The International Economy

1. International Trade: Comparative Advantage

info

Board-Specific Note CIE (9708) requires formal proof of comparative advantage using numerical examples and covers the Ricardian and Heckscher-Ohlin models. AQA focuses on the gains from trade and limitations of the comparative advantage model. Edexcel emphasises diagrammatic analysis of trade flows and the UK's trade relationships. OCR (A) covers trade theory alongside the impact of MNCs and requires evaluation of trade policies.

1.1 Absolute vs Comparative Advantage

Absolute advantage: a country can produce more of a good with the same resources than another country (higher productivity).

Comparative advantage (Ricardo, 1817): a country should specialise in producing the goods for which it has the lowest opportunity cost, even if it has an absolute disadvantage in all goods.

1.2 The Ricardian Model: Proof of Comparative Advantage

Proposition: Trade based on comparative advantage makes both countries better off.

Setup. Consider two countries, Home and Foreign, producing two goods, Cloth ($C$) and Wine ($W$), using one factor (labour). Unit labour requirements:

	Cloth (labour per unit)	Wine (labour per unit)
Home	$a_C = 2$	$a_W = 4$
Foreign	$a_C = 6$	$a_W = 3$

Home has absolute advantage in Cloth ($2 \lt{} 6$). Foreign has absolute advantage in Wine ($3 \lt{} 4$).

Opportunity costs:

$\mathrm{OC of Cloth in terms of Wine:}$

• Home: $\frac{a_C}{a_W} = \frac{2}{4} = 0.5$ units of Wine per unit of Cloth
• Foreign: $\frac{a_C}{a_W} = \frac{6}{3} = 2.0$ units of Wine per unit of Cloth

Home has a comparative advantage in Cloth (lower OC: 0.5 < 2.0). Foreign has a comparative advantage in Wine.

$\mathrm{OC of Wine in terms of Cloth:}$

• Home: $\frac{a_W}{a_C} = \frac{4}{2} = 2$ units of Cloth per unit of Wine
• Foreign: $\frac{a_W}{a_C} = \frac{3}{6} = 0.5$ units of Cloth per unit of Wine

Foreign has a comparative advantage in Wine (lower OC: 0.5 < 2.0).

Gains from trade. Suppose each country has 1,200 units of labour.

Autarky (no trade):

• Home: splits labour equally: $C = 1200/4 = 300$, $W = 1200/8 = 150$. Total: 300C + 150W.
• Foreign: splits labour equally: $C = 1200/12 = 100$, $W = 1200/6 = 200$. Total: 100C + 200W.
• World total: 400C + 350W.

Specialisation:

• Home specialises in Cloth: $C = 1200/2 = 600$, $W = 0$.
• Foreign specialises in Wine: $C = 0$, $W = 1200/3 = 400$.
• World total: 600C + 400W.

World output increases: 400C → 600C (+200) and 350W → 400W (+50). Both countries gain if they trade at an exchange rate between the two opportunity cost ratios:

$0.5 \mathrm{ W/C} \lt{} \mathrm{World price } p \lt{} 2.0 \mathrm{ W/C}$

For example, at $p = 1$ (1 unit of Wine for 1 unit of Cloth):

• Home exports 200C, imports 200W. Home consumes: 400C + 200W (gains: +100C, +50W vs autarky).
• Foreign imports 200C, exports 200W. Foreign consumes: 200C + 200W (gains: +100C, 0W vs autarky).

Both are strictly better off. $\blacksquare$

tip

tip costs for both countries, (2) identify which country has the lower OC for each good, (3) show specialisation increases world output, (4) show a mutually beneficial exchange rate. Use a numerical example.

1.3 Limitations of the Ricardian Model

1. Constant returns to scale: assumes constant opportunity costs (linear PPF). In reality, increasing opportunity costs (concave PPF) limit the degree of specialisation.
2. One factor of production: ignores capital, land, and technology differences.
3. Zero transport costs: in reality, transport costs reduce the gains from trade and may prevent trade in some goods.
4. Perfect labour mobility within countries: workers can move freely between sectors.
5. No trade barriers: tariffs and quotas reduce the gains from trade.
6. Complete specialisation: in practice, countries rarely specialise completely due to increasing opportunity costs.

Heckscher-Ohlin model (more advanced): countries export goods that intensively use their abundant factor. A capital-abundant country exports capital-intensive goods; a labour-abundant country exports labour-intensive goods.

2. Terms of Trade

2.1 Definition

The terms of trade (ToT) measure the ratio of a country's export prices to its import prices:

$\mathrm{ToT} = \frac◆LB◆\mathrm{Index of Export Prices}◆RB◆◆LB◆\mathrm{Index of Import Prices}◆RB◆ \times 100$

2.2 Interpretation

• ToT > 100 (improvement): export prices have risen relative to import prices. A given quantity of exports buys more imports. This is beneficial — "favourable" terms of trade.
• ToT < 100 (deterioration): export prices have fallen relative to import prices. A given quantity of exports buys fewer imports. This is harmful — "adverse" terms of trade.
• ToT = 100: no change from the base year.

2.3 Calculation

Worked Example

Base year (2020): Export price index = 100, Import price index = 100. ToT = 100.

2024: Export prices rose by 15%, Import prices rose by 25%.

$\mathrm{ToT}_{2024} = \frac{115}{125} \times 100 = 92$

Terms of trade deteriorated by 8%. The country needs to export 8.7% more (115/105 = 1.087) just to buy the same quantity of imports as in 2020.

2.4 Factors Affecting the Terms of Trade

Factor	Effect on ToT
Exchange rate appreciation	Export prices rise, import prices fall → ToT improves
Higher global demand for exports	Export prices rise → ToT improves
Rising commodity prices (for importers)	Import prices rise → ToT deteriorates
Inflation differentials	If domestic inflation > trading partners' inflation → ToT deteriorates
Technological progress in export sector	Unit costs fall → export prices may fall → ToT deteriorates

warning

warning deterioration is caused by cheaper imports (e.g., due to technological progress abroad), consumers benefit from lower prices. Conversely, an improvement caused by a fall in export volumes (due to declining competitiveness) may actually reflect economic weakness.

3. Exchange Rates

info

info Marshall-Lerner condition, and J-curve effects. CIE (9708) covers exchange rate determination, purchasing power parity, and the effects of exchange rate changes on the balance of payments. Edexcel emphasises the UK context including Brexit impacts on trade and the pound. OCR (A) links exchange rates to macroeconomic policy objectives and requires evaluation of intervention.

3.1 Definition

The exchange rate is the price of one currency in terms of another.

$\mathrm{Spot rate: } e = \frac◆LB◆\mathrm{units of domestic currency}◆RB◆◆LB◆\mathrm{one unit of foreign currency}◆RB◆$

A depreciation of the pound means $e$ rises (more pounds per dollar — the pound is weaker). An appreciation means $e$ falls (fewer pounds per dollar — the pound is stronger).

3.2 Exchange Rate Systems

1. Fixed (pegged) exchange rate:

The central bank commits to buying and selling currency to maintain $e = \bar{e}$.

$\mathrm{If } e \gt{} \bar{e} \mathrm{ (depreciation pressure): central bank sells foreign reserves, buys domestic currency}$

$\mathrm{If } e \lt{} \bar{e} \mathrm{ (appreciation pressure): central bank buys foreign reserves, sells domestic currency}$

Advantages: certainty for trade and investment, discipline on monetary policy (cannot inflate away the peg), reduces speculative volatility.

