Lecture notes international trade and international finance
Objectives: international economics & international business. Two subfields are international trade and international finance.
Facts about the world economy
The world has been globalized. From the 1950s, the GDP, production, trade, and FDI have increased a lot.
Economic globalization: two main factors that have contributed to economic globalization are technological developments and trade liberalization. Anti globalization movements are a response to disruptive effects of economics globalization.
Globalization and economic efficiency
In an economy, the price in one country for a certain good can be higher than the price in the other country. If trade is allowed, the country with the higher price will import the product from the other country, the exporting country.
In equilibrium, both countries’ welfare is maximized. But it can be disturbed by tariffs, transport costs, or any other barrier to trade. Then, a ‘price wedge’ appears between prices in the two countries.
Globalization is partly determined by:
Changes in supply and demand
Changes in the size of the price wedge
A combination of both
If demand in importing country rises, the world market experiences excess demand. This leads to an increase in the price. A new equilibrium has been attained, with a higher price in both countries. If supply in exporting country rises, the price falls. The price wedge shifts to the right. If both supply and demand rise equal-proportionally, there will be no change in the price/amount of goods being traded.
The gains from specializing: comparative advantage
David Ricardo: differences in productivity motivate international trade.
Labor productivity: units per hour. Even though one country may produce more units per hour in both products, it is not the case that that country is solely exporting and the other country is solely importing. But they combine it. Each country is exporting the product where it has a greater relative cost advantage at.
Link between comparative advantage and competitive advantage.
Ricardo: differences in productivity
Alternative models: differences in factor endownments
Differences in factor endowments
Capital and Labour
A graph showing the amounts of capital and amounts of labour needed to produce a certain amount:
Isoquant: shows different combinations of K&L that give you the production that equals 1 (or any other number).
The factor intensity ray: if this line is more steep, relatively more capital is used compared to labour.
Relative wage tangent
W/r indicates whether capital or labour is relatively cheap.
If K/L is bigger for one good than for the other good, the first good is produced relatively capital intensive.
As the price of the relatively labour intensive good rises, the relative wage w/r rises. And the capital intensity, K/L, rises too. (for both goods)
This shows how the factor intensity for the production changes as the price of a good change.
We suppose that the prices of goods differ between countries. A capital abundant country has a relatively high price of the labour intensive good, while a labour abundant country has a relatively high price of the capital intensive good.
The labour abundant country: export labour intensive good.
Capital abundant country: import labour intensive good.
The demand from the capital abundant country will tend to raise the price of the labour-intensive good. This also raises the relative wage.
Perfectly working markets: equilibrium will be a single, integrated world market with a single relative price of the labour intensive good. This also leads to a single relative wage: international wages and interest rates have moved closer together.
Markets rarely work perfectly, because of transport costs, policies, … This can introduce a price wedge. Even if a wedge exists, prices will converge. But not completely.
Characterising trade periods:
1820-1950s: North-South trade dominant, classic theories of trade. (Ricardo, Heckscher-Ohlin).
1950-1990s: North-North trade dominant. Theories to explain intra-industry trade. (Increasing returns to scale, product differentiation).
2000s-now: re-emergence of North-South trade. Increasing trade between developed and developing countries.
Use the Heckscher-Ohlin model to explain this re-emergence.
US/Europe: high-skilled labour
Asia: low-skilled labour
In the US, the relative price of high-skilled labour is low.
Replace K by high skilled workers (North)
Replace L by low skilled workers (South)
Understanding intra-industry trade
If marginal costs are constant, average cost will fall as output rises… Fixed costs can be ‘spread’ among more units of output.
Welfare maximization: P=MC
If there is a foreign monopolist entering a market, it will look to the demand that is left after the supply-demand of the domestic monopolist. The foreign monopolist will also look at MC=MR. Because sales of the foreign monopolist will increase the supply, the price falls.
Because of the entrance of the foreign monopolist, the price falls and the average costs will decrease. A part of the old revenue is lost, but there are also new revenues.
Trade due to different market structures
In monopolistic competition, firms can freely enter the market. If profits in a monopoly are positive, new firms will enter. Each firm has its own ‘unique variety’. The demand curve will shift inwards as new firms enter the market, until the price at profit maximization (MC=MR) will equal AC. Profits are zero. International trade has the same effect. New varieties make demand more elastic.
Firm heterogeneity is caused by differences in productivity. In strong industries (where firms have comparative advantage), many firms don’t export. While in weak industries (with a comparative disadvantage) some firms still do export.
