Global Economics

Question 1

Optimal currency area

Answer 1

A geographical area which would maximise its efficiency if the entire region shared a single currency

Question 2

What are the criteria for a successful currency union as established by Mundell?

Answer 2

1) Labour mobility, including physical ability to travel (e.g. visas), lack of cultural barriers (e.g. language) and institutional arrangements (e.g. ability to transfer pensions)
2) Capital mobility and wage and price wage flexibility so that market forces can distribute money and goods where they are needed
3) Risk sharing (e.g. fiscal transfers to redistribute income to less well off areas)
4) Economic cycle convergence so that the central bank is able to promote growth in downturns and contain inflation in booms

Question 3

What are the main arguments for adopting a fixed exchange rate?

Answer 3

1) Trade and investment
2) Reductions in the costs of currency hedging for businesses
3) Disciplines on domestic producers
4) Reinforcing gains in comparative advantage

Question 4

How does a fixed exchange rate boost trade and investment?

Answer 4

Overseas investors will be more certain and confident that the returns from their investments will not be destroyed by sudden fluctuations in the value of a currency (less currency risk)

Question 5

How does a fixed exchange rate create discipline on domestic producers?

Answer 5

Forces them to keep costs and prices down as in the LR one country’s inflation must fall in line with another, potentially encouraging attempts to raise productivity and focus on research and innovation

Question 6

How does a fixed exchange rate reinforce gains in comparative advantage?

Answer 6

Differences in relative until labour costs will be reflected in the growth of exports and imports

Question 7

What are the main arguments for adopting a floating exchange rate?

Answer 7

1) Less need to hold huge foreign currency reserves
2) Can be a useful instrument of macroeconomic adjustment (e.g. a lower currency can boost AD)
3) Provides partial ‘automatic correction’ for a trade deficit (i.e. large trade deficit should lead to an excess supply of sterling and hence cause a depreciation)
4) Freedom for domestic monetary policy

Question 8

What are the risks with a floating exchange rate?

Answer 8

1) Currency volatility could damage international trade and capital investment
2) Fluctuating currencies increase the need for hedging costs by exporters and importers

Question 9

What is the Mundell Fleming Trilemma?

Answer 9

States that a country always faces constraints in choosing their exchange rate regime, only being able to access two of the following three:

1) An independent monetary policy (freedom to set interest rates)
2) A fixed exchange rate (currency stability and predictability)
3) An open capital account (freedom to finance a current account deficit)

Question 10

What is the theory on exchange rates?

Answer 10

Mundell Fleming Trilemma

Question 11

Formula for Terms of Trade

Answer 11

Terms of Trade index = [ (price index for exports) ÷ (price index for imports) ] x 100

Question 12

Terms of Trade

Answer 12

The amount of imported goods or services an economy can purchase per unit of exported goods or services

Question 13

How does a rise in the price index affect the Terms of Trade?

Answer 13

Improves the ToT since a country can buy more imports for any given level of exports

Question 14

What factors cause a change in the Terms of Trade?

Answer 14

1) A rise/fall in the world price of a country’s main export (e.g. heavy reliance on primary commodities can see volatile ToT)
2) Changes in the exchange rate that change the price of imported goods
3) A change in relative inflation rates

Question 15

What impact does a improvement in the ToT have?

Answer 15

1) Standard of living improves as a nation is able to import cheaper food so may increase real incomes
2) The price of imported technology decreases
3) Import and export prices affect the value of trade flows and hence the Balance of Payments

Question 16

Balance of Payments

Answer 16

Records all financial transactions made between consumers, businesses and the government in one country with others

Question 17

What does the Balance of Payments do and why?

Answer 17

Balances because if a £ is sold someone must be buying that £

Question 18

What are the components of the BoP?

Answer 18

1) Current account
2) Financial account
3) Capital account
4) The balancing item

Question 19

What does the current account consist of?

Answer 19

1) Balance of trade in goods
2) Balance of trade in services
3) Net primary income (i.e. net investment income) - includes income from interest, profits and dividends from foreign investment
4) Net secondary income (i.e. transfers) - includes aid and remittances

Question 20

What does the financial account consist of?

