Examine the factors which might explain the depreciation of sterling against the euro. (20 Marks)

The value of the pound fell from £1 = €1.47 in May 2007 to £1 = €1.18 in November 2008. Examine the factors which might explain this depreciation of sterling against the euro. (20 Marks)

A depreciation of the Pound is when the value of the Pound becomes weaker relative to other currencies around the world. In the example provided, one pound could buy 1.47 Euros in May 2007 however by November 2008 the Pound had depreciated and could only buy 1.18 Euros. There are a variety of factors which could lead to a depreciation of the Pound against the Euro.

Interest rate in Monetary Policy affects the value of the Pound and in the past 2 years the UK has set low interest rates. This is because of the recession and therefore, they wanted to try and boost economic growth. Low interest rates led to a depreciation in the Pound in the following ways. Firstly, fewer Pounds were demanded by foreign investors because they didn’t want to put their money in UK banks as they would get less money if they saved their money in the UK banks with low interest rates. So as Demand decreased, the value of the Pound decreased as well (DIAGRAM SHOWING A SHIFT TO THE LEFT IN DEMAND). Also, Supply for the Pound would increase as people who saved their money in UK banks would take their money out and place it in other banks with higher interest rates. Therefore as supply of the Pound increased the value of the Pound depreciated (SUPPLY SHIFTING TO THE RIGHT IN DIAGRAM).

A trade deficit is when a country’s imports have a higher value than a country’s exports. The UK has a massive trade deficit and this affects the value of the Pound. Imports depreciate the Pound because as domestic UK consumers buy goods from abroad they need to convert their British Pounds for the other currency for example Euros if they are buying Beer from Germany. Therefore, the supply of the Pound will increase as they are exchanging their Pounds for Euros and hence, the value of the Pound will depreciate as Supply of the Pound increases. Exports tend to appreciate the value of the pound because when foreign consumers buy domestic UK goods they must exchange their currency to Pounds to purchase the UK goods. For example, Germans buying British Pharmaceuticals from the UK must exchange their Euros to Pounds and as the demand for Pounds increases the value will increase. However, in a trade deficit the overall effect is a depreciation of the Pound as the value of imports is larger than the value of exports so the depreciation effect is larger than the appreciation effect.

Another factor which could lead to a depreciation of the Pound is speculation. Speculation in the currency market is the buying and selling of a currency based on future prices. During November 2008, global recession had just started. The UK was massively affected by this global economic meltdown and its currency was also affected as a result. Because the UK was regarded as an unstable economy many investors decided not to invest within the UK and speculators also decided to sell the British Pound and buy other more stable currencies. Because of the fall in the demand for the Pound AND the increase in the supply of the Pound within the market, the value of the Pound fell massively and lead to a depreciation of the Pound.  

Eval. The UK can use interest rates (Monetary Policy) to control their economy as they have control of the Bank of England. All the other countries in the Euro Zone cannot use interest rates to control their economies. Anyway, the UK has had low interest rates over the last 2 years and still saw an appreciation in the value of their currency and therefore there must be other more significant factors which are affecting the value of the Pound. Due to this I believe that interest rates may not be a significant factor affecting the value of the Pound plus it could take time before effects are actually seen!

Eval. In my opinion, the UK trade deficit is a major factor which led to the depreciation in the value of the Pound. The UK faces a large deficit in the trade of goods which offsets the surplus in investment income and trade in services. Therefore, I believe this huge trade deficit must be the major factor affecting the value of the Pound… especially because the UK consumers have a high marginal propensity to import. Marginal Propensity to import is when incomes increase and how much of this increased income is used to buy imports. The UK has a high Marginal propensity to import and therefore I believe that the trade deficit is one of the most significant factors which depreciated the Pound.

Eval. I also believe that speculation has a major impact on the value of the pound especially during the critical time of a recession. Most people were scared about their money so they wouldn’t spend their money on investing in things such as the Pound as they are scared about how strong the UK economy was at the time. People would also be naturally scared of their money at this credit crunch time so they would just save their money rather than spend it. Thus, I believe speculation and the recession was a major factor affecting the value of the pound. However, if people decided to save their money in UK banks during this recession time then demand for the Pound would increase and actually the value could appreciate!

