4.1 international economics

explain the characteristics of globalisation

increased international trade
- increasing multinational corporations (MNC's)
- increased international movement of labour
- increased specialisation
- greater dependance on the global economy
- easier movement for goods and services
- recognition of companies such as McDonald's in LIC's
- global supply chains
- trade to GDP ratios increase (Luxembourg 400%)

Explain the causes of globalisation

🔹 1. Trade Liberalisation

• Countries have reduced tariffs, quotas, and other trade barriers.

• WTO and trade agreements (e.g. NAFTA, EU,) promote freer trade.

This makes it easier and cheaper to export and import goods and services.

🔹 2. Technological Advancements

• Improvements in transport (e.g. container shipping, ) and communication (e.g. internet, smartphones).

• Enables faster movement of goods, people, and information.

evaluate the impact of globalisation on Consumers

• Lower Prices

  • Global competition and efficient supply chains lead to cheaper goods for consumers, especially in developing economies.

• Increased Variety & Quality

  • Consumers enjoy a wider range of products, with access to better-quality goods from around the world.

1. Cultural Homogenisation

   • Global brands may overshadow local traditions and products, reducing cultural diversity.

   • Example: McDonald's and Starbucks spreading globally, diminishing local food culture.

2. Vulnerability to Supply Chain Disruptions

   • Complex global supply chains make consumers vulnerable to delays or shortages due to disruptions (e.g., pandemics, disasters).

   • Example: COVID-19 causing product shortages and price increases.

impact of globalisation workers

1. Job Creation in Emerging Markets

   • Globalisation leads to job opportunities in developing countries as companies relocate production to cheaper labour markets.

   • Example: Manufacturing jobs in countries like China and India have increased due to foreign investment.

2. Higher Wages for Skilled Workers

   • Demand for skilled labour in sectors like technology and finance can lead to higher wages in developing economies.

   • Example: IT and finance professionals in India benefit from global outsourcing.

Negative Impacts on Workers

1. Job Losses in Developed Countries

   • Outsourcing and offshoring of jobs to lower-cost countries can lead to unemployment in high-wage economies.

   • Example: Manufacturing jobs have been outsourced from the US and UK to countries like China and Mexico.

2. Exploitation in Developing Countries

   • While globalisation creates jobs in developing countries, workers often face poor conditions, low pay, and exploitation.

   • Example: Garment factory workers in Bangladesh endure unsafe conditions for low wages

impact on producers of globalisation

Access to Larger Markets

• Globalisation opens up international markets, allowing producers to sell goods and services to a broader consumer base.

• Example: Companies like Apple and Samsung sell products worldwide, reaching millions of new customers.

1. Lower Production Costs

   • Producers can benefit from lower costs by outsourcing or offshoring production to countries with cheaper labour and resources.

   • Example: Many multinational corporations, like Nike, manufacture in low-cost countries like China and Vietnam

Negative Impacts on Producers

impact of globalisation on governments

1. Economic Growth

   • Globalisation boosts trade, investment, and economic activity, helping governments grow their economies through increased exports and foreign direct investment (FDI).

   • Example: Countries like China and India have seen rapid growth due to increased global trade and investment.

2. Access to Technology and Knowledge

   • Globalisation facilitates the transfer of technology and expertise, which can improve productivity and innovation within the public and private sectors.

   • Example: Developing countries can adopt advanced technologies and management practices from developed nations, enhancing their own industries.

Negative Impacts on Governments

1. Loss of Sovereignty

   • Globalisation can limit governments' control over domestic policies, as international agreements, foreign investment, and global corporations exert influence on national decisions.

2. Increased Inequality

   • While globalisation can stimulate economic growth, it often benefits wealthier groups, leading to greater income inequality within countries. Governments may struggle to address the growing gap between rich and poor.

     footless companies may not pay the tax as they can just leave the country
     TNC's may bribe or lobby the government
     Tax avoidance (e.g starbucks)

globalisation on environment

Increased Environmental Awareness

• Global interconnectedness raises awareness, fostering international cooperation on climate change and conservation.

• Example: The Paris Climate Accord unites countries to address global environmental challenges.

