International Economics

Question 1

What is international trade?

Answer 1

International trade is the exchange of goods and services between countries.

Question 2

What are the seven advantages of trade?

Answer 2

1. Lower prices - Main aim of trade is to buy goods/services at a lower price. Consumers are able to buy less expensive products, whereas producers purchase raw materials/semi-manufactured goods at a cheaper price.
2. Greater choice - It allows consumers to have a greater choice of products.
3. Differences in resources - Some country simply doesn’t have specific resources which are required. Hence, they can export goods/services in order to earn foreign currency which can be used to buy the required resources.

I.E. Singapore - Low resources –> dependent on trade

4. Economies of scale - Global market is greater than domestic. Hence, demand increases which means that level of production and size of production units increases.
5. Increased competition - More firms –> more competition –> greater efficiency –> Cheaper prices/increased quality and variety of goods.
6. Efficient allocation of resources - Free trade –> The countries best at producing goods/services produce them (i.e. production at lowest cost).
7. Source of foreign exchange - trade acts a source of foreign currency which can then be used to buy other goods/services. Especially important for developing countries. I.e. Ghana sells cocoa –> receives euros –> import industrial machinery.

Question 3

On a global market, what theory could we use to decide what country produces what product?

Answer 3

Comparative advantage theory

Question 4

What is absolute advantage?

Answer 4

Absolute advantage means that an economy can produce a greater total of goods for the same quantity of inputs.

Example below

Absolute advantage is best used when comparing two countries that each have an absolute advantage in producing a product (Reciprocal absolute advantage).

Question 5

What is a comparative advantage?

Answer 5

Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another.

Basically, country ‘A’ has to give up fewer units of other goods in order to produce X, than country ‘B’.

Comparative advantage is best used when 1 country has an absolute advantage in producing 2 goods in comparison to the other country.

The example below –> if both countries specialise using comparative advantage, the output of both textiles and books would increase (3–>4 / 7–>8)

Question 6

In what situation would the theory of comparative advantage not work?

Answer 6

When both countries have the same opportunity cost then there is no point for trade to take place.

This is shown on a PPF curve by two parallel lines

Question 7

What are the assumptions made in the comparative advantage theory?

Answer 7

1. No transport cost is taken into account
2. Only two goods are being produced
3. Only two economies/countries
4. Cost of production remains constant
5. Both economies –> same resources –> they will not become depleted
6. Free trade
7. Goods are identical –> no difference in quality.

Question 8

What diagram is used to show comparative advantage?

Answer 8

A PPF diagram can show the output of two goods between two countries.

Question 9

What factors result in a country having a comparative advantage?

Answer 9

Highly dependent on the factors of the endowment.

i.e. A country with abundant unskilled labour can develop its comparative advantage in the production of labour intensive, low skilled, manufactured goods. Whereas, a country with well-educated labour will have a comparative advantage in the financial sector.

The abundance of a specific factor –> decrease in the price of a factor –> opportunity cost of goods/services using that factor lower.

Question 10

What are the limitations of the theory of comparative advantage?

Answer 10

1. It is assumed that producers/consumers have perfect knowledge –> aware of where the least expensive good may be purchased.
2. Assumed no transport costs –> not the case –> in reality, decrease the comparative advantage as they are less competitive.
3. External costs of trade. Exporting goods leads to increased pollution
4. Diminishing returns/diseconomies of scale –> in some cases increasing output leads to diminishing returns.
5. Assumed goods traded are identical –> Not the case for consumer durables –> i.e. Toshiba television is different from a Philips television.
6. Assumed that there is perfect free trade –> trade barriers.
7. Assumed that the factors of production remain in a country –> Not the case! –> Developed countries invest into producing goods in LDC’s.

Question 11

What is the World Trade Organisation?

Answer 11

The WTO is an international trade organisation that sets rules for global trading and resolves disputes between member countries.

Members are supposed to grant “most favoured nation” status to one another –> trade concessions granted must be granted to all WTO members.

Question 12

What are the aims/functions of the WTO?

Answer 12

Main aim –> Increase trade by lowering trade barriers and providing a forum for negotiation.

Functions are to…

1. Administer WTO trade agreements
2. Forum for trade negotiations
3. Handle trade disputes
4. Monitor national trade policies
5. Provide technical assistance/training for developing countries.
6. Cooperate with other international organizations

Question 13

What are the advantages of the WTO?

Answer 13

1. Lower prices for consumers. (Less tariffs –> cheaper imports)
2. Free trade encourages greater competitiveness –> increased efficiency.
3. The law of comparative advantage states that free trade will enable an increase in economic welfare. Cause, countries specialize where the Opp. Cost is low.
4. Economies of scale. By encouraging free trade, firms can specialize and produce a higher quantity.

Question 14

What are the successes of the WTO? (examples)

Answer 14

1. WTO has over 160 members representing 98 percent of world trade –> large number involved.
2. Increased number of trade disputes have been brought to the WTO, showing the WTO is a forum for helping to solve disputes.
3. WTO regulations and co-operation helped avoid a major trade war; this was significant during 2008/09 global recession.

Question 15

What are the disadvantages of the WTO?

Answer 15

1. Unfavourable for developing countries –> Inhibits diversification –> developing countries need some trade protection to be able to develop new industries (infant industry argument)
2. Most favoured nation principle –> unfair advantage to MNCs –> costs for local firms and the right of developing economies to favour their own emerging industries.
3. Failure to reduce tariffs on agriculture –> US and EU still have high tariffs –> hurts developing country farmers who face the high tariffs.
4. Diversification —> To diversify, LDCs might require tariffs to protect new industries.
5. Environment. Free trade has often ignored environmental considerations –> WTO’s philosophy of maximising GDP no always useful.
6. Free trade ignores cultural and social factors –> Free trade leads to MNCs reducing cultural diversity and tend to swamp local industries and firms.
7. The WTO is criticised for being undemocratic –> richer countries get what they desire.
8. Slow/difficult process to reach an agreement.

Question 16

What is free trade?

Answer 16

Free trade means that countries can import and export goods without barriers to trade (Tariffs, quotas, etc)

Question 17

What is protectionism?

