INTERNATIONAL TRADE

WHY DO COUNTRIES TRADE

international trade: exchange of goods and services between countries

Gains from international trade

1) Lower prices: ability to buy goods and services at a lower price than the domestic one

- prices may be lower in some countries than others because of access to natural resources

- di erences in the quality of the levels of technology

2) Greater choice: enables consumers to have a greater choice of products

they have access products that come from a number of di erent countries

3) Di erences in resources: di erent countries poses di erent resources

- some resources that a country may need but don't have

example: Singapore have very few natural resources so they are dependent on trade for their

survival / they export manufactured goods

4) Economies of scale: when producing for an international market, the size of the market

- thus demand will increase the level of production and size of the production will increase

- as production increases the economies of scale increase / production is more e cient

- larger rms means specialisation = e ciency

- larger production = greater division of labour and e ciency

5) Increased competition: lead to increased competition because rms compete with foreign
rms

- consumer gain with less expensive goods and services

- the quality and variety of goods available to consumers will increase

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 6) More e cient allocation of resources: when international trade takes place, without
government interference, the countries which are best at producing a certain good will
produce them

- they will produce these goods at the lowest cost and take advantage of their e ciency

- assume that during free trade the resources are being used most e ciently

7) Source of foreign exchange: international trade enables countries to obtain foreign exchange

- if a country produces export products, then the country will be paid in foreign currency

- this is especially important for countries that do not have convertible currency

- the foreign exchange can be used to buy goods from abroad

COMPARATIVE ADVANTAGE THEORY

ABSOLUTE ADVANTAGE

absolute advantage: it can produce a good using fewer

resource than another country

Co enia: absolute advantage in producing co ee

Robotia: absolute advantage in producing robots

COMPARATIVE ADVANTAGE

comparative advantage: one country has a lower

opportunity cost than a mother country when producing
a goods

France should specialise in wine / Poland should special

in cheese

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 if two countries have the same comparative advantage, there is not point to trade

WHAT GIVES A COUNTRY COMPARATIVE ADVANTAGE?

- Comparative advantage is based on a countries factor endowments

a country that is endowed with a large land, it may develop comparative advantage in agricultural
products

- a country with abundant unskilled labour can develop its comparative advantage in the
production of labour-intensive, low-skilled, manufactured goods

- a country with well-educated labour may develop comparative advantage in the output of
nancial services

*the abundance of a particular factor will make the price of this factor relatively lower than the
price of other factors / allowing the opportunity cost for producing this good to be lower than it
would be in other countries

LIMITATIONS OF COMPARATIVE ADVANTAGE

ASSUMPTIONS THAT LIMIT THE THEORY IN REAL LIFE

1) assumed perfect competition knowledge: assumes that the producers and the consumers
have perfect knowledge and are area of where to least expensive goods may be purchased

2) assumed no transport costs: in reality the transport costs may remove the country’s
comparative advantage

3) assume that there are only 2 rms: while there are more

4) assumed that costs do not change and that returns to scale are constant: there are no
economies or diseconomies of scale / the existence of economies of scale increase a
countries comparative advantage

5) assumes that goods being traded are identical: a problem arises with consumer durables
(such as brands fo TV)

6) assumed that the factors of production remain in the country: factors of production may
moved from country to country

7) assumed that there is perfectly free trade among countries: yet trade barrier exists

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World trade organisation

- sets rules for global trading and resolves disputes between its member countries

Aims of the WTO

aims to increase international trade by lowering trade barriers and providing a forum for
negotiation

FUNCTIONS OF THE WTO

- administer WTO trade agreements

- be a forum for trade negotiations

- handle trade disputes among member countries

- monitor national trade polices

- provide technical assistance and training for developing countries cooperate with other
international organisation

FREE TRADE AND PROTECTIONISM

free trade: the absence of government intervention of any kind in international trade / trade that
takes place without any restrictions

FOR PROTECTIONISM

protecting domestic employment

- at any given time there are industries in decline (sunset industries) as they cannot compete with
foreign competition

- if industries are large, this will lead to structural unemployment

- governments can protect these industries to avoid unemployment

protecting economy from low cost labour

- economy should be protected from imports that are produced in countries where the cost of
labour is very low

- job lesses may be concentrated in a particular industry / greater job insecurity in manufacturing
workers throughout developed countries as they fear that they may lose their jobs from
emerging markets such as China

 protecting infant industries

- an industry that is just developing may not have the economic of scale advantages that larger
industries in other countries may enjoy

- domestic industry will not be competitive against foreign imports until it can gain the cots of
production

- industry needs to be protected until it achieves a size that it is able to compete on an equal
footing

however:

- developed countries do not have this because they have access to capital markets

- developing countries can do this however they may not have the political power to do so /
compliant from developed countries

avoid the risks of over-specialisation

- governments want to limit over-specialisation because they may become over dependent

