The Issue of custom union

(chapter 10)

Degree of Economic Integration

• Preferential trade area (PTA): Lower level of trade tariff within the area

• Free trade area (FTA): No tariff between member counties + each nation retains its own barriers to trade with non-members

• Custom union: FTA+ harmonized trade policies toward the rest of the world

• Common market: = custom union + free movement of labor and capital within the member states

• Economic union: = common market + harmonizing or even unifying the monetary and fiscal policies

Trade Creation Customer Union

Assumption: -Country 2 needs to import a commodity which is produced in both countries 1 and 3.-Country 2 imposes a tariff of 100%.- The selling price is P3 = 1.5 and P1 = 1

Conclusion: Country 2 will imports JH=30 units from country 1 at P1 = 1 and the domestic price in country 2 is P2 = 2

Trade Creating Customer UnionAfter a custom union is created between countries 1 and 2:

-Country 2 still import from country 1 because it is cheaper than from country 3

-The domestic price in country 2 now is 1, instead of 2 (because of no tariff)

-County 2 will now import CB=60 unit > JH=30 units. Country 2 imports more from nation 1 (which means country 2 reduces its domestic production). We call this trade creation.

-Net benefit to country 2 is represented by JCM and HNB

Trade - Diverting Customer UnionAssumption: -Country 2 needs to import a commodity which is produced in both countries 1 and 3.-Country 2 imposes a tariff of 100%.- The selling price is P3 = 1.5 and P1 = 1

Conclusion: Country 2 will imports JH=30 units from country 1 at P1 = 1 and the domestic price in country 2 is P2 = 2

Trade - Diverting Custom Union

After a custom union is created between countries 2 and 3:

-Country 2 will now import from country 3 , not from country 1 as before, because the after-tax price if importing from country 1 is now higher than if importing from country 3

-We call the above: trade diverting custom union

-This trade-diverting custom union also lead to some trade creation, because country 2 now import C’B’ =45 , instead of JH=30.

-Net gain to country 2 = C’J’J+B’H’H-MNH’J’

Trade – Creating versus Trade – Diverting Custom Union

• Trade creation occurs when some domestic production in a nation that is a member of the custom union is replaced by lower-cost imports from another member nation.

– Trade creation union increases welfare of member nations because it leads to greater specialization in production based on comparative advantage.

Trade – Creating versus Trade – Diverting Custom Union

• Trade diversion occurs when lower – cost imports from outside the customs union are replaced by higher cost imports from a union member.

– Trade diversion reduce welfare because its shifts production from more efficient producers outside the customs union to less efficient producers inside the union

– Trade diversion worsens the international allocation of resources and shifts production away from comparative advantage.

– Regarding member nation: because trade diversion results in both trade creation and trade diversion, therefore the final welfare effects on member nations is not clear

Conditions more likely to lead to increased welfare

• High preunion trade barriers of member countries• Low customs union’s barriers on trade with the rest of

the world• Great number of countries forming the customs union

and the large size of the custom union• Member countries are competitive rather than

complementary • Close geography of member countries• Great preunion trade and economic relationship among

potential members of the custom union

The Issue of International Capital and Labor Movement

Advantages/ disadvantages of a company investing in other countries

Advantages• Earn a higher returns • Diversify risk (risk diversification)• Have some unique production knowledge or

managerial skill that could easily and profitably be utilized abroad. The company wants to retain direct control over them.

• Obtain control of a needed raw material, ensuring an uninterrupted supply at the lowest possible cost

• Avoid import tariff imposed by the host countriesDisadvantages (think yourself)

Advantages/ disadvantages of a country that receives foreign investment (host country)

Advantages

• Gain a net welfare (see figure 12.1 in next slide)

• Job creation, redistribution of income from capital to labor

• Improved BoP

• Tax collection

Disadvantages (think yourself)

FIGURE 12-1 Output and Welfare Effects of International Capital Transfers.

Effects on the investing country

• Gain a net welfare (see the figure 12.1 in previous slide)

• Redistribution of income from labor to capital

• Deteriated BoP in initial years, improved BoP in later years (the lag is about 5-10 years)

• Reduced tax collection• Others (think yourself)

Welfare Effects of International Labor Migration

World net welfare increases by EGM

Wage in nation 1 increases from OC to ON

Wage in nation 2 drops from O’H to O’T

FIGURE 12-2 Output and Welfare Effects of International Labor Migration.

The Issue of Strategy for Industrialization (chapter 11)

Import Substitution Industrialization (ISI): Advantages

• The market for the industrial product already exists, as evidenced by imports of the commodity, so that risks are reduced in setting up an industry to replaced imports

• It is easier for developing nations to protect their domestic market against foreign competition than to force developed nations to lower trade barriers against their manufactured goods

• Foreign firms are induced to established so-called tariff factories to overcome the tariff wall of developing nations

Import Substitution Strategy (ISI): Disadvantages

• Domestic industries can grow accustomed to protection from foreign competition and have no incentive to become more efficient

• Import substitution can lead to inefficient industries because of small economies of scale

• After the simpler manufactured imports are replaced by domestic production, import substitution becomes more and more difficult and costly are more capital-intensive and technologically advanced imports have to be replaced by domestic production

