International trade is shaped by differences in production capabilities across countries. A country has an absolute advantage when it can produce a good using fewer resources than another country, but trade patterns are explained more fully by comparative advantage, which exists when a country can produce a good at a lower opportunity cost than its trading partner. Even a country that is less efficient at producing everything can still benefit from trade by specializing in the goods where its disadvantage is smallest.
Governments intervene in trade through instruments such as tariffs, which are taxes on imported goods that raise their domestic price, and quotas, which are quantitative limits on how much of a good may be imported. Both tools shelter domestic industries from foreign competition and generate government revenue in the case of tariffs, but they typically raise prices for consumers and reduce the overall volume of trade.
A country's transactions with the rest of the world are recorded in the balance of payments, a comprehensive statement that divides economic exchanges into the current account and the capital/financial account. The current account covers trade in goods and services, net income from abroad, and net current transfers; a current account deficit means the country is a net borrower from the rest of the world. The capital/financial account records cross-border flows of financial assets, including foreign direct investment, portfolio investment, and changes in reserve assets. By accounting identity, the current account and the capital/financial account must sum to zero. The balance of trade, the difference between exports and imports of goods and services, is the most familiar component of the current account.
Terms of trade measure the ratio of export prices to import prices, with an improvement indicating that a country can purchase more imports for each unit of exports. Exchange rates determine the prices at which currencies trade. Under a floating exchange rate regime, currency values are determined by supply and demand in foreign exchange markets without direct government intervention. Under a fixed or pegged regime, the government or central bank ties the currency to another currency or basket and intervenes to defend the peg. A currency appreciates when demand for it rises, due to higher interest rates, trade surpluses, or capital inflows, and depreciates when demand falls or supply increases.
Two important concepts help compare prices and currencies across countries. Purchasing power parity (PPP) is the theory that exchange rates should adjust so that identical goods cost the same across countries when expressed in a common currency, suggesting long-run alignment of price levels. The real exchange rate adjusts the nominal exchange rate for differences in national price levels, calculated by multiplying the nominal exchange rate by the ratio of the domestic price level to the foreign price level, providing a better measure of a country's competitive position in international trade.