ED0101 - Introduction to Economics - Topic 11 - Learners Guide.pdf

Introduction to Economics ED0101 Topic 11 Introduction This topic helps us to explore the increasing interdependencies between countries. We begin by considering how economic and financial interdependencies can have important implications for national economies. The topic mainly focuses on trade. Tr...

Introduction to Economics ED0101 Topic 11 Introduction This topic helps us to explore the increasing interdependencies between countries. We begin by considering how economic and financial interdependencies can have important implications for national economies. The topic mainly focuses on trade. Trade between nations has the potential to benefit all participating countries. Totally free trade, however, may bring problems to countries or to groups of people within those countries. Many people argue strongly for restrictions for trade. But are people justified in fearing international competition or are they merely trying to protect some vested interest at the expense of everyone else. The topic also covers Balance of Payment. An enormous number of transactions take place each year between any one country and the rest of the world. Some of these are related to imports and exports of goods and services, some relate to investment, and some are purely financial. The balance of payment summarizes these transactions. Learning Objectives At the end of this topic, the students should be able to: Explain how a country can gain from trade. Discuss the history and why countries restrict trade. Explain what foreign exchange, foreign exchange markets and foreign exchange rates are. Explain what determines exchange rates in a flexible regime. Explain how exchange rates are fixed. Describe how a country's international trade is financed. Explain what determines a country's current account balance. Study Resources Suggested Study Time  Suggested Study Time. Tutorials: 2 hours Online Learning 4 hours (6 hours per week for 13 weeks) Required Resources https://sites.bu.edu/manove-ec101/files/2019/04/UMinnMicroeconomics.pdf Textbooks Sloman, J., Norris, K. and Garrett, D., 2013. Principles of economics. Pearson Higher Education AU. Required: Contents Reference Mapping Contents The Global Economy Monetary & Fiscal Policy Global interdependence refers to worldwide mutual dependence between countries. In other words, mutual dependence at a worldwide level. One nation depends on another for something. That country also depends on another for either the same thing or something else. As more countries depend on other nations for things especially key things like energy and food, global interdependence evolves. Global interdependence is largely the result of international trade, i.e., the importing and exporting of products and services. In fact, countries today cannot survive for long without each other S imports and exports. Oll and natural gas have created global interdependence between the major producing nations and those that do not have enough. "Mutual dependence at a global level. One country depends on another country for something and that country may depend on another country, which eventually creates global interdependence. Importing and exporting of goods and services highly contributes to global interdependence. Nations and their citizens would not voluntarily trade with other countries unless there were benefits from this exchange. A consequence of this decision to import and export is that today we can produce more goods efficiently. We can also use resources more efficiently. rut simply; international trade increases material standards of living across the world, I.e., It makes us richer. As international trade evolves, countries that are more efficient in certain things begin to specialize. In other words, they focus on making specific goods or offering certain services. Those specializing countries subsequently need to import. They need to import because some sectors have contracted as more resources went to making certain goods. As more and more countries specialize, the need for imports also grows. Consequently, today no country can survive without trading with other nations. Hence, global interdependence has become a fact of life for everybody. The Global Economy and Global Interdependence The global economy refers to all the economies of the world. Specifically, it refers to how countries* economies have been developing and operating collectively as one giant system. If you say "We live in a global economy," what does it mean? It means that we live in a world comprising many economies that depend on each other. They are intertwined and interdependent. In other words, they all operate like different parts of one unit. That one unit is the global economy. The global economy has many advantages. By specializing and trading with other countries, nations become richer. However. global interdependence also has some disadvantages. for example, what happens if your country depends on another for oil, and its leader decides to stop selling to you? What happens to your country if the other country suddenly doubles the price of oil? Countries that depend on other nations are also vulnerable. Especially if they rely on other nations for strategic goods like fuel or food. 11.2 Arguments for Restricting Trade The most common arguments for restricting trade are the protection of domestic jobs, national security, the protection of infant industries, the prevention of unfair competition, and the possibility to use the restrictions as a bargaining chip. We will look at each of those arguments in more detail below. 