International trade II

Question 1

What is the financial account balance? Explain.

Answer 1

Financial account (the main one): net acquisition and disposal of financial assets and liabilities.
Includes: Direct investment, portfolio investment, financial derivatives, other investment, reserve assets
Also includes reserve assets = foreign currency reserves hold by central banks if hold by individuals/companies it is other investment

Question 2

Give two reasons for why countries specialize in specific industries.

Answer 2

Reasons for specialization: comparative advantage resulting from differences in labour productivity/technology (Ricardo Model) or differences in endowments (Heckscher-Ohlin Model); economies of scale at the industry level (e.g. industry clusters such as Silicon Valley) or at the firm level (expansion to new markets increases production and thus efficiency).

Question 3

In an international setting, who trades with whom (gravitiy model of world trade, other relevant factors)?

Answer 3

Gravity model of world trade - positive relationship with GDP, negative relationship with GDP i.e.: Trade between two countries increases with both of their GDPs and decreases with their distance

Economies with high GDP are wealthy and they both import and export more. They produce wide range of products i.e. they attract large share of other countries’ spending

Other relevant factors: differences in language/history/culture/currency and trade barriers

In analogy to Newton’s law of gravity: gravitational attraction between two objects increases with their masses (correspond to GDP) and decreases with their distance

Question 4

Describe the Danish trade pattern from 1973-2015 (in broad strokes)

Answer 4

Decreasing trade with EU-area and more trade with China and Sweden. Less trade with the UK and instead more with Germany.

Question 5

Where is Danish export concentrated?

Answer 5

Only 10% of all private Danish firms export goods
Approx. 40% of manufacturing firms export
Exporters and non-exporters within all industries
A few super exporters account for the vast majority of total exports

Question 6

How can we use trade data to observe comparative advantage?

Answer 6

Revealed Comparative Advantage (RCA) measures international patterns of specialization

Measures the relative export performance of an industry

RCA_ij > 1 - country i has a revealed comparative advantage in sector j

RCA_ij < 1 - country i has a revealed comparative disadvantage in sector j

In conclusion: simply look at in which industries a country has higher share of export than it has in world export or than other countries have in the same industry. We use this as a basis for concluding that if a country has a higher share, it must have a comparative advantage in that industry.

Question 7

Describe Denmark’s RCA

Answer 7

Denmark’s specialization: many low-tech industries (food, furniture, toys) and some high-tech industries (pharmaceuticals, machinery and equipment)

Industries are classified according to output instead of technology, in DK for instance in food the technology is rather advanced - i.e. DK is not a low-tech industry.

Question 8

Describe the Danish trade pattern in broad strokes

Answer 8

Geography matters: largest trade partners are Germany (especially the north) and Sweden

DK has a smaller share of intra-industry trade than large countries as small countries need to specialize their exports to a higher degree and Danish export is highly concentrated on few firms

Question 9

What is the terms of trade (TOT)?

Answer 9

TOT gives the relative price of exports to imports, and an improvement in the TOT is thus the same as saying that export prices have increased more than import prices

Terms of trade (ToT) =Export price index/Import price index

Question 10

What happens to the income of a country if TOT increases ?

Answer 10

Denmark recently benefitted from price increases in design and pharmaceuticals
If TOT ↑ increases, it increases a country’s real income
Real GDP is higher when adjusting for TOT

Question 11

Caveat: Rise of export prices can have two different reasons (increase in TOT). What are they?

Answer 11

Increase in foreign demand for domestic goods (good news)
Increase in domestic production costs (bad news)

Hence: caution when using TOT as indicator for competitiveness

The prices at which goods and services are traded are as important as the quantities

Whether the real income generated from trade goes up or down depends on the elasticity of demand: if demand is very elastic, real income decreases and vice versa

Question 12

How can we use unit labour costs in relation to international competitiveness?

Answer 12

There are other measures of international competitiveness, one of them is the unit labour costs.

More focused on the supply/cost side whereas TOT is focused on the demand side.

Unit labour costs (ULC): the average cost of labour that is needed to produce one unit of output

ULC=Nominal labour compensation/Real GDP≠Nominal labour compensation/Nominal GDP
Can write as:
ULC=Nominal wage/Labour productivity

Increase in ULC: Wages have increased by more than productivity

Caveat: With inflation, increases in nominal wages and thus ULC are justified to keep real wages stable and rising ULC less problematic if export prices have increased due to higher foreign demand

Question 13

How do we derive the current account?

Answer 13

Adding to GDP (expenditure approach):
add net income payments (NI)
GNI =C + G + I +NX+NI =GDP+NI
Then we get the gross national income (”the value of what we earn”)
Next we add net transfers (NT)
GNIdisp =C + G + I +NX+NI + NT = GDP + NI + NT = GNI + NT
We then get disposable income (”the value of what is at our disposal”)
NX+NI + NT is called the current account balance CA ≡ NX + NI + NT

Question 14

What does it mean when the current account is negative or positive?

