4.1 Flashcards
What is globalisation?
Its a process by which economies and cultures have been drawn deeper together and have become more inter-connected through global networks of trade, capital flows and the rapid spread of technology and global media.
What is the main benefit of globalisation?
It allows businesses and countries to specialise in producing goods and services where they have a comparative advantage, i.e able to produce at a lower opportunity cost. Specialisation and trade enable a gain in economic welfare, e.g. through lower prices for consumers which increases their real incomes. It also allows consumers to buy a greater range of goods and services, increasing choice.
What are 8 characteristics of globalisation?
Trade to GDP ratios are increasing for many countries.
- Expansion of financial capital flows across international borders
- Increasing foreign direct investment and cross border acquisitions
- More global brands including a number from developing countries
- deeper specialisation of labour e.g. in making specific component parts.
- Global supply chains and investment routes
- higher levels of cross- border labour migration
- Increased connectivity of people and businesses through networks.
What 4 factors have contributed to globalisation in the last 50 years?
- Containerisation- decreases shipping costs by using standardised containers and reaping economies of scale in freight industries. Decreases unit cost of transporting products across the world.
- Technological advances- cuts cost of transmitting and communicating information- key factor behind trade in knowledge- incentive products using the latest digital technology.
- Differences in tax systems- some nations cut corporate tax to attract inflows of foreign direct investment as deliberate strategy to drive growth
- Less protectionism- average import tariffs have fallen- however, there has been a rise in non tariff barriers e.g. import quotas, domestic subsidies and tougher regulations hinting at a phase of de-globalisation.
What are TNC’s?
Transnational corporations base their manufacturing, assembly, research and retail operations in a number of countries. Many TNC’s have become synonymous with globalisation, like nike and facebook.
Why are TNC’s a driver of globalisation?
They have been relocating manufacturing to countries with relatively lower unit labour costs to increase profits and returns for shareholders. E.g. VW, toyota and nissan have plants in mexico, which has helped mexico build a comparative advantage in assembling, manufacturing and then exporting vehicles to other countries including the US and canada.
What is a key recent feature of globalisation?
A surge in the number of transnational businesses from emerging markets. E.g. china mobile is in the top 10 consumer brands in the world and Alibaba has expanded to be one of the biggest online retailers.
What are 7 advantages of globalisation?
- Encourages producers and consumers to use division of labour in global supply chains and using economies of scale- increase in economic welfare
- more competitive markets through trade reduces level of monopoly supernormal profits- increases cost reducing innovations
- Drives faster economic growth leading to higher per capita incomes. Has reduces extent of extreme poverty
- Freer movement of labour, relieving labour shortages and promoting the sharing of ideas from diverse workforces
- Opening up of capital markets such as stock increases opportunities for developing countries to borrow money
- Increased awareness of the systemic challenges from climate change and effects of wealth/ income inequality
- Competitive pressures may prompt improved standards of gov. and better labour protection through improved monitoring by international organisations.
What are 7 disadvantages of globalisation?
- Rising inequality/ relative poverty- gains will be unequal leading to growing political and social tensions if inequality of income and wealth increases.
- Threats of the global commons e.g. irreversible damage to ecosystems
- Greater exploitation of the environment e.g. increased production of raw materials
- Macroeconomic fragility- external shocks can rapidly spread to other centres( systemic risk)
- Trade imbalances- can lead to increase in protectionist tensions, wider use of tariffs and quotas
- Workers may suffer structural unemployment as a direct result of the out-sourcing of manufacturing to lower-cost countries
- Dominant global brands- businesses with dominant brands and superior technologies may squeeze out smaller local producers.
What are the impacts of globalisation on the UK economy?
- Expanded choice and higher consumer surplus
- effects on retail prices and the rate of inflation
- impact of UK firms relocating to lower wage economies
- impact of net inward migration on real wages and UK gov spending/ tax revenues
- impact of inward investment into UK on employment
- impact of share prices and profits of UK companies
What are external shocks?
Events that come from outside a domestic economic system. Negative external shocks create instability and can lead to persistent periods of weaker economic growth, higher unemployment, falling real incomes and rising poverty.
Positive external shocks can include the emergence of and widespread adoption of technologies used by businesses and households in may countries.
Give 8 examples of external shocks in a globalised world.
- global financial crisis 2007-2009
- Eurozone economic crisis
- volatile world commodity prices
- growth slowdowns in emerging nations
- international and regional trade and investment deals
- currency volatility and policy changes e.g. devaluation
- extreme weather e.g. flooding
- Geo-political uncertainty and risks from terrorism
When does absolute advantage occur?
It occurs when a country can supply a product using fewer resources than another nation. If a country using the same factors of production can produce more of a product, then it has absolute advantage.
When does comparative advantage exist?
- the relative opportunity cost of production for a good or service is lower in one nation than another
- a country is relatively more productively efficient than another.
- The basic rule is to specialise your scarce resources in the goods and services than you are relatively best at.
- This opens up gains from specialisation and trade which then leads to a more efficient allocation of resources.
What are the key assumptions behind the theory of comparative advantage and trade?
- constant returns to scale- i.e. no economies of scale.
- Perfect factor mobility between industries.
- No trade barriers such as tariffs and quotas which artificially change the prices at which trade occurs.
- Low transportation costs to get products to market- high logistics costs might erode comparative advantage.
- No significant externalities from production and or consumption of the products being traded
What are the 4 main gains from trade?
- Allows for deeper specialisation and benefits from economies of scale
- Free trade increases market competition and choice and also drives higher product quality for consumers
- Increased market contestability reduces prices for consumers leading to higher real incomes
- Trade can lead to a better use of scarce resources e.g. sustainable technologies.
What are the possible impacts of trade on economic efficiency?
Allocative efficiency- competition from lower-cost import sources drives market prices down + reduces level of monopoly
Productive efficiency- specialising and selling in larger markets encourages increasing returns to scale
Dynamic efficiency- more innovative businesses who invest more in R+D, increase in human capital of workforce, increase in labour productivity
X-inefficiency- Competition provides discipline on businesses to keep unit costs under control to remain price competitive + profitable.
What are the main drawbacks of trade and specialisation?
-Transport costs e.g. carbon emissions from increased food miles
- Negative externalities from both production and consumption
- risk of rising structural unemployment as trade patterns change
- Inequality, benefits from globalisation are unequally shared
- Pressure on real wages to fall in advanced and emerging economies
- Risks from global shocks e.g. the financial crisis.
What is the geographical pattern of trade?
The counties with whom businesses and people trade.
Intra-regional trade is trade between different countries in the same region- e.g. European Union, Africa, Asia.