• Biodiversity Loss

  • Expansion of agriculture and urbanisation for global supply chains leads to deforestation and habitat destruction.

  • Example: Deforestation in Southeast Asia for palm oil production.

How is growing inequality dealt with

1. Progressive Taxation

   • Action: Governments can implement progressive tax systems where higher earners are taxed at higher rates to redistribute wealth. could fund social services, education, and healthcare for lower-income groups.

2. Investing in Education and Skills Development

   • Action: Increasing investment in education and training programs can help reduce inequality by improving workers' skills and employability.to ensure workers can access better-paying jobs in a globalised economy.

1. Progressive Taxation

   • Cons: High taxes on the wealthy may discourage investment or capital flight, potentially slowing economic growth.

2. Investing in Education and Skills Development

   • Cons: Education alone cannot solve all inequality issues, especially if structural problems like lack of job opportunities persist. The effectiveness depends on quality and accessibility.

structural unemployment

Education and Retraining

• Action: Invest in retraining programs to help workers transition to new industries

• Geographical Mobility

  • Action: Encourage workers to relocate to areas with more job opportunities through subsidies.

  • Example: Offering financial assistance for workers to move to urban areas with growing industries.

• Education and Retraining

  • Can lead to brain drain

  • Cons: Takes time and resources, and not all workers can access or complete retraining.

Impact on a country from foreign competition

Explain the benefits of trade

Greater Consumer Choice: Access to a wider variety of goods, often cheaper or better quality.Improving living standards

Lower Prices & Competition: Imports force domestic firms to be efficient and cut costs, benefiting consumers.

Economies of Scale: Firms selling globally reduce average costs by producing more.

costs of trade (4 )

• Structural Unemployment: Some industries decline due to foreign competition, causing job losses.

• Over-Specialisation Risk: Dependence on few products makes economies vulnerable to shocks.

• Exploitation: Poor labour conditions in some exporting countries.

• Dependence: Heavy reliance on imports can create vulnerability to disruptions.

Explain absolute advantage

Absolute advantage occurs when a country can produce more of a good or service with the same quantity of resources than another country.

✅ It shows which country is more efficient in producing a good.

Example of absolute advantage

• Country A can produce 100 cars or 200 computers.

• Country B can produce 80 cars or 150 computers.

👉 Country A has an absolute advantage in both cars and computers because it produces more of each using the same resources.

Explain comparative advantage

Comparative advantage occurs when a country can produce a good at a lower opportunity cost than another country.

✅ It’s not about who produces more, but who sacrifices less to produce one more unit.

Explain the assumptions of comparative advantage for each assumption explain its limitations when applied to the real world

No Transport Costs

• Assumption: Trade is costless; goods can be moved freely between countries.

• Limitation:

  • In reality, transport costs can be high, especially for bulky or perishable goods.

  • High costs may eliminate any gains from trade

No Trade Barriers

• Assumption: There are no tariffs, quotas, or regulations.

• Limitation:

  • Protectionism is common (e.g. US-China tariffs), which distorts comparative advantage and restricts trade.

evaluation for absolute advantage

Maximising output to exploit absolute advantage may lead to pollution, overuse of resources, or poor labour conditions in some countries.

“Pursuing absolute advantage could result in negative externalities, particularly in countries with weak environmental regulations.”

over reliance comparative advantage

• Countries that specialise may become vulnerable to external shocks (e.g. a global drop in demand for their exports).

• E.g. if a country specialises in oil and prices fall, their whole economy suffers.

🗣 “Over-reliance on a single export sector can leave an economy vulnerable to commodity price fluctuations or global demand changes.”

In 2020, the total value (including export and import) of UK trade was..