Answer 14

If positive: C + G + IGNIdisp - we absorb (consume and invest) more than we have - we borrow from foreigners

Question 15

What is net foreign wealth and how does it relate to net lending (surplus or deficit on the current account)?

Answer 15

Net foreign wealth = foreign assets minus foreign debt (liabilities)
Current account surplus (CA>0) implies positive net lending to foreigners: foreigners sell assets to residents or borrow from residents (liabilities)
That means there is an increase in net foreign wealth.
Current account deficit (CA<0) implies negative net lending (=net borrowing) to foreigners: residents sell assets to foreigners or borrow from foreigners (liabilities)
That means there is a decrease in net foreign wealth

Question 16

What is the balance of payments (BOP)?

Answer 16

Balance of payments: a statement that summarizes transactions between residents and nonresidents during a period of time
Following the IMF Balance of Payments Manual (BPM6), the BOP consists of: Current account, Capital account and Financial account
Based on the principles of double-entry accounting. This means that each transaction will end up two different places in the accounts.

Question 17

The current account consists of three accounts, describe them.

Answer 17

Goods and services account (“net exports” - NX): goods and services (exports and imports)
Primary income account (“net income payments”- NI): amounts payable and receivable in return for providing temporary use of: labour (e.g. salary) and financial resources (e.g. dividends, interests)
Secondary income account (“net transfers” - NT):
redistribution of income (e.g. personal transfers and current international aid)

Question 18

What is the capital and the financial accounts?

Answer 18

Capital account: capital transfers (e.g. debt forgiveness)

Financial account (the main one): net acquisition and disposal of financial assets and liabilities.

Includes: Direct investment, portfolio investment, financial derivatives, other investment, reserve assets

Also includes reserve assets = foreign currency reserves hold by central banks if hold by individuals/companies it is other investment

Question 19

What is the idea behind double-entry bookkeeping?

Answer 19

Idea of double-entry bookkeeping: sale of Danish Lego toys to U.S. will occur on the current account as an export and receipt of dollars increase financial assets, i.e. will occur on financial account
We always have two entries happening in the BOP: current account and financial account roughly “balance”
Double-entry bookkeeping in the BOP: each transaction is recorded consisting of two equal and opposite entries
We can distinguish between inflow of foreign currency: exports of goods and services, income receivable, reduction in assets, or increase in liabilities and outflow of foreign currency: imports of goods and services, income payable, increase in assets, or reduction in liabilities

Question 20

What should the sum of the current account balance, capital account balance and financial account balance be?

Answer 20

0

Question 21

Are Current account deficits a problem?

Answer 21

Naive notion of trade: exports are “good”, imports are ”bad”. Trade as zero-sum game. Trade is not a zero sum game but a plus sum game (there are gains from trade)

What does a current account deficit really mean?

Current account deficit = more is consumed and invested than what has at its disposal i.e. net borrowing

So is borrowing ”bad”?

Question 22

What is the relationship between the current account and savings?

Answer 22

Open economies can save by acquiring foreign wealth
Total savings = disposable income minus consumption
S ≡GNIdisp -C -G=I +NX+NI” + NT”
In a closed economy:
CA = 0 ⇒ S = I
I.e. a closed economy can only save by building up capital stock (i.e. investment)
In an open economy:
⇒ S = I+CA
I.e. an open economy can save by building up capital stock or acquiring foreign wealth

Question 23

Is borrowing/dissaving “bad”?

Answer 23

Not per se, it depends…
It depends on investment opportunities: developing economies have more investment opportunities than they can afford to undertake because of low levels of domestic savings
And it depends on intertemporal trade-off: demographics: young individuals save for retirement, while old individuals dissave and consumption smoothing: alleviate adverse effects of e.g. natural disasters

Question 24

Are persistent deficits a problem?

Answer 24

Persistent deficits accumulate liabilities with other countries that eventually need to be paid back

Consider if the the foreign money is used efficient investments that allow for running current account surpluses in the future (basic solvency). If it is, it is not a problem.

If the money is used for consumption rather than investment, it might be a problem.

Question 25

The Revealed Comparative
Advantage (RCA) measure informs us about the trade specialization of a given country. Describe in
words how RCA is defined.

Answer 25

The RCA of an industry is defined as a country’s share in world exports in the given industry, divided by the country’s share in world exports across all industries. Alternatively, the RCA of an industry can be defined as the industry’s share in the country’s total exports, divided by the industry’s share in total world exports. A country is said to have a revealed comparative advantage in a certain industry, if the RCA for that industry exceeds 1.