International Trade, Balance of Payments and Exchange Rates
This domain links the domestic economy to the rest of the world. You should be able to demonstrate comparative advantage numerically, explain the effects of protection, read a balance of payments, and analyse what a change in the exchange rate does to competitiveness and inflation. Cyprus is a small open economy inside a currency union, with a persistent goods deficit offset by a large services surplus from tourism, shipping and professional services.
Trade theory
- Absolute advantage compares productivity; comparative advantage compares opportunity cost. Both parties gain if each specialises where its opportunity cost is lower.
- Terms of trade = export price index ÷ import price index × 100; a rise means one unit of exports buys more imports.
- Protection: tariffs raise revenue and prices; quotas restrict quantity and create no tariff revenue; subsidies support domestic producers; administrative barriers and embargoes also restrict trade. Costs include consumer loss, resource misallocation and retaliation.
The balance of payments
- Current account: goods, services, primary income (investment income, compensation of employees) and secondary income (transfers).
- Capital account, then financial account. In principle the accounts balance, with errors and omissions absorbing discrepancies.
- A current account deficit must be financed by inflows on the financial account, meaning rising external liabilities.
Exchange rates
- Floating rates are set by demand and supply; fixed rates are pegged; managed floats intervene occasionally.
- Depreciation makes exports cheaper and imports dearer, improving the current account only if the Marshall-Lerner condition holds (|PED of exports| + |PED of imports| > 1); the J-curve describes the short-run deterioration first.
- Cyprus adopted the euro on 1 January 2008, giving up an independent exchange rate and interest rate but removing currency risk and transaction costs.
Worked example
With one unit of resources, Country A can produce 10 units of wine or 5 units of cheese; Country B can produce 6 units of wine or 6 units of cheese. A's opportunity cost of one cheese is 2 wine; B's is 1 wine. B has the comparative advantage in cheese and A in wine, even though A is absolutely more productive in wine only. If A specialises in wine and trades at a rate between 1 and 2 wine per cheese, both gain.
Traps that cost marks
- Confusing absolute with comparative advantage.
- Describing a current account deficit as automatically a sign of weakness; it may reflect strong investment inflows.
- Forgetting that depreciation raises import prices and therefore inflation.
- Mixing debit and credit signs or placing the financial account before the current account.