Foreign Exchange Market and International Trade Theory

8/7/2019 Foreign Exchange Market and International Trade Theory

1/11

Assignment No:1Assignment No:1 Managerial EconomicsManagerial Economics

INTERNATIONAL TRADE THEORYINTERNATIONAL TRADE THEORY&&

FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET

Submitted on 11/01/2010Submitted on 11/01/2010

Submitted to: SubmittedSubmitted to: Submittedby:by:Malati Subba (Lecturer) Vinaya VijayanMalati Subba (Lecturer) Vinaya VijayanSub:Sub: Managerial Economics MBA; 1Managerial Economics MBA; 1stst SemSem

1


2/11


International Trade Theory and ForeignInternational Trade Theory and Foreign

Exchange MarketExchange MarketAmericans drive cars made in Germany, use VCRs made in Japan and wearclothing made in China. Japanese watch American movies, Egyptians drinkAmerican cola and Swedes jog in American running shoes. Whole worldconsumes Iraqi Oil; India stands on top of BPO services examples are endless.The world economy is more integrated than ever before.

What is international trade?

International trade shapes our everyday lives and the world we live in.Nearly every time we make a purchase we are participating in the globaleconomy. Products and their components come to our store shelves from allover the world.

International trade is the system by which countries exchange goods andservices. Countries trade with each other to obtain things that are betterquality, less expensive or simply different from what is produced at home.

Goods and services that a country buys from another country are calledimports, and goods and services that are sold to other countries are called

exports. Trade mostly takes place between companies. However,governments and individuals frequently buy and sell goods internationally.

Basis of International Trade::

The basis of international trade is the difference in the resourceendowments of different nations. That is, trade between the nations takesplace because nations differ in their resource endowments. Resourceendowment means availability of natural and man-made resources can beused to produce goods and services. While Arab countries are rich in oil, theyare deficient in man power and technology. While India has large supply ofhuman power, it lacks capital and technology. While Japan is advanced intechnology, it lacks iron ore and coal. Russia with largest area and highlyadvanced technology lacks agricultural potential. This kind of unevendistribution of resources is the basis of foreign trade.

Theory of International trade:

The theories of international trade provide answer to the questionwhy there is trade between the nations, i.e. why nations export and importgoods and services. The theory of international trade seeks to answer such

questions as: What is the basis of international trade? ,What determines

2


3/11


the volume and direction of foreign trade?, How are the gains from foreigntrade measured?

The theory of international trade has been growing with the growthof economic science from Adam Smiths theory of absolute advantage, to

Ricardos theory of comparative advantage, to Heckscher Ohlin theoriesof International trade.

I) Adam Smiths Theory of Absolute Advantage

A country tends to specialize in production of commodities whichit has absolute advantage in cost of production. This common sense logic ofinternational division of labour was suggested by Adam Smith.

Adam Smiths theory of absolute advantage can beillustrated through a simple, hypothetical two country and two commodity example. Let us suppose that per quintal labour cost ofproduction of rice and jute in India and Bangladesh is given as in :-

Country Rice Jute

India 30 60Bangladesh 50 20

Per Quintal Labour Cost (Man hour)

As table shows, India needs 30 man-hours to produceone quintal of rice whereas Bangladesh needs 50 man-hours. The cost of riceproduction in India is thus much lower than that in Bangladesh. India has anabsolute advantage in rice production. In case of jute production, whileBangladesh needs 20 man-hours to produce one quintal of jute, India needs60 man-hours. Thus, Bangladesh has absolute advantage in jute production.According to theory, India would specialize in rice production and importjute and Bangladesh would specialize in jute production and import rice.

According to Adam Smith, trade between the twocountries will prove advantageous to both since both of them can avail,

given their labour force, a larger quantity of both the commodities and at alabour cost.

II) Ricardos Theory of Comparative Advantage

The theory of absolute advantage gives impressionthat trade between two countries can be possible and mutually gainful onlyif both countries have absolute advantage in the production of at least onecommodity.

However, the Ricardian theory of comparative

advantage suggests the possibility of gainful trade between two countrieseven if one has absolute advantage in the production of both the

3


4/11


commodities and the other absolute disadvantage in the production of bothcommodities. For example, let us suppose that in our two-country-two-commodity model, India is more efficient in producing goods, rice and jute.

Country Rice Jute

India 30 60Bangladesh 50 80

As table shows, India can produce both the goods moreefficiently, i.e. at a lower cost, compared to Bangladesh. India hascomparative advantage in rice production because she needs only(30/50)100 = 60 per cent of the cost of rice production in Bangladesh. ButIndia has comparative disadvantage in jute production because her cost ofjute production is twice her cost of rice production. On the other hand,

Bangladesh has comparative advantage in jute production because herrelative cost of jute production is less than Indias. Therefore, if Indiaspecializes in rice production and Bangladesh in jute production and theytrade their surplus, both stand to gain.

