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International Economics HL (EXCHANGE RATES (Freely floating exchange rates…
International Economics HL
ECONOMIC INTEGRATION
Trade Agreements
Bilateral Trade Agreements: between two countries
Multilateral Trade Agreements: between multiple countries
Trading Blocs
Free Trade Areas
Countries can trade freely among themselves and can trade freely with countries outside of the free trade area
Customs Unions
An agreement where countries agree to trade freely among themselves as well as an agreement to adopt common external barriers against any country attempting to import into the customs union
Common Markets
Monetary Union
A common market with a common currency and a common central bank
Benefits:
Decreased exchange rate fluctuations so reduced uncertainty in investment and trade
Large currency zone = more stability (so less speculation)
increased business confidence (due to lower perceived trade risks)
removal of exchange rate transaction costs
common currency = more obvious price differences/changes to stakeholders
Disadvantages:
individual countries cannot alter their exchange rate to affect competitiveness of X or M
initial costs of converting to a common currency are high (e.g. re-pricing everything)
countries involved do not share the same fiscal policies, SO fiscally irresponsible countries threaten stability of union
individual countries can no longer set their own interest rates and use monetary policy to control inflation, unemployment rate or economic growth - would be damaging if one country is experiencing an economic decline + others are not
A common market is defined by the fact that in addition to free trade and a common trade policy towards non-members there is also free movement of labour and capital between members
Complete Economic Integration
Full monetary union with complete harmonisation of fiscal policy. This means that it effectively functions as a single economy.
Impacts
Trade Creation:
occurs when the entry of a country into a customs union leads to the production of a product transferring from a high-cost producer to a low-cost producer
Trade Diversion:
occurs when the entry of a country into a customs union leads to the production of a product transferring from a low-cost producer to a high-cost producer
Benefits:
Increase market size
increase competition
more choice for consumers
larger market size = further stimulus for investment
greater political stability and cooperation
trade negotiations made easier
Problems:
enact discriminatory policies against non-members = damage achievements of WTO negotiations
larger problem for poorer economics with little bargaining power
EXCHANGE RATES
Freely floating exchange rates
Determined by demand and supply in the currency market
To buy a currency such as Indian rupees, one must sell another currency such as US dollars
Causes for Appreciation:
Increase in foreign demand for country X exports; a decrease in country X's demand for imports; decrease in Country X incomes; lower inflation rate in country X relative to others; increase in country X interest rates; Increase in investment in Country X from abroad; currency speculation; central bank intervenes by buying
Causes for Depreciation:
Decrease in foreign demand for country X exports; increase in Country X demand fro imports; increase in Country X incomes; Higher inflation rate in Country X to others; decrease in Country X interest rates ; decrease in investment inCountry X from abroad; currency speculation; central bank intervenes by selling
Consequences of appreciation:
net exports decrease
Consequences of depreciation:
exports increase
Stakeholders appreciation:
Consumers:
benefit from lower import prices and lower inflation.
Firms:
depend on imported inputs benefit as costs of production decrease
Firms/workers export industries
and import-competing industries lose.
Foreign countries
exporting gain more exports
Stakeholder depreciation:
Consumers
hurt from higher import prices and higher inflation
Firms
depend on imported inputs lose as costs of production increase
Firms/worker export industries
and import-competing industries gain
Foreign countries
exporting to a country lose from fewer exports
Inflation:
cost push inflation and demand pull decrease in appreciation They both increase in depreciation
Unemployment:
Appreciation increases unemployment. Depreciation decreases
Economic growth:
Net effect on growth depends on which of the effects is stronger
Appreciation:
AD decreases. SRAS increase positive effect on output Depreciation has the opposite effect
Current Account balance:
Appreciation decreases current account Depreciation increases current account (marshall learner condition and J curve)
Fixed Exchange rates
Exchange rate fixed by a country's gov or central back at a certain level
Revaluation: an increase in the fixed exchange rate set by the government
Devaluation: decrease in value of currency in fixed exchange rate system
Managed exchange rates
A combination of the two above policies where the exchange rate is largely determined by the demand and supply however the central bank intervenes at times by buying and selling foreign exchange to avoid sharp short term flucutations
This is the typical policy of most governments in the World currently
Calculations
Value of currency in terms of another: One pound = US$1.65 US1= 1/1.65= 0.65 pounds
BALANCE OF PAYMENTS:
A record of all the transactions between one country and all other countries over a given period of time.
Current Account
1)
Balance of Goods and Services:
Measure of the revenue received from the exports of products (surplus/deficit)
2)
Income:
The net monetary movement of profit, interest and dividend moving in and out of the country as a result of financial investment abroad
Profit: Domestic firms have set up branches in other countries
Interest: residents and institutions in the country may have invested in banks in other countries and receive interest
Dividends: residents may have purchased shares in foreign companies and receive dividends
3)
Current Transfers:
Payments made between countries when no goods or services change hands.
Government example: foreign aid + grants
Individual example: foreign workers sending money back (remittances)
Current Account deficit/surplus
Deficit
Foreign exchange reserves may be used to increase capital account
may be due to foreign investors purchasing assets, so capital account is reliant on foreign confidence.
lending from abroad creates high indebtness.
exchange rates - depreciation of currency from CAD at a deficit, X>M and there is less demand for exports thus their currency depreciation.
