Economics 2

13011413 Robert Alexandruuu Moray College
1

Contents
1. Free trade (laissez-faire) ................................................................................................................. 2
2. Absolute and comparative advantage ........................................................................................... 4
3. International trading ......................................................................................................................... 5
4.Protectionism and barriers to trade ............................................................................................. 7
5. World Trade Organisation (WTO) .................................................................................................. 8
6. The North American free Trade Agreement (NAFTA) ................................................................ 8
7. UK balance of payments ............................................................................................................... 10
9. Balance of payment and exchange rates ............................................................................... 21
10. Fixed exchange rates/floating exchange rates advantages/disadvantages ....................... 26
11. Effects of fixed exchange rates/floating exchange rates on individuals and companies .. 28
12. Newly Industrialized Countries (NICs) ..................................................................................... 30
13. Issues facing NICs and LDCs .................................................................................................. 30
14. Impact of TNCs on NICs ........................................................................................................... 31
List of references ................................................................................................................................ 34

2

1. Free trade (laissez-faire)
Free trade or laissez-faire can be defined as the unrestricted purchase and sale of
goods and services between countries without the imposition of constraints such as
tariffs, duties and quotas. Free trade is a win-win proposition because it enables
nations to focus on their core competitive advantages, thereby maximizing economic
output and fostering income growth for their citizens.
Free trade enables nations to concentrate their efforts on manufacturing products or
providing services where they have a distinct comparative advantage, according to
the theory first espoused by economist David Ricardo two centuries ago. A free trade
policy should enable a nation to generate enough foreign currency to purchase the
products or services that it does not produce indigenously. The process works best
when there are few if any barriers to entry for such imports. The imposition of artificial
constraints such as tariffs on imports or the provision of subsidies to exports will
introduce distortions and impede free trade. (Britannica, c. 2014)
The division of labour among countries leads to specialization, greater efficiency, and
higher aggregate production. From the point of view of a single country there may be
practical advantages in trade restriction, particularly if the country is the main buyer
or seller of a commodity. In practice, however, the protection of local industries may
prove advantageous only to a small minority of the population, and it could be
disadvantageous to the rest. Since the mid 20 century, nations have increasingly
reduced tariff barriers and currency restrictions on international trade. Other barriers,
however, that may be equally effective in hindering trade include import quotas,
taxes, and diverse means of subsidizing domestic industries. (Investopedia, c. 2014)

Advantages of free trade:
Increased production
Production efficiencies
Benefits to consumers
Foreign exchange gains
Employment
Economic growth

Disadvantages of free trade:
With the removal of trade barriers, structural unemployment may occur in the
short term
Increased domestic economic instability from international trade cycles, as
economies become dependent on global markets
International markets are not a level playing field
Developing or new industries may find it difficult to become established in a
competitive environment
3

Free trade can lead to pollution and other environmental problems
Pressure to increase protection during the GFC
An example of how a country can benefit from free trade is Australia. Here are some
facts according to Department of Foreign Affairs and Trade:
Over the 2000s Australia's ratios of exports and imports to GDP have each
risen every year. Australia is an open economy, the size of its import and
export sectors being greater than 20% of Gross Domestic Product. Australia is
one of the countries that has benefitted most from rising international trade. It
bought imported goods more cheaply than they could be made in Australia
and sold exports overseas that commanded rising prices because they were in
international demand.
One result of the increase in trade and openness of the Australian economy
was has been structural change with a narrowing of the manufacturing and
industrial base and a rise in the resources base. China became the world's
manufacturing centre and increasingly lower priced manufactured goods made
in China were imported into Australia, leading to the closure of inefficient
manufacturers. At the same time, demand by China for Australian raw
materials such as coal and iron ore increased rapidly, leading to expansion in
the minerals sector.
Whilst the manufacturing base in Australia has narrowed, manufacturing
output has actually increased by 40% and exports have risen by 400%,
according to DFAT.
Greater access to imports has benefitted consumers and businesses by
widening the choice of products available and boosting the living standards for
many Australians.
Reducing tariffs has resulted in savings estimated to be at least $1000 per
year to the average Australian family. For example, without the reductions in
tariffs on motor vehicles, Australians would pay around $10,000 extra on a
$30,000 car.
Having a bigger market to sell to means that a business can sell more, earn
more profits and pay higher wages. Exporting businesses in Australia, on
average, pay more to workers and sell more per worker than non-exporters.
Export growth has been essential to economic growth and job creation in
Australia. For example, over 400 000 jobs were created between 198384 and
1993-94. By 2010, one in four jobs in Australia were related to exports.
Some current developments in Free Trade Agreements in Australia:
Thailand. Australia signed a free trade agreement with Thailand in 2005. The
agreement was designed to reduce tariffs on products exported and imported
by both countries. By 2010 tariffs on 95% of current trade between both
countries were to fall to 0%.
4

The United States. Australia signed a free trade agreement with the United
States in 2005. This agreement was designed to increase exports of
Australian raw materials and agricultural products and increase imports of US
services from the US economy.
Singapore. Australia signed a free trade agreement with Singapore in 2003 to
increase the import and exports of banking and education services as well as
other services like environmental and telecommunications services.
Chile. Australia signed a free trade agreement with Chile in 2009 to reduce
tariffs and boost trade between these two countries. Tariffs on all existing
merchandise trade were to be removed by 2015.
ASEAN-Australia-New Zealand Free Trade Agreement (AANZFTA). On
January 3 2010 the Australian Trade Minister announced the commencement
of our largest free trade agreement. This agreement sees the removal of a
range of tariffs on Australian exports to ASEAN nations such as Malaysia and
the Philippines. It should eliminate tariffs on 96% of our current exports to
ASEAN nations by 2020.
Future FTAs. Australia is also negotiating with countries including China,
Japan, Korea, Malaysia and Gulf countries on possible future FTAs. (NSW
HNC online, n.d.)

2. Absolute and comparative advantage
Absolute advantage can be defined as the ability of a country, individual, company or
region to produce a good or service at a lower cost per unit than the cost at which
any other entity produces that good or service. Entities with absolute advantages can
produce a product or service using a smaller number of inputs and/or using a more
efficient process than another party producing the same product or service.
Here are some examples of how absolute advantage works:

-The United States produces 700 million gallons of wine per year, while Italy
produces 4 billion gallons of wine per year. Italy has an absolute advantage because
it produces many more gallons of wine (the output) in the same amount of time (the
input) as the United States.

