With trade, each country can concentrate on producing goods and services that it produces more efficiently, while trading to obtain goods and services that it does not produce efficiently.
As a result, the total output of trading nations can be increased, leading to higher living standards of the residents of those nations. The mutual benefits realised as a result of trade are the gains from trade.
1.1 Theory Of Comparative Advantage
The theory of comparative advantage attempts to explain what leads to gains from trade.
Assumptions:
• Resources are fully employed
• Only two countries (e.g. A and B)
• Two products (e.g. rice and cloth)
• No transportation cost for goods across national boundaries
The following table shows the amounts of rice and cloth that can be produced
with one unit of resources in Country A and Country B:
Rice (Kg)
Cloth (Yard)
Country A
50
30
Country B
5
10
The following table shows the opportunity costs of rice and cloth in Countries A and B:
Rice (Kg)
Cloth (Yard)
Country A
0.6 yards of cloth
1.67 kg of rice
Country B
2.0 yards of cloth
0.50 kg of rice
The table shows that the sacrifice of cloth in producing rice is much lower in Country A than it is in Country B. Country A has a lower cost in producing rice.
Similarly, the sacrifice of rice involved in producing one yard of cloth is lower in Country B than in Country A. Country B has the lower cost in producing cloth.
If trade is allowed between these two countries, they can specialise in the production of goods that have lower opportunity cost. The following illustrates the changes in production resulting from each country’s producing one more unit of a commodity in which it has the lower opportunity cost:
Rice (Kg)
Cloth (Yard)
Country A
+1.0
-0.6
Country B
-0.5
+1.0
Changes in production
+0.5
+0.4
The total production will increase because of the re-allocation of resources when trade is possible between these two countries. These are the gains from trade, which arise from differing opportunity costs in the two countries.
Definition
A country is said to have a comparative advantage in the production of a
good if it is able to produce that good at lower opportunity cost than other
countries.
Differences in opportunity costs in producing both goods make it possible to increase production of both goods by a suitable re-allocation of resources within each country. Therefore, the gains from specialisation and trade depend on the pattern of comparative advantage.
1.2 Trade Restrictions
A country can impose different restrictions on international trade for various reasons.
1.2.1 Tariffs
Definition
A tariff is a form of tax imposed on imports.
Tariffs can increase the price of foreign products when they enter a country. The quantity demanded for imported goods will fall, while the demand for domestic goods will increase. This brings tariff revenue to the government, which represents a transfer from consumers and producers.
Tariffs can be levied on an ad valorem basis, which is as a percentage of the value of the import, or they can be levied on a specific basis, which is on a unit of weight or specific quantity.
Figure 1 The effects of a tariff
1.2.2 Quotas
Definition
A quota is a limit on the quantity of a product which can be imported during
a particular period of time.
Figure 2 The effects of a quota
The resulting price can be the same as that of tariff (i.e. $7), as in Figure 2, if the quota is carefully set. Domestic demand for the import substitute will increase and domestic employment can be protected.
1.2.3 Embargoes
Definition
An embargo is a ban on certain goods to be imported into a country.
These are usually imposed for non-economic reasons, such as war or political differences (i.e. Cuba and North Korea).
1.2.4 Exchange controls
Since trade requires financing with foreign exchanges, the government can impose trade restrictions by instituting exchange controls. Under the exchange controls, the government demands that all foreign receipts be surrendered to the central bank in exchange for national currency, and all foreign payments be approved in order to obtain the necessary foreign exchange. Thus, the government monopolises all foreign receipts, and all foreign payments have to be decided by it.
1.2.5 Administrative procedures
Some discriminatory administrative practices such as stricter hygiene regulations for imported foodstuffs and safety standards for toys can be imposed to limit imports.
1.2.6 Subsidies to local goods
The government gives subsidies to producers so as to lower the selling prices. This will increase the competitiveness of domestic output in the face of foreign competition.
Activity 1
A tariff only restricts the import price and a quota only restricts the import volume. Explain whether this statement is true or false.
