1

International Trade

International Trade involves the exchange, or buying and selling of goods and services across
international boundaries. When a country sells its goods and services produced domestically to
buyers abroad, this is referred to as exports. When it buys goods and services from other countries
for domestic use, we refer to these as imports.

The main reasons for international trade (benefits of trade) can be summarised as follows:

1. Uneven distribution of natural, human and capital resources: This means that different
countries have different factor endowments. For example, some countries are land rich whereas
some countries are capital rich. This means that they will not be able to manufacture all the goods
and services that they want. Trade allows a country to acquire goods and services that it is not
able to produce to unavailability of certain factors of production.

2. Specialisation: With trade, countries are able to specialise in goods and services in which they
are more efficient because of their own particular factor endowments and technologies. They will
cut down on waste of resources and can produce a larger quantity of goods and services. They
can exchange some of these goods and services for other products produced elsewhere more
cheaply.

3. Economies of scale: Trade expands the size of the market for firms, and allow them to exploit
economies of scale. If countries specialise in the production of goods and services that offer
economies of scale, they can achieve greater efficiency and lower costs, and can sell their output
at lower prices.

4. Trade can increase the variety and quality of goods available to consumers: The goods and
services that each country can produce differ widely with respect to their variety and their quality.
By trading with each other, countries can acquire a larger variety of goods and services, and may
be able to import higher quality goods and services than the one they are able to produce
themselves.

5. Trade allows countries to acquire needed resources: Countries may need for their domestic
production a number of natural resources or capital goods that are not available domestically. For
example, all countries are dependent on oil and yet may do not produce oil and are therefore force
to import it.

6. Trade results in increased competition, leading to greater efficiency: With trade, domestic
firms are exposed to competition from foreign firms. As a result they need to become more
efficient if they want to survive.

7. Trade makes possible the flow of new ideas and technology: As goods and services flow from
one country to another, they enable new ideas and new technologies and skills to be transferred
from one country to another.

8. Trade makes countries interdependent, reducing the possibility of hostilities and violence.

Ayaz Nujuraully – 5937-6351

 2

9. Increased exports and greater efficiency in production lead to more economic growth:
Increased specialisation, economies of scale, acquisitions of needed resources, increased
competition, technological advances and expanding markets, all of which are made possible by
international trade, contribute to increases in domestic output and therefore greater economic
growth. In addition more exports means that a country has more possibilities to import resources
that are important to increase domestic production, also contributing to domestic production.
Trade, therefore, acts as an engine to growth.

10. Non economic advantages: There may be political, social and cultural advantages to be gained
by fostering trading links between countries

International Specialisation

The main benefit from international trade is specialisation which leads to the production of a larger
amount of goods and services. The principle that countries can gain through specialisation and trade
can be explained by the theories of absolute and comparative advantage.

The theory of absolute advantage

Absolute advantage refers to the ability of one country to produce something with fewer resources
than another country. In other words, a country is said to have absolute advantage in the production
of a good when with the same amount of resources it can produce more of a product than another
country.

Let us consider a two countries world, Mars and Venus, both producing coffee and tea. The following
assumptions are made:
i. they devote their resources equally in the production of both goods
ii. the opportunity cost of one good in terms of another is constant

Their production possibilities, using one unit of labour, before trade were as follows:
Coffee Tea
(units) (units)
Mars 8 3
Venus 4 6
The table shows that Mars can produce 8 units of coffee or 3 units of Tea with the same unit of
labour. Venus, on the other hand, can produce 4 units of coffee or 6 units of tea with the same
quantity of labour.
Mars is said to have an absolute advantage in the production of coffee as with the same amount of
resources it can produce more coffee than Venus. However, Venus has an absolute advantage in the
production of tea which it can produce more than Mars with the same amount of resources.

The above table can be used to construct the production possibilities curves for both countries.

Ayaz Nujuraully – 5937-6351

 3

According to the theory of absolute advantage, countries should specialise in the production of goods
and services in which they have absolute advantage. This will lead to an increase in output as
illustrated in the table below:

Production possibilities after specialisation

Coffee Tea
(units) (units)
Mars
Venus

Hence, a country will benefit if it specialises in and export the product in which it has an absolute
advantage.

