Chapter 1: Introduction to International Economics

Introduction
Economics is a social science designed to understand how the real-world
economy functions. We can only examine the whole economy. It is a study,
something that nobody can thoroughly understand. We are all part of the economy,
all buy and sell every day, but not every economic factor or feature can be taken into
account simultaneously.
Economic segregation does not occur in the world today. The economies of
its trading partners contribute to every aspect of a nation's economy, its
manufacturing, service sectors, rates of revenue, education and living standards.
This partnership is made up of foreign trade in goods and services, jobs, companies,
investment funds and technology. In fact, national economic policies cannot be
developed without their possible impacts on other countries' economies being
assessed.

Learning Outcomes:
• Explain the recurring issues in international economics and discuss their
significance.
• Distinguish the domestic and international issues related to international
trade.
• Enumerate and discuss evidence that support trade and economic growth.

Lesson 1: International Economics and International Interdependence

What is international economics and why I need to study about it? With our
relatively close trade relation with the US and Japan, does it help the country grow?
International economics is a field of study which assesses the implications of
international trade in goods and services and international investment. It consists of
the issues raised by the special problems of sovereign state economic interaction.
These issues are not limited only to gains from trade, patterns of trade,
protectionism, balance of payments, exchange rate determination, international
policy coordination and international capital market. It includes slow growth and high
unemployment in advance economies, trade protectionism in advance countries due
to globalizing world, excessive fluctuation in exchange rate and financial crisis,
economic structural imbalances and restructuring, poverty, depleting resources,

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environmental degradation and sustainable development which greatly affect the
economic activity domestically and internationally.
There are two broad sub-fields within international economics: international
trade and international finance.
International trade is a field in economics that applies microeconomic models
to help understand the international economy. Its content includes the same tools
that are introduced in microeconomics courses, including supply and demand
analysis, firm and consumer behavior, perfectly competitive, oligopolistic and
monopolistic market structures, and the effects of market distortions. The typical
course describes economic relationships between consumers, firms, factor owners,
and the government. It points out the effects on individuals, businesses policies on
the changes in trade and other economic conditions. International trade develops
arguments that support a free trade policy as well as arguments that support various
types of protectionist policies. As a rough measure of the importance of international
trade in a nation’s open-economy, we can look at that nation’s exports and imports
as a percentage of its gross domestic product (GDP). This ratio is known as
openness.
𝑬𝒙𝒑𝒐𝒓𝒕 + 𝑰𝒎𝒑𝒐𝒓𝒕
𝑶𝒑𝒆𝒏𝒏𝒆𝒔𝒔 =
𝑮𝑫𝑷

International finance applies macroeconomic models to help understand the

international economy. Its focus is on the interrelationships between aggregate
economic variables such as GDP, unemployment rates, inflation rates, trade
balances, exchange rates, interest rates, etc. This field expands macroeconomics to
include international exchanges. Its focus is on the significance of trade imbalances,
the determinants of exchange rates and the aggregate effects of government
monetary and fiscal policies. Among the most important issues addressed are the
pros and cons of fixed versus floating exchange rate systems.
Symptoms of international interdependence according to Yarbrough and
Yarbrough include the growing volume of trade, both in absolute terms and as a
share of total world production. Additional measures of interdependence might
include: (a) the quantity of resources spent by countries in influencing the policy
decisions of other countries or in supporting international agencies such as the World
Bank or the World Trade Organization, (b) the degree to which countries’ output
prices, factor prices, and interest rates converge, and (c) the extent of foreign
investment.

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 In recent times, high level of economic interdependence or international
interdependence has become a trendy problem, often resulting in strong and unequal
impacts among nations and sectors with within a given country. Business, labor,
investors and consumers all feel the consequences of the adjustment of economic
conditions and trade policies in other countries. Today's current economy requires
cooperation at world level to address a variety of issues and complications.
International interdependence means all aspects of a nation’s economy are linked to
the economies of its trading partners.

Lesson 2: Facts about the World Economy and Globalization

The term world economy refers to every country and to all economic
activities among countries in the world. Many partner countries see a change in their
economies when one country does well, while other countries suffer if one performs
poorly. The world's countries now depend on one another. This idea is understood as
globalization to be connected together for free trade. Globalization has permitted
trade between less restricted countries. As we all know, it depends on the
macroeconomic policy whether the is following open macroeconomic model or close
economic model. In an open macroeconomic model, the company can then market
its goods internationally, and customers can choose between a range of products
from different countries. Conversely speaking, in a close macroeconomic model
follows autarky where protectionism of trade is very high.
In trade policy debates, subjects like protectionism, free trade and trade
liberalization are often used. Initially, it is important to describe these terms. Another
word is widely used in the study of exchange models, namely national autarky or
simply autarky.
Two extreme state or situations can potentially be produced by national government
policies. On the one hand, a government may adopt a laissez-faire trade-related
policy, thus imposing no rules which prohibit (or encourage) free and voluntary
exchange of goods between nations. We call that precondition as free trade. On the
other side, export controls can be applied so restrictively that all barriers to
international exchange are eradicated. This is described as a national autarky
situation where there is no foreign trade. Autarky reflects a system of isolation. See
illustration below.

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 In the modern world there has never been a pure free trade or autarky state.
Each nation imposes a trade policy of some kind. Several countries, such as
Singapore and Hong Kong, are considered highly focused on free trade. Similar to
the autarkies system of other nations, including North Korea and Cuba have for a
long time been relatively close economies. The rest of the world lies somewhere in
between. The reduction of foreign competition inevitably benefits domestic industries
from new trade policies. When trade controls are lifted, a transition to free trade
occurs. Debates about foreign policy usually concentrate on whether or not
protectionism will increase in the world. Under this concept, trade improvements
measures, such as export subsidies, are considered protectionist. This means
protectionism is much more complicated than can be expressed in a single
dimension. This means protectionism is much more complicated than can be
expressed in a single dimension (as shown in the above diagram), as protection can
both increase and decrease trade flow. Nevertheless, the inclusion of the consumer
sector is advantageous in several ways.
The Gross Domestic Product (GDP) has been greatly increased since the
1950s as a result of globalization, in production, trade and Foreign Direct Investment
(FDI). The essence of globalization, for instance cultural, economic, geographical,
institutional and political globalization, has various forms. Technological advances
and trade liberalization are two main factors leading to economic globalization. Anti-
globalization campaigns, on the other hand, are a reaction to the destructive impact
of globalization. The increase in supply and demand, changes in price wedge, and
variations of these are partly influenced by globalization and economic growth. The
security in both countries is maximized in equilibrium. Nonetheless, tariffs,
transportation costs or other trade barriers may interrupt it. Instead, between the
markets of the two countries there is a "demand gap."
Between 1870 to 1914, the first wave of world interdependence happened.
The decline of tariff barriers and new technologies, such as transportation from sail to
steamships and railways, led to a decline in the interdependence. In particular,
European and American companies and individuals powered this wave of
globalization. The world's wealthiest countries, like the United States, were actively
involved in globalization. The second wave of globalization: the rich world,
specialized in productive market segments that acquired productivity from
agglomeration economies, introduced a new kind of exchange. More and more
companies are clustered, some clusters have produced the same product and others
are linked by vertical linkage. For example, Japanese car companies became famous
because they insisted that the parts manufacturers are located a short distance from

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the main assembly plant. A distinctive characteristic of the new wave of globalization,
which began in around 1980. Firstly, many developing countries like China, India and
Brazil broke into manufacturers' world markets. Second, in the global economy,
many developed countries have become more and more disadvantaged and have
experienced lower wages and poverty. International capitalist movements were again
important, which were modest during the second wave of globalization.
Our country has been involved in the process of globalization since the nation
signed agreements with the World Trade Organization in 1995. Globalization was
very successful in the Philippines, bringing about major changes in the region, for
example more jobs, and more domestic and foreign companies emerged to support
the economy of the developing world. Indeed, some benefits and inconveniences
impact the country's experience with globalization, but the challenging reality is that –
the pro is stronger than the con.

Suggested Reading:
INTROSPECTION
The Manila Galleon Trade: Events, effects, lessons
By Ma. Isabel Ongpin
Published: March 3, 2017
The Manila Times
Source: https://www.manilatimes.net/2017/03/03/opinion/analysis/manila-galleon-
tradeevents-effects-lessons/315101/

The Manila Galleon Trade lasted for 250 years and ended in 1815 with
Mexico’s war of independence. In terms of longevity alone, plus the trade that it
engendered between Asia, Spanish America and onward to Europe and Africa, it
brought in its wake events and movement of people among the various continents
that are still apparent and in place today.
It made Mexico a world city. The Philippines, ostensibly a Spanish colony,
was governed from Mexico which gave it an Asian extension. Population flows
between Asia and Spanish America via Acapulco were, in terms of the times, huge.
About 40,000 to 60,000, maybe 100,000, mostly Chinese and in particular Filipinos,
made up that flow. There is an existing Filipino presence in Louisiana and definitely
in Mexico from those times. Some of the founders of California seem to be of Filipino
descent. Emiliano Zapata, the Mexican revolutionary, was said to have Filipino
ancestry.

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 The migrants came as servants, slaves, sailors, barbers, vendors, harp
players, dancers, scribes, tailors, cobblers, silversmiths and coachmen. Mexico’s
Plaza Mayor, known as the Zocalo, became a place of stalls and shops selling the
Asian imports where the city’s myriad populations mixed in buying and selling. They
called it the Parian after the Chinese district of Manila known as such. Manila’s
Chinatown is considered the oldest in the world. In Mexico, the Parian began in the
late 16th century and by the 18th century was a permanent edifice. Items sold or
traded were spices from the Orient, ivory, diamonds, Chinese porcelain, Indian
fabrics, Siamese ebony, rubies and emeralds from India. From the Philippines, I
would guess, ivory religious images, our indigenous fabrics in cotton, indigo and
wooden furniture.
Asian arts found a market in Mexico and beyond. They were eventually
emulated and adapted locally. Thus, Japanese lacquer desks, Chinese wall hangings
and Chinese porcelain were imitated and reproduced in Mexico. For example, the
folding screens called “biombo” in Spanish were originally from the Japanese word
for them “byobu.” Eventually, these “biombos” showed images of Mexico City’s best-
known places.
Mexico became a multi-cultural, cosmopolitan nation in urbanization and
sophistication. At the time of the Manila Galleon, it was one of the richest cities in the
world with leading cultural and intellectual aspects to its urban life. It had a printing
press as early as 1535. Its native costumes had an Oriental influence acknowledging
its opening to the world. It introduced chocolate and other crops (sweet potato,
vegetables, fruits) not only to the world but particularly to the Orient because of trade.
Mexico and the rest of Spanish America (also grown rich from trading and silver
mines) had the first universities in the American continent, long before those of North
America. Mexico was then a city of books, writers, students, with influences from
Asian cultures. A historian, Juan Gonzales de Mendoza published in Mexico Historia
de las Cosas Mas Notables, Ritos y Costumbres del Gran Reyno de la China in
1583. It became the first popular book on China in the West. Antonio de Morga who
wrote Sucesos de las Islas Filipinas in 1609 (not only about relations with the
Philippines but with China, Japan and Southeast Asia) published it in Mexico in 1609.
Here was a city on the cutting edge of world knowledge, trade and diplomacy.
Potosi in Bolivia began mining a mountain of silver in 1545 and soon
produced half of the world’s silver, which during the Manila Galleon trade was
coveted by the Chinese economy in exchange for its goods. As a result, Potosi’s
population was larger than that of any other city in the Americas at the end of the
16th century. It had more than a dozen dancehalls, 80 churches, and fountains (?) of

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wine and chicha (Andean corn beer). It is estimated that one-third of its silver
production ended up in China. By that time Mexican silver mines had made an
industrial innovation – the use of mercury to extract silver from ore as against
smelting. This was certainly in the light of today and its consequences, an unhealthy
and anti-environmental industrial innovation but at that time it made things easier –
more silver could be extracted from ore. Potosi was so famous it was mentioned in
Don Quijote and Mateo Ricci placed it in the Chinese world map of 1602.
Manila ranked just below Mexico in urbanization and sophistication. It was not
quite a world city compared to Mexico, being more a regional trading hub where
China, India, Japan and Southeast Asia sent their goods to be consolidated for
shipping. Those who ran the hub and did most of the work were Chinese. They
packed the goods (no one could pack better than them, putting more merchandise in
the limited spaces and chests on the galleon than anyone else could). They came in
junks yearly, bringing goods that not only competed in price but in quality and
innovation with the rest of the world. The Chinese served as part of the galleon crews
together with Filipinos and other nationalities (the galleon crews were mostly East
Asian with a sprinkling of various European nationalities). They most probably
clandestinely participated in the galleon trade which no one but Spaniards were
allowed to do. Many Chinese became very wealthy through hard work. Manila was
almost a Chinese city with the huge migration of Chinese due to the Manila Galleon
trade as against the few Spaniards and Filipino natives. So much so that the
Spaniards feared them, taxed them, sent them out to the Parian and eventually,
when tensions rose, massacred them. Such massacres were at their height in the
17th century from suspicion, unease and fear, until the Spaniards and the Chinese
learned to live with each other in the next few centuries.
Manila was the gateway to China not only for being the entrepot where
Chinese goods along with those of Japan, India, Southeast Asia were assembled for
re-export to the West, but for its role in mediating information about China. Martin de
Rada acquired Chinese books in Manila in 1575. The first translation of classical
Chinese texts into a European language took place in Manila when Mingxin Borojiau
was translated into Espejo Rico de Claro Corazon in 1593 and published in Manila by
Juan Cobo who also translated Seneca into Chinese.
Manila was so widely famed as the galleon trade hub that it attracted
predators who dreamed of or imagined the riches it had. For example, the Dutch East
India Company believed trade could not be maintained without war. It proved it in the
Dutch East Indies. The British East India Company led the way (with the British Navy
in complicity) to take Manila in 1762, using the Seven Years’ War in Europe as an

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excuse. But when it came to larger longstanding nations in the East like China and
Japan and Thailand, European colonizers could not project much force. Spain did
not, but it was able to run the Manila Galleon trade for years despite its problems with
the Chinese in Manila and the fact that both sides were breaking the rules along the
way. There was an equilibrium between China and Spain (the Sinic-Spanish global
trade) that brought on trade understanding, diplomatic relations, enduring
relationships. Much different from the Anglo-American and Dutch events in Asia with
colonization, trade with colonies, industrialization and gunboat diplomacy, the opium
wars, oppressive demand for cash crops, taking advantage of the chaos in China,
and the weakness of the East Indies.
In the above trade relations, China is the other, the hostile, the dangerous.
There must be a lesson to be learned from the Sinic-Spanish Manila Galleon Trade
which could be applicable today for better relations in the modern world. The authors
of The Silver Way have interesting insights and recommendations along this line.
There is much more to be said and learned about the initial globalization
chapter of history that was the Manila Galleon Trade. Indeed, it was the first
established world trade relationship that can only be recognized as global for its
influence on not only those directly involved but by diffusion, the rest of the world.

Critical Thinking
1. Is the Galleon trade still significant at present time? Why?
2. What factors that made the Galleon Trade a success?
3. How it helps the Philippine economy, if any, when we become
independent?
4. Identify the factors or reasons why it ended its operation? Does it matter in
our present trade relations?
5. Describe the Philippines specifically Manila as center of trade when it
ended in 1815?

Chapter Exercise
1. A country that is not involved in international trade is a(n) __________.
2. A country that is interested in foreign trade is a(n) ____________.
3. An important insight of international trade theory is that when countries
exchange goods and services one with the other it is usually beneficial to
both countries. True or False?

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4. What are the international interdependence indicators? Which international
events or policy debates are currently taking place that could relate to
microeconomic tools?
5. Is it possible to achieve the same results in a country which engages in
free trade as it implements its macroeconomic policies alongside its
economic independence?

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 Chapter 2: The World Economy: Comparative Advantage I:
Labor, Productivity and Trade

Introduction
Differences in relative productivity of labor across countries promote
international trade. Absolute advantage by Adam Smith is the precursor of trade
theories. Ricardian model generates important insights into comparative advantages
and trade gains. These insights are necessary foundations for the more complex
models of international economics and business. After these definitions have been
developed for a single country, a second country with different relative unit labor
requirements is added to establish the general equilibrium of demand and supply.
This indicates that at least one country is growing. An interesting idea to highlight in
presenting the benefits of trade claim lies in the principle of indirect production, that
is, by producing a good for which a nation has a competitive advantage, and then
exchanging for the other good. Students are taught the Ricardian comparatives
theory to explore the misunderstandings about the benefits of free trade. This topic
may clarify why a small country specialize in producing a few items, while a large
country specializes in producing a large number of goods. Finally, the module
addresses the role played by transport costs in non-trading goods.

Learning Outcomes:
After reading this module, the student will be able to:
• Contrast the concepts of Absolute and Comparative advantage.
• Analyze numerical examples of Absolute and Comparative advantage.
• Explain how a country gain from trade without absolute advantage

Lesson 1: Early Thinking about Trade

Mercantilism was the collection of economic thinking that came into being in
Europe during the 1500-1750 period. Gold and silver circulated as money, and the
quantity of these precious metals a country held symbolized that nation's wealth.
Mercantilist countries practiced the so-called zero-sum game, which meant that world
wealth was limited and that countries only could increase their share at the expense
of their neighbors. The economic system is consisting of three components: a
manufacturing sector, a rural sector (domestic hinterland), and the foreign colonies
(foreign hinterland). Mercantilist employed a labor theory of value - commodities
were valued relatively in terms of their relative labor content. They stressed the need

10
for a favorable trade balance to be achieved through excess exports over imports.
The basic doctrine of economic policy is that governments controlled the use and
exchange of precious metals, which is often referred to as bullionism. Mercantilists
assumed that fixed amounts of goods and gold existed in the world and that trade
merely determined their distribution among nations.
In 1776, Adam Smith, a Scottish economist, developed a trade theory of
absolute advantage. A country with an absolute advantage produces more goods or
services than other countries with the same quantity of resources. Smith claimed that
foreign trade should not be restricted in terms of tariffs and quotas; the market forces
should allow it to flow. Unlike the mercantilist, Smith claimed that a country should
focus on the production of goods that have an absolute advantage. The belief that
international trade is a zero-sum game is undermined in the principle of absolute
advantages. Based on the theory of absolute advantage, international trade is a
positive game, since both countries profit from the exchange. In contrast to
mercantilism, this theory measures the nation's wealth by the standard of living of its
people, not by gold and silver.

