GR 12 Economics U3 PDF

GR 12 ECONOMICS U3 TITLE PAGE GRADE 12 ECONOMICS UNIT MODULE 3 THE GLOBAL ECONOMY TOPIC 1: INTERNATIONAL TRADE AND PROTECTION TOPIC 2: BALANCE OF PAYMENTS...

GR 12 ECONOMICS U3 TITLE PAGE GRADE 12 ECONOMICS UNIT MODULE 3 THE GLOBAL ECONOMY TOPIC 1: INTERNATIONAL TRADE AND PROTECTION TOPIC 2: BALANCE OF PAYMENTS TOPIC 3: EXCHANGE RATES 1  GR 12 ECONOMICS U3 ACKNOWLEDGEMENT ACKNOWLEDGEMENT We acknowledge the contributions of all Secondary Teachers who in one way or another have helped to develop this Course. Our profound gratitude goes to the former Principal of FODE, Mr. Demas Tongogo for leading FODE team towards this great achievement. Special thanks to the Staff of the English Department of FODE who played an active role in coordinating writing workshops, outsourcing lesson writing and editing processes, involving selected teachers of Central Province and NCD. We also acknowledge the professional guidance provided by Curriculum and Development Assessment Division throughout the processes of writing, and the services given by member of the English Review and Academic Committees. The development of this book was Co-funded by GoPNG and World Bank. DIANA TEIT AKIS PRINCIPAL. Flexible Open and Distance Education Papua New Guinea Published in 2017 @ Copyright 2017, Department of Education Papua New Guinea All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means electronic, mechanical, photocopying, recording or any other form of reproduction by any process is allowed without the prior permission of the publisher. ISBN 978 9980 89 726 8 National Library Services of Papua New Guinea Compiled and finalised by: Social Science Department-FODE Printed by the Flexible, Open and Distance Education 2  GR 12 ECONOMICS U3 CONTENTS TABLE OF CONTENTS Title…………………………………………………………………………………………………......................................1 Acknowledgement and Copy Right……………………………………………………………………………………...2 Contents…………………………………………………………………………………………………………………..............3 Secretary’s Message…………………………………………………………………………………………....................4 Unit Introduction……………………………………………………………………………………...............................5 Learning Outcomes…………………………………………………………………………………..............................5 12.3.1: INTERNATIONAL TRADE AND PROTECTION 12.3.1.1: Reasons for Trade ……………………………………………………………………………………7 12.3.1.2: Principle of Trade: Absolute and Comparative Advantage …………………......10 12.3.1.3: Free Trade …………………………………………………………………………......................14 12.3.1.4: Trade Protection………………………………………………………………........................15 Summary 12.3.1......................................................................................................................22 Student Learning Activity 1 …………………………………………………………………………......................23 12.3.2: BALANCE OF PAYMENTS 12.3.2.1: Introduction to Balance of Payments …………………………………………............25 12.3.2.2: Current Account …………………………………………………………………....................28 12.3.2.3: Capital or Financial Account …………………………………………………………….......30 12.3.2.4: Overall Balance of payments ……………………………………………………………..….32 12.3.2.5: Improving Balance of Payment Deficit …………………………...........................34 12.3.2.6: Terms of Trade ………………………………………………………………….......................35 Summary 12.3.2......................................................................................................................38 Student Learning Activity 2 ……………………………………………………………………………….................39 12.3.3: EXCHANGE RATES 12.3.3.1: Factors Determining an Exchange Rate ……………………………………………..…..43 12.3.3.2: Methods of Determining Exchange Rates…………………………………………....…45 12.3.3.3: Calculation and Conversion of Exchange Rates ………………………………....…..53 12.3.3.4: Globalisation in an Economic Context ………………………………………..…..........54 Summary 12.3.3......................................................................................................................57 Student Learning Activity 3 ……………………………………………………………………………………….........58 ANSWERS TO STUDENT LEARNING ACTIVITIES 12.3.1 to 12.3.3...........................................62 BIBLIOGRPHY..........................................................................................................................70 3  GR 12 ECONOMICS U3 SECRETARY’S MESSAGE SECRETARY’S MESSAGE Achieving a better future by individual students and their families, communities or the nation as a whole, depends on the kind of curriculum and the way it is delivered. This course is a part of the new Flexible, Open and Distance Education curriculum. The learning outcomes are student-centred and allows for them to be demonstrated and assessed. It maintains the rationale, goals, aims and principles of the national curriculum and identifies the knowledge, skills, attitudes and values that students should achieve. This is a provision by Flexible, Open and Distance Education as an alternative pathway of formal education. The course promotes Papua New Guinea values and beliefs which are found in our Constitution, Government Policies and Reports. It is developed in line with the National Education Plan (2005 -2014) and addresses an increase in the number of school leavers affected by the lack of access into secondary and higher educational institutions. Flexible, Open and Distance Education curriculum is guided by the Department of Education’s Mission which is fivefold:  To facilitate and promote the integral development of every individual  To develop and encourage an education system satisfies the requirements of Papua New Guinea and its people  To establish, preserve and improve standards of education throughout Papua New Guinea  To make the benefits of such education available as widely as possible to all of the people  To make the education accessible to the poor and physically, mentally and socially handicapped as well as to those who are educationally disadvantaged. The college is enhanced to provide alternative and comparable pathways for students and adults to complete their education through a one system, many pathways and same outcomes. It is our vision that Papua New Guineans’ harness all appropriate and affordable technologies to pursue this program. I commend all those teachers, curriculum writers, university lecturers and many others who have contributed in developing this course. DR. UKE KOMBRA, EdD Secretary for Education 4  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3: THE GLOBAL ECONOMY This unit talks about the importance of Papua New Guinea’s trade relations with other countries. The basis for, and the costs and benefits of international trade and the issues surrounding globalisation are the main focus in this unit. Students develop an understanding of foreign relationships by identifying trade motives behind trade and defining and analysing the key economic concepts, principles and economic theories that apply to Papua New Guinea’s international relations with the rest of the world. Broad Learning Outcomes On successful completion of this module, students will be able to:  use trends in Balance of Payments, Terms of Trade and Exchange Rates to identify key issues facing the domestic and external economy of Papua New Guinea  discuss the likely effects of these issues on the domestic economy and propose appropriate micro-economic and macro-economic strategies to manage these issues  describe and illustrate the impacts of globalization on the economy of Papua New Guinea Time Frame This unit should be completed within 10 weeks. If you set an average of 3 hours per day, you should be able to complete the unit comfortably by the end of the assigned week. Try to do all the learning activities and compare your answers with the ones provided at the end of the unit. If you do not get a particular exercise right in the first attempt, you should not get discouraged but instead, go back and attempt it again. If you still do not get it right after several attempts then you should seek help from your friend or even your tutor. Do not pass any question without solving it first. 5  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.1: INTERNATIONAL TRADE AND PROTECTION ___________________________________________________________________________ Topic 1: Introduction In this topic we will discuss the importance of trade within and between countries, the reasons and benefits gained, advantages of free trade and trade protection and the emergence of global economy. Trade has played a critical role in the emergence of the global economy. Historically, trade brought countries together, created significant wealth and resulted in the type of economic system to adopt. If there were no trade, there would only be national economies (countries would exist in isolation) and the emergence of a global economy would never have occurred. ___________________________________________________________________________ Specific Learning Outcomes On successful completion of this topic, students will be able to:  define trade  identify reasons for trade  explain principles of trade in terms of absolute and comparative advantage  identify and describe various methods of trade protection ___________________________________________________________________________ 6  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.1.1: Reasons for Trade Let us define and differentiate international and domestic trade before we discuss the reasons and benefits of trade. What is trade? Trade is swapping or exchanging of goods and services between two individuals or groups. Trade existed in traditional economy called Barter. Barter is the swapping of goods for goods without the use of money. Now, we will discuss trade in modern economy in which money is widely used as a standard of payment or a medium of exchange. What is a domestic trade? Domestic (local) trade is a trade within a country. For example, Ramu Sugar Company supplies its product to wholesalers and retail stores in the country. In modern economy, a country does not only trade within the country but goes beyond its shore to trade with other countries and this is called International trade. International trade is the exchange of