Specialisation and trade will result in increased production and consumption, allowing the trading
countries to consume a point outside their PPC as illustrated below.

Theory of comparative advantage

The theory of absolute advantage works well when different countries have absolute advantage in
different products. However, it may happen that a country has absolute advantage in both goods.
According to the theory of absolute advantage the country having absolute advantage will have to
produce the goods and the other country nothing at all. However, this is not realistic and as such the
theory of comparative advantage will be used instead.

A country is said to have comparative advantage in the production of a product if it can manufacture
that product at a lower opportunity cost than the other country. Consider the table below where Mars
has absolute advantage in the production of both goods.
Coffee Tea
(units) (units)
Mars 25 50
Venus 20 10
Ayaz Nujuraully – 5937-6351
 4

To know which country has comparative advantage in which product an opportunity cost table has to
be constructed:

It can be seen that Mars has the lower opportunity cost in the production of tea meaning that it has a
comparative advantage. On the other hand, Venus, despite having no absolute advantage at all, will
have comparative advantage in the production of coffee. Their production possibilities will be as
follows after specialisation.

Mars will specialise in and export tea whereas Venus will specialise in and export coffee. It should be
noted that for exchange to be mutually beneficial, exchange should take place between the domestic
opportunity costs which are as follows.

Another point to be noted is that if the opportunity costs for both countries are the same (PPC are
parallel), it means that no country has comparative advantage in any product. There will be no
specialisation and no trade.

Ayaz Nujuraully – 5937-6351

 5

Evaluating the theory of comparative advantage

The theory of comparative advantage have been strongly criticised because it is based on many
unrealistic assumptions:
 Factors of production are immobile and fixed. In other words they do not move from one country to
another and they do not change. However, in the real world, factors of production do move and
there are likely to be changes in their quantity and quality.
 Technology is fixed which is an unrealistic assumption as technology does evolve and may
change the pattern of comparative advantage.
 There is perfect competition but in the real world markets are likely to be imperfect.
 There is free trade meaning that the governments do not intervene in markets and trade flows. In
the real world, governments do intervene by imposing barriers to trade. This makes specialisation
difficult.
 Transportation costs are ignored. But transportation costs may be so high that it eliminates all
comparative advantage.
 Trade on basis of comparative advantage may lead to excessive specialisation. This may make
the country extremely vulnerable to change in demand conditions and fluctuations in prices.

Ayaz Nujuraully – 5937-6351

 6

Free Trade and Protectionism

Free Trade
Free Trade is defined as the absence of government intervention of any kind in international trade,
so that trade takes place without any restrictions (barriers) between individuals or firms in different
countries. Free trade, according to the theory of comparative advantage, would lead to an efficient
global allocation of resources, maximisation of global output, with all countries sharing the benefits
of trade. The three diagrams below illustrate the situation before and after trade.

Before trade

Free Trade and Exports Free Trade and Imports

Ayaz Nujuraully – 5937-6351

 7

Protectionism
Protectionism involves government intervention in international trade through the imposition of trade
barriers to prevent free entry of imports into a country and protect the domestic economy against
foreign competition.

Types of protectionist measures

1. Tariffs: Tariffs, also known as custom duties, are Advantages of tariffs

taxes on imported goods and are the most a. Government revenue will increase
common form of trade restriction. Tariffs may equivalent to the quantity of new imports
serve two different purposes. One is to protect a times the tariff per unit.
domestic industry from foreign competition and b. Domestic producers are better off: The
the other is to raise revenue for the government. tariff will increase the price of the product
The diagram below illustrates the impact of a hence leading to an increase in domestic
tariff on the economy production.
c. Domestic employment rises: Since
domestic producers sell a larger quantity,
this has the effect of increasing
employment in the economy.

Disadvantages of tariffs
a. Domestic consumers are worse off as they
have to pay a higher price and they can
buy a smaller quantity.
b. There is a negative impact on the
distribution of income as the tariff is a
regressive tax affecting the poor most
c. Society is worse for two reasons. One
because consumers are worse off, and the
other is that the increase in domestic
output represents an increase in
production by relatively inefficient
producers, thereby resulting in a waste of
resources.
d. The exporting countries are worse off
because they can now export a lower
output at the same price. Their export
revenue falls.
e. There results a global misallocation of
resources. The decrease in consumption
and the shift of production away from more
efficient foreign producers and towards
inefficient domestic producers indicate that
there is an increase in the misallocation of
resources both domestically and globally,
with negative effects on both consumers
and producers.