1. Protecting Domestic Jobs: The first and arguably most common argument against free trade is that it destroys domestic jobs. According to critics, free trade can destroy entire industries, because it causes prices to fall to the point where local producers cannot compete with suppliers from abroad. Often, the reasoning behind this is that virtually anything can be produced more cheaply in some other country somewhere else in the world. To illustrate this, think of an imaginary country called Freeland. Assume that Freeland has recently opened its country to free trade. Before this new policy, all goods and services consumed in the country were produced domestically. Among other products, Freeland now imports thousands of computers from a neighboring country, that can provide them cheaper. As a result, the prices of computers are falling, domestic production is decreasing, and people in the computer industry are losing their jobs. However, it is Important to note that even if everything could be produced cheaper abroad, countries could still benefit from trading with one another. The reason for this is that the benefits from trade arise mom comparative advantage as opposed to absolute advantage. For an in- depth explanation of the concept of comparative advantage, make sure to check out our article on comparative advantage and trade. 2. National Security: Another common argument for restricting trade is that tree trade threatens national security. The reason behind this is that trade allows countries to become dependent on other countries to supply vital resources. In the case of a war, these dependencies can become a lability, it countries are unable to be self-sufficient and produce essential goods themselves. For example, assume that Freeland imports the vast majority of all the steel used within the country from another one of its neighboring countries, called Mean land. Steel is a vital resource for the defense industry because it is used to produce weapons and armaments. Now, if a war broke out between the two countries and Mean land stopped supplying steel, Freeland would have a hard time producing enough steel itself to maintain its armed forces and defend its borders. It is undisputed that protecting critical industries from foreign competition may be appropriate if there are legitimate concerns about national security. The real challenge, however, Is to determine which are the key industries and which concerns are justified. After all, it is important to keep in mind that producers have  an incentive to overstate their role in national security to obtain protection from international competition. 3. Protecting Infant Industries: The third argument for trade restrictions is that it is sometimes necessary to protect infant industries. That means new domestic industries should be protected Dy temporary trade restrictions to help them develop and become competitive. The reason behind this is that these industries need time to catch up to their more developed and well-established competitors from abroad. Sometimes, this argument is also put forward to protect older industries that need to adjust to new circumstances. For example, let's say that Freeland recently started producing microchips for computers. Because this industry is still in its infancy, production processes aren't quite as efficient as they could be. As a result, the chips are more expensive than similar products from other countries. Therefore, industry leaders ask the movement to impose temporary trade restrictions on microchips. to allow their industry to mature and become more competitive. Although this may seem like a reasonable argument at first glance, it IS challenging to Implement in reality. Imposing these kinds of restrictions would require the government to essentially bet on the future profitability of new industries and determine whether the benefits of protecting them could potentially outweigh the additional costs to consumers (incurred due to higher prices) in the future. In addition to that, it is politically difficult to remove protection from an industry once it has been introduced, even If it was considered temporary from the outset 4. Preventing Unfair Competition: Another argument for restricting trade is that free trade leads to unfair competition. That means, critics argue that producers from different countries are subject to different rules and regulations, which results in an uneven playing field. To illustrate this, suppose that Mean land subsidizes its automotive industry by granting significant tax benefits to producers. In that case, those firms can produce at lower prices than Freeland's producers, which might be considered unfair. To counteract this, the government of Freeland could level the playing field by imposing tariffs on foreign cars. However, whether or not a country suffers from unfair competition depends on many factors. While the producers in the affected industries certainly suffer, the consumers usually benefit from the lower prices. Therefore, the country as a whole might even be better off with "unfair" competition than it would be otherwise.  5. Using Restrictions as a Bargaining Chip: Finally, some people argue that trade restrictions (or the threat thereof) can be valuable assets in trade negotiations. That means they can be used as bargaining chips in negotiations to remove existing trade restrictions or prevent other countries from restricting free trade in the first place. for example, let's assume that Meanland imposes a tariff on all ice cream imports from Freeland. That obviously hurts Freeland's economy. Therefore, the government of Freeland threatens to impose a tariff on all candy imports from Meanland, unless the restrictions are removed. This may be a successful negotiation strategy if Meanland determines that the cost of the new restrictions would outweigh the benefits of their existing tariffs. In that case, they are better off lifting the current restrictions instead of engaging in a trade war. The issue with this strategy is that it may not always work. In fact. If the other country doesn't respond to the threat, the plan may even backfire. In that case, the government has to make a choice. If it still decides to follow through, the new restrictions may hurt its own economy. On the other hand, It it backs down, it loses credibility, and it becomes even less likely that a similar threat would work in the future. 