International Economics

INTERNATIONAL
ECONOMICS
Prepared by
MSc. Chan Bonnivoit

for NU & HRU
20010-2011
Table of Contents
1. Introduction
2. The classical models of international trade
3. The Hecksher-Ohline (HO) theorem
4. The tariffs
5. Non-tariff barriers and arguments for protection
6. Other commercial policy
7. The international trade and economic growth
8. The commercial policy (Cambodia)
9. The foreign exchange market
10. The exchange rate & PPP
11. The balance of payment
12. The interest rate and the exchange rate
13. The dollarization
1. Introduction
1. Terminology
§ GNP : the value of new goods and services produced
by domestic factors of productions.
§ GDP : the value of new goods and services produced
within a Country.
§ Export goods are goods that are sold by economic
agents located in one Country to economic agents
located in another Countries.
§ Import goods are goods that are purchased by
economic agents located in one Country from
economic agents located in another Countries.
éføRTBü nig esva - ΣéføRTBüGnþrkarI = plitplkñúgRsuksrub = ΣtMélbEnßm
Σ
370 – 220 = GDP = 150

The Flow of Currencies:
Whisky sold to Italian hotel
Export earnings for UK

(Credit on Balance
of Payments)
€ changed to £
The Flow of Currencies:
Oil from Russia
Oil
£ changed into Roubles Export earnings for Russia
Import expenditure for the UK

(Debit on balance of payments)
1. Introduction
1. Terminology (con’t)
§ Trade deficit: The Country has a trade deficit if
merchandise imports exceed its merchandise
exports.
§ Trade surplus: The Country has a trade surplus if the
merchandise exports exceed its merchandise
imports.
§ Balance of trade: The value of merchandise exports
minus imports.
§ Balance of payments equilibrium: Credits equal
debits for a particular account.
1. Introduction
Imports (Debits) Exports (Credits)
§ Current Account: (M) § Current Account: (X)
§ Goods and services § Goods and services
§ Factor- and assets income § Factor- and assets income
§ Assets transfer (= transfer § Assets transfer (= transfer
account) account)
§ Aids, gifts etc. (= unilateral § Aids, gifts etc. (= unilateral
transfer) transfer)
§ Capital Account: (CM) § Capital Account: (CX)
§ Direct investments § Direct investments
§ Security purchase § Security purchase
§ Bank claims, liabilities, § Bank claims, liabilities,
obligations, etc. obligations, etc.
§ Government assets abroad § Government assets abroad
1. Introduction
1. Terminology (con’t)
§ Balance of payments equilibrium:
§ X + CM = M + CX
§ => X –M = CX –CM
§ If X > M (trade surplus) => CX > CM => The Country

exports capital.
§ If X < M (trade deficit) => CX < CM => The Country

imports capital.
Balance of Payments
The UK Balance of Payments on Current Account 1998 - 2004

Source: ONS (http://www.statistics.gov.uk/cci/nugget.asp?id=194) (Crown copyright material is
reproduced with the permission of the Controller of HMSO and the Queen's Printer for Scotland.)
1. Introduction
2. Structure of the world trade
§ The range of goods that are internationally traded
§ Direction of the international trade
§ Volume or value of international trade
§ Trend of the international trade

Basic Facts About World
Trade
— About a quarter of world trade is in primary products,
the remaining three-quarters in manufactures.
— World trade centers on the industrialized countries.
— Value of $2.4 trillion in 2006 (about 25% of

international trade)
World Trade in Services
— Most traded services: transportation, travel, other

services (banking, medicine, consulting, insurance
& education)
— U.S is largest exporter and importer of services
— Trade has been growing more quickly than world

income, and is increasingly important.
Value of World Merchandise Exports
($ Billion)
12000
10000
8000
$ Billion
6000
4000
2000
0
1928 1935 1950 1980 1990 2000 2005
Sources: League of Nations, Europe’s Trade, WTO
Growth in World Exports and GDP
14
12
10
8
6
4
2
0
-2
-4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
World Merchandise Exports World GDP
Source: The WEO Database (IMF),

http://www.imf.org/external/pubs/ft/weo/2004/02/data/index.htm
Leading Importers in World Merchandise
Trade, 2006
Annual
Rank Importer Value (B$) Share (%) change (%)
1 United States 1919 15,5 11
2 Germany 909 7,3 17
3 China 791 6,4 20
4 United Kingdom 619 5,0 21
5 Japan 580 4,7 13
6 France 535 4,3 6
7 Italy 437 3,5 14
8 Netherlands 416 3,4 14
9 Canada 358 2,9 11
10 Belgium 354 2,9 11
25 Sweden 127 1,0 14
35 Finland 69 0,6 17
World 12413 100,0 14
Leading Exporters in World
Merchandise Trade, 2006
Annual
Rank Exporter Value (B$) Share (%) change (%)
1 Germany 1112 9,2 15
2 United States 1038 8,6 15
3 China 969 8,0 27
4 Japan 650 5,4 9
5 France 490 4,1 6
6 Netherlands 462 3,8 14
7 United Kingdom 448 3,7 17
8 Italy 411 3,4 10
9 Canada 390 3,2 8
10 Belgium 369 3,1 10
21 Sweden 147 1,2 13
35 Finland 77 0,6 17
World 12083 100,0 15
International Monetary Fund
(IMF)
— The IMF describes itself as "an organization of 186
countries (as of June 29, 2009),working to foster
global monetary cooperation, secure financial
stability, facilitate international trade, promote high
employment and sustainable economic growth, and
reduce poverty".
— With the exception of Taiwan (expelled in 1980),
North Korea, Cuba (left in 1964), Andorra, Monaco,
Liechtenstein, Tuvalu and Nauru, all UN member
states participate directly in the IMF.
1. Introduction
3. Conditions of international trade
§ Absolute price advantage
§ P1 Country A < P1 of Country B, in this case A exports good 1
to B. (only with the stable exchange rate)
§ Comparative price advantage
§ P1/P2 of Country A < P1/P2 of Country B, in this case A
exports good 1 to B, and B exports good 2 to A (only with
the stable exchange rate)
§ Exchange rate and inflation (interest rate)
§ The rates varied occur the change of the price of goods
trading and can change the direction of trade. (One
example : if S($/pound) = 1, the good (price in England 20
pound und in USA 30 US$) is exported to US, but if the
S($/pound) = 2, then can the trade change the direction)
• Price absolute advantage
PA PB
PW
SB
SA
SA
DB
DB
DA
XA XW XB
Country A has comparative World Market Country B
advantage in product X.
Factors that Shift R F and R D
It present only
return, not relating
to exchange rate
presented in the
ordinal axe
Factors that Shift RF and RD
1. Introduction
3. Conditions of international trade (con’t)
§ Domestic demand for the product.
§ Profit and cost variation
§ It depends on variation of production condition like
production factor, technology, salary, state policy (tax
and expenditure for infrastructure) and money supply.
§ Tariffs and non-tariff barriers
§ Ad valorem, specific tax, compound tariff, MFN and GSP.
§ Quota, voluntary export restriction, dumping price,
subsidies, SPS, TBT, safeguard and government
procurement.
§ Location of export Country
§ Production diversifying in different areas can provide the
difference factor allocation as well salary.
The quantity equation is an identity: the definitions of the four
variables make it true. If one variable changes, one or more of the
others must also change to maintain the identity. The quantity equation
we will use from now on is the money supply (M) times the velocity of
money (V) which equals price (P) times output (Y):
Money ´ Velocity = Price ´ Output
M ´ V = P ´ Y
Because Y is also total income, V in the quantity equations is called the
income velocity of money. This tells us the number of times a dollar
bill changes hands in a given period of time.
2. The classical model of international
trade
2. 1 Adam Smith theory (The wealth of nation, 1776)
§ His theorem is absolute advantage as a basic for trade.
§ He argued that the Countries specialized in the

production of goods in which they have an absolute
advantage.
§ In this case, rather than producing both goods, as they

would do in autarky, Country A should concentrate on
the production of soybean and Country B on the
production of textile.
trade
§ The table below will be illustrated Adam Smith
theorem before the Countries take the measures to
specialize the production.
Items Country A Country B The world

production
Soybean 3 h for producing 1 12 h for producing 2 units of
unit of soybean 1 unit of soybean soybean
Textile 6 h for producing 1 4 h for producing 1 2 units of textile

unit of textile unit of textile
trade
§ If Country A reduce 1 unit for textile in order to
produce soybean, then the Country A gets 2 units of
soybean.
§ In similar fashion, let the output of soybean in

Country B fall by 1 unit. In this case, 12 hours of
input factor are released to the textile industry.
§ With 12 more hours of input factor, 3 additional

unit of textile can be produced.
trade
§ The table below will be illustrated Adam Smith
theorem after the Countries took the measures to
Items Soybean Textile
Country A + 2 units of soybean - 1 unit of textile (as 6H

(as 6H/3H=2) took to produce soybean)
Country B - 1 unit of soybean (as 12H + 3 unit of textile
took to produce textile) (as 12H/4H=3)
The world + 1 unit of soybean + 2 units of textile
production
trade
§ The table below will be illustrated the gain of the
world production after the both Countries have a
specialization.

production
Soybean 1 unit + 2 units = 0 unit 3 units of soybean
3 units
Textile 0 unit 1 unit + 3 units = 4 units of textile
4 units
trade
2. 2 Comparative advantage as a basic for trade (David
Ricado’s model in the principle of political
economic 1819 )
§ Ricado first pointed out, is that, in this case, the

Country should specialize where they have their
greatest absolute advantage (if they have an absolute
advantage in both goods) or in their least absolute
disadvantage (if they have an absolute advantage in
neither goods).
§ This rule is known as the law of comparative advantage.

trade
§ The table below will be illustrated David Ricado
theorem before the Countries take the measures to

production

trade
§ In the table above Country A is 4 times (12/3) more
efficient in the production of soybean relative to
Country B.
§ However, Country A is only 4/3 times (8/6) more
efficient in the production of textile relative to Country
B.
§ Because Country A’s greatest absolute advantage is in
the production of soybean, it is said to have a
comparative advantage in soybean.
§ Likewise, because Country B’ s least absolute
disadvantage is in the production of textile, it is said to
have a comparative advantage in textile.
trade
§ The table below will be illustrated the per unit gain
after the both Countries have a specialization (the
general equilibrium solution of the Ricado model .
Items Soybean Textile
Country A + 2 units of soybean - 1 unit of textile (as 6H

(as 6H/3H=2) took to produce soybean)
Country B - 1 unit of soybean (as 12H + 1.5 unit of textile
took to produce textile) (as 12H/8H=1.5)
The world + 1 unit of soybean + 0.5 units of textile
production
trade
§ The table below will be illustrated Ricado theorem
after the Countries took the measures to specialize
the production.

production
Soybean 1 unit + 2 units = 0 unit 3 units of soybean
3 units
Textile 0 unit 1 unit + 1.5 units 2.5 units of textile
= 2.5 units
trade
§ As you can see table above, we have the remarkable
result that even though there are no new resources in
the World and even though Country A has an absolute
advantage in both goods, by following the law of
comparative advantage, and the result is that:
§ The output of both goods rises
§ The world production of both goods increases
§ Both Country can be trading better than they would

be in autarky.
2. The classical model of international trade
2. 3 An Evaluation of the classical models
• The important notion of the classical model:
§ The international trade occurs along the line of
comparative advantage.
§ The international trade is a phenomenon ()atuPUt)
which aids in increasing the productivity
capacity of our planet,
§ The international trade leads to higher standard
of living for the Countries involved, and
§ The international trade occurs as a direct
consequence of the free market activities.
2. The classical model of international trade
2. 3 An Evaluation of the classical models
• The problem of the classical model:
§ The model is seriously incomplete in many way.
§ Nowhere does it explain why exist the differences in
the productivity level between Countries which can
occur the trade.
§ It is not borne out in the real world.

