International Trade: Economic Analysis
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In 3–4 pages, analyze the concept of exchange rate and explain the purchasing power parity theory of exchange rates. Explain why a quota is more detrimental to an economy than a tariff.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
International Trade: Economic Analysis 5 In 3–4 pages, analyze the concept of exchange rate and explain the purchasing power parity theory of exchange rates. Explain why a quota is more detrimental to an economy than a tariff. By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria: Requirements This assessment has two parts. Be sure to complete both parts before submitting. Part 1 • Analyze the concept of exchange rate. • Explain how the dollar price of euros is determined. • Identify a factor that can increase the dollar price of euros. • Identify a factor that can decrease the dollar price of euros. • Explain why a rise in the dollar price of euros means a fall in the euro price of dollars. • Explain the purchasing power parity theory of exchange rates, using the euro-dollar exchange rate as an example. Part 2 • Explain why a quota is more detrimental to an economy than a tariff that results in the same level of imports as the quota. • What is the net outcome of either tariffs or quota for the world economy? Organize your assessment logically with appropriate headings and subheadings. Support your work with at least 3 scholarly or professional resources and follow APA guidelines for your citations and references. Be sure you include a title page and reference page. Additional Requirements • • • • • Include a title page and reference page. Number of pages: 3–4, not including title page and reference page. Number of resources: At least 3. APA format for citations and references. Font and spacing: Times New Roman, 12 point; double-spaced. • Must have an introduction and conclusion International Trade: Economic Analysis 5 Scoring Guide Criteria Analyze the concept of exchange rate.International Trade: Economic Analys
Explain the purchasing power parity theory of exchange rates. Proficient Distinguished Analyzes the concept of exchange rate. Analyzes the concept of exchange rate; explains how rates are determined, the factors that affect rates, and the relationship between different monetary systems. Explains the purchasing power parity theory of exchange rates. Analyzes the purchasing power parity theory of exchange rates. Explains why a quota is more Explain why a quota is more Explains why a quota is more detrimental to an detrimental to an economy than a detrimental to an economy than a economy than a tariff tariff. tariff. using real world examples. Correctly format citations and references using current APA style. Correctly formats citations and references using current APA style with few errors. Writes content clearly and Write content clearly and logically logically with correct use of with correct use of grammar, grammar, punctuation, and punctuation, and mechanics. mechanics. Correctly formats citations and references using current APA style with no errors. Writes clearly and logically with correct use of spelling, grammar, punctuation, and mechanics; uses relevant evidence to support a central idea.International Trade: Economic Analys
Running head: INTERNATIONAL TRADE International Trade Shweta Kanwar Capella University Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. 1 INTERNATIONAL TRADE 2 International Trade Economies, markets, industries, and policy makers all over the world are highly integrated through trade, communication, and transportation. Trade has especially contributed to countries increasingly depending on each other. Global trade has increased immensely; of this, the trade of manufactured goods increased a hundredfold in value from $95 billion to $12 trillion in the 50 years since 1955 (“Definition of globalization,” n.d.). The increase in international trade has made it crucial to understand exchange rates, purchasing power parity, and trade restrictions. What Are Exchange Rates? The exchange rate is the value of one currency in terms of another currency (“Exchange Rate,” n.d.). The exchange rate is a vital factor for international trade as a trader must first exchange domestic currency for foreign currency. For example, a supplier in the United States requires payment in U.S. dollars. Therefore, it is crucial that countries understand and analyze exchange rates. How Are Exchange Rates Determined? Over time, the world has seen three major international monetary systems. For approximately 50 years before World War I, the gold standard, a fixed exchange rate system, was used by a majority of the world. Under the gold standard, governments exchanged gold for currency at pre-announced rates. From the late 1940s to the early 1970s, the Bretton Woods monetary system came into force. The U.S. dollar was pegged to gold and used as reserve currency. It was a modified fixed rate system as governments could alter exchange rates if needed (Lin, Fardoust, & Rosenblatt, 2012). After the collapse of the Bretton Woods system in 1972, the major economies of the world adopted a flexible exchange rate regime. Under this Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
INTERNATIONAL TRADE 3 regime, the value of one currency in terms of another currency is determined by the foreign exchange (forex) market based on the demand for and the supply of the currency in relation to the other currency. Therefore, the exchange rate in a flexible exchange rate regime is subject to fluctuations. Smaller economies either fixed their currencies against major currencies like the U.S. dollar or allowed their currency to float with some government interference to manage exchange rates (McEachern, 2015).International Trade: Economic Analysis