Tariffs and similar trade impediments
The introduction of tariffs will lead to a price wedge. This diminishes the total welfare. The price in the importing country will go up because of the tariff (and price wedge). The amount that is purchased is decreased. At the same time, producers in the importing country gain because of the ‘protection’ by tariffs. The government will earn tariff revenue. The revenue is ((Price import – Price export) x post-tariff imports).
Trade creation and trade diversion
If trade is allowed and two countries, 1 and 2, offer their products at the market, the ‘home’ market will buy from the country with the lowest price (suppose that in this case, country 1 has a lower price). The result is a welfare gain. If it buys from the country with the higher price, the result is a lower welfare gain.
Suppose that the home country introduces a non-discriminatory tariff, the domestic price of imports from both country 1 and country 2 starts to rise with the same amount, so the price in country 1 is still the cheapest. The home country loses because of the tariff. The home government receives tariff revenue. Country 1 receives import revenue. Consumers in the home country pay the total…
Another situation can be that the home country wants to integrate with country 2 (with the higher price), so it eliminates its tariff against imports only from country 2. The result is that the price of country 2 is lower than that of country 1 and the home country starts to import from country 2. Some of the previous dead weight losses are recovered.
These welfare benefits are due to trade creation.
However, the pre-integration tariff revenue which the domestic government received is lost.
Other welfare is lost because of trade diversion
Another instrument of trade policy is an import quota: direct restriction on the quantity of a good that is imported. The restriction is usually enforced by issuing licenses to some group of individuals or firms. License holders are able to buy imports and resell them at a higher price in the domestic market (the profits are called quota rents).
Trade and capital accounts
Balance of payments account: payments to and receipts from foreigners.
International transactions enter the accounts twice, once as a credit (+) and once as a debit (-).
Current account: goods and services (imports and exports)
Financial account: financial assets
Capital account: special categories of assets.
Overall balance = 0
Open economy: Y = C + I + G + EX – IM
GDP can be measured by:
Y = C + I + G + EX – IM
wL + rK
The sum of the value added that firms generate. GO – II = VA
Current account CA = EX – IM = Y – (C + I + G)
Production > domestic expenditure - exports > imports - current account > 0 and trade balance > 0.
Production < domestic expenditure - exports < imports - current account < 0 and trade balance <0
A country’s CA surplus is referred to as its net foreign investment.
Private saving is the part of disposable income that is saved rather than consumed.
Multinational activity can be horizontal or vertical.
Characteristics that influence the firm’s decision to ‘go MNE’:
The exporting firm:
Low transport costs
Relatively large home market
High ‘plant level’ fixed costs
High transport costs
Low ‘disintegration costs’
Low ‘plant level’ fixed costs
In home, the profit is everything between the price and AC. If you take the opportunity to export to foreign market, the profit is between P and MC, because on the foreign market there is no AC-curve because there are no fixed costs for headquarters or plants.
Horizontal MNE: production in home and foreign. HQ costs F only apply to home, while the foreign AC only reflect plant operations P.
Vertical MNE: all production in foreign market. Home sales are met via exporting from foreign back to home. Home AC are only HQ costs F. Foreign AC are only plant operations P.
Tij = Z*((YiYj)/disij)
Liability of foreignness
For a firm, the concept of distance also includes non-financial aspects in areas such as culture, economics or institutions. These represent additional burdens liability of foreignness.
Spatial distance: transport costs increase and the communication and coordination costs increase.
Unfamiliarity with and lack of roots in foreign environment.
Host county environment costs.
Home country environment costs.
Sales tend to be lower in countries that are cultural distant from the home country.
Hofstede dimensions of cultural distance.
Firm strategy, structure, and rivalry.
Related and supporting industries
International capital arbitrage
X-M = S-I
The capital account KA can be split up in KAprivate and KAgovernment.
Financial flows between countries:
Gross flows: total mobility
Net flows: remain fairly constant
If you look at flows, you should distinguish them from the accumulation of stocks. Measured flows pertain to changes.
Capital mobility looses the assumption Sdomestic = Idomestic. This raised the global productivity. It also allows for specialisation, leading to comparative advantages. welfare increases.
If there is a negative CA, there is an outflow of money. If the confidence falls, the private sector no longer matches the CA deficit with respect to capital flows. There are four alternatives if there occurs a currency crisis. However, each of these solutions can make things worse, leading to a currency crisis.
