AS Unit 6: International economic issues

Question 1

Absolute advantage

Answer 1

International trade occurs because countries have different factor endowments. They differ in supply and quality of labour, capital, alnd and enterprise and climate. The differences affect the types of products, quality and quantity and costs of produced products. It is easier to move goods and services than factors so international trade occurs. A country has an absolute advantage in producing a product if it can produce more with the same quantity of resources. If each country specialises in the product with an absolute advantage and then trades, based on opportunity cost rations, total output will rise and both consume more

Question 2

Comparative advantage

Answer 2

More trade is based on comparative advantage. Some countries buy products from abroad when their own producers would be able to produce those products with less resources. This allows the purchasing country’s producers to concentrate on producing those products they are even better at producing. Both countries can still benefit from specialising and trading

Question 3

What is free international trade?

Answer 3

The exchange of goods and services across national borders without government restrictions. Firms are free to export and import what they want in the quantities they want. No taxes or limits are imposed on exports are imports, no subsidies are given to create cost advantages and there is no red tape

Question 4

The benefits of specialisation and free trade

Answer 4

Allows an efficient allocation of resources with countries specialising on products where they have a comparative advantage. Should increase world output and employment and so should raise living standards. Factor endowments differ
Competition can put pressure on firms to keep prices and costs down and raise quality. COnsumer may enjoy lower prices and better products. FIrms may be able to buy raw materials and capital at lower prices
Firms might produce more if selling internationally. Could take greater advantage of economies of scale. Consumers can buy a greater variety and firs have wider source of raw materials and capital

Question 5

Trading possibility curve

Answer 5

Shows how an economy can benefit from specialising and trading. Engaging in international trade may enable the country to specialise and import. Trading will increase the total quantity of products the country can consumer

Question 6

Exports, imports and the terms of trade

Answer 6

The benefits a country can gain from engaging in international trade are influenced by how many imports they can purchase with the revenue from its exports. This is influenced by the price it gets for the exports and the prices it pays for its imports

Question 7

Measurement of the terms of trade

Answer 7

It is a measure of the ratio of export and import prices. The ratio is calculated form the average prices of many goods and services that are traded internationally. The prices are weighted by the importance of each products. If the terms of trade index increases this is unfavourable since fewer exports have to be sold to buy any quantity of imports. The index number falls

Question 8

Terms of trade index formula

Answer 8

Index of export prices/index of import prices x 100

Question 9

Favourable and unfavourable movement in the terms of trade

Answer 9

Favourable movement is when there is a rise in export prices relative to import prices
Unfavourable movement is when there is a fall in export prices relative to import prices

Question 10

Causes of changes in the terms of trade

Answer 10

Changes in the demand and supply of exports and imports, the price level and exchange rate. An increase in demand for exports would increase their price so cause favorable movement. A rise in relative inflation would make export prices higher. Reducing exchange rate can be called the deliberate deterioration of the terms of trade. This is because it is a deliberate attempt to reduce export prices and raise import prices to make products ore internationally competitive

Question 11

The Prebisch-Singer hypothesis

Answer 11

Suggests terms of trade move against countries that produce primary products. This is the view that demand for manufactured goods and services rises by more than that for primary products when income increases

Question 12

The impact of changes in the terms of trade

Answer 12

Impact of favourable movement may not always be beneficial because effects depend on cause. If the price of exports increases because of a rise in demand it will be more beneficial as more domestic products are sold. If the cause is a rise in costs of production, demand for the country’s products will fall and so will export revenue
Unfavourable movement may reduce a deficit on the current account. If demand for exports and imports is elastic, the fall in export prices relative to import prices should increase export revenue relative to import expenditure

Question 13

Limitations of absolute and comparative advantage

Answer 13

Some governments may want to avoid over specialisation
High transport costs may affect the comparative advantage
Exchange rate may not lie between opportunity cost values
Other governments may impose trade restrictions
Comparative advantage assumes that resources are mobile and there are constant returns
Countries do not always adapt to changes in comparative advantage
May be difficult to determine where a country’s comparative advantage lies

Question 14

Protectionism

Answer 14

When governments seek to protect domestic industries from foreign competition. Involves the restriction of free trade. The tools of protection often seek to increase the price competitiveness of domestic industries

