National Debt

The national debt is the amount of money that a government owes to lenders. For example, when
you buy a government bond, you are lending money to the government. The amount owed to you
and other lenders is the national debt. The debt grows whenever the government has a deficit
because the government is borrowing more money.
National debt stock/flow
Lets think about this question using the bathtub as a metaphor. A countrys national deficit is
similar to the flow of water into a bathtub; the deficit is the rate at which the country borrows
money. The countrys national debt is like the water in the bathtub. It is the stock of accumulated
debt. By turning the faucet down and reducing the deficit, the rate at which the debt accumulates
will slow down, but the debt itself will still keep accumulating. To reduce the stock of debt
would require that the flows out of the stock be greater than the flows in. This would require
paying off the debt at a higher rate than money is borrowed.
Fiscal indiscipline
When government is greater than government revenue.
Domestic and Foreign debt
Domestic debt consists of borrowing locally. The government is simply moving money around
from one group to another. To pay off the people it owes interest it borrows from another group.
When they must be repaid it borrows from another group. The money remains in the country and
the wealth of the country has not changed.
Foreign debt is money owed overseas. Interest must be paid to foreigners in foreign currency.
Therefore the country has to export goods and services to earn foreign currency. This payment or
servicing of the debt represents a loss to the nation and a burden on the society as this money
could have been more useful in producing goods and services.
Causes of the national debt
Persistent budget deficits increase the national debt. If the debt is rising faster than the GDP the
problem worsens. The causes of the debt include:
1. The negative effects of external shocks and natural disasters. Substantial amount of
resources may be needed to rebuild the economy some of which will have to be borrowed
from abroad. Adverse movement in terms of trade (X< M) also forces government to
borrow to meet certain fiscal needs.
2. To cover public sector consumption even when revenues are stagnant or declining.
Mismanagement of funds is also a big problem in Caribbean economies.
3. To speed up growth and development process.

The effects of the national debt on the economy

1. Output and investment decisions
Interest payments reduces money available to be spent on education, encourage the growth of
non-traditional sectors who have comparative advantages in trade and the creation of better
infrastructure to attract foreign direct investment inflow of export oriented sectors.
2. Exchange rate pressures
Countries may be unable to finance current account deficits because debt servicing reduces
the amount of foreign currency reserves. Export revenues maybe reduced worsening the
Balance of Payment position and causing the currency is depreciated as more foreign
currency is demanded to service the debt.
3. Inflation
National debt should be looked at in real terms and not nominal terms. As the inflation rate
increases the government gains and the debt holder loses because inflation reduces the real value
of the debt. The real burden of the debt falls as inflation rises.
4. Crowding out and crowding in
Crowding out
Where a country cannot lower its consumption levels in order to release resources to service the
debt the government may borrow from the domestic commercial banking system. This increases
the demand for loanable funds causing the interest rate to rise as government competes with
firms for capital leading to a crowding out private sector investment as less capital is available
for the private sector.
Crowding in
This is where increasing national debt is meant to stimulate growth and development in the
borrowing economy. Once the economy is expanding and economic activity is growing and
businesses have confidence in the buoyancy of the economy then domestic investors will invest.
The responsibility of debt payment
This refers to the burden of the debt which includes:
1. the size of the debt in relation to the ability to pay
2. who pays the debt, that is whether one government borrows and another government pays
interest payment.
The burden is bourne by:

1. The present government. This generation has to go without consumer goods in order to
purchase capital goods. Eg. If government borrows to finance crime fighting resources
are directed from providing consumer goods to buying guns etc.
2. When money is borrowed for corrupt or fiscally irresponsible activities the entire society
bears the burden.
Management of the national debt
1. Internal and external borrowing
Internal borrowing keeps wealth at the same level but external borrowing results in a leakage of
resources. External borrowing also has conditionalities especially when borrowing from the IMF
and WB. For instance they require that the government to play a minimal role in the economy
which may result in unemployment and poverty.
2. Taxation
Reforming the tax system
3. Debt Rescheduling
This is an agreement between creditors and debtors by which a new schedule and timetable for
the debt repayment is negotiated. Some of the debt can be written off or the repayment of debt
extended.
Debt retirement
A debtor (bank/country) paying off the outstanding amount owed as debt so that there are no
longer any repayment obligations.

4. Debt Forgiveness
Where a creditor (bank/country) decides to efficiently write off from the official records all
outstanding payments owed to it by a borrower from official records so that the debtor no longer
has an obligation to make outstanding payments.
Debt service Ratio
Principal + Interest x 100
Export

This measures the security of the debt burden of the country. If the ratio is increasing it impacts
negatively on the countrys export earnings ie more export earnings is being used to service the
debt.
Developing countries and the national debt
1. Large portion of the GDP used to service the debt and less for local development which
brings hardship on the population.
2. reduction in economic growth
3. lower standard of living
4. high taxation
5. reduced spending on infrastructure and investment
To reduce the debt burden
1.
2.
3.
4.
5.
6.

reduce external borrowing

seek more grants from international institutions which usually do not have to be repaid
debt forgiveness and cancellation
repay regularly to avoid increased interest payments
avoid rescheduling the debt
Change loan profile from short term to long term.

Public sector borrowing requirement

The annual change in debt from year to year
Review questions
1. How is the national debt measured?
2. How does a government incur debt?
3. What are the measures used to reduce the debt?
4. How does the national debt affects the Balance of Payment?
5. How does the conditions of the IMF impacts on the country?

