Trade liberalisation and trading blocs

Preferential trade agreement

Members agree to reduce tariffs and other trade barriers on certain goods and services

eg. Economic cooperation organisation

Benefits of preferential trade agreement

• Allows greater quantity imports and exports

• Increases purchasing potential & productive capacity (as they trade according to comparative advantage)

Drawbacks of preferential trade agreement

• Decrease government tax revenue from lower tariffs

• Local firms driven out - unable to compete with low prices of large international firms (economies of scale)

Free trade agreement

• All tariffs and quotas removed on trade between members

BUT

• Members have freedom to place their own barriers on imports from members outside of trading bloc

eg. USMCA, ASEAN

Benefits of free trade agreement

• Increase free trade - TRADE CREATION (import more from country with comparative advantage in that good)

• Increase production and export revenue

Drawbacks of free trade agreement

• May have trade diversion (import more from countries without comparative advantage in that good - inefficient allocation of resources, due to tariffs on other countries)

• Over-reliant on trade - vulnerable to supply side shocks, or unable to shift to service sectors and develop economy

Customs union

• All tariffs and quotas removed internally + place common external tariffs on non-member countries (CET)

eg. Southern African customs union

Common market

• All tariffs and quotas removed internally + CET

• Allows free trade of labour and capital between member countries

• Countries can still have their own laws and tax systems

eg. European economic area

Benefits of common market

• Larger consumer market - allows firms to achieve economies of scale

• Allows greater specialisation (like outsourcing of IT)

• More integrated economy = shared product standards, sales tac and homogenous user preferences

• Drives out less competitive firms (creative destruction)

Drawbacks of common market

• Risks international monopolies

• Requires shared institutions (parliament, bureaucracy)

  • Paid by members, wealthier economies end up having to pay more

• Unequal benefits based on geographical location

  • Centrally located means lower transport and communication costs

• Risk of capital flight and brain drain

  • BUT could be balanced if poorer countries attract investment from cheaper and more abundant factors of production

Schengen Area:

• 1995, 29 european countries (EU + EFTA)

• Abolished border controls, allows free unrestricted movement of people

• Decreased cost of trade and increased efficiency

Monetary unions

When two or more countries share the same currency 

• Countries either adopt a common currency, or a country adopts another’s currency instead of using their own

• Usually occur when countries already have converging economic policies

Members still have their own fiscal policy

• By joining a monetary union, a country will permanently fix the value of their currency to other members 

Single currencies require common monetary policy (eg set interest rates)

• Done with a common central bank to set monetary policy and manage foreign currency reserves

Formal vs informal →  monetary unions

Formal:

• Official agreement between countries to share a single currency

Informal:

• A country adopts another countries currency without agreement, shared governance or control over monetary policy

EMU (European monetary union)

• Eurozone includes 20 EU nations

• Denmark is in the European exchange rate mechanism (Euro waiting room)

  • No obligation to join euro, but keeps within +- 2.25% of EUR incase of joining

• Some economists believe that for EMU to survive in long-term, it must become even more integrated and form a fiscal union(centralised taxation and spending powers

  • Reduces problems of different members setting own fiscal policies

  • But countries may fear consequent loss of sovereignty

Advantages of monetary union:

• Reduces exchange rate risk and uncertainty

• Encourages price transparency

• Eliminates transaction costs

• Promotes higher level of inward investment

• Encourages low rate of inflation and low interest rates

How monetary union reduces exchange rate risk and uncertainty

• Certainty on future exchange rates help importers and exporters + consumers, firms and investors

• Lead to more efficient allocation of resources, increased trade and economies of scale

How monetary union encourages price transparency

• Consumers don't have to make exchange rate calculations and comparisons (easier to see price differences in countries)

• Therefore promotes competition and efficiency

How monetary union eliminates transaction costs

• No more conversion fees or commissions paid to banks or other foreign exchange institutions

• Savings encourage trade

How monetary union promotes higher level of inward investment

• Less risk in domestic economy, investors more likely to invest domestically

How monetary union encourages low rate of inflation and low interest rates

• When countries join, they commit themselves to low rate of inflation (can't devalue currency to be more competitive), contributes to low interest rates → shift AD outwards, increasing output

Disadvantages of monetary union:

• Loss of domestic monetary policy as instrument of economic policy

• Monetary policy impacts members differently

• Can’t use exchange rates to adjust trade deficit

• Fiscal policy may be constrained by convergence requirements

• Loss of national government’s authority in economic policy

How monetary union leads to loss of domestic monetary policy as instrument of economic policy

• Central bank always in charge of interest rates, countries cant raise/lower interest rates to change value of currency and affect import/export prices

• Not all policies suit all members

• Countries may still be able to issue their own bonds

How monetary union impacts members differently

• Different magnitudes of impact in change in interest rates etc..

• Members can't adjust interest rates if suffering high inflation, and can't do QE

How monetary union means members cant use exchange rates to adjust trade deficits

• Lose ability to devalue currency to make goods more competitive and and increases demand = trade surplus

• May have to use contractionary fiscal policies instead (change taxes and government spending)

  • Higher taxes = save, decrease imports

  • Lower government spending decreases disposable income and spending power, decreasing imports

How monetary union means fiscal policy may be constrained by convergence requirements

• Members can still control fiscal policy, however may be restricted by rules of monetary union

• Eg. Eurozone public debt cant be greater than 60% of GDP and annual budget deficit can’t be more than 3% of GDP

How monetary union can lead to loss of national governments authority in economic policy

• Central bank overseas monetary systems of monetary union

• Authority moved from democratically elected officials to unelected central bankers

• Countries may become over-reliant on one another (risk contagion)

Requirements of successful monetary unions:

• Changeover costs minimised

• Initial exchange rate correct

• Optimum currency area

• Timing

• Automatic fiscal transfers

Successful monetary union requirement - changeover costs minimised

• Consumers and firms given enough time to adjust to new currency

Successful monetary union requirement - initial exchange rate correct

• Exchange rate between old and new currency must be suitable

Successful monetary union requirement - optimum currency area

• Monetary union covers a geographical area where a shared currency would be advantageous

Successful monetary union requirement - timing

• Countries must be on same phase of trade cycle

• Implementing single monetary policy during different phases may harm one country and benefit another

Successful monetary union requirement - automatic fiscal transfers

• Money goes from richer to poorer countries when performing badly