Surplus
allows countries to have a CAD by building up official reserve account or purchasing assets abroad.
may lead to protectionism from other counrteis
leads to appreciation of currency on the FOREX, as CAS implies demand for the currency. will make imports cheaper, and exports more expensive.
Capital Account
1) Capital Transfers - This is the inflows of credit minus the outflows of debt from overseas
2) Transaction in non-financial assets. This is the inflows minus outflows for natural goods such as land or labour.
The financial account
2)
Portfolio Investment
- The inflows minus outflows of capital for investment in financial capital (Such as shares and bonds)
Examples of this include bringing money into Australia to invest in a firm on the ASX (Australian Stock Exchange)
3)
Reserve assets
- When foreign exchange is held by the central bank is sold or bought to influence the value of a country's exchange rate.
For example, Venezuela had a managed currency and held USD in reserve until it faced economic crisis.
1)
Foreign Direct Investment
- The inflows minus outflows of funds used for investment in physical capital (Most commonly by MNC's)
For example Nestle has invested in manufacturing facilities for Cocoa in Cote D'Ivory
TERMS OF TRADE
Causes of Changes
Short Run
Shifts in demand and supply of exports and imports
Changes in the global supply of key outputs
Changes in the domestic inflation rate relative to the foreign inflation rate and changes in relative exchange rates.
Long Run
Changes in world income levels
Changes in productivity within the country and technological developments
Consequences of Changes
Global Distribution of Income
: Countries with greater TOT get more income at the expense of countries with high TOT in the long-run as countries with high TOT pay less for imports and receive more for exports.
Current Account
: Improvement in TOT leads to improved CAS as demand for exports increases.
Improvement in TOT caused by inflation will improve CAB when exports demand is inelastic
Developing Countries Economy
: Low TOT due to falling price of primary commodities; PED is inelastic and thus demand has not increased enough to cover loss of revenue.
An index that shows the value of a country's average export prices relative to their average import prices. TOT = (Average Export Price/Average Import Price) * 100
Consequences of Low TOT:
Developing countries must sell more exports to buy the same amount of imports.
Falling export prices makes it harder to service national debt as the country earns less money.
Developing countries may want to boost their exports in order to earn more money but may do so through exploitation of their resources.
INTERNATIONAL TRADE
Benefits of Trade
Lower Prices -causes supply to increase, which creates an equilibrium at a lower price level
Greater choice
Differences in Resource
Economies of Scale: specialisation creates efficiency
Increased competition
Access to certain goods
Definition of International Trade:
The exchange of capital, goods, and services across international borders
World Trade Organisation
The WTO is an international organisation that sets the rules for global trading and resolves disputes between its member countries.
Objective:
Increase international trade by lowering trade barriers and provide a forum for negotiations.
Functions of the WTO:
Administer WTO trade agreements, be a forum for trade negotiation and facilitate setting up trade deals, handle trade disputes among member states, monitor national trade policies, provide technical assistance and training for developing countries, cooperate with other organisations to increase trade.
Most countries are members of the WTO, it has a total of 164 members
TRADE ADVANTAGE
Absolute Advantage
A country had an absolute advantage in the production of a good if it can produce it using fewer resources than another country.
measures total goods produced, not necessarily efficiency.
Comparative Advantage
A country has comparative advantage if it can produce the good at a lower opportunity cost than another country.
Theory of Comparative Advantage works so long as the opportunity cost are different
Limitations
Assumption that there are no transport costs
Assumption that costs do not change.
Assumption that products are identical
FREE TRADE VS. PROTECTIONISM
For Free Trade/Against Protectionism
Gains from Free Trade:
Lower prices
Difference in resources = different countries have a different factor endowment so countries can specialise
Specialisation = economics of scale
increase competition
more efficient allocation of resources
source of foreign exchange
Barriers pave ways for bribes and illegal smuggling activity
Barriers also can lead to trade wars and diminish competition
reduce resource scarcity due to world supply - solves economic problems
countries can have comparative advantages
free trade is an engine to growth
increase motivation to compete = innovation
international competitiveness: Companies gain more access to international technology and improve their own efficiency
Lowered gov. expenditure on domestic subsidies, reduced opp. cost
For Protectionism/Against Free Trade
Protection can reduce dependence on international trade, protecting national security
Domestic goods are protected as domestic consumers are more dependent on domestic production
protection of domestic and infant industries
Tariffs - a tax on imported goods
Quotas: a physical limit on the numbers of value of goods that can imported into a country
Subsidies: A payment to a firm by the government for each unit of output produced
Red Tape: when goods are imported, lengthy and costly processes leads to import restriction
Health, Safety and Environmental Standards: various restrictions placed on goods that can be sold in domestic market or on methods used in the manufacture of certain goods
Embargoes: an extreme quota, a complete ban on imports and is usually put in place as a form of political punishment
MARSHALL-LERNER CONDITION AND J-CURVE
Marshall-Lerner Condition:
The condition states that reducing the value of the exchange rate will only be successful if the total value of the price elasticity of demand for imports is greater than 1.
The J Curve:
Shows what happens to a CAD over time when the exchange rate is depreciated.
In the short run, the PED for EXPORTS will be inelastic and export revenue will fall as prices will fall more than demand will rise.
In the short run, the PED for IMPORTS will also be inelastic and import expenditure will increase.
When exchange rate is devalued or depreciated, the CAD will increase.
PED (exports) + PED (imports) > 1