goods and services in payment for money between countries. International trade involves exports and imports of commodities between countries. Export is the selling of goods and services to foreign countries. For example, RD Tuna cannery exports its Dolly brand to Europe. Import is the buying of goods and services from foreign countries. For example, Ela Motors imports Toyota Land Cruizer vehicles from Japan. What is a commodity? It is something that has value and can be traded on the market. Some examples of Papua New Guinea’s exports from Primary, Secondary and Tertiary sectors of the country are listed in the table below. Table 1: This table shows Papua New Guinea’s Exports Papua New Guinea’s Exports Primary products Secondary products Tertiary products (raw materials) (manufactured goods) (services provided to foreigners) Timber British American Tobacco Air Niugini Airbus Fish RD Tuna –Dolly Tourism services (Tour firms) Oil palm Ox & Palm Accommodation (Hotels, Copra Export Lager Beer Lodges, Inns, Guesthouses) Coffee Buses, Taxis, Hire cars Minerals (gold, copper) Shipping services Crude oil Liquefied Natural Gas (LNG) 7  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Some examples of Papua New Guinea’s imports from other countries are listed in the table below. Table 2: This table shows Papua New Guinea’s Imports Papua New Guinea’s Imports Primary products Secondary products Tertiary products (raw materials) (manufactured goods) (services received from foreign countries) -Apples -Clothes -Quantas Airbus -Grapes -Capital goods -Expatriate workers -Onions (machineries / Equipment) -Nautilus undersea mining -Capsicum -Medicines -Australian Federal Police -Orange -Consumer goods (butter, attached to PNG Constabulary (mainly fruits and salt, fresh meat, rice) vegetables) -Stationeries We can identify from the exports and imports of PNG listed in the above two (2) tables that, PNG mainly exports primary products (raw materials) and imports secondary products (manufactured goods). The main trading partners of Papua New Guinea are:  Australia  New Zealand  Japan  China  Indonesia  Singapore  Malaysia  India The Honorable Member of Parliament and Governor of Western Highlands Province Paias Wingti, when he was a Prime Minister in the mid 1980s he introduced the ‘Look North policy’. This policy resulted in increased trade with Asian countries and multi-million investments in PNG from the Asian companies. These are some reasons countries trade: 1. Lack resources such as raw materials, technology, finance or labour. Therefore, countries need to trade to get resource inputs for the production of goods and services. 2. Countries trade to have variety of goods and services in their country so that its people should satisfy their basic needs and wants to improve their standard of living. 8  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 3. Countries specialize in the production of certain products in which they have absolute advantage and/or comparative advantage in order to achieve efficiency in production. 4. Countries trade to improve international relations in terms of political, economic and cultural relations. Some benefits of trade are: 1. Countries earn revenue through exports. 2. Countries acquire (get) resources they lack in production. 3. People (consumers) are exposed to variety of foreign made goods. 4. Countries specialize in producing what they are good at and trade with others. 5. Countries establish relationship through trade. 6. Countries can learn and adopt efficient production methods from other countries. Below is an extract taken from The National newspaper that highlights benefits of a trade. Trade delegation from French, New Caledonia firms visit Lae A trade delegation consisting of 12 French and New Caledonian companies have visited Lae looking for business opportunities in Papua New Guinea and in the Pacific. Lae Chamber of Commerce Inc president Alan McLay told The National: “we are hopeful to be able to sister the New Caledonia Chamber of Commerce.” “The visit was very positive one and I think the delegation was quite surprised at what they saw in Lae. This was more an exploration visit to make some initial contacts,” McLay said. Prime Minister Peter O’Neill had said earlier that France was a potential market for Papua New Guinea’s exports and was a gateway for Papua New Guinea products to European Union.”......... Source: The National, November 9, 2015. The benefits emphasized (said) in the articles are:  PNG has established a trade relationship or link the two countries (named)  Find new markets for PNG exports in those two countries. 9  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.1.2: Principle of Trade: Absolute Advantage and Comparative Advantage The basic principle of international trade is absolute advantage and comparative advantage. Importantly, a country should specialise in producing a product which it has either an absolute advantage or comparative advantage. Let us first discuss the concept (idea) of absolute advantage in production. Absolute advantage basically looks at how efficiently resources are used in production process. It is assumed that PNG and Australia use the same amount of resources in production. What is efficiency? It is maximizing (increasing) output with minimum (less) resource input in the production process. Now, let us use the example below to work out the absolute advantage for PNG and Australia in producing rice and tea. Example; PNG and Australia, with an equal amount of resources can produce rice and tea as shown in the table. The absolute advantage in producing both rice and tea can be worked out using the data provided on basis of efficiency in production Product PNG (Quantity produced) Australia (Quantity produced) (in tons) (in tons) Rice 400 100 Tea 100 200 Explanation:  Absolute advantage in rice production; It can be seen from the data provided that PNG produces 100 tons while Australia produces 400 tons with the given amount of resources. Australia has produced greater quantity of rice than PNG. This means Australia is more efficient in production of rice than PNG. Therefore, Australia has absolute advantage in producing rice and should specialise in rice production and trade with PNG.  Absolute advantage in tea production; It can be seen from the data provided that PNG produces 200 tons while Australia produces 100 tons with the given amount of 10  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY resources. PNG has produced greater quantity of tea than Australia. This means PNG is more efficient in production of tea than Australia. Therefore, PNG has absolute advantage in producing tea and should specialise in tea production and trade with Australia. Now, we can discuss the concept of comparative advantage in production Comparative advantage is when a country can produce a particular product at a least or lower opportunity cost than the others. What is opportunity cost? It is the sacrifice or given up of one best alternative to produce the other. For instance, a farmer has a fixed amount of resources including land, finance, capital, labour, etc. and faced with two alternatives whether to produce rice or tea. A higher market demand for rice attracted the farmer to divert (use) all resources to produce rice. This means the opportunity cost or sacrifice made to produce rice is producing tea. However, the opportunity cost is measurable when the quantities of output of two alternative productions are given. In this case, the opportunity cost can be calculated to find out the comparative advantage of a country. The formula used for calculating opportunity cost (OC) is: Opportunity Cost = Loss /Gain. For example, PNG and Australia, with a given amount of resources can produce rice and tea as stated below in the table. Calculate the opportunity cost to determine the comparative advantage in production of rice and tea. PNG (Quantity produced) Australia (Quantity produced) Product (in tons) (in tons) Output Opportunity cost Output Opportunity cost Rice OC = 100/400 = 0.25 100 OC = 200/100 = 2.0 400 Tea OC = 100/200 = 0.5 200 100 OC = 400/100 = 4.0 11  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY What is:  Loss? It is the value of one good sacrificed or given up to produce another. For example, PNG sacrificed 200 tons of tea to produce 100 tons of rice. The loss is the 200 tons of tea sacrificed. Therefore, the opportunity cost of producing 100 tons of rice is calculated as; OC = 200/100 = 2.0.  Gain? It is the value of the good produced by sacrificing the other commodity. For instance, based on the above example, the gain for PNG is 100 tons of rice produced at the loss (sacrifice) of 200 tons of tea. Explanation for comparative advantage: It basically looks at opportunity cost involved in production of a commodity. It is assumed that PNG and Australia used the same amount of resources in production of rice and tea. Now, let us explain comparative advantage in terms of the calculations of opportunity cost in the table above.  Opportunity cost in production of Rice; Solutions: 1. PNG sacrificed 200 tons of tea to produce 100 tons of rice. The loss is the 200 tons of Tea sacrificed. Therefore, the opportunity cost of producing 100 tons of rice is calculated as; OC = 200/100 = 2.0. That is, 2 tons of tea sacrificed to produce 1 ton of rice. 2. Australia sacrificed 100 tons of tea to produce 400 tons of rice. The loss is the 100 tons of tea sacrificed. Therefore, the opportunity cost of producing 400 tons of rice is calculated as; OC = 100/400 = 0.25. That is, 0.25 tons of tea sacrificed to produce 1 ton of rice. Interpretation: The opportunity cost for PNG is 2.0 while Australia is 0.25. It can be seen that Australia has the lowest opportunity cost in producing rice. This means Australia has the comparative advantage in producing rice because it can produce rice at a lower opportunity cost (0.25) than PNG (2.0). Therefore, Australia should specialise in producing rice and trade with PNG.  