National Debt

National Debt

The national debt is the amount of money that a government owes to lenders. For example, when you buy a government bond, you are lending money to the government. The amount owed to you and other lenders is the national debt. The debt grows whenever the government has a deficit because the government is borrowing more money.

National debt stock/flow

Lets think about this question using the bathtub as a metaphor. A countrys national deficit is similar to the flow of water into a bathtub; the deficit is the rate at which the country borrows money. The countrys national debt is like the water in the bathtub. It is the stock of accumulated debt. By turning the faucet down and reducing the deficit, the rate at which the debt accumulates will slow down, but the debt itself will still keep accumulating. To reduce the stock of debt would require that the flows out of the stock be greater than the flows in. This would require paying off the debt at a higher rate than money is borrowed.

Fiscal indiscipline

When government is greater than government revenue.

Domestic and Foreign debt

Domestic debt consists of borrowing locally. The government is simply moving money around from one group to another. To pay off the people it owes interest it borrows from another group. When they must be repaid it borrows from another group. The money remains in the country and the wealth of the country has not changed.Foreign debt is money owed overseas. Interest must be paid to foreigners in foreign currency. Therefore the country has to export goods and services to earn foreign currency. This payment or servicing of the debt represents a loss to the nation and a burden on the society as this money could have been more useful in producing goods and services.Causes of the national debt

Persistent budget deficits increase the national debt. If the debt is rising faster than the GDP the problem worsens. The causes of the debt include:

1. The negative effects of external shocks and natural disasters. Substantial amount of resources may be needed to rebuild the economy some of which will have to be borrowed from abroad. Adverse movement in terms of trade (X< M) also forces government to borrow to meet certain fiscal needs.2. To cover public sector consumption even when revenues are stagnant or declining. Mismanagement of funds is also a big problem in Caribbean economies.

3. To speed up growth and development process.The effects of the national debt on the economy

1. Output and investment decisions

Interest payments reduces money available to be spent on education, encourage the growth of non-traditional sectors who have comparative advantages in trade and the creation of better infrastructure to attract foreign direct investment inflow of export oriented sectors.

2. Exchange rate pressures

Countries may be unable to finance current account deficits because debt servicing reduces the amount of foreign currency reserves. Export revenues maybe reduced worsening the Balance of Payment position and causing the currency is depreciated as more foreign currency is demanded to service the debt.3. InflationNational debt should be looked at in real terms and not nominal terms. As the inflation rate increases the government gains and the debt holder loses because inflation reduces the real value of the debt. The real burden of the debt falls as inflation rises.4. Crowding out and crowding in

Crowding out

Where a country cannot lower its consumption levels in order to release resources to service the debt the government may borrow from the domestic commercial banking system. This increases the demand for loanable funds causing the interest rate to rise as government competes with firms for capital leading to a crowding out private sector investment as less capital is available for the private sector.Crowding in

This is where increasing national debt is meant to stimulate growth and development in the borrowing economy. Once the economy is expanding and economic activity is growing and businesses have confidence in the buoyancy of the economy then domestic investors will invest.

The responsibility of debt payment

This refers to the burden of the debt which includes:

1. the size of the debt in relation to the ability to pay

2. who pays the debt, that is whether one government borrows and another government pays interest payment.

The burden is bourne by:1. The present government. This generation has to go without consumer goods in order to purchase capital goods. Eg. If government borrows to finance crime fighting resources are directed from providing consumer goods to buying guns etc.

2. When money is borrowed for corrupt or fiscally irresponsible activities the entire society bears the burden.

Management of the national debt1. Internal and external borrowing

Internal borrowing keeps wealth at the same level but external borrowing results in a leakage of resources. External borrowing also has conditionalities especially when borrowing from the IMF and WB. For instance they require that the government to play a minimal role in the economy which may result in unemployment and poverty.2. Taxation

Reforming the tax system

3. Debt Rescheduling

This is an agreement between creditors and debtors by which a new schedule and timetable for the debt repayment is negotiated. Some of the debt can be written off or the repayment of debt extended.

Debt retirement

A debtor (bank/country) paying off the outstanding amount owed as debt so that there are no longer any repayment obligations.

4. Debt Forgiveness

Where a creditor (bank/country) decides to efficiently write off from the official records all outstanding payments owed to it by a borrower from official records so that the debtor no longer has an obligation to make outstanding payments.Debt service Ratio

Principal + Interest x 100

ExportThis measures the security of the debt burden of the country. If the ratio is increasing it impacts negatively on the countrys export earnings ie more export earnings is being used to service the debt.Developing countries and the national debt

1. Large portion of the GDP used to service the debt and less for local development which brings hardship on the population.

