Why do countries trade?

Countries trade with each other when, on their own, they do not have
the resources, or capacity to satisfy their own needs and wants. By
developing and exploiting their domestic scarce resources, countries
can produce a surplus, and trade this for the resources they need.

Clear evidence of trading over long distances dates back at least 9,000
years, though long distance trade probably goes back much further to
the domestication of pack animals and the invention of ships. Today,
international trade is at the heart of the global economy and is
responsible for much of the development and prosperity of the modern
industrialised world.

Goods and services are likely to be imported from abroad for several
reasons. Imports may be cheaper, or of better quality. They may also be
more easily available or simply more appealing than locally produced
goods. In many instances, no local alternatives exist, and importing is
essential. This is highlighted today in the case of Japan, which has no
oil reserves of its own, yet it is the world’s fourth largest consumer of oil,
and must import all it requires.

The production of goods and services in countries that need to trade is

based on two fundamental principles, first analysed by Adam Smith in
the late 18th Century (in The Wealth of Nations, 1776), these being
the division of labour and specialisation.

Division of labour
In its strictest sense, a division of labour means breaking down
production into small, interconnected tasks, and then allocating these
tasks to different workers based on their suitability to undertake the task
efficiently. When applied internationally, a division of labour means that
countries produce just a small range of goods or services, and may
contribute only a small part to finished products sold in global markets.
For example, a bar of chocolate is likely to contain many ingredients
from numerous countries, with each country contributing, perhaps, just
one ingredient to the final product.

Specialisation
Specialisation is the second fundamental principle associated with
trade, and results from the division of labour. Given that each worker, or
each producer, is given a specialist role, they are likely to become
efficient contributors to the overall process of production, and to the
finished product. Hence, specialisation can generate further benefits in
terms of efficiency and productivity.

Specialisation can be applied to individuals, firms, machinery and

technology, and to whole countries. International specialisation is
increased when countries use their scarce resources to produce just a
small range of products in high volume. Mass production allows a
surplus of good to be produced, which can then be exported. This
means that goods and resources must be imported from other countries
that have also specialised, and produced surpluses of their own.

When countries specialise they are likely to become moreefficient over

time. This is partly because a country's producers will become larger
and exploit economies of scale. Faced by large global markets, firms
may be encouraged to adopt mass production, and apply new
technology. This can provide a country with a price and non-price
advantage over less specialised countries, making it
increasingly competitive and improving its chances of exporting in the
future.

The advantages of trade

International trade brings a number of valuable benefits to a country,
including:

1. The exploitation of a country's comparative advantage, which

means that trade encourages a country to specialise in producing
 only those goods and services which it can produce more
effectively and efficiently, and at the lowestopportunity cost.
2. Producing a narrow range of goods and services for the domestic
and export market means that a country can produce in at higher
volumes, which provides further cost benefits in terms
of economies of scale.
3. Trade increases competition and lowers world prices, which
provides benefits to consumers by raising thepurchasing
power of their own income, and leads a rise inconsumer
surplus.
4. Trade also breaks down domestic monopolies, which face
competition from more efficient foreign firms.
5. The quality of goods and services is likely to increases as
competition encourages innovation, design and the application of
new technologies. Trade will also encourage the transfer of
technology between countries.
6. Trade is also likely to increase employment, given that
employment is closely related to production. Trade means that
more will be employed in the export sector and, through the
multiplier process, more jobs will be created across the whole
economy.

The disadvantages of trade

Despite the benefits, trade can also bring some disadvantages,
including:

1. Trade can lead to over-specialisation, with workers at risk of

losing their jobs should world demand fall or when goods for
domestic consumption can be produced more cheaply abroad.
Jobs lost through such changes cause severe structural
unemployment. The recent credit crunch has exposed the
inherent dangers in over-specialisation for the UK, with its reliance
on its financial services sector.
 2. Certain industries do not get a chance to grow because they face
competition from more established foreign firms, such as new
infant industries which may find it difficult to establish themselves.
3. Local producers, who may supply a unique product tailored to
meet the needs of the domestic market, may suffer because
cheaper imports may destroy their market. Over time, the diversity
of output in an economy may diminish as local producers leave
the market.