Ayaz Nujuraully – 5937-6351


2. Import Quota: An import quota is a legal limit on
the quantity of a good that can be imported into a
country over a particular period. The impacts of
quotas are similar to the impacts of tariffs, except
that they may or may not create revenue for the
government.
Ayaz Nujuraully – 5937-6351
8
Advantages of quotas
a. Importers or government gain quota
revenues: Quota revenues arise when the
good is purchased at the world price and
sold to consumers at the higher domestic
price. Whoever gets this revenue depends
on how the import licences are distributed.
When the government sets quotas, it
issues a limited number of import licences
to importers. If the licences are sold then
the government gets the quota revenue
whereas if the licences are issued free of
charge, the importers will get the quota
revenue.
b. Domestic producers are better off: The
quota will increase the price of the product
hence leading to an increase in domestic
production.
c. Domestic employment rises: Since
domestic producers sell a larger quantity,
this has the effect of increasing
employment in the economy.
Disadvantages of quotas
a. Domestic consumers are worse off as they
have to pay a higher price and they can
buy a smaller quantity.
b. There is a negative impact on the
distribution of income: Quotas do not
involve a tax in the same way that tariffs
do; however, they do result in a higher
price which is likely to affect the low
income people most.
c. Society is worse off.
d. The exporting countries are worse off
e. There results a global misallocation of
resources.
 9

3. Production Subsidies: The subsidies are grants given by the government to domestic producers
that compete with foreign firms. The subsidies can be given to producers in both the exporting and
importing industries. In both cases, their supply curves will shift downwards and reduce the prices
of their products. This means that they will be more competitive on the world market. The
disadvantage with such a measure is that tax payers money is being used is being used to protect
inefficient producers. Consumers are also worse off as they may not be able to buy foreign goods
which may be of better quality.

4. Voluntary exports restraints (VERs): VERs are voluntary restrictions by exporting countries that
have been requested by importing countries. In fact they are not really voluntary, but imposed by
importing countries through the use of threats that if the exporters do not reduce the quantity of
their exports, the importing countries will impose stronger restrictions that will be far more
damaging to the exporters.

5. Foreign exchange controls: To import goods and services, foreign currencies are needed. The
government may reduce the amount of foreign exchange available which de facto will reduce
imports.

6. Administrative regulations: Whenever goods are imported from another country, it must go
through a number of customs procedures involving inspections, valuation and others. In an effort
to impose obstacles to imports and reduce their quantity, countries may increase the amount of
red tape checks and procedures, making them very time consuming and difficult. In addition, the
importing countries can impose requirements that imported goods must be packaged in particular
ways. Since exporters do not always fulfil the requirements the quantity of exports is reduced.

7. Health and safety and environmental standards: Many countries impose requirements that
imported goods must fulfil particular technical standards, which involve health, safety and
environmental conditions. In many cases, these standards automatically eliminate a range of
imports. In other cases, certain products must undergo testing and inspection procedures that are
costly and time consuming that once again the effect is to reduce imports.

Additional disadvantages of barriers to trade

 Protectionism may give rise to further negative effects on a country’s export competitiveness.
Some domestically produced goods that are protected may be used as inputs in the production of
other goods that are exported. As a result the price of the other good would be higher than it
should have been if the lower price imported substitutes had been used.
 Protectionism may give rise to trade wars: as one country imposes barriers on imports, other
countries retaliate by imposing their own barriers. This can produce chain reactions with countries
becoming more and more protectionist, with serious negative impacts on global output and
resource allocation.

