The UK and Global
Unit 4 Macro Economics
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Geoff Riley acknowledges the help of Mark Johnston, Ben Cahill, Penny Brooks, Liz Veal, Mo Tanweer, Ruth
Tarrant, Jim Riley, David Carpenter, Jonny Clarke, Tom White, Oliver Fernie and Bob Nutter in developing
resources that have been used in this guide.
Study Companion Table of Contents
1. Globalisation......................................................................................................................................... 3
2. Trade ................................................................................................................................................... 8
3. The Terms of Trade (ToT) ....................................................................................................................... 12
4. Protectionism........................................................................................................................................ 14
5. The Balance of Payments (BoP)............................................................................................................... 24
6. Exchange Rates.................................................................................................................................... 31
7. European Monetary Union...................................................................................................................... 44
8. What is Economic Development? ............................................................................................................. 50
9. Millennium Development Goals............................................................................................................... 52
10. Human Development Index (HDI)............................................................................................................. 57
11. Inequality of Income and Wealth............................................................................................................ 61
12. Developing Countries – Similarities and Differences................................................................................... 64
13. Measuring National Income.................................................................................................................... 66
14. Measuring the Standard of Living ........................................................................................................... 72
15. Sources of Economic Growth................................................................................................................... 74
16. Consequences of Economic Growth.......................................................................................................... 88
17. Constraints on Growth and Development.................................................................................................. 92
18. The Prebisch-Singer Hypothesis..............................................................................................................105
19. Productivity – Economic Growth and Development....................................................................................109
21. Development Strategies........................................................................................................................119
22. Private Sector and Economic Development...............................................................................................124
23. State Intervention – Growth and Development .........................................................................................131
24. Overseas Aid, Remittances and Debt Relief.............................................................................................135
25. Micro Finance, Fair Trade and Tourism....................................................................................................142
26. Macroeconomic Policies and Economic Growth .........................................................................................147
27. Keynesian Economics ............................................................................................................................161
28. Labour Migration Economics ..................................................................................................................164
29. Sustainable Development......................................................................................................................167
30. Growth and Development in China.........................................................................................................172
31. Growth and Development in India..........................................................................................................180
32. Growth and Development in Brazil.........................................................................................................183
33. Growth and Development in South Africa................................................................................................187
34. Growth and Development in South Korea................................................................................................191
35. Growth and Development in the European Union......................................................................................196
36. Economic Developments in the UK Economy..............................................................................................202
37. Development and Global Institutions.......................................................................................................209
38. Unit 4 Economics Glossary.....................................................................................................................211
39. Past Exam Questions for Unit 4 Macro (EdExcel).......................................................................................220
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51 of the largest economies in the world are
corporations. The top 500 TNCs account for
nearly 70% of world trade.
The Shifting Centre of Global Influence
“In 1980, North America and Western
Europe produced more than two-thirds of
the world’s income, so as a result, in 1980
the world’s economic center of gravity was
a point in the middle of the Atlantic Ocean.
By 2008, because of the continuing rise of
India, China and the rest of East Asia, that
center of gravity had shifted to a point just
Source: Professor Danny Quah, LSE
The OECD defines globalization as
“The geographic dispersion of industrial and service activities, for example research and
development, sourcing of inputs, production and distribution, and the cross-border networking of
companies, for example through joint ventures and the sharing of assets.”
Globalisation is a process of deeper economic integration
between countries involving:
(1) An expansion of trade in goods and services
(2) An increase in transfers of financial capital
including the expansion of foreign direct investment
(FDI) by trans-national companies (TNCs) and the rising influence of sovereign wealth funds
(3) The development of global brands
(4) Spatial division of labour– for example out-sourcing and off shoring of production and support
services as production supply-chains has become more international. As an example, the iPod is
part of a complicated global supply chain. The product was conceived and designed in Silicon
Valley; the software was enhanced by software engineers working in India. Most iPods are
assembled / manufactured in China and Taiwan by TNCs such as FoxConn
(5) High levels of labour migration within and between countries
(6) New nations joining the trading system. Russia joined the World Trade Organisation in July 2012
(7) A fast changing shift in the balance of economic and financial power from developed to emerging
economies and markets
(8) Increasing spending on investment, innovation and infrastructure across large parts of the world
Global inter-dependence and shifts in world economic influence
Globalisation is a process of making the world
economy more inter-dependent
It is also bringing about a change in the balance of
power in the world economy. Many of the newly
industrializing countries are winning a rising share of
world trade and their economies are growing faster
than in richer developed nations especially after the
global financial crisis (GFC)
Previous waves of globalisation
There have seen several previous waves of globalisation:
o Wave One: Began around 1870 and ended with the descent into protectionism during the interwar
period of the 1920s and 1930s. This first wave started the pattern which persisted for over a century
of developing countries specializing in primary commodities which they export to the developed
countries in return for manufactures. During this wave of globalisation, the ratio of world exports to
GDP increased from 2 per cent of GDP in 1800 to 10 per cent in 1870, 17 per cent in 1900 and 21
per cent in 1913.
o Wave Two: After 1945, there was a 2nd wave of globalization built on a surge in trade and
reconstruction. The International Monetary Fund was created in 1944 to promote a stable monetary
system and provide a sound basis for multilateral trade, and the World Bank to help restore
economic activity in the devastated countries of Europe and Asia. Their aim was to promote lasting
multilateral co-operation between nations. The General Agreement on Tariffs and Trade (GATT)
signed in 1947 provided a framework for a mutual reduction in import tariffs. GATT eventually
became known as the WTO.
o Wave Three: The most recent wave of globalisation has seen another sharp rise in the ratio of trade
to GDP for many countries and secondly, a sustained increase in capital flows between counties
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What factors have contributed to globalisation?
Among the main drivers of globalisation are the following:
1. Containerisation – the costs of ocean shipping have come down, due to
containerization, bulk shipping, and other efficiencies. The lower cost of
shipping products around the global economy helps to bring prices in the
country of manufacture closer to prices in the export market, and makes
markets contestable in an international sense.
2. Technological change – reducing the cost of transmitting and
communicating information - known as “the death of distance” – a key
factor behind trade in knowledge products using web technology
3. Economies of scale: Many economists believe that there has been an increase in the minimum efficient
scale associated with particular industries. If the MES is rising, a domestic market may be regarded as
too small to satisfy the selling needs of these industries. Overseas sales then become essential.
4. De-regulation of global financial markets: This has included the removal of capital controls in many
countries which facilitates foreign direct investment.
5. Differences in tax systems: The desire of trans-national corporations to benefit from lower labour costs
and other favourable factor endowments abroad and develop and exploit fresh comparative advantages
in production has encouraged many countries to adjust their tax systems to attract foreign direct
6. Less protectionism - old forms of non-tariff protection such as import licencing and foreign exchange
controls have gradually been dismantled. Borders have opened and average tariff levels have fallen –
that said in the last few years there has been a rise in protectionism as countries have struggled to
achieve growth after the global financial crisis. The table below tracks average import tariffs since 1991.
Average Most Favoured Nation Applied Import Tariffs (%) 1991 2001 2009
27.7 13.5 9.9
Low Income Developing Countries
44.4 14.4 11.8
Source: World Bank
Fall in Transport Costs /
Entry of new countries
into the official world
Decline in tariff and
non-tariff barriers to
trade Rising Living Standards
– growing demand for
Domestic Markets –
opened up to
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The breakdown of the Doha trade talks a few years back dashed hopes of a globally based multi-
lateral reduction in import tariffs and other trade barriers. In its place there has been a rising number
of bi-lateral trade deals between countries and the emergence of regional trading blocs such as
NAFTA, MECOSUR and plans for a new Trans-Pacific Partnership (TPP)
Globalization no longer necessarily requires a business to own or have a physical presence in terms
of either owning production plants or land in other countries, or even exports and imports. For
instance, economic activity can be shifted abroad using licensing and franchising which only
needs information and finance to cross borders.
Increasingly we see many examples of joint-ventures between businesses in different countries
• BMW and Toyota agreed a partnership in 2011 to co-operate on hydrogen fuel cells, vehicle
electrification, lightweight materials and a future sports car. Partnership agreements between
competing automakers are becoming increasingly common in the industry as manufacturers
seek to pool efforts on costly technologies.
• Renault-Nissan’s joint venture with Indian firm Bajaj to produce a £1,276 car
• Alliances in the airline industry e.g. Star Alliance and One World
• Burger King, the US fast food restaurant chain plans to open 1,000 stores in China through a
new joint venture with a Turkish private equity business
• Sony and Olympus agreed to form an alliance in September 2012
Our chart above tracks the annual growth of real GDP for the world economy and for developing countries as
a group. In nearly every year the developing world has seen faster growth. 2009 marked a difficult year for
the world economy with a recession – this was felt most severely in rich advanced countries.
