Macroeconomics guide, Unit 6, step 19 of 23Previous step Next step

Step 19: Trade, Exchange Rates and the Balance of Payments

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Macro 6.1–6.2 · Cambridge 6.3–6.5 · IB 4.5–4.6

In 30 seconds

Comparative advantage, not absolute advantage, decides who should produce what. Both countries gain when each specialises in the good it produces at a lower opportunity cost.
An exchange rate is a price, set by the demand for and supply of a currency. Higher interest rates attract capital and make the currency appreciate.
The impossible trinity: a country can have at most two of a fixed exchange rate, free capital movement and independent monetary policy.
Exam point: the balance of payments sums to zero, and $ CA = S_p – I + (T – G) $. A current account deficit means a country invests more than it saves.

Video lesson coming soonA short animated lesson for this step will appear here.

Comparative advantage: why both sides gain from trade

Imagine a head chef who chops vegetables faster than her assistant and also cooks better. Should she do both? No: every hour chopping is an hour not cooking, which is far more valuable. The assistant is slower at both, but by chopping he frees her to cook, and together they serve more meals.

David Ricardo applied this to countries in 1817. What matters is what you give up to make a good: its opportunity cost.

Key termComparative advantage: the ability to produce a good at a lower opportunity cost than another producer; it decides who should specialise in what.

Absolute advantage (using fewer resources) does not decide the pattern of trade. Ricardo’s example: England needs 100 hours to make a unit of cloth and 120 for wine; Portugal needs 90 and 80. Portugal is better at both. But one unit of cloth costs England $ \frac{100}{120} = 0.83 $ units of wine, while it costs Portugal $ \frac{90}{80} = 1.13 $ units. England gives up less, so England has the comparative advantage in cloth and Portugal in wine.

\[ \text{Opportunity cost of X} = \frac{\text{hours (resources) for X}}{\text{hours (resources) for Y}} \quad \text{(in units of Y)} \]

The terms of trade is the rate at which one good swaps for the other. Both countries gain if it lies between their two opportunity costs.

Worked example

To make one unit, Country A needs 4 hours for a bicycle and 2 hours for a jacket. Country B needs 9 hours for a bicycle and 3 hours for a jacket. Who has the comparative advantage in each good, and what terms of trade benefit both?

Step 1A: 1 bicycle costs $ \frac{4}{2} = 2 $ jackets. B: 1 bicycle costs $ \frac{9}{3} = 3 $ jackets.

Step 2A gives up fewer jackets per bicycle ($2 < 3$), so A has the comparative advantage in bicycles. For jackets: A gives up $ \frac{2}{4} = 0.5 $ bicycles, B gives up $ \frac{3}{9} = 0.33 $, so B has it in jackets.

Step 3Both gain at any rate strictly between 2 and 3 jackets per bicycle. At 2.5, A gets 2.5 jackets for a bicycle that cost it 2, and B pays 2.5 for a bicycle that would cost it 3: each gains 0.5 jackets.

A is absolutely better at both goods, yet both countries gain, because their opportunity costs differ.

Exam tipCalculate the opportunity cost of each good in both countries; the lower figure wins. Absolute advantage is often included as a distractor. Always state the terms-of-trade range between the two opportunity costs.

Protectionism: why trade is restricted anyway

Why restrict trade? Because the gains are spread thinly across consumers, while the losses fall on a small, visible group of workers.

Tariffs: a tax on imports. The domestic price rises, so domestic firms produce more and consumers buy less. Producers gain and the government collects revenue, but consumers lose more than both gains combined. The difference is deadweight loss: one triangle from inefficient domestic production and one from consumption that no longer happens.
Other tools: quotas (a limit on import quantities, with the gain going to licence holders), subsidies to domestic producers (paid by taxpayers), and non-tariff barriers such as standards and customs delays.

The chapter assesses the arguments:

Argument	Verdict in the chapter
Infant industry: protect a new industry until it can compete	Strongest in theory, but governments struggle to pick winners. South Korea is the classic success; Latin American import substitution the classic failure.
Strategic and national security	Can be valid (Europe’s reliance on Russian gas before 2022), but easily stretched.
Protecting jobs	Weak. The 2018 US steel tariffs saved roughly 1,000 steel jobs at about $650,000 each, and steel-using industries lost more jobs.
Correcting a trade deficit	Fails because of the savings identity (see the balance of payments below).

