Often in the political world, trade is seen as a game of tit for tat. e.g. US places tariffs on imports of Chinese chickens, China retaliates by placing tariffs on US cars e.t.c

However, the theory of comparative advantage and free trade suggests, that a country can increase its economic welfare by cutting tariffs – even if these tariff cuts are not reciprocated. In other words cutting tariffs is a win win situation.

The below example shows how reducing import tariffs leads to a net gain in economic welfare for the country (even if others don’t respond by cutting their import tariffs)

Diagram for Trade Creation

• The removal of tariffs leads to lower prices for consumers and an increase in consumer surplus of areas 1 + 2 + 3 + 4
• Imports will increase from Q3-Q2 to Q4-Q1
• The govt will lose tax revenue of area 3
• Domestic firms producing this good will sell less and lose producer surplus equal to area 1
• However overall there will be an increase in economic welfare of 2+4 (1+2+3+4 – (1+3))

However, it is not as simple as this.

There are some losers from free trade.

- Domestic firms protected by tariffs will lose out – these are often politically vocal. They will make more fuss than consumers who benefit from marginally lower prices.

It is true that countries benefit from cutting tariffs, but they would benefit even more if it is part of a mutual tariff reduction, helping to increase exports. Countries may not want to unilaterally cut tariffs, preferring to use them as a bargaining chip in trade negotiations.

Also, free trade can be damaging under certain circumstances. This is especially true for developing countries seeking to diversify their economy.

See:

Disadvantages of Free Trade

Benefits of Free Trade

Current Account Surplus

The Chinese current account surplus is very large. In 2007, $371 billion. Reasons for this Surplus

• High saving rate in China. Chinese consumers have a higher propensity to save than the rest of the world. This means they save rather than buy imports from abroad. The US has a very low savings rate and so US consumers have been buying Chinese imports
• Undervalued Yuan. It has been the policy of China to keep the value of the Chinese Yuan low. True it has appreciated but, less than if market forces had fully operated. The lower value of the Yuan keeps exports cheaper and imports more expensive.
• Shifting Comparative Advantage. China has developed a significant comparative advantage in manufactured goods which encourages a trade surplus.

Solutions to Current Account Surplus

1. Allow Yuan to Appreciate. Making exports more expensive, imports cheaper.
2. Encourage greater consumer spending and less reliance on exports. This may be necessary to maintain Chinese economic growth.
3. The deficit may narrow as the West (US in particular spends less on imports due to recession.)

source: pic

See also: Causes of Current account deficit

Productivity is defined as output per worker or output per input. Rising productivity implies that the economy is becoming more competitive and will be able to produce goods at a lower cost. If UK firms can produce goods at a lower cost this will make UK exports more competitive and therefore increase exports.

For example, if there is an improvement in labour productivity following better education and training, firms will be help to produce more for the same costs. This will help the UK compete and sell more exports.

Increasing exports will help improve the current account as exports will be rising relative to imports.

However, there are many other factors that influence the current account as well as rising productivity. Firstly the current account deficit is often cyclical. During periods of high growth consumers spend more on imports causing an increase in the size of the deficit. Therefore, even an improvement in productivity may be insufficient to improve the deficit if it occurs during a period of rising consumer spending.

The fortunes of the current account also depend on the exchange rate. If there was an appreciation in the exchange rate then exports would become less competitive and this would offset the improvements from the increased productivity.

Also, it depends on how much UK productivity has increased relative to other countries. If UK productivity increases by 3%, it may still be less than improvements by our main trading partner. For example, China can benefit from rising productivity and low wages and therefore it remains more competitive than the UK.

It appears the UK has an underlying structural deficit caused by a high marginal propensity to consume and declining comparative advantage in many manufacturing export sectors. A rise in productivity will do a little to help improve the situation. However, it is only part of the equation; for a sustained improvement the UK may need to increase its saving ratio, reduce spending on imports and increase competitiveness even more

An appreciation in the exchange rate would tend to reduce aggregate Demand and lead to lower economic growth. An appreciation makes exports less competitive, decreasing quantity of exports. An appreciation also  makes imports cheaper, increasing quantity of imports (and hence money leaving the economy). Therefore, the (X-M) component of AD will be lower. This will reduce Economic growth.

AD/AS Diagram showing effect of appreciation

However, an appreciation doesn’t necessarily lead to slower growth. If UK house prices have been rising, then there will have been a positive wealth effect leading to higher consumer spending. Also, if demand for exports is inelastic, an appreciation will not reduce the value of exports. Therefore, the strong growth in the UK may not be due to supply side policies but because AD continues to rise due to various other factors.

Supply side policies can help to increase growth. For example, recently, the government have attempted to improve education and training (new deal and other policies); this should increase labour productivity and shift AS to the right. Although, these take a long time they will help to increase the economic growth rate in an economy.

Diagram showing effect of Successful Supply Side Policies

Another supply side policy could be privatisation. This has helped increase the efficiency of privatised firms and boost productivity in the economy. This shift in AS helps to increase growth. It is also possible that successful supply side policies can increase confidence and investment in the economy and therefore, help boost AD as well as AS.

But, mainly supply side policies help to increase the long run trend rate of growth rather than deal with temporary demand side shocks. Supply side policies can help increase the long run trend rate, but, don’t necessarily increase AD.

Growth has been maintained in the UK because AD continues to rise as well as rising AS. This reflects the strength of consumer spending and perhaps expansionary fiscal policy.

To get full marks you would also need to make reference to the data and give precise figures.

