ECS 1601
Learning Unit 4: The foreign sector
Take
outventure
your
text book.
Keep
The
Let’s
slides
for this
learning
out
to unit
it
next
to
you!
Remember,
the
best
areour
in
two
parts,
A
and
B,to
so
foreign
friends
If the slide has a red speech
way
to
learn
is to
take
bubble
that
saysfinished
READ
section
once
you
have
this
see what
influences
so-and-so,
hit pause.
Readthrough
the
presentation,
also
work
notes
and
ASK
if
you
section
andof
watch
the
slide
the
rest
the
world
part B.don’t
thereafter!
understand.
have on our economy.
Content
In this study unit you will learn more about:
– Why countries trade
– The balance of payments
– Exchange rates
– Terms of trade
Read section
4.1 in textbook
pp 65
4.1 Why countries trade
• The world’s economies have become
increasingly integrated; this process is called
globalisation.
• The extent of a country’s involvement in
globalisation is called openness, or the degree
of integration into the international economy.
• The South African economy is described as an
open economy.
Continued
• A country is self-sufficient (autarky) if it makes everything
it consumes within the borders of the country.
• But Adam Smith said it is better to specialise in a couple of
goods and services and trade with other countries because
countries have different resources
• Factors of production are not equally distributed amongst
countries
– For example, South Africa has a lot of gold and platinum (natural
resources) but not a lot of computer factories. Therefore, South
Africa specialises in mining gold and platinum, exporting the
surplus and importing computers (capital) from America and
Japan.
• But both countries could also be endowed with the same
factors of production
• Therefore countries can have an absolute or a comparative
advantage in a particular resource
Absolute advantage
• The principle of absolute advantage was
brought forward by Adam Smith (1776).
• This theory argues that a country can produce
greater quantity a goods and services than its
competitors using few resources.
• According to Adam Smith this formed the
bases for trade between countries.
• A country or a firm has absolute advantage in
the production of a good if it is more efficient
in producing that good than the other country
or firm.
Absolute advantage: Example
A
man
and
a better
woman
woman
is
atand
IfThe
they
do
trade
The
man
is a not
better
swimmer
climbing
trees.
Inmin
one
are
stranded
on
and
catches
20 30
fish
inan
anhour
each
spend
on
she
gets
10
coconuts.
The
hour.
The They
woman
only30fish
island.
need
catching
fish 6.
and
min
man
only
gets
She
has an
catches 8. He has an
absolute
and
coconuts
to will
on
coconuts,
they
absolute
advantage
getting
advantage
in catching in
fish.
have
the following:
survive.
coconuts.
Catching fish
Climbing
trees for
coconuts
Man
20
6
Woman
8
10
Absolute advantage: Example
If
they
each
specialise
Now
they
can
trade
Let’s
write
in
the
corner
Compare
how
much
and
the
manthen
onlythey
fishes
their
goods,
how
much
they
will
theyeach
have
if they
trade
and
the
woman
only
will
have
more
have
if values
they doinnot
to
the
the
picks
coconuts,
they
will
coconuts and more
fish
trade
(just
to
corners!
have
the following after
than
previously!
remember).
an hour:
Catching fish
(Not trade=10)
Man
10
20
(Not trade=4)
Woman
4
Climbing
trees for
coconuts
(Not trade=3)
3
(Not trade=5)
10
5
Comparative (relative) advantage
• Trade can also be beneficial when one individual or
country has an absolute advantage in both goods.
• All that is required for both to benefit is that the
opportunity costs differ.
• According to the theory of comparative advantage
each country will tend to specialise in and export those
goods for which it has a comparative advantage.
• If both countries or persons have the same opportunity
costs for the same quantities of the same goods there
is an equal advantage and no basis for trade.
• Let’s take a look at our example again ...
Comparative advantage: Example
A year later the man
Catching fish
Climbing
trees for
coconuts
Man
20
21
6
=3
2
Woman
81
10
= 1.25
8
Now
the
woman
The
has
a higher
Now
the
man
hashas
a an
Yes!man
Let’s
look
at the
became
and
was
not
In
the time ill
itadvantage
takes
the
man
absolute
in
(opportunity)
cost In
in
getting
opportunity
cost.
the
time
COMPARATIVE
to
catch
one
fish,
he to
could
able
swim
any
more.
fish.