Annual % change in world real GDP and real GDP for developing countries
World Growth and Developing Country Growth
World Emerging & Developing Economies
Source: International Monetary Fund, World Economic Outlook
00 01 02 03 04 05 06 07 08 09 10 11
growth has out-paced
global GDP growth in
every year since 1999
1999 – A year of deep recession for
many advanced economies
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What are the Key Gains from Globalisation?
(1) Trade enhances the division of labour as countries
specialise in areas of comparative advantage
(2) Deeper relationships between markets across borders
enable and encourage producers and consumers to
reap the benefits of economies of scale
(3) Competitive markets reduce monopoly profits and
incentivize businesses to seek cost-reducing
innovations and improvements in what they sell
(4) Gains in efficiency should bring about an improvement
in economic growth and higher per capita incomes.
The OECD Growth Project found that a 10 percentage-
point increase in trade exposure for a country was
associated with a 4% rise in income per capita
(5) Globalisation has helped many of the world’s poorest
countries to achieve higher rates of economic growth
and reduce the number living in extreme poverty
(6) For consumers globalisation increases choice and
there are gains from a rapid pace of innovation driving
dynamic efficiency benefits
What are some of the Risks and Disadvantages from
1. Inequality: Globalisation has been linked to rising
inequalities in income and wealth. Evidence for this is a
rise in the Gini-coefficient and a growing rural–urban divide in countries such as China, India and
Brazil. This leads to political and social tensions and
instability as a backlash.
2. Inflation: Strong demand for food and energy has
caused a steep rise in commodity prices. Food price
inflation (known as agflation) has placed millions of the
world’s poorest people at great risk.
3. Macroeconomic Instability: A decade or more of strong
growth, low interest rates, easy credit in developed
countries created a boom in share prices and property
valuations. The bursting of speculative bubbles prompted
the credit crunch and the contagion from that across the
world in from 2008 onwards. This had negative effects on
poorer & vulnerable nations.
4. Threats to the Global Commons: A major long-term
threat is the impact that rapid growth and development is
having on the environment. Threats of irreversible
damage to ecosystems, land degradation, deforestation, loss of bio-diversity and the fears of a
permanent shortage of water are afflicting millions of the most vulnerable people are vital issues.
5. Trade Imbalances: Trade has grown but so too have trade imbalances. Some countries are
running enormous trade surpluses and these imbalances are creating tensions and pressures to
introduce protectionist policies such as new forms of import control.
6. Unemployment: Concern has been expressed by some that investment and jobs in advanced
economies will drain away to developing countries as firms switch their production to countries with
lower unit labour costs. This can lead to higher levels of structural unemployment.
7. Standardization: Some critics of globalisation point to a loss of economic and cultural diversity
as giant firms and global brands come to dominate domestic markets in many countries.
8. Dominant Global Brands – globalisation might actually stifle competition if global businesses with
dominant brands and superior technologies take charge of key international markets be it
telecommunications, motor vehicles, heavy industrial equipment or digital cameras.
Globalisation and the Risk of
In 2007-08, financial crises
generated in developed countries
quickly spread affecting the
poorest and most distant nations,
which saw weaker demand and
lower prices for their exports,
higher volatility in capital flows
and commodity prices, and lower
Globalisation and Dynamic
Efficiency - China Stimulates
Innovation in the West
Apple’s iPhone and iPad were both
designed and prototyped in
California and then produced in
China. Chinese manufacturing
competition is increasingly capturing
low-skill production while
simultaneously fostering high-skill
innovation in the West.
About 15 percent of technical
change in Europe in the past decade
can be attributed directly to
competition from Chinese imports,
an annual benefit of almost €10
billion to European economies.
Firms have responded to the threat
of Chinese imports by increasing
their productivity—adopting better
IT, boosting R&D spending, and
Source: Von Reenen & Bloom, LSE,
Economic Journal 2012
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Sovereign Wealth Funds (SWF)
o Investment funds run by foreign governments, also called ‘sovereign wealth funds’ have been in
existence since the 1950’s. China, Singapore, Dubai, Norway, Libya, Qatar and Abu Dhabi have all
built up a sizeable surplus of domestic savings over investment.
o Norway’s $760bn oil fund is the world’s largest sovereign wealth fund. According to a report in the
Financial Times in August 2013, it owns on average about 2.5% of every listed European company
o Now some other countries with large reserves of oil and gas are considering setting up their own
funds – in 2012, Tanzania announced it is to set up a sovereign wealth fund. Not all have been
successful. Nigeria’s has operated an Excess Crude Account the surpluses from which have been
largely used to pay off existing international debts.
o China established its official sovereign wealth fund China Investment Corp (CIC) five years ago
with the aim of earning high returns by investing abroad the dollars China earns from its exports. In
January 2012, CIC’s $410bn sovereign wealth fund, bought an 8.68 per cent stake in Thames
Water, the water network that serves London. It also has investment stakes in France’s GDF Suez,
Canada’s Sunshine Oil sands and Trinidad and Tobago’s Atlantic Liquid Natural Gas Company.
o Sovereign wealth funds are already having an important effect on the UK. Singapore's Temasek
owns stakes in Barclays and Standard Chartered, while Qatar and Dubai between them own about a
third of the London Stock Exchange. The government of Singapore has also built up a 3% stake in
British Land. Dubai's sovereign wealth fund, Dubai International Capital (DIC) has invested money in
building stakes in UK companies, including Travelodge and the London Eye.
o Many sovereign wealth funds have provided an injection of fresh capital for the UK banking system
in the wake of the losses sustained from the sub-prime crisis and the credit crunch. The banks
have needed to re-capitalize to repair their balance sheets, improve their chances of survival and
provide a stronger platform for a recovery in lending to businesses and individuals who need loans.
Rising Trade and FDI Flows in the World Economy
The chart below tracks the annual value of world trade in goods and services together with the value of
foreign direct investment flows. Both have seen a strong trend rise which reflects the rapid process of
globalisation. There have been dips – notably in 2001 and in 2008-09 following the global financial crisis. But
trade and investment has recovered quite strongly in 2011 and 2012. There is some evidence of a
complementary relationship between FDI and trade. For example inwards investment that leads to the
building of new factories, hotels, ports, roads and airports helps facilitate trade within and between regions.
Foreign direct investment and trade have risen
far more rapidly than global output since 1990,
with FDI rising faster even than trade. The FDI
stock jumped from 9 per cent of world output in
1990 to 33 per cent in 2012; exports of goods
and services went from 20 per cent of world
output to 31 per cent
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Trade is the exchange of products between countries
When conditions are right, trade brings benefits to all
countries involved and can be a powerful driver for
sustained growth and rising living standards.
One way of expressing the gains from trade in goods
and services is to distinguish between static gains from
trade (i.e. improvements in allocative and productive
efficiency) and dynamic gains (i.e. gains in welfare that
occur over time from improved product quality,
increased choice and faster innovative behaviour).
Gains from Trade – Understanding Comparative Advantage
First introduced by David Ricardo in 1817, comparative
advantage exists when a country has a ‘margin of
superiority’ in the production of a good or service i.e. where
the marginal cost of production is lower
Countries will generally specialise in and export products,
which use intensively the factors inputs, which they are most
If each country specializes, then total output can be
increased leading to an improvement in allocative
efficiency and welfare.
Because production costs are lower, providing that a good
market price can be found from international buyers,
specialisation should focus on those goods and services that
provide the best value
In highly developed countries, comparative advantage is
shifting towards specialising in producing and exporting
high-value and high-technology manufactured goods
and high-knowledge services.
Example of comparative advantage
Usually we take a standard two-country + two-product example
to illustrate comparative advantage
Consider two countries producing two products – digital
cameras and vacuum cleaners
With the same factor resources evenly allocated by each country to the production of both goods,
the production possibilities are as shown in the table below.
DIGITAL CAMERAS VACUUM CLEANERS
UK 600 600
United States 2400 1000
Total 3000 1600
Working out the comparative advantage
o To identify who should specialise in a particular product, consider the internal opportunity costs
o Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each
vacuum cleaner is one digital television
o For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore,
the UK has a comparative advantage in vacuum cleaners
Quotes on Gains from Trade
“According to a recent study, one
iPhone has an export value of
$150 per unit in Chinese trade
statistics but the value added
attributable to processing in
China is only $4, with the
remaining value added
assembled in China coming from
the United States, Japan, and
other Asian countries”
Pascal Lamy, Director-General of
the World Trade Organisation
“The case for free trade is robust.
It extends not only to overall
prosperity or gross national
product (GNP), but also to
distributional outcomes, which
makes the free trade argument
morally compelling as well”
“The dramatic upturn in GDP
growth rates in India and China
after they turned strongly towards
dismantling trade barriers in the
late 1980s and early 1990s is
“In India, the shift to accelerated
growth after reforms that included
trade liberalization has pulled
nearly 200 million people out of
poverty. In China, which grew
faster, it is estimated that more
than 300 million people have
moved above the poverty line
since the start of reforms.”
