No country produces everything it needs. This chapter covers why countries trade, the barriers they put in the way, the exchange rates that link currencies, and the balance of payments.
6.1 Specialisation and free trade
Specialisation by country
Basis: best use of resources (a country with fertile land specialises in farming; one with oil in oil) and low-cost production (cheap labour, skilled workers, technology). It then exports its specialist goods and imports others.
| Advantages | Disadvantages |
|---|---|
| higher output and efficiency (resources used where they are most productive) | overdependence on a few products: a fall in world prices or demand harms the economy |
| lower prices and more choice for consumers | decline of other industries and job losses (structural unemployment) |
| economies of scale | vulnerable to changes in other countries or disruption of trade |
| more trade and income | risk of depleting natural resources |
Free trade
| Advantages | Disadvantages |
|---|---|
| lower prices and greater choice for consumers | domestic firms may be driven out by foreign competition, causing job losses |
| competition pushes firms to be efficient and innovate | new (infant) industries cannot grow against established foreign firms |
| firms access bigger markets and economies of scale | risk of dumping and dependence on imports |
| encourages specialisation and growth | less control over strategic industries; harms the environment through more transport |
6.2 Globalisation and trade restrictions
Globalisation
Causes of changes in globalisation:
- fewer trade restrictions (tariffs lowered, trade agreements and trading blocs)
- falling transport costs (container ships, air freight)
- falling communication costs (the internet, mobile phones)
- the movement of multinational companies (MNCs) to new countries.
Effects of globalisation on:
| Area | Effect |
|---|---|
| International trade | grows (more imports and exports) |
| Competition | rises (foreign firms enter markets), forcing efficiency but harming weaker firms |
| The environment | more transport, pollution and resource use; but also spread of green technology and agreements |
| Migration | more people move for work |
| Income distribution | can widen inequality (skilled workers gain; low-skilled workers in rich countries lose jobs; wages low in poor countries) or narrow the gap between countries |
| Economic development | more trade, investment, technology and jobs may speed development; but poorer countries may become dependent |
Multinational companies (MNCs)
An MNC is a firm that operates in more than one country.
| Host country (where the MNC operates) | Home country (where it started) | |
|---|---|---|
| Advantages | jobs, investment, new technology and skills, exports, tax revenue, more choice | profits are sent back (repatriated), may create jobs in head office, access to cheaper goods |
| Disadvantages | local firms may close, profits repatriated, exploitation of workers or resources, pollution, the MNC may leave | jobs lost if production moves abroad, lower tax revenue from moved activity |
Trade restrictions (methods of protection)
| Method | Meaning |
|---|---|
| Tariff | a tax on imports, raising their price |
| Import quota | a limit on the quantity of a good that may be imported |
| Subsidy | government payment to domestic producers, lowering their costs and so their prices compared with imports |
| Embargo | a complete ban on trade with a country or in a product (often for political reasons) |
Reasons for trade restrictions
- Protect infant (sunrise) industries: new industries need time to grow before they can compete.
- Protect declining (sunset) industries: to slow job losses while workers retrain.
- Protect strategic industries: defence, food, energy, for national security.
- Avoid dumping: selling goods abroad below cost to drive out competition.
- Reduce a current account deficit: imports fall.
- Raise tax revenue (tariffs).
- Restrict imports of demerit goods (drugs).
- Promote environmental sustainability (restricting imports of products that harm the environment).
Consequences of trade restrictions
| Home country | protects jobs and industries; higher prices and less choice for consumers; less efficient firms; may raise revenue (tariffs) |
| Trading partners | lower exports and income; risk of retaliation (a trade war) |
Overall: restrictions protect certain groups at the cost of consumers and efficiency, and risk retaliation, while helping home firms to survive or grow.
6.3 Foreign exchange rates
Why currencies are bought and sold
- Trade in goods and services: importers need foreign currency; foreign buyers of exports need the exporter's currency.
- Speculation: buying a currency in the hope it will rise in value and selling for profit.
- Government intervention: central banks buy or sell currency to influence the rate.
- Payment of profit, interest and dividends between countries (for example an MNC sending profits home).
- Workers' remittances: money sent home by people working abroad.
- Investment in capital goods between countries (buying foreign companies and property).
Determination of the exchange rate
A floating exchange rate is determined by the demand for and supply of the currency in the foreign exchange market, without government fixing.
- Demand for a currency comes from foreigners buying that country's exports, investing there or speculating on it. The demand curve slopes downwards.
- Supply of a currency comes from residents buying imports and investing abroad. The supply curve slopes upwards.
- The equilibrium exchange rate is where demand = supply.
Appreciation: the currency rises in value (it buys more foreign currency). Depreciation: the currency falls in value.
Causes of fluctuations:
| Change | Effect |
|---|---|
| Increase in demand for exports | more demand for the currency, so appreciation |
| Increase in demand for imports | more supply of the currency (to buy foreign money), so depreciation |
| Higher interest rate | foreign savers want to deposit money there, so demand for the currency rises and it appreciates |
| Speculation | if people expect a currency to fall, they sell it, so it depreciates |
Consequences of changes
| Currency appreciates | Currency depreciates | |
|---|---|---|
| Export prices (to foreigners) | rise, so demand for exports falls | fall, so demand for exports rises |
| Import prices (in the home market) | fall, so demand for imports rises | rise, so demand for imports falls |
| Overall | exporters and tourism lose; importers and consumers gain | exporters gain; imports (and inflation) become dearer |
6.4 Current account of the balance of payments
The balance of payments records all money flowing into and out of a country in a year. The current account records trade and income flows.
Components
| Component | What it includes |
|---|---|
| Trade in goods | exports and imports of physical goods (the "visible" balance) |
| Trade in services | exports and imports of services (tourism, banking, shipping) |
| Primary income | income from abroad: profits, interest and dividends, and wages of workers abroad |
| Secondary income | transfers with no payment in return: remittances, foreign aid, gifts |
Causes of a deficit and surplus
- Deficit: imports greater than exports: high consumer demand for imports, uncompetitive exports (high prices, poor quality), an overvalued exchange rate, a rise in oil import prices, falling demand abroad.
- Surplus: strong exports, a low (competitive) exchange rate, high savings and low spending on imports, large remittances.
Consequences
| Deficit | Surplus | |
|---|---|---|
| GDP and employment | exports less than imports lowers total demand, so slower growth and lower employment; but cheaper imports help consumers | more demand for exports, so higher GDP and employment |
| Inflation | a falling currency makes imports dearer, causing inflation | rising currency lowers import prices; strong demand may cause inflation |
| Exchange rate | pressure for the currency to depreciate | pressure to appreciate |
| Other | must borrow or use reserves to pay for the deficit; a large persistent deficit is unsustainable | may mean low consumption at home and tension with trading partners |
Policies for balance of payments stability
| Policy | How it helps |
|---|---|
| Higher interest rates / contractionary fiscal policy | reduce demand for imports (but also slow growth) |
| Lower exchange rate | makes exports cheaper and imports dearer |
| Supply-side policies | raise productivity and quality, making exports more competitive (slow, but long-term) |
| Trade restrictions (tariffs and quotas) | cut imports (but may cause retaliation) |
| Promoting exports | export grants, trade missions, tourism |
Effectiveness: demand-side policies work quickly but reduce growth and employment; a lower exchange rate may raise import prices and inflation; supply-side policies are long-term; trade restrictions risk retaliation. Combining them is usually best.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.