The increase in the value of a currency in terms of another currency is called revaluation under the fixed exchange rate system and appreciation under the flexible exchange rate system. A decrease in the value of a currency in terms of another currency is called devaluation under the fixed exchange rate system and depreciation under the flexible exchange rate system. In the forex market, the exchange rate is determined at the point where the demand for and supply of foreign exchange are equal. The graph given above shows the changes in the EUR/USD exchange rate because of the changes in the demand for and the supply of euros in the Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. INTERNATIONAL TRADE 4 forex market. Suppose the EUR/USD exchange rate is 1.5 and there is an increase in the demand for euros but no change in the supply of euros. This could shift the demand curve for euros from D to D’ and increase the exchange rate from 1.5 to 1.7. At the initial exchange rate, $1.5 could buy €1. Now, however, $1.7 is required to buy €1. The exchange rate can be presented as either the amount of domestic currency required to purchase a unit of foreign currency or the amount of foreign currency required to purchase a unit of domestic currency. In other words, earlier, €0.66 could buy $1, but after a change in supplydemand equilibrium, €0.58 is required to buy $1. It can be seen that, when the dollar price of euros increases, the euro price of dollars falls. In this scenario, the dollar depreciates and the euro appreciates. Similarly, an increase in the supply of euros could cause the supply curve to shift from S to S’ and the exchange rate to fall from 1.5 to 1.1. In this case, the dollar appreciates and the euro depreciates.International Trade: Economic Analysis
The United States has a flexible exchange rate regime. The European Union, on the other hand, has a single currency within the Union but follows a flexible exchange rate externally. Therefore, the EUR/USD exchange rate is determined according to demand–supply movement and shows how many euros can be exchanged for one dollar. As a flexible exchange rate regime is adopted in both the regions, there are several factors that can cause the exchange rate to fluctuate. Interest rates are an important factor that can lead to changes in exchange rates. When a country offers higher interest rates, it attracts more foreign capital as lenders can earn higher returns than they could in other countries. This causes the exchange rate to rise. The inverse holds true when the country offers lower interest rates. However, in 2009, when the European Central Bank (ECB) increased its interest rate to 1.5%, the dollar price of euros fell from Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.International Trade: Economic Analys
INTERNATIONAL TRADE 5 $1.3946 to $1.2545 because investors thought the move was untimely and did not welcome it. On realizing the failure of its strategy, the ECB lowered its prime rate. Consequently, the euro rose by 20% from March 2009 to December 2009. By the end of the year, the euro’s value increased to $1.4332 (Amadeo, 2016). Apart from interest rates, there are many other factors that cause exchange rates to fluctuate. Some of the factors are discussed below: • Difference in inflation: A high level of inflation in a country indicates that the purchasing power of the country’s currency is lower than that of its trading partners. This causes the demand for currency to decline. Therefore, the currency depreciates. On the other hand, the currency of a country with low inflation levels tends to appreciate.International Trade: Economic Analysis
• Current account deficits: A deficit in the current account indicates that a country is spending more on its imports than it is earning from its exports. The country demands more foreign exchange than it is receiving, and as a consequence, the country’s exchange rate depreciates. • Government debt: The government often borrows to stimulate development projects in the country. Countries with high public debt tend to have high inflation. Investors tend to lose confidence in the currencies of such countries. Consequently, the currencies depreciate. • Terms of trade: Favorable terms of trade for a country indicate increased demand for its exports and, therefore, its currency. This causes the currency to appreciate. However, unfavorable terms of trade cause a country’s currency to depreciate. • Political stability and economic performance: A country with a stable political environment and healthy economic performance attracts more foreign capital. The currencies of such countries tend to appreciate. On the other hand, the currencies of countries with political and economic turmoil tend to depreciate. Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [N1]: Analyzes the concept of exchange rate; explains how rates are determined, the factors that affect rates, and the relationship between different monetary systems
INTERNATIONAL TRADE •6 Monetary policy: Expansionary monetary policy increases the supply of a country’s currency and causes the currency to depreciate. Inversely, contractionary monetary policy reduces the supply of a country’s currency and causes the currency to appreciate (Bergen, 2016).International Trade: Economic Analysis
Exchange rates determined by the forces of demand and supply are nominal exchange rates and do not account for inflation or indicate the purchasing power of a currency. To measure the value of a country’s goods against those of the rest of the world at the prevailing nominal exchange rate, the real exchange rate between currencies must be determined. The real exchange rate is the ratio of foreign to domestic prices measured in the same currency. The real exchange rate = ePf/P, where Pf is the foreign price, P is the domestic price, and e is the nominal exchange rate. If the real exchange rate is equal to one, currencies are at purchasing power parity (PPP). A real exchange rate that is higher than one indicates that prices abroad are higher. Purchasing Power Parity The purchasing-power-parity theory of exchange rates compares the purchasing powers of different countries’ currencies on the basis of a basket of goods and services. According to this theory, two currencies are in equilibrium if a basket of goods has the same price in two countries. A change in the exchange rate of currencies is determined by the change in the relative price level of the respective countries. Absolute PPP depends on the law of one price, which states that the price of a good will be the same in every country when quoted in the same currency. If PPP holds, then a good, say, a Big Mac burger, will cost $1.5 in the United States and €1 in Austria if the EUR/USD exchange rate is 1.5. If the Big Mac costs €1.3 in Austria, then the euro is overvalued and the burger costs more in Austria. In reality, the prices of a given good may not be equal in different locations at a given time. Prices may deviate because of transportation costs, information costs, or other barriers to trade like tariffs and quotas. Thus, Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [N2]: Good points. Please provide support for you analysis. INTERNATIONAL TRADE 7 locational differences in prices can occur (McEachern, A. W., 2015). To overcome this, the relative purchasing power parity is considered. This takes into account changes in relative price levels in both locations.International Trade: Economic Analysis