11.3 The Balance of Payments Balance of Payment (BOP) is a statement that records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should be zero in a perfect scenario. This means the inflows and outflows of funds should be balanced out. However, this does not ideally happen in most cases. A BOP statement of a country indicates whether the country has a surplus or a deficit of funds, i.e. when a country's export is more than its import, its BOP is said to be in surplus. On the other hand, the BOP deficit indicates that its imports are more than its exports. Tracking the transactions under BOP is similar to the double-entry accounting system. All transactions will have a debit entry and a corresponding credit entry For example, funds entering a country from a foreign source are booked as credit and recorded in the BOP Outflows from a country are recorded as debits in the BOP. Lets say Japan exports 100 cars to the U.S. Japan books the export of the 100 cars as a debit in the BOP, while the U.S. books the imports as a credit in the BOP Formula for Balance of Payments The formula for calculating the balance of payments is: A country's BOP is vital for the following reasons: The formula for calculating the balance of payments is: The BOP of a country reveals its financial and economic status. A BOP statement can be used to determine whether the country's currency value is appreciating or depreciating. The BOP statement helps the government to decide on fiscal and trade policies. It provides important information to analyze and understand the economic dealings with other countries By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the county's economy and, thus, then take appropriate measures Elements of a Balance of Payment: There are three components of the balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations. (A) Current Account: The current account monitors the inflows and outflows of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism. transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, they make up a country's Balance of Trade (BOT). There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries is referred to as visible items, and import/export of services (banking, information technology etc.) are referred to as invisible items. Unilateral transfers refer to money sent as guts or donations to residents of foreign countries. This can also be personal transfers like - money sent by relatives to their family located in another country. The term current is used in describing the current account because the goods, services and income being traded in will be consumed or received in the current period (specifically, within the quarter). (B) Capital Account: All capital transactions between the countries are monitored through the capital account. Capital transactions include purchasing and selling assets (non- financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc. by migrants moving out into a different country. The deficit or surplus in the current account is managed through the finance from the capital account and vice versa. There are three major elements of a capital account: Loans and borrowings - It includes all types of loans from the private and public sectors located in foreign countries. Investments - These are funds invested in corporate stocks by non-residents. Foreign exchange reserves - Foreign exchange reserves held by the country's central bank to monitor and control the exchange rate do impact the capital account. The much larger financial account component records transactions between parties that involve a change of ownership of Australia's assets or liabilities. It is structured according to the different classes of investment that owners of these assets or liabilities can undertake. (C) Financial Account: The flow or funds from and to foreign countries through various investments in real estate, business ventures. foreign direct investments etc.. Is monitored through the financial account. This account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. Analyzing these changes can be understood if the country is selling or acquiring more assets (like gold, stocks, equity, etc.). 11.4 Foreign exchange markets Foreign exchange market (forex, or FX, market), institution for the exchange of one country's currency with that of another country. Foreign exchange markets are actually made up of many different markets, because the trade between individual currencies- say, the euro and the U.S. dollar- each constitutes a market. The foreign exchange markets are the original and oldest financial markets and remain the basis upon which the rest of the financial structure exists and is traded: foreign exchange markets provide international liquidity, preferably with relative stability. A foreign exchange market is a 24-hour over- the-counter (OTC) and dealers' market, meaning that transactions are completed between two participants via telecommunications technology. The currency markets are also further divided into spot markets--which are for two-day settlements and the forward, swap, interbank futures, and options markets. London, New York, and Tokyo dominate foreign exchange trading. The currency markets are the largest and most liquid of all the financial markets; the triennial figures from the Bank for International Settlements (BIS) put daily global turnover in the foreign exchange markets in trillions of dollars. It is sobering to consider that in the early 21st century an annual world trades foreign exchange is traded in just less than every five days on the currency markets, although the widespread use of hedging and exchanges into and out of vehicle currencies--as a more liquid medium of exchange -means that such measures of financial activity can be exaggerated.