Answer 20

Assets: Direct investment, portfolio investment, hot money and loans

Question 21

What does the capital account consist of?

Answer 21

The financial transactions that affect a country’s future income, production or savings (least important account)

Question 22

Why can a Current Account deficit be a problem?

Answer 22

1) Can reduce AD, affecting growth
2) Can create unemployment
3) Sign of an uncompetiive economy
4) Size of deficit may be unsustainable
5) BoP crisis (potentially from capital flight) may require intervention from the IMF

Question 23

Why may a Current Account deficit not be a problem?

Answer 23

1) Some of the richest countries in the world have deficits (e.g. US’ = 2.4% in 2019)
2) Does not necessarily impact unemployment (e.g. UK experiencing record low unemployment)
3) May indicate that the citizens of these countries are buying lots of imports and enjoying a high standard of living
4) Many developed countries generate most of their income from services which are mainly domestically traded, hence deficit not surprising

Question 24

What level of BoP deficit is regarded as sustainable?

Answer 24

2-3%

Question 25

What causes a deficit in the Current Account?

Answer 25

1) Overvalued exchange rate
2) Economic growth
3) Decline in competitiveness
4) Higher inflation
5) Recession in other countries

Question 26

How does an overvalued exchange rate cause a deficit in the Current Account?

Answer 26

Imports will be cheaper and exports less competitive

Question 27

How does economic growth cause a deficit in the Current Account?

Answer 27

If there is an increase in national income people will tend to have more disposable income to consume consumer goods, including imports

Question 28

How does a decline in competitiveness cause a deficit in the Current Account?

Answer 28

Leads to a decrease in exports

Question 29

How does higher inflation cause a deficit in the Current Account?

Answer 29

Exports become less competitive and imports more competitive (BUT could be offset by depreciation of currency)

Question 30

How does a recession in other countries cause a deficit in the Current Account?

Answer 30

Foreign countries will consume fewer UK exports

Question 31

What policies could be implemented to reduce a current account deficit?

Answer 31

1) Expenditure reducing policies
2) Protectionism
3) Supply side policies to improve price and non-price competitiveness

Question 32

What expenditure reducing policies could be implemented to reduce CA deficit and what are the problems associated with them?

Answer 32

1) Contractionary fiscal policy - would reduce C and hence lead to fall in AD
2) Contractionary monetary policy - Impact mitigated by likely appreciation of currency from hot money flows AND preference given to controlling inflation over CA deficit

Question 33

Why is protectionism flawed?

Answer 33

1) Retaliation may take place
2) It is bad for consumers in terms of price, choice and quality
3) It is allocatively and productively inefficient as it props up inefficient industries and therefore misallocates resources

Question 34

What defines a customs union?

Answer 34

Common external tariff and free trade within it

Question 35

Washington Consensus

Answer 35

1) Refers to a set of 10 broadly free market economic ideas

2) Advocates free trade, floating exchange rates, free markets and macroeconomic stabilitiy

Question 36

Criticisms of the Washington Consensus

Answer 36

1) Strategic trade theory
2) Low government borrowing is not always appropriate
3) The Chinese approach
4) Problems of privatisation

Question 37

Strategic trade theory

Answer 37

1) Argument that free trade is not always in the best interest of developing economies
2) Strict adoption of free trade and comparative advantage can leave developing economies producing low-income growth and volatile priced primary products
3) Hence supports targeted economic diversification, using tariffs and government subsidies

Question 38

Why is low government borrowing not always appropriate?

Answer 38

1) Fiscal consolidation during the great recession has causes low growth rates and a failure to reduce debt to GDP ratios
2) Can cause welfare support programmes to be hit, increasing poverty

Question 39

Defence of the Washington Consensus

Answer 39

The problem with any broad set of economic principles is that it always depends on how and when they are implemented (free market economic policy may have sound justification but not be universally applicable)

Question 40

Human Development Index (HDI)

Answer 40

A summary measure of the basic dimensions of human development in a country, taking into account income, health and education