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ECONOMICS Johnson Hsu July 2014 The global economy 1. 2. 3. 4. Macroeconomic performance Trade and integration Development and sustainability The economics of globalisation World Trade Organization An international body responsible for negotiating trade agreements and ‘policing’ the rules of trade to which its members sign up. Trade disputes between members are settled by the WTO Absolute advantage Where one country is able to produce more of a good or service with the same amount of resources, such that the unit cost of production is lower refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources Example 1 Party B has the absolute advantage. Party A can produce 5 widgets per hour with 3 employees. Party B can produce 10 widgets per hour with 3 employees. Assuming that the employees of both parties are paid equally, Party B has an absolute advantage over Party A in producing widgets per hour. This is because Party B can produce twice as many widgets as Party A can with the same number of employees. Example 2 One of your friends, Gina, can print 5 t-shirts or build 3 birdhouses an hour. Your other friend, Mike, can print 3 t-shirts an hour or build 2 birdhouses an hour. Because your friend Gina is more productive at printing tshirts and building birdhouses compared to Mike, she has an absolute advantage in both printing t-shirts and building birdhouses. Example 3 Suppose Gina wasn't as agile with the hammer and could only make 1 birdhouse an hour, but she took a sewing class and could print 10 t-shirts an hour. Mike on the other hand takes woodworking and so he can build 5 birdhouses an hour, but he doesn't know the first thing about making t-shirts so he can only print 2 t-shirts an hour. While Gina would have the absolute advantage in printing shirts, Mike would have an absolute advantage in building birdhouses. Reciprocal absolute advantage where, is a theoretical world of two countries and two products, each country has an absolute advantage in one of the two products Comparative advantage Where one country produces a good or service at a lower relative opportunity cost than others Absolute vs Comparative Advantage Comparative advantage can be described as the ability of a particular country to produce a certain product better than another country. A country will have an absolute advantage over another country when it produces the highest number of goods after the same resources are supplied to both of them. While absolute advantage is a condition where the trade is not mutually beneficial, comparative advantage is a condition in which the trade is mutually beneficial. While cost is a factor involved in absolute advantage, opportunity cost is the factor that is involved in comparative advantage. Unlike absolute advantage, comparative advantage is always reciprocal and mutual. Relative opportunity cost The cost of production of one good or service in term of the sacrificed output of another good or service in one country relative to another What Is Law of Increasing Ans: Opportunity Cost? The Law of Increasing Relative Cost, also know as, the Law of Diminishing Returns is a term used in economics which suggests that diminishing returns as a decrease in marginal output of a production process is the single a factor of production while all other factors are constant. Though the marginal productivity of the workforce decrease, the output increases, and the number of workers exceed the number of available workspace. Term of trade The price of a country’s exports relative to the price of its imports. The terms of trade can measured using the formula: Index of average export prices ------------------------------------- x 100 Index of average import prices Trading possibility curve A representation of all the combinations of two products that a country can consume if it engages in international trade. The TPC lies outside the production possibility curve, showing the gains in consumption possible from international trade Factor endowments The mix of land, labour and capital that a country possesses. Factor endowments can be determined by, among other things, geography, historical legacy, and economic and social development Factor intensities The balance between land, labour and capital required in the production of a good or service Measuring factor intensity in the real world is not a simple task. Numerous factors of production exist; a country's abundant factor may depend on the countries being compared, and an intensive factor may depend on the industries being compared. For example, consider the laborto-land ratio among different countries by assuming that a country's labor force is a constant fraction of its population. Compare the population-to-land ratio (population density) in the United States to that in the United Kingdom. Then compare the ratio in the United States to that in Australia. Do you expect the United States to be a net exporter of agricultural goods because of its "abundance" or "scarcity" of labor? Depending on how you compare the US to other countries, it is hard to predict. Labour-intensive production Any production process that involves a large amount of labour relative to other factors of production Capital-intensive production Where the production of a good or service requires a large amount of capital relative to other factors of production Heckscher-Ohlin theory of international trade A theory that a country will export products produced using factors of production that are abundant and import products whose production requires the use of scarce factors The model essentially says that countries will export products that use their abundant and cheap factor(s) of production and import products that use the countries' scarce factor(s) Theoretical assumptions of Heckscher-Ohlin Both countries have identical production technology Production output is assumed to exhibit constant returns to scale The technologies used to produce the two commodities differ Factor mobility within countries Factor immobility between countries Commodity prices are the same everywhere Perfect internal competition Infant industries Industries in an economy that are relatively new and lack the economies of scale that would allow them to compete in international markets against more established competitors in other countries Profit margin The difference between a firm’s revenue and cost expressed as a percentage of revenue Dynamic efficiencies Efficiencies that occur over