Disadvantages: requires large foreign reserves, loss of independent monetary policy (impossible trinity), vulnerability to speculative attacks (e.g., Soros vs Bank of England, 1992 — Black Wednesday).

2. Floating exchange rate:

The exchange rate is determined by market forces (supply and demand for the currency).

$e^* : \mathrm{Supply of } £ = \mathrm{Demand for } £$

Advantages: automatic adjustment to BoP imbalances (deficit → depreciation → exports cheaper, imports dearer → deficit narrows), independent monetary policy, no need for large reserves.

Disadvantages: volatility creates uncertainty for trade and investment, may overshoot (Dornbusch, 1976), can be manipulated for competitive advantage (competitive devaluation).

3. Managed (dirty) float:

The central bank allows the market to set the exchange rate but intervenes occasionally to smooth excessive fluctuations or achieve policy objectives.

$\bar{e}_{\min} \lt{} e \lt{} \bar{e}_{\max}$

3.3 Determinants of Floating Exchange Rates

$e = f(P, r, Y, Y^*, \mathrm{expectations, speculation})$

Factor	Mechanism
Relative inflation rates	Higher domestic inflation → exports less competitive, imports more attractive → $e$ rises (depreciation) — purchasing power parity (PPP)
Relative interest rates	Higher domestic interest rates → capital inflows (hot money) → demand for £ rises → $e$ falls (appreciation)
Relative growth rates	Faster domestic growth → higher import demand → current account worsens → $e$ rises (depreciation)
Speculation	If markets expect depreciation → sell £ → self-fulfilling depreciation
Current account balance	Persistent deficit → downward pressure on currency
Government debt	High debt → lower confidence → capital outflows → depreciation

3.4 Purchasing Power Parity (PPP)

Absolute PPP: the exchange rate should equalise the price of identical baskets of goods across countries:

$e = \frac{P_{domestic}}{P_{foreign}}$

Relative PPP: the exchange rate should adjust to reflect inflation differentials:

$\frac◆LB◆\Delta e◆RB◆◆LB◆e◆RB◆ \approx \pi_{domestic} - \pi_{foreign}$

PPP holds approximately in the long run but fails in the short run due to: trade barriers, non-traded goods, price stickiness, and speculation.

4. The Marshall-Lerner Condition

4.1 Derivation

The Marshall-Lerner condition determines whether a currency depreciation improves or worsens the current account.

Proposition: A depreciation improves the current account if and only if the sum of the price elasticities of demand for exports and imports (in absolute value) exceeds unity.

$|E_X| + |E_M| \gt{} 1$

where:

• $E_X = \frac◆LB◆\% \Delta Q_X◆RB◆◆LB◆\% \Delta P_X◆RB◆$ = price elasticity of demand for exports
• $E_M = \frac◆LB◆\% \Delta Q_M◆RB◆◆LB◆\% \Delta P_M◆RB◆$ = price elasticity of demand for imports

Proof sketch. The current account balance (in domestic currency):

$CA = P_X \cdot X - e \cdot P_M^* \cdot M$

where $X$ = export volume, $M$ = import volume, $P_X$ = domestic currency price of exports, $P_M^*$ = foreign currency price of imports, $e$ = exchange rate.

A depreciation ($e$ rises) makes exports cheaper for foreigners ($P_X/e$ falls) and imports more expensive for domestic consumers ($e \cdot P_M^*$ rises). The effect on $CA$ depends on whether the volume responses are large enough to outweigh the price changes:

$\Delta CA \approx \left(\frac◆LB◆E_X \cdot P_X \cdot X◆RB◆◆LB◆P_X \cdot X + e \cdot P_M^* \cdot M◆RB◆\right) \times \left(|E_X| + |E_M| - 1\right) \times \frac◆LB◆\Delta e◆RB◆◆LB◆e◆RB◆$

If $|E_X| + |E_M| \gt{} 1$: the volume effect dominates → $CA$ improves. If $|E_X| + |E_M| \lt{} 1$: the price effect dominates → $CA$ worsens (the country spends more on imports because they are more expensive, without selling enough extra exports). $\blacksquare$

4.2 The J-Curve Effect

In the short run, $|E_X|$ and $|E_M|$ are low because contracts are fixed, consumers are slow to change habits, and production takes time to adjust. So $|E_X| + |E_M| \lt{} 1$ initially → the current account worsens after a depreciation.

Over time (6–18 months), elasticities increase as consumers find substitutes and firms adjust production → $|E_X| + |E_M| \gt{} 1$ → the current account improves.

The path of the current account traces a J-shape:

$CA \mathrm{ falls initially, then rises above the starting level}$

tip

tip distinguish between the short run (J-curve — CA may worsen) and the long run (Marshall-Lerner — CA improves). Draw the J-curve diagram. State the Marshall-Lerner condition explicitly.

5. Globalisation

5.1 Definition

Globalisation is the increasing interdependence of national economies through the growth of international trade, investment, capital flows, and migration.

5.2 Drivers of Globalisation

1. Technological change: containerisation (shipping costs fell 80% from 1950–2000), the internet, communication technology
2. Trade liberalisation: GATT/WTO rounds, regional trade agreements (EU, NAFTA/USMCA, CPTPP)
3. Capital mobility: deregulation of financial markets, floating exchange rates
4. Multinational corporations (MNCs): production spread across multiple countries (global value chains)
5. Transport improvements: air freight, high-speed rail

5.3 Benefits of Globalisation

1. Lower prices for consumers: access to cheaper imported goods
2. Greater product variety: consumers benefit from a wider range of goods
3. Comparative advantage and efficiency gains: specialisation raises world output
4. Technology transfer: developing countries gain access to advanced technology through FDI
5. Economies of scale: access to larger markets allows firms to exploit scale economies
6. Capital flows to developing countries: FDI and portfolio investment finance development
7. Cultural exchange and understanding

5.4 Costs of Globalisation

1. Inequality: globalisation may increase within-country inequality (skilled workers gain, unskilled workers lose from import competition). Stolper-Samuelson theorem: trade liberalisation reduces the real wage of the scarce factor.
2. Job losses in import-competing industries: structural unemployment in manufacturing (e.g., Rust Belt in the US, northern England)
3. Environmental degradation: "race to the bottom" in environmental standards; increased transport emissions
4. Loss of sovereignty: international institutions (WTO, IMF) constrain domestic policy
5. Cultural homogenisation: dominance of Western (especially American) culture
6. Vulnerability to external shocks: global financial crises, supply chain disruptions (COVID-19)
7. Exploitation: sweatshop labour in developing countries, tax avoidance by MNCs

5.5 Evaluation

Globalisation is not an unambiguous good or bad — it creates winners and losers. The policy challenge is to capture the benefits while compensating the losers (retraining programmes, regional development, social safety nets). The retreat from globalisation since ~2016 (Brexit, US-China trade war, reshoring) reflects these tensions.

