A2 macroeconomic

Chapter 15: International aspects

Note: the foundations of all the topics covered in this chapter have been covered in AS so to
go revise the foundations pls go through chapters 8-10 of AS.
Policies to correct BoP deficits and their effectiveness

1) Fiscal Policy: Contractionary policy can be used by increasing direct taxes snd reducing
govt spending to restrict people’s ability to spending, which lowers AD and hence reducing
people’s demand for imports as well as foreign investment by locals falls, while also
increasing exports as local goods become cheaper and available, thus reducing BoP deficit.
Effectiveness of FP: (i) FP has time lags and hence may take time, (ii) reduce local investor’s
incentive to invest in the economy if corporate taxes have been raised or subsidies reduced
which can lower exports, (iii) reduces incentives for MNCs to invest in local country due to
the same reasons, (iv) reduces economic growth and can increase unemployment.

2) Monetary policy: Contractionary policy to be used by increasing interest rates and

lowering money supply to encourage savings and discourage borrowing to invest abroad or
buy expensive foreign goods or reduce imported raw materials and hence reducing BoP
deficits.
Effectiveness of MP: (i) discourages investment in local country due to high IR, (ii) can lead to
artificially high ER which further discourages investments and demand for exports can fall as
well, (iii) slow down of the economy which can increase unemployment.

3) Protectionism policy: refer to AS chapter 7 for methods of protectionism and their

effectiveness in their pros and cons. Can reduce outflow of money through restriction on
imports and can even reduce investments abroad through exchange controls.
Effectiveness: (i) tariffs not very useful in case of inelastic imports, (ii) may cause retaliation.

4) Exchange rate policy: devaluation can reduce BoP deficits. Effectiveness will be covered
ahead.

5) Supply side policy: discussed ahead in expenditure switching policies

Expenditure switching vs expenditure reducing policies to reduce BoP or CA deficits

Expenditure switching policies:- These are the policies used by government to encourage
domestic households by spending away from imports to local products and to encourage
foreigners to buy local products.
Their 3 types are discussed ahead.
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 These policies are of three types

i. Reducing exchange rate by decreasing interest rate or by buying forex reserves

(monetary policy). These are effective when:
a) Marshall- learner conditions are met ( PED✗ +
PEDM 1) >

b) In the long run (J curve takes effect).

c) There should be no retaliation by other countries.
d) Inflation should be kept low.+ quality ↑

ii. These policies also support protectionism through tariffs, quotas, exchange controls,
domestic subsidies, red tapes etc. These could only be effective when:
a) PED of imports is elastic.
b) No retaliation by the consumers. other countries
oooo
.

c) Local supply should be capable enough to meet the local demand.

d) The quality of the local product should be reasonably good and according to the standards.
e) The prices of the local goods should be competitive etc.

iii. To encourage the supply side policies the policy makers should focus on:
a) Education and training of employees.
b) Labour market reforms.
c) Privatization of sick industrial units.
d) Giving subsidies to encourage producers

Effectiveness of Supply Side Policies

• It is only effective in the long run.

• Expensive for government that leads to an increase in opportunity cost.

➢ Expenditure dampening policies: These are government policies that are designed to
reduce total spending in an economy, through contractionary fiscal policy (increase in taxes and
decrease in government spending) and contractionary monetary policy (decrease in money
supply or increasing interest rate or increasing exchange rate).

There are two types of expenditure reducing policies:

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Contractionary fiscal policy
A reduction in govt spending or an increase in tax to reduce AD will reduce people’s ability to
spend on local goods as well as imports, thus reducing imports and increasing exports

Contractionary monetary policy

A reduction in money supply or an increase in interest rate tax to reduce AD will reduce
people’s ability to spend on local goods as well as imports, thus reducing imports and
increasing exports.
Note: their effectiveness has already been covered a couple of pages earlier. See that.

Exchange Rates

Nominal exchange rate

It is the price of one currency in terms of another.

Trade weighted exchange rate

It is an index measure of the value of currency against a basket of currencies, with each
currency assigned a weight depending on its relative importance in terms of trade with that
country. (Calculations to be done in class)

Real effective exchange rate

Nominal exchange rate x 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (𝐶𝑃𝐼) / 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 (𝐶𝑃𝐼)
It measures how many goods in the domestic country can be exchanged for other country’s
goods. So e.g the The NER of Chinese yuan compared to US dollar is 7 lira per dollar, and
the CPI in US (domestic country) is 100, while CPI is China (foreign country) is 150, so putting
these values in the formula will give us the answer of 4.7. This means the on average 1 US
good can be exchanged for 4.7 Chinese goods.
The details of floating ER are covered in AS.

