dennismclain.files.wordpress.com€¦ · Web viewISA, Grade 12 Economics SL / HL, April 2016. REVISION IB DP ECONOMICS. Section 3: International Economics. This purpose of this section

ISA, Grade 12 Economics SL / HL, April 2016

REVISION IB DP ECONOMICSSection 3: International Economics

This purpose of this section of the syllabus is to understand why countries trade and which problems can arise from this. In this part of the syllabus there is great scope to evaluate economic theories through considering stakeholders and by distinguishing between long and short-term consequences. You also need to understand the role and impact of exchange rates and the important of external balance as can be shown by changes on the balance of payments. It is important to realise that the actions of the government or firms (MNCs) of one country can have real consequences for other countries and which role the WTO plays in international trade

3.1 Reasons to TradeEconomists support free trade, because it often provides large benefits both to the country with the open economy and the rest of the world. Below, list 7 different gains (benefits) from trade (for consumers, producers, economy). You should be able to explain these gains:1.2.3.4.5.6.7.

Define ‘trade protection’:

List the four main types of protectionism:1.2.3.4.Using a diagram, explain the effects of imposing a tariff on imported goods on:

Domestic producers:

Foreign producers:

Consumers:

Government:Using a diagram, explain the effects of setting a quota on goods from foreign producers:

Domestic producers:0

1

Foreign producers:Consumers:Government:

Using a diagram, explain the effects of giving a subsidy to domestic producers in a market with international trade on:

Domestic producers:Foreign producers:Consumers:Government:Define ‘free trade’:

Describe how administrative barriers may be used as a means of protection:

Different stakeholders have different opinions on imposing trade barriers. List 7 different arguments which are often used in favour of trade protection:1.2.3.4.5.6.7.Especially supply-side economists disprove of any type of protectionism. What are their arguments against trade protection? Again, list 7 different contra-arguments:1.

0

2

2.3.4.5.6.7.

Governments use many arguments to defend protectionism. List at least three situations in which an economist would / could agree with trade protection:1.2.3.3.2 Exchange ratesDefine ‘exchange rate’:

Explain how the value of an exchange rate is determined:

Illustrate how exchange rates are determined in a freely floating exchange rate system:

List 6 causes of changes in the exchange rate (these need to change the demand for or supply of the currency):1.2.3.4.5.6.Using an appropriate diagram below, explain the effect of an increase in demand for exports when the exchange rate is freely floating.

0

03

If interest rates increase in Sweden, what will happen to the exchange rate of the Swedish Kr?

If inflation increases faster in Norway than in the economies of its trading partners, what will be likely to happen to the exchange rate of the Norwegian Krone?

Distinguish between depreciation and appreciation of a currency:

Distinguish between depreciation and devaluation of a currency:

Explain the possible economic consequences of a depreciation of a currency on:1. Inflation rate

2. current account balance

3. economic growth

4. Employment

Note that the above arguments could be needed to evaluate the possible economic consequences of a change in the value of a currency of a particular country mentioned in the article of a data response question.

Define a ‘fixed exchange rate’ system:

Distinguish between devaluation and revaluation of a currency:

4

Explain using a diagram how a fixed exchange rate can be maintained:

Define a ‘managed exchange rate’ of ‘managed float’:

Define ‘undervalued currency’:

Explain possible consequences of an undervalued currency:

What is the opposite of an undervalued currency?

List 4 major differences to discuss when comparing different exchange rate systems (mainly needed when asked to compare and contrast a fixed exchange rate system with a floating exchange rate system):1.2.3.4. 3.3 Balance of PaymentsWhat is the role of the ‘balance of payments’?

Distinguish between debit and credit items in the balance of payments:

There are three main components of the balance of payments and a fourth item: 1.2.3.4.

0

5

Which four components make up the current account?1.2.3.4.Distinguish between a current account deficit and a current account surplus:

Explain the three components of the financial account:1.2.3.Know that the capital account consists of capital transfers and transactions in non-produced, non-financial assets.Complete the following formula (HL paper 3 calculations) in balances:Current account = ………………………. + ……………………….+ ………………Explain how the current account and the financial account are interdependent:

Explain how a deficit in the current account of the balance of payments may impact the exchange rate of the currency of that country:

Using an appropriate diagram, illustrate this downward pressure on the exchange rate of a currency of a country with a deficit in the current account of the BOP.

