International Economics: Introduction to International Economics and the Gravity Model

Summary

This video introduces the field of international economics, tracing its origins to David Hume's essay and Adam Smith's 'The Wealth of Nations.' It highlights the growth of international trade from 4% to 20% of US GDP and emphasizes its significance in global economies. The video discusses the unique challenges of international trade, such as sovereign nations' restrictions and currency exchange rates. It also previews themes like gains from trade, the pattern of trade, and the gravity model, which correlates trade volume with economic size and distance between countries.

Takeaways

• 📚 International economics began with David Hume's essay in the mid-1700s, which focused on British international trade policy.
• 🌐 International trade has grown significantly from accounting for 4% of US real GDP in the 1960s to around 20% today.
• 🔄 The field of international economics is distinct from domestic economics due to the involvement of two sovereign nations with potential trade restrictions.
• 💵 Currency exchange is a key aspect of international trade, with exchange rates determining the price of one currency in terms of another.
• 🌟 The concept of gains from trade is central to international economics, indicating that trade can be a positive-sum game where all parties benefit.
• 🏭 Comparative advantage is a driving force behind why countries specialize in certain goods and services for trade.
• 🌍 The gravity model is an empirical relationship used to understand the amount of trade between countries, based on GDP and distance.
• 📈 The size of economies (GDP) and the distance between countries are significant determinants of trade volumes.
• 💼 Trade patterns are not always straightforward and can involve complex models with multiple goods, unlike the simplified two-good models.
• 📊 Exchange rate determination is a topic that will be covered, focusing on how demand and supply dynamics affect currency values.

Q & A

What is the significance of David Hume's essay in the field of international economics?

David Hume's essay, published in the mid-1700s, was significant because it was one of the first to discuss British international trade policy in a formal, model-based way, which laid the groundwork for the field of economics as we know it today.

How has the importance of international trade evolved over time in the US economy?

In the 1960s, international trade accounted for about 4% of the US real GDP, but it has grown significantly and now represents roughly 20% of the real GDP, indicating that international trade has become a substantial part of the US economy.

What are the main differences between domestic and international trade?

International trade involves two sovereign nations, which can impose restrictions on what and how much can be bought. Additionally, international trade involves different currencies and exchange rates, which can affect the price of goods.

Why is the exchange rate considered the price of currency?

The exchange rate is considered the price of currency because it determines how many units of one currency are required to purchase a unit of another currency, similar to how prices determine the cost of goods.

What is the concept of gains from trade?

Gains from trade refer to the mutual benefits that arise when parties engage in trade, allowing both parties to be better off compared to not trading. This concept is based on the idea of specialization and comparative advantage.

How does the gravity model explain the amount of trade between two countries?

The gravity model suggests that the amount of trade between two countries is positively related to the size of their economies (GDP) and inversely related to the distance between them. It is an empirical relationship that helps estimate trade volumes based on these factors.

What are the implications of a change in exchange rates for international trade?

A change in exchange rates can affect the price of goods from a foreign country, potentially making them more or less expensive. This can influence the volume of trade and the balance of trade between countries.

What does the script suggest about the distribution of gains from trade?

While trade can make all parties involved better off, it does not necessarily imply that everyone is made better off. There can be cases where one group benefits while another does not or even becomes worse off.

Why is it important to understand the pattern of trade?

Understanding the pattern of trade helps to determine which goods a country exports and imports, which is crucial for economic planning and policy-making. It also provides insights into a country's comparative advantage.

What role does the size of economies play in international trade according to the gravity model?

According to the gravity model, larger economies tend to have more trade between them. The model suggests that the product of the GDPs of two countries is a significant factor in the amount of trade that occurs.

How does the distance between two countries affect trade according to the gravity model?

The gravity model posits that the distance between two countries has an inverse relationship with the amount of trade. The farther apart the countries are, the less trade tends to occur between them.

Outlines

00:00

📚 Introduction to International Economics

This paragraph introduces the field of international economics, tracing its roots back to the mid-1700s with David Hume's essay on British international trade policy. It highlights the evolution of economics from an informal discussion-based field to a model-based one, emphasizing the importance of international trade. The speaker notes the significant growth of international trade as a portion of GDP, from about 4% in the 1960s to roughly 20% today. The differences between domestic and international trade are also discussed, including the involvement of sovereign nations, potential restrictions on trade, and the use of different currencies with exchange rates affecting the price of goods.