It to
will
bewoman
better
for
the
fishing
and
itboth
takes
the
catch
advantage
in
getting
have
gotten
3Do
coconuts
man
tohe
get
the
coconuts
and
one
fish,
she
could
have
Now
could
only
coconuts.
you
think
coconuts.
for
the woman
to a
fish.
gotten
1.25
coconuts.
catch
2 fish
in
hour.
they
should
still
trade?
6
10
Read section
4.2 in the
textbook on
pp 70 - 71
4.2 Trade policy
• As the government take steps to open its
economy to international trade that it may
also benefit from such trade.
• The government also takes steps to put in
place policy measures that regulate the
volume of trade and protect domestic firms
from foreign competition and to protect jobs
in the domestic country.
4.2 Continues
• The protection policies are:
• Import tariffs
Protects firms from foreign competition
Are taxes and duties imposed on imported goods
purchased by domestic residents.
Example are specific tariff which is a fixed levy charged
per unit of a good imported and an advalorem tariff
which is levied as a percentage of the value of the
product.
• Import quotas
Limits imports that come into the domestic country.
4.2 Continues
This policy limits the quantity of goods that
come into the country. For example a
production quotas may be set to limit the
number of handbags to 200 000 a year.
• Subsidies
These are funds provided by the government to
domestic firms, to improve competitiveness of
these firms.
4.2 Continues
• Non-tariff barriers
These are strict contracts by the government
that sets high standards for domestic firms,
which makes it difficult for foreign firms to
meet.
• Exchange controls
This policy restricts imports by liming the
amount of foreign currency that is available to
domestic consumers and firms.
4.2 Continues
• Exchange rate policy
Influence movements in exchange rate between
currencies to control amount export and
imports of goods. Movement in exchange rate in
the foreign market is determined by the demand
and supply of currencies.
Read section
5.5 in the
textbook on
pp 99.
4.3 The balance of payments
Exports and
imports
Current
account
Surplus =
exports> imports
The balance of payments is a record each
country keeps on its transactions with the rest
Balance of
of the world.
Payments
Deficit =
exports< imports
Financial flows
between
countries
Financial
account
Surplus = net
inflow of foreign
capital
Capital transfer
account
Deficit = net
outflow of foreign
capital
Unrecorded
transactions
4.3 The balance of
payments
• Current account
– An important good traded in South Africa is gold
– Services traded included transport, construction,
etc.
– Income receipts are shown separately. That is
income earned by South Africans in other countries.
– Income payments are money earned by non-South
Africans in South Africa.
– Current transfers: money, gifts, services,
etc traded for ‘nothing’ in return.
4.3 The balance of
payments
• Financial account
– Direct investment
Investments made in order to gain control of the
management of the enterprise.
– Portfolio investment
Purchasing assets such as bonds or shares.
– Other investments (residual category)
All investments that are not classified as either a direct
or portfolio investment.
– Unrecorded transactions
Used to balance the financial account.
Gold and foreign reserves
• Exports = the country GETS foreign currency.
• Imports = the country PAYS foreign currency.
• If EXPORTS < IMPORTS (meaning the country pays
more foreign currency than it earns) then foreign
reserves decrease.
• If EXPORTS > IMPORTS (meaning the country gets
more foreign currency than it pays) then foreign
reserves increase.
• A portion of South Africa’s foreign reserves are held
in gold.
Read section 4.3
table 4-1 and table
4-2 in the textbook
pp 71-79
4.4 Exchange rates
• Foreign trade involves payment in foreign currencies.
• South African importers have to pay for their products in
foreign currencies, while importers in other countries need
South African rands to pay for their imports.
• If you want to import a car from Germany, you have to buy
the car in euro (€).
• Thus, you have a demand for euro.
• If Americans wants to visit South Africa, they will have to buy
rands in exchange for dollars ($); in other words they supply
dollars in exchange for rands.
• The exchange rate is the amount of one currency you need in
order to buy another.
4.4 Exchange rates
• The market where currencies are traded for one another is
called the foreign exchange market.
• And the prices of one currency is quoted in terms of
another currency – like a barter system.
• Thus the rate of exchange is a ratio.