15 trillion

Distinguish between the pattern of trade and the level of trade

Pattern of Trade

• what a country is trading at a given time

Level of Trade

total amount of trade in the world (e.g possibly measured as a proportion of global GDP)

comparative advantage how it affects global trade

• As countries develop and new comparative advantages are established, the pattern of countries’ trade with each other may change

  • E.g. the shift of manufacturing from developed to developing countries in recent decades
    ✅ Example: Bangladesh focuses on textiles due to low labour costs.

chains of reasoning for comparative advantage

specialisation
produce on a large scale
allocative efficiency
lower unit costs
lower prices

emerging economies - how they impact global trade

the industrialisation of emerging economies means that they are more able to produce higher value goods (e.g. manufactured goods) compared to the low value commodities they had typically exported previously

• Rapid growth in countries like China and India is adding extra consumers to global demand

exchange rate- how it impacts patterns of trade

• Over time the appreciation or depreciation of a currency will affect the relative competitiveness of goods and services from different countries

• E.g. the depreciation of a country’s currency will make their exports more price competitive abroad

• Exchange rates can be manipulated by a government as part of their macroeconomic policy

• ✅ Example: After the 2016 Brexit vote, the pound depreciated sharply, boosting UK exports by making them more price-competitive.

explain what is meant by terms of trade

• If ToT > 100 → Improved terms of trade: Export prices have risen relative to import prices.

• If ToT < 100 → Deteriorated terms of trade: Import prices have risen relative to export prices.

Key idea: Better ToT means a country can import more for a given value of exports.

formula for ToT

index of export prices / index of import prices

and x100

Terms of trade is the ratio of export prices to import prices

how do inflation rates influence terms of trade

• Explanation: Higher domestic inflation → export prices rise → improved ToT.

• Evaluation: May reduce competitiveness → lower export demand.

• Example: UK inflation in 2022 raised export prices but worsened current account due to falling competitiveness.

How do exchange rates influence terms of trade

if the £ appreciates then export prices will increase more than import prices - improving ToT

evaluation on terms of trade

• Improved ToT isn’t always good — if caused by uncompetitive exports, it can hurt growth.

• Deteriorating ToT isn’t always bad — if it reflects rising export volumes or investment in productivity.

how much have shipping/containerization costs fallen since the 1950s

how much has trade increased as a result of this

100%

790%
this is shipping through containers

how does a change in raw material prices impact terms of trade

decreased raw material prices means improvement in terms of trade

BUT

this could make exports cheaper, worsening terms of trade

impact of changes in terms of trade

if terms of trade favours and the PED for your goods is inelastic, the BoP will see an improvement
improvement in the ToT may lead to a decrease in GDP because export prices rising means there is a decrease in exports

cost of production is not always constant

increased specialisation might result in rising average costs caused by diseconomies of scale

advantages of specialisation of trade

lower prices and more choice for consumers
- competition will encourage firms to innovate
• larger markets and economies of scale for firms
• higher economic growth and living standards (countries that isolate themselves, like North Korea, have tended to have economic stagnation

disadvantages of specialisation of trade

• a deficit on the trade in goods and services balance could arise if a country's goods and services are uncompetitive
• danger of dumping by foreign firms, i.e. selling at below average cost
• increased unemployment resulting from the above
- firms that cannot compete will shut down and there will be increased unemployment. This will be especially severe if the workforce lacks mobility (Manchester shipbuilding shut down)
• increased economic integration might result in increased exposure to external shocks

overdependance on exports

saudi arabia GDP is 50% of exports

hypothesis terms of trade

An increase in world incomes will lead to a deterioration in the terms of trade for developing countries

manufactured goods have income elastic demand so will get more expensive
primary products have income inelastic demand so will remain cheap therefore terms of trade worsen

what is a bilateral trade agreement

a trade agreement between two countries

regional trade agreement

a treaty between two or more countries, usually in the same geographic region, to reduce or eliminate trade barriers like tariffs and quotas to increase trade and economic cooperation among themselves

how much higher would world trade tariffs be without the WTO

3%

what does the WTO do

overseeing the rules of international trade.