Countries tend to be more concerned about trade deficits than capital account deficits. A current account deficit will have different effects. Explain how this situation will impact:Indebtedness:

Ownership of domestic assets:

0

6

Interest rates:

International credit ratings:

Trade protection:

Macro-economic policy:

Exchange rates:

Using an appropriate diagram, illustrate this upward pressure on the exchange rate of a currency of a country with a surplus in the current account of the BOP.

A surplus in the current account may not only impact the exchange rate, but also impact the following two aspects:1.2.3.4. Economic integrationDefine ‘economic integration’:

There are three main forms of economic integration. List these:1.2.3.Distinguish between bilateral and multilateral trade agreements:

Give a real world example of a multilateral trade agreement:

0

7

Define ‘preferential trading agreements’:

There are three types of trading blocs which you need to know:1.2.3.Distinguish between a free trade area, a customs union and a common market:

Note that you could be asked to compare and contrast the different types of trading blocs.

List two main advantages to domestic consumers from economic integration:

List two main advantages to the macro economy from economic integration:

Define ‘monetary union’:

List three possible advantages and 3 possible disadvantages of a monetary union:

What is the ‘Doha (Development) Round’?

OVERVIEW TERMS SECTION 3

Retaliation Trade / trading blocsSelf-sufficient reciprocity Economic integrationFactor endowment Dumping Free trade areaAbsolute advantage International trade Customs unionComparative advantage (HL)

Protectionism Economic union

Specialisation Sunset industry Single marketMonoculture Sunrise industry Monetary union

8

Labour intensive Anti dumping (duties) Common marketCapital intensive Managed exchange rate Export competitivenessEconomies of scale Foreign exchange

reservesWTO

Closed economy Exchange controls Balance of tradeOpen economy Depreciation Invisible balanceTo diversify Devaluation Current account deficitFree trade Dirty float Current account surplusProtectionism Fixed exchange rate Expenditure reducing

policyEmbargo Freely floating

exchange rateExpenditure switching policy

Tariff Appreciation Supply side policiesSpecific tariff Revaluation Capital account deficitAd valorem tariff Speculation Capital account surplusquota Balance of payments Portfolio investmentProducer subsidy Current account Foreign direct

investmentExport subsidy Visible trade Terms of tradeWorsening terms of tradeInfant industry Trade surplus/deficit Price indexSunset industry Twin deficits ExportsFree trade Capital account ImportsAbundant resource FDI Trade barriersASEAN EU NAFTAMERCUSOR Preferential trade OverspecialisationDeregulation Liberalisation PrivatisationWelfare loss Consumer surplus Producer surplusWorld supply Entry barriers Common external tariffSingle market Transfer payments

9

DIAGRAMS TO KNOW

Using an appropriate diagram, explain:

1. an absolute advantage when trading internationally; 2. HL only: a comparative advantage when trading internationally; 3. HL only: the gains from specialisation through economies of scale; 4. the effects of introducing a tariff on Chinese tires by the US government;5. that a tariff ‘saves’ domestic jobs; 6. that a tariff can help a country to diversify its economy; 7. that a tariff could help to reduce a trade deficit; 8. how anti-dumping tariffs work; 9. that a tariff on a foreign product leads to inefficient use of domestic resources; 10. that a tariff can hurt domestic firms (think of the good they import); 11. how a tariff reduces welfare;12. that a government could gain from the imposition of a tariff; 13. how agricultural EU subsidies reduce international trade;14. how agricultural EU subsidies reduce the ability of a low-income country to grow

economically; 15. that an import quota will reduce the imported quantity;16. that an import quota will reduce welfare; 17. HL only: a potential advantage of forming a customs union;18. HL only: a potential disadvantage of forming a customs union; 19. how a freely floating exchange rate is determined; 20. the operation of a fixed exchange rate system; 21. the effect on the Norwegian currency (the Krone) of a significant current account

surplus; 22. how higher inflation in Mexico will affect the peso (the Mexican currency); 23. the depreciation of the exchange rate as a consequence of higher inflation rates than in

the economies of trading partners; 24. revaluation; 25. a lowering of the intervention rates of a managed exchange rate; 26. how the central bank will intervene when the exchange rate is above the ceiling rate; 27. that speculation against the euro will be a self-fulfilling prophecy; 28. the impact of an increase in demand for German cars on the exchange rate of the euro;29. the effect of a higher interest rate in the UK on the exchange rate of the pound;30. the effect of larger investment flows into India on the exchange rate of the rupee. 31. HL only: the Marshall – Lerner condition; 32. HL only: the J – curve33. that a managed change in the exchange rate could lower a current account deficit; 34. that a reduction in AD could reduce a current account deficit; 35. that supply –side policies could increase international competitiveness; 36. that trade barriers can lower a current account deficit.

