Instructor's Manual

INSTRUCTOR'S MANUAL

SECTION 3

Chapter 17

1. According to official estimates, world income will increase by over $500 billion following implementation of the Uruguay Round. What, in your view, are the main sources of these gains? Why have so many countries, both developed and developing, participated in this major movement towards global free trade?

2. What is comparative advantage and what determines it? Can a comparative advantage be developed through judicious use of economic policies?

Comparative advantage refers to a country's relative cost advantage in certain industries. It contrasts with the idea of absolute advantage. As explained in the text, a country could have an absolute disadvantage in all products relative to another country, but it can still obtain gains from trade by exporting those products in which it has a comparative advantage. This is the core proposition of the theory of comparative advantage (or costs). Porter's competitive advantage is similar to an absolute advantage concept; and should not be confused with comparative advantage.

Comparative advantage in the simplest framework is explained by differences in costs. Thus countries with abundant low-cost labour are likely to have a comparative advantage in labour intensive goods. Porter's diamond presents a richer framework within which to analyse the determinant of comparative advantage.

Comparative advantage is not static, nor cast in stone; it changes, and government can speed or hamper this change. Japan is often cited approvingly as an example of successful use of government policies to alter the pattern of comparative advantage. But since governments are as limited as anyone else in their power to predict the future, emphasis should be on the word judicious when discussing policies for intervention to 'develop' future comparative advantage. Government policies can affect comparative advantage, both positively and negatively, as Porter points out. Successful interventions lay the groundwork, ensure a level playing field, and let the market forces decide which specific activities will prove most competitive. (See Porter chapter 9 for a good discussion of this issue.)

3. Why do smaller countries trade more as a percentage of GNP than large countries? Does this help or hinder their efforts to improve living standards?

4. The WTO's Trade Policy Review Board has on occasion expressed concern about the vulnerability of some developing economies arising from their heavy export reliance on a limited number of products and markets. Explain why such concentation might be a problem. What measures would you suggest to help a country achieve greater export diversification?

5. Adjustment to freer trade can involve heavy economic costs to the people affected, arising from financial and employment losses in import-competing industries. What measures should the government take in order to minimise these adjustment costs?

The opening statement is correct. Adjustment can be costly. Shareholders in import-competing industries can often lose, and so do employees, as a result of trade liberalisation. It takes time for an employees who is made redundant to find a new job; and in the case of blue collar employees the new job will entail a fall in pay.

Economics suggests a number of approaches to the adjustment problem:

1) provide a reasonable transition period to allow time to adjust, 2) assist affected industries to become competitive through training and re-equipment support, 3) where industry has no reasonable hope of viability, provide a welfare 'floor' for redundant employees, 4) re-training assistance, 5) get industrial development agencies to seek out replacement industries. In addition to these microeconomic measures, governments implement policies that encourage growth (adjustment is easier in a rapidly growing economy) and price and wage flexibility.

6. Is there a case for the government using subsidies to encourage the development of domestic industries by helping them win export markets? Is this fair play, or is it a form of hidden protectionism?

Exercises (17)

1. Suppose that in Sweden 1 unit of labour can produce 10 units of timber and 10 units of steel, whereas in the UK 1 unit of labour can produce 8 units of steel and 6 units of timber. In what product does the UK have a comparative advantage? In what product does Sweden have a comparative advantage? Would your answer be different if 1 unit of Swedish labour could produce 14 units of steel instead of 10?

Chapter 19 Questions for Discussion

1. Under what circumstances could a country simultaneously have a balance-of-trade surplus and a current account deficit?

This could happen if the trade surplus were accompanied by a larger deficit on services trade or on current transfers. Countries with natural resource exports will often have heavy outgoings of repatriated profits and interest payments on foreign investment.

2. Why are statistics of capital account transactions less accurate and more difficult to record than those of merchandise trade transactions?
They are more difficult to record because unlike merchandise trade they are intangible transactions. One cannot see and measure a capital flow. The problem of accurate recording has been exacerbated by the huge increase in volume of capital transactions during the past decade. Behind each transaction may be a layers of complementary transactions. Because it is often impossible to know the origin or destination of capital flows, they are not classified by geographical market as merchandise trade is.

3. What, if anything, does the fact that a country has a current account surplus tell us about the strength of that economy?

It is a common error to identify a balance of payments surplus with economic strength. Nothing whatever, good or bad, can be inferred from the current account balance. Some surplus countries are powerful and economically strong (Japan during the 1980s and 1990s for example): others have to run a surplus in order to reduce the debt burden and restore credit worthiness (examples from South America???).

4. How would you define a balance-of-payments disequilibrium? Discuss some of the economic forces which tend automatically to restore the balance of payments to equilibrium.
5. What problems, if any, is a country which runs a persistent current account balance of payments surplus likely to encounter? Contrast them with the problems of a country with a persistent deficit.

