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The International Economy

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The International Economy

Governments, businesses, and individuals around the world are waking up to the realisation that everything around them is interconnected. This interconnectedness is not just within their national borders, but with the governments, businesses, and individuals of other countries, directly or indirectly. This global interconnectedness has some advantages and disadvantages. Let’s learn about the international economy and how it connects us all.

Understanding the international economy

The international economy refers to economic activity around the world.

The International Economy Illustration showing Symbols of currencies around the world StudySmarterFigure 1. The international economy, Alanna Odagbu. Made with icons from Flaticon - StudySmarter Originals

When economists study the international economy as a whole, they look for patterns in any transactions between individuals, firms, and governments in different countries.

Most economics studies will look at countries' trades, investments, and any other financial or political transactions. But why do countries engage in trade with other countries? And what is the importance of international trade?

The International Economy: Differences in resource endowments

Every country has different endowments that their land naturally has.

The resource endowments of a country consist of its natural resources, its workflows (the workers’ skills and abilities), and its capital stock that is made up of machinery, infrastructure, etc.

The Democratic Republic of Congo (DRC) is abundant in natural wealth like diamonds, gold, copper, coffee, and oil.

Because of the difference in resource endowments, countries engage in advantageous trade to benefit from each other's resource endowments and add to their economic activity.

Unlike the DRC, the United Kingdom (UK) is not abundant in natural resources. Therefore, the UK would initiate a trade deal with the DRC so it can have gold and add it to its economic activity.

The International Economy: Differences in technology

Countries also differ from each other in terms of technology.

Technology turns input (resources) into output (goods and services).

Technology can help countries produce goods and services at a cheaper cost or make higher quality products that they can trade with.

The International Economy: Differences in demand

Demand is different in each country. This could be due to many reasons. One of the main reasons is the difference in consumers’ preferences and tastes.

Consumers in China may demand more rice than consumers in Canada. Consumers in Canada might eat more bread than consumers in Germany, who prefer and demand more beer than consumers in France.

These demands and preferences can’t be fulfilled often by domestic resources. Hence the need to engage in international trade.

The International Economy: Economies of scale

Some firms in certain countries can produce a particular good or service at lower costs than others. Using economies of scale, countries, where the production costs are lower, would trade with countries where the domestic production of those goods or services would be more expensive.

Don’t worry if you are unsure of what economies of scale are. Our Economies of Scale explanation will help you.

The International Economy: Government policies

Certain government policies like subsidies, tariffs, and quotas help firms achieve lower production costs. That way they can engage in the trade and exchange of those goods and/or services.

International economic relations and business international relations

International economic relations play a huge part in the international economy. These interactions include trade in goods, services, assets, and ideas. These, in turn, lead to the development of new rules, regulations, and policies like tariffs, trade quotas, controls on the international flow of capital and the exchange rate regime.

Having strong international economic relations is important and beneficial. It is important because it helps economists understand the workings and transitions of past societies. Additionally, as the world becomes more interconnected, having good relations with every nation is important to maintain peace and cooperative relations.

Global issues highlight another importance of international economic relations. There are many issues, like climate change, pandemics, etc. that are faced everywhere around the world. Having strong and stable relations between countries will allow them to take on these global concerns. This allows nations to share relevant information and their pool of resources quickly.

As we looked at earlier, countries trade for many different reasons. Having good economic relations allows for effective trade policies. These policies benefit national businesses, allowing domestic firms to have good business international relations with other international firms. They will be able to trade their goods and services perhaps more freely, and this helps the businesses grow.

An example of this is the travel and tourism industry.

Importance of travel and tourism to the international economy

Tourism contributed 10.4% to the global economy in 2018.1 There are millions of jobs in the tourism industry and many more millions are being created. Having strong economic relations benefits many firms in the industry.

Tourists have a high marginal propensity to consume, so having a lot of tourists means an increase in consumption in a country’s economy. The tourists’ spending increases aggregate demand (AD) and thus a country’s GDP.

Job creation is the key benefit that highlights the importance of travel and tourism to the international economy. It creates jobs in a country which boost their economy, as well as the global economy.

Croatia is a good example of how travel and tourism can impact an economy. In 2019, the country generated $13 billion from tourism alone. With a population of 4 million, 25% of the population work in the travel and tourism industry.

The political economy and the international economy

Often, economics and politics go hand in hand, so it's no surprise that the political economy also has an impact on national economies. The behaviour of governments and the central authorities’ decisions on economic issues all over the world are bound to structure the world's economy.

We can explain this with an example:

Country A and Country B have been trading partners for centuries. Country A is now facing social and political unrest. The government in Country B doesn't agree with how the situation is being handled in Country A, so they decide to cut their trade agreements and impose sanctions on Country A.