Answer 17

Protectionism –> imposing restrictions on trade with the aim of protecting domestic businesses and industries from overseas competition.

Basically, preventing the outcome to solely result from the interplay of free market forces of supply and demand.

Question 18

What are the arguments in favour of protectionism?

Answer 18

1. Protecting domestic employment –> Gov. use protectionist measures in order to prevent unemployment of a declining industry due to foreign competition.
2. Protecting from low-labour costs –> Some argue that the declining domestic industries are as a result of cheaper labour costs in foreign countries.
3. Protecting infant industries —> Developing industries lack economies of scale –> less competitive –> Need protection until they are able to compete.
4. Avoid the risk of overspecialisation –> Governments may want to limit overspecialisation –.> cause a small change in global market may have detrimental impacts.
5. Strategic reasons –> Some industries need to be protected in case they needed for war (steel, agriculture, etc.)
6. Prevent dumping –> This is when a country sells large quantities of a commodity at low prices in another country. Hence, damaging domestics firms.
7. Protect product standards –> Country imposes safety, health or environmental standards on imported goods –> imports match domestic standards.
8. Raise government revenue –> Developing countries –> difficult to collect taxes –> so they impose import taxes –> increase revenue
9. Correct B.O.P deficit –> Used to reduce import expenditure.

Question 19

What are the counter-arguments to the points in favour of protectionism

Answer 19

1. Protecting domestic employment –> Industry will still decline –> Protectionist measures only prolong the process. Better idea? –> move resources to other expanding areas in the economy –> depends on extent of social cost of unemployment
2. Protecting from low-labour costs –> Goes against the idea of comparative advantage –> domestic consumers pay more.
3. Protecting infant industries —> Developed countries –> unjustified (large amount of financial capital) –> developing countries potentially applicable –> but do they have global political power?
4. Avoid the risk of overspecialisation –> No-counter
5. Strategic reasons –> Unlikely countries will go to war + if they do, it is unlikely they will be disconnected from supplies.
6. Prevent dumping –> Difficult to prove dumping and aren’t subsidized industries supporting dumping.
7. Protect product standards –> Valid only if concerns are true. Another issue –> Cost to meet standards, getting approval and documentation are high –> disadvantage for developing countries
8. Raise government revenue –> No-counter –> its just imposing taxes on consumers that are buying.
9. Correct B.O.P deficit –> Short term solution –> doesn’t tackle cause –> may lead to retaliation.

Question 20

What are the arguments against protectionism?

Answer 20

Basically restating the benefits of trade.

1. Protectionism leads to higher prices for producers and consumers.
2. Protectionism leads to less choice.
3. Protectionism leads to less competition which may result in inefficiency.
4. Protectionism distorts comparative advantage –> inefficient use of worlds resources.
5. Less specialisation –> reduction is global output.
6. For the reasons listed above –> negative impact on economic growth.

Question 21

What does a normal diagram look like without protectionist measures (tariffs, quotas, etc)?

Answer 21

If there was no foreign trade the domestic farmers would produce at the level Q_e.

However, once the domestic market opens up to all other markets, the world supply is introduced (Perfectly elastic). Note–> S (Wolrd) must be below Q_e otherwise there is no point in trading.

When world supply is introduced –> domestic suppliers will only produce at the level Q_2. Thus, the excess demand is satisfied by foreign producers (Q₂ —> Q_1.

Question 22

What are tariffs?

Answer 22

Tariff is a tax that is charged on imported goods.

Question 23

Explain the tariff diagram?

Answer 23

The tariff will shift the world supply upwards (placed on foreign producers) –> this results in an increase in domestic producer surplus.

The upward shift of the World supply curve results in an increase in price P₁ –> P₂ . As a result, the total quantity demand falls (Q₂ –> Q₃) because the price has increased.

Furthermore, there is an increase in domestic supply (Q₁ –> Q₄) –> accompanied by an increase in revenue.

Foreign supply decreases (Q₂ –> Q₃) –> their revenue falls.

Question 24

Show the changes in revenue for domestic/foreign suppliers and show the tariff revenue received by the government on a tariff diagram.

Answer 24

Domestic revenue increases –> increase in area from ‘g’ to ‘g+a+b+c+h’.

Foreign suppliers revenue decreases –> decrease in area from ‘h+I+j+k’ to ‘i+j’.

Government now receives tariff revenue –> d+e

Question 25

On a tariff diagram what area represents a dead-weight loss?

Answer 25

There are two areas that correspond to a dead-weight loss. 1. **Loss of consumer surplus** equivalent to **'f'** --\> this area represents the dead-weight loss of welfare. 2. **Inefficiency** --\> Foreign farmers produced Q₁ --\> Q₃ for a min revenue of 'h' but domestic producers need a min revenue of 'h+c'. Thus, C represents inefficiency of domestic producers/loss of world efficiency.

Question 26

What are the impacts of the tariff on Domestic/foreign producers, consumers and the government?

Answer 26

**Domestic producers** 1. Increased output --\> increased revenue 2. Less incentive to innovate. **Foreign producers** 1. Decreased output --\> less revenue 2. Increased efficiency --\> in order to compete **Consumers** 1. Less choice 2. More expensive products **Government** 1. Decreased unemployment 2. Increased government revenue.

Question 27

Explain what happens when a subsidy is applied to a trade diagram?

Answer 27

Subsidy used to make domestic producers more competitive --\> outward shift in the domestic supply Subsidy is represented by area --\> e+f+g Domestic production increases --\> 0 --\> Q₃ --\> increase in revenue from 'a' to 'a+b+e+f+g'. Foreign producers supply the rest which is a decrease from Q₁--\>Q₂ to Q₃ --\> Q₂ . Hence, their revenue falls from 'b+c+d' to 'c+d'.

Question 28

On a trade diagram + subsidy what area represents the deadweight loss?

Answer 28

With subsidy Q₁ --\> Q₃ is produced inefficiently by domestic producers as opposed to more efficient foreign producers. Foreign producers --\> would produce for a min revenue of 'b'. Domestic producers --\> would produce for a min revenue of 'b+g' Misallocation of the world's resources.

Question 29

On a trade diargam, do subsidies impact consumers?