Exchange rates

An exchange rate is the price of one currency in terms of another. Under a floating system it is set where demand meets supply. Demand for pounds comes from foreigners buying British exports or assets; supply comes from Britons buying imports, investing abroad or travelling.

More demand makes the pound appreciate (exports dearer, imports cheaper); more supply makes it depreciate. Under a fixed regime, deliberate changes are called revaluation and devaluation.

If the Bank of England raises rates, capital flows in, demand for pounds rises and the pound appreciates. Net exports fall and AD shifts further left: the exchange rate channel from Step 9.

A depreciation improves the trade balance only if the Marshall–Lerner condition holds: $ PED_x + PED_m > 1 $ (the price elasticities of demand for exports and imports sum to more than one). Even then there is a J-curve: at first quantities hardly change, so imports just cost more and the balance gets worse before it improves.

Exchange rate regimes and the impossible trinity

Key termImpossible trinity: a country can have at most two of these three: a fixed exchange rate, free movement of capital and an independent monetary policy.

Why? With a fixed rate and free capital, an interest rate below the world rate makes money flow out, so the central bank must raise the rate again or drop the peg. Its monetary policy is not its own.

Example	Keeps	Gives up
United States, UK, Japan	Free capital, independent monetary policy	Fixed rate (they float)
Hong Kong	Fixed rate (to the US dollar), free capital	Independent monetary policy
China for decades	Fixed rate, independent monetary policy	Free capital (capital controls)
Eurozone members	Shared currency, free capital	National monetary policy

Britain, which had only pegged the pound, left the European Exchange Rate Mechanism on 16 September 1992 and recovered. Greece in 2010 had no currency to devalue and could not set interest rates, so it cut wages through unemployment, an internal devaluation: output fell about 25% and unemployment reached 27.5%.

Common mistakeUsing “devaluation” for a floating currency, or “depreciation” for a fixed one. Depreciation and appreciation happen in a floating market; devaluation and revaluation are deliberate changes to a fixed official rate.

The balance of payments

The balance of payments records every transaction between a country’s residents and the rest of the world.

Current account: trade in goods and services, plus net primary income (interest, profits, dividends) and net secondary income (transfers, remittances).
Financial account: transactions in assets, such as foreign direct investment, portfolio investment and reserves.

Every transaction has two sides, so the accounts sum to zero (allowing for a statistical discrepancy). A country that buys more than it sells must pay by selling assets or borrowing, so a current account deficit is always matched by a financial account surplus.

\[ CA = S_p – I + (T – G) \]

Here $S_p$ is private saving, $I$ is domestic investment and $T – G$ is the budget balance (negative in deficit). A current account deficit means the nation invests more than it saves and borrows the difference abroad. There is no tariff term, so a tariff cannot durably cut the deficit unless it changes saving or investment: after the 2018 to 2019 US tariffs, the US deficit widened from about $450bn to $480bn.

Worked example

Private saving is $500bn, investment is $560bn, tax revenue is $400bn and government spending is $450bn. Find the current account balance. What happens if the government balances its budget?

Step 1$ CA = 500 – 560 + (400 – 450) $

Step 2$ CA = -60 + (-50) = -\$110\text{bn} $, a current account deficit

Step 3With $T = G$: $ CA = 500 – 560 + 0 = -\$60\text{bn} $

Balancing the budget shrinks the deficit from $110bn to $60bn, but it does not vanish, because private investment still exceeds private saving by $60bn.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Country X needs 6 hours for a shirt and 3 hours for a hat. Country Y needs 8 hours for a shirt and 2 hours for a hat. Who has the comparative advantage in shirts? Show worked answer

X: 1 shirt costs $ \frac{6}{3} = 2 $ hats. Y: 1 shirt costs $ \frac{8}{2} = 4 $ hats.
X gives up fewer hats, so X has the comparative advantage in shirts.
For hats: X gives up 0.5 shirts, Y gives up 0.25 shirts, so Y has the comparative advantage in hats.

EasyQ2. The Bank of England raises interest rates while other central banks hold theirs. What happens to the pound and to UK net exports? Show worked answer

Higher UK returns attract capital, so demand for pounds rises and the pound appreciates.
UK exports become dearer abroad and imports cheaper, so net exports fall and AD falls further.

