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INTERNATIONAL ECONOMICS

 International trade refers to the exchange of goods and services

between the people of two countries

 International trade can increase world production and gives consumers

a greater variety of products  Every country involves in international trade for the same reason which is specialization  When countries specialize, total world output increases and world consumption also increases  Through the international trade, a country can consume a combinations of goods that lie outside the boundary of that country  International trade occurs because a country may not be able to produce all goods and services itself  An international market increases competition and through competition, efficiency increase

Reasons for International Trade

Trade may take place because of the diversity in conditions of productions among countries. Countries with tropical climates will naturally specializes in banana & papaya while freezing countries will specialize in grape or strawberry.

International trade which involves a vast global market, may also take place because of increasing return to scale. For example, Japan, which has been a leader in the production of consumers electronics, exports its products and enjoys economies of scale due to its cost and technological advantage over other countries

Even if conditions of production will identical in all regions, countries might engaged in trade if their tastes for goods were different. For example, China might trade local oranges from New Zealand if both countries is likeness for each other s product
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A country is said to have an absolute advantage in the production of a good when it can produce more of that good than another country, using the same amount of resources Table 16.1 Country Malaysia China Total Cotton (ton) 20 40 60 Rice (ton) 60 20 80

*Both countries allocate 50% of the their resource to produce cotton and rice

Cotton (ton)

AB China s PCC CD Malaysia s PCC

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Country Malaysia China

Cotton (ton) 20 40 60

Rice (ton) 60 20 80

20 C

Total

B 20

D 60

Rice (ton)

Country Malaysia China Total

Cotton (ton) 20 40 60

Rice (ton) 60 20 80

Conclusion:
1. Malaysia have absolute advantage in producing rice 2. China have an absolute advantage in producing cotton

Since both countries have a mutual absolute advantage in the production of cotton and rice, specialization can take place.

Table 16.2 after specializatio

Country Malaysia i a Total After specialization:

1. 2.

Cotton (ton) 0 0 0

Rice (ton) 120 0 120

Malaysia can fully utilize their resource to produce 120 ton of rice China can use all their resource to produce 80 ton of cotton.
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 With specialization, both countries are able to trade with each other in order to consume both products.  Assume that there is arrangement to trade 1-ton of cotton for 1-ton of rice.  Malaysia need to give 20-ton of rice if need 20-ton of cotton.
Country Malaysia China Total Cotton (ton) 20 60 80 Rice (ton) 100 20 120

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1.

There are only two countries in the world that involve in international trade. For example Malaysia and China.

2. There are only two goods produced by two countries. For example rice and car. They used all of their resources to produce those two goods only. No other goods are produced 3. Free trade exist between these two countries 4. No transportation costs are involved 5. There is constant cost of production

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According to David Ricardo, when there are two countries, a country should specialize (export) in the production of goods and services in which the country has a greater comparative advantage or lower opportunity cost and imports the commodity where the opportunity cost is higher or comparative advantage is less.
Table 16.4

Country Malaysia China Total

Cotton (ton) 60 20 80

Rice (ton) 10 10 20
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Country Malaysia China Total

Cotton (ton) 60 20 80

Rice (ton) 10 10 20

To determine which country is to specialize in rice or cotton, must be calculated. the

Country
Table 16.5

Cotton (ton) 60 C = 10 R 1 C = 0.17 R 20 C = 10 R 1 C = 0.5 R

Rice (ton) 10 R = 60 C 1R=6C 10 R = 20 C 1R=2C

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Malaysia China

Table 16.5

Country Malaysia China

Cotton (ton) 0.17* 0.5

Rice (ton) 6 2*
*Compare the lowest opportunity cost

Conclusion: i. Malaysia has the lower opportunity cost in producing of cotton* ii. China has the lower opportunity cost in producing of rice*

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Table 16.6-After Specializatio

Country Malaysia i a Total

Cotton (ton) 60 + (10/0.17) = 120 0 120

Rice (ton) 0 10 + (20/2) = 20 20

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y Terms of trade refers to the rate at which goods are exchanged. y For international trade to be mutually beneficial for each country, the

terms of trade country. formula:

Terms of Trade (%) = Average price of exports v Average price of imports
y If

for both

y We calculate the terms of trade as an index number using the following

100%

are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports. rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services.
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y If

Country
Table 16.5

Cotton (ton) *1 C = 0.17 R 1 C = 0.5 R

Rice (ton) 1R=6C *1 R = 2 C

Malaysia China
*Malaysia export cotton *China export rice

Cotton Malaysia 1C = 0.17R range of trade China 1C = 0.5R Which mean trade is in between; 0.17R < 1 C < 0.5R To be accurate, calculate the 1average: C = = 0.34 R 0.17 + 0.5 2

Rice Malaysia 1R = 6C range of trade China 1R = 2C Which mean trade is in between; 6C < 1 R < 2C To be accurate, calculate the 1average: R = = 4C 6 + 2 2
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1. 2. 3.

