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INTERNATIONAL ECONOMICS
"You have to be very rich or very poor to live without trade."
- Albert Camus
SECTIONS
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3.1 International Trade
Why trade?
Difference in factor endowments
Not every country has the same quantity and quality of goods. Saudia Arabia may have a lot of oil, but not enough lumber. Sweden has lumber but no oil. There is a potential for trade there. There are many examples of this - some countries rubber, diamonds or gold - and some countries don't. Crops are also a good example of this, as Mexico is the worlds largest exporter of avocados but France is the biggest exporter of sugar beets, because they have different natural resources and climate. To maximize the benefits of this countries must trade. Additionally, some countries benefit from having an enourmous working force, like China or India, which is quite low-paid. Compare that to, say the UK, who doesn't have the same capacities in terms of labour but may perhaps have a more skilled or educated workforce over all. Some countries are labour intensive and some aren't.​
Some countries have a climate suited to grow apples, some to grow exotic fruits as kiwi. This is a difference in resource endowments and thus trade occurs!
The Benefits of Trade
1. Lower prices for consumers
Prices will become lower for consumers because of increased competition between producers from all around the world. This means producers need to become more effective and lower prices to be able to compete; benefitting consumers.
2. Greater choice
Trade allows consumers to have greater choices. Northern citizens can buy avocados and coconuts, southeners can enjoy Alaskan Pollock. Similarly, inhabitants of Fiji can buy Swedish furtniture at IKEA or Japanese cars from Toyota. Today, evertime one enters a big grocery shop, every other item is imported. This gives consumers a much greater choice of products to buy from!
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3. Economies of Scale ​
The theory of economies of scale, that we touched upon when looking at firms, applies with traqde as well but on a much bigger scale. Companies can now expand much more globally thanks to free trade, benefitting from even larger economies of scale.
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4. Increased competition
Increased compeittion is what leads to what has been stated above: greater choice, lower prices and more economies of scale. It also leads to companies needing to innovate, spend money on research and development.
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5. Political
Some countries may choose to trade to forge closer political bonds or to make a statement on the international theatre. Guy Tozzoli, head of WTC association, once said that "When you are promoting business, you are promoting peace. Because when I understand your aims and your culture, I don't have any reason to declare war on you, and we can instead work together." When two countries are closely related in terms of trade any type of conflict is likely to be very detrimental economically on both countries. There are many examples of countries that trade extensively, possibly because historical and political favoritism. Examples include Japan-USA, Israel-USA, Scotland-England and so forth.
6. More efficient allocation of resources
Resources can be allocated and distrubuted globally in a more efficicent manner; they go where they are wanted, quite simply put.​
7. Cultural
The good that a country has absolute and or comparative advantage in is likely to become a strong culture good, perhaps attached to the country's natural identity. Examples include watches for Switzerland, wine from France and cars for Sweden.
8. Source of foreign exchange
When a country sells a large amount of exports to other countries, they acquire a lot of foreign currency. They can use this to make payments to other countries, or control currenct exchange rates. This will come up more further down in this section.
WTO
The World Trade Organization
Established in 1995, the World Trade Organization comprises 157 countries. It was created ut of the previous GATT agreement (General Agreement on Tariffs and Trade) The member countries are required to grant each other 'most favoured nation' status. The IB requires its Economics students to know its objectives and and functions, listed below.
WTO functions
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Administers trade agreements.
The WTO agreements cover goods, services and intellectual property. They spell out the principles of liberalization, and the permitted exceptions. They include individual countries’ commitments to lower customs tariffs and other trade barriers, and to open and keep open services markets. Many agreements are now being negotiated under the Doha Development Agenda, launched by WTO trade ministers in Doha, Qatar, in November 2001.
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Settles disputes. The WTO members occasionally disagree on trade isssues: so the WTO makes decicions to resolve this differences.
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Provide a forum for negotiations. The WTO brings together countries in different rounds, giving them a chance to negotiate.
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Monitors national trade policies. The WTO regularly checks up on member countries, making sure they follow guidlines and implement free trade.
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Assistance to developing countries. The WTO provides technical assistance and training - to help them become a part of a global free trade society and grow. However, how succesful they have been with this has been hotly debated.
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Co-operation with other international organisations. The WTO regularly works together with similar organisations, like the World Bank or the IMF.
Principles
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The World Trade Organization has the following principles, which it officially aims towards.
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Free Trade. All barriers between countries should be lowered - and potentially completely removed.
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Predictability. Everyone, from governments, firms, investors and the like should know that tariffs will not just be raised from one day to another.
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Non-discrimination. All members should be treated as equal when trading and negotiating.
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Fair competition. Illegal trade practices, such as dumping, are strictly forbidden.
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Development and reform are good things. Developing countries should have special terms anc conditions: more flexibility, help and assistance.
Absolute and Comparative Advantage
HL
Absolute Advantage
What is it? Absolute advantage occurs when a country can produce more of one good than another using the same amount of resources.
This scenario is shown in the table below where a country can either produce electronics or bananas using the same amount of resources. Costa Rica for example can either produce 4 electronics or 10 bananas.