2. reduction in economic growth

3. lower standard of living

4. high taxation

5. reduced spending on infrastructure and investment

To reduce the debt burden

1. reduce external borrowing

2. seek more grants from international institutions which usually do not have to be repaid

3. debt forgiveness and cancellation

4. repay regularly to avoid increased interest payments

5. avoid rescheduling the debt

6. Change loan profile from short term to long term.

Public sector borrowing requirement

The annual change in debt from year to year

Review questions

1. How is the national debt measured?2. How does a government incur debt?

3. What are the measures used to reduce the debt?

4. How does the national debt affects the Balance of Payment?

5. How does the conditions of the IMF impacts on the country?

THE ENDInternational Economic Relationship

World Trade Organisation (WTO)

Emerged out of the General Agreement on Tariff and Trade (GATT). It came into existence January 1, 1995. It administers agreements regarding trading of goods, trade in services (GATS) and trade in related intellectual property(s) (TRIPS). Member countries try to reduce the level of protectionism between them.Role and Functions

1. to administer and implement the multi-lateral and pluri-lateral trade agreements.

2. to act as a forum for negotiation

3. to seek to resolve disputes

4. oversees national trade policies. This is done through the traded policy review mechanism.

5. to cooperate with other international institutions involved in global economic policy making such as the IMF and World Bank

Principles of the WTO

1. Non-Discrimination

a) Most favoured nations clause Any trade concessions made to one country must be granted to all members. Exceptions include countries which have free trade areas and customs unions where trade restrictions are eliminated between member states but maintained with the rest of the world.b) National Treatment imported goods must be treated equally with domestic goods and services.

2. Reciprocity any nation which benefits from another country must reduce tariffs itself.

3. Quotas this is discouraged and tariffs recommended.

4. Fair trade unfair barriers or dumping is not allowed and sanctions will be brought against countries that do this without permission.

5. Market Access promoting an open trading system

6. special arrangements for developing countries poorest countries are given longer periods of time to reduce barriers to the agreed levels and to be given various trade concessions.

7. They have the power to impose sanctions unlike the GATT

The International Monetary Fund (IMF)

Designed to be the central institution of the post war monetary order which was initially shaped by US national capitalist assumptions. It was established as a part of the Bretton Woods system in 1944 now a part of the united nation. It was intended to supply international liquidity to members with Balance of Payment problems. It has short term focus designed to support the flow of international trade. It has become deeply involved in domestic macroeconomic policies as a means of assisting countries in difficulty to restore balance between the international political economy. It was designed to operate in the relatively stable international conditions after the post war transition period.

Role and Functions

1. to promote monetary cooperation through a permanent institution which provides consultation and collaboration on monetary problems.

2. to facilitate the expansion and balanced growth of trade and hence promote and maintain high levels of employment and real income and the development of members productive resources.

3. to promote exchange stability, to maintain orderly exchange arrangements among members and to avoid competitive exchange depreciation.

4. to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign restrictions which hamper the growth of trade.

5. making general resources of the fund temporarily available to members so as to correct Balance of Payment problems.

6. to shorten the duration of and lessen the degree of disequilibrium in the international balance of payment of members.

The International Bank for reconstruction and Development (IBRD) or the World Bank

The World Bank was established to facilitate the rebuilding of developed countries shattered after WW1 as the international community expanded to eventually assist in the more basic task of economic development of least developed countries.Main Goals

1. to promote sustainable economic development

2. to reduce poverty

3. to promote long term economic development

Role and Function

1. Provide long term assistance to help countries in their economic reconstruction and development progress.

2. Offers technical research advice. They do not finance full project but requires that developing economies have some financial input.

3. Providing loans, guarantees and related technical assistance for projects and programmes in its developing members.

4. Assist with infrastructural development such as building roads, bridges, schools, hospitals and so on.

Multinational (transnational) CorporationsThese have plants or subsidiaries all over the world. They invest to:1. Access raw material and markets

2. to avoid trade barriers

3. lower labour cost

4. technical and organizational advantages over locals

Factors influencing location of MNCs or FDIs

1. macroeconomic stability

2. tax concessions/ holidays

3. political stability

4. less trade barriers

5. subsidies

6. low cost of production (cheap labour)

7. less stringent government regulations

Why MNCs may leave a country

1. economic and political instability

2. civil unrest

3. strict labour restrictions (trade unions)

4. strict trade barriers

5. high levels of taxation

Foreign Direct Investment (FDI)

The movement of capital across national borders which gives investors control over the assets they acquire. It is investment by non-residents in a domestic firm they thereby establish or come to control because of that investment.

OR

Non-residential investment in the form of a takeover, mergers or capital investment in a domestic branch, plant or subsidiary corporation in which the investor has voting control.

The nature of FDI 1. equity or portfolio investment

2. establishment of a new firm usually a subsidiary of a foreign based multi-national company

3. takeover of an existing firm, usually through the sale of ownership to foreigners.

4. mergers the assets and operations of firms from different countries are combined to establish a new legal entity.

Benefits/Advantages

1. inflow of foreign currency without having to export more

2. increase in the countrys real wealth

3. job creation

4. Access to technology and capital. The stock of physical capital per person increases. Improvement in technological progress for the host country 5. links local economy with world economy

6. Access to management skills. They offer scholarships and bursaries to students and upgrade opportunities to staff. Labour training and skill acquisition is meant to improve the stock of knowledge in the host country. FDI facilitates the introduction of alternative (superior) managerial and organizational practices.Disadvantages/Cost

1. crowding out of domestic business/investment in the same line of business because of their superior technology and managerial expertise (concession given to foreigners are usually not given to locals). Inhibits the growth of infant industries

2. introduction of inappropriate technology

3. repatriation of profits, interest and dividends which are not available to the local economy.

