International Trade Theory & Balance of Payments - International Business | International Business - B Com PDF Download

International Trade Theory deals with the different models of international trade that have been developed to explain the diverse ideas of exchange of goods and services across the global boundaries. The theories of international trade have undergone a number of changes from time to time. The basic principle behind international trade is not very much different from that involved in the domestic trade. The primary objective of trade is to maximize the gains from trade for the parties engaged in the exchange of goods and services. Be it domestic or international trade, the underlying motivation remains the same. The cost involved and factors of production separate international trade from domestic trade.

International trade involves across border exchange and this increases the cost of trading. Factors like tariffs, restrictions, time costs and costs related with legal systems of the countries involved in trade make the international trade a costly affair; whereas the extent of restrictions and legal hassles are considerably low in case of domestic trade.

When it comes to the comparison between international trade and domestic trade, the factors of production assume a crucial role. There is no denying that mobility of factors of production is less across nations than within the domestic territory. The incidence of trade in factors of production like labor and capital is very common in case of domestic trade; while in case of international trade exchange of goods and services contributes the major share of the total revenue.

International trade theory has always been a preferred field of research amongst the traditional and contemporary economists. The international trade models attempt to analyze the pattern of international trade and suggest ways to maximize the gains from trade.

Among the different international trade theories, the Ricardian model, the Heckscher-Ohlin model and the Gravity model of trade are worth mentioning.

The Ricardian model of international trade is developed on the theory of comparative advantage. According to this model countries involved in trade, specialize in producing the products in which they have comparative advantage.

The Heckscher-Ohlin model put stress on endowments of factors of production as basis for international trade. As per this theory countries will specialize in and export those products, which make use of the domestically abundant factors of production more intensively than those factors, which are scarcely available in the home country.

The Gravity model of trade provides an empirical explanation of international trade. According to this model, the economic sizes and distance between nations are the primary factors that determine the pattern of international trade.

The international trade theories also deal with challenges before international trade, international trade laws, rules of international trade and many other related issues.

Balance of Payments: Accounting Concepts of Foreign Trade

The balance of Payments (BoP) and Balance of Trade (BoT) are two confusing concepts for even economics graduates. These terms are connected with international trade accounting. In this post, we provide a mind-map approach to study Balance of Payments. 

What is Balance of Payments (BoP)?

• The balance of payments (BoP) record the transactions in goods, services, and assets between residents of a country with the rest of the world for a specified time period typically a year.

• It represents a summation of country’s current demand and supply of the claims on foreign currencies and of foreign claims on its currency.

• There are two main accounts in the BoP – the current account and the capital account.

• Current Account: The current account records exports and imports in goods, trade in services and transfer payments.

• Capital Account: The capital account records all international purchases and sales of assets such as money, stocks, bonds, etc. It includes foreign investments and loans.

• Note: The IMF accounting standards of the BOP statement divides international transactions into three accounts: the current account, the capital account, and the financial account, where the current account should be balanced by capital account and financial account transactions. But, in countries like India, the financial account is included in the capital account itself.

Balance of Payments: Mindmap

What would happen if a country spends more than it receives from abroad?

What would happen if an individual spends more than his income? He must finance the same by some other means, right? It may be by borrowing or by selling assets.

The same way, if a country has a deficit in its current account (spending more abroad than it receives from sales to the rest of the world), it must finance it by borrowing abroad or selling assets. Thus, any current account deficit is of necessity financed by a net capital inflow.

Filling Current Account Deficit with Foreign Exchange Reserves

A country could also engage in official reserve transactions, running down its reserves of foreign exchange, in the case of a deficit by selling foreign currency in the foreign exchange market. But, official reserve transactions are more relevant under a regime of pegged exchange rates than when exchange rates are floating.

A country is said to be in balance of payments equilibrium when the sum of its current account and its non-reserve capital account equals zero so that the current account balance is financed entirely byinternational lending without reserve movements.

Note: A BOP surplus is accompanied by an accumulation of foreign exchange reserves by the central bank.

Ideally, BoP should be Zero! How?

From a balance of international payments point of view, a surplus on the current account would allow a deficit to be run on the capital account. For example, surplus foreign currency can be used to fund investment in assets located overseas. Also, if a country has a current account deficit (trade deficit), it will borrow from abroad.

In reality, the accounts do not exactly offset each other, because of statistical discrepancies, accounting conventions and exchange rate movements that change the recorded value of transactions.

BoP Deficit or Surplus

• The decrease (increase) in official reserves is called the overall balance of payments deficit (surplus).

• The balance of payments deficit or surplus is obtained after adding the current and capital account balances.

• The balance of payments surplus will be considered as an addition to official reserves (reserve use).

BoP Crisis

• Countries with current account deficits can run into difficulties. If the deficit is large and the economy is not able to attract enough inflows of foreign investment, then their currency reserves will dwindle.

• There may come a point when the country needs to seek emergency borrowing from institutions such as the International Monetary Fund, that may lead to external debt.

• Countries with deficits in their current accounts will build up increasing debt and/or see increased foreign ownership of their assets.

• BoP crisis is also known as the currency crisis.

Autonomous Transactions vs  Accommodating Transactions

• International economic transactions are called autonomous when transactions are made independently of the state of the BoP (for instance due to profit motive).

• These items are called ‘above the line’ items in the BoP.

• The balance of payments is said to be in surplus (deficit) if autonomous receipts are greater (less) than autonomous payments.

• Accommodating transactions (termed ‘below the line’ items), on the other hand, are determined by the net consequences of the autonomous items, that is, whether the BoP is in surplus or deficit.

• The official reserve transactions are seen as the accommodating item in the BoP (all others being autonomous).

Errors and Omissions

Errors and Omissions constitute the third element in the BoP (apart from the current and capital accounts) which is the ‘balancing item’ reflecting our inability to record all international transactions accurately.

BoT vs BoP

• The balance of Trade (BoT) or Trade Balance is a part of the Balance of Payments (BoP). BoT just includes the balance between export and import of goods.

• BoP not only adds the service-trade but also many other components in the current account (Eg: Transfer payments) and capital account (FDI, loans etc).

Rupee Convertibility

Indian rupee is fully convertible only in the current account and not in the capital account.

Things to note:

• If an Indian investor earns interest or dividend in his investment abroad, that will be included in the current account of India.

• If FDI is done by an American company in India, that investment will be accounted in the capital account of India.

• NRI deposits are calculated under Capital Accounts while Private Remittances are calculated under Current Account.

• In general, National Income (Y) = Private Consumption Expenditure (C) + Investment (I) + Government Expenditure (G) + Net Exports (E).

• In a closed economy, Savings (S) = Investment (I).

• In an open economy, Savings (S) = Investment (I) + Net Exports (E)

• OR, Net Exports = Savings – Investment. This is actually the Balance of Trade (Trade Balance).