Vocabulary List
- Trade Surplus: When a country’s exports exceed its imports.
- Trade Deficit: When a country’s imports exceed its exports.
- Balance of Payments (BoP): A record of all economic transactions between a country and the rest of the world.
- Current Account: The section of the BoP that tracks trade in goods and services, net income, and transfers.
- Capital and Financial Account: The section of the BoP that tracks financial flows, including investments and foreign reserves.
- Net Exports (X – M): The value of exports minus imports, a key component of GDP.
- Exchange Rate: The price of one currency in terms of another currency.
- Appreciation: When a currency gains value relative to another currency.
- Depreciation: When a currency loses value relative to another currency.
- Floating Exchange Rate: A system where exchange rates are determined by supply and demand in the foreign exchange market.
- Fixed Exchange Rate: A system where a country’s government or central bank sets and maintains an exchange rate.
- Managed Exchange Rate (Dirty Float): A system where exchange rates fluctuate but central banks intervene to stabilize them when necessary.
- Purchasing Power Parity (PPP): The theory that exchange rates should adjust so that identical goods cost the same in different countries.
- Foreign Exchange Market (Forex): The global market for buying and selling currencies.
- Tariff: A tax on imported goods.
- Quota: A limit on the quantity of a good that can be imported.
- Subsidy: A government payment to domestic producers to make their goods cheaper relative to imports.
- Trade Barrier: Any policy that restricts international trade (e.g., tariffs, quotas, or subsidies).
- Free Trade Agreement: An agreement between countries to reduce or eliminate trade barriers.
- Comparative Advantage: The ability of a country to produce a good at a lower opportunity cost than another country.
- Absolute Advantage: The ability of a country to produce a good more efficiently than another country.
- Protectionism: The use of trade barriers to shield domestic industries from foreign competition.
- Terms of Trade: The ratio of export prices to import prices, indicating how much a country can import for each unit of its exports.
- Trade Liberalization: The reduction or removal of trade barriers to encourage free trade.
Need to test your knowledge of Trade or Balance of Payments? Check out our AP Macro Notes on Trade, Balance of Payments, and Exchange Rates.
1. Trade and Its Importance
Trade allows countries to specialize in goods they can produce efficiently and exchange them for goods they cannot produce as efficiently. The benefits of trade include:
- Increased Efficiency: Countries produce goods where they have a comparative advantage.
- Greater Variety: Consumers have access to a wider range of goods and services.
- Lower Prices: Competition from foreign producers keeps prices down.
- Economic Growth: Trade can increase output and employment.
Comparative vs. Absolute Advantage
- Absolute Advantage: A country has an absolute advantage when it can produce more of a good using the same resources as another country.
- Comparative Advantage: A country has a comparative advantage when it can produce a good at a lower opportunity cost than another country.
Example of Comparative Advantage
If the U.S. produces 10 cars or 5 computers and Japan produces 8 cars or 4 computers, the U.S. has a comparative advantage in computers (lower opportunity cost), while Japan has a comparative advantage in cars.
2. Balance of Payments (BoP)
The Balance of Payments (BoP) records all economic transactions between residents of a country and the rest of the world. It consists of two main accounts:
Current Account
Tracks the flow of goods, services, income, and transfers.
- Trade Balance (X – M): The difference between exports and imports.
- Net Income: Profits, interest, and dividends from investments abroad.
- Transfers: Foreign aid, remittances, and pensions.
A current account surplus means more money is coming into the country than leaving, while a current account deficit means the opposite.
Capital and Financial Account
Tracks investment flows and changes in foreign exchange reserves.
- Foreign Direct Investment (FDI): When a firm or individual invests in business operations in another country.
- Portfolio Investment: Buying stocks, bonds, or other financial assets in another country.
- Official Reserves: The foreign currency reserves held by a country’s central bank.
Since all transactions are recorded, the sum of the Current Account + Capital/Financial Account should theoretically equal zero.
3. Exchange Rates and Their Impact
An exchange rate is the price of one currency relative to another. Exchange rates impact trade and economic stability.
Types of Exchange Rate Systems
- Floating Exchange Rate:
- Determined by supply and demand in the forex market.
- Example: The U.S. dollar, euro, and Japanese yen.
- Advantage: Adjusts automatically to economic conditions.
- Disadvantage: Can be volatile, affecting businesses and investors.
- Fixed Exchange Rate:
- The central bank maintains a set value for the currency.
- Example: The Chinese yuan was pegged to the U.S. dollar for many years.
- Advantage: Provides stability for international trade.
- Disadvantage: Requires constant intervention and reserves.
- Managed Exchange Rate (Dirty Float):
- Mostly market-determined but with occasional central bank intervention.
- Example: India and Russia use this system.
Factors Affecting Exchange Rates
- Interest Rates: Higher interest rates attract foreign capital, increasing demand for the currency and causing appreciation.
- Inflation: Higher inflation reduces purchasing power, leading to depreciation.
- Trade Balance: A trade surplus increases demand for the domestic currency, leading to appreciation.
- Speculation: Investors buying a currency in anticipation of appreciation can drive up its value.
4. Trade Policies and Their Effects
Trade Barriers
Governments use trade barriers to protect domestic industries, but these can lead to inefficiencies and retaliation.
- Tariffs: Taxes on imports that raise prices for consumers but protect domestic industries.
- Quotas: Limits on the number of goods imported, reducing foreign competition.
- Subsidies: Government payments to domestic producers to lower production costs.
Free Trade Agreements and Organizations
- World Trade Organization (WTO): Promotes global trade and resolves disputes.
- North American Free Trade Agreement (NAFTA) / USMCA: Eliminated tariffs between the U.S., Canada, and Mexico.
- European Union (EU): A single market allowing free movement of goods, services, and labor.
5. The Relationship Between Exchange Rates and Trade Balance
- Stronger Currency:
- Pros: Makes imports cheaper, reducing inflation.
- Cons: Makes exports more expensive, reducing demand for domestic goods abroad.
- Weaker Currency:
- Pros: Makes exports cheaper and boosts trade.
- Cons: Increases import prices, potentially leading to inflation.
Example of Exchange Rate Impact
If the U.S. dollar depreciates against the euro:
- European goods become more expensive for Americans, reducing imports.
- American goods become cheaper for Europeans, increasing exports.
- The U.S. trade deficit decreases.
Mark is an A-Level Economics tutor who has been teaching for 6 years. He holds a masters degree with distinction from the London School of Economics and an undergraduate degree from the University of Edinburgh.