Here, e = βP/Pf, where β represents trade obstacles. Although trade barriers tend to lower international trade and affect exchange rates, the impact of an individual trade barrier may differ from that of another. For example, the impact of a tariff is different from the impact of a quota on international trade Impact of Tariffs and Quotas on International Trade Both tariffs and quotas are used to control the amount of imports in a country. A tax imposed upon imported goods and services to protect domestic industries from foreign competition and to generate revenue for the government is called a tariff. An upper limit set on the quantity of imports that can enter a country is called a quota. The graph given above can be used to analyze the economic effects of tariffs and quotas on the domestic economy of a country and the world economy. Without international trade, the domestic price and quantity of a good, X, are PD and OC units, respectively. Suppose the Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [N3]: Analyzes the purchasing power parity theory of exchange rates. INTERNATIONAL TRADE 8 domestic economy opens to international trade. Now, the domestic price will be same as the world price of X, which is PW. At PW, the quantity supplied of the good is OA units and the quantity demanded of the good is OE units. The gap between the domestic supply and domestic demand at PW is (OE – OA) units, which is the total amount of imports. The other countries that the country imports from can be considered as the rest of the world.International Trade: Economic Analysis
The country imposes a tariff, T, on imports. The domestic price inclusive of the tariff is PT. At PT, the quantity supplied of the good increases from OA units to OB units and the quantity demanded of the good decreases from OE units to OD units. This is because the price of the good increases by an amount equivalent to the tariff for both consumers and suppliers. The quantity of the good imported is (OD – OB) units, which is less than (OE – OA) units. The rectangle, mnst, indicates the revenue generated by the tariff. Under the tariff, consumer welfare decreases as consumers now pay PT − PW more for each unit of good X. On the other hand, producer welfare increases as producers receive higher price per unit. The welfare of the exporters declines as the amount received from higher prices accrues to the domestic government. However, the net outcome of the tariff on the importing country and the rest of the world depends on whether the magnitude of the terms of trade effect is greater or smaller than the size of the distortions created by the tariff. If the terms of trade effect is greater than the size of the distortions created by the tariff for both the importing country and the rest of the world, the total welfare of the importing country increases and that of the exporting country decreases. However, if the size of the distortions is greater than the size of the terms of trade, total welfare decreases for the importer as well as the exporters. Suppose, instead of imposing the tariff, the country imposes a quota of BD units to result in the same level of imports. The effect of the quota on the price is equivalent to that of the tariff. Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. INTERNATIONAL TRADE 9 Therefore, the price increases to PT. As a result of the quota, the supply curve shifts from SS to SS + Q. The quantity supplied under the quota, which is OD units, includes both domestic supply (OB units) and the fixed amount of imports (BD units). The economic effects and the net outcome of the quota on the world economy are similar to those of the tariff. The price of the good increases as imports are curtailed from (OE – OA) units to (OD – OB) units. The quantity demanded of the good decreases from OE units to OD units, and the quantity supplied of the good increases from OA units to OB units. However, in the case of the quota, the increased price does not generate any revenue for the domestic government. This is because the quota generates additional revenue for the foreign exporters (McConnell, Brue, & Flynn, 2015).International Trade: Economic Analysis
For example, in 2011, the US government earned $28.6 billion as tariff revenue, which they would have lost under quota restrictions unless they had charged a license fee from importers (Riley, 2013). Tariffs are better for a country as the revenue generated through tariffs can be used by the government to undertake developmental activities in the country. Another drawback of quotas is that they strictly restrict the imports of a country. That is, once the quota limit for a good is reached, the good cannot be imported further. In this way, quotas can lead to the shortage of a good in a country. However, a tariff does not prohibit the quantity imported of a good, allowing imports to increase and the government to earn higher revenue. For example, the U.S. government imposed a quota on textiles from China in 2005. This was done to protect beleaguered American textile producers. However, some administrators did not welcome this move and asserted that the quota would only create a shortage in the American market and increase prices. Quotas can also create monopolies for those who have import licenses, and this can convert consumer surplus into monopoly profits. Tariffs, on the other hand, do not deprive Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
INTERNATIONAL TRADE 10 consumers of their surplus. Therefore, it can be seen that quotas are more detrimental to an economy than tariffs. Despite being undesirable, tariffs are preferred over quotas. The trade restrictions imposed in the form of tariffs and quotas imposed by a country are often retaliated against by its trading partners. This may result in the shrinking of the volume of trade in the world economy. As a result, the overall welfare of the countries engaged in international trade is also likely to decrease. Conclusion Over time, the world has developed different monetary systems to deal with the problems associated with exchange rates in different ways. The international monetary system has evolved from the gold standard, which was a fixed exchange rate regime, to a flexible exchange rate regime where the exchange rate is determined by the market forces of demand and supply. Factors like interest rates, inflation rates, current account deficit, government debt, terms of trade political and economic stability, and monetary policy impact exchange rates. Analyzing fluctuations in exchange rates is complex because countries have to deal with not only nomin …International Trade: Economic Analysis