THE END

International Economic Relationship

World Trade Organisation (WTO)
Emerged out of the General Agreement on Tariff and Trade (GATT). It came into existence
January 1, 1995. It administers agreements regarding trading of goods, trade in services (GATS)
and trade in related intellectual property(s) (TRIPS). Member countries try to reduce the level of
protectionism between them.
Role and Functions
1. to administer and implement the multi-lateral and pluri-lateral trade agreements.
2. to act as a forum for negotiation
3. to seek to resolve disputes
4. oversees national trade policies. This is done through the traded policy review
mechanism.
5. to cooperate with other international institutions involved in global economic policy
making such as the IMF and World Bank
Principles of the WTO
1. Non-Discrimination
a) Most favoured nations clause Any trade concessions made to one country must be
granted to all members. Exceptions include countries which have free trade areas and
customs unions where trade restrictions are eliminated between member states but
maintained with the rest of the world.
b) National Treatment imported goods must be treated equally with domestic goods and
services.

2. Reciprocity any nation which benefits from another country must reduce tariffs itself.
3. Quotas this is discouraged and tariffs recommended.
4. Fair trade unfair barriers or dumping is not allowed and sanctions will be brought
against countries that do this without permission.
5. Market Access promoting an open trading system
6. special arrangements for developing countries poorest countries are given longer
periods of time to reduce barriers to the agreed levels and to be given various trade
concessions.
7. They have the power to impose sanctions unlike the GATT

The International Monetary Fund (IMF)

Designed to be the central institution of the post war monetary order which was initially shaped
by US national capitalist assumptions. It was established as a part of the Bretton Woods system
in 1944 now a part of the united nation. It was intended to supply international liquidity to
members with Balance of Payment problems. It has short term focus designed to support the
flow of international trade. It has become deeply involved in domestic macroeconomic policies
as a means of assisting countries in difficulty to restore balance between the international
political economy. It was designed to operate in the relatively stable international conditions after
the post war transition period.
Role and Functions
1. to promote monetary cooperation through a permanent institution which provides
consultation and collaboration on monetary problems.

2. to facilitate the expansion and balanced growth of trade and hence promote and
maintain high levels of employment and real income and the development of
members productive resources.
3. to promote exchange stability, to maintain orderly exchange arrangements among
members and to avoid competitive exchange depreciation.
4. to assist in the establishment of a multilateral system of payments in respect of
current transactions between members and in the elimination of foreign
restrictions which hamper the growth of trade.
5. making general resources of the fund temporarily available to members so as to
correct Balance of Payment problems.
6. to shorten the duration of and lessen the degree of disequilibrium in the
international balance of payment of members.

The International Bank for reconstruction and Development (IBRD) or the World Bank
The World Bank was established to facilitate the rebuilding of developed countries shattered
after WW1 as the international community expanded to eventually assist in the more basic task
of economic development of least developed countries.
Main Goals
1. to promote sustainable economic development
2. to reduce poverty
3. to promote long term economic development
Role and Function

1. Provide long term assistance to help countries in their economic reconstruction and
development progress.
2. Offers technical research advice. They do not finance full project but requires that
developing economies have some financial input.
3. Providing loans, guarantees and related technical assistance for projects and programmes
in its developing members.
4. Assist with infrastructural development such as building roads, bridges, schools, hospitals
and so on.
Multinational (transnational) Corporations
These have plants or subsidiaries all over the world. They invest to:
1. Access raw material and markets
2. to avoid trade barriers
3. lower labour cost
4. technical and organizational advantages over locals
Factors influencing location of MNCs or FDIs
1. macroeconomic stability
2. tax concessions/ holidays
3. political stability
4. less trade barriers
5. subsidies
6. low cost of production (cheap labour)
7. less stringent government regulations

Why MNCs may leave a country

1. economic and political instability
2. civil unrest
3. strict labour restrictions (trade unions)
4. strict trade barriers
5. high levels of taxation
Foreign Direct Investment (FDI)
The movement of capital across national borders which gives investors control over the
assets they acquire. It is investment by non-residents in a domestic firm they thereby
establish or come to control because of that investment.
OR
Non-residential investment in the form of a takeover, mergers or capital investment in a
domestic branch, plant or subsidiary corporation in which the investor has voting control.
The nature of FDI
1. equity or portfolio investment
2. establishment of a new firm usually a subsidiary of a foreign based multi-national
company
3. takeover of an existing firm, usually through the sale of ownership to foreigners.
4. mergers the assets and operations of firms from different countries are combined to
establish a new legal entity.
Benefits/Advantages
1. inflow of foreign currency without having to export more
2. increase in the countrys real wealth

3. job creation
4. Access to technology and capital. The stock of physical capital per person increases.
Improvement in technological progress for the host country
5. links local economy with world economy
6. Access to management skills. They offer scholarships and bursaries to students and
upgrade opportunities to staff. Labour training and skill acquisition is meant to improve
the stock of knowledge in the host country. FDI facilitates the introduction of alternative
(superior) managerial and organizational practices.
Disadvantages/Cost
1. crowding out of domestic business/investment in the same line of business because of
their superior technology and managerial expertise (concession given to foreigners are
usually not given to locals). Inhibits the growth of infant industries
2. introduction of inappropriate technology
3. repatriation of profits, interest and dividends which are not available to the local
economy.
4. destroys the environment of the host economy eg costal damages which occur as a result
of drilling for crude oil and deforestation in Guyana.
5. promote wage inequality in the host country as they offer higher wages than local firms.
Eg oil workers in Trinidad and Tobago.
6. transfer pricing

