IA1 - The Global Economy

Question 1

Explain how unequal distribution of natural resources contributes to the international economic problem, using example to illustrate.

Answer 1

• nations are not endowed with the same quantity and quality of natural resources
• e.g. poor climatic conditions = limited capacity to produce agricultural products
• e.g. the unequal distribution of mineral resources throughout the world gives rise to a vast volume of trade

Question 2

explain how the unequal distribution of human skills contributes to the international economic problem, using example to illustrate

Answer 2

• the knowledge, experience and skills of individuals in which nations must invest in to advance is called human capital
• advanced economies generally have populations in which the proportion of skilled labor and therefore quality of human capital is higher than that found in less-developed economies
• relative scarcity in less-developed economies of the endowment of the factor of production, which is skilled labour
• e.g. advanced economies can diversify production and initiate technological change, whereas LEDC nations rely on advanced nations for provision of goods and services they do not have the skills to produce themselves.

Question 3

explain how the unequal distribution of capital and technology contributes to the international economic problem, using an example to illustrate.

Answer 3

• growth in capital-intensive techniques of production results in increased productivity and lower cost of goods –> improving standard of living
• less developed economies are unable to develop capital-intensive forms of production, typically produce primary products and rely on trade with more advanced economies to meet needs for manufacturing goods
• less developed economies are confronted with trade deficits and are unable to accumulate sufficient capital to establish an efficient infrastructure upon which economic growth can be based –> widening gap of LEDC and MEDC GDP’s.

Question 4

explain how different national currencies contribute to the complexity of international trade, using an example to illustrate.

Answer 4

• national currency is considered legal tender
• international banking system converts payment to another currency
  
  • e.g. Japanese retailer pays
    for imported goods in yen
    and Australian producer
    receives payment in
    Australian dollars
• complicated by exchange rate –> different currencies have different purchasing power’s
  
  • e.g. one Australian dollar
    has different purchasing
    power than one Jap yen

Question 5

explain how different cost structures between nations, contribute to the complexity of international trade for labour capital mix, using examples to illustrate

Answer 5

1. labour-capital mix
   - producers choose this mix depending on the availability and relative costs of these resources within a country
   - shift from labor intensive to capital-intensive production in Aus due to availability of capital, increase cost of labour (Aus wage standards)
   - countries where abundant labor available and scarce capital are labor-intensive:
   - because labor productivity low in these countries = wages are low
   - eg. Australian companies produce off-shore as can’t compete with Asian manufacturers that have similar methods but cheaper labor comparatively.

Question 6

explain how different cost structures between nations, contribute to the complexity of international trade for the size of the domestic market, using examples to illustrate

Answer 6

2. Size of the domestic market
   - domestic markets in Aus are relatively small and local producers are unable to attain economies of scale that are available to foreign competitors
   
   • e.g. car industry –> plants
     were tiny so Aus
     consumers paid same for
     vehicles whether imported
     or local

Question 7

explain how different national policies have contributed to the complexity of international trade, using examples to illustrate

Answer 7

• prime function of democratic governments is welfare of their own citizens first
• governments interfere with international trade by changing their policies for their domestic economies changing conditions –> profit- maximisers
• e.g. LEDCs social structures: inequitable distribution of national income –> majority of income to small group (leaders) while rest of nation’s disposable income is very low
• meaning for Aus:
  while there may be nations populations larger than Aus, their consumer markets may be smaller than ours.

Question 8

advantages of international trade

Answer 8

consumers:
- wide access to variety of goods and services
- price of imports can be cheaper (produced at lower cost)

producers/sellers:
- increases market (production)
- enables economies of scale (efficiencies which enable production at a lower cost)

Economic growth and improved standard of living:
- access to physical capital not produced domestically (technology, tools and equipment)
- physical capital often increased productivity

Increased opportunities for developing nations:
- China (manufacturing powerhouse) and India (leader in exporting services)
- escape poverty through increased trade

Question 9

disadvantage of international trade

Answer 9

Third parties:
- companies selling products that cannot compete in a global market, eg Australian motor vehicle industry (workers lose jobs and must be retrained)

Question 10

How would an increase in Australian’s purchase of Indian goods impact the CFM?

Answer 10

increase in imports -> leakage to CFM

Question 11

How would an increase in India’s purchase of Australian coal impact the CFM?

Answer 11

increase in exports –> injection

Question 12

what is absolute advantage?

Answer 12

• the ability of a nation to produce commodities more efficiently than another nation
• mutual benefit of all if trade occurs after each nation devotes resources to those productive processes in which it is more efficient

Question 13

what is comparative advantage?

Answer 13

• the ability of a nation to produce a product at a lower opportunity cost
• nations may benefit from specialization and trade even in cases where one nation has the absolute advantage over another in the production of all commodities.
• agree on trade terms and then both nations trade surplus of the item they specialized in producing

Question 14

describe what an exchange rate is?

