Reading 20. International Trade and Capital Flows explains the flows of goods and services, physical capital, and financial capital across national borders.

The reading explains how the different types of flows are linked and how trade may benefit trade partners.

The accounting for these flows and the institutions that facilitate and regulate them are also covered.

The payment system supporting trade and investment depends on world currency markets.

Investment practitioners need to understand how these markets function in detail because of their importance in portfolio management and economic analysis.

Reading 21. Currency Exchange Rates provides an overview of currency market fundamentals.

The candidate should be able to:

1. compare gross domestic product and gross national product;

2. describe benefits and costs of international trade;

3. distinguish between comparative advantage and absolute advantage;

4. explain the Ricardian and Heckscher–Ohlin models of trade and the source(s) of comparative advantage in each model;

5. compare types of trade and capital restrictions and their economic implications;

6. explain motivations for and advantages of trading blocs, common markets, and economic unions;

7. describe common objectives of capital restrictions imposed by governments;

8. describe the balance of payments accounts including their components;

9. explain how decisions by consumers, firms, and governments affect the balance of payments;

10. describe functions and objectives of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization.

Some countries may be attractive from an equity perspective because of their strong economic growth and the profitability of particular domestic sectors or industries. Other countries may be attractive from a fixed income perspective because of their interest rate environment and price stability. To identify markets that are expected to provide attractive investment opportunities, investors must analyze cross-country differences in such factors as expected GDP growth rates, monetary and fiscal policies, trade policies, and competitiveness.

From a longer term perspective investors also need to consider such factors as a country’s stage of economic and financial market development, demographics, quality and quantity of physical and human capital (accumulated education and training of workers), and its area(s) of comparative advantage.

International trade can facilitate economic growth by increasing the efficiency of resource allocation, providing access to larger capital and product markets, and facilitating specialization based on comparative advantage. The flow of financial capital (funds available for investment) between countries with excess savings and those where financial capital is scarce can increase liquidity, raise output, and lower the cost of capital. From an investment perspective, it is important to understand the complex and dynamic nature of international trade and capital flows because investment opportunities are increasingly exposed to the forces of global competition for markets, capital, and ideas.

defines basic terminology used in the reading and describes patterns and trends in international trade and capital flows. It also discusses the benefits of international trade, distinguishes between absolute and comparative advantage, and explains two traditional models of comparative advantage.

Section 3 describes trade restrictions and their implications and discusses the motivation for, and advantages of, trade agreements

Section 5 discusses the function and objectives of international organizations that facilitate trade.

Gross domestic product (GDP) measures the market value of all final goods and services produced by factors of production (such as labor and capital) located within a country/economy during a given period of time, generally a year or a quarter.

Gross national product (GNP) measures the market value of all final goods and services produced by factors of production (such as labor and capital) supplied by residents of a country, regardless of whether such production takes place within the country or outside of the country.

The difference between a country’s GDP and its GNP is that GDP includes, and GNP excludes, the production of goods and services by foreigners within that country, whereas GNP includes, and GDP excludes, the production of goods and services by its citizens outside of the country.

Countries that have large differences between GDP and GNP generally have a large number of citizens who work abroad (for example, Pakistan and Portugal), and/or pay more for the use of foreign-owned capital in domestic production than they earn on the capital they own abroad (for example, Brazil and Canada).

GDP is more widely used as a measure of economic activity occurring within the country, which, in turn, affects employment, growth, and the investment environment.

If a Greek shipping company transports the wine that the United States imports from France, the United States would classify the cost of shipping as an import of services from Greece and the wine would be classified as an import of goods from France.

The terms of trade are defined as the ratio of the price of exports to the price of imports, representing those prices by export and import price indices, respectively. The terms of trade capture the relative cost of imports in terms of exports. If the prices of exports increase relative to the prices of imports, the terms of trade have improved because the country will be able to purchase more imports with the same amount of exports.2 For example, when oil prices increased during 2007–2008, major oil exporting countries experienced an improvement in their terms of trade because they had to export less oil in order to purchase the same amount of imported goods. In contrast, if the price of exports decreases relative to the price of imports, the terms of trade have deteriorated because the country will be able to purchase fewer imports with the same amount of exports. Because each country exports and imports a large number of goods and services, the terms of trade of a country are usually measured as an index number (normalized to 100 in some base year) that represents a ratio of the average price of exported goods and services to the average price of imported goods and services.

Net exports is the difference between the value of a country’s exports and the value of its imports (i.e., value of exports minus imports). If the value of exports equals the value of imports, then trade is balanced. If the value of exports is greater (less) than the value of imports, then there is a trade surplus (deficit) . When a country has a trade surplus, it lends to foreigners or buys assets from foreigners reflecting the financing needed by foreigners running trade deficits with that country. Similarly, when a country has a trade deficit, it has to borrow from foreigners or sell some of its assets to foreigners. Section 4 on the balance of payments explains these relationships more fully.

Net exports is the difference between the value of a country’s exports and the value of its imports (i.e., value of exports minus imports). If the value of exports equals the value of imports, then trade is balanced. If the value of exports is greater (less) than the value of imports, then there is a trade surplus (deficit) .

When a country has a trade surplus, it lends to foreigners or buys assets from foreigners reflecting the financing needed by foreigners running trade deficits with that country. Similarly, when a country has a trade deficit, it has to borrow from foreigners or sell some of its assets to foreigners. Section 4 on the balance of payments explains these relationships more fully.

Autarky is a state in which a country does not trade with other countries. This means that all goods and services are produced and consumed domestically. The price of a good or service in such an economy is called its autarkic price . An autarkic economy is also known as a closed economy because it does not trade with other countries.