Question 15

Tariffs

Answer 15

The best-known tool of protection called customs duties. They are taxes, usually on imports but may also be imposed on exports. Can be specific (a fixed sum per unit) or ad valorem (a percentage of the price)

Question 16

Import tariffs

Answer 16

Imposed to discourage the consumption of imports and raise tax revenue. A tariff imposes an extra cost on suppliers which pushes up the price. Will benefit domestic producers as output rises. Domestic consumers lose out as they pay more and consume less. A tariff is more effective in raising revenue if demand for imports is inelastic but will be more effective protecting the domestic industry is elastic. May not make domestic products more price competitive if the price of import+tariff is still below the domestic price or if firms selling the imports absorb the tariff and don’t raise prices

Question 17

Export tariffs

Answer 17

Used to raise revenue. If demand for the export is inelastic, it will not impact demand. May be used to ensure an adequate supply of the product on the home market. Can reduce the risk of absolute poverty increasing. Can also be a form of protectionism because if placed on raw materials can protect domestic industries that use the raw materials

Question 18

Import quotas

Answer 18

Quotas are limits on imports. Usually on the quantity. Restricting supply of imports will drive up their price. Will disadvantage consumers as they result in them paying higher prices and consuming fewer products. Do not raise revenue for the government. It is the sellers of imports that will receive the extra amount per unit paid by consumers. Sometimes licences are sold to foreign firms to sell some allocation of the quota. Can put import quotas on exports. The motive may be to ensure an adequate supply on the home market or as protectionism

Question 19

Export sunsidies

Answer 19

May be given to exporters and those domestic firms that compete with imports. In both, domestic firms will experience a fall in costs. This encourages them to increase output and can lower prices. Enables them to capture more of the market at home and abroad. Losers are foreign firms and domestic taxpayers. Domestic producers gain. Consumers gain in the short run. May lose in the long run if more efficient foreign firms are driven out of business and subsidised domestic firms raise prices

Question 20

Embargoes

Answer 20

A complete ban either on the imports of a product or trade with a country. The government may want to ban a good they think is harmful. A ban on trade may arise from political disputes

Question 21

Voluntary export restraints

Answer 21

An agreement by an exporting country to restrict the amount of a product that is sells to the importing country. The exporting country may be pressured into this or may agree in return for the importing country also agreeing to limit exports of another product

Question 22

Excessive administrative burdens

Answer 22

A government may discourage imports by requiring importers to fill out long, time consuming forms. May also set artificially high product standards to restrict foreign competition. Restructs consumer choice

Question 23

Exchange control

Answer 23

A government may limit the amount of foreign exchange that can be bought to buy imports, travel or invest abroad

Question 24

Arguments for protectionism

Answer 24

Protect infant industries
Protect declining industries
Protect strategic industries
Prevent dumping
Improve terms of trade
Improve the balance of payments
Provide protection from cheap labour

Question 25

To protect infant industries

Answer 25

Firms in a new industry may find it hard to survive when faced with competition from larger firms since they can take advantage of economies of scale. An infant industry may be protected to give it time to grow and gain a reputation. If it has the potential to develop a comparative advantage, trade restrictions are justified. The industry ,ay become dependent on protection and feel no pressure to lower costs

Question 26

To protect declining industries

Answer 26

If declining industries have lost comparative advantage and lose business fast there may be rapid unemployment. If given protection which is gradually removed unemployment will be reduced as the industry reduces output so workers retire or leave for other jobs. Industry may resist reductions in its protection causing inefficiency

Question 27

To protect strategic indsutries

Answer 27

Governments may not want to be reliant on other countries for goods such as weapons and food so protect these industries even if inefficient

Question 28

To prevent dumping

Answer 28

Dumping involves selling products below cost In the short run consumers benefit from lower prices but in the long run if foreign firms drive out domestic firms they have a monopoly and then raise prices. Foreign firms may dump for control of another market by destroying competition. They can cover losses with previous profits by charging high prices in home countries or from government subsidies