Go to comparative advantage

The pattern of trade

The global economy has grown continuously since the Second World
War. Global growth has been accompanied by a change in
the pattern of trade, which reflects ongoing changes in structure of the
global economy. These changes include the rise of regional trading
blocs, deindustrialisation in many advanced economies, the increased
participation of former communist countries, and the emergence of
China and India.

Changes in the global economy

The main changes in the global economy are:

1. The emergence of regional trading blocs, where members freely

trade with each other, but erect barriers to trade with non-
members, has had a significant impact on the pattern of global
trade. While the formation of blocs, such as the European Union
and NAFTA, has led to trade creation between members,
countries outside the bloc have suffered from trade diversion.
2. Like several advanced economies, the UK's trade in
manufactured goods has fallen relative to its trade in commercial
and financial services. Many advanced economies have
 experienced deindustrialisation, with less national output
generated by their manufacturing sectors.
3. The collapse of communism led to the opening-up of many
former-communist countries. These countries have increased
their share of world trade by taking advantage of their low
production costs, especially their low wage levels.
4. Newly industrialised countries like India and China have
dramatically increased their share of world trade and their share
of manufacturing exports. China, in particular, has emerged as an
economic super-power. China's share of world trade has
increased in all areas, and not just in clothing and low-tech goods.
For example, in 1995, the US had captured nearly 25% of global
trade in hi-tech goods, while China had only 3%. By 2005, the US
share had fallen to 15%, while China's share had risen to 15%.
(Source: European Central Bank - ECB, Occasional Paper - China and India's Role in Global Trade and
Finance, 2008)

Growth in trade
Although subject to short term fluctuations as a result of the economic cycle, the value of trade has
continued to grow, reflecting the increased significance of trade and globalisation. The chart below shows
that, as a % of world GDP, trade increased from 40% in 1990 to 60% in 2014. The effects of thefinancial
crisis and subsequent recession can also be seen, as world trade fell as a % of GDP between 2008 and
2010.

Growth in world trade (as a % of GDP) 1990 - 2014Source: World

Bankwww.economicsonline.co.uk199020062008201020122014203040506070%
World GDP

Trade openness
The ratio of trade to GDP - an indicator of trade 'openness' - has
increased for most trading nations, and is a result ofglobalisation, and
trade liberalisation.

According to the UK's Department for Business, Innovation and

Skills (BIS) the trade to GDP ratio increase from 51.6 to 61.6 between
2003 and 2013. However, according to the World Bank, UK trade
openness fell to 59% in 2014.

Trade openness is calculated using the following equation:

Trade Openness - selected countries2014 - Source World Bank

(Trade/GDP)www.economicsonline.co.ukSwedenGermanyFinlandNorw
ayGreeceCanadaSpainUKFranceItalyIndiaAustraliaChinaUSA02040608
0100Trade openness = Exports + Imports/GDP

Benefits of trade openness

It is argued that trade openness brings many economic benefits,

including increased technology transfer, transfer of skills, increased
labour and total factor productivity and
economicgrowth and development.
Foreign Direct Investment (FDI)
FDI refers to the flow of capital between countries. According to the
United Nations Conference for Trade and Development (UNCTAD), FDI
is 'investment made to acquire lasting interest in enterprises operating
outside of the economy of the investor.'*

FDI is distinguished from 'portfolio' investment in that, as well as being

'lasting', it means that the investor has control over the assets invested
in. A single flow of capital between two countries is described as
outward for the investing country and inward for the recipient country.
FDI is undertaken by both private sector firms and governments.

FDI associated with cross-border mergers and aquisions can

behorizontal - where the firms are at the same stage of
production;vertical - where firms are at different stages of production;
andconglomerate - where firms are in different industries.
*Source: UNCTAD.ORG : http://www.unctad.org

The growth of FDI has accompanied the rise of globalisation.

According to the World Investment Report, FDI flows in 2013

increased to $1.45 trillion, with developing countries increasing their
share of inflows to (a record level of) 54 per cent, with Asia now ahead
of both the EU and USA.

Globalisation refers to the integration of markets in the global

economy. Markets where globalisation is particularly common
include financial markets, such as capital markets, money and credit
markets, and insurance markets, commodity markets, such as markets
for oil, coffee, tin, and gold, and product markets, such as markets for
motor vehicles and consumer electronics.

