ECW3121 International Trade and Finance

1
ECW3121 International Trade and Finance
Revision Lecture (13)
2
International Finance
Examination

• The examination for this semester will take
  format as previous years.
• There are four sections A, B, C, and D, and two
  to three questions in each section.
• Your are supposed to attempt four questions one
  question from each section.

3
International Finance
Examination topics

• Theories of trade.
• There are two questions relating to the theories
  of trade. One is on one of the comparative static
  models, another is on the economic growth aspects
  of the trade.
• Trade policy
• Tariffs and not tariff barriers
• Trade blocs
• Theories of exchange rates determination
• Interest arbitrage.
• Balance of Payments (research question)

4
Section D Research Question

• Australia's current account deficit presents a
  serious problem, which must be addressed
  immediately. Explain and discuss.
• or
• The current account deficit is not a national
  priority and should not be a target for action by
  Australian policy makers. Explain and discuss.
• or
• Apply question 8 or 9 to a country of your choice.

5
International Finance
Examination topics

• Each of the questions relates to an area of the
  course as outlined in the study guides contained
  within the subject book.
• Careful revision of the learning objectives from
  each of the study guides will assist you.

6
Subject Outline
Trade Theory Study Guide 1 Weeks 1-5
Section A, Q1 Q2
International Trade and Finance
Section B, Q3 or Q4
Section C, Q5, Q6 or Q7
Finance Study Guide 3 Weeks 9-12
Trade Policy Study Guide 2 Weeks 6-8
Section D, Q7, 8, 9 or 10
7
Trade Theory
Comparative Advantage
Increasing cost PPF
Autarky
Televisions
Televisions
Singapore
Australia
Pw/Pt (Singapore)
S
A
Pw/Pt (Australia)
0
0
Wine
Wine
8
Trade Theory
Comparative Advantage
Increasing cost PPF
Autarky
Televisions
Pw/Pt (Singapore)
Singapore
A
A
Pw/Pt (Australia)
Australia
0
Wine
9
Trade Theory
Comparative Advantage
Specialisation
Increasing cost PPF
Televisions
Pw/Pt (Singapore)
Singapore
B
B
Pw/Pt (Australia)
Australia
0
Wine
10
Trade Theory
Comparative Advantage
Specialisation
Increasing cost PPF
Televisions
Pw Pt
(Singapore)
Singapore
Pw Pt
(Australia)
Australia
0
Wine
11
Trade Theory
Comparative Advantage
Free trade
Increasing cost PPF
Televisions
Singapore
C
Pw/Pt (Singapore)
Pw/Pt (Australia)

C
Australia
0
Wine
12
Main points
Trade Theory
Heckscher-Ohlin theorem

• Each nation will export the good which uses its
  abundant factor intensively and will import the
  good which uses its scarce factor intensively.
• Factor abundance refers to a comparison of the
  two nations.
• Factor intensity compares the two goods.

13
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
O
O
O
O
Y
130X
Factor diagram for the product Y.
50X
20Y
95x
45Y
- isoquants for the product Y
K
K
60Y
O
x
L
Factor diagram for the product X.
- isoquants for the product X
14
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
O
Y
130X
Factor diagram for the product Y.
50X
20Y
95x
45Y
- isoquants for the product Y
K
K
60Y
O
x
L
The contract curve of Nation 1 - efficient
combinations of factors and products
Factor diagram for the product X.
- isoquants for the product X
15
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
O
130X
Y
The contract curve for Nation 1 - efficient
combinations of factors and products A, F, B -
efficient points
20Y
50X
95x
B
45Y
F
K
K
60Y
A
O
x
L
Edgeworth Box Diagram for Nation 1
Y
A
60Y
F
45Y
B
20Y
X
50X
95x
130X
16
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
O
130X
Y
The contract curve for Nation 1 - efficient
combinations of factors and products A, F, B -
efficient points
20Y
50X
95x
B
45Y
F
K
K
60Y
A
O
x
L
Edgeworth Box Diagram for Nation 1
Y
A
60Y
F
45Y
B
20Y
Production posibility frointier for Nation 1
X
50X
95x
130X
17
Trade Theory
Derivation of the Edgeworth Box Diagram
Heckscher-Ohlin theorem
L
L
L
L
L
L
O
O
O
Y
Y
Edgeworth Box Diagram for Nation 2 Nation 2 has
a relative abundance of K compare with Nation 1.

