ASSIGNMENT-2: TOPIC “Offshore Outsourcing: Trends and Issues”

● Background:

Offshore outsourcing (also known as foreign outsourcing or offshoring) has increasingly

emerged as one of the key approaches in global businesses. Outsourcing/offshoring can

produce positive, negative, mixed, moderated or no significant impact on the firm. Offshore

outsourcing of many of the activities of the firm has become a major issue of concern in

welfare economics, business management, and international business scholarship.

● Topic:

In the above background, consider you are an economic adviser to the Organisation for

Economic Co-operation and Development (OECD). The OECD Chief wants you to prepare

a Report (your assignment) analysing the following aspects of offshore outsourcing.

(a) Trends in and drivers of offshore outsourcing.

(b) Implications of offshore outsourcing for the environment.

(c) Opportunities and challenges in offshore outsourcing.

(d) Risk and management of exchange rate changes in offshore outsourcing.

(e) Policy recommendations and solutions to challenges in offshore outsourcing to ensure

inclusive, socially responsible and sustainable practices in offshore outsourcing by

enterprises/firms.

Notes:

● The assignment is neither country-specific nor industry (or firm) specific. Instead, it

requires you to critically evaluate the issues (outlined above) in general. You need to

provide relevant citations from the literature and use data/graphs (where available) to

support your reasoning.

● This is another topical issue, and the analysis undertaken in this assignment will help you

gain deeper insights into the issue of offshore outsourcing. These insights come handy when

you appear for a job interview.

● As you would notice, all the issues are clearly listed to help you determine the focus and

design the structure of your assignment.

● Length of the Assignment: 2000 words.

Write the total word count on the top left corner of the front page of your assignment.

Note: References/diagrams/graphs/tables are NOT included in word count.

● Weight: 30 Marks (30% of overall assessment).

● Submission Due: 14 May 2025; Time: 5PM AEST

Open Economy Macroeconomics: Global Value Chains & The Firms

Learning Objectives

• Understand how internal economies of scale and product differentiation lead to international trade and intra-industry trade.

• Recognize new types of welfare gains from intra-industry trade.

• Describe how economic integration can lead to both winners and losers among firms in the same industry.

• Explain why economists believe that “dumping” should not be singled out as an unfair trade practice, and why the enforcement of antidumping laws leads to protectionism.

• Understand foreign direct investment and global value chains.

Market Structures & Intra-Industry Trade

Internal Economies of Scale

• Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become uncompetitive.

• Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces.

Perfect competition

• Perfect competition that drives the price (P) of a good down to marginal cost (MC) would imply losses for those firms because they would not be able to recover the higher costs incurred from producing initial units of output.

• As a result, perfect competition would force those firms out of the market.

• In most sectors, goods are differentiated from each other, and there are other differences across firms.

Monopoly

• Monopoly is an industry with only one firm.

• Oligopoly is an industry with only a few firms.

• In these industries, the marginal revenue (MR) generated from selling more products is less than the uniform price (P) charged for each product.

• To sell more, a firm must lower the price of all units, not just the additional ones.

• Marginal revenue (MR) function therefore lies below the demand function (which determines the price (P) that customers are willing to pay).

• Assume that firm’s demand curve is a straight line (linear): $Q = A – B(P)$

  • Q: number of units the firm sells, P: price per unit, and A and B are constants.

• Marginal revenue (MR) equals: $MR = P - \frac{Q}{B}$

• Suppose the total cost (C) function: $C = F + c(Q)$

  • F is fixed costs (independent of the level of output) and c is the constant marginal cost (MC).

• Average cost (AC) is the total cost of production (C) divided by the total quantity of production (Q).
  $AC = \frac{C}{Q} = \frac{F}{Q} + c$

• Marginal cost (MC) is the cost of producing an additional unit of output.

• Larger firm is more efficient because AC decreases as output (Q) increases: internal economies of scale.

Average versus Marginal Cost

• Figure illustrates average cost (AC) and marginal cost (MC) corresponding to total cost function: C = 5 + x. Marginal cost is always 1. Average cost declines as output rises.

• Profit-maximizing output occurs where Marginal Revenue (MR) equals Marginal Cost (MC).
  $MR = MC$

• So, revenue gained from selling an extra unit equals the cost of producing that unit.

• Monopolist earns some monopoly profits when P > AC.

Monopolistic Competition

• Monopolistic competition is a model of an imperfectly competitive industry that assumes that each firm:

  • (1) can differentiate its product from the product of competitors, and

  • (2) takes the prices charged by its rivals as given.

• In imperfect competition, firms are aware that they can influence the prices of their products, and that they can sell more only by reducing their price.

• This situation occurs when there are only a few major producers of a particular good or when each firm produces a good that is differentiated from that of rival firms.

• Each firm views itself as a price setter, choosing the price of its product.

• Firm in a monopolistically competitive industry is expected to sell

  • (a) more as total sales in the industry increase and as prices charged by rivals increase.

  • (b) less as the number of firms in the industry decreases and as the firm’s price increases.

• These concepts are represented by function: $Q = S[\frac{1}{n} - b(P - \bar{P})]$

  • Q: individual firm’s sales

  • S: total sales of the industry

  • n: number of firms in the industry

  • b: constant term representing the responsiveness of a firm’s sales to its price. It measures the sensitivity of each firm's market share to the price it charges.

  • P: price charged by the firm itself

  • $\bar{P}$: average price charged by its competitors

  • All firms have equal (constant) share of the market.