Arguments for protectionism

Valid Arguments

1. Infant industry argument: An infant industry is a new domestic industry that has not had the time
to establish itself and achieve efficiencies in production, and may therefore be unable to compete
with more mature competitor firm from abroad. The foreign firms, operating more efficiently, in
other words with lower costs of production, will be able to sell at lower prices; the domestic firm
Ayaz Nujuraully – 5937-6351
 10

being unable to compete, will not be able to grow and may be forced to shut down. Therefore, to
enable the small domestic firm to compete with the bigger foreign competitors, it is protected with
tariffs and quotas. The tariffs and quotas are not imposed indefinitely. They will be removed as
soon as the domestic firm has sufficiently grown in size and is able to compete with its foreign
competitors.

Limitations of the argument

 It may be difficult for the government to know which particular industries have the potential to
become low cost producers, presenting difficulties in selection of industry to protect.
 Once the selection is made, industries protected may not have a very strong incentive to
become efficient.
 Governments may continue to protect an industry even long after it has matured and is no
longer an infant. This represents a misallocation of resources and is detrimental to consumers.

2. Strategic industry argument: The strategic industry argument is basically non economic; it is
that certain industries are of strategic importance in times of crisis or armed conflict. Thus a
government might wish to expand or maintain the capacity of domestic production of a strategic
industry through protection. It can be argued that industries such as agriculture, aerospace,
armaments, shipbuilding and fuel industries are strategic. A decision to protect an industry is
clearly political. The economist can only point out that to protect an industry with a comparative
disadvantage has an economic cost.

3. Anti dumping argument: Dumping occur when a firm sells a product in the international market
at a price below the price in the country of origin. A firm acting as a price discriminating
monopolist, for example, may sell a product at a lower price in an overseas market. Another
motive for dumping is the intention by a firm to increase its market by driving its competitors out of
business; this is sometimes known as ‘predatory dumping’. The dumping firms may be able to sell
temporarily at a loss making low price in a particular market through cross subsidization in other
markets. However, we can argue that dumping will benefit from lower prices and a larger choice of
products. Local producers would be forced to review their methods of production so as to increase
efficiency and decrease costs.

4. To prevent the importation of harmful goods and to take account of externalities: A country
may want to ban or severely curtail the importation of things such as drugs, pornographic literature
and live animals. On the other hand, free trade will tend to reflect private cost. Both imports and
exports, however, can involve externalities. Hence, government imposes tariffs or subsidies on
such goods to take into account the externalities and attempt to influence consumer expenditure.

5. Non economic advantages of diversification : Comparative advantages might dictate that a

country should specialize in producing a narrow range of products. The government may decide,
however, that there are distinct social advantages in encouraging a more diverse economy.
Citizens would be given a wider range of occupations, and the social and psychological
advantages of diversification would more than compensate for a reduction in standard of living. As
such, the government should protect the industries in which the country does not have a
comparative advantage.

Ayaz Nujuraully – 5937-6351

 11

Questionable arguments

1. Tariff as a source of government revenue

2. Means to overcome BOP / current account deficit
3. Protection of domestic employment

Non valid arguments

1. Wage protection argument
2. Exports raise living standards and imports lower them

Ayaz Nujuraully – 5937-6351

 12

Economic Integration

It refers to economic interdependence between countries, often achieved by agreement between

countries to reduce or eliminate trade and other barriers between them. There are various degrees of
integration, depending on the type of agreement and the degree to which barriers between countries
are removed.

Trading Blocs

A trading bloc is a group of countries that have agreed to reduce tariffs and other barriers to trade for
the purpose of encouraging the development of free or freer trade and cooperation between them.

The main types of trading blocs are:

1. Free Trade Area: It consists of a group of countries that agree to gradually eliminate trade
barriers between themselves, and it is the most common type of integration area. Each member
countries retain the right to pursue its own trade policy towards non member countries.
In trade relations between the members there could be free trade in some products and protection
in others. Examples of FTA are: North American Free Trade Area (NAFTA), Association of
Southeast Asian Nations (ASEAN) and South Asian Association for Regional Cooperation
(SAARC).

2. Customs Union: It fulfils the requirements of a free trade area (elimination of trade barriers
between members) and in addition adopts a common policy towards all non member countries.
Each country in the custom union must adopt a trade policy agreed by the customs union. For
example, the members of the customs union will have a common external tariff towards non
members.
Examples of customs union are: South African Customs Union (SACU) and Pacific Regional
Trade Agreement (PARTA).

