Economic Integration and terms of trade

Question 1

What is economic integration?

Answer 1

This refers to economic cooperation between countries and coordination of their economic policies, leading to increased economic links between them.

Question 2

What is a preferential trade agreement (PTA)?

Answer 2

A preferential trade agreement is an agreement between two or more countries to lower trade barriers (liberalisation of trade) between each other for certain products.
They sometimes involve agreements on labour standards, environmental issues, or intellectual property.

Question 3

What is the difference between bilateral and multilateral trade agreements?
Regional?

Answer 3

Bilateral is between two countries, multilateral is many. Regional is between countries that are within a certain geographical area.

Question 4

Are PTAs discriminatory?

Answer 4

Yes as they discriminate against non-members of the agreement but the WTO makes an exception for it.

Question 5

What is a trading bloc?

Answer 5

A group of countries that have agreed to reduce tariff and other barriers to trade for the purpose of encouraging free or freer trade between them.

Question 6

Types of trading blocs:

Answer 6

1. Free trade area
2. Customs union
3. Common market

Question 7

What is a free trade area (FTA)?

Examples?

Answer 7

A group of countries that agree to gradually eliminate trade barriers between themselves, it is the most common type of trading bloc.
E.g. NAFTA (North American Free Trade Agreement)
ASEAN (Association os South East Asian Nations).

Question 8

Problems with free trade areas?

Answer 8

A product may be imported into the FTA by the country that has the lowest external trade barrier to countries with the highest external trade barrier, meaning the latter may import more than they would like. FTAs make ‘rules of origin’ for imports, preventing goods from entering countries with lower external barriers.

Question 9

What is a customs union?

Examples?

Answer 9

A group of countries that fulfils the requirements of a free trade area and in addition adopts a common policy towards all non-member countries. They act as a group for all trade agreements with non-members.
E.g. SACU (South African Customs Union)

Question 10

Compare customs unions to free trade areas:

Answer 10

Custom unions have the advantage of not having to create rules of origin for imports but they must coordinate their policies towards non-members which gives rise to the possibility of disagreements, as they may not all agree on what are appropriate levels of tariff and other barriers for non-members.

Question 11

What is a common market?

Example?

Answer 11

A group of countries that have a common external policy as well as eliminating all restrictions on movements of any factors of production within the common market. They have common policies such as common minimum wages and workers rights and agricultural product standards. For example, the European Economic community (EEC) which was a precursor to the EU.

Question 12

Advantages and disadvantages of a common market?

Answer 12

Pros:
Members enjoy free trade which leads to lower prices and greater consumer choice amongst other advantages. Workers are free to move and work in any member country without restrictions. This results in a better use of factors of production as if there is high unemployment in one country and high demand for labour in another this is reduced in both countries, as is the case without the UK and Poland with considerably undesirable jobs. Factor mobility improves the allocation of resources.
Cons:
The development of a common market requires even greater policy coordination among members than in a customs union and requires willingness of governments to give up some of their policy making authority. As there has to be agreement policies can take a long time to be determined.

Question 13

Advantages of economic integration:

Answer 13

1. Increased competition - removal of trade barriers, leads to increased efficiency.
2. Expansion into larger markets
3. Economies of scale - if a country opens itself up for free trade it will produce more if it is efficient which allows it to take advantage of economies of scale.
4. Lower prices for consumers and greater consumer choice
5. Increased investment - firms want to take advantage of larger market size, firms can escape tariffs which lowers costs.
6. Better use of factors of production, increased resource allocation
7. Improved efficiency in production and greater economic growth
8. Political advantages - interdependency reduces the likelihood of hostilities between countries.

Question 14

Disadvantages of economic integration:

Answer 14

1. Trading blocs may not be the best way to achieve trade liberalisation as they discriminate against non-members.
2. Trading blocs may create obstacles to the achievement of free trade on a global scale - discrimination against non members leads to a global misallocation of resources, lowering global output and leading to a weakened role for the WTO with the risk of breaking up the economy into multiple individual trading blocs.
3. Unequal distribution of gains and possible losses

Question 15

What is trade creation?