$Q = S[\frac{1}{n} - bP + b\bar{P}]$
$Q = \frac{S}{n} - bP + b\bar{P}$
$Q = (\frac{S}{n} + b\bar{P}) - bP$

• Eqn (7) is in the same form as Eqn (1), with $(\frac{S}{n} + b\bar{P})$ in place of A, and $b$ in place of the slope coefficient B.

• Assume that firms are symmetric: all firms face the same demand function and have the same cost function.

• Thus, all firms should charge the same price and have equal share of the market.
  $Q = \frac{S}{n}$

• By substituting the value of Q from equation (8) into Eqn (4), AC can be written as:
  $AC = \frac{C}{Q} = \frac{F}{Q} + c = \frac{nF}{S} + c$

• So, AC depends on size/sale (S) of the market and number (n) of firms.
  $AC = (\frac{n}{S})F + c$

• As the number of firms (n) in the industry increases, the AC increases for each firm because each produces less.

• As total sales (S) of industry increase, the AC decreases for each firm because each produces more.

• Recall from Eqn (1), monopolistic firms face linear demand functions: $Q = A – B(P)$

• Also recall from Eqn (5) that firms maximize profits when they produce until MR = MC. So, we have:
  $MR = P - \frac{Q}{B} = c$

• By substituting the value of $B = \frac{S}{n}$ into Eqn (11), we have:
  $P - \frac{Q}{\frac{S}{n}} = c$

• Eqn (8) can be solved to get $\frac{S}{Q} = n$. So, Eqn (12) becomes:
  $P - \frac{Q}{\frac{S}{n}} = c$
  $P = c + \frac{Q}{ \frac{S}{n}}$
  $P = c + \frac{Qn}{S}$
  $P = c + \frac{1}{b n}$

• As number of firms (n) increases (↑) in the industry, the price (P) that each firm charges decreases (↓) due to increased competition.

• Each firm’s markup [P - c] over marginal cost (c) decreases (↓) with the increase (↑) in number (n) of competing firms.
  $P - c = \frac{1}{bn}$

• Equilibrium number of firms: At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n).

• At this long-run equilibrium number of firms in the industry, the firms have no incentive to enter or exit the industry.

• If the number of firms is greater than or less than the equilibrium number, then the firms have an incentive to exit or enter the industry.

• Firms have an incentive to exit industry when P < AC.

• Firms have an incentive to enter industry when P > AC.

Monopolistic Competition & Trade

• Because trade increases market size (S), trade is predicted to decrease average cost in an industry described by monopolistic competition.

• Industry sales increase with trade leading to decreased average costs [See Eqn (9)]:
  $AC = (\frac{n}{S})F + c$

• Because trade increases the variety of goods that consumers can buy under monopolistic competition, it increases the welfare of consumers.

• And because average costs decrease, consumers can also benefit from a decreased price.

Gains of Integration

• Integration causes the better-performing firms to thrive and expand, while the worse-performing firms to contract.

• Additional source of gain from trade: As production is concentrated toward better-performing firms, the overall efficiency of the industry improves.

• These better-performing firms have a greater incentive to engage in the global economy.

• Monopolistic competition predicts intra-industry trade but does not predict changes in income distribution within a country.

Gains from an Integrated Market: A Numerical Example

• Suppose b = 1/30,000, fixed cost F = $750,000,000 and a marginal cost c = $5,000 per automobile. Total cost (C) is:
  $C = 750,000,000 + (5,000 * Q)$

• Therefore, AC is:
  $AC = (\frac{750,000,000}{Q}) + 5,000$

• Suppose there are two countries, Home and Foreign.

• Home has annual sales of 900,000 automobiles; Foreign has annual sales of 1.6 million.

• Two countries are assumed (for now) to have the same costs of production.

• Integrated market supports more firms, each producing at a larger scale and selling at a lower price than either national market does on its own.

• Everyone is better off as a result of the larger market with integration:

  • Consumers have a wider range of choices, and

  • Each firm produces more and is therefore able to offer its product at a lower price.

Hypothetical Example of Gains from Market Integration

Monopolistic Competition & Trade

• Product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage differences between them.

• This is a very different kind of trade than the one based on comparative advantage, where each country exports its comparative advantage good.

Significance of Intra-Industry Trade

• Intra-industry trade refers to two-way exchanges of similar goods.

• Two new channels for welfare benefits from trade:

  • (1) Benefit from a greater variety at a lower price.

  • (2) Firms consolidate their production and take advantage of economies of scale.

• A smaller country stands to gain more from integration than a larger country.

• About 25%–50% of world trade is intra-industry.

• Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade.

• For the U.S., industries that have the most intra- industry trade — such as pharmaceuticals, chemicals, and specialized machinery — require relatively larger amounts of skilled labor, technology, and physical capital.

Firm Responses to Trade

• Increased competition tends to hurt worst-performing firms — they are forced to exit.

• Best-performing firms take the greatest advantage of new sales opportunities and expand the most.

• When better-performing firms expand and worse- performing firms contract or exit, overall industry performance improves.

• Trade and economic integration improve industry performance as much as the discovery of a better technology does.

• Before 1965, tariff protection by Canada & the United States produced a Canadian auto industry that was largely self-sufficient, neither importing nor exporting much.

• Canadian auto industry was about 1/10 the size of the United States and had a labor productivity about 30 percent lower than that of the United States.

• Most Canadian plants produced several different things, requiring the plants to shut down periodically to change over from producing one item to producing another, to hold larger inventories, to use less specialized machinery.

Intra-Industry Trade in Action: North American Auto Pact of 1964 and North American Free Trade Agreement (NAFTA)

• United States & Canada agreed in 1964 to establish free trade in automobiles.

• Both exports and imports increased sharply.

• By the early 1970s, Canadian industry was comparable to the U.S. industry in productivity.

