Module 5

276

Mod

The O

Introd

dule 5

Open E

uction

Outcomes

conom

Earlcloscentthe n

In thwherese

Theratesexchchanecon

Lasttheopoli

Upo

y

lier study mosed economytury, nationanotion of glo

his module, were surplus inerves.

n you will les systems. Ahange rates annels of monnomy.

tly, we will dories, the advcies which m

on completio

define th

explain

compare

explainexchang

distinguexchang

explainhence ag

outline topposed

compareand reva

odules have sy but most ecl economies

obalisation is

we will intron BOP will in

earn about exA governmentand hence agnetary policy

discuss aboutvantages of pmay favour fr

n of this mod

he concept o

the determin

e and contras

the importange rate system

uish the shortge rates.

how monetaggregate dem

the channels d to a closed

e and contrasaluation.

simplified economies are are becomin

s increasingly

oduce balancencrease a cou

xchange rate,t’s monetary

ggregate demy in an open e

t absolute anparticipating ree trade or p

dule you wil

f the exchan

nants of exch

st fixed and f

nce of foreignm.

t-run from th

ary policy infmand.

of monetaryeconomy.

st the exchan

conomic analnot closed. I

ng more closy accepted.

e of paymentuntry’s foreig

, its determiny policy will

mand. You wieconomy as o

nd comparatiin internationprotectionism

ll be able to:

ge rate.

hange rates.

flexible exch

n exchange r

he long-run d

fluences the e

y policy in an

nge-rate polic

lysis by assuIn the twentyely interrelat

t (BOP) accogn exchange

nants and excinfluence theill be introduopposed to a

ve advantagenal trade and

m.

hange rates s

reserves in a

determinants

exchange rat

n open econo

cies of deval

uming a y-first ted and

ounts e

change e

uced a closed

e d trade

ystems.

fixed

of the

tes and

omy as

luation

T

Over

erminology

rview

Abso

Curr

Currdefic

Exch

Mixe

Prevcloslinkand impwor

list policexpendit

understa

list and internat

distingu

name an

explain

extrapolnews ev

state arg

olute advanta

rent account:

rent account cit:

hange rate:

ed economy:

vious study msed economyked to the rest

services, andort goods an

rld financial m

cies that chature-switchin

and the expe

elaborate ontional trade.

uish between

nd define som

how gains fr

late differentents.

guments in fa

ge: A coumore a prod

The cutransaand setrade iinvest

The cuin surpservic

The raanothe

Certaiownerother owner

modules havey but most ect of the world finance. W

nd services frmarkets. In f

C5

nge expenditng policies.

nditure switc

n the reasons

absolute and

me alternativ

rom trade ar

t types of tra

favour and ag

untry has an aefficient than

duct.

urrent accouactions associervices. It incin merchandtment income

urrent accouplus when a

ces that it imp

ate at which er.

in sectors of rship and fresectors have rship and gov

e simplified onomies are d through tw

We export goorom abroad. Wfact, in the tw

Economic Env

tures, and co

ching policie

s for which c

d comparativ

ve trade theo

e shared by t

de policy fro

gainst free tr

absolute advn any other c

nt summarisiated with excludes four tyise, trade in e and transfe

nt of the balacountry expoports.

one currency

the economye market mesignificant g

vernment pla

economic anopen. Our lo

wo broad chaods and serviWe also borr

wenty-first ce

vironment of B

ontrast them

es.

countries eng

ve advantage

ries.

trading partn

om current ec

rade.

antage whencountry at pro

es all foreignxchange of gypes of transservices, flow

ers.

ance of paymorts more go

y is converte

y are left to pechanisms, wgovernment anning.

nalysis by asocal economnnels: trade ices abroad arow and lendentury, natio

Business

277

with

gage in

e.

ners.

conomic

n it is oducing

n goods sactions: w of

ments is oods and

d into

private while

suming a my is

in goods and we d in nal

Module 5

278

The ba

alance of

econglobincr

Theand perccentopenrelatand

f paymen

The the rCan

CA

Curre

Good

Curre

Capit

Capit

Finan

Capit

Statis

Chan

(Sou

Tab

nomies are bbalisation – treasingly acc

re are many importing).

centage of tht of its GDP n economy. Ctively little in15 per cent o

ts accou

balance of prest of the w

nada in 2001.

ANADA’S IN

ent Account

ds and Services A

Net Exports (Go

Exports

Imports

Net Exports (Se

Exports

Imports

Net Investment I

Receipts

Payments

Net Transfers

Receipts

Payments

ent Account Bal

tal and Financia

tal Account Net F

Inflow

Outflow

ncial Account Net

Canadian Liabilit

Canadian Assets

tal and Financia

stical Discrepan

nge in Official Re

urce: Statistics C

ble 5.1

becoming mothat we are mepted.

degrees of eA country weir GDP sucand its impoCompared tonternational of its GDP, t

nts

payments is aorld. Table 5.

NTERNATI2001 (MILL

Account

ods)

rvices)

Income

lance

al Account

Flow

t Flow

ties, Net Inflow

s, Net Outflow

al Account Balan

ncy

eserves

Canada: Nation

ore closely inmoving towar

engagement iwhose exports

h as Canada,orts over 40 po Canada, thetrade. With e

the U.S. is a

a record of th5.1 summari

IONAL BALLIONS OF D

414

350

56

64

34

62

7

5

6

83

-110,

nce

nal Account (Au

nterrelated anrds a single g

in internations and import, with its expper cent of itse United Statexports and irelatively clo

he transactioses the balan

LANCE OFDOLLARS)

64,

4,638

0,623

-8,

6,612

4,994

-27,

4,990

2,524

1,950

7,024

5,074

5,

6,482

-804

-26,

3,789

, 385

ugust, 2002))

nd the notionglobal econo

nal trade (expts constitute aports close tos GDP, are ctes engages iimports betwosed econom

n of a countrnce of payme

F PAYMENT)

015

382

534

3

678

596

-2

n of my – is

porting a large o 50 per called an in

ween 12 my.

ry with ents for

TS,

30,049

20,918

-9,131

-3,353

As ymajoaccogrouto thexpoassesign

Paymeconforegive

The

The exchof trwellinco

Tra

The expopeopequavalucurrsurpcurrdeficbookprocacco

Tra

The servmer

Serv

Servand domreprcounin foof fu

you can see ior accounts: ount. Moreovups: receipts he Canadian orts and infloets. Receipts n in the accou

ments naturanomy. They eign financialen a minus si

e current acc

current accohange of gooransactions: tl as in three iome and tran

ade in good

most signifiorts and impple of a counally broad raue of exportsrent account plus. In contrrent account cit. These trakkeeping priceeds from thount and will

ade in non-

three remainvices, investmrchandise tran

vices

vices includetelecommun

mestic firms sresents a servntries. Conveoreign countrunds to forei

in this table, the current a

ver, transactiand paymeneconomy, in

ows from forare consider

unts.

ally represeninclude outlal assets. Paymign (−) in the

count

ount summarods and servitrade in mercinvisible itemsfers.

ds (mercha

icant and obvorts of goods

ntry sell a broange of merch of visibles oshows a posirast, in yearsshows a negansactions arinciple. For ehe sale will bl appear with

-merchand

ning invisiblment income nsactions.

e tourism, tranication. Spesuch as whenvice export thersely, whenries is considign hands.

C5

the balance account as wions in these nts. The receincluding bothreigners whered positive,

nt monetary oays by Canadments are coe accounts.

rises all foreiices. The curchandise (in ms: trade in s

andise)

vious compos: visibles, asoad range of handise impooutweighs thitive mercha when impor

gative merchare structured example, if ybe treated as h a positive s

dise

e componentand transfer

ansportation ending by forn foreign touhat creates an

n we travel oudered a servi

Economic Env

of paymentswell as the cap

accounts areipts represenh foreign puren they buy Cso they appe

outflows fromdians for fore

onsidered neg

ign transactiorrent accountother words

services, flow

onents of the s they are kn

f merchandiseorts. In yearsat of importsndise balancrts of goods oandise balanon the basis

you sell a gooa receipt (cr

sign.

ts of the currrs are collect

(freight and reigners on srists travel inn inflow of futside our coce import tha

vironment of B

is made up pital and finae divided intont monetary irchases of CaCanadian finaear with a plu

m the Canadieign importsgative, so the

ons associatet includes fou, tangible go

w of investm

current acconown. Each ye exports ands when the ds of visibles, ce of trade oroutweigh exp

nce of trade o of the doublod abroad, thredit) in the c

rent account:ively known

shipping), inervices offern a country, funds from foountry, our spat causes an

Business

279

of two ancial o two inflows anadian ancial us (+)

ian s and ey are

ed with ur types

oods) as ment

ount are year, the d buy an ollar the

r a trade ports, the

or a trade le

he current

: trade in n as non-

nsurance red by

oreign pending outflow

Module 5

280

Net

Paymcateretuon bprofapplissuis trfigugoveor a betw

Tran

The fromcounthesgove

Cur

The receresuConthersurpof m

The

Tabcalleagen(Inteaccoinveitemis necapi

ThisinvogoveTheexpofundaccocom

investment

ments of incegory of the irns on assets

bonds), dividfits. The samlies here too.ed by the Uneated as a re

ure. Converseernment bonnegative fig

ween these tw

nsfers

final item, “m family memntry. When nse funds are cernment spen

rrent acco

current accoeipts in the coults in a neganversely, where is a positivplus. Accordimore than $30

e capital an

ble 5.1 showsed the capitancies aroundernational Mount and finaestment and p

ms such as inhew and for siital account.

s account sumolving Canadernment bonse transactioorted from hds (receipts),ount. Conver

mpany is view

income

ome on inveinvisible items (financial indends (return

me double boo. For instancnited States gceipt (credit)ely, paymentnd is treated agure. Net incowo items.

“transfers”, rmbers in onenew immigraconsidered annding on for

unt balanc

ount balance ountry’s curr

ative net balaen receipts ove net balancing to Table0 billion in y

nd financia

s another poral and financd the world ha

Monetary Funancial accounportfolio invheritances animplicity, we

mmarises thedian dollars. nd or holds baons are treateome to abroa, marked withrsely, a local wed as an imp

estment in asms in the currnstruments) on stocks) aokkeeping pre, for a Malagovernment, ) in Malaysiat to a Germanas a paymentome from as

refers to iteme country to fants to the con inflow to theign aid is co

ce

is the sum orent account

ance known an the currente, which is k

e 5.1, Canadayear 2002.

al account

rtion of the bcial account. ave followed

nd) to divide nt. The finan

vestment whind trade in ine will refer to

e foreign tranSuppose a foank deposits

ed as ownershad and therefh a positive sinvestor’s p

port of owne

sets constitutrent accountare in the for

and other formrinciple empaysian who hany interest

a’s current acn who owns t (debit) in thsets refers to

ms such as forfamily membountry bring he economyonsidered an

of the above iare lower th

as a current at account outknown as a ca enjoys a cu

t

balance-of-paRecently ma

d the lead of the capital a

ncial account le the capital

ntellectual pro these accou

nsactions of oreigner buy valued in Chip of financfore, are recosign, on the curchase of st

ership, so the

te this secon. These incomrm of interesms of return loyed for go

holds a bond earned on thccount, or a pa Malaysian

he current aco the differen

reign aid or abers in anothfunds with th. In contrast,

n outflow.

items. Whenan the paymaccount defictweigh paymurrent accou

urrent accoun

ayments stateany statisticathe IMF ccount into crecords dire

l account incroperty. Thisunts together

financial asss a domesticanadian doll

cial of assets orded as an icapital and ftocks in a fore transaction

nd mes or st (return

such as ods that was

hat bond positive

n counts,

nce

a gift her hem, ,

n the ments, this

cit. ments, unt nt surplus

ement al

capital ect cludes division r as the

sets

lars. being nflow of

financial reign is

Capitaal (financ

consthis

The currexisrecoaccopropassoflowportf

Port

Thisbondintercontthat bond

Dire

In cgivenum

ial) accou

WhecapiaccoTabover

The

The settlOffiTechaccoappesuchacco

Thecentor mcurrlend

sidered an ouaccount.

current accorently producsting assets isords direct inount includesperty. The mociated with tws are often rtfolio investm

tfolio invest

s refers to puds, when therest in the cotrol pertain tocompany, nds by foreign

ect investme

ontrast, direces rise to own

merous well-k

unt balan

en receipts oital account bount surplus;ble 5.1, Canar $20 billion

e official se

final item inlements accocial reserveshnically, offiount. Howevear as part ofh a case, theyount to illustr

se transactiotral authority

managing it frrent account d abroad or o

utflow, mark

ount transactced goods ans recorded in

nvestment ans items such

most significathe buying areferred to asment and dire

tment

urchase of finese investmenompany that o equity purcot its debt (bners automat

ent

ct investmennership and cknown exam

nce

on the countrybalance is po; the obverse

ada faces a co.

ettlements

n the balanceount, which rs are the govficial reservesver, in some cf the capital ay would be prate the balan

ons arise fromy for the purpfrom time to deficit, we m

our official re

C5

ked with a ne

tions discussend services. Tn the capital (d portfolio inas inheritanc

ant transactioand selling ofs financial inect investmen

nancial assetsnts do not coissued these chase into a cbonds). Theretically belong

nt refers to pucontrolling in

mples of direc

y’s capital acositive and it e is a capital ombined cap

s account

e of paymentrecords the chernment's hos should be lcountries, offand financia

put at the endncing role of

m foreign excpose of eithertime. In othe

must either boeserves must

Economic Env

egative sign (

ed above refTrade betwee(financial) acnvestment wces and tradens on the cap

f stocks and bnvestment annt.

s (of a componstitute own

assets. Notecompany, i.eefore, a purchgs to portfoli

urchase of finnterest of a cct investment

ccount exceeis referred toaccount defi

pital-financia

ts account is hange in offioldings of forlisted separatfficial settleml account un

d of the balanf official rese

change intervr keeping theer words, in oorrow more decrease to

vironment of B

(for payment

fer to trade inen countries iccount. This

while the capie in intellectupital accountbonds. Thesed can be div

any), stocks nership or coe that ownerse., shares (stohase of domio investmen

nancial assetcompany. Tht.

ed payments,o as a capita

ficit. Accordil account def

the official icial reservesreign currenctely, in this th

ment transactider the asset

nce of paymeerves.

ventions by te exchange rorder to pay from abroad cover the sh

Business

281

ts) from

n in account

ital ual t are e capital ided into

and ntrolling

ship and ocks) of estic

nt.

ts that here are

, the al ng to ficit of

s. cy. hird ions ts. In ents

the rate fixed for our

d than we hortfall.

Module 5

282

Bal

It shIndispendefia defromby thdefithe balsothe o

A lothe cfundis nebougpurclumpaccotran

In pstatiomiequarecomaystatiterm

Accbillido n

Cur

As dborrcounborrthat rest

ance of pa

hould be cleaividuals and nd more thancit by selling

eficit in its cum sales to thehe sale of ascit must be fbalance on th

o be zero sincofficial settle

Current + Offici

ogical impliccentral bank ds into the hoegative, this ght foreign rchase of thesp the capitalount would insactions.

ractice, anotistical discressions, the sual zero. Therords, or that ty be funds thistical discrep

m such that:

Current + Offici

cording to Taion, explain wnot add up to

rrent acco

discussed aborow from thentries tend torow more thaenjoys a curof the world

ayments b

ar that the ovfirms must p

n your incomg assets or neurrent accoune rest of the wsets or borro

financed by ahe third accoce the sum ofement balanc

t account balial settlement

cation, if the (monetary a

ome country means that t

reserves (a flse reserves). A and the offinclude not o

ther item statepancies. Becum of balancre may be mathe authoritieat enter or lepancies ente

t account balial settlement

able 5.1, theswhy the sum

o zero in year

unt, lendin

ove, a countre rest of the wo lend and boan it lends, brrent accountd than it borro

alance

verall balancepay for what

me, you wouldegotiating a lnt, spending world, the deowing abroadan offsetting ount (the offif the balancece, always eq

lance + Capit balance = 0

third accounauthority) has

from the salthe central baow of funds As indicatedcial balance nly the priva

tisticians neecause of dataces on all thrany transacties are unableeave the counr the balance

lance + Capit balance + S

se discrepancm of the curre

r 2001.

ng and bor

ry that has a world. Since orrow at the ecoming a nt surplus is aows.

e of paymentthey buy abrd be obliged loan. Similarmore abroad

eficit would nd. Therefore,

capital accoicial settlemees on all threequals zero: th

ital account 0

nt item is poss sold foreignle of these reank (monetarout of the ho

d above, it is together. Th

ate transactio

ed to be conca imperfectioree accounts ions for whice to directly mntry illegallye of payment

ital account Statistical di

cies, measureent and capita

rrowing

current accoat any point same time, aet borrower.

a net lender, l

ts must be zeroad. If you wto finance y

rly, if a cound than it receneed to be fin any current

ount inflow. Hent account) e accounts, ihat is:

balance

sitive, it meann reserves (a

eserves). If thry authority)ome country also customa

his way, the cons but also o

cerned about on and errorswill most lik

ch there are nmeasure, or t

y. Therefore, t account as a

balance iscrepancies

ed at more thal account ba

ount deficit hin time, man

a deficit coun. Similarly, alending more

ero. were to

your ntry runs ives nanced account

However, must ncluding

(1)

ns that a flow of his item has from the

ary to capital official

is s and kely not no there

a fourth

= 0 (2)

han $9 alances

has to ny ntry must a country e to the

Exchaange rates

s

Anyinvoforesombuy econget fforepeopsellicouncurrinter

The MonToroTokVananotexchof w

Aus

Brit

Can

EUR

Hon

Japa

Swe

Unit

(Sou

Tab

As icurrrate

y transaction olves tradingeign goods an

me of that coudomestically

nomy, they hforeign curre

eign exchangple: importering of foreignntry’s sector rencies such rnational cur

foreign exchnday morninonto and New

kyo, Bahrain,ncouver. Thether is calledhange. Table

world currenc

E

Count

stralia

tain

nada

RO

ng Kong

an

eden

ted States

urce: The Econo

ble 5.2

indicated in Trency. Furthees of exchang

1. the numof dome

that appearsg domestic cund services ountry’s curreny produced ghave to obtainency and fore

ge market. Thrs and exportn exchange cof this markas the U.S. drrencies.

hange markeng in Hong Kw York. As t, Frankfurt, L price at whi

d the foreign e 5.2 shows tcies and the U

Exchange R

ry

omist, August 2

Table 5.2, thermore, nomige between c

mber of units estic currency

C5

s in the balanurrency for anor invest in anncy to make goods and sen some of theigners get ohe global maters, banks acalled foreignket, domesticdollar, Japane

et operates onKong, which i

the day advaLondon, Newich one currerate of exchathe exchangeU.S. dollar ($

Rates for 28/0

per US

1.81

0.65

1.55

1.02

7.8

118.16

9.28

-

28, 2002)

here are manyinal exchangurrencies, ar

of foreign cuy, or

Economic Env

nce-of-paymenother currennother countthe transacti

ervices or invhe home counour domestic rket is made nd specialistn exchange b

c currency is ese yen, Euro

n a daily basis still Sunda

ances, marketw York, Monency can be eange, or simpe rate betwee$).