6. Economic Development

6.1 Indicators of Development

Economic indicators:

• GDP per capita (PPP-adjusted for comparability)
• GNI per capita (World Bank classification: low <$1,145, lower-middle$1,146–$4,515, upper-middle$4,516–$14,005, high \gt{}$14,005)
• GDP growth rate
• Industrial structure (share of agriculture/manufacturing/services)

Social indicators:

• Human Development Index (HDI): composite of life expectancy, education (mean years + expected years), and GNI per capita. $0 \leq HDI \leq 1$.
• Poverty rates ($1.90/day extreme poverty line)
• Access to clean water, sanitation, electricity
• Infant mortality rate, maternal mortality rate
• Literacy rate, school enrolment rates

Composite indicators:

• HDI ($0 \leq \mathrm{HDI} \leq 1$): health + education + income
• Multidimensional Poverty Index (MPI): health, education, and living standards
• Genuine Progress Indicator (GPI): adjusts GDP for environmental costs, inequality, and unpaid work

warning

warning ignores income distribution, (2) it doesn't capture health, education, or political freedom, (3) it is biased toward market activity (excludes subsistence farming, unpaid work). Always use multiple indicators.

6.2 Barriers to Economic Development

1. Poverty trap: low income → low savings → low investment → low growth → low income (vicious cycle)
2. Institutional failure: corruption, weak property rights, poor governance (Acemoglu & Robinson, 2012: "Why Nations Fail")
3. Human capital deficiency: poor education and health reduce labour productivity
4. Infrastructure deficit: inadequate transport, energy, and communications
5. Geography: landlocked countries, tropical climate, disease burden (Sachs, 2005)
6. Demographic trap: high population growth outpaces economic growth → falling GDP per capita
7. Conflict and political instability: war destroys physical and human capital, discourages investment
8. Terms of trade: primary commodity exporters face volatile and declining terms of trade (Prebisch-Singer hypothesis)
9. Debt burden: heavy debt servicing crowds out public spending on health and education
10. Brain drain: skilled workers emigrate to developed countries

6.3 Strategies for Economic Development

1. Industrialisation: moving from agriculture to manufacturing (Lewis dual-sector model). East Asian "tiger" economies followed export-oriented industrialisation.
2. Import substitution industrialisation (ISI): replacing imports with domestic production (Latin America, 1950s–70s). Often led to inefficient, uncompetitive industries.
3. Export-oriented industrialisation: focusing on producing goods for export (South Korea, Taiwan, Singapore). Higher growth rates than ISI.
4. Agricultural reform: land reform, investment in irrigation and seeds (Green Revolution in India).
5. Investment in human capital: universal education, healthcare, gender equality (World Bank, 2018: 25% of GDP growth attributed to improved health and education).
6. Institutional reform: anti-corruption measures, strengthening property rights, rule of law.
7. Foreign aid: can provide capital, technology, and expertise. But may create dependency and be misappropriated. Effective aid targets institutions and infrastructure, not just cash transfers.
8. Microfinance: small loans to entrepreneurs in developing countries (Grameen Bank, Muhammad Yunus).
9. Debt relief: HIPC (Heavily Indebted Poor Countries) Initiative, cancelled debt for qualifying countries.

7. Trading Blocs and Protectionism

7.1 Types of Trading Blocs

Type	Definition	Example
Free trade area	No tariffs between members, but each sets own external tariffs	NAFTA/USMCA
Customs union	Free trade + common external tariff	EU (as customs union)
Common market	Customs union + free movement of factors of production	EU single market
Monetary union	Common market + single currency + common central bank	Eurozone
Economic union	Monetary union + harmonised fiscal and structural policies	EU (partial)

7.2 Trade Creation vs Trade Diversion

Trade creation (Viner, 1950): a trading bloc replaces high-cost domestic production with lower-cost imports from a member country. This increases efficiency.

Trade diversion: a trading bloc replaces low-cost imports from a non-member with higher-cost imports from a member country (due to preferential tariffs). This reduces efficiency.

7.3 Protectionist Policies

Policy	Mechanism	Effect
Tariff	Tax on imports	Raises import price → reduces imports, generates revenue
Quota	Physical limit on imports	Restricts supply → raises import price
Subsidy	Payment to domestic producers	Lowers domestic cost → competitive vs imports
Administrative barriers	Health/safety standards, customs procedures	Raises cost/delay of importing
Embargo	Complete ban on imports/exports	Eliminates trade in the targeted good

Welfare analysis of a tariff:

Consumer surplus falls by more than producer surplus and government revenue increase → net welfare loss (deadweight loss from inefficient domestic production and reduced consumption).

$\mathrm{DWL} = \frac{1}{2} \times (P_w + t - P_w) \times (Q_d^{domestic} - Q_s^{domestic}) = \frac{1}{2} t \times \Delta Q$

8. Problem Set

Problem 1. Country A can produce 10 cars or 5 trucks per worker per month. Country B can produce 6 cars or 6 trucks per worker per month. (a) Which country has an absolute advantage in each good? (b) Calculate opportunity costs. (c) Which country should specialise in which good? (d) Show that trade can benefit both countries.

Details

Hint

(a) Country A: absolute advantage in cars (10 \gt\{\} 6). Country B: absolute advantage in trucks (6 \gt\{\} 5). (b) OC of 1 car: A = 5/10 = 0.5 trucks, B = 6/6 = 1 truck. OC of 1 truck: A = 10/5 = 2 cars, B = 6/6 = 1 car. (c) A has lower OC in cars (0.5 \lt\{\} 1) → specialise in cars. B has lower OC in trucks (1 \lt\{\} 2) → specialise in trucks. (d) World price between 0.5 and 1 truck per car. At $p = 0.75$: A gains by exporting cars at a price higher than its OC (0.5). B gains by importing cars at a price lower than its OC (1.0). Both better off.

Problem 2. A country's export price index rises from 120 to 132, while its import price index rises from 100 to 120. (a) Calculate the initial and new terms of trade. (b) Has the ToT improved or deteriorated? (c) Explain why this may not be entirely beneficial.

Details

Hint

(a) Initial ToT = 120/100 = 120. New ToT = 132/120 = 110. (b) ToT deteriorated from 120 to 110 (fell by 8.3%). (c) Even though export prices rose by 10%, import prices rose by 20%. The country now needs to export more to buy the same imports. However: if the export price rise is due to higher quality (better technology), the "real" ToT may not have deteriorated. And if import price rise is due to cheaper goods from abroad (more competition), consumers benefit from lower prices.

Problem 3. The exchange rate falls from $1.50/£ to$1.20/£. (a) Has the pound appreciated or depreciated? (b) If the price elasticity of demand for exports is 0.6 and for imports is 0.8, use the Marshall-Lerner condition to determine the short-run effect on the current account. (c) Explain the J-curve effect.

Details

Hint

(a) More dollars per pound before → now fewer dollars per pound → pound has depreciated (you get fewer dollars for each pound). (b) $|E_X| + |E_M| = 0.6 + 0.8 = 1.4 \gt{} 1$. The Marshall-Lerner condition is satisfied → in the long run, the current account improves. However, these are long-run elasticities. (c) J-curve: in the short run (first 6–12 months), elasticities are lower because contracts are fixed and consumers are slow to change habits. So initially $|E_X| + |E_M| \lt{} 1$ → CA worsens. Over time, as consumers and firms adjust, elasticities rise above 1 → CA improves. The path traces a J-shape.

Problem 4. Explain the advantages and disadvantages of a fixed exchange rate system compared with a floating exchange rate system. In your answer, refer to the concept of the "impossible trinity" (trilemma).

Details

Hint

The impossible trinity: a country cannot simultaneously have (1) free capital mobility, (2) a fixed exchange rate, and (3) independent monetary policy. It must give up one. Fixed advantages: certainty for trade/investment, discipline on inflation, no speculative volatility. Fixed disadvantages: loss of monetary independence (must set interest rates to defend the peg, not for domestic objectives), requires large reserves, vulnerable to speculative attacks (e.g., ERM crisis 1992). Floating advantages: automatic BoP adjustment, independent monetary policy, no reserve requirement. Floating disadvantages: volatility, overshooting, competitive devaluation risk. Revision: see The Financial Sector for monetary policy.