It polices free trade agreements, settles trade disputes between governments and organises trade negotiations.

positives of the WTO

- Resolved the 20 year long Banana Trade war
- bali agreement 2013 (would boost global trade by $1 billion)1.
- Promote free trade with increased efficiency
- Helps to dissipate and prevent trade wars

criticisms of the WTO

- Inconsiderate to the needs of developing countries

- Biased in favor of the US and the interests of the European Union (EU)

- Poor countries sometimes cannot afford trade representatives, thus their negotiations are thought to favor rich countries.

how does protectionism of jobs cause growth

>reduces imports->less leakages->consumers purchase local goods->firms increase production->derived demand for labour->AD increased->Positivie multipleir

trade blocs

A group of neighboring countries that promote trade with each other and erect barriers to limit trade with other blocs

types of trading blocs

A group of neighboring countries that promote trade with each other and erect barriers to limit trade with other blocs

advantages of trading blocs

Freeing regional trade may allow individual members to specialise in line with their country's comparative advantages
Improves competition
Volume of trade increases
Resources easier to source
Labour easier to recruit
Production and transport costs fall

disadvantages of trading blocs

Trade Diversion
Occurs when higher cost producers replace lower cost external producers.
This results in a less than efficient allocation of resources as it distorts the concept of comparative advantage.
- Environmental damage
- heightens regional inequality
- may be a retaliation as other trading blocs open
- More external costs and shipping costs
- Unemployment

benefits of regional trade agreements

Trade Creation
RTAs reduce or eliminate tariffs and other trade barriers between member countries → this lowers the cost of imports → leads to greater trade flows within the region → consumers benefit from lower prices and greater choice → allocative efficiency improves. (this leads to lower inflation)

Economies of Scale
A larger regional market allows firms to expand output → they benefit from internal economies of scale (e.g. bulk buying, technical efficiencies) → lowers long-run average costs → these cost savings may be passed onto consumers as lower prices → improving welfare. - higher living standards

Trade Creation

• Explanation: Tariffs and other barriers to trade between member countries are removed, so members import goods from the most efficient producers within the region.

• Effect: Leads to lower prices, greater efficiency, and consumer welfare gains.

• Example: The EU allows tariff-free trade between member states, boosting intra-EU trade

costs of regional trade agreements

Trade Diversion
RTAs may shift trade from low-cost global producers to less efficient regional partners due to preferential treatment → this distorts comparative advantage → leads to inefficient resource allocation and higher prices than if goods were sourced globally → reduces global welfare.

1. Risk of Overdependence
   Firms may become too reliant on regional trade partners → if demand in the region falls or if political tensions arise, export earnings may decline sharply → increases vulnerability to regional shocks

what is a regional trade agreement

A Regional Trade Agreement (RTA) is a treaty between two or more countries within a specific region that aims to reduce or eliminate trade barriers (such as tariffs and quotas) on goods and services traded between the member states.

impact of increasing protectionism

Higher prices for consumers, especially on
goods/services that can't be produced
domestically, e.g. bananas in the UK, increasing
inflation globally
- Higher prices for consumers due to domestic
firms facing less competition from abroad
• Less choice for consumers as imports become too
expensive
- Deadweight welfare loss
Protection of domestic industries helps to protect
domestic employment and income, helping to
reduce global inequality
• Protection of infant industries to allow them time
to grow and expand in order to benefit from
economies of scale to compete internationally
• Protection of an economy from a foreign

protectionist policies on producers

Point: Tariffs protect domestic producers from foreign competition. Imported goods become more expensive, so consumers switch to cheaper domestic alternatives. Domestic firms enjoy higher sales, higher profits, and greater market share, allowing them to expand output and employment.

Evaluation

• Complacency risk: Reduced competition may make domestic firms less efficient over time.

• Higher production costs: If tariffs are placed on imported raw materials, domestic producers’ costs rise, reducing competitiveness.

• Retaliation: Other countries may impose tariffs in response, harming exporters.

infant industries

Developing industries that are too small to benefit from economies of scale and often require protection to get started

protectionism on jobs

>reduces imports->less leakages->consumers purchase local goods->firms increase production->derived demand for labour->AD increased->Positivie multipleir

