Chapter 4: The Foreign Sector

Question 1

What are the two advantages applicable to foreign trade?

Answer 1

Absolute advantage: a country is better at producing a certain good than another.

Comparative advantage: opportunity costs or relative prices differ between countries. This means that both countries can benefit.

Question 2

What is the law of comparative advantage?

Answer 2

When a country has to give up less to produce a good than another trade country the costs are relatively less than in the other country.

Germany 2 cars to 8 barrels of wine
SA 1 car to 6 barrels of wine

Countries will specialise in and export goods that they have the comparative advantage in.

There would be no basis for trade even if one country has an absolute advantage in both goods but the opportunity cost ratio is the same.

Question 3

What is the purpose of a subsidy and what are some examples?

Answer 3

Used by countries to protect local firms:

Import tariffs: duties or taxes imposed on imports - possibly result in net loss of welfare domestically

Import quotas: control volume - same result as above

Subsidies: granted to local producers and can result in the same consequences as the taxes on imports

Non-tariff barriers: Red tape, favouring local producers etc

Exchange controls: limiting currency available for purchase of imports

Exchange rate policy: potentially more effective than the above

Question 4

Discuss demand and supply in terms of exchange rates.

Answer 4

Imports increase demand for foreign currency

Exports increase supply of foreign currency

Question 5

List the characteristics of the foreign exchange market with reference to demand, supply, equilibrium and changes in the market.

Answer 5

Demand for dollars = supply of rand

Importers, offshore investors, offshore investors selling SA assets, tourists and speculators all contribute to the demand for dollars.

Supply of dollars

Exporters, foreign investors, offshore investors disinvesting offshore and buying rands, tourists and speculators all contribute to the supply.

Equilibrium exchange rate

Where the R/$ is too high there will be an excess supply of dollars, where too low excess demand.

Changes in supply and demand: currency appreciation and depreciation

Leftward shift in supply of dollars (less dollars caused by decrease in gold etc) = appreciation of dollar.

The stronger the rand the fewer exports to the US, worsen the balance of payments.

Exporters prefer weaker rand to make products more competitively priced, but it does make imports more expensive, ultimately contributing to higher inflation.

Intervention in the foreign exchange market

Exchange rates fluctuate drastically without controls.

Central bank manipulation = managed floating

Supply additional currency to the market to avoid exchange rate increase and inflation impact. OR buy dollars to avoid devaluation of dollar.

To avoid depreciation of a currency a central bank will need reserves.

Question 6

What is central bank manipulation called?

Answer 6

Managed floating: Supply additional currency to the market to avoid exchange rate increase and inflation impact. OR buy dollars to avoid devaluation of dollar.