Why has globalisation increased?

The pace of globalisation has increased for a number of reasons:

1. Developments in ICT, transport and communications have

accelerated the pace of globalisation over the past 30 years. The
internet has enabled fast and 24/7 global communication, and the
use of containerisation has enabled vast quantities of goods and
commodities to be shipped across the world at extremely low
cost.
2. Increasing capital mobility has also acted as a stimulus to
globalisation. When capital can move freely from country to
country, it is relatively straightforward for firms to locate and invest
abroad, and repatriate profits.
3. The development of complex financial products, such
asderivatives, has enabled global credit markets to grow rapidly.
4. Trade has become increasingly free, following the collapse of
communism, which has opened up many former communist
countries to inward investment and global trade. Over the last 30
years, trade openness, which is defined as the ratio of exports
and imports to national income, has risen from 25% to around
40% for industrialised economies, and from 15% to 60% for
emerging economies.[1].
5. The growth of multinational companies (MNCs) and the rise in the
significance of global brands like Microsoft, Sony, and
McDonalds, has been central to the emergence of globalisation.

The advantages of globalisation

Globalisation brings a number of potential benefits to international
producers and national economies, including:

1. Providing an incentive for countries to specialise and benefit from

the application of the principle ofcomparative advantage.
 2. Access to larger markets means that firms may experience higher
demand for their products, as well as benefit fromeconomies of
scale, which leads to a reduction in average production costs.
3. Globalisation enables worldwide access to sources of cheap raw
materials, and this enables firms to be cost competitive in their
own markets and in overseas markets. Seeking out the cheapest
materials from around the world is called global sourcing.
Because of cost reductions and increased revenue, globalisation
can generate increased profits for shareholders.
4. Avoidance of regulation by locating production in countries with
less strict regulatory regimes, such as those in many Less
Developed Countries (LCDs).
5. Globalisation has led to increased flows of inward
investment between countries, which has created benefits for
recipient countries. These benefits include the sharing of
knowledge and technology between countries.
6. In the long term, increased trade is likely to lead to the creation of
more employment in all countries that are involved.

The disadvantages of globalisation

There are also several potential disadvantages of globalisation,
including the following:

1. The over-standardisation of products through global branding is a

common criticism of globalisation. For example, the majority of the
world’s computers use Microsoft’s Windows operating system.
Clearly, standardising of computer operating systems and
platforms creates considerable benefits, but critics argue that this
leads to a lack of product diversity, as well as presenting barriers
to entry to small, local, producers.
2. Large multinational companies can also suffer fromdiseconomies
of scale, such as difficulties associated with coordinating the
activities of subsidiaries based in several countries.
3. The increased power and influence of multinationals is also seen
by many as a considerable disadvantage of globalisation. For
 example, large multinational companies can switch their
investments between territories in search of the most
favourable regulatory regimes. MNCs can operate as
local monopsonies of labour, and push wages lower than the
free market equilibrium.
4. Critics of globalisation also highlight the potential loss of jobs in
domestic markets caused by increased, and in some
cases, unfair, free trade.
5. Globalisation can also increase the pace ofdeindustrialisation,
which is the slow erosion of an economy's manufacturing base.
6. Jobs may be lost because of the structural changes arising from
globalisation. Structural changes may lead tostructural
unemployment and may also widen the gap between rich and
poor within a country.
7. One of the most significant criticisms of globalisation is the
increased risk associated with the interdependence of economies.
As countries are increasingly dependent on each other, a
negative economic shock in one country can quickly spread to
other countries. For example, a downturn in car sales in the UK
affects the rest of Europe as most cars bought in the UK are
imported from the EU. The Far East crisis of the 1990s was
triggered by the collapse of just a few Japanese banks.

Most recently, the collapse of the US sub-prime housing

market triggered a global crisis in the banking system as banks
around the world suffered a fall in the value of their assets and
reduced their lending to each other. This created a liquidity crisis
and helped fuel a severe downturn in the global economy.