- any change in the world market price may have serious consequences for the country’s
economy / changes in technology

strategic reasons

- industries need to be protected in case they are needed in times of war

prevent dumping

dumping: selling by a country of large quantities of a commodity, at a price lower than its
production cost, in another country

- may ruin the domestic producers in developing countries

however:

- it is di cult to prove

- government may subsidise a product to support dumping

to protect standards

- a country may want to impose health, safety or environmental standards on goods being
imported into its domestic market

- to ensure that the goods match the standards of the domestic markets

- costs for high standards and documentation is high

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 - developing countries are at a disadvantage because it makes it di cult for such countries to
exploit their comparative advantage

raise government revenue

- di cult to collect tax in some countries

- government impose tari s to raise revenue

correct balance of payments de cits

- governments impose protectionist measures to reduce import expenditure

- to improve the current account

however

- this only works in the short run

AGAINST PROTECTIONISM

raises prices

protectionism raises prices to consumers and producers of the import that they buy

less choice
protectionism means less choice as import is limited

less competition

competition would diminish if forge in rms are kept out of a country

rms become ine cient without the incentive to minimise costs

innovation is reduced

distorts comparative advantage

specialisation is reduced so it reduced the potential level of output

ine cient use of the worlds resources

hinder economic growth

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 TYPES OF PROTECTIONISM

free trade

domestic producers with no trade: 0Qe / Pe

domestic producers with free trade: 0Q1 / P

foreign producers: Q1Q2 / P

tari s

tari : a tax that is imposed on imported goods

domestic producers without tari :

0Q1 / Pw

revenue : g

foreign producers without tari :

Q1Q2 / Pw

revenue : h+i+j+k

domestic producers with tari :

0Q3 / Pw +T

revenue : g+a+b+c+h

foreign producers with tari :

Q3Q4 / Pw +T

revenue :d+e

government revenue: d+e

- most common type of anti-dumping measure

- place a tari on imported goods to raise their prices and eliminate the costs advantage of
dumped imports

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 f = deadweight loss / welfare loss
loss of consumer surplus / that commodity is now not purchased

c : ine ciency

of the domestic producers and a loss of old e ciency / more of the resources are needed to
produce the same quantity

subsides

subsidy: an amount of money paid by the

government to a rm per unit of output

domestic producers without tari :

0Q1 / Pw

revenue : a

foreign producers without tari :

Q1Q2 / Pw

revenue : b + c + d

domestic producers with tari :

0Q3 / Pw + S

revenue : a + b + e + f + g

foreign producers with tari :

Q3Q2 / Pw +T

revenue : c + d

government loss: e + f + g

g : ine ciency

of the domestic producers and a loss of old e ciency / more of the resources are needed to
produce the same quantity

- no loss of consumer because the price doesn’t change

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 quotas

quotas: the physical limit on the numbers or

value of goods that can be imported into a
country

domestic producers without tari :

0Q1 / Pw

revenue : a

foreign producers without tari :

Q1Q2 / Pw

revenue : b + c + d + e

domestic producers with tari :

0Q1 + Q3Q4 / P quota

revenue : a + c + d + f + i + j

foreign producers with tari :

Q1Q3 / P quota

revenue : b + g + h

government loss: e + f + g

g : ine ciency

of the domestic producers and a loss of old e ciency / more of the resources are needed to
produce the same quantity

ADIMISITRATIVE BARRIERS

1) red tape
if the administrative processes are long and complicated, they can act as a restriction to imports

- go through complicated paper work

- slow down imports

- raise the cost to the importer

example: Venezuela where it gets more than a year

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 2) health and safety standards and environmental standards
restrictions may be placed on the type of goods that can be sold in the domestic market

example: EU and food

3) embargos

embargo: an extreme quota which is placed as a form of political punishment

example: USA with Cuba

Nationalistic campaigns

governments will run markets to encourage people to buy domestic goods instead of foreign ones
in order to generate more demand for domestic goods

example: Turkey and their ‘national buy domestic goods’ day

EXCHANGE RATES

exchange rate: value of one currency expressed in terms of another currency

FIXED EXCHANGE RATES

xed exchange rate: exchange rate regime where the value of a currency is xed 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)

example: Bosnian KM and euros

- maintained by government intervention in the foreign exchange market

revaluation: xed exchange rate is raised

devaluation: xed exchange rate is lowered

EXCESS SUPPLY

- increase in the supply = fall in exchange rate (without

government intervention)

- increase in supply due to the local buying more imported

goods (leading to an excess supply of the local currency)

- Government needs to buy up the excess currency in order to

maintain its xed exchange rate (shifting the demand curve to
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 the right)

EXCESS DEMAND

- caused by more foreigners visiting the country / more exports being demanded

- Excess demand without government intervention: the exchange rate will rise

- maintain exchange rat : government needs to sell its own currency on the FEM

- this will increase the local reserves of foreign currencies

another way of maintaining exchange rate; making it illegal to trade currency at any other rate

- di cult to reinforce unless government has monopoly power

- black markets may emerge in the currency (operating at a di erent exchange rate)