Answer 29

Directly, No --\> Price stays the same --\> no drop in consumer surplus. Indirectly they may be affected by higher taxes (to fund subsidy) as well as decreased government expenditure on other sectors (opportunity cost of subsidy)

Question 30

What is a quota?

Answer 30

A quota is a physical limit on the numbers goods that can be imported into a country.

Question 31

Explain the quota diagram.

Answer 31

Before... 0 ---\> Q₁ is supplied domestically Q₁ ---\> Q₂ are imports Then.. The government imposes quota (limit) --\> Q₁ --\> Q₃ This results in a shortage (excess demand) Q₃ --\> Q₂ as there is decreased supply --\> upwards pressure on price. Shortage pushes the price up ---\> domestic producers attracted by higher prices --\> enter the market. Eventually, price settles at P_quota --\> demand = supply (Q₄) Now... Domestic producers supply --\> 0 to Q₁ and Q₃ to Q₄ Foreign producers supply --\> Q₁ to Q₃

Question 32

How does the quota diagram impact revenue for domestic and foreign producers?

Answer 32

Domestic revenue increases --\> from 'a' to 'a+c+d+f+i+j' Foreign revenue decreases --\> from 'b+c+d+e' to 'b+g+h'. Usually a decrease but not always.

Question 33

What area represents the dead-weight loss on a quota diagram?

Answer 33

Two areas of deadweight loss. 1. Area 'k' --\> represent a decrease in consumer surplus which is a dead-weight loss. 2. Area 'J' --\> represents inefficiency of domestic producers and loss of world efficiency --\> more of the worlds resources are used to produce wheat.

Question 34

What are the two main types of administrative barriers?

Answer 34

1. **'Red Tape'** When goods are imported it involves an administrative process. If these processes are lengthy and complicated ---\> acts as a restriction on imports. 2. **Health/safety/ environmental standards** Restrictions on the type of good sold in the domestic market or on the method of manufacturing.

Question 35

How can nationalistic campaigns be used to promote domestic goods rather than foreign?

Answer 35

Governments may run marketing campaigns to encourage people to buy domestic goods instead of foreign ones.

Question 36

What is the definition of an exchange rate?

Answer 36

The exchange rate is the value of one currency in terms of another. 1€ : 4$ This means that 1€ can be exchanged for 4$

Question 37

What are the three main types of exchange rate systems?

Answer 37

A country manages its exchange rate system (exchange rate regime) 1. Fixed exchange rate 2. Floating exchange rate 3. Managed exchange rate.

Question 38

What is a fixed exchange rate?

Answer 38

A fixed exchange rate is when the value of a currency is fixed, or pegged, to the value of another currency, to the average value of a selection of currencies or to the value of some other commodity, such as gold. Value of the variable to which the currency is pegged changes --\> value of the currency itself changes. Raise in the value of a currency in a fixed exchange rate ---\> revaluation. Decrease in the value of a currency in a fixed exchange rate ---\> devaluation.

Question 39

How is a fixed exchange rate maintained?

Answer 39

A fixed exchange rate is maintained via government intervention in the foreign exchange rate market. Example: Barbadian $ fixed to US $ Two main methods of maintenance. **Situation 1** --\> increase in the supply (outward shift) of Bbs $ due on foreign exchange market (F.E.M) due to Barbadians purchasing more imports. No gov intervention? exchange rate falls But the Barbadian **government can buy up an excess supply of its own currency on the F.E.M** using reserves of foreign currencies --\> increase in demand --\> balance out of effects. **Situation 2** --\> Increased demand (outward shift) for the Bds$ due to increased tourism. Without gov intervention --\> exchange rate would rise. But to maintain the exchange rate --\> Barbadian government sell its own currency on the foreign exchange market --\> Outward shift in supply --\> this increases Barbadian reserves of foreign currency.

Question 40

What is a floating exchange rate?

Answer 40

A floating exchange rate is when the value of a currency is allowed to be determined by the interaction between demand and supply on the foreign exchange market. Rise in the value of a floating exchange rate --\> appreciation. 1$ : €0.80 ---\> 1$ : €0.85 --\> dollar has appreciation The decrease in the value of a floating exchange rate --\> depreciation. €1 : 1:25$ ---\> €1 : 1:18$ --\> euro has depreciated

Question 41

What demand factors influence the value of a currency in a floating exchange rate?

Answer 41

Example --\> E.U and U.S **Demand** 1. Increase in demand for U.S good/services - US inflation is lower --\> cheaper products - E.U income increases --\> demand for all things increase - Cange in taste 2. U.S investment prospects improve 3. U.S interest rates increase --\> more attractive to save in their banks 4. Speculators think the U.S dollar will rise.

Question 42

What supply factors influence the value of a currency in a floating exchange rate?

Answer 42

Example --\> E.U and U.S Increase in supply --\> increase in supply of US $ on the foreign exchange market. 1. **Increased demand for E.U goods/services** --\> more U.S dollars exchange for euros. - U.S inflation rates are higher than E.U --\> U.S goods/services are more expensive - An increase in general income level --\> overall increase in demand - Change in taste 2. **EU investment prospects improve** 3. **EU interest rates increase** --\> making it more attractive to save money there 4. **Speculators think the value of the U.S dollar will fall** --\> so they sell it now and buy euros.

Question 43

What is a managed exchange rate?

Answer 43

In reality --\> no currency is 'freely floating' --\> there is always some level of government intervention during periods of extreme fluctuations. Hence, most exchange rates are **managed** --\> currency is allowed to float between an upper and lower limit but there is some level of interference from the government when value surpasses U.L or falls below L.L. Most common --\> central bank sets upper and lower limits.

Question 44

What are the advantages of a high exchange rate?

Answer 44

1. **Downward pressure on inflation** - Price of finished imported goods will be relatively low --\> force domestic producers to keep price low. - Price of imported materials/components will reduce costs of production --\> lower prices for consumers 2. **More imports can be bought** - Higher value of currency --\> more foreign currency can be bought with a single unit of domestic currrency --\> cheaper imports. Benefits for both visible imports -\> technology and invisible imports --\> foreign travel. 3. **High value of currency forces increased domestic efficiency** - High exchange rate will threaten international competitiveness --\> forced to lower costs and increase efficiency.

