Introduction
Remaining topics to be covered:
◦ BOP and Exchange Rates
◦ International Trade and Comparative Advantage
◦ Government Budgets, Deficits and Debt
Topics already covered:
◦ National Income Accounting and GDP Growth
◦ AD, Fiscal Policy and the Multiplier Effect
◦ Money; the Central Bank and Monetary Policy
◦ The IS-LM Model
Relating what you know to Ghana
Real GDP 2014
Real Per Capita GDP 2014
Real GDP Growth
Unemployment Rate
Inflation
Why trade? (Basis for trade)
Gains and losses from trade
Trade barriers/Protectionism
Arguments
for
and
against
Protectionism
Typical Trading arrangements
Key Concepts
◦ Autarky and Free Trade
◦ Absolute and Comparative advantage
◦ Terms of Trade
◦ Welfare Gains
◦ Deadweight Loss
The exchange of goods between traders in
two national markets; the inflow and
outflow of goods between two countries
Is it Avoidable?
May be not. Due to Globalisation
Globalisation is the increased integration of
product and resource markets across
nations through trade, immigration, and FDI
Greater interdependence among countries
and their citizen.
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Mercantilists view: Exports should be
encouraged but imports should be discouraged (reduced or restricted)
Adam Smith disagreed slightly and proposed
that there could be gains from Free Trade under the principle of Absolute Advantage
Free Trade is international trade without
restrictions between countries – open markets
Autarky is absolutely NO trade; zero trade;
closed borders
This shows that a country can be ‘better off’
by specialising in the production of some goods and trading with other countries to have other goods
That is the country is ‘better off’ by trading
than by being self-sufficient.
In other words, through trade a country
reach a consumption point that is outside its domestic production possibility curve?
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In the following table, Switzerland has an
absolute advantage in both products.
With a given set of resources, it can
produce more of both products than Ghana.
Ghana has an absolute disadvantage in
both products.
9
Country
Chocolate
Watches
Switzerland
Ghana
2,000 boxes
1,000 boxes
800 pieces
200 pieces
Production possibilities in a
Adam Smith suggested that international
trade would only benefit both countries (in a two-country two-product model), where
each country had an absolute advantage in one of the products.
In the previous table, Smith would see no
benefits from specialisation and trade.
Unlike Smith, Ricardo saw the possibilities
of each country benefiting from
specialisation and trade (in a 2 × 2 model), even when one country was absolutely
efficient in both products and the other
absolutely inefficient.
Ricardo suggested that each country should
specialise in that product in which it had a
comparative advantage.
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In a two-product two-country model, a
country has a comparative advantage in that product:
◦ In which its absolute advantage is greatest or its absolute disadvantage least.
In the original table:
◦ Switzerland is comparatively more efficient than Ghana in Watches than in Chocolate.
◦ Ghana is comparatively less inefficient than Switzerland in Chocolate than in Watches.
Switzerland has a comparative advantage in
Watches.
Ghana has a comparative advantage in
Chocolate.
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More modern approaches use the idea of
opportunity cost to identify comparative
advantages.
Opportunity cost for a product X is the
amount of the other product foregone
(lost) as a result of producing one more
unit of X.
We can work out the opportunity costs
from our original table for each country
and product.
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Country Opportunity cost of 1 extra box of Chocolate
Opportunity cost of 1 extra Watch
Switzerland
Ghana
0.4 watches
0.2 watches
2.5 chocolate
5.0 chocolate
In a two-product two-country model, a
country has a comparative advantage in
that product:
◦ In which its opportunity cost is lowest.
Switzerland has a lower opportunity cost
than Ghana for watches and, therefore,
has a comparative advantage in watches.
Ghana has a lower opportunity cost than
Switzerland for Chocolate and, therefore,
has a comparative advantage in
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19
Economic welfare
‘Economic welfare’ is an attempt to measure
the impacts on the economy (or society) of a policy change.
It is usually expressed as the sum of
Economic welfare (Continued)
Economic Welfare (EW) is often defined as:
EW = Consumer Surplus + Producer Surplus
Consumer surplus is the amount
consumers are willing to pay over and
above what they have to pay (market
price).
Producer surplus is the amount producers
actually receive (market price) over and
above what was needed for them to
21
In Autarky the consumer is Ghana will need
25 boxes of Chocolate to exchange for one watch
But with free trade she only needs to give
up 12.5 boxes of chocolate for a Swiss Watch
In Autarky the consumer in Switzerland
would buy only 6.25 boxes of Chocolate with 1 Swiss Watch
But with free trade they will get 12.5 boxes
of chocolate for that same Watch
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Terms of trade
Refers to the rate at which the goods
exported exchange for the goods imported.
It measures the relationship between the
prices a country gets for its exports and prices it pays for its imports.
