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
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