Balance of Payments, Exchange Rates and International Competitiveness
Balance of Payments, Exchange Rates and International Competitiveness
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PREMIUM
A country keeps one record of all its money dealings with the rest of the world, and that record always balances.
Menda is a country whose currency is the naro. A coffee exporter in Menda sells beans abroad. A family in Menda buys an imported car. Both deals are between residents of Menda (people and firms based there) and the rest of the world.
Balance of payments: a record of all a country's financial dealings with the rest of the world over the course of a year.
Put simply, it is the country's account book with the rest of the world.
Money coming in, such as the coffee payment, is a credit. Money going out, such as the car payment, is a debit.
The record has three accounts: the current account (trade and income), the capital account (transfers of fixed assets: things such as land and buildings, which are used for many years) and the financial account (buying and selling financial assets, such as shares, and borrowing and lending).
Why must they balance? Every transaction is recorded twice, once as a credit and once as a debit. The coffee sale is a credit on the current account. The exporter is paid in US dollars, so Menda now owns a new foreign asset (something of value that it owns, here money held abroad). Buying a foreign asset is recorded like money going out, so it is a debit on the financial account. The car works the other way. Paying for it is a debit on the current account, and the foreign carmaker now holds a claim on Menda (a right to be paid by Menda), such as naro in a Menda bank, which is a credit on the financial account. In each case the two entries cancel. So a deficit on one account (more money out than in) is matched by a surplus on another.
Real records never match exactly, because some transactions are missed. So published accounts add a net errors and omissions item, a figure for what the records missed, which brings the total to zero.
What a country earns from and pays to the rest of the world includes income and gifts, not only trade.
Menda earns money from its coffee and pays for imported cars. Buying and selling across borders is called trade. Trade in goods means physical products, such as coffee. Trade in services means work with no physical form, such as tourism or insurance. Money also crosses Menda's borders for other reasons. Profit, interest and dividends (a share of a firm's profit paid to its owners) on things owned abroad are called primary income. Gifts, such as money that people abroad send home, are called secondary income.
Current account: the part of the balance of payments that records trade in goods and services, primary income and secondary income.
Put simply, it is what Menda earns and pays abroad in a normal year, apart from buying and selling assets.
The first measure looks at trade alone.
Balance of trade: the difference between the value of goods and services exported and the value of goods and services imported.
Put simply, it is what Menda sells abroad minus what it buys from abroad.
Primary income: income earned by domestic citizens who own assets overseas minus income earned by foreign citizens who own assets in this country; it includes profits, dividends and interest.
Put simply, it is what Menda's residents earn on things they own overseas (abroad), minus what foreigners earn on things they own in Menda. Wages that Menda residents earn by working abroad for less than a year count here too, because these workers are still residents of Menda.
Secondary income: transfers of money between countries for which nothing is given in return, such as money sent home by workers abroad and government aid.
Put simply, it is gifts between countries. A nurse who has moved abroad to live is now a resident of another country, so the money she sends to her parents in Menda is a gift from abroad: a secondary income credit.
The gap comes from goods. Menda's balance of trade is −$50bn + $24bn = −$26bn, but primary and secondary income together add $8bn − $2bn = $6bn. So a gap on goods does not decide the current account alone.
Current account deficit: when the value of money leaving the country on the current account exceeds the value of money entering it.
Current account surplus: when the value of money entering the country on the current account exceeds the value of money leaving it.
Put simply, a country with a deficit pays the rest of the world more than it earns from it, and a country with a surplus earns more than it pays. Menda's −$20bn is a deficit of $20bn.
Exam Matters: In a Calculate question, add every part the data give, keeping each sign. Give the answer with its unit and sign, and say whether it is a deficit or a surplus.
A country that pays out more than it earns must sell things it owns, or borrow, to pay the difference.
In one year, Menda paid the rest of the world $20bn more on its current account than it earned. Foreign sellers still expect to be paid. So where does the $20bn come from?
Capital account: the part of the balance of payments that records transactions in fixed assets.
Put simply, it is the small account: sales of land to foreigners, and transfers such as a debt that one government cancels for another. Menda's is $1bn.
The second account deals in financial assets, such as shares and bank deposits, and in liabilities, which are what a country owes, such as loans.
Financial account: the part of the balance of payments that records changes in the ownership of a country's foreign financial assets and liabilities.
Put simply, it records who owns and who owes what across borders. Menda's is $19bn: that much more money came in for assets and loans than went out for them. Besides loans, it has three main parts, each defined here. Two words in them need explaining first: equities are shares in firms, and debt securities are bonds (loans that can be resold).
Direct investment: capital provided to, or received from, an enterprise by an investor in another country.
Put simply, a foreign firm builds or buys a business (an enterprise) in Menda and runs it.
Portfolio investment: investment in equities and debt securities.
Put simply, foreigners buy shares or bonds in Menda without running anything.
A country's monetary authorities (its central bank, which manages its money, and its government) also keep a store of foreign currency.
Reserve assets: foreign financial assets that are available to, and controlled by, the monetary authorities for financing or regulating payments imbalances.
Put simply, they are the central bank's savings in foreign money, which it can spend if no one else will pay for a deficit.
Paying for a deficit by selling assets or borrowing from abroad is called financing it. Menda pays $20bn more abroad than it earns, so it must sell assets or borrow the difference. The $1bn and the $19bn bring in exactly that $20bn. A country with a current account surplus does the reverse: it earns more than it pays, so it lends the difference or buys assets abroad, and its financial account is in deficit.
Financing has a cost later. Foreign owners want profits and foreign lenders want interest, and both leave Menda as primary income debits in future years. Loans must also be repaid.
A current account deficit can come from goods that are hard to sell abroad, or from spending that pulls in imports.
Why might a country pay out more than it earns abroad? Three terms help to explain it.
The exchange rate is the price of one currency in terms of another: at $0.50 per naro, one naro buys half a US dollar. Productivity means output per worker. International competitiveness means a country's ability to sell its goods and services abroad.
There are five main causes of a deficit:
Each cause lowers international competitiveness or raises spending on imports. A narrow export base, where most export earnings come from one or two goods, adds a risk: if most export earnings come from one good, a fall in its world price cuts them, even when Menda sells as much as before.
A deficit is not always a problem. It depends on the cause, on its size as a percentage of GDP (the value of everything an economy produces in a year) and on how long it lasts. A deficit from importing machines for new factories can raise output later. A deficit from buying imported consumer goods brings no such return.
Exam Matters: In an Explain question on a cause, pick the cause the data point to. Then link it to exports or imports, and to the current account, using the figures given.
A surplus can come from the causes of a deficit in reverse, and from two causes of its own.