10

Globalization
The opening up of world trade, it refers to the integration and interdependence of the world
economy. It has occurred due to fewer barriers to trade and less protectionism.
OR
It refers to the process of a growing economic and social interdependence between all people
and countries through trade, investments and governance.
Features of globalization
1. More free trade across nations because of reduced tariffs and other trade barriers
2. Greater investment flows across nations. The amount of cross-border international
investment has increased dramatically in recent times.
3. Greater interdependence among nations as the economic fortunes of all countries have
become interlinked. Whatever happens in one country like a recession affects others.
Forces driving globalization
1. Technological innovation innovation in information technology, communication and
transport system and the internet have contributed significantly to globalization
phenomenon. Reductions in the costs of transport and transmission of data have played a
critical role in furthering the process of globalization.
2. Trade liberalization the removal of trade barriers and the signing of many free trade
agreements have also contributed to globalization. It makes it easier and less costly to
embark on international trade as trade is freer.

11

3. Liberalization of capital markets the deregulation of national financial markets in

developing countries opened the door for increased foreign capital flows, especially into
high yielding stock markets.
4. The abolition of exchange control and floating exchange rates the freeing up of the
system made international transfers of funds with these countries much quicker and more
convenient. Floating exchange rates make currency conversion easier and facilitates
international trade.
5. Privatization the privatization of major state enterprises, a policy implemented in both
industrialized and developing countries during the 1980s and 1990s provided
international investors with an additional avenue for portfolio diversification and
increased profits.
6. Financial Innovations the development of new financial instruments also made
international financial integration cheaper by reducing the cost differential between the
rate of return paid to the investor and the cost of capital paid by the ultimate borrower.
7. The growth or spread of MNCs.
Implications of globalization
1. greater competition
2. access to markets
3. Access to technology
4. cheaper prices and greater variety of goods
5. loss of preferential markets
Dangers to Caribbean economies
1. Reduced competitiveness due to slow adoption to advanced technology.

12

2. Problems in one part of the world spread other parts eg. Recession
3. greater vulnerability to world trade fluctuations
4. loss of markets; decrease in exports
5. Increase trade with developed/industrialized countries can lead greater capital flight.
6. Changes in interest rates in one country will affect financial flows to and from other
countries and hence their exchange rates, interest rates and national income.
7. eliminate infant and vital industries

Review Questions
1. Evaluate the effectiveness of THREE of the factors affecting globalization.
2. Discuss whether globalization is a help or hindrance to the international trading process.
3. Assess the pros and cons of FDIs by MNCs in terms of any THREE benefits of FDI.
4. Discuss THREE major functions of WTO, IMF and IBRD

THE END

13

Economic Integration
This is the removal of trade barriers to allow for free movement of people, money goods and
services among member states. It is the coming together of a group of countries with the goal of
increasing economic linkages among the group vis--vis the rest of the world.
Forms and stages of Economic Integration
1. Free trade area (FTA)
Elimination of tariffs within the group but each country maintains its own tariff arrangements
with other countries. This is a very low level of economic integration. Eg North American
Free Trade Area (NAFTA) between USA, Canada and Mexico.
2. Customs Union (CU)
Formed when the countries in a FTA implement a common external tariff (CET) for its
members. This means that all goods from non-member countries coming into the region will
command the same tariff rate regardless as to which member country it comes in.
3. Common market
A common market is formed when the members of a CU with free labour and capital
mobility. Eg. CSME
4. Economic Union
This is the most extensive form of economic integration. It is a common market where the
level of integration is more developed. Eg. Having a common macroeconomic policy and

14

fixed exchange rate between countries also having a single currency within the union eg.
European Union.
Advantages
1. Freer trade among the group, the movement of goods within the group will be easier;
consumers have greater choice of products, greater scope for employment across the
region.
2. Lower or no tariffs within the group. This results in saving for exporters and possibly
lower prices for consumers in the region.
3. Welfare gains trade creation when barriers are removed more trade generally occurs
than before this is called trade creation. That is, economic integration increases the
amount of trade.
4. Higher economic growth firms can take advantage of economics of scale in companies
as they produce for a larger market.
5. greater efficiency in production
6. Increases in resources used in the region which results in development and growth and
ultimately improvement in standard of living.
Disadvantages
1. Loss of tax revenues as tariffs are removed from regional goods entering any country
within the group.
2. Loss of sovereignty as countries within the groups establish closer ties. Each has to give
up some amount of national sovereignty as they now have coordinated policies towards
the rest of the world.