• Later on, this transformation of automotive industry was extended to include Mexico.

• This process continued with the implementation of NAFTA (North American Free Trade Agreement between the United States, Canada, and Mexico).

• For each model of car, there is typically a plant in one of these three countries that sells to the whole North American market.

Protectionism and Dumping

Dumping

• Dumping is the practice of charging a lower price for exported goods than for goods sold domestically.

• Dumping is an example of price discrimination: the practice of charging different customers different prices.

• Price discrimination and dumping may occur only if

  • (a) Imperfect competition exists: firms are able to influence market prices.

  • (b) Markets are segmented so that goods are not easily bought in one market and resold in another.

• Dumping can be a profit-maximizing strategy:

  • Firm with higher marginal cost (MC) chooses to set a lower markup over marginal cost.

  • Therefore, an exporting firm will respond to the trade cost by lowering its markup for the export market.

  • This strategy is considered to be dumping, and is regarded by most countries as an “unfair” trade practice.

• Dumping may be a profitable strategy when a firm faces little competition in its domestic market and faces heavy competition in foreign markets.

Protectionism & Dumping

• If a dumping by foreign firms causes damage to domestic firm, then the government may impose an “anti -dumping duty” (tax) to protect the domestic firm.

• Tax equals the difference between the actual and “fair” price of imports, where “fair” means “price the product is normally sold at in the manufacturer's domestic market.”

• Most economists believe that the enforcement of dumping claims is misguided.

• Trade costs have a natural tendency to induce firms to lower their markups in export markets.

• Such enforcement may be used excessively as an excuse for protectionism.

• In the early 1990s, the bulk of anti-dumping complaints were directed at developed countries.

• But since 1995, developing countries have accounted for the majority of anti-dumping complaints.

• Among those countries, China has attracted a particularly large number of complaints.

• Nonmarket economy with substantial export growth, China has been subject to antidumping duties on:

  • TVs, furniture, crepe paper, hand trucks, shrimp, ironing tables, plastic shopping bags, iron pipe fittings, saccharin, solar panels, tires, and cold- rolled steel.

  • These duties are as high as 78% on color TVs, 266% for cold-rolled steel, and 330% on saccharin.

Foreign Direct Investment (FDI) & Global Value Chains (GVCs)

Firm’s Decision Regarding FDI

• Proximity-concentration trade-off:

  • High trade costs associated with exporting create an incentive to locate production near customers.

  • Increasing returns to scale in production create an incentive to concentrate production in fewer locations.

• Foreign Direct Investment (FDI) activity concentrates in sectors with high trade costs.

• Foreign outsourcing or offshoring occurs when a firm contracts with an independent firm to produce in the foreign location.

• In addition to deciding the location of where to produce, firms also face an internalization decision: whether to keep production done by one firm or by separate firms.

• FDI should benefit the countries involved for reasons similar to why international trade generates gains.

• Multinationals and firms that outsource take advantage of cost differentials that favor moving production (or parts thereof) to particular locations.

• FDI is very similar to the relocation of production that occurred across sectors when opening to trade.

• There are similar welfare consequences for the case of multinationals and outsourcing: Relocating production to take advantage of cost differences leads to overall gains from trade.

Global Value Chains

• International production sharing, a phenomenon where production is broken into activities and tasks carried out in different countries. They can be thought of a large-scale extension of division of labour (Adam Smith).

• Companies used to make things primarily in one country. That has all changed.

• Today, a single finished product often results from manufacturing and assembly in multiple countries, with each step in the process adding value to the end product.

• Full range of activities (design, production, marketing, distribution and support to the final consumer, etc) that are divided among multiple firms and workers across geographic spaces to bring a product from its beginning to its end use and beyond.

• Through GVCs, countries trade more than products; they trade know-how, and make things together.

• GVCs integrate the know-how of lead firms and suppliers of key components along the stages of production and in multiple offshore locations. The international, inter-firm flow of know-how is the key distinguishing feature of GVCs.

• Cross-border production has been made possible by the liberalization of trade and investment, lower transport costs, advances in information and communication technology, and innovations in logistics (e.g. containerization).

• Manifest example of relocation is the offshoring of labour- intensive stages of production from industrialized economies to low-wage, labour-abundant developing countries. Business operations are, however, also reshuffled among industrialized economies.

• Countries can participate in GVCs by engaging in either backward or forward linkages.

• Backward linkages are created when country A uses inputs from country B for domestic production. Firms in country A can source inputs from country B through direct as well as indirect imports.

• Forward linkages are created when country A supplies inputs that are used for production in country B. The goods produced in foreign countries may be final products (for local consumption and investment) or intermediate products which are exported further elsewhere for use as inputs.

• GVCs are important for economic growth:

  • International fragmentation of production, can lead to increased job creation and economic growth.

  • GVCs are a powerful driver of productivity growth, job creation, and increased living standards.

  • Countries that embrace them grow faster, import skills and technology, and boost employment.

Summary

• Internal economies of scale imply that more production at the firm level causes average costs to fall.

• With monopolistic competition, each firm can raise prices somewhat above those on competing products due to product differentiation but must compete with other firms whose prices are believed to be unaffected by each firm’s actions.

• Monopolistic competition allows for gains from trade through lower costs and prices, as well as through wider consumer choice.

• Monopolistic competition predicts intra-industry trade, and does not predict changes in income distribution within a country.

• Location of firms under monopolistic competition is unpredictable, but countries with similar relative factors are predicted to engage in intra-industry trade.

• Dumping may be a profitable strategy when a firm faces little competition in its domestic market and faces heavy competition in foreign markets.