Question 45

What are the disadvantages of a high exchange rate?

Answer 45

**Disadvantages** 1. **Damage to export industries** - High exchange rate --\> difficulty selling goods/services abroad --\> lead to unemployment/industry decline 2. **Damage to domestic industries** - More imports being purchased (relatively less expensive) --\> increased competition leading to falling in domestic demand --\> industry decline/unemployment.

Question 46

What are the advantages of a low exchange rate?

Answer 46

Advantages of a low exchange rate 1. **Greater employment in export industries** - Value of exchange rate is low --\> value of exports relatively less --\> more competitive --\> increased employment in export industries 2. **Greater employment in domestic industries** - Low exchange rates make imports relatively more expensive --\> encourages consumers to buy from domestic industries --\> increased employment.

Question 47

What are the disadvantages of a low exchange rate?

Answer 47

Disadvantages of low exchange rate 1. Inflation --\> Low value of the currency makes imported final goods/services, raw materials, components more expensive These materials are required for producers which then raises costs of production --\> higher prices --\> inflation.

Question 48

Summary of benefits/disadvantages of high/low exchange rates

Answer 48

1. Appreciation/high value of the currency - Imports are cheaper --\> pushes down cost - Exports are more expensive for foreign consumers --\> discouraged Hence ---\> Good to fight inflation but can create unemployment. 2. Depreciation/low value of a currency - Imports are more expensive --\> Inflation (higher costs of production) - Exports are now cheaper for international buyers --\> increased demand. Hence --\> may result in inflation but can help solve unemployment problems.

Question 49

Three things to consider when evaluating whether a change in exchange rate is detrimental or not.

Answer 49

1. Businesses are held by contracts --\> are the changes going to have an impact on them? 2. Price is not the only factor --\> quality of goods/services. 3. Are the changes short or long term?

Question 50

Why would a government intervene to influence the value of their currency?

Answer 50

They may wish to... 1. Lower exchange rate in order to **increase employment.** 2. Raise the exchange rate in order to **fight inflation** 3. Maintain fixed exchange rate 4. Avoid fluctuations in floating exchange rate 5. Improve stability --\> improve **business confidence** 6. Improve a **current account deficit**

Question 51

What are the two main methods of intervention by government in order to manipulate the exchange rate?

Answer 51

1. **Use reserves of foreign currencies to buy or sell foreign currencies.** - Increase the value of currency --\> use foreign reserves to buy their own currency --\> increase demand - Lower value of currency --\> buy foreign currency reserves on the F.E.M using their own currency --\> increases supply --\> decrease value. 2. **By changing interest rates** - Increase the value of their currency --\> raise interest rates --\> attract people to save money in domestic banks from abroad / financial investment --\> increases demand and raises the value. - Lower interest rates --\> lower level of interest rates --\> less attractive --\> more domestic investors attracted to foreign markets --\> they buy foreign currency which increases the supply on the F.E.M --\> decreases the value.

Question 52

What are the advantages of a fixed exchange rate?

Answer 52

1. Fixed exchange rate should **reduce uncertainty** for all economics agents --\> businesses can plan ahead with the knowledge that predicted costs/prices will not change. 2. The fixed exchange rate may have harmful effects on demand for exports/imports --\> governments must control and ensure inflation is as low as possible --\> ensures sensible gov policies on inflation. 3. In theory --\> fixed exchange rate should reduce speculation (Balance --\> not always cause there are attempts to destabilize in order to make speculative gains).

Question 53

What are the disadvantages of a fixed exchange rate?

Answer 53

**Disadvantages** 1. Must keep the exchange rate fixed --\> main method: interest rates --\> conflict between macroeconomic goals (Monetary policy). 2. In order to maintain fix and keep confidence --\> country has to keep high levels of foreign reserves --\> ensure that it can buy/sell foreign currency. 3. Setting the level of fix exchange rate is not simple --\> many variables to consider. i.e. Wrong level can negatively impact exporting firms. 4. Fixing exchange rate at a low level can create international disagreement --\> makes countries exports more competitive --\> unfair --\> disputes/retaliation.

Question 54

What are the advantages of a floating exchange rate?

Answer 54

1. **No level to maintain** --\> **interest rates are free** to be used as a domestic monetary tools (demand management policies) --\> inflation 2. In theory, **floating exchange rate should adjust to keep current account balanced** (However, this will depend on Marshall-learner condition) i. e. Current account deficit --\> demand for currency is low (exports are low) and supply is high (imports are high) --\> should result in fall of the exchange rate. Hence, opposite will occur export increase/import decrease. 3. No need to keep a high level of reserves of foreign currencies/gold.

Question 55

What are the disadvantages of a floating exchange rate?

Answer 55

**Disadvantages** 1. **They can create uncertainty** --\> businesses unable to make accurate predictions about costs/revenues. Investments are difficult to assess + increase doubt --\> leading to a reduction in international investment. 2. Floating exchange rate are **not only affected by demand and supply** but also by government intervention, world events and speculation --\> hence they do not necessarily self-adjust to resolve current account deficit. 3. Worsen existing levels of inflation --\> i.e. high inflation (bad for exports/increase in imports (cheaper) --\> Exchange rate falls --\> increase price of imports --\> further fuel inflation.

Question 56

What is the balance of payments?

Answer 56

The B.O.P is a record of the value of all transactions between the residents of one country and the residents of all other countries over a given time period (usually 1 year). Two main parts of the B.O.P 1. Current account 2. Capital account

Question 57

In the B.O.P, how can we differentiate between money entering and leaving the economy?

Answer 57

1. Money entering the economy --\> known as a credit item --\> given a positive value. 2. Money leaving the economy --\> known as a debit item --\> given a negative value.

Question 58

What is the current account?

Answer 58

The current account is a measure of the flow of funds from trade in goods and services, inflows minus outflows of income and current transfers. Basically, it is made of 4 parts 1. Balance of trade in goods 2. Balance of trade in services 3. Income 4. Current transfers

Question 59

What is the balance of trade in goods (current account)?