§ It seems clear that the Countries often continue to
produce import-competing products.
§ The Countries will not completely specialize in
production of exportable and get out of the business
wholly of producing import-competing goods.
3. The Hecksher-Ohline Theory
• Eli Hecksher laid out the basic fundamentals of the
model of the patterns and determinants of international
trade in a paper first published in 1919.
• This paper was written in Swedish and was not

translated into English for almost 30 years.
• An English translation of this paper entitled “ the Effect

of Foreign Trade on the Distribution of Income”
appears in Howard S. Ellies and Lloyd A. Metzler,
“Reading in International Trade, Philadelphia: The
Blakiston Co., 1949”.
3. The Hecksher-Ohlin (HO) Theory
• Hecksher’s pupil, Ohlin, elaborated on the ideas
of Hecksher in his 1924 doctoral dissertation (also
in Swedish) and later in a book published in
English by Harward University in 1933.
• Ohlin’s book is titled “Interregional und

international trade”, in Boston: Harward
University Press, 1933.
• Ohlin has got the Nobel Price of Economic in

1977.
• Hecksher and Ohlin built their theory around two basic
characteristics of Countries and products.
• Countries differ from each other according to the factors of

the production they possess.
• Goods differ from each other according to the factors that are
required in their production.
• Given these features of the world, HO argued that a Country

will be able to produce at lower cost those products whose
production requires relatively large amounts of the factors of
production with which that Country is relatively well
endowed.
3. 1 Assumption of HO Theory
• Having 2 Countries, each Country produce 2
goods, soybean (S) and textile (T).
• Using intensively Capital (C) for S and
intensively labor (L) for T.
• Having constant return of scale.
• Having uncompleted specialization.
• Having identical taste for both goods.
• Having identical technology of both Countries.
3. 1 Assumption of HO Theory (con’t)
• Having transparently competition of both products.
• Full movement of domestic factor inputs in the Country, but

not for international factor inputs.
• Transport cost, tax, etc. were exempted, if the both goods

flow out or in from or to the both Countries.
• Full using all domestic resources relatively endowed.
• Balance Payment of both Countries has the balance situation

(BP=X-M=0)
Factor intensity, and factor abundance
L L
C/L in T = 1/4
C/L in T = 1
8
C/L in S = 1
4 C/L in S = 4 4
2 2
2 4 8 C 1 2 4 8 C
Country A Country B
PPF of both Countries base on assumption
T T
Y
E Z
S S
Country A (a) Country B (b)
3. 2 HO Theory
• HO theory is summary in 2 form
• Solving and predicting the trade model.
• Factor price equilibrium theorem.
• HO theorem (hypothesized) said a Country will have

comparative advantage and should therefore export that
good those production is required relatively intensive factor
with which that Country is relatively well endowed.
• If we simplify the theory, then the theorem states that a

Country, that is relatively capital abundance compared with
the other Country, will have a comparative advantage in the
good that requires more capital per labor to produce.
3. 2 HO Theory (con’t)
• In the example (or hypothesis):
• Country A (B) will have a comparative advantage in soybean
(textile), since we assumed that Country A (B) is relatively
capital (labor) abundant and soybean (textile) production is
required relatively capital (labor) intensive.
• Let trying to prove the HO theorem graphically

• Our goal is to find the autarky (pre-trade price ratio) for the 2
Countries to determine the direction of comparative advantage.
• To do that we employ the simple trick.
§ The Equilibrium in the autarky situation of the Country A and B
T T We assume that the
Country B has 9,600
hours in producing
soybean and textile.
Slope=1/2 Slope=3/2
or 1200 or
2000 PS/PT=1/2 PS/PT=3/2
K L
4000 S 800 S
Country A Country B
§ We take the data in the table below to illustrated
the theorem of HO and to find the price in autarky
situation.

production

• PPF of both Countries base on assumption
T T
Y
E Z
S S
Country A (a) Country B (b)
• Taking PPF of both Countries into one panel
T
(PS/PT) of B
Y PPF of B
J
D CIC0
I (PS/PT) of A
PPF of Country A
Z E S
(c)
• Taking the panel (a) and (b) on the panel (c).
• We introduce the consumption of identical taste in the two

Countries by drawing in one Community indifference curve
(CIC) which reflects the common taste of either population.
• In this case the curve is labeled CIC0 (see the figure above)
• (PS/PT) of Country A and (PS/PT) of Country B are a tangency

point between CIC0 with both PPFs and occur a different
points (point I for Country A and point J for Country B)
• I and J present the autarky equilibrium production and
consumption points for the respective Countries.
• As we knew the tangency or slope of PPFs at the

production point define the relative price (or price
ratios or term of trade) for the Country.
• Consequently, from the diagram it is clear that:

• PS/PT of Country A < PS/PT of Country B or
• PT/PS of Country B < PT/PS of Country A
• This established that Country A (B) has a comparative
advantage in the production of good S (T)
• It recalls that a Country has a comparative advantage in

a good if the good has a lower autarky price in that
Country.
• Now, let go back to our assumption that S was assumed

to be the capital intensive good, and that Country A was
assumed to be the capital abundant Country.
• This explanation proves the theorem of HO.
• Here we have not only prove the theorem of Country A,

but we have established that is true for Country B as
well.
• The answer to this question here is the same of classical

model that namely in a comparative environment the
trade flows are determined by profit-seeking activities
of economic agents, and
• If a product is cheap in one Country, it will tend to be
exported to those place where it is relatively expensive.
• Consequently, we would expect to see Country A export

good S to Country B.
• Likely, exporters in Country B should want to export T

to Country A
3. 4 Equilibrium of HO
• 2 steps will be analyzed for this case.
• Considering the effect of the introduction of international

trade on the production and consumption decision of a
single Country.
• After we analyze this question, we turn to an examination

of the world trade equilibrium in the HO model.
3. 4 Equilibrium of HO (con’t)
• Again, we know for previous chapter that one trade is
allowed between two Countries.
• Consequently, the price of S will begin to rise in

Country A (where it was initially low) and fall in
Country B (where it was initially high).
• Let to focus our attention on the Country A in figure

below. If one trade is begun, the price of S will start to
rise in Country A. This is illustrated by the price lines
(PS/PT)0, (PS/PT)1 and (PS/PT)2.
T
C2 CIC2
C1
CIC1
X0=C0 CIC0
V1 X1
(PS/PT)0
V2 X2
(PS/PT)1
(PS/PT)2
S
Country A
• (PS/PT)0 is tangent to Country A’s PPF at autarky point
x0 (=c0).
• As the price rises to (PS/PT)1 and (PS/PT)2 the production

of textile declines and the factors are released to the
soybean industry allowing Country A’s production point
to move to point x1 and x2.
• At that point, the supply of soybean exceeds the local

demand for it, and some can be exported to Country B
in exchange for textile.
• This allows consumption to move of Country A’s PPF to
point C1 and C2.
• How much is traded at price (PS/PT)1 and (PS/PT)2. This

is given in the figure by the triangle v1c1x1 and v2c2x2.
• The base of the triangle, v1x1 and v2x2 represent export

while the side, v1c1 and v2c2 is Country A’ s desired
imports.
• At this point, A is almost completely specialized in the
production of soybean.
• Country A’s consumption point moves from c1 to c2.

Thus, Country A relies more and more on Country B for
the textile it consumes.
• Country A’s trade triangle has grown in size to v2c2x2.

• Diagrammatically, the condition for international
equilibrium is that the trade triangles of the two countries
are similar.
• Example of international trade equilibrium is given in figure

below.
• The Country A’s desired export (VAXA) so long as the price

(PS/PT) of Country A is equally price (PS/PT) of Country B. It
means that Country A’s desired export so long as the Country
B desired import VAXA = VBCB as well VACA = VBXB.
T
C2 CIC2
C1
CIC1
X0=C0 CIC0
V1 X1
(PS/PT)0
V2 X2
(PS/PT)1
(PS/PT)2
S
Country A
T
Country A
CA
• Production in XA
D A’s imports
VA XA
• Consumption in CA
A’s exports • A’s export VAXA
• A’s import VACA
(PS/PT)
E
S
Country A
T
D
XB
Country B
B’s exports • Production in XB
VB
CB • Consumption in CB
B’s imports • B’s export VBXB
• B’s import VBCB
(Ps/PT)
E
S
Country B
• If the international market for product soybean is in
equilibrium, we know that is also in the equilibrium for
product textile
• Hence, we know that the sides of the two triangles are

also equal in length.
• Like our studied in the classical models note first that

neither Country completely specialize in the production
of its comparative advantage good. It means that it
continues to produce some of the good it imports.
3. 5 Some new HO theorem
• In addition to HO theorem, which predict the direction
of comparative advantage, the HO model offers several
other important theorem about economic behavior in
economic engaged in international trade.
• These theorem refers to issue such as the effect of

economic growth on trade, and the impact trade has on
the distribution of income in a society.
• The first of these is known as the Rybczyusky theorem.

3. 5 Some new HO theorem (con’t)
• Rybczyusky theorem: At constant world price, if a
Country experiences an increase in the supply of one
factor, it will produce more of the product intensive in
that factor and less of the other.
• The effect of an increase in Country A’s capital: Country

A were increasing capital above its initial endowment,
every things else constant. The Country will produce
more soybean than before and less textile.
T0 X0
T1 X1
S0 S1
S
E E’
CT/LT
L
G0 To suppose
G1 • E: Economic factor
(Capital) endowed
• E’: Economic factor
F
CS/LS (Capital) endowed rises
H1
H0
D
C
• In figure above capital were increasing. This occurs that
PPF shifts outward along the soybean axis, because
soybean is capital intensively.
• Then we have the new production point is X1.
• The factor price equalization theorem: Given all the

assumptions of the HO model, free international trade
will lead to the international equalization of individual
factor prices.
• The Stolper Samuelson Theorem: Free international
trade benefits the abundant factor and harms the scarce
factor.
• Country A that the labor is scarce has declining the cost

of labor, because Country A uses intensively capital.
• Country B that the capital is scarce has declining the

cost of capital, because Country B uses intensively
labor.
4. The Tariff
• Action take by a government to influence the volume
and composition of trade flows (into or out of a
Country) are known as commercial policy.
• A government has a varieties of options in conducting

commercial policy. These options include tariffs and
non-tariff barriers.
• Non-tariff barriers include a variety of government

policies or regulations, such as wealth and safety
standard or government procurement policies.
4. The Tariff
• So far we have focused our discussion on the causes and
the consequences of international trade.
• We have seen that international trade lead to the

redistribution of production in the economy and also
affects the returns paid to the factors of production.
• For both of these reasons, some individuals in every

society favor government policies aimed at affecting the
volume and composition of international trade.
• Now we turn our attention in this section to the role of

government in the area of international trade.
4. The Tariff
4. 1 The gain from free trade
• When a Country opens its market to free international
trade, it benefits in several different ways.
• First the Country enjoys (1) static gain from trade. These
gain are illustrated in figure above.
• One resource are allowed to move away from point A,

the Economy accrues (adds) further economic gains.
• These gain are reflected in the movement of the

consumption point from B to C and, in term of
community welfare, from CIC1 to CIC2.
4. The Tariff
4. 1 The gain from free trade (con’t)
• These gains come about because productive resources
are channeled into the economy’s comparative
advantage industries, and
• Because of this redistribution of resource, overall

output GNP rises.
• Hence, this second increase in welfare is known as the

static production gain from trade.
4. The Tariff
• Free trade also leads to (2) dynamic gains. These refer
to the relationship between trade and economic
growth.
• A economy grows over time either because it

experiences increases in its stock of productive factors
or because of technological innovation that a Country’s
existing stock of factor become more efficient.
4. The Tariff
• In term of our model economic growth refers to
outward shift in a nation’s PPF.
• Trade effects positive on productive capacity.
• Trade effects enhancing diffusion of technology.
• Trade effects increasing saving.

4. The Tariff
• In addition to economic gain from trade, a Nation that
trades may enjoy (3) political benefits.
• These come about because of the probability that the

Countries become more economically interdependent.
• They are less likely to revert to aggressive (hostile)

action among themselves.
4. The Tariff
4. 2 The tariff
• Ad valorem tariff: a trade tax is equally to a given
percentage of selling price.
• Ex: 13% for imported knit cotton headwear in US$.
• Specific tariff: a trade tax is equally to a fixed amount of

money per unit sold.
• Ex: 14 cents on each pound of imported fertilizer.
• Compound tariff: a trade tax that has both a specific

and an ad valorem.
• Ex: 19 cents per pound plus 18.5 percent ad valorem on
imported cashmere sweaters ( Gavcak;BIeramstV
).
4. The Tariff
4. 2 The tariff (con’t)
• Tariff has several effects on the economy
• Revenue effect: The amount of revenue increasing to the
Government comes from tariff.
• Protective effect: The amount by which domestic

producers are able to expand their output, because the
tariff is in place.
• Generally, both the revenue and the protective effects of

the tariff will operate at the same time.
4. The Tariff
• However, there are special case when only one of these
effects is present.
• For instance, a tariff that is imposed on a import

when no domestic producer exists would be a pure
revenue tariff.
• A prohibit tariff is one that is so high that no goods

are imported. A prohibitive tariff is a example of a
purely protection tariff – in such circumstance no
government revenue is collected.
4. The Tariff
• MFN (most favored nation):
• If any other Country grants another Country MFN status,
it agrees to charge tariffs against that Country’s good that
are no higher than those imposed against the goods of any
other Country.
• GSP (general system of preference)

• Which was instituted by the United States in the early
1970.
• Other industrialized Countries, including Canada, EC and
Japan have their own GSP programs.
• The idea behind the GSP is that by charging lower tariffs
on goods from Developing Countries
4. The Tariff
• GSP (general system of preference) (con’t)
• Importers in the preference granting Countries such a the

United States will have an incentive to expand their
purchases from the preference receiving Countries.
• In turn, expanded exports should improve the standards

of living for the Countries ( and raise demand for imports
from industrialized Countries such as the United States).
4. The Tariff
4. 3 Economic Analysis (con’t)
• Consumer surplus: The difference between the

amount consumers are willing to pay to purchase a
given quantity of goods and the amount they have to
pay to purchase those goods
• That is, if the market price of grapes were to rise to P’,

consumer surplus would fall. Lower market price
increase the amount of consumer surplus.
4. The Tariff
4. 3 Economic Analysis:
Consumer Surplus
P
P2
P1
P’
P A
X
Consumer Surplus
Consumer Surplus
Price of
Album
$100 John’s willingness to pay
80 Paul’s willingness to pay

