Economic Integration Review Questions & 3 Extra Questions

End of chapter review questions

1. Using a diagram, explain the difference between a free trade area and a customs union. Use real world examples.

A free trade area and a customs union are both trading blocks. A trading bloc is a group of countries that join together in some form of agreement in order to increase trade between themselves and/or to gain economic benefits from cooperation on some level. These are the types of trading blocks: preferential trading areas, free trade areas, customs unions, common markets, economic and monetary union, and complete economic integration.

Members of a customs union are further economically integrated with one another than members of a free trade area. A free trade area is an area in which countries within the area have agreed to trade with one another freely. This means that are no tariffs, or if there are, they have been reduced. NAFTA is an example of a free trade area. While the countries (USA, Mexico, and Canada) have reduced tariffs when trading with each other, they do not have a common policy for trading with countries outside of NAFTA. Therefore, NAFTA is not a customs union.

A customs union is a free trade area in the sense that free trade occurs between its members. Countries that are part of a customs union have a common foreign trade policy. What that means is that they have a common tariff on goods/services that are imported from countries outside of the customs union. The SACU is a real world example of a customs union.

Figure 1.1: A free trade area

Figure 1.2: A customs union

As you view the two figure above, notice how the two trading blocks treat outer parties differently. In a free trade area, countries within the free trade area simply trade freely with one another, meaning that they trade with no or reduced tariffs. How they trade with outer parties (for example country D) is for them to decide separately. Country C trades freely with country D, while country B imposes tariffs on country D. In a customs union, however, all members in the union have agreed on a common policy. It is usually a tariff of sorts.

2. Discuss the likely effects of membership of a customs union. Be sure to use a real world example.

A customs union is an agreement made between countries, where the countries agree to trade freely among themselves, and they also agree to adopt common external barriers against any country attempting to import into the customs union. This situation can be seen in Figure 1.2 above. When a country joins a customs union, for example Uganda joining the EAC, trade creation and trade diversion occurs. Trade creation has occurred between Uganda, Tanzania, Rwanda, Kenya, and Burundi. Since they are all part of the EAC, they can trade freely among themselves. When Uganda wasn't part of the EAC, they most likely had to pay some sort of tariff to export to members of the EAC. Now that they are part of the EAC, they no longer have to pay tariffs to do so. Trade creation occurs when a country that leads the production of a good/service enters a customs union and transfers from a high-cost producer to a low-cost producer.

Even though trade creation has happened, countries that used to be able to trade with Uganda in a certain way may no longer be able to after Uganda joins the EAC. After Uganda joins the EAC, countries outside the EAC that want to trade with Uganda will have tariffs imposed on their goods, this creating trade diversion. Trade diversion occurs when a country that leads the production of a good/service enters a customs union and transfers from a low-cost producer to a high-cost producer. Due to these pros and cons of membership, Uganda must carefully consider whether it is beneficial for them to remain a part of the EAC.

3. Evaluate the consequences of membership of a monetary union. Be sure to use a real world example.

A monetary union is a common market with a common currency and a common central bank. The consequences of membership in a monetary union will be evaluated by providing the real world example of the eurozone. When Austria became a member of the eurozone, a monetary union, it had already adopted the euro as their currency. They had also accepted the ECB as their central bank. By joining the eurozone Austria can forget about exchange rate fluctuations between itself and other members of the eurozone, because they now share a common currency. Trade and cross-border investment between Austria and other eurozone members should improve as a consequence.

Austria will no longer be able to set interest rates, because the ECB is responsible for such matters. Changing the interest rates will no longer be an option for influencing the inflation rate, unemployment rate, and the rate of economic growth. Austria is also unable to alter their own exchange rates in order to make their exports more internationally competitive and to change the cost of imports. Austria also experienced a huge cost when joining the eurozone, because they had to take off the old currency off the market and make many other adjustments in their country. Therefore, we can see that there are both positive and negative consequences when obtaining membership of a monetary union.

Three review questions, with answers, about the entire unit we have just finished for 28.10.2015

1. What is trade creation? Be sure to use a real world example to illustrate trade creation.

Trade creation occurs when a country that leads the production of a good/service enters a customs union and transfers from a high-cost producer to a low-cost producer. Let’s assume that when Mexico joined NAFTA in 1994, it had a comparative advantage over the US in taco production. Before the birth of NAFTA the US had placed a tariff on Mexican tacos. The situation is shown in Figure 1.1 (see next slide).

