International Trade and Finance — Diagnostic Tests

Unit Tests

UT-1: Comparative Advantage and Gains from Trade

Question: Two countries, Hong Kong and Vietnam, can produce the following per worker per day:

	Electronics (units)	Garments (units)
Hong Kong	8	4
Vietnam	2	6

(a) Which country has an absolute advantage in each good? (b) Calculate the opportunity cost of 1 unit of electronics in each country. (c) Which country has a comparative advantage in which good? (d) If they specialise and trade at a rate of 1 electronics $=$ 2 garments, show that both countries gain compared to autarky (assuming each has 100 workers and splits them equally without trade).

Solution:

(a) Hong Kong has an absolute advantage in electronics (8 $\gt$ 2). Vietnam has an absolute advantage in garments (6 $\gt$ 4). Neither country has an absolute advantage in both goods.

(b) Opportunity cost of 1 unit of electronics:

• Hong Kong: $4/8 = 0.5$ garments.
• Vietnam: $6/2 = 3$ garments.

(c) Hong Kong has a comparative advantage in electronics (lower opportunity cost: 0.5 garments vs 3 garments). Vietnam has a comparative advantage in garments.

(d) Without trade: Hong Kong uses 50 workers for each good: $50 \times 8 = 400$ electronics, $50 \times 4 = 200$ garments. Vietnam: $50 \times 2 = 100$ electronics, $50 \times 6 = 300$ garments. World total: 500 electronics, 500 garments.

With specialisation: Hong Kong (100 workers on electronics) $= 800$ electronics. Vietnam (100 workers on garments) $= 600$ garments. World total: 800 electronics, 600 garments. Gains: 300 extra electronics, 100 extra garments.

If Hong Kong exports 300 electronics at 1:2, it receives 600 garments. Hong Kong consumes $800 - 300 = 500$ electronics and 600 garments (gains: 100 electronics, 400 garments). Vietnam consumes 300 electronics and $600 - 600 = 0$ garments -- that leaves Vietnam with nothing.

At the 1:2 exchange rate, both countries gain. For example, if Hong Kong exports 120 electronics and receives 240 garments: Hong Kong consumes 680 electronics and 240 garments (gains: 280 electronics, 40 garments compared to autarky). Vietnam consumes 120 electronics and 360 garments (gains: 20 electronics, 60 garments compared to autarky). Both are better off, confirming that trade at this rate is mutually beneficial.

UT-2: Exchange Rate and Trade

Question: The exchange rate between USD and HKD is 1 USD $=$ 7.8 HKD. A smartphone costs \600$USD in the US and$$5200$HKD in Hong Kong. (a) Calculate the Hong Kong price of the US phone in HKD. (b) Is the smartphone cheaper in the US or Hong Kong? (c) If the HKD appreciates to 1 USD$=$ 7.0 HKD, recalculate and explain the effect on Hong Kong's exports. (d) Explain the concept of purchasing power parity (PPP).

Solution:

(a) US price in HKD: 600 \times 7.8 = HK\4680$.

(b) In Hong Kong: HK$5200. The US phone costs HK$4680, which is cheaper than HK$5200. The smartphone is cheaper in the US.

(c) New US price in HKD: 600 \times 7.0 = HK\4200. The US phone is now even cheaper in HKD terms (HK\4200 vs HK$5200). HKD appreciation makes imports cheaper and exports more expensive. This reduces Hong Kong's export competitiveness -- foreign buyers need fewer USD to buy HKD, but Hong Kong's goods become more expensive in foreign currency. For example, a HK$5200 phone now costs 5200/7.0 = \743$USD (vs$5200/7.8 = $667$ USD before). Hong Kong's exports become 11% more expensive.

(d) Purchasing Power Parity (PPP) states that exchange rates should adjust so that identical baskets of goods cost the same in all countries. PPP exchange rate $= \frac{P_D}{P_F}$. If the PPP rate for the smartphone is $5200/600 = 8.67$ HKD per USD, but the actual rate is 7.8, the HKD is overvalued relative to PPP (fewer HKD per dollar than PPP suggests). In the long run, PPP predicts the HKD should depreciate to equalise prices.

