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SECTION: INTERNATIONAL TRADE:
CHAP: 36 TRADE AND PROTECTIONS:
INTERNATIONAL TRADE: is the exchange or trade of goods and services beyond national border. For example,
export (this is when goods and services are sold to overseas customers) and import (when foreign goods and
service are bought by domestic households and firms).
FREE trade: means international trade between countries (export and import) without any forms of trade
barriers or protections, like tariff or quota.
REASONS FOR INTERNATIONAL TRADE: (why do countries engage in international trade?)
•
•
•
•
•
•
•
To gain ACCESS TO RESOURCES: international trade enables consumers and firms to gain
access to goods and services that they cannot produce themselves.
LOWER PRICES: free trade between countries can reduce cost of trading, for which goods
produced in one country A can be made available to another B at cheaper price if the govt
of country B does not impose trade barrier or protections on imports. For example,
unfavourable weather condition is Sweden means it is better off importing fruits from
Jamaica at lower cost, if there is free trade between the two countries. This can result in
lower prices of fruits for Swedish customers.
To enjoy ECONOMIES OF SCALE: international trade encourages firms to operate in large
SCALE and produce for the global market. Large scale operation can thus reduce average
cost of production due to economies of scale, which can be passed on to the customer at
lower price. This can increase firms revenue and profit.
GREATER CHOICE: free trade or international trade enables customers and firms to access
a larger variety of goods and service from different producers around the world. For
example, like Germans can choose from domestic motor vehicles such as Audi, BMW, or
Mercedez Benz, they are also able choose from foreign suppliers like Toyota (Japan),
Jaguar (India) and Cadillac (USA).
INCREASED MARKET SIZE: International trade enables firms TO sell goods in global market
which can increase firms revenue and profit. For example, a BD firms can sell products to
domestic market 160 million people, whereas it can sell to larger market of more than 2.4
billion customer by selling their products in India and China.
Increase efficiency: free trade forces domestic firms to focus on producing those set of
goods in which they are best at, and can rely on other countries for other goods and
service that the country cannot produce. This encourages international specialization and
increase efficiency in resource allocation.
Improved international relations: Free trade or absence of trade barrier encourages
international trade and co-operation between countries. They can now rely on one
another for goods and service that they cannot produce themselves. By contrast, if a
country uses trade barrier, other nations are likely to retaliate by doing the same.
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TYPES OF TRADE BARRIER/TRADE RESTRICTION/PROTECTIONISMS:
These are measures used by the govt to restrict imports into a country, and thereby protecting
domestic firms from foreign competition.
1. Tariff: It is a tax imposed on imported goods that makes import more expensive. Higher cost
of imports can thus reduce supply of import and price of imports will increase. At higher
price qty of imports will fall.
For example, a tariff of upto 400% is imposed on imported cars in BD
Price of a Toyota: 5000 Yen
Tariff= 400%, tax= 5000*400%= Yen20,000
Cost of import= (5000+20000) yen = 25000yen
However, if demand for the country’s imports are inelastic (import is an essential raw material),
then higher tariff may only reduce demand for import by a smaller %. Thus tariff may not be
effective to reduce demand for import, protect domestic firms, OR reduce current account deficit.
However, if rate of inflation in home is very high in home, then domestic residents may still prefer to
go for imports which are relatively cheaper even paying tariff. Thus tariff might be ineffective to
reduce demand for import.
However, if quality of domestic goods and service are poor then domestic residents might still resort
to imports despite higher tariff.
However, tariff on a trading partner country might result in trade retaliation, when foreign govt’s
imposes similar against home’s export. Thus home’s export revenue may fall, and tariff in ineffective
to improve current account position.
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Q2. Analyse how tariff can be used to protect domestic industries from foreign competition and
improve current account position.(5)
Tariff is an indirect tax imposed on imported goods and service that makes import more expensive.
Higher cost of imports can thus reduce supply of import and price of imports will increase. At higher
price qty of imports will fall and domestic customers might shift to buying local products as
domestic goods are relatively cheaper and more price competitive. This can help domestic firms to
attract more customer and compete against foreign firms. As domestic firms grow and expand, they
can gain international competitiveness which can increase export revenue. Also, as domestic
customers are shifting to cheaper domestic goods, this reduces demand for import and import
expenditure, causing an improvement in current account position. (5)
Q3. Discuss whether or NOT tariff is always successful to improve current account position (8)
Tariff is a tax imposed on imported goods that makes import more expensive. Higher cost of imports
can thus reduce supply of import and price of imports will increase. At higher price qty of imports
will fall and domestic customers will shift to buying more domestic goods. Lower IMPORT
EXPENDITURE can thus improve current account position. (4)
However, if demand for the country’s imports are inelastic (import is an essential raw material),
then higher may only reduce demand for import by a smaller %. Thus tariff may not be effective to
reduce demand for import. Thus current account position may not improve. (2)
However, if quality of domestic goods and service are poor then domestic residents might still resort
to imports despite higher tariff. Thus tariff may not be successful to reduce import expenditure and
hence current account position may not improve. (2)
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Q4. Discuss whether or not tariff is always successful to reduce import in a country (6)
Tariff is a tax imposed on imported goods that makes import more expensive. Higher cost of imports
can thus reduce supply of import and price of imports will increase. At higher price qty of imports
will fall and domestic customers will shift to buying more domestic goods. Thus demand for import
and IMPORT EXPENDITURE will fall if PED of import is elastic. (2)
However, if demand for the country’s imports are inelastic (import is an essential raw material),
then higher may only reduce demand for import by a smaller %. Thus tariff may not be effective to
reduce demand for import. (2)
Also, if quality of domestic goods and service are poor then domestic residents might still resort to
imports despite higher tariff. Thus tariff may not be successful to reduce import expenditure. (2)
Q1. Analyse how tariff can help to protect employment in a country (5)
Tariff is a tax imposed on imported goods that makes import more expensive. Higher cost of imports
can thus reduce supply of import and price of imports will increase. At higher price qty of imports
will fall and domestic customers might shift to buying local products as domestic goods are
relatively cheaper and more price competitive. This can help domestic firms to attract more
customer for which demand domestic goods will increase. This will encourage domestic firms to
expand by producing more output which will require more workers. Thus employment will increase.
(5)
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2. QUOTA: It is a physical limit on the quantity of imports set to enter a country in a year. This can
restrict the quantity of imports in a country.
For example, a quota of upto 8000 cars can be set to enter in BD in a year.
Price of import
S1
S
P1
P
D
Qty of import
Q1
Q
Fig: Quota on imports
However, if quota is high then it allows more imports too enter into a country. This might make it ineffective
to reduce import expenditure, compared to when quota is low.
3. Trade embargo: it is a complete ban on imports from a specific country. For example, a trade
embargo exists between US with Cuba.
4. Subsidies to domestic firms: Subsidy is govt’s lump-sum payment or cheaper loan to domestic
producers that reduces cost of production of domestic products, increase market supply and lower
price of domestic goods. As price of domestic goods decrease it help local firms to compete against
foreign imports, by encouraging domestic customers to buy more domestic goods which are now
relatively cheaper. This can reduce demand for imports and import expenditure. For example, the EU
subsidized it farmers to increase agricultural output and protect domestic farmers.
S
Price of domestic goods
S1
P
P1
D
Q
Fig: effect of subsidy:
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Subsidy reduces cost of production, and shifts supply curve to the right to S2. This leads to a fall in price of
domestic goods from P to P1, and domestic increases from Q to Q1.
HOWEVER, subsidy to domestic firms can make producers very inefficient in the long run and dependent govt
support. Thus, if subsidy is removed domestic firms will again become uncompetitive.
However, subsidy may provoke retaliation by the foreign govts. They may also offer higher subsidy to protect
foreign firms or they may impose higher tariff on domestic products which lower home’s export. Thus
subsidy might be ineffective to protect domestic industries and increase export revenue.