If the terms of trade are ‘appropriate’ both
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Terms of trade (Continued)
Index of export prices
Index of import prices
If Terms of trade (Ts of T) rise, there is said
to be a
favourable
movement in the Ts of T
because more imports can now be bought
for any given volume of exports.
If Ts of T fall, there is said to be an
unfavourable
movement in the Ts of T,
with less imports now exchanged for any
given volume of exports.
Terms of trade (Continued)
Whether ‘favourable’ or ‘unfavourable’ is
an accurate term depends on the reasons
for change in the Ts of T.
Example
: if export prices rise because of
increased demand
by overseas consumers
‘favourable’ seems an appropriate term.
However, if export prices rise because of
The restriction of imports into a country by
government measures
Trade barrier is a general term covering any
government limitation or restriction on the free international exchange of goods
In spite of the potential gains from free trade,
in reality all countries have some restrictions to free trade
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Tariff barriers
Non-tariff barriers
◦ Quotas
◦ Voluntary export restraints
◦ Subsidies
◦ Exchange controls
◦ Safety standards.
To prevent dumping
To maintain employment (Job Protection) To protect infant industries
To protect strategically important industries Fairness in Trade: a level playing field
Revenue Mobilisation
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Retaliation
Misallocation of resources Welfare losses
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Free trade areas Customs unions Common markets Economic unions.
There are 4 categories of cooperation We can regard each of these as being
progressively more co-operative
Degrees of co-operation
Progressively closer relationships between economies
Free Trade Area
Common Market Customs Union
Where member countries reduce or abolish
restrictions on trade with each other while maintaining their individual protectionist measures against non-members.
Where, as well as freeing trade among
members, a common external tariff is established to protect the group from imports from any non-member.
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Where the customs union is extended to
include the free movement of factors of production as well as products within the designated area.
Where national economic policies are also
harmonised among member states within the common market.
37
Discuss the arguments for and against
Ghana (together with its West African
Partners) signing the Economic Partnership Agreement With the EU.
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Number of units of the foreign
currency needed to purchase one unit
of the domestic currency
Example: GhS 1= £0.182
The price of the foreign currency in
terms of the domestic currency
i.e. £1= GhS5.5
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Exchange rate (Continued)
This is known as the Nominal Exchange Rate
The rate at which one currency is quoted
against any other currency (i.e. bilateral exchange rate).
The price of one currency expressed in terms
of another
For imports and export
In order to buy and sell products
For investment purposes
To purchase foreign capital (Physical and
financial)
For speculation
▶Those who buy and sell currency simply to make profit
Changes in the Exchange
Rates
Appreciation
A rise in the value of GhS in relation to other
currencies – each GhS buys more of the other currency
Or each foreign currency buys less domestic
currency
E.g. £1=5.5GhS £1=5 GhS
Ghanaian exports appear to be more expensive
Changes in the Exchange
Rate
Depreciation
A fall in the value of the Cedi in relation to
other currencies
Each £ buys more of the Cedi
Ghanaian exports appear to be cheaper
Imports to the Ghana appear more expensive
What about Revaluations and
Changes in the Exchange
Rate
Calculating a Depreciation:
Currency Depreciation
where e0 = old currency value e1 = new currency value
Changes in the Exchange
Rate
Currency Appreciation
where e0 = old currency value e1 = new currency value
Note: Resulting sign is always positive
0
0 1
e
Changes in the Exchange
Rate
EXAMPLE: GhS Depreciation
If in January £1 was 4.9Ghs, but now it is going for £1= 5.5 GhS, then by how much has the Ghana Cedi depreciated?
= -10.91%
100
0
0
1
e
Determining Currency
Values
Many years ago…….. Up to 1971
◦ Various versions of the Gold Standard was used: ▶The value of a currency pegged to a certain amount
of gold
▶ the US fixed the price of gold at $20.67 per
Today…..
◦ Exchange rates are prices and determined in the same way as other prices
◦ By the demand for and the supply of currencies on the foreign exchange markets
◦ The demand and supply of currencies is in turn determined by ?????
Currency Markets
GHS per £
Quantity on Currency Markets D£ S£ 5.5 Q1
Assume an initial exchange rate of £1 = GhS 5.5 What would
cause an increase in the value of the £ against the GhS?
What would cause an
Factors that influence supply of
or demand for currencies
The demand for Ghana goods from overseas
(the UK) - exports (Supply of £)
The local demand for UK goods - imports
(Demand of £)
Investment opportunities
Speculative sentiments
Equilibrium Exchange
Rates
Equilibrium Exchange Rate:
occurs when the quantity suppliedequals the quantity demanded of a foreign
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Real exchange rate (RER)
Seeks to measure the rate at which
home products exchange for products
from other countries, rather than the
rate at which the currencies
themselves are traded.
