Economics, International

International economics is a standard, and perhaps the oldest, field discipline within economics. This discipline involves an analysis of all economic aspects of an international nature, aspects that coincide with the existence of multiple countries and to some extent separated economies. In a historical coincidence, parts of international economics that developed prior to general micro- or macroeconomics deal in a peculiar way with essentially the same phenomena as general economic theory.

International economics addresses such issues as international trade, movements of factors of production between countries, exchange rates, open-economy macroeconomic policy, international monetary institutions, and globalization. All these issues relate to the so-called open economy, a term economists use for an economy of a country that is to some extent separated from the rest of the world (politically, monetarily, or otherwise) but at the same time has economic ties to it. These ties manifest themselves on one hand as flows of physical goods or factors of production and their services, or on the other as flows of money or its substitutes. For broad classification, then, it is possible to divide international economics into two areas of study: international trade and international finance.

INTERNATIONAL TRADE THEORY

Probably the most prominent position within international economics is enjoyed by international trade theory, which seeks to identify the gains from trade between countries; the factors that determine the pattern of specialization; the volume of trade and the terms of trade (i.e., prices); the impact of trade on income distribution; and the impact of the barriers to trade on all of the above. From a practical point of view, however, its goal has always been, as the international economist Edward Leamer remarked, to answer one single question of paramount importance: when, if ever, is it beneficial to put obstacles to the flow of goods between countries?

It is precisely this question that gave rise to early economic speculations and philosophizing, and in that sense international trade theory was an indispensable part of political economy (and later economics) from the very beginning. All the scholars who can be considered among the founding fathers of economics—Richard Cantillon (1680–1734), David Hume (1711–1776), Adam Smith (1723–1790), and David Ricardo (1772–1823)—explicitly addressed this question, and for the most part their answer was negative. The work of these early economists formed the basis of what would be known as the free-trade doctrine and provided the intellectual foundation for the free-trade movement in the nineteenth century. These authors showed that many of the apprehensions surrounding foreign trade (trade deficits and crises) were based on myth.

The theory of comparative advantage made a major contribution to the theory of international trade (and later to general microeconomics). This theory, attributable to Robert Torrens (1780–1864), James Mill (1773–1836), and Ricardo, demonstrated that two countries can engage in trade even when one of the countries can produce all goods more cheaply (because of greater productivity or lower nominal cost).

Although the theory of comparative advantage understood trade to be based on differences in productivity, later theories enriched the perspective by pointing to two other sources of trade. First, trade can also result from differences in resource endowments; in other words, countries can specialize in, and export, products made from resources that are plentiful in that country. This has come to be known as the Heckscher-Ohlin theorem (which became the basis of the Heckscher-Ohlin-Samuelson model, after its authors, Eli Heckscher, Bertil Ohlin, and Paul Samuelson). Second, the source of trade can be the consumers themselves: the difference in their preference. Before this model was developed, much of the trade flows between countries seemed puzzling, as they consist of similar types of products (so-called intra-industry trade), rather than dissimilar products as the theory based on differences in productivity or resource endowment would predict.

Besides sources of trade, international trade theory focuses on the consequences of trade for prices of factors of production, and explains the tendency of trade to bring about their equalization across countries (which became known as the Factor Price Equalization Theorem, developed, independently, by Abba Lerner and Samuelson). Further development of international trade theory incorporated the effects of the economies of scale and market structure (imperfect competition) on all aspects of trade. A special part of the theory is concerned with the alternative to international movements of goods: the movement of labor and capital across borders.

During the twentieth century, the answers offered by international trade theory developed greater precision. Although the theory, as it became increasingly refined, made some theoretical qualifications of the conditions under which free trade is the first best policy, the practical presumption in favor of free-trade policy remains largely unchallenged. Indeed, in opinion surveys of economists the statement “trade barriers reduce general economic welfare” typically draws the greatest consensus.

INTERNATIONAL FINANCE

A corollary to flows of tangible goods, services, and factors of production are financial flows. The openness of an economy, and the existence of “the rest of the world,” adds several new dimensions to the discussion of such macroeconomic topics as national product, price level, interest rates, and their interrelations, and government policies aimed at their management. Only the international context gives rise to such frequently discussed issues as balance of payments, exchange rates, international monetary institutions, international aid, borrowing, and indebtedness.

Balance of Payments Balance of payments refers to the financial flows between the given economy on one hand and the rest of the world on the other. Understanding the logic of the balance of payments and knowing the determinants and consequences of its various subcomponents, although not a policy goal in itself, is helpful in setting policy goals and formulating policy measures.

