +0.01$ (domestic buyers benefit) The average TFP of domestic manufacturing firms is 1.00 (base year). (a) Calculate the net effect on domestic TFP from a 10 percentage point increase in FDI share. [4 marks] (b) Under what conditions would horizontal spillovers be positive? [3 marks] (c) Evaluate the policy of offering tax incentives to attract FDI. [3 marks] (a) Change in FDI share: $\Delta \text{FDI} = 10$ percentage points. Horizontal effect: $-0.02 \times 10 = -0.20$ (TFP decrease from competition) Backward effect: $+0.05 \times 10 = +0.50$ (TFP increase from supply chain linkages) Forward effect: $+0.01 \times 10 = +0.10$ (TFP increase from access to better inputs) Net effect on TFP: $-0.20 + 0.50 + 0.10 = +0.40$. New TFP $= 1.00 + 0.40 = 1.40$. Domestic firms are 40% more productive. (b) Horizontal spillovers are positive when: 1. **Technology demonstration:** domestic firms learn from MNCs by observing their production techniques and management practices 2. **Labour mobility:** workers trained by MNCs move to domestic firms, transferring knowledge 3. **Competition effect:** MNC competition forces domestic firms to innovate and improve efficiency (this is positive when domestic firms are capable of responding) 4. **Small technology gap:** when the gap between MNC and domestic technology is moderate, domestic firms can imitate and adapt. If the gap is too large, domestic firms cannot compete and are crowded out (c) **Evaluation of tax incentives:** *Advantages:* 1. Signal commitment to openness, attracting additional FDI beyond the direct incentive 2. Create jobs and increase tax revenue from economic activity (even if the corporate tax rate is lower) 3. Facilitate technology transfer and productivity spillovers *Disadvantages:* 1. **Race to the bottom:** countries compete by offering increasingly generous incentives, eroding the tax base without increasing net FDI (investment is diverted rather than created) 2. **Revenue cost:** tax incentives reduce government revenue, potentially reducing spending on public goods (education, infrastructure) that are more important for long-run growth 3. **Rent-seeking:** MNCs may negotiate incentives that exceed the benefits they create 4. **Temporary:** firms may leave when incentives expire (footloose FDI) **Recommendation:** tax incentives should be targeted at FDI with high spillover potential (high-tech, export-oriented, with strong supply chain linkages) rather than applied broadly. They should be time-limited and performance-based. </details> <details> <summary>Question 5: Current Account Sustainability (10 marks)</summary> Country Y has the following balance of payments data (USD billion): | Item | Value | |---|---| | Exports of goods | 120 | | Imports of goods | 180 | | Exports of services | 60 | | Imports of services | 40 | | Primary income (net) | -25 | | Secondary income (net) | 5 | | Net FDI inflow | 30 | | Net portfolio investment | 15 | | Net other investment | -10 | | Reserve assets change | -5 | (a) Calculate the current account balance. [3 marks] (b) Calculate the capital and financial account balance. [2 marks] (c) Is the current account deficit sustainable? Discuss using the savings-investment identity. [5 marks] (a) Current account $= (120 - 180) + (60 - 40) + (-25) + 5 = -60 + 20 - 25 + 5 = -60$ billion. Country Y has a current account deficit of USD 60 billion. (b) Capital and financial account $= 30 + 15 - 10 = 35$ billion. Current account (-60) + capital account (35) + reserve change (-5) $= -60 + 35 - 5 = -30$. This does not sum to zero, suggesting errors and omissions of USD 30 billion. (c) **Sustainability analysis using the savings-investment identity:** $\text{CA} = S - I = (S_{\text{private}} + S_{\text{government}}) - I$ A current account deficit of USD 60 billion means $I - S = 60$ billion: the country invests 60 billion more than it saves, financing the gap with foreign capital inflows. **Is this sustainable?