Cima c04 2013 Class Chapter 14 The International Context Part II

Chapter 14
The international
context
w w w . s t ud y i n t e r a c t i v e . o r g
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CHAPTER 14
T H E I N TE R N A T I O N A L C O N T E X T
CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 160
BALANCE OF PAYMENTS ----------------------------------------------- 161
CURRENT ACCOUNT DEFICIT / SURPLUS
162
THE TERMS OF TRADE -------------------------------------------------- 165

ABSOLUTE & COMPARATIVE ADVANTAGE THEORY ----------------- 166
THE ROLE OF GLOBAL FINANCIAL INSTITUTIONS ------------------ 169
GLOBALISATION -------------------------------------------------------- 170
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ww w. stu dyi n t e ra cti v e .or g
CHAPTER 14
LEARNING OUTCOMES
a) Explain the concept of the balance of payments and its implications for
government policy.
b) Identify the main elements of national policy with respect to trade.
c) Explain the impacts of exchange rate policies on business.
d) Explain the role
development.
of
major
institutions
promoting
global
trade
and
e) Explain the role of supra-national financial institutions in stabilising

economies and encouraging growth.
f) Explain the concept of globalisation and the consequences for businesses
and national economies.
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CHAPTER 14
BALANCE OF PAYMENTS
The balance of payments records financial transactions between one country and
the rest of world.
The balance of payments comprises three accounts:

i)
Current account;
ii)
Capital account;
iii)
Financial account.
The current account which measures trade in goods and services, net investment
incomes and transfers, whereas the capital and financial accounts record flows
of financial capital arising from saving, investment and currency speculation.
balance of payments for 2008, all figures in m
The current account

Balance of trade in goods
-92,877
Balance of trade in services
+54,479
Net income flows
+26,940
Net current transfers
-13,610
Balance of payments on current account
-25,068
The capital account
+3,393
The financial account
+18,121
Net errors or omissions
+3,554
Overall balance of payments
Key points
The sum of the balance of payments accounts must always be zero.
Net errors / omissions arise as a result of statistical errors.
If there is a current account surplus
-
Then there will be a corresponding negative on the assets and

liabilities section i.e. outward investment and/or reduced overseas
debts.
If there is a current account deficit

-
16 1
Then there will be a similar positive amount on the assets and

liabilities section i.e. this will consist of inward investment and/or
increased overseas indebtedness, showing how the deficit was
financed.
CHAPTER 14
Current account deficit / surplus

Surpluses arise from a country exporting a greater value of goods than are
imported. Deficits arise from a country importing a greater value of goods than are
exported.
Reasons for deficits:
Increased import penetration
Poor export performance
Imports are relatively cheaper.
Exports are un-competitive.
Domestic currency overvalued

therefore less expensive.
imports
Domestic currency overvalued

exports
therefore more expensive than overseas
goods.
Growth in national income

consumers
increase demand for imports.
Growth in national income, producers

focus on domestic market at expense of
exports.
Imported goods offer greater value /

durability (factors other than price).
Exported goods of an insufficient quality

to compete on target markets.
Conversely, surpluses will be created by the reverse factors detailed above.
Consequences:
In order to fund a balance of payments deficit, there will need to be a rise in
external debt, which is clearly not sustainable.
Similarly, a balance of payments surplus is also unsustainable, for one country

to be in surplus, another must be in debt.
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CHAPTER 14
Policies to eliminate a current account deficit

