International trade and finance shape global economic relationships. Countries exchange goods, services, and capital, creating complex networks of trade balances and financial flows. Understanding these dynamics is crucial for grasping how economies interact on a global scale.

Comparative advantage drives international trade, with nations specializing in goods they can produce most efficiently. This concept, based on opportunity costs, explains why countries trade and how they benefit from it. Trade balances and foreign investment are closely linked, influencing each other and shaping global economic integration.

International Trade and Finance

Trade balances and capital flows

• Difference between a country's exports and imports determines its trade balance
  • Positive trade balance (surplus) when exports exceed imports
  • Negative trade balance (deficit) when imports exceed imports
• International financial capital flows involve movement of money across borders for investment
  • Capital inflows when foreign investors buy domestic assets or lend to domestic economy
  • Capital outflows when domestic investors buy foreign assets or lend to foreign economies
• Trade balances and international financial capital flows are interconnected
  • Trade deficit financed by net capital inflows from abroad
    • Country must borrow or attract foreign investment to pay for excess imports
  • Trade surplus balanced by net capital outflows to other countries
    • Country can lend or invest in foreign assets with surplus
• Exchange rates influence trade balances and capital flows
  • A stronger currency makes exports more expensive and imports cheaper, potentially leading to trade deficits
  • A weaker currency has the opposite effect, potentially leading to trade surpluses

Comparative advantage through opportunity costs

• Comparative advantage is ability to produce a good or service at lower opportunity cost than another country
  • Opportunity cost is value of next best alternative forgone when making a decision
• Calculating comparative advantage using opportunity costs:
  • Determine opportunity cost of producing each good in each country
    • Opportunity cost = $\frac{Quantity \space of \space good \space Y \space given \space up}{Quantity \space of \space good \space X \space produced}$
  • Compare opportunity costs between countries
    • Country with lower opportunity cost for a good has comparative advantage in producing it
• Example: Country A can produce 1 unit of Good X or 2 units of Good Y, Country B can produce 1 unit of Good X or 4 units of Good Y
  • Country A's opportunity cost of producing Good X: $\frac{2 \space units \space of \space Y}{1 \space unit \space of \space X} = 2$
  • Country B's opportunity cost of producing Good X: $\frac{4 \space units \space of \space Y}{1 \space unit \space of \space X} = 4$
  • Country A has comparative advantage in producing Good X with lower opportunity cost (2) than Country B (4)
• Terms of trade affect the benefits countries receive from international trade based on their comparative advantages

Trade balance vs foreign investment

• Balanced trade occurs when value of country's exports equals value of imports
  • Trade balance is zero in this case
• Foreign investment involves purchase of assets in a country by foreign entities
  • Foreign direct investment (FDI) establishes or acquires business in another country
  • Foreign portfolio investment purchases financial assets (stocks, bonds) in another country
• Capital movements involve flow of financial capital across borders
  • Can be investments, loans, or other financial transactions
• Relationship between balanced trade, foreign investment, and capital movements:
  • Balanced trade leads to balanced capital account
    • Capital account records international transactions related to investments and capital movements
  • Trade deficit results in capital account surplus
    • Capital account surplus represents net foreign investment and inflows to finance trade deficit
  • Trade surplus results in capital account deficit
    • Capital account deficit represents net foreign investment and outflows from excess savings generated by trade surplus

Global Economic Integration

Trade balances and capital flows

• Balance of payments (BOP) records all international transactions for a country over specific period
  • Consists of current account, capital account, and financial account
  • Current account includes trade balance (exports minus imports) and net income from abroad
  • Capital account includes capital transfers and acquisition/disposal of non-produced, non-financial assets
  • Financial account includes transactions involving financial assets and liabilities between residents and non-residents
• BOP must always balance, sum of current account, capital account, and financial account should equal zero
  • Current account deficit financed by capital and financial account surplus (net inflows)
  • Current account surplus balanced by capital and financial account deficit (net outflows)
• Changes in trade balance affect international financial capital flows
  • Increase in trade deficit may lead to increased foreign borrowing or selling domestic assets to foreigners (capital inflows)
  • Increase in trade surplus may lead to increased lending to foreign countries or purchasing foreign assets (capital outflows)

Comparative advantage through opportunity costs

• Absolute advantage is ability to produce a good using fewer resources than another country
  • Determined by comparing productivity of countries in producing specific good
• Comparative advantage considers opportunity costs of production and determines which country should specialize
  • Country should specialize in producing and exporting goods for which it has comparative advantage
  • Country should import goods for which it has comparative disadvantage
• Law of comparative advantage states specialization based on comparative advantages increases total output, benefiting all countries
• Calculating comparative advantage using opportunity costs:
  • Formula: $Opportunity \space cost \space of \space Good \space X = \frac{Quantity \space of \space Good \space Y \space given \space up}{Quantity \space of \space Good \space X \space produced}$
  • Country with lower opportunity cost for a good has comparative advantage in producing it
  • Each country should specialize in producing good for which it has lower opportunity cost

Trade balance vs foreign investment

• Balanced trade and its impact on foreign investment and capital movements:
  • Balanced trade means net exports (exports minus imports) equal zero
  • Implies country's savings equal its investments
    • Savings = Domestic Investment + Net Exports
    • If Net Exports = 0, then Savings = Domestic Investment
  • No net foreign investment or net capital movements in this case
• Trade imbalances and their impact on foreign investment and capital movements:
  • Trade deficit (negative net exports) implies country's savings less than investments
    • Country must attract foreign capital inflows to finance deficit
    • Can be foreign direct investment, portfolio investment, or borrowing
  • Trade surplus (positive net exports) implies country's savings exceed investments
    • Country can invest excess savings abroad, leading to capital outflows
    • Can be foreign direct investment, portfolio investment, or lending
• Relationship between trade balances, foreign investment, and capital movements ensures BOP always balances
  • Trade deficit (current account deficit) offset by capital and financial account surplus (net capital inflows)
  • Trade surplus (current account surplus) offset by capital and financial account deficit (net capital outflows)

International Economic Systems and Policies

• Globalization has increased economic interdependence between countries through trade, investment, and financial flows
• The international monetary system facilitates global trade and investment by providing a framework for currency exchange and international payments
• Protectionism involves government policies that restrict international trade to protect domestic industries, potentially affecting trade balances and capital flows