Countries tend to trade most with other nations in close proximity- Gravity theory.
What is the geographical pattern of trade for the UK?
The EU taken as a whole is the UK’s main trading partner. In 2023, UK exports to the EU were 42% of all exports.
EU’s share of UK exports has been falling in recent years, US is now the UK’s biggest trading partner.
What is the commodity pattern of trade?
This is the type of products that are traded internationally. We can see the extent that ad country has a dependence on primary vs manufactured vs service imports
Many less economically developed countries rely heavily on primary product exports.
How can patterns of trade change in general?
As a country moves through different stages of development. As a nation develops, increasing complexity and more capabilities, then they become capable of supplying and then exporting a boarder range of products within the global economy. E.g. south korea.
What factors affect comparative advantage?
- Natural resources, quantity and quality
- unit wage costs
- infrastructure, rates of spending on it.
- non- price factors, aging population, net migration ect.
- import controls e.g. tariffs
- exchange rate.
What are the impacts of emerging economies on trade patterns
- Rising incomes means they can start to purchase more goods and services elsewhere in the world and over and above basic necessities. Can include increasing imports of commodities, pushes up prices.
- Attract MNC activity, as well as grow their own large companies which start to operate elsewhere in the world.
- Selling more medium to high value exports e.g. manufactured items and electronics, rather than commodities
or low-value-added items - Currency volatility in emerging markets can have a large impact on commodity prices and raw material prices
in other countries - Rising tension between developed economies e.g. US and emerging economies e.g. China, resulting in trade wars / protectionist measures.
What are the impact of trade blocs and bilateral trading agreements on trade patterns?
A trade bloc consists of a number of countries that agree to trade with each other with reduced or no trade barriers (such as tariffs or quotas). There are varying degrees of integration and types of trade bloc:
* Preferential trade area – there is reduced protectionism on a number of select goods/services amongst the countries involved
- This could just be between 2 countries i.e. bilateral
* Free trade area – there is completely free trade between the countries involved, but each country can set their own trade restrictions on countries outside of the agreement
- Examples include USMCA and EFTA
* Customs Union – there is completely free trade between the countries involved and they all agree to impose
the same trade restrictions on other countries as each other.
- they often lead to more intra-regional trade (i.e. within the trade bloc itself) and less inter-regional trade (i.e. trade between
region / blocs). This may mean that countries do not always gain the benefits from specialising according to their comparative advantage. There may be trade creation at the expense of trade diversion.
What are the impact of changes in relative exchange rates on trade patterns?
A strong currency (i.e. one that requires a lot of other currencies to buy it) makes exports appear relatively more expensive and imports appear relatively cheaper. A weak currency (i.e. one that does not require a lot of other
currencies to buy it) makes exports appear relatively cheap and imports relatively expensive. Exchange rates can therefore affect the pattern of trade.
What are the terms of trade?
- The terms of trade (ToT) measures the relative prices of a country’s exports compared to the cost (prices) of
imported goods and services. - Terms of trade is the ratio of the weighted price index for exports to the price index for imports
- The terms of trade can be interpreted in words as the amount of imported goods and services an economy can purchase per unit of exported goods and services.
- A rise in the price index for exports of goods and services improves the terms of trade and this means that a country can buy more imports for any given level of exports.
- Terms of trade is one measure of a country’s trade competitiveness – another is relative unit labour cost
What is the formula for calculating the terms of trade?
Terms of Trade (ToT) index = (price index for exports) / (price index for imports) x 100
What does an improvement in the terms of trade mean?
An improvement in the terms of trade mean that export prices are rising relative to import prices.
- the ToT has improved when export prices rise because fewer goods have to be
exported to buy a certain amount of imports.
What factors influence the terms of trade?
- Global (world) prices for raw materials and components
- Rising oil prices improve terms of trade for oil exporters
o Rising gas prices worsen terms of trade for energy importers - The exchange rate:
- A stronger currency lowers import prices – leading to improved terms of trade
- A weaker currency increases import prices – leading to reduced terms of trade
- Import tariffs and other trade barriers such as quotas
- An import tariff (tax) increases the price of imports, other factors remaining the same, this worsens
the terms of trade - Domestic and global inflation rates
- Changing factor endowments
How does a fall in the relative prices of imported technology cause an improved terms of trade? evaluate.
- This gives a country the chance to import capital goods more cheaply which will then help to increase labour productivity & their long-run
competitiveness. - Capital-intensive production e.g. using robotics may not necessarily create many new jobs & extra incomes.
How does a rise in the unit export prices of a country’s exports cause and improvement in the terms of trade? Evaluate.
- Rising export prices cause an increase in revenues from exports. This is an injection into the circular
flow and improves the balance of payments on current account. It also increases the stock of foreign exchange reserves. - There are risks of demand-pull inflation from a surge in export revenues. Inflation hits hardest lower income families i.e. it has a regressive effect on the distribution of income.
Give 5 examples of regional trading blocs.
- USMCA - United States-Mexico-Canada agreement (which replaced NAFTA in 2018)
- Mercosur – Brazil, Argentina, Uruguay, Paraguay and Venezuela
- Association of Southeast Asian Nations Free Trade Area – known as ASEAN
- Common Market of Eastern and Southern Africa includes Zambia, Rwanda, Swaziland, Ethiopia and Kenya
- Trans-Pacific Partnership (TPP) – an agreement negotiated between Australia, Brunei, Chile, Canada, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam (the USA under Trump dropped out).
What are free trade areas? Give some examples.
A free trade area (FTA) is where there are no import tariffs or quotas on products from one country entering another.
Current examples of free trade areas include:
* EFTA: European Free Trade Association consists of Norway, Iceland, Switzerland and Liechtenstein
* USMCA: Revised trade agreement between the USA, Mexico & Canada
* South Asian Free Trade Area between Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka
* African Continental Free Trade Area: New agreement with 55 nations
* Pacific Alliance: Chile, Colombia, Mexico and Peru
What is a bilateral trading agreement? Give examples
- It is the exchange of goods between two economies/ groups of economies promoting trade in goods and services and flows of foreign investment. The two countries will reduce or eliminate import tariffs, import quotas, export restraints and other non-tariff trade barriers to encourage trade and investment.
- EU-Japan Economic Partnership Agreement
- ASEAN – China Free Trade Area
- EU-South Korea Free Trade Deal
- China-Australia Free Trade Agreement
How would free trade areas stimulate economic growth in Sub-Saharan Africa?
- A free trade agreement can - in
theory – lead to faster
economic growth because it
encourages nations and
businesses to specialise & then
trade on the basis of their
developed comparative
advantage. - The absence of import tariffs
and other barriers reduces the
costs of trading goods and
services across borders. E.g.
