International Economics Corrected...INTERNATIONAL ECONOMICS iii Ideal International E- Publication...

INTERNATIONAL ECONOMICS

(For B.Com. IV Semester and B.A. V Semester Economics Students of Akkamahadevi

Women’s University, Vijayapura and Other Universities of Karnataka)

By

Dr.Siddalingareddy

M.A., M.Phil., Ph.D. and K-SLET

Lecturer in Economics

Godutai Doddappa Appa Arts and Commerce Degree College for Women

Kalaburagi-585103

Mobile: 9945616334

Email.ID: [email protected]

Dr. Teekappa M M.A., B.Ed., Ph.D. and K-SLET

Assistant Professor of Economics

HKE Society's

A.V. Patil Degree College of Arts, Science and Commerce, Aland-585302

Mobile: +918105423677

Email: ID: [email protected]

2020

Ideal International E – PublicationPvt. Ltd. www.isca.co.in

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Title: INTERNATIONAL ECONOMICS

Author(s): Dr.Siddalingareddy, Dr. Teekappa M

Edition: First

Volume: I

© Copyright Reserved

2020

All rights reserved. No part of this publication may be reproduced, stored, in a

retrieval system or transmitted, in any form or by any means, electronic,

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ISBN: 978-93-89817-17-1

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AND AND AND AND

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INTERNATIONAL ECONOMICS iii

Ideal International E- Publication www.isca.co.in

PREFACE

We are pleased to place before you the book on International Economics.

The book is prepared as per the revised syllabus of Akkamahadevi Women’s

University, Vijayapura, for Economics students of B.A. and B.Com. It is written

in a simple and easily understandable language to make the student understand

the subject matter thoroughly. The book contains five chapters and at the end of

all the chapters, five model question papers and most important questions for

examinations have been provided. We hope that the present book International

Economics will be very useful to the students and teachers of the concerned

subject in particular and others in general.

While preparing the book, we have referred various invaluable reference

books authored by eminent scholars and professionals. We express sincere

gratitude’s to them.

We gratefully acknowledge the invaluable assistance of the librarian,

colleagues and members of the faculty of Godutai Degree College, Kalaburagi

and A.V.Patil Degree College, Aland during the preparation of the manuscript.

Special thanks to the publisher, Ideal international e publication Pvt.Ltd ,

Indore for very neat printing and publishing the book.

Constructive comments and concrete suggestions to further improve the

book are welcome and shall be gratefully acknowledged.

Kalaburagi . Dr.Siddalingareddy

January, 2020 Dr.Teekappa M

INTERNATIONAL ECONOMICS iv


CONTENTS

------------------------------------------------------------------------------------------------

SYLLABUS OF THE B.COM. AND B.A.

LIST OF ABBREVIATIONS IN THE TEXT

LIST OF COUNTRIES AND CURRENCIES

IMPORTANT INTERNATIONAL ORGANISATIONS: A View

------------------------------------------------------------------------------------------------

UNIT: 1- INTERNATIONAL TRADE 1 - 20

1.1. Meaning of Trade

1.2. Types of Trade

1.3. Differences between Internal trade and External Trade

1.4. Significance of International Trade

1.5. Theories of International Trade

1.5.1. Theory of Comparative Cost Advantage

1.5.2. Theory of Opportunity Costs

1.5.3. The Modern Theory of International Trade

1.6. Gains from trade

1.6.1. Meaning of Gains from trade

1.6.2. Measurement of Gains from trade

UNIT: 2-TERMS OF TRADE 21- 29

2.1. Introduction

2.2. Meaning of Terms of Trade

2.3.. Concepts or types of Terms of Trade

2.4. Factors Effecting Terms of Trade

2.5. Reasons for unfavourable Terms of Trade of Under Developed Countries

UNIT: 3-THE TRADE POLICY 30 - 49

INTERNATIONAL ECONOMICS v


3.1. Meaning of Trade Policy

3.2. Types of Trade Policy

3.3. Free Trade Policy

3.3.1. Meaning of Free Trade

3.3.2. Definitions of Free Trade Policy

3.3.3. Advantage of Free Trade Policy

3.3.4. Disadvantages of Free Trade Policy

3.4. Policy of Protection

3.4.1. Meaning Policy of Protection

3.4.2. Forms of Policy of Protection

3.4.3. Advantages of Policy of Protection

3.4.4. Disadvantages of Policy of Protection

3.4.5. Role of Protection in Developing countries or LDC’s

3.5. Tariffs

3.5.1. Meaning of Tariffs

3.5.2. Types of Tariffs

3.5.3. Effects of Tariffs

3.6. Quotas

3.6.1. Meaning of Quotas

3.6.2. Effects of Quotas

3.7. Dumping

3.7.1. Meaning of Dumping

3.7.2. Objectives of Dumping

UNIT: 4- FOREIGN EXCHANGE 50 -73

INTERNATIONAL ECONOMICS vi


4.1. Meaning of Foreign Exchange

4.2. Meaning of Foreign Exchange Market

4.3. Functions of Foreign Exchange Market

4.4. Foreign Exchange Rate

4.4.1. Meaning of Rate of Exchange

4.4.2. Determination of Equilibrium Exchange Rate

4.5. Types of Exchange Rate

4.6. Argument for or Advantages of Fixed Exchange Rate

4.7. Argument against Fixed Exchange Rate or Disadvantages

4.8. Argument for or Advantages of Flexible Exchange Rate

4.9. Argument against or Disadvantages of Flexible Exchange Rate

4.10. The Purchasing Power Parity Theory

4.11. Exchange Control

4.11.1. Meaning of Exchange Control

4.11.2. Features of Exchange Control

4.11.3. Objectives of Exchange Control

4.11.4. What are the methods of Exchange Control

UNIT: 5-BALANCE OF PAYMENTS 74 -91

5.1. Meaning of Balance of Payments

5.2. Meaning of Balance of Trade

5.3. Structure of Balance of Payments Account

5.4. Equilibrium and Disequilibrium in Balance of Payments

5.5. Surplus in Balance of payments

5.6. Deficit in Balance of payments

INTERNATIONAL ECONOMICS vii


5.7. Causes of Disequilibrium in Balance of Payments

5.8. Methods of correcting disequilibrium in BOP

5.9. Devaluation

5.9.1. Meaning of Devaluation

5.9.2. Effects of Devaluation

5.9.3. Evaluation of Devaluation

Question Papers of Last Five Years 92 - 103

The Most important Questions and Answers of Two Marks 104 - 111

The Most Important Questions of Ten or Fifteen Marks 112- 113

References 114

INTERNATIONAL ECONOMICS viii


SYLLABUS OF THE B.COM. FOURTH AND B.A

FIFTH SEMESTER Syllabus

INTERNATIONAL ECONOMICS

(80 Marks Paper of 3 hours duration and 20 marks IA) 5 hours per

week

OBJECTIVES:

1. To enable the students to learn the fundamental theories of international trade. 2. To enable the students to apply the knowledge gained from the study of micro

and macroeconomics in the field of international economics. 3. To enable the students to understand the international trade system as it exists

today. 4. To study various aspects of international trade policy and regional economic

cooperation.

UNIT–I: INTERNATIONAL TRADE

Introduction, meaning, significance of international trade, international v/s internal

trade, Theories of international trade: The Classical theory, Modern theory and Opportunity

cost theory. Gains from international trade.

UNIT –II: TERMS OF TRADE

Introduction, meaning, concepts, factors affecting terms of trade, measurement of

terms of trade

UNIT– III: THE TRADE POLICY

Meaning of Free trade and protection policy: advantages and disadvantages, role of

protection in developing countries, Methods of protection: tariff, quotas – types and effects,

concept of dumping.

UNIT- IV: FOREIGN EXCHANGE

Meaning, importance, foreign exchange market, functions, determination of rate of

exchange, Purchasing power parity theory; Fixed and Flexible exchange rates: Meaning,

advantages and disadvantages; Exchange control: Meaning, objectives and methods of

exchange control.

MODULE V: BALANCE OF PAYMENTS

Meaning and components of balance of payments, equilibrium and disequilibrium in

the balance of payments; causes and consequences, methods of correcting disequilibrium in

balance of payment.

INTERNATIONAL ECONOMICS ix


LIST OF ABBREVIATIONS IN THE TEXT

ADB : Asian Development Bank

ASEAN : Association of South East Asian Nations

BOP : Balance of Payments

BOT : Balance Of Trade

FEMA : Foreign Exchange Management Act.

FERA : Foreign Exchange Regulation Act.

GAAT : General Agreement on Tariffs and Trade

H.O : Heckscher-Ohlin

IBRD : International Bank for Reconstruction and development

ICSID : International Centre for Settlement of Investment Disputes

IDA : International Development Association

IFC : International Finance Corporation

IFAD : International Fund for Agricultural Development

IMF : International Monetary Fund

LDC'S : Least Developed Countries

MIGA : Multilateral Investment Guarantee Agency

OPEC : The Organisation of the Petroleum Exporting Countries

R&D : Research and Development

SAARC : South Asian Association for Regional Co- operation.

TOT : Terms of trade

WTO : World Trade Organisation

INTERNATIONAL ECONOMICS x


LIST OF COUNTRIES AND CURRENCIES

Country Name

Capital

Currency

Official Language

Afghanistan Kabul Afghani Dari Persian; Pashto

Albania Tirane Lek Albanian

Algeria Algiers Dinar Arabic; Tamazight; French

Angola Luanda New Kwanza Portuguese

Argentina Buenos Aires Peso Spanish

Armenia Yerevan Dram Armenian

Australia Canberra Australian

dollar

English

Austria Vienna Euro (formerly

schilling)

German

The Bahamas Nassau Bahamian

dollar

English

Bahrain Manama Bahrain dinar Arabic

Bangladesh Dhaka Taka Bangla

Barbados Bridgetown Barbados dollar English

Belarus Minsk Belorussian

ruble

Belarusian; Russian

Belgium Brussels Euro (formerly

Belgian franc)

Dutch; French; German

Bhutan Thimphu Ngultrum Dzongkha

Bolivia La Paz

(administrative);

Sucre (judicial)

Boliviano Spanish; Quechua; Aymara

Bosnia and

Herzegovina

Sarajevo Convertible

Mark

Bosnian; Croatian; Serbian

Botswana Gaborone Pula English; Tswana

Brazil Brasilia Real Portuguese

INTERNATIONAL ECONOMICS xi


Bulgaria Sofia Lev Bulgarian

Burundi Gitega Burundi franc Kirundi; French

Cambodia Phnom Penh Riel Khmer

Cameroon Yaounde CFA Franc French; English

Canada Ottawa Canadian dollar English; French

Chile Santiago Chilean Peso Spanish

China Beijing Chinese Yuan Mandarin

Colombia Bogota Colombian

Peso

Spanish

Comoros Moroni Franc Comorian; Arabic; French

Costa Rica San Jose Colón Spanish

Cuba Havana Cuban Peso Spanish

Cyprus Nicosia Euro Greek; Turkish

Czech Republic Prague Koruna Czech; Slovak

Denmark Copenhagen Danish Krone Danish

Dominica Roseau East Caribbean

dollar

English; French;

Antillean Creole

Dominican

Republic

Santo Domingo Dominican

Peso

Spanish

East Timor

(Timor-Leste)

Dili U.S. dollar Tetum; Portuguese;

Iindonesian

Ecuador Quito U.S. dollar Spanish

Egypt Cairo Egyptian pound Arabic

Estonia Tallinn Estonia Kroon;

Euro

Estonian

Ethiopia Addis Ababa Birr Amharic

Fiji Suva Fiji dollar English; Bau Fijian; Hindi

Finland Helsinki Euro (formerly

markka)

Finnish; Swedish

France Paris Euro (formerly

French franc)

French

The Gambia Banjul Dalasi English

Georgia Tbilisi Lari Georgian

INTERNATIONAL ECONOMICS xii


Germany Berlin Euro (formerly

Deutsche mark)

German

Ghana Accra Cedi English

Guinea Conakry Guinean franc French

Guinea-Bissau Bissau CFA Franc Portuguese

Guyana Georgetown Guyanese

dollar

English

Haiti Port-au-Prince Gourde Haitian Creole; French

Honduras Tegucigalpa Lempira Spanish

Hungary Budapest Forint Hungarian

Iceland Reykjavik Icelandic króna Icelandic

India New Delhi Indian Rupee Hindi; English

Indonesia Jakarta Rupiah Indonesian

Iran Tehran Rial Persian

Iraq Baghdad Iraqi Dinar Arabic; Kurdish

Ireland Dublin Euro (formerly

Irish pound

[punt])

English; Irish

Israel Jerusalem* Shekel Hebrew; Arabic

Italy Rome Euro (formerly

lira)

Italian

Jamaica Kingston Jamaican dollar English

Japan Tokyo Yen Japanese

Jordan Amman Jordanian dinar Arabic

Kazakhstan Nur Sultan Tenge Kazakh; Russian

Kenya Nairobi Kenya shilling Swahili; English

Kiribati Tarawa Atoll Kiribati dollar English; Gilbertese

Korea, North Pyongyang Won Korean

Korea, South Seoul Won Korean

Kosovo Pristina Euro (German

Mark prior to

2002)

Albanian; Serbian

Kuwait Kuwait City Kuwaiti Dollar Arabic; English

INTERNATIONAL ECONOMICS xiii


Kyrgyzstan Bishkek Som Kyrgyz; Russian

Laos Vientiane New Kip Lao (Laotian)

Latvia Riga Lats Latvian

Lebanon Beirut Lebanese

pound

Arabic; French

Liberia Monrovia Liberian dollar English

Libya Tripoli Libyan dinar Arabic

Liechtenstein Vaduz Swiss franc German

Lithuania Vilnius Litas Lithuanian

Luxembourg Luxembourg Euro (formerly

Luxembourg

franc)

German; French;

Luxembourgish

Macedonia Skopje Denar Macedonian

Malawi Lilongwe Kwacha English

Malaysia Kuala Lumpur Ringgit Malay

Maldives Male Rufiyaa Dhivehi

Mali Bamako CFA Franc French

Mauritania Nouakchott Ouguiya Arabic

Mauritius Port Louis Mauritian rupee English

Mexico Mexico City Mexican peso Spanish

Monaco Monte Carlo Euro French; Italian; English

Mongolia Ulaanbaatar Togrog Mongolian

Montenegro Podgorica Euro Montenegrin

Morocco Rabat Dirham Arabic

Myanmar

(Burma)