K
80X
40Y
40
(A)
65x
A
K
85Y
85
F
40X
(F)
120Y
120
(B)
B
L
O
x
65
80
40
x
(B)
(F)
(A)
18
Trade Theory
Heckscher-Ohlin theorem
O
L
L
L
Heckscher-Ohlin Theory
Y
Nation 2
A and A - Autarky
Nation 2 - steep w/r ratio Nation 1 - flat w/r
ratio
K
A
K
L
O
Y
F
B
Nation 1
B
F
K
A
L
Ox
19
Factor Abundance
Trade Theory
Heckscher-Ohlin theorem
L
0Y
Need to Compare Two Nations
Capital Abundant
K
0Y
L
K
Labour Abundant
K
K
0X
L
L
0X
20
Factor Intensity
Trade Theory
Heckscher-Ohlin theorem

• Factor Intensity refers to the proportion of each
  factor used in the production of the goods.
• Good X is labour intensive if it uses more labour
  per unit of capital than Good Y.

21
Trade Theory
Heckscher-Ohlin theorem
L
O
Y
K
K
Capital Intensive
O
x
L
Need to Compare two goods
22
Trade Theory
Heckscher-Ohlin theorem
O
L
L
L
Heckscher-Ohlin Theory
Y
Nation 2
A and A - Autarky
Nation 2 - steep w/r ratio Nation 1 - flat w/r
ratio
K
A
K
L
O
Y
F
B
Nation 1
B
F
K
A
L
Ox
23
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Labour Abundant Nation 1 has comparative
advantage in producing labour intensive good X
Nation 2

• Capital abundant Nation 2 has comparative
  advantage in producing the capital intensive good
  Y

K
A
K
L
O
Y
F
B
B
F
A
K
L
Nation 1
Ox
24
Trade Theory
Stolper- Samuelson theorem
O
L
L
L
Y
Increase in the price for X causes increase in
the production of X by the labour abundant Nation
1. This will cause increase in w/r ratio (or
increase in wage in the units of capital
rent) Specialisation of nation 2 in good Y
causes increase of r/w ratio.
Nation 2
K
A
K
L
O
F
Y
B
Nation 1
F
B
K
A
L
Ox
25
Trade Theory
Stolper- Samuelson theorem

• In a Labour Abundant Nation, which exports a
  Labour Intensive Commodity,
• wages will increase relative to rental and the
  Labour force will be the winners......
• capital owners the losers when free trade is
  opened.
• In a Capital Abundant Nation, which exports a
  Capital Intensive Commodity,
• rental will increase relative to wages and the
  Capital Owners will be the winners......
• labour owners the losers when free trade is
  opened.
• Because Each Nation gains from free trade, the
  winner will gain enough to fully compensate the
  losers......
• the result being a net gain

26
Trade Theory
Factor-Price Equalisation

• The end result of free trade
• The wage- rental ratio will be the same in
  each nation corresponding to an equal commodity
  price ratio.
• This result shows that even with the assumption
  of factor immobility between nations, factor
  prices will still adjust as though the factors
  were mobile.
• The factor prices (wages, rental) are embedded in
  the commodity price.
• Free trade is a substitute for factor mobility.

27
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
L
O
Y
B
Nation 1
K
F
F
K
A
B
Ox
Ox
L
28
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
Nation 2
Nation 1
29
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
F
Nation 2
F
Nation 1
30
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
B
Nation 2
B
Nation 1
31
Trade Theory
Factor-Price Equalisation
O
Y
Nation 2
A
O
Y
B
Nation 1
F
F
A
B
Ox
Points B and B are points of stable Equilibrium,
free trade will tend towards these points.
B
Nation 2
B
Nation 1
32
In international trade theory
Trade Theory
Economic growth

• Small economy/country - does not affect world
  prices (the price for a particular commodity)
• Large economy/country - affects world prices (the
  price for a particular commodity).

33
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country

• At constant commodity prices, an increase in the
  endowment of one factor will cause, by a greater
  proportion, an increase in the commodity
  intensive in that factor and will reduce the
  output of the other commodity.