Answer 15

The situation where higher cost products (imported or domestically produced) are replaced by lower cost imports after the formation of a trading bloc. E.g. the removal of tariffs. This creates trade.

Question 16

What is trade diversion?

Answer 16

The situation where lower cost imports are replaced by higher cost imports from a member after the formation of a trade block. For example if a country has tariffs on all imports of a certain good, and then joins a trading bloc with a country that is not the lowest cost importer then they will reduce the tariffs for this country and not the lower cost imported. The result will be an increase in trade from a the country that is not the lower cost country, since their price without the tariff is cheaper than the other’s price with the tariff.

Question 17

How is trade diversion an argument against trading blocs

Answer 17

Trade diversion cannot occur with multilateral trade liberalisation such as the WTO. Trade liberalisation causes a country to reduce tariffs everywhere, meaning it is not possible for lower cost imports to be replaced by higher cost imports.

Question 18

When does a trading bloc increase efficiency of resource allocation?

Answer 18

When trade creation effects are larger than trade diversion effects. However this is in the short term, and long term effects are generally considered to be more important.

Question 19

What is a monetary union? Example?

Answer 19

Member countries in a monetary union adopt a common currency and a common central bank responsible for monetary policy. It has been formed of many countries within the European Union, known as the ‘euro zone countries’.

Question 20

Brief explanation of Eurozone countries:

Answer 20

• 11 countries in the European Union adopted a single currency, the euro, in 1999.
• Countries have to agree to convergence requirements, which include limiting the rate of inflation, limiting their budget deficit to 3% of GDP, and limiting govt debt to 60% of GDP.
• They gave up their economic sovereignty to a supranational body, the European Central Bank.

Question 21

Advantages of monetary unions:

Answer 21

1. A single currency eliminates exchange rate risk and uncertainty - this leads to higher inward investment.
2. A single currency eliminates transaction costs - banks charge a fee for currency conversion. Without this cost trade is encouraged.
3. A single currency encourages price transparency - it is easier for economic decision makers to see price differences quickly and accurately.
4. Low rates of inflation give rise to low interest rates meaning more domestic investment and increased output.
5. Low inflation gives rise to low interest rate (spending is allowed to increase), more investment and increased output.

Question 22

Disadvantages of monetary unions:

Answer 22

1. A single currency involves loss of exchange rates as a mechanism for adjustment - inflation or trade deficit cannot be combatted by appreciation/depreciation or devaluation or revaluation.
2. A single currency involves the loss of monetary policy as an instrument of economic policy, instead it is controlled by the European Central Bank.
3. Fiscal policy is constrained by the convergence requirements - e.g. total public debt cannot go above 60%, inflation rate allowance is limited. For example in Greece when there was a recession the government could not apply expansionary fiscal policy as it was already running a deficit and public debt cannot go above 60% in accordance with Eurozone standards.
4. Monetary policy pursued by the single Central Bank impacts differently on each member country, depending on its own particular circumstances - if some countries face inflation and other unemployment the monetary policy for one will be inappropriate for the other.

Question 23

How would you combat inflation with foreign exchange rate?

Answer 23

You want to shift AD to the left so that PL decreases. AD = C + G + I + (X - m), therefore you must decrease exports and increase imports, which you can do by appreciating or revaluing the currency. Exports cost more for foreign consumers but imports cost less.

Question 24

What is an optimum currency area (OCA)?

Answer 24

An area in which all members have fixed exchange rates with each other, but flexible exchange rates with outsiders.

Question 25

When will OCAs be more successful?

Answer 25

1. There is greater mobility of capital resources.
2. There is close cooperation or coordination of fiscal policies, or there is an OCA-wide fiscal authority determining fiscal policy.
3. There is greater synchronisation of the phases of the business cycle among members, i.e. members face phases of the business cycle roughly together.

Question 26

What is the biggest disadvantage of the EMU and why?