Kenya may trade more with
Ethiopia – this is known as
intra-regional trade and is low
within Sub Saharan Africa. - As a result, the prices of traded
goods and services are likely to
fall since trade stimulates
increased competition and can
therefore cause improvements
in labour productivity and also
helps businesses to achieve
internal economies of scale - This leads to an increase in the
real incomes of consumers
which then means that they
can afford to increase demand
and consumption. Lower prices
are a welfare gain for
consumers, economists call this
trade creation. - A likely effect of this is to
stimulate increased output
which will then lead to an
increase in the demand for
labour (a derived demand) and
also capital investment e.g. in
trade infrastructure such as
new ports and better roads. - This means that the free trade
agreement could cause a rise in
capital spending which will
then cause an outward shift of
long run aggregate supply. In
this way, countries involved
may see an increase in their
potential growth rate.
What are the gains of a new African continental free trade area. Evaluate
- Lower prices for consumers
- Economies of scale for suppliers
- Increased competition in markets
- Improved allocative efficiency - i.e. a gain in economic efficiency
EV; - Lost tariff revenues for national governments
- Financing costs for building the necessary trade infrastructure
- Regulatory reforms for common product standards will add costs for businesses
- Local SME’s may suffer a loss of profit / jobs when facing stronger competition
What is a customs union?
A customs union comprises a group of countries that agree to:
* Abolish tariffs and quotas between member nations to encourage free movement of goods and services.
* Adopt a common external tariff on imports from non-members countries. In the case of the EU, the tariff
imposed on, say, imports of South Korean TV screens will be the same in the UK as in any other EU country
* Preferential tariff rates apply to trade agreements that the European Union has entered into with third
countries or groupings of third countries
How do trading blocs differ from custom unions?
- A trading bloc is essentially an agreement between countries to lower their import tariffs and perhaps extend this to reducing the use of non-tariff barriers to trade. In a free trade area, each country continues to be able to set their own distinct external tariff on goods imported from the rest of the world.
- A customs union is different from a free trade area, in which means no tariffs are charged on goods and
services moving within the area. It adds on a common external tariff (CET) on all products flowing from
countries outside the customs union, unless specific trade deals have been established. Revenues from import tariffs are combined for all member states. The countries in a customs union negotiate as a bloc when discussing trade deals with countries outside the union. A good example is the recently introduced bilateral trade deal between the European Union and Japan.
In what way does a customs union differ from a single market?
- A single market is a stronger and deeper form of integration than a customs union.
- A single market involves the free movement of goods and services, capital and labour.
- In addition to a common external tariff, a single market also tries to cut back on the use of non-tariff barriers such as different rules on product safety and environmental standards replacing them with a common set of rules governing trade in goods and services within the common market.
What is common (single) markets?
Common markets represent a deeper integration between participating countries. They usually extend beyond free trade in goods and services to include free movement of labour across borders and the relaxation of capital controls.
What are the 4 key freedoms that the EU single market is built on?
- Free trade in services
Free movement of
capital. Free Trade in Goods: Businesses can sell their products anywhere in EU member states and consumers can buy where they want with no penalty - Mobility of Labour: Citizens of EU states can live, study and work in any other EU country
- Free Movement of Capital: Financial capital can flow freely between member states and EU citizens can use financial services such as insurance in any EU state.
- Free Trade in Services: Services such as pensions, architectural services, telecoms and advertising can be offered in any EU member state.
What are the possible economic advantages of joining the EU single market?
- Import-tariff free access to a single market of nearly 50 million people. Opportunity cost to exploit economies of scale- lower LR unit costs
- Easier to access FDI from inside/ outside the EU; Inward FDI can lift trend growth and raise factor productivity.
- Access to EU structural funds - made available to poorer EU nations; Investment helps improve infrastructure and potential output.
- Better access to EU capital markets; Eu companies can raise investment funds from bond and capital markets.
- Discipline of intense competition from being inside the EU single market. Businesses must become more cost efficient and improve dynamic efficiency.
What is a monetary union?
- It is a form of economic integration beyond participation in a single market.
What are the risks from joining a single currency? `
- A country’s central bank loses the freedom to set monetary policy interest rates solely to meet macro
objectives such as lowering inflation (higher interest rates) or preventing a recession (lower interest rates) - Joining a common currency means that the option of a managed depreciation / devaluation of the exchange rate to help improve price competitiveness in overseas markets is also lost. Instead to become more price competitive, a government may have to maintain deflationary fiscal policies to achieve an internal devaluation of the price level
- There are also adjustment costs when switching currencies including menu costs and the risk that some
retailers will increase prices when the currency is switched to make extra profit in the short term.
What are the conditions necessary for the success of a monetary union?
Conditions necessary for the success of a monetary union
These conditions are associated with the concept of an optimal currency area (OCA). An Optimal Currency Area (OCA)
works best when:
* Countries are highly integrated i.e. a high percentage of trade is with fellow currency union nations. A good example is Slovenia. Well over 80 percent of their trade is done with fellow members of the Euro Zone.
* Where each economy has a flexible labour market to cope with external shocks. Flexibility might include:
- Flexibility in real wages and salaries during an economic cycle
o Workers with adaptable skills to reduce the risk of structural unemployment
- High geographical mobility within & between countries
- Flexible employment contracts including short-term job contracts
* When the effects of interest rate changes or a movement in the exchange rate have a broadly similar effect on businesses and households from country to country.
* When nations are willing to make fiscal transfers between each other & provide financial support during
difficult economic times.
What is trade creation?
Trade creation occurs when countries agree a trade deal that lowers tariffs between them (this may extend to a formal customs union). As a result of a reduced tariff, consumers in a participating nation can now source imports from a lower cost country which leads to lower prices and a rise in real incomes. Trade creation can be illustrated using a trade liberalisation diagram.
What is the role of the WTO in trade liberalisation?
A key principle of the WTO is that of multilateral trade. The WTO describes itself as having 4 roles: conductor, tribunal, monitor and trainer.
- They believe that- Global rules of trade provide assurance and stability. Consumers and producers know they can enjoy secure supplies and greater choice of the finished products, components, raw materials and the services they provide.
Explain the conductor role of the WTO.
Members of the WTO have come up with a set of rules that apply to international trade; the WTO ensures that these rules are followed. The WTO organises ‘rounds’ of negotiations to be able to develop new rules (e.g. in response to the rise of trade in services), but these can take well over a decade to be agreed upon, as there needs to be a consensus
amongst members. The latest round is known as the Doha round, and was launched in 2001. Any agreements reached are then ratified by domestic parliaments.