34
Trade Theory
Economic growth
Extensive growth, no technical progress
Rybczynski theorem Small Country
The output of the product X increases. The output
of the product Y decreases.
(w/r)A
0y
0y
y
K
(w/r)A
y
x
x
0x
L
Y
A
y1
A
y2
PA
PA
0
x2
x1
X
35
Trade Theory
Economic growth
Immiserising Growth Large Country
If the production possibility of the commodity X
increases (corresponding factor endowment
increases), at a new equilibrium consumption
point F, the country consumes XFClt XEC of the
product X and YFClt YEC.
Y
E
Yec
YFC
F
C
Ybp
B
Pc
Pb
0
XFC
Xec
X
Xbp
36
Trade Policy
Tariffs
Import tariff - a tax or duty on Imports
37
Trade Policy
Tariffs

• Consider the partial equilibrium model.
• In which sector of the diagram will an import
  tariff have its initial impact (shock)?
• Which curve will it affect?
• Will it cause a shift of the curve or a movement
  along the curve?
• Which way will it shift or move?
• Which price will each nation now be paying and
  receiving?
• What are the welfare effects?

38
Trade Policy
Tariffs
Large Nations
Assumptions

• Perfect competition
• Perfect substitution between the imported
  and locally produced commodity
• The domestic supply curve is less than perfectly
  elastic
• The tariff does not eliminate all imports.

• The foreign supply curve is not perfectly
  elastic both the importer and the exporter are
  price makers

39
Trade Policy
Tariffs
Large Nations
Partial Equilibrium
Welfare Effects Free Trade
International Market
Nation 1
Nation 2
Px Py
Px Py
Px Py
Sx
Sx
Sm t
Deadweight Loss
Sm
C.S.
Pt
C.S.
Pe
G
Pe
G
P.S.
P
P
Dm
P.S.
Deadweight Loss
Dx
Dx
0
0
0
Qx
Qm
Qx
Qt
40
Trade Policy
Small Nation
Assumptions

• Perfect competition
• Perfect substitution between the imported
  and locally produced commodity
• The domestic supply curve is less than perfectly
  elastic
• The tariff does not eliminate all imports.

• The foreign supply curve is perfectly elastic at
  the world market place unlimited quantities can
  be purchased at the world price.

41
Trade Policy
Tariffs
Small Nation
Partial Equilibrium
Import Tariff
Pt Pw Tariff Qd - Qd decrease in
consumption Qs-Qs increase in
domestic production Qd-Qs the
remaining export (Qd-Qs) x Tariff
additional government revenue
P
S
Imports
Pt
Sf t
Pw
Sf
D
0
Qs
Qd
Qs
Qd
Q
42
Trade Policy
Non Tariff Barriers
Import Quotas
Export subsides

• A direct quantitative restriction on import of a
  particular commodity

• Granting
• tax relief and/or subsidised loans to potential
  exporters or
• low-interest loans to foreign buyers of the
  nations export.

43
Trade Policy
Non Tariff Barriers
Import Quotas
Small Nation
P
S
quota
Pw
Sf
D
0
Total Supply
Total Demand
Q
44
Trade Policy
Non Tariff Barriers
Import Quotas
Small Nation
Qd - Qd decrease in
consumption Qs-Qs increase in
domestic production Qd-Qs the remaining
import
P
S
Pd
quota
Pw
Sf
D
Total Supply Total Demand
0
Qs
Qd
Qs
Qd
Q
45
Trade Policy
Non Tariff Barriers
Import Quotas
Small Nation
Where the revenue is going, at the quota regime,
that went to the budget at the tariff regime?
P
S
Pd
Pw
Sf
D
0
Q
Total Supply Total Demand
Tariff
Quota
46
Trade Policy
Non Tariff Barriers
Import Quotas
large Nation
47
Trade Policy
Non Tariff Barriers
Import Quotas
large Nation
International Market
Nation 1
Nation 2
Px Py
Px Py
Px Py
Sm
Sx
Sx
Sm
Pq
P
Dm
Dx
Dx
0
0
0
Qx
Qm
Qx
Qq
48
Trade Policy
Non Tariff Barriers
Import Quotas
large Nation
International Market
Px Py
Nation 1
Nation 2
Px Py
Px Py
Sm
Sx
Sx
Sm
Pq
Exports
Imports
P
Dm
Dx
Dx
0
0
0
Qx
Qm
Qx
Qq
49
Foreign Exchange
International Finance
Foreign Exchange Market