4. destroys the environment of the host economy eg costal damages which occur as a result of drilling for crude oil and deforestation in Guyana.

5. promote wage inequality in the host country as they offer higher wages than local firms. Eg oil workers in Trinidad and Tobago.6. transfer pricing

GlobalizationThe opening up of world trade, it refers to the integration and interdependence of the world economy. It has occurred due to fewer barriers to trade and less protectionism.OR

It refers to the process of a growing economic and social interdependence between all people and countries through trade, investments and governance.

Features of globalization

1. More free trade across nations because of reduced tariffs and other trade barriers

2. Greater investment flows across nations. The amount of cross-border international investment has increased dramatically in recent times.

3. Greater interdependence among nations as the economic fortunes of all countries have become interlinked. Whatever happens in one country like a recession affects others.

Forces driving globalization

1. Technological innovation innovation in information technology, communication and transport system and the internet have contributed significantly to globalization phenomenon. Reductions in the costs of transport and transmission of data have played a critical role in furthering the process of globalization. 2. Trade liberalization the removal of trade barriers and the signing of many free trade agreements have also contributed to globalization. It makes it easier and less costly to embark on international trade as trade is freer.

3. Liberalization of capital markets the deregulation of national financial markets in developing countries opened the door for increased foreign capital flows, especially into high yielding stock markets.4. The abolition of exchange control and floating exchange rates the freeing up of the system made international transfers of funds with these countries much quicker and more convenient. Floating exchange rates make currency conversion easier and facilitates international trade.

5. Privatization the privatization of major state enterprises, a policy implemented in both industrialized and developing countries during the 1980s and 1990s provided international investors with an additional avenue for portfolio diversification and increased profits.6. Financial Innovations the development of new financial instruments also made international financial integration cheaper by reducing the cost differential between the rate of return paid to the investor and the cost of capital paid by the ultimate borrower.

7. The growth or spread of MNCs.

Implications of globalization

1. greater competition

2. access to markets

3. Access to technology 4. cheaper prices and greater variety of goods

5. loss of preferential marketsDangers to Caribbean economies

1. Reduced competitiveness due to slow adoption to advanced technology.

2. Problems in one part of the world spread other parts eg. Recession

3. greater vulnerability to world trade fluctuations

4. loss of markets; decrease in exports

5. Increase trade with developed/industrialized countries can lead greater capital flight.

6. Changes in interest rates in one country will affect financial flows to and from other countries and hence their exchange rates, interest rates and national income.

7. eliminate infant and vital industries

Review Questions

1. Evaluate the effectiveness of THREE of the factors affecting globalization.

2. Discuss whether globalization is a help or hindrance to the international trading process.

3. Assess the pros and cons of FDIs by MNCs in terms of any THREE benefits of FDI.

4. Discuss THREE major functions of WTO, IMF and IBRD

THE ENDEconomic Integration

This is the removal of trade barriers to allow for free movement of people, money goods and services among member states. It is the coming together of a group of countries with the goal of increasing economic linkages among the group vis--vis the rest of the world.Forms and stages of Economic Integration

1. Free trade area (FTA)Elimination of tariffs within the group but each country maintains its own tariff arrangements with other countries. This is a very low level of economic integration. Eg North American Free Trade Area (NAFTA) between USA, Canada and Mexico.

2. Customs Union (CU)

Formed when the countries in a FTA implement a common external tariff (CET) for its members. This means that all goods from non-member countries coming into the region will command the same tariff rate regardless as to which member country it comes in.3. Common market

A common market is formed when the members of a CU with free labour and capital mobility. Eg. CSME

4. Economic Union

This is the most extensive form of economic integration. It is a common market where the level of integration is more developed. Eg. Having a common macroeconomic policy and fixed exchange rate between countries also having a single currency within the union eg. European Union.

Advantages

1. Freer trade among the group, the movement of goods within the group will be easier; consumers have greater choice of products, greater scope for employment across the region.2. Lower or no tariffs within the group. This results in saving for exporters and possibly lower prices for consumers in the region.

3. Welfare gains trade creation when barriers are removed more trade generally occurs than before this is called trade creation. That is, economic integration increases the amount of trade.

4. Higher economic growth firms can take advantage of economics of scale in companies as they produce for a larger market.

5. greater efficiency in production6. Increases in resources used in the region which results in development and growth and ultimately improvement in standard of living.

Disadvantages

1. Loss of tax revenues as tariffs are removed from regional goods entering any country within the group.

2. Loss of sovereignty as countries within the groups establish closer ties. Each has to give up some amount of national sovereignty as they now have coordinated policies towards the rest of the world.

3. Brain drain within the region as educated persons may all migrate to countries that are doing well at the time.

4. Welfare loss trade diversion the formation of FTA often diverts trade away from relatively efficient trade partners outside of the FTA towards relatively inefficient suppliers from within the FTA.5. Interdependence of states making small economically weak states vulnerable to other states.