Question 29

To improve terms of trade

Answer 29

If a country buys a large proportion of another’s exports it may be able to force the price down. By trade restrictions, the country can lower demand leading to a lower price. This improves the country’s terms of trade and allow it to buy more imports for the same exports. If one country has a large supply of a product, export quotas improve terms of trade by driving up prices and raise export purchasing power. Distorts trade and will reduce global output possibly leading to retaliation

Question 30

To improve the balance of payments

Answer 30

Imposing tariffs may encourage consumers to switch from buying imports to domestic products. May lead to retaliation. If foreign governments retaliate by imposing their own trade restrictions, imports and exports may fall. If the products are not internationally competitive, restrictions would only boost the current account short term

Question 31

To provide protection from cheap labour

Answer 31

Restrictions should be imposed on products where wages are low. This view is that to compete, wages so living standards would fall. Low wages don’t always mean products can be produced cheaply as productivity may be low so labour costs are relatively high. If low wages are linked to low costs, the country may have a comparative advantage. There may be moral arguments for imposing trade restrictions on these products so other approaches may be appropriate since restrictions may drive down wages further especially in LICs

Question 32

Other reasons for protectionism

Answer 32

Tariffs may be used to raise revenue. Successful if import demand is inelastic. Trade restriction may be used to persuade another government to reduce trade protection. Risk of trade war. The government may be concerned that imports don’t meet health and safety standards. A government may seek to protect a range of industries to avoid the risks attached to over specialisation

Question 33

Arguments against protectionism

Answer 33

May prevent countries from specialising in the products in which they have a comparative advantage, lowering global output and living standards
Reduce international competition so increase prices and lower the quality of products
Reduce the choice of products available to consumers
Lower the size of firms markets so reduce ability to take advantage of economies of scale
Reduce firms choice of raw materials and capital goods which may increase costs of production
Result in trade war with tariffs pushing up prices

Question 34

The balance of payments

Answer 34

A record of all economic transactions between residents of that and other countries. Consists of the current account, the capital account and the financial account. Money coming into the country creates credit items which are positive. Money leaving the country gives rise to debit items and is negative

Question 35

Trade in goods

Answer 35

The exports and imports of goods. Exports give rise to credit items, imports give rise to debit items. Trade in goods balance is the revenue earned from exports of goods-expenditure on imports. A surplus is when export revenue>import expenditure

Question 36

Trade in services

Answer 36

Trade in exports and imports of services. A deficit is when revenue from exports <expenditure on other countries services

Question 37

Primary income

Answer 37

Income in the form of profit, interest and dividends on the direct investment abroad and foreign earnings on investment in the country. Dividends paid on foreign shares by residents are credit items while interest paid to foreigners on bank accounts they hold in the country are debit items. Also includes employee compensation which is wages earned by residents working in other countries and paid for by those residents

Question 38

Secondary income

Answer 38

Payments made and receipts received for which there isn’t an exchange of an actual good or service. Include government transfers. Transfers by private individuals are also included. These include work remittances

Question 39

Current account balance

Answer 39

This is the overall balance of trade in goods and services and primary and secondary income. A deficit means the combined debit items are greater than the combined credit items

Question 40

Balance and imbalance in the current account of the balance of payments

Answer 40

There is usually an imbalance in individual countries. When the current account deficit value equals the surpluses so the world’s current account is always balanced

Question 41

Current account balance calculations

Answer 41

Subtract the value of imports of goods from the value of exports of goods. The balance of trade in services deducts the value of imports from the value of exports but of services. The balance of trade in goods and services is calculated by adding the balance of trade in goods to the balance of trade in services. To calculate the current account balance the balance of the primary account and the balance of the secondary income are added to the balance of trade in goods and services

Question 42

Causes of a current account deficit - a growing domestic economy

Answer 42

When firms are increasing output, they may uy more raw materials and capital from abroad. Import expenditure increases and export revenue may decline as a result of exports being diverted to the domestic market. This is not considered a problem. Likely to be short term and self correcting. The country’s firms use the imported raw material and capital to produce more so can sell more abroad and at home. Export revenue may rise to match import expenditure

Question 43

Causes of a current account deficit - declining economic activity in trading partners

Answer 43

If the countries that buy the imports experience recessions or falls in economic growth, import expenditure may fall or rise slower. Cyclical deficit. Relatively short term and self correcting

