Introduction

🔁 Where We Came From

We have treated the economy as if it were closed. What is missing is the rest of the world. 🌍

Today we open the borders: trade, exchange rates and capital flows.

It is the last session, and the one closest to daily life on a trading floor. 💼

🗺️ Today’s Map

  1. 🤝 Absolute and comparative advantage
  2. 💱 The exchange rate and the currency market
  3. 🛒 Purchasing power parity
  4. 📈 Interest rate parity
  5. 🌐 The balance of payments and the carry trade

Part 1 · International Trade

🤝 Why Trade

We already saw this in session 1: specialization and exchange make us richer.

The same principle applies to countries. None produces everything well; each focuses on what it does best. 🌍

The interesting question: what if a country is better at producing everything? Is trade still worth it?

⚖️ Absolute Advantage

Absolute advantage: producing a good using fewer resources than another country.

It looks as if a country with an absolute advantage in everything gains nothing from trade. But that is wrong. 🤔

What matters is not absolute advantage, but comparative advantage.

🔑 Comparative Advantage

Comparative advantage: producing a good at a lower opportunity cost than another country.

Even a country that is better at everything has to choose. It specializes where its advantage is greatest.

And leaves to the other the goods where its own disadvantage is smallest. Both gain. ✨

📊 An Example

Portugal and a partner produce wine and cloth. Hours per unit:

Wine Cloth
Country A 1 h 2 h
Country B 3 h 4 h

Country A is better at both (absolute advantage). But look at the opportunity costs.

🔎 Reading the Example

Country A: 1 wine costs 1/2 cloth. Country B: 1 wine costs 3/4 cloth.

Country A has the lower opportunity cost in wine: it specializes there. Country B, in cloth.

By trading, both consume more than if they produced everything on their own. 🍷🧵

📐 Session 1, Made Precise

Remember the frontier from session 1. Here it is again, with the numbers of this example:

Country A has 100 hours. All wine gives 100 units; all cloth gives 50. It trades at 0.7 cloth per wine:

Specialize, then trade along the green line: consumption outside your own production frontier. 🎯

📏 Where Can the Trading Price Sit?

Not just anywhere. The terms of trade must lie between the two opportunity costs, which here are \(1/2\) for A and \(3/4\) for B:

\[\tfrac{1}{2} \;<\; \frac{\text{cloth}}{\text{wine}} \;<\; \tfrac{3}{4}\]

Outside that range, one of the two countries does better producing at home and refuses to trade.

Inside it, both gain. Where exactly it lands inside the range decides how the gains are split, and that is bargaining power, not comparative advantage.

Which is most of what trade negotiations are actually about. The existence of gains is settled; the division is not. 🤝

⚖️ Who Loses From Trade

The gains are real, and they are not evenly spread. Saying so is not a concession, it is the model.

A country specializing in wine contracts its cloth sector. Owners and workers in cloth lose their jobs and often their industry.

The theorem says the country gains: total gains exceed total losses, so the winners could compensate the losers. It does not say they do. 💶

When compensation and retraining do not happen, opposition to trade is a rational response, not economic illiteracy. Keep those two claims apart. 🧠

📝 Review · Part 1

Two multiple choice questions and one exercise. ✍️

❓ Multiple Choice 1

Comparative advantage is based on:

A. Having the lower opportunity cost.

B. Producing with fewer resources in absolute terms.

C. Having a larger population or more capital.

D. Exporting more than you import.

✅ A. Opportunity cost, and nothing else, decides where each country specializes. Option B is absolute advantage, which is neither necessary nor sufficient for gains from trade.

❓ Multiple Choice 2

Two countries have identical opportunity costs in both goods. Then:

A. Both gain a great deal, since trade always helps.

B. The larger one gains and the smaller one loses.

C. There are no gains from specialization: neither has a comparative advantage.

D. They should trade anyway, to diversify.

✅ C. Comparative advantage requires a difference in opportunity costs. With none, the terms of trade range collapses to a point and there is nothing to divide. It is the difference that creates the gain, not trade in itself.

🧮 Numerical Exercise

Country A makes 1 wine in 1 hour and 1 cloth in 2 hours. Country B needs 3 hours for wine and 4 for cloth.

a) Compute the opportunity cost of 1 wine in each country.
b) Who exports wine, and who exports cloth?
c) Give the range of terms of trade at which both gain.
d) Does country A have an absolute advantage, and does it matter?

