The Global Economy: Trade, Balance of Payments, Exchange Rates and Development
Domain 7 tests comparative advantage, protection, the balance of payments, exchange-rate determination and the links between trade and development.
Core rules
- Absolute advantage compares output per unit of input; comparative advantage compares opportunity cost. Trade gains arise even when one country is absolutely better at everything.
- Terms of trade = (index of export prices ÷ index of import prices) × 100. A rise means more imports per unit of exports.
- Protection: tariffs (raise price, generate revenue, create deadweight loss), quotas (limit quantity, raise price, create quota rent), subsidies, embargoes. Arguments: infant industry, dumping, employment, strategic industries; risks: retaliation and higher consumer prices.
- The current account covers goods, services, income and transfers; a deficit must be financed by capital or financial inflows.
- Exchange rates: floating (market-determined), fixed (central bank intervention using reserves) and managed. Depreciation makes exports cheaper and imports dearer.
- Marshall–Lerner: a depreciation improves the current account only if |PED exports| + |PED imports| > 1; the J-curve shows the lag.
- Development: the HDI combines income, health and education; obstacles include primary-product dependence, debt, capital flight and weak institutions.
Worked example
With one labour unit, Country A produces 10 cloth or 5 wine; Country B produces 6 cloth or 6 wine. A's opportunity cost of 1 cloth is 0.5 wine; B's is 1 wine. A specialises in cloth and B in wine, so total output rises and consumption can exceed each country's own PPF after trade.
Traps
Confusing absolute with comparative advantage; assuming depreciation always cures a deficit (J-curve, inelastic demand, imported inflation); calling any current account deficit a failure; mixing up devaluation (fixed regime) with depreciation (floating).