Professor Jagdish Bhagwati
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o If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera
is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
o USA has comparative advantage in producing digital cameras because its opportunity cost is lowest.
Showing the Output after Specialisation
DIGITAL CAMERAS VACUUM CLEANERS
UK 0 (-600) 1200 (+600)
United States 3360 (+960) 600 (-400)
Total 3360 1800
o The UK specializes totally in producing vacuum cleaners – doubling its output - now1200
o The United States partly specializes in digital cameras increasing output by 960 having given up 400
units of vacuum cleaners
o As a result of specialisation output of both products has increased - a gain in economic welfare.
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange
of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one
vacuum cleaner, the post-trade position will be as follows:
o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
o The USA exports 840 digital cameras and imports 420 vacuum cleaners
Showing the Gains from Trade - Post Trade Output / Consumption
DIGITAL CAMERAS VACUUM CLEANERS
UK 840 780
United States 2520 1020
Total 3360 1800
Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods
What are the key assumptions behind this theory of trade?
This theory of trade based on comparative advantage depends on a number of assumptions:
1. Occupational mobility of factors of production (land, labour, capital) - this means that switching
factor resources from one industry to another involves no loss of efficiency and productivity. In
reality we know that factors of production are not perfectly mobile – labour immobility for example is
a root cause of structural unemployment
2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a
doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing
returns in which case the benefits from trade are reduced. Conversely increasing returns to scale
means that specialisation brings even greater increases in output.
3. No externalities arising from production and/or consumption – no discussion about the overall
costs and benefits of specialisation and trade should ignore many of the environmental
considerations arising from increased production and trade between countries.
The Growing Importance of Intra-Industry Trade and Supply Chains
The standard model of trade focuses on trade between countries. In reality,
most trade takes place between businesses across national boundaries –
i.e. intra-industry trade. In the last twenty years we have seen huge
changes in both the pattern of trade between developed and developing
countries. And also the complexity of manufacturing supply chains around
the world. Typically for example, a tablet computer or a smart phone will be
manufactured in one or two centers but the components will have come from
dozens of other countries.
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The Heckscher-Ohlin Trade Model
According to the Heckscher-Ohlin model of
trade, countries have a comparative
advantage in sectors that make more
intensive use of their relatively abundant
factors. For example many lower income
countries have exports concentrated in
primary commodities or lower value-added
What are the Main Sources of Comparative Advantage?
Comparative advantage is a dynamic concept meaning that it changes over time.
For a country, some of the factors below are important in
determining the relative unit costs of production:
1. The quantity and quality of natural resources
available for example some countries have an
abundant supply of good quality farmland, oil and gas,
fossil fuels. Climate and geography have key roles in
creating differences in comparative advantage. More
recently shale gas revolution is likely to lead to
dramatic shifts in the future pattern of world energy
production and trade as North America becomes energy
sufficient. Severe worries about water scarcity in the
future in large parts of the developing world might have
hugely significant effects on their ability to export
2. Demographics - An ageing population, net outward or
inward migration, educational improvements and
women’s participation in the labour force will all affect
the quantity and quality of the labour force available for
industries engaged in international trade.
3. Rates of capital investment including infrastructure:
Greater public infrastructure investment can reduce trade costs and hence increasing supply
capacity. Investment in roads, ports and other transport infrastructure strengthens regional trade ties.
ICT infrastructure is particularly important for countries wanting to build a competitive advantage in
information-intensive sectors such as mobile telecommunications, gaming and financial services
4. Increasing returns to scale and the division of labour – increasing returns occur when output
grows more than proportionate to inputs. Rising demand in the markets where trade takes place
helps to encourage specialisation, higher productivity and internal and external economies of
scale. These long-run scale economies give regions and countries a significant cost advantage.
5. Investment in research & development which can drive innovation and invention
6. Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and
cause changes in demand from domestic and overseas customers.
7. Import controls such as tariffs, export subsidies and quotas – these can be used to create an
artificial comparative advantage for a country's domestic producers.
8. The non-price competitiveness of producers - covering factors such as the standard of product
design and innovation, product reliability, quality of after-sales support. Many countries are now
building comparative advantage in high-knowledge industries and specializing in specific knowledge
sectors – an example is the division of knowledge in the medical industry, some countries specialize
in heart surgery, others in pharmaceuticals.
9. Institutions – these are important for comparative advantage and important for growth too. Banking
systems are needed to provide capital for investment and export credits, legal systems help to
enforce contracts, political institutions and the stability of democracy is a key factor behind decisions
about where international capital flows.
Comparative advantage is often a self-reinforcing process.
o Entrepreneurs in a country develop a new comparative advantage in a product either because they
find ways of producing it more efficiently or they create a genuinely new product that finds a growing
demand in home and international markets
o Rising demand and output encourages the exploitation of economies of scale; higher profits can be
reinvested in the business to fund further product development, marketing and a wider distribution
network. Skilled labour is attracted into the industry and so on
o The expansion of an industry leads to external economies of scale.
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What are some of the Wider Benefits of International Trade?
Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below
tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991.
Some of the broader gains from trade in goods and services are:
1. Welfare gains: Supporters of trade believe trade is a ‘positive-sum game’ – all counties engaged
in open trade and exchange stand to gain – although the gains from trade may not be equal
2. Economies of scale – trade and increased market size allows firms to exploit scale economies
leading to lower average costs of production that might be passed onto consumers
3. Competition / market contestability – trade promotes increased competition particularly for
domestic monopolies that would otherwise face little competition.
Trade is a spur for higher productivity – a stimulus to higher
efficiency across many industries.
4. Dynamic efficiency gains from innovation - trade enhances
choice and stimulates product and process innovations bringing
better products for consumers and enhances the standard of
5. Access to new technology and inflows of new knowledge:
trade is a mechanism by which countries can have access to new
technologies. Trade is a stimulus to the exchange of ideas and
inflow of human capital. Openness to trade allows imports of
capital equipment at lower prices.
6. Rising living standards and a reduction in poverty - a growing body of evidence shows that
countries that are more open to trade grow faster over the long run and have higher per capita
income than those that remain closed. Growth through trade directly benefits the world's poor
although free trade is not necessarily equitable. The United Nations Development Programme
(UNDP) believes that greater openness in trade can be a major factor behind reducing extreme
poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to
a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010.
Prior to joining the
WTO, Indian trade as a
share of GDP was low
by global standards at
just 15%. That figure
has doubled in the last
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3. The Terms of Trade (ToT)
David Ricardo’s theory of comparative advantage explains that if countries specialise in the production of
the good/service in which they have a comparative advantage, then all countries can move outside their PPF
and gain from trade. How the gains from trade themselves are distributed depends on the actual terms of
trade.) The terms of trade measures the rate of exchange of one good or service for another when two
countries trade with each other.
We calculate the terms of trade as an index number using the following formula:
Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index
If a country can buy more imports with a given quantity of exports, its terms of trade have improved.
For example, during the commodity price boom, many resource-exporting developing countries
experienced increases in their terms of trade. In other words, for the same physical quantity of
exports (copper, oil etc.) as before, they could buy more consumer and capital goods from abroad
If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume
of exports has to be sold to finance a given amount of imported goods and services. Typically this
leads to a fall in the standard of living because imports of food and technologies are more costly
The terms of trade fluctuate in line with changes in export and import prices. The exchange rate and
the rate of inflation can both influence the direction of any change in the terms of trade
A key variable for many developing countries is the world price received for primary commodity
exports e.g. the world export price for Brazilian coffee, raw sugar cane, iron ore and soybeans.
In our chart below we track what has happened to the terms of trade for Brazil in recent years.
Brazil is a commodity exporter – her terms of trade are sensitive to world commodity prices
After a period of time when the Brazilian terms of trade was declining (1998 through to 2005) the
economy then saw a steep increase in the terms of trade index rising from to 125 in 2010
High and rising demand for commodities from Asia—China is now Brazil’s largest trading partner—
drove Brazilian export prices to record highs and a strong improvement in her trade surplus in many
Commodity prices jumped by 75% in real terms between 2001 and 2010, a period during which
Brazil’s terms of trade improved by 34%
This has had some second-round consequences damaging for the rest of her economy. One effect
has been to cause the Brazilian currency (the Real) to appreciate which has damaged the price
competitiveness of many of Brazil’s manufacturing businesses such as steel and vehicle making.
A rise in the index shows
an improvement in the
terms of trade i.e. the ratio
of export prices to import
prices for Brazil
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For countries such as Brazil, the commodity boom has led to an improvement in their terms of trade. Next we
look at a developing country whose terms of trade have moved in the opposite direction – Nepal.