Problem 5. Evaluate the argument that globalisation has increased income inequality both within and between countries.

Details

Hint

Between countries: globalisation has reduced inequality between nations — China, India, and other emerging economies have grown rapidly through trade, narrowing the gap with developed countries. Within countries: globalisation has increased inequality in many developed countries (Stolper-Samuelson theorem: trade liberalisation benefits the abundant factor — skilled labour in developed countries, unskilled labour in developing countries). In the UK/US: skilled workers and capital owners gained; manufacturing workers lost jobs to import competition and offshoring. Top 1% captured disproportionate gains. However: technology (skill-biased technological change) may be a larger driver of within-country inequality than trade. Policy response: progressive taxation, education and retraining, regional development policies.

Problem 6. "Foreign aid is an effective strategy for promoting economic development." Evaluate this statement.

Details

Hint

Arguments for: (1) Provides capital that poor countries cannot generate domestically (savings gap). (2) Finances infrastructure (roads, hospitals, schools) with long-term benefits. (3) Can improve health and education (human capital). (4) Emergency/humanitarian aid saves lives. Arguments against: (1) Dependency — may discourage domestic savings and tax effort. (2) Corruption and misappropriation — aid may not reach intended beneficiaries. (3) Dutch disease — large aid inflows appreciate the real exchange rate, making exports less competitive. (4) Tied aid — may benefit donor countries more than recipients. (5) Aid effectiveness depends on institutional quality (Burnside & Dollar, 2000). Evidence: countries with good institutions (Botswana) used aid effectively; countries with poor institutions (DRC) did not. Best practice: aid targeted at institutions, health, and education; with conditionality and monitoring.

Problem 7. Using AD/AS analysis, explain the effects of a depreciation of the exchange rate on the domestic economy. Under what conditions might a depreciation be inflationary?

Details

Hint

AD effects: depreciation makes exports cheaper and imports dearer → net exports rise → AD shifts right → output and price level rise. SRAS effects: imported raw materials become more expensive → production costs rise → SRAS shifts left → price level rises, output falls. Net effect on output: ambiguous (AD shift right vs SRAS shift left). Net effect on prices: unambiguously inflationary (both AD and SRAS shifts push prices up). Conditions for inflationary effect: (1) High import dependence (the UK imports ~30% of consumption). (2) Inelastic demand for imports (necessities like oil, food). (3) Economy near full employment (no spare capacity to absorb demand increase). Revision: see Aggregate Demand and Aggregate Supply.

Problem 8. Explain the Prebisch-Singer hypothesis. Why might developing countries that specialise in primary commodity exports face a long-term deterioration in their terms of trade?

Details

Hint

Prebisch-Singer hypothesis: the terms of trade for primary commodity exporters decline relative to manufactured goods exporters over the long run. Reasons: (1) Low income elasticity of demand for primary commodities (Engel's law — as income rises, the share spent on food/raw materials falls). (2) High income elasticity of demand for manufactured goods. (3) Technological progress reduces the demand for raw materials (synthetic substitutes, recycling). (4) Agricultural productivity growth is faster than in manufacturing (supply grows faster than demand → prices fall). (5) Oligopolistic pricing in manufacturing vs competitive pricing in primary commodities (manufacturers have pricing power). Implications: developing countries specialising in primary commodities face declining ToT → need to diversify into manufacturing and services.

Problem 9. A customs union is formed between three countries. Explain the difference between trade creation and trade diversion. Under what conditions is a customs union more likely to create trade than divert it?

Details

Hint

Trade creation: the union replaces high-cost domestic production with lower-cost imports from a partner country → efficiency gain (consumers benefit, world output increases). Trade diversion: the union replaces low-cost imports from a non-member with higher-cost imports from a partner (because of preferential tariffs) → efficiency loss (consumers lose, world output decreases). Conditions for net trade creation: (1) The union includes countries that are efficient producers (so intra-union trade is genuinely lower-cost). (2) External tariffs are not too high (so trade diversion from non-members is limited). (3) The member countries are economically complementary (different comparative advantages). (4) The union is geographically proximate (lower transport costs). The EU's expansion is estimated to have created more trade than it diverted, but the net effect varies by sector and country.

Problem 10. "A country with a persistent current account deficit should devalue its currency to restore balance." Evaluate this policy recommendation.

Details

Hint

Devaluation could help: (1) Makes exports cheaper, imports dearer → improves trade balance (Marshall-Lerner condition). (2) Improves competitiveness of domestic industries. (3) Reduces the trade deficit. But: (1) J-curve effect — the CA may worsen initially. (2) Imported inflation — devaluation raises import prices, potentially causing cost-push inflation. (3) If the deficit is structural (caused by lack of competitiveness, not the exchange rate), devaluation is a temporary fix. (4) Capital flight — if markets expect further devaluation, investors sell the currency, making things worse. (5) Retaliation — trading partners may also devalue (competitive devaluation, "currency wars"). Better approach: address the root cause. If the deficit reflects low productivity → supply-side reforms. If it reflects excessive consumption → fiscal tightening. Devaluation is one tool among many, not a panacea. Revision: see Fiscal Policy for alternative policy approaches.

Problem 11. Compare and contrast import substitution industrialisation (ISI) with export-oriented industrialisation (EOI). Use examples to illustrate your answer.

Details

Hint

ISI: replace imports with domestic production behind tariff walls. Examples: Latin America (Brazil, Argentina, Mexico) 1950s–70s, India pre-1991. Advantages: protects infant industries, reduces dependence on imports, retains foreign exchange. Disadvantages: protected industries become inefficient (no competitive pressure), small domestic market limits economies of scale, leads to balance of payments problems (importing capital goods while exporting little). EOI: focus on producing for export. Examples: East Asian tigers (South Korea, Taiwan, Singapore, Hong Kong) 1960s–90s, China post-1978. Advantages: access to large world markets → economies of scale, competitive pressure drives efficiency and innovation, export earnings finance further investment. Disadvantages: vulnerability to external demand shocks, initially difficult to compete with established firms. Evidence: EOI countries achieved significantly higher growth rates (7–10% vs 3–5% for ISI). The East Asian miracle is widely attributed to EOI combined with education, land reform, and industrial policy.

Problem 12. Explain how the UK's decision to leave the EU (Brexit) can be analysed using the theory of comparative advantage and the concept of trade creation and diversion.

Details

Hint

Comparative advantage: leaving the EU's single market means the UK faces tariffs and non-tariff barriers when trading with EU members. This reduces the gains from trade based on comparative advantage — UK producers who were competitive within the EU now face higher costs of exporting. Trade creation/diversion: leaving the EU is like reverse trade creation — the UK loses the trade-creating effects of the single market. New trade agreements with non-EU countries may create some trade, but: (1) EU is the UK's largest trading partner (43% of exports) — hard to replace. (2) Non-tariff barriers (regulatory divergence, customs checks) increase costs even without tariffs. (3) Services (80% of UK economy) are particularly affected — harder to negotiate services trade deals. Estimated cost: OBR estimates Brexit reduces long-run UK productivity by 4%. Potential benefits: regulatory autonomy, independent trade policy, control over migration. The net effect depends on how effectively the UK uses its new regulatory freedom.

