Open-economy macroeconomics deals with the mechanisms of adjustment in balance-of-payments disequilibria (deficits and surpluses). More importantly, it analyses the relationship between the internal and external sectors of the economy of a nation, and how they are interrelated or interdependent with the rest of the world economy under different international monetary systems.
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International trade theory and the policies are the microeconomic aspects of international economics because they deal with individual nations treated as single units and with the relative price of individual commodities. on the other hand since the balance of payments deals with total receipts and payments, as well as with adjustment and other economic policies that affect the level of national income and the general price level of the nation as a whole, they represent the macroeconomic aspects of international economics. These are often referred to as open-economy macro-economics or international finance.
International economic relations differ from interregional economic relations (i.e., the economic relations among different parts of the same nation), thus requiring somewhat different tools of analysis and justifying international economics as a distinct branch of economics. I.e. nations usually impose restrictions on the flow of goods, services, and factors across there borders, but not internally .in addition, international flows are to some extent hampered by difference in language, customs, and laws. Furthermore, international flows of goods, services, and resources give rise to payments and receipts in foreign currencies which change in value over time.
International economics has enjoyed a long, continuous, and rich development over the past two centuries, with contributions from some of the world’s most distinguished economics, from Adam Smith to David Ricardo, John Smart Mill, Alfred Marshall, John Maynard Keynes, and Paul Samuelsson.
Purpose of international economics theories and policies:
The purpose of economic theory in general is to predict and explain. That is, economic theory abstracts from the details surroundings an economic event in order to isolate the few variables and relationships deemed most important in predicting and explaining the event. Along these lines, international economic theory usually assumes the two-nations, two-commodity and two-factor world. It further assumes no trade restrictions to begin with, perfect mobility of factors within the nations but no international mobility, perfect competition in all commodity and factor markets and no transportation costs.
These assumptions may seem unduly restrictive. However, most of the conclusions reached on the basis of these simplifying assumptions hold even when they are relaxed to deal with a world of more than two nations, two commodities, and two factors, and with a world where there is some international mobility of factors, imperfect competition, transportation costs and trade restrictions.
Current International Economic Challenges:
The discussion of the most important international economic problems or challenges facing the world is very important. These are the problems that the study of international economic theories and policies can help us understand an evaluate suggestions for their resolution. The most serious international trade problems facing the world today is the rising trade protectionism in advance countries. The most serious international monetary problem is the excessive volatility and large and persistent exchange rates misalignments or disequilibria.
Other serious international economic problems are increasing international competition from China and the fear of job losses in United States and other advance countries; high structural unemployment and slow growth in Europe, and the need of restructuring in Japan; financial crises in emerging market economies; restructuring challenges of transition economies, and deep poverty in many developing countries. A brief description of these problems is as follows:
Trade Protectionism in Advance Countries:
In the real world, however, most nations impose some restrictions on the free flow of trade. Although invariably justified on national welfare grounds, trade restrictions are usually advocated by and greatly benefit a small minority of producers in the nation at the expense of a mostly silent majority of consumers. The problem is now rendered more complex mostly silent majority of consumers. The problem is now rendered more complex by the tendency of the world to break up into three major blocs: A North-American bloc (including the United States, Canada and Mexico), a European trading bloc, and much less defined Asian bloc.
Increasing International Competition from China and Fear of Job Losses in the Unite States and Other Advance Countries:
Rapid technological change and increased competition from the manufactured exports of emerging market economies, especially China, are causing widespread fears of large job losses in the United States and other rich countries. With 1.3 million people and several hundred million still living from subsistence agriculture, industrial wages are likely to remain very low in China for many years to come. At the same time, China is receiving massive inflows of capital and technology from advanced nations and is able to produce at much lower costs more and more products that have traditionally been produced by rich countries. The challenge for advance countries is how to remain competitive, avoid major job losses, and share in the benefits of globalization.