Some countries earn more from the rest of the world than they pay to it, year after year. Each cause of a deficit, reversed, can cause a surplus:
Two causes are not simply mirrors.
Weak domestic demand and high saving. Domestic demand is the total spending of households, firms and the government inside the country. When households save a large share of their income, they spend less of it, so domestic demand is weak. Saved income is not spent on goods, so none of it buys imports directly. Firms may not use all these savings to invest (spend on new machines and buildings). When saving is greater than investment, total spending at home stays low. Spending on imports stays low too, while exports continue, so the current account moves towards a surplus.
Resource endowment (the natural resources a country has, such as oil, gas or minerals). A country that exports these at high world prices can earn a large surplus, even if its other industries sell little abroad.
A surplus is not costless. A country with a surplus spends less than it produces, so its people consume less today than they could. It builds up claims on foreigners, such as loans and foreign assets, instead of goods for its own people.
Real Example: In 2015, Germany's current account surplus was about 8½% of its GDP. A 2017 study by the ifo Institute found that the surplus came mainly from high saving, not from weak investment, and linked the saving to an ageing population. This is the high-saving cause at work: saving that is higher than investment keeps spending on imports low.
A government can shrink a deficit by lowering total spending, because part of that spending is on imports.
One way to reduce Menda's $20bn deficit is to make people in Menda spend less. Total spending on an economy's goods and services is called aggregate demand.
The government can lower aggregate demand with fiscal policy (changes in taxes and government spending). Higher taxes leave households less to spend, and lower government spending removes spending directly. Fiscal policy used in this way is called deflationary, because it lowers spending. The central bank can also raise interest rates (the price of borrowing), so households and firms borrow and spend less.
Expenditure-reducing policies: measures designed to reduce aggregate demand, such as deflationary fiscal policy.
Put simply, the government makes the whole economy spend less, knowing that part of what is no longer bought would have come from abroad.
Why do imports fall when no one has targeted them? Imports are part of everything people buy. When spending falls, spending on imports falls with it. How much it falls depends on the marginal propensity to import: the share of each extra dollar of income spent on imports. The same share applies when spending falls. With a marginal propensity to import of 0.2, 20 cents of each dollar that is no longer spent would have gone on imports.
The other $16bn of the fall was spending on goods made in Menda. Menda's firms sell less, so they produce less and need fewer workers. Output (the total amount an economy produces) falls, and unemployment (the number of people who want a job but cannot find one) rises. The deficit is smaller only because Menda buys less, not because it sells more abroad.
A country with a large surplus can do the reverse. Lower taxes or higher government spending raise aggregate demand. Part of everything bought is imported, so spending on imports rises and the surplus shrinks. The rest of the extra spending is on goods made at home, so firms sell more, produce more and need more workers: output rises and unemployment falls.
Exam Matters: When you evaluate this policy, weigh the smaller deficit against the lost output and jobs, and say which matters more for the country in the question.
A government can move spending from imports to home-made goods by making imports more expensive than home goods.
A second approach to a deficit changes where spending goes, by changing prices.
A tariff (a tax on imports) makes imports more expensive, and a quota (a limit on their quantity) makes them harder to get. Under a fixed exchange rate (a rate the government holds at one level), the government can also set a lower value for the currency. This is called a devaluation.
Expenditure-switching policies: measures that encourage people to buy domestic goods rather than imports, such as tariffs, quotas or a devaluation of the currency.
Put simply, foreign goods become more expensive than home goods, so people choose the home goods.
Unlike expenditure-reducing policies, total spending need not fall: it moves from imports to goods made in Menda.
A currency can also fall in the market. This is a depreciation (a fall in the value of a currency against other currencies). A rise in its value is called an appreciation. Either kind of fall changes two prices at once. The dollar price of Menda's exports falls, and the naro price of its imports rises.
Why 20% one way and 25% the other? The naro's value has fallen by $0.10, a fifth of the old $0.50, so the 100-naro export costs buyers abroad $10 less, a fifth of the old $50. Each dollar now costs 0.5 naro more, a quarter of the old 2 naro, so each import costs a quarter more in naro.
The deficit narrows only if buyers change the quantities they buy enough: more of Menda's exports abroad, and fewer imports at home. If the quantities barely change, Menda earns fewer dollars per export and pays more naro per import, and the deficit can grow.
Tariffs and quotas have costs: retaliation (other countries' tariffs on Menda's exports), and more expensive imported parts for Menda's own firms.
A surplus country can switch spending the other way, from home goods to imports, so that its surplus shrinks. An appreciation, or a revaluation (a rise in the value of a currency that a government sets under a fixed exchange rate), makes its exports more expensive abroad and its imports cheaper at home.
A country can also reduce a deficit by making its firms better at producing, so their goods sell abroad more easily.
Expenditure-reducing and expenditure-switching policies change what people spend or the prices they pay. A third approach changes what Menda can produce. Supply-side policies (policies that raise an economy's ability to produce) include education and training, better roads and ports, and incentives for firms to invest (rewards, such as lower taxes, for buying new machines).
How do they help the current account? Trained workers with better machines each produce more, so productivity rises and each unit costs less to make. Menda's firms can charge less abroad, or sell better goods at the same price, so international competitiveness rises. Exports grow, and some buyers at home choose Menda's goods over imports.
These policies are slow: training workers and building ports take years. They also need public spending (spending by the government) now, money that could have paid for hospitals or housing. So they do little for a deficit that must shrink this year.
A government can also do nothing. Under a floating exchange rate (a rate set by the demand for and supply of the currency, not held by the government), a deficit can correct itself. Importers sell naro to buy the dollars they pay with, and exporters sell the dollars they earn to buy naro. With a deficit, imports are larger than exports. So through trade, importers sell more naro than exporters buy, and the naro tends to fall. Money flowing in to buy Menda's assets can hold it up for a time. If the naro does fall, exports become cheaper abroad and imports more expensive at home. If buyers respond enough, spending then switches without any policy.
Which route is best depends on the cause of the deficit and on how urgent it is.
Exam Matters: In an Examine question, judge a policy against the cause of the deficit and how quickly it must shrink, using the data you are given.
One country's deficit is matched by surpluses in other countries, so imbalances matter for both sides.
Every dollar that Menda pays abroad is received by someone in another country. So when Menda runs a $20bn deficit, other countries together earn $20bn more from Menda than they pay to it. Added across the whole world, all countries' current account balances sum to zero. This is why not every country can run a surplus at the same time: one country's surplus needs other countries' deficits.
Sometimes the same countries run large surpluses year after year, while others run large deficits year after year. Gaps that last like this are called persistent.