However, subsidy to domestic firms is an OPPORTUNTIY COST for the govt. Govt could spend the money
elsewhere like education and training, healthcare or infrastructure, which are equally for a increasing a
country’s international competitiveness.
Q1. Analyse how subsidy can be used to protect domestic firms and employment in a country (5)
Q2. discuss whether or not subsidy is always successful to protect domestic firms (8)
Q3. Discuss whether or not Subsidy is always successful to improve a country’s balance of trade
(Export of goods-import of goods) (8)
Ans:
Subsidy is govt’s lump-sum payment or cheaper loan to domestic producers that reduces cost of production
of domestic products, increase market supply and lower price of domestic goods. As price of domestic goods
decrease it help local firms to compete against foreign imports, by encouraging domestic customers to buy
more domestic goods which are now relatively cheaper. This can reduce demand for import and import
expenditure. Also, cheaper domestic products are now more internationally competitive which can increase
demand export and export revenue. Higher export revenue and lower import expenditure can thus improve
balance of trade. (4)
HOWEVER, subsidy to domestic firms can make producers very inefficient in the long run and dependent govt
support. Thus, if subsidy is removed domestic firms will again become uncompetitive, for which export may
fall again fall, and import expenditure may again rise. This can worsen balance of trade. (2)
However, subsidy may provoke retaliation by the foreign govts. They may also offer higher subsidy to protect
foreign firms. Thus domestic export may not rise and import may not fall. Thus home’s balance of trade may
not improve.
5. Product standard: A country may set product standard to dissuade other countries from selling its
products into a country if it does not meet the set product standard. This can restrict import.
For example: Bangladesh has set a product standard that permits import of right-hand drive cars
only, which automatically restrict imports of other left-hand drive cars.
6. De-valuation of exchange rate: it occurs when the external value of one currency falls in terms of
another currency. Due to a fall in exchange price or cost of import increases. When import is
expensive, it will reduce demand for import and import expenditure if demand for imported goods
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is price elastic. This will encourage domestic customer to shift to domestic consumption, rather
than import. This protects domestic industries and enables them to expand by producing more and
by recruiting more workers.
Q1. Analyse the effect of a fall in exchange rate on a country’s balance of trade (Xgs-Mgs) (6)
A fall in XR, also known as a depreciation of XR, which occurs when the price of one currency falls in terms
of another currency. Due to fall in XR, a country’s export price fall making exports more internationally
competitive. This can increase demand for export as well as export revenue. Also, a fall in XR can increase
import prices, making imports more expensive. Higher costs of import can thus reduce demand for import
as well as import expenditure. Lower import expenditure and higher export revenue can thus improve
balance of trade if PED of export and import are both price elastic. (6)
How export increases….
How import falls….
Higher export revenue and lower import expenditure can thus improve balance of trade if PED of export
and import are both elastic.
Q2.Explain TWO types of trade protection that can be used to protect domestic industries (4)/ (6)
One type of trade protection that govt can use to protect domestic industries is HIGHER TARIFF ON
IMPORTS. A tariff is a tax of imported goods that can increase cost and prices of imports, for which
domestic customers tend to switch to buying more domestic goods rather than imports. This can increase
domestic demand for goods and services, which will encourage domestic firms to expand as they are
protected against foreign competition. (3)
Another type of trade protection that govt use to protect domestic industries is A SUBSIDY TO DOMESTIC
FIRMS. A subsidy lump sum payment made by the govt to domestic firms that reduce cost of production of
domestic goods, making them more internationally competitive and relatively cheaper than imported
goods. This can help to increase export and reduce dependence on imports, increasing total demand in the
economy. Thus domestic industries can easily grow and flourish. (3)
Q3. Explain two ways of reducing imports in a country (4)
One way of reducing imports is increasing tariff. Tariff is a tax of imported goods that can increase cost and
prices of imports, for which domestic customers tend to switch to buying more domestic goods rather than
imports. Thus demand for import falls. (2)
Another ways of reducing imports is by reducing quota. Quota is a physical limit on the quantity of imports
set to enter a country in a year. Reducing quota will allow fewer imports to enter a country, hence
reducing the volume of imports. (2)
Q4. Explain two ways of increasing exports in a country (4)
One way of increasing export is by increasing the level SUBSIDY TO DOMESTIC FIRMS. A subsidy lump sum
payment made by the govt to domestic firms that reduce cost of production of domestic goods, making
them more internationally competitive. This can increase demand for export. (2)
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Another way of increasing exports is by DEVALUAITON OF EXCHNAGE RATE. It occurs when the external
value of one currency falls in terms of another currency. Due to a devaluation of exchange price domestic
goods (home’s export) falls, making them more internationally competitive as it would be cheaper for the
foreign importers. Thus demand for export increases. (2)
Topic: BALANCE OF PAYMENT:
BALANCE OF PAYMENT: It is a financial record of a country’s transaction with the rest of the world. BOP is the
difference a country’s total inflow of money (receipts) and outflow of money (payments) with the rest of the
world over a year.
BOP=
a.
b.
total inflow of money – total outflow of money.
Visible balance or trade in goods =
= total value export of goods(Xg) – total value import of goods(Mg)
Invisible balance or trade in service
= total value of export of service (Xs) - total value of import of service (Ms)
1. CURRENT ACCOUNT = visible balance + invisible balance + income account +current transfers
= (Xg-Mg) + (Xs-Ms) + (Yi-Yo) + (Ti-To)
= (Xg+Xs+Yi+Ti) – (Mg+Ms+Yo+To)
= total recipts from export of goods and services, incomes and current transfers minus total
payments for import of GnS, income and current transfers.
A country’s foreign trade data:
Export fish: $5000
Imports petroleum: $2000
Import cars: $8000
Exports garments: $3000
Import education: $10,000
Export medical service:$500
Tourism: $11000
Investment income received: $500
Dividend paid out to foreigners: $100
Remittance received: $1000
Parents transferred money to kids abroad: $1000
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Calculate:
a. TRADE IN GOODS: ($5000+$3000) – ($2000+$8000) = - $2000 (deficit on BOT)
b. Invisible balance or trade in service: ($11000+ $500) – ($10,000) = +$1500(surplus on invisible balance)
c. Income account: $500-$100 = $400
d. Current transfers: $1000-$1000= 0
e. Current account: -$2000+$1500+ $400+0= -$100 (deficit on current account)
Current account= BOT+ invisible balance + income account + current transfer
= (Xg-Mg) + (Xs-Ms) + (Ir-Ip) + (CTi – CTo)
=(Xg+Xs+Is+CTi) – (Mg+Ms+Ip+CTo)
= inflows from X of GnS, Income and CT – outflows from M of GnS, income and CT.
COMPONENTS OF BALANCE OF PAYMENT:
•
•
•
CURRENT ACCOUNT:
- Visible balance/trade in goods: Xg-Mg
- Invisible balance/trade in service: Xs-Ms
- Income account (primary income): Yi-Yo
- Current transfer (secondary income): CTi-CTo
FINANCIAL ACCOUNT:
CAPITAL ACCOUNT:
1. CURRENT ACCOUNT: this is one of the components of BOP, which records all the exports and imports
of goods and service, incomes and current transfers between a country with the rest of the world. It
is the difference between a country’s inflow of money from of export of goods and service, income
and current transfers minus outflow of money from import of goods and service, income and current
transfers.
Current account surplus exists if the financial inflows of money from export of goods and service,
income and current transfer is greater than the financial outflows of money from import of goods
and service, income and current transfers. This means it will have a positive balance on current
account.
Current account deficit exits if the financial outflows of money from import of goods and service,
income and current transfer is greater than the financial inflows of money from export of goods
and service, income and current transfers.
This means it will have a negative balance on current account.
Parts of current account:
a. Trade in goods or visible balance: Xg- Mg
b. Invisible balance: Xs-Ms
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c. Income account: investment income earned – investment income paid out, e.g: interest,
dividend, profits, etc.
d. Current transfer: records transfer of money between countries without any corresponding
exchange of goods and service. E.g: remittance, parents sending funds to kids studying abroad.