70 George’s willingness to pay
50 Ringo’s willingness to pay
Demand
0 1 2 3 4 Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Consumer Surplus
(a) Price = $80

Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
Albums

Measuring Consumer Surplus with the Demand
Curve
(b) Price = $70

Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
70 surplus ($10)
Total
50 consumer
surplus ($40)
Demand
Albums

How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers
F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity

How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B C
Demand
0 Q1 Quantity

4. The Tariff
• Producer surplus: The difference between the price

paid in the market for a good and the minimum price
required by an industry to produce and market that
unit.
• That is, if the market price of grapes were to rise to P,

producer surplus would increase. Higher market price
increase the amount of producer surplus.
4. The Tariff
Producer Surplus
P
S
P’
0 1 Q X
The Costs of Four Possible Sellers
Copyright©2004 South-Western
The Supply Schedule and the
Supply Curve
The Supply Schedule and the Supply Curve
Measuring Producer Surplus with the Supply
Curve
(a) Price = $600
Price of
House
Painting Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0 1 2 3 4
Quantity of
Houses Painted
Measuring Producer Surplus with the Supply
Curve
(b) Price = $800
Price of
House
Painting Supply
Total
producer
$900 surplus ($500)
800
600 Georgia’s producer

500 surplus ($200)
Grandma’s producer
surplus ($300)
0 1 2 3 4
Quantity of
Houses Painted
How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Additional producer Supply
surplus to initial
producers
D E
P2 F
B
P1
Initial C
Producer surplus
producer to new producers
surplus
0 Q1 Q2 Quantity
How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
B
P1
C
Producer
surplus
0 Q1 Quantity
4. The Tariff
• The gain from the free trade: one more time
PA PW PB
SB
SA
SA
DB
DB
DA
XA XW XB
Country A has comparative World Market Country B
advantage in product X.
4. The Tariff
• The welfare lost of the tariffs imposed by small Country
P S
PW+T
a b c d Tariff (T)
PW
0 Q3 Q4 Q2 X
4. The Tariff
• The welfare lost of a tariff imposed by a small Country
base on the above figure.
• Change in consumer surplus: - a$ - b$ - c$ - d$

• Change in producer surplus : + a$
• Change in government revenue: + c$
• Net welfare change: - b$ - d$

4. The Tariff
• The welfare lost of a tariff imposed by a large Country
• Country A imposes the tariff T like in the graphic center

of the figure below
• Imposing the tariff T occurs increasing the price in

Country A
• It can be effected to reduce the demand in the foreign

trade quadrant from L0 to L1.
4. The Tariff
• The welfare lost of the tariffs imposed by large Country
P S
P’= PW+T
Tariff (T)
PW
P’’
D
0 Q3 Q4 Q2 X
4. The Tariff
• The welfare lost of the tariffs by the large Country
SB + Tariff
PA PW PB
SA
Tariff SB
P’ SB
a c
PW PW PW
e
P’’ b d
P’’
DA DB
DA
XA L1 L0 XW XB
Country A: Market large World Market Country B: Market small

Country Country
4. The Tariff
• The welfare lost of a tariff imposed by a large Country
base on the above figure.

• Change in government revenue: + c$ + e$
• Net welfare change: - b$ - d$ + e$

Schedules of Concession on Goods
Most Favored Nation Tariff Part I
Agricultural Products Section I State A
Tariffs IA
Tariff Rate Quota IB
Section II
DOHA SCHEDULE
Non-Agricultural products
Preferential Tariffs Part II
Non-tariff Concessions Part III
Agricultural products:
Part IV
Commitments limiting subsidization
4. Tariff
(Schedules of concessions for WTO Members)
4. Tariff
(Schedules of concessions for WTO Members)
Schedule VI – SRI LANKA
This Schedule is authentic only in the English language
PART I – MOST-FAVOURED NATION TARIFF
SECTION II – Other Products
Tariff item Description of products Base rate of duty Bound rate of duty Initial negotiating Other duties and
number (U/B) right charges
1 2 6 4 5 6
0301 LIVE FISH

030110 - ornamental fish 66% (U) 50%
030191 -- trout (salmo trutta, salmo gairdneri, salmo 66% (U) 50%
clarki, salmo agua bonita, salmo gilae)
030192 -- eels (anguilla spp.) 66% (U) 50%
030193 -- carp 66% (U) 50%
030199 -- other: 66% (U) 50%
0302 FISH, FRESH OR CHILLED,
EXCLUDING FISH FILLETS AND
OTHER FISH MEAT OF HEADING NO.
0304
030211 -- trout (salmo trutta, salmo gairdneri, salmo 66% (U) 50%
clarki, salmo agua bonita, salmo gilae)
030212 -- pacific salmon (oncorhynus spp.), atlantic 66% (U) 50%
salmon (salmo salar) and danube salmon
(hucho hucho)
4. Tariff (Schedules of concessions for WTO Members)
4. Tariff (Schedules of concessions for WTO Members)
Bound and Applied MFN Tariffs
200.0%
180.0%
160.0%
140.0%
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
2006 2006 2005 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006
Bangladesh Norway India Korea Indonesia Brazil Philippines Japan Malaysia China EC United Australia
States
Bound Tariff Applied Tariff

Bound Rates and Applied Rates by Sector
Wood, pulp, paper and

Philippines furniture China Wood, pulp, paper and
furniture
40.0 40.0
Petroleum Textiles and clothing Petroleum Textiles and clothing
30.0 30.0
Leather, rubber, Leather, rubber,
Fish and Fish and
footw ear 20.0 footw ear
fish products 20.0 fish products
and travel goods and travel goods
10.0
10.0
Manufactured
Manufactured
articles not
articles not 0.0 Metals
0.0 Metals elsew here
elsew here specified
specified
Mineral products Chemicals and

Mineral products Chemicals and and precious stones photographic
and precious stones photographic and precious metals supplies
and precious metals supplies
Electric machinery Transport equipment
Electric machinery Transport equipment
Non-electric machinery
Non-electric machinery
Binding coverage : 61.8% Binding coverage :100.0%

Average of bound duties : 23.4% Average of bound duties : 9.1%
Average of applied duties : 4.3% Average of applied duties : 11.3%
Bound Duty
Applied Duty
Source) World Trade Report 2004 13
Wood, pulp, paper and Wood, pulp, paper and

India furniture Brazil furniture
40.0 40.0
30.0 30.0
Fish and Fish and
20.0 footw ear 20.0 footw ear
fish products fish products
10.0 10.0
Manufactured Manufactured
articles not articles not
0.0 Metals 0.0 Metals
elsew here elsew here
specified specified
Mineral products Chemicals and Mineral products Chemicals and

and precious stones photographic and precious stones photographic
and precious metals supplies and precious metals supplies
Electric machinery Transport equipment Electric machinery Transport equipment
Non-electric machinery Non-electric machinery
Binding coverage : 69.8% Binding coverage :100.0%

Bound Duty
Applied Duty
Wood, pulp, paper and Wood, pulp, paper and

US furniture EU furniture
40.0 40.0
30.0 30.0
Fish and Fish and
20.0 footw ear 20.0 footw ear
fish products fish products
10.0 10.0
Manufactured Manufactured
articles not articles not
0.0 Metals 0.0 Metals
elsew here elsew here
specified specified
Mineral products Chemicals and Mineral products Chemicals and

and precious stones photographic and precious stones photographic
and precious metals supplies and precious metals supplies
Electric machinery Transport equipment Electric machinery Transport equipment
Non-electric machinery Non-electric machinery
Binding coverage :100.0% Binding coverage :100.0%

Bound Duty
Applied Duty
Tariff peaks and high tariffs
— Generally used by IOs:
— National peaks: 3 times the national

average
— International peaks: >15%
— BUT, THERE IS NO AGREED WTO

DEFINITION
EC-15: bound AVG per HS Chap.
20
Bound Duty AV
18 Intern. Peak > 15%
16
14 Nation. Peak > 12%
Average (%)
12
10 3X
8 Nat.
AVG
6 Nat. AVG = 4%
4
2
0
Gr
48
84
34
41
69
91
03
27
55
62
76
HS Chapter (Non Ag tariff lines only)
Brazil: bound AVG per HS Chap.
Nation. Peak > 90%
90
80 Bound duty AV
3X
70 Nat.
AVG
Average (%)
60
50
40 Nat. AVG = 30%

30
Intern. Peak > 15%
20
10
0
44
48
84
88
28
28
43
68
78
85
86
91
96
03
32
31
36
51
56
61
66
71
72
HS Chapter (Non AG tariff lines only)
Tariff escalation: textiles and clothing
Tariff
(%)
45
40
35
30
25
20
15
10
0
Raw material Semi-manufactured Finished product
Tariff only but problems still exist
Tariff Peaks:
Japan
minimum tariff 0% maximum tariff 958%
Tariff Escalation:
cocoa imports into the EC
cocoa beans milk chocolate
0% 18.7%
Forms:
Specific duties and ad valorem duties
Seasonal duties
Matrix tariffs
5. Non-tariff barriers and argument for
protection
• Quota:
• Government imposed the limitation on the volume or

value of international trade.
• Quota rent: Profit that come about, because a quota has

artificially raised the price of imported products.
• Quota occurs the loss of the consumers

protection
• The welfare Effects of the Quota
P SM
SM + Quota
Quota (Q1 + Q2)
PM+Q
a b C1 C2 d
PW
0 Q1 Q2 X
Remark: C = C1 + C2
protection
• The welfare lost of a Quota.

• Change in government revenue: + c$ (= C1+ C2)
• Net welfare change: - b$ - d$
• c$ is a Quota Rent.
Tariff Quotas or Tariff Rate Quotas
Applied duty %
Out-of-quota
tariff
In-quota
tariff
Quota volume Imports (MT)

Tariff Quotas or Tariff Rate Quotas
protection
• Embargo:
• Embargo is a complete ban on trade in product or
products.
• Voluntary export restraint (VER)

• Agreement between imported and exported Countries
whereby the export agree to limit the amount of their
export.
• Through this agreement these foreign industries are able

to raise their prices.
• In the case, the imported Country loss the revenue C= C +

C2 (seen figure below).
protection
• The welfare Effects of voluntary export restraint
P SM
SM + VER
VER (=C1+C2)
PM+VER
a b C1 C2 d
PW
0 Q1 Q2 X
Remark: C = C1 + C2
protection
• The welfare lost by a voluntary export restraint.
• Change in government revenue: + 0$
• Net welfare cost or change: - b$ - c$ - d$

protection
Export Subsidies
§Financial contributions and kinds of contribution by
Government as Examples
— Grants — Provision of goods or
— Loans services other than general
infrastructure
— Loan guarantees
— Purchase of goods
— Investment tax credits
— Income or price supports
— Tax exemptions — Gov’t entrusts or directs
— Import duty exemptions private body to carry out
on capital equipment used above functions
protection
Other Non-Tariff Barriers
§ Export subsidy:
§ A payment by a government to an industry that leads to
an expansion of exports by that industry.
§ Export subsidies Policy coverage - Article 9.1 (WTO)
(a) direct subsidies contingent on (e) favourable internal transport
export performance and freight charges for exports
(b) sale or disposal for export by (f) subsidies on ag. Products
gov’t at price below domestic contingent on incorporation in
market exported products
(c) payments on exports financed
by gov’t action
(d) marketing subsidies, including
handling, upgrading, transport,
freight
Pillars of the Agreement on Agriculture
Market Domestic Export

Access Support Competition
Tariffication Amber Box Volume
Bindings AMS Reduction Reduction
Reductions
Market Access Blue Box
Production Limiting Value Reduction
Tariff Rate Quotas
Programmes
Special Roll-over
Green Box
Safeguard Non Trade Distorting
Amber box
Calculating the Current Total AMS
Annexes 3 and 4
l Market price support
Product-specific l Compensatory payments
support l Product-specific
+ subsidies
l Fertilizers
Non-product specific
l Irrigation, drainage
support
l Electricity
l Subsidized credits
= Current Total AMS
Domestic Support
Amber Box and De Minimis
Current Total Aggregate Measure of Support

Product Specific AMS
1. Market Price Supports But
2. Non Exempt Direct Payments If less than 5% (10% for
3. Other product specific supports DC) of production
of product then zero
Product Specific AMS
+ But
If less than 5% (10%
Non Product Specific AMS for DC) of total
production then zero
=
Current Total AMS Note Reduction Commitments

Apply to Current Total AMS only
Limits based on 1986-1988 average

Reductions 45% to 75% for developed, 30% for dev’g
protection
§ Countervailing duty:
• A tax imposed by importing Country designed to offset
artificially low prices charged by exporters.
• This measures is to impose the tax in order to offset the

subsidized export goods.
INJURY FACTORS (Article 3.4)
Include:
— Actual and potential decline in:
– Sales - Productivity
– Profits - Return on investment
– Output - Utilisation of capacity
– Market share
— Actual and potential negative effects on:
– Cash flow - Growth
– Inventories - Ability to raise capital
– Employment - Ability to raise investment
– Wages
— Factors affecting domestic prices
CALCULATION OF CVD RATE
— Domestic subsidies:
Amount of benefit allocated to POI
All products sales value for POI
— Export subsidies: (persistence of benefits over time (POI)