Table 1. Absolute Advantage

Production Production and Production after Consumption

possibility when Consumption specialization with trade based
each country under Autarky according to on Absolute Adv.
produces only Cell (no trade) Absolute Adv.
Phone or Potato
Chips
Cell Potato Cell Potato Cell Potato Cell Potato
Phone Chips Phone Chips Phone Chips Phone Chips
Country A 8 4 4 2 8 0 5 3
Country B 3 6 1.5 3 0 6 3 3
Total 5.5 5 8 8 6
Production

The absolute advantages are easy to notice in the example. In country A,

workers take eight hours to produce a cell phone while it takes three hours in country
B. In country A, on the other hand, it takes four hours for a worker to make a ton of
potato chips, which takes six hours in country B. Accordingly, Adam Smith argued
that if Country A specializing allows production of cell phones and Country B
specializes in potato chips both countries would profit from trade. Thus, while country
B is specialized in manufacturing fairly straightforward fine- potato chips, the
difference from the mercantilist point of view is that they continue to benefit from
foreign trade. He also recognized, however, that potato chip manufacturers in
Country A would push for preserving and limiting potato chip imports from Country B,

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and cell phone producers in Country B would attempt to negotiate for cell phone
import restrictions in Country A.
An absolute advantage refers to one country's ability to produce a good while
using fewer resources than another. Absolute advantage can be the result of a
country natural endowment factor. In other words, a country has an absolute
advantage in the good if it can produce better than another country with the same
quantity of resources. According to the theory of absolute advantage, if countries
specialize in and export the good in which they have an absolute advantage (can
produce with fewer resources), the result is increased production and consumption in
each country.
Production possibility curves (PPC) showing absolute advantage

Figure 1.
Cellphone PPC
Absolute
Advantage
of
CP and PC
Potato PPC

Using this information, we can construct production possibilities curves

(PPCs) for Country A and Country B, shown in Figure 1. For simplicity, we use
straight-line PPCs (rather than the curved PPCs we are familiar with). When Country
A produces 8 units of coffee, it is at point A, producing 0 potato chip; and when it
produces 4 potato chips, it is at point B producing 0 units of cellphone. In the same
way, we plot points C and D for Country B. Joining points A and B, we get
Cellphone’s PPC; joining points C and D gives potato chips PPC. Comparing the two
PPC’s, we immediately see Country B absolute advantage in potato chips, because
its PPC extends further to the right on the potato axis; and Country A absolute
advantage in cellphone, since its PPC extends further up on the cellphone axis.

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Lesson 2: Production and Consumption with no Trade
If they do not trade with each other, each one produces both potato chip and
cellphone, as this is the only way they can consume both. The absence of trade is
called autarky (from αυτα′ ρκεια, the Greek word for self-sufficiency). Under autarky,
suppose that each worker in Country A and Country B spends half her/his time
producing potato chip and half producing cellphone (this is just one possible point on
the PPC; any other could be used as well). The results are shown in columns 3 and 4
in Table 1, and correspond in Figure 2 below to point E on Country A, PPC (4 units of
cellphone and 2 potato chip) and point F on Country B, PPC (1.5 units of cellphone
and 3 potato chip). Total production in both countries is therefore 5.5 units of
cellphone and 5 potato chip, appearing at the bottom of columns 3 and 4.

Lesson 3: Production and consumption with Trade

In figure 3, both countries agree to specialize in and export the good in which
they have absolute advantage. Country A specializes entirely in production of
cellphone, moving to point A on its PPC, and Country B specializes in potato chips.
Compared to autarky, production has increased by 2.5 units of cellphone and 1
potato chips. Where Country A and Country B wanted to trade in 1:1, that is 1 unit of
mobile phone trades with 1 potato chip. They commit to trade 3 cell phone units
(exchange) for 3 potato chips (Country A exported 3 potato chips imported by
Country B and Country B exported 3 potato chips imported by Country A). The
results are given in Table 1 column 7 and 8 where Country A consumes 5 cellphone
units (= 8 — 3 export units) and 3 potato chips (imported) and Country B consumes 3
(imported) cellphone units and 3 (= 6 − 3 of exporting) potato chips.
Conditions where absolute advantage occur when there is a 1) exchange of
goods between two countries; 2) only two commodities are traded; 3) free trade exist

13
between countries and 4) only labor is the production factor. A country can achieve
absolute advantage through low cost of production. This refers to an individual,
company, or country that can produce at a lower marginal cost (compared to
competitors) through fewer resources, cheaper material, less time, and cheap labor
used to produce a product. The benefit of absolute advantage is Absolute cost
advantage results from the specialization of labor as explicated in the economies of
scale. The presence of lots of natural resources would significantly provide an
advantage to such a country while producing the goods or natural advantage. When
that country includes advantages in technology and level of skill development (like
the advanced countries say Japan and South Korea) it becomes acquired advantage.
Absolute and comparative advantage are commonly misunderstood concepts. An
absolute advantage looks at the financial costs of production while a comparative
advantage looks at the opportunity cost of production. Limitation of Absolute
advantage model is that, it did not take into account the multilateral trade as
exchange started to increase. Another criticism is that it only exists between nation a
free trade not considering the protectionist measures adopted by partner country
such as quantitative restrictions, technical barriers to trade, and restrictions on trade
on account of environmental protection or public policy.
There's a potential problem with an absolute advantage. If there is one
country that has no absolute advantage in the production of any product, will trade
still benefit and even trade? The answer can be found in the extension of the
absolute advantage, the theory of the comparative advantage.

Lesson 4: Comparative Advantage Theory

The principle of comparative advantage was first introduced by David Ricardo
in 1817. It remains a major influence on much international trade policy. It states that
a country should specialize in products in which it has a relative cost advantage. Out
of such specialization, it is argued, will increase greater benefit for all. Theory of
comparative advantages explains how trade can be beneficial and making a small
change in Smith's example above, the difference gets obvious.
The theory of absolute advantage can explain only a small part of gains from
specialization and trade. David Ricardo's theory of comparative advantage explains
how countries can benefit from trade. Ricardo was able to show that countries can
gain from trade even if one country has an absolute advantage in both goods.
Comparative advantage refers to the situation where one country has a lower
opportunity cost (relative cost) or the marginal rate of transformation (MRT) in the
production of a good than another country. A simple world economy of two countries,

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Monkey and Chaturbate, producing banana and microchips is shown in Table 2
below.
Table 2: Comparative Advantage
Production possibilities when each
Opportunity cost of Opportunity cost of
country produces only Banana or
Banana Microchip
Microchip
Monkey 20 10
10 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑚𝑖𝑐𝑟𝑜𝑐ℎ𝑖𝑝 1
=
20 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑏𝑎𝑛𝑎𝑛𝑎
=2
20 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑏𝑎𝑛𝑎𝑛𝑎 2 10 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑚𝑖𝑐𝑟𝑜𝑐ℎ𝑖𝑝
Chaturbate 25 50
50 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑚𝑖𝑐𝑟𝑜𝑐ℎ𝑖𝑝
=2
25 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑏𝑎𝑛𝑎𝑛𝑎 1
=
25 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑏𝑎𝑛𝑎𝑛𝑎 50 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑚𝑖𝑐𝑟𝑜𝑐ℎ𝑖𝑝 2

Monkey can produce 20 cotton units (and 0 microchip units), or 10 microchip

units (and 0 cotton). On the other hand, Chaturbate can produce 25 cotton units (and
0 microchip units) or 50 microchip units (and 0 banana units). Chaturbate has an
absolute advantage for banana and microchip production, as it can produce more of
both items than monkey with the same resources (one worker in a day). Figure 4
below, plots the PPCs of each of the two countries based on the data of Table 2
(assuming straight-line PPCs). Chaturbate’s absolute advantage in the production of
both goods is apparent from the fact that its PPC lies entirely above the PPC of
Monkey. In determining which has the cost advantage compare the PPCs of two
countries, we can see immediately whether one country has the absolute advantage
in one or both of the goods. If the PPCs intersect (as shown in Figure 1), this means
that each country has an absolute advantage. If they do not intersect (as shown in
Figure 4 below), it means that the country lying fully above the second PPC has an
absolute advantage.

If two PPCs do not intersect, how can we determine comparative

advantages? The country that has the flatter PPC has a comparative advantage in

15
the good measured on the horizontal axis. It follows that the country with the steeper
PPC also has an advantage in a good measured along the vertical axis. These points
are summarized in Figure 5 above. The opportunity costs for all goods in each
country are determined by columns 3 and 4 in Table 2. (Because we use straight-line
PPCs, that means that the cost of opportunity is constant across the PPC;). Banana's
opportunity cost is the amount of microchips that must be sacrificed to generate an
additional unit of banana and microchips' opportunity cost is the amount of banana
that must be sacrificed per unit of microchips obtained. In order to calculate the
opportunity cost of bananas, we divide the maximum number of microchips that can
be produced by the maximum amount of bananas in the same country, thus finding
microchips sacrificed per unit of banana produced; we make a similar calculation to
find the opportunity cost of microchips.
The results show that Chaturbate has a lower opportunity cost in producing
microchips than Monkey. Monkey has a higher absolute cost in production of
banana, but a lower relative cost. If Monkey wants to produce more banana, it needs
to sacrifice a smaller quantity of microchip. In fact, the opportunity costs can be
calculated directly from Figure 4, using the same method as above. A country has a
comparative advantage in the production of goods that has a lower opportunity cost
(lower relative cost).
The law of comparative advantage states that if countries specialize and trade
according to their comparative advantage, global production and consumption will
increase. Monkey should specialize in the production of cotton and Chaturbate
should export microchips. This will make both countries better off and an
improvement in the 'global' allocation of resources will result.

As illustrated in table 2, both countries will consume beyond their PPCs at a

time when they are dealing with trade. Monkey produces bananas at point A of its

16
PPC in figure 6(a); Chaturbate produced at point C in figure 6(b), where it is entirely
specialized in microchips. It then agrees to trade banana and microchips at a price
ratio of 1:1, to allow 1 banana unit to trade on 1 microchip unit, and to sell (trade) 10
microchip units for 10 banana units. Thus, in the scope of trade, Monkey consumes
10 Banana units (= 20 – 10 Export units) and 10 Microchip units (which it is
importing), and Point B outside the PPC. If opportunity costs are identical between
these countries – meaning, there is no country in which one good is relatively
cheaper; consequently, there is no country that has a comparative advantage in the
production of one or the other good.

Lesson 5: Significance of comparative advantage in the real-world

In many countries the theory of comparative advantages forms the basis of
trade policy. It claims that free trade increases global production and consumption,
leading to an improved global allocation of resources. However, in spite of its
potentials, the theory of Comparative Advantage is strongly criticized. First, it
depends on many unrealistic assumptions such as factors of production are immobile
and constant, technology is fixed, competition is perfect, full use of resources, a
balance import and export and free trade. Second, economic structural changes may
not be required in specialization. It is hard for a country to ignore transportation cost,
and lastly comparative advantage as basis for trade my result to excessive
specialization.
In the real world, transportation cost and non-trade goods plays an important
role in the world economic growth. Transport costs pose barriers to the movement of
goods and services. The inclusion of transport costs alters the results covered by this
point because the cost of moving a product from one country to another affects
relative prices.
Transportation costs are perceived as an increase in the amount of relative labor
required per unit of output in the exporting country. It is assumed that all transport
costs are paid by the importer and labor costs are measured in terms of their labor
content. The inclusion of transport costs is important because it produces a third
category of goods – the non-traded goods which will not enter into international
trade. In view of relative labor requirements, goods which lie close to the wage ratio
are likely to be non-traded. It is not surprising that many bulky, heavy goods are not
being traded.
There are many reasons for trade in comparative advantage, but the most
common are differences in technology, difference in resource endowments,

17
differences in demand, economies of scale in production and the government
economic policies.

Chapter Exercise
Table 1
Country Coco Sugar Electronic
Philippines 50 40
South Korea 20 100

1. The data in the above table illustrate the amount of Coco Sugar and Electronics
that the Philippines and South Korea will generate if they are able to efficiently
utilize all their resources.
a. Calculate the opportunity cost of Coco Sugar and Electronics in Philippines,
and the opportunity cost of Coco Sugar and Electronics in South Korea.
b. State which country has a comparative advantage in Coco Sugar, which in
Electronics, and which has an absolute advantage in both goods.
c. Using data in the table above, draw a diagram to show the comparative
advantage of both countries.
d. Provide a Table analogous with Table 1 to show absolute advantage and
Table 2 showing your calculation in item (a).
2. Provide an analysis of transportation cost and nontrade goods at a time when they
are dealing with trade.

18
 Chapter 3: Comparative Advantage II: Factor Endowments,
Trade Distribution and Welfare

Introduction
The chapter presents a second competitive component, Capital (K), and
analyzes the effects of cost substitution and the form of output possibilities. A strong
understanding of these principles is essential to understanding the effects of trade
and protectionism on factor prices and income distribution. When the module is
completed, you can understand how decisions on output and distribution are made
both self-sufficient and free trade nation with increasing costs, along with how
increased costs represent growth opportunities. The disparities between the cost
case and the cost increase case, especially technology versus factor endowments,
should also be seen as a source of comparative advantages, and the different
impacts on complete specialization and the role of tastes in determining comparative
benefits. The definition of factor intensity and factor abundance is introduced in the
Heckscher-Ohlin Theorem and other theories are considered because their function
is important in determining the effect of trade on income distribution.

Learning Outcomes:
• Criticize differences in resources that creates a pattern of trade.
• Utilize the Heckscher-Ohlin Trade model in analyzing trade patterns between
countries with two input and two output.
• Evaluate the possible impact of different factor of production and income
distribution in developing world.

Lesson 1: Factor Endowment

Adam Smith and David Ricardo believed that each nation would possess its
own technology, environment and resources, which would result in differences in
production, resulting in differences in comparison. The theory of Heckscher-Ohlin
argues that the difference of labor, work skills, physical capital or land (production
factors) generates productive differences which explain why the trade takes place.
Trade in Hecksher-Ohlin Theory: Output factors (country supply endowments)
used to generate each good contribute to variations in efficiency between countries.
Abundance of factor versus scarcity: if a country enjoys a relative abundance of a
factor, the relative cost of this factor is lower than in those countries that do not have
a factor. A country’s comparative advantage lies in the production of goods that use

19
relatively abundant factors over a country which has relatively small supply of
resources or scarce factor.
Table 3.1 Example of Factor Endowment
United States China
Capital 80 machines 40 machines
Labor 160 workers 20 workers
China is labor-abundant and United States is capital-abundant.

Application of the H-O Theory

Two countries: Home and Foreign.

Two goods: Aircraft (US) and Shoes (China) both countries engage in
production of both products.
Two factors of productionn: labor (L) and capital (K).
China capital-labor ratio: Kchi / L chi is 2/10 or 1/5 while, U.S. capital-labor ratio:
Kus / L us is 50/150 or 1/3. Since the U.S.’s capital-labor ratio is higher, it is
the capital abundant country: (KU.S. / L U.S. > Kchi. / Lchi or 1/3 > 1/5)

HO Model’s Prediction of U.S. Export Basket

Hecksher-Ohline Model of US prediction on its export basket depends on
richly endowed of wide variety of factors: natural resources, skilled labor, and
physical capital. Its expectation is that U.S. will export agricultural products
(particularly those requiring skilled labor and physical capital) and machinery and
industrial goods (requiring physical capital and scientific and engineering skills). Its
result based on evidence that most major U.S. exports include grain products made
with small labor and large capital inputs; and commercial aircraft made with physical
capital and skilled labor.

Lesson 2: Gains from Trade Basic Assumption

Ricardian model assumed that each country faced a constant set of tradeoffs
(e.g., 2 loaves of bread for 3 tons of steel in the U.S.) because of only one
homogeneous input - labor. The HO model assumes: First is that, multiple inputs—
labor capital, land, etc., and secondly, variations in the quality of inputs. Thus, the
PPC cannot be assumed to have constant costs. Under the HO model, each country
has a rising opportunity cost for each type of production. As with constant costs, the
tradeoff between bread and steel is equal to the slope of the PPC; however, since
the PPC is curved, tradeoff is different at each point of production.

20
 Figure 3.1 Gains from Trade in HO Model

If the U.S. exploits it comparative advantage and increases steel production,

the gap between the opportunity cost of production and the trade price narrows. At
B, they are equal: B maximizes U.S. income. The HO model provides a more
sophisticated way to analyze the impact on different groups from trade under the
following condition; a) There are more inputs than labor; b) Labor can be divided into
categories of different skill levels; c) Industries can require different mixes of various
inputs. There is a systematic relationship between the factor endowments of a
country and the winners and losers from trade.
Assumptions of the Heckscher-Ohlin Model
1. Both factors can move freely between industries.
2. Shoe production is labor-intensive; it requires more labor per unit of capital to
produce shoes than computers, so that LS/KS > LC/KC.
3. Foreign is labor abundant. Equivalently, Home is capital abundant
4. The final outputs, shoes and computers, can be traded freely, without
restrictions, between nations, but labor and capital do not move between
countries.
5. The technologies used to produce the two goods are identical across the
countries. This is opposite of the assumption in the Ricardian model.
6. Consumer tastes are the same across countries, and preferences for
computers and shoes do not vary with a country's level of income. These are
not realistic assumptions, but they allow us to focus on differences in factor
endowments as the basis for trade.