• A decrease in the value of rands (in terms of dollars)
automatically translates to an increase in the value of
dollars.
• A decrease in the value of a currency is called a
depreciation.
• An increase in the value of a currency is called an
appreciation.
4.4 Exchange rates
Assume one dollar costs R10, that is the rand-dollar
exchange rate. $1=R10
If the exchange rate changes as follows:
$1=R11
It means, the rand depreciated against the dollar (the
dollar became more expensive and you now need more
rands to buy one dollar).
At the same time, it means that the dollar appreciated
against the rand.
But, who decides what the exchange rate should be?
4.4 Exchange rates
ANSWER: The market
decides what the exchange
rate should be.
To be specific, the foreign
exchange market.
See the following market for
dollars in South Africa.
Take a minute to study the
.
axes
4.4 Exchange rates
There is a demand for
dollars in South Africa.
The demand comes from
every SOUTH AFRICAN
household, firm or
government institution
that needs to buy dollars,
for example to buy goods
or services from America
or to visit America as a
tourist.
4.4 Exchange rates
There is a supply of dollars
in South Africa.
The supply comes from every
AMERICAN household,
firm or government institution
that wants the rand,
for example the buy
goods or services from
South Africa or to visit
South Africa as a tourist.
4.4 Exchange rates
R/$
S
Price of dollars (exchange rate)
The demand and supply of dollars in
South Africa determine the exchange rate.
The equilibrium exchange rate is
the rate at which the dollars
demanded equals the dollars supplied.
The equilibrium price is
the exchange rate ($1=R8).
And the equilibrium quantity is
the amount of dollars that
will be traded for rands at
that specific rate ($10 billion per day).
8
E1
D
0
10
Quantity dollar (Q$) in billions per
day
4.4 Exchange rates
R/$
S
Price of dollars (exchange rate)
After a crime wave in South Africa is reported in
the American media, a lot of
tourists decide to not visit South Africa any more.
This affects the supply of dollars.
The new equilibrium is at E2,
with an exchange rate of $1=R9 and $8 billion
traded daily in South Africa.
This means that the rand depreciated
against the dollar (that also means the
dollar appreciated against the rand,
and you now need more rands
to buy one dollar).
9
E2
8
E1
D
0
8 10
Quantity dollar (Q$) in billions per
day
4.4 Exchange rates
S2
R/$
S1
Price of dollars (exchange rate)
The market can cause the exchange rate
to fluctuate a lot.
If the SARB has enough foreign reserves,
they can intervene in order to stabilise the exchange rate.
For example, the SARB can supply dollars,
which will have the following effect:
The exchange rate is now only R8.50 for $1
in stead of R9 for $1, thus the SARB
stabilised the exchange rate a bit.
The process whereby the SARB
intervenes in the market is called managed floating.
However, because of the high volumes
and volatility of currency traded everyday,
it becomes very difficult for the SARB to
consistently manage the stability of the
currency, as the reserves that are
kept by the SARB are limited.
9
8.5
8
E2
E3
E1
D
0
8 9 10
Quantity dollar (Q$) in billions per
day
4.4 Exchange rates
• Most large economies have floating exchange rates – in other words, the
exchange rate is not fixed by the government of the country.
• Market forces thus determine the value of different currencies.
• However, the government or central bank of a country would sometimes like
to intervene in the foreign exchange market, as the value of a currency has
an impact on the country’s economic growth, unemployment rates, etc.
• With a floating exchange rate, the central bank only has three options:
1. Do nothing – this means allowing market forces to determine the value of
the currency.
2. Apply managed floating – as discussed earlier, the practice of buying and
selling foreign exchange by the central bank. This requires large volumes of
foreign reserves.
3. Use interest rates – an increase in interest rates could attract foreign capital
and results in the demand for the local currency, most likely causing an
appreciation of the local currency.
4.4 Exchange rates
•
•
•
•
•
•
•
•
define and explain absolute advantage?
define and explain comparative advantage?
list the sources of comparative advantage?
distinguish between a specific tariff and
an ad valorem tariff?
distinguish between the current account and the financial account of the
balance of payments?
define and explain what the exchange rate is?
list the sources of demand for, and the sources of supply of the dollar in
South Africa?
define terms of trade?