1.3 Reasons For Trade Protectionism
Main reasons for countries to restrict trade are:
• To protect infant industries
A new industry will not be able to compete with large established foreign firms in other countries as they can operate at lower costs due to economies of scale. Trade barriers are imposed to protect firms from foreign competition in an attempt to allow the industry to develop in the hope that it will finally be able to compete with well-established foreign firms.
• To protect employment
If import goods are made more expensive or their quantity is restricted, consumers will buy more domestic goods instead. As a result, more local labour will be employed and the unemployment rate is reduced.
• Defence reasons
Many strategic resources such as fossil fuels, iron, steel and agricultural produce are critical for national defence. Many nations impose quotas and tariffs to protect domestic production so as to ensure that they are not dependent on other countries for these vital goods.
• To obtain revenue
The revenue raised from tariffs can be a major source of government revenue.
• To correct trade deficits
A country may try to reduce imports when the earnings from exports cannot afford to pay for imports.
2. BALANCE OF PAYMENTS
Definition
The balance of payments is a record of all transactions of a country with the rest of the world over a given period of time.
It includes any economic transactions that result in:
• receipt of foreign currencies from abroad are credit items
• payment of foreign currencies abroad are debit items
2.1 Balance Of Payments Accounts
Balance Of Payments Accounts
Credit
Debit
Balance
(A) Current account
(a) Visible trade
(i) Exports of goods
A
(ii) Imports of goods
B
Balance of visible trade
(A – B) = C
(b) Invisible trade
(i) Services
– Exports of services
D
– Imports of services
E
(ii) Interest and dividends
– Receipts from abroad
F
– Payments abroad
G
(iii) Transfers (remittance, donations,
international aids, etc.)
– Receipts from abroad
H
– Payments abroad
I
Balance of invisible trade
(D – E) + (F – G)
+ (H – I) = J
Balance of current account
C + J = K
(B) Capital account
(a) Capital inflow
L
(b) Capital outflow
M
Balance of capital account
L – M = N
Balance of current account plus balance
of capital account
K + N = P
(C) Official reserve account
-P
Total balance
0
2.2 Components Of The Balance Of Payments
2.2.1 Current account
This is a record of all transactions in goods, services, interest and dividends, and net transfers between a country and other countries. This account is further divided into visible trade and invisible trade.
• Visible trade
Visible trade refers to the export and import of physical goods, e.g. raw materials, food and manufactured goods. The difference between the value of export and import of goods is called the balance of visible trade.
If the value of exports exceeds the value of imports, the country enjoys a favourable balance of visible trade, or trade surplus. If the value of imports exceeds the value of exports, the country suffers an unfavourable balance of visible trade, or trade deficit. The country has a balanced balance of visible trade when its value of exports equals value of imports.
• Invisible trade
Invisible trade refers to the export and import of services (includes transportation services, insurance services, tourist expenditure, etc.), interest, dividends, gifts, remittance, donations and international aid.
• Current account
The sum of net exports, net income received from investments abroad, and net transfers from abroad. If a country has a positive current account balance, its current account is in surplus; if there is a negative current account, it is a current account deficit.
2.2.2 Capital account
The capital account records all capital movements, i.e. the inflow and outflow of capital of a country.
• Short-term capital flow refers to the movements of capital for short-term profit, known as hot money, e.g. countries offering a higher rate of interest can often attract the inflow of short-term capital.
• Long-term capital flow refers to the movements of capital for acquiring long-term assets such as office buildings. International loans are also capital transfers from one country to another. If the total inflows exceed total outflows of capital funds, there will be a favourable balance on the capital account (a capital account surplus). If total outflows exceed total inflows of capital funds, there will be an unfavourable balance on the capital account (a capital account deficit).
2.2.3 Official reserve account
It is a record of the changes in official reserves as a result of international transactions.
A country’s official reserves consist of assets that are accepted as payment in international trade, e.g. foreign currencies. This account may also record a government’s borrowings from other countries and lending to other countries.
Activity 2
If a country experiences a balance of trade deficit, its current account will also run into a deficit. Do you agree? Explain why.
