Brief summary: International Economics
By: Thomas Konings
Contents
Lecture 1: World trade & Gravity Model................................................................................................. 2
Lecture 2 & 3: The Ricardian Model ........................................................................................................ 3
Lecture 4: Specific Factors model ............................................................................................................ 5
Lecture 5 & 6: Heckscher-Ohlin model.................................................................................................... 6
Lecture 7: Standard Trade Model............................................................................................................ 8
Lecture 8: External Economies of Scale (EoS) ....................................................................................... 10
Lecture 9: Instruments of Trade Policy ................................................................................................. 11
Lecture 10: Trade Policy in Practice ...................................................................................................... 13
Lecture 11 & 12: Firms in the Global Economy ..................................................................................... 14
Lecture 13: National Income Accounting and Balance of Payments .................................................... 16
Lecture 14 & 15: Money, Interest Rates, and Exchange Rates ............................................................. 17
Lecture 16 & 17: Price Levels and the Exchange Rate in the Long Run ................................................ 19
Lecture 18: Exchange Rates and Open Economy Macro Economics..................................................... 21
Lecture 18-2: Fixed Exchange Rates and Foreign Exchange Intervention............................................. 23
Lecture 19: International Monetary System ......................................................................................... 25
Lecture 20: International Financial Institutions .................................................................................... 26
1
© Thomas Konings - 2018
,Lecture 1: World trade & Gravity Model
World trade: how much & with whom? US trades with everyone, but 15 partners are 70% of it
Gravity model: explaining trade flows Introduced by Jan Tinbergen
Size matters: GDP related with volume of trade, why? Countries with large GDP:
- Produce more goods and services, so more to sell and export
- Larger economies generate more income, so they can buy more imports
Trade impediments: how easy can countries exchange goods
1. Distance between markets influences transaction costs (cost of imports/exports)
2. Cultural affinity, if two countries have cultural ties, they likely also have economic ties
3. Geography, ocean harbors, easily navigable rivers, lack of mountain barriers
4. Borders (trade policies): crossing borders involves formalities that take time and can involve
(substantial) monetary costs like tariffs. implicit/explicit costs reduce trade
𝒃
(𝒀𝒊)𝒂 (𝒀𝒋 )
Formula Gravity Model: 𝑻𝒊𝒋 = (𝐷𝑖𝑗 )𝑐
with: Tij value of trade, Yi/Yj GDP of i,j, Dij trade impediments, and a,b,c > 0 importance of vars
a,b,c can be determined using real word data, latest evidence shows: a,b,c close to 1
Use of Gravity Model: assess effects of trade policies (does this trade policy reduce/increase trade
more than we expect based on the model?)
1. Borders: are impediment if trade over same distance within country more than with foreign
2. Trade agreements: did trade agreement cause more trade than expected?
NAFTA: yes, more than EU partners but might as well be distance (false conclusion)
Globalization (then and now)
World economy more integrated than ever, but distance still affects trade (but less than before).
Due to: technology, easier to trade and communicate (but country’s location still very important in
determining ease of access to markets)
History: after industrialization, trade grew rapidly (1870-1913), sharp decline due to WW I, Great
Depression (increased protectionism), WW II. Came back to pre-WW I levels around 1970 and has
been growing since. (Less trade barriers between developing countries) (Fall of SU, open China)
Changing composition of trade
History: mainly agricultural / natural commodities Now: mainly manufactures (products)
Recently developing countries also move towards mainly trading manufactured products
Two recent developments:
1. Trade in intermediate goods (used for production) complex international supply chains
“In the future, it will take many imports to make an export” Now 50% of trade
Countries can specialize (more efficient production) but production more vulnerable
(complex) solve it by producing intermediate goods in even more countries (reliable)
2. Trade in services advances in communication technology (internet speed) lead to
outsourcing/offshoring of services (call centers, accounting, consulting, law services) to other
countries. Anything that can be transmitted electronically can be outsourced easily.
Now makes up 20% of trade. Some are still non-tradable (house painting, dentist).
