International Economics

“No Nation was ever ruined by trade”.

- Benjamin Franklin
- The rules of trade between nations at a global or near global
level are governed by the World Trade Organization (WTO).
World Trade Organization (WTO)
- It deals with regulation of trade in goods, services and
intellectual property between participating countries by
providing a framework for negotiating trade agreements and
a dispute resolution process aimed at enforcing participants'
adherence to WTO agreements, which are signed by
representatives of member governments and ratified by their
parliaments.
WTO
- Its principles regarding multilateral trading system should be
without discrimination, freer, predictable, more competitive and
more beneficial for less developed countries.

-The country (Philippines) actively participates in numerous

Regional Trade Agreements (RTAs) such as Association of Southeast
Asian Nations Free trade Area (AFTA), ASEAN-China Free Trade Area
(ACFTA), Japan-Philippines Economic Partnership Agreement (JPEPA)
etc.
*One of the objectives of RTAs and multilateral trade agreements is
to ensure free flow of trade by eliminating or reducing trade
barriers (tariffs and non-tariff barriers).
Selected Theoretical Bases of International Trade
1. Mercantilism (Thomas Munn)
- According to this theory, for a nation to become wealthy, it
should encourage exports and restrict imports.
- The goal of this mercantile system would be an inflow of
bullion, or precious metals, primarily gold and silver.
- The more gold a nation had, the richer and more powerful it
was.
* Since not all nations can do this, they acquired precious
metals at the expense of weaker nations, thus will result to
zero-sum game.
- From the 17th to 18th century, mercantilism was the
predominant economic philosophy on international trade
particularly in Great Britain, the Netherlands, Spain and France.
2. Law of Absolute Advantage (Adam Smith)
- In the Wealth of Nations by Adam Smith, he rejected the views
of mercantilism and advocated free trade as the best policy for
the nations of the world.
- He stressed that when one nation is more efficient than (or
has an absolute advantage over) another in the production of
one commodity but is less efficient than (or has an absolute
disadvantage with respect to) the other nation in producing a
second commodity, then both nations can gain by specializing
in the production of the commodity of its absolute advantage
and exchanging part of its output with other nations for the
commodity of its absolute disadvantage.
- The international specialization of factors of production
would increase the world output.
Hypothetical Data of Absolute Advantage

- This table shows that the Philippines has an absolute advantage

in the production of rice, while Japan is more efficient than, or
has an absolute advantage over the Philippines in the production
of sugar.
- With trade, the Philippines will specialize in the production of
rice and Japan will specialize in the production of sugar.
3. Law of Comparative Advantage (David Ricardo)
- It states that even if a nation had an absolute disadvantage in
the production of both commodities with respect to other
nations, mutually advantageous trade could still take place.

- The first nation should specialize in the production and

export of the commodity in which its absolute disadvantage
is smaller (comparative advantage), and import the
commodity in which its absolute disadvantage is greater
(comparative disadvantage).
- On the other hand, the second nation should specialize in
the production and export of the commodity in which its
absolute advantage is greater (comparative advantage), and
import the commodity in which its absolute advantage is
smaller (comparative disadvantage).
Hypothetical Data of Comparative Advantage

Products Philippines Japan

Rice (tons/labor day) 7 10

Sugar (tons/day) 4 6

- The Philippines has an absolute disadvantage over Japan with respect to the production of both rice
and sugar.
- But the Philippines has less absolute disadvantage over Japan in producing rice (7:10) so its
comparative advantage lies in rice, and it has greater absolute disadvantage over Japan in the
production of sugar (4:6), thus, it has a comparative disadvantage in sugar.
- Japan has a comparative advantage in producing sugar and a comparative disadvantage in producing
rice.
- David Ricardo’s suggestion is for the Philippines to export rice and import sugar; for Japan to export
sugar and import rice.
4. Heckscher – Ohlin (HO) Theory (Factor Endowment Theory)
- It postulates that each nation will export the commodity
intensive in its relative abundance and cheap factor, and
import the commodity intensive in its relative scarcity and
expensive factor.
- Factor endowments and their corresponding prices differ
among nations.
- Highly developed countries are abundant with capital, while
less developed countries are abundant with excess labor.
- Since capital is abundant in highly developed nations, the
price of capital is low; the same is true with the price of
labor in less developed countries due to its abundance.
5. Heckscher – Ohlin – Samuelson (HOS) Theorem (Factor
Price Equalization Theorem)
- According to this theorem, international trade will eliminate
or reduce any difference in relative and absolute
homogenous factors across nations.
- International trade will cause the wages and interest rate to
be the same in all trading nations.
- The HO theorem was extended by Paul Samuelson by
incorporating the effects of international trade to the factor
payments, interest rate (capital), and wage (labor).