Global trade imbalances: large and persistent current account surpluses in some countries, matched by large and persistent deficits in others.
Put simply, the same countries keep lending to the world, and the same countries keep borrowing from it.
Why do they matter? There are three reasons.
Deficits must be financed. A country with a persistent deficit must keep selling assets or borrowing abroad. A deficit is sustainable, meaning able to continue for many years, only while foreign lenders keep lending and foreign buyers keep buying the country's assets. If they lose confidence, the financing stops. Without that financing, the country cannot pay for the imports its exports do not cover, so the deficit is likely to close quickly, through sharp falls in imports and spending.
Surpluses have costs too. A surplus country uses its workers and machines to make goods for other countries rather than for its own people. Its people may then have less choice and lower living standards (fewer goods and services to use) than they could have, because more of what the country makes is sent abroad.
Exchange rates can swing. When large flows of money change direction, currencies can rise or fall sharply. Investors who move their money out of a country sell its currency to buy another. When more of a currency is for sale than buyers want, its value tends to fall. That makes prices hard to plan for firms that trade, and it can disrupt world trade.
Surplus countries are sometimes accused of holding the value of their currency down, by selling their own currency to buy foreign currency, so that their exports stay cheap abroad.
Real Example: In 2007, before the global financial crisis, the United States ran a current account deficit of about $740 billion, over 5% of its GDP. In the same year, China ran a surplus of about 10% of its GDP. It shows the two sides of a global trade imbalance: a large deficit in one major economy in the same year as a large surplus in another.
A currency has a price, and when the market sets it, demand and supply decide it.
Menda is a country whose currency is the naro. A firm abroad buys coffee from a Menda exporter and pays in US dollars. But the exporter pays its workers and farmers in naro, so in the end it needs naro, not dollars. So someone has to swap dollars for naro. Either the buyer does it before paying, or the exporter does it after being paid. So when a buyer abroad orders Menda's coffee, it also creates demand for the naro.
How many dollars does one naro cost? That price has a name.
Exchange rate: the price of one currency in terms of another.
Put simply, it tells you how much of another currency one unit of yours will buy. Menda's rate is $0.50 per naro, which is the same fact as 2 naro per dollar.
Currencies are bought and sold on the foreign exchange market, the market where one currency is swapped for another. Like any market, it has two sides.
When the market alone sets the price, the rate settles where the quantity of naro demanded equals the quantity supplied. Suppose that at $0.50, the quantity of naro demanded is greater than the quantity supplied. This is a shortage, or excess demand. Buyers who cannot get naro offer more dollars for each one, so the price rises towards $0.55.
This gives one rule for every change in a rate that the market sets. Anything that increases demand for the naro raises its price. Anything that increases the supply of naro lowers its price. So to explain any such change, first ask which side of the market it moves, and why.
Exam Matters: When you explain any change in a currency's price, start in the currency market. Say which side the event moves, demand or supply, and which way, before you say what happens to the price.
Countries choose how far the market sets the price of their currency, and each choice has a cost.
Who decides how many dollars one naro costs? Menda's central bank is the body that issues the naro and holds Menda's reserves of foreign currency. Together, the central bank and the government are called the monetary authorities. Countries answer the question in three ways, depending on how far the central bank acts in the currency market.
Floating exchange rate: a system in which demand and supply determine the rate at which one currency exchanges for another.
Fixed exchange rate: a system in which a country's exchange rate is fixed in relation to another currency, such as the US dollar, and can only be changed by the central bank.
Managed exchange rate: a system in which the monetary authorities control the exchange rate through the buying and selling of the country's currency.
Put simply, under a floating rate the market sets the price. Under a fixed rate the central bank sets it and holds it there. Under a managed rate the market sets it most of the time. The authorities act only when it moves too far or too fast.
The key difference shows when holders of naro start to sell. Their selling raises the supply of naro, so its price comes under pressure to fall. Each system meets that pressure in its own way.
Why does a fixed rate need reserves? To hold the price when others sell naro, the central bank must add to the demand for naro. It can only buy naro by paying with another currency, so it uses its reserves. A fixed rate is held by buying and selling the currency.
It may also have to raise interest rates. A higher rate makes holding naro earn more, so savers buy naro, which adds to the demand for it. The central bank may have to do this even when Menda's economy needs lower rates and more jobs.
Real Example: Saudi Arabia has fixed its riyal at 3.75 riyals per US dollar since 1986, and its central bank buys and sells riyals to hold that rate. Singapore runs a managed rate: its central bank lets the Singapore dollar move within a band against the currencies of its main trading partners. Both show that a country chooses how much the market decides.
Exam Matters: In an Explain or Analyse question about a currency, name the exchange rate system first. The same rise in the supply of a currency lowers its price under a floating rate, but uses up reserves under a fixed rate.
A currency's value can rise or fall, and the word for each change depends on who caused it.
The naro's price does not stay still. When you describe a change, two facts matter: which way the price moved, and what caused it. Under a floating rate, the market causes the change. Under a fixed rate, the central bank does.
Appreciation: an increase in the value of a country's currency in relation to other currencies under a floating exchange rate system.
Depreciation: a decrease in the value of a country's currency in relation to other currencies under a floating exchange rate system.
Put simply, a floating naro appreciates when buying and selling push its price up, and depreciates when they push it down. Nobody decides it.
Revaluation: an increase in the value of a country's currency in relation to other currencies under a fixed exchange rate system, set by the country's central bank.
Devaluation: a decrease in the value of a country's currency in relation to other currencies under a fixed exchange rate system, set by the country's central bank.
Put simply, under a fixed rate the central bank chooses a new, higher or lower price for its currency, announces it and then holds it there.
The key difference is the cause, not the direction. Appreciation and revaluation are both rises. Depreciation and devaluation are both falls. In each pair, what differs is who caused the change: the market, or the central bank. So the same 10% rise is an appreciation in a country whose rate floats, and a revaluation in a country whose rate is fixed. The system decides the word.
The effect on prices does not depend on the word. A depreciation and a devaluation of the same size make exports cheaper abroad and imports more expensive at home by the same amounts.
Always divide by the old value, because a percentage change measures the change against where the value started. If Menda's rate floats, the first change is a 20% depreciation and the second a 10% appreciation.
Exam Matters: In a Calculate question on a currency's value, divide the change by the old value and give the answer as a percentage with its sign. Then name the change: a depreciation or an appreciation if the rate floats.
Savers move money to where it earns more, so a higher return in Menda raises demand for the naro.
Menda's banks pay savers 5% a year on deposits (money kept in a bank), while banks in the rest of the world pay 3%. This 5% is Menda's interest rate: the price of borrowing money, and the reward for saving it. Savers compare the two. What matters is the relative interest rate: the rate in Menda compared with the rate abroad.
