International Trade and Exchange Rates
This domain tests why countries trade, how protection affects welfare, how the balance of payments is structured, and how floating and fixed exchange rates adjust. Strong answers use opportunity cost, elasticities and the Marshall-Lerner condition rather than assertion.
Core rules and concepts
- Absolute advantage compares output per unit of input. Comparative advantage compares opportunity cost; a country gains from specialising where its opportunity cost is lower.
- The terms of trade index = (index of export prices / index of import prices) × 100. A rise means one unit of exports buys more imports.
- Tariffs raise the domestic price, cut imports, transfer surplus from consumers to producers and government, and create deadweight loss. Quotas restrict quantity directly; subsidies and standards also protect domestic producers.
- The current account records trade in goods and services, primary income and secondary income. The financial account records investment flows. A deficit must be financed by inflows or reserves.
- A floating exchange rate is determined by demand and supply for the currency. Appreciation raises the foreign price of exports; depreciation lowers it.
- The Marshall-Lerner condition says devaluation improves the current account only if |PED exports| + |PED imports| > 1. The J-curve shows a short-run worsening before improvement.
- Fixed rates require reserves and interest-rate defence; devaluation is a discrete policy choice.
Worked example
Country A can produce 10 wheat or 5 cloth; Country B can produce 6 wheat or 6 cloth. For A, 1 cloth costs 2 wheat; for B, 1 cloth costs 1 wheat. B has comparative advantage in cloth and A in wheat. A's opportunity cost of 1 wheat is 0.5 cloth; B's is 1 cloth, so the trade price of wheat lies between 0.5 and 1 cloth. If they trade 1 wheat for 0.75 cloth, A receives more cloth than it could make at home and B pays less wheat than it would cost domestically. Both gain, even though B has an absolute advantage in cloth only and neither country has an absolute advantage in both goods.
Traps that cost marks
- Confusing absolute and comparative advantage.
- Forgetting that the terms of trade is an index, not a price.
- Counting the whole price rise as tariff revenue; revenue is the tariff per unit times the new import quantity.
- Assuming depreciation always improves the current account; the Marshall-Lerner condition must hold.
- Treating a current account deficit as automatically bad; it may reflect strong investment inflows.