International Economics
Domain 10 covers why countries trade, how the balance of payments records trade and capital flows, and how exchange rates are determined and adjusted.
Trade theory
- Absolute advantage (Smith): produce what you make most cheaply.
- Comparative advantage (Ricardo): trade pays even when one country is absolutely better at everything, because the opportunity-cost ratio decides specialisation.
- Terms of trade = export price index / import price index x 100. Gains from trade arise from specialisation.
Balance of payments
- Current account: visible goods (merchandise), invisibles (services, transfers, income).
- Capital account: FDI, portfolio investment, external loans, banking capital.
- Then errors and omissions, and the change in reserves. The BoP always balances in accounting terms.
- Convertibility: current account convertible since 1994; capital account only partial.
Exchange rate
- Fixed versus floating; demand for and supply of foreign exchange determine a floating rate.
- Devaluation is a deliberate official cut under a fixed regime; depreciation is a market fall. Appreciation is the opposite.
Worked example
India needs 2 units of wheat to make 1 unit of cloth; Country B needs 4 units of wheat for 1 unit of cloth. India cloth is cheaper in opportunity cost, so India exports cloth and imports wheat; B exports wheat even if its cloth industry is larger in absolute size.
Traps
- Confusing absolute and comparative advantage.
- Placing services outside the current account.
- Saying a BoP deficit means the accounts do not balance; the gap is met from reserves.
- Using devaluation and depreciation interchangeably.