CURRENT ACCOUNT CONSISTS OF FOUR PARTS:
a. Trade in goods or visible balance: is the difference a country’s total value of EXPORT OF GOODS
minus the total value of IMPORT OF GOODS.
For example, BD exported garments of $100 and imported petroleum of $90. So, BD visible
balance will be $10 (surplus)
b. Trade in service or invisible balance: it is the difference between a country’s total value of
EXPORT OF SERVICE minus the total value of IMPORT OF SERVICE.
For example, BD exported medical service or tourism of $500 and imported education of $510.
So, invisible balance will be -$10 (deficit)
c. Income account (primary income): it records the flow of income in and out of a country in the
form of investment income or as a reward of investment. Investment income includes profits,
dividends, interest on deposits, etc.
For example, BD residents received dividend and profit from investment in US assets of $600,
and US resident are paid out $590 as a reward of their investment in BD assets.
So, BD income account will be $10 surplus.
d. Current transfers (secondary income): this records transfer of money between countries against
which there is no corresponding exchange of goods and service. For example, parents sending
money to kids studying abroad (outflow), remittance received (inflow) etc.
Questions:
The data below shows BD’s international trade data with US over a year:
Export fish $500
Import Falcon5: $800
Import petroleum $50
Income from Tourism: $100
Import education: $10
Remittance received: $500
Received foreign aid: $50
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Private transfers by families to kids studying in US: $600
Dividend and profit received: $900
Interest paid out to US residents saving money in BD banks: $250
CALCULATE:
a. trade in goods: 500-800-50 = -350 debit
b. trade in service: 100-10 = 90 credit
c. balance of trade: TiG+TiS= -350+90 = -$260
d. primary income: 900-250 = 750 credit
e. secondary income: 500+50-600 = -50 debit
f. current account:
-350+90+750+(-50) = $340 surplus
2. CAPITAL ACCOUNT: it is a relatively smaller part of balance of payment which
record capital transfers and the acquisition and disposal (sale) of non
produced, non financial assets. For instance, govt debt forgiveness, money
brought into and taken out of the country by migrants, the sale and purchase
of copyright, patents and trademark.
3. Financial account: financial account is a significant part of balance of payment
which records transfer of financial assets (investments) between one country
with the rest of the world. It records large movement of funds into and out of
the country.
Data:
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BD received direct foreign investment from US: $500
BD residents purchased shares in US stock market: $550
Purchase of a US company copyright by BD govt: $200
Bd received loan from US govt: $300
a. Capital account: $300-$200= $100 (surplus/CREDIT)
b. Financial account: $500-$550= -$50 (deficit/DEBIT ITEM)
Balance of payment: current account + capital account + financial account
= $340+$100+(-$50)
=$390
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4. Explain why a country having a deficit on trade balance of $500 bn, might still has a surplus of
$200bn on the current account of BOP. (3)
ANS: This is because the other components of current account such as capital and financial account might
have a large surplus of $700bn to cover the deficit on the trade balance.
CAUSES OF CURRENT ACCOUNT DEFICIT:
A deficit on the current account can occur due to a combination of TWO factors:
1. Lower demand for export (fall in export revenue):
• This could be caused by a decline a manufacturing sectors’ competitiveness,
perhaps due to a fall in labour productivity, rise in labour cost in home, or rise in
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price of raw materials. This can increase cost and price of domestic goods, for
which its international competitiveness, demand for export and export revenue
may fall.
• Also, if there is a recession in the foreign countries it may lower income and
purchasing power of foreign residents and firms to spend on buying home’s
export. This can reduce home’s export revenue.
• Moreover, if there is a rise in domestic exchange rate in terms of foreign
currency it would be difficult and expensive for foreign importers to buy home’s
export. This can reduce the quantity of export and also export revenue of home.
• In addition, if there is a relatively high inflation in home than in foreign it would
reduce international competiveness, for which foreigners will buy less domestic
goods and service. This can lower export.
2. Increased demand for import (or rise in import expenditure):
• This could occur if domestic residents and firms tend to buy more foreign
goods and service, perhaps due cheaper price and its better quality
compared to domestic product.
• Also, if there is a rise in domestic exchange rate it would cheaper to buy
foreign and service. Thus quantity of import and import expenditure can
both increase.
• Moreover, if there is a relatively high inflation in home than in foreign it
would make imported goods appear relatively cheaper, for which
domestic residents and firms may prefer to buy more imports. Thus
import expenditure will increase.
• Removal of trade restrictions like tariff and quota by the govt:
CONSEQUENCES OF CURRENT ACCOUNT DEFICIT:
+ve effects:
1. Improvement in short term living standard: a rise in current account deficit
indicates that there is a greater import of goods and service and the country
is living beyond its means. This enable people to enjoy a wide variety of
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goods and service even if they are produced domestically, which can improve
short term standard of living.
2. It can reduce inflationary pressure: a current account results in a fall in export
revenue and a rise in import expenditure for which net export (X-M) and AD.
This can lower price level and leading to a fall in demand pull inflation.
3. It could be a temporary deficit: a current account deficit could be caused by
an increase in import of raw materials and capital goods, and excess capital
goods can be used to produce more and more consumer goods. These extra
production of consumer goods can then be used to increase export and offset
the deficit in the current account. Also, extra output produced from imported
raw materials and capital goods, can increase long term GDP and living
standard.
Negative effects:
1. Reduce aggregate demand in the economy: AD= C+I+G+X-M= total demand
A current account deficit means that the economy is spending more of foreign
goods or imports and less money is received from export of goods and
service. This causes net export and aggregate demand (total demand) to fall
for which output and GDP will also decrease. This can trigger RECESSION in
the economy.
2. UNEMPLOYMENT: A current account deficit means that a country incurs more
import expenditure than export revenue. This can result in a fall in aggregate
demand, for which less output will be produced. This will also reduce demand for
labour since demand for labour depends on demand for the product. This forces
employers or business to lay off workers or cut wages, causing a rise in
unemployment.
3. FALL IN STANDARD OF LIVING: A current deficit means higher import expenditure
and lower export revenue, for which there more outflow of money than inflows.
This can lower total demand, output and GDP, which means people will now have
less income, for which they also consume less goods and service. Thus they will
suffer from lower standard of living.
4. A fall in exchange rate: Exchange rate is the value of one currency in terms of
another currency. For example, exchange rate of $1 is Tk85 today
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iF there is a current account deficit it means there is greater import expenditure,
which would require domestic to buy more foreign currency and sell home
currency in order to pay for import. Thus supply of home currency (TK) in the FEM
will increase, causing a fall in exchange rate of Home currency (TK).
Also, a current account deficit means lower export revenue, for which foreign
residents and firms will require to buy less home currency to buy fewer home’s
exports. This will reduce demand for home currency (tk) in the FEM, causing a fall in
exchange rate of Home currency (tk). When XR falls this can increase domestic
producers’ cost of import of raw materials and components leading to an in total
COP. Thus market supply may fall and prices may increase leading to cost push
inflation.
OR
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WAYS OF CORRECTING DEFICIT ON CURRENT ACCOUNT/ OR
DEALING WITH CURRENT ACCOUNT DEFICIT:
1. By using fiscal policy: fiscal policy deals with changing govt income (taxes) and
govt expenditure (G) to influence AD and manage the economy.
To correct deficit on current account, govt need to raise taxes like income tax,
or tariff.
If direct tax such as income tax is raised it will reduce people’s disposable
income, for which they will have less money to pay for imports. Thus demand
for import and import expenditure would fall.
Also if indirect tax such as tariff is raised, it will increase cost of import and
make import more expensive. At higher price, demand for import and import
expenditure would both fall. These can correct any deficit on current account.