08/02

$ pe

1.16

0.42

-

0.65

5.02

76.07

5.97

0.64

y exchange rge rates or altre quoted in t

urrency you c

vironment of B

ents accountsncy. When wtry, we have ion. When fovest in their dntry’s currencurrency in up of thousats in the buyibrokers. In thexchanged fopean euro a

is. It opens oay evening ints open in Si

ntreal, Torontexchanged foply the rate

en a selected

er C$

rates for a ceternatively, mtwo ways:

can get for o

Business

283

s we buy to obtain

oreigners domestic ncy. We

the ands of ing and he home for major and other

on n ingapore, to and or of number

ertain market

one unit

Module 5

284

Foreig

gn exchan

In ACanUS$dollunitthe sof dCan

Exc

Excminnomapprforeof thdomexch

Simof thcorrmarTheof th

nge mark

Simnon-by dsuppdomexchpric

Dem

The relatdemcurrtradHowalso

2. the numof foreig

August 2002,nadian dollar $0.64 for onear. In this uns of domestisecond way –

domestic currnada, E, in ter

change rat

hange rates aute during th

minal deprecireciation of

eign currencyhe exchange

mestic currenhange rate, E

milarly, a deprhe foreign curesponds to arkets to quoterefore, apprehe U.S. dolla

ket

milar to any ot-financial) cademand and sply and dema

mestic currenhange rate me of foreign

mand for f

demand for tionship betw

manded in excrency demanders plan to bwever, the exo determined

Domesti

Domesti

mber of units gn currency.

for example(C$) and the

e Canadian dnit, we definec currency y– or equivalerency. This rrms of U.S. d

te determin

among foreighe day. Theseiations, apprethe domestic

y in terms of rate as the pcy, an apprec

E.

reciation of turrency in teran increase ine the value oeciations andar.

ther market, an be characsupply of forand for the focy (Canadian

measured on texchange.

foreign cur

foreign currween the pricchange for oded in the fouy during a g

xchange rate by others in

ic and foreig

ic and foreig

of domestic

e, the nominae U.S. dollar

dollar, or, eque the nomina

you can get foently, as the ate will be ddollars, is eq

nation

gn currenciese changes areciations or dc currency is the domestic

price of the fociation corre

the domesticrms of a domn E. It is custf every curre

d depreciation

the foreign eterised by dereign currenc

foreign currenn dollars) in the vertical a

rrency (exc

rency, in termce of the foreur own curre

oreign exchangiven time pis only one f

ncluding:

gn interest rat

gn income.

currency you

al exchange rr (US$) was quivalently, Cal exchange ror one unit oprice of fore

denoted by E.qual to 1.55 (

s change evee called nomdepreciationa decrease i

c currency. Goreign currenesponds to a d

c currency is mestic currentomary in foency in termsns tend to be

exchange maemand and sucy. Figure 5ncy (U.S. dothe exchang

axis as the do

change)

ms of domesteign currencyency. The qunge market i

period at a givfactor. The q

tes.

u can get for

rate betweenquoted as eit

C$ 1.55 for onrate as the nuof foreign cureign currency. Accordingl(and not 0.64

ery day, indeminal appreci

s for short. Ain the price oGiven our dency in terms decrease in t

an increase ncy, and thus

reign exchans of the U.S. e expressed in

arket (financupply – in th.1 illustrates

ollars) in terme market wit

omestic curre

tic currency, y and its qua

uantity of a fos the amountven exchang

quantity dema

r one unit

n the ther ne US umber of rrency – y in terms y, for

4).

eed every iations or An of the efinition of the

the price

nge dollar. n terms

ial or his case

the ms of th the ency

is a antity oreign t that

ge rate. anded is

As icurrFigucurr

For let unothin thdemfactodemprim

Nevanyt

For the lU.ScurrlocaprofCan

For exchand dem

Figuexch

Figu

Domesti

The exp

is customaryrency. This reure 5.1. As erency and the

example, if tus say Canadhing else chahe foreign ex

mand curve’s ors behind th

mand for its umarily becaus

1. America

2. Americabusiness

vertheless, ththing else tha

example, whlocal currenc.-made good

rency also affal currency, ofit from buyinadian dollars

the two reashange rate riwhen the ex

manded increa

ure 5.1 showhange marke

ure 5.1

ic and foreig

pected future

, we will choelationship cexpected, thee quantity of

the price of tdian dollar, franged, the quxchange mark

downward shis curve. Thunderlying else of their de

an goods and

an financial ases and real e

e law of demat people val

hen the pricecy), there is ads and serviceffects the demother things rng Americans demanded.

ons we haveses, the quan

xchange rate ases.

ws the demanet.

C5

gn inflation ra

exchange ra

oose the U.Scan be exprese relationshipf it demanded

the U.S. dollrom C$1.55,

uantity of U.Sket would deslope can be he demand foements. Peop

emand for:

d services (A

assets such aestate.

mand applies lue.

e of the U.S.an import effes more chea

mand for Amremaining thn dollars and

e just reviewentity of the Ufalls, the qua

nd curve for U

Economic Env

ates.

ate.

. dollar ($) assed in as a cp between thed is an invers

lar rose againper one (US

S. dollars thaecrease. The understood b

or a currencyple demand t

American exp

as bank accou

to dollars ju

dollar ($) drfect: foreigneaply. Apprec

merican assetshe same, the ld the greater t

ed, ceteris paU.S. dollars dantity of the

U.S. dollars

vironment of B

as the foreigncurve as showe price of these one.

nst the local cS) $ to C$1.6at people planreason for thby considerin

y is derived frthe U.S. doll

ports) and

unts, bonds,

ust as it does

ops (appreciers can purchciation of thes. The stronglarger the exthe quantity

aribus, whendemanded deU.S. dollars

in the foreig

Business

285

n wn in e foreign

currency, 60, but n to buy he ng the

from the lar

stocks,

to

ation of hase e local ger the pected of

n the creases

n

Module 5

286

AccC$)dow

Cha

As iinfluforeexchthesthe i

Inte

Peopthe iforewe smattrate howthenthe fconsforethe igap attrademdolldem

Inco

Whebecoof thgreawhiccomdiffeincoSimdomsmaprosfor fcurv

Infla

Wheexam

cording to Fig, the greater

wnward-point

anges in th

indicated abouence the demeign interest rhange rate case factors cauimpact of the

erest rates

ple and busininterest rate t

eign assets, thshould be carters in decidi(i) is high or

w it comparesn is: ‘What isforeign interstant, the inte

eign interest rinterest rate (differential

active domesmand for fore

ars in the formand curve sh

omes

en an economome more atthe economy,ater the demach asset to bu

mparison witherential (Y −ome remains

milarly, if foremestic economaller this incospects from iforeign curreve shifts to th

ation rates

en prices chample, domes

gure 5.1, thethe demand ting arrow.

he demand

ove, there aremand for a frates, domesause a movemuse the demaese factors in

nesses buy fithat people che more domreful not to ving which asr low, or whes with the fors the interest rest rate riseserest rate difrate stays condifferential (l), the more astic assets beign assets anreign exchanhifts to the ri

my grows, itstractive in th the greater t

and for foreiguy is how fah the foreign Y*). For exaflat (no grow

eign income my shrinks (rome gap (diffinvesting in fency, and viche right.

ange, they tenstic prices ris

e lower the rafor the foreig

d for dolla

e other factorforeign currentic and foreig

ment along thand for the cun detail.

inancial assecan make on

mestic assets tview each intsset to buy isether in fact reign interestrates differe

s and the domfferential (i −nstant while (i – i*) decreattractive forecome. The snd thereby, thnge market. Iight.

s GDP increahat environmthe inflow ofgn currency.

ast the domeseconomy (Ymple, if forewth), the incostays constarecession), thferential), theforeign econce versa. In te

nd to affect ese at a faster

ate of exchangn currency,

rs

rs besides thncy, includingn income. Whe demand currency to sh

ets to make adomestic asthey buy. In terest rate in not whetherin has risen t rate (i*). Thential (i − i*)mestic interes− i*) decrease

the domesticases. The smeign assets amaller the gahe greater theIn terms of F

ases and invement. The fast

f investment Again, what

stic economyY*). This relaeign income rome differennt (no growthe differentiae more attracomy and theerms of Figu

exports and irate than for

nge (apprecia, as shown fr

he exchange rng domestic While changeurve, change

hift. We shall

return. The sets compareanalysing thisolation. W

r domestic inor fallen, buthe critical qu)?’ For examst rate remaines. Similarlyc interest rat

maller this intare and the leap, the greatee demand for

Figure 5.1, th

estment proster the (real) and hence tht matters in d

y (Y) expandsates to the incrises and domntial decreaseth) while the al decreases.ctive are the greater the d

ure 5.1, the d

imports. If, freign prices (

ation of rom the

rate that and es in the es in l examine

higher ed to his issue,

What nterest t rather,

uestion mple, if

ns y, if the e falls, terest ess er the r foreign

he

spects growth

he deciding s in come mestic es.

The

demand demand

for (there is a

highprodther(Amdemmattinflait coinfla

Exc

Otheratewhyare eLet C$1preddollmak

The the sU.Sdoll

In sucurrto D

Sup

The relatsuppcurrtradHowalso

her domestic ducts becomerefore, buy a merican) prodmanded. (The

ters in decidiation rate is hompares withation rates di

change rate e

er things rem, the greater

y, suppose yoexpecting theus assume th.55 and you

diction turns ars, at the en

king a gain o

higher the esame, the gre. dollars. Agar shifts to th

ummary, therency (U.S. dD$2 in Figure

An incredifferen

An increincome

An incredifferen

A rise in

pply of for

supply of thtionship betwplied in exchrency supplieders plan to sewever, the exo determined

Domesti

Domesti

inflation rate more expenlesser quant

ducts, increasere is a rightwing which prhigh or low, h the foreign ifferential?’

expectation

maining the sthe demand

ou, a Canadiae U.S. dollarhat you buy tare expectinout correct,

nd of the weef C$0.05 for

expected futueater the exp

gain, in termshe right.

e following edollars) and se 5.1, and vic

ease in the fotial).

ease in the grgrowth diffe

ease in dometial).

n the expecte

reign curre

he foreign cuween the prichange for oured in the foreell during a g

xchange rate by other fac

ic and foreig

ic and foreig

C5

te relative to nsive than foity of domessing the amoward shift in roducts to buor whether iinflation rat

s

same, the higfor a foreignan, are plannr to gain valuthe U.S. dollng the exchanyou will sell

ek to obtain Cr every U.S. d

ure exchangepected profit,s of Figure 5

events increashifts the demce versa:

oreign intere

rowth of foreerential).

estic inflation

ed future exc

ency (exch

urrency, in terce of the forer own curreneign exchanggiven time peis only one f

ctors includin

gn interest rat

gn income.

Economic Env

the foreign roreign producstic products ount of foreigthe demand

uy is not whein it rises or fte. In other w

gher the expen currency (Uning to buy Uue in the nearars at today’nge rate to ril your U.S. dC$1.60 per edollar initiall

e rate with ot, the greater i5.1, the dema

se the demanmand curve r

st rate (a dec

eign econom

n rate (an inc

change rate.

hange)

rms of domeeign currency

ncy. The quange market is teriod at a givfactor. The qng:

tes.

vironment of B

rate), a countcts. Citizens and more fo

gn currency curve.) Agai

ether domestifalls, but rath

words, ‘What

ected future eU.S. dollars).US dollars sinr future (say,s rate of excse to C$1.60

dollars for Caeach U.S. dolly purchased

her things reis the demanand for the U

nd for the forrightward fro

crease in inte

my (a decreas

crease in infl

estic currencyy and its quantity of a forethe amount tven exchangequantity dema

Business

287

try’s will,

oreign

in, what ic her how is the

exchange To see nce you , a week). hange of

0. If your anadian llar,

d.

emains nd for the U.S.

reign om D$1

erest

e in

lation

y, is a antity eign that e rate. anded is

Module 5

288

Agarelatrelata po

PeopotheexchCanof Ugoodexchrisesto an

Figu

The greaFor but nsell suppthat domelemcurr

For the CAmeC$ adollfrom

Domesti

The exp

ain, choosingtionship can tionship betw

ositive one.

ple supply Uer currencieshange for Ca

nadian goods U.S. dollars rds, services ahange for Cas as its price nything else

ure 5.2

higher the eater the quanexample, if tnothing else in the foreig

ply curve’s uthe supply o

mestic currenments. Peoplerency primar

1. domesti

2. domesti

example, whCanadian doericans to pualso affects tar with other

m buying Can

ic and foreig

pected future

g the U.S. dobe expressed

ween the pric

U.S. dollars in. The reason

anadian dollaand servicesises, it will band assets an

anada dollarsdoes. The lathat people p

exchange ratetity of dollarthe price of tchanges, the

gn exchange mupward slopeof foreign curcy, which itse supply the ily because o

c goods and

c assets.

hen the priceollars), the expurchase Canathe demand fr things remanadian dollar

gn inflation ra

exchange ra

llar as the fod as a curve ce of the curr

n the foreign for this is th

ars to finances or Canadianbe cheaper fond hence to ss. Therefore, aw of supply plan to sell.

e, with all elsrs supplied inthe U.S. dolle quantity of market will i

e can be underrency is derself is deriveU.S. dollar i

of their dema

services (do

e of the U.S.xport effect oadian goods afor Canadianaining the sars. Therefore

ates.

ate.

oreign currenin Figure 5.rency and its

n exchange mhat U.S. dollae foreign purn financial a

or Americanssupply more the supply oapplies to do

se remainingn the foreignlar rises fromf U.S. dollarsincrease. Theerstood if yorived from thd from demain exchange and for:

omestic expor

dollar increaccurs: it willand services.

n assets. The me, the large

e, as the Can

ncy, the suppl2. As expect

s quantity sup

market when ars are supplrchases of eitassets. When s to buy CanU.S. dollars

of the U.S. doollars just as

g the same, thn exchange mm C$1.55 to Cs that people e reason for u consider th

he demand foand for is undfor domestic

rts), and

ases (deprecil be cheaper . Depreciatioweaker the Cer the expectadian dollar

ly ted, the pplied is

they buy ied in ther the price adian in

ollar s it does

he market. C$1.60, plan to the he fact or derlying

c

iation of for

on of the Canadian ted profit

deprsupp

Cha

As iinfluinterexchchannow

Inte

RecdifferemIn thassecauscurrleft.

Inco

Anoof thi.e., domdominvecurrcurrleft.

