Econ5

Session 5 Economics

Define International Trade

Define International Trade

International trade is the exchange of goods and services between countries.

What are the benefits of international trade?

Lower prices -> lower labour costs in other countries lead to lower production costs and lower prices of goods and services

Singapore produces manufactured goods -> higher technology Australia is the opposite

Greater choices -> More choices for consumers -> increased consumption

Differences in resources/acquisition of resources

Access to larger market -> higher imports -> higher firm profits

Economies of scale -> cheaper to produce a larger amount of goods -> increasing economies of scale -> specialisation

More efficient production/more efficient -> due to increased competition

resources allocation

Increased competition -> domestic firms versus international firms, however, it can increase unemployment

Source of foreign exchange -> easily convertible currencies

Why are there lower prices during international trade?

Consumers are able to buy less expensive products and producers are able to purchase less expensive raw materials and semi-manufactured goods. This is the main reason for trade.

The cause of these lower prices is mainly determined by the concept of comparative advantage, which is a higher level topic and is dealt with in the next section.

lower labour costs in other countries lead to lower production costs and lower prices of goods and services

Why are there greater choices due to international trade?

International trade enables consumers to have a greater choice of products, including domestic and international products

Why are there differences in resources due to international trade?

Different countries possess different resources.

Some countries, such as Singapore, have very few natural resources and so are dependent on trade for their survival, economic growth, and well-being. Singapore has to import almost every natural resource, even water! However, Singapore is able to export high levels of manufactured goods and services in order to fund their imports.

Why are there economies of scale due to international trade?

When producing for an international market, as well as for a domestic one, the size of the market, and thus demand, will increase. This means that the level of production and the size of production units will also increase.

Also, larger production units will enable the amount of specialization to increase. When firms are large, individuals may specialize in specific, narrower tasks, such as accounting manager or marketing manager, and they should become more knowledgeable and so more efficient. Larger production units will also lead to greater scope for the division of labour. This is where a production process is broken down into a number of simple and basic tasks. Workers may then concentrate on a small, repetitive task and achieve a high degree of efficiency.

Moving down the learning curve, gaining more experience. It should also make the producers more competitive. It should lead to a reduction in long- run average costs.

Why is there increased competition due to international trade?

International trade may lead to increased competition, as domestic firms compete with foreign firms -> lower prices for consumers -> higher efficiency -> It is also likely that the quality and variety of goods available to consumers will increase, with increased competition.

Why is there more efficient allocation of resources due to international trade?

If this happens in all of the different trading countries, then it is fair to assume that the world's resources are being used most efficiently when free trade is taking place.

Each country will allocate their resources more efficiently for trade

Why is there a source of foreign exchange due to international trade?

International trade enables countries to obtain foreign exchange. If a country exports products, then that country will be paid in foreign currencies. For example, when Ghana sells gold and cocoa to the Netherlands, it will be paid in euro, which it can then use to buy essential products from abroad, such as industrial machinery or petroleum. This is especially important to countries such as Ghana which do not have a convertible currency (one which can be freely exchanged for other)

Typically used for developing countries to provide a source of foreign exchange for trading

What is the absolute advantage of comparative advantage theory?

Comparative advantage theory is at the core of international trade theory

Absolute advantage A country is said to have an absolute advantage in the production of a good if it can produce it using fewer resources than another country.

What is the comparative advantage of comparative advantage theory?

Comparative advantage A country is said to have a comparative advantage in the production of a good if it can produce it at a lower opportunity cost than another country.

What gives a country a comparative advantage?

When it gives up less than others to engage in a particular type of production

Based on a country's factor endowments

What are the limitations of the theory of comparative advantages?

Assume perfect competition All producers and consumers have perfect knowledge

No transport costs

• In reality, the existence of transport costs may eliminate a comparative advantage and prevent international trade

Only two economies producing two goods

• Technological developments have resolved this problem enabling the comparison of multiple countries and goods and services

Costs do not change and the returns to scale are constant. (There are no economics of scale)

In reality, increased production will result from economies of scale where the production is more efficient if more goods and services are demanded. Ie - Bulk buying

The goods being traded are identical

• In reality, goods can be different, for instance, comparing Panasonic TVs versus Phillip's TVs. Difficult to make comparison

Factors of production remain in the country However, it may be the factors of production, rather than the goods, that move from country to country. For example, developed countries, rather than exporting finished goods to LDCs, may invest capital in LDCs to enable goods to be produced there. Labour may migrate from low-wage to high-wage countries. (Apple products produced in China)

Assume perfectly free trade (No government intervention)

• Government-imposed trade barriers

What is the WTO?

The WTO is an international organization that sets the rules for global trading and resolves disputes between its member countries. Established on 1 Jan 1995 More than 160 members Its predecessor the General Agreement on Tariffs and Trade (GATT) Credited with the significant reduction in average world tariffs for manufactured goods

What is the aim of WTO?

The WTO aims to increase international trade by lowering trade barriers and providing a forum for negotiation. The WTO operates through a system of trade negotiations or rounds.

