chapter 14 the international context

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Chapter 14

The international

context

CHAPTER 14 THE INTERNATIONAL CONTEXT

164 www.studyinteractive.org

CHAPTER CONTENTS

LEARNING OUTCOMES ------------------------------------------------- 165

BALANCE OF PAYMENTS ----------------------------------------------- 166

CURRENT ACCOUNT DEFICIT / SURPLUS 167

THE TERMS OF TRADE -------------------------------------------------- 169

ABSOLUTE & COMPARATIVE ADVANTAGE THEORY ----------------- 170

THE ROLE OF GLOBAL FINANCIAL INSTITUTIONS ------------------ 172

GLOBALISATION -------------------------------------------------------- 173



LEARNING OUTCOMES

a) Explain the concept of the balance of payments and its implications for

government policy.

b) Identify the main elements of national policy with respect to trade.

c) Explain the impacts of exchange rate policies on business.

d) Explain the role of major institutions promoting global trade and

development.

e) Explain the role of supra-national financial institutions in stabilising

economies and encouraging growth.

f) Explain the concept of globalisation and the consequences for businesses

and national economies.



BALANCE OF PAYMENTS

The balance of payments records financial transactions between one country and

the rest of world.

The balance of payments comprises three accounts:

1. Current account;

2. Capital account;

3. Financial account.

The current account measures trade in goods and services, net investment

incomes and transfers. The capital account and financial account record flows

of financial capital arising from saving, investment and currency speculation.

9 balance of payments for 2008, all figures in £m

The current account

Balance of trade in goods -92,877

Balance of trade in services +54,479

Net income flows +26,940

Net current transfers -13,610

Balance of payments on current account -25,068

The capital account +3,393

The financial account +18,121

Net errors or omissions +3,554

Overall balance of payments -

Key points:

The sum of the balance of payments accounts must always be zero.

Net errors / omissions arise as a result of statistical errors.

If there is a current account surplus

o Then there will be a corresponding negative on the assets and liabilities

section i.e. outward investment and/or reduced overseas debts.

If there is a current account deficit

o Then there will be a similar positive amount on the assets and liabilities

section, ie this will consist of inward investment and/or increased overseas

indebtedness, showing how the deficit was financed.



Current account deficit / surplus

Surpluses arise from a country exporting a greater value of goods than are

imported. Deficits arise from a country importing a greater value of goods than

are exported.

Reasons for deficits:

Increased import penetration Poor export performance

Imports are relatively cheaper. Exports are un-competitive.

Domestic currency overvalued imports

therefore less expensive.

Domestic currency overvalued exports

therefore more expensive than overseas

goods.

Growth in national income consumers

increase demand for imports.

Growth in national income, producers

focus on domestic market at expense of

exports.

Imported goods offer greater value /

durability (factors other than price).

Exported goods of an insufficient quality

to compete on target markets.

Conversely, surpluses will be created by the reverse factors detailed above.

Consequences:

In order to fund a balance of payments deficit, there will need to be a rise in

external debt, which is clearly not sustainable.

Similarly, a balance of payments surplus is also unsustainable, for one country

to be in surplus, another must be in debt.

Policies to eliminate a current account deficit

The value of imports exceeds the value of exports.

To eliminate a deficit the government must achieve one, or a combination of the

following:

Increase demand for exports of domestically produced goods;

Reduce demand for imports of foreign produced goods.

Currency devaluation

Whilst a deficit will lead to an increase in supply of the domestic currency on foreign

exchange markets, and thus reduce the value of the currency, devaluation becomes

an option when a government has artificially retained a high rate.

Devaluation will increase the competitiveness of domestically produced goods,

therefore increasing demand for exports.



The J-Curve Effect

The problem with devaluation being that low price elasticities of demand for imports

and exports immediately following an exchange rate change may lead to an

increase in the deficit. The delayed impact, often due to contracts in place, means

that the volume of imports does not immediately fall away.

Protectionist measures

Aimed at reducing imports, measures might include:

Import tariffs;

Import quotas;

Embargo (total ban);

Administration burdens (excessive paperwork!).

Domestic deflation

An attempt to reduce demand for imports by:

Increasing interest rates;

Increasing taxation;

Cutting government expenditure.

The above measures unfortunately may lead to some unwanted consequences:

namely unemployment, a reduction in the standard of living, and a loss of industrial

output.

Surplus

Deficit

Balance

on

current

acct Time



THE TERMS OF TRADE

The balance of trade depends not only on the volumes of goods traded, but more

importantly

terms of trade.

