F585 Trade and Integration

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What is Absolute Advantage?
When an economy is able to produce more products than another, with the same amount of resources (i.e.. At a lower ULC)
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What is Reciprocal AA?
when in a theoretical world of 2 countries and 2 products, each country has AA in one product
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What is Comparative Advantage?
When a country can make a product at a lower opp cost relative to others
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How does Opp Cost Ratio work?
Good A/Good B, economy with lowest value has CA in Good B
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What is International Trade?
Exchange of Goods and Services across national borders
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Gains from International Trade
Complete Specialisation in good with CA, total output increases and both countries benefit.
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Why do economies trade?
Heckscher Olin Theory of International Trade - Countries trade as they differ in intensity of factor endowments. i.e. Labour abundant econ, X labour intense goods, M capital intense goods
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How can an Economy gain CA?
in high value products, by investing in industry related technology and education
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Effect of International Trade on P and Q
Without Trade, natural E. With Trade, S world is lower and horizontal at P2, Domestic firms supply up to intersect of S(UK) and S(W), Trade supply rest. (See page 27 revision)
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Effect of International Trade on surplus’
Consumer increase (P1,SUK/DUK,Sw/DUK, SUK/SW) Producer fall (P1,SUK/DUK, SUK/SW,P2) see page 27 revision
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Effect of International Trade on GDP
increase in world output (if specialisation), more efficient use of resources, more wants are met, Trade increase X, AD increase, GDP and EG,
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Effect of International Trade on EoS
increase size of market, X’ing Firms increase production, Benefit from EoS, LR lower Unit Cost and LRAS growth.
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Effect of International Trade on Competition
Domestic monopoly must compete with M. incentive to decrease X inefficiency, increase productivity, LR Growth.
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Effect of International Trade on Dynamic Efficiency
Increase Competition(encourages new Tech), increase Productivity, Increase DE and LREG
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Effect of International Trade on Factor Prices
Trade leads to convergence of factor prices. i.e. increase of D of L in china will increase P of L, which will cause D of L in UK to fall and thus decrease prices.
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Pattern of International Trade
Developed Economies dominate. Trade usually takes place within regional trade blocs to minimise tariffs and transport costs
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Use CA to explain Pattern of International Trade
CA explains interindustry trade, Capital abundant economy exports capital intense and imports labour intense. CA doesn’t explain intraindustry trade, specialisation doesn’t occur because of diff opp cost ratios but because of EoS and market segments
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Pattern of Trade within a Trading Bloc
Specialisation and trade based on CA occurs within bloc. But non member trade limited by tariffs quotas etc.
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What are the Terms of Trade
ratio of X prices to M prices, stated as index ratio
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How to calculate ToT
(index of X prices/ index of M prices) x 100
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When does ToT improve?
When X prices increase faster than M prices
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Factors that change ToT in SR
change in market forces of X&M, relative inflation rates, exchange rate changes
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Factors that change ToT in LR
Changes in incomes/ productivity/ technology
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Prebisch Singer Hypothesis
LR Decline in ToT due to dependance on the export of primary commodities. Due to YED and wealth effect. Natural resource; YED inelastic. As incomes rise; D of M rise=P of M rise. D for natural resources no change so P the same. ToT falls
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How to avoid development trap from Primary Dependance?
Use revenues from exporting to promote diversification.
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Improvement in ToT is good if:
ToT rise =>Higher X revenues, hence increasing purchasing power of economy. Explain using cause of change in ToT and D/S diagram
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Deterioration in ToT is good if:
leads to rise in international competitiveness
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Analysis of ToT changes
effect depends on International competitiveness, revenues(Q of X/M), PED of X/M
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What is a Free Floating Exchange Rate System
External value of currency depends wholly on market forces
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Appreciation in Free Floating Exchange Rate System
fall in S/ rise in D
