Economic growth and development:

Foreign exchange market

(Globalisation)

CAPS requirements

Examination of the foreign exchange market, the establishment of exchange rates, and how the balance of payments account is affected.• The main reasons for international trade• The balance of payments• Foreign exchange markets• The establishment of foreign exchange rates• Corrections of BOP surplus and deficit

(disequilibria)

The main reasons for international trade

International trade: exchange of goods and services across international boundaries.

Globalisation: worldwide movement toward economic, financial, trade, and communications integration.

Uneven distribution of factors of production

Natural resources are unevenly distributed

Labour and technology differences• Differences in skills• Lower production costs • Inability to convert raw materials into

consumer products.

Different climatic conditions

Absolute Advantage

Absolute advantage: due to specialisation, one country can produce a product at a lower cost than the other country.

What should they do?

What will equitable terms of trade be?

Current Opportunity Cost/Domestic terms of trade for DVD’s

Opportunity cost of DVD’s lower in Japan. Basis for trade exists.Opportunity cost of DVDs in SA = 5 bags of wheat.

Opportunity cost of DVDs in Japan = 0,25 bags of wheat.

Ship 5 bags of wheat to Japan = 20 DVDs(5 ÷ 0.25 = 20)

Trade is beneficial if SA specialise in wheat and trade surplus with Japan in exchange for DVD’s.

Opportunity cost/Domestic Terms of Trade for Wheat

Opportunity cost of one bag of wheat in Japan = 4 DVDsOpportunity cost of one bag of wheat in SA = 0,2 DVDs

Ship 4 DVDs to South you’d get 20 bags of wheat.(4 ÷ 0.2 = 20)

Trade is beneficial if Japan specialise in DVD’s and trade surplus with SA in exchange for wheat.

Comparative advantageIf one country has absolute advantage everything, does not mean that they shouldn’t trade.

Why not? Principle of comparative advantage.

SA has an absolute advantage in production of both Wheat and DVD’sShould SA trade with Japan??? We need to look at opportunity costThe opportunity cost of producing a DVD is

lower in Japan than in SA.

Relative cost of producing DVDs lower in Japan than SA even though absolute cost is higher.

A basis for trade now exists.Japan specialise in DVDs.

Exchange 1 DVD for 5 bags of wheat from SA.

SA specialise in wheatExchange 5 bags of wheat for 2,5 DVDs.

Comparative (relative) advantage

All that is required for both countries to benefit from trade is that the opportunity costs of production differ between the two countries. David Ricardo (1772–1823)

Comparative Advantage Example

• Germany has an absolute advantage over South Africa in the production of __________.

Cars(per day)

Barrels of wine(per day)

South Africa 1 6Germany 2 8

Gains from trade

• Has Germany got anything to gain from trading with South Africa???

• Lets look at the OC of production…OC of producing 1

CarOC of producing 1

Barrel of wine

South Africa 6 1/6Germany 4 1/4

Cars(per day)

Barrels of wine(per day)

South Africa 1 6Germany 2 8

Germany has a relative or comparative advantage in the production of _______

South Africa has a relative or comparative advantage in the production of _______

Terms of trade

South Africa will shift resources into wine production if it can exchange fewer than 6 barrels of wine for a car from Germany.

Germany will shift resources into car production if it can obtain more than 4 barrels of wine for every car it sends to South Africa.

Beneficial if 1 car is exchanged for more than 4 but fewer than 6 barrels of wine.

OC of producing 1 Car

OC of producing 1 Barrel of wine

South Africa 6 1/6

Germany 4 1/4

Gains From Trade

Suppose 1 car exchanges for 5 barrels of wine:Germany receives 5 barrels of wine for each car sent to SA. Beneficial for Germany to shift resources from wine to car production and trade the excess cars.

Without trade: 4 barrels of wine for each car sacrificed. After trade: 5 barrels of wine for each car given up.