Menda's rate is 2 percentage points higher. A percentage point is the plain difference between two percentages: 5% − 3% = 2 percentage points.
Now Menda's central bank raises its rate to 7%, and rates abroad stay at 3%. The gap widens to 4 percentage points, so a saver abroad can earn more in Menda. But a Menda bank deposit is held in naro. So the saver must first sell their own currency and buy naro. Demand for the naro rises, its price rises, and the naro appreciates.
Savings moved between countries to earn the highest return are called hot money. Hot money can move within days, so a change in relative interest rates can move the rate quickly.
Now the reverse case. Suppose the rest of the world raises its rates from 3% to 5%, and Menda keeps its rate at 5%. The gap closes from 2 percentage points to nothing, although Menda did nothing. Savers who held naro for the extra return now sell naro to move their money abroad. The supply of naro rises, and the naro depreciates.
So a high rate is not enough on its own. A rate of 5% may attract little money if other countries pay 7%. Savers may also stay away from a rate that was raised because inflation (a rise in the general price level) is high. They care about what their money will buy, and high inflation takes away part of the return.
Exam Matters: In an Analyse question on interest rates, compare the rate with rates abroad, then follow the money through the currency market: who buys or sells the currency, and what that does to its price.
If prices rise faster in Menda than abroad, the naro tends to fall until goods cost about the same in both.
Take a basket of goods: a fixed list of everyday items, such as rice, cooking oil and bus fares. The basket costs 200 naro in Menda. The same basket costs $100 abroad. At $0.50 per naro, 200 naro is worth $100, so the basket costs the same in both places. Relative inflation is a country's rate of inflation compared with the rates in the countries it trades with. When a country's inflation is higher than theirs, the cost of the basket rises faster at home. Economists use the basket to say where a currency's price should settle over the long run, the period in which prices and quantities have had time to adjust. This can take several years.
Purchasing power parity (PPP) theory: the theory that, in the long run, exchange rates move so that the same basket of goods costs the same in each country once the prices are converted into one currency.
Put simply, a naro should buy the same amount of goods in Menda as it buys abroad once it is changed into dollars. If it does not, the rate should move until it does, given enough time.
Why would the naro actually fall? Look at both sides of the currency market. Menda's goods are now more expensive for foreign buyers, so they buy fewer of Menda's exports and demand less naro. Imports are now cheaper than Menda's own goods, so Menda's buyers buy more imports and sell more naro to pay for them. Demand for the naro falls and supply rises, so the naro depreciates.
When the gap between two inflation rates is small, the fall is close to the gap: if prices in Menda rose 5% and prices abroad did not change, the naro would fall by about 5%. The reverse is also true. A country with lower inflation than its trading partners finds its goods becoming cheaper than theirs. Foreign buyers buy more of its exports and need more of its currency, while its own buyers switch from imports to home goods and supply less of it. Demand rises and supply falls, so its currency tends to appreciate.
PPP describes the long run. In the short run, the months before that, money moving between countries to buy assets (such as bonds, shares and buildings) can be larger than money paying for goods. So interest rates and traders' beliefs about the future can hold a currency far from its PPP value for years.
Trade is also trade in currencies, so a current account deficit tends to push a currency down.
When Menda sells exports, someone must buy naro to pay for them. When Menda buys imports, its importers must sell naro to get the dollars the foreign seller wants. So trade in goods and services is also trade in naro.
Menda has a current account deficit of $20bn: it pays the rest of the world $20bn more than it earns. So through trade and income, more naro is sold than bought: the supply of naro is greater than the demand for it. The extra supply tends to push the naro's price down.
A surplus works the other way. A country that earns more abroad than it pays out has more demand for its currency than supply of it from trade. So its currency tends to rise.
The link also runs back, from the rate to the current account. When the naro falls, Menda's exports become cheaper abroad and its imports more expensive at home. Foreign buyers tend to buy more of Menda's exports, and Menda's buyers fewer imports. So the deficit tends to narrow. In this way a floating rate pushes a deficit towards closing.
This is what tends to happen, but it is not certain. Whether the deficit closes depends on how much the quantities of exports and imports respond to the new prices. And money flowing in on the financial account, such as foreign savers buying Menda's bonds, adds to the demand for naro. That inflow can hold the naro up for years despite a deficit.
Investors put money where it seems safe, so a strong economy raises demand for its currency.
A pension fund abroad has money to invest. It could buy bonds or shares in Menda, or build a factory there. Before it does, it asks two questions: will the money be safe, and can it take the money out again? The answer depends on the strength of the economy: its general condition as a place to hold wealth (savings and other things of value).
Four things make up that strength:
When these are strong, foreigners are more likely to invest in Menda: through direct investment, owning and running a business there, and through portfolio investment, buying its shares and bonds. Each investment must first be paid for in naro, so demand for the naro rises and it appreciates. A weak economy does the reverse. Investors sell Menda's assets and then sell the naro they receive, so its supply rises and the naro depreciates.
The rate can move even before any money moves into or out of Menda, because investors act on what they expect to happen. Investor confidence is investors' belief that their money will be safe and earn a return. When it falls, some sell naro at once, before the economy itself has changed.
The four parts can point in opposite directions. Fast growth with prices rising 15% a year may not attract much money. Investors expect the gains to be lost to rising prices and a falling currency.
When people fear for their wealth, money can rush out of a country and push its currency down fast.
Rumours spread that Menda's government may not be able to repay its debts. People who hold Menda's bonds, bank deposits and shares grow afraid that their wealth will lose value. Money held as bonds, bank deposits and shares is called financial capital. Many decide to move it abroad, quickly.
Capital flight: the rapid movement of large amounts of financial capital out of a country.
Put simply, it is a rush to get money out of a country. It is driven by fear of loss, not by the hope of a higher return elsewhere.
The fear can take several forms: that the government will default (fail to repay its debts), that the currency will be devalued, or that political disorder will make property unsafe.
Suppose $6bn leaves Menda in three months. Bonds and shares cannot simply be sent abroad. Holders first sell their Menda assets, and they are paid in naro. Then they sell the naro to buy dollars. That second sale reaches the currency market: naro worth $6bn is offered for sale. The supply of naro rises, and its price falls.
The fall can then continue on its own. Holders who have not sold now see their wealth lose value in dollars, which is exactly what they feared. So more of them sell, and the naro falls further. Where the central bank is holding the rate, it must buy every naro sold with its reserves, so capital flight also uses them up.