What are the functions of WTO?

The functions of the WTO are to

Administer WTO trade agreements Be a forum for trade negotiations Handle trade disputes among member countries Monitor national trade policies Provide technical assistance and training for developing countries Cooperate with other international organisations

Define free trade

Free trade is said to take place between countries when there are no barriers to trade put in place by governments or international organizations. Goods and services are allowed to move freely between countries.

Why would protectionism benefit domestic markets? What are the limitations?

Declining markets (sunset markets). If large markets are declining due to increased competition with foreign firms. If the industry is large, there will be large scale structural unemployment. Hence, domestic markets and employment require protecting from the government.

But, in some cases, the negative externalities of a rapidly declining major industry may be so great that the government feels obligated to intervene and protect the market.

Limitations: Industry will continue to decline and that protection will simply prolong the process.

• Although there will be short-run social costs, it could be better to let the resources employed in the industry move into other, expanding areas of the economy.

Why would protectionism protect the economy from low-cost labours? What are the limitations?

The main reason for declining domestic industries is the low cost of labour in exporting countries and that the economy should be protected from imports that are produced in countries where the cost of labour is very low. Trade may be beneficial; however, job losses will be concentrated in specific industries. There is much greater job insecurity among manufacturing workers throughout the more developed countries as workers fear that they will lose their jobs to workers in emerging markets such as China and India. Workers and their trade unions may lobby vigorously for protection against imported goods.

For example, China controls 35% of the Worlds production due to the lower wage costs

Limitations:

• Goes against the comparative advantage concept. Domestic consumers would pay higher prices and production within a protected economy would be at an inefficient level. = Comparative advantage changes over time

As relative factor costs change in different countries, it is important that resources should move as freely as possible from industries where comparative advantage is waning, into industries where it is growing. Supply-side policies that focus on labour markets emphasize the importance of making labour flexible enough to adapt to changing economic circumstances. This puts some responsibility on governments to help those workers who have lost their jobs due to increased competition from countries that have developed their comparative advantage in the production of labour-intensive goods.

Why would proctectionism protect infant economies? What are the limitations?

Indsutries maybe developing and may not have economics of scale compared to larger industries in other countries. The domestic industry will not be competitive against foreign imports until it can gain the cost advantages of economies of scale.

Limitations:

• Most developed countries would have highly efficient capital markets -> access to large financial capital (more to due globalisation) -> new industries would be highly developed

For example, the Saudi Arabian government has been diversifying into petrochemical production in recent years. It has undertaken a number of projects in partnership with large multinationals, such as Chevron, BP, and Exxon Mobil. The plants constructed have been among some of the largest in the world, gaining almost immediately from economies of scale.

It is likely that developing countries, without access to sophisticated capital markets, can use the infant industry argument to justify protectionist policies. However, whether they have the international political power to be able to impose protectionist policies, without complaints and action from developed countries, is debatable.

Why would proctectionism prevent over-specialisation? What are the limitations?

Governments may want to limit over-specialization, if it means that the country could become over-dependent on the export sales of one or two products. Any change in the world markets for these products might have serious consequences for the country's economy. For example, changes in technology could severely reduce the demand for a commodity, as the development of quartz crystal watches did for the Swiss wristwatch industry, harming the economy.

There are no real arguments against this view. It does not promote protectionism, it simply points out the problems that countries may face if they specialize to a great extent.

Why would proctectionism be used for strategic reasons? What are the limitations?

It is sometimes argued that certain industries need to be protected in case they are needed at times of war,

Steel is needed for many defence items such as planes and tanks, and a steel industry would argue that it must be protected in order to stay competitive. To a certain extent, this argument may be a valid one, although it is often overstated. In many cases it is unlikely that countries will go to war or, if they do, that they will be completely cut off from all supplies. It is likely that the argument is being used as an excuse for protectionism.

How does protectionism prevent dumping?

Dumping is the selling by a country of large quantities of a commodity, at a price lower than its production cost, in another country.

For example, the EU may have a surplus of butter and sell this at a very low cost to a small developing economy. This may ruin the domestic producers in the developing country. Where countries can prove that their industries have been severely damaged by dumping, their governments are allowed, under international trade rules, to impose anti-dumping measures to reduce the damage.

It is very difficult to prove whether or not a foreign industry has actually been guilty of dumping. In addition, a government that subsidizes a domestic industry may actually support dumping. For example, developing countries argue that when the EU exports subsidized sugar, it is actually a case of dumping because the price doesn't reflect the actual costs of the EU sugar producers. So, if dumping does occur, it is more likely that there will be a need for talks between governments, rather than any form of protectionism. There is always a danger that protectionism will invite retaliatory actions by foreign governments and this reduces the benefits that can be gained by all consumers and producers in all countries.

How does protectionism protect product standards? What are the limitations?

A country might wish to impose safety, health, or environmental standards on goods being imported into its domestic market in order to ensure that the imports match the standards of domestic products.

For example, in the 1990s, the EU banned US beef because it was treated with hormones.

