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Terms in this set (35)
Arguments for protectionism
To protect domestic employment
To protect sunrise or infant industries. Blocking imports with tariffs will protect infant industries and give them a competitive advantage.
To prevent the dumping of foreign goods onto the domestic market.
To diversify the production base of a developing country. Developing countries usually specialize due to a comparative advantage, and often only produce one good, which is usually a primary good, making them vulnerable to price changes. Protectionism raises import prices, so domestic firms in other industries can prevail under an artificial competitive advantage.
To enforce product standards
To raise government revenue
To protect strategic industries
To overcome a balance of payments deficit by making imports less attractive to correct a trade deficit.
Arguments against protectionism
Misallocation of resources
Escalation of a trade war
Higher import costs
Reduced export competitiveness in the long run
Banned by WTO
Three ways to manipulate a currency
By using foreign and domestic currency reserves
By manipulating interest rates
By putting limits on the amount of foreign currency allowed into the country
Economic effects of appreciation
Inflation: Demand for imports increases and demand for exports decreases, so deflation occurs.
Economic growth: Growth will slow as imports increase but exports decrease, and Xn falls.
Unemployment rate: Ur will rise as AD falls
Balance of payments: Current account moves towards deficit, financial account moves towards surplus.
Less expensive imports lowers the costs of production for firms. For developing countries, a strong currency gives the ability to buy cheaper capital goods and energy resources. When any country relies heavily on imports, an appreciation of the exchange rate can put downward pressure on inflation.
Economic effects of depreciation
Inflation: There will be inflation, as demand for exports increases while demand for imports decreases, shifting AD out.
There is imported inflation in the economy if a country needs to import significant levels of raw materials or resources
Economic growth: Growth will increase as AD shifts out.
Unemployment rate: Ur will decrease, as AD shifts out.
Balance of payments: Current account moves into surplus and financial account moves towards deficit.
Advantages of a floating exchange rate
Domestic policy freedom - The CB is free to manipulate monetary policy, specifically interest rates, to manage the balance between domestic growth rates and inflation.
Self-adjustment - A floating exchange rate should automatically adjust changes in the BoP.
No surplus currency reserves which can be expensive
Disadvantages of a floating rate
Uncertainty for investors
There are many random events that can prevent automatic adjustment.
Countries that have constant need for foreign resources may find themselves with a persistently low exchange rate. In such cases, it will import inflationary pressure.
Advantages of a fixed exchange rate
Protection against speculation
Limitations on domestic policy
Disadvantages of a fixed exchange rate
When an exchange rate is managed by manipulation of interest rates, the option of using interest rates for domestic policy purposes is limited.
Need to hold foreign reserves
Risk of speculation - If a country has fixed a high exchange rate and is running low on reserves, speculators aggravate the problem by betting against the currency.
Balance of payments - current account
Goods & services - exports, imports
Income - inflows, outflows
Current transfers - inflows, outflows
Balance of payments - financial account
Direct investment domestic, abroad
Portfolio investment domestic, abroad
Balance of payments - capital account
Capital transferred to, from
Why is BoP always in balance
Because every dollar domestic consumers spend on foreign good, eventually ends up being spent on something from the domestic country.
Capital Account + Current account + Financial account + Foreign reserves = 0
If in a given year, the flow of money into a country exceeds the flow of money out of the country, the difference is added to the CB's official reserves of foreign exchange. If there is a net outflow of money in a year, the difference is made up by a withdrawal from the central bank's reserves of foreign exchange.
Consequences of a persistent current account deficit
Depreciation of the currency - If domestic consumers demand more imports than foreigners demand of the home country's exports, then the value of the domestic currency will fall. A weaker currency makes imported raw materials more expensive and can contribute to cost push inflation.
Increased foreign ownership of domestic assets - A deficit in the current account means a surplus in the financial account. This means foreigners own more of the home country's assets than domestic investors own of foreign assets. Such foreign ownership of domestic assets may pose a threat to the economic freedom of the deficit country.
Higher interest rates - A country may try to strengthen the currency by raising interest rates to attract foreign capital to the country. A higher interest rate will negatively effect domestic investment by firms, slowing growth in the nation's capital stock over time.
Increased indebtedness - Countries that have current account deficits will often finance them by running financial account surpluses. The easiest way to do this is by acquiring debt, selling bonds. However as a country accumulates debt, lenders may lose confidence in the country's ability to pay it back. Countries must pay interest on their debt, which reduces the governments ability to spend on domestic projects. A current account deficit that becomes too extreme can be unsustainable.
A current account deficit is an indication of a lack of competitiveness in the export sector, therefore a weaker currency may not actually increase demand by that much, and may actually lead to cost-push inflation.
Methods to correct a persistent current account deficit (expenditure switching)
Exchange rate manipulation - A country may devalue its currency to make imports less attractive to domestic consumers. A country may lower interest rates to make foreign investment less appealing, reducing demand for its currency and lowering the exchange rate.