Explain the tribunal role of the WTO.
This role involves settling disputes between members. Member are encouraged to sort out disputes by themselves, but occasionally the WTO needs to convene a panel of experts.
Explain the monitor role of the WTO.
The WTO reviews the trade policies of its members to make sure that WTO rules are being applied fairly and consistently.
Explain the trading role of the WTO.
The WTO provides training to government officials in (mostly) developing countries, to help them engage in trade with other WTO members.
What are the conflicts between trade blocs and the WTO?
- Trade blocs engage in free trade with their members (which is in line with WTO aims) but often put up trade restrictions / barriers against non-members (which is against WTO aims). All WTO members are also currently members of at least
1 regional trade agreement. - The WTO has said that regional trade agreements can, however, often support the WTO’s aims. Agreements on a local or regional scale often go beyond what might have been possible in multilateral trade discussions, and can pave
the way for new policies to be rolled out to all WTO members. Agreements on intellectual property, environmental
protection and investment at regional level have informed WTO discussion on a multilateral level.
What are the main reasons for protectionism?
- Infant industry argument- protecting emerging industries until they have achieved economies of scale.
- Sunset industry argument – use tariffs to slow the decline of old sectors and limit structural unemployment
- Diversify an economy thought to be too dependent on one product (e.g. primary product dependence)
- Raise tax revenues - this is important for many developing countries with a limited domestic tax base
- Improve the trade balance & preserve jobs in key industries
- Prevention of unfair trade practices such as import dumping – where excess output is sold in another country at a price below costs of production. Protectionism can be a retaliatory response to another country’s policies, for example, poor environmental or labour standards.
- Protect strategic industries – these might include national defence, electricity generation, supply of basic foodstuffs
Why is import dumping a reason for protectionism?
- Dumping happens when firms sell exports at below costs or below normal prices in the home market.
- The former implies predatory pricing – which is illegal
- The latter implies a strategy of price discrimination – this is not illegal.
- A topical recent example is the global steel industry. China’s steel industry is experiencing significant excess
capacity and China has been accused of dumping its steel products on the European Union, selling them for
less than they are worth. That makes it harder for EU steel producers to compete - Anti-dumping duties (or tariffs) raise the price of a product to help protect local producers.
What are antidumping tariffs? Give examples.
Anti-dumping tariffs are allowed under WTO rules when cases of dumping have been established. There are three
main options when introducing an anti-dumping import duty
1. An ad valorem duty – % of the net EU frontier price. This is the most common import duty.
2. A specific duty – a fixed value e.g. €100 per tonne of a product
3. A variable duty – a minimum import price (MIP). Importers in the EU do not pay an anti-dumping duty if the foreign exporter’s export price to the EU is higher than the MIP. The lesser-duty rule is that duties can’t exceed the level needed to repair the harm done to European industry by the unfair dumping practices – currently between 9-13% for a range of steel products imported into the EU from China.
What are the different types of trade restriction?
- Import tariffs
- Import quotas
- Subsidies; Payments by the government to suppliers that reduce their costs. The effect of a subsidy is to increase supply and therefore reduce the market equilibrium price.
- Rules of origin; e.g. a country might set a minimum percentage for locally sourced components.
- Migration controls
- Managed currencies
Evaluate the impact of import tariffs
- Import tariffs are taxes on imports and they aim to protect domestic suppliers from overseas competition by increasing the relative price of imports in the home market thereby causing a switch of spending towards domestic producers.
- Import tariffs also generate tax revenues for the government and may – over time – lead to an improvement in a nation’s trade balance.
- Expansion of domestic output
- Contraction in domestic demand
- Fall in vol. of imports
- Increase in gov. tax revenues
- Increase in domestic producer revenue
- Fall in foreign producer revenue
- Consumer surplus falls
- Overall economic welfare falls.
What are the impacts of an import quota on consumers?
- Consumers likely to face a higher price in the market because of limit on import products. Less competition in the market might also affect the quality of products available – impact on utility.
- Consumers who work for domestic firms may benefit from higher employment and wages Import cap might stimulate increased investment in alternatives.
What is the impact of an import quota on domestic producers?
Domestic producers benefit from the cap on imports – this increases the market price and makes it more profitable for them to stay in / enter the market.
- Quota is a barrier to trade, might encourage domestic firms to become less productively efficient Some producers hampered by scarce supply of higher quality overseas imports – hurts their
competitiveness.
What is a domestic subsidy?
- A domestic subsidy is any form of government financial help to domestic businesses
- The subsidy helps firms to lower their costs and thus become more competitive in home and overseas markets
- Export subsidies are financial incentives to sell products in overseas markets at a profit.
What are the impacts of import quotas on the government?
- Improved external balance from the reduction in imports and an expansion of GDP from the
increase in domestic production. - No immediate tax revenues from an import quota - a contrast with an import tariff.
What are the impacts of a domestic subsidy on domestic producers?
- Domestic producers gain from the subsidy – they get the world price + a subsidy payment. Higher revenues will lift profits and might therefore lead to a higher share price. Increased output creates the possibility of economies of scale.
- Risk of a dependency culture emerging – i.e. businesses relying on the subsidies rather than taking their own steps to become more
competitive by increasing productivity, eliminating inefficiency and accelerating the pace of process/product innovation.
What are the impacts of a domestic subsidy on consumers?
- Assuming that the subsidy is not large enough to change the world price, not direct effect on the prices that consumers pay for their products.
- They may face higher taxes if expensive subsidies take up a high percentage of government spending.
What are the impacts of domestic subsidies on the government?
- Subsidy can be an effective non-tariff barrier to reduce the volume of imports by encouraging domestic production.
- Unlike a tariff, a subsidy doesn’t generate tax revenues directly. Increased spending on subsidies may then cause a growing budget deficit.
What are some of the types of non-tariff barriers?
- Intellectual property laws e.g. patents and copyright protection.
- Technical barriers to trade including labelling rules and stringent sanitary standards. These rules and regulations increase product compliance costs and act a friction cost for importers.
- Preferential state procurement policies – where government favour local producers when finalizing contracts for state spending.
- Domestic subsidies – aid for domestic businesses facing financial problems e.g. subsidies for car
manufacturers or loss-making airlines. - Financial protectionism – e.g. when a government instructs banks to give priority when making loans to domestic businesses
- Murky or hidden protectionism - e.g. state measures that indirectly discriminate against foreign workers, investors and traders.
- Managed exchange rates – government intervention in currency markets to affect relative prices of imports
and exports.
What are the main drawbacks of protectionism?