FLOATING EXCHANGE RATES

oating exchange rate: exchange rate where the value of a currency is allowed too be
determined solely by the demand and supply for the currency on the foreign exchange market

example: USA

- no government intervention to in uence the value of the currency

appreciation: the value of the currency in a oating exchange rate rises

depreciation: the value of the currency falls

Showing that 1USD = 0.80 EUROS

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 CHANGE IN THE CALUE OF A COUNTRY’S CURRENCY

DEMAND

- more local exports are bought

- more people travel to the place

- foreigners invest in local rms

- money is saved in local banks

- local currency is speculated

Demand will increase:

- increase in the demand for local goods and

services

*increased by in ation rates being lower in the

local economy / making local products cheaper
than foreign products

*increase in income of foreigners / demand for

exports increase

*change of taste of foreigners

- foreign investment prospects improve

- foreign interest rates increase making it more attractive to save there than their own local
nancial institutions

- foreign speculators think the value of the local currency will rise in the future / they they buy it
now

SUPPLY

-more imports are bought

-people travel abroad

-invest in foreign rms

-save money in foreign banks or other

nancial institutions

-speculate on foreign currency

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 Supply will increase:

- demand for imports increases / exchanging more local currencies for forge in currencies

* local in ation rates are higher than foreign ones / local goods are more expensive

* locals have an increase in income / increasing their demand for things such as imports

* change in tastes in the local economy in favour of foreign products

- foreign invest prospects improve

- foreign interest rates increase / making it more attractive to save there than local nancial
institutes

- local speculators think the local in currency is about to fall so they sell it now and buy foreign
currency

MANAGED EXCHANGE RATES

managed exchange rate: exchange rate where the value of a currency is allowed too be oat,
but with some element of interference from the government

example: Malaysia

- most central banks set an upper and lower exchange rate

- then allow the current to oat freely (as long as it doesn’t move out of the band)

- central banks do not make the upper and lower values public due to fear of speculation

appreciation: the value of the currency in a oating exchange rate rises

depreciation: the value of the currency falls

ADVANTAGES OF HIGH EXCHANGE RATE HOW

Downward pressure on in ation exchange rate is high = price of imported goods =

low

lower price of imports = pressure on domestic

producers to be competitive by keeping prices low
More imports can be bought value of exchange rate = high

- each unit of currency can buy more foreign

currency / more foreign goods and services

- visible goods and travel

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 ADVANTAGES OF HIGH EXCHANGE RATE HOW

Forces domestic producers to improve their threaten international competitiveness

e ciency - forced to lower costs

- become more e cient in order to maintain

competitiveness

- may lead to high unemployment

- increasing e ciency = greater economic

productivity

DISADVANTAGES OF HIGH EXCHANGE RATE HOW

Damage to export industries value of exchange rate = high export industries may
nd it hard to sell they goods abroad due to high
prices

- lead to unemployment
Damage to domestic industries Greater levels of imports being purchased / imports
are less expensive

- domestic producers nd the increase completion

- causes a fall in demand for their goods and

services

- further increase in unemployment / as rms cut

back

ADVANTAGES OF LOW EXCHANGE RATE HOW

Greater employment in export industries value of the exchange rate is low / exports from
country will be less expensive / more competitive

- greater employment
Greater employment in domestic industries low exchange rate = imports more expensive than
they were

- encourage domestic consumers to buy

domestically produced goods

DISADVANTAGES OF LOW EXCHANGE RATE HOW

In ation low value of the currency = imported nal goods/

imported raw material / imported components more
expensive

- cost of production rise = higher prices

- leads to in ation

High value currency: good to ght in ation / may lead to unemployment problems

Low value currency: good for solving unemployment / may create in ationary pressure

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 GOVERNMENT INTERVENTION IN FOREIGN EXCHANGE MARKET

why does a government intervene?

- lower the exchange rate in order to increase employment

- raise the exchange rate in order to ght in ation

- maintain xed exchange rate

- avoid large uctuations in a oating exchange rate

- achieve ex=change rate stability to improve business con dence

- improve a current account de cit

how does the government intervene?

- using reserves of foreign currencies to buy or sell foreign currencies

increase the value of the currency: uses foreign currency to buy it’s own currency on the foreign
exchange market / increase the demand for the currency so forces up exchange rate

decrease the value of the currency: uses foreign currency to sell it’s own / buys foreign currency
on the foreign exchange market / increasing foreign currency reserves // to buy foreign currency
the government uses its own currency to increase the supply of the foreign exchange market and
so lowers its exchange rate

- changing interest rates

increase the value of the currency: raise the level of interest rates / domestic interest rate high =
attracting nancial investment from abroad

decrease the value of the currency: lower interest rates / domestic interest rates lower than those
abroad = making nancial investment abroad more attractive / invest abroad

investors will buy foreign currencies to invest abroad / exchanging domestic currency and
increasing the supply of it in the foreign exchange market

