Running head: INTERNATIONAL TRADE
International Trade
Shweta Kanwar
Capella University
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INTERNATIONAL TRADE
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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
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INTERNATIONAL TRADE
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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).
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
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INTERNATIONAL TRADE
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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.
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
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INTERNATIONAL TRADE
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$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.
•
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
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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).
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,
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Comment [N2]: Good points. Please provide
support for you analysis.
INTERNATIONAL TRADE
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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. 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
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Comment [N3]: Analyzes the purchasing
power parity theory of exchange rates.
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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. 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.
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INTERNATIONAL TRADE
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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). 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
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INTERNATIONAL TRADE
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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 nominal exchange rates but also real exchange rates and purchasing power parity.
Exchange rates are also impacted by trade restrictions like tariffs and quotas, which influence the
volume of trade between countries. Although both tariffs and quotas aim at restricting imports,
quotas are more detrimental than tariffs.
Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
Comment [N4]: Explains why a quota is
more detrimental to an economy than a
tariff using real world examples.
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References
Amadeo, K. (2016). Value of the U.S. dollar: What the 3 methods of measurement tell you.
Retrieved from https://thebalance.com/value-of-us-dollar-3306268.
Bergen, V. J. (2016). 6 factors that influence exchange rates. Retrieved from
http://investopedia.com/articles/basics/04/050704.asp
Catao, L. (2012). Real exchange rates: What money can buy. Retrieved from
http://imf.org/external/pubs/ft/fandd/basics/realex.htm
Definition of globalization (n.d.). Retrieved from http://lexicon.ft.com/Term?term=globalisation.
Exchange Rate (n.d.). Retrieved from http://investopedia.com/terms/e/exchangerate.asp
Lin, Y.J., Fardoust. S., & Rosenblatt, D. (2012). Reform of the international monetary system: A
jagged history and uncertain prospects (World Bank Report WPS6070). Retrieved from
The World Bank, Office of the Chief Economist website:
http://documents.worldbank.org/curated/en/955581468336647083/pdf/WPS6070.pdf
McConnell, R. C., Brue, L.S., & Flynn, M. S. (2012). Economics: Principles, problems, and
policies (p. 768). New York: McGraw Hill/Irwin.
McEachern, A. W. (2015). Macro 4: Principles of macroeconomics (p. 334, 337). (n.p.):
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Riley, B. (2013). Tariff reform needed to boost the U.S. economy (No. 2792). Retrieved from
The Heritage foundation, website: http://heritage.org/research/reports/2013/04/tariffreform-needed-to-boost-the-us-economy
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