International trade and balance

of payments
 What is international trade?
• International trade is trade between different
countries or trade across political frontiers.
International trade occurs because different
countries posses different kinds of resources
and skills.
• This therefore leads countries into producing
goods and services in line with what they are
endowed in terms of natural resources.
 Comparative advantage
• The theory (law) of comparative advantage states that international
trade is most efficient or advantageous if each country sells the
goods of which the country has advantage in production relative to
other goods received in exchange.
• In other words international trade is mutually beneficial, even when
one national is absolutely more efficient in the production of every
good, as long as there are differences in the relative costs of
producing the various goods in the two potential trading nations.
• What is important therefore is for countries to specialise and
produce goods in which they incur less cost relative to the cost of
producing other goods.
• The law of comparative advantage therefore guides trading amongst
nations.
 Advantages of international trade
• International trade increases the production of goods and
services and therefore increases the standard of living of
countries involved.
• - Due to international trade different goods and services are
made available to countries where there is a shortage of these
things.
• - International trade creates competition among the countries as
a result prices and wages in trading countries tend to be
equalised over time if trade is free of restrictions.
• - International trade increases productivity because each country
applies its resources to those branches of production where its
relative efficiency is the greatest.
 Free trade versus protectionism

• Trade restrictions
• Inspite of the benefits expected from free trade,
governments in practise intervene and restrict free
trade. The major government interference with free
trade are as follows: -
• Protective tariffs
• These are excise taxes or duties imposed on imported
goods. Mostly designed to shield domestic producers
from foreign competition. They impede free trade by
increasing the prices of imported goods.
• Import quotas
• This refers to maximum limits on the quantity or total
value of specific imported items. Once quotas are met,
imports are completely cut off. Import quotas can be
more effective in retarding international trade than tariffs.
• Non tariff barriers
• These include licensing requirements, unreasonable
standards pertaining to product quality or simply
unnecessary bureaucratic red tape in customs
procedures
Why do governments pursue protectionism?

• Infant industry argument

• New domestic industries allegedly may need temporary
protection to gain productive efficiency. Protection is said
to be of a short-term nature but it is possible that
protection may persist even after the industry has
developed
• Protection of domestic employment
• Allowing in, imports consisting of cheap goods that can
compete with high priced domestically produced goods
can result in increasing unemployment in the domestic
economy
Why do governments pursue protectionism?
Cont’d
• Protection against dumping
• Some countries produce in surplus and then
dump the excess products into another countries
market at a very low price that is below cost.
This practise is referred to as dumping.
• Reduction of balance of trade deficit
• Protection is viewed as a method, which can be
used to reduce its balance of trade deficit by
imposing quotas, or tariffs on imports.
 Balance of payments
• Balance of payments is defined as a record of
economic transactions (involving foreign payment)
between one country and the rest of the world.
• The balance of payments is shown in the form of a
balance sheet which enumerates how much has
been received from foreigners and how much has
been paid to them during a particular accounting
period.
• Usually the accounts are prepared on an annual
basis.
 Balance of payment account

• The balance of payment distinguishes a

number of sub-accounts, each of which
records a different type of transaction. The
main sub-accounts are the:
• current account
• the capital account
• the official reserve account.
 The Current Account

• The current account of the balance of

payments records current transactions with
the rest of the world. Current transactions
can be subdivided in transactions concerning.
• - Merchandise trade
• - Non factor services(invisible trade)
• - Transfer income
 The Capital Account

• The Capital account records all international financial

transactions of a country. These include
international transactions in assets and liabilities, like
the issuance of a loan abroad, international trade in
shares and other assets.
• In general, it records medium and long-term capital
flows. The balancing item of the capital account is
net inflow that is defined as the difference between
capital inflows and capital outflows. The balance can
be negative or positive.
 Official reserves

• The official reserves account records how the

reserve of gold, foreign currency and IMF credit
of the central bank change. Together
(monetary) gold, foreign currency, the reserves
position in the IMF and net credit from the IMF
of the Central bank are referred to as official
reserves. These official reserves are (net) claims
of the Central bank on the rest of the world.
•
 Balance of Payments disequilibrium
• Disequilibrium in the balance of payments may be caused by
external as well as internal factors. Potential factors which
can lead to a balance of payment disequilibrium are as
follows:-
•  
• National income
• The balance of payments position is influenced by
fluctuations in the national income. Changes in the national
income lead to changes in the demand and supply conditions
of the exports and imports. The changes in export and
import volumes affect the balance of payment position.
Balance of Payments disequilibrium cont’d

• Rate of foreign exchange

• The balance of payments position is affected
by the changes in the rate of foreign
exchange. If the external value of a country’s
currency is increased, imports into it become
cheaper and exports from it become dearer.
Therefore imports increases and exports
decline. The reverse is experienced when
external value is reduced.
Balance of Payments disequilibrium cont’d
• Speculation
• Speculative transfers of funds from one country to another may
affect the balance of payments position. This may happen as a
result of existing opportunities for earning higher returns because
of differential interest rates, fear of currency depreciation or
appreciation.
•  
• Price and Cost
• Changes in the price or cost structure of a country’s export
industries affect the volume of exports and the balance of
payment position. Similarly increase in prices due to higher
wages, higher prices of inputs reduce exports.
 Rectification of a balance of payment disequilibrium

• Direct measures to reduce imports.

• A balance of payment deficit can be adjusted
by taking deliberate measures to restrict
imports
• Imposition of tariffs
• Import quotas
• Total Ban
• Foreign Exchange Control
 Rectification of a balance of payment
disequilibrium cont’d
• Stimulation of exports
• Reduction in the external value of money (Devaluation)
• Deflationary measures  
• Excess demand in the economy can result into a balance of
payment deficit. Deflationary measurers aimed to reducing
excess demand would eventually reduce imports and increase
exports. Deflationary measurers which can be undertaken by
the government include:-
• - Cutting government spending
• - Increasing taxation
• - Raising interest rates.