UT-3: Tariff Analysis

Question: A country imports shoes. World price = \40$per pair. Domestic demand:$Q_d = 200 - 2P$. Domestic supply:$Q_s = 2P - 40$. (a) Calculate the quantity of imports before any tariff. (b) The government imposes a 25% tariff. Calculate the new domestic price, quantity of imports, tariff revenue, and deadweight loss. (c) Calculate the change in consumer surplus and producer surplus.

Solution:

(a) At $P = 40$: $Q_d = 200 - 80 = 120$, $Q_s = 80 - 40 = 40$. Imports $= 120 - 40 = 80$.

(b) Tariff = 25\% \times 40 = \10$. New domestic price$= 40 + 10 = $50$.

$Q_d = 200 - 100 = 100$. $Q_s = 100 - 40 = 60$. Imports $= 100 - 60 = 40$.

Tariff revenue = 10 \times 40 = \400$.

DWL = \frac{1}{2} \times 10 \times (60 - 40) + \frac{1}{2} \times 10 \times (120 - 100) = \frac{1}{2} \times 10 \times 20 + \frac{1}{2} \times 10 \times 20 = 100 + 100 = \200$.

(c) CS before: \frac{1}{2}(100 - 40)(120) = \frac{1}{2}(60)(120) = \3600$. CS after:$\frac\\{1\\}\\{2\\}(100 - 50)(100) = \frac\\{1\\}\\{2\\}(50)(100) = $2500$. Change in CS$= -$1100$.

PS before: \frac{1}{2}(40 - 20)(40) = \frac{1}{2}(20)(40) = \400$. PS after:$\frac\\{1\\}\\{2\\}(50 - 20)(60) = \frac\\{1\\}\\{2\\}(30)(60) = $900$. Change in PS$= +$500$.

Net welfare change = -1100 + 500 + 400 = -\200$ (equals DWL).

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Integration Tests

IT-1: Exchange Rates and Macroeconomic Policy (with Fiscal and Monetary Policy)

Question: Country X has a fixed exchange rate of 1 USD $=$ 7.75 of local currency (LC). (a) If the central bank wants to maintain this peg but there is capital outflow (investors selling LC for USD), explain what the central bank must do and the consequences for the domestic money supply. (b) If the country simultaneously faces high unemployment, explain why the fixed exchange rate constrains monetary policy (the impossible trinity). (c) Calculate the impact if the central bank must sell USD 5 billion from reserves to defend the peg, given a money multiplier of 4.

Solution:

(a) To maintain the peg, the central bank must buy LC (using its USD reserves) or sell USD. This reduces the domestic money supply as LC is taken out of circulation. The reduced money supply raises domestic interest rates, which should attract capital inflows and stabilise the exchange rate.

(b) The impossible trinity (trilemma) states a country cannot simultaneously have: (1) a fixed exchange rate, (2) free capital mobility, and (3) independent monetary policy. To reduce unemployment, the central bank would want to lower interest rates (expansionary monetary policy), but this would cause capital outflow and put downward pressure on the exchange rate, threatening the peg. The central bank must choose between maintaining the peg or pursuing independent monetary policy.

(c) Selling USD 5 billion and buying LC removes LC 5 billion from circulation. With a money multiplier of 4: $\Delta M = m \times \Delta B = 4 \times (-5) = -LC 20$ billion. The domestic money supply contracts by LC 20 billion, which is contractionary and would worsen unemployment -- illustrating the trilemma constraint.

