International Trade, Balance of Payments, Exchange Rates and Integration
Trade theory
Understand absolute advantage (Smith) versus comparative advantage (Ricardo): countries gain by specialising where their opportunity cost is lowest. Know arguments for protection (infant industry, national security, dumping) and costs (higher prices, retaliation, inefficiency). Trade barriers: tariffs, quotas, subsidies, standards.
Balance of payments
The current account (goods, services, income, transfers) plus the capital and financial account plus changes in reserves must balance. A current account deficit must be financed by capital inflows or reserve losses. Do not confuse a trade deficit with a budget deficit.
Exchange rates
Appreciation raises the currency's value (exports dearer, imports cheaper); depreciation does the reverse. Fixed vs floating regimes; purchasing power parity as long-run anchor. A J-curve shows the trade balance may worsen before improving after depreciation.
Integration
Levels: free trade area, customs union (common external tariff), common market (factor mobility), monetary union, full economic union. Examples: EU, WTO, Arab Free Trade Area, GAFTA.
Traps
- Confusing absolute with comparative advantage - comparative advantage is the basis for gains.
- Mixing appreciation with inflation.
- Forgetting that the balance of payments always balances by construction.
- Confusing a customs union with a free trade area.
Worked example
If country A needs 2 labour hours to make 1 unit of cloth and 4 for wine, and B needs 6 and 3, A has the lower opportunity cost in cloth (0.5 wine vs 2 wine), B in wine. Each should specialise accordingly.