Unit 4: The Global Economy

Free trade

is the absence of government intervention of any kind in international trade, so that trade takes place without any restrictions (barriers) between individuals, firms or governments of different countries.

Tariffs

also known as custom duties are taxes on imported goods.

Before the tariff: Domestic production =

Pw x Qs

Before the tariff: Domestic consumption =

Pw x Qd

Before the tariff: Foreign production =

(Qd - Qs) x Pw

After the tariff: Domestic production =

Pw + tariff x Qs1

After the tariff: Domestic consumption =

Pw + tariff x Qd1

After the tariff: Foreign production =

(Qd1 - Qs1) x Pw

After the tariff: Government revenue =

(Qd1 - Qs1) x tarif

Import quota

a legal limit to the quantity of a good that can be imported in a particular time period.

Quota revenue =

(Qd1 - Qs1) x (Pq - Pw)

Production subsidies

payments per unit of output granted by the government to domestic firms that compete with imports.

after subisidy: Government expenditure =

(Psub - pw) x Qs1

Export subsidies

a per-unit amount paid by the government to producers to increase exports.

after export subsidy : Government expenditure =

(Qs1 - Qd1) x Per-unit sub

Administrative barriers

are administrative obstacles that importers must overcome to get their goods into a country

Infant industry

allows domestic producers to gain efficiencies in production to be able to compete with more efficient firms abroad.

National security

industries like airlines, minerals, and chemical production can be seen as essential for national security and therefore worth protecting.

Health and safety

countries may be concerned that imported goods don’t meet their standards.

Diversification

protection can help the economically least developed countries protect domestic industries that can help diversify the economy away from the primary sector.

Anti-dumping

dumping is the act of selling a good below its production cost. Dumping is illegal according to international agreements but is extremely difficult to prove and therefore used as an excuse to impose trade protections.

Unfair competition forms

○ Dumping

○ Production/export subsidies

○ Administrative barriers

○ Undervalued currencies

○ Violation of international property right

Economic integration

economic cooperation between countries and coordination of their economic policies and economic links between them.

Preferential trade agreement (PTA)

an agreement between two or more countries to lower trade barriers on particular goods in trade with each other.

Bilateral trade agreement

an agreement between two countries.

Multilateral trade agreement

an agreement between many countries.

Regional trade agreement

an agreement between countries in a specific geographical location.

Trading bloc

a group of countries that have agreed to reduce tariffs or other barriers to trade with the purpose of having free or freer trade and cooperation between them.

Free trade area (FTA)

a group of countries that agree to gradually eliminate trade barriers between themselves. This is the most common type of integration.

Customs unions

have all of the characteristics of FTAs with the addition of a common trade policy with all non-member countries. Individual countries cannot make their own trade agreements with non-member countries.

Common market

has all of the characteristics of a FTA and customs union with the addition of removing all trade barriers between them and eliminating barriers on movement of any factors of production.

Monetary union

involves the characteristics of a common market with the addition of a common currency and common central bank.

World Trade Organization (WTO)

an organization that aims to liberalize trade across the world.

Foreign exchange

refers to foreign national currencies.

Exchange rate

the value of one country’s currency in terms of another.

Appreciation

is the increase in the value of one currency in terms of another in a free floating exchange rate system.

Depreciation

a fall in the value of a currency in terms of another in a free floating exchange rate system.

Causes of changes in ER - demand

Exports and factors affecting exports:

● Foreign demand for exports of goods.

● Foreign demand for exports of services.

● Rate of relative inflation to other countries.

● Relative growth rates.

Investment and factors affecting investment:

● Inward FDI (foreign direct investment) and portfolio investment (financial investments).

● Relative interest rates.

Other factors:

● Inward inflow of remittances.

● Speculation that the currency will appreciate.

● Central bank intervention to buy more of the currency (not part of free floating).

Causes of changes in ER - supply

Imports and factors affecting imports:

● Domestic demand for imports of goods.

● Domestic demand for imports of services.

● Rate of relative inflation to other countries.

● Relative growth rates.

Investment and factors affecting investment:

● Outward FDI and portfolio investment.

● Relative interest rates.

Other factors affecting currency supply:

● Outward flow of remittances.

● Speculation that the currency will depreciate.

● Central bank intervention to sell more of the currency (not free floating).

If you were given information that 1€ is equal to $1.16 USD you could use this data to calculate how much $1 is in terms of euros.

1 dollar = 1/1.16 euro = 0.86206897 euro - which rounds to $1 = 0.86€

f you owned a ski shop in Austria but imported your skis from the US for $1,200 a pair and you ordered 50 pairs how much would the skis cost in euros if we used the exchange rate from above?

$1,200 x 50 = $60,000 - then to find the price in euro you multiply $60,000 by 0.86€ = 51,600€

Revaluation

the increase in value of one currency in terms of another in a fixed or managed exchange rate system.

Devaluation

the decrease in value of one currency in terms of another in a fixed or managed exchange rate system.