Real Example: In 1997 investors lost confidence in Thailand and moved money out quickly. Its central bank used most of its reserves defending the fixed rate of the baht, Thailand's currency, against the dollar. On 2 July 1997 it let the baht float, and the baht fell about 20% against the dollar that month. This shows capital flight draining reserves until a fixed rate cannot be held.
Beliefs about the future, and prices set in world markets, can move a currency without any change inside the country.
Not all buying and selling of currencies pays for goods. Banks and investment funds (firms that invest other people's savings) trade currencies every day, hoping to profit as their prices change.
Speculation: buying or selling a currency to make a profit from an expected change in its value.
Put simply, speculators buy a currency they think will rise and sell one they think will fall.
Traders' expectations, their beliefs about what will happen, can move the rate on their own. Suppose traders come to believe the naro will fall next month. Anyone holding naro will lose by waiting, so they sell now. The extra supply makes the naro fall now. So traders' belief that the naro will fall can be what makes it fall.
This is why an expected change in policy moves the rate before it happens. If traders expect Menda's central bank to cut its interest rate, they sell naro beforehand. When the cut is announced, the rate may hardly move, because traders have already acted.
The naro can also move because of events outside Menda. Coffee is a commodity: a raw material or crop traded worldwide, such as oil, copper or cocoa. Its price is set in world markets, not in Menda.
Why does this lower the naro? Foreign buyers now spend fewer dollars on the same coffee. So fewer dollars are swapped for naro to pay Menda's exporters. Demand for the naro falls, and the naro depreciates, although nothing inside Menda has changed.
Real Example: In the second half of 2014 the world price of oil fell sharply, and Russia's rouble fell with it. Over 2014 the rouble lost about half its value against the US dollar, although Western sanctions also played a part. It is a real case of a currency falling when the world price of the country's main export fell.
A central bank can raise or lower its currency by buying or selling it, but it can buy only while its reserves last.
Menda's central bank thinks the naro has fallen too far. It can act in the currency market itself. Action by a central bank to change the exchange rate is called intervention. The most direct kind is foreign currency transactions: the central bank buying or selling currencies itself.
To raise the naro's price, the central bank buys naro and pays with dollars from its reserves, the foreign currency it holds. This adds to the demand for naro. Its price then rises, or at least falls by less than it would have without the buying. Holding a currency up in this way is called defending it.
To lower the naro's price, it does the reverse. It sells naro and buys dollars. This adds to the supply of naro, so its price falls.
Raising the price and lowering it are not equally easy. The central bank creates naro, so it never runs out of naro to sell. But it cannot create dollars. It can buy naro only while its reserves last.
In practice the end usually comes sooner. Traders can see the reserves falling, and they expect the defence to fail. So they sell naro before it does. Each sale must be met with more reserves, so the reserves fall faster than $5bn a month.
Real Example: Sri Lanka's central bank used its reserves to hold the rupee steady against the US dollar. Over the years up to 2022, its official reserves fell from about $8bn to less than $2bn. In March 2022 it let the rupee move, and by September 2022 the rupee had lost more than 45% of its value against the dollar. This shows a defence ending when the reserves run low.
Raising interest rates can hold a currency up, but households, firms and workers at home pay for it.
Menda's central bank has a second way to defend the naro: its interest rate. Raising the rate from 5% to 7% widens the gap with the 3% paid abroad. The wider gap draws savers' money in and raises demand for the naro.
An interest rate is an instrument (a tool of policy) that cannot run out, unlike reserves, because the central bank sets the rate itself: there is no stock of it to use up. Its cost falls on people at home instead. Banks in Menda borrow from the central bank at its rate, so when that rate rises they raise the interest rates they charge and pay: the rate households and firms pay on loans as well as the rate savers receive.
The longer the defence lasts, the larger this cost grows. Each month of higher rates means less output and fewer jobs.
So the choice between the two instruments is a choice about who bears the cost. Buying naro with reserves uses up the country's stock of foreign currency, and the stock can run out. Raising interest rates keeps the reserves, but households (families who share their income and spending), firms and workers at home pay instead.
Exam Matters: In an Examine question on defending a currency, set the two instruments side by side: what each costs, who bears it and how long each can last. Then judge which cost the economy in the case can better bear.
When a central bank creates money to buy bonds, returns at home fall, and the currency tends to fall too.
Menda's economy is weak, and its central bank wants households and firms to spend more. Suppose its interest rate cannot be lowered any further. It has one more tool. The Menda government borrows by selling government bonds, loans to the government that can be bought and sold. Banks, pension funds and other firms and people outside the government hold many of them. Together they are called the private sector.
Quantitative easing: the creation of new money by a central bank to buy financial assets, such as government bonds, from the private sector.
Put simply, the central bank creates money and uses it to buy bonds from banks, pension funds and other investors.
A bond pays a fixed amount of interest each year. Its yield is that interest as a percentage of the bond's price. Take a bond that pays 5 naro a year. At a price of 100 naro, its yield is 5%. If buyers push its price up to 125 naro, the same 5 naro is only 4% of the price. So a higher bond price means a lower yield.
This has the same effect as a cut in the interest rate, because both lower the return on holding naro.
The weaker naro is often a side effect: a result that the central bank did not aim for. Quantitative easing usually aims to raise spending at home. And if other central banks do the same at the same time, their bonds earn less too. Savers then have less reason to move money out of Menda, and the naro need not fall.
A fall in the currency improves the current account only if buyers change the quantities they buy by enough.
When the naro falls from $0.50 to $0.40, each import costs 25% more in naro. Menda's buyers will buy fewer imports. But will Menda spend less on imports? Not necessarily, because it now pays more for each one.
Spending on imports is the price of imports times the quantity bought. The price has risen, so spending falls only if the quantity falls by enough. How strongly the quantity demanded responds to a change in price is measured by the price elasticity of demand.
The price rose by 25%. A 10% fall in the quantity gives a price elasticity of demand of 10 ÷ 25 = 0.4. That is below 1, so demand for imports is price inelastic: the quantity falls by a smaller percentage than the price rises, and the bill rises. A 30% fall gives 30 ÷ 25 = 1.2, above 1, so demand is price elastic and the bill falls. So the import bill in naro falls only when demand for imports is price elastic.
Exports work differently. A 100-naro export still earns 100 naro, but its price abroad has fallen, so foreign buyers tend to buy more. Menda's export earnings in naro rise only as the quantity sold rises.
Put the two together. The current account improves only if the quantities of exports and imports respond enough to their new prices. This idea has a name.
Marshall-Lerner condition: a depreciation or devaluation improves the current account only if the sum of the price elasticities of demand for exports and imports is greater than 1.
Put simply, a fall in the currency helps only if buyers at home and abroad change what they buy by enough. The test adds the two elasticities together; it does not look at each one on its own.
