Assignment No:1 Managerial Economics

INTERNATIONAL TRADE THEORY

&
FOREIGN EXCHANGE MARKET

Submitted on 11/01/2010

Submitted to: Submitted

by:
Malati Subba (Lecturer) Vinaya Vijayan
Sub: Managerial Economics MBA; 1st Sem

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Assignment No:1 Managerial Economics

International Trade Theory and Foreign

Exchange Market
Americans drive cars made in Germany, use VCR’s made in Japan and wear
clothing made in China. Japanese watch American movies, Egyptians drink
American cola and Swedes jog in American running shoes. Whole world
consumes Iraqi Oil; India stands on top of BPO services examples are endless.
The world economy is more integrated than ever before.

What is international trade?

International trade shapes our everyday lives and the world we live in.
Nearly every time we make a purchase we are participating in the global
economy. Products and their components come to our store shelves from all
over the world.

International trade is the system by which countries exchange goods and

services. Countries trade with each other to obtain things that are better
quality, less expensive or simply different from what is produced at home.

Goods and services that a country buys from another country are called
imports, and goods and services that are sold to other countries are called
exports. Trade mostly takes place between companies. However,
governments and individuals frequently buy and sell goods internationally.

Basis of International Trade::

The basis of international trade is the difference in the resource

endowments of different nations. That is, trade between the nations takes
place because nations differ in their resource endowments. Resource
endowment means availability of natural and man-made resources can be
used to produce goods and services. While Arab countries are rich in oil, they
are deficient in man power and technology. While India has large supply of
human power, it lacks capital and technology. While Japan is advanced in
technology, it lacks iron ore and coal. Russia with largest area and highly
advanced technology lacks agricultural potential. This kind of uneven
distribution of resources is the basis of foreign trade.

Theory of International trade:

The theories of international trade provide answer to the question

why there is trade between the nations, i.e. why nations export and import
goods and services. The theory of international trade seeks to answer such
questions as: What is the basis of international trade? , What determines

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Assignment No:1 Managerial Economics

the volume and direction of foreign trade?, How are the gains from foreign
trade measured?

The theory of international trade has been growing with the growth
of economic science – from Adam Smith’s theory of absolute advantage, to
Ricardo’s theory of comparative advantage, to Heckscher – Ohlin theories
of International trade.

I) Adam Smith’s Theory of Absolute Advantage

A country tends to specialize in production of commodities which

it has absolute advantage in cost of production. This common sense logic of
international division of labour was suggested by Adam Smith.

Adam Smith’s theory of absolute advantage can be

illustrated through a simple, hypothetical two – country and two –
commodity example. Let us suppose that per quintal labour – cost of
production of rice and jute in India and Bangladesh is given as in :-
Country Rice Jute

India 30 60……
Bangladesh 50 20

Per Quintal Labour Cost (Man – hour)

As table shows, India needs 30 man-hours to produce

one quintal of rice whereas Bangladesh needs 50 man-hours. The cost of rice
production in India is thus much lower than that in Bangladesh. India has an
absolute advantage in rice production. In case of jute production, while
Bangladesh needs 20 man-hours to produce one quintal of jute, India needs
60 man-hours. Thus, Bangladesh has absolute advantage in jute production.
According to theory, India would specialize in rice production and import
jute and Bangladesh would specialize in jute production and import rice.

According to Adam Smith, trade between the two

countries will prove advantageous to both since both of them can avail,
given their labour force, a larger quantity of both the commodities and at a
labour cost.

II) Ricardo’s Theory of Comparative Advantage

The theory of absolute advantage gives impression

that trade between two countries can be possible and mutually gainful only
if both countries have absolute advantage in the production of at least one
commodity.

However, the Ricardian theory of comparative

advantage suggests the possibility of gainful trade between two countries
even if one has absolute advantage in the production of both the

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commodities and the other absolute disadvantage in the production of both

commodities. For example, let us suppose that in our two-country-two-
commodity model, India is more efficient in producing goods, rice and jute.

Country Rice Jute

India 30 60……
Bangladesh 50 80

As table shows, India can produce both the goods more

efficiently, i.e. at a lower cost, compared to Bangladesh. India has
comparative advantage in rice production because she needs only
(30/50)100 = 60 per cent of the cost of rice production in Bangladesh. But
India has comparative disadvantage in jute production because her cost of
jute production is twice her cost of rice production. On the other hand,
Bangladesh has comparative advantage in jute production because her
relative cost of jute production is less than India’s. Therefore, if India
specializes in rice production and Bangladesh in jute production and they
trade their surplus, both stand to gain.