Critical Appraisal of Theory

1. Labour is not homogenous2. Labour is not the only factor3. Demand-side ignored.4. Other criticisms

III) Heckscher Ohlin Theory of Trade

The theory of trade expounded by Heckscher and Ohlin is mostpopularly known as the Heckscher Ohlin theory of trade, also referred to asfactor endowment theory of trade or the modern theory of trade.TheHeckscher-Ohlin theory of trade states that comparative advantage in thecost of production is explained exclusively by the differences in the factorendowment of the nations.

Heckscher-Ohlin theories

It can be stated in the form of two theorems.

Theorem I Heckscher-Ohlin Trade Theorem: A country tends to specializein the export of a commodity whose production requires intensive use of itsabundant resources and imports a commodity whose production requiresintensive use of its scarce resources.

Theorem II Factor - Price Equalization Theorem: The international tradeequalizes the factor prices between the trading nations. The Heckscher

Ohlin theorem II postulates that foreign trade eliminates the factor pricedifferentials.

4


5/11


Trade: Important for economic well being

With the increase in volume, trade has become very important to theeconomic well-being of many countries. In early 1960s, the United Statesbought less than $1 billion of foreign cars and parts. By 2001, this figure hadincreased to more than $189 billion.

Financial ties between United States and the rest of the world have grownsignificantly over time:

Number of foreign banking offices operating in the United States rosefrom fewer than 40 to over 600 at present.

Amount of foreign direct investment (FDI) was $158 billion in 2001. Gross transactions of long-term U.S. government securities by

foreigners rose from $144 billion in 1978 to over $9.1 trillion in 2000.

Foreign direct investment is the amount of money individuals invest incompanies, assets and real estate of another country.

The cost of international transportation and communication has fallendrastically, resulting in greater integration among the economies of theworld. Because of this interdependence, economic trends and conditions in

one country can strongly affect prices, wages, employment and productionin other countries. Events in Tokyo, London and Mexico City have a directeffect on the everyday life of people in the U.S., just as the impact ofevents in New York, Washington and Chicago is felt around the globe. Ifstocks on the New York Stock Exchange plummet in value, the news istransmitted instantly worldwide, and stock prices all over the world mightchange. This means that countries have to work together more closely andrely on each other for prosperity.

World Trade is Diverse

Most international trade consists of the purchase and sale of industrialequipment, consumer goods, oil and agricultural products. Services such asbanking, insurance, transportation, telecommunications, engineering andtourism accounted for one-fifth of world exports in 2000.

Since the end of World War II, there has been a rapid increase ininternational trade.

In 1950, total world merchandise exports amounted to $58 billion In 2000, exports were $6.3 trillion, over a 100-fold increase

5


6/11


Benefits of Trade

Specialization and Its Benefits

To become wealthier, countries want to use their resourcesland, labor,capital and entrepreneurshipin the most efficient manner. However, thereare differences among countries in the quantity, quality and cost of theseresources. The advantages that a country may have vary:

abundant minerals climate suited to agriculture well trained labor force new innovative ideas highly developed infrastructure like good roads, telecommunications

system, etc.

Instead of trying to produce everything by themselves, countries oftenconcentrate on producing things that they can produce most efficiently.They then trade those for other goods and services. In doing so, both the

country and the world become wealthier.

6


7/11


Foreign Exchange Market: What is it?

To buy foreign goods or services, or to invest in other countries, companiesand individuals may need to first buy the currency of the country with whichthey are doing business. Generally, exporters prefer to be paid in their

countrys currency or in U.S. dollars, which are accepted all over the world.

When Indians buy oil from Saudi Arabia they may pay in U.S. dollars and notin Canadian dollars or Saudi dinars, even though the United States is notinvolved in the transaction.

The foreign exchange market, or the "FX" market, is where the buying andselling of different currencies takes place. The price of one currency interms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected bytelephone lines and computer screensthere is no central headquarters.There are three main centers of trading, which handle the majority of all FXtransactionsUnited Kingdom, United States, and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France andAustralia account for most of the remaining transactions in the market.Trading goes on 24 hours a day: at 8 a.m. the exchange market is firstopening in London, while the trading day is ending in Singapore and HongKong. At 1 p.m. in London, the New York market opens for business and laterin the afternoon the traders in San Francisco can also conduct business. As

the market closes in San Francisco, the Singapore and Hong Kong marketsare starting their day.

The FX market is fast paced, volatile and enormousit is the largest marketin the world. In 2001 on average, an estimated $1,210 billion was tradedeach dayroughly equivalent to every person in the world trading $195 eachday.

Foreign Exchange Market Participants

There are four types of market participantsbanks, brokers, customers, and

central banks.

Banks and other financial institutions are the biggest participants.They earn profits by buying and selling currencies from and to eachother. Roughly two-thirds of all FX transactions involve banks dealingdirectly with each other.