IT-2: Trade Policy and Welfare (with Market Failure)

Question: Country A imposes a quota of 30 units on imported steel. World price = \100$. Without the quota, domestic demand is$Q_d = 150 - 0.5P$and supply is$Q_s = 0.5P - 25$. (a) Calculate the free trade imports and domestic price with the quota. (b) Calculate the change in consumer surplus, producer surplus, and deadweight loss compared to free trade. (c) Who gains the quota rent? How does this differ from a tariff? (d) If the steel industry generates positive externalities (strategic industry for defence), explain how this affects the welfare analysis.

Solution:

(a) Free trade: $Q_d = 150 - 50 = 100$, $Q_s = 50 - 25 = 25$. Imports $= 75$.

With quota of 30: $Q_d - Q_s = 30$. $150 - 0.5P - (0.5P - 25) = 30$. $175 - P = 30$. P = \145$.

$Q_d = 150 - 72.5 = 77.5$, $Q_s = 72.5 - 25 = 47.5$. Imports $= 77.5 - 47.5 = 30$.

(b) CS loss (using the area method):

CS free trade = \frac{1}{2}(300 - 100)(100) = \frac{1}{2}(200)(100) = \10,000$. CS with quota$= \frac\\{1\\}\\{2\\}(300 - 145)(77.5) = \frac\\{1\\}\\{2\\}(155)(77.5) = $6006.25$.$\Delta CS = -$3993.75$.

PS free trade = \frac{1}{2}(100 - 50)(25) = \frac{1}{2}(50)(25) = \625$. PS with quota$= \frac\\{1\\}\\{2\\}(145 - 50)(47.5) = \frac\\{1\\}\\{2\\}(95)(47.5) = $2256.25$.$\Delta PS = +$1631.25$.

Quota rent = (145 - 100) \times 30 = 45 \times 30 = \1350$ (goes to whoever holds the import licenses).

DWL = |\Delta CS - \Delta PS - quota rent| = |{-3993.75} - 1631.25 - 1350| = |{-3993.75} + 1631.25 + 1350| = |-1012.5| = \1012.5$.

(c) Quota rent goes to import licence holders (foreign exporters if they hold the licences, or domestic importers if allocated by the government). With a tariff, the equivalent revenue goes to the domestic government. This is a key difference: tariffs generate government revenue while quotas create quota rents that may benefit foreign producers.

(d) If steel has positive externalities (e.g., national security, technology spillovers), the free market underprovides it. The protection (quota) moves production closer to the socially optimal level, and part of the "deadweight loss" may actually be a welfare gain from the externality correction. The net effect depends on whether the marginal external benefit of additional domestic steel production exceeds the marginal cost of the quota distortion. This is the strategic trade policy argument.

IT-3: Balance of Payments and National Income (with National Income)

Question: An economy has the following BOP data (in billions): Exports of goods $= 300$, Imports of goods $= 400$, Exports of services $= 150$, Imports of services $= 100$, Net primary income $= -50$, Net secondary income $= 20$, Financial account surplus $= 80$. (a) Calculate the current account balance. (b) Calculate the capital and financial account balance. (c) Verify the BOP identity. (d) Explain how a persistent current account deficit relates to national savings and investment identity.

Solution:

(a) Current account $= (X_g - M_g) + (X_s - M_s) + Net primary income + Net secondary income$ $= (300 - 400) + (150 - 100) + (-50) + 20$ = -100 + 50 - 50 + 20 = -\80$ billion (deficit).

(b) Assuming no change in reserve assets: Capital and financial account = +\80$ billion (surplus to balance the current account deficit).

(c) BOP identity: Current Account $+$ Capital Account $+$ Financial Account $+$ Reserve Assets $= 0$. $-80 + 0 + 80 + 0 = 0$. The identity holds.

(d) From the national income identity: $(S - I) + (T - G) = (X - M)$.

A current account deficit $(X \lt M)$ means the country is spending more on imports than it earns from exports. This must be financed by: (1) foreign borrowing (financial account surplus), or (2) running down foreign reserves. Equivalently, $S - I \lt 0$, meaning domestic investment exceeds domestic saving. The country is importing capital to finance investment that exceeds domestic savings. This is sustainable if the borrowed funds are invested productively (generating future export capacity), but unsustainable if used for consumption.

