The Global Economy

Gains from trade (5/8/24)

• international trade → buying and selling goods/services across international borders

  • impacts GDP calculations (exports → X, imports → M)

    • GDP=C+I+G+X-M

• countries export products when the domestic price is lower than the world price (Pd<Pw)

  

  • 30 = quantity demanded domestically

  • 50 = quantity supplied domestically

    • there is a surplus as quantity supplied exceeds quantity demanded (at the world price) which causes the country to export the surplus (20)

• countries import products when the domestic price is higher than the world price (Pd>Pw)

• 

  • 90 = quantity demanded domestically

  • 20 = quantity supplied domestically

    • there is a shortage as quantity demanded exceeds quantity supplied (at the world price) which causes the country to import the shortage (70)

• free international trade (free trade) → trade without any restrictions

  • no government intervention

    • effects:

      • maximizes competition

      • provides most benefits

• benefits from international trade

  • producers

    • greater efficiency

    • access to capital

    • access to more/better resources

    • access to larger markets

    • economies of scale

  • consumers

    • lower prices

      • competition increases supply and incentivizes efficiency

    • greater choice

      • access to more/better products (not always better)

  • countries

    • foreign exchange

    • efficiency in resource allocation

    • specialization

      • do what you do best and trade for the rest

    • increased economic growth

    • access to technology, skills, ideas

    • peace

Absolute and Comparative advantage (6/8/24)

• absolute advantage → ability of one country to produce a good using fewer resources than another country

  • that country can produce more of a good than another country when given the same resources

• theory of absolute advantage (Adam Smith) → specialization and trade make countries better off

  • allows for increased competition in both countries

    

• point E and point F → with trade

  • both countries consume more than they would have been able to produce

• comparative advantage → ability of one country to produce a good at a lower opportunity cost than another country

  • lower relative cost

• theory of comparative advantage (David Ricardo) → all countries can benefit from specialization and trade

  • allows for increased consumption in both countries

  • applicable even when one country has absolute advantage in both goods

  • limitations: (7/8/24)

    • interferes with necessary structural changes over time

      • developing countries need to transition out of the primary sector

        • primary sector → low value added so low income (ex: agriculture)

    • excessive specialization is risky

      • overspecialized countries are vulnerable to unforeseen changes

    • depends upon unrealistic assumptions

      • factors of production are assumed to be fixed

        • labour and capital are mobile

        • education and training affects quality

      • technology is assumed to be fixed

      • employment of resources is assumed to be full

      • free trade is assumed

      • products are assumed to be homogenous

      • transportation costs are ignored

• law of comparative advantage → results in greater global output and consumption beyond the PPC

  • only works when either one country has one absolute advantage and/or countries face different opportunity costs

    

    • both countries consume more than they could have produced (cottonia at B, microchippia at A)

  • case of parallel PPCs

    • one country has absolute advantage in the production of both goods

    • both countries face equal opportunity costs in the production of both goods

      • comparative advantage does not exist → no benefit to specialization and trade

    • very unusual

      

• sources of comparative advantage (7/8/24)

  • differences in factor endowments (factors of production)

    • used in manufacturing

    • helps determine what a country should specialize in

  • differences in levels of technology

    • impacts efficiency and productivity

Tariffs (12/8/24)

• trade protection → government intervention in international trade

  • use of trade restrictions (trade barriers)

  • prevention of imports (despite comparative disadvantage)

• tariff → tax on imported goods (customs duties)

  • most common form of trade restriction

    • protects domestic industries from foreign competition → inefficiency

    • generates tax revenue (government)

    • 

  winners → less efficient domestic producers, efficient domestic producers, domestic employment, foreign producers, domestic income

• losers → domestic consumers, foreign producers, domestic income distribution (regressive tax), global efficiency, resource allocation

  • regressive tax → same % tax but greater % of income depending on income level

    • ex: $100 tax is different %income for different people

• welfare effects (economic well-being)

  • consumer surplus (CS) → reduced

    • transferred to government, producers, or just lost due to inefficiency and reduced consumption