Lesson 3: Application of H-O Model: Factor Price Equalization

As part of our assumptions, we assume that factor intensities in each industry
are the same in both countries. For example, shoes are labor intensive in both
countries. Although all countries may have access to the same technologies, the

21
machines used in the U.S. are different from those used in Asia and elsewhere.
While the U.S. still produces some shoes, the production is different from the
production in Asia. Asian production uses old technology and workers earn relatively
little compared to the U.S, where Asia is labor intensive. In call centers or BPO,
technologies and therefore factor intensities are similar across countries. So, shoes
in India for example are labor intensive compared to the call center than of the U.S.
The situation illustrates Reversal of Factor Intensities (RFI) between the two
countries. The RFI holds wage/rental ratio equal and disregard possibility of
reversal. Only two countries are modeled: domestic and foreign. As always, H-O
model starts with no trade equilibrium on production where domestic and foreign
country has competitive advantage over the other based on factor abundance and
intensity (combined with total endowments) determine by home as presented in the
table above. The Heckscher-Ohlin Theorem follows that; With two goods and two
factors, each country will export the good that uses intensively the factor of
production it has in abundance, and will import the other good. It is really possible,
since we trade something we specialize in production with our surplus as
recommended by the Ricardian model.

Figure 3.2
H-O Theorem:
Factor Price Equalization

Based on the diagram (above), Home produces at panel B (a) and consumes
at C point at point B, exports computers, and imports shoes at a relative world price
for computers, (PC / PS)w. The 'Triangle of Trade' has a basis equal to computer
home exports (the difference between production and trade in quantities, QC2 −
QC3). (The equilibrium of non-trade equilibrium is A); The height of this triangle is the
domestic shoes imports (the difference between shoe quantity consumed and trade
quantity QS3 − QS2).
The H-O Theorem was evaluated by using data from the United States of
1947, which directly analyzed the production of final good exportations in each

22
industry by Wassily Leontief in 1953. Leontief rightly assumed that, compared to the
rest of the world, America was capital abundant in 1947. Under the HO model,
Leontief expected the United States to export goods that are intense in capital and to
import goods that are labor intensive. However, Leontief found the contrary. For
American imports the capital labor ratio was higher than for exports. This
contradiction has been known as the Leontief’s paradox. Trade barriers and
transportation costs may prevent goods prices and factor prices from equalizing.
After an economy liberalizes trade, factors of production may not quickly move to the
industries that intensively use abundant factors. In the short run, the productivity of
factors will be determined by their use in their current industry, so that their wage/rate
may vary across countries.

Lesson 4: Trade and Income Distribution

The Heckscher-Ohlin model predicts that owners of abundant factors will gain
from trade and owners of scarce factors will lose from trade. Changes in income
distribution occur with every economic change, not only international trade. Changes
in technology, changes in consumer preferences, exhaustion of resources and
discovery of new ones all affect income distribution. It would be better to compensate
the losers from trade (or any economic change) than prohibit trade. The economy as
a whole does benefit from trade.
Wages of unskilled workers should increase in unskilled labor abundant
countries relative to wages of skilled labor, but in some cases the reverse has
occurred where wages of skilled labor have increased more rapidly than wages of
unskilled labor. The HO model provides a more sophisticated way to analyze the
impact on different groups from trade such as, a) there are more inputs than labor; b)
labor can be divided into categories of different skill levels; and c) industries can
require different mixes of various inputs. There is a systematic relationship between
the factor endowments of a country and the winners and losers from trade. There is a
political bias in trade politics: potential losers from trade are better politically
organized than the winners from trade. Losses are usually concentrated among a
few, but gains are usually dispersed among many.
To study the effect of trade on income equality with Stolper-Samuelson
Theorem derived from H-O model. Assumption of the Stolper-Samuelson model are
based on the following premise; 1) Labor earns wages proportionate to its skill level;
2) Owners of capital earn profits; 3) Landowners earn rents; 4) The amount of
income earned per unit of input depends on both the demand for inputs and the
supply of inputs (demand for an input = derived demand) and 5) If an output is in high

23
demand, its price is high and the inputs used to produce it receive higher returns.
While its argument follows that: a) An increase in the price of a good raises the
income earned by factors that are used intensively in its production. Conversely, a
fall in the price of a good lowers the income of the factors used intensively in its
production as shown in the graph below.

Figure 3.3
Stolper-Samuelson
Theorem

Take note that not all factors used in the export industries will be better off,
and not all factors used in import competing industry get hurt: abundant factors will
benefit, while scarce ones will be hurt. In addition, factors face magnification effect—
the change input prices has a magnified effect on incomes: 75% decline in the price
of bread can lead to a more than 75% decline in the income of labor used in the
production of bread. Ultimately, the effect of trade opening on income distribution
depends on the flexibility of the affected factors. For example, if labor is stuck in
bread production and unable to move to making steel, it will be hurt much worse than
when it is flexible and free to move. Further, Philippine avocado producers might not
oppose Mexico avocado imports as fiercely as they do, if they could easily move to
producing other goods.
HO model assumes that factors are mobile: migrate easily from one sector to
another referred as specific factor model. Specific factors model assumes that: (1)
land and capital are immobile and cannot migrate; and (2) labor is fully mobile and
can migrate from one sector to another. A country’s endowment of a specific factor
plays a more critical role than a factor in the HO model in determining comparative
advantage; 1) When trade opens, incomes rise for the owners of the abundant
specific factor and 2) Income distribution effect on labor is indeterminate, as workers
can easily move to the expanding sector.

24
 Table 3.2 Specific Factors Model
OUTPUTS
INPUT
Bread Steel
Specific factors Land Capital
Variable factors Land Land

The specific of Land and Capital can be used to produce only one good. The
variable factor of labor is used in both bread and steel.

Lesson 5: Empirical Test on Comparative Advantage the Heckscher-Ohlin

Model
Based on US data test, Leontief found that US exports were less capital-
intensive than US imports, even though the US is the most capital-abundant country
in the world: Leontief paradox. Tests on global data, Bowen, Leamer, and
Sveikauskas tested the Heckscher-Ohlin model on data from 27 countries and
confirmed the Leontief paradox on an international level. Tests of theories based on
factor endowments yield mixed results, how to measure factor endowments or prices
in an autarky, where data is difficult to obtain like North Korea. Besides factor
endowments, trade is affected by, technological differences, economies of scale,
corporate structures and, economic policies.
Extension of the H-O Model
There are several alternative trade models that elaborate on the theory of
comparative advantage based on H-O model.
1. Product cycle model which focuses on the speed of technological change and
life history of many manufactured items through periods of innovation,
stabilization, and standardization.

Figure 3.4
The Product-Cycle
In High-Income
Countries

25
 Product Cycle developed by Raymond Vernon, claims that production of a
good is cyclical grounded on the following idea: When a manufactured good is
developed, producers experiment and seek consumers’ reactions and when
production leaves the early stage, the good begins to be standardized in terms of
size, features, and manufacturing process. Finally, consumption of the good in a
high-income country (South Korea) exceeds its production: production moves where
labor costs are lower. However, a different situation occurs in a low-income
(Philippines) country.

Figure 3.5
Product Cycle in
Low-income
Country

2. Intra-firm trade model that allows for comparative advantage but incorporates
industrial organization. Much of international trade is driven by foreign investment
by multi-national firms because firms prefer to invest abroad and produce there
directly, rather than export (they substitute foreign investment for foreign trade).
Output also produced in the foreign operation can be sold directly to the foreign
market or shipped back to the home nation (they engage in intra-firm trade to
take advantage of advantageous foreign conditions). Reasons for intra-firm
trade:
a. Firms take advantage of cross-country differences in the price of inputs
b. A firm may reduce distribution costs in a foreign market by operating through
an affiliate
Intra-firm trade is growing in importance in mid-90’s, about 1/3 of US
merchandise exports and 2/5 of merchandise imports were intra-firm. Ownership-
Location-Internalization (OLI) theory. Firms investing abroad own an asset that gives
them a competitive advantage (Ownership), Firms seek a production location that
offers them advantages (Location), Firms try to internally capture the advantages of
foreign asset ownership (Internalization).

26
Lesson 6: Impact of Trade on Wages and Jobs
In the short-run, trade may (1) reduce jobs in an industry that is not
competitive vis-à-vis foreign industries and (2) increase jobs in competitive industries.
In the medium- and long-run, trade has very little effect on the number of jobs. The
abundance or scarcity of jobs is a function of (1) labor market policies, (2) incentives
to work, and (3) government macroeconomic policies.
For further reading, you may read Chapter 4 on International Economics by J.
Gerber; Chapter 4 & 5 book by Krugrman, etal; Chapter 3 book by Carbaugh, R.J.
and Chapter 3 of Yarbrough and Yarbrough.

Chapter Exercise
1. Describe the Hecksher-Ohlin Theorem in your own words.
2. Even if factors are immobile between two countries, unrestricted trade tends
to lead toward the same relative price for factors across countries as stated
by the ___________.
3. Discuss reasons why complete factor price equalization isn’t observed.
4. There are two methods of defining __________, by relative factor quantities
or relative factor prices. Using the quantity definition, if (Ka∕La) > (Kb∕Lb),
country A is said to exhibit ____________ which (given only two factors
and two countries) means that country B exhibits ____________.
5. Consider the given data below on factor endowment of two countries A and B,
answer the following question based on H-O model.

Country A Country B
Labor Force 45 20
Capital Stock 15 10

a. Which country is relatively capital abundant? Labor abundant? Explain.

b. Assume that Smartphone is capital intensive relative to Shoes, which country
will have comparative advantage of Shoes?
c. Under what circumstances might factor price equalization not occur between
country A and B.

27
 Chapter 4: Beyond Comparative Advantage: New Trade Theories

Introduction
Comparative advantage is borne out of country differences as foundation of
trade models discussed earlier. Differences in productivity or factor endowments
contributed to the growth of living standard through specializing production and trade.
That productivity advantage becomes the model for altering trade following the
industrialist policy in predicting country’s pattern of trade. But in real world of
business, a precise measure of comparative advantage is difficult to achieve since
major share of international trade is a result of mixed data or facts on key economic
activity. Trade models assume a perfect market or competition which is difficult to
realized given the terms of trade of countries competitive advantage and economic
growth. The phenomenon gives rise to standard trade model as special case in
international market competitiveness.

Learning Outcomes:
• Analyze the components of the standard trade model and recognize the link
to trade patterns.
• Formulate ideas that affects the changes in the terms of trade.
• Analyze the effect of terms of trade in a monopolistic competitive market.

Lesson 1: The Standard Trade Model

A rapid productivity growth of industrializing country should not be exclusively
attributed to the implications of trade models of comparative advantage such as the
Ricardian model, specific factor model, HOT and SST model. Most or some growth
were attributed to the omitted factor of economic focus. International trade or market
system is not solely dependent on the supply side but rather it shifts from the
movement of supply and demand in an imperfect market or monopolistic competition.
Important exceptions to the models are necessary to examines how and why many
countries try to select and plan the development of their export industries. It also
explains why an important share of world trade consists of countries exporting the
same thing they import.

The standard trade model is built on four key relationships:

1. the relationship between the production possibility frontier and the relative
supply curve;

28
 2. the relationship between relative prices and relative demand;
3. the determination of world equilibrium by world relative supply and world
relative demand; and
4. the effect of the terms of trade - that is the price of a country’s exports
divided by the price of its imports that affect the nation’s welfare.

Lesson 2: Reason to Trade

Trade models built exclusively on the idea of comparative advantage have a
mixed record when it comes to predicting a country’s trade patterns. It is exceedingly
difficult to precisely measure a country’s comparative advantage – we’re good at
different things, that’s why we trade. Say, luxury car and coconut, is it possible to
trade given a different economy of scale? Therefore, a large share of international
trade is not based on comparative advantage – similar in abilities and each country
picks a good requiring large scale of production.
Country often seek to alter their comparative advantages through
industrial/commercial policies as exceptional cases which become more important
overtime. This phenomenon is the increasing importance of intra-industry trade (the
prefix “intra” means within). Intra-industry trade is the international trade of products
made within the same industry, for example steel-for-steel or bread-for-bread. Intra-
industry trade is growing increasingly important in international trade especially
between industrial countries. The opposite of intra-industry trade is inter-industry
trade (the prefix “inter” means between). Interindustry trade is international trade of
products between two different industries (for example, bread-for-steel). See table
below for reference.

Table 4.1

Lesson 3: Intra-industry Trade and the New Trade Theory

Characteristics of intra-industry trade is common in industrial countries but
fundamental issue is defining an industry. Example, computers are defined as office

29
machinery, therefore, computers and stapler are both in the same industry, and one
country will export stapler and import computer engage in intra-industry trade.
Generally, the more broadly an industry defined, the more trade appears; conversely,
the more detailed the definition, the less trade is defined as intra-industry. Suggested
evidence that intra-industry trade is greater in high industries where there is more
scope for product differentiation; in countries more open to trade; in nations that have
received larger amounts of foreign direct investment. The production of many goods
is characterized by economies of scale as the new model of international trade as the
New Trade Theory based on models with constant returns or decreasing returns to
scale.
Economies of scale based on the new trade theory is decreasing average
costs over a relatively large range of output (as opposed to constant or increasing
costs). Two types of economies of scale; 1) Internal economies of scale – lead to
larger firms because size confers a competitive advantage and 2) External
economies of scale - lead to larger industries (however, larger firms have no inherent
advantage over smaller ones). When larger firms are more competitive, market
structure changes. Oligopoly where handful of firms produce the entire market
output, with each firm formulating its strategies in response to those of its
competitors. Monopolistic competition which unlike under pure monopoly,
competition among many firms exists. However, competition is attenuated by the
practice of product differentiation—each firm produces a slightly different product.

Intra-industry Trade Gains

The trade gains from intra-industry trade creates lower costs of goods where
the increase in the size of the market allows for scale economies, which lowers
production costs and eventually lower prices of export and import costs to
consumers. With the fact that intra-industry trade lower export costs, a potential
expansion of production occurs. As such there is a high likelihood that intra-
industry trade expands the number of firms and the quantity of both domestic and
foreign goods. In addition to the aforementioned benefits, another benefit of the intra-
industry is that it increases in consumer choices. Intra-industry trade tends to give
access to a much greater variety of goods than produced domestically, without trade,
consumers are limited to goods produced in the domestic market.

Lesson 4: Trade and Geography, Transportation cost and Economies of Scale

Trade and geography are connected in two fundamental ways. First, a place
such as a major city may attract economic activity because it is a large market.

30
Second, there may be opportunities for firms to find critical inputs, including skilled
labor, and stay up to date on current developments. For both of these reasons, the
characteristics of the locations on the output and input sides are an important part of
the firm decision-making process. As a result, geography has a key role to play in
some trade.
In the case of most manufactured goods, it is not practical to produce next to
each market due to economies of scale (producing cars next to dealers). Not all
types of production have the same level of transport costs (presence of economies of
scale makes almost market production unworkable). Most foreign investment today is
directed towards high-income countries (to access larger markets) rather than
developing countries. All the rest of the same, lower transport costs often outweigh
other costs that could be higher (the south shift of U.S. car manufacturing to closer to
final assembly). Trade and geography considerations for intra-industry are that when
tariffs fall, some industries may relocate production to take advantage of lower trade
costs. Geographical concentration can give an industry a competitive advantage: it
will join the regional industrial cluster (agglomeration) to strengthen its export
performance.
External economies of scale occur when firms become more productive as
the number of firms in an industry increase. If a firm in a region produce similar
products, they will benefit from knowledge spillovers. When the presence of a large
number of producers in one area creates a deep labor market for specialized skills. If
an area holds a dense network of input suppliers, manufacturers locate near the
suppliers.
A firm’s decision about where to locate depends on, among other things, the
characteristics of the production process in the industry. Industries can be classified
as resource oriented, market oriented, or footloose. Resource-oriented industries
locate near sources of their inputs or raw materials like mining operations. Since raw
material like ore is heavy, transport cost is high thus firms have an incentive to avoid
when it is being moved long distance at a lighter form. Industries in which the good
becomes lighter as it moves through the production stages tend to locate near the
raw-material source to avoid having to move the good in its heavy form. A market-
oriented industry is retail sales operations. Market oriented involve goods that
become heavier or more difficult to move during the production process such as
construction material and beverage. It is likely logical to gather the building input
material and assemble it on sight than to move the whole building to the construction
site. Similarly, it wouldn’t make sense if all bakeries will be put up near a wheat farm
and to sell no fresh goods to customers made in small batches. While a footloose

31
or light industry need not to locate neither near raw material sources or market.
Their products typically neither gain nor lose a significant amount of weight or volume
as they move through the stages of production. Goods such as semiconductor chips
and electronics components fall into this category because of their high value-to-
weight ratios. Such light industries are free to move around the world in response to
changes in the prices of inputs and assembly.

Lesson 5: Industrial Policies and Market Failure

Industrial policy is a government’s policy designed to create new industries or
support existing industries. Industrial policies are controversial because it limits the
scope of action to support the industries. They are obviously politically motivated in
some situations, and end up wasting enormous amounts of money. Common
industrial policy tools used by governments in some newly developed countries:
selling foreign exchange to targeted companies at below-market prices, providing
government loans to private firms at below-market interest rates, providing
government guarantees on loans from the private sector, and offering special tax
benefits to targeted industries. Uruguay Round and WTO prohibit subsidies for
competitive policies. However, governments can use other policies: providing
information about foreign markets to domestic firms, helping negotiate contracts,
lobbying foreign governments to adopt home country standards, or tying foreign aid
to purchases from domestic firms.
Basic problems with industrial policies are that it is difficult to obtain
information for measuring market failure. Another issue it is difficult to determine
which target industry to support: positive externalities may not be readily visible as it
encourages rent seeking. Rent-seeking is an economics phenomenon whereby an
individual or organization seeks to create its own wealth without creating social
advantages or benefits. A rent seeking behavior in business includes activity such as
lobbying, by individuals, firms, or special interests to alter the distribution of income in
their favor. The following factors are listed by critics of industrial policy: sound
macroeconomic policy, high saving and investment levels, and high level of
education have been the keys to success, not industrial policy. The advocates
argued that the rationale of the critics is rhetorical.
In the absence of optimal quantities of products and services in a private
market economy (the value of a commodity to private consumers and society does
not equal its production costs), the market is called market failure. A market failure
is a discrepancy between private returns and social returns. In the case of market
failure, some of the costs or advantages of an operation are externalized — apart

32
from the area of concern of the economic agents engaged in the activity. The market
failure that results from the externalization is referred as externality by economist.
For example, a steel mill that pollutes a river imposes a cost on inhabitants
downstream, and parents who vaccinate their children create a benefit for their
neighbor’s children. In an accounting sense, the private returns are the cost and
benefits to the steel mill or to the parents with the vaccinated child, while the social
returns include the private costs or benefits, but also take into account the costs and
benefits to the rest of society—the downstream inhabitants or the neighbor’s children.
Market failure is a key justification for industrial policies. For example, knowledge
spillover is cited as a justification for industrial policy: a single industry may spread
awareness about new technologies and processes, making social returns greater
than private returns. Research and development (R&D) are experiencing similar
spillovers.
New trade theory developed by Paul Krugman suggests that the ability of
firms to gain economies of scale (unit cost reductions associated with a large scale of
output) can have important implications for international trade. Countries may
specialize in the production and export of particular products because in certain
industries, the world market can only support a limited number of firms. His Nobel
prize work supports that nations may benefit from trade even when they do not differ
in resource endowments or technology, a country may dominate in the export of a
good simply because it was lucky enough to have one or more firms among the first
to produce that good. Governments should consider strategic trade policies that
nurture and protect firms and industries where first mover advantages and
economies of scale are important. Strategic trade policy must be of selective use of
trade barriers and industry subsidies in order to capture some of the profits of foreign
firms. Strategic trade policy requires that (1) industry has economies of scale and (2)
firms in the industry have market power. Strategic trade policy is, like market failure,
a justification for industrial policies.