Infla

At a(the foredomin thforecurvdomrate

Exc

Simremeconsmasupp

reciates, the ply of U.S. d

anges in th

indicated abouence the suprest rates, dohange rate canges in these

w look at the

erest rates

all that one oerential. If thains constanhis case, domets, causing thses the demarency) to fall

omes

other factor thhe domestic income diffe

mestic econommestic assets estment opporency, whichrency situatio

ation rates

any given rat U.S. dollar)

eign (Americmestic produche demand foeign currencyve. Again, wh

mestic inflatioes differentia

change rate e

milarly, the hiaining the sanomy) and thaller is the suply curve shi

demand for dollars that ne

he supply

ove, there arepply of a for

omestic and fause a moveme factors causimpact of the

of the determhe foreign intnt, the domesmestic assets he demand f

and for dome. In terms of

hat determineconomy (Y)erential (Y − my becomes dwindles. Th

ortunities to f is equal to t

on. In terms o

te of exchang), increases inan) products

cts, reducing or our curreny (U.S. dollarhat matters ion comparesl.

expectation

igher the expame, the smahe smaller is

upply of U.S.ifts to the lef

C5

domestic cureeds to be ex

of dollars

e other factoreign currencforeign incomment along thse the demanese factors.

minants of invterest rate ristic interest raare relatively

for domestic estic currencyf Figure 5.3,

nes which assY) in comparis

Y*). If the drelatively le

his causes thfall as well athe supply ofof Figure 5.3

ge between dn the price ofs means that

their demanncy corresponr), shown as n deciding w with the for

s

pected future aller the expe

the demand dollars). Ag

ft.

Economic Env

rrency rises axchanged for

rs, besides thcy including dme and etc. Whe demand c

nd for the cur

vestment flowses and the date differentiy less attractassets to dro

y (or the suppthe supply c

sets to buy isson with fore

differential deess attractive e demand fo

as the demandf the foreign 3, the supply

domestic andf domestic pAmericans w

nd for domestnds to a fall ia leftward sh

which producreign inflatio

exchange raected profit (

for domesticgain, in terms

vironment of B

as also does r it.

he exchange domestic andWhile changecurve, Figurerrency to shif

w is the interdomestic inteial (i – i*) detive than foreop. This, in tuply of foreigcurve shifts t

s the relative eign income ecreases, theand the dem

or domestic d for domestcurrency in t

y curve shifts

d the foreign roducts relat

will purchasetic currency.in the supplyhift in the sucts to buy is hn rate: the inf

ate, other thinin domestic c currency (os of Figure 5

Business

289

the

rate, that d foreign es in the e 5.2, ft. Let us

rest rate erest rate ecreases. eign urn,

gn o the

growth (Y*),

e mand for

tic this two-s to the

currency tive to e fewer . This fall y of the upply how nflation

ngs

or the 5.2, the

Module 5

290

In cin tha risdomsupparroreve

Mar

Recthe mexceallowwillquancurrthe erefe

The 5.3.

Figu

Forea woand plan

As dthis surplowthe esurpshor

Whaand equi

onclusion, a he growth of se in the expe

mestic currenply curve to

ow in Figure ersed.

rket equilibri

all that in comarket to aneption. Figurws the value move towarntity demandrency. Such aexchange ratrred to as a f

demand cur

ure 5.3

eign exchangorldwide comthe price adj

ns in balance

discussed earcase) acts as

plus (excess o, there is a shexchange ratplus of U.S. drtage of U.S.

at happens isnot enough b

ilibrium poin

drop in the if the domestiected future cy (decreaseshift leftward5.2. The opp

ium

ompetitive mn equilibriumre 5.3 shows

e of its currenrds equilibriuded and therea system of ete to be deterflexible (or fl

rve is shown

ge markets armputer netwojusts second . Foreign exc

rlier, in effics a regulator.of supply) ofhortage (excte C$1.70, indollars, wher dollars.

s that when abuyers – the nt, C$1.60. C

interest rate dc economy; exchange rat

es the supply d from S$1 toposite will h

arkets, the fom point. Foreis such a situancy to vary (fum where thee is neither aexchange ratermined by thfloating) exch

by D$ and th

round the woork. Informaby second tochange mark

ient markets. If the exchaf a currency.ess demand)

n Figure 5.3,reas, at the ra

a surplus siturate is press

Conversely, w

differential; a rise in the te; decreasesof U.S. doll

o S$2. This is appen if the

orces of demign exchangeation. When tfluctuate), me quantity su shortage noes where the

he foreign exchange rate sy

he supply cur

orld are brouation flows fro keep buyinkets are indee

s the price (thange rate is to When the ex

) of a currenc, (C$1.70 perate of exchan

uation is facesured down towhen there is

a relative sloinflation diff

s the demandars); causes tshown alongscenarios are

mand and suppe markets arethe governm

markets for cuupplied equalr a surplus o central bankchange markystem.

rve by S$ in F

ught togetherrom dealer tong plans and ed very effic

he exchange oo high, therxchange ratecy. For examr US$1), thernge C$1.50, t

d – too manyowards the s a shortage o

ow-down ferential; d for the the g the e

ply bring e no

ment urrencies ls the f a k allows ket is

Figure

r through o dealer selling ient.

rate in re is a e is too

mple, at re is a there is a

y sellers

of the

currthe a

Cha

As wdemfacto

Supits laexpehas proddemprodof Uhencwillin su

Figu

Starexchbillishiftfromexchdoll

The volachanthe fto pu

rency – too marrows show

anges in e

we have seenmand and sup

ors.

pose again thargest trade periences a lotwo effects o

ducts less expmand for U.S.ducts in favo

U.S. dollars sce they incre increase theupply of U.S

ure 5.4

rting from anhange rate E1

ion), the lowft leftward from S$1 to S$2. Ahange rate faars and the v

question thaatile behaviounge. The ansforeign curreush demand

many buyers wn in this figu

exchange r

n, several facpply curves. L

hat the homepartner, is thwer inflationon the foreigpensive com. dollars – Ca

our of Canadiince Americ

ease their demeir demand foS. dollars.

n initial equil1 (1.60) and er inflation rom D$1 to D$

As a result ofalls to E2 (1.4volume of tra

at arises is wur, given thawer is that, a

ency are influand supply i

C5

and enough ure.

rates

ctors can cauLet us exami

e country is Che U.S. Now n rate than thgn exchange mmpared to the

anadians buyian products

cans find Canmand for Canor Canadian

librium pointquantity of thrate in Canad$2 and the supf these dema45), depictingansactions fa

why the exchaat the volumeas we saw eauenced by thin opposite d

Economic Env

sellers – the

use a shift in ine the impac

Canada and tsuppose that

he U.S. As exmarket. By mU.S. produc

y a lesser vol– and (b) it i

nadian produnadian produdollars, whic

t, point A, cohe U.S. dolla

da causes thepply curve toand-and-suppg an apprecia

alls to 44 bill

ange rate some of dollars trarlier, the demhe same set odirections.

vironment of B

rate is bid u

the foreign ect of some of

the foreign et Canadian explored earliemaking domects, (a) it redulume of Ameincreases the

ucts more attructs. As a resch means an

orrespondingar transactede demand curo shift rightwply changes, ation of Canaion, point B.

metimes exhiraded may bmand and supof variables th

Business

291

up, along

exchange f these

conomy, conomy er, this estic uces the erican e supply ractive sult, this increase

to the d ($50 rve to ward

the adian

ibits arely pply of hat tend

Module 5

292

Rea

The chan(Canhowtheirper increxpobut compric

ConMacStatthis rate C$1follo

Heredenoof U

TheC$3Mac

ThisMac

But to cogoodcomMac

TheU.SUS$

al exchange

previous secnges in the renadians) tour

w many U.S.r dollar will Canadian do

reased propororting to Canalso the pric

mpete. This lee of Canadia

nsider the casc bought in thtes and in Caprice in US$of exchange.60), so the p

ows:

PUSUS ×

US$2.30

e the superscotes the curre

US and C den

refore, the C3.68. The secc (ratio of the

Real exc

q = C$3

s equation tec costs 27 pe

since the Unonstruct a reds produced

mbined pricesc.

refore, if Pca

. respectively$ (C$/US), th

q = E ×

rates

ction, as illuselative price rists thinkingdollars they be able to bu

ollars if the Urtionately. Innada needs toe in C$ of Ceads us to thean goods in t

se of a McDohe U.S. In 20

anada, it costs$ to a price ine, which is asprice of a Bi

E = PCUS

0 × 1.60 = C

cript denotesency in whicnote the U.S.

Canadian dollcond step woe price of the

change rate =

.68/C$2.90 =

lls us that, mr cent more t

nited States aal exchange in the two c

s index instea

an and Pus arey, and if E ishen

Pus / Pcan

strated by Fiof the two c

g of visiting tcan get for 1

uy. It does thU.S. dollar prn the same wo know not oanadian prode constructioerms of Ame

onald’s Big M002, a Big Ms C$2.90. Thn C$. In ordessumed to beg Mac in Ca

$3.68.

the country ch the price i and Canada

lar price of auld be to come Big Mac) in

= q = PCUS/P

= 1.269.

measured in athan the Can

and Canada prate that reflountries. In oad of an indi

e, say, the GDs the nominal

igure 5.4, telurrencies. Hthe U.S., the

1 C$, but alsohem little goorices of good

way, an Ameronly the nomducts with won of real excerican goods

Mac bought Mac costs UShe first step wer to do this, e E = 1.60 (a anadian dolla

of origin ands measured,

a, respectivel

a U.S. Big Mmpute the reln the two cou

CC

a common cunadian Big M

produce morlects the relatorder to do thvidual price,

DP deflator fl exchange ra

lls us only abowever, to d

e question is no how many od to get mords in the U.S.rican firm thi

minal exchanghich it will hchange ratess.

in Canada an$2.30 in the

would be to cwe need theUS$ is wort

ars is calculat

d the subscriwhere the su

ly.

Mac in 2002 elative price ountries:

urrency, the UMac.

re Big Macs, tive price of his, we must, such as that

for Canada anate between

bout domestic not only goods

re US$ . have inking of ge rate have to s, the

nd a Big United

convert e current th ted as

ipts ubscripts

equals of a Big

(3)

U.S. Big

we need f all the t use a t of a Big

nd the C$ and

(4)

S

Study skills

wheAmegood

An igooddeprnowrelatas thPcan)rate

1.

2.

Solu

Exc

UndexchFigusupp

FlexelimeachDrambusi

ere multiplyinerican goodsds in C$ is P

increase in thds is called areciation. Th

w referring totive price of he price of fo), a real appr. Similarly, a

Which of thedomestic cur

A. Red

B. Incr

C. Red

D. Incr

Use the folloyear 2001 andepreciated?

Year

2001

2002

utions:

1. B. The rthe foreign vOnly a rise i

2. q (2001)1.75. Since q

change rate r

der a flexiblehange rate toure 5.4, we eply and, ther

xible exchangminate shortah other. Howmatic changeinesses invol

ng Pus by thes in CanadianPcan.

he relative pra real appreche word realo changes in t

currencies. Goreign goodsreciation corra real deprec

e following errency?

duction in E

rease in E

duction in P*

rease in P

owing informnd year 2002?

E P

1.6 1.2

1.55 1.5

real exchangvariable. Reain E can do t

) = 1.6 x 1.5/q has fallen,

regimes

(or floating)o be determinexamined theefore, the ex

ge rates offerges or surplu

wever, flexibles in exchanlved in impor

C5

e exchange ran dollars, E ×

rice of domeciation; a dec, as opposed the relative pGiven our des in terms of responds to aiation corres

events would

(foreign pric

mation to cal2. Has the rea

P*

1.5

1.7

e rate is defial depreciatiohis amongst

/ 1.2 = 2, andthe real exch

) exchange rned by the foe factors that

xchange rate.

r one main auses so that ile rates also hge rates mearting or expo

Economic Env

ate, E, gives × Pus, and the

estic goods increase is callto nominal,

price of goodefinition of thdomestic goa decrease insponds to an

d cause a rea

ce)

culate the real exchange r

ned as E x Pon requires ththese choice

d q in (2002)hange rate ha

rate, the centoreign exchant influence th

advantage: mnflows and ohave an impo

an consideraborting.

vironment of B

us the price e price of Ca

n terms of foled a real indicates tha

ds rather thanhe real exchaods, (q = E ×n the real excincrease in q

al depreciatio

al exchange rate apprecia

P*/P, where *hat this ratio es.

) = 1.55 x 1.7as appreciate

tral bank allonge market. Ihe demand an

market forcesoutflows sooortant disadvble risks for

Business

293

of anadian

reign

at we are n in the ange rate × Pus/ change q.

on of the

rate in ated or

* denotes rise.

7/ 1.5 = ed.

ows the In nd

quickly n match

vantage.

Module 5

294

Condompushdomexpoexamdollmarquanemp

To aofteratestancurrdemrefethat foreThuU.Scurr

In ccountakecurrsuppheldsettlcasecountake(U.Ssituacentacco

Figuexchexchfore

nsider, for exmestic currenhed up to the

mestic consumorters and thmple, our curar. The expo

rket finds thantity demandployment in t

avoid the uncn intervene d

es offer the mnd ready to burency) at a fix

mand arising frred to as exthe rate stay

eign exchangus, central ban. dollars – an

rencies for th

ase of an excnterpart of anes the form orency (U.S. dply situation d by the centrlement accoue of an excesnterpart of anes the form oS. dollars) ination has trantral bank, whount – a defic

ure 5.5 illusthange rate if hange, the ceeign currency

xample, a loccy depreciate

e point that thmers and quaeir suppliersrrency jumps

orter who expat they becomded decreasethe import an

certainty caudirectly in fo

most striking uy and sell thxed exchangfrom private

xchange markys fixed, it is ge that can benks hold resend gold that che purpose of

cess supply on excess demf the domest

dollars) in exhas translate

ral bank, whunt – a surplus demand fon excess suppf the domest

n exchange fonslated into ahich appears cit in the bal

trates the casf fixed belowentral bank hy for domesti

al importer oes suddenly,he products bantity deman face similars up in valueports domest

me too expens. Because ond export ind

used by flexiboreign exchanoption. In a heir currency

ge rate to make transactionsket interventiobviously n

e sold in excherves of majcan be sold ff exchange m

of the foreignmand for domtic central ba

xchange for ited into an incich appears aus in the balar the foreignply of dometic central baor its own cua decrease inas a positiveance of paym

se of a deficiw the equilibrhas to meet thic currency, C

of American- the price of become too e

nded decreaser uncertaintye in relation ttic products tnsive for the Aof these fluctudustries are h

ble exchangenge markets.fixed rate syy (in exchangke up for anys. Such purchion. In order ecessary to hhange for door (vehicle) cfor U.S. dollamarket interv

n currency (wmestic currenank’s purchasts own currecrease in the as a negativeance of paymn currency (wstic currency

ank’s selling urrency. The n the official e entry in thements.

t. This occurrium level, Ehe excess demCanadian do

-made produf the productsexpensive foes. Domestic. Suppose, foto the Amerito the AmeriAmerican muations, inco

harmed.

e rates, gover. Fixed excha

ystem, centrage for foreigny excess supphases and salr to be able tohold an invenmestic currecurrencies – ars and other

vention.

which is the ncy), the intersing the forency. The exc official rese

e entry in thements. Convewhich is the y), the intervethe foreign cexcess demareserves hel

e official settl

rs where the 0. At this ratemand by exc

ollars in this c

ucts. If s is r

c or can can arket and

omes and

rnments ange al banks n ply or les are o ensure ntory of ency.

mostly r

rvention ign cess erves e official ersely, in

ention currency and d by the lement

e of changing case.