With the tariff in place, the US would supply Q2 tacos in the US. Mexico would supply Q2Q3 tacos to the US. Both suppliers set a price of P(Mexico)+tariff. When Mexico joined NAFTA, however, the tariff was removed. Now the US supplies Q1 tacos in the US, which Mexico supplies Q1Q4 tacos to the US. Both suppliers sell tacos at a price of P(Mexico). There are Q3Q4 more tacos being bought and therefore trade creation has taken place. Consumer surplus increased by the right shaded triangle, and world efficiency increased by the left shaded triangle.

There has been a world welfare gain because less resources are being used to produce the tacos. It is likely that with the integration of free trade the US may had a comparative advantage in another good/service that it began supplying more of to Mexico.

2. Discuss the consequences of a appreciation of a country's currency on the country's economy.

In order to adequately answer this question, we must understand what appreciation is. Appreciation occurs when a country's currency increases in value relative to other currencies. The positive consequences will be listed first. When a currency appreciates in value, its exchange rate value becomes higher. A higher exchange rate value will make imports cheaper. Not only will imported finished goods be cheaper, but also raw materials. If raw materials can be imported at a lower cost, then domestic producers will be able to produce goods at a lower cost. This situation will increase welfare gain in the country because prices will decrease. Since finished imported goods will also become cheaper, domestic producers will have more pressure to keep their prices competitive, and therefore lower than before. Since imports are cheaper, it means that more things can be imported. Every unit of currency will grant more goods/services.

Even thought there are a lot of advantages to an appreciating currency for a country, there are also negative consequences. Domestic unemployment is likely to increase, because domestic producers will now have more pressure to compete with the cheaper imports. In order to cut costs, workers will be laid off. It is also likely that demand for domestic goods/services will decrease, due to the cheaper imports. More imports will be demanded, since they are now relatively cheaper. Also, export industries will suffer because a high exchange rate will make their exports more expensive for other countries. Having more expensive exports means that demand for them will decrease, thus reducing revenue. Reduced revenue will also play a part in the increase in unemployment, because less workers may be needed for the level of demand.

3. With the help of a diagram, explain three factors that would cause a currency to depreciate in value.

A currency is said to depreciate in value when its relative value to other currencies has decreased. If demand for the country's goods/services decreases, then demand for the country's currency will decrease as a consequence. A decrease in demand will make the currency more likely to depreciate. Even though that may be true, why would demand for a country's goods/services decrease? Demand would decrease if inflation rates in the country were higher than in other countries, because it would mean that the goods/services in that country are more expensive compared to other countries. Another factor could be a decrease in incomes in other countries. The lower their incomes, the less they are able to buy. As such, demand for a certain country's goods/services should decrease. Also, a change in tastes could decrease demand. What the country offers may not be what the consumers want. They may want another country's goods/services, thus decreasing demand.

If the country's investment prospects worsen, less investors will be investing in that country. Investors will invest in a country where the prospects are better. If interest rates in the country decrease, then people will save their money in another country, and therefore in another currency. This will decrease demand for the currency, and thus make it depreciate. Also, if speculators believe that the currency will depreciate in value, then they will exchange to a safer currency, in order to maximise the value of their currency.

A situation in which demand for the Euro has decreased can be seen in Figure 1.3:

Figure 1.3

We can see from Figure 1.3 that when the quantity demanded for the Euro (or any currency) decreases, it will depreciate in value. We can see that happening on the graph, where the price of Euros in Pesos has decreased from P to P1. Why this occurs can be discovered in the preceding paragraphs.

Trading Blocs/Economic Integration Group Presentation

Exchange Rate Manipulation-Balance of Payments

1. How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?

China undervaluing its currency threatens the industrial economies of its largest trading partners in the following way. To devalue a currency means to simply lower the value of the currency. In other words, it means that other currencies, such as the USD, can purchase a larger quantity of RMB's per unit of USD. By undervaluing the RMB, China's exports become very cheap for global consumers, such as the US. This increases demand for Chinese exports in the global market from countries such as the US. In the US, for example, that would mean that demand for domestic goods would decrease, because they can import those goods from China at a lower price. This harms the domestic market in the US, and may lead to an increase in unemployment within the US.

