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IFT Notes for Level I CFA® Program

LM07 International Trade and Capital Flows

Part 1


1. Introduction & International Trade-Basic Terminology

This reading will cover:

  • Basic terminology used in international trade and capital flows.
  • Benefits and costs of international trade.
  • Trade restrictions, and the advantages of trade agreements.
  • Balance of payments.
  • The objectives of international trade organizations such as the World Bank and IMF that facilitate trade.

1.1 International Trade

Basic Terminology

Terminology used in international trade
Term What it means
GDP The market value of all new goods and services produced within a country/economy during a given period of time, usually a year or a quarter, by domestic factors of production (labor, land, and capital). So long as it is produced within the country, it does not matter who produced the good and service, i.e., it includes foreigners within the country. Resold products within that period are not included.
GNP The market value of all new goods and services produced during a given period of time, usually a year or a quarter, by factors of production (labor, land, and capital) supplied by the residents of the country, irrespective of where they are located. It excludes goods and services produced by foreigners within the country, but includes those produced by citizens residing out of the country.

For countries, such as Pakistan, with large differences between GDP and GNP, it is implied that a large number of its citizens are working abroad.

Imports Goods and services that a domestic country (i.e., households, firms, and government) purchases from other countries. Any good/service that crosses the border into a country for commercial purposes (for consumption by the domestic country). Ex: The U.S. imports cloth from India. India imports several processed foods from the U.S., olive oil from Italy, and motorcycles from Europe.
Exports Goods and services that a domestic country sells to other countries (crosses the border). Ex: China exports clothing to the European Union, South Korea exports cell phones to other countries.
Terms of trade Ratio of the price of exports to the price of imports. For instance, if the terms of trade increase from 1.1 to 1.3, it means the terms of trade have improved because the country will be able to purchase more imports for the same amount of exports.
Net exports Net Exports = Value of a country’s Exports – Value of its Imports

Trade balanced if value of Exports = Value of Imports.

Trade surplus if value of Exports > Value of Imports.

Trade deficit if value of Exports < Value of Imports.

Autarky A country that is self-sufficient and does not engage in international trade. All goods and services are produced and consumed domestically; it does not import from or export to other countries.

For example, North Korea. Before India opened up to international trade in 1991, it was close to an autarkic state. Price of a good or service in such an economy is called autarkic price.

Closed economy An autarkic economy is also known as a closed economy as it does not trade with other economies.
Open economy In contrast, an economy that trades with other countries with no restrictions on trade is called an open economy.
World price The price of goods and services in the world market; the prevailing price outside the domestic country.
Free trade No government restrictions on a country’s ability to trade. The country freely exports to and imports from the rest of the world. For a similar product, free trade assumes domestic price and world price must be equal. Global demand and supply determine the equilibrium price for exports and imports.
Trade protection Government imposes certain trade restrictions such as tariffs and quotas that prevent market forces from determining the equilibrium price and quantity of imports and exports. Ex: India imposes custom duties of 100% on import of completely built unit luxury cars such as Porsche and BMW. To restrict the amount of iron ore exported, it imposes an export duty on iron ore pellets.
FDI/MNC/FPI FDI stands for foreign direct investment. In FDI, a firm in any country (source country) invests in a foreign country (host country). Unlike financial investments, these are investments in productive assets of the host country (that involves a certain amount of infrastructure). For example, Ikea/Walmart setting up stores in China and India is an example of FDI. Volvo setting up a bus plant in India is an example of FDI. Typically, a multi-national corporation makes an FDI. There can be FDI in real estate where the foreign country is developing a residential project in the domestic country. There are rules governing what percentage of FDI is allowed based on the sector. For example, it may be 49% in banking, but less than 10% in retail.

FPI stands for foreign portfolio investment. If an investment management company in the U.S. invests in financial assets of another country such as the Indian stock market, then it would be an example of FPI.

2. Patterns and Trends in International Trade and Capital Flows

Note: There is a lot of data covered in this section in the curriculum. But, only certain testable points are highlighted here.

The following exhibits are reproduced from the curriculum. The main points are summarized below:

  • Trade as a percentage of regional GDP has increased substantially all over the world in the last few decades. The developing countries in Asia experienced the fastest growth.

The exhibit below shows trade and FDI as a percentage of GDP for select countries from 1980-2007. Trade increased from 37.2% to 50.7% from 1980 to 2006.

Concept 31

Trade Openness and GDP Growth

Trade as Percent of GDP

(averaged over the period)

Average GDP growth (%)
Country Group 1980-1989 1990-1999 2000-2006 1980-1989 1990-1999 2000-2006
World 37.2 41.0 50.7 3.1 2.7 3.2
High income:            
All 38.1 40.3 49.5 3.1 2.6 2.5
OECD 35.3 37.2 44.7 3.1 2.5 2.4
Non-OECD 120.0 128.1 172.5 3.9 4.5 5.0
Low and Middle Income:            
All 32.4 44.4 56.9 3.4 3.5 5.8
Middle 32.4 44.5 57.1 3.4 3.5 5.8
Upper middle 33.4 44.3 53.5 2.1 1.7 4.1
Lower middle 31.4 44.8 61.4 6.0 6.1 7.7
Low 32.5 39.9 51.7 2.6 2.7 4.8

Note: Averages indicate the average of the annual data for the period covered

Source: World Bank

3. Benefits and Costs of International Trade

Benefits of international trade:

  • Countries gain from the exchange and specialization. For example, if one country is good at producing cloth, while another is good at manufacturing machinery, then the two countries can exchange the goods. A country benefits from exchange trade if either of the following two conditions occur in an exchange, as there is efficient allocation of resources:
    • Higher price for exports relative to selling internally.
    • Lower price for imports relative to producing internally.
  • Households and firms have greater product variety. For example, after South Korean electronics manufacturers such as LG and Samsung entered the South Asian markets, consumers benefited because they have access to a wide range of products. This argument can be extended to almost any industry from automobiles to food products.
  • Competition increases and resources are allocated more efficiently.
    • In an open economy, the monopoly of domestic firms reduces as competition from foreign firms increase, and forces them to be efficient. For example, automobile and steel industries exhibit increasing returns to scale.
  • Industries experience greater economies of scale.
    • In an open economy, companies are forced to compete with global players and that forces them to become more efficient or go out of business. Extending the LG and Samsung example from above, economies of scale allows these firms to benefit from the larger market size in India/Middle East and experience lower average cost of production.
  • Greater employment in exporting countries.
    • The garment factories in India export cotton clothing to the rest of the world for various labels. The work in this industry is labor-intensive and hence generates a lot of employment opportunities.

Note: The term “gains from trade” implies that the overall benefits of trade outweigh the losses from trade. It does not mean that all stakeholders (producers, consumers, government) benefit (or benefit equally) from trade.

Costs of international trade:

  • Potential income inequality.
    • It depends on whether the industry is expanding or contracting. For example, the IT industry in the late 90’s and early 2000’s created high-paying jobs. This led to an income disparity between the IT industry and other traditional industries such as automobiles.
  • Loss of jobs because less inefficient firms will be forced to exit.
    • For example, the U.S. textile industry has faced tough competition because of cheaper imports from other countries forcing many companies to exit.

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