International Economics: Trade, Policy, Balance of Payments and Exchange Rates

This chapter answers Section XH1.4 of the Humanities and Social Sciences (XH) paper, "International Economics" — part of Section XH1 Economics, one of the six optional sections, chosen at application. It teaches the theories of international trade (absolute and comparative advantage, Heckscher–Ohlin and the new trade theory under imperfect competition), the gains from trade, the terms of trade and the trade multiplier; trade policy through tariff and non-tariff barriers, dumping and anti-dumping, GATT, the WTO and regional trade blocs; the balance of payments — its composition, equilibrium and disequilibrium and the adjustment mechanisms; and the foreign-exchange market, arbitrage, exchange-rate determination and the roles of the IMF and the World Bank. Worked numericals cover the commodity terms of trade, the foreign-trade multiplier, an arbitrage-free cross rate and the effective rate of protection.

1. Absolute and comparative advantage

Adam Smith's theory of absolute advantage holds that a country should specialise in and export the good it can produce with fewer resources than its partner, and import the other. David Ricardo's deeper theory of comparative advantage shows that gains exist even if one country is absolutely more productive in everything: a country should specialise where its opportunity cost is lower — the amount of the other good given up. If Portugal gives up less cloth to make a unit of wine than England does, Portugal has the comparative advantage in wine (and England in cloth), whatever the absolute figures. Trade then lets both consume beyond their own production possibility frontier.

Worked example: in one hour Country X can make 6 units of cloth or 3 of wine, and Country Y 2 of cloth or 2 of wine. X is absolutely better at both. But the opportunity cost of a unit of wine is 2 cloth in X and 1 cloth in Y, so Y has the comparative advantage in wine and X in cloth. Any exchange rate between 1 and 2 units of cloth per unit of wine leaves both better off than at home; where it settles within that range divides the gain.

⚠️ Comparative, not absolute, advantage drives trade
The common error is to say a country that is less productive at everything cannot gain from trade. Ricardo's point is the opposite: as long as opportunity-cost ratios differ, both countries gain by specialising according to comparative advantage. Only if the two countries' opportunity-cost ratios are identical is there no basis for trade.

2. Factor endowments and the new trade theory

The Heckscher–Ohlin theorem explains comparative advantage by factor endowments: a country exports the good that uses its abundant factor intensively and imports the good using its scarce factor. Three related results follow. The Stolper–Samuelson theorem: a rise in a good's relative price raises the real return of the factor used intensively in it and lowers the other's — so protection helps the scarce factor. The factor-price equalisation theorem: free trade in goods tends to equalise factor prices across countries even without factor mobility. The Rybczynski theorem: at constant relative goods prices, a rise in the endowment of one factor raises the output of the good that uses it intensively and lowers the output of the other good. The Leontief paradox is the empirical finding that the capital-abundant United States exported relatively labour-intensive goods, contradicting a naïve reading of Heckscher–Ohlin.

The new trade theory (associated with Paul Krugman) explains trade that classical theory cannot: trade between similar countries, in similar goods. Its engines are internal economies of scale — larger output lowers unit cost — and product differentiation under monopolistic competition. This produces intra-industry trade (a country both exports and imports cars) and gives consumers more variety at lower cost. Because scale and first-mover advantages matter, outcomes can depend on history and policy, which is the theoretical basis for strategic trade policy, though that is hard to implement in practice.

3. Gains from trade, terms of trade and the trade multiplier

The gains from trade split into a production gain (resources shift to the comparative-advantage good) and a consumption gain (consumers reach a higher indifference curve). How the gain is divided between countries depends on the terms of trade — the rate at which exports exchange for imports, set by reciprocal demand (J. S. Mill), shown graphically by offer curves. The further the terms of trade settle from a country's own domestic cost ratio, the larger its share of the gain.