To reduce deficit on current account govt needs to lower govt expenditure (G),
which will reduce the amount of money available in the economy. With less
money available people can spend less on imports. Thus import expenditure
falls, and corrects deficit on current account.
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Q1. Analyse how fiscal policy can be used to correct deficit on the current account of
BOP (6)
2. Using monetary policy: MONETARY POLICY deals with changing the rate of
interest in order to influence AD and manage the economy.
If interest rate is lowered it will attract less hot money inflow into the
economy as foreign residents and firms will be discouraged to save in home’s
banks and earn lower interest on deposit. For this reason they will not
convert foreign currency into home currency or buy HC, for which demand for
home currency in the foreign exchange market (FEM) will fall causing a fall in
exchange rate of home currency. This will increase international
competitiveness of home’s product as export is cheaper. Thus demand for
export and export revenue will increase. Also, a fall in exchange rate can
make import more expensive, for which demand for import and import
expenditure would fall. Lower import expenditure and higher export revenue
can thus reduce deficit on current account.
However, lower interest might encourage households and firms borrow more
and spend behind imports. Thus current account deficit might increase
instead.
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Q. discuss whether or not lower interest rate can always reduce correct account
deficit (8)
Also, if PED of export and import are both inelastic (price inelastic demand), then a
fall in XR may not increase demand for export or many not reduce demand for
import. Thus current account deficit may not fall.
3. Using SUPPLY SIDE POLICY: SS policy deals with measures designed to
increase the productivity of economy’s FOP, and overall productive capacity
of the economy. Example include:
• Govt investment behind education, training and healthcare: it can
improve workers’ health, skill, productivity and overall human capital
the economy. Greater productivity can reduce average cost of
production and increase international competitiveness of domestic
goods. This can increase export revenue, reducing deficit of current
account of BOP.
• Govt investment behind infrastructure: infrastructural support to
export industries, like special industrial area with better roads and
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railway network, gas, electricity, etc for garments in BD, can reduce
cost. This can make a country’s export more internationally
competitive, for which export revenue will increase.
• Govt subsidy and tax incentives to new start-ups: subsidy and tax
incentives to export-based start-ups can reduce cost and encourage
setting up more new export-related business. This can increase export
revenue.
4. PROTECTIONIST MEASURE: protectionist measures deals with reducing the
competitiveness of imports, and making domestic goods appear relatively
cheaper and attractive. This is can be achieved by imposing higher tariff (tax
on import) and tighter/reduce quota (limit on the quantity of import).
QUESTIONS:
Q1. Analyse how fiscal policy can be used to deal with current account deficit (6)
-definition of FP and also Current account deficit. (2)
-To correct deficit on current account, govt need to raise taxes like income tax, or
tariff.
-If direct tax such as income tax is raised it will reduce people’s disposable income, for
which they will have less money to pay for imports. Thus demand for import and
import expenditure would fall. (3)
-To reduce deficit on current account govt needs to lower its expenditure, which will
reduce the amount of money available in the economy. With money available people
can spend less on imports. Thus import expenditure falls, and corrects deficit on
current account.(3)
Q2. Analyse how monetary policy can be used to reduce current account deficit (6)
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Q3. Analyse the use of supply side policy to deal with current account deficit (6)
Q4. Identify and explain two protectionist measure govt can use to reduce import
(4)
One protectionist measure that govt can use to reduce import is by increasing tariff.
Tariff is a tax imposed on imported goods that increases cost of import. This makes
import more expensive, which can then demand for import as well as import
expenditure. (2)
Secondly, govt can also reduce quota as a mean of reducing import. Quota is a
physical limit on the quantity of imports set to enter a country in a year. Lower
quotas will lead to fewer imports, increasing prices for which demand for import
falls (2)
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CAUSES OF CURRENT ACCOUNT SURPLUS:
It occurs when the total value of export of goods and service is greater than the
total value of import of goods and service.
1. Higher demand for export (higher export revenue):
- This could be caused by an improvement in manufacturing sectors’
competitiveness, perhaps due to a LOW labour cost in home, or FALL in price of
raw materials, increase in labour and capital productivity. This can REDUCE cost
and price of domestic goods, for which its international competitiveness WILL
INCREASE, demand for export and export revenue may fall.
- Also, if there is an economic BOOM in the foreign countries it may increase
income and purchasing power of foreign residents and firms for which they can
spend more on buying home’s export. This can increase home’s export
revenue.
- Moreover, if there is a FALL in domestic exchange rate in terms of foreign
currency it would be cheaper for foreign importers to buy home’s export. This
can reduce the quantity of export and also export revenue of home.
2. FALL IN DEMAND FOR IMPORT (low import expenditure):
- This could occur if domestic residents and firms tend to buy LESS foreign
goods and service, perhaps due HIGHER price and its POOR quality of
imported goods compared to domestic product.
- Also, if there is a FALL in domestic exchange rate it would BE EXPENSIVE to
buy foreign goods and service. Thus quantity of import and import
expenditure can both decrease.
- Moreover, if there is a relatively LOW inflation in home than in foreign it
would make imported goods appear relatively EXPENSIVE, for which domestic
residents and firms may prefer to buy LESS imports, rather they switch to
domestic consumption. Thus import expenditure will increase.
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CONSEQUNCES OF CURRENT ACCOUNT SURPLUS:
Positive effects:
1. INCREASE aggregate demand in the economy: AD= C+I+G+X-M
A current account SURPLUS means that the economy is spending LESS ON
foreign goods or imports and MORE money is received from export of goods
and service. This causes aggregate demand (total demand) to INCREASE for
which output and GDP will also INCREASE. This can trigger ECONOMIC
GROWTH in the economy.
2. INCREASE IN EMPLOYMENT: A current account SURPLUS means that a country
incurs more EXPORT REVENUE than IMPORT EXPENDITURE. This can result in
an increase in net export and aggregate demand, for which more output will
be produced. This will also increase demand for labour since demand for
labour depends on demand for the product. These will employers to recruit
workers, causing A RISE IN EMPLOYMENT.
3. RISE IN STANDARD OF LIVING: A current SURPLUS means higher EXPORT
REVENUE and lower IMPORT EXPENDITURE, for which there WILL BE more
INflow of money than OUTflows. This means people will now have MORE
income, for which they also consume MORE goods and service. Thus they will
ENJOY A BETTER standard of living.
4. A RISE in exchange rate leading to a fall in cost push inflation: Exchange rate is
the value of one currency in terms of another currency. For example,
exchange rate of $1 is Tk85 today
iF there is a current account SURPLUS it means there is greater EXPORT
REVENUE and lower IMPORT EXPENDITURE, which would require FOREIGN
HOUSEHOLDS AND FIRMS to buy more H currency and sell foreing currency in
order to pay for their import (home’s export). Thus demand of home currency
(TK) in the FEM will increase, causing a rise in exchange rate of Home
currency (TK). A rise in XR of home currency will make it cheaper for home’s
producers to import raw materials, components and capital from abroad. This
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can lower COP, increase market supply, and lower prices leading to a fall in
cost push inflation.
Q1. Analyse how a growing current account surplus can lead to a fall in inflation
rate (5).
Negative effects:
1. Risk of demand pull inflation: A current account SURPLUS means that a country
incurs more EXPORT REVENUE than IMPORT EXPENDITURE. This can result in an
increase in net export and aggregate demand. If aggregate fails to increase at the
same pace, then excess demand will increase price level leading to a rise in
demand pull inflation.
Q. Discuss whether or NOT a rise in current account surplus always lead to an
increase in inflation (8) HW
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Topic: Specialization:
Specialization: it occurs when an individual, firms, regions, or a country
concentrates on producing a particular good or service. It can exist for:
• Individuals: it occurs when a person concentrates in producing one particular
goods or service, and only performs that task only. For example, a teacher,
lawyer, dentists, etc. Specialization allows worker to become more skilled and
efficient in their jobs, for which they can increase the quantity (productivity
increases) and the quality of goods and service being produced.