- Resource misallocation – leading to a loss of economic efficiency
- Dangers of retaliation – and risks of a persistent trade war as countries engage in tit for tat responses.
- Potential for more corruption - tariffs are higher in less democratic countries, revenues can be appropriated.
- Higher prices for domestic consumers – this have a regressive impact on poorer people / communities.
- Increased input costs for home producers – this damages competitiveness for businesses that require key.
imported component parts and raw materials that are subject to an import tariff or stringent quota. - Barrier to entry – protectionism reduces market contestability and thereby increases monopoly power.
Analyse the impact of a tariff on consumer and producer surplus.
- Import tariffs tend to be good for domestic producers and the government but bad news for domestic consumers of a product to which a tariff is applied. Tariffs increase the price for domestic consumers – this leads to a contraction in demand and leads to lower consumer surplus.
What is the impact of protectionist policies on domestic producers?
- Producers benefit initially from an import tariff – they are protected from lower priced imports and can expect an increase in output at a higher price which increases their revenues and operating profits.
- Possible X-inefficiencies because of reduction in intensity of market competition. Other producers affected e.g. a tariff on steel raises the cost of car and construction companies.
What are the impacts of protectionist policies on foreign producers?
- Import tariff is a barrier to trade and squeezes demand leading to lower revenues and profits.
- Producers may be able to shift production / exports to countries or regions where import tariffs are lower.
What are the impacts of protectionist policies on consumers?
- Consumers face higher prices after the tariff – leading to a fall in real incomes. May affect lower income households more – regressive?
Loss of consumer choice (lower utility). - Impact on demand depends on the price elasticity of demand for the affected product. Tariffs on essential items such as foodstuffs
tend to have a lower price elasticity of demand.
What are the impacts of protectionist policies on the government?
- Government tax revenues rise initially from having import tariffs – rising GDP and increasing profitability of suppliers.
- Adverse effects of possible retaliatory tariffs on other industries. Slower economic growth from higher inflation.
What is the current account made up of?
(1) Net balance of trade in goods
(2) Net balance of trade in services
(3) Net primary income (includes interest, profits, dividends and migrant remittances)
(4) Net secondary income (includes transfers i.e. contributions to EU, military aid, overseas aid)
What is the capital account? What does it include?
The capital account of the balance of payments is a small element of it. The main items included are the following:
* Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be
international buying and selling of land by businesses)
* Debt forgiveness/cancellation (forgiving debt is counted as a negative in this account)
* Capital transfers of ownership of fixed assets (i.e. international death duties)
What is the financial account? What does it include?
- The financial account includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents – this includes:
(1) Net balance of foreign direct investment flows (FDI)
(2) Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
(3) Balance of banking flows (e.g. hot money flowing in/out of banking system)
(4) Changes to the value of reserves of gold and foreign currency
What is FDI?
- FDI is investment from one country into another (normally by companies rather than governments) that
involves establishing operations or acquiring tangible assets, including stakes in other businesses - Foreign direct investment flows:
o Inward investment is a positive for the UK accounts
§ E.g. an overseas business decides to build a manufacturing factory in the UK
§ A foreign retail firm invests to open new stores in the UK - Outward investment is a negative for the UK financial account of the balance of payments
o Investment made overseas by UK businesses
What are portfolio investment flows?
- Portfolio investment happens when people / businesses from one country buy shares or other securities such
as bonds in other nations. - For example:
o A UK investor buys some shares in Google (this is a portfolio investment outflow for the UK accounts)
o A German investment bank might buy some of the sovereign debt issued by the UK government
(this counts as a portfolio investment inflow for the UK)
What are the causes of deficits on the current account?
- Poor price and non-price competitiveness which is perhaps the result of:
o Higher inflation than trading partners over a lengthy period of time
o Low levels of capital investment and research and development spending
o Weaknesses in design, branding and product performance – affecting non-price competitiveness - Strong exchange rate affecting demand for exports and imports
o A high currency value increases the overseas prices of exports - leading to a fall in demand
o Appreciating currency also makes imports cheaper – leading to rising import demand from
consumers - Recession in one or more major trade partner countries
o Recession cuts value of exports to these countries - Volatile global prices (e.g. soft and hard commodities)
o Exporters of primary commodities might be hit by a fall in global prices and a therefore direct fall in
the value of their export earnings.
o Importing nations could be hit by higher world prices for oil and gas, raw materials.
o If demand for imports is price inelastic (i.e. Ped<1), then increased world prices will cause higher
spending on imports. - Strong domestic economic growth can also be a cause of a widening current account deficit:
o Rising demand for imported raw materials and component parts used by domestic industries.
o Increased demand for and spending on imported capital equipment / new technologies.
o Rising demand for luxury imported goods (i.e. products with a positive income elasticity of demand).
What are the structural causes of the current account deficit?
(1) Relatively low productivity / high unit labour costs
(2) Insufficient investment in capital which limits a nation’s export capacity
(3) Low levels of national saving
(4) Long term declines in the real prices of a country’s major exports
What are the consequences of a current account deficit?
- A loss of aggregate demand if there is a trade deficit (M>X) causes weaker real GDP growth and might lead to reduced living standards and rising unemployment.
- Big current account deficits will usually cause the currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade
- Some countries running current account deficits may choose to borrow to achieve a financial account surplus but this increase in external debt carries risks especially if interest rates rise
- Unsustainable current account deficits can ultimately lead to a loss of investor consequence, leading to capital flight and a possible currency / balance of payments crisis.
What is a current account surplus?
- A current account surplus means that there is a net injection of income into a country’s circular flow. Surplus nations are also known as creditor countries and – other things being the same – a surplus will lead to an accumulation of foreign exchange e.g. from rising export sales or an increase in net primary and secondary income.
What are the main causes of a current account surplus?
- A large and persistent surplus of savings (S) over investment (I) for households, firms and the government. In
these countries, consumption could be higher, and this would help to rebalance trade - A large positive gap between exports and imports, when net income balance and net transfers are small
- An export surplus may be the result of high world prices for exports of commodities such as oil and gas.
