IB SL Economics Chapter 4 INTERNATIONAL ISSUES Compiled by Minna Pöntinen 24/11/02 ----------------------------------------------------------------------------- A D V A N T A G E S O F T R A D E ----------------------------------------------------------------------------- General - Trade raises the standard of living; makes everyone involved economically better off - Certain groups may still suffer - Beneficiaries = consumers - Losers = small groups of producers ----------------------------------------------------------------------------- Why there are gains from trade? - Comparative advantage -> the country with the lower opp. cost for a good has this (Absolute adv. -> the country can produce the good with fewer resources) Comp. advantage in good -> the country will export - Economics of scale -> the size of the market is a limiting factor for the growth of firms - International competition -> consumers are better off with increased competition - Spread of technology -> increases output in different countries ----------------------------------------------------------------------------- Limits to specialization - An advantage in opportunity cost is not constant - Transport costs are not taken into account - Mobility of factors of production is not infinite - At times of war specialization may not be a good thing - Existence of unemploymenet is relevant - Governments restrict trade ----------------------------------------------------------------------------- Major patterns of world production and trade - Some of world's biggest traders: USA, Germany, Japan, France, UK - Exports of primary materials are less beneficial to a country than exp. of value added goods - Large part of trade involves goods that have been made/assembled in a variety of countries - Growth of world trade continues - Nature of world trade has changed (from agricult. products, fuels and textiles to processed foods, high-tech consumer products etc) ----------------------------------------------------------------------------- Uneven direction of trade - The poor buy and sell a little -> most of imp/exp transactions are carried out by MDCs - LDCs produce quite little that which is required by the MDCs ----------------------------------------------------------------------------- P R O T E C T I O N I S M ----------------------------------------------------------------------------- General - Imposing barriers to protect domestic producers - Even though there are major advantages in trade, small domestic producers may suffer ----------------------------------------------------------------------------- Types of protectionism - Embargo - Total ban of trade - Imposition from the outside -> political or military reasons - Most efficient when the country can't produce the good itself or only at a very high cost - Self-imposed bans are imposed on narcotics etc - Tariffs - Tax on imports - Specific tariff or an ad valorem tariff - A tariff will be more effective the more price elastic the good is - Often used by the LDCs to gather government revenue - Quotas - Physical limit upon the amount of imported goods - Subsidies - Can be applied to domestic goods to lower domestic prices - Helps domestic producers fight with cheaper imports - Can also be placed on exports (dumping) - Voluntary export restraints - A country agrees to a voluntary quota - Exchange controls - Gov. limits the amount of foreign currency available to importers - Import licensing - A form of rationing - A license has to be obtained from the government to import a certain good - Adminstrative barriers - Country may set eg. health requirements on products - Discriminates against foreign products ----------------------------------------------------------------------------- Arguments for the use of protectionism - Theory of comparative advantage may not be totally realistic because of - Opportunity cost is not static - Uncertainty & risk of real life - In the model prices reflect opportunity cost - Who really gains from the trade? - Full employment is assumed - Thee model does not account for economics of scale - Infant industry argument - Protection is essential for industry to develop within a LDC - Otherwise it would be impossible to compete ----------------------------------------------------------------------------- Arguments against protection - Declining industries - MDCs protect old, declining industries - Protecting employment - Protection may be used to protect against rapid structural unemployment - Consumers pay the costs in terms of higher prices - Balance of payments disequilibrium - Protectionism may be used to overcome a deficit in the BoP - Costs of long-run reliance on protectionism: - Loss of comparative advantage - Prices will be higher (for both traded- & non-traded goods) - The danger that governments may protect the wrong industries ----------------------------------------------------------------------------- Role of WTO (former GATT) - Over 100 member countries, consisting of 90% of the world trade - GATT forbade the use of quotas and restricted the use of tariffs - Special allowances for the LDCs - Periodic negotiations ----------------------------------------------------------------------------- Economic integration Trading blocs: - Free trade areas - Goods and services move freely - Each country retains its own sovereignty - Customs union - Unification of customs or trade policies - Individual country barries have disappeared - The countries are not sovereign anymore - Represented