• Foreign Direct Investment (FDI) activity concentrates in sectors with high trade costs.

• Global value chains (GVCs) involve International sharing of production.

• GVCs are a powerful driver of productivity growth, job creation, and increased living standards.

• Countries that embrace them grow faster, import skills and technology, and boost employment.

References

• International Economics: Theory and Policy; Global Edition; Krugman, Obstfeld and Melitz; Chapter 8.

• The World Bank, “Global Value Chains”, https://www.worldbank.org/en/topic/global-value-chains

• Adnan Seric and Yee Siong Tong (2019), “What are global value chains and why do they matter?” https://iap.unido.org/articles/what-are-global-value-chains- and-why-do-they- matter#:~:text=Global%20value%20chains%20(GVCs)%20 refer,back%20to%20Adam%20Smith's%20time.

Open Economy Macroeconomics: Exchange Rate & Competitiveness

Foreign Exchange (FOREX) Market

• Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.

• Exchange rates allow us to denominate the cost or price of a good or service in a common currency.

• Depreciation: A decrease in the value of a currency relative to another currency. A depreciated currency is less valuable and can be exchanged for a smaller amount of foreign currency.

• Appreciation: An increase in the value of a currency relative to another currency. An appreciated currency is more valuable and can be exchanged for a larger amount of foreign currency.

• FOREX markets are sets of markets where foreign currencies and other assets are exchanged for domestic ones, where institutions buy and sell deposits of currencies or other assets for investment purposes.

• Daily volume of foreign exchange transactions was $4.0$ trillion in April 2010, up from $500$ billion in 1989.

• Most transactions (85% in April 2010) exchange foreign currencies for U.S. dollars.

• Participants in FOREX Market:

  • Commercial banks: buying/selling of deposits in different currencies for investment purposes.

  • Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment.

  • Non-financial businesses conduct foreign currency transactions to buy/sell goods, services, and assets.

  • Central banks conduct official international reserves transactions.

• Buying and selling in the foreign exchange market are dominated by commercial and investment banks.

• Inter-bank transactions of deposits in foreign currencies occur in amounts $\$1$ million or more per transaction.

• Computer & telecommunications technology transmit information rapidly and have integrated markets. Integration of financial markets implies that there can be no significant differences in exchange rates across locations.

• Arbitrage: Buy at a low price and sell at a higher price for a profit.
  Example: If euro were to sell for $\$1.1$ in New York and $\$1.2$ in London, you could buy euros in New York (where cheaper) and sell them in London at a profit.

• Spot rates: Exchange rates for currency exchanges “on the spot,” or when trading is executed in the present.

• Forward rates: Exchange rates for currency exchanges that will occur at a future (“forward”) date.

• Forward dates are typically 30, 90, 180, or 360 days in the future.

• Rates are negotiated between two parties in the present, but the exchange occurs in the future.

• Foreign exchange swaps: A combination of a spot sale with a forward repurchase.

• Swaps allow parties to meet each other’s needs for a temporary amount of time, and they often cost less in fees than separate transactions.
  Example: Suppose Toyota receives $\$1$ million from American sales, plans to use it to pay its California suppliers in three months but wants to invest the money in euro bonds in the meantime.

• Factors that influence the return on assets determine the demand for those assets.

  • Rate of return: The percentage change in value that an asset offers during a time period.
    Example: Annual return for $\$100$ savings deposit with an interest rate of 2% is $100 × 1.02 = \$102$.

  • Risk: Risk of holding assets also influences decisions about whether to buy them.

  • Liquidity of an asset: It is the ease of using the asset to buy goods and services.

• Risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination.

• Investors are primarily concerned about the rates of return on currency deposits, determined by:

  • Interest rates that the assets will earn

  • Expectations about appreciation or depreciation

• Rate of return for a deposit in domestic currency is the interest rate that the deposit earns.

Demand for Currency Deposits

• To compare the rate of return on a deposit in domestic currency with one in foreign currency, let’s consider:

  • Interest rate for the foreign currency deposit

  • Expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency.
    Example:

  • Suppose the interest rate on a dollar deposit is 2%.

  • Suppose the interest rate on a euro deposit is 4%.

  • If today the exchange rate is $\$1/€1$, and the expected rate one year in the future is $\$0.97/€1$, then $\$100$ can be exchanged today for €100. These €100 will yield €104 after one year (at 4% interest rate). These €104 are expected to be worth $\$0.97/€1 × €104 = \$100.88$ in one year.

• The rate of return in terms of dollars from investing in euro deposits is:

• Expected rate of appreciation of the euro was:

• Dollar rate of return on euro deposits approximately equals:

  • Interest rate on euro deposits PLUS

  • Expected rate of appreciation of euro deposits

  • $4$

Model of Foreign Exchange Markets

• Equilibrium: Model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.

• Interest parity implies that deposits in all currencies are equally desirable assets.

• Interest parity implies that arbitrage in the foreign exchange market is not possible.

• Interest parity condition:

• If the interest parity condition does not hold, then no investor would want to hold euro deposits, driving down the demand and price of euros. All investors would want to hold dollar deposits, driving up the demand and price of dollars. Dollar would appreciate and euro would depreciate, increasing the right side until equality was achieved.

Model of Foreign Exchange Markets

How do changes in current exchange rate affect the expected rate of return of foreign currency deposits?
* Depreciation of domestic currency today lowers the expected rate of return on foreign currency deposits. When domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits.
* Appreciation of domestic currency today raises the expected return of deposits on foreign currency deposits. When domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby lowering the expected rate of return of foreign currency deposits.

• Equilibrium in the foreign exchange market is where the expected dollar returns on dollar and euro deposits are equal.