Figu

As sfixeincrfromU.Scurrrighinter

The its sdefiof reeithemardevemorloca

ReaDevincrthe dExctheirdolldevadecr

Undcleaand officpracfloafloathus

ure 5.5

shown in Figd rate of exc

rease in the em happening,. dollars out

rency, C$. Thhtward. Note,rvention has

ability of a ctock of foreicit in its balaeserves and wer a realignm

rket value, orelopments sure recently inal currency w

lignment of valuation referease in E), vdollar is the hange Standr gold contenar and ultimaaluation. It rerease in E).

der flexible ean floating, c

thus allow ecial settlemectice, howeveting hut rathting, central

s attempting

gure 5.5, therchange (Qd$ –xchange rate, the Central of its inventhis interventi, however, thto continue.

country to mign exchangeance of paymwill be unabl

ment of the fir a serious cuuch as the finn Asia, Southwas accompan

the fixed excers to an offi

vis-à-vis anotworld’s mos

dard (1944–1nt and as sucately againstefers to an in

exchange rateentral banks

exchange ratent account der, the flexiber than manabanks intervto influence

C5

re is an exce– Qs$) whiche towards its Bank of Canories of reserion causes thhis is an ongo

maintain the ve reserves. If

ments, the cenle to continuixed value ofurrency crisisnancial crisish America annied by a cur

change rate ticial decreasether currencyst widely use973), curren

ch, a devaluat gold. Revalncrease in the

es, interventi do not interves to be freel

does not chanble rate systemaged (dirty) fvene by buyinexchange ra

Economic Env

ess demand foh, if not remomarket valu

nada must inrves in excha

he US dollar oing operatio

value of its cuf a country pentral bank w

ue interventiof the exchangs. In many ws in Mexico ind Russia, therrency crisis

takes two dife in the valuey: usually theed currency. Dncies were detion was def

luation is thee value of th

ion is not reqvene in foreily determinednge as no entm has not befloating. Undng or selling

ates.

vironment of B

for U.S. dollaoved, will re

ue, E1. To prentervene by sange for its osupply curve

on and, if nec

urrency depeersistently ruill eventually

on. The outcoge rate with t

well-known in the last dee realignmen

s.

fferent formse of the curree U.S. dollarDuring the G

efined in termfined against e opposite of e currency (a

quired. In a sign exchanged. In this casry is necessa

een one of cleder managed

g foreign curr

Business

295

ars at this sult in an event this selling own e to shift cessary,

ends on uns a y run out ome is the

cade and nt of the

s. ency (an , since

Gold-ms of

the U.S.

a

ystem of e markets se, the ary. In ean

d rency,

Module 5

296

The ex

Curren

Net ex

xchange

nt accoun

xports

Supby inwiththe eexpecaseexchfacemarof foits sappe

rate and

A futhat expo

wheexpoof hdete

nt

As y

Fluccurrfluclook

The morrealexpetherimpdeprexpe

Chadom

pose the cenntervening in

hin. Alternatiexchange ratect the centrae, the central hange rate ane a surplus orrkets. In caseoreign currentock of foreiear as change

the aggre

ull discussionwe incorpor

orts (X − M)

Y = C +

ere the last teorts, NX, or t

how net expoerminants of

you know, th

CAB = N

ctuations in nrent account btuate much.

king at what

key determire precisely rl exchange raensive to forreby decreasiact on the agreciation – bensive – caus

anges in incomestic income

ntral bank setn foreign excively, supposte below whial bank to intbank will be

nd, thereforer a shortage o of a shortagncy reserves ign currency es in the offi

egate dem

n of the aggrrate the fourtas follows:

I + G + (X −

erm on the rigthe trade accrts affect the(X − M).

he current acc

Net exports o + Net inves

net exports abalance. TheTherefore, ydetermines n

inants of expreal exchangeate appreciareigners and oing our net exggregate demby making ouses aggregat

ome also affee increases o

ts a target ranchange markse there is a mich if the martervene to pre dealing wit, in its pursuof the foreignge, the centra

and in case reserves. Eit

icial settleme

mand cur

regate demanth componen

− M)

ght-hand sidount balance

e economy, f

count balanc

of goods andstment incom

are the main se other two ityou can studynet exports.

ports and impe rates), domtion, for examour imports cxports. This

mand curve. Sur exports che demand to

ct aggregate our imports a

nge: a range kets, to keep tminimum psrket rate fallrop up the cuth a non-clea

uit of its objen currency in

al bank will hof a surplus, ther way, theent account.

rve

nd side of thent of aggregat

e, as you rece. To have a first let us ex

ce (CAB) is d

d services me + Net tran

source of flutems have trey the current

ports are the mestic and for

mple, makescheaper to dodecrease, in

Similarly, reaheaper and ou

rise.

demand. Anand hence red

that it will atthe exchange

sychological s, the market

urrency. In eiaring level ofctives, it wiln foreign exchave to use it

it will have ese transactio

e economy rete demand, n

call, represenbetter undersamine the

defined as:

nsfers.

uctuations in ends, but theaccount bala

exchange ratreign incomes our exports omestic consturn, has a nal exchange ur imports m

n increase in duces aggreg

ttempt, e rate level of t will ither f l either

change ts stock to add to ons will

equires net

(5)

nts the net standing

(6)

the ey do not ance by

tes (or es. A more sumers, negative rate

more

gate

demexpo

Fromgoveexpoequa

As wmin

By s

or,

This

whereprinveexceborrsurpexpegovesurp(gov

ThisAccprivsmaarisecurr

The budgthe sthe rbetwnegasupp

mand, whereaorts) raises a

m a differenternment budorts are deteration (1) as f

Y − C −

we did in Mous taxes (T):

YD = Y –

substituting i

(YD + T

(YD − C

s can be writ

(Sp – I)

ere (YD – C) resent the priestment, the peeds saving, rowing from plus or deficienditures on ernment saviplus which isvernment def

s equation shcordingly, nevate surplus. all transfers) es is: “What rent account b

answer is thget deficit onsame directioright-hand si

ween the twoative but onlport the fact

as an increaseaggregate dem

t perspectivedget and privrmined accorfollows:

G − I = NX

odule 3, defin

– T

in the above

T) – C − G − I

C) + (T − G) −

tten as

+ (T − G) =

is private (seivate sector sprivate sectothe resultingother sector

it and is equagoods and s

ing, Sg. A pos to be lent ouficit) must be

hows the relat exports equIt is also trueequals the cuis the relatiobalance) and

hat generallyn the left-hanon with the tide. This, howo, as the privay coincidentthat there is

C5

e in foreign imand.

e, net exportsate saving anrding to this

ne disposabl

equation

I = NX

− I = NX

NX

ector) savingsurplus or deor surplus is lg private sects. (T − G) real to net taxeervices. (T −

ositive Sg reput to other see financed by

ationship betwual the sum oe that net expurrent accounonship over td the governm

, there is a tend side of eqtrade deficit (wever, does ate-sector batally equal toa tendency f

Economic Env

income (by i

s are determinnd investmenview, we ne

e income (YD

g and we deneficit. If savinlent to other tor deficit wipresents the

es minus gov− G) is also represents a goectors, and a y borrowing

ween the throf the governports plus dent balance. Ttime betweenment budget

endency for tquation (8), to(or current anot necessar

alance could o zero. Nonetfor the curren

vironment of B

increasing ou

ned by the nt. To see hoed to rearran

D) as income

note it by Sp.ng exceeds sectors. If in

ill be financegovernment ernment eferred to as

overnment senegative Sg from other s

ee balances. nment surplusebt interest (aThe question n net exports balance?”

the governmeo move togetccount deficrily imply eqbe either postheless, obsent account to

Business

297

ur

ow net nge

e (Y)

(7)

(8)

. (Sp – I)

nvestment ed by

sector

ector

sectors.

s and the and other that (or

ent ther in it), on

quality sitive or rvations

o go into

Module 5

298

Interes

st rate pa

a deBec

Subfollo

wheus thdomus ufromand eachcan flow

If dodomless Theinveto orwaymus

The capimob4, wtaxeopenabrogoveinter

arity

Oneshorassea U.assuregusuppyearIn thToroonly

eeper deficit wause of this t

stituting in eows:

S − I = N

ere Sp + Sg =hat, in an ope

mestic investmunderstand wm the balance

capital accoh other for babe interprete

ws in terms o

Net For

omestic savinmestic saving

than domestrefore, the le

estment, whicr borrowing

y to look at thst equal the tr

key to undeital mobility.bile internatio

we discussed es, printing mn economy foad. High capernments as rnational fin

e of the most rt run is Interets: a Canadia.S. dollar assumed alike inulatory and bpose the Canr and a U.S. dhis situation,onto pay 2 py reason why

when the govtendency, the

equation (8),

NX

= S denotes den economy,ment must eq

why the two de of paymentunt (includinalance of payed in terms of net lending

eign Lending

ngs is greategs is lent abrotic investmeneft-hand sidech is the amo(on a net bas

he equilibriumrade balance

rstanding thi. In today’s wonal capital. three method

money and boframework, apital mobilitywell as the pancial marke

popular theorest Parity Tan dollar ass

set (a U.S. don every respebanking restrnadian dollar dollar saving capital shouer cent (5−3)

y all the mon

vernment buey have been

we obtain an

domestic (nat, the excess oqual net expodeficits in equt equation, eqng the officiayments equilof trade in gog or borrowin

g = Trade Ba

er than domeoad (to foreignt, the shortf

e of equation ount that domsis) from form condition

e in equilibriu

is link is the world, econoIn the closed

ds of financiorrowing froa fourth possiy or unrestricprivate sectorets.

ories of exchTheory. Consset (say a Canollar saving dect (risk of deictions) excesaving depo

g deposit in Nuld fly to Tor) more return

ney in New Y

udget goes inn called twin

n alternative

tional) savingof domestic sorts. This reluation (8) arquation (1) thal settlement librium. Theroods and servng.

alance

stic investmegners), and iffall is borrow(9) is equal

mestic residereigners. Accis that net fo

um.

phenomenonomies are linkd economy ming a governmm the (domeibility emergcted capital fr to borrow d

hange rate deider two kindnadian dollardeposit). Theefault, tax treept for their rosit in TorontNew York earonto since sn than those

York does no

nto a deeper ddeficits.

relationship

g. Equation (savings overationship alse linked. Wehat current aaccount) mu

refore, equatvices equallin

ent, the excef domestic sa

wed from abrto net foreignts are either

cordingly, anoreign invest

n of internatiked through model of Uniment deficit:estic) public.ges: borrowinflows allow directly in

etermination ds of homogr saving depoese two asseteatments andreturns. For eto earns 5 pearns 3 per cenaving deposiin New Yorkt fly to Toron

deficit.

as

(9)

(9) tells r so helps e know account ust offset tion (9) ng capital

(10)

ss avings is road. gn r lending

nother tment

ional highly its 3 and raising In an ng from

in the geneous osit) and ts are d other example, er cent a nt a year. its in k. The nto is the

Exchaange rate

possdepointer

SupThisa retin a worthe CIn thintercent2 pe

AdjupariSupto 3 assuquicTorosecoprofand rates

policy

Somdomrate

Hig

A loimpinhiinitiincrexchoutpis re

Howis theconcurvtradtheirorig

sibility of exosited in Torrest advantag

pose people s depreciatioturn of 3 per Toronto ban

rks as a negatCanadian prohis case, the rest rate parit deposit rateer cent expec

usted for riskty always prpose that savper cent pai

ume that Canck comparisoonto. Therefoonds that thisfits disappearthe exchangs of return ar

metimes govemestic output

policy to dif

gh exchang

ow target rateorts more exbits import siating a drop rease net exphange rate (dput and empleduced.

wever, there he danger of nomy is nearve primarily ding partners r own export

ginal relative

change rate cronto) in a dige that Toron

expect the Cn must be su

r cent a year tnk. The expetive return tooceeds at thetwo returns a

ity, which mee in New Yorcted deprecia

k of exchangrevails. Fundving depositsd to similar d

nadian dollar on indicates tfore, funds flos opportunityr very quickl

ge rate rises, cre equal.

ernments initand prices. T

fferent ends,

ge rates (lo

e for our domxpensive. Thispending, thein the value orts and hen

depreciation)loyment are b

are several pinflation. Thr its potentialaffect pricesmay respondt markets. Wvalues, and

C5

changes in thirection that mnto has over

Canadian dolubtracted fromthat Americacted depreci

o American ie time of withare equal, aneans equalityrk = 5 per ceation of Cana

ge rate changds move to ges in Toronto deposits in Nis expected

that it is advaow into Toroy lasts – a sigly – the demacausing it to

tiate a changTo see how plet us consid

ow currenc

mestic currenis policy stimereby increas

of the currence aggregate

) serves as anboosted and

problems in shis hazard is l output, whe. Second is td by raising t

When this hapthe original p

Economic Env

he future (whmight wipe oNew York.

lar to deprecm the 5 per cans can earn ation of the Cnvestors whohdrawals into

nd the situatioy between raent deposit raadian dollar)

ges (exchangeet the highestpay 5 per ce

New York. Tto depreciateantageous toonto’s markegn that in effiand for Canaappreciate u

e in the exchpolicymakerder the follow

cy values)

ncy makes oumulates exposing net exponcy, the cent

e demand. Hen expansionaany recessio

setting a highespecially imen shifts in ththe chance ththeir exchan

ppens, currenpolicy achiev

vironment of B

hile all the mout the 2 per

ciate by 2 percent interest by depositinCanadian doo will be cono their own con is referredtes of interes

ate in Toronto).

e risk), interet return avail

ent return as ohis time, howe by 1 per ce deposit mon

et. For the fewficient markeadian dollarsuntil the expe

hange rates tors can use excwing scenari

)

ur exports chrt revenues a

orts. Therefortral bank canence, raising

ary policy. Boonary gap tha

h exchange rmminent if thhe aggregatehat a countrynge rates to mncies return toves nothing.

Business

299

money is r cent

r cent. to obtain

ng funds llar

nverting currency. d to as st (3 per o minus

est rate lable. opposed wever, ednt. A ney in w

ets, rises

ected

o affect change ios.

heap and and re, by

n help g the oth real at exists

ate. First he e demand ’s

maintain o their

Module 5

300

Despursand encotheirof-precewhictremcomimmduri

Low

Settcurrboosservaggron r

Nonproboutpredu

Sooholdbolstheirtradmarsupp

Mon

As srelatThiscurrforewhedemdecrcurr

Intesuppthat thro

pite these rissued with sucSouth Korea

ouraging expr large holdi

payments surently, the evich had until

mendous econmpetition by imediate neighing the econo

w exchang

ting a high tarency value tst prices of d

ves as contraregate demanreal output an

netheless, usiblems. Not oput and empluce the gover

ner or later, dings are depster their currr foreign cur

de it privatelyrkets, with prply.

netary policy

suggested bytive to those s is because arency drops weign exchangen domestic i

mand for forereases, forcinrency).

rest rates theply of moneyinfluences th

ough its mone

sks, a policy ccess. In the a have depreport-driven gings of foreigrpluses assocdence from Llately fixed inomic crisis its strong curhbours who homic crisis o

ge rates (h

arget for the ctargets (low edomestic expctionary polnd. This putsnd employme

ing a low excnly will a low

loyment, esprnment’s for

through contpleted. In thisrency reserverrency to the y. These lawsrices set at eq

y and excha

y interest pariof other curr

as domestic while the sup

ge market – winterest ratesign currencyng the exchan

emselves are y (see Modulhe supply ofetary policy.

of high exchpast, for exassed the valu

growth. Evidegn currency wciated with a Latin Americits peso againmainly beca

rrency relativhad experienf year 1997.

igh curren

currency hasexchange ratports. Therefoicy by reducs downward pent.

change rate aw exchange ecially in expeign currenc

tinual balancs situation, ces by measurgovernment

s produce unquilibrium le

ange rates

ity, an increarencies causeinterest rates

pply of the fowhere upon th fall relative

y increases annge rate high

normally deles 3 and 4). f money (and

hange rates hample, countues of their cence of this swhich resultehigh exchanca indicates tnst the U.S.

ause its exporve to the currnced significa

ncy values)

s the oppositetes) make imore, loweringing net expopressure on i

as an anti-infrate policy cporting indu

cy holdings.

ce-of-paymenountries somres such as fot rather than anderground foevels determi

ase in the domes our currens rise, demanoreign currenhe exchangeto those in o

nd the supplyher (deprecia

etermined byHowever, it

d consequent

has sometimetries such as currencies as strategy was ed from the b

nge rate policthat Argentindollar, sufferrts were drivrencies of itsant depreciat

)

e effect. Highmports cheape

g the exchanrts and decreinflation as i

flationary toocause a reducustries, but it

nts deficits, tmetimes attemforcing citizeallowing the

foreign exchained by dema

mestic interency to apprecnd for the forncy increases rate falls. Si

other countriy of foreign cation of our

y the demandis the centra

ly the exchan

es been Taiwan a way of found in

balance-cy. More na, red a

ven out of s tion

h er and ge rate easing is well as

ol has its ction in will also

the mpt to ens to sell em to ange and and

est rate ciate. reign s in the imilarly, es, the currency

d for and al bank nge rate)

Thecan Conapplinflu

The

The thatresuUndthe ppric

We persRecU.SUS$assudollrelat= 1.U.SEvid

If, has thwe hequaexchrelat

This26.9rate

Withabourelatthe o

Marfromto PtowacountherSom– whSom

refore, if theforce up inte

nversely, an elied to depreuences the cu

e exchange

purchasing , in the long

ult of the diffder this theorpoint where e index, will

can gain an spective of a all the examp. In that illus

$2.30 in the Uumed that E =ar price of a tive price of 269. This eq. Big Mac codently, the tw

however, we he exchange have just desal value of mhange rate istive price) eq

s Big Mac st9 per cent and

would appre

h reference tut the generationship betwone that wou

rket forces prm remaining PP work slowards PPP. Thntries. The sere are many bme are naturahile others (t

metimes mov

e central bankerest rates usexpansionaryciate the excurrency by ad

e rate in th

power parityrun, the nom

ference in priry, the nominthe average pl be the same

understandinsingle good ple of a McDstration, we aU.S. while it= 1.60 (a USU.S. Big Maa big Mac (r

quation tells uosts 26.9 per wo monies do

were to calcrate, this rel

scribed is calmoney. In this

the level thaqual 1.