Critical Appraisal of Theory

1. Labour is not homogenous

2. Labour is not the only factor
3. Demand-side ignored.
4. Other criticisms

III) Heckscher – Ohlin Theory of Trade

The theory of trade expounded by Heckscher and Ohlin is most

popularly known as the Heckscher – Ohlin theory of trade, also referred to as
factor – endowment theory of trade or the modern theory of trade.The
Heckscher-Ohlin theory of trade states that comparative advantage in the
cost of production is explained exclusively by the differences in the factor
endowment of the nations.

Heckscher-Ohlin theories

It can be stated in the form of two theorems.

Theorem I – Heckscher-Ohlin Trade Theorem: A country tends to specialize

in the export of a commodity whose production requires intensive use of its
abundant resources and imports a commodity whose production requires
intensive use of its scarce resources.

Theorem II – Factor - Price Equalization Theorem: The international trade

equalizes the factor prices between the trading nations. The Heckscher –
Ohlin theorem II postulates that foreign trade eliminates the factor price
differentials.

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Assignment No:1 Managerial Economics

Trade: Important for economic well being

With the increase in volume, trade has become very important to the
economic well-being of many countries. In early 1960s, the United States
bought less than $1 billion of foreign cars and parts. By 2001, this figure had
increased to more than $189 billion.

Financial ties between United States and the rest of the world have grown
significantly over time:

 Number of foreign banking offices operating in the United States rose

from fewer than 40 to over 600 at present.
 Amount of foreign direct investment (FDI) was $158 billion in 2001.
 Gross transactions of long-term U.S. government securities by
foreigners rose from $144 billion in 1978 to over $9.1 trillion in 2000.

Foreign direct investment is the amount of money individuals invest in

companies, assets and real estate of another country.

The cost of international transportation and communication has fallen

drastically, resulting in greater integration among the economies of the
world. Because of this interdependence, economic trends and conditions in
one country can strongly affect prices, wages, employment and production
in other countries. Events in Tokyo, London and Mexico City have a direct
effect on the everyday life of people in the U.S., just as the impact of
events in New York, Washington and Chicago is felt around the globe. If
stocks on the New York Stock Exchange plummet in value, the news is
transmitted instantly worldwide, and stock prices all over the world might
change. This means that countries have to work together more closely and
rely on each other for prosperity.

World Trade is Diverse

Most international trade consists of the purchase and sale of industrial

equipment, consumer goods, oil and agricultural products. Services such as
banking, insurance, transportation, telecommunications, engineering and
tourism accounted for one-fifth of world exports in 2000.

Since the end of World War II, there has been a rapid increase in
international trade.

 In 1950, total world merchandise exports amounted to $58 billion

 In 2000, exports were $6.3 trillion, over a 100-fold increase

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Assignment No:1 Managerial Economics

Benefits of Trade

Specialization and Its Benefits

To become wealthier, countries want to use their resources—land, labor,

capital and entrepreneurship—in the most efficient manner. However, there
are differences among countries in the quantity, quality and cost of these
resources. The advantages that a country may have vary:

 abundant minerals
 climate suited to agriculture
 well trained labor force
 new innovative ideas
 highly developed infrastructure like good roads, telecommunications
system, etc.

Instead of trying to produce everything by themselves, countries often

concentrate on producing things that they can produce most efficiently.
They then trade those for other goods and services. In doing so, both the
country and the world become wealthier.

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Assignment No:1 Managerial Economics

Foreign Exchange Market: What is it?

To buy foreign goods or services, or to invest in other countries, companies

and individuals may need to first buy the currency of the country with which
they are doing business. Generally, exporters prefer to be paid in their
country’s currency or in U.S. dollars, which are accepted all over the world.

When Indians buy oil from Saudi Arabia they may pay in U.S. dollars and not
in Canadian dollars or Saudi dinars, even though the United States is not
involved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying and
selling of different currencies takes place. The price of one currency in
terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by

telephone lines and computer screens—there is no central headquarters.
There are three main centers of trading, which handle the majority of all FX
transactions—United Kingdom, United States, and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and

Australia account for most of the remaining transactions in the market.
Trading goes on 24 hours a day: at 8 a.m. the exchange market is first
opening in London, while the trading day is ending in Singapore and Hong
Kong. At 1 p.m. in London, the New York market opens for business and later
in the afternoon the traders in San Francisco can also conduct business. As
the market closes in San Francisco, the Singapore and Hong Kong markets
are starting their day.

The FX market is fast paced, volatile and enormous—it is the largest market
in the world. In 2001 on average, an estimated $1,210 billion was traded
each day—roughly equivalent to every person in the world trading $195 each
day.

Foreign Exchange Market Participants

There are four types of market participants—banks, brokers, customers, and

central banks.

 Banks and other financial institutions are the biggest participants.