High Structural Unemployment and Slow Growth in Europe and the Need for Restructuring in Japan:
In Western Europe, unemployment averaged above 10% of the labor force during the last decade, as compared with less than 5% in the United States. Worse still, almost half of Europe’s jobless were unemployed for over a year, as compared with 11% in the United States. Although conditions have improved somewhat since the beginning of the present decade, the problem persists. The problem is believed to be caused by rigidities and inflexibility in the economic system, especially in labor markets. The attempt to increase flexibility, however, is strongly restricted by labor, which asks for trade protection in the vain effort to protect jobs. Overregulation also leads to sluggish. Growth resumed in Japan but the need for economic restructuring remains. Slow growth in Europe and inadequate restructuring in Japan leads to protectionism and dampens the growth of the entire world economy. Thus, we see how national and regional challenges quickly become global economic problems in our inter-dependent world.
Financial Crises in Emerging Market Economies:
Since the early 1990s there have been a series of financial crises in emerging market economies that threatened the stability of the entire international monetary system. In 1994-1995, Mexico faced financial and economical collapse. In 1997, deep financial and economic crises started in the countries of South-East Asia (Thailand, Korea, Malaysia, Indonesia and Philippines). In the summer of 998, Russia suffers a financial, economic and political collapse, and in January 1999, Brazil plunged into the crises. Since the beginning of the new century, turkey and Argentina have gotten in trouble and there was a danger that Brazil might join them. Although east crises was somewhat different, most were precipitated by a massive and sudden withdrawal of a short term liquid capital that had poured into these emerging economies as a result of the liberalization of capital markets during the past decade. Some reforms are now being adopted and more are being proposed to avoid such crises in future or at least to minimize their depth and chance of spreading to other countries.
Restructuring Challenges of Transition Economies:
Although considerable progress has been made in restructuring and establishing market economies in transition economies (the former centrally planned economies of central an Eastern Europe and the Soviet Union) the process is far from complete. Ten transition countries in central and Eastern Europe were admitted into a European union in 2004 and other are in line for admission. This creates increasing opportunities but also create competitive challenges. The study of international economies can help us to better understand the nature of these challenges and to evaluate current efforts for their solutions
Deep Poverty in Many Developing Countries:
Even though many developing countries, especially china and India are now growing very rapidly, many of the poorest developing nations, particular those of sub-Saharan Africa, face deep poverty, unmanageable international debts, economic stagnation, and widening international inequalities in living standards. There are today more than 1 billion people (about one-sixth of the world population) who live and earn less than $1 a day. A world where millions of people starve s not acceptable as an ethical point of view but can hardly be expected to be peaceful and tranquil.
The Globalization Challenge
The world is today in the midst of a revolution comparable to the Industrial Revolution in terms of scope and effects. Globalization refers to the increasing integration of economies around the world, particularly through trade and financial flows, but also through the movement of ideas and people, facilitated by the revolution in telecommunication and transportation. Globalization is inevitable because with tastes converging, consumers around the world increasingly demand similar products. Firms must outsource parts and components from wherever in the world they are made better or cheaper, and they must invest their capital and technology wherever they are more productive in order to remain internationally competitive. For the same reason, firms must outsource the labor services or employ labor offshore wherever it is cheaper or more convenient.
Globalization is important because it increases efficiency; it is inevitable because international competition requires it. Globalization, however, is also being blamed for a number of serious worlds problems, ranging from increased world income inequalities, to child labor, environmental pollution and others, and it give rise to a strong anti-globalization movement. This is a loose organization which blames globalization for many human and environmental problems throughout the world and for sacrificing human and environmental well-being to the corporate profits of multinationals.
Globalization depends on the openness and on the free exchange of goods, services, resources, technologies, money and ideas. The terrorists attack in the September 11, 2001 and the subsequent attacks in the United States and elsewhere sharply reduced travel, trade and investment in the weeks followings these tragedies. Although condition have somewhat now have returned to near normality, the cost of travel, transportation and communication has risen in order to pay for increased controls and protection. This is like the imposition of a tariff or tax on international transactions and tend tends to slow down the process of globalization. The challenge is how to make globalization more inclusive and give it a more human face by spreading its benefits more equitably around the world.
Although the pure theory of international trade has much in common with the micro-economic theory, for obvious reasons trade theory should be and treated as a spate discipline. Nevertheless, a clear comprehension of the micro-economic concepts is essential for the exploration of various issues that arise in the field of international trade.