This is a valid argument, as long as the concerns themselves are valid. However, many of the reasons given for bans when standards are not reached are considered to be simply subtle means of protectionism.

Another issue relating to the use of product standards as a trade barrier is the cost involved in meeting product standards. This is a particular concern for producers in developing countries. Not only does it cost a great deal to meet the standards, but the costs of getting appropriate approval and documentation to prove that the standards have been met are extremely high. This puts producers in developing countries at a disadvantage and may make it difficult for such countries to exploit their comparative advantage successfully.

The World Trade Organization recognizes this and, in cooperation with the World Health Organization, the World Bank, the World Organization for Animal Health, and the Food and Agricultural Organization, has established a Standards and Trade Development Facility (STDF) . This programme is designed to help developing countries improve their expertise and their capacity to analyse and implement international standards on food safety and animal and plant health.

How does protectionism increase government revenue?

In many developing countries, it is difficult to collect taxes and so governments impose import taxes (tariffs) on products in order to raise revenue.

This is not so much an argument for protectionism, but more a means of raising government revenue. In effect, the import duties are actually a tax on the consumers in the country who are buying the imports.

How does protectionism correct a balance of payments deficit?

Protectionism -> reduce import expenditure -> improve current account deficit -> wants to decrease imports and increase exports

However, this will only work in the short run. It does not address the actual problem, because it does not rectify the actual causes of the deficit. Also, if countries do this, then it is likely that other countries will retaliate with protectionist measures of their own.

What are the primary arguments against protectionism?

Protectionism may raise prices to consumers and producers of the imports that they buy. Protectionism would lead to less choice for consumers. Competition would diminish if foreign firms are kept out of a country, and so domestic firms may become inefficient without the incentive to minimize costs. Innovation may also be reduced for the same reason. Protectionism distorts comparative advantage, leading to the inefficient use of the world's resources. Specialization is reduced and this would reduce the potential level of the world's output. For the reasons listed above, protectionism may hinder economic growth.

What are types of protectionism?

Tariffs Subsidies Quotas Administrative barriers Nationalistic campaigns

What is a tariff?

A tariff is a tax that is charged on imported goods. In the case of a tariff, it will shift the world supply curve upwards, since it is placed on the foreign producers of the good and not the domestic producers.

How would tariffs affect trade?

Increases world supply -> increased price of imported goods

The importers must pay a higher price for the imported good. In the case of wheat, the higher price will be passed on to millers and eventually to the cereal companies or bakeries that buy the refined wheat.

Consumers keep the amount k that they would have spent on the wheat, but there is a loss of consumer surplus equivalent to f, because the wheat is not now purchased. This is known as a dead-weight loss of welfare, because of the loss of consumer surplus.

More goods and services are produced by inefficient domestic producers rather than efficient foreign producers

What are subsidies?

a subsidy is an amount of money paid by the government to a firm, per unit of output.

How do subsidies affect trade

Increased government subsidies to domestic industries -> more competitive -> increase in domestic supply -> increased production

Thus g represents the inefficiency of the domestic producers and a misallocation of the world's resources, since more of the world's resources are being used to produce the wheat than are necessary. This is another dead-weight loss of welfare.

There is no loss of consumer surplus, because the price of the wheat does not change. However, consumers are indirectly affected as governments will use tax revenues to fund the subsidies. This may mean higher tax payments and also involves an opportunity cost in terms of reduced government spending on other things.

What are quotas?

A quota is a physical limit on the numbers or value of goods that can be imported into a country.

How do quotas affect trade?

Domestic producers supply 0Q1 at a price of Pw and the importers produce their quota of Q1Q3. However, once this has happened, there is an excess demand of Q3Q2 at the price Pw and so price begins to rise. As the price rises, importers are not allowed to supply more wheat, because they have filled their quota, and domestic producers begin to enter the market, attracted by the higher price of wheat. The domestic supply curve has, in effect, shifted to the right, above Pw. Eventually, the price settles at PQ uota, where demand now equals supply again and the total quantity of wheat demanded falls to Q4

Consumers keep the amount e that they would have spent on the wheat, but there is a loss of consumer surplus equivalent to k, because the wheat is not now purchased. This is a dead-weight loss of welfare, because of the loss of consumer surplus.

The foreign farmers would produce this quantity for a minimum revenue of c d, whereas the domestic producers need a minimum revenue of c + d + j . Thus j represents the inefficiency of the domestic producers and a loss of world efficiency, since more of the world's resources are being used to produce the wheat than are necessary. This is another dead-weight loss of welfare.

Excess demand -> increase in prices -> attracts new domestic firms -> increases supply from S(domestic) to S(domestic) + quota -> new price at P(quota)

What are administrative barriers?

Administrative barriers "Red tape": administrative processes for imports, including paper work and legal work Health and safety standards and environmental standards Embargoes: a form of political punishment; an extreme quota; a complete ban on imports

How do administrative barriers affect trade?

