Slezská univerzita v Opavě
Obchodně podnikatelská fakulta v Karviné
INTERNATIONAL ECONOMICS
Ingrid Majerová
Karviná 2014
Projekt OP VK č. CZ.1.07/2.2.00/28.0017
„Inovace studijních programů na Slezské univerzitě,
Obchodně podnikatelské fakultě v Karviné“
Subject: Economics
Anotation: The aim of this study material is to provide a comprehensive view on issue of
international economics at its theoretical level. The attention is paid to the theory of
international trade, international trade policy and to instruments of trade policy. This
study material also introduces the issue of balance of payments, the area of exchange
rates and their relationship to money and prices. Furthermore, it deals with international
macroeconomic policy through the development of international monetary relations and
the part of this text is devoted to the issue of global capital markets, macroeconomic
stability and financial crises. This publication is also dedicated to the issue of developing
economies as a substantial majority of contemporary world. This part focuses on analysis
of external economic relations of developing economies and particularly on the analysis
of their business policies and the issue of debt.
Key words: International Economics, International trade, Theory of International trade, International trade
policy, International monetary policy
Autor: Ing. Ingrid Majerová, Dr.
Recenzenti: doc. Ing. Martina Halásková, Ph.D., Ing. Eva Schwartzhoffová, Ph.D.
ISBN 978-80-7510-074-0
- 3 -
CONTENT
INTRODUCTION.................................................................................................................... 7
1 PURE THEORY OF TRADE........................................................................................ 8
1.1 CHARACTERISTIC OF INTERNATIONAL TRADE ........................................................................ 8
1.2 THE DEVELOPMENT OF THE THEORY OF INTERNATIONAL TRADE TO THE 18TH
CENTURY........ 9
1.2.1 MERCANTILISM ........................................................................................................ 10
1.2.2 CAMERALISM ........................................................................................................... 11
1.2.3 DAVID HUME........................................................................................................... 11
1.3 PURE THEORY OF INTERNATIONAL TRADE – CLASSICAL ECONOMICS APPROACH ............... 11
1.3.1 ADAM SMITH AND THE THEORY OF ABSOLUTE ADVANTAGE...................................... 12
1.3.2 DAVID RICARDO AND THE THEORY OF COMPARATIVE ADVANTAGES......................... 13
1.3.3 JOHN STUART MILL AND THE THEORY OF RECIPROCAL DEMAND .............................. 14
2 NEO-CLASSICAL AND STANDARD THEORY OF INTERNATIONAL TRADE..16
2.1 NEOCLASSICAL THEORIES OF INTERNATIONAL TRADE......................................................... 16
2.1.1 THE THEORY OF OPPORTUNITY COST ...................................................................... 16
2.1.2 THE FACTOR-PROPORTIONS THEORY....................................................................... 18
2.1.3 CRITICISM OF THE HECKSCHER-OHLIN THEOREM.................................................... 20
2.1.4 THE THEORY OF FACTOR PRICE EQUALIZATION....................................................... 21
2.2 THE STANDARD THEORY OF INTERNATIONAL TRADE........................................................... 22
3 ALTERNATIVE AND INTEGRATIVE THEORIES OF TRADE......................... 25
3.1 THE ALTERNATIVE THEORIES OF INTERNATIONAL TRADE ................................................... 25
3.1.1 THE THEORY OF THE INFANT INDUSTRY ................................................................... 25
3.1.2 THE THEORY OF INTERNATIONAL VALUE.................................................................. 26
3.1.3 THE THEORY OF THE SECOND BEST ......................................................................... 27
3.1.4 THE DEPENDENCY THEORY...................................................................................... 28
3.1.5 THE THEORY OF IMMISERIZING GROWTH.................................................................. 29
3.1.6 OVERLAPPING DEMAND THEORY ............................................................................. 30
3.1.7 THE TECHNOLOGICAL GAP THEORY......................................................................... 30
3.2 INTEGRATIVE THEORIES OF INTERNATIONAL TRADE............................................................ 30
3.2.1 THE THEORY OF CUSTOMS UNION ........................................................................... 31
3.2.2 THE THEORY OF OPTIMUM CURRENCY AREA ........................................................... 33
4 MODERN THEORIES OF INTERNATIONAL TRADE AND MOVEMENT OF
FACTORS OF PRODUCTION .................................................................................. 35
4.1 MODERN THEORIES OF TRADE – MODELS OF ECONOMIES OF SCALE ................................... 35
4.1.1 MODEL OF INTERNAL ECONOMIES – THE MODEL OF MONOPOLISTIC COMPETITION 36
4.1.2 MODEL OF EXTERNAL ECONOMIES .......................................................................... 38
4.2 THE INTERNATIONAL FACTOR MOVEMENTS......................................................................... 39
4.2.1 INTERNATIONAL LABOUR MOVEMENT ...................................................................... 39
4.2.2 INTERNATIONAL CAPITAL MOVEMENT ...................................................................... 41
4.2.3 MULTINATIONAL COMPANIES AND THEIR ROLE IN THE INTERNATIONAL MOVEMENT OF
FACTORS OF PRODUCTION....................................................................................... 44
- 4 -
5 THE THEORY OF FOREIGN TRADE POLICY.................................................... 46
5.1 FOREIGN TRADE POLICY AND ITS INSTRUMENTS .................................................................. 46
5.2 CHARACTERISTICS OF AUTONOMOUS INSTRUMENT FOR EXTERNAL TRADE POLICY............. 46
5.3 THE EFFECT OF CUSTOMS DUTIES ON SMALL AND LARGE ECONOMIES............................... 50
5.3.1 IMPACTS OF CUSTOMS DUTIES FROM THE PERSPECTIVE OF GENERAL EQUILIBRIUM53
5.4 THE EFFECT OF QUANTITATIVE RESTRICTION ON THE ECONOMY ......................................... 54
6 INTERNATIONAL TRADE AGREEMENTS AND COMMERCIAL TREATIES.. 56
6.1 CONTRACTUAL INSTRUMENTS ............................................................................................... 56
6.2 A BRIEF HISTORY OF INTERNATIONAL AGREEMENTS AND COMMERCIAL TREATIES........... 57
6.3 THE GENERAL AGREEMENT ON TARIFFS AND TRADE........................................................... 59
6.4 THE WORLD TRADE ORGANIZATION..................................................................................... 62
6.4.1 THE DOHA DEVELOPMENT ROUND .......................................................................... 63
7 OPEN ECONOMY MACROECONOMICS ............................................................. 66
7.1 THE THEORY OF BALANCE OF PAYMENTS............................................................................. 66
7.1.1 THE CLASSICAL THEORY OF BALANCE OF PAYMENTS ............................................... 66
7.1.2 THE EFFECT OF FOREIGN TRADE ON PRODUCT....................................................... 68
7.1.3 THE MONETARY MECHANISM OF ADJUSTMENT ........................................................ 71
7.2 THE STRUCTURE OF THE BALANCE OF PAYMENTS................................................................ 72
7.3 OPEN ECONOMY MACROECONOMICS .................................................................................... 73
7.3.1 A BALANCE OF PAYMENT CURVE ............................................................................. 73
7.3.2 MODEL IS-LM-BP................................................................................................... 75
7.3.3 CHANGES IN EXCHANGE RATES AND J-CURVE.......................................................... 76
8 MONEY, FOREIGN EXCHANGE RATE AND FOREIGN EXCHANGE
MARKETS .................................................................................................................... 78
8.1 THE FOREIGN EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET.......................... 78
8.1.1 TYPES OF FOREIGN EXCHANGE RATES ..................................................................... 78
8.1.2 THE FOREIGN EXCHANGE MARKET.......................................................................... 79
8.2 MONEY, INTEREST RATES AND THE FOREIGN EXCHANGE RATE.......................................... 82
8.2.1 THE DEFINITION OF MONEY .................................................................................... 82
8.2.2 THE EQUILIBRIUM IN THE MONEY MARKET.............................................................. 83
8.3 MONEY AND EXCHANGE RATE IN THE SHORT AND LONG TERM .......................................... 85
8.3.1 THE SHORT RUN ...................................................................................................... 86
8.3.2 THE LONG RUN........................................................................................................ 89
8.4 THE ISSUE OF INFLATION AND OVERSHOOTING .................................................................... 90
8.4.1 INFLATION AND THE FOREIGN EXCHANGE RATE ...................................................... 90
8.4.2 THE FOREIGN EXCHANGE RATE OVERSHOOTING ..................................................... 91
9 PRICES AND FOREIGN EXCHANGE RATE ........................................................ 93
9.1 PRICES AND THE FOREIGN EXCHANGE RATE IN LONG RUN.................................................. 93
9.1.1 THE LAW OF ONE PRICE .......................................................................................... 93
9.1.2 THE PURCHASING POWER PARITY THEORY .............................................................. 93
9.2 THE FOREIGN EXCHANGE RATE AND OUTPUT IN THE LONG RUN ........................................ 95
9.2.1 THE PPP THEORY AND MODEL OF THE FOREIGN EXCHANGE RATE IN THE LONG RUN.... 96
- 5 -
9.3 THE FOREIGN EXCHANGE RATE AND OUTPUT IN THE SHORT RUN....................................... 97
9.3.1 BALANCE OF AGGREGATE DEMAND ......................................................................... 98
9.3.2 DETERMINATION OF OUTPUT ................................................................................... 99
9.3.3 OUTPUT AND FOREIGN EXCHANGE RATE................................................................. 99
9.4 SHORT-TERM EQUILIBRIUM OF THE OPEN ECONOMY ......................................................... 103
9.4.1 SHORT RUN EQUILIBRIUM WITH THE IMPLEMENTATION OF NET EXPORT ............... 104
10 INTERNATIONAL MACROECONOMIC POLICY ............................................ 106
10.1 THE FIXED EXCHANGE RATE POLICY.................................................................................. 106
10.1.1 THE FIXED EXCHANGE-RATES SYSTEM................................................................... 107
10.1.2 CONDITIONS OF FIXATING THE FOREIGN EXCHANGE RATE.................................... 108
10.2 THE INTERNATIONAL MONETARY SYSTEM IN 1870-1973................................................... 108
10.2.1 INTERNATIONAL MACROECONOMIC POLICY IN 1870 - 1914 ................................... 108
10.2.2 THE INTERWAR PERIOD 1918 - 1939...................................................................... 109
10.2.3 THE BRETTON WOODS SYSTEM IN 1944 – 1973 ...................................................... 110
10.3 THE POLICY OF FLOATING EXCHANGE RATES .................................................................... 112
10.3.1 THE INTERNATIONAL MONETARY SYSTEM AFTER THE COLLAPSE OF THE FIXED
EXCHANGE RATE SYSTEM....................................................................................... 113
10.4 THE INTERNATIONAL MACROECONOMIC POLICY IN THE FLOATING EXCHANGE RATE
SYSTEM ................................................................................................................................ 114
11 GLOBAL CAPITAL MARKETS ............................................................................. 119
11.1 THE STRUCTURE OF INTERNATIONAL CAPITAL MARKET.................................................... 119
11.2 INCOMES FROM INTERNATIONAL TRANSACTIONS............................................................... 120
11.2.1 RISK AVERSION AND PORTFOLIO DIVERSIFICATION ................................................. 120
11.3 THE DEVELOPMENT OF THE INTERNATIONAL BANKING AND CAPITAL MARKET ............... 121
11.3.1 THE GROWTH OF THE EUROCURRENCY TRADE ...................................................... 122
11.3.2 CREATION OF EUROCURRENCY .............................................................................. 122
11.4 MACROECONOMIC STABILITY AND EUROCURRENCIES ....................................................... 123
11.4.1 REGULATION OF INTERNATIONAL BANKING............................................................ 124
11.5 FINANCIAL CRISES IN 90‘S YEARS....................................................................................... 126
11.5.1 THE ASIAN CRISIS IN 1997...................................................................................... 126
11.5.2 THE RUSSIAN CRISIS IN 1998.................................................................................. 127
11.5.3 THE BRAZILIAN CRISIS IN 1999............................................................................... 128
11.5.4 THE ARGENTINE CRISIS IN 2002............................................................................. 128
12 DEVELOPING COUNTRIES AND EXTERNAL ECONOMIC RELATIONS . 131
12.1 THE CHARACTERISTIC OF THE DEVELOPING COUNTRIES.................................................... 131
12.2 THE IMPORTANCE OF THE WORLD TRADE ON DEVELOPMENT OF INDIVIDUAL ECONOMIES ...... 132
12.2.1 IMPORT AND EXPORT.............................................................................................. 132
12.2.2 EXPORT INSTABILITY AND ECONOMIC DEVELOPMENT............................................ 133
12.3 INDUSTRIALIZATION ............................................................................................................ 135
12.3.1 INDUSTRIALIZATION THROUGH THE FORM OF IMPORT SUBSTITUTIONS.................. 135
12.3.2 EXPORT-ORIENTED INDUSTRIALIZATION ................................................................ 135
12.4 THE ISSUE OF DUAL ECONOMY ........................................................................................... 136
- 6 -
12.5 LIBERALISM VERSUS PROTECTIONISM ................................................................................. 137
12.5.1 WTO AND THE ROLE OF DEVELOPED COUNTRIES IN TRADE NEGOTIATIONS........... 138
12.5.2 OTHER ISSUES OF THE WORLD TRADE FROM THE PERSPECTIVE OF DEVELOPING
COUNTRIES............................................................................................................ 139
13 DEVELOPMENT COUNTRIES AND A DEBT ISSUE ........................................ 141
13.1 THE WORLD BANK AND ITS ROLE ....................................................................................... 141
13.1.1 LEGISLATIVE FRAMEWORK..................................................................................... 142
13.1.2 THE ROLE OF THE WORLD BANK............................................................................ 142
13.1.3 THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT ................ 144
13.1.4 CLASSIFICATION OF ECONOMIES............................................................................ 145
13.2 THE ISSUE OF DEVELOPING COUNTRIES DEBT .................................................................... 145
13.2.1 HISTORICAL DEVELOPMENT OF INDEBTEDNESS OF DEVELOPING ECONOMIES....... 146
13.2.2 INTERNATIONAL DEBT CRISIS................................................................................. 148
13.2.3 THE CONSEQUENCES OF DEBT FOR DEVELOPING COUNTRIES ............................... 149
13.2.4 DEBT AND STRUCTURAL REFORMS ......................................................................... 149
13.2.5 ILLEGITIMATE DEBTS AND MORAL HAZARD............................................................ 150
13.2.6 CURRENT SITUATION AND THE HIPC INITIATIVE .................................................... 150
13.2.7 THE TROUBLESHOOTING DEBT – DEBT MANAGEMENT ............................................ 151
CONCLUSION..................................................................................................................... 153
THE LIST OF LITERATURE ........................................................................................... 154
- 7 -
INTRODUCTION
Dear students,
this study text International Economics is addressed to all of you who are interested to
obtain basic information about the issue of international economics at its theoretical level. The
publication is divided into thirteen separate chapters.
The first four chapters are devoted to the theory of international trade and they gradually
map the development of the above-mentioned theoretical approaches to the issues of
international economics from its beginnings to the modern theories or alternative ones. There
is mentioned both the beginnings of the theory of international trade and the classical
approaches, as well as modern approaches in the form of alternative and integrative theories.
The fifth chapter is dedicated to international trade policy and to autonomous trade
policy instruments. The sixth chapter is closely related to the fifth chapter and describes
contractual trade policy instruments, which are agreements and contracts.
The seventh to ninth chapter introduce the issue of balance of payments, theoretical
approaches to it, its structure and issue of the model in an open economy. Attention is also
paid to the area of exchange rates and their relationship to money and price, and
macroeconomic equilibrium in the model of an open economy.
The tenth chapter deals with the international macroeconomic policy through the
development of the global monetary relations and the eleventh chapter is devoted to the issues
of global capital markets, macroeconomic stability and financial crises.
In last two chapters – the twelfth and thirteenth chapters – are dedicated to the issue of
developing economies as the substantial part of the contemporary world. Those chapters are
focused on the analysis of external economic relations of developing economies, especially on
the analysis of their trade policies and the issue of debt.
In the individual chapters, graphs and tables could be found and those graphs and tables
complement their theoretical parts. At the end of this publication is a list of literature and
Internet sources which were used while writing this study material.
Karviná, June 2014
Author
1 Pure theory of trade
- 8 -
1 PURE THEORY OF TRADE
Before we start with the analysis of theories dealing with international trade, we will
clarify what the international economics is, what is the object of its interest, what it is based
on and why we use this term within the area of international trade.
1.1 CHARACTERISTIC OF INTERNATIONAL TRADE
International economics uses basic methods of economic analysis as well as other
fields of economics, because motives and behaviour of economic subjects are the same,
whether they are domestic or foreign transaction (Krugman and Obsfeld, 2003, p. 3).
International economics analyse both the flows of goods and services and transactions among
the economies and furthermore it analyse policies designed for the regulations of those flows
and their effects on the wealth of economies.
International economics can be divided into two sub-areas: the area of international
trade and area of international flow of money. Analysis of international trade deals with
transactions of international economics such as movements of goods or allocations of
economic resources. Analysis of flow of international flow of money deals with the monetary
side of international economics and these are financial transactions. In essence, both of these
areas cannot be separated since one cannot function with the other. The most of international
trade requires financial operations and on the other side, many financial transactions play an
important role for trade. Above-mentioned links between trade and cash transactions affect
the level of interdependency among individual countries.
The aim of the investigation of international economics is revenues from trade, trade
restrictions, foreign exchange markets, balance of payments and its adjustment and
international capital markets. Pure theory of trade deals with revenues from trade and basic
premises for them and the results of this theory will be analysed in this and other three
chapters. The results and effects of trade restrictions on individual economies are being
explored in the theory of trade policy as the part of international trade policy. A relatively
new area of international economics is the investigation of the basic framework of an
“exchange” one currency for another and their often rapidly changing relative values, a thus
the area of foreign exchange markets, since before the World War I were all currencies
pegged to gold and after the World War II (till 70s of last century) they were pegged to dollar.
The balance of payments measures total payments and receipts of the resident of the
country in their transactions with the rest of the world. Its analysis has to be made in a context
of other subjects of international economics – international movement of capital, international
transactions in the account of national income or aspects of international monetary policy.
Balance of payments adjustment is associated with the mechanism of correction of the
external imbalance in case of difference international exchange system and their effects on the
wealth of individual economies. International capital market is developing together with
the development of international trade by combining the individual capital markets of national
economies and an analysis of its functioning after the series of debt and financial crisis in
Latin America acquired a great importance.
The first two objectives of the exploration of the international economics, the pure trade
of international trade and theory of trade policy, are the microeconomic aspect of international
economics, because they discuss about individual national economies as separate entities as
well as the relative prices of commodities. Macroeconomic aspect of international economics
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 9 are
represented by the follow-named objectives – the foreign exchange markets, the issue of
balance of payments and its adjustments, since they discuss about the total flows and affect
the national income. It means that the theory of international economics with its
microeconomic concept will lead us to an understanding of the functioning of the economy as
a whole (whether national or international), i.e. to understanding of entire macroeconomics.
The most important objective and theoretical concept of international economics on the
basis of past experience seems to be the first objective, and that is the revenues from trade.
Since the rise of modern statecraft in the 16th
century is the one of the most important and the
most common political issues is the effect of the international competition in the prosperity of
the domestic industry and its protection against this competition. In last twenty years, the
international trade goes in the other direction – except restrictions and export promotion
makes an effort to liberalize international trade, whether through integration groupings or
activities of the World Trade Organization. International trade, representing the exchange
of goods of one country with other countries, expands consumer potential of economies and
there are several reasons, which despite all above-mentioned negatives contribute to the
ongoing development:
•••• The diversity of production conditions and technology between economies – south
will specialize in the development of coastal tourism and the cultivation of citrus,
north in salmon farming and development of ski resorts
•••• The increasing returns to scale – or economies of scale, when average cost of
production decreases with the increase in production
•••• Differences in consumer tastes and therefore in demand – e.g. in Sweden and Norway
is the production of reindeer meat and salmon the same, Swedes love to eat meat and
Norwegians love to eat fishes – the reciprocal export of meat and fish would be
beneficial to both countries and would increase the wealth
•••• The existence of government economic policy – tax and subsidy measures may
change the price of goods and services that can create advantages while producing
•••• And conflict between production and consumption – based on the fact that no
country in the role of producer of goods and services is able to satisfy all requirements
of its consumers1
.
For understanding of the functioning of international trade, we must build on theoretical
assumptions involved in so-called the theory of international trade. This theory has gone
through historical development and we will devote to this development in the first three
chapters.
1.2 THE DEVELOPMENT OF THE THEORY OF INTERNATIONAL TRADE TO THE
18TH
CENTURY
International economics underwent during several centuries a long continuous path of
development supported by many renowned economist such as were David Hume, Adam
Smith, David Ricardo, John Stuart Mill, Alfred Marshall, Paul Samuelson and many others.
In this section of this text we will analyse the findings of their theories and we will
begin with the first of opinion groups – mercantilists.
1
In case of the closed economy, its consumer and production capabilities are the same. Such a situation when the country
is relatively self-sufficient and the country consumers everything that is produced, it called autarchy.
1 Pure theory of trade
- 10 -
1.2.1 MERCANTILISM
Mercantilists did not form a coherent group of theoretic. It was a rather different
opinion group of merchants (came from Greek Mercator – merchant, mercantilisms is derived
from this word). This group was dealing with the economic conditions of the mid 14th
to mid
18th
century. The expression of the nation’s wealth was the amount of gold and silver and
other means of payment at that time. Increasing wealth could occur in three ways: (1)
domestic extraction of precious metals, (2) in case of their lack by the use of the resources of
colonies or (3) active trade balance (more exports than exports). In other words, it meant to
promote export and restrict imports through tariffs, export subsidies, tax favouring domestic
producers, etc.. Nowadays, it still belongs to frequently used tools of support of domestic
economy.
Mercantilism itself is divided into two development phases – early mercantilism, also
known as bullionism (mid 14th
– mid 16th
century)2
and developed mercantilism (mid 16th
–
mid 18th
century). Although early mercantilism absolutely refused to export money from the
country, what should serve as a means of accumulation money in the economy (thus
increasing its wealth) and promoted active trade balance with each country separately, the
both phases show some common features, which are seen from the point of view of the
international economy in:
• Restriction of imports, especially of luxury consumer goods
• The prevention of exports and import promotion of raw materials
• The favouring and export promotion of industrial consumer goods and agricultural
products
• A support the development of domestic industry
• And reduction of consumption (weakening incentives to import and the chance to
export more)
International trade was at that time considered to be disadvantageous when each country
participating to foreign trade earns and automatically the other lose, and therefore it was
always more beneficial to export than import (a thus have active trade balance). The first, who
used a term balance of foreign trade, was mercantilist Edward Misselden3
. He argued that the
state should rather focus on the monitoring of trade, i.e. monitoring the trade balance, than
focusing on the application of restrictions.
On the base of the above-mentioned principles of mercantilism was the target of
criticism its most known representative, Thomas Mun4
, since the British East India Company
precious metals exported from the country. Mun’s argument that for these exported precious
metals can be imported goods, which are further processed and exported, that ultimately the
precious metals flowing back into the economy. Another point of criticism was the passive
trade balance of Company with India. However, Mun argued that there is no need to have an
active balance with each country, but it is enough to have active only overall trade balance,
which enriches the state. He also knew that the active trade balance increases the amount of
money (precious metals) in the economy and this leads to an increase in the price level and
reducing the price competitiveness of domestic producers (due to rising prices of goods). That
is the principle of price compensatory mechanism of balance of payments, which is based on
the quantity theory of money.
2
The most known mercantilist was Gerard de Malynes (1586-1641), which recommended the state regulatory
measures in foreign trade.
3
English businessman (1608-1654), who combined his trade activities with the Dutch East India Company.
4
English businessman and board member of the British East India Company (1571-1641).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 11 -
1.2.2 CAMERALISM
At the turn of the 18th
and 19th
century the central European mercantilism (German and
Austrian) so-called cameralism (name derived from the Latin word camera) is formed. More
than mercantilists they focused on matters related to the administration (finance, accounting,
administrative law etc.) and they place more emphasis on population growth. In addition, they
not consider precious metals for the country’s wealth. The country’s wealth was
manufacturing and agriculture. They saw the active trade balance as a means of increasing
employment in the economy. They explained that export increases domestic demand for
goods and thus the labour demand and that import of foreign goods displaces domestic goods
and reduces the labour demand and employment.
Otherwise, their thoughts meet mercantilism:
• They forbid export of precious metals and raw materials
• They negatively perceive import of luxury goods and consumer goods that could
compete with domestic producers
• And they promote stagnation of consumption
1.2.3 DAVID HUME
David Hume5
is the most prominent representative of the so-called formative
economics, which became the basis of classical economics. This economist was a strong
critic of mercantilism, particularly in the determination of the country’s wealth, which is
according him determinate by the amount of labour in the country. He refused active trade
balance through the mentioned quantity theory of money, whose main essence was
formulated by Thomas Mun. According Hume, the achieving of an active trade balance does
not make a sense, since it accumulated the amount of precious metals increases the price level
and reduces the international competitiveness of the economy. The result of this is lower
export of country and higher import. Trade balances are again equalized or get into deficit6
.
To avoid the increasing price level in the economy caused by the increasing amount of
precious metals is necessary to increase production in the economy. Hume also argues that
country that prevents foreign trade mainly harms itself. He also understood the significance of
the international division of labour and indirectly formulated the theory of absolute
advantages, for whose author is considered Adam Smith.
1.3 PURE THEORY OF INTERNATIONAL TRADE – CLASSICAL ECONOMICS
APPROACH
The basis for trading in the pure theory of international trade (whether classic or
neoclassic which is analysed in next chapter) is technological differences between countries in
terms of cost and productivity. We can define two different ways how to describe these
differences: the first way is absolute advantage described by Adam Smith7
and the second
method is comparative advantage whose author is considered David Ricardo8
.
5
A Scottish philosopher, historian and economist (1711-1776) and close friend of Adam Smith.
6
The quantity theory of money interpreted by Hume had some shortcomings, which were based on the economic
conditions of that time: he assumed fixed Exchange rates, since value of money was determined by the amount of value
of precious metals contained in them and he did not expect that amount of money can increase domestic production.
7
A Scottish philosopher and economist (1723-1790), which is considered the founder of classical economic theory.
8
An English merchant and politician (1772-1823), who was follower of Adam Smith and supporter of the labour theory
of value.
1 Pure theory of trade
- 12 The
pure theory of international trade tried to uncover the causes of trade seen in the
benefits deriving form it and to determine the nature of these benefits. In practical testing was
found that only applies to the interdisciplinary area and that means for trade with non-
substitutes9
.
The classical approach is based on an analysis of the supply side and the following
assumptions:
• Economic subjects are behave rationally and make decisions based on real relative
prices
• The market is perfectly competitive and thus there are no trade barriers,
externalities, transaction costs and information is perfect
• There are only two economies, two goods and two factors of production
• Factors of production are limited, fully utilized and there is a mobility between
sectors, but not between individual economies
• Production technologies exhibit constant returns to scale (PPF is a straight line)
• A workforce determines the cost and productivity
• Consumer preferences are the same, as well as their indifference curves
• And balanced foreign trade balance.
1.3.1 ADAM SMITH AND THE THEORY OF ABSOLUTE ADVANTAGE
The most important contribution of Smith to the issue of international trade was his
theory of absolute advantages. It assumes that country should specialize in the production
of those commodities that are able to produce more cheaply, respectively lower cost or
higher labour productivity. We did mention that in this model the workforce determines the
labour cost and that means that it is based on the labour theory of value, which argue the
value of a commodity is given by the amount of labour expended on its production. Absolute
advantage has that economy whose cost per unit of goods are lower than those in other
economy (1.1) or which has the higher labour productivity (1.2.)
FCDC cc 〈 (1.1)
where: cDC – labour cost expended on domestic production of good
cFC – labour cost expended on the production of foreign good
or
FCDC cc
11
〉 (1.2)
where: 1/cDC – labour productivity in the production of domestic good
1/cFC – labour productivity in the production of foreign good
To sum up, the thoery of absolute advantages says that the international trade is a source
of growth in wealth, since it allows more efficient use of factors of production on a global
scale and thus allows the growth of production, which is a source of growing wealth.
9
International interdisciplinary trade is being explored by the modern trade theory.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 13 However,
the theory of absolute advantatges do explain only a small part of the
principles of world trade such as inteantional trade between developed and developing
countries. The majority of current global trade (especially between developed countries) is
ongoing on the principle of comparative advantages.
1.3.2 DAVID RICARDO AND THE THEORY OF COMPARATIVE ADVANTAGES
The theory of comparative advantages, also known as a single-factor model, is the
most important concept of the theory of international trade. The first, who described the
principle of this theory, was Robert Torrens10
, who uses the example of trade between
England and Poland with wheat and denied the correctness of the theory of absolute
advantages11
. Two years later, David Ricardo formalized the principle of the theory of
comparative advantage while using mathematical apparatus and he was recognized as its
author. He showed that not only countries that have an absolute advantage could enter the
international markets. This theory is based on the premise of mutual trade between the
countries while comparing the opportunity cost (an opportunity cost theory itself was
developed by G. Haberler, see chapter 2.1.1), furthermore the labour productivity or benefits
derived from mutual convertibility.
Before we explain the principle of comparative advantage, we will take a look at how to
set up the opportunity cost. The opportunity costs are generally defined as the value of the
second earliest opportunity. For example, the economy Alpha has the ability to produce beer
and cheese. If economy Alpha would like to produce more cheese, the labour would have to
be – due to their rarity and take full advantage – move from beer production into cheese
production. The loss in production of beer means for the economy the opportunity cost.
The opportunity cost is expressed by the amount of beer production that the economy
must give up to produce one kilogram of cheese. Concretely, this relationship can be
mathematically expressed by equation (1.3) and generally by equation (1.4).
1
X
ac
−
= (1.3)
P
S
ac
ac
l
kg −
= (1.4)
where: ac – the opportunity cost
acS – the opportunity cost of producing cheese
acp – the opportunity cost of producing beer
The country has a comparative advantage in the production of such a good, in which
has the lower opportunity cost than the other economy. In our case, the economy Beta has a
comparative advantage in cheese production against economy Aplha, because it has to give up
the less beer production towards the production of cheese than economy Alpha. That means
that Alpha economy can produce beer at a lower opportunity cost than Beta. In other words,
Alpha economy has a comparative advantage in production of beer. It also means that if
Alpha has a comparative advantage in production of one from two goods, Beta has a
10
A British army officer and political economist (1780-1864), who in addition of describing the principal of comparative
advantage (1815) was the first who described the principle of optimal duty.
11
See Suranovic, Chapter 2, Section 12: Appendix.
1 Pure theory of trade
- 14 comparative
advantage in the production of the second good. Within the international trade, it
is impossible to have a comparative advantage in production of both goods. Mathematically
principle of comparative advantage in international trade is expressed by equation (1.5).
DS
DP
FS
FP
FP
FS
DP
DS
c
c
c
c
c
c
c
c
〈⇒〈 (1.5)
where: cDS – the cost in production of cheese in domestic economy
cDP – the cost of beer production in the domestic economy
cFS – the cost of producing cheese in the foreign economy
cFP – the cost of producing beer in the foreign economy
The country has a comparative advantage in production of such a good in which it
has the greatest absolute advantage (economy Alpha in beer production) or the smallest
absolute disadvantage (economy Beta in production of cheese). We could also say that if the
more developed country having the largest absolute advantage in production of certain good
will specialise in this good and the other one leave to the less developed trade partner, it can
reached the larger world production of other commodity, even though its production is shifted
to less favourable conditions.
In practice, this theory has shown as disadvantageous for developing countries in a
long-term perspective, since it can bring only short-term effect. Specialisation in manufacture
and export of “comparative advantageous” goods does not allow developing of such industrial
branches, which are necessary for the development of economy a thus deepen their economic
backwardness.
1.3.3 JOHN STUART MILL AND THE THEORY OF RECIPROCAL DEMAND
The last representative of the English classical school was John Stuart Mill12
, whose
father was a close friend and supporter of economic D. Ricardo. While Ricardo settled for
determining mutual benefits of international trade, Mill led his theory further and dealt with
the issue of determining the exchange ratio between countries (i.e. setting the world price) and
then how to share the benefits of international trade. He created the theory of international
value, or the theory of reciprocal demand.
Mill found out that international value of goods is moving within the boundaries of
national labour costs and specific numeric value of goods is determined by the two countries'
mutual demand for the offered goods. He indirectly defined the international value of the
goods, which is determined by the costs (supply) and by demand. This value is expressed in
international exchange ratio and borders are the national exchange ratios. However, the
question arises, where exactly in this interval will be the international exchange ratio. The
answer is the law of reciprocal demand, which says that the international exchange ratio is
fixed at a level at which the supply and demand for both products will be balanced13
.
Based on the above findings, we can describe the overall benefits of international trade,
which derives from Mill's theory of reciprocal demand:
12
A British philosopher, politician and economist (1806-1873).
13
That was the way he differed from the classic theory, which assumed that the Exchange value (ratio) affect costs. In this
theory, the above-mentioned demand affects this value.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 15 •
The economy gaining a larger share of international trade, if the international
exchange ratio is approaching the national exchange ratio of its trade partner
• And if there are two countries trading with each other – one large (meaning
economically) and the other small, the small one always appropriates a larger share of
the benefits from international trade. In economical terminology: if the economy
Alpha has a large demand for goods of economy Beta and Beta has a little demand for
goods of economy Alpha, the international exchange ratio approaching the national
ratio of economy Alpha.
2 Neo-classical and standard theory of international trade
- 16 -
2 NEO-CLASSICAL AND STANDARD THEORY OF
INTERNATIONAL TRADE
2.1 NEOCLASSICAL THEORIES OF INTERNATIONAL TRADE
Neoclassical economists, except that they focuse on the demand side, differs from its
predecessors mainly in the refusing of the theory of labour value as the essence of the price of
goods. The fundamental argument is a fact that goods are not produced only while using
labour but also by other factors of production such as capital or land14
. Hence the name multifactor
model.
2.1.1 THE THEORY OF OPPORTUNITY COST
The price of good in the neoclassical approach is given by the opportunity cost. The
author of the theory of opportunity cost is Gottfried Haberler15
, which introduced a graphical
representation of this theory while using curves of the production possibility frontier (PPF).
You already know from microeconomics, what these curves represent and what shape they
have. In terms of international economics and our example of the opportunity cost of beer
represent the amount of cheese that economy Alpha has to give up to produce additional litres
of beer, as we have already described in the previous section 1.3.1.
Now we are going to analyse these curves in different situations - at constant or
increasing costs, particularly in individual economies and then while engaging in the
international trade. First, let's take a look at how the PPF looks like in the case of constant
costs for individual economies. If we stay with our example and in the economy Alpha will
produce six litres of beer with the same cost (P) and 8 kg of cheese (S), and in the economy
Beta 2 litres of beer and 4 kg of cheese (see figure 2-1).
Figure 2-1 PPF at the constant costs
14
We will use in our analysis two factors of production – labour and capital.
15
Gottfried von Haberler (1900-1995) was an American economist of Austrian origin dealing with international
economics.
P
6
8 S 4 S
P
2
Alpha Beta
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 17 What
happens when those two countries engaged in international trade? We construct a
PPF in one graph on a larger scale with the involving of indifference curves. These
indifference curves are in our case social indifferent curves expressing consumer
preferences and demands of the population of the economy that are analogous to individual
indifferent curves. In economy Alpha will be for 40 kg of cheese bartering 30 l of beer and in
the economy Beta for 40 kg of cheese 20 l of beer. In case that Beta will be autarkic economy,
its production and consumption possibilities would reach 20 kg of cheese and 10 l of beer (E).
In the case of participation in international trade and specialization, according to the theory of
comparative advantage, its production and consumption possibilities grew to E' (due to the
production of 40 kg of cheese), and thus the economy Beta would export larger quantities of
cheese and import larger quantities of beer, which is shown in Figure 2-2.
Figure 2-2 PPF curve and participation of countries in international trade
If we leave this model situation, because specialization leads to the reallocation of
factors of production and thus increasing costs, we construct a PPF corresponding to this
situation. The case of a closed economy is shown by the curve on Figure 2-3. E represents
equilibrium in an economy that is in a situation of maximum efficiency, since the slope of the
tangent of the international exchange ratio, the marginal rate of transformation of product
(PPF) and the marginal rate of substitution (IC) are equal.
Figure 2-3 PPF curve in case of inreasing costs
P
S
P
30
20
10
Alpha
Beta
Export of cheese
Import of beer
20 40 S
Production of economy
Beta after entry into
international trade
2 Neo-classical and standard theory of international trade
- 18 If
the economy enters into international trade, due to the situation which it occurs, the
new equilibrium would be as follows: If a country has entered into international trade, shifts
the equilibrium to F (see Figure 2-4). How big will be this shift depends primarily on the
terms of trade, whose balance shows a dashed line. With this trade, the economy consumes
such a quantity of goods corresponding to G.
Figure 2-4 PPF curve and participation of countries in international trade
The above figure graphically shows the effects and implications of the participation of
economies in international trade, which are:
• An increase of consumption possibilities of the given economy
• The reallocation of factors of production in the given economy
• New markets
• An expansion of production
• The increase the standard of living economies entering into international
trade
• And last but not least, the dynamic changes such as increasing
productivity, increasing economies of scale and market power
2.1.2 THE FACTOR-PROPORTIONS THEORY
The most significant contribution to the definition of two-factor model of the theory of
international trade was the factor-proportions theory created by economists Eli Heckscher16
and Bertil Ohlin17
. To understand this theory, we need to know the following assumptions:
• The existence of perfect competition, free trade and the same consumer preferences,
the absence of transaction costs and factor mobility between economies
• The existence of two economies with two goods and two factors of production (labour
and capital)
• Economies have different resource endowments of factors of production, in our case it
means that economy Alpha has a relatively capital-intensive and Beta is labourintensive
(K/LA>K/LB)
16
Eli Filip Heckscher (1879-1952) was a Swedish politician economist and economic historian.
17
Bertil Gotthard Ohlin (1899-1979) was a Swedish economist and politician, Nobel laureate in economics.
S
Export
Import
P
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 19 •
Productions are differently intensive on factor-proportion and the use of factors of
production, in our case, beer is more difficult to capital and cheese to work
• The both economies use the same production technologies, and thus factors of
production can not be replaced (e.g. replace labour to capital or vice versa and)
• The existence of decreasing returns to scale.
Heckscher and Ohlin came out from the presumption that the price of factor of
production depends on the relative supply, i.e. on the relative sufficiency and insufficiency. If
enough is its price is low and vice versa. This means that the country will specialize in the
production and export of such a good that use relatively intensively its relatively plentiful
factor of production and import will be focused on goods that use relatively intensively the
factor of production that the given country has a less. This is the essence of HeckscherOhlin
theorem. In other words, the classical theory of international trade see the causes of
trade in the existence of comparative advantages and costs, while the neoclassical theory
extending comparative advantage of differences of countries in the endowments of factors of
production.
Assuming the above mentioned, we can convert this verbal explanations in graphic
form (see Figure 2-5). On the left side of the graph we can see autarchic economies and on the
right side we can see economies involved in international trade. ICs are equal by assuming the
same preferences. These IC intersect PPF at A and A', what means that just as many will be
produced and consumed in each country for the relative price given by the tangents of
individual PPFs. From this graph it is clear that the economy Alpha will have a comparative
advantage in the production of beer (production is a capital-intensive) and the economy Beta
in the production of cheese (production is labour-intensive). If both economies enter into
mutual trade, the situation is changing. The economy Alpha producing at B due to exchange
of beer for cheese reaches E as well as Beta, which produces at B' and by the exchange of
cheese for a beer will gain a consumer equilibrium at E'. Both economies therefore benefit
from international trade, since they consume at a higher level of indifferent curve.
Figure 2-5 Heckscher-Ohlin Theorem
S S
P
Beta
Alfa
II
I
II
I
A
A´
B
B´
E = E´
P
2 Neo-classical and standard theory of international trade
- 20 -
2.1.3 CRITICISM OF THE HECKSCHER-OHLIN THEOREM
First, we will deal with the criticism of some of the underlying assumptions of the factor
proportion theory. Leaving aside the controversy of traditional assumption of perfect
competition, free trade and the absence of transaction costs, the assumption of lack of
mobility of factors of production (especially capital) is also unrealistic, because the
economy where is the fewer of capital there is no problem to bring into the economy and
focus on the capital-intensive production despite the fact that the country is better endowed
with labour. Another controversy is the impossibility of replacing the factors of
production. It is possible that a certain good can be produced in the country that is relatively
better endowed with capital of in larger quantities, while in the country endowed with labour
not, which means that the same product can be capital-intensive in the first country, while in
the second country can be labour-intensive. As was already mentioned, Heckscher and Ohlin
also rely on the assumption of dependence of the price of the factor of on relative supply.
On the other hand, we also must take into account the demand for factors of production, since
for instance, if the supply of labour is high in the given economy, it does not automatically
mean that this factor of production is cheap. If there is a high demand for labor, its price may
be high, even if there is a relative insufficiency.
