3. Global economy
Tariff
A tariff is an indirect tax on imported goods.
Effect of the tariff on different stakeholders:
Consumers: prices are higher than before, possible loss of higher living standards and consumer surplus is lost. Consumers pay all tax revenue because world supply is assumed to be perfectly price elastic.
Government: gain of government revenue due to the introduction of the tariff.
Domestic producers: domestic producers gain surplus.
Foreign producers lose revenue as tariff decreases the number of imported goods.
Deadweight welfare loss: The social surplus is lost to nobody due to the tariff.
Quota
A quota is a restriction/import barrier on the quantity or value of a particular import.
Effect of the quota on different stakeholders:
Consumers: they lose consumer surplus limited. Because the price of goods is now higher, there could be a loss of possible higher living standards.
Government: quota does not affect the government.
Domestic producers cheer as their producer surplus increases since they charge a higher price and sell larger quantities.
Foreign producers: the quantity they sell fell. Hence, foreign producers lose revenue limited. However, because of the quota, they get a higher price than before, so a surplus appears in the purple areas on the diagram.
Deadweight welfare loss: due to the trade barrier quota, the social surplus is lost to nobody.
Subsidy
The subsidy is a government payment to producers attempting to lower the price of produce and increase the quantity produced (encourage production). In the international trade context, the subsidy is given to domestic producers to increase their international competitiveness.
Effect of the subsidy on different stakeholders:
Government: taxpayers' money is used to subsidize inefficient producers. (To evaluate: could this money be used more effectively?).
Consumers: loss of the consumer surplus does not occur, as the price of the good does not change.
Domestic Producers: the price that they receive increases. Their revenue increased.
Foreign Producers: their revenue decreased since the number of imports decreased.
Deadweight welfare loss: due to increased production by the inefficient domestic producers (over-allocation of resources to those producers), Deadweight Welfare Loss emerges.
Benefits of international trade
Lower consumer prices are as low as possible if no trade barriers are imposed.
Greater choice for consumers – free trade means consumers have a greater variety of products.
Producers can benefit from economies of scale – the market size for producers increases due to foreign buyers. That means producers can take advantage of economies of scale by increasing the scale of their production.
Greater ability to acquire required production resources – free trade (no trade barriers) allows producers who require, for example, raw materials to acquire them easier and at a lower cost. That lowers production costs and increases efficiency.
More efficient allocation of resources – free trade (no government intervention) should, in theory, lead to the best possible allocation of resources. That should happen because countries would specialise in producing goods they have a comparative advantage at.
Benefits of increased competition – free trade means higher competition. That drives improvement in the price and quality of products, incentivises producers to innovate, and looks for more efficient ways of production.
Source of foreign exchange – since trade is one of the sources of foreign exchange, free trade should increase the amount of foreign exchange received.
Argument for protectionism
Protection of domestic employment: due to the higher price more domestic producers are able to compete in the market, and, therefore, more domestic firms are demanding the labour.
Source of government revenue.
Strategic reasons/national security
Means to overcome a balance of payments disequilibrium: Assuming this refers to a current account deficit (rough interpretation & most common case: X < M).
Anti-dumping & prevention of unfair competition.
Maintenance of health, safety and environmental standards.
Infant industry argument.
Efforts of a developing country to diversify.
Argument against protectionism
Misallocation of resources (Inefficiency of resource allocation)
Increased costs of production due to lack of international competition
Reduced export competitiveness
Increased prices of goods and services to domestic consumers.
The danger of retaliation and "trade wars."
Potential for corruption.
Costs of long-run reliance on protectionist measures
Stages of economic integration
A free trade area is formed if members eliminate or agree to phase out trade barriers between them, but each member country maintains its trade policy towards non-members.
A customs union is formed if free trade area members agree to adopt a common trade policy towards non-members.
A common market is formed if members of a customs union additionally agree to permit the free flow of capital and labour.
An economic union is formed if members of a common market additionally harmonize certain macroeconomic and regulatory policies.
