International Finance
Ms. Shada Tarek
Factors Affecting International Trade Flows
1. Impact of Inflation
If a country’s inflation rate increases relative to the countries with which it trades, its
current account will be expected to decrease, other things being equal.
• Consumers and corporations in that country will most likely purchase more goods
overseas (due to high local inflation), while the country’s exports to other countries
will decline.
2. Impact of National Income
If a country’s income level (national income) increases by a higher percentage than those
of other countries, its current account is expected to decrease, other things being equal.
• As the real income level (adjusted for inflation) rises, so does the consumption of
goods. A percentage of that increase in consumption will most likely reflect an
increased demand for foreign goods.
3. Impact of Government Policies
A country’s government can have a major effect on its balance of trade due to its policies
on subsidizing exporters, restrictions on imports, or lack of enforcement on piracy.
• Subsidies for Exporters.
Some governments offer subsidies to their domestic firms, so that those firms can produce
products at a lower cost than their global competitors. Thus, the demand for the exports
produced by those firms is higher as a result of subsidies.
• Restrictions on Imports.
If a country’s government imposes a tax on imported goods (often referred to as a tariff),
the prices of foreign goods to consumers are effectively increased.
In addition to tariffs, a government can reduce its country’s imports by enforcing a quota,
or a maximum limit that can be imported.
• Lack of Restrictions on Piracy.
In some cases, a government can affect international trade flows by its lack of restrictions
on piracy.
4. Impact of Exchange Rates
Each country’s currency is valued in terms of other currencies through the use of exchange
rates, so that currencies can be exchanged to facilitate international transactions.
• If a country’s currency begins to rise in value against other currencies, its current
account balance should decrease, other things being equal.
• As the currency strengthens, goods exported by that country will become more
expensive to the importing countries. As a consequence, the demand for such goods
will decrease.
International Finance
Ms. Shada Tarek
Correcting a Balance-of-Trade Deficit
• A balance-of-trade deficit may enable a country’s consumers to benefit from
imported products that are less expensive than locally produced products.
• However, the purchase of imported products implies less reliance on domestic
production in favor of foreign production.
• It may be argued that a large balance-of trade deficit causes a transfer of jobs to
some foreign countries.
Consequently, a country’s government may attempt to correct a balance-of-trade deficit.
Any policy that will increase foreign demand for the country’s goods and services will
improve its balance-of-trade position.
1. Foreign demand may increase if export prices become more attractive. This can
occur when the country’s inflation is low or when its currency’s value is reduced,
thereby making the prices cheaper from a foreign perspective.
2. A floating exchange rate could possibly correct any international trade imbalances.
• A deficit in a country’s balance of trade suggests that the country is spending
more funds on foreign products than it is receiving from exports to foreign
countries.
• Because it is selling its currency (to buy foreign goods) in greater volume
than the foreign demand for its currency, the value of its currency should
decrease. This decrease in value should encourage more foreign demand for
its goods in the future.
Why a Weak Home Currency Is Not a Perfect Solution?
Even if a country’s home currency weakens, its balance-of-trade deficit will not necessarily
be corrected for the following reasons.
1. Counter pricing by Competitors.
When a country’s currency weakens, its prices become more attractive to foreign
customers, and many foreign companies lower their prices to remain competitive with the
country’s firms.
2. Impact of Other Weak Currencies.
The currency does not necessarily weaken against all currencies at the same time. Even if
the dollar weakens in Europe, the dollar’s exchange rates with the currencies of Hong
Kong, Singapore, South Korea, and Taiwan may remain more stable.
• For Example, as some U.S. firms reduce their demand for supplies produced in
European countries, they tend to increase their demand for goods produced in Asian
countries. Consequently, the dollar’s weakness in European countries causes a
change in international trade behavior but does not eliminate the U.S. trade deficit.
3. Prearranged International Transactions.
Many international trade transactions are prearranged and cannot be immediately adjusted.
Thus, exporters and importers are committed to continue the international transactions that
they agreed to complete.
International Finance
Ms. Shada Tarek
Identifying Factors That Will Affect the Foreign Demand at the Sports Exports
Company
Identify the factors that affect the current account balance between the U.S. and the U.K.
Explain how each factor may possibly affect the British demand for the footballs that are
produced by the Sports Exports Company.
ANSWER:
1. High inflation in the U.K. could cause a shift in the demand for U.S. products instead
of British products. However, at this time there is not a British producer of footballs,
so that high British inflation will not cause an increase in the demand for U.S.-produced
footballs.
2. High national income in the U.K. could increase the amount of spending by British
consumers, and would therefore cause an increase in the demand for footballs produced
by the Sports Exports Company. A lower national income in the U.K. would have the
opposite effect.
3. Government restrictions could be imposed by the British government on goods (such
as the footballs) exported by U.S. firms. However, footballs are not likely to be targeted
by the British government as a product that should be subject to restrictions.
4. The exchange rate of the British pound will change over time. However, since the
Sports Exports Company is willing to accept pounds when it sells footballs to the
distributor, the distributor does not have to convert the pounds into dollars. Therefore,
the British demand for footballs is not affected by changes in the value of the pound
(unless this causes the Sports Exports Company to change the price it charges for the
footballs someday).