** The deficit is sustainable if: 1. **The deficit finances productive investment:** if FDI (30 billion) finances productive capacity that generates future export earnings, the deficit is sustainable. Portfolio investment (15 billion) is more volatile and may reverse 2. **The debt trajectory is manageable:** if the country's external debt-to-GDP ratio is stable or declining, the deficit is sustainable. If it is rising rapidly, a crisis may ensue 3. **The exchange rate is flexible:** a floating exchange rate provides an automatic adjustment mechanism (depreciation improves competitiveness) 4. **The country has credible institutions:** investors are more willing to finance deficits in countries with strong institutions **Warning signs:** - The deficit (60 billion) is large relative to FDI inflows (30 billion). The remaining 30 billion is financed by portfolio investment and other flows, which are more volatile - The reserve change is negative (USD 5 billion outflow), suggesting the central bank is selling reserves to support the currency - If GDP is, say, USD 500 billion, the CA deficit is 12% of GDP -- above the 5% threshold often cited as a warning level **Recommendation:** the deficit is likely unsustainable at current levels. Policy options include: 1. Fiscal consolidation (increase $S_{\text{government}}$) 2. Structural reforms to boost competitiveness and exports 3. Allow exchange rate depreciation to improve the current account 4. Macroprudential measures to reduce capital flow volatility </details> ## Comparative Advantage: Formal Treatment (HL Extension) ### Ricardian Model with Two Countries Country A can produce 1 unit of cloth with 4 labour hours or 1 unit of wine with 8 labour hours. Country B can produce 1 unit of cloth with 6 labour hours or 1 unit of wine with 6 labour hours. **Opportunity costs:** | | Cloth (per unit of wine) | Wine (per unit of cloth) | |---|---|---| | Country A | 2 cloth | 0.5 wine | | Country B | 1 cloth | 1 wine | Country A has a comparative advantage in cloth (lower opportunity cost: 0.5 wine < 1 wine). Country B has a comparative advantage in wine (lower opportunity cost: 1 cloth < 2 cloth). **Gains from trade:** Before trade (autarky): if each country allocates 12 labour hours equally (6 to each good): Country A: cloth $= 6/4 = 1.5$, wine $= 6/8 = 0.75$. Total world output: 3 cloth, 1.5 wine. Country B: cloth $= 6/6 = 1$, wine $= 6/6 = 1$. Total world output: 3 cloth, 1.5 wine. With specialisation (A produces only cloth, B produces only wine): Country A: cloth $= 12/4 = 3$, wine $= 0$. Country B: cloth $= 0$, wine $= 12/6 = 2$. Total world output: 3 cloth, 2 wine. World wine output increases from 1.5 to 2 (a gain of 0.5 wine). Both countries can consume more wine through trade. **Terms of trade:** the world price of wine (in terms of cloth) must be between the two autarky prices: $0.5 \leq P_w/P_c \leq 1$. If the world price is $P_w/P_c = 0.75$ (1 wine $= 0.75$ cloth): Country A exports cloth, imports wine. Gains from 1 unit of export: - Cost of producing 1 cloth: 4 hours - Revenue from 1 cloth: $1/0.75 = 1.33$ wine (worth 10.67 hours of domestic wine production) - Gain: $10.67 - 4 = 6.67$ hours worth of wine per unit of cloth exported Country B exports wine, imports cloth. Gains from 1 unit of export: - Cost of producing 1 wine: 6 hours - Revenue from 1 wine: 0.75 cloth (worth 4.5 hours of domestic cloth production) - Gain: $4.5 - 6 = -1.5$ hours Wait, this gives a loss for Country B. Let me recalculate. At $P_w/P_c = 0.75$: 1 cloth trades for 1.33 wine. Country A (exporting cloth): produces 1 cloth (4 hours). Trades for 1.33 wine. To produce 1.33 wine domestically would take $1.33 \times 8 = 10.67$ hours. Gain: $10.67 - 4 = 6.67$ hours. Country B (exporting wine): produces 1 wine (6 hours). Trades for 0.75 cloth. To produce 0.75 cloth domestically would take $0.75 \times 6 = 4.5$ hours. Gain: $4.5 - 6 = -1.5$ hours. This gives a loss for Country B because the terms of trade are too favourable to Country A. The price must be within the autarky range: $0.5 \leq P_w/P_c \leq 1$. At $P_w/P_c = 0.75$: this is within the range. Let me recalculate for Country B. Country B exports 1 wine, receives 0.75 cloth. Cost of producing 1 wine domestically: 6 hours. Value of 0.75 cloth if produced domestically: 4.5 hours. But Country B receives 0.75 cloth for 6 hours of work. To get 0.75 cloth domestically would take 4.5 hours. So Country B is "spending" 6 hours to get what would cost 4.5 hours domestically. This is a loss. The issue is that at $P_w/P_c = 0.75$, 1 wine buys only 0.75 cloth. Country B's autarky exchange rate is 1:1 (6 hours each). For trade to benefit Country B, the terms of trade must be at least 1:1 in Country B's favour. Let me reconsider. The terms of trade must satisfy: Country A gains from exporting cloth, and Country B gains from exporting wine. For Country A to gain from exporting cloth: the world