Another criticism of the stable economy endowment of factors of production was
carried out by the English economist Tadeusz Rybczynski18
, whose conclusions are
summarized in the Rybczynski theorem, which says that in the economy may occur the
situation where the above-mentioned rule does not apply and there will be a change, for
example, due to an epidemy or, conversely, the population explosion or inflow of capital into
the economy. For instance, if there will be an increase in the economy's endowment of capital
(where the labour endowment stay at the same level), it will be reflected in a shift of the PPF,
but disproportionately from higher degree of capital-intensive (rotation curves). In layman's
terms the production should increase in both of goods – in beer and in cheese as well. The
opposite is true, while in beer production there is a large increase, in the production of cheese
is on decline corresponding E' (see Figure 2-6). The conclusion of this theorem states that if
there is a rise in the endowment of one factor, production of good that uses relatively
intensively this factor of production increases, but at the same time the production of good
that uses relatively intensively the factor of production, whose endowment stay the same,
will decrease.
18
Tadeusz Rybczynski (1923-1998) was an English economist of Polish origin.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 21 Figure
2-6 International trade and Rybczynski theorem
2.1.4 THE THEORY OF FACTOR PRICE EQUALIZATION
This theory is sometimes placed among the criticism of the Heckscher-Ohlin theorem,
since the authors drew on constant prices of factors of production. In our opinion, it is better
to consider this theory as an extension of the theory of the factor-proportions theory. The
conclusion of this theory is the Stolper-Samuelson theorem19
. And it is the assumption of
the change of price of factor of production and then the change of a (world) price of a good
while involving of the economy in international trade.
If the economy is well endowed with capital, labour is scarce and therefore there is a
low price of capital r and high price of labour w. If the countries are involved in international
trade, expand the production (and export) of beer, and since the beer is capital-intensive, the
demand for capital will increase as well as profits. Conversely, cheeses (as labour-intensive
products) will begin to import, the demand for labour decrease as well as nominal wages.
This means that the involvement of the economy in international trade leads to an
increase of the price of that factor of production on which its production is relatively
intensive and reduces the price of the factor of production on which the production is less
intensive. After opening the economy, the price and profitability of the good with a
comparative advantage (production intensive on abundant factor of production, the cheap one)
increase and the price of good intensive on a less abundant factor of production – scarce
source – decreases. This leads to a reduction (balancing) the differences in prices of factors
of production between countries with different endowment of these factors.
Stolper a Samuelson drew a conclusion that the increase of the world price of the good
leads to an increase of the price of that factor on which its production is relatively intensive
and reduces the price of the factors on which the production is less intensive. Other two
conclusion derive from this theorem:
• Not all economic entities benefit from international trade. Taking into account our
example, these entities that own capital will be in profit, while the owners of the
labour will be worse off. Economically speaking, the entry of economy into the
19
This theorem is named after its authors – an American economist of Austrian origin Wolfgang Friedrich Stolper
(1912-2002) and American economist and Nobel laureate in economics Paul Anthonyho Samuelson (1915-2009).
P
S
2 Neo-classical and standard theory of international trade
- 22 international
economy implies a change in the structure of the national income
distribution.
• After opening the economy, the price and profitability of a good with a comparative
advantage (with production intensive on abundant factor – the cheap one) increases
and the price of good intensive on less abundant-factor – the precious resource –
decreases. This leads to a reduction of differences in prices of factors between
countries with their different endowment.
2.2 THE STANDARD THEORY OF INTERNATIONAL TRADE
Based on the findings resulting from the above described theories and the subsequent
changes in the world economy, e.g. the Japan's huge export growth or expansion of the group
of newly industrialized countries, economist Paul Krugman20
performed the generalization of
all hitherto existing theories of international trade. He did that in terms of the analysis of the
supply and demand curves, which we refer to as the standard theory of international trade.
This theory analyses the model of two economies that produce two goods, and based on the
following key relationships:
• there is a correlation between the PPF and relative supply curve (RS)
• there is a correlation between relative prices and relative demand (RD)
• a world equilibrium is determined by means of RS and RD,
• the impact of terms of trade (TT) on nation’s welfare.
If we analyse the first relationship, with regard to our example, we can say that RS of
beer increases if the relative price of beer (and its relative quantity) is increasing. Production
possibility frontier is the same as the term of terms of trade (TT) and tangents represent the
relative prices of PP/PS, whose slope depends on the preferences of consumers. Graphically
speaking, if relative prices are rising (dashed tangent PPF), the volume of beer will increase
from Q1 to Q2, while reducing supply and price of cheese (see Figure 2-7).
Figure 2-7 The relative supply and PPF curve
If we analyse the second assumption, we can build on what we already know from the
previous chapter. In Figure 2-8, the preferences of consumers are graphically expressed
through indifference curves. Initially, the economy Alpha produces at Q1 and demand is at D1.
The difference between demand and production will be balanced by foreign trade, as is shown
20
Paul Robin Krugman (1953) is an American economist and Nobel laureate in economics.
QS
QP
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 23 in
Fig 2-8. In case that the relative price of beer increases in this economy (e.g., because of
the entry into the international trade), produced quantity is shifted to Q2 and the demand from
D1 to D2. The effect of an increase in the relative price is such that it increases the well being
of the economy, but if there will be a decline, the economic welfare would also decline.
Figure 2-8 The effect of an increase in the relative price in relation to the relative demand
To derive the third assumption and its analysis, the second economy Beta must enter
“into the game". As with the previous examples, this economy exports cheese, while the
economy Alpha is dedicated to export of beer. The following figure 2-9 shows the situation
before and after the entry of economies into international trade. On the left side of the chart is
shown the derivation of the relative supply and demand curves of Alpha autarkic economy. PR
and QR represent relative prices and relative quantities of beer. RS is increasing since the
higher relative prices of beer leads to an increase in the production of beer in relation to
cheese, RD is declining due to increasing relative demand in case of an increase of the relative
price of beer.
Figure 2-9 Relative demand and supply curves
On the right side of the graph, we can see changes after the entry of economies into the
international trade. RD remains the same due to identically consumer preferences, but only
the supply differs. Why? Economies have different technologies and different endowment of
production factors. While the economy Alpha is well-endowed with capital and is "poor" with
PR
RD RS RD RSB RSSV RSA
PR
QS
Import of
cheese
QP
Q1
Q2
D2
D1
Export of beer
QR QR
2 Neo-classical and standard theory of international trade
- 24 labour,
the economy Beta is doing the opposite. Therefore, relative supply of Alpha is on the
right side of the relative supply of Beta (her PR of beer is lower). When these two countries
enter into international trade, brewing and cheese production is the sum of these productions
in individual countries, and therefore the world's RS is between RS of individual countries (as
well as the world PR). This means that international trade increases the prices of beer in the
economy Alpha and reduces in the economy Beta. In other words, it improves the terms of
trade in the economy Alpha and worsens in the economy Beta. This improvement or
deterioration has an impact on the well-being of individual economies. Whereas the wellbeing
in the economy Alpha is increased, the economy Beta records a decline.
So far we have assumed that the relative demand for beer remains the same (i.e.
consumer preferences are the same in both economies), what may not be true in a particular
case. When does the RD change? The answer is simple – in case of changes in consumer
preferences in individual economies. Imagine that consumers in the economy Alpha begin to
prefer greater consumption of cheese and consumers of economy Beta begin to prefer greater
consumption of beer. This is reflected in the relative demand shifts, as is shown in figure 2-
10. While the relative supply remains the same, the national relative prices differ. Different
preferences lead to different demand for goods of the other economy, which means that the
given countries benefit from participation in international trade, since the prices of the
exported goods are increasing (for the economy Alpha the terms of trade of beer and economy
Beta has an improving terms of trade of cheese).
Figure 2-10 Shifts in the relative demand curve
In this subsection, we analysed the basic assumptions of the standard theory of
international trade and we showed how to create the relative supply and relative demand as
well as the influence of factors of production and preferences and how they affect the shifts of
the curves. Author of this theory also analysed the effects on the shifts of curves, for instance
the economic growth (taking into account the growth in the production of one or other goods),
income transfers, reparations, foreign aid or protectionist measures. Given the limited scope
of this chapter the author of this textbook did not make a deeper analysis of these effects and
she refers avid readers to the author’s book21
.
21
Krugman P. R. and M. Obsfeld, 2003. International Economics: Theory an Policy. 6th ed. Addison-Wesley. ISBN 0-
321-11639-9.
PR
RS
RDB
RDS
RDA
QR
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 25 -
3 ALTERNATIVE AND INTEGRATIVE THEORIES OF
TRADE
3.1 THE ALTERNATIVE THEORIES OF INTERNATIONAL TRADE
In previous chapters, we have analysed the pure theory of trade, which is the main
essence of examining of the comparative advantage and factor endowment. Now, we are
going to focus on the analysis of theories, which are from the point of view of the
international economics considered for alternative theories. These theories are – according to
chronology – the theory of the infant industry, the theory of international value, the theory of
the second best, the theory of peripheral economies, the dependency theory, the theory of
immiserizing growth, overlapping demand theory and the technological gap theory.
3.1.1 THE THEORY OF THE INFANT INDUSTRY
The theory of the infant industry is one of the oldest alternative theories. Friedrich
List22
is considered as the author of this theory. Although List formulated his thoughts into the
form of theory, this theory is not his own. The first who dealt with this issue was Alexander
Hamilton23
, who initiated the debate on industrialization through protectionist of infant
industry in 1791 (he promoted the protectionist measures of the United States on products
imported from the UK). His follower was Henry Ch. Carey24
advocating protectionist
measures necessary to removing barriers to the development of young companies that are
created by activities older and richer nations.
This theory is based on the idea that an economy whose production is in its initial
(infant) stage, cannot operate on the basis of free trade with countries that are already mature,
because of the absence of competitiveness of their products (see chapter 4.1.3). Industrial
production of this economy would not develop and would be driven out by stronger
competitors. The essence of this theory is not in direct conflict with the classic "laisses-faire",
since Smith and Mill do not condemn protectionist measures in the case of the young or
established industries, however, they are uncompromising and require a free trade policy. In
connection with this theory, the problem raises with defining and identifying the various
stages of "immaturity" and "maturity" that are not actually measurable.
Despite the constant efforts to liberalize international trade, the protectionist arguments
of the theory of the infant industry are still relevant, since with the new arrangement of postwar
world economy and the emergence of a group of developing economies, raised the
problem of whether they are able to be involved in liberalized trade. The fact that businesses
from the developed economies operate in international trade for a longer time and over time
were able to increase their production, they have better information and knowledge about the
production process, about the characteristic of market (as well as about the labour market) and
in consequences of that they are able to offer their production on the international market at
lower prices (and because of economies of scale also with higher profits), that is the reason
enough to apply the theory of infant industry in practice of developed economies (and the
22
A German economist, the founder of German economist, founder of the German historical school that significantly
contributed to the formation of a customs union between the German states (1789-1846).
23
An American lawyer, financier and political economist (1755-1804).
24
Henry Charles Carey was an American economist and representative of American School of capitalism (1793-1870).
3 Alternative And Integrative Theories Of Trade
- 26 least
developed ones25
in particular). This theory, in accordance with the above-mentioned
conclusions of the pure trade theory does not assume that the protectionist measures could be
limited. On the other hand, domestic firms, protected by e.g. import tariffs, would be able to
cover the increased costs of production and began to profit from higher prices of products
and, over time, because of the experience and knowledge reduce costs of production and the
degree of protectionism then could be continuously reduced.
In connection with this theory, raises the question of why does it imply into the
international trade and why complicates international trade relations, if each country based on
the comparative advantages should specialize in the production, which has a lower costs and
other less productive and less effective production leave to the others. But the problem is
hidden in the resolution of static and dynamic comparative advantages. While pure theory of
international trade is based on static comparative advantages (the most efficient allocation
at one point in time), the theory of infant industry is based on dynamic comparative
advantages (the most efficient allocation in the long term).
The conclusion is as follows: The positive effect in the long term (dynamic model)
eliminates the negative effects of short-term (static model), and therefore the application of
the theory of infant industry for emerging industries is (in our case the beer production in the
economy Beta) justified.
The above-stated analysis is a simplified model that is subjected to criticism with
arguments against the introduction of the theory of infant industry. These arguments include:
• A possible emergence of externalities, when in this case is this theory only the
second-best choice (for the theory see the chapter 3.1.3) and there is other, more
efficient, method, and that is production subsidy, which does not cause the shift of
supply curve (that remains at S, the difference is equalized by subsidies so that the
final prices P1), therefore no losses of consumer and surplus of producer – the cost
of introduction of subsidies are thus smaller than in the theory of infant industry
(which moreover causes the loss of consumer), which means that even though it is
beneficial for the economy, it does not necessarily be the best.
• The problem of providing protectionist measures that may be in the long term
counterproductive (bring more costs than profit from protectionism and bring even
to inefficient firms profits)
• A removal of impulses to the development of firms themselves
• A lack of awareness in the implementation of protectionist measures – the
government have to know the potential of each sector, as these sectors (and their
support) will affect the others, etc.
• And last but not least, a complicated estimate of the correct settings of the above
measures for the right sector and for the right time.
3.1.2 THE THEORY OF INTERNATIONAL VALUE
26
In the context of the theory of value was proposed by Karl Marx27
, based on the
classical theories of international trade while he also criticize them, the theory of
international value. In his conclusions, he tried to prove the erroneousness of the theory of
25
These less developed countries or developing countries are abbreviated as LDC – Least Developing Countries.
26
As a basis for writing of this subchapter was not only Marx's Capital, but especially textbook of prof. Robert Holman,
PhD. From 1991 (see bibliography) that very closely and thoroughly summarized the conclusions of Marx's most
comprehensive work.
27
Karl Heinrich Marx (1818-1883) was a German philosopher, publicist and economic theorist and co-founder of the
communist movement.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 27 reciprocal
demand. He argued that reciprocal demand cannot affect the international exchange
ratios (relative price changes), but the change of demand in one economy for the products of
second economy (price increase) will cause a change in supply of demanded product (and
return to the original value of production). International exchange ratios and according Marx,
these international exchange ratios are not determined by relative prices, but by the value of
the international exchange.
Since Marx, as well as his classical predecessors, was based on the labour theory of
value, the conclusions of his theory were also related to this theory. The international value
was determined on the basis of the international division of labour by social relation between
producers of different countries, which was shown by exchanging their products. The size of
this international value was determined by the socially necessary labour or labour expended
by the largest suppliers of products on international market. This means that international
trade is not a mere exchange of use value of goods for goods, but also by the exchange of
national labour, which is included in this goods. But there is a fundamental contradiction in
this theory: If the products are exchanged in international trade, it means as mentioned above
that there is exchanged the same amount of socially necessary labour, but since in individual
economies, there are different initial conditions and thus different costs of production, the
amount of national work is differ.
Marx assumed that firms in less developed countries produce their products at higher
national costs (on labour) and if they are not the largest suppliers, then they trade on
international markets at lower price than their national ones and vice versa (the developed
economies have lower costs and sell at higher value than is their national one). Thus,
international trade expresses the economic inequality and its removal at the international level
is not possible in most cases due to limiting factors such as less skilled labour force or less
access to modern technologies.
Despite the above-mentioned shortcomings and inequalities Marx recommend
international trade, since on the base of comparative advantages the less developed economy
obtains more use value than if would produce the product by itself. And that is because of the
imported product would – said in modern technology when import substitution – expends
more national labour then before. According Marx, the economic inequality can be removed
by accelerating economic development and reducing national costs of less developed
countries and international trade on the classic "laisses faire" can only work when advanced
economies cease to promote the principles of profit.
3.1.3 THE THEORY OF THE SECOND BEST
In 1956, Richard G. Lipsey28
and Kelvin J. Lancaster29
formulated the theory of the
second best, which is focused on exploring what happens in the economic model, if the
optimum conditions are not meet. The conclusions of the theory are applicable to all
government policies. We will deal with the impact of its use in international trade and it can
be generally said that this theory is among the group of “protectionist” theories.
To analyse the theory of the second best, we have to realize the basic principle of all
economic models and that is the achieving economic equilibrium. A perfectly competitive
market includes:
• Prices of firms’ output are equal to marginal cost
• The ratio of the prices of two products are equal to the ratio of substitution of these
two products
28
Richard George Lipsey (1928) is a Canadian economist.
29
Kelvin John Lancaster (1924-1999) was an American economist.
3 Alternative And Integrative Theories Of Trade
- 28 •
In the long run, the economic profit of firms is equal to zero
• The supply of products are equal to demand for them.
But what happens if one of the above-mentioned conditions is not met for any reason?
What happens if the market does not reach equilibrium and demand will not match the
supply? Will firms set prices based on marginal rates and consumers their optimum
comparing prices and marginal rates of substitution or will market operate on different
principles? The conclusion of the theory of the second best is that if one of the conditions of
equilibrium will not be met, it will change the other conditions (i.e. firms will not set their
prices based on marginal costs and consumers will set their optimum based on above
mentioned ratio).
Now let’s look at how we apply this theory to international trade. If an open economy is
in equilibrium, it follows from the fact that the optimal government policy is a free trade
policy and each protectionist intervention reduces economic efficiency and national wealth. In
this case, we can name the free trade policy as the first best choice and such a situation when
economic efficiency cannot increase, we call economic nirvana. However, the real economy
does not reach this situation, there are plenty of distortions and imperfections (externalities,
government intervention, firms are price makers, imperfect information, etc.). If there are
these imperfections, it reduces economic efficiency and national wealth. We can call the
optimum achieved in such a situation as the second-best optimum. The policy – in our case
– trade policy through action (protectionist measures) will lead the economy to the second
best optimum, and this optimum, which is at a lower level than the best optimum, is called the
second best option30
.
3.1.4 THE DEPENDENCY THEORY
At the end of the 50s of the last century, independently on each other, Raúl Prebisch31
and Hans W. Singer32
formulated conclusions known as the Singer-Prebisch thesis (also
known as Prebisch-Singer thesis or Prebisch-Singer hypothesis) and this is the underlying
concept of dependency theory. Their researches showed that economic activity in the
developed countries, which they called "centres" (they were OECD member countries) often
caused economic problems of poorer countries, called "periphery" (they considered for them
countries of Latin America, Africa and Asia, and countries with a low GNP per residents and
single-commodity export specialization). The above-mentioned thesis is based on the fact that
"primary production is located in the periphery and the other degrees of sophistication and
spending in centres" (Prebisch, 2006, p. 90) and they exchange this production between each
other. All incomes from international trade flowed into the centre, since they processed
industrial products from primary commodities and sold them back to peripherals, which
creates value added. This was an obstacle to the development of peripheral economies, which
was recommended to remove by focusing on industrialization through the form of import
substitution (see chapter 17).
Prebish and Singer came in their thesis to the conclusion that over time the terms of
trade worsen between primary products and manufactured goods, which mean that peripherals
are able to import still smaller quantities of industrial products at the same – unchanging
volume of foreign trade. As one of the reasons for this deterioration they stated that the
30
However, there is an exception and that is the „big“ open economy that can influence world prices and because of
optimal duties, quotas and other measures may be this policy the first-best choice.
31
Raúl Prebisch (1901-1986) was an Argentine economist, director of ECLAC and co-founder UNCTAD.
32
Hans Wolfgang Singer (1910-2006) was a German economist dealing with the issue of development.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 29 income
elasticity of demand for industrial goods is greater than the income elasticity of
demand for primary products. As income grows, so the demand for industrial goods is
growing faster than the demand for primary commodities. Over time, the technology is also
improving, which means that wages are increasing and profits of firms and centre are able to
accumulate savings, but in the peripheral economies, where is not so noticeable technological
progress is not achieved high profits and wages and savings are "dissolved" in lower prices.
In the 70s and 80s of the last century, the theory was very popular, which corresponds
to the trend in the development of economic theories, but we have to say that from current
perspective, the conclusions of this theory have several shortcomings. If we omit the
impossibility of the existence of economies of scale, little political will or degree of control of
exported primary production, we can find several contentious issues:
• The distinction of the concept of backwardness and underdevelopment – while the
backwardness reflects the use of available resources in a peripheral economy, but in
favour of centres, underdevelopment means unused resources
• Peripheral economies in terms of historical context are not poor because they lagged
behind the scientific or enlightened development of centres, but because of they
were relegated by these centres to the role of supplier of cheap agricultural products,
raw materials and cheap labour force and thus were deprived of the opportunity to
trade their resources to compete with centres
• The definition of term national interest, which is identified with meeting the needs
of the poor people from peripheries and is neglect of meeting the needs of
companies or government needs
• A misuse of resources over time, which is maintained not only through the power of
dominant states (centre), but also through the power of elites in the dependent states
(peripheries), whose interests are the same, since these elites were educated in the
centres.
3.1.5 THE THEORY OF IMMISERIZING GROWTH
Jagdish Bhagwati33
formulated the theory of immiserizing growth based upon the
assumptions of pure theory of international trade, a world economy consisting of two
countries that produce two commodities. By his examining he tried "to formulate the
conditions under which occurs the immiserizing growth" (Bhagwati, 1958, pp. 201-202).
While using the graphical model he argued that economic growth might lead to a decline in
economic welfare. Although he did not define that these economies may be developing
countries, this theory was accepted by many advocates of protectionism, especially in less
developed economies, "in whose exports dominate simple primary products" (Pryor, 2007, p.
211).
The theory of immiserizing growth is based on the analysis of the impact of
deteriorating terms of trade. However, the possibility that immiserizing growth occurs is
conditioned by the inelastic demand of the rest of the world (in our model, i.e. the second
economy) and growth reducing the domestic production of the exported goods. Other
conditions of immiserizing growth include low ratio of export to domestic production (GDP)
and low elasticity of demand for exported goods, due to their changing prices.
33
Jagdish Natwarlal Bhagwati (1934) was an Indian economist working in the United States of America.
3 Alternative And Integrative Theories Of Trade
- 30 -
3.1.6 OVERLAPPING DEMAND THEORY
In 1961, H. M. S. Burenstam Linder34
published a hypothesis later called Linder
hypothesis, in which is the theory of trade based on demand unlike the theory factorproportion
theory that are focused on the supply side. This hypothesis assumes, that
economies with the similar demand will develop a similar industry, hence the name the
overlapping demand theory. Then these economies will trade with each other with a similar,
but differentiated product.
This theory is based on the fact that the main determinant of trade flows between the
two economies is the structure of preferences and the effect of the domestic market in the
selection of exported products. In other words, this means that the economy should export
those goods for which they have a large domestic market35
. On the other hand, with
increasing distance the trade between economies is increasing, while it cannot be understood
only as the geographic remoteness, but rather as the economic distance. The structure of
preferences can also be assigned to the economic distance as well as institutions and language
understanding. The way to reduce the cost of export is through exports to countries that have
a similar structure of preferences as the domestic market.
But how do we find that the markets are similar in demand (preferences)? One way is to
compare the average income of each economy: the smaller the difference between the average
income of each country, the greater the mutual trade. This approach has the advantage of easy
estimablity, but on the other hand it says nothing about how income is distributed in the given
economies. It may therefore happen that in two similar income economies the structure of
preferences is different, if there is different income distribution. Another shortcoming of this
theory is that it analyses international trade in industrial products and it does not deal with the
export of primary commodities. And last but not least, we can consider as a controversial the
conclusion of this theory based on the fact that the products will be more mutually
marketable, the more they will be similar to each other and their properties will overlap.
3.1.7 THE TECHNOLOGICAL GAP THEORY
In the same year, as Burenstam Linder published his hypothesis, a British economist M.
V. Posner formulated the contradictory theory – the technological gap theory. This theory
"assumes that trade can be caused by technological changes and development that affect
certain sectors and not the others" (Posner, 1961, p 323).
Based on these changes, which are actually innovations, arise comparative advantages
accompanied by increased exports of these goods (and increased income). However, over
time this advantage is losing, since the rest of the world begins to imitate innovation. In this
situation, the original innovator economy try to "come into the market" with another
innovation that should lead and then repeats the above-described mechanism. If follows that
innovations cause the constant time-limited technological gaps of innovator and imitators.
3.2 INTEGRATIVE THEORIES OF INTERNATIONAL TRADE
In previous subsections, we have discussed the theory of international economics based
(more or less) on the comparative advantages of pure theory of international trade. Since there
is in the current global economy a growing interdependence of economies and their
integration into international trade, these countries tried to deepen benefits resulting from the
34
Hans Martin Staffan Burenstam Linder (1931 – 2000) was a Swedish economist and conservative politician.
35
P. Krugman, who included in this model transaction costs and decreasing returns of scale, developed this thought in 80s
of last century.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 31 international
trade through the integration process. In this chapter we will analyse the impact
of these processes on the international trade in terms of economic theories. First, we examine
the theory of customs union and then we describe the theory of optimum currency areas.
3.2.1 THE THEORY OF CUSTOMS UNION
In 1950, Jacob Viner36
described the static and dynamic effects of the lower forms of
integration along with its effects on international trade, which he called the creation, transfer
and deflection of trade, in the theory called the theory of customs union. Trade creation is
the process by which the result of the establishment of the custom union the international
trade increases. The reason for such a growth is:
• A consumption effect, which is reflected in a decline in domestic prices of the
imported product, when consumers increase purchases of goods
• A production effect, which does not have such a positive effect on domestic
economy, because the elimination of tariffs can cause that foreign production crowd
out the domestic production.
Transfer of trade will occur when imports from third countries are substitute of import
of another member state of the union on the basis of the abolition of tariff barriers. To the
reduction of the trade occurs when they are imposed higher duties on imports from nonmember
countries than were before the creation of the customs union, which leads to a
reduction in imported products.
Our analysis will be further developed in two directions – we will try to summarize the
short-term reactions (static effects) and long-term reactions (dynamic effects) on the
establishment of a customs union. Static effects can be expressed best by using the graphical
model of a customs union in trade with one product between two economies (Alpha and Beta)
with a common customs policy against the economy Gama (see figure 3-1).
Figure 3-1 Static effect of the customs union
36
Jacob Viner (1892-1970) is an American economist of Canadian origin who deals with the international trade and the
theory of firm (he introduced the curves of short-term and long-term costs).
SA+B
SW+T
SW
Q QW Q
P
3 Alternative And Integrative Theories Of Trade
- 32 Consider
that the supply of the economy Alpha is at SA and demand is at DA. This
economy has no tariff barriers with the outside world. Price of product corresponds to the
price PW while consumption QW. If this economy imposes duties on other economies, the
supply of the rest of the world moves to a higher level at SW+T (an increase of customs duties),
prices will increase and the amount of consumed goods reduces (these effects will be
discussed in chapter 10). Equilibrium point is now at F. If this economy creates a customs
union with Beta and the economy Gama becomes the third economy, the supply curve shifts
to SA+B as a common supply of domestic producers and equilibrium is reached at E, what
means the reduction of prices and increase of consumption (but also reduction of customs
revenues to the state budget). If economy Gama also joins the customs union, international
trade would be settled at the position corresponding to the initial level PW and SW. The
introduction of the customs union has a static positive effect in the short term.
If we interpret the impact of the customs union from the long-term dynamic
perspective, conclusions will be different and that because of the changed initial conditions.
In the long run, companies in the customs union may as a result of the increased market more
efficient use of their resources achieve economies of scale and thereby reduce costs and
prices. This will be reflected in the shape of the supply curve, which has a decreasing trend
(see Figure 3-2). The graph shows the situation in the economies Alpha (larger economy with
heavier sales) and Beta (smaller economy with small market) before and after the introduction
of the customs union. Economy Beta has higher production costs before entering the customs
union, but after the entry, due to a larger increase of sales than at economy Alpha and thus
greater economies of scale, we can see that the supply curve of the economy Beta gets under
the curve of economy Alpha. There is an optimal impact of the customs union because of
the economies reach the maximum volume of consumption with minimal cost. However, it
can also occur the situation, which we call sub-optimal impact. This occurs when firms in
the economy Beta will not adjust to the new conditions and products from economy Alpha
flow (through lower prices) into the economy Beta. This causes a further decline in demand
for goods from economy Beta, which are ultimately crowded out and the price will appoint at
P'CU and the consumed amount will reduce. To avoid that those not very optimal conditions
are not met, the state interventions through appropriate economic policy are necessary.
Figure 3-2 Dynamic effects of the custom union
Market economy Alpha Market economy Beta Customs union
P
PB
P´CU
PA
PCU
DA+B
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 33 Although
the effects of the customs union on international trade seem to be for a free
trade generally positive, there are obstacles that prevent the unlimited mobility – these include
physical, fiscal and technical barriers:
• Physical barriers in the form of physical checks at national borders (for example
EC quotas on Japanese products, which were broken down between the Member
States, the license check against international transport or subsidies under the
common agricultural policy, when he had to control the movement of agricultural
commodities)
• Fiscal barriers through various indirect and direct taxes (value added tax,
consumption tax)
• And technological barriers in the form of non-uniform technical, sanitary and
environmental standards that are the most difficult to remove from these three types
of barriers and there are the subject of lawsuits (see Example 3-3).
3.2.2 THE THEORY OF OPTIMUM CURRENCY AREA
In 1961, Robert Mundell37
published his theory of optimum currency areas and
defined the optimum currency area (OCA) as the geographical area with internal mobility
and external factor immobility, where should maximize its economic efficiency based on
the single currency. Although Mundell is officially considered as the author of this theory,
many people consider as the author of this thoughts Abba P. Lerner38
.
The theory describes the optimum conditions for the unification of currencies, or to
create a new currency, and often is used for affirmative or disapproving justification, whether
one or other economy is ready to enter into the higher forms of integration39
. Meeting these
conditions guarantees a good balance between the costs and benefits of monetary union, and
if these conditions are not met, they lead to the opposite situation. These conditions include:
• The sufficient level of labour mobility between different parts of the monetary union
• The lowest possible degree of wage and price fixation within the individual
economies
• Similar endowments of natural resources
• The synchronization of the business cycle
• The high degree of diversification of foreign trade and homogeneous structure of
production
• A symmetry of positive and negative external shocks
• The existence of an adequate mechanism of fiscal compensation.
In the OCA theory, the exchange rate of the national economy is considered as an
important tool for economic policy to adapt to an asymmetric shock. Asymmetric shock
refers to a situation, which affects only a particular national economy and causes in
various economies differentiated impacts, especially on economic growth and employment.
M. Friedman has already formulated the assumption, based on the fact that if there is an
external factor immobility, prices and wages are fixed and if there are supply or demand
shocks (asymmetric shocks) is better when the economy has a floating exchange rate. Thanks
37
Robert Mundell (1932) is a Canadian economist and Nobel laureate in economics for this issue.
38
Abba Ptachya Lerner (1903-1982) was an American economist, author of NAIRU a co-author of Marshall-Lerner
condition.
39
For instance, in case of the European Union, individual economies do not have the form of OCA, but Europe as the
whole shows this characteristic.
3 Alternative And Integrative Theories Of Trade
- 34 to
this exchange regime, the economy can adjust these shocks. However, if economy fixe an
exchange rate, it results in negative changes in the price level and unemployment.
As we have already noticed, the later concept of the theory of optimum currency area
places emphasis on analysing the benefits and costs of the creation of OCA. Impacts are
significantly different in the case of fixed and floating exchange rates. Benefits of monetary
efficiency belong to the positive effects and there are expressed:
• Elimination of transaction costs in the form of e.g. the abolition of bank charges for
foreign transactions (it is estimated that banks in the EU have lost half their income
– see Krugman, Obsfeld, 2003, p. 620)
• For small open economies, reducing the impact of changes of exchange rate on the
price level and real growth.
The benefits of OCA in international trade include a reduction in the uncertainty of
financial investment40
by increasing the stability of the exchange rate and reduction of the risk
of currency crises and especially by the expansion of foreign trade and increase of mobility of
capital between member states of monetary union (due to lower transaction costs and risks).
In addition to the positive impact, the currency area also has its negatives or cost. This
negative can be the loss of economic stability that arises from the inability to use exchange
rates and monetary policy to stabilize output and employment. There are also some unclear
impacts and these can be the impact of the fiscal policy of nation-states, since the
centralization of the policy can eliminate the asymmetric shocks and on the other hand, leads
to higher costs of it, and further it is a loss of so-called seigniorage (revenue that government
obtained by financing the budget deficit by changing the monetary base) and its distribution
among the participating economies.
40
However, this impact can be positive or negative, since risk reduction brings lower profitability of
investments, which has an impact on product and thus on the functioning of the economy.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 35 -
4 MODERN THEORIES OF INTERNATIONAL TRADE AND
MOVEMENT OF FACTORS OF PRODUCTION
So far we have dealt with the analysis of international economics from the perspective
of perfect competition in the absence of market power (sellers were only "price takers" and
the demand for their products was perfectly elastic), when the assumption of constant,
respectively increasing costs of scale or different endowment of factors of production was
met. Currently, the substantial part of international trade is among advanced economies that
have similar technologies, similar factors endowment and just a little different preferences.
According above-mentioned models (classical single factor model or neoclassical HeckscherOhlin
one) these economies would not have many reasons to trade with each other. Mutual
trade is made on the basis of other then so far discussed conditions.
4.1 MODERN THEORIES OF TRADE – MODELS OF ECONOMIES OF SCALE
The different conditions include economies of scale or otherwise increasing returns to
scale. In the 80s of the last century, P. Krugman worked in the pure theory of international
trade also economies of scale. Economies of scale mean that with a lower cost can be
achieved a higher production output. If production shows such a characteristic, then
specialization and mutual trade can lead to an improvement in global production and to
increase the welfare of all participating economies. Modern theories of trade deal with these
economies of scale and they analyse the effect of internal economies, dumping and external
economies to the national economy.
To analyse the effect of international trade between the two economies Alpha and Beta,
we used the PPF curve and a map of indifference curves. PPF curve has a convex shape, since
there are increasing returns to scale and economies trading with each other in two different
commodities – beer and cheese, when this type of trade is called an interdisciplinary trade.
However, generally the trade of interdisciplinary product (in this case, beer and cheese)
does not match the current international trade, on which the theory of comparative advantage
can be applied. In recent decades dominate the trade with diversified products, so-called
intra-industry trade, which cannot be explained by using classical and neoclassical
apparatus. Many countries export and import similar products. For example, the Czech
Republic imports and export almost in identical ratio of transport equipment, manufactured
goods and raw materials.
To some extent there is intra-industry trade because one category includes many
different types of products. For example, the largest commodity items of Czech foreign trade
are road vehicles, electrical equipment and appliances and office equipment. It may therefore
happen that production of road vehicles requires different technology and different range of
resources than the production of office machines, in which the second economy may have a
comparative advantage. But since all machine types are included in one category, it may seem
that the economy imports and exports the same products, although the economy exports, for
instance, more road vehicles and imports more office equipment.
From the above-mentioned it follows that a country that uses intra-industry trade,
benefits from a larger market by reducing the number of manufactured goods in favour of
their diversity, and that is based on demand and also on efforts to satisfy domestic consumers.
From a mathematical point of view, the degree of intra-union trade shows Grubel-Lloyd
index (Grubel and Lloyd, 1975), whose notation can be expressed by using equation (4.1) or
(4.2). In the formula (4.2) the numerator expresses the absolute value of trade balance of the
4 Modern theories of international trade and movement of FActors of production
- 36 economy
and the denominator is the value of trade turnover. GLi has a value in the interval
{0,1}, where 0 means complete inter-branch specialization (international trade in a model of
comparative advantage) and 1 means total inter-branch specialization of the economy.
( )Im
ImIm)(
+
−−+
=
Ex
ExEx
GLi (4.1)
or more often
( )Im
Im
1
+
−
−=
Ex
Ex
GLi (4.2)
where: Ex – export
Im – import
As we have already mentioned, the pure and standard theories of international trade
analyse interdisciplinary trade (on the basis of comparative advantages) in perfect competition
where there are no economies of scale and firms are price takers. However, in the real world,
this assumption is almost impossible to meet, because firms that are mainly engaged in
international trade, profit from increasing economies and they are price makers. It is clear that
they operate in conditions of imperfect competition. You have already been familiar with the
forms of imperfect competition in the study of microeconomics (more Tuleja, Majerová and
Nezval, 2005). However, since the analysis of behaviour in monopoly and oligopoly in
relation to international trade is complicated, only the analysis of the last type of imperfect
competition – monopolistic competition – will be performed, because its behaviour that is
closest to the perfect competition and it is also the most common type of competition in
economies. On the basis of this type of competition was created a model of internal
economies. In addition to this model, we will further analyse the model of external economies
and model of dumping.
4.1.1 MODEL OF INTERNAL ECONOMIES – THE MODEL OF MONOPOLISTIC COMPETITION
Before we will talk about the principles of the functioning of the model itself, remind
the conditions for the functioning of monopolistic competition. It is a type of imperfect
competition, which is based on the following assumptions:
• Existence of many companies in the industry (corresponding the assumption of
perfect competition)
• Each firm produces a differentiated product (i.e. the product of a different nature) –
one produces a black beer, another one low alcohol, third economy produces light
highly alcoholic beer and the fourth economy focuses on the production of nonalcoholic
beer (assumption corresponding the monopoly)
• Differentiated products are imperfect substitutes in consumption, which means that
if a price increase, consumers will move to the consumption of another product – a
function of demand has a declining shape, but its slope will depend on the type and
price of the substituted product (corresponding the assumption of monopoly)
• The possibility of free entry and exit of firms to and from the sector – economic
profit attracts new firms to the industry and a large number of firms will lead in the
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 37 long
term to zero economic profit (corresponding to the assumption of perfect
competition)
• The existence of internal economies of scale, which are expressed by decreasing
average cost curve – with increasing production the costs per unit of production are
decreasing (assumption correspond to monopoly).
Model of internal economies also known as a model of monopolistic competition is a
model which can be explained by intra-industry trade, even though in individual economies
are no differences in resources or in technologies. Its emphasis is placed on consumer demand
for different qualities of goods sold in the same product category.
Take a closer look at the functioning of the model of internal economies. We explain
this on the graphical model. We stay in our example – in the economy Alpha there is a plenty
of firms producing an excellent beer (differentiated products). Firms are price makers (the
effort to maximize profits MR=MC) and there are economies of scale (internal economies). In
the diagram (see Figure 4-1), the amount of beer produced in thousand litres is applied to the
axis x amount and prices for one litre are applied to the axis y. Initially, assume that entry into
the international is disabled because of restrictive measures of the rest of the world (i.e. the
second economy Beta). The profit that is created by production is not large (the field shown
by the little arrow), and given the deadweight loss it could increase (by increasing
production), which is not possible because of low demand. The only way to do that is to
expand into foreign markets.
Figure 4-1 Model of internal economies
Now suppose that due to political negotiations with the economy Beta, the restrictive
measures were successfully cancelled. Since the beer production in the economy Beta is not
able to compete with the production of beer in economy Alpha, demand for beer of economy
Alpha shifts to a higher position, what results in a shift in the marginal revenue (MR) and
increase in profit (the field with the larger arrows). The volume of beer production in the
economy Alpha can theoretically go up to level 730, but only under the assumption of perfect
competition, in this situation, it is preferable to produce at 400 and "collect" the highest
possible profit.
5
4
3
220 MRA 400 MRA+B 730 Q
AC
DA+B
M
QA
QA+B
4 Modern theories of international trade and movement of FActors of production
- 38 From
the above-described functioning of internal economics can be concluded that on
the one hand, the expansion of trade brings an increase in living standards and on the other
hand, it raises enormous pressure on the competitiveness of individual producers. Fight for
consumers will result in the need to constantly offer new and better products, what leads to
their differentiation. That means limiting the substitutability resulting in gaining more market
power and manipulation with consumer preferences. Success can be provided in many sectors
only by access to international markets.
Impacts of international trade
We have already mentioned that the emphasis in this model is placed on consumer
demand for different qualities of goods sold in the same product category and we add that the
expansion of trade should also lead to an increase in their standard of living. This growth is
based on three main determinants:
• An increase of diversity of demanded products, which is caused by product
differentiation within a certain group
• A reduction of the price of each differentiated product through a shift in AC curve
and increase in supply of products to other markets and reduction of their prices due
to the transfer of free resources from existing production.
In the model of internal economies, we can distinguish two negative impacts of
international trade – those are the potential costs of adapting production and the risk
associated with the increasing diversity of products and that the increasing transaction costs:
• The growth of output is accompanied by growth in productivity of factors of
production, what could mean that each firm would be forced to reduce the use of
factors of production and in the long term it could lead to the firm closure. This
closure is associated with the alternative cost of closed production, with the costs
associated with the growth of unemployment, the costs associated with searching for
a new job, further with moving costs, etc.
• And furthermore, assuming the preference of the extension of product diversity
preferred by consumers, we must take into account the associated costs – for
instance, when the demand for beer consumers must test each beer, finding
information about the content of hops, alcohol, etc., which are called in sum
transaction costs.
4.1.2 MODEL OF EXTERNAL ECONOMIES
Models of internal economies and dumping analysed the involvement in international
trade and the consequent effects on the firms level. However, since we examine international
trade in particular on the level of economies, in terms of economies of scale, we must also
accede to the analysis of this phenomenon on a higher level than firm level. To do this, we
used a model of external economies, when external (industrial) economies are such
economies, which we analyse on the level of sector, not on the level of individual firms.
They mainly occur due to the geographical concentration of production of one sector that is
on the local market either because of the provision of specialized services supporting this
production or because of the larger flexibility of specialized workforce (a typical example is
the Silicon Valley).
We might ask ourselves, what is a difference between those two models – model of
internal economies and model of external economies? Are not their impacts on involved
economies the same? We will try to find an answer while using a graphical apparatus.
