End of chapter review questions
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
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.
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.
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