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danger

Common Pitfalls

• Confusing absolute and comparative advantage: A country with absolute advantage in BOTH goods still benefits from trade based on comparative advantage (lower opportunity cost). Students often incorrectly conclude that a country with absolute disadvantage in everything should not trade.

• Assuming a depreciation always improves the current account: The Marshall-Lerner condition must hold (|PED exports| + |PED imports| > 1) for depreciation to improve the current account. In the short run, the J-curve effect means the current account may WORSEN after depreciation before it improves.

• Confusing terms of trade improvement with economic welfare: A terms of trade improvement (export prices rising relative to import prices) is not always beneficial. If it is caused by falling export volumes due to declining competitiveness, it may reflect economic weakness. Context matters.

• Miscalculating opportunity costs in comparative advantage questions: Always calculate the opportunity cost in terms of the OTHER good. If Country A can produce 10 cars or 5 trucks, the opportunity cost of 1 car is 0.5 trucks, NOT 2 trucks. Many students invert the ratio.

13. Advanced Topics in International Economics

13.1 The Marshall-Lerner Condition: Formal Derivation

The Marshall-Lerner condition states that a depreciation of the exchange rate improves the current account balance if and only if:

$|\text{PED}_X| + |\text{PED}_M| > 1$

Proof. The current account balance in domestic currency is:

$CA = P_X \cdot X(P_X^*) - P_M^* \cdot e \cdot M$

where $P_X$ is the export price in domestic currency, $X$ is export volume, $P_M^*$ is the import price in foreign currency, $e$ is the exchange rate (domestic currency per foreign currency), and $M$ is import volume.

After depreciation ($e \uparrow$), export volumes rise ($\Delta X > 0$ since exports are cheaper abroad) and import volumes fall ($\Delta M < 0$ since imports are more expensive). The effect on the trade balance depends on whether the volume effect dominates the price effect.

Define $\epsilon_X = -\frac◆LB◆\Delta X/X◆RB◆◆LB◆\Delta e/e◆RB◆$ (elasticity of export volume to exchange rate) and $\epsilon_M = -\frac◆LB◆\Delta M/M◆RB◆◆LB◆\Delta e/e◆RB◆$ (elasticity of import volume to exchange rate). The current account improves when:

$\epsilon_X \cdot \frac◆LB◆P_X \cdot X◆RB◆◆LB◆CA◆RB◆ + \epsilon_M \cdot \frac◆LB◆P_M^* \cdot e \cdot M◆RB◆◆LB◆CA◆RB◆ > \frac◆LB◆P_M^* \cdot e \cdot M - P_X \cdot X◆RB◆◆LB◆CA◆RB◆$

If trade is initially balanced ($P_X \cdot X = P_M^* \cdot e \cdot M$), this simplifies to:

$\epsilon_X + \epsilon_M > 1$

Since $\epsilon_X = |\text{PED}_X|$ and $\epsilon_M = |\text{PED}_M|$, the condition is $|\text{PED}_X| + |\text{PED}_M| > 1$. $\blacksquare$

Empirical estimates for the UK. The UK's price elasticity of demand for exports is approximately 0.5-0.7 in the short run and 1.0-1.5 in the long run. The price elasticity of demand for imports is approximately 0.3-0.5 in the short run and 0.8-1.2 in the long run. In the short run, $|\text{PED}_X| + |\text{PED}_M| \approx 0.8 - 1.2$, which may be below 1, consistent with the J-curve effect. In the long run, the sum exceeds 1, so depreciation does improve the current account.

13.2 J-Curve Effect: Worked Example

Example. The UK current account is initially in balance. The pound depreciates by 20%. Short-run PED for exports $= 0.4$ and for imports $= 0.3$. Long-run PED for exports $= 1.2$ and for imports $= 1.0$.

Short run:

• Export revenue: the pound price of exports falls (UK goods are cheaper), but export volumes rise by only $0.4 \times 20\% = 8\%$. Since prices fall by 20% but volumes rise by only 8%, export revenue in pounds falls.
• Import spending: the pound price of imports rises by 20%, but import volumes fall by only $0.3 \times 20\% = 6\%$. Import spending rises by approximately $20\% - 6\% = 14\%$.
• Net effect: the trade balance WORSENS because the price effect dominates the volume effect in the short run. $|\text{PED}_X| + |\text{PED}_M| = 0.4 + 0.3 = 0.7 < 1$.

Long run:

• Export revenue: export volumes rise by $1.2 \times 20\% = 24\%$. Net effect on export revenue: $+24\% - 20\% = +4\%$ (improves).
• Import spending: import volumes fall by $1.0 \times 20\% = 20\%$. Net effect on import spending: $-20\% + 20\% = 0\%$ (no change in pound terms).
• Net effect: the trade balance IMPROVES. $|\text{PED}_X| + |\text{PED}_M| = 1.2 + 1.0 = 2.2 > 1$.

13.3 The Terms of Trade

The terms of trade (ToT) measure the ratio of export prices to import prices:

$\text{ToT} = \frac{P_X}{P_M} \times 100$

where $P_X$ is the export price index and $P_M$ is the import price index.

Improvement ($\text{ToT} \uparrow$): export prices rise relative to import prices. Each unit of exports buys more imports. This is beneficial IF caused by higher export demand (increased quality, innovation). It may be harmful IF caused by falling import demand (global recession).

Deterioration ($\text{ToT} \downarrow$): export prices fall relative to import prices. Each unit of exports buys fewer imports. This is harmful IF caused by declining competitiveness. It may be beneficial IF caused by falling import prices (cheaper imported inputs reduce production costs).

Prebisch-Singer hypothesis: the terms of trade for primary commodity exporters tend to deteriorate over time relative to manufactured goods exporters, because:

1. Income elasticity of demand for primary commodities is low (Engel's law)
2. Technological progress reduces demand for raw materials (synthetic substitutes, recycling)
3. Supply of primary commodities grows faster than demand (entry of new producers)

13.4 Trading Blocs: EU, NAFTA/USMCA, CPTPP

Types of trading blocs:

Type	Definition	Example
Free trade area	No tariffs between members, each sets own external tariffs	EFTA
Customs union	No tariffs between members, common external tariff	EU (as customs union)
Single market	Free movement of goods, services, capital, and labour	EU (single market)
Economic union	Single market + common fiscal and monetary policy	Eurozone (partial)

Trade creation vs trade diversion (Viner, 1950):

• Trade creation: joining a bloc causes imports to shift from a higher-cost domestic producer to a lower-cost member producer. This increases efficiency and welfare.
• Trade diversion: joining a bloc causes imports to shift from a lower-cost non-member producer to a higher-cost member producer (due to tariff preference). This reduces efficiency and welfare.

Example. Before joining the EU, the UK imported butter from New Zealand (most efficient producer) at a world price of GBP 2,000/tonne plus a 20% tariff (GBP 400), total = GBP 2,400. EU producers supplied at GBP 2,200/tonne. After joining, the UK imports from the EU tariff-free at GBP 2,200 instead of New Zealand at GBP 2,400. This is trade CREATION (GBP 200 saving per tonne).

But if EU producers were less efficient (GBP 2,600/tonne) and New Zealand remained at GBP 2,400/tonne, the UK would shift to the EU producer at GBP 2,600 instead of New Zealand at GBP 2,400. This is trade DIVERSION (GBP 200 cost per tonne).