Theorem – An idea accepted or proposed as a demonstrable

truth often as a part of a general theory.
The Need for Trade Protection of Developing Nations
- Poorer countries dependent on the export of few primary
agricultural products are wary about the exploitative power
of rich nations which have highly industrial bases.
- Without a certain level of protection from rich nations, these
developing countries will find themselves trapped in being
“poor” for a long period of time.
- Trade policies being implemented in different trading blocks
are influenced by developed countries such as the U.S.,
European countries, and Japan.
- All trading agreements and disputes shall favor and advance
their interests.
Types of Trade Protections
1. Tariff - This is a tax on imported products.
- It raises the costs to foreign suppliers and reduces their
revenues thereby reducing the import spending of the
country.
2. Quota - This is a fixed limit placed on the quantity of
imports allowed into a country.
- Although the volume of imports is limited, their price may be
forced upward because of the scarcity, thus, the spending on
imports may not fall too much.
3. Government Regulations - These are forms of protections
arising from health and safety standards and preservation of
the environment.

4. Exchange Controls - The Bangko Sentral ng Pilipinas

restricts the sale of dollars (and other forms of currency) to
importers.
- Only those importers who have permits are allowed to
obtain dollars due to the necessity of the product they are
importing.
Arguments for the Imposition of Tariff Protection
1. Infant Industry Argument
- This argument asserts that a temporary imposition of tariff
will cut down imports while local industries will learn how
to produce at low costs to compete without the help of a
tariff.
- This is the most valid argument for an industrializing country.
- In the Philippines, many industries have been protected
during the time of Marcos, but these industries never grew
up.
- They continue to be “infants” in spite of the opportunity
afforded them to compete with foreign products.
2. Higher Standard of Living Argument
- A tariff will promote high wages because local industries
cannot provide competition with foreign competitors and pay
high wages at the same time.
- High wages and a large number of workers secure a high
standard of living for most of the population.
- But this argument lost its steam when it was observed that
higher wages is a result of higher productivity.
3. Increased Employment Argument
- This argument contends that tariff creates employment
opportunities for labor.
- Goods that should have been imported can now be
produced at home (import substitution) and therefore
would increase the demand for labor.
- But the weakness of this argument lies in the fact that if
imports decrease, exports will decrease also and
employment will decrease as an outcome.
4. Self-sufficiency Argument
- This argument is advocated to secure economic
independence or national self-sufficiency.
- If war erupts, a country cannot depend upon other
countries for a continuous supply of essential commodities.
- Important industries should be strengthened to ensure self-
sufficiency in case of conflict.
Foreign Exchange Market
- A Filipino and a Chinese communicating with each other
need an interpreter to converse.
- Just like different people with different languages, different
nations have different currencies.
- The exchange rate acts like a translator for currencies, such
as the price of the Philippine peso to a dollar or other
currencies in terms of unit.
Ex. If an American wants to buy Philippine products, he has
to sell his dollars in exchange for pesos in a foreign exchange
market.
Foreign Exchange Market
- It is the organizational framework wherein individuals,
businesses and banks buy and sell foreign exchange.
- The foreign exchange market for the Philippine peso is
located in places where there are Filipinos and where trading
occurs.
- The main function of foreign exchange is to transfer funds
of purchasing power from the Philippines to other countries
or vice versa.
Foreign Exchange Rate
- It is the price of a unit of foreign currency in terms of the
domestic currency.
- The exchange rate is made the same in all markets by
arbitrage.
Foreign Exchange Arbitrage - It is the buying of a currency
when its price is low and selling it when it is high.
- When the value of a currency declines/increases because of
market forces (demand and supply factors), it is referred to as
currency depreciation/currency appreciation.
- On the other hand, when the value of a currency
declines/increases due to legislation, it is referred to as
currency devaluation/currency appraisal.
- In the Philippines, for instance, the exchange rate is
conventionally expressed as the value of one U.S. Dollar in
peso equivalent.
Example. US $1 = P 45.62. Therefore, there are always two
currencies involved in every exchange rate quotation.
Importance of Exchange Rate
- The exchange rate is important for several reasons:
1. It serves as the basic link between the local and the
overseas market for various goods, services, and financial
assets.
- Prices of goods, services, and assets quoted in different
currencies (U.S. dollar, British pound, euro, Swiss franc,
Japanese yen, Hong Kong dollar, etc.) can be compared to the
prices in the Philippines using the exchange rates.
2. Exchange rate movements can affect actual inflation as
well as expectations about future price movements.
- Domestic prices of imported goods and services are directly
affected by the appreciation or depreciation of the peso.
- Once the peso depreciates, it raises the peso prices of
imported goods as well as import-intensive services such as
the transport and telecommunication systems.
Example. A decrease in the value of the peso from US $1: P 25
to US $ 1: P 35 will increase the price of a $1 per liter gasoline
from P25 (P25 x $ 1) to P 35 (P 35 x $ 1).
3. Exchange rate movements can affect the country’s external
sector through their impact on foreign trade.
- The level of competitiveness of Philippine exports will be
greatly affected by the changes in the peso exchange rates
with other currencies.
- A favorable change in the peso (appreciation) could lower
the price competitiveness of Philippine exports versus the
products of those competitor exporters whose currencies
have not changed in value.
4. The exchange rate affects the cost of servicing (principal
and interest payments) on the country’s foreign debt.
- A peso depreciation increases the amount of pesos needed
to buy foreign exchange to pay interest and maturing
obligations on foreign debts.
Determination of Exchange Rate
- If the Bangko Sentral ng Pilipinas (BSP) does not intervene in
the market to defend the currency against its depreciation,
we have a floating exchange rate.
Floating Exchange Rate - This system is market-driven,
determined by the interaction of the demand for dollars and
the supply for it.
- There is no need for the BSP to buy or sell dollars to achieve a
desirable exchange rate (BSP uses the international reserve in
selling dollars).
- We have two types of floating or flexible exchange rates, the
manage float and the dirty float.
Manage Float - The BSP will intervene in the market to
smooth out short-run fluctuations in the foreign exchange
market without affecting the long-run movement of the
exchange rate.