In the example above, we can see how the political economy can impact the international economy. It was beneficial to both countries to trade with each other. Politics has influenced Country A to condone the actions of Country B, which leaves both countries in a worse off position.

Trade for developing and developed economies

We have considered some reasons why a country might engage in trading their goods and services. But some reasons and motivations for trade will differ between developing, emerging, and developed economies.

Let's take a look at some reasons each type of economy might have.

Trade for Developing economies

International trade can really benefit developing countries' economies. Some benefits are:

  • Reducing poverty.
  • Fast economic growth.
  • Higher incomes.
  • Increased number of goods and services available.
  • Increased investment.

Trade for Emerging economies

International trade can benefit emerging countries' economies too. Some benefits are:

Trade for Developed countries

Even though developed countries experience sustainable economic growth and development, they can still benefit from international trade. Some benefits are:

  • Maintaining high standards of living.
  • Can produce goods cheaply because of the availability of cheap labour.
  • Greater choice for its citizens.

Digital trade is the future of the international economy?

Besides the conventional international trade and the tourism industry, another emerging trend in the international economy is that of the 'digital trade' enabled by the Fourth Industrial Revolution, technological change, and digitalisation. But, what is digital trade?

Digital trade is digitally enabled or digitally ordered cross-border transactions in goods and services which can be digitally or physically delivered.

Digital trade is enabled due to the decreasing costs of sharing information, which results in more international trade, more transactions, or order processing across borders, a rise in trade of services that can be digitally delivered, and consequently increased data flows across borders.

The reason why digital trade could be the future of the international economy is that thanks to it countries can sell more products and reach more markets.

Previously, digitalisation was only being promoted for sectors such as textiles, manufacturing, agriculture, and healthcare, but its importance for exports and digital deliverable services is increasingly prominent.

But digital trade is no different from other conventional trade for the risks it faces with trade barriers. These could look like barriers that can affect communications infrastructure or measures that can negatively impact e-payments. These barriers could limit a firm's ability to offer digital services that can compete against other firms in the international market.

Structure of the international economy

Let's take a look at some of the articles StudySmarter has on the international economy.

Structure of the international economy: Globalisation

As we mentioned previously, the world is more connected than ever before. This increasing interconnectedness is known as globalisation.

In our explanation of Globalisation, you will understand the characteristics of globalisation, its benefits and drawbacks, and the impacts of globalisation on both developing and developed countries.

With the topic of globalisation come three more interesting topics:

  1. Free Trade
  2. Protectionism
  3. Trading Blocs

Globalisation: Free Trade

Free trade is all about international trade without restrictions. Free trade makes the world more connected as there are no barriers to international trade.

In our explanation about Free Trade, you will learn about the benefits and costs to free trade and the UK's pattern of trade.

Globalisation: Protectionism

Protectionism is the complete opposite to free trade. It is trade with government-specific restrictions. Its main aim is to benefit domestic firms in an economy.

Our Protectionism explanation will consider the different types of protectionist policies a government can implement. It will also explore real-life examples of these policies, and the benefits and costs of protectionism.

Globalisation: Trading blocs

We have looked at some reasons why a country might engage in trading with other countries. But how does each country know who to trade with and what to trade for?

Our Trading Blocs explanation will help you answer those questions. You will understand the different types of trading blocs that exist and study real-life examples. You will also learn about two other important concepts in the international economy: trade diversion and trade creation.

Structure of the international economy: Exchange rate

When countries engage in international trade, they must bear in mind that every country has different currencies.

Our Exchange Rate explanation will help you understand the different types of exchange rate systems that exist and how you can calculate a foreign exchange rate.

Floating exchange rate

As mentioned previously, there are different types of exchange rates. Our Floating Exchange Rate explanation will discuss this type of exchange rate system in more detail. You will understand how it differs from the other exchange rates and how it is determined.

Fixed exchange rate

Our Fixed Exchange Rate explanation will discuss this type of exchange rate system in more detail. You will understand how it differs from the other exchange rates and its costs and benefits.

Structure of the international economy: Specialisation

Specialisation focuses on international trade in detail. It considers what countries should produce, what goods and services, and why.

In the Specialisation article, you will understand trade from a more mathematical point of view.

The International Economy - Key takeaways

  • The international economy is the economic activity around the world.
  • When economists study the international economy as a whole, they look for patterns in any transactions between individuals, firms, and governments in different countries.
  • Some of the reasons for international trade are the differences in resource endowment, the differences in technology, the differences in demand, economies of scale, and government policies.
  • Globalisation is known as the increasing level of interconnectedness.
  • International trade without restrictions is known as free trade, and international trade with restrictions is protectionism.
  • There are many different types of exchange rates, two are fixed and floating exchange rates.
  • International trade causes some countries to specialise in producing a particular good or service.

