Exchange Rate Gravity Model and Variables

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3.1 Theory of International Trade

Trade is the transfer of the ownership of goods or services from one person or entity to another in exchange for other goods, services, or money. In the era of globalization, trade does not only occur in a single country. Trade between two traders is called bilateral trade, while trade between more than two traders is called multilateral trade. According to Oktaviani, et al. 2009, trade that is conducted between the population of one country and the population of another country, on the basis of mutual agreement, is called international trade. Population can be either inter-individual individual to individual, between the individual and the government of a country, or a state government with other governments. Adam Smith 1776 first developed the theory of international trade. Adam Smith stated that trade among nations is influenced by its absolute advantages. When a country has the best technology and specialization in the production of one good it has an absolute advantage. The country that has an absolute advantage will gain from export. In 1821, David Ricardo developed the theory of comparative advantage. This theory state that even if a country has no absolute advantage in producing two types of goods than any other country, the beneficial trade can occur as long as the ratio of prices between countries are different than in an autarky situation. Furthermore, the development of trade patterns proposed by Eli Heckscher 1919 and Bertil Ohlin 1924 explained that the Heckscher Ohlin HO theory is also called the factor-proportion theory because it stresses on the interaction between the different proportions of the country’s production factors, as well as the differences in the usage of these factors on producing a wide range of items. The HO model predicts that a country tends to export the good, which uses its abundant factor intensively. The new trade theory is the modification of assumptions on the HO and Ricardian models result. The market structure in this new trade theory is different than with perfect competition. The concept of monopolistic competition was introduced by Krugman 1980, and states that the two main assumption are differentiated goods and increasing returns to scale. Krugman et al., 2012. In both domestic and international trade, all of the participants traders, consumers, etc. are seeking benefit from the economic activity. Each country trades to gain profit, as well as gain the more efficient incentive from the trade. In addition to the profit motive, Krugman, et al. 2012 revealed that the main reasons for international trade are as follows: 1. Countries trade because they are different from each other. 2. Countries trade in order to achieve economies of scale economics of scale. Theoretically, a country e.g.,: country A will tend to export a commodity, Y, to another country e.g.,: country B, if the domestic price of commodity Y from country A prior to the international trade is relatively lower than the price of the same commodity in country B. The relatively low prices in country A are caused by excess supply, which means that the domestic production exceeds domestic consumption, thus enabling a country to sell its production to another country country B. On the other hand, country B exhibits excess demand, which means that the domestic consumption exceeds domestic production. Consequently, the price of