Definitions:
-Export: a product or service sold abroad
-Unemployment: the number or proportion of unemployed people

The situation described above will be illustrated by figure 1.1 and 1.2:

Figure 1.1

Figure 1.2

Figure 1.1 represents a situation in which the US is not importing calculators from China. The domestic producers produce Q4 at P3 and the US imports Q4Q5 calculators at a price of P3 from the. In figure 1.2 we can see a situation in which the US is importing calculators from China. Since China's currency is undervalued, China is able to export its supply of calculators at a lower price than the rest of the world. In this situation the domestic producers produce Q2 calculators at a price of P2, while Q2Q3 is imported from China at a price of P2. From these graphs we can see exactly how China's cheap exports affect the calculator market in the US. Domestic producers get less revenue, and the domestic market for calculators has gotten smaller, therefore increasing unemployment. This is how it threatens the industrial economies of its larger trading partners.

Definitions:
-Import: bring (goods or services) into a country from abroad for sale.
-Revenue: income, especially when of an organization and of a substantial nature.

2. What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?

China's purpose for maintaining the low value of the RMB relative to the currencies of other nations is as follows. By maintaining a relatively low value of RMB, China's exports will be a lot cheaper than if the value of the RMB was relatively higher compared to currencies of other nations. A cheap RMB allows producers within China to keep production costs low. This makes their exports cheaper, and as such increases demand for them in the global market. Other nations, in this situation, will have higher production costs than China, and will be unable to set their exports at a price lower than that of China. This gives China a competitive advantage in the global market and increases the money entering the country. That is China's purpose for maintaining a low value of RMB relative to other nation's currencies.

3. What would be a unilateral protectionist measure the US government may advocate if the WTO refuses to take action against China’s currency manipulations? How would you advise president Obama on the issue of whether to take protectionist action against China in the context of the current economic crisis in America?

A unilateral protectionist measure the US government may advocate if the WTO refuses to take action against China's currency manipulation can be imposing a tariff on Chinese imports entering the US. A tariff is a tax or duty to be paid on a particular class of imports or exports. In the context of the current economic crisis in America, I would advise Obama to impose a tariff on Chinese imports entering the US to improve the US economy. A tariff on Chinese imports would decrease demand for them in the US, and would grant domestic producers a higher market share. What I mean by that is that they will be able to supply more goods at a higher price, which should help improve unemployment. It should help improve unemployment because if more goods are being produced domestically, through reason we can assume that that would require a larger workforce, therefore creating more jobs in the US. Unemployment and growth was one of the issues mentioned in worksheet 23.1, and due to reasons explained previously, a tariff on Chinese imports entering the US would improve the rate of unemployment, and also growth. It would improve growth because more goods are being produced in the US than before.

This situation can be illustrated with the following graph:

Figure 1.3

Without the tariff domestic producers produced Q1 marshmallows at a price of P1. Q1Q5 was imported from China. With the tariff imposed on China, domestic producers now produce Q2 marshmallows at a price of P2. Q2Q4 is now imported from China at a price of P2. Domestic producers receive a larger market share, which benefits the US in ways mentioned previously. While that may be true, welfare loss does occur represented by the triangles between Q1Q2 and Q4Q5. Freedom is not free.

Exchange Rate Regimes Worksheet - Real World Situations

Worksheet-ExchangeRateDeterminants

1.

Determinant: US economic growth

Price of Peso in terms of USD

Supply of Peso from Mexico

Demand for Peso in US

Quantity of Peso in US

Demand line shifts right because more Pesos are demanded from the US

2.

Determinant: Political turmoil in Syria

Price of SP in terms of euros

Supply of SP

Demand for SP

Quantity of SP

Demand line shifts left

3.

Determinant: Investors sweeping in to Romania

Price of RON in terms of euros

Supply of RON

Demand for RON

Quantity of RON

Demand line shifts right because investors are demanding RON

4.

Price of CHE in terms of euros

Supply of CHE

Demand for CHE

Quantity of CHE

Demand line shifts right because europeans will want to save their money in Switzerland to get a higher return on their investment

5.

Price of Indian Rupee in terms of euros

Supply of Indian Rupee

Demand for Indian Rupee

Quantity of Indian Rupee

Demand line shifts left because demand for Indian Rupee falls.

6. 

Price of Krone in terms of Euro

Supply of Krone

Demand for Krone

Quantity of Krone

Demand line shifts left because europeans will demand less Krone due to higher prices in Norway. They will demand less goods/services from Norway, and therefore Krone.

