ToT = Terms of Trade

A country's terms of trade (ToT) is the weighted average of its average export prices over it's average import price times 100.  A value of 100 means the prices for both are the same, but if in the next year the country sees a ToT of 103, that means the country's exports now buy 3% more than what they did the year before and we've seen an improvement in the terms of trade.  Conversely, if the number is 97, then the country's exports can now only buy 97% of what they could wth their exports.  This is a deterioration of a country's terms of trade. 


Why do ToT's change?
In the SR...
- forces of supply and demand for exports
- relative inflation increases or decreases
- exchange rate fluctuations

In the LR...
- consumer incomes
- improvement in worker/FoP productivity

PED for exports: %∆ demand for exports / %∆ average price of exports
- if elastic, good for when export prices are falling (bigger change in demand, more export revenue)


PED for imports: %∆ demand for imports / %∆ average price of imports
- if inelastic, bad for when export prices are falling (smaller change in demand, less revenue)

Interesting article : Coping with Terms-of-Trade Shocks in Developing Countries (please read and evaluate)

Marshall-Lerner Condition and J-Curve

The Marshall-Lerner condition states that a country's depreciation/devaluation on its currency will cause exports to increase, imports to decrease, and thus an improvement in its current account (usually from deficit to surplus).  For this to occur, PED of exports plus PED of imports must be greater than one (because demand needs to be elastic for the process of going from deficit to surplus to work...think logically).  Here is the J-curve which simply shows this condition graphically:

The J-curve shows us what would happen over time if a government devalued/depreciated its currency over time.  As first, because the value of the currency would be immediately lowr, the capital account would actually worsen as less money would come in for exports.  This is the downward-sloping part of the J-curve.  However, over time, foreigners would notice these exports are cheaper and the domestic consumers/firms would notice imports were more expensive, so the balance of trade would improve theoretically until the deficit was replaced by a surplus (moving up the curve to the right).

Mmm BoP! Balance of Payments

The balance of payments, comprised of the current account and the capital account (and an error value), is a means of accounting transactions between one country and all other countries with whom it trades.  "The Economist web site defines this term as "the total of all the money coming into a country from abroad less all of the money going out of the country during the same period."

The current account is the balance of trade (X-M) + net factor income (interest/dividends) + net transfer payments (i.e. foreign aid), and "The Economist" web site states "the current account includes:

*visible trade (known as merchandise trade in the United States), which is the value of exports and imports of physical goods;

*invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;

*private transfers, such as money sent home by expatriate workers;

*official transfers, such as international aid".

The capital account includes the net purchase and sale of all assets between countries.  As per the famous "The Economist" web site : "The capital account includes:

*long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;

*short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies."

Simplified example of US (2005) BoP (from FTE Program Curriculum) :

CONSEQUENCES...of a current account deficit

- countries use reserves of foreign currencies to control current account deficits, but these may run out even for the largest economy.
- if foreigners are investing largely in a country and that country's people are buying foreign g/s, then the country is susceptible to changes in foreign behavior which could turn sour.  Furthermore, foreigners can have considerable economic power over the country (i.e. China and US).
- if countries borrow from abroad with high-interest loans, then they can end up owning other countries billions of dollars.  This can lead to instability and possible default which would wreak havoc on the economy.

CONSEQUENCES...of current account surpluses

-a country with a current account account surplus funded by sales of its g/s may face a surge in protectionsist practices from those with current account deficits.
- a current account surplus tends to correspond with currency appreciation (see post on advantages and disadvantages of a strong currency). 

From "The Economist" web site:

"As bills must be paid, ultimately a country's accounts must balance (although because real life is never that neat a balancing item is usually inserted to cover up the inconsistencies).

A"Balance of payments crisis" is a politically charged phrase. But a country can often sustain a current account deficit for many years without its economy suffering, because any deficit is likely to be tiny compared with the country's national income and wealth. Indeed, if the deficit is due to firms importing technology and other capital goods from abroad, which will improve their productivity, the economy may benefit. A deficit that has to be financed by the public sector may be more problematic, particularly if the public sector faces limits on how much it can raise taxes or borrow or has few financial reserves.