Additional DSE Exam-Style Questions

EQ-1: Terms of Trade and Export Revenue

Question: Country A exports electronics and imports raw materials. In 2020, the export price index was 120 and the import price index was 100 (base year 2015 $= 100$). In 2025, the export price index is 144 and the import price index is 130. Country A exported \500$ billion worth of goods in 2025. (a) Calculate the terms of trade for 2020 and 2025. (b) Has the terms of trade improved or deteriorated? (c) Calculate the income terms of trade for 2025 if the export quantity index is 110. (d) Explain why an improvement in the terms of trade does not necessarily mean the country is better off.

Solution:

(a) Terms of trade $= \frac{\text{Export price index}}{\text{Import price index}} \times 100$.

• 2020: $ToT = \frac{120}{100} \times 100 = 120$.
• 2025: $ToT = \frac{144}{130} \times 100 = 110.77$.

(b) The terms of trade have deteriorated from 120 to 110.77. The country now needs to export more to buy the same amount of imports. Export prices rose by 20% ($144/120$) while import prices rose by 30% ($130/100$). Since import prices rose faster, the terms of trade worsened.

(c) Income terms of trade $= ToT \times \text{Export quantity index} = 110.77 \times 110 = 12\,185$ (index).

Alternatively, export revenue in base-year prices = \frac{500}{144} \times 100 \times \frac{110}{100} = 3.472 \times 110 \times 100 = \text{approximately } \381.9$ billion (in base-year prices).

Income terms of trade $= 110.77 \times 110 / 100 = 121.85$.

(d) The terms of trade measures the ratio of export to import prices, but it does not capture: (i) changes in export volumes (a country may have worse terms of trade but export much more, increasing total export revenue), (ii) changes in import volumes (import prices may rise but the country imports less due to domestic substitution), (iii) changes in product quality (higher export prices may reflect quality improvements, not inflation), and (iv) the causes of the price changes. If export prices fall because of productivity improvements (lower production costs), the terms of trade deteriorate but the country is genuinely better off because it can produce more efficiently. The income terms of trade (which accounts for export volumes) is a better welfare indicator.

EQ-2: Effective Rate of Protection

Question: Country B imports components at a world price of \100$per unit and uses domestic labour and capital to assemble them into final products sold at a world price of$$200$per unit. The value added is$$100$. The government imposes a 20% tariff on the final product and a 10% tariff on imported components. (a) Calculate the nominal rate of protection. (b) Calculate the effective rate of protection. (c) Explain why the effective rate can differ from the nominal rate. (d) Apply this concept to Hong Kong's trade policy.

Solution:

(a) Nominal rate of protection $= 20\%$ (tariff on the final product).

(b) With tariffs: domestic price of final product = 200 \times 1.20 = \240$. Domestic cost of components$= 100 \times 1.10 = $110$.

Value added with tariffs = 240 - 110 = \130$.

Free-trade value added = 200 - 100 = \100$.

Effective rate of protection $= \frac{V_{tariff} - V_{free}}{V_{free}} \times 100\% = \frac{130 - 100}{100} \times 100\% = 30\%$.

(c) The effective rate of protection (30%) exceeds the nominal rate (20%) because the tariff on the final product raises the price domestic producers receive, while the tariff on imported components raises their costs. Since the output tariff (20% on $200 = $40) exceeds the input tariff (10% on $100 = $10), the net effect is to increase domestic value added by more than the nominal tariff rate would suggest. If the input tariff were higher than the output tariff, the effective rate could be negative (the tariff structure actually penalises domestic producers).