Nay Pyi Taw Kyat Burmese

Namibia Windhoek Namibian

dollar

English; Afrikaans; German

Nepal Kathmandu Nepalese rupee Nepali

New Zealand Wellington New Zealand

dollar

English

Niger Niamey CFA Franc French

Nigeria Abuja Naira English

INTERNATIONAL ECONOMICS xiv


Norway Oslo Norwegian

krone

Norwegian

Oman Muscat Omani rial Arabic

Pakistan Islamabad Pakistani rupee Urdu; English

Palau Melekeok U.S. dollar English; Palauan

Paraguay Asuncion Guaraní Spanish; Guarani

Philippines Manila Peso Filipino; English

Poland Warsaw Zloty Polish

Portugal Lisbon Euro (formerly

escudo)

Portuguese

Qatar Doha Qatari riyal Arabic

Romania Bucharest Romanian

Rupee

Romanian

Russia Moscow Ruble Romanian

Sao Tome and

Principe

Sao Tome Dobra Portuguese

Saudi Arabia Riyadh Riyal Arabic

Senegal Dakar CFA Franc French

Serbia Belgrade Serbian Dinar Serbian

Singapore Singapore Singapore

dollar

English, Chinese and Malay

Somalia Mogadishu Somali shilling Somali Arabic

South Africa Pretoria

(administrative);

Cape Town

(legislative);

Bloemfontein

(judiciary)

Rand Afrikaans, English, Southern

Ndebele, Northern Sotho, Southern

Sotho, Swazi

Tsonga, Tswana, Venda, Xhosa, Zulu

South Sudan Juba Sudanese

Pound

English

Spain Madrid Euro (formerly

peseta)

Spanish, Catalan Galician , Gasque

Sri Lanka Colombo Sri Lankan Sinhala, Tamil

INTERNATIONAL ECONOMICS xv


rupee

Sudan Khartoum Sudanese

Pound

Arabic, English

Swaziland Mbabane Lilangeni English, Swati

Sweden Stockholm Krona Swedish

Switzerland Berne Swiss franc German

Syria Damascus Syrian pound Arabic

Taiwan Taipei Taiwan dollar Standard Chinese

Thailand Bangkok Baht Thai

Togo Lome CFA Franc French

Tonga Nuku'alofa Pa'anga English

Tunisia Tunis Tunisian dinar Arabic

Ukraine Kiev Hryvnia Ukrainian

UAE Abu Dhabi U.A.E. Dirham Arabic

UK London Pound sterling English

USA Washington

D.C.

Dollar English

Uruguay Montevideo Uruguay peso Spanish

Uzbekistan Tashkent Uzbekistani

sum

Uzbek

Vatican City Vatican City Euro Italian

Venezuela Caracas Bolivar Spanish

Vietnam Hanoi Dong Vietnamese

Zambia Lusaka Kwacha English

Zimbabwe Harare US dollar English, Shona, Ndebele

INTERNATIONAL ECONOMICS xvi


IMPORTANT INTERNATIONAL ORGANISATIONS: A View

SL.No. Organisation Year

Establishment

Head

Quarter

Member

Countries

Objective

1

IMF

1945

Washingto

n D.C

189

To promote

international

monetary co

operation

2

IBRD (World

Bank)

1945

Washingto

n D.C

189

To provide long

term capital to

members countries

for economic

reconstruction and

development.

3 IFC 1956 Washingto

n D.C

184 To Provide loans to

private Sector

4 IDA 1960 Washingto

n D.C

173 To provide loans to

its member countries

without interest

5

MIGA

1988

Washingto

n D.C

181

To promote flow of

direct foreign

investment into the

less developed

member nations

6

ICSID

1966

Washingto

n D.C

159

To provide facilities

for conciliation and

arbitration of

international

investment disputes.

IBRD was established in December 1945 with the IMF on the basis of the recommendation

of the Bretton Wood Conference. That is the reason why IMF and IBRD are called Bretton

Wood Twins’.

IDA is an associate institution of World Bank known as soft loan window of World bank

IBRD, IFC, IDA, MIGA, ICSID are associate institution of World Bank.

7

European

Union

Changed form

of EEC

Established in

1958

Brussels

28

To create and

implement laws and

regulations that

integrates the

member states of

the EU.

8

SAARC

1985

Kathmandu

8

To develop the

welfare of the

INTERNATIONAL ECONOMICS xvii


people of South Asia

and to promote their

quality of life.

9

ADB

1966

Manila,

Philippines

68

To accelerate

economic and social

development in Asia

and pacific region.

10 WTO 1995 Geneva 164 To resolve trade

dispute

11

ASEAN

1967

Jakarta

10

To form a common

market similar to

the European Union

12

OPEC

1960

Vienna

14

To "coordinate and

unify the petroleum

policies of its

member countries

and ensure the

stabilization of oil

markets.

13 G-15 (A

Group of 17

developing

countries)

1989 Geneva 17 To foster

cooperation and

provide input for

other international

group

14 GATT 1948 Geneva - On December 12,

1995, GATT was

abolished and

replaced by WTO.

15

IFAD

1977

Rome

(Italy)

176

To empower poor

rural men and

women in

developing countries

to achieve higher

incomes and

improved living

16

FAO

1945

Rome

(Italy)

197

To bridge the gap

between the DD and

SS of Agricultural

products in the

world by making a

regular supply of

food products.

INTERNATIONAL ECONOMICS 1


_____________________________________________________________________________

UNIT–1

INTERNATIONAL TRADE

_____________________________________________

1.1. Meaning of Trade:

Trade refers to the exchange of goods and services at a certain price at a given

time. Thus, trade involves sale and purchase of commodity or services.

1.2. Types of Trade:

There are two types of trade. They are as follows.

� Internal Trade or Domestic Trade:

Internal trade refers to the exchange of goods and services within a country

between individuals or regions or localities. Internal trade is also known as home trade

or inter- regional trade or domestic trade.

� Meaning of External Trade or International Trade:

External trade refers to the exchange of goods and services between two or

more nations. It is also known as international trade or foreign trade.

1.3. Differences between Internal and External Trade:

There are several differences between Internal (Domestic) and External

(Foreign) trade the main differences between the two are as follows.

1. Different Currencies:

Same currencies would be use in internal trade. But in international trade

different currencies are used. Rupee is accepted throught India , but if we cross over

to England or USA , we must convert our rupee into their currency to buy goods and

services there.

2. Different Markets:



Internal market faces same kind of marketing conditions but international

trade faces variety of marketing conditions. The system of weights and measures and

pattern and styles in machineries and equipment’s differ from country to country.

3. Different Economic Policies:

Another difference between Internal and international trade arises from the

fact that policies relating to commerce, trade, taxation, etc, are the same within a

country. But in international trade There are artificial barriers in the form of quotas,

tariffs, exchange control etc, on the movement of goods and services from one

country to another country.

4. Different Political Conditions:

Transaction of goods internally has same political conditions but

international trade has different political conditions.

5. Different Natural Resources:

Different countries has different types of natural resources. In Australia land is

in abundance but labour and capital are relatively scarce, in other countries like

England capital is relatively abundant while land is scarce.

6. Different Transport Cost:

Trade between countries involve high transport cost as against inter regionally

because of geographical distance between different countries in international trade.

7. Different in Cost of Production:

There will be difference in the cost of production of goods and services in

different countries. but there will be no difference in the internal trade.

8. Balance of Payments (BOP):

Another important point which difference international trade from inter

regional trade is the problem of Balance of Payments . In international trade the

problem of BOP crops up . But in internal trade this problem does not exists.

9. Mobility of Factors:

The factors of production like labour, Capital , etc, can freely move inside the

country. But in international trade , there are restrictions on the movement of the

labour, capital.



Thus, International trade fundamentally different from domestic trade or internal

trade.

The following (Table 1. 1.) shows the differences between internal trade and external

trade.

Table: 1.1. Differences between Internal and International

Trade

SL.No Basic Differences Internal Trade External Trade

1 Currencies Same Currencies Different Currencies

2 Markets Single market Different market

3 Economic Policy Same economic

Policy

Different Economic policy

4 Political conditions Similar Political

conditions

Different Political

conditions

5 Geographical conditions Similar Different

6 Transport cost Low transport cost High transport cost

7 Cost of production No difference Differences

8 Balance of payments problems Not there It will there

9 Factor mobility Free movement Restricted movement

1.4. Significance or Benefits or Importance or

Advantages of International trade

International trade between different countries is an important factor in raising living

standards, providing employment and enabling consumers to enjoy a greater variety of goods.

International trade has occurred since the earliest civilisations began trading, but in recent

years international trade has become increasingly important with a larger share of GDP

devoted to exports and imports.

The following points shoes the significance of international trade in an economy.

1. Industrialization:

International trade mainly caused the rapid industrialization. The backward

counties faces many problems like lack of capital, lack of technology, and lack of



skill. When these countries participate in international trade , can buy required

different capital goods, necessary technology and thus will lead to rapid

Industrialisation.

2. Import of Essential Commodities:

There is a inequality in distribution of resources among the different countries

of the world. No one countries of the world can not able to produce all the goods

which they required. When these countries participate in international trade these

countries will import essential commodities from other countries.

3. Meeting Emergencies:

At the time of emergencies situations like natural calamities (Flood, famine,

earthquake etc.) and war, the production of goods are relatively scarce. When these

countries enter into international trade at this situation can buy the goods from other

countries which are relatively scarce.

4. Capital Movement:

The most advantage of international trade is movement of capital from one

country to another country. The countries which are facing the lack of capital enter

into international trade can buy the capital from other developed countries. Capital

will lead to increase in industrial production and promotes the employment etc.

5. Widened Market:

Trade expand the countries market. When countries enter into international

trade. The international trade create the market for countries goods. Widened market

leads to increasing in the production, employment opportunities, income of the

countries and standard of the living of the people.

6. International Co-operation:

Different countries of the world participated in the international trade will lead

to co operation between countries. Counties can get more advantage from the co-

operation.

7. Efficient use of Resources:

Participation of different countries in international trade. These countries use

efficient availability of natural resources as a result countries produce more goods.

8. Control of Monopoly:



Monopoly industries are dominant where there is no international trade. When

countries participated in international trade and exchange various goods from country

to country. It controls monopoly.

9. Maximum Production:

International trade will help to produce more when countries use the efficient

availability of natural resources of different countries and it will lead to increase in the

world production as a result of this increase the living standard of the people.

1.5. Theories of International Trade

1.5.1. Theory of Comparative Cost Advantage

1. Introduction :

The theory of comparative cost advantage was firstly systematically formulated by the

English classical economist David Ricardo in his famous book The principles of political

economy and taxation published in 1817.

According to David Ricardo Comparative differences in costs is the basis of

international trade. when a country enters into trade with some other country, it will export

those commodities in which its comparative production costs are less, and will import those

commodities in which its comparative production costs are high.

2. Assumptions of the Theory:

Ricardo explains his theory with the help of following assumptions:

� There are only two countries, say England and Portugal.

� They produce the same two commodities say , wine and cloth.

� There are similar tastes in both countries.

� There is a perfect competition both in commodity and factor market.

� Cost of production is expressed in terms of labour.

� Labour is the only factor of production.

� Prices of two commodities are determined by labour cost.

� The supply of labour is unchanged. Labour is perfectly mobile within a country but

perfectly immobile between countries.

� There is free trade i.e. the movement of goods between countries is not hindered by

any restrictions.



� Production is subject to constant returns to scale.

� There is no technological change.

� Full employment exists in both countries.

� There is no transport cost

3. Explanation of the Theory:

Given these assumptions, Ricardo shows that trade is possible between two countries

when one country has an absolute advantage in the production of both commodities, but a

comparative advantage in the production of one commodity than in the other. This is

illustrated in terms of Ricardo's well-known example of trade between England and Portugal

as shown in Table.1.2.

Table: 1.2. Man – Years of labour Required for Producing One Unit

Country Wine Cloth

England 120 100

Portugal 80 90

The table shows that the production of a unit of wine in England requires120 men for

a year, while a unit of cloth requires 100 men for the same period. On the, other hand, the

production of the same quantities of wine and cloth in Portugal requires 80 and 90 men

respectively. Thus, England uses more labour than Portugal in producing both wine and cloth.

In other words, the Portuguese labour is more efficient than the English labour in producing

both the products. So Portugal possesses an absolute advantage in both wine and cloth, But

Portugal would benefit more by producing wine and exporting it to England because it

possesses greater comparative advantage in it. This is because the cost of production of wine

(80/120 men) is less than the cost of production of cloth (90/100 men).)On the other hand, it

is in England's interest to specialise in the production of cloth in which it has the least

comparative disadvantage. This is because the cost of production of cloth in England is less

(100/90 men) as compared with wine (120/80 men). Thus, trade is beneficial for both the

countries. The comparative advantage position of both is illustrated in Fig. 1.1. in terms of

production possibility curves.



Fig.1.1. The Comparative Advantage Position

In the above figure,

� PL is the production possibility curve of Portugal, and EG that of England.

� Portugal enjoys an absolute advantage in the production of both wine and cloth over

England. It produces OL of wine and OP of cloth, as against OG of wine and OE of

cloth produced by England.

� But the slope of ER (parallel to PL) reveals that Portugal has a greater comparative

advantage in the production of wine because if it gives up the resources required to

produce OE of cloth, it can produce OR of wine which is greater than OG of wine of

England.

� On the other hand , England had the least comparative disadvantage in the production

of OE of cloth. Thus, Portugal will export OR of wine to England in exchange for

OE cloth from there.



4. Criticism of the Theory:

This theory is not free from some defects. In particular, it has been several times

criticised by B Ohlin and Frank D. Graham. We discuss some of the important criticism as

under:

�� Unrealistic assumption of Labour Cost:

The most severe criticism of the comparative advantage doctrine is that it is based on

the labour theory of value. In calculating production costs, it takes only labour costs and

neglects non-labour costs involved in the production commodities. This is highly unrealistic.

�� No Similar Tastes:

The assumptions of similar tastes are unrealistic because tastes differ with different

income brackets in a country.

�� Ignores Transport Costs:

Ricardo ignores transport costs in determining comparative advantage in trade. This is

highly unrealistic because transport costs play an important role in determining the pattern of

world trade

�� Two-country, Two-commodity model is Unrealistic:

The Ricardian model is related to trade between two countries on the basis of two

commodities. This is again unrealistic because in actuality, international trade is among

countries trading many commodities.

�� Unrealistic assumption of Free Trade:

Another serious weakness of the doctrine is that it assumes perfect and free world

trade. But in reality, world trade is not free.

Every country applies restrictions on the free movement of goods to and from other

countries. Thus, tariffs and other trade restrictions affect world imports and exports.