Nepal joined the World Trade Organisation in 2004 and in global terms her exports account for only 0.01% of
total world trade. Crucially 70% of her exports are manufactured products and 66% of total exports flow to
India (the next highest is 11% to the European Union).
Our chart above shows that the Nepalese terms of trade has declined in nearly every year since 2002. A key
reason for this has been a trend decline in world prices of manufactured products – a trend linked
directly to the effects of globalisation. Nepal is an extremely small economy with little pricing power in world
markets. It must compete with huge-scale manufacturers in China and India which puts pressure on
Nepalese businesses to reduce their prices to remain competitive in the international market.
Another factor causing the terms of trade in Nepal to fall further has been the high cost of imports of
essential imports including food and energy which by definition will have a low price elasticity of demand.
Our chart below shows the extent of the increase in the value of imports coming into Nepal since 2001.
A decline in the index
shows that the terms of
trade for Nepal have fallen
Higher import prices have
contributed to the fall in
the terms of trade
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Solar Panel Trade Dispute is Resolved
The EU and China have settled a trade
dispute over solar panels that upset
relations between two of the world’s largest
economies and threatened to spread to
other industries in a spiral of tit-for-tat
The agreement will allow Chinese
companies to export to the EU single
market up to 7 gigawatts per year of solar
products without paying import duties
(tariffs) provided that the price is no less
than 56 cents per watt. Any products sold
above the quota or below that minimum
price will be hit with anti-dumping duties.
The case sparked fears of a wider trade
war, with China launching its own
investigation into imported European wine
and polysilicon and threatening another
against European luxury cars.
Adapted from news reports, August 2013
These include all costs of getting a good to the final consumer other than the cost of supplying the good itself
Protectionism - Import Controls
Trade disputes between countries happen because
one or more parties either believes that trade is being
conducted unfairly, on an uneven playing field, or
because they believe that there is one or more
economic or strategic justifications for import controls.
Protectionism represents any attempt to impose
restrictions on trade in goods and services.
The aim is to cushion domestic businesses and
industries from overseas competition and prevent the
outcome resulting from the inter-play of free market
forces of supply and demand.
Protectionism can come in many forms including the following:
1. Tariffs - a tax that raises the price of imported products
and causes a contraction in domestic demand and an
expansion in domestic supply – for example, the
average import tariff on goods entering the Russian
economy is 10%, although there will be higher rates for
a number of products
2. Quotas – these are quantitative (volume) limits on the
level of imports allowed or a limit to the value of
imports permitted into a country in a given time period
3. Voluntary Export Restraint Arrangements – where
two countries make an agreement to limit the volume of
their exports to one another over an agreed time period
• Import Tariffs
Internal trade and transaction costs
•Contract enforcement costs
- 15 -
4. Intellectual property laws (e.g. patents and copyright protection)
5. Technical barriers to trade including product labeling rules and stringent sanitary standards.
These increase product compliance costs and impose monitoring costs on export agencies in many
countries. Huge scale vertically integrated transnational businesses can cope with these non-tariff
barriers but many of the least developed countries do not have the some technical sophistication to
overcome these barriers.
6. Preferential state procurement policies – where a government favour local/domestic producers
when finalizing contracts for state spending e.g. infrastructure projects
7. Export subsidies - a payment to encourage domestic production by lowering their costs. Soft loans
can be used to fund the ‘dumping’ of products in overseas markets. Well known subsidies include
Common Agricultural Policy in the EU, or cotton subsidies for US farmers and farm subsidies
introduced by countries such as Russia. In 2012, the USA government imposed tariffs of up to 4.7
per cent on Chinese manufacturers of solar panel cells, judging that they benefited from unfair export
subsidies after a review that split the US solar industry.
8. Domestic subsidies – government financial help (state aid) for domestic businesses facing financial
problems e.g. subsidies for car manufacturers or loss-making airlines.
9. Import licensing - governments grants importers the license to import goods.
10. Exchange controls - limiting the foreign exchange that can move between countries.
11. Financial protectionism – for example when a national government instructs its banks to give
priority when making loans to domestic businesses.
12. Murky or hidden protectionism - e.g. state measures that indirectly discriminate against foreign
workers, investors and traders. A government subsidy that is paid only when consumers buy locally
produced goods and services would count as an example. Deliberate intervention in currency
markets might also come under this category.
Quotas, embargoes, export subsidies and exchange controls are examples of non-tariff barriers
China joined the WTO in 1991 and since then average import tariffs have been falling on a consistent basis.
Our analysis diagram below shows the standard effects of an import tariff on an imported product. The world
price before the tariff is Pw and at this price, domestic demand is Qd and domestic supply is Qs.
Sustained fall in the
average import tariffs on
imports into China. But
there has been an
expansion of non-tariff
barriers to trade
- 16 -
EU Extends Anti-Dumping Tariffs
on Ironing Boards
The European Union has extended
anti-dumping duties on ironing
boards imported from China by five
years, but lifted them for these
products coming from Ukraine.
China used to control around 40 to
45 per cent of the EU ironing board
market – but this fell to 15 to 20 per
cent when the duties were
introduced in 2011.
When duties were originally
imposed in 2007, imports from
China were levied at a top rate of
38.1 per cent. In 2010 the top rate
increased to 42.3 per cent for China.
Source: News reports, July 2013
Because of the tariff, the import price rises to Pw + T. This causes a contraction in demand to Qd2 and an
expansion of supply to Qs2. The result is that the volume of imports falls to quantity M.
Tariffs have welfare consequences, one of which is that the welfare of consumers who must now purchase
the imported product at a higher price has fallen – there is a deadweight loss of consumer surplus.
The effects of a tariff on quantities depend on the price elasticity of demand and price elasticity of supply of
domestic businesses that have been given a cushion of increased competitiveness by the tariff.
Arguments for Protectionism
1) Fledging industry argument: Certain industries possess a
possible comparative advantage but have not yet exploited
economies of scale. Short-term protection allows the ‘infant
industry’ to develop its comparative advantage at which point
the protection could be relaxed, leaving the industry to trade
freely on the international market.
2) Externalities and market failure: Protectionism can also be
used to internalize the social costs of de-merit goods. Or to
correct for environmental market failure in the supply of
3) Protection of jobs in home industries and an improvement in
a country’s balance of payments
4) Protection of strategic industries: The government may
also wish to protect employment in strategic industries,
although value judgments are involved in determining what
constitutes a strategic sector. This might involve attempting to
reduce long-term dependence on certain imports
5) Anti-dumping duties: Dumping is a type of predatory
pricing behaviour and a form of price discrimination. Goods
are dumped when they are sold for export at less than their
normal value. The normal value is usually defined as the price
for the like goods in the exporter’s home market. In the short
term, consumers benefit from the lower prices of the foreign
goods, but in the longer-term, persistent undercutting of
Pw + Tariff
Revenue from Import
Pw + T
Tariff diagram is a key
analysis diagram to use
when discussing the
economic effects of
- 17 -
Protectionism in Brazil
The car-making sector is one of Brazil’s
largest industries, accounting for 6 to 8 per
cent of GDP and about 25 per cent of
manufacturing. Like other nations, Brazil
values the sector because it generates
skilled employment and jobs at suppliers.
Fiat, Volkswagen, General Motors, and
Ford Motor, South Korea’s Hyundai,
Japan’s Nissan, Fiat, Toyota, and China’s
Chery Automobile have all invested in
Brazil to build car plants.
But the Brazilian government has not been
slow to use protectionist measures to
support this industry. In September 2011
the government raised the taxes on
imported cars by 30 percentage points, to
between 37 and 55 per cent, in response to
surging imports caused by an appreciating
exchange rate. The rise in the import tariff
hit producers such as Hyundai and BMW
that do not yet produce locally, while
leaving cars made in Mexico and
MERCOSUR countries (including
Argentina) eligible to enter the country duty-
Car imports from Mexico soared as buyers
switched to cheaper vehicles, prompting
Brazil to impose a three-year import quota
regime, restricting the value of imported
cars each year to less than $1.5 billion.
Adapted from News Reports, autumn 2012
domestic prices might force a domestic industry out of business and allow the foreign firm to
establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase
its prices and exploit the consumer. Therefore protection, via tariffs on 'dumped' goods can be
justified to prevent the long-term exploitation of the consumer.
The World Trade Organisation allows a government to act against dumping where there is genuine
‘material’ injury to the competing domestic industry. In order to do that the government has to be able to
show that dumping is taking place, calculate the extent of dumping (how much lower the export price is
compared to the exporter’s home market price), and show that the dumping is causing injury. Usually an
‘anti-dumping action’ means charging extra import duty on the particular product from the particular exporting
country in order to bring its price closer to the “normal value”.
Tariffs are not a major source of tax revenue for the Government that imposes them. In the UK for example,
tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total
tax take. Developing countries tend to be more reliant on tariffs for revenue.