Answer 59

The balance of trade in goods (visible trade balance) It is a measure of the revenue received from the exports of tangible (physical) goods minus the expenditure on imports of tangible goods over a period of time. When exports revenue greater than import expenditure -- Surplus in the balance of trade in goods When export revenue is less than import expenditure -- deficit in the balance of trade in goods

Question 60

What is the balance of trade in services (current account)?

Answer 60

The balance of trade in services (invisible balance) It is a measure of the revenue received from the exports of services minus the expenditure on the imports of services over a given period of time. Includes services such as banking, insurance and tourism.

Question 61

What is 'income' refer to in the current account?

Answer 61

'Income' often known as investment income. It is a measure of the net monetary movement of profit, interest and dividends moving into and out of the country over a given period of time as a result of financial investment abroad I.e. Domestic firms with branches abroad may send profits back into the country (positive item). Whereas, profits sent out of the country by foreign firms will count as a negative item.

Question 62

What is current transfer (current account)?

Answer 62

Current account This is a measurement of the net transfer of money, often known as net unilateral transfer from abroad. These are payments made between countries when no goods/services are exchanged. I.e. On the government level --\> Foreign aid/grants Individual-level --\> foreign workers sending money back to their families in their home country (remittances).

Question 63

Summary of current account?

Answer 63

**Current account balance** = Balance of trade in goods + balance of trade in services + Net income flows + Net transfers The current account balance is an overall balance and may be in a deficit or in a surplus.

Question 64

What is the capital account?

Answer 64

Capital account: to the inflows minus the outflows of funds for capital transfers and the purchase or use of non-produced natural resources. Makes up relatively small part of the balance of payments --\> doesn't have a significant effect. Two main components: 1. Capital transfer 2. Transactions in non-produced, non financial assets.

Question 65

What are capital transfers in the capital account?

Answer 65

**Capital transfer** A measure of the net monetary movements gained or lost through actions such as the transfer of goods and financial assets by migrants entering or leaving the country, debt forgiveness, transfers relating to the sale of fixed assets, gift taxes, inheritance tax and death duties.

Question 66

What are the transactions in non-produced, non-financial assets in the capital account?

Answer 66

Transactions in non-produced, non-financial assets This consists of the net international sales and purchases of non-produced assets such as land or the rights to natural resources and the net international sales and purchases of tangible assets such as patents, copyrights, brand names and franchises.

Question 67

What is the financial account?

Answer 67

The financial account measures the net change in foreign ownership of domestic financial assets. I.e. Foreign ownership of domestic financial assets increases more quickly than domestic ownership of foreign financial assets --\> more money coming in than exiting --\> Financial account surplus. It consists of three components 1. Direct investment 2. Portfolio investment 3. Reserve assets

Question 68

What is direct investment in the financial account?

Answer 68

Direct investment --\> a measure of the purchase of long-term assets, where the purchaser is aiming to gain a lasting interest (increase profit/value) in a company in another economy. Includes buying property rights, purchasing of a business or stocks or shares. Mainly refers to F.D.I.

Question 69

What is portfolio investment in the financial account?

Answer 69

Portfolio investment --\> measure of stock and bond purchases which are not a direct investment as they do not lead to lasting interest in a company. I.e. Buying and selling of treasury bills and government bonds.

Question 70

What are reserve assets in the financial account?

Answer 70

Reserve assets are the reserves of gold and foreign currencies which all countries hold and which are specified on the official reserve account. Movement in and out of this account ensure that the B.O.P always remains zero.

Question 71

Will the B.O.P in reality balance out to zero?

Answer 71

The balance of payments will not actually balance. There are too many transactions taking place for the measurement to balance. Hence, a balancing item called "net errors and omissions" is put into the account to ensure that it does balance.

Question 72

What is the relationship between the current account and the exchange rate?

Answer 72

A deficit in the current account of the balance of payments may result in downward pressure on the exchange rate of the currency. Current account deficit --\> Importing more than exporting --\> Hence, on F.E.M --\> more supply of the dollar (buying more foreign currency to import) than demand for dollar (Low exports implies fewer people are buying domestic currency) More problematic for fixed exchange rate than floating exchange rate.

Question 73

What happens in the short and long-term with the exchange rate when there is a current account deficit? How does a deficit in the current account put downward pressure on the exchange rate?

Answer 73

Remember the B.O.P must balance out to zero. Hence... In the short.... A deficit may be covered by increases by increases in the capital/financial account or by government reserve assets --\> can't continue indefinitely (reserve run out). In the long run... The value of the currency will have to depreciate because... When imports are greater than exports --\> supply of currency is greater on F.E.M --\> more people are buying foreign currencies --\> outward shift --\> depreciation. Consequently... A lower value of currency --\> Better for exports (relatively cheaper) --\> worse for imports (relatively more expensive) ---\> Improvement in current account (auto-correct of current account).

Question 74

Why is a fixed exchange rate more problematic than a floating exchange rate when one has a current account deficit?

Answer 74

In order to correct a current account with a fixed exchange rate, one could artificially lower it. In the short term --\> deficit may be covered by capital/financial account/reserve assets. In the long run --\> other countries may be unhappy with an artificially low exchange rate --\> makes the domestic country more competitive (exports cheaper).

Question 75

What are the consequences of a current account deficit?

Answer 75

Consequences If the current account is in a deficit than the capital account will need to be in a surplus --\> B.O.P = 0 1. **Foreign exchange reserves used to increase the capital account** and so to balance deficit created by current account. (Reserves will eventually run out) 2. **Negative impact on AD** --\> current account deficit will most likely imply that the net exports value is negative --\> pulling down AD 3. The deficit may be financed via high levels of **lending from abroad**. Especially problematic if lending involves high interest rates --\> short-term solution but it may increase the deficit in the long run. 4. **Downward pressure** on the exchange rate --\> depreciation.

Question 76

What are the impacts of having a current account surplus?

Answer 76

1. Current account surplus --\> allows the capital account to be in a deficit in order to build up official reserve accounts/purchasing assets abroad. 2. Current account surplus --\> leads to an appreciation of the currency --\> implies an increased demand for the currency. Imports --\> cheaper --\> reduction in inflation Exports --\> more expensive --\> harms exporters Controversial especially if it is caused by low exchange rate --\> makes countries more competitive on the global market (I.e. Germany and the Euro)

Question 77

When does one consider a current account deficit or surplus to be "big"?