Dirty Float - The country will artificially keep their currency

low to induce its exports.
Fixed Exchange Rate System - The BSP allows the exchange
rate to move within a range of values and permits that rate
to fluctuate in that range.
- There are two types of fixed exchange rates, the adjustable
peg system and the crawling peg system.
Peg - A predetermined level at which something (as a price) is
fixed.
Adjustable peg system – The BSP will set up a maximum and
minimum value of the currency.
- If there is too much inflow or outflow of foreign currency
due to an expansion or reduction of exports respectively, the
BSP will adjust the currency to correct a surplus or a
shortage.
Crawling peg system - It is a type of fixed exchange rate
system wherein the pegged exchange rate is changed often
(maybe monthly) according to the discretion of the BSP or
some economic indicators (such as inflation, balance of
payments, and reserves).

*At present, the country’s exchange rate policy supports a

freely floating exchange rate to market forces.
- Under a market-determined exchange rate framework, the
BSP does not set the foreign exchange rate but instead allows
the value of the peso to be determined by the supply and
demand of foreign exchange.
• BSP’s participation in the foreign exchange market is limited
to temper sharp fluctuations in the exchange rate.
- On such occasions of excessive movements, the BSP enters
the market mainly to maintain order and stability.
- The BSP also stands ready to provide some liquidity and
ensure that legitimate demands for foreign currency are
satisfied.
- The Floating rate system is consistent with the current
regime’s national strategy of achieving external
competitiveness through efficiency, which is also a central
theme of the recent bold liberalization efforts.
 Positive and Negative Effects of Peso Appreciation and Peso Depreciation
Peso Appreciation Peso Depreciation
Advantages Disadvantages Advantages Disadvantages
Helps dampen inflationary Lowers domestic value of OFW Increases the country’s export It could lead to inflationary
pressures remittances sent to their earnings measures
families in the Philippines

Translates to lower debt Lowers incomes of export- The peso equivalent of OFW
servicing oriented companies, domestic remittances in foreign
producers of import currencies means more pesos
substitutes, tourism sector, in exchange of one foreign
foreign investors, and creditors currency unit.
who had lent money in foreign
currency.

