Unit 6: The foreign Sector
1.1 Introduction
1.2 Why Countries Trade
1.3 Exchange Rates
1.4 Trade Policy
1.5 Terms of Trade
Learning Outcomes
The main outcomes of this unit are that, after you have studied the unit, you
should be able to explain as to why international trade takes place.
More specifically, you should be able to:
▪ Explain how exchange rates are determined in the foreign exchange
market
▪ Evaluate the case for and against the use of trade barriers
▪ Define the term of trade and explain their significance
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1.1
Introduction
Trade between different regions of a country can improve the welfare of all
the people involved. This is also true for international trade. Trade between
different nations can benefit importers as well as exporters, as it enables us
to consume goods produced in other countries. In other words, international
trade can improve the standards of living in a country. It is widely accepted
that the most successful economies are those who trade extensively, but
those who cannot compete tend to stagnate.
Although most people benefit from an open economy, some are hurt. This
one of the reasons why nations impose restrictions on international trade.
We have to deal with different cultures and languages, different currencies
and trade barriers such as tariffs and quotas. In this unit we will focus on the
reasons why people trade, trade barriers, exchange rates and policies.
1.2
Why Countries Trade
Nations find it beneficial to trade with each other for several reasons. One of
the basic reasons for trade is the fact that every country does not have every
natural resource. One country may have a large supply of oil, while a
mountainous (or waterfalls) country may be able to generate large amounts
of hydroelectric power, or may have a large amount of fertile land. Other
countries may have limited resources but large amount of capital, skilled
workers and entrepreneurs. International trade may lead to lower prices for
certain goods and services as some countries may be able to produce these
goods and services at a lower production cost than other countries. The
countries with the lower production cost can specialize in these goods and
services and export them to countries with higher production cost.
1.3
Exchange Rates
All countries in the world have their own currencies. This brings up the
question of how payment should be made for foreign goods and services.
When international sales are made, the sellers want to be paid in their own
currency, rather than in the domestic currency of the buyers. Therefore, a
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conversion must be made from the buyer’s currency to seller’s currency.
This is known as an exchange rate.
An exchange rate is determined on a foreign exchange market and
represents the rate at which one currency can be exchanged for another
currency. The exchange rate is, therefore, the price of a currency.
Depreciation means the weakening of a currency; in other words, more
units of a nation’s currency are needed to purchase a unit of some foreign
currency.
Appreciation means the strengthening of currency; in other words, fewer
units of a nation’s currency are needed to purchase a unit of some foreign
currency.
Most nations use direct method to quote and exchange rate. With this
method we show how much of the local currency (in our case the N$) must
be exchanged for 1 unit of a foreign currency. For instance, if we have to pay
N$12.50 to get one US dollar, the direct method will state 1USD = N$12.50.
Demand for Dollars
The people who demand US dollars are those who hold Namibian dollars and
want to exchange it for US dollars. Namibians need US dollars for the
following reasons:
▪ To pay for imports
▪ To repay foreign loan
▪ To invest outside the country
The demand for US dollar curve has a negative slope. As the Namibian dollar
depreciates against the US dollar, more Namibian dollars have to be paid for
one US dollar and imports will become more expensive. Namibians will buy
less imports and demand less US dollars.
Supply of Dollars
The people who supply US dollars are those who hold US dollars and want
to exchange them for Namibian dollars. Foreigners supply foreign currency
to the domestic market for the following reasons:
▪ To pay for domestic exports
▪ As capital inflows
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The supply of dollar curve has a positive slope. As the Namibian dollars
depreciates against the US dollar, Namibian exports become cheaper to
foreigners and they will buy more of our exports and supply more US dollars.
Determination of the Exchange rate
The equilibrium exchange rate is the rate at which the quantity demanded of
dollars equals the quantity supplied, in other words where the demand and
supply curves intersect. The equilibrium will continue until one or both of
the curves changes due to some influence from outside.
In figure 1 below, the equilibrium exchange rate is E and the equilibrium
quantity of US dollars is Q.
This example shows how market forces determine exchange rates and we
refer to it as a freely fluctuating exchange rate system.
Figure 1: Determining Exchange Rates
Intervention in the Foreign Exchange Markets: Managed Floating
If the foreign exchange market is allowed to determine exchange rates by the
interaction of demand and supply, exchange rates may fluctuate quite a lot.
Apart from that, authorities often wish to use the exchange rate to achieve
certain policy objectives and will, therefore, manipulate the exchange rate.
We refer to this as managed floating. Please remember that in our case, Bank
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of Namibia cannot influence the exchange rate because the Namibian dollar
is linked (pegged) to the Rand.
Central banks have the responsibility to keep a watchful eye on the exchange
rate and they are in a position to influence the exchange rate by buying and
selling currency. I will briefly explain in the next two paragraphs how the
SARB do this.
To prevent Depreciation of the Rand: If the South Africa Reserve Bank
(SARB) wishes to prevent the Rand from depreciating too much, it can enter
the market and buy a large amount of Rand, paying with foreign currencies.
By doing this, the SARB supports the value of the Rand and prevent a further
depreciation. You should note however, that a central bank is only able to
intervene to stabilize a depreciating currency if it has enough foreign
exchange reserves to do so.