• Effects of changing interest rates:

  • Increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. This leads to an appreciation of the currency.

    • Higher interest rates on dollar-denominated assets cause the dollar to appreciate.

    • Higher interest rates on euro-denominated assets cause the dollar to depreciate.

• If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods. Expected rate of return on euros therefore increases.

• Expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy).

• Covered interest parity relates interest rates across countries and the rate of change between forward exchange rate and spot exchange rate:
  where F$\$ /€$ is the forward exchange rate.

• It says that rates of return on dollar deposits and “covered” foreign currency deposits are the same.

Money Market & FOREX Market

• Domestic interest rates directly affect the rates of return on domestic currency deposits in the foreign exchange markets. Now, what determines the domestic interest rates?

  • Money Supply: The central bank substantially controls the quantity of money that circulates in an economy.

  • Money demand represents the amount of monetary assets that people are willing to hold (instead of illiquid assets).
    What influences willingness to hold monetary assets?

• Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets.

• Risk: The risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money.

• Liquidity: A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases.

• Interest rates/expected rates of return: Monetary assets pay little or no interest, so the interest rate on non-monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets. Higher interest rate means a higher opportunity cost of holding monetary assets ® lower demand for money.

• Prices: Prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. Higher level of average prices means a greater need for liquidity to buy the same amount of goods and services ® higher demand for money.

• Income: Greater income implies more goods and services can be bought, so that more money is needed to conduct transactions. Higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity ® higher demand for money.
  Aggregate demand for money can be expressed as:
  Where:
  P is the price level
  Y is real national income
  R is a measure of interest rates on nonmonetary assets
  L(R,Y) is the aggregate demand for real monetary assets.
  Aggregate demand for real monetary assets is a function of national income and interest rates.
  Money market is where monetary or liquid assets, which are loosely called “money,” are lent and borrowed.
  Domestic interest rates directly affect the rates of return on domestic currency deposits in the foreign exchange markets.
  When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium:
  Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium:

• For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2 reduces the interest rate from R1 to R2 .

• Given the real money supply, , a rise in real income from Y1 to Y2 raises the interest rate from R1 to R2 .

• Both asset markets are in equilibrium at the interest rate R1 and exchange rate E1; at these values, the money supply equals money demand and the interest parity condition holds.

• Monetary policy actions by Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The ECB can affect exchange rate by changing the European money supply and interest rate.

• Given PUS and YUS when money supply rises from M1 to M2 the dollar interest rate declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates against the euro (as foreign exchange market equilibrium is reestablished at point 2’).

Changes in Money Supply

• (A) Changes in Domestic Money Supply

  • Increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.

  • Decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate.

• (B) Changes in Foreign Money Supply

  • How would a change in the supply of euros affect the U.S. money market and foreign exchange markets?

  • Increase in the supply of euros causes a depreciation of euro (an appreciation of dollar).

  • Decrease in the supply of euros causes an appreciation of euro (a depreciation of dollar).

  • Increase in the supply of euros reduces interest rates in the EU, reducing the expected rate of return on euro deposits. This reduction in the expected rate of return on euro deposits causes the euro to depreciate.

• By lowering dollar return on euro deposits (shown as a leftward shift in the expected euro return curve), an increase in Europe’s money supply causes the dollar to appreciate against the euro. Equilibrium in the foreign exchange market shifts from point 1’ to point 2’ but equilibrium in the U.S. money market remains at point 1.

Long Run and Short Run

• The analysis heretofore has been a short-run analysis.

• In the short run, prices do not have sufficient time to adjust to market conditions.

• In the long run, prices of factors of production and of output have sufficient time to adjust to market conditions.

• Wages adjust to the demand and supply of labor.

• (Real) interest rates depend on the supply of saved funds and the demand for saved funds.

• In the long run, the quantity of money supplied is predicted not to influence the amount of output, (real) interest rates, and the aggregate demand for real monetary assets L(R,Y).

• Quantity of money supplied is predicted to make the level of average prices adjust proportionally in the long run.

• Equilibrium condition shows that P is predicted to adjust proportionally when Ms adjusts because L(R,Y) does not change.

• In the long run, there is a direct relationship between inflation rate and changes in money supply.

• Inflation rate is predicted to equal the growth rate in money supply minus the growth rate in money demand.

Money and Prices in the Long Run

How does a change in money supply cause prices of output and inputs to change?

• Excess demand for goods and services: A higher quantity of money supplied implies that people have more funds available to pay for goods and services. To meet high demand, producers hire more workers, creating a strong demand for labor services, or make existing employees work harder. Wages rise to attract more workers or to compensate workers for overtime. Prices of output will eventually rise to compensate for higher costs.

• Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the high demand.

• Inflationary expectations: If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. And if producers expect the same, they are more willing to raise wages. Producers will be able to match higher costs if they expect to raise prices. Result: expectations about inflation caused by an expected increase in money supply causes actual inflation.

• When we consider price changes in the long run, inflationary expectations will have an effect in foreign exchange markets. Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterward.

• Permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency. However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.

• Permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency. However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

• Exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response.

• Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.

• Overshooting helps explain why exchange rates are so volatile.

Summary

• Equilibrium in foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity.

• Increase in interest rate on a currency’s deposit leads to an increase in its expected rate of return and to an appreciation of currency.

• Expected appreciation of a currency leads to an increase in expected rate of return for that currency and leads to an actual appreciation.

• Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using forward exchange rate are the same.

• When money market is in equilibrium, there are no surpluses or shortages of monetary assets: the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded.

