The Macro Economy (Trade)

Question 1

What are the terms of trade?

Answer 1

A country’s current account position is heavily influenced by it’s relative export and import prices. The terms of trade is a measure of ratio of relative export and import prices.

(A numerical measure of the relationship between export and import prices.)

Is a measure of prices, not value.

Question 2

Explain the terms of trade index.

Answer 2

Terms of trade index = (index of export prices / index of import prices) * 100

The ratio is calculated from the average prices of many goods and services that are traded internationally. The prices are weighted by the relative importance of each product traded.

If the index increases, it is an improvement in the terms of trade. Fewer experts have to be sold to buy any given quantity of imports. (And vice versa.)

Question 3

What are the causes for change in terms of trade?

Answer 3

A rise in export prices relative to import prices or a fall in import prices relative to export prices causes a favorable movement in the terms of trade.

Changes in these are caused by changes in demand for and supply of exports and imports, the price level and the exchange rate.

An increase in the demand for exports will increase their price and will be good for the terms of trade.

A rise in the country’s relative inflation rate will also make the export prices rise relative to import prices.

A devaluation is sometimes referred to as a deliberate deterioration of it’s terms of trade. It is a deliberate attempt to decrease export prices and raise import prices in order to make the country’s products more internationally competitive.

Prebisch-Singer hypothesis suggests that terms of trade tends to move against countries who rely on the primary sector.

Question 4

What are the impacts of changes in terms of trade?

Answer 4

While a rise in terms of trade is described as a favorable movement, it’s impact is not always favorable. It’s effect will depend on it’s cause.

If the price of exports increases because of a rise in demand, then it is likely to be beneficial as more domestic products will be sold.

If the cause is a rise in costs of production, demand for a country’s product will fall and export revenue may decline.

An unfavorable movement in the terms of trade may actually reduce a deficit on the current account of the balance of payements.

If the Marshall-Lerner condition is met, the fall in export prices relative to import prices should increase export revenue relative to import expenditure.

Question 5

Describe absolute advantage.

Answer 5

A country has an absolute advantage in producing a product if it can produce more of a product than another country with the same quantity of resources. (In international trade.)

Ex. Indonesia has an absolute advantage in producing rice, Brazil has an … in coffee.

If a country specializes in a product in which it has an absolute advantage and then trades, based on opportunity cost ratios total output will rise and both countries will be able to produce more products.

Question 6

Describe comparative advantage.

Answer 6

More trade is based on comparative advantage. Some countries buy products from aboard that their own countries will be capable of producing with fewer resources. This is because it enables the producers to produce the products they are even better at producing.

Ex. Two countries can produce both x and y. Both countries will benefit if they specialize and trade the products they are more efficient at producing.

A country can produce a product at a lower opportunity cost than another country.

Question 7

Why does comparative advantage not provide a full explanation for the pattern of global trade.

Answer 7

Some governments may want to avoid over-specialization, transport costs may offset the comparative advantage, the exchange rate may not lie between the opportunity cost ratios and other countries may impose trade restrictions.

Comparative advantage also assumes that resources are mobile and there are constant returns which may not be the case.

There is no guarantee that workers and resources will be able to shift from one product to another.

Even if they do so, it does not mean that the extra resources will be productive. Double the resources may not lead to double the output.

In addition, countries do not always adapt to changes in comparative advantage. This may negate other country’s comparative advantage if a trade restriction is imposed.

Question 8

What is free trade?

Answer 8

International trade not restricted by tariffs and other protectionist measures.

Firms are free to export and import what they want in the quantities that they want. No taxes or limits are imposed on exports and imports. No subsidies are given to distort cost advantages and there is no unnecessary paperwork.

Question 9

What are the benefits of free trade?

Answer 9

Allows efficient allocation of resources with countries being able to concentrate on producing those products which they have a comparative advantage in. (more efficient production)

This increases world output, employment rate and living standards.

Factor endowment differs between countries. Free trade allows countries to focus on one thing. The competition that arises from free trade will put pressure on firms to keep their prices and costs down, and to raise the quality of their products.

This greatly benefits consumers, firms will also be able to buy raw material and capital goods at lower prices.

Consumers will have greater variety of products and producers will have a greater variety of raw material and capital goods due to the global market. Firms will also have a larger target market.

Question 10

Explain the trading possibility curve.

Answer 10

Shows the effects of a country specializing and trading.

A country may be able to produce 50 units of clothing max and 100 units of food. For every 1 unit of clothing it gives up the opportunity to produce 2 units of food.

Engaging in international trade may enable the country to specialize in clothing production and import 3 units of food for every 1 unit of clothes it imports.

This will increase the total quantity of products that a country can consume.

Question 11

What are trade blocs?

Answer 11

A regional group of countries that has entered into trade agreement.

Question 12

What are free trade areas?

Answer 12

Where member govts. agree to remove trade restrictions among themselves. The members are allowed to determine their own external policies towards non-members.

Ex. NAFTA

Question 13

What is a customs union?

Answer 13

A trade block where there is free trade among member countries and a common external tariff among imports of non-members. The countries share tariff revenues and coordinate some trading policies.

Ex. SACU

Question 14

What is an economics union?

Answer 14

A trade bloc where there is free trade between member countries, a common external tariff and some common economic policies which may include a common currency.

Ex. EU

Question 15

Describe a monetary union and full union.

Answer 15

Involves economies operating at the same currency.

Involves same currency and following all the same economic policies.

Question 16

What is trade creation?