Consider our classic example – the economy Alpha and economy Beta. We know that each
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 39 economy
specializes in the production of something else. Alpha specializes in beer production
and Beta in production of cheese since they are traditional producers of these goods and they
have some comparative advantages. But what would happen, if the economy Beta also wants
to export beer, for example, because the price of inputs is lower and therefore Beta is able to
produce at lower average costs? Could we conclude that the global price of beer of the
economy Beta will be lower and so the demand for the beer will be bigger?
The conclusion is clear: Countries that started out as large producers of goods in certain
sectors, probably still remain their major producers, even if some other country can
potentially produce the same goods more cheaply (Soukup, 2009). External economies of
scale play an important role in international trade, but their effect is different from those
internal ones:
• External economies does not have to lead (in the existence of many small firms in
the industry) to imperfect competition
• And international trade in their existence does not bring benefits to all participating
countries.
4.2 THE INTERNATIONAL FACTOR MOVEMENTS
The subjects of so far analysed theories of international trade were only goods,
eventually services and their “movements” between economies. Over time, because of the
growing involvement of economies into the world economy, this analysis has ceased to be
enough, since in contemporary world economy, the real economic processes in the areas of
specialization, concentration, spatial distribution of production capacities and flows of goods
and services between each other cannot be interpreted without the exploring of flows of
capital and labour (Cihelková a kol., 2008).
The international movement of production results (goods and services) is not the only
form of international trade. The another form is an international factor movements, which is
further divided into:
• International labour movement
• And international capital movement
Although the international movement of labour is less mobile and less frequent than the
international movement of capital, the analysis of both are based on the following
assumptions:
• The world economy consists of two countries Alpha and Beta
• The both economies use factors of production – labour (L) and capital (K), which
are free to "spill over" from one economy to another
• The economy Alpha is technologically advanced, that there is a better valuation of
the work (higher wage rate w) and capital (higher profits r)
• The marginal products of labour and capital in both economies have decreasing
trend.
4.2.1 INTERNATIONAL LABOUR MOVEMENT
Except that the labour force (L) is generally considered as the less mobile factor than
the capital, another difference is that the only one who “moves” makes the movement of
labour unlike capital. Based on the above-mentioned assumptions, we must also take into
account that we analyse a model that is a static model and therefore, it does not reflect
4 Modern theories of international trade and movement of FActors of production
- 40 population
changes or technological advances and differences in labour productivity (having a
relationship with the price of the work).
This international labour movement has both economic and non-economic motives.
In the past, the economic motives were the finding new experiences and possibility of
livelihood and currently it is the prospect of higher wages and pensions. Among the noneconomic
motives are political, racial, national and religious repression or military and
political situation in emigration economy. In our analyses, we will discuss the economic
aspects of the movement of labour force. For a better understanding we provide a graphic
example to our well-known economies – economy Alpha and Beta (Figure 4-2).
Figure 4-2 International labour movement and its impacts
Before we analyse the international mobility of labour based on the graphical model, we
have to first make a connection between two economies to draw the consequences of this
movement and that by the mirror image of the situation in the economy Alpha and its
"insertion" into the graph of economy Beta. This creates mutual crossing curves of marginal
product of labour, which is shown by the graphical representation of the real wage w. Before
the labour force will start to migrate, the supply of labour in the economy Beta is 0L1 and in
the economy Alpha 0'L1. The level of wages in the economy Beta corresponds to 0WB and a
total amount of product is 0ADL1. On the other hand, the level of wages in the economy
Alpha is at 0WA a total output is given by the area 0BCL1. Since wages in the economy Alpha
are higher than in the economy Beta, these wages attract the labour force from the economy
Beta and thus causing its move from L1 to L2 (from economy Beta to economy Alpha).
As a result of the international labour movement there is the equalization of wage level
in both economies, when the total production of the economy Beta decrease from 0ADL1 at
0AEL2 and the economy Alpha increase from 0BCL1 at 0BEL2. This will lead to a net
increase in world output, which is shown by the area ECD. Except that it will cause to
damage of some group of population in the emigration economy (owners of capital and land
MPLB
MPLA
0 L2 L1 0´
Global supply of worforce
A
WB
B
WA
C
E
D
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 41 are
disadvantaged by the smaller supply of labour) and in immigration economy to the
pressure on real wages.
Impacts of the international labour movement
Decisions of economic entities regarding the migration of the labour are based on the
same stimulus as every other investment decisions and bring both relative costs and benefits –
in other words both positive and negative economic and non-economic impact.
The positive effects of international labour mobility are:
• An increasing of economic efficiency in global scale
• A reduction of the level of unemployment in less developed countries
• An increasing of incomes of immigrants
• A higher possibility of education and job opportunity
• An increasing of income from trade in the recipient country
• And inflow of highly qualified labour force (brain-gain)
The negative effects (costs) of international labour movement are:
• „Immigration" costs in the host country (administrative costs)
• The issue of adaptation in a new country (separation, culture, language, racial and
criminal problems)
• Costs associated with the relocation and temporary loss of employment
• The increasing of the level of unemployment in the recipient country
• A loss of labour productivity in the emigration policy due to loss of workforce
• A brain drain from less developed economies (brain-drain)
4.2.2 INTERNATIONAL CAPITAL MOVEMENT
The next (and also the last) of the factors of production, which will be analysed from the
point of view of its movement, is the capital. Capital is both the financial instruments
(securities, loans, business loans) and non-financial assets (stocks of grain, machinery and
equipment) and last but not least, there are intangible assets (patents, copyrights). However,
we have to realize that the international movement of capital does not involve the physical
movement of machinery and equipment, but "only" their movements through the financial
flows (purchases and sales of securities and loans).
We analyse the international capital movements from several perspectives. The first of
all is the viewpoint of stakeholders (capital transactions of central banks, governments,
commercial banks and other entities), the another one is the aspect of ownership (private
capital, public capital or capital of international institutions), in terms of time (short, medium
and long-term capital) and the viewpoint of its function. The last aspect is the most important
for the analysis of international capital movements and from this point of view we divide
capital into:
• Foreign direct investment (FDI) which are transactions between direct investors
and companies in which investments flows to acquire a significant share of the
management company, where the major holders are mainly multinational companies
(this includes a stock capital, reinvested incomes and other capital) and they are the
most important item of capital flows to all regions of the world (see table 4-2)
• Portfolio investments, which are transactions in shares and bonds, etc.
• Other investments in which we classify business loans (the largest part), loans,
deposits, loans from the International Monetary Fund, etc.
4 Modern theories of international trade and movement of FActors of production
- 42 •
Reserves or foreign assets of the central bank (monetary gold, special drawing
rights, assets in foreign currency)
• And capital transfers, i.e. transactions without countervalue and a specific type of
international capital movements, which are divided into government (forgiveness of
debt, investment grants) and other (capital transfers related to migration, forgiveness
of private debts, transfers of copyrights and patents, etc.).
If we will take a look at the motives of the international capital movement, we
conclude that the main motive is to achieve higher profits. Another motive is the distribution
of portfolio and diversification of risk in the case of portfolio investment. In the case of FDI it
is a searching of sales markets, favourable economic conditions (lower taxes, lower wage
costs, higher qualification, infrastructure, fiscal policy, market size, inflation rate, the
possibility of spillover profit, etc.), or overcoming barriers to international trade (protectionist
barriers) or the use of preferential position of the developing countries (some have lower,
respectively. no customs).
The economic analysis of the impact of international capital movement is similar to
international labour movement and it is shown in Figure 4-7. First, we have to connect two
economies to draw the consequences of this movement by the mirror image of the situation in
the economy Alpha and its “insertion” into the graph of economy Beta. This creates mutual
crossing curves of marginal product of capital, which are the graphical representation of the
returns on capital r. If the economy Beta would be autarkic, it would invest its total stock of
capital 0K1 at its price level 0RB and its total product would be at 0ADK1
41
. Likewise, in the
autarkic economy Alpha is invested 0´K1 at the price 0´RA and the output is at 0´BCK1
42
.
If there is the international capital movement, the part of the capital stocks will move
from the economy Beta into the economy Alpha (because there are higher returns on capital),
and thus a movement from K1 to K2. This rate of return on capital in both countries equals.
Total domestic product of the economy Beta is now at 0EK2, to which must be added the area
K2EFK1, as income from investment abroad. This means that the overall national product will
be at 0AEFK1. The overall domestic product of the economy Alpha rose to the level of
0'BEK2.
41
0RDK1 will belongs to the owners of capital and the rest to the other owners of labour and capital.
42
0´RCK1 will belongs to the owners of capital and the rest to the other owners of labour and capital.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 43 Figure
4-3 International capital movement and its impacts
The above-described movement caused a net increase in world output at CDE, where
CEF is for the economy Alpha and EDF for the economy Beta. Moreover, in case of the
economy Alpha earnings from the international capital movement will distribute among the
economy Alpha (area CEF) and the economy Beta (area K2EFK1). And although there has
been a growth of the production in the individual economies, the effects on the distribution of
income will be different in both economies:
• In the economy Beta, there will be an increase in returns of capital of owners of
capital (from 0RBDK1 at 0VBFK1) and then the incomes of owners of factors of
production will decrease (from RBAD at VBAE)
• And vice versa, in the economy Alpha, there will be a decrease in profits of owners
of capital and increase in incomes of other factors of productions
Impacts on international capital movement
The international capital movement leads to the increase of the total volume of
production, but also to income redistribution and then to the pressures on the
(un)employment. Whereas in the investing economy (Beta) the foreign investments reduce
incomes of owner of other factors of productions and increase unemployment, in the host
economy (Alpha) it is opposite – foreign investments increase employment. Another
economic impacts are:
• An equalization of returns of capital
• An increasing of the efficient allocation of resources
• An impact on the balance of payments (short term), when the investing country has
a deterioration in the balance of payments by higher foreign expenditures (imports)
and the receiving country contrary shows the improvement
• Impacts on tax revenues when firms investing abroad does not pay in most of the
countries double taxes and state will loses tax revenue (for example, if a firm from
the economy Alpha invest into the economy Beta, where taxes are lower and where
MPKB
MPKA
0 K2 K1 0´
Global supply of capital
A
VB
RB
B
RA
VA
C
E
D
F
4 Modern theories of international trade and movement of FActors of production
- 44 exist
agreements on avoidance of double-taxation between states, the economy
Alpha will pay to Beta e.g. 20 % tax and in the economy Alpha will pay the rest –
let say 8 %, what means the state Alpha “lost” 20 percent of taxes)
• The impact on terms of trade, technological progress and independent economic
policy.
4.2.3 MULTINATIONAL COMPANIES AND THEIR ROLE IN THE INTERNATIONAL MOVEMENT OF
FACTORS OF PRODUCTION
In current globalized world economy, the holders of the international movement of
factors of production (especially the capital) are multinational companies. Multinational
company is a company, which has its headquarters in one country and develops a
permanent activity under its supervision at least in two other countries, where has at least
ten percent of its turnover. There are two types of multinational companies. The first is
multinational corporation, which was formed as a result of the merger of two or more firms
from different countries and the other type is transnational corporation that arises by the
allocation of a company's capital into the other countries. These companies with their incomes
and number of employees dominate in international trade and they indicate the growth rate of
not only their home economies.
The national firm may become a multinational company by several ways, namely
merger, acquisition, consolidation or join venture. Merger is the situation when two
companies will merge in one company, where the first company (acquiring) absorbs another
company that after this merger ceases to exist (Lebiedzik, Majerová, Nezval, 2007).
An acquisition means that one company join to another one (taking over all or at least a
majority of the stocks) without their cessation. A consolidation occurs when two companies
combines together to form a new company, which assumes the rights and obligations of
consolidated companies. A joint venture is an association of two or more companies that
carry out the single business with the participation of domestic and foreign capital in various
fields of economic activity.
The main reason of the existence of multinational firms is a competitive advantage of
the globalization of production and distribution. This advantage arose partly from the
horizontal and partly from the vertical integration of foreign subsidiaries. Striving for the
better protection of society, the use of monopoly power and quality improvement of
production as well as distribution networks has led these companies to horizontal
integration. This is based on controlling the various phases of the industry, from acquisition
of raw material through production and their subsequent sale. Currently, vertical integration is
increasingly promoted in order to diversify risks, better supply of goods, their better
distribution and service network, and therefore there is a merger of companies on the
customer-supplier level through the conglomerate structure. This is such a merger of
companies that control the production of many unrelated industries (Lebiedzik, Majerová and
Nezval, 2007).
The above-mentioned competitive advantages are based on economies of scale, funding
opportunities for research and development and better marketing. If we classify the
advantages of multinational companies, we can divided into three areas:
• The advantage of ownership, when multinational firms own special kind of capital
called “knowledge capital” (in the Czech Republic it is intangible property),
consisting of human capital, patents, know-how, trademarks, etc. whose shifts
between branch offices of company are almost cost-free
• The location advantage, which means that the appropriate location of production of
multinational company saves transport costs and company pay less for certain
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 45 factors
of production and also bypasses tariff barriers (i.e. so-called tariff-jump
argument)
• And internalisation advantage related to the technologies, patents, etc. They are
based on two assumptions. If there is an absence of multinational companies that
“wrap-up” these technologies and try to avoid a leakage and dispersion of important
knowledge and also if one company produces products for the other one and both of
them are monopoly it may lead to price conflicts, which are eliminated due to the
existence of multinational companies.
Although multinational companies increase the world wealth and output, the impacts of
their operation on the national economy may be full of contradiction. We have to distinguish
impacts of the parent and the host country, which are considerably different. In the case of the
parent country, the substantial problem could be the increasing unemployment, especially the
less qualified workforce, which may be damaged due to the operation of the company abroad
(on the other hand, the activities of multinational company may cause the increase in
employment in high-skilled labor). The problem may be worsening of balance of payment
because of the deterioration in the trade balance by import of their own production and the
deterioration of the financial account by the export of capital. Another negative effect is that
these companies reduce tax revenues and distort the tax base in its country, if we ignore the
illegal tax evasion. Last but not least, multinational companies may because of their
approaches to international capital markets bypass monetary policy and thus hinder the
control of government over the economy. We have to also conclude that despite these
negatives, there are some also some positive effects of multinational companies. For instance,
they create modern values through the development of advanced technologies based on
research and development where these companies due to their financial position can finance
this development.
In case of the host country, the impacts of activities of multinational companies are
much more problematic. One of the arguments "against" is the dominance over the
economies. It is based not only on concern about the political, but especially the economic
influence. Except the control of the most of the capital in the country, there is an argument of
foreign loans, which bypass the credit terms set by the host country, while lending funds to
foreign debtors on more accommodating terms. Also significant is the "attack" on national
habits through massive advertising and last but not least, the technological dependence of the
host economy on multinational companies. However, this argument can be very positive,
since these companies bring new technologies, modern organization and management, reduce
unemployment and have at least partly effect on the economic growth of the given country.
5 The theory of foreign trade policy
- 46 -
5 THE THEORY OF FOREIGN TRADE POLICY
The involvement of individual countries into the world economy, in this case in world
trade in goods and services, affects the state. This affecting takes a place in trade policy of the
state.
5.1 FOREIGN TRADE POLICY AND ITS INSTRUMENTS
Foreign trade policy of the state represents the behaviour of the state against foreign
trade. This is a set of objectives and instruments, which the government uses in order to
directly or indirectly regulate the scope and structure of foreign trade. Foreign trade policy of
the state is a part of economic policy as well as its foreign policy. This double bond of trade
policy can become a source of some tension when the needs of the economic policy may
come into conflict with the foreign policy orientation of the country. Contradictions may also
relate to more prosaic things such as competence and management of commercial
representation of the Czech Republic abroad.
The general long-term objective of trade policy is to increase the well-being of the
country and therefore the effective participation into the international division of labour. The
short-term objectives are usually attempts to remove undesirable developments of balance of
payments or the balance of trade, or the protection of the weak domestic producers against
foreign competition. To meet these objectives can be applied two different approaches,
namely the principle of protectionism or free trade (see above).
The state uses to promote its objectives instruments of trade policy. In their
application applies the complex of principles, including the principle of reciprocity, the
principle of national equality and the principle of equality of provided benefits. Trade policy
instruments can be divided into two groups: contractual instruments, which country can
apply by agreement with another country (or group of countries), which we will discuss in the
next chapter and then autonomous instruments. These can country apply in its sole
discretion, if it is not bound by commitments from multilateral agreements such as GATT.
Autonomous instruments of foreign trade policy are different measures of the
government unilaterally applied in order to regulate the import or export. They consist of
tariff instruments (application of customs) and non-tariff instruments. Given that the issue
of tariffs has extensive theoretical background and customs themselves belong to the oldest
instruments of foreign trade policy, there will be a chapter 2.5 devoted to them as well as it
will be devoted to other autonomous instruments.
5.2 CHARACTERISTICS OF AUTONOMOUS INSTRUMENT FOR EXTERNAL TRADE
POLICY
As was already mentioned, the autonomous instruments are measures of government,
which government use in order to influence export from the country or the import into the
country, their size and structure to meet the established economic and political goals. These
instruments are mostly defensive in nature and designed to prevent unfair foreign competition
and protect domestic consumers. On the other hand, it is important to realize that they can be
used as protection of domestic less-competitive producers. The use of these instruments has a
long history. In international economics, the theory of trade policy deals with them.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 47 Although
autonomous measures are one-sided in nature, indeed unilaterally may be
used only by this country that is not a signatory to the multilateral trade agreements. WTO
members can use them for short periods and only with the consent of the WTO, otherwise the
country exposes the legal action of WTO brought by the affected country and eventual
sanctions. Autonomous instruments are divided into two groups – into the tariff instruments
i.e. customs duties and non-tariff instruments.
Tariff instruments are customs duties, which are fees charged for goods when crossing
the customs border. Customs duties have a relatively long history and they have evolved from
various trade and transport charges levied for the use of roads, bridges, ports and markets but
also to protect buyers. Customs duty as a single dose charged only when crossing the borders
of the country began to collect in the United Kingdom in the mid-17th
century, in France after
the revolution in 1790. The first single tariffs were introduced in Germany in Prussia (1818)
and in 1834 were enforced by the founding of the German Customs Union (1834). In the USA
were introduced in 1789.
Customs duties are differentiated instruments of foreign trade policy, which is due to its
rich history further divided into groups according to various criteria. For guidance, the
following survey of these aspects:
• According to the direction of transport:
Export duties, their purpose is to prevent undesirable export of certain
commodities (usually for political reasons)
Import duties, their purpose is to regulate the import of goods into the country,
there are imposed on imported goods, their purpose is protectionist
Transit duties, their purpose is fiscal and the other purpose is to charge the
transit countries, nowadays is replace by other forms of transit charges
• According to the calculation:
Ad valorem duties, which are determined as a percentage of the invoiced
valued of goods (the customs value)
Specific duties are determined from the unit quantity of goods (weight, volume,
pieces) and is taken as the basis for the gross weight of goods (gross)
Compound duties are determined as a combination of specific and ad valorem
duty (e.g. 10 % of the customs value, but not less than 1 USD per 100 kg)
Differential duties are determined on the basis of graded tariff rates depending
on the height of the prices of goods
Sliding-scale duties are determined in relation to the prices of the commodity
in the domestic market
• According to the purpose of the duty
Revenue duties, i.e. whose main purpose is to obtain customs revenue, when
these duties are used primarily in developing countries
Protective duties represents a classical instrument of protectionist policy and
they can be divided into:
o Educational duties which serves as the protection of young emerging
industries against advanced foreign competition
o Negotiation duties are set to provide the opportunity to achieve
concessions in trade negotiations
o Differential duties represents the implementation of a variety of duties
for the given commodity depending on the direction or type of
transportation, the objective is to prefer some ways of transportation or
means of transport of some countries
5 The theory of foreign trade policy
- 48 o
Contingent duties should eliminate the disadvantages of domestic
producer caused by the subsidization of production in the country of
importer
o Anti-dumping duties are introduced in the case of proven dumping, they
should not be higher than the so-called dumping margin
o Compensating tariffs should eliminate the disadvantages of domestic
goods given by the higher taxation than is the customs duty for the
same, but imported goods, it is so-called import duty
o Retaliation duties are levied as a reprisal for an increase of tariffs by any
country, what can lead to the phenomena referred to as the tariff war
o Customs-contingent duties are levied for the customs contingents down
in trade agreements, the importing country sets differentiated tariffs by
the imported quantities – the minimum is sets at an agreed quantity,
while imports over this amount of customs tariff increases
o Prohibitive duties are used to the complete prevent of import of a certain
commodity
o Preferential duties are customs duties, which are provided on the basis
of an international agreement on preferential trade such as the Customs
Union. There are also customs duties provided to the developing
countries based on Generalized System of Preferences (GSP)
• According to the scope of validity:
Autonomous duties (also known as general customs duties) are custom duties
unilaterally announced by the state and are valid against all countries where is
not applied the most-favoured nation clause and customs duty may be high
enough to prevent import
Contractual duties are used against countries with which it concluded bilateral
or multilateral trade agreement.
In addition to the tariff instruments in international trade relations, there is used a wide
range of non-tariff instruments. They often create deliberate obstacles to trade. Non-tariff
instruments can also be divided according to various criteria into.
• Paratariff barriers are duties related to customs procedures. They are applied
primarily in developing countries, which procure by that way funds to cover the
costs of customs procedures. These are especially duties for customs procedure:
Fiscal tax levied in addition to the custom duties (for selected commodities)
Statistical duties (1 % of the payment of customs for customs statistics)
Charges for stamps
A tax on imports (transaction fee)
Transport and port duties (e.g., $ 5 per truck)
A tax on the development of foreign trade
Fees for consular formalities.
• Quantitative restrictions of export or import are determined by the quantity of
product that can be exported or imported in a certain period (e.g. in a given
year). Upon exhaustion of the agreed quotas is another import or export is
prohibited. Quantitative restrictions are connected with the granting of import or
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 49 export
licenses and they are negotiated in the so-called sensitive items within the
annual bilateral trade agreements.
• Technical Barriers of Trade include a variety of measures that try to set
technical and other characteristics of imported goods and the obligation of their
proof (examination). On the one hand, these should protect domestic consumers,
but on the other hand they can significantly hamper imports. Technical barriers
are divided into natural technical barriers that are given by the different
historical and cultural level of consumption (e.g. steering wheel on the right,
voltage, etc.) and artificial technical barriers given by domestic technical,
sanitary, veterinary and other regulations. They are related to the mandatory
checking of the functionality of a harmlessness of product and it is obligated to
grant the relevant certificate. Technical barriers and their application are
governed by the Agreement on Technical Barriers to Trade (1979), which was
updated in 1994. Guiding principle of the agreement is to ensure that technical
regulations and standards do not become obstacles to international trade. For this
reason, member states should be based on the existing international standards
while developing standards. If there are not exist and countries develop their
own standards, the must to provide an explanation to the standard if is requested
by another member state. In addition, each member state shall ensure that its
normalization body proceeded in its activity in accordance with the Code of
Good Practice for the Preparation, Adoption and Application of Standards,
which are annexed to the Agreement. If the confirmation concerned the issue if
product meets the international standard and regulation is required, the member
states grant to the foreign products the same conditions. Each member state shall
ensure the establishment of an information centre that will answer answers of
other member countries, provide a documentation of all received or preparing
regulations and technical standards for the conformity assessment. Member
states shall take measures to ensure that governmental and non-governmental
institutions act in conformity with the Agreement.
• To the other non-tariff barriers we can assign the following actions:
•An import charge – the amount levied on imports of goods and set as a
percentage of the customs value
•An import deposit – the amount paid in interest-free import of a specified
amount for a specified period, after its expiration is returned
•The monitoring of imports or exports – keeping the volume of trade if there are
available information about the possibility of damage of the given industry and
therefore it is necessary to monitor the situation on the market, or if it is required
by the international agreement
•A minimum price – a measure which determines the lower limit of exported
product the to foreign exporter, in the case of non-compliance can be imposed
sanctions in the form of additional duties or quantitative restrictions
• Support instruments of export are the base of pro-export policy that can be
characterized as the objectives that should be reached by the export and set of
instruments and measures to their ensuring. The part of the pro-export policy is
also the activity of supporting governmental and non-governmental institutions
to assist the activities of exporting companies.
5 The theory of foreign trade policy
- 50 -
5.3 THE EFFECT OF CUSTOMS DUTIES ON SMALL AND LARGE ECONOMIES
As was already mentioned, the duties are the oldest instruments of foreign trade policy.
The considerable attention of the economic theory – the theory of international trade –
is devoted to these instruments. The significant part of this theory considers customs duty for
the basic barrier to international trade and tries to prove their versatility harmfulness. On the
other hand, there is also the theory of optimal duty that shows also advantages that the
customs duties may bring to the economy.
The effects of customs duties are multifaceted and interrelated. They have an
significant impact on a small open economy where the price at which it sells production on its
markets is affected by foreign importers. A small economy is in this case in the position of
price taker. The effects of tariffs on the economy are as follows:
• Protectionist – an increasing price of imported products protects domestic
industry, but the economy as a whole loses, because it expend more social costs
(factors) on the production that could be used somewhere else
• An effect on consumption – there is the increase in prices for consumer and
reduction of consumption
• An effect on the state budget – tariffs represents customs revenues, however
their imposition on imports must be chosen in order to do not worsen the
conditions of consumption (from this point of view, the duties should be
imposed on avoidable, luxury and in the goods that is not produced in the
country)
• A redistributive effect – the imposition of duty leads to the transfer of consumer
surplus (through increase of price) in favour of the protected producers
• And effect on competition – the imposition of duties at the same time eliminates
foreign competition, thus creating a domestic producer of greenhouse conditions
that lead to long-term decline in the efficiency of the national economy, and
therefore it is possible to proceed with this step only if it is for the protection of
the young industries that need protection for the period before they will be able
to produce under conditions comparable with global competitors.
Above-mentioned effects can be illustrated graphically on our well-known case of the
economy Beta that produces cheese (see Figure 5-1). The price of production in a closed
economy is to at equilibrium level PD and domestic producers provide all demand for
production. After opening the economy to foreign production, the price of goods stabilizes at
PW. However, at this price, they sell only the production of Q1, but domestic consumers are
willing to buy the amount of Q4. The gap between the supplied and demanded quantity is
filled by import (supply SW). This development has a negative impact on domestic producers
and they are lobbying for their own benefit and the government to protect them, imposes a
duty on imports of production. The price of cheese rises to the level of PT, where domestic
producers are able to offer quantity Q2, but buyers are at this price able to buy only the
quantity Q3 and the supply of foreign manufacturers fall to SW+T.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 51 The
customs duties are the following effects:
• There will be a decrease of consumption, which is shown be the decrease from
Q1Q4 at Q2Q3, the area d expresses the limit of consumer possibilities due to the
limitation of supply possibilities Q3Q4
• The area b express the inefficiency associated with shifting of resources into the
supported production, it is the loss of other sectors
• The area a represents additional income of supported producers at the expense
of consumer surplus
• The area c represents the customs revenues into the state budget
• And the area c represents the revenue to the state budget associated with a
change of terms of trade due to the imposition of customs duty.
However, customs duties may have other effects since they can be used to influence the
macroeconomic aggregates, namely:
• Income and inflation – the imposition of customs duty decrease the supply for
foreign goods, thus there is a saving of resources that can be used for the
mobilization of available factors of production at home, which will lead to the
growth of income. However, if there are not enough free factors, the resulting
savings may have inflationary consequences and increasing of duties leads to
inflation. This effect can be used in the opposite situation – by the reduction of
tariffs eliminates inflation, e.g. in the overheated boom (demand for factors
outstrips supply of factors) the reduction of tariffs may lead to increased inflow
of foreign factors and deceleration of inflation (e.g. this policy applied by the
German government in the 50s of the 20th
century).
• A balance of payments – a limitation of expenditures abroad currently means
decline in imports, which in the case of passive trade balance that may lead and
thus to the improvement and thus to improvement of the balance of payments.
Figure 5-1 The effect of customs duty on the small economy
P
PD
PT
PW
PT*
S
SW+T
SW
D
c
b
d
e
Q1 Q2 Q3 Q 4 Q
5 The theory of foreign trade policy
- 52 •
Terms of trade – customs duty increases the price of imported goods and
relatively reduces the cost of domestic production, which can be simultaneously
exported what results in relative improvement of terms of trade.
As can be seen, customs duties represent an instrument of economic policy. However, is
shown that their use as a tool for improvement, e.g. the balance of payments, is time-limited
and does not solve the problems that are the cause of the given development. The main use of
tariffs is to protect domestic industry. But it is need to take into account their negative effects
on other sectors and populations.
The mentioned effects of the imposition of duties are related to small economies. But
what are the effects of introduction of customs duties if they will be imposed in a large
economy, i.e. the economy, where the consumption of the given commodity is globally very
important? Such an economy can acquire so-called the market power, when introducing of
customs duties may get the economy into the position of worldwide oligopoly, respectively
oligopsony, and it becomes a price maker. Country may affect the terms of trade through
tariffs to its advantage. This is illustrated in the following Figure 5-2.
The demand for the given commodity in a large economy is given by the line D, initial
supply of world exporters by line S line and it is buying the Qo units at a price P0. The
introduction of duties means a shift in the global supply position at S1. In this situation, the
price would rise to PX and demanded quantity would fall at QX. This would mean serious
problems for manufacturers in the world (unutilized capacity), and therefore the price drops to
a level P2. Taking into account the duty, the final selling price is P1. At this price, the
demanded quantity falls at Q1 and equilibrium will establish at E1. If there will be no duty, the
price would equalize at Ey (it would be inefficient situation and manufacturers would not be
able to supply on the given market). Rectangles ca and cb represent the total amount of
customs revenue of the state budget and on the other hand, they show that domestic
consumers do not pay duties, but importers on whose goods the duty was imposed as well as
it was enforced the price reduction pay. Triangle d expresse
s the loss of consumers in the large economy and triangle f expresses the loss of
manufacturers because of the unutilized capacity. As is evident, the large economy obtains a
net income.
Figure 5-2 The impact of custom duty on a large economy
S1
S
D
ca
d
QX Q1 Q 0 Q
f
Cb
P
Px
P1
P0
P2
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 53 Other
problems with the imposition of duties in a large economy are revealed in chapter
2.1.4 by the analysed Stolper-Samuelson theorem. Suppose that a country is abundant in
capital-intensive goods, it specialized in their production and import the labour-intensive
goods. However, the imposition of duties on imported goods, which are labour-intensive,
changing conditions on the domestic market. The increasing price of the production is a
stimulus to produce it in the inland. There is a pressure on increasing of wages and it reduces
the price of capital. The opposite process occurs in the rest of the world. Stolper-Samuelson
theorem demonstrates the fundamentally anti-market nature of the duties. This can
significantly affect the distribution of income and economic activity related to the factors of
production. There is a distortion of the basic rules under which the international division of
labour and optimal allocation of resources run:
• Instead the prices converge to a single world price, they diverge
• Similarly should evolve price factors, but they are developing in the opposite
direction
• Two previous trends give wrong signals for resource allocation
• Increasing of transaction costs associated with trade (costs of overcoming tariff
barriers, negotiation, but also by the customs agenda grows)
• And the imposition of duties has dangerous political implications not only
outside economies (the threat of customs war), but also within the economy,
where are built groups of people against each other (trade unions are pushing for
the introduction of custom duties and forcing wage policy to the outside world).
5.3.1 IMPACTS OF CUSTOMS DUTIES FROM THE PERSPECTIVE OF GENERAL EQUILIBRIUM
So far we have dealt with the effects of the imposition of duties in terms of partial
equilibrium. However, the international economics also analyses their impacts in terms of
general equilibrium. We also have to distinguish the impact on small and large economies. If
we stay with our example, Slovakia will be considered as the small economy (therefore it can
not influence its terms of trade), it will export cheese and import beer. The impacts of the duty
are shown in Figure 5-3.
Figure 5-3 The impact of duty on small economy
QP
QS
Q2
Q1
D1
D2
TT after the introduction of
duties
TT before the introduction of
duties
5 The theory of foreign trade policy
- 54 Solid
lines represent the domestic terms of trade and dashed lines indicate the foreign
terms of trade. You can see that before the introduction of tariffs, the economy "operates" on
the level of production Q1 and consumption D1. Within the application of protectionist policy,
the production of beer increased, but the level of exported production decreased to Q2 and
also consumption decreased to a lower IC at D2.
This was the case of the impact of customs duties on a small economy, but what
happens if the economy, which has the ability to influence world prices and is a large
economy? The large economy exports beer and import cheeses (see Figure 5-4). This graph is
very similar to the previous one, except that there is an improvement of the economic
situation after the imposition of duties because of the improvement in their terms of trade and
deterioration of trade of trade of the rest of the world. The country raised its beer production
from Q1 at Q3 and consumption from D1 at D3.
5.4 THE EFFECT OF QUANTITATIVE RESTRICTION ON THE ECONOMY
To protect the economy can be used also a quantitative restrictions that mean the
limits of the quantity of production by setting of quotas, which happens at the concluding
annual trade agreements. On the given quota is granted an import licence and import over this
licence is prohibited.
Figure 5-4 The impact of customs duty on large economy
QP
QS
Q3
Q1
D3
D1
World relative prices
before the introduction
of duties
World relative prices after the
introduction of duties
Cheese (Slovakia export)
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 55 The
impact has much more harder impact on the economy that negative effects of the
imposition of customs duties (see Figure 5-7). PD represents the equilibrium price in a
situation where only domestic producers provide all the demand for the production of cheese
and the economy is closed. The price dropped at PW when the economy has opened to foreign
production. Domestic producers are calling for protection and thus a quota on imports of the
given commodity is established while its price rose up from the level PW at PK and total
supply changes from level to level SW at SD+K (SW'). Supply curve has a cranked shape
because the demand is in its horizontal part is hedged by imports and its growing part is
hedged by domestic production. Imports will fall from Q1Q4 at Q2Q3 and the sum of the areas
a+b+c+d expresses the loss of consumer surplus (due to increasing of prices). The area c will
not accrue to the state budget, as is the case of the imposition of custom duty, but to the
domestic importers or foreign companies that received the import license. This area is referred
to as a pure monopoly rent.
By the introducing of quotas the economy looses the state budget revenue and eventual
production of public goods, while this loss increases the net monopoly rent, that accrue to
foreign importers and domestic producers. The consumer loses as in the case of the custom
duty.
Figure 5-5 Quantitative restrictions and their impacts on the economy
P
PD
PK
PW
S
SD+K
(SW´)
SW
a c
b
d
Q1 Q2 Q3 Q4 Q
6 International Trade Agreements And Commercial Treaties
- 56 -
6 INTERNATIONAL TRADE AGREEMENTS AND
COMMERCIAL TREATIES
In the previous chapter, we have analysed the autonomous trade policies. Now we will
discuss the second type of instruments – the contractual instruments. Contractual instruments
are further divided into bilateral and multilateral instruments. Bilateral instruments are trade
agreements, commercial treaties and payment agreements.
6.1 CONTRACTUAL INSTRUMENTS
A commercial treaty is a framework agreement between the two states, which contains
the general principles of mutual handling of the parties in the field of economic relations.
These treaties are concluded at the highest level (head of state) and they are long-term. They
contain provisions on conditions of import and export of goods and customs, tax and fee
issues. Using the clause sets these provisions, where the most important clauses are:
• A reciprocal clause that commits the partners to provide to each other the same
or equivalent benefits. This is a direct contractual arrangement because the
scope of the rights and obligations arises directly from the agreement. These
rights and obligations are interconnected so that the parties are deemed to be
equivalent and mutually conditional. Reciprocity may refer to the same thing
(both sides are agreed to the same process) and the various things that the parties
are stipulating.
• A parity clause (equal treatment or national treatment), which expresses the
same commitment to the treat the people and goods in the other country as in
own country. This clause eliminates discrimination in the treatment of foreign
persons and things in comparison to national. GATT governs by this clause in
Article III of the Treaty.
• The most-favoured-nation clause (equal treatment or national treatment), which
commit the country to provide each other with all the benefits, which were
provided or will be provided in a future to the third country. This clause can be
defined positively or negatively. In the first case, countries undertake to provide
all the benefits granted to third parties, in the second case, undertake to not treat
the goods and persons worse than in the third countries. This is the most
important clause in international trade. Its application has contributed
significantly to the liberalization of world trade. The use of this clause is binding
on all member countries of GATT.
A trade agreement is also bilateral in nature and is based on commercial treaty. Trade
agreements specify the commercial treaties for a given period (usually one year). They adjust
the trade relations, set the scope and commodity structure of the exchange of goods. Annexes
contain lists of traded commodities, which are either contingent (includes fixed amount of
each commodity) or non-contingent that have only indicative nature with showing such
commodities can be traded. A contingent agreement sets only the commitment that state will
not prevent the imports or exports as well as it issue an import license.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 57 Payment
agreements are concluded if the issue of payments is not addressed in the
payments commercial treaty. It is an agreement between states or central banks about ways of
settlement of claims and liabilities arising from mutual relations. The agreement specifies the
currency in which it will be charged, the number of accounts, payment titles, interest yield,
credit limit, etc. There are two types of credit agreements: a payment agreement in free
convertible currency or agreement of payments in clearing currency. The clearing is the
situation that is used if the currency of one or both countries is not freely convertible. In
clearing payments, the settlements do not pass the state borders. Importers of participating
countries refer their salaries to the clearing bank of their country and exporters getting paid
from the same bank in terms of national currency. After a certain period of time (usually at
the end of the year) the balance between authorized banks is just adjusted by the agreed way.
6.2 A BRIEF HISTORY OF INTERNATIONAL AGREEMENTS AND COMMERCIAL
TREATIES
International trade is the oldest form of external economic relations. At the dawn of
modern history, the long-distance trade was linked at that time known civilizations. Silk Road
linked China and the Middle East, which was the trade that connected the Mediterranean
region and Europe. The successful development of this trade required stable conditions and
rules under which it could take place. These should be ensured by contracts concluded
between parties concerned – states (in the Middle Ages they were also various port cities and
their groupings, such as "Hansa") – to the ensuring these conditions. In these contracts were
reflected both the approaches of the concerned parties to the trade as a source of wealth and
their power-political interests. A huge impetus to the further development of international
trade was represented by overseas voyages of discovery.
The approach of individual countries to the international trade was given by the
prevailing economic doctrine. The oldest one is mercantilism, whose antipode is the doctrine
of free trade (lazess faire).
As you already know from Chapter 1.2.1, representatives of mercantilism considered
trade as the source of the country's wealth, whose source is the inflow of gold into the
country. Its increasing can be achieved by limiting imports, by protecting of their own
manufacturers and export support. They promoted a principle of protectionism and required
the state to intervene in external economic relations to decelerate the "negative tendency for
the national economy" and strengthen the positive one. This approach is characterized by both
tariff protection and by promoting unequal treaties. The extreme form of this doctrine was
expressed by the slogan "Enrich yourself at the expense of their neighbours."
In contrast, as we explained in section 1.3, supporters of the principles of free trade
are based on the principles of classical economics, where is considered as the resource of
wealth the efficient production and trade that enables the efficient allocation of resources with
regard to comparative advantages. They required free conditions for trade, while refusing the
state intervention in foreign trade by letting the space for free market forces since only by this
way could be achieved an optimal integration of each country into the international division
of labour. A state shall keep only records of statistics of goods and services flows and the
necessity of intervene came only in cases that threaten health.
These doctrines were also reflected in the concluded bilateral trade agreements. An
example of mercantile treaty is called Treaty of Tordesillas concluded in 1494 between
Portugal and Spain. In this treaty, they defined spheres of influence in the Western
Hemisphere. Another agreement of a similar sense was the Methuen Treaty concluded
between England and Portugal in 1703. In this treaty, England enforced the increase of its
exports to Portugal in exchange for a reduction in customs duties on imports of Portuguese
6 International Trade Agreements And Commercial Treaties
- 58 wine.
This treaty basically meant a partial economic subordination of Portugal by England.
An example of liberal agreements is an agreement on the establishment of the German
Customs Union in 1850 or Cobden-Chevalier Treaty concluded in 1860 between France and
England, which removed all tariffs between these countries.
In the history of the world economy prevailed, with the exception of the second half of
the 14th
century, protectionist approaches to foreign trade. It is a paradox that at the time when
the most developed countries were concluding liberal commercial treaties, in other countries
came a new wave of protectionism, which is known as economic nationalism. Many German
economists claim allegiance to the mercantilism (F. List, W. Sombart) for those the
mercantilism meant the state-building policy. The newly united Germany entered the path of
catching-up advanced countries (England and France) and it just took advantage of
protectionism in international trade. However, this policy resulted in a power conflict caused
by the effort of redistribution of colonies, which were seen as a source of wealth.
The protectionism was very massive applied mainly between the two world wars, when
it was one of the causes of slow economic recovery of economies from the crisis in 30s of the
last century. The impulse for introduction of general tariff war was the adoption of SmoothHawley
Tariff Act in 1930, which introduced the highest tarrifs in their previous history in
the U.S.
International trade policy at the time represented a summary of the foreign trade
policies of states that sought to subordinate the interests of foreign trade to the domestic
economy. From this to some extent resulted confrontational nature of foreign trade policy,
which culminated in the tariff war in the 30s of the 20th
century.