Red tape -> lengthy or complicated to deter imports -> if the paperwork requires legal work, it requires money and time -> increases costs for importers

Health and safety standards These regulations will apply to imports and may restrict their entry. As mentioned earlier, while it is important that countries be able to guarantee the health and safety of the population by preventing the import of unhealthy or unsafe goods, it is extremely important that governments are legitimately keeping out imports rather than simply protecting their own country's workers.

Embargoes In effect, an embargo is an extreme quota. It is a complete ban on imports and is usually put in place as a form of political punishment.

What are nationalistic campaigns?

Governments will sometimes run marketing campaigns to encourage people to buy domestic goods instead of foreign ones in order to generate more demand for domestic goods and preserve domestic jobs. Such campaigns have happened in countries such as the UK, Australia, and the US. This may be described as "moral suasion", where the government links consumption of imported goods to the creation of unemployment.

What are the consequences of tariffs?

Affects producers that import cheaper resources and raw materials to make finished goods -> translates to higher prices for the consumers. A deadweight loss in efficiency as inefficient domestic firms are producing more, requiring more world resources.

What are the consequences of subsidies?

Opportunity cost of government revenue and resources use by inefficient domestic firms Makes domestic firms less competitive Reduces incentives to cut costs and become more efficient

What is economic integration?

Economic integration describes a process whereby countries coordinate and link their economic policies and thus the trade barriers between countries decrease.

What are trade agreements?

Agreements made between countries to transfer goods or service

Trade agreements aim to reduce or remove tariffs and/or quotas.

ex North American Free Trade Agreement

What is a bilateral trade agreement?

A bilateral trade agreement is an agreement relating to trade between two countries.

What is a multilateral trade agreement?

A multilateral trade agreement is an agreement relating to trade between multiple countries.

What are trading blocs?

A trading bloc is defined as a group of countries that join together in some form of agreement in order to increase trade between themselves and/or to gain economic benefits from cooperation on some level. Different trading blocs reflect different levels/stages of economic integration.

What are the types of trading blocs?

Preferential trading areas Free trade areas Customs unions Common markets Economic and monetary union Complete economic integration

What are preferential trading areas?

A PTA is a trading bloc that gives preferential access to certain products from certain countries, generally by reducing but not eliminating, tariffs.

E.g. the one between EU and the African, Caribbean, and Pacific Group of States (ACP)

What are free trade areas?

A free trade area is an agreement made between countries, where the countries agree to trade freely (tariff-free) among themselves, but are able to trade with countries outside of the free trade area in whatever way they wish.

E.g. the North American Free Trade Area (NAFTA) the European Free Trade Association (Iceland, Norway, Switzerland, and Liechtenstein) the South Asia Free Trade Agreement (India, Pakistan, Nepal, Sri Lanka, Bangladesh, Bhutan, and the Maldives)

What are custom unions?

A customs union is an agreement made between countries, where the countries agree to trade freely among themselves, and adopt common external barriers against any country attempting to import into the customs union.

E.g. the EU the Switzerland-Liechtenstein customs union the East African Community (Kenya, Uganda, and Tanzania) Mercosur (Brazil, Argentina, Uruguay, Paraguay, and Venezuela)

What are common markets?

A common market is a customs union with common policies on product regulation, and free movement of goods, services, capital and labour.

E.g. the EU the CARICOM Single Market and Economy (CSME): Caribbean community island countries

What are economic and monetary unions?

Economic and monetary union An economic and monetary union is a common market with a common currency and a common central bank. E.g. the EU

What are the advantages and disadvantages of economic and monetary unions?

Advantages Exchange rate fluctuations between member countries will disappear. A large currency zone should be more stable against speculation. Business confidence in the member countries tends to improve. Transaction costs are eliminated A common currency leads to prices equalizing across borders.

Disadvantages Individual countries lose the tool of monetary policy, not be able to set their own interest rate. The tool of monetary policy (see Chapter 1 4) is no longer an option to influence the inflation rate, the unemployment rate, and the rate of economic growth. This is especially damaging if one country in the union is experiencing an economic situation that is not being experienced by the others.

A monetary union will be weak and vulnerable without fiscal integration. A monetary union will be weak and vulnerable, since some countries will be more fiscally irresponsible than others and this may threaten the stability of the union.

Individual countries are not able to alter their own exchange rates to achieve the possible macro goals.

The initial costs of converting the individual currencies into one currency are very large The costs include such things as taking the old currencies off the market, printing and distributing the new currency, converting databases and software, rewriting all price lists and invoice systems, re pricing all goods and services in the economy, and recalibrating all machinery that takes coins and notes, such as parking meters and vending machines.

What is complete economic integration?

This would be the final stage of economic integration, at which point the individual countries involved would have no control of economic policy, full monetary union, and complete harmonisation of fiscal policy. This is what the Eurozone is moving towards.

What are the general advantages of trading blocs?

Benefits of being a member of a trading bloc, similar to benefits of free trade Some producers benefit Possibly further stimulus for investment due to larger markets Possibly greater political stability and cooperation Favour increased trade among members Depend on the situation of individual countries

What are the general disadvantages of trading blocs?