13.5 The Balance of Payments and Exchange Rate Models

Purchasing Power Parity (PPP):

$e = \frac{P_{domestic}}{P_{foreign}}$

Absolute PPP: the exchange rate should equal the ratio of domestic to foreign price levels. A Big Mac should cost the same everywhere (the "Big Mac index" published by The Economist).

Relative PPP: the exchange rate should adjust to reflect inflation differentials:

$\%\Delta e \approx \pi_{domestic} - \pi_{foreign}$

If UK inflation is 5% and US inflation is 3%, the pound should depreciate by approximately 2% against the dollar.

Limitations of PPP:

• Non-traded goods (haircuts, housing) are not subject to arbitrage, so their prices can differ permanently.
• Transport costs and trade barriers prevent full arbitrage.
• Different consumption baskets across countries (different CPI weights).
• PPP holds only in the very long run (10-20 years); exchange rates deviate significantly in the short run.

14. Exam-Style Questions with Full Mark Schemes

Question 1 (25 marks). "A weaker pound will automatically correct the UK's current account deficit." To what extent is this statement correct?

Details

Full Mark Scheme

Analysis of the mechanism (8 marks):

• Depreciation makes UK exports cheaper abroad and imports more expensive.
• This should increase export volumes and decrease import volumes, improving the trade balance.
• Chain of reasoning: $e \downarrow \Rightarrow P_X^* \downarrow \Rightarrow X \uparrow$, $P_M \uparrow \Rightarrow M \downarrow$, $(X - M) \uparrow$.
• Diagram showing the effect on the trade balance over time (J-curve).

Conditions for correction (8 marks):

• Marshall-Lerner condition must hold ($|\text{PED}_X| + |\text{PED}_M| > 1$). In the short run, PED is low (contracts fixed, consumer habits), so the J-curve effect means the current account initially worsens.
• Spare capacity: UK firms must be able to increase export production. If at full employment, they cannot expand output without inflationary pressure.
• Import content of exports: if UK exports contain a high proportion of imported components (e.g., cars with imported parts), depreciation raises production costs, offsetting the competitiveness gain.
• Foreign retaliation: trading partners may impose tariffs or devalue their own currencies (competitive devaluation).
• Pass-through: the extent to which exchange rate changes are passed through to import prices. In the UK, pass-through is estimated at 50-70% for most goods.

Evaluation (9 marks):

• The word "automatically" is the key weakness. Depreciation creates the CONDITIONS for correction but does not guarantee it.
• Short-run vs long-run: the J-curve means the current account worsens before improving (6-18 months).
• The UK's current account deficit is partly structural (low savings ratio, strong consumer demand) rather than purely a competitiveness issue. Exchange rate adjustment alone cannot address a structural deficit.
• Inflationary consequences: depreciation raises import prices, causing cost-push inflation, which may erode the competitiveness gain (the wage-price spiral).
• Conclusion: depreciation is a necessary but not sufficient condition for current account correction. Supply-side policies to improve competitiveness and fiscal policies to address the savings-investment imbalance are also needed.

Mark allocation: Analysis (10 marks), Evaluation (10 marks), Structure (5 marks).

Question 2 (12 marks). Country A can produce 100 cars or 200 tonnes of wheat with all its resources. Country B can produce 80 cars or 40 tonnes of wheat. (a) Which country has an absolute advantage in each good? (b) Which country has a comparative advantage in cars? (c) If they trade at an exchange rate of 1 car = 1.5 tonnes of wheat, what are the gains from trade?

Details

Full Mark Scheme

(a) Absolute advantage (3 marks): Country A can produce more cars (100 vs 80) AND more wheat (200 vs 40). Country A has an absolute advantage in both goods.

(b) Comparative advantage (4 marks): Opportunity cost of 1 car:

• Country A: $200/100 = 2$ tonnes of wheat.
• Country B: $40/80 = 0.5$ tonnes of wheat.

Opportunity cost of 1 tonne of wheat:

• Country A: $100/200 = 0.5$ cars.
• Country B: $80/40 = 2$ cars.

Country B has a comparative advantage in cars (lower opportunity cost: 0.5 wheat vs 2 wheat). Country A has a comparative advantage in wheat (lower opportunity cost: 0.5 cars vs 2 cars).

(c) Gains from trade (5 marks): The terms of trade (1 car = 1.5 wheat) lies between the two opportunity costs (0.5 and 2 wheat per car).

For each car Country B exports, it receives 1.5 tonnes of wheat, whereas domestically it could only produce 0.5 tonnes by reallocating resources. Gain: $1.5 - 0.5 = 1.0$ tonne of wheat per car exported.

For each tonne of wheat Country A exports, it receives $1/1.5 = 0.667$ cars, whereas domestically it could only produce 0.5 cars by reallocating resources. Gain: $0.667 - 0.5 = 0.167$ cars per tonne of wheat exported.

Both countries gain from specialisation and trade based on comparative advantage.

10. Extended Worked Examples

10.1 Exchange Rate Determination: Purchasing Power Parity

Example. The Big Mac Index (a light-hearted PPP measure) shows:

Country	Big Mac price (local currency)	Big Mac price (USD)	Implied PPP	Actual exchange rate	Over/undervaluation
UK	GBP 4.50	$5.15	1.14 GBP/USD	1.25 GBP/USD	9.6% undervalued
USA	$5.15	$5.15	--	--	--
Switzerland	CHF 7.00	$8.05	1.36 CHF/USD	0.87 CHF/USD	56.3% overvalued
Japan	JPY 450	$3.30	87.4 JPY/USD	136 JPY/USD	35.8% undervalued

Interpretation:

• The pound is 9.6% undervalued against the dollar according to PPP. If PPP held exactly, GBP 1 should buy USD 1.14, but it only buys USD 0.80. The pound is "too cheap" relative to the dollar.
• The Swiss franc is 56.3% overvalued. Switzerland has high wages and high non-tradable costs (rent, services) that are reflected in Big Mac prices but are not relevant for traded goods.
• The Japanese yen is 35.8% undervalued. Japan has low inflation and relatively low non-tradable prices.

Limitations of the Big Mac Index:

• Big Macs are not tradable (they include local labour, rent, and service costs).
• The Big Mac is a homogeneous product globally, but local costs vary enormously.
• The index ignores trade barriers, transportation costs, and differences in demand.
• It is a better measure of relative price levels than of exchange rate misalignment.

10.2 Balance of Payments and Exchange Rate: Full Numerical Model

Example. A small open economy has the following data:

Current account (USD billions):

• Exports of goods: 200
• Imports of goods: 280
• Exports of services: 120
• Imports of services: 80
• Primary income received: 50
• Primary income paid: 90
• Secondary income: -10

Financial account (USD billions):

• FDI inflows: 40
• FDI outflows: 20
• Portfolio investment inflows: 60
• Portfolio investment outflows: 30
• Other investment (net): 15

Current account: Trade in goods: $200 - 280 = -80$. Trade in services: $120 - 80 = +40$. Primary income: $50 - 90 = -40$. Secondary income: $-10$. Current account: $-80 + 40 - 40 - 10 = -90$.

Capital account: assumed to be 0 (small open economy).

Financial account: $(40 - 20) + (60 - 30) + 15 = 20 + 30 + 15 = 65$.

Statistical discrepancy: $CA + KA + FA + SD = 0$. $-90 + 0 + 65 + SD = 0$. $SD = 25$.

The discrepancy of 25 may reflect unrecorded transactions (e.g., capital flight, informal trade).