✅ Solution

a) A: 1 wine costs \(1/2\) cloth. B: 1 wine costs \(3/4\) cloth.

b) A has the lower opportunity cost in wine, so A exports wine and B exports cloth.

c) Any price between \(1/2\) and \(3/4\) cloth per wine. Outside it, one country prefers autarky.

d) Yes, A is faster at both. And it does not matter: A still gains by concentrating where its edge is largest, and B still gains where its disadvantage is smallest. That is the whole Ricardian point. ✅

Part 2 · The Exchange Rate

💱 The Price of a Currency

Exchange rate: the price of one currency in terms of another (EUR/USD, for example).

It comes out of the supply and demand for each currency in the foreign exchange market.

Whoever wants European goods or assets demands euros; whoever invests abroad supplies euros. 💶

📉 The Euro Against the Dollar, in Practice

Neither fixed nor predictable: in 2022 the euro reached parity with the dollar. Source: Eurostat. 💱

🔀 Appreciation and Depreciation

📈 Appreciation: the euro becomes more expensive in another currency. European exports become more expensive abroad.

📉 Depreciation: the euro becomes cheaper. Exports become more competitive, but imports get more expensive.

📈 Supply and Demand for Euros

Whoever wants to buy European goods demands euros; whoever invests abroad supplies euros.

🛒 Purchasing Power Parity

A first, long-run theory: the law of one price applied to baskets.

PPP: the exchange rate adjusts so that the same basket costs the same in both countries.

\[ S = \frac{P}{P^*}, \]

where \(S\) is the exchange rate, \(P\) the domestic price level and \(P^*\) the foreign one.

🍔 The Intuition Behind PPP

If a basket costs €100 in the euro area and $120 in the US, PPP implies \(S = 1.20\) USD per euro.

If the euro sits above that, European goods become expensive, exports fall, and the euro tends to depreciate toward PPP.

PPP works in the long run. In the short run, exchange rates deviate a great deal. ⏳

📊 The Real Exchange Rate

What actually determines competitiveness is not \(S\) but the real exchange rate:

\[\varepsilon = \frac{S \cdot P}{P^{*}}\]

It answers: how many foreign baskets does one domestic basket buy? PPP is exactly the statement that \(\varepsilon = 1\) in the long run.

Note there are two ways to lose competitiveness: the nominal rate appreciates, or domestic prices rise faster than abroad. The second works just as well as the first. 📈

🇪🇺 Which Is the Euro Area’s Problem

Inside a monetary union, \(S\) against your main trading partners is fixed at one, permanently.

So if \(P\) rises faster than \(P^{*}\), \(\varepsilon\) rises and competitiveness falls, and there is no devaluation available to undo it.

The only route left is to push \(P\) down relative to partners: wage restraint and falling costs. That is internal devaluation, and it is slow and painful.

Portugal, Spain, Greece and Ireland all did exactly this after 2010. It is the price of the exchange rate stability the euro buys. ⚖️

📈 Interest Rate Parity

In the short run, what moves the exchange rate is capital flows and interest rates.

Uncovered parity (UIP): the interest differential equals the expected depreciation of the currency.

\[ i - i^* = \frac{S^e - S}{S}. \]

🔎 Reading Interest Parity

If the euro area raises rates (a higher \(i\)), capital flows into the euro, which appreciates.

But UIP says that, in equilibrium, that higher rate is offset by an expected depreciation.

This is the basis for how currency markets react to ECB and Fed decisions. 🏦

📝 Review · Part 2

Two multiple choice questions and one exercise. ✍️

❓ Multiple Choice 3

A euro area country inside the monetary union sees its prices rise faster than its partners’. Its real exchange rate and competitiveness:

A. Are unaffected, because the nominal rate is fixed at one.

B. Improve, because higher prices mean higher value added.

C. Are corrected automatically by a nominal devaluation.

D. Worsen, and only internal devaluation can correct them.

✅ D. With \(\varepsilon = SP/P^{*}\) and \(S\) fixed, all the adjustment has to come through \(P\). Option C is precisely what union membership removes, and that is the trade-off the euro represents.

❓ Multiple Choice 4

Under uncovered interest parity, a currency offering a higher interest rate is expected to:

A. Depreciate, by roughly the interest differential.

B. Appreciate, since capital flows in.

C. Stay flat, since parity means equality.

D. Move only if inflation differs.

✅ A. Otherwise there would be a riskless gain from simply holding the high-rate currency. Note this concerns the expected future path: on the announcement, that currency typically appreciates on the spot, and is then expected to drift back.