Answer 14

the value of the currency of a nation expressed in terms of the currency of another nation

Question 15

covert dollars from one currency to another at the current exchange rate

Answer 15

If $1 AU = $0.75890 US,
then
$1US = (1/0.75890) $1.31770 AU

Question 16

explain the effects of changes in Australian exchange rates - depreciation of AUD

Answer 16

• Australian exports become less expensive to overseas buyers
• growth in income and employment in export oriented industries
• Australian imports become more expensive and this could lead to a decline in imports and increased inflation
• there is an increased level of external debt that is measured in overseas currencies
• The RBA may increase interest rates to slow down depreciation of the dollar, and this may have an impact on domestic consumption and investment

Question 17

explain the effects of changes in Australian exchange rates - appreciation of AUD

Answer 17

• Australian exports become more expensive to foreign buyers
• income and employment in export industries may decline
• Australian imports become cheaper and increased demand for imports may lead to an increase in the current account deficit
• the government may be more able to repay interest on external debt
• inflation may decrease as domestic prices on imports decline

Question 18

what is fixed exchange rate and how does it work?

Answer 18

fixed exchange rate: the value of a currency that is determined by the government fixing it to the value of another currency at a certain level, and guaranteeing to maintain that level

• currency devaluation: a deliberate downward adjustment to the value of a country’s currency relative to another currency under a fixed exchange rate
• currency revaluation: a deliberate upward adjustment to the value of a country’s currency relative to another currency under a fixed exchange rate

Question 19

what is the floating exchange rate and how does it work?

Answer 19

floating exchange rate: the value of a currency determined by the forces of supply and demand in the foreign exchange market

• appreciation of the AU dollar due to changes in demand (all those who wish to buy AU$). increased demand of the AU$ from D1 to D2 will lead to an increase in the price of the AU$ in terms of the US$ from P1 to P2.
• appreciation of the AU dollar due to changes in supply (all those who wish to sell AU$). decrease in supply of the AU$ from S1 to S2 will lead to an increase in the price of the AU$ in terms of the US$ from P1 to P2
• depreciation of the AU$ due to changes in demand (represented by those who wish to by AU$). decrease in demand of the AU$ from D1 to D2 will lead to a decrease in the price of AU$ in terms of the US$ from P1 to P2
• depreciation of the AU$ due to a change in supply (represented by those who wish to sell AU$). increase in supply of AU$ from S1 to S2 will lead to a decrease in the price of the AU$ in terms of the US$ from P1 to P2

Question 20

describe how Australia’s exchange rate is determined

Answer 20

December 1983, the Australian Govt floated the AUD. Meant that market forces of supply and demand would determine the value of AUD. The RBA would no longer be burdened with the daily task of announcing the value of AUD

Question 21

explain the RBA’s role in monetary policy (ie, dirtying the float and setting cash rate) and the impact of these on the AUD

Answer 21

• the RBA is able to intervene to achieve short term effects on the AUD
• it may buy AUD in the FOREX market to slow down a rapid depreciation
• alternatively, it may sell AUD to slow down an excessive appreciation of the currency
• when the government or the RBA intervenes in the FOREX market to influence the value of the currency, it is said to be managing or ‘dirtying the float’
• RBA can also influence the AUD indirectly by altering interest rates
• by increasing the Aust interest rates (monetary policy) relative to overseas interest rates, the RBA would encourage a larger than normal inflow of overseas savings into the FOREX market, This would result in an increased demand for AUDs and a consequent appreciation of the currency

Question 22

describe and interpret the Trade-Weighted Index

Answer 22

TWI: an index compiled on the basis of importance of trade; at one stage used in determining the value of the Australian dollar
- the average of a basket of currencies that reflects the importance of the sum of Australia’s exports and imports of goods by country

Question 23

explain the factors affecting demand for AUD$

Answer 23

1. to buy AU exports, purchasers must use AU$. An increase in demand for Australian exports should result in an appreciation of the AU$ as more overseas consumers demand more AU$ to pay for their purchases.
2. demand can be influenced by relative inflation rates
   - e.g. if the AU general price level is lower than that in other countries then people will buy AU goods and this will result in an appreciation of the AUD$.
3. a change in relative income of consumers - people overseas become richer, demand our G/S and AUD appreciates
4. a movement in a trend for or against Australian goods and services - Australian goods are out of favor - reduction in demand results in depreciation of AUD
5. Australian’s earn money overseas in the form of dividends, profits and interest loans. Moving this money back to Australia therefore appreciates the AUD.
6. Capital inflows due to investment in Australia are largely determined by relative interest rates and investor confidence. An increase in domestic interest rates relative to overseas rates means investors are more likely to move their money to AU, therefore creating an increased demand for the AU$ and appreciation of AUD.