Implications for the exchange rate: The current account deficit of 90 means the country is consuming more than it produces, financed by net capital inflows of 65 (plus 25 statistical discrepancy). The country is a net borrower from the rest of the world. If capital inflows dry up (loss of investor confidence), the currency must depreciate to restore balance:

• Depreciation makes exports cheaper and imports more expensive.
• The current account improves (Marshall-Lerner condition permitting).
• The required depreciation: if the current account deficit must be eliminated through exchange rate adjustment, and the sum of PEDs is 1.5, the required depreciation is approximately $\frac◆LB◆90◆RB◆◆LB◆200 \times 1.5 - 280 \times 0.75◆RB◆ \times 100 \approx 20\%$ (very approximate).

10.3 Trading Blocs: Numerical Welfare Analysis

Example. Three countries form a customs union:

Country	Wheat price (USD/tonne)	Demand (million tonnes)	Supply (million tonnes)
A (home)	100	200	100
B (partner)	80	300	200
C (rest of world)	60	--	--

Before the customs union: Country A imports from C at $60 (cheapest source). Tariff on C:$20/tonne. Price in A: $80. Imports from C:$Q_D(80) - Q_S(80)$. Assume demand$Q_D = 300 - P$and supply$Q_S = P$.$Q_D = 300 - 80 = 220$.$Q_S = 80$. Imports$= 220 - 80 = 140$. Tariff revenue:$20 \times 140 = 2800$.

After forming a customs union with B (tariff-free trade with B, common external tariff of 20 on C): A can import from B at $80 (no tariff) or from C at$80 (60 + 20 tariff). Price is the same. Assume A imports from B for political reasons. Imports from B: $Q_D(80) - Q_S(80) = 140$ (same quantity). No tariff revenue (free trade with B).

Trade creation vs trade diversion:

• Trade creation: the removal of the tariff on B reduces the price from 100 (B's price + tariff) to 80. Previously, A produced some wheat domestically that it now imports from B more cheaply. Domestic production falls from 100 to 80 (20 million tonnes of trade created). Welfare gain from trade creation: $\frac{1}{2}(100 - 80)(20) = 200$.

• Trade diversion: previously, A imported from C at 80 (60 + 20). Now A imports from B at 80. The cost is the same! There is no trade diversion in this case.

Let me change the numbers to create trade diversion:

If the tariff on C were 10 (not 20): price from C = 70. Imports from C = $Q_D(70) - Q_S(70) = 230 - 70 = 160$. Tariff revenue = $10 \times 160 = 1600$.

After customs union: A imports from B at 80 (no tariff). Price from C = 60 + 10 = 70. But A cannot import from C at 70 because... actually, in a customs union, the external tariff is common. If the common external tariff is 20: price from C = 80. Price from B = 80. No change.

If the common external tariff is 10: price from C = 70. Price from B = 80. A imports from C (cheaper). No trade diversion.

For trade diversion to occur, the partner's price must be between the world price (without tariff) and the world price (with tariff): $P_C < P_B < P_C + t$. Here: $60 < 80 < 60 + 20 = 80$. Since $P_B = P_C + t$, trade diversion is marginal.

Better example: $P_C = 50$, $P_B = 80$, tariff on C = 20. Price from C = 70. Imports from C = 160. After customs union (common tariff 20): price from C = 70. Price from B = 80. A imports from C (still cheaper). No trade diversion.

Trade diversion requires $P_B < P_C + t_{CU}$ but $P_B > P_C$: $P_C = 50$, $P_B = 65$, tariff on C = 20. Before CU: price from C = 70, from B = 85 (with tariff 20). A imports from C: 160 million tonnes. Tariff revenue = $20 \times 160 = 3200$.

After CU (no tariff on B, tariff on C = 20): price from B = 65, from C = 70. A imports from B: 140 million tonnes. Tariff revenue = 0.

Trade creation: domestic production falls from 70 to 65 (5 million tonnes). Gain $= \frac{1}{2}(65 - 65)...$ This is getting confused. Let me simplify.

$Q_D = 300 - P$. $Q_S = P$. Before CU (import from C at 70): $Q_D = 230$, $Q_S = 70$. Imports = 160. CS = $\frac{1}{2}(300 - 70)(230) = 26450$. PS = $\frac{1}{2}(70)(70) = 2450$. Government revenue = 3200. Total welfare = 32100.

After CU (import from B at 65): $Q_D = 235$, $Q_S = 65$. Imports = 170. CS = $\frac{1}{2}(300 - 65)(235) = 27612.5$. PS = $\frac{1}{2}(65)(65) = 2112.5$. Government revenue = 0. Total welfare = 29725.

Net welfare change: $29725 - 32100 = -2375$. The customs union REDUCES welfare! This is because trade diversion (switching from low-cost C to higher-cost B) outweighs trade creation (lower domestic production).

Key insight: customs unions are not always welfare-improving. They create trade (good) but also divert trade (bad). Whether the net effect is positive depends on the specific prices, tariffs, and elasticities.

10.4 Fixed vs Floating Exchange Rates: A Full Comparison

Example. An economy experiences a negative demand shock. Compare the adjustment under fixed and floating exchange rates.

Floating exchange rate: AD falls. Output falls, price level falls. Lower prices make exports cheaper and imports more expensive (assuming Marshall-Lerner holds). Net exports increase, partially offsetting the AD shock. The exchange rate depreciates automatically, providing a stabilising mechanism.

Fixed exchange rate: AD falls. Output falls, price level falls. The central bank must intervene to maintain the fixed rate: it buys domestic currency (selling foreign reserves) to prevent depreciation. This reduces the money supply, raising interest rates and further reducing AD. The fixed exchange rate AMPLIFIES the shock rather than offsetting it.

Numerical illustration: Suppose the shock reduces net exports by 50. The multiplier is 2.

Floating rate: $\Delta Y = 2 \times (-50) = -100$. But the exchange rate depreciates by 5%, improving net exports by 25 (PED sum = 1.5). Net $\Delta Y = 2 \times (-50 + 25) = -50$.

Fixed rate: $\Delta Y = 2 \times (-50) = -100$. The central bank intervenes, tightening monetary policy. This reduces investment by 20. Net $\Delta Y = 2 \times (-50 - 20) = -140$.

The fixed exchange rate results in a deeper recession (-140 vs -50). However, the fixed rate provides certainty for international trade and investment, which may be beneficial in the long run.

When is a fixed rate preferable?

• Small, open economies with a single major trading partner (e.g., Monaco pegs to the euro).
• Countries with a history of hyperinflation (the peg provides an anchor for inflation expectations).
• Economies with limited monetary policy credibility (the peg "imports" the anchor country's credibility).

When is a floating rate preferable?

• Large economies with diverse trading partners (e.g., the US, Japan).
• Economies subject to asymmetric shocks (the floating rate provides an automatic stabiliser).
• Countries that want independent monetary policy (the "impossible trinity": you cannot have free capital flows, a fixed exchange rate, AND independent monetary policy simultaneously).

11. Extended Worked Examples

11.1 Terms of Trade: Numerical Analysis

Example. Country A exports copper and imports manufactured goods. The price data (index, 2020 = 100):

Year	Export price index	Import price index	Terms of trade
2020	100	100	100
2021	120	105	114.3
2022	150	115	130.4
2023	130	120	108.3

Terms of trade calculation: $ToT = \frac◆LB◆\text{Export price}◆RB◆◆LB◆\text{Import price}◆RB◆ \times 100$.