Only after the World War 2 can again experienced the attempts to limit the
regimentation of foreign trade and its release, since the level of tariffs became the obstacle of
mutual trade and hence the economic growth of individual countries. This activity is
associated with the signing of the General Agreement on Tariffs and Trade (GATT) and the
attempt to create the International Trade Organization (ITO International Trade
Organization). Only in this context we can talk about the emergence of international trade
policy as such, since only GATT brought rules and principles, which signatory countries
committed to follow in their trade policies. Its guarantor should be an organization that should
solve all problems connected to the international trade. However, this was created much later
and also other international organizations that dealt with the international trade had effects on
the formation of international trade policy. There were primarily organizations that were
created under the auspices of the United Nations (UN), but also non-governmental
international organizations such as the International Chamber of Commerce (see below).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 59 Although,
the negotiations under the GATT helped to significantly reduce the level of
tariffs in international trade, there is no unambiguous victory of the principles of free trade.
Problems of protection of domestic production are transferred to another position and
discrimination took the form of the application of technical obstacles. Even thought these
problems have been resolved on the ground of GATT, a fundamental problem of international
trade remained unsolved and that is the problem of integration of less developed economies
into world trade.
Developing countries consider the current trade liberalization and its form as
unacceptable for themselves. They crave entry on the markets of the developed countries for
those products, which can compete, with low level of wages (e.g. textiles and clothing,
agricultural production). Is obvious, that economically developed countries prevent to that
from the internally political reasons, but on the other side they try to enforce the principles of
fight against so-called social dumping. It appears that further liberalization of international
trade has encountered an obstacle, which will be very difficult to remove and probably it is
also the cause of unfinished Doha round of negotiations, which should lead to a further
deepening of multilateral agreements that are so far concluded.
6.3 THE GENERAL AGREEMENT ON TARIFFS AND TRADE
High level of tariffs from the years between two World Wars and post-war difficulties
with the achieving of economic development led to the efforts to liberalize the mutual trade
between countries. The expression of these efforts was the signing of the General Agreement
on Tariffs and Trade – GATT (General Agreement on Tariffs and Trade) in a September
23, 1947. This is a multilateral trade agreement containing a set of rules to be followed by the
concerned parties in the modification and implementation of foreign trade relations. The
original GATT was signed by 23 countries, including the Czechoslovakia and in 1992, the
GATT had 116 countries, which accounted 90 % of world trade. GATT is the basis of
international trade policy.
A significant benefit of this agreement for liberalization of world trade was achieved
mainly due to the fact that all signatory countries committed themselves by signing to the
unconditional observance of the main articles of agreement. It was an international legal
norm, which included the possibility of sanctions. To check the implementation of the
agreements and organizing other meetings has been established the GATT secretariat, which
was settled in Geneva. GATT principles were based on neo-liberalistic ideas of the benefits of
liberalized world trade for all countries that have sought to eliminate all barriers to
international trade. From the beginnings, the general agreement advocated the following basic
principles:
• International trade should be pursued without discrimination, what should be
ensured by the granting of most-favoured-nation clause
• Domestic industry may be protected only by tariffs and use of quantitative
restrictions should be exceptional
• Controversial issues should be solved through consultations between the
concerned parties.
Integral parts of the GATT agreement are so-called schedules of concessions. These are
documents in which the specific commitments of countries are listed. These documents
contain mainly import tariffs of each member country, which this country has undertaken to
apply to imports of products originating in any other member country of GATT. Unification
of these multilateral concessions was a difficult process, based on reciprocity. Therefore, the
6 International Trade Agreements And Commercial Treaties
- 60 schedule
of concession of each member country is relatively stable and cannot be modified on
the basis of the requirements of importers or manufacturers.
The process of reducing tariffs and removing obstacles was carried out through the
GATT negotiating rounds (tariff conferences). Only a few of the largest producers of the
given commodity was attended these meetings. The meeting was led on the basis of
reciprocity and results of arrangements – a reduction of duties to other participants in GATT –
were transmitted through the most-favoured-nation clause.
There is a possibility to provide some exceptions either one-time or permanent from the
GATT. For instance, the most-favoured-nation clause is not applied to advantages granted to
the countries that provided them under other contracts. These are the following cases:
• An agreement on free trade zone
• An agreement on customs union
• Tariff preferences among former metropolises and colonies
• A movement of workers in the local border traffic
• Tariff references in cabotage transport
• The generalized system of preferences.
GATT has played in the post-war world a positive role because this agreement has
prevented further tariff increases, ensured a gradual reduction of tariff barriers and it made
through the most-favoured-nation clause and organizing of special tariff conferences. Their
purpose was to negotiate on the basis of bilateral negotiations the tariff concessions between
the major suppliers, which were automatically extended to the other contracting countries of
GATT. From 1947 to 1960, the fourth tariff conferences took place. Further negotiations took
longer time than one year and for this reason they were marked as GATT negotiation rounds.
The first was the Dillon Round, which took place in the years 1960-61 and aims to
reduce tariffs. Negotiations in this round were carried out by representatives of producers,
who accounted for 80 % of world production of the given commodity and they agreed with
major customers to reduce tariffs. The other round was the Kennedy Round took place from
3 May 1964 to mid-May 1967. During the negotiation round, the gradually reduction of tariffs
by an average of 50 % was achieved. In addition, this round also dealt with the issue of antidumping
measures.
The great importance in world trade liberalization has the Tokyo Round (1973-1979),
where in addition to the reduction of tariffs, non-tariff measures and framework trade
agreements were discussed. Tariffs were reduced by another 20 %. However, the Tokyo
round had to deal with a new phenomenon – the rise of the use of technical barriers to trade,
which often had more restrictively effect than custom duties.
The Agreement on Technical Barriers (TBT), which aimed to eliminate confusion of
technical law, was adopted. In the agreement, there was enshrined an obligation of
notification, i.e. the obligation of country to provide the prepared technical standard or
regulation for comment and assessment to other member states. Furthermore, there was also
emphasized the requirement to base on the existing international standards adopted by the
ISO (International Organization for Standardization) and IEC (International Electrotechnical
Commission) while when formation of the national standards and regulations. Due to the
increased transparency of technical law, entities that are interested in a particular market or
are established on it, are in time informed about the technical terms and their changes, what
reduces their costs and increase their competitiveness. The drawback of the Tokyo round was
a lack of institutional ensuring of agreement and thus the possibility of continuing
discrimination.
The last GATT round of negotiation was the Uruguay Round, which took place from
1986 to 1992. This round was focused on the conclusion of the most comprehensive
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 61 agreement
on intellectual property and trade in services and furthermore on enforcement of
proposal for further reduction of tariffs by one-third, but also reduction of government
subsidies on agricultural production and the liberalization of agricultural trade. Negotiations
came to a dispute between the USA and the EU. The essence of this problem is evident from
the contents or round negotiations, and especially from the Blair House agreement. The
content of the Uruguay Round constituted the following problems:
• The reduction of tariffs by 30%
• The liberalization of trade in tropical plants
• The liberalization of trade in fish, wood, non-ferrous metals and minerals
• The reduction in subsidies, tariff reduction and reducing of the impacts of
sanitary standards in agricultural production
• The change the trading rules of intellectual property
• The development of a framework of rules for trade liberalization in services and
audio-visual equipment
• A simplification of procedural forms in resolving disputes
• And institutional reorganization of GATT with the aim to establishing the World
Trade Organisation, which should replace GATT.
The Uruguay round was completed on April 15, 1994 in Marrakesh (Morocco), where
was signed the Marrakesh Declaration appreciating the results of the Uruguay Round and
also signed the Final Act summarizing the results of the negotiations. They are covered in the
Agreement establishing the World Trade Organization and its attachments are all
accepted multilateral agreements. These include:
• The Marrakesh Protocol to the GATT 1994 confirming the attached Schedule of
concessions and commitments resulting from agreements on industrial products,
textiles and clothing and agriculture and includes measures to eliminate tariffs
and non-tariff barriers in these areas
• Update of the interpretation and application of certain articles of GATT 1994
and the provisions of the new trade rules, which should lead to improvement of
trade rules when it had the following agreements:
The Agreement on the Application of Sanitary and Phytosanitary Measures
(the new agreement preventing the conversion of measures in trade barrier)
The Agreement on Technical Barriers to Trade (clarifies the provisions of the
Agreement on Technical Barriers 1979)
The Agreement on Trade-Related Investment measures relating to trade Trims,
which was the first attempt to unify the international approach to foreign
investment
The Agreement on the application of anti-dumping code (revision of 1979)
The Agreement on Customs Valuation (revision of 1979)
The Agreement on Preshipment Inspection (new agreements aimed at the
unification of all activities associated with the inspection before shipment)
The Agreement on Rules of Origin (new agreement to harmonize the rules on
determining the origin of goods)
The Agreement on Import Licensing Procedures (revision of 1979)
The Agreement on Subsidies and Countervailing Measures (revision of 1979,
introducing the concept of specific subsidies and subsidies)
The Agreement on Safeguards (revision of the agreement, based on a desire to
eliminate discriminatory measures)
6 International Trade Agreements And Commercial Treaties
- 62 The
conclusion of the General Agreement on Trade in Services GATS
(General Agreement on Trade in Services)
The conclusion of the Agreement on Trade-Related Aspects of Intellectual
Property Rights, including trade in counterfeit goods
The conclusion of the Agreement establishing the World Trade Organization
WTO (World Trade Organisation).
The successful conclusion of the Uruguay Round and the signature of other major
contracts and in particular the creation of the World Trade Organization may conclude an
important stage in the formation of international trade policy. Nevertheless, as is pointed out
by other developments in the negotiations organized under the auspices of WTO, the Uruguay
Round did not solve the problem that shown as fundamental for the functioning of world trade
and that is the issue of protectionism of agriculture production from the EU and the USA.
They will be outlined in the chapter dealing with the WTO.
6.4 THE WORLD TRADE ORGANIZATION
GATT negotiations were marked by that it was initially created as a temporary business
arrangement. Leaving the intention to create ITO, the contracting parties faced the task if deal
with a considerable number of legal and institutional issues in a pragmatic way – case-bycase.
And this rooted the pragmatism in the function and application of GATT. Various
subsidiary bodies were created as well as the rules of negotiations were set. These facts gave
to GATT the character of an international organization. This situation did not complicate the
GATT activities, if only a few countries signed the agreement. In the 60s of the last century, a
significant number of countries – especially developing countries – acceded to an agreement
and they have brought their economic problems, but also customs and traditions.
As a critical was shown the situation during the Tokyo Round, when the contracting
parties stood in front of virtually insurmountable procedural problems especially in non-tariff
area was adopted a number of side agreements and arrangements. Each of the agreements of
Tokyo Round was signed by only part of the members of the GATT, which in later years led
to conflicts and disputes between member countries. GATT has become complex and difficult
to manage. Therefore, there were made proposals to establish an umbrella organization. These
proposals were supported especially by the EC, Canada and Switzerland. USA held the
reticent attitude to the establishment of an organization.
In December 1995, in Marrakech held 51st
meeting of the GATT member countries that
decided to terminate the activities of the secretariat and the replacement of the activities of the
World Trade Organisation (WTO). It commenced operations on 1 January 199543
. WTO is
a new entity in the world economy and has a role to play third pillar affecting world trade and
the world economy along with the IMF and the IBRD. WTO is a full-fledged organization,
while the GATT was the only intergovernmental agreement. The core of the WTO action is
the issue groomed by GATT, but expanded to all changes and arrangements that were added
to the original agreement during its existence. WTO unlike GATT has a wider scope, brings
to the regulation of international trade in services, intellectual property and investment issues.
The agreement establishes a common institutional framework for trade relations of
member countries to all agreements that annexed to the agreement. This is the current GATT
adjusted in the Uruguay Round. WTO has legal personality and it is built on the approach of
43
To this date, the WTO had 125 members and 28 countries applied for admission (among them China and Russia). In
2008 there were already 153 member countries, including China, which joined the WTO in 2001. Russia has joined in
2012. Currently, WTO has 159 members.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 63 the
single commitment, where WTO members must adopt a set of commitments. This
principle allows avoiding the free-riding of some members on the benefits without providing
appropriate reciprocity. A membership is conditioned by participation in the four multilateral
agreements (Agreement on Trade in Civil Aircraft, Agreement on Government Procurement,
Agreement on meat and Agreement on dairy products).
The activities of the WTO are based on the following principles:
• The principle of liberalization – the effort of permanent removal of tariff and
non-tariff barriers to trade)
• The principle of multilateralism – it expresses the situation when the discussion
of problems involving more participants
• The principle of consolidation – it lays in the fixation of the existing tariff level,
the signatory countries can not arbitrarily change their amount
• The principle of non-discrimination – lays in the providing of the same
treatment in comparison with other entities and is promoted through the mostfavoured-nation
clause
• The principle of parity – the same treatment to foreign goods and persons as
with the domestic from the moment they cross the country's borders.
The supreme body of the WTO is Ministerial Conference, which addresses the issues
of paramount importance, meets at least once a year. The first meeting was held in 1996 in
Singapore. Individual countries then represent permanent representatives at the WTO. The
General Council is highest-level decision-making body, which carry out the functions of the
WTO. There are other permanent bodies subordinated to the General Council – the Council
for Trade in Goods, the Council for Trade in Services and the Council for Trade-Related
Aspects of Intellectual Property Rights.
When deciding is proceeding by consensus and if consensus is not attained it is proceed
to the vote. At meetings of the Ministerial Conference and the General Council, each country
has one vote and decisions are taken by majority of votes with the exception of decisions on
the release of liabilities and interpretation of agreements, when is requiring a three-quarters
majority. Ministerial Conference and the General Council have the exclusive right to make
the interpretation of the WTO Agreement and all multilateral agreements. Regarding the
amendments to agreements and then such actions lead Ministerial Conference and decides by
consensus. With certain exceptions they become mandatory for every member state of the
WTO after the adoption of amendments by two-thirds of the members. The agreement also
makes the provision on the non-multilateral agreements between some members.
6.4.1 THE DOHA DEVELOPMENT ROUND
The World Trade Organization, which was launched January 1, 1995, undertook not
only the agenda of GATT and GATS, but also its methods of work. However, WTO also
enriched them by other important elements such as the introduction of monitoring the
development of the trade policies of member countries and the dispute settlement system.
The basic element of the WTO remained regular conferences of trade ministers of
member countries and negotiation rounds. Since the birth of WTO was held by seven
conferences. The first conference was held in Singapore (9 to 16 December 1996), the second
one in Geneva (18 to 20 May 1998), the third one in Seattle (30 November to 3 December
1999) and fourth in Doha, Qatar (9 to 13 November 2001). The fifth conference was held in
Cancun, Mexico (10 to 15 September 2003). The sixth conference was held in Hong Kong
(December 2005) and seventh in Geneva (30 November to 2 December 2009).
6 International Trade Agreements And Commercial Treaties
- 64 Conference
in Doha Qatar has launched the so-called the Doha Development Round,
which should be completed on 1 January 2005. Fundamental text that was adopted at the
meeting in Doha, is so-called the Doha Development Agenda, which represents the first
working program of multilateral trade liberalization and the adoption of new rules since the
establishment of WTO. Previous negotiations were still in progress under the GATT. The
Doha Development Round has chosen an ambitious goal to resolve the most contentious area
of protection of agricultural markets, namely the reduction of subsidies to farmers that distort
the free market, reduction of import duties on agricultural production and the reduction of the
export subsidies, both on the side of economically developed countries and in developing
countries.
In addition, the service market should be released, the competitive environment for
foreign investment should be strengthened and there should be an increase in transparency of
government procurement and non-tariff barriers to trade should be disposed, the so-called
Singapore issues. They are mainly related to:
• The guaranteeing the rights of foreign investors in the host country
• The ensuring of equal conditions of free competition for domestic and foreign
firms
• The simplification of procedures when moving goods across borders and
reducing the cost of customs procedures
• And ensuring of possibilities allowing foreign companies to bid for government
contracts.
Negotiations of the fifth Ministerial Conference in Cancun, Mexico should summarize
the results already achieved in the agricultural area. The proposed compromise text should be
the basis for further negotiations and the issue of agricultural subsidies should not be closed.
However, negotiations ended in failure and did not achieve neither its minimum objective and
a dispute that occurred between economically developed countries and developing countries
was such a nature that questioned the functioning of the WTO. The essence of the problem is
evident from the following brief summary of the progress of the negotiations. A key
milestone in the negotiations was an agreement the U.S. and the EU in June 2003, when they
agreed on a common approaches certain issues. They committed themselves in Doha to
substantially reduce subsidies to farmers, which reach 300 billion USD per year, what is six
times more than the economic aid to developing countries. Developed countries did not want
to abandon them before developing countries accept their proposals of broad legal and
business reforms and thus they will be willing to offer something (Pospíchalová, 2004).
Developing countries, in their effort to enforce the U.S., EU and Japan to make
concessions, formed a pressure group known as the G2144
and they categorically rejected the
conditional reduction of agricultural subsidies by concessions on Singapore issues from their
side. Although the EU has offered a compromise and excluded the issues of investments and
competition from negotiations, the agreement was not reached because Japan and South
Korea protested and conference was ended.
The Geneva Compromise overcame the crisis of WTO, when the agreement between
the group of economically developed countries and the G21 was concluded in the night of 31
June to 1 August 2008. This agreement should allow further negotiations so that Doha Round
could be concluded at the meeting in Hong Kong in late 2005 or during the following year.
44
The members of the G21 were the following countries: Argentina, Bolivia, Brazil, Chile, Ecuador, Egypt, the
Philippines, Guatemala, India, Indonesia, South Africa, Cuba, Costa Rica, Colombia, Mexico, Nigeria, Pakistan,
Paraguay, Peru, Thailand, Venezuela. These countries represented in 2002 8.1% of world exports.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 65 The
essence of this compromise is that the economically developed countries agreed with the
gradual elimination of agricultural subsidiarity as a forward-looking objective, with a few
particularly sensitive commodities while Singapore issues were pushed aside. The main
argument of the G21 was the fact that they cannot introduce the necessary standards in
business because they do not have the necessary infrastructure since they have no money.
Nevertheless, the lack of compromise is the fact that it does not contain specific dates or
borders for allowable tariffs and quotas. They should be negotiated under a for-last WTO
Director-General, who became Pascal Lamy from September 1, 200545
(former EU Trade
Commissioner and a representative of the EU at the WTO). The Doha Round negotiations
have not been completed neither during 2009 at a conference in Geneva. The meeting was
designed as an exchange of views on the future direction of the WTO, with the political
support was expressed for further negotiations in the Doha Development Agenda.
45
The last - sixth Director-General of the WTO is nowadays Roberto Azevêdo. His appointment took effect on 1
September 2013 for a four-year term.
7 Open Economy Macroeconomics
- 66 -
7 OPEN ECONOMY MACROECONOMICS
Adam Smith and David Ricardo developed the classical theory of trade and they proved
the advantageousness of international trade for all countries involved, but with no matter of
different level of their development. In less developed countries, which could not export their
goods, arose fears of difficulties with their balance of payments, if they open up their markets
to cheaper foreign goods. There was a threat that money (gold) flow out of the economy and
the debt rises up as well as the external economic imbalances of country. The answer to this
question was the classical theory of the balance of payments, which proved that there are
mechanisms, which eliminate the imbalances in the balance of payments. This theory was
later developed by both the Keynesian and monetary economics.
7.1 THE THEORY OF BALANCE OF PAYMENTS
The Theory of balance of payments defines mechanisms that in the absence of trade
barriers should lead to the elimination of external economic imbalances, which are caused by
different flows of money due to the specific form of integration of country into the global
economy. In the following text, we discuss three approaches to the given issue, which are:
• The classical theory of balance of payments and the price-specie flow mechanism
• The Keynesian model and the income adjustment mechanism
• The monetarist approach and monetary mechanism of adjustment.
7.1.1 THE CLASSICAL THEORY OF BALANCE OF PAYMENTS
David Hume formulated the classical theory of balance of payments (in the work
Political Discourses, 1752). The assumptions on which David Hume built up were a
quantitative theory of money, the existing gold-coin standard and thus fixed exchange rates
that prevailed in international monetary relations. Another important moment was the fact that
the demand for foreign currencies resulted primarily as a result of foreign trade and
international capital movements played only a minor role. Therefore, it was possible to
identify the balance of payments with the balance of trade.
The exchange rate was given by the gold parity and money used for cash payments were
fully fledged. The resulting imbalances did not have an affect on the movement of exchange
rates, which remained stable. However, there were international movements of gold.
The quantity theory of money showed that the growth of money in circulation in the
country (for example, due to growing exports) reduces the purchasing power of money (there
is an internal devaluation), thus increasing the price level in the country. The decrease of
money in circulation has the opposite effect. On this basis, D. Hume clarified the price–
specie flow mechanism:
• In a country, which has a negative balance of trade, gold would flow out of the
country to decrease the amount of money in circulation (central banks can issue only
paper money with regard to the amount of held gold). It caused a decline in the
prince level, which resulted in the growth of competitiveness of goods (cost of
goods compared to foreign goods decreased). Foreign demand increased and hence
there was a rise in exports and decline in imports (foreign goods become more
expensive), and this process continued until the balance of payments will be
balanced.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 67 •
And conversely, in a country, which has a positive balance of trade, due to the
export of gold, the amount of money in circulation increased as well as the price
level, the competitiveness of goods decreased (domestic goods versus foreign goods
were more expensive) and foreign demand also decreased. Export decreased and
vice versa import began increasing until the balance of payments adjusted it.
This theory proved that the external balance of the economy is automatically restored.
However, there is a condition – a general application of the policy of free trade. Over time,
individual countries have begun to adopt a floating exchange rate policy and the abovementioned
mechanism underwent modification. The imbalance of balance of payment was
adjusted by a change in the exchange rate. This modification is sometimes referred to the
exchange rate adjustment mechanism. It is a variant of neoclassical price adjustment
mechanism. This mechanism works as follows:
• In a country with a passive balance of payment leads to excess of supply of the
domestic currency over demand (payments abroad). It leads to a currency
depreciation of the domestic currency’s exchange. It also cheaper domestic goods
and imports are more expensive, which leads to an adjustment of balance of
payment.
• And in a country with an active balance of payments it is opposite and it leads to
excess of demand for the domestic currency over its supply (exporters sell foreign
currency and buy the domestic currency to pay to domestic subcontractors). There is
a currency appreciation of the domestic currency’s exchange, which in turn leads
to higher prices of production exported and cheaper imported production, which
leads to equalization of balance of payments.
But the question arose – how large the changes of exchange rates have to be to ensure
the restoration of balance of payments equilibrium? This problem was solved by A. Marshall,
which introduced into monetary theory a term price elasticity of imports and exports. It
shows a change in demand for products of the country in response to a change in price by 1
%. Price elasticity of imports and exports show the sensitivity of exports and imports to price
changes. The imbalance of balance of payments does not induce changes in internal prices of
the economy, but changes of exchange rates and through them, the changes in the prices of
goods in foreign currency. The price elasticity expresses e.g. the volume change of the
English exports to the U.S. in decline (rise) of exchange rate GBP/USD. The price elasticity
of imports and exports depend on substitution of one good to other one. The easier the goods
are substitutable, the price elasticity of imports and exports increased. For instance, when a
country exports goods that are easily substitutable, then at the rise in its price, sharply
decreases demand for these goods and is replaced by other goods or those goods from other
countries.
To remove the deficit of balance of payments through the currency depreciation socalled
Marshall-Lerner condition must be fulfilled. This is defined by equation (7.1):
where: eM – elasticity of import
eX – elasticity of export
Marshall-Lerner condition says:
eM + eX >1 (7.1)
7 Open Economy Macroeconomics
- 68 •
If the sum of the elasticity of demand for export and elasticity of demand for import
demand elasticity greater than 1, then the devaluation improves net export
• If the sum of these elasticities is equal to 1, then devaluation has no effect on the
current account
• And if the sum is less than 1, the devaluation worsens the current account
However, these theories did not take into account the possibility of thesauration of
money in the country with the inflow of gold and in the existence of available factors of
production, the ability to invest idle funds into the next production, which would prevent the
rises in prices. The connection between foreign trade and GDP growth was devoted to the
Keynesian macroeconomics.
7.1.2 THE EFFECT OF FOREIGN TRADE ON PRODUCT
For understanding the relationship between foreign trade and the product of the
economy is necessary to remind the basic Keynes’ idea that the size of the product is
determined by the level of purchase effective demand, i.e. the amount of cash expenditures in
the country. In a closed economy, the purchase effective demand consists of spending on
consumption, investment and government spending. The left side indicates the right side,
what means that the size of expenditure determines the amount of product and there is relation
(7.2):
where: C – consumption
I – investment
G – government expenditures
Y – product
In an open economy, there are additional expenditures accruing to above-mentioned
expenditures, and that are the expenditures of foreign entities spent on goods of the given
country, which are the value of exports of the given country. At the same time, the part of the
expenditures of the domestic population is spent on foreign products, whose value is the value
of imports of the country. This value is not involved in product formation of the given
country, but in the product formation of other countries, and therefore it must be deducted
from the expenditure. Then apply the relation (7.3):
where: M – import
X – export
Equation (5.3) can be also written by following:
C+I+G = Y (7.2)
(C-M)+I+G+X = Y (7.3)
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 69 where:
(X-M) – trade balance of the country
Expression (X-M) is also known as a net export (NX). Previous equation (7.4) can be
written as:
From the above it follows that export increases product and import reduces it, or trade
surplus increases product and deficit of the balance of payment reduces it. From the abovementioned
relationship can be derived the condition for the equilibrium of open economy. If
there is a balance of closed economy expressed by the relationship I=S and simultaneously
G=T, it can also be written as:
where: S – household savings
T – taxes
Then the equilibrium condition for an open economy can be expressed by following
expression (7.7):
Equilibrium condition of an open economy is not only the equality between savings and
investments and taxes and government expenditures, but also between exports and imports.
Expression (7.7) can then be written as follows:
Expression 7.8 shows that the economy is in equilibrium if is reached the internal and
inner equilibrium and if there is the internal equilibrium then there is also external
equilibrium. However, this also means that if they are saving less than investment, then there
is a deficit of the current account (assuming that government expenditures and taxes are equal
and the state budget is balanced). The state budget deficit, then the deficit of the current
account is widening.
Another feature of Keynesian theory is the definition of the function import. It is based
on the Keynesian consumption function, which says that consumption is an increasing
function of the product and is conditioned by the marginal propensity to consume of the
C+I+G+(X- M) = Y (7.4)
C+I+G+NX = Y (7.5)
I+G = S+T (7.6)
X+I+G = S+T+M (7.7)
X-M = (S-I)+(T-G) (7.8)
7 Open Economy Macroeconomics
- 70 population.
Since consumption expenditure46
includes also expenditure on imported consumer
goods, it can similarly formulate the imports. It says that imports are increasing function of
the product. There is a expression (7.9):
where: mpi – marginal propensity to import
The marginal propensity to import show the increase in imports caused by a one-unit
increase in Y. Marginal propensity to import is a necessary variable for determining the
multiplicative effect of foreign trade on the product.
As well as investments having multiplicative effect on Y (there is a much greater
increase in income than the increase of investment) has a multiplicative effect of exports (X).
The size increment of the product due to increase exports can be determined using the export
multiplier which indicates how many times the product is increased if there will be one-unit
unit increase in export. Its formula is identical to the pattern of investment multiplier of open
economy (relation 7.10):
mpitmpc
moe
+−−
=
)1(1
1
(7.10)
where: moe – open economy multiplier
mpc – marginal propensity to consume
t – the rate of income tax
Is evident that an open economy multiplier is the greater, the smaller the marginal
propensity to save and marginal propensity to import. The multiplier effect of exports lies in
the fact that the export produces primary exports of exporters. They are transformed into
savings and consumer expenditures. Expenditure on consumer goods in this country is
creating additional income for producers of consumer goods, etc. The multiplier operates in
the opposite direction.
Export creates an increase in income and it leads to an increase in savings and imports.
It follows that rising exports raises import. The same goes for investment. It should be borne
in mind that everything is based on the assumption that all imports consist of imports of
consumer goods. If capital goods are imported, those relations have only limited validity
The income adjustment mechanism
The above-defined relations between exports and product became the essence of the
Keynesian approach to the adjustment of the balance of payments. They are based on the fact
that the system of fixed exchange rates is transmitted by impulses from the external economy
46
For simplicity, we consider only autonomous expenditures.
M = mpi * Y (7.9)
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 71 in
the form of income effects. Income effect means the increase in the product in the domestic
economy through net exports and it is transferred to the foreign economy and vice versa. The
degree of mutual transfer depends on the marginal propensity to import in domestic and
foreign economies. Export growth leads to an increase in aggregate demand, product and
employment. Growth in import means that the demand is shifted to abroad, on the contrary, it
leads to a decrease in product and employment. This so-called income adjustment
mechanism then operates as follows:
• A country with passive balance of payments records a decline in aggregate
spending, which leads to a decline in real output, which leads to a decline in imports
while maintaining the current level of exports what should lead to the adjustment of
balance of payments
• A country with active balance of payments records the growth of aggregate
expenditures, and therefore the growth of real output resulting in import growth
while maintaining the current level of exports what should lead to the adjustment of
balance of payments
7.1.3 THE MONETARY MECHANISM OF ADJUSTMENT
At the end of the 60s of the 20th
century, economists R. Mundell47
and H. G. Johnson48
elaborated the alternative to the above-mentioned approach. The monetary model is an
extension of the monetarism to an open economy. The monetary approach is based on the
relationship between the demand for real money balances and their supply and it is not limited
to relationships in the current account of balance of payments and is available both in the
fixed and floating exchange rates.
The monetary mechanism of adjustment is based on the fact, that excess demand for
goods, services and capital (current account deficit) reflects the excess supply of money that
flows to abroad. Balance of payments surplus arises on the contrary by the excess demand for
money. If this demand is not met by growth in the domestic money supply, it is met by the
inflow of money from abroad through surplus balance of payments (e.g. the allows explaining
the balance of payments surpluses in rapidly growing economies).
The monetary mechanism of adjustment works as follows: the balance of payments
surplus leads to pressure on the appreciation of the currency, the central bank in its effort to
keep the exchange intervenes by selling the currency. Consequently, the money supply
increases. This leads to both the direct growth of import and the increase in the price level
(inflation) and thus to the growth of import and finally to the growth of real output growth is
again to the growth of import. As a result of these pressures on growth of import there is an
increase in import and the equilibrium of balance of payments is restored. As is evident, the
monetary mechanism of adjustment contains elements of both the price–specie flow
mechanism and income adjustment mechanism. It is also focused on the overall balance of
payments of the country, not only on the balance of trade, which has great influence on the
issue of relations between external and internal balance.
From the above text is evident a shift in the importance of the balance of payments and
its structure, so it is good to become familiar with more detail. It is also good to take into
consideration the relationship between internal and external balance that will be further
developed.
47
Robert Mundell (1932) is an American economist of Canadian origin, the laureate of Nobel Prize in Economic
Sciences
48
Harry Gordon Johnson (1923-1977) was an Canadian economist dealing with the international trade and international
finances
7 Open Economy Macroeconomics
- 72 -
7.2 THE STRUCTURE OF THE BALANCE OF PAYMENTS
The balance of payments (BoP) is a systematic record of all international monetary
transactions at a specific period of time. The balance of payments was originally considered
for overview of the sources of foreign exchange and their use, was expressed by the trade
balance. With the gradual increasing importance of services, the trade balance was extended
on the balance of goods and services, and the income balance. Later it began to monitor the
movement of capital from different perspectives in the capital balance (nowadays the
financial account balance). The main reason for keeping these records is to provide
information to government institutions on the international status of the country and to assist
in determining of monetary and fiscal policy and trade and payment issues.
IMF member countries prepare their balance of payments in accordance with the
approved scheme. It has the following parts:
• A. Current Account
Trade balance
Balance of services (tourism, transport, insurance)
Income balance (transfers of wages of foreign workers, received and paid
interest, etc.)
Current transfers (private and government gifts, such as inheritance, donations,
pension contributions to international organizations, etc.)
• B. Capital Account
Capital transfers due to population migration
Transfers of non-tangible assets and intangible assets49
• C. Financial Account
Direct investment
Portfolio investment
Financial derivate
Other investment
Long-term liabilities granted abroad
Long-term liabilities from abroad
Net short-term capital
• D. Net errors and omissions, valuation changes
• E. Change in reserves.
The balance of payments is conducted in a standard double-entry accounting in which
every international transaction results in a debit and credit at the same size. Thus, export of
goods is a credit on the current account and simultaneously the debit on the account of shortterm
capital (debt creation abroad), import of goods is contrary a debit on the current account
and a credit account short-term capital (establishment of liability). Each record with a plus
sign must be accompanied by offsetting liability with a minus sign or each source must have
its use. Credit entries must equal the debit entries, because the balance is always compiled as
balanced. Items of balance of payments can be distinguished between credit and debit. Credit
entries of balance of payments are recorded with a plus sign and represent such transactions,
which result in the receipt of payments from non-residents. E.g. income from exports of
49
The change of the structure of the balance of payments was introduced during the year 1998 in accordance with the
requirements of the IMF for processing balance for 1997. Existing capital account has been renamed to the financial
account and the content of capital account has been changed. Capital transfers, including transfers of non-productive
financial assets, tangible and intangible rights, were allocated from the current account.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 73 goods
and services, the inflow of incomes from factors of production of the country, but
involved abroad, the inflow of direct investment or income from loans abroad.
Debit entries of balance of payments are recorded with a minus sign and represent
providing payments to non-residents. These include the payments for imports of goods and
services, the outflow of income from foreign production factors involved in home economics,
foreign direct investment, credit abroad. These include e.g. the payments for imports of goods
and services, the outflow of income from foreign factors of production involved in domestic
economy, foreign direct investment or providing credit abroad.
Transactions in balance of payments are recorded in current and capital account on net
turnover principle (such as incomes and expenses, respectively as export and import), while
in the case of all the items of the financial account as the net change in assets and liabilities.
For understand the accounting in the balance of payments we use the following example
5-1. For clarity it will be charged only on the current and financial account and on the account
of currency reserves. It is necessary to realize that in all financial account items, we assume
that the default value is 0 and therefore items shown in the example represent a change from
this condition. It should also be noted that the meaning of some of the records and their
location in the balance is evident at first sight (the so-called autonomous records). In
additional records it may not be the case, their purpose is to compensate for balance (i.e.
accommodating record).
The sufficient information about transactions is not always possible to obtain, because
there is a time gap between the duration of the operation, its payment and its statistical
recording. Some items can only be estimated. These are transaction of individuals who
regularly do not report their foreign transaction, or inaccuracies in the customs statistics, and
finally the exchange rate differences. Consequently, it is necessary for the for counting of all
credit and debit entries introduce a balancing item recording errors and omissions and
exchange rate differences to offset the balance of payments. Given that fact, the balance of
payments is first draw as a preliminary (third month after the beginning of the following year)
and one year later as a final balance for the given year.
7.3 OPEN ECONOMY MACROECONOMICS
Macroeconomics mainly works with models of the national economy and that in both a
closed economy and an open economy. An open economy is associated with foreign
economies through two basic channels and those are international trade and international
financial markets. These two channels can be found in models of open economy in the form
of balance of payments. In this chapter, we briefly introduce the basic framework of open
economy macroeconomics, which is the model IS-LM-BP.
An essential feature of open economy macroeconomics is the distinction between
internal and external balance. Internal balance means achieving a level of real income, which
corresponds to the natural rate of unemployment and price stability. External balance means a
situation when the balance of payments is in equilibrium. In this case, the external economic
balance occurs when the central bank does not lose or accumulate foreign exchange reserves.
Internal and external balances are mostly achieved through automatically acting market
mechanism. However, this often does not respond quickly enough and therefore, there
remains scope for regulatory role of the state and its policies.
7.3.1 A BALANCE OF PAYMENT CURVE
According the Keynesian theory, changes of the balance of payments are caused by two
factors, namely by the growth of economy (leading to growth in imports and therefore to the
7 Open Economy Macroeconomics
- 74 balance
of payments deficit) and changes in interest rates, which affect the import or export of
capital. The balance of payments curve reflects these relationships and it is valid at a given
exchange rate. The curve reflects all combinations of interest rates and income, in which the
balance of payments in equilibrium. The balance of payments curve is therefore referred to
as a balance of payments in equilibrium. Points above the BoP curve represent the balance
of payments surplus while points under the curve represent its deficit (see Figure 7-1). BoP
curve is increasing because the increasing income worsens the BoP and is necessary to attract
more foreign capital to the restore the balance, which is possible only through the increasing
interest rates. Conversely, if there is the BoP surplus, it must be offset by capital exports,
which must contribute to the decline in interest rates.
Figure 7-1 The balance of payments curve formation
The slope of the curve is affected by the mobility of international capital. If the capital
is more mobile, then the curve is approaching the horizontal. The mobility means the
sensitivity/elasticity to changes in interest rates between countries. Conversely, the capital is
less mobile (barriers to the movement of capital), the balance of payment curve is steeper. The
BoP curve has three basic shapes that reflect the three different situations:
• BP curve is horizontal (perfectly elastic) – there is a perfect capital mobility, which
means that domestic and foreign financial assets are perfect substitutes and capital
flows react quickly to changes in the interest rate differential (the difference in
domestic and foreign interest rates): if is the interest rate differential positive, there
will be an unrestricted inflow of capital and a surplus of the balance of payments,
regardless of the status of BoP, the situation in the balance of payments situation
will be determined by financial account and interest rates (a situation typical for
economically developed countries
• BP curve is vertical (perfectly inelastic) – the mobility of capital is null and capital
flows to changes in interest rate differentials do not react (a situation typical of
many developing countries with undeveloped monetary systems and non-convertible
currency), this BoP is completely determined by the development of the current
account and that affect it
i
Y Y
BoP surplus
BP zero capital mobility
BoP deficit
Revaluation R
BP partial
capital
mobility
Devaluation R
BP Perfect
capital
mobility
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 75 •
And BP curve is increasing (elastic) – this is a limited respectively ultimate
mobility of capital, the impact on the BoP has both the current account and the
financial account.
The position of the curve is not stable and the competitiveness of a country's goods
leads to its shifts. Movements of the exchange rate of the country cause change in the
competitiveness. The decline in the domestic currency leads to an increase in competitiveness
of goods the given country when the BP curve shifts to the right, and appreciation leads to
shifts to the left.
7.3.2 MODEL IS-LM-BP
Model IS-LM-BP is the basic model of an open economy that allows exploring the
possibilities of stabilization policy, thus maintaining internal and external balance of the
economy. It was created by the extending IS-LM model, which expresses the balance in
goods and services market (IS curve) and the money market (LM curve) in a closed economy.
This model has been extended to external relations, as expressed through the curve BP. This
model is referred as its authors – the Mundell-Fleming model50
. Since the book of
macroeconomics deals with this model, we outline only the necessary context.
The Mundell-Fleming model is based on following assumptions:
• A fixed price level and therefore no inflation
• A real product is lower than the potential
• An economy is open
• A central bank controls the money supply
• An equilibrium is formed in goods markets and financial markets
• A supply is adjusting to demand
• Savings and tax increases are direct proportionally to income, the marginal
propensity to save and income tax rate are constant
• Economic entities do not expect changes in exchange rates
• Countries taking world prices
• A perfect capital mobility
• A validity of Marshall-Lerner condition.
The model is based on the above assumptions and it is shown in Figure 7-2. The model
demonstrates that the equilibrium product (Y) is reached if there is equilibrium in goods and
services market, while domestic and foreign financial assets are perfect substitutes and capital
flows react quickly to changes in the interest rate differential. As was already mentioned, this
model is used to study the impact of fiscal and monetary policy on a balance of the economy
in an open economy. External relations enter into the model as foreign demand for domestic
goods and services and supply of foreign goods in the domestic market as well as the
movement of capital into and out of the economy, which is all reflected in the movement of
the exchange rate of the national currency. Therefore, it is necessary to examine the behaviour
of the model particularly in a situation of fixed exchange rate and particularly in terms of a
floating exchange rate.
50
Authors of this models are already-mention Robert Mundell a John Marcus Fleming (1911-1976) the director of the
Research Department of the IMF
7 Open Economy Macroeconomics
- 76 Figure
7-2 Model IS-LM-BP
In a system of floating exchange rates, a central bank does not have to intervene in
favour of the exchange rate of the national currency. Monetary policy is more effective than
fiscal policy. When monetary expansion (LM curve moves to the right) and floating exchange
rate the net export (NX) increases. In a system of fixed exchange rates, the central bank
must intervene and therefore fiscal policy is more effective. When fiscal expansion (IS curve
moves to the right) and in a fixed exchange rate, the NX is decreasing. These conclusions
could be applied only on to the above-mentioned assumption for in the short run.
7.3.3 CHANGES IN EXCHANGE RATES AND J-CURVE
If there are fluctuations in exchange rates, this results in displacement from equilibrium
of the BoP. It is caused by reaction of the current account balance of BoP. For example, if
there is a depreciation of the currency, the current account immediately records a deterioration
of its balance. This reaction can be represented graphically by using the J-curve (see Figure
7-3).
i
id=if
LM
BP
IS
Y
Y 0
Y 0
E 0
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 77 Figure
7-3 J-Curve
The current account of the BoP (measured through domestic output) may be
deteriorated after the real depreciation of the currency. This is recorded by the movement
from point A to B in the figure above and this situation arises because that most of the import
and export transactions were agreed several months in advance. In the following months after
the depreciation, exports and imports may reflect a buying decision based on "old" exchange
rate, and therefore the primary effect of depreciation increases the value of imports, while
export value has not changed (and thus causing deterioration of the current account). After a
certain period of time, the domestic production will be cheaper abroad (export) and imported
goods in the domestic economy will be more expensive, what improves the current account
balance and this process is shown by the shift between points B and C. At point C, the level of
the current account balance achieves original values and in the long run, the depreciation
causes its surplus. This is caused by substitution of foreign products by domestic products.
