International Economics — Trade & Exchange Rates
International economics examines how countries trade goods and services and how exchange rates link national price levels. The principle of comparative advantage — not absolute advantage — determines the pattern of trade: a country should export goods in which its opportunity cost is lower than its trading partners', even if it is less efficient in all goods in absolute terms. Exchange rates translate prices across currencies; the real exchange rate determines actual competitiveness. The balance of payments records all international transactions and must balance: current account surpluses equal capital and financial account deficits.
Comparative Advantage & Trade
Country A has a comparative advantage in good $X$ if its opportunity cost of producing $X$ (in terms of good $Y$ forgone) is lower than country B's. The gains from specialization and trade exist whenever opportunity costs differ.
If A needs $a_X$ hours/unit of $X$ and $a_Y$ hours/unit of $Y$, and B needs $b_X$ and $b_Y$:
A has comparative advantage in $X$ iff $\frac{a_X}{a_Y} < \frac{b_X}{b_Y}$.
The price of exports relative to imports. Gains from trade require that the terms of trade lie strictly between the two countries' domestic opportunity cost ratios.
Nominal exchange rate $e$: price of one currency in terms of another (e.g., USD per EUR).
Real exchange rate: adjusts for relative price levels:
$$\varepsilon = e \cdot \frac{P^*}{P}$$
where $P$ = domestic price level, $P^*$ = foreign price level. $\varepsilon > 1$ means domestic goods are relatively cheap.
In the long run, exchange rates adjust so that identical goods cost the same internationally:
$$e^{\text{PPP}} = \frac{P}{P^*}$$
Relative PPP predicts that currency depreciation $\approx$ inflation differential: $\hat{e} \approx \pi - \pi^*$.
$$CA + KA + FA = 0$$
Current Account ($CA$) = trade in goods/services + income + transfers.
Financial Account ($FA$) = net capital flows. A current account deficit is financed by a financial account surplus (net capital inflow).
If capital markets are integrated and there is no arbitrage:
$$(1+i) = (1+i^*)\frac{F}{S}$$
where $i$ is the domestic interest rate, $i^*$ is foreign, $S$ is the spot rate, and $F$ is the forward rate.
England produces 1 cloth unit/labor-hour or 0.5 wine units/hour. Portugal produces 1/0.9 cloth and 1/0.8 wine. Which has comparative advantage in wine?
- England's OC of wine $= 1/0.5 = 2$ cloth.
- Portugal's OC of wine $= (1/0.8)/(1/0.9)= 0.9/0.8 = 1.125$ cloth.
- Portugal's OC is lower
- so Portugal has comparative advantage in wine.
USD/EUR $= 1.10$, US price index $= 120$, EU price index $= 100$. Find the real exchange rate.
- $\varepsilon = 1.10 \times (100/120) = 0.917$.
- European goods are relatively more expensive in real terms.
Practice Problems
Show Answer Key
1. US OC of computer $= 4/2 = 2$ shirts. China OC $= 3/1 = 3$ shirts. US has comparative advantage in computers.
2. USD depreciates by $\approx 3\%-1\%=2\%$ against GBP (dollar weakens relative to pound).
3. Real exchange rate rises (domestic goods become relatively more expensive), hurting export competitiveness.
4. Financial account deficit of $\$200\text{B}$ (net capital outflow).
5. Net borrower — running a current account deficit means financing consumption/investment via foreign capital inflows.
6. $\varepsilon = 1.20 \times (100/110) \approx 1.091$.
7. $F = S(1+i)/(1+i^*) = 1.00 \times 1.05/1.03 \approx 1.0194$.
8. New industries need temporary protection to reach efficient scale. Critique: governments pick losers, protection becomes permanent, creates rent-seeking.
9. Pre-tariff imports $= 100-60=40$. Post-tariff imports $= 90-70=20$. Reduction $= 20$ units.
10. Depreciation initially worsens the trade balance (prices adjust faster than quantities). As export volume rises and import volume falls over months, the balance eventually improves, tracing a J-shape over time.