To conclude, it is not one factor that affects the value of the pound… it is the interlocking combination of factors and how they affect each other which leads to an overall effect on the value of the Pound. In this case, the Pound depreciated. 

Unit 4 : Protectionism 30 Marks

Evaluate the significance for the UK balance of payments on current account of increased use of protectionist policies (30)

The Current Account is an account which measures the level of imports and exports within the UK and lets the government know whether they are in Surplus        (Imports< Exports) or Deficit (Exports< Imports). The main factors on the Current Account are (in decreasing order): Trade of goods, Trade of services, Investment Income and Balance Transfers. Currently, the UK faces a huge balance of trade deficit.

Protectionism is where the UK will try to reduce the amount of imports entering the country for various reasons. Hence, reducing the huge trade deficit they are already facing and also to protect employment and domestic industries.

The first form of protectionism is tariffs. These are taxes places on imports entering the UK. If tariffs are successful they will reduce the number of Imports because they increase the price of goods entering the country and this will tend to discourage consumers from buying the goods because of the inflated prices. DIAGRAM OF TARIFFS INCLUDED HERE. As you can see from the diagram, the tariffs will reduce the quantity of imports and will reduce consumer surplus as price increases and less people are prepared to charge high prices for the good. The reduction of imports will improve the UK balance of payments on the current account and reduce the huge trade deficit.

The second form of protectionism is Quotas. Quotas work by completely restricting the amount of goods entering a country to a certain level for example the UK may only allow 100,000 Cars from America enter the economy per year, no more than that is allowed. Unlike tariffs, Quotas do not let the government gain any additional revenue as the goods are not being taxed, they are merely being restricted from entering the country. INCLUDE DIAGRAM HERE. The diagram above shows how the quota level which is perfectly inelastic completely restricts the quantity of goods entering the country thus increasing price and also reducing consumer surplus. This form of protectionism again reduces imports as less foreign goods enter the country and this reduces the UK’s trade deficit.

Other forms of protectionism are non-tariff barriers. The first one is red-tape and administration costs. These are when a country makes it difficult for goods to enter the country such as health and safety checks and a lot of paper work which will waste a lot of time. These are very difficult to prove and countries will do it to reduce the amount of imports entering the country. The UK would definitely do it because they are facing a huge trade deficit and will try any method to stop imports from entering the country.

Another form of protectionism tends to be controversial - embargos. An Embargo is where a country completely bans the importing of a certain product. For example, due to poor political relationships, America decided to place an embargo on all goods from Cuba. If the UK placed an embargo on goods for certain products, this form of protectionism completely stops the importing of certain products so reduces the number of imports entering a country leading to a reduction in the trade deficit to the UK.

Eval. Tariffs do not place a stop to importing of products, it merely reduces the price of the good and so should deter the number of imports entering the UK. Therefore, the effectiveness of tariffs depends on the elasticity of the product being taxed. For example, oil is a highly inelastic product as nearly everyone in the UK relies on oil for heating, electricity, manufacturing and of course transportation. Therefore, a tariff placed on oil may not be effective in reducing the quantity of imports and hence may not lead to a reduction in the trade deficit faced by the UK.

Eval. Quotas I believe, are very effective at reducing the trade deficit faced by the UK. Unlike tariffs, they will definitely lead to a reduction in imports because it places a limit to the number of imports and hence I believe is one of the most effective ways of reducing the quantity of imports. Quotas have high significance in trying to reduce imports but they do have their disadvantages: they may lead to retaliation by other countries. Other countries may in fact, place Quotas on UK exports entering their countries and thus the UK’s exports may reduce as a result. The overall effect, may not lead to a reduction in the trade. Thus, their aim of reducing their trade deficit by using Quotas may back fire and therefore is government failure.

Eval. I believe red tape and administration work are not very significant ways of trying to reduce imports. Although, time consuming, imports may not be reduced if the goods being imported are highly important for example a firm in the UK may need a highly specialised piece of machinery to enhance efficiency and thus will go through the time consuming work just to help them in the long run. Thus I believe red tape is not an effective form of reducing imports and also it may again lead to retaliation although it is of course hard to prove.

