International Economics

Overview

Organise international economics around flows. Goods and services flow according to comparative advantage and scale economies. Money flows according to interest differentials, expectations and risk. The balance of payments records both, and the exchange rate is the price that reconciles them. When a question asks about a tariff, trace its effect on domestic price, production, consumption, imports, government revenue and welfare, in that order. When a question asks about a currency movement, ask first whether the shock came from goods markets, asset markets or policy, because each implies a different adjustment path. When a question asks about an institution, ask what problem it was created to solve: the WTO disciplines protection, the IMF addresses balance of payments crises, and the World Bank finances long-term development. That problem-first habit keeps institutional answers analytical rather than descriptive.

International trade: concepts and theories

Absolute advantage means a country produces a good with fewer resources than another; comparative advantage means it produces a good at lower opportunity cost, giving up less of other goods to produce it. Ricardo showed that comparative advantage, not absolute advantage, determines trade patterns: even a country less productive at everything gains by specialising in the good where its disadvantage is smallest and importing the good where its disadvantage is largest. Trade then raises world output because resources move to their relatively most productive uses, and the terms of trade, the ratio of export prices to import prices, determine how the gains are shared. A country gains from trade if its terms of trade allow it to consume beyond its own production possibility frontier. The Ricardian model uses a single factor, labour, with constant returns and perfect competition; its predictions are clean but it cannot explain trade within industries or the role of capital and land.

The Heckscher-Ohlin model adds factor endowments: a country exports goods intensive in its abundant factor and imports goods intensive in its scarce factor. A labour-abundant country exports labour-intensive goods; a capital-abundant country exports capital-intensive goods. Factor price equalisation says free trade tends to equalise factor prices across countries when assumptions hold, because trade in goods substitutes for trade in factors. The Stolper-Samuelson theorem links product prices to factor rewards: a rise in the price of a good raises the real return to the factor used intensively in that good and lowers the return to the other factor, which is why trade creates domestic winners and losers even when the nation gains overall. The Rybczynski theorem says growth in one factor expands output of the good intensive in that factor and contracts output of the other good. Empirical puzzles qualify the simple model: the Leontief paradox found a capital-abundant country exporting labour-intensive goods, explained by human capital, natural resources, technology differences and demand patterns. Intra-industry trade, the simultaneous export and import of similar goods, is large between similar countries and is not explained by endowment differences at all, motivating newer theories based on scale and variety.

Trade under imperfect competition

Much world trade is in differentiated goods produced by firms with market power under increasing returns to scale, which changes the logic of trade. With economies of scale, larger markets allow lower average costs, so opening to trade expands market size, lets firms exploit scale, increases product variety and sharpens competition, all of which can raise welfare even between identical countries. The monopolistic competition model of trade formalises this: each firm produces a differentiated variety, trade increases the number of varieties available to consumers and reduces each firm's markup as competition intensifies, while the number of domestic firms may fall as some exit. Intra-industry trade emerges naturally: countries exchange different varieties of the same product category, such as different car models, rather than exchanging entirely different goods.

Firm heterogeneity adds a further layer: within an industry, only the most productive firms export, because exporting involves fixed costs of entering foreign markets. Trade liberalisation then reallocates market share toward productive exporters and away from less productive firms that serve only the domestic market, raising average industry productivity through selection. Dumping, selling abroad below domestic price or below cost, can reflect price discrimination across markets with different elasticities rather than predation, though persistent below-cost selling aimed at driving out rivals is treated differently in trade remedy law. Strategic trade policy argues that in oligopolistic industries with excess profits, a government subsidy or tariff can shift profits from foreign to domestic firms, improving national welfare. The argument is theoretically valid in narrow models but fragile in practice: it requires precise knowledge of market structure, invites retaliation that leaves all countries worse off, and is vulnerable to lobbying for protection by firms that claim strategic importance. The practical lesson is that strategic arguments justify at most targeted, temporary intervention, not general protection, and the burden of proof lies on the intervention.

Balance of payments and exchange rates

The balance of payments records all transactions between residents and non-residents, using double-entry bookkeeping so that every transaction appears as a credit and a debit. The current account covers trade in goods and services, primary income such as wages, interest and dividends, and secondary income such as remittances and aid. The capital account covers capital transfers and acquisition of non-produced assets, while the financial account covers direct investment, portfolio investment, other investment and reserve assets. A current account deficit means a country spends more abroad than it earns and must finance the gap by net capital inflows or by running down reserves; it is not by itself a sign of weakness, because it may reflect productive investment financed from abroad, but persistent deficits financed by debt raise sustainability questions. The accounting identity requires the sum of current, capital and financial accounts plus errors and omissions to be zero, so a deficit in one part must be matched elsewhere.