Answer 77

Either one could... - View the total value or. . - Examine the magnitude of the deficit in the context of the country's GDP. (more relevant) Becuase the extent to which the deficit/surplus can be harmful depends on the countries ability reduce it.

Question 78

How can expenditure-switching policies be used to correct persistent current account deficits?

Answer 78

Expenditure-switching policies Policies implemented by the government that attempt to switch expenditure of domestic consumers away from imports towards domestically produced goods/services. - Governments policies to depreciate or devalue to the value of the currency --\> favour exports rather than imports --\> reduce C.A - Protectionist measures --\> Restrict imports of products --\> any sort of trade barrier. Balance --\> governments reluctant to use such measures as they lead to retaliation/goes against WTO agreement + protectionism --\> inefficiency.

Question 79

How can expenditure-reducing policies be used to correct a persistent current account deficit?

Answer 79

Expenditure reducing policies are policies implemented by the government that reduce the overall expenditure in the economy (Decrease AD). Example --\> Deflationary fiscal and monetary policies. All expenditure falls --\> import expenditure falls. However, size of fall in imports depends on the marginal propensity to import. **Balance** --\> Conflict of interest with macroeconomic goals! ---\> Fall in domestic employment/growth.

Question 80

What are export promotion policies + examples?

Answer 80

Export promotion policies are aimed at increasing the level of exports and are used by governments to avoid current account deficit. Examples include: Government-run trade missions, hoping to develop new markets and government-sponsored advertising campaigns.

Question 81

Why do we need the Marshall-Lerner condition?

Answer 81

As mentioned previously, theoretically a negative current account deficit should auto-correct itself. However, this is not the case... Because the price of a product might fall when there is depreciation in the value of a currency. Thus, according to the law of demand, the Q. demanded will increase, but whether or not this leads to an increase in export revenue depends on foreigner's price elasticity of demand for exports. Hence, the Marshall Lerner condition is a rule that determines whether a depreciation/devaluation will lead to increased export revenue.

Question 82

What is the Marshall Lerner condition?

Answer 82

It states that the current account deficit will only autocorrect itself if.... PED_exports + PED_Imports \> 1 This is because **E**lastic **O**nly **I**rritates **S**kin (EOIS) --\> Link between demand elasticity and revenue **E**lastic **O**pposite -\> Increase in price / decrease in revenue **I**nelastic **S**ame -\> Increase in price / increase in revenue Taking the above into consideration, if the overall elasticity PED_x-m were to be **elastic** --\> then we would expect a fall in price to lead to an increase in revenue.

Question 83

What are some possible evaluation points when considering the Marshall Lerner condition?

Answer 83

- How elastic is the demand curve --\> How do we know? Is our information accurate? --\> Different people react differently to changes in price - In the Short or Long term? --\> PED changes/becomes more elastic over time --\> J-Curve effect - Some economies rely on a fixed exchange rate --\> doesn't change - Impact of the changing exchange rate --\> does it influence any other economic objectives.

Question 84

What is the J-Curve effect?

Answer 84

If an economy satisfied the Marshall Lerner condition then we would expect to see an improvement in the current account as the value of the currency depreciates. However.... This is not the case. The J-Curve effect explains why in the short run the current account deficit actually gets worse before it improves in the long run, even though it satisfies all the condition.

Question 85

Explain why the J-curve effect happens.

Answer 85

In the short term, the current account deficit doesn't improve and gets worse because... - It takes time for other countries to realize that the prices have fallen + other countries most likely have contracts for goods/services which can't be broken quickly ---\> In the Short-term --\> PED_Exports --\> considered inelastic --\> decrease in revenue. - Likewise, the price of imports will increase but it will take time for purchasers of imports to find new suppliers + they may be tied to contracts ---\> In the short term --\> PED_imports --\> considered inelastic --\> import expenditure increases. However, over time the PED for exports and imports become more elastic --\> improves the deficit. The minimum on the J-curve graph corresponds to the point where PED_exports + PED_Imports \> 1

Question 86

What is economic integration?

Answer 86

Economic integration describes the process whereby countries coordinate and link their economic policies.

Question 87

What are bilateral and multilateral trade agreements?

Answer 87

Bilateral --\> trade agreement between **two** countries. Multilateral --\> trade agreement between **multiple** countries.

Question 88

What is a trading bloc?

Answer 88

A trading bloc is defined as a group of countries that join together in some form of agreement in order to increase trade between themselves and/or gain economic benefits from cooperation.

Question 89

What are the 6 main types of trading blocs?

Answer 89

The following list is in order of increasing economic integration. 1. Preferential trading areas 2. Free trade areas 3. Customs Union 4. Common Markets 5. Economic and monetary union 6. Complete economic integration

Question 90

What is a preferential trading area? (trading bloc)

Answer 90

Preferential Trade Areas (PTAs) exist when countries within a geographical region agree to reduce tariff barriers on selected goods imported from other members of the area. Example --\> EU, African Caribbean and the Pacific Group of states --\> Enables the EU to provide regular supplies of raw materials and duty-free trade between countries. However, such agreements are not mandatory for all nations as they may opt out.

Question 91

What are 'Free trade areas'? (trading bloc)

Answer 91

Free Trade Areas (FTAs) is an agreement made between countries, where the countries agree to trade freely among themselves but are able to trade with countries outside the free trade area in whatever way they wish. Example --\> North American Free Trade Area (NAFTA)

Question 92

What are customs unions? (trading bloc)

Answer 92

A customs union is an agreement made between countries, where the countries agree to trade freely among themselves, and they also agree to adopt a common external tariff/barriers on imports from non-member countries. Example --\> The East African Community or Mercosur.

Question 93

What are common markets? (trading bloc)

Answer 93

A common market is a customs union with common policies on product regulation and free movement of goods, services, capital and labour. Best Example --\> E.U.