For instance, when the Russian government failed to pay the interest on its foreign debt in August 1998 it found it impossible to borrow any more money in the international financial markets. Nor was it able to increase taxes in its collapsing economy or to find anybody within Russia willing to lend it money. That truly was a balance of payments crisis.

In the early years of the 21st century, economists started to worry that the United States would find itself in a balance of payments crisis. Its current account deficit grew to over 5% of its GDP, making its economy increasingly reliant on foreign credit."

Video: Exchange Rates

Exchange Rates....that'll be 10,000 Japanese yen please?!

An exchange rate is the value of one currency in terms of another.  For example, as of May 9, 2010, 1CHF (Swiss franc) = € (EU euro) 0.71.  The graph above shows the floating exchange rate of CHF as expressed in EUR as of May 2010.  In such a floating / mixed exchange rate regime, the value of the currency is allowed to be determined by the market forces of supply and demand as determined on the foreign exchange market.  In this case, it is the demand for CHF in terms of euro.  The demand curve is downward-sloping representing the demand for CHF by Europeans in the Eurozone (or people holding EUR).  The supply curve is upward-sloping and represents the supply of CHF which comes from Switzerland.  The equilibrium price, the exchange rate, is CHF1 = .71 EUR.  If the value of a currency in a floating exchange rate increased (i.e. CHF1 = 1.00 EUR), then we would say the CHF has appreciated.  On the flip side, if the value decreased, it has depreciated.  Changes in the value of currency depends on different factors and would be represented by a shift in demand or supply curves.  Factors that affect the value of the currency include an increase in exports bought by Europeans, an increase in European investment in Switzerland, an increase in European saving in Swiss banks, an interest to speculate on the value of the CHF.  

What increases the demand for a currency, i.e. Russian ruble (rightward shift in D)?

- an increase in demand for Russian g/s

- lower rates of inflation in Russia compared to other countries with similar products

- foreigners make more money, so they demand more of all g/s, including Russian ones

- foreigners develop tastes/preferences for Russian g/s

- Russian investment prospects improve and the interest rate increases (more savings)

- speculators believe the RUR will appreciate in the future, demand more now to make money (buy low, sell high)

What decreases the demand for a currency, i.e. Indian rupee (rightward shift in D)?

- Indians demand more foreign g/s

- higher rates of inflation in India compared to other countries with similar products

- Indians make more money, so they demand more of all g/s, including foreign ones

- Indians develop tastes/preferences for foreign g/s

- Foreign investment prospects improve and the interest rate decreases relative to other countries (less desire for domestic savings)

- speculators believe the INR will depreciate in the future, demand les

More generally, there are three different types of exchange rate regimes : floating, managed (mixed) and fixed.  In a floating exchange rate regime, the value of the one currency in terms of another is determined solely by the forces of supply of and demand for that currency.  Here, if the value goes up, the currency has appreciated, and if it goes down, it has depreciated.  Conversely, in a fixed regime, the exchange rate is determined by the government (or a governmental body).  If this currency gets stronger, it has revalued and if it has gone down, we say it has devalued.  In the middle, where exchange rates are allowed to float but are "managed" if their value goes too low or too high, then we have a managed exchange rate regime.  Managed towards floating is what most currencies are today.  

ADVANTAGES                  DISADVANTAGES

...of a high exchange rate (currency is strong compared to others)

- inflation is pushed downwards - export industries lose because their

because imports, FoPs cheaper   g/s become more expensive, U up

- purchasing power for imports     

strengthens                                  - domestic producers in general can

- domestic producers must be      lose because domestic consumers

more efficient to compete with    may switch to cheaper imports;

foreign producers, we win!          unemployment (U) may go up

...of a low exchange rate (currency is weak compared to others)...JUST REVERSE THOSE ABOVE FOR A STRONG CURRENCY!!!

          

 Let's continue...