-Jane can knit a sweater in 10 hours, while Kate can knit a sweater in 8 hours. Kate
has an absolute advantage over Jane, because it takes her fewer hours (the input) to
produce a sweater (the output).

An entity can have an absolute advantage in more than one good or service.
Absolute advantage also explains why it makes sense for countries, individuals and
businesses to trade with one another. Because each has advantages in producing
certain products and services, they can both benefit from trade. For example, if Jane
5

can produce a painting in 5 hours while Kate needs 9 hours to produce a comparable
painting, Jane has an absolute advantage over Kate in painting. Remember Kate has
an absolute advantage over Jane in knitting sweaters. If both Jane and Kate
specialize in the products they have an absolute advantage in and buy the products
they don't have an absolute advantage in from the other entity, they will both be
better off.
Comparative advantage can be summed up as the ability of a firm or individual to
produce goods and/or services at a lower opportunity cost than other firms or
individuals. A comparative advantage gives a company the ability to sell goods and
services at a lower price than its competitors and realize stronger sales margins.
Having a comparative advantage - or disadvantage - can shape a company's entire
focus. For example, if a cruise company found that it had a comparative advantage
over a similar company, due to its closer proximity to a port, it might encourage the
latter to focus on other, more productive, aspects of the business.

It is important to note that a comparative advantage is not the same as an absolute
advantage. The latter implies that one is the best at something, while the former
relates more to the costs of the particular endeavour. (Investopedia, c. 2014)

3. International trading
International trade is allowing markets to expand for both goods and services that
otherwise may not have been available so far. It is the reason why you can pick
between a Japanese, German or American car. As a result of international trade, the
market contains greater competition and therefore more competitive prices, which
brings a cheaper product home to the consumer.
For example, if you walk into a supermarket and are able to buy South American
bananas, Brazilian coffee and a bottle of South African wine, you are experiencing
the effects of international trade.
International trade is the exchange of goods and services between countries. This
type of trade gives rise to a world economy, in which prices, or supply and demand,
affect and are affected by global events. Political change in Asia, for example, could
result in an increase in the cost of labor, thereby increasing the manufacturing costs
for an American sneaker company based in Malaysia, which would then result in an
increase in the price that you have to pay to buy the tennis shoes at your local mall. A
decrease in the cost of labor, on the other hand, would result in you having to pay
less for your new shoes.

Trading globally gives consumers and countries the opportunity to be exposed to
6

goods and services not available in their own countries. Almost every kind of product
can be found on the international market: food, clothes, spare parts, oil, jewellery,
wine, stocks, currencies and water. Services are also traded: tourism, banking,
consulting and transportation. A product that is sold to the global market is an export,
and a product that is bought from the global market is an import. Imports and exports
are accounted for in a country's current account in the balance of payments.
Global trade allows wealthy countries to use their resources - whether labor,
technology or capital - more efficiently. Because countries are endowed with
different assets and natural resources (land, labor, capital and technology), some
countries may produce the same good more efficiently and therefore sell it more
cheaply than other countries. If a country cannot efficiently produce an item, it can
obtain the item by trading with another country that can. This is known
as specialization in international trade.
Here is a simple example: Country A and Country B both produce cotton sweaters
and wine. Country A produces 10 sweaters and six bottles of wine a year while
Country B produces six sweaters and 10 bottles of wine a year. Both can produce a
total of 16 units. Country A, however, takes three hours to produce the 10 sweaters
and two hours to produce the six bottles of wine (total of five hours). Country B, on
the other hand, takes one hour to produce 10 sweaters and three hours to produce
six bottles of wine (total of four hours).

But these two countries realize that they could produce more by focusing on those
products with which they have a comparative advantage. Country A then begins to
produce only wine and Country B produces only cotton sweaters. Each country can
now create a specialized output of 20 units per year and trade equal proportions of
both products. As such, each country now has access to 20 units of both products.

It can be seen then that for both countries, the opportunity cost of producing both
products is greater than the cost of specializing. More specifically, for each country,
the opportunity cost of producing 16 units of both sweaters and wine is 20 units of
both products (after trading). Specialization reduces their opportunity cost and
therefore maximizes their efficiency in acquiring the goods they need. With the
greater supply, the price of each product would decrease, thus giving an advantage
to the end consumer as well.

Note that, in the example above, Country B could produce both wine and cotton more
efficiently than Country A (less time). This is called an absolute advantage, and
Country B may have it because of a higher level of technology. However, according
to the international trade theory, even if a country has an absolute advantage over
another, it can still benefit from specialization.
7

International trade not only results in increased efficiency but also allows countries to
participate in a global economy, encouraging the opportunity of foreign direct
investment (FDI), which is the amount of money that individuals invest into foreign
companies and other assets. In theory, economies can therefore grow more
efficiently and can more easily become competitive economic participants.

For the receiving government, FDI is a means by which foreign currency and
expertise can enter the country. These raise employment levels, and, theoretically,
lead to a growth in the gross domestic product. For the investor, FDI offers company
expansion and growth, which means higher revenues. (Investopedia, c. 2014)

4.Protectionism and barriers to trade
Protectionism occurs when there are government actions and policies that restrict or
restrain international trade, often done with the intent of protecting local businesses
and jobs from foreign competition. Typical methods of protectionism are import tariffs,
quotas, subsidies or tax cuts to local businesses and direct state intervention.
Any time a government undertakes any of these actions, they are engaging in
protectionism. There is significant debate surrounding the merits of protectionism.
Critics argue that, over the long term, protectionism often ends up hurting the people
it is intended to protect and often promotes free trade as a superior alternative to
protectionism. (Investopedia, c. 2014)
A barrier to trade is a government-imposed restraint on the flow of international
goods or services.
The most common barrier to trade is a tariffa tax on imports. Tariffs raise the price
of imported goods relative to domestic goods (goods produced at home).

Another common barrier to trade is a government subsidy to a particular domestic
industry. Subsidies make those goods cheaper to produce than in foreign markets.
This results in a lower domestic price. Both tariffs and subsidies raise the price of
foreign goods relative to domestic goods, which reduces imports.