�� Unrealistic Assumptions of Full Employment:

Like all classical theories, the theory of comparative advantage is based on the

assumption of full employment.



This assumption also makes the theory static. Keynes falsified the assumption of full

employment and proved the existence of underemployment in an economy. Thus the

assumption of full employment makes the theory unrealistic.

�� Neglects the Role of Technology:

The theory neglects the role of technological innovations in international trade. This is

unrealistic because technological changes help in increasing the supply of goods not only for

the domestic market but also for the international market. World trade has gained much from

innovations and research and development (R & D).

�� Impossibility of Complete Specialization:

Professor Frank Graham has pointed out that complete specialization will be

impossible on the basis of comparative advantages in producing commodities entering into

international trade. When a big country trade with small country. If big country specialises

completely in a particular commodity , the smaller country will not be able to import the

whole of it.

5. Conclusion:

Despite these Weaknesses. Political economy has found few more pregnant principles

. A nation that neglects comparative advantage may have to pay a heavy price in terms of

living standards and potential rate of growth.

1.5.2.Theory of Opportunity Costs

1. Introduction:

The most severe criticism of Ricardo's comparative cost theory has been that it is

based on the labour theory of value. This means that Labour is the only factor of production ,

prices of commodities are determined by labour cost and labour is homogeneous and it is

used in the same fixed proportions in the production of all commodities. But all these

assumptions are unrealistic. Haberlers opportunity costs theory overcomes these short

comings.

The theory of Opportunity cost was formulated by G.Haberler in the theory of

international trade, 1936.



What is opportunity cost?

The opportunity cost of any goods is the next best alternative goods that is sacrificed.

or The next best choice sacrificed in the production of a commodity.

Let us assume that the producer can produce either X commodity or Y commodity

with the help of A resources. Now , if he produces X, then he cannot produce Y. Therefore,

the opportunity cost of X is the amount of the other commodity Y that must be given up in

order to get one additional unit of commodity X. Because of we cannot produce both the

commodities with the help of availability of A resources. Thus, the exchange ratio between

the two commodities is expressed in terms of their opportunity costs. The concept of

opportunity costs has been illustrated in international trade theory with production possibility

curves.

2. Assumptions of the Theory:

Haberler explains his theory with the help of following assumptions :-

� There are only two countries, say A and B.

� They produce the same two commodities say , X and Y.

� Each country possesses two factors of production, labour and capital.

� There are similar tastes in both countries.

� There is a perfect competition both in commodity and factor market.

� The supply of each factor is fixed.

� There is free trade i.e. the movement of goods between countries is not hindered by

any restrictions.

� There is no technology change.

� Full employment exists in both countries.

� There is no transport cost

3. Explanation of the Theory :

Given these assumptions, a production possibility curve shows the various

alternative combinations of the two commodities that a country can produce most efficiently

by fully utilising its factors of production with the available technology. The slope of the

production possibility curve measures the amount of one commodity that a country must give



up in order to get an additional unit of the second commodity. It is illustrated in the following

figure (1.2)

Fig.1.2. Opportunity Cost

Let’s assume that the farmer can produce either 50 quintals of rice (ON) or 40 quintals of

wheat (OM) using this land. Now, if he produces rice, then he cannot produce wheat.

Therefore, the OC of 50 quintals of rice (ON) is 40 quintals of wheat (OM). Further, the

farmer can choose to produce any combination of the two crops along the curve MN

(production possibility curve). Let’s say that he chooses the point A as shown above.

Therefore, he produces OD amount of rice and OC amount of wheat. Subsequently, he

decides to shift to point B. Now, he has to reduce the production of wheat from OC to OE in



order to increase the production of rice from OD to OF. Therefore, the opportunity cost of DF

amount of rice is CE amount of wheat.

Types of Opportunity Cost:

Following are the important types of opportunity cost

�� Constant Opportunity Cost:

If the amount of Y required to be given up to get additional quantity of X remain

constant, the production possibility curve would be a straight line and it would indicate

constant opportunity costs.

� Increasing Opportunity Cost:

If more quantities of Y is required to be given up in order to have an additional quantity of X,

the production possibility curve would be concave to the Origin and it would indicate

increasing opportunity costs.

� Decreasing Opportunity Cost:

Lastly, if in order to get an additional quantity of X, less quantity if Y is required to be

given Up, the production possibility curve would be convex to the origin, and it would

indicate diminishing opportunity costs.

4. Criticisms of the Theory :

1. Ignores changes in Factor Supplies:

Viner criticises the opportunity cost theory on the ground that the production possibility

curve does not take into account changes in factor supplies.

2. No Similar Tastes:

The assumptions of similar tastes are unrealistic because tastes differ with

different income brackets in a country.

3. Ignores Transport Costs:

Haberlers ignores transport costs. This is highly unrealistic because transport

costs play an important role in determining the pattern of world trade.



4. Two-country, Two-commodity model is Unrealistic:

The Haberlers model is related to trade between two countries on the basis of two

commodities. This is again unrealistic because in actuality, international trade is among

countries trading many commodities.

5. Unrealistic assumption of Free Trade:

Another serious weakness of the doctrine is that it assumes perfect and free world

trade. But in reality, world trade is not free. Every country applies restrictions on the free

movement of goods to and from other countries. Thus, tariffs and other trade restrict ions

affect world imports and exports.

6. Unrealistic Assumptions of Full Employment:

Theory of opportunity cost is based on the assumption of full employment. This

assumption also makes the theory static. Keynes falsified the assumption of full


assumption of full employment makes the theory unrealistic.

7. Neglects the Role of Technology:

The theory neglects the role of technological innovations in international trade.

This is unrealistic because technological changes help in increasing the supply of goods

not only for the domestic market but also for the international market. World trade has

gained much from innovations and research and development (R & D).

1.5.3. The Modern Theory of International Trade

(The Heckscher-Ohlin Theory)

1. Introduction:

The modern theory of international trade is also known as the Factor Endowment

theory or H.O theorem ( Heckscher-Ohlin theory). It was firstly formulated by Swedish

economist Eli Heckscher in 1919 and later on fully developed by his student B Ohlin in his

famous book Inter Regional and International trade published in 1933.

According to Heckscher trade results from difference in Factor endowments in

different countries, and Ohlin carried it forward to build the modern theory of international

trade.



The H.O. theory states that the main determinant of the pattern of production,

specialisation and trade among regions is the relative availability of factor endowments and

factor prices. Regions or countries have different factor endowments and factor prices.

"Some countries have much capital, others have much labour. The theory now says that

countries that are rich in capital will export capital-intensive goods and countries that have

much labour will export labour-intensive goods.

Thus the main cause of trade between regions is the difference in prices of

commodities based on relative factor endowments and factor prices.

2. Assumptions of the theory :

Modern theory of international trade is based on the following assumptions.

� There are only two countries , say A&B

� Two countries produce two commodities , say X&Y

� There are two factors of production ( Labour and Capital)

� Differences in factor Endowments in different countries.

� There is a perfect competition market

� There is full employment

� There are no transport cost

� There is no change in technological knowledge

� There is free trade between two countries

� The production functions of the two commodities have different factor intensities,

i,.e., labour -intensive and capital intensive.

3. Explanation of the theory:

The H.O.theorem is explained in terms of two definitions:

� Factor Abundance in Terms of Factor Prices � Factor Abundance in Physical Terms

We discuss these one by one below:

� Factor Abundance in Terms of Factor Prices:

Heckscher-Ohlin explain richness in factor endowment in terms of factor prices.

According to their definition, country A is abundant in capital if (PC/PL)a<(PC/PL)b where

PC and PL, refer to prices of capital and labour, and the subscripts a and b denote the two



countries. In other words, if capital is relatively cheap in country A, the country is abundant

in capital, and if labour is relatively cheap in country B, the country is abundant in labour.

Thus country A will produce and export the capital- intensive good and import the labour-

intensive good and country B will produce and export the labour -intensive good and import

the capital - intensive good.

� Factor Abundance in Physical Terms:

Another way to explain the H.0.theorem is in physical terms of factor abundance. If

country A is relatively capital-abundant and country B is relatively labour-abundant, then

measured in physical amounts Ca/La> Cb/Lb where Ca and La are the total amounts of

capital and labour respectively in country A, and Cb and Lb are the total amounts of capital

and labour respectively in country B. This is explained in the following figure 1.3.

Fig.1.3. Factor Abundance in Physical Term



In this figure,

� Where the production possibility curve of country A is AA1 and that of country B

is BB1.

� The slopes of these two curves show that commodity Y is capital intensive and

commodity X is labour intensive.

� When both produce at their respective points, country A will produce at point E

where the factor-price line ST touches the production Possibility curve AA1. It

will produce more of commodity Y (that is OS ) which is cheaper in it and less

(OT) of commodity X which is dearer in it.

� Country B will produce at point F where the factor-price line KR touches the

production possibility curve BB1. It will produce more (OR) of commodity X

which is cheaper in it and less (OK) of commodity Y which is dearer in it.

� The difference between both factor-price lines TR on X-axis indicates that OR of

commodity X is produced more in country B relatively to OT quantity of X in

country A.

� Similarly, the difference between both factor price lines KS on Y-axis shows that

OS of commodity Y is produced more in country A relatively to OKquantity of Y

in country B.

� Thus the capital-abundant country A has a bias in favour of capital-intensive

commodity Y from the production side, and the labour- abundant country B has a

bias in favour of producing the labour-intensive commodity X.

4. Criticism of the Theory :

The modern theory (or factor endowment theory or factor comparison theory) though

makes a considerable improvement over the classical theory of comparative costs. It is not

completely free from defects. The theory has been criticized on the following grounds



1. Two-by-two-by-two Model:

The H.O model is related to trade between two countries on the basis of two

commodities and two countries possess two factors of production. This is again

unrealistic because in actuality, international trade is among countries trading many

commodities and countries possess different factors of production.

2. Highly Static in Nature:

The theory is highly static in nature and therefore, unsuitable to explain a

dynamic situation. The theory assumes that the factor endowments in two countries are

fixed and unchanging in quantum: This is quite an unrealistic assumption because

productive resources in` any country, are not fixed in quantity.

3. Neglects the Role of Technology:

The theory neglects the role of technological innovations in international trade.

This is unrealistic because technological changes help in increasing the supply of goods

not only for the domestic market but also for the international market. World trade has

gained much from innovations and research and development (R & D).

4. Ignores Transport Costs:

This theory does not consider transport cost in trade between two countries. This

is highly unrealistic because transport costs play an important role in determining the

pattern of world trade.

5. Unrealistic assumptions of full employment:

The H.O theory is based on the unrealistic assumptions of full employment. This

assumption also makes the theory static. Keynes falsified the assumption of full


assumption of full employment makes the theory unrealistic



6. Unrealistic assumption of free trade:

Another serious weakness of the theory is that it assumes perfect and free world

trade. But in reality, world trade is not free. Every country applies restrictions on the free

movement of goods to and from other countries. Thus, tariffs and other trade restrict ions

affect world imports and exports.

7. Leontief Paradox :

American economist Dr. Sassily Leontief tested H-O theory under U.S.A

conditions. Prof.Leontief's empirical study of the Ohlin theorem , known as the Leontief

Paradox. He found out that U.S.A exports labour intensive goods and imports capital

intensive goods, even though it is a capital rich country. As being a capital abundant

country must export capital intensive goods and import labour intensive goods than to

produce them at home.

8. Haberlers Criticism :

According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to

give a complete, comprehensive and general equilibrium analysis.

9. International Trade is Possible even with Identical Factor-

Endowment

The modern theory explains that international trade takes place due to differences

in factor-endowments. But it is not correct in all the cases. International trade can take

place even when factor-endowments are similar in two countries. If the tastes and

preferences of the consumers in two countries differ, the trade between two countries will

take place despite the identical nature of their factor endowments.

10. Commodity Prices Determine Factor Prices :

The modern theory holds that international trade ultimately takes, place due to

differences in factor endowments. Factor-endowments result in factor prices and factor

prices are the results of the differences in relative commodity prices. In other words factor

prices determine the relative commodity prices as established in the theory. But, it is not



correct. Prof. Wijanhold, however, holds that it is commodity prices that determine the

factor prices and not the factor prices that determine the commodity prices

Conclusion:

Despite these criticisms, the Ohlin theory of international trade is definitely an

improvement over the classical theory as it attempts to explain the basis of international trade

in the general equilibrium setting.

1.6. Gains from Trade

1.6.1. Meaning of Gains from Trade :

The gains from trade refer to a net benefits or increase in goods that a country obtains

by trading with other countries.

1.6.2. Measurement of Gains from Trade :

There are many factors measures the gains from trade which are explained as under.

1. Terms of Trade :

The most important factor which determines the gains from trade is the terms of

trade. The terms of trade refer to the rate at which one commodity of a country is exchanged

for another commodity of the other country. it expressed relationship between export prices

and import prices of its goods. When the export prices of a country rise relatively to its

import prices its gain from will be larger . On the other hand when import prices of a country

exceeds the export prices , it’s gain from Trade will be small.

2. Level of Income:

The level of money income of a country is another factor which measures the

countries gains from trade. If the demand for its exports is high, the level of money incomes

will tend to be high in the country and the greater will be the gain from trade. If the demand

for its exports is low, the level of money incomes will be low and the lesser will be the gains

from trade.

3. Cost of Production:



Cost of production also measures the countries gain from trade . If the countries cost

of production is lower, then the country gain more from trade. On the other hand , higher the

countries cost of production lead to less gain from trade.

4. Technological Conditions:

A country which is technologically advanced and it’s volume of trade will be larger

and it’s gains from trade will be large.

On the other hand, if a country is technologically backward and it’s volume of trade

will be small and it’s gains from trade will be small.

5. Nature of Commodities Exported:

Another factor which measures countries gains from trade is the nature of

commodities exported by a country. if a country which exports mainly primary products has

unfavourable terms of trade. Consequently, its gain from trade will be smaller. On the

contrary, a country exporting manufactured goods has favourable terms of trade and its gain

from trade will be larger.

6. Size of the Country :

The gain from trade also depends on the size of the country. A small country which

specialises in the production of those commodities in which it enjoys a comparative

advantage, exchanges them with a large country. the greater will be the gain from trade for

the small country.

7. Productive Efficiency:

An increase in the productive efficiency of a Country also measures its gain from

trade. It lowers costs of production and prices of goods in the home country. As a result, the

other country gains by importing cheap goods and its terms of trade improve but that of the

home country deteriorate. On the other hand, if productive efficiency increases in the foreign

country, its goods will be cheaper. The home country will increase its imports of these goods.

Its terms of trade will improve and it will gain from trade.



