The International Economy

Content• The Pattern of Trade Between the UK and the Rest of the World• Trade with developing economies• The principal of comparative advantage• The benefits and costs of international trade• Protectionism• The balance of payments account• The determination of exchange rates• Exchange Rate Systems and their Implications for the Conduct

of Economic Policy• European Monetary Union (EMU)

The Pattern of Trade Between the UK and the Rest of the World

• The world economy is becoming increasingly global• The UK has an open economy as far as trade is concerned • The EU is a customs union which allows free trade of

goods and services between member countries• Majority of UK’s trade is within the EU – this is increasing• The UK’s largest trading partner is the USA accounting for

15% of trade although this is decreasing

The Pattern of Trade Between the UK and the Rest of the World

• Increasingly the UK is trading more with emerging economies such as China, Thailand, Malaysia, Singapore, South Korea and Taiwan

• At the moment the UK is the 2nd largest exporter of services in the world and the 8th largest exporter of goods

Trade with developing economies

• Trade is seen as a crucial way of increasing the development of a countries economy

• Many developing countries are now producing more manufactured goods which they are exporting overseas

• However there is still a reliance on commodities such as agricultural products for many of the worlds poorest economies which makes them vulnerable to changes in supply or demand

Trade With Developing Economies

• Two major ways economies can pursue their goal of development:

1. Import substitution – the country produces what it had originally imported, idea is that you import capital goods to produce the consumer goods required however this strategy has had little success

2. Export promotion – where the country seeks to identify markets where they can exploit their comparative advantage

The principal of comparative advantage

• A country has a comparative advantage in the production of those goods which (compared to other goods and countries in the world) it produces more efficiently than other goods

• A country has absolute advantage if it is able to produce a good more efficiently than all other countries

• Countries are able to gain from trade if they specialise in the production of goods which have a lower opportunity cost

Determinants of Comparative Advantage

• Comparative advantage results from differences in the costs of production

• The following factors influence costs of production:– Quantity and Quality of Factors of Production Available– Research and Development Investment– Changes in exchange rates (accounting for inflation)– Import controls– The degree of non-price competition between producers

Importance Of Comparative Advantage

• Comparative advantage emphasises the differences in relative productivity between countries

• Comparative advantage allows a country to make decisions about the best use of resources

• Comparative advantage allowed many developing countries to identify markets for their products

Limitations of Comparative Advantage

• Economic models of comparative advantage only use a small number of products and countries – in reality the situation is more complex making comparative advantage harder to work out

• Doesn’t consider the impact of transport costs – in reality these may make comparative advantage void

• Many countries want to protect new industries and strategic industries and keep a more diverse industrial structure than suggested by comparative advantage

Benefits of international trade

• Comparative advantage allows businesses to specialise and increase their income and standard of living

• With specialisation countries are able to exploit economies of scale

• Increases efficient allocation of world resources• Increased competition for producers which leads to

improved productive and allocative efficiency • Greater choice for consumers

Costs of international trade

• Can lead to diseconomies of scale if production gets too large

• Transport costs are not included in comparative advantage model

• Countries may become over dependent on one industry therefore may be vulnerable to any changes in global markets

• Can damage infant industries

Protectionism

• Protectionism is where the government shields domestic producers by restricting foreign competition

• There are a number of ways a government can protect industry including:– Tariffs– Quotas– Embargoes– Subsidies– Exchange controls

Protectionism - Causes• Governments protect for a number of reasons:

– To protect employment especially structural unemployment in declining industries

– Changes to comparative advantage in the world economy may lead to governments seeking to protect declining / infant industries

– Governments may seek to control imports to improve their balance of payments account

– As a reaction to dumping of excess capacity at low prices by other countries

– To increase government revenue– To try and encourage import substitution to occur

Protectionism - Consequences• Protectionism increases the prices of imported goods for

consumers resulting in a loss of consumer surplus• Increased cost to the government to enforce the controls • Domestic companies who import materials or components

from overseas are faced with higher costs• Threat of retaliation from other countries• Protectionism makes domestically produced goods more

attractive

Direct Protectionism

• Direct Protectionism includes tariffs• Tariffs act as taxes on imports which make them

more expensive for domestic consumers• As imports become more expensive relative to

exports it means consumption of them declines• Tariffs also earn money for the government