FIXED AND FLOATING EXCHANGE RATES

ADVANTAGES OF A FIXED EXCHANGE RATE HOW

reduce uncertainty businesses can plan ahead / predicting their costs

and prices for international trading agreement
government is forced to ensure in ation is as low as in ation is very harmful if to goods and services
possible exchange rates are xed / in order to keep
businesses competitive on the foreign market,
in ation is kept low

- xed exchange rate ensure sensible government

policies on in ation
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 ADVANTAGES OF A FIXED EXCHANGE RATE HOW

reduce speculation exchange rate doesn’t usually uctuate // however

people try to destabilise the xed exchange rate in
order to make speculative gains

DISADVANTAGES OF A FIXED EXCHANGE RATE HOW

manipulation of interest rates the government needs to keep exchange rate

xed / does so by manipulating interest rates

exchange rate is falling = government will have to

raise interest rate / increase demand for the
currency

- de ationary e ect on the economy, lowering

maintain high levels of foreign reserves
must be xed at the right level
Fixing exchange rate arti cially low creates
international disagreement
demand and increasing unemployment
in order to maintain xed currency by buying or
selling foreign currencies
Setting the level of xed exchange rate is not
simple. Variables change with times / exchange rate
not set right = export rms may nd it that they are
not competitive in a foreign market
low exchange rate will make the exports more
competitive oil world market s and may be seen as
unfair trade advantage

ADVANTAGES OF A FIXED EXCHANGE RATE HOW

exchange rate doesn’t have to be constant
adjust itself
reserves are not used to control value
interest rates are free to be employed as monetary
tools / used for demand management policies
(controlling in ation)
CA de cit = demand for currency is low / export
sales are low / supply for currency is high / demand
for currency is low / exchange rate would fall /
exports are less expensive
reserves are not needed

DISADVANTAGES OF A FIXED EXCHANGE RATE HOW

create uncertainty businesses trying to plan for the future nd it

di cult to make accurate predictions about their
likely costs

- investment is more di cult to asses / volatile

exchange rate = less international investment /
di cult to assess exact level of return and risk
do not self adjust a ected by demand and supply / government
intervention / world events / speculation

cannot self adjust and eliminate CA

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 DISADVANTAGES OF A FIXED EXCHANGE RATE HOW

worsen levels of in ation high in ation / exports less competitive and imports
less expensive

exchange rate will fall (attempting to rectify the

situation) / lead to higher import prices of nished
goods / increasing in ation rate

BALANCE OF PAYMENTS

balance of payments: records of the value of all the transactions between the residents of one
country and the residents of all other countries in the world in a given time period (usually one
year)

credit item (positive value): money entering the country from abroad

negative item (negative value): money leaving the country from abroad

CURRENT ACCOUNT

current account: measure of the ow of funds from trade in goods and services, plus other
income ows

1) the balance of trade in goods

visible trade balance / mechanise balance / balance of trade

measure of the revenue received from the exports of tangible goods - expenditure on the imports
of tangible goods over a period of time

export revenue > import expenditure: surplus on the balance of trade in goods

import expenditure > export revenue: de cit on the balance of trade in goods

example: airplanes / chickens

2) the balance of trade in services

invisible trade balance / net services

measure of the revenue received from the exports of services - expenditure on the imports of
services over a period of time

export revenue > import expenditure: surplus on the balance of trade in goods

import expenditure > export revenue: de cit on the balance of trade in goods

example: banking, insurance and tourism

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3) income

net investment incomes (net factor income from abroad)

measure of net monetary movement of pro t, interest and dividends moving into and out of the
country over a given period of time / result of nancial investment from abroad

positive item: domestic rms set up branches in other countries: pro ts being repatriated

- residents and institutions in the country may have invested in banks and other nancial
institutions in other countries and any interest received from these nancial investments will
count as positive

- residents or institutions may have purchased shares in foreign companies / dividend received
are positive

negative item: foreign rms set up within a country who send money back

- payment of interest to foreign investors that leave the country counts as negative

- dividends paid by domestic rms to foreign shareholders will count as a negative item

example: investment in other countries banks

4) current transfers

payment made between countries when no goods or services change hands

measure of the net transfers of money / net unilateral transfers from abroad

example: foreign aid, grants / foreign workers sending money banks, private gifts

current account balance = balance of trade + balance of trade in services + net income ows +
net transfers

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 CAPITAL ACCOUNT

capital account: the capital transfers and the purchase or sue of non-produced natural resources
/ relatively unimportant part of the balance of payments

1) capital transfers

visible trade balance / mechanise balance / balance of trade

measure of the in ow minus out ows such things such as debt forgiveness, non-life insurance
claims and investment

export revenue > import expenditure: surplus on the balance of trade in goods

import expenditure > export revenue: de cit on the balance of trade in goods

example: gift taxes, inheritance taxes, death duties, debt forgiveness, non life insurance claim

1) transactions in non-produced, non nancial assets

measure of the net international sales and purchases of non-produced assets

example: land, right to natural resources, net international sales and purchases of intangible

assets (patents, copy rights, brand names or franchise)