• Short-run scenario: changes in money supply affect domestic interest rates, as well as exchange rate.

  • An increase in domestic money supply lowers domestic interest rates, thus lowering the rate of return on deposits of domestic currency and thus causing the domestic currency to depreciate.

• Long-run scenario: changes in the quantity of money supplied are matched by a proportional change in prices and do not affect real income and real interest rates.

Exchange Rate & Competitiveness-II

Learning Objectives

• Explain the purchasing power parity theory and its relationship to international goods-market integration.

• Describe how monetary factors like price level inflation affect exchange rates in the long run.

• Discuss the concept of the real exchange rate.

• Understand factors that affect real exchange rates and relative currency prices in the long run.

• Explain the relationship between international real interest rate differences and expected changes in real exchange rates.

Price Levels and the Exchange Rate in the Long Run

• Models can predict how exchange rates behave.

• Two models are developed, building on the long-run approach to exchange rates.

• Long run: prices of all goods and services adjust to market conditions so that their markets and the money market are in equilibrium.

• Prices influence interest rates and exchange rates in long-run models.

• Long-run models represent how market participants may form expectations about future exchange rates and how exchange rates tend to move over long periods.

Law of One Price

• The same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important.

• If the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is$40, many people will buy the $20 pizza, few will buy the$40 one.

• Entrepreneurs would have an incentive to buy pizza at the cheap location and sell it at the expensive location for an easy profit.

• Due to strong demand and decreased supply, the price of the $20 pizza would tend to increase.</p></li><li><p>Due to weak demand and increased supply, the price of the$40 pizza would tend to decrease.

• People would have an incentive to adjust their behavior, and prices would tend to adjust until one price is achieved across markets (across restaurants).

• Consider a pizza restaurant in Seattle in the U.S. and one across the border in Vancouver in Canada.

• The price of the same pizza (using a common currency to measure the price) in two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important.

Purchasing Power Parity

• Purchasing power parity (PPP) is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services.

• Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices:

• If the price level in the U.S. is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the C$/US$ exchange rate should be C$400/US$200 = C$2/US$1.

• PPP predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices in Canada are twice as high.

• Purchasing power parity (PPP) comes in 2 forms:

  • Absolute PPP: exchange rates equal the level of relative average prices across countries.

  • Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods: $\frac{E<em>{t}-E</em>{t-1}}{E_{t-1}}=\pi - \pi^{*}$ …… (1)

Monetary Approach to Exchange Rates

• Monetary approach to the exchange rate: long run adjustments based on the absolute version of PPP.

• The levels of average prices across countries adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded.

• To the degree that PPP holds and to the degree that prices adjust to equate the quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we have the following prediction:

• Exchange rate is determined in the long run by prices, which are determined by relative supply and demand of real monetary assets in money markets across countries.

Predictions about the effects of changes in:

• Money supply: A permanent rise in the domestic money supply causes a proportional increase in the domestic price level, thus causing a proportional depreciation in the domestic currency (through PPP).

  • This is the same prediction as the long-run model without PPP.

• Interest rates: A rise in domestic interest rates lowers the demand of real monetary assets and is associated with a rise in domestic prices, thus causing a proportional depreciation of the domestic currency (through PPP).

• Output level: A rise in the domestic level of production and income (output):

  • raises domestic demand of real monetary assets and is associated with a decreasing level of average domestic prices (for a fixed quantity of money supplied), thus causing a proportional appreciation of domestic currency (through PPP).

  • All 3 changes affect money supply or money demand and cause prices to adjust so that the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange rates to adjust according to PPP.

• Change in money supply results in a change in the level of average prices.

• Change in the growth rate of money supply results in a change in the growth rate of prices (inflation).

• A constant growth rate in money supply results in a persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant.

• Inflation does not affect the productive capacity of the economy and real income from production in the long run.

• Inflation, however, does affect nominal interest rates.

Fisher Effect

• Fisher effect describes the relationship between nominal interest rates and inflation.

• If financial markets expect (relative) PPP to hold, then expected exchange rate changes will equal the expected inflation between countries. {i-\i^}=E_e({\pi - \pi^{}})…… (2)

• a rise in domestic inflation rate causes an equal rise in interest rate on deposits of domestic currency in the long run, when other factors remain constant. $i = i^* + E<em>e(\pi - \pi^)$ $i = i^ + E</em>e(\pi)$

• Suppose that the U.S. central bank unexpectedly increases the growth rate of money supply at time t0.

• Also suppose that the inflation rate is π in the US before t0 and π + πΔ after this time, but that the European inflation rate remains at 0%.

• According to Fisher effect, the interest rate in the U.S. will adjust to the higher inflation rate.

• Increase in nominal interest rates decreases the demand of real monetary assets.

• In order to for the money market to maintain equilibrium in the long run, prices must jump so that

• In order to maintain PPP, the exchange rate must jump (the dollar must depreciate)

• Thereafter, money supply and prices are predicted to grow at rate π + πΔ and the domestic currency is predicted to depreciate at the same rate.

• In the monetary approach (with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases permanently.

• With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate.

• Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate.

• In the long-run model (without PPP), the level of average prices does not immediately adjust even if expectations of inflation adjust,

• causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value.

• In monetary approach (with PPP), the level of average prices adjusts with expectations of inflation,

• causing the domestic currency to depreciate, but with no overshooting.

Shortcomings of PPP

• There is little empirical support for absolute purchasing power parity.

• Prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.

• Relative PPP is more consistent with data, but it also performs poorly to predict exchange rates (See Figure-2). Reasons why PPP may not be accurate: the law of one price may not hold because of:

  • Trade barriers and nontradable products.

