Cambridge Syllabus Notes

Effectiveness of International Trade Policy – Cambridge AS & A‑Level (9708)

1. Why Countries Trade

Absolute advantage – a country can produce a good with fewer resources (labour, capital, land) than another country.
Example: Country A can produce 1 ton of wheat with 2 units of labour, whereas Country B needs 3 units.
Comparative advantage – a country specialises in the good that has the lower opportunity cost.
Opportunity‑cost ratio for good X in country A: $$\text{OC}_{X}^{A}= \frac{\text{Units of Y given up}}{\text{Units of X produced}}$$ Even if a country has an absolute disadvantage in both goods, it will export the good for which its OC is relatively lower.
Limitations of the theories
- Transport costs and trade barriers raise the effective cost of imports.
- Factors of production are not always mobile (e.g., land, skilled labour).
- Assumes perfect competition and constant returns to scale – rarely true in reality.
- Does not capture externalities (environmental damage, congestion).
Terms of Trade (ToT) – the ratio of export prices to import prices: $$\text{ToT}= \frac{P_{\text{exports}}}{P_{\text{imports}}}$$
- An improvement (higher ToT) means a country can import more for a given amount of exports – raising real income.
- Factors that shift ToT: changes in world commodity prices, exchange‑rate movements, trade‑policy measures (tariffs, subsidies), and changes in the composition of exports/imports.
Trading‑Possibility Curve (TPC) – shows the maximum combinations of two goods a country can produce and trade.
- Slope = opportunity‑cost ratio.
- Any point on the curve is efficient; points inside are inefficient; points outside are unattainable without trade.
- Moving from autarky to a point on the TPC that lies outside the autarky consumption point illustrates the gains from trade.

2. Protectionist Instruments (Syllabus 6.2)

Governments intervene for a variety of reasons – protecting infant industries, preserving strategic sectors, correcting market failures, or achieving macro‑economic objectives.

Instrument	How it works	Typical macro‑objective	WTO / compliance note
Tariff (specific or ad‑valorem)	Tax on each unit (or value) of an imported good.	Reduce imports → improve current‑account; protect domestic producers.	Generally allowed, but must not exceed bound rates.
Import quota	Quantitative limit on the volume of a specific import.	Directly caps imports → larger CA improvement.	Considered a quantitative restriction – requires WTO justification (e.g., balance‑of‑payments).
Export subsidy	Payment to domestic producers for each unit exported.	Boost export volume and employment in target sectors.	Prohibited under the WTO Agreement on Subsidies and Countervailing Measures.
Export tax / duty	Levy on each unit of a good leaving the country.	Conserve scarce resources; raise fiscal revenue.	Generally permissible, but must be non‑discriminatory.
Import licensing	Administrative permission required before an import can occur; may be quantitative or qualitative.	Control volume or ensure standards (e.g., health, safety).	Allowed if applied uniformly and not a disguised restriction.
Embargo	Complete ban on trade (imports, exports, or both) with a specific country or product.	Political or security objectives; sometimes used to protect domestic industry.	May be challenged under the WTO if not justified on security grounds.
Non‑tariff barriers (NTBs) – “red‑tape”	Technical standards, sanitary‑phytosanitary (SPS) rules, licensing, etc., that restrict trade without a tax.	Protect health, environment, consumer safety; sometimes used to protect domestic producers.	Must be based on scientific evidence and be no more trade‑restrictive than necessary (WTO SPS Agreement).

3. Current‑Account Components & Balance‑of‑Payments (BoP) (Syllabus 6.3)

Current account (CA) – records transactions that involve a change in ownership of goods, services, primary income and secondary income.
- Goods (merchandise) balance: exports – imports of tangible products.
- Services balance: tourism, transport, financial services, royalties, etc.
- Primary income: investment income (dividends, interest) and compensation of employees.
- Secondary income: unilateral transfers such as remittances, foreign aid, gifts.
Capital & financial account (CFA) – records capital transfers and changes in ownership of financial assets.
- Direct investment (FDI): acquisition of lasting interest (≥10 % of voting power).
- Portfolio investment: purchases of stocks, bonds, and other securities.
- Other investment: loans, currency deposits, trade credits.
- Reserve assets: official foreign‑exchange holdings used to intervene in the FX market.
Balance‑of‑Payments identity (including the “statistical discrepancy”): $$\text{CA} + \text{CFA} + \text{Official Reserves} + \text{Statistical Discrepancy}=0$$ The discrepancy captures measurement errors and unrecorded transactions.
How trade policy influences the CA
- Tariffs & quotas → lower import volume → improve the goods balance.
- Export subsidies → raise export volume → can improve the goods balance but may trigger retaliation, affecting the services and income balances.
- Export taxes → reduce export earnings → may improve the primary‑income balance if the tax is on a scarce resource that otherwise generates large royalty payments abroad.