andard implid therefore, Peciate 26.9 p

to the Big Mal level of priween a singleuld equate pr

revent the exaway from Pwly. There ahe first reasoecond reasonbarriers to thal barriers – ttariffs, for ex

vement of fin

C5

k wishes to rsing contractiy money polichange rate. Idjusting its e

he long run

y (PPP) theominal exchanice level behnal exchangeprice of good

e when meas

ng of PPP bythat is produ

Donald’s Bigassumed thatt was sold forS$ is worth Cac equals C$real exchangus that, meascent more th

o not have th

ulate the relaative price wlled purchasis example, that would mak

ies that the CPPP would p

per cent: fallin

ac example, ices in two ee good, the Price levels in

xchange rate PPP indefinitare several ren is that mar

n for slow moe movement transportationxample) are inal goods is n

Economic Env

raise the valuionary moneicy of low inIn either caseequilibrium v

n: Purchas

ry of the excge rate move

haviour betwee will apprecids, as measuured in a com

y looking at tuced in two dg Mac sold int in year 2002r C$2.90 in C

C$1.60) so th$3.68 (US$2.ge rate, q) equsured in a comhan the Canahe same valu

ative Big Mawould be equing power pahe PPP level ke the real ex

Canadian dolpredict that thng to 1.269.

when you reeconomies asPPP level of t

two countrie

from movintely. Howeveeasons for slorket baskets dovement towof goods betn costs are oimposed by gnot enough: w

vironment of B

ue of its curreetary policy. nterest rates ce, the centralvalue.

sing powe

change rate ses primarily een two couniate or depre

ured by somemmon curren

this theory frdifferent coun Canada and2, a Big MacCanada. We at the Canad.30 × 1.60). Tuals C$3.68/mmon curren

adian Big Maue.

ac price usingual to 1. The arity, which mof the nomin

xchange rate

lar is undervhe nominal e

elate PPP as s opposed to the exchangees.

g too far fromer, pressures ow movemendiffer across

wards PPP is tween countrne obvious egovernmentsworkers and

Business

301

ency, it

can be l bank

r parity

states as a ntries. ciate to

e overall ncy.

rom the untries. d in the c costs also

dian The /C$2.90 ncy, the ac.

g 1.269 situation means nal

e (the

valued by exchange

a theory the e rate is

m PPP or to move

nt

that ries. extra cost s. capital

Module 5

302

wougood

The

An udiffeownand typeexam

A coservservbeyodefi

As igovethe adefi

If thcouneconinflothe abelofinathe dservwith

uld have to mds – land is t

e importan

unsustainablerent reasonsn set of problpressing pro

es of problemmine what ru

ountry with avices from fovices to themond its meancit is being u

it turns out, ternment budargument pucit case.

he deficit is untry’s future nomic sense.ows through accumulatedow the value nce imports deficit will b

viced — and h a situation

1. As the cand ‘couratings afinanciascores ointerest foreign volatilitycreditorscapital cnation. Tcreditor countrie

2. The lossof the exinflationdeficit c

move. Third athe classic ex

nce of curr

le current accs. Each type lems. Howevoblems than am likely to counning a defi

a current accoreigners than

m. Therefore, ns. But does iused?

there are strikdget deficit anut forth here i

used to purchearning cap

. The deficit the public o

d debt to be sof domestic of consumer

become unmaworse still, nsuch as this c

current accouuntry risk’ raare compiledal service comon credit ratinfor further crcreditors, they of internatis lose confidcan dry up reThere are nuconfidence a

es, such as M

s of confidenxchange ratenary repercuscountry. A be

and probablyxample – are

rent accou

count imbalaof imbalance

ver, a deficit a surplus. Beonfront a chricit implies.

count deficit in it is earninga deficit signit make a dif

king similarind that of a cis similar to t

hase capital eacity, runninshould then r private secerviced and production.

rs goods, runanageable annever be repacan be prese

unt worsens, atings are expd regularly bympanies. Higngs generallyredits. The me greater is thional capital

dence in the degardless of tmerous examamongst hea

Mexico, Indon

nce can lead t, which invossions that onest example t

y of greatest ie non-tradabl

nt

ance matters e deficit andtends to resu

efore we begonic deficit c

is absorbing g from expornifies that a cfference how

ities betweencurrent accouthe one prese

equipment thng a deficit mbe financed tors. When trepaid, spenHowever, if

nning a deficind the growinaid. The probnted in the fo

foreign indepected to incy internationghly indebtedy have to paymore these cohe country’s markets. Fu

debtor countrthe interest ramples of suchavily indebtednesia and Bra

to excessivelolves both losnly add to thto illustrate t

importance, le and canno

for a numbed surplus creault in more imgin considerincountry, let u

more goods rt of goods acountry is liv

w the current

n the case of unt deficit. Tented in the b

hat will enhanmight make g

by long-termthe time comding will hav

f the deficit isit make no seng debt may blems associ

following cat

ebtedness inccrease. Counnal banks andd countries wy high rates oountries rely exposure to

urthermore, ifry, the supplate paid by thh a collapse od developingazil.

ly large devass of real inc

he problems othis would be

many ot move.

r of ates its mmediate ng the us

and and ving account

a Therefore, budget

nce the good m capital

mes for ve to fall s used to ense and never be

iated egories.

creases ntry credit d by with poor of on the

f the ly of he debtor of g

aluations come and of the e Turkey.

Cor

Whasurpgove

Reccouninveeitheoptiexpe

Exprevacom

3. Accumuthe perspaccumulKorea isper cent

rrective po

at can be donpluses? The fernments.

all equation nterpart of thestment over er (S − I) shoons fall into enditure-swi

1. Expendthe aggrin the prof a currcurrent adomestidomestisavings governminterest treatmensame timgeneral Furthermtaxes mogovernmshould e

2. Expendchanginof the agexampleimplemespendingConversexpendiimportedother woswitch th

penditure swialuation (app

mmercial poli

ulation of extpective of folation is the s the best exat of its GDP i

olicy optio

ne to tackle tfollowing sec

(9): S – I = Nhe current acsavings, (S –

ould decreasetwo groups:tching polici

diture changregate domesresence of a crent account account deficc savings or c savings co(Sg). In orde

ment can incrrates on sav

nt of retired sme tend to dilevel of intermore, increasotivates less

ment savings either reduce

diture switchg policies, thggregate expe, faced by a ent an expeng on importssely, faced byture switchind goods vis-àords, this typheir spendin

itching policipreciation) anicy including

C5

ternal debt moreign ownercreditor’s deample of escin the 1990s.

ns

the problemsction discuss

NX. Accordincount deficit– I) < 0. Thee or NX incre expenditureies.

ging policiesstic spendingcurrent accoudeficit. In thcit, the goverreduce invesnsist of privaer to encourarease the retu

ving accountssaving deposiscourage corest rates alsoses in businespending an(reducing th

e its expendit

hing policieshese policies penditure dire

current acconditure switchs in favour ofy a surplus, tng policy thaà-vis domest

pe of policy tg from foreig

ies consist ofnd devaluatiog but not limi

Economic Env

may pose a sership. The boemand for assalating exter.

s of chronic dses policy op

ng to this equt, (NX < 0), ierefore, to cuease or both.

e-changing po

: These policg (C + I + G)unt surplus a

his current carnment shoustment. But aate savings (age private saurn on savings or by offerisits. Note thansumption. Ao tends to disess taxes andnd more savinhe budget deftures or incre

s: In contrast tend to chan

ectly rather tount deficit, thing policy tf domesticallthe governmat encouragestically produtends to indugn to domest

f exchange ron (depreciatited to:

vironment of B

erious probleorrower’s debsets as collatrnal debt at n

deficits and ptions availab

uation, the is the excess ure this probl. These policolicies and

cies tend to c. They are inand reduced base, faced byuld either incras discussed Sp) and goveavings, the gs by increasing better taxat such policiAn increase iscourage inv

d/or consumpng. To encouficit), the govease its taxes

to expenditunge the compthan its levelthe governmthat discouraly produced ent can empls spending o

uced productsuce consumertic and vice v

rate policy: tion) as well

Business

303

em from bt teral. nearly 50

ble to

of em

cy

change ncreased by that

y a rease the earlier,

ernment

sing x ies at the in the vestment. ption urage vernment s.

ure position l. For

ment can ges products. loy an n s. In rs to versa.

as

Module 5

304

The withbala

Cau

ThecounpartincoHenthe lin thoil, a coalsodecrthenmet leadforeinveand imp

The Nevtrad

Incr

At thA trmorcaseposscurrconscons

Incr

A trby boffic

Tariffs, sometim

Quotas,

Export s

Dumpinat a pric

reality, howh the trading ance of paym

uses and imp

re are a few ntry is growiners. The str

ome) enablesnce, the total large trade dhe internationrising prices

ountry’s savino contribute treased while n the differen

via foreign pds to a large ceign investorsestment, peopconsume moorted goods

large trade dvertheless, mde deficits, as

reased curre

he time a trarade deficit mre goods and e, domestic csibilities curvrent consumpsumption. If sume less tha

reased indeb

rade deficit isborrowing frocial reserves

which are simes on expor

which are qu

subsidies, wh

ng, the act of ce below cost

wever, is that partners and

ment crisis.

plications of

reasons thating more raprong growth s the people tvolume of it

deficits may bnal market. I tend to aggrng rate (meato the large trthe investm

nce or gap bepurchases ofcapital and fis or savers arple of the couore. Part of thand services

deficits shoumost researches follows:

ent consump

ade deficit is means that th

services as iconsumers arve. Howeverption may cothe trade def

an before and

btedness lev

s considered om the rest o. Recall that

milar to taxerts.

uantitative re

hich are the o

f selling expots or below d

these types od are rarely a

f trade defic

account for pidly than theof the countrto buy more ts imports is be caused byIf a country iravate trade dsured as savirade deficits.ent rate rema

etween savinf the countryinancial capire willingly funtry will behat added co

s.

uld be of signers see both a

ption

occurring, che consumersimports fromre able to conr, it is importome at the exficits declined may be les

vel

not favourabof the world, trade deficit

es typically o

estrictions on

opposite of ta

orted productdomestic pric

of policies tean efficient w

cits

large trade de economies ry (means hiimported gohigher than

y the frequentimports a largdeficits. Finaing divided b. For examplains the sameg rate and in’s real and fiital surplusesfinancing a le able to saveonsumption s

nificant conceadvantages a

onsumers ofs of the count

m abroad thannsume outsidtant to note th

xpense of rede, the consumss than they p

ble because iselling off a

ts are finance

on imports bu

n imported p

axes.

ts to foreign ces.

end to create way of rectify

deficits. Firstof its trading

igh growth oods and servits exports. St rise of the oge proportionally, the declby total incomle, if saving re, or even in

nvestment ratinancial asses. This is beclarger portione less than otspending is o

ern to the coand disadvan

f the country try are receivn its exports.de its producthat the incre

duced future mers may havproduce.

it must be finassets, or dipped primarily

ut

products.

markets

frictions ying a

t, a g f

vices. Secondly, oil price n of its lining of me) may rate is creased, te will be ts. This

cause the n of their therwise

on

untry. ntages to

benefit. ving In this tion ase in

ve to

nanced ping into by net

Interna

Why d

ational tr

do countr

repacounbothasseyieldand examasseU.Swanwillsituaneed

rade

The spreglobbounyou Such

Sominterand sombord

ries trade

The signprodcomcom

Spe

The Withand focucoma resprodof thof cby s

ayments of fontry are not sh its debt to pets in the couded a larger financial ass

mple, in 200ets (such as la. citizens and

nts to regain o have to expation, domesd to export m

rapid growtead of internabalisation. Mndaries. Evedo not know

h interdepen

me countries rnational tradJapan). Non

me extent on oders.

e?

most straighnificant econoduction by al

mpetitive, it inmpetition.

ecialisatio

most importhout trade, abe self-suffi

us on producmpete in the e

sult of speciaducts from thhe nation sinonsumption

specialisation

oreign currensufficient to people abroauntry. Hence,foreign accusets than the 6, foreignersand, corporad institutionsownership ofort more than

stic consumpmore of its ou

th of foreign ational busin

Markets are nory day you r

w, to providendence is pos

such as Belgde whereas s

netheless, eveother econom

htforward anomic gains tollowing specncreases vari

n and trad

tant gain froma country wouicient. With iing products

expanded maalisation andhe rest of thence the standa

and imports n.

C5

ncies to a coufinance its im

ad and the va, financing o

umulation of country’s cl

s have ownedations, stockss owned in fof these domen it imports a

ption will be utput abroad

trade and invness and marko longer conely on peopl you with gosible becaus

gium and Cansome show leery country, mies and is in

nswer to this o all parties eialisation in iety for cons

de

m internationuld have to pinternationals in which it arkets. The cod increased exe world. Thisard of living per capita, a

Economic Env

untry. Whenmports, the clue of foreigf the countryclaims againaims againstd about US$2s, bonds, loanoreign assetsestic real andat some futulower as the than it receiv

vestment flokets are part

ntained withinle from arounoods and serve people trad

nada are moress reliance oregardless ofnfluenced by

question is thengaged in itproducts in wumers and it

nal trade is sproduce everl trade, the sais efficient, aountry’s incoxports, which increases this best meas

and these, in

vironment of B

the exports country incregn claims agay trade deficinst the countrt foreign asse2.5 trillion mn notes, etc.). If the Unite

d financial asure times. In t

United Stateves as impor

ws and the rof a trend kn

n national nd the worldvices that youde with one a

re dependenton trade (thef its size, dep

y events outsi

hat trade brint. It increasewhich a count promotes

specialisationrything it coname country allowing it toome will incrh enables it t

he standard osured by the turn, are also

Business

305

of the eases ainst its has ry’s real ets. For

more U.S. than ed States ssets, it this es will rts.

esulting nown as

, whom u enjoy. another.

t on e U.S. pends to ide its

ngs s ntry is

n. nsumes can

o rease as to import f living amount o driven

Module 5

306

As tspeccom

Abs

The advaand absoit usdoesher her doescan typeadvaabso

If eaadvapracprodeacheverin thprodothe

As icomgenenatioIn fareso

Com

A coprod– lowhypoForecoun(lab(labin th(in cthirdunit

the first step cialisation, le

mparative adv

solute advan

easiest way antage is to cnations. Acc

olute advantases fewer ress. Suppose a documents fsecretary cans not have thdo a better jo

ed pages thanantage over tolute advanta

ach trading pantage, everycticing law anduction increh party were rything. The he context ofduce one proer), specialisa

indicated earmparative adveral enough tons can specact, trade allo

ource and pro

mparative ad

ountry enjoyduce that comwer marginaothetical caseign (F). Alsntries, wheatour). The nuour) work re

he second cocubic metresd column, fiv of cloth in H

in developinet us look intvantage.

ntage

to grasp the consider the cordingly, a page over anoources to prolawyer who

for her. The ln type 10 paghe required trob in practicn the lawyer.the secretaryage in typing

partner speciayone can bennd the secreteases beyondconfined to gains from s

f productivityoduct more efation allows

rlier, the prinvantage, to beto apply to a

cialise in prodows two natioductivity co

dvantage

ys comparativmmodity or ial cost – thane. Suppose to, suppose tht (X) and clo

umber in eachequired to prolumn, two ho) of wheat inve hours of wH compared

ng a framewoto the source

concepts of case of two tperson, a firm

other countryoduce that pr practices law

lawyer can tyges per hour.raining to pracing law and . The lawyer

y in practicing.

alises in the pnefit. The lawtary in typingd the levels thself-sufficienspecialisationy and saved rfficiently (ustrading partn

nciple of absoe explored in

all possibilitieducts that theions to move

onstraints.

ve advantageitem at a lown other produthere are twohat there are th (Y), and th cell of the toduce one unours of work

n H comparework is requito 10 hours i

ork to analyses of these ga

f absolute andtrading partnm or a county in the produroduct than tw can use a sype three pag. Also, suppoactice law. Tthe secretary, thus, enjoyg law and th

product for wwyer should g. This way, hat would hancy and forcn can be alteresources. Sising fewer reners to save r

olute advantan the followies. Accordiney have an a

e out beyond

e in a producwer cost relatiucers. Table o countries, H

two goods pthere is one ftable below nit of each prk is required d to 20 hoursired to produin F.

se gains fromains: absolute

d comparativners; personstry will enjoyuction of a pthe other cousecretary to pges per hour,ose that the s

Therefore, they can producs an absolutee secretary h

which it has specialise inthe volume

ave been achied to producrnatively expince each paresources thanresources.

age (and alsong subsectio

ngly, two firmabsolute adva

their previou

t when it canive to other p5.3 illustrate

Home (H) anproduced by factor of prodshows the amroduct. As into produce os in F where

uce one (in m

m e and

ve s, firms y an roduct if

untry prepare , while secretary e lawyer ce more e has an

absolute of ieved if ce plained rtner can n the

o on) are ms or two antage in. us

n products es a d both duction mount of ndicated one unit as in the

metres)

Hom

Fore

Tab

AccX: twThumorThucoun

HowBritadvashowcom

The trancostsecoprodmeaX. T

Hom

Fore

Tab

Accsuggunitcounby runit Y caTheForeresp

NowHomHomFore

me (H)

eign (F)

ble 5.3 Labo

cordingly, H wo labour ho

us, H has an are efficient thus, H enjoys antry to enjoy

wever, the patish economiantage but raw H has a co

mparative adv

simplest waslate these nt of producinond product tduct. Therefoasured in termTable 5.4 sho

me (H)

eign (F)

ble 5.4 Oppo

cordingly, thegests that in s of Y. The lntry must adrelocating tw of Y requireauses only a refore, the opeign countrypectively.

w, we are in ame has a lowme has a comeign’s opport

ur content o

is more efficours requiredabsolute advahan F in prodan absolute a

y an absolute

attern of tradst David Ric

ather by comomparative advantage in Y

ay of showingumbers into

ng a product ithat needs toore, in this illms of Y and ows these op

ortunity cost

e opportunityorder to prodlogic behind

dd two units owounits of labes five units drop of 2/5 opportunity co, the opportu

a position to wer opportunimparative advtunity cost o

C5

X

of one unit o

cient (producd to produce antage in X.

ducing Y as wadvantage in advantage in

e, as we havcardo, is not d

mparative advdvantage in X(cloth).

g the patternopportunity is the forego

o be sacrificelustration, ththe opportun

pportunity co

X

2/5 = 0.