An exchange rate is the price of one currency in terms of another, quoted directly or indirectly depending on convention. Under a floating regime the rate is market-determined; under a fixed regime the central bank commits to a parity and intervenes with reserves to defend it; managed floats and crawling pegs lie between. Exchange rate determination has several complementary approaches. Purchasing power parity says exchange rates move to equalise price levels, so the rate reflects relative prices, with absolute parity equating price levels and relative parity linking depreciation to inflation differentials. Interest rate parity links exchange rates to interest differentials: covered parity uses forward rates and holds by arbitrage, while uncovered parity uses expected future spot rates and requires risk neutrality and rational expectations. The monetary approach treats the exchange rate as the relative price of two monies, determined by relative money supplies, outputs and interest rates. The asset approach and overshooting model add dynamics: with sticky goods prices, a monetary expansion causes the exchange rate to overshoot its long-run level in the short run because asset markets adjust instantly while goods prices adjust slowly. Real exchange rates adjust nominal rates for price levels and measure competitiveness; a real appreciation makes exports dearer and imports cheaper.

Foreign exchange market and gains from trade

The foreign exchange market is a decentralised, over-the-counter market where currencies are traded spot for immediate delivery and forward for delivery at an agreed future date and price. Market participants include commercial banks, central banks, firms hedging trade receipts, investors and speculators. Arbitrage enforces consistency across markets: triangular arbitrage ensures cross rates agree, so converting through a third currency cannot yield riskless profit; covered interest arbitrage ensures the forward premium equals the interest differential, otherwise borrowing in one currency, converting, investing in another and covering forward would yield a riskless gain. Speculators take open positions based on expectations, providing liquidity but also amplifying movements when expectations shift suddenly. Hedging uses forward contracts, futures, options and swaps to lock in rates and reduce exposure, and the choice among them trades off cost, flexibility and counterparty risk.

Gains from trade are measured against autarky, the no-trade position. Consumption gains arise because trade lets a country consume bundles outside its own production frontier by exchanging at world prices. Production gains arise from specialisation according to comparative advantage. Terms-of-trade gains arise when export prices rise relative to import prices, allowing more imports per unit of exports. Offer curves, which plot a country willingness to trade at each terms of trade, intersect to determine equilibrium terms of trade and trade volumes; a large country can influence its terms of trade, unlike a small country that takes world prices as given. The optimal tariff argument follows for a large country: a tariff improves its terms of trade by reducing demand for imports, and up to a point the terms-of-trade gain exceeds the efficiency loss, though retaliation can erase it. Dynamic gains extend beyond static reallocation: trade spreads technology, increases competition and innovation, allows learning by doing, and disciplines domestic monopolies. These dynamic gains are harder to measure but are often larger than static triangles, which is why evaluations that count only static effects understate the case for openness.

Tariffs, WTO, IMF and World Bank

A tariff is a tax on imports. In a small country it raises the domestic price by the tariff amount, increases domestic production, reduces domestic consumption, reduces imports, raises government revenue equal to tariff multiplied by imports, and creates two deadweight loss triangles: a production distortion loss from producing units that cost more than the world price, and a consumption distortion loss from forgoing units valued above the world price. The net welfare effect is negative for a small country, equal to the sum of those triangles. A quota limits import quantity directly and has similar price and quantity effects, but revenue accrues as quota rents to whoever holds import licences rather than to the government, unless licences are auctioned. Voluntary export restraints, export subsidies and non-tariff barriers such as standards and licensing add further distortions, and effective protection measures protection on value added rather than on the final good price, so tariffs on inputs can reduce effective protection for downstream producers.

The World Trade Organization provides the multilateral framework: most-favoured-nation treatment requires any trade advantage given to one member to be extended to all, national treatment requires imported goods to be treated no less favourably than domestic goods once inside the market, and the dispute settlement system enforces commitments. Rounds of negotiation have reduced tariffs and extended rules to services and intellectual property, while agriculture, subsidies and development asymmetries remain contested. The International Monetary Fund oversees exchange rate policies, lends to countries facing balance of payments difficulties subject to conditionality, and allocates Special Drawing Rights as supplementary reserve assets. The World Bank group lends for long-term development projects and programmes, provides technical assistance, and focuses on poverty reduction and shared prosperity, distinguishing its development mandate from the Fund stabilisation mandate. Together these institutions embody a rules-based order, but they are debated on grounds of governance, conditionality, and whether their rules adequately reflect developing country interests, a debate that should be answered with specific mechanisms rather than general slogans.

Trade theories compared

Tariff versus quota in a small country

Exchange rate regimes