Answer 26

There has never been a common fiscal policy. This would benefit the EMU because tax-financed investments could be made in depressed areas, or transfer payments to be paid to vulnerable groups in depressed areas. It would also control member’s spending.

Question 27

What are terms of trade?

Answer 27

A concept that relates to the prices that a country receives for its exports to the price it pays it pays for its imports. It is also a measure of how many imports can be bought per unit of exports.

Question 28

How do you calculate terms of trade?

Answer 28

Terms of trade = average price of imports / average price of exports. It must be measured in the same currency.

Question 29

Distinguish between an improvement and a deterioration in the terms of trade:

When do these occur?

Answer 29

There is an improvement in the terms of trade when there is an increase in the value of the ratio of average export prices to average import prices.
A deterioration is when there is a decrease in the value of average export prices to average import prices.

An improvement results from an increase in the price of exports or decrease in the price of imports.
A deterioration results from a decrease in the price of exports or increase in the price of imports.

Question 30

How do you calculate the price index of exports/imports?

how do you calculate the terms of trade from this?

Answer 30

The price of a specific year / the price of a base year.

Terms of trade = index of average export prices / index of average import prices * 100

Question 31

How can you tell an improvement/deterioration using the index of average export prices?

Answer 31

Terms of trade = index of average export prices / index of average import prices * 100

If the number is larger than 100 it has improved since the base year
If the number is less than 100 it has deteriorated since the base year

Question 32

Causes of changes in terms of trade in the short term?

Answer 32

1. Changes in global demand - if demand increases for export, the price will rise and your terms of trade will improve. The countries that demand it will face deterioration.
2. Changes in global supply - If global supply of a good you export increases, price will go down and your terms of trade will deteriorate. If supply goes down, then your price will go up and your terms of trade will appreciate.
3. Changes in the domestic rate of inflation relative to other countries - if domestic inflation goes up your exports become more expensive relative to other countries, but your imports become cheaper. More imports and less exports mean deterioration of terms of trade.
4. Changes in exchange rates - a depreciation of a currency means exports are cheaper and imports are more expensive so there is a improvement in terms of trade.

Question 33

Causes of changes in terms of trade in the long term?

Answer 33

1. Growth in incomes which affects global demands. The effect on terms of trade however depends on the YED of the good. Generally the YED for food snd agricultural products is lower than the YED for manufactured goods so as incomes increase in the long term, exports of primary products decrease and imports of manufactured goods increase, meaning terms of trade for countries with manufactured goods improve and those with agricultural products deteriorate.
2. Changes in productivity (output per unit of hour worked) - may increase due to technological advancements or more educated workers. if productivity increase occur in industries producing goods for export, the terms of trade will deteriorate as the export price will fall relative to the import price.
3. Trade protection - if a country has a large share in the world production of a good then it can influence world prices. For example the US, a huge importer of automobiles, could lower the world demand for automobiles, lowering the exports for Japan, a big automobile exporter. Subsidies for big producers depress world prices, such as with agricultural products in the US and EU. Exporters of the products face deterioration.

Question 34

How do changes in the terms of trade in the long run result in a global redistribution of income?

Answer 34

If a country is facing long term improvements in terms of trade then global output is redistributed towards this country. This corresponds to a loss of output for countries experiencing a long term deterioration of terms of trade. The first country has greater chances of growth while the deteriorating country has fewer possibilities to acquire imports for production.

Question 35

When does a change in the terms of trade lead to an improvement in the balance of trade?

Answer 35

When there is an increase in the value of exports and a decrease in the value of exports, i.e. an improvement in the terms of trade.

Question 36

Will an improvement in the terms of trade always lead to an improvement in the balance of trade?

Answer 36

No it also depends on the quantity changes, as terms of trade only deals with the price changes. If the cause of changing terms of change lies in changes in demand the terms of trade and balance move in the same direction. If the cause lies in changes in supply then the terms of trade will change in the same direction only under certain conditions.

Question 37

Why will a change in demand change terms of trade and balance of trade in the same direction?