10

DIAGRAMS – TEST YOURSELF

EVALUATION PRACTICE: EVALUATE THE EFFECT OF A TARIFF

Show the imposition of a tariff on the diagram below:

Use the above diagram to explain the consequences of a subsidy on:

Domestic producers:

--------------------------------------------------------------------------------------

Foreign producers:

---------------------------------------------------------------------------------------

Consumers:

----------------------------------------------------------------------------------------

Government:

-----------------------------------------------------------------------------------------

Resource allocation

-------------------------------------------------------------------------------------------

Many stakeholders are impacted by the imposition of a tariff. It seems that the disadvantages

in terms of a higher price of the taxed good, the higher production costs if this good is used as

an input, the inefficient use of domestic resources and the loss of jobs in foreign countries

outweigh the advantages of the domestic jobs saved and the increase in government revenues.

It is important to realise that powerful lobby groups can however convince governments to

implement a tariff despite these disadvantages. Also most governments think from a domestic

point of view and may not be too concerned with the most efficient use of resources

0

11

worldwide, but rather focus on the full use of labour domestically.

Economic theory assumes that countries have equal negotiating power internationally. In

reality this is not the case, especially low-income countries may not have a lot of bargaining

power. Although the rise of several trade blocs however reduced the use of tariffs and

increasingly more countries are a WTO member, protectionism is still an often used tool.

Tariffs sometimes are used as a quick-fix by governments during recessions. The idea is that

tariffs will lower imports and increase exports. In times of falling AD, this is very welcome.

However, this ignores that retaliation could lower future export revenues and that foreign

countries no longer able to export can no longer afford to import. This will reduce the ability

of the first country to export and thus reduce the positive impact of this measure. Also, tariffs

increase prices and production costs. Inflation could therefore increase which could affect a

country’s international competitiveness.

Tariffs are accepted by the WTO to prevent goods from being dumped. When a country sells

their goods in a foreign country at a price below the original production costs, then imposing

tariffs will increase the price of these goods to outweigh the impact of the selling below cost.

Several governments, especially when the tax system is not well-functioning may decide to

use tariffs to increase tax revenues. The additional benefits from this extra government

spending are not likely to outweigh the disadvantages from limiting international trade.

Countries do not tend to set one tariff for all the foreign goods. Lobby groups can influence

the tariff. Many low-income countries face higher tariffs on processed goods than raw

12

materials. This will then force low income countries to sell cheap primary goods which could

slow down the growth of the country.

EVALUATION PRACTICE: EVALUATE THE SPECIALISATION

IN A PRIMARY COMMODITY

Define a primary commodity:

Show why you would advice a particular country to specialise in coffee rather than LCD

screens on the diagram below:

HL only: when specialising firms in the long-run can profit from costs reductions as shown on

the diagram below:

Specialising in the appropriate good can lead to a higher level of output, stimulate trade and

reduce the long-run production cost. However, many low-income countries find themselves in

a situation where they can not afford to import needed capital goods or technology and are

stuck producing labour-intensive and or primary goods goods. These goods tend to have a low

price internationally. It will be more difficult for low income countries to earn significant

0

0

13

export revenues which could increase domestic AD and stimulate economic growth.

Another barrier that low-income countries may face is that the goods in which they would

have a comparative or absolute advantage may be heavily protected in their potential export

markets. This could be through tariffs, quotas, administrative barriers (in the form product

specifications) or subsidies to the local producers. This will prevent low-income countries

from specialising in the production where they are most efficient.

In addition, specialisation could lead to overdependence on a narrow range of goods as many

countries tend to have absolute or comparative advantages in similar goods. This can make a

country very vulnerable to demand shocks and price changes. Neighbouring countries could

have similar production advantages which could lead to competition between countries rather

than cooperation in finding additional export markets.