___________________________________________________________________________

UNIT:2

TERMS OF TRADE

2.1. Introduction:

The terms of Trade is the most important determinant of the distribution of gains from

trade. It determines how the gains from trade are allocated among the trading countries. The

concept of TOT was developed by John Stuart Mill in the form of the equation of demand . It

was further improved and developed by Marshall, Viner, Meier and others.

2.2. Meaning of Terms of Trade:

The terms of trade refers to the rate at which the goods of one country exchange for

the goods of another country. It expressed as the relation between export prices and import

prices of its goods.

� Improved TOT Or Favourable TOT :

When the export prices of a country rise relatively to its import prices, it’s terms of

trade are said to have improved. The country gains from trade because it can have a larger

quantity of imports in exchange for a given quantity of exports.

� Worsened TOT Or Unfavourable TOT :

On the other hand , when it’s imports prices rise relatively to its export price, it’s

terms of trade are said to have worsened. The country’s gains from trade is reduced because it

can have a smaller quantity of imports in exchange for a given quantity of exports than

before.

2.3. Types or Concepts of Terms of Trade:

There are various concepts of TOT, such as : Net barter TOT, Gross barter TOT,

income TOT, Single factoral TOT, Double factoral TOT, Real cost TOT, and Utility TOT.

These are explained in the following ways.



1. Net Barter Terms of Trade or Commodity Terms of Trade:

Alfred Marshal introduced the concept if net barter terms of trade, which

was later called as commodity terms of trade by Jacob Viner.

Net barter terms of trade is the ratio between the prices of a countries

export goods and import goods. Symbolically, it can be expressed as,

Tc = Px/Pm

Where ,

Tc stands for net barter or commodity terms of trade.

P stands for price

m stands for Imports

x stands for Exports

Net barter terms of trade measures the relative changes in the import and export

prices.

2. Gross Barter Terms of Trade:

Prof. Tausig introduced Gross barter terms of trade. The gross barter terms

of trade is the ratio between the quantities of a countries imports and exports.

Symbolically, it can be expressed as ,

Tg = Qm/Qx

Where, Tg indicates Gross barter terms of trade

Qm indicated quantities of imports

Qx indicates quantities of Exports

3. Income Terms of Trade:

G.S. Dorrance formulated the concept of income terms of trade. Thus

index takes into account the volume of exports of a Country and it’s export and

import prices ( The net barter terms of trade) It shows a countries changing import

capacity in relation to changes in its exports. Thus , the income terms of trade is

the net barter terms of trade of a country multiplied by its exports volume index. It

can be expressed as



Ty = Tc.Qx = Px.Qx/Pm= Index of export prices×export quantity/Index of Import

Prices.

Where, Ty is the income terms of trade, Tc the commodity terms of trade, Qx the

export volume index.

4. Single Factoral Terms of Trade:

The concept of commodity terms of trade does not take account of

productivity changes in export industries. Prof.Viner had developed the concept of

single factoral terms of trade which allows changes in the domestic export sector.

It is calculated by multiplying the commodity terms of trade index by an index of

productivity changes in domestic export industries. It can be expressed as:

Ts=Tc.Fx = Px.Fx/Pm

Where Ts is the single factoral terms of trade, Tc is the commodity terms

of trade, and Fx is the productivity index

of export industries.

5. Double Factoral Terms of Trade:

Double factoral terms of trade take into account productivity changes both

in the domestic export sector and the foreign export sector producing the country's

imports. The index measuring the double factoral terms of trade can be expressed

as,

Td = Tc. Fx/Fm = Px/Fm. Fx/Fm

Where Td is the double factoral terms of trade, Px/Pm is the commodity

terms of trade, Fx is the export productivity index, and Fm is the import

productivity index.

It helps in measuring the change in the rate of exchange of a country as a

result of the change in the productive efficiency of domestic factors

manufacturing exports and that of foreign factors manufacturing imports for that

country. A rise in the index of double factoral terms of trade of a country means



that the productive efficiency of the factors producing exports has increased

relatively to the factors producing imports in the other country.

6. Real Cost Terms of Trade:

Vinerr has also developed a terms of trade index to measure the real gain

from international trade. He calls it the real cost terms to trade index. This index is

calculated by multiplying the single factoral terms of trade with the reciprocal of

an index of the amount of disutility per unit of productive resources used in

producing export commodities. It can be expressed as:

Tr= Ts. Rx = Px/Pm. Fx.Rx

Where Tr is the real cost terms of trade, Ts is the single factoral terms of

trade and Rx is the index of the amount of disutility per unit of productive

resources used in producing export commodities.

7.Utility Terms of Trade:

The utility terms of trade index measures "changes in the disutility of

producing a unit of exports and changes in the relative satisfactions yielded by

imports, and the domestic products foregone as the result of export production." In

other words, it is an index of the relative utility of imports and domestic

commodities Forgone to produce exports. The utility terms of trade index is

calculated by multiplying the real cost terms of trade index with an index of the

relative average utility of imports and of domestic commodities foregone. If we

denote the average utility by u and the domestic commodities whose consumption

is foregone to use resources for export production by a, then u = Um1/Ua1

/Um0/Uo, where u is the index of relative utility of imports and domestically

foregone commodities. Thus, the utility terms of trade index can be expressed as:

Tu=Tru = Px/Pm. Fx.Rx.u

Since the real terms of trade index and utility terms of trade index involve

the measurement of disutility in terms of pain, and sacrifice, they are elusive

concepts. As a matter of fact, it is not possible to measure disutility (for utility) in

concrete terms.



2.4. Factors Effecting Terms of Trade

The terms of trade of a country are influenced by a number of factors which are

explained below.

1. Inflation and Deflation:

Inflation worsens the TOT because with the rise in domestic prices the demand for

imports goes up and for export declines. On the other hand, deflation improves the TOT

because the prices of domestic goods fall, the demand for exports increases and for

imports falls.

2. Tariffs:

An import tariff improves the TOT of the tariff-imposing country. As a result of

the imposition of tariff duties, imports will be reduced in relation to exports and its TOT

will improve.

3. Quotas:

Fixation of quotas also reduces imports and thus improves the terms of trade of

the country fixing quotas.

4. Devaluation:

By devaluation is meant a reduction of the value of domestic currency in terms of

the foreign currencies. Devaluation makes imports costlier and exports cheaper in foreign

markets. Thus it reduces imports and increases exports and makes the TOT favourable for

the devaluing country.

5. Economic Development :

Economic development of a country may possible have two effects on the terms

of trade (i) income effect, or demand effect and (ii) supply effect. Due to economic

development, the income per capita of the country will increase and therefore, the

demand for more goods will also register an increasing. It will lead to more demand for

imported goods. Moreover, the economic development may lead to an increase in the

output possibly of those goods which are otherwise imported from foreign countries. It



will reduce imports and push up exports. This may be known as supply effect. These two

effects combined will influence the terms of trade of the country. If demand effect is more

powerful than the supply effect, the terms of trade will turn against the country.

Contrarily if the supply effect is more powerful, the terms of trade will be favourable.

6. Nature of Goods:

If a country is producing and exporting only primary goods, and importing

manufactured goods, the terms of trade will be unfavourable. On the other hand , if a

country is producing and exporting manufactured goods and importing only primary

goods, the terms of trade will be favourable.

7. Size of Population:

An overpopulated country will have larger demand for imports. As a result, the

terms of trade will tend to be unfavourable .on the other hand under populated or

optimally populated country will have lesser demand for imports. As a result , the terms

of trade will tend to be favourable.

8. Changes in Technology:

Technological changes also affect the TOT of a country. If the technological

changes lead to the production of more export goods, their supply will increase, prices

will fall relative to their imports. It will export more than its imports. Hence, the TOT will

be unfavourable. On the contrary, if it leads to more production of import competing

goods, then the volume of trade will be less and the TOT will be favourable.

9. Change in Tastes:

Changes in tastes of the people of a country influences its TOT with another

country. If the tastes for the products of another country increase, it leads to increase in

the demand for the imported goods. Consequently, the TOT will become unfavourable.

10. Change in Demand:

The TOT are also influenced by the size of demand for exports and imports of a

country. Other factors remaining the same, if the demand for exports increases, it will



raise the prices of exportables as against the prices of importables. The TOT will be

favourable. On the other hand, if the demand for importables increases, their prices will

rise as against the prices of importables, thereby worsening the TOT exportable.

11. Import Substitutes:

If the country produces import substitute goods in sufficient quantities, it’s import

demand for such goods will be low . As a result, it will import less and it’s terms of trade

will be favourable and vice versa.

2.5. Reasons for the Unfavourable Terms of Trade of Underdeveloped

Countries or Developing Countries

In comparison to advanced countries, underdeveloped countries have, usually,

unfavourable terms of trade. The following are the main reasons for unfavourable and

declining terms of trade of less developed countries:

1. High Cost-Ratios:

As compared to advanced countries, underdeveloped countries have high cost-ratios

on account of the low productivity of factors of production

2. Backward Technology:

Underdeveloped countries are in a backward state of technology; hence, their relative

productivity is low, so the cost of production and domestic price-structure is relatively high.

This puts the poor country at a disadvantageous bargaining position and declining terms of

trade of these countries.

3. Primary Products:

Underdeveloped countries exports consist of primary products and imports consist of

capital goods. Again in these countries agricultural production is very much prone to the

operation of the law of diminishing returns due to lack of mechanisation and agricultural

reforms. On the other hand, industrial production in advanced countries is subject to the law

of increasing returns due to improved and changing technology. Thus, terms of trade between



the exchange of primary products and industrial products are always settled in favour of the

latter and against the former.

4. Lack of factors of Production :

Most if the underdeveloped countries faces the problem of lack of factors of

production. This causes to reduce the level of production in these countries. So it’s terms of

trade will be unfavourable.

5. High Population Growth:

Most of the underdeveloped countries are over-populated and their growth rate is also

high. Consequently, there is a high internal demand for the goods produced in general which

causes low exportable surplus with these countries. Again, the relative import demand of

these countries is also high and inelastic. This causes unfavourable terms of trade of these

countries.

6. Greater Dependency:

Poor countries are greatly dependent for their capital goods requirement and other

needs on the advanced countries. They have no other alternative in view of the absence of

import substitution. While, advanced countries are least dependent on the poor countries as

they are capable of producing import substitutes. Hence, poor countries have always weak

bargaining power, so it’s terms of trade will be unfavourable

7. Inefficiency of Labourers:

Least developed countries have a inefficiency of labourers compare to the developed

countries on account their lack of training, lack of skill and lack of education. This reduces

the quality of production of a goods and rises the cost of production of a goods and hence the

terms of trade of these countries will be unfavourable.

8. Lack of Import Substitutes :

Poor countries are greatly dependant on the advanced countries for their imports and

have not developed import substitutes. On the other hand, the advanced countries are not so

much dependant on the poor countries because they are capable of producing import



substitutes. Thus, the poor countries have weak bargaining position in the international trade

and it’s terms of trade will be unfavourable.

9. Lack of Adaptability:

Advanced countries can quickly adapt the production of such goods which are high in

demand and whose prices are rising faster than the goods whose prices remain steady or

declining. Underdeveloped countries lack such adaptability on account of their primary

production, backward state of technology, market imperfections, immobility of factors of

production and the over-all rigidity of their economy as a whole. Thus , the terms of trade of

less developed countries tend to deteriorate and these countries fail to reap gains by

increasing their supplies of exports during inflation.



___________________________________________________________________________

UNIT: 3

THE TRADE POLICY

3.1. Meaning of Trade Policy: Trade policy refers to the regulations and agreements that control imports and exports

to foreign countries.

3.2. Types of Trade Policy :

There are two types of trade policy as explained below:

� Free trade Policy

� Policy of Protection

3.3. Free Trade Policy

3.3.1. Meaning of Free Trade Policy:

Free trade is that policy of trade where there is complete freedom of international

trade without any restrictions on the movement of goods between countries.

3.3.2. Definitions of Free Trade Policy :

According to Jagdish Bhagwati free trade is the complete absence of tariffs, quotas,

exchange restrictions, taxes on production , factor use and consideration.

According to R.G. Lipsey, A world of free trade would be one with no tariffs, and no

restrictions of any kind on importing or exporting.

3.3.3. The Case for Free Trade Policy or Advantages of Free Trade Policy

The classical economist were in favour of the free trade policy. Of the modern

economist , Haberler advanced the Following arguments in favour of free trade.

1. Maximisation of Out Put:



Under free trade a country specialises in the production of those commodities

which it is relatively best suited to produce and exports them in exchange for those

imports which it can obtain more cheaply. This maximises the output of all the

participating countries because all gain from trade which, in turn, increases the real

national income of the world economy. Thus free trade leads to the maximisation of

output income and employment.

2. Benefits the Consumer’s:

it benefits the consumers when they are able to buy a variety of commodities from

abroad at the minimum possible prices. This, in turn has the effect of raising their

standard of living.

3. High Factor Incomes :

Under free trade, there is perfect mobility of factors of production. They can

move from one place to another and between counties in order to earn more. Thus such

factor incomes as wages, interests, rents and profits are high under free trade. There is

increase in the real income of the world economy and of its participant countries.

4. Meeting Emergencies:

Free trade policy help us in order to meet the emergency situations. At the

time of emergencies situations like natural calamities (Flood, famine, earthquake etc.)

and war, the production of goods are relatively scarce. Under free trade, When these

countries enter into international trade at this situation can buy the goods from other

countries which are relatively scarce.

5. Promotes International Co-operation:

Free trade also promotes international co-operation among nations. To solve

bilateral and multilateral trade problems, different countries come into contact with each

other and hold trade talks with each other. International organisations like WTO are

meant to solve trade problems and promote international co-operation

6. Best Policy for Economic Development:

Free trade policy is the best policy for countries economic development Free

trade fosters development in the following ways: (a) it leads to the importation of capital



goods, and raw materials(b) it installs new ideas, and brings technical knowhow, skills,

managerial talents and entrepreneurship to the developing countries; (c) it facilitates the

flow of foreign capital.

7. Encourages Inventions:

Free competition and trade encourage nations to produce the best and the

cheapest products in order to gain more. It stimulate them to invent new techniques and

processes of production, to find new markets, new sources of raw materials, etc.

8. Develops Transport and Communications :

Free trade encourages the development of the means of transport and

communications not only within countries but also among countries. Rail, road, sea and

air transport systems expand with better and more cargo facilities which move safely and

quickly globally. The development of internet , E- mail and E-COMMERCE Commerce

has been possible due to more free trade globally.