Here, simply by looking at the figures above, it becomes clear that Sweden has an absolute advantage in producing electronics but Costa Rica has an absolute advantage in producing bananas.
So which goods should a country choose to export and which to import? Well here the answer is simple - Costa Rica should export bananas and import electronics, and Sweden should do the reverse, using all resources solely on one product. This will also allow the countries to specialize, meaning that the good they produce will in time become better in quality and may also increase in quantity.
The diagram above illustrates the concept of absolute advantage. The country that reaches the highest on the x-axis has absolute advantage in that good, just as the country that stretches the furthest on the y-axis has absolute advantage in that.
Just using the diagram you can calculate each country's opportunity costs and which good they should specialize in!
Must watch explanation
Summarization
Comparative Advantage
What is it? Comparative Advantage occurs when a country can produce a good with a lower opportunity cost than another. It basically states that trade can be beneficial even if one country has absolute advantage in the production of both goods!
Below is a good example of this.
Opportunity Cost
To find out Thailand's opportunity cost for producing bags, simply put the meters in cloth over bags: 12/3, which equals 4. That's Thailands opportunity cost: for every bag produced, Thailand could have produced 4 meters of cloth. That's a very high opportunity cost. In comparison, for Bangladesh the opportunity cost of producing 1 bag would be 5/2, which equals 2.5. For every bag produced, they could have made 2.5 metres of cloth. That is clearly a lower opportunity cost than Thailand had. Thus Thailand should focus on producing cloth, and Bangladesh on bags.
In comparative advantage diagrams, the countrys curves never intersect. This is because one of them have absolute advantage in the production of BOTH goods. However, it would be wasteful and take a lot of effort for that country, in this example Thailand, to use half their resources for cloth and have for bags when they clearly have a lower opportunity cost for producing cloth. As Bangladesh had a lower opportunity cost for bags.
The theory of comparative advantage has been very important in the world, and many countries trade policies rest on it. It's main assumption, that it will lead to increasing global consumption and improved allocation of resources, is championed under the banner of free trade.
However, the theory of compartive advantage relies on some assumptions of the world that are often unrealistic.
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All resources in all countries are fully employed. This is seldom the case - particularly in developing countries. They suffer from high unemployment and often underemployment.
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That technology remains in a status quo. This is not at all realistic, as new technology is continously discovered.
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There is perfect competition - which is rarely if ever the case irl.
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All factors of production are fixed. In reality, they change - particularly labour and capital.
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Imports and exports always balance. However, trade deficits exist in practically every country. Problems with how to pay for the "extra" imports take place every year all around the world.
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Complete free trade exists. This is not the case in reality.
Other problems with comparitive advantage
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Excessive specialisation. Comparative advantage might lead a country to specialize in the production of one good, excessively, meaning that it stops producing or caring for other industries. There are many reasons for why a country might want to be able to produce a variety of goods: agriculture, for example, is necessary for most countries to maintain in case of disasters or wars. Over specialization can also make them vunerable, because they haven't diversified their exports. Should the global market hit one product hard, they will be left to suffer because they put all their eggs in one basket.
Free Trade
Imports under free trade
In an unregulated international market, with free trade, the opposite can occur - a country can export goods.
A countries domestic supply and domestic demand may meet at equillibrium - but when the world price is introduced, it is situated a lot higher than equillibrium. This means that the domestic producers can produce alot more than is domestically demanded. The surplus is therefore exported at Pw - World Price.
You have probably realized now that the these diagrams look a lot like what was looked at in the first section of economics, with price ceilings and price floors.
Unregulated market
The domestic supply and domestic demand function in the interational trade diagram just as the normal 'demand' and 'supply' of microeconomics - look at it just like a normal supply and demand diagram! The only difference here is that the price is already set, decided by the world market. This is because, generally speaking, no single country has a strong enough global market share to affect the global price of the good. Thus, every country is a price-taker rather than a price-maker. This is very reminiscent of Theory of the Firm (HL) with the firms in perfect market.
It is important to remember that economics is theory - and in theory no country has a strong enough global market share to affect prices. In reality, that is not always true. India exports 1/6 of all the worlds rice, and has affected the price before when they decided to stop exporting it.
In the diagram to the left, illustrating an unregulated market, the world price hits the country's demand and supply curves under the equilibrium, resulting in the domestic demand being greater than the domestic supply. In other words, at that price, the producers in that country won't supply enough to satisfy the population, so it must be imported at the world price. The difference betweeen Q1 and Q2 is therefore the imports.
Exports under free trade
Restrictions on Free Trade
Protectionism
For a number of different reasons, some countries impose restrictions on trade to limit imports. This is the opposite of free trade and is called protectionism.
There are a number of ways for countries to hinder free trade.
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Tariffs
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Quotas
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Legilsation
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Volountary Export Restraints (VERs)
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Why countries restrict trade
Tariffs
Plotting the tariff
Explaining the tariff
Tariffs are the most common of trade protections and is imposed on imports of a specific good. It raises the price of those imported goods, making the domestically produced ones cheaper in comparison.
