International Econs

Question 1

What is the theory of comparative advantage?

Answer 1

The theory of CA states that if 2 countries have differing CA in the production of 2 goods, each country should specialize in their area of CA (where the country has the ability to produce that good at a lower opportunity cost). Trade based on mutually agreeable terms of trade will allow both countries to consume outside their original possibility production curve and enjoy higher living standards.

Question 2

List the assumptions underlying the Theory of CA

Answer 2

Other than simplifying assumptions such as the existence of 2 countries producing 2 goods each, the theory also assumes:

i. the absence of transport costs,
ii. no barriers to trade,
iii. perfect factor mobility within countries (resulting in constant opportunity costs of production), and
iv. imperfect factor mobility across countries

Question 3

What should students observe when presenting numbers under the Theory of CA explanation (this applies to both table / PPC representations)?

Answer 3

Depict one country having absolute advantage (AA) in the production of both goods. This makes the case for free trade more compelling, since we are able to explain why even a resource-rich giant like China is willing to trade with a smaller country like Vietnam. Furthermore, it avoids sending the signal that the basis of trade is due to differences in AA.

Question 4

What is the 70/30 rule in this topic?

Answer 4

When explaining the basis of trade, 70% of the answer should be dedicated to explaining the Theory of CA, while 30% pertains to explaining other reasons for trade. The latter includes:

• greater variety; access to cheaper imports
• economies of scale from large-scale production
• competition from imports spurs efficiency among domestic producers
• (X-M) as an engine of growth

Question 5

What is protectionism?

Answer 5

It is the practice of erecting barriers e.g. import tariffs to inhibit free trade, usually to protect domestic interests.

Question 6

What is an infant industry?

Answer 6

It is an industry with potential comparative advantage in the production of a good, but is too underdeveloped to realise its potential. Exposure to foreign competition (e.g. firms with larger economies of scale) may prematurely crush the industry

Question 7

What is dumping?

Answer 7

It is the act of selling goods at a cheaper price in foreign markets, sometimes below cost in order to chase out foreign producers and to establish market leadership

Question 8

How can we describe a country’s pattern of trade?

Answer 8

By looking at its volume, composition and direction of trade between a country and other trading partners

Question 9

What is trade creation and trade diversion?

Answer 9

Trade creation is the increase in trade among member countries of a trade agreement due to the removal of trade barriers. Trade diversion occurs when trade is diverted from a more efficient producer to a less efficient one due to the formation of a FTA or regional trade agreement.

Question 10

What is globalization?

Answer 10

It is greater integration of national economies, leading to increased flow of (i) goods and services, (ii) capital and (iii) labour across national boundaries.

Question 11

What are the factors that affect a country’s currency?

Answer 11

a) The demand for the country’s currency. The demand for a country’s currency is derived from foreigners’ demand for its goods and services and financial assets.
b) The supply of the country’s currency. The supply of a country’s currency is derived from residents’ demand for foreign goods and services and financial assets.

Question 12

Break down the factors that affect the demand for a country’s currency

Answer 12

a) The demand for the country’s exports, which is affected by the price-competitiveness of the country’s exports, the income levels of trading partners, and the quality-competitiveness of the country’s exports
b) The demand for investments into the country, which consists of short-term investments (hot money) and long-term investments. Hot money flows are affected by changes in interest rates and expected changes in exchange rates. Long-term investments are affected by the level of corporate taxes in the country and investor confidence. Lower exchange rates also make it cheaper to set up physical assets (e.g. factory) within the country, although future earnings will be worth less in domestic currency.

Question 13

Break down the factors that affect the supply of a country’s currency

Answer 13

a) The country’s demand for imports, which is affected by the price-competitiveness of imports, the income levels of the country’s citizens and the quality-competitiveness of imports.
b) The level of the country’s outward investments, which consists of short-term investments (hot money) and long-term investments. Hot money flows are affected by changes in interest rates and expected changes in exchange rates. Long-term investments are affected by the level of corporate taxes and investor confidence. Lower exchange rates also make it cheaper to set up physical assets (e.g. factory) within the country, although future earnings will be worth less in domestic currency.

Question 14

What does the internal value of a currency refer to?