Exported products sales value for POI
— Subsidies tied to a market, products or producer:

Market, products or producer sales value for POI
protection
§ Government procurement policies:

• Direct purchasing agents of state and local government to
purchase American product unless comparable foreign
good are substantially cheaper.
protection
§ Health and safety standard:
• Government often regulate the production and
distribution of products deemed (considered) to be
hazardous to the health and safety of their Citizens.
• Some time, however, such standard provide a mechanism
to protecting domestic products from the foreign
competition.
• In example Japan bans importing of skis, because of
unsafely.
• Regarding the WTO agreements these non-tariff barriers
are described in the SPS (sanitary and phyto-sanitary) and
TBT (technical barriers to trade) agreements.
Definition of an SPS Measure in WTO
Agreement
To protect : from :
risks arising from additives,

human or animal contaminants, toxins or disease-causing
life organisms
human life diseases carried by animals or plants
animal or plant pests, diseases or disease-causing

life organisms
damage caused by the entry,
a country
establishment or spread of pests
What type of SPS’s measures ?
All types of measures with SPS objectives,
including :
— product criteria — inspection

— quarantine treatments — sampling procedures
— production methods — packaging and labelling
— certification and approval directly related to food
safety
The WTO’s TBT Agreement….
To start: some definitions
Technical Regulation
— "Document which lays down product characteristics or their
related processes and production methods...with which
compliance is mandatory.”
Standard
— Document, approved by a recognized body that provides, for common
and repeated use, rules, guidelines or characteristics for products or
related processes and production methods, with which compliance is not
mandatory
Conformity assessment procedure

— Any procedure used, directly or indirectly, to determine that relevant
requirements in technical regulations or standards are fulfilled
protection
§ Protect intellectual property right:
• Defined as the innovative or creative ideas of inventors,

artists or authors.
• Patent, copyright and trademark laws exist to provide

incentive to create intellectual property by ensuring that
the owners of the intellectual property maintain exclusive
control over these ideas at least for a certain period of
time.
protection
§ Protect intellectual property right:
• Patent allows inventors the opportunity to recover their

investment and the cost of creating and marketing
inventions.
• Copyright give authors control over the reproduction,

dissemination and public performance of their work.
• Trademark assures consumers about the product

characteristics such as quality.
protection
§ Protect intellectual property right (con’t):
• Geographical Indication is any geo. sign (word or symbol)
used to indicate that a product originates in a given
country/region/place and its quality, reputation or other
characteristic are essentially due to its geographical
origin.
• Industrial design is aesthetic shape (ex. Model of shirt) of

mass-produced products.
• Neigbouring right is Performers, Phonogram Producers

and Broadcasting Organizations
Patents
DEFINITION
§ Patentable subject matter

§ Industrial applicability
§ Novelty
§ Inventive Step
§ Disclosure
Non-tariff barriers
Copyright
Fields Protected:
§ Literary Works
§Musical Works
§Artistic Works
§Photographic Works
§Cinematographic Works
§Maps
§Computer Programs
§Works of Applied Art
Non-tariff barriers
Main Characteristics of Industrial
Design
§ Industrial
§ New (Worldwide)
§ NO if dictated purely by the function
§ NO if contrary to public order and morality

• Dumping:
• Defined a selling a product in a foreign Country at a price
that is lower than the price charged by the same firm in
its home market or at a price below cost of production.
• Many reasons for “dumping”:

• May be predatory pricing policy
• May be result of custom production
• May be unintentional / technical dumping
• May be conscious economic decision relating to profits from
increased marginal production.
— Break-Even analysis :
Profit = (P x Q) – [(CV x Q) + CF]
— For Break-Even analysis the profit is 0

=> 0 = (P x Q) – [(CV x Q) + CF]
= Q (P – CV) – CF
=> Q = CF/(P – CV)
Revenue
Total Cost
Cost and Revenue
Profit
Break-Even Point
Fixed Cost
Loss
Variable Cost
Q
Volume
Definition of Dumping base on WTO agreement
§ Dumping = when a product is sold for export to another
country at less than its “normal value”.
§ Normal Value is
§ the price in the home market when the good is sold at a
price above the cost of production
§ the price charged for the good when sold at a price above
cost in third-country markets
§ “constructed normal value” calculated as the total costs of
producing the product plus a reasonable amount for
selling, general and administrative expenses and profit.
§ Antidumping law:
• Dumping margin: The difference between the normal

value of a product and its dumped price.
• Injury test: Investigation to determine the cause of the

foreign trade practice to harm a domestic producer.
INJURY FACTORS (Article 3.4)
Include:
— Actual and potential decline in:
– Sales - Productivity
– Profits - Return on investment
– Output - Utilisation of capacity
– Market share
— Actual and potential negative effects on:
– Cash flow - Growth
– Inventories - Ability to raise capital
– Employment - Ability to raise investment
– Wages
— Factors affecting domestic prices
— The magnitude of the margin of dumping
§ Safeguard:
• A measure trade law that allows for temporary
protection (5 years) against fairly trade foreign
import.
• Reason for using this measure is trade adjustment in

the domestic producers.
• But for using this measure it should be investigated

the injury of the domestic industry through the
foreign products.
SAFEGUARDS (WTO): BASIC REQUIREMENTS
§ A determination that,
§ As a result of (i) unforeseen developments and (ii) the
effect of a Member’s obligations under GATT 1994
§ A product is being imported in such increased quantities
§ As to cause or threaten to cause
§ Serious injury to the domestic industry
§ Producing “like products” or directly competitive
products
… serious injury …
(threat of)
= significant overall impairment in the position of a
domestic industry
— Relevant factors:
— Increased imports (value and volume)
— Market penetration of imports
— Changes in sales
— Production
— Productivity
— Capacity utilization
— Profits / losses
— Employment
“New” Safeguard Measures
— Maximum duration
— 4 years
— Extension (max. + 4 years)
— Compensation
— In principle (agreement on compensation)
— If no agreement :
— “retaliation”
— not within the first 3 years (if absolute increase in
imports)
Other non-tariff barriers and argument
for protection
Rule of Origin (ASEAN case):
• Agriculture products (chapter 01-24) and
agricultural products commit to WTO, such
as cotton chapter 52, silk chapter 50.
• Non-agricultural products
for protection
Rule of Origin (ASEAN Case) (con’t):
Agricultural Products
• Apply the rule of wholly produced or obtained applicable for
goods which are made wholly from domestic raw material.
• The value of raw materials from exporting country and

ASEAN Country is not less than 60% of total production cost.
for protection
Rule of Origin (ASEAN Case) (con’t):
Non-agricultural Products
• Apply the rule of wholly produced or obtained
• The value of raw materials from exporting

country and ASEAN Coutry is not less than 40%
of total production cost.
for protection
— The local ASEAN content can be cumulative, that
is, the value of inputs from various ASEAN
members can be combined to meet the 60% or 40%
requirement. The following formula is applied:
— (Raw material cost + Direct labor cost + Direct

overhead cost + Profit + Inland transport cost) x
100/ FOB value
for protection
The formula for calculating the RCV shall be:
A- Build-Up Method
RVC = (VOM / FOB) x 100%
B- Build-Down Method
RVC = [(FOB – VNM) / FOB] x 100%
- RVC: Regional Value Content

- VOM: Value of originating materials used by the producer in
the production of good
- VNM: Value of non-originating materials used by the
producer in the production of good
HOW DO YOU DETERMINE THE “LIKE PRODUCT” ?
§ Consider on:
§ Characteristics of product
§ Uses of product
§ Raw materials used
§ Manufacturing process
§ Tariff classification
§ Consumer preference and end-use
§ Quality
§ Preferential trading arrangement
• FTA (free trade area): Agreement between several
Countries to eliminate internal barriers to trade, but
to maintain existing barriers against non-member
Countries.
• Custom Union (CU): Agreement between several

Countries to eliminate internal barrier to trade, but
to erect common barrier against the non-member
Countries.
ASEAN Vision 2020
AEC
— At the 12th ASEAN Summit in January 2007, the Leaders affirmed
their strong commitment to accelerate the establishment of an
ASEAN Community by 2015 as envisioned in the ASEAN Vision
2020 and the ASEAN Concord II, and signed the Cebu Declaration
on the Acceleration of the Establishment of an ASEAN Community
by 2015.
— In particular, the Leaders agreed to hasten the establishment of the

ASEAN Economic Community by 2015 and to transform ASEAN
into a region with free movement of goods, services, investment,
skilled labour, and freer flow of capital
— ASEAN ECONOMIC COMMUNITY BLUEPRINT.

ASEAN Trade Cooperation
• Agreement on the common effective preferential
tariff (CEPT) scheme for AFTA
— Ultimate Goal : 0% tariff rate in 2010 for ASEAN- and

2015 (2018) for new members Countries.
ASEAN Trade Cooperation
The common effective preferential tariff (CEPT) is a
mechanism to achieve the AFTA’s target by reducing
import tariff rates and eliminating quantitative
restriction and non-tariff barriers among ASEAN
member states.
ASEAN Cooperation in Services
Main Provisions Governing Market Access and
National Treatment
— Market Access
— No limitations on the numbers of service suppliers,*
— No limitations on the value of service transactions,*
— No limitations on the number of service operations,*
— No limitations on the number of natural persons in a sector,*
— No restrictions on types of legal entity,
— No limitations on foreign capital participation
* Includes limitations in the form of economic needs tests.
— National Treatment (non-discrimination de facto)

— No measures which modify the conditions of competition in favour of
domestic services or service suppliers
ASEAN Cooperation in Services
Modes of supply: 1) Cross-Border supply 2) Consumption abroad 3) Commercial presence 4) Presence of natural persons
Sector or sub-sector Limitations on market access Limitations on national treatment Additional commitments
B. SECTOR-SPECIFIC COMMITMENTS
I. BUSINESS SERVICES
1. Professional Services
(a) Legal services (1) None (1) None
(CPC 861): (2) None (2) None
(3) In commercial association with (3) None
Cambodian law firms[1], and may not (4) Unbound, except as indicated
directly represent clients in courts. in the horizontal section.
(4) Unbound, except as indicated in
the horizontal section.
Foreign legal consultancy (1) None (1) None
on law of jurisdiction where (2) None (2) None
service supplier is qualified as a (3) None (3) None
lawyer (including home country (4) Unbound, except as indicated in (4) Unbound, except as indicated
law, third country law, and the horizontal section. in the horizontal section.
international law)
(b) Accounting, auditing, (1) None, except must have (1) None
bookkeeping commercial presence in Cambodia for (2) None
(CPC 86211, 86212, 86220) auditing services. (3) None
(2) None (4) Unbound, except as indicated
(3) None in the horizontal section.
the horizontal section
Other ASEAN Cooperation
• Cooperation in Investment
• Industrial Cooperation
• Cooperation in Transport
§ Economic Analysis of FTA (CU)
• Assumption:
• 3 Countries A, B and C.
• Country B and C export Beer to A.
• Country B has 2 $ per 1 bottle and Country C has 1.5 $
per bottle in case of autarky.
• A charge the ad valorem 100%.
• Country A and B make the agreement to build up the
FTA.
• According the assumption consumers of Country A
shift their consumed product to Country B, because
product from Country B don’t impose tariff.
§ Economic Analysis of FTA (CU) (con’t)
S
4$ SB + T
3$ SC + T
a b c d
2$ SB
1.5$ Sc
e f g h i D
0 XC1 XB1 XC1+T XB1+T XB2+T XC2+T XB2 XC2 X

• The welfare effect on the Country A of an FTA
between Countries A and B
• Change in consumer surplus: +a$ +b$ +c$ +d$

• Change in producer surplus : -a$
• Change in government revenue: -c$ -g$
• Net welfare cost or change: +b$ +d$ -g$