Exam questions examine the overall impact on the balance of payments as a

consequence of the ratio changing.

If price of exports fall relative to imports the trade balance will deteriorate.

If the price of exports increases relative to imports the trade balance will

improve.

Measuring the terms of trade

The terms of trade are measured as:

Unit value of exports

Unit value of imports

Using indices for the average prices of imports and exports, the movement in the

terms of trade between 2010 and 2011 would be computed as:

Price of exports 2011/price of exports 2010

Price of imports 2011/price of imports 2010

Exercise 1

Index numbers for import and export prices for the two years are given below.

Exports Imports

2010 150 ?

2011 144 216

What is the missing index number?



ABSOLUTE & COMPARATIVE ADVANTAGE THEORY

The case for specialisation and trade is based on the idea that all countries in total

will gain in terms of increased production, economic efficiency, and welfare.

Absolute advantage

Axioms:

Two countries A & B;

Each produce just two commodities, bread and bananas.

Each country has 10 units of resources.

Using all of their resources they can produce

Table 1 Country A Country B

Bread 400 320

Or Or

Bananas 400 160

It is clear that Country A has an absolute advantage in the production of both

bread and bananas.

If each country was self-sufficient, and did not trade then their respective output

would be as follows

Table 2 Country A Country B Total

Bread 200 160 360

Bananas 200 80 280

Overall total economic output is 640.

Comparative advantage

Despite Country B having an absolute disadvantage in producing both bread and

bananas, the question is whether there is a benefit from specialisation.

The theoretical basis for free trade is comparative advantage theory. Global

resources can be more effectively utilised when countries specialise in producing

those goods and services in which they have a comparative advantage.

Comparative advantage means that that the opportunity cost of producing the good

is less in a country than elsewhere.



Based upon table 1, the following ratios may be created:

Country A Country B

1 bread = 1 banana 1 bread = 0.5 of a banana

1 banana = 1 bread 1 banana = 2 bread

The above ratios show that Country B has a comparative advantage in bread. As to

produce an extra unit of bread it only has to give up half a banana, compared to

Country A that would need to give up 1 whole banana to produce 1 extra bread.

Thus the two countries specialise in the commodity for which they have a

comparative advantage.

Production based on specialisation, would be as follows:

Table 3 Country A Country B Total

Bread 0 320 320

Bananas 400 0 400

Overall economic output is therefore 720, which is greater than under self-

sufficiency.

Exercise 2

Assume that two small countries, X and Y, produce two commodities P and Q and

that there are no transport costs. One unit of resource in Country X produces 4

units of P or 8 units of Q. One unit of resource in Country Y produces 1 unit of P or

3 units of Q.

Which of the following statements are true?

A Country X has an absolute advantage over Country Y in producing P and Q,

and so will not trade.

B Country X has a comparative advantage over Country Y in producing Q

C Country Y has a comparative advantage over Country X in producing Q

D Country X has a comparative advantage over Country Y in producing both P

and Q.



THE ROLE OF GLOBAL FINANCIAL INSTITUTIONS

Global financial institutions are designed to promote stability throughout the world

economy.

World Bank

The World Bank is an international financial institution that provides loans to

developing countries for capital programs.

The World Bank's official goal is the reduction of poverty. All decisions must be

guided by a commitment to promote foreign investment, international trade, and

facilitate capital investment.

International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization that was

created on July 22, 1944 at the Bretton Woods Conference and came into existence

on December 27, 1945 when 29 countries signed the Articles of Agreement.

Countries contribute money to a pool through a quota system from which countries

with payment imbalances can borrow funds temporarily. The IMF currently has 188

members.

The Group of 20 (G20)

The Group of Twenty Finance Ministers and Central Bank Governors (also known as

the G20) is a group of finance ministers and central bank governors from 20 major

economies: 19 countries plus the European Union.

Collectively, the G20 economies account for more than 80 percent of the gross

world product (GWP), 80 per cent of world trade, and two-thirds of the world

population

The G20 meets to discuss such matters as:

Financial crisis;

Harmonization of taxes

Environmental issues such as C02 emissions.



GLOBALISATION

Globalisation may be defined as the widespread extension of trade between

countries and a high degree of interdependence of production between countries.

Briefly discuss and makes notes regarding the following headings:

Factors driving globalisation

Impact of globalisation

chapter 14 the international context

Documents

capital account

current account measures

balance of payments

current account deficit

current account surplus

overall balance of payments

net current transfers

international context