Overvalued currency

a currency that has a value that is too high relative to its free market value

Undervalued currency

a currency that has a value that is too low relative to its free market value.

Fixed exchange rate system

exchange rates are fixed by the central bank of each country at a particular level (or narrow range), and are not permitted to change freely in response to changes in supply or demand.

Managed exchange rate (managed float)

when an exchange is allowed to float within certain upper and lower limits.

Pegged exchange rate

when an exchange rate is allowed to float within a certain range of the dollar or euro.

Balance of payments

a record (usually a year) of all transactions between a country’s residents and all other countries

Credits

all payments received from other countries.

Debits

all payments paid to other countries.

Income

the inflow of all rents, interest, and profits from abroad.

Current transfers

the inflow of transfers such as gifts, remittances (money sent home to relatives), foreign aid, and pensions.

Foreign direct investment (FDI)

when MNCs invest into the productive capacity of domestic firms.

Portfolio investment

buying of financial investments like stocks and bonds.

Reserve assets

the central bank buying and selling currency. If they buy their own currency it will count as a credit if they add more reserve currencies it counts as a debit.

Official borrowing

money borrowed counts as a credit while money loaned counts as a debit.

BoP =

Current Account + Capital Account + Financial Account = 0

current account

tracks the difference between a country's total exports and total imports (including goods, services, and transfers)

trade deficit

Imports exceed exports

(Net Exports is negative)

Trade Surplus

Exports exceed Imports

(Net Exports is positive)

financial capital account

tracks the ownership of assets held by foreigners and ownership of foreign assets

Positive Net Capital OUTFLOW

a country invests outside more than other countries invest inside it (Net Capital INFLOW is negative)

Net Capital OUTFLOW is negative

a country has a current account deficit, they will have a capital account surplus

Monetary Unions (HL)

when members of a common market adopt a common currency and a central bank that conducts monetary policy.

Advantages of a monetary union (HL)

• Single currency eliminates exchange rate risk and uncertainty. 

• Single currency encourages price transparency. 

• Single currency eliminates transaction costs. 

• Single currency promotes inward investments. 

• Low rates of inflation give rise to lower interest rates, more investment, and more output.

Disadvantages of a monetary union (HL)

• No control over monetary policy (for single countries). 

• Monetary policy will have different impacts depending on the domestic context. 

• Loss of exchange rate flexibility. 

• In regards to the Eurozone, countries must maintain certain debt to GDP ratios/budget deficit ratios.

Flexibility offered to policy makers 

• Fixed exchange rates (HL)

Little to no flexibility for policy makers since monetary policy must be used to maintain the fixed value. 

Flexibility offered to policy makers 

• Free floating exchange rates (HL)

Gives policy makers more freedom since they’re not worried about keeping a fixed value for their exchange rate.

Consequences of persistent current account surpluses (HL) 

If a country runs persistent current account surpluses there can be the following consequences: 

• Low domestic consumption for goods and services. 

• Insufficient domestic investment. 

• Appreciation of a country’s currency. 

• Inflation 

• Reduced export competitiveness. 

• Possible retaliatory trade protections.

The Marshall-Lerner Condition states the following: (HL)

• If the sum of the PED for imports and exports is greater than 1, a devaluation/depreciation will move a country’s current account deficit towards a surplus. 

• If the sum of the PED for imports and exports is less than 1, a devaluation/depreciation will move a country’s current account deficit further towards a deficit. 

• If the sum of PED for imports and exports is equal to 1, a devaluation/depreciation will leave the current account unchanged. 

The J-Curve effect (HL)

A depreciation or devaluation can first worsen the trade balance because consumers do not immediately change buying habits.

Over time, as demand becomes more elastic, the Marshall–Lerner condition holds and the trade balance improves.

Consequences of under valued currencies 

comes with the advantage that it makes exports cheaper and can lead to export-led growth but this can be seen as ‘cheating’ and create political difficulties. It also comes with the disadvantage of making imports more expensive and could lead to cost-push inflation.  

Consequences of over valued currencies 

mean that imported goods are cheaper, which can reduce production costs for domestic firms that have imported costs of production.  However, this comes with the trade-off of a country’s exports being more expensive which can lead to a country’s trade balance moving towards a deficit. 

Fixed exchange rates - how they’re maintained : Limiting imports

limiting imports will mean that there will need to be less supply of BAM to buy goods from the Eurozone shifting the supply of BAM from S to S1 after the fall in demand.

Ways that the government can limit imports include: 

• Contractionary monetary/fiscal policy. 

• Trade protections

Fixed exchange rates - how they’re maintained : Borrowing from abroad

higher relative interest rates will incentivize investors to buy financial investments which will increase the demand for the BAM.

Fixed exchange rates - how they’re maintained :Changing interest rates

higher relative interest rates will incentivize investors to buy financial investments which will increase the demand for the BAM.

The current account includes:  

• Balance of trade in goods and services (Net exports) 

• Income - is the inflow of all rents, interest, and profits from abroad. 