Answer 14

Internal value refers to the purchasing power of a currency (which shares an inverse relationship with inflation)

Question 15

What does the external value of a currency refer to?

Answer 15

It refers to the country’s exchange rate.

Question 16

How is the internal value of a currency related to its external value?

Answer 16

1) Assuming the internal value of a currency falls due to higher inflation, the demand for its currency falls. This is because exports become less price-competitive. High inflation may also cause investors to lose confidence, hence FDI inflow falls.
2) High inflation may also cause the supply of the currency to rise. Imports are now relatively cheaper than domestic goods, leading to a rise in import spending, Investments will also flow out to other countries with stable prices and more predictable returns.
3) Overall, the fall in demand and the rise of supply of the currency leads to a depreciation of the currency. Hence, its external value falls too.

Question 17

How is the internal value of a currency related to its external value?

Answer 17

A fall in external value of the currency (a depreciation) leads to a fall in its internal value (higher inflation). Specifically, assuming the MLC holds, a depreciation leads to an increase in (X-M) and hence higher demand-pull inflation. At the same time, imported inflation rises since the prices of imported raw materials and final products are higher in terms of domestic currency.

Question 18

What is the impact of an appreciation of the currency on an economy?

Answer 18

Use DICE to examine.

Question 19

Explain why protectionism is justified in the case of infant industries.

Answer 19

Protectionism is justifiable if its purpose is to protect infant industries. Protectionism gives these industries the chance to grow and earn economies of scale, before competing with big foreign players. There have been actual examples of success such as the car industry in Japan and the entertainment industry in Korea.

However, the extent and duration of protectionism matter. If industries are indiscriminately protected, or if protectionism is extended for a protracted period of time, this may breed complacency and lead to inefficiency instead.

Question 20

Explain why protectionism is justified in the case of dumping.

Answer 20

Protectionism is justifiable if its purpose is to protect a country from predatory dumping. Predatory dumping refers to the selling of goods by foreign firms in a country at artificially low prices (sometimes below the marginal cost of production) in order to drive out domestic producers and to establish a monopolistic presence. Prices can then be raised to boost firm profits in the future. Hence, while consumers may benefit from lower prices in the short term, consumer welfare is affected in the long run due to the exploitation of monopoly power.

However, it is difficult to prove dumping as a country may indeed have a CA in the production of a specific good, leading to competitive pricing.

Question 21

When is protectionism not justified?

Answer 21

If protectionism is used to reduce unemployment or a BOP deficit, it is not justified.

Retaliation and beggar-thy neighbor effect often worsen the original problem.

Protectionism also does not tackle the root cause of the problem, which may be due to a lack of price or quality competitiveness of exports.

However, if the root cause of unemployment or a BOP deficit is due to domestic infant industries lacking competitiveness or dumping, protectionism may then be more justified.

Question 22

What are the main pros and cons of protectionism?

Answer 22

(We should draw the tariff diagram in our answer)

Pros:

1) The imposition of tariffs result in an increase in the level of domestic output, hence favoring local infant industries.
2) The prices of imports rises, hence mitigating any unfair pricing advantage that a country practicing dumping may enjoy.
3) The fall in the level of imports improves the country’s BOP, while the increase in the level of domestic output results in a decrease in cyclical unemployment.

Cons:

1) Protectionism is undesirable since consumer surplus falls (as seen from tariff diagram)
2) There is also deadweight loss to society
3) Protectionism may not tackle the root cause of a problem.
4) Retaliation or the beggar-thy-neighbour effect may worsen the original problem (applicable to growth/BOP problems)
5) Protectionism denies a country potential gains from trade.

Question 23

What constitutes the volume of a country’s trade?

Answer 23

Its main imports and export categories. This usually complies with the Theory of CA.

Question 24

What constitutes the composition of a country’s trade?

Answer 24

All types of goods imported and exported by the country. Exceptions to the predictions of the Theory of CA may be observed here, specifically in the case of intra-industry trade.

Question 25

What should we consider when examining the direction of a country’s trade?

Answer 25

The country’s key trading partners

Question 26

What is the reason that not all trade patterns comply with the theory of CA?

Answer 26

It is due to some assumptions underlying the theory of CA not holding in reality.

