Trade Restrictions and Exchange Rates: Impact on Global Commerce
Trade Without Restrictions: Disadvantages of Restrictions
- Higher prices for consumers.
- Fewer choices for consumers.
- Protectionism often leads to retaliation, resulting in higher import prices and, consequently, higher consumer prices.
- Higher prices can lead to lower overall demand, causing job losses in other industries.
Trade With Restrictions
- Protection of national defense and citizens’ health.
- Protection against dumping.
- Potentially lower prices for consumers in specific cases.
- Protection for new and vulnerable industries.
Exchange Rates
The exchange rate is the price of one currency in terms of another currency.
Types of Exchange Rates
Fixed Exchange Rate
A fixed exchange rate occurs when the government seeks to keep the value of a currency fixed against another currency.
Advantages of a Fixed Exchange Rate
- Avoids currency fluctuations: Significant currency fluctuations can create challenges for businesses engaged in international trade.
- Helps to keep inflation low: Governments that allow their exchange rate to devalue may experience inflationary pressures. Devaluation can cause inflation because aggregate demand increases, import prices rise, and firms have less incentive to reduce costs.
Disadvantages of a Fixed Exchange Rate
- Less flexibility: A fixed exchange rate makes it difficult to respond to temporary economic shocks. For instance, if the price of oil increases, a country that is a net oil importer will see a deterioration in its current account balance of payments. However, with a fixed exchange rate, there is no ability to devalue the currency and reduce the current account deficit.
- Potential for current account imbalances: Fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit.
Flexible Exchange Rate
A flexible exchange rate occurs when governments allow the exchange rate to be determined by market forces without attempting to influence it.
Advantages of a Flexible Exchange Rate
- Freedom to choose domestic policy: Governments can implement domestic policies with a floating exchange rate because it self-corrects any balance of payments disequilibrium arising from those policies.
- Protection from external economic events: A country’s currency won’t be affected by economic movements in other nations. When supply and demand move freely, the domestic economy is protected from fluctuations in the global economy. This is possible because the currency is not linked to a high inflation rate, unlike a fixed exchange rate.
Disadvantages of a Flexible Exchange Rate
- Flexible currencies can be volatile, making it harder for businesses to operate.
- An unexpected fall in the exchange rate can also cause rising inflation.
How Exchange Rates Affect International Trade
An increase in the exchange rate of the Euro against a foreign currency would appreciate the Euro. This would make imports cheaper but exports more expensive, potentially destabilizing the current account.
Conversely, if a currency depreciates, exports may increase due to lower prices, while imports may decrease due to higher prices. However, this depends not only on price but also on elasticity. If a country is energy-dependent, it may continue to buy the same amount of oil and gas, albeit at a higher price. Similarly, if exports have low elasticity, even a price reduction may not significantly increase demand.