ADVANTAGES                 DISADVANTAGES

...of a fixed exchange rate regime

 - very predictable (b/c    - may see unemployment through ∆i

fixed) means easier to do - hard to do, thus very inefficient because

business with respect to    market can't clear

exchange rate costs           - the government must be

of inflation because it       mindful  - needs large foreign reserves

could destroy the              to maintain rate

macroeconomy,               - can make other countries angry

so low inflation                (i.e. US v. PRC)

 - its hard to speculate 

on a fixed rate!

ADVANTAGES                      DISADVANTAGES

...of a floating exchange rate regime

- ∆i can be used as a tool to "fix"  - can create uncertainly (S and D)

economy depending on problem   - may see unemployment through ∆i

- easier to manage balance           - can be attacked by speculators

of payments                                  - can make inflation worse (if high)

ADVANTAGES                      DISADVANTAGES

...of a single currency (ie. €)

- cuts transaction costs             - country must follow union

- more certainty in value          monetary policy (i.e. no control i)

- easier to compare prices       - can be expensive to switch from

- more FDI (easier to do         one currency to another

business)                                 - hard to fight BoP deficit

purchasing power parity (PPP) theory : a theory states that different floating currencies will, over time, adjust until one unit of currency can buy the exactly the same amount of products as one unit of another currency.  "The Economist" web site defines the term as "a method for calculating the correct value of a currency, which may differ from its current market value [which...] is helpful when comparing living standards in different countries, as it indicates the appropriate exchange rate to use when expressing incomes and prices in different countries in a common currency."

PPP Map from Wikipedia :

From 2003 and using USD as the base currency, this map shows us how much more expensive (reds and oranges) or less expensive (yellows and below) the exact same basket of g/s is in the country (i.e. Scandinavian prices for the exact same basket of g/s are more than 20% higher than in the US, whereas Mexico's basket is 70% of the price of the American basket so 30% less).

Click here to discover The Economist's "Big Mac Index"!

Video: GATT/WTO

Globalization and Economic Integration

As globalization continues, countries are joining together to form trade blocs to lower or eliminate trade barriers and to try to accede to the WTO (see post).  A trade bloc is an agreement between nations to create a “free trade area” of varying integration that is formed through international agreements (i.e. treaties) and/or with intergovernmental organization help to reduce of eliminate different forms of protections.  Please see my Model United Nations blog for further information on international relations: http://schmidtmun.blogspot.com/.

There are six levels of trade areas, from the least extensive (the Preferential Trade Area) to the most extensive (complete economic integration).

1. Preferential Trade Area (PTA): a trading bloc giving preferential treatment for some g/s between some countries/groups of countries (i.e. EU and ACP countries, India and Afghanistan).

2. Free Trade Area (FTA): a trading bloc comprised of countries that have agreed to eliminate tariffs, quotas and preferences on most (if not all) g/s between them (i.e. North American Free Trade Area (NAFTA) between Canada, the US and Mexico).  However, the countries can have different external tariffs to non-members.

3. Custom Union (CU): an FTA with a common external tariff (i.e. MERCOSUR in much of South America, CARICOM in the Caribbean).

4. Common Market (CM): a CU with free movement of FoPs (specifically capital and labor) and unified policies on product regulation (i.e. the European Union).

5. Economic and Monetary Union (EMU): a CM with a single market and common currency (i.e. 16 countries of the Eurozone, West African EMU and the West African CFA franc).

6. Complete economic integration i.e. think of the US from colonial times to today

trade creation: the advantage of a country joining (at least) a customs union as specialization according to comparative advantage from high-cost producers to low-cost producers occurs.

Graph Analysis:
In this example, we address what happens to Slovenia when it joins the European Union.  Before joining, Slovenia faced an EU tariff on beef (P-EU+Tariff).  When Slovenia joined the EU, the tariff was eliminated, leading to a gain in the world efficiency lost before with the tariff (the orange triangle) and a gain in the consumer surplus also previously lost (green triangle).  If there were any g/s the Slovenes placed on the EU, those would also we eliminated.  A full-fledged analysis would include the full pre- and post-tariff situation with new labels (see tariff post).


trade diversion: the disadvantage of a country joining (at least) a customs union since the country may have to put tariffs on g/s from countries they previously traded with to adhere to the new agreement (low-cost to high-cost).