A monetary union is formed if members of an economic union agree to adopt a common currency and establish a common central bank.
Advantages of trading blocks
greater access to markets offer potential for economies of scale
with freedom of labour, there are greater employment opportunities
membership in a trading bloc may allow for stronger bargaining power in multilateral negotiations
greater political stability and cooperation
Disadvantages of trading blocks
Loss of sovereignty
Challenge to multilateral trading negotiations
Advantages of monetary union
lower transaction costs as currency conversions are unnecessary
greater price transparency, facilitating price comparisons
no exchange rate risks and the associated uncertainty costs
greater negotiating and bargaining power in world affairs.
Disadvantages of monetary union
no independent monetary policy
no exchange rate policy
limited room for independent fiscal policy
loss of economic sovereignty.
World Trade Organisation (WTO)
was set up in 1995 as a successor of the GATT (1948)
has 164 member countries responsible for 98% of world trade
sets trade rules and ensures that they are followed
is the arbitrator of trade-related disputes
assists developing countries.
Evaluation—the WTO:
has decreased tariff and other trade barriers and has helped world trade to increase dramatically, stimulating growth
has prevented governments to resort to protection during crises
has been able to enforce trade rules and to settle trade disputes
is accused of being biased in favour of the USA, EU and other large economies while being inconsiderate to the needs of developing countries; for example, services and other markets in developing countries have been forced open whereas US and EU agriculture is still protected with subsidies and other barriers
has been accused of paying insuficient attention to increasingly important issues such as the environment, child labour, health and workers’ rights.
Exchange rates
Exchange rate – the value of a currency expressed in terms of another currency. (In other words: the currency's price in terms of another currency).
Floating (or flexible) exchange rate system is when the exchange rate is determined only by the interaction of demand and supply without any government or central bank intervention.
Fixed exchange rate system: this is when the government sets the exchange rate at some level and is maintained at that level through appropriate intervention by the central bank.
Managed exchange rate system: this is when the exchange rate is allowed to float but there is periodic intervention by the central bank whenever the direction or the speed of change is considered undesirable. The frequency of such interventions varies. Most currencies are traded in a “managed float” system.
Appreciation (of a currency) – occurs when a currency increases in value against another currency, i.e. it can buy more of another currency.
Depreciation (of a currency) – occurs when a currency loses value against another currency, i.e. it can buy less of another currency.
Factors affecting the exchange rate of a currency
Changes in trade flows
Changes in the foreign demand for a country’s exports If foreign demand increases then the exchange rate appreciates. If foreign demand decreases then the exchange rate depreciates.
Changes in the domestic demand for imports If domestic demand increases then the exchange rate depreciates. If domestic demand decreases then the exchange rate appreciates. Trade flows are in turn affected by:
changes in relative growth rates—faster growth increases import absorption so the currency will tend to depreciate (but see below)
changes in relative inflation rates—faster inflation decreases exports and increases imports so the currency tends to depreciate.
Changes in investment flows
Portfolio investment flows If these are inward then the currency appreciates. If these are outward then the currency depreciates. Portfolio investment flows are in turn affected by changes in relative interest rates.
If domestic interest rates increase then the currency will tend to appreciate.
If domestic interest rates decrease then the currency will tend to depreciate.
Foreign direct investment (FDI) flows If these are inward then the currency appreciates. If these are outward then the currency depreciates. FDI ows are in turn affected by growth prospects of a country.
If faster growth is expected in a country then, ceteris paribus, FDI inows will increase and the currency will appreciate.
Speculation
If speculators expect a currency to appreciate then they will buy the currency and it will tend to appreciate.
If speculators expect a currency to depreciate then they will sell the currency and it will tend to depreciate.
Workers’ remittances
Inflows will tend to appreciate the currency of the recipient country.
Intervention by the central bank
If it buys the currency it will appreciate.
If it sells the currency it will depreciate.