05:02

🌐 Understanding International Trade Dynamics

The second paragraph delves into the nuances of international trade, focusing on the gains from trade and the concept of comparative advantage. It challenges the zero-sum game misconception, explaining that trade can be a positive-sum game where both parties can benefit. The paragraph also touches on the distribution of trade benefits and the potential for some groups to be worse off despite overall gains. The discussion sets the stage for exploring models that explain trade patterns, including the gravity model, which is introduced as an empirical relationship to understand the determinants of trade amounts. The model considers GDP and distance between countries as key factors influencing trade volumes.

10:02

🔍 The Gravity Model of Trade

In this paragraph, the gravity model of trade is explained in detail. The model suggests that the amount of trade between two countries is influenced by the size of their economies (GDP) and the distance between them. The model is likened to Newton's law of universal gravitation, where the 'gravitational pull' between two economic bodies is stronger when their economies are larger and weaker when they are farther apart. The speaker clarifies that while the class will not estimate the model parameters, understanding the gravity model helps to grasp empirically how trade is determined. The paragraph concludes by setting the stage for future discussions on behavioral models of trade.

Keywords

💡International Economics

International Economics is a branch of economics that deals with economic transactions across national borders. It encompasses trade, investment, and the flow of capital and goods between countries. In the video, the lecturer discusses how international economics began and its importance in today's globalized world. International trade is highlighted as a significant portion of many countries' GDP, indicating its relevance in economic studies.

💡David Hume

David Hume was an 18th-century Scottish philosopher, economist, and historian who is considered one of the early contributors to the field of economics. The video mentions Hume's essay on British international trade policy, which predates Adam Smith's 'The Wealth of Nations' and laid some foundational concepts for economics as a field based on models rather than just discussions.

💡The Wealth of Nations

This is a seminal work by Adam Smith published in 1776, often considered the first modern work of economics. The video references this book to emphasize the historical focus on international trade policy, which occupies a significant portion of the text.

💡Model-Based Field

A model-based field in economics refers to the use of theoretical models to understand economic phenomena. The video discusses how Hume helped transition economics into a discipline that relies on models such as supply and demand or comparative advantage to analyze and predict economic behavior.

💡International Trade

International trade involves the exchange of goods and services across international borders. The video script explains how international trade has grown from about 4% of US real GDP in the 1960s to approximately 20% today, underscoring its increasing importance in global economics.

💡Sovereign Nations

Sovereign nations are states that have supreme authority over their respective territories. The video script points out that international trade involves transactions between two sovereign nations, which can impose restrictions or taxes that affect the trade dynamics, unlike domestic trade.

💡Currency Exchange

Currency exchange is the process of changing one currency into another. The video explains that international trade involves different currencies and exchange rates, which are the prices of one currency in terms of another. This is a fundamental aspect of international economics not present in domestic transactions.

💡Gains from Trade

Gains from trade refer to the mutual benefits that result from trading between parties. The video script discusses how trade can be a positive-sum game, where both parties can be better off, contrasting with the zero-sum game concept where one's gain is another's loss.

💡Comparative Advantage

Comparative advantage is an economic concept that suggests that countries should specialize in producing goods for which they have the lowest opportunity cost compared to other goods. The video mentions that this concept is central to understanding why countries engage in trade and how they benefit from it.

💡Gravity Model

The gravity model in economics is an empirical model that predicts trade volumes between countries based on their economic sizes (GDP) and their geographical distance. The video uses this model to illustrate how trade is influenced by these factors, with more trade occurring between larger economies that are closer to each other.

💡Econometrics

Econometrics is the application of statistical methods to economic data. The video briefly mentions that the gravity model could be estimated using econometrics, which would involve determining the parameters that best fit the observed data on trade, GDP, and distance.

Highlights

International economics began with David Hume's essay in the mid-1700s, focusing on British international trade policy.

Hume's work transitioned economics from an informal discussion-based field to a model-based one.

Adam Smith's 'The Wealth of Nations' also focused significantly on British international trade policy.

International trade as a percentage of real GDP has grown from about 4% in the 1960s to roughly 20% today.

Some countries have more than half of their economic activity accounted for by international trade.

International trade involves two sovereign nations with potential restrictions on what and how much can be bought.

Different rules in different countries can affect international trade.

International trade involves different currencies and exchange rates, affecting the price of goods.

The exchange rate is the price of one currency in terms of another and is determined by demand and supply.

Gains from trade come from countries specializing in what they have a comparative advantage in.

Trade can be a positive-sum game, where both parties can be made better off.

The benefits of trade are not always evenly spread across different groups of people.

The pattern of trade is determined by a model with multiple goods, not just two as in the basic model.

The amount of trade is determined by factors such as GDP and distance between countries.

The gravity model is an empirical relationship that helps understand the amount of trade between countries.