Arguments against Protectionism
1. Market distortion and loss of allocative efficiency:
Protection can be an ineffective and costly means of
a. Higher prices for consumers: Tariffs push up
the prices faced by consumers and insulate
inefficient sectors from competition. They
penalize foreign producers and encourage the
inefficient allocation of resources both
domestically and globally.
b. Reduction in market access for producers:
Export subsidies depress world prices and
damage output, profits, investment and jobs in
many developing countries that rely on
exporting primary and manufactured goods for
2. Loss of economic welfare: Tariffs create a
deadweight loss of consumer and producer surplus.
Welfare is reduced through higher prices and restricted
3. Extra costs for exporters: For goods that are
produced globally, high tariffs and other barriers on
imports act as a tax on exports, damaging economies,
and jobs, rather than protecting them
4. Regressive effect on the distribution of income:
Higher prices that result from tariffs hit those on lower
incomes hardest, because the tariffs (e.g. on
foodstuffs, tobacco, and clothing) fall on those products
that lower income families spend a higher share of their
5. Production inefficiencies: Firms that are protected
from competition have little incentive to reduce
production costs. This can lead to X-inefficiency and
higher average costs.
6. Trade wars: There is the danger that one country
imposing import controls will lead to retaliatory action
by another leading to a decrease in the volume of world
trade. Retaliatory actions increase the costs of
importing new technologies affecting LRAS.
- 18 -
7. Negative multiplier effects: If one country imposes trade restrictions on another, the resultant
decrease in trade will have a negative multiplier effect affecting many more countries because
exports are an injection of demand into the global circular flow of income.
8. Second best approach: Protectionism is a ‘second best’ approach to correcting for a country’s
balance of payments problem or the fear of structural unemployment. Import controls go against the
principles of free trade. In this sense, import controls can be seen as examples of government
failure arising from intervention in markets
o Economic nationalism describes policies to protect domestic consumption, jobs and investment
using tariffs and other barriers to the movement of labour, goods and capital
o The term gained a more specific meaning in recent years after several European Union governments
intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the
national governments also endorsed counter-bids from compatriot companies to create 'national
champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel
(India). And the French government listing of the food and drinks business Danone (France) as a
'strategic industry' to block potential takeover bid by PepsiCo (USA
The Rise of Trading Blocs and Regional Trade Agreements (RTAs)
Over the years tariffs have declined with progress especially marked in developing Asia and in Eastern
Europe. But the breakdown of the Doha trade talks has dashed hopes of a globally based multi-lateral
reduction in import tariffs and other forms of protectionism. In its place there has been a flurry of bi-lateral
trade deals between countries and the emergence of regional trading blocs. For example, the European
Union now has over 30 international trade agreements including those with countries such as Colombia and
Some of these deals are free-trade agreements that involve a reduction in tariff and non-tariff import
controls to liberalise trade in goods and services between countries. The most sophisticated RTAs include
rules on flows of investment, co-ordination of competition policies, agreements on environmental policies and
the free movement of labour.
Examples of Regional Trade Agreements (RTAs):
The number of RTAs has risen from around 70 in 1990 to over 300 today – this both reflects and reinforces a
switch towards greater intra-regional trade most notably between many of the world’s fast-growing emerging
market economies. No regional trade agreement is the same.
The European Union (EU) – a customs union, a single
market and now with a single currency
The European Free Trade Area (EFTA)
The North American Free Trade Agreement (NAFTA)
Mercosur - a customs union between Brazil,
Argentina, Uruguay, Paraguay and Venezuela
Association of Southeast Asian Nations (ASEAN) Free
Trade Area (AFTA)
Common Market of Eastern and Southern Africa
South Asian Free Trade Area (SAFTA) created in
January 2006 and containing countries such as India
Pacific Alliance – established 2013 – a trade agreement between Chile, Colombia, Mexico and Peru
Trans-Pacific Partnership (TPP) - a proposed free trade agreement being negotiated during 2013
between Australia, Brunei, Chile, Canada, Malaysia, Mexico, New Zealand, Peru, Singapore, the
United States, and Vietnam
Malaysia and Australia agree a
free trade pact
Malaysia and Australia have signed
a free trade agreement. The
agreement, which has been in
negotiations since 2005, aims to
scrap the majority of export tariffs. It
is hoped that the deal will boost
trade between the two countries
which currently stands at £8bn a
year on average
Source: BBC news, May 2012.
- 19 -
Free Trade Area X
Customs Union X X
Single Market X X X
Monetary Union X X X X
Economic Union X X X X X
The Economics of a Customs Union
The European Union is a customs union. A customs union comprises countries which agree to:
o Abolish tariffs and quotas between member nations to encourage free movement of goods and
services. Goods and services that originate in the EU circulate between Member States duty-free.
However these products might be subject to excise duty and VAT.
o Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the
case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the UK
as in any other EU country.
o Preferential tariff rates apply to preferential or free trade agreements that the EU has entered into
with third countries or groupings of third countries.
1. A customs union shares the revenue from the CET in a pre-determined way – in this case the
revenue goes into the EU budget fund. The EU receives its revenues from customs duties from the
common tariff, agricultural levies and countries paying 1% of their VAT base. Payments are also
made through contributions made by member states based on their national incomes. Thus relatively
poorer countries pay less into the EU and tend to be net recipients of EU finances.
2. A single market represents a deeper form of integration than a customs union. It involves the free
movement of goods and services, capital and labour and the concept are broadened to encompass
economic policy harmonization for example in the areas of health and safety legislation and
monopoly & competition policy. Deeper economic and business ties requires some degree of
political integration, which also requires shared aims and values between nations
Trade Creation and Trade Diversion with Customs Unions and Regional Trade Agreements
o Trade creation arising from trade deals between countries involves a shift in domestic consumer
spending from a higher cost domestic source to a lower cost partner source for example - within the
EU - as a result of the abolition tariffs on intra-union trade
o So for example UK households may switch their spending on car and home insurance away from a
higher-priced UK supplier towards a French insurance company operating in the UK market
o Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper
source of glass or rubber for tyres from other countries within the customs union than if they were
reliant on domestic supply sources with trade restrictions in place.
o Trade creation should stimulate an increase in trade between countries that have signed trade
agreements and should, in theory, lead to an improvement in the efficient allocation of scarce
resources and gains in consumer and producer welfare.
- 20 -
o Trade diversion is best described as a shift in domestic consumer spending from a lower cost world
source to a higher cost partner source (e.g. from another country within the EU) as a result of the
elimination of tariffs on imports from the partner
o The common external tariff on many goods and services coming into the EU makes imports more
expensive. This can lead to higher costs for producers and higher prices for consumers if previously
they had access to a lower cost / lower price supply from a non-EU country
o The diagram next illustrates the potential welfare consequences of imposing an import tariff on
goods and services coming into the European Union.
o In general, protectionism in the forms of an import tariff results in a deadweight social loss of
welfare. Only short term protectionist measures, like those to protect infant industries, can be
defended robustly in terms of efficiency. The common external tariff will have resulted in some
deadweight social loss if it has in total raised tariffs between EU countries and those outside the EU.
The overall effect of a customs union on the economic welfare of citizens in a country depends on whether
the customs union creates effects that are mainly trade creating or trade diverting.
Supply price from EU Supply
Supply price from outside the EU
Trade creation – access
to cheaper supplies allows
a lower price – which
Lower price leads to an
expansion of demand and
a rise in consumer surplus
+ a net improvement in
- 21 -
Case Study: Ambitious Plans for an ASEAN Economic Community
ASEAN is a trade bloc of 10 nations with an
aggregate economic size of $2.3 trillion. Their aim is
to establish a fully-fledged economic community
(AEC) by the end of 2015.
The trading bloc’s diversity – ranging from advanced
economies like Singapore to developing countries like
Myanmar is an interesting feature – who will be the
winners and losers from deeper economic integration
in the region?
10 countries - Brunei Darussalam, Cambodia,
Indonesia, Lao People’s Democratic Republic,
Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam
Economic Background to ASEAN
ASEAN is a middle-income region but with big
differences in per capita incomes
Countries such as Singapore and Brunei enjoy a
very high GDP per capita at around USD 49,000
and USD 39,000, respectively, on par with the top
tier of developed-market economies. In contrast,
Myanmar and Cambodia have a GDP per capita of
just below USD 900.
Region has a population of over 600 million,
roughly half that of China’s or India’s and around
9% of the world’s total
GDP of USD 2.3 trillion in 2012 – around 30% the
size of China’s, roughly the same size as that of
the UK and 25% larger than India’s. ASEAN GDP
accounts for 3% of the world’s total
25% of ASEAN trade is intra-regional trade – the
aim is to increase this as economic ties deepen
and also for a rise in intra-regional FDI flows
China has emerged as the No. 1 trading partner for ASEAN
5 “ASEAN+1” FTAs have been signed, with China, Japan, Korea, India and Australia/New Zealand
The basics of a single market / economic community
As part of the ASEAN integration plans, barriers to trade in goods and services will be brought down or kept
to a minimum. Flows of investment, capital and skilled labour will be facilitated and co-operation in sectors
designated as priority integration sectors will be promoted.