CARICOM and CSMECARICOM Caribbean Community - it ranges between a CU and CM and includes a CET for member states, allowing for free movement of capital and some categories of skilled persons. CSME CARICOM Single Market and Economy entails the integration of CARICOM states into a singular economic unit, and subsequently removing tariff barriers within the region. It includes the free movement of commodities and factors, a single economic space and single market. It is meant to stimulate growth and international competitiveness as well as serves to address challenges that small developing CARICOM economies face because of globalization.Objectives of CARICOM

1. foster economic cooperation among member states

2. coordinate foreign policy

3. foster cooperation in health, education, culture and communication among member states.

4. encourage the use of raw materials of the region by member states

5. encourage regional trade in agricultural products.

Rationale and Objectives of CSME

A single market involves a market structured and functioning to a large extent as if it were within the borders of a single country. There must be freedom of movement of goods, services, labour, capital and supportive fiscal and monetary measures and administrative arrangements. The single market must be a regional economy closely approximating a national economy, incorporating measures to achieve a balance in the distribution of costs and benefits. While many policy functions may be carried out at the national level, those should be conducted within a coordinated policy framework at the regional level. There are many benefits with regards to production and development which will occur as a result of having a single market.1. The increase in the size of the home market would allow for significant cooperation in production, transport and marketing. Firms would not have to worry about government or bureaucratic obstacles in other caricom countries and could safely introduce more technology. Marketing firms would emerge automatically focused on the wider Caribbean and the world. The success of beer exports by more than one caricom firms first nationally, then regionally and ultimately extra-regionally is typical of what can be expected. Beer producers now have both a regional and extra-regional production and marketing network.2. Development of key services and professions allowing for a size of firm capable initially of servicing the entire region but ultimately developing sales to the wider Caribbean and outside the region. Eg. Accounting, architecture, engineering etc. more jobs would be created. The financial sector can benefit from single market and already regional insurance co. and commercial banks are beginning to appear.

3. Development of genuine Caribbean franchise type operations in areas such as restaurants, merchandising, specialist foods, travel agencies, hotels/motels etc. The expanded home markets permit the investment and development of systems for more than one country. If it works in Port of Spain and Kingston it can work in Miami, Toronto etc. the mindset of people would change which is necessary for genuine export-led growth. It will allow for joint ventures, licensing and other forms of business enveavours.Objectives of CSME

1. Intended to benefit people in the region by providing more and better opportunities to produce and sell our goods and services and to attract investment. It will create one large market among the participating members.

2. full use of labour (full employment)

3. Full exploitation of the other FOP4. competitive production leading to greater variety and quantity of products and services to trade with other countries.

These objectives will provide:

1. Improve standard of living

2. sustainable economic development

Key elements of CSME

1. free movement of goods and services

2. right of establishment of say a business

3. free movement of capital

4. common trade policy

5. free movement of labour

6. free movement of goods

Implication of EU and NAFTA for the CaribbeanNAFTA can get cheaper labour and lower cost of production and lower transportation cost, therefore more USA and Canadian business will move out of the Caribbean to set up in Mexico. Therefore less income, job opportunities and advantages to be gained from MNCs.

European Union no more preferential treatment as they are concentrating on developing their economies.Caricom has to deepen and widen integration economic and otherwise in order to survive. The regional bloc must be greater established. (DO MORE READING ON THIS)

FTAA Free Trade Areas of the AmericasThe removal of tariffs and other trade barriers among members who, however, retain their own commercial policies to non-members.

Eg. NAFTA

Review questions.

1. Name the member states of Caricom and CSME.

2. Analyse the implications of international integration arrangements for Caribbean economies.

3. Evaluate the objectives of Caribbean integration.4. Describe the stages of economic integration of Caribbean countries up to the level of the Caribbean Single Market and Economy.

5. Discuss FOUR advantages to Caricom member states arising from the free movement of factors of production goods, services, capital and people under the CSME.

THE END

Balance of Payment (To be used with the BOJ handout)

A record of a countrys transaction with the rest of the world during a specific period of time, it shows the countrys payments and receipts from its trade. It consists of a current account and a capital and financial account. It is concerned with transactions and thus deals with flows rather than stocks.Current Account

Goods

Services

Income

Current Transfers

Capital and Financial Account

CapitalCapital transfers

Acquisition/ Disposal of non-produced, non-financial assets.

Financial Accounts

Balance of Payment Account

1. Current Account

A. Goods Balance

-xx Exports

xx Imports

-xxB. Services Balance

xx Transportation

xx Travel

xx Other services

xxC. Income

xxD. Current transfers

xx Official

xx Private

xx

2. Capital and Financial A/C

xxA. Capital A/C

xx

B. Financial A/C

xx

Other official investment

xx

Other private investment

xx

Reserves

xx

Balance of payment disequilibrium1. persistent trade imbalance

2. persistent current account imbalance

3. persistent positive or negative overall balance

Causes and consequences of BOP disequilibria

1. Current account surplus expanding sector can result in an appreciation of the currency. Other sectors may contract as they become less competitive. One booming sector makes the currency so strong that the other industries are less competitive. Eg oil in T&T and remittances for Jamaica.

2. Misaligned Relative Prices the currency may be overstated. If foreign goods are relatively cheaper then consumers are likely to buy them leading to a current account deficit.3. Overheating Economy Domestic production cannot support AD. So the country has to import to fill the orders. Eg. Importing bananas to fill orders abroad. This leads to a deficit.