  • producer surplus (PS) → increased

    • taken from consumers

  • social surplus is reduced (total)

    

    • was → CS=a+b+c+d+e+f, PS=g

    • now → CS=a+b, PS=c+g. DWL (deadweight loss)=d+f, government revenue=e

Import Quotas (13/8/24)

• legal limit on imports

  • limits quantity of a certain good over a particular period of time (ex: 1 year)

  • limits foreign competition for domestic industries

    • government issues a limited amount of “import licenses”

      • not license like driving license, more like tickets

      • recipients gain quota revenues (quota rents)

    • importers buy at Pw and sell at Pd (Pd>Pw) OR were selling at Pw and are now selling at Pd (foreign producers)

• 

  • winners → efficient domestic producers, less efficient domestic producers, domestic employment, holders of licenses

  • losers → domestic consumers, domestic income distribution, global efficiency, resource allocation

  • neutral → government

    • no revenue generated, unlike tariffs

  • uncertain: foreign producers

    • might balance out (wins and losses)

    • Pd>Pw, but less quantity can be imported → depends if they have a license

• 

  • welfare effects (economic well-being)

    • CS is reduced

    • PS increases

      • was → CS=a+b+c+d+e+f, PS=g

      • now → CS=a+b, PS=c+g, DWL=d+e+f

    • DWL comes from inefficiency and reduced consumption

    • social surplus is reduced

Tariffs and Quotas (14/8/24)

• tariff VS quota

  • same but tariffs generate tax revenues (less DWL)

    • therefore tariff > quota

• tariffs

  • domestic consumers: higher price, lower quantity (-)

  • domestic producers: higher price, increased quantity (+)

  • government: increased revenue (+)

  • foreign producers: decreased quantity sold (-)

  • welfare loss: inefficiency and reduced consumption (-)

• import quotas

  • domestic consumers: higher price, lower quantity (-)

  • domestic producers: higher price, increased quantity (+)

  • government: no impact (…)

  • foreign producers: higher price (?), decreased quantity (?)

  • welfare loss: inefficiency and reduced consumption and reduced CS (-)

    • same as tariff but it moves the supply curve, not the price (price moves with supply)

Production Subsidies (15/8/24)

• subsidy → payment by the government to a firm for each unit of output produced

  • production subsidy → protects domestic firms from foreign competition

  • export subsidy → protects domestic firms that export to foreign countries

• subsidy is the effect of production, not the cause (incentivizes)

• production subsidy → protectionist measure that pays domestic firms for each unit of output produced

  • allows firms to remain competitive against imports

• 

  • domestic consumers pay Pw, domestic firms receive Pw+s

  • shifts the product supply curve

    • by the amount per unit subsidy

  • all output for domestic market only

  • winners: efficient domestic producers, less efficient domestic producers, domestic employment

  • losers: foreign producers, government budget, taxpayers, global efficiency, resource allocation

  • neutral: domestic consumers

    • face the same price regardless

• 

  • welfare effects

    • CS is not affected

    • PS increases at the expense of the government

    • DWL from inefficient production

Export Subsidies (19/8/24)

• protectionist measure that pays domestic firms for each unit of output produced and exported

  • allows exporting firms to compete in foreign markets (Pw>Pd)

  • the world price stays the same, domestic supply curve shifts

    • increases domestic price to Pw+s

• 

  • winners: efficient domestic producers, less efficient domestic producers, domestic employment

  • losers; domestic consumers, government budget, taxpayers, domestic income distribution, foreign producers, global efficiency, resource allocation

  • domestic producers face two prices when the export subsidy is implemented

    • foreign market → Pw + subsidy (Pw+s)

    • domestic market → Pw

      • domestic < foreign, so they choose the foreign market

        • forces domestic producers to match the foreign price, which increases price (Pw → Pw+s)

• 

  • welfare effects

    • CS is reduced

      • higher price lower quantity

      • all transferred to firms (domestic producers)

    • PS is increased

      • at the expense of domestic consumers and government

    • social surplus is reduced

      • DWL → b+d

Exchange Rates (20/8/24)

• the rate at which one currency can be exchanged for another (price of a currency)

  • number of units of a foreign currency that correspond to the domestic currency

  • necessary mechanism for international trade to exist

• foreign exchange market (FOREX) → global marketplace that allows for the trading of one currency for another

  • necessary for international transactions

    • supports the continuous flow of money in and out of countries

    • individuals, firms, banks, governments, etc.