The value of imports exceeds the value of exports. To eliminate a deficit the
government must achieve one, or a combination of the following
a) Increase demand for exports of domestically produced goods;

b) Reduce demand for imports of foreign produced goods.
Currency devaluation
Whilst a deficit will lead to an increase in supply of the domestic currency on foreign
exchange markets, and thus reduce the value of the currency, devaluation becomes
an option when a government has artificially retained a high rate.
Devaluation will increase the competitiveness of domestically produced goods,

therefore increasing demand for exports!
The J-Curve Effect

Surplus
Balance
on
current
acct
Time
Deficit
The problem with devaluation being that low price elasticities of demand for imports
and exports immediately following an exchange rate change may lead to an
increase in the deficit. The delayed impact, often due to contracts in place, means
that the volume of imports does not immediately fall away!
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CHAPTER 14
Protectionist measures
Aimed at reducing imports, measures might include:

i)
Import tariffs;
ii)
Import quotas;
iii)
Embargo (total ban);
iv)
Administration burdens (excessive paperwork!).
Domestic deflation
An attempt to reduce demand for imports by:

i)
Increasing interest rates;
ii)
Increasing taxation;
iii)
Cutting government expenditure.
The above measures unfortunately may lead to some un-wanted consequences,

namely unemployment, a reduction in the standard of living and a loss of industrial
output.
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CHAPTER 14
THE TERMS OF TRADE

The balance of trade depends not only on the volumes of goods traded, but more
importantly
terms of trade!
The terms of trade is expressed

questions examine the overall impact on the balance of payments as a consequence
of the ratio changing.
If price of exports fall relative to imports
the trade balance will deteriorate.
If the price of exports increases relative to imports

improve.
the trade balance will
Measuring the terms of trade

The terms of trade are measured as:
Unit value of exports

Unit value of imports
Using indices for the average prices of imports and exports, the movement in the
terms of trade between 2010 and 2011 would be computed as:
Price of exports 2011/price of exports 2010

Price of imports 2011/price of imports 2010
EXERCISE 1
2010 value.
Index numbers for import and export prices for the two years are given below.
Exports
Imports
2010
150
2011
144
216
What is the missing index number?
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CHAPTER 14
ABSOLUTE & COMPARATIVE ADVANTAGE THEORY

The case for specialisation and trade is based on the idea that all countries in total
will gain in terms of increased production, economic efficiency, and welfare.
Absolute advantage -
Axioms
o Two countries A & B;

o Each produce just two commodities, bread and bananas.
o Each country has 10 units of resources.
Using all of their resources they can produce
Table 1
Bread
Bananas
Country A
Country B
400
320
Or
Or
400
160
It is clear that Country A has an absolute advantage in the production of both

bread and bananas.
If each country was self-sufficient, and did not trade then their respective output
would be as follows
Table 2
Country A
Country B
Total
Bread
200
160
360
Bananas
200
80
280
Overall total economic output is 640.
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CHAPTER 14
Comparative advantage
Despite Country B having an absolute disadvantage in producing both bread and

bananas, the question is whether there is a benefit from specialisation!
The theoretical basis for free trade is comparative advantage theory. Global
resources can be more effectively utilised when countries specialise in producing
those goods and services in which they have a comparative advantage.
Comparative advantage means that that the opportunity cost of producing the good
is less in a country than elsewhere.
Based upon table 1, the following ratios may be created
Country A
Country B
1 bread = 1 banana
1 bread = 0.5 of a banana
1 banana = 1 bread
1 banana = 2 bread
The above ratios show that Country B has a comparative advantage in bread ! As to
produce an extra unit of bread it only has to give up half a banana, compared to
Country A that would need to give up 1 whole banana to produce 1 extra bread!
Thus the two countries specialise in the commodity for which they have a
comparative advantage!
Production based on specialisation, would be as follows
Table 4
Bread
Bananas
Country A
Country B
Total
320
320
400
400
Overall economic output is therefore 720, which is greater than under selfsufficiency.
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CHAPTER 14
EXERCISE 2
Assume that two small countries, X and Y, produce two commodities P and Q and
that there are no transport costs. One unit of resource in Country X produces 4
units of P or 8 units of Q. One unit of resource in Country Y produces 1 unit of P or
3 units of Q. Which of the following statements are true?
Country X has an absolute advantage over Country Y in producing P and Q,

and so will not trade.
Country X has a comparative advantage over Country Y in producing Q
Country Y has a comparative advantage over Country X in producing Q
Country X has a comparative advantage over Country Y in producing both P

and Q.
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CHAPTER 14
THE ROLE OF GLOBAL FINANCIAL INSTITUTIONS