Sources

1. James Reily, 'How important is international tourism to the global economy?', Schrodes 2020.

Frequently Asked Questions about The International Economy

In the year 1929, Wall Street crashed and caused the Great Depression. This triggered a collapse of the international economy. It was further made worse by the policy decisions of the government of the United States. Tariffs, as well as speculation, are considered to be the causes that led to it.

International trade is the biggest factor that drives the international economy. It forms the basis of patterns of trade between countries. Each country makes decisions for its allocation of resources in the domestic economy based on specialisation and the comparative advantage it has over other countries and their trading partners.           

The international economy consists of international trade, international investments, and international finance.


International markets, the competitive behaviour of firms, and the role and relationship of the governments with all of these actors form a major part of the international economy. 

Some examples of international economics are international trade, comparative advantage and opportunity costs, competition, specialisation, international finance, international relations, and the global financial system.

International economics is the study of the economic activity between different countries in the international market.


The interaction of countries over trade, finances, investments, aid, technological assistance, etc. results in many challenges and problems, and the field of international economics aims to study these areas to solve the issues and avert international crises.

Final The International Economy Quiz

Question

What is globalisation?

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Answer

Globalisation is a process of growing integration of the world's economies, populations, and cultures. 

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Give three characteristics of globalisation.

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Answer

Any three of:

  • Greater international mobility of capital
  • Growth of international trade 
  • Reduction of trade barriers and trade liberalisation (WTO)
  • Increased power of multinational corporations (MNCs)
  • Greater international mobility of labour
  • Deindustrialisation of previously industrial regions
  • Decreased power of governments
  • Reduced distance between countries (technology development)
  • Lower transportation costs (transport development)

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What are MNCs?


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Answer

Multinational corporations (MNCs) are companies that operate in at least one country other than their home country.

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What is WTO?


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WTO stands for World Trade Organization. It is an international organisation that encourages countries to trade with one another by promoting free trade.

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What is free trade?


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Free trade refers to reducing or completely removing import tariffs and any other trade barriers.

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What are two advantages of globalisation regarding labour and jobs?


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Any two of:

  • New job opportunities leading to the reduction of poverty and the increased output and productivity of an economy. 
  • Filling labour and staff shortages by immigrants preventing an economy from being stagnant.
  • Increase in migration of highly qualified labour sharing new skills and technologies.

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How does globalisation influence politics?


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Answer

It encourages international cooperation between countries and governments.

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What is FDI?

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Foreign direct investment

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What encourages companies to expand internationally?


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Technology development, transport development, new customers, revenue increase, cheaper labour, and lower land costs.

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What are three disadvantages of multinational corporations?


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Answer

Any three of:

  • Environmental pollution
  • Driving local companies out of business
  • Encouraging political corruption
  • Monopoly creation
  • Labour overuse
  • Repatriating profits 

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Question

Provide a definition of developing countries.


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Developing countries are countries with a low level of economic development, low income per person, and low living standards. Their economy is typically dependent on export.

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What is the dominant industry in developed countries?


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Answer

The service industry.

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What are the consequences of globalisation on developed countries?


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  • Closing factories and moving them to less developed countries
  • Increasing social inequalities
  • Higher number of immigrants
  • Market dominated by multinational corporations
  • Increased business competitiveness

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What are the three main ways in which globalisation affects the environment?


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Growth of multinational corporations, transport development, and environmental awareness.

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Define specialisation.

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Specialisation occurs when a country focuses on the production of a narrow range of goods or services to increase its efficiency.

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What is the absolute advantage?

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Absolute advantage is an ability of a country to produce more of a good or service than other countries from the same amount of resources.

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What is the comparative advantage?


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Comparative advantage is an ability of a country to produce a good or service at a lower opportunity cost than other countries.

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Define opportunity cost.


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Opportunity cost is a potential benefit that was missed when choosing an alternative option.

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What theory states that the difference in costs of production between countries is related to the relative amounts of factors of production?


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Heckscher-Ohlin theory

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According to the Heckscher-Ohlin theory, what are the three factors of production?

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Capital, labour, and land.

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Does specialisation maximise the output?


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No

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Give a real-life example of specialisation.

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China specialises in the production of clothes. It is because the country has a high level of cheap labour.

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What are the three types of globalisation?

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Economic, political, and cultural globalisation

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Define free trade.

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Free trade is international trade without restrictions.

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Give some examples of trade barriers.

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Tariffs, quotas, subsidies, embargoes, product standard regulations.

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What is EFTA?


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European Free Trade Association is a free trade agreement between Norway, Iceland, Switzerland, and Liechtenstein.

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What is the North American Free Trade Agreement?


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A free trade agreement between the United States, Mexico, and Canada.

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Who receives the most welfare in the world of free trade?