  • demand creates supply (only in FOREX)

    • foreign demand = domestic supply since it is exchanging, not buying

      • if I buy 10 USD for 150k IDR, the demand for USD increases as I am requesting USD in exchange for 150K IDR. at the same time, the supply for IDR increases as I am supplying IDR into the market in exchange for USD.

• consequences of currency appreciation (increasing value of particular currency)

  • imports become cheaper and exports more expensive (decreased net exports)

  • worsening trade balance (increasing trade deficit)

  • decreasing cost-push and demand-pull inflationary pressure

  • cyclical unemployment

  • indeterminate impact on economic growth

  • indeterminate impact on living standards

• consequences of currency depreciation (decreasing value of particular currency)

  • imports become more expensive and exports cheaper (increased net expors)

  • improving trade balance (decreasing trade deficit)

  • increasing cost-push and demand-pull inflationary pressure (factors of production)

  • job growth

  • indeterminate impact on economic growth

  • indeterminate impact on living standards

The Trade Protection Debate (22/8/24)

• arguments for trade protection (trade restrictions) → despite known inefficiencies / misallocation of resources

  • infant industries → new domestic industry that is without economies of scale (in a developing country)

    • ex: pharmaceuticals

    • may disincentivize efficiency (-)

  • national security → some industries are essential for national defense

    • not an economic argument, but political/military

    • ex: aircraft, weapons

      • may be overextended (ex: steel) (-)

  • health and safety standards

    • imported goods might fall short (ex: food, medicine, etc.)

    • may actually be an administrative barrier (-)

  • LEDC (least economically developed country) diversification

    • opposite of specialization

    • LEDCs are often dependent on a limited number of commodities

    • difficult to identify (-)

  • anti-dumping

    • dumping: selling a good in an international market below the cost of production

      • due to export subsidies

    • difficult to justify → may actually be administrative barriers (-)

  • balance of payments correction

    • outflow of money > inflow of money

      • imports > exports

    • risk of retalliation (-)

• arguments against trade protection

  • misallocation of resources

    • less efficient markets

  • retalliation

    • potential for trade war

  • increased costs

    • raw materials and capital are more costly

  • higher prices

    • true for tariffs, quotas, and administrative barriers

    • less Qd

  • less choice

    • fewer options to satisfy needs/wants

    • result of decreased competition

  • domestic firms lack incentive to become more efficient

    • lack of competition permits inefficiencies

  • reduced export competitiveness

    • inefficient firms must charge more than foreign competition

    • foreign demand for products is typically greater than domestic

Preferential Trade Agreements (PTA) (26/8/24)

• form of economic integration (trade policies that increase interdependence)

• agreement to lower/remove trade barriers

  • ensures easier access to specific markets in 2+ member countries

  • may include cooperation on additional issues (ex: labor/environmental standards)

• promotes trade liberalization

  • bilateral trade agreement (mutual agreement between 2 countries)

  • regional trade agreement (according to geographic region)

  • multilateral trade agreement (legally binding agreement between 3+ countries)

    • accomplished through the World Trade Organization (WTO)

Administrative Barriers (27/8/24)

• protectionist measures that impose bureaucratic standards and regulations on foreign firms

• ‘red tape’ checks and procedures that create obstacles for imports

  • overly concerned with procedure at the cost of efficiency/common sense

  • costly → both time and money

    • ex: customs inspections/valuations, packaging requirements, strict health/safety/environmental

• winners: efficient domestic producers, less efficient domestic producers, domestic employment

• losers: domestic consumers, foreign producers, global efficiency, resource allocation

Trading Blocs (2/9/24)