2021: $ToT = 120/105 \times 100 = 114.3$. An improvement of 14.3%. 2022: $ToT = 150/115 \times 100 = 130.4$. A further improvement (copper boom). 2023: $ToT = 130/120 \times 100 = 108.3$. A deterioration (copper prices fell, import prices rose).

Impact on the trade balance: Export revenue (index): $P_X \times X$. Import expenditure (index): $P_M \times M$.

If export volumes are 100 and import volumes are 80: 2020: Export revenue $= 100 \times 100 = 10\,000$. Import cost $= 100 \times 80 = 8\,000$. Trade surplus $= 2\,000$. 2022: Export revenue $= 150 \times 100 = 15\,000$ (assuming volumes unchanged). Import cost $= 115 \times 80 = 9\,200$. Trade surplus $= 5\,800$.

The terms of trade improvement increased the trade surplus by 3,800 (from 2,000 to 5,800), even though volumes did not change.

With volume effects (elasticity): If $PED_X = -0.3$ and $PED_M = -0.5$:

2021: Export prices up 20%. Export volumes fall by $0.3 \times 20 = 6\%$ to 94. Import prices up 5%. Import volumes fall by $0.5 \times 5 = 2.5\%$ to 78.

Export revenue $= 120 \times 94 = 11\,280$. Import cost $= 105 \times 78 = 8\,190$. Trade surplus $= 3\,090$.

The volume effects reduce the gain from the ToT improvement (3,090 vs 3,920 without volume effects), but the ToT improvement still increases the trade surplus because the demand for both exports and imports is inelastic.

Prebisch-Singer hypothesis: This hypothesis predicts that the terms of trade of primary commodity exporters deteriorate over time because:

1. Technological progress in manufacturing reduces production costs and prices (benefiting importers).
2. Income elasticity of demand for manufactured goods exceeds that for primary commodities (so demand shifts away from primary exports over time).

For Country A, the 2023 deterioration (ToT fell from 130.4 to 108.3) is consistent with this hypothesis. However, the long-term trend is mixed: commodity prices are cyclical (boom-bust), and the hypothesis does not always hold.

11.2 Foreign Direct Investment: Costs and Benefits

Example. A multinational car company invests GBP 5 billion in a new factory in the UK, creating 5,000 direct jobs.

Benefits:

• Direct employment: 5,000 jobs at average salary GBP 35,000. Total wages: GBP 175 million/year.
• Indirect employment (multiplier 1.5): 7,500 additional jobs in the supply chain. Total: 12,500 jobs.
• Tax revenue: corporation tax (19% of profits, assume GBP 500m profit) = GBP 95m/year. Income tax + NIC on wages = GBP 70m/year. Total: GBP 165m/year.
• Technology transfer: the factory may introduce advanced manufacturing techniques that spill over to domestic firms.
• Export revenue: if 50% of output is exported, at GBP 20,000 per car and 100,000 cars/year: GBP 1 billion/year of exports.
• Training: the company invests GBP 50m in training, creating a skilled workforce that benefits the wider economy.

Costs:

• Profit repatriation: if the company is foreign-owned, profits (GBP 500m/year) are repatriated, worsening the primary income account by GBP 500m/year.
• Crowding out: the factory may bid up wages, making it harder for domestic firms to recruit. Wage inflation in the region.
• Environmental costs: factory emissions, traffic congestion, land use.
• Tax competition: the government may have offered tax incentives (reduced corporation tax for 10 years) worth GBP 200m, reducing net tax revenue.
• Vulnerability: the factory depends on the parent company's strategy. If the parent decides to close the factory (e.g., Sunderland Nissan's periodic closure threats), the local economy suffers.

Net present value calculation: Benefits (per year): tax revenue 165 + training spillovers 20 + export revenue 1000 (but this is gross, not net) = approximately GBP 200m in net fiscal and wider economic benefits. Costs (per year): profit repatriation 500 + tax incentives 20 = GBP 520m. Net annual cost: GBP 320m.

Over 20 years (discount rate 3.5%): PV of costs $= 320 \times \frac{1 - 1.035^{-20}}{0.035} = 320 \times 14.2 = 4544$. PV of initial investment: 5000.

Net cost to the UK: $5000 + 4544 = \text{GBP } 9544\text{m}$.

But this ignores the dynamic benefits: if the factory raises productivity in the local supply chain by 5%, the cumulative benefit over 20 years could be GBP 2-5 billion. The training spillovers and technology transfer are difficult to quantify but may be substantial.

Conclusion: FDI generates both costs (profit repatriation, tax competition) and benefits (jobs, technology transfer, exports). The net effect depends on the type of FDI (greenfield investment is better than mergers and acquisitions), the sector (manufacturing and technology are better than extractive industries), and the policy environment (domestic content requirements, technology transfer conditions).

11.3 Currency Crises: First-Generation Model

Example. A country pegs its currency at 1 peso = 1 dollar. The government runs a fiscal deficit of 5% of GDP, financed by central bank credit creation (money printing). Reserves = USD 50 billion.

Crisis dynamics:

1. The fiscal deficit creates inflationary pressure. Domestic prices rise faster than foreign prices.
2. The real exchange rate appreciates (the peg becomes overvalued), making exports less competitive.
3. The current account deteriorates (imports rise, exports fall).
4. The central bank must sell reserves to maintain the peg.
5. As reserves fall, speculators anticipate devaluation and sell the domestic currency.
6. The speculative attack accelerates reserve loss.
7. When reserves are exhausted, the government is forced to devalue.

Shadow exchange rate: The rate that would prevail if the peg were abandoned today. $e_{shadow} = e_{peg} \times \frac{M}{M^*}$ where $M$ is the domestic money supply and $M^*$ is the money supply consistent with the peg.

If money growth is 15% per year (due to fiscal deficit financing) and the anchor country's money growth is 5%: After 1 year: $e_{shadow}/e_{peg} = 1.10$ (10% overvaluation). After 2 years: $e_{shadow}/e_{peg} = 1.21$ (21% overvaluation).

Speculative attack timing: Speculators attack when $e_{shadow} > e_{peg}$, i.e., when the expected devaluation exceeds the cost of attacking (the interest rate differential).

If the domestic interest rate is 15% and the US interest rate is 5%, the cost of borrowing pesos to sell is 10% per year. Speculators will attack if they expect a devaluation of more than 10%.

At 21% overvaluation (year 2), speculators expect a devaluation of at least 21%. Since 21% > 10%, the attack is profitable. The attack occurs in year 2 (or earlier if speculators are forward-looking).

Reserve depletion: Initial reserves: USD 50 billion. Current account deficit: 3% of GDP = USD 15 billion/year. Reserves after year 1: 35 billion. Reserves after year 2: 20 billion. Reserves after year 3: 5 billion.

The speculative attack likely occurs in year 2 or 3, when reserves are still positive but the overvaluation is large enough to make the attack profitable. The government may try to defend the peg by raising interest rates (to 30-40%), but this causes a deep recession and further fiscal deterioration.

Policy lessons:

1. Fixed exchange rates require fiscal discipline. If the government cannot control the fiscal deficit, the peg is unsustainable.
2. The first-generation model (Krugman, 1979) predicts that currency crises are inevitable when fundamentals deteriorate -- they are not random events.
3. Early warning indicators: rapid reserve loss, large fiscal deficits, overvalued real exchange rate, widening current account deficit.
4. The optimal policy is to abandon the peg BEFORE reserves are exhausted, rather than fighting a losing battle.