FINANCIAL ACCOUNT

nancial account: the nancial account measures the net change in foreign ownership of
domestic nancial assets

surplus: foreign ownership of domestic nancial assets increase more quickly than domestic
ownership of foreign nancial assets

de cit: domestic ownership of foreign nancial assets increase more quickly than foreign
ownership of domestic nancial assets

1) direct investment

measure of the purchase of long term assets (purchaser is aiming to gain lasting interest in a
company in a noter country)

in all cases the assets is expected to have a positive return in the future (by making pro ts or by
increasing in value over time ) / buyer of the asset is taking a risk

example: buying property, purchasing of a business of purchasing of stocks or shares in a

business

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 2) portfolio investment

measure of the stock and bond purchases, which are not direct investment (no lasting interest in a
country)

investor is putting forward the money in order to purchase the asset / expectation that the money
will be repaid at given point in time // simply borrowing and lending on the international market

example: treasury bulls and government bonds / saving account deposits

3) reserve assest

measure of gold and foreign currencies which all countries hold and which are itemised in the
o cial reserve

movement in and out of this account ensure that the balance of payments = 0

example: buying property, purchasing of a business of purchasing of stocks or shares in a

business

RELATIONSHIP BETWEEN CURRENT ACCOUNT AND EXCHANGE RATE

DEFICIT IN THE CURRENT ACCOUNT

- downward pressure on the exchange rate of the current

FIXED EXCHANGE RATE

exchange rate has been set too high of a value

To x the de cit:

short run: xed by increase in the capital and nancial account / government using reserve assets
to balance the account

- reserve assets will run out

FLOATING EXCHANGE RATE

excess supply of the currency on the foreign exchange market / demand for exports has fallen /
demand for imports has increased = more demand fro other foreign currencies = greater supply of
domestic currency

To x the de cit (self adjust):

exchange rate should fall improving the competitiveness of the countries exports and increasing
the domestic prices of imports

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 SURPLUS IN THE CURRENT ACCOUNT

- upwards pressure on the exchange rate of the current

FIXED EXCHANGE RATE

exchange rate has been set too low of a value

To x the surplus:

short run: increase reserve assets to increase exchange rate

long run: other countries will not be happy with the arti cially low exchange rate / demand higher
rates / will threaten protectionism measures against the country

example: China

FLOATING EXCHANGE RATE

excess demand of the currency on the foreign exchange market / demand for exports has risen /
demand for imports has decreased = less demand fro other foreign currencies = lower supply of
domestic currency (rising the exchange rate)

To x the de cit (self adjust):

exchange rate should rise decreasing the competitiveness of the countries exports and lowering
the domestic prices of imports

CONSEQUENCES OF THE CURRENT AND CAPITAL ACCOUNT

CONSEQUENCES OF A CURRENT ACOUNT DEFICT

current account in de cit = capital account in surplus

1) foreign exchange reserves used to increase capital account

regain balance with a de cit in the current account

- no country is able to fund (long term) current account de cits from it’s reserves

- reserves will run out

2) high level of buying assets for ownership

capital account funding current account de cit: foreign investors purchases property, business,
stocks or share in business

- based upon foreign con dence in the domestic economy / not harmful

- if foreign ownership of domestic assets becomes too great = threat to economic sovereignty

- drop in con dence = foreign investors may prefer to shift their assets to other countries

- selling assets would result in increase in supply of the currency / fall in revenue

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 3) nanced from high levels of lending from abroad

high rates of interest will be paid / short term drain to the economy (further increasing current
account de cit )

CONSEQUENCES OF A CURRENT ACOUNT SURPLUS

current account in surplus = capital account in de cit

1) capital account builds up reserve account / purchasing assets from abroad

- may lead to other countries putting up protectionist measures to reduce their own de cits

2) appreciation of currency

- increase in the demand of a currency

- imports cheaper

- reducing in ationary pressures

- exports more expensive

CORRECTING A PERSISTENT CURRENT ACCOUNT DEFICIT

EXPENDITURE-SWITCHING

expenditure switching: policies implemented by the government that attempt to switch

expenditure of domestic consumers away from imports towards domestically produced goods
and services

if successful: expenditure on imports will fall and current account should improve

government policies to depreciate/devalue the value of the current

- reduce the level of exchange rate

- exports are less expensive

- depending on how responsive domestic consumers are to price changes

- should be an improvement in current account as export revenue rises

protectionist measures

- restrict the imports of products by reducing their availability (embargoes, quotes, administrative
barriers, health and safety, environmental barriers, tari s)

- domestic consumer switch from imports to exports

- often not allowed to use these measures because they are against the WTO agreements