Imposing a tariff normally happens because of one of two reasons:
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The government wants to protect domestic industry
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The government needs to raise money.
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Diagramming a tariff on imports
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In the diagram to the right, the effects of a tariff are shown. Before the tariff is levelled, the world price results in an import between Q1 and Q2. However, the tariff increases the price of the good, as the tariff is added to the world price (Pw) set by the World Supply.
At this new price, the domestic producers are willing to supply more, at Q3. However, some imports are still needed to fill the domestic demand, so the area between Q3 and Q4 becomes the new imported area.
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Consumers: The consumers in the home country are worse off, because they must now pay a higher price.
Domestic producers: These are however, are better off - they now receive a higher price AND sell a higher quantity.
Home country:Employment domestically increases. However, income distribution domestically grows more unequal, as the tariff is a regressive tax. Everyone pays the same amount, meaning that the tariff will eat up a proportionately larger portion of low-income earners income.
Government: The government gains revenue from the tariff, which it can use to spend in the economy.
Foreign producers: These are worse off however, because they only receive the world price yet sell a smaller quantity.
Misallocation of resources.
Effect on stakeholders
Import Quotas
What is it?
A quota is a set target by the government, a fixed legel limit that is the maximum that may be imported. In prctice nad in the diagrams, they function more or less exactly as the tariffs. The only difference is that they don't provide any cash for the government.
Diagram
On the right is the diagram illustrating the effects of a quota. The Domestic supply increases witht he quota, shifting to the right, since foreign producers are now limited in what they are allowed to sell. The foreign producers restrictions are thus the domestic suppliers boon. This also increases the price that domestic consumers will have to pay. The price they pay goes from Pw (price world) to Pq (price quota). The overall quantity consumed in the economy decrease, from point d to point c. The quantity imported also decreases, from the area a-d to b-c.
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Domestic producers: Are better off, because they receive a higher price and sell a larger quantity. However, their effeciency may lack some now, since their competition is less.
Foreign producers: Are worse off, because they now export less and thus earn less.
Consumers: Consumers domestically are worse off, because they now suffer from higher prices and less quantity to consume.
The government: Receives no revenue from the quota at all, but domestic employment increases.
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Effect on stakeholders
Plotting the quota
Domestic Subsidies
What are they?
Domestic subsidies are grants levied by the government to domestic producers. They often concern an entire industry, and are done to increase the production of that good and service. These are the same ones that were discussed in microeconomics. Subsidies to domestic industries lower their prices, thus making them more competitive in relation to foreign producers. It also increases their production.
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Explaining the diagram
To the right, we see the diagram after the subsidy has been applied. After the subsidy has been applied, the domestic supply increases by shifting to the right. They will now produce at the new intersection of the Domestic supply curve and the world price. Their production thus goes from the quantity at point a to point b. The total of imports shrinks from the quantity a-c to the quantity b-c.
Effect on stakeholders
Domestic producers: Are better off, because they produce more while still receiving the higher price. They do become more inefficient because they have to compete less with the foreign imports.
Foreign producers: Are worse off, because they now export less and thus earn less.
Consumers: Consumers are the same. More of the goods they consume may now be from domestic sources rather than imported ones, but the quantity imported and the price remains the same.
The government: Loses revenue; a subsidy is very costly. However, the country gains in terms of increased employment.
Arguments for and against trade protectionism
Arguments for protectionism
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Infant Industry Argument. This one argues that to protect small domestic industries it is necessary to shield them from the cheaper imported goods available on the international market. Thus, by restricting imports of that type of good, the domestic industries may grow until they are big enough to compete internationally.
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Protection of domestic jobs. The country in question, for example France, might have a large number of farmers with a strong agricultural tradition. Thus, tarrifs and other types of trade protection are put in place to protect those jobs and those people.
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Efforts of a developing country to diversify. Developing countries often suffer from overspecialization on commodities; in some countries over 40 % of the GDP comes from production of a single good like coffee or bananas. This is damaging to a country so it might use protectionism to allow its other industries to develop and thus diversify.
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Political reasons. Occasionally, a country may choose to place an embargo on another country to hinder all trade due to political, strategic, diplomatic, military or ideological reasons. A good example is America's long-standing embargo of Cuba - that however appears to begin to change!
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Health, safety and environmental standards. Several developed countries today impose trade protection against goods that are produced in severely environmentally degrading ways or that utilize sweatshop labour or child labour. Similarly, goods produced under extremely health hazaderly circumstances may be banned or taxed to prevent them from being imported.
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As a source of revenue for the government. Tariffs or selling import licences can make a lot of money for the government, and in times of need, that is a large incentive for governments to impose trade protectionism.
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Against anti-dumping and unfair advantages. Occasionally, countries may impose bans or tariffs against country's suspected of dumping.
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Means to overcome a balance of payments deficit.
Arguments against protectionism
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Misallocation of resources. What trade does is essentially, in the words of an economist, re-allocate resources to where they are most needed. Trade moves resources from one part of the world to another, trying to achieve the most effective allocation for all. Protectionism disrupts this, thus resulting in a mis-allocation of resources.