Mercantilists view on Trade
Economics as an organized science can be said to have originated with the publication in 1776of the Wealth of Nations by Adam Smith. However, writings on International Trade preceded this date in such countries as England, Spain, France, Portugal, and the Netherland as they developed into modern national states. Specifically, during the seventeenth and eighteenth centuries a group of men (merchants, bankers, government officials, and even philosophers) wrote essays and pamphlets on international trade that advocated on economic philosophy known as mercantilism. Briefly, the mercantilism maintained that the way for a nation to become rich and powerful was to export more than it imported. The resulting export surplus would be settled by an inflow of bullion, or precious metals, primarily gold and silver. The more gold and silver a nation had; the richer and more powerful it was. Thus, the government has to do all in its power to stimulate the nation’s exports and discourage and restrict imports (particularly the import of luxury consumption goods). However, since all nations could not simultaneously have an export surplus and the amount of gold and silver was fixed at any particular point in time, one nation could gain only at the expense of other nations. The mercantilists thus preached economic nationalism, believing as they did that national interests were basically in conflict.
The mercantilists measured the wealth of nation by the stock of precious metals it possessed. In contrast, today we measure the wealth of a nation by its stock of human, man-made, and natural resources available for producing goods and services. The greater this stock of useful resources, the greater is the flow of goods and services to satisfy human wants, and the higher the standard of living in nations.
At a more sophisticated level of analysis, there were more rational reasons for the mercantilist’s desire for the accumulation of precious metals. This can be understood if it is remembered that the mercantilists were writing primarily for rulers and to enhance national power. With more gold, rulers could maintain larger and better armies and consolidate their power at home; improved armies and navies also made it possible for them to acquire more colonies. In addition, more gold meant more money (i.e. more gold coins) in circulation and greater business activity. Furthermore, by encouraging exports and restricting imports, the government would stimulate national output and employment.
In any event, mercantilists advocated strict government control of all economic activity and preached economic nationalism because they believed that the nation could gain in trade only at the expense of other nations. These views are important for two reasons. First, the ideas of Adam Smith, David Ricardo, and other classical economists’ can best be understood if they are regarded as reactions to the mercantilists’ views on trade and on the role of the government. Secondly, today there seems to be a resurgence of neo-mercantilism, as nations plagued by high levels of unemployment seeks to restrict imports in an effort to stimulate domestic production and employment.
Mercantilism theory gives an answer to the question that why do nations trade. This theory was very popular in eighteenth century when gold was the only currency. Mercantilism holds that a government can improve the economic well-being of the country by encouraging exports and stifling imports. The result is a positive balance of trade that leads to wealth (gold) flowing in the country. While most international trade experts believe that mercantilism is a simplistic and erroneous theory, it has had followers.
Theory of absolute advantage
Adam smith started with simple truth that for two nations to trade with each other voluntarily, both nations must gain. If one nation gain nothing or lost, it would simply refuse to trade. According to him, the trade between two nations is based on absolute advantage. This theory holds that, by specializing in the production of goods they can produce more efficiently than anyone else, nations can increase their economic well-being. When one nation is more efficient than or has an absolute advantage over another in the production f 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 each specializing in the production of the commodity of its absolute advantage and exchanging parts of its output with the other nation with the commodity of its absolute disadvantage. By this was, resources are utilized in the most efficient way and the output of both the commodities will rise. This increase in the output of both commodities measures the gain from specialization in production available to be divided between the two nations through trade.
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Since the nation as a whole benefits from trade, the gainers could compensate the losers, and there will still be a surplus to be distributed in some way. If such compensation did not take place, however, the losers would have an incentive to try to prevent the country from opening itself to trade. In this respect, a nation behaves no differently from an individual who does not attempt to produce all the commodities he need. Rather, he produces only that commodity that he can produce more efficiently and than exchanges part of his output for the other commodities he need or wants. This way, total output and welfare of all the individuals are maximized.
Thus, while the mercantilists believed that one nation could gain only at the expense of another nation and advocated strict government control of all economic activity and trade. Adam Smith and all other classical economists who followed him believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire; i.e. the government interference with the economic system would be as little as possible. Free trade would cause world resources to be utilized most efficiently and would maximize world welfare.
This simple model of absolute advantage has several important implications for international trade:
If a country has an absolute advantage in producing a product, there exists a potential for gain from trade.
The more a country is able to specialize in the production of good it produces most efficiently, the greater its potential gains in national well-being.