Specialization & trade brings about increased world output and gains for the individual country. Consumers enjoy a wide variety of goods & services to choose from and this means a higher standard of living. Trade generates income and brings about higher income & economic growth. The production of goods for exports also creates employment. Relationship among trading partners can be improved, political differences can be minimized and compromises can be made easily through ASEAN, EEC and other trading bodies. It also promotes travel and understanding through visits and exchanges.
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4.

5. 6.

Trade also brings about the sharing of knowledge, information & technology among trading nations. It leads to proper resource allocation when the resources are used according to the comparative advantage of the country. With international trade, there will be keen competition, which leads to efficiency and cost-effectiveness. This may also prevent the formation of monopoly in a country. Through trade, international indebtedness can be solved. Earning foreign exchange through an increase in exports can reduce a deficit in the balance of payments.
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7.

8.

The continuous export of raw materials such as oil may deplete a nation's reserve of the deposit in the long run. If this happens, it will affect the nation's growth in the long run.

Economic specialization may lead to a nation having to depend on other countries for other goods. This makes the country vulnerable to external forces. A fluctuation in price employment may affect economic growth.

If transportation costs are too high, then international trade will not be a profitable venture for some countries.
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 Taxes imposed on imported goods.  Ad-volerem- based on the value/price of the goods  Specific tariff- based on the quantity of the goods.

 Legal limit of number of units that can be imported.

 Total ban on imported goods

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 Requirement of the import license  High license fees and delays in the processing applications forms may discourage producers from importing these gods and services

 Control the amount of money to be brought into or out of the country.  Restriction on the sale or purchase of foreign currencies  Government give subsidy to protect domestic company by reducing the cost of production and hence increasing government revenue.
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 Balance of payments is a statement showing the net exchange of that nation currency for foreign currencies from all transactions between that nation and foreign nations in a given year.  Balance of payment is also a summary record of a country economic transaction in a given period of time.  The major components of that activity: 1. Current Account Balance, 2. Capital Account Balance and 3. Official Financing Account.
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Tra e / visible balance

Service / invisible balance

Net income

Transfer payment balance

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1. Trade / visible balance is the difference of export and import of physical goods.

Deficit Trade Balance Surplus Trade Balance

Import > Export Export > Import

2. Service / invisible balance is the difference of receipts and expenditures from

services like insurance, tourism, freight, interest, dividends etc.

3. Net Income

refers to the difference between investment income flows into and out of a country. Such as compensation paid to employees, investment on income.
3. Transfer payments may come from private or government. Net private transfer

may include any flow or transfer of money by foreign workers to their families in their own countries. Net government transfer includes military or financial aid or gifts by one government to another.
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Refers to long term loans (more than a year) made by a government. A government may borrow from other nations or from IMF (International Monetary Fund) or World Bank. Only the principal amount of the borrowing or the repayment of the principal value will be included.

May come from direct (physical) investment or portfolio investment. Direct investment is investment on capital goods, for example Telekom invests in telecommunication goods in Thailand, or Proton sets up a factory in United Kingdom. Portfolio investment is investment in foreign stocks or foreign exchange market.
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The flow of money from commercial banks or other financial institutions. For example, an American deposits a sum of money in our local bank. Errors and omissions are also included in shortterm capital. This includes illegal transactions, unrecorded flow of money or any missing items. It acts as the balancing item.
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Official financing consists of government's gold and foreign currency reserves as well as government's account with IMF and BNM Reserve.

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Items Exports Imports Transportation Net transfer Errors and omissions Official long-term capital Direct investment Other services Travel Investment income Government transaction

RM Million 319,568 233,519 8,464 6,567 4,924 9,397 36,854 8,395 6,135 20,275 23

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Occurs when there is a deficit or surplus in the balance of payment

Factors that contribute to the disequilibrium: 1. Development programs 2. Income 3. Price effect 4. Elasticity of demand for exports and imports 5. Population growth

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1.