Yet another barrier to trade is an embargoa blockade or political agreement that
limits a foreign country's ability to export or import.

Barriers to trade are often called "protection" because their stated purpose is to
shield or advance particular industries or segments of an economy. From an
economic perspective, though, the costs to the economy almost always outweigh the
benefits enjoyed by those who are protected. (Library of economics and liberty, c.
1999-2010)
8

5. World Trade Organisation (WTO)
The World Trade Organization (WTO) deals with the global rules of trade between
nations. Its main function is to ensure that trade flows as smoothly, predictably and
freely as possible.
As they say on their web-site, WTO is NOT for for free trade at any cost.
One of the principles of the WTO system is for countries to lower their trade barriers
and to allow trade to flow more freely. After all, countries benefit from the increased
trade that results from lower trade barriers.
But just how low those barriers should go is something member countries bargain
with each other. Their negotiating positions depend on how ready they feel they are
to lower the barriers, and on what they want to obtain from other members in return.
One countrys commitments become another countrys rights, and vice versa.
The WTOs role is to provide the forum for negotiating liberalization. It also provides
the rules for how liberalization can take place.
The rules written into the agreements allow barriers to be lowered gradually so that
domestic producers can adjust.
They have special provisions that take into account the situations that developing
countries face. They also spell out when and how governments can protect their
domestic producers, for example from imports that are considered to have unfairly
low prices because of subsidies or dumping. Here, the objective is fair trade.
Just as important as freer trade perhaps more important are other principles of
the WTO system. For example: non-discrimination, and making sure the conditions
for trade are stable, predictable and transparent. (World Trade Organisation, c. 2014)

6. The North American free Trade Agreement (NAFTA)
On January 1, 1994, the North American Free Trade Agreement between the United
States, Canada, and Mexico (NAFTA) entered into force.
All remaining duties and quantitative restrictions were eliminated, as scheduled, on
January 1, 2008.
9

NAFTA created the world's largest free trade area, which now links 450 million
people producing $17 trillion worth of goods and services.
Trade between the United States and its NAFTA partners has soared since the
agreement entered into force.
U.S. goods and services trade with NAFTA totaled $1.6 trillion in 2009 (latest data
available for goods and services trade combined). Exports totaled $397 billion.
Imports totaled $438 billion. The U.S. goods and services trade deficit with NAFTA
was $41 billion in 2009.
The United States has $918 billion in total (two ways) goods trade with NAFTA
countries (Canada and Mexico) during 2010. Goods exports totaled $412 billion;
Goods imports totaled $506 billion. The U.S. goods trade deficit with NAFTA was
$95 billion in 2010.
Trade in services with NAFTA (exports and imports) totaled $99 billion in 2009 (latest
data available for services trade). Services exports were $63.8 billion. Services
imports were $35.5 billion. The U.S. services trade surplus with NAFTA was $28.3
billion in 2009.
Exports
The NAFTA countries (Canada and Mexico), were the top two purchasers of U.S.
exports in 2010. (Canada $248.2 billion and Mexico $163.3 billion).
U.S. goods exports to NAFTA in 2010 were $411.5 billion, up 23.4% ($78 billion)
from 2009, and 149% from 1994 (the year prior to Uruguay Round) and up 190%
from 1993 (the year prior to NAFTA). U.S. exports to NAFTA accounted for 32.2% of
overall U.S. exports in 2010.
The top export categories (2-digit HS) in 2010 were: Machinery ($63.3 billion),
Vehicles (parts) ($56.7 billion), Electrical Machinery ($56.2 billion), Mineral Fuel and
Oil ($26.7 billion), and Plastic ($22.6 billion).
U.S. exports of agricultural products to NAFTA countries totaled $31.4 billion in
2010. Leading categories include: red meats, fresh/chilled/frozen ($2.7 billion),
coarse grains ($2.2 million), fresh fruit ($1.9 billion), snack foods (excluding nuts)
($1.8 billion), and fresh vegetables ($1.7 billion).
U.S. exports of private commercial services* (i.e., excluding military and government)
to NAFTA were $63.8 billion in 2009 (latest data available), down 7% ($4.6 billion)
from 2008, but up 125% since 1994.
Imports
The NAFTA countries were the second and third largest suppliers of goods imports to
the United States in 2010. (Canada $276.5 billon, and Mexico $229.7 billion).
10

U.S. goods imports from NAFTA totaled $506.1 billion in 2010, up 25.6% ($103
billion), from 2009, and up 184% from 1994, and up 235% from 1993. U.S. imports
from NAFTA accounted for 26.5% of overall U.S. imports in 2010.
The five largest categories in 2010 were Mineral Fuel and Oil (crude oil) ($116.2
billion), Vehicles ($86.3 billion), Electrical Machinery ($61.8 billion), Machinery ($51.2
billion), and Precious Stones (gold) ($13.9).
U.S. imports of agricultural products from NAFTA countries totaled $29.8 billion in
2010. Leading categories include: fresh vegetables ($4.6 billion), snack foods,
(including chocolate) ($4.0 billion), fresh fruit (excluding bananas) ($2.4 billion), live
animals ($2.0 billion), and red meats, fresh/chilled/frozen ($2.0 billion).
U.S. imports of private commercial services* (i.e., excluding military and government)
were $35.5 billion in 2009 (latest data available), down 11.2% ($4.5 billion) from
2008, but up 100% since 1994.
Trade Balances
The U.S. goods trade deficit with NAFTA was $94.6 billion in 2010, a 36.4%
increase ($25 billion) over 2009. The U.S. goods trade deficit with NAFTA accounted
for 26.8% of the overall U.S. goods trade deficit in 2010.
The United States had a services trade surplus of $28.3 billion with NAFTA countries
in 2009 (latest data available).
Investment
U.S. foreign direct investment (FDI) in NAFTA Countries (stock) was $357.7 billion in
2009 (latest data available), up 8.8% from 2008.
U.S. direct investment in NAFTA Countries is in nonbank holding companies, and in
the manufacturing, finance/insurance, and mining sectors.
NAFTA Countries FDI in the United States (stock) was $237.2 billion in 2009 (latest
data available), up 16.5% from 2008.
NAFTA countries direct investment in the U.S. is in the manufacturing,
finance/insurance, and banking sectors. (Office of the United States trade
representatve Executive office of the president, n.d.)

