Chapter 16:

The foreign sector

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 CHAPTER OUTLINES
LEARNING OUTCOMES
16.1 INTRODUCTION
16.2 WHY COUNTRIES TRADE
16.3 TRADE POLICY
16.4 EXCHANGE RATES
16.5 THE TERMS OF TRADE
IMPORTANT CONCEPTS

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LEARNING OUTCOMES
Once you have studied this chapter you should be able to
• explain what globalisation entails
• explain why international trade occurs
• identify various possible trade barriers
• explain how exchange rates are determined in the foreign exchange market
• define the terms of trade and explain their significance

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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain what globalisation entails

16.1 INTRODUCTION
Open economy: The extent of a country’s involvement in international
trade and finance The South African economy may be described as an open
economy.

Globalisation: The process whereby the world’s economies have become

increasingly integrated.

See Box 16-1 International trade and financial organisations

(Textbook page 300)
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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain why international trade occurs

16.2 WHY COUNTRIES TRADE

• Why do individuals trade?

• What is the basis for specialisation and exchange?

• Same applies to countries

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE LO: explain why international trade occurs

Absolute advantage

Absolute advantage: When a country, company or individual can produce a

good or service at a lower cost per unit (i.e. most efficiently) than any other
entity can produce the same good or service.

• Benefits of trade obvious

• Specialise in what you are best at

But what if an individual or country is better at everything than another

individual or country?

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE LO: explain why international trade occurs

Comparative (or relative) advantage

Comparative advantage: Two countries will benefit from trade in specific
goods with one another if the opportunity costs of production (or relative
prices) differ between the two countries.

• As long as opportunity costs (or relative prices) differ, there is always

scope for trade

• Specialise where opportunity costs are lowest

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE
LO: explain why international trade occurs
Comparative (or relative) advantage

Germany 2 cars OR 8 barrels of wine per day

South Africa 1 car OR 6 barrels of wine per day

• Germany has an absolute advantage in both

• South Africa has a relative advantage in wine:
Opportunity cost of 1Τ6 of a car for 1 barrel of wine;
Lower than in Germany: 1Τ4 of a car for 1 barrel of wine
• Germany has relative advantage in cars:
Opportunity cost of 4 barrels of wine per 1 car;
Lower than in South Africa: 6 barrels of wine per 1 car

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE
LO: explain why international trade occurs
Comparative (or relative) advantage

• Germany → cars
South Africa → wine
then trade at (for example) 5 barrels of wine per 1 car

• Exchange ratio must lie between the opportunity cost ratios

• If opportunity costs are similar in both countries – no benefits from

specialisation and trade

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE
LO: explain why international trade occurs
Comparative (or relative) advantage

Figure 16-1 Production possibilities in Germany and South Africa (Textbook page 303)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
WHY COUNTRIES TRADE LO: explain why international trade occurs

Comparative advantage in action

Countries do not trade with each other, firms do.

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CHAPTER 16: THE FOREIGN SECTOR
 LO: identify various possible trade barriers

16.3 TRADE POLICY

Trade policy: Government policy that has the purpose of opening the
economy to and benefitting from international trade, while protecting
domestic firms from foreign competition and controlling the volume of
imports entering the country.

Measures include:
• Import tariffs
• Import quotas
• Subsidies
• Non-tariff barriers
• Exchange controls
• Exchange rate policy

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the foreign exchange market

16.4 EXCHANGE RATES

Exchange rate: Price of a currency in terms of another currency

See Box 16-2 Direct and

indirect quotation of
exchange rates
(Textbook page 305)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

The foreign exchange market

Foreign exchange market: The international market in which one currency
can be exchanged for other currencies.

• Foreign exchange market (forex market)

– demand for a currency
– supply of a currency
– equilibrium exchange rate

• Appreciation and depreciation

NB: Always check which currency is being analysed – important because

exchange rate always involves two currencies

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Figure 16-2 The foreign exchange market

(Textbook page 306)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
EXCHANGE RATES LO: explain how exchange rates are determined in the
The foreign exchange market foreign exchange market

• The demand for dollars

See Box 16-3 The speculative nature of the foreign exchange market (Textbook page 310)

• The supply of dollars

• The equilibrium exchange rate

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Changes in supply and demand: currency depreciation and appreciation

Figure 16-3 A decrease in the supply of

dollars (Textbook page 307)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Table 16-1 Changes in supply and demand of dollars: a summary (Textbook page 308)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Table 16-2 Impact of changes in rand/dollar exchange rate for South Africa (Textbook page 308)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Intervention in the foreign

exchange market

Figure 16-4 Managed floating

(Textbook page 309)

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: explain how exchange rates are determined in the
EXCHANGE RATES
foreign exchange market

Exchange rate policy

Exchange rate policy: The manner in which a country manages its currency
in respect to foreign currencies and the foreign exchange market. The
exchange rate policy is managed by the central bank.

With a floating currency, there are basically only three policy options:
• Do nothing
• Intervene in the foreign exchange market
• Use interest rates to influence

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 LO: define the terms of trade and explain their significance

16.5 THE TERMS OF TRADE

Terms of trade: The ratio between export prices (expressed as an index) and
import prices (also expressed as an index); the rate at which a country can
trade domestically produced goods for imported goods.

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR
 IMPORTANT CONCEPTS
• Open economy • Indirect quotation
• Globalisation • Appreciation
• Absolute advantage • Depreciation
• Comparative (or relative) advantage • Foreign exchange market
• Equal advantage • Floating exchange rates
• Trade policy • Speculation
• Import tariffs • Managed floating
• Import quotas • Exchange rate policy
• Exchange rate • Terms of trade
• Direct quotation

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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 16: THE FOREIGN SECTOR