A fall in the currency usually makes the current account worse at first, and better later.
The naro falls from $0.50 to $0.40. The new prices apply at once. But buyers cannot change what they buy at once.
In the first months, importers and exporters are tied by contracts that fix the quantities they buy and sell. Firms hold stocks (stores) of imported parts. Buyers abroad take time to notice that Menda's goods are cheaper. So at first the quantities hardly change: demand for imports and exports is price inelastic, because the quantities change by a smaller percentage than the prices. Menda pays 25% more in naro for almost the same imports, and its deficit widens.
Over a year or two, contracts end and are renewed. Economists call the first months the short run, and this later period the long run. Menda's firms find suppliers at home, and buyers abroad switch to Menda's cheaper goods. Demand becomes more price elastic, the Marshall-Lerner condition is then likely to hold, and the deficit narrows.
If you draw the current account balance against time, it first falls, then rises above where it started. The path looks like the letter J.
J-curve effect: the tendency for the current account to worsen in the short run after a depreciation or devaluation, before it improves in the long run.
Put simply, a fall in the currency makes the current account worse before it makes it better, because buyers need time to switch. So a deficit that widens in the first months does not mean the fall has failed.
Exam Matters: When you analyse a depreciation's effect on the current account, say when each effect arrives. In the short run the balance can worsen; over a year or two it improves if the Marshall-Lerner condition then holds.
Once a fall in the currency raises net exports, more is spent on the country's output, and firms hire.
Two years after the naro fell, Menda's current account deficit has narrowed from $20bn to $12bn. Suppose all of this change comes from trade. Then net exports (exports minus imports) have risen by $8bn.
Why does this raise Menda's output, the total amount it produces? Net exports are part of aggregate demand, the total spending on a country's goods and services. Foreign buyers spend more on goods made in Menda. Menda's buyers switch from imports to Menda's own goods. Both are extra spending on Menda's output.
Exporters hire first, because the extra orders from abroad reach them first. Firms that compete with imports, such as Menda's makers of machinery, also get back orders that had gone to foreign firms, and they hire too. So employment rises and unemployment falls.
How much of the extra demand becomes extra output depends on spare capacity: idle workers and machines that firms can put to use. With plenty of spare capacity, firms produce more. Near full capacity, they cannot, so the extra demand mostly raises prices.
An appreciation reverses each step. Exports become more expensive abroad and imports cheaper at home, so net exports fall. Aggregate demand falls, and output and jobs fall, in exporting firms first.
A fall in the currency raises the price of imports, and so raises the country's price level.
After the naro falls from $0.50 to $0.40, imports cost 25% more in naro. Does that raise inflation in Menda? Imported goods are part of what Menda's households buy, so their prices are part of Menda's price level, the average level of all prices.
Inflation is measured with a consumer price index: a measure of the average price of a basket of goods and services that households buy. Imports make up 20% of the goods in Menda's index.
These 5 percentage points are the largest direct effect, reached only if all of the rise reaches buyers. Importers may keep their prices lower and accept a smaller profit on each sale. Buyers may switch to goods made in Menda. Then only part of the rise reaches buyers, and the price level rises by less.
There are also indirect effects. Imported fuel and materials raise firms' costs, and firms raise their prices to cover them. This is cost-push inflation: inflation caused by rising costs of production. Higher net exports also add to demand, which raises prices when the economy is near full capacity.
Workers may then ask for higher wages to match the higher prices. If firms raise prices again to pay those wages, a wage-price spiral can follow: wages and prices push each other up in turn.
An appreciation works the other way. Imports become cheaper in the home currency, so the price level rises less than it would have.
Exam Matters: In a Calculate question on import prices, multiply the share of imports in the price index by the rise in import prices. Give the answer in percentage points and say it is the largest possible direct effect.
A fall in the currency makes a country's assets cheaper for foreign buyers, and assets abroad more expensive.
A foreign food company wants to buy a food plant in Menda. The plant's owner asks 4bn naro, and that price stays the same when the naro falls. What changes is the cost in the buyer's own currency.
The plant is the same; only its dollar price has fallen. So a depreciation tends to attract foreign direct investment (FDI): a foreign firm buying or building a business that it owns and runs. Each purchase is a credit on Menda's financial account. Shares and bonds in Menda, bought as portfolio investment, are cheaper in dollars too.
The same fall makes assets abroad more expensive for Menda's residents. A Menda firm that wants a factory abroad now needs 25% more naro for it. So investment abroad by Menda's residents tends to fall.
There is another side. Foreign investors who already own assets in Menda have just seen them lose 20% of their value in dollars. If they expect the naro to fall further, they may sell before it does. Then more money can leave through these sales than comes in through the cheaper assets.
An appreciation reverses the price effect. Menda's assets become more expensive for foreign buyers, and assets abroad become cheaper for Menda's residents.
When rival countries all let their currencies fall, none gains a price advantage over the others, but all pay more for imports.
Veltia is a country that competes with Menda for the same export orders. Both sell coffee to buyers who pay in dollars. Menda lets the naro fall 20% against the dollar. Menda's exports then cost buyers less in dollars, so Menda hopes to win orders from Veltia. Veltia sees its exporters losing orders, and it lets its own currency fall 20% too.
Competitive depreciations and devaluations: falls in the value of currencies that countries cause or allow in turn, each to gain a price advantage for its exports over the others.
Put simply, countries take turns lowering their currencies, each trying to make its exports cheaper than the others'.
Why does Menda gain no advantage over Veltia? Menda's advantage over Veltia depends on the exchange rate between the naro and Veltia's currency, not on the rate against the dollar. Both fell by 20% against the dollar, so the rate between them has not changed. A buyer comparing Menda's coffee with Veltia's sees the same relative prices as before. Neither country wins orders from the other. The advantage does not vanish against everyone. A buyer who compares Menda's coffee with coffee from a country whose currency did not fall still finds Menda's cheaper. Price is also not the only thing that decides an order: quality and reliability matter too. So how much a country gains depends on which rivals match the fall and on what else buyers care about.
The costs remain. Both now pay 25% more in their own currency for imports from the rest of the world, and both face the inflation that follows.
If many countries join in, world trade can shrink. Frequent changes in currencies make trade less certain. Countries may also retaliate: they answer with measures that hurt the other side, such as tariffs (taxes on imports) and quotas (limits on the quantity of imports). Then trade falls and many countries lose some of their gains from trade.
Real Example: In the 1930s many countries let their currencies fall, one after another, as their central banks ran short of gold, which they held as reserves. The changes were large and sudden, and they disrupted world trade. Many countries also raised tariffs and quotas on imports, and world trade collapsed. This is a real case of falling currencies and trade barriers together reducing world trade.