Export-Oriented Industrialization: Advantages vs Disadvantage

Advantages:• Overcomes the smallness of the domestic market and allow to take

advantage of economies of scale• Production of manufactured goods for export requires and

stimulates efficiency throughout the economy• The expansion of manufactured exports is not limited

Disadvantages:• It may be very difficult for developing nations to set up export

industries because of external competition• Developed nations often provide a high level of effective protection

for their industries producing simple labor-intensive commodities in which developing nations already have or can soon acquires a comparative advantage

International Experiences

• Example of countries pursuing ISI: India, Pakistan, Argentina, Nigeria, former socialist countries such as Soviet Union, Vietnam etc

• Example of countries pursing export-oriented industrialization: South Korea, Taiwan, Singapore and Hongkong

• International experience seems to show that countries following the export-oriented strategy is more successful than countries following ISI (Read table 11-3 you will find that “Globalizers” grow much faster than “Nonglobalizers”)

The Issue of choosing foreign exchange rate regime (chapter 20)

Advantages of flexible exchange rate Regime

1. Market efficiency: • In order to correct a BoP disequilibrium,

– Under flexible exchange rate regime: Only need the change in the exchange rate

– Under the fixed exchange rate regime: All internal prices need to be perfectly flexible

– It is more efficient or less costly to change only one price (that is the exchange rate) than to change all the internal prices. Thus flexible exchange rate regime is more efficient than fixed exchange rate regime in correcting a BoP disequilibrium

Advantages of flexible exchange rate Regime

1. Market efficiency: • Speculations:

– Under flexible exchange rate regime: Exchange rate corrects the BoP disequilibrium smoothly. This more likely to results in stabilizing speculation, reducing the exchange rate fluctuation

– Under the fixed exchange rate regime: Govt. usually reluctant to change the exchange rate, leading to destabilizing speculation. This finally forces govt. to make a large discrete change in its exchange rates

• Exchange rate contributes to the determination of prices. A flexible exchange rate will help to determine the right prices of goods and service, therefore the nation will allocate resources more efficiently.

Advantages of flexible exchange rate Regime

2. Policy advantage:• Under flexible exchange rate regime: The govt. need not concern

itself with its external balance and thus can concentrate on other goals of economy (full employment, price stability, internal balance etc..)

• Flexible exchange rate regime enhances the effectiveness of monetary policy (in controlling inflation, in pursuing the trade-off between inflation and employment)

• Flexible exchange rate prevents the govt. from setting different exchange rates for different economic sectors, which creates inequality and inefficient allocation of resources

• Flexible exchange rate regime help the govt. saves its foreign reserve because it does not have to intervene in the foreign exchange market to restore its equilibrium

Advantages of Fixed exchange rate Regime

1. Less certainty• Fixed exchange rate regime avoids the day-to-day fluctuations of the

exchange rate, thus making it easier for businessmen to make financial plan, for flow of international trade and investment

2. Stabilizing speculation• Fixed exchange rate regime reduces the operation of Destabilizing

speculation• Destabilizing speculation: Purchase a foreign currency when the

exchange rate is rising, in the expectation that the exchange rate will rise even more; and selling the foreing currency when the exchange rate is falling, in the expectation that the exchange rate will fall even more.

• Destabilizing speculation: amplifying the exchange rate fluctuation, amplifying the uncertainty and risk for international transaction. It is not good.

Advantages of Fixed exchange rate Regime, conclusion

2. Price discipline

• Under flexible exchange rate: politicians can overstimulate the economy to increase the chance of reelection.

• Under fixed exchange rate: stimulation will leads to inflation which, in turns, lead to BoP deficit. Thus politicians can not overstimulate the economy, especially for a long time. They face harder disciplines

Conclusion (view point)

• Fixed exchange rate is preferable for a small open economy that trades mostly with one or a few larger nations and in which disturbances are primarily of a monetary nature

• Flexible exchange rate system seems superior for a large, relatively closed economy with diversified trade and a different inflation – unemployment trade-off than its main trading partners, and facing primarily disturbances originating in the real sector abroad

The Issue of Bretton Woods System (chapter 21)

The Bretton Woods System

• Read Section 21.3, page 476-479• It is the Gold-exchange standard that operated from the end of the

World War II until 1971• US was to maintain the price of gold fixed at 35$/ounce and be

ready to exchange on demand dollars for gold at that price without any restriction or limitation.

• Other nations were to fix the price of their currencies in terms of dollars and intervene in foreign exchange markets to keep the exchange rate from moving by more than 1% above or below the par value

• When a country face large BoP deficit, it is not allowed to devaluate their currency (except for special cases). The deficit must be settled by foreign reserve or by borrowing from IMF

The Bretton Woods System

• When a country is allowed to change their currency par value (the devaluate its currency): only when it faces a fundamental disequilibrium:– If it devaluate less than 10%: no need of an approval from IMF– If it devaluate 10% or more: need an approval from IFM before devaluation

• The operation, the collapse of the Bretton Woods system (read section 21.4 and 21.5)

• The problems of the current international monetary systems (read more on section 21.6 C) : – Large volatility and wide and persistent misalignment of exchange rate– Failure to promote greater coordination of economic policies among the

leading industrial nations– The inability to prevent international financial crises or to deal with them

adequately when they do arise