3. Common market: It is an even higher degree of economic integration, in which countries that
have formed a custom union proceed further to eliminate any remaining tariffs between them; they
continue to have a common external policy, and in addition, they agree to eliminate all restrictions
on movement of any factors of production within them. The factors of production of importance
(labour and capital) are free to cross all borders, move, travel and find employment freely within all
member countries. Examples of a common market are the Carribbean Community (CARICOM)
and the MERCOSUR.

4. Economic and monetary union: It has all the characteristics of the common market and in
addition it involves the unification of the monetary and fiscal systems of the members, as well as a
unified system of economic policy making. The members can also adopt a common currency.
They can also have a single Central Bank. However, members still maintain their national
sovereignty or their identity as separate political units. An example of an economic and monetary
union is the European Union.

Advantages of Trading Blocs

1. Trade creation: Trade creation occurs when some domestic production of one customs-union
member is replaced by another member's lower-cost imports. The welfare of the member
Ayaz Nujuraully – 5937-6351
 13

countries is increased by trade creation because it leads to increased production specialization

according to the principle of comparative advantage. The trade-creation effect consists of a
consumption effect and a production effect.
Assume a world composed of three countries: Luxembourg, Germany, and the United States.
Suppose that Luxembourg and Germany decide to form a customs union, and the United States is
a non member. The decision to form a customs union requires that Luxembourg and Germany
abolish all tariff restrictions between themselves while maintaining a common tariff policy against
the United States.
Prior to the formation of the customs union, Luxembourg had a tariff of 10% against Germany and
a tariff of 5% against USA. The table below illustrates each country’s cost of producing one ton of
maize before the formation of the customs union.

Country Cost of production of 1 ton of maize Cost + Tariff

Luxembourg $4 $4
Germany $3 $3.3
USA $3.1 $3.25

It can be seen that Luxembourg will import the maize from the USA which has the lowest price
after tariff. However, Germany is a lower cost producer than USA. With the formation of the
customs union between Luxembourg and Germany, Luxembourg will be able to import the maize
from Germany at a lower price as there will be no tariff on Germany’s product. At the same time
there has been a movement from a high cost producer to a low cost producer. With the same
amount of money Luxembourg citizens can now buy more maize (consumption effect) whereas
eliminating the tariff barrier against Germany means that Luxembourg producers must now
compete against lower-cost, more efficient German producers. Inefficient domestic producers drop
out of the market, resulting in a decline in home output which is replaced by the cheaper German
imports (production effect).

2. Economies of scale and specialization: Perhaps the most noticeable result of a customs union
is market enlargement. Being able to penetrate freely the domestic markets of other member
nations, producers can take advantage of economies of scale that would not have occurred in
smaller markets limited by trade restrictions. Larger markets may permit efficiencies attributable to
greater specialization of workers and machinery, the use of the most efficient equipment, and the
more complete use of by-products.

3. Competition and efficiency: Broader markets may also promote greater competition among
producers within a customs union. It is often felt that trade restrictions promote monopoly power,
whereby a small number of companies dominate a domestic market. Such companies may prefer
to lead a quiet life,forming agreements not to compete on the basis of price. But with the
movement to more open markets under a customs union, the potential for successful collusion is
lessened as the number of competitors expands. With freer trade, domestic producers must
compete or face the possibility of financial bankruptcy. To survive in expanded and more
competitive markets, producers must undertake investments in new equipment, technologies, and
product lines. This will have the effect of holding down costs and permitting expanded levels of
output.
Ayaz Nujuraully – 5937-6351
 14

4. Rise in investment and employment: Capital investment may also rise if non member nations
decide to establish subsidiary operations inside the customs unions to avoid external tariff
barriers. As a result output and employment will rise in the member countries, helping government
to achieve its objectives of economic growth and full employment.

5. Lower prices for consumers: The elimination of trade barriers along with all the advantages
listed above result in lower prices for the consumers and possibly access to better quality
products.

6. Better use of factors of production: If a trading bloc develops into a common market, in which
case there is also the free movement of factors of production within all member countries, there is
also likely to be better use of all factors of production. For example, there may be high
unemployment in one country, and a high demand for labour in another country. This will
encourage unemployed workers to seek work in the country facing labour shortages.