§ Economic Analysis of FTA (CU) (con’t)
• The source moves from C to B that means the trade
will move from low cost world producer to high
cost world producer or lowest cost FTA member (=
trade diversion).
• Trade expands in the Country A, their importing
Beer is increased (trade creation).
• Why: FTA exists only with Country A and B, not
with C, it has the following reasons:
• Being the economic policy in the region
• Not being calculation of the dynamic gain, only
considering the static gain.
7. International Trade and
Economic Growth
Comparative advantage in trade
§ A country can have a relatively lower opportunity cost
and potentially a comparative advantage over another
country based on the supply and price of labour, on
technology, on environmental and climatic factors or
it could be due to an abundance of natural resources.
Economic Growth
Comparative advantage in trade
— A country has a comparative advantage in producing a
good if the opportunity cost of producing that good in
terms of other goods is lower in that country than it is in
other countries.
— So China has a comparative advantage in the production
of textiles and clothing because the (opportunity) cost of
producing clothing (due to cheaper labour) is lower in
China than in most other countries.
— Trade between two countries can benefit both economies
if each country exports the goods and services in which it
has a comparative advantage.
Economic Growth
The Terms of Trade
— The Terms of Trade looks at the relationship
between the price received for exports and the
amount of imports we are able to buy with that
money.
Average Price of Exports
Terms of Trade = ------------------------------
Average Price of Imports
Economic Growth
Costs of Protection
§ to the economy
§ inefficiency & lower productivity
§ hidden tax on consumers
§ higher prices on imports & domestic goods & services
§ reduced choice & quality
§ to efficient producers/exporters
§ higher input prices
§ higher-cost economy - competition for resources
from less efficient activities
Economic Growth
Trade policy, economic growth, and poverty
— In a poor country, labour-intensive activities will often have a
comparative advantage
— Expansion of such activities will usually help the poor
— Policy - focus on constraints to the poor participating in economic
activities
— Empirical evidence mixed, but provides strong presumption in favour
— problems with empirical studies (cross-country regression analysis,
country case studies)
— Difficulty in taking account of institutional differences between
countries
— Causality in dispute (economic growth leads to higher trade vs
higher trade leads to higher economic growth)
— DCs open to trade grow faster & higher income countries are more
open to trade (see following charts)
Economic Growth
Chart: DCs Open to Trade Grow Faster
8
7
Average Annual Growth in GNP per Person (%)
0
1963-73 1974-85 1986-92
-1
Open Moderately Open Moderately Closed Closed

Economic Growth
Chart: Higher Income Countries are Much More Open
40
35
30
% of GDP, 1999 (PPP)
25
20
15
10
0
Low Income Lower Middle Income Upper Middle Income High Income
Trade in Goods Gross Private Capital Flows Gross Foreign Direct Investment
Economic Growth
Trade liberalization Û Growth Û Poverty Alleviation

§ No evidence that
§ trade liberalization harms growth or raises poverty
§ import substitution policies generate sustained rapid growth
§ Agriculture and labour-intensive activities (e.g., textiles)

will often have a comparative advantage in poor countries
§ agricultural development essential in developing countries with
large land and rural labour endowments
§ non-farm rural & urban income & employment opportunities
also
Economic Growth
Economic Growth
Designing Trade Liberalization & Poverty Reduction
Strategies
§ There is no evidence to support the idea that trade
liberalization can be designed to reduce poverty (evidence
that agricultural investment reduces poverty is because
this sector has a comparative advantage)
§ Remember Tinbergen’s rule “One policy instrument for
each policy objective”
§ Best to regard trade policy as part of growth-enhancing
package
Economic Growth
Prioritizing Trade Liberalization & Poverty Reduction
Strategies
§ begin with poverty analysis that identifies the poor
§ identify constraints faced by the poor to earning income
§ focus policy on alleviating the constraints
§ note reasons for the status quo
§ poor have little political influence
§ vested interests against change
§ need to build coalition of interests in support of change
§ empower poor to participate in the benefits of economic
growth
Economic Growth
Trade Liberalization
§ identify constraints to reform
§ property rights / security of contracts
§ credibility of reforms; ‘package of reforms’
§ stable macroeconomic environment
§ mobilization of factor markets
§ investment/competition policies
§ trade liberalization itself is good competition policy
§ open investment policies promote trade in services
Economic Growth
Gains From Trade Liberalization
§ Static gains
§ allocate efficiency
§ specialization on activities with comparative advantage
(economies of scale), more efficient input and output markets
§ governments cannot ‘create’ comparative advantage
§ Access to a larger variety of products and services

§ Note that smaller countries tend to trade more. Why?
§ Access to new technologies
§ Access to new ideas
§ Result:
§ Usually Leads to Higher Level of GDP
Economic Growth
Gains From Trade Liberalization
§ dynamic gains
§ more competitive markets
§ improved efficiency over time
§ removes rent seeking/”X-inefficiencies”
§ better technology/production methods

§ difficult to measure
§ thought to exceed static gains of 1-2% of GDP
Economic Growth
WTO - General Objectives
§ Raising Standards of living
§ Ensuring full employment
§ Ensuring large and steadily growing volume of real
income and effective demand
§ Expanding the production of and trade in goods and
services, while allowing for the optimal use of the
world’s resources (sustainable development)
§ … seeking both to protect and preserve the
environment […] in a manner consistent with [the
Member’s needs]
Economic Growth
WTO - Main Functions
§ Implementation, administration and operation of
WTO Agreements
§ Framework to further the objectives of the WTO
Agreements
§ Forum for trade negotiations
§ Framework to administer the Understanding on
Rules and Procedures Governing the Settlement
of Dispute (DSU)
§ Framework to administer the Trade Policy Review
Mechanism (TPRM)
Economic Growth
Integrated Framework
§ Integrated Framework (IF) for LDCs
§ coordinated delivery of trade-related technical
assistance
§ run by 6 institutions; WB, WTO, ITC, UNCTAD, UNDP,IMF
§ formed in 1997, revamped in 2000; endorsed at
Doha
§ based on principles of
§ country ownership
§ partnership & policy coherence
Economic Growth
Integrated Framework (con’t)
§ LDCs to mainstream trade policy priorities into
national development plans & Poverty Reduction
Strategies
§ Diagnostic Trade Integration Study (DTIS) & Action Plan
§ program designed in consultation with governments and
stakeholders
§ funded by donors (multilateral, bilateral)
§ success depends on making basic policy changes
§ problems well known, but poor implementation record
8. Commercial Policy of Cambodia
Rectangular strategy of RGC
1. The rectangular Strategy of RGC
§ The core of the rectangular strategy is good governance focused at
four reform areas:
§ Anti-Corruption
§ Legal and judicial reform,
§ Public administration reform, including decentralization and de-
concentration, and
§ Reform of the armed forces, especially demobilization
§ The integration of Cambodia into the region and the world is a

significant part of the rectangular strategy of RGC.
2. The Integrate Framework of RGC
§ The Integrated Framework (IF) is the outcome of a commitment made by six multilateral
Agencies (IMF, ITC, UNCTAD, UNDP, World Bank, and WTO) to coordinate their
assistance in the area of trade and investment integration into the global economy among
themselves and with other multilateral and bilateral donors.
§ IF came about as a result of the High Level Meeting (HLM) for LDCs organized by the
WTO in October 1997 in Geneva.
§ The IF’s strategy must be fully “mainstreamed” in the country’s national strategy for
poverty reduction. In other words, the country’s trade sector strategy must be fully support
and coherent with national objectives of poverty reduction.
§ In the donor community based in Cambodia, UNDP has taken the lead to ensure effective
implementation of IF and coordination among local donors. UNDP-Phnom Penh and the
International Trade Center (Geneva) are cooperating and working directly with RGC and
others to backstop work in this area.
2. The Integrate Framework of RGC (con’t)
§ The IF was undergoing some restructuring that include the creation of an
Integrated Framework Trust Fund (IFTF) and the adoption of a Pilot Phase
Work Program during the Second IFTF Steering Committee Meeting held in
New York in late March 2001
§ The Pilot Phase Work Program is to be implemented by the IF Agencies under

the leadership of the World Bank in a small number of Pilot Countries using
IFTF and other resources.
§ Cambodia has been designated as one of the Pilot Countries.
§ The IF “Pilot Phase Work Program” seeks to provide financial and technical
support to the selected pilot countries for the formulation of a full-fledged pro-
poor trade sector strategy that is fully mainstreamed into the PRSP
3. The Pro-Poor Trade Strategy of RGC
§ Preliminary evidence examined suggests that trade is making a significant
positive contribution to economic growth and poverty reduction and that such
contribution can be further enhanced and provided Cambodia to become
proactive in promoting trade for poverty reduction.
§ Regarding this issue RGC established a Pro-Poor Trade Strategy organized

around tree basic concepts:
§ Shifting the balance of policy emphasis from issues of market access and macro-
reforms for trade to micro and meso-level issues of supply capacity
§ Focusing strongly on the delivery of capacity-building support at the export
enterprise and export sector level; and
§ Stressing the regionalization and geographical decentralization of export
business within Cambodia
3. The Pro-Poor Trade Strategy of RGC (con’t)
§ The early efforts of the RGC to formulate a pro-poor trade sector strategy – initially
under the umbrella and with the support of the Integrated Framework (IF) for Trade –
coincides closely with the PRSP effort.
§ The pro-poor trade integration strategy will include:

§ (1) policy and institutional reforms to target key bottlenecks and constraints that
emerge from the analysis;
§ (2) several action plans at the product-sector level including project proposals to
capitalize on major opportunities identified in the strategy;
§ (3) assessment of technical assistance and capacity-building priorities to support

implementation of the trade strategy as well as recommended actions that might
be taken by high-income and regional partner countries to improve access to
their markets.
3. The Pro-Poor Trade Strategy of RGC (con’t)
§ The RGC has identified eight sectors with current or potential
opportunities for expanding, diversifying, and developing exports
under the Pro-Poor Trade Strategy. These are:
§ Specialty crops and agro-processing
§ Rice
§ Fresh water fish and seafood
§ Handicraft (including furniture making)
§ Tourism
§ Labor services
§ Garment and shoe manufacturing
§ Rubber, sawn timber and processed wood
4. Trade Sector wide Approach (SWAp)
§ SWAp is an instrument for better management, coordination
and effectiveness of resources. Now RGC is willing to utilize
SWAp in the Trade Sector.
§ The Ministry of Commerce stands ready to develop SWAp in

order :
§ To include all initiatives, strategies, measures and actions,
§ To strengthen partnerships for consensus building and
coordination with the private sector, civil society and donors, and
§ To improve implementation and delivery.
4. Trade Sector wide Approach (SWAp) (con’t)
§ The Trade SWAp is lead by the Ministry of Commerce in
close cooperation with other line Ministries, Cambodian
Trade Stakeholders and Development Partners.
§ The Trade SWAp is to be guided and monitored by the Sub-

Steering Committee on Trade Development and Trade-
Related Investment chaired by the Ministry of Commerce.
4. Trade Sector wide Approach (SWAp) (con’t)
§ The Sub-Steering Committee on Trade Development and Trade-
Related Investment has endorsed the creation of three teams
responsible for formulating the three “pillars” of the program
aimed at implementing the broad objectives of the Cambodia’s
2007 Trade Integration Strategy.
§ The three pillars are:

§ Legal Reform and Cross-Cutting Issues
§ Product and Service Export Sectors Development
§ Capacity Development for Trade
5. Integrating Cambodia into the international Community
§ Cambodia’s membership in ASEAN (30-04-1999) and WTO
(13-10-2004), as well as cooperation within the framework of
the ASEM.
§ Cambodia’s membership in Great Mekong Sub-Region, the
Ayeyawadee-Chao Phraya-Mekong Economic Cooperation
Strategy (ACMECS) and other Triangular Developments at
sub-regional level.
§ Integrating Cambodia into the international Community will
provide great opportunities to reform the investment and
foreign trade regime.
Schedules of Tariff Rate of Cambodia in
ASEAN
Country Industrial and Agro- Agricultural Products
Industrial Products
IL TEL IL TEL SL
ASEAN-6 1993-2003 1996-2003 1996-2003 1997-2003 2001-2010
Vietnam 1996-2006 1999-2006 1999-2006 2000-2006 2004-2013
Laos & Myanmar 1998-2008 2001-2008 2001-2008 2002-2008 2008-2015
Cambodia 2000-2010 2003-2010 2003-2010 2004-2010 2008-2017

Cambodia’s Tariffs by Product Groups for
Accession into WTO
Cambodia’s Service Commitments for Accession into WTO
§ Undertaken market access and national treatment commitments in at least one sub-sector
under each of 11 different service which are communications services, construction and
related engineering services, distribution services, education services, environmental
services, financial services, health-related services, tourism and travel services, recreational
services and transport services.
§ Allowing foreign firm to operate in the areas of legal services (with some exceptions),
accounting, auditing, bookkeeping, banking, management consulting, telecommunication and
transport, but some conditions were attached to market access in areas of financial services
(banking and insurance) and telecommunication services.
§ Allowing foreign firms to provide higher education and adult education services.
§ Reserving part of a market for Cambodian small and medium sized enterprise in areas such
as banking, tourism and courier service (tourist guides services; opening hotel market only
for hotels of three stars or higher; and allowing foreign supply of retailing services only a
small number of specific items or for very large supermarkets or department stores.
Modes of supply: 1) Cross-Border supply 2) Consumption abroad 3) Commercial presence 4) Presence of natural persons
Sector or sub-sector Limitations on market access Limitations on national treatment Additional commitments
B. SECTOR-SPECIFIC COMMITMENTS
I. BUSINESS SERVICES
1. Professional Services
(a) Legal services (1) None (1) None
(CPC 861): (2) None (2) None
(3) In commercial association with (3) None
Cambodian law firms[1], and may not (4) Unbound, except as indicated
directly represent clients in courts. in the horizontal section.
the horizontal section.
Foreign legal consultancy (1) None (1) None
on law of jurisdiction where (2) None (2) None
service supplier is qualified as a (3) None (3) None
lawyer (including home country (4) Unbound, except as indicated in (4) Unbound, except as indicated
law, third country law, and the horizontal section. in the horizontal section.
international law)
(b) Accounting, auditing, (1) None, except must have (1) None
bookkeeping commercial presence in Cambodia for (2) None
(CPC 86211, 86212, 86220) auditing services. (3) None
(2) None (4) Unbound, except as indicated
(3) None in the horizontal section.
the horizontal section
6. Trade related to Investment: Investment Protection
§ Equal treatment of all investors
§ No nationalization adversely affecting the property of
investors
§ No price controls on products or service
§ No restriction on foreign equity participation
§ No restriction on foreign convertibility
§ Remittance of foreign currencies abroad
9. The Foreign Exchange
Market
§ In a typical foreign exchange transaction a party
purchases a quantity of one currency by paying a
quantity of another currency.
§ The modern foreign exchange market started forming

during the 1970s when countries gradually switched to
floating exchange rates from the previous exchange rate
regime, which remained fixed as per the Bretton Woods
system.
§ The foreign exchange market, as we usually think of it,

refers to large commercial banks in financial centers
such as New York or London trading foreign-currency-
dominated deposits with each other.
International Monetary Arrangements
in Theory and Practice
— The Bimetallism, 1791-1879