Based on empirical studies, estimated duration of the J-curve is between six months and one
year and depends on many factors, such as the possibility of substitution of foreign
production, sales markets, technological capabilities of domestic production, etc.
Current
Account PB
Longterm
effect of
depreciation on
current account
Y 0
The beginning of
depreciation and
J-curve
A
The end of the
J-curve
time
B
C
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 78 -
8 MONEY, FOREIGN EXCHANGE RATE AND FOREIGN
EXCHANGE MARKETS
This chapter will be devoted to the role of exchange rates in international trade and to
their formation and determination. But first, we explain what means the term exchange rate.
8.1 THE FOREIGN EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET
The foreign exchange rate is the price that is traded in the foreign exchange markets.
In other words, the exchange rate is the relative price of two national currencies, and thus the
price of foreign currency expressed in domestic currency (so-called direct quotation), or the
price of domestic currency denominated in foreign currency (so-called indirect quotation). In
practice, there are used four types of exchange rates: nominal and real effective and bilateral
(multilateral).
8.1.1 TYPES OF FOREIGN EXCHANGE RATES
The price of foreign currency units expressed in units of domestic currency is expressed
in nominal bilateral exchange rate. However, this does not reflect the development of the
purchasing power of the currency against another currency. That gives the real bilateral
exchange rate (R), which is most commonly expressed as an index of the ratio of the nominal
exchange rate multiplied by the foreign price level and the domestic price level, as shown in
equation (8.1). This means that R is the ratio of external and domestic goods in units of
domestic currency and this is an important indicator of export competitiveness of the
economy.
D
F
P
P
ER ∗= (8.1)
where: PF – foreign price level in domestic currency
PD – domestic price level
Changes in the exchange rate are called appreciation or depreciation51
.
An appreciation is an increase in the value of a currency relative to another currency
and means that goods of the given country becomes cheaper for foreign entities and imports
become more expensive for domestic entities. Currency depreciation lowers the relative price
of exports of the given country and increases the relative price of its import.
The depreciation is an increase in the value of a currency relative to another currency
and means that domestic goods become more expensive for foreign entities and domestic
entities pay less for foreign products. In other words, the appreciation of the currency of the
economy increases the relative price of its exports and lowers the relative price of its import.
51
In the case of fixed exchange rates we talk about revaluation and devaluation
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 79 -
8.1.2 THE FOREIGN EXCHANGE MARKET
The foreign Exchange market is a system in which the transfer of the amount in one
currency into another currency takes place. These markets are used for settlement of debts
arising in international trade, for hedging against exchange rate risk, for arbitrage and
speculation:
• International Trade – in this case, banks operate in the foreign exchange market as
a clearing centres for supply of foreign exchange and demand for foreign exchange
arising from the transactions of entities of the given economy and foreign entities
(spots, where the transaction takes place at one time for the current exchange rate
and forwards that are a certain type of forward transaction, which is currently
carrying out and payment takes place in the future for an agreed exchange rate)
• Hedging against exchange rate risk – against fluctuations in the exchange rate
market through term foreign exchange or futures (promise to pay an agreed amount
in the future) or options (they give its owner the right to buy or sell a specified
amount of foreign currency at a specified price at any time until the maturity date)
• An arbitration – means buying one currency in one market and its selling in the
other market for profit (profit from the price difference), this activity is not
speculative and is risk-free because the result is certain in advance
• And a speculation – is the opposite of hedging and although it is based on the same
principle as the arbitrage is very risky with forward unknown outcome, because it
only predicts the future development of the exchange rate.
Commercial banks, firms (brokers and dealers), non-banking financial institutions
(investment funds, insurance companies and pension funds) and central banks participate
operations in the foreign exchange market.
• Commercial banks are centres of foreign exchange markets because the most of
international transactions requires operations on accounts held by commercial banks
in different financial centres and also so-called interbank trades or trading in foreign
currencies between banks themselves take place there
• Companies operate in the foreign exchange market in case if they need a different
currency than their domestic, for instance Korean multinational corporations paying
wages and buying goods in the Czech Republic
• Non-banking financial institutions that offer to its clients a wider range of services,
especially transaction exchange rate
• And central bank intervening in the foreign exchange markets; their range of
transactions is smaller, but with an extensive influence.
The foreign exchange market consists of demand for foreign assets and the demand for
domestic assets, which is actually a supply of foreign assets. Assets in this case mean foreign
exchange and price of assets is thus the exchange rate. The demand for foreign assets is
influenced by rate of return on assets, specifically the expected rate of return (Re
).
Generally, people want to keep those assets that have the highest expected rate of return. For
the determination of the expected rate is necessary to know the interest rate of assets i* and
the expected rate of change of the exchange rate Ee
. The expected rate of return on assets is
therefore determined on the basis of the sum specified in equation (8.2).
e
F
e
EiR += (8.2)
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 80 where:
iF –interest rate assets
Ee
– the expected rate of return on the exchange rate
when:
( )
t
tte
E
EE
E
−
= +1
(8.3)
where: Et+1 – future nominal exchange rate
Et – current nominal exchange rate
The demand for the domestic asset is determined by the rate of the asset-return, i.e. its
interest rate i. For the determination of the equilibrium exchange rate, we have to accept the
assumption that economic entities want to keep an exactly offered number of domestic and
foreign assets, where these assets offer the same expected rate of return. This can be written
using the formulas given in equations (8.4) and (8.5).
D
e
iR = (8.4)
or:
e
FD Eii += (8.5)
This situation can be graphically illustrated using Figure 8-1. The vertical axis shows
the exchange rate and on the horizontal axis is rate of return R. Vertical curve shows the rate
of return of domestic assets, which is independent on the level of the exchange rate. The
declining curve of expected return of foreign assets has a slope given by the inverse
relationship between the change in the exchange rate and the consequent change in Re
. If the
exchange rate grows, future incomes from foreign assets decrease (E2
) and vice versa (E3
). In
other words, if the market is in a situation E2, the rate of return on foreign assets is less than
the rate of return on domestic assets. Each entity owning foreign assets wants to sell for more
favourable domestic assets and this leads to the depreciation of the domestic currency. If there
is a situation corresponding to E3
, income from foreign assets exceeds the income from
domestic assets and there is to the domestic currency appreciation (selling foreign currency).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 81 Figure
8-1 Determination of the equilibrium of exchange rate
Now let’s take a look at how changes in interest rates and changes in the rate of return
of foreign assets affect the exchange rate. Imagine that the rate of return of domestic assets
has changed and shifted from i1
at i2
by an amount equal to the area marked by the arrows.
This shift has resulted in a decline in the exchange rate and appreciation of the domestic
assets, which is shown in Figure 8-2
Figure 8-2 The effect of increase in the rate of return of domestic assets
What happens in case of increase in interest rates of foreign assets shows Figure 8-3. If
there is a shift in expected returns of foreign assets, this returns exceed these returns from
domestic assets and this leads to a decline in the exchange rate and the depreciation of the
domestic assets. The increase in expected rate of foreign exchange assets has therefore the
opposite effect than increase in interest rates.
E
E1
E2
Re
i1
i2
R
Re
i R
E
E2
E1
E3
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 82 Figure
8-3 The effect of increase in foreign interest rates
From the above it follows that a rise in interest rates of the given currency causes the
appreciation of this currency against foreign currencies. However, we have to realize
however that it is always the view from the "inside": that is clear from Figure 8-2 and Figure
8-3 shows on the above-mentioned conclusion that the domestic currency is actually the
foreign currency and its interest rate is expressed through Re
.
8.2 MONEY, INTEREST RATES AND THE FOREIGN EXCHANGE RATE
In the previous part of the previous chapter, we analysed the effect of interest rates and
expected changes in the exchange rate on the development of this exchange rate. Now we take
a look at how the interest rate is set and how the expectations of future exchange rates are
formed. But first, we repeat the definition of money we know and subsequently we explain
how to form the money supply and money demand and how they affect both the interest rate
and the exchange rate.
8.2.1 THE DEFINITION OF MONEY
Money is generally accepted tender that performs several functions. The most important
is that money is a medium of exchange, since it eliminates the huge money transaction costs
associated with barter trade. Another important function of money is the unit of account,
because the value of goods, services and assets are mostly expressed in money, and it
simplifies economic calculations for comparing of the prices of various commodities. Given
the money is used to convert the current value into the future value it is considered as the
store of value. This attribute is important for each medium of exchange, because nobody
accepts payments whose value (expressed in goods and services) immediately ceases.
When we talk about money, we must also analyse their supply and demand. In our case,
the money supply MS is defined as supply of monetary aggregate M1 (it includes money in
circulation and demand deposits) of households and firms. Other financial assets are less
liquid and are not used to the ordinary financial transactions. Suppose that the money supply,
which is controlled by the central bank, is fixed and at the demanded level.
Money demand MD is distinguished from the viewpoint of the individual and the
aggregate. Three aspects determine individual demand for money:
E
E2
E1
Re´
Re
i R
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 83 •
The expected returns – if returns (or interest rate) of less liquid assets rises, demand
for money falls52
• A risk – money holdings is risky because an unexpected increase in the prices of
goods may cause a decline in their value as well as fall in the value of other
financial assets (e.g. government securities), but the increase in risk does not have
an impact on reducing the demand for money, but increase demand for assets
bearing interest
• A liquidity – the highest profit money came out from liquidity because cash is the
easiest way of financing everyday expenses and there is a rule that the larger value
of transactions induces the greater need for liquidity. This means that the increase in
the value of transactions increase raises the demand for money
The aggregate demand is the sum of the individual demands and is influenced by the
following factors:
• An interest rate whose growth causes less willingness of economic entities to keep
money in liquid form and aggregate money demand declines
• A price level which if grows it causes higher costs of economic entities and it
resulting in the growth of aggregate demand
• And a real national product, whose growth induces the growth of output and
foreign exchange transactions in the economy, which is caused the growth of
aggregate demand.
The relationship between the interest rate i, the price level P, income Y and aggregate
demand for money MD can be expressed by equation (8.6):
( )YiLPM D ,∗= (8.6)
where: L(i,Y) – real aggregate demand for money
or:
( )
P
M
YiL D
=, (8.7)
where: MD/P – required money holdings measured by the CPI
8.2.2 THE EQUILIBRIUM IN THE MONEY MARKET
Equilibrium in this market occurs if supply equal demand and thus MS=MD. The real
balance can be derived by using equation (8.6) and it can be expressed by the equation (8.8):
52
In this case we can considered the interest rate as the opportunity costs of money holdings
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 84 (
)
P
M
YiL S
=, (8.8)
where: MS/P – the real money supply
The above-mentioned relationship is graphically shown by Figure 8-4, which shows the
equilibrium in situation i1, Q1. In the case that the interest rate is higher (i2), money demand is
low and the real money holding is also low (Q2). If the interest rate is below the equilibrium
(i3), the demand for money is high as well as holdings of money (Q3). The money market has
a tendency to return to equilibrium: if the economy is in situation 2, high interest rates are
compressed to their equilibrium level by the high demand for financial assets and similarly in
situation 3, the high demand for money causes rising interest rates of financial assets.
This means that the market always tends to achieve such a interest rate at which the
real aggregate supply equals real aggregate demand. If this rate exceeds the money supply,
it tends to fall and vice versa.
Figure 8-4 Determination of equilibrium in the money market
But what happens if the central bank decides to increase the money supply? Since
people have more money than before, they try to invest this surplus – they try to buy financial
assets. They compress the price of these assets (i) downward, as illustrated in the following
figure 8-5. It also leads to the increase in the money supply at a given price level and income
that causes a decrease in the interest rate and vice versa.
i
i2
i1
i3
L(i,Y)
MS/P
Q2 Q1 Q 3 Q
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 85 Figure
8-5 The effect of the increase money supply on interest rate
As was already mentioned, the output will cause a shift of real demand, which means
that if income rises, it also rises the real money demand, as shown in Figure 8-6. If income
increases from level Y1
at Y2
, a real money holding could rise as well (at Q2
). But since the
money supply is fixed, the increase in income causes only an increase in interest rates, which
gets at the new equilibrium level. The increase in a real income at given money supply and
at given price level cause an increase in the equilibrium interest rate and vice versa.
Figure 8-6 – The effect of the increase in income on interest rate
8.3 MONEY AND EXCHANGE RATE IN THE SHORT AND LONG TERM
After we explained the effects of changes in individual determinants of supply and
demand for money, we can analyse how monetary changes affect the exchange rate. This
analysis will be performed in the short run, where is a stable price level and stable
expectations of exchange rate changes, and then in the long run, where prices are flexible and
always adjusts to maintain optimal allocation of resources.
i
i2
i1
L(i,Y2
)
L(i,Y1
)
MS/P
Q1 Q2 Q
i
i1
i2
L(i,Y)
MS/P
Q1 Q2 Q
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 86 -
8.3.1 THE SHORT RUN
The short run equilibrium and movements of foreign exchange rate in the short run is
explained by the theory of interest rate parity. This theory analyses the situation in the
money and foreign exchange markets on the basis of changes in the domestic interest rate
(determined by the interaction of supply and demand for money). These changes affect the
inflow of portfolio capital from abroad, the demand for the domestic currency and the
exchange rate. The theory of interest rate parity is based on the assumptions:
• The same liquidities and risks of domestic and foreign assets
• Preferences of investments of economic entities in certain economies on the basis of
profitability
• And different profitability of domestic and foreign assets.
In this context, we distinguish between covered and uncovered interest rate parity
when the difference lies in the coverage of risk of uncertainty about the development of the
exchange rate. While in the first case it leads to elimination of risk through forward rates and
in the second case, the risk is not eliminated and the expected development of the exchange
rate plays an important role. Uncovered interest rate parity will be the subject of our further
analysis. Given that the market balance of assets (cash and foreign exchange) requires the
equality of income, we can express the parity of the interest rate differential in equation (8.9).
FD
e
iiE −= (8.9)
where : iD - iF – interest rate differential
For graphical analysis of the relationship between money and the exchange rate in the
short term we use two images that are discussed separately and this is Figure 6-1 regarding
the balance of the foreign exchange market, and Figure 8-7 regarding the equilibrium in the
money market. We combine them together and this figure relating to the real money holding
turn 90 degrees clockwise. Equilibrium occurs at point 1, in which the interest rate encourages
economic entities to demand such an amount of money that is given price level offered, i.e.
the intersection of the curves L and MS/P. The interest rate of domestic assets with the
expected rate of return of foreign assets forms the balance of the foreign currency market (and
in fact on the both markets together).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 87 Figure
8-7 The equilibrium in the domestic money market and foreign currency markets
It is clear that the previously analysed variables are not static, evolving and changing
and we take a look at how the foreign exchange rate is influenced when there will be a change
in:
• The domestic money supply
• A household income
• The foreign money supply
• And foreign income.
Domestic money supply, domestic income and foreign exchange rate changes
If the central bank of domestic economy will change the money supply, it will also have
impacts on the exchange rate, as shown in Figure 8-8. Suppose that the central bank increases
the money supply in the economy (for increase in AD). How it will affect the foreign
exchange market? Original interest rate dropped and money market reaches a new
equilibrium. However, this step increases the expected returns of foreign currency and owners
of domestic try to "exchange" this currency for more attractive foreign currency. This leads to
a depreciation of the domestic currency and an increase in the exchange rate.
The conclusion is that the increase in the domestic money supply causes a depreciation
of this currency in the foreign exchange market and conversely a reduction of the money
supply causes its appreciation. The opposite effect has a change domestic income. If this
income increases, it causes an appreciation of foreign currency appreciation and depreciation
of the domestic currency.
E
E1
0
MS/P
Increase
Q
Re
R
L(i,Y)
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 88 Figure
8-8 The effect of the increase in the money supply on the domestic market
Foreign money supply, foreign income and foreign Exchange rate changes
If the foreign central bank increases money supply in its economy, it leads in a given
economy to the same final effect, as we already shown – the depreciation of the currency (and
appreciation of domestic currency). The difference is that it will not "affect" the domestic
interest rate. If foreign income increases it leads to the expected return of Re
and foreign
currency appreciation and depreciation of the domestic currency.
The impact of the increase in money supply on domestic economy shows the figure 8-9
If there is a depreciation of foreign currency caused by the increase in the money supply on
the foreign market, it reduces the interest rate of this currency and thus expectations
concerning its future income. All shifts the curve to the left down and this leads to a reduction
in the exchange rate (appreciation) on the domestic market.
Re
R
L(i,Y)
E
E2
E1
0
MS/P1
MS/P2
Q
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 89 Figure
8-9 The effect of increase in the foreign money supply
8.3.2 THE LONG RUN
We already mentioned, the prices in long run are flexible and dependent on the interest
rate, real output and domestic money supply. This assumption can be expressed by modifying
equation (8.8.) on the given relationship in equation (8.10):
( )YiL
M
P S
,
= (8.10)
If we accept the realistic assumption that i and Y remains in a long run unchanged, the
increase in money supply in the economy has resulted in a price increase. In order to maintain
a balance on this market (at unchanged real money demand and constant real money supply),
the price level P has to increase as well as money supply, MS.
But how it is possible that in the long run the money supply does not affect the real
output, neither interest rates? The level of output at full utilization of productive resources
depends on the endowment of the economy with labour and capital. It results in monetary
reform, when the reduction in the money supply does not affect the output any effect (just a
few zeros was deleted). The same applies for the interest rates: for instance, if the supply and
prices doubling and the interest rate remains the same, because ten crowns at the beginning of
the year and eleven crowns at the end of the year are the same as twenty crowns at the
beginning of the year and twenty-two crowns at the end of the year (i is always 10 %). On this
basis, it was concluded that a permanent increase in money supply in the domestic economy
produces a proportional long-term depreciation of the domestic currency against foreign
currencies and vice versa.
E
E1
E2
0
MS/P
Q
Re
R
L(i,Y)
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 90 -
8.4 THE ISSUE OF INFLATION AND OVERSHOOTING
So far we did not assume significant changes in the price level and we did not include in
our model inflation. Now we will show how this inflation resulting from inflation
expectations or excess demand, influence the exchange rate.
8.4.1 INFLATION AND THE FOREIGN EXCHANGE RATE
A figure 8-10 illustrates on the left side the short run and the long run on the right side.
If prices are initially at P1
, then the increased money supply M2
increases the real money
supply (M2
/P1
) and it decrease interest rates at i2
. On the foreign exchange market, revenues
from the domestic currency are reduced. But it does not end due to the expected change in the
exchange rate. Since the increase in the money supply is constant, people expect that in the
long term the exchange rate will increase. This expectation has resulted in an increase in the
expected rate of return of foreign assets (in the depreciation of the domestic currency). This
shifts the curve R to the right, what cause the growth of exchange rate at E2
. You may notice
that the change of exchange rate is greater than if the expected exchange rate would remain
the same (this would correspond to point E3
).
Figure 8-10 Money supply and inflation
We are moving to a long period in which we assume that prices vary (growth up to P2
).
Because the increase in the price level must correspond to growth in the money supply, new
real money supply M2
/P2
comes to the level of the original real money supply M1
/P1
. Because
the output is constant and real money supply returned to its original level, there must be a
change in the interest rate – the increase back on i1
. In the long term it leads to appreciation of
the domestic currency against foreign currencies in relation to its initial level, although it
E
E2
E1
0
MS
1
/P1
MS
2
/P1
Q
Re
L(i,Y)
MS
2
/P1
MS
2
/P2
E2
long runshort run
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 91 created
a new equilibrium exchange rate corresponding to E3
(final depreciation). This means
that both the price level and exchange rate increases proportionally to the increase in the
money supply.
8.4.2 THE FOREIGN EXCHANGE RATE OVERSHOOTING
Based on the above analysis, we concluded that based on the increase in the money
exchange rate depreciate in the short run from E1
at E2
and in the long run from E1
to E3
. In
this context, we talk about the exchange rate overshooting, so, if the initial fluctuations are
greater than in the long run. It is an important phenomenon because it helps to explain why
the exchange rate varies dramatically from day to day and this explanation came out of the
level of uncovered interest parity. This situation is illustrated graphically by using Figure 8-
11.
In this picture we see the analysis of various economic variables that change in the
money supply at time T changes. Increase if the domestic money supply M, the pressure on
the money market causes an initial drop in interest rates and who "gets" the interest rate below
the rate of foreign. According to interest rate parity condition is then expected to decline in
the exchange rate E coupled with the appreciation of the domestic currency. However, he may
drop after first overshoots the level of E2 (and, in the long term falls to a level E3). For all
variables occurring in the final stage of change (increase M, P and E, after overshooting), in
addition to interest rates, which, after an initial decrease (due to an increase in the money
supply in the domestic economy) returns in the long term to the original level.
We can see on this picture the analysis of various economic variables that change by the
change in the money supply at time T. If the domestic money supply M increase, the pressure
on the money market causes an initial drop in interest rates i and which "gets" this interest rate
under the foreign rate. According to interest rate parity condition is then expected a decline in
the foreign exchange rate E coupled with the appreciation of the domestic currency. However,
it may drop after first overshooting of the level of E2
(and then in the long run the level E3
falls). All variables leads in the final stage to a change (increase M, P and E, after
overshooting) and in addition to interest rates, which is returns in the long term to the original
level after an initial decrease (due to an increase in the money supply in the domestic
economy).
8 Money, Foreign Exchange Rate And Foreign Exchange Markets
- 92 Figure
8-11 Overshooting of the foreign Exchange rate
Finally, we can conclude that the increase in the money supply may cause in the short
run the overshooting of the level of long run of the exchange rate. If the output is fixed,
permanent increase in money supply causes more than proportionally short-term
depreciation of the currency followed by the appreciation of the currency in the long term.
It is a direct consequence of the "slow" price-level adjustment and the condition of the
equilibrium interest rates.
M2
M1
P2
P1
i1
i2
Ti
E2
E3
E1
Ti
Ti0 Ti0
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 93 -
9 PRICES AND FOREIGN EXCHANGE RATE
In the previous chapter we have analysed the issue of determination of the exchange
rate by both the interest rate and expectations for the future that are on the other hand
influenced by conditions of the money market. As we have indicated, the development of
exchange rates affects the price level and this issue will be examined in this chapter.
9.1 PRICES AND THE FOREIGN EXCHANGE RATE IN LONG RUN
In the long run, national price levels play a key role in determining of interest rates and
relative prices, for which produced goods and services are exchanged. Theories that deal with
this issue explain changes in foreign exchange rates at the time, which is called as the law of
one price and the theory of purchasing power parity. These theories are based on the
following assumptions:
• Free trade between countries
• Zero transaction costs
• Zero costs of acquiring information
• And zero time costs.
9.1.1 THE LAW OF ONE PRICE
If all above assumptions are met, then we can accept the assumption that prices in
different economies cannot differ in the long term because it would be exported goods out of
the economy, which would be cheaper in the economy in which is more expensive (which
would lead to prices adjustment). This is the essence of the law of one price, which claims
that the price of goods in one economy equals to the product of price of goods in the second
economy and the exchange rate, as shown in Equation (9.1):
FD PEP ∗= (9.1)
The exchange rate would match on the basis of the above-mentioned the quotient of
domestic and foreign prices (7.2)
F
D
P
P
E = (9.2)
A major shortcoming of this law is that it assumes homogeneity of goods – in terms of
quality and other utility properties and cannot be applied to services or construction. Another
drawback are the above-mentioned assumptions themselves (lack of protectionist barriers,
transaction costs or time) since in certain products, these costs are so high that it prevents
their mutual tradability (this issue was analysed in sub-section 7.1.3).
9.1.2 THE PURCHASING POWER PARITY THEORY
The law of one price generalizes the purchasing power parity theory (hereinafter PPP
theory), and that the price of one good goes to the price level. The PPP theory tries to explain
9 Prices and Foreign exchange rate
- 94 the
exchange rates (like the law of one price) by comparison of price levels and this is based
on the idea that price should not differ in different countries in the long term if these countries
are not closed economy. If we would like to apply this theory to the currency, then based on
this theory and the above comparison of price levels, the unit of currency in the domestic
economy will have the same purchasing power in the international economy.
Although the thought of the purchasing power parity is much older, the author of this
theory is considered Gustav Cassel53
. In the 15th
and 16th
centuries, at the time of scholastic
teaching and time when the Catholic Church forbade usury, theologians lecturer at the
University of Salamanca (Spain) responded to the growing interest by claiming that creditors
could justify interest payments in relation to move through the PPP by loans in foreign
currency. One of them was Domingo de Banuez54
that in 1594 wrote about the loans and
interest wrote: "One party can legally agree with overpaying of large sums of money to the
other party, corresponding to the amount needed to purchase the same package of goods, as
this other party could buy if they do not provide their money to the other party."(Sarno and
Taylor, 2002, p. 51). The classical economists in their analysis of foreign trade developed the
thought of purchasing power parity, but in 1918, already mentioned G. Cassel called the ratio
of the purchasing power of money and exchange rate as purchasing power parity: "Only the
exchange rate at which the trade balance is in equilibrium, can be permanently stable. Such an
exchange rate is a purchasing power parity." (Cassel, 1932, p. 658)
The extending of the law of one price is the absolute version of PPP (sometimes also
referred to as static), which compares the price levels of the two economies on the basis of the
consumer price index, set of the consumer basket – a mathematical expression is the same as
the equation (9.2). Absolute version is based on the fact that the internal and external
purchasing power of both currencies must be identical, then the exchange rate is determined
by purchasing power parity. This means that if the price level in the "crown" economy Alpha
is five times higher than in the "euro" economy Beta, the internal purchasing power of the
crown is five times lower than the euro and on the basis of this, the exchange rate is creates as
5 crowns for 1 euro. Since the preferences of consumers and the composition of their
consumer baskets vary in different countries, the more practical version of PPP is used and
that is the relative version of PPP.
The relative version of PPP (also known as dynamic) is based on the same assumptions
and it tries to capture the changes of the foreign exchange rates by differences in inflation
rates of the both economies. These changes may be mathematically expressed by the equation
(9.3):
FD
e
E ππ −= (9.3)
where: πD – change in the domestic price level
πF – changes in foreign price level
53
Karl Gustav Cassel (1866-1945) was a Swedish economist, the founder of Swedish modern economic theory.
54
Domingo de Banuez (1528-1604) was a Dominican theologian who works at several Spanish universities and he was
also a big supporter of the doctrine of Thomas Aquinas.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 95 This
means that if the annual rate of inflation in the economy Alpha was 4 % and in the
economy Beta 2 %, it would result in a depreciation of the Czech crown by 2 %. Higher
inflation would worsen the competitiveness of Alpha’s goods on Beta’s market and it would
create the deficit in the current account of BoP with the economy Beta. The decline of the
Czech crown against the euro would be done as long as it is not equal purchasing power of the
crown to market of Alpha as well as Beta.
Relative version says that the external depreciation of the domestic currency against
foreign currency will equal the difference between the internal depreciation of the domestic
currency and internal depreciation of foreign currencies. If the absolute theory is applied,
then the relative version is applied as well, but if the relative version is applied it does not
mean that the absolute theory is also applied and that is because of the changes in nominal
foreign exchange rates (e.g. because of existence of transaction costs).
The empirical verification of the PPP theory is the subject of many studies dealing with
the analysis and evidence of shortcoming that this theory shows, especially in the post-war
period, when Bretton Woods’s monetary system began to operate with the dollar as a reserve
currency. The most important shortcomings of this theory include:
• It ignores international movements of capital and therefore it does not count with the
BoP as such, but only with the current account balance of payments
• It does not count with the cost of transportation and protectionist measures, when
transaction costs are included in the price of goods and not-including reduces profits
(losses increases) of producers, the costs of trade restrictions have a similar effect
• It does not imply the existence of imperfect competition because monopolistic or
oligopolistic position of firms on the product market may affect the price level of
similar goods in different economies
• In international comparisons is the determination of the rate of inflation difficult,
because the baskets vary by country (the empirical verification of this theory is also
almost impossible)
• And this theory does not analyse the effects of a short run, when short-term
fluctuations in the exchange rate fluctuations are larger than those of the long-term.
If we will take a look closer to the latter deficiency in deviation of exchange rate from
PPP, we can provide three types of measurements, through:
• The static version of the real exchange rate, when compared to the price level of
foreign and domestic economies converted to a common currency (domestic
economy) with the nominal exchange rate
• The exchange rate variations ERDI index, which expresses the ratio of GDP
converted from national currencies using purchasing power parity exchange and
GDP converted using the official exchange rate (Lebiedzik, Majerová and Nezval,
2007) and which is essentially identical to the static version of the real exchange rate
• And comparative price level index CPL expressing the ratio of the price levels of
domestic and foreign economies and corresponding to the inverse value of the static
version of the real exchange rate.
9.2 THE FOREIGN EXCHANGE RATE AND OUTPUT IN THE LONG RUN
Although the theory of PPP on the basis of the above mentioned shortcomings are
subjected to criticism, we will further deal with its analysis and for this reason, the base for
understanding the relationship of long-term foreign exchange rates and long-term
development of the price level.
9 Prices and Foreign exchange rate
- 96 -
9.2.1 THE PPP THEORY AND MODEL OF THE FOREIGN EXCHANGE RATE IN THE LONG RUN
The PPP theory itself deals with factors affecting supply and demand for money only
marginally, but because in the long term in economies experiencing growth in money supply
and thus inflation and currency depreciation, was created a model so called the monetary
approach to exchange rate. This approach is based on three basic assumptions:
• Products are freely tradable (the validity of PPP theory)
• Assets are freely tradable (the validity of uncovered interest parity)
• And prices are perfectly flexible (long run55
).
If there is applied first and simultaneously second assumption, it means that the interest
rate of the domestic economy must be equal to the world real interest rate plus the expected
rate of inflation. Prices and inflation depends on the level and extent of changes in the
nominal money supply and real demand for money. In an analysis of the monetary approach
to exchange rate, we will extend the assumption of the influence of exchange rates of money
supply in the domestic economy and the foreign economy by further determinants. These are
real exchange rate, interest rate and changes in output of economies.
Real foreign exchange rate
For determination of the monetary approach, we must base on the definition of the
exchange rate using PPP, which we derive from (9.2) and from the relationship between
nominal and real exchange rate defined in the previous section (relation 8.1). Purchasing
power parity is therefore the basis for estimating the price level in the long term determined
by equilibrium in the money market. When modelling this balance, we have to realize that the
ratio of prices can be expressed as the ratio of money supply and money demand on the
domestic and foreign markets, as shown in equation (9.9):
( )
( )





∗=
YiL
YiL
MS
MS
P
P
D
F
F
D
F
D
,
,
(9.9)
where: MS – money supply
L – demand for money
This equation can be modified into a final form that expresses the basic balance of the
monetary approach. For the real exchange rate, changes in the money supply and money
demand in domestic or foreign economy affect the long-term nominal exchange rate:
( )
( )





∗∗=
YiL
YiL
MS
MS
RE
D
F
F
D
,
,
(9.10)
55
We will deal with the monetary approach in short run after we will perform an analysis in long run. We based on the
fact that long run from the point of view of the perfect competition less complicated than short run, which is given by
fixed prices.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 97 The
interest rate and the Fischer effect
From the equation (9.9) we can deduce the effect of other variable on the development
fot he price level, and thus the interest rate. In its analysis we will bring to the reality the
monetary approach to the exchange rate by including the demand for money. From this
relation it follows that the real demand for real money balances is a function of not only
income, but also a decreasing function of the interest rate. It is based on the fact that the
increasing rate of assets increases the opportunity cost of money holdings, which reduces the
demand for money.
Now let's look at what determines the interest rate, if prices are perfectly flexible. First,
we must realize that the expected changes in the exchange rate are influenced by both the
interest rate differential (uncovered interest rate parity condition in equation 8.9) and
differences in inflation rates in individual countries (relative version of PPP in equation 9.3).
If we combine these two conditions together, we can express them by using equation (9.11):
FDFD ii ππ −=− (9.11)
If the long-term domestic interest rate is higher than this rate abroad, it must also be
higher expected rate of inflation in the domestic economy than in the foreign economy and
vice versa. This effect is known as the Fisher effect. In order to clarify the full functioning of
the model of monetary approach to exchange rate, we have to add to our assumptions the real
interest rate (nominal interest rate minus inflation). As a consequence of this, we modify the
Fisher effect: if there is the uncovered interest rate parity and real version of PPP, then the
real interest rate must be the same in both economies and equal to the world real interest rate
(we talk about real interest parity). The nominal interest rate of the domestic economy must
equal the sum of the world real interest rate and the expected domestic inflation rate, which is
equal to the difference in money growth and the growth rate of real output. Therefore, sudden
changes in the growth of the money supply lead to fluctuations in exchange rates on the basis
of changes in money demand that are caused by changes in interest rate.
Aggregate expenditures and output
The last variables, which will be discussed in relation to the movements of the exchange
rate are the aggregate spending and output. The effects of these macroeconomic variables are
the same as the effects of the money supply: increase in expenditures in the domestic
economy causes the real appreciation of the domestic currency and a decline in the real
exchange rate, which results in a decrease of E (because of changing the slope of the curve).
In case of the output, the result is not so clear, even if is based on the same principle as
the previous one. In case that the output of the domestic economy increases, this results in a
depreciation of the domestic currency (steeper slope of the curve). But the increase in output
has also resulted in increase in demand for money, which causes a decline of curve (despite an
increase in interest rates) and currency appreciation. Thus, the final net effect of the change in
the nominal exchange rate is ambiguous and depends which effect predominates.
9.3 THE FOREIGN EXCHANGE RATE AND OUTPUT IN THE SHORT RUN
In the previous interpretation, we clarified how interest rates and the price level affect
exchange rates. Mostly we assumed that the output level is given. Now we complete
macroeconomic model analysis and we will try to answer on exchange rate and interest rates
affect the economy product and it will be analysed from the point of view of short run when
the price level is fixed. To determine the output in the short run, we must first undergo an
9 Prices and Foreign exchange rate
- 98 analysis
of aggregate demand. We will modify the basic model of an open economy (Y = C +
I + G + NX) by the involvement of factors that affect the individual items of this relationship:
• The disposable income (YD), except consumption it also affects the amount of net
export
• And the real exchange rate (R), which affects net export
If we want to determine the effect of real exchange rate on NX, we have to analyse its
changes on both the export and import. As regards export, if R rises, foreign goods in
comparison with domestic goods become more expensive and demand for domestic goods
increases, that induces the growth of export. In the case of import, the impact of the growth of
R is not unambiguous, since import reflects the value of import, not the volume of import of
foreign goods (in the first conception is the growth in imports caused by the growth of R, in
the second one there is a decrease in imports). We will assume for simplicity that the effect of
the volume effect always exceeds the value effect and therefore the real currency depreciation
improves NX and vice versa.
The increase in disposable income increases consumption expenditures and thus the
expenditures on import. This means that the increase in YD has resulted in a reduction in NX
and vice versa, despite the increase (decrease) the import. The export has no effect, it is
autonomous and it is independent of Y.
9.3.1 BALANCE OF AGGREGATE DEMAND
If we summarize the above-mentioned findings and include them into the equation on
aggregate demand, we can express this by the using the equation (9.12):
( ) ( )YDRNXGIYDCD ,+++= (9.12)
where: C – consumption
I – investment
G – government expenditures
D – aggregate demand
The above-stated equation indicates a functional relationship, when the aggregate
demand for domestic product can be expressed as a function of the real exchange rate,
disposable income, investment´s demand and government expenditures. We can write this
down by using equation (9.13):
( )GIYDRDD ,,,= (9.13)
How can we interpret the above functional relationship? The growth of R cheapens
domestic goods and moving expenditures on foreign goods to domestic goods. The result is
the growth of NX and aggregate demand. The real depreciation of the domestic currency
increases aggregate demand for domestic products and vice versa. Domestic real income
effect on aggregate demand is somewhat more complicated. If taxes are fixed at a given level,
the growth of Y represents the same growth YD. The growth of YD increases consumption
and deteriorates NX because of increasing domestic spending on foreign goods. However,
since the effect of increasing consumption on the growth of aggregate demand is greater than
the effect of the deterioration of NX, we can conclude that the increase in domestic real Y
increases AD for domestic output and vice versa.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 99 -
9.3.2 DETERMINATION OF OUTPUT
The market is in equilibrium if the real output Y is equal to aggregate demand D, what
is true for a short run, in which we expect stable prices and long term, as well as for a long
run, when prices adjust the way to achieve the balance. This can be expressed by using
equation (9.14):
( )GIYDRDY ,,,= (9.14)
Graphical representation of equilibrium is shown in figure 9-1 as a point Y1
. In point Y2
demand is higher than output and firms increase production to meet this demand (by returning
to the point Y1
). In the case of point Y3
demand is less than the output and companies are
reshaping their production to supplies. To avoid this, they must reduce production to the point
of Y1
.
Figure 9-1 Output in short run
9.3.3 OUTPUT AND FOREIGN EXCHANGE RATE
For the analysis of output and R, we must first determine the relationship between the
output and the exchange rate in the case of macroeconomic equilibrium using the DD curve,
and then determine this relationship in the case of equilibrium on the money and foreign
exchange markets using the AA curve.
When constructing the DD curve we use the income-expenditure model that you know
from macroeconomics and we will based on the relationship between the real exchange rate
(its changes) and output. The increasing of the real exchange rate will lead to the increase of
D and to depreciation of the domestic currency against foreign currency, and that based on
changes in nominal exchange rate (movement from E1
at E2
).
Simultaneously this shift can by shown by the direct relationship between the nominal
exchange rate and output, which is expressed by DD curve assuming constant prices. This
curve shows all combinations of output and exchange rate, which are in equilibrium in a short
run (see Figure 9-2). For better understanding of the reciprocal links, the real exchange rate is
shown here in its original form according the equation (8.1).
D
Y1
D (R, YD, I, G)
Y
Y2
Y 1
Y 3
9 Prices and Foreign exchange rate
- 100 Figure
9-2 Derivation of the DD curve
In this context, we have to mention that certain situations can lead to the shifts of DD
curve. Factors that cause this shift are following:
• Changes of the government expenditures – their increase causes the increasing of
Y and while unchanged E there is a shift of DD curve to the right
• Changes in taxes – their increase causes (if the E remains unchanged) decreasing of
D (a DD curve shift to the left)
• Changes in investment – whose rise has the same effect as an increase in
government expenditures and raises DD curve shift to the right
• Changes in domestic prices – when E and PF remains the same – their increase
causes the raises domestic goods, decrease in NX, resulting in a decrease in AD and
shift of DD to the left
• Changes in foreign prices – their increase has the opposite effect than the increase
in domestic prices, causing a shift to the right DD
• Changes in consumption – the increase in consumer expenditures results in
increase in domestic aggregate demand curve DD and its shift to the right
• Change in demand between domestic and foreign goods, which are not caused by a
change in consumption, but in the decisions of domestic and foreign entities, for
D
E
E2
E1
D (E2
.PF/PD, YD, I, G)
D (E1
.PF/PD, YD, I, G)
Y
DD
Y
Y 1
Y2
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 101 instance
to consume domestic goods more than ever before. This decision (when
YD and R remains the same) causes a rise in exports and decline in imports (and
thus the improvement of NX), resulting in a shift of DD to the right.
Impact of factors (on the example of increase in government expenditure), which results
in an increase in aggregate demand and shift of the DD curve to the right (at the unchanged E)
is shown in Figure 9-3. The function of aggregate demand is detailed to accurately reflect the
above impacts:
• Real exchange rate consists of the nominal exchange rate and the ratio of the price
levels of foreign and domestic economy
• And YD consists of the difference between the total income Y and net taxes T.
Figure 9-3 The shift of DD curve based on the changes in factors affecting the aggregate demand
Once we have established a relationship of exchange rate and output in the model of
aggregate demand, we move on to complete the analysis of the foreign exchange rate in the
short run and that by the establishing equilibrium on the foreign exchange and money market
using AA curve. First, we look at how the change of level of income affects the equilibrium
on foreign exchange and domestic money market (see Figure 9-4). An increase in the output
D
E
E0
D (E0
.P*/P,Y – T, I, G2
)
D (E0
.P*/P,Y – T, I, G1
)
(G2
> G1
)
Y
Y
Y 1
Y2
D1
D2
9 Prices and Foreign exchange rate
- 102 level
from Y1
at Y2
causes a rise in the real money supply and establishes a new equilibrium
interest rate i2
. When Re
and iF are constant, this step causes a shift E, i.e. appreciation of the
domestic currency. To achieve equilibrium in asset markets it means that the increase in
domestic output must be accompanied by an appreciation of the domestic currency and vice
versa.
Figure 9-4 Effect of change in output to the foreign exchange and money market
Now we can model the AA curve on the basis of the above relation. The AA curve
shows a direct relationship between the change in Y and the subsequent change in E (Figure
9-5).