15

3. Brain drain within the region as educated persons may all migrate to countries that are
doing well at the time.
4. Welfare loss trade diversion the formation of FTA often diverts trade away from
relatively efficient trade partners outside of the FTA towards relatively inefficient
suppliers from within the FTA.
5. Interdependence of states making small economically weak states vulnerable to other
states.
CARICOM and CSME
CARICOM Caribbean Community - it ranges between a CU and CM and includes a CET for
member states, allowing for free movement of capital and some categories of skilled persons.
CSME CARICOM Single Market and Economy entails the integration of CARICOM states
into a singular economic unit, and subsequently removing tariff barriers within the region. It
includes the free movement of commodities and factors, a single economic space and single
market. It is meant to stimulate growth and international competitiveness as well as serves to
address challenges that small developing CARICOM economies face because of globalization.
Objectives of CARICOM
1. foster economic cooperation among member states
2. coordinate foreign policy
3. foster cooperation in health, education, culture and communication among member
states.
4. encourage the use of raw materials of the region by member states
5. encourage regional trade in agricultural products.
Rationale and Objectives of CSME

16

A single market involves a market structured and functioning to a large extent as if it were within
the borders of a single country. There must be freedom of movement of goods, services, labour,
capital and supportive fiscal and monetary measures and administrative arrangements. The single
market must be a regional economy closely approximating a national economy, incorporating
measures to achieve a balance in the distribution of costs and benefits. While many policy
functions may be carried out at the national level, those should be conducted within a
coordinated policy framework at the regional level. There are many benefits with regards to
production and development which will occur as a result of having a single market.

1. The increase in the size of the home market would allow for significant cooperation in
production, transport and marketing. Firms would not have to worry about government or
bureaucratic obstacles in other caricom countries and could safely introduce more
technology. Marketing firms would emerge automatically focused on the wider Caribbean
and the world. The success of beer exports by more than one caricom firms first
nationally, then regionally and ultimately extra-regionally is typical of what can be
expected. Beer producers now have both a regional and extra-regional production and
marketing network.
2. Development of key services and professions allowing for a size of firm capable initially
of servicing the entire region but ultimately developing sales to the wider Caribbean and
outside the region. Eg. Accounting, architecture, engineering etc. more jobs would be
created. The financial sector can benefit from single market and already regional
insurance co. and commercial banks are beginning to appear.

17

3. Development of genuine Caribbean franchise type operations in areas such as restaurants,

merchandising, specialist foods, travel agencies, hotels/motels etc. The expanded home
markets permit the investment and development of systems for more than one country. If
it works in Port of Spain and Kingston it can work in Miami, Toronto etc. the mindset of
people would change which is necessary for genuine export-led growth. It will allow for
joint ventures, licensing and other forms of business enveavours.
Objectives of CSME
1. Intended to benefit people in the region by providing more and better opportunities to
produce and sell our goods and services and to attract investment. It will create one large
market among the participating members.
2. full use of labour (full employment)
3. Full exploitation of the other FOP
4. competitive production leading to greater variety and quantity of products and services to
trade with other countries.
These objectives will provide:
1. Improve standard of living
2. sustainable economic development
Key elements of CSME
1. free movement of goods and services
2. right of establishment of say a business
3. free movement of capital
4. common trade policy
5. free movement of labour

18

6. free movement of goods

Implication of EU and NAFTA for the Caribbean
NAFTA can get cheaper labour and lower cost of production and lower transportation cost,
therefore more USA and Canadian business will move out of the Caribbean to set up in Mexico.
Therefore less income, job opportunities and advantages to be gained from MNCs.

European Union no more preferential treatment as they are concentrating on developing their
economies.

Caricom has to deepen and widen integration economic and otherwise in order to survive. The
regional bloc must be greater established. (DO MORE READING ON THIS)
FTAA Free Trade Areas of the Americas
The removal of tariffs and other trade barriers among members who, however, retain their own
commercial policies to non-members.
Eg. NAFTA
Review questions.
1. Name the member states of Caricom and CSME.
2. Analyse the implications of international integration arrangements for Caribbean
economies.
3. Evaluate the objectives of Caribbean integration.
4. Describe the stages of economic integration of Caribbean countries up to the level of the
Caribbean Single Market and Economy.

19

5. Discuss FOUR advantages to Caricom member states arising from the free movement of
factors of production goods, services, capital and people under the CSME.
THE END
Balance of Payment
(To be used with the BOJ handout)
A record of a countrys transaction with the rest of the world during a specific period of time, it
shows the countrys payments and receipts from its trade. It consists of a current account and a
capital and financial account. It is concerned with transactions and thus deals with flows rather
than stocks.
Current Account
Goods
Services
Income
Current Transfers
Capital and Financial Account
Capital
Capital transfers
Acquisition/ Disposal of non-produced, non-financial assets.
Financial Accounts
Balance of Payment Account
1. Current Account
A. Goods Balance
Exports

-xx
xx

20

Imports
B. Services Balance
Transportation

-xx
xx
xx

Travel

xx

Other services

xx

C. Income

xx

D. Current transfers

xx

Official

xx

Private

xx

2. Capital and Financial A/C

xx

A. Capital A/C

xx

B. Financial A/C

xx

Other official investment

xx

Other private investment

xx

Reserves

xx

Balance of payment disequilibrium

1. persistent trade imbalance
2. persistent current account imbalance
3. persistent positive or negative overall balance
Causes and consequences of BOP disequilibria
1. Current account surplus expanding sector can result in an appreciation of the currency.
Other sectors may contract as they become less competitive. One booming sector makes