A country's ability to sell abroad can be measured by comparing it with a rival, for example by how much each worker produces.
Menda, a country whose currency is the naro, sells cloth abroad. Veltia, a country that competes with Menda for the same export orders (orders from buyers in other countries), sells cloth too. A buyer abroad compares the two before ordering.
International competitiveness: the ability of a country to sell its goods and services abroad.
Put simply, it is how well a country wins orders from buyers in other countries, against rivals who want the same orders.
A buyer compares countries, so competitiveness is measured by comparing a country with a rival. There are three measures:
Productivity means output per worker. A worker in Menda makes 40 units of cloth a year. A worker in Veltia makes 100. To compare them, economists use an index number (a figure that shows each value against a base set at 100).
Why compare with a rival? Suppose Menda's output per worker rises by 2% this year. If Veltia's rises by 5%, the gap widens, and Menda falls further behind in the contest for orders. If both rise by the same share, the ratio between them stays the same, so Menda's index stays at 40. For example, if output per worker rises by a fifth in both, Menda's 40 units become 48 and Veltia's 100 become 120, and 48 ÷ 120 × 100 = 40.
Productivity can be measured per worker or per hour worked, and the two can give different answers. Suppose workers in one country work very long hours. Each worker then makes a lot in a year, but less in each hour. So the country looks better per worker than per hour. Always say which measure a figure uses.
A low wage does not make a country's goods cheap to produce if each worker also makes fewer units.
Menda pays each worker half what Veltia pays. Does that make Menda's goods cheaper to produce? A buyer pays for units of cloth, not for workers. So the question is how much labour cost goes into each unit.
Labour cost per worker is what an employer pays for one worker in a year: the wage plus the other costs of employing that worker. Spread it over what the worker makes, and you get the labour cost in each unit.
Unit labour cost: the labour cost of producing one unit of output.
Put simply, the labour cost goes on top and the output goes underneath. A higher labour cost per worker raises unit labour cost. Higher output per worker lowers it, because the same cost is spread over more units.
To compare two countries, both costs must be in one currency, because a buyer abroad compares them in one currency. Menda's wages are paid in naro, so they are first converted into dollars at $0.50 per naro.
So Menda pays half as much per worker, yet each unit carries 25% more labour cost. Why? Menda's labour cost per worker is half of Veltia's, but each Menda worker makes 40 units, fewer than half of Veltia's 100. Menda's output per worker is 40% of Veltia's, but its labour cost per worker is 50% of Veltia's. Output is further behind than cost, so each Menda unit carries more labour cost.
Comparing unit labour costs like this, in one currency, is the second measure: relative unit labour costs. An index above 100 means each unit costs more in labour than the rival's. A low wage does not make a country cheap if output per worker is low too.
A buyer abroad compares export prices in one currency, so the exchange rate can change them while costs stay the same.
A buyer abroad chooses between cloth from Menda and cloth from Menda's rivals. The buyer compares the prices in one currency: the one the buyer pays in.
Relative export prices: the price of a country's exports compared with the price of its competitors' exports, measured in the same currency.
Put simply, it shows whether a buyer abroad finds a country's goods more expensive or cheaper than the same goods from its rivals.
It is usually shown as an export price index (export prices set against a base of 100). With competitors' prices at 100, Menda's index is 110. So Menda's exports are 10% more expensive than its competitors'.
Three things can change this measure. The first is costs and prices at home: if Menda's firms raise their naro prices, the index rises. The second is the exchange rate. It can move the index even when nothing in Menda changes. The third is the competitors' own prices: if they cut their prices, Menda's index rises, although nothing in Menda has changed.
Menda's workers produce the same output, at the same naro cost and the same quality. Only the price a buyer abroad pays has fallen, because each naro now buys fewer dollars. So a better relative export price does not always mean a country has become more efficient.
The reverse also holds. If the naro rises 20%, from $0.50 to $0.60, the same naro prices are worth 20% more in the buyer's currency: 110 × 1.2 = 132. Menda's exports are then 32% more expensive than its competitors'. A fall in the naro also lowers Menda's labour cost per worker measured in dollars, so its unit labour cost in dollars falls too. A rise in the naro does the opposite.
Three factors behind competitiveness are about workers: how much they produce, how skilled they are, and what they cost.
Why do some countries win export orders more easily than others? Seven factors influence a country's international competitiveness. Three of them are about its workers: how much they produce, what skills they have, and what they cost to employ.
Productivity. When each worker makes more, the labour cost of each unit falls.
Quality of human capital. Human capital is the skills, education, training and health of a country's workers. It is one of the main sources of productivity, alongside machinery and technology. A trained worker makes fewer mistakes and can use more advanced machines, so output per worker rises. A healthy worker misses fewer days of work, so produces more over the year. But human capital changes slowly: a better school system takes years to reach the workforce.
What workers cost. Wage costs are what an employer pays workers for the work they do. But the wage is only part of what it costs to employ someone. Employers also pay for pensions, holiday pay and social security contributions (payments to the government, set as a share of each worker's pay, that help fund benefits such as state pensions and health care).
Non-wage costs: the costs of employing a worker other than the wage, such as employers' social security contributions, pensions and holiday pay.
Put simply, they are the bills an employer pays for each worker as well as the wage.
Why do they belong in labour cost per worker? The employer pays them for every worker, just like the wage. So labour cost per worker is the wage plus the non-wage costs. So low wages do not always mean a low labour cost per worker. A country with low wages but high non-wage costs can cost more per worker than a country with higher wages and low non-wage costs.
Some factors can win or lose export orders even when a country's labour costs in its own currency have not changed.
Why can a country whose costs are falling still lose export orders? Four more factors influence its international competitiveness.
The exchange rate. This is the fastest-moving factor, and it changes competitiveness without changing anything a country makes. A 20% depreciation of the naro, from $0.50 to $0.40, cuts Menda's labour cost per worker from $6,000 to $4,800 in dollars. Each worker still makes 40 units, so unit labour cost falls from $150 to $120. The relative unit labour cost falls by 20% too: 125 × 0.8 = 100, level with Veltia.
Regulations. Regulations are the rules firms must follow, on safety, employment, planning and the environment. Each one adds cost and time: forms to complete, inspections, and waiting for permits. Many exist for good reasons, such as safe workplaces, so removing one is a choice with a cost of its own.
Quality of infrastructure. Infrastructure means the ports, roads, power and communications that firms depend on. A firm may produce cheaply, but if its goods wait at a crowded port, the buyer receives them late. None of this shows in unit labour cost, because the delay happens after the goods are made.
