Chapter Introduction


International Trade, Capital Flows, and Exchange Rates



The production and consumption of smartphones are examples of today’s hyperglobal world with its soaring levels of international trade.
Vlad Teodor/Shutterstock

What You Will Learn in This Chapter

  • How comparative advantage leads to mutually beneficial international trade

  • The sources of international comparative advantage

  • Who gains and who loses from international trade, and why the gains exceed the losses

  • How tariffs and import quotas cause inefficiency and reduce total surplus

  • The meaning of the balance of payments accounts and the determinants of international capital flows

  • The role of the foreign exchange market and the exchange rate

image | interactive activity

“WE FELL IN LOVE WHEN I was nineteen / Now we’re staring at a screen.” These lyrics, from Arcade Fire’s 2013 hit song “Reflektor,” describe an era in which everyone does indeed seem to be staring at the screen of a smartphone. Apple introduced its first iPhone in 2007, and since then the iPhone and its competitors have become ubiquitous.

They’re everywhere—but where do smartphones come from? If you answered “America,” because Apple is an American company, you’re mostly wrong: Apple develops products, but outsources nearly all manufacturing of those products to other companies, mainly overseas. But it’s not really right to say “China” either, even though that’s where iPhones are assembled. You see, assembly—the last phase of iPhone production, in which the pieces are put together in the familiar metal-and-glass case—only accounts for a small fraction of the phone’s value.

In fact, a study of the iPhone 4 estimated that of the average factory price of $229 per phone, only around $10 stayed in the Chinese economy. A substantially larger amount went to Korean manufacturers, who supplied the display and memory chips. There were also substantial outlays for raw materials, sourced all over the world. And the biggest share of the price—more than half—consisted of Apple’s profit margin, which was largely a reward for research, development, and design.

So where do iPhones come from? Lots of places. And the case of the iPhone isn’t unusual: the car you drive, the clothing you wear, even the food you eat are generally the end products of complex supply chains that span the globe.

Has this always been true? Yes and no. Large-scale international trade isn’t new. By the early twentieth century, middle-class residents of London already ate bread made from Canadian wheat and beef from the Argentine Pampas, while wearing clothing woven from Australian wool and Egyptian cotton.

In recent decades, however, new technologies for transportation and communication have interacted with pro-trade policies to produce an era of hyperglobalization in which international trade has soared thanks to complex chains of production like the one that puts an iPhone in front of your nose. As a result, now, more than ever before, we must have a full picture of international trade to understand how national economies work.

This chapter examines the interaction of national economies. We begin with a discussion of the economics of international trade. With that foundation established, we move on to discuss how trade and capital flows are part of the balance of payments accounts. Finally, we look at the various factors that influence exchange rates.