Graph Analysis:
In this example, we address what would happen if Albania entered at least a customs union with the European Union.  We assume Albania had an agreement with India by which they could purchase shirts at a price of P-India.  If Albania signs an agreement with the EU, they'll have to assume the EU's tariff on the Indian shirts (P - EU+T) which is a price higher than the EU price for shirts.  In this instance, Albania ceases to trade with India and, instead, purchases EU shirts beyond domestic production.  Therefore, the red trapezoid represents the loss of world efficiency (the left triangle and rectangle) and the loss of consumer surplus (the right triangle) enjoyed before the agreement.  A full-fledged analysis would include the full pre- and post-tariff situation with new labels (see tariff post).

World Trade Organization (WTO)

The World Trade Organization (WTO) is an intergovernmental organization based in Geneva, Switzerland that "deals with the rules of trade between nations at a global or near-global level."  Born in 1995 under the Marrakesh Agreement, the WTO continues the liberalization process started by the now defunct General Agreement on Tariffs and Trade (GATT from 1947) and is currently comprised of 153 countries.

Map (from Wikipedia, dark green = original member, light green = subsequent member) :

Please see this link for information on the WTO's structure and successes.
Please see this link for the pros and cons of the WTO.  They're pretty straight-forward and logical.

Video: Protectionism

Protectionism - Tariffs and Subsides and Quotas et al.

Protectionism, whose antonym is free trade, occurs when countries use techniques (formal or informal) to prevent or to make difficult imports coming into their border for sale.  There are several forms of protectionism.  A tariff is a tax on imports and is probably the best-known way countries use to stop free trade.  In fact, the other types of trade barriers are often referred to as non-tariffs barriers (NTBs)!  These include subsidies (assistance to domestic firms by the government to cheapen production), quotas (a numerical limit of the amount of imports that can enter), and government policies such as health and environmental standards which work to keep foreign g/s out. 

There are several reasons for protectionism (can be evaluative when pros and cons are discussed):
- assist domestic producers (and thus "save" jobs and ensure votes?)
- protect an infant industry
- combat dumping and low cost labor from abroad
- make money for the government
- avoid over reliance on too few industries
- have important products in case of emergency
- fix balance of payments deficit
- protect domestic consumers against dangerous imports

Tariff:

Graph Analysis:
If this country (Domestic) were closed to trade, equilibrium would occur at a price of Pe and a quantity of Qe for corn.  However, when the country opens itself to uninhibited free trade, the country benefits from a global supply of corn, much of which is produced at a lower cost (and thus a lower price) from foreign producers.  In this situation, the domestic producers produce 0Q1 corn and foreign produces make the rest, Q1Q2.  Both groups of producers accept a price of Pworld, and by multiplying price by quantity, we see domestic producers earn box a and foreign producers earn b, c, d and e.

Let's now assume the domestic government imposes a tariff on foreign corn to protect its own producers.  The supply curve Sworld shifts up the value of the tariff to Sworld+Tariff and the new price is Pworld+Tariff.  When this occurs, moving up along the domestic supply curve, we observe domestic producers produce 0Q3.  Because these firms are more inefficient than the foreign producers who can produce more cheaply, we identify box h as a loss in world efficiency.  Moreover, we also have to move backwads up along the demand curve because the price has changed, showing us that foreign producers produce Q3Q4 since Q4Q2 is now lost.  This represents a loss of consumer surplus (see relevant post) and is labeled k.  As for earnings, the domestic producers now make a, b, f, g, h and foreign producers make c, d.  The domestic government receives i, j as tariff (tax) revenue from the foreign producers.  The combination of losses in world efficiency and consumer surplus together are called a deadweight loss of welfare because they make some people worse off.

Subsidy:

Graph Analysis:
If this country (Domestic) were closed to trade, equilibrium would occur at a price of Pe and a quantity of Qe for barley.  However, when the country opens itself to uninhibited free trade, the country benefits from a global supply of barley, much of which is produced at a lower cost (and thus a lower price) from foreign producers.  In this situation, the domestic producers produce 0Q1 barley and foreign produces make the rest, Q1Q2.  Both groups of producers accept a price of Pworld, and by multiplying price by quantity, we see domestic producers earn box a and foreign producers earn b, c, d.