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Depreciation in Free Floating Exchange Rate System
Rise in S/ Fall in D
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Causes of fluctuations in Free Floating Exchange Rate System
Change in level of X/M (rise in X=rise in D, rise in S=rise in S& vice versa); Official buying & selling of currency by central bank; Expectation & speculation, relative inflation rates, relative interest rates, confidence in economic state; BoP +/-
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How do relative inflation rates affect Free Floating Exchange Rate
high compared to competitors, X fall(D falls) and M rise(S rises), hence fall in $ rate
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How do Relative Interest Rates affect Free Floating Exchange Rate
High rates => increase D due to hot money flows
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How does BoP position affect Free Floating Exchange Rate
Deficit= high S due to high M(Depreciation); Surplus= low S due to high X(Appreciation)
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Advantages of Free Floating Exchange Rate System
Reduced need for currency reserves; can help reduce BoP C/A Deficit; MP not needed to maintain forex rate.
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Disadvantages of Free Floating Exchange Rate System
Can flux widely (makes business planning difficult); Speculation can artificially strengthen rate; Fall in rate can lead to inflationary pressure
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Examples of Free Floating Exchange Rate Systems
UK/ USA and many more
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What is a Fixed (Pegged) Exchange Rate System
when Gov try to maintain currency value that is constant against a specific currency or commodity.
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How does a Fixed (Pegged) Exchange Rate System work
Gov decides worth in terms of fixed weight of an asset, another currency, or basket of other currencies. Central Bank remains committed at all times to buy and sell currency at this fixed price
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Advantages of Fixed (Pegged) Exchange Rate System
Creates certainty (encourages I); Reduction in speculation; Competitive pressures placed on firms (increase efficiency)
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Disadvantages of Fixed (Pegged) Exchange Rate System
Lose control of Interest rate as they are used to maintain rate; if regulators feel rate is unsustainable, may take advantage by selling currency; difficult to maintain.
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What is a Semi Fixed Exchange Rate System
Where exchange rate allowed to flux between set band, gov/central bank use MP to keep in range
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What is a Managed Floating Exchange Rate System
Gov influence rate to stop excessive flux. Mainly left to D/S. Use MP to stop excessive flux.
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What is PPP
Exchange rate that equalises price of an identical basket of goods in different countries
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What does PPP do
Equalises Purchasing power of 2 currencies by taking into account cost of living and inflation differences. Allows for equitable comparison between countries
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What is the J Curve Effect
Trade Deficit can get worse after depreciation in the SR before getting better in the LR.
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Why does the J curve effect occur?
A fall in $ occurs, Prices adjust quickly, UKbuyers face rise in P of M (M falls) and opposite for X. Q adjusts more slowly, consumers slow to notice price changes and firms may have fixed price contracts
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How does J Curve Effect Work
SR: D of X& M inelastic but elastic in LR, so devaluation causes X P fall & M P rise. Q doesn’t change, C/A deteriorates. LR: Consumers and Firms adjust to prices, Q of M falls, Q of X rises, Given Marshall Lerner Condition met, C/A improves
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What is the Marshall Lerner Condition
Depreciation => increase in CA if; PED(M)+PED(X)>1
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Causes of Exchange Rate Fluctuation
Inflation; Interest Rates; Speculation; change in competitiveness; Relative Strength of other economies; BoP position; Gov Debt; Gov intervention; Economic Position
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How does Inflation affect Exchange Rate
high, X fall(D falls) and M rise(S rises), hence fall in $ rate, opposite for low rate of inflation
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How do Interest Rates affect Exchange Rate
High rates => increase D due to hot money flows=> Appreciation; Low rates has opposite effect
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How does Speculation affect Exchange Rate
If speculators believe rate will rise in future, They will buy now, raising D, hence raising rate
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How does change in Competitiveness affect Exchange Rate
Increase, X fall(D falls) and M rise(S rises), hence fall in $ rate, opposite for decrease
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How does BoP position affect Exchange Rate
Deficit= high S due to high M(Depreciation); Surplus= low S due to high X(Appreciation)
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How does Gov Debt affect Exchange Rate
If markets fear gov may default on debt, investors will sell bonds, D fall, S rises, hence depreciation