9. Wide Markets :

Free trade leads to wide extent of markets for goods. As the demand for goods is

not confined to one country but to a number of countries, the entire world becomes the

market for all types of goods. This leads to the production of quality goods at low prices

because of world competition.

10. Prevents Monopolies:

Free trade prevents growth of domestic monopolies and consumers’ exploitation due to

competition from abroad. Thus, free trade ensures a lower price for exports as well as

imports and the price mechanism under perfect Competition prevents the formation of

monopolies.

11. Equitable Distribution of Resources:

Resources have not been distributed equally among the different countries of the

world. Under free trade policy, there is equitable distribution of resources between the

countries.



3.3.4. Case Against Free Trade Policy or Disadvantage of Free Trade

Policy

At present times, no country in the world follows the policy of free trade.

Every country imposes some restrictions on the import and the export of goods in the

broader interest of the country. Finally, as T. Scitovsky has pointed out, free trade can

be shown to be beneficial to the world as a whole but has never been proved to be the

best policy for a single country.

1. One-sided Development:

Under the policy of free trade, some industries expand in which the country

possesses comparative advantage but other Industries are not developed. An

agricultural country may develop only agriculture and neglect the industrial sector.

Or, one type of industries may be developed while others may remain undeveloped.

This naturally leads to the one-sided development f the economy.

2. Production of Inferior and Harmful Goods:

There being no restrictions on the movement of goods under free trade,

substandard and harmful commodities are likely to be produced and traded. This leads

to diminutions of social welfare. Trade restrictions on the import of such commodities

become unnecessary.

3. Spread of Economic Evils:

Free trade leads to flow of Economic Evils such as Inflation and depression

from one country to another country. Depression in America spreads to the whole

world in the year 1929.

4. Economic Dependence:

Free trade increases the Economic Dependence on other countries for certain

essential products such as good, raw materials, etc. Such Dependence proves harmful

particularly during war time.

5. Dumping :



Free trade policy may lead to cut throat competition and dumping. Under

dumping goods are sold at very cheap rates and even below their cost of production in

order to capture the foreign markets. LDC's unable to compete with developed

countries under this policy and it may lead to exploitation of poor countries and close

down of industries.

6. Unrealistic Policy :

Free trade policy is based in the assumptions of laissez faire or government

non – intervention. It’s success also requires the pre condition of perfect competition.

However, conditions are unrealistic and do not exist in the actual world.

7. Non-Cooperation of Countries:

Free trade policy works smoothly if all the countries cooperate with each

other and follow this policy. If some countries decide to gain more by imposing

import restrictions, the system of free trade cannot work.

8. Political Slavery:

Free trade leads to economic dependence and economic dependence leads to

political slavery. For political freedom, economic Independence is necessary. This

requires abandonment of free trade.

9. International Monopolies:

Free trade may lead to international monopolies. It encourages the

establishment of multinational corporations. These corporations tend to acquire

monopoly position and thus harm the interest of the local people.

10. Harmful to Less Developed Countries:

Free trade is harmful for the less developed countries for the following

reasons:

I) Competition under free trade is unfair and unhealthy. The less

developed countries find it difficult to compete with the economically

advanced countries.



II) Under free trade, gains of trade are unequally distributed depending

upon the level of development of different countries. The terms of

trade are favourable for the developed countries, and unfavourable for

the poor countries.

III) Less developed countries generally experience unfavourable balance of

payments . The problem of un-favourable balance of payments cannot

be solved under free trade policy.

IV) The less developed countries cannot protect their infant industries

under the policy of free trade.

3.4. Policy of Protection

Protective trade policy was advocated by Alexander Hamilton and Henry Carey of

America, Fredrick List of Germany, J. S. Mill of England, and others.

3.4.1. Meaning of Policy of Protection :

The term protection refers to a policy where by domestic industries are to be protected

from foreign competition. The aim is to impose restrictions on the imports of the low priced

products in order to encourage domestic industries.

3.4.2. Forms of Protection or Instruments or Devices or Methods of

Protection

When a country intends to follow the protective trade policy, it can adopt many

alternative devices or forms of protection. The important among them are:

� Tariffs

� Quotas

� Subsidies

� Exchange restrictions

� Import restrictions



� Import licences

� Dumping

3.4.3. Arguments for Policy of Protection or Advantages of Policy of

Protection

There are a number of arguments put forward in favour of Protection. The Popular

arguments are as follows:

1. Infant Industry Argument :

This argument was formulated by J.S.Mill , Alexander Hamilton, Fredrick list and

others . It is held that infant industries during the early stages of their development require

protection from competition from foreign exporters. An infant industry is one which has

been started rather late or newly, and which has not been mature enough to face

competition from long established foreign industries. Such an industry, in the initial

stages of its growth, needs full protection from the state without which it cannot survive.

2. Employment Argument:

Policy of protection can raise the level of employment. The imposition of a tariff

reduces imports and encourages employment directly in import competing industries.

This, in turn, generates employment in other industries dependent upon this import

competing industry and may even spread to import substitution industries.

3. Anti-Dumping Argument :

Protection is advocated against the practice or dumping. Dumping means selling a

product in a foreign market at a lower price than in the home market. Dumping aims at

flooding a foreign market with low priced commodities. As a result, the import competing

firms are ruined. To protect such firms, a high tariff is imposed. This will raise the price

of the product in the importing country and remove the threat of dumping.

4. Key Industry Argument :

Protection should be given to socially important industries such as agriculture and

strategically important industries as iron and steel, heavy electricals, machine making,



heavy chemicals’. The development of key and other socially important industries under

protective tariffs are one of the principal aims of trade policy in a country.

5. Revenue Argument :

Tariffs are levied to generate revenue for the government and to protect

domestic industries from foreign competition. In LDCs revenue collection is

considered the main objective of import and export tariffs.

6. Keeping Money at Home Argument:

According to Abraham Lincon protection prevents the purchase of foreign

goods and thereby keeps money at home. This argument runs as follows: When we

buy manufactured goods abroad we get the goods and the foreigners get the money.

When we buy the manufactured goods at home we get both the goods and the money.

and This may raise demand for countries goods and employment and generates

revenue. "This is possible only when we imposes restrictions on the import of goods.

7. Expanding Home Market Argument :

According to this argument, protection should be given to new industries and

protected industries can produce more goods which led to increase the level of

employment and revenue. this would expand the home market for all domestic

products. This is possible only when we imposes restrictions on the import of goods.

8. Nationalism Argument :

To encourage nationalism among the people, imports of foreign goods are

restricted through high import duties so that they consume the goods manufactured

within the country. This is what Gandhiji advocated in his Swadeshi movements. For

the success of a policy, it is essential that goods produced within the country should

be of high quality and available in sufficient quantities.

9. Balance of Payment Arguments :

A deficit in the balance of payments (BOP) can be cured by imposition of

restrictions on imports. However, imports will decline following a rise in tariff rate

Policy of protection helps in restricting the imports of unnecessary commodities and



try to reduce the deficit in balance of payments. And this will correct the counties

BOP.

10. Terms of Trade Argument :

Policy of protection improves the countries terms of trade through high level

tariffs on importing commodities. The restrictions on imports for the purpose of

protection will create a surplus in the terms of trade of the country.

11. Control of Harmful Goods Argument :

Policy of Protection controls the production and supply if harmful goods from

one country to another country. Thus leads to raising the social welfare if the people.

3.4.4. Arguments Against Policy of Protection (Dis advantages or De merit

of Policy of Protection)

Critics also point out certain dangers of protection. The important arguments against

protection are given below:

1. Producers Become Lethargic:

Protection makes the home producers lethargic. In the absence of competition

from abroad, the home producers do not bother to reduce the cost of production in

their units and make them more efficient.

2. No Cure for Unemployment:

Protection may not prove to be a successful method of generating employment.

The creation of employment because of the expansion of the protected domestic

industries may be offset by the reduction in employment due to the resultant decline

in exports.

3. Loss to Consumer:

The ultimate burden of protection falls on consumers. Protection results in

restriction on cheap imports and rising of domestic prices. The consumers suffer from

these effects.

4. Unequal Distribution of Income:



Protection encourages unequal distribution of income and wealth. Under

protection, the rich (producers) become richer because of high profits in the protected

industries and the poor (consumers) become poorer because of higher prices.

5. Creation of Monopolies:

Policy of protection encourages the establishment of Monopolies. The

absence of foreign competition, the domestic producers combine to reap higher

profits.

6. Loss of Revenue:

There may be a loss of revenue to the government due to protection.

Imposition of tariffs reduces imports and, as a result, the revenue from custom duties

falls.

7. Retaliation:

Imposition of tariffs by one country often leads to the similar retaliation

action by other countries. This results in tariff war among the trading countries and

spread of international hatred.

8. Encouragement to Corruption:

Protection may lead to political corruption. The producers of the protected

industries, instead of paying their attention to improve the efficiency of these

industries, use their money and energies to bribe the legislators for the continuation of

protection to their industries.

9. Fall in world output Consumption Levels:

Protection is inefficient for the world economy because it results in reduction

of world output and world consumption levels.

10. Fall in International Trade :

Protection leads to fall in international trade. Imposition of tariffs on imports

by one country often lead to the similar retaliation action by other countries. This

results in reduction in volume of countries Exports and imports and fall in

International trade.



3.4.5. Role of Protection in Least Developed Countries (LDCs) or

Developing Countries

� Terms of Trade :

LDCs, have unfavourable terms of trade in relation to the developed countries. The

imposition of tariffs is essential to shift the terms of trade in favour of LDCs which increases

its gains from trade. If an LDC imposes tariffs that bring about a fall in import prices or rise

in export prices, it's terms of trade are improved. lts income will increase and it will be in a

position to import larger quantities of capital goods.

� Balance of Payments :

One of the principal objectives of protection in an LDC is to prevent disequilibrium

in the balance of payments. Such countries are prone to serious balance of payments

difficulties to fulfil the planned targets of development. An imbalance is created between

imports and exports which continues to widen as development gains momentum. This is due

increase in imports and decline in exports. The imposition of tariffs lead to the restriction of

imports and encouragement of exports, thereby making the balance of payments favourable

for the country.

� Revenue :

Import and export duties are an important source of revenue for LDCs because other revenue

sources are limited due to the low level of income and Corporate profits, the existence of

large non-marketed output, the lack of an etticient bureaucratic system, etc

� Capital Formation :

In LDCs, the income of the people being low, they save and invest less. So the rate

of capital formation is low. Domestic savings can be increased by restricting the importation

of luxury consumer goods through prohibitive import duties. Traded goods become more

expensive. The consumption expenditure is thereby reduced which is equivalent to an

increase in savings. This increase in savings is, in turn, utilised for importing capital goods.

Thus the necessary condition for capital formation is that a education in the import of capital

goods must be followed by an increase in the export of goods of the same value.



� Planned Economic Development :

LDCs follow the policy, of planned economic development. They aim at the

utilisation of their scarce resources in the most efficient manner so as to provide more

employment and income to the people and to raise their standard of living. This requires the

importation of essential raw materials and capital goods in place of unnecessary consumer

goods. This is only possible by levying low import duties on the former goods and heavy

import duties on the latter goods.

� Diversification and Self-sufficiency :

The majority of LDCs have won their freedom from the colonial rule after much Struggle.

They want to maintain it by becoming strong on the economic and defence fronts, These

requires a policy of protection in order to diversify their economics so that they become self

sufficient through all-round development and have self sustaining growth.

� Infant industries :

In these countries the infant industry argument assumes far greater importance than in

developed countries. Thus, selective or discriminating protection may be suggested as a

remedy for certain economic ills and for the industrial growth of these countries.

3.5. Tariffs

3.5.1. Meaning of Tariffs:

Tariffs is a very important instrument of trade protection . It is a very old, popular and

most effective method of protection.

Tariffs are the duties imposed on the goods coming into or going out of the country. But

as restrictive measure, import duties are more important than export duties.

3.5.2. Types of Tariffs:

Tariffs are classified in a number of ways. On the basis of purpose. Tariffs are used for

two different purposes: for revenue and for protection.



� Protective Tariff: They are used to protect domestic industries from foreign

competition . Such tariffs are known as Protective tariff.

� Revenue Tariff: They are also used to raise revenue for the government,

known as revenue tariffs.

3.5.3. Effects of Tariffs

Tariffs have a variety of effects which depend upon their power to reduce imports.

Kindleberger has discussed eight effects of tariff on the imposing country: (a) protective

effect; (b) consumption effect; (c) revenue effect; (d) redistribution effect; (e) terms of trade

effect; (f) income effect; (g) balance of payment effect; and (h) competitive effect.

All these effects are the result of the price effect which we first explain.

1. Price Effects:

The price effect of a tariff is explained in terms of Fig. 3.1 where D and S are the

domestic demand and supply curves of a commodity. OP represents the constant world price

at which the foreign producers are prepared to sell their commodity in the domestic market.

Thus the horizontal line PB is the supply curve of imports which is perfectly elastic at OP

price. Thus under free trade (before the imposition of a tariff) the equilibrium market

position is given by point B where the domestic demand curve D intersects the world supply

curve PB at the price OP. The total demand for the commodity is OQ3. The domestic supply

is OQ. the difference between domestic demand and domestic supply is met by importing

OQ3 quantity at OP price Suppose a tariff of PP1 is imposed on the import of the commodity.

Given a constant foreign price, the domestic price of the commodity rises by the full amount

of the tariff of OP1. Thus the rise in the price of the commodity by PP1 is the price effect of

the tariff.



Fig.3.1. Effects of Tariffs

2. Protective Effect :

The protective effect shows how the domestic industry can be protected from

foreign competition by imposing an import duty. in Fig 1 under free trade, OQ3 quantity of

the commodity is imported at OP price. With the imposition of the import duty of PP1,

imports are reduced to Q1Q2, while the domestic production (supply) of the commodity

increases from OQ to OQ1 . Thus the increase in the domestic production of the commodity

by QQ1 as a result of the tariff is the protective or production effect.

3. Consumption Effect :

The consumption effect of the tariff is to reduce the consumption of the commodity

on which the tariff is imposed, as also to reduce consumers' net satisfaction. These are



illustrated in Fig. 1. Before the imposition of a tariff, consumers were consuming OQ3,

quantity of the commodity at OP price, with the levying of an import duty of PP1, the price

of the commodity rises to OP1. Now imports are reduced by Q3Q2 and the total consumption

of the Commodity is also reduced from OQ3 , to OQ2. Thus Q3Q2(= OQ3-OQ2) is the

Consumption effect of the tariff. This, in turn, leads to a net loss of consumers satisfaction

equal to the area PP1NB.