Exchange Rate Systems
Floating
Exchange Rates:
◦ Price determined only by demand and supply of the currency – no government intervention
Fixed
Exchange Rates:
◦ The value of a currency fixed in relation to an anchor currency – not allowed to fluctuate
Managed
Exchange Rate:
◦ Value of a currency allowed to fluctuate
Floating Exchange Rate
System
Government takes no action
Rate determined purely by interaction
between
◦ Buyers and Sellers
◦ Demand and Supply
No requirement for government to support
the currency
Can give rise to sudden and or wide
Fixed Exchange Rate
System
Exchange rate maintained at a particular
level
Government dictates exchange rate
◦ Either by directly controlling market
◦ Indirectly intervening
Very stable
Managed Exchange Rate
Systems
Currency is allowed to float with the central
bank intervening periodically
◦ Usually to maintain the currency between certain upper and lower bands
Fixed and Managed systems may require
governments to
intervene
to
maintain
the
rate.
How can they do this?
◦ Open market operations - Buying or selling currency
◦ Monetary policy - Increasing or decreasing interest rates
◦ Exchange controls - Controlling the supply of local currency
Can have significant implications for the price
and volume imports and exports
But this depends on the Elasticities of Exports
and Imports (the Marshall-Lerner Condition)
The Marshall-Lerner elasticity conditions state
that for a fall in the exchange rate to improve the balance of payments a certain elasticity condition is necessary.
PED exports + PED imports > 1.
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Marshall-Lerner elasticity conditions (Continued)
The more elastic the demand for exports and
imports, the more effective will be
expenditure switching policy instruments.
For example a fall in the exchange rate will
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Marshall-Lerner elasticity conditions (Continued)
J-curve effect
In the short-run (e.g. 18 months or less)
elasticities tend to be lower than they are in the long run.
As a result it may take time before a fall in
the exchange rate causes the balance of payments to improve.
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J-curve effect (Continued)
Expenditure switching policy instruments
These involve changing the relative prices of
exports and imports.
Examples would include raising the
exchange rate (appreciation) or lowering the exchange rate (depreciation).
The change in relative prices may cause a
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Expenditure switching policy instruments (Continued)
A fall in the exchange rate will make exports
cheaper and imports dearer.
Overseas consumers may switch to purchase
more (now cheaper) exports from the country.
Domestic consumers may switch to purchase
Expenditure reducing policy instruments
These involve reducing aggregate
expenditure
Examples might include
◦ Deflationary fiscal policy (e.g. reduced government spending, increased taxes)
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Expenditure reducing policy instruments (Continued)
With less real income to spend, the
expectation is that domestic consumers will purchase less imports from abroad
Domestic consumers may also purchase less
domestic production, causing these
The current depreciation of the Ghana
Cedi is caused by the re-denomination of
the currency that took place in 2007. True
of False? Explain.
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Defining the Balance of
Payments
Nothing more or less than a giant bank
account
Lists all the flows of money or income;
◦ Into a country as payment for exports
◦ Out of a country to finance imports
Important to Balance these flows
◦ Described as achieving Balance of Payments
equilibrium
Defining the Balance of
Payments
A record of all recorded transactions
between the Ghana and the rest of the world in a particular financial year.
The balance of payments accounts are
constructed in such a way that there is always an overall balance when all items are taken into account.
Balance of Payments
Accounts
The key components include :
◦ Current account
Income flows as a result of goods and services
◦ Capital account
Income flows resulting from the sale or purchase of
fixed assets
◦ Financial account
Income flows resulting from investment or any other
financial activity
Direct investment, Portfolio investment, Other
financial flows
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Balance of payments deficit/surplus
If the sum of the current, capital and
financial accounts is negative, we speak of a
balance of payments deficit
If the sum of the current, capital and
financial accounts is positive, we speak of a
Balance of payments
policies
Various policies can be used to correct a
balance of payments ‘disequilibrium’, whether deficit or surplus.
The terms expenditure switching and
expenditure reducing are often applied to
groups of policies.
Having an unbalanced
Balance of payment is bad
for Ghana – True or False?
Discuss.
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This is the total amount the government
Plans to spend/ spends in a given year
It is financed by
◦ Tax Revenues
◦ Savings
◦ Aid
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Deficits, Surpluses, and the
Balanced Budget
When government spending is greater than
tax revenue, we have a budget deficit
The government borrows to make up the difference Deficits are prescribed to fight recession
When the budget is in a surplus position,
tax revenue is greater than government spending
Government is saving
A
deficit
is a shortfall of revenues over
Spending.
National
debt
is the total accumulated
borrowing or dissavings
Debt
is accumulated deficits minus
accumulated surpluses.
Deficits and surpluses are flow concepts.
Debt is a stock concept.
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Why Are Large Deficits So
Bad?
Large deficits raise interest rates, which, in turn, discourages investment
Deficits ‘crowd out’ private spending
The government has become increasingly dependent on foreign savers to finance the deficit