- protecting industries reduces competition = ine cient

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 EXPENDITURE-REDUCING POLICIES

expenditure switching: policies implemented by the government that attempt to reduce the
overall expenditure in the economy / shifting AD to the left

if successful: expenditure on all goods and services fall / including expenditure on imports

size of the fall in imports depends on the marginal propensity to import

- de ating an economy may reducing current account de cit but it is likely to lead to a fall in
domestic employment / fall in economic growth

de ationary scal policy

increasing direct taxes and reducing government expenditure

- politically unpopular

de ationary monetary policy

increase interest rate / increase capital ows from abroad

- foreigners put money into nancial institutions / attracted by higher interest rates

- surplus in capital account

- politically unpopular as higher interest rates increase loans

- higher cost of borrowing = disincentive to domestic investment / potential growth

* economic cost of reducing a large current account = import to prevent it

* a lot of governments actively pursue export promotion polices

example: government-run trade missions / develop new markets / government sponsored

advertising campaigns

MARSHALL LERNER CONDITION

marshall-lerner condition: a rule that tells us how successful a depreciation or devaluation of a

currency exchange rate will be as a means to improve a current account de cit in the balance of
payments

reducing the value of the exchange rate will only be successful if t

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 Demand for exports was price inelastic:

if price fell as a results of a fall in exchange rate, the proportionate increase in the quantity of
exports demanded would be less than the proportionate decrease in the price of exports

- export revenue would fall

Demand for imports was price inelastic:

price rises as a result of a fall in exchange rate

- proportionate fall in the demand for imports would be less than then proportionate increase in
the price of imports

- import expenditure would increase

- current account de cit would become worse

Assumptions

1) short-run elasticity values are lowers than the long-run values / price elasticity values increase
over time

THE J-CURVE

To reduce the current account de cit:

- government will reduce the exchange

rate of its currency in order to make exports
less expensive

SHORT RUN

j-curve e ect: current account de cit gets worse before it gets better

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X: the country’s present current account de cit

- the government lowers the exchange rate

- price of exports fall

- communication is not perfect

- will take time for other countries to realise that the prices in this country have fallen

- contracts exist / they cannot be broke quickly

- suppliers cannot be changed so quickly

- price of imports rise

- purchasers of import will take time to nd new suppliers

- tied to contracts / wait for them to expire

The short run:

PED for exports = inelastic / export revenue will fall (prices have fallen by proportionately more
than demand has risen)

PED for imports = inelastic / import expenditure will increase (prices have risen by proportionately
more than the demand has fallen)

increasing overall current account de cit (moving from x to y)

Y: the country’s present current account de cit

PED imports + PED exports > 1

- the Marshal Lerner condition is satis ed

- less expensive exports / increase export revenue

- more expensive imports / decrease import expenditure

improving the current account balance (moving from Y to Z)

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ECONOMIC INTEGRATION

Economic integration: economic interdependence between countries, achieved by agreement

between countries to reduce or eliminate trade or other barrier between them

Bilateral trade agreement: an agreement relating to trade between two countries / aim is usually
to reduce or remove tari s/quotas that have been placed on items tarred between the two
countries

Multilateral trade agreement: agreement relating to trade between multiple countries / aim is
usually to reduce/remove tari s/quotas that have been placed on traded items - the agreement
applies to all countries involved.

Trading bloc: group of countries that join together in some form of agreement in order to increase
trade between themselves and/or gain economic bene ts from cooperation on some level

1) Preferential trading areas

Preferential trading areas (PTA): trading block that gives preferential access to certain products
from certain countries

this is usually carried out by reducing / not eliminating tari s

example: between the EU and the ACP (African, Caribbean and paci c group of states)

However not all ACP have to open up to the EU

2) Free trade areas

Free trade areas: free trade area is an agreement made between countries, where the countries
agree to trade freely among themselves, but are able to trade with countries outside of the free
trade area in whatever way they wish

example: NAFTA (North American free trade area)

3) Customs unions

Customs unions: an agreement made between countries,

where the countries agree to trade freely among themselves,
and they also agree to adopt common external barriers against
any country attempting to import into the customs union

example: EU / Switzerland - Liechtenstein

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 4) Common markets

Common markets: a customs union with common polices on product regulation, and free
movement of goods, services, capital and labour

example: EU / CARICOM

5) Economic and monetary union

Economic and monetary union: a common market with a common currency and a common
central bank

example: EU / European central bank

ADAVNATGES HOW

exchange rate uctuations disappear
enhanced credibility
transaction costs are eliminated
using common currency, it eliminates exchange rate
uncertainty between countries // increases corse-
boarder investment and trade
used in a large currency zone makes it more stable
against speculation than individual currencies
will not happen when there is only one currency

makes price di erences more obvious over leads to equalising across boarders

DISADAVNATGES HOW

interest rates are decided by the central bank individual countries are no longer free to set their
own interest rates / the tool of monetary pole is no
longer an option to in uence the in ation rate, the
unemployment rate or rate of economic growth

- especially damaging if only one country was

scally irresponsible
individual country cannot alter their own exchange
rate
initial costs of covering currency is very high
experiencing this issue
without scal integration, in the form of common
treasury, harmonised tax rates and a common
budget: union is weak and vulnerable
in order to a ect competitiveness of their exports
cost of imports
taking old current o the market, printing and
redistribution new currency / converting data base /
rewriting all the price lists / repricing all the goods