by supra-national organisations such as the EU - Common markets - Customs union for trade & four factors of production: land, labour, capital and enterprise ----------------------------------------------------------------------------- B A L A N C E O F P A Y M E N T S ----------------------------------------------------------------------------- General - The country's account with the rest of the world - Current account records all trade ----------------------------------------------------------------------------- Current account - Split into two - Visible account (merchant trade account) - Trade in goods - Invisible account - Trade in services - If CuAc is negative several years a row, something should be done ----------------------------------------------------------------------------- Capital account - Record of asset transactions across international boundaries - Net BoP = Current account balance + capital account balance = 0 ----------------------------------------------------------------------------- E X C H A N G E R A T E S ----------------------------------------------------------------------------- Determination of exchange rates - Exc. rate = the rate at which one currency trades for another - In a market exchange system, rate of exchange is determined only by demand & supply = floating exchange rate system - In a two-country system (A&B): - B want to buy A goods or services or something -> D for A$ u - The lower the price of A$ the higher the demand - The higher the A$/B$ exchange rate -> more B$ will be bought and more A$ supplied ----------------------------------------------------------------------------- Modifications to the floating exchange rates - Change in incomes - If A$ incomes rise, the D for imports and thus the D for A$ will rise -> A$ will depreciate - If B incomes fall the D for A goods and A$ will fall -> A$ depreciates - Change in relative prices - Inflation will affect the exchange rate - Prices rise -> imports become relatively cheaper -> S of currency will rise and D for it fall -> exchange rate falls - If A inflation is higher than B inflation -> A imports will become less competitive -> D for A$ will fall -> B imports will become relatively cheaper for Canadians -> S of A$ will rise -> A$ depreciates - Change in relative investment prospects - If eg. investors raise their expectations on a country, the D for that currency increases -> interest rate rises - Better investment prospects in B, the demand for A$ falls -> S of A$ increases as A investors buy more B$ -> A$ depreciates - A change in relative interest rates - A interest rates fall -> less demand for A$ (fewer people hold their money in A) -> D for B$ rises -> S of A$ rises -> A$ depreciates - It is thought that A$ will fall -> people sell their A$, S of A$ increases -> delay demand for A$ -> demand for A$ will fall - Use of foreign reserves - Government buys or sells its own currency -> a so-called dirty float - If A government wants to stop A$ from falling, it can buy A$ with foreign currencies -> D for A$ rises -> A$ appreciates ----------------------------------------------------------------------------- Purchasing power parity / Theory of exchange rates - PPP exists when a given amount of currency will buy exactly the same bundle of goods (If A$ = 2B$ -> PP ecists if bundle of goods costing 10A$ in A costs 20B$ in B) - PPP theory argues that the exchange rate falls in line with inflation ----------------------------------------------------------------------------- Balance of payments & exchange rates Changes in exchange rate - A change in incomes - Direct effect upon the current account balance - Rising domestic incomes -> exchange rate depreciates - A change in relative prices - High prices/high inflation -> current account worsens -> currency depreciates - A change in relative investment prospects - Affect capital account - Good investment prospects -> exchange rate rises - A change in relative interest rates - Affects the capital account - A rise in interest rates -> capital account strengthens -> exchange rate rises - Use of foreign reserves - Government sells or buys currency from its foreign reserve -> affects capital account ----------------------------------------------------------------------------- External balance, AD and the domestic macroeconomy - Strong relationship between the ext. balance and the AD - Increase in X -> increase in AD - Increase in M -> reduction in AD - Increase in (X-M) -> increase in NI ----------------------------------------------------------------------------- Exchange rate in countries that use protectionistic measures - Floating exchange rate system -> imbalances in the BoP adjust automatically - For example, BoP deficit -> currency slices down in value - If there is an exchange rate mechanism, the government has to restore balance - WTO/GATT has nearly banned the use of protectionism in balancing the BoP for the MDCs ----------------------------------------------------------------------------- Terms of trade - Trade is the rate at which exports will trade for imports - International trade is only rarely bartered -> trade is conducted through the use of prices - If exp. prices rise relative to imp. prices -> terms of trade 'improve' -> exp. volumes will fall more than proportionately, worsening the balance - Changes in the terms of trade affect the country's external AND internal economy (for example, inflation) -----------------------------------------------------------------------------