21

the currency so strong that the other industries are less competitive. Eg oil in T&T and
remittances for Jamaica.
2. Misaligned Relative Prices the currency may be overstated. If foreign goods are
relatively cheaper then consumers are likely to buy them leading to a current account
deficit.
3. Overheating Economy Domestic production cannot support AD. So the country has to
import to fill the orders. Eg. Importing bananas to fill orders abroad. This leads to a
deficit.
4. Persistent fiscal deficit short term loans and long term loans increases. The short term
pay back is more critical.
5. Narrowing of IR differentials People may choose to invest abroad to earn greater IR.
6. Persistent negative OB NIR declines - If IR is attractive people will invest in bonds
instead of produce to sell to earn foreign exchange. Instability in the FX market leads to a
decrease in money supply, IR increases, GDP falls, no insurance fund , start borrowing
from the IMF.
7. Persistent Positive OB NIR increases MS increases, IR falls, Inflation increases
competiveness declines increased sterilization.
Policy response to BOP crisis
1. Devaluation/ depreciating the currency makes exports cheaper compared to imports.
2. Expenditure switching these attempts to make imports relatively more expensive than
exports by using tariffs and devaluing the currency.
3. Expenditure Reducing reduce government spending (deflate the Economy). To do this
government could increase taxation rates, cut its own spending or increase IR.

22

4. Fiscal measures decrease the fiscal deficit by spending less and /or increase taxes.
5. Monetary policies increase the IR to encourage savings, encourage savings, reduce
domestic investment and reduce inflation, govt. can also sell bonds.
Policy Packages
A combination of policies can be used to cure a BOP deficit eg. Depreciation will result in
consumers switching from imports to exports but, if Jamaica industry is at or near full
capacity it cannot produce enough and result in inflation. The government might deflate the
economy (expenditure reducing) to provide capacity for depreciation (expenditure
switching). Both policies are complementing each other.
Deficit and Surplus Problems and Solutions
Deficit problems
a) inflation increases prices and exports
to be low (UK 1989)
b) Interest rate low so hot money flows
out to earn interest from abroad

a) Increase productivity, reduce

prices and increase exports.
b) Tight fiscal policy and dear
money policy to deflate the
economy, higher interest rates
to encourage inflows of hot

a) currency overvalued so export

earnings fall (UK 1981 & 1992)
b) capital outflow because of
investments overseas or too much
government expenditure abroad.

money
a) depreciate or devalue the
currency if import/export
elasticities are favourable.
b) Stop or reduce drain by
exchange control regulations
on investment.

23

Surplus problems
c) Spare capacity in the

a) Easy fiscal and cheap money policies with

economy, prices relatively

low taxes and higher govt. expenditure boost

low leading to high levels of

internal economy while lower interest rate

export. (West Germany 1982)

reduces the inflow of hot money.

d) Interest rate high, hot money

flows in to earn interest.
a) Currency undervalued,

a) Appreciate or revalue

embarrassment to trading partners,

currency, this will reduce

exports artificially cheap while

exports and increase imports.

imports expensive, domestic living

standards restricted.
(Japan 1983)

b) Increase capital expenditure

overseas or increase foreign
aid.

The Exchange Rate

(To be used with the BOJ handout)
The rate at which units of a countrys currency are exchanged for units of foreign currency. The
price of one currency in terms of another. The amount of foreign currency that can be obtained
with a unit of the domestic currency and vice versa.
Demand for Jamaican dollar
The desire to change other currencies to Jamaican currency in order to:
1. buy Jamaican goods
2. to save in Jamaican banks and other financial institutions

24

3. to speculate on the currency in the hope that it will gain value

The demand for Jamaican dollars will increase if:
1. demand for goods and services
2. interest rate (returns) are greater therefore more savings and investment
3. people think the value of the currency will increase in the future.
The extent of the change in demand depends on the price elasticity of demand for goods and
services, the more elastic the demand for Jamaican goods and services, the more elastic the
demand for Jamaican dollars.
The supply of Jamaican dollars
The desire to change Jamaican dollars into other currencies in order to:
1. buy goods and services from abroad
2. save in overseas financial institutions
3. speculation a foreign currency in the hope that it will increase in value
The supply of Jamaican currency increases if:
1. overseas interest rate attracts savings and investment
2. overseas goods are demanded more
3. people think that Jamaican dollars will fall in the future so they sell it now.

Appreciation and depreciation

Appreciation a rise in the value of a countrys currency in relation to that of another countrys
currency. The term is used for a managed or floating system while devaluation is used for a fixed
regime.

25

Depreciation - a fall in the value of a countrys currency in relation to that of another countrys
currency. The term is used for a managed or floating system while devaluation is used for a fixed
regime.
Type of exchange rates
Fixed exchange rate regime
1. The rate is held within a common band around a predetermined par value by the
countrys central bank.
2. The central bank sets the rate by law and meets any excess demand and buys
when there is excess supply at the stated rate.
3. Devaluation or revaluation of the currency though policy changes.
Determination of the fixed exchange rate
In a fixed exchange rate system is set by the govt. or central bank at a particular rate. Eg
Barbados to US 2:1. The forces of supply and demand do not determine the rate. The central
bank holds reserves of $US dollars and intervenes in order to keep the exchange rate pegged at
that level.
Eg. D0 curve shows the demand for Barbados dollars that are purchased with $US dollars. The
current price P1 $US per dollar. If the Americans decide to purchase more Barbados made goods.
To do so they must exchange more $US for Barbados dollars. This means that the demand for
Barbados dollars increases to D1. This would increase the price of Barbados dollars to P2 if the
Barbados monetary authorities did not take action. However, with a fixed exchange rate of P1
$US per dollar, the Barbados authorities would step in and increase the supply of Barbados
dollars to S1. They may do so by taking Barbados dollars that they have held in reserve and
purchasing $US dollars.