2.3 Payment Balances And Imbalances
2.3.1 Balance of payments must always balance
The sum of the balances on the three accounts always equals zero. In other words, when all the payments and receipts of a country are added up, they must be equal to zero.
2.3.2 Some parts of payments accounts need not balance
Although the overall payments must balance, some parts of the payments accounts need not balance. The terms that balance of payments deficit and balance of payments surplus are usually referred to as the balance on the sum of current and the capital accounts.
If the total debits exceed the total credits in the current and capital accounts, the net debit balance means that the country suffers the balance of payments deficit. This deficit represents a debt to foreign nations and must be settled with an equal withdrawal (i.e. net credit balance) in the country’s official reserve account. A balance of payments deficit means that the central bank is reducing its reserves.
If the total credits exceed the total debits in both accounts, the country enjoys a balance of payments surplus. Other nations have to pay gold or foreign exchange and this means that the central bank is increasing its foreign exchange reserves.
3. EXCHANGE RATE
Definition
The exchange rate of a currency is defined as the price of that currency in terms of another currency.
The demand and supply of that currency determine the exchange rate in a freely adjustable foreign exchange market.
3.1 Demand For A Currency
The quantity of a currency of a country, say X, depends on holders of other currencies wishing to exchange those currencies for the currency of Country X. People buy the currency because they can then buy the goods and services of Country X. They can also buy the assets of Country X, such as real estate.
Just as with all other demand curves, the demand curve for a foreign currency, e.g. Japanese yen, is downward sloping. If the price of yen drops, more yen will be demanded.
Figure 3 The demand for US dollars
3.2 Supply Of A Currency
People sell the currency so that they can buy foreign goods and services, and foreign assets. The supply curve of the currency is upward sloping. All other things being equal, the higher the exchange rate, the greater is the quantity of the currency supplied in the foreign exchange market.
Figure 4 The supply of US dollars
3.3 Market Equilibrium
The demand and supply of a currency in the foreign exchange market determines the exchange rate of that currency. The following diagram shows the intersection of the demand curve and supply curve of a currency:
Figure 5 Equilibrium exchange rate
3.4 Types Of Exchange Rate Systems
3.4.1 Fixed exchange rate system
Under such a system, the exchange rate is fixed with other currencies. Central banks are held responsible for maintaining the values of their currencies. If the government lowers the exchange rate of its currency in terms of other currencies, it devalues (i.e. devaluation) its currency. When it raises the exchange rate of its currency in terms of other currencies, it revalues (i.e. revaluation) its currency.
3.4.2 Floating exchange rate system
Under such a system, the exchange rate of a currency is freely adjustable, i.e. by demand and supply. When the exchange rate of a country’s currency in terms of another currency increases, the currency is said to appreciate (i.e. appreciation). When the exchange rate decreases, it is said that the currency depreciates (depreciation).
Chapter Review
• Re-allocation of resources leads to specialisation and gains from trade.
• A balance of payment surplus will add to the official reserve account and a deficit will lower the official reserve account.
What You Need To Know
• International trade: Exchange of goods and services across international boundaries.
• Comparative advantage: The advantage that a country has if it is able to produce a tradable good at a lower opportunity cost than other countries.
• Tariff: A form of tax imposed on imports.
• Quota: Limit on the quantity of a product which can be imported during a particular period of time.
• Balance of payments: A record of all transactions of a country with the rest of the world over a given period of time.
• Exchange rate: The price of a currency in terms of another currency.
Work Them Out
1. Reasons for limiting international trade are
(i) currency differences
(ii) national security reasons
(iii) trade protectionism
(iv) high transportation cost
A (i) and (ii)
B (ii) and (iii)
C (ii), (iii) and (iv)
D (i), (ii) and (iii)
2. Which of the following are trade protectionist measures?
(i) subsidies to local industries
(ii) import quotas
(iii) import tariff
(iv) foreign exchanges control
A (i) and (ii)
B (ii) and (iii)
C (i), (ii) and (iii)