More and more can be outsourced because of rapid changes in communication
technology, standardization of services (accounting), increasing education around the globe
2
© Thomas Konings - 2018
, Lecture 2 & 3: The Ricardian Model
Theories of trade (two categories): 1. Differences between countries main driver of trade (Ricardian)
2. Models emphasizing economies of scale (no a priori differences, still one country more efficient)
Real world: determined by both
Ricardian Model: trade arises because of differences (endowments) in relative labor productivity.
Opportunity costs and comparative advantage are two crucial concepts in this model.
Opportunity costs: costs faced by a country by producing X, now resources can’t be used to make Y.
Example: I can produce 10 roses or 5 apples. Opportunity cost of a rose: 5/10 = 0.5 apples.
Example 2: Country A can produce 10mln X or 30k Y, B can produce 10mln X or 100k Y.
A has lower opportunity cost in producing X comparative advantage (B has one in Y as well)
Without trade: A produces 30k Y, B 10mln X, can they be better off?
With trade: A stops producing Y (higher cost), B stops X (ditto), switch to their comparative
advantage Now: combined output (with their resources) higher: Y went from 30k to 100k
Gains from trade: when countries specialize this is comparative advantage, then they trade and
together they produce more than in a closed economy scenario This,plus prices is Ricardian model
One factor (labor) Ricardian model: assumptions (important to criticize model later)
1. Labor is the only production factor
2. Labor productivity varies between countries (different technologies) (not due to efficiency)
3. Labor supply of each country is constant
4. Only two goods are important for production and consumption (wine and cheese)
5. Perfect competition between firms (free entry/exit of firms)
6. Perfect labor mobility between sectors (wine and cheese) (not present in specific factors)
7. The world consists of two countries: home and foreign
Production possibilities: (production possibility frontier (PPF)) 𝑎𝐿𝐶 ∙ 𝑄𝐶 + 𝑎𝐿𝑊 ∙ 𝑄𝑊 ≤ 𝐿
Equilibrium (all labor used): 𝑎𝐿𝐶 ∙ 𝑄𝐶 + 𝑎𝐿𝑊 ∙ 𝑄𝑊 = 𝐿
L (total hours worked),Qc/Qw (how many cheese/wine),aLC/aLW (unit labor requirement hours/unit)
𝐿 𝑎 𝑎
PPF in Qw: 𝑄𝑊 = 𝑎 − (𝑎 𝐿𝐶 ) 𝑄𝐶 𝑎 𝐿𝐶 is the opportunity cost of 1 extra cheese in terms of wine
𝐿𝑊 𝐿𝑊 𝐿𝑊
𝑃
Actual production: depends on prices (Pc and Pw), perfect competition (profits = 0) 𝑤𝐶 = 𝑎 𝐶
𝐿𝐶
(With Wc, wages cheese) Hourly wage = hourly value produced Workers go to sector with
highest wage. (Wc > Ww, only cheese is made) Economy specializes in good of which relative
price exceeds opportunity cost (e.g. cheese yields more than it costs in terms of wine cheese)
Autarky (no trade): if home wants to produce both goods then 𝑤𝐶 = 𝑤𝑊 (both have workers).
𝑃 𝑎
Can only be produced if prices = opportunity costs, e.g. 𝑃 𝐶 = 𝑎 𝐿𝐶
𝑊 𝐿𝑊
∗ ∗
Trade (absolute advantage, both goods): 𝑎𝐿𝐶 < 𝑎𝐿𝐶 𝑎𝑛𝑑 𝑎𝐿𝑊 < 𝑎𝐿𝑊 (* for foreign)
Even though most efficient in both, can still benefit from trade, comparative advantage matters!
Country is always better at producing one good compared to the other, not other countries.
Prices under trade: where do they settle? Relative supply, relative demand.
