Memory tricks for international trade

Q: Explain comparative advantage and why free trade benefits both countries.

A: Absolute advantage means producing more output per unit of input — a country is simply more productive. Comparative advantage means producing at a lower opportunity cost. Ricardo's 1817 insight: both countries gain from trade when each specializes according to comparative advantage, even if one country has absolute advantage in producing everything. The logic: total world output rises when each country allocates resources to the use where they are relatively most productive. Both countries can then consume combinations beyond their individual Production Possibilities Frontiers. The terms of trade — the exchange ratio between goods — must fall between both countries' opportunity costs for trade to benefit both. Criticisms include that the model assumes full employment, ignores distributional effects within countries, and does not account for dynamic comparative advantage where industries develop competitive strength through learning and investment rather than inheriting it from initial factor endowments.

Q: Explain exchange rate determination and how currency movements affect trade balances.

A: The exchange rate is determined by supply and demand in foreign exchange markets. Demand for dollars arises from foreigners buying US goods and services (exports), purchasing US assets, or holding dollars as reserve currency. Supply of dollars arises from Americans buying foreign goods (imports) and foreign assets. When the dollar appreciates, US exports become more expensive for foreigners so export volume falls, and US imports become cheaper so import volume rises — the trade balance worsens. Depreciation has the opposite effects — exports become cheaper and imports more expensive, improving the trade balance. Key determinants of exchange rates: relative inflation rates (high domestic inflation causes depreciation through purchasing power parity), relative interest rates (higher US rates attract capital inflows, appreciating the dollar), current account balances, and speculation. The Mundell impossible trinity: a country cannot simultaneously maintain a fixed exchange rate, allow free capital flows, and conduct independent monetary policy — one must be sacrificed.

Q: What is the Balance of Payments and why must it always sum to zero?

A: The Balance of Payments is the systematic record of all economic transactions between residents of a country and the rest of the world during a period. The Current Account records trade in goods (the merchandise trade balance), trade in services (tourism, financial services, software), primary income (wages and investment income flowing across borders), and secondary income (remittances and foreign aid). The Financial Account records cross-border investment: foreign direct investment (building factories), portfolio investment (buying stocks and bonds), other investment, and changes in official reserve assets. The identity CA + KA + FA = 0 holds always because every transaction has two sides recorded in offsetting accounts. When the US imports more than it exports (current account deficit), foreigners accumulate dollars which they use to buy US assets — recording a financial account surplus of equal size. This means a persistent trade deficit is not necessarily a sign of economic weakness — it reflects that foreigners want to invest in the US more than Americans want to invest abroad.

Q: Compare the economic arguments for and against protectionism.

A: Arguments for protection: National security — some industries must remain domestic regardless of cost, widely accepted for genuine defense needs but the definition is easily abused. Infant industry — temporary protection allows new industries to achieve economies of scale and learning before facing foreign competition, valid in theory but protection rarely proves temporary and often protects inefficient incumbents. Jobs protection — tariffs save jobs in the protected sector, but destroy more jobs in export industries through retaliation and raise costs for all consumers. Anti-dumping — selling below cost to eliminate competitors then raise prices, WTO allows countervailing duties. Arguments for free trade: comparative advantage means specialization raises total world output. Consumer gains from lower prices and greater variety. Competition spurs domestic efficiency and innovation. Political economy of protection: the losses from trade are concentrated among specific workers and firms who organize politically, while the gains are dispersed among all consumers who have little individual incentive to lobby. This systematic bias explains why protection persists despite its economic costs. Trade adjustment assistance for displaced workers is critical for the political sustainability of free trade agreements.

Q: Explain the role of the WTO, IMF, and World Bank in the global economy.

A: World Trade Organization (WTO, founded 1995, 164 members): successor to GATT. Functions: forum for negotiating multilateral trade liberalization (Uruguay Round, stalled Doha Round), administering trade agreements under the most-favored-nation principle (any advantage given to one member must be given to all) and national treatment (imported goods treated same as domestic after entry), and binding dispute resolution between member countries. Challenges include the stalled Doha Round, the rise of bilateral and regional agreements, and debates over China's compliance. International Monetary Fund (IMF, Bretton Woods 1944, 190 members): surveillance of member economies to identify risks, emergency financial assistance during balance of payments crises with conditionality (structural reform requirements), and technical assistance. Criticized for imposing overly severe austerity conditions, especially during the 1997-98 Asian financial crisis. World Bank Group: long-term development lending through the IBRD (middle-income countries) and IDA (concessional loans to poorest countries) focused on infrastructure, education, health, and governance. Criticized for imposing a single development model and sometimes ignoring environmental and social costs. Complementary roles: WTO handles trade rules, IMF handles monetary stability and crises, World Bank handles long-term development finance.