7. Political advantages arising from increased economic integration: Greater economic

integration is likely to result in a reduced likelihood of hostilities arising between countries whose
economies are becoming more interdependent through increased trade, investment, labour and
financial flows. Further, economic integration may lead to political cooperation, resulting in further
benefits for member countries.

Disadvantages of trading blocs

1. Trade diversion: Trade diversion occurs when imports from a low-cost supplier outside the
union are replaced by purchases from a higher-cost supplier within the union. This suggests
that world production is reorganized less efficiently. Trade diversion therefore means a welfare
loss. For example if the USA was the lowest cost producer and the formation of the customs
union causes Luxembourg to import from Germany which has a higher cost of production, then
trade diversion will arise.

2. Trading blocs may be the second best solution: Many economists believe that free trade is
the best policy towards international trade. This means that trading blocs are inferior to a
complete elimination of all trade barriers towards all countries. Indeed trading blocs can lead to
an increase in protectionist measures towards non member countries.

3. Unequal distribution of gains from trading blocs: Countries joining to form a trading bloc
are unlikely to gain equally from the formation of the trading bloc, and this creates the potential
for conflicts between members and makes it difficult to reach agreements.

4. The gains from a trading bloc may be limited if major trade links are with countries
outside the bloc. Developing countries in particular often produce a limited range of primary
commodities that they export to developed countries in exchange for industrial and other
goods that they do not produce. This means that the establishment of a trading bloc among
developing countries is unlikely to be of significant benefit to them if the developed countries
are excluded.

Ayaz Nujuraully – 5937-6351

 15

Barriers to Integration

1. Economic sovereignty issues: Economic integration means common policies for the members
of the trading bloc. However, sovereignty issues may arise as countries may feel that the common
policies are interfering in their domestic policies. There is a risk of losing autonomy in terms of
monetary and fiscal policies especially in the case of an economic union.

2. Different levels of economic development: Countries which were more competitive prior to
trade integration will benefit the most from trade integration. Countries which were less
competitive will experience trade diversion with trade integration. They will stand to lose with trade
integration. As such they may resist the formation of the trading bloc.

3. Different features of economic system: trade between market economies and centrally planned
economies can be difficult. Prices are determined differently in both types of economy. In market
economy, prices are determined by demand and supply whereas in planned economy it’s the
state that fixes price. Because market-determined prices underlie the basis for trade according to
the theory of comparative advantage, the theory has little to say about how nonmarket economies
carry out their international trade policies.

4. Historical influences: Different countries have different cultures and if there is a feeling that
integration may impact negatively on their domestic cultures, then integration will be difficult to
achieve.

Ayaz Nujuraully – 5937-6351

 16

Balance of Payments

The balance of payments of a country is a record, usually for a year, of all transactions between the
residents of the country and the residents of all other countries. It shows all payments received from
countries, called credits, and all payments made to other countries, called debits. In the course of a
year, all inflows of payments into the country must exactly equal the outflows of payments to other
countries; in other words, the sum of all the credits must equal the sum of all debits.

Format of the Balance of Payments

Current account RS bn RS bn
Export of goods 40
Import of goods (65)
Balance of Trade (or visible (25)
balance)
Exports of services 25
Imports of services (15)
Balance on services (invisible 10
balance)
Net flows of income (inflows – (6)
outflows)
Net transfers (inflows – outflows) 1
Current account balance (20)
Capital account
Net transfers of capital 1
Balance on capital account 1
Financial account
Foreign investments and loans 23
received
Investments abroad and loans to -5
other countries
Changes in official reserves 1
Balance on financial account 19
Sum of all balances 0

The current account

The current account of the balance of payments is composed of the sum of the balance of trade plus
the balance on services, plus net income plus net transfers.
i. The balance of trade: This section of the balance of payments deals with visible trade. It is
made up of exports of goods and imports of goods. If the revenue from the export of goods is
greater than the expenditure on the imports of goods then we say that there is surplus on the
balance of trade. In the above example, there is a deficit on the balance of trade meaning that
expenditure on imports of goods is greater than revenue from exports of goods.