• When there is a depreciation and the exchange rate goes down, the exports of a country will be cheaper and imports will become more expensive.
• e.g. a depreciation of the dollar makes US exports more competitive.
• Therefore there will be an increase in exports and decrease in quantity of imports. Therefore, domestic firms will benefit from increased sales. This may lead to job creation and lower unemployment, especially in exporting industries.
• The increase in X-M will help increase AD and therefore lead to economic growth
• The current depreciation in the US dollar is helping US exports. The boost in the US export sector is particularly beneficial because the US economy is currently facing a recession from lower consumer spending.
• A depreciation will also help improve the current account balance of payments. This is because exports increase relative to imports. However, this assumes that demand for exports and imports are elastic. (Marshall Lerner condition states that a depreciation improves current account deficit if PED x + PED m >1)

See also: Effects of an Appreciation in the exchange rate

The Australian Dollar has appreciated against the US Dollar because

• Large US current account deficit
• Australia has benefited from rising commodity prices, commodities which Australia produces a lot of.
• US interest rates are lower than Australia and the US economy has been weakening.

April 2008 $1 Aus Dollar = US 0.9300

Effects of AUS Dollar Appreciation

• It makes Australian exports more expensive. Therefore there will be a fall in demand for Australian exports.
• Imports into Australia will become cheaper, therefore there will be an increase in demand for imports.
• This is likely to worsen the current account deficit. However, this assumes that demand for exports and imports is relatively elastic. The Marshall Lerner condition states that if PED of exports + PED of imports > 1 then an appreciation will worsen the current account.
• In the short term demand is often inelastic, however over time consumers become more responsive to price changes therefore, the current account may improve in the short term, but worse, if the appreciation lasts for a long time.

Evaluation

• There are many other factors affecting the Australian current account apart from the exchange rate between US and Australia. For example, it depends on the value of the Aus dollar against its other main trading partners such as Japan and the EU.
• It also depends on the level of consumer spending and imports
• Ceteris paribus an appreciation in the AUS dollar will worsen the deficit. However, if demand for Australian commodities is inelastic (because there are no alternatives) then the deficit may not get much bigger.

Australian Current account deficit has averaged – 5.7% of GDP in 2007-08

Please see: Does a current account deficit matter?

I would add that some countries are better able to finance a current account deficit. E.g. the US could run a current account deficit because Chinese investors were willing to buy US assets. US debt was bought at a relatively low interest rates because of the dollar’s status as the reserve currency.

Some countries like the UK, may be an attractive destination for long term investment (Capital inflows) and this makes a current account deficit easier to finance. So it does depend on the size of the country and also the confidence people have in investing their. E.g. a developing economy may find it more difficult to attract capital flows.

 Policies to Reduce Current account deficit

• Solving UK current account deficit 
• Can government reduce current account deficit 
• Reasons for current account deficit 

I will be taking lots of dollars to take advantage of the discrepency in the dollar / sterling exchange rate.

Economists, often say there should be no ‘free money on the table’. But, buying a new Mac laptop in the US, could save me £500 due to the weakness of the dollar. I guess someone has to do well out of the declining dollar…

Globalization is not a new phenomena. The world economy has become increasingly interdependent for a long time. I have previously written various factors that have helped explained the rise in globalization here 

In evaluation I would make the following points.

• It is hard to precisely define globalisation there are different interpretations about what we actually mean, therefore, there are differing factors that explain it.
• Improved technology is undoubtedly very influential in helping globalisation; without technologies such as the internet and global communication it would not have been possible to witness the increased interdependence of coompanies and countries.
• Increased free trade is important. However, there are various trade barriers still in existence and this has not stopped the growth of globalisation.
• Could there be a backlash against globalisation as people look for local alternatives to multinational products? I think this is unlikely as people prefer the security of buying established brand names.

Diagrams for Globalisation

I would draw a diagram for trade creation, showing how the removal of trade barriers increases exports and imports. Also economies of scale are very important for encouraging increased specialisation of global production.

It depends, there is no straight answer. The two phenomena may occur simultaneously. Also it is complicated by the fact that many factors affect the exchange rate apart from just inflation. (e.g. short term interest rates)

2)  My next question is that I’m aware that factors such as rising commodity prices can exert upward inflationary pressure,  but are there any other factors that affect the devaluation of a currency – or is it purely down to inflation?

Many factors can affect exchange rates. These include:

• Interest Rates – lower interest rates cause less hot money flows and depreceation.
• Expectations – If investors expect a currency to devalue they will sell less. Confidence and market expectations are important in determining exchange rate
• Current account deficit. A large current account deficit may put downward pressure on exchange rates

3)  Next, if devaluation does cause inflation, which in turn causes more devaluation, what tools does the government have to combat this vicious circle?

In the UK, the government target low inflation. They don’t have a specific target for the exchange rate. The main tool for controlling inflation is monetary policy and interest rates. If inflation is increasing above the target the MPC is likely to increase interest rates to reduce demand and inflationary growth

4)  Finally, looking at a recent example, I saw on the news a few weeks ago that some manufacturing companies in the UK were enjoying a boost in demand.  Would it be correct to say that inflation caused by rising energy prices, (which makes their exports less competitive) caused the pound to weaken, which balanced out the effect of inflation and then some, making their goods more competitive abroad?

The Pound has become weaker against the Euro. The Euro is our main trading partner. I think it is fair to say the benefits of lower exchange rate are greater than the increased costs of imported inflation.