Many of the goods in which low-income countries specialise tend to have income and price

inelastic demand. Even though income world wide is increasing, the demand for these goods

will not increase. Low income countries will then not be able to profit from global growth in

the form of higher export revenues.

The recent commodity price boom has been good news for countries exporting at higher

prices. However, this increase in price will most likely also have impacted the price of

imports, often making countries less able to afford imports and have resulted in countries

being worse off, facing high levels of imported inflation and lower imports of essential goods.

14

EVALUATION PRACTICE: EVALUATE THE JOINING OF A

TRADE BLOC

Show the effect of a country opening up to tariff-free imports from large foreign suppliers;

Use the above diagram to explain the consequences of joining an economic trade bloc:

Explain how this can increase trade and thus AD in the country:

International creates many advantages for a country. However, it is difficult for all the

countries of the world to agree on the conditions of trade. This is why increasingly more

countries start bilateral trade talks or join trade blocs. The advantage is that a smaller group of

countries will often have similar levels of output, development and growth. This will make it

easier to agree on priorities and countries will share the same priorities.

Although trade will become freer in this way, high barriers to trade can also be formed

through this. These trade blocs could become so powerful that regional interest are more

important that global interest.

0

15

Reallocation of production within the trade bloc is quite often neutral where the loss in

production is offset by new production. As trust and security increase so does trade and this

will then increase output within the trade bloc. (HL only: trade creation)

However, as these trade blocs still impose trade barriers on non-member countries, it is quite

likely that these trade barriers are high. This will make trade outside the trade bloc less likely.

It could even mean that goods and services produced outside the trade bloc appear more

expensive as the tariffs imposed tend to be higher. This tends to lead to reallocation of

production from outside the region to within the trade bloc. (HL only: trade diversion)

These trade blocs have developed so much power that especially low-income countries find it

increasingly difficult to negotiate beneficial condition to trade.

Trade blocs tend to focus on exchange of goods and services. If economic integration

continues free movement of resources may also be possible. However, macroeconomic and

political cooperation tends to much slower. This can sometimes cause problems.

EVALUATION PRACTICE (Ms Blink)

The advantages and disadvantages of a tariff depend on the impact on various stakeholders. The diagram showing the effect of a tariff is very useful for pointing out the various advantages and disadvantages. As can be seen in the diagram below, ___ . . .

A country may decide to deal with a current account deficit by using expenditure reducing policies. These include __ . . . The problems with these are __ . . . An alternate policy would be expenditure switching. This can be done by ____ . . Disadvantages associated with these are ___ . . .

A high value of a currency is good for ____ and . . . . because ___ . . . However, it can be very damaging for ___ . . . because _____ . . .

A low value of a currency is good for ____ and . . . . because ___ . . . However, it can be very damaging for ___ . . . because _____ . . .

16

EVALUATION PRACTICE: EVALUATE THE IMPACT OF AN APPRECIATION Show two possible ways for a country to experience appreciation of its freely floating

exchange rate:

Use the above diagram to explain the consequences of an appreciation:

The above consequences will make it clear that in the long-run this appreciation may not

continue as exchange rates and current accounts may adjust themselves automatically.

Despite the fact that a strong currency is often seen as a strength, the overall impact will

depend on whether a country is a net exporter or importer, how open the economy is how

price elastic the demand for exports and imports is.

When a net exporting country experiences a higher exchange rate, this will make it more

expensive to buy goods and services from this country expressed in the foreign currency. If

demand is price elastic in the short-run, this will lower the export revenues. Net exporters will

experience a much larger disadvantage than countries which can import more as the import

price in the domestic currency has just fallen. This may only happen if the demand for imports

is price elastic.

00

17

A change in the exchange rate could be unwelcome when a country is already implementing

macroeconomic policies to impact AD and AS. An appreciation of the currency could be

welcome during a domestic boom, but could also worsen a recession. At the same time,

countries have tried to use export-led strategies to grow when domestic consumers do not

have enough confidence to spend a country out of a recession.

What tends to be more important than the strength of a currency is its stability. For business to

take place, it is important that costs and prices can be clearly calculated in advance. Constant

changes in the exchange rate will make this more difficult.