20/10 =

ts of X and Y

y cost of X induce one unithis is that to

of labour (wobour from theof labour, reof a unit of Yost of Y in th

unity costs of

establish coity cost in X vantage in prf Y is less th

Economic Env

Y

2

20

of output of

ctive) than F one unit of XOn the other

well, five labY. Hence it

n both goods

e learnt fromdetermined b

vantage. In thX (wheat) w

n of comparatcosts. Recalne alternativd to produce

he opportunitnity of Y is mosts.

Y

4 5/2 =

2 10/20

Y

n terms of Yit of X, Homo produce onork hours). Te other sectomoving two

Y. The same he home couf X and Y are

mparative ad(0.4) compa

roducing X. Shan of Home

vironment of B

Y

5

10

X or Y

in the produX versus 20 hr hand, note

bour hours veis possible f

s.

m the 18th cenby absolute his example,

while F has a

tive advantagll that the oppve – the amoue one unit of ty cost of X imeasured in t

Y

= 2.5

= 0.5

in Home is e must give une unit of X, This can be ar, Y. But, sinunits of labologic applie

untry is 5/2 (2e 2 and 0.5,

dvantages. Sared to ForeigSimilarly, sin, 0.5 versus 2

Business

307

uction of hours. that H is ersus 10. for a

ntury

we can

ge is to portunity unt of the the first is terms of

0.4. This up 0.4 the

arranged nce one our from s to all. 2.5). For

ince gn (2), nce 2.5,

Module 5

308

Forewillbe F

The adva

NoteHomas RadvafounForedisaspeaHomHom

The partsenslinkprod

Ter

We quesnatiointerintertradsidethe rprodexchabseexpoothein Hsitua

Simableoppofor iacceas fo

or

eign has a co export X an

Foreign’s exp

pattern of inantage.

e that the abome is assumeRicardo showantage but rend exporting eign has an aadvantage (deaking, it has me’s margin me has a rela

important pners; even thse. If markets

ked to goods-ducing those

rms of trad

have establisstion that arions. The ansrnational prirnational pri

de must be sees or otherwirate at whichduct must behange the samence of tradeort one unit oerwise, the tr

Home, one unation.

milarly, in orde to import onortunity costit. Thereforeeptable to boollows:

0.4 < ter

omparative adnd Foreign wports and For

nternational t

ove conclusied to have anwed us, the paelative advan

both producabsolute disaeficiency) is a relative (coof advantage

ative advanta

oint is that sphose that mays are compet-and-services

products in

de

shed the factses is how th

swer is that dce of producce of one pro

et in such a wse, there will

h a country w at least equame two good

e. In terms ofof X, it mustrade is not benit of X exch

der for the fone unit of X t – or less, or, terms of tra

oth sides. In o

rms of trade

dvantage in pwill export Y.

reign’s impo

trade is deter

ion is reachedn absolute advattern of tradntage, otherwcts and not juadvantage in

smaller in Yomparative) e in Y is smage in X.

pecialisationy be inefficietitive and if fs exchange, cwhich they h

t that both nahe benefits odistribution octs, the termsoduct in term

way that they l not be an in

will end up seal to or betteds internally f the examplet be able to imeneficial to Hhanges for 0.4

reign countryin exchange

r otherwise, tade consist oour example,

< 2

producing Y Of course, H

orts will be H

rmined by co

d despite thevantage in b

de is not detewise Home wust X. In otheboth X and Y

Y than in X anadvantage in

aller than tha

n and trade caent producerforeign exchacountries wilhave a comp

ations benefif trade are sh

of gains depes of trade. Tems of another

are beneficincentive to trelling its expr than the rat– its opportue above, in omport at leas

Home. The re4 units of Y

y to engage i for at most tthere will be f a range of p, the limits o

Y. Therefore, Home’s impo

Home’s expor

omparative

e fact in our eoth X and Yrmined by ab

would have beer words, althY, its marginnd hence rel

n Y. Similarlat in X; there

an benefit alls in an absolange marketsll specialise iarative advan

t from trade.hared betweends on the

erms of trader product. Teial to both trarade. In otherports for an imte that countrunity cost – iorder for Homst 0.4 units ofeason for thisin the pre-tra

in trade, it mtwo units of no gains fro

prices that mf terms of tra

Home orts will rts.

example . Thus, bsolute een hough n of atively ly, fore,

l trading lute s are in ntage.

. A en

e are the erms of ading r words, mported ry can in the me to f Y; s is that ade

must be Y – its

om trade may be ade are

S

Study skills

The eachoppolargis tothe s

Refeshow

1.

2.

Solu

The

The two exis

0.4 < pr

actual termsh product. Thortunity coster the gains

o Foreign’s osmaller the g

er to the follows the possib

Home

Foreign

According to

A. an a

B. an a

C. a co

D. the p

The opportu

A. 5/12

B. 12/5

C. 3 kg

D. 2 kg

utions:

1. A. Homan absolcountry and D ar

2. A. The obananasneeds 1/other secauses awork in produce

e sources

sources of cgroups. Acc

stence of a co

ice of X in te

s of trade arehe closer the t (0.4), the smfor Foreign.

opportunity’sgains for For

owing table tble output lev

Milk (Litr

o the table, H

absolute adva

absolute adva

omparative di

potential to e

unity cost of

2 kg of banan

5 kg of banan

g of bananas.

g of bananas.

me can simplylute disadvancannot havere wrong.

opportunity cs to be sacrifi/12 unit (houctor. But rem

a loss of 5/12Bananas pro

es 5/12 units.

of compar

comparative cording to Riountry’s com

C5

erms of Y <

e then set by final interna

maller the gaConversely,

s cost (2), theeign.

to answer thevels from on

re) Banan

12

4

Home has

antage in mil

antage in ban

isadvantage

export both g

one litre of m

nas.

nas.

.

.

y produce montage in banae relative adv

cost of one liiced. To produrs) of labourmoving 1/12 2 kg of bananoduces 5 unit

rative adva

advantage caicardo – Rica

mparative adv

Economic Env

2

the internatiational price ains from trad the closer th

e larger the g

e next two qune hour of lab

nas (Kilo)

5

6

lk.

nanas.

in both.

goods.

milk in Home

ore milk thananas only, sovantage in bo

itre milk is thduce one litrer work to be hours of wor

nas. Remembts, therefore,

antage

an be broadlyardian theoryvantage is ex

vironment of B

onal demandis to Home’sde for Homehe internationgains for Hom

uestions. Thebour input.

e is

n Foreign. Ho B is wrong.oth goods, an

he quantity oe of milk, Hotransferred frk from banaber that one h, 1/12 hours o

y categorisedy of trade – t

xplained by it

Business

309

d for s and the nal price me and

e table

ome has . A nd thus C

of ome from the anas hour of of work

d into the ts

Module 5

310

S

Study skills

techexplof Hendoreso

The exisa cothat prod

FacttradlandA coa co

Comcounimpas ininterRicaoccuof taindugoodUS timeis a

In ccoman e(incsuchcharmarquan

Switbest

hnological sulanation is th

Heckscher anowments: the

ources of a co

Heckscher-Ostence of a coountry has a c

country is reduction of th

tor endowmede patterns. Td per person ountry with a

omparative ad

mparative advntries trade. Fort and expontra-industryr-industry traardian and Hurs as industrastes that exiustrialised cod example ofexports cars e imports smnatural respo

ontrast to intmpetition andenvironment reasing returh as cars, cheracterised byrket conditionntities of out

tzerland is faexplained by

A. the largepotentia

B. Swiss st

C. Swiss di

D. economi

uperiority: prhe one advannd Ohlin. Thee quantity anountry.

Ohlin theoreountry’s comcomparative elatively welat product.

ents seem to This idea is siis likely to ha large amoudvantage in l

vantage, howFor instance

ort the same ky trade — traade — trade

Heckscher-Ohries differentists worldwidountries is of f a product thof large mod

maller and moonse to diver

ter-industry td conditions o

of imperfecrns to scale).emicals, petry increasing rns, which metput.

amous for way

e population l watch mak

teel refineries

iamond mine

ies of scale i

roductivity. Tnced by two Seir theory is bnd quality of

em of internamparative adv

advantage inll endowed w

explain a sigimple. A cou

have a compaunt of labour labour-intens

wever, is cert, it does not kinds of gooade within thbetween ind

hlin theories tiate their prode. In fact, thf intra-industrhat follows tdels with powore fuel-efficrse preferenc

trade which tof constant cct competition In reality, m

rochemicals areturns and means there ar

atches, which

of Switzerlaers.

s, which prod

es, as diamon

n the watch

The alternativSwedish econbased on thelabour, land

ational trade evantage by itn the productwith inputs u

gnificant poruntry with a larative advanbut little cap

sive goods.

tainly not theexplain whyds. Trade of e same indus

dustries — asof trade. Introducts to plehe bulk of trary type. Autothis pattern. Awerful enginient cars. Pro

ces across eco

tends to occuosts, intra-inn and decrea

most manufacand pharmacmonopolistic re advantages

h it exports.

and, which pr

duce steel us

nds are used

industry.

ve and more nomists by th

e concept of fand natural

explains the s factor endotion of a prosed intensive

rtion of actualot of good fentage in agricpital is likely

e only reasony many count

this nature istry — as ops explained ura-industry trease the wideade amongst omobiles serA country su

nes, and at theoduct differeonomies.

ur under perfndustry tradeasing costs cturing indusceuticalsare

or oligopolis to producin

This speciali

rovides many

sed in watch

in watch par

popular he names factor

owments: duct if ely in the

al world fertile culture. y to have

n that tries both s known

pposed to under the rade e variety

rve as a uch as the e same

entiation

fect requires

stries

istic ng large

isation is

y

parts.

rts.

Trade policy

Solu

Havprepovertradby wcomobstexpo

A li

A taImpraisimayreduby pmanto dtrad

Highreseheavthat remcounheav

The quanThefor a

ution:

D. As the wnetwork devcould teach lowered the

ving covered pared to thinkr the main in

de policy is towhich some s

mpetition. Tratacles, take mort subsidies

st of protecti

Tariffs.

Quotas (

Export s

Governm

Adminis

Other re

ariff is usuallport tariffs tening the domey be primarilyucing foreignproduct and cnufacturing somestic firm

de.

h-technologyearch and devvily on exporgovernmentain very mucntries, especivily subsidis

most commntity of impose licences aa price (creat

atch industryveloped withtheir techniqcost of firm

the basic ecok about trade

nstruments ofo restrict impsectors of theade policies, many forms. and quotas,

ive policies i

(quantitative

subsidies.

ment procure

strative barri

egulations.

ly a tax on imnd to act as aestic price ofy increasing

n competitioncountry of orectors. Expo

ms to encoura

y and aerospvelopment arrt subsidies. ts around thech a part of tially in Euroing exports o

mon non-tarifforts and is usare obtained bting revenue

C5

y became estin Switzerlan

ques to new wexpansion o

onomics of ie policy morf trade policyports. Trade pe economy asometimes cThe most cobut there are

includes:

e restrictions)

ement policie

iers to trade (

mports, but soa tax on impof imported prrevenue for

n to protect drigin. Tariffsort subsidiesage exports a

ace industriere prime examAgriculture

e world tendthe internatioope, continueof agricultura

ff barrier is thsually implemby importers) or governm

Economic Env

tablished, an nd. Also, exiworkers. Botor the cost to

international re directly. Thy. The most cpolicies are f

are shielded fcalled trade bommon tradee other forms

).

es.

(red tape).

ometimes onorts. They reroducts. The the governm

domestic ind are most visare governm

and can also a

es that depenmples of indis another exto target this

onal trade lane to appease tal products.

he quota. A qmented by ms from the goments grant th

vironment of B

input supplyisting watch th developmenew firms.

trade, you ahe next step common objforms of profrom foreign barriers or tre policies ares as explaine

n exports as westrict import

objective ofment or altern

ustries. Tarifsible in

ment paymentact as a barri

nd on intensivdustries that rxample of ans way. Farm ndscape todatheir farmers

quota is a limmeans of licenovernment, nhem an allow

Business

311

y makers ents

are now is to go ective of tection

rade e tariffs, ed below.

well. ts by f tariffs natively, ffs vary

ts made ier to

ve rely n industry subsidies

ay. Many s by

mit on the nces. normally wance to

Module 5

312

brintwo

A goprodvoluagriand for t

Wheprefwillobtasuppwhicloca

The lininthe oto exmeabusi

Quitsuchpowout

The

The the comeconappaIn oprocbusipresmod

Howtradevermucone othebe dbeneprotargu

ng in a specifways.

overnment cducers to set untary exportcultural sectVERs is tha

the governm

en it comes tference to do give prefere

ained elsewhpliers to quotch preferenti

al competitio

term admining up at custother adminixport rather t

asure the effeiness people

te frequentlyh as making

wer is not abuof the domes

e case for tra

gains in eclaw of com

mpelling casenomists to oparent policy ther words, c

curement polinesses assocscription maddern econom

wever, a few de is the best ry country fach of the intecountry to g

er countries. defensible to efits from othtection can buments.

fic number of

an impose antheir own vot restraints (Vors and texti

at unlike ordient, nor can

to governmenomestic produence to a locahere. Such a pte higher pricial purchasinn.

istrative barroms offices, istrative procthan to produ

ects of adminargue that su

y, regulationssure the food

used but in fastic market.

ade protectio

conomic wemparative adv

for free tradppose governimplication icountries sholicies, exportciated with inde by Ricard

mists.

complicatiopolicy for th

aces a unilateernational congain from inteFrom the natpursue a polher countriese defended w

f units of goo

n import quooluntary quoVERS). Nowile industriesinary quotas,they be give

nt procuremeucers. This mal supplier evpolicy createces than they

ng causes pric

riers refers twaiting to g

cedures that muce and sell nistrative baruch barriers a

s seem to be d supply is saact they often

on

elfare associvantage are gde. Consequenment policieis that the beould not use t subsidies ornternational t

do, and this p

ns persist. Fihe world as aeral incentivenflict over trerventionist tionalist publicy whose ps. Nonethelewith either ec

ods. Import q

ota itself or ittas, which ar

wadays, most. The differe VERs do no

en to domesti

ent, most coumeans that a ven if a lowe

es an incentivy otherwise wces to rise de

to the cost ofget permissiomake it hardlocally. Whi

rriers to tradeare a serious

focused on aafe or makinn serve to ke

iated with sgenerally largently, it is coes that preve

est policy is atariffs, quotar other intervtrade. This isrescription is

irst, even if wa whole, it doe to avoid trarade policy retrade policy

blic interest principle effess, particularconomic or n

quotas can w

t can ask forere known as t quotas are f

ence betweenot generate reic importers.

untries give domestic gov

er price couldve for domeswould. The eepends on th

f filling in foron to export, der (and moreile it is diffice, many smals impediment

a non-trade ong sure that mep foreign pr

pecialisationge enough tommon for

ent trade. Thea policy of fras, preferentiventions in s, in fact, thes widely acc

we agree thatoes not followade barriers. eflects an attat the expen

point of viewct is to transr cases of tranon-economi

work in

eign

found in n quotas evenue

vernment d be stic extent to e level of

rms, and all e costly) cult to ll t.

objective monopoly roducts

n and o make a

e ree trade. ial

e epted by

t free w that In fact, tempt by nse of w, it might

fer ade ic

SecoperfcomThe

Tarireceworthe Wof reespeimpin th

By seithemarsettiand incr

Bechavein thlevedomsectactivthe gemploss

A relaboto prargudiffewithbecacoun

ond, the presfectly. Espec

mpetition, the following is

1. Raising

2. Improviexploit m

3. Increasi

4. Protectinworkers

5. The ‘inf

6. Non-eco

iffs have beeent years, howrld economy’World Tradeegional tradiecially devellication for the same way

setting tariffser the sole pl

rket – can turing a tariff onhence reduc

reases the ter

ause importse a dampeninhe level of imel of econommestic worker

oral level, novity may onlgovernment

ployment gai in other sect

elated argumour need to brotect the jobument is flawerences amonh a higher peause of their ntries are com

scription thatially in the p

ere are potents a list of rati

revenue.