• Current transfers - is the inflow of transfers such as gifts, remittances (money sent home to relatives), foreign aid, and pensions.

the current account will be in surplus.  

If the value of credits (inflows) is greater than debits (outflows)

the current account will be in a deficit.  

If the value of credits (inflows) is less than debits (outflows)

Consequences of changes in exchange rates: Effects on unemployment:

• If a country’s currency depreciates and causes a increase in AD this could lead to a fall in cyclical unemployment if the country is in a recessionary gap or if output is near potential it could cause a temporary fall in the natural rate of unemployment. 

• As exports rise this should lead to an increase in employment in export industries. 

• Depreciation could also lead to cost-push inflation which would lead to higher unemployment. 

• Appreciation will lead to the opposite effects as stated above.

Consequences of changes in exchange rates: Effects on the current account balance:

• Will be discussed further when we focus on Balance of Payments. 

Consequences of changes in exchange rates: Effects on foreign debt:

• Depreciation will make it more difficult to payback national debt which is a situation that many developing countries find themselves in. 

WTO influence in international trade

• The WTO is accused of promoting trade rules that don’t favour developing countries 

  • Developed countries receive greater tariff reductions vs developing countries. 

  • Non-tariff and hidden barriers used against developing countries has increased. 

  • There hasn’t actually been a reduction in agricultural subsidies that have been promised. 

  • Intellectual property rights have been enforced making new technology more difficult to acquire. 

  • MNCs no longer have to buy their goods locally which doesn’t help promote local employment. 

• There has been no agreement on agricultural protection. 

• The WTO treats all countries the same

• The WTO has been accused of ignoring environmental and labour issues

• WTO members have unequal bargaining power

Consequences of changes in exchange rates: Effects on the rate of inflation:

• Demand-pull inflation - depending on the model and where AD/AS intersect in that model an increase in AD from the depreciation of a country’s currency could lead to demand-pull inflation. 

•  Cost-push inflation - If domestic producers are reliant on imports as a part of their cost of production, depreciation of a country’s currency could lead to cost-push inflation.

Consequences of changes in exchange rates: Effects on economic growth:

Growth through changes in exchange rate mostly come through changes in AD and net exports.  Export led growth could also in theory lead to more capital spending by domestic firms which could lead to increases in productive capacity and LRAS.   

Using official reserves

If demand for BAM falls, the central bank buys BAM using foreign reserves to maintain the fixed rate, risking reserve depletion. If demand rises, it sells BAM and buys euros.

The capital account includes: 

• Capital transfers - includes debt forgiveness, non-life insurance claims, investment grants. 

• Non produced, non financial assets - includes mineral rights, fishing rights.

the capital account will be in surplus

If the value credits is greater than debits

The financial account includes: 

• Foreign direct investment (FDI) - when MNCs invest into the productive capacity of domestic firms. 

• Portfolio investment - buying of financial investments like stocks and bonds. 

• Reserve assets - the central bank buying and selling currency. If they buy their own currency it will count as a credit if they add more reserve currencies it counts as a debit. 

• Official borrowing - money borrowed counts as a credit while money loaned counts as a debit. 

the financial account will be in surplus and vice versa. 

If the value credits is greater than debits

the financial account must be in deficit and vice versa. 

If the current account is in surplus

The sum of all of the items in the balance of payments will always be

zero

if a country’s current account is in deficit it means that

it consumes more than it produces and that extra output has to be paid through a surplus in the financial account.

if a country’s current account is in surplus it means that

they consume less than it produces and part of the income generated by the sale of extra output contributes to a financial account deficit.

Gains from trade include: 

• Increased competition

• Greater efficiency in production

• Lower prices for consumers

• Greater choice for consumers

• Acquiring needed resources 

• Source of foreign exchange

• Access to larger markets 

• Economies of scale in production 

• Increases in domestic production and consumption as a result of specialization 

• More efficient allocation of resources 

• More interdependence and less of a chance of hostility or violence 

Absolute advantage (HL)

the ability of a country to produce more of a good with the same quantity of resources as another country. 

comparitive advantage (HL)

the situation where one country has a lower opportunity cost in the production of a good than another country.

Calculating Comparative Advantage steps

• USA: 80 planes, 60 cars

• Germany: 30 planes, 40 cars

Step 1: Calculate opportunity cost using “other goes over”

• USA:

  • 1 plane = 60 ÷ 80 = 0.75 cars

  • 1 car = 80 ÷ 60 = 1.33 planes

• Germany:

  • 1 plane = 40 ÷ 30 = 1.33 cars

  • 1 car = 30 ÷ 40 = 0.75 planes

Step 2: Compare opportunity costs

• Lower OC of planes: USA

• Lower OC of cars: Germany

Step 3: Specialise and trade

• USA exports planes

• Germany exports cars

If I live in the US and I want goods from Austria. Do those goods from Austria classify as imports or exports?

Imports