𝑃 𝑎 𝑎∗
0 when 𝑃 𝐶 < 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶 (opp. cost > price, nobody produces)
𝑊 𝐿𝑊 𝐿𝑊
∗
𝑎𝐿𝐶 𝑎𝐿𝐶 𝑃𝐶
infinite when: 𝑎𝐿𝑊
< ∗
𝑎𝐿𝑊
< 𝑃𝑊
(opp. cost < price, everybody produces)
3
© Thomas Konings - 2018
By: Thomas Konings
Contents
Lecture 1: World trade & Gravity Model................................................................................................. 2
Lecture 2 & 3: The Ricardian Model ........................................................................................................ 3
Lecture 4: Specific Factors model ............................................................................................................ 5
Lecture 5 & 6: Heckscher-Ohlin model.................................................................................................... 6
Lecture 7: Standard Trade Model............................................................................................................ 8
Lecture 8: External Economies of Scale (EoS) ....................................................................................... 10
Lecture 9: Instruments of Trade Policy ................................................................................................. 11
Lecture 10: Trade Policy in Practice ...................................................................................................... 13
Lecture 11 & 12: Firms in the Global Economy ..................................................................................... 14
Lecture 13: National Income Accounting and Balance of Payments .................................................... 16
Lecture 14 & 15: Money, Interest Rates, and Exchange Rates ............................................................. 17
Lecture 16 & 17: Price Levels and the Exchange Rate in the Long Run ................................................ 19
Lecture 18: Exchange Rates and Open Economy Macro Economics..................................................... 21
Lecture 18-2: Fixed Exchange Rates and Foreign Exchange Intervention............................................. 23
Lecture 19: International Monetary System ......................................................................................... 25
Lecture 20: International Financial Institutions .................................................................................... 26
1
© Thomas Konings - 2018
,Lecture 1: World trade & Gravity Model
World trade: how much & with whom? US trades with everyone, but 15 partners are 70% of it
Gravity model: explaining trade flows Introduced by Jan Tinbergen
Size matters: GDP related with volume of trade, why? Countries with large GDP:
- Produce more goods and services, so more to sell and export
- Larger economies generate more income, so they can buy more imports
Trade impediments: how easy can countries exchange goods
1. Distance between markets influences transaction costs (cost of imports/exports)
2. Cultural affinity, if two countries have cultural ties, they likely also have economic ties
3. Geography, ocean harbors, easily navigable rivers, lack of mountain barriers
4. Borders (trade policies): crossing borders involves formalities that take time and can involve
(substantial) monetary costs like tariffs. implicit/explicit costs reduce trade
𝒃
(𝒀𝒊)𝒂 (𝒀𝒋 )
Formula Gravity Model: 𝑻𝒊𝒋 = (𝐷𝑖𝑗 )𝑐
with: Tij value of trade, Yi/Yj GDP of i,j, Dij trade impediments, and a,b,c > 0 importance of vars
a,b,c can be determined using real word data, latest evidence shows: a,b,c close to 1
Use of Gravity Model: assess effects of trade policies (does this trade policy reduce/increase trade
more than we expect based on the model?)
1. Borders: are impediment if trade over same distance within country more than with foreign
2. Trade agreements: did trade agreement cause more trade than expected?
NAFTA: yes, more than EU partners but might as well be distance (false conclusion)
Globalization (then and now)
World economy more integrated than ever, but distance still affects trade (but less than before).
Due to: technology, easier to trade and communicate (but country’s location still very important in
determining ease of access to markets)
History: after industrialization, trade grew rapidly (1870-1913), sharp decline due to WW I, Great
Depression (increased protectionism), WW II. Came back to pre-WW I levels around 1970 and has
been growing since. (Less trade barriers between developing countries) (Fall of SU, open China)
Changing composition of trade
History: mainly agricultural / natural commodities Now: mainly manufactures (products)
Recently developing countries also move towards mainly trading manufactured products
Two recent developments:
1. Trade in intermediate goods (used for production) complex international supply chains
“In the future, it will take many imports to make an export” Now 50% of trade
Countries can specialize (more efficient production) but production more vulnerable
(complex) solve it by producing intermediate goods in even more countries (reliable)
2. Trade in services advances in communication technology (internet speed) lead to
outsourcing/offshoring of services (call centers, accounting, consulting, law services) to other
countries. Anything that can be transmitted electronically can be outsourced easily.
Now makes up 20% of trade. Some are still non-tradable (house painting, dentist).