EVALUATION PRACTICE: EVALUATE THE IMPACT OF A FIXED EXCHANGE RATEShow the effect of a fixed exchange rate;

Use the above diagram to explain the consequences of a fixed exchange rate:

Many countries have considered and several even implemented a fixed or heavily managed

exchange rate. The big advantage is that it creates certainty which exporters and importers

prefer. However, fixing an exchange rate takes away the signals that a change in price /

exchange can bring. The distortions from this intervention could be so large that a government

in the end has to devaluate its currency suddenly creating economic upheaval which destroyed

confidence of foreign investors in the domestic economy. In that case the short-run

advantages do not seem to have outweighed the long-run disadvantages.

0

18

EVALUATION PRACTICE: EVALUATE USE SUPPLY-SIDE POLICIES TO INCREASE COMPETITIVENESSShow the effect of the use of supply-side policies:

Use the above diagram to explain the consequences of supply-side policies:

Although many governments may be tempted to opt for short-run solutions to a current

account deficit, the use of supply-side policies seems to be a highly appropriate longer-term

solution. If successful, supply-side policies increase the production possibility of a country.

This increase in production potential also tends to have a downward pressure on the price

level. In times of a booming economy, this can also ensure future growth. If import of capital

goods and technology were the cause of the current account deficit, then it is important for a

country to realise that this is less of a problem than when demerit or luxury consumers goods

were imported. Supply-side policies could result in changes in job security and social security.

Many citizens will be sceptical of these changes. It would important for governments to create

sufficient support for the new measures to be successful. Certain groups in a country may

profit more from this than others. It would be the responsibility to ensure that inequality

would not increase above an agreed upon level. These policies tend to be very beneficial, but

the effects may only be noticeable in the long-run. Improving primary education may only

result in productivity improvements several years later for example.

0

19

EVALUATION EXAMPLES (Ms. Blink)

..effects of a tariff

Industries may lobby governments for tariffs because they argue that foreign products are being dumped in the domestic market. If it can be correctly demonstrated that dumping has actually taken place, then anti-dumping tariffs may be justified. However, if lower priced imports are due to the comparative advantage of foreign producers, then the biggest problem associated with tariffs is simply that they result in a misallocation of the world’s scarce resources. Also, the WTO will allow countries to impose counter-measures during the investigation of the dumping claims after which these claims may prove unjustified. Tariffs allow domestic producers to be inefficient and uncompetitive and give no incentive for the producers to become more efficient in the long run. If governments are concerned about the structural unemployment that results from changing comparative advantage, then they could implement policies to re-train unemployed workers and to give them short term support until labour can be re-allocated or skills can be improved.

.consequences of a low value of a country’s exchange rate.

A low value of a country’s exchange rate will make the country’s exports more competitive in international markets. Furthermore, imports will become more expensive and so consumers may prefer to buy from domestic producers. Either way, the low exchange rate may reduce a current account deficit. However, the biggest advantage is that it may result in a lower unemployment rate. On the other hand, a low exchange rate will cause the price of imported raw materials and capital goods to rise and can therefore create cost-push inflation. Furthermore, if exports rise and imports fall, then this might create demand-pull inflationary pressure. (But if the economy has spare capacity, then this would be an advantage.) Whether or not a low value of a currency significantly damages an economy depends on the state of the economy at the time (of both the domestic country and the trading partners).

..consequences of a high value of a country’s exchange rate.

A high value of a country’s exchange rate will make the country’s exports appear less competitive in international markets, and it will make imports appear more competitive against a country’s domestic producers. Therefore, the biggest disadvantage is a likely increase in unemployment when export volume falls. However, imported factors of production (such as technology and capital goods) and raw materials become less expensive and so if inflation is problem, then inflationary pressure will be reduced. Whether or not a high value of a currency significantly damages an economy depends on the state of the economy at the time (of both the domestic economy and the trading partners).

..policies that a government might use to reduce a current account deficit.

Expenditure switching, in the form of trade barriers can reduce spending on imports, but they may not be permitted by the WTO. Expenditure switching, in the form of a devaluation in the currency is only possible in a fixed exchange rate system. A government might try to bring about a depreciation of its currency by lowering interest rates or by buying foreign currencies, but this is unlikely to be sustainable in the long run and may conflict with its domestic objectives. Furthermore, as shown by the J-curve effect, this is only likely to be effective in the long run when demand for imports and exports become more elastic. The most effective way of bringing about a reduction in a current account deficit is to use supply side policies to increase the competitiveness of a country’s exports as this can provide a long term solution. More importantly, supply side policies also help to reach the other important macroeconomic goals of reducing unemployment, reducing inflation and achieving economic growth. However, it could take some time before these measures take effect, could lead to social resistance and these measures may be expensive.