MediumQ3. In one hour, Alphaland makes 12 steel or 4 software; Betaland makes 6 steel or 3 software. Find each country’s comparative advantage and the terms of trade (software per steel) at which both gain. Show worked answer

Here output per hour is given, so the opportunity cost of steel is software output divided by steel output.
Alphaland: 1 steel costs $ \frac{4}{12} = 0.33 $ software; 1 software costs $ \frac{12}{4} = 3 $ steel.
Betaland: 1 steel costs $ \frac{3}{6} = 0.5 $ software; 1 software costs $ \frac{6}{3} = 2 $ steel.
Alphaland has the comparative advantage in steel ($0.33 < 0.5$); Betaland in software ($2 < 3$).
Both gain at any terms strictly between 0.33 and 0.5 software per steel.

MediumQ4. Exports of goods $340bn; imports of goods $410bn; exports of services $130bn; imports of services $95bn; net primary income −$18bn; net secondary income −$12bn. Find the current account balance and the financial account balance. Show worked answer

Goods balance $ = 340 – 410 = -\$70\text{bn} $.
Services balance $ = 130 – 95 = +\$35\text{bn} $.
Current account $ = -70 + 35 – 18 – 12 = -\$65\text{bn} $.
Ignoring errors and omissions, the financial account is $+\$65\text{bn}$: the country financed the gap by selling assets to, or borrowing from, foreigners.

MediumQ5. Private saving is $900bn, investment $1,050bn, government revenue $700bn and spending $820bn. Find the current account. A tariff then cuts imports by $80bn with saving, investment and the budget unchanged. What happens to the current account? Show worked answer

$ CA = 900 – 1{,}050 + (700 – 820) = -150 – 120 = -\$270\text{bn} $.
With saving, investment and the budget unchanged, the identity gives the same answer: the current account stays at −$270bn. Lower imports raise demand for the currency, it appreciates, exports fall and other imports rise. The tariff changes the pattern of trade, not the total.

ExamQ6. Explain the impossible trinity and use it to explain why Greece could not use monetary policy or depreciation after 2010. [5 marks] Show worked answer

Definition (1): a country can have at most two of a fixed exchange rate, free capital movement and independent monetary policy.
Logic (2): with a fixed rate and free capital, a domestic interest rate below the world rate causes capital to flow out and pressure on the currency (1), so the central bank must raise rates or abandon the peg; monetary policy is not independent (1).
Application (2): as a eurozone member, Greece had a shared currency and free capital, so it gave up national monetary policy; the ECB set rates for the whole area (1). With no currency of its own it could not depreciate, so adjustment came through falling wages and high unemployment, an internal devaluation (1).

Check yourself

1. A country has a comparative advantage in a good when it:

Using fewer resources is absolute advantage; comparative advantage is about opportunity cost.

2. A country running a current account deficit must also be running:

The balance of payments sums to zero, so the deficit is financed by selling assets or borrowing.

3. The impossible trinity says a country cannot have all three of:

Any two are possible; all three are not.

Your score: 0 out of 3

The short version

Comparative advantage (lower opportunity cost) decides the pattern of trade; both countries gain at terms of trade between their opportunity costs.
A tariff helps producers and raises revenue but costs consumers more, leaving deadweight loss. Infant industry and security arguments have some force; job protection rarely does.
Exchange rates are set by demand and supply; higher interest rates cause appreciation. A depreciation helps the trade balance only if Marshall–Lerner holds, and only after a J-curve delay.
Impossible trinity: at most two of a fixed rate, free capital and independent monetary policy.
The balance of payments sums to zero, and $ CA = S_p – I + (T – G) $: a tariff cannot close a deficit without changing saving or investment.

This guide covers the core of Chapter 30 of Economics Made Simple. For the full chapter, with the Britain 1992 and Greece 2010 case study and 15 exam-style questions with a complete answer key, see the book.

Step 19: Trade, Exchange Rates and the Balance of Payments

Comparative advantage: why both sides gain from trade

Protectionism: why trade is restricted anyway

Exchange rates

Exchange rate regimes and the impossible trinity

The balance of payments

Practise: 6 questions

Check yourself

The short version

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