7. UK balance of payments
The Balance of Payments is the record of a countrys transactions / trade with the
rest of the world.
The balance of payments consists of:
11

1. Current Account (trade in goods, services + investment incomes + transfers)
2. Capital Account / Financial Account (capital and financial flows, net
investment, portfolio investment)
3. Errors and omissions. It is hard to collect all data so some is missed out.
In theory there should be a balancing between capital and current / financial account.
If there is a current account deficit, there should be a surplus on the capital / financial
account.
UK Current Account
The UK current account deficit was 20.7 billion in Quarter 3 2013, up from a revised
deficit of 6.2 billion in Quarter 2 2013. The deficit in Quarter 3 2013 equated to 5.1%
of GDP at current market prices, up from 1.5% in Quarter 2 2013.
In 2012, the UKs current account deficit was 59.8 billion.

This shows deterioration in the current account. The current account deficit for Q3
2012 was over 12bn (Seasonally adjusted measure). Q3 2012 as a % of GDP 3.2%
Components of Current Account
1. Trade in goods
12

2. Trade in services
3. Total income (e.g. investment income)
4. Total current transfers
UK Current Account from Jan 2013

Q3 2012 (Not seasonally adjusted figures for current account)
UK Current Account Deficit
Since the mid 1980s, the UK has generally had a persistent current account deficit.
Essentially, the UK has been importing more goods and services than it has been
13

exporting.

Reasons for a Current Account Deficit
1. Overvalued exchange rates. Countries in the Eurozone which became
uncompetitive (e.g. Greece, Portugal and Spain) experienced large current account
deficits. This is because an overvalued exchange rates means exports are more
expensive, but imports are cheaper. This encourages domestic consumers to buy
imports. It also makes it hard for exporters because they are relatively uncompetitive.
2. High Consumer Spending. If there is rapid growth in consumer spending, then
there tends to be an increase in imports causing a deterioration in the current
account. For example, in the 1980s boom, there was a fall in the savings rate and a
rise in UK consumer spending; this caused a record current account deficit. The
recession of 1991 caused an improvement in the current account as import spending
fell.
3. Unbalanced Economy. An economy focused on consumer spending rather than
investment and exports will tend to have a bigger current account deficit.
4. Competitiveness. Related to the exchange rate is the general competitiveness of
firms. If there is a decline in relative competitiveness, e.g. rising wage costs,
industrial unrest, poor quality goods then it is harder to export causing a
deterioration in the current account.

14

Components of UK current account deficit

15

UKs Persistent Current Account deficit
1. Deficit in Goods. Since the process of de-industrialisation accelerated in the early
1980s, the UK has had a large deficit in goods. The UK still manufactures goods, but
it has become a net importer especially of manufactured goods (e.g. clothes,
computers, cars). The graph below shows the sectors with the biggest deficit.

For example, this shows the UK had a deficit of 12.56 bn for finished manufactured
goods in Q2 of 2012. The UK is also a net importer of oil and food.

16

This deficit in goods, is partly offset by a surplus in services (e.g. insurance and
finance) but, it is not sufficient to overcome the trade deficit.
2. Financial flows. The UK has been able to attract sufficient financial flows, e.g.
portfolio flows to finance the UKs current account deficit.
3. Relatively Low Saving Rate. The UK has had a relatively low saving rate
compared to some of its competitors. Though recent increases in the saving rate
havent prevented a deterioration in the current account.
Policies to Reduce a Current Account Deficit
To reduce a current account deficit, we need to pursue policies involving some or all
of the following:
1. Reduce consumer spending through tight fiscal and tight monetary policy.
E.g. higher income tax will reduce disposable income and therefore reduce
spending on imports (however, it will also lead to lower economic growth)
2. Supply side policies to improve competitiveness.
3. Devaluation of the exchange rate. This makes exports cheaper and imports
more expensive.
UK Balance of Payments

17

In Q2 2012, the main components of the balance of payments were:
Current Account -15 962m
Financial Account + 5 785
Capital Account + 1000 m
net errors and Omissions + 9177 m
net balance = 0 m
In other words, if there is a deficit on the current account to buy goods from China,
foreign currency is needed to come from some other source to keep buying these
imports.
One example is to think of UK consumers buying Chinese goods causing a
deficit on the current account.
Then Chinese banks and firms invest some of this money back into UK
investment trusts or build a factory in the UK. These leads to a credit on the
financial account.
The current account deficit is being financed by a surplus on financial flows.
Components of Financial Account
Direct investment
Portfolio investment
Financial derivatives (net)
Other investment
Reserve assets
UK Current Account Compared to other Countries

18

By 2012, the UK has developed one of largest current account deficits.
Does a Current Account Deficit Matter? Should UK worry if they have a current
account deficit?
Yes
It is a sign of uncompetitiveness, which will lead to lower economic growth and
poorer prospects in the long run.
If capital / financial flows dry up, it could lead to depreciation in the exchange
rate and a fall in living standards
It is a sign of an unbalanced economy.
No
The UK has had a persistent deficit since the mid 1980s. Countries with large
current account surplus have not necessarily done better, e.g. Japan had a
long period of stagnation.
In era of globalisation, financial flows are easier to attract and therefore the
deficit is financed by these capital inflows.
If the current account was too large, there should be a depreciation in the
exchange rate to restore the balance. A current account deficit is a bigger
concern in a fixed exchange rate (like Euro) because there is no option of
depreciation.

19

Graphs on Balance of Payments since 1945

UK current account actual m since 1950

Current account as % of GDP.