  • Net barter (commodity) terms of trade = (export price index / import price index) × 100, with a base year set to 100 — a rise means a unit of exports buys more imports.
  • Gross barter terms of trade (Taussig) = import quantity index / export quantity index; income terms of trade = net barter terms × export quantity index, measuring the import capacity of exports.
  • The foreign-trade (export) multiplier shows how an autonomous rise in exports raises national income: k = 1 / (MPS + MPM), where MPS is the marginal propensity to save and MPM the marginal propensity to import. Imports are a leakage, so a higher MPM lowers the multiplier.

4. Tariffs, non-tariff barriers and dumping

A tariff is a tax on imports — specific (a fixed sum per unit), ad valorem (a percentage of value) or compound. In a small country it raises the domestic price by the full tariff, cuts imports, protects domestic producers and raises revenue, but imposes a net deadweight loss, because consumers lose more than producers and the government gain. A large country can shift part of the burden onto foreign exporters and may gain from an optimum tariff. The effective rate of protection measures protection to an industry's value added, not just its output price, and exceeds the nominal tariff when inputs are taxed more lightly than the finished good.

  • Non-tariff barriers (NTBs): import quotas (a quantity ceiling), voluntary export restraints, subsidies to domestic producers, local-content rules, and technical, health or safety standards used as disguised protection.
  • Dumping is selling exports below home-market price (or below cost). It is persistent (ongoing price discrimination), predatory (to drive out rivals, then raise prices) or sporadic (unloading a surplus). WTO rules permit anti-dumping duties where dumping causes material injury to a domestic industry.

Trade policy issues turn on the case for and against protection. The main arguments for it are the infant-industry argument (temporary protection lets a young industry reach efficient scale), strategic trade policy under imperfect competition, and short-run balance-of-payments or employment concerns; the main arguments against are the net deadweight loss to the economy, the risk of retaliation and rent-seeking. Development strategy has swung between import substitution (protect home industry to replace imports) and export promotion (support exports through subsidies, exchange-rate and incentive schemes). On the standard analysis, a production subsidy is a better way to nurture an industry than a tariff, because it corrects the targeted distortion without taxing consumption.

5. GATT, the WTO and regional trade blocs

The General Agreement on Tariffs and Trade (GATT, 1947) cut tariffs through successive rounds; its Uruguay Round created the World Trade Organization (WTO, 1995) as a permanent body with binding dispute settlement. Two core principles: most-favoured-nation (MFN) treatment — a concession to one member is extended to all — and national treatment — imported goods are treated no worse than domestic ones once inside the border. The WTO administers the goods agreement, GATS for services and TRIPS for intellectual property.

Regional trade blocs deepen in stages: a free-trade area removes internal tariffs (members keep their own external tariffs); a customs union adds a common external tariff; a common market also allows free movement of factors; and an economic union harmonises policies and may share a currency. Jacob Viner distinguished trade creation (cheaper partner output replaces costly domestic production — welfare-raising) from trade diversion (a low-cost outside supplier is displaced by a tariff-free but higher-cost partner — welfare-reducing). A bloc is beneficial on balance when creation outweighs diversion.

6. Balance of payments: composition, equilibrium and adjustment

The balance of payments (BoP) records all transactions between residents and the rest of the world, by double entry, so it always balances in the accounting sense. The current account covers goods (the trade balance), services, primary income and transfers; the capital and financial account covers investment flows and reserve assets. A BoP disequilibrium means a gap in the autonomous transactions (done for their own sake), which must be financed by accommodating transactions, chiefly a change in official reserves. A persistent deficit draws down reserves and is unsustainable.

Four adjustment mechanisms correct a deficit. The classical price–specie-flow mechanism (Hume) works under a gold standard: a deficit drains gold, lowers the money supply and prices, and restores competitiveness. The income mechanism works through the trade multiplier as income and imports fall. The exchange-rate mechanism uses devaluation or depreciation, which improves the trade balance only if the Marshall–Lerner condition holds — in its simple form (trade initially balanced, supplies perfectly elastic), the sum of the absolute demand elasticities for exports and imports exceeds one — and typically worsens it first (the J-curve). The monetary approach treats a deficit as an excess supply of money that corrects itself.