• group of countries that have agreed to reduce barriers to trade to encourage free/freer trade

  • amongst those in the bloc

  • includes free trade areas, customs unions, and common markets

• free trade area (FTA)

  • group of countries agree to eliminate trade barriers among members

    • most common intergration → relatively low degree

    • members can pursue their own policies with non-member countries

    • creates dependence upon the country with the lowest non-member barriers to trade (-)

      • I don’t like country O but country A does and I’m in a FTA with A so I’ll get O’s products from A

    • ex: USMCA, CAFTA, ANZFTA, EFTA

• customs union

  • group of countries agree to eliminate trade barriers among members AND adopt a common policy towards all non-member countries (FTA+)

    • members act together in all negotiations with non-members

    • no need for ‘rules of origin’

    • more complicated (-)

    • ex: Mercosur, GCC, ECOWAS

• common market

  • group of countries agree to eliminate trade barriers among members AND adopt a common policy towards all non-member countries AND agree to eliminate all restrictions on movement of the factors of production (FTA++)

    • labour and capital can move freely across borders

    • most efficient allocation of factors of production

    • extremely complicated → countries lose autonomy (-)

    • ex: EU, SACU

• possible advantages

  • increased competition

  • expansion into larger markets

  • economies of scale

  • lower prices and greater choice

  • increased investment

  • improved resource allocation

  • productive efficiency and economic growth

  • stronger bargaining power (with non-member countries)

  • peace and political stability

• possible limitations

  • inferior to WTO’s multilateral approach

    • aims for free trade for all

  • unequal distribution of gains and some losses

  • loss of sovereignty

Trade Creation and Trade Diversion (2/9/24)

• trading blocs change patterns of trade → through reduced trade barriers

• trade between non-member nations is discouraged → through trade barriers

• trade creation → higher cost products are replaced low cost imports through a customs union

  • original products may have imported or domestically produced

  • combines comparative advantage and trade liberalization

  • increases consumption, greater productive efficiency, greater allocative efficiency, increases social welfare

• trade diversion → lower cost imports (from non-member countries) are replaced by higher cost imports (from member countries) through a customs union

  • is an argument against trading blocs and for multilateral trade liberalizations (WTO)

  • decreases consumption, productive inefficiency, allocative inefficiency, decreases social welfare

    • long-term benefits still (likely) outweigh the costs

      • political relationships

      • economic integration

      • if I trade within my trading bloc, member countries will buy my products too

Monetary Union (3/9/24)

• a common market that requires market countries to adopt a single common currency and a common central bank (FTA+++)

  • responsible for one monetary policy

  • has strict membership requirements

    • ex: rate of inflation, interest rate, debt to GDP ratio

  • many similarities to a fixed exchange system

• RWE → EU (eurozone countries)

Evaluation of monetary union (5/9/24)

• advantages

  • single currency encourages price transparency

    • allows consumers and firms to easily compare prices

    • promotes competition and efficiency

  • single currency eliminates transaction costs

    • conversion fees are always paid → not anymore

    • encourages trade and investment → supports allocative efficiency

  • single currency eliminates exchange rate risk and uncertainty

    • exchange rates typically fluctuate

    • benefits importers, exporters, consumers, and investors

    • encourages trade and investment → supports allocative efficiency

  • single currency promotes inward investment

    • encourages investment from outsiders → appeal of expanded market and single currency → supports economic growth

  • low rate of inflation give rise to low interest rates

    • member countries are deeply concerned with inflation (single monetary policy)

      • to remain competitive

    • encourages investment → supports economic growth

    • encourages consumption spending → increases output

• disadvantages

  • loss of sovereignty

  • loss of domestic monetary policy

  • each member country is affected differently by shared monetary policy

    • varying positions in the business cycle

    • varying levels of inflation/unemployment

  • loss of exchange rates as a mechanism for adjustment

    • unable to depreciate/devalue

      • when seeking balance of trade / trying to counter inflation

  • convergence requirements constrain fiscal policy

    • economic/financial requirements

      • potentially limiting expansionary fiscal policy

      • ex: debt deficit limits

The World Trade Organization (WTO) (9/9/24)