Worksheet-ManagedExchangeRatesinSingapore

1. What are the advantages and disadvantages of a floating exchange rate?

There are a number of disadvantages and advantages of a fixed exchange rate. The following sentences provide advantages of a floating exchange rate. Interest rates can be used to control inflation since the exchange rate does not have to be kept at a certain level. Another advantage is that ff the Marshall-Lerner condition is satisfied, the exchange rate should adjust itself to keep the current account in balance. Another advantage is that high reserves of foreign currency and gold do not need to be stored in order to control the value of the currency. For example, China keeps high amounts of foreign currency, such as USD, in order to keep their currency pegged to the USD. When they need to appreciate their currency, they increase demand for it by exchanging their high amounts of foreign currency into their currency. If they had a floating exchange rate, this hassle would be unnecessary.
Disadvantages

Now let us go over the disadvantages. International markets become uncertain with a floating exchange rate. Businesses will have difficulty predicting their future costs and revenues. For example, the tech company Apple would be unable to accurately predict future costs and revenues with floating exchange rates affecting their endeavors. This could significantly harm the company and would cause many repercussions. Another disadvantage is that a floating exchange rate can make inflation even worse. High inflation will lead to exports becoming more expensive and imports becoming cheaper. The exchange rate will fall to save the current account from a deficit. However, a lower exchange rate will cause imports to become more expensive, which will worsen the inflation.

2. What are the advantages and disadvantages of a fixed exchange rate?

There are a number of disadvantages and advantages of a fixed exchange rate. The following sentences provide advantages of a fixed exchange rate. Businesses will be able to predict future costs and revenues with a fixed exchange rate, because it is more predictable. Another advantage is that a fixed exchange rate ensures reasonable government policies on inflation, because a fixed exchange rate can lead to harmful effects on the demand for exports and imports. Another advantage is that speculation in foreign exchange markets are reduced, however, attempts to destabilize the fixed exchange rate have been made to profit financially.

Now let us go over the disadvantages. The government has to keep the exchange rate fixed. For example, if the exchange rate was in risk of depreciating, the government would increase interest rates to get the currency to appreciate. The issue, however, is that that will lead to increased unemployment. Another disadvantage is that the government has to keep high amounts of foreign currency in order to keep the exchange rate fixed. Another disadvantage is that finding the right value for the exchange rate can be very difficult, and if it is not set correctly firms may feel as if they are not competitive enough in foreign markets.

3. What is the common tool used by many governments to control inflation. Why can’t all countries use the Singapore approach?

The common tool used by many governments to control inflation is the manipulation of exchange rates. An increase in interest rates will lower inflation due to money being less accessible to investors, businesses, and consumers. A decrease in interest rates will have the opposite effect. A decrease in interest rates will lower demand for the currency, since saving in that particular country has become less attractive, which will depreciate the currency. That will make exports cheaper and imports more expensive. Not all countries use the Singapore approach, because not all countries have exports making up over 100% of their GDP. For Singapore this approach is very effective, however, for other countries it may not be.

4. Can a country use both Monetary Policy and a managed exchange rate to control inflation? Do trade-offs exist?

Monetary policy is used to control the amount of money in an economy, interest rates, and the buying/selling of government bonds. As mentioned before, interest rates may be manipulated in order to control demand for a currency. The level of demand for a currency can affect inflation, and therefore we can use monetary policy and a managed exchange rate to control inflation.

5. Evaluate the effects on the Chinese economy of an appreciation of the yuan.

The Chinese economy has a gigantic export industry. The appreciation of the yuan would have devastating consequences on the Chinese economy, and the world. An appreciation of the yuan would make their exports more expensive, and therefore less competitive in foreign markets. This would raise costs for many foreign businesses if they were relying on China as a supplier. Lower sales of exports will lead the current account to a deficit, which will have a major impact on China's economy. In conclusion, the effects of the appreciation of the yuan would be felt all around the world.

Non-price Determinants-Supply & Demand

Non-price determinants of supply and demand:

• These are the following non-price determinants of demand: branding, market size, demographics, seasonality, available income, complementary goods, and future expectations.
• These are the following non-price determinants of supply: costs of production, productivity, government intervention in the form of taxes and subsidies, price of related goods, and supply side shocks.

What would cause a demand or supply shift within a market for currency exchange?
A change in any of the non-price determinants of demand will cause the demand curve to shift either left or right. A change in any of the non-price determinants of supply will cause the supply curve to shift either left or right. If the demand curve shifts to the right, then the equilibrium quantity and price will increase. The producers will supply more and will charge higher prices due to increased demand for their good/service. If the supply curve shifts to the right, then the equilibrium quantity will increase whilst the equilibrium price will decrease. With an increase in supply producers are able to supply more. The price will decrease because the good/service is now more abundant. These non-price determinants of supply and demand can affect supply and demand for goods and services, and thus can cause changes in the exchange rate because countries supply and demand goods/services from one another.