• Exchange Rate (R) - one currency in terms of
  another
• The ratio of two currencies.
• Two ways of quoting an exchange rate
• Direct (Price) Quote
• R AUD/USD
• Indirect (Volume) Quote
• R USD/AUD

50
What influences demand for and supplyof
currencies?
International Finance
Foreign Exchange Market

• Flows of goods and services
• Capital Flows, interest rates
• Political Stability
• Travel, tourism
• Supply of money (currency)
• Confidence, risk assessment

51
Purchasing Power Parity Theory
International Finance
Exchange Rate Theories

• Law of one price - a commodity will be the same
  price in each country once the exchange rate
  differences are accounted for.
• Therefore, the exchange rate is just the ratio of
  prices that exist in each country.
• P AUD x R P USD
• Therefore R P USD / P AUD

52
Predictions
International Finance
Exchange Rate Theories
Monetary Approach

• Assuming k and Y are constant
• Changes in the exchange rate will be a direct
  consequence of changes in the money supply.
• If M then P will and R will
  causing the local currency to depreciate.
• Inflation reduces the purchasing power (value) of
  money, currency now worth less - depreciation.

R
53
Deficiency
International Finance
Exchange Rate Theories
Monetary Approach

• Monetary version of exchange rate determination
  depends upon the purchasing power parity theorem.
• Generally been successful in predicting long run
  exchange rate movements but does not account for
  short run volatility.
• Original version did not regard interest rates as
  an important factor due to perfect capital
  mobility and the resulting interest parity.

54
Interest Parity
International Finance
Exchange Rate Theories
Further Developments

• Assume that behaviour of individuals and firms is
  consistent with profit maximisation.
• Differences in interest rates between nations
  will give an opportunity to make a profit.
• Capital will move around the world seeking the
  highest return.
• This can be in the form of covered or uncovered
  interest arbitrage.
• The profit seeking activity will quickly move to
  close the interest rate differential and return
  the market to interest parity.

55
Interest Parity
International Finance
Exchange Rate Theories
Further Developments

• Adjustments in the exchange rate can come from
  the real sector (goods and services) or the
  financial sector (capital flows)....most likely
  both.
• It is generally recognised that the financial
  sector reacts a lot faster than the real sector.
• Therefore short term volatility in the exchange
  rate is likely to be caused by capital flows
  chasing profit.
• Long term trends in interest rates are likely to
  be as a result of the adjustment of the real
  sector (prices, output).

56
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments

• If the economy is not at full employment, Y
  cannot be held constant.
• Keynesian theory also questioned if k is
  constant.
• Therefore a more acceptable explanation of the
  exchange rate is

57
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments

• M - home country's money supply
• M- foreign countrys money supply
• Y - home countrys real income
• Y- foreign countrys real income
• i - home countrys interest rate
• i - foreign countrys interest rate
• ? - home country's expected inflation
• ?? - foreign countrys expected inflation
• TB - home countrys trade balance
• K - foreign to home country velocity of money
  ratio

58
A Generalised Model
International Finance
Exchange Rate Theories
Further Developments
The price of foreign currency R should be raised

• A rise in the home country's money supply (M)
• A drop in the foreign countrys money supply
  (M)
• A rise in the foreign countrys real income (Y)
• A drop in the home countrys real income (Y)
• A rise in the foreign countrys interest rate
  (i)
• A drop in the home countrys interest rate (i)
• A rise in the home country's expected
  inflation(?)
• A drop in the foreign countrys expected
  inflation (??)
• A drop in the home countrys trade balance (TB).

59
International Finance
Interest Arbitrage

• Assume that behaviour of individuals and firms is
  consistent with profit maximisation.
• Differences in interest rates between nations
  will give an opportunity to make a profit.
• Capital will move around the world seeking the
  highest return.
• This can be in the form of covered or uncovered
  interest arbitrage.