Over-specialisation, such as being over-reliant on producing a

limited range of goods for the global market, is a further risk
associated with globalisation. A sudden downturn in world
demand for one of these products can plunge an economy into a
recession. Many developing countries suffer by over-specialising
in a limited range of products, such as agriculture and tourism.
 8. Globalisation generates winners and losers, and for this reason it
is likely to increase inequality, as richer nations benefit more
than poorer ones.
9. Increased trade associated with globalisation has increased
pollution and helped contribute to CO2emissions and global
warming. Trade growth has also accelerated the depletion of non-
renewable resources, such as oil.

Comparative advantage
It can be argued that world output would increase when the principle
of comparative advantage is applied by countries to determine what
goods and services they should specialise in producing. Comparative
advantage is a term associated with 19th Century English
economist David Ricardo.

Ricardo considered what goods and services countries should produce,

and suggested that they should specialise by allocating their scarce
resources to produce goods and services for which they have a
comparative cost advantage. There are two types of cost advantage –
absolute, and comparative.

Absolute advantage means being more productive or cost-efficient than

another country whereas comparative advantage relates to how much
productive or cost efficient one country is than another.

Example
In order to understand how the concept of comparative advantage might
be applied to the real world, we can consider the simple example of two
countries producing only two goods - motor cars and commercial trucks.
Comparative advantage
Using all its resources, country A can produce 30m cars or 6m trucks,
and country B can produce 35m cars or 21m trucks. This can be
summarised in a table.

In this case, country B has the absolute advantage in producing both

products, but it has a comparative advantage in trucks because it is relatively
better at producing them. Country B is 3.5 times better at trucks, and only
1.17 times better at cars.
However, the greatest advantage - and the widest gap - lies with truck
production, hence Country B should specialise in producing trucks, leaving
Country A to produce cars.

Economic theory suggests that, if countries apply the principle of

comparative advantage, combined output will be increased in comparison
with the output that would be produced if the two countries tried to become
self-sufficient and allocate resources towards production of both goods.

Taking this example, if countries A and B allocate resources evenly to both

goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15,
therefore world output is 45 m units.
Opportunity cost ratios

It is being able to produce goods by using fewer resources, at a

lower opportunity cost, that gives countries a comparative advantage.

The gradient of a PPF reflects the opportunity cost of production. Increasing

the production of one good means that less of another can be produced. The
gradient reflects the lost output of Y as a result of increasing the output of X.
Having a comparative advantage in X, Country A sacrifices less of Y than
Country B. In terms of two countries producing two goods, different PPF
gradients mean different opportunity costs ratios, and hence specialisation
and trade will increase world output.

Only when the gradients are different will a country have a comparative
advantage, and only then will trade be beneficial.

Identical PPFs

If PPF gradients are identical, then no country has a comparative advantage,

and opportunity cost ratios are identical. In this case, international trade does
not confer any advantage.
Criticisms

However, the principle of comparative advantage can be criticised

in a several ways:

1. It may overstate the benefits of specialisation by ignoring a number of

costs. These costs include transport costs and any external
costs associated with trade, such as air and sea pollution.
2. The theory also assumes that markets are perfectly competitive - in
particular, there is perfect mobility of factors without any diminishing
returns and with no transport costs. The reality is likely to be very
different, with output from factor inputs subject to diminishing
returns, and with transport costs. This will make the PPF for each
country non-linear and bowed outwards. If this is the case, complete
specialisation might not generate the level of benefits that would be
derived from linear PPFs. In other words, there is an increasing
opportunity cost associated with increasing specialisation. For
example, it may be that the maximum output of cars produced by
country A is only 20 million (compared with 30), and the maximum
output of trucks produced by country B might only be 16 million
instead of 21 million. Hence, the combined output from trade might
only be 46 million units (instead of the 51 million units initially
predicted).