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Danger of retaliation and "trade wars". When one country begins with protectionism, it is most likely just a matter of time before others will follow. This tends to be the case always. Retaliation and resulting "trade wars" are hugely detrimental to all involved, resulting in much higher prices for all consumers.
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Potential for corruption
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Increased costs of production due to lack of competition: Because of the sudden disappearance of competition, domstic producers have much less incentive to compete with one another. Corporations that produce and sell to larger indsutries no longer have to compete with international firms. Less competition = less quality, less quantity, and higher prices.
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Higher prices for domestic consumers: Domestic consumers are hit the hardest, as the imported goods increase in price due to higher tariffs. And domestic products may be far more expensive than those that a country with comparative advantage might have been able to produce.
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Increased costs of imported factors of production. All imported factors of production, perhaps something like machinery, will now be much more expensive for the domestic industries that rely on them.
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Reduced export competitivness. Because of all the increased prices for domestic producers, their competitiveness will shrink. IN the long haul, they will be less well poised to compete with their international counterparts, because they cannot take advantage of the low prices for their resources that the others can do.
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3.2 Exchange Rates
Freely floating exchange rates
Introduction
What is an exchange rate?
An exchange rate is the price of one currency, expressed in the price of another. Essentially, exchange rates are all around us - present every day at every minute of the day. Money flowing in and out of all countries of the world affect exchange rates. The exchange rate market, Forex, is the largest financial market on the planet. If you would like to go travelling from England to France, you would have to exchange your pounds to euros. The amount of euros you get for your pounds is the exchange rate.
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Demand and Supply
A freely floating exchange rate is one that the markets of demand and supply establish. As described above, at any given time their is a certain demand for a currency, as well as a cetain supply of it. This will fluctuate, and thus, the demand and supply market will work to change the exchange rate from day to day, hour to hour, when it is freely floating. It is thus at the mercy of the market. The diagram to the right illustrates the exchange rate for pounds, in euros. It is much like a similar demand and supply diagram you saw in microecnomics.
Diagram: The exchange rate
Below is a diagram of the exchange rate for the Briitsh Pound Sterling (£). It's value, on the price axis, is measured in Euros. Essentially, the price of pounds is measured in euros. At an given time, there is a supply of pounds in the market and a demand for them in exchange for euros.
Causes of changes in the exchange rate
The effects of exchange rate changes
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Foreign demand of exports: When foreign nations either increase or decrease their demands, that will affect the exchange rate. The more goods are demanded, the more of that nations currency is demanded too - since you need their currency to buy their goods.
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Domestic demand for imports: When more and more people in a country buy imports, the opposite happens: they have to exchange their currency in order to buy the others. This in turn will increase the supply of their currency, since more of it is now in the market, and the value of it will decrease. The opposite is true.
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Relative interest rates: The world is full of capital that moves around, from country to country, in search of high interest rates where it can earn money by depositing it in those banks. Thus, when a country raises its interest rates, it will receive an influx of money from abroad eager to profit from them. This will increase demand for the country's currency, thus raising the exchange rate.
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Relative inflation rates: Inflation is a source of uncertainty, and as it raises the price level within a country, their exports will become to expensive for other nations. Thus, exports fall, demand for their currency falls, and so does it's strength. Additionally, because the country is now experiencing high levels of inflation, it will find it cheaper to import from other countries experiencing a lower rate of inflation - thus increased imports will lead to a larger supply of its currency, lowering its value further.
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Investment from overseas in a country's firms (foreign direct investment): When firms from overseas invest in a country, they must first exchange their money into the currency of that country. This increases demand for the currency, thus making it stronger.
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Speculation: This refers to currency speculation with the intent to profit. That's part of why forex is thelargest market in the world - there are always investors looking to profit from currency fluctuations. They purchase large amounts of one currency, hoping for it to soon depreciate or appreciate, and then sell it off. This affects the demand and supply of a currency, thus also affecting its exchange rate.
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Appreciation in the currency: This is jargon to decrease an increase in the value of the currency. If the US dollar appreciates relative to the Mexican pesos, the exchange rate falls: It now takes fewer dollars to purchase the same amount of pesos.
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Depreciation in a currency: This refers to the decrease in the value of the currency: the exchange rate rises. That is, it would now take more US dollars to purchase the corresponding amount of Mexican pesos.
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Affects the inflation rate: When the exchange rate changes, it effectively changes how much is demanded in terms of exports and imports. It may have an affect on both aggregate demand and aggregate supply. Firstly, if the currrency depreciaties and imports become more expensive, this will hit hard at a economy that is dependent upon importing goods for production. Thus aggregate supply will shift to the left, resulting in cost-push inflation. On the other hand, if the currency depreciates the country's exports become cheaper - and if htey export a lot, this will increase their aggregate demand because foreigners can now afford to buy more. This will shift the aggregate demand curve to the right, resulting in demand-pull inflation. On the other hand, changes in the exchange rate may reduce inflation, if it makes imported goods used for production cheaper or if it makes exports more expensive and therefore lowers aggregate demand.
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Employment: Because a weaker currency leads to increased exports, it also follows that the production of more goods and services results in more jobs in the economy. The opposite will result in more unemployment; if exports become too expensive due to currency appreciation.