60
Spot exchange rate
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates

• The exchange rate in foreign exchange
  transactions that calls for the payment and
  receipt of foreign exchange within two business
  days from the date when the transaction has
  agreed upon.
• Is driven by market forces as was discussed in
  the previous lecture.

61
Forward exchange rate
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates

• The exchange rate in foreign exchange
  transactions involving delivery of the foreign
  exchange one, three or six months after the
  contract is agreed upon.
• Is driven by market forces as forecasted by the
  buyers and sellers of foreign exchange of the
  period of contract maturity.

62
Forward discount and forward premium
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates

• Forward Discount - the difference between a
  higher spot and a lower forward rate
• Forward Premium - the difference between a lower
  spot and a higher forward rate.

63
Foreign Exchange Risk (Open Position)
International Finance
Interest Arbitrage
Speculation and Hedging

• The risk, resulting from changes in exchange
  rates over time
• Faced by anyone who expects to make or to receive
  a payment in a foreign currency at a future date.
  

64
Speculation
International Finance
Interest Arbitrage
Speculation and Hedging

• The acceptance of foreign exchange risk (open
  position) in the hope of making a profit.
• Short-term mechanism of equilibrating exchange
  rates.

65
Hedging
International Finance
Interest Arbitrage
Speculation and Hedging

• The avoidance of foreign exchange risk.
• (Covering of an open position).

66
Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• The transfer of short-term liquid funds abroad to
  earn a higher return.
• Based on interest disparities.

67
Covered Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• Foreign Exchange dealings (for trade or profit)
  involve foreign exchange risk.
• Hedging can be undertaken to minimise or
  eliminate this risk. The risk is then regarded
  as covered
• One form of hedging is the forward contract.
• A forward contract is an agreement to exchange
  currency at some future date at a fixed (forward)
  exchange rate.
• The forward rate is determined by the market for
  forward contracts and embodies expectations about
  the future spot rate.

68
Covered Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
Covered Arbitrage

• The covering of foreign exchange risk means that
  a risk free profit can be made.
• This profit will be less than what could be made
  by speculators who are prepared to accept the
  risk.
• The existence of risk free profit will give
  incentive for profit maximisers to enter the
  market and take advantage.

69
Covered Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• The transfer of short-term liquid funds abroad to
  earn a higher return -
• with the foreign exchange risk covered by
• spot purchase of the foreign currency
• and a simultaneous offsetting forward sale.
• Question does it always necessary to be covered
  by a forward rate to be higher than a spot rate?

Profit can be made because the gain on interest
rates more than offset the loss on the exchange
rate.
70
Uncovered Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• The transfer of short-term liquid funds abroad to
  earn a higher return with the foreign exchange
  risk not covered by a simultaneous offsetting
  forward sale.
• May be chosen, for example, when
• a forward rate is considerably lower than a spot
  one, and
• the speculator hopes that the spot rate at the
  time of the maturity of his contract will be
  higher than the current forward one.

71
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• Spot Rate 0.7386
• Discount 0.0386
• Forward Rate 0.7000
• Australian i/r p.a. 6.3
• U.S. i/r p.a. 7.0
• Term of borrowing 360 days
• Borrowing Limit 1M AUD

• DAY 1
• Borrow 1M AUD _at_ 6.3 1000000 AUD
• Exchange for USD at spot 738600 USD
• Lend in US _at_ 7
• DAY 360
• Receive from investment 790302 USD
• Exchange for AUD at forward 1129003 AUD
• Repay Loan (1M _at_6.3) 1063000 AUD
• RISK FREE PROFIT 66003 AUD

72
Interest Parity
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage

• With Risk Free profit to be made, capital will
  flow from Australia to U.S.
• This activity will have four effects on the
  financial sector
• spot rate will fall due to strong demand for USD
  (capital outflow)
• forward rate will rise due to increased demand
  for forward contracts in AUD .
• demand for loanable funds will increase in
  Australia, causing the interest rate to rise.
• supply of loanable funds will increase in USA,
  causing a fall in U.S. interest rates.

73
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
Interest Parity

• This process will continue until
• s/f (1 i) / (1i)
• No profit to be made
• The gains/losses from the interest will be
  exactly offset by losses/gains from the exchange
  rate.
• Ability to make profit depends on ability to
  recognise an open position and act on it
  accordingly.