• Firms: it occurs when a firm concentrates on producing one particular good or
service, instead of producing a different type of product. For example:
Mcdonalds in fast food, Fedex in courier service.
• Regions: it occurs when a particular area of a country concentrates in
producing a type of product, may due to the favourable weather,
temperature or landscape, that supports the production process. For
example, Sylhet in BD in specialized for Tea production.
• Countries: it occurs when a country concentrates and devote resources on
producing one type of product in which it is best at. For example, BD has
specialization in garments, Vietnam in rice, Jamaican Island for tourism.
INTERNATIONAL SPECIALIZATION: occurs when a countries concentrate on the
production of those goods and service in which they have cost advantage
ADVANTAGES OF INTERNATIONAL SPECIALIZATION:
1. INCREASE EFFICIENCY: Efficiency means producing output using fewer
resources. Due to specialization countries can concentrate on producing
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2.
3.
4.
5.
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goods in which they are best at, which can make better use of resources, and
there will less wastage. This can increase productivity and efficiency, thereby
increasing output and GDP.
Increase in labour productivity: labour productivity is the output produced
per worker. Due to specialization workers gain skill and efficiency in their jobs
and can concentrate on what they best at producing. Due to repetition of the
same task over and over again, workers productivity and quality of output
will both increase.
Economies of scale: Economies of scale refers to the advantages of large scale
production, for which average cost starts to decrease. When there is
international specialization countries can devote more resources to produce
one type of product, and can produce in large scale. This results in lower
average cost. This results in lower prices which can keep inflation under
control.
Improved international competitiveness: Specialization can result in lower
average cost of production, for which the country can sell goods at lower
prices abroad. This can increase international competitiveness of domestic
goods, for which the country’s export revenue and current account position
will improve.
Increase in productive potential (or productive capacity): Due to
specialization countries can use its resources more efficiently and make can
thereby produce a greater combination of goods using existing resources. This
result in an increase in productive potential for the which the PPC will shift
outward.
goods
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Services
DIS-ADVANTAGES OF INTERNATIONAL SPECIALIZATION:
1. Overspecialization: it occurs when a country specialization on a single
type of product and if this sector declines this may create serious
consequences, like structural unemployment. Countries that overspecialize
also suffer during economic downturn, or recession, as they do not have a
variety of goods and service that they can rely on to survive when the
specialized industry declines. If the specialized industry in Liberia, that is
agriculture declines due to bad weather, it will not have other goods and
service or export revenue, that could used to purchase other essentials that it
cannot produce. This could be a very harmful for an economy.
2. HIGH LABOUR TURNOVER: high labour turnover is when existing
labour has to be replaced with fresh new workers. This occurs when existing
workers choose to leave their job in search of more challenging and
interesting jobs. When a there is specialization in a country in a single
product, more number workers have to repeat the same task over and over
again, which makes working practice boring. This results in high labour
turnover, which is harmful for domestic industries as it involves high cost of
new recruitment and training cost.
3. LOW MOBILITY OF LABOUR: MOBILITY OF LABOUR refers to a
workers ability to move, either from one job to another
(occupational mobility) or from one region to another (geographic
mobility). When a country specializes it makes the labour force
inflexible which makes cross functional training difficult if the
industry declines. This is because most workers in the country were
expert in one type of job, and would find it difficult to switch jobs.
This reduces occupational mobility of labour (making them
occupationally immobile). This can reduce economic efficiency and
affect international competitiveness, as it would require time and
money to re-train workers in other jobs.
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4. Lack of variety for consumers: specialization often leads to massproduces standardized products, for which customer do not get much variety
from the domestic market. So, customers may look for alternative products
through imports from other countries, for which demand for domestic goods
may fall, and domestic industries might suffer loss.
5. Increase in COST: when a country specializes in one type of product firms
will require to hire more number of skilled labour. Higher demand for labour
can increase wage rate which inturn can increase cost of production. This can
raise prices of domestic goods and reduce international competitiveness for
which export revenue may decline in future.
Chapter: EXCHANGE RATE:
EXCHANGE RATE: it is the price of one currency in terms of another currency. For example, exchange rate of
$1= TK 85
For example, exchange rate of $1 in terms of British pound might be £1=$1.5 ( $1=£0.67). This means a
British resident buying $600 worth of US goods they will have to spend £(600*0.67) = £400.
If the exchange rate of US$ against pound falls to £1=$1.6, then the British resident buying $600 goods from
US will have to spend £375. Due to fall in the exchange rate of $ per £, or a rise in the exchange rate £ per $
then it is cheaper for the British residents to import goods from US.
1. AUD 1= CNY6.5, cost for import for a Chinese customer to buy textbook from Australia will be CNY
(6.5*65)= CNY 422.4
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2. CAD 1= GBP 0.65, and CAD 1= Euro 0.75,
hence GBP 0.65 = Euro 0.75. thus GBP 1 = Euro 1.15
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Types of Exchange rate system:
1. Floating exchange rate system: this is when the price or value of a currency is determined by the
market forces of DEMAND AND SUPPLY of currency in the foreign exchange market.
o In the FEM, if demand for the currency increase, or if supply of currency decrease, then the
price or value of the currency will increase. This is known as a rise in floating exchange rate,
or an appreciation of exchange rate.
o In the FEM, if demand for the currency decrease, or supply of currency increases, then the
price or value of the currency will FALL. This is known as a fall in floating exchange rate, or a
depreciation of exchange rate.
Appreciation of exchange rate: this is when there is a rise in a country floating exchange rate, caused by a
rise in demand for currency or a fall in supply of currency in the foreign exchange market.
Depreciation of exchange rate: this when there is a fall in floating exchange rate, caused by a fall in demand
for currency, or a rise in supply of currency.
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One cause of a rise in floating XR of $ is an increase in the demand for $ in the FEM. If Europeans are buyijng
more $ then demand for $ increases in the FEM, shifting D-curve of $ to the right to D1. Thus FXR of $ will rise
from Xr to Xr1, known as an appreciation of $ against Euro, as shown in fig 1.
Another cause of a rise in floating XR of $ is a fall in the supply for $ in the FEM. If US residents and firms are
selling less $ in the FEM $ then supply for $ will fall, shifting S-curve of $ to the left to S1. Thus FXR of $ will
rise from Xr to Xr1, known as an appreciation of $ against Euro, as shown in fig 2.
A
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FACTORS AFFECTING DEMAND FOR A CURRENCY:
If demand for a currency increases in the FEM it will shift demand curve to the right,
resulting in a rise in floating exchange rate, known as an appreciation of XR.
Whereas if demand for a currency falls, it will result in a fall in floating XR, known as
a depreciation of XR.
1.
INTEREST RATE (on savings): if interest rate on savings in HOME’s
banks is higher than in FOREIGN banks, it will encourage foreign residents and
firms to convert FC into HC in order to save their money in home’s banks. As
foreigners require to buy more HC, it will increase demand for HC in the
market, causing a rise in floating XR of home currency: known as an
appreciation of home currency.
Whereas, if interest rate on savings is lower in home’s banks than in foregn
banks, it will discourage foreign residents and firms to convert FC into HC, to
save in home’s banks. This will require to buy less HC, for which demand for
HC in the FEM will fall, causing a fall in home’s floating XR: known as a
depreciation of home currency.
2. Demand for export: if demand for home’s export increases, it means foreign
residents and firms are more willing to buy home’s products, which will
require pay in terms of home’s currency. This will require foreigner to buy HC
from the FEM, for which demand for home currency will increase, causing a
rise home’s floating XR: known as an appreciation of home currency.
If demand for home’s export abroad fall, then foreign buyers or importers will
buy less home currency from the market to pay for few purchases from home.
Thus demand for home currency in the market will fall, causing a fall in
home’s floating XR: known as a depreciation of home currency.
