trade and investment

1. Introduction

Countries differ markedly in their stage of economic development. These differences shape the patterns of international trade, investment and the policies that governments adopt. Understanding how development level influences comparative advantage, the balance of payments and capital flows is a core part of the Cambridge A‑Level syllabus (Syllabus 11).

2. Classification of Economies and Development Indicators

2.1 Cambridge classification of economies

Category	Typical GNI per‑capita (2023, US$)	Examples
Low‑income (Least‑Developed Countries – LDCs)	< 1 200	Afghanistan, Haiti, Mozambique
Lower‑middle‑income (Developing)	1 200 – 3 995	India, Nigeria, Vietnam
Upper‑middle‑income (Developing)	3 996 – 12 375	Brazil, China, South Africa
High‑income (Developed)	> 12 375	United Kingdom, United States, Germany

2.2 Key development indicators

• Monetary: GDP per‑capita (nominal), Gross National Income (GNI) per‑capita, Purchasing Power Parity (PPP) adjustments.
• Non‑monetary: Human Development Index (HDI), Multidimensional Poverty Index (MPI), Mean Years of Schooling (MYS), Gender Inequality Index (GII).
• Structural characteristics:
  • Sectoral employment (agriculture, industry, services)
  • Urbanisation rate
  • Population growth and stage of the demographic transition
  • Factor endowments (land, labour, capital, technology)
• Income distribution:
  • Gini coefficient (0 = perfect equality, 1 = perfect inequality)
  • Lorenz curve – graphical representation of the cumulative share of income earned by cumulative population percentages.
• Growth‑inequality relationship: Kuznets curve – predicts that inequality first rises and then falls as a country moves from low to high income.

2.3 The development‑trade‑investment link

Higher income levels usually imply a shift from land‑intensive primary production to capital‑ and technology‑intensive manufacturing and services. This structural transformation underpins the comparative‑advantage patterns described later and creates the demand for foreign capital.

3. Trade Between Countries at Different Development Levels

3.1 Comparative advantage and typical export composition

According to the theory of comparative advantage, each country specialises in the production of goods for which its opportunity cost is lowest. In practice this yields a fairly regular pattern of export composition across development groups.

• Least‑developed countries (LDCs): primary commodities – agricultural products, minerals, crude oil.
• Developing countries: a mix of primary commodities and low‑value manufactured goods – textiles, footwear, processed foods.
• Developed countries: high‑value manufactured goods, services and technology‑intensive products – pharmaceuticals, aircraft, software, financial services.

3.2 Terms of trade (ToT)

The terms of trade measure the relative price of a country’s exports to its imports:

\[ \text{ToT} = \frac{P_{\text{exports}}}{P_{\text{imports}}}\times 100 \]

Developed economies typically enjoy improving ToT because they export goods with rising global demand while importing lower‑priced commodities. LDCs often experience a deteriorating ToT as commodity prices fall relative to the price of manufactured imports.

3.3 Heckscher‑Ohlin (H‑O) model

The H‑O model predicts that a country will export goods that intensively use its abundant factor of production:

• Land‑abundant economies (usually LDCs) → export agricultural and mineral goods.
• Capital‑abundant economies (usually developed) → export capital‑intensive manufactures.

3.4 Linder’s hypothesis

Linder argued that countries with similar per‑capita incomes have similar demand structures and therefore trade more with each other, especially in manufactured goods. This helps explain the strong intra‑group trade among developed nations.

3.5 Policies to correct current‑account imbalances (11.1)

Two families of policy are examined in the syllabus:

• Expenditure‑switching policies – aim to shift demand from imports to domestically produced goods.
  • Currency devaluation (or real‑exchange‑rate depreciation)
  • Export subsidies, import tariffs, import quotas
• Expenditure‑reducing policies – aim to lower overall demand for imports (and sometimes for exports).
  • Contractionary fiscal policy (higher taxes, reduced government spending)
  • Contractionary monetary policy (higher interest rates)

In practice governments often combine both approaches; the choice depends on the size of the imbalance, the exchange‑rate regime and the political economy of the country.

3.6 Empirical illustration of export‑import patterns

Development Level	Typical Export Goods	Typical Import Goods	Average ToT Trend (last 10 years)
Least‑developed	Agricultural commodities, minerals, crude oil	Machinery, transport equipment, processed foods	Declining
Developing	Textiles, footwear, processed agricultural products	Capital goods, chemicals, high‑tech components	Stable to slightly improving
Developed	Pharmaceuticals, aircraft, software, financial services	Raw materials, consumer electronics, energy	Improving

4. Balance of Payments, Exchange‑Rate Regimes and Their Interaction with Trade

4.1 The three BoP accounts

A country’s balance of payments records all monetary transactions with the rest of the world. It is divided into three main accounts:

1. Current account – trade in goods and services, primary income (remittances, interest) and secondary income (transfers).
2. Capital account – transfers of non‑produced, non‑financial assets (e.g., debt forgiveness, migrants’ assets).
3. Financial account – direct investment, portfolio investment, other investment (loans, deposits) and changes in reserve assets.

The accounts must balance (including a statistical “errors & omissions” line). A current‑account deficit is financed by a surplus in the capital & financial accounts (net inflow of foreign capital).

4.2 Exchange‑rate regimes (11.2)

Regime	Key Features	Typical Policy Tools
Fixed (or pegged) rate	Official parity set against another currency or a basket; central bank intervenes to maintain the peg.	Foreign‑exchange reserves, legal limits on capital flows, direct market intervention.
Managed (or dirty‑float) rate	Market‑determined rate with occasional central‑bank intervention to smooth excessive volatility.	Foreign‑exchange interventions, interest‑rate adjustments, capital controls.
Floating (flexible) rate	Rate set by supply and demand for the currency; no systematic intervention.	Monetary policy (interest rates) only; occasional “verbal” guidance.

