International Economics: One Mark Questions, Book Back Answers and Notes

About International Economics

Medium ~120 min study

International economics asks two plain questions: why do countries trade with each other, and what happens to their money, prices and reserves when they do? No country produces everything it needs at a reasonable cost, so trade across borders is normal. What makes it different from trade inside a country is that it involves different currencies, different laws, and factors of production that do not move freely between nations.

The chapter starts with theory. Adam Smith explained trade through absolute cost advantage, Ricardo through comparative cost advantage, and the modern Heckscher-Ohlin theory through differences in factor endowments. It then turns to measurement and money: the terms of trade tell us how much a country gains, the balance of payments records all its dealings with the rest of the world, and the exchange rate links its currency to others. The last section looks at foreign direct investment and its effects on a host country.

Book back questions often ask who gave which concept, so link each name to its idea: Taussig with net and gross barter terms of trade, Dorrance with income terms of trade, Viner with single and double factoral terms. Also be clear on the difference between balance of trade and balance of payments, and on the measures used to correct a deficit.

What you'll learn

• Distinguish internal trade from international trade on points such as currency, factor mobility and trade restrictions.
• Explain the absolute and comparative cost theories and compare them with the Heckscher-Ohlin theory.
• Define each type of terms of trade and name the economist associated with it.
• Distinguish between balance of trade and balance of payments and list the accounts of the BoP.
• Explain the types and causes of BoP disequilibrium and the measures used to correct it.
• Explain how the exchange rate is determined in a floating system and list the factors that influence it.
• Assess the merits and demerits of foreign direct investment for a developing country.

Before you start

• Demand and supply analysis and how equilibrium price is found.
• Basic macroeconomic ideas such as national income and inflation.
• The meaning of money, banks and the central bank from the earlier units.

International Economics explained

Trade Theory, Terms of Trade and the Balance of Payments

Theories of International Trade

Adam Smith's theory of absolute cost advantage says a country should specialise in the goods it can produce at a lower absolute cost than its partner, and import the rest. Ricardo went further. His comparative cost theory shows that even if one country is more efficient in producing both goods, both countries still gain when each specialises in the good where its relative (comparative) advantage is greater. Trade is possible whenever the cost ratios differ. The modern theory associated with Heckscher and Ohlin explains trade through factor endowments: a capital-abundant country exports capital-intensive goods and a labour-abundant country exports labour-intensive goods.

Terms of Trade

The terms of trade are the rate at which a country's exports exchange for its imports, and they show how the gains from trade are shared. The net barter terms of trade, named by Taussig, compare the export price index with the import price index. Taussig also used gross barter terms of trade, which compare the physical quantities of imports and exports. G.S. Dorrance's income terms of trade multiply the net barter terms by the export volume index, showing a country's capacity to import. Jacob Viner's single factoral terms adjust the net barter terms for productivity changes in the export sector; double factoral terms adjust for productivity changes in both the home export sector and the foreign export sector.

Balance of Trade and Balance of Payments

The balance of trade covers only visible items, that is, exports and imports of goods. The balance of payments is a systematic record of all economic transactions between residents of a country and the rest of the world during a year. It has a current account (goods, services, transfers), a capital account and an official reserves account. Because it is kept by double entry, the BoP always balances in the accounting sense. Economists still speak of a deficit or surplus when autonomous receipts and payments do not match and the gap has to be covered by reserves or borrowing. Such disequilibrium may be cyclical, secular or structural. It can be corrected through automatic price adjustments or through deliberate measures such as devaluation, exchange control, import restrictions and export promotion.

Exchange Rate Determination

The exchange rate is the price of one currency in terms of another. Under a flexible (floating) system, it is set in the foreign exchange market by the demand for and supply of foreign currency, and the equilibrium rate is where the two are equal. Under a fixed system the government or central bank pegs the rate. Exchange rates are influenced by inflation differences between countries, interest rates, current account deficits, public debt, the terms of trade and political and economic stability.

Foreign Direct Investment

FDI is long-term investment by a foreign firm, often a multinational company, that gives it ownership and a say in management of an enterprise in the host country. Foreign portfolio investment, by contrast, is the purchase of shares and bonds without management control, and it can leave the country quickly. FDI helps fill the savings gap and the foreign exchange gap, brings technology and managerial skills, creates jobs and can raise exports. On the other side, it may lead to monopoly power, hurt small and medium domestic firms and drain foreign exchange through royalties, dividends and profit repatriation.

Common mistakes to avoid

• Using balance of trade and balance of payments as if they mean the same. Balance of trade covers only visible goods; balance of payments covers goods, services, transfers and capital flows.
• Thinking a country with an absolute disadvantage in every good cannot gain from trade. Ricardo showed it gains by specialising where its comparative disadvantage is smallest.
• Saying a BoP deficit is impossible because the accounts always balance. The accounts balance by double entry, but a deficit exists when autonomous payments exceed autonomous receipts and reserves or loans fill the gap.
• Confusing nominal and real exchange rates. The nominal rate is the quoted price of one currency in another; the real rate adjusts it for price levels in the two countries.
• Treating FDI and portfolio investment as the same. FDI carries ownership and management control and is long term; portfolio investment is in financial assets only and can leave quickly.
• Linking income terms of trade to Taussig. Taussig gave net and gross barter terms; Dorrance gave income terms of trade.

Test yourself on these with the practice test, then check the worked reasoning in the solved MCQs.

Frequently asked questions

How is internal trade different from international trade?

Internal trade takes place within one country, uses one currency and follows one set of laws, and labour and capital move fairly freely. International trade crosses national borders, involves different currencies and exchange rates, faces tariffs, quotas and other restrictions, and factors of production move far less between countries.

What is the difference between absolute and comparative advantage?

A country has an absolute advantage when it can produce a good with fewer resources than another country. It has a comparative advantage when its cost of producing a good, relative to other goods, is lower than the other country's. Ricardo showed that comparative advantage is enough for both countries to gain from trade.

What are the terms of trade?

The terms of trade are the rate at which a country's exports exchange for its imports. The net barter terms of trade are calculated as (export price index / import price index) × 100. A value above 100 means the terms have improved compared with the base year: each unit of exports now buys more imports.

What causes disequilibrium in the balance of payments?

Common causes are cyclical swings in business activity, structural changes in demand or production, large development spending that raises imports, high domestic demand and inflation, population growth and technological backwardness that keeps exports low. Disequilibrium can be cyclical, secular (long-term) or structural.

How does devaluation correct a trade deficit?

Devaluation is an official reduction in the external value of a country's currency. Exports become cheaper for foreign buyers and imports become dearer at home. If exports rise and imports fall enough in response, the deficit narrows and the balance of payments moves towards equilibrium.

What factors influence exchange rates?

The main factors are differences in inflation between countries, interest rates that attract or repel foreign capital, the current account position, the level of public debt, changes in the terms of trade, and the political and economic stability of the country.

What is the difference between FDI and portfolio investment?

FDI is long-term investment in which a foreign investor owns a significant share of an enterprise and takes part in its management, for example a foreign car maker building a plant in Chennai. Portfolio investment is the purchase of shares, bonds or other securities for financial returns, with no management control, and it can be withdrawn quickly.