Examination of the foreign exchange market, the
establishment of exchange rates, and how the
balance of payments account is affected.
• The main reasons for international trade
• The balance of payments
• Foreign exchange markets
• The establishment of foreign exchange rates
• Corrections of BOP surplus and deficit
(disequilibria)
International trade: exchange of goods and services
across international boundaries.
Globalisation: worldwide movement toward
economic, financial, trade, and communications
integration.
Natural resources are unevenly distributed
Labour and technology differences
• Differences in skills
• Lower production costs
• Inability to convert raw materials into
consumer products.
Absolute advantage: due to specialisation, one
country can produce a product at a lower cost
than the other country.
What should
they do?
What will equitable terms of trade be?
Opportunity
Shipis5Current
bags of
cost
wheat
DVD’s
toSA Japan
20
in Japan.
DVDs
Opportunity
Cost/
Trade
beneficial
ifofof
SA
specialise
in=wheat.
wheat
and
Opportunity
cost
DVDs
in
= 5 lower
bags of
Opportunity cost of DVDs in Japan = 0,25 bags of wheat.
trade
surplus
with
for DVD’s.
Basis
(5 for
÷Japan
0.25
trade
=exchange
20)
exists.
Domestic
terms
ofintrade
for DVD’s
Opportunity
cost/
Trade
Ship
is 4beneficial
DVDs
toof
South
if one
Japan
you’d
specialise
20inbags
of wheat.
and
trade
Opportunity
cost
bag
of get
wheat
inDVD’s
Japan
= 4 DVDs
Opportunity
cost
of one
bag
of20)
wheat
inwheat.
SA = 0,2 DVDs
surplus
with
(4
SA
÷
in
0.2
exchange
=
for
Domestic Terms of Trade for Wheat
If one country has absolute advantage
everything, does not mean that they shouldn’t
trade.
Why not? Principle of comparative advantage.
Relative
costSA
of
producing
DVDsin
lower
in Japan than
SA
specialise
wheat
The
cost
of
producing
a
SAopportunity
has
an
absolute
advantage
in
Japan
specialise
in
DVDs.
evento
though
absolute
cost
isJapan???
higher.
We
need
look
at
opportunity
cost
Should
SA
trade
with
Exchange
1
DVD
for
5
bags
of
wheat
from
SA.
Exchange
bags
of
wheat
forand
2,5
DVD is lower
Japan
than
inDVDs.
SA.
A5basis
forin
trade
now exists.
production
of both
Wheat
DVD’s
Comparative (relative) advantage
All that is required for both
countries to benefit from
trade is that the opportunity
costs of production differ
between the two countries.
David Ricardo (1772–1823)
Comparative Advantage Example
South Africa
Germany
Cars
(per day)
Barrels of wine
(per day)
1
2
6
8
• Germany has an absolute advantage over South
Africa in the production of __________.
Cars
(per day)
Barrels of wine
(per day)
1
2
6
8
Gains from trade
South Africa
Germany
 Germany has a relative or comparative advantage in the
• Has
Germany
got anything to gain from trading with
production
of _______
South Africa???
 South Africa has a relative or comparative advantage in the
• Lets
look at
the OC of production…
production
of _______
OC of producing 1
OC of producing 1
Car
Barrel of wine
South Africa
Germany
6
4
1/6
1/4
OC of producing 1
Car
OC of producing 1
Barrel of wine
South Africa
6
1/6
Germany
4
1/4
Terms of trade
South Africa will shift resources into wine production if it can
exchange fewer than 6 barrels of wine for a car from
Germany.
Germany will shift resources into car production if it can
obtain more than 4 barrels of wine for every car it sends to
South Africa.
Beneficial if 1 car is exchanged for more than 4 but fewer
than 6 barrels of wine.
OC of producing 1
Car
OC of producing 1
Barrel of wine
6
1/6
Gains From Trade
South Africa
Germany
4
1/4
Suppose 1 car exchanges for 5 barrels of wine:
Germany receives 5 barrels of wine for each car sent to
SA. Beneficial for Germany to shift resources from wine
to car production and trade the excess cars.