Lesson 6: Understanding the Terms of Trade

In the trade analysis, concept that relates the prices that a country receives
for its exports to the prices it pays for its imports, and can be defined as terms of
trade (TOT).

𝐴𝑣𝑒.𝑝𝑟𝑖𝑐𝑒 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = 𝐴𝑣𝑒.𝑝𝑟𝑖𝑐𝑒 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 × 100

33
 Note that prices of exports and imports are both measured in terms of the
domestic currency (alternatively, in terms of a foreign currency; in other words, both
are measured in terms of the same currency). Although the terms of trade measure
prices of exports relative to prices of imports, it is also a measure of the amount of
imports that can be bought per unit of exports. An increase in the price of exports,
with the price of imports constant, means more imports can be bought with the same
quantity of exports. On the other hand, an increase in the price of imports, with the
price of exports constant, means fewer imports can be bought with the same quantity
of exports. This will be explained below.
To distinguish between an improvement and a deterioration of trade, let us
take the example of Monkey and Chaturbate in module 2. Suppose Chaturbate
exports microchips and imports banana. Initially, Chaturbate receives $10 per
microchips exported and pays $1 per unit of banana imported. It therefore imports 10
units of banana by exporting 1 microchip. If the terms of trade change, so the price of
microchips increases to $15 per microchips (the price of banana remaining constant),
Chaturbate imports 15 units of banana for one microchip. Chaturbate gets more
imports for the same amount of exports. This is an improvement in the terms of trade,
which is an increase in the value of the ratio of average export prices to average
import prices. It involves a fall in the opportunity cost of imports. If the price of
banana goes up to $2 per unit (with the price of exports constant), Chaturbate
imports only 5 units of coffee for one robot. Chaturbate now gets fewer imports for
the same amount of exports. This is a deterioration in the terms of trade, and
involves a decrease in the value of the ratio of average export prices to average
import prices. It involves an increase in the opportunity cost of imports. An
improvement in the terms of trade can arise from either an increase in the price of
exports or a fall in the price of imports. Similarly, a deterioration can arise from either
a fall in the price of exports or an increase in the price of imports.
Export prices and import prices are measured by a weighted price index of
consumer price index (CPI). The value of the terms of trade is always 100, to
calculate consider the equation below where the price index for exports is divided by
the price index for imports, and the result is multiplied by 100:

𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝐴𝑣𝑒. 𝑝𝑟𝑖𝑐𝑒 𝑒𝑥𝑝𝑜𝑟𝑡𝑠

𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = × 100
𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝐴𝑣𝑒. 𝑝𝑟𝑖𝑐𝑒 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

As illustration, if the base year is 2012, the terms of trade for the year 2012 is
100. Suppose that in 2014 the index of export prices is 103 and the index of import
prices is 105. The terms of trade in 2014 are:

34
 103
𝑇𝑂𝑇 2014 = × 100 = 98.1
105

We can say that the terms of trade have deteriorated in the period 2012-14;
since average export prices (103) have fallen relative to average import prices (105)
and a ratio below 100 (a balance trade must be 1:1 ratio). An increase in the ratio of
the index of average export prices to the index of average import prices shows an
improvement in the terms of trade. A decrease in that ratio shows a deterioration in
the terms of trade.
The cause on the changes of trade are affected by any factors that give rise to
changes in relative prices of internationally traded goods (exports and imports), as
well as changes in exchange rates. In general, if the world price of a product
increases, countries that export it experience an improvement in their terms of trade,
whereas importing countries experience deterioration; if the world price falls,
exporters experience deterioration and importers face an improvement. Clearly,
changes in prices of internationally traded goods have a different (and opposite)
impact on countries depending on whether they are exporters or importers of the
goods. Some changes of trade are short term in nature, say the global demand and
supply condition (fuels) while there is long term change on trade such as trade
protection.
The reason why countries are interested in changes in their terms of trade is
that these affect their balance of trade - measures export revenues minus import
expenditures. Values of exports and imports are determined by export and import
quantities times their respective prices. Since the terms of trade involve export and
import prices. It follows that changes in the terms of trade cause changes in the
balance of trade which is the most important component of a country’s current
account in its balance of payments, changes in the terms of trade affect the current
account. Deteriorating terms of trade effects on the economies of developing
countries like transfer of income away from country, import dependence, trade deficit,
falling rural income and increasing poverty and slow growth and development
resulting to trapped poverty cycle.

Chapter Exercise
1. What is intra-industry trade? What products are important for intra-industry trade?
Why do economies of scale play an important role in intra-industry trade
explanations?
2. Compare and contrast external and internal economies of scale in terms of size of
firms, market structure, and gains from trade?

35
3. Below is the table showing indices of average export and import prices. (a) Which
is the base year? (b) Calculate the terms of trade for each year shown. (c) Explain
in which years there was a terms of trade improvement or deterioration relative to
the base year. (d) Explain in which years there was a term of trade improvement
or deterioration relative to the previous year.

2013 2014 2015 2016

Index of Ave.
Export prices 100 103.2 109.8 110.5
Index of Ave.
100 104.7 105.3 107.5
Import prices

36
 Chapter 5: Trade Policy

Introduction
A variety of models on trade that is beneficial to a free market which most
countries adopt, describes the causes and effects of international trade and the
functioning of a trading world economy. Somehow we ask ourselves “What would be
the country’s trade policy would be? Do we need to restrict trade or not? Who will
benefit and who will lose from this policy? Would the benefit outweigh the cost? For
an international affair professional or a trade policy analyst, knowing that factor
conditions lead to the demand for import protection is not enough. These individuals
are often called on to assess, both qualitatively and quantitatively, the numerous
impacts of government interventions in international trade. The most often used
instrument of trade policy are the ways in which countries adopt policies toward
international trade and different actions involved. The discussion in this module
provides a framework for understanding the workings and the effects of the most
important instruments of trade policy. If you pursue an international economic affairs
career, it is likely that you will either be involved in making these assessments or in
interpreting the assessments made by someone else. Therefore, it is important for
you to understand how the assessments are made. This is the purpose of the
present module.

Learning Outcomes:
• Evaluate the cost and benefit of trade policy and its welfare effect
• Differentiate and explain the effective trade protection.
• Calculate the effect of protective rate in free-trade prices.
• Recognize and assess the extent on the nations gains and losses of trade.

Lesson 1: Free Trade

Free trade can be described as a government policy not discriminating
against or interfering with importations by imposing (imported) tariffs or export
subsidies. It means the without restrictions, such as tariffs, taxes and quotas, of the
purchase and selling of goods and services between countries. Free trade helps
countries to focus on their core competitive advantages, maximizing economic
production and promoting their citizens' growth in earnings. One of the most basic
theories of contemporary economics, dating from at least o Adam Smith (176) and
David Ricardo (1816), is that free trade is increasing social welfare. But the free trade

37
policy has always been controversial as countries have no choice between free trade
and autarky (no trade). They always chose a strategy of varying levels of
liberalization in a range of free trade regimes.

Lesson 2: Arguments against Free Trade

Trade protectionism is used to achieve a variety of potential goals at different
times and places. Very few countries have zero tariffs across all industries (Hong
Kong is the only country although some others such as Singapore have very few or
low tariff. In general, there are eight (8) reasons why nations protect their industries.
1. Infant Industry Argument: Governments are sometimes urged to support
the development of infant industries, protecting home industries in their early
stages, usually through subsidies or tariffs. Subsidies may be indirect, as in
when import duties are imposed or some prohibition against the import of a
raw or finished material is imposed. If developing countries have industries
that are relatively new, then at the moment these industries would struggle
against international competition. However, if they invested in the industry
then in the future, they may be able to gain Comparative Advantage.
2. The Confused industry argument: If industries are declining and inefficient
hey may require large investment or make them efficient again. Protection for
these industries would act as an incentive to for firms to invest and reinvent
themselves. However, protectionism could also be an excuse for protecting
inefficient firms.
3. To diversify the economy: Many developing countries rely on producing
primary products in which they currently have a comparative advantage.
However, relying on agricultural products have several disadvantages. One of
the most important determinants of Agricultural Prices is the environmental
factors. Hence, they can fluctuate with climatic changes. Agricultural
commodities have a low income and price elasticity of demand. Therefore,
with proportionate rise in economic growth will lead to less than proportionate
rise in demand. Agricultural commodities have relatively low-price elasticity of
supply. A proportionate rise in prices will lead to less than proportionate rise
in supply of agricultural commodities. This is because of the time lag involved
in the production of agricultural gods. This is given by the fact that the
production of agricultural goods at time t is determined by the prices
prevailing in time ‘𝒕−𝟏 ’.
4. Raise revenue for the govt: Import taxes and tariffs can be used to raise
money for the government.

38
 5. Help the Balance of Payments: Reducing imports can help the current
account. However, in the long term this is likely to lead to retaliation.
6. Cultural Identity: This is not really an economic argument but more political
and cultural. Many countries wish to protect their countries from what they
see as an Americanization or commercialization of their countries.
7. Protection against dumping: The EU sold a lot of its food surplus from the
CAP at very low prices on the world market. This caused problems for world
farmers because they saw a big fall in their market prices
8. Environmental: It is argued that free trade can harm the environment
because Developing countries may use up natural reserves of raw materials
to produce exportable commodities. Also, countries with strict pollution
controls may find consumers import the gods from other countries where
legislation is lax and pollution allowed.

Lesson 3: Trade Policy Measures

A country can grant to a sector of its economy in form of either obvious
(transparent) such as tariff, import quotas, others are not (non-transparent) like
export subsidies trade barriers or import protection against international competition
might be the optimal choice. A tariff is a tax (duty) levied on indirect limits of import
products as they move between nations. The effect of a tariff is to raise the price of
the imported product. It helps domestic producers of similar products to sell them at
higher prices. The money received from the tariff is collected by the domestic
government. An import tariff is a duty on Import commodities and an export tariff is a
duty on export commodities. Tariffs can be ad valorem specific or compound. Ad
valorem tariff is expressed as a fixed percentage of the value of the traded
commodity. For example, government-imposed ad valorem tax on the distilled spirit
is 22% of the net retail price, if Jack Daniels an American whiskey worth ₱1,450 in
the market, the importer pays ₱319. The specific tariff is expressed as a fixed sum
per physical unit of the traded commodity. In the example of distilled spirit, the
specific tax is P42.00 per proof liter irrespective of price. For all types of wines, the
excise tax is P50.00 per liter. For other fermented liquor including beer, the excise
tax is P35.00 per liter. A compound tariff is the combination of ad valorem and
specific tariffs. Finally, a sales tax or VAT of 12% will be collected for every imported
goods sold.
Besides these classifications, tariffs can be classified as protective and
revenue tariffs. Protective tariffs are put in place specifically to make foreign god
more expensive to protect domestic industries from competition. Revenue tariffs are

39
put in place to raise money for the government. It all depends on the intention of the
government that implements the tariff. The impact of a tariff is often different from its
stated amount. The effective tariff rate measures the total increase in domestic
production that the tariff makes it possible, compared to free trade. Domestic
producers may use imported inputs or intermediate goods subject to various tariffs,
which affects the calculation. When tariff rates are low on raw materials and
components, but high on finished goods, the effective tariff rate on finished goods is
much higher than it appears from the nominal rate this is referred to as tariff
escalation.

Lesson 4: Analysis of a Tariff and Welfare Distribution Effect

The key distributive effects of a tariff are the redistribution of capital to
producers from consumers. Let me introduce these two concepts; Consumer
surplus is the value received by consumers more than the price they pay, i.e.
difference between the willingness to pay for the good (that depends on income,
preferences, physical conditions, etc.) and the price. While Producer surplus is the
value received by producers in excess of the minimum price at which they are willing
to produce. Consumer and producer surpluses can be measured only if the demand
and, respectively, the supply curve are known as shown in the figure below.

Shown in the graph above is the perfectly competitive market for oranges.
The market is in balance between the price P* and the quantity Q*. As we know, the
demand curve indicates the willingness of consumers to pay. In the chart, the amount
that consumers actually pay is P*—the fair market price for oranges. For example, if
you'd be willing to spend ₱10 on a good, but you'd be able to buy it for just ₱7, your
consumer surplus is ₱3. You get ₱3 more value from the good than it cost you.
Consumer surpluses on a large market are based on demand curves that are very
valuable in measuring consumer surpluses on the market as a whole. The demand
curve on the demand-supply graph shows the relationship between the price of the

40
product and the quantity of the product purchased at that price. Due to the law of
decreasing marginal utility, the demand curve is downwards. The pink shaded part of
the above illustrated graph represents the consumer surplus.
In order to calculate the total consumer surplus achieved on the market, we
would like to calculate the area of the shaded pink triangle. Looking back to geometry
class, the formula for the triangle area is ½ x base x height. In this case, the balance
quantity (Q*) is the basis of the triangle. And the height of the triangle is the price by
which the y-intercept of the demand curve (i.e. the price at which the quantity
demanded is zero) exceeds the equilibrium price (P*). On the other hand, producer
surplus is the value that producers derive from transactions. For example, if a
producer is willing to sell a good for ₱4, but is able to sell it for ₱10, the producer's
surplus is ₱6. Like the surplus of the consumer, the surplus of the producer can also
be shown through the supply and demand chart. This time, however, the surplus of
each transaction is represented by the distance between the supply curve (which
indicates that the lowest price suppliers would be willing to accept) and the market
price. The total producer surplus achieved in the orange market would be
represented by blue area in the chart. The area of the blue triangle (representing
producer surplus) is calculated as ½ x base x height, with the base of the triangle
being the equilibrium quantity (Q*) and the height being the equilibrium price (P*).
In theory, large countries can improve their national welfare by imposing a
tariff but increases domestic price of imported product above world price. It may
affect domestic consumers with increased costs, low income consumers are
especially hurt by tariffs on low-cost imports. On macrolevel an overall net loss for
the economy (deadweight loss) will occur through production distortion loss - too
much produced at higher price; and consumption distortion loss - too little
consumed .at higher price. Export industries will face higher costs for inputs caused
by tariff. Although it benefits producers and government, losses imposed on
consumers outweigh benefits. From an economic standpoint, tariff hurts the nation it
may retaliate to further restricting trade that may lead to war on trade like the US-
China trade relation. Further, society as a whole is affected with rising cost of living
resulting to poverty.
Reducing tariff barriers leads to the creation of trade that occurs when
consumption shifts from high cost producers to low-cost producers aimed at creating
free trade in an economy to assist countries in establishing trade. The diagram below
explains the above concept.

41
 Benefit and cost of a tariff on consumers, producers and employment. The
removal of tariffs leads to lower prices for consumers and an increase in consumer
surplus of areas 1 + 2 + 3 + 4. A tariff raises the price of a good in the importing
country and lowers it in the exporting country. As a result of these price changes
consumers lose in the importing country and gain in the exporting country (Imports
will increase from Q3-Q2 to Q4-Q1), the government collects tariff revenue equal to
the tariff rate times the quantity of imports with the tariff in area 3. Producers gain in
the importing country and lose in the exporting producer surplus equal to area 1.
However overall, there will be an increase in economic welfare of 2+4 (1+2+3+4 –
(1+3). The magnitude of this increase depends upon the elasticity of supply and
demand. If demand is elastic consumers will have a big increase in welfare for large
country.
With more trade domestic firms will face more competition from abroad. As a
result of this there will be more incentives to cut costs and increase efficiency. It may
prevent domestic monopolies from charging to high prices. If an economy protects its
domestic industry by increasing tariffs industries may not have any incentives to cut
costs. Trade liberalization is often justified in terms of the efficient market outcome
and efficient price fixation through a competitive price fixing mechanism.

Lesson 5: Non-Tariff Trade Measures

Non-tariff barriers to trade (NTBs) are trade barriers that restrict imports but
are not in the usual form of a tariff. Some common examples of NTB's are anti-
dumping measures and countervailing duties, which, although called non-tariff
barriers, have the effect of tariffs once they are enacted. Non-tariff barriers to trade
include import quotas, special licenses, unreasonable standards for the quality of
gods, bureaucratic delays at customs, export restrictions, limiting the activities of
state trading, export subsidies, countervailing duties, technical barriers to trade,
sanitary and environmental measures, rules of origin, etc.