Exchange rate diagrams
Determinants of exchange rate
Foreign demand for a country’s export:
Foreign demand for a country’s export increases. Foreigners must have more of that country’s currency to buy larger quantities of that export. So, the demand for the exporting country’s currency increases; hence, its currency appreciates.
If the demand for a country’s export decreases, the demand for that country’s currency will fall and, therefore, depreciate.
Domestic demand for imports:
Demand for imports increases. To buy more of that import, people need to get more of that country’s currency. To acquire that currency, they must sell their currency. The supply of domestic currency increases, and hence, it depreciates.
If the demand for an import decreases, the domestic currency will appreciate because the less foreign currency will be needed. So the supply of domestic currency will decrease.
Relative interest rates:
Interest rates in country A are higher than in country B → people of country B want to keep their money in country A banks. Hence, they require more of country A currency. Demand for the country’s A currency increase, and it appreciates. Also, people living in country A might supply less currency to earn higher interest in their domestic banks. Hence, the supply of the currency decreases, and it appreciates.
Interest rates in country A are lower than interest rates in country B → people in country A want to keep their money in country B banks offering higher interest, so they start purchasing more of their currency by selling more of their own. Supply of country A currency increases, and it depreciates. Also, foreigners might decide to keep more money in the country’s B banks and demand less of their A currency. Demand falls, and the country’s A currency depreciates.
Relative inflation rates – the country's inflation does not directly affect the exchange rate. However, the relative inflation rate (compared to other countries’ inflation) does.
Say the inflation rate in the US is 5%, and the inflation rate in Germany is 2%. Because goods and services are becoming more expensive in the US quicker than in Germany, people might choose to buy goods/services from Germany. This action requires having euros; to get euros, you need to sell USD. Hence, the supply of USD increases and the US Dollar depreciates. Or it could be the case that US exports are becoming less competitive when compared to Germany’s (because their price is increasing faster), so people might start demanding less of US exports and more of Germany’s. Therefore, demanding fewer US Dollars → demand for USD decreases, and the currency depreciates.
If the inflation in the US is lower than in Germany, the story reverses. People will demand more US exports, so the demand for the currency will grow, leading to currency appreciation. Also, people might supply less USD as they might need fewer euros because the imports became too expensive, leading to an appreciation of the US Dollar.
Investment from overseas in a country’s firms (foreign direct investment and portfolio investment):
For foreigners to invest in a country (FDI and portfolio investment), they must acquire that country’s currency. Hence, they will increase the demand for that currency, and it will appreciate. It is also possible that they will decrease supply because some investors might already be holding USD which they were planning to sell but decide not to.
It is important to note that this works both ways: foreign investors might pull the money out (sell the factories or their shares) and then exchange that country’s currency for another. It increases supply (and possibly falling demand) and a currency depreciation.
Speculation (“hot money” flows): same as relative interest rates, as speculators usually chase higher interest rates.
Advantages of fixed exchange rate
Discipline: A fixed exchange rate system imposes discipline on policymakers by limiting their ability to pursue expansionary monetary policies. It also discourages governments from running large trade deficits or accumulating excessive amounts of debt.
Advantages of floating exchange rate
Autocorrection of balance of payments
Reduced need for foreign currency reserves
Smooth change of exchange rates
Relative freedom to focus on internal economic cycle
Interest rate can either be used to stimulate the aggregate demand or to increase the value of the currency. If the interest rate is increased, it attracts inflows of currency
Balance of payments
current account balance =
Measures of economic growth and development
Single indicators
GDP / GNI per capita at purchasing power parity
Health and education indicators
life expectancy at birth
infant mortality
mean years of schooling
Economic and social inequlity indicators
the GINI coefficient (A measure of the degree of income inequality of a country that ranges from zero (perfect income equality) to one (perfect inequality). Diagrammatically it is the ratio of the area between the Lorenz curve and the diagonal over the area of the half-square.)