26

If the US decided to buy fewer Barbados made goods, the demand for the Barbados dollars
would fall back to D0. This means that less US need to be exchanged for B dollars. The price of
the B dollar will therefore fall to P1 with supply of S1. Here the Barbados monetary authorities
will intervene in the market to reduce the supply of the B dollars back to S0. They may do so by
taking US dollars that they have and purchase B dollars. This act would maintain the price of the
dollar at P1.

27

Advantages
1. stability in knowing the exchange rate
2. makes business and investment planning possible
3. limits speculation on the exchange rate because it is fixed

Disadvantages
1. need reserves to protect the value
2. exchange rate may be undervalued or overvalued
3. monetary policy focuses on keeping the rate stable
Floating/Flexible exchange rate regime
1. The value of a currency is allowed to be determined by the forces of demand and supply
on the foreign exchange market. There is no government intervention.

28

2. Appreciation and depreciation of the currency based on market forces.

Determination of the floating exchange rate
In the free-floating exchange rate system, the forces of supply and demand for a countrys
currency determine the value of the exchange rate. The government does not intervene to affect
the value of the exchange rate. An increase in demand for the local currency causes it to
appreciate but if there is a greater demand for the foreign currency the value of the local currency
falls/depreciates to the foreign currency.
Eg.
When there is a great demand for the US dollars the value of the Jamaican dollars will
fall/depreciates.

When demand for the US dollars fall then there may be excess supply of US dollars as people
begin to demand the local currency. The local currency appreciates.

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Advantages
1. market determined, so it is more efficient
2. no need for reserves to intervene
3. exchange rate would reflect its true value
4. absorbs economic shocks better
5. freedom of govt. to pursue internal policy
6. Automatic BOP adjustment, less likelihood of a BOP crisis.
Disadvantages
1. large depreciation may occur
2. instability of exchange has a negative impact on domestic economy
3. terms to trade may decline with fall in exchange rate
4. uncertainty
5. speculation

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6. reduced investment
Managed/ Dirty Float Exchange rate
1. The exchange rate is allowed to float, but the central bank intervenes from time to time to
prevent major exchange rate fluctuations. It is a form of managed flexibility.
Determination
The central bank seeks to stabilize the exchange rate within a predetermined range for a
given period of time, but does not fit it at any particular level. This allows for policy makers
the benefit of planning with some degree of certainty, for the macroeconomic affairs of a
country.
The effect of exchange rate changes
If the currency is devalued/ depreciated then:
1. The price effect goods become cheaper and imports become more expensive. The
devaluation worsens the BOP.
2. the volume effect cheaper exports mean that more will be sold and less imports will be
bought thus improving the BOP.
In the long run this results in a J effect.

31

The devaluation worsens the current account balance initially, and then it improves. Reasons
being:
1. Time lag in consumer response people may still want the expensive good. Consumers
may be concerned about the quality and quantity of the local good and may continue
buying the foreign goods in the short-run.
2. Time lag in producer response producers may take a long time to adapt to say changing
their plant size to accommodate the increase in demand.
3. Imperfect competition import competing firms from abroad may reduce their prices
when the dollar is devalued to compete with local producers, resulting in imperfect
competition.
In the short run changes are inelastic but in the long run changes are elastic.

32

Review Questions
1. With the use of diagrams tell how monetary authorities manage to maintain a fixed
exchange rate.
2. With the use of diagrams tell how the fixed and floating exchange rates are determined.
3. Discuss the effect of exchange rate changes on Caribbean economies with a flexible
exchange rate.
4. Analyze TWO causes and consequences of balance of payment disequilibrium.
5. Discuss the effectiveness of policies used to correct balance of payment disequilibrium.
6. Select 6 Caribbean countries and identify the rate of their currency to the US, also
identify their exchange rate regime.

The End

33

Growth and Development

Economic Growth
This is an increase in the level of national income usually expressed in constant prices. This
is an expansion of a countrys real output (GDP) or an outward shift of the PPF. The increase
in national income of a country, measured by the GNP in relation to the increase in the
population. Growth is quantitative.

Structural characteristics of Caribbean economies

1. Small size in terms of land mass they are relatively small which limits what can be
produced and economies of scale.
2. Openness which makes them vulnerable to external economic shocks such as recession.
3. Composition of exports there is a tendency to concentrate on exporting one or two
commodities such as bananas, agriculture and tourism
4. Resource base each country has one or two resource bases that they depend on for
export earnings for instance Jamaica bauxite and beautiful beaches, T&T hydrocarbon
base minerals and Guyana- gold, diamond, bauxite and natural forest.
5. Poverty every economy has a Gini Coefficient of 0.42 which suggests that they are
closer to the line of inequality and there is a large proportion of people living below the
poverty line.
6. Economic dependence great dependence on the international community. Some depend
on it as a principal export destination, foreign direct investment, loans and aid.