3. Level of INWARD FOREIGN DIRECT INVESTMENT (FDI): if there is more inward
FDI in home from foreign, it will require foreign investors to convert large
sum of foreign currency into home currency in order to invest in home’s
market and set up plant and factories. This will require foreign investors to
buy large sum of home currency from the FEM, which will increase demand
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for HC. This will result in a rise in home’s floating exchange rate, known as an
appreciation of home currency.
If there is a fall inward FDI in home it means foreign investors are less willing
to invest in home, which will require to buy less home currency. Thus demand
for home currency in the FEM will decrease, causing a fall in home’s floating
exchange rate, known as a depreciation of exchange rate of home.
4. Speculation/future expectation: if there is a speculation or anticipation of a
future rise in exchange rate of home currency, it will encourage foreign
residents and firms to buy more HC today in order to make a profit in future.
This will increase demand for HC in the FEM causing a rise in floating
exchange rate of home currency.
On the contrary in there is an expectation of a future a fall in exchange rate of
HC, it will discourage foreigners to buy HC. Thus demand for home currency in
the market will fall causing a fall in home’s floating exchange rate.
Q. using an appropriate diagram, explain the effect of an increase
in the rate of interest in US banks compared to UK’s bank, of the
floating XR of US$. (4+4)
Fig: a rise in floating exchange rate of US$ against Pound
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if interest rate on savings increases in US banks, it will encourage UK residents and
firms to save money in US banks, for which UK people will convert £ into $ in order
to save in US banks. This will result in hot money inflow in US and demand for $ will
also increase. Higher demand for $ will result in a rise in floating exchange rate of $
against £, from XRe to XR1.
FACTORS AFFECTING SUPPLY OF CURRENCY:
1. INTEREST RATE (on savings) in foreign country: if interest in foreign is higher
than in HOME’s bank it will encourage home’s residents to convert home
currency into foreign currency in order to save in foreign banks and earn
higher interest. This will home’s residents to sell home currency, which will
increase supply of home currency in the foreign exchange market. This will
result in a fall in home’s floating exchange rate, known as a depreciation of
home currency.
2. Demand for import: if there is a rise in demand for home’s import it means
home’s residents are more willing to buy foreign goods and service. This will
require to convert home currency into foreign currency by selling HC in the
FEM. This will increase supply of home currency in the market causing a fall in
home’s floating exchange, known as a depreciation of exchange rate.
3. Level of outward FDI (foreign direct investment): if there is more OUTWARD
FDI from home to foreign, it will require home’s investors to convert large
sum of home currency into foreign currency in order to invest in foreign
market and set up plant and factories abroad. This will require HOME'S
investors to SELL large sum of home currency IN the FEM, which will increase
SUPPLY for HC in the FEM. This will result in a FALL in home’s floating
exchange rate, known as a DEPRECIATION of home currency.
If there is a fall in OUTWARD FDI FROM home it means HOME’S investors are
less willing to invest in FORIEGN, which will require to SELL less home
currency. Thus SUPPLY for home currency in the FEM will decrease, causing a
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RISE in home’s floating exchange rate, known as An APPRECIATION of
exchange rate of home.
4. Speculation/future expectation: if there is a speculation or anticipation of a
future rise in exchange rate of FOREIGN currency, it will encourage HOME
residents and firms to buy more FC today in order to make a profit in future.
This will REQUIRE SELL HOME CURRENCY IN THE FEM, which will increase
supply for HC in the FEM, causing a FALL in floating exchange rate of home
currency, KNOWN AS A DEPRECIATION OF CURRENCY.
QUESTION:
Q. show the effect of the following, on the floating exchange rate of US$ against
Euro. EXPLAIN . (7*3)
1. rise in interest rate in Europe:
2.
3.
4.
5.
6.
7.
more inward FDI in US from France:
higher demand for import in US from Germany:
lower demand for US export to Europe:
Higher inflation rate in US than in Europe:
anticipation of a future rise in exchange rate of Euro/$:
lower interest rate in US than in Europe:
1. a rise in interest rate in Europe: hot money OUTFLOW from US to Europe. US
residents and firms are more willing to save in Eurpean banks. Thus supply of US$ in
the FEM will increase, causing a fall in US$ floating XR: known as a depreciation of $
against Euro.
2. more inward FDI in US from France: More inward FDI in US from FRANCE will
increase demand for US$ in the FEM, as French investors will require to buy large
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sum of US$ to invest in US market. Higher demand for US$ will result in a rise in
floating XR of US$: known as an appreciation of $ against Euro.
3. higher demand for import in US from Germany: this will require US residents and
firms to buy more Euro to pay for German goods. So, US residents and firms will sell
US$ in the FEM, for which supply of $ in the market will increase causing a fall in
floating exchange of $ against Euro: known as a depreciation of $
4. lower demand for US export to Europe: this means European residents and firms
are buying less US goods, which will require to buy less $ from the FEM. Thus
demand for $ in the FEM will fall causing a fall in $ floating exchange rate, known as
a depreciation of $ against Euro.
5. Higher inflation rate in US than in Europe: this will reduce international
competitiveness of US exports in Europe. This will reduce US demand for export and
also lower demand for US $ in the FEM, leading to a fall in $ floating XR: a
depreciation of $ against Euro.
6. anticipation of a future rise in exchange rate of Euro/$: US residents and firms
will convert US$ into Euro to earn profit in future. This will increase supply of $ in
the FEM, causing a fall in $ floating XR: a depreciation of $ against Euro.
7. lower interest rate in US than in Europe: DEPRECIATION. Reduce HOT money
inflow. Demand for $. A fall in FXR. Depreciation of $.
Q2. Using a demand- supply of currency diagram, show the effect of a rise in
demand for US export in UK, on the US exchange rate against Pound. Explain your
answer. (6)
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If there an increase in demand for US export to UK, it would UK residents and firms
to convert pound into $ to buy $ and pay from US goods. This will increase demand
for US$ in the FEM, for XR of $ will increase from XRe to XR1. This is known as an
appreciation of $ against pounds.
Fixed exchange rate system: this is an exchange rate system, where the
govt intervenes in the foreign exchange market to maintain or fix the
exchange rate at a predetermined level.
THIS IS AN EXCHAHGE RATE SET BY THE GOVERNMENT AND MAINTAINED BY THE
CENTRAL BANK. For instance, the value of taka 1 may be fixed at $0.12. To do so,
the central bank of Bangladesh needs to intervene in the foreign exchange rate,
and/or changing the rate of interest. For instance, if there is a downward pressure
on the exchange rate of TAKA to fall may because of the increase in the supply of
TAKA in the foreign exchange market, then the central bank will take action to
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prevent this. Central bank may decided to increase the rate of interest in BD banks,
which will attract HOT MONEY FLOWS, with foreigners buying home currency to
save in home’s banks. This will increase demand for home for currency in the
foreign exchange market, reducing any downward pressure on the exchange rate,
and fix the exchange rate at tk1= $0.12
The figure below shows that if the supply of the home currency increases to S1
causing a downward pressure on the exchange rate of TAKA, central can intervene
by buying enough of the home currency from the foreign exchange market, or
increase the interest rate in home, to increase its demand to D1, and maintain thus
a fixed exchange rate at tk1= $0.12
Q. using an demand and supply diagram, explain how the Bank of China can intervene to prevent
an upward pressure on the exchange rate of YUAN from rising and fix it at 1Yuan = $0.15. (8)
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Fig: fixed XR of 1yuan = $0.15
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ADVANTAGES OF FLOATING EXCHANGE RATE:
1. It can automatically restore balance of current account of BOP: if a country’s
current account balance is in deficit this is due to higher import expenditure
and lower export revenue. Lower export revenue can reduce demand for
home currency, and a higher import expenditure can increase supply of home
currency in the foreign exchange market. Higher supply of currency of home
currency, accompanied by a lower demand of home currency can cause a fall
in floating exchange rate (known as a depreciation of XR). A low exchange
rate can make export cheaper and increase competitiveness for which
demand for export and export revenue will increase. Also a low exchange rate
can make import expensive, for which demand for import and import
expenditure will fall. Lower import expenditure and higher export revenue
can thus reduce the current account deficit and restore a balance on the
current account of BOP.
