The global economy: trade, exchange rates, BoP and integration
What this domain tests
International trade, exchange rates, the balance of payments and economic integration. You need comparative advantage, trade protection, exchange-rate determination and the structure of the BoP.
Core rules
- Comparative advantage: produce where opportunity cost is lower. Absolute advantage is not necessary for trade gains.
- BoP: current account (goods, services, income, transfers), capital/financial account, errors and omissions. It must balance overall.
- Floating exchange rates are determined by demand/supply of currency; appreciation makes exports dearer and imports cheaper. Fixed rates require reserves or interest-rate defence.
- Protection: tariffs, quotas, subsidies, standards. Integration: free-trade area, customs union, common market, monetary union.
Worked example
Country A can produce 10 wine or 5 cloth; Country B can produce 6 wine or 6 cloth. A's opportunity cost of 1 cloth = 2 wine; B's = 1 wine. B has comparative advantage in cloth; A has comparative advantage in wine (1 wine costs 0.5 cloth vs B's 1 cloth). If A specialises in wine and B in cloth and they trade between 1 and 2 wine per cloth, both can consume beyond their domestic PPCs.
Traps
Do not confuse absolute and comparative advantage. A current account deficit is not automatically a problem; it may reflect strong investment. A depreciation does not always fix a deficit immediately (J-curve; Marshall-Lerner condition). A customs union adds a common external tariff; a free-trade area does not.