42
 A quota is a quantitative limit on the amount of goods that can be imported.
Putting a quota on a good creates a shortage, which causes the price of the good to
rise and enables domestic producers to increase their prices and increase their
production. The import quota is a limit on the quantity of goods that can be produced
abroad and sold domestically. It is a type of trade protectionist restriction that sets a
physical limit on the quantity of goods that may be imported into a country within a
given period of time. If a quota is placed on a good, less of it is imported. Quotas, like
other trade restrictions, are used to benefit he producers of a good in a foreign
economy at the expense of all consumers of the good in the domestic economy, this
is also called as quota rent.
The most transparent type of quota is an outright limitation on the quantity of
imports. Limitations are sometimes specified in terms of the quantity of a product
coming from a particular country and at other times there is an overall limit set
without regard to which country supplies the product. For example, in the apparel
sector, until 2005, the United States set quotas for imports of each type of garment
(men’s suits, boys’ shirts, socks, and so on). A second type of quota is an import
licensing requirement, by regulating number of licenses granted and quantity
permitted under each license are essentially the same as quota. Import licensing
requirement force importers to obtain government license on their imports, and less
transparent than quotas since government do not publish information on allowable
imports and specific limit of export. A third form of quota is the voluntary export
restraint (VER) common in US commercial policy, is also known as voluntary
restraint agreement (VRA). These restraints are usually requested by the importing
country (with the implicit or explicit threat of a tariff if the exporting country doesn’t
comply). Finally, Local Content Requirement –a regulation that requires a specified
fraction of a final good to be produced domestically. The local content requirement
may be specified in value terms, by requiring that some minimum share of the value
of a good represent home value added, or in physical units. LCR does not provide
government revenue nor quota rents, difference between the prices of home goods
and imports is averaged into the price of the final good and is passed on to
consumers.
On the effect of quota and tariffs on profits, foreign producers prefer quota
over tariffs as they can obtain quota rents. Remember that unlike tariffs, quotas do
not generate tariff revenue for the government (but extra profits for foreign
producers). Put it differently, the advantages of protection go to the foreign producers
that are selected to export and that can charge higher prices. Two circumstances that
can limit quota rents (i.e. rents for foreign producers); a) If there is a large number of

43
foreign producers, competition may limit their ability to increase prices, and b) The
government can extract the extra profits from foreign producers through an auction
for import licenses.
Export subsidies are the direct payments to nation’s exporters. Export
subsidies are of different types. They include the practice of granting tax relief and
subsidized loans to the nation’s exporters or potential exporters, providing low
interest loan to foreign buyers so as to stimulate the nation exports etc. Export
subsidies as such may be regarded as a form of dumping.
All major industrial nations are lending low interest loans to foreign buyers of
the nation's exports to finance purchases. This is done through agencies such as the
Export Import Bank. These low interest loans finance about 2% of US exports
compared to 32% for Japan, 18% for France and 9% for Germany. This is one of the
most serious trade complaints the U.S. has against many other industrial countries.
The amount of the subsidies can be measured by the difference between the interest
that would have been paid on a commercial loan and what is actually earned at the
rate of the subsidies.
Duties imposed to counteract the negative impact of import subsidies to
protect domestic producers are called countervailing duties. Countervailing duties
or CVDs are often imposed on imports to compensate for export subsidies by the
foreign government. In cases where foreign producers are trying to subsidize the
goods being exported by them in order to cause domestic production to suffer as a
result of a shift in domestic demand towards cheaper imported goods, the
government makes it compulsory to pay a countervailing duty on the import of those
goods into the domestic economy. This raises the price of these goods, which again
leads to domestic goods being equally competitive and attractive. As a result,
domestic businesses are cushioned. These duties may be imposed in accordance
with the specifications given by the WTO (World Trade Organization) after the
investigation has determined that the exporters are engaged in dumping. They are
also known as anti-dumping duties.
Dumping is international price discrimination wherein the price of a product
is below the normal value of a similar product of the exporting country. Price
discrimination is usually practiced by a monopolist and refers to the demand for
different people at different prices for the same commodity. For domestic consumers,
a business may charge a higher price and for foreign consumers a lower price. This
can be seen as a barrier to trade. To consider a condition of price disparity and
dumping the following must be observed. First, the markets should be subdivided
and the distribution so easily distributed that items sold in one market have to be sold

44
in another market. Second, the price elasticity demand should be different in each
market. There are different types of dumping based on activity.
a. Persistent Dumping - A domestic monopolist is a continuous holding
company to maximize its overall profit by selling the goods on domestic markets at a
higher price than on the foreign market.
b. Predatory Dumping - This is the 'temporary selling' of a product at a
cheaper price (may be low cost) to foreign country in order to force foreign suppliers
out of business.
c. Sporadic Dumping - is the “occasional selling” of a product at a cheaper
price abroad than domestically for the purpose of unloading an unexpected and
temporary surplus of the product without having to cut domestic prices.
Trade restrictions toward predatory dumping are warranted and require
domestic industries to be protected from unfair foreign competition. Such limits
typically take the form of anti-dumping duties to compensate for price differentials or
to prevent the enforcement of countervailing duties. Through trade restrictions, they
discourage imports and promote their own products.

Chapter Exercise
1. What is a tariff, and for what reasons might a country decide to impose a
tariff on imports?
2. Distinguish between specific and ad valorem tariffs.
3. What are the two ways of calculating an industry’s effective rate of
protection?
4. Relative to generating tax revenue as tariffs do, subsidies require tax
revenue. Therefore, they are not an effective protective device for the home
economy. Do you agree?
5. If the free-trade price of a cigarette is ₱12 and a 10% ad valorem tariff is put
in place. As a result, domestic production in a small country rises from
1,000 units to 1,300 units and imports fall from 300 units to 100 units. Who
wins and loss and what is the size of their gains and losses? What is the net
effect on society?

45
 Chapter 6: Political Economy of Trade Policy

Introduction
Perhaps the best feature of the history of foreign trade and economic policy is
the ambivalence of countries in terms of trade. In the sense of global welfare as a
whole, there are benefits and drawbacks to the national character of foreign policy.
The existence, definition, and economic significance of the national borders and
those cases where policy making on economic significance is conducted at levels
other than national levels are attracted to the fact that most are determined by
member states. We recognize that countries sometimes form groups and harmonize
economic policies such as WTO, GATT and ASEAN. In several instances, policy
makers subject sub-national regions to specific policies, such as those in special
economic zones on the southern coast of China where economic activity follows a
more market-driven direction than within the country. Interregional trade shows
similitudes and disparities in foreign trade between various regions. Recent events in
the global economy remind us that countries can change even in their definitions. In
addition to the co-ordination of their economies and trade policies by some groups of
countries others disintegrate or threaten. The development of China's silk road as the
latest global trading road, for instance. Throughout this lesson we discuss the internal
political mechanisms that affect national trade policies, the history of the international
trading system and some examples of supranational and sub-national trade policies.

Learning Outcomes:
• Summarize free trade claims that goes beyond conventional trade gains.
• Point out the economic validity of common justifications for protectionism.
• Determine the reasons why economist favor preferential trade agreement and
negotiation in free trade.

Lesson 1: The Political Reality of International Trade

Free trade occurs when governments do not attempt to restrict what its
citizens can buy from another country or what they can sell to another country. Free
trade occurs when governments do not attempt to restrict what its citizens can buy
from another country or what they can sell to another country. While many nations
are nominally committed to free trade, they tend to intervene in international trade to
protect the interests of politically important groups.

46
 We have learned earlier the different issues of free trade argument. Firstly,
producers and consumers allocate resources most efficiently when governments
do not distort market prices through trade policy. However, because tariff rates are
already low for most countries, estimated benefits of moving to free trade are only a
small fraction of national income for most countries and such protection was
substantial. A second argument for free trade is that allows firms or industry to take
advantage of economies of scale. A third argument for free trade is that it provides
competition and opportunities for innovation. These dynamic benefits would not
be reflected in static estimates of the elimination of efficiency losses of producers,
caused by distorted prices and overproduction. A fourth argument, called the
political argument for free trade, says that free trade is the best feasible political
policy, even though there may be better policies in principle. Any policy that deviates
from free trade would be quickly manipulated by special interests, leading to
decreased national welfare (which will be discuss in the next module). Finally, the
effect of market failure with marginal social benefit. This concept states that
government intervention which distorts market incentives in one market may increase
national welfare by offsetting the consequences of market failures elsewhere.
Political activity is often described as a collective action problem when consumers as
a group have an incentive to advocate free trade, each individual consumer has no
incentive because his benefit is not large compared to the cost and time required to
advocate free trade.

Lesson 2: Arguments of Government on Market Intervention

There are two argument of government on market intervention aside from
trade policy. First is the Political Argument – is concerned with protecting the
interests of certain groups within a nation (normally producers), often at the expense
of other groups (normally consumers. Government requires revenue to fund the
country's needed growth and development while caring for its people to have a better
life. Then, the Economic arguments - which concerned with boosting the overall
wealth of a nation – benefits both producers and consumers.
The following are recognized as political argument for government
intervention which are necessary to address both national and interregional trade
level.
1. Protecting jobs - the most common political reason for trade restrictions.
This results from political pressures by unions or industries that are "threatened" by
more efficient foreign producers, and have more political clout than consumers.

47
 2. Protecting industries deemed important for national security -
industries are often protected because they are deemed important for national
security. Developed countries like the US restrict trade on aerospace or
semiconductors, it only allowed government to government procurement.
3. Retaliation for unfair foreign competition - when governments take, or
threaten to take, specific actions, other countries may remove trade barriers. If
threatened governments do not back down, tensions can escalate and new trade
barriers may be enacted like the US-China trade war which is risky strategy.
4. Protecting consumers from “dangerous” products – trade policy of the
government limit “unsafe” products such as drugs and medicine, fertilizer and military
hardware that may compromise the health and safety of the country.
5. Furthering the goals of foreign policy - preferential trade terms can be
granted to countries that a government wants to build strong relations with countries
whose trade policy can also be used to punish rogue states (US as the prime mover)
and the Helms-Burton Act and the D’Amato Act, have been passed to protect
American companies from such actions.
6. Protecting the human rights of individuals in exporting countries –
through trade policy actions particular example is the decision to grant China Most
Favored Nation (MFN) status in 1999 was based on this philosophy.
7. Protecting the environment – international trade is associated with a
decline in environmental quality. The concern for global warming and enforcement of
environmental regulations of the government forms part of trade negotiation, say
mining, oil exploration fishing and farming industry.
Economic argument for government intervention emerges with the
development of the new trade theory and strategic trade policy until 1980. Most
economists have seen little advantage in government action and are firmly in favor of
a free trade policy. With the development of the strategic trade policy this position on
the margins has changed and strong economic arguments continue to dominate for
the free trade position to remain in force.
1. The infant industry argument – as argued by free trade advocate, it is the
only accepted as a justification for temporary trade restrictions under the WTO. But
When is an industry “grown up”? Critics argue that if a country has the potential to
develop a viable competitive position, its firms should be capable of raising
necessary funds without additional support from the government.
2. Strategic trade policy - first mover advantages can be important to
success in with existence of substantial economies of scale and predominate in the

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export market but profitably support with only few firms. There are two components
on strategic trade policy;
a. Governments can help firms from their countries attain these
advantages through subsidies to support promising firms active in
emerging industries, for example, Boeing with substantial R&D gran
from US government.
b. Governments can help firms overcome barriers to entry into industries
where foreign firms have an initial advantage like the case of Airbus
Industries with the consortium of companies from G. Britain, France,
Germany and Spain it was able to break into the commercial aircraft
market which was dominated by Boeing.
Theoretically, strategic trade policy looks attractive, and in practice it may be
impractical. Paul Krugman argues that strategic trade policies designed to establish
domestic firms’ dominance in a global industry are beggar-thy-neighbor policies
that boost national incomes at the expense of others. Those countries that are trying
to pursue such policies are likely to provoke retaliation. Moreover, Krugman argues
that since special interest groups can influence governments, strategic trade policy is
almost certain to be captured by those groups that will distort it to their own ends.

Lesson 3: World Trading System

Until the Great Depression of the 1930s, most countries had some degree of
protectionism. After WWII, the U.S. and other nations realized the value of freer trade
and established the General Agreement on Tariffs and Trade (GATT) - a
multilateral agreement to liberalize trade under US leadership which was established
in 1948. The foundation of all world trade organization (WTO) and GATT agreements
are the principles of national treatment and nondiscrimination. National treatment is
the requirement that foreign goods are treated similarly to the same domestic goods
once they enter a nation’s markets. Nondiscrimination is embodied in the concept of
most-favored nation (MFN) status. MFN requires all WTO members to treat each
other as they treat their most-favored trading partner. Consultation among nations in
solving trade disputes within the GATT framework. The Uruguay Round of GATT
negotiations began in 1986 focusing on services and intellectual property going
beyond manufactured goods to address trade issues related to services and
intellectual property, and agriculture. It was hoped that enforcement mechanisms
would make the WTO a more effective policeman of the global trade rules.
The WTO encompassed GATT along with two sister’s organization, the
General Agreement on Trade in Services (GATS) working to extend free trade

49
agreements to services and the Agreement on Trade Related Aspects of Intellectual
Property Rights (TRIPS) working to develop common international rules for
intellectual property rights.
The E.U is also known as European Union common market. The European
Union (EU) is an economic and political union of 28 member states that are located
primarily in Europe. It was founded by the Treaty of Rome, signed in March 1957 by
West Germany, France, Italy, and Belgium. The EU is represented at the United
Nations, the WTO, the G8, and the G-20. The EU has developed a single market
through a standardized system of laws that apply in all member states. EU policies
aim to ensure the free movement of people, goods, services, and capital, enact
legislation in justice and home affairs, and maintain common policies on trade,
agriculture, fisheries, and regional development.
The North American Free Trade Agreement (NAFTA) is an agreement
signed by Canada, Mexico, and the United States, creating a trilateral rules-based
trade bloc in North America. The agreement came into force on January 1, 1994. The
creation resulted in the formation of one of the world’s largest free trade zones
thereby laying the foundations for strong economic growth and rising prosperity for
Canada, the United States, and Mexico. Since then, NAFTA has demonstrated how
free trade increases wealth and competitiveness, delivering real benefits to families,
farmers, workers, manufacturers, and consumers.
Association of Southeast Asian Nations, or ASEAN, was established on 8
August 1967 in Bangkok, Thailand, with the signing of the ASEAN Declaration
(Bangkok Declaration) by the Founding Fathers of ASEAN, namely Indonesia,
Malaysia, Philippines, Singapore and Thailand. Brunei Darusalam, Vietnam, Lao
PDR, Myanmar and Cambodia are the additional member making up what is today
the ten Member States of ASEAN with one observer – Papua New Guinea. Main
objectives of the ASEAN were to accelerate the economic growth, social progress
and cultural development in the region through joint endeavors in the spirit of equality
and partnership in order to strengthen the foundation for a prosperous and peaceful
community of Southeast Asian Nations. The association aims to promote active
collaboration and mutual assistance on matters of common interest in the economic,
social, cultural, technical, scientific and administrative fields. It also intends to
collaborate more effectively for the greater utilization of their agriculture and
industries, the expansion of their trade, including the study of the problems of
international commodity trade, the improvement of their transportation and
communications facilities and the raising of the living standards of their subjects.

50
 The South Asian Association for Regional Cooperation (SAARC) was
established in 1985, seeks to promote the welfare of the peoples of South Asia,
promote active collaboration and mutual assistance, and cooperate with international
and regional organizations. Its member countries are Afghanistan, Bangladesh,
Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka. Six observers—China,
Japan, European Union, Republic of Korea, United States, Iran. The SAARC seeks
to promote the welfare of the peoples of South Asia, strengthen collective self-
reliance, promote active collaboration and mutual assistance in various fields, and
cooperate with international and regional organizations.
The World Trade Organization (WTO) was established in 1995 as an
international institution that oversees global trade rules between nations. It
superseded the General Agreement on Tariffs and Trade (GATT) of 1947,
established in the aftermath of World War II. The WTO is based on agreements
signed by the majority of trading nations in the world. The main function of the
organization is to help producers of goods and services, exporters and importers to
protect and manage their businesses. As of 2019, the WTO has 164 member
countries, with Liberia and Afghanistan the most recent members joining in July
2016, and 23 "observer" countries. Generally, WTO function as;
1. The WTO oversees global trade rules among nations.
2. The WTO has fueled globalization with both positive and negative effects.
3. The main focus of the WTO is to provide open lines of communication
concerning trade among its members.

The WTO is essentially an alternative dispute or mediation body that upholds

international trade rules between nations. The organization provides a platform for
member governments to negotiate and resolve trade issues with other members. The
main aim of the WTO is to provide open lines of communication on trade between its
members. For example, the WTO has lowered trade barriers and increased trade
between member countries. On the other hand, trade barriers have also been
maintained when it makes sense to do so in a global context. The WTO is therefore
seeking to mediate negotiations that will benefit the global economy. Once the
negotiations have been concluded and an agreement has been reached, the WTO
will then offer to interpret the agreement in the event of a future dispute. All WTO
agreements include a settlement process in which the organization is legally
engaged in a neutral conflict resolution process. Without the basic WTO agreements,
no negotiation, mediation or resolution would be possible. These agreements set out
the legal basis for international trade under the supervision of the WTO. They bind

51
the government of a country to a set of constraints that must be observed when
setting up future trade policies. These agreements protect producers, importers and
exporters while encouraging world governments to comply with specific social and
environmental standards.
Advantages and Disadvantages of WTO
1. It fueled globalization with both positive and adverse effects.
2. Have increased global trade expansion.
3. Organization is beneficial to business and the global economy.
4. Negative impact on local communities and human rights.
5. WTO undermines the principles of organic democracy and widens the
international wealth gap.
6. U.S. withdrawal from the WTO could disrupt trillions of dollars in global
trade that would be a total disaster.
In the 1980s and early 1990s protectionist trends emerged, but which
industries are protected? Agriculture in the US, Europe and Japan farmers make up
a small fraction of the electorate but receive generous subsidies and trade protection.
Examples are the European Union’s Common Agricultural Policy, Japan’s 1000%
tariff on imported rice, America’s sugar quota. Then, the clothing industry including
textiles (fabrication of cloth) and apparel (assembly of cloth into clothing). Import
licenses for textile and apparel exporters are specified in the Multi-Fiber Agreement
between the US and many other nations.

Chapter Exercise
1. Do you think governments should consider human rights when granting
preferential trading rights to countries? What are the arguments for and
against taking such a position?
2. The Philippines was targeting to be the prime mover in rice production
through its development of International Rice Research Institute, why is it that
until today we are importing rice? What happen to protectionist trend?
3. Which argument of government intervention do you feel relevant today? How
can this intervention be useful in welfare enhancing?
4. What is meant by favored nation clause? Do you agree that CHINA is the
favored nation by ASEAN and WTO? Explain your answer.
5. According to Paul Krugman, government pursuing the beggar-thy neighbor
policy must expect retaliations from trade or other form. Why?