(d) Application to Hong Kong: Hong Kong is a free port with virtually no tariffs on imports (except for a few excisable goods: tobacco, alcohol, hydrocarbon oil, and methyl alcohol). This means Hong Kong's nominal and effective rates of protection are both essentially zero. This policy: (i) keeps import prices low, benefiting consumers and downstream industries, (ii) forces domestic industries to be internationally competitive (no tariff protection), (iii) makes Hong Kong attractive as a re-export hub (goods can be imported, processed, and re-exported without tariff costs). The trade-off is that Hong Kong has no tariff policy to protect domestic industries, which is acceptable because Hong Kong's comparative advantage lies in services (finance, logistics, professional services) rather than manufacturing.

EQ-3: J-Curve Effect and Current Account Dynamics

Question: Country C has a current account deficit of 5% of GDP. The government allows the currency to depreciate by 15%. The price elasticity of demand for exports is 0.6 in the short run and 1.4 in the long run. The price elasticity of demand for imports is 0.4 in the short run and 1.1 in the long run. (a) Verify the Marshall-Lerner condition in the short run and long run. (b) Explain the J-curve effect and why the current account may initially worsen after depreciation. (c) Calculate the percentage change in the trade balance in the short run and long run. (d) What conditions determine how long the J-curve effect lasts?

Solution:

(a) Marshall-Lerner condition: $|PED_X| + |PED_M| > 1$.

Short run: $0.6 + 0.4 = 1.0$. The condition is not satisfied (it is exactly 1, but in practice, if it equals 1, the trade balance is unchanged in volume terms while worsening in value terms due to the higher import prices).

Long run: $1.4 + 1.1 = 2.5 > 1$. The condition is satisfied.

(b) The J-curve effect occurs because: (i) immediately after depreciation, import prices rise in domestic currency (imports become more expensive), but quantities are slow to adjust due to contracts, habits, and search costs. The value of imports rises faster than the value of exports, worsening the trade balance. (ii) Over time, consumers switch to domestically produced substitutes (reducing import quantities) and foreign consumers buy more of the now-cheaper exports (increasing export quantities). (iii) Eventually, the quantity effects dominate the price effects, and the trade balance improves.

(c) Short run: With a 15% depreciation:

• Exports become 15% cheaper for foreigners: $\%\Delta X = 0.6 \times 15 = 9\%$ increase in export quantity.
• Imports become 15% more expensive domestically: $\%\Delta M = -0.4 \times 15 = -6\%$ decrease in import quantity.
• Export revenue change: $+9\%$ quantity but $-15\%$ price $= 1.09 \times 0.85 - 1 = -0.0735$ ($-7.35\%$).
• Import spending change: $-6\%$ quantity but $+15\%$ price $= 0.94 \times 1.15 - 1 = +0.081$ ($+8.1\%$).
• Net effect: trade balance worsens because import spending rises by 8.1% while export revenue falls by 7.35%.

Long run:

• Export quantity increase: $1.4 \times 15 = 21\%$. Export revenue: $1.21 \times 0.85 - 1 = +0.0285$ ($+2.85\%$).
• Import quantity decrease: $1.1 \times 15 = 16.5\%$. Import spending: $0.835 \times 1.15 - 1 = -0.0398$ ($-3.98\%$).
• Net effect: trade balance improves (export revenue rises 2.85%, import spending falls 3.98%).

(d) The duration of the J-curve depends on: (i) the flexibility of contracts (short-term contracts adjust faster), (ii) consumer search costs and brand loyalty (habitual consumers are slower to switch), (iii) the availability of domestic substitutes (more substitutes $=$ faster adjustment), (iv) the size of the depreciation (larger depreciations create stronger incentives to adjust), and (v) the state of the global economy (if trading partners are in recession, export demand may not respond strongly). Empirical evidence suggests the J-curve typically lasts 6--18 months for most economies.