Figure 9-5 The AA curve
E
E3
E1
E2 AA
Y
Y3
Y 1
Y 2
E
E1
E2
0
MS/P
Q
Re
R
L(i,Y1
)
(Y2
> Y1
)
L(i,Y2
)
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 103 Like
there are factors causing the shifts of the DD, likewise also in case of the AA curve
exist some factors. These include changes in the domestic money supply, the domestic price
level, in anticipation of future exchange rate, foreign interest rate and changes in the real
demand for money:
• Changes in domestic money supply – their increase at a fixed level of income
causes the depreciation of the domestic currency in the foreign exchange market (E
increases) and shifts the AA to the right up
• Changes in domestic prices – their increase causes the decrease in the real money
supply and i shifts to the right up what cause a decrease in E and shift of the AA
curve to the right
• Changes in the expected rate of return – if economic entities expect that the
expected rate of return of the domestic currency increases, the Re
curve shifts to the
right what causes a depreciation of the domestic currency and a shift of the AA to
the right
• Changes in foreign interest rate – they have the same effect as changes in the Re
–
their increase shifts the AA curve to the right
• And changes in the real demand for money, if economic entities decide to reduce
their holdings of money, the real money demand L (shifts left) is reduced, that
decreases i and increases E and there is the same effect as in the case of an increase
in MS, a thus the AA curve shifts to the right up.
9.4 SHORT-TERM EQUILIBRIUM OF THE OPEN ECONOMY
So far, we have determined the relations between output and the exchange rate in terms
of aggregate demand (DD curve) and asset markets (AA curve) separately. To determine the
macroeconomic equilibrium must be maintained equilibrium condition of these two markets
simultaneously and for this reason it is necessary to combine these models and determine the
point at which this short-run equilibrium occurs. Assuming fixed interest rates and expected
foreign exchange rates we combine DD and AA curves (see Figure 9-6). Balance in all
markets occurs at Y1 and E1.
Figure 9-6 Determination of short-term equilibrium
E
E1
DD
AA
Y
Y 1
9 Prices and Foreign exchange rate
- 104 Like
in the macroeconomic balance, also in this model DD-AA occurs imbalance, either
through the points outside of the intersection of curves or by shifts of DD and AA curves. In
the first case there is a return to the equilibrium point relatively quickly, because the asset
markets have a large adjustment capacity. To the curves shift occurs by acting of the
economic policy, fiscal (u curves DD) or monetary (for curves AA).
9.4.1 SHORT RUN EQUILIBRIUM WITH THE IMPLEMENTATION OF NET EXPORT
If we want to include the macroeconomic effects of macroeconomic policies (monetary
and fiscal) in the context of international trade into the short-term balance, we have to include
in the created model DD-AA the effects on net exports. This quantity is shown using the XX
curve and expresses a combination of foreign exchange rate and output, in which the net
export is equal to a required level X. If actual level of the net export does not match X, the
short-run equilibrium is not on the XX curve. The above conclusion can be expressed by
equation (9.15):
( ) XYDRNX =, (9.15)
where: NX – current account balance
X – required level of the NX
We can graphically represent the short-term balance with the implementation of the
curve XX using the figure 7-8. The curve has an upward trend since the increase in output
causes an increase in expenditure on imports, which worsens NX, if this is not accompanied
by a depreciation of the currency. However, its course is flatter, because of the smaller growth
in domestic demand for domestic output than is the increase in output itself (because the
income is partly saved and partly converted in expenditure on import). Equilibrium occurs at
point 1, where NX=X. Up to this point the balance is NX> X, which means that in case of an
expansionary monetary policy (point C on the curve DD) net export in the short run is
growing. Down from this point is NX<X and fiscal expansion reduces NX (point F on the
curve AA).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 105 Figure
9-7 The XX curve
E
DD
XX
AA
Y
Y 1
10 International Macroeconomic Policy
- 106 -
10 INTERNATIONAL MACROECONOMIC POLICY
In the first chapter it was said that international trade is associated with the movement
of money, when every international transaction has to be paid, which requires not only a
functioning system of international monetary relations, but also international macroeconomic
policy. This policy can be expressed only through the IS-LM-BP, but mainly through DD-AA
model.
However, if we want to analyse international macroeconomic policy, we also need to
monitor the evolution of the international monetary system56
, which we will deal with first.
Although its post-war history dates back to 1944, when the agreement establishing the
International Monetary Fund and the International Bank for Reconstruction and Development
was created in Bretton Woods, its origin goes much more into history, concretely in the
second half of the 19th
century. We look therefore at how this international monetary system
evolved and then we will analyse the formation of macroeconomic policy in the case of fixed
and floating exchange rate in the context of the development of the international monetary
system.
10.1 THE FIXED EXCHANGE RATE POLICY
Before we proceed to the actual analysis of macroeconomic policies in different
exchange rate regimes, we will describe how the central bank can maintain a fixed exchange
rate. The initial condition is that ongoing financial transactions ensure balance on the market
assets. Suppose that the central bank fixes exchange rate (in Figure 10-1 at level E0
), which
implies that it must maintain domestic interest rate equal to the interest rate abroad. Based on
the original relationship of equality (6.5), where the domestic interest rate is equal to the sum
of the foreign interest rate and the expected change in the domestic currency against foreign
currency (in the case of fixed rate is equal to zero). Participants in the foreign exchange
markets are therefore willing to keep as many domestic and foreign currencies that offer the
same interest.
The central bank can meet the equality of domestic and foreign interest rates only if
adjust the money supply to equal iF to the real money supply and real demand for money.
However, not always there is this ideal situation. Suppose that there will be an increase in the
income in the economy, which automatically causes a rise in the demand for money. What the
central bank must do to keep rate at a fixed level is shown in figure 10-1. If the demand for
money increases, domestic i automatically decreases and nominal exchange rate decreases as
well. However, since the central bank keeps the exchange rate fixed at the level (and will not
allow appreciation of the domestic currency), it must buy foreign currency, which is
accompanied by the expansion of the domestic money supply, which will happen as long as
the domestic money supply does not reach the level of MS2
. This step is called central bank
intervention. It is thus reach a new equilibrium point, which corresponds to the condition of
equality of both interest rates.
56
International monetary system is the sum of the linkages between currencies and monetary systems of individual
economies (Lebiedzik, Majerová and Nezval, 2007).
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 107 Figure
10-1 The fixed exchange rate and equilibrium on the market assets
10.1.1 THE FIXED EXCHANGE-RATES SYSTEM
So far we have talked about fixing the exchange rate, but we did not tell anything about
the system that allows this fixation. The first system of fixed exchange rates is a gold
standard. In this system, the central bank (CB) fixes the value of its currency to gold and
hold gold as official international reserves. This system worked between the years 1870-1914,
even though some economies tried on its reintroduction after the First World War57
.
The second system of fixed exchange rates was the gold bullion standard, which
operated briefly in the interwar period. It was founded on the principle of convertibility of
currency into gold, but only for the entire ingot 12.4 kg of gold (Tuleja, Majerová and Nezval,
2006). Even before World War II was replaced by the gold exchange standard, which was
based on central bank reserves in the form of gold and simultaneously a reserve currency.
The reserve currency is a set currency that is part of the international reserves of
central banks and each CB fixes its currency against the reserve currency. That is given by the
reason that CB has to be able to exchange domestic money for reserve assets precisely at this
exchange rate. These reserve currencies (until the Second World War it was the British pound
and the U.S. dollar, after the war it was only dollar) were fixed to the price of gold and each
CB fixed the exchange rate to this currency. This system worked like the gold standard, but
allowed greater flexibility in the growth of international reserves.
57
Before 1870 the international monetary system was characterized by the use of bimetallic currency - see Lebiedzik,
Majerová and Nezval (2007). Although the year 1870 is generally cited as the beginning of the gold standard, the exact
date is disputed. The first economy, which started using the gold standard, the United Kingdom under the law
(Resumption Act) of 1819, which established the pound's convertibility into gold at a fixed rate. In the second third of the
19th century, other economies adopted this system (e.g. Germany, Japan and Russia). USA had introduced it in 1879, but
institutionally was implemented in 1900. France abandoned the system of bimetallism also very slowly (until the turn of
the 19th and 20th centuries).
E
E0
0
MS1
/P
MS2
/P
Q
Re
i
L(i,Y1
)
L(i,Y2
)
10 International Macroeconomic Policy
- 108 -
10.1.2 CONDITIONS OF FIXATING THE FOREIGN EXCHANGE RATE
For functioning of this system, following condition had to be fulfilled:
• CB must guarantee trade with gold in unlimited amount at a fixed price and there
had to be a free coinage (with the exception of the gold exchange standard)
• The state must guarantee the free import and export of gold and gold coins by
private entities
• Parity of all forms of money with the value of the gold monetary unit and free
convertibility into gold had to be maintained
• And all the money in circulation had to be covered by gold reserves.
Because of the above-mentioned conditions, this system has shown for a
macroeconomic stability certain positives as well as negatives. The positive was that CB,
because of obligation to fix the price of money in gold or reserve currency, could not increase
the money supply faster than growth in demand for money. Therefore, the system
automatically set the limits for the increase in the domestic price level (through monetary
expansion), which maintained the real value of domestic money more stable. The negatives
were that the system made the use of monetary policy to stabilize the price level and
unemployment impossible (CB did not think about increase in money supply even if the
economy was in recession). Furthermore, the money supply (supply of gold or reserve
currency) grew ever slower than real product and demand for money, which resulted in
deflationary pressures (prices were more flexible and therefore this did not lead to significant
recessions), and last but not least, the big gold producers (Russia and South Africa) could
affect the global macroeconomic conditions by production and sale of gold.
10.2 THE INTERNATIONAL MONETARY SYSTEM IN 1870-1973
Now let's look at how the international monetary system affects macroeconomic
bearers. Macroeconomic policy in an open economy has two objectives: internal balance
ensuring full employment and price stability and external balance, which eliminates the
current account imbalance in BoP. This means that the economy does not have such a current
account deficit that the economy would not be able to pay the foreign debt and neither such
surplus to put into this situation its business partners (and thus deprive itself of the loss of
wealth represented by foreign currency).
10.2.1 INTERNATIONAL MACROECONOMIC POLICY IN 1870 - 1914
In terms of the gold standard was the obligation of the CB to maintain the official parity
between currencies and gold, to which needed the appropriate supplies. It meant that the CB
had to watch that gold would not flow out of abroad into the economy and what is more
important – that gold would not flow out of the economy to abroad. In modern terminology,
the CB tried to limit large fluctuations in BoP, the sum of the current account and nonreserved
components of the capital account. At that time, surpluses or deficits BoP were
financed by transfers of gold between CB and to avoid this, the surplus (deficit) non-reserved
components of the capital account "have been pushed" into the line deficit (surplus) of current
account. Generally true that the economy has its BoP in equilibrium when the sum of the
current account and capital account equal zero. This meant that the current account was
financed by international loans without movement of the reserves. In this period, there was a
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 109 rule
of the game of the gold standard58
, which was based on the sale of domestic assets in
the case of a deficit and on purchase of domestic assets in the case of BoP surplus.
As regards price stability, the gold standard tried to eliminate the monetary growth in
the world economy and thus ensured the stability in the level of world prices. In the long run,
while the world price developments during this period did not show a large increase, but the
national price level fluctuated unpredictably over short periods between inflation and
subsequent deflation. This is due to the orientation of the economy to external balance and not
on the internal balance that was "on the agenda" after the First World War, as a result of
economic instability.
10.2.2 THE INTERWAR PERIOD 1918 - 1939
During the First World War the governments left the gold standard due to funding of
military spending by printing money. Stocks of capital and workforce have been reduced by
war losses and that all caused a general increase in the price level.
First economies returned to the gold standard in the USA in 1919, followed by other
countries that profited from the financial stability of the system. At a conference in Genoa in
1922, Italy, Great Britain, France and Japan agreed a general return to the gold standard and
the partial gold standard currency for small economies was granted. In 1924, the first country
in the post-war period that restored the gold standard was Sweden, followed by Great Britain
in 1925. The Great Britain decided to return to the gold standard at pre-war prices and this
step was accompanied by restrictions on monetary policy, high unemployment and as a result,
this economy has got into stagnation.
This situation supported by the global economic crisis of 1929 (in the sense of reducing
the volume of international trade and the sharp rise in unemployment) resulted in mistrust of
London as a financial centre and in creation of currency blocks. These blocks were as
follows:
• The pound block was created after the devaluation of the pound in 1931, it consisted
of about 40 economies – countries of the Commonwealth, Scandinavian countries,
Japan and China reached a relatively high stability
• The gold block was founded in 1933 and lasted until 1935, it kept the gold parity
and was formed by France, Belgium, Holland, Switzerland, Italy, Poland and the
Czechoslovakia
• And dollar block, which was established in 1934 and it consisted of the USA,
Canada, Central America and the Philippines, where these economies, due to the
growing influence of the U.S. dollar, showed a most satisfactory macroeconomic
development.
The period of the 30s was marked by great instability accompanied by enlarging trade
barriers, output declines and deflation. About this time we talk as about the international
economic disintegration that led to the breakdown of the gold standard. In addition to the
Great Depression, the causes of this collapse were the following:
• The underestimation or overestimation of major currencies after the end of the
First World War
• No adjustment mechanism of BoP – since the incorrect exchange rate parities were
maintained, many countries had gold reserves, deficits has been deepening inflation,
what has led to the stagnation of the economy, deficits of BoP and restrictions on
foreign trade
58
Set by J. M. Keynes.
10 International Macroeconomic Policy
- 110 •
A competitive devaluation – given the poorly defined exchange parities many
countries devalued their currencies, which raised a revaluation of the currency in the
foreign countries where central banks protected themselves by devaluations with
efforts to restore the original parity
• And destabilizing capital flows between the traditional financial centre London and
the new centres – Paris and New York.
10.2.3 THE BRETTON WOODS SYSTEM IN 1944 – 1973
The depression 30s of the last century and the subsequent World War II caused a
nearly perfect disposal of international trade, international trade and capital flows of money
(lots of economies had almost autarchic character). However, during the World War II, the
economies began to realize the need for reform of international monetary relations, not only
to the world economy avoid economic and social chaos and devaluations that took place in
the interwar period.
The first step to restore the international monetary system was the negotiations of the
Monetary and Financial Conference of the United Nations in the American town of Bretton
Woods, which was attended by 44 countries and on which was the negotiated agreement
having a basis for the Bretton Woods monetary system. At this conference agreed
mechanism for regulating the international financial system and establishing international
monetary institutions with responsibilities in the area of foreign relations.
By signing the agreement of Bretton Woods was established:
• The creation of international monetary institutions59
whose purpose is to lend to any
member country that will have problems with the current account of balance of
payments and will have a shortage of foreign exchange, particularly the IMF had
gold for other currencies to lend on the basis of the subscription, which meant that
each entrant economy had to pass on account of IMF gold and its currency
according to quotas set according to the size and economic power (quota represents
both the contribution and the right drawing)
• As a reserve currency in the international monetary system was established U.S.
dollar (pegged to gold, which gave rise to the gold dollar standard) and other
economies maintained its foreign exchange reserves in that currency or in gold
• Each economy has set a par value of its currency and maintained a fixed exchange
rate with a tolerance of ± 1% through intervention purchases and sales of USD on
foreign exchange markets
• Member countries could devalue or revalue the parity value of its currency without
the consent of the given international institutions, and only in a situation when BoP
showed the fundamental imbalance60
• After a certain time, all the currencies of member countries were to become
convertible, in terms of convertibility on current account transactions BoP
Maintaining a fixed exchange rate and gold reserves required considerable effort, which
was in later years, as we show below, still bigger but less successful.
59
These institutions are the International Monetary fund and International Bank for Reconstruction and Development
(original World Bank).
60
This imbalance was not strictly formulated, but it was considered that it was the economy, which suffered permanent
adverse movements of international demand for their products.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 111 The
international monetary system began to operate after the war, because the states
were committed to the convertibility of their currencies, which was accompanied by a
necessity of devaluations and adequate reserves for interventions on foreign exchange
markets. The US initially did not have the willingness to provide their currency, but during
the Cold War and fears of the spread of communism, the situation has changed due to the
Marshall Plan, whose essence was to provide USD for recovering of the economies and
militaries of European economies. This period was in relation to macroeconomic equilibrium
period of stability when the dollar maintained its position as a reserve currency, mainly due to
inconvertibility of the most currencies (except the Canadian dollar which was convertible
since 1945) and current account deficits of BoP in relation to the USA. The Marshall Plan had
efficiency, but European countries considered it as unsatisfactory and therefore, they tended
to mutual trade among themselves.
In the fifties, the situation was reversed and a period of the "calm before the storm"
has come. Since 1958, most European economies considered their dollar reserves to be
sufficient and they have restored the convertibility of currency and with that related
convertibility of goods and surplus current accounts with the US. The fear of devaluation of
the dollar against gold have began to arise, for instance the fear of increase in the price of
gold. The US responded to these concerns by interventions on the gold market (price
remained the same) and other steps – credit restrictions and capital controls to prevent the
buying of dollars by foreign economic entities. In this period there was a substantial increase
in the mobility of capital and thus a new approach to deficits or current account surpluses of
BoP. Economies that showed fundamental imbalances were obliged to devalue or revalue its
currency. Expectations of devaluation and revaluation resulted in a speculation when central
banks most of the time awaited with these steps until the last moment and speculators could
before selling or buying currencies to earn.
In the next period – in the period of the Vietnam War and the "Great Society", was
the macroeconomic policy of the USA considered as a major mistake that helped to end the
system of fixed exchange rates. The huge increase in government expenditures (on the war in
Vietnam and program of "Great Society" with expenditures on public education and housing)
was accompanied by monetary expansion, which resulted in growth of inflation and taxes.
Contrary to the belief of sufficient dollar holdings of European economies, in the world
economy prevailed beliefs about the lack of international reserves or international liquidity.
This was the essence of so called the Triffin Dilemma, which was based on the questionable
commitment to the US about the dollar's convertibility into gold. In other words – if demand
for the dollar increases (due to the increase of international trade), the money supply should
increase as well, but in practice it was not possible anymore because of the exogenous offer.
If the US satisfies the demand for dollars, it would cause the decrease in the ratio of the golddollar
and would lead to the loss of confidence in the dollar as a reserve currency. If not
satisfy, this demand would reduce the international trade and global growth.
A solution would be to introduce more than gold reserve assets. In 1967, the Special
Drawing Right (SDR) was created. This is a type of artificial, paper gold, traded only among
central banks to offset imbalances of BoP61
. Originally it amounted to 1 USD and currently is
set up of a basket of four currencies (euro, British pound, U.S. dollar and Japanese yen).
Since 1968, US monetary policy on the one hand and on the other hand, Germany and
Japan, diametrically opposed and the dollar against these currencies was overvalued. This
period has been called the period of golden crisis. The solution was twofold: either in
61
Nowadays, due to the floating exchange rates, international mobility of capital and creditworthiness of economies, SDR
is ineffective for developed countries and they may help in the case of developing economies, which cannot raise funds
on global financial markets (but for this purpose have not been created).
10 International Macroeconomic Policy
- 112 monetary
growth, a revaluation of the DEM and JPY (which would imply a devaluation of the
dollar) or changes in monetary policy. No central bank did want to step aside and the situation
came to a head in 1971 when the Bundesbank interventions were such strong that the
Bundesbank left the exchange rate float and the dollar has depreciated strongly against the
Deutschmark.
This devaluation was not a simple matter for the USA, because it was tied to the consent
of the other economies with fixing of their exchange rates at a new level62
. Therefore,
devaluation could be made only on the basis of negotiations. These negotiations took place at
the end of 1971 in Smithsonian institution (Washington) and they are known as Smithsonian
agreement. The dollar was devalued by an average of 8 %, the price of gold rose by $ 3 per
ounce (at 38), the fluctuation band was expanded to 2.25 %63
and the convertibility of the
dollar into gold was cancelled.
Between 1972 and early 1973 there were further speculative attacks and devaluations of
the dollar, which led to the closure of the international foreign exchange market. March 19,
1973, this market was reopened and most currencies against the dollar were floating. This
situation has been reported as end the regime of fixed exchange rates and as the beginning of
a new era of international monetary relations.
10.3 THE POLICY OF FLOATING EXCHANGE RATES
The system of floating exchange rates is based on the principle of non-intervention of
the central bank on foreign exchange markets. The functioning of this system is followed by
many arguments for and against64
. For the affirmative arguments we consider:
• The autonomy of monetary policy when the central bank does not have to intervene
in the foreign exchange markets, monetary policy can be used to achieve the internal
and external balance of the economy and economies do not have to import inflation
(deflation) from abroad
• A symmetry, when the US does not have to determine monetary conditions to other
economies and simultaneously they have the same opportunity as to influence their
exchange rates against foreign currencies other economies
• And exchange rates are automatic stabilizers, when even in the absence of active
monetary policy the rapid adaptation of market determined exchange rate helps the
economy to support internal and external balance by changes in aggregate demand.
Among the arguments that have reservations about the introduction of floating exchange
rate regimes, we rank the following disadvantages:
• A discipline – if central banks do not the obligation to fix their exchange rates, they
may tend to inflationary policies
• The destabilizing speculation and fluctuations in the money market – for example,
destabilizing sales of a weak currency may support future inflation expectations and
bring home a wage-price spiral, which results in additional depreciation
• A damage to international trade and investment – a floating exchange rate
developments raise the unpredictability of development of the relative international
prices
62
This meant consent with the revaluation of their currencies.
63
In 1973, even these measures proved insufficient.
64
Only the arguments concerning the macroeconomic level are mentioned, at the microeconomic level may be
an argument against for example costs to hedge against exchange rate movements.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 113 •
A lack of coordination of macroeconomic policies – the damage of other
economies can be caused by the application of independent macroeconomic policies
due to the loss of the rules of the Bretton Woods system
• And a great illusion of autonomy – a floating exchange rate do not allow to
penetrate foreign inflation into the economy, and thus it allows the central bank to
influence the money supply, but the exchange rate is also so important
macroeconomic variable that policy makers cannot apply tools of monetary policy
without including their impact on exchange rate.
To incline more to the arguments against is a disputable issue since the world economy
after the collapse of the fixed exchange rate system was exposed to many strong shocks,
which also managed due to floating exchange rates. Now, these shocks will be analysed.
10.3.1 THE INTERNATIONAL MONETARY SYSTEM AFTER THE COLLAPSE OF THE FIXED
EXCHANGE RATE SYSTEM
The world economy and the international monetary system were after the collapse of
the Bretton Woods system exposed to many strong shocks, whose overcoming would be very
problematic in the system of fixed exchange rates. After the outbreak of war between Israel
and the Arab countries, the OPEC countries decided to impose an embargo on oil exports to
the US and the Netherlands as a protest against their support of Israel. This resulted in the
overstocking of customers and a huge increase in oil prices, which resulted in a reduction in
consumption and investment in individual economies and led to a recession in the world
economy, which is known as the first oil crisis in 1973-1975. In countries that were
dependent on oil imports, there was a significant deterioration in the current account of BoP
and in case of exporters of oil there was a significant improvement in the current account.
Reactions were varied, mostly in the form of an expansionary fiscal and monetary policies,
which led to stagflation and external and internal imbalances. The return to fixed exchange
courses was in this situation impossible.
This situation forced the developed economies to decision to legalize the use of
floating exchange rates in the IMF and that on the G7 meeting at the Chateau Rambouillet
near Paris (where it was agreed that member states do not return to fixed exchange rate, but
will coordinate "enormous fluctuations") and then in 1967 at a meeting in Jamaica (Kingston
town), which was the beginning of the Jamaican currency system. On this meeting was
arranged:
• A cancellation of the official price of gold, which resulted in a huge increase in its
price (see Example 8-2)
• An elimination of gold from official foreign exchange reserves, which was
effectively the end of the process of demonetization of gold
• A cancellation of parities of currencies to gold, which did not mean anything other
than the recognition of floating exchange rates
• The use of SDR as an international reserve currency
• And the eligibility of exchange rate system of each member economy in its sole
discretion and IMF surveillance over those policies.
In the next four years, there was a period of a weak dollar. Because the US used
expansionary policies (for recovering of economy) separately, it resulted in inflationary
pressures and then the sharp depreciation of the dollar against the Yen and the Deutschmark.
This caused deflationary tendencies in the German and Japanese economy, which prevented
themselves by interventions against the dollar by increasing the money supply. The
10 International Macroeconomic Policy
- 114 weakening
dollar was the impetus for a change of monetary policy to strictly restrictive with
the limitation of monetary growth, which resulted in a brief but sharp recession.
However, in 1979 due to political and economic problems in Iran there was further
significant price increase and the second oil crisis came. The results were similar to those of
the first one – oil importers’ current account deficits of BoP and stagflation. Monetary
policies in most economies were restrictive, because their creators worried about further
inflation and inflation expectations. This has led to a rise in interest rates and a sharp
recession, which had very negative consequences especially for oil-exporting developing
countries in a form of increased indebtedness.
The effectiveness of restrictive monetary policy of the US has been proved. On the
foreign exchange markets early disinflation was expected and the dollar strengthened. This
resulted in a drop in output and rise in unemployment in the USA and also negative reactions
to the strengthening abroad (disinflation occurred partially exporting inflation abroad). All
this, together with the effects of the second oil shock, led to a greater recession in the world
economy than was the great crisis in the 30s. Strengthening dollar raised deterioration in the
current account of balance of payments of USA (cheapening imports has been accompanied
by increasing prices of exports), which reduced demand of certain sectors – agriculture,
textiles, steel and automotive industries. This raised the need for protectionist measures.
The most developed economy have begun to worry about the collapse of the world
economy and in 1985, at the Plaza hotel (New York) agreed on joint intervention on the
international foreign exchange market and thus the pressure on the dollar. This intention was
achieved. The dollar has been declining until 1987 and unfortunately, despite the adequate
appreciation of other currencies against the dollar, the dollar has depreciated and there was a
threat of another crisis. In early 1987, when sufficient appreciation of currencies against the
dollar was considered, the meeting of the six most advanced economies in the Louvre was
carried and a plan to stop falling of the dollar was adopted. However, reducing of the current
account deficit of the US balance of payments and increasing expenditures and money supply
growth in Germany and Japan conditioned it. It did not happen and the dollar steadily
declined. Alan Greenspan, a new Fed chairman, prevented this crisis, because he improved
the liquidity of the international financial system by providing dollars to the international
financial market. Since other governors of central banks followed him, the global reduction of
interest rates and partial stability of the dollar was achieved.
However, this situation did not last long and the fluctuations of the dollar began to
appear again in the late 90s of last century and the dollar is unstable till these days. Based on
past experience it cannot clearly determine how to precede in the future. It is shown that the
system with relative exchange-rate flexibility works quite satisfactorily, but not optimally. It
was developed in the context of changing international financial system and this development
process was not always satisfactory and it was partly because it was uneven and activities of
many supporting institutions lagged behind this development. This occurred financial crisis,
but they are not a phenomenon of the past few years and they are proof that international
financial system has been breaking down rather than the monetary one.
10.4 THE INTERNATIONAL MACROECONOMIC POLICY IN THE FLOATING
EXCHANGE RATE SYSTEM
Given that the analysis of the functioning of macroeconomic policy in the system of
fixed exchange rates can also be found in Czech literature (Neumann, Žamberský and
Jiránková, 2010), we focus on the coordination of macroeconomic policies in the system of
floating exchange rates and individual effects, then we will compare to the situations that
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 115 occur
in a fixed exchange rate regimes65
. We will use the well-known DD-AA model, whose
nature we explained in the previous chapter. First, we analyse the impact of the decline in
foreign demand for exports of the domestic economy, then we will analyse the impact of the
growth in demand for money.
In the case of a decline in foreign demand for exports will rely in particular on the
argument, mentioned at the beginning of chapter 10.3 and this is the argument of exchange
rates as automatic stabilizers. The best explanation is the graphical one (see Figure 8-3). The
decline in foreign demand for domestic goods causes a decline in aggregate demand and shift
of the DD curve to the left up (to the level DD2
). So far, the effects do not differ for any of the
exchange rate regimes. But impacts of this shift will be different for floating rates (Figure 10-
2 (a)) as well as for fixed exchange rates (Figure 10-2 (b)). If implemented the policy of
floating exchange rates it will not lead to a change of the AA curve, but to the depreciation
of the currency and the decline in output. This is caused by a decline in demand and output
which lead to the reduction in the transaction demand for money. In order to maintain
equilibrium in the money market, the interest rate must also decrease because it causes a
devaluation of domestic currency appreciation (a shift from E1
at E2
). In the case of fixed-rate
policy there is also a decrease in the output, but to a greater extent due to intervention of the
central bank to maintain the stability of the exchange (at E1
). The central bank buys foreign
currency for domestic currency and this reduces the money supply (shown in curve shift from
AA1
at AA2
). The exchange rate thus remains fixed, but there will be a drop to the level of the
output Y3
.
The above-described situation shows the movements and effects in terms of short run.
What happens in the case of the long-term (permanent) decline in foreign demand? The
effects are the same, only deeper: in floating-rate policy, there will be a shift of the AA curve
up and greater depreciation and a decline in output and in terms of the policy of fixed
exchange rate a decline in long-term leads to fundamental imbalance of BoP.
65
For instance, Krugman and Obsfeld (2003) deal with that issue very clearly.
10 International Macroeconomic Policy
- 116 Figure
10-2 The effects of the decline in external demand in the regime of floating and fixed rates
E
E2
E1
E
E1
DD2
DD1
AA
Y
DD2
DD1
AA1
AA2
Y
Y 2
Y1
(a) The floating foreign exchange rate
Y3
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 117 If
we mentioned the argument for choosing policy of floating exchange rates, we also
have to analyse the negative impacts, using the argument of destabilizing speculation and
fluctuations in the money market, which cause fluctuations in the demand for money. When
the exchange rates are floating, the economy becomes more sensitive to shocks originating in
the domestic money market, as shown in Figure 8-4. In the floating exchange rates regime
(Figure 10-3 (a)) is shown that the effects of the growth of the real money demand curve AA
to the right at AA2
. This causes a drop in output and the appreciation of the currency. In the
long run, the growth of money demand leads to a decline in the domestic price level. In a
fixed exchange rate regime (Figure 10-3 (b)), changes in the demand for money will not affect
the economy at all – to avoid the currency appreciation, the central bank buys domestic
currency for foreign currency and thus it increases the money supply, thereby negating the
growing demand for money. Because of this intervention the AA curve remains at its original
level (and the exchange rate as well). It also means that the output does not change and in the
long term neither the price level.
10 International Macroeconomic Policy
- 118 Figure
10-3 The effects of growth in external demand for money in the regime of floating and fixed rates
From the above arguments and the experience of the two systems exchange rate
regimes we cannot incline neither to the side of advocates nor the critics of those policies.
However, one thing is very clear – no system of exchange rates can function without the
international economic cooperation.
E
E1
E2
E
E1
DD1
AA1
AA2
Y
DD1
AA1
Y
Y 2
Y1
(a) Floating exchange rates
Y1
(b) Fixed exchange rates
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 119 -
11 GLOBAL CAPITAL MARKETS
The international capital market (ICM) is a market on which residents of different
economies trade with their assets. It historically evolved from national capital markets in
Europe, USA and Japan. The integration process has become both an important factor for
investing in international assets, but also for the determination of exchange rates and finance.
11.1 THE STRUCTURE OF INTERNATIONAL CAPITAL MARKET
The international capital market is a group of closely related markets in which there
is trade with assets in international dimensions. The assets include securities and bonds,
which are bonds, which in this case can be divided into two groups. The first group are the socalled
foreign bonds, or bonds issued by a foreign borrower in a given country in its
currency, for instance dollar bonds issued by the British issuer on the capital market in the
USA. The second group are the so-called Eurobonds or bonds, which are issued beyond the
scope of currency in which they are denominated (e.g. Czech company may issue bonds
denominated in US dollars and sold outside the US market).
Issuers of these assets are mostly companies and public organizations and investors are
mostly non-financial organizations that collect money from those economic entities that are
interested in a stable interest income. Banks arrange and implement all. This brings us to the
structure of ICM. It is very similar to that of the foreign exchange markets and consists of:
• Commercial banks, which are centres of the ICM, because they provide a chain of
international financial activities and may carry on foreign activities that cannot be
carried out in their own economy and by this way they promote the growth of
international banking
• Corporations (companies) that usually finance their investments by drawing foreign
funds, in the form of bonds or loans from international banks and financial
institutions
• Non-banking financial institutions (insurance companies, pension funds, so-called
investment banks), which are important "players" on the ICM, because they
participate on this market in order to diversify their portfolios
• And central banks and government agencies, the CB to participate in operations on
the ICM by interventions on foreign exchange market and government agencies by
borrowing from foreign commercial banks66
.
From the point of view of the international economics – we are interested in relation to
the international capital market to three things:
• How this market increased revenues from international trade to the economies
involved in it
• What caused the huge increase in international financial activities in the last forty
years
• And how can economic policy-makers minimize problems arising on the ICM
without a drop in profits this market brings.
66
This applies especially to the governments of developing economies and state-owned companies. For example, Poland
and Hungary were indebted this way at the time of the Council for Mutual Economic Assistance.
11 Global Capital Markets
- 120 -
11.2 INCOMES FROM INTERNATIONAL TRANSACTIONS
All transactions between residents of individual countries can be summarized into three
categories:
• A Trade of goods and services for goods and services, which we discussed in
connection with models (theories) international trade. Revenues from this type of
trade resulting from the fact that the economy can concentrate on producing of those
goods, which are more efficient.
• A trade of goods and services for assets resulting from Intertemporal trade, where
goods and services are exchanged for the right on future goods and services, i.e. for
assets (e.g. when the economy borrows abroad, that means that is sell bonds abroad,
it may import goods and services to domestic investment project). This type of trade
allows higher incomes for the domestic economy, because of higher investment,
which is financed by foreign capital, as well as for foreign investor, since it achieves
a greater return on assets than would be achieved in their economies.
• And trade of assets for assets – this type of market is numerically expressed in the
capital account of BoP (foreign assets held by domestic residents – debit, domestic
assets held by foreign entities – credit), which may be balanced by purchase or sale
of assets.
11.2.1 RISK AVERSION AND PORTFOLIO DIVERSIFICATION
When the participants in the ICM decide on buying assets, an important role in their
decision plays the risk of each asset and its expected return. Behaviour of these economic
entities is usually very influenced by the risk aversion67
. This explains the existence and
profiting of insurance companies that "sell protection against the risk" (theft, illness, etc.). It
also explains the existence of the ICM, because investing on the foreign markets, which may
not recorded e.g. price fluctuations in the domestic economy, offers the possibility of reducing
portfolio risk.68
.
James Tobin, the founder of modern portfolio theory69
with risk aversion, described
this process, called portfolio diversification as follows: " Don't put all your eggs in one
basket", i.e. divide the amount you want to invest on different parts these deposit with a
different interest. When the economy is open ICM, investor may reduce risk of his wealth by
placing some of his "eggs" in foreign "basket". This risk reduction is the basic motive for
market assets.
However, economic entities know that even on domestic markets is portfolio
diversification into different sectors to reduce risk to expected return, because it is possible to
eliminate unsystematic (diversified) risk. However, the systematic elimination (undiversified)
of the risk is very limited. What is hidden under these terms? Unsystematic (specific) risk is
linked to the situation of individual companies and the industry. It can be removed in such a
way that when one company (industry) is loss, the second is profitable. The systematic
(market) risk is associated with the macroeconomic situation in the economy, such as
economic cycles and fluctuations, the situation on foreign markets, etc. In the domestic
market is not possible to eliminate the systematic risk of the reason that prices are influenced
67
Those who prefer risk are called „risk lovers“.
68
Except the possibility to reach higher incomes.
69
J. Tobin (1918-2002) acquired for this theory in 1981 the Nobel prise in Economic Science.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 121 by
the same factors, such as fluctuations in interest rates, money supplies, economic and
political cycle
Asset prices in individual national markets are not influenced by the same factors and
therefore their incomes are different. The variability of returns and risk can be eliminated by
international diversification. In other words, a risk that is systematic in terms of one economy
may not be systematic in terms of the global economy (see oil shocks).
But why in the globalization process are still preferred the investment in domestic
assets? This is given by the existence of barriers of international diversification, including:
• Legislative barriers – foreign exchange regulations, controls limiting investment of
domestic entities abroad, limiting ownership of domestic assets by foreign entities,
the double taxation of income from foreign assets, etc.
• Indirect economic barriers – information and transaction costs of investing in
foreign assets, inaccessible or incomplete information about the issuers and about
the market itself, different accounting standards, inadequate protection of minority
shareholders, etc.
• A lack of liquidity national markets – inefficient and slow marketability on the
stock market, the rapid devaluation of the domestic currency, unstable
macroeconomic and political situation etc.
• And psychological barriers – based on insufficient knowledge of foreign markets,
lack of understanding of the customs and culture, underestimating the stability of
these markets, etc.
11.3 THE DEVELOPMENT OF THE INTERNATIONAL BANKING AND CAPITAL
MARKET
Despite the above-mentioned barriers occurred in the last fifty years the globalization of
the banking industry by that the bank "crossed" boundaries of economies and joined the
foreign financial centres. Such a trade that is managed by foreign bank offices outside their
domestic economies is called offshore banking70
. Hand in hand with offshore banking, the
offshore currency trading has been growing. Offshore deposits are bank deposits denominated
in a currency other than the currency of the country in which the bank is located (e.g. Yen
deposits in the Bank of London). They are typically short-term deposits (from overnight to
one year) with a fixed interest rate. Banks that accept such deposits are called eurobanks.
The motivation for the development of offshore banking and currency was the growth
of international trade and transnational nature of business activities. Another reason for the
expansion of international banking was a "desire" of banks to escape from domestic
government regulation of financial activities by moving their operations abroad and in foreign
currencies. Last but not least, it includes also a political factor, when some depositors, due to
legal conditions demanded possession of currencies outside the domestic economy. The above
types of deposits are usually referred to as the Eurocurrency, which is a little misleading
name, because it is often traded on non-European markets such as in Singapore or Hong
Kong. They also include dollar deposits deposited outside the US, called Eurodollars and
Eurobonds.
70
It can be explained as external support of banking.
11 Global Capital Markets
- 122 -
11.3.1 THE GROWTH OF THE EUROCURRENCY TRADE
The market with Eurocurrency is not a new phenomenon, since many banks in
Europe before and after World War I accepted deposits in other currencies. Origin
Eurocurrency market as we know it today, refers to the period of the Cold War, when the
reserves of the former Soviet bloc held in the USA in danger of being frozen. At the time of
the gold standard had these economies, if they wanted to trade with the West, to accept dollars
and therefore to avoid this blocking, the reserves held in England and France.
The above-mentioned sanctions have an impact on the emergence of the Euro-dollar
market. This also helped develop two types of regulation by the Federal Reserve Committee
– regulation Q and regulation M:
• Regulation Q is based in determining the interest rate ceiling on deposits in the US,
because European banks did not participate in this regulation, they could pay higher
interest rates for dollar deposits in the European market, where interest was higher
• And regulation M is based in determining the rate of minimum required reserves for
the US banking system, because reserves do not bring any interest, its pose
represents for banks high costs. European banks were no obligation to maintain
minimum reserves of dollar deposits, which reduced their costs compared to US
banks and allow them to pay higher interest rates "to attract" deposits.
Two other measures helped to the development of the Eurodollar market:
• In 1963, the tax on the income of US residents of foreign securities was introduced.
To compensate this tax, foreign borrowers have to pay higher interest rates, which
was for foreign economic entities expensive and they have oriented the Eurodollar
market, where the measure did not apply
• And in 1965 restrictions on the use of foreign domestic assets was introduced and
therefore, many American companies that planned investments abroad, shifted its
activities to the above market.
It would seem that the euro money market has suffered by these measures
(contradictory) but the opposite is true. After their removal in the mid 70s, this market has
seen tremendous flourish, partly due to the large quantity leading to economies of scale and
also because these transactions are appropriate for the current globalized world (it is
impractical to deal with different banks in different economies in different currencies).
Now we show what is the process of deposits´ making and we try to understand the
benefits of the above-mentioned markets. And we will try to refute unfounded objections that
Eurocurrencies are the part of the money supply in the given economy and thus may cause
outflow of cash reserves.
11.3.2 CREATION OF EUROCURRENCY
To show the best this process we use an example. Imagine that BMW Company sold in
the US car worth 50,000 USD. American – the new owner pays by check bank A and BMW
becomes the owner this check and it thinks what will do with that. It is expected that in about
a month will need dollars to pay for the laptops that intends to purchase in the USA. So BMW
decides to keep those dollars for one month and in a form that will bring interest.
It may decide for two ways – either buy some type of security (e.g. treasury bills, or
bills issued by US banks), or buy Eurodollars depositing this check to the Bank of England. If
BMW decides for the second option – the Eurodollars was created.
Suppose that the Bank of England has a dollar account in US B bank, then the
transaction described above has the impact on the change in the balance of the three banks:
for A bank it means loss of 50,000 USD (on both sides) because of increasing deposits of
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 123 American
owner of BMW car. For the bank of England has the increment of this money in the
form of increment of the BMW account and this transaction has the same effect on the
balance of B bank (see Tables 11-1 to 11-3).
Assets – changes Liabilities – changes
Reserves -50.000
Deposits (owner
account)
-50.000
Assets – changes Liabilities – changes
Deposits of B
bank
+50.000
Deposits (account
of BMW
company)
+50.000
Assets – changes Liabilities – changes
Reserves +50.000
Deposits (account
of the Bank of
England)
+50.000
Source: own processing
The above transaction has the consequence that the monetary base71
remains
unchanged. And because the monetary base is the passive side of CB, it means that the
increase in Eurodollar supply (in our case) is not cause by a decrease in the money supply.
This process continues further and due to a multiple expansion of bank deposits leads to a
further increase in the volume of Eurodollars, but because of the interconnect of the
international capital market there is not an outflow of money from the US money market.