Question 24

explain the factors affecting supply of AUD

Answer 24

1. increased demand for imports will lead to an increase in supply of AU$ in the market, as consumers change AU$ for foreign currency. Demand for imports is essentially determined by:
   - inflation rates in Australia relative to those overseas - (if higher in Australia, prices of goods will be higher so consumers will demand overseas product and this will increase the supply of AUDs and depreciate the currency)
   - changes in consumer preference (if consumers prefer the domestic goods, they will exchange less AUDs for foreign currency and this will reduce the supply of AUDs on the FOREX market, and appreciate the currency)
   - changes in relative incomes of Australian consumers (if consumers in Australia earn more income, they will probably buy more imports, this will increase the supply of AUDs on the FOREX market, and depreciate the currency)
2. Australian’s must pay dividends, interest and profits to the foreign sector when foreign investments and loans are made in Australia. Moving this money overseas creates a supply of AU$
3. capital outflows due to investment overseas are largely determined by relative interest rates, if interest rates in overseas markets are higher
4. speculation in the forex market that the AU$ is about to depreciate relative to other currencies would lead to cashing-in of AU$ for other currencies.

Question 25

explain the concept of globalization

Answer 25

globalization: the growing integration of national economies to from a single interdependent global economy

KEY IDEA - economic globalization is the increasing convergence and interdependence of national economies.
- The international scope and availability of markets, distribution systems, capital, labor and technology have increased.
- economy is changing - not multiple nations but a single global economy
- interdependence of national economies: linages between events in one economy and outcomes in another by cross-border transactions and international flows of trade, capital and technology
- globalization implies that national economies lose some of their interdependence and separate identities as they become merged into one global economy
- Channels of globalization include: globalization of markets, globalization of production, capital mobility and technology transfers

Question 26

explain the concepts of trade intensity and the law of one price

Answer 26

• trade intensity: a measure of economic integration based on the ratio of trade (sum of exports and imports) to output
• law of one price: a measure of economic integration based on the theory that the prices of similar products traded in linked markets should converge to the one price.
• If prices of similar products in markets that are linked do not converge t o the one price, people can profit by buying cheaper in one market and selling for a product in a higher priced market.

Question 27

explain how technological change contributed to globalization

Answer 27

1. TECHNOLOGICAL CHANGE
   improvements in transportation and communication systems
   - enabled products, people and ideas to move faster and more cheaply internationally
   - enabled firms to manage and coordinate the production and marketing activities of its foreign affiliates
   - has led to the establishment of new business opportunities:
   eg. international call centers etc.

Question 28

explain how trade and investment liberalization have contributed to globalization

Answer 28

• tariffs, quotas, licenses and limits to the transfers of foreign exchange are the more obvious cross-boarder barriers to trade and investment
• less transparent barriers are government policies and regulations that can give preferential treatment to domestic business over foreign business.
• Examples include government-purchasing policies, labelling regulations, health and safety standards and foreign ownership limits.
• international trade negotiations, conducted by the world trade organisation have yielded to some significant reductions to government imposed barriers to trade.
• Australia has negotiated a number of bilateral free trade agreements, including with NZ, USA, Singapore and Thailand

Question 29

define terms of trade

Answer 29

a statistical concept that highlights the relationship between export and import prices

Question 30

define export price index

Answer 30

shows the change in the weighted average of the prices of goods exported

Question 31

define import price index

Answer 31

shows the change in the weighted average of the prices of goods imported

Question 32

terms of trade index

Answer 32

shows whether the relative movement in exports and imports is favorable or unfavorable

Question 33

why have australia’s terms of trade become more favorable since 2000?

Answer 33

as a reflection of the mining boom experienced since then

Question 34

what does a fall of the terms of trade index indicate?

Answer 34

an unfavorable movement
- less imports can be purchased from the same volume of exports. the reduced imports represent a fall in welfare.

Question 35

what does a rise of the terms of trade index indicate?

Answer 35

a favorable movement
- more imports can be purchased from the same volume of exports. The additional imports represent an increase in welfare

Question 36

equation for determining the terms of trade index

Answer 36

terms of trade = (export price index/ import price index)*100

Question 37

recall the 5 situations which would lead to a favorable movement in the terms of trade

Answer 37

1. export prices rising faster than import prices
2. export prices rising while import prices remain constant
3. export prices rising while import prices fall
4. export prices fall slower than import prices falling

Question 38

recall the 5 situations which would lead to an unfavorable movement in the terms of trade

Answer 38

1. import prices rising faster than export prices
2. import prices rising while export prices stay constant
3. import prices rising while export prices fall
4. import prices constant while export prices fall
5. import prices fall slower than export prices falling