💶AP Macroeconomics Unit 6 – Open Economy – International Trade and Finance

Key Concepts and Definitions

• International trade involves the exchange of goods, services, and capital across international borders or territories
• Absolute advantage refers to a country's ability to produce a particular good or service more efficiently than any other country
• Comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than another country
• Balance of payments is a statement that summarizes an economy's transactions with the rest of the world for a specific time period
• Current account records a nation's transactions in goods, services, income, and current transfers
• Capital account records a country's transactions in financial assets and liabilities
  • Includes foreign direct investment (FDI), portfolio investment, and reserve assets
• Exchange rate is the price of one currency in terms of another currency
• Trade deficit occurs when a country's imports exceed its exports
• Trade surplus happens when a country's exports are greater than its imports

Theories of International Trade

• Mercantilism emphasizes that countries should accumulate wealth by promoting exports and discouraging imports
• Adam Smith's theory of absolute advantage suggests that countries should specialize in producing goods for which they have an absolute advantage
• David Ricardo's theory of comparative advantage states that countries should specialize in producing goods for which they have a comparative advantage
  • Even if a country has an absolute advantage in producing all goods, it can still benefit from specialization and trade
• Heckscher-Ohlin model proposes that countries export goods that use their abundant factors intensively and import goods that use their scarce factors intensively
• New trade theory explains the occurrence of intra-industry trade and the role of increasing returns to scale in driving trade patterns
• Gravity model of trade predicts bilateral trade flows based on the economic sizes and distance between two countries
  • Larger economies tend to trade more, while greater distances reduce trade flows

Balance of Payments

• Balance of payments consists of the current account, capital account, and financial account
• Current account includes trade in goods and services, primary income (investment income), and secondary income (transfers)
  • Trade in goods is recorded as exports and imports of tangible products (cars, clothing)
  • Trade in services involves intangible products (tourism, financial services)
• Capital account records capital transfers and the acquisition or disposal of non-produced, non-financial assets
• Financial account captures transactions in financial assets and liabilities between residents and non-residents
  • Includes direct investment, portfolio investment, and reserve assets
• Errors and omissions account is used to balance any discrepancies in the balance of payments
• A country with a current account deficit is a net borrower from the rest of the world
• A country with a current account surplus is a net lender to the rest of the world

Exchange Rates and Currency Markets

• Exchange rates can be fixed, floating, or managed
  • Fixed exchange rates are set and maintained by the government or central bank
  • Floating exchange rates are determined by the forces of supply and demand in the foreign exchange market
• Appreciation occurs when the value of a currency increases relative to another currency
• Depreciation happens when the value of a currency decreases relative to another currency
• Nominal exchange rate is the rate at which one currency can be exchanged for another
• Real exchange rate adjusts the nominal exchange rate for differences in price levels between countries
• Purchasing power parity (PPP) theory suggests that exchange rates should adjust to equalize the prices of identical goods in different countries
• Interest rate parity (IRP) states that the difference in interest rates between two countries should equal the expected change in the exchange rate

Trade Policies and Agreements

• Free trade allows countries to trade goods and services without government restrictions or interventions
• Protectionism involves the use of trade barriers to protect domestic industries from foreign competition
  • Tariffs are taxes imposed on imported goods to make them more expensive
  • Quotas limit the quantity or value of goods that can be imported
  • Subsidies are government payments to domestic producers to help them compete with foreign firms
• World Trade Organization (WTO) is an international organization that oversees the global trading system and resolves trade disputes
• Regional trade agreements (RTAs) are treaties between two or more countries to promote trade and economic integration (European Union, NAFTA)
• Preferential trade agreements (PTAs) provide preferential market access to certain products from participating countries
• Trade creation occurs when a trade agreement leads to an increase in trade between member countries
• Trade diversion happens when a trade agreement diverts trade away from more efficient non-member countries to less efficient member countries

International Financial Institutions

• International Monetary Fund (IMF) promotes global monetary cooperation, financial stability, and sustainable economic growth
  • Provides loans to countries experiencing balance of payments difficulties or economic crises
  • Conducts surveillance of member countries' economic policies and provides policy advice
• World Bank Group consists of five institutions that provide financing, advice, and technical assistance to developing countries
  • Focuses on poverty reduction, economic development, and improving living standards
• Bank for International Settlements (BIS) serves as a bank for central banks and promotes monetary and financial stability
• Regional development banks support economic and social development in specific regions (African Development Bank, Asian Development Bank)
• Multilateral development banks (MDBs) are institutions created by a group of countries to provide financing and technical assistance for development projects

Global Economic Interdependence

• Globalization refers to the increasing integration of economies around the world through trade, financial flows, and the exchange of technology and information
• Global value chains (GVCs) involve the fragmentation of production processes across different countries
  • Each country specializes in a specific stage of production based on its comparative advantage
• Multinational corporations (MNCs) are companies that operate in multiple countries and play a significant role in global trade and investment
• Foreign direct investment (FDI) occurs when a company invests in a foreign country to establish a lasting interest and control over the enterprise
• Portfolio investment involves the purchase of financial assets (stocks, bonds) in a foreign country without active management or control
• International trade and financial linkages can transmit economic shocks and business cycles across countries
• Global economic imbalances, such as large current account deficits or surpluses, can create risks and vulnerabilities in the global economy

Real-World Applications and Case Studies

• China's economic rise and its impact on global trade patterns and imbalances
  • China's export-led growth strategy and its large trade surplus with the United States
  • The role of China in global value chains and its increasing outward foreign direct investment
• The European debt crisis and its implications for the eurozone and global financial stability
  • The accumulation of unsustainable public debt levels in countries like Greece, Ireland, and Portugal
  • The role of the European Central Bank and the IMF in providing financial assistance and promoting structural reforms
• The impact of Brexit on trade and economic relations between the United Kingdom and the European Union
  • The challenges of negotiating a new trade agreement and the potential economic costs of increased trade barriers
• The US-China trade war and its effects on global trade and economic growth
  • The use of tariffs and other trade barriers by both countries and the escalation of trade tensions
  • The implications for global supply chains and the potential for trade diversion and economic decoupling
• The role of international trade in promoting economic development and poverty reduction in developing countries
  • The success stories of export-oriented industrialization in East Asian countries (South Korea, Taiwan)
  • The challenges faced by least developed countries (LDCs) in integrating into the global trading system and benefiting from trade liberalization