Foreign Exchange Market and Exchange Rate Determination

Definitions:-Exchange rate: the value of one currency for the purpose of conversion to another.
-Inflation: a general increase in prices and fall in the purchasing value of money.

-Prospect: the possibility or likelihood of some future event occurring.

1. Exchange rates are like prices, in that they are determined by supply and demand. But not all exchange rates are allowed to float freely, since the governments or central banks of some countries actively intervene in the market for their currency to manipulate its value. Identify one policy a government or central bank could use to strengthen the value of its currency and one policy that could weaken the value of a currency.
One policy a government or central bank could use to strengthen the value of its currency is the policy in which they use their reserves of foreign currency to purchase its own currency. This will lead to an increase in demand for the currency which will strengthen the value of their currency.

One policy a government or central bank could use to weaken the value of its currency is the policy in which they lower the level of interest rates in their country. By doing so domestic interest rates will be relatively lower than interest rates in other countries, which will lead to less foreign financial investment in the domestic country. This is because financial investment in other countries will be more attractive. Investors that will be investing in other countries will need to exchange the domestic currency for foreign currency, which will increase the supply of the domestic currency in the foreign exchange market. This usually weakens the value of the domestic currency.

2. What are the benefits of having a stronger currency?
The benefits of having a stronger currency are: downward pressure on inflation, more imports can be bought, and improved domestic efficiency. A stronger currency will make imports cheaper, which will increase competition and put pressure on domestic producers to decrease their prices. They can lower prices due to cheaper imports. Cheaper imports reduce their production costs. The increased competitiveness will also lead to increased domestic efficiency so that domestic producers can remain competitive in their industries.

3. What are the benefits of having a weaker currency?
The benefits of having a weaker currency are: increased employment in export and domestic industries. Increased employment in export industries due to a weaker currency occurs because a weaker currency will make exports relatively cheaper. This will increase their competitiveness and will lead to employment in the export industries.

A low exchange rate will make imports more expensive, so domestic producers will be more inclined to purchase goods and services from domestic producers. This will increase demand for domestic good and services, which will lead to an increase in employment.

4. Which determinant of exchange rates presented in the video do you think are most attributable to the fluctuating values of currencies on foreign exchange markets, and why? Relative incomes, relative interest rates, relative inflation rates, speculation or simply the tastes and preferences of global consumers?
I think that the most attributable determinant of exchange rates presented in the video is "relative inflation rates". Inflation rates determine a whole country's price levels, which can have a significant impact on exchange rates. Relatively lower inflation rates than in other countries will increase foreign demand, because the goods/services in the country with the lower inflation rates will be relatively cheaper.

-Lastly, pick one world currency (besides the Euro of the US Dollar). List and explain the factors that might lead to a fall in the supply of the selected currency in relation to the Euro market.

Chosen currency: GBP. In the following text please assume that when I say "other EU countries", I mean all EU countries except: Bulgaria, Croatia, Czech Republic, Denmark, Hungary, Poland, Romania, Sweden, and England.

There are several factors that might lead to a fall in the supply of GBP in relation to the Euro market. If British people decrease their demand for goods and services from other EU countries, they will be exchanging less GBP for Euros, which will lead to a decrease in the supply of GBP. British demand for goods/services from the EU can decrease if incomes in England decrease, if British people change their tastes in favor of non-EU goods/services, and if inflation rates in England are lower than in other countries in the EU. Relatively lower inflation rates in England means that goods/services in other EU countries will be more expensive.

Another factor to consider is the following. If investment prospects worsen in EU countries (except England), the supply of GBP will decrease. Worse investment prospects will make British people less inclined to invest in other EU countries.

Another factor to consider is the following. If interest rates in other EU countries decrease, British people will be more attracted to save in England, which will decrease the supply of GBP.

Another factor to consider is the following. If British people speculate that the value of GBP will increase, they won't convert their GBP's into other currencies to make a financial gain. This will reduce the supply of GBP.

Next, draw a diagram to illustrate the fall in the supply of the the Euro and its effect upon the exchange rate of your selected currency in terms of the euro.

A fall in the supply of the Euro will have the following effect on GBP. For every quantity of GBP, less Euros can be bought. The exchange rate will increase from a fall in the supply of the Euro. The euro will appreciate while GBP will depreciate.