• the only global international organization dealing with the rules of trade between countries

  • responsible for WTO agreements

    • help producers, exporters, and importers conduct their business

    • negotiated and signed by the bulk of the world’s trading countries and ratified in their parliaments

• objectives → lengthy and complex legal trade documents that encourage:

  • non-discrimination, open trade, predictability + transparency, fair competition, support for LDCs, protection of the environment, inclusion

• six functions:

  1. administrating WTO agreements

  2. forum for trade negotiations

  3. handling trade disputes

  4. monitoring national trade policies

  5. cooperation with other international organizations

  6. technical assistance and training for developing countries

• criticisms

  • WTO allows unfavourable treatment of LDCs

    • MDCs continue to subsidize agricultural products

      • MDC → more developed countries

    • MDCs receive greater tariff reductions

    • exposed to non-tariff barriers

    • protection of intellectual property increases costs of technology

    • MNCs not required to purchase supplies locally

      • MNC → multinational company

  • WTO fails to distinguish between developed and developing economies

    • only recognize/protect LDCS → LEAST

    • developing countries _> infant industry ptoection

    • developing countries may need to diversify

      • reduce reliance on primary commodities

  • WTO ignores environmental issues

    • encourages removal of trade barriers against countries with low standards

    • permits subsidies on harmful products (ex: agriculture, coal, transporation)

  • WTO ignores labour issues

    • ex: child labour

  • WTO members have unequal bargaining power

    • LDCs often silent in fear of retalliation

    • includes agenda setting

Floating exchange rates (18/9/24)

• an exchange rate determined entirely by market forces

  • supply and demand determine equilibrium (Qd=Qs)

  • no government intervention

  • no central bank interaction

  • free float / flexible exchange rate

• downward sloping demand curve

  • currency demand occurs when there are inflows of foreign currencies into a country

• upward sloping supply curve

  • currency supply occurs when there are outflows of domestic currency out of a country

• 

  • prices are reciprocals of one another

  • the quantity on the x axis will always be the denominator on the y axis

• currency appreciation → increase in currency’s value (in relation to another)

  • caused by increased demand or decreased supply

  • increase in price (value)

• 

• currency depreciation → decrease in currency’s value (in relation with another)

  • caused by decreased demand or increased supply

• 

• causes of change in demand and supply for a currency

  • foreign demand for exports

    • goods and services

  • domestic demand for imports

    • goods and services

  • inward/outward foreign direct investment

    • expanding operations of MNCs

  • inward/outward portfolio investment

    • financial instruments

  • remittances

    • overseas nationals send money back

  • speculation

    • currency as a financial asset

    • saving in hopes of appreciation

  • relative inflation rates

    • general price levels

  • relative interest rates

    • price of money

  • relative growth rates

    • increased wages and consumption

  • central bank intervention

    • reserves of FOREX currencies

• strengths

  • policy makers have great flexibility → no need for central banks to hold foreign reserves

    • balance of payments is achieved automatically

  • automatic adjustments to excess demand or supply

  • naturally provides downward pressure on high inflation

• limitations

  • uncertainty for stakeholders

  • currency speculation can be destabilizing

Fixed exchange rates (19/9/24)

• an exchange rate that is fixed by a country’s central bank and not permitted to change freely

  • “pegging” → verb for definition above (relative to another country’s currency)

  • requires constant central bank intervention

    • manipulating demand/supply of currencies → mostly buying/selling reserve currencies

• 

  1. fall in demand for exports reduce demand (D1→D2)

  2. central bank buys excess of the country’s currency, increasing demand (D2→D1)

  

  1. fall in demand for exports reduce demand (D1→D2)

  2. imports are reduced, so supply of the currency falls (S1→S2)

• central bank must respond to excess demand for currency

  • caused by increased demand or decreased supply

    • ex: increasing exports or decreasing imports

    • can buy foreign currency (domestic supply)

• central bank must respond to excess supply of currency

  • caused by increased supply or decreased demand

    • ex: increasing imports or decreasing exports

    • can buy domestic currency (using foreign reserve supply)