..consequences of a deterioration in the terms of trade on developing countries.

It is not appropriate to group all low-income countries into one category. However, we can identify a particular group of low-income countries which are dependent on their exports of (primary) commodities for the bulk of their export revenues and evaluate the effect of a fall in commodity prices. Given that the demand for commodities tends to be price inelastic, deterioration in the terms of trade will result in a worsening of the current account. There will be pressure to increase the output of cash crops and this will worsen the problem by further lowering the prices of such commodities. An increase in the output of cash crops or minerals can cause environmental problems such as soil erosion and negative externalities of production, which are a threat to sustainable development. If the country suffers from indebtedness, it will harm its ability to repay its debts. The biggest problem is that countries may become stuck in a poverty trap where they cannot earn enough export revenues to finance the necessary expenditure on development priorities such as the provision of health care, education and infrastructure. As a result, economic growth and development and sustainable development are hindered.

20

21

GLOSSARY MOST ESESNTIAL TERMS (Ms Blink) SECTIION 4  4.1 Factor endowment – the factors of production (quantity and quality) that a country has available to produce goods and services. Specialisation – where a country specialises in the production of goods and services where they have a comparative advantage in production.  They will then trade to get the goods and services that they do not specialise in.   4.2 Free trade – international trade that takes place without any barriers, such as tariffs, quotas, or subsidies. Tariff - a duty (tax) that is placed upon imports to protect domestic industries from foreign competition (and /or to raise revenue for the government). Quota - import barriers that set limits on the quantity or value of imports that may be imported into a country over a certain period of time. Subsidy – a grant given by the government to a firm, per unit of output (or a lump sum) to encourage output and / or to lower the selling price to give the firm an advantage over foreign competition (or outside of an international economics context: to ensure households cheaper access to the particular good). Voluntary export restraint (VER) – a voluntary agreement between an exporting country and an importing country that limits the volume of trade in a particular product (or products) over a certain period of time. Infant industry argument – the argument that new industries with potential to compete internationally are to be protected from foreign competition until they are large enough to achieve economies of scale that will allow them to be competitive. Dumping - it is the selling of a good in another country at a price below its original unit cost of production. Anti-dumping – measures to protect a market / country against the importing of a good at a price below its unit cost of production.   4.3 Free trade area (FTA) - an agreement made between countries, where the members countries agree to trade freely among themselves, but are able to trade with countries outside the free trade area in whatever way they wish. Customs union – 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. Common market – a customs union with common policies on product regulation, and free movement of goods, services, capital, and labour. 4.4 World Trade Organisation - is an international body that sets the rules for global trading and resolves disputes between its member countries.  It also hosts negotiations concerning the reduction of trade barriers between its member nations.   4.5 Balance of payments – is a record of the value of all the transactions (due to trade and investment) between the residents of a country with the residents of all other countries over a given time period. Balance of trade – a measure of the revenue received from the exports of tangible goods minus the expenditure on the imports of tangible goods over a given period of time. Invisible balance - 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.