Opportunity cost in production of Tea; Solutions: 1. PNG sacrificed 100 tons of rice to produce 200 tons of tea. The loss is the 100 tons of rice sacrificed. Therefore, the opportunity cost of producing 200 tons of tea is calculated as; OC = 100/200 = 0.5. That is, 0.5 tons of rice sacrificed to produce 1 ton of tea. 12  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 2. Australia sacrificed 400 tons of rice to produce 100 tons of tea. The loss is the 400 tons of rice sacrificed. Therefore, the opportunity cost of producing 100 tons of tea is calculated as; OC = 400/100 = 4.0. That is, 4.0 tons of rice sacrificed to produce 1 ton of tea. Interpretation: The opportunity cost for PNG is 0.5 while Australia is 4.0. It can be seen that PNG has the lowest opportunity cost in producing tea. This means PNG has the comparative advantage in producing tea because it can produce tea at a lower opportunity cost (0.5) than Australia (4.0). Therefore, PNG should specialise in producing tea and to trade with Australia. Conclusions:  PNG has both absolute and comparative advantages in producing tea. Therefore, it should specialize in producing tea to trade with Australia.  Australia has both absolute and comparative advantages in producing rice. Therefore, it should specialize in producing rice to trade with PNG.  A country specializes or concentrates in producing one particular good in which it has either an absolute or a comparative advantage in producing it. 13  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.1.3: Free Trade Free trade is a situation where there are no artificial barriers to trade imposed by governments that restrict the free exchange of goods and services between countries. Or it can be simply defined as a trade without trade protection or restrictions placed such as embargo, import tariff, import quota, trade discrimination, etc. Advantages of free trade are:  It allows countries to obtain sufficient amount of goods which they cannot produce to satisfy the domestic demand.  It allows countries to specialize in production of goods for which they have an absolute advantage or comparative advantage.  It helps to improve the efficient allocation of resources since producers in countries are exposed to international competition and try to produce at a lower opportunity cost.  It allows for specialisation, which leads to economics of scale, in which achieve lower average cost in production and increase efficiency and productivity.  International competitiveness will improve since the government will promote domestic industrial efficiency.  It encourages innovation and spread of technology and production processes throughout the world.  It leads to higher standard of living as a result of lower prices, increased quantities and increased variety as countries would have greater access to goods and services. On the other hand, there are several disadvantages associated with free trade: 1. A rise in short term unemployment may be experienced as some domestic businesses may find it hard to compete with imports. 2. New industries may find it more difficult to establish themselves when they receive no short term establishment protection. Source: P.M.N. Bandara, 2013. Economics for Grade 12. 14  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.1.4: Trade Protection Protected trade is the opposite of free trade that is, it is a trade where artificial barriers are imposed by the government that restrict the free exchange of goods and services between countries. Trade protection barriers are such as import tariff, quotas, embargo, etc. Protected trade is also called restricted trade. Reasons for trade protection Below are some arguments that justify why countries impose protectionist barriers to trade, including the need to assist infant industries, protecting industries from overseas firms dumping goods, reducing unemployment and arguments for self-sufficiency in certain items.  Protect infant (new) industries: Usually new industries generally face many difficulties and risks in their early years of operation. These ’infant industries’ or new firms may need protection so that they can compete with the rest of the world. For example, if a new local company is producing rice then the PNG government should protect the infant or new company from competition from overseas companies. That is, the government may pay subsidy to the local company to reduce its cost of production, hence, local rice can be cheaper than the imported rice.  Prevention of dumping: Dumping occurs when foreign firms attempt to sell their surplus goods in another country’s domestic market at an unrealistically lower price (lower than the domestic market price). This sort of practice can push out domestic producers from market and eventually shut down of business. Hence, in the best interest of the economy a restriction is imposed to stop such imports. For example, Japanese used vehicle is a dumping of surplus vehicle in Japan. The PNG government can protect the local car dealers by imposing a higher import tariff.  Protection for domestic employment: Importation of foreign goods at a cheaper price and selling them at the lower prices than the domestic firm in the domestic market can push out local firms from operation which results in increased unemployment. Therefore, protection such as high import tariff ensure prices for imported goods are expensive than locally produced goods which maintains or increases demand for locally produced goods and keep the local firms in operation which may results in increased employment.  Self-sufficiency: Countries would want to produce their own products even though it may be expensive. They should be independent and can be able to produce that good, and it is not that they have absolute advantage or comparative advantage in production. Source: P.M.N. Bandara, 2013. Economics for Grade 12. 15  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Below is an article taken from ‘The National’ on the concept of self-sufficiency proposition made by Honourable MP and Opposition Leader, Don Polye. Focus on agriculture, Polye says Opposition Leader Don Polye has called on the Government to begin focussing on developing the country’s agriculture sector. Polye said PNG’s future depends on agriculture because the majority of the county’s population lives in the rural areas. He said the Government continue to ignore agriculture which had the potential to cushion the effects of the downturn in commodity prices. Polye said he would push to establish major agricultural projects in the country’s fertile basins, plains and valleys. He added that the Sepik Plains had the potential to become country’s food basket. “The Sepik Plains present to PNG the best solution as the food basket for PNG’s economy prosperity, so do other valleys like Markharm and Ramu, New Guinea Islands and Papuan Basin,” said Polye said. He said an alternative government would establish major oil palm and cocoa among other cash crops in these basins and plains. “The revenue from these projects will then be injected into educating young Papua New Source: Thethrough Guineans National, September skills 24, 2015 development,” Polye said. Methods of Protection Most countries now agree that overall free trade is beneficial. However, no country in the world follows a policy of absolute/complete free trade. Most countries attempt to shield their domestic producers from foreign competition which with protectionist measures. The methods of protection are: 1. Import tariff 2. Import Quota 3. Paying Subsidies 4. Embargo Let us discuss each of trade protection methods and their effects on the international trade and the economy of a country as a whole. 16  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 1. Import tariff What is tariff? It is a tax placed by the government on the importation of goods from overseas. It has the effect of raising the price of the imported goods, making the domestic (local) products cheaper and more competitive on the international market. Refer to graph on the next page for further explanation on effects of tariff on price, domestic supply and demand for imports to solve excess demand in the domestic market. The effects of a tariff are show in the following graph. Price S (Kina) A: Domestic (local) supply before tariff B B: Domestic (local) supply after tariff C: Demand for imported goods before 2 A tariff 1 D D: Demand for imported goods after tariff D C 0 100 200 250 400 Quantity Supply (S) and demand (D) curves represent the domestic (local) supply and demand of a certain good. Before tariff:  existence of free trade  domestic market price is K1  domestic supply is 100  at price K1 the shortage in the domestic market is 300 (Os–Qs = 100 – 400).  quantity of imported goods before import tariff is 300 (shortage amount) The Effect of a tariff: 1. price of imported goods increased from K1 to K2 2. quantity of imported good after import tariff is 50 (200 – 250) 3. imposition of import tariff decreased the quantity of imported good (300 to 50) as tariff increases cost of importation thus, increases its price (K1 to K2) in the domestic market 4. hence, increased demand for cheap locally produced good so domestic supply extended from 100 to 200 5. so at price K2 the shortage is 50 (200-250) which is the quantity to be imported 17  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 2. Import Quotas Import quota is imposed by the government to limit or control the volume (quantity) of a particular good that is allowed to be imported over a given period of time. The quota guarantees domestic producers a share of the market, that is, it reduces foreign imports and encourages increased supply of locally produced goods. Import quota has a similar effect as import tariff; let us look at its effect graphically. The graphical illustration of the effects a quota is shown below. Price S (Kina) A: Domestic (local) supply before tariff B B: Domestic (local) supply after tariff C: Demand for imported goods before tariff 2 D: Demand for imported goods after tariff A 1 D D C 0 100 200 250 400 Quantity Supply (s) and demand (D) curves represent the domestic supply and demand of a certain good. Before import quota The imported goods would be sold at K1 if there was no quota imposed. At this price consumers demand 400 goods but, domestic producers supply only 100 goods. It results in shortage of 300 goods. Therefore, the quantity imported would be 300 goods to solve the shortage problem in the domestic market. After import quota imposed Imposition of import quota restricts (reduces) imports to 50 goods (200 – 250), thus rise in price for imported goods from K1 to K2. This price allows domestic supply to extend to 200 (from 100 to 200). The effects of an import quota are largely the same as those of import tariff, except that import quota does not contribute to government revenue while import tariff does. Countries can use a system of tariff quotas. Here, goods imported up to the quota pay a standard tariff rate, whereas goods imported above the quota pay a higher rate of tariff. For 18  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY instance, in the past, many of Australia’s most highly protected industries such as textiles, clothing, footwear and motor vehicle were shield from foreign competition in this way. Source: P.M.N. Bandara, 2013. Economics for Grade 12. 