4. Persistent fiscal deficit short term loans and long term loans increases. The short term pay back is more critical.

5. Narrowing of IR differentials People may choose to invest abroad to earn greater IR.

6. Persistent negative OB NIR declines - If IR is attractive people will invest in bonds instead of produce to sell to earn foreign exchange. Instability in the FX market leads to a decrease in money supply, IR increases, GDP falls, no insurance fund , start borrowing from the IMF.

7. Persistent Positive OB NIR increases MS increases, IR falls, Inflation increases competiveness declines increased sterilization.Policy response to BOP crisis

1. Devaluation/ depreciating the currency makes exports cheaper compared to imports.2. Expenditure switching these attempts to make imports relatively more expensive than exports by using tariffs and devaluing the currency.

3. Expenditure Reducing reduce government spending (deflate the Economy). To do this government could increase taxation rates, cut its own spending or increase IR.4. Fiscal measures decrease the fiscal deficit by spending less and /or increase taxes.

5. Monetary policies increase the IR to encourage savings, encourage savings, reduce domestic investment and reduce inflation, govt. can also sell bonds.

Policy PackagesA combination of policies can be used to cure a BOP deficit eg. Depreciation will result in consumers switching from imports to exports but, if Jamaica industry is at or near full capacity it cannot produce enough and result in inflation. The government might deflate the economy (expenditure reducing) to provide capacity for depreciation (expenditure switching). Both policies are complementing each other.

Deficit and Surplus Problems and Solutions

Deficit problems

a) inflation increases prices and exports to be low (UK 1989)b) Interest rate low so hot money flows out to earn interest from abroada) Increase productivity, reduce prices and increase exports.

b) Tight fiscal policy and dear money policy to deflate the economy, higher interest rates to encourage inflows of hot money

a) currency overvalued so export earnings fall (UK 1981 & 1992)b) capital outflow because of investments overseas or too much government expenditure abroad.a) depreciate or devalue the currency if import/export elasticities are favourable.b) Stop or reduce drain by exchange control regulations on investment.

Surplus problemsc) Spare capacity in the economy, prices relatively low leading to high levels of export. (West Germany 1982)d) Interest rate high, hot money flows in to earn interest.a) Easy fiscal and cheap money policies with low taxes and higher govt. expenditure boost internal economy while lower interest rate reduces the inflow of hot money.

a) Currency undervalued, embarrassment to trading partners, exports artificially cheap while imports expensive, domestic living standards restricted.(Japan 1983)a) Appreciate or revalue currency, this will reduce exports and increase imports.b) Increase capital expenditure overseas or increase foreign aid.

The Exchange Rate(To be used with the BOJ handout)

The rate at which units of a countrys currency are exchanged for units of foreign currency. The price of one currency in terms of another. The amount of foreign currency that can be obtained with a unit of the domestic currency and vice versa.Demand for Jamaican dollar

The desire to change other currencies to Jamaican currency in order to:

1. buy Jamaican goods

2. to save in Jamaican banks and other financial institutions

3. to speculate on the currency in the hope that it will gain valueThe demand for Jamaican dollars will increase if:

1. demand for goods and services

2. interest rate (returns) are greater therefore more savings and investment

3. people think the value of the currency will increase in the future.

The extent of the change in demand depends on the price elasticity of demand for goods and services, the more elastic the demand for Jamaican goods and services, the more elastic the demand for Jamaican dollars.

The supply of Jamaican dollars

The desire to change Jamaican dollars into other currencies in order to:

1. buy goods and services from abroad

2. save in overseas financial institutions

3. speculation a foreign currency in the hope that it will increase in value

The supply of Jamaican currency increases if:

1. overseas interest rate attracts savings and investment2. overseas goods are demanded more

3. people think that Jamaican dollars will fall in the future so they sell it now.

Appreciation and depreciation

Appreciation a rise in the value of a countrys currency in relation to that of another countrys currency. The term is used for a managed or floating system while devaluation is used for a fixed regime.

Depreciation - a fall in the value of a countrys currency in relation to that of another countrys currency. The term is used for a managed or floating system while devaluation is used for a fixed regime.

Type of exchange rates

Fixed exchange rate regime 1. The rate is held within a common band around a predetermined par value by the countrys central bank.

2. The central bank sets the rate by law and meets any excess demand and buys when there is excess supply at the stated rate.

3. Devaluation or revaluation of the currency though policy changes.Determination of the fixed exchange rate

In a fixed exchange rate system is set by the govt. or central bank at a particular rate. Eg Barbados to US 2:1. The forces of supply and demand do not determine the rate. The central bank holds reserves of $US dollars and intervenes in order to keep the exchange rate pegged at that level.

Eg. D0 curve shows the demand for Barbados dollars that are purchased with $US dollars. The current price P1 $US per dollar. If the Americans decide to purchase more Barbados made goods. To do so they must exchange more $US for Barbados dollars. This means that the demand for Barbados dollars increases to D1. This would increase the price of Barbados dollars to P2 if the Barbados monetary authorities did not take action. However, with a fixed exchange rate of P1 $US per dollar, the Barbados authorities would step in and increase the supply of Barbados dollars to S1. They may do so by taking Barbados dollars that they have held in reserve and purchasing $US dollars.