— Free flow of goods and services
— Freer flow of capital and the Free flow of skilled labour
— Priority integration sectors
— Food, agriculture and forestry
This will be added to by establishing regional standards for Competition policy, Consumer protection,
Intellectual property rights, Taxation and E-commerce
The ASEAN Infrastructure Fund was established with the Asian Development Bank to fund physical
infrastructure projects in ASEAN. An example is the building of a new high speed railway between Malaysia
- 22 -
The UK Pattern of Trade
UK Share in world total exports 2.59 UK Share in world total imports 3.46
Breakdown in economy's total exports Breakdown in economy's total imports
By main commodity group By main commodity group
Agricultural products 7.3 Agricultural products 10.8
Fuels and mining products 18.7 Fuels and mining products 18.4
Manufactures 72.1 Manufactures 69.1
By main destination By main origin
1. European Union (27) 53.4 1. European Union (27) 51.3
2. United States 13.3 2. China 9.0
3. China 3.0 3. United States 8.1
4. India 1.8 4. Norway 6.0
5. Switzerland 1.8 5. Japan 2.1
Key points on the UK pattern of trade
• Well over half of UK merchandise trade is with the other nations of the EU single market
• Manufacturing remains a crucial source of UK exports – around 60% of total manufacturing output is
exported – the UK is particularly strong in pharmaceuticals, vehicles, high-end engineering products
• The UK now runs a trade deficit in crude oil and gas
• Overall the UK runs a large trade deficit in goods (>£100bn in 2011) and a rising surplus in services
(>£75 billion in 2011).
• Only 3% of UK exports go to China and less than 2% go to India – one of the key aims of macro
policy in the coming years will be to increase the share of UK trade in goods and services that goes
to faster-growing areas / regions of the world including the BRIC nations.
Percentage of world trade
Share of World Trade in Goods and Services
Source: Reuters EcoWin
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Asian Emerging Nations (Inc China)
- 23 -
Britain inside the European Single Market / European Union
During 2012 it seemed that the suggestion that Britain might leave the EU single market and renegotiate her
trade relationships with other EU countries was gaining support. “Brexit” is the media term used when
discussing the costs and benefits of such a momentous decision. There are strongly held views on both
sides of this debate.
The case for British exit from the European Union
Some counter-arguments – the case for staying within the EU single market
•Britain could negotiate new free trade agreements with major EU trade partners and
fast-growing emerging countries
•Britain would benefit from freeing itself from many of the EU's laws & regulations
•Leaving the EU would cut our contributions to the EU budget - a UK fiscal windfall
•Food prices would possibly be lower if we left the Common Agricultural Policy (CAP)
•The UK is Europe’s biggest export market. So Europe needs the UK as a trade partner
•The UK would retain greater control over fiscal and monetary policy and also gain more
freedom over labour market, competition and environmental policies
• Risk of losing trade benefits of being inside single market, lower per capita GDP
• Attractiveness of the UK as a destination for FDI would be diminished
• Adopting a position similar to Norway (which is outside of the EU) would mean the
UK accepting many EU rules without having a say in their formulation
• UK will lose tariff-free access to its largest export market
• London would no longer be the EU’s financial hub
• No guarantee that the UK could negotiate an arrangementto Norway or Switzerland
• Extra costs for businesses as they ajust to new legal frameworks
• Europe might decide to retaliate and prevent favourable trade deals with UK
• UK’s net spending on the EU is tiny – less than 1% of GDP (about the same as
overseas aid) - for small budget savings, the long-run economic cost will be high
- 24 -
5. The Balance of Payments (BoP)
What is the Balance of Payments?
The balance of payments (BOP) records all financial transactions made between consumers,
businesses and the government in one country with others
The BOP figures tell us about how much is being spent by consumers and firms on imported goods
and services, and how successful firms have been in exporting to other countries.
Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas)
Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services)
The balance of payments is made up of these key parts
i) The current account
ii) The capital account
iii) Official financing account
(Note: You will need to understand all three for A2 exams, the AS course focused only on current account)
Stylised Example of the Balance of Payments
The example below refers to a hypothetical country, data is in $ billion
Item of the BoP Net Balance
(1) Balance of trade in goods -25 A trade deficit
(2) Balance of trade in services +10 A trade surplus
(3) Net investment income -12
Net outflow of income i.e. due to profits of
(4) Net overseas transfers +8
Net inflow of transfers perhaps from
remittance payments from migrants
Sum of 1+2+3+4 = Current account balance -19
Overall – this country runs a current
Net balance of foreign direct investment flows +5 Positive net inflow of FDI
Net balance of portfolio investment flows +6
Positive net inflow into equity markets,
Net balance of short term banking flows -2
Small net outflow of currency from
country’s banking system
Balancing item +2
There to reflect errors and omissions in
Changes to reserves of gold and foreign currency +8
+8 means that this country’s gold and
foreign currency reserves have been
Overall balance of payments 0
Key point: If a country is running a current account surplus, this means there is a net inflow of foreign
currency into their economic system. From a balance of payments point of view, a surplus on the current
account would allow a deficit to be run on the capital account. For example, surplus foreign currency can be
used to fund investment in assets located overseas. The balance of payments must balance.
- 25 -
Countries with current account deficits can run into difficulties. If the deficit is large and the economy is not
able to attract enough inflows of foreign investment, then their currency reserves will dwindle and there may
come a point when the country needs to seek emergency borrowing from institutions such as the
International Monetary Fund. Trade deficits and the resulting borrowing lead to a rise in external debt.
Measuring the Current Account
The current account of the balance of payments comprises the balance of trade in goods and
services plus net investment incomes from overseas assets and net transfers.
Net investment income comes from interest payments, profits and dividends from external assets
o For example a UK firm may own a business overseas and send back profits to Britain. This
is a credit item for the current account
o Similarly, an overseas investment in the UK might generate a good rate of return and the
profits are remitted back to another country – this would be a debit item in the account
Transfers include overseas aid payments. For the UK the net transfers figure is negative each year,
mainly due to the UK being a net contributor to the budget of the EU. As a rich nation, the UK makes
sizeable foreign aid payments, close to a target of 0.7% of GDP per year
Trade in Goods and Services
Trade in goods includes items:
Semi-finished goods and components
(i) Durable goods (washing machines)
(ii) Non-durable goods (e.g. foods)
Capital goods (e.g. equipment)
Trade in services includes:
Banking, insurance and consultancy
Other financial services including foreign
exchange and derivatives trading
Transport and shipping
Education and health services
Research and development
Net Exports and Net Imports
The table below shows the value of net trade in goods for the UK economy in 2012. It excludes trade in
services. Net exports show products where the value of UK exports exceeds the value of imports. This data
reveals competitive advantage in a number of manufacturing industries such as pharmaceutical products,
aerospace, fertilizers and photographic equipment. The net import column reveals where the UK runs a
trade deficit in a specific group of products including crude oil, motor vehicles others than cars (e.g.
passenger vans and coaches) and electrical machinery.
Net Trade Balances for the UK Economy
Net Exports for the UK
(value of exports > value of imports)
£m Net Imports for the UK
(value of exports > value of imports)
1 Mechanical machinery £7,910 1 Electrical machinery -£26,388
2 Medicinal & pharmaceutical products £3,381 2 Other miscellaneous manufactures -£13,483
3 Beverages £2,976 3 Crude oil -£9,500
4 Aircraft £2,968 4 Refined oil -£8,170
5 Fertilizers & other chemicals £2,034 5 Road vehicles other than cars -£5,766
6 Toilet & cleansing preparations £1,898 6 Miscellaneous metal manufactures -£2,522
7 Scientific & photographic £1,514 7 Plastics -£1,463
8 Precious stones £1,409 8 Cars -£1,441
9 Works of art £1,275 9 Non-ferrous metals excl. silver -£592
10 Organic chemicals £1,273 10 Iron & steel -£332
Source: Office for National Statistics
- 26 -
What does a current account deficit mean? Does it matter?
Running a deficit on the current account means that an economy is not paying its way in the global economy.
A deficit means a country is drawing in money from elsewhere and, as a consequence, building up
corresponding liabilities – i.e. an increase in external debt.
Balance of payments and the standard of living
In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on
foreign direct investment or borrow money to make up the difference
In the short term, if a country is importing a high volume of goods and services this is a boost to
living standards because it allows consumers to buy more consumer durables
The deficit might also be the result of importing much needed capital equipment that will boost a
country’s productive capacity in the long run
Especially for a developing country, a trade deficit can bring beenfits. Economists might justify a trade deficit
by arguing that poorer nations should be importing capital by running a current-account deficit. Providing
productive investments are made, this gives a country the extra capital to drive future GDP growth so it can
pay the foreigners back.