Implications for regional economies

34

1. Dependence on aid this may be humanitarian for instance food relief after a hurricane.
Political for the economic to support their political agenda. Economic to boost their
market especially after a natural disaster. This may slow down economic reform and slow
down growth.
2. Preferential trade agreements the new trend is for this to be based on reciprocity which
means that preference are given to member states but they are also expected to provide
preferences to the other members within the preferential trading agreement. Eg EU
bananas, sugar, rice and rum.
3. Foreign direct investment important part of the economic development for the
Caribbean see benefits and cost to the Caribbean of FDIs
4. Vulnerability to natural and man made changes (market developments) these affect
exports. Natural disasters. External trade and exchange related shocks such as global
interest rate fluctuations, severe decreases in demand, instability of commodity prices etc.
Non-environmental domestic shocks such as political instability as well as uprisings and
so on.
5. Changes in world prices developing countries have a comparative advantage of
producing primary instead of manufactured goods where the price and income tend to be
low. Developing economies depend mainly on the sale of one/two commodities and
change in prices on the world market may reduce the demand for the product. Eg. The
increase in the price of fuel increases the price of travel resulting in a decrease in demand
for travel and a decrease in demand for tourism.
Benefits of growth
1. increase in the level of consumption

35

2. better standard of living

3. better care for the environment
4. more money to be redistributed from the rich to the poor as the rich earn more.
Potential costs of economic growth
1.

unequal distribution of income

2. inflation
3. environmental degradation
4. social services suffers
5. machines displaces workers
6. sustainable development sacrificed

Impediments to economic growth faced by Caribbean economies

1. lack of resources
2. lack of domestic investment
3. lack of FDI
4. natural disasters
5. lack of technology
6. small size, openness and vulnerability
7. debt burden
Review Questions
1. Discuss how the structure of Caribbean economies stifles growth and development.
2. To what extent is growth a prescription for development.

36

3. What fiscal and monetary measures can be used to stimulate growth and development in
the economy and what are the implications of these.
4. How can you promote sustainable development in your community?
The End

International Trade
Trade between nations. It consists of the selling (exporting) of goods and services to other
countries and the purchasing (importing) of goods and services from other countries.
Reasons for international trade
1. differences in countrys cost of production
2. economic welfare of each country increases since they have a wider range of goods and
services available for consumption.
3. some countries do not have the necessary natural, human and capital resources included
technologically to make/produce some goods
4. countries have different climate conditions and therefore cannot produce some goods.
Principles of International trade
Absolute and comparative advantage.
The role of exports in creating domestic income and the role of imports in generating
income for foreigners
Exports create employment and generate income from the factors of production for locals while
imports provide jobs and income from the factors of production for foreigners.
Factors that influence/determine exports and imports

37

1. International price - this is dependent on factor prices and the state of technology, if this
allows a country to produce goods cheaply they will sell to other countries and import
goods produced more cheaply by other countries.
2. Domestic production a country tends to export more of a good that its factors of
production can produce in abundance because the FOPs are plentiful and import those
goods it cannot abundantly produce because the FOPs are not plentiful.
3. Domestic prices and exchange rate an overvalued exchange rate cause local goods to be
more expensive resulting export prices being high and import prices being low therefore
more goods will be imported than exported. Whereas, if the dollar is
devalued/depreciated domestic goods will be cheaper resulting in greater levels of
exports and a favourable BOP.
4. International economic activity as it affects the tourism market in the Caribbean tourism
provide valuable foreign exchange which can be used to import capital goods necessary
for development. Tourism helps to develop unused natural resources and create
employment, it also results in the consumption of non-tradable and niche industries like
craft which has a multiplier effect on the economy and improves the BOP. But tourism is
prone to international shock such as recessions when income falls and some tourists
cannot afford to travel.
5. Shifts in international demand and the emergence of substitutes an economy suffers
when the export it relies on is substituted causing demand for it to fall for instance nylon
replacing cotton, copper as fiber optic cable replacing traditional telecommunication
infrastructure. The economy looses valuable export revenues.

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6. Changes in international income as income increases demand for certain primary goods
exported by Caribbean economies falls as consumption patterns change. At lower income
levels demand for certain primary exports may increase generating income for these
economies.
Benefits of exporting
1. earn foreign exchange
2. create jobs
3. improve BOP
4. improved standard of living
Problems with importation
1. uses up scarce foreign exchange
2. harm local industries
3. unfavourable BOP
The effect of foreign exchange earnings on small open economies
1. Access to capital goods these goods can be purchased to produce other goods to
improve development. These goods are vital to production and productivity but are not
produced locally.
2. The export multiplier The multiplier for a change in exports; that is, the increase in
GDP caused by a one-unit increase in exports. It may be defined as the amount by
which national income of a nation will be raised by a unit increase in domestic
investment on exports. As exports increase there is an increase in the income of all
persons associated with the exports industries. These in turn create demand for goods.
But this is dependant upon their marginal propensity to save (MPS) and import (MPM).