More and more can be outsourced because of rapid changes in communication
technology, standardization of services (accounting), increasing education around the globe
2
© Thomas Konings - 2018
, Lecture 2 & 3: The Ricardian Model
Theories of trade (two categories): 1. Differences between countries main driver of trade (Ricardian)
2. Models emphasizing economies of scale (no a priori differences, still one country more efficient)
Real world: determined by both
Ricardian Model: trade arises because of differences (endowments) in relative labor productivity.
Opportunity costs and comparative advantage are two crucial concepts in this model.
Opportunity costs: costs faced by a country by producing X, now resources can’t be used to make Y.
Example: I can produce 10 roses or 5 apples. Opportunity cost of a rose: 5/10 = 0.5 apples.
Example 2: Country A can produce 10mln X or 30k Y, B can produce 10mln X or 100k Y.
A has lower opportunity cost in producing X comparative advantage (B has one in Y as well)
Without trade: A produces 30k Y, B 10mln X, can they be better off?
With trade: A stops producing Y (higher cost), B stops X (ditto), switch to their comparative
advantage Now: combined output (with their resources) higher: Y went from 30k to 100k
Gains from trade: when countries specialize this is comparative advantage, then they trade and
together they produce more than in a closed economy scenario This,plus prices is Ricardian model
One factor (labor) Ricardian model: assumptions (important to criticize model later)
1. Labor is the only production factor
2. Labor productivity varies between countries (different technologies) (not due to efficiency)
3. Labor supply of each country is constant
4. Only two goods are important for production and consumption (wine and cheese)
5. Perfect competition between firms (free entry/exit of firms)
6. Perfect labor mobility between sectors (wine and cheese) (not present in specific factors)
7. The world consists of two countries: home and foreign
Production possibilities: (production possibility frontier (PPF)) 𝑎𝐿𝐶 ∙ 𝑄𝐶 + 𝑎𝐿𝑊 ∙ 𝑄𝑊 ≤ 𝐿
Equilibrium (all labor used): 𝑎𝐿𝐶 ∙ 𝑄𝐶 + 𝑎𝐿𝑊 ∙ 𝑄𝑊 = 𝐿
L (total hours worked),Qc/Qw (how many cheese/wine),aLC/aLW (unit labor requirement hours/unit)
𝐿 𝑎 𝑎
PPF in Qw: 𝑄𝑊 = 𝑎 − (𝑎 𝐿𝐶 ) 𝑄𝐶 𝑎 𝐿𝐶 is the opportunity cost of 1 extra cheese in terms of wine
𝐿𝑊 𝐿𝑊 𝐿𝑊
𝑃
Actual production: depends on prices (Pc and Pw), perfect competition (profits = 0) 𝑤𝐶 = 𝑎 𝐶
𝐿𝐶
(With Wc, wages cheese) Hourly wage = hourly value produced Workers go to sector with
highest wage. (Wc > Ww, only cheese is made) Economy specializes in good of which relative
price exceeds opportunity cost (e.g. cheese yields more than it costs in terms of wine cheese)
Autarky (no trade): if home wants to produce both goods then 𝑤𝐶 = 𝑤𝑊 (both have workers).
𝑃 𝑎
Can only be produced if prices = opportunity costs, e.g. 𝑃 𝐶 = 𝑎 𝐿𝐶
𝑊 𝐿𝑊
∗ ∗
Trade (absolute advantage, both goods): 𝑎𝐿𝐶 < 𝑎𝐿𝐶 𝑎𝑛𝑑 𝑎𝐿𝑊 < 𝑎𝐿𝑊 (* for foreign)
Even though most efficient in both, can still benefit from trade, comparative advantage matters!
Country is always better at producing one good compared to the other, not other countries.
Prices under trade: where do they settle? Relative supply, relative demand.
𝑃 𝑎 𝑎∗
0 when 𝑃 𝐶 < 𝑎 𝐿𝐶 < 𝑎∗𝐿𝐶 (opp. cost > price, nobody produces)
𝑊 𝐿𝑊 𝐿𝑊
∗
𝑎𝐿𝐶 𝑎𝐿𝐶 𝑃𝐶
infinite when: 𝑎𝐿𝑊
< ∗
𝑎𝐿𝑊
< 𝑃𝑊
(opp. cost < price, everybody produces)
3
© Thomas Konings - 2018