China US trade war

Trump was unhappy with the trade agreements with china, leading to a trade war.
He decided to impose tariffs on products coming from china to be sold in the US
China then put tariffs on goods produced in the US coming to China ex: whiskey

effects of a tariff

1. Increase the domestic price of the protected good
2. Increase domestic production of the good
3. Decrease consumption of the good
4. Decrease consumer surplus
5. Increase producer surplus
6. Tariff revenue
7. Production inefficiency
8. Welfare loss

negatives of trade barriers

risk of retaliation
higher prices for consumers
regressive effect on income inequality
incentives to by-pass controls in shadow markets

export subsidies

An export subsidy is a government payment to domestic producers to encourage them to sell goods on overseas markets. These subsidies lower the cost of production, making the goods more competitive and cheaper for foreign buyers, which increases exports.

dumping

selling products in a foreign country at lower prices than those charged in the producing country (or predatory pricing at an international scale) e.g china's toys

tariffs on living standards

decrease (tarrif diagram deadweight loss) as less choice for consumers
could also cause trade wars

• Protectionism can impact living standards by affecting the availability and affordability of goods.

• It can protect jobs but may reduce consumer choices and increase prices

name reasons for restrictions on free trade

1. Protecting Domestic Industries:

   • Governments may impose trade restrictions to shield domestic industries from foreign competition.

   • This is often done to prevent job losses and maintain national self-sufficiency in critical sectors

1. Infant Industry Argument:

   • Governments may protect emerging or "infant" industries until they can compete internationally.

   • Temporary trade barriers, like tariffs, can provide domestic industries time to grow and become competitive.

1. Anti-Dumping Measures:

   • Anti-dumping duties are imposed when foreign companies sell products below their production cost in the domestic market, harming domestic producers.

   • These measures protect local industries from unfair competition.

protectionism on government

• Positive Impact: Governments can generate revenue through tariffs. (refer to diagram)

• Negative Impact: Protectionist policies may strain diplomatic relations and lead to retaliation by trading partners.

balance of payments

• The balance of payments current account measures the total value of goods and services that enter and leave the economy.

A deficit implies that an economy is importing more goods than they are exporting,

why does the UK import more than export

1. lack of raw materials
2. strong currency
3. goods are not our comparative advantage
4. economic growth / high standards of living - YED positive
5. relative infaltion
6. low demand for financial services

cyclical causes of a current account deficit

When an economy is experiencing a boom, rising real incomes and consumer spending and falling savings ratio can lead to a surge in import demand which can cause an increase in the size of a trade deficit.
----------------------------------------------------------------------
Over valued exchange rate (short run)
Increase in domestic demand (short run)
Recession in key export markets
Slump in global prices of exports
Increased demand for imported technology
Global supply constraints

explain the causes of imbalances on the current account

Exchange rate movements

• Appreciation → exports more expensive, imports cheaper → likely deficit.

Structural weaknesses

• Decline in manufacturing and reliance on imported goods.

• Limited domestic supply capacity (skills shortages, low investment) means imports fill the gap.

Strong domestic demand

• When UK consumers/firms spend heavily, import demand rises (especially for consumer goods, raw materials and capital goods).

• Import growth can outpace export growth → deficit.

Exchange rate devaluation - to reduce deficit

If the UK government were to devalue the pound, exports would become cheaper to foreign buyers because they can convert less of their currency to receive the same amount of pounds as previously. The government could do this by selling pounds and buying more foreign currencies like the Yen, increasing the supply of the pound and lowering the exchange rate to ER1. This increase in international competitiveness means that the demand for British exports such as financial services (which make up 40% of our trade) would increase hugely. This would mean that the UK begins to export more and the current account deficit improves. Moreover, the devaluation would make imports more expensive, which would reduce the MPM of UK consumers as it is now more expensive for them to import foreign goods

However, a competitive devaluation may not improve the current account deficit because the Marshall-Lerner condition may not be satisfied.states that a country's trade balance will improve after a currency depreciation if the combined price elasticities of demand for its exports and imports are greater than oneIf this is not met, then the revenues from exports will actually decrease and the current account would worsen. Even if Marshall-Lerner was met, the J-curve shows that in the short run, our balance of payments currency account would actually worsen, further showing that this devaluation may not work.

supply side policies to reduce a country’s imbalance on the current account

• Improve long-term productivity, competitiveness, product quality → sustainably raise exports.