If the US decided to buy fewer Barbados made goods, the demand for the Barbados dollars would fall back to D0. This means that less US need to be exchanged for B dollars. The price of the B dollar will therefore fall to P1 with supply of S1. Here the Barbados monetary authorities will intervene in the market to reduce the supply of the B dollars back to S0. They may do so by taking US dollars that they have and purchase B dollars. This act would maintain the price of the dollar at P1.

Advantages1. stability in knowing the exchange rate

2. makes business and investment planning possible

3. limits speculation on the exchange rate because it is fixedDisadvantages

1. need reserves to protect the value

2. exchange rate may be undervalued or overvalued

3. monetary policy focuses on keeping the rate stable

Floating/Flexible exchange rate regime

1. The value of a currency is allowed to be determined by the forces of demand and supply on the foreign exchange market. There is no government intervention.2. Appreciation and depreciation of the currency based on market forces.Determination of the floating exchange rate

In the free-floating exchange rate system, the forces of supply and demand for a countrys currency determine the value of the exchange rate. The government does not intervene to affect the value of the exchange rate. An increase in demand for the local currency causes it to appreciate but if there is a greater demand for the foreign currency the value of the local currency falls/depreciates to the foreign currency.

Eg.

When there is a great demand for the US dollars the value of the Jamaican dollars will fall/depreciates.

When demand for the US dollars fall then there may be excess supply of US dollars as people begin to demand the local currency. The local currency appreciates.

Advantages

1. market determined, so it is more efficient2. no need for reserves to intervene

3. exchange rate would reflect its true value

4. absorbs economic shocks better

5. freedom of govt. to pursue internal policy

6. Automatic BOP adjustment, less likelihood of a BOP crisis.

Disadvantages

1. large depreciation may occur

2. instability of exchange has a negative impact on domestic economy

3. terms to trade may decline with fall in exchange rate

4. uncertainty

5. speculation

6. reduced investment

Managed/ Dirty Float Exchange rate1. The exchange rate is allowed to float, but the central bank intervenes from time to time to prevent major exchange rate fluctuations. It is a form of managed flexibility.Determination

The central bank seeks to stabilize the exchange rate within a predetermined range for a given period of time, but does not fit it at any particular level. This allows for policy makers the benefit of planning with some degree of certainty, for the macroeconomic affairs of a country.

The effect of exchange rate changesIf the currency is devalued/ depreciated then:

1. The price effect goods become cheaper and imports become more expensive. The devaluation worsens the BOP.2. the volume effect cheaper exports mean that more will be sold and less imports will be bought thus improving the BOP.In the long run this results in a J effect.

The devaluation worsens the current account balance initially, and then it improves. Reasons being:1. Time lag in consumer response people may still want the expensive good. Consumers may be concerned about the quality and quantity of the local good and may continue buying the foreign goods in the short-run.

2. Time lag in producer response producers may take a long time to adapt to say changing their plant size to accommodate the increase in demand.3. Imperfect competition import competing firms from abroad may reduce their prices when the dollar is devalued to compete with local producers, resulting in imperfect competition.In the short run changes are inelastic but in the long run changes are elastic.Review Questions

1. With the use of diagrams tell how monetary authorities manage to maintain a fixed exchange rate.

2. With the use of diagrams tell how the fixed and floating exchange rates are determined.

3. Discuss the effect of exchange rate changes on Caribbean economies with a flexible exchange rate.4. Analyze TWO causes and consequences of balance of payment disequilibrium.

5. Discuss the effectiveness of policies used to correct balance of payment disequilibrium.

6. Select 6 Caribbean countries and identify the rate of their currency to the US, also identify their exchange rate regime.

The EndGrowth and DevelopmentEconomic Growth

This is an increase in the level of national income usually expressed in constant prices. This is an expansion of a countrys real output (GDP) or an outward shift of the PPF. The increase in national income of a country, measured by the GNP in relation to the increase in the population. Growth is quantitative.Structural characteristics of Caribbean economies

1. Small size in terms of land mass they are relatively small which limits what can be produced and economies of scale.

2. Openness which makes them vulnerable to external economic shocks such as recession.

3. Composition of exports there is a tendency to concentrate on exporting one or two commodities such as bananas, agriculture and tourism4. Resource base each country has one or two resource bases that they depend on for export earnings for instance Jamaica bauxite and beautiful beaches, T&T hydrocarbon base minerals and Guyana- gold, diamond, bauxite and natural forest.5. Poverty every economy has a Gini Coefficient of 0.42 which suggests that they are closer to the line of inequality and there is a large proportion of people living below the poverty line.6. Economic dependence great dependence on the international community. Some depend on it as a principal export destination, foreign direct investment, loans and aid.Implications for regional economies