4. Revenue Effect :

The revenue effect is the change in government receipts as a result of the tariff. In

the case illustrated in Fig. I initially the tariff is assumed Zero at price OP. So when PP1

import duty is levied, the revenue to the government is equal to the amount of the import duty

multipled by the quantity of imports. The revenue effect is, therefore, PP1 x Q1Q2, or the

rectangular shaded area R.

5. Redistributive Effect :

The redistribution effect results from producers receiving a higher price for their

commodity after the imposition of the tariff. This is shown in Fig. 1 by the area PP1 MA.

This amount is a surplus over production costs and is an economic rent which goes to

producers.

6. Terms of Trade Effect:

The terms of trade effect of a tariff is that it improves the terms of trade of country

imposing it.

7. Income Effect :

The income effect refers to the effect of a tariff on the levels of income and

employment of a country imposing the tariff. A tariff reduces the demand for imported goods

by reducing imports, and increases the demand for home-produced goods. This will raise

money and real incomes and employment.

8. Balance of Payments Effect:

Tariff has favourable effect on the balance of payments position of the imposing

country. It reduces imports and increases the export surplus of the country. Thus, through

tariffs, a deficit in the balance of payment can be corrected. The balance of payments effects

is illustrated in Fig. 1. Under free trade conditions, QQ3 commodity is imported at OP price.



The total value of imports is represented by the rectangle AQQ3B. This represents a balance

of payments deficit since the price paid by importer sis the amount received by the other

country. To remove this deficit, PP1 import duty is levied on the imported commodity. As a

result, imports are reduced from QQ3, to Q1Q2. The government gets a revenue equal to the

area R. There is also improvement in the balance of payments because the amount paid to the

other country equals the area aQ1Q2b which is less than under free trade AQQ3B.

9. Competitive Effect :

The competitive effect of a tariff is to protect the domestic industry from foreign

competition by imposing a tariff on the commodities imported. This effect is usually

associated with the infant industry argument of protection.

3.6. Quotas

3.6.1. Meaning of Quotas :

Quotas are more popular and an old form of trade restriction . As. Protective device,

import quotas are more important. Import quotas refers to the fixed quantities of goods ,

which is allowed to be imported into a country during a specified period.

3.6.2. Effects of Quotas :

The import quotas can have various effects such as price effect, protective or

production effect, consumption effect, revenue effect, redistributive effect, terms of trade

effect and balance of payments effect. Some of them can be studied under the partial

equilibrium analysis while some others under general equilibrium system. However, these

effects have been almost exclusively analysed under the partial equilibrium conditions. The

effects of import quotas can be discussed with the help of Fig. 3.2 In this figure, S0 is the

foreign supply curve under free trade and it is perfectly elastic. S1 is the domestic supply

curve which slopes positively. D is the demand curve for the given commodity and it slopes

negatively. The quantity demanded and supplied of the given commodity is measured along

the horizontal scale and price is measured along vertical scale.

In the conditions of free trade, the quantity supplied is OQ and the quantity demanded is OQ1.

The excess of demand over supply is met through the import from abroad.



Fig. 3.2 : Effects of Import Quotas

1. Price Effect:

Import quota is the direct physical limitation of the quantity of the given commodity

imported from the foreign country. The enforcement of import quota restricts its availability

in the home market and creates shortage and consequent rise in its price. Originally, the price

of the commodity was Po and the quantity imported amounted to QQ1. The government of

the home country fixes the import quota to the extent of Q2Q3. The initial total supply in the

home market, made up of OQ as the domestic output and QQ1 as the import, amounted to OQ

+ QQ1 = OQ1. After the enforcement of import quota, the total supply is OQ3 out of which

domestic production is OQ2and import quota is Q2Q3 (OQ3 = OQ2+ Q2Q3). It signifies a

shortage of the commodity compared with the original situation. As a consequence, given the



supply OQ3 and demand curve D, the price rises from P0 to P1. This rise in the price of the

commodity is the price effect of import quota.

2. Protective or Production Effect:

An import quota has a protective effect. As it reduces the imports, the domestic

producers are induced to increase the production of import substitutes. The increased

domestic production due to import quota is called as the protective or production effect.

According to Fig. 16.1, originally the domestic production was OQ. After the import quota is

fixed at Q2Q3, the domestic production expands from OQ to OQ2. Thus there is an increase in

domestic production by QQ2. This is the protective or production effect.

3. Consumption Effect:

After the import quota is prescribed, there is a rise in the domestic price of the given

commodity. As a consequence, the consumption of the commodity gets reduced. This is

known as the consumption effect. In Fig. 16.1, the consumption under free trade situation is

OQ1. After the fixation of import quota up to Q2Q3, the total consumption at the higher price

P1 is reduced to OQ3. Thus there is a reduction in consumption by OQ1– OQ3 = Q1Q3,

subsequent to the fixation of import quota. This is the consumption effect.

4. Revenue Effect :

Unlike tariff, the revenue effect of import quota is complex and difficult to

determine. If the government follows the policy of auctioning the import licenses, the

revenue accruing to the government will amount to P0P1 × Q2Q3=GHKF. Such a revenue

effect is equivalent to the revenue effect in the event of equivalent tariff. But in fact the

governments do not auction the import licenses in recent times. In such an event, the revenue

effect is either captured by the domestic importers or foreign exporters, or shared between the

domestic importers and foreign exporters in some proportion. It is, therefore, not easy to

quantify exactly what the revenue effect of import quota will be and to which group or groups

will it accrue and in which proportion.

5. Redistributive Effect:

The fixation of import quota leads to a rise in the price of the given commodity. It may

result in a loss in consumer’s surplus for the importing country. At the same time, higher



price and increased production ensures a gain in producer’s surplus. Thus import quota

causes redistributive effect in the quota enforcing country. According to Fig. 16.1 after the

fixation of import quota, the price rises from P0 to P1and the loss in consumer’s surplus

amounts to P0EFP1. The gain is producer’s surplus amounts to P0CGP1. If importers are

organised, an amount equal to the revenue effect GHKF will accrue to them. Consequently,

the net loss to the community will be P0EFP1 – (P0CGP1 + GHKF) = ΔGCH + ΔFKE. If the

revenue effect neither accrues to the government nor to the importers, the redistribution effect

will involve a large net loss in welfare. In this case, the net loss in welfare will amount to

P0EFP1 – P0CGP1 = GCEF.

6. Balance of Payments Effect:

One of the objectives of enforcing import quota is to reduce the balance of payments

deficit by restricting imports. That portion of national income going into imports can be

utilised for investment in the import- substitution or export industries. The expansion in

exports, coupled with restriction of imports is likely to bring about improvement in the

balance of payments position of the country.

According to Fig. 3.2. the quantity imported under free trade conditions at the price P0 is

QQ1 and the total value of imports is QCEQ1. In case, the government prescribes the imports

quota as Q2Q3, the physical quantity imported has been slashed. Since price of imported

commodity rises to P1, the value of imports is Q2GFQ3. If the government auctions the import

licenses, its revenue receipt is GFKH. Alternatively, if the importers are organised, the gain

due to higher price in the form of additional profit can be obtained by them. In either of the

case, there can be saving of foreign exchange of the size of GFKH and actual payment to

foreign country is Q2HKQ3 which is less than the payment QCEQ1 for imports under the free

trade. Thus import quota brings about a reduction in the balance of payments deficit.

7. Terms of Trade Effect:

The imposition of import quota can influence the terms of trade of a country in a

favourable or unfavourable way depending upon the elasticity of the offer curve or

monopolistic and monopoly power of the importing and exporting countries respectively. If

the offer curve of importing country is elastic or it has a monopsony power, the terms of trade

will become favourable to it.



3.7. Dumping

3.7.1. Meaning of Dumping :

Dumping is an international price discrimination in which an exporter firm sells a

potion of its output in a foreign market at a very low price and the remaining output at s high

price in the home market.

3.7.2. Objectives of Dumping :

The main objectives of Dumping as follows:

1. To Find a Place in the Foreign Market:

A monopolist resorts to dumping in order to find a place or to continue himself in the

foreign market. Due to perfect competition in the foreign market he lowers the price of his

commodity in comparison to the other competitors so that the demand for his commonly may

increase. For this, he often sells his commodity by incurring loss in the foreign market.

2. To Sell Surplus Commodity:

When there is excessive production of a monopolist’s commodity and he is not able to

sell in the domestic market, he wants to sell the surplus at a very low price in the foreign

market. But it happens occasionally.

3. Expansion of Industry:

A monopolist also resorts to dumping for the expansion of his industry. When he

expands it, he receives both internal and external economies which lead to the application of

the law of increasing returns. Consequently, the cost of production of his commodity is

reduced and by selling more quantity of his commodity at a lower price in the foreign market,

he earns larger profit.

4. New Trade Relations:

The monopolist practices dumping in order to develop new trade relations abroad. For

this, he sells his commodity at a low price in the foreign market, thereby establishing new

market relations with those countries. As a result, the monopolist increases his production,

lowers his costs and earns more profit.



___________________________________________________________________________

UNIT- 4

FOREIGN EXCHANGE

4.1. Meaning of Foreign Exchange :

Foreign exchange is the system or process of converting one national currency into

another.

4.2. Meaning of Foreign Exchange Market :

The foreign exchange market is the market in which different currencies are bought

and sold for one another. For example, dollars are traded for yens, yens for pound, pound for

rupees.

4.3. Functions of Foreign Exchange Market :

The foreign exchange market is commonly known as FOREX, a worldwide network,

that enables the exchanges around the globe. Foreign exchange market is the market in

which foreign currencies are bought and sold. The principal participants in the

foreign exchange market are banks, foreign exchange dealers, brokers, firms and central

bank. In India RBI authorizes banks and other financial institutions to transact foreign

exchange business. The following are the main functions of foreign exchange market, which

are actually the outcome of its working:

Figure : 4.1. Functions of Foreign Exchange Market



1. Transfer Function :

The basic and the most visible function of foreign exchange market is the transfer of

funds (foreign currency) from one country to another for the settlement of payments. It

basically includes the conversion of one currency to another, wherein the role of FOREX is to

transfer the purchasing power from one country to another.

For example, If the exporter of India import goods from the USA and the payment is

to be made in dollars, then the conversion of the rupee to the dollar will be facilitated by

FOREX. The transfer function is performed through a use of credit instruments, such as bank

drafts, bills of foreign exchange, and telephone transfers.

2. Credit Function:

FOREX provides a short-term credit to the importers so as to facilitate the smooth

flow of goods and services from country to country. An importer can use credit to finance the

foreign purchases. Such as an Indian company wants to purchase the machinery from the

USA, can pay for the purchase by issuing a bill of exchange in the foreign exchange market,

essentially with a three-month maturity

3. Hedging Function :

A third important function of the foreign exchange market is to hedge foreign

exchange risks. When exporters and importers enter into an agreement to sell and buy goods

on some future date at the current prices and exchange rate, it is called hedging. The purpose

of the hedging is to avoid losses that might be caused due to exchange rate variations in the

future.

4.4. Foreign Exchange Rate

4.4.1. Meaning of Foreign Exchange Rate:

The foreign exchange rate is the rate at which one currency is exchanged for another

currency. It is the price of the one currency in terms of another currency. The exchange rate

between the dollar and the pound refers to the number of dollars required to purchase a

pound.



4.4.2. Determination of Equilibrium Exchange Rate :

The exchange rate in a free market is determined by the demand for and the supply of

foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign

exchange equals to supply of foreign exchange.

We assume that there are two countries, India and USA, the exchange rate of their

currencies (namely, rupee and dollar) is to be determined. Thus, we explain below how the

value of a dollar in terms of rupees (which will conversely indicate the value of a rupee in

terms of dollars) is determined.

In our case of the determination of exchange rate between US dollar and Indian rupee,

the Indians sell rupees to buy US dollars (which is a foreign currency) and the Americans or

others holding US dollars will sell dollars in exchange for rupees. It is the demand for and

supply of a foreign currency or exchange that will determine the exchange rate between the

two.

� Demand for Foreign Exchange (US Dollars):

The demand for US dollars comes from the Indian people and firms who need US

dollars to pay for the goods and services they want to import from the USA. The greater the

imports of goods and services from the USA, the greater the demand for the US dollars by the

Indians.

Further, the demand for dollars also arises from Indian individuals and firms wanting

to purchase assets in the USA, that is, desire to invest in US bonds and equity shares of the

American companies or build factories, sales facilities or houses in the USA.

The demand for dollars also arises from those who want to give loans or send gifts to

some people in the USA. Thus, for whatever reasons the Indian residents need dollars they

have to buy them in the foreign ex-change market and pay for them with the Indian currency,

the rupees. All of these constitute demand for dollars, the foreign exchange.

To sum up, the demand for dollars by the Indians arises due to the following factors:

1. The Indian individuals, firms or Govern-ment who import goods from the USA into

India.



2. The Indians travelling and studying in the USA would require dollars to meet their

travelling and education expenses.

3. The Indians who want to invest in equity shares and bonds of the US companies and other

financial instruments.

4. The Indian firms who want to invest directly in building factories, sales facilities, shops in

the USA.

An important thing to understand is how the demand curve for a foreign exchange

would look like. When there is a fall in the price of dollar in terms of rupees, that is, when the

dollar depreci-ates, fewer rupees than before would be required to get a dollar.

With this, therefore, a dollar’s worth of US goods could be purchased with fewer

rupees, that is, the US goods would become cheaper in terms of rupees for Indians. This will

induce the Indian individuals and firms to import more from the USA resulting in the

increase in quantity demanded of dollars by the Indians.

On the other hand, if the price of US dollar rises, (that is US dollar appreciates) a

dollar’s worth of US goods would now cost more in terms of rupees making American goods

relatively expensive than before. This will discourage the imports of US goods to India

causing a decrease in quantity de-manded of dollars for imports.

It therefore follows from above that at a lower price of dollars, the greater quantity of

dollars is demanded for imports from the USA and at a higher price of dollar, the smaller

quantity of dollars is demanded for imports from the USA by the Indians. This makes the

demand curve for dollars downward sloping as shown by the DD curve in Fig.4.2.



Fig.4.2

� Supply of US Dollars (i.e., Foreign Exchange):

What determines the supply of dollars in the foreign exchange market? The individual

firms and Government which export Indian goods to the USA will earn dollars from the

American residents who would buy the Indian goods imported into the USA and pay their

price in dollars. Further, the Americans who travel in India and use the services of Indian

transport, hotels etc., will also supply dollars to be converted into rupees for meeting these

expenses.