- A surplus on the current account would allow a deficit to be run on the financial account.
o For example, surplus foreign currency can be used to fund investment in assets located overseas
o For example, some current account surplus countries have large sovereign wealth funds - Current account surplus countries nearly always have a strong exchange rate as a result
What are expenditure switching policies?
o These are policies designed to change the relative prices of exports and imports
o For example - an exchange rate depreciation ought to improve the price competitiveness of exports
and also make imports more expensive when priced in a domestic currency
o Import tariffs are also designed to create expenditure-switching effects
What are expenditure reducing policies?
o These are policies designed to lower real incomes and AD and thereby cut demand for imports
o E.g. higher direct taxes, cuts in government spending or an increase in monetary policy interest rates
Give examples of expenditure switching policies
- Depreciation of the exchange rate; Reduces relative price of exports &
makes imports more expensive
;Risk of cost-push inflation – which
erodes competitive boost + fall in
real incomes - Import tariffs; Increases the price of imports & makes domestic output more price competitive;
Risk of retaliation from other
countries if import tariffs are used
as BoP policy
-Low rate of inflation (perhaps
deflation); Keeps general price level under control and makes exports more competitive; Risks from deflation as a way of achieving internal devaluation – including lower investment.
Give examples of expenditure switching policies and evaluate.
-Increase in income taxes; Reduces real disposable incomes causing falling demand for imports;
Cut in living standards and risk of
damage to work incentives in
labour market.
- Cuts in real level of government
spending; Lowers aggregate demand, firms may look to export their spare capacity; Damage to short term economic growth, risks that austerity hits investment.
To what extent is the current account deficit corrected by changes in a country’s exchange rate?
- In theory, a large current
account deficit leads to an outflow of currency from the circular flow which then causes an exchange rate depreciation (within a floating currency system). And a weaker currency in theory helps bring about an adjustment of the trade
balance as exports become more competitive in overseas markets and imported goods and services appear more expensive in domestic markets. - In reality, the extent to which a current depreciation helps to improve the trade balance depends on a number of factors.
What is the J curve effect?
- In the short term, a currency depreciation may not improve the current account of the Balance of Payments
- This is because the price elasticities of demand for exports & imports are likely to be inelastic in the short term
- Initially the quantity of imports bought will remain steady in part because contracts for imported goods are already signed. Export demand will be inelastic in response to the exchange rate change as it takes time for export businesses to increase their sales following a fall in prices.
- Earnings from selling more exports may be insufficient to compensate for higher total spending on imports.
- The balance of trade may therefore initially worsen. This is known as the ‘J-Curve’ effect
- Providing that the price elasticity of demand for imports and exports are greater than one, then the trade
balance will improve over time. - This is known as the Marshal-Lerner condition.
How do free floating exchange rate systems correct trade imbalances?
- if, say, a country has a trade deficit, then demand for exports will be low which in turn causes reduced demand for the currency. This leads to a depreciation of the currency, thus making exports more price competitive and stimulating
demand for them.
Why does a trade deficit matter?
o Run up large external debts and are reliant on foreign capital
o May decide to switch towards using protectionist policies
o Deficits can lead to a fall in relative living standards over time if economic growth slows down.
Why does a trade surplus matter?
o Are saving more than they spend, thereby depressing global economic demand and growth
o May be adopting a policy to keep their currency deliberately under-valued
o Might be under-consuming (thus affecting living standards) and allocating domestic scarce resources to exporting overseas rather than allowing higher levels of domestic consumer spending
What are the main exchange rate systems?
- A free-floating currency where the external value of a currency depends wholly on market forces of supply and demand – there is no central bank intervention
- A managed-floating currency when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives
- A fixed exchange rate system e.g. a hard currency peg either as part of a currency board system or
membership of the ERM Mark II for those EU countries eventually intending to join the Euro.
What are the characteristics of a free floating exchange rate?
- The external value of the currency is set by market forces
o The strength of currency supply and demand drives the external value of a currency in the markets
o The currency can either appreciate (rise) or depreciate (fall) - There is no intervention by the central bank
o Central bank allows the currency to find its own market level
o It does not alter interest rates or intervene directly by buying/selling currencies to influence the price - There is no target for the exchange rate
o External value of currency is not an intermediate target of monetary policy (i.e. interest rates not set
to influence the currency)
What factors cause changes in a free floating exchange rate?
- Trade balances – countries that have strong trade and current account surpluses tend (other factors remaining the same) to see their currencies appreciate as money flows into the circular flow from exports of goods and
services and from investment income
* A good ‘rule of thumb’ is that demand for exports tends to affect the demand for currency curve
(because if people overseas want to buy UK exports they will need to buy £s in order to pay for
them), whereas demand for imports tends to affect the supply of currency (because we need to
supply £s to the foreign exchange market to buy foreign currencies to pay for imports) - Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment (i.e. long term capital flows) from overseas will see an increase in currency demand and a rising exchange rate.
- Portfolio investment – strong inflows of portfolio investment into equities and bonds from overseas can cause a currency to appreciate
- Interest rate differentials - countries with relatively high interest rates can expect to see ‘hot money’ (i.e. short term capital) flowing coming in and causing an appreciation of the exchange rate.
- Speculation – this is responsible for much of the day-to-day volatility
What are the impacts of higher interest rates on a floating exchange rate?
- Rise in policy interest rates by central bank
- Currency more attractive for investors
- Attracts inflows of short term hot money
- Causes outward shift in currency demand
- Currency appreciates in value in a floating exchange system.
What are the impacts of a fall in export demand on a floating exchange rate?
- Recession in a trading partner
- Causes a fall in export sales
- Worsening of trade balance
- Inward shift of currency demand
- Currency will depreciate
Give the characteristics of a managed exchange rate.
- Currency is usually set by market forces
o Central bank gives a degree of freedom for market exchange rates on a daily basis. - A central bank may intervene occasionally to influence the price:
o Buying to support a currency (i.e. selling their FX reserves)
o Selling to weaken a currency (i.e. adding to their FX reserves)
o Changes in policy interest rates to affect hot money flows i.e. increase rates to attract inflows of
money into the banking system looking for a favourable rate of return - In a managed floating system, the currency becomes a key target of monetary policy
o Higher exchange rate might be wanted to control demand-pull and cost-push inflationary pressures
o A government might want to engineer a competitive devaluation to improve export competitiveness.
What are the policy tools for managing floating exchange rates?
- Changes in monetary policy interest rates
o Changes in interest rates e.g. lower interest rates to depreciate the exchange rate
o Causes movements of “hot money” banking flows into or out of a country - Quantitative easing
o Increase liquidity in the banking system leading to lower interest rates, usually causes outflow of
money – depreciation of the exchange rate - Direct buying / selling in the currency market (intervention)
o Direct intervention in the currency market
o Buying and selling of domestic / foreign currencies - Taxation of overseas currency deposits and capital controls
o Taxation of foreign deposits in banks cut the profit from hot money inflows
o Controls on the free flow of capital into and out of a country
How can a central bank influence the value of a currency? - managed floating
- In a managed floating currency system, one way that a central bank can influence the external value is by changing interest rates.