An open economy , is an economy that trades with other countries. If there are no restrictions on trade, then members of an open economy can buy and sell goods and services at the price prevailing in the world market, the world price .

An open economy can provide domestic households with a larger variety of goods and services, give domestic companies access to global markets and customers, and offer goods and services that are more competitively priced.

In addition, it can offer domestic investors access to foreign capital markets, foreign assets, and greater investment opportunities.

For capital intensive industries, such as automobiles and aircraft, manufacturers can take advantage of economies of scale because they have access to a much larger market.

Free trade occurs when there are no government restrictions on a country’s ability to trade. Under free trade, global aggregate demand and supply determine the equilibrium quantity and price of imports and exports. Government policies that impose restrictions on trade, such as tariffs and quotas (discussed later in the reading), are known as trade protection and prevent market forces (demand and supply) from determining the equilibrium price and quantity for imports and exports. According to Deardorff, globalization refers to the “increasing worldwide integration of markets for goods, services, and capital that began to attract special attention in the late 1990s.”3 It also references “a variety of other changes that were perceived to occur at about the same time, such as an increased role for large corporations (multinational corporations) in the world economy and increased intervention into domestic policies and affairs by international institutions,” such as the International Monetary Fund, the World Trade Organization, and the World Bank.

The levels of aggregate demand and supply and the quantities of imports and exports in an economy are related to the concepts of excess demand and excess supply.

The aggregate output of a nation over a specified time period is usually measured as its gross domestic product or its gross national product.

This study session focuses on the microeconomic principles used to describe the marketplace behavior of consumers and firms.

Reading 13 explains the concepts and tools of demand and supply analysis—the study of how buyers and sellers interact to determine transaction prices and quantities.

Reading 14 covers the theory of the consumer, which addresses the demand for goods and services by individuals who make decisions to maximize the satisfaction they receive from present and future consumption.

Reading 15 deals with the theory of the firm, focusing on the supply of goods and services by profit-maximizing firms. That reading provides the basis for understanding the cost side of firms’ profit equation.

Reading 16 completes the picture by addressing revenue and explains the types of markets in which firms sell output. Overall, the study session provides the economic tools for understanding how product and resource markets function and the competitive characteristics of different industries.

economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics

Macroeconomics deals with aggregate economic quantities, such as national output and national income.

Macroeconomics has its roots in microeconomics , which deals with markets and decision making of individual economic units, including consumers and businesses.

Demand and supply analysis is the study of how buyers and sellers interact to determine transaction prices and quantities.

prices simultaneously reflect both the value to the buyer of the next (or marginal) unit and the cost to the seller of that unit.

In private enterprise market economies, which are the chief concern of investment analysts, demand and supply analysis encompasses the most basic set of microeconomic tools.

microeconomics classifies private economic units into two groups: consumers (or households) and firms.

The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption)

The theory of the firm deals with the supply of goods and services by profit-maximizing firms.

Investment analysts, particularly equity and credit analysts, must regularly analyze products and services, their costs, prices, possible substitutes, and complements, to reach conclusions about a company’s profitability and business risk (risk relating to operating profits). Furthermore, unless the analyst has a sound understanding of the demand and supply model of markets, he or she cannot hope to forecast how external events—such as a shift in consumer tastes or changes in taxes and subsidies or other intervention in markets—will influence a firm’s revenue, earnings, and cash flows.

This reading is organized as follows.

Section 2 explains how economists classify markets.

Section 3 covers the basic principles and concepts of demand and supply analysis of markets.

Section 4 introduces measures of sensitivity of demand to changes in prices and income.

Factor markets are markets for the purchase and sale of factors of production. In capitalist private enterprise economies, households own the factors of production (the land, labor, physical capital, and materials used in production).

Goods markets are markets for the output of production. From an economics perspective, firms, which ultimately are owned by individuals either singly or in some corporate form, are organizations that buy the services of those factors. Firms then transform those services into intermediate or final goods and services

Generally, market interactions are voluntary. Firms offer their products for sale when they believe the payment they will receive exceeds their cost of production. Households are willing to purchase goods and services when the value they expect to receive from them exceeds the payment necessary to acquire them. Whenever the perceived value of a good exceeds the expected cost to produce it, a potential trade can take place. This fact may seem obvious, but it is fundamental to our understanding of markets. If a buyer values something more than a seller, not only is there an opportunity for an exchange, but that exchange will make both parties better off.

In one type of factor market, called labor markets , households offer to sell their labor services when the payment they expect to receive exceeds the value of the leisure time they must forgo. In contrast, firms hire workers when they judge that the value of the productivity of workers is greater than the cost of employing them. A major source of household income and a major cost to firms is compensation paid in exchange for labor services.

Through, saving households can accumulate financial capital, the returns on which can produce other sources of household income, such as interest, dividends, and capital gains.

Households may choose to lend their accumulated savings (in exchange for interest) or invest it in ownership claims in firms (in hopes of receiving dividends and capital gains).

A major purpose of financial institutions and markets is to enable the transfer of savings into capital investments.

Indeed, a major purpose of financial institutions and markets is to enable the transfer of these savings into capital investments. Firms use capital markets (markets for long-term financial capital—that is, markets for long-term claims on firms’ assets and cash flows) to sell debt (in bond markets) or equity (in equity markets) in order to raise funds to invest in productive assets, such as plant and equipment. They make these investment choices when they judge that their investments will increase the value of the firm by more than the cost of acquiring those funds from households. Firms also use such financial intermediaries as banks and insurance companies to raise capital, typically debt funding that ultimately comes from the savings of households, which are usually net accumulators of financial capital.

Microeconomics, although primarily focused on goods and factor markets, can contribute to the understanding of all types of markets (e.g., markets for financial securities).