Answer 16

Where high cost domestic production is replaced by more efficiently produced imports from within the customs union.

Membership of a trade bloc may give rise to trade creation. A removal of tariffs allows members to specialize in those products in which they have a comparative advantage. Expensive domestic products are replaced by cheaper imported ones. Efficient firms will be able to sell to a larger market and will be able to become even more cost competitive.

Domestic govt. will lose out on tariff revenue, but this is a welfare gain.

Outcompeted firms will become more efficient or shift to specialization.

Question 17

What is trade diversion?

Answer 17

When trade with low-cost country outside a customs union is influenced by a higher cost products supplied from within.

Membership of a trade bloc results in a country buying imports from a less-efficient country within a trade-bloc rather than from a more efficient country.

This results in a less efficient allocation of resources. Efficient countries outside the trade bloc may also lose out… A country in the trade bloc will also lose out in this situation.

Question 18

What is protectionism?

Answer 18

Protecting domestic producers from foreign competition. Restricts free trade. Aims to make domestic products more price competitive.

Question 19

Explain tariffs.

Answer 19

• Tariffs: (Customs Duties)Taxes on imports (usually) and exports. There are 2 main reasons why exports are taxed:
  1. Raise revenue.
  2. Increase supply of product in domestic market.

Raising revenue may also be the reason of taxing imports. The other motive is to discourage consumption of imports.

A tariff can be a fixed sum per unit or percentage. This imposes extra cost on supplier which usually pushes up the price.

Tariff will raise revenue if demand for imports is inelastic and increase protection of domestic industries if demand for imports is elastic.

Imposing a tariff may not completely work. If firms selling the imports absorb the tariff and leave the price unchanged or the price of imports is below domestic prices despite the tariff.

Question 20

Name the methods of protection.

Answer 20

Tariffs.
Quotas.
Exchange Control.
Export Subsidies.
Embargo.
Voluntary export restraint.
Economic and administrative burdens.
Keeping exchange rate below it’s market value.

Question 21

Explain quotas.

Answer 21

A limit on imports and exports. This will drive up the price and restrict consumption. Unless licenses for allocation of quotas are sold, govts. do not make revenue from this. Sellers of imports will get the extra amount paid.

Question 22

What is exchange control?

Answer 22

Restrictions on the purchase of foreign currency. This reduces the ability for buying imported products, travelling and investing abroad. Indirectly limits imports.

Question 23

What are export subsidies.

Answer 23

Subsidies given to exporters or firms competing with imported goods. Domestic firms will have a fall in costs which will encourage them to increase output and decrease price.

Foreign firms will lose out. Consumers will benefit in the short run but in the long run more efficient firms may be driven out by less efficient, subsidized firms. Consumers pay the tax for subsidy.

Question 24

What is an embargo?

Answer 24

Ban on imports and / or exports. Complete ban on a product or country. A govt. may want to ban a harmful product or ban a country over political disputes.

Question 25

What is voluntary export restraint?

Answer 25

A limits placed on imports reached with the agreement of the supplying country. The country in question may be pressured into it or sign it alongside another country upon agreement.

Question 26

Explain economic and administrative burdens.

Answer 26

“Red tape”. Govt. may seek to discourage importers by asking them to fill out time consuming forms, meet artificially high products standards, etc.

Question 27

Explain keeping the exchange rate below it’s market value.

Answer 27

A govt. may manipulate the country’s exchange rate in order to give it’s producers a comparative advantage. This may lead to other govts. lowering their exchange rates.

Question 28

Explain protecting infant industries.

Answer 28

• Protect infant industries: Established and larger foreign firms that are taking advantage of economies of scale and benefiting from their names being well-known, make it difficult for infant industries to survive.

Protecting the industry may give it time to grow, which will lead them to benefit from economies of scale and gain a global reputation.

If it has the potential to develop into an efficient industry in line with comparative advantage, then trade restriction is justified.

It is very difficult to determine the long-run average cost curves of firms in the industry.

There is a risk that the industry may become dependent on protection. May not feel pressured to lower it’s costs.

For new industries that have low output and high average costs.

Question 29

Explain protecting declining industries.

Answer 29

If declining industries which have lost comparative advantage go out of business quickly there may be a large increase in unemployment. If the industry is protected and the protection is gradually removed, unemployment might be avoided. As industry loses output, workers retire or change jobs.

There is a risk that the industry resists the protection that it receives and can lead to considerable inefficiency.

Question 30

Explain protecting strategic industries.

Answer 30

Protection of products which the govt. regards as strategic such as weapons, fuel and food. They may not want to rely on foreign supply of these in case it stops due to political or military disputes. As a result they are protected even if they are inefficient.

Question 31

Explain preventing dumping.

Answer 31

Dumping involves selling products below their cost price. This may be regarded as unfair. In short-run consumers benefit from very low prices. In the long run, foreign firms may drive out domestic firms. They may gain a monopoly and raise their prices.

The foreign firms do this by covering their losses with previous supernormal profit, charging high prices in home country or through subsidy.

It is difficult to determine whether a firm is dumping or has comparative advantage.

Question 32

Explain improving the terms of trade.

Answer 32

More experts by introducing quotas which restrict supply and increase demand if it is inelastic.

Trade restrictions to reduce import consumptions.

This improves terms of trade but may invite retaliation.

Question 33

Explain improving balance of payments.

Answer 33

Improve current account position by promoting domestic products through tariffs.

Invites retaliation. Global output falls. Only a short-term solution. (If products are not internationally competitive.)