Exchange Rate The exchange rate, the value of domestic currency with respect to foreign currencies, has a major influence on the balance of payments. The theory of how the exchange rate is determined is therefore central to this part of international economics, which examines the role of export and import demands, differences in interest rates, and expected inflation across countries. One theory, the interest rate parity, points out certain necessary relations between the expected changes in the exchange rate and countries’ interest rate differentials. As the rate of return on assets in each country must be equal, lower interest rates in one country as compared to the other will be seen as justifiable only if the currency of this country is expected to gain in value with respect to the currency of the other country. If this were not so, one of the currencies would be seen as more attractive by investors, and their attempt to exploit this opportunity would bring the real rates of return ultimately to equality.

Another theory of exchange rate determination, the theory of Purchasing Power Parity (PPP), stipulates that the exchange rate tends to correspond to the ratio of price levels in the two respective countries (or, in its modern version, that changes in exchange rate correspond to changes in the price level ratios, i.e., inflation rates). If this were not so, prices in the one country would be generally lower than in the other, which would make buying in the first more attractive than in the second. Greater demand for currency of the first country compared to that of the second would cause its value (i.e., its exchange rate) to appreciate, which would tend to eliminate the difference in the attractiveness of buying in the two countries. Only when the exchange rate will equal the ratio of the price levels will there be no difference between the countries, and no tendency for change.

Exchange rates, in their relation to the balance of payments, are also linked to the open-economy output determination. They are related to the national product through two channels. First, the exchange rate is decisive in determining the amount of production demanded by, and thus produced for, buyers in foreign countries. The less valuable the domestic currency vis-à-vis the foreign one, the higher the output the country tends to generate. Second, through the asset market, any level of product corresponds to a particular interest rate, and the interest rate in turn is important in determining the exchange rate. The higher the output, the higher the interest rate and the more valuable the domestic currency. Thus there is likely to be one particular level of exchange rate compatible with a given level of output.

Given the importance of exchange rates as a factor in open-economy macroeconomics, it is no wonder that exchange rates are subject to different degrees of government attention. A country’s policy may vary from nonintervention (a “floating” currency) to a fixed exchange rate (a currency “peg”). In the latter case, a government, typically through its central bank, attempts to keep the exchange rate within certain limits. Besides the standard tools of monetary policy (influencing domestic money supply), this is generally achieved through foreign exchange interventions. These are purchases or sales of foreign exchange currency for domestic currency through which the value of domestic currency is decreased (if foreign currency is purchased) or increased (if foreign currency is sold). The feasibility of such management is limited, on one hand by the danger of inflation (if too much domestic currency is swapped for foreign currency), and on the other by limited supplies of foreign currency (a central bank can boost the value of its currency only as long as it has foreign currency at its disposal). Special fixed-rate monetary and exchange rate regimes would include two somewhat similar arrangements: the gold standard and a currency board. The former—historically prevalent internationally but now abandoned for not entirely economic reasons—consists of defining the monetary units of currencies in terms of gold. The currency board, a relatively recent though still not very common phenomenon, replaces gold metal in a currency definition with a foreign exchange. If domestic currency becomes defined as a particular amount of gold or a particular number of units of foreign currency, both money supply and the exchange rate are determined.

If market forces are suppressed altogether and domestic currency cannot be freely exchanged for the foreign one (as assumed so far), the domestic currency is considered nonconvertible. In such cases, the official exchange rate becomes a matter of government fiat and decree, although it is likely to coexist with a much different exchange rate that is likely to develop on a black market.

The policy choice regarding the exchange rate regime has important repercussions for macroeconomic policy. Floating exchange rates allow for greater autonomy in monetary policy and provide insulation from outside monetary shocks and an automatic mechanism for maintaining external balance. This comes, however, at a cost of greater uncertainty about its level and the lack of any disciplining factor for domestic monetary authority. Yet, at the beginning of the twenty-first century, floating exchange rates seem to have prevailed. In an open economy, it is generally considered unfeasible to maintain fixed exchange rates while insisting on autonomous policy.

In some sense, the heritage of fixed exchange rates survives in the theory of optimum currency areas (developed by Robert Mundell). For the countries involved, fixed exchange rates have the same effect on (in)dependence of monetary policy as would the common currency. And just as fixed exchange rates are not always feasible, neither can common currency always be thought of as an improvement. The theory of optimum currency areas recognizes both benefits (lower transaction cost) and costs (loss of policy autonomy and openness to shocks) of monetary integration, and thus makes clear under what conditions such integration is beneficial.

In today’s globalized world economy, international economics stands only to gain in importance. However, as borders between countries become increasingly irrelevant and their policies harmonized, international economics may become indistinguishable from conventional economics. After all, if the world were one country, the difference between international and domestic would disappear altogether.

SEE ALSO Absolute and Comparative Advantage; Cantillon, Richard; Central Banks; Customs Union; Dornbusch-Fischer-Samuelson Model; Economics; Exchange Rates; Free Trade; Heckscher-Ohlin-Samuelson Model; Hume, David; Mundell-Fleming Model; Policy, Monetary; Protectionism; Quotas, Trade; Ricardo, David; Samuelson, Paul A.; Smith, Adam; Tariffs; Trade