      • until they run out of foreign currencies

• additional measures to maintain a fixed rate

  • response to excess supply of domestic currency:

    • increase interest rates

      • attracts inflow of foreign currency

      • (-) contractionary monetary policy may cause recession

    • borrow from abroad

      • access to foreign currency

      • (-) increasing foreign debt

    • efforts to limit imports

      • decreases excess domestic supply

      • contractionary policy to decrease spending → (-) potential recession

      • trade protection policies → (-) potential retalliation by trade partners

• devaluation of a currency

  • officially and deliberately decreasing the value of a pegged currency

  • looks similar to depreciation of a floating currency

    • results in cheaper exports and more expensive imports

• revaluation of a currency

  • officially and deliberately increasing the value of a pegged currency

  • looks similar to appreciation of a floating currency

    • results in cheaper imports and more expensive exports

• strengths

  • high degree of certainty for stakeholders

  • very little speculation activity

• limitations

  • requires constant monitoring to eliminate disequilibrium

  • requires central banks to hold sufficient FOREX reserves

  • policy makers have little flexibility → most maintain fixed exchange rate

  • requires contractionary fiscal policies to keep exports competitive during inflation

  • imbalance of payments is not easily corrected

Managed exchange rates (26/9/24)

• an exchange rate determined by market forces but periodically influenced by a country’s central bank

  • “managed float”

  • combines floating and fixed systems

    • closer to floating

• intervention aims for short term stability

  • prevention of large and abrupt fluctuations

    • fluctuations discourage investment and spending

  • typically buying/selling currencies

    • generally done within upper and lower ‘bands’

      • freedom to float within a determined range

• consequences of overvalued currencies (greater than equilibrium free market value)

  • cheaper imports → cheaper capital and raw materials

    • helpful for LDCs to grow manufacturing

  • (-) expensive exports, worsening trade balance, increased competition for domestic firms, domestic unemployment

    • may need to be devalued

• consequences of undervalued currencies (lower than equilibrium free market value)

  • considered cheating (unfair competitive advantage) → “dirty float”

  • cheaper exports, growth of export industries, job creation

  • (-) expensive imports, cost-push inflation

    • may need to be revalued

• both overvalued and undervalued currencies only occur in fixed and managed systems, not free floats

BOP accounts (14/10/24)

• BOP → balance of payments

• record of all transactions between a country’s residents and the rest of the world

  • over a defined period (ex: one quarter)

  • households, firms, and government

  • ex: imports/exports, travel, financial investments, foreign direct investment, etc.

• “balance of international payments”

• credits = debits

  • credit → inflow, debit → outflow

  • inflow of payments received (credits) create foreign demand for country’s currency which is the supply for foreign currency

  • outlfow of payments made (debits) create domestic supply of nation’s currency which is the demand for foreign currency

• BOP consists of three accounts

  • current account (4)

    • balance of trade in goods (X-M)

    • balance of trade in services (X-M)

    • income (inflows - outflows)

    • current transfers (inflows - outflows)

  • capital account (2)

    • capital transfers (inflows - outflows)

    • transactions in non-produced, non-financial assets (inflows - outflows)

      • capital account is relatively small and unimportant

  • financial account (4)

    • (foreign) direct investment (inflows - outflows)

    • portfolio investment (inflows - outflows)

    • reserve assets (inflows - outflows)

    • official borrowing (inflows - outflows)

The balance of payments (15/10/24)

• there is interdependence between the three accounts

  • a deficit in one account will be offset by a surplus in another

  • sum of the three accounts will always be zero (“zero balance”)

    • credits match the debits; surpluses match the deficits

  • current account = -(capital account + financial account)

    • current = -(capital + financial + errors and omissions)

• if a country has a current account deficit (exports < imports)

  • inflows (credits) < outflows (debits)

  • financial (and capital) accounts surplus provides foreign exchange to pay for deficit

    • zero balance is achieved

  • country consumes beyond PPC (more than they can produce)