Balance of Payments and Aggregate Demand
1. When there is a current account deficit – this means that there is a net outflow of demand and
income from a country’s circular flow. In other words, trade in goods and services and net flows from
transfers and investment income are taking more money out of the economy than is flowing in.
Aggregate demand will fall.
2. When there is a current account surplus there is a net inflow of money into the circular flow and
aggregate demand will rise.
The global economy will always have some deficit countries and some surplus countries. But the scale of
global trade imbalances has increased over the years and this has created tensions between nations and
poses a threat to globalisation. More countries are using managed exchange rates as a way of dealing with
growing trade deficits.
A Balance of Payments Crisis
A BoP crisis occurs when a country cannot pay for essential imports or service its debt (i.e. pay interest),
often as a result of currency devaluation; usually preceded by large capital inflows in order to boost growth
but then investors get worried about their debt and remove their capital.
- 27 -
What are the Key Dangers from running Persistent Trade Deficits?
Countries with Trade Surpluses
Many countries operate with a trade and current account surplus – good examples are China, Germany,
Japan, Norway and several emerging market countries with strong export sectors.
A country with a surplus on the current account sees capital outflows of the same amount. This capital is
either deposited in banks overseas or used to purchase foreign assets, from government bonds to
companies, leading to an increase in the surplus nation’s ownership of foreign assets.
A deficit leads to lower aggregate demand and thereforeslower growth
In the long run, persistent trade deficits undermine the standard of living
Trade deficit can lead to loss of jobs in home-based industries
Deficit countries need to import financial capital to achieve balance
A trade deficit can lead to currency weakness and higher imported inflation
Countries may run short of vital foreign currency reserves
A trade deficit is a reflection of lack of price / non-pricecompetitiveness
Currency weakness can lead to capital flight / loss of investor confidence
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“If a currency is weaker another is stronger; if a
trade balance is improved another is worsened.
There is a zero sum game in currencies/trade
Economist Nouriel Roubini
What are the Main Causes of Structural Trade Surpluses?
There are several causes of a trade surplus and each country will have a unique set of circumstances:
Export-oriented growth: Some countries have set
out to increase the capacity of their export
industries as a growth strategy. Investment in new
capital provides the means by which economies of
scale can be exploited, unit costs driven down and
comparative advantage can be developed.
Foreign direct investment: Strong export growth can be the result of a high level of foreign direct
investment where foreign affiliates establish production plants and then export from this base
Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate
its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by
currency intervention by a nation’s central bank, i.e. selling their own currency and accumulating
reserves of foreign currency. One of the persistent disputes between the USA and China has
revolved around allegations that the Chinese have manipulated the Yuan so that Chinese export
industries can continue to sell huge volumes into North American markets.
High domestic savings rates: Some economists attribute current account surpluses to high levels
of domestic savings and low domestic consumption of goods and services. China has a high
household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States
has collapsed and their trade deficit has got bigger. Critics of countries with persistent trade
surpluses argue they should do more to expand domestic demand to boost world trade.
Closed economy – some countries have a low share of national income taken up by imports –
perhaps because of a range of tariff and non-tariff barriers.
Strong investment income from overseas investments: A part of the current account that is
often overlooked is the return that investors get from purchasing assets overseas – it might be the
profits coming home from the foreign subsidiaries of multinational businesses, or the interest from
money held on overseas accounts, or the dividends from taking equity stakes in foreign companies.
Current Account Deficits and Surpluses
Data is measured as a % of GDP, data is 2012, Source: World Bank Global Economic Prospects
Deficit Countries (Highest deficit first) % of GDP Surplus countries % of GDP
Mongolia -49.5 China 3.1
Niger -22.7 Germany 5.3
Cyprus -22.3 Sweden 6.2
Uganda -14.8 Taiwan, China 8.1
Zimbabwe -12.4 Sub-Saharan Africa Oil exporters 8.8
Jamaica -11.4 Netherlands 9.5
Rwanda -10.0 Asian High-Income NIEs 9.9
Cambodia -9.9 Nigeria 10.4
Middle East & North Africa Oil importers -9.3 Malaysia 11.1
Ghana -8.6 Switzerland 13.9
Kenya -8.2 Angola 16.2
Ethiopia -7.8 Singapore 17.7
Sub-Saharan Africa - Fragile states -6.3 Norway 18.2
Low Income Countries -6.3 Trinidad and Tobago 18.7
Sub-Saharan Africa Oil importers -5.9 Oman 19.1
Portugal -5.0 Gabon 19.6
South Africa -4.6 Azerbaijan 24.9
Sri Lanka -4.4 Saudi Arabia 31.8
India -3.6 Kuwait 39.7
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Policies / approaches to reduce a persistent current account deficit
There are a number of policies that can be introduced to achieve an improvement in a country’s trade
balance – some of them focus on changing the growth of demand, others look to improve the supply-side
competitiveness of an economy. As with any macroeconomic ‘problem’ effective policies are those that target
the underlying causes.
1. Demand management: Reductions in government spending, higher interest rates and higher taxes
could all have the effect of dampening consumer demand reducing the demand for imports. This
leads to an increase in spare productive capacity which can then be allocated towards exporting.
2. Natural effects of the economic cycle: One would expect to see a trade deficit fall during a
recession – so some of the deficit is partially self-correcting – but this does little to address the
problems of a structural balance of payments problem.
3. A lower exchange rate:
a. The central bank of a country might decide that a lower exchange rate provides a suitable
way of improving competitiveness, reducing the overseas price of exports and making
imports more expensive
b. For those countries operating with a managed exchange rate, the government may decide
to authorise intervention in the currency markets to manipulate the value of the currency
4. Supply-side improvements:
a. Policies to raise productivity, measures to bring about more innovation and incentives to
increase investment in industries with export potential are supply-side measures designed to
boost exports performance and compete more effectively with imports. The time-lags for
supply-side policies to have an impact are long.
b. Policies to encourage business start-ups – successful small businesses with export potential
c. Investment in education and health-care to boost human capital and increase
competitiveness in fast-growing and high value industries such as bio-technology,
engineering, finance, medicine
d. Investment in modern critical infrastructure to support businesses and industries involved in
5. Protectionist measures such as import quotas and tariffs are rarely used because of our
commitments to the World Trade Organisation and our membership of the European Union.
Expenditure- reducingpolicies- designed to
control demand and limit spending on imports -
squeeze on demand, encouraging rising private
Expenditure-switchingpolicies- designed to
change the relative prices of exports and imports -
this causes changes in spending away from
imports and towards domestic/export production
Improvingthe supply-sideperformanceof the
economy - to boost competitiveness - economic
reform is a long-run strategy
Improvingmacroeconomicstability to make a
country more attractive to inward investment -
investment can raise productivity and increase a
country's capacity for exporting
Performance in the Short
and Long Run
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Case Study: The UK Balance of Payments
The UK current account comprises the trade balance in goods and services; net international income, for
instance from dividends and rents; and net payments by governments and international organisations, such
as contributions to the EU and overseas aid.
Britain has run a current account deficit since 1984. Our trade deficit in goods has increased significantly –
surging past £100 billion in 2012. In contrast, Britain now achieves strong surpluses in trade in services but
not enough to fully offset the trade gap in goods. Net investment income is usually positive although this
dropped sharply in 2012. Our transfers balance is negative largely because of financial commitments to the
European Union and also due to the UK being a net donor of overseas aid equal to around 0.7% of her GDP.
The balance of payments must balance! So a nation running a current account deficit requires a capital
account surplus. The counterpart to Britain’s current account has been heavy inflows of foreign deposits to
UK banks and lending by foreign banks to UK residents.
Britain’s current account deficit is sustainable in the sense that the country remains attractive to foreign
investment and also because it is regarded as having a flexible economy and a floating exchange rate. This
makes it possible for the country to achieve a balance of payments adjustment in the years ahead, for
example by successfully improving competitiveness and/or having a lower exchange rate to boost sales and
profits from export industries.
But the persistent current account deficit is also the result of a relatively low savings rate (mirrored by high
levels of consumer debt) and some weaknesses in the supply-side of the economy.
Annual balances for each component, £ billion
Components of the UK BoP on the Current Account
Source: Reuters EcoWin
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Trade in Goods Current account
Trade in Services
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6. Exchange Rates
• Currencies are traded in foreign exchange markets and
the volume of money bought and sold is huge! Daily
foreign exchange market turnover averages over $4 trillion
• An exchange rate is the price of one currency in terms of
another – in other words, the purchasing power of one
currency against another.