Besides, the American firms and individuals who want to buy assets in India, such as

bonds and equity shares of Indian companies or wish to make loans to the Indian individuals

and firms will also supply dollars. There are Indians who are working in the USA and send

their earnings in dollars to their relatives and friends.

The supply of these dollars by the Indians working in the USA popularly called

remittances from the USA also adds to the supply of dollars. Those holding dollars who have

earned them from exports to the USA and the foreign firms and individuals who want to

invest in India or those who want to make loans to Indians or the American tourists travelling

in India, and remittances from USA by the Indians working there will supply dollars in the

foreign exchange market.

The supply curve of dollars plotted against the price of dollar in terms of rupees is

positively sloping as shown in Fig. 4.2.. What accounts for the upward sloping nature of the

supply curve of the dollars? At a higher price of dollar in terms of rupees (or, in other words,

lower value of the Indian rupee in terms of dollar), 100 rupees worth of Indian goods would

be relatively cheaper in terms of dollars.

This will tend to boost exports of the Indian goods to the USA at a higher price of

dollar and thus ensure more supply of dollars in the foreign exchange markets. On the other

hand, if the price of dollar in terms of rupees falls (i.e. its exchange rate for Indian rupee

declines) the 100 rupees worth of Indian goods would become relatively expensive in terms

of dollars. This will discourage the exports of Indian goods to the USA and reduce the

quantity supplied of dollars in the foreign exchange market.

� The Equilibrium Exchange Rate:

It will be seen from Figure 4.2. that the equilibrium exchange rate, that is, the

equilibrium price of dollar in terms of rupees is equal to OR or Rs. 45.50 per dollar at which

demand for and supply curve of dollars intersect and therefore the market for dollars is

cleared at this rate.

At a higher price of dollars OR’ or Rs. 46 the quantity supplied of dollars exceeds the

quantity demanded. With the emergence of excess supply of dollars, its price, that is, the

exchange rate will again fall to OR or Rs. 45.50. On the other hand, if the rate of exchange is

lower than OR, say it is OR” or Rs. 44 per dollar, there will emerge the excess demand for

dollars. This excess demand of dollars would push up the price of dollars to the level of OR

or Rs. 45.50 per dollar.



4.5. Types of Exchange Rates

There are various rates of exchange as explained below.

A. Spot Rate of Exchange :

The spot rate is the current exchange rate for any currency. It is the rate at which your

currency shall be converted if you decided to execute a foreign transaction “right now”. They

represent the day-to-day exchange rate and vary by a few basis points every day.

B. Forward Rate of Exchange:

A market for foreign exchange for future delivery is known as forward market.

Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is

called forward Rate. Thus, forward Rate is the rate at which a future contract for foreign

currency is brought and sold.

C. Dual Exchange Rate :

In this type of system, the currency rate is maintained separately by two values-one

rates applicable for the foreign transactions and another for the domestic transactions. Such

systems are normally adopted by countries who are transitioning from one system to another.

This ensures a smooth changeover without causing much disruption to the economy.

D. Fixed Exchange Rate (Stable Exchange Rate or Pegged Exchange

Rate) :

Fixed exchange rate is also known as stable exchange rate. Under this system,

currencies are assigned a fixed par value in terms of other currencies and Countries are

committed to maintaining this value by support buying and selling under fixed exchange rate

all exchange transactions take place at an exchange rate that is determined by the monetary

authorities.

E. Flexible Exchange Rates (Floating Exchange Rate or Fluctuating

Exchange Rate)

Flexible exchange rates can be defined as exchange rates determined by global supply

and demand of currency. In other words, they are prices of foreign exchange determined by

the market that can rapidly change due to supply and demand, and are not pegged nor

controlled by central banks



4.6. Case for Fixed Exchange Rates or Advantages or Merits of Fixed

Exchange Rates

The main arguments advanced in favour of the system of fixed or stable exchange

rates are as follows:

1. Promotes International Trade:

Fixed or stable exchange rates ensure certainty about the foreign payments and inspire

confidence among the importers and exporters. This helps to promote international trade.

2. Necessary for Small Nations:

Fixed exchange rates are even more essential for the smaller nations like the U.K.,

Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating

exchange rates will seriously affect the process of economic growth in these economies.

3. Promotes International Investment:

Fixed exchange rates promote international investments. If the exchange rates are

fluctuating, the lenders and investors will not be prepared to lend for long-term invest-ments.

4. Removes Speculation:

Fixed exchange rates eliminate the speculative activities in the international

transactions. There is no possibility of panic flight of capital from one country to another in

the system of fixed exchange rates.

5. Necessary for Small Nations:

Fixed exchange rates arc even more essential for the smaller nations like the U.K.,

Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating

exchange rates will seriously disturb the process of economic growth of these economies.

6. Necessary for Developing Countries:

Fixed exchanges rates are necessary and desirable for the developing countries for

carrying out planned development efforts. Fluctuating rates disturb the smooth process of

economic development and restrict the inflow of foreign capital.

7. Suitable for Currency Area:



A fixed or stable exchange rate system is most suitable to a world of currency areas,

such as the sterling area. If the exchange rates of the countries in the common currency area

are flexible, the fluctuations in the leading country, like England (whose currency

dominates), will also disturb the exchange rates of the whole area.

8. Economic Stabilization:

Fixed foreign exchange rate ensures internal economic stabilization and checks

unwarranted changes in the prices within the economy. In a system of flexible exchange

rates, the liquidity preference is high because the businessmen will like to enjoy wind fall

gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities

in country.

9. Not Permanently Fixed:

Under the fixed exchange rate system, the exchange rate does not remain fixed or is

permanently frozen. Rather the rate is changed at the appropriate time to correct the

fundamental disequilibrium in the balance of payments.

10. International Monetary Co –Operation n

It ensures smooth functioning of the international monetary system. That is why, IMF

has adopted pegged or fixed exchange rate system.

4.7. Case against Fixed Exchange Rates or Disadvantages or Demerits of

Fixed Exchange Rates

The system of fixed exchange rates has been criticized on the following grounds:

1. Outmoded System:

Fixed exchange rate system worked successfully under the favourable conditions of

gold standard during 19th century when

(a) The countries permitted the balance of payments to influence the domestic economic

policy;

(b) There was coordination of monetary policies of the trading countries;



(c) The central banks primarily aimed at maintaining the external value of the currency in

their respective countries; and

(d) The prices were more flexible. Since all these conditions are absent today, the smooth

functioning of the fixed exchange rate system is not possible.

2. Discourage Foreign Investment:

Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system

discourages long-term foreign investment which is considered available under the really fixed

exchange rate system.

3. Monetary Dependence:

Under the fixed exchange rate system, a country is deprived of its monetary

independence. It requires a country to pursue a policy of monetary expansion or contraction

in order to maintain stability in its rate of exchange.

4. Cost-Price Relationship not Reflected:

The fixed exchange rate system does not reflect the true cost-price relationship

between the currencies of the countries. No two countries follow the same economic policies.

Therefore the cost-price relationship between them go on changing. If the exchange rate is to

reflect the changing cost-price relationship between the countries, it must be flexible.

5. Not a Genuinely Fixed System:

The system of fixed exchange rates provides neither the expectation of permanently

stable rates as found in the gold standard system, nor the continuous and sensitive adjustment

of a freely fluctuating exchange rate.

6. Difficulties of IMF System:

The system of fixed or pegged exchange rates, as followed by the International

Monetary Fund (IMF), is in reality a system of managed flexibility.

It involves certain difficulties, such as deciding as to

(a) When to change the external value of the currency,

(b) What should be acceptable criteria for devaluation; and



(c) How much devaluation is needed to re-establish equilibrium in the balance of payments of

the devaluing country.

4.8. Advantage of Flexible Exchange Rates

Flexible exchange rate system is claimed to have the following advantages:

1. Independent Monetary Policy:

Under flexible exchange rate system, a country is free to adopt an independent policy

to conduct properly the domestic economic affairs. The monetary policy of a country is not

limited or affected by the economic conditions of other countries.

2. Shock Absorber:

A fluctuating exchange rate system protects the domestic economy from the shocks

produced by the disturbances generated in other countries. Thus, it acts as a shock absorber

and saves the internal economy from the disturbing effects from abroad.

3. Promotes Economic Development:

The flexible exchange rate system promotes economic development and helps to

achieve full employment in the country. The exchange rates can be changed in accordance

with the requirements of the monetary policy of the country to achieve the planned national

objectives.

4. Solutions to Balance of Payment Problems:

The system of flexible exchange rates automatically removes the disequilibrium in the

balance of payments. When, there is deficit in the balance of payments, the external value of

a country's currency falls. As a result, exports are encouraged, and imports are discouraged

thereby, establishing equilibrium in the balance of payment.

5. Promotes International Trade:



The system of flexible exchange rates does not permit exchange control and promotes

free trade. Restrictions on international trade are removed and there is free movement of

capital and money between countries.

6. Increase in International Liquidity:

The system of flexible exchange rates eliminates the need for official foreign

exchange reserves, if the individual governments do not employ stabilization funds to

influence the rate. Thus, the problem of international liquidity is automatically solved. In fact,

the present shortage of international liquidity is due to pegging the exchange rates and the

intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.

7. Market Forces at Work:

Under the flexible exchange rate system, the foreign exchange rates are determined by

the market forces of demand and supply. Market is cleared off automatically through changes

in exchange rates and the possibility of scarcity or surplus of any currency does not exist.

8. International Trade not Promoted by Fixed Rates:

The argument that fixed exchange rates promotes international trade is not supported

by historical facts of inter-war or post-war period. On the other hand under the flexible

exchange rate system, the trend of the rate of exchange is generally assessed through the

forward market, and the traders are protected from financial losses arising from fluctuating

exchange rates. This helps in promoting international trade.

9. International Investment not Promoted by Fixed Rates:

The argument that long-term international investments are encouraged under fixed

exchange rate system is not valid. Both the lenders and borrowers cannot expect the exchange

rate to remain stable over a very long-period.

10. Fixed Rates not Necessary for currency Area:

This stable exchange rates are not necessary for any system of currency areas. The

sterling block functioned smoothly during the thirties in spite of the fluctuating rates of the

member countries.



11. Speculation not Prevented by Fixed Rates:

The main weakness of the stable exchange rate system is that in spite of the strict

exchange control, currency speculation is encouraged. This destroys the stability in the

exchange value of the home currency and makes devaluation of the currency inevitable. For

instance, the pound had to be devalued in 1949 mainly because of such speculation.

4.9. Disadvantage (Defects or Drawbacks)

of Flexible Exchange Rates

The following are the main drawbacks of the system of flexible exchange rates :

1. Low Elasticity’s:

The elasticity’s in the international markets are too low for exchange rate, variations

to operate successfully in bringing about automatic equilibrating adjustments. When import

and export elasticity’s are very low, the exchange market becomes unstable. Hence, the

depreciation of the weak currency would simply tend to worsen the balance of payments

deficit further.

2. Unstable conditions:

Flexible exchange rates create conditions of instability and uncertainty which, in turn,

tend to reduce the volume of international trade and foreign investment. Long-term foreign

investments arc greatly reduced because of higher risks involved.

3. Adverse Effect on Economic Structure:

The system of flexible exchange rates has serious repercussion on the economic

structure of the economy. Fluctuating exchange rates cause changes in the price of imported

and exported goods which, in turn, destabilise the economy of the country.

4. Unnecessary Capital Movements:

The system of fluctuating exchange rates leads to unnecessary international capital

movements. By encouraging speculative activities, such a system causes large-scale capital

outflows and inflows, thus, seriously disturbing the economy of the country.



5. Depression Effects of Capital Movements:

Speculative capital movements caused by fluctuating exchange rates may lead to the

problem of extremely high liquidity preference. In a situation of high liquidity preference,

people tend to hoard currency, interest rates rise, investment falls and there is large-scale

unemployment in the economy.

6. Inflationary Effect:

Flexible exchange rate system involves greater possibility of inflationary effect of

exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to

further depreciation of the external value of the currency.

7. Factor Immobility:

The immobility of various factors of production deprives the flexible exchange rate

system of its advantages arising from the adoption of monetary and other policies for

maintaining internal stability. Such policies produce desirable effects on production and

employment only when supply of factors of production is elastic.

8. Failure of Flexible Rate System:

Experience of the flexible exchange rate system adopted between the two world wars

has shown that it was a flop.

4.10. Purchasing Power Parity Theory of Foreign Exchange Rate

No country today is rich enough to have a free gold standard, not even the U.S.A. All

countries have now paper currencies and these paper currencies of the various countries are

not convertible into gold or other valuable things. Therefore, these days various countries

have paper currency standards. The exchange situation is difficult in such cases. In such

circumstances the ratio of exchange between the two currencies is determined by their

respective purchasing powers.

The purchasing power parity theory was propounded by Professor Gustav Cassel of

Sweden. According to this theory, rate of exchange between two countries depends upon the

relative pur-chasing power of their respective currencies.



Such will be the rate which equates the two purchasing powers. For example, if a

certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs. 80

in India, then it is clear that the purchasing power of £1 is equal to the purchasing power of

Rs. 80. Thus, the rate of exchange, according to purchasing power parity theory, will be £1

=Rs. 80.

Let us take another example. Suppose in the USA one $ purchases a given collection

of com-modities. In India, same collection of goods cost 45 rupees.

Then rate of exchange will tend to be:

$1=45 rupees.

Now, suppose the price levels in the two countries remain the same but somehow

exchange rate moves to

$1 =46 rupees.

This means that one US$ can purchase commodities worth more than 45 rupees. It

will pay people to convert dollars into rupees at the rate ($1 = Rs. 46), purchase the given

collection of commodities in India for 45 rupees and sell them in U.S.A. for one dollar again,

making a profit of 1 rupee per dollar worth of transactions.

This will create a large demand for rupees in the USA while supply thereof will be

less because very few people would export commodities from USA to India. The value of the

rupee in terms of the dollar will move up until it will reach $1 = 45 rupees. At that point,

imports from India will not give abnormal profits. $ 1 = 45 rupees is called the purchasing

power parity between the two countries.

Thus while the value of the unit of one currency in terms of another currency is

determined at any particular time by the market conditions of demand and supply, in the long

run the exchange rate is determined by the relative values of the two currencies as indicated

by their respective purchasing powers over goods and services.

In other words, the rate of exchange tends to rest at the point which expresses equality

between the respective purchasing powers of the two currencies. This point is called the

purchasing power parity.

Thus, under a system of autonomous paper standards the exter-nal value of a currency

is said to depend ultimately on the domestic purchasing power of that cur-rency relative to

that of another currency. In other words, exchange rates, under such a system, tend to be



determined by the relative purchasing power parities of different currencies in different

coun-tries.