EQ-4: Trading Blocs and Hong Kong

Question: Hong Kong is a member of the WTO and a signatory to various free trade agreements including CEPA (Closer Economic Partnership Arrangement with mainland China) and RCEP (Regional Comprehensive Economic Partnership). (a) Explain the difference between trade creation and trade diversion. (b) Suppose RCEP eliminates tariffs on electronics between member countries but maintains a 10% tariff on electronics from non-member countries. Before RCEP, Country X (a non-member) was the lowest-cost producer of electronics at \100$per unit. Country Y (a member) produces at$$105$. Calculate the trade creation and trade diversion effects if Hong Kong switches from importing from X to importing from Y. (c) Explain how CEPA benefits Hong Kong's economy. (d) Evaluate the argument that free trade agreements undermine the multilateral trading system.

Solution:

(a) Trade creation: When a free trade agreement causes a member country to replace domestic production with imports from a more efficient partner country. This increases efficiency and welfare because resources are reallocated from higher-cost domestic production to lower-cost partner production.

Trade diversion: When a free trade agreement causes a member country to switch imports from a lower-cost non-member country to a higher-cost member country (because the tariff on the member is removed). This reduces efficiency and welfare because resources are allocated to a higher-cost producer.

(b) Before RCEP: Hong Kong imports from X at \100 + 10% \text\\{ tariff\\} = $110$ per unit.

After RCEP: Hong Kong imports from Y at \105 + 0% \text\\{ tariff\\} = $105$ per unit.

Trade diversion effect: Hong Kong switches from the more efficient producer (X at $100) to the less efficient producer (Y at $105). The world loses \5$ per unit of efficiency. This is trade diversion because the trade flow is diverted from the most efficient source to a less efficient one due to the tariff preference.

Trade creation effect: Before RCEP, Hong Kong may have produced some electronics domestically (if domestic cost was between $105 and $110). After RCEP, this domestic production is replaced by cheaper imports from Y, creating trade and improving efficiency. The trade creation gain equals the difference between the domestic cost and Y's cost for these units.

Net welfare effect depends on whether trade creation or trade diversion dominates. In this case, trade diversion dominates because X was the lowest-cost producer and is now excluded.

(c) Benefits of CEPA to Hong Kong:

1. Market access: Zero tariffs on Hong Kong-origin goods entering the mainland, giving Hong Kong exporters a price advantage over foreign competitors (who face mainland tariffs).
2. Service sector liberalisation: Hong Kong service providers (finance, legal, accounting, logistics, tourism) receive preferential access to the mainland market with lower entry barriers.
3. Investment facilitation: Hong Kong companies receive preferential treatment for investment in the mainland, including in sectors partially closed to foreign investment.
4. Individual travel: The Individual Visit Scheme (part of CEPA) allows mainland residents to visit Hong Kong individually, boosting tourism and retail.

(d) Evaluation of FTAs vs multilateralism:

Arguments that FTAs undermine multilateralism:

• FTAs create a "spaghetti bowl" of different rules of origin, creating complexity and compliance costs.
• They divert trade from more efficient non-members to less efficient members.
• Countries may have less incentive to negotiate multilateral agreements (WTO Doha Round) if they can achieve bilateral gains.
• FTAs can marginalise smaller developing countries that lack bargaining power in bilateral negotiations.

Arguments that FTAs complement multilateralism:

• FTAs can serve as "building blocks" toward broader multilateral agreements by demonstrating the benefits of liberalisation.
• They allow deeper integration (services, investment, IP) than the WTO currently covers.
• They are politically more feasible than comprehensive multilateral deals (fewer parties, fewer veto points).
• They create competitive liberalisation -- countries join FTAs to avoid being left out, accelerating global liberalisation.

EQ-5: Balance of Payments and Exchange Rate Determination

Question: An economy has the following BOP data (in billions of USD): Merchandise exports $= 250$, Merchandise imports $= 350$, Services exports $= 180$, Services imports $= 120$, Primary income receipts $= 60$, Primary income payments $= 100$, Secondary income receipts $= 20$, Secondary income payments $= 10$, Direct investment inflows $= 80$, Portfolio investment inflows $= 50$, Portfolio investment outflows $= 30$, Reserve assets change $= -20$. (a) Construct the full BOP accounts and verify the identity. (b) Calculate the current account, capital account, and financial account balances. (c) Is the country accumulating or losing foreign reserves? (d) Explain the relationship between the current account and the capital/financial account.