Global financial institutions are designed to promote stability throughout the world
economy.
World Bank The World Bank is an international financial institution that provides loans to
developing countries for capital programs.
The World Bank's official goal is the reduction of poverty. All decisions must be
guided by a commitment to promote foreign investment, international trade, and
facilitate capital investment.
International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization that was
created on July 22, 1944 at the Bretton Woods Conference and came into existence
on December 27, 1945 when 29 countries signed the Articles of Agreement.
Countries contribute money to a pool through a quota system from which countries
with payment imbalances can borrow funds temporarily. The IMF currently has 188
members.
The Group of 20 (G20)

The Group of Twenty Finance Ministers and Central Bank Governors (also known as
the G20) is a group of finance ministers and central bank governors from 20 major
economies: 19 countries plus the European Union.
Collectively, the G20 economies account for more than 80 percent of the gross
world product (GWP), 80 per cent of world trade, and two-thirds of the world
population
The G20 meets to discuss such matters aso Financial crisis;

o Harmonization of taxes
o Environmental issues such as C02 emissions.
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CHAPTER 14
GLOBALISATION
Globalisation may be defined as the widespread extension of trade between
countries and a high degree of interdependence of production between countries.
Briefly discuss and makes notes regarding the following headings -
Factors driving globalisation
Impact of globalisation
17 0

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Chapter 14

THE TERMS OF TRADE -------------------------------------------------- 165

ww w. stu dyi n t e ra cti v e .or g

e) Explain the role of supra-national financial institutions in stabilising

ww w. stu dyi n t e ra cti v e .or g

The balance of payments comprises three accounts:

balance of payments for 2008, all figures in m

The current account

Balance of trade in services

Net income flows

Net current transfers

Balance of payments on current account

The capital account

The financial account

Net errors or omissions

Overall balance of payments

Then there will be a corresponding negative on the assets and

If there is a current account deficit

Then there will be a similar positive amount on the assets and

ww w. stu dyi n t e ra cti v e .or g

Current account deficit / surplus

Reasons for deficits:

Increased import penetration

Poor export performance

Imports are relatively cheaper.

Exports are un-competitive.

Domestic currency overvalued

Domestic currency overvalued

Growth in national income

Growth in national income, producers

Imported goods offer greater value /

Exported goods of an insufficient quality

Conversely, surpluses will be created by the reverse factors detailed above.

Similarly, a balance of payments surplus is also unsustainable, for one country

ww w. stu dyi n t e ra cti v e .or g

Policies to eliminate a current account deficit

a) Increase demand for exports of domestically produced goods;

Devaluation will increase the competitiveness of domestically produced goods,

The J-Curve Effect

ww w. stu dyi n t e ra cti v e .or g

Aimed at reducing imports, measures might include:

Embargo (total ban);

Administration burdens (excessive paperwork!).

An attempt to reduce demand for imports by:

Increasing interest rates;

Cutting government expenditure.

The above measures unfortunately may lead to some un-wanted consequences,

ww w. stu dyi n t e ra cti v e .or g

THE TERMS OF TRADE

The terms of trade is expressed

If price of exports fall relative to imports

the trade balance will deteriorate.

If the price of exports increases relative to imports

the trade balance will

Measuring the terms of trade

Unit value of exports

Price of exports 2011/price of exports 2010

What is the missing index number?

ww w. stu dyi n t e ra cti v e .or g

ABSOLUTE & COMPARATIVE ADVANTAGE THEORY

o Two countries A & B;

Using all of their resources they can produce

It is clear that Country A has an absolute advantage in the production of both