Adam smith a classical economist formulated the theory of absolute advantage which stated that trade can only be beneficial if two trading countries have absolute advantage in one good (i.e. given the same input one country can produce more output than the other). However, David Ricardo showed that even if one country has absolute disadvantage in production of two goods if it concentrates on producing the good which it has comparative advantage, Comparative advantage is a concept used in international economics to signifying that trade between two countries can lead to net gains if each country were to produce goods and export goods which it had the lowest opportunity cost or that they can produce most efficiently and importing goods that they have comparative disadvantage or they produce expensively (Suravonic, 2005)
The most important determinants of terms of trade are:
Factor endowment. Different countries have different resources therefore produce different commodities which they can in turn trade to get what they lack. For example Middle Eastern countries are rich in oil deposit thus they can trade this for other products such as food.
Existence of Economic integration. This feature is unique to international trade. Terms of trade are largely determined by the economic integration such as the EU, LAFTA and NAFTA. Thus terms of trade between countries in the same economic integration can be more favourable especially if they have agreed to offer each other tax incentives and charge outsiders a common tariff or relatively higher taxes.
Government policy. Government policy such as taxation, custom duty sanctions affect two countries term of trade. Unfavourable terms of trade can be caused by the tariffs imposed by a government thus making the imports expensive (Suravonic, 2005).
Transportation. Transportation facilitates the possibility of trade. If the cost of transportation is high then the term of trade between two countries becomes unfavourable. For example it might be very hard for Australia to trade with Alaska due to transportation costs (Suravonic, 2005).
Free trade leads to overall increase to the world output. Countries can specialize in what they can produce best and import what they produce expensively thus lead to net gain that is mutually benefiting.
Free trade also increases consumer sovereignty by increasing variety of goods and protecting consumers against the evils of monopoly thus improving material welfare of the consumers.
International trade introduces competition and this might lead to the demise of industry and thus increasing unemployment. Importing of goods economically translates to exporting of labour opportunity at the expense of the domestic workforce; therefore, to ensure that employment opportunities are created, local industries have to be protected so that they can create employment in the country.
International trade also exposes an economy to dumping. A good example is that China has been accused of dumping its products in foreign market, given it’s low cost of production and availability of labour, this has led to unfair competition hence the need for protection in the domestic market.
Trade restriction and policies lead to the following effects on quantity and price of import
Figure showing Shift of equilibrium price and quantity of imports.
Assuming without trade restriction the equilibrium price and quantity were P and Q respectively, imposition of tariffs such as custom duty can lead increasing the cost of imports therefore leading to shifting of supply curve from S to Si. Given the demand curve the equilibrium point will thus shift from e to ei with the new increased price of Pi and reduced quantity of Qi.
Balance of trade is a record showing international transaction of goods and services between the resident’s one country and the residents of another in a given period of time. It shows the net exports or net imports that result from international trade within a given period of time normally one year.
There are two main types of exchange rate systems
Fixed exchange rate system is where the government fixes the rate at which the a amount of foreign currency will be exchanged for a single unit of the local currency
Floating exchange rate or a flexible exchange rate is the system where the value of exchange is determined in the foreign exchange market through derived demand of goods traded between two countries.
Determinants of exchange rate include
Productivity and level of development in an economy. If an economy is productive then it will have more products to sell thus have a favourable terms of trade thus will have a persistent surplus balance of payment. Since the value of the currency is pegged on the value of exports, then the currency of the country in question will have a relatively higher value compared to other currencies.
Business environment. If a country has a favourable business environment such as competitive advantage, factor abundance, low production cost large market size etc. this will attract more investors as everyone wants to invest in this market thus increasing the value of foreign currency and consequently makes the local currency valuable.
The effect of fiscal and monetary policy on balance of trade and exchange rate are creating or facilitating trade or inhibit trade therefore causing increased benefits or reduced benefits with respect to international trade. There are two major effects that can affect balance of trade and exchange rate assuming that the country applies a flexible exchange rate system:
If the economy pursues a contractionary monetary and fiscal policy:
This will result to decreased supply of the domestic currency and consequently resulting to price increase or appreciation of the domestic currency in the foreign exchange rate market.
The appreciation or increase in value of the domestic currency relative to foreign currency will result to the countries export being more expensive and imports being cheaper thus export earnings will decrease while imports will increase therefore worsening the balance of trade position.
If the economy pursues an expansionary monetary and fiscal policy:
There will be increased supply of the domestic currency in the economy and consequently, price of the domestic currency relative to foreign currency will depreciate in the foreign exchange market.
The depreciation of the domestic currency will make exports cheaper thus encouraging exports and discourage imports since importing will be relatively expensive. This lead to increase in export earnings and decrease in import earnings resulting to a favourable balance of trade position
Therefore contractionary monetary and fiscal policies causes the domestic currency to appreciate and worsens the balance of trade position while expansionary policies leads to depreciation of the country’s’ domestic currency in the exchange market and a more favourable balance of trade position.
The most important thing that I learnt is that international trade is subject to a few features that make it complex and more unstable compared to the domestic market.
Firstly, I observed that international market instability is caused by existence of government policies, political boundaries and economical factors between two countries. This makes it international trading unstable since a little political indifference can fundamentally affect export and import policies of two countries.
Secondly, the existence of different currencies in two different countries makes the determination and valuation of exports and imports more complex and in turn opens up the economy to economical problems of other countries such as inflation. This makes countries more dependent on each other both economically and politically since there problems can easily spill over to become our problems due to enhanced economic relations and international trade.
Monetary policies are more effective due to the following reasons.
Given a fully monetized economy, the outreach of monetary policies can be facts and have a larger outreach. To curb recession in the economy, policies that will increase money supply will trigger the market to react by investing thus creating jobs and restoring the economies growth and development.
Secondly, As opposed to fiscal policy monetary policies are practical, flexible, cost efficient and easily implemented therefore useful as a tool of curbing recession.
Suranovic, S. (3rd November 2005). International Finance theory and policy. Retrieved 12th march 2008 from http://internationalecon.com/Finance/Fch5/F5-5.php