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 Chapter 7: Growth, Development and Trade

Introduction
There has been a long and serious discussion between economists and
policy makers about which kinds of policies promote economic growth and the
development of economy. In order to solve the challenges of economic growth and
mobility, we expand our basic trade model. When more complex factors, such as
economic growth, are added, the basic characteristics of the world economy,
including the pattern of comparative advantage, may change over time. Changes can
drastically alter both the structure of trade and government trade policies. The
perspective is unique from that of a policymaker involved in fostering economic
development. In particular, we are interested in the trade-related effects of growth
rather than how to achieve it. We will look into the pursuit of growth and development
through trade from the viewpoint of developing countries.

Learning Outcomes:
• Discuss the bias in economic growth and its impact to growth and
development in trade.
• Evaluate areas of disagreement on growth and development of developed
and developing country.
• Explore the effect of trade in growth and development of the country.

Lesson 1: Economic Growth and Trade

Economic growth is a complex phenomenon, particularly when viewed as an
objective of economic policy making. A country’s forward shift that allows to produce
larger quantity of more goods with less cost is called economic growth. Types of
growth are:
a. Endogenous growth - these new approaches to growth recognize knowledge
or ideas as an input, along with capital and labor, into an economy’s ability to
produce goods and services. Example innovations, inventions and technology
development.
b. Balanced growth – refers to a relative increase of the country’s labor-force
participation and per capita consumption.

Lesson 2: Interrelation of Growth and Trade

Economic growth leads to a different pattern of trade, based on the following:

53
 1. Export-led growth: It is where a large portion of the growth of real GDP,
jobs and per capita income flows from productive exports of goods and services from
one country to another. Countries like Ireland, China, Singapore and Hongkong are
the best example. There are advantage and disadvantages of export-led growth.
a. Increase per capita income and reduce extreme poverty, especially in
developing / emerging economies
b. Boost capital investment spending and potential export.
c. Increased investment and employment in trade insurance, logistics and port
facilities.
d. Exporting lead to overdependence of economic cycle of trade
e. Persistent trade surplus may result to protectionism
f. Export focus of production deprived domestic needs and wants
g. Rapid export-led growth could lead to higher inflation and higher interest rates
h. Growth is unsustainable
2. Biased economic growth: The unequal economic growth where a
production of other good is more favored in terms of trade.
a. Import-biased growth: supports production of imported goods
b. Export-biased growth: excessive production of export goods
3. Technical Progress: the increase in the productivity of labor, capital or
both.
a. Neutral Technical Progress: firm’s capital-labor ratio is unchanged
b. Capital-saving technical progress raises the marginal productivity of
labor relative to that of capital.
c. Labor-saving technical progress involves an increase in the marginal
product of capital relative to that of labor.

Lesson 3: Economic Development and Trade

Economic development refers to economic growth accompanied by changes
in output distribution and economic structure.
Approaches to Development
1. Free Market approach: rely of the allocation role of markets and limited
government involvement in economics. There are several areas in which markets fail
to achieve efficient outcomes on income distribution, public goods, trade relations
and market power.
2. Market-friendly approach: improve market operation through
“nonselective” interventions such as income redistribution system, investment in
social and human capital, environmental protection policy and anti-trust laws.

54
 3. Public-choice approach: public officials and bureaucrats in the position of
authority are “rent-seeking” citizens acting on self-interest rather than public-interest.
Trade theory and Development: The Traditional Arguments
Economic advocates of free trade summarized the five basic issues with
particular importance for the developing nations.
a. Trade which stimulates economic growth
b. Trade promotes international and domestic equality
c. Trade promotes and rewards sectors of comparative advantage
d. International prices and costs of production determine trading volumes
e. Outward-looking international policy is superior to isolation

Lesson 4: Trade Theory and Economic Development Strategy

With the arguments on trade theory, some set of conclusions on trade theory
and economic development were identified grounded on the diversity of developing
countries.
1. Trade can lead to rapid economic growth under some circumstances
2. Trade seems to reinforce existing income inequalities
3. Trade can benefit less developed countries (LDCs) if favored by
developed countries
4. Generally, less developed countries must trade
5. Active participation in regional cooperation may help LDCs
Trade Strategies for Development
Traditional approach on the issues of appropriate trade policy for
development is between export promotion (outward-looking development policy) and
import substitute (inward-looking development policy).
Export Promotion (EP) policy claims that with limited demand of primary
commodity except for petroleum and few minerals provide majority earnings for low-
income countries. The following factors slow down the rapid expansion of primary
commodity demand in developing countries.
1. Low income elasticities
2. Low population growth rates in developing economies
3. Decline in prices implies low revenue
4. Lack of success with international commodity agreements
5. Development of synthetic substitutes
6. Agricultural subsidies
Following an import-substitution development strategy, which involved
extensive use of trade barriers to protect domestic industries from import competition,

55
stressing economic self-reliance for developing countries? Import substitution focus
on three areas of political and economic strategy.
1. Tariff
2. Infant industry protection and subsidy
3. other forms of protection such as ban on foreign ownership of firms
Several factors led to the perceived failure of the import substitution strategies
of developing countries.
a. Protected industries get inefficient and costly
b. Foreign firms benefit more
c. Subsidization of imports of capital goods tilts pattern of industrialization and
contributes to BOP problems
d. Overvalued exchange rates hurt exports
e. Does not stimulate self-reliant integrated industrialization
Sometimes developing countries want developed ones to change their
policies or want international organizations to allow them special privileges because
of the difficult development tasks they face. Development strategy focus on three
areas of disagreement and negotiation concern agricultural policy, technology-
transfer and intellectual-property issues, and the environment.

Lesson 5: Debts for Development

The debts owed by developing economies mostly external debts affect
relations between developed-country creditors and their developing-country debtors
and its inability to pay interest and principal threatened stability of world financial
institution.
A country’s external debts can be classified according to:
1. Time horizon can be divided into short-term and long-term; its creditor is
the international monetary fund or IMF.
2. Debtor: mostly offer in long-term debts. Private– nonguaranteed debts
and Public or publicly guaranteed debts
3. Creditor: Official creditor (official debt) and Private Creditor (commercial
or market debt)
4. Borrowing: Debt instrument thru Bonds and Bank loans
Equity Instrument – Foreign Direct Investment (FDI) and
Portfolio Equity
The trade-oriented aspects of developing countries’ lead to debt problems—

56
contributed by the following factors; 1) how one measures the debt; 2) fundamental
rules of sound debt management; 3) policy responses to the debt crisis of the 1980s.

Chapter Exercise
1. What is export biased growth and import biased growth? Where can you
place our country between the two? Explain.
2. Briefly describe some major areas of disagreement between developing and
developed countries over international trading system.
3. According to economic studies, growth and economic development of the
country is debt-driven, what does it mean? Substantiate your answer.

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 Chapter 8: Currency Market and Exchange Rate

Introduction
To determine how prices in the home currency are converted to prices in the
foreign currency, each country must opt for an exchange rate system. Many
countries bind the currency to a fixed standard, while others allow their value to be
dictated by market forces. There are advantages and disadvantages of both
approaches. The selection of an exchange rate system ranges from completely set
without variability to totally dynamic, with adjustments dictated minute by minute by
supply and demand for the country's currency. There are several other systems with
semi-fixed or semi-flexible rates between these two extremes.
Each exchange rate system needs to have credible policies in place that
support the selected system, as trading, capital flows and other global economic
pressures push currencies up and down. In this module, we define the agents on
currency markets and analyze the basic mechanisms that determine the value of a
currency in one country and discuss how countries should choose their currency
system. Each of these elements determines the exchange rate system of the country
and its currency value.

Learning Outcomes:
• Describe the structure and functions of the foreign exchange market.
• Differentiate the short-run, medium-run and long-run forces that determine the
value of a currency.
• Relate exchange rate changes to changes to the relative prices of countries
exports.

Lesson 1: The Foreign Exchange Market

We need money from that country for the purchase of goods and services
produced in another country. The foreign currency includes foreign bank notes,
coins, and bank deposits. In the foreign exchange market, we get foreign currency.
The foreign exchange market is the market where the currency of one country is
exchanged for the currency of another. It also refers to an organization of individuals,
businesses, governments and banks, who facilitate foreign currency and other debt
instruments purchases.

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 Function / Reasons for Holding Foreign Currencies
1. Fund Transfer: It convenes the transfer of funds and purchasing power from one
nation and currency to another as foreign exchange is demanded to
exchange commodities between nations. It is realized through the inflow and
outflow of money by exports and imports.
2. Credit for Trade: The flow of gods and services across countries demand
sufficient financial support. Through various monetary instruments like
external commercial borrowing, Eurobonds, foreign bonds etc. foreign
exchange market performs this function effectively.
3. Hedging and Speculation: Exchange rate risk is very fundamental to the foreign
exchange market. The market itself offers ways to reduce or avoid it. Hedging
means the measures adopted for avoiding risks. But speculation is an open
position in the market with an expectation of gains through the fluctuations.

Four main groups involved in foreign currency markets:

a. Retail customers/Individuals: firms and individuals that hold foreign
currency
b. Commercial banks: hold inventories of foreign currencies as part the
services to customer; most important of four participants
c. Foreign exchange brokers: middlemen between buyers (banks) and sellers
of foreign currency
d. Central banks: a country’s overall financial/fiscal regulating agency

Lesson 2: Exchange Rate and Risk

Exchange Rate refers to the price of one currency stated in terms of a second
currency. It is somehow confusing as it is express in one or two ways;
a. as unit of domestic currency per unit of foreign currency; example, Philippine
Peso – US Dollar exchange rate as peso per dollar which ₱0.020
$1= ₱50 thus, 1/50 =0.020
b. as US dollar per unit of foreign currency; $1=¥120 (US dollar-Japanese yen)
A fall in the value of one domestic currency in terms of another currency is
called currency depreciation, say, you need ₱60 to buy $1. While a rise in value of
one domestic in terms of another currency is called currency appreciation: you only
need ₱20 to buy $1. Most traded currencies are: European Union’s euro, Japanese
yen and British pound which has flexible exchange rates and subject to constant
fluctuation value per unit.

59
 Exchange rate risks refer to currencies which are constantly changing in
value either up or down. There are three types of Exchange Rate Fluctuations.
1. Forward exchange rate: The price of currency that will be delivered in the future.
For example, a Canadian company is purchasing computer equipment worth
100,000 dollars from Japan for 90 days. Current exchange rate is ¥360 is equal a
Canadian dollar, if the selling price is agreed on the yen exchange rate for the
dollar no guarantee is given that in ninety days the Canadian dollar is paid in the
amount of 360 yen. Assume that the exchange rate is 350 yen for a dollar. Then
the Canadian dollars received will only yield ¥35 million instead of the expected
¥36 million a loss of 3% to the Japanese company if there is no agreement to
settle the difference. But traders agreed flexible terms of agreement, such as the
counterparty shall compensate the exporter for paying the difference between the
flat rate and the exchange rate currently applicable to the exporter in equal
measure. Take note further that if the US dollar has strengthened instead of
weakening, then the exporter would have made the payment to the counterparty.
2. Forward market: A market in which the buying and selling of currencies for future
delivery takes place. It eliminates risk from future payments since contract is
signed the day they agree to ship/receive goods that guarantees price for 30, 90,
or 180 days. Note: a similar example above but without agreement to settle the
difference to compensate the buyer or seller for a premium or discount upon
maturity of the contract.
3. Spot market: Buying and selling of foreign currencies in the present. For instance,
Mr X want to buy Adidas from S. Korea, and the company wants Mr X pay KRW
5,000. If the Phil. Piso-S. Korean exchange rate as of this moment is KRW 24.37-
₱1, therefore Mr X will exchange of ₱205.170 to KRW equivalent to KRW 5, 000 in
order to pay the adidas shoes he ordered at the S. Korean company.
Exporter and importer are the real client of the market, the following tools are
important to financial investor in the absence of significant exchange rate intervention
where exchange rates fluctuate significantly over time.
Hedging: Use forward market to protect them against foreign exchange risk
while holding foreign assets. This is done by buying forward contract to sell foreign
currency at the same time the interest earning asset matures. For instance, a U.S.
company will receive 25 million British pounds in three months, so the company sells
futures for delivery in 90 days. If the pound depreciates against the dollar, the
expected amount is protected. However, if the pound appreciates, the company won’t
make any profit from the favorable exchange rate.

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 Covered interest arbitrage: Use of forward market by an interest rate broker
against exchange rate risk. Suppose the spot rate is ¥100/$1. Converting $1,000 at
this rate yields ¥100,000. If interest rates in Japan are 8% vs. 5% in the U.S., in one
year the funds in Japan will earn ¥8,000 vs. $50 in the U.S. If a forward contract to
sell ¥108,000 was initially signed at the rate of ¥101/$1, it will obtain a $1,069.31.
This is greater than the $1,050 that would have been obtained in the U.S.

Lesson 3: Supply and Demand of Foreign Currency

Demand in the Foreign Exchange Market: The quantity of U.S. dollars that
traders plan to buy in the foreign exchange market during a given period depends on
1. The exchange rates
2. World demand for U.S. exports
3. Interest rates in the United States and other countries
4. The expected future exchange rate

The Law of Demand for Foreign Exchange: Other things remaining the same,
the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in
the foreign exchange market. The exchange rate influences the quantity of U.S.
dollars demanded for two reasons:
a. Exports effect: The larger the value of U.S. exports, the greater is the quantity of
U.S. dollars demanded on the foreign exchange market.
b. Expected profit effect: The larger the expected profit from holding U.S. dollars,
the greater is the quantity of U.S. dollars demanded today.

Supply in the Foreign Exchange Market: The quantity of U.S. dollars supplied
in the foreign exchange market is the amount that traders plan to sell during a given
time period at a given exchange rate. This quantity depends on many factors but the
main ones are:
1. The exchange rates
2. U.S. demand for imports
3. Interest rates in the United States and other countries
4. The expected future exchange rate
The Law of Supply of Foreign Exchange: Other things remaining the same,
the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in
the foreign exchange market. The exchange rate influences the quantity of U.S.
dollars supplied for two reasons:
a. Imports effect

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 b. Expected profit effect

Lesson 4: Causes of Exchange Rate Fluctuation

Purchasing power parity (PPP): a long run fluctuation where the equilibrium
value of an exchange rate is at the level that allows a given amount of money to buy
the same quantity of goods abroad as it will buy at home.

Cost of the Same Basket of

Goods in Each Country
Price in peso ₱ 1,000
Price in dollar $ 20
Long-run equilibrium exchange rate ($ 1, 000/$20) = ₱50/$

Absolute PPP: measured by comparing price of one good across in different

currency. For example, if one kg of banana costs ₱50 in our country and similar
quality of banana costs ₱1 dollar in US, then the PP exchange rate would be ₱50 per
US dollar.

Drawbacks with PPP Theory

The major problem with the PP theory is that the PP condition in a country is
rarely satisfied. These are the following reasons;
a. Transportation cost and trade restrictions
b. Cost of non-tradable inputs
c. Perfect information
d. Other market participants

While purchasing power parity is working steadily in the background, other

forces have more immediate impacts on the position of the supply and demand
curves for foreign exchange correlated to business cycle. The medium run forces
such as country’s economic growth related to increases incomes, increases demand
for imports and an outward shift in the demand for foreign currency, thus reduces the
currency value or devaluation. on the other hand, a growth abroad as results in an
increase of exports and an increase in the supply of foreign currency which makes
the currency more expensive or revaluation.

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 Short run foreign exchange fluctuation (a year or less) effects on the
exchange rate stem from financial capital flows. These flows are determined by (1)
interest rates and (2) expectations of future exchange rates.
Interest Parity: the difference between any two countries’ interest rates is
equal to the expected change in the exchange rate as illustrated below.
If i = i*, investors are indifferent
If i > i*, investors prefer home to foreign investment
Best choice is also determined by exchange rate movements during the
period similar to the illustration in covered interest arbitrage. For future exchange rate
or speculation: the acceptance of foreign exchange risk in the hope of making a
profit. Assume that speculator expects the spot rate in three months’ time to be
$1/€1, she may sell euros at a current three-month forward rate of $1.10/€1 with the
expectation that she will be able to buy euros to cover her sale at the lower spot rate.
Condition between the forward exchange rate (F) and the spot rate (R) is expected
appreciation or depreciation:
F > R: home currency expected to depreciate and is selling at a discount
F<R: home currency expected to appreciate and is selling at a premium
However, say, i < i* and F = R: no changes are expected in the exchange rate, and
investors should invest in foreign. To achieve equilibrium, processes in economy
continue until interest parity condition is reached, where:
i – i* = (F-R)/R
Interest rate differentials are approximately equal to expected changes in the
exchange rate. The utility of the interest parity condition is that it brings together
capital flows, domestic interest rate policy, and exchange rate expectations.

Lesson 5: Exchange Rate Policy

Foreign prices ultimately determine the purchasing power of the domestic
currency in terms of the foreign currency.

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 Real exchange rate: the market exchange rate (nominal exchange rate)
adjusted for price differences between countries. There are three possible exchange
rate policies since real exchange rate plays an important role in international
macroeconomic relation.
Fixed exchange rate system: The value of a nation’s money is defined in terms of a
fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar); the
Gold standard exchange rate system.
Flexible (floating) exchange rate system: The value of the currency is
allowed to float up and down with market forces.
Crawling Peg: an exchange rate that follows a path determined by a decision
of the government or the central bank and is achieved by active intervention in the
market. Example, China is a country that operates a crawling peg.
Purely fixed or floating systems today are rare because some governments
may choose to have a "floating" ("floating") or "crawling" peg allowing the
government to re-evaluate the value of the peg on a periodic basis and then to
modify its peg rates accordingly. This usually causes devaluation, but it is controlled
to prevent market panic. The most important rule for countries is that their exchange
rate system is credible.

Lesson 6: Expanding Exchange Rate Systems

Currency board: a monetary authority that issues note and coins convertible
into aforeign anchor currency at a fixed exchange rate. Sole function is to exchange
its notes and coins for the anchor at a fixed rate, no discretionary power and
operates completely passive and automatic.