Question 44

Causes of a current account deficit - structural problems

Answer 44

A long run deficit is more of a concern since it indicates domestic firms aren’t internationally competitive and the country may have to borrow to fund surplus spending. Causes of a lack of international competitiveness are an overvalued exchange rate maintained by government intervention and a high inflation rate. Low labour and capital productivity causes a lack of international competitiveness. This results from poor education, low investment and innovation. Not self-correcting

Question 45

Causes of a current account surplus - declining domestic economy

Answer 45

If an economy is in a recession, demand for imports will decline. Consumers buy less goods and services and firms buy less raw materials and capital as output falls. Not beneficial

Question 46

Causes of a current account surplus - increasing activity in partners

Answer 46

If a countries trading partners are doing well they will buy more of the countries exports. The countries people working in these countries earn higher wages which can be sent back

Question 47

Causes of a current account surplus - structural advantages

Answer 47

Firms may be competitive due to good education and training and high investment and innovation. Other reasons include low inflation and a low exchange rate causing them to be price competitive

Question 48

Consequences of imbalances in the current account on the economy

Answer 48

A deficit allows residents to consume more than it produces (lives beyond means). Country has to finance the deficit by attracting investment or borrowing. Involves and outflow of money in the future as investment income. Increase in a deficit may reduce AD, slowing growth and causing unemployment. A surplus may be always thought of an beneficial as involves a country earning more than it spends. Means that residents could have a higher quality of life. High demand and additions to money supply may generate inflationary pressure. Those with deficits may pressure the country to change policies to reduce a surplus. Size significance is assessed more effectively by considering as a % of GDP

Question 49

The exchange rate

Answer 49

The foreign exchange rate is the price of one currency in terms of another

Question 50

How a floating exchange rate is determined

Answer 50

Determined by market forces. Currencies are bought and sold on the foreign exchange market. This is made of financial institutions that buy and sell currency on behalf of price and business customers. The price is determined by demand and supply. Currency is sold to buy imports and to invest abroad and in expectations that the value will fall in the future

Question 51

Why currency traders buy domestic currency

Answer 51

Buy goods and services from the country
Invest in the country
Speculate on making a profit if the value rises in the future

Question 52

Depreciation

Answer 52

A fall in the value of a currency due to market forces is a depreciation. Will cause a reduction in export prices and a rise in import prices

Question 53

Appreication

Answer 53

A rise in the value of a currency due to an increase in demand or fall in supply is an appreciation. Exports are more expensive and imports are cheaper

Question 54

Causes of changes in the floating exchange rate - exports

Answer 54

Demand will rise if more exports are being sold. This may happen if the relative inflation has fallen, relative productivity has risen, quality of production has risen or incomes abroad have increased

Question 55

Causes of changes in floating exchange rate - foreign demand

Answer 55

Foreigners may buy more of a currency if they want to buy shares in the countries firms due to improving economic prospects. May also want more of the currency to open accounts in the countries banks because of higher interest rates. There is movement of money to gain financial advantage by earning higher interest and currencies that are expected to rise in price. Short term money movements are hot money. Speculation influences demand

Question 56

Causes of changes in the floating exchange rate - foreign firms

Answer 56

May buy more of a currency to set up branches in the country because of a rise in labour productivity, a growing market or to avoid trade restrictions

Question 57

Causes of changes in the floating exchange rate - other currencies

Answer 57

More of a currency may be sold to purchase other currencies to buy more imports, undertake foreign travel, buy more government bonds, set up firms abroad and in anticipation of a fall in the currency or interest rate value

Question 58

Impact of a depreciation on national income and output

Answer 58

Exports are cheaper and imports are more expensive. Enables domestic firms to sell more products at home and abroad. Some domestic consumers may now buy domestically more than imports. Some foreigners buy the exports rather than from other countries. A rise in net exports will increase AD

Question 59

Impact of a depreciation on domestic inflation

Answer 59

Higher AD because of a rise in net exports may cause inflationary pressure. As full capacity is neared, resources become more scarce and prices rise. More expensive imports rise costs of production. Domestic firms feel less pressure to keep costs and prices low