- E.g. if they want to achieve a depreciation, they might opt to lower their main monetary policy interest rate.
- A fall in IRs reduces the returns on overseas money held in a country’s banking system. The real return may become negative.
- As a result, lower interest rates might cause an outflow of short-term hot money from commercial banks to other countries.
- This will cause an outward shift of the supply curve for the currency as investors look for currencies with higher expected returns
- In this way, assuming other central banks have kept their rates constant, a fall in interest rates might lead to a depreciation.
What are competitive devaluations/ dirty floating?
- Competitive devaluations occur when a country deliberately intervenes to drive down the value of their currency to provide a competitive lift to demand, output and jobs in their export industries.
- They may try this when faced with a deflationary recession or perhaps to attract extra foreign investment
- For nations with persistent trade deficits and rising unemployment, a competitive devaluation of the exchange rate can become an attractive option - but there are also risks involved
- Devaluing an exchange rate can be seen by other countries as a form of trade protectionism that invites some form of retaliatory action such as an import tariff
- Cutting the exchange rate makes it harder for other countries to export negatively affecting their growth rate which in turn can damage the volume of trade that takes place between nations
- Competitive devaluations of a currency go against the principles of trade based on comparative advantage
What are the characteristics of a fixed exchange rate system?
- The government / central bank fixes the currency value
o External value is pegged to one or more currencies (known as the anchor currency)
o The central bank must hold sufficient foreign exchange reserves in order to intervene in currency
markets to maintain the fixed peg
§ i.e. they may need to buy domestic currency using foreign currency to push up the value of
their domestic currency
§ holding foreign exchange reserves can create an opportunity cost - Pegged exchange rate becomes official rate
o Trade takes place at this official exchange rate
o There might be unofficial trades in shadow currency markets - Adjustable peg
o Occasional realignments may be needed
o E.g. a devaluation or revaluation depending on economic circumstances – the currency may have
drifted from the fundamental value
How do exchange rates impact business activity?
- Price of exports in international markets
- Costs of goods bought from overseas
- Revenues and profits earned overseas
- Converting cash receipts from customers overseas
Who benefits from lower exchange rates?
- Businesses exporting into international markets
- Businesses earning substantial profits in overseas currencies
Who loses out from a lower exchange rate?
- Businesses importing goods and services
- Overseas businesses trying to compete in the domestic market.
What does the mnemonic to remember impact of lower exchange rate on imports
SPICED- Strong Pound Imports Cheaper Exports Dearer
What are the impacts of a currency depreciation on inflation?
- Higher import prices feed into increased consumer prices – may help a country to avoid deflation and it also lowers real interest rates. But higher inflation threatens real living standards especially for groups with weak bargaining power in the labour market who are unable to bid for higher wages.
What are the impacts of a currency depreciation on economic growth?
A weaker currency is usually a stimulus to GDP growth e.g. from higher net exports but much depends on the price elasticity of demand for exports. Also, many exports require imported
components which will have become more expensive as a result of the depreciation.
What are the impacts of a currency depreciation on unemployment?
A more competitive currency will help to increase domestic production and perhaps create a
positive export multiplier effect which will further stimulate aggregate demand and jobs. There
might also be an upturn in tourism / demand from overseas students to come to a country’s universities.
What are the impacts of a currency depreciation on the balance of trade?
- Dependent on price elasticities of demand for X&M – possible J curve effect in the short run. The impact on export sales also depends in part on the strength of GDP growth in key export markets.
What are the impacts of a currency depreciation on business investment?
Should help to improve profitability e.g. a fall in the external of the £ increases the overseas earnings of UK plc in US dollars and Euros which will be now be worth more in £s.
What are the impacts of a currency depreciation on FDI?
- Depreciation of a currency makes a country’s FDI assets (i.e. investments abroad that are
denominated in foreign currency) appear more valuable when converted into the domestic
currency. Likewise, FDI liabilities (i.e. investments in the domestic economy from overseas,
denominated in the domestic currency) appear less valuable to overseas investors. This can
ultimately therefore reduce inwards FDI.
How might a currency depreciation affect international competitiveness?
- A depreciation is a fall in the external value of a currency inside a floating exchange rate system.
- E.g. the £ might fall from Euro 1.50 to Euro 1.20, a drop of 20%.
- As a result, exporters can reduce the foreign price of goods and services sold overseas.
- This makes UK exports relatively cheaper in overseas markets. Relative export prices fall leading to improved competitiveness.
- In addition, the UK price of imported products will increase as £1 buys fewer euros.
- A rise in import prices will make domestic producers in the UK appear relatively more competitive purely in cost and price terms.
What do the effects of a currency depreciation depend on?
- The variable length of time lags as consumers and businesses respond.
- The scale of any change in the exchange rate i.e. a 5%, 10%, 20%
- Whether the change in a currency is temporary or longer-lasting
- The coefficients of price elasticity of demand for X&M (relate this back to the Marshall-Lerner condition)
- The size of any second-round multiplier and accelerator effects
- When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc.)
- The type of economy (e.g. the impact will be different for small developing nations v large advanced countries)
- The degree of openness of the economy to international trade i.e. measured by the value of trade as a % of GDP.
What are the advantages of floating exchange rates?
o Reduces the need for a central bank to hold large amounts of currency reserves
o Freedom to set monetary policy interest rates to meet domestic objectives
o May help to prevent imported inflation
o Insulation for an economy after an external shock especially for export-dependent countries
o Partial automatic correction for a current account deficit
o Less risk of a currency becoming significantly over/undervalued
What are the disadvantages of a floating exchange rate?
o No guarantee that floating exchange rates will be stable
o Volatility in a floating currency might be detrimental to attracting inward investment
o A lower (more competitive) exchange rate does not necessarily correct a persistent balance of
payments deficit - consider the J curve theory and also the importance of non-price competitiveness
What are the advantages of a fixed exchange rate?
o Certainty of currency value gives confidence for inward investment from overseas businesses
o Reduced costs of “currency hedging” for businesses such as airlines
o Currency stability helps to control inflation – i.e. it is a discipline on businesses to keep labour costs low
o A stable currency can lead to lower borrowing costs (i.e. lower yields on government bonds)
o Imposes responsibility on government macro policies e.g. to keep inflation under control
o Less speculation in the currency market if the fixed exchange rate is regarded by traders as credible
What are the disadvantages of a fixed exchange rate?
o Reduced freedom to use interest rates for other macro objectives such as stimulating GDP growth
o Many developing countries do not have sufficient foreign currency reserves to maintain a fixed exchange rate
o Difficult for countries to use a competitive devaluation of their fixed exchange rate – this creates
political tensions and might lead to a protectionist response
o Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation – this is damaging for
competitiveness and has regressive effects on poorer families
Compare floating and fixed exchange rates.