Additional points required by the syllabus:

• Nominal vs. real exchange rate:
  \[ \text{Real ER} = \frac{E \times P_{\text{foreign}}}{P_{\text{domestic}}} \] where \(E\) is the nominal rate, \(P\) are price levels.
• Trade‑weighted exchange‑rate index – aggregates bilateral rates using trade‑share weights.
• Revaluation / appreciation – rise in the value of the domestic currency; devaluation / depreciation – fall in the value.

4.3 Effect of a depreciation/appreciation on the current account

The impact of a change in the exchange rate on the trade balance is summarised by the Marshall‑Lerner condition:

\[ \varepsilon_X + \varepsilon_M \; > \; 1 \]

where \(\varepsilon_X\) is the absolute price elasticity of export demand and \(\varepsilon_M\) is the absolute price elasticity of import demand. If the condition holds, a depreciation improves the trade balance.

4.4 The J‑curve

In the short run a depreciation may initially worsen the trade balance because import prices rise immediately while volumes adjust slowly. Over time, export volumes increase and import volumes fall, producing the characteristic “J‑shaped” trajectory.

5. Investment Flows Between Countries at Different Development Levels

5.1 Types of international investment

• Foreign Direct Investment (FDI) – long‑term interest and control (≥10 % ownership); includes greenfield projects, mergers & acquisitions, joint ventures.
• Portfolio investment – purchase of stocks, bonds and other securities without seeking control.
• Official Development Assistance (ODA) and aid‑related investment – concessional flows from governments and multilateral institutions, often earmarked for infrastructure or capacity‑building.
• External debt – loans from foreign governments, commercial banks, or international capital markets. Debt can be:
  • Public vs. private
  • Short‑term vs. long‑term
  • Concessional (low‑interest) vs. commercial

5.2 Motives for FDI (Cambridge 11.3)

1. Market‑seeking – access to a large or growing consumer base.
2. Resource‑seeking – acquisition of natural resources, cheap labour or strategic inputs.
3. Efficiency‑seeking – lower production costs through off‑shoring, economies of scale or proximity to markets.

Developed economies are typically net exporters of capital, while developing and LDCs are net recipients.

5.3 The Eclectic Paradigm (OLI Framework)

• Ownership advantages (O): proprietary technology, brand reputation, managerial expertise.
• Location advantages (L): natural resources, market size, labour costs, infrastructure, regulatory environment.
• Internalisation advantages (I): benefits of retaining control over production or technology rather than licensing.

5.4 Investment‑development nexus

Empirical work shows a positive but non‑linear relationship between FDI inflows and economic growth. A common specification includes a “threshold” dummy:

\[ \Delta GDP = \alpha + \beta \ln(FDI) + \gamma D_{\text{threshold}} + \varepsilon \]

where \(D_{\text{threshold}} = 1\) when FDI exceeds about 5 % of GDP. Below the threshold the impact on growth is weak; above it the impact becomes statistically significant.

5.5 Risks and policy responses

• Volatility of portfolio flows – can trigger sudden capital flight and exchange‑rate pressure.
• “Race to the bottom” – competition for low‑cost labour may erode labour standards, environmental regulations and tax bases.
• Policy tools:
  • Capital controls (e.g., taxes on short‑term inflows, limits on foreign ownership).
  • Investment promotion agencies and incentives (tax holidays, subsidies, one‑stop‑shops).
  • Regulations on technology transfer, intellectual‑property protection and corporate governance.

5.6 Multinational enterprises and globalisation (11.5)

Multinationals (MNEs) are the main conduit for FDI and for the diffusion of technology, management practices and standards. Their activities illustrate three dimensions of globalisation:

• Trade‑linked globalisation – MNEs integrate supply chains across borders, increasing intra‑industry trade.
• Investment‑linked globalisation – cross‑border production facilities spread capital, jobs and skills.
• Knowledge‑linked globalisation – R&D networks, licensing and joint ventures spread innovation.

External debt, aid and the activities of international organisations also shape the global economic architecture, influencing the ability of low‑income countries to participate in trade and attract investment.

6. Summary Points (AO1–AO3)

• Economies are classified by income (low, middle, high) and development status (LDC, developing, developed); a range of monetary, non‑monetary and structural indicators measures progress, including Gini, Lorenz and the Kuznets curve.
• Factor endowments determine comparative advantage: land‑abundant LDCs export primary commodities; capital‑abundant developed economies export high‑value manufactures and services.
• Terms of trade tend to improve for capital‑abundant economies and deteriorate for resource‑abundant economies.
• The Balance of Payments records current, capital and financial transactions; a current‑account deficit is financed by capital inflows.
• Exchange‑rate regimes (fixed, managed, floating) affect how quickly price changes feed through to trade; measurement (nominal, real, trade‑weighted) and terminology (devaluation/appreciation) are essential.
• Depreciation improves the trade balance only if the Marshall‑Lerner condition holds; the short‑run J‑curve explains the initial deterioration.
• Current‑account imbalances can be tackled with expenditure‑switching (devaluation, tariffs) or expenditure‑reducing (fiscal/monetary tightening) policies.
• FDI flows mainly from developed to developing economies, driven by market‑, resource‑ and efficiency‑seeking motives; the OLI framework explains location choices.
• FDI positively affects growth once a threshold (≈5 % of GDP) is passed; however, volatility, “race‑to‑the‑bottom” effects and external‑debt sustainability must be managed.
• Multinational enterprises, external debt, ODA and broader globalisation processes link trade, investment and development, shaping the policy choices of governments at every income level.