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How does Gov Intervention affect Exchange Rate
Changing D/S to influence Rate i.e. China buying dollar bonds to keep Yuan low
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How does Economic Position affect Exchange Rate
Recession causes depreciation, due to a few factors like fall in interest rate, vice versa for Boom
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What are the Consequences of Exchange Rate Flux
International Trade (fall=>X rise and M fall)=> Economic Growth as X-M rises; Capital Flows -stable rate attacks foreign investors; Inflation (devalued currency leads to M inflation); Interest rates (Exchange rate key consideration when setting MP
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Causes of BoP Deficit
Structural Factors; Domestic firms can’t compete with overseas in P or Q. Lack of Competitiveness due to low productivity. Cyclical Factors; economy in recovery or boom prefers M, But depends on rate of EG and Marginal Propensity to M(mpM)
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Solution to BoP Deficit
Expenditure reducing policies (cut GDP and thus decrease D(M); Cut G, Raise T, Raise interest rates. Expenditure Switching polices that increase P of M &/or decrease P of X. Fall in exchange rate/import tariffs? Subsidise X.
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What is Protectionism?
Gov Policies to create barriers to trade
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Types of Protectionism
Tariffs; Quotas; Regulation; subsidise domestic firms; undervalue currency to gain CA.
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Arguments for Protectionism
Infant industry protection; protect diversification of developing countries; protect domestic employment; tariffs as source of gov revenue; Anti price dumping; overcome BoP deficit.
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Arguments Against Protectionism
Misallocation of resources; Danger of retaliation and trade wars; potential for corruption; rise in costs of production; higher prices for domestic consumers; higher costs of imported FoP; reduced international competitiveness
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What is Economic Integration?
Process by which economies become more closely linked.
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Stages of economic integration
Free trade areas- no tariffs inside bloc; Customs Union - FTA then set a common external tariff on non members; Single Market- Customs plus free movement of FoP; monetary union - single currency; Economic Union- like 1 country, adopt same policies
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Examples of economic integration
FTA - NAFTA; Customs Union - Mercosur; Single Market - Single European Market; Monetary- Eurozone
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Internal Impact of Economic Integration
Free trade within markets; Significant barriers to trade for non members
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Static (SR) Impact of Economic Integration
Trade Creation(replace high cost domestic for efficient source within bloc); Trade Diversion (replace low cost with less efficient inside bloc); Trade deflection (creation of FTA allows countries to import into FTA via country with lowest tariff)
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Dynamic (LR) Impact of Economic Integration
Reduction in monopoly power -increase consumer choice, fall in P, increase efficiency; Innovation and R&D - increase competition, LREG in bloc; Larger Market => EoS
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External Impact of Economic Integration
Trade Diversion- low X, n rises, issues for X led economies
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Costs of Economic Integration
Geographical Segmentation - based on different AA/CA attracting I, leads to regional and structural n; oli/monopoly emergence - complete integration requires competition policy to assure no one abuses market power; Collusion across borders=>high P
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Benefits of Monetary Union
Lower prices; low cost of production; high non price competition; increase in cross border investment
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Micro Impact of Monetary Union
fall in transaction cost; fall in exchange rate risks; Price transparency
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Macro Impact of Monetary Policy
Increase in AD - increase trade/I/international competitiveness; Increase AS - fall CoP/Increase FoP mobility/increase productivity; Should cause EG and stable inflation
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Impact of Monetary Policy on individual economies
loss of MP sovereignty; Constraints on Fiscal Policy (i.e. Stability and Growth Pact); Removal of automatic stabilisers; need for fiscal transfers; deflationary bias; Economic Convergence.
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How to solve problems of economic convergence?
Flexible Labour Markets; High capital mobility; agreed system of fiscal transfers to help those experiencing negative effects; Absence of economic shocks/ability to deal with them.
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What is Reciprocal AA?


when in a theoretical world of 2 countries and 2 products, each country has AA in one product

Card 3


What is Comparative Advantage?


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Card 4


How does Opp Cost Ratio work?


Preview of the front of card 4

Card 5


What is International Trade?


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