Some producers may be unable to compete Discriminatory policies against non members Depend on the situation of individual countries

In a situation where there were large fluctuations between the exchange rates of the countries involved, where the union is going to create a single currency with a significant proportion of the world's foreign currency market and where business confidence will be strongly boosted between member countries, then it is likely that membership of a common currency will be beneficial to the individual countries.

If countries are in a situation where fluctuations in exchange rates are minimal, where the common currency would not be significant on the world market, so would still be susceptible to speculation, and where business confidence is already high, then the advantages of joining a single currency would be few and the disadvantages may well be greater.

What is trade creation?

Trade creation occurs when the entry of a country into a customs union leads to the production of a good or service transferring from a high-cost producers to a low-cost producer A world welfare gain

Advantage

What is trade diversion?

Trade diversion occurs when the entry of a country into a customs union leads to the production of a good or service transferring from a low-cost producers to a high-cost producer A world welfare loss

What is an exchange rate?

An exchange rate is the value of one currency expressed in terms of another currency

What occurs if there is an increase in the supply of a currency on the foreign exchange market?

Import increases; sell the currency for foreign currency Local inflation rate relatively higher An increase in the local income

Investment in foreign currency increases, e.g. FDI Foreign investment prospects improve

Saving in foreign currency increases Local interest rate relatively lower

Speculation Local currency is going to fall in the future; foreign currency is going to rise in the future

What occurs if there is an increase in the demand of a currency on the foreign exchange market?

Export increases; buy the currency using foreign currency Local inflation rate is relatively lower An increase in the income of foreign countries

Foreign investment in the local economy increases Local investment prospects improve

Foreign saving in the local currency increases Relatively higher local interest rate

Speculation The value of the local currency is going to increase The value of the foreign currency is going to fall

What are the advantages and disadvantages of a high exchange rate?

Local currency is worth more than foreign currency

Advantages Downward pressure on inflation If the value of the exchange rate is high, then the price of finished imported goods will be relatively low. In addition, the price of imported raw materials and components will reduce the costs of production for firms, which could lead to lower prices for consumers. The lower price of imported goods also puts pressure on domestic producers to be competitive by keeping prices low.

More imports can be bought -> local currency can be used to buy more goods and services A high value of a currency forces domestic producers to improve their efficiency The high exchange rate will threaten their international competitiveness so they will be forced to lower costs and become more efficient in order to maintain competitiveness. While this might result in the laying off of workers (see next point), there are other means of increasing efficiency that will result in greater economic productivity for the country.

Disadvantages Damage to export industries export industries may find it difficult to sell their goods and services abroad, because of their relatively high prices. This could lead to unemployment in these industries.

Damage to domestic industries Increased competition due to higher imports, decreasing domestic revenue and possibly leading to structural unemployment.

What are the advantages and disadvantages of low exchange rates?

Advantages Greater employment in export industries: Exports from the country will be relatively less expensive and so more competitive. This in turn may lead to more employment in the export industries.

Greater employment in domestic industries: Imports are more expensive, This may encourage domestic consumers to buy domestically produced goods, instead of imports, and this may also raise employment.

Disadvantages Inflation: A low value of the currency will make imported final goods and services, imported raw materials, and imported components more expensive. Increased costs of factors of production will increase the price of goods and services.

What is a fixed exchange rate

A fixed exchange rate is an exchange rate regime where the value of a currency is fixed, or pegged

to the value of another currency, or to the average value of a selection of currencies, or to the value of some other commodity, such as gold

As the value of the variable (the above) changes, so does the value of the currency

The government or the central bank decides upon and maintains the fixed value of the currency. Government intervention in the foreign exchange market Making it illegal to trade currency at any other rate

What is a floating exchange rate?

A floating exchange rate is an exchange rate regime where the value of a currency is allowed to be determined solely by the demand for, and supply of, the currency on the foreign exchange market. No government intervention.

What are the advantages and disadvantages of a floating exchange rate?

Advantages

Interest rate are free to be employed as domestic monetary tools Because the exchange rate does not have to be kept at a certain level, interest rates are free to be employed as domestic monetary tools and can be used for demand management policies, such as controlling inflation.

May keep the current account balanced For example, if there is a current account deficit, then the demand for the currency is low, since export sales are relatively low, and the supply of the currency is high, since the demand for imports is relatively high. This should mean that the market will adjust and that the exchange rate should fall. Following this, export prices become relatively more attractive, import prices relatively less so, and so the current account balance should right itself.

No need for high levels of reserves Because reserves are not used to control the value of the currency, it is not necessary to keep high levels of reserves of foreign currencies and gold.

Disadvantages Uncertainty on international market Floating exchange rates tend to create uncertainty on international markets. Businesses trying to plan for the future find it difficult to make accurate predictions about what their likely costs and revenues will be.

Not necessarily self-adjust in order to eliminate current account deficits Floating exchange rates are affected by more factors than simply demand and supply, such as government intervention, world events like 9/1 1 , and speculation. Because of this, they do not necessarily self-adjust in order to eliminate current account deficits.

