Core Principles of International Trade and Finance
Benefits and Disadvantages of Specialisation
Advantages of Specialisation
- Increased Output: As production becomes more efficient, output is maximised with the same amount of resources.
- Greater Variety for Consumers: Consumers gain access to a greater variety of higher-quality products from around the world.
- Economic Growth: Specialisation and international trade increase the size of the market, allowing for economies of scale and boosting the GDP.
- Enhanced Efficiency: It leads to greater overall efficiency, as production is carried out by the most efficient producers.
Disadvantages of Specialisation
- Over-reliance on Imports: A country can become vulnerable if it needs to import too many essential goods.
- Risk of Obsolescence: A country is at risk if the single product it specialises in is later replaced by an alternative.
- Job Vulnerability: Production jobs may be vulnerable if cheaper labour is available elsewhere.
- Exchange Rate Vulnerability: A country can be vulnerable to fluctuations in exchange rates.
The Current Account of the Balance of Payments
The current account of the balance of payments shows the income a country earns and the expenditure it makes in dealings with other countries. It consists of four other balances:
Balance of Trade in Goods and Services
This shows the flows of money coming into and going out of a country as a result of trading. Exports result in money inflows, while imports mean money outflows. The balance can be positive (a credit or surplus, if exports exceed imports) or negative (a debit or deficit, if imports exceed exports). An economy benefits from exporting more than it imports, as this means the world is helping to finance its economy.
Net Income Flows
These are transfers of money back to their original country and the investment income earned (e.g., profits from foreign investments).
Current Transfers
These are transfers of money, goods, and services that are not part of the trading process. Examples include sending gifts, donations, and foreign aid from charities.
Current Account Deficit and Surplus
The current account balance reflects a country’s trade in goods and services. There are two possible outcomes:
- Trade Surplus: Exports > Imports
- Trade Deficit: Exports < Imports
Trade deficits and surpluses can refer to trade with a particular partner (e.g., another country) or as a total (between one country and the rest of the world).
Consequences of a Long-Term Deficit
When a country is exposed to a long-term deficit, it normally leads to several challenges:
- The country may need to issue public debt to pay for imported goods and services, leading to interest payments and debt repayment obligations, which reduces available funds for the economy.
- A loss of sovereignty can occur, as the country may have to accept terms imposed by international lenders and implement economic policies it might not agree with (e.g., Greece).
- The value of the currency may fall, meaning the country has to sell more goods to earn the same amount of money.
- Imports become more expensive, which can decrease the quality of life for residents.
Causes and Benefits of a Trade Surplus
A country will normally have a trade surplus if:
- Its exports are in high demand, or it becomes a major global manufacturer (e.g., Vietnam’s textile industry).
- Its exports are cheap due to a low exchange rate against other currencies (e.g., China has historically maintained an artificially low exchange rate to boost its exports).
The main benefits of having a trade surplus are:
- Increased sales lead to higher profits. With more profits, companies may hire more people, produce more, achieve greater economies of scale (and thus produce more cheaply), and invest more in innovation, becoming increasingly efficient.
- The country can build up foreign currency reserves or invest in other countries to obtain a return.
Drawbacks of a Trade Surplus
- Domestic consumers could lose the opportunity to consume certain products if they are more profitable to sell on the international market.
- The value of the currency may rise because there is more demand for it from importers. This makes exports more expensive over time.
Exchange Rate Fluctuations
The exchange rate of a currency is determined by supply and demand. If demand for a currency increases, its price (value) also increases. There are two primary movements:
- Appreciation: If there is high demand, the currency appreciates (becomes more expensive).
- Depreciation: If there is low demand, the currency depreciates (becomes cheaper).
While many factors affect a currency’s value, international trade is one of the most important. Most currencies have different exchange rates against every other currency.
Consequences of Fluctuating Exchange Rates
Changing exchange rates affect governments, importers, exporters, and the economy as a whole.
- When the home currency appreciates: Exports from the home country become more expensive for foreign customers, potentially reducing sales. Imports from other countries become cheaper, including raw materials and finished goods. The total value of imports may increase.
- When the home currency depreciates: Exports from the home country become less expensive for foreign customers, making them easier to sell. Imports from other countries become more expensive. The total value of imports may decrease.
Methods of Trade Protection
Protectionism involves restricting the entry of foreign goods into a domestic market. This is often done by imposing taxes to raise the price of imports, making them less competitive. Governments can also limit the number of goods imported or restrict the availability of foreign exchange required to purchase them.
Methods of Trade Protection:
- Import Tariffs: Tariffs are taxes on imported goods. They increase the final price, reducing the price gap with locally produced goods.
- Import Quotas or Licenses: These are legal limits on the quantity of a specific product that can be imported. Without a license, it is not possible to import the goods.
- Administrative Complexity: Complicated bureaucracy and extensive paperwork can persuade companies not to export or import goods.
- Subsidies: These are payments or tax breaks given to local producers. This helps lower their production costs, making their final prices more competitive against imports.
- Exchange Rate Manipulation: Governments can influence the foreign exchange (FX) market to depreciate their own currency, making their exports more price-attractive.
- Embargo: This is a complete ban on the import of certain types of goods or all goods from specified countries.
Free Trade and Comparative Advantage
Free trade is the practice of trading without barriers like tariffs or quotas. It enables countries to specialise in producing what they do most efficiently and then trade with others to buy what they do not produce efficiently, often at a lower cost. Free trade tends to make countries and people more prosperous.
Comparative advantage is an economic theory stating that a country should concentrate on producing goods and services where it has a lower opportunity cost. In most cases, this is because it has access to specific raw materials or a highly skilled labour force. For example, India specialises in the textile industry due to its abundant cotton (a cheap raw material), while the UK has London as an international financial hub (a highly skilled service sector).
Benefits of Free Trade
- Enables producers to sell their products to those willing to pay the highest price globally.
- Increases the range of products available to consumers (e.g., potatoes and tobacco from the Americas).
- Allows consumers to buy better-quality products from other countries.
- Enhances the spread of new ideas, lifestyles, and products.
- Creates new job opportunities resulting from the growth of production for export.
- Increases the quality of life and the purchasing power of money.