International economics
International economics
This domain tests comparative advantage, balance-of-payments accounting, exchange-rate determination, and how openness changes the power of domestic policy.
Core rules
- Absolute advantage compares productivity; comparative advantage compares opportunity cost. Gains from trade follow from the latter, so a country can gain even with no absolute advantage anywhere.
- The terms of trade are export prices divided by import prices; a rise benefits the domestic economy.
- The balance of payments must balance overall: current account (goods, services, income, transfers) plus the capital and financial account plus errors and omissions sums to zero.
- Exchange-rate regimes: floating, fixed and managed. Purchasing power parity is a long-run anchor; covered interest parity links the forward premium to the interest differential; uncovered parity underpins carry trades.
- The Marshall–Lerner condition: devaluation improves the current account only if the sum of the price elasticities of export and import demand exceeds one. The J-curve describes the short-run deterioration before improvement.
- Tariffs create consumption, production, revenue and redistribution effects; quotas work through quantity; customs unions bring trade creation and trade diversion.
- Mundell–Fleming: with perfect capital mobility and a fixed rate, monetary policy is ineffective; with a floating rate, fiscal policy is weaker.
Worked example
Home can produce 10 units of wine or 20 of cloth; Foreign can produce 6 of wine or 18 of cloth. Home's opportunity cost of a wine is 2 cloth; Foreign's is 3 cloth. Home therefore has the comparative advantage in wine and Foreign in cloth. Any terms of trade between 2 and 3 cloth per wine benefits both, and total output rises after specialisation.
Traps
- Confusing absolute with comparative advantage.
- Treating a current account deficit as automatically harmful.
- Forgetting the balance of payments must balance in total, not each component.
- Assuming depreciation always improves the trade balance immediately.