OC of producing 1 Car

OC of producing 1 Barrel of wine

South Africa 6 1/6

Germany 4 1/4

Gains From Trade

Suppose 1 car exchanges for 5 barrels of wine:South Africa receives 1 car for 5 barrels of wine it sends to Germany. Beneficial for South Africa to shift resources from car to wine production and trade the excess.

Without trade: 1 car for 6 barrels of wine given up. After trade: 1 car for 5 barrels of wine given up.

OC of producing 1 Car

OC of producing 1 Barrel of wine

South Africa 6 1/6

Germany 4 1/4

The Balance of Payments

Foreign exchange markets

Foreign exchange market: market where currencies of different countries are traded for one another.

How are exchange rates determined???• Foreigners demand Rands to buy SA products

or if they wish to visit the country. • South Africans supply Rands when they buy

foreign goods/services or visit a foreign country.

Prices of Currencies

The supply of Rands is determined by:value of imports of goods and servicesprimary income outflowsoutflows on capital transfer and financial accountssale of Rands by the SARB

The demand for Rands is determined by:value of exports of goods and servicesprimary income inflowsinflows on capital transfer and financial accountspurchase of Rands by the SARB

Excess demand (D>S)At US$1 = R4; excess demand for dollarsPrice of dollar rises to US$1 = R6Excess supply (S>D)US$1 = R8; excess supply of dollarsPrice of dollar falls to US$1 = R6

Currency appreciation: currency becomes worth more in terms of another currency.

Eg. R1 = $0,15 to R1 = $0,25.

Currency depreciation: currency becomes worth less in terms of another currency.

Eg. R1 = $0,20 to R1 = $0,15.

The establishment of foreign exchange rates

Exchange rate systems: ways that countries choose to manage their currencies in relation to the foreign exchange market.

3 types of exchange rate systems…1. Free floating exchange rates2. Controlled/managed floating exchange rates3. Fixed exchange rates

1. Free floating/flexible exchange rate system: exchange rate determined by market forces.

• No intervention by central banks

2. Managed floating exchange rates: central bank allows the currency’s value to be determined by market forces, but intervenes in the foreign exchange markets to manage the process.

• Central bank needs significant level of foreign currency reserves to implement this.

Example of central bank interventionDesired rate: R7 = $1 ↑in the D for importedgoods by SA; DD → D1D1

Excess demand → R depreciates (R9 = $1 )SARB supplies $ to the marketSupply curve shifts (SS to S1S1)Exchange rate remains at R7 = $1.

3. Fixed exchange rate: government determines the exchange rate (short term) based on the value of another country’s currency.

Revaluation: raise the value of the country’s currency in relation to a foreign currency.• R20 : $1 → R10 : $1

Revaluation: decreases the value of the country’s currency in relation to a foreign currency.• R10 : $1 → R20 : $1

Please answer Activity 3 on page 103

Corrections of BOP surplus and deficit (disequilibria)

Balance of payments disequilibria: when outflow of foreign currency continuously > or < inflow of foreign currency.

What does a deficit/surplus on BOP accounts mean?

Current accountDeficit: imports > exports• Lacking productive potential?• High inflation?• Investing in capital goods for future growth?Surplus: exports > imports• High levels of productivity• Meeting foreign demand ahead of domestic

demand?• Weak domestic demand?

Financial Account• Are we worth investing in?• Are investments increasing or decreasing?

Capital Transfer Account• Are we a desirable place to live & work?• Shows immigrants/emigrants moving assets

into/out of the country

Causes of disequilibria

If current account deficit is the cause, increase exports and/or decrease imports. • export promotion • import substitution – producing products

locally and decrease imports,• import tariffs, duties and quotas –increases

price of imports

If financial account deficit is the cause, increase financial capital inflows and/or decrease financial capital outflows.

• interest rates –increase in relative interest rate in SA causes inflows of hot money

• exchange controls –limit placed on capital outflows.

Automatic corrections

Assume a free-floating exchange rate.• Deficit in SA’s BOP. • Demand for foreign exchange > supply, • Fall in value of R• Exports become relatively cheaper/imports

costlier • Leads to increase in exports/fall in imports • BOP equilibrium restored!