Eval. Embargos will definitely lead to a reduction in the UK’s balance of trade deficit however, embargos are not placed on goods to help improve the UK’s balance of trade deficit. They are placed on goods to try and improve consumer welfare by reducing the imports of de-merit goods and goods which will lead to negative externalities such as Cuban cigars. So, embargos I believe, will not be used by the UK as an effective way of reducing the quantity of imports entering and will be used for other reasons. Hence, in my opinion, it is not an effective way of improving the UK’s balance of trade deficit.

Overall, I believe that tariffs and quotas are the only significant ways of reducing the UK’s balance of trade deficit and in my opinion the UK should start thinking about increasing its exports rather than reducing their imports if they want to remain competitive and improve their massive trade deficit.

Unit 4: Protectionism 20 Marks

Assess the main economic determinants of a country's demand for imports (20)

An import is a good or service which enters a country resulting in money leaving the economy. Although goods/services are entering the country, the result is a withdrawal of the circular flow of income as money leaves the economy. 

One reason a country would want to import is the fact that they would like to remain competitive in foreign markets, thus leading to an increase in the imports for new machinery. For example, the UK want to stay competitive in the agriculture industry so they import the newest, most efficient farming machinery to allow them to be more specialised in the industry compared to competition from foreign countries. So trying to improve the dynamic, allocative and productive efficiency of an industry is a determinant which would affect the demand for a country’s imports.

The income of the people within a country affects a country’s demand for imports. Usually, people with higher incomes tend to demand imports because imports tend to be better quality and they are more expensive than domestic goods. The imported goods are better quality because the goods are made in countries which are speicalised in making that specific good so will make it at a high quality and efficiently for example Japanese cars. The goods tend to be more expensive when you import them because you must pay the import tax (tariffs) which tend to increase the price of the good, so a Japanese car would be cheaper if bought in Japan compared to when it is bought abroad i.e. Egypt. Therefore the average level of income for people within an economy will affect a country’s demand for imports.

Another factor which affects a country’s demand for imports is whether a good is available within the country or not. For example, the UK does not have a large supply of sand and will therefore tend to import the sand from places such as the UAE. Therefore, the supply of a good within a country will affect the demand for imports. This is especially the case when it comes to goods which are vital to a country, for example, oil and energy will be needed in manufacturing and building houses so the UK will demand oil from abroad leading to a rise in the UK’s imports.

Eval. I believe the significance of importing technology to help maintain competitiveness in foreign markets is a major determinant of a country’s imports. The UK especially must stay competitive in order to be able to compete with emerging markets such as China. Therefore, this pressure of trying to stay competitive, efficient and productive is one of the main factors which affect a country’s demand for imports.

Eval. In my opinion, the UK’s main imports arise from foreign firms setting up within the UK and sending their profits back to their domestic country – Japanese car makers set up within the UK and send profits back to Japan (this is an import). Therefore, incomes of people within some countries may not be a major determinant affecting the demand for imports. Also, some goods that are imported are actually the same price as domestic goods because the country is within a trading bloc and there may not be any tariffs. Therefore some goods/services may not be more imported when they are imported so people’s incomes may not be a main determinant in affecting the demand for imports. However, income could become a main determinant because developing countries may have a population earning a low wage so the local people may prefer to live off of local products rather than spend more money for imports. I believe, imports is a peculiar factor and may be a country’s main determinant however it depends on the country you are dealing with!

Eval. As we develop we take for granted that we can get all sorts of products all year round without having to worry about harvests and various other factors. I believe, the main determinant affecting the demand for imports is whether the good or service is available within the country or not. Nowadays, products can be transported from one continent to another in only a matter of days. Therefore, it is relatively easily to import products which are not available within a country and the government will choose to do this because they want their citizens to have as much choice as possible. Also, nowadays, people cannot live without electricity or petrol to power their cars. So for countries without inelastic goods such as oil, the main determinant which affects the level of imports is the supply of these inelastic goods within the country. Again, it depends on which country you are talking about because some countries will have all the essentials it needs and will not import goods and some countries are very socialist and will not import goods even if they are lacking this good within the economy.