ii. Balance on services: Services include a variety of activities, such as insurance, tourism,
transportation and consulting. For example, when foreigners visit a country as tourists, the
country is exporting tourism services; similarly, insurance bought by foreigners from the
country’s companies represents export of insurance services. When residents of the country visit
Ayaz Nujuraully – 5937-6351
 17

other countries or buy insurance from other countries, they are importing tourism & insurance
services. In the above table it can be seen that the country’s exports of services are larger than
its imports of services. So the balance on services, also known as the invisible balance, is
positive meaning that it is in a surplus position.

iii. Net income: This section refers to all inflows into the country of wages, rents, interests and
profits from abroad minus wages, rents, interests and profits that flowed out of the country.
Nationals of the country may earn income abroad such as wages if they work outside the
country and send their wages home, or if they own rental property abroad that earns rental
income, or have bank accounts abroad that earn interest, or if they own shares in another
country that earn dividend income. Whatever income is generated abroad that flows into the
country is a credit and whatever income earn by foreigners that flows out of the country is a
debit. The credits minus the debits make up the net income which in the above case is negative
(deficit), indicating that the income earned by foreigners in the country is more than income of
nationals of the country earned abroad.

iv. Net transfers: This section refers to transfers such as gifts, foreign aid, pensions paid to citizens
living outside the country minus receipts of such transfers into the country. In the above table,
this item is positive meaning that the country receives more transfers from abroad than it makes
to other countries.

When we add up all the four sections on the current account we get the balance on the current
account. The country has a deficit on the current account, that is, the debits (payment outflows) are
larger than the credits (payment inflows), resulting in a net outflow.

Capital account

The capital account refers to inflows of funds into the country for the purchase of assets in the country
that have not been produced such as land or natural resources, minus the outflow of funds from the
country to other countries for the same purpose. The capital account is relatively unimportant in terms
of size compared to the other two accounts and does not significantly affect a country’s balance of
payments.

Financial account

The financial account shows the inflows of funds into a country from the purchase of assets in the
country by foreigners, and foreign loans to the country. The purchase of assets involves investment in
physical capital, such as in buildings and factories, and investment in financial capital. These inflows
will appear as a credit in the financial account.
Similarly the country can make investments in other countries as well as give them loans. These will
be outflows and will appear as debits in the financial account.
The financial account also includes changes in official reserves which refer to actions taken by the
government to influence the exchange rate as well as managing deficits or surpluses on the balance
of payments.

The meaning of ‘balance’ in the balance of payments

In the balance of payments, the sum of all debits equals the sum of all credits meaning that the
balance at end is zero. However, it should be noted that the balance of payments does not balance
Ayaz Nujuraully – 5937-6351
 18

automatically, it is made to balance. This means that there is usually a balance on the balance of
payments which could be a surplus or a deficit.
For example, if there is a surplus on the balance of payments, the surplus is used to reimburse past
loans or added to the official reserves. These will be included as outflows in the financial account and
the surplus will be eliminated.
Similarly, if there’s an overall deficit on the BOP, it can be financed by borrowings from international
institutions or friendly countries or by withdrawing from the official reserves. These will be counted as
inflows in the financial account and thus eliminate the deficit.
Therefore, BOP deficit means there is a deficit in the combined current, capital and financial
accounts, excluding central bank intervention. Balance of payments surplus means there is a surplus
in the combined current, capital and financial accounts, excluding central bank intervention. The
deficit or surplus will be eliminated with the intervention of the central bank (included in the financial
account)

Relationship between current account and financial account

When a country trades with other countries, its imports of goods and services are unlikely to be
exactly equal to its exports. If imports are greater than exports, it has a deficit in its balance in trade in
goods and services. This means that it must have a surplus on the financial account which provides it
with the foreign exchange it needs to pay for the excess of imports over exports. The surplus on its
financial account may arise from investments in physical capital or financial capital by foreigners or
from loans from foreigners.
If, on the other hand, the country has a surplus on its current account it means that the country has
an excess of foreign currencies in the economy. This can be used to invest in other countries or to
give them loans. As a result, there will be a deficit on the financial account.

Errors and Omissions section

Given that the balance of payments is a record of millions of transactions, errors and omissions are
likely to occur. This means that the balance of payments will fail to balance. To make it balance, an
error and omissions section is included.