Question 94

What are economic and monetary unions? (trading bloc)

Answer 94

An economic and monetary union is a common market with a common currency and a common central bank. Best example --\> Eurozone.

Question 95

What is Complete economic integration? (trading bloc)

Answer 95

Complete economic integration --\> This is the final stage of economic integration at which point the individual countries involved have no control of economic policy, full monetary union and complete harmonisation of fiscal policy.

Question 96

What are the advantages of a Monetary Union?

Answer 96

**Advantages** 1. Common currency --\> eliminates exchange rate fluctuations --\> eliminates exchange rate uncertainty --\> increase cross-border investment/trade. 2. Increased stability of currency against speculation --\> increased credibility as it is used in a large currency zone. 3. Business confidence improves --\> Less perceived risk in trading --\> internal and trade growth. 4. Transaction costs eliminated --\> no change in currency. 5. Common currency makes prices differences more obvious --\> overtime leads to prices equalizing across borders.

Question 97

What are the disadvantages of a monetary union?

Answer 97

1. Interest rates are decided by a central bank --\> individual countries aren't able to use monetary policy as a tool --\> problematic if there is a clash in economic objectives between member nations. 2. Individual countries can't manipulate their own exchange rate in order to influence international competitiveness. 3. The initial cost incurred by converting to a single currency is large. 4. Asymmetric shocks are external shocks that have an unequal impact on an economy --\> difficult to tackle problems like these in a monetary union.

Question 98

Generally speaking, what are the benefits and of trading blocs?

Answer 98

Remember --\> extent of the benefits/downfalls will depend on the degree of integration. **Advantages** 1. Similar advantages to 'Free trade' --\> greater market size (more demand), encourages specialization, more choice, lower prices, exchange of information/technology, etc. 2. More stimulus for investment due to larger market size/ foreign investors may be attracted from outside. 3. Increased economic stability/cooperation. 4. Economies of Scale 5. Jobs --\> created by trade --\> economic growth. 6. Protection from cheaper imports from outside

Question 99

Generally speaking, what are the disadvantages of trading blocs?

Answer 99

1. **Loss of benefits** --\> The benefits of free trade between countries in different blocs is lost. 2. **Distortion of trade** --\> Trading blocs are likely to distort world trade, and reduce the beneficial effects of specialisation and the exploitation of comparative advantage. 3. Trading blocs can use **discriminatory policies** against non-members --\> damaging to achievements of multilateral trade negotiations. 4. **Inefficiencies and trade diversion** --\> inefficient producers in a block can be protected from more efficient ones outside. Trade diversion --\> trade is diverted away from efficient producers outside the bloc. 5. **Retaliation** The development of one regional trading bloc is likely to stimulate others. This can lead to trade disputes, such as those between the EU and NAFTA, including the recent Boeing (US)/Airbus (EU) dispute

Question 100

What does trade creation refer to when a country joins a customs union?

Answer 100

Trade creation occurs when a country joins/enters into a customs union. Trade creation refers to the movement of high-cost domestic producer to a low-cost producer in a customs union.

Question 101

Explain the trade creation diagram?

Answer 101

It is basically the opposite of the tariff diagram. Best explained using a example Examining the change that takes before and after the UK enters the EU. Uk has the comparative advantage in the production of lawnmowers. Before entering --\> The UK would export Q₂ --\> Q₃ to the EU because of the tariff. After entering --\> The tariff is gone --\> UK can export Q₁ ---\> Q₄ which is greater than before. Whereas, France domestic production dropped 0 --\> Q1. This might look unbeneficial for the E.U but one must remember that it is a **two-way process.**

Question 102

Explain the welfare gained on the trade creation diagram?

Answer 102

There are two areas on the diagram that represent Welfare gains 1. The Extra demand results in an increase in consumer surplus --\> shaded triangle on the right. 2. The movement from high-cost to low cost producers (increase in production from UK producers who are more productively efficient as they have a comparative advantage) --\> fewer resources wasted --\> area on the left --\> world welfare gain.

Question 103

What is trade diversion?

Answer 103

Trade Diversion occurs when a country joins a customs union and... It involves the movement from a low-cost foreign producer to a high-cost producer in the customs union. This is a disadvantage of economic integration.

Question 104

Explain the trade diversion diagram?

Answer 104

Before joining the custums union (E.U), the U.K imported textiles from Thailand which had the comparative advantage --\> S (Thai) However, once the UK joined the E.U they had to impose tariffs which pushes the supply curve from S(Thai) --\> S(Thai) + tariff. Consequently, due to the increased price of textiles from thailand --\> E.U firms become more competitive --\> the U.K will import from other E.U countries (Q2 - Q3) instead.

Question 105

Explain the dead-weight loss on the trade diversion diagram?

Answer 105

There are 2 areas that show a dead-weight loss 1. Triangle Area on the right --\> As there is an overall decrease in consumer surplus (Q4 --\> Q₃) --\> there is a dead-weight loss. 2. Triangle Area on the left --\> As there is a movement from low cost (Thailand) to high-cost producers (E.U) --\> world welfare loss as more resources are being used to produce the textiles.

Question 106

What is 'Terms of Trade'?

Answer 106

The Terms of trade is an index that shows the average value of a country's export price relative to the average value of a country's import price. Note --\> Don't confuse with Balance of Payments!!! Terms of trade is important as it highlights one of the big problems facing developing countries.

Question 107

What is the equation for terms of trade?

Answer 107

TOT = ((Weighted index of average export prices)/(Weight index of average import prices)) x 100 The imports and exports are weighted in order to reflect the relative importance of different goods/services to a country's export/import revenue.

Question 108

What are the different results for the 'terms of trade'?

Answer 108

TOT \> 100 --\> Average export price is greater than the average import price. TOT \< 100 --\> Average import price is greater than the average export price. Increase in TOT --\> Improvement A decrease in TOT ---\> Deterioration The increases/decrease are compared to a base year

Question 109

What does the T.O.T for developing countries normally look like?

Answer 109

- A developing country normally imports goods that are expensive --\> manufactured/technology - A developing country normally exports goods that are cheaper --\> agricultural products Hence, developing countries tend to have a TOT that is less than 100. This highlights the importance of TOT for developing countries as it shows whether a country is diversifying away from agricultural products/commodities.