Dollarization: occurs when a country chooses to use another currency

especially strong currency, say using the U.S. dollar instead of Piso.
a. Partial dollarization: country holding dollar denominated bank deposits
or Federal Reserves Bill to protect against high inflation of domestic
currency.
b. Full dollarization: elimination of the domestic currency and its
complete replacement with the US dollar.
Single Currency: optimal currency areas within geographical regions like the
Eurozone and Brexit. The criteria for an optimal currency area are a synchronized
business cycle, complete factor mobility, regional programs for lagging areas, and a
desire to achieve a higher level of economic and political integration.

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Chapter Exercise

1. Which of the three reasons for holding a foreign exchange applies to each of the
following?
a. A tourist
b. A bond trader
d. A manufacturer
2. How can countries address currency market pressures in a fixed exchange rate
regime, which seek to decrease or increase the value of its currency?
3. Angel Locsin has received two job offers since ABS-CBN is no longer airing. A job
in Milan which pays €85,000 a year. A job in Boston which pays $104,000 a year.
The exchange rates were £1 = $1.42 and £1 = €1.25. Which job offer has the
highest salary? Show calculation to explain your answer
4. While you were visiting Japan, you want to buy a high-end gaming Laptop for
¥350,000, payable in three months. You have enough cash at your bank in BDO,
which pays 0.5% per month, compounded monthly, to pay for the car. The current
spot exchange rate is ¥2.15/₱ and the three-month forward exchange rate is
¥1.85/₱. In Japan, the money market interest rate (not annual) is 3.10% for a
three-month investment. Which course of action you will take:
a. Keep the funds at your bank in BDO and buy ¥350,000 forward.
b. Buy a certain Yen amount at the spot rate today and invest it in Japan for three
months so that maturity value would cover the payment you need to make for
your Laptop. Which method would you prefer? Why? Show your work.

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 Chapter 9: The Balance of Payments Account

Introduction
This chapter describes the accounting system used to track financial
transactions of a country. Individuals and governments must keep track of all their
financial relations with the rest of the world. We call this a balance of payment (BoP)
account a record of any money transactions that move to or from a country over a
long period of time. The balance of payments appears to be a broad subject, but
once you have come to know the particular elements of trade and wealth, everything
makes sense.
Components of international transaction are in three separate accounts: the
current account, the capital account and the financial account. For most nations, the
capital account is relatively small, with the current and financial accounts being the
two major accounts. One of its primary objectives is to consider the accounting
relations between domestic investments, domestic savings and international flows.
We will also explore the characteristics of international indebtedness and discuss its
implications through international accounts.

Learning Outcomes:
• Compare and contrast Balance of Trade and Balance of Payment
• Apply national income accounting to the interaction of saving, investment and
net exports.
• Relate the current account changes to changes in country’s net foreign
wealth.

Lesson 1: Balance of Trade and the Balance of Payment

The balance of trade (or trade balance) is any gap between a nation’s dollar
value of its exports, or what its producers sell abroad, and a nation’s dollar worth of
imports, or the foreign-made products and services that households and businesses
purchase. Recall from The Macroeconomic Perspective that if exports exceed
imports, the economy is said to have a trade surplus. If imports exceed exports, the
economy is said to have a trade deficit. If exports and imports are equal, then trade is
balanced. But what happens when trade is out of balance and large trade surpluses
or deficits exist?
Factors that can affect Balance of Trade
1. Exchange rates

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 2. Trade agreements or barriers
3. Other tax, tariff and trade measures
4. Business cycle at home or abroad.
The main purpose of the Balance of Payment is to inform the Government of
the international economic position of the nation and to help in formulating its of
monitory, fiscal and trade policies. The Balance of Payment account have significant
role in an open economy. An open economy is one which has economic relations
with the rest of the world. An economic transaction is an exchange of value, involving
a payment or receipts of money in exchange of a good, a service or an asset for
which payment is made between the resident of a country with resident of the rest of
the world. Balance of Payment includes:
a. Trade in goods
b. Trade in services
c. The net flow of investment income from India overseas assets
d. Transfers of money between people and governments
(a) to (d) comprises the Current Account

If the exchange happens between residents of two countries, that transaction

is an International economic transaction. An international economic transaction is
systematically recorded in the books of accounts of balance of payments. Balance of
payments are maintained in a ‘Double entry book keeping principle’ - the principle in
each transaction is the balance of payments entered as a Credit or a Debit entry. The
context of the double entry accounting principles includes all income contributing to
the total national income.
Simple depiction on the difference of BoT and BoP

Differences between Balance of Trade and Balance of Payments

1. Balance of Trade is the difference in the monetary values of a country’s
export and import whereas Balance of Payment is the difference in the
monetary values of transactions within the country and the rest of the world.

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 2. Balance of Trade is also known as commercial balance or net balance
whereas Balance of Payments is also known as Balance of International
Payments.
3. The former is abbreviated as NX and the latter is abbreviated as BOP or
B.O.P.
4. Currencies of traded countries are involved in calculating the Balance of
Trade whereas the currency of that particular country is involved while
estimating the Balance of Payments.
5. The country exports more when there is a trade surplus and the country’s
currency start appreciating when there is a BOP surplus. Both surpluses
boost the country’s economy with enhanced internal production or services.
6. NX is formulated as Country’s (Export-Import) whereas BOP is formulated as
Country’s Fund flow (Within the country – rest of the world).
7. If there is a deficit in the Balance of Trade, then it is better to save more
&consume less foreign goods to bring it to surplus. Similarly, when there is a
deficit in BOP, supporting healthy competition within the local manufacturers
or industry can help to improve it.
8. The government usually imposes a higher import tax to reduce the imports
and thus to improve the Balance of Trade. Also, an encouragement to use
domestically manufactured goods can improve BOP.
9. The net effect of the former can be positive or negative or zero whereas the
latter is always zero.

Lesson 2: Economic Effect of Balance of Trade

Listed below is the Economic Effect of Balance of Trade:
1. Negative impact on aggregate demand represented by the formula
C+I+G+(X-M) may result to fall in national output – multiplier effect on
incomes and spending, could trigger an economic slowdown / recession
ultimately actual GDP will fall below potential GDP (negative output gap).
2. Negative effect on company profits and business confidence: example, less
demand implies less capital investment, can lead to plant closures / job
losses / cyclical unemployment
3. Government finances will be affected resulting to slower growth hits tax
revenues + extra welfare spending
4. Export earnings are an infusion of aggregate demand - A rise in exports
boosts national income.

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 5. Employment effects from exports: directly or indirectly, changes in export
demand have effects in other sectors further down the supply chain (e.g.
component suppliers for manufacturers and also the distribution and
marketing industries)
6. Regional economy and exports: Some regions are more dependent on
exports than others

Lesson 3: Double Accounting System

On Balance of payments it includes, record of the economic transactions
between the residents of one country and the rest of the world and uses the double-
entry accounting system. For International transaction – the account on exchange of
goods, services, or assets between residents of one country and those of another.
While Residents includes businesses, individuals, and government agencies that
make the country in question their legal domicile. Credit transaction is a positive
entry represented by receipt of a payment from foreigners, on the other hand debit
transaction is a negative entry through payment to foreigners.
Credit transaction (Inflow) includes the following: Merchandise exports,
Transportation and travel receipts, Income received from investments abroad, Gifts
received from foreign residents, Aid received from foreign governments, Investments
in the Philippines by overseas residents.
Debit transaction (Outflow) represents the : Merchandise imports,
Transportation and travel expenditures, Income paid on the investments of
foreigners, Gifts to foreign residents, Aid given by the Philippine government and
Overseas investment by Filipino residents.
The effect of BoP to the national economy: If positive (credit), there is surplus
of goods and services transactions and it will be added to GDP, on the other hand, if
negative: a deficit of goods and services transactions thus, a deduction point of the
GDP.
According to the Double entry book keeping principle, for each Debit entry a
corresponding Credit entry is made to keep the balance of payment always in
balance including total trade balance. Problems arise since, theoretically importers in
a country pay the exporters in that same country in the national currency but in
reality, importers and exporters in a given country do not deal directly with one
another to facilitate payments, it is the banks who carry out these transactions.
Example of international payment transaction process presented below.

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 Current Account
The current account includes exports and imports of goods and services &
unilateral transfers. Exports, weather it is goods or services are by convention
entered as a credit items in the account. Imports are normally calculated free on
board. That means that the cost of transportation, insurance etc. are not included.
Imports are normally calculated CIF (cost, insurance, freight). Transportation,
insurance cost and freight are included. In the current account of Balance of payment
accounts, we have a visible part of commodities and Invisibles part of Services.
Invisible trade is much more heterogeneous than the trade in goods. Trade in the
latter, of which shipping, banking and insurance services and payments by residents
as tourists abroad are usually the most important, Exports and imports of such
services are flows of outputs whose values will be determined by the same variable
that could affect the demand on supply for goods unilateral transfer or transfer
payments.

Unilateral transfers are receipts which the residents of a country receive for
free, without making any present or future service transaction in return. Unilateral
receipts from abroad are entered as positive items and they are credited. Unilateral
payments abroad are entered as negative items and they are debited. Unilateral
transfers may be private unrequited transfers, which may be in the form of gifts
received by domestic residents from foreign residents. Secondly official unrequited
transfers, is the payment of pure aid by governments in developed countries to
government in less developed countries (LDCs). A third form of unilateral transfer
has been important reparation payments. Typically, such payments occurred when a
morally and physically superior country came out of war and was in a position to
make the foreign country or its former enemy pay indemnities.

The net value of the balance of visible trade and invisible trade and of
unilateral transfers defined the balance on current account. It is, however, services

70
and transfer payments or invisible items of the current account that reflect the true
picture of the balance of payments account. They, along with the visible items,
determine the actual current account position. If export of goods and services exceed
import of goods and services, the balance of payments is said to be favorable. In the
opposite case, it is unfavorable. In the current account, the exports of goods and
services and the receipts of transfer payments are entered as credit because they
represent the receipt from foreigners. On the other hand, the imports of goods and
services and transfer of payments to foreigners are entered as debits because they
represent payments to foreigners.

Capital Account

The capital account records all international financial transactions that involve
resident of the country concerned- changing either his assets with or his liabilities to
a resident of another country. Transactions in the capital account reflect change in a
stock – either assets or liabilities. It is often useful to make distinctions between
various forms of capital account transactions. The basic distinctions are between
private and official transaction; between portfolio and direct investments. Distinction
between private and official transaction is fairly transparent and need not concern us
too much. On the other hand, portfolio investments are the acquisition of an asset
that does not give the purchaser control over it. An example is the purchase of
shares in a foreign company or of bonds issued by a foreign government. Loans
made to foreign firms or governments come into the same broad category. Foreign
Direct investment (FDI) is the act of purchasing an asset and at the same time
accruing control of it. The acquisition of a firm residing in one country by a firm in
another country is an example.

The purchase of an asset in another country whether it is direct or portfolio

investment, would appear as a debit item in the capital account for the country of the
firm which purchase it and as a negative item in the capital account for the other
country. The capital account outflows appear as a debit item in country’s balance of
payments and capital inflows as credit items. The net value of the balance of direct
and portfolio investment defines the balance on capital account.

Statistical discrepancy means the errors and omissions, which reflect

transactions that have not been recorded for various reasons and cannot be entered
under a standard heading. Balance of payments is constructed as an accounting
identity with each transaction theoretically recorded twice, the sum total of debits and

71
credits should in theory always be equal. That means that if a debit entry is made to
record an outflow of value, a corresponding credit entry is to be made in some other
part of the books of account for theoretically maintaining balance in the books of
accounts of the balance of payments. However, one or other of the parts of
transaction takes more than one year. discrepancy may arise and the Balance of
payment may not balance

Official Reserve Account

The official reserves account measures the changes in the official reserves
and changes the foreign official assets in the country during the year. Official
reserves consist of gold, Special Drawing Rights (SDRs) borrowed from the IMF, and
holding of foreign convertible currencies. The changes in the country’s reserves must
reflect he net value of all the other recorded items in the balance of payments. These
changes will of course be recorded accurately, and it is the discrepancy between the
changes in reserved and the net value of the other recorded items that allows
identifying the errors and omissions.

Increase in official reserves represents capital outflows from the country and
are recorded as debits in the official reserves’ accounts of the books of accounts of
Balance of Payments of the country. Any decrease in the official reserves is recorded
as capital inflows and are credit entries in the reserves accounts of the books
accounts of Balance of Payments of the country. The entries are similar to that of
private capital but we are here dealing with the official capital.

Lesson 4: Policy Approach to Correct Imbalance of Balance of Payment

A continuous imbalance in the balance of payments, particularly a deficit in
balance of payments, is undesirable because it (a) weakens the country’s economic
position at the international level, and (b) affects the progress of the economy
adversely. It must be cured by taking appropriate measures. There are important
measures to correct disequilibrium in the balance of payments that the policy maker
should adopt.
1. Depreciate the value of their currency to enable exports to be cheaper and
imports to be more expensive.
2. Protectionism – restriction of imports, (embargo, tariffs, quotas etc) – WTO
may step in.
3. Expenditure policy – reduce overall expenditure including imports.
4. Encouraging people to buy locally produced products.

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 5. Attempt to devalue currency to make imported products more expensive and
exports more attractive to overseas buyer.
6. Broader expenditure reduction policies – reducing aggregate demand.

Relationship between Balance of Payments and National Income

Accounting
a. National income ; Y = GDP = C + I + G + (X – M)
where; (Y), or gross domestic product (GDP) is equal to the sum of the
nominal consumption (C) of goods and services, private investment (I),
government spending (G), and the difference between exports (X) and
imports (M)
b. Private savings is defined as the amount left from national income after
consumption and taxes (T) are paid, where,
S = Y – C – T or
S = C + I + G + (X – M) – C – T
Notice that, Balance on Current Account is BCS=(X-M) , we can rearrange
the last equation as
(S – I) + (T – G) = X – M = BCA
Interpretation: This shows that there is an intimate relationship between a
country’s BCA and how it finances its domestic investment and pays for government
spending. If (S – I) < 0 then a country’s domestic savings is insufficient to finance
domestic investment. Similarly, if (T – G) < 0, then tax revenue is insufficient to
cover government spending and a government budget deficit exists. When BCA < 0,
government budget deficits and or part of domestic investment are being financed by
foreign-controlled capital. To reduce a BCA deficit, one of the following must occur:
a. For a given level of S and I, the government budget deficit (T – G) must be
reduced
b. For a given level of I and (T – G), S must be increased
c. For a given level S and (T – G), I must fall.
c. The Current Account and Foreign Indebtedness
Recall the Balance of Current account (BCA) formula: BCA = X – M

BCA measures the size and direction of international borrowing. If we import

more than we export (BCA<0), we must pay for the difference by borrowing from
foreigners. BCA equals the change in a country’s net foreign wealth. BCA balance is
equal to the difference between national income and domestic residents’ spending or
absorption:

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 Y – (C+ I + G) = BCA

BCA balance is what we produce (Y) less domestic demand. We can live
“beyond our means” if we run a current account deficit, import more than we export,
and borrow the difference from foreigners. BCA balance is the excess supply of
domestic financing., thus, if we produce and earn more than domestic demand
(BCA>0), we lend our “excess” saving to foreigners.

d. Sources of Income = Uses of Income

C + I + G + BCA = T + Sp + C

I = Sp + (T – G) – BCA = Nat’l Saving + Capital Inflows

Domestic investment is financed by our own saving plus our net “borrowing”
from foreigners becomes our national borrowing or Nat’l Borrowing = - CA = (I - Sp) +
(G – T). Eventually, a greater borrowing lead to the so called twin deficit effect of
private saving Sp and government saving Sg , thus:

Private Saving (Sp ) and Government Saving (Sg )

Sp = Y – T – C = I + CA – (T – G) = I + CA – Sg

Sp = I + CA + (G – T)

Note: Private saving finances domestic investment, net foreign investment,

and the government’s deficit

Lesson 5: International Debts

Most countries either rich or poor experience current account deficit.

Persistent current account deficit is finance with inflow of capital from foreign direct
investment, stock purchases, bond currency and loans. When this is not enough
government resort to lending to finance a fiscal deficit. Common sources of assets for
lending are treasury bonds, government bonds. The investors lend the money in
order to purchase the assets in the expectation that interest will be paid on the
investment and then also a later date they will also get all their money back. Loans
from abroad add to a country’s stock of external debt and generate debt service
obligations requiring interest payments and repayment of the principal (presented in
Chapter 7). Externa debts are debts that are payable in foreign currency, with
different time horizon, creditor, debtor and terms of borrowing. Borrowed funds must
be used for growth and development as suggested by some economic theorist, but
the reality it does not contribute to expansion of skill and production level and often

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debt service becomes an unsustainable burden that holds back economic
development. Reasons for unsustainable debts servicing are identified based on the
following:

a. countries are dependent on exports of one or two basic commodities such

as oil or copper

b. shock of sudden drop of commodity prices reduces value of exports

c. natural disaster need for relief, foreign assistance and civil/arm conflicts
hinders growth and development

d. misguided policy: Public choice, corruption etc

e. pressure from foreign lenders to deliver the condition set in granting

borrowed funds.

A nation runs a current account deficit, it borrows from abroad and adds to its
indebtedness to foreigners, while a country that runs a current account surplus, it
lends to foreigners and reduces its overall indebtedness. If the total of all domestic
assets owned by foreigners is subtracted from the total of all foreign assets owned by
residents of the home country; the result is the international investment position. The
possibility to counter current account deficit is under debate if technology transfer is
beneficial to developing country running with fiscal deficit. Proponents argue that
when capital inflows take the form of direct investment, they may bring new
technologies, new management techniques, and new ideas to the host country. This
transfer is particularly important for developing countries that lack access or
information about newer technologies, but it is also important for high-income
countries. Technology transfer is by no means an inevitable outcome of foreign direct
investment, and much of the current research on this type of capital flow seeks to
understand the conditions that encourage or discourage it.

Chapter Exercise

1. Give the distinction of balance of trade and balance of payment. Differentiate

capital account from current account.

2. Why might a government be concerned about a large CA deficit or surplus?

Explain the implication (i.e., its “balance of payments”).