  • Imperfect competition.

  • Differences in measures of average prices for baskets of goods and services

Trade barriers and nontradable products:

• Transport costs and governmental trade restrictions make trade expensive and in some cases create nontradable goods or services.

• Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts).

• The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value.

• So, one price need not hold in two markets.

Imperfect competition:

• This may result in price discrimination: “pricing to market.”

• A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay.

• So, one price need not hold in two markets.

Differences in the measure of average prices for goods and services:

• Levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured.

• Because measures of groups of goods and services are different, the measure of their average prices need not be the same.

• So, one price need not hold in two markets.

Real Exchange Rate Approach to Exchange Rates

• Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory.

• Real exchange rate is the rate of exchange for goods and services across countries.

• In other words, it is the relative value/price/cost of goods and services across countries.

• For example: it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services: $q<em>{\$/€} = \frac{E</em>{\$/€}*P<em>€}{P</em>{\$}}$

• If the EU basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1 U.S. basket per 1 EU basket.

• Real depreciation of the value of U.S. products means a fall in a dollar′s purchasing power of EU products relative to a dollar′s purchasing power of U.S. products.

• This implies that U.S. goods become less expensive and less valuable relative to EU goods.

• This implies that the value of U.S. goods relative to value of EU goods falls.

• According to PPP, exchange rates are determined by relative average prices:

• According to more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate. Equation (5) can be solved for nominal exchange rate to get: ${E<em>{\$/€} = \frac{q</em>{\$/€}*P<em>{\$}}{P</em>€}}$

• Now, what influences the real exchange rate?

(1) Change in relative demand of U.S. products:

• (a) Increase in relative demand (RD) of the U.S. products causes the value (price) of U.S. goods relative to the value (price) of foreign goods to rise.

  • Real appreciation of the value of U.S. goods: PUS rises relative to P∗US.

  • Real appreciation of the value of U.S. goods makes U.S. exports more expensive and imports into the U.S. less expensive (thereby reducing the relative quantity demanded of U.S. products).

• (b) Decrease in relative demand of U.S. products causes a real depreciation of the value of U.S. goods.

(2) Change in relative supply of U.S. products:

• (a) Increase in relative supply (RS) of the U.S. products (caused by an increase in U.S. productivity) causes the price/cost of U.S. goods relative to the price/cost of foreign goods to fall.

  • Real depreciation of the value of U.S. goods: PUS falls relative to P∗US

  • Real depreciation of the value of U.S. goods makes U.S. exports less expensive and imports into the U.S. more expensive (thereby increasing relative quantity demanded to match increased relative quantity supplied).

• (b) Decrease in relative supply of U.S. products causes a real appreciation of the value of U.S. goods.

• Real exchange rate is a more general approach to explain exchange rates. Both monetary factors and real factors influence nominal exchange rates:

  • Increases in monetary levels lead to temporary inflation and changes in expectations about inflation.

  • Increases in monetary growth rates lead to persistent inflation and changes in expectations about inflation.

  • Increases in relative demand (RD) of domestic products lead to a real appreciation.

  • Increases in relative supply (RS) of domestic products lead to a real depreciation.

• When only monetary factors change and PPP holds, we have the same predictions as before.

  • No changes in the real exchange rate occurs.

• When factors influencing real output change, the real exchange rate changes.

  • With an increase in relative demand of domestic products, the real exchange rate adjusts to determine nominal exchange rates.

• With an increase in relative supply of domestic products, the situation is more complex.

  • With an increase in the relative supply of domestic products, the real exchange rate adjusts to make the price/cost of domestic goods depreciate, but the relative amount of domestic output also increases.

  • This second effect increases the demand of real monetary assets in the domestic economy:

  • Thus, the level of average domestic prices is predicted to decrease relative to the level of average foreign prices.

  • Effect on nominal exchange rate is ambiguous:

• When economic changes are influenced only by monetary factors, and when the assumptions of PPP hold, nominal exchange rates are determined by PPP.

• When economic changes are caused by factors that affect real output, exchange rates are not determined by PPP only, but are also influenced by the real exchange rate.

Interest Rate Differences

• More general equation for the differences in nominal interest rates across countries can be derived {i-\i^}=Ee(\frac{{\Delta q{\$/€}}}{q{\$/€}})+Ee({\pi - \pi^{}})

• So, the difference in nominal interest rates across two countries is now the sum of the:

  • (a) Expected rate of depreciation in the value of domestic goods relative to foreign goods, and

  • (b) Difference in expected inflation rates between the domestic economy and the foreign economy.

Real Interest Rates

• Real interest rates are inflation-adjusted interest rates: $\r = R - \pi^e$

• Real interest parity equation says that differences in real interest rates (in terms of goods and services that are earned or forgone when lending or borrowing) between countries are equal to the expected change in the value/price/cost of goods and services between countries.

Summary

• Law of one price says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between markets are not important.

• Purchasing power parity applies the law of one price for all goods and services among all countries.

• Absolute PPP says that currencies of two countries have the same purchasing power.

• Relative PPP says that the changes in the nominal exchange rate between two countries equals the difference in inflation rates between two countries.

• Monetary approach to exchange rates uses PPP and the supply and demand of real monetary assets.

• Changes in the growth rate of money supply influence inflation and exchange rates.

• Expectations about inflation influence the exchange rate.

• Fisher effect shows that differences in nominal interest rates are equal to the differences in inflation rates.

• Empirical support for PPP is weak.

• Trade barriers, nontradable products, imperfect competition, and differences in price measures may cause the empirical shortcomings of PPP.

• Real exchange rate approach to exchange rates generalizes the monetary approach.