ing a countrymonopoly po

ng employm

ng a countrys from impor

fant industry

onomic objec

en traditionalwever, this to’s progress toe Organizationg blocs. Nooping countrthe governme

y that taxes do

s on importelayer or one rn its terms on its imports

ces the price rms of trade.

s are a withdng effect on tmports througic activity inrs. In reality,ot at the natioly materialisetrade policy

in in the targetors that are

ment suggestse blocked frob domestic w

wed because ng wage rater capita GDPhigher produmpared with

C5

t free trade ispresence of etial benefits tionales for tr

y’s terms of tower in worl

ment.

y’'s safety starts produced

’ argument f

ctives (milita

lly the most pool has lost iowards furthon (WTO) anonetheless, onries, to emploent. Tariffs go.

d products, aof the small

of trade to its, reduces thefor the impo

drawal from atotal spendingh trade barr

n a country an, however, thonal level. Te within the . In fact, evideted sector mpaid less atte

that importsom entering

workers. In itit ignores the

es in various P tend to earnuctivity. Wh

h these differe

Economic Env

s the best polconomies ofto be obtainerade policy.

trade throughd markets).

andards and sby cheap for

for protection

ary or cultura

popular tool its usefulnesser trade liber

nd through thne reason foroy tariffs hasgenerate reve

a large countnumber of p advantage. A

e world demarted product

an economy’ng and outpuriers can potend provide mhis may only

That is, the insector that hadence suggesmay be offsetention.

s produced ban industrial

ts basic forme reason pertcountries. Wn more than en average went productiv

vironment of B

licy does notf scale and imed from inter

h monopoly t

shielding domreign labour.

n.

al objectives)

of trade polis because of ralisation bothe growing nr many couns been its revenue for gove

try – a countrplayers in theA major playand for that p, which in tu

’s circular flout. Thus, a redentially incremore jobs for be valid at t

ncrease in ecoas been boossts that the pt by an empl

y cheap forelised country

m, however, thtaining to the

Workers in coworkers else

wages in varivity levels, w

Business

313

t hold mperfect rvention.

tariffs (to

mestic

).

icy. In the th under

number ntries, venue ernments

ry that is e world yer, by product urn

ow, they duction ease the r the onomic sted by rojected oyment

eign y in order his e ountries ewhere ious

workers

Module 5

314

Activ

vity 5.1

Activity

in inlabo

An ifrominexbaseprodexpetrouprodnatiomea

Amonatio

If soothe

Trad

Tradwhic

Reg

Theacroagrecurrand agrecommov

ndustrialised our in many t

infant industm establishedxperienced aned volume anducers behinerience and t

uble is that noducers that qon’s efforts t

asures by its t

ong the mostonal security

ome countrieers frequently

de agreemen

de agreemench can be us

Trade ageach othreductioprocedu

Trade licreates lcompetiallowinggreater c

gional trade

re has been aoss the worldeements are srent tariff andservices betw

eements inclumpetition polivement of lab

nations still types of prod

try is made od compared tnd often too nd scale. Thed tariff barrithe necessaryormally gove

qualify for theto help its owtrade partner

t important ny and cultura

es are so keeny attempt to e

nts and trad

nts and trade ed to increas

greements inher’s goods bon of bureaucures.

iberalisationlarger markeition. It also eg firms to gachoice also in

agreements

a significant d economy ovsimply free-td non-tariff iween countrude regional icies, agreembour.

possess an aduction.

of domestic pto foreign comsmall to be a

erefore, theirers until theyy scale of proernments havese protectivwn industriesrs – trade ret

non-economial sovereignty

n to reduce berect barriers

de liberalisat

liberalisationse the rate of

nvolve the rebetween two cracy by simp

might involvets, greater acencourages t

ain economiencrease cons

s

expansion over the last twtrade agreemimport controies. The morrules on flow

ments on envi

advantage ov

producers thampetitors. Thable to compr governmenty have maturoduction to bve difficulty ve measures. s are also coualiation.

ic argumentsy.

barriers to tras?

tion

n are two essf growth of w

eduction/remcountries. Itplifying imp

ve creating fccess to raw the lowering es of scale. Lsumers’ welf

of regional trawo decades.

ments which iols to liberalre sophisticatws of investmironmental p

ver low-wage

at are young hese industri

pete on a globts may try tored, gained be left alone.in identifyinFurthermore

untered by si

one can refe

ade, why do m

sential mechaworld trade.

oval of tarifft also includeport/export

free-trade arematerials anof unit costsower prices

fare.

ade agreemeSome of the

involve a redise trade in gted regional ment, coordinpolicies and f

e foreign

and far ies are bally protect

The ng e, a imilar

er to are

many

anisms

fs on es the

eas. This nd more s, thus, and

ents ese duction in goods trade nation of free

Exa

Eco

Thefree remin gthe E(AFstag

Sta

Fre

Cus

Sing

Mon

Eco

Tab

Doecountradagai

Und

WorprimWTor se

amples of reg

The AssTrade A

The Eurnow wit

The Eur

The Norcreated i

The Sou2006 an

MercosuParagua

The Com(COME

onomic integ

re are variou trade area isove tariff anoods and serEuropean Fr

FTA) are somges of econom

age of economintegration

e trade area

stoms union

gle market

netary union

onomic union

ble 5.5 Stage

es a country antry? The fol

de talks with Uinst free trad

derstanding

rld Trade Ormary role is tO currently heparate custo

gional trade

sociation of SArea (AFTA)

ropean Unionth a single cu

ropean Free T

rth Americanin 1994.

uth Asian Frend containing

ur – a customay and Venez

mmon MarkeESA).

gration betw

us versions os a mild formd non-tariff b

rvices. The Nree Trade Areme of the exammic integratio

mic No internatrade

barriers

X

X

X

X

X

es of econom

always gain llowing articU.S.’ gives y

de agreement

World Trade

rganization (Wo encourage has 153 memoms territorie

C5

e agreement

Southeast As.

n (EU) – a cuurrency.

Trade Area (

n Free Trade

ee Trade Areg countries su

ms union betwzuela.

et of Eastern

ween countri

f economic im of integratibarriers betw

North Americea (EFTA) amples. Tablon between c

al

Common external

tariff

X

X

X

X

mic integratio

from a free tcle entitled ‘Myou some inss.

e Organizat

WTO) is the trade for the

mbers, of whies. WTO act

Economic Env

ts are as foll

sian Nations

ustoms union

(EFTA).

Agreement

ea (SAFTA) uch as India

ween Brazil,

n and Souther

es

integration bion where coween them tocan Free Trand ASEAN Fe 3 summaricountries.

Factor and asset

mobility

X

X

X

on between

trade agreemMalaysian prsights of why

ion (WTO)

internationae benefit of mich 117 are divities are su

vironment of B

ows:

(ASEAN) F

n, a single m

(NAFTA) –0

created in Jaand Pakistan

Argentina, U

rn Africa

etween counountries agreeo promote frede Area (NAFree Trade Aises the differ

Common currency

Cec

X

X

countries

ment with anorotest againsty certain part

al organisatiomember coundeveloping cupported by a

Business

315

ree

market and

000

anuary n.

Uruguay,

ntries. A e to ee trade AFTA), Area rent

ommon conomic policy

X

other t free ties are

on whose ntries. ountries a

Module 5

316

SecrSecrcounmemonceregu

The calleAgrto n200agrewhetheyevercounnegomemagrebindBesiimpsettlcurrdiffeand mem

DecentirConWT

retariat of soretariat is locntries or govmbership as ae every two yularly in Gen

bulk of the Wed the Urugureement on Tew negotiati1. WTO proveements and ere member gy face with earything the Wntries have faotiations havmber countrieeements provding governmides, WTO alementation ling disputesrent body of terent multilatwo differen

mbers are par

cisions made re membersh

nference, whiO's main act

negotiat(import governinantidum

adminisagreed rintellect

monitorwell as eagreeme

settling and appl

buildinginternati

assistingnot yet m

ome 700 staffcated in Genevernments. Aa whole, eithyears) or by

neva).

WTO’s funcuay Round anTariffs and Tr

ons, under thvides a forumto settle trad

governmentsach other. He

WTO does is faced trade bave helped to oes negotiatedvide the legalments to keepalso providesand monitor arising fromtrade agreem

ateral agreemnt plurilateralrties).

in the WTOhip. The highich meets abtivities are:

ting the reductariffs, otherng the condu

mping, subsid

tering and mrules for tradtual property

ring and revieensuring tranents

disputes amolication of th

g capacity of ional trade m

g the processmembers of t

f, led by the Weva, Switzer

All major tradher by ministtheir ambass

ctions come fnd earlier nerade (GATT)he ‘Doha Dem for membede disputes. Es try to sort oence, WTO wthe result of

arriers and wopen marketd and signed l ground rulep their trade ps a legal and ring of these m their interpments compriments (to whi

l agreements

O are commonhest institutioout every tw

ction or elimr barriers to tuct of internadies or produc

monitoring thde in goods, ty rights

ewing the transparency of

ong our memhe agreement

f developing matters

s of accessionthe organisat

WTO Directrland. WTO ide decisions aers (who ususadors or del

from the 198gotiations un). The WTO

evelopment Aer countries tEssentially, thout the trade iwas born outf negotiationswanted them s for internatthe WTO ag

es for internapolicies withinstitutional trade agreem

pretation and ising the WTch all WTO

s (to which o

nly taken by onal body is

wo years. Mor

mination of obtrade) and agational trade ct standards.

e applicationtrade in servi

ade policies of regional and

mbers regardits

country gove

n of some 30tion

tor-General. is run by its mare made by ually meet at legates (who

86-94 negotiander the Gen is currently

Agenda’ launto negotiate the WTO is aissues or prot of negotiatis. For examplowered, thetional trade. greements, thational trade hin agreed limframework f

ments, as welapplication.

TO comprisedmembers arenly some WT

consensus othe Ministerre specificall

bstacles to trgreeing on ru(for example)

n of the WTOices and trad

of our membd bilateral tra

ing the interp

ernment offi

0 countries w

The member the least meet

ations neral

the host nched in trade a place oblems ions, and ple, when e Once the

he and mits. for the ll as for The d of 16 e parties) TO

of the ial ly, the

rade ules e,

O’s e-related

bers, as ade

pretation

cials in

who are

The borddisccomopenexcesustfosteaccoto ecaspi

conducttrade da

explainimission

founding anders, the guarcriminatory trmmitment to tning of natioeptions or wiainable deveer peace andompanied byconomic devirations.

ing economiata in support

ing to and edand its activ

nd guiding prrantee of moreatment by transparency

onal markets ith adequate elopment, incd stability. Aty sound domevelopment ac

C5

ic research ant of the WTO

ducating the pvities.

rinciples of Wost-favoured-and among c

y in the impleto internatioflexibilities,

crease peoplet the same timestic and inteccording to e

Economic Env

nd collectingO’s other mai

public about

WTO remain-nation princcountries meement of its aonal trade, wi will encourae’s welfare, rme, such marernational poeach member

vironment of B

g and dissemin activities

the WTO, it

n the pursuit ciple and nonembers, and aactivities. Thith justifiableage and contreduce poverrket opening

olicies that cor's needs and

Business

317

minating

ts

of open n-a he e tribute to rty, and

g must be ontribute

Module 5

318

Modu

ule sum

Summary

mmary

In th

Whebankexchon itin thcurrman

Net balaexchsurfacapineut

Exchauthexpeshiftequiinco

DefigovestimbudgExpinduservchan

The RicaspecComHeckby foquot

his module y

en currency ik must intervhange rate frots supply of fhe foreign exency. When

naging its cur

exports (the ance plus the hange rates, pface. Impendiital flows, witralise the thr

hange rate flhorities no leserienced by ct the demandilibrium poinome growth d

icit countriesernment spen

mulate importget policies. enditure-swi

uce a switch ivices. Two sunges.

theory of coardo showed cialisation in mparative advkscher-Ohlin

focusing on thtas and expor

you learned:

is not allowevene in the foom changingforeign exch

xchange markthis is done,

rrency (mana

trade balancprivate secto

problems reling deficits oill bring aboureatened imb

luctuations mss acute thancountries witd and supply nt are inflatiodifferences a

s can ease thending or encot demand andThese are re

itching policiin spending b

uch policies a

omparative adthat both trathe good in

vantage hingn theorem buhe different frt subsidies a

ed to vary (fixoreign exchag. This is donhange reserveket to smooth the central b

aged float).

ce) are equal or balance. Inlating to balaor surpluses,ut exchangebalance.

may, howevern the balanceth a fixed exccurves for a

on differenceand exchange

eir balance oouraging savd reduce the eferred to as eies refer to pbetween tradare: commer

dvantage proading partnerwhich they h

ges on the nouilds on the tfactor endoware examples

xed exchangange market tne by the cenes. A central hen fluctuatibank is said t

to the govern a world of

ance of paymif not matchrate fluctuati

r, raise diffice of paymentschange rate rparticular cu

es, interest rae rates expect

of payments bving. Surplussurplus throuexpenditure-

price incentivded and non-cial policy an

ovides the ratrs could benehave the comtion of oppo

theory of comwments of cos of trade bar

ge rates), the to prevent thntral bank’s dbank can intons in its natto be involve

rnment sectorf freely floatinments are unlihed by offsettions which w

culties for thes difficultiesregime. Facturrency and tates differenctations.

by curbing ns countries caugh expansio-changing poves designed traded goodsnd exchange

tionale for frefit from

mparative advrtunity cost.

mparative adountries. Tarirriers.

central he drawing tervene tional ed in

r ng ikely to ting

will

e tors that the

ces,

net an onary olicies.

to s and e rate

ree trade.

vantage. The vantage iffs,

Assig

A

gnment

Assignment

t

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20.

What is the e

What are theexchange ratactual excha

How do purcexchange rat

How can the

What is the cthe relations

How is a cur

What is real

What causes

What are the

What is the p

What is a “m

How does th

What is a defrom a depre

How does mdemand and

What are exp

What is com

Why does tr

What are terreal exchang

Name the tra

List the adva

exchange rat

e influences ote on the dem

ange rate in th

chasing powte expectatio

e Bank of Ca

current accouship between

rrent account

exchange ra

s a real appre

e long-run de

purchasing p

managed floa

he central ban

evaluation? Weciation and

monetary polioutput?

penditure ch

mparative adv

rade benefit a

rms of trade age rates?

ade barriers t

antages and d

C5

te and how is

of interest ramand for, andhe foreign ex

wer parity andons?

anada influen

unt and whatn these two ac

t deficit finan

ate? How is i

eciation of a

eterminants o

power parity

ating rates of

nk maintain

What is a revappreciation

icy influence

hanging and e

vantage?

all trading pa

and how are

that are comm

disadvantage

Economic Env

s it determin

ates and the ed supply of dxchange mar

d interest rate

nce the foreig

t is the capitaccounts?

nced?

it calculated?

currency?

of the exchan

rate of excha

f exchange” s

a fixed exch

valuation? Hon?

e the exchang

exchange rat

arties?

they related

monly used i

es of trade pr

vironment of B

ed?

expected futudollars as werket?

e parity affec

gn exchange

al account? W

?

nge rates?

ange?

system?

hange rate?

ow are they d

ge rate, aggre

te switching p

to the conce

in your coun

rotection.

Business

319

ure ell as the

ct

market?

What is

different

egate

policies?

ept of

ntry.

Module 5

320

Asse

A

essmen

Assessment

t

1.

2.

3.

4.

5.

6.

In what wayservices that

Which of thenot? In each

A. Cars

B. Com

C. Hair

D. Rest

Does your cabout your cthe perspectCan you exp

For each trancountry’s cupayment:

A. A do

B. A fo

C. A do

D. You

For each trancountry’s capayment:

A. A fo

B. YouYor

C. An A

D. A fonew

E. You

Consider the

ys do importst you have us

e following gh case, explai

s

mputers

rcuts

taurant meal

ountry’s curcountry’s capive of the indplain your fin

nsaction belourrent accoun

omestic fabr

oreign bank i

omestic resid

u send funds

nsaction beloapital accoun

oreign compa

ur neighbour rk Stock Exch

American pu

oreign giant mwspaper.

u open an acc

e following h

s affect your sed recently.

goods and sein your answ

s

rrent accountpital accountdividual comndings?

ow, identify nt and wheth

ric dealer buy

is paid intere

dent spends h

to relatives l

ow, identify nt and whethe

any opens a

buys 1,000 Mhange.

urchases a bo

media comp

count in a Eu

hypothetical

life? (Think )

ervices are trawer briefly.

t show a defit? What is themponents of t

where it appher it is classi

ys fabrics fro

est by your g

her holidays

living abroad

where it apper it is classif

chain of stor

Microsoft sh

ond issued by

any takes ov

uro-bank in U

economy.

of imported

adable, and w

cit or a surple situation lithe current ac

pears on yourified as a rec

om abroad.

government.

abroad.

d.

pears in your fied as a rece

res in your co

hares on the N

y your gover

ver your natio

U.S. dollars.

d goods or

which are

lus? How ke from ccount?

r eipt or a

eipt or a

ountry.