4. Complete specialisation might create structural

unemployment as some workers cannot transfer from one
sector to another.
5. Relative prices and exchange rates are not taken into
account in the simple theory of comparative advantage. For
example if the price of X rises relative to Y, the benefit of
increasing output of X increases.
6. Comparative advantage is not a static concept - it may
change over time. For example, nonrenewable resources can
slowly run out, increasing the costs of production, and reducing
the gains from trade. Countries can develop new advantages,
such as Vietnam and coffee production. Despite having a long
history of coffee production it is only in the last 30 years that it
has become a global player. seeing its global market share
increase from just 1% in 1985 to 20% in 2014, making it the
world's second largest producer.
7. Many countries strive for food security, meaning that
even if they should specialise in non-food products, they still
prefer to keep a minimum level of food production.
8. The principle of comparative advantage is derived from a
highly simplistic two good/two country model. The real world is
far more complex, with countries exporting and importing many
different goods and services.
9. According to influential US economist Paul Krugman, the
continual application of economies of scale by global producers
using new technology means that many countries, including
China, can produce very cheaply, and export surpluses. This,
along with an insatiable demand for choice and variety, means
that countries typically produce a variety of products for the
global market, rather than specialise in a narrow range of
products, rendering the traditional theory of comparative
advantage almost obsolete.
10. Modern approaches to explaining trade patterns and
trade flows tend to use gravity theory - which explains trade in
terms of the positive attractivness between two national
economies - based on economic size (in a similar fashion as
planets attracting each other based on their mass) - and the
'economic distance' between two economies. Economic
size attracts countries to trade, and economic distancemakes
trade harder. Economic distance is increased bybarriers to
trade, and cultural, political and linguistic differences. One
advantage of gravity theory is that it can help economists
predict the likely effect of changes in government policy on
trade patterns, including decisions regarding joining (or
leaving) trading blocs.
11. Despite these significant criticisms, the underlying
principle of comparative advantage can still be said to give
some ‘shape’ to the pattern of world trade, even if it is
 becoming less relevant in a globalised world and in the face of
modern theories.
12. Read more on: Gravity Theory
13.

Trade liberalisation
Two opposing forces have shaped the changing pattern of world trade
over the last 200 years; the promotion of free trade and
the protection against free trade. Trade protection is the process of
erecting barriers to trade, such as taxes on imports, called tariffs, and
trade liberalisation is the process of making trade free from such
barriers.

The UK is an extremely open economy with a long history of promoting

trade openness. By 2009, trade accounted for around 60% of the UK's
national income.

The advantages of free trade

It can be argued that free trade creates the following advantages:

Specialisation and comparative advantage

Free trade encourages countries to specialise and benefit from the
application of the principle of comparative advantage.

Increased world output

If countries specialise and trade, world output is likely to increase as
scarce resources will be used more efficiently. Mass production will
generate considerable economy of scale, which reduce average costs.

Increased competition and lower prices

Free trade increases competition, which generates further benefits,
including lower prices, greater use of new technology and technology
transfer between countries. Free trade will also encourage the
breakdown of domestic monopolies, and provide greater choice for
consumers and firms.

Higher quality
Open economies are likely to see an increase in the quality of products
available as overseas firms compete on non-price factors, such as
design and reliability.

Terms of trade
A country’s terms of trade measures a country’s export prices in relation
to its import prices, and is expressed as:

For example, if, over a given period, the index of export prices rises by
10% and the index of import prices rises by 5%, the terms of trade are:

110 x 100 / 105

= 104.8

This means that the terms of trade have improved by 4.8%.

When the terms of trade rise above 100 they are said to
beimproving and when they fall below 100 they are said to beworsening.
The terms of trade can also be expressed in terms of the number 1, with
figures above 1 indicating an improvement, and those below 1 a
worsening. This is shown in the chart below.

Improving terms of trade

If a country's terms of trade improve, it means that for every unit of
exports sold it can buy more units of imported goods. So potentially, a
rise in the terms of trade creates a benefit in terms of how many goods
need to be exported to buy a given amount of imports. It can also have
a beneficial effect on domestic cost-push inflation as an improvement
indicates falling import prices relative to export prices.

However, countries may suffer in terms of falling export volumes and a

worsening balance of payments.

Terms of trade
Terms of tradeSelected countries; 2005 =100; Source:
https://datamarket.com/data/set/1xsq/www.economicsonline.co.uk1960
197019801990200020100123Terms of trade for selected countries
ChinaIndiaJapanMexicoSaudi ArabiaUKUSA

The UK's terms of trade have generally improved over the last 20 years,
indicating that exports price have has been rising relative to import
prices. This is partly caused by the fact thatglobalisation has tended to
have less impact on the export price of UK invisibles, in comparison to
its effect on the price of its visible imports.

The danger of an improving terms of trade is that it can worsen

the balance of trade if UK and overseas consumers are elasticin their
response to the relative export and import price changes.

