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 • Disadvantages of floating
exchange rates exchange rates
– Value of the currency is – Can be difficult to predict
determined by market costs
forces – Currency may be affected
– There is no need for by volatile market
government / central bank conditions
intervention
 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