Enables the BSP to build up Less cost for tourism and

international reserves investment activities
Allows prepayment of foreign Higher incomes of domestic
exchange obligations producers of import
substitutes and creditors who
had lent money in foreign
currency.
Demand and Supply in the Foreign Exchange Market
- Within the foreign exchange market, people buy money for
various reasons such as trading of goods and services, and
they are making or receiving payments for these goods and
services.
- Some are engaged in financial transactions of buying and
selling assets where they need to convert one currency to
another.
- A country’s exportation of goods and services generates a
supply for foreign currency.
Example. The Philippines exports electronic products to the
U.S.; American importers will sell U.S. dollars in the foreign
exchange market to obtain Philippine pesos and be able to pay
Filipino exporters who demand Philippine pesos as payment for
their products.
- In this case, Philippine export of goods and services will create
a supply of foreign currency (specifically, U.S. dollars) and a
demand for Philippine pesos.
- Importing goods and services to the U.S. by Filipinos causes
the Philippine peso to be sold in the foreign exchange market
to acquire the U.S. dollars.
- Just like Filipino exporters, American exporters prefer to be
paid in American dollars.
- Philippine import of goods and services causes a demand for
foreign currency (U.S. dollars in our example) and a supply of
Philippine pesos.
- The same reasoning is also applied to financial transactions of
assets between nations.
Balance of Payments (BOP) - It is a summary of the economic
transactions of a country with the rest of the world, for a
specific time period.
- It serves as an accounting statement on the economic
dealings between residents and non-residents of the country.
- It is compiled quarterly but with a monthly breakdown.
- It is released to the public electronically via the Bangko
Sentral ng Pilipinas (BSP) website or in the form of hard
copies about 12 weeks after the reference quarter
accompanied by a press release.
- The BOP is one of the most important tools for national and
international policy formulation as countries have
increasingly become interdependent.
- Policy makers are guided by the sources of imbalances as
presented in the BOP and therefore become better equipped
in determining and implementing adjustment measures.
- National development programs could be directed to
increase competitiveness in the global market for local
products and/or develop new industries that will produce
import substitutes.
Details of Balance of Payments
- Economic transactions are grouped into two major
categories:
1. Current account ;
2. Capital and financial account
Balance of Payments
Current Account
Goods and Services
- Exports (electronic products)
- Imports (raw inputs to electronic products)
- Services (travel, transportation, communication, insurance, computer and
information, business and professional services)
Income
- Overseas Filipino earnings (job contracts do not exceed one year)
- Investment income
- Interest payments to foreign creditors
Current
- Remittance of OFWs (job contracts for one year or morte as well as coming
from migrants)
- Gift, grants, and donations (consumption purposes, e.g., food, clothing,
supplies and materials)
Capital and Financial Account
Capital Account
- Capital Transfers
- Gains and donations (investment purposes, e.g., machinery and equipment, buildings and
structures)
Financial Account
- Direct Investment
- Portfolio holdings
- Stocks, bonds, and notes
- Money market instruments
- Other investments
Net Unclassified items
Overall BOP Position
Change in Reserve Assets (Gross International Reserves)
- Foreign Issued Securities
- Monetary Gold
- Foreign Exchange (US Dollar, Japanese Yen, Euros and other foreign currencies)
Change in Reserve Liabilities
- Use of Fund Credits (borrowings from the IMF)
- Short-term
- The overall BOP position is a summary measure of the
performance of the country’s external transactions.
- This can be estimated using two approaches:
1. Current Account Balance + Capital and Financial Account
Balance; or
2. Change in Net International Reserves due to transactions
(change in reserve assets and change in reserve liabilities).
* Ideally, these two approaches should yield the same result.
But in reality, they do not equate due to data imperfections
(e.g., lag in reporting) in the current account and the capital
and financial account.
- The discrepancy between the two approaches is termed as
the “net unclassified items” or “errors and omissions”.
End of the Lecture.