• It defines real exchange rate as the value/price/cost of domestic products relative to foreign products.

• It predicts that changes in relative demand and relative supply of products influence real and nominal exchange rates.

• Interest rate differences are explained by a more general concept: expected changes in the value of domestic products relative to the value of foreign products plus the difference of inflation rates between the domestic and foreign economies.

• Real interest rates are inflation-adjusted interest rates and show how much purchasing power savers gain and borrowers give up.

• Real interest parity shows that differences in real interest rates between countries equal expected changes in the real value of goods and services between countries.

Detailed Assessment Plan on Offshore Outsourcing

This plan outlines a comprehensive assessment of offshore outsourcing, drawing upon the provided notes and incorporating economic principles.

1. Introduction (10% of total marks)

• Background: Start by defining offshore outsourcing and its increasing relevance in global businesses.

• Context: Briefly introduce the OECD's interest in this topic and the role of an economic advisor. Reference the initial background notes.

• Objectives: Clearly state the assessment's objectives based on the OECD Chief's requirements:

  • Trends and drivers of offshore outsourcing.

  • Environmental implications.

  • Opportunities and challenges.

  • Exchange rate risk management.

  • Policy recommendations.

• Thesis Statement: Provide a clear thesis statement outlining the assessment's main argument or conclusion.

2. Trends and Drivers of Offshore Outsourcing (20%)

• Historical Context: Discuss the evolution of offshore outsourcing, referencing how companies have shifted from primarily domestic production to global value chains (GVCs).

• Key Drivers: Analyze the factors driving offshore outsourcing:

  • Cost differentials: Emphasize the cost advantages of relocating labor-intensive stages to low-wage countries.

  • Technological advancements: Highlight the role of IT, communication, and logistics (e.g., containerization) in enabling cross-border production.

  • Trade liberalization: Mention the impact of trade and investment liberalization policies.

  • Economies of scale: Discuss how internal economies of scale encourage firms to concentrate production in fewer locations.

• GVC Integration: Explain how countries integrate into GVCs through backward and forward linkages, referencing the GVCs section.

• Data/Graphs: Use relevant data and graphs to illustrate the trends in offshore outsourcing and its growth over time.

3. Implications for the Environment (15%)

• Environmental Impact: Analyze the environmental consequences of offshore outsourcing:

  • Pollution: Discuss how the relocation of production to countries with less stringent environmental regulations can lead to increased pollution.

  • Resource Depletion: Address the impact on resource depletion due to increased production and transportation.

  • Carbon Footprint: Evaluate the carbon footprint associated with global supply chains and transportation.

• Real Exchange Rate Approach: Use the real exchange rate approach to discuss how environmental regulations and costs can affect a country's competitiveness.

• Sustainable Practices: Explore examples of sustainable practices and policies that can mitigate the environmental impact.

4. Opportunities and Challenges (20%)

• Opportunities: Analyze the opportunities arising from offshore outsourcing:

  • Economic Growth: Highlight the potential for increased job creation and economic growth, referencing the GVCs section.

  • Productivity Growth: Discuss how GVCs drive productivity growth and improve living standards.

  • Access to Skills and Technology: Mention how countries import skills and technology through GVC participation.

  • Consumer Benefits: Explain how consumers benefit from lower costs and a wider variety of goods.

• Challenges: Address the challenges associated with offshore outsourcing:

  • Job displacement: Discuss the potential for job losses in domestic markets.

  • Wage stagnation: Analyze the impact on wages and income distribution.

  • Ethical concerns: Address issues related to labor standards, working conditions, and human rights.

  • Coordination costs: Mention the challenges of coordinating complex global supply chains.

5. Risk and Management of Exchange Rate Changes (15%)

• FOREX Market Dynamics: Explain the dynamics of the foreign exchange (FOREX) market and how exchange rates are determined.

• Impact on Firms: Analyze how exchange rate fluctuations affect firms engaged in offshore outsourcing:

  • Cost fluctuations: Discuss how changes in exchange rates can impact production costs and profitability.

  • Competitive advantage: Evaluate how exchange rate movements affect a firm's competitive position.

• Risk Management Strategies: Explore strategies for managing exchange rate risk:

  • Hedging: Explain the use of forward contracts and other hedging instruments.

  • Currency diversification: Discuss the benefits of diversifying currency exposure.

  • Location decisions: Mention how firms can strategically choose locations to minimize exchange rate risk.

6. Policy Recommendations and Solutions (10%)

• Policy Recommendations: Provide specific policy recommendations to ensure inclusive, socially responsible, and sustainable practices in offshore outsourcing:

  • Labor standards: Advocate for the enforcement of fair labor standards and working conditions.

  • Environmental regulations: Promote stricter environmental regulations and the adoption of sustainable practices.

  • Education and training: Suggest investments in education and training programs to help workers adapt to changing labor market demands.

  • Trade policies: Discuss the role of trade policies in promoting fair trade and preventing exploitation.

• Solutions to Challenges: Offer practical solutions to address the identified challenges, such as:

  • Reskilling programs: Implement programs to reskill workers displaced by offshore outsourcing.

  • Incentives for sustainable practices: Provide incentives for firms to adopt sustainable and socially responsible practices.

7. Conclusion (10%)

• Summary: Summarize the main findings and arguments of the assessment.

• Implications: Discuss the broader implications of offshore outsourcing for the global economy.

• Final Thoughts: Provide final thoughts on the future of offshore outsourcing and the importance of addressing its challenges and opportunities.

This detailed plan provides a structured approach to assessing offshore outsourcing, ensuring a comprehensive and well-supported analysis based on the provided notes.