Consider first the adverse effects of a deficit. The experience of the USA can be used to illustrate.

First, one definite cost is the accumulation of foreign debt and the consequent obligation to deliver a steam of interest payments, rents and dividends. Second, the greater its reliance on foreign creditors, the greater is the country's exposure to the volatility of international capital markets Third, in the event of a loss of confidence the deficit country can suffer excessively large devaluations of the exchange rate, the inflationary repercussions of which only add to the problems of the deficit country. Fourth, the further a country's international investment position moves into the red, the more ownership over its assets moves into the hands of foreigners

To illustrate the adverse effects of a surplus, on can take the case of Japan:

First, surplus countries tend to be blamed for their trading partners' deficit problems. They are likely to be pressurised to import more from the deficit countries.

Second, surplus countries are also likely to be subjected to 'voluntary' restraint on their exports and will be encouraged to invest more abroad (while at the same time, and inconsistently, this very increase in investment may arouse nationalistic unease). Third, such investments may be unprofitable because of exchange rate losses as the surplus itself leads to a strengthening of the currency vis-a-vis the borrower. Furthermore, investment decisions taken under pressure to placate the deficit countries may end up being poorly advised. Finally surplus countries have to aware of the potential inflationary repercussions of a sustained surplus.

6. Should a tax be imposed on countries running a persistent balance of payments surplus, on the grounds that such surpluses are deflationary and a danger to the world trading system?

Exercises (ch 19)

1. Honey and Moon from Korea spend a holiday in Britain. During their visit, they affect all four major components of the current account of the UK's balance of payments. What transactions could they have made?
2.Classify the following transactions in the UK balance of payments:
aA US. tourist travels to Britain and spends £1000 financed by dollar travellers' cheques.
b.Mercedes Benz sells DM400,000 of its cars to a UK distributor, allowing 90 days' trade credit until payment is due.
c.Herr Schmidt in Bonn, West Germany, sends his grandson in London DM 4,000 for his university fees.
d.A resident in Phoenix, Arizona, receives a £40,000 dividend from British Telecom plc which is deposited in a local bank.
3. Consider any country with a balance of payments deficit on current account. Reviewing the economic record of the country, should the authorities take steps to reduce this deficit? If so, how should this be done?

The UK economy in the mid 1990s was an example of a deficit country where the authorities decided that no remedial action was required. By contrast the US deficit is seen as a problem by the Clinton Administration. (Sylvia: see Economic Report of the President; do they have anything on the deficit and how they propose solving it??) Developing countries frequently see the current account deficit as serious constraint on faster economic growth. Unlike more developed countries, their access to world capital markets is problematic and uncertain. See for example the Mexican case.

Students should discuss the measures proposed to reduce the deficit using the expenditure reducing and expenditure switching classification described in the text.

4. Review recent trends in the current account balance of payments of a major industrial country. How would the current account balance be affected by: a) faster economic growth in your economy? b) faster economic growth in the economy of its trading partners and c) rapid inflation relative to its trading partners?

a) faster growth in the economy will stimulate demand for imports and will, other things being equal, tend to worsen a balance of payments deficit. (This answer would have to be qualified if the prime cause of the faster growth happened to be a boom in exports.)

b) faster growth in trading partners is good for the home country’s exports and could be expected to strengthen the balance of payments.

c) inflation will make exports less competitive and imports more competitive relative to domestic goods and so will worsen the balance of payments. Perhaps in the very short run there might be J curve effects but these will not last.

20COPING WITH EXCHANGE RATES

Questions for Discussion

1. Purchasing power parity states that countries with high inflation rates tend to have depreciating currencies. Can you explain why?

First, PPP should be explained. In this context, relative PPP is being referred to. Second, the consequences of one country having a sustained higher inflation than its trading partner should be explained step-by-step as follows:

• Exports become less cost competitive
• Import-competing industries find it harder to compete against foreign rivals
• The current account balance of payments position deteriorates
• Capital may start to flow outwards as markets start talking of a possible weakening of the currency
• In the short run these pressures may be resisted by running down reserves or by interest rate hikes.
• Eventually if the inflation persists the exchange rate will have to be devalued.

2. Why should the discovery of a natural resource, say North Sea oil, be expected to lead to a strengthening of a country's currency?

Taking the rise in sterling in the early 1980s as an example, what effect would you expect such an appreciation to have had on: a) Britain's manufacturing sector, b) British exporters, c) British consumers?

The discovery of oil will produce balance surplues through the following mechanisms

• An initial net capital inflow into the country ( from new investment opportunities etc).
• As the economy becomes self-sufficient in its energy needs, future energy related imports will decline.