Worsening terms of trade

A worsening terms of trade indicates that a country has to export more
to purchase a given quantity of imports. According to the Prebisch-Singer
hypothesis, this fate has befallen many developing countries given the
general decline in commodity prices in relation to the price of
manufactured goods. However,globalisation has tended to reduce the
price of manufactured goods over the past 15 years, so the advantage
that industrialised countries had over developing countries may be
falling.

The impact of globalisation has tended to halt the decline in the terms of
trade of developing economies.

Terms of trade - Selected regionsSelected countries; 2005 =100;

Source:
https://datamarket.com/data/set/1xsq/www.economicsonline.co.uk1990
1994199820022006201020140.60.81.01.2Terms of trade for selected
regions
Developing countriesEULow income countrriesSub-saharaLand locked

The terms of trade for the EU has fallen relative to developing countries
since the financial crisis of 2009.

The WTO
The WTO attempts to promote free and fair trade – an increasingly
difficult task, which it undertakes with varying success. The WTO was
established in 1995 when it replaced the General Agreement on Tariffs
and Trade (GATT). It has its headquarters in Geneva, Switzerland and,
by 2012, had 153 member countries, including China, which was the
last major nation to join.

The purpose of the WTO is to promote free and fair trade through
multilateral talks and negotiations, and to arbitrate between countries
that are in dispute. The WTO itself claims that, unlike GATT that
preceded it, its rules of trade have been worked out by the direct
involvement of all countries, and not just a few powerful ones.

valuation of the WTO

Trade liberalisation clearly brings many economic and political benefits,
but many argue that the WTO has had limited success in certain areas.
The main criticisms are:

Too few agreements

Critics argue that the number of trade disputes settled through the
WTO's DSU (Dispute Settlement Understanding) is inadequate given
the number of disputes. However, the number of settlements did rise
from 20 in 1990 to 157 in 2007. But still, by January 2008, only 136 of
the 370 cases had reached the full panel process.

(Sources: UNCTAD and WTO).

Failure to confront ethical issues

Many argue that the WTO has failed to confront ethical issues, such as
the use of child labour and poor working conditions in developing
economies.

Failure to tackle environmental issues

Similarly, many argue that it has failed to tackle environmental issues,
such as the depletion of global fish stocks, deforestation,
and climate change.

Takes too long to arbitrate

Critics also complain that the WTO takes too long to arbitrate and settle
disputes. For example, it can take over five years from the initial receipt
of a complaint from one member to the final panel ruling.

See: Example of WTO process

Favours the powerful

Critics also argue that the WTO has an inbuilt bias favouring developed
and powerful nations and trading blocs such as the USA and the EU,
and operating against weaker, developing ones.

Failure to promote multilateralism

Despite the WTO operating as a multilateral organisation, many
member countries and trading blocs favour bilateral discussions with
partners or competitors. This is because bilateral negotiations can be
fully focussed and relatively quick to complete. The result is that many
countries prefer to bypass the WTO process, and deal directly with
other countries. The failure of the most recent round of WTO
negotiations, the Doha round, is widely regarded as evidence of the
inherent problems of multilateral discussions. While the WTO is likely to
argue that it encourages such agreements when they do not have a
negative impact on third parties, it is very difficult to find cases where
third-party countries are not, at least indirectly, negatively affected by a
specific bilateral agreement.

The Doha round

The most recent round of talks is the Doha Round, which began in
2001, with major summit meetings in Cancun, Mexico, Hong Kong, and
Davos in 2003, 2005, and 2007 respectively. The Doha round of talks is
also called the development round, reflecting its emphasis on promoting
free trade for the benefit of developing nations. In particular, the Cancun
talks focussed on three areas: reducing agricultural subsidies and
industrial tariffs imposed by developed nations, which limit the market
access of developing nations; harmonising competition rules within
different countries; and helping poor countries.

The talks collapsed for a number of reasons. Significantly, while the US

and EU failed to agree reductions in agricultural support, many
developing countries refused to agree new investment rules which
would make it easier for multinationals to invest in their countries. Since
the collapse, the USA and EU have returned to bilateral agreements
with favoured nations, rather than entering into multilateral agreements.
This highlights a major limitation of the WTO in not gaining a complete
consensus that multilateral negotiations should be the method of choice
of its members.