Factors of production are in fact not perfectly homogeneous in the real world. Hence countries do not specialize completely, and instead produce a range of goods and services.

In the real world, there are transport costs. Hence, countries will trade more with neighbouring countries and not necessarily trade with countries with the highest CA

Question 27

Why does intra-trade occur between countries?

Answer 27

1) Consumers may have different tastes and preferences, hence countries may trade different brands of the same good to add variety.
2) Countries specialize in different production phases, e.g Singapore imports raw oil and refines it before re-exporting it.

Question 28

What aspects should we consider when explaining the trend towards globalization?

Answer 28

Factors that have accelerated the flow of 1) goods and services 2) investments 3) labour across countries. These can be broken down into

• economic reasons (explain Theory of CA and note that signing of FTAs open up trade and capital flows.)
• technological reasons
• political and social reasons.

Question 29

What is the general framework we can use when addressing globalization question?

Answer 29

The 4-3-2 framework

Pay special attention to the 2 themes:

1st theme: Greater reliance on global trade, capital and labour results in greater vulnerability to external conditions such as global recessions and supply shocks)

2nd themes: Globalization is a 2-way traffic. While ac country cam benefit by tapping on global trade, capital and labour, it also faces competition for consumer markets.

Question 30

What policies can countries adopt to address the 2 challenges of globalization

Answer 30

To address the first challenge (greater reliance = greater vulnerability to global recessions and supply shocks)
- Most countries cannot adopt inward-looking policies. Hence, short-term macroeconomic policies are needed to mitigate the effects of external recessions. E.g. an appreciation of the currency could be used to tackle imported inflation during a global supply shock, while expansionary fiscal policies can be used to support an economy hit by a global recession.

To address the second challenge (2 way traffic)
- To improve competitveness, supply side policies could be used. In Singapore, raising the productivity and skills of workers help to maintain the competitiveness of local workers and exports, hence boosting our attractiveness to foreign invesments.

Question 31

What should students note when discussing the reasons for protectionism?

Answer 31

The context is important. Essay questions on protectionism are usually anchored to a context e.g. global recession. DO NOT provide a rehearsed answer on protectionism.

For example, if the question asks whether protectionism should be practised given the slowdown in the Eurozone, students should examine protectionism in the context of a recession. E.g. protection of infant industries may be even more necessary during a recession, as these firms could already be weakened by the fall in demand. Foreign producers are also more likely to dump unsold goods. More focus should also be placed on explaining how trade can boost AD and alleviate the effects of a recession.

Question 32

In light of growing challenges, how should Singapore change its approach towards globalization?

Answer 32

1) Due to the growing competition from emerging economies, Singapore need to remain flexible by shifting towards new areas of CA to avoid head-on competition with low-cost producers.
2) Despite the growing tide of protectionism, Singapore should remain open as SG has too small a domestic market and lacks natural resources to be self-sufficient.

Question 33

Summarise Singapore’s approach to managing its current account.

Answer 33

• Focus on exporting goods and services where it possesses a comparative advantage (CA). These include capital-intensive products like pharmaceuticals and advanced electronic equipment, given that Singapore possesses skilled labour, and has strong technological capabilities.
• In promoting the competitiveness of exports, Singapore focuses on boosting quality instead of price, as evident from the gradual and modest appreciation of the Sing dollar over time, which erodes price-competitiveness.
• Singapore embraces free trade and does not turn to protectionistic measures to shield domestic industries from external competition.

Question 34

Summarise Singapore’s approach to managing its financial account.

Answer 34

• Singapore maintains its openness to capital flows and focuses on boosting its attractiveness to foreign investors. This is achieved through a combination of supply-side policies (e.g. good infrastructure and productive workforce) and fiscal policies (competitive tax rates).
• Singapore ties its interest rates to global rates (typically US rates) to minimise flows of hot money due to interest-rate differentials between Singapore and other financial centres.

Question 35

Explain how to assess the international competitiveness of an economy.

Answer 35

The competitiveness of an economy can be considered from three perspectives – (i) export competitiveness (price and quality); (ii) attractiveness as a foreign direct investment (FDI) destination; and (iii) labour competitiveness.