Energy indicators
percentage of traditional fuel energy use
total energy consumption per capita
Environmental factors
Ecological footprint
Composite indicators
Human development index
The index is based on three dimensions: long and healthy life (measured by the life expectancy at birth), Knowledge (measured by mean schooling years or expected schooling years), and a decent standard of living (measured by GNI per capita).
Inequality-adjusted Human Development Index (IHDI)
The inequality-adjusted HDI (IHDI) measures development in the same three dimensions as the HDI, adjusted for inequality in each dimension
Gender inequality index (GII)
The Gender Inequality Index (GII) measures inequalities between the genders in three dimensions. Women and girls are often discriminated against in health care, education and the labour market. The GII captures the loss in the development of women due to inequalities in these areas.
Poverty cycle or trap
Poverty locks individuals into a vicious poverty cycle or trap, or what Nobel Laureate Gunnar Myrdal called “circular and cumulative causation.” The poverty cycle is shown in the figure above.
Poor people live on a very low income, which is spent entirely on necessities. This means that, in poor countries, the level of available savings in the economy is very low. As a result, investments in physical capital (machines, equipment and infrastructure) and human capital (education and health care) cannot be financed, so they are also low. Productivity will remain low, so incomes will remain low. The country is trapped in a situation where people’s poverty leads to more poverty.
It is important to note that the poverty cycle is transmitted across generations as children are caught in the trap with their parents, which limits their possibilities for higher earnings. Therefore, the poverty cycle is a significant barrier to growth and development in the short and long term.
Economic barriers to growth and/or development
High and rising economic inequality deters access to health care, education and credit, reduces savings, and can increase corruption while fuelling social and political instability. As such, productivity and investment spending remain low, leading to lower growth rates and restricting development.
Lack of infrastructure access increases transportation costs and limits access to local markets, education, and health facilities.
Lack of appropriate technology means less employment, less income and more poverty. These factors limit economic growth and development.
Low levels of human capital—lack of access to health care and education is responsible for decreased labour productivity, individuals facing fewer employment opportunities, higher risk of spreading diseases, fewer technological innovations and therefore, more poverty. This acts as a barrier to economic growth and development.
Dependence on primary sector production is an obstacle to growth and development because of the low-income elasticity of demand that prevents demand for primary products from growing fast enough to generate growth. Also, primary product prices are highly volatile, leading to fluctuations in farmers’ incomes, the country’s export revenues and employment levels.
Lack of access to international markets results from the agricultural support developed economies offer their farmers and the trade barriers developed countries impose. Restricting the ability to develop countries’ exports to reach international markets leads to lower incomes, lower agricultural investment, lower employment opportunities for farm workers and increased poverty. All of these factors impede growth and development.
An informal economy will hurt economic growth and development. In the informal sector, worker productivity and incomes are low, and there is decreased job security and poor working conditions. This means that living standards for workers in the informal economy are low. Also, tax revenues are lower, limiting the ability to finance pro-development goals.
Capital flight is a barrier to economic growth and, in turn to economic development because it involves a loss of financial capital and a loss of tax revenue that could have been invested within the country.
Indebtedness requires large debt repayments, so the government has fewer funds available to invest in health care, education and infrastructure, which are all necessary for economic growth and development. Also, there is the less foreign exchange for financing the purchase of necessary imports.
Geography, including being landlocked, is often an economic barrier. Economic growth and development depend heavily on international trade, which is significantly more difcult and costly for landlocked countries. Also, countries in mountainous regions or exposed to natural disasters may face issues in terms of growth and development.
Tropical climates and endemic diseases affect the economy. A feature of a tropical climate is warm weather all year round, which negatively affects crop productivity, water availability and labour productivity while favouring the spread of endemic diseases such as malaria. These factors lead to slower growth and impede economic development.
Political and social barriers to growth and/or development
a weak institutional framework, in terms of:
an inadequate legal system
ineffective taxation structures
lack of property rights and land rights
an ineffective banking system
gender inequality
poor governance and the prevalence of corruption.