7. Foreign exchange, arbitrage, exchange rates and the Bretton Woods institutions

The foreign-exchange market trades currencies at a spot rate (immediate) or a forward rate (a future date agreed now). Arbitrage — buying where a currency is cheap and selling where it is dear — keeps rates consistent: two-point arbitrage aligns a pair across centres, and triangular arbitrage aligns three currencies, so the cross rate between any two must equal the product implied by their rates against a third, leaving no riskless profit. Covered interest parity links the forward premium to the interest-rate differential.

Exchange rates are determined, in the long run, by purchasing power parity (PPP) — the rate that equalises the price of a common basket, so high relative inflation depreciates a currency — and, in the short run, by interest rates and expectations (the asset-market view). Regimes range from fixed to freely floating, with managed floats between. The IMF, conceived at the Bretton Woods conference (1944), promotes exchange-rate stability and lends to members facing short-run balance-of-payments difficulties, issuing Special Drawing Rights (SDRs). The World Bank (IBRD) provides long-term finance for development and reconstruction — the division of labour between a short-run stabiliser and a long-run development lender.

Key takeaways

  • Absolute advantage (Smith) compares resource cost; comparative advantage (Ricardo) compares opportunity cost, so both countries gain as long as their opportunity-cost ratios differ, even if one is absolutely more productive in everything.
  • Heckscher–Ohlin ties trade to factor abundance; Stolper–Samuelson says protection aids the scarce factor; the Leontief paradox is its empirical puzzle. New trade theory explains intra-industry trade through economies of scale and product differentiation.
  • Net barter terms of trade = (export price index / import price index) × 100; the foreign-trade multiplier is 1/(MPS + MPM). Terms of trade, set by reciprocal demand, divide the gains from trade between the two countries.
  • A tariff raises the domestic price and protects producers at a deadweight loss; the effective rate of protection can exceed the nominal rate. Dumping is below-price export; WTO allows anti-dumping duties on injury. NTBs include quotas, VERs and standards.
  • GATT (1947) became the WTO (1995), built on MFN and national treatment. Blocs deepen from free-trade area to customs union to common market; Viner's trade creation raises welfare while trade diversion lowers it.
  • The BoP always balances by accounting; disequilibrium is in autonomous items, financed by reserves. Devaluation improves the balance only if the Marshall–Lerner condition holds. Arbitrage enforces cross rates; the IMF lends short-run and the World Bank long-run.

Practice questions (17)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

  1. Taking the base year index as 100, a country's export price index rises to 120 and its import price index rises to 96 in the current year. Compute the net barter (commodity) terms of trade for the current year, defined as (export price index / import price index) × 100. Give the number to the nearest integer.

    Numerical answer — type the value.

    Show answer

    Answer: 125

    Net barter terms of trade = (export price index / import price index) × 100 = (120/96) × 100 = 125. A value above 100 means the terms of trade have improved: a unit of exports now commands more imports than in the base year.

  2. In a simple open economy with no government sector, the marginal propensity to save is 0.2 and the marginal propensity to import is 0.3. Compute the value of the foreign-trade (export) multiplier, k = 1/(MPS + MPM).

    Numerical answer — type the value.

    Show answer

    Answer: 2

    The foreign-trade multiplier k = 1/(MPS + MPM) = 1/(0.2 + 0.3) = 1/0.5 = 2. Both saving and importing are leakages from the circular flow, so including the import leakage makes the open-economy multiplier smaller than the closed-economy multiplier 1/MPS = 5.

  3. Assume no transaction costs and an arbitrage-free market. Bank quotes are 1 USD = 80 INR and 1 USD = 1.6 AUD. Compute the implied cross rate: how many INR equal 1 AUD? Give the answer as a whole number.

    Numerical answer — type the value.