A floating exchange rate regime may worsen existing levels of inflation. If a country has high inflation relative to other countries, then this will make its exports less competitive and its imports relatively less expensive. The exchange rate will then fall, in order to rectify the situation. However, this could lead to even higher import prices of finished goods, components, and raw materials, and thus cost-push inflation, which may further fuel the overall inflation rate.

When will a consumer need to use an exchange rate?

Higher income -> higher imports as able to increase expenditure Foreign goods are cheaper and produced more efficiently -> will buy foreign currency Business policies better in foreign goods -> foreign direct investment or portfolio building Consumer preferences -> prefer foreign goods

What occurs if the foreign interest rate is higher than the domestic interest rate?

Increased saving of the foreign currency as there are higher interest rates and returns

What is a managed exchange rate?

A managed exchange rate is an exchange rate regime where the currency is allowed to float, but with some element of interference from the government.

Why do governments intervene in the foreign exchange market?

Reasons for intervention

Lower the exchange rate in order to increase employment Domestic currency is worth less than foreign currencies. Domestic goods are cheaper and exports are more competitive; hence, employment increases in exporting and domestic industries.

Raise the exchange rate in order to fight inflation Price of imported raw goods and factors of production are cheaper as the domestic currency can buy more. Decreases costs of factors of production, reducing cost-push inflation.

Maintain a fixed exchange rate

Avoid large fluctuations in a floating exchange rate

Achieve relative exchange rate stability in order to

improve business confidence

Improve a current account deficit

How do governments intervene in the foreign exchange market?

Achieved by Using the reserves of foreign currencies to buy, or sell foreign currencies If the government wishes to increase the value of the currency, then it can use its reserves of foreign currencies to buy its own currency on the foreign exchange market. This will increase the demand for its currency and so force up the exchange rate.

By changing interest rates If the government wishes to increase the value of the currency then they may raise the level of interest rates in the country. This will make the domestic interest rates relatively higher than those abroad and should attract financial investment from abroad. In order to put money into the country, the investors will have to buy the countrys currency, thus increasing the demand for it and so its exchange rate.

What are the advantages and disadvantages of a fixed exchange rate

Advantages Reduce uncertainty -Businesses will be able to plan ahead in the knowledge that their predicted costs and prices for international trading agreements will not change.

It may force government to take measures to keep inflation as low as possible. If exchange rates are fixed, then inflation may have a very harmful effect on the demand for exports and imports.

Reduce speculation in the foreign exchange markets -The existence of a fixed exchange rate should reduce speculation in the foreign exchange markets. (However, in reality, this has not always been the case and there are often attempts to destabilize fixed exchange rate systems in order to make speculative gains.)

Disadvantages No control over their monetary policies

May sacrifice other domestic macroeconomic goals and MP loses effects

The government is compelled to keep the exchange rate fixed. The main way of doing this is through the manipulation of interest rates. However, if the exchange rate is in danger of falling, then the government will have to raise the interest rate in order to increase demand for the currency, but this will have a deflationary effect on the economy, lowering demand and increasing unemployment. This means that a domestic macroeconomic goal (low unemployment) may have to be sacrificed.

High levels of foreign reserves A country with a fixed exchange rate has to maintain high levels of foreign reserves in order to make it clear that it is able to defend its currency by the buying and selling of foreign currencies.

Fixed exchange rate may be set at the wrong level Setting the level of the fixed exchange rate is not simple. There are many possible variables to take into account and, also, these variables will change with time. If the rate is set at the wrong level, then export firms may find that they are not competitive in foreign markets. If this is the case, then the exchange rate will have to be devalued, but again, finding the exact right level is very difficult.

May create international disagreement A country that fixes its exchange rate at an artificially low level may create international disagreement. This is because a low exchange rate will make that country's exports more competitive on world markets and may be seen as an unfair trade advantage. This may lead to economic disputes or to retaliation.

How can the government maintain the fixed exchange rate?

The government can buy their own currency or sell their own currency

If the supply for the domestic currency increases, the government can buy their own currency with their reserves, increasing the demand by foreigners for the domestic currency so that the exchange rate remains the same.

If the demand for the domestic currency increases, the government can buy foreign currency with their reserves, increasing supply by domestic individuals for the forging currency so that the exchange rate remains the same.

If the government does not have enough reserves, what happens?

It will collapse.

What would occur to HKD if the USD were to increase interest rates?

Demand for HKD from the US would decrease because Americans are getting a higher return on USD

Supply of HKD increases because people from HKD buy USD to get the higher return

What are the two forms of government intervention that the HK government can use after the increase in interest rates in the US?

Buy HKD and shift the demand

Change the interest rates to match the US

HK has limited control over their monetary policy

What would occur to the exchange rate of the US is experiencing slow economic growth

Output of USD decreases -> less demand for imports -> less demand for HKD

If the HK Government does not intervene, the HKD will depreciate

But HK government will offset this by buying HKD, HK may experience economic growth

FDI will increase in Hong Kong

Demand for HKD will shift the demand outwards

But HK government will offset this by selling HKD

Why is it called the trade weighted index?