For all the factors above, the country we are talking about will determine which factor is the main determinant of a country’s imports.

Examine the significance of the factors which have contributed to increased globalisation in recent years

Globalisation is the international integration of markets around the world for goods, labour and capital.

Trading blocs are groups of countries that have agreements in place to engage in free trade – there are no barriers to trade and no protectionism. Over recent years there has been a massive increase in the number of trading blocs such as the European Union which contains 28 European countries with the ability to freely trade goods, services, labour and capital. Trading blocs lead to an increase in globalisation because it encourages firms to set up businesses within the trading blocs as they can sell their goods or services without any barriers. Therefore, more foreign firms will start to invest and move abroad to be part of the trading blocs. As firms are moving around the world to gain trade advantages, globalisation is increased and consumers will benefit as they will have more choice for goods and services.

Transportation cost is the cost of transferring goods around the world. As we have developed, it has become cheaper to travel by plane, boat and rail. This is because our technology has developed we have been able to make planes for relatively low prices and relatively quickly. The increase in supply of the vehicles and the availability of transport options means that firms can transport their goods for very low prices. This increases globalisation because firms will be willing to produce their goods abroad for cheap costs and then transport the finished product to many markets around the world. For example, Marks and Spencer could set up in China, produce clothes for cheap costs and then transport the finished clothes to retailers all over the world. The low transport costs will encourage firms to set up in other countries and the cost of transport will not matter to them as it is relatively cheap. Also, as transportation becomes more efficient, goods cam be transported very quickly and the products can be in stores practically every day of the year!

Communication is vital to the running of a business, without good communication messages and important decisions cannot be passed on from managers and directors down to the employees and labour work force. In the modern world, it is very easy and cheap to communicate with people from overseas. As these communication networks improve, firms will find it cheap and easy to set up abroad yet keep their communication networks strong. Globalisation can also increase, because it is easier for people (labour) to move to other countries and find jobs as they have the internet with all the information they need – housing and job vacancies. The internet has also made it possible for most good to be sold online and available to be sent all over the world. Therefore, this encourages firms to set up abroad in countries where production costs are low and then the goods can be sold domestically or sold to consumers via the internet.

Eval. I believe trade blocs had a significant impact on increasing globalisation. Before trade blocs, firms would not have any incentive to invest in foreign countries because of tariffs (taxation on imports). Now that trade blocs are found in many places around the world, firms have a massive incentive to set up (Foreign Direct Investment) within these trade blocs because they can freely move resources between countries in that bloc without having to pay any tariffs. They can easily move capital and labour to any of the countries in that bloc without facing taxation. This has lead to many firms setting up within these trade blocs so globalisation increases as the main incentive for any firm is increased profits and being able to set up in a trade bloc where labour can be brought in from any country in the bloc will reduce the firms costs and increase its profit.

Eval. Currently, with low transportation costs globalisation will increase. I believe that in the long run when raw materials run out, the cost of transporting goods around the world will increase dramatically because the supply of fossil fuels decreases leading to an increase in the price of oil and petrol. Therefore, in the long run, the reduction in the supply of fossil fuels may lead to a decrease in globalisation as firms will find it extremely costly to transport their goods from country to country in planes that use up a lot of fuel. However, in contrast, I believe that transportation costs may not increase dramatically because of the emergence of other sources of energy such as renewable solar power and bio fuels.

Eval. The increase in globalisation will have negative effects in the long run to many stakeholders. Firstly, the environment will become deteriorated as the increased transportation will pollute the earth and increase the effect on global warming. Also, labour in the countries encouraging FDI may become exploited and earn wages below the minimum wage. The labour will work just to earn this wage as they find it hard to find a job and will therefore continue to work for such a low wage. The firm may be a victim of this approach because if the media find out and spread the word then the firm may suffer from negative publicity and consumers will avoid buying their products. Negative publicity is extremely significant and has devastating effects on the firm because a reduction in demand may eventually lead to a loss being made and the firm shutting down.