1. Dependence on aid this may be humanitarian for instance food relief after a hurricane. Political for the economic to support their political agenda. Economic to boost their market especially after a natural disaster. This may slow down economic reform and slow down growth.2. Preferential trade agreements the new trend is for this to be based on reciprocity which means that preference are given to member states but they are also expected to provide preferences to the other members within the preferential trading agreement. Eg EU bananas, sugar, rice and rum.3. Foreign direct investment important part of the economic development for the Caribbean see benefits and cost to the Caribbean of FDIs4. Vulnerability to natural and man made changes (market developments) these affect exports. Natural disasters. External trade and exchange related shocks such as global interest rate fluctuations, severe decreases in demand, instability of commodity prices etc. Non-environmental domestic shocks such as political instability as well as uprisings and so on. 5. Changes in world prices developing countries have a comparative advantage of producing primary instead of manufactured goods where the price and income tend to be low. Developing economies depend mainly on the sale of one/two commodities and change in prices on the world market may reduce the demand for the product. Eg. The increase in the price of fuel increases the price of travel resulting in a decrease in demand for travel and a decrease in demand for tourism. Benefits of growth

1. increase in the level of consumption

2. better standard of living

3. better care for the environment

4. more money to be redistributed from the rich to the poor as the rich earn more.Potential costs of economic growth

1. unequal distribution of income

2. inflation

3. environmental degradation

4. social services suffers

5. machines displaces workers

6. sustainable development sacrificed

Impediments to economic growth faced by Caribbean economies

1. lack of resources

2. lack of domestic investment

3. lack of FDI

4. natural disasters

5. lack of technology

6. small size, openness and vulnerability

7. debt burden

Review Questions

1. Discuss how the structure of Caribbean economies stifles growth and development.

2. To what extent is growth a prescription for development.

3. What fiscal and monetary measures can be used to stimulate growth and development in the economy and what are the implications of these.

4. How can you promote sustainable development in your community?

The EndInternational TradeTrade between nations. It consists of the selling (exporting) of goods and services to other countries and the purchasing (importing) of goods and services from other countries.Reasons for international trade

1. differences in countrys cost of production

2. economic welfare of each country increases since they have a wider range of goods and services available for consumption.

3. some countries do not have the necessary natural, human and capital resources included technologically to make/produce some goods

4. countries have different climate conditions and therefore cannot produce some goods.

Principles of International trade

Absolute and comparative advantage.

The role of exports in creating domestic income and the role of imports in generating income for foreignersExports create employment and generate income from the factors of production for locals while imports provide jobs and income from the factors of production for foreigners.Factors that influence/determine exports and imports

1. International price - this is dependent on factor prices and the state of technology, if this allows a country to produce goods cheaply they will sell to other countries and import goods produced more cheaply by other countries.

2. Domestic production a country tends to export more of a good that its factors of production can produce in abundance because the FOPs are plentiful and import those goods it cannot abundantly produce because the FOPs are not plentiful.3. Domestic prices and exchange rate an overvalued exchange rate cause local goods to be more expensive resulting export prices being high and import prices being low therefore more goods will be imported than exported. Whereas, if the dollar is devalued/depreciated domestic goods will be cheaper resulting in greater levels of exports and a favourable BOP.4. International economic activity as it affects the tourism market in the Caribbean tourism provide valuable foreign exchange which can be used to import capital goods necessary for development. Tourism helps to develop unused natural resources and create employment, it also results in the consumption of non-tradable and niche industries like craft which has a multiplier effect on the economy and improves the BOP. But tourism is prone to international shock such as recessions when income falls and some tourists cannot afford to travel.

5. Shifts in international demand and the emergence of substitutes an economy suffers when the export it relies on is substituted causing demand for it to fall for instance nylon replacing cotton, copper as fiber optic cable replacing traditional telecommunication infrastructure. The economy looses valuable export revenues.

6. Changes in international income as income increases demand for certain primary goods exported by Caribbean economies falls as consumption patterns change. At lower income levels demand for certain primary exports may increase generating income for these economies.Benefits of exporting

1. earn foreign exchange

2. create jobs

3. improve BOP

4. improved standard of living

Problems with importation

1. uses up scarce foreign exchange

2. harm local industries

3. unfavourable BOP

The effect of foreign exchange earnings on small open economies

1. Access to capital goods these goods can be purchased to produce other goods to improve development. These goods are vital to production and productivity but are not produced locally.2. The export multiplier Themultiplierfor achangeinexports; that is, the increase in GDP caused by a one-unit increase inexports. It may be defined as the amount by whichnational incomeof a nation will be raised by a unit increase in domestic investment onexports. As exports increase there is an increase in the income of all persons associated with the exports industries. These in turn create demand for goods. But this is dependant upon theirmarginal propensity to save(MPS) and import(MPM). The smaller these two propensities are, the larger will be the value of multiplier and vice versa.

3. Access to consumer goods consumers can buy more foreign goods and improve their level of consumption and SOL.

4. Increased domestic production with the increase in the purchase of capital goods more domestic goods and services can be produced and exported to earn more foreign currency.Principles of International tradeA. Absolute advantage

Where countries have equal quantity of resources but one can produce more of the good than another. Adam Smith suggest that the country specialize in the production and export of the goods it has absolute advantage in producing and import the one it has an absolute disadvantage in producing.

Assumption of the theory

1. two countries, two commodities and two factors of production2. factors are easily substitutable between productive options

3. this is for a specific period of time with a given technology

4. constant cost economies of scale, changes in production does not affect cost

5. no barriers to trade.