Let's then assume the domestic government assists its producers by given them a subsidy (financial aid to domestic producers of g/s making production cheaper).  The supply curve Sdomestic shifts out the value of the subsidy to Sdomestic+Subsidy.  Domestic firms receive the new price Pworld+Subsidy.  When this occurs, moving up along the domestic supply curve, we observe domestic producers produce 0Q3.  The foreign producers supply the rest, Q3Q2 and earn c, d.  Because the domestic firms are more inefficient than the foreign producers since they require a higher price to produce Q1Q3, we identify box g as a loss in world efficiency (and thus deadweight loss in welfare).  The domestic producers now make a, b, e, f, g and foreign producers make c, d. 

Quota:

Graph Analysis:
If this country (Domestic) were closed to trade, equilibrium would occur at a price of Pe and a quantity of Qe for sorghum.  However, when the country opens itself to uninhibited free trade, the country benefits from a global supply of sorghum, much of which is produced at a lower cost (and thus a lower price) from foreign producers.  In this situation, the domestic producers produce 0Q1 of sorghum and foreign produces make the rest, Q1Q2.  Both groups of producers accept a price of Pworld, and by multiplying price by quantity, we see domestic producers earn box a and foreign producers earn b, c, d and e.

Let's then assume the domestic government imposes a quota (a limit on foreign g/s) on foreign sorghum to benefit its own producers.  The supply curve Sdomestic shifts out to assume production after the quota is reached to Sdomestic+Quota.  When this occurs, moving up along the domestic supply curve, we observe domestic producers produce 0Q1, foreign producers produce Q1Q3 (the value of the quota) and domestic producers pick up the rest, Q3Q4.  Because these firms are more inefficient than the foreign producers who can produce more cheaply, we identify box j as a loss in world efficiency.  We move up backwards along the demand curve because the price has changed to Pw+Quota, showing us that domestic producers stop at Q4 since Q4Q2 is now lost.  This represents a loss of consumer surplus and is labeled k.  As for earnings, the domestic producers now make a, f, c, i j and foreign producers make b, g, h.   Like a tariff, the combination of losses in world efficiency and consumer surplus together are called a deadweight loss of welfare because they make some people worse off.

Video: Comparative Advantage & Trade

Introduction to International Economics - Absolute and Comparative Advantage

Welcome to the study of international economics!

If we look at any country, say, Brunei, and we add all the FoPs (land, labor, capital and enterprise) the country can use to make g/s, we have determined Brunei's factor endowment.  Of course, these vary greatly between countries in terms of simple numbers of all four components and how advanced these components are.  For example, China has the most potential labor on Earth, but consider how productive workers are in Liechtenstein.  Moreover, think about how many valuable raw materials Nigeria has at its disposal and compare and contrast that with resource poor Singapore and its economic performace!  These are issues  discussed further in the field of development economics (see May posts).

There are two critical theories that are an excellent introduction to international economics: absolute and comparative advantage.  Developed by the great Adam Smith of “invisible hand” fame, a county has an absolute advantage in producing a g/s if it can produce more of it with the same number of productive inputs.  Although absolute advantage is helpful to know, it doesn’t explain why some countries trade since they may be able to create more of many, many g/s than many other countries.  It’s David Ricardo’s comparative advantage that explains why countries trade.  A country has a comparative advantage when it can produce a g/s at a lower opportunity cost than another country.  Consider the following example.

Switzerland                        Austria

Production of cheese              12,000 tons                        8,500 tons

with same FoPs

Production of tanks                 2,300 tanks                        2,000 tanks

with same FoPs

The opportunity cost of producing 1,000 more tons of cheese for Switzerland is about 522 tanks. The cost of producing 1,000 more tons in Austria is 425 tanks.  Austria thus has a comparative advantage in the production of tanks because it can produce them at a lower opportunity cost, even though Switzerland has an absolute advantage in both.  A trick on the graph…the country with no absolute advantage with either product will produce the product where the two lines are closer at the axis.