20

Relationship between economic growth and current account. (Economics Help, c.
2014)

8. General trends in UK trade over the last 30 years
The UK produces a wide range of products for export but also imports a vast amount
of food, electronics, energy and other consumer goods. According to the government
department for Business, Innovation and Skills between 1998 and 2008, goods
exports grew by nearly 100 per cent and goods imports grew by 111.5 per cent. The
report says that UK manufacturing exports have been shifting towards high and
medium high technology manufacturers, demonstrating a change in trend in the past
10 years. Barring slight dips around the years 1985, 1994 and every year since 2007,
goods exports, imports, services exports, imports and GDP have been increasing.
The value of the import and export of goods has consistently been over twice the
value of the import and export of services. Since 1994, the UKs share of the global
21

import and export market has stayed pretty stable, though dropped slightly from
around 5 per cent to around 3 per cent, around the same level as France and Japan,
above Russia and Brazil, below Germany and the USA and overtaken by China in
2004. Sterling fell dramatically in 2007/08, but the Bank of England claimed that this
held up the exports of goods, with products from Britain costing less to overseas
buyers as the rate of the pound was lower than usual. As mentioned earlier, the UK
has shifted to higher technology manufactured goods, valued at around 250 billion
USD in 2008, 150 billion USD higher than in 1990. This total is higher than the global
average. The last 10 years have seen a massive increase in exports to the BRIC
countries (Brazil, Russia, India and China) and a minor increase in exports to France
and Germany. Britains imports from China have trebled in the period between 2002
and 2007. All the facts, figures and trends can be backed up by accessing UKs
government web-site at the following link
http://www.bis.gov.uk/assets/biscore/international-trade-investment-and-
development/docs/u/11-720-uk-trade-performance.pdf (Blurtit, n.d.)

9. Balance of payment and exchange rates
The Marshall Lerner condition
Assume that the UK has a current account deficit. If the pound were to devalue (a
large drop in its value) then one would expect the deficit to reduce. Thats because
exports will become relatively cheaper, and so their demand should rise in foreign
markets, and imports will become relatively more expensive, so their demand should
fall in the UK.
The success of a devaluation of the pound in terms of reducing a current account
deficit will depend on foreigners' elasticity of demand for British exports and UK
consumer's elasticity of demand for foreign imports.
The Marshall Lerner condition states that for a devaluation to be successful in terms
of a reduced current account deficit, the sum of the two elasticities, must be greater
than one.
To illustrate that this should be true, exports and imports should be analised
separately.
Export elasticity
UK exporters can't go wrong if the pound falls in value. However small
the depreciation in the pound is, and however low the elasticity for their exports is,
the revenue they will receive will have to rise.
For example, let's take a car company that is exporting cars to the USA whose price
is 10,000 in the UK. Let us also assume that the exchange rate between these two
countries is 1 = $2. These cars will have a price of $20,000 in the USA. Now
22

assume that the pound devalues by 10% so that the new exchange rate is 1 =
$1.80. The price in the USA is now $18,000. Unless the elasticity of demand for
these cars in the USA is zero (highly unlikely) then the demand for these cars in the
USA will increase. Although American consumers now only have to pay $18,000, the
British car company still receives 10,000 for each sale. However large or small the
fall in the value of the pound is, the sterling price of the car stays the same. Even if
this company only sells one extra car, they will still receive an extra 10,000.
In summary, for export revenue to rise following a devaluation of the pound, the
elasticity of demand for these exports simply has to be greater than zero (which
is perfectly inelastic demand). Obviously, the higher the elasticity the bigger the
increase in export revenue, but anything over zero will help reduce the current
account deficit.
Import elasticity
In the case of imports the situation is a little less favourable. A devaluation of the
pound will cause the price of imports into the UK to rise. The demand for these
imports will fall, but the revenue that the foreign producers receive will not necessarily
fall.
For example, assume that an American car company exports their cars into the UK.
The price for these cars in the USA is $30,000. Again, assume that the initial
exchange rate is 1 = $2. This means that the price of these cars in the UK will be
15,000. Now assume that the pound devalues by 25% giving an exchange rate of
1 = $1.50. Swapping this exchange rate around to give the price of dollars in terms
of pounds, we have $1 = 0.67. So now the American cars are priced at 20,000 in
the UK. The change in the revenue received by the American car company will
depend on the elasticity of demand for their cars in the UK.
Assume that the elasticity is 1.5, which is relatively elastic. As you will know from the
topic called 'Elasticities', if demand is relatively elastic and the price rises, the
decrease in demand will be relatively larger. This means that the loss in revenue from
the decrease in demand is higher than the gain in revenue on each unit due to the
higher price. The diagram below helps to explain:
23

Note that the elastic demand curve is relatively flat, so that when the price rises, the
fall in demand is relatively larger, and the 'gain' box is much smaller than the 'loss'
box. The more elastic the demand for UK imports is, the more successful a
devaluation will be in terms of reducing import revenues (which go out of the country)
and the bigger the reduction in the current account deficit.
Now assume that the elasticity is 0.5, which is relatively inelastic. Again, you should
know that, in this case, when the price rises, the decrease in demand in relatively
smaller. This means that the loss in revenue from the decrease in demand is lower
than the gain in revenue on each unit due to the higher price:

This demand curve is relatively inelastic, and so is fairly steep. You can see that the
price rise is proportionately much larger than the fall in demand, so the 'gain' box is
much larger than the 'loss' box. If the demand for UK imports is
relatively inelastic then devaluation will result in increasing import revenues (which go
out of the country), which contribute to a larger current account deficit.

24

Putting exports and imports together
The condition for exports and imports separately can be summarised as follows:
E
ex
> 0 for a devaluation to increase export revenues
E
im
> 1 for a devaluation to reduce foreigners import revenue
By adding the zero and the one, we get the following overall condition:
E
ex
+ E
im
> 1 For a devaluation to be successful in terms of reducing a current
account deficit.
Note that, overall, as long as the two elasticities add up to more than one the
devaluation will reduce the deficit, even if the two individual conditions above are not
satisfied. For example, if E
ex
= 0.6 and E
im
= 0.6, import revenue will rise following a
devaluation, but this will be more than compensated for by a larger rise in export
revenue. The elasticities add up to 1.2, which is more than one, so overall the
situation improves. Obviously, the higher both elasticities are, the more successful
devaluation will be in terms of reducing the current account deficit.
The J-curve
As the title suggests, this is a curve that is shaped like a 'J'. Look at the diagram
below:

Lets assume that the economy is at point A, experiencing a current account deficit.
The government decides to devalue the pound to help eliminate this deficit. The J-
curve shows that, in the short term, the deficit may get bigger before, eventually, it
starts to reduce. In other words, the Marshall Lerner condition is not satisfied in the
short run, even though it will be in the medium to long term.
The main reason for this is time lags. It takes time for producers and consumers to
adjust their purchases to the changed prices brought about by the devalued
25

exchange rate. Certainly, firms will have orders planned in advance, and will not react
to the price changes for a number of months.
Exports revenues may not rise immediately, but they will not fall either, but foreign
import revenues may well rise, as increased import prices are combined with static,
or at least very inelastic, demand. The current account deficit will probably get worse.
After a period of time, foreigners will react to the lower export prices and UK firms
and consumers will react to the higher import prices. The Marshall Lerner condition
should be satisfied as demand for both exports and imports become more elastic and
the deficit should start to fall.
Higher import prices will feed through to higher inflation eventually. This will reduce
the competitiveness of British industry causing long-term problems for the current
account. This is why many politicians see devaluation as failure. Once the economy
is past the trough of the J-curve and the deficit is falling, the devaluation may seem
like a good idea. But the subsequent rise in inflation (the government's number one
macroeconomic objective nowadays) and its implications for competitiveness mean
that devaluation is never a good long-term solution. British exporters complain of the
high pound, but devaluation will not necessarily do them any favours.
It should be noted that in today's world of free flowing capital, it is very hard (some
would say impossible) for a government to actually implement a policy of devaluation.
The markets decide the country's exchange rate. When the UK was part of
the Bretton Woods fixed exchange rate system, occasional 'realignments' would
occur (i.e. devaluations). Now that the pound floats on the foreign exchange markets,
the currency might appreciate (rise gently in value) or depreciate (fall gently in value)
but big, one off drops in the value of the currency do not really happen. The last big
devaluation was when the pound fell out of the ERM and the pound fell by around
15% in one day.
The 'upside down' J-curve
The analysis above can work for countries with persistent current account surpluses
that they want to eliminate. Look at the diagram below:

26

Assume that the economy is at point B, experiencing a current account surplus.
Rather than devaluation, the government will want to revalue their currency to make
exports relatively more expensive (reducing their demand) and imports relatively
cheaper (increasing their demand). Again, there will be time lags. Consumers and
producers will not react to these changes immediately. The demand for both exports
and imports will be relatively inelastic in the short run. Export revenues will not
change (a fixed UK price) but the revenue paid for foreign imports will fall. This will
make the current account surplus get even bigger in the short run.
In the medium term, firms and consumers will adjust their purchases in line with the
changed prices. The demand for both exports and imports will become more elastic
and the surplus will eventually start to fall. The result is an upside down J-curve. (S-
cool, c. 2014)

10. Fixed exchange rates/floating exchange rates advantages/disadvantages
Fixed exchange rates advantages:
Reduced risk in international trade - By maintaining a fixed rate, buyers and
sellers of goods internationally can agree a price and not be subject to the risk
of later changes in the exchange rate before contracts are settled. The greater
certainty should help encourage investment.
Introduces discipline in economic management - As the burden or pain of
adjustment to equilibrium is thrown onto the domestic economy then
governments have a built-in incentive not to follow inflationary policies. If they
do, then unemployment and balance of payments problems are certain to
result as the economy becomes uncompetitive.
Fixed rates should eliminate destabilising speculation - Speculation flows can
be very destabilising for an economy and the incentive to speculate is very
small when the exchange rate is fixed.
Fixed exchange rates disadvantages:
No automatic balance of payments adjustment - A floating exchange rate
should deal with a disequilibrium in the balance of payments without
government interference, and with no effect on the domestic economy. If there
is a deficit then the currency falls making you competitive again. However, with
a fixed rate, the problem would have to be solved by a reduction in the level of
aggregate demand. As demand drops people consume less imports and also
the price level falls making you more competitive.
Large holdings of foreign exchange reserves required - Fixed exchange rates
require a government to hold large scale reserves of foreign currency to
maintain the fixed rate - such reserves have an opportunity cost.
27

Loss of freedom in your internal policy - The needs of the exchange rate can
dominate policy and this may not be best for the economy at that point.
Interest rates and other policies may be set for the value of the exchange rate
rather than the more important macro objectives of inflation and
unemployment.
Floating exchange rates advantages:
Automatic balance of payments adjustment - Any balance of payments
disequilibrium will tend to be rectified by a change in the exchange rate. For
example, if a country has a balance of payments deficit then the currency
should depreciate. This is because imports will be greater than exports
meaning the supply of sterling on the foreign exchanges will be increasing as
importers sell pounds to pay for the imports. This will drive the value of the
pound down. The effect of the depreciation should be to make your exports
cheaper and imports more expensive, thus increasing demand for your goods
abroad and reducing demand for foreign goods in your own country, therefore
dealing with the balance of payments problem. Conversely, a balance of
payments surplus should be eliminated by an appreciation of the currency.
Freeing internal policy - With a floating exchange rate, balance of payments
disequilibrium should be rectified by a change in the external price of the
currency. However, with a fixed rate, curing a deficit could involve a general
deflationary policy resulting in unpleasant consequences for the whole
economy such as unemployment. The floating rate allows governments
freedom to pursue their own internal policy objectives such as growth and full
employment without external constraints.
Absence of crises - Fixed rates are often characterised by crises as pressure
mounts on a currency to devalue or revalue. The fact that, with a floating rate,
such changes are automatic should remove the element of crisis from
international relations.
Floating exchange rates disadvantages:
Uncertainty - The fact that a currency changes in value from day to day
introduces instability or uncertainty into trade. Sellers may be unsure of how
much money they will receive when they sell abroad or what their price
actually is abroad. Of course the rate changing will affect price and thus sales.
In a similar way importers never know how much it is going to cost them to
import a given amount of foreign goods. This uncertainty can be reduced by
hedging the foreign exchange risk on the forward market.
Lack of investment - The uncertainty can lead to a lack of investment internally
as well as from abroad.
Speculation - Speculation will tend to be an inherent part of a floating system
and it can be damaging and destabilising for the economy, as the speculative
28

flows may often differ from the underlying pattern of trade flows. (Bized, c.
1996-2012)

