ACJC H2 External Macro Issues Lecture Notes

©ACJC Econs Dept/2024/External Macroeconomic Issues 1 ANGLO-CHINESE JUNIOR COLLEGE JC2 Economics H2 EXTERNAL MACROECONOMIC ISSUES Exchange Rate & Balance of Payments Section Contents Page 1 Overview of External Macroeconomic Aims and Problems 3 2. Exchange Rate 5 3.1 Exchange Rate Determination 5 2.2 Importance of Exchange Rate Stability 8 2.3 Impact of Exchange Rates on an Economy 9 3. 3.1 Balance of Payments: Definition and Components 11 3.2 Rationale for a Healthy Balance of Trade 15 3.3 Balance of Trade Deficit: Causes 16 3.4 Balance of Trade Deficit: Consequences 18 3.5 Balance of Trade Deficit: Desirability 20 3.6 Capital and Financial Account Deficit/Surplus: Causes 21 Learning Reflection 23 Annex: Balance of Trade Surplus: Consequences 24 References: 1. Principles of Economics: Case, Fair & Oster, 11th edition, chapter 35 2. Principles of Economics, Asian Edition: Mankiw, Quah & Wilson, chapter 31 3. Economics: John Sloman & Alison Wilde, 7th edition, chapter 25

©ACJC Econs Dept/2024/External Macroeconomic Issues 2 UNIT SUMMARY Most countries trade with and have financial transactions with the rest of the world. With economies being open to trade and capital flows, no economy operates in a vacuum and economic events in one country can have significant repercussions on the economies of other countries. Recall that t he strength of a country’s aggregate demand (AD) is not only dependent on consumption, investment and government expenditure on domestic goods & services, but also on exports of both goods and services. Apart from international trade, capital and financial flows between countries also have a major impact on the performance of an economy. The global economic inter -connectedness makes countries vulnerable to economic volatilities, particularly for the highly open economy of Singapore. This unit examines the relationship between a country’s balance of payment and its macroeconomic aims. It is essential to examine a country’s balance of payment because macroeconomic issues arise due to a confluence of internal and external factors many of which are often interrelated. The complexity and relatedness of domestic and external macroeconomic problems makes them difficult to solve and policy decisions will also involve hard choices and constraints. The choice of economic policies adopted by governments will depend on their economic priorities and the economic characteristics of their countries. LEARNING OUTCOMES: Students will have an understanding of the following: • Determinants of a country’s exchange rate • Current, capital & financial accounts of Singapore balance of payments • Causes of balance of trade (BOT) disequilibrium • Role of foreign direct investment (FDI) and its impact on the Singapore economy • Consequences of balance of trade deficit and surplus from perspectives of different economic agents (households, producers and governments) Essential Questions: 1. What causes external imbalances in a country’s balance of trade and exchange rate? 2. How would such external imbalances impact a government’s objective in attaining macroeconomic goals?

©ACJC Econs Dept/2024/External Macroeconomic Issues 3 In this set of notes, we will be studying the 4th macroeconomic objective (Favorable Balance of Trade ) and its related problems. It is important to understand the causes and the consequences of this problem and how it can impact the domestic macroeconomic objectives. As the Balance of Trade is heavily influenced by the exchange rate between currencies, it is first important to understand the determinants of the exchange rate. The Balance of Trade is a component within the Balance of Payments. While the focus of the external macroecon omic objective in our syllabus is on Balance of Trade only, knowledge of the key components of the Balance of Payments account will help us understand the implications and effects of changes in the BOT better. Later in the term, we will learn about the policies used by governments to address the problems of having an unfavourable position of Balance of Trade. SECTION 1: OVERVIEW OF EXTERNAL MACROECONOMIC ISSUES Favourable position of Balance of Trade (BOT) Persistent and large Balance of Trade Deficit / Surplus SLS Lesson: “Overview of External Macroeconomic Issues”

©ACJC Econs Dept/2024/External Macroeconomic Issues 4 Article: South Korea’s Rising Trade Deficit with China South Korea’s growing imports of secondary battery materials and intermediate goods from China were blamed for South Korea’s trade balance with China which is expected to post its first deficit in 31 years. According to the Bank of Korea (BOK) on Dec. 20, South Korea’s trade balance with China posted a deficit of US$18 billion through November this year. The balance of trade has been in deficit every month this year, starting with a US$3.9 billion deficit in January. As the overall trade deficit hit US$14.31 billion through last month, South Korea’s trade deficit with China accounts for a significant portion. While South Korea imported raw materials from China and sold intermediate products which South Korea made with the raw materials to China, the game has begun to change as China began to invest heavily to boost its self -sufficiency in intermediate products. At the same time, the two countries’ roles have been completely reversed as Korean secondary battery producers rely on China for most of their raw materials and import intermediate materials such as batteries from China. “In terms of secondary batteries, China exports a lot to the rest of the world because of its technological superiority and price competitiveness,” said a BOK official. Accordingly, voices are growing that South Korea needs to expand its exports from intermediate goods to consumer goods, develop technology and diversify its import and export markets in order to respond to the reversed trade situation with China. Source: Business Korea, 21 Dec 2023 Pre-Lecture Questions: (a) Explain the reason why South Korea’s balance of trade deficit is growing. (b) What are some ways for South Korea to reduce its trade deficit? (c) What are some likely consequences for South Korea’s economy should they fail to do so?

©ACJC Econs Dept/2024/External Macroeconomic Issues 5 2.1 EXCHANGE RATE DETERMINATION International trade and capital flows (foreign direct investment, financial investment and other funds) between countries require the use of exchange rates for conversion between different currencies. This section explains how the exchange rate of a currency changes and is determined. The concepts of appreciation and deprecation will be explained too. The exchange rate of a currency is its price in terms of other currencies. It is the external price of a currency. Exchange rate is primarily determined by demand and supply conditions in the foreign exchange market (forex market). Even if there is central bank’s intervention in influencing the exchange rate, this intervention will usually be done through intervention in the forex market (through the buying and selling of the domestic currency). How Is Exchange Rate Determined? To understand how exchange rate is determined in a floating exchange rate system, apply your knowledge of the working of markets. Recall that: • Demand curve in a market is downward sloping + rightward shift of demand (increase) applies upward pressure on equilibrium price and quantity (appreciation). • Supply curve is upward sloping + rightward shift of supply (increase) applies downward pressure on equilibrium price and quantity (deprec