New

rnment.

onal

Bala

Cur

M

Tr

Inv

Tr

Cap

Po

Di

Ot

7.

ance of Paym

rrent Accou

erchandise tr

rade in servic

vestment inc

ransfers

pital Accoun

ortfolio inves

irect investm

ther capital f

A. Fill

B. Calc

C. Calc

D. Doe

In Yorktoniaare given as

Price of US(in Yorktoncurrency)

A. Sketon t

B. If thvalu

C. If inUS$the U

D. Doeat th

ments Accou

nt

rade

ces

come

nt

stment

ment

flows

in the blanks

culate the cu

culate the cap

es the balanc

a, the foreignfollows:

S dollars nia’s

0.1.70

0.1.65

0.1.60

0.1.55

0.1.50

tch the demahe informati

he exchange ue of the U.S

nstead the go$1.65, will thU.S. dollar in

es Yorktonia his target exc

C5

unts (in $mi

Receipts

183.4

187.9

192.3

_______

_______

32.7

_______

s.

urrent accoun

pital account

e of paymen

n currency’s

Quantity Dollars Su

($ billionyear)

and and suppion provided

rates were flS. dollar be in

overnment sehere be an exn terms of th

face a balanchange rate?

Economic Env

illions)

Paymen

4 323

9 _____

3 157

_ 24

_ 65

7 45

_ 15

nt balance.

t balance.

nts balance?

demand and

of US upplied

s per )

D

75

65

55

45

35

ply of the USabove.

lexible, whatn terms of ou

t a target excxceed demanhe local curre

nce of payme

vironment of B

nts Balan

3.6 ___

___

7.9 ___

4.5

5.9

5.8 ___

5.2

d supply sche

Quantity oDollars Dema

billions per

S dollar curve

t would the mur local curre

change rate od or excess sency?

ents surplus o

Business

321

nce

_____

+ 90

_____

+ 32

− 20

_____

+ 22

edules

of US anded ($ r year)

35

45

55

65

75

es based

market ency?

of supply of

or deficit

Module 5

322

8.

9.

10.

E. Calcin Y

For each of show the effcurrency:

A. A cocent

B. Domthe U

C. Amfina

Assuming thand French wprice of a mexchange rabetween Ho

A. A Fwin

B. A Fwin

C. A Fwin

Home, whosyear 2002:

Imports of

Exports of

Borrowing

Lending to

Increase incurrency

A. Calc(thecapi

B. Basinter

C. Doepaym

culate the “chYorktonia’s b

the followinfect on the pr

ontractionarytral bank in w

mestic real ouU.S. is fallin

ericans find ancial investm

hat the only gwine and alsetre of cloth te (the price me and Fran

rench franc ie in France i

rench franc ie in France i

rench franc ie in France i

se currency i

Item

goods and s

goods and s

from the res

o the rest of th

n official hold

culate the thr trade accounital account b

ed on this inrvene in the

es this countrments? Why

hanges in ofbalance of pa

g cases, drawrice of the U

y monetary pwhich it raise

utput rises atng.

your countryments.

goods in the o assuming tis H$5 (5 Hof foreign g

nce when:

is worth H$0is 25 francs.

is worth $0.2is 30 francs.

is worth H$0is 30 francs.

is H$, condu

m

ervices

ervices

st of the worl

he world

dings of fore

ree balance ont balance, cbalance) for

formation, dforeign exch

ry face a defiy?

fficial reserveayments acco

w a demand aU.S. dollar in

policy initiatees the domes

t a time when

y a more attr

world are Hthat in the hoome dollar). oods in term

0.20, and the

20, and the p

0.25, and the

cted the follo

(

ld

eign

of payments current accouHome.

does Home’s hange market

icit or a surp

es” that woulounts.

and supply gterms of dom

ed by the domstic interest r

n the real out

active place

ome countryome country,Determine t

ms of domesti

price of a bo

rice of a bott

price of a bo

owing transa

(Billions of H

accounts balunt balance a

central bankt?

lus in its bal

ld appear

graph to mestic

mestic rate.

tput in

to make

y’s textile , the the real ic goods)

ottle of

tle of

ottle of

actions in

H$)

350

500

60

200

10

lances and

k

ance of

12.

13.

14.

15.

16.

17.

18.

19.

Suppose thathe price lev

A. Wha(the[Hinof a

B. Wharose

C. Comapprperc

Suppose thainterest rate exchange raand the expe

A. Howearnyear

B. Ignopref

C. Whathe H

Under what balance of tr

How would transactions years?

What, if anysurplus tell u

How would some of the balance of p

What are somof strategic t

Which of theconomicall

A. The

B. Imp

C. Prod

D. Dom

at it takes fivevel in France

at is the real price of Frent: First, calcfranc in doll

at would hape to eight Fre

mparing yourreciation or centage?

at the interestin Foreign cte, H$ (Homected nomina

w many H$ wn for each Hor?

oring risk anfer to invest i

at is the expeHome dollar

circumstancrade surplus

you explain relative to m

ything, does tus about the

you define beconomic fo

payments to e

me argumentrade policy?

e following ily inefficient

government

ports rise, and

ducers are sa

mestic prices

C5

e French franis 1.2, and th

l exchange raench goods inculate the nomlars.]

ppen to the reench francs?

r answers in a real deprec

t rate in Homcountry (F) is

me dollar) prial exchange r

would a residome dollar in

d transactionin Home or F

ected rate of r?

ces could a coand a curren

the rapid gromerchandise

the fact that strength of t

balance of paorces that tenequilibrium.

nts that could?

is correct? Tt because

t does not co

d this reduce

aved from the

s must be red

Economic Env

ncs to buy onhe price leve

ate between Cn terms of Caminal exchan

eal exchange

parts (a) andciation of the

me country (Hs 1 per cent, ce of a F$ (Frate next yea

dent of Homenvested in Fo

n costs, shouForeign bond

appreciation

ountry simulnt account de

owth in capittrade transac

a country hahat economy

ayments disend to automat

d be made for

Tariffs and qu

ollect any rev

es the welfare

e pressure of

duced.

vironment of B

ne Canadian el in Canada

Canada and Fanadian goodnge rate as th

e rate if the d

d (b), is this ae dollar? Wh

H) is 5 per cethe current n

Foreign dollaar is 0.011.

e country exporeign bonds

ld a Home reds?

n or deprecia

ltaneously haeficit?

tal account ctions in rece

as a current ay?

equilibrium? tically restor

r and against

uotas are

venues under

e of consume

f foreign com

Business

323

dollar, is 1.5.

France ds)? he price

dollar

a real hat is the

ent, the nominal ar) is 0.01

pect to for one

esident

ation of

ave a

ent

account

Discuss re the

t the use

r a tariff.

ers.

mpetition.

Module 5

324

20.

21.

22.

Refer to the shows the po

Home

Foreign

Home—

A. has

B. has

C. has

D. shou

The opportu

A. 1/2

B. 2 m

C. 6 m

D. 12 m

Which of th

A. Fore

B. HomFore

C. TheHom

D. Themetr

following taossible level

Wheat

absolute adv

an absolute a

a comparativ

uld export cl

unity cost of

metre of clot

etres of cloth

etres of cloth

metres of clo

e following s

eign has an a

me should exeign.

opportunityme.

opportunityre of wheat.

able to answes from one d

t (cubic metr

12

1

vantage in th

advantage in

ve advantage

loth to Foreig

one cubic m

th.

h.

h.

oth.

statements is

absolute adva

xport wheat t

y cost of whe

y cost of a me

er three quesday of labour

res) Clo

e production

n the product

e in the produ

gn.

etre of whea

s wrong?

antage in wh

to Foreign an

at is twice as

etre of cloth

tions. The tar input.

oth (metres)

6

12

n of cloth.

tion of wheat

uction of clo

at in Foreign

heat.

nd import clo

s high in fore

in Home is o

able

t.

oth.

is

oth form

eign as in

one cubic

Asseessmen

t answe1.

2.

3.

4.

5.

6.

ers Imports areproduced elwell-being not only proquality than

Answers ar

A. Trad

B. Tradbecainsu

C. C antravwellhair

The answer

Answers ar

A. Impmer

B. Theaccoand

C. Travpaym

D. Senclas

Answers ar

A. A fois a your

B. Thetran

C. An Aport

D. A foinve

E. Opeand

Answers ar

A. Cur

M

e important inlsewhere. Cand the standoduct varietyn those produ

re:

deable.

deable. Bothause transacturmountable.

nd D are impvelling to a dil as transactircutter and th

r is a function

re:

port of fabricrchandise acc

payment of ount transactis classified

velling abroament.

ding funds tosified as a pa

re:

oreign compaforeign direcr perspective

purchase ofnsaction and a

American putfolio investm

oreign takeovestment and a

ening an accoa payment, f

re:

rrent Accou

Merchandise t

C5

n that they aronsumption dard of liviny for differenuced domesti

h A and B artion costs and

possible to trifferent counion costs of ihe restaurant

n of your cou

s is an imporcount) and is

f interest by ttion under thas a paymen

ad is a servic

o relatives abayment.

any opening ct investmene.

f 1,000 sharea payment.

urchasing yoment and a re

ver of your na receipt.

ount in a Eurfrom your pe

nt

trade

Economic Env

re consumer per capita isg of a nation

nt tastes but aically.

re the same ind barriers to

ade since trantry to get a hmporting themeal, are pr

untry of choi

rt of goods (gs a source of

he governmee net flow ofnt.

ce account tra

broad is a tra

a chain of stnt and classifi

s of Microso

ur governmeeceipt.

newspaper is

ro bank is a perspective.

Balance

vironment of B

items that ars the best mean. Also, impoalso, at times

n this respecttrade are not

ansaction coshaircut or dine service of tohibitive.

ice.

goods or payment.

ent is a curref investment

ansaction and

ansfer item an

tores in yourfied as a rece

oft is a portfo

ent securities

a foreign dir

portfolio inve

e (−$140.2) m

Business

325

re asure of orts offer s, better

t, t

sts of ne, as the

ent-income

d a

nd

r country ipt, from

olio

s is a

rect

estment

million

Module 5

326

7.

8.

T

In

T

Cap

P

D

O

B. Curr

C. Cap

D. No. officare n

Answers a

A.

B. E =

C. At 1

D. Yorbilli

E. At 1will

Answers ar

A. As ieconfore(an

Trade in servi

nvestment in

Transfers

pital Accoun

ortfolio inve

Direct investm

Other capital

rent Accoun

pital Account

The gap, $5cial reserves no errors or

are:

$1.60

1.65 there wi

rktonia faces ion.

1.65 rate of el appear as (−

re:

interest ratesnomy from aeign currencyappreciation

ices

ncome

nt

estment

ment

flows

t Balance: +

t Balance: −$

5.1 billion, mtransactions

statistical dis

ill be an exce

a surplus, at

exchange, the−20 billion) i

rise, capital abroad, indicy. This causen of domestic

Paymen

Balance

Receipt

Receipt

Balance

Receipt

16.2 million

$11.1 million

must be due ts (not shown)screpancies.

ess supply of

t this rate of

e excess suppin the officia

flows into thating an incres a decreasec currency).

nts ($97.9) m

e ($34.4) mil

s ($56.5) mil

s ($45.9) mil

e (−$13.1) m

s ($37.2) mil

n.

n.

o the change), assuming t

f US$, AB.

exchange, of

ply of $20 bial reserves ac

he domestic rease in suppe in the exch

million

lion

llion

llion

illion

llion

es in that there

f $20

illion ccount.

ply of ange rate

9.

B. Theand impdemThedemof oThehom

C. Foreincrincrmar

Real exchan

prices respeof foreign c

A. Rea

B. Rea

C. Rea

increase in dservices by orted goods

mand for fore decrease in

mand for our our goods and combination

me currency).

eign (Americreases demanrease in the surkets. The ex

nge rate = E

ectively, andcurrency.

al exchange r

al exchange r

al exchange r

C5

domestic outdomestic resand servicesign currencyforeign (Amcurrency as Ad services (thn of the two .

can) capital fnd for your cuupply of the xchange rate

P

PE *.where P

d E, as before

rate = *.

P

PE

rate = 5

302. x

rate = 5

325. x

Economic Env

tput increasesidents, inclus (imports risy to increase merican) outp

Americans rhe supply curpushes E hig

flowing into urrency, whiUS dollar infalls. This is

P and P* are

e, is the dome

5

252.0

x

2.156

.15

5.70

vironment of B

es demand fouding demandse). This cau(a shift to th

put decreaseseduce their prve shifts to gher (depreci

your economich is the samn foreign excs the same as

e Home and F

estic price of

1

5.

Business

327

or goods d for

uses he right). s foreign purchase the left). iation of

my me as an change s part (a).

French

f one unit

Module 5

328

10.

11.

Pr

Pr

i

12.

13.

Answers ar

A. The(sur

Theinflosurp

Thecapi(defchanbilli

B. Yes(+10

C. ExcbalaAcc($−

Answers ar

A.

r

Canaofice

Frenofice

B. 5.1

2.1

C. Canbecaappr

Answers ar

A. Hominter

E

inve11¢

B. Forether

C.

E

CA balanceTherefore,

re:

Trade Accorplus).

Current Accow of net invplus (there is

Capital Accital outflow (ficit). The Cunges in holdiion.

. The increa0) indicates t

luding the ofance of paymcount ($150) 140) = $10. T

re:

goodsdian

goodsnch

1.81 x

nadian dollar ause at givenreciated (from

re:

me rate of retrest rate +

01.

E

Ee

ested in forei.

eign return, 1refore, Foreig

10

E

Ee

e = Trade balCA balance

ount Balance

count Balancvestment incno informat

count Balanc(payments) =urrent Accouings of reserv

ase in officialthe central ba

fficial holdinments is net o

and the defiThat is, it sho

5.1

2.1

nx

has apprecian prices, the nm $1 per ff 5

turn = 5%, F

01.

01.011.1

ign bonds yo

11%, is greatgn bonds sho

% .

lance + net incan be negat

= (500 −350

ce = Trade acome = $150 tion on the la

ce = capital in= ($60) − ($2unt Balance, ves, = (60) −

l holdings ofank’s interve

ngs of foreignof the surpluscit in the Capows a an ove

min exalno

ated in real tenominal exch5 to $1 to 8 f

Foreign rate o

%.1111.

ou should exp

ter than Homould be prefe

nflow of invtive (deficit)

0) = + $150 b

ccount balan+ 0 = $150 b

atter here).

nflow (receip200) = −$14including the− (210) = $−

f foreign currention.

n reserves, ths in the Currepital Accounerall surplus.

ratechange

erms. This ihange rate

ff).

of return = fo

. For every

pect 11% retu

me return, 5%erred.

estment incodespite a tra

billion

nce + net billion

pts) − 40 billion e 150

rency

he ent nt .

5.1

24.)2.0( e

s so

oreign

H dollar

urn =

%,

ome. ade

16.4

14.

15.

16.

17.

18.

19.

20.

21.

surplus if thbigger than

The onslaugmovementspart of the wgreater thanopportunitiopportuniti

A current acountry shointernationaout.

When the sfrom zero, pcentral authforeign exchappens, hocentral bankmovement receipts andtend to elimpayments.

It is sometimassume priofirms show retaliation b

Discuss you

A. Home ha

D. (12 metr

A.

he second tern the trade ac

ght of compus that have acworld now bn the flow ofes are enormes.

account surplowing a surpal payments

um of the cupayments dohority to stepchange markeowever, whek aims to maof the exchad payments (

minate this ga

mes difficultor governmepotential. A

by the trade p

ur answer wi

as an absolut

res of cloth).

C5

rm on the rigcount surplu

uterization teccelerated so

benefits fromf trade in goo

mous compare

lus is a sign olus need not are covered

urrent and capo not match rp in to bridgeet known as n the exchan

anage its currnge rates in r(excess demaap, restoring

t to justify stnt knowledg

Also, such popartners. Thi

ith your tutor

te advantage

Economic Env

ght-hand sideus.

ends to enhano rapidly in th

m unrestrictedods and servied to newly

of a clean bilborrow exteand there rem

pital accountreceipts and te the gap, a trchanges in o

nge rates are rency. Underesponse to tand/excess suequilibrium

trategic tradege as to whicholicies are invis is controve

r.

e in wheat.

vironment of B

e shows a def

nce the freerhe last decad

d capital flowices. Investmexplored trad

ll of health. Ternally. All mains money

t surplus is dthere is a neeransaction inofficial reserv

fixed or wheer flexible ratthe gap betwupply of currin balance o

e policies, sinh industries vitation for ersial.

Business

329

ficit

r capital de. A big w far ment de

The

y to lend

different ed for the n the ves. This en the tes, the

ween rencies)

of

nce they and

Module 5

330

Referreadi

R

rences ings

References

and su

Bald

Ban

Ban

Barr

Boa

Bran

Cas

Che

Dor

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w splits worksian Onlinecom/minimu

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flights to CStar Online, ory.asp?file

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s/index.htm.

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