The gravity model is based on the idea of gravitational pull between two bodies, relating to the size of economies and distance between countries.

The gravity model suggests that the amount of trade increases with the size of economies and decreases with distance.

Countries that are geographically close tend to have a larger volume of trade.

The gravity model is not used for estimating in this class but helps understand empirically how trade is determined.

Upcoming videos will discuss models that explain why countries trade with each other.

Transcripts

so in this video we're going to think

about kind of an introduction to what

international economics

is the field of Economics as as it

exists today really began with

International economics um it started

when David Hume published a a essay in

the mid 1700s about 20 years before Adam

Smith published The Wealth of Nations

and in hume's essay really what he was

discussing was uh British International

Trade policy and if you read The Wealth

of Nations um you'll see that a good

portion of that most of it is is devoted

to um British International Trade policy

and it was Hume that kind of turned the

field of Economics from a a an informal

discussion-based

field into a a a modelbased field which

is is how you've been taught the

economics that you know we we think

about models like the demand and supply

model or the model of uh comparative

advantage um and so it was really Hume

that that started

that in terms of how important

international trade is um if you go back

to say the 1960s at least with the us

about 4% of real GDP um was accounted

for by International Trade um and that's

continued to grow if you uh look now

it's roughly 20% of of uh real GDP so

international trade is a good sized

portion of of our economy it's even

bigger for other countries so if you

there are several countries

where more than half of their um

economic activity is accounted for by

international trade

let's talk for a second about how the

field of international econ is different

from other subdisciplines of Economics

so if you're thinking about say buying a

good um from somebody in another state

let's say you drive to Kansas and uh you

stop at a store and you buy something

well we've studied how that transaction

works we know that price is going to be

determined by demand and supply fly and

um you can take the money that you've

got in your pocket or the money that's

represented by your um debit card and

you can buy that product and you can

drive home and that's really kind of the

extent of it if you buy something from

somebody in a foreign

country these days the transaction still

kind of feels that way it's you're going

to a lot of times get on on uh the

internet and buy something maybe maybe

through Amazon or um some

other online store and it'll be shipped

to you and the transaction feels very

similar to that transaction of buying

something from somebody in Kansas but

there are some important differences and

the first one is

that there are two Sovereign Nations

that are involved there and so there can

be restrictions in terms of what you buy

or how much you buy that are imposed by

the United States they might limit how

much you can purchase from somebody in

another country or those restrictions

could be imposed by the other country it

could be maybe not just a limit on how

much you buy but our country May impose

a tax on you when you buy it or or the

foreign country May impose a tax on you

when you buy it um so that's the first

difference is that depending on the

country there can be different rules

about what you can buy or how much you

buy the other interesting thing is

that you're going to be paying for the

product with a different currency than

what they use in the foreign country if

you buy something from somebody in

Kansas that's not even a consideration

because we're using the dollar they're

using the dollar and and you don't even

think about it but if you buy something

from somebody in another country there's

going to be two currencies involved

there's going to be an exchange rate and

what we'll see in this class is that the

exchange rate is really the price of

currency so if we think about the dollar

and the Euro the exchange rate between

the two tells us how many dollars it

takes you to buy a

Euro and that can change and what we'll

see is that that's determined by the

demand and supply for euros versus

dollars and so um that's an interesting

um characteristic of it you could if the

exchange rate changes the price that you

pay for that good from the foreign

country could be different um in a week

than what it is today and so we have to

think about how the exchange rate and

the fact that we're using different

currencies affects um economic

activity there are going to be some

themes that we're going to cover in this

class and the first one is one that

you've already talked about and that is

gains from trade so if you think back to

um your principles of macro class or

possibly even at the beginning of

principles of micr class you probably

studied a model of why people

trade um we'll begin um in our next

video talking about that model of why

people trade and the reason that people

trade is that there are gains from

Trading the world is not a zero sum game

we're used to thinking about a lot of

people think about the world as if it's

a zero SU game and what that means is

that um if I'm made better off by some

transaction then that must mean that the

other person's made worse off by that

transaction and it turns out that that's

not really how it works there are some

times when a particular situation might

be a zero sum game but in terms of of

trade between two people or trade

between two countries it's actually a

positive sum game and what that means is

that both the parties involved in the

trade can be B made better off and

that's counterintuitive to a lot of

people so we'll talk about where the

gains from trade come

from you probably hopefully remember

that it comes from people or countries

specializing in what they have the

comparative advantage in we'll review

that um we'll also talk about the fact

that everybody can be made better off by

trade but that's not necessarily that

doesn't necessarily imply that everybody

is made better off by trade so in some