• Non-inflationary way to boost net trade.

Cons / Evaluation:

• Long time lag before effects materialise (5–10+ years).

• High opportunity cost for governments.

• No guarantee that firms will export more — depends on global demand.

marshall lerner condition

States that a depreciation, or devaluation, of a currency will only lead to an improvement in the current account balance if the elasticity of demand for exports plus the elasticity of demand for imports is greater than one.

J curve effect

following a currency depreciation, a country's balance of trade may get worse before it gets better (time lag)

Takes a while for consumers to realise imports have gotten more expensive and takes a while for other countries to realise our exports have gotten more expensive

Trade protection to reduce a deficit of the current account

• Quickly reduces imports; may help domestic industries grow.

Cons / Evaluation:

• Causes retaliation, escalating trade wars → exports fall.

• Higher prices for consumers and lower choice.

• Usually illegal under WTO rules; only temporary measures allowed.

tariff diagram

the tariff means domestic consumers consume less of imported goods

how does exchange rate effect FDI

Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDIThe money they have available to invest is worth more when the currency has depreciated

BUT
continued depreciation means investment would become worth less in their own currency

evaluate spiced

1) inflation elsewhere = exports cheaper
2) cheaper imports -> less costs of production -> cheaper exports
3) time lag

capital flight on exchnage rate

depreciation = because less demand for currency/more supply

This depreciation can make imports more expensive, potentially leading to inflation, while making exports cheaper and potentially boosting economic growth. 

floating exchange rate

• Exchange rates are determined solely by free market forces

• Example: The US Dollar (USD) against the Euro (EUR) fluctuates daily depending on trade, investment flows, and interest rates.

• Key point: No government intervention; the rate changes freely.changes in demand and supply determine the value

Quick addition (optional for flashcard):

• If demand for a currency rises → currency appreciates.

• If demand falls → currency depreciates.

fixed exchange rate

Definition: A currency whose value is pegged to another currency or commodity (like gold)

• Example: Hong Kong Dollar (HKD) pegged to US Dollar (USD).

Quick addition:

• Protects against currency volatility but can limit monetary policy flexibility.

managed exchange rate

• A currency whose value is mainly determined by the market, but the central bank intervenes occasionally to prevent excessive fluctuations.

• Govt. may buy and sell currency to influence its rate

• Govt. may actively use changes in the rate of interest to influence the currency

• Example: Indian Rupee (INR) against USD – mostly floating, but RBI intervenes if it moves too fast.

• Key point: Combines market forces with government intervention for stability.

Explain the distinction between a revaluation and appreciation of a currency

revaluation: An increase in the value of a currency imposed officially by the government or central bank in a fixed exchange rate system

appreciation:An increase in the value of a currency due to market forces (supply and demand) in a floating exchange rate system.

when a country's currency increases in value relative to another currency. This means that one unit of the appreciated currency can now buy more of another currency or a greater quantity of goods and services in that foreign currency. For example, if the British pound appreciates against the US dollar, one pound would be able to buy more dollars than before, making imported goods from the US cheaper.

Explain the distinction between devaluation and depreciation of a currency

depreciation-  is the decline in a currency's value compared to another currency in a floating exchange rate system

• Example: if £1 used to buy $1.30 but now only buys $1.15, the pound has depreciated against the dollar

devaluation:A fall in the value of a currency imposed officially by the government or central bank in a fixed exchange rate system.

impact of depreciation of the currency will have on the current account BoP

Theory -
A devaluation means that the pound gets weaker, meaning the price of british exports appears to be relatively cheaper than other goods on the international market. Subsquently, the demand for these goods increases and Britain will export more leading to a balance of payments surplus.

Evaluation -
A devaluation would actually worsen Britain's current account because Britain specialises in financial services, the PED for which is relativley inelastic. Therefore, lower prices mean that the total revenue received by Britain will be lower than if there was an appreciation, this will lead to a worsening balance of payments deficit.
Also depends on size of devaluation

advantages of a free floating exchange rate (3)

1. Monetary Policy Autonomy: Under a floating exchange rate, the central bank has full freedom to set interest rates according to domestic macroeconomic conditions. It does not need to use interest rates to maintain a particular exchange-rate target.If inflation rises above target, the central bank can raise interest rates even if this causes the currency to appreciate.Tighter monetary policy reduces AD and limits inflationary pressure. A floating exchange rate supports effective, independent inflation control — improving macroeconomic stability.