Answer 37

If demand for a good increases it shifts to the right. This increases price and quantity traded, both of which increase the value, which improves terms of trade and balance of trade for the exporter.

global price of internationally traded good on y,
quantity of internationally traded good on x.
Global demand for good, global supply for good (supply/demand curves)
Show one supply with multiple D curves.

Question 38

Why might a change in supply change terms of trade and balance of trade in the same direction?

Answer 38

global price of internationally traded good on y,
quantity of internationally traded good on x.
Global demand for good, global supply for good (supply/demand curves)
Show one supply with multiple S curves.

Explain that as supply increases, price decreases but quantity demanded increases so it depends on the elasticity of demand for the exports.

Question 39

How do you measure the price elasticity of demand for exports (PEDx)?

Answer 39

PEDx = %∆quantity exports demanded / %∆price of exports

Question 40

How do you measure the price elasticity of demand for imports (PEDm)?

Answer 40

PEDx = %∆quantity imports demanded / %∆price of imports

Question 41

How do elastic PEDx and PEDm effect terms of trade?

Answer 41

If PEDx is elastic, then a rise in the price of exports will cause a proportionately larger fall in the quantity, meaning the exporter countries terms of trade will deteriorate. If PEDm is elastic, a rise in the price of imports will cause a proportionately larger fall in the quantity imported, meaning an improvement in the terms of trade for this importing country since the value of imports falls.

Question 42

How do inelastic PEDx and PEDm effect terms of trade?

Answer 42

If PEDx is inelastic, then an increase in price will cause a proportionately smaller decrease in demand, meaning the value of the export increases and the terms of trade for the exporting country will improve.
If PEDm is inelastic then an increase in price (due to decrease in supply) will cause a proportionately smaller decrease in demand and the value of the imports goes up, meaning the terms of trade for the importing country deteriorates.

Question 43

How are terms of trades effected by PED and changes in exchange rates?

Answer 43

According to the Marshall Lerner condition if PEDx + PEDm > 1, depreciation leads to an improvement in trade balance. This is because imports will decrease. If PEDx + PEDm < 1 it leads to a deterioration in trade balance. This is because imports won’t decrease, despite the depreciation but they still become more expensive relevant to the value of the currency.

Question 44

Explain impacts of short term fluctuations in the terms of trade in economically less developed countries:

Answer 44

Commodities such as agricultural products and oil have low price elasticities of demand as they are very necessary. Due to their low price elasticities of demand a shift in the supply curve causes large price fluctuations.
Short term fluctuations come with negative side effects:
1. Uncertainties that can be highly destabilising. Consumers cannot plan and producers cannot determine the future profitability of investments.
2. Changing relative prices affects the signalling function of prices and results in poor allocation outcomes and inefficiency.
3. Windfall gains (unexpected income gains) from higher export prices are often spent on increased on imports of consumer goods rather than investment into domestic manufacturing or capital goods.
4. Windfall gains leads to unequal distribution of income as some people gain some people lose. It is redistributed when prices fall again.
5. Banking system affected due to large withdrawals at times of falling prices.
6. Inappropriate fiscal policies due to high fluctuations and unpredictability.
7. Improvements in terms of trade does not favour policies that promotes diversification of products. The undeveloped countries become dependent on the products.

Question 45

Why is there long term deterioration in terms of trades for developing countries that specialise in the production of non-oil commodities?

Answer 45

1. There is low income elasticity of demand for primary products - as income increases, a relatively lower amount is spent on these commodities such as grain, as it is a staple good and you probably already buy enough. More of this disposable income is spent on manufactured goods, this increase in demand causes RELATIVE prices of agricultural products to fall (compared to manufactured goods).
2. Technological advancements in agriculture - while there are decreases in the growth of demand due to low YEDs, technological advancements are allowing for increasing supply. You can show this in a graph by showing P, Q with D and S and then show a relatively small increase in D while there is a large increase in S, leading to a larger fall in price.
3. Protection of agriculture in developed countries - when the US puts subsidies and tariffs on agricultural products it increases supply and decreases demand.