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Economic growth: Weaker currency, more exports more produced, more jobs and thus more economic growth. The opposite is also true.
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Current account balance. When a country's currrency is weaker, it's exports become cheaper. This will lead it to increase it's exports, thus making its current account more focused towards exports. The opposite is also true.
Trade and exchange rates
Government Intervention
Fixed exchange rates
What is a fixed exchange rate?
A fixed exchange rate is one that the government sets and enforces: a set rate that the currency is worth. The central bank controls this. If the government of the UK were to fix the pound to the dollar, so that 1 pound was always to be equal to one dollar. £1 = $1.
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How is this maintained?
To maintain the £1 = $1 fixed exchange rate, the UK central bank will have to intervene in the market to make sure it stays that way. It essentially has to offset the workings of demand and supply. When there is a surplus of pounds in the market, meaning that the value of the pound is not $1, the central bank will use it's foreign currency reserves to buy the surplus pounds, thus creating articifial demand to maintain the fxed exchange rate. The opposite is also true - if there is a shortage of pounds in the market, meaning that the pound is worth more than $1, the central bank will sell some pounds by buying foreign reserves.
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The digram below explains this. In this example, the Central Bank has decided that the red dotted line is supposed to be the fixed price. At the equillibrium between S1 and D1, this is sustained. But then there is an increase in demand for pounds, and the demand curve shifts from D1 to D2. At this new intersecction between S1 and D2, the price is too high. So the government will sell a bunch of its pounds in exchange for euros, to drive down the price. This will increase demand, and S1 will shift to S2. At the new intersection of D2 and S2, the value of the pound is back at it's fixed price.
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Managed exchange rates
Managed exchange rates (managed float)
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A managed float attempts to be something in between the two; the best of both worlds. It is when the government or the central bank sets up parameters for how much or how little they will allow the currency to fluctuate. This is quite a common type of currency manipulation. According to IMF, 43% of all countries use a version of the managed float. The purpose of this is to maintain stability over the long-term, while not having to work as much at it as the fixed exchange rate since it is more flexible. Government intervention is periodic, not constant.
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Distinguish between a devaluation and a revaluation of a currency
If the UK government realizes that the £1 = $1 fixed exchange rate is untenable, they may either devalue or revalue their currency - essentially changing the exchange rate completely, re-fixing it. If they believe that the fixed exchange rate is too high, and their currency is actually weaker, they may devalue it, changing the exchange rate to £1 = $2. If they believe the pound is actually stronger, they may revalue it, changing it to £2 = $1.
Evalutation of exchange rate systems
These offer maximum flexibility to policy makers who don't have to constrain themselves to fit a fixed price level.
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Central banks don't need to amass international reserves at all, because they don't need to maintain the exchange rate.
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In a floating exchange rate scheme, stakeholders have very little security at all. The exchange rate will change depending on the global market.
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Maximum ease of adjustement.
Floating
Flexibility to policy makers
Role of international reserves
Degree of certainty for stakeholders
Ease of adjustment
Fixed
There is no flexibility to policy-makers at all under a fixed exchange rate scheme.
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To maintain a fixed exchange scheme, the government needs to have a large amount of international reserves available to them.
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In a fixed exchange rate scheme, all stakeholders have the maximum amount of certainty. They know what the exchange rate will be for a very long time.
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There is no adjustment at all. Policymakers cannot easily adjust the exchange rate to sudden changes, such as current account deficits or supply shocks.
Managed
Some flexibility to policy makers, but not as much as in a floating exchange rate scheme.
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The central bank needs some international reserves, but doesn't
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In a managed exchange rate system, stakeholders have a certain amount of certainty They know the parameters and that the exchange rate won't change much from between them.
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There is some adjustment. The policymakers can allow the exchange rate to fluctuate between the set parementers, but cannot flout them should they need to.
3.3 Balance of Payments
Introduction
What is the balance of payments?
This refers to the overall long-term balance between a countries income and expenditures - the balance between the flow of money into the country and the flow of money out of it.
It consists of three components:
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Current Account
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Capital Account
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Financial Account
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The balance of payments of a country is very important, as it provides an overview of just how much currency is being demanded and supplied. Payments made into the country are known as credit items, while payment made out of it are called debit items. The balance of payments is measured, usually, over a year - and at the end of that year all debits must equal all credits. The same amount of money that goes out should also come in. That is why it is known as the balance of payments. It consists of three major accounts.
The four Components of the Current Account
Balance of trade in goods
Goods are easily tradable between all countries on the globe. In the current account, this refers to imports and exports. Because exports bring in money into the economy, they are known as a credit. Imports, on the other hand, are registered as debit, because they send money out of theb economy. It is calculated by taking imports minus exports.
Balance of trade in services
This is very similar to the balance of trade in goods, but simply with services. These are things like banking, tourism, technological services, consulting, spas and the like. Credits are tourists visiting one's country, or buying one's services. Debits occur when one's citizens holiday in other countries or buy their services.