Currency appreciation can offset the subsequent balance of payments surpluses.

a) The manufacturing sector is part of the traded sector and is therefore subject to competing imports. An appreciation makes imports cheaper, consequently, we should expect the sector to decline. However, note that depending on the extent of the appreciation, it could have potentially beneficial long run effects as it could force the sector to develop more efficient production techniques and to compete in terms of quality rather than price.

b) As they become more costly in the world markets as a result of an appreciation, we would expect exports to decline.

c) Consumers would tend to be better off after the appreciation as imports become less expensive.

3. Why do large differences in interest rates continue to prevail between countries notwithstanding the increasing international mobility of capital which must tend to reduce them?

Differnces in interest rates persist between countries because of two reasons

Risk premia may be required by some investors to invest in some countries. For example if the country is already highly indebted, and if the risk of default is high then interest rate differentials will exist.

With regards Italy and Japan this argument does not apply (despite Italy’s large debt, risk of default is relatively low). However, if the Italian authorities are expected to engage in a devaluation of their currency ( thereby reducing the value of foreign held debt) then investors will require an additional premium to compensate for any adverse depreciation of the currency. This is notion is formally known as the covered interest rate parity theorem ( domestic interest rate less foreign rate is equal to the expected change in exchange rate). Since expected currency movements are at the root of interest rate differentials one must ask as to what causes an expectation of exchange rate depreciation. Many factors can be cited such as, lax monetary policy ( inevitably leads to inflation and a devalued currency), persistent balance of payments deficits, known cost competitiveness policies by the use of the exchange rate, and large amounts of public debt .. (any more ?)

4. Why are exchange rates volatile? What can government do to try and reduce such volatility? Does government action sometimes cause volatility?

There is no easy answer as to why exchange rates are so volatile. However it is generally accepted that volatility arises from the following sources;

Macroeconomic shocks to the system. Changes in the conduct of monetary and fiscal policy will affect exchange rates. Demand and supply shocks, such as acts of god and war, changes in tastes, preferences and technology will affect exchange rates.

The interaction of uncoordinated monetary policy should also be mentioned as a source of instability .

Price stickiness in other markets. For example if wages are inflexible, labour market shocks could have repercussions in the currency market.

Lack of perfect rationality in the forex market. The existence of speculative bubbles and band wagon (phenomenon whereby the actions of investors cause spiraling upward movements in prices, for no apparent economic reason) is testament to the fact that investors may perhaps be prone to “animal spirits” and the herd instinct rather than perfect rationality. Speculation (holding a risky position in a currency in the hope of earninng profits) itself can be a source of instability in the forex market. For example, soppose speculators expect a fall in the value of a currency. This gives rise to anticipatory purchases of foreign currency, propelling the exchange rate downwards and causing an expectation of a future fall.

Related to this point is the use of charts and technical analyis in the forex market. Some traders, rather than basing their strategies on economic fundamentals have developed techniques to predict trends and patterns from currency data. The use of these “charts” may cause distortionary effects in the forex markets. For example, if a large enough group of traders use the same charting method, then it is possible that that they have enough power to change prices. This creates the potential for volatilty. Moreover such volatility is exacerbated where chartists and fundamentalists exist in tandem.

Government action to reduce volatilty in the forex markets include

Open market operations - Central Banks can conduct the purchase or sale of domestic currency so as to maintain the exchange rate at a particular level. However, in todays world, given the sheer volume of capital market transactions governments may not not necessarily have the resources to persistently beat the markets.

Institutional mechanisms such as controls on exchange rates and international capital movements, high capital reserve requirements, taxes on speculation can also be used to limit volatility (by limiting trading ..any other examples..)

The introduction of specific monetary and fiscal policies that are seen to be consistent with accepted long run value of the currency. In such cases monetary and fiscal policy need to be credible to avoid time inconsistency problems. To avoid currency speculation changes in policy should not be pre-announced or introduced with delays.

Finally sovereign governments may enact international agreements guaranteeing exchange rate cooperation and coordination of policies.

Normally these agreements provide for a system of (semi) fixed exchange rates amongst member countries and detail institutional mechanisms/arrangements in the event of currency instabilty and needs for realignments.

The European Exchange Rate Mechanism (ERM ) is an example of such an international agreement (essentially where European Monetary Authorites agree upon a system of semi-fixed exchange rates between member countries. - See Chapter 21)

Government action can cause volatility in a number of ways;

If open market operations and central bank intervention are seen to be at odds with market sentiment about the value of the currency, such “confused signals” will give rise to volatilty. Moreover, volatilty will be exacerbated by speculative trading (speculation that the monetary authorities strategy is untenable and will eventually have to be changed). A similar result arises when intervention in the currency market is seen to be inconsistent with prevailing monetary and fiscal policy. For example, the currency crisis of 1992, and Sterlings eventual ejection from the ERM was partly due to the fact that the market perceived the Sterling/DM link was unsustainable and that monetary policy was tighter than required for the weak British economy(See Chapter 21).