3. Subsidies Subsidies are financial assistance given by the government to domestic producers, which enable them to decrease their cost of production in terms of average cost (AC) thus reducing their selling price and compete more easily with imported goods. Economists generally favour subsidies over tariff as a form of protection as subsidies tend to reduce prices, thus lowering inflation and benefiting the consumers. New SME policy needs government funding: Maru Trade, Commerce and Industry Minister Richard Maru says the new small medium enterprises (SME) policy will not be successful if there is no Government funding. Maru said the policy recently approved by the Government, aimed at the SME sector from 50 000 businesses to 500 companies by 2030. However, the lack of government funding would be a setback to implementing the policy, he said. Source: The National, September 24, 2015 4. Embargo Embargo is a ban placed on the importation of certain goods. It totally stops bringing of those goods embargoed and gives a greater market share for the local producers to increase their supply in the domestic market. However, embargo can result in decreasing a variety of goods available for consumers in the domestic market and may possibly lead to retaliation by that country by also putting an embargo on importation. 19  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Some advantages of trade protection are: 1. Encourage local infant (new) industries 2. Encourage investors to invest in the domestic market 3. Protection of employment 4. Encourage economic growth 5. Use of local resources Some disadvantages of trade protection are: i. Countries which trade restrictions are placed against can retaliate and do the same. ii. Imposing import tariff results in high pricing for imported goods in the domestic market. iii. Trade restriction discourages importing foreign made goods and thus reduces variety of goods available for people or consumers in the domestic market. iv. Trade restrictions or protection shield domestic producers from foreign competition and may lead to lack of local producers’ ability to be competitive on the international market and result in production of low quality goods. v. Lead to food security problem in the domestic market as trade protection limit amount and variety of goods available in the domestic market. vi. Local producers might not be able to get the needed resource inputs like raw materials, technology, etc. for production due to trade protection. Source: P.M.N. Bandara, 2013. Economics for Grade 12. 20  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Let us read the newspaper extract taken from ‘’The National’ which highlights a trade restriction placed on PNG tuna export to European Union countries by European Union. Yellow-card on PNG tuna export removed The European Union (EU) has lifted the “yellow-card” it imposed on the country’s tuna industry, thus removing the threat of a complete ban on the multi-billion kina export commodity. National Fisheries Authority (NFA) managing director John Kasu said the lifting of the yellow- card meant EU countries would continue to import tuna from PNG. It is estimated that PNG’s annual export of tuna is around US$1.5 billion (K4.3 billion). The yellow-card is a warning issued to tuna-exporting countries such as PNG that fail to provide sufficient measures to curb (control) illegal fishing in their waters. If they fail to fix that within a specified time, EU issues a red card – which means a total ban on the export of tuna to EU countries. “The European Commission has threatened to ban our high revenue export earnings from our marine products to them due to our incapability to prevent the increasing and unmonitored illegal fishing activities in our waters,” Kasu said........................ Source: The National, October 5, 2015 __________________________________________________________________________________ YOU HAVE COME TO THE END OF TOPIC 1. YOU MAY NOW READ THE SUMMARY ON THE NEXT PAGE. 21  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Summary 12.3.1 ___________________________________________________________________________  International trade is the exchange of goods and services between countries due to lack of resources for production, to have variety of goods and services in the domestic market, specialize in producing goods in which they have absolute and/or comparative advantages, and to improve and maintain international relations with trading partners.  The principle of absolute advantage states that a country has an absolute advantage in the production of a product if it can maximize output with a fewer resources than another country.  The principle of comparative advantage states that a country has a comparative advantage in the production of a product if it can produce a product at a lower opportunity costs than another country.  Free trade is free flow of imports and exports between countries without restrictions.  Trade protection is imposing artificial barriers by the government for free trade.  Protectionist measures include tariffs, quotas, subsidies, embargoes, exchange controls and administrative controls.  The arguments for trade protection are: 1. Infant industry argument 2. Self-sufficiency argument 3. Protection of employment argument 4. Protection from dumping argument  Some disadvantage of trade protection are: 1. Retaliation by other countries 2. Reduce variety of goods available in the domestic market 3. Lack of competition results in low quality goods produced 4. Leads to food security problem ___________________________________________________________________________ NOW DO STUDENT LEARNING ACTIVITY 12.3.1 ON THE NEXT PAGE. 22  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Learning Activity 12.3.1 ___________________________________________________________________________ 1. Define international trade. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 2. State at least two reason for trade. i. _______________________________________________________________________ _______________________________________________________________________ ii. _______________________________________________________________________ _______________________________________________________________________ 3. Distinguish between free trade and restricted trade. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 4. What is another name for restricted trade? ___________________________________________________________________________ 5. Identify at least two benefits of free trade. i. _______________________________________________________________________ _______________________________________________________________________ ii. _______________________________________________________________________ _______________________________________________________________________ 6. Identify at least two benefits of protected trade. i. _______________________________________________________________________ _______________________________________________________________________ ii. _______________________________________________________________________ _______________________________________________________________________ 23  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 7. Explain the difference between absolute and comparative advantages. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 8. Identify at least four (4) methods of trade protection. i. _______________________________________________________________________ ii. _______________________________________________________________________ iii. _____________________________________________________________________ iv. _____________________________________________________________________ 9. Choose any two of the above listed and describe them briefly. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 10. State at least two disadvantages of trade protection. i. _______________________________________________________________________ _______________________________________________________________________ ii. _______________________________________________________________________ _______________________________________________________________________ ___________________________________________________________________________ CHECK YOUR ANSWERS AT THE END OF THE UNIT. 24  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2: BALANCE OF PAYMENTS ___________________________________________________________________________ Topic 2: Introduction Under this topic we will discuss the record keeping of cash flows in and out of a country resulting from international trade and other transactions between countries. We will identify transactions, the items and types of account and calculate the balance of payment. Then, explain its effect on the economy and measures (ways) to improve it. ___________________________________________________________________________ Specific Learning Outcomes On successful completion of this topic, students will be able to:  define balance of payment  identify items in the balance of payment and  calculate and explain terms of trade  describe measures to improve terms of trade ___________________________________________________________________________ 25  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.1: Introduction to Balance of Payments Like any other organizations, PNG as a country keeps records of its money inflows and outflows of the country and it is called Balance of payments (BOP). BOP for PNG shows the trade and money flows in and out of the PNG economy. Below is a sample of a Balance of payment account. Balance of Payment Account Items Current Account K’million Visible exports 4 930 Visible imports -2 733 Balance of trade 2 197 Invisible exports (credits) 680 Invisible imports (debits) -2 606 Net Invisibles -1 926 Net private transfer -21 Official transfers 69 Net transfers 48 Balance on Current Account 319 Capital Account Official capital flows 116 Private capital flows -197 Non-official monetary sector transactions -6 Change in Offshore account balances 22 Balance of Capital Account -65 Revaluations (if any) -8 Net errors and omissions -86 Overall Balance 160 Source: Economics for Developing Nations; Book Two 26  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Balance of payment is a record of all transactions of money coming in and going out of a country. All money that flows in is referred to as a credit (+) and all money that flows out is referred to as a debit (-). Credits are denoted with a positive sign while debits are denoted with a negative sign. For instance, if PNG exports goods to Australia, the money we receive for these exports is an inflow and thus, credit. On the other hand, if PNG imports goods from Australia, the money paid out for these imports is a debit. The BOP figures are presented in two accounts – the Current Account and the Capital Account. These accounts are compiled to a set of international accounting standards, which make it easier to compare balance of payments for different countries. Balance of Payment Current Account Capital Account Reasons for keeping accurate BOP account records are: i. helps to identify balance of payment problems or disequilibrium such as BOP surplus or deficit ii. BOP shows the trade pattern of a country in terms of exports and imports. Trade pattern can help the government to formulate economic policy, for instance, a Balance of Trade (BOT) deficit indicates more imports than export. Therefore, it can come up with corrective measures to encourage local production for export. iii. BOP data indicates the economic performance of a country, for instance, BOP surplus indicates more cash inflow than cash outflow of a country. 27  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.2: Current Account The current account shows the money flows from all exports and imports of goods and services, income and current transfers during a year. Current account comprises of: 1. Balance of trade 2. Net Invisibles 3. Net Transfers 1. Balance of Trade (BOT) is the difference between the merchandise (visible) exports and imports. BOT surplus (+) means merchandise exports exceeds imports, BOT deficit (-) means merchandise imports exceeds exports. Visible exports are exports of physical goods such as primary goods (coffee, copra, timbers, minerals -gold, copper, nickel, etc.) and manufactured goods such as RD Tuna Dolly, Ramu sugar, Ox & Palm, etc). Visible imports are physical imports such as rice, machineries, medicines, clothes, etc. Balance of Trade = Visible exports - Visible imports Balance of Trade = K4 930m – K2 733m = K2 197m. A BOT surplus occurs due to greater exports than imports. 2. Net Invisibles is the difference between the invisible exports and invisible imports. It refers to services that are bought and sold without people receiving a good. Invisible exports refer to payments for services provided to foreigners such as transport, insurance charges, telephone charges and tourist accommodation. Invisible imports refer to foreign owned services used paid for by residents or citizens of a country. For example, a Papua New Guinea flying on Quantas to Australia, paying freight on foreign owned shipping company for its import of goods, a payment for Tour company in New Zealand for a travel planning, etc. Net Invisibles = Invisible exports - Invisible imports Net Invisibles = K680m – K2 606m = -K2 926m. A deficit balance occurs due to greater invisible imports than exports. 28  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 3. Net Transfers is the difference between the Net private transfer and official transfers. Net Private Transfers include expatriates working in PNG sending money to their relatives, for examples, Philipinos working in PNG sending money to their relatives in Philippines. Likewise, Papua New Guineans working in foreign countries sending money to relatives in PNG. Official transfer includes financial aids given to other countries to assist in disasters, (not for building capital – in this case, will be recorded in official capital flow), pensions received by foreigners, payout of insurance claims. For example, the PNG government donates K50 million to Fiji government for a disaster relief program. Likewise, cash inflow into PNG is in similar ways. Balance on Current Account is the sum of Balance of Trade, Net invisibles and Net transfers. Balance on Current Account = BOT + Net Invisibles + Net Transfers Balance on Current Account = K2 197m + (-K1 926m) + K48m = K319m. A surplus in this account is due to increased cash inflow from visible exports and official transfers. 29  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.3: Capital or Financial Account The capital account concerns financial assets and liabilities, that is, the money flows that result from international borrowings, lending and foreign Investments (purchasing of assets such as shares and real estate) for a period of one year. Capital Account comprises of: 1. Official capital flows (OCF) 2. Private capital flows (PCF) 3. Non-official monetary sector transactions (NOMST) 4. Change in Offshore account balances (CIOAB) 1. Official Capital Flow refers to transaction that involves the government or public sector of the economy such as: i. borrowing and repayment of debt ii. travel expenses of government officials (delegates) for overseas trips iii. foreign aid to build infrastructure iv. special Drawing Rights with International Monetary Fund (IMF)) v. the government investment in foreign countries 2. Private Capital Flow refers to transaction that involves the individuals and firms or the private sector of the economy such as:  foreign company investment ( buying shares, financial capital transfer-seed capital)  business borrowing from foreign bank and paying of debt  paying dividends to foreign shareholders 3. Non-Official Monetary Sector Transactions refer to the transaction for the purchase and sale of intellectual property rights such as:  patents – a payment to the government by a certain firm for allowance of non-payment of company profit tax  copyrights – a payment to the original producer (writer or singer) for copying part or whole of it  Trademarks – a payment to the parent company for using a popular product such coca cola, puma, KFC, etc.  franchise (such as buying the rights from Australian based company (McDonald) to operate McDonald in PNG) 30  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 4. Change in Offshore Account Balances refers to those foreign financial assets that are available to and controlled by the central authorities (BPNG) for financing and regulating payment imbalances. It includes reserve assets comprising monetary gold (gold held by the Reserve/Central Bank), Special Drawing Rights with International Monetary Fund (IMF), and foreign exchange held by the Central bank. Balance on Capital Account = OCF + PCF + NOMST + CIOAB Balance on Capital Account = K116m + (-K197m) + (-K6m) + K22m = -K65m. A deficit in this account is due to huge cash outflow in private capital flow and non-official monetary sector transaction. 31  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.4: Overall Balance of payments Overall Balance is the difference between the Balance on Current Account and Balance on Capital plus the Revaluation and Net errors & Omissions. The following two items are added onto the current account balance and capital account balance to calculate overall balance. Revaluation refers to an official decision to raise the value of PNG Kina against a foreign currency. If such revaluation takes place during the year then it is recorded. Net Errors and Omissions is referred to as a balancing item if there are any discrepancies. Overall Balance comprises of: 1. Current account balance 2. Capital account balance 3. Revaluation (if any) 4. Net errors and Omissions (NE&O) Overall Balance = Current Acc Bal. + Capital Acc Bal. + Revaluation + NE&O Overall Balance = K319m + (-K65m) + (-K8m) + (-K86m) = K160m. A positive figure in the overall balance is called a BOP surplus. This means there were more cash inflow than cash outflow in that time period. It is due to a huge surplus in the current account balance, specifically from the large volume of visible exports than imports and the large cash inflow from official transfers. If the Overall balance is a positive (+) figure then, it is called Balance of payment (BOP) surplus or favourable. If the Overall balance is a negative (-) figure then, it is called Balance of payment (BOP) deficit or unfavourable. The PNG government under its Macroeconomic Policy goal aim to achieve Balance of payment (BOP) surplus and not Balance of payment (BOP) deficit. Let us discuss the effects of balance of payment surplus and balance of payment deficit on the economy. 