    Show answer

    Answer: 50

    One USD equals both 80 INR and 1.6 AUD, so 1.6 AUD = 80 INR, giving 1 AUD = 80/1.6 = 50 INR. If the market quoted anything other than 50, triangular arbitrage through the US dollar would yield a riskless profit, which is why the arbitrage-free cross rate is exactly this ratio.

  4. Under free trade a product sells for 100, of which an imported input accounts for 60 (so the input's share of the free-trade product price is 0.6). The country sets a nominal tariff of 20% on the final good and 10% on the imported input. Using ERP = (t − a·tᵢ)/(1 − a), where t is the nominal tariff on the final good, tᵢ the tariff on the input and a the input's cost share, compute the effective rate of protection as a percentage.

    Numerical answer — type the value.

    Show answer

    Answer: 35

    ERP = (t − a·tᵢ)/(1 − a) = (0.20 − 0.6 × 0.10)/(1 − 0.6) = (0.20 − 0.06)/0.40 = 0.14/0.40 = 0.35, i.e. 35%. Because the input is taxed more lightly than the finished good, the protection to value added (35%) far exceeds the 20% nominal tariff on the output.

  5. Country A can produce both wheat and cloth using fewer labour hours than Country B. According to the theory of comparative advantage, what is the correct conclusion?

    1. No mutually beneficial trade is possible, since Country A is more efficient at making both goods than Country B is
    2. Both countries can still gain if their opportunity-cost ratios between wheat and cloth differ
    3. Country A should produce both goods itself and export both to Country B
    4. Country B should specialise in whichever good it produces with fewer absolute labour hours
    Show answer

    Answer: B — Both countries can still gain if their opportunity-cost ratios between wheat and cloth differ

    Comparative advantage rests on opportunity cost, not absolute efficiency: so long as the two countries give up different amounts of one good to make the other, each has a comparative advantage in one good and both gain by specialising accordingly. Absolute superiority in both goods does not block trade; what Country B should produce depends on its opportunity costs relative to Country A's, not on which of its own labour requirements happens to be smaller (the Smith absolute-advantage test, which compares across countries, would wrongly leave Country B with nothing to specialise in).

  6. The Heckscher–Ohlin theorem predicts that a country will export the good that:

    1. uses its relatively abundant factor intensively
    2. uses its relatively scarce factor intensively
    3. it can produce at the lowest absolute money cost
    4. has the highest world demand regardless of factor use
    Show answer

    Answer: A — uses its relatively abundant factor intensively

    Heckscher–Ohlin explains trade by relative factor endowments: a country exports goods intensive in its abundant (hence cheaper) factor and imports goods intensive in its scarce factor. The scarce-factor answer reverses the prediction; absolute money cost is the pre-Ricardian view; and world demand alone does not determine the pattern in this theorem.

  7. A small country imposes a tariff on an imported good. Compared with free trade, which outcome is the standard partial-equilibrium result?

    1. The domestic price is unchanged, because the world price falls by the full amount of the tariff in a small country
    2. Domestic consumers gain while domestic producers lose
    3. The domestic price rises by the full tariff, and there is a net deadweight loss to the country
    4. The country gains at the expense of foreign exporters, because its terms of trade improve once the tariff is imposed
    Show answer

    Answer: C — The domestic price rises by the full tariff, and there is a net deadweight loss to the country

    A small country faces a given world price, so it cannot affect it: the tariff raises the domestic price by the full amount, and the producer-surplus gain plus tariff revenue fall short of the consumer-surplus loss, leaving a net deadweight loss (the production and consumption distortion triangles). Consumers lose, not gain; and only a large country can improve its terms of trade with a tariff.

  8. Which set of transactions is recorded in the current account of the balance of payments?

    1. Foreign direct investment, portfolio investment and changes in official reserves
    2. Trade in goods and services, primary income and secondary income (current transfers)
    3. Only the trade balance in physical goods, excluding all services
    4. Commercial-bank lending and government borrowing from abroad
    Show answer

    Answer: B — Trade in goods and services, primary income and secondary income (current transfers)

    The current account covers trade in goods and services, primary income (such as investment income and compensation) and current transfers. Investment flows and reserve changes belong to the capital and financial account, and the current account is far broader than merchandise trade alone, since services are a major component.