Income
This section is quite straightforward. Income refers to profits, wages, salaries and rents. Credits are wages and rents that are paid to one's country from abroad, while debits are wages, rents and profits that are collected by those overseas on labour or building's in one's country.
Current transfers
These are transfers from one country to another without receiving any form of good or service in return. Most often, these are things like government aid, pensions, donations, official assistance or gifts.
Current account deficit and surplus
Deficit: When debits outnumber credits in one of the components of the current account, there is a deficit - more money is going out than coming in.
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Surplus: When credits outnumber debits in one of the components of the current account, and there is more money coming in than going out.
Capital Account's two components
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Capital transfers. These are the transfers of money for ownership of assets, rather than the income rom the assets. Also includes debt forgiveness, from one government to the other, and things like
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Transactions in non-produced non-financial assets. This is the sale of assets that are resources of sorts but which are not material. Such as fishing rights, between two countries corporations, for example, or the land rights (for crop production or forestry).
Financial Account's three components
How do the three belong together?
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Portfolio investment. This is investment in the more traditional sense you might have come across, with stocks and bonds on the financial market.
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Direct investment. This is the investments by a foreign company in capital such as buildings, factories or production material. Also known as foreign direct investment, which is something that will be discussed more in the development economics section.
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Reserve assets. These are assets that the central bank of a country holds in other currencies. THese are assets that the central bank could, should it decide it needs to, sell for its own currency in order to keep it strong.
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Trade and exchange rates
Explain that the current account balance is equal to the sum of the capital account and financial account balances
There must be a balance in the balance of payments, and that is to be found between the current account and the sum of the capital and financial account. As we've already mentioned, all debits must equal all credit. In other words, the sum of the current, financial and capital account will always be zero. Thus, if there is a current account surplus of 60 million euro, there must be a combined captial and financial account deficit of 60 million euro.
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Examine how the current account and the financial account are interdependent.
The current account and the financial account are interdependent. This is because the financial account also handles foreign currencies, in the form of reserve assets. If htere is a large current account suplrus, meaning that the country exports more than it imports, it will have accumulated a lot of foreign currencies that it receives as payment. These will have to be spent overseas, with portfolio or direct investments. Thus, if there is a current account surplus it follows that there is afinancial account deficit. If there is a large current account deficit, that means the country imports more than it exports. That also means that by its very interdependent nature, the country will thus have a financial account surplus with enough foreign reserves to be able to purchase all the foreign imports.
HL
Current account deficits
The relationship between the current account and the exchange rate
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A deficit in the current account will have a profound effect on a country's exchange rate. That means that the country is importing more than it is exporting. In short, they are trading away more of their own currency than people are trading to it. There is more of a supply of the currency, and because of the law of scarcity, that also means that the currency is less strong. A current account deficit therefore results in the downward pressure on the exchange rate of the currency. The majority of all countries have current account deficits, the largest of which belong to the United States and the United Kingdom. A few notable examples who have current account surpluses are currently China, Germany and Japan.
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Implications of a current account deficit
How to solve a current account deficit
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Foreign ownership of domestic assets: A current account deficit, as discussed above, will exercise downward pressure on the exchange rate. When the exchange rate is low, it becomes cheaper for foreign companies and individuals to buy up domestic assets, such as stocks, bonds, lands and industries. In some way or another, the current account deficit must be financed. As you've studied earlier, if there is a current account deficit, there must be a surplus in the combined capital and financial accounts to counterbalance it. One way is by the sale of domestic assets to foreigners.
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Exchange rates: A persistent current account deficit will lower the exchange rate, since more is imported than exported, meaning more currency is being supplied than is being demanded.
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Interest rates: There is a risk that interest rates have to be raised in response to a persistent current account deficit. This is because of the need for balance between the current account and the combined financial and capital accounts. When interest rates are higher, foreign capital floods into the country, eager to take advantage of the higher interest rates. This will represent an inflow of capital into the country, as well as increasing the exchange rate, which will in turn help balance out the payments.
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Indebtedness: The balance of payments needs to be zero - so the country may need to borrow money in order to balance out their current account deficit with their financial and capital accounts. If this carries on for a long time, the country may end up with very high levels of debt.
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International credit ratings: If a country needs to finance it's current account by borrowing as well as selling off its domestic assets, it is playing a dangerous games - this can only continue as long as foreign investors believe in it. If it is downgraded by international credit agency's, it will suffer a serious blow in credibility. If investors no longer think that the country is able to successfully finance its current account deficit, they may think that they will not be able to continue running and effectively go bankrupt. If this happens, they will withdraw their assets from the country, which will make it's current account deficit even worse.
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Demand management: With a persistent current account deficit, countries that which to also manage their demand will find this painful adn difficult.
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Methods to correct a persistent current account deficit
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Expenditure switching policies
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These are policies aimed in switching, so that not so much is imported anymore but rather more is exported. This can be done in a number of different ways, two of which are the most notable.
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Depreciation. When a country's exchange rate depreciates, and weakens in relation to others, it's exports become cheaper. This will encourage and stimulate trade with other countries, which will help balance out its current account deficit. When the currency is cheap, domestic consumers will also stop purchasing as many imports because those become more and more expensive (as their currency is worth less and less), which will help switch the country from mainly importing to mainly exporting.