11. Effects of fixed exchange rates/floating exchange rates on individuals and
companies
Fixed exchange rates effects on individuals:
Permit the stability of investments for individual retirees in fixed income
investments. Example, if a retiree is invested in an international bond fund with
volatile currencies, then the fixed income portfolio has to be hedged for
currencies or there is a risk of loss. As a result, many retirees invest in bond
investments in their own country's currencies. If you live in Great Britain, then
most likely you will stick with a Great Britain fixed income investment
Gives an individual "peace of mind" that his standard of living will not have the
risk of volatility in the area that you live in. You always know what items cost,
no fear and guess work. Fixed exchange rates do not reduce your standard of
living in your area.
Allow stable savings
Fixed exchange rates effects on businesses:
Increases the business financial stability knowing that there wont be any
major increase in the exchange rate
Decreases competition
Allows smaller companies to develop faster
Floating exchange rates effects on individuals:
Wages will be affected. A sudden increase might result in a stagnation or even
a decrease of salary. Floating the dollar has had an effect on wages
growth. In the USA, average weekly earnings for the private non-farm sector
was rising at 1.2% per annum in real terms, from 1964 to 1972, immediately
before the US dollar was floated. In the next 20 years they declined at an
average rate of 1.2% per annum. Then between 1992 and 2004, they have
been rising slowly at an average rate of 0.6% per annum in real terms: half the
rate of the first period. Even so, average real wages for private non-farm
workers in the USA in 2010 are still 16% below the levels they were in 1972 as
shown below. If average real wages in the US had maintained their pre-float
growth rate, they would be 70% higher than they are today.
29

Unemployment will increase/decrease as exchange rates increase or
decrease. Floating the dollar affected unemployment, also. In the USA, the
rate of unemployment has increased significantly since 1973 when the US
dollar was floated, as shown below.

Increase in inflation (Buoyant Economies, c. 2013)

30

Floating exchange rates effects on businesses:
Higher risks
Might generate more new businesses, casuing an auto-corection in the market
The demand and supply might cause smaller businesses to go bankrupt

12. Newly Industrialized Countries (NICs)
The term newly industrialized country ("NIC") is an economic classification used by
economists to represent economies that fall somewhere between a developed
country and a developing country. Countries falling under this categorization are
characterized by rapid export-driven economic growth and a secular migration of
workers from rural to urban areas.
Some examples of newly industrialized countries include China, India, and Brazil,
although definitions of so-called NICs vary between economists. The one thing most
people can agree on is that NICs tend to be attractive investment destinations given
their strong economic growth rates, which makes the term very important for
international investors.
Developing countries are often classified as those with a low living standard,
underdeveloped industrial base, and low Human Development Index (HDI) relative to
others. Newly industrialized countries share some of these characteristics, but are
decidedly moving in the direction of freer and stronger developed market countries,
much like many emerging markets.
Some common attributes seen in newly industrialized countries include increased
economic freedoms, increased personal liberties, transition from agriculture to
manufacturing, large national corporations present, strong foreign direct investment,
and rapid growth in urban centers resulting from a migration into cities from rural
areas. (About, c. 2014)

13. Issues facing NICs and LDCs
A good example for a NIC is India where one of the biggest issue out there is
industrial sickness. In the private industrial sector a growing number of industrial units
are becoming sick. Widespread sickness has, indeed, become a major problem of
this sector. The causal factors for this sickness are: (i) deficient management, (ii)
under-utilisation of capacity due to shortage of raw materials, coal and power and
transport, (iii) obsolete machinery, equipment and production techniques, (iv)
uneconomical scale of production, (v) faulty choice of products and processes, (vi)
difficulties in selling the products, (vii) diversion of funds to new units under same
ownership, and (viii) conflict between different interest groups among the owners. As
31

at the end of March 1999 there were 3, 09,013 sick/weak units (3, 06,221 in SSI and
2,792 in non-SSI sectors). A total of Rs. 19,464 crores of bank credit was locked up
in these sick units. Sometimes, the government takes over sick units which further
worsen the problem.
In order to provide a focal point for the revival of sick units, the Industrial
Reconstruction Corporation was reconstituted in 1985 as the Industrial
Reconstruction Bank. It is now the principal agency for reconstruction and
rehabilitation of sick units.
The Central Government set up in 1986 two Funds, the Textile Modernisation Fund
(TMF) and the Jute Modernisation Fund (JMF) to provide assistance on concessional
terms to healthy as well as sick units for modernisation. These two Funds are being
administered by the IDBI and the IFCI respectively. There is also a need for constant
monitoring and deterrent penalties to the parties responsible for sickness. (Preserve
Articles, c. 2012)
One of the biggest problems in less developed countries is the increasing levels of
pollution. Pollution of air, land and water is a major problem in most developing world
cities. The drive to industrialisation brings with it inevitable problems, especially as
legislation to protect the environment is often non-existent or rarely enforced.
Furthermore, the hidden economy can add to the levels of pollution as small,
unlicensed industries are set up in peoples homes or on rooftops. These industries
release their pollutants into the air, land and water. (S-cool, c. 2014)

14. Impact of TNCs on NICs
TNCs can provide developing countries with critical financial infrastructure for
economic and social development. However, these institutions may also bring with
them relaxed codes of ethical conduct that serve to exploit the neediness of
developing nations, rather than to provide the critical support necessary for
countrywide economic and social development.
When a TNC invests in a host country, the scale of the investment (given the size of
the firm) is likely to be significant. Indeed governments will often offer incentives to
firms in the form of grants, subsidies and tax breaks to attract investment into their
countries. This foreign direct investment (FDI) will have advantages and
disadvantages for the host country.
Advantages
The possible benefits of a TNC investing in a country may include:
Improving the balance of payments - inward investment will usually help a
country's balance of payments situation. The investment itself will be a direct
32

flow of capital into the country and the investment is also likely to result in
import substitution and export promotion. Export promotion comes due to the
TNC using their production facility as a basis for exporting, while import
substitution means that products previously imported may now be bought
domestically.
Providing employment - FDI will usually result in employment benefits for the
host country as most employees will be locally recruited. These benefits may
be relatively greater given that governments will usually try to attract firms to
areas where there is relatively high unemployment or a good labour supply.
Source of tax revenue - profits of TNCs will be subject to local taxes in most
cases, which will provide a valuable source of revenue for the domestic
government.
Technology transfer TNCs will bring with them technology and production
methods that are probably new to the host country and a lot can therefore be
learnt from these techniques. Workers will be trained to use the new
technology and production techniques and domestic firms will see the benefits
of the new technology. This process is known as technology transfer.
Increasing choice - if the TNC manufactures for domestic markets as well as
for export, then the local population will gain form a wider choice of goods and
services and at a price possibly lower than imported substitutes.
National reputation - the presence of one TNC may improve the reputation of
the host country and other large corporations may follow suite and locate as
well.
Disadvantages
The possible disadvantages of a TNC investing in a country may include:
Environmental impact TNCs will want to produce in ways that are as
efficient and as cheap as possible and this may not always be the best
environmental practice. They will often lobby governments hard to try to
ensure that they can benefit from regulations being as lax as possible and
given their economic importance to the host country, this lobbying will often be
quite effective.
Access to natural resources TNCs will sometimes invest in countries just
to get access to a plentiful supply of raw materials and host nations are often
more concerned about the short-term economic benefits than the long-term
costs to their country in terms of the depletion of natural resources.
33