32  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Impacts of Balance of payment (BOP) surplus on the PNG economy are:  increase money flow into PNG economy  Exchange rate appreciate (increase in Kina value against foreign currencies)  increases money supply  increase in National Income  increase in investment and employment level  increase in Production level and GDP  improved standard of living  economic growth However, the major disadvantage or drawback of having Balance of Payment (BOP) surplus may result in high inflation in the domestic market due to increased money supply (Refer to Quantity Theory of Money in Unit 2). Impacts of Balance of payment (BOP) deficit on the PNG economy are:  decrease money flow into PNG economy  exchange rate depreciate (decrease in Kina value against foreign currencies)  decreases money supply  decrease in National income  decrease in investment and unemployment level rises  decrease in Production level and GDP falls  decline in standard of living  decline in economic growth Source: P.M.N. Bandara, 2013. Economics for Grade 12. 33  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.5: Improving Balance of Payment Deficit Measures to correct Balance of Payment deficit are:  PNG government should encourage Import Substitution Manufacturing (Industrialization) – producing goods to substitute imports instead of importing from foreign countries which lessen capital outflow from the country and finally achieve balance of payment surplus.  PNG government should encourage Export Oriented Manufacturing (Industrialisation) – produce goods which can be exported overseas which increase the capital inflow into the economy and results in balance of payment surplus,  PNG government should impose trade protection or trade barriers to encourage local producers to produce increased variety of goods to satisfy domestic market demand and thus reduces importation of foreign made goods which will lead to favourable balance of payment.  The PNG government should encourage Down-stream processing of raw materials extracted in the country into final goods and export only final goods overseas that will increase capital inflow and ultimately achieve balance of payment surplus.  Promoting foreign direct investment (FDI) may result in huge inflow of seed capital flow into the country.  Promoting tourism may generate capital inflow as it is the untapped resource and has the potential to generate increased revenue.  The government should reduce borrowing from overseas and would prefer borrowing from within the country. This will reduce cash outflow of the country.  Firms operating in the country should sell most of its shares to the local investors rather than the foreign investors. This will lessen cash outflow of the country. 34  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.2.6: Terms of Trade (TOT) Terms of trade is defined as a measure of the number of imports that can be bought with the foreign currency earned from the sale of a given volume of exports. It shows the relationship between the prices PNG receives for exports and the prices that it pays for its imports. If export prices are increasing relative to import prices, PNG’s terms of trade will improve. However, if import prices were increasing relative to export prices, then the terms of trade will deteriorate. The export price index shows the proportional change in the level of export prices, while the import price index shows the proportional change in the level of import prices. It should be noted that, as with all index numbers, the proportional change is relative to a base year, or starting point, which is given an index number of 100. Terms of trade is expressed as a number known as the terms of trade index. It shows the ratio of the export price index over the import price index. The formula for calculating TOT is: Terms of Trade (TOT) = Export Price Index x 100 Import Price Index 1 Once, the terms of trade for the current year is calculated it should minus the base year index (100) to find out the change in terms of trade. Current year index – base year index = change in TOT (improve/decline) Note:  Current year is the same as Year 2  Base year is the same as Year 1 Your calculation of terms of trade will end up in either of these situations: 1. A positive figure indicates an improved TOT or favourable TOT. If the term of trade calculated is more than 100 then it is considered as favourable or improved terms of trade. This means that more than 100 units of imports can be bought with a 100 unit of exports. For instance, if the terms of trade calculated in the current year is 110, then, terms of trade has improved by 10% (i.e. 110 – 100 = 10). In conclusion, this situation indicates:  favourable terms of trade  increase in revenue received from exports 35  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY  increase in foreign exchange earnings from exports  revenue earned from the sale of exports is able to buy more and more imports 2. A negative figure indicates a decline TOT or unfavourable TOT. However, if the terms of trade calculated is less than 100 then it is considered as unfavourable or deteriorating terms of trade. This means that less than 100 units of imports can be bought with a 100 unit of exports. For instance, if the terms of trade calculated in the current year is 92, then, terms of trade declined by 8% (i.e. 92 – 100 = -8). In conclusion, this situation indicates:  unfavourable terms of trade  decrease in revenue received from exports  decrease in foreign exchange earnings from exports  revenue earned from the sale of exports is able to buy fewer and fewer imports Example The following examples demonstrate changes in the terms of trade, based on the information in the table. Year Export Price Index Import Price Index Terms of Trade Index 1 100 100 100 2 115 105 109.5 3 120 130 92.3 1. Calculate the terms of trade for year 2 Now, you look in the table and get the year 2 export price index and import price index shown below. Year Export Price Index Import Price Index Terms of Trade Index 2 115 105 109.5 Then, substitute correctly the figures in the formula as shown below Year 2 Terms of trade index = 115 x 100 = 109.5 105 1 36  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Once, you have calculate the year 2 terms of trade index, then, use the following formula to work out the changes in terms of trade. Current year index – base year index = change in TOT (improve/decline) In this example, the terms of trade has improved by 9.5% (109.5 – 100 = 9.5). That is, the increase in the export price index is higher than the increase in the import price index. 2. Calculate the terms of trade index for Year 3 (Use the same steps used in calculating terms of trade index for year 2) Year 3 Terms of trade index = 120 x 100 = 92.3 130 1 In this example, the terms of trade has deteriorated by 7.7% (92.3 – 100 = -7.7). That is, the increase in the import price index is higher than the increase in the export price index. Terms of trade are influenced by balance of payments. If terms of trade deteriorate, it means that the same (given) volume of exports can buy less or fewer imports. If terms of trade improve, it means that the same (given) volume of exports can buy more imports. Deteriorating terms of trade can be improved through: o increase in export prices (given lower increase in import prices) o increasing volume of exports through encouraging export-oriented manufacturing (industrialisation) o decreasing imports through encouraging import-substitution manufacturing (industrialisation) o decreasing imports through imposing trade barriers or restrictions (trade protection) Source: P.M.N. Bandara, 2013. Economics for Grade 12. YOU HAVE COME TO THE END OF TOPIC 2. YOU MAY NOW READ THE SUMMARY ON THE NEXT PAGE. 37  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Summary 12.3.2 ___________________________________________________________________________  BOP is a record of economic transactions of a country with the rest of the world over a specific period of time.  BOP records the exports and imports of goods and services. Income receipts and payments, transfers, capital and financial flow.  BOP consists of two main accounts known as Current Account and Capital Account.  A negative overall balance indicates a BOP deficit and a positive overall balance denotes a BOP surplus. Equality between money inflow and out flow of the country is called overall balance equilibrium.  The most widely used terms of trade is the net barter terms of trade.  Terms of trade index calculated greater than 100 is favorable because exports of 100 units buys more than 100 units of import and is called favorable or improved terms of trade.  Terms of trade index calculated when less than 100 is unfavorable because exports of 100 units buys less than 100 units of import and is called unfavorable or deteriorating terms of trade. ___________________________________________________________________________ NOW DO STUDENT LEARNING ACTIVITY 12.3.2 ON THE NEXT PAGE. 38  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Learning Activity 12.3.2 ___________________________________________________________________________ 1. Define the terms below: i. Balance of payment _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ ii. Terms of trade ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________ 2. Identify and state the two main accounts in the balance of payment. ___________________________________________________________________________ 3. What is another name for balance of payment? ___________________________________________________________________________ 4. What does a positive figure in balance of payment indicates? ___________________________________________________________________________ ___________________________________________________________________________ 5. What does a negative figure in balance of payment indicates? ___________________________________________________________________________ ___________________________________________________________________________ 6. State at least two impacts of balance of payment deficit on the economy. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 39  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 7. Write down the formula for calculating terms of trade. ___________________________________________________________________________ 8. Differentiate between deteriorating terms of trade and improving terms of trade. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 9. Given the following information in the table, calculate the answers in the fourth (4 th) in the table. Year Export Price Import Price Terms of Trade Index Index Index 1 100 100 100 2 120 125 ______ 3 130 120 ______ i. Compute the terms of trade for year 1 and 2. __________________________________________________________________ ii. What is the’ terms of trade’ for year 2 and 3? __________________________________________________________________ 40  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 10. Given the data in the table below, identify the ‘terms of trade’ for their respective years and compared to previous year, then, write in the last column whether ‘terms of trade’ has improved or deteriorated and how much in percentage. Year Terms of trade Improved/Deteriorated by how much % 1991 – 2 104.1 1992 – 3 99.7 1993 – 4 96.9 1994 – 5 99.4 1995 – 6 102.4 1996 – 7 105.4 1997 - 8 108.4 __________________________________________________________________________________ CHECK YOUR ANSWERS AT THE END OF THE UNIT. 41  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.3: EXCHANGE RATES ___________________________________________________________________________ TOPIC 3: Introduction Exchange rates play a central or important role in the relationships between individual economies and the global economy. Essentially, all of the trade and financial relationships between countries are processed through the exchange rate. For this reason, exchange rate movements have a significant impact on international competitiveness, trade flows, investment decisions, inflation and many other factors in the economy. ___________________________________________________________________________ Specific Learning Outcomes By the end of this topic students can be able to:  define exchange rate  Conversion of one currency into another currency  identify methods of exchange rate and describe them  explain government intervention in fixing of exchange rate 42  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.3.1: Factors Determining an Exchange Rate Before we discuss the factors affecting an exchange rate, let us define what an exchange rate is. Exchange rate is the value (or price) of one currency in terms of another currency. In other words, it is the value of PNG kina against a foreign currency. Or it is the rate at which PNG kina can be exchanged into a foreign currency. Exchange rate allows traders and investors to convert their local currency into foreign currency. The reason why this is necessary is that the exporters in the world trade want to be paid in their own currency, which means that importers need to be able to convert their domestic (local) currency into the foreign currency in order to make payment for imports. Conversion of currencies takes place in the foreign exchange market. Foreign exchange market refers to the act of exchanging of one currency into another. Now, we will discuss the factors that influence exchange rates. Exchange rates are determined using different methods but before we look at each of them, let us discuss some of the factors that influence exchange rates. They are: 1. Interest rate 2. Inflation 3. Balance of Payment 4. Economic growth /recession 1. Interest rate: How? The investors are more likely to transfer their financial assets to invest in financial markets of countries where interest rates are higher with the hope of earning higher return. For example, if there is higher interest rate on investment in the Australian financial market, many investors from PNG will invest there. This will result in huge cash outflow and results in depreciation or lower value of PNG Kina against Australian Dollar. 2. Inflation: How? Inflation increases the cost of production for locally produced goods and becomes expensive. As a result, exports become expensive while imports from overseas become cheaper. For example, let us assume that PNG experiences a high inflation or rising prices of goods and services, exports will be expensive while imports will be cheaper. This will result in more cash outflow than cash inflow which will affect the Kina exchange rate against foreign currencies. 3. Balance of Payment: How? A Balance of Payment surplus indicates more cash inflow than cash outflow. This will appreciate increase Kina exchange rate against foreign currencies. Vice versa, Balance of payment deficit indicates a greater cash outflow than cash inflow. This will result in depreciation or decrease Kina exchange rate. 43  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 4. Economic growth/recession: How? During economic recession there is high inflation so local exports become expensive and imports become less expensive. This means more imports will be bought than exports which will affect the exchange rate. However, an economic shows that a country is increasing its local production and exports and reduces its dependency on imports. This will appreciate or increase the exchange rate. 44  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.3.2: Methods of Determining Fixed Exchange Rates Under this section we will look at fixing or determining of exchange rates and various methods used in fixing exchange rate. In our discussion, we will look at three main methods used in PNG, especially the Bank of Papua New Guinea (BPNG) or Central Bank uses to determine the exchange rate of PNG kina against foreign currencies such as US Dollar, Australian Dollar, Euro Dollar, Japanese Yen, New Zealand Dollar, etc. Three main methods of fixing exchange rate in PNG are: 1. Free (flexible) Exchange Rate 2. Managed Float 3. Fixed Exchange Rate Let us discuss each of the methods of fixing exchange rate in detail. 1. Free (flexible) Exchange Rate Method Under free or flexible exchange rate method exchange rate is determined by the demand for and supply of currency (kina). Appreciation is increase in the value of one currency (kina) against another currency (US dollar) due to increase in demand for money (PNG kina) or increase in level of foreign reserves held in the banks. Depreciation is decrease in the value of one currency (kina) against another currency (US dollar) due to increase in supply of money (PNG kina) or increase in level of foreign reserves held in the banks. An Appreciation of the currency value (kina value) An appreciation or increase in the value of currency (Kina) results from either increase in demand for currency (Kina) or decrease in the supply of kina at the bank. Increase in demand for Kina or decrease in supply of Kina comes from:  revenue earned from exports  foreign companies transferring money into PNG as staring capital  Tourists or foreigners coming to PNG  Aid or grants given to PNG by overseas countries  Papua New Guineans residing in foreign countries send money to relatives in PNG 45  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY  Borrowing from overseas countries  Foreign delegates (government officials) coming to PNG In general, the above listed economic activities represent cash inflow into the country. When more cash inflow than cash outflow this results in appreciation of Kina exchange rate. Increase in demand for Kina/Decrease in supply of Kina Increase in demand for Kina from cash inflow into the country appreciates kina value. How? By looking at the simple diagram below, the cash inflow is usually in foreign currencies so in order to use them in PNG, the foreign currencies need to be brought to the banks to be exchanged into PNG Kina. By doing that, we are demanding for PNG Kina. When there is an increase in cash inflow, it results in the increase in demand for PNG kina. But, what happens to supply of Kina at the bank? When increasing quantities of Kina is demanded, the supply of Kina at the bank decreases, because increasing amounts of foreign currencies are exchanged into Kina. E.g. Goods export Overseas PNG Countries Economy Foreign currency PNG Kina (cash inflow) Bank: Foreign currency exchange Let us look at the graphical illustration of appreciation and depreciation of a currency value (kina value) according to demand for and supply of money (kina). (Refer to graphs on the next page) 46  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Case 1: Due to increase in demand for kina Key: Sk = Supply of PNG Kina Dk = Demand for PNG Kina E1 = Original Exchange rate Exchange rate E2 = New Exchange rate Sk Market exchange rate US$0.70 E2 Market exchange rate US$0.60 E1 D2k D1k 0 Demand and Supply for Kina In this case, the kina value has appreciate from PNGK1.00 = US$0.60 to PNGK1.00 = US$0.70 due to increase in demand for Kina. Key: S1k = Original Supply of PNG Kina S1k = New Supply of PNG Kina Case 2: Due to decrease in supply for kina D1k = Original Demand for PNG Kina D2k = New Demand for PNG Kina S2k Exchange rate S1k Market exchange rate US$0.70 E2 Market exchange rate US$0.60 E1 Dk 0 Demand and Supply for Kina In this case, the kina value has appreciate from PNGK1.00 = US$0.60 to PNGK1.00 = US$0.70 due to decrease in supply of Kina. Source: P. M. N. Banadara, 2013. Economics for Grade 12. 47  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY A Depreciation of the currency value (kina value) A depreciation or decrease in the value of currency (Kina) results from either decrease in demand for currency (Kina) or increase in the supply of kina at the bank. Increase in demand for Kina or decrease in supply of Kina comes from:  Payment for imports  PNG companies transferring money to overseas as staring capital  Papua New Guineans going overseas  Aid or grants given by PNG to overseas countries  Foreigners residing in Papua New Guinea sending money to relatives in their countries.  