The trade-weighted index, or TWI, is the price of the Australian dollar in terms of a basket of foreign currencies based on their share of trade with Australia. This index is often used as an indicator of Australia's international competitiveness.

What is the balance of payments accounts

The balance of payments account is a record of the value of all the transactions between the residents of one country and the residents of all other countries within a period of time

What is current account

The balance of trade in goods and services

The current account is a measure of the flow of funds from trade in goods and services, plus other income flows

= -(capital account + financial account + errors and omissions)

What are the four factors within the current account?

The balance of trade in goods The visible trade balance, the merchandise account balance, the balance of trade

The balance of trade in services The invisible balanced the services balance or net services

Income (primary income) Net investment incomes; net factor income from abroad (profit, interest and dividends)

Current transfers (secondary income) Net unilateral transfers from abroad. E.g foreign aid and grants; remittances or private gifts

What is the formula for the current account?

Current account = -(capital account + financial account + errors and omissions)

What is the current account?

The current account is a measure of the flow of funds from trade in goods and services, plus other income flows (income and current transfers)

Current account deficit if this sum is negative and current account surplus if this sum is positive

What is the balance of trade in goods

The balance of trade in goods is also variously known as the visible trade balance, the merchandise account balance, or simply the balance of trade. It is a measure of the revenue received from the exports of tangible (physical) goods minus the expenditure on the imports of tangible goods over a given period of time. It includes trade in all tangible goods, from airplanes to chickens.

What is the balance of trade in services?

The balance of trade in services is also known as the invisible balance, the services balance, or net services. It is a measure of the revenue received from the exports of services minus the expenditure on the imports of services over a given period of time. It includes the import and export of all services such as banking, insurance, and tourism. For example, an Italian tourist on holiday in Vienna would be spending money that represents an invisible export to the Austrian economy (money coming in) and so an invisible import to the Italian economy (money going out) .

What is the income (primary income) (Current Account)

This is often known as net investment incomes (net factor income from abroad). It is a measure of the net monetary movement of profit, interest, and dividends moving into and out of the country over a given period of time, as a result of financial investment abroad. Domestic firms may have set up branches in other countries and any profits being repatriated will count as a positive item in this account. In the same way, profits sent out of the country by foreign firms set up within the country will count as a negative item. Residents and institutions in the country may have invested in banks and other financial institutions in other countries and any interest received from these financial investments will count as a positive item. In the same way, any payment of interest to foreign investors that leaves the country will count as a negative item. Residents and institutions may have purchased shares in foreign companies and any dividends received from those companies will count as a positive item. In the same way, any dividends paid by domestic firms to foreign shareholders will count as a negative item.

What are current transfers (secondary income)?

This is a measurement of the net transfers of money, often known as net unilateral transfers from abroad. These are payments made between countries when no goods or services change hands. At a government level these payments include things such as foreign aid and grants. At an individual level they include foreign workers sending money back to their families in their home country (remittances) or private gifts sent from a person in one country to a person in another.

When is the current account in surplus?

Money inflows are greater than outflow and vice versa for current account deficit

What are the demand side causes and consequences of a current account deficit?

Demand side i) Strong domestic growth Increase in AD -> increases consumption -> increased imports -> money outflow increases -> worsening account deficit

ii) Recession overseas Incomes abroad are falling -> decreases exports from domestic -> money inflow decreases -> worsen account deficit

iii) Strong exchange rate If currency is appreciated -> more currency can buy goods and services

If exchange rate is low -> prices of exported goods are cheaper for foreign consumers -> increasing outflow

What are the supply side causes and consequences of a current account deficit?

Supply side i) Low investment ii) Low productivity iii) High relative inflation

Means that domestic exports are less competitive than others -> worsens account deficit

iv) High ULC -> labour costs V) Poor quality vi) Depletion of resources

Why is a current A/c deficit worse if it is a consequence of supply side factors as compared to demand side factors?

Low productivity and investment -> decrease in world efficiency

Strong domestic growth -> overall better for the economy

What is the capital account?

The capital account is a relatively small part of the balance of payments accounts and does not have a significant effect on the balance. The capital account has two components.

Capital transfers: a measure of the net monetary movements gained or lost through actions such as the transfers of goods and financial assets by migrants entering or leaving the country, debt forgiveness, transfers relating to the sale of fixed assets (tangible assets that firms own and use in production that have a useful life of at least one year) , gift taxes, inheritance taxes, and death duties.

Transactions in non-produced, non-financial assets: consisting of the net international sales and purchases of non-produced assets, such as land or the rights to natural resources, and the net international sales and purchases of intangible assets, such as patents, copyrights, brand names, or franchises.

• Land

• Rights to natural resources

• Sales and purchases of intangible resources

What is the financial account?

The financial account measures the net change in foreign ownership of domestic financial assets. If foreign ownership of domestic financial assets increases more quickly than domestic ownership of foreign financial assets, then there is more money coming into the country than going out, and so there is a financial account surplus. In the same way, if domestic ownership of foreign financial assets increases more quickly than foreign ownership of domestic financial assets, then there is more money going out of the country than coming in, and so there is a financial account deficit.