4. Exchange‑Rate Determination (Syllabus 6.4)

Key concepts
- Spot rate (E): domestic currency units per unit of foreign currency.
- Expected future rate (E⁽ᵉ⁾).
- Real exchange rate (RER): $RER = \frac{E \times P^{*}}{P}$ where $P^{*}$ and $P$ are foreign and domestic price levels.
Regimes
- Floating (flexible) exchange rate – market forces of supply and demand determine E; central banks may intervene occasionally to smooth volatility.
- Fixed (pegged) exchange rate – the government sets E at a predetermined level relative to another currency or a basket; the central bank must buy/sell reserves to maintain the peg.
- Managed (dirty‑float) exchange rate – primarily market‑determined but with occasional official intervention to prevent excessive appreciation/depreciation.
Fundamental determinants
- Interest‑rate parity (IRP) (under high capital mobility): $$i = i^{*} + \frac{E^{e}-E}{E}$$ where $i$ = domestic nominal interest rate, $i^{*}$ = foreign rate.
- Purchasing‑power parity (PPP) (long‑run): $$E = \frac{P^{*}}{P}$$ If domestic prices rise faster than foreign prices, the domestic currency depreciates.
- Monetary‑approach model: a surplus of domestic money supply relative to foreign money leads to depreciation; a deficit leads to appreciation.
Mundell‑Fleming model (small open economy, perfect capital mobility)
- In a fixed regime, fiscal expansion (right‑shift of IS) raises output but forces a loss of reserves to keep the peg – the BP curve stays unchanged.
- In a floating regime, the same fiscal expansion shifts IS right, causing the currency to appreciate; the BP curve moves left, partially offsetting the output gain.
- Monetary policy is effective only under a floating regime (LM shift changes E, which restores BP equilibrium).

5. Policies to Correct Current‑Account Imbalances (Syllabus 6.5)

When a persistent deficit (or surplus) threatens macro‑stability, policymakers may combine the following tools. The choice depends on the underlying cause (e.g., low export competitiveness vs. excessive import demand).

Policy tool	Mechanism	Typical effect on CA	Key considerations
Exchange‑rate devaluation (or depreciation)	Exports become cheaper; imports become more expensive.	Improves goods balance if export and import demand are price‑elastic.	May trigger import‑price inflation; effectiveness depends on elasticity and pass‑through.
Export taxes / duties	Reduces outflow of scarce resources; generates fiscal revenue.	Directly improves the primary‑income balance; may lower export earnings.	Useful for natural‑resource management; can be regressive if revenue is not redistributed.
Import licensing / quantitative restrictions	Limits volume of specific imports.	Improves goods balance; effect size depends on compliance and possible rent‑seeking.	Administrative costs; may provoke WTO disputes.
Tariff adjustments (increase or reduction)	Higher tariffs reduce imports; lower tariffs stimulate export‑oriented sectors.	Higher tariffs → CA improvement; lower tariffs → possible CA deterioration but may boost growth.	Need to balance short‑term CA gains against long‑term welfare loss.
Fiscal & monetary policy coordination	Contractionary fiscal stance or tighter monetary policy lowers domestic demand for imports.	Reduces import bill → CA improves.	Risk of slowing growth and raising unemployment.
Structural reforms (productivity, infrastructure, education)	Raise export competitiveness and diversify the export base.	Long‑run CA improvement through higher export earnings.	Time‑lagged; requires political commitment.

6. Evaluation Framework for Trade Instruments

Criterion	What to assess
Direct impact on the targeted macro‑objective	Effect on growth, unemployment, inflation, CA balance, exchange‑rate stability.
Spill‑over effects on other objectives	e.g., a tariff may improve the CA but raise consumer prices (inflation) and reduce equity.
Time‑lag	Immediate (tariffs, quotas) vs. medium‑/long‑term (structural reforms, skill‑training).
Feasibility & WTO compliance	Whether the measure breaches WTO rules (e.g., export subsidies, quantitative restrictions).
Distributional consequences	Who gains (producers, workers) and who loses (consumers, import‑dependent sectors).
Administrative & enforcement costs	Complexity of licences, monitoring of quotas, customs administration, risk of corruption.
Dynamic effects	Impact on investment, innovation, resource allocation over time.