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Trade protection: One way to reduce imports is to engage with protectionism, either by imposing tariffs or quotas on imported goods to discourage them. While this will effectively lower the amount of imports, it's dangers are that it may produce a trade war with other countries, which will shield themselves in response from your exports, meaning you would be worse off than before and your current account deficit still a problem.
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Expenditure reducing policies
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These are policies aimed in reducing aggregate demand, to reduce how much people purchase. These are the ones we've spoken about before: contractionary fisacal and monetary policy. Raising interest rates lowers spending, and raising taxes reduces spending.​
Supply-side policies
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These are policies aimed at lowering or increase the short-run or long-run aggregate supply, shifting them to the right. When the aggregate supply increases by shifting, the country is producing more goods and often of better quality. This will increase their exports, thus bettering the balance of payments. But supply-side policies take a long time.
The Marshall-Lerner condition and the J-curve effect
The Marshall-Lerner condition and the J-curve effect
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The Marshall-Lerner condition: This is a condition that would allow a depreciation/devaluation of one's currency to lead to a bettering of the country's balance of trade, solving it's current account deficit. The condition refers to PED - both the country in questions elasticity of demand for imports (PEDm) and the foreign countries elasticty of demand for their exports (PEDx). Before devaluing one's currency, the government must ask itself the same question that the business owner in Theory of the Firm must ask himself before lowering the price: will this lead to a loss or a gain? That has to do with the PED.
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The Marshall-Lerner condition is only fulfilled if the PED for imports is more than 1. That means that as the currency depreciates, the amount of imports will fall significantly enough to be positive for the trade balance.
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PEDm + PEDx >1 Devaluation will improve the current account
PEDm + PEDx <1 Devaluation will make the current account worse
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The J-curve effect
Current account surpluses
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Current account surplus leads to upward pressure on the exchange rate
Earlier, it was stated that a current account deficit lead to lowering exchange rates, since more was being imported than exported. A current account surplus results in exactly the opposite. Since more is being exported than imported, the country's own currency is in high demand - foreigners want the goods and thus have to exchange their currency for the country's own. This leads to a rising exchange rate, an appreciation.
Implications of a persistent current account surplus
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Lower domestic consumption and investment: Because of the stronger exchange rate, the country's own currency is strong and allows for plenty investments and imports from abroad. It is cheaper to go to other countries to tourist and such.
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Appreciation of domestic currency: As explained in the box to the left.
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Reduced export competitiveness: As the country's currency rises, it's export become more and more uncompetitive because it's exports become more and more expensive. This will in turn lead to lower exports, meaning it might flatten out the current account surplus.
3.4 Economic Integration
WHAT IS ECONOMIC INTEGRATION?
WHY ECONOMICALLY INTEGRATE?
Economic integration occurs when diffferent countries band together and streamline their policies on tariff and non-tariff restrictions on trade. In essence, they either abolish protectionism completely, or agree to limit and unify protectionism.
Countries that integrate their economic policies regarding trade make all trade between them easier, thus increasing the incentive to trade. This will increase trade between the countries which will, for some producers and thus for some countries, be very beneficial economically.
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Types of Economic Integration
Trade treaties are signed between states, where they grant each other a number of concessions with regards to trade. These can be either bilateral, meaning between two countries, or multilaterial, meaning involving a large number of nations. These preferential trading agreements limit or completely abolish tariffs, either on certain products, industries or from specific countries.
What does free trade result in?
Increased competition between all hte countries and their producers involved. All of a sudden, producers in one country that might have been shielded are now subject to intense competition from the other states industries. This, of course, can have both positives and negatives.
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There are a number of trading blocs that can be formed. The three main ones are listed below.
Free trade area: This is an area in which the states have agreed to lower or compeltely abolish tariffs against one another, as well as streamlining standards and procedures of trade. While the countries in the free trade area have the same trading rules with one another, they are free to trade with outside countries however they would like. A good example of this would be NAFTA, the North American Free Trade Area that includes Canada, the US and Mexico. While the US has a complete embargo against Cuba, neither Canada or Mexico need to do the same.
Customs Union: This is largely similar to a free trade area, except that the states involved have the same policies towards any outside states. All common markets and monetary unions are customs unions. The EU, while also being a common market and monetary union, is therefore also an example of a customs union.
Common market: Same as a customs union, but has the same laws and policies on product regulation. Additionally, all goods, services and labour have freedom of movement.
A monetary union is a bit special. It is like a common market, but the countries have taken it one step further - they now share the same currency. They therefore share a common central bank and therefore also monetary policy. This would be exemplified by the Eurozone, which is comprised by a number of countries who are in the European Union. Not all countries in the EU have the euro; only those in the Eurozone. The the European Central Bank (ECB) controls the monetary policy of Austria, Belgium, Cyprus, Spain, Slovenia, Luxembourg, Malta, Greece, Italy, France, the Netherlands, Ireland, Germany, Portugal, Finland and Slovakia.