Governments want to have:
Fixed exchange rates
Only two of the thee are possible at the same time, so there are three possible cases.
Welfare and capital mobility
If no capital restrictions, regulations, or other barriers to capital mobility exist, the equilibrium on the world market is characterized by the same interest rate in both countries, and the amount of capital mobility is such that the international supply of funds equals the international demand of funds. The welfare in both countries is maximized. The appearance of regulations, or an increase in risk results in a ‘wedge’. The price in the exporting country falls and that in the importing country rises.
If S > I - country will supply funds
If S < I - country will demand funds
Welfare is maximized
The case for international capital mobility
The area under the MPK curve for a certain amount of capital mobility (K*) shows the GDP of that country. National output (GDP) is divided among the two factors of production, Labor and Capital. The amount of Labor is fixed. The GDP has two parts: the lower part are the capital payments (=r* x K*) and the upper part is the labor’s share of national income (=national income – capital’s share).
If K* rises, then Home’s national output rises. The interest rate falls, and labor’s share of output rises. The two graphs of foreign and home can be slided together so that the length of the horizontal axis measures the sum of ‘home’ and ‘foreign’ capital.
In the lecture slides, the initial situation shows that without capital mobility, ‘foreign’ has a higher interest rate. If than capital mobility is allowed, the higher interest rate of ‘foreign’ attracts capital from ‘home’ so that the interest rate in ‘home’ increases and in ‘foreign’ decreases until it is equal.
Firm investment and assymetric information
There are two problems of assymetric information:
A firm has a demand for funds to finance projects; this demand is a negative function of the price of funds, i.e., the interest rate. Depending on a firm’s net worth (NW), it will be able to draw on internal funds. The greater NW, the larger this source of funds is. The price of these funds is their opportunity cost.
NW will fall when its assets decline and/or its liabilities rise. A home currency depreciation raised a firm’s liabilities because the home currency value of foreign liabilities goes up: home currency depreciations may lower NW.
If NW falls, moral hazard and adverse selection problems increase because the lower NW increases the risk of lending to the firm. A firm becomes more risky as it embarks on more projects so the price at which additional funds are supplied to the firm increases as more funds are acquired.
If capital mobility increases, NW will rise. The result is a right-ward shift of the external supply of funds curve. The increased scope for attracting external funds increases the firm’s NW.
As capital becomes more mobile, a greater variety of suppliers of funds becomes available to the firm. Suppliers of funds are better able to judge the firm’s NW so they will require a lower interest rate to supply funds. Then, the external supply of funds curve becomes flatter.
A wedge between the price firms pay for funds and the yield supplier receive appears at inefficient markets. The greater the wedge, the lower the amount of funds which firms acquire. The size of the wedge falls if markets become more internationally integrated.
Financial crises and firms
A financial crisis occurs when the financial institutions can no longer function effectively/efficiently caused by an increase in assymetric information problems. In that case, the institutions can no longer channel funds to the most productive investment opportunities.
5 channels through which a financial crisis can arise:
Increasing interest rate: moral hazard and adverse selection occur
Rising uncertainty: interest rates rise
Falling asset prices: lower stock prices or real asset prices lowers a firm’s NW
Deflation: increases the real debt burden and reduces future cash flow: NW decreases
Bank run - increase in interest rate - lower availability of funds - increase in uncertainty - decrease in firm’s NW.
Because of a financial crisis, the NW will decline. Therefore, in the graph of demand and supply of investment funds, the NW will decrease and the Fs will be steeper than before, because the increased risk increases, for any level of supply, a higher return is asked.
As the interest rate rises, it eventually becomes so high that savers become afraid that the borrowers will not be able to repay loans. In response, savers will reduce their saving… the S-curve will become backward bending.
The saving function S has three intersection points with the investment function I. Look at the slides or in the book to see the graph.
The normal part of the saving function intersects I at point 1. This intersection is stable, because with excess demand, the interest rate will rise and with excess supply, the interest rate will fall.
The perverse part of the saving function intersects I at point 2 and at point 3. Point 2 is unstable, because with excess supply the interest rate will fall so that it ends in point 1, and with excess demand the interest rate will rise so that it ends in point 3. Point 3 is stable.
In the lower part of the graph, it will move to point 1 and in the upper part of the graph, it will move to point 3.
The ongoing financial crisis
Main causes and consequences of the financial crisis:
This time is different
Large imbalances between countries
The financial crisis started as a banking crisis.