2. Shock Absorption :floating exchange rate acts as a shock absorber when external conditions change.If a country faces a negative external shock (e.g., fall in export demand), the currency will depreciate.The fall in the exchange rate boosts price competitiveness of exports. This partially offsets the negative shock by supporting export-led growth. The domestic economy experiences less volatility in output and employment.

5. Currency reserves: When operating a free-floating exchange rate system, the central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best returns

disadvantages of a floating exchange rate

1. Exchange Rate Volatility: Exchange rates can fluctuate significantly based on market forces like supply and demand. This creates uncertainty for businesses involved in international trade, as they cannot be sure of the future profitability of an investment.The volatility associated with floating rates can deter foreign investors who prefer a more stable and predictable economic environment. 
Therefore: Lower investment and trade can reduce long-run economic growth

Potential cost-push inflation- Depreciation under a floating system can lead to higher inflation. A weaker currency increases the cost of imported goods and raw materials (imported inflation). Firms’ production costs rise. They may raise prices to maintain profit margins.
: Inflation may accelerate, making it harder for the central bank to keep inflation at target.

advantages of a fully fixed exchange rate

1. Price Stability: A fixed exchange rate system provides a high degree of price stability since fluctuations in the exchange rate are minimized. This stability can help control inflation and provide a predictable environment for businesses and consumers.
2. Trade Confidence: Businesses can plan for transactions without worrying about sudden currency value changes, making cross-border trade more predictable and manageable.

Foreign Investment: A stable exchange rate can attract foreign investment. Investors may be more inclined to invest in a country with predictable currency values, reducing the risk associated with currency fluctuations.

disadvantages of a fixed exchange rate

Loss of monetary policy autonomy -A fixed exchange rate forces the central bank to prioritise defending the peg.
Interest rates may need to be adjusted to maintain the currency’s value rather than respond to domestic economic conditions.The central bank cannot use monetary policy freely to control inflation or stimulate growth. Domestic unemployment or inflation may persist because policy cannot target them directly.

Difficulty adjusting to external shocks - A fixed exchange rate makes it harder to respond to external economic shocks.: The currency cannot depreciate to restore competitiveness after a negative shock (e.g., a drop in export demand).Exports remain expensive, imports cheap, worsening trade deficits.
Slower economic recovery and potentially higher unemployment.
Therefore: Fixed systems reduce the economy’s flexibility to adjust naturally to changes in global markets.

what causes depreciation?

Lower demand for exports

Point: If foreign demand for a country’s exports falls, fewer foreign buyers need the domestic currency.
Because: Exporters sell less, so the currency is less in demand on the foreign exchange (FX) market.
Therefore: The supply of the currency exceeds demand.
Which leads to: Its value falls — the currency depreciates.
Consequence: Exports become cheaper, potentially restoring competitiveness over time.

Higher domestic inflation

Point: Higher domestic inflation makes domestic goods relatively more expensive than foreign goods.
Because: Foreign buyers demand fewer domestic goods, reducing demand for the currency.
Therefore: Currency value falls due to lower demand on the FX market.
Which leads to: Depreciation occurs, potentially making exports more competitive again.

how does demand for exports impact exchange rate

If foreign demand for UK exports increases,
2. then foreign buyers need pounds in order to pay UK firms,
3. so demand for the pound (GBP) in the foreign exchange market increases,
4. which causes the exchange rate to appreciate (as the price of GBP is bid up),
5. making UK exports relatively more expensive and imports cheaper,
6. which may reduce export growth in the long run depending on price elasticity,
7. and therefore the initial boost to aggregate demand could be partly offset.

effect depends on PEDx: if UK exports are highly price-inelastic (e.g., specialist services), appreciation may not significantly reduce export volumes.”

how does demand for imports impact exchange rate

If UK consumers increase their demand for imports,
2. they need to sell pounds to buy foreign currency,
3. which increases the supply of pounds on the foreign exchange market,
4. causing the exchange rate to depreciate (a fall in the value of GBP),
5. making imports more expensive and exports cheaper,
6. which may worsen cost-push inflation (due to pricier imported goods and raw materials),
7. and could reduce real incomes and increase business costs.