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In the world of free trade, welfare is transferred away from domestic firms to domestic customers.

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What happens to the price of imported and domestic goods in the world of free trade?


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The price of imported goods and services is lower than the price of domestic goods.

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What is the impact of imposing tariffs and duties?


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Imposing tariffs can increase the welfare of domestic producers.

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How to measure the government’s tariff revenue?


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The government’s tariff revenue is measured by total imports multiplied by the tariff per unit of imports.

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What are trading blocs?

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Trading blocs are associations and agreements between different governments around the world with the purpose of managing and promoting trade between countries. These agreements help reduce or sometimes entirely remove trade barriers or protectionist policies which then help to improve and increase trade. 

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What are the types of trade blocs? 

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The different types of trade blocs are Preference areas, Free trade areas, Customs unions, Common markets, Economic unions, Monetary unions, and Political unions. 

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What are some advantages of trading blocs? 

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  • Free trade results in lower prices and more opportunities which is good for economic growth.
  • Greater specialisation.
  • More consumer choices.
  • Free movement of factors of production.
  • Improving relations between countries.
  • An opportunity for smaller countries to be involved in the international economy.

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List four major disadvantages of trading blocs.

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Answer

  • Higher trading costs with non-member countries
  • Membership of trading blocs is mutually exclusive
  • Loss of sovereignty and independence
  • Higher dependence on the economies of member countries 

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What are the most common features of the EU? 

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  • It functions as a customs union
  • It forms the basis of the Single Market system
  • The EU member countries have no trading borders and all goods move freely within the EU borders, whether domestic production or imported from outside of  the EU (trade with non-members) 

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How do trading blocs lead to trade creation? 

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Trade creation happens with the removal of barriers and new patterns of trade emerge. Countries opt for the cheapest source to procure products and/ or services. 

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What is the idea behind trade diversion in trading blocs? 

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Trade diversion is when trade is diverted away from any cheaper non-members because of trade barriers imposed on anyone outside of the union. This puts the non-member countries who have a comparative advantage in those products and/or services in a disadvantaged position. 

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Some of the biggest trading blocs in the world are: 


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  • European Union (EU)
  • European Free Trade Association (EFTA)
  • North American Free Trade Agreement (NAFTA)
  • Mercado Comun del Cono Sur or Southern Common Market (MERCOSUR)
  • ASEAN Economic Community (AEC)
  • Common Market of Eastern and Southern Africa (COMESA) 

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What is a fixed exchange rate system? 

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A fixed exchange rate system is where the rate is fixed or set up through government intervention. Either the government or the central bank decides and sets the exchange rate. 

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How is the target rate determined in a fixed exchange rate? 

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This target rate could depend on the economic goals or objectives being pursued by the government through trade or foreign exchange. 

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What are the other terms for the 'target rate'?

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The exchange rate fixed by the central bank or the government is the target rate and is also called 'central peg' or 'central rate', 'parity' or 'par value'. 

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What is 'ceiling' and 'floor' in a fixed exchange rate system? Explain with an example. 


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The ceiling is the upper limit while the floor is the lower limit in an exchange rate system. For example, if the government decides the central rate on 1.5 euros, the ceiling rate could be 1.55 euros while the floor rate could be 1.45 euros. 

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What is the role of the foreign exchange market in a fixed exchange rate system? 

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Once the government or the central bank have fixed the exchange rate along with its upper and lower limits, it is left to fluctuate in the foreign exchange market freely. It is not tempered until it stays within the exchange rate band. 

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What are two ways used to bring the exchange rate back within the exchange rate band (ceiling to floor) determined by the government or the central bank, if and when breached? 


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Answer

The two ways used are exchange equalization which is buying or selling its own currency and manipulation of the domestic interest rate in the economy.

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What does the central bank do, in case of exchange equalization, if the exchange rate crosses the ceiling rate? 

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Sell its own currency

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How does the central bank use its official foreign reserves if the exchange rate drops below the floor rate? 

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To bring the exchange rate above the floor rate, the central bank buys its own currency in the foreign exchange market. 

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What role do the domestic interest rates play in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

In the case of intervention through interest rates, if the exchange rate crosses the ceiling rate, lowering interest rates might trigger international holders of domestic currency to sell it in the Forex market. If the exchange rate drops below the floor rate, then increasing interest rates will attract investment into the country's currency and this will likely push the exchange rate up to a point where it is within the exchange rate band. 

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What is the downside to using interest rates in maintaining the exchange rate in a fixed exchange rate system? 

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Answer

When interest rates are used to maintain the exchange rate in a fixed exchange rate system, they cannot be used for any other domestic macroeconomic objectives such as low unemployment or economic growth. 

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Question

What is the idea behind protectionism?

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The idea of Protectionism is an attempt to protect domestic industries from foreign competition.

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