Chapter 16: The foreign sector
Introduction
Open economy (degree of integration into international economy)
❖ Extent of country’s involvement in international trade & finance
❖ SA economy = open
Globalisation
❖ Process whereby world’s economies become increasingly integrated
❖ Trade expanded; capital markets sprung up; ↑ tourism; new technologies
❖ FoP became extremely mobile & development in 1 country have implications for other countries
Why countries trade
Absolute advantage
❖ When country, company, individual produces g+s at lower cost per unit (more efficiently) than
any other can produce same g+s
❖ Obvious benefits of trade
❖ Specialise in what you’re best at
Comparative/relative advantage
❖ Total output of group of individuals, economy, countries greatest when output of each good
produced by person, firm, country with lowest opportunity cost for that good
❖ 2 Countries benefit from trade in specific g+s with one another if opportunity cost of production
/ relative prices differ between 2 countries
❖ Specialise where opportunity costs are lowest
❖ In action = countries don’t trade with each other, firms do
⬧ Exchange ratio must lie between opportunity cost ratios
Equal advantage
❖ Opportunity costs for producing g+s is same in 2 countries
❖ No basis for international trade between 2 countries for g+s
❖ International trade only occurs if comparative advantages exist
Trade policies
Gvrn policy with purpose of opening economy to & benefitting from international trade, while
protecting domestic firms from foreign competition & controlling volume of imports entering the
country
Import tariffs
❖ Measures implemented by gvrn to directly intervene in market mechanism & control physical
level of imports to country
❖ Protective tariffs:
⬧ Protect domestic firms against international import competition
❖ Revenue tariffs:
⬧ Imposed on items not produced in local market
⬧ Raises gvrn revenue
❖ 2 Categories:
⬧ Specific tariffs - Fixed amount per unit
⬧ Ad valorem tariffs - Levied as % on items not produced in local market
Import quotas
❖ Measures implemented by gvrn to directly intervene in market mechanism & control physical
level of imports to country
❖ Serves to protect domestic firms against international competition and has same economic
consequences as import tariffs
Subsidies
❖ Type of gvrn aid in form of amount paid to / tax benefit for producers / consumers to remove
burden of cost
❖ Ensures that price remains competitive / income remains stable
❖ Alternative to max / min prices
❖ Advantages:
⬧ Doesn’t interfere with market’s natural pricing mechanism, while protecting consumer &
producer from price changes
⬧ Cost of subsidy is explicit
Other non-tariff barriers
❖ Admin process of country makes it difficult for countries to trade with another
❖ Red tape; licensing requirements; deliberately channelling gvrn contracts to domestic firms;
technical standards
Exchange controls
❖ Restricts imports by limiting amount of foreign currency available for purchase
Exchange rate policy (floating / fixed)
❖ Way country manages its currency in respect to foreign currencies & foreign exchange market
❖ Managed by central bank & more effective than other measures as it directly affects X + Z
❖ Movements in exchange rates impact:
⬧ Economic growth
⬧ Employment
⬧ Inflation
⬧ BoP
⬧ Wellbeing of individuals
Arguments for
❖ BoP better
❖ Prevents dumping
❖ Export subsidies
❖ Protects infant industries
❖ Improves employment
❖ Raises gvrn revenue
❖ National security
Arguments against
❖ Retaliation by trade partners
❖ Welfare cost to society:
⬧ Consumers pay higher prices
❖ Inefficiency:
⬧ Producers have less incentive to reduce cost & increase efficiency
❖ Consumers in protected country lose out on foreign prices & products
❖ Producer in protected country lose out on foreign trade
Exchange rates
Price of currency in terms of another currency
Can be
❖ Direct quotation: (used by most countries) $1 = R0.05
⬧ Foreign currency in terms of home currency
❖ Indirect quotation: R1 = $18
⬧ Home currency in terms of foreign currency
Foreign exchange market
❖ International market in which 1 currency exchanged for other currencies
❖ Doesn’t have specific location
❖ Forex market consists of:
⬧ Demand for currency
⬧ Supply of currency
⬧ Equilibrium exchange rate
❖ SA’s consists of all authorised currency dealers+major banks
Appreciation
❖ Increase in value / price on 1 currency in terms of another
Depreciation
❖ Decrease in value / price of 1 currency in terms of another
Impact
Change Illustrated by
Rand Dollar
↑ demand for dollars Demand curve shifts Depreciates Appreciates
right
↑ supply of dollars Supply curve shifts Appreciates Depreciates
right
↓ demand for dollars Demand curve shifts Appreciates Depreciates
left
↓ supply for dollars Supply curve shifts Depreciates Appreciates
left
Impact on
Change
Export prices in $ Import prices in R Current account Domestic prices
R depreciates ↓ ↑ Improves ↑
R appreciates ↑ ↓ Worsens ↓
Fixed exchange rate
❖ Gvrn (via central bank) determines value of country’s currency relative to other currencies
Floating exchange rate
❖ Price of country’s currency determined by supply & demand on open market, relative to other
currencies
❖ 3 policy options:
⬧ Do nothing
⬧ Intervene in foreign exchange market
⬧ Use interest rates to influence
❖ Managed floating:
⬧ Managed to some extent by central banks through buying / selling foreign exchange
⬧ Done due to potential volatility of exchange rates & authorities want to pursue policy
objectives
Terms of trade
Ratio between export prices (expressed as index) & import prices (expressed as index)
Rate at which country can trade domestically produced goods for imported goods
𝑒𝑥𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥
𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = 𝑥 100
𝑖𝑚𝑝𝑜𝑟𝑡 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