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Chapter 5 Macro II

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32 views22 pages

Chapter 5 Macro II

Uploaded by

alexjacky718
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FOREIGN TRADE AND BALANCE OF

PAYMENT

(AgEco)

Instructor: kumala.D
Objectives of the lesson
At the end of this lesson, you
able to understand;

◦ Foreign Trade and Balance of Payment


◦ Theory of Absolute Cost Difference (Adam Smith)
◦ Balance of Payment Impacts of Foreign Exchange
Rate on BOP
Foreign Trade and Balance of Payment

Domestic (nations) trade with one other


because they gain from exchange of goods
and services.

Domestic trade is among people living in the


same country.
….Cont’d
International trade refers to the exchange of goods
and services among different countries of the world.

 Factors determining international trade;


◦ Unequal distribution of natural resources,
◦ unequal distribution of population,
◦ unequal distribution of capital,
◦ Level of technological development,
◦ Increasing returns to scale,
◦ Difference in demand.
….Cont’d
Advantages of international trade:

 Variety of goods,


 Availability of raw material and specialized goods,
 Specialization and division of labour,
 Increase in efficiency through widening of market,
 Cheaper goods,
 Competition,
 Optimum allocation of resources,
Theory of Absolute Cost Difference

An absolute cost difference arises when one


country can produce a commodity at a lower
cost compared to another country, and the
other country can produce some other
commodity at a lower cost compared to the
first country.
….Cont’d
 Thus, an absolute cost difference arises when each
of the two countries can produce some commodities
at an absolutely lower production cost than the other.

A country tends to specialize in producing that


particular commodity which it can produce at an
absolutely lower cost and exports it to other
countries.
Country Coffee Wheat
India 4 8
Ethiopia 8 4

1 labourer can produce 4 units of coffee and 8 units of wheat


in India, whereas in Ethiopia 1 labourer can produce 8 units
of coffee and 4 units of wheat.

•India has an absolute advantage in producing wheat and an


absolute disadvantage in producing coffee.

•Hence, India would specialise in the production of wheat


and export it in exchange for coffee from Ethiopia.
Theory of Comparative Cost (David Ricardo )

One country can produce both commodities


at a lower cost than the other country.

The first country has an absolute advantage


in the production of both of the commodities,
and the other has an absolute disadvantage in
the production of both commodities.
….Cont’d
A comparative difference in costs means that
one country can produce both goods at an
absolutely lower cost than a second country,

 but the first country’s cost for the


production of one of those goods is
comparatively lower than its cost of
….Cont’d
 The second country produces both goods at an

absolutely higher cost than the first country does, but it

has less of a comparative in the production of one good

than in the production of the other good.

 According to the theory of comparative cost, a country

tends to specialize in the production of those goods for

which it has lower comparative costs.


Balance of payment

 Balance-of-payments accounting records all economic

transactions (trade in goods, services, and assets) between a

country and the rest of the world.

 A country’s balance of payment accounting accounts for its

payments to and its receipts from foreigners.

 An international transaction involves two parties, and each

transaction enters the accounts twice: once as a credit (+) and


FOREIGN EXCHANGE RATES

Foreign Exchange Rate


 The price of one currency in terms of another is known
as their foreign exchange rate.
 It is the rate at which one unit of a foreign currency is
exchanged for domestic currency.
 There are various concepts of exchange rate system.
 Its two broad types are
◦ Fixed Exchange Rate and

◦ Floating Exchange Rate.


….Cont’d
 Fixed Exchange Rate

 The fixed exchange rate is the rate which is officially


fixed (or pegged) in terms of gold or any other
currency by the government and adjusted only
infrequently.

 In this system, foreign central banks stand ready to


buy and sell their currencies at a fixed price.
….Cont’d
 Floating Exchange Rate
 The floating exchange rate is the rate which is
determined by forces of supply and demand in the
foreign exchange market.

 There is no (official) government intervention.


 Under this system, the central banks, without
intervention, allow the exchange rate to adjust so as to
equate the demand and supply for foreign currency.
Changes in the Value of a
Currency
 The value of a currency in terms of foreign
currency may increase or decrease under these
two systems of exchange rate, i.e., fixed and
floating.

 Under a fixed exchange regime, when a country


raises the value of its currency in terms of foreign
currency, it is called revaluation.
….Cont’d
when a country brings down the value of its
currency in terms of foreign currency it is
called devaluation.

For example, in 1983 E.C., the Ethiopian


transitional government devalued the
exchange rate of birr from birr 2.07 per US
….Cont’d
Thus, because of devaluation, more birr

were required to buy one US dollar, i.e., the

value of birr in terms of dollar went down.


….Cont’d
Under the floating exchange rate system;
 an increase in the value of a currency
interims of foreign currency is called
appreciation.

A fall in the value of a currency in terms of


foreign currency is called depreciation.
Impacts of Foreign Exchange Rate on BOP

The balance of payments account of a country


largely indicates the monetary aspect of its
foreign trade, i.e., exports and imports.

Exports earn foreign currency for a country,


whereas imports imply the spending of
foreign currency by the country.
….Cont’d
Naturally, a change in the value of the currency
of the country, in terms of foreign currency, has
an impact on its balance of payments.

 An increase in the value of the currency of a


country makes its imports cheaper and its
exports costlier (for foreign countries).
….Cont’d
 In such a situation, imports increase and exports decrease,
thus leading to a trade deficit, i.e., an unfavorable balance
of payments.

 A decrease in the value of the currency of a country in terms


of foreign currency makes its imports costlier (for the local
buyers) and exports cheaper (for the foreign buyers).

 In this situation, imports decrease and exports increase, thus


leading to a trade surplus or favorable balance of payments.

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