International Trade: Economic Analysis 5
Global Economic Environment
Money plays a significant in global economy. The value of currency has an effect on international trade and supply and demand. Entering into another market to purchase a product internationally means buying the nation’s currency in that particular foreign exchange market. Supply and demand for certain products shift in order to change prices for those products which changes the price of currency resulting in a price of money change as the demand for foreign currency changes. This assessment shows us the role of globalization and international trade and how it is connected to global economic conditions and the effect it has on nations trading of goods and services.
Concept of Exchange Rate
Exchange rates are a nation’s currency amount that can be exchanged for another nation’s currency amount and tells how much of your nation’s currency is worth in foreign currency and can be thought of as a price charged for purchasing a different nation’s currency. Exchange rates are decided by exchange traders trading currencies 24 hours a day, seven days a week (Amadeo, 2017).
Exchange rates have two components domestic currency and foreign currency. They can also be quoted as directly or indirectly. Directly unit price of foreign currency can be expressed in terms of domestic currency. Quoted indirectly unit price of domestic currency can be expressed as foreign currency. Missing domestic currency as one of two currency components it would be listed as a cross currency or cross rate meaning neither currency is an official currency of the country where the quote for exchange rate is given. The U.S. dollar is not involved in these currency quotes no matter the country the quote is quoted in (Investopedia, n.d.).
For Americans currencies are constantly changing for those that are used. These currencies are the Mexican pesos, Canadian dollar, European euros, British pounds and Japanese yen. All of these use the flexible exchange rate that will be discussed below. There is no intervention from the government or central bank to help keep the exchange rates fixed but their policies can influence exchange rates (Amadeo, 2017).
There are two types of exchange rates, flexible and fixed. Almost all exchange rates are determined by the foreign exchange market or forex. This is a flexible exchange rate. Flexible exchange rates fluctuate minute by minute and determined on the forex of what it is believed the currency is worth with certain factors to take into consideration. These factors are the central banks interest rates, amount of the country’s debt and the strength of the economy at this particular time. In the United States, the forex market is determined by the value of the U.S. dollar. During the 2008 financial crisis the U.S. dollar was strong against other currencies. The falling worldwide stock market pushed traders towards the dollar. Even though the crisis started in the United States many felt the dollar was still safe putting trust in the fact the U.S. Treasury would guarantee safety of global currency. A fixed exchange rate does not vary according to the forex market keeping the value against the dollar or other important currencies the same by buying and selling large quantities of its currency and other currency helping to maintain the fixed value. (Amadeo, 2017).
Supply and demand sets the exchange rate between the dollar and the euro. The exchange rate floats or adjust to demand and supply of dollars versus euros. The dollar has declined against the euro due to factors that determine the exchange rates between two currencies. These factors are comparable interest rates, relative inflation rates, income levels and the governments’ macro policies. Interest rates and macro polices are two of the causes of the dollar loss in value against the euro (Crawford, Young, & Takhtarov, 2004). The interest rate difference between the U.S. Federal Reserve and the European Central Bank effects each of the values in comparison to one another. Intervention in open market by the FED in order to have a stronger U.S. dollar results in EUR/USD cross declining because of how strong the U.S. dollar
is becoming compared to the euro. The base currency of the euro and dollar is fixed representing one unit. Strengthening or weakening has no reflection on the rate. The EUR/USD rate increases when the euro gets stronger or the dollar gets weaker which can result if either condition has an upward movement in rate (Investopedia, n.d.).
Purchasing power parity or PPP is known as the law of one price and is the exchange rate currency between currencies with equal purchasing power between two countries which in effect means the ratios of the two countries are equal for purchasing goods and services. When domestic prices increase (inflation) for a country their exchange rate will need to depreciate to return to PPP. When there is no transportation cost or other transaction costs competitive markets have equal prices if identical goods in two different countries when prices are in the same currency (Antweiler, 2016). PPP is useful when comparing international living standards of countries since it defines exchange rates that are correct when comparing prices and incomes of different currencies. The law of one price requires both countries prices to be conveyed in common currency (Griffin, n.d.). A given example of PPP is the cost of a KFC snack box. If a snack box is sold in London for £2 and the same snack box is sold in California for $4 implies a PPP exchange rate of 1 pound to 2 U.S. dollars. The PPP exchange may be different in other financial markets which may indicate that the cost of the KFC snack box may be more or less in London than the $4 KFC snack box sold in California (Callen, 2012).
Why a Quota is More Detrimental than a Tariff
The government of a country has the right to impose both tariffs and quotas on imports and exports. They are both put in place to protect the domestic industries of countries by restricting quantities of products imported or exported while earning revenue for the government. Tariffs are taxes imposed on exports and imports while quotas are limitations imposed on quantities of products that are either exported or imported in the country (Kaushik, 2011).
A tariff can be defined as a duty or form of tax that is levied on goods solely for revenue and protective purposes. These duties and taxes are levied when goods are transported from one customs locations to other customs locations. Tariffs are also defined as comprehensive schedules or merchandise with rates that has a payment attached according to rules and regulations implied by governments. Simply stated, tariff is money paid by who trades their products by importing or exporting with the traded product price increasing when tariffs are imposed. Tariff are useful to countries because they earn revenue and raises GDP. Protective tariffs control trade between two countries and helps industries become more developed and competitive and are mostly imposed on imported products instead of their exports which can lead to the consumer paying extra money. These restrictions or protective tariffs are in place to help control the entrance of foreign goods into domestic markets (Kaushik, 2011).
Quotas impose limitations on what is traded, the quantity traded, how much needs to be paid for each product and where the product can be traded. These limitations are imposed by the government of those effected nations. Quotas do not deal with limitations of how much is paid but there is a neutral effect on the GDP. Consumer loss and producer surplus gives benefits to the quota holders but there is no revenue to the government which in turns opens doors for administrative corruption and smuggling. Quotas are harmful to consumers but domestic and foreign producers benefit from quotas higher prices meaning consumers lose out which can be detrimental to the economy (Kaushik, 2011).
Exchange rates are influenced by certain factors such as imports and exports, interest rates, inflation rate and balance of payment. These factors effect international trade and financial flow through the economy. Therefore, monitoring economic growth is vital for all nations. Knowing the value of currency for imports and exports are important for the development and growth of economies.
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