Protectionism and the EU

• The EU is a customs union which allows free movement of goods, services and factors of production between member states

• No EU member can protect against any other EU member

Balance Of Payments

• The balance of payments records all trade between one country and all other countries

• It includes:– Trade in goods– Trade in services– Net flow of investment income– Money transfers

Current Account

• The current account records all trade in goods and services for a countries economy

• This includes – Imported goods– Exported goods– Imported services– Exported services

Capital Account

• The capital account records all capital flows into and out of a country including:– Financial investment – Direct investment– Currency Trading

Payment Deficits• Payment deficits result where more is imported than exported• This causes an imbalance in the balance of payments• In recent years the UK has run a large current account deficit• The government have been less worried about this deficit because of

the following:– Investment and capital inflows mean the capital account balances the current

account– There will be some automatic correction with changes in demand due to the

business cycle– Some of the deficit could be caused by importing capital goods which will

increase productivity of the economy in the longer term

Payment Deficits

• However there are also issues concerned with payment deficits including:– Falling exchange rate caused by excess supply of £s– Structural weaknesses – may be a symptom of a lose of

comparative advantage / competitiveness– May be a sign of too much consumption and rising personal debt – Can lead to a loss in output and employment as consumers

purchase goods from abroad decreasing domestic demand– Problems associated with funding a current account deficit

What is an Exchange Rate?

• The value of a nation’s currency in terms of another currency

• i.e. £1=$2

• An exchange rate is set by demand and supply of a currency

Exchange rates - floating• Floating exchange rates are determined by the interaction

of demand and supply for a countries currency• Demand is determined by the need to purchase £ which is

influenced by:– Exports– Investment – Speculative demand

• Supply is determined by the need of agents to use £ in place of their own currency its influenced by:– Imports– Outflows of investment– Speculative selling of £s

Fixed Exchange rates

• Fixed exchange rates are where the rate for converting one currency into another is fixed

• Fixed exchange rates can be pegged to another currency and no fluctuations are allowed

• Pegged exchange rates allow for costs to be calculated easily

• You can also have semi-fixed exchange rates where the exchange rate needs to stay within set boundaries

Exchange rate systems and their implications for the conduct of monetary

policy• Advantages of Floating

exchange rates– Value of the currency is

determined by market forces

– There is no need for government / central bank intervention

• Disadvantages of floating exchange rates– Can be difficult to predict

costs – Currency may be affected

by volatile market conditions

Fixed Exchange Rates – Advantages and Disadvantages

• Advantages– Know what the exchange

rate is so makes it easy to plan for the future

– A country can reduce costs and therefore increase competitiveness

• Disadvantages– Needs government

intervention– Can cause macro-economic

problems keeping the exchange rate at a set rate

– May reduce stability of domestic economy

European Monetary Union

• European Monetary Union is the plan for a single European bank and a single European currency – the euro

• Countries wishing to join the Euro have to meet convergence criteria

• There are currently 13 EU countries that use the Euro

Advantages to the UK of joining the Euro

• The Euro could improve productivity by increases trade flows between member countries

• Investment in the UK would increase• Increased price transparency would allow consumers and

businesses to compare relative prices• Costs of changing £ to euros for trade would disappear• There would be a reduction in business uncertainty• It would enhance the working of the single European

market• There would be political and economic benefits

Disadvantages of the UK joining the Euro

• Historical reasons – similar currency unions have collapsed previously

• Lack of economic convergence of member states• Loss of domestic monetary freedom – UK will no

longer be able to set own interest rate which has worked very successfully since 1997

• Adjustment costs• Constraints of the fiscal stability pact

Summary • The UK is trading increasingly with Europe and decreasingly with the USA• There is an increased role of trade with developing economies by the UK • A country has a comparative advantage in the production of those goods which it produces

more efficiently than other goods• International trade allows efficient allocation of resources• International trade can result in countries becoming too reliant on a few protects• Protectionism is where the government tries to protect certain industries from

international trade using a number of policies including tariffs • The balance of payments account is made up of the current and capital accounts• Exchange rates can be determined by market forces (floating exchange rates) or by the

government (fixed exchange rates)• European Monetary Union (EMU) refers to the adoption of a single currency in the EU• There are advantages and disadvantages of the UK joining the Euro – the largest

disadvantage is that they will lose power to set their own interest rates