“The magnitude depends on PEDm and how reliant the UK is on imported inputs—if imports are necessities (e.g., oil, pharmaceuticals), depreciation increases inflation significantly.”

changing interest rates so the government can intervene in a fixed exchange rate

To prevent depreciation:

• Raise interest rates.

• Attracts hot money inflows → more demand for domestic currency.
  → Exchange rate strengthens to the fixed level.

To prevent appreciation:

• Lower interest rates.

• Reduces hot money inflows → reduces currency demand.
  → Exchange rate returns to peg.

However This can damage domestic goals (e.g., high interest rates may cause recession).

Interest changes can be uncertain and have unintended outcomes

foreign currency reserves (risk of depreciation)

1. Suppose market forces push the value below the fixed rate.
2. The central bank intervenes by buying its own currency (e.g., £) using its foreign currency reserves (e.g., USD/€).
3. This artificially increases demand for the domestic currency in FX markets.
4. At the same time, foreign currency reserves fall because they are used to purchase domestic currency.
5. With higher demand and reduced supply pressure, the currency appreciates back up to the fixed rate.

This restores the peg.

foreign currency reserves -risk of appreciation

1. If market forces push the value above the fixed rate,
2. the central bank sells domestic currency and buys foreign currency.
3. This increases the supply of the domestic currency on the FX market.
4. With greater supply, the value of the currency falls back down to the fixed level.
5. Meanwhile, the central bank’s foreign currency reserves increase, giving more ammunition for future intervention.

Evaluate - To defend the currency from depreciation, the country needs large stocks of foreign currencies (USD, €).
If reserves run out → the peg collapses.
This happened to the UK in 1992 (“Black Wednesday”) when the Bank of England ran out of reserves defending the pound.

Exam line: “A fixed system is only credible if the central bank has sufficient reserves to sustain prolonged intervention.”

Measure of international competitiveness - relative unit labour costs

• Unit labour costs = total wages ÷ real output

• A rise in unit labour costs suggest an economy is becoming less competitive

Relative export prices

• The export prices of domestic goods compared to the export prices of main trading partners

• A rise in relative export prices shows that there has been a fall in domestic competitiveness

how does the exchange rate impact international competitiveness

• SPICED

• A rise in an exchange rate makes domestic goods less price competitive abroad and imports more competitive

• Affects the relative export prices

• Evaluation

  • Firms may choose to maintain their foreign retail prices and accept smaller profit margins

    • However, this may not be viable for longer-term trends in exchange rates

  • The significance depends on the elasticity of demand

    • If demand is inelastic then higher export prices may not be a problem

how does productivity impact international competitievness

• Rises in productivity should reduce the average costs of production

• A rise in labour productivity should lead very directly to a fall in relative unit labour costs

• The productivity ‘gap’ is a key factor explain the UK’s lack of competitiveness in some industries

• Evaluation

  • If trading partners’ productivity levels improve by a larger amount then in relative terms domestic producers are becoming less competitive

• Us workers are 49% more productive than UK workers

wage and non wage costs on international competitievness

• A rise in wages, ceteris paribus, reduces the competitiveness of domestic producers

  • Direct impact on unit labour costs

• Other non-wage costs can also have an impact:

  • Company pension contributions, employer national insurance payments, etc.

• Evaluation

  • If wage rises are earned by increases in productivity, the rise in costs may be more than offset by rises in output per worker

how does being internationally competitive impact employment in a positive way

• Employment

  • Greater competitiveness should lead to increased demand for exports, creating a boost to domestic employment levels

Evaluation: can lead to inflation (Philip’s curve)

how can international competitiveness impact the current account

• Current account surpluses

  • High levels of competitiveness should lead to current account surpluses

    • There should be greater total spending on exports than imports