The failure of the Doha round means that the rich countries of the world
still protect themselves from goods produced by the poor nations. By
2005, average agricultural tariffs imposed by the USA and EU were
60%, against average industrial tariffs of only 5%*.
(*Source: WTO).

Exchange rates
Exchange rates are extremely important for a trading economy such as
the UK. There are several reasons for this, including:

1. Exchange rates represent a cost to firms, which arises when

commission is paid on the exchange of one currency for another.
2. Exchange rate changes create a risk to those firms that
hold assets in currencies other than Sterling.
3. Exchange rates affect the price of exports, which form a
significant part of aggregate demand, and the price of imports,
and hence the balance of payments.

The Monetary Policy Committee of the Bank of England will often take
the exchange rate into account when setting short term interest rates,
hence changes in the exchange rate have another transmission route
into the economy, via their effect on interest rates.

Measuring exchange rates

Exchange rates can be measured in two ways:

Bi-lateral rates
A bilateral rate is the rate of exchange of one currency for another, such
as £1 exchanging for $1.50.
Multi-lateral rates
A multilateral rate is the value of a currency against more than one other
currency. Economists calculate multi-lateral rates to understand what is
happening to the exchange rate, on average. This is achieved by using
an index that reflects changes in one currency against a basket of other
currencies. The use of a trade weighted index enables a country to
measure its effective exchange rate.

Effective exchange rates - the Sterling Exchange Rate Index (ERI)

In the UK, Sterling’s average rate is measured by the Sterling

Exchange Rate Index. (ERI)

This index tracks changes over time, starting with a base year index of
100, and is weighted to reflect the relative importance of different
countries in terms of UK trade. It is an example of aneffective exchange
rate.

It has come in for criticism because the weights get adjusted too
infrequently, and changes to the pattern of UK trade take too long to be
included in revised weightings. In the early 2000's, many observers
argued that the index required modification, including the Chief
economist at the HSBC, who argued that the index understated
Sterling’s strength by around 5%.

As a result of these criticisms, in 2005 the Bank of England introduced a

new version of the index which can adjust more rapidly to changes in
trade patterns.

Changes in trade patterns

Weights for the ERI are adjusted to reflect changes in trade patterns.
For example, the weighting of the Chinese yuan and Indian rupee have
increased over the last 15 years, while the weighting of the
US dollar the Japanese yen and the euro have been reduced, reflecting
the increased significance of trade with the BRIC economies compared
with the UK's traditional markets and trading partners in the euro-area,
Japan and the US.

Real Effective Exchange Rates (REERs)

The Real Effective Exchange Rate (REER) for a currency is found by

adjusting the nominal exchange rate index to take into account relative
inflation rates between a country and its trading partners.

For example, if the UK experiences a lower rate of inflation compared

with a single trading partner, such as India, the normal rate of exchange
of Sterling to the rupee is adjusted upwards (reflated). Hence, if UK
inflation is running at 2% and the rate in India is 7%, the rupee is
adjusted downwards by the average price difference - that is by 5%.

To calculate the REER, the value of the ERI (the effective exchange
rate) will be adjusted by taking into account relative inflation rates for all
those currencies in the index.

Exchange rate regimes

An exchange rate regime is a system for determining exchange rates for
specific countries, for a region, or for the global economy. Throughout
history, three basic regimes have existed:

Floating
A floating regime is one where currencies are allowed to move freely up
and down according to changes in demand and supply.

Fixed
Fixed rates are currency values which are tied to a precious metal such
as gold, or anchored to another currency, like the US Dollar.

Managed
Managed exchange rates exist when a currency partly floats and is
partly fixed, such as happened between 1990 and 1992, when Sterling
was managed in the Exchange Rate Mechanism (ERM) of the
European Monetary System. This system preceded the European Euro
(€), which was launched in 1999.

Floating exchange rates

Under a floating system a currency can rise or fall due to changes in
demand or supply of currencies on the foreign exchange market.

Changes in exchange rates

Changes in the exchange rate in a floating system reflect changes in
demand and supply of currencies. On a demand and supply diagram,
the price of a currency such as Sterling (£) is expressed in terms of the
other currency, such as the USD ($).