Uncertainty TNCs firms are increasingly 'footloose'. This means that they
can move and change at very short notice and often will. This creates
uncertainty for the host country.
Increased competition - the impact the local industries can be severe,
because the presence of newly arrived TNCs increases the competition in the
economy and because multinationals should be able to produce at a lower
cost.
Crowding out - if overseas firms borrow in the domestic economy this may
reduce access to funds and increase interest rates.
Influence and political pressure - TNC investment can be very important to
a country and this will often give them a disproportionate influence over
government and other organisations in the host country. Given their economic
importance, governments will often agree to changes that may not be
beneficial for the long-term welfare of their people.
Transfer pricing - TNC will always aim to reduce their tax liability to a
minimum. One way of doing this is through transfer pricing. The aim of this is
to reduce their tax liability in countries with high tax rates and increase them in
the countries with low tax rates. They can do this by transferring components
and part-finished goods between their operations in different countries at
differing prices. Where the tax liability is high, they transfer the goods at a
relatively high price to make the costs appear higher. This is then recouped in
the lower tax country by transferring the goods at a relatively lower price. This
will reduce their overall tax bill.
Low-skilled employment - the jobs created in the local environment may be
low-skilled with the TNC employing expatriate workers for the more senior and
skilled roles.
Health and safety TNCs have been accused of cutting corners on health
and safety in countries where regulation and laws are not as rigorous.
Export of Profits - large TNCs are likely to repatriate profits back to their
'home country', leaving little financial benefits for the host country.
Cultural and social impact - large numbers of foreign businesses can dilute
local customs and traditional cultures. For example, the sociologist George
Ritzer coined the term McDonaldization to describe the process by which
more and more sectors of American society as well as of the rest of the world
take on the characteristics of a fast-food restaurant, such as increasing
standardisation and the movement away from traditional business
approaches. (Business organisation and environment, n.d.)

34

List of references
1. Britannica (c. 2014) Free trade [Online] available from
http://www.britannica.com/EBchecked/topic/218403/free-trade
2. Investopedia (c. 2014) Free trade [Online] available from
http://www.investopedia.com/terms/f/free-trade.asp
3. NSW HNC online (n.d.) Free trade and protection: advantages and
disadvantages of free trade [Online] available from
http://www.hsc.csu.edu.au/economics/global_economy/tut7/Tutorial7.html
4. Investopedia (c. 2014) Absolute advantage [Online] available from
http://www.investopedia.com/terms/a/absoluteadvantage.asp4
5. Investopedia (c. 2014) Comparative advantage [Online] available from
http://www.investopedia.com/terms/c/comparativeadvantage.asp
6. Investopedia (c. 2014) What Is International Trade [Online] available from
http://www.investopedia.com/articles/03/112503.asp
7. Investopedia (c. 2014) Protectionism [Online] available from
http://www.investopedia.com/terms/p/protectionism.asp
8. Library of economics and liberty (c. 1999-2010) Barriers to trade [Online]
available from
http://www.econlib.org/library/Topics/HighSchool/BarrierstoTrade.html
9. World Trade Organisation (c. 2014) [Online] available from
http://www.wto.org/english/thewto_e/whatis_e/10mis_e/10m02_e.htm
10. Office of the United States trade representatve Executive office of the
president (n.d.) North American Free Trade Agreement (NAFTA) [Online]
available from http://www.ustr.gov/trade-agreements/free-trade-
agreements/north-american-free-trade-agreement-nafta
11. Economics Help (c. 2014) UK Balance of Payments [Online] available from
http://www.economicshelp.org/blog/5776/trade/uk-balance-of-payments/
12. Blurtit (n.d.) The General Trends In UK Trade Over The Last 30 Years
[Online] available from http://society-politics.blurtit.com/208733/what-are-the-
general-trends-in-uk-trade-over-the-last-30-years
13. S-cool (c. 2014) The Exchange Rate and the Balance of Payments [Online]
available from http://www.s-cool.co.uk/a-level/economics/exchange-
rates/revise-it/the-exchange-rate-and-the-balance-of-payments
14. Bized (c. 1996-2012) Advantages and disadvantages of fixed exchange rates
[Online] available from
http://www.bized.co.uk/virtual/bank/economics/markets/foreign/further1.htm
15. Buoyant Economies (c. 2013) Impact of the Floating Exchange Rate System
on Employment and Growth [Online] available from
http://www.buoyanteconomies.com/Impact%20of%20floating%20exchange%2
0rate%20Growth.htm
16. About (c. 2014) What are Newly Industrialized Countries (NICs) [Online]
available from http://internationalinvest.about.com/od/gettingstarted/a/What-
Are-Newly-Industrialized-Countries-nics.htm
35

17. Preserve Articles (c. 2012) 12 important Industrial Problems faced in India
[Online] available from http://www.preservearticles.com/2012013022074/12-
important-industrial-problems-faced-in-india.html
18. S-cool (c. 2014) Problems and solutions: less developed countries [Online]
available from http://www.s-cool.co.uk/a-level/geography/urban-profiles/revise-
it/problems-and-solutions-less-developed-countries
19. Business organisation and environment (n.d.) Impact of multinational
companies on the host country [Online] available from
http://www.gregglee.biz/ftp/student/BusinessOrg/page_144.htm

Economics 2

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Economics 2

Uploaded by

Copyright:

Available Formats

13011413 Robert Alexandruuu Moray College

You might also like