- Thus home’s export revenue will increase, and import expenditure will fall,
causing a fall in current acc deficit and restore a balance of the current ac of
BOP.
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Q4. Analyse how a floating XR system can restore a balance when its current
account is in a large surplus (6).
Q1. Analyse the effect of a rise in current account deficit on its floating
exchange rate (5).
Ans: If a country's current account balance is in deficit this is due to higher import expenditure and
lower export revenue. Lower export revenue can reduce demand for home currency, and a higher
import expenditure can increase supply of home currency in the foreign exchange market. Higher
supply of home currency, accompanied by a lower demand of home currency can cause a fall in
floating exchange rate.
Q2. Analyse the effect of a rise in current account surplus on its floating
exchange rate (5)
A floating XR of a currency is the price of a currency in term another currency
which is set the market forces of demand and supply of currency in the FEM .
A rise in current account surplus is caused by an increase export revenue and
a fall in import expenditure (2). A rise in export revenue will increase demand
for HC in the FEM (1), and fall in import expenditure will cause a fall in supply
HC in the FEM (1). Lower supply of HC and higher demand for HC will cause a
rise in home’s floating XR (1). (5)
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Q3. Analyse how a floating XR system can restore a balance when its current
account is in a large deficit (6).
Ans. Floating exchange rate is the price or value of a currency in terms of
another currency determined by the market forces of demand and supply. A
current account deficit is caused by a rise in import expenditure which is
higher than export revenue. This will create a downward pressure on floating
XR to fall or to depreciate. As the floating exchange rate falls, price of exports
falls and price of imports rises. This will increase demand for export and export
revenue, and reduce demand for imports and import expenditure. Higher
export revenue and lower import expenditure can thus reduce current account
deficit and restore a balance. (6)
2. DO not have to hold reserve of foreign currency: if the govt does not influence
the value of it exchange rate, and allow a freely floating exchange rate to
operate, it will not have to hold reserve of foreign currency or gold to fix the
exchange rate. Thus the reserve can be used for other important purposes.
Since exchange rate manipulation is not a govt objective, govt can now
concentrate on other important aims, by allowing exchange to be set by market
forces.
DISADVANTAGES OF FLOATING EXCHANGE RATE:
1. It creates uncertainty: if exchange rate is floating it makes it difficult to
estimate for the exporters how much money they will earn by selling exports.
Also for the importers it gets difficult for the importers to estimate how much
money they will have to spend for imports. This uncertainty may discourage
international trade (export & import) and investment in home.
Q1. Discuss whether or not govt of BD should allow its XR to float
freely (6)
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FIXED EXCHANGE RATE:
this is an exchange rate system, where the govt intervenes in the foreign
exchange market to maintain or fix the exchange rate at a predetermined
level.
THIS IS AN EXCHAHGE RATE SET BY THE GOVERNMENT AND MAINTAINED BY THE
CENTRAL BANK. For instance, the value of taka 1 may be fixed at $0.12.
ADVANTAGES OF FIXED EXCHANGE RATE:
1.
IT CAN CREATE CERTAINTY: if exchange rate is FIXED it makes it EASY
to estimate for the exporters how much money they will earn by selling
exports. Also for the importers it gets EASIER for the importers to estimate
how much money they will have to spend for imports. This certainty may
encourage international trade (export & import) and investment in home.
DIS-ADVANTAGES OF FIXED EXCHAGE RATE:
1. It CANNOT automatically restore balance of current account of BOP: if a
country’s current account balance is in deficit this may be due to higher
import expenditure compared to export revenue, which could lead to a fall in
floating exchange rate to restore balance on the current account. This would
be prevented by the CENTRAL BANK by making an intervention by either
buying currency or raising interest rate to fix exchange. As a result the deficit
on current account will NOT be automatically corrected.
2. Govt needs to hold reserve of foreign currency: if the govt needs to influence
the value of it exchange rate or maintain, it will have to hold reserve of foreign
currency or gold in order to fix the exchange rate. Thus the reserve cannot be
used for other important purposes. This involves an OPPORTUNITY COST as the
foreign exchange reserve of $ or gold could be used for other purposes.
3. Govt needs to sacrifice other important objective: Maintaining a fixed
exchange rate is not a govt objective or aim. So there is a risk that govt may
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have to sacrifice other important policy objective to fix the exchange rate. For
instance, if there is a downward pressure on exchange rate, the central bank
may needs to intervene by raising the rate of interest in a bid to increase
demand for home currency. This can prevent the fall in exchange rate, and
maintain the Fixed rate. However, a higher rate of interest can borrowing
expensive for domestic households and firms, which can discourage
consumption and investment. This can lower AD and output causing a rise in
unemployment.
Q. Discuss whether or not govt should maintain a fixed exchange rate (8)
Effects of change in EXCHANGE RATE on the economy:
EFFECTS OF a depreciation of XR OR a fall in floating XR:
POSTIVE EFFECTS of a fall in exchange rate:
1. Reduce a deficit on current account: a fall in FXR will make a
country’s export cheaper. Thus demand for export and
export revenue will increase if PED of export is price elastic.
Also, a fall in XR increase import prices, for which demand
for import and import and import expenditure fall, if PED of
import is elastic. Higher export revenue and lower import
expenditure can thus reduce the deficit on the current
account of BoP.
However, if demand for export and import are both
inelastic, then a fall in XR may lower export revenue and
increase import expenditure. Thus current account deficit
may not fall.
2. Increase employment: a fall in exchange rate will make
export cheaper and increase competitiveness of domestic
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goods abroad. This will increase demand for home’s export
as well as export revenue, as foreigners are buying more of
home’s exports. Also, a fall in exchange rate will make
import more expensive for which domestic residents and
firms will switch to domestic consumption, rather than
relying on imports. Higher export revenue and lower import
expenditure can thus increase net export and total demand
(AD) in home. This will encourage domestic businesses to
increase output which will create more jobs. Thus
employment will increase.
3. Increase economic growth: a fall in exchange rate will make
export cheaper and increase competitiveness of domestic
goods abroad. This will increase demand for home’s export
as well as export revenue, as foreigners are buying more of
home’s exports. Also, a fall in exchange rate will make
import more expensive for which domestic residents and
firms will switch to domestic consumption, rather than
relying on imports. Higher export revenue and lower import
expenditure can thus increase net export and total demand
(AD) in home. This result in greater output, employment and
real GDP, for income and living standard will increase
causing ECONOMIC GROWTH. This is also known as exportled growth.
Q1. discuss whether or not a fall in XR always reduce current account deficit (6)
A fall in XR, also known as a depreciation of XR occurs when the price of one currency increases in terms of another
currency. A fall in FXR will make a country’s export cheaper. Thus demand for export and export revenue will increase
if PED of export is price elastic. Also, a fall in XR increase import prices, for which demand for import and import and
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import expenditure fall, if PED of import is elastic. Higher export revenue and lower import expenditure can thus
reduce the deficit on the current account of BoP. (3)
However, a fall in XR may NOT always reduce current account deficit. This is because, if demand for export
and import are both inelastic, then a fall in XR may lower export revenue and increase import expenditure.