Loan repayment to overseas countries  PNG delegates (government officials) going overseas In general, the above listed economic activities represent cash outflow from the country. When there is more cash outflow than cash inflow it results in depreciation of Kina exchange rate. Decrease in demand for Kina/Increase in supply of Kina Decrease in demand for Kina from cash outflow of the country depreciates kina value. How? By looking at the simple diagram below, the cash outflow is usually in foreign currencies so in order to use money in overseas countries, the PNG Kina need to be brought to the banks to exchange into foreign currencies. By doing that, there is less demand for PNG Kina. When there is an increase in cash outflow, it results in decrease in demand for PNG kina. But, what happens to supply of Kina at the bank? When decreasing quantities of Kina is demanded, the supply of Kina at the bank increases, because decreasing amounts of Kina is exchanged into foreign currencies. E.g. Goods import Overseas PNG Countries Economy Foreign currency PNG Kina (cash outflow) Bank: Foreign currency exchange 48  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Let us look at the graphical illustration of appreciation and depreciation of a currency value (kina value) according to demand for and supply of money (kina). Case 1: Due to decrease in demand Exchange rate Sk Market exchange rate US$0.70 E1 Market exchange rate US$0.60 E2 D1k D2k 0 Demand and Supply for Kina In this case, the kina value has depreciate from PNGK1.00 = US$0.70 to PNGK1.00 = US$0.60 due to increase in demand for Kina. Case 2: Due to increase in supply S1k Exchange rate S2k Market exchange rate US$0.70 E1 Market exchange rate US$0.60 E2 D1k 0 Demand and Supply for Kina In this case, the kina value has depreciate from PNGK1.00 = US$0.70 to PNGK1.00 = US$0.60 due to increase in supply of Kina. Source: P.M.N. Bandara, 2013. Economics for Grade 12. 49  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Below is an example of PNG Kina exchange rate against foreign currencies determined using free or flexible exchange rate method supplied by the Bank of Papua New Guinea. What your kina worth (September 23, 2015) USD 0.3500 PHP 16.38 AUD 0.4977 JPY 41.96 CAD 0.4651 NZD 0.5592 CHF 0.3414 SGD 0.4981 GBP 0.2282 SDR 0.4981 HKD 0.2.726 KRW 416. 90 EUR 0.3146 FJD 0.7552 Courtesy: Bank of Papua New Guinea Source: The National, September 24, 2015 2. Managed Float Exchange Rate Method Manage float is partly free exchange rate and partly fixed exchange rate. This means exchange rate is determined by the demand for and supply of money (kina) but an upper limit and lower limit is fixed for the exchange rate to fluctuate (appreciate or depreciate according to demand for and supply of money). Upper limit is the limit to which exchange rate is allowed to appreciate and devaluation is necessary. Lower limit is the limit to which exchange rate is allowed to depreciate and revaluation is necessary. Graphical illustration of managed float exchange rate method Exchange rate Sk Upper Limit US$0.70 Market exchange rate US$0.60 E Lower Limit US$0.50 Dk 0 Demand and Supply for Kina Source: P.M.N. Bandara, 2013. Economics for Grade 12. 50  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY In this case, if the kina value has appreciate from PNGK1.00 = US$0.60 to PNGK1.00 = US$0.70 and reaches an upper limit, then, a devaluation is necessary. If the kina value has depreciate from PNGK1.00 = US$0.60 to PNGK1.00 = US$0.50 and reaches a Lower limit, then, a revaluation is necessary. 3. Fixed Exchange Rate Under fixed exchange rate method the Central bank (BPNG) officially set a standard exchange rate. This fixed exchange rate is used for a certain period of time and is subject to review depending on the economic condition. In the 1980s, PNG was using fixed exchange rate method under its Hard Kina Policy. Illustration of fixed exchange rate method Exchange rate Sk Fixed Exchange rate US$0.70 Market exchange rate US$0.60 Dk 0 Demand and Supply for Kina Source: P.M.N. Bandara, 2013. Economics for Grade 12. In the above graph, the fixed exchange rate is set at PNGK1.00 = US$0.70, however, according to the market forces of demand for and supply of kina the exchange rate is PNGK1.00 = US$0.60. In this case, fixed exchange rate is set above the real market value of kina, it is referred to as over-valuing of kina value and the government (BPNG) needs to intervene to devaluate (devaluation) the value of kina closer to the real market value (Market exchange rate). Likewise, if the fixed exchange rate is set below the real market value of kina, it is referred to as under-valuing of kina value and the government (BPNG) needs to intervene to revaluate (revaluation) the value of kina closer to the real market value (Market exchange rate). The disadvantage of the fixed exchange rate is that it can lead to over-valuation or under- valuation of currency (kina) from its real market (natural) value according to demand for and supply of money (kina). 51  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY Devaluation is an official decision by the government (Central bank – BPNG) to decrease the value of one currency (kina) against another currency (US dollar). Revaluation is an official decision by the government (Central bank – BPNG) to increase the value of one currency (kina) against another currency (US dollar). 52  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.3.3: Calculation and Conversion of Exchange Rates Currency conversion is necessary when making payments for imports. Hence, when converting local currency (PNG kina) to foreign currency you may multiply by the exchange rate, and when converting overseas currency to local currency (PNG kina) you divide by the exchange rate. For simplicity a magic word ‘POM’ can be used to convert PNG kina into Overseas (Foreign) currency. ‘P’ stands for PNG Kina, ‘O’ stand for operation sign, and ‘M’ stand for Multiplication. However, reverse (opposite) is also true, when converting overseas currency to PNG kina it should be divided by the exchange rate. For example, given an exchange rate of PNGK1.00 = to US$0.40. K50 has been converted into US Dollar as follows: K50 × US$0.40 = US$20. Conversely, a US$100 has been converted to PNG kina as follows: US$100 ÷ US$0.40 = K250 Effects of exchange rate on Exports and Imports and Balance of Payment Increase or decrease in exchange rate (kina value) affects price and volume of exports and imports. This is because: i. Increase in exchange rate (kina value) results in: o exports becoming expensive and thus decrease volume of exports o imports becoming cheaper and thus increase volume of imports o may lead to Balance of payment deficit ii. decrease in exchange rate (kina value) o exports becoming cheaper and thus increase volume of exports o imports becoming expensive and thus decrease volume of imports o may lead to Balance of payment surplus Effects of Balance of payment on the exchange rate  Effects of Balance of payment surplus leads to appreciation of currency value (kina value)  Effects of Balance of payment deficit leads to depreciation of currency value (kina value) 53  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY 12.3.3.4: Globalisation in an Economic Context Realistically, a society or country is not independent or being self-reliant and produces all of its needs and wants. In other words, not one society or country exists in isolation without any link or communication with other societies or countries. May be to some extent several countries are independent but in fact, countries need each other to progress in their economic development through establishing mutual relationships. Hence, the concept of globalisation evolves to connect countries together. Globalisation is the process of connecting internal markets to global economy allowing goods and services and capital flows to flow freely between countries. The final aim of globalisation is to make the whole world a single market (P.M.N. Bandara) Let us discuss globalisation in terms of economic globalisation. Economic globalisation refers to the increasing economic interdependence of national economies across the world through the rapid increase in cross –border movements of goods, services, technology, capital flows and labour. Economic interdependence occurs when one economy depends on another economy. Globalisation has gone beyond international trade to connect economies to become increasingly dependent and could not survive without other countries. Rapid improvement of information and communication technology sped up globalisation process in which countries become more interdependent on each other. Some characteristic of globalisation (benefits):  Growing economic interdependence; acquire needed things from other countries. Most of the goods found in PNG are imported from other countries.  Spread of improved or advanced technology across the world and thus, improved production process. As a result, companies are using a lot of new advanced technologies in the workplace to achieve efficiency in production.  Development of global telecommunications infrastructures, internet, communication satellites and mobile phones results in efficient communication. For instance, Digicel investing in PNG greatly improved the efficiency of communication in the country.  A decrease in communication cost for voice, text and data as a result of faster and wider spread of advanced ICT technologies. Hence, PNG is enjoying the 60 free sms for K1.20, K3 for Day data of 60 MB, etc.  Removal of trade barriers and free flow of goods and services between countries.  Integration of economies and markets between developing and developed economies.  Increase in foreign direct investment as a means of economic growth for developing countries. For instance, Exon Mobil, a multinational company investing in PNGLNG project.  Easy access to global financial markets for corporate and national borrowers that is, the government or multinational companies can be able to borrow from financial institutions in other countries. For instance, PNG government recently (2014) acquired a K6 billion loan from Axim bank from China. 54  GR 12 ECONOMICS U3 THE GLOBAL ECONOMY  Greater labour mobility between countries that is, skilled labour and knowledgeable people free to migrate to other countries to work.  Availability of a greater variety of goods and services to consumers at competitive prices. Hence, we have plenty of various goods in the stores for