22

Current account – a measure of the flow of funds from trade in goods and services, plus net investment income flows (profit, interest, and dividends) and net transfers of money (foreign aid, grants, and remittances). Capital account – a measure of the buying and selling of assets between countries.  The assets are often separated to show assets that represent ownership (FDI) and assets that represent lending.   4.6 Exchange rate – the value of one currency expressed in terms of another, e.g. €1 = US$1.5. Fixed exchange rate - an exchange rate regime where the value of a currency is fixed, or pegged, to the value of another currency, (or to the average value of a selection of currencies, or to the value of some other commodity, such as gold). Floating exchange rate – an exchange rate regime where the value of a currency is allowed to be determined solely by the demand for, and supply of, the currency on the foreign exchange market. Depreciation - a fall in the value of one currency in terms of another currency in a floating exchange rate system. Appreciation - an increase in the value of one currency in terms of another currency in a floating exchange rate system. Devaluation – a decrease in the value of a currency in a fixed exchange rate system or the downwards re-adjustment of the intervention rates of a managed exchange rate. Revaluation – an increase in the value of a currency in a fixed exchange rate system of the upwards re-adjustment of the intervention rates of a managed exchange rate. Purchasing power parity theory (HL only) – states that under a floating exchange rate system and no other barriers, exchange rates adjust to offset difference in prices (for example due to inflation) between countries that are trade partners. In the long run, this will restore balance of payments equilibrium.   4.7 Current account surplus - where the revenue from the export of goods and services and income flows is greater than the expenditure on the import of goods and services and income flows over a given period of time, for example a year. Current account deficit - where revenue from the exports of goods and services and income flows is less than the expenditure on the import of goods and services and income flows over a given period of time, for example a year.  Expenditure-switching policies – policies implemented by the government that attempt to switch the expenditure of domestic residents away from imports towards domestically produced goods and services. Expenditure-reducing policies - policies implemented by the government that attempt to reduce overall expenditure (AD) in the economy, including expenditure on imports.   4.8 Terms of trade – a ratio that shows the value of a country’s weighted average export price index relative to their average import price index. Deteriorating / worsening of terms of trade/ adverse terms of trade - where the average price of exports falls relative to the average price of imports which lowers a country’s ability to finance the purchase of imports. Elasticity of demand for exports – a measure of the responsiveness of the quantity demanded of exports when there is a change in the price of exports, ceteris paribus. Elasticity of demand for imports - a measure of the responsiveness of the quantity demanded of imports when there is a change in the price of imports, ceteris paribus.

23

REAL WORLD EXAMPLES TO KNOW

For two countries of your choice, know indicators relating to international economics such as: Exchange rate fluctuations in last two years; Terms of trade movements in last two years; Current and capital account position; Level of Foreign Direct Investment into and out of the country Balance of payments position WTO member or not Member of which trading blocs

Be able to give current real-world examples related to:

Countries which have a comparative advantage in a particular good or service and why;

Countries which have relatively low trade barriers (Singapore) and high trade barriers (Turkey);

Countries which have (over)specialised in a particular good or narrow range of goods; Example of recent trade barriers such as the USA imposing tariffs on Chinese solar panels or China imposing tariffs on US chicken paws;

Know examples of trade barriers other than tariffs, example of quotas and subsidies to an infant industry;

A freely floating and a managed exchange rate (note that there are not many examples of large economies with a fixed exchange rate)

Which currency has recently appreciated or depreciated a lot and how much; Know a net exporting and net importing country; Know the main trading partners of 2 countries of your choice; Know which trading blocs your 2 countries of choice are a member of; Country with a structural current account deficit and capital account deficit; A central bank which recently used its foreign currency reserves (e.g. Japan) and why;

24

4.2 Free Trade and ProtectionismAn economy operating "free international trade"

Effect of a tariff 1:Reduction in quantity imported. Import revenues will change depending on tariff increase in price elasticity of demand.

Effect of a tariff 2:tax revenues for government

Effect of an import quota: reducing the amount which can be imported into a country.

Effect of a subsidy: increase in supply, reducing the price of the domestic good enabling domestic firms to compete better internationally, reducing imports.

25

4.6 Exchange Rates

Freely floating exchange ratesThe determination of the exchange rate under a floating exchange rate is shown to the left. The demand curve, (DD) indicates the quantity of Australian dollars that buyers (those who hold US dollars) are willing to purchase at each possible exchange rate. The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those who hold Australian dollars) at each exchange rate.

At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, as $A1.00 = $US0.60, an excess supply of Australian dollars exits and market forces will force the exchange rate down towards equilibrium.

With floating exchange rates, changes in demand and supply of the currency will cause a change in value. In the diagram to the right we see the effects of a rise in the demand for Pond Sterling (perhaps caused by a rise in British exports or an increase in the speculative demand for Pond Sterling). This causes an appreciation in the value of the Pound Sterling.

Changes in currency supply also have an effect. In the diagram to the left there is an increase in currency supply (S1-S2) which puts downward pressure on the market value of the exchange rate. Many factors have a simultaneous impact on the exchange rate of a country.

In the diagram to the right the official exchange rate has been fixed at a level of $A1.00 = $US0.60, which is above the market rate of $A1.00 = $US0.50. This requires intervention by the Reserve Bank of Australia. The bank would have to buy the excess supply of Australian dollars equivalent to Q1Q2 at a price of $US0.60. To buy the surplus of Australian dollars the government would need to sell its reserves of foreign currency.

26