They earn profits by buying and selling currencies from and to each
other. Roughly two-thirds of all FX transactions involve banks dealing
directly with each other.
 Brokers act as intermediaries between banks. Dealers call them to
find out where they can get the best price for currencies. Such
arrangements are beneficial since they afford anonymity to the
buyer/seller. Brokers earn profit by charging a commission on the
transactions they arrange.
 Customers, mainly large companies, require foreign currency in the
course of doing business or making investments. Some even have their

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Assignment No:1 Managerial Economics

own trading desks if their requirements are large. Other types of

customers are individuals who buy foreign exchange to travel abroad
or make purchases in foreign countries.
 Central banks, which act on behalf of their governments, sometimes
participate in the FX market to influence the value of their
currencies.

With more than $1.2 trillion changing hands every day, the activity of these
participants affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

 to earn short-term profits from fluctuations in exchange rates,

 to protect themselves from loss due to changes in exchange rates, and
 to acquire the foreign currency necessary to buy goods and services
from other countries.

Foreign Exchange Rates

Most common contact with foreign exchange occurs when we travel or buy
things in other countries.

Suppose a U.S. tourist travelling in London wants

to buy a sweater. Price tag is 100 pounds.
Current exchange Price of sweater in
rate dollars
$1.45 to £1 100 x 1.45 =
$1.30 to £1 Pound $145.00
$1.60 to £1 falls 100 x 1.30 =
Pound $130.00
rises 100 x 1.60 =
$160.00
Thus, small changes in exchange rates may not
seem significant. But when billions of dollars are
traded, even a hundredth of a percentage point
change in exchange rates becomes important.

Stronger US 1. U.S. can buy foreign goods  Cost of purchasing

dollar implies more cheaply foreign goods falls

2. Foreigners find U.S. goods Does not help firms that

more expensive and  produce for exports
demand falls
Weaker U.S. 1. Foreigners buy more U.S.  Helps firms that rely on
dollar implies goods

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exports
2. Foreign goods become
more expensive Demand for imports falls


It would seem logical that if the dollar weakens, the trade balance will
improve, as exports would rise. However, this does not always happen. U.S.
trade balance usually worsens for a few months.

The J–curve explains why the trade position does not improve soon after the
weakening of a currency. Most import/export orders are taken months in
advance. Immediately after a currency’s value drops, the volume of imports
remains about the same, but the prices in terms of the home currency rise.
On the other hand, the value of the domestic exports remains the same, and
the difference in values worsens the trade balance until the imports and
exports adjust to the new exchange rates.

Exchange rates are an important consideration when making international

investment decisions. The money invested overseas incurs an exchange rate
risk.When an investor decides to "cash out," or bring his money home, any
gains could be magnified or wiped out depending on the change in the
exchange rates in the interim. Thus, changes in exchange rates can have
many repercussions on an economy:

 affects the prices of imported goods

 affects the overall level of price and wage inflation
 influences tourism patterns
 may influence consumers’ buying decisions and investors’ long-term
commitments.

Determination of Foreign Exchange Rates

Exchange rates respond directly to all sorts of events, both tangible and
psychological—

 business cycles;
 balance of payment statistics;
 political developments;
 new tax laws;
 stock market news;
 inflationary expectations;
 international investment patterns;
 and government and central bank policies among others.

At the heart of this complex market are the same forces of demand and
supply that determine the prices of goods and services in any free market. If
at any given rate, the demand for a currency is greater than its supply, its
price will rise. If supply exceeds demand, the price will fall.

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Assignment No:1 Managerial Economics

The supply of a nation’s currency is influenced by that nation’s monetary

authority, (usually its central bank), consistent with the amount of spending
taking place in the economy. Government and central banks closely monitor
economic activity to keep money supply at a level appropriate to achieve
their economic goals.

Too much
money  inflation  value of
money declines  prices rise
Too little money  sluggish economic
growth  rising unemployment

Monetary authorities must decide whether economic conditions call for a

larger or smaller increase in the money supply.

Sources for currency demand on the FX market:

 The currency of a growing economy with relative price stability and a

wide variety of competitive goods and services will be more in
demand than that of a country in political turmoil, with high inflation
and few marketable exports.
 Money will flow to wherever it can get the highest return with the
least risk. If a nation’s financial instruments, such as stocks and
bonds, offer relatively high rates of return at relatively low risk,
foreigners will demand its currency to invest in them.
 FX traders speculate within the market about how different events
will move the exchange rates. For example:
 News of political instability in other countries drives up demand
for U.S. dollars as investors are looking for a "safe haven" for their
money.
 A country’s interest rates rise and its currency appreciates as
foreign investors seek higher returns than they can get in their
own countries.
 Developing nations undertaking successful economic reforms may
experience currency appreciation as foreign investors seek new
opportunities.

After all this we can conclude that there is interdependency in

international trade though it is a disputed topic that change in
exchange rate affects the trade or is it vice-versa? Many experts
are expounding various theories and hypothesis to prove their
point.

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Assignment No:1 Managerial Economics

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