11.4 MACROECONOMIC STABILITY AND EUROCURRENCIES
Often happens that politicians and journalists are sounding the alarm because of the
huge range Eurocurrency deposits when these "non-state money" – in their opinion no
uncontrollable – are not any national monetary authority can thwart the government effort to
maintain economic stability and may even cause global inflation
Eurocurrencies and monetary control
Monetary base must equal liabilities CB, you directly control the transactions based on
the domestic and foreign market assets. The course of the relationship between the monetary
71
Powerful money - the amount of reserves and currency.
Table 11-1 Balance of A bank
Table 11-2 Balance of the Bank of England
Table 11-3 Balance of the B bank
11 Global Capital Markets
- 124 base
and the various monetary aggregates is dependent on the money multiplier. The need to
reserve different types of deposits has a major influence on the determination of the size of
money multiplier. This fact causes the euro currency trade multiplier somewhat destabilized.
To avoid this instability CB must control monetary aggregates in the short term. Therefore, it
would seem that the economic perspective, this market seems inappropriate. On the other
hand, we must take into account the economies of scale that benefit the consumer market
assets, which facilitate the exchange of assets currently Eurobank.
Monetary base must equal liabilities of CB that directly control the transactions based
on the domestic and foreign market assets. The course of the relationship between the
monetary base and the various monetary aggregates is dependent on the money multiplier.
The need of reserves of different types of deposits has a major influence on the determination
of the size of money multiplier. This fact causes that the Eurocurrency trade somewhat
destabilized this multiplier. To avoid this instability, the CB must control monetary
aggregates in the short run72
. Therefore, it would seem that from the economic perspective,
this market seems inappropriate. On the other hand, we must take into account the economies
of scale that are benefits for the consumer on the market assets, when the Eurobank enable
this exchange of assets currently.
Moreover, this instability has no effect on the monetary base, as we have already said.
When some economic entity selects dollar of deposits in a A bank and places it in an account
in the Bank of England, the reserves are not affected by this operation and it will not be
shown in the balance of CB. In terms of the balance of payments, the capital outflows from
the domestic economy will be abroad as capital inflow if a foreign bank lends the dollars to
buy goods and services or assets in the domestic economy. Fear of outflow of currency and
the subsequent flooding of vast domestic money market is unfounded.
Eurocurrencies and world inflation
Inflation causes the growth of monetary supply, which includes money in circulation
and non-term deposits73
. Eurocurrency deposits cannot be explicitly included in this category
because they are relatively illiquid, resemble the term deposits and are usually referred to as a
broad monetary aggregate, so called quasi-money. However, it does not mean that the effect
of these deposits on the price level can be completely ignored because they are a medium of
exchange and rising substitution for money may cause in the future large inflationary
pressures.
Meanwhile, the Eurocurrency market is under the control (although such a control in the
short run is not a simple matter) and the only one threat is that it might get out of the control
by introducing compulsory reserves on foreign currency transactions of banks. It would be
necessary to implement the legislative coordination of governments, which is technically and
politically difficult.
11.4.1 REGULATION OF INTERNATIONAL BANKING
At the international level, the regulation of the banking market is less effective, than at
the national level, where domestic banks are subjected to legislative regulation, which is
internationally not possible. This national regulation is associated with the elimination of
bank insolvency and to it belongs:
• The deposit insurance
• Minimum reserves
72
The effect of instability in long run is not large enough.
73
or Monetary aggregate M1
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 125 •
A regulation of bank capital and risk assets (bank capital represents bank shares
and risk assets represents ordinary securities whose prices are volatile)
• Banking supervision
• And lending of commercial bank by the CB (a tool to prevent panic in the banking
system).
If we look at the international regulation from the perspective of the above measures,
we can conclude that:
• The deposit insurance in international banking is missing, due to the fact that the
amount that is available for insurance is too small to cover all deposits used in
international banking
• The absence of minimum reserves is a major factor in the development of
Eurocurrency market is actually competitive advantage of Evrobank and no
economy is willing to address the problems that would arise by the introduction of
this measure to domestic banks that do business abroad
• A regulatory of capital and risk assets and bank supervision is problematic as
regards the first – the CB regulate its commercial banks, but they do not dare "get"
into the accounts of foreign subsidiaries and affiliates (subsidized) members, and in
the second case, who would carry out supervision (which other CB – in the case of
the association of the Bank of England in Italian – Italian, British or American CB)?
• as well as the issue of lending is problematic, given the above example, who should
take responsibility for the loan in the event of withdrawal of dollar deposits –
American CB, British or Italian commercial bank?
The issue of national security against the banking collapse took on the severity of the
particular events of bankruptcy of largest private bank in Italy (Banco Ambrosino) in 1982.
Addressing this issue, however, does not date from this event is related to the huge
development ICM beginning in the 60s.
By the year 1974, in addressing of this issue was not done that much – till 1974 there
have been many bankruptcies of major banks for losses on foreign exchange markets. In
1974, under the banking crisis, was appointed the group of central banks of eleven industrial
countries, which is called the Basel Committee, whose main goal was cooperation in banking
regulation.
In 1975, the Committee adopted a resolution called Concordat in which was established
the responsibility in the international banking system between the domestic and host
countries, e.g. through monitoring of assets of foreign subsidiaries or the unification of
financial balance of international banks).
A major step to improve the situation to ensure ICM was performed in 1988, when the
Committee agreed common standards for adequate valuation of bank capital (minimum was
set at 8 % of risk assets).
An open problem remains the lending in the interbank market and the international
activities of non-bank financial sector, because the bankruptcy of insurance companies as well
as banks failures may cause a collapse of the banking system. The growing securitization,
which is the process of converting assets into multiple bank market form (investment and
insurance funds), makes the supervision of financial flows and balance sheets of banks
difficult.
In the next chapter, we describe how the crisis of the banking system in the 80s resulted
in the debt crisis of some developing countries.
11 Global Capital Markets
- 126 -
11.5 FINANCIAL CRISES IN 90‘S YEARS
After years of relative global economic stability some financial markets were hit by
certain monetary crisis. In February 1994 in Mexico, interest rates dropped due to declining
inflation, because interest rates in the US rose at such a level that did not bring interest
earnings in Mexico what led to the leaving of first investors and government was not able to
finance increasing current account deficit. Foreign exchange reserves of the CB declined and
the solution was twofold: either currency devaluation, or the introduction of a flexible
exchange rate. The Mexican central bank conducted this devaluation in late 1994 and then
there were a huge capital outflows, further devaluation of the Mexican peso (in total by 120
%) and it led to the transition to a freely floating currency exchange rate.
The outflow of capital caused the financial crisis in Mexico, subsequent economic
depression, started further declines in currencies and asset prices in other countries of Latin
America and Latin America was hit by the financial crisis, which was continued in 1999 in
Brazil (see below). This process was called tequila effect and this term also took the Asian
financial crisis mentioned below.
For solving of this crisis, US provides to Mexico the stabilization loan to prevent a
collapse of the banking sector and this loan was very helpful – Mexico during the year
liberalized economy, restore investor confidence and consequently there was a significant
increase in foreign direct investment.
These crises were reflects of the growing problems of global capital markets and cause
of short-term speculation in the currency markets. Now we look at each crisis separately and
we will try to analyse the causes and specifics of each crisis.
11.5.1 THE ASIAN CRISIS IN 1997
The origin of the Asian crisis is in fundamental changes in the economies of the region
and in the transition of many Asian countries from the position of net exporters to net
importers position. At the beginning of 90 years, Thailand was the most developing economy
of the Far East and it began to import more than export and required together with other
economies net capital flows to support their fixed currencies. If capital flows were made (the
development of companies, infrastructure, construction of dams and even speculation in real
estate) currencies were kept at a fixed level, once these flows ceased, the crisis was inevitable.
A most noticeable was this situation in Thailand between 1996 and 1997. In the context
of rapid economic growth and increasing profits Thai companies, banks and financial
companies entering the international capital markets and substantial credit burden on
investment, because they thought that these dollar loans are cheap. How does this investment
"bubble" has been increasing, they began to hear voices warning against the (un)ability to pay
growing debt.
Thai CB and the government began to intervene in the foreign exchange market and that
directly (using large foreign exchange reserves) and indirectly (rise in interest rates to prevent
the outflow of currency). That stopped the flow of investment, what caused huge monetary
losses and bank failures and then the CB allowed a floating of the Thai baht. From hour to
hour currency fell against the US dollar by 17 %, against the yen by 12 % and this process
have been continued and in November 1997, the baht fell against the dollar by as much as
38 %.
This was followed by the Asian version of tequila effect when other countries in the
Asian region came under the pressure of brokers and capital market. Philippine peso,
Malaysian ringgit and the Indonesian rupiah and other currencies fell against the dollar, as
shown in Table 11-4. Only in the case of Hong Kong (due to direct interventions of the CB)
and China (due to inconvertibility) there were no changes.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 127 Source:
Eiteman et al. (2001)
The Asian economic crisis was more monetary crisis, since it had, in addition to
difficulties in the balance of payments, many other causes, including as market socialism, the
existence of state-owned enterprises and banking liquidity (large speculative investment) poor
management of banks (underestimating the role of banks in business management).
The Asian crisis has had a worldwide impact, because the slowdown in the Asian region
caused a major reduction in world demand for various commodities (oil, copper, agricultural
products). Russian and Brazilian crises were a reflection of the decline.
11.5.2 THE RUSSIAN CRISIS IN 1998
This crisis was the culmination of prolonged worsening economic conditions in Russia.
From 1995 to 1998 Russian loan grew on the international capital market (governmental and
non-governmental). Debt operator began to be a growing problem and dollar flows inflowing
into the economy immediately outflow. In the spring of 1998, the Russian export began
decline (so far showed a current account surplus), since this export was most commodityoriented
and that because of the decline in prices in global markets caused by the
aforementioned Asian crisis.
The Russian ruble fell until mid-August 1998 under the regime of managed floating and
to keep this regime the central bank intervened – usually by purchase of rubles while using
gold reserves. Consequently, the result of a decline in the value of Russian assets (due to
devaluation of the Chinese renminbi) CB announced in mid-August (on 17th
) the decline of
the ruble against the US dollar, which continued until the end of the year (see Figure 11-1).
Table 11-4 The development of the foreign exchange rates in the period of Asian crisis (1997)
Country
Exchange rate (to USD)
% change
July November
Indonesia (rupiah) 2400 3600 -33.3
South Korea (won) 900 1100 -18.2
Malaysia (Ringgit) 2,5 3.5 -28.6
Philippines (Peso) 27 34 -20.6
Thailand (Baht) 25 40 -37.5
China (Renminbi) 8.4 8.4 0.0
Hong Kong (Dollar) 7.72 7.73 0.0
Singapore (Dollar) 1.43 1.60 -10.6
Taiwan (Dollar) 27.8 32.7 -15.0
11 Global Capital Markets
- 128 Figure
11-1 The development of the Russian ruble in time of Russian Crisis (ruble/USD)
Source: Eiteman et al. (2001)
The Russian crisis had an impact not only at the international capital market, but also to
the Russian society that began increasingly ask question concerning the meaning of a market
economy (in the style of Western democracy), and also because the level of economic
environment and its stability is currently compared with states such as Sudan, Iraq, Congo or
Afghanistan.
11.5.3 THE BRAZILIAN CRISIS IN 1999
Between 1997 and 1998, the most of economists did not speak in the context of the
Brazilian real about whether devalued, but when and how much will be this devaluation.
Since 1994 (the devaluation of the Mexican peso and the beginning of the financial crisis), the
value of was artificially maintained in the hope of stabilizing expectations of economic and
financial growth. The inability of the government to reduce the ever-growing current account
deficit and domestic inflation resulted in currency devaluation in early 1999.
The decline in value of the Brazilian real (from the initial value of the exchange rate
1.207 to 2.2 in early March 1999) was reflected in a decline in the value of Brazilian
securities, as shown in Table 11-5. This decline negatively affected cash flow and possibilities
of net earnings of Brazilian companies, which resulted in a decline in their market value and
with that related problems.
Source: Eiteman et al. (2001)
11.5.4 THE ARGENTINE CRISIS IN 2002
Further and till this time also the last is the crisis on the Latin American continent
called as the Argentine crisis of 2002. The huge increase in private and public debt preceded
0
5
10
15
20
25
30
1.6.1998
1.7.1998
1.8.1998
1.9.1998
1.10.1998
1.11.1998
1.12.1998
1.1.1999
1.2.1999
1.3.1999
1.4.1999
1.5.1999
Day
Capital flows (in
bill USD)
Change in value of
securities
Monday 11.1. 0.19 -5.8 %
Tuesday 12.1. 1.20 -4.9 %
Wendesday13.1. 1.05 -4.4 %
Thursday 14.1. 1.00 -7.2 %
Friday15.1. 0.00 28.0 %
Table 11-5 Decline in the value of securities on the Brazilian market assets in January 1999
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 129 this
(from 8 to 43 billion US dollars) in the period of the military dictatorship in the years
1976-1983 in order to finance the war on Falkland Islands in 1982. This increase was the
main reason for the crisis. At the end of the eighties of last century, it seemed that the
situation is stable – debt was maintained at a relatively constant level and at the same time
extensive privatization of state enterprises was conducted, which attracted foreign capital74
.
However, once you have exhausted the proceeds from privatization, public debt began to rise
again and in 1998 reached 110 billion USD75
. At the end of 2000, a total debt amounted more
than 200 billion USD.
Except the aforementioned privatization, which was a part of the reforms, it was also
its part the establishment of an absolute fixed exchange rate so-called currency board, when
the Argentine peso was pegged to the US dollar at a ratio of 1:1. Due to the currency board,
inflation fell from 5 000 % in 1989 to 1.1 % deflation from 1999 until 2001. On the other
hand, this absolutely fixed exchange Argentine goods more expensive, with negative
consequences for domestic exporters and at the same time encourage the purchase of foreign
goods competed with the whole sector of the domestic economy.
While in 1996-1998 the economic growth in Argentina amounted to 4-8 % per year, in
1999, came the recession, mainly due to the Brazilian currency crisis and the appreciation of
the US dollar. This recession has been to mitigate the expansionary monetary policy, currency
board but it did not allow the devaluation of the peso and the government policy of a fixed
exchange rate would not give up. It had three reasons:
• The first was the fear that hyperinflation occurs again
• The second, Argentine businesses and households had their debts in dollars and
break away from the dollar would lead to bankruptcies
• The third, the Argentine government hoped that the US dollar would weaken, leading
to increased competitiveness of Argentina, which it did not.
In the Argentine economy, there was a gradual deterioration of public finances and
growth of foreign debt. Along with the growth of debt grew naturally (in December 2001
amounted to 155 billion USD) and logically interest grew as well (to 20 %), but Argentina
was unable to pay them. In 2001, Argentina had to put on the full repayment of interest of 9
% of GDP. In that year there has been a deepening recession (-4.4 %) and the IMF refused to
provide further loans (in December 2000 the government received 39,7 billion dollars in
August 2001 and a further 8 billion). It subsequently led to outstanding debts to private
creditors (national bankruptcy) and the beginning of 2002 to the devaluation of the peso
(January) and the introduction of floating (February). The peso has depreciated by 380 %,
recession continued, GDP fell by 11 % and there was a return of inflation to 26 %. In 2003, it
has managed to restore economic growth (8.3 %) and inflation fell to 13.4 %.
Argentine financial crisis had a negative impact not only on the economy but also the
standard of living:
• The income per capita dropped to about one-third the level of 1998
• The cost of living index rose during the first half of 2002 by 39.1 %
74
Banks, telephone companies, television stations, gas, water, electricity, roads, railways, ports, airports,
military industry, post office and metro were privatized – overwhelmingly in the hands of foreign owners. Also
because of this investment boom, Argentina's GDP grew rapidly – in 1991-94 by an average of almost 8 % per
year.
75
While the public debt in the years 1992-1998 doubled, the debt of the private sector increased tenfold (from
3,5 billion to 35 billion USD).
11 Global Capital Markets
- 130 •
The number of people living below the poverty line (2 USD per person/day)
increased from 38.3 % in October 2001 to 52.2 % in March 2002 (in the 70 years of
the 20th
century there were only a million out of 37 million inhabitants)
• From 1997 to July 2000, the unemployment rate has been increasing from 13.8 % to
15.4 % and in early 2002 it climbed to 21.5 %.
Brazilian and Argentine economic crisis weakened not only because of that were
affected the economy but also the entire region of Latin America and the Caribbean. On the
other hand, further developments have shown that those economies with the crisis and trying
to learn through stabilization programs and social changes capitalize on their growth potential
and to participate fully in the global economy.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 131 -
12 DEVELOPING COUNTRIES AND EXTERNAL
ECONOMIC RELATIONS
If we talk about trade policy in developing countries, we must first clarify the concept in
its historical context. Already at the time of colonialism, were the colonial economies,
respectively semi-colonies (e.g. China) or dependent countries (e.g. Argentina) termed
backwards countries, what means underdeveloped countries. Their features were economic
stagnation or slow economic growth and redistribution of wealth and income in these
countries to controlling economies. After they gained independence, representatives of these
countries refused to use such a designation that they associated with elements of racism and
therefore they began to be used the term less developed countries or underdeveloped
countries. Neither the first nor the second term was adopted and for this reason there was
adopted a term – one could say diplomatic – developing countries. This name is assumed and
is used in the literature on international negotiations.
12.1 THE CHARACTERISTIC OF THE DEVELOPING COUNTRIES
From the perspective of development, the developing country is most often
characterized as an economy with low (or very low) level of income per capita, a high
proportion of the labour force in agriculture and other primary sectors (mining and minerals),
short life expectancy, high illiteracy, high population growth and low growth in real income
per person. From the perspective of international trade, the difference between developed and
developing economies expressed by that the developing countries mainly exports food and
raw materials (OPEC countries, Botswana – diamonds), while the developed economies
export industrial goods.
Neither of the above characteristics applies in general. In the case of some oil barons
(see below) it cannot be talked about the low per capita income and its low growth, as well as
the latter division does not apply to so-called newly industrialized countries76
exporting
labour-intensive manufactured products and also for India.
The only reliable indicator of classification of developing and developed countries
remains the sectorial structure of the economy, respectively the share of employed people in
each sector. The larger the importance of the primary sector in the national economy and the
more people work in it, the less economically advanced countries. The share of each sector on
the GDP is shown in Table 16-1. For comparison, there are both developing and developed
economies. We can see that the share of both types of economies is different. While
developing countries does not show large differences in individual sectors, in developed
economies dominates service sector and the share of the primary sector is minimal. On the
contrary, in the proportion of employees in each sector, which in developing economies
dominated employment in the primary sector (e.g. in Egypt is 30.5 %, in Burundi even
92.6 %), but in developed economies, this ratio is significantly lower (e.g. UK 1.8 %, the
Czech Republic 6.5 %).
76
Thailand, Malaysia, Indonesia, China, Taiwan, South Korea, Hong Kong and Singapore.
12 Developing countries and external economic relations
- 132 A
I S
1995 2008 1995 2008 1995 2008
Developing countries 15 10 34 37 51 53
Developed countries 2 1 29 27 68 72
Source: WORLD DEVELOPMENT INDICATORS 2010.
Based on the above we can say that in the group of developing economies, there is
differentiation, which divides these economies to more advanced and less advanced.
Therefore, these economies are further divided77
into sub-groups:
• A group of major oil exporters ("oil barons") which play a significant role in the
world economy duet to their large revenues from oil exports
• A group of newly industrialized countries (NIC), i.e. countries with a high rate of
growth, which is approaching with its parameters economically advanced countries
• Developing countries not having access to the sea (ocean) called Landlocked
Developing Countries (LLDC), which includes 31 countries of Asia, America,
Africa and Europe
• Small Island Developing Countries (SIDC) include 38 states and 14 dependent
territories
• And a group of world's poorest countries, the Least Developed Countries (LDC78
)
and there about 49 countries
12.2 THE IMPORTANCE OF THE WORLD TRADE ON DEVELOPMENT OF
INDIVIDUAL ECONOMIES
The world trade is very important for economic growth of developing countries. The
share of foreign trade in GDP in 2006 amounted about 30 % and recorded growth compared
to 1996 by more than 10 percent, while in developed economies, it was only 17 % (in 1996
showed 20 % in the 60s of last century, the ratio developing countries/developed countries 15
and 9 %). By 2050 it is expected that the share of developing economies on world trade will
double and rise up to 70 % of global GDP. This development reflects the fact that developing
countries are in the development phase, which is characterized by building a diversified
economies and make efforts to remove the structural disproportions.
12.2.1 IMPORT AND EXPORT
As already said, for developing countries is paramount the acceleration the pace of
economic growth and the implementation of far-reaching structural changes, i.e. mobilization
of human and capital resources for industrialization. Although increasing the share of savings,
it does not mean the increase in investment. On the world market of capital goods, these
countries import share of 30 %, but exports only 5 %. This process is logical, since the initial
77
This is the classification of UNCTAD – the United Nation Conference on Trade and Development was found in 1964
for supporting of integration of the developing countries into the world economy
78
Some developing economies belong to several groups at once – in LDC, LLDC or SIDC.
Table 12-1 GDP composition in developing and developer economies in 1995 and 2008
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 133 phase
of industrialization is characterized by high intensity of capital (e.g. implementation of
infrastructure projects). Imports of machinery and introducing them into production is
associated with an additional import of raw materials, when the individual developing
countries are major producers of raw materials, but highly specialized, while domestic
consumption of raw materials is very diversified.
Another problem is the large-scale import of primary energy and that is oil. While
developing countries are in overall terms its exporters, it is due to a few countries. These
economies are not able to use alternative energy as an advanced economy, because of the
capital intensity and their consumption will not decline neither from the reason of still
growing energy needs of the rural population while dwindling supplies of coal and wood.
A significant disproportion is the slow development of agricultural production, which
leads to a deepening of structural imbalances and negative effects on the development of
some developing countries. Particularly perceptible is this development reflected in the food,
when the unchanged share of world production does not fully correspond with population
growth. Some countries such as Sub-Saharan Africa are even dependent on food supplies in
humanitarian aid. Developing economies in the post-war period has changed themselves in
the largest importers of cereals, when import of cereals increased from 50 years (15 million
tons) over 70 years (50 million tonnes), 80 years (100 million tons) to 150 million tons in the
90s of the last century.
A raw material export is concentrated on six items – oil, copper, iron ore, coffee,
cocoa beans and sugar. However, this kind of commodity trade is significantly cheaper
unstable and characterized by sharp fluctuations in prices as compared to manufacturing
products. In addition, the development of raw material production in the developing world is
dependent on sufficient capital, skilled labour and technology. For the development of raw
material exports on the other hand speaks the fact that developed economies tend to secure
long-term raw material resources which developing countries have a return for a guarantee of
long-term access to raw materials entering into mining projects multinational company
(including its financing).
Regarding the export of the manufacturing industry, this is mostly labour-intensive
products, although the slow move towards areas technically intensive can be recorded
(especially ANIZ). The dynamics of manufacturing exports would have been even higher but
there are protectionist measures in developed economies, which comprise more than 50 % of
exports of developing countries. Developed countries are worried about competition from
developing countries, which have certain advantages: longer working week, a smaller number
of holidays in a year, multi-shift operation, unpaid overtime, skilled and cheap labour, weak,
respectively, no labour unions, etc.
Dynamics of export and import of developing countries in international trade is
increasing, which is also due to the overall expansion of world trade. The positive trend was
interrupted in 2008, when impacts of the global economic crisis began to weigh on these
economies and it was deepened the drop in 2009. In 2010 is no longer based on the global
recovery expected to rebound.
12.2.2 EXPORT INSTABILITY AND ECONOMIC DEVELOPMENT
Developing countries shows export price instability, which reflects the price
fluctuations of their primary exports and which seriously bind their development. This
instability is caused by inelastic and unstable supply and demand. Inelasticity of demand
reflected by the fact that households in these economies expended a very small proportion of
their income on goods such as coffee, cocoa or sugar. So if they change the prices of these
commodities, households do not change their expenditure on these commodities equally,
12 Developing countries and external economic relations
- 134 which
results in price inelasticity. Demand for commodities is inelastic also due to the
absence (or small options) substitutes and the instability is due to fluctuations in economic
cycles. The offer is inelastic because of the rigidity and inflexibility of use of resources in
these economies and unstable due to weather conditions, epidemics, etc.
The above facts can be displayed graphically (see Figure 12-1). The curves S and D
represent export demand and supply of developing countries. If there is a shift in the demand
(D') or the supply S (S'), then the equilibrium price falls to a level P'. If there will be a shift in
both curves, the equilibrium will be reached in P''. It may also happen that the curves D and S
move back to its original level and the price rises again to P. Price inelasticity and instability
of S and D lead to price fluctuations.
Figure 12-1 Price export instability
To avoid this price instability, the developing economies began after the Second World
War to take certain measures, which were always specific to a particular economy. Such
measures may include business offices that bought the production of domestic producers for
stable prices in order to avoid their fluctuations. In favourable times they bought at a price
lower than the world prices, in order to form the financial stocks and at times worse then
bought up the production of these stocks at prices higher than the world. This type of defence
did not work too well and more frequently international commodity agreements began to
appear, which should guarantee an increase in export prices and earnings. There were three
basic types of these agreements:
• Buffer stocks, which were based on the principle that if the price of commodities
fell, this commodity imposed to the warehouse where it waited until prices rise –
e.g. Cocoa Agreement, natural rubber or tin
• A control of export which was regulation of the amount of exported commodities to
stabilize prices – e.g. an agreement on coffee or sugar
• And purchase contracts – long-term multilateral agreements that determine the
minimum price for which given import country purchase this commodity and
maximum prices for which the export economy will purchase given commodity –
e.g. agreements on grain.
Although the degree and rate of economic development depends primarily on the
internal conditions of developing countries, international trade contributes significantly to the
development process. We have already reported the view of some economists that the
classical theory of international trade based on comparative advantages is irrelevant for these
P
P*
P´
P´´
D
D´
Q
S S´
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 135 countries
and their development process – better than focusing on the production of primary
commodities – is development through the form of industrialization.
12.3 INDUSTRIALIZATION
Industrialization is a process in which there is rapid technological progress and the
growth of the industry (especially manufacturing). Industrialization supports the creation of
well-paying jobs to relieve the unemployment problem, stabilization of production processes,
leads to increasing values of terms of trade and stable export prices and to facilitate balance of
payments difficulties due to faster growth in demand for industrial goods in developing
economies.
If developing countries want to industrialize, they have the option to choose between
the form of industrialization through import substitution or export-oriented industrialization,
when each of them has its advantages and disadvantages.
12.3.1 INDUSTRIALIZATION THROUGH THE FORM OF IMPORT SUBSTITUTIONS
Industrialization through the form of import substitutions means that previously
imported industrial products are replaced by domestic production, mainly due to the
introduction of protectionist measures. Among the advantages of this form of substitution is
the existence of a market for industrial products, so the risk of introducing new types of
import substituting production are minimized and the development of the economy itself is
easier to protect their markets against foreign competition than the force developed economies
to reduce trade barriers on their export. On the other hand, there are disadvantages including:
• The risk of inefficiency, when the domestic industry is growing on the base of
protection against foreign competition and thus losing the initiative to be effective in
this context and in this situation this substitution of imports becomes costlier
• A minimization of economies of scale due to the small size of the domestic market
• And last but not least, this substitution occurs often in the case of less demanding
manufacturing industry, although the substitution of capital-intensive and high-tech
production would be desirable
In reality, the impact of import substitution had on the developing world rather negative
consequences, although during the 50th
to 70th
years of the last century, this policy was very
successful in large development countries of Latin American (Argentina, Brazil and Mexico),
but on the other hand, for smaller economies such as Ecuador, Honduras or the Dominican
Republic did not bring bigger success, mainly for the reasons given above. Also in Asia (e.g.
in Turkey and Pakistan) import substitution resulted in inefficient industries in these
economies and slowing exports.
12.3.2 EXPORT-ORIENTED INDUSTRIALIZATION
In the case of export-oriented industrialization these is a focus on foreign markets
through production, in which the economy has a comparative advantage. As well as import
substitution, the export-oriented industrialization has its advantages and disadvantages. The
benefits include:
• An overcoming the small scale of the domestic market and the ability to achieve
economies of scale
• Production of manufacturing goods for export is a stimulus for achieving efficiency,
because the output of this (domestic) industry is input of another (foreign) industry
12 Developing countries and external economic relations
- 136 •
And the expansion of export is not conditioned by the potential of the domestic
economy, as it is in case of import substitution.
However, there are two major drawbacks – firstly for developing countries is very
difficult to develop export industry resulting from better conditions already established and
efficient industries in developed countries, and second, there is a high level of effective
protection by the developed economies to less labour-intensive commodities in which
developing countries have a comparative advantage and thus penetrate their markets is very
difficult.
In practice, the implemented export-oriented policy is typical for the development of the
Asian newly industrialized countries after World War II and in recent years, especially for one
very expanding economy, which is China.
12.4 THE ISSUE OF DUAL ECONOMY
In developing economies, on the one hand, there are sectors that are very
underdeveloped, such as agriculture and on the other hand, relatively modern, capitalintensive
industrial sector. This phenomenon, when in one economy there are two sectors of
two different levels of development, we call economic dualism and economy in which this
phenomenon occurs we call dual economy. When the economy exhibits the following
characteristics, we talk about this phenomenon:
• The level of output per worker in the modern sector is higher than in the rest of the
economy
• A high level of output is accompanied by high wage rates (industrial workers can
earn, on average, ten times more than workers in agriculture)
• Although wages in the industrial sector are high, capital incomes are low
• A modern industrial sector is more capital intensive than the agricultural sector
(which is not true in developed economies, where agriculture shows signs of capitalintensive
sector), and for this reason, that agricultural work carried out using
primitive tools, while industry with its level approaching those used in industrial
countries.
Economic dualism is a sign of economic inefficiency since in the effective economy
workforce does not get very different wages in different sectors and it is also the cause of
using protectionist measures to protect the seemingly efficient industry. The substitution of
import helps to the creation of dual economies. This inefficiency can be represented
graphically by using the situation on the labour market (see Figure 12-2). Wages in the
industrial sector (WP) are high and there is only few people employed, while in agriculture
(WZ) the situation is reversed. The highlighted triangle indicates the inefficiency of the
economy. The efficiency could be achieved if it would be in both sectors employ as many
workers the corresponding point of conflict MPL curve in industry and agriculture.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 137 -
12.5 LIBERALISM VERSUS PROTECTIONISM
The developed countries have the largest share of international trade and trade mainly
among themselves. Terms of trade between developed countries are very open, and therefore
they require the release of trade borders and demand from developing countries. Developed
countries through the International Monetary Fund, World Bank and WTO often conditioned
financial aid for less developed and developing countries just through the opening markets
and liberalization of trade conditions.
Nevertheless, the main requirement of developing countries, is to protect their own
markets and populations, respectively determination of the playing field for trade, since the
developed countries often protect a certain part of their different market by barriers and
quotas that other developed countries does not matter because trading in more commodities
and types of products at once. Developing countries are often dependent on one type of crop
or raw materials, whose values determine the world's stock exchanges, which are very
sensitive to various external influences. Commodities prices on which are many developing
countries depend, very volatile or even declining.
Protectionism is one of the basic tools that the government can use to influence
economic policy. Their removal belongs to the fundamental tools of globalization and the
expansion of world trade. They along with the liberalization of business and economic
globalization companies become less dependent on the state, where business and government
therefore increasingly used last tools that remain in the economic field. In the area of trade are
mainly customs duties and import quotas, which the government can regulate the movement
of goods flowing both from the ground and into the ground. The traditional approach of most
governments always consisted in the imposition of the highest tariffs on imported goods to
encourage domestic production, or the set quota for a certain kind of goods that could be
imported into a country for a certain period. In addition, there are tariffs and quotas and nontariff
barriers to trade, such as various orders or regulations to protect consumers of products
to which the products from the developing countries cannot meet.
Figure 12-2 Economic Dualism
MPL, MPL,
wages wages
WZ
WP
Employed Employed
in industry in agriculture
12 Developing countries and external economic relations
- 138 -
12.5.1 WTO AND THE ROLE OF DEVELOPED COUNTRIES IN TRADE NEGOTIATIONS
In order to liberalization, acceleration and improvement of the exchange of goods, the
developed countries after the World War II established organizations which aimed to
gradually abolish the tariffs and quotas. The first such organization was the General
Agreement on Tariffs and Trade (GATT), which was in 1994 transformed into the WTO with
a stronger structure, as mentioned in chapter 10. WTO Agreements currently manage around
97 percent of world trade and through them grow the volume of world trade by average rate
of 6 % per year while the ongoing efforts of its progressive liberalization in other sectors.
Trade negotiations under the GATT and the WTO have in the past led by centres of the
world economy – by the United States, the European Union and Japan. Therefore, the
discussions focused on those areas that are a priority for developed countries and almost did
not take into account the needs of developing countries, although developing countries
account for two thirds of the WTO. Developing economies gradually try to change this. At
the fourth ministerial conference in Doha was adoption so-called the Doha Development
Agenda (DDA), which allows deepening the integration of developing economies into global
trade. DDA should address in particular:
• The agrarian reform, the so-called NAMA (non-agricultural trade liberalization
products)
• Liberalization of trade in services
• Certain elements of the Agreement on Trade-Related Aspects of Intellectual
Property Rights (TRIPS)
• The issue of trade and environment
• And trade facilitation (customs procedures), the multilateral trade rules (antidumping),
preferential agreements, subsidies and countervailing measures.
In 2001, within the Framework of DDA the Doha Development Agenda Global Trust
Fund was established. From this fund are through the form of technical assistance funded
various programs related to the trade of developing countries (the Czech Republic contributes
to this found since 20005 and in 2008 its voluntary contribution was 1.36 million of Czech
Crowns).
Another breakthrough was the Ministerial Conference in Cancun in 2003, where the
developing countries under the leadership of Brazil, India, China, South Africa and other
developed countries, called the G20 group, for the first time were able to unite and jointly
formulate an opinion. Its ultimate requirements in the area of agriculture encountered a tough
stance of developed countries and then these talks collapsed. At the Ministerial Conference in
Hong Kong in December 2005 it was already clear in advance that further negotiations on the
liberalization of world trade is not achievable, but at least it managed to adopt certain
procedures that allow continuing the negotiations of the Doha Development Agenda. During
the negotiations, the conference was being developed very strong pressure on other members
of the WTO to EU to agree to these substantial concessions on agriculture, the liberalization
of trade in non-agricultural products (NAMA) and services. However, negotiations collapsed
on the intransigence of both parties – the developed countries do not want to retreat to
developing countries in the release of its markets and on the other hand, developing countries
are resisting negotiations on the Singapore issues.
During 2006, should be submitted draft amendments to the negotiation of agreements,
but after negotiations six trading powers (EU, USA, Brazil, India, Japan and Australia) in July
2006 in Geneva has been no progress. The negotiations failed because of issues elimination of
subsidies in agriculture, distorting world trade and has not found a unified view on access to
the world market for agricultural as well as industrial products and agreement on further
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 139 liberalization
of world trade was postponed by half a year (new negotiation meeting was held
in 2007 in Potsdam, Germany). In July 2008, an extraordinary ministerial meeting of the
WTO was held in Geneva in order to save existing development Qatari round. Even those
negotiations failed, and the issue of the so-called special safeguard measures for developing
countries – their possible range of criteria, the amount of trigger mechanisms (in particular on
the base of contradictions between the USA and India and China). If negotiations are restored
quickly, it can lead to a complete collapse a threat to the multilateral trading system in the
entire world, even the WTO itself.
The most typical example of a commercial dispute between developing and developed
countries is thus a dispute on agricultural products. Developed countries (EU, USA,
Australia, Japan and New Zealand) expend annually on support of domestic farmers over 300
billion USD. Simultaneously, these developed countries have high tariffs and specific quotas
on food imports from developing countries, although they are usually cheaper than those
produced by farmers in developed countries. Subsidies to farmers and food companies in
developed countries in addition allow exporting their products into the developing countries at
dumped prices, which local producers cannot compete. This unequal relationship does not
allow to local farmers to sell not only the world but also in the domestic markets, resulting in
extrusion of local agricultural production, with serious consequences for the region. In the
context of world trade talks while developed countries are pushing for the liberalization of
markets in developing countries, which thus lose the opportunity to protect their agriculture
against subsidized by the dumped imports.
A similar situation also exists in other fields. This is especially the industry is labour
intensive industries, where developing countries have a comparative advantage and developed
countries often protect their producers by quotas. In the area of trade in textiles and fabrics is
also under an agreement concluded within the WTO only a gradual opening of Western
markets
12.5.2 OTHER ISSUES OF THE WORLD TRADE FROM THE PERSPECTIVE OF DEVELOPING
COUNTRIES
Since the 80s of the 20th
century many countries deregulated financial markets and most
of restrictions on capital movements were removed, which make a space for speculative
capital. Integration of financial markets, modern technology and the rapid transmission of
information currently allow very quickly responding to any impulses and they may therefore
cause a number of problems. The movement of capital is very flexible and also investors who
otherwise operate in the financial markets in the longer-term and are interested in more
stability, trade with it. That may cause a certain fragility and vulnerability of these markets.
Developed countries have a greater opportunity to influence the financial markets than
the governments of developing countries, which generally cannot prevent a decline in its
currency that would support its value on the stock market, because they do not have enough
money.
In trade with raw materials there is between the developed and developing parts of the
world a lot of tension. Many developing countries may not offer anything else than minerals
that are mined in their territory into the world trading exchange. The uncertain financial
markets determine prices. In addition, developed countries consume considerably more
minerals than developing countries because their industry is more developed and they often
can also handle the material better because they have more advanced technology. It is not the
exception that for example the developed country exports expensive products from iron ores
into the developing country in which these iron ores were bought. Customs regimes of
12 Developing countries and external economic relations
- 140 developed
countries this trend support, since the duty on imports of processed products is
higher than the import of raw materials (so-called tariff escalation).
Developing countries do not have enough money to support their own firms and
therefore they try to obtain foreign capital through foreign direct investment. It is therefore an
investment of multinational companies that build or buy a factory, begin to produce, employ
local people, pay taxes while goods exported from the country and sold. Investors can choose
from a variety of locations for their businesses and for this reason the local governments try to
offer them the best possible conditions and often retreat to the detriment of their own people.
These companies also have very often tax reliefs, so the result of levied taxes to the state
budge does not match the original expectations while exporting a large part of their profits
especially in the form of dividends abroad. Very often these companies are building assembly
plants, which may, in the case that labour seems too expensive, easily move throughout the
world elsewhere.
International financial institutions and other advocates of the free market came in the
eighties of the last century with the policy known as neoliberalism. According to this policy,
the economic development will be effectively ensured by the most the privacy of the owners
and the freest market. Within this concept, trade was liberalized, capital market was
deregulated and the most sectors of the economy were privatized especially in countries that
are still undergoing the process of decolonization, are exempted from dictatorships or socialist
tendencies. Institutions that in established democracies are able to regulate the free market
and the environment in developing countries, however, did not exist or did not work correctly.
The result was that in many countries, even privatize public services that traditionally ensured
the state and for which the Company has existed replacement, and that such privatization and
price increases have become inaccessible to many citizens. Often it was about health care,
access to electricity or drinking water, which, although poorly managed state, but often the
basic level of service to ensure all. After privatization, a price of services rose sharply or there
was a decrease in quality. In developing countries people frequently protest against the
proposed privatization of such public services.
It is obvious that each country or region would have in searching of a place in the world
economy to approach after careful analysis of their own possibilities and position and taking
into account to the local traditions and skills. Uniformed approach has in many cases proved
to be not too well chosen.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 141 -
13 DEVELOPMENT COUNTRIES AND A DEBT ISSUE
In the previous chapter, you were acquainted with the important role of capital inflows
into the less developed countries that are significant for their development, but currently
insufficient. This was the main reason of the creation of an international institution called the
World Bank, whose role has expanded over time also to help in investment patterns,
implementation of trade liberalization, privatization, macroeconomic stabilization, eradication
of corruption and debt management.
13.1 THE WORLD BANK AND ITS ROLE
The World Bank was founded in 1944 and its original official name was the
International Bank for Reconstruction and Development (IBRD). When it started to carry out
its activities in 1946, it had 38 members79
. Their number has increased significantly in the
fifties and sixties of last century, when many former colonies gained independence and
became its members. Nowadays this instuition has 188 member countries whose views and
interests are represented by Board of Governors and Board of Directors based in Washington.
World Bank raises money for development programs of global capital markets and through
contributions from richer member countries (in the case of IDA).
As part of its growth the World Bank has created new institutions that specialize in
different activities. Together, these organizations called the World Bank Group80
and it
consist of:
• IBRD – the International Bank for Reconstruction and Development, which
provides loans and technical assistance for development of middle-income countries
and creditworthy poorer countries. IBRD obtains most of the funds from the sale of
its own bonds in international capital markets.
• IDA – the International Development Association, which strongly supports the
missions of the World Bank, which is the reducing of poverty. Its assistance is
intended to poorest countries and IDA provides them the interest-free loans and
other services. Most funding comes from contributions from IDA richer member
states, including several developing countries.
• IFC – the International Finance Corporation, which promotes the growth of the
developing world by financing private sector investment, and provides technical
assistance and consulting services to governments and businesses. In cooperation
with private investors, IFC provides loans and direct investment in business projects
in developing countries.
• MIGA – the Multilateral Investment Guarantee Agency supporting foreign
investment in developing countries through guarantees, which guarantees to foreign
investors against losses caused by non-commercial risks. The MIGA also provides
technical assistance aimed at disseminating information on investment
opportunities.