• Exchange rates are an important instrument of monetary
policy – a growing number of countries are intervening in
currency markets as part of their economic strategies
Measuring the exchange rate
Exchange rates are expressed in various ways:
o Spot Exchange Rate - the spot rate is the rate for a currency at today’s market prices
o Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the
future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy
their currency ‘forward’ on the market
o Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples
include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
o Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of
currencies the weights are based on the importance of trade between the UK and each country.
o Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the
real exchange rate implies a worsening of competitiveness for a country.
Value of one Euro, daily closing exchange rate
Euro - Sterling Exchange Rate
Source: Reuters EcoWin
May Sep Jan
May Sep Jan
May Sep Jan
May Sep Jan
May Sep Jan
in the value
of sterling v
the US dollar
here – fewer
- 32 -
Exchange Rate Systems
The choice of exchange rate regime is one of the most important that a country can make as part of
monetary policy. The main options are:
1. A free-floating currency where the external value of a currency depends wholly on market
forces of supply and demand
2. A managed-floating currency when the central bank may choose to intervene in the foreign
exchange markets to affect the value of a currency to meet specific macroeconomic objectives
A fixed exchange rate system e.g. a currency peg either as part of a currency board system or
membership of the ERM II for countries intending to join the Euro.
System Main Characteristics Recent UK History
The value of a currency is determined purely by
demand and supply of the currency
Trade flows and capital flows affect the exchange
rate under a floating system
There is no target for the exchange rate and no
intervention in the market by the central bank
Sterling has floated since the UK
suspended membership of the ERM in
The Bank of England has not intervened
to influence the pound’s value since it
Value of the currency is determined by market
demand for and supply of the currency
Some currency market intervention might be
considered as part of demand management (e.g.
a desire for a lower currency to boost exports)
Governments normally engage in
managed floating if not part of a fixed
exchange rate system. Managed floating
was a policy pursued in the UK from
Exchange rate is given a specific target. The
currency can move between permitted bands of
fluctuation on a day-to-day basis
Interest rates are set at a level necessary to keep
the exchange rate within target range – or direct
intervention in the FOREX market
Re-valuations are seen as a last resort
The UK operated a semi-fixed system
from October 1990 - September 1992
when a member of the ERM. Sterling
was eventually forced out of the ERM by
a wave of speculative selling
The exchange rate is pegged and there are no
fluctuations from the central rate
A country can automatically improve its
competitiveness by reducing its costs below that
of other countries – knowing that the exchange
rate will remain stable
Several countries operate with fixed
exchange rates or currency pegs. The
Ivory Coast Franc is pegged to the Euro,
with the French Treasury guaranteeing
convertibility. This facilitates exchange
rate and price stability. The peg is not
threatening international competitiveness
given the low inflation rate in the Ivory
- 33 -
Countries with floating exchange rates
The Case for Floating Exchange Rates
The main arguments for adopting a floating exchange rate system are as follows:
1. Reduced need for currency reserves: There is no exchange rate target so there is little
requirement for a central bank to hold foreign currency reserves to use during intervention
2. Useful instrument of economic adjustment: For example depreciation of the exchange rate can
provide a boost to exports and stimulate growth during a recession and/or when there is a risk of
deflation. A good example of this is Poland whose currency the Zloty depreciated against the Euro in
2009-10 which helped Poland to avoid recession during the global financial crisis. Indeed Poland
was one of the few EU countries to avoid a slump during this difficult period.
3. Partial automatic correction for a trade deficit: Floating exchange rates can help when the
balance of payments is in disequilibrium – i.e. a large current account deficit puts downward
pressure on the exchange rate, which should help exports and make imports relatively more
expensive. Much depends on the price elasticity of demand and supply of exports and the price
elasticity of demand for imports – see the later section on the Marshall-Lerner condition and the J-
4. Less opportunity for currency speculation: The absence of an exchange rate target might reduce
the risk of currency speculation. Speculators tend to attack weaker currencies where a government
is trying to maintain a fixed exchange rate out of line with macro-economic fundamentals.
5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target
allows policy interest rates to be set to meet domestic aims such as controlling inflation or stabilising
the business cycle. Countries locked into a single currency system such as the Euro do not have the
same freedom to manage interest rates to meet their key macroeconomic aims. This has become
obvious as one of the limitations of being inside the Euro during the ongoing crisis.
Floating exchange rates have their disadvantages – some of these are discussed next when we look at the
advantages of fixed systems. One of the main disadvantages is that floating currencies can be volatile which
makes doing businesses harder. An unexpected fall in the exchange rate can also be a cause of rising
New Zealand Dollar
- 34 -
Countries with Managed Floating Exchange Rates
The Case for Fixed Exchange Rates
The main arguments for adopting a fixed exchange rate
system are as follows:
1. Trade and Investment: Currency stability can
promote trade and capital investment because of
less currency risk. Overseas investors will be more
certain and confident that the returns from their
investments will not be destroyed by sudden
fluctuations in the value of a currency.
2. Some flexibility permitted: Some adjustment to the
fixed currency parity is possible if the case becomes
unstoppable (i.e. the occasional devaluation or
revaluation of the currency if agreement can be
reached with other countries). Some countries are
tempted to engage in competitive devaluations and this threatens the outbreak of “currency wars”.
3. Reductions in the costs of currency hedging: Businesses have to spend less on currency
hedging if they know that the currency will maintain a stable value in the foreign exchange markets.
4. Disciplines on domestic producers: A stable currency acts as a discipline on producers to keep
costs and prices down and may encourage attempts to raise productivity and focus on research and
innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with
another (and thus put competitive pressures on prices and real wages)
5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with
another, then differences in relative unit labour costs will be reflected in the growth of exports and
imports. Consider the example of China and the United States. For several years China pegged the
Yuan against the dollar. Until July 2005 the exchange rate was fully fixed; since then the Chinese
have allowed only a gradual depreciation of the dollar against the Yuan. Most estimates indicate that
the Chinese currency is persistently undervalued against the dollar. This makes Chinese products
cheaper and has led to numerous calls from US manufacturers for the Chinese to be persuaded to
switch to a floating exchange rate or to adjust their currency by appreciating against the dollar.
Ghana - Cedi
- 35 -
What economics factors affect the value of a nation’s currency?
In floating exchange rate systems, the market value of a currency is determined by the demand
for and supply of a currency
Most currency dealing is speculative but trade and investment decisions also have a role to play
Some of the key factors that can affect a currency are as follows:
Trade balances – countries that have strong trade and current account surpluses tend (ceteris
paribus) to see their currencies appreciate as money flows into the circular flow from exports of
goods and services and from investment income. This increases the demand for a currency and
brings about an appreciation in its value. Persistent trade deficits can lead to currency depreciation.
Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment
from overseas will see an increase in currency demand and a rising exchange rate.
Portfolio investment – much currency trading is used to finance cross-border portfolio investment,
for example investors putting their funds into stocks and shares, government bonds and property.
Strong inflows of portfolio investment from overseas can cause a currency to appreciate
Interest rate differentials - if a country’s interest rates are higher than rates on offer in other
countries then ceteris paribus we expect to see an inflow of currency into banks and other financial
institutions. The higher the interest rate differential, the greater is the incentive for funds to flow
across international boundaries and into the economy with the higher interest rates. Countries
offering high interest rates can expect to see ‘hot money’ flowing across the currency markets and
causing an appreciation of the exchange rate.
There are inevitable risks in shifting funds across international markets. What might happen to the currency
if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if
sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars
and putting it into the UK stock market or into government bonds? Investors often consider the risk-adjusted
relative rate of return from different financial investments.
Chinese Yuan to the US Dollar
China Spot Exchange Rate against the US Dollar
Source: Reuters EcoWin
04 05 06 07 08 09 10 11 12 13
the fully fixed
the US dollar
in July 2005
of Yuan v
a return to
- 36 -
Currency Markets – Demand and Supply in Action
Demand and supply charts help to show how a change in the exchange rate can come about. In the left-
hand diagram below we see the effect of a rise in Chinese exports to the United States which leads to an
increase in the demand for Chinese Yuan and appreciation in the exchange rate. In the right hand diagram
we see the effects of the Chinese central bank intervening to lower the Yuan by selling their own currency
and buying US dollars.
How can a government manage the value of an exchange rate in the currency market?
There are various options for a government / central bank that wishes to intervene in the currency market to
bring about a change in the external value of the currency
• Changes in policy interest rates e.g. lower interest rates to depreciate the exchange rate
• Causes movements of “hot money” banking flows
• Direct intervention in the market
• Buying and selling of domestic / foreign currencies
Directbuying/ sellingin the currencymarket (intervention)
• Taxation of foreign deposits in commercial banks cut the profit from hot money inflows /
carry trade effect
• Controls on the free flow of capital into and out of a country
Taxation of overseascurrencydepositsand capital controls
Quantity of currency
Quantity of curren