6) Complete economic integration

Complete economic integration: (the nal stage of economic integration) individual countries
involved would have no control of economic policy, full monetary union, complete harmonisation
of scal policy

example: Eurozone is moving towards

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 ADVANTAGES OF TRADING BLOCS HOW

Increased competition removal of trade barriers results in increase

competition among producers in member countries

- no barriers = imports increase / domestic

producers have to compete with lower costs
producers

- lowering prices for consumers and improved

allocation of resources
Expansion into larger markets Ability of rms to sell beyond their national
boundaries / increasing their exports / economic
growth

- Long run average costs begin to fall

- exports increase

- size of the market expands

- rm can achieve lower costs of production on

average

- economies of scale
Lower prices for consumers and greater consumer elimination of trade barriers = lower cost for
choice consumers / increased imports = greater variety of
goods from which consumer can choose
Increased investment enlarged market = increase investment by rms
who want to take advance of the larger market size

an incentive for outsider rm to invest within the

bloc = escape the protectionist measures

trading bloc attract investment by multinational

corporations
Better use of factors of production / improved free movement of the factors of production = better
resource allocation use of resources // capital can also move freely
Improved e ciency in production and economic elimination of trade bloc = better utilisation of
growth resources and improved e ciency in production =
rapid economic growth
political advantages reduced hostilities between countries / economies
are more interdependent through increased trade,
investment, labour and nancial laws

DISADVANTAGES OF TRADING BLOCS HOW

Not best way to achieve trade liberalisation
create obstacles to free trade world wide
trading blocs increase the amount of discrimination,
violating the WTOS;s non discrimination policy
trade blocs may create trade con icts between
di erent blocs / slowing down the process of trade
liberalisation

non members of the bloc face disadvantages which

limit trade / worsening global allocation of
resources
unequal distribution of gain countries forming the bloc gain unequally / creating
a potential con ict between members / di cult to
make agreements
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TRADE CREATION AND TRADE DIVERSION

TRADE CREATION

trade creation: the replacement of higher-cost products (imported or domestically produced) by

lower cost imports that results when a trading block is formed and trade barriers are removed / an
advantage of economic integration

-greater allocative e ciency

-drops from S (UK + tari ) to S (UK)

TRADE DIVERSION

trade diversion: lower cost are replaced by higher costs imports from a member after the
formation of a trading blocgreater allocative e ciency

- trade diversion as a result fo trading blocs

(another agreement against them) / in favour of
multilateral trade liberalisation

- trade diversion cannot occur with multilateral

reduction or elimination of trade barriers

- trade diversion occurs: importing country is

forced to import from a higher cost producer
within a trading bloc / whereas before it was
importing from a lower cost else where

- trade creation has an e ect on increasing social welfare, while trade diversion reduces it

- trading block creates free trade for the member it doesn’t always improve the allocation of
resources

- resources of allocation will only improve if trade creation e ects > trade diversion e ects

- trade creation = short term

- trade diversion = long term / long term outweighs the short term

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 TERMS OF TRADE

terms of trade : prices a country receives for its exports to the price paid for its imports, given by
the ratio of average export prices (x100)

This re ects the relative importance of di erent goods and services to the countries export
revenue and import expenditure

Mathematical example:

improvement in TOT: the country’s export can buy more imports that they did in the previous year

deterioration in the TOT: the given amount of exports can buy fewer imports than the year before

TOT improves: if export prices rise relative to import prices, or if they fall relatively less than import
prices fall

TOT deteriorates: import prices rise by more than export prices, or they fall by relatively less than
export prices

* if the price of a basket of exports fall: country will need to sell more exports in order to keep
imports at the same level

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 CHANGES IN A COUNTRY’S TERMS OF TRADE

SHORT RUN
WHAT HOW

conditions of demand and supply - demand of exports change (demand shift to the
left, there will be a change in the price of exports)

- prices of competitive goods in other countries

may change (a ecting competitiveness)

- incomes in importing countries may change

(a ecting the demand for exports)

- consumers tastes may change

- changes in supply (eg. weather)

Relative in ation rate in ation is hight in one country than another =
export prices will rise

- improving TOT / the exports will become less

competitive
Change in exchange rates Change in the value of a country’s currency will lead
to a change in the price of exports relative to
imports

LONG RUN

WHAT HOW

Income changes rising incomes lead to an increase in demand for

secondary and tertiary products (income elasticity
tends to be income elastic)

- TOT of develop countries improves are they

export more secondary and tertiary products
improvements in productivity within the country a gradual deterioration of the TOT

- prices will not rise

however a country exports would be more

improvements in technology within a country
competitive on the international markets and so the
result would be positive (if the demand for exports
is elastic)
lower costs of production, increase in supply, and
lower prices

a gradual deterioration in its TOT // making

country’s exports more competitive and if the
elasticity of demand is elastic = balance of trade
improve too.
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 ELASTICITY OF DEMAND FOR IMPORTS AND EXPORTS

