Cambridge International as and a level Economics Ebook

Terms of trade: 
a numerical measure of the relationship 
between export and import prices.
KEY TERM
SELF-ASSESSMENT TASK 
4.8
At the end of 2013, the UK’s foreign exchange rate 
rose to its highest level in almost two and a half years. 
Th
is was despite the country’s current account defi cit 
worsening, which might have been expected to have 
put downward pressure on the value of the pound 
sterling. Th
e increase did, however, follow favourable 
predictions for the UK’s future economic performance.
Th
e appreciation of the pound sterling was good 
news for UK tourists but not for UK exporters. Some 
economists also claimed that the appreciation might 
threaten the recovery, which was a major reason why 
it had occurred.
1
Explain why a rise in a country’s current account 
defi cit would be expected to reduce its foreign 
exchange rate.
2
Analyse why a rise in the pound sterling might 
help UK tourists but harm UK exporters.
3
Discuss whether a rise in a country’s foreign 
exchange rate would always threaten an 
improvement in its economic performance.
101

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Cambridge International AS Level Economics
Absolute and comparative 
advantage
Absolute advantage
Some of world trade is explained by 
absolute advantage
. A 
country has an absolute advantage in producing a product 
if it can produce more of a product with the same quantity 
of resources than another country. For example, Indonesia 
has the absolute advantage in producing rice while Brazil 
has the absolute advantage in producing coff ee. 
Figure 4.20 
shows simplifi ed production possibilities for the two 
countries. Th
is is based on each country devoting half of 
its resources to each of the products.
If each country specialises in the product in which 
it has an absolute advantage and then trades, based on 
opportunity cost ratios, total output will rise and both 
countries will be able to consume more products.
 Table 4.4 
shows output before and aft er specialisation.
In this case, the opportunity cost of producing 
1 tonne of rice in Indonesia is two-fi ft hs of a tonne 
of coff ee while in Brazil it is 2.5 tonnes of coff ee. An 
exchange rate of 1 tonne of rice for 1.5 tonnes of coff ee 
lies between the opportunity cost ratios and will benefi t 
both countries. 
Table 4.5
 shows the countries’ positions 
aft er Indonesia has exchanged 300 tonnes of rice for 
450 tonnes of coff ee.