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)

exchange of goods and services across international boundaries. International trade: exchange of goods and services across international boundaries. worldwide movement toward economic, financial, trade, and communications integration. Globalisation: worldwide movement toward economic, financial, trade, and communications integration.

Natural resources are unevenly distributed Labour and technology differences Differences in skills Lower production costs Inability to convert raw materials into consumer products.

due to specialisation, one country can produce a product at a lower cost than the other country. 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 Current Opportunity Cost/ Domestic terms of trade for DVD’s Opportunity cost of DVD’s lower in Japan. Basis for trade exists. SA5 Opportunity cost of DVDs in SA = 5 bags of wheat. Japan 0,25 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/ Domestic Terms of Trade for Wheat Japan 4 DVDs Opportunity cost of one bag of wheat in Japan = 4 DVDs SA0,2 DVDs Opportunity 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.

If 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’s Should SA trade with Japan??? We need to look at opportunity cost The opportunity cost of producing a DVD is lower in Japan than in SA. Relative absolute 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 wheat Exchange 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 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 16 Germany28

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 Car OC of producing 1 Barrel of wine South Africa 61/6 Germany41/4 Cars (per day) Barrels of wine (per day) South Africa 16 Germany28  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 61/6 Germany41/4

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: Without trade: 4 barrels of wine for each car sacrificed. After trade: 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 61/6 Germany41/4

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: Without trade: 1 car for 6 barrels of wine given up. After trade: 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 61/6 Germany41/4

market where currencies of different countries are traded for one another. Foreign exchange market: market where currencies of different countries are traded for one another. How are exchange rates determined??? demand Foreigners demand Rands to buy SA products or if they wish to visit the country. supply South Africans supply Rands when they buy foreign goods/services or visit a foreign country.

At US$1 = R4; excess demand for dollars Price of dollar rises to US$1 = R6 US$1 = R8; excess supply of dollars Price of dollar falls to US$1 = R6

more Currency appreciation: currency becomes worth more in terms of another currency. $0,15 $0,25. Eg. R1 = $0,15 to R1 = $0,25. less Currency depreciation: currency becomes worth less in terms of another currency. $0,20 $0,15. Eg. R1 = $0,20 to R1 = $0,15.

ways that countries choose to manage their currencies in relation to the foreign exchange market. 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 rates 2.Controlled/managed floating exchange rates 3.Fixed exchange rates

exchange rate determined by market forces. 1.Free floating/flexible exchange rate system: exchange rate determined by market forces. No intervention by central banks

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

Desired rate: R7 = $1 ↑ in the D for imported goods by SA; DD → D 1 D 1 Excess demand → R depreciates (R9 = $1 ) SARB supplies $ to the market Supply curve shifts (SS to S 1 S 1 )Exchange rate remains at R7 = $1.

government determines the exchange rate (short term) based on the value of another country’s currency. 3. Fixed exchange rate: government determines the exchange rate (short term) based on the value of another country’s currency. raise the value of the country’s currency in relation to a foreign currency. Revaluation: raise the value of the country’s currency in relation to a foreign currency. R20 : $1 → R10 : $1 R20 : $1 → R10 : $1 decreases the value of the country’s currency in relation to a foreign currency. Revaluation: decreases the value of the country’s currency in relation to a foreign currency. R10 : $1 → R20 : $1 R10 : $1 → R20 : $1

Activity 3 Please answer Activity 3 on page 103

when outflow of foreign currency continuously > or or < inflow of foreign currency.

Current account Deficit: 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

current account deficit 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

financial account deficit 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.

Assume a free-floating exchange rate. Deficit in SA’s BOP. Deficit in SA’s BOP. Demand for foreign exchange > supply, Demand for foreign exchange > supply, Fall in value of R Fall in value of R Exports become relatively cheaper/imports costlier Exports become relatively cheaper/imports costlier Leads to increase in exports/fall in imports Leads to increase in exports/fall in imports BOP equilibrium restored! BOP equilibrium restored!