Thus current account deficit may rise. (3)
Q2. Analyse the benefits of a fall in XR for an economy (6)
A fall in XR, also known as a depreciation of XR occurs when the price of one currency increases in terms of another
currency. A fall in FXR will make a country’s export cheaper. Thus demand for export and export revenue will increase
if PED of export is price elastic. Also, a fall in XR increase import prices, for which demand for import and import and
import expenditure fall, if PED of import is elastic. Higher export revenue and lower import expenditure can thus
reduce the deficit on the current account of BoP. (3)
Also, a fall in exchange rate will make export cheaper and increase competitiveness of domestic goods
abroad. This will increase demand for home’s export as well as export revenue, as foreigners are buying more
of home’s exports. Also, a fall in exchange rate will make import more expensive for which domestic
residents and firms will switch to domestic consumption, rather than relying on imports. Higher export
revenue and lower import expenditure can thus increase net export and total demand (AD) in home. This will
encourage domestic businesses to increase output which will create more jobs. Thus employment, people’s
income and living standard will improve causing economic growth. (3)
Q3. Analyse how exchange rate can be changed to increase output and employment in a country (5)
To achieve an increase in output and employment govt needs to DEVALUE the exchange rate. An XR devaluation will
make export cheaper and increase competitiveness of domestic goods abroad. This will increase demand for home’s
export as well as export revenue, as foreigners are buying more of home’s exports. Also, a devaluation of exchange
rate will make import more expensive for which domestic residents and firms will switch to domestic consumption,
rather than relying on imports. Higher export revenue and lower import expenditure can thus increase net export and
total demand (AD) in home. This result in greater output, employment and real GDP, for income and living standard
will increase causing ECONOMIC GROWTH. (5)
NEGATIVE EFFECTS:
1. Risk of demand pull inflation: a fall in exchange rate will make export
cheaper and increase competitiveness of domestic goods abroad. This will
increase demand for home’s export as well as export revenue, as foreigners
are buying more of home’s exports. Also, a fall in exchange rate will make
import more expensive for which domestic residents and firms will switch to
domestic consumption, rather than relying on imports. Higher export revenue
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and lower import expenditure can thus increase net export and total demand
(AD) in home. Excess demand can push price level upward leading to
DEMADN PULL INFLATION, if the economy is close to full capacity.
2. Risk of cost push inflation: When there is a fall in exchange rate, it increase import
prices (import gets expensive). This can increase domestic producers’ cost of importing raw
materials, components and capital goods. Higher cost of production can lower market supply,
leading to rise in prices and cost push inflation.
Q4. Discuss whether or not a fall in XR is always beneficial for an economy (8)
A fall in XR, also known as a depreciation of XR occurs when the price of one currency increases in terms of another
currency. A fall in FXR will make a country’s export cheaper. Thus demand for export and export revenue will increase
if PED of export is price elastic. Also, a fall in XR increase import prices, for which demand for import and import and
import expenditure fall, if PED of import is elastic. Higher export revenue and lower import expenditure can thus
reduce the deficit on the current account of BoP. Also, a fall in exchange rate will make export cheaper and
increase competitiveness of domestic goods abroad. This will increase demand for home’s export as well as
export revenue, as foreigners are buying more of home’s exports. Also, a fall in exchange rate will make
import more expensive for which domestic residents and firms will switch to domestic consumption, rather
than relying on imports. Higher export revenue and lower import expenditure can thus increase net export
and total demand (AD) in home. This will encourage domestic businesses to increase output which will create
more jobs. Thus employment, people’s income and living standard will improve causing economic growth. (6)
However, a fall in XR may not always be beneficial. This is because it can lead to inflationary pressure. A fall in
exchange rate will make export cheaper and increase competitiveness of domestic goods abroad. This will
increase demand for home’s export as well as export revenue, as foreigners are buying more of home’s
exports. Also, a fall in exchange rate will make import more expensive for which domestic residents and firms
will switch to domestic consumption, rather than relying on imports. Higher export revenue and lower import
expenditure can thus increase net export and total demand (AD) in home. Excess demand can push price
level upward leading to DEMADN PULL INFLATION, if the economy is close to full capacity. Also, when there
is a fall in exchange rate, it increase import prices (import gets expensive). This can increase domestic
producers’ cost of importing raw materials, components and capital goods. Higher cost of production can
lower market supply, leading to rise in prices and cost push inflation. (4)
Q. using demand supply diagrams, explain how a fall in XR can lead in
inflationary pressure (8)
- cost push inflation
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- Demand pull inflation
CONSEQUENCES OR EFFECTS OF AN APPRECIATION
OF EXCHNAGE RATE IN AN ECONOMY:
POSITIVE EFFECTS of a rise in XR:
1. CAN LOWER DEMAND PULL INFLATION: when there is a rise in exchange rate
(an appreciation of XR), this increase export prices and lowers international
competitiveness of domestic goods and service. This can lower demand for
export and export revenue as foreigners are buying LESS of home’s exports.
Also, a RISE in exchange rate will make import CHEAPER for which domestic
residents and firms will switch to consumption OF FOREIGN PRODUCTS,
rather than BUYING DOMESTIC ONES.
LOWER export revenue and HIGHER import expenditure can thus REDUCE net
export and total demand (AD) in home. FALL IN TOTAL demand can push price
level DOWNWARDS leading to A FALL IN DEMAND PULL INFLATION.
2. CAN LOWER COST PUSH INFLATION: When there is a RISE in exchange rate, it
REDUCES import prices (import gets CHEAPER). This can LOWER domestic producers’ COST
of importing raw materials, components and capital goods. LOWER cost of production can
INCREASE market supply, leading to A FALL IN prices LEVEL. This can lower cost push
inflation.
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Q4. using demand supply diagrams, explain how a rise in XR can lead to a
fall in inflationary pressure (8)
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A fall in XR or a depreciation of XR occurs when the price of a currency falls in terms
of another currency. This can make export cheaper, and increase international
competitiveness abroad. Thus demand for export and export revenue increase. At
the same time, a low exchange rate can make import expensive, for which demand
for import and import expenditure falls. Higher export revenue and lower import
expenditure can thus increase net export and total demand. Excess demand can
push prices upward causing a rise in demand pull inflation. (3)
Also, a fall in exchange rate can increase cost of import of raw materials,
components and capital goods from abroad. This can increase producers’ cost of
production, and lower market supply. This can push prices upward causing a rise in
cost push inflation. (3)
NEGATIVE EFFECTS of an appreciation of XR:
1. A RISE IN CURRENT ACCOUNT DEFICIT: a RISE in FXR will make a
country’s export EXPENSIVE. Thus demand for export and export
revenue will FALL if PED of export is price elastic.
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Also, a RISE in XR LOWER import prices, for which demand for
import and import and import expenditure INCREASES, if PED of
import is elastic. LOWER export revenue and HIGHER import
expenditure can thus INCREASE the deficit on the current account of
BoP if PED of export and import are both elastic.
However, if demand for export and import are both inelastic, then a
RISE in XR may INCREASE export revenue and LOWER import
expenditure. Thus current account deficit MAY FALL.
2. FALL IN ECONOMIC GROWTH: a RISE in exchange rate will make export
EXPENSIVE and REDUCE competitiveness of domestic goods abroad. This
will DECREASE demand for home’s export as well as export revenue, as
foreigners are buying LESS of home’s exports. Also, a RISE in exchange rate
will make import CHEAPER for which domestic residents and firms will
switch to BUYING FOREIGN GOODS AND SERVICE, rather than relying on
DOMESTIC ONES.
LOWER export revenue and HIGHER import expenditure can thus REDUCE
net export and total demand (AD) in home. This result in lower domestic
output, employment and GDP, for WHICH income and living standard will
DECREASE causing A FALL IN ECONOMIC GROWTH.
3. INCREASE IN UNEMPLOYMENT: a RISE in exchange rate will make export
EXPENSIVE and REDUCE competitiveness of domestic goods abroad. This will REDUCE
demand for home’s export as well as export revenue, as foreigners are buying LESS of
home’s exports.
Also, a RISE in exchange rate will make import CHEAPER for which domestic residents
and firms will switch to FOREIGN PRODUCTS, rather than DOMESTIC ONES.
LOWER export revenue and HIGHER import expenditure can thus LOWER net export
and total demand (AD) in home. This will DISCOURAGE domestic businesses to increase
output which will create LESS jobs. Thus unemployment will increase.
Ends.
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