D All of the above
3. Which of the following is an item in the current account of the balance of payments?
A Tourists expenditures in Hong Kong
B Direct foreign investment
C Imports of foreign goods
D Send goods oversea by foreign shipping company
4. Which of the following is not a reason for trade protectionism?
A Infant industry protection
B National defence
C Correct balance of payment deficit
D Promote comparative advantage
5. A tariff will
(i) raise the price of imported goods
(ii) lower the level of local consumption of the imported goods
(iii) raise the level of domestic production of the substitute
(iv) increase the level of domestic wage rates
A (i) and (ii)
B (i), (ii) and (iii)
C (ii), (iii) and (iv)
D All of the above
6. The following are effects of import quota:
(i) Quantity of high-quality imported goods will rise
(ii) Domestic production will fall
(iii) Price of the imported goods rises
(iv) Trade volume decreases
A (i), (ii) and (iii)
B (i), (iii) and (iv)
C (ii), (iii) and (iv)
D All of the above
7. Country X has a comparative advantage in producing commodity M if
A it can produce more M than other countries
B it can use less resources to produce M
C it can produce M at lower opportunity cost
D it has sufficient resources to produce M
8. Balance of payment deficit can be caused when
(i) demand for imported goods rises
(ii) inflow of capital increases
(iii) more tourists stay in our hotels
(iv) more shipping services are sold to overseas companies
A (i)
B (ii) and (ii)
C (i), (ii) and (iii)
D All of the above
9. The exchange rate of a currency is defined as
A the term of trade of a country
B the amount of another currency that can be exchanged with
C the maximum price of a currency
D the intrinsic value of a currency
10. The remittance of money from Hong Kong to Australia is recorded in the
A current account
B capital account
C official account
D financial account
SHORT QUESTIONS
Determine whether the transactions would show up in the Hong Kong’s balance of payments account as part of the capital account or the current account and whether each is a credit or a debit item.
An office machine sold by a USA firm to Hong Kong
A Hong Kong resident buys a house in Australia
Japanese firm sets up a plant in Hong Kong
A rich man in the USA deposits money in Hong Kong
A Hong Kong investor receives dividends from his investment in the USA
A Canadian aircraft uses the landing facilities of Hong Kong International Airport
A bank in Hong Kong takes over a bank in Canada
A Hong Kong citizen goes to Malaysia for a holiday trip
A restaurant in Hong Kong buys red wine from France
A local airfreight service company buys a plane from the USA
A merchant bank in Britain receives commission for arranging the sale of bonds of MTRC in Hong Kong
2. (a) What is an exchange rate?
(b) Assume a LCD TV produced in Japan is sold for 1,200,000 yen.
(i) What is the dollar price of the LCD TV if the exchange rate is 100 yen/$?
(ii) What is the dollar price of the LCD TV if the exchange rate is 120 yen/$?
(iii) As the price of dollar in terms of yen has risen, what happens to the dollar price of Japanese-produced goods?
(iv) What would you expect to happen to the number of LCD TVs imported into the US after the dollar has improved in exchange rate?
ESSAY QUESTION
1. The following table shows hypothetical data on the balance of payments accounts of Country A.
Balance Of Payments Accounts
HK$ (m)
(i)
Long-term capital inflow
1,400
(ii)
Exports of goods
18,500
(iii)
Freight and shipping receipts
1,200
(iv)
Freight and shipping payments
1,130
(v)
Short-term capital inflow
1,180
(vi)
Imports of goods
16,500
(vii)
Long-term capital outflow
800
(viii)
Short-term capital outflow
1,050
(ix)
Interest and dividend receipts
520
(x)
Interest and dividend payments
1,600
(xi)
Other travel payments
200
Distinguish between balance of visible trade and balance of invisible trade.
What is the value of the balance of visible trade? Is the visible trade balance a deficit or surplus?
What is the value of the balance of invisible trade? Is the invisible trade balance a deficit or surplus?
What is the balance on the current account?
What is the balance on the capital account?
What will happen to the official reserves as a result of these international transactions?
2. (a) Distinguish between the fixed and floating exchange rate systems.
(b) Explain how governments can attempt to keep their exchange rates fixed under the fixed exchange rate system.
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