revision 3204 (1)

PART ONE

INTERNATIONA TRADE THEORIES AND POLICIES

MERCANTALISM

• Precious Metals• Zero Sum Game : One gains, one losses• Exports > Imports = Trade Surplus• Policies : Monopoly rights, restrictions• Economic System: manufacturing; rural, overseas colonies• Labor Theory of Value: Commodity is valued in relation

to the L

FAILURES OF MERCANTALISM

State Monopoly collapsedTechnology, market system

Views of Two Classical Writers

DAVID HUME ADAM SMITH

MERCANTALIST IDEAS VIEW CHALLENGED

DAVID HUME AGAINST MERCANTALISM

• Competitiveness Cannot Be Maintained At The Same Level

• Price Specific Flow Mechanism

• Two Countries

Country With A Surplus Country With A Deficit

(X>m) (X<m)

Inflow Of Gold Outflow Of Gold

Increase In Money Supply Decrease In Money Supply

Increase In Prices And Wages Decrease In Prices And Wages

Decrease Indemand For Exports Increase In demand For Exports

X , M X M

X=M X=M

ADAM SMITH AGAINST MERCANTALISM

• ROLE OF THE GOVERNMENT• (NO GOVERNMENT INTERVENTION)

– NATIONAL DEFENCE AND JUSTICE– PROVISON OF PUBLIC GOODS– INTERVENTION IN TIMES OF MARKET FAILURES

THEORY OF ABSOLUTE ADVANTAGE

ABSOULTE ADVANTAGE THEORYUSE hypothetical EXAMPLEs when you are writing your answer;

1. Labor Hours 2. 200 labor hours: 100 hours Per Each commodity

3. Domestic Production ( After Trade)

Labor hours per unitFood Cloth

Sri Lanka 5 2

India 4 10

Units of GoodFood Cloth Total

Sri Lanka 100/5=20 100/2=50 70

India 100/4=25 100/10=10 35

Units of GoodFood Cloth Total

Sri Lanka … 200/2=100 100

India 200/4=50 …… 50

What?Assumptions?Failures?

COMPARATIVE ADVANTAGE THEORY(RICARDO)

LABOR HOURS

1 Cloth 1 wine

Sri Lanka

50 60

India 45 40

Opportunity Cost

1 Cloth 1 wine

Sri Lanka 50/60=0.83 60/50=1.2

India 45/40=1.12 40/45=0.88

Cloth wine Price ratio

Sri Lanka 50 60 1 cloth:5/6 wine or1 wine:6/5 cloth

India 45 40 1 cloth: 9/8 wine or1 wine: 8/9 cloth

What?Assumptions?Failures?

PRODUCTION FUNCTIONisocost and isoquant

Q=F(K,L)

K

L0

3

3

ISOQUANT CURVE

ISOCOST CURVE

LINEARLY HOMOGENEOUS PRODUCTION FUNCTION

Constant Returns To Scale;

10 20 30

302010

X=100

X=200

X=300

45 degree curve shows all the equilibriums where Constant Returns to Scale

Good X

K

L

K

L

Production points of good X

Production points of good Y Adding two graphs

together = edgeworth box

EDGEWORTH BOX

garments

software

S2

S2

S1

L

K

Factor Endowment Theory

• Basis of HO model is Factor Endowment• Assumptions

– 2- countries,products,factors– Technology, transportation cost, perfect competition,CRS, mobility,

Taste

• Ownership of different FOCs• Different shapes of PPC

Factor endowments

garments

software

S2

S1

So

K

L

garments

software

S2

S2

S1

L

K

Country A

Country B

Capital Intensive country Labor Intensive country

H-O Theory

• Countries will tend to specialize in the production of goods using relatively abundant factor. Comparative advantage based on resource endowments.

• More demand for that factor will be created which will increase price of that factor. Eventually they will tend to equalize with the increase in trade.

H.O. Model Equilibrium

P1

P1

P0

P0

software

garments

P0P0 & P1P1 (price curves) show different price ratios in autarky. This is the basis for comparative advantage.

Gains from trade after specialization

• Country A • Country B

400

300

250

800

800

300

250 400

800

800

ba a

b

CONSUMPTION POSSIBILITY C URVE after trade

PPC before trade

CONSUMPTION POSSIBILITY CCURVE after trade

PPC before trade

GOOD Y

GOOD X

GOOD Y

GOOD X

COUNTRY A, SPECIALIZE GOOD Y COUNTRY B, SPECIALIZE GOOD X

PRODUCTION POINTS

INTERNATIONAL TRADE POLICIES

IS FREE TRADE INEFFICIENT?