Within one country the competitive market does not evenly distribute the gain from trade.
The government also restricts this type of trade in order to protect the industries which are important for national defense.
In view of this belief, it seems paradoxical that today most nations impose many restrictions on the free flow of international trade. Trade restrictions are invariably rationalized in terms of national welfare. In reality, trade restrictions are advocated by few industries and their workers who are hurt by imports. As such trade restrictions benefit the few at the expense of many who will have to pay higher prices for competing domestic goods.
This theory served the interest of factory owners who were able to play lower wages because of cheaper food imports and harmed landowners because food become less scarce due to cheaper imports and it shows the link between social pressures and the development of new economic theories to support them.
A more complicated picture of the determinants and effects of trade emerge when one of the trading partners has an absolute advantage in the production of both goods. The trade under these conditions still brings gains, as David Ricardo first demonstrated this in his theory of comparative advantage.
Theory of Comparative Advantage
In 1817 Ricardo published his Principles of Political Economy and Taxation, in which he presented the law of comparative advantage. This is one of the most important and still unchallenged laws of economics, with many practical applications.
The law of comparative advantage says that, even if one nation is less efficient than, i.e. has an absolute advantage with respect to the other nation in the production of both commodities, there is still a basis for mutually beneficial trade. The first nation should specialize in the production of and export commodity in which its absolute disadvantage is smaller and import the commodity in which its absolute disadvantage is greater. The former is the commodity of its comparative advantage and later is the commodity of comparative disadvantage.
The key to the whole thing is that the theory of comparative advantage says that it is advantageous for us to import some goods simply in order to free up our workforce to produce more-valuable goods instead. We, as a nation, have better things to do with our time than produce these less valuable goods.
As a result, it is sometimes advantageous for us to import goods from less efficient nations. This logic doesn’t only apply to our time, i.e. our man-hours of labor, either. It also applies to our land, capital, technology, and every other finite resource used to produce goods. Economists call the resources we use to produce products “factors of production.” So the theory of comparative advantage says that if we could produce something more valuable with the resources we currently use to produce some product, then we should import that product, free up those resources, and produce that more valuable thing instead.
So if we have complete freedom to trade, we can systematically shrug off all our least valuable tasks and reallocate our time to our most valuable ones. Similarly, nations can systematically shrink their least valuable industries and expand their most valuable ones. This benefits these nations and under global free trade, with every nation doing this, it benefits the entire world. The world economies, and every nation in it, become as productive as they can possibly be.
This all implies that under free trade, production of every product will automatically migrate to the nation that can produce it at the lowest opportunity cost-the nation that wastes the least opportunity by being in that line of business.
The theory of comparative advantage thus sees international trade as a vast interlocking system of tradeoffs, in which nations use the ability to import and export to shed opportunity costs and reshuffle their factors of production to their most valuable uses. And this all happens automatically, because if the owners of some factor of production find a more valuable use for it, they will find it profitable to move it to that use. The natural drive for profit will steer all factors of production to their most valuable uses, and opportunities will never be wasted.
It follows that any policy other than free trade just traps economies producing less-valuable output than they could have produced. It burdens them with higher opportunity costs-more opportunities thrown away- than they would otherwise incur. In fact, when imports drive a nation out of an industry, this must actually be good for that nation, as it means the nation must be allocating its factors of production to producing something more valuable instead. If it weren’t doing this, the logic of profit would never have driven its factors out of their former uses. In the language of the theory, the nation’s “revealed comparative advantage” must lie elsewhere, and it will now be better off producing according to this newly revealed comparative advantage.
The theory of comparative advantage is sometimes misunderstood as implying that a nation’s best move is to have as much comparative advantage as it can get-ideally, comparative advantage in every industry. This is actually impossible by definition. If a country had superior productivity, therefore lower direct costs, and therefore absolute advantage, in every industry, it would still have a greater margin of superiority in some industries and a lesser margin in others. Resulting, it would have comparative advantage where its margin was greatest and comparative disadvantage where it was smallest. This pattern of comparative advantage and disadvantage would determine the imports and exports of the country.
The theory of comparative advantage is thus a wonderfully optimistic construct. Not only does it explain the complex web of international trade at a single stroke, but it also tells us what to do and guarantees that the result will be the best outcome we could possibly have obtained.