39

The smaller these two propensities are, the larger will be the value of multiplier and vice
versa.
3. Access to consumer goods consumers can buy more foreign goods and improve their
level of consumption and SOL.
4. Increased domestic production with the increase in the purchase of capital goods more
domestic goods and services can be produced and exported to earn more foreign
currency.
Principles of International trade
A. Absolute advantage
Where countries have equal quantity of resources but one can produce more of the good than
another. Adam Smith suggest that the country specialize in the production and export of the
goods it has absolute advantage in producing and import the one it has an absolute
disadvantage in producing.
Assumption of the theory
1. two countries, two commodities and two factors of production
2. factors are easily substitutable between productive options
3. this is for a specific period of time with a given technology
4. constant cost economies of scale, changes in production does not affect cost
5. no barriers to trade.
B. Comparative advantage
Assumptions of the theory
40

1. factor mobility
2. both countries must demand the product
3. limited resources must be fully employed
4. constant returns to scale
5. constant average cost in both industries
6. 2 domestic ratios = one international ratio
When one country can produce a good at a lower opportunity cost than another. This means that
the country sacrifices less in the production of say Good X therefore it is more efficient in
producing Good X say against Good Y. When many commodities are produced, they are
arranged in order of comparative advantage. Countries will specialize in the product they
produce best. Resources are allocated evenly between 2 goods X and Y in countries A and B and
output is as follows:
Country

Good X

Good Y

Total

The opportunity costs of production are as follows:

Country

Opportunity cost 1X (y/x)

Opportunity cost 1Y (x/y)

4Y ( 4/1) give up 4 Y to

1/4X give up X to produce

produce 1X

1Y

1.5Y (3/2) give up1.5 Y to

2/3X give up 2/3 X to produce

produce 1X

1Y

41

A will specialize in producing good Y because the opportunity cost of producing Y is less than X
B will specialize in producing good X because the opportunity cost of producing X is less than Y
If all resources are diverted into the production of the good the country has comparative
advantage in producing, assuming constant returns to scale, the output will double because twice
as much resources are now being used to produce one good. Therefore:
Country

Good X

Good Y

Total

Before comparative advantage total goods traded 3+7=10

After comparative advantage total goods traded 4+8=12
Trade in both goods has increased therefore comparative advantage results in an increase in the
number of goods and services produced. There is a wider range of goods at a lower price.
Relative efficiency - Efficiency in the production of one particular commodity over the same
commodity in another country.
Benefits of free trade for the region
1. Access to larger foreign markets
2. cheaper goods
3. better quality goods
4. increase in exportation

42

5. improved standard of living

Disadvantages for the region
1. damage to domestic producers
2. unemployment
3. kill infant industries
4. dumping/cheap labor
5. protection to improve the terms of trade
Free Trade
This occurs when there are no barriers to trade. Countries may see the need to set up barriers for
certain reasons these are call protectionisms for instance quotas and tariffs.
Arguments for protectionism
1. Damage to domestic producers local industries may not be able to compete with cheaper
imports and so may have to close down or scale down on operations thereby creating
unemployment.
2. Infant industries protecting these industries until they mature and are able to compete with
international firm.
3. Dumping dumping involves large exporters selling their products at below cost price to
gain market share. Local firms must be protected against this.
4. To improve the terms of trade when a country can exert monopoly or monopsony power
by restricting international trade on a particular good. When the country can do this and

43

affect the price of the good, thereby improving its terms of trade, then we say that they are
using protection to improve their terms of trade.
5. Employment- cheaper labour may be brought in to do the jobs of locals which may displace
local workers. Eg from China to build roads.
6. Food security this is done to protect primary producers such as farmers and to reduce the
dependence on foreign foods. Banning the importation of harmful goods.
Arguments for trade liberalization/Arguments against protectionism
1. improves competition in an economy forcing firms to be more efficient
2. prevents retaliations in the form of trade restrictions from other countries
3. help domestic industries that depends on foreign imports especially of capital goods
4. based on comparative advantage free trade benefits the participants by improving
welfare/SOL. Also cheaper goods and services.
5. greater access to technology/earn foreign exchange to buy capital equipment
6. improves international trade relations
7. when there are restrictions prices may increase and consumers may have to pay more for
imports thus reducing their surplus.
Methods of trade protection
1. Tariff Tax on imports designed to increase their prices and raise revenues. Tariffs are
meant to reduce importation in an effort to improve the BOP and encourage consumers to
buy local goods.
The effect of Tariffs
44

With a tariff:
a) govt. earns revenue from QS2 to QC2
b) QS1-QS2 inefficient area, inefficient domestic producers can now supply because of the
tariff. There is deadweight loss.
c) QC2 QC1 is welfare loss to the consumer refuse to pay a higher price for these goods.
d) domestic producer surplus increases as consumers pay more for local goods
2. Quotas limits the quantity of imports. This is meant to protect infant industries and reduce
competition against local products.

45

3. Non-tariff barriers administrative procedures which make it difficult for foreign firms to
sell their goods in the country such as difficult safety standards.
4. Embargos- no trade is allowed, often done for political reasons.
5. Voluntary agreement/ voluntary export restraint - one govt. pressurize another to reduce its
exports. Eg Japan agreeing to limit car exports to UK.
6. Exchange controls limit the amount of money that can be converted to foreign currency.
Commodity terms of trade
This is an index of the price of a country's exports in terms of its imports. The terms of trade are
said to improve if that index rises. The ratio of the index of export prices to the index of import
prices. An improvement in the terms of trade follows if export prices rise more quickly than
import prices (or fall more slowly than import prices).
Formula
Export price index/Import price index X 100
Review Questions
1. With the use of a diagram discuss the implications of an increase in tariffs
2. Assess THREE factors that determine export revenues.
3. Evaluate THREE arguments for and THREE arguments against protectionism
4. Evaluate whether the benefits of international trade outweighs the cost of for the region.
5. Demonstrate and explain the benefits of comparative advantage.

The End

46