Export Promotion
Strengthening the competitiveness of exports, which can be achieved by developing the use of products and using good pricing & marketing strategies, can do this. The government may also help by giving subsidies or tax holidays to exporters or abolishing export duties. Government may also promote local goods in international markets and provide information that may help exporters market their products.

2.

Discourage Import
The government may discourage imports and substitute imported goods with locally produced goods. This can be done by imposing or increasing tariffs or quota on imports, which will lead to an increase in the price of imported goods. By inculcating a sense of loyalty among locals to buy local goods and controlling the amount of foreign currencies that can be held by individuals or importers will also discourage imports and lead to expenditure switching from import goods to local goods.

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3.

Control on Inflation The reason people buy import goods could be inflation. Inflation or the increase in prices of local goods makes foreign goods more attractive, while foreign investors might not be interested to invest because of high production costs. Thus, to solve a deficit in the balance of payments, inflation problem needs to be taken care of first. Using The Government s Reserve Government's gold and foreign currency reserves are often used to balance any deficit in the balance of payments. However, this is a short-term solution to improve the deficit problem. Continuously using the reserves will deplete them in the long run.
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4.

5.

Devaluation Devaluation means the deliberate policy of the government to reduce the par value of the country's currency vis-a vis other currencies. This method is usually taken as a last resort. Undertake Accommodating Transaction This means transactions that are meant to balance the balance of payments. This can be done by restricting locals from visiting foreign countries, stopping aid & grants, selling property and encourage capital inflows from foreign investment.
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6.

The price of one currency in terms of another currency As an example RM 3.00 = US $1, meaning, the price of a Ringgit equal to US 0.33 cents.  There are of exchange rate systems used by nations until today:
1. 2. 3.

The Gold Standard The Bretton Woods System (Fixed Exchange Rate) Flexible Exchange Rate System
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I. II.

The gold standard was the major system of exchange rate determination before 1914. All currencies were priced in terms of gold - that is, an ounce of gold was worth so much in each currency. When all currencies exchanged at fixed ratios to gold, exchange rates could be determined easily. For instance, one ounce of gold was worth $20 U.S.: that same ounce of gold exchange for 4 British pounds. Since $20 and 4 were each worth one ounce of gold, the exchange rate between dollars and pounds was $20 / 4, or $5 to 1. by the country's willingness to buy and sell gold at the determined price. terms of gold and as long as each is willing to buy and sell gold.

III. For the gold standard to be effective, however, it had to be backed up IV. As long as countries maintain their currencies at a fixed value in V.

One major problem with the gold standard is that a country had little control over its money supply.
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y Under the Bretton Woods system countries were to peg their currencies in

terms of U.S. dollar instead of gold. U.S. dollars was then pegged directly to gold which is $35 to an ounce of gold. The US guaranteed that it would freely convert dollars (US$) into gold. It was hoped that this would encourage countries to hold dollars as their major reserve currency. After all, if dollars were freely convertible into gold, they were as good as gold. So all the other countries continue to peg their currency to US dollar. From time to time, however they would revalue or devalue their currency against the dollars. The Bretton Woods system allowed for different types of adjustment to balance of payment disequilibrium depending on the severity of their economic problem.

y If Malaysia were to trade with Japan and need to import Japanese goods worth

100 million, the payment using the exchange rate would be:

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y Under this system, the exchange rate is permitted to vary with market demand and supply conditions. Under a system of flexible exchange rate, the exchange moves up or down to choke off any excess supply or demand for foreign exchange. With flexible exchange rates, the quantity of foreign exchange demand equal to the quantity supplied.

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y For the same reason there is no need for foreign exchange reserves. Although

flexible exchange rate eliminates balance of payment and foreign reserve problems, it cannot solve all problems of international trade experienced by a country. y Exchange rate movement associated with flexible rate may disrupt import and export flows. As noted before, depreciation of the dollar, raises the price of all imported good. y The price increase may lead to increase in domestic price causing inflation. Further more local businessmen that sell imported goods or use imported goods in their production may suffer sales losses. On the other hand, appreciation of the dollar raises the foreign price of US goods and reduces the sales of US exports.

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