What the buyer gets. A buyer does not choose on price alone.
Non-price factors: the features of a product, other than its price, that affect a buyer's choice, such as quality, design, reliability and delivery time.
Put simply, they are the reasons a buyer may pay more for one supplier's goods. A cheap order that arrives late, or with faulty items, can cost the buyer more than a more expensive one that arrives on time and works.
So a country can cut its costs and still lose export share (its part of the world's sales of a product). If rivals offer better quality or faster delivery, many buyers choose them and pay the higher price.
Real Example: The World Bank's 2023 Logistics Performance Index (a survey that compares how well countries move goods) found that, on average, 44 days pass between a container (a large steel box in which goods are shipped) entering the exporting country's port and leaving the port at its destination. It found that the biggest delays occur at seaports, airports and the places where goods change between ship, rail and road. These 44 days cover the whole journey, including time at sea, so they do not measure one country's infrastructure. But time lost at ports and transfer points is time a buyer waits for the goods, however low the price was.
Better skills and better machinery raise output per worker, and so lower the labour cost of each unit.
A government that wants its country to win more export orders can choose from several measures. They fall into three groups. Some raise what the economy can produce. Some increase competitive pressure (the threat that firms lose customers to rivals). One lowers the price at which the country sells, by reducing the exchange rate.
The first group raises output per worker. Policies to improve education and training, such as technical colleges, apprenticeships (jobs that include training) and retraining, work in three links:
Investment incentives are tax allowances (cuts in the tax a firm pays when it buys machinery), grants or cheap loans that encourage firms to buy capital, such as machinery and equipment. A worker with a faster machine produces more in the same hours. So output per worker rises and unit labour cost falls, through the same last two links.
Both measures cost public money now, and both work over years, not months. A college opened today trains its first workers years later. Training also works only under a condition. It raises output per worker only if workers learn the skills that employers need. Training people for jobs the economy does not have costs money and raises nothing. In both cases, unit labour cost falls only if labour cost per worker rises by a smaller share than output per worker. If workers win a pay rise bigger than their extra output, each unit costs more, not less.
Some measures raise competitiveness by giving firms a reason to cut their costs, often by giving them rivals.
A firm that cannot lose its customers has little reason to cut its costs. A firm that can lose them to a rival has a strong reason. Three measures aim to give firms that reason.
Privatisation means selling a state-owned firm to private owners. The owners keep any profit and bear any loss, so every cost they cut adds to their profit.
Deregulation means removing rules that limit competition, such as rules that stop new firms entering a market. When new firms can enter, existing firms must keep their costs and prices down, or lose customers to the new firms.
Trade liberalisation means removing barriers to trade, such as tariffs (taxes on imports) and quotas (limits on the quantity imported). Domestic firms then face rivals from abroad. They can also buy cheaper imported inputs, such as parts and materials, which lowers their costs directly.
Deregulation and trade liberalisation work through competitive pressure: the threat of losing customers to rivals. Privatisation works through ownership, because private owners keep the profit from every cost they cut. It adds competitive pressure only if the firm also faces rivals. A firm under pressure looks for ways to cut costs and improve quality, and lower costs make its exports more competitive.
Each works only under a condition. A monopoly is the only firm in a market. If the state sells a monopoly to private owners, it becomes a private monopoly. It still has no rivals, so it faces no more competitive pressure than before. Removing rules may also remove protections, such as safety standards. And liberalisation exposes some firms that cannot survive, so their workers lose their jobs.
Real Example: India opened its mobile phone market to more private firms. In 2001 it issued 17 licences (official permissions) to private companies to run a fourth mobile network in its telecom areas. Before the 1999 tariff order (a ruling on call prices) by the regulator (the government body that oversees the market), a mobile call cost Rs 16.80 (16.80 rupees) a minute; outgoing calls later fell to less than Re 1 (one rupee). The regulator also set call prices in those years, so these figures do not show how much of the fall the new rivals caused.
A lower exchange rate cuts unit labour cost, measured in dollars, at once, but leaves output per worker where it was.
Menda's unit labour cost is $150 against Veltia's $120. One way to close that gap works on price, not on output: reducing the exchange rate. A government can reduce its country's exchange rate in three ways. It can cut interest rates, so that holding its currency earns less and demand for it falls. Its central bank can use quantitative easing (creating new money to buy bonds), which lowers returns (the interest earned on savings and bonds) in the same way. Or it can sell its own currency for foreign currency, which increases the supply of it.
A lower exchange rate makes exports cheaper abroad and imports more expensive at home. It also lowers unit labour cost measured in dollars, because wages paid in naro are worth fewer dollars. Higher output per worker lowers it too. Here are the two routes side by side for Menda.
Both routes end at $120, level with Veltia. But the two routes leave Menda in different positions, as the next two paragraphs show.
The productivity route leaves each Menda worker making 50 units instead of 40. The economy can now produce more with the same workers, and higher wages can later be paid out of the extra output.
The exchange-rate route leaves each worker making 40 units, as before. Menda's goods are cheaper only because its workers are paid less in dollars. Imports now cost 25% more in naro, so imported machines and fuel cost firms more, and wages buy fewer imported goods. A rival can also cancel the gain by letting its own currency fall by the same amount.
Whether a country is competitive affects its growth, its jobs and its current account.
Why does a government care whether its country is competitive? Workers are hired to make goods that are sold. So demand for a country's exports, and for its goods in place of imports, is also demand for its workers.
Advantages of being competitive. When buyers abroad choose a country's goods, its exports rise. Rising exports add to aggregate demand (total spending on a country's output), so firms can produce and sell more, and the economy can grow. This is export-led growth (growth driven by rising exports). To make the extra exports, firms hire more workers. Higher export earnings strengthen the current account, so the country needs less foreign financing, such as borrowing from abroad. Foreign firms are also more likely to build factories where they can produce at low cost, and they bring capital and skills.
Problems of being uncompetitive. When a country is uncompetitive, each of these effects is reversed. Buyers abroad choose rivals, so the country's exports lose their share of world markets. At home, imports take customers from domestic firms. With exports falling and imports rising, the current account deficit widens. It must be financed by borrowing from abroad or by selling assets to foreigners. Jobs are lost first in exporting firms and in firms that compete with imports, because demand for their output falls.
Why can each position reinforce itself? A competitive country attracts investment, and the new capital raises output per worker, which keeps it competitive. An uncompetitive country loses orders and firms, so less is invested there, and its output per worker falls further behind its rivals'.
A country keeps one record of all its money dealings with the rest of the world, and that record always balances.
What a country earns from and pays to the rest of the world includes income and gifts, not only trade.