— The International Gold Standard, 1879-1913
— The Spirit of the Bretton Woods Agreement, 1945
— The Fixed-Rate Dollar Standard, 1950-1970
— The Floating-Rate Dollar Standard, 1973-1984
— The Plaza-Louvre Intervention Accords and the Floating-
Rate Dollar Standard, 1985-1999
The Bimetallism, 1791-1879
— For example, if the dollar is pegged to silver at

U.S.$1.293 = 1 ounce of silver, and if the dollar is
pegged to gold at U.S.$19.395 = 1 ounce of gold
(28.35g gold).
— The “mint ratio” was 15 to 1. In other word, the mint
price of gold was 15 times that of silver.
— Reestablishment in 1834, the dollar is pegged to gold
at U.S.$20.67 = 1 ounce of gold.
— Then, the “mint ratio was 16 to 1 in USA, while in
Abroad 15½ to 1.
The Spirit of the Bretton Woods
Agreement, 1945
Price of D S
Sterling
$2.82
a
$2.78
S D
Quantity of sterling/Time
The Role of International Reserves in

Exchange Rate Determination
The Spirit of the Bretton Woods Agreement,
1945 The Bank
must supply
D cd £ each D”
Price of period.
S
Sterling b
$2.82 c d
D’ a D”
$2.78
f g
The Bank of e
England uses
its US$ S D’ D
reserves to
buy up fg £ Quantity of sterling/Time
each period.
The Role of International Reserves in

Exchange Rate Determination
The Fixed-Rate Dollar Standard,
1945-1972
— In practice, the Bretton Woods system evolved into a
fixed-rate dollar standard.
Industrial countries other than the United States :
Fix an official par value for domestic currency in terms
of the US$, and keep the exchange rate within 1% of
this par value indefinitely.
United States : Remain passive in the foreign

exchange market; practice free trade without a
balance of payments or exchange rate target.
Bretton Woods System: 1945-
1972
German
British mark French
pound franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
The purpose of FX
§ The purpose of the foreign exchange market
is to assist international trade and
investment.
§ The foreign exchange market allows
businesses to convert one currency to
another.
§ For example, it permits a U.S. business to
import European goods and pay Euros, even
though the business's income is in U.S.
dollars.
9. The Foreign Exchange Market
Market participants
— Banks: The interbank market caters for both the majority of
commercial turnover and large amounts of speculative trading every
day. A large bank may trade billions of dollars daily.
— Commercial companies: An important part of this market comes from

the financial activities of companies seeking foreign exchange to pay
for goods or services. Commercial companies often trade fairly small
amounts compared to those of banks or speculators
— Central Bank: National central banks play an important role in the

foreign exchange markets. They try to control the money supply,
inflation, and/or interest rates and often have official or unofficial
target rates for their currencies. They can use their often substantial
foreign exchange reserves to stabilize the market.
— Hedge funds as speculators: About 70% to 90% of the foreign exchange
transactions are speculative. In other words, the person or institution
that bought or sold the currency has no plan to actually take delivery
of the currency in the end; rather, they were solely speculating on the
movement of that particular currency.
— Investment management firms: Investment management firms (who

typically manage large accounts on behalf of customers such as
pension funds and mutual funds) use the foreign exchange market to
facilitate transactions in foreign securities.
— Retail foreign exchange brokers: There are two types of retail brokers
offering the opportunity for speculative trading: retail foreign
exchange brokers and market makers. Retail traders (individuals) are
a small fraction of this market and may only participate indirectly
through brokers or banks.
— Non-bank foreign exchange companies: Non-bank foreign
exchange companies offer currency exchange and international
payments to private individuals and companies. These are also
known as foreign exchange brokers but are distinct in that they
do not offer speculative trading but currency exchange with
payments.
— Money transfer/remittance companies: Money transfer

companies/remittance companies perform high-volume low-
value transfers generally by economic migrants back to their
home country. In 2007, the estimated that there were $369
billion of remittances (an increase of 8% on the previous year).
The largest and best known provider is Western Union with
345,000 agents globally.
9. The Foreign Exchange Market Setting
The foreign exchange market is unique because of
— its trading volumes,
— the extreme liquidity of the market,
— its long trading hours: 24 hours a day except on weekends

(from 22:00 UTC on Sunday until 22:00 UTC Friday),
— the variety of factors that affect exchange rates.
— the low margins of profit compared with other markets of

fixed income (but profits can be high due to very large
trading volumes)
— The foreign exchange market is a geographical dispersion,
broker-dealer market, and hence lacks transparency.
— Dealers can trade in a number of ways:
— direct telephone contact with a dealer at another bank (direct
dealing)
— telephone contact with a voice broker
— electronic direct trading and broking systems
Determinants of FX rates
— International parity conditions: purchasing power parity, interest rate
parity, Domestic Fisher effect, International Fisher effect. Though to some
extent the above theories provide logical explanation for the fluctuations in
exchange rates, yet these theories falter as they are based on challengeable
assumptions [e.g., free flow of goods, services and capital] which seldom
hold true in the real world.
— Balance of payments: This model, however, focuses largely on tradable
goods and services, ignoring the increasing role of global capital flows. It
failed to provide any explanation for continuous appreciation of dollar
during 1980s and most part of 1990s in face of soaring US current account
deficit.
— Asset market: It views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by
people’s willingness to hold the existing quantities of assets, which in turn
depends on their expectations on the future worth of these assets. The asset
market model of exchange rate determination states that “the exchange rate
between two currencies represents the price that just balances the relative
supplies of, and demand for, assets denominated in those currencies.”
Foreign Exchange Market Products and Activities
The spread
— The difference between selling and buying rates
called the spread. E.g. Bank bid to buy foreign
exchange rate at lower rates than the exchange
rate quoted to sell.
Spot market
— Spot market is where currencies are traded for
current delivery (actually, deposits traded in the
foreign exchange market generally take 2 working
days to clear).
Spot Rate Quotations
— Direct quotation
— the U.S. dollar equivalent
— e.g. “a Japanese Yen is worth about a penny”
— Indirect Quotation
— the price of a U.S. dollar in the foreign currency
— e.g. “you get 100 yen to the dollar”
Country USD USD equiv Currency per Currency per

equiv Thursday USD Friday USD Thursday
Friday
The direct quote

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 for British pound

Britain (Pound) 1.5627 1.5669 0.6399 0.6386
is: £1 = $1.5627
1 Month Forward 1.5596 1.5629 0.6412 0.6398
3 Months Forward 1.5535 1.5568 0.6437 0.6423
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975

Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
The indirect
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
quote for
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 British pound
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 is:
Britain (Pound) 1.5627 1.566 0.6399 0.6386
1 Month Forward 1.5596 1.5629 0.6412 0.6398 £0.6399 = $1
3 Months Forward 1.5535 1.5568 0.6437 0.6423
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
USD equiv USD equiv Currency per Currency per Note that the
Country Friday Thursday USD Friday USD Thursday
direct quote is
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
the reciprocal of
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 the indirect
Britain (Pound) 1.5627 1.566 0.6399 0.6386 quote:
1 Month Forward 1.5596 1.5629 0.6412 0.6398 1
3 Months Forward 1.5535 1.5568 0.6437 0.6423 1.5627 =
0.6399
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
Settlement and Settlement Risk
Settlement and Settlement Risk
Forward exchange market
— Forward exchange market is where currencies may

be bought and sold for delivery in future period.
— Forward premium means that the forward

exchange rate exceeds the current spot rate.
— Forward discount means that the forward

exchange rate is less than the current spot rate.
Forward Rate Quotations
— Consider the example from above:
For British pound, the spot rate is
£1.00 = $1.5627
While the 180-day forward rate is
£1.00 = $1.5445
— What’s up with that?

Forward Rate Quotations
USD equiv USD equiv Currency per Currency per

Country Friday Thursday USD Friday USD Thursday Clearly the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 market
participants
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
expect that
1 Month Forward 1.5596 1.5629 0.6412 0.6398 the pound
3 Months Forward 1.5535 1.5568 0.6437 0.6423 will be
6 Months Forward 1.5445 1.5477 0.6475 0.6461
worth less
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
in dollars in
3 Months Forward 0.6658 0.6717 1.502 1.4888 six months.
6 Months Forward 0.662 0.6678 1.5106 1.4975
Forward Premium or discount
— Forward Exchange Market: where currencies may be bought and sold
for delivery in a future period.
— For 1 month S(£/$) = forward rate F(£/$) for £:
— if for 1 month S(£/$) < F(£/$)! forward premium
— if for 1 month S(£/$) > F(£/$)! forward discount
— Used to avoid the risk of exchange rate changes
— Suppose I need to pay my supplier of US-cars in dollar (10,000$) in 1
month:
— S(£/$) = 0.69; for 1 month F(£/$) = 0.70 but in one month S(£/$) = 0.71
— If I sign the forward contract I would need £7,000 instead of £7,100.
Forward Premium
— The percentage difference (annualized) between the current forward rate
and spot rate is the forward premium (if positive) or discount (if negative).
— For example, suppose the € is appreciating from S($/€) = 0.5235 to
F180($/€) = 0.5307
— The forward premium or the percentage return (annualized) is given by:
F180 ($/ €) - S($/ €) 360 .5307 - .5235

FP180,€/$ = ´ = =Í.01375
2 = .02750
S($/ €) 180 .5235
— We may approximate this using natural logarithms as:
é Fn ($/ €) ù 360 360

fpn,€ /$ = ln ê ú ´ = ( fn,t - st ) ´
ë S ($/ €) û n n
Foreign Exchange Market Products and Activities
Foreign Exchange Swap

— an agreement to trade currencies at one date and
reverse the trade at a later trade.
— Citibanks wants pounds now and arranges a swap
with Barclays.
— Citibanks trades dollars for pounds now and pounds
for dollars in one month.
— Swap is like borrowing on one currency while
lending another currency for the duration of the
swap period
S(£/$) = 0.69; for 1 month F(£/$) = 0.70
Annual % return of pound : 0.014 x 12 = 0.17

— Speculation entails more than the assumption of a
risky position. It implies financial transactions
undertaken when an individual’s expectations differ
from the market’s expectation.
Simple Hedging Strategies
Activity to Hedge Strategy
Payable in domestic currency Nothing, no FX risk.
Payable in foreign currency Accelerate payment if foreign currency

expected to appreciate.
Delay payment if foreign currency
expected to depreciate.
Receivable in domestic No FX risk.

currency
Receivable in foreign currency Accelerate payment if foreign currency
expected to depreciate.
Delay payment if foreign currency
expected to appreciate.
— Arbitrage is the simultaneous, or nearly
simultaneous, purchase of securities in one market
for sale in another market with the expectation of a
risk-free profit.
— Cross rates arbitrage condition:

— $/£ = x$, ¥/£ = y¥ => $/¥ = ($/£)/(¥/£)
— Cross rate means that the third exchange rate
implied by any two exchange rates involving three
currencies.
Cross Rates
— Suppose that S($/£) = .50
— i.e. $1 = 2 £
— and that S(¥/£) = 50
— i.e. £1 = ¥50
— What must the $/¥ cross rate be?
$ $ €£
since = ´ ,
¥ £€ ¥
$1 £€11 $1
´ = Þ S ($ / ¥) = .01 or $1 = ¥100
£€2
2 ¥50 ¥100
Triangular Arbitrage
Suppose we
observe these $
banks posting
Barclays Credit
these exchange Lyonnais
rates. S(¥/$)=120
S(£/$)=1.50
First calculate the
¥ Credit Agricole
implied cross £
rates to see if an S(¥/£)=85
arbitrage exists.
Government intervention & factors
influenced
— Supply and demand for any given currency, and
thus its value, are not influenced by any single
element, but rather by several. These elements
generally fall into three categories:
— Economic factors,
— Political conditions and
— Market psychology.
Economic factors
These include:
1. Economic policy comprises:
Government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government's
central bank influences the supply and "cost" of money,
which is reflected by the level of interest rates).
2. Economic conditions include:
• Government budget deficits or surpluses
• Balance of trade levels and trends
• Inflation levels and trends
• Economic growth and health
• Productivity of an economy
The Effect of a Government Budget Deficit
Interest S2
Rate Supply, S1
1. A budget deficit
6%
decreases the
5% supply of loanable
funds . . .
2. . . . which
raises the
equilibrium Demand
interest rate . . .
0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Copyright©2004 South-Western
The Mundell-Fleming Model
Under Floating Exchange Rates
e LM* LM*'
e LM*
+DG, or –DT Þ +DM Þ
+De, no DY -De, +DY
IS*
IS* IS*'
Income, Output, Y Income, Output, Y
When income rises in a small open economy, due to When the increase in the money supply puts downward
the fiscal expansion, the interest rate tries to rise but pressure on the domestic interest rate, capital flows out
capital inflows from abroad put downward pressure as investors seek a higher return elsewhere. The capital
on the interest rate.This inflow causes an increase in outflow prevents the interest rate from falling. The
the demand for the currency pushing up its value outflow also causes the exchange rate to depreciate
and thus making domestic goods more expensive making domestic goods less expensive relative to
to foreigners (causing a –DNX). The –DNX offsets foreign goods, and stimulates NX. Hence, monetary
the expansionary fiscal policy and the effect on Y. policy influences the e rather than r.
Political conditions
• Internal, regional, and international political conditions and events can

have a profound effect on currency markets.
• All exchange rates are susceptible to political instability and

anticipations about the new ruling party. Political turmoil and
instability can have a negative impact on a nation's economy. For
example, destabilization of coalition governments in Pakistan and
Thailand can negatively affect the value of their currencies.
• Similarly, in a country experiencing financial difficulties, the rise of a

political faction that is seeming to be fiscally responsible can have the
opposite effect.
• Also, events in one country in a region may spur positive or negative

interest in a neighbouring country and, in the process, affect its
currency.
Market psychology
Market psychology and trader perceptions influence the

foreign exchange market in a variety of ways:
• Flights to quality
• Long-term trends
• "Buy the rumor, sell the fact"
• Economic numbers
• Technical trading considerations
Daily Trading Volumes by Hour
FX Turnover (2002)
FX Turnover (2008)
This approximately $3.21 trillion in main
foreign exchange market turnover was
broken down as follows:
• $1.005 trillion in spot transactions

• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting
10. The exchange rate
— The rate at which one currency can be exchanged

for another e.g.
— £1 = $1.90
— £1 = €1.50
— Important in trade and investments

Converting currencies:
— To convert £ into (e.g.) $ - Multiply the sterling
amount by the $ rate
— To convert $ into £ - divide by the $ rate: e.g.
— To convert £5.70 to $ at a rate of 1£ = $1.90,
multiply 5.70 x 1.90 = $10.83
— To convert $3.45 to £ at the same rate, divide 3.45 by 1.90
= £1.82
Determinants of Exchange Rates :

— Exchange rates are determined by the demand for
and the supply of currencies on the foreign
exchange market
— The demand and supply of currencies is in turn

determined by:
— Relative interest rates
— Changes in relative inflation rates
— The demand for imports
— The demand for exports
— Investment opportunities
— Speculative sentiments
— Global trading patterns
Factors affecting R D
RD shifts right when:

iD↑, because RD↑at each St
Note: This assumes that

domestic πe is unchanged, so
domestic real rate ↑
Factors affecting R F
RF curve shifts right when:

iF↑ because RF ↑ at each St
E(St+1)↓ because expected
appreciation of Foreign Deposits
causes RF↑
Other factors that will shift RF

rightward:
1. Domestic P↑
2. Imports ↑
3. Exports ↓
4. Productivity ↓
Factors that Shift R F and R D
Factors that Shift RF and RD
Appreciation of the exchange rate:
— A rise in the value of £ in relation to other
currencies – each £ buys more of the other
currency e.g.
— £1 = $1.85 £1 = $1.91
— UK exports appear to be more expensive
( Xp)
— Imports to the UK appear to be cheaper
( Mp)
Investing in the

UK would now be
more attractive
and demand for £
would rise
Exchange Rates Assume an initial
exchange rate of
S£
£1 = $1.85. There
$ per £ are rumours that
the UK is going to
increase interest
rates
1.90
The rise in demand
creates a shortage
in the relationship
1.85 between demand
for £ and supply –
the price (exchange
rate) would rise
D£1
Shortage
D£
Q1 Q3 Q2 Quantity on
Foreign Ex. Markets
Depreciation of the Exchange Rate
— A fall in the value of the £ in relation to other
currencies - each £ buys less of the foreign
currency e.g.
— £1 = € 1.50 £1 = € 1.45
— UK exports appear to be cheaper
( Xp)
— Imports to the UK appear more expensive
( Mp)
Investing in the UK
Exchange Rates would now be not

more attractive and
supply for £ would
S£ (S$) rise
$ per £
(£ per $) Assume an initial
exchange rate of £1
Surplus = $1.85. There are
S’£ (S$) rumours that the
UK is going to
decrease interest
rates
1.85 (0.54)
The rise in supply
1.70 (0.58) creates a surplus in
the relationship
between supply for
£ and demand – the
D£1
price (exchange
rate) would decline
D£ (D$)
Q1 Q3 Q2 Quantity on
Foreign Ex. Markets
— A depreciation in exchange rate should lead to a rise

in demand for exports, a fall in demand for imports –
the balance of payments should ‘improve’
— An appreciation of the exchange rate should lead to a
fall in demand for exports and a rise in demand for
imports – the balance of payments should get ‘worse’
BUT
What is the government debt
and the annual budget deficit?
When a government spends more than it collects in taxes, it borrows
from the private sector to finance the budget deficit.
Annual Deficit (2002)

The government debt
is an accumulation
of all past annual
deficits. In 2001, the
debt of the U.S. federal
government was $3.2
trillion.
What Does the Trade Balance
Really Mean?
— So in spite of its name, and it’s definition, the
trade balance
— Is not really about trade, which is just the symptom
— It is about whether we are living within our means
— When is a trade deficit good?
— When the country (like a young person) is investing
for the future (like a successful developing country)
— Not when it is going into debt just to finance current
consumption (like the US)
International Transactions: Data
account) account)
transfer) transfer)
International Transactions: Data
The U.S. Balance of Payments, 2005 (Millions of Dollars)
279
Exchange Rates
— The volumes and the actual amount of income
and expenditure will depend on the relative price
elasticity of demand for imports and exports.
— Elasticity of M = %ΔQM/% ΔPM
— Elasticity of X = %ΔQX/% ΔPX

Exchange Rates
— Floating Exchange Rates:
— Price determined only by demand and supply of the
currency – no government intervention
— Fixed Exchange Rates:
— The value of a currency fixed in relation to an
anchor currency – not allowed to fluctuate
— Dirty Floating or Managed Exchange Rate:
– rate influenced by government via central bank
around a preferred rate
Fixed vs Flexible Exchange Rate
Regimes
Pro & Cons for Floating Exchange Rate
— Arguments in favor of flexible exchange rates:

— Easier external adjustments.
— National policy autonomy.
— Arguments against flexible exchange rates:
— Exchange rate uncertainty may hamper
international trade.
— No safeguards to prevent crises.
Regimes
— Suppose the exchange rate is $1.40/£ today.
— In the next slide, we see that demand for British
pounds far exceed supply at this exchange rate.
— The U.S. experiences trade deficits.
Regimes
Dollar price per £
Supply
(exchange rate)
(S)
Demand
$1.40 (D)
Trade deficit
Q of £
S D
Flexible Exchange Rate
Regimes
— Under a flexible exchange rate regime, the dollar will
simply depreciate to $1.60/£, the price at which supply
equals demand and the trade deficit disappears.
Regimes
Dollar price per £
Supply
(exchange rate)
(S)
$1.60
Dollar depreciates Demand
$1.40 (flexible regime) (D)
Demand (D*)
Q of £
D=S
Regimes
— Instead, suppose the exchange rate is “fixed” at
$1.40/£, and thus the imbalance between supply and
demand cannot be eliminated by a price change.
— The government would have to shift the demand
curve from D to D*
— In this example this corresponds to contractionary
monetary and fiscal policies.
Regimes
Dollar price per £
Supply
(exchange rate)
Contractionary
policies (S)
(fixed regime)
Demand
$1.40 (D)
Demand (D*)
Q of £
D* = S
Purchasing Power Parity (PPP)

— The nominal exchange rate e is the price in foreign
currency of one unit of a domestic currency.
— The real exchange rate (RER) is defined as

RER = e(P/Pf), where Pf is the foreign price level
(price index) and P the domestic price level (price
index).
Purchasing Power Parity
in a Perfect Capital Market
— Purchasing power parity (PPP) is built on the notion

of arbitrage across goods markets and the Law of One
Price. P and Pf must have the same arbitrary value in
some chosen base year. Hence in the base year, RER =
e.
— The Law of One Price is the principle that in a PCM
setting, homogeneous goods will sell for the same
price in two markets, taking into account the
exchange rate.
PUS, wheat = PUK, wheat ´ S$ / £
Purchasing Power Parity (PPP)

— The RER is only a theoretical ideal. In practice, there
are many foreign currencies and price level values to
take into consideration.
— Correspondingly, the model calculations become
increasingly more complex. Furthermore, the model
is based on purchasing power parity (PPP), which
implies a constant RER.
— The empirical determination of a constant RER value
could never be realized, due to limitations on data
collection.
Purchasing Power Parity and Exchange Rate
Determination
— The exchange rate between two currencies should equal the

ratio of the countries’ price levels:
P$
S($/£) =
P£
For example, if an ounce of gold costs $300 in the U.S. and £150
in the U.K., then the price of one pound in terms of dollars
should be:
P$ $300
S($/£) = = = $2/£
P£ £150
Purchasing Power Parity and Exchange Rate Determination
— The exchange rate would be a proper reflection of the

purchasing power in each country if the relative values
bought the same amount of goods in each country.
— E.g. if the price of a pint of Stella in the UK was £3.00

and in Europe €4.50, the exchange rate between the
two countries should be £1 = €1.50
— If any lower than this value, the £ would be

undervalued and if any higher, the £ would be
overvalued.
Purchasing Power Parity and Overvalued
or Undervalued Currencies
— Nominal exchange rates greater than the PPP implied
exchange rate represent foreign currency overvaluation,
— while nominal exchange rates less than the PPP implied

exchange rate represent domestic overvaluation (or
foreign undervaluation).
The Big Mac PPP Standard
Purchasing Power Parity and Exchange Rate
Determination
— PPP exchange rates are especially useful when
official exchange rates are artificially manipulated
by governments.
— Countries with strong government control of the

economy sometimes enforce official exchange
rates that make their own currency artificially
strong.
— By contrast, the currency's black market exchange

rate is artificially weak. In such cases a PPP
exchange rate is likely the most realistic basis for
economic comparison.
11. The Balance of Payments
— A record of the trade between one Country
(UK) and the rest of the world.
— Trade in goods
— Trade in services
— Income flows
= Current Account
— Transfer of funds and sale of assets and liabilities
= Capital Account
account) account)
transfer) transfer)
U.S. Balance of Payments Data
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
3 Unilateral Transfers $10.24 ($64.39)
Balance on Current Account ($444.69)
Capital Account
4 Direct Investment $287.68 ($152.44)
5 Portfolio Investment $474.39 ($124.94)
6 Other Investments $262.64 ($303.27)
Balance on Capital Account $444.26
7 Statistical Discrepancies 0.73
Overall Balance $0.30
Official Reserve Account ($0.30)
§ Balance of payments equilibrium:
§ X + CM = M + CX
§ => X – M = CX – CM
§ If X > M => CX > CM => The Country exports

capital.
§ If X < M => CX < CM => The Country imports

capital.
§ Balance of trade (BT) is the value of
merchandise exports minus import:
§ BT = X - M
§ Basic Balance is the current account plus long

term capital.
The Balance of Payments Identity
BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account
Under a pure flexible exchange rate regime,

BCA + BKA = 0
Because BRA = 0
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18)
Capital Account
Credits Debits
Current Account In 2000, the
1 Exports $1,418.64
U.S. imported
2 Imports ($1,809.18)
more than it
Balance on Current Account ($444.69) exported, thus
Capital Account
running a
5 Portfolio Investment $474.39 ($124.94) current account
6 Other Investments $262.64 ($303.27) deficit of
$444.69
Overall Balance $0.30 billion.
Credits Debits During the
Current Account
1 Exports $1,418.64
same year, the
2 Imports ($1,809.18)
U.S. attracted
net investment
Balance on Current Account ($444.69) of $444.26
Capital Account
billion—clearly
5 Portfolio Investment $474.39 ($124.94) the rest of the
6 Other Investments
Balance on Capital Account
$262.64 ($303.27) world found the
$444.26
7 Statistical Discrepancies 0.73 U.S. to be a
Overall Balance $0.30 good place to
invest.
Credits Debits
Current Account
1 Exports $1,418.64
Under a pure
2 Imports ($1,809.18)
flexible
3 Unilateral Transfers $10.24 ($64.39) exchange rate
Balance on Current Account ($444.69) regime, these
Capital Account
numbers would
5 Portfolio Investment $474.39 ($124.94) balance each
Balance on Capital Account
other out.
$444.26
Credits Debits
Current Account
In the real
1 Exports $1,418.64
world, there
2 Imports ($1,809.18)
is a statistical
Balance on Current Account ($444.69) discrepancy.
Capital Account
Credits Debits
Current Account
1 Exports $1,418.64
2 Imports ($1,809.18) Including that,
3 Unilateral Transfers $10.24 ($64.39) the balance of
Capital Account
payments
4 Direct Investment $287.68 ($152.44) identity should
5 Portfolio Investment $474.39 ($124.94) hold:
Balance on Capital Account $444.26 BCA + BKA = – BRA
-($444.69) + $444.26 + $0.73 = $0.30= –($0.30)
Balance of Payments and the Exchange
Rate
Credits Debits
Current Account Exchange rate $
1 Exports $1,418.64
2 Imports ($1,809.18) P S
Capital Account
Balance on Capital Account $444.26 D
Official Reserve Account ($0.30) Q
Rate
As U.S. citizens import, they supply dollars to the FOREX market.
Credits Debits Exchange rate $
Current Account
1 Exports $1,418.64 P S
2 Imports ($1,809.18)
Capital Account
6 Other Investments $262.64 ($303.27) D
Overall Balance $0.30 Q
Rate
As U.S. citizens export, others demand dollars in the FOREX market.
Current Account
1 Exports $1,418.64 P S
2 Imports ($1,809.18)
Capital Account
Rate
As the U.S. government sells dollars, the supply of dollars increases.
Current Account
1 Exports $1,418.64 P S
2 Imports ($1,809.18)
S1
Capital Account
Statistical Discrepancy
What is the government debt
and the annual budget deficit?
When a government spends more than it collects in taxes, it borrows
from the private sector to finance the budget deficit.