Question 110

What causes short-term changes in the Terms of Trade (T.O.T)?

Answer 110

1. Changes in Demand and Supply --\> If the demand/supply of exports changes --\> the demand curve will shift --\> change in price of exports. i. e. Improved weather --\> more agricultural products --\> outwards shift in supply --\> decrease in price 2. Changes in relative inflation rates --\> If inflation rates are higher in one country than another then their export price will begin to rise (things are basically more expensive) Balance --\> not necessarily good --\> less competitive 3. Changes in exchange rates --\> A change in exchange rate will change the price of export relative to imports

Question 111

What causes long-term changes in the Terms of Trade (T.O.T)?

Answer 111

1. **Changes in income** --\> Rising incomes in developed countries leads to increases in demand for secondary/tertiary products which have an elastic income elasticity. - Improvement in TOT of developed (export secondary/tertiary products) - Deterioration in TOT of developing (importing secondary/tertiary products) 2. **Long-run improvements in productivity** --\> Will lead to gradual deterioration of TOT --\> price of products decreases. Bad? Not necessarily --\> increases competitiveness which is beneficial if demand for exports is elastic. 3. **Long-run improvements in technology** --\> Will lead to gradual deterioration of TOT -- \> price of products decreases. Bad? Not necessarily --\> increases competitiveness which is beneficial if demand for exports is elastic.

Question 112

What is the price elasticity of demand for exports?

Answer 112

Price elasticity of demand for exports is a measure of the responsiveness of the demand for exports when there is a change in price. PED_Exports = (% change in demand)/(% change in price) In the long run --\> mos imports face elastic demand However, commodities tend to have inelastic demand.

Question 113

What is the price elasticity of demand for imports?

Answer 113

Price elasticity of demand for imports is a measure of the responsiveness of the demand for imports when there is a change in price. PEDExports = (% change in demand)/(% change in price) In the long run --\> mos exports face elastic demand However, commodities tend to have inelastic demand.

Question 114

What factors that improve T.O.T lead to an improvement in the current account?

Answer 114

1. An improvement in TOT, when caused by an increase in demand for exports, leads to an improvement in the current account. Increase demand --\> outward shift --\> increase in price. Due to... competition becomes less competitive, a global increase in income, change in taste, etc. 2. An improvement in the terms, when caused by inflation, leads to an improvement in the current account when the demand for exports is inelastic.

Question 115

What factor that improves T.O.T leads to a deterioration in the current account?

Answer 115

- An improvement in the terms of trade, when caused by inflation, leads to a depreciation in the current account balance when the demand for exports is relatively elastic. More applicable because... - The PED of most exports tends to be elastic (due to a large amount of competition on a global scale). Generally, commodities tend to face inelastic demand. However, if demand is on the inelastic part of the curve --\> high inflation continues --\> price will eventually become elastic. Generally speaking... An improvement in TOT due to inflation will lead to a depreciation in the Current account balance.

Question 116

Why has there been a long-run downward trend in commodity prices?

Answer 116

Factors are important to consider as they have an impact on countries that export commodities (negative impact on T.O.T). 1. Increase in the supply of commodities due to increased technology. 2. Synthetic replacements for natural commodities --\> results in a decrease in demand. 3. As commodities have an inelastic income elasticity ---\> increases in income have not resulted in more demand. 4. Agricultural policies in developed countries --\> subsidies for farmers --\> increased world supply.

Question 117

What are the negative consequences of the fall in T.O.T for developing countries that depend on commodities?

Answer 117

In order to manage fall in price the government might: 1. Sell more and more exports to buy imports ---\> increase supply which pushes down commodity prices even more. Results in overuse of resources --\> negative externalities --\> degradation of land, desertification, soil erosion, etc. 2. Borrow money --\> High levels of indebtedness ---\> difficult in repaying debt --\> more borrowing --\> more debt --\> vicious circle.

Question 118

What is specialisation?

Answer 118

Specialisation --\> workers/businesses/countries are assigned specific tasks within a production process. Hence, they will require less training to become efficient at the particular task.

Question 119

Benefits of specialisation?

Answer 119

Benefits: 1. Increased productive efficiency --\> increase revenue 2. Benefit from economies of scale --\> more competitive/increased output 3. `Improved quality --\> perfecting the craft 4. Lower prices for consumers/producers 5. Fewer resources wasted --\> fewer negative externalities.

Question 120

What is international competitiveness?

Answer 120

International competitiveness refers to a country's ability to sell its goods and services in domestic and international markets at a price and quality that is attractive in those markets. It can be measured using... Price factors --\> relative labour cost Non-price factors ---\> Quality, desgn, reliability, etc.

Question 121

How could governments make their country more competitive?

Answer 121

1. Subsidising 2. Providing education 3. Remove taxes 4. Decreasing/increasing regulations --\> depends on situation.

Question 122

What are factors that influence competitiveness?

Answer 122

1. Connectability 2. Political situation (war/humanitarian situation) 3. Ethical issues 4. Trade barriers 5. Availability of resources 6. Infrastructure 7. Absolute/comparative advantage

Question 123

Paper 3 Questions 1. Dollar against euro is currently 1:0.8, what is the rate for 1 euro? 2. With the exchange rate of 1:0.8, how much does of a good in euros that is selling at $75 3. Exchange rate changes 1:0.8 to 1:0.9 --\> what would happen to the price of US dress shirts ($150) in euros?

Answer 123

1. Dollar against euro --\> 1 : 0.8 Euro against dollaer --\> 0.8/0.8 : 1/0.8 = 1 : 1.25 2. 75 x 0.8 = $60 3. The price of the dress shirt would increase as you need more euros to get 1 dollar (euro depreciated). 0. 9 x 150 = 135

Question 124

How can one find the equilibrium exchange rate using the demand and supply functions?

Answer 124

This is no different from finding the equilibrium price in a demand and supply question. 1. Use the diagram and find the intersection 2. Use simultaneous equations --\> equate both equations.

Question 125

What are embargoes?

Answer 125

Embargoes An embargo is an extreme quota. A complete ban on imports and it is usually used as a political punishment