79
The founding members included the former Czechoslovakia, but its membership was suspended in 1955 and it was
restored in the year 1990.
80
Nowadays, the term World Bank usually refers only IBRD and IDA, however in another interpretation, we will use
for the whole group only the generic name.
13 Development countries and a debt issue
- 142 •
And ICSID – the International Centre for Settlement of Investment Disputes,
which helps settle or arbitrate investment disputes between foreign investors and
host countries.
According to its purpose, the above-mentioned institutions (except ICSID) distribute
funds in various developing regions. Total expenditure of the World Bank in 2008 amounted
to 324 billion USD, of which IBRD and IDA consisted of both 44 % (143 billion USD), IFC
10 % (32 billion USD) and MIGA remaining 2 percent (7 billion USD).
13.1.1 LEGISLATIVE FRAMEWORK
The greatest decision-making powers in the World Bank have member countries as its
shareholders. Each member country nominates one governor and his deputy, who are
executors of this power and consists of the Board of Governors. Governors are usually
Ministers of Finance or Planning and they meet every fall at the Annual Meetings of the
World Bank. They make decisions on major strategic issues, they accept new members,
decide to suspend the membership, decide on changes in subscribed capital, determine the
allocation of the net income of the IBRD and approving the financial statements and budgets.
The executive body of the World Bank is Executive Directors, which make up the
Boards of Directors. This body represents President and 25 Executive Directors (since
2010). The Boards of Directors meets at least twice a week council to oversee the business of
Bank’s, approve significant strategic documents, the administrative budget, operational
policies, rules and procedures of the World Bank, but also individual operations, i.e. the
provision of technical assistance, grants, loans and guarantees.
Member countries are on the Board divided into 25 constituencies (each represented by
one executive director), that the while voting they stand out as one unit. Grouped into
constituencies takes place on a voluntary basis, make up the majority on the basis of
geographical proximity, common interests, or other factors that may advantage from this
connection. Currently, eight countries, including the five largest shareholders of bank have
they own constituency (China, France, Germany, Japan, Russia, Saudi Arabia, USA and the
United Kingdom), the other members joined in the remaining 17 constituencies81
. The voting
power of each constituency is derived from the voting rights of its members.
The president of the World Bank is traditionally a citizen of the state, which is the
largest shareholder, i.e. the United States of America. He is elected for a five-year period and
may be renewed. He chairs meetings of the Boards of Directors and is responsible for the
overall management of the World Bank Group82
.
13.1.2 THE ROLE OF THE WORLD BANK
The World Bank is not the bank in the true sense of the word. It is an institution that, as
the leading world source of development aid and annually provide to its member countries
that are members credits and loans. It focuses in particular to help the poorest countries in the
framework of the following programs:
• An investment in human development (health and education)
• A protection of the environment
• A support the development of private enterprise
81
The Czech Republic is a member of the Austrian (EU says Belgian title) constituency, along with Austria, Belgium,
Hungary, Luxembourg, Slovak Republic, Slovenia, Belarus, Kazakhstan and Turkey, which has one of the highest voting
shares (the higher is only the USA and Japan).
82
Nowadays it is Dr. Jim Yong Kim.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 143 •
A support for reforms leading to the creation of a stable macroeconomic
environment conducive to investment and long-term planning
• And social developments, full integration, form of government and institution
building as the main tool to reduce poverty.
The Bank also assists countries to develop and consolidate the basic elements required
to attract private investment and retention of them. Governments may reform their economic
systems and strengthen national banking due to loans and advisory activities of the World
Bank. They invest in human resources, infrastructure and environmental protection, thereby
increase the attractiveness and return on private investment. Guarantees of the World Bank
and guarantees against political risks along with capital investments lead to the fact that
investors reduce their risks to a minimum and they do not afraid to invest into developing
countries and countries in transition to a market economy.
The main objective of the World Bank is to reduce poverty by supporting sustainable
economic growth in countries that are its members83
. Overcoming these problems is in the
interest of all countries, because raising living standards and promoting development in
poorer countries expands markets, provides jobs and increases incomes of richer countries.
Conversely, increasing poverty in developing countries can have a negative impact on richer
countries, since their markets and investment opportunities are decreasing and it leads to
environmental degradation and migration of people looking for work. Successes in
developing countries are dependent on economic developments in the US, Europe and Japan.
As well as is important whether developing countries will be able to lead such a policy and
implement those structural reforms that will allow them to grow strong.
In 1999, the World Bank in cooperation with developing countries has introduced the
approach referred as the Comprehensive Development Framework (CDF). Within the CDF
is sought to ensure that individual countries feel their own involvement in the developing
plan, which would focus on the changes required in the long term perspective and that would
be supported by close cooperation between all economic entities. In connection with the
implementation of this framework, the World Bank has focused its attention on what it
regards as fundamental pillars of effective development, namely:
• A structure – an effective way of government and incorruptible, transparent
government, effective legal and judicial system, well organized and supervised
financial system, a network of social security and social management
• A physical security – water and sanitation, energy, roads, transport and
telecommunications, cultural background and environment
• And a specific strategy – for urban development, agriculture and the private sector.
Each country has besides their own priorities, such as macroeconomic and budgetary
issues, trade and regulation, labour market and employment conditions or the role of the
private sector. Comprehensive Development Framework is a process that is expected to
support more efficient development and contribute to the overall goal of reducing poverty.
83
The aim of the global fight against poverty is to give people the opportunity to better living standards for current and
future generations. In the process of poverty reduction in the developing world has achieved considerable success, such as
an increase in average life expectancy of 55 to 65 years, doubling the income per capita, and of less than half to threequarters
of the increase in the number of children attending school and infant mortality decreased by 50 %. The antithesis
of these achievements still exist problems. 3 of 4.7 billion people in 100 countries that are members of the World Bank
live on less than $ 2 a day and 1.3 billion on less than $ 1 a day. 40,000 people die every day from diseases that can be
prevented by the effective prevention, 130 million people have no opportunity to attend school and 1.3 billion people do
not have access to safe drinking water.
13 Development countries and a debt issue
- 144 Since
the deformation of the economic environment have resulted in increasing poverty,
the World Bank helps developing countries improve economic and social policies in order to
increase its efficiency and transparency, strengthen stability and enable the achievement of
steady economic growth. The World Bank provides finance, advisory services and technical
assistance to support reform efforts to reduce the budget deficit, reduce inflation,
liberalization of trade and investment, privatization of state enterprises to build reliable
financial system, the judicial system and guarantee property rights. These reforms will help to
attract foreign private capital to generate domestic savings and investment and allow
governments to provide effective social services.
However, reform measures may lead due to the closure of unproductive companies to
increase unemployment and the end of inefficient government subsidies and to higher prices,
and so in the short term may adversely affect the lives of poor people. For this reason the
World Bank often includes in its support of reforms also funding for social safety nets to
protect the poor and vulnerable population groups.
13.1.3 THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT
The International Bank for Reconstruction and Development (IBRD), on which
annually accrue about three-quarters of all loans that the World Bank provides, it obtains
almost all the money from international capital markets (only 5 % comes from fees of
Member States). The IBRD as one of the most conservative and conservatively managed
global institutions sells bonds rated AAA and other debt securities to pension funds, insurance
companies, corporations, other banks and individuals around the globe. The interest rate
charged by the IBRD to loan recipient complies with the conditions under which the bank
lends money alone.
The IBRD provides professional assistance to more than a hundred developing
economies, financial, technical and therefore it is one of the largest sources of aid in the
world. It provides loans in two ways. The first type is loans for 15-20 years (with 3 or 5-year
grace period) to richer developing economies that can afford to pay the interest. These loans
are granted to finance programs that reduce poverty, providing social services, support
environmental or economic growth. For example, in 2003 it was granted 11,2 billion USD to
99 projects in 37 economies. In 2007 it was 12,8 billion and in 2008 it was 13.5 billion USD.
The highest share has traditionally region of Latin America and the Caribbean. Liabilities of
eight largest borrowers – Argentina, Mexico, Brazil, Colombia, China, Indonesia, India and
Turkey – account for 62 % of the total amount corresponding to 102 billion USD.
The International Development Association (IDA) was established in 1960 to provide
loans to countries that are too poor to be able to borrow at normal commercial rates. The IDA
helps to the development and the fight against poverty as well as the IBRD, but it provides
interest-free loans, technical assistance and consulting services. The IDA’s loans contribute to
all loans of the World Bank about one quarter.
Recipients of the loan have to pay a fee to cover the administrative costs of loan, which
amounts less than 1 % of the sum borrowed. The loans have maturity between 35-40 years,
with the possibility of a ten-year deferment of the payment. Almost 40 countries contribute to
the IDA funds, which are complemented every three years. Among the donors are the only
developed countries such as France, Germany, Japan, United Kingdom and the United States,
but also Argentina, Botswana, Brazil, Hungary, South Korea, Russia and Turkey, which were
in the past among the recipients of loans.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 145 The
IDA is one of the largest sources of assistance in the world for 79 poorest countries
(39 of them are in Africa84
). The IDA also provides grants to countries at risk of debt. Almost
free-interest loans for 35-40 years with the possibility of a ten-year deferment of the payment
are used for investments in agriculture, health, education and safe water. Since its creation
IDA loans and grants amount on average 140 billion USD and the largest share goes to Africa
(especially the sub-Saharan) and South Asia. Like in the IBRD, the eight borrowers is tied to
the total amount of about 112 billion USD. Those borrowers are Bangladesh, Vietnam,
Ethiopia, Niger, India, Tanzania, Uganda and Côte d'Ivoire, who make up 58 % of the total
amount.
13.1.4 CLASSIFICATION OF ECONOMIES
Since each institution of the World Bank focuses its resources on different area,
especially in different region, it must classify their borrowers in order to properly allocate
these funds. This classification is based on indicators of economic maturity, i.e. GDP per
capita and the World Bank divides countries into five groups, as shown in Table 13-1. This
classification is renewed each year on 1 July and remains the same for the full fiscal year.
Income Group Number of countries GNP per capita
low-income 40 995 and less
lower-middle-income 56 996 – 3.945
upper-middle-income 48 3.946 – 12.195
high-income non OECD member 39 12.196 and more
high-income-OECD member 30 12.196 and more
Source: Worldbank (online)
Also in terms of debt the methodology of the World Bank distinguishes different levels
of debt. The following classification applies to those countries that announce detailed
statistics on debt within the Debt Reporting System (DRS):
• Heavily indebted economies are characterized by critical levels of two key variables
– the present value of debt service to GNP is 80 % and the present value of debt
service to export 220 %, it includes 37 low-income and 13 middle income countries
• Moderately indebted economies, their present value of debt service to GDP is 48 %
and the present value of debt service to export 132 %, it comprises 15 low and 26
middle-income economies
• And least indebted economies are economies whose debt service does not reach the
above-mentioned values (this also includes the Czech Republic), there are 14 low
and 33 middle-income countries.
13.2 THE ISSUE OF DEVELOPING COUNTRIES DEBT
On the basis of what was stated in the previous chapter, we can conclude that debt is a
major obstacle for economic development. What does this term mean? In the economic
84
For instance, due to the IDA African schoolchildren received more than 6 million books. About 6 billion USD come
from IDA to the social development projects, which are used for investments in agriculture, health, education and safe
water.
Table 13-1 Country classification according to economic maturity in 2010 (in USD)
13 Development countries and a debt issue
- 146 analysis,
we distinguish between the gross debt and debt service. Gross foreign debt is
defined as the total value of foreign liabilities of domestic economic entities to the contractual
maturity, which accounts for non-residents (creditors) the interest in the form of interest
(Tuleja, 2007). In addition, this indicator also pays attention to the debt service, what is the
total amount of funds, which domestic entities in a given year expended on instalments of
principals and payment of interest of their liabilities to non-residents (Tuleja, 2007). Since the
gross debt itself and debt service have limited explanatory power, the relative indicators (debt
indicators) are used for analysis of debt, namely:
• Debt to GDP ratio, which influences the decisions of foreign investors (limit value
40 %)
• Debt to export ratio, which shows how much money from exports is necessary to
cover debt
• A share of debt service to GDP (limit value 5 %)
• A share of debt service to exports (limit value 20 %).
The World Bank analyse for its own needs and for the allocation of aid in terms of debt
three indicators – the Debt to GDP ratio, debt ratio and the share of debt service to exports.
The international debt of developing economies is one of the biggest challenges of the
current global economy, and as mentioned above, it limits their further development. But this
is not a new phenomenon. The debt occurred prior to the creation of separate economies and
of the next chapter we will describe this development further.
13.2.1 HISTORICAL DEVELOPMENT OF INDEBTEDNESS OF DEVELOPING ECONOMIES
Before the First World War there were significant capital flows from Europe to
developing areas, mostly in the form of loans85
. In this period, when the London was a
financial centre and many economies borrowed by selling their bonds through banks in
London. Given that the terms of repayments were not exactly specified in contracts for loans,
there were delays and defaults (e.g. in 1891, Portugal officially announced the inability to
repay debt). The immediate effect of these delays was the sharp decline in the value of bonds.
This meant rapid losses for holders of these assets, which did not have too many opportunities
to intervene against this trend due to the fact that they were mostly individual and private.
Despite the above-mentioned problem of delays, in this period the international capital
flows into the country (nowadays known as development – hereinafter we will use the term
developing countries) increasing, which was caused by three major factors:
• Opportunities of foreign investment seemed to be very convenient – areas rich in
resources were relatively unused and there was expected a large return on capital
construction (factories, railways, etc.)
• Countries such as USA, Canada, Argentina and Australia, which absorbed most
loans from Europe, were sparsely populated areas and thus attracting many
experienced workforce and entrepreneurs. European lenders hoped that the results of
the Industrial Revolution will transfer to these areas and the repayment of loans will
be easier. European countries have also invested in tropical areas in the form of
direct investment (mines, plantations, etc.) that has generated higher returns than
bonds
• And last but not least, the British leadership in the world economy played a key role
in the development of international investment – England was a source of saving of
85
For instance the Great Britain invested abroad on average 5 % of its GNP in 1870 – 1914.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 147 the
rest of the world and it has being the market on which developing exporters
could earn the money needed to repay foreign debts, on the other hand, the British
loans to the developing countries allowed to these countries to import equipment
and other goods from the UK and for this reason the British government played an
active role in ensuring the rapid settlement delays, which did not lead to the collapse
of international finance and trade.
After the First World War, England lost the position as the leading financial centre. The
US became the leading financial centre. The Great Britain and France have become debtors of
the United States. Germany was burdened with large reparations. Because of that neither of
European lenders before 1914 already played this role86
. In the 20s of the last century, many
developing countries sell bonds in the US, which provided them foreign direct investment. In
the mid 20s the prices of agricultural products decreased. They were the main source of
export revenue for many of these economies and after 1928 loans abroad fell down when the
US savings began to focus on increasing the stock exchange in New York. In 1929, there was
a stock market crash and subsequent global depression caused a large drop in foreign
investment. In contrast to England in 1914, the US was not able to reverse the global financial
collapse and only a small part of the savings was lent abroad.
Developing countries have not been able to continue to borrow abroad. They had to
reduce its imports, which resulted in a decrease in aggregate supply of developed economies.
Their response was the introduction of barriers to imports (mainly high tariffs), which had a
negative impact on developing economies as exporters, who covered by export revenues
foreign debts. In 1931, Bolivia began as the first delay with payments and within three years
almost all countries in Latin America followed it. Many of them at that time left the gold
standard, adopted a regime of floating exchange rates and used expansionary policies to
mitigate the effects of depression. In this period there was a huge delay, all developing
countries (Germany accompanied by the rise of fascism) did not repay their debts due to the
depression and trade restrictions, which also meant the impossibility of a return to normal
foreign loans.
From 1945 until the 70s, the capital flows to developing countries had three forms:
official loans, short-term commercial credits guaranteed by foreign exporters87
and foreign
direct investment. International financial institutions and banks believed that using borrowed
capital the developing countries will build up their economies and it will result in increase in
export and consequently they will not be able to repay their debts. More and more borrowers
had problems to repay debt and therefore governments and international institutions
established the Paris Club in 1956. The objective of this club was to create a framework for
the transfers of debt to official creditors (such transfers occur in the case of deferred
payments, subject to commissions that have the character of interests from those deferred
interest payments).
The first oil shock caused the first wave of private commercial bank lending to
developing countries. It was caused by a sudden current account surplus of oil exporters (due
to the increase in oil prices), who lent to industrialized countries. It was financially
advantageous for banks in these economies to over-lend them to developing countries. On the
other hand, current account deficits of BoP in developed economies (deepening recession in
1974-1975) resulted in a huge increase in deficits of developing economies (those pursued an
expansionary policy to encourage investment and maintain the output at level relative to that
86
Therefore, some states did countermeasures (in order to avoid fluctuations in BoP) and for instance, the Great Britain
banned the domestic economic entities foreign loans.
87
They mostly had a nature of loans guaranteed by the creditor government as a way of indirect export subsidies
13 Development countries and a debt issue
- 148 in
the developed economies). Costs of these measures were large and persistent deficits were
arisen based on large loans abroad spilling into foreign debt. So developing countries' debt
rose from 130 billion USD in 1973 to 399 billion USD in 1978.
The second oil shock in 1979 resulted in a further increase in the current account
surpluses of oil exporters and worsening of deficits of other developing economies. At that
year, the US began to implement a restrictive monetary policy, which had a negative effect on
the debt, because the dollar interest rates and value of the dollar exchange rate rose up. This
increased the LIBOR88
, on which interest rate loans to developing countries were bound and
loans have become more expensive, interest payments for already provided loans also
increased and interest burden of the developing world and has seen a huge rise.
In 1982 debt of developing world was 750 billion USD. From this year also oil
exporters showed a deficit because they could no longer provide financial funds to finance
ever-larger deficits in other developing countries. The result was that less developed
borrowers caused the rising problems in loans from developed economies even before there
was a culmination of debt crisis in the second half of 1982.
13.2.2 INTERNATIONAL DEBT CRISIS
The international debt crisis began on 12 August 1982 when Mexico announced a
lack of central bank reserves and the inability to repay foreign debt. This debt amounted to 80
billion USD, and this was after Brazil the second largest world developed debtor. Mexico also
asked the IMF to restructure its debt. This situation was caused both by external shocks and
also poor internal macroeconomic policy. In 1970, public external debt of Mexico was 4.26
billion USD. At the end of a presidency of Lopez Portillo (in 1982), it was the sum of 58.87
billion. In 1982, just for interests on foreign debt Mexico had to pay 14 billion USD. At this
time, it found itself in the middle of Mexico's overall economic crisis. The outgoing president
had to accept the result of the devaluation of the peso by 500 % and rising inflation in the
country for the nationalization of all major banks.
Even the other borrowers in Latin America (Brazil with 88 billion USD debt and
Argentina with 40 billion of debt in 1982) were unable to repay their debts, nor borrow, and
because the economic conditions of countries in Latin America were similar, there was an
overall decline in loans and foreign capital of commercial banks. At the end of 1986, more
than forty countries in Latin America, Africa and Asia had huge external financial problems.
The most indebted economy suffered especially for large decrease in GDP per capita,
which in the period 1981-1984 showed a decline over ten percent. Since 1985 the trade
balance showed a surplus of these economies, but they were used to finance the interest
payments (which accounted up to 5 % of GDP), so current accounts again turned negative.
The above-mentioned results of the current account improvement were achieved by reduction
of domestic investment and by a decline in capital formation at half its previous share of
GDP. Net private capital flows into these economies have declined significantly and the most
striking feature of the debt strategy was that since 1982 the net inflow of capital was much
lower than the interest payments abroad.
Although it might seem that the situation five years after the outbreak of the crisis began
to improve, the opposite is true – neither of economy did recover its normal access to
international markets and economic problems still appeared.
In addition to the external causes of indebtedness (the development of world interest
rates, income from exports, foreign exchange rates and terms of trade), there are also a
number of errors committed by some governments of developing countries themselves, which
88
Its determination is developer on the interest rate of assets located in the USA.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 149 resulted
in the increase of debt. The economic unfavourable projects were financed by loans,
when these projects were often awarded on the basis of corruption and on which supply
companies from developed countries and often-undemocratic leadership of developing
countries earned. Most of the less developed countries were facing with their own political
problems, especially with the various dictatorships, when these regimes used the loans,
including those developing ones, strengthening their power, support for the army or for their
own consumption. At that time a major role played a bipolar division of the world, when
powers both financially and otherwise supported friendly regimes and they ingratiate them
with a mild credit policy.
13.2.3 THE CONSEQUENCES OF DEBT FOR DEVELOPING COUNTRIES
Large debt raises and enhances the economic, social and political problems of debtor
countries. In particular, the following issues:
• A pressure to export because of high repayment instalments are needed foreign
exchange, which can only be obtained by exports and therefore debtor country must
support it at the expense of the economy, focusing on local, domestic needs
• A elimination of social benefits when the expenditure on debt repayments are much
higher than spending on education and health, while mostly privatized public
services (water and electricity) and their accessibility for all residents so worsens
• A money from development aid in the repayment of debts, which must be
increasingly used to amortize a debt, such as sub-Saharan Africa expend more than
half of bilateral loans for debt service
• An unemployment, which is a result of cuts in public expenditures, thus it reduces
the number of workers in the public services, support small businesses and along
with the privatization of state-owned enterprises are driving up unemployment
• A deterring of investors when the country is unable to invest in infrastructure,
which, along with the impending tax increase (compensate for state spending on
debt servicing), rising interest rates and concerns about the use of foreign exchange
to service the old debt, discourages domestic and foreign private investors
• A loss of capital in form of leaving of investors because of a lack of confidence in
the economic stability of highly indebted countries
• A destruction of the environment, because the pressures on export force indebted
countries to increasingly exploiting its natural resources and the consequence is the
destruction of the environment such as tropical timber production forests or damage
to industrial mass production of export monoculture crops
• And rise in the poor groups of the population, when the largest social burden is
mostly on women, because they are in charge of maintenance and day to day
running of families in a declining real wages and the absence of social networks
must balance rising cost of living increased work effort.
13.2.4 DEBT AND STRUCTURAL REFORMS
For overcoming the debt of countries, international financial institutions adopted
Structural Adjustment Programmes (SAPs), which had through the reform of the national
economy, through stabilization and restructuring, bring the country to economic growth and
ability to repay debts. The weakness was failure to adapt to specific conditions and
differences in individual countries and regions. There was thus to cut public spending in order
to eliminate the budget deficit, which resulted in the above mentioned growth of social
inequality and the decline of education.
13 Development countries and a debt issue
- 150 This
strategy has not worked well because the preferred orientation on export of raw
materials, instead of the required support of domestic demand and industrial growth and
support of companies, it resulted in a reduction in their prices on world markets. Unrestricted
movement of capital has resulted in speculative movements, increasing uncertainty and
outflows of deposits (for example in the case of the Asian crisis in 1997 and Argentina in
2001) and this led to a rapid decline in the economy
On this basis, the program SAPs was stopped and international financial organizations
to adopt a new approach based on Poverty Reduction Strategy Papers (PRSPs), which
should become the basis for structural reforms in developing economies. The World Bank and
the International Monetary Fund does not prepare news, but the debtor governments that are
involved in their implementation as well as civil society. Unfortunately focus on raw material
export, liberalization of trade and financial markets and the privatization of public services is
still a priority. Since July 2002, the World Bank strategy based on assistance for developing
countries – Country assistance Strategies (CAS), which are states – active borrowers from
the IBRD and IDA. Their aim is to set up a selective program of support for the World Bank
Group to correspond to the development priorities and strategies of individual developing
countries and the World Bank's comparative advantages in the context of other developing
and donor activities. CAS is also designed to promote cooperation and coordination among
development partners and donors in each country.
13.2.5 ILLEGITIMATE DEBTS AND MORAL HAZARD
The issue of debt is also associated with the risk of illegitimate debt and moral hazard.
Illegitimate debt is considered a loan provided representatives of the dictatorial regime to
maintain its power (it is the debt of the leaders and not of the state), as well as debt, where at
the time of its adoption all the legal requirements given by the legislation were not fulfilled
and the loan granted against the interest of the people and to suppress their rights.
International financial institutions and developed countries this type of debt officially
does not recognize. The main reason is that such debt forgiveness to one country could trigger
massive requirements for forgiveness from other countries. If there were mass nonrepayments,
it can decrease the high rating of the World Bank (and IMF) on the global
financial markets. This would result in less access to low-cost private loans, which may
provide favourable conditions for the poorest countries. Nowadays, many African countries
would not survive longer than three months without special loans of the World Bank. The
inability to repay debts of countries that got rid of the debt would also limit and it would
significantly more expensive access to credit.
Another reason against debt forgiveness is a risk of moral hazard, since debt
forgiveness would essentially have been rewarded many poorly managing country and they
would not be motivated to further reforms. They would also have been "punished" by better
managing countries that tried to repay their debts properly. Therefore, the debt discharge of
international institutions are conditioned by reforms in the debtor countries. Experts point out
that the practice of large debt forgiveness has rather the opposite tendency (an example is a
debt forgiveness of post-war Germany in 1953).
13.2.6 CURRENT SITUATION AND THE HIPC INITIATIVE
The high degree of indebtedness is considered as a serious obstacle to the
implementation of key reforms in less developed countries. To protect the reform efforts from
the risks associated with high indebtedness and repayment of interest, the World Bank and the
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 151 International
Monetary Fund established in 1996 (with revisions in 1999) the Initiative for
help to heavily indebted poor countries (HIPC).
This initiative contains two commitments of official creditors89
that they will be jointly
organized way seek to reduce the debt of the poorest countries on the HIPC sustainable
levels90
. To be eligible for the application of HIPC assistance, countries must also be eligible
for IDA loans witch must be burden with unsustainable debt obligations and must
demonstrate a commitment to implement economic reforms. Debt forgiveness provided under
this initiative depends on a country's ability to repay its debt in the context of economic
development and poverty reduction.
The first phase represents the three-year period during which the HIPC countries
cooperating with the support of the World Bank and IMF to create the conditions for
economic reforms and policies to reduce poverty. Countries, which meet these conditions and
wish to sign up to this initiative, can achieve the so-called Pre-Decision Point. At the end of
this period it is determined whether the country's debt is sustainable. If so, the country will
receive the Completion Point and debts are relieved. For those countries whose debt burden
remains unsustainable, the package in the framework of the Decision Point is prepared for
them. In 2009, the Competition Point was reached by 30 economies, Decision Point by 6
economies and Pre-Decision Point by 4 countries.
What we can but imagine the concept of sustainable debt or debt sustainable? The
World Bank defines debt such as debt as the net present value (NPV) to export up to a
maximum of 150 %. If the country achieves the share of exports in GDP of at least 30 % and
government revenues to GDP at least 15 %, it can be a sustainable debt is defined as one
where NPV of debt to GDP is maximum 250 %.
13.2.7 THE TROUBLESHOOTING DEBT – DEBT MANAGEMENT
The most common tool to solve the outstanding debt is debt restructuring. It is
actually a change in the structure of the debt, consisting in the change of the maturity of the
loans, interest rate and interest payments. During the debt crisis maturity was to extend to
double (15-20 years) and there was a lower interest rates on previously provided loans.
Another way is to sell debtor obligations that take the form of bonds and the sale of reducing
or terminating the engagement of individual creditors and debt issues are of course sold with a
large discount. A similar tool is the conversion of debtor liabilities when indebted economy
themselves traded with these obligations by buying back maturing securities and they offer
them for goods or bonds with high interest rates91
.
As the solution of debt crises a number of plans has been proposed but that have been
largely unsuccessful and the comprehensive survey presented in the following chronology:
• 1985 – In this the Baker's plan was introduced when the US Ministry of Finance –
Baker proposed to ensure the solvency of the fifteen most affected countries by
providing new loans and this step should encouraged the growth, which would lead
to the redemption of debt, but which did not happen and new loans went directly to
the debt service
• 1988 – based on the Toronto’s conditions the creditor governments at the G7
meeting in Toronto for the first time provided the possibility of bilateral forgive the
89
This group includes the Paris Club bilateral creditors (Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Ireland, Italy, Japan, Netherlands, Norway, Russian Federation, Spain, Sweden, Switzerland, United Kingdom
and USA) multilateral creditors (international financial institutions like the World Bank and IMF) and commercial lenders
– about 1 000 commercial banks (London Club).
90
This is a public foreign debt with domestic debt and excluding all private debts of unguaranteed governments.
91
Such operations take place for example in Argentina, the Philippines, Equador or in Morocco.
13 Development countries and a debt issue
- 152 debts
of poor countries. As an upper limit of forgiveness was determined 33 % of
the total current debt service payments, which immediately proved insufficient.
• 1989 – in that time, it began the most successful plan, named after former Minister
of Finance – Brady plan, which should reduce bank debt of 39 most indebted
countries through debt forgiveness of private creditors and debt relief, news loans
and by converting the debt into shares in state-owned enterprises (so-called Brady
bonds). It was founded on the principle of medium-term reforms, debt reduction and
debt service lender, use of the international financial institutions to operations
associated with the debt issue and not least the continued support of creditor
governments through restructuring and new lending. Brady's plan led to temporary
relief for some large middle-income borrowers, but did not deal with the situation of
the poorest economies whose major creditors were governments and multilateral
organizations.
• 1991 – at the G7 summit in London were accepted London conditions, which
meant an increase in the upper limit of debt forgiveness for poor countries to 50 %.
• 1994 – at the G7 summit in Naples, it was decided to further increase quotas
forgiveness to 67 % and thus could be reduced not only current payments, but also
the total amount of debt – these was called the Naples terms
• 1995 – in this year, the G7 meeting in Halifax (Halifax Initiative) dealt with the
debt problem of highly indebted poor countries (HIPC) against multilateral creditors
and this initiative HIPCI was developed
• 1996 – Lyon conditions were adopted at the G7 summit in Lyon. Creditor
governments were call upon to support the HIPCI initiative and advanced further
than the Naples terms required. Based on these, Mozambique gained in 1998 as the
first country in the framework of the HIPCI initiative debt forgiveness of 80 %.
• 1999 – showed that the HIPCI initiative was insufficient since only six countries
have achieved in its framework the partial debt forgiveness and therefore at the G7
Summit in Cologne, Germany, hence the name of the Cologne Initiative, agreed to
extend this initiative (HIPC II) and reduction of the access barriers should allow
countries HIPC debt forgiveness of up to 90 %.
• 2002 – neither previous initiative did not achieve the expected results and from this
reason, at the G7 Summit in Kananaskis (Canada) was adopted a resolution on the
additional funding to remedy a lack of funds caused by inadequate calculations of
international financial institutions.
• Currently, in the World Bank and IMF there is a debate on the proposal to forgive
the debt to 100 % (instead of the original 90 %) of the poorest countries, which they
have in developed countries, the African Development Bank and the World Bank
None of the existing debt management practices brought any optimal and final solution
for over-indebted countries. This is due to the fact that debts, which have not ever been paid,
are mostly excused and assistance focuses mostly on the poorest countries and does not
include those who are not the poorest, but have a greater debit while all debts are not excused,
but only that much that the country can get in a sustainable situation, which still marks a debt
in the amount of 150 % of export revenues. However, it seems that despite everything, there
is an effective tool of debt forgiveness through the debt swaps.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 153 -
CONCLUSION
Dear students,
you have just read study material devoted to the issue of international trade. Given the
extent of this publication, only a theoretical overview of the basic issue of this part of
economics was given. In case you want to deeper study of international economics it is
necessary to study literature focuses on this area in more detail.
This publication is divided into thirteen chapters, which correspond to the thirteen
weeks of the semester, where each of these chapters is discussed in the lectures. This study
material was structured to first explain the evolution of views on international economics,
respectively on the area of international trade and subsequently advance into more detailed
theoretical parts.
I hope that the text above interested you and clarified many issues and helped in the
study of issues of international economics. If you have any comments, please feel free to
contact me at majerova@opf.slu.cz.
Karviná, June 2014
Author
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 154 THE
LIST OF LITERATURE
1. Adamcová, L. and S. Sýkovorá, 2002. Rozvojová ekonomika: vybrané problémy II.
Praha: VŠE. ISBN 80-245-0462-6.
2. Balassa, B., 1961. The Theory of Economic Integration. Homewood: Richard D.
Irwing, Inc..
3. Baldwin, R.E., 1971. Determinants of the Commodity Structure of U. S. Trade.
American Economic Review. Vol. 61, No. 1, 1971, pp. 126-145. ISSN 00028282.
4. Bhagwati, J., 1958. Immiserizing Growth: A Geometrival Note. The Review of
Economic Studies. 1958, Vol. 3 No. 25, pp. 201-205, ISSN 00346527.
5. Blaug, M., 1996. Economic Theory in Retrospective. 5th Ed. Cambridge: Cambrige
University Press. ISBN 0 521 57701 2.
6. Bohman, H. and D., Nilson. Introducing income distribution to the Linder hypothesis
[online]. Available from: http://www.etsg.org/ETSG2006/papers/DNilsson.pdf
7. Cihelková et al., 2002. Světová ekonomika: regiony a integrace. Praha: Grada
Publishing. ISBN 80-247-0193-6.
8. Cihelková et al., 2005. Světová ekonomika – základní rysy a tendence vývoje. Praha:
VŠE. ISBN 80-245-0687-4.
9. Cihelková et al., 2008. Mezinárodní ekonomie II. Praha: C. H. Beck. ISBN 978-80-
7400-054-6.
10. Cihelková, E. 2003. Vnější ekonomické vztahy Evropské unie. Praha: C. H. Beck. ISBN
80-7179-804-5 .
11. Cole, H.L., Ohanian, L.E. and R. Leung. The International Great Depression:
Deflation, Productivity and the Stock Market [online]. Available from:
http://www.imf.org/external/np/seminars/eng/2009/macro/pdf/hclorl.pdf
12. Dunn, Jr.R. and J. Ingram, 1996. International Economics. New York: John Wiley &
Sons, Inc. ISBN 0-471-11669-6.
13. Eiteman, D.K., Moffett, M.H and A.I. Stonehill, 2001. Multinational Bussines Finance
9th edition. New York: Addison-Wesley. ISBN 0-201-63538-0.
14. FLO. Annual Report 2009-10 [online]. Available from:
http://www.fairtrade.net/fileadmin/user_upload/content/2009/resources/FLO_Annual-
Report-2009_komplett_double_web.pdf
15. Frait, J., 1998. Mezinárodní peněžní teorie. Ostrava: VŠB-TU, 1998. ISBN: 80-7078-
395-8.
16. Grubel, H. and P.J. Lloyd, 1975. Intra-Industry Trade: The Theory and Measurement
of International Trade in Differentiated Products. New York: John Wiley&Sons.
17. Holman, R., 1991. Dějiny teorií mezinárodního obchodu. Praha: VŠE. ISBN 80-7079-
505-0.
18. Holub, A., Foltýn, J. and N. ORDNUNG, 1993. Rozvojová ekonomika. Praha: VŠE.
ISBN 80-7079-423-2.
19. Jensen, P. Thomas Mun [online]. Available from:
www.maths.tcd.ie/local/JUNK/econrev/ser/html/tommy.html
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 155 -
20. Jung, Z. and M. PRUŠA, 2001. Výsledky Uruguayského kola a jejich význam pro
Českou republiku. Praha: Ústav mezinárodních vztahů Praha. ISBN 80-85864-08-8.
21. Kindelberger, Ch.P. , 1978. Světová ekonomika. Brno: Academia. ISBN 509-21-857.
22. Krugman, P.R. and M. Obsfeld, 2003. International Economics: Theory and Policy.
6th Ed. New York: Addison-Wesley, 2003. ISBN 0-321-11639-9.
23. Kubišta, V., 1999. Mezinárodní ekonomické vztahy. Praha: HZ Editio. ISBN 8086009-
29-7.
24. Kubišta, V., 2003. Mezinárodní měnové vztahy. Praha: VŠE. ISBN 80-245-01616-5.
25. Lebiedzik, M., Majerová, I. and P. Nezval., 2007. Světová ekonomika. Brno: Computer
Press, 2007. ISBN 978-80-5-251-1498-9-8.
26. Leontief, W., 1953. Domestic Production and Foreign Trade: The American Capital
Position Re-Examined. Proceedings of the American Philosophical Society, Vol. 97,
No. 4., 1953, pp. 332-349.
27. Majerová, I., 2008. Cooperation of Developed Economies and International
Organizations with Developing Economies. Acta Academia Karviniensia 2008.
Karviná: SU OPF, 2008. s. 111-121. ISSN 1212-415X.
28. Majerová, I., 2007. Mezinárodní integrační procesy. Karviná: OPF. ISBN 978-80-
7248-420-1.
29. Majerová, I., 2008. Rozvojové ekonomiky. Karviná: SU OPF. ISBN 978-80-7248-459-
1.
30. Majerová, I., 2005. Vícefaktorový model v čisté teorii mezinárodního obchodu. Acta
Academia Karviniensia 2005, Karviná: SU OPF, 2005. s. 134-140. ISSN 1212-415X.
31. Maneschi, A., 1998. Comparative Advantage in Internationale Trade. A Historical
Perspective. Cheltenham: Edwar Eldgar Publishing, Ltd. ISBN 1 85898 300 2.
32. Marx, K., 1987. Kapitál I. Teorie o nadhodnotě. Bratislava: Nakladatelství Pravda.
ISBN 075-028-87.
33. Montiel, P. and L. SERVÉN, 2006. Macroeconomic Stability in Developing Countries:
How Much Is Enough? The World Bank Research Observer, Vol 21, No. 2, 2006,
ISSN 0257-3032.
34. Mundell, R.A., 1961. A Theory of Optimum Currency Areas. The American Economic
Review, American Economic Association 51, Nov. 1961, pp. 657-665. ISSN 0002-
8282.
35. Neumann, P., Žamberský, P. and M. JIRÁNKOVÁ, 2010. Mezinárodní ekonomie.
Praha: Grada Publishing. ISBN 978-80-247-3276-3.
36. Oatley, T., 2010. International Political Economy: Interests and Institutions in the
Global Economy, 4th Ed. New York: Longman. ISBN 978-0205723775.
37. Posner, M.V., 1961. International Trade and Technical Change. Oxford Economic
Paper. 1961, vol. 13, No. 3, pp. 323-341. ISSN 0030-7653.
38. Prebisch, R., 2006. Power, Principle and Ethics of Development. 1st ed. Buenos Aires:
IDB-INTAL. ISBN 950-738-226-7.
39. Pryor, F., 2007. Immiserizing Growth as Seen by Bhagwati, Samuelson, and Others.
Journal of Economic Education, Vol. 28, No. 2, pp. 208-214. ISSN 0022-0485.
Ingrid Majerová; INTERNATIONAL ECONOMICS
- 156 -
40. Salvatore, D., 1987. International Economics. 2nd Ed. New York:
MacmillanPublishing Company. ISBN 0-02-405360-0.
41. Shafaeddin, M. What did Frederick List actually say? Some Clarifications on the Infant
Industry Argument [online]. Available from:
http://www.unctad.org/en/docs/dp_149.en.pdf
42. Schiller, B.R., 2004. Mikroekonomie dnes. Brno: Computer Press. ISBN 80-251-0109-
6.
43. Soukup, A., 2009Mezinárodní ekonomie. Plzeň: Aleš Čeněk. ISBN 978-80-7380-197-
7.
44. Suranovic, S., 2011. International Trade: Theory and Policy. ISBN 978-1-936126-44-
6.
45. Šťastný, D. Protekcionismus: „Ptolemaiovský“ systém populární ekonomie [online].
Available from:
http://nb.vse.cz/~svobodam/Archiv_textu/Mezinarodni_obchod/Stastny_Protekcionism
us.pd
46. Truman, E. D. The International Monetary System and Global Imbalances [online].
Available from: http://www.iie.com/publications/papers/truman0110.pdf
47. Tuleja, P., 2007. Analýza pro ekonomy. Brno: Computer Press. ISBN 978-80-251-
1801-6.
48. Tuleja, P., Majerová, I. and P. NEZVAL, 2006. Základy makroekonomie. Brno:
Computer Press. ISBN 80-251-0952-6.
49. Tuleja, P., Majerová, I. and P. NEZVAL, 2005. Základy mikroekonomie. Brno:
Computer Press. ISBN 80-251-0603-9.
50. UNCTAD. Trade and Development Report 2004 [online]. Available from:
http://www.unctad.org/en/docs/tdr2004_en.pdf
51. Williamson, G.J., 1995. The Evolution of Global Labor Markets since 1830:
Backround Evidence and Hypotesis. Explorations in Economic History. Vol. 32, Issue
25, pp. 141-196. ISSN 0014-4983.
52. World Bank, 2010. GLOBAL DEVELOPMENT FINANCE. External Debt of
Developing Countries. Washington: The World Bank. ISBN 978-0-8213-829-5.
53. Worldbank. WORLD DEVELOPMENT INDICATORS 2010 [online]. Available from:
http://data.worldbank.org/data-catalog/world-development-indicators/wdi-2010
Ingrid Majerová; Název: International Economics
- 157 Název:
International Economics
Autor: Ing. Ingrid Majerová, Dr.
Vydavatel: Slezská univerzita v Opavě
Obchodně podnikatelská fakulta v Karviné
Určeno: studentům SU OPF Karviná
Počet stran: 157
Vydání: on-line
ISBN: 978-80-7510-074-0
Tato publikace neprošla jazykovou úpravou.