The government debt
is an accumulation
of all past annual
deficits. In 2001, the
debt of the U.S. federal
government was $3.2
trillion.
What Does the Trade Balance
Really Mean?
— So in spite of its name, and it’s definition, the
trade balance
— Is not really about trade, which is just the symptom
— It is about whether we are living within our means
— When is a trade deficit good?
— When the country (like a young person) is investing
for the future (like a successful developing country)
— Not when it is going into debt just to finance current
consumption (like the US)
Balances on the Current (BCA) and Capital (BKA)
Accounts of the United States
500
400
300
200
100
U.S. BCA
0
U.S. BKA
-1001982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-200
-300
-400
-500
Accounts of United Kingdom
40
30
20
10
0 UK BCA
-101982 1984 1986 1988 1990 1992 1994 1996 1998 2000 UK BKA
-20
-30
-40
-50
Accounts of Japan
150
100
50
Japan BCA
0
Japan BKA
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-50
-100
-150
Accounts of Germany
80
60
40
20
Germany BCA
0
Germany BKA
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-20
-40
-60
-80
Accounts of China
35
30
25
20
15
China BCA
10
China BKA
5
0
-51982 1984 1986 1988 1990 1992 1994 1996 1998 2000
-10
-15
11. Interest Rates & Exchange Rates
— What is the interest rate?

— What is its relationship to exchange
rates?
Present Value
Four Types of Credit Instruments
1. Simple loan
2. Fixed-payment loan
3. Coupon bond
4. Discount (zero coupon) bond
Concept of Present Value
Simple loan of $1 at 10% interest

Year 1 2 3 n
$1.10 $1.21 $1.33 $1 x (1 + i)n
$FV
PV of future $1 =
(1 + i)n
Yield to Maturity: Loans
1. Simple Loan (i = 10%)
$100 = $110/(1 + i) Þ
$110 – $100 $10
i= = = 0.10 = 10%
$100 $100
2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126
$1000 = + + + ... +
(1+i) (1+i)2 (1+i)3 (1+i)25
FP FP FP FP
LV = + + + ... +
(1+i) (1+i)2 (1+i)3 (1+i)n
Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
$100 $100 $100 $100 $1000
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)10 (1+i)10
C C C C F
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)n (1+i)n
Consol: Fixed coupon payments of $C forever

C C
P= i =
i P
4. Discount Bond (P = $900, F = $1000), one year
$1000
$900 =
(1+i)
Þ
$1000 – $900
i= = 0.111 = 11.1%
$900
F–P
i=
P
Current Price or (Current Price + Par Value)/2

Distinction Between Interest
Rates and Returns
Rate of Return
C + Pt+1 – Pt
RET = = ic + g
Pt
C
where: ic = = current yield
Pt
Pt+1 – Pt
g= = capital gain
Pt
Relationship Between Price
and Yield to Maturity
Distinction Between Real & Nominal
Interest Rates
Real Interest Rate (the Fisher hypothesis (sometimes Fisher
parity)
—Interest rate that is adjusted for expected changes in the
price level
— ir = in – πe
— Real interest rate (ir) more accurately reflects true cost of
borrowing
— When real rate is low, greater incentives to borrow and less
to lend
—if in = 5% and πe = 3% then:
ir = 5% – 3% = 2%
—if in = 8% and πe = 10% then
ir = 8% – 10% = –2%
U.S. Real and Nominal
Interest Rates
The International Fisher Effect
The Fisher hypothesis says that the real interest rate

in an economy is independent of monetary variables.
If we add to this the assumption that real interest
rates are equated across countries, then the country
with the lower nominal interest rate would also have a
lower rate of inflation and hence the real value of its
currency would rise over time.
The International Fisher Effect
—Suppose that the current spot exchange rate for U.S.
Dollars into British Pounds is $1.4339 per pound. If the
current interest rate is 5 percent in the U.S. and 7 percent
in Britain, what is the expected spot exchange per pound
rate 12 months from now according to the International
Fisher Effect?
—The International Fisher Effect estimates future exchange
rates based on the relationship in nominal interest rates.
Multiplying the current spot exchange rate by the nominal
annual U.S. interest rate and dividing by the nominal
annual British interest rate yields the estimate of the spot
exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 =
$1.4071.
Covered Interest Parity (CIP)
Suppose you have $100,000 to invest for one year.
You can either
1. invest in the U.S. at i$. Future value = $100,000(1 + i$)
or
2. trade your dollars for pounds at the spot rate, invest in England at i£
and be cautious your exchange rate risk by selling the future value of
the British investment forward.
The future value = $100,000(F/S)(1 + i£ )
Since both of these investments have the same risk, they must have
the same future value—otherwise an arbitrage would exist, therefore
(F/S)(1 + i£) = (1 + i$)
Formally,
(F/S)(1 + i£) = (1 + i$)
or if you prefer,
1 + i$ F
=
1 + i£ S
IRP is sometimes approximated as
i$ – i£ = F – S
S
— Depending upon how you quote the exchange rate ($ per £
or £ per $) we have:
1 + i£ F£/$ 1 + i$ F$/£
= or =
1 + i$ S£/$ 1 + i£ S$/£
CIP and Covered Interest
Arbitrage
A trader with $1,000 to invest could invest in the U.S., in one year
his investment will be worth $1,071 = $1,000´(1+ i$) =
$1,000´(1.071)
Alternatively, this trader could exchange $1,000 for £800 at the

prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800
at i£ = 11.56% for one year to achieve £892.48. Translate £892.48
back into dollars at F360($/£) = $1.20/£, the £892.48 will be exactly
$1,071.
Interest Rate Parity
According to IRP only one 360-day forward rate,
F360($/£), can exist. It must be the case that
F360($/£) = $1.20/£
Why?
If F360($/£) ¹ $1.20/£, an smart trader could make money

with one of the following strategies:
Arbitrage Strategy I
If F360($/£) > $1.20/£
i. Borrow $1,000 at t = 0 at i$ = 7.1%.

ii. Exchange $1,000 for £800 at the prevailing spot
rate, (note that £800 = $1,000÷$1.25/£) invest £800
at 11.56% (i£) for one year to achieve £892.48
iii. Translate £892.48 back into dollars, if
F360($/£) > $1.20/£ , £892.48 will be more than enough
to repay your dollar obligation of $1,071.
Arbitrage Strategy II
If F360($/£) < $1.20/£
i. Borrow £800 at t = 0 at i£= 11.56% .
ii. Exchange £800 for $1,000 at the prevailing spot

rate $1.20/£, invest $1,000 at 7.1% for one year to
achieve $1,071.
iii. Translate $1,071 back into pounds, if
F360($/£) < $1.20/£ , $1,071 will be more than enough
to repay your £ obligation of £892.48.
12. Dollarization
Dollarization
— Dollarization: occurs when residents of a
country extensively use a foreign currency
alongside or instead of the domestic
currency.
— Official dollarization occurs when the
government adopts the foreign currency as
a legal tender.
12. Dollarization
— Unofficial dollarization: there is no legal element.
(different stages: asset substitution (holding foreign
bonds and deposits abroad), currency substitution
(holding foreign currency deposits in domestic
banking system).
— Panama is an example of official dollarization;
— Andorra had two currencies as legal tender: French
franc and Spanish Peseta.
— Difficult to assess the performance of dollarized
economy: not much evidence.
12. Dollarization
How does dollarization work?
— An officially dollarized country is part of a unified

currency zone with the country whose currency it
uses, otherwise called issuing country.
— An officially dollarized country relinquish (giving up)
independent monetary policy and imports monetary
policy of the country whose currency it uses.
12. Dollarization
— Within the currency zones, arbitrage tends to keep
prices of similar goods within a narrow range =>
inflation rates tend to be similar throughout the zone.
— Interest rates tend also to be equalized across the
currency zone (still country risk element might
contributing in creating a wedge between interest
rates).
— Supplied of money is determined by the balance of
payment: the monetary base is determined by the
issuing country and if people want to acquire more
foreign currency notes they have to spend less.
12. Dollarization
Cost of dollarization for officially dollarized
Countries:
— Lost of seigniorage (profit by government);
— One time cost of converting prices;
— Losing central bank as a lender of last resort;
— Losing flexibility in monetary and exchange rate
policy;
12. Dollarization
Benefits of dollarization for officially dollarized
Countries:
— Lower transaction costs;
— Reducing the country risk premium on foreign
borrowing;
— Lower inflation and lower risk of future inflation;
— Greater economic openness and transparency;
12. Dollarization
When should countries adopt an official
Dollarization regime?
— History of poor monetary performance;
— Many economists have proposed the theory of
optimum currency area to judge where official
dollarization is desirable.
— Critical role of major trading partners;
— Political considerations;
sUmGrKuN
THANKS YOU

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INTERNATIONAL

MSc. Chan Bonnivoit

370 – 220 = GDP = 150

Whisky sold to Italian hotel

Export earnings for UK

Oil from Russia

£ changed into Roubles Export earnings for Russia

Import expenditure for the UK

§ If X > M (trade surplus) => CX > CM => The Country

§ If X < M (trade deficit) => CX < CM => The Country

The UK Balance of Payments on Current Account 1998 - 2004

§ The range of goods that are internationally traded

§ Direction of the international trade

§ Volume or value of international trade

§ Trend of the international trade

— World trade centers on the industrialized countries.

— Value of $2.4 trillion in 2006 (about 25% of

— Most traded services: transportation, travel, other

— U.S is largest exporter and importer of services

— Trade has been growing more quickly than world

World Merchandise Exports World GDP

Source: The WEO Database (IMF),

§ He argued that the Countries specialized in the

§ In this case, rather than producing both goods, as they

Items Country A Country B The world

Textile 6 h for producing 1 4 h for producing 1 2 units of textile

§ In similar fashion, let the output of soybean in

§ With 12 more hours of input factor, 3 additional

Country A + 2 units of soybean - 1 unit of textile (as 6H

Items Country A Country B The world

§ Ricado first pointed out, is that, in this case, the

§ This rule is known as the law of comparative advantage.

Items Country A Country B The world

Textile 6 h for producing 1 8 h for producing 1 2 units of textile

Country A + 2 units of soybean - 1 unit of textile (as 6H

Items Country A Country B The world

§ The output of both goods rises

§ The world production of both goods increases

§ Both Country can be trading better than they would

§ It is not borne out in the real world.

• This paper was written in Swedish and was not

• An English translation of this paper entitled “ the Effect

• Ohlin’s book is titled “Interregional und

• Ohlin has got the Nobel Price of Economic in

• Countries differ from each other according to the factors of

• Given these features of the world, HO argued that a Country

• Full movement of domestic factor inputs in the Country, but

• Transport cost, tax, etc. were exempted, if the both goods

• Full using all domestic resources relatively endowed.

• Balance Payment of both Countries has the balance situation

• HO theorem (hypothesized) said a Country will have

• If we simplify the theory, then the theorem states that a

• Let trying to prove the HO theorem graphically

Items Country A Country B The world

Textile 6 h for producing 1 8 h for producing 1 2 units of textile

• We introduce the consumption of identical taste in the two

• (PS/PT) of Country A and (PS/PT) of Country B are a tangency

• As we knew the tangency or slope of PPFs at the

• Consequently, from the diagram it is clear that:

• It recalls that a Country has a comparative advantage in

• Now, let go back to our assumption that S was assumed

• Here we have not only prove the theorem of Country A,

• The answer to this question here is the same of classical

• Consequently, we would expect to see Country A export