B. Comparative advantage

Assumptions of the theory

1. factor mobility

2. both countries must demand the product

3. limited resources must be fully employed

4. constant returns to scale

5. constant average cost in both industries

6. 2 domestic ratios = one international ratio

When one country can produce a good at a lower opportunity cost than another. This means that the country sacrifices less in the production of say Good X therefore it is more efficient in producing Good X say against Good Y. When many commodities are produced, they are arranged in order of comparative advantage. Countries will specialize in the product they produce best. Resources are allocated evenly between 2 goods X and Y in countries A and B and output is as follows:CountryGood XGood Y

A14

B23

Total37

The opportunity costs of production are as follows:

CountryOpportunity cost 1X (y/x)Opportunity cost 1Y (x/y)

A4Y ( 4/1) give up 4 Y to produce 1X1/4X give up X to produce 1 Y

B1.5Y (3/2) give up1.5 Y to produce 1X2/3X give up 2/3 X to produce 1Y

A will specialize in producing good Y because the opportunity cost of producing Y is less than XB will specialize in producing good X because the opportunity cost of producing X is less than Y If all resources are diverted into the production of the good the country has comparative advantage in producing, assuming constant returns to scale, the output will double because twice as much resources are now being used to produce one good. Therefore:

CountryGood XGood Y

A08

B40

Total48

Before comparative advantage total goods traded 3+7=10

After comparative advantage total goods traded 4+8=12Trade in both goods has increased therefore comparative advantage results in an increase in the number of goods and services produced. There is a wider range of goods at a lower price.

Relative efficiency - Efficiency in the production of one particular commodity over the same commodity in another country.

Benefits of free trade for the region

1. Access to larger foreign markets

2. cheaper goods

3. better quality goods4. increase in exportation

5. improved standard of living

Disadvantages for the region

1. damage to domestic producers

2. unemployment

3. kill infant industries

4. dumping/cheap labor

5. protection to improve the terms of trade

Free Trade

This occurs when there are no barriers to trade. Countries may see the need to set up barriers for certain reasons these are call protectionisms for instance quotas and tariffs.

Arguments for protectionism

1. Damage to domestic producers local industries may not be able to compete with cheaper imports and so may have to close down or scale down on operations thereby creating unemployment.

2. Infant industries protecting these industries until they mature and are able to compete with international firm.

3. Dumping dumping involves large exporters selling their products at below cost price to gain market share. Local firms must be protected against this. 4. To improve the terms of trade when a country can exert monopoly or monopsony power by restricting international trade on a particular good. When the country can do this and affect the price of the good, thereby improving its terms of trade, then we say that they are using protection to improve their terms of trade.

5. Employment- cheaper labour may be brought in to do the jobs of locals which may displace local workers. Eg from China to build roads.

6. Food security this is done to protect primary producers such as farmers and to reduce the dependence on foreign foods. Banning the importation of harmful goods.Arguments for trade liberalization/Arguments against protectionism

1. improves competition in an economy forcing firms to be more efficient

2. prevents retaliations in the form of trade restrictions from other countries

3. help domestic industries that depends on foreign imports especially of capital goods

4. based on comparative advantage free trade benefits the participants by improving welfare/SOL. Also cheaper goods and services.5. greater access to technology/earn foreign exchange to buy capital equipment 6. improves international trade relations

7. when there are restrictions prices may increase and consumers may have to pay more for imports thus reducing their surplus.

Methods of trade protection

1. Tariff Tax on imports designed to increase their prices and raise revenues. Tariffs are meant to reduce importation in an effort to improve the BOP and encourage consumers to buy local goods.The effect of Tariffs

With a tariff:

a) govt. earns revenue from QS2 to QC2b) QS1-QS2 inefficient area, inefficient domestic producers can now supply because of the tariff. There is deadweight loss.

c) QC2 QC1 is welfare loss to the consumer refuse to pay a higher price for these goods.d) domestic producer surplus increases as consumers pay more for local goods

2. Quotas limits the quantity of imports. This is meant to protect infant industries and reduce competition against local products. 3. Non-tariff barriers administrative procedures which make it difficult for foreign firms to sell their goods in the country such as difficult safety standards.4. Embargos- no trade is allowed, often done for political reasons.

5. Voluntary agreement/ voluntary export restraint - one govt. pressurize another to reduce its exports. Eg Japan agreeing to limit car exports to UK.

6. Exchange controls limit the amount of money that can be converted to foreign currency.

Commodity terms of trade

This is an index of the price of a country's exports in terms of its imports. Theterms of tradeare said to improve if that index rises. The ratio of the index of export prices to the index of import prices. An improvement in the terms of trade follows if export prices rise more quickly than import prices (or fall more slowly than import prices). Formula

Export price index/Import price index X 100

Review Questions1. With the use of a diagram discuss the implications of an increase in tariffs

2. Assess THREE factors that determine export revenues.

3. Evaluate THREE arguments for and THREE arguments against protectionism

4. Evaluate whether the benefits of international trade outweighs the cost of for the region.

5. Demonstrate and explain the benefits of comparative advantage.

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