time. International trade can lead to change in behavior over a period of time that can increase productive and allocative efficiency Knowledge and technology transfer The process by which knowledge and technology developed in one country is transferred to another, often through licensing and franchising Licensing arrangement An agreement that ideas and technology ‘owner’ by one company can be used by another, often for a charge Regional trading bloc Countries in a region that have formed an ‘economic club’ based on abolishing tariffs and non-tariff barriers to trade, e.g. the European Union, the North American Free Area and the Association of South East Asian Nations is a type of intergovernmental agreement, often part of a regional intergovernmental organization, where regional barriers to trade, (tariffs and nontariff barriers) are reduced or eliminated among the participating states. Advantages and Disadvantages of trade blocs There are five major advantages of trade bloc agreements: foreign direct investment, economies of scale, competition, trade effects, and market efficiency. The disadvantages, on the other hand, include: regionalism vs. multinationalism, loss of sovereignty, concessions, and interdependence. Primary commodities Goods produced in the primary sector of the economy, such as coffee and tin Prebisch-Singer hypothesis The argument that countries exporting primary commodities will face declining terms of trade in the long run, which will trap them in a low of development as more and more exports will need to be sold to ‘pay for’ the same volume of imports of secondary sector or capital goods postulates that terms of trade, between primary products and manufactured goods, deteriorate in time. Developed economies Countries with a high income per capita and diversified industrial and tertiary sectors of the economy. Examples of developed economies would include the USA, the UK, Japan and South Korea Developing economies Countries with relative low income per capita, an economy in which the industrial sector is small or undeveloped and where primary sector production is a relatively large part of total GDP Liberalisation Reduction in the barriers to international trade, in order to allow foreign firms to gain access to the market for goods and services that are traded internationally Transition economies Economies in the process of changing from central planning to the free market Intra-regional trade Trade between countries in the same geographical area, for example trade between the UK and Germany or the USA and Canada Inter-industry trade Trade involving the exchange of goods and services produced by different industries Intra-industry trade Trade involving the exchange of goods and services produced by the same industry Freely floating exchange rate A system whereby the price of one currency expressed in terms of another is determined by the forces of demand and supply Fixed exchange rate An exchange rate system in which the value of one currency has a fixed value against other countries. This fixed rate is often set by the government Semi-fixed/semifloating exchange rate An exchange rate system that allows a currency’s value to fluctuate within a permitted bank of fluctuation Foreign exchange market A term used to describe the coming together of buyers and sellers of currencies Short-term capital flows Flows of money in and out of a country in the form of bank deposits. Short-term capital flows are highly volatile and exist to take advantage of changes in relative interest rates Long-term capital transactions Flows of money related to buying and selling of assets, such a land or property or production facilities or shares in companies. External economic shocks Unexpected events coming from outside the economy that cause unpredicted changes in AS or AD. Examples might include rapid rises in oil prices or a global slowdown Purchasing power parity The exchange rate that equalises the price of a basket of identical traded goods and services in two different countries. PPP is an attempt to measure the true value of a currency in terms of the goods and services it will buy J-curve effect Shows the trend in a country’s balance of trade following a depreciation of the exchange rate. A fall in the exchange rate causes an initial worsening of the balance of trade, as higher import price raise the value of imports and lower export prices reduce the value of exports due to short-run inelasticity of the demand for imports and exports. Eventually the trade balance improves. An appreciation of the currency causes an inverted J-curve effect The J-Curve Figure: The J-Curve Current account (in domestic output units) Long-run effect of real depreciation on the current account 1 3 2 Time Real depreciation takes place and J-curve begins Copyright © 2003 Pearson Education, Inc. End of J-curve Slide 16-55 Marshall-Lerner condition States that for a depreciation of the currency to improve the balance of trade the sum of the price elasticities of demand for imports and exports must be great than 1 Hedging Business strategy that limits the risk that losses are made from changes in the price of currencies or commodities is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. Hedging strategies Forward exchange contract for currencies Currency future contracts Money Market Operations for currencies Forward Exchange Contract for interest Money Market Operations for interest Future contracts for interest Covered Calls on equities Short Straddles on equities or indexes Categories of hedgeable risk Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.[3] Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate. Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure. Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps. Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency. Volumetric risk: the risk that a customer demands more or less of a product than expected. Futures market Markets where people and businesses can buy and sell contracts to buy commodities or currencies at a fixed price at a fixed date in the future is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. Foreign currency reserves Foreign currencies held by central banks in order to enable intervention in the FOREX markets to affect the country’s exchange rate Bilateral exchange rate The exchange of one currency against another Effective exchange rate The exchange rate of one currency against a basket of currencies of other countries, often weighted according to the amount of trade done with each country Single currency A currency that is shared by more one country. The euro is shared by 15 countries in the European Union Expenditure-switching policies Policies that increase the price of imports and/or reduce the price of exports in order to reduce the demand for import and raise the demand for exports to correct a current account deficit on the balance of payments Expenditure-switching policies can be achieved by A fall in the exchange rate Tariff on import Subsidising export Expenditurereducing policies Policies that reduce the overall level of national income in order to reduce the demand for imports and correct a current account deficit of the balance of payments Expenditure-reducing policies can be achieved by Raising the level of taxation Reducing government expenditure Raising interest rates Economic integration Refers to the process of blurring the boundaries that separate economic activity in one nation state from that in another is the unification of economic policies between different states through the partial or full abolition of tariff and non-tariff restrictions on trade taking place among them prior to their integration. This is meant in turn to lead to lower prices for distributors and consumers with the goal of increasing the combined economic productivity of the states. The degree of economic integration can be categorized into seven stages Preferential trading area Free trade area Customs union Common market Economic union Economic and monetary union Complete economic integration Stages of Economic integration common barriers in external relations activities inside the trade bloc Trade pact type goods (tariffs) Preferential trade agreement Free trade agreement Economic partnership Common market Monetary union Fiscal union Customs union Customs and monetary union Economic union Economic and monetary union Complete economic integration Shared policies eliminating barriers for exchange of goods (non-tariff) servi ces capit al TIFA BIT, TIFA lab our mone tary fis cal dsgoo Tar iff Nontariff serv ices cap ital lab our Non-tariff barriers Things that restrict trade other than tariff Trade deflection Where one country in a free trade area imposes high tariffs on another to reduce imports but the imports come in from elsewhere in the free trade area Trade deflection Free trade area An agreement between two or more countries to abolish tariffs on trade between them is a theoretical concept where a trade bloc whose member countries have signed a freetrade agreement(FTA), which eliminates tariffs, import quotas, and preferences on most(if not all)goods and services traded between them. Customs union An agreement between two or more countries to abolish tariffs on trade between them and to place a common external tariff on trade with non-members. Single market Deepens economic integration from a customs union by eliminating non-tariff barriers to trade, promoting the free movement of labour and capital and agreeing common policies in a number of areas Economic union Deepens integration in a single market, centralising economic policy at the macroeconomic level Monetary union The deepest form of integration in which countries share the same currency and have a common monetary policy as a result Monetary policy sovereignty The ability of country to pursue an independent monetary policy Trade creation Where economic integration results in high-cost domestic production being replaced by imports from a more efficient source within the economically integrated area Trade diversion Where economic integration results in trade switching from a low-cost supplier outside the economically integrated area at a less efficient source with the area The dynamic effects of economic integration A reduction in monopoly power Greater innovation and R&D A larger market and economies of scale Transaction costs The costs of trading, which includes cost of changing currencies Stability and Growth Pact Limits agreed to public sector borrowing and national debt for those EU countries that are part of the euro area Automatic stabilisers Elements of fiscal policy that cushion the impact of the business cycle without any need for corrective action by the government. For example, higher spending on unemployment benefits and welfare payments and lower taxation receipts provide and automatic fiscal stimulus in times of economic slowdown Fiscal transfer Occur where taxation raised in one country is used to fund government expenditures in another country Economic convergence The process by which economic conditions in different countries become similar. Economists distinguish between monetary convergence and real convergence. Membership of the euro area only requires monetary convergence to have taken place is the hypothesis that poorer economies’per capita incomes will tend to grow at faster rates than richer economies. As a result, all economies should eventually converge in terms of per capita income. Types of Convergence Absolute Convergence: Lower initial GDP will lead to a higher average growth rate. The implication of this is that poverty will ultimately disappear 'by itself'. It does not explain why some nations have had zero growth for many decades (e.g. in Sub-Saharan Africa) Conditional Convergence: A country's income per worker converges to a country-specific long-run level as determined by the structural characteristics of that country. The implication is that structural characteristics and not initial national income determine the long-run level of GDP per worker. Thus, foreign aid should focus on structure (infrastructure, education, financial system etc.) and there is no need for an income transfer from richer to poorer nations. Club Convergence: It is possible to observe different "clubs" or groups of countries with similar growth trajectories. Most importantly, several countries with low national income also have low growth rates. Thus, this adds to the theory of conditional convergence that foreign aid should also include income transfers and that initial income does in fact matter for economic growth. Optimal currency area Refers to conditions that need to be avoid the costs of monetary union. These conditions include: a high degree of labour market flexibility, mechanisms for fiscal transfer, and the absence of external shocks that impact differently on different economies With trade, Crusoe’s Consumption-Possibilities Curve (CPC)can lie beyond his Production-Possibilities Curve (PPC)