To prevent Appreciation of the Rand: If the Rand appreciates too much, it
may encourage imports and hurts exports. In this case the SARB will sell
large quantities of Rand. This will decrease the value of the Rand and prevent
it from appreciating too much.
1.4
Trade Policy
Economists believe that trade between countries lead to an increase in the
world production of goods and services and to greater economic welfare.
However, all governments take steps to protect local industries and to
control imports. Consequently, there are many restrictions in trade markets
all over the world. Government intervention or protection in international
trade can occur for a number of reasons, can take a variety of forms and can
have both negative and positive effects. We will discuss these measures first.
1.4.1
Import Tariffs
A tariff (or a customs duty) is a tax on imported goods. Tariffs are used to
protect domestic industries against competition from imports. They
increase the price of the imported goods and this discourages imports. It is
also a source of revenue for the government.
There are three types of tariffs namely ad valorem tariffs, specific tariffs and
compound tariffs.
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Ad Valorem Tariffs: An ad valorem tariff is mostly used for manufactured
goods and is levied as a percentage of the value of the imported item. If the
value of the good is N$ 2000 and the tax rate is 15% then the tax payable is
15% of N$ 2000 = N$ 300.
Specific Tariffs: A specific tariff is a fixed amount that is levied on each
imported item. For instance, an amount of N$20 is levied on an imported
bottle of wine.
Compound Tariffs: A compound tariff is a combination of ad valorem and
specific tariffs. It is levied on manufactured goods on which the raw
materials are also taxable.
1.4.2
Non-tariff Restrictions
Apart from tariffs or customs duties, there are several other ways of
restricting international trade. Let’s discuss some of them here below:
Import Quotas: An import quota is a limit that is placed on the quantity of a
specific good that may be imported. Quotas protect local producers from the
full effect of foreign competition.
Export Quotas: Export quotas placed a restriction on the quantity of a good
that may be exported. It can be used to protect strategic resources or to
ensure that a minimum quantity of a specific good remains in the country.
Subsidies: A subsidy is a government payment to private firms to encourage
the export of local goods and to make the goods more competitive on world
markets. Subsidies make it possible for producers to sell their products at
lower prices and this gives them an unfair advantage on international
markets.
1.5
Terms of Trade
A country’s terms of trade tell us how the value of its exports compared to
the value of its imports. If a country’s exports can buy more and more goods
on the world market, its term of trade are improving. If its exports can buy
less and less goods on the world market, its terms of trade are declining.
We calculate the terms of trade by dividing the indexed prices of exports by
the indexed prices of imports.
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𝑬𝒙𝒑𝒐𝒓𝒕 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙
𝑻𝒆𝒓𝒎𝒔 𝒐𝒇 𝑻𝒓𝒂𝒅𝒆 = × 𝟏𝟎𝟎
𝑰𝒎𝒑𝒐𝒓𝒕 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙
Table 7: Example of Terms of Trade
Year Export price Index Import price Index Terms of trade
1993 92.4 93.7 98.6
1994 96.6 97.7 98.9
1995 100.0 100.0 100.0
1996 101.4 101.2 100.2
1997 103.5 102.1 101.4
1998 116.1 112.3 103.4
1999 118.7 116.1 102.2
The base year is 1995 when the indexed prices of exports and imports are
made equal to 100, thus giving the term of trade of 100. A rise in the terms
of trade is called a favourable movement while a decrease is called an
unfavourable movement. In the above table 7 the terms of trade for 1999
was unfavourable.
Terms of trade are important for most third world countries. Most of them
export raw materials and import machines and manufactured goods. When
terms of trade decline, more and more of raw materials need to be produced
for export to import the same number of goods as in the past.
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Tutorial Questions
1.1
A Namibian product costing N$300 is exported to the United States. What is the price of
the product in US dollars if the exchange rate is USD 1 = N$ 6.80?
1.2
An imported cell phone costs USD 200. What is the price of the cell phone in Namibian
dollars if the exchange rate is USD 1: N$ 6.50?
1.3
Use a numerical example to distinguish between an appreciation and a depreciation of
the Namibian dollar against the US dollar.
Tutorial Questions – Solution
1.1
300
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝑈𝑆 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 = 6.80 = 𝑈𝑆𝐷 44.12
1.2
Price in Namibian dollars = 200 x 6.50 = N$ 1 300
1.3
A depreciation means the weakening of a currency; in other words, more units of a
nation’s currency are needed to purchase a unit of some foreign currency.
Example:
Yesterday: USD 1 = N$ 6.85
Today: USD 1 = N$ 6.95
An appreciation means the strengthening of currency; in other words, fewer units of a
nation’s currency are needed to purchase a unit of some foreign currency.
Example:
Yesterday: USD 1 = N$ 6.63
Today: USD 1 = N$ 6.25
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Self-evaluation
1.
Explain the similarities and distinctions between the following pairs of concepts:
a) Ad valorem tariffs and Specific tariffs.
b) Import quotas and Export quotas.
2.
What is the foreign exchange market and an exchange rate?
3.
Explain the difference between floating exchange rates and manage floating exchange
rates.
4.
Why do tariffs benefit domestic producers but increase cost for domestic consumers?
~THE END~
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