Brokers act as intermediaries between banks. Dealers call them tofind out where they can get the best price for currencies. Sucharrangements are beneficial since they afford anonymity to thebuyer/seller. Brokers earn profit by charging a commission on thetransactions they arrange.

Customers, mainly large companies, require foreign currency in thecourse of doing business or making investments. Some even have their

7


8/11


own trading desks if their requirements are large. Other types ofcustomers are individuals who buy foreign exchange to travel abroador make purchases in foreign countries.

Central banks, which act on behalf of their governments, sometimesparticipate in the FX market to influence the value of their

currencies.

With more than $1.2 trillion changing hands every day, the activity of theseparticipants affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

to earn short-term profits from fluctuations in exchange rates, to protect themselves from loss due to changes in exchange rates, and to acquire the foreign currency necessary to buy goods and services

from other countries.

Foreign Exchange Rates

Most common contact with foreign exchange occurs when we travel or buythings in other countries.

Suppose a U.S. tourist travelling in London wantsto buy a sweater. Price tag is 100 pounds.Current exchangerate

Price of sweater indollars

$1.45 to 1$1.30 to 1$1.60 to 1

PoundfallsPoundrises

100 x 1.45 =$145.00100 x 1.30 =$130.00100 x 1.60 =$160.00

Thus, small changes in exchange rates may notseem significant. But when billions of dollars aretraded, even a hundredth of a percentage pointchange in exchange rates becomes important.

Stronger USdollar implies

1. U.S. can buy foreign goodsmore cheaply

2. Foreigners find U.S. goodsmore expensive anddemand falls

Cost of purchasingforeign goods falls

Does not help firms thatproduce for exports

Weaker U.S.dollar implies

1. Foreigners buy more U.S.goods

Helps firms that rely on

8


9/11


2. Foreign goods becomemore expensive

exports

Demand for imports falls

It would seem logical that if the dollar weakens, the trade balance willimprove, as exports would rise. However, this does not always happen. U.S.trade balance usually worsens for a few months.

The Jcurve explains why the trade position does not improve soon after theweakening of a currency. Most import/export orders are taken months inadvance. Immediately after a currencys value drops, the volume of importsremains about the same, but the prices in terms of the home currency rise.On the other hand, the value of the domestic exports remains the same, andthe difference in values worsens the trade balance until the imports andexports adjust to the new exchange rates.

Exchange rates are an important consideration when making internationalinvestment decisions. The money invested overseas incurs an exchange raterisk.When an investor decides to "cash out," or bring his money home, anygains could be magnified or wiped out depending on the change in theexchange rates in the interim. Thus, changes in exchange rates can havemany repercussions on an economy:

affects the prices of imported goods

affects the overall level of price and wage inflation influences tourism patterns may influence consumers buying decisions and investors long-term

commitments.

Determination of Foreign Exchange Rates

Exchange rates respond directly to all sorts of events, both tangible andpsychological

business cycles;

balance of payment statistics; political developments; new tax laws; stock market news; inflationary expectations; international investment patterns; and government and central bank policies among others.

At the heart of this complex market are the same forces of demand andsupply that determine the prices of goods and services in any free market. Ifat any given rate, the demand for a currency is greater than its supply, itsprice will rise. If supply exceeds demand, the price will fall.

9


10/11


The supply of a nations currency is influenced by that nations monetaryauthority, (usually its central bank), consistent with the amount of spendingtaking place in the economy. Government and central banks closely monitoreconomic activity to keep money supply at a level appropriate to achievetheir economic goals.

Too muchmoney inflation value ofmoney declines prices rise

Too little money sluggish economicgrowth rising unemployment

Monetary authorities must decide whether economic conditions call for alarger or smaller increase in the money supply.

Sources for currency demand on the FX market:

The currency of a growing economy with relative price stability and awide variety of competitive goods and services will be more indemand than that of a country in political turmoil, with high inflationand few marketable exports.

Money will flow to wherever it can get the highest return with theleast risk. If a nations financial instruments, such as stocks andbonds, offer relatively high rates of return at relatively low risk,foreigners will demand its currency to invest in them.

FX traders speculate within the market about how different events

will move the exchange rates. For example: News of political instability in other countries drives up demand

for U.S. dollars as investors are looking for a "safe haven" for theirmoney.

A countrys interest rates rise and its currency appreciates asforeign investors seek higher returns than they can get in theirown countries.

Developing nations undertaking successful economic reforms mayexperience currency appreciation as foreign investors seek newopportunities.

After all this we can conclude that there is interdependency ininternational trade though it is a disputed topic that change inexchange rate affects the trade or is it vice-versa? Many expertsare expounding various theories and hypothesis to prove theirpoint.

10


11/11


11

Documents

Foreign Exchange Market and International Trade Theory