price of cloth (in wine) must exceed Country A's opportunity cost of cloth: $P_c/P_w > 0.5$, i.e., $P_w/P_c < 2$. For Country B to gain from exporting wine: the world price of wine (in cloth) must exceed Country B's opportunity cost of wine: $P_w/P_c > 1$. So the mutually beneficial range is: $1 < P_w/P_c < 2$. At $P_w/P_c = 1.5$: 1 wine $= 1.5$ cloth. Country A: exports 1 cloth, gets $1/1.5 = 0.667$ wine. Cost: 4 hours. Value domestically: $0.667 \times 8 = 5.33$ hours. Gain: 1.33 hours per unit of cloth exported. Country B: exports 1 wine, gets 1.5 cloth. Cost: 6 hours. Value domestically: $1.5 \times 6 = 9$ hours. Gain: 3 hours per unit of wine exported. Both countries gain. The terms of trade (1.5) is closer to Country B's autarky price (1), so Country B gains more (3 hours vs. 1.33 hours). ### Limitations of the Ricardian Model 1. **Labour-only production:** ignores other factors of production (capital, land) 2. **Constant returns to scale:** ignores economies of scale 3. **Zero transport costs:** trade costs reduce the gains from trade 4. **Perfect labour mobility within countries:** workers can move freely between sectors 5. **Complete specialisation:** the model predicts complete specialisation, but in practice countries produce some of most goods ### The Heckscher-Ohlin Model (Extension) The Heckscher-Ohlin (H-O) model explains comparative advantage through factor endowments: ** theorem:** a country exports goods that intensively use its abundant factor and imports goods that intensively use its scarce factor. **Stolper-Samuelson theorem:** trade increases the real return to the abundant factor and reduces the real return to the scarce factor. In a labour-abundant country, trade increases wages and reduces rents. **Factor price equalisation:** trade in goods leads to equalisation of factor prices (wages, rents) across countries, even without factor mobility. **Empirical test -- Leontief paradox (1953):** Wassily Leontief found that the US (a capital-abundant country) exported labour-intensive goods and imported capital-intensive goods, contradicting the H-O prediction. Possible explanations: 1. US labour is more skilled (human capital), so "labour-intensive" exports actually reflect human capital intensity 2. The US exports technology-intensive goods where the classification of factors is ambiguous 3. Trade barriers (tariffs) distort the pattern of trade ## Exam-Style Questions: International Economics (Additional) <details> <summary>Question 6: Comparative Advantage and Trade Gains (10 marks)</summary> Country X and Country Y produce two goods: cars and wheat. Labour requirements (hours per unit): | | Cars | Wheat | |---|---|---| | Country X | 100 | 10 | | Country Y | 80 | 20 | Each country has 1000 labour hours available. (a) Which country has an absolute advantage in each good? [2 marks] (b) Which country has a comparative advantage in each good? [2 marks] (c) If the countries specialise and trade at a price of 1 car = 7 wheat, calculate the gains from trade for each country. [6 marks] (a) Country Y has an absolute advantage in cars (80 < 100 hours). Country X has an absolute advantage in wheat (10 < 20 hours). (b) Opportunity costs: Country X: 1 car $= 100/10 = 10$ wheat. 1 wheat $= 10/100 = 0.1$ cars. Country Y: 1 car $= 80/20 = 4$ wheat. 1 wheat $= 20/80 = 0.25$ cars. Country X has a comparative advantage in wheat (lower opportunity cost: 0.1 < 0.25 cars). Country Y has a comparative advantage in cars (lower opportunity cost: 4 < 10 wheat). (c) **Autarky (no trade):** Assume each country splits labour equally: 500 hours to each good. Country X: cars $= 500/100 = 5$, wheat $= 500/10 = 50$. Country Y: cars $= 500/80 = 6.25$, wheat $= 500/20 = 25$. Total: 11.25 cars, 75 wheat. **With specialisation:** Country X produces only wheat: $1000/10 = 100$ wheat. Country Y produces only cars: $1000/80 = 12.5$ cars. Total: 12.5 cars, 100 wheat. World output increases by 1.25 cars and 25 wheat. **With trade at 1 car = 7 wheat:** Suppose Country Y exports 6 cars and imports 42 wheat: Country Y: consumes $12.5 - 6 = 6.5$ cars, $0 + 42 = 42$ wheat. Country X: consumes $0 + 6 = 6$ cars, $100 - 42 = 58$ wheat. **Gains from trade:** Country X: was consuming 5 cars and 50 wheat. Now: 6 cars and 58 wheat. Gain: +1 car, +8 wheat. Country Y: was consuming 6.25 cars and 25 wheat. Now: 6.5 cars and 42 wheat. Gain: +0.25 cars, +17 wheat. Both countries gain from trade. </details>