What are the three components of the financial account?

Direct investment: a measure of the purchase of long-term assets, where the purchaser is aiming to gain a lasting interest in a company in another economy. It includes things such as the buying of property, the outright purchasing of a business or the purchasing of stocks or shares in a business. In all cases, the asset is expected to have a positive return in the future, by making profits or by increasing in value over time. Buyers taking a risk. Returns gained are recorded as primary income.

Typically form of foreign direct investment (FDI, investment by multinational corporations in another country)

Portfolio investment: a measure of stock and bond purchases, which are not direct investment since they do not lead to a lasting interest in a company. They tend to consist of the buying and selling of things such as treasury bills and government bonds. Investor is putting forward the money in order to purchase the asset, in the expectation that interest will be paid on the investment and that the money will be repaid at a given point in time. These assets are simply borrowing and lending on the international market.

Reserve assets: the reserves of gold and foreign currencies which all countries hold and which are itemized in the official reserve account. It is movements into and out of this account that ensure that the balance of payments will always balance to zero. If there is a surplus on all of the other accounts combined, then the official reserve account total will increase. If there is a deficit on all of the other accounts combined, then the official reserve account total will decrease. It is net changes in the official reserve account, over the period of time being considered, that balances the accounts.

What are errors and omissions?

"Errors and omissions" is a balancing item to ensure the accounts do balance.

What is the relationship between the current account and the exchange rate?

A deficit in the current account may result in downward pressure on the exchange rate of the currency. Currency depreciates, , current account will improve.

A surplus in the current account may result in upward pressure on the exchange rate of the currency. Currency appreciates, current account will improve.

What are the consequences of a current account deficit?

Foreign exchange reserves may be used Financed by high levels of foreign investors buying of assets for ownership Financed by high levels of lending from abroad

The current account deficit increases the levels of foreign debt, and this may lower the credit rating

• credit rating agencies including Fitch, Moody's and Standard and Poor (S&P)

• Lower credit rating indicates greater risk and higher interest on loans; make it more difficult to borrow

Interest rates may be used to reduce the current account deficit and lose its functions as MP May reduce AD and employment due to the increase in net import

What are the consequences of current account surplus?

Builds up its official reserve

Allows to have a deficit on its capital account or purchasing assets abroad

Appreciates the currency this may reduce the export competitiveness this may reduce inflationary pressure

Households may have high saving ratios and expenditure on consumption in general and imports may be low

May increase AD and employment due to the increase in net export (Possibly resulting in demand pull inflation)

Financial account deficit

May lead to trade retaliation Can harm international relations Sign of unbalance economy

What are expenditure switching methods of correcting a persistent current account deficit?

Expenditure-switching policies

Government policies to depreciate or devalue the value of the currency Government policies to depreciate or devalue the value ofthe currency: If the government adopts policies that will reduce the level of the exchange rate then exports should become less expensive and imports should become more expensive. Depending upon how responsive domestic consumers and foreign consumers are to these price changes, this should see an improvement in the current account as export revenue rises and import expenditure falls. Opportunity cost -> loss of foreign reserves Goes against world trade organisation

Protectionist measures The government may attempt to restrict the imports of products either by reducing their availability using embargoes, quotas, voluntary export restraints, and administrative, health and safety, and environmental barriers, or by increasing their prices using tariffs. If this happens then domestic consumers will switch their expenditure from imports to domestic products. However, governments are often reluctant or unable to use such measures because they tend to lead to retaliation and are often against WTO agreements. Also, protecting domestic industries reduces competition, possibly encouraging them to be inefficient. Therefore it is not a long-run solution.

What are the expenditure reducing policies used to correct account deficits?

Expenditure-reducing policies

Deflationary fiscal policies

Deflationary fiscal policies: Increasing direct tax rates and/or reducing government expenditure. Clearly, these would be politically unpopular and a government might be reluctant to use such a policy.

Decreases output, decreases economic growth and increasing unemployment (Macro-objectives)

Deflationary monetary policies Increasing the rate of interest and/or reducing the money supply. Interestingly, the higher interest rates should also increase capital flows from abroad, as foreigners put money into financial institutions attracted by the higher rates. This would lead to a surplus on the capital account, which helps to offset the current account deficit.

The economic costs of reducing a large current account deficit suggest why it is important to prevent it from occurring. To avoid these costs many governments are actively pursuing export promotion policies, which may include government-run trade missions, hoping to develop new markets, and government-sponsored advertising campaigns.

How do expenditure switching policies function

If there is an account deficit,

Imports and income flowing out of the country is higher than exports and income flowing into the country

Decreasing the exchange rate, decreases domestic export prices as foreign currencies have higher purchasing power. Increases price of imports and decreases price of exports. Leading to a more balanced account

What is the Marshall-Lerner condition?

The Marshall-Lerner condition states that reducing the value of the exchange rate to improve a current account deficit will only be successful if the PED(export) + PED(imports) >1.

It is more possible in the long-run