🧮 Numerical Exercise

A basket costs 200 euros in the euro area and 240 dollars in the United States.

a) What exchange rate does PPP imply, in dollars per euro?
b) The market rate is 1.35. Is the euro over or undervalued?
c) Compute the real exchange rate at the market rate.
d) Euro area rates are 4 percent and US rates 2 percent. What does UIP predict for the euro?

✅ Solution

a) \(S = 240/200 = 1.20\) dollars per euro.

b) At 1.35 the euro is overvalued by about 12.5 percent against PPP. European goods look expensive abroad.

c) \(\varepsilon = SP/P^{*} = (1.35 \times 200)/240 = 1.125\). Above one, confirming the overvaluation.

d) UIP predicts an expected depreciation of the euro of about 2 percent, which points the same way as PPP here. They usually do not agree, and when they do it is worth noticing. ✅

Part 3 · Capital Flows

🌐 The Balance of Payments

All of a country’s transactions with the rest of the world are organized into two accounts.

📦 Current account: trade in goods and services, income and transfers.

💰 Capital and financial account: the purchase and sale of assets between countries.

⚖️ The Two Accounts Mirror Each Other

A fundamental identity of the open economy:

A deficit in the current account is financed by a surplus in the financial account. The sum balances.

Importing more than you export means capital flows in from abroad to finance the difference. 🔄

🧮 The Saving-Investment Identity

In an open economy, the current account is linked to saving and investment:

\[ CA = S - I. \]

A country that saves more than it invests domestically exports capital (a current account surplus). If it invests more than it saves, it imports capital. 📊

💼 The Carry Trade

A direct application of interest parity, widely used in finance.

Carry trade: borrowing in a low interest currency and investing in a high interest one.

You earn the interest differential, as long as the exchange rate does not move against the position. 💱

⚠️ The Risk of the Carry Trade

UIP is the warning: the higher rate should be offset by an expected depreciation.

If that depreciation happens suddenly, the carry trade can suffer large losses.

This is currency risk: the main risk in any international portfolio. 🎯

📝 Review · Part 3

Two multiple choice questions and one exercise. ✍️

❓ Multiple Choice 5

Under the identity \(CA = S - I\), a country that invests more than it saves:

A. Runs a current account surplus.

B. Runs a current account deficit and imports capital.

C. Does not trade with the rest of the world.

D. Has a fixed exchange rate.

✅ B. Investing above saving requires external financing: a current account deficit.

❓ Multiple Choice 6

A carry trade earns the interest differential quietly for years, then loses several years of gains in a week. This pattern is:

A. Evidence that UIP holds exactly at all times.

B. Purely bad luck, with no economic content.

C. What UIP warns about: the differential is compensation for an expected depreciation that arrives abruptly.

D. Impossible, since parity rules out losses.

✅ C. The strategy is short volatility on the currency. Practitioners call it picking up coins in front of a steamroller, and it is why a carry return series looks safe right up until it is not. 🎯

🧮 Numerical Exercise

A country has national saving \(S = 120\) billion euros and investment \(I = 150\) billion.

a) Compute the current account.
b) Does the country export or import capital?
c) What must the financial account show?
d) Is a current account deficit necessarily a bad sign?

✅ Solution

a) \(CA = S - I = 120 - 150 = -30\) billion euros: a deficit.

b) It imports capital, 30 billion of it, to fund investment above domestic saving.

c) A surplus of 30 billion. The two accounts mirror each other by construction, so this is arithmetic, not a coincidence.

d) No. A country borrowing to fund productive investment is doing what any firm does. It becomes a problem when the borrowing funds consumption, or when the maturity is short and the financing can leave suddenly. Which is 2010 to 2012 in the euro area. ✅

Wrap-Up

🎯 What to Take From This Session

🔑 Gains from trade come from comparative advantage, not absolute: what counts is opportunity cost.

🛒 In the long run PPP anchors the exchange rate; in the short run interest rate parity rules.

🌐 The current and capital accounts mirror each other: an external deficit is financed by capital inflows.

💼 The carry trade lives precisely off the gap between interest and exchange rates, and that is where the risk sits.

👋 End of the Course

We have gone the whole way: from one person’s scarcity to capital flows between countries. 🌍

The final test is in the exam period. Good luck with the studying, and thank you. 🙌