Without trade: 4 barrels of wine for each car sacrificed.
After trade: 5 barrels of wine for each car given up.
OC of producing 1
Car
OC of producing 1
Barrel of wine
6
1/6
Gains From Trade
South Africa
Germany
4
1/4
Suppose 1 car exchanges for 5 barrels of wine:
South Africa receives 1 car for 5 barrels of wine it sends to
Germany. Beneficial for South Africa to shift resources
from car to wine production and trade the excess.
Without trade: 1 car for 6 barrels of wine given up.
After trade: 1 car for 5 barrels of wine given up.
Foreign exchange market: market where
currencies of different countries are traded for
one another.
How are exchange rates determined???
• Foreigners demand Rands to buy SA products
or if they wish to visit the country.
• South Africans supply Rands when they buy
foreign goods/services or visit a foreign
country.
At
US$1
=
R4;
excess
demand
for
US$1
=ofR8;
excess
supply
of
dollars
Price
dollar
rises
to
US$1
=
R6
Priceof
dollar
falls
to
US$1
=
R6
dollars
Currency appreciation: currency becomes worth
more in terms of another currency.
Eg. R1 = $0,15
to
R1 = $0,25.
Currency depreciation: currency becomes worth
less in terms of another currency.
Eg. R1 = $0,20 to R1 = $0,15.
Exchange rate systems: ways that countries
choose to manage their currencies in relation to
the foreign exchange market.
3 types of exchange rate systems…
1. Free floating exchange rates
2. Controlled/managed floating exchange rates
3. Fixed exchange rates
1. Free floating/flexible exchange rate system:
exchange rate determined by market forces.
• No intervention by central banks
2. Managed floating exchange rates: central
bank allows the currency’s value to be
determined by market forces, but intervenes in
the foreign exchange markets to manage the
process.
• Central bank needs significant level of foreign
currency reserves to implement this.
Excess
→imported
R depreciates
↑indemand
the D for
Exchange
Supply
curve
rate
remains
shifts
(SS
at
to
R7
S
1
=
S
1
$1.
)
SARB
Desired
supplies
rate:
$
to
R7
the
=
market
$1
(R9
$1 )→ D1D1
goods by
SA;= DD
3. Fixed exchange rate: government determines
the exchange rate (short term) based on the
value of another country’s currency.
Revaluation: raise the value of the country’s
currency in relation to a foreign currency.
• R20 : $1
→
R10 : $1
Revaluation: decreases the value of the
country’s currency in relation to a foreign
currency.
• R10 : $1
→
R20 : $1
Please answer Activity 3 on page 103
Balance of payments disequilibria: when
outflow of foreign currency continuously > or <
inflow of foreign currency.
Current account
Deficit: imports > exports
• Lacking productive potential?
• High inflation?
• Investing in capital goods for future growth?
Surplus: exports > imports
• High levels of productivity
• Meeting foreign demand ahead of domestic
demand?
• Weak domestic demand?
Financial Account
• Are we worth investing in?
• Are investments increasing or decreasing?
Capital Transfer Account
• Are we a desirable place to live & work?
• Shows immigrants/emigrants moving assets
into/out of the country
If current account deficit is the cause, increase
exports and/or decrease imports.
• export promotion
• import substitution – producing products
locally and decrease imports,
• import tariffs, duties and quotas –increases
price of imports
If financial account deficit is the cause, increase
financial capital inflows and/or decrease
financial capital outflows.
• interest rates –increase in relative interest
rate in SA causes inflows of hot money
• exchange controls –limit placed on capital
outflows.
Assume a free-floating exchange rate.
• Deficit in SA’s BOP.
• Demand for foreign exchange > supply,
• Fall in value of R
• Exports become relatively cheaper/imports
costlier
• Leads to increase in exports/fall in imports
• BOP equilibrium restored!