Increased protectionism - This will make imports less attractive and domestically produced goods and services more attractive. In the long run such policies may promote inefficiency.
Methods to correct a persistent current account deficit (expenditure-reducing)
Contractionary fiscal policy
Expansionary supply-side policies
The costs of aforementioned methods likely outweigh the benefits. The government can pursue supply-side policies that increase the competitiveness of domestic producers in the global economy.
Investments in education and healthcare
Public funding for scientific research and development
Investments in modern transportation and communication infrastructure
The Marshall-Lerner condition
If the combined PEDs for exports and imports are greater than 1, then a depreciation of the currency will cause current account to move towards surplus.
If the MLC is met, then a devaluation of the currency can fix a trade deficit.
If the MLC is not met, then a devaluation of the currency will actually worsen a trade deficit.
In the first weeks following a currency devaluation, consumers at home and abroad are relatively unresponsive to the country's now higher price imports and lower priced exports. The current account deficit will worsen.
Over time, consumers at home and abroad will begin to respond to the country's cheaper exports and more expensive imports, and the current account will move to surplus.
Consequences of a current account surplus
Appreciation of the currency - X > M
Increased ownership of foreign assets
Reduced levels of domestic consumption - Money earned from the sale of exported goods but not spent on imported goods is money saved by the nation with the trade surplus.
Preferential trade agreement
When two or more countries reduce or remove tariffs on particular goods or services produced in participating countries, or make other agreements reducing the barriers to free trade between nations.
Bilateral between two nations, multilateral between multiple nations
Free trade area
When two or more nations make an agreement to eliminate tariffs on all goods and services traded between them.
A group of nations that have agreed to impose the same tariffs on non-members as each other and usually to allow free trade between themselves.
Goods and services are traded freely between the member nations, and the four factors of production flow freely between member nations.
Nation members have free trade with each other, common tariffs on non-member nations are adopted by member states, land, labour and capital may flow free of intervention between member states, regulations regarding labour and capital are shared, and a currency is shared with a single central bank.
Advantages of economic integration
Higher real incomes
Larger export markets
Disadvantages of economic integration
Fall in employment in certain industries
Exploitation of workers
Rising trade imbalances if imports rise faster than exports.
Loss of economic sovereignty - No longer able to undertake monetary policy.
Trade creation vs diversion
When nation's enter a trading bloc, this usually leads to trade between the countries as the nations trade goods for which they have a comparative advantage.
Trade diversion occurs if a nation with a lower comparative advantage trades a good to a nation with a higher comparative advantage for that good. This happens rather often in high levels of economic integration. Also, when nations agree to place tariffs on non-member nations, this can lead to trade diversion.
Terms of trade
The average price of exports relative to the average price of imports.
Improvement in the terms of trade
When the average price of exports increases relative to the average price of imports.
Deterioration in the terms of trade
When the average price of exports decreases relative to the average price of imports.
Measuring the terms of trade
((index of average export prices)/(index of average import prices))*100
Reasons for a change in the terms of trade - SHORT RUN
Demand changes - All the factors that affect demand for imports and exports can affect their prices as a result.
Supply changes - All the factors that affect supply of imports and exports can affect their price as a result.
Relative inflation rates - If a country's domestic price levels rise relative to other countries, its terms of trade improves as well. However, this improvement will make exports less attractive and competitive globally.
Changes in exchange rates - Changes in the exchange rate effectively change the prices paid by foreigners, so the prices of exports and imports fluctuate, affecting the terms of trade.
Reasons for a change in the terms of trade - LONG RUN
When global demand is altered by income changes - As incomes grow, nations will demand more secondary and tertiary goods, which are produced in developed countries. Therefore, as incomes grow, the terms of trade for LEDCs deteriorates as the value of their exports decrease.
Productivity changes - If a nation is able to produce output more efficiently, this will drive export prices down and deteriorate the terms of trade. However, if the demand for a nation's output is elastic, then this deterioration may increase exports sufficiently for total export revenue to increase.
Monopoly power - can be used to drive up prices and enhance a nations terms of trade (oil).
Terms of trade and the trade balance
An increase in export prices (an improvement in the terms of trade) might actually decrease export revenue and lead to a decrease in the current account. However, this depends on the elasticity of demand for exports.
If PEDx is inelastic, then falls in the average price of exports do not significantly affect demand for them, and hurt overall revenue.
If PEDm is inelastic, then falls in the price of imports will not have much effect on demand for them, and overall spending on imports will decrease.
Long-term deterioration of terms of trade and LDCs
Demand for the output of developing countries has relatively low-income elasticity, meaning that as global income grows, the demand for these goods grows rather slowly, while more advanced and specialised products see their market demand grow much faster.
As a result, LDCs experience an ever-decreasing share of world output and resources. The consumption of needed imports of capital goods, healthcare items, and necessary resources is more difficult and requires more and more export sales. Without access to the imported goods, economic development is likely to be stifled indefinitely.
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