• if a country has a current account surplus (exports > imports)

  • inflows (credits) > outflows (debits)

  • surplus provides foreign exchange used to pay for financial (and capital) deficit/spending

    • zero balance is achieved

  • country consumes beyond PPC

The BOP and exchange rates (17/10/24)

• relationship between current account and exchange rate

  • floating exchange rate system

    • current account deficit causes downward pressure on the exchange rate

      • increasing debits require outflows of domestic currency (increased supply = decreased value)

    • current account surplus causes upward pressure on the exchange rate

      • inflows of foreign currency must be exchanged (increased demand = increased value)

  • managed exchange rate system

    • central bank responds to current account surplus by buying foreign currency

      • done to avoid appreciation

    • central bank responds to current account deficit by selling foreign currency

      • done to avoid depreciation

  • fixed exchange rate system

    • central bank responds to current account surplus by increasing debits

      • ex: buy foreign currency, decrease interest rates, lend abroad

      • done to avoid revaluation

    • central bank responds to current account deficit by increasing credits

      • ex: sell foreign currency, increase interest rates, borrow from abroad

      • also can increase debits by limiting imports

      • done to avoid devaluation

• relationship between financial account and exchange rate

  • financial account surplus is typically caused by investment in domestic economy from outside

    • foreign direct investment or response to high interest rates

    • increased demand for currency increases its value

  • financial account deficit is typically caused by investment in foreign economies

    • foreign direct investment or response to high interest rates

    • increased supply for currency decreases its value

Current account deficits and surpluses (29/10/24)

• consequences of persistent current account surpluses (extended trade surplus, balanced with financial account)

  • low domestic consumption

    • production > consumption → lower standard of living

  • upward pressure on exchange rate

    • damage on domestic economy

  • insufficient domestic investment

    • caused by financial account deficit

  • reduced export competitiveness

    • due to currency appreciation

  • unemployment

    • workers begin to lose jobs

  • (+) downward pressure on price levels

    • demand-pull and cost-push

• consequences of current account deficits (extended trade deficit, balanced with financial account)

  • downward pressure on exchange rate

    • imported inflation (from countries with higher prices)

  • need for high interest rates to attract inflows

    • contractionary monetary policy → discourages investment

  • foreign ownership of domestic assets (ex: U.S.)

    • satisfies need for credits in financial account

  • increasing levels of debt

    • risk of default → cannot pay the debt

  • poor international credit rating

    • considered less credit-worthy

  • cost of paying interest on loans (debt servicing)

    • opportunity cost

  • painful demand management policies

    • contractionary policies to limit imports (debits)

  • lower economic growth

    • result of contractionary policies and government paying interest on loans

• policies to correct persistent current account deficits

  • expenditure reducing policies (aims to limit AD)

    • contractionary policies → reduces output, income, consumption, imports

      • (+) lower rate of inflation → more competitive exports

      • (-) likely recession → higher interest rates put upward pressure on exchange rates

  • expenditure switching policies (from imported to domestic goods)

    • trade protection

      • (-) retalliation, higher domestic prices, lower domestic consumption, misallocation of resources

    • depreciation

      • (+) benefits export industries

      • (-) demand-pull, cost-push inflation

  • supply-side policies (increase competitiveness)

    • ex: limit power of trade unions, reduce minimum wage/corporate taxes, deregulation

      • (+) greater potential output, downward pressure on inflation

      • (-) requires a lot of time

  • Marshall-Lerner condition → measure of effectiveness of devaluation/depreciation to reduce a trade deficit

    • if sum of the PEDs of imports and exports is greater than 1, devaluation/depreciation will improve trade balance

    • if sum of the PEDs of imports and exports is less than 1, devaluation/depreciation will reduce trade balance

    • if sum of the PEDs of imports and exports is equal to 1, devaluation/depreciation will not affect trade balance

  • 

  • 

    • suggests that a devaluing/depreciating country may initially experience a worsening trade balance, followed by a shrinking deficit, then a trade surplus

      • “J-curve” effect

    • result of initially low PED (due to time lags) that increases with time