An increase in the exchange rate

For example, an increase in UK exports to the USA will shift the
demand curve for Sterling to the right and push up the exchange rate of
the pound against the US dollar
Changes in interest rates
Changes in interest rates affect a country’s currency. Higher interest
rates lead to an increase in the demand for a country’s financial assets,
and an increase in the demand for a currency.

Lower interest rates reduce speculative demand for assets and reduce
demand for a currency. These speculative flows are called hot money.

Increases in supply of a currency

An increase in the supply of a currency will depress its price. This could
result from and increase in imports relative to exports, or speculative
selling of the currency.
Equilibrium exchange rates
An ‘equilibrium’ exchange rate is the specific rate where export revenue
and import spending are equal.

Equilibrium
At currency ‘£’, import spending equals export revenue, at ‘Q’. At a
higher rate, say at £1 imports now appear cheap in the UK, and
spending increases to Qm, and exports appear expensive abroad, and
fall to Qx. This opens up a trade gap (Qx to Qm).
Those in favour of a floating exchange rate regime argue that allowing
exchange rates to float will enable trade to balance more quickly.

Fixed exchange rates

The IMF system

A fixed exchange rate regime involved currencies being fixed against a

precious metal or against another currency, or basket of currencies.

The International Monetary Fund (IMF) was conceived in 1944, at

Bretton Woods, New Hampshire (USA) and became operational in
1945. Its aim was to stabilise the world economy through a system
of fixed exchange rates. The IMF was one of three pillars to support the
development of post-war economies, the other two being GATT (The
General Agreement on Tariffs and Trade), later to become the WTO
(World Trade Organisation), and the International Bank for
Reconstruction and Development, later to be called the World Bank.

The IMF system involved the US$ as the anchor for the system with the
US$ given a specific value in terms of gold, and other currencies were
then given a value in terms of the US$, such as £1 = $2.40c.

However, the system collapsed in 1971 for a number of reasons,

including the build up of US debts abroad as a result of the need to fund
the war in Vietnam. In addition, inflation in the USA and growing doubts
about the stability of the US$ caused intense speculative activity against
the US$. Speculators frantically sold US$s during 1971 until President
Nixon, took the US out of the system.

Managed regimes
Managed regimes involve a mixture of free-market forces and
intervention.

A recent example is the European Exchange Rate Mechanism (ERM),

which operated from 1979 to 1999.

In this system, currencies were kept inside an agreed band of (+/-)

2.25% for most members. This was achieved by the monetary
authorities either raising or lowering interest rates, or by buying or
selling currency.

Exchange controls

Some currencies are subject to exchange controls, which mean that the
relevant Central Bank will only allow buying and selling through its own
system, rather than be subject to fluctuations associated with fully
floating rates. Although most countries abandoned these controls many
years ago, some, like Chinaand Cuba, still practice very strict exchange
rate control.
Advantages of floating exchange rates
Flexibility and automatic adjustment

Over time, an economy may experience changes in imports and

exports, and this can lead to a balance of paymentsdisequilibrium
(deficit or surplus). Under a floating regime, the deficits and surpluses
will lead to adjustments in the exchange rate, which alter relative import
and export prices in the future. Therefore, imports and exports can
readjust to move the balance of payments back towards a desirable
equilibrium. Exogenous shocks, like the financial crisis of 2008-09, can
occur from time to time and floating exchange rates can help the
readjustment process.

Freedom

Policymakers are free to devalue or revalue to achieve specific

objectives, such as stimulating jobs and growth and
reducinginflationary pressure.

Advantages of fixed regimes

Stability for firms

Exporting firm’s prices are more stable, as are importing firm’s costs.
This is the main reason the Chinese Yuan has been fixed against the
US Dollar for nearly 20 years, creating a very stable framework for
Chinese manufacturing.

Predictability and confidence

Firms can plan ahead and are likely to invest more. Confidence is a
necessary condition for investment.

Discipline

Another advantage of fixed exchange rates is that policy makers cannot

devalue the currency in an attempt to hide inflation or a balance of
payments deficit. Deliberately holding a currency down would reduce
export prices abroad and nullify any domestic inflation, as well as
providing a boost to exports. In addition, policy makers cannot revalue
to keep a currency artificially high to reduce imported cost-push
inflation.