Advantages of a montetary union:
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Stable against currency speculation, because it has more credibility.
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No exchange rate fluctuations between the countries, making it safer for countries and companies to trade.
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No transaction costs.
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Any potential price differences are clear across the borders, which increases competition and is beneficial for consumers.
Dis-advantages of a monetary union:
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Countries no longer control hteir monetary policy, only fiscal. This makes it difficult for them to control inflation, unemployment rate and their economic growth. The central bank is responsible for this, but as the different countries have different economic growth rates and basic needs, it becomes difficult.
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Some therefore argue that fiscal integration is key - to have a central bank as well that controls both monetary and fiscal policy. Opponents of this cite democracy and different political wills - would the central bank be Keynesian or Monetarist?
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Countries can no longer control their exchange rates, making them more vulnerable against outside fluctuations.
3.5 Terms of Trade
Measurement
What is terms of trade? The terms of trade (ToT) is a measurement used to compares the difference between the price that a country pays for its exports with the prices it receives for its imports. The terms of trade are calculated with the following formula:
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ToT =
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Improvement in terms of trade
This is when one's imports become relatively cheaper in relation to one's imports. An example: Russia sells computers for cotton from India. For 1 computer, they get 20 balls of cotton. But say the price of computers increases? Now, all of a sudden, when Russia trades 1 computer they get 25 balls of cotton instead. Their terms of trade have improved.
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Deterioration in terms of trade
This is the opposite from the example above, when one's imports become relatively more expensive in relation to one's exports. For example, in the example above with Russia and India, India experienced deteriorating terms of trade because they now got less in return for their exports.
Calculate the terms of trade using the equation
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The base of the terms of trade is always 100, for the base year. That is the number that represents the starting point.
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Let's make an example calculation, using the following information.
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2015 2016
Imports: 100 106
Exports: 100 108
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Calculation: 108/106 x 100 = 101.8
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The terms of trade for this country has improved, as they are 1.8 more than they were in 2015, at 100.
Average price of exports
x 100
Average price of imports
Causes of changes in the terms of trade
Short-term
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Changes in demand for exports and imports: In the short run, the terms of change can be affected by the changes in demand for exports and imports. When something is in high demand, it's price is also high - when something is in low demand, it is cheaper. When Russia's computers got more pricey, that was likely due to an increase in demand for them - which in turn gave them more favourable terms of trade.
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Changes in global supply of key inputs, such as oil: Global supplies of vital resources greatly affect the price of the goods which use them in their production.
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Changes in relative inflation rates: The change of inflation rates affects a country's price level. This, in turn, will immedietly impact its terms of trade because it's exports or imports will become cheaper or more expensive relative to others.
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Changes in relative exchange rates: If the pound becomes weaker relative to the euro, that means that the terms of trade has worsened for England - imports have now become more expensive.
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Long-term
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World Income Levels: If the global economy is in a stage of meltdown, people in all country's generally have left less money to spend on incomes. This will affect long-term demand patterns, which will in turn affect prices.
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Changes in productivity within the country: When a country increases in productivity, it produces more of a product - increased supply. As that occurs, the products will lower in price and thus become cheaper to export. The terms of trade change.
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Technological developments: As means of production become more technologically advanced, supply tends ot increase. This will affect the price. This affets the terms of trade in turn, and there are many examples with this, particularly within low income countries that export commodities like coffee and cotton. Increases in technology to produce it, means thar
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Consequences of changes in the terms of trade
Explain how changes in the terms of trade in the long term may result in a global redistribution of income.
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When the terms of trade improve in one country - so that they receive more imports per share of their exports - that will shift global wealth across borders. For each product or good imported, that is one type of job that is essentially lost to that country, one source of income. And when prices decrease in a country's exports, that represents a loss, since they now receive less in payment for the same amount of work. worsening terms of trade has been an issue for developing countries for many years now, as the commodities they produce become cheaper and cheaper and as the goods the rich world produces become more and more expensive.
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Terms of Trade: Explained
Examine the effects of changes in the terms of trade on a country’s current account, using the concepts of price elasticity of demand for exports and imports.
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The current account's largest component is that of trade. Because of this, a chane in the terms of trade will greatly impact the current account, and in extension, the balance of power.
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Price elasticity of demand
Ped measures how responsive demand is to changes in price. This has an important effect on a change in terms of trade. Because long-term changes can affect supply of an export, how price elastic of demand the good is determines just how much the price will change for that good, and thus the country's terms of trade. For goods that are inelastic, the result can often be quite deterimental for the countries that rely on their production. Commodities are most often inelastic. Take coffee, for example. Most people would not want to live without it, regardless of price, and it is has a fairly inelastic PED. On the other hand, that means that when technologicala dvances make producing it much cheaper, so that there is a larger supply, not a lot more is demanded. Few people will drink much more coffee just because it is cheap, not as they would with, say, clothes. So the country in question suffers much worsening terms of trade, since the price will respond to the expansion in supply similarly.
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While this is a fairly complicated process, the best thing to do is watch the video to the left, which explains and goes through examples to fully make you comofrtable with the concept of terms of trade and price elasticity of demand.
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