• INFANT INDUSTRY ARGUMENT• NATIONAL SECURITY• DUMPING: CAPTURING,MC• REVENUE• DISCOURAGING LUXURIES• DIVERSIIFICATION• IMPROVING THE TERMS OF TRADE

TRADE RESTRICTIONS• TARRIFFS

EXPORTS – TO STOP THE OUTFLOW OF RESOURCESIMPORTS – TYPES,EFFECTS

• EFFECTSS

World Price with Tariff

World Price

500 1800

45

40

30

PART TWOEXCHANGE RATE AND BALANCE OF

PAYMENTS

EXCHANGE RATE

THEORYwhat?Determinants?D and S of F. Currency?Factors?Regimes?Appreciation?Depreciation?

YEAR RUPEE PER DOLLAR

1960 4.77

1970 5.96

1980 18.00

1990 40.24

2000 80.06

2010 110.95

Exchange Rate – Sri Lanka2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

3.6

1980 1985 1990 1995 2000 2005 2010

REER

4.2

4.3

4.4

4.5

4.6

4.7

4.8

1980 1985 1990 1995 2000 2005 2010

RER

0.8

1.2

1.6

2.0

2.4

2.8

3.2

1980 1985 1990 1995 2000 2005 2010

NEER

2.4

2.8

3.2

3.6

4.0

4.4

4.8

5.2

1980 1985 1990 1995 2000 2005 2010

NOMINAL ER

5

6

7

8

9

10

1980 1985 1990 1995 2000 2005 2010

DEFICIT

4.0

4.4

4.8

5.2

5.6

6.0

6.4

1980 1985 1990 1995 2000 2005 2010

TOT

Rupee has been hepreciated overtime

CAUSES OF DEPRECIATION

3 CAUSES

1. PERSON VISITS ANOTHER COUNTRY2. IMPORT FROM ANOTHER COUNTRY3. INVEST IN ANOTHER COUNTRY

CAUSES FOR APPRECIATION ARE THE OPPOSITE OF THESE 3

DEPRECIATION• Depreciation (weaker currency)Advantages• Producers will sell more exports• It becomes cheaper for foreigners to travel into the country• Foreign investment in domestic assets will become cheaper• There is less foreign price competition for domestic producers Disadvantages• Domestic consumers pay more for imports• It becomes more expensive to travel outside the country• It becomes more expensive to invest in foreign assets• There is less foreign competition for domestic pricing

CURRENCY APPRECIATIONAppreciation (stronger currency)Advantages• Consumer can buy more imports at a lower price• Travelers abroad can get more foreign currency• Investors can buy more foreign assets• The competition from foreign suppliers keeps domestic prices down Disadvantages• Producers will sell fewer exports• Foreigners traveling into the country will find it more expensive• Foreign investment of domestic assets will be more expensive• Domestic suppliers will have more price competition

BALANCE OF PAYMENTSA systematic record of all economic transactions with the world

• Components– Trade Account– Invisible Trade– Transfers– Current Account– Capital Account– The Overall Balance– Monetary movements– Credit and Debit Transactions– Double Entry Book Keeping

BOP IN SRI LANKA (2012 DATA)

Debit (-) Credit (+) Balance

Trade Account Total Exports Total ImportsTrade Balance

2440,8991245,531

-1195,368

Services Receipts PaymentsService Balance

324,181483,502

159,321

Net Transfers 6,899

Current Account Balance -495,853

Capital Account Balance 630,769

OVERALL BALANCE 72,638

SOURCE: CBSL ANNUAL REPORT 2012SEE THE OVERALL BALANCE OVER TIME ( 2000 TO 2012)

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

3.6

1980 1985 1990 1995 2000 2005 2010

REER

4.2

4.3

4.4

4.5

4.6

4.7

4.8

1980 1985 1990 1995 2000 2005 2010

RER

0.8

1.2

1.6

2.0

2.4

2.8

3.2

1980 1985 1990 1995 2000 2005 2010

NEER

2.4

2.8

3.2

3.6

4.0

4.4

4.8

5.2

1980 1985 1990 1995 2000 2005 2010

NOMINAL ER

5

6

7

8

9

10

1980 1985 1990 1995 2000 2005 2010

DEFICIT

4.0

4.4

4.8

5.2

5.6

6.0

6.4

1980 1985 1990 1995 2000 2005 2010

TOT

1977 2012

0

-10

0

-15

-20

-5

CONSEQUECES OF UNFAVOURABLE BALANCE OF TRADE

PART THREE

INTERNATIONAL TRADE ORGANISATIONS

THEORY OF INTEGRATIONFree Trade Area : No Trade Restrictions

Custom Union : No Restrictions + Common Policies With Non Members

Common Market : No Restrictions + Common Policies With Non Members + Free Mobility Of Factors Of Production

Economic Union : No Restrictions + Common Policies With Non Members + Free Mobility Of Factors Of Production + Monetary , Fiscal And

Other Policies

THEORY OF CUSTOM UNION

D

S

S(partner Country)

S(world)

S(world + tax=15)

500 1600900 1800

45

40

30

50

TRADE ORGANISATIONS

• UNCTAD• GATT• WTO• ROUNDS OF TALKS (URUGUA ,TOKIO)

THANK YOU