of the simple models that we'll talk

about at the beginning um we'll see that

that everybody involved will become

better off but we'll have a little bit

more complicated models that that are

more representative of the real world

and we'll see that in those cases it

could be the case that that one group

can be made better off while another

group is not made better off they could

be made worse off so we have to think

about that how how are the benefits of

trade spread across different groups of

people we'll spend some time talking

about what determines the pattern of

trade so who trades what um in this

simplest model that you've already

talked about in your principal class you

know that you tend to specialize in the

good for which you have the comparative

advantage but but in that particular

model there's only two goods and so you

specialize in one and you import the

other well typically in a country there

are thousands of goods and so we'll need

to talk about a model where there are

multiple Goods we won't have a thousand

but we'll have more than two and we'll

talk about what determines which of

those goods you export and which of

those goods you

import we'll also spend some time

talking about

the amount of trade what it what

determines how much trade takes place um

we'll talk a little bit at the end of

the semester or at the excuse me at the

end of the class about exchange rate

determination so what determines the

price of a euro in terms of dollars um

you already know I already said it just

a little bit ago that it's going to come

down to demand and Supply but we'll talk

more explicitly about about um how that

works let's start by talking about a

model that that helps us understand

empirically um something about how trade

works and the amount of trade that takes

place and this is a model that is known

as the gravity model um it it's really

nothing more than an empirical

relationship and what that means is it

it's something that helps us understand

the data we can look at the data and we

can um start to get a basic

understanding of of what are the

important determinants

in term that that help us understand the

amount of trade that takes place um so

if we think about how this gravity model

works it's actually very simple so if we

start with ti J we're going to let TI

represent the amount of trade that takes

place between country I and Country J

okay so this is the amount of

trade and empirically what we see is

that the amount of trade that takes

place between two countries is going to

be a function of the GDP of those two

countries the size essentially of their

economies and it's also going to be a

function of the distance between these

two countries now the way this

relationship works is we're going to put

a number a out here we're just going to

let that be a general number for right

now but when we would empirically

estimate this this might turn out to be

a model a number like five or 7 okay so

for now just think about it as some some

number and we're going to multiply that

by y i times y

j these are going to be the gdps of our

two countries so this is the GDP of

country I and the GDP of country J okay

and then we're going to divide that by D

J and this is going to represent the

distance between the two countries so

here's

distance and right here is uh

GDP so what this tells us is that the

amount of trade that takes place between

two countries is related to the the size

of the two economies and notice that if

the size of the two economies goes up or

if one of these goes up that's going to

increase the amount of trade so all

other things equal the bigger the two

countries are the bigger the amount of

trade that takes place between

them we've got the distance between the

two down here in our denominator and so

what that tells us is that the bigger D

is the farther apart these two countries

are the smaller the amount of trade that

takes place and on the other side of the

coin the smaller the distance here the

bigger the amount of trade that we tend

to observe between the two countries and

that makes intuitive sense we tend to

see that countries that are close to

each other Canada and the United States

tend to have a large volume of trade

countries that

are far apart all other things equal

tend to have a smaller amount of trade

that takes place between them and this

is again referred to as the gravity

model and the reason it's referred to as

the gravity model because this is really

based upon Newton's idea of the

gravitational pull between two celestial

bodies so if you think about how that

works we can think about the mass of the

two bodies if you have two celestial

bodies the bigger those two bodies are

the greater the gravitational pull

between them and then the farther apart

those two celestial bodies are the less

gravitational pull between them so this

is very much based upon Newton's idea of

how much how to estimate the

gravitational pull between two bodies

now in terms of of how we take this and

and make it

useful we're not in this class going to

be gathering information on this and

somehow estimating it if you've had an

econometrics class then then you may

have talked about how you would estimate

a uh a function like this it's actually

relatively easy

um but we're not going to be doing that

in this class if if we did want to

estimate it and you might in the future

um typically what we do is we estimate a

little bit more General version of this

so if we take the amount of economic

activity I'm going to kind of rewrite

what we've got

here the way that we tend to actually

estimate this is to estimate parameters

on it alpha beta and

gamma and again if you've had an

econometrics class you know that that

doesn't really make it any more

complicated it just makes it operational

it it it helps us estimate the relative

importance how the data tells us Yi y j

and this distance variable are actually

related to each other so that's the

gravitational or the gravity model um

we're really not going to do anything

more with that it it just helps us

understand

empirically um

how the amount of trade is is determined

we'll get in the next set of videos

we'll start talking about actual models

that help us understand behaviorally why

countries would trade with each other so

we'll do that in our next

video