  9. According to the theory of absolute purchasing power parity, the exchange rate between two currencies in the long run is determined by:

    1. The ratio of the two countries' nominal interest rates, adjusted for the expected rate of inflation in each
    2. The difference in the two countries' real GDP growth rates
    3. The size of each country's official foreign-exchange reserves
    4. The ratio of the price levels of a common basket of goods in the two countries
    Show answer

    Answer: D — The ratio of the price levels of a common basket of goods in the two countries

    Absolute PPP says the exchange rate equals the ratio of the two countries' price levels for the same basket, so the same goods cost the same when expressed in one currency; relative PPP links the rate of depreciation to the inflation differential. Interest rates drive parity conditions in the short run, and growth rates and reserve size are not what the PPP theory points to.

  10. A country with a floating exchange rate lets its currency depreciate to correct a trade deficit, but the deficit initially widens before improving. Which pair of ideas together best explains this?

    1. The Marshall–Lerner condition and the J-curve effect
    2. The Stolper–Samuelson theorem and factor-price equalisation
    3. Covered interest parity and the forward premium
    4. Trade creation and trade diversion
    Show answer

    Answer: A — The Marshall–Lerner condition and the J-curve effect

    Depreciation improves the trade balance only if the Marshall–Lerner condition holds (export plus import demand elasticities sum above one); in the short run quantities are sticky while the import bill rises in domestic-currency terms, so the balance first worsens and then improves — the J-curve. The other pairs concern income distribution, interest arbitrage and customs-union welfare, none of which describes this time path.

  11. Which statement correctly distinguishes the roles of the IMF and the World Bank?

    1. The IMF makes long-term development loans for infrastructure while the World Bank manages exchange-rate stability
    2. Both institutions exist only to set tariff rates for member countries
    3. The IMF provides short-term balance-of-payments finance while the World Bank funds long-term development
    4. The IMF issues commercial-bank licences to members and the World Bank prints a single world currency for them
    Show answer

    Answer: C — The IMF provides short-term balance-of-payments finance while the World Bank funds long-term development

    The IMF promotes exchange-rate stability and lends short-term to members in balance-of-payments difficulty (issuing SDRs), while the World Bank provides long-term finance for development and reconstruction. The tempting pairing that swaps the two roles is wrong; tariff rates are the WTO's domain; and neither institution licenses banks or prints a world currency.

  12. Which of the following are non-tariff barriers to trade?

    1. An import quota setting a ceiling on the quantity admitted
    2. A voluntary export restraint negotiated with the exporting country
    3. Technical and health standards designed to keep out foreign goods
    4. An ad valorem customs duty charged as a percentage of import value
    Show answer

    Answer: A — An import quota setting a ceiling on the quantity admitted; B — A voluntary export restraint negotiated with the exporting country; C — Technical and health standards designed to keep out foreign goods

    Quotas, voluntary export restraints and disguised standards all restrict trade without being a tax on imports, so they are non-tariff barriers. An ad valorem customs duty is a tariff — a tax levied as a percentage of value — which is precisely what 'non-tariff' excludes.

  13. A customs union is formed. Which of the following statements about its welfare effects are correct?

    1. Trade creation occurs when cheaper partner output replaces higher-cost domestic production, raising welfare
    2. Trade diversion occurs when a tariff-free partner displaces a lower-cost outside supplier, which can reduce welfare
    3. A customs union has a common external tariff against non-members
    4. A customs union necessarily raises the welfare of every member and the world as a whole
    Show answer

    Answer: A — Trade creation occurs when cheaper partner output replaces higher-cost domestic production, raising welfare; B — Trade diversion occurs when a tariff-free partner displaces a lower-cost outside supplier, which can reduce welfare; C — A customs union has a common external tariff against non-members

    Viner's analysis gives trade creation (welfare-raising) and trade diversion (potentially welfare-reducing), and a customs union by definition adds a common external tariff to internal free trade. The last claim is false: the net effect depends on whether creation outweighs diversion, so a union is not guaranteed to raise welfare.