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3. Based on the outline of the measures to correct BoP disequilibrium, identify the
economic sector that is most affected in the process. Present your work in table
form.

4. In 2006, US income receipts on foreign assets were $647.6 billion while payments
on liabilities (foreign owned assets in the US) were $604.4 billion. Yet the US is a
substantial net debtor to foreigners. How then is it possible that the US received
more foreign income than it paid out?

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 Chapter 10: Banking System, Macroeconomic Policy under Fixed
Exchange Rates

Introduction
The world’s banking system plays a vital role in facilitating international
transactions and maintaining economic prosperity. Financial crisis brought down
governments, ruined economies and destroyed individual lives. The flow of money,
banking systems and monetary policy once again become the center piece of the
world economy. Private and government banks take action to finance trade and
investment and provide loans to international borrowers. Central banks such as the
Federal Reserve serve as a lender of last resort to commercial banks and sometimes
intervene in foreign currency markets to stabilize currency values. Also, the
International Monetary Fund (IMF) serves as a lender to nations having deficits in
their balance-of-payments. This chapter concentrates on the role money, general
banking system and monetary policies play in world financial markets.

Learning Outcomes:
• Discuss the concept of money and describe the role and function of money
and banking system
• Point out the how monetary policy and interest rate flow into the foreign
exchange market
• Examine how price levels and exchange rates react to monetary factors over
time.

Lesson 1: Money and Banking

We are so used to using money that we rarely notice the roles it plays in in
almost all of our daily transactions. Money is worth it only because everybody knows
it is recognized as a form of payment. But the use and form of money have changed
throughout history. Money and currency are two terms that are used interchangeably.
The main distinction of money and currency are the:
a. Concept: money is inherently intangible t while the latter is the tangible
manifestation of money.
b. Form: Money is numbers on the other hand currency are coin, notes paper etc.
c. Value /Terms: Money is perceived quantity value, currency the actual physical
value of an item

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 The main distinction of the two based on context is very important, thus we
take a look of the evolution of money.
1. Barter: direct exchange of goods and services. For instance, a farmer could
replace a shoemaker with a bushel of wheat for a pair of shoes. These
arrangements are time consuming thus, the terms of agreement were altered.
2. Coin: introduced by Chinese in a form of metal, a replica of tools or weapons
used as medium of exchange. Some forms are sharp, spades and hoes,
pointed and later rounded miniature replicas that become the first coin.
3. Mint: generally originated in Europe as the printed object of exchange to
facilitate convenience guaranteed by its sovereign income. The first mint is a
mixture of silver and gold stamped with picture acted as denomination.
4. Paper Currency: started during the time of Marco-Polo, since colonized
nation always runs out of coins, issued IOU as a medium of trade.
5. Mobile Payment: money rendered for a product or service through a portable
electronic device, such as a cell phone, smartphone, or a tablet device started
in the 21st century. Example, Paypal, Apple Pay etc.
6. Virtual Currency: released in 2009 by an alias Satoshi Nakamoto. It has no
physical coinage and it offers the promise of lower transaction fees than
traditional online payment mechanisms, and virtual currencies are operated
by a decentralized authority with, unlike government-issued currencies.
In reality, the easiest way to understand how important money is to
understand how economic life would be without money. This distinguish money from
assets and its function that individuals persistently to lead a hold it.

Lesson 2: The Functions and Components of Money

The three functions of money are:
1. medium of exchange: generally accepted means of payment, example
buying a pack of sardines paying it Piso not Dollar or Riyal unless you are
dealing with international store;
2. unit of account: based on standardized unit of measurement, say, the price
of a slice of pizza is equal to two fingers of banana.
3. store of value: attributes that the asset is automatically converted or liquid
asset

A generally accepted medium of exchange for goods and services is

considered as money as long as it performs the three functions of money.

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 a. Commodity money: the simplest and, most likely, the oldest type of money.
It builds on scarce natural resources that act as a medium of exchange, store of
value, and unit of account. The disadvantage about commodity money is that its
value is defined by the intrinsic value of the commodity itself. In other words, the
commodity itself becomes money. Examples of commodity money include gold coins,
beads, shells, spices, etc.
b. Fiat money: its value from a government order (i.e., fiat). That means, the
government declares fiat money to be legal tender, which requires all people and
firms within the country to accept it as a means of payment. The critical issue, it is not
backed by any physical commodity and its intrinsic value is significantly lower than its
face value. Hence, the value of fiat money is derived from the relationship between
supply and demand. Most modern economies are based on a fiat money system.
Examples of fiat money include coins and bills.
c. Fiduciary money: depends for its value on the confidence that it will be
generally accepted as a medium of exchange. It does not require by law to accept as
payment, instead, issuer of fiduciary money promises to exchange it back for a
commodity or fiat money if requested by the bearer. Examples of fiduciary money
include cheques, banknotes, or drafts.
d. Commercial bank money: described as claims against financial institutions
that can be used to purchase goods or services. It is a portion of currency made from
debt generated by commercial bank that can be exchange for good or services.
Example: Mortgage, Cartel and Insurance.

Two definitions of the U.S. money supply are M1 and M2.

M1 is the narrowest definition of the money supply, whereas M2 is a more
broadly defined money supply.

M1 money = Currency + Checkable Deposits

Meaning the currency includes coins and paper money guaranteed by the
government issuing country. All coins in circulation are token money and Paper
money, issued by the Federal Reserve Banks, are known as Federal Reserve Notes.
Checkable deposits (checkbook money) are a large component of the stock of
money in the U.S. These are deposits in commercial banks and “thrifts” or savings
institutions against which checks may be written. Institution the offers checkable
deposits;

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 a. Commercial banks are the primary deposit institutions in the country.
These institutions accept deposits, offer checking accounts and make loans.
Example, BDO, MetroBank and BPI

b. Thrift institutions include savings and loan associations (S&Ls), credit

unions and mutual savings banks. These “thrifts” offer savings and checking
accounts, (e.g. CitySavings and BanKo)

Currency held at commercial banks and other financial institutions is excluded

from M1 and other measures of the money supply. This prevents the error of double
counting.

M2 money = M1 + near monies

Near monies are financial assets that do not directly serve as a medium of
exchange but can be easily converted into M1. Near monies include savings deposits
(including money market deposit accounts), small time deposits (less than
₱100,000), and money market mutual funds.
The nation’s money supply is guaranteed by government’s ability to keep the
value of money relatively stable.
1. Value of Money: Money has value because of its acceptability, legal
tender designation, and relative scarcity. Government has decreed currency as legal
tender; paper money is a valid and legal means of payment of debt.
2. Money and Prices: The purchasing power of money is the amount of
goods and services a unit of money will buy. The purchasing power of the dollar
varies inversely with the price level. If the price level rises, the purchasing power of
the dollar falls, and vice versa. Inflation may also affect the purchasing power of
money and its acceptability. When the government prints too much money, the
purchasing power of money declines. Also, runaway inflation may significantly reduce
the purchasing power of the dollar and may cause it to cease being used as a
medium of exchange.
Composition of the Money Supply in the Philippines

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Lesson 3: Demand for Money
The demand for money refers to holding on with your money and the
following are the three types of demand:
1. Transaction demand : The transaction motives for demanding from the fact
that most transactions involve an exchange of money.
2. Precautionary demand : people often demand money as a precaution
against an uncertain future. Unexpected expenses, such as medical or car repair
bills, often require immediate payment.
3. Speculative demand : Money is also a way for people to store wealth
The Philippine Financial System consists of three major groups of Institutions
involved in the mobilization and intermediation of private savings as well as allocation
of financial resources. These institutions include:
a. Banko Sentral ng Pilipinas (BSP)
The Bangko Sentral ng Pilipinas (BSP) was created in 1993, replacing the
earlier Central Bank of the Philippines which began operations in 1949. The primary
mandate of the BSP is to maintain price stability conducive to a balanced and
sustainable economic growth. The BSP provides the policy direction in the areas of
money, banking and credit. It supervises operations of the bank and exercises
regulatory powers over no-bank financial institutions with quasi-banking functions.
Under the New Central Bank Act, the BSP performs the ff. functions, all of which
relate to its status as the Republic’s Central Monetary authority.
1. Liquidity Management
2. Currency Issue
3. Lender of last Resort
4. Financial Supervision
5. Management of Foreign Currency Reserves
6. Determination of Exchange Rate Policy
7. Other Activities

b. Banking System
The Philippine Banking System consists of duly licensed and registered
banking entities engaged in the lending of funds obtained in the form of deposits.
These institutions include Universal Banks, Commercial Banks, Thrift Banks, Rural
Banks, Cooperative Banks, and Islamic Banks.

c. Non-Financial Institution

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 No-Bank Financial Institutions (NBFIs) refer to all Financial Institution other
than banks engaged principally in the provisions of a wide range of financial services.
NBFIs are engaged in a variety of financial services, which include those performed
by pawnshops, lending investor, stock brokers, money brokers, investment
houses, financing companies, insurance companies and intermediaries performing
quasi banking.

Lesson 4: Monetary Policy: Philippine Context

Monetary policy is the measure or action by Central Bank to regulate the
supply of money in the economy. Monetary policy actions of the BSP are aimed at
influencing the timing cost and availability of money and credit, as well as other
financial factors, for the purpose of influencing the price level. In the Philippines,
monetary policy instruments are classified into:
a. Open Market Operations (OMO): It involves the buying and selling of
government securities from banks and financial institutions of the BSP in order to
expand or contract the supply of money.
b. Rediscounting: transactions whereby the BSP extends credit to a bank
collateralized by its loan papers with customers. The role of rediscounting is to
allocate preferred credit and as instrument to influence supply of money and credit.
Rediscounting Rate is the interest rate charged by the BSP to the banks that borrow
for them.
c. Reserve requirement: minimum amount of reserves that bank must hold
against deposit. They are held by banks as cash in their vaults and deposits with the
BSP, help to control the money and credit by affecting the demand for money
reserves and the money multiplier. Usually in a form of Treasury Bond and PDIC
bond.
d. Direct Controls: quantitative and qualitative limits on the ability of banks to
undertake certain activities. The most common type includes limitations on
aggregate bank lending and interest rate regulation.
e. Moral Suasion: persuade banks to make their lending policies responsive
to the needs of the economy. Banks must tighten credit program during inflation and
loosen them when recession.

Transactions in Bank
The financial transaction of the bank is somehow unique because of the
nature of its business. The following presentation is an example of the fundamental
general accounting entries based on its services or transaction.

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 Creating money of a bank, an individual must secure a state or national
charter and sell stock certificates to buyers. This creates outstanding stock
certificates and cash on hand equal to the value of the certificates.

Balance Sheet 1
Assets Liabilities and net worth
Cash ₱ 250,000 Stock shares ₱250,000

Acquiring property Equipment: The bank’s owners must then acquire

property (a building) and equipment. It uses cash on hand to make these purchases.

Balance Sheet 2
Assets Liabilities and net worth
Cash ₱ 10,000 Stock shares ₱ 250,000
Property ₱ 240,000

Accepting Deposit : Once the bank is operating, suppose businesses and

citizens open up accounts and deposit ₱100,000 in the bank.

Balance Sheet 3
Assets Liabilities and net worth
Cash ₱ 110,000 Checkable Deposit ₱ 100,000
Property ₱ 240,000 Stock shares ₱ 250,000

Forwarding Reserve Deposit to Central Bank: All commercial banks and

thrifts that provide checkable deposits must by law keep required reserves. Required
reserves are an amount of funds equal to a specified percentage of the bank’s own
deposit liabilities, must be kept on deposit with Central Bank and held as cash in the
bank’s vault. The “specified percentage” of checkable deposit liabilities that a
commercial bank must be keep as reserves is known as the reserve ratio.

𝑏𝑎𝑛𝑘 ′ 𝑠𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑠𝑒𝑟𝑣𝑒

𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑏𝑎𝑛𝑘 ′ 𝑠𝑐ℎ𝑒𝑐𝑘𝑎𝑏𝑙𝑒 − 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Conditional operation under reserve deposit: If Central Bank sets a reserve

ratio of 20%, the bank must hold ₱20,000 in required reserves (₱100,000 x .2 =
₱20,000). Thus, the balance sheet is presented below based on our example above.

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 Balance Sheet 4
Assets Liabilities and net worth
Cash ₱ 108,000 Checkable Deposit ₱ 100,000
Reserve ₱ 2,000
Stock shares ₱ 250,000
Property ₱ 240,000

If the bank decides to hold all its cash in reserves with the Central Bank, then
its cash amount will be zero the following transaction will reflect in its balance sheet
entry as follows:

Balance Sheet 5
Assets Liabilities and net worth
Cash ₱0 Checkable Deposit ₱ 100,000
Reserve ₱ 110,000
Stock shares ₱ 250,000
Property ₱ 240,000

When a bank holds more in reserves then is required, it holds excess

reserves. Excess reserves are actual bank or thrift reserves minus legally required
reserves. Actual reserves are the funds that a bank or thrift has on deposit at the
Federal Reserve Bank or is holding as vault cash. Again, from our example, our bank
has ₱90,000 (=₱110,000 - ₱20,000) in excess reserves.

Clearing a check Drawn from the Bank

Assume a bank customer writes a ₱50,000 check against her deposit
account. As the check clears through the Federal Reserve Bank, it reduces our
bank’s reserves by ₱50,000. The bank also reduces its customer’s deposit account
by ₱50,000.

Balance Sheet 6
Assets Liabilities and net worth
Reserve ₱ 110,000 Checkable Deposit ₱ 100,000
Property ₱ 240,000 Stock shares ₱ 250,000

Note: Whenever a check is drawn against one bank and deposited in another
bank, collection of that check will reduce both the reserves and the checkable deposit
of the bank on which the check is drawn.

When Granting Loan / Creating Money

Let’s assume that Mr Lalosa a bank customer desire a loan from our
bank of ₱50,000. When the loan is approved, the customer signs a promissory note

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to repay the loan plus some amount of interest in the future. The customer’s deposit
account increases by ₱50,000 and the bank’s loans increase by ₱50,000. A granted
loan by a bank creates money.

Balance Sheet 7
Assets Liabilities and net worth
Reserve ₱ 60,000 Checkable
Loans ₱ 50,000 Deposit ₱ 100,000
Property ₱ 240,000 Stock shares ₱ 250,000

Suppose Mr Lalosa writes a check for ₱50,000 to another individual and

deposits the check into his account, this changes the balance sheet. The check is
collected and clears in the same manner described in balance sheet 6.

Balance Sheet 7
Assets Liabilities and net worth
Reserve ₱ 10,000 Checkable
Loans ₱ 50,000 Deposit ₱ 50,000
Property ₱ 240,000 Stock shares ₱ 250,000

Note: The bank’s assets and liabilities are both reduced by ₱50,000

Lesson 5: Bank System on Multiple-Deposit Expansion

An individual bank can only lend an amount equal to its excess reserves, but
the commercial banking system can lend by a multiple of its excess reserves. The
banking system magnifies any original excess reserves into a larger amount of newly
created checkable-deposit money. The monetary multiplier, M, is the multiple of its
excess reserves by which the banking system can expand checkable deposits and
thus the money supply by making new loans.
1 1
𝑀𝑜𝑛𝑒𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = ; 𝒐𝒓 𝑀 =
𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑎𝑡𝑖𝑜 𝑅

The maximum checkable-deposit creation, D, is equal to total excess

reserves, E, times the monetary multiplier, or, in symbols in the formula:
𝐷 = 𝐸∗𝑚
For example, if R = .20, m = 5 (1/.20). If excess reserves is ₱80, then D =
₱80 x 5 = ₱400. Just as banks can create money through loans, money is destroyed
when loans are paid off. Loan repayment sets off a process of multiple destruction of
money akin to the multiple creation process.

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Chapter Exercise
1. Based on the given history of money, which the most safe and convenient?
Explain your answer.
2. What is the most common motive for holding money?
3. Use the following data to answer the questions. Assume that transactions
accounts and demand deposits are the same thing.
Table 1. Balance Sheet

Cash in Vault 50
Member Bank Deposit at Central Bank 20
Currency in circulation 985
Managers Check 16
Transaction accounts (Demand Deposit) 700
Time and Savings Account 1600
Retail Money Market Account 900

a. What is the level of bank reserve?

b. What is the total money created (base)?
c. What is the level of M1 and M2 based on Philippine money supply?
d. Calculate the value for money multiplier in deposit?
e. Assume that Mr Lalosa made ₱1,000 deposit, what will happen to the
banks balance sheet? Show the balance sheet reflecting the deposit made
by Mr Lalosa.

References
Books
Feenstra and Taylor. (2017). “International Economics”, 4th Ed., Worth Publishers.
Krugman, Obstfeld, and Melitz. (2018). “International Economics: Theory and Policy”,
11th Ed., Pearson.
Yarbrough, Beth V & Yarbrough, Robert M (2006). “The World Economy:
International Trade (7th ed). Thomson/South-Western.
Thomas Pugel. 2016). “International Economics”, 16th Ed, McGraw-Hill.
Salvatore, D. (2016). “International Economics” 12th Ed., John Wiley & Sons.
Pindyck, R.S and Rubinfeld, D.L. (2018). Microeconomics 9th Ed., Pearson.
Lim, T.C. (2014). International Political Economy – An Introduction to Approaches,
Regimes, and Issues, Saylor Foundation.

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Konrad, Kai A. (2011). Strategy and Dynamics in Contests, Oxford University Press,
Oxford.
Bagwell, Kyle and Robert Staiger. (201). “The Economics of the World Trading
System,” Cambridge: MIT-Press.
Hill, Charles W. (2013). “International Business: Competing in the Global
Marketplace”, 9th Ed., McGraw-Hill.
Gerber, J. (2010) “International Economics”, 5thed., Pearson.
Bjornskov, C. (2005). “Basic International Economics-Compendium, Ventus
Publishing Aps.

Website
A glossary of terms in international economics is available at Alan Deardorff’s
website http://www-personal.umich.edu/~alandear/glossary/
http://stevesuranovic.blogspot.com
NEDA, PSA, WTO, OECD, WB, IMF, UNCTAD, The Economist, the Wall Street
Journal, China Morning Post
https://www.youtube.com/watch?v=uwKKliDER4E
http://www.Resource-Analysis.com/

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