Relationship between countries at different levels of development

Economics A2 · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Resources flow between richer and poorer countries through aid, trade, investment and loans. Aid can be bilateral (one government to another) or multilateral (through bodies such as the World Bank), and tied or untied. It can fill the gaps in saving and foreign exchange that hold back investment, but it may create dependency, be wasted or add to debt when given as loans.

A multinational company (MNC) produces in more than one country. Its foreign direct investment (FDI) brings capital, jobs, technology and tax revenue, but profits are sent home and local firms may be squeezed out.

External debt has to be serviced in foreign currency, which takes resources away from development.

Rules to remember

Tied aid: the recipient must spend it on goods and services from the donor country, or on a named project.
Terms of trade index = index of export prices ÷ index of import prices × 100.
MNC: a firm that owns or controls production in more than one country. FDI: investment that sets up or buys a lasting controlling interest in a business abroad.
FDI inflow: a credit in the host's financial account. Profits sent home later: a debit in primary income on the host's current account.
Transfer pricing: an MNC sets prices between its own subsidiaries so that profit appears in low-tax countries.
If debt is in foreign currency, a depreciation raises its cost in local currency. Debt servicing uses export earnings that could have paid for imports, schools and health.
IMF: short-term loans to countries with balance of payments problems, usually with conditions, and support for exchange rate stability. World Bank: long-term loans and grants for development projects and poverty reduction.

Common mistake

Students mix up the two institutions. The IMF deals with balance of payments and currency crises; the World Bank finances long-term development projects.

Worked example

A country's index of export prices rises from 100 to 120 and its index of import prices rises from 100 to 150. What happens to its terms of trade?

Terms of trade index = 120 ÷ 150 × 100 = 80.
The index falls from 100 to 80, a fall of 20%.
To buy the same volume of imports it must now export 100 ÷ 80 = 1.25 times as much, which is 25% more.

Answer: The terms of trade worsen to 80: each unit of exports buys 20% fewer imports.

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