Question 60

Impact of depreciation on domestic economy

Answer 60

If higher AD firms producing for domestic and abroad will take on more workers to expand output causing a fall in cyclical unemployment

Question 61

Impact of appreciation on national income and output

Answer 61

Exports are more expensive and imports are cheaper. Fall in demand for domestic products. Slow in economic growth or recession. Incomes fall

Question 62

Impact of appreciation on domestic inflation

Answer 62

Reduction in inflation pressure if close or at capacity. AS may also shift right because of lower cost of material imports. Increased competitive pressure on domestic firms to restrict price rises to maintain sales home and abroad

Question 63

Impact of appreciation on unemplyoment

Answer 63

Increases. If AD falls, firms may not replace workers who retire or make redundant

Question 64

Objective of current account stability

Answer 64

Most governments seek stability. If export revenue equals import revenue they will not be in international debt. It will not be giving up the opportunity to buy foreign products it can afford. In the short run a government may welcome more being spent on imports than earned from exports if this arises from more raw materials and capital being imported. A deficit allows a country to consume more than it is producing. A government may encourage a surplus of export revenue over import expenditure to boost AD and provide funds to repay debt

Question 65

Contractionary fiscal policy on the current account

Answer 65

If experiencing a deficit, fiscal may be used. To reduce demand for goods and services it could use contractionary. A rise in income tax will reduce disposable income leaving less income for households to spend domestically and on imports. Lower government spending will reduce demand for goods and services reducing imports and putting pressure on domestic firms to increase exports

Question 66

Expansionary fiscal policy on the current account

Answer 66

To reduce a surplus, expansionary may be used. Lower income tax and higher government spending will increase consumer expenditure. More imports will be bought and some may be diverted from the export to home market

Question 67

Limitations of fiscal policy for the current account

Answer 67

Unlikely to be a long term solution since once the policy measures have stopped households and firms will go back to spending the same amount on imports relative to export revenue earned. Raising taxes lower demand, increasing unemployment and slowing growth. Can also create disincentive effects so reduce AS

Question 68

Contractionary monetary policy on the current account

Answer 68

If an economy has a low rate of inflation and a deficit, the central bank may reduce interest rates to put downward pressure on a floating exchange rate. A lower exchange rate may cause higher international competitiveness but could generate inflationary pressure. A higher interest rate may reduce consumer expenditure, reducing demand for imports and reducing inflationary pressure. May raise a floating exchange rate that could reverse the fall in demand for imports

Question 69

Expansionary monetary policy on the current account

Answer 69

To reduce a surplus a government may want to increase consumer expenditure by using expansionary monetary policy. May also try to encourage an appreciation

Question 70

Limitations of monetary policy on the current account

Answer 70

Reducing the growth of money supply may be used to reduce spending on imports but it can be hard to control money supply. Most monetary tools are not effective in the long term since they are not tackling the structural weaknesses like low productivity causing a deficit. May not have long term effects on structural strengths like high innovation and owning scarce materials causing a surplus

Question 71

Education and training and subsidies on the current account (supply policy)

Answer 71

Increased spending on education and training and increased subsidies may increase exports. Reduces relative price of domestic output and raise quality. Both increase domestic firms share of the homes and international market. Also attracts MNCs so they can produce good quality at low cost. Contributes to exports

Question 72

Trade union reforms on the current account (supply policy)

Answer 72

Trade union reform enables domestic firms to be more flexible and more able to respond to changes in demand. Fall in industrial action and greater flexibility makes foreign firms more willing to buy the exports

Question 73

Limitations of supply side policies on the current account

Answer 73

May reduce a deficit by making domestic products more competitive and by making domestic markets more attractive for investment. Unlikely to be quick to correct imbalances. Not designed to reduce a surplus since seeks to increase quantity and quality of resources. Can correct a deficit in the long run

Question 74

Effect of protectionist policy on the current account

Answer 74

Can encourage domestic consumers and firms to buy domestically through tariffs. More effective when high quality substitutes to by domestic firms are available

Question 75

Limitation of protectionist policy on the current account

Answer 75

Tariffs on trading partners in a trade bloc isn’t possible. On other countries could provide retaliation and may reduce pressure on domestic firms to become more efficient