  14. Which of the following statements about the new trade theory and intra-industry trade are correct?

    1. Internal economies of scale can make specialisation and trade beneficial even between identical countries
    2. Product differentiation under monopolistic competition gives consumers greater variety through trade
    3. Intra-industry trade means a country both exports and imports goods within the same industry
    4. New trade theory requires large differences in factor endowments to generate any trade
    Show answer

    Answer: A — Internal economies of scale can make specialisation and trade beneficial even between identical countries; B — Product differentiation under monopolistic competition gives consumers greater variety through trade; C — Intra-industry trade means a country both exports and imports goods within the same industry

    The new trade theory relies on economies of scale and differentiated products under monopolistic competition, which generate variety-expanding intra-industry trade even among similar economies. The claim that large endowment differences are needed is wrong: that is the Heckscher–Ohlin view, and the new trade theory was devised precisely to explain trade that arises without them.

  15. Under WTO rules, the most-favoured-nation (MFN) principle requires that:

    1. a tariff concession granted to one member be extended to all other members alike
    2. each member charge its lowest tariff only on goods from the single most favoured partner
    3. imported goods be taxed more heavily than equivalent domestic goods
    4. every member abolish all tariffs on all goods immediately on joining
    Show answer

    Answer: A — a tariff concession granted to one member be extended to all other members alike

    MFN means non-discrimination among trading partners: a concession to one member must be granted to all members, so all enjoy the best terms offered to any. It does not single out one favoured partner (the name is historical), it does not permit taxing imports more than domestic goods (that violates national treatment), and the WTO does not require instant abolition of all tariffs.

  16. Assume trade is initially balanced and that export and import supplies are perfectly elastic. A country's currency depreciates. The absolute price elasticity of foreign demand for its exports is 0.8 and its own absolute price elasticity of demand for imports is 0.5. Once quantities have fully adjusted, what happens to its trade balance?

    1. It worsens, because each of the two elasticities is individually below one
    2. It is unchanged, because a depreciation cannot alter the trade balance once quantities have adjusted fully
    3. It worsens, because the import bill rises by more than export earnings do in domestic-currency terms
    4. It improves, because the sum of the two elasticities, 1.3, exceeds one
    Show answer

    Answer: D — It improves, because the sum of the two elasticities, 1.3, exceeds one

    The Marshall–Lerner condition (with initially balanced trade and perfectly elastic supplies) asks whether the sum of the two absolute demand elasticities exceeds one: 0.8 + 0.5 = 1.3 > 1, so the balance improves once quantities have fully adjusted. The tempting wrong answer tests each elasticity alone against one, which is not the condition; the sum is what matters. A short-run J-curve worsening is a different, temporary effect that the stem excludes by saying quantities have fully adjusted.

  17. In a two-good, two-factor Heckscher–Ohlin model, a labour-abundant country exports labour-intensive cloth and imports capital-intensive machinery. Moving from autarky to free trade raises the relative price of cloth in this country. On the Stolper–Samuelson theorem, what happens to the real returns of the two factors?

    1. The real returns to both labour and capital rise, since the whole country gains from trade
    2. The real return to labour falls and the real return to capital rises, as capital is the scarce factor
    3. The real return to labour rises and the real return to capital falls
    4. Neither return changes, because factor prices are fixed by technology alone
    Show answer

    Answer: C — The real return to labour rises and the real return to capital falls

    Stolper–Samuelson: a rise in the relative price of a good raises the real return of the factor used intensively in that good and lowers the real return of the other. Cloth is labour-intensive, so labour gains and capital loses. The tempting answer that both factors gain confuses the country's aggregate gain from trade with its distribution; the scarce-factor reversal would hold under protection that lifts the price of the capital-intensive good.