Economic growth and development: trade strategies
Import substitution
Import substitution creates an industrial base to substitute domestically produced manufactured goods for imports.
A manufacturing sector is created, reducing reliance on the primary sector.
Disadvantages:
It reduces competition, leading to inefficiency
It hurts primary sector exports, increasing poverty among the rural population.
Inequality may widen.
The increased use of capital-intensive production technology can lead to jobless growth.
Export promotion
Export promotion is when a country attempts to achieve economic growth by expanding its exports.
Export growth increases export revenue and foreign exchange earnings.
Foreign competition increases the production efficiency.
Export growth changes the structure of the economy.
Disadvantages
Dependence on exports makes the economy vulnerable as it is subject to any shock its trading partners may undergo.
The trade barriers of developed economies still need to be successfully overcome.
Income distribution may worsen as the exporting sector enjoys a greater share of national income.
Policy focus may shift away from creating a social safety net.
Economic integration
Economic integration is regional integration among developing countries through preferential trading agreements.
The size of the potential market is increased.
The protectionist barriers of developed countries are avoided.
Dependence on developed countries’ markets decreases
The integration provides member countries with greater political and bargaining power.
Division of labour is encouraged
Disadvantages:
There are organizational and administrative problems.
Political rivalry and lack of commitment prevent progress.
Transport costs are high due to poor infrastructure.
Similarities in the structure of some countries’ economies may restrict mutually beneficial trade.
Economic growth and development: diversification
One of the major problems that many developing countries face is their overdependence on a narrow range of agricultural products. Diversification involves broadening the range of goods and services developing countries can produce. This allows such economies to benefit from worldwide economic growth as manufactured products and services have a higher income elasticity of demand. Also, they will no longer be subject to price volatility, which will stabilize incomes and export earnings.
At the same time, diversification may create new jobs. It can lead to improving skills and technologies to support the broader range of production.
Nevertheless, diversification may not guarantee that developing countries' exports will no longer be subject to trade protectionism. Also, some of the benefits of specialization in efficiency may be lost.
Economic growth and development: Market-based policies
Trade liberalization refers to the reduction or complete removal of protectionist measures that prevent free trade.
However, developing countries lack skills, technology and are focused on the primary sector→ they will still export a narrow range of products → they have low export shares in world trade.
Privatization: this refers to the transfer or sale of state-owned sets (typically firms but also airports, harbours and so on) to the private sector
However, the results of privatization can be unemployment and monopoly pricing, which may hinder the development process.
Deregulation: this refers to the process of dismantling or relaxing inappropriate rules, restrictions and laws in the operation of firms or markets
However, this policy may not always be successful, especially in cases where special interest groups manage to get preferential treatment.
Economic growth and development: Provision of merit goods
Healthcare and education
Increased labour productivity → economic growth → development
Better and higher-paid employment → improved living standards
External benefits
Interdependence: greater health improves education while greater education improves health.
Infrastructure
Lower costs of production → higher productivity → economic growth → economic development
Access to clean water and sanitation prevents diseases → reducing public health risks.
Problems
Developing countries’ governments may be deprived of the funds necessary to subsidize or directly provide health care, education and infrastructure.
Poor governance and corruption may also prohibit public expenditure on these merit goods.
Inward foreign direct investment (FDI)
When a firm establishes a production facility in a foreign country or acquires controlling interest (at least 10% of the ordinary shares) in an existing foreign firm.
Advantages
increased employment opportunities
training of the local workforce, leading to improved human capital
transfer of organizational and managerial know-how and new production technologies
providing a source of foreign exchange
higher tax revenues that can be used to fund spending in other areas
higher savings, leading to more investment.
Disadvantages
lack of training if the local workforce is employed only in low-skill positions
capital-intensive technology that does not create employment
elimination of competition
tax contribution that is not significant
forced relaxation of labour and environmental protection laws
environmental damage.
Foreign aid
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