Is a current account deficit a cause for concern?

It is not a cause for concern when:
 The deficit is short term and small in size and one year deficit is matched by another year’s
surplus. Also strong foreign currency reserves are sufficient to match a temporary deficit.
 The deficit is matched by other inflows
 The deficit reflects comparative advantage meaning that resorting to protectionist measures to
eliminate the deficit will bring more disadvantages than benefits.
 May reflect rising living standards
 Arises due to imports of capital goods. This means that later benefits will exceed current outflows

It is a cause for concern:

 The deficit is a chronic one – large in size and it has been going on for several years
 Leads to excessive borrowing – increase the debt burden of future generation
 Leads to depletion of the country’s foreign currency reserves
 Reflects lack of international competitiveness – may affect other macro-economic objectives such
as employment.
 Arise mainly because of imports of consumption goods – do not have long term benefits.

Ayaz Nujuraully – 5937-6351

 19

Terms of Trade

The terms of trade is a concept that relates the prices that a country receives for its exports to the
prices that it pays for its imports. Export prices and import prices are measured by constructing a
price index for each, based on a base year. The price index for exports is divided by the price index
for imports, and the result Is multiplied by 100:
TOT = Index of export prices X 100
Index of import prices
The value of the terms of trade is 100 for the base year. An increase in the terms of trade means an
improvement; the export prices have increased relative to the import prices. On the other hand, a
decrease in the terms of trade means a worsening or deterioration of the terms of trade; import prices
have increased relative to the exports prices.
Movements in TOT

Causes of changes in Terms of Trade

Since the terms of trade depicts the relationship between export prices and import prices, it will be
affected by any factors that give rise to changes in relative prices of internationally traded goods
(exports and imports) as well as changes in exchange rates.

1. Changes in global demand: Increases in the global demand for a product causes its price
to increase; decreases in global demand cause its price to fall. Change in global demand
may arise due to a change in global income, taste and needs, etc… Changes in consumer tastes,
for example, in favour of textiles made cotton, gives rise to an increase in the global demand for
cotton, therefore an increase in its global price. This may be expected to result in a favourable
change in the terms of trade of cotton exporters and an unfavourable change in the terms of trade
of cotton importers.

2. Changes in global supply: Prices of internationally traded goods can also change in response to
changes in supply, which can occur due to a number of factors such as climatic conditions,
Ayaz Nujuraully – 5937-6351
 20

technology advances, etc… For example, good climatic conditions will increase the supply of
agricultural products and reduce their prices. As a result the terms of trade of agriculture exporting
countries will worsen and that if the agriculture importing countries will improve.

3. Changes in the domestic rate of inflation relative to other countries: If the price level within a
country changes relative to other countries, this will have immediate impacts on its terms of trade.
A higher rate of domestic inflation means that the country’s exports prices will increase relative to
its import prices, resulting in an improvement in its terms of trade; at the same time this
corresponds to deterioration in the terms of trade of countries that import goods from the high
inflation country, as they experience higher import prices.

4. Protectionism: This applies to large countries which have a large share in the world market for
an import good or export good; it may be able to affect the level of world prices. Protectionist
policies that restrict imports may result in a fall in world demand for the product, leading to a lower
world price, which improves the terms of trade of the importing country.
On the other hand, if a country uses export subsidies to increase its exports, this may lead to an
increase in the global supply of the good, further reducing its price. Other countries that export the
same goods (without imposing export subsidies) face deterioration in their terms of trade.

5. Degree of monopoly power: Producers with a high degree of monopoly power have the ability to
raise the prices of their products by restricting the quantity of the output they produce. If the export
industry is composed of firms with significant monopoly power, there can result higher global
prices for their goods. The countries in which such types of industries are located will experience
an improvement in their terms of trade.

6. Changes in exchange rates: Exchange rates fluctuate continuously over time and they can
increase (appreciation) as well as decrease (depreciation). An appreciation of the exchange
means an increase in the export prices and a fall in the imports prices. The terms of trade will
improve. A depreciation of the exchange rate will have the opposite effect.

Ayaz Nujuraully – 5937-6351