PRICE ELASTICITY OF DEMAND FOR EXPORTS

elastic: a change in the average price of exports will lead to a greater than proportional change in
the demand for them

good for a country where export prices were falling: export demand rise proportionately more than
the prices fall (increase in export revenue)

- most sports (in the long run) face elastic demand (PED > 1)

however: commodities (raw materials) have inelastic demand

PRICE ELASTICITY OF DEMAND FOR IMPORTS

inelastic: a change in the price of imports will lead to a smaller proportional change in demand for
them

- not good for a country where import prices where rising / demand would fall by more than the
prices increased

- imports (in the long run) face elastic demand (PED > 1)

- however: commodities have inelastic demand

HOW BENEFICIAL IS AN IMPROVEMENT IN TOT

the e ect of the an improvement on the country’s current account balance

REASONS FOR IMPROVEMENT HOW GRAPH

Increase in demand for a - prices in other countries has

country’s exports risen / exports more
competitive

- consumer tastes changed (in

favour)

- demand increase = average

sports rise

- improves the current account

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 REASONS FOR IMPROVEMENT HOW GRAPH

Higher exports price caused by export prices increase because a

domestic in ation country is experiencing in ation
that is higher than the countries
with which it trades with

- improvement in TOT depends

on the elasticity of demand for
exports

- demand curve for exports is

normal / usual relationship with
the MR and TR curves

- the price of price elasticity on a

demand curve falls as price
falls

- demand for exports =

inelastic / price is on the lower
part of the demand curve

- - increase in price will lead to a

smaller decrease in demand /
export revenue will rise

- improvement in TOT caused by

in ation: improvement in the
CA / when demand is inelastic

- demand is elastic (price on

upper side of the demand
curve) / increase in price =
greater decrease in demand /
total export revenue will fall /
depreciate current account

- price elasticity of demand for most exports tends to be elastic

there is a lot of competition between countries so demand tends to be elastic / commodities face
inelastic demand so most countries will be on the elastic part of the demand curve for their
exports

- demand is on the inelastic part of the demand curve: relatively high in ation

if high in ation continues, the price of exports will eventually move into elastic region of the
demand curve

an improvement in TOT due to in ation = depreciation in the CA

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 TOT FOR DEVELOPING COUNTRIES

long run downward trend in commodity prices for year

FACTORS CAUSING HOW EXAMPLE

DECREASE IN PRICES

increases in the supply of caused by improvements in Improvement is the agricultural

commodities technology yields

- better fertilisers

- better machines

- scienti c research into plant

disease

- discovery of more minerals /

discovery of synthetic
replacements for natural
commodities
Developed countries get richer
and incomes rise / demand for
commodities doesn’t change
agricultural policies in developed
countries have a damaging fact
and the US / high prices and over
on world agricultural markets
products have become smaller
more e cient mineral
extraction
slow increase in demand or the synthetic rubber, man made
natural commodes concerned fabrics and plastics replacing
metals
as incomes rise the demand for the demand for potatoes
manufactured goods and services
has increase / demand for
commodities has not risen as
much as other products
subsidies lead to over production price support schemes in the EU
by domestic producers
production by domestic
over production is sold world producers
wide pushing the agricultural
prices down (dumping)
miniaturisation of many products computers
and improvement in plastics
technology has led to a fall in the
demand for the commodities that
were traditionally used to make
and package these products

- the combination of low income elasticity of demand, the increased use of synthetics
substitutions and miniaturisation = relatively small increase in demand

- TOT index is based on a weighted average of export prices / countries are dependent on
commodities will see a fall in the index of their export prices and deterioration in their terms of
trade

- deterioration in TOT = depreciating current account // demand for commodities tends to be

inelastic

- fall in average export prices when demand is inelastic = fall inexpert revenue

- fall exports / price of imports has risen relative to the exports

the goods that developing countries need to import are necessities (raw materials) because they
are not available domestically and are required for economic growth / demand is inelastic

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DETERIORATION IN TOT FOR DEVELOPING COUNTRIES

CONSEQUENCES

WHAT WHY

developing country have sell more exports in order in order to do this, the developing countries
to buy the same amount of imports increase supply

- pushing commodity pries down even more // a

cycle
developing countries have high levels of falling export prices export revenue makes it harder
indebtedness to service their debt

- increase borrowing (extreme cases)

- increasing their levels of indebtedness // a cycle

- countries have to increase their output of the

commodities / which they have comparative
advantage

- increase supply and drives prices down

developing countries have overused their resources increase supply and gain more export revenue /
overused their resources

- causing negative externalities

eg. land degradation, deserti cation, soil erosion

and deforestation

not sustainable in the long run

- commodity prices tend to be more volatile

- vulnerable to to circumstances beyond their control

- export revenues uctuate signi cantly // di cult for government to plan

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