- Fixed rates may be optimal for developing countries wanting to control inflation
- Export-dependent economies may favour a managed floating rate e.g. to offset fluctuating world prices
- Not every country has the reserves to influence currency
- Choice of currency regime is hugely important for developing countries. Some countries have opted to join a monetary union e.g. the nineteen members of the Euro Zone.
What is competitiveness?
External competitiveness is the sustained ability to sell goods and services profitably at competitive prices overseas.
What are non-wage cost factors that companies can compete on?
- Environmental taxes e.g. minimum prices on carbon emissions
- Employment protection laws & health and safety regulations
- Statutory requirements for employer pensions
- Employment taxes e.g. employers’ national insurance costs
What are relative unit labour costs?
Unit labour costs are labour costs per unit of output. There is a simple formula for calculating unit labour costs:
Unit labour costs = total labour costs / total output
What are unit labour costs mainly determined by?
- Average wages / salaries in a country’s labour market – one measure tracked is the hourly labour cost of employing people in the labour market
- Labour productivity i.e. output per person employed or output per hour worked
How can relative unit labour costs be lowered?
- Relative unit labour costs will rise when
o A country’s exchange rate appreciates
o Wage costs rise relatively faster than other nations
o Labour productivity growth is relatively slower - Options for reducing relative unit labour costs
o Monetary policy interventions aimed at a currency depreciation e.g. a managed floating exchange rate
o Wage controls e.g. wage/pay freezes in the public sector
o Supply-side measures designed to raise labour productivity / efficiency across many industries
When will relative export prices rise
- There is an appreciation of the currency – causing export prices in overseas markets to rise
- There is a period of high relative inflation in one country compared to others – again this tends to make
exports appear more expensive when priced in an overseas currency - When export businesses experience higher costs e.g. arising from environmental taxes, increased minimum wages which leads them to raise price to protect their profit margins
- When exporters of goods and services are hit by import tariffs
What are the policies to improve competitiveness?
- Competitive exchange rate – perhaps involving a managed floating currency
- Competitive tax environment to attract inward investment and encourage new business start-up’s
- Investment in human capital to improve the quality of the workforce
- Increased research & development to drive a faster pace of innovation
- Stronger market competition to raise factor productivity and lower relative export prices
- Stable macroeconomic environment e.g. maintaining low inflation with steady economic growth to support
business confidence - Investment in critical infrastructure such as better road, air and rail links, improved ports, faster broadband and fibre-optic internet connections
How can fiscal policies be used to drive competitiveness?
- Subsidies to lower the cost of research e.g. in pharmaceuticals, life sciences, robotics and artificial intelligence
- Tax incentives can encourage the commercialisation of ideas e.g. ideas coming out of universities
- Lower employment taxes to stimulate skilled migration from overseas
- Lower capital gains taxes encourage small businesses / start-ups
- Special economic zones (SEZ) to attract research-intensive businesses
What is essential to being competitive in the long run?
- Macro competitiveness has micro foundations
o Competitive markets and innovative businesses
o Skills, aptitudes and attitudes within a diverse workforce
o Expanding opportunities for female entrepreneurs /refugees - Recognition that infrastructure and innovation are crucial: increasingly, competitiveness flows from smart urbanization
- Competitive advantage comes from having
o Globally scaled businesses close to or at the technological frontier
o A culture of innovative business start-ups / social entrepreneurs
o A financial system that can provide appropriate and affordable credit for education, business research and funding for business expansion - Reliance on currency depreciation / devaluation and wage cuts is not a sustainable competitiveness strategy
o The most competitive countries have the highest minimum wages
o There is a continuous global battle for the most talented workers
o Races to the bottom” e.g. in taxes and wages have a limited impact.
What are the benefits of international competitiveness?
o Improved living standards e.g. measured by real GNI per capita (PPP)
o Stronger trade performance from an increase in export sales
o Virtuous circle of economic growth
o Employment creation
o Higher government tax revenues
What are the problems that come from international competitiveness?
o Trade surpluses might invite a protectionist response
o Possible risks of demand-pull inflation
o Competitiveness might be achieved at the expense of growing inequality of income and wealth
o Higher productivity might be achieved at expense of a worsening work-life balance and increased
incidence of mental health problems
o Increased competitiveness might cause a country’s exchange rate to appreciate
What is internal devaluation?
- Internal devaluation happens when a country seeks to improve price competitiveness through lowering their wage costs and increasing productivity and not reducing the external value of their exchange rate.
- Good examples in recent years have applied to Latvia (a Baltic State) and Greece, in the wake of a severe depression which followed the Global Financial Crisis. Ecuador is also implementing internal devaluation.
- An internal devaluation requires several years of low relative inflation i.e. a country’s inflation rate lower than price increases in other countries. With Greece, this involved price deflation i.e. a negative rate of inflation.
- Internal devaluation can be brought about by fiscal austerity (via higher taxes and cuts in government spending) and/or a sharp rise in real interest rates – both impose deflationary pressure on output & prices.
- Internal devaluation is more likely to happen with a country that has a fixed exchange rate e.g. Ecuador has a fixed rate against the US dollar. Greece is inside the Single European Currency zone and cannot devalue unilaterally.
What is external devaluation?
- An external devaluation happens when a country operating with a fixed or semi-fixed exchange rate system decides to deliberately lower the external value of their currency against one or a range of other currencies.
- A devaluation of the currency means a domestic currency buys less of a foreign currency. One motivation is to make exports more price competitive in overseas markets and to make imports relatively more expensive
than domestic supply. - Linked aims might include reducing the size of a trade deficit and also to cut the real value of sovereign. Debt owed to international creditors. In theory, currency devaluation is a fast way of improving price
competitiveness than an internal devaluation. - Examples of countries that have devalued in recent years include Egypt (a 16% fall v the US$ in 2016) and Ghana whose currency was devalued by 17% against the US$ in 2019.
What are the risks from an internal devaluation?
- Severe loss of output and rising unemployment.
- Fall in nominal wages reduces living standards
- Risks from sustained price deflation
- Real value of debt increases
- Danger of a country suffering a permanent loss of output (known as “hysteresis”)
What are the risks of external devaluation?
- Increase in cost-push inflation from higher import prices
- Reduces real incomes because of a rise in inflation
- No guarantee that the trade deficit will improve (refer to the J Curve concept)
- Foreign creditors will demand higher interest rates on new issues of government & corporate debt
- Currency uncertainty makes country less attractive to inward FDI