Fixed ER system

Fixed exchange rate: it is the government or a central bank of a country that sets and keeps
a fixed rate of
currency known as official exchange rate.

A central bank can keep its exchange rate fixed through 2 tools:
• Buying and selling Foreign exchange reserves
• Interest rates

$
If there is an appreciating pressure on Sz
currency i.e rise in demand or decrease in ②
supply , central bank can buy foreign
- - - - - - - - - - - ± --
. _ . Crout

reserves by selling local currency which Jagtion

would increase the supply of local currency OER •

or decrease in interest rate which would %

lower the demand hence the appreciating Dz
pressure would be then normalized as the
exchange rate would come back to the fixed D.
exchange rate.
 51 Sz

If there is an depreciating pressure on *

currency i.e. decrease in demand or
increase in supply , central bank can sell
OER
foreign reserves by buying local currency •
which would increase the demand of local
②GoueDz
- - - - " "
. . _ - - - - - -
- = ._

currency or increase in interest rate which

action
would increase the demand and normalize
D,
the exchange rate.

Revaluation vs devaluation

Revaluation
- It is when the govt increases the value of
its currency and makes it more expensive
compared to another currency
- This is done either by selling foreign
exchange reserves that central bank has
(which increases demand of the local
currency) or by increasing the IR in the
local country(which increases demand and
lowers supply of local currency)
- This is done to make imports more cheaper
or reduce the external debt burden that the
country has accumulated
- Its consequences are similar to ER
appreciation effects
- Many such countries like Pakistan which
are experiencing a depreciating pressure
on their currency artificially overvalue their
currency for above mentioned reasons
Devaluation
- It is when the govt decreases the value of its
currency and makes it cheaper compared to
another currency
- This is done either by buying foreign exchange
reserves that central bank has (which increases
supply of the local currency) or by reducing the
IR in the local country(which decreases demand
and increases supply of local currency)
- This is done to make exports more cheaper to
increase export revenue, improve GDP and
employment, and improve local industry’s
prospects and make it more internationally
competitive
- Its consequences are similar to ER depreciation
effects
- Many such countries like China which are
experiencing a appreciating pressure on their
currency artificially undervalue their currency
due to the above mentioned reasons

Managed float ER System

It is a system that is often used by developing countries to reduce ER fluctuations yet at

the same time reduce the problems faced by fixed ER systems discussed ahead. In it, an
upper and lower limit is set by the central bank for the currency’s value to fluctuate
between. In some cases only a lower limit is placed especially in case when the country
experiences consistent depreciating pressure in its ER. The ER is allowed to fluctuate
between the limits. However, as soon as the ER goes beyond these limits, the govt
intervenes through the two tools used in fixed ER discussed earlier. The diagram is drawn
in the preceding pages.
 > P×↓→D×↑
F- R↓[→Pm↑→Dm↓
Consequences of Exchange Rate Depreciation

Short Run Long Run

Elasticities ( PED) Inelastic
Current account As exchange rate falls the price
of exports falls by a lot but the
demand rises by less due to
demand being inelastic in short
run which leads to decrease in
export revenue. Similarly, price
of imports rises by a lot but the
decrease in demand for imports
decreases by less hence causing
increase in import expenditure.
Hence together with decrease in
export revenue and increase in
import expenditure the current
account deficit worsens.
Aggregate Demand It decreases as current account
deficit worsens.
GDP/Incomes/Employme It falls due to decrease in
nt aggregate demand
Inflation Demand pull fall, cost push rises
J-Curve CAN
+
Elastic
As exchange rate falls the price of
exports falls by less but the
demand rises by a lot due to
demand being elastic in long run
which leads to increase in export
revenue. Similarly, price of imports
rises by less but the decrease in
demand for imports decreases by a
lot hence causing decrease in
import expenditure. Hence
together with increase in export
revenue and decrease in import
expenditure the current account
-55s
deficit becomes better.
It increases as current account
becomes better.
It increases due to increase in
aggregate demand.
Demand pull rises, cost push
remains high

>
#
time

CA v

Marshall-Lerner Condition If the sum of price elasticity of demand of exports and price elasticity
of demand of imports is less than 1 so exchange rate deprecation will
have positive effects in the long run. [PEDX + PEDM > 1]

Hence exchange rate depreciation is good in long run but bad in short run.