7. Effectiveness Summary – Trade Instruments vs. Macro Objectives

Instrument	Growth	Unemployment	Inflation	Balance of Payments	Equity	Sustainability	Key trade‑offs / notes
Tariffs	Low‑Medium – protect domestic firms but reduce allocative efficiency.	Medium – preserve jobs in protected sectors.	Medium – higher import prices raise CPI.	Medium – lower import volume improves CA.	Low – consumers pay higher prices.	Low – may encourage resource‑intensive production.	Risk of WTO disputes and retaliation; effectiveness depends on price elasticity.
Import quotas	Low‑Medium	Medium	Medium	Medium‑High – directly caps imports.	Low – quota rents often captured by importers.	Low – may lead to over‑use of domestic inputs.	Creates rent‑seeking; can generate black‑market activity.
Export subsidies	Medium‑High – boost export‑led growth.	Medium‑High – protect export‑oriented jobs.	Low‑Medium – higher aggregate demand may push up prices.	Low‑Medium – larger export volume can worsen CA if retaliation follows.	Low – benefits narrow industries.	Low – may ignore environmental costs.	Prohibited under WTO rules; can provoke trade wars.
Export taxes	Low – reduce export revenue.	Low – cut jobs in export sectors.	Low‑Medium – reduce aggregate demand.	High – reduce outflows, improving CA.	Medium – revenue can be redistributed.	Medium – discourages over‑exploitation of scarce resources.	Useful for natural‑resource preservation.
Import licensing	Low‑Medium	Low‑Medium	Medium – administrative delays raise costs.	Medium‑High – restricts import volumes.	Low – creates barriers for consumers.	Medium – can block harmful imports (e.g., hazardous chemicals).	Often justified on health, safety or environmental grounds.
Embargoes	Low – severe market distortion.	Low‑Medium – depends on sector exposure.	Variable – price shocks possible.	High – drastic reduction in targeted trade flows.	Low – consumer welfare falls sharply.	Variable – can be used for environmental or human‑rights reasons.	Highly contentious; may breach WTO obligations.
Exchange‑rate devaluation	Medium‑High – cheaper exports, pricier imports.	Medium‑High – export‑linked employment rises.	Medium‑High – import‑price inflation.	Medium‑High – improves CA if price elasticities are high.	Low – import‑dependent households face higher costs.	Medium – expansion may raise carbon output.	Effectiveness hinges on elasticity; may trigger inflationary spiral.
Free Trade Agreements (FTAs)	High – larger markets, economies of scale.	Medium‑High – sectoral job creation, but adjustment costs.	Low‑Medium – import competition can lower prices.	Low‑Medium – trade volume rises; CA impact depends on export‑import mix.	Medium – overall welfare gain but winners/losers exist.	Medium‑High – can spread greener technologies; may increase carbon‑intensive trade.	Requires complementary policies (re‑training, safety nets).
Regulatory standards (NTBs)	Low‑Medium – may raise production costs.	Low‑Medium – possible job loss in non‑compliant sectors.	Low – generally price‑neutral.	Low‑Medium – act as non‑tariff barriers to imports.	Medium – protects health, safety, consumer rights.	High – environmental standards promote sustainability.	Must be non‑discriminatory to satisfy WTO rules.

8. Illustrative Economic Models (Exam‑style diagrams)

8.1 Tariff – AD/AS Diagram

A specific tariff raises the domestic price of the imported good. The immediate effects are:

Left‑ward shift of AD (reduced import consumption).
Left‑ward shift of SRAS if the imported good is an important intermediate input (higher production costs).
Result: lower output (Y) and higher price level (P) – a classic stagflation‑type outcome.

8.2 Exchange‑Rate Devaluation – IS‑LM‑BP (Mundell‑Fleming)

Assume a small open economy with perfect capital mobility and a floating exchange rate.

Devaluation makes exports cheaper and imports more expensive → net export (NX) rises.
NX increase shifts the IS curve rightward.
Higher output raises money demand, shifting the LM curve leftward; however, capital outflows caused by the higher domestic price level move the BP curve rightward.
Equilibrium moves to a higher level of output (Y) and a higher price level (P), with a depreciated currency.

8.3 Balance‑of‑Payments Diagram

The BoP can be represented by two stacked rectangles:

Top rectangle – Current account (surplus = positive, deficit = negative).
Bottom rectangle – Capital & financial account + Official reserves.
Policy that improves the CA (e.g., a tariff) reduces the height of the deficit rectangle, moving the overall balance toward equilibrium.

9. Integrated Policy Recommendations (Sample answer framework)

Exchange‑rate management – a modest, orderly devaluation combined with a temporary tightening of monetary policy to contain import‑price inflation.
Targeted “green” NTBs – adopt environmental and safety standards that are scientifically justified and non‑discriminatory, thereby protecting health while preserving trade openness.
Gradual tariff reform – phase out high tariffs on intermediate inputs to raise productivity, while maintaining modest protective tariffs on strategically important industries.
Skills and structural adjustment programmes – retraining for workers displaced by import competition; support for SMEs to upgrade technology and improve export competitiveness.
Export taxes on scarce natural resources – preserve the resource base, raise fiscal revenue, and redistribute proceeds to affected communities.
Strengthen institutional capacity – improve customs efficiency, reduce corruption, and ensure WTO‑compliant implementation of trade measures.

10. Quick Revision Checklist

Know the definitions and formulas for absolute advantage, comparative advantage, opportunity cost, terms of trade, and the trading‑possibility curve.
Be able to list and briefly explain each protectionist instrument, its macro‑objective, and its WTO status.
Recall the four components of the current account and the three components of the capital & financial account; write the BoP identity with the statistical discrepancy.
Understand the three exchange‑rate regimes, the IRP and PPP equations, and the key predictions of the Mundell‑Fleming model.
Identify at least three policy tools for correcting a persistent current‑account deficit and explain the mechanism for each.
Apply the evaluation framework (impact, spill‑overs, time‑lag, WTO compliance, distribution, administrative cost, dynamic effects) when discussing any trade policy.

international trade policy