INTERNATIONAL TRADE AND FINANCE LECTURE 2: Introduction: World Trade, An Overview

Recall: What is International Economics about? International economics deals with economic interactions that occur between independent nations. The role of governments in regulating international trade and investment is substantial. There are several issues that recur throughout the study of international economics. The Gains from Trade The Pattern of Trade How Much Trade? The Balance of Payments Exchange Rate Determination International Policy Coordination The International Capital Market Int. econs uses the same fundamental methods of analysis as other branches of economics, because the motives and behavior of individuals are the same for int. trade as they are for domestic transactions.

Outline What determines the direction of trade (The largest trading partners of the U.S.) Gravity model: influence of an economy’s size on trade distance and other factors that influence trade Borders and trade agreements Globalization: then and now Changing composition of trade Service outsourcing

Who Trades with Whom? The 5 largest trading partners with the U.S. in 2005 were Canada, China, Mexico Japan and Germany. The total value imports from and exports to Canada in 2005 was about $500 billion dollars. The largest 10 trading partners with the U.S. accounted for 56% of the value of U.S. trade in 2005.

Fig. 2-1: Total U.S. Trade with Major Partners, 2006 Source: U.S. Department of Commerce

Size Matters: The Gravity Model 3 of the top 10 trading partners with the U.S. in 2005 were also the 3 largest European economies: Germany, UK, and France. These countries have the largest gross domestic product (GDP) in Europe. GDP measures the value of goods and services produced in an economy. Why does the U.S. trade most with these European countries and not other European countries?

Size Matters: The Gravity Model (cont.) In fact, the size of an economy is directly related to the volume of imports and exports. Larger economies produce more goods and services, so they have more to sell in the export market. Larger economies generate more income from the goods and services sold, so people are able to buy more imports.

Fig. 2-2: The Size of European Economies, and the Value of Their Trade with the United States Source: U.S. Department of Commerce, European Commission

The Gravity Model Other things besides size matter for trade: Distance between markets influences transportation costs and therefore the cost of imports and exports. Distance may also influence personal contact and communication, which may influence trade. Cultural affinity: if two countries have cultural ties, it is likely that they also have strong economic ties. Geography: ocean harbors and a lack of mountain barriers make transportation and trade easier.

The Gravity Model (cont.) Multinational corporations: corporations spread across different nations import and export many goods between their divisions. Borders: crossing borders involves formalities that take time and perhaps monetary costs like tariffs. These implicit and explicit costs reduce trade. The existence of borders may also indicate the existence of different languages (see 2) or different currencies, either of which may impede trade more.

The Gravity Model (cont.) In its basic form, the gravity model assumes that only size and distance are important for trade in the following way: Tij = A x Yi x Yj /Dij where Tij is the value of trade between country i and country j A is a constant Yi the GDP of country i Yj is the GDP of country j Dij is the distance between country i and country j Perhaps surprisingly, the gravity model works fairly well in predicting actual trade flows

Distance and Borders Estimates of the effect of distance from the gravity model predict that a 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0.7% to 1%.

Distance and Borders (cont.) Besides distance, borders increase the cost and time needed to trade. Trade agreements between countries are intended to reduce the formalities and tariffs needed to cross borders, and therefore to increase trade. The gravity model can assess the effect of trade agreements on trade: does a trade agreement lead to significantly more trade among its partners than one would otherwise predict given their GDPs and distances from one another?

Distance and Borders (cont.) The U.S. signed a free trade agreement with Mexico and Canada in 1994, the North American Free Trade Agreement (NAFTA). Because of NAFTA and because Mexico and Canada are close to the U.S., the amount of trade between the U.S. and its northern and southern neighbors as a fraction of GDP is larger than between the U.S. and European countries.

Fig. 2-3: Economic Size and Trade with the United States Source: U.S. Deparment of Commerce, European Commission

Distance and Borders (cont.) Yet even with a free trade agreement between the U.S. and Canada, which use a common language, the border between these countries still seems to be associated with a reduction in trade. E.g. Due to the use of different national currencies

Geographic Trade Patterns Developed countries account for the bulk of world trade (largest exporters and importers). Developed countries trade primarily with each other. Developing countries rely on developed countries for their export markets. Countries trade mainly with neighbors. (What can explain why sub-Sahara Africa countries does less trading amongst themselves? 17

Geographic Trade Patterns ctd The Issues: Similar commodities Trade barriers: Did you know until recently, if you wanted to go to say Tunisia, you may have had to go to Germany?

Globalization Globalization is the term used to convey the idea that international factors are becoming a more important part of the world economy The simplest measure of globalization is the ratio of exports to GDP Countries with a high ratio of exports to GDP are generally more open to the world economy than countries with a low ratio 19

GLOBALIZATION Globalization or the increasing openness of an economy, means changes that are not universally positive Globalization involves not only the goods and service but the movement of people and money as well International transactions occur because both parties expect the transaction to improve their welfare 20

Index of Openness Index of Openness—a measure of how much a country participates in international trade; defined as the ratio of a country’s exports to its GDP (or GNP). Open Economy—a country with a high value of the index of openness. Closed Economy—a country with a relatively low index of openness. 21

The Growth of Globalization Since the end of WWII, world trade has grown much faster than world output.

FIGURE 1.1 Openness Index for Selected Nations (1913–2000)

International Trade Exports—goods and services produced in one country and sold to other countries. Imports—goods and services consumed in a country but which have been purchased from other countries. Trade Deficit (Surplus)—a country has a trade deficit (surplus) if its imports (exports) exceeds its exports (imports). 24

Growth of World Exports What has caused the explosion of world trade? Refer to Figure 1.1 (next slide) 25

FIGURE 1.1 World Exports and Output in Real Terms: 1950–2007 26

Growth of World Exports What has caused the explosion of world trade? Reduction in trade barriers Advances in transportation, communication and technology Proliferation of trade agreements 27

Commodity composition – What goods do countries trade? But Manufactured product exports is a relatively new phenomenon (table below): Source: Krugman and Obstfeld

Commodity composition – What goods do countries trade?

Commodity composition – What goods do countries trade? Changing composition of Developing-Country Exports

Service outsourcing One of the current areas of considerable debate It is a situation in which a service that was previously done within a country is shifted to a foreign location (also called service offshoring) Blinder (2006) argues “in the future, and to a great extent already in the present, the key distinction for international trade will no longer be between things that can be put in a box and things that cannot. It will, instead, be between services that can be delivered electronically over long distances with little or no degradation of quality, and those that cannot.” E.g: Shop Accounts keeping; radiologist who reads X-ray. Source: Krugman

END OF WEEK 1