of ✗ &
}
M
/
value
NI : -

Qx Qm → volume CA depends
on

✗R / ME →
Value
of ✗ dry

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 F- R↑P×↑→D×↓
↳ Pm↓→Dm↑
Consequences of Exchange Rate Appreciation
Short Run
Elasticities Inelastic
Current account As exchange rate rises the price
of exports increases by a lot but
the demand decreases by less
due to demand being inelastic in
short run which leads to
increase in export revenue.
Similarly, price of imports falls
by a lot but the increase in
demand for imports is by less
hence causing decrease in
import expenditure. Hence
together with increase in export
revenue and decrease in import
expenditure the current account
tick
deficit becomes better.
Aggregate Demand It increases as current account
deficit becomes better.
GDP/Incomes/Employme It rises due to increase in
nt aggregate demand
Inflation Demand pull rises, cost push
falls
Inverse J-Curve CAN
+
*
Hence exchange rate appreciation is good in short run but bad in long run.
SOHAIB ARSHAD ALAVI sohaib.alavi@gmail.com
Long Run
Elastic
As exchange rate rises the price of
exports increases by less but the
demand decreases by a lot due to
demand being elastic in long run
which leads to decrease in export
revenue. Similarly, price of imports
fall by less but the increase in
demand for imports increases by a
lot hence causing increase in
import expenditure. Hence
together with decrease in export
revenue and increase in import
expenditure the current account
deficit worsens.
It decreases as current account
deficit worsens.
It falls due to decrease in aggregate
demand.
Demand pull falls, cost push
remains low
>
time
Typed by Hashaam Tauseef
Assisted by Khubaib Murtaza
LGS Gulberg A levels 2020-22
Globalisation

Globalization is defined as a process that moves businesses, organizations, workers,

technology, products, ideas and information beyond national borders and cultures. In the
recent economy, trade agreements have become the cornerstones of globalization, creating
and expanding networks for trade and infrastructure.

Advantages

1. Globalization Broadens Access to Goods and Services which are of better quality and lower
prices.
2. Globalization Can Lift People Out of Poverty by creating new jobs for labor and also increasing
income inflows to the country

3. Information and Technology Spread More Easily With Globalization which further improves
living standards.

Disadvantages

1. Workers Can Lose Jobs to Countries With Low-Cost Labor as local firms move abroad or hire
foreign labor.
2. It has made environment and human rights worse.
3. Makes MNCs too powerful

Trade blocks

International economic integration or trade blocs means regional groupings of countries that
have preferential trade agreements between member countries.
The following are the different types of trade block agreements that countries are normally a
part of, and their characteristics:
 Free trade area Custom union Economic and Full economic
Monetary union union
Free trade among
members
Common external
tariff with non-
members
Common currency
Free mobility of
resources
Common fiscal
policy
North America free The world’s oldest 1. Mercosur is a In effect, the
trade agreement customs union is the south American different economies
(NAFTA). This south Africa custom trading bloc which become one
consists of USA, union(SACU). Its has Argentina, Brazil, economy. This
Examples Canada and Mexico. members include Paraguay, Uruguay, occurred when the
Botswana, Lesotho, and Venezuela as full 13 original states
Namibia, south members. formed the united
Africa and states of America.

za swaz-laud.ae
Switzerland. 2. The European
union (EU)

Consequences of formation of trade Block

Positive affect: Trade Creation

Trade creation occurs when high-cost domestic production is replaced by more efficiently
produced imports from within the trading partner. This happens when a country which was
not a member of a union initially becomes a member and hence tariffs on that country
goods are eliminated.

This gives the countries already in the union to specialize in goods in which they have a
current account in, and import those goods from the country which has just entered the
union at cheaper rates.

In this diagram, Germany which is a part of

the union produces Clothes at a higher price
Negative effects: Trade Diversion
(Pc) than turkey, which produces at (Pt).
however, as turkey is not a member, tariffs
are imposed on their goods, making them
expensive. (Pt+t)
But if turkey becomes a member and hence
tariffs are removed, Germany will import
more from turkey at cheaper Price, creating
mutually beneficial Trade. German consumers
also benefit as their consumer surplus rises.

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Negative eaffect: Trade diversion
Trade diversion means trade with low count cost production country outside of a union is
diverted to higher-cost production country from within the union. This is where the low-cost
production country is charged a higher tariff to make their goods artificially expensive which
means they are to import from a lesser efficient country within the union this makes the
country worse off.

In this diagram, Germany produces clothes

more expensively at Pc and thus it has 2
options, either to import from Denmark or non
union based New Zealand. Even though New
Zealand produces clothes cheaper than
Denmark , as NZ is not in the union , Germany
imposes a tariff on NZ’s goods to make it more
expensive than Denmark’s clothes , and thus it
imports from Denmark , making its imports
more expensive than if they had imported from
NZ . thus, trade has been diverted away from
cheaper to expensive alternatives due to
existence of union. Consumer surplus of
Germany falls as well.

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LGS Gulberg A levels 2020-22