Solution:

(a) Current Account:

• Trade balance: $(250 - 350) + (180 - 120) = -100 + 60 = -40$.
• Primary income balance: $60 - 100 = -40$.
• Secondary income balance: $20 - 10 = +10$.
• Current account $= -40 - 40 + 10 = -70$.

Capital Account: Assumed negligible (typically very small) $= 0$.

Financial Account:

• Direct investment: $+80$.
• Portfolio investment: $50 - 30 = +20$.
• Other investment: not given, assume $= 0$.
• Financial account $= 80 + 20 = +100$.

Reserve assets: $-20$ (negative means the central bank is accumulating reserves, since a negative change in reserve assets means the central bank is buying foreign assets).

Verification: Current Account $+$ Capital Account $+$ Financial Account $+$ Reserve Assets $= -70 + 0 + 100 + (-20) = 10$. This does not sum to zero due to rounding or omitted "other investment" flows. For exact balance, other investment $= -10$ (net other investment outflows of 10).

Revised: Financial account $= 80 + 20 + (-10) = 90$. Total: $-70 + 0 + 90 + (-20) = 0$. The identity holds.

(b) Current account $= -70$ billion (deficit). Capital account $= 0$. Financial account (excluding reserves) $= 90$. Reserve assets $= -20$ (accumulation).

(c) The reserve assets change is $-20$, meaning the central bank is accumulating \20$ billion in foreign exchange reserves. (A negative sign in the BOP convention means an increase in reserve assets.)

(d) The relationship is: Current Account $+$ Capital Account $+$ Financial Account $+$ Reserve Assets $= 0$.

A current account deficit (the country spends more on imports than it earns from exports) must be financed by: (i) a financial account surplus (foreign capital inflows -- foreigners buying domestic assets, or domestic entities borrowing from abroad), or (ii) running down foreign reserves. In this case, the current account deficit of \70$billion is financed by a financial account surplus of$$90$billion (more than covering the deficit) and the central bank accumulates$$20$ billion in reserves. The country is a net recipient of foreign capital, and the excess is added to official reserves.

Common Pitfalls

1. Confusing absolute advantage with comparative advantage: Absolute advantage refers to producing more output with the same resources. Comparative advantage refers to producing at a lower opportunity cost. A country should specialise based on comparative advantage, not absolute advantage. A country can have an absolute disadvantage in all goods but still gain from trade by specialising in the good where its comparative disadvantage is smallest.

2. Forgetting that exchange rate changes have opposing effects on different groups: Currency appreciation benefits importers and consumers (cheaper imports) but hurts exporters and import-competing industries (more expensive exports). Currency depreciation benefits exporters but hurts consumers (more expensive imports). DSE questions often require identifying winners and losers from exchange rate changes.

3. Assuming trade is always beneficial for everyone within a country: While trade increases total welfare, it creates winners and losers domestically. Exporting industries expand (gaining workers and profits) while import-competing industries contract (losing workers and profits). The net gain may be positive, but the distributional impact requires attention. This is why trade adjustment assistance (retraining, unemployment benefits) is important.

4. Misapplying the Marshall-Lerner condition: The condition applies to the sum of the absolute values of export and import price elasticities. A common error is to use the elasticities without taking absolute values or to confuse price elasticity with income elasticity. The condition $|PED_X| + |PED_M| > 1$ must be satisfied for a depreciation to improve the trade balance in the long run.

5. Confusing the trade balance with the current account: The trade balance (exports minus imports of goods and services) is only one component of the current account. The current account also includes primary income (investment income, compensation of employees) and secondary income (transfers such as remittances and foreign aid). For financial centres like Hong Kong, investment income flows can be larger than trade flows.