In the above example, if prices in India get doubled, the value of the rupee will be

exactly halved. The new parity will be $1 = 90 rupees. This is because now 90 rupees will

buy the same collection of commodities in India which 45 rupees did before. We suppose that

prices in USA remain as before. But if prices in both countries get doubled, there will be no

change in the parity.

In actual practice, however, the parity will be modified by the cost of transporting

goods (includ-ing duties etc.) from one country to another.

4.11. Exchange Control

4.11.1. Meaning of Exchange Control :

Exchange control is one of the important devices to control international trade and

payments. It aims at equilibrating foreign receipts and payments, not through such market

forces or flexible exchange rates but through direct and indirect control of foreign exchange.

Thus exchange control means that all foreign receipts and payments in the form of foreign

currencies are controlled by the government.

Prof. Crowther defines exchange control as “When the Government of a country

intervenes directly or indirectly in international payments and undertakes the authority of

purchase and sale of foreign currencies it is called Foreign Exchange Control”.

4.11.2. Features of Exchange Control :

The exchange control system has the following main features:

1. It involves complete government control over the foreign exchange market

2. All foreign currencies are required to be surrendered to the central bank

3. The central bank sanctions and allocates all foreign payments in respect of different

currencies.



4. The central bank fixes the official exchange rate.

5. It regulates demand and supply so as to maintain the official exchange

rate.

6. There is regulation of currency to be supplied to importers.

7. Exporters are required to surrender foreign currencies to the central bank

8. Only specified banks and licensed dealers can deal in foreign exchange

9. The central bank acts as a discriminating monopolist by charging low rates of

exchange for the purchase of essential imports and high rates for purchasing luxury imports.

4.11.3. Objectives of Exchange Control:

The system of exchange control may be adopted to achieve different objectives.

Important among them are given below:

1. To Correct Adverse Balance of Payments:

A country may follow the system of exchange control when it faces a deficit in its

balance of payments and does not want to leave the process of adjustment either on the mercy

of automatic mechanism of fluctuating foreign exchange rates or on deflation. By adopting

exchange control, imports are restricted to the level permitted by the availability of foreign

exchange reserves and, thereby, the balance of payments equilibrium is established.

2. To Check Flight of Capital:

Exchange control may be adopted to prevent the flight of capital from the country.

Flight of capital refers to the action of the citizens of a country to convert their cash holdings

(i.e., short- term securities and bank deposits) into foreign currencies. Flight of capital maybe

the result of speculative activities, economic fluctuations and political uncertainty. Flight of

capital exhausts the country’s limited reserves of foreign exchange and destabilise the

economy. Through exchange control, the government imposes restrictions on the sale of

foreign currencies and there-by checks the flight of capital.

3. To Stabilise Exchange Rate:

The government may adopt exchange control to check fluctuations in the rate of

exchange. Fluctuations in the rate of exchange are the normal feature in a free exchange



market and cause disequilibrium in the economic life of a country. These fluctuations can be

checked by officially fixing the exchange rate at a predetermined level.

4. To Conserve Foreign Exchange:

Exchange control may be used to conserve country’s foreign exchange reserves

through exports. These reserves are restricted for- (a) paying off external debt, (b) importing

essential goods for economic development, and (c) purchasing defence materials.

5. To Check Economic Fluctuations:

Cyclical fluctuations depression and inflation, spread from one country to another

through international trade. Exchange controls are used to check the spread of the

destabilising tendencies by controlling imports and exports.

6. To Protect Home Industry:

Exchange control may be resorted to protect the home industry from foreign

competition. For this purpose, the government restricts the imports through foreign exchange

controls and thus provides opportunity to the domestic industries to develop without any fear

of international competition.

7. To Practise Discrimination in Trade:

Exchange control helps a country to follow a policy of discrimination in international

trade. The government fixes favourable rates of exchange for the countries with which it

wants to strengthen its trade relation.

8. To Check Undesirable Imports:

Exchange control is also needed to check the import of certain nonessential, harmful

and socially undesirable goods in the country.

9. Source of Income:

Exchange control can also be used as a source of income to the government. Under

the multiple exchange rate system, the government fixes the selling rates higher than the

buying rates and earns income equal to the difference between the two rates.

10. Important for Planning:

Exchange control forms an integral part of economic policy in a planned economy.

Planned economic development requires expansion, conservation and proper use of foreign

exchange reserves of the country according to the national priorities. Exchange control

system is directed to achieve these objectives.

11. To Check Enemy Nations:



Exchange control is also used by some countries to prevent the enemy countries from

using their foreign assets. Regulations are adopted to freeze the assets held by the residents of

the enemy country and they are not allowed to use or transfer these assets.

12. Overvaluation:

Overvaluation refers to the fixing of the value of a currency at a rate higher than the

free market rate. It! is also called ‘pegging up’. Overvaluation, by making the home currency

dearer for the foreigners, reduces the prices of imports and raises the prices of exports.

The policy of overvaluation is adopted to facilitate the country to make its purchases

at cheaper prices and to pay off the foreign debts.

13. Undervaluation:

Undervaluation refers to the fixing of the value of a currency at a rate lower than the

free market rate. It is also known as ‘pegging down’. Undervaluation, by making the currency

cheaper for the foreigners, reduces the prices of exports and raises the prices of imports. The

policy of undervaluation is adopted to promote exports, reduce imports and to give support to

general rise in prices

4.11.4. What are the Methods of Exchange Control?

The various methods of exchange control may broadly be classified into two types,

direct and indirect. Direct methods of exchange control include those devices which are

adopted by governments to have an effective control over the exchange rate, while indirect

methods are designed to regulate international movements of goods.

1. Direct Exchange Control

2. Indirect Exchange Control

1. Direct Methods of Exchange Control

In direct exchange control, certain measures are adopted which effectuate immediate

direct restriction on foreign exchange from all sides – its quantum, use and allocation.

In general, direct exchange control includes measures like::

� Intervention;

� Exchange restrictions;



� Exchange clearing agreements;

� Payment agreements; and

� Intervention:

It refers to the government’s intervention or interference in the free working of the

exchange market with a view to overvalue or undervalue the country’s currency in terms of

foreign money. The government or its agency – the central bank – can intervene in the free

market by resorting to buying and selling the home currency against foreign currency in the

foreign exchange market to support or depress the exchange rate of its currency.

Pegging Operations:

Government intervention in the foreign exchange market takes the form of pegging up

or pegging down of the currency of the country to a chosen rate of exchange. Since

undervaluation or overvaluation is not the equilibrium rate, it has to be pegged. Thus,

pegging means keeping a fixed exchange value of a currency; however, intervention may be

practised by a government without resorting to pegging as such.

Pegging operations take the form of buying and selling of the local currency by the central

bank of a country in exchange for the foreign currency in the foreign exchange market, in

order to maintain an exchange rate whether, it is overvalued or undervalued.

Thus, pegging may be pegging up or pegging down. Pegging up means holding fixed

overvaluation, i.e., to maintain the exchange rate at a higher level. Pegging down means

holding fixed undervaluation, i.e., to maintain the exchange rate at a lower (depressed) level.

In the case of pegging up, the central bank shall have to keep itself ready to buy unlimited

amount of local currency in exchange for foreign currencies at a fixed rate, because

overvaluation tends to increase the demand for foreign currencies by creating import surplus.

In the case of pegging down, the central bank or central agency shall have to keep

itself ready to sell any amount to local currency by creating export surplus. Similarly,

pegging up involves holding of sufficient amount of foreign currencies while pegging down

involves holding of sufficient amount of local currency by the central bank. It goes without

saying that pegging up, is more difficult to maintain as it requires huge amounts of foreign

currencies which is difficult to obtain. As such pegging up can be adopted only as a



temporary expedient. It should be noted that intervention by a government in the foreign

exchange market has the effect of neutralising the forces of demand and supply of foreign

exchange. However, it is generally assumed that government intervention or pegging up and

pegging down operations should be used as temporary expedients to remove fluctuations in

the exchange rate.

� Exchange Restrictions:

Exchange restrictions refer to the policy or measures adopted by a government which

restrict or compulsory reduce the flow of home currency in the foreign exchange market.

Exchange restrictions may be of three types:

(i) The government may centralise all trading in foreign exchange with itself or a central

authority, usually the central bank; (ii) the government may prevent the exchange of local

currency against foreign currencies without its permission; (iii) the government may order all

foreign exchange transactions to be made through its agency.

Exchange restrictions may take various forms, the most common of them being: (1)

Blocked accounts, (2) Multiple exchange rates.

Blocked Accounts:

Under the condition of severe financial crisis, a debtor country may adopt the scheme of

blocking the accounts of its creditors. In 1931, Germany, for instance, had done so in order to

have exchange restrictions.

Blocked accounts refer to bank deposits, securities and other assets held by foreigners

in a country which denies them conversion of these into their home currency. Blocked

accounts, thus, cannot be converted into the creditor country’s currency. Under the blocked

accounts scheme, all those who have to make payments to any foreign country will have to

make them not to the foreign creditor directly but to the central bank of the country which

will keep the amount in the name of the foreign creditor. This amount will not be available to

the foreigners in their own currency, but can be used by them for purchase in the controlling

country.

Multiple Exchange Rates:

In the early thirties, Germany had initiated the device of multiple rates, as a weapon to

improve her balance of payments position. Under this system, different exchange rates are set



for different classes and categories of exports and imports. Generally a low rate, i.e., low

prices of foreign money in terms of domestic currency, is confined to imports of necessary

items having an inelastic demand, while a high penalty rate is fixed for the imports of luxury

items. In short, the multiple exchange rates system implies official price discriminatory

policy in foreign exchange transactions.

By simply fixing a high exchange rate for a commodity, the government can check its

imports (when its elasticity of demand for import is greater than unity). Similarly, its imports

can be encouraged by fixing a low exchange rate.

Likewise, the export of a commodity can be encouraged by setting a high rate of

exchange. Thus, the device of multiple exchange rates can be effectively used by the

government for making short-term adjustments in the balance of payments, without resorting

to quantitative restrictions and licensing. Indeed, multiple exchange rates amount to

discriminatory export taxation and varying rates of tariffs on imports.

In other words, the system of multiple exchange rates in essence is a form of

discriminatory partial devaluation, because instead of devaluing the currency for the whole of

foreign trade, under this system, the currency is devalued for imports and exports of goods

with an elasticity greater than unity and appreciating the currency for goods with an elasticity

less than unity. It is thus more effective in bringing about the desired effect on the level of

trade and thereby, improve the balance of payments.

Exchange Clearing Agreements :

European countries had adopted this form of exchange control in the Thirties. It was

a system for the direct bilateral bartering of goods on a national scale. Under this device, two

countries engaged in trade pay to their respective central banks the amounts payable to their

respective foreign creditors. These central banks then use the money in offsetting the

corresponding claims after fixing the value of the currencies by mutual agreement. And,

importers have to deposit their payment with the central bank can use such money to pay the

domestic exporters. This economises exchange needs for trade. Therefore, exchange clearing

device is helpful to a country which has little or no foreign exchange reserves and which is

more interested in selling than buying. However, this system is essentially one of offsetting

each other’s payments, and the basic assumption is that countries entering into such an



agreement should try to equalise their imports and exports so that, there will be no necessity

for either making or receiving payments from the other countries.

Payment Agreements :

To overcome the difficulties of the problems of waiting and centralisation of payments

observed in clearing agreements, the device is formed as payment agreements. Under this

scheme, a creditor is paid as soon as informants.

Under this scheme, a creditor is paid as soon as information is received by the central

bank of the debtor country from the creditor country’s central bank that its debtor has

discharged his obligation and vice versa. By designing the arrangement for mutual credit

facilities, thus, possibilities of delay are ruled out. Payment Agreements have the advantage

that direct relation between exporters and importers are maintained.

2. Indirect Methods of Exchange Control

Apart from the direct methods, there are several indirect methods also regulating the

rates of exchange. Important ones are briefly discussed below.

� Changes in Interest Rates :

Changes in interest rate tend to influence indirectly the foreign exchange rate. A

rise in the interest rate of a country attracts liquid capital and banking funds of foreigners. It

will tend to keep their funds in their own country. All this tends to increase the demand for

local currency and consequently the exchange rate move in its favour. It goes without saying

that, a lowering of the rate of interest will have the opposite effect.

� Tariffs Duties and Import Quotas :

The most important indirect method is the use of tariffs and import quotas and other

such quantitative restrictions on the volume of foreign trade. Import duty reduces imports and

with it rise the value of home currency relative to foreign currency. Similarly, export duty

restricts exports; as a result, the value of home currency falls relative to foreign currencies. In

short, when import duties and quotas are imposed, the rate of exchange tends to go up in

favour of the controlling country.



� Export Bounties :

Export bounties of subsidies increase exports. As such the external value of the

currency of the subsidy-giving country rises. It should be noted that import duties and export

bounties are treated as indirect instruments of exchange control only if they are imposed with

the object of conserving the foreign exchange. Otherwise, the fundamental aim of import

duty is merely to check imports and that of export bounty is to encourage exports.

In fine, interest rates, import duty or export subsidy, each has its limitations. For

instance, import duty cannot go so far as to completely restrict imports. There is also the fear

of retaliation in regard to tariff policy. Similarly, the volume of subsidy depends upon the

support of public fund. Likewise, manipulation of exchange rate through changes in interest

rate may not be always effective. Moreover, rates of interest cannot be raised to any limit

without engendering depression.



___________________________________________________________________________

UNIT:5

BALANCE OF PAYMENTS

5.1. Meaning of Balance of Payments :

The balance of payments of a country is a systematic record of all its economic

transactions with the outside world in a given year.

5.2. Meaning of Balance of Trade :

Balance of trade refers to only the value of imports and exports of goods, like visible

items only. Import or export of goods is a visible item because it is an open trade between the

countries and can be easily certified by the Customs officials.

5.3. Structure of Balance of Payments Account :

The balance of payments account of a country is constructed on the principle of

double-entry book keeping. Each transaction is entered on the credit and debit side of the

balance sheet. But balance of payments accounting differs from business accounting in one

respect. In business accounting, debits (-) are shown on the left side and credits (+) on the

right side of the balance sheet. But in balance of payments accounting, the practice is to show

credits on the left side and debits on the right side of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while

payment to a foreign country is a debit transaction. The principal items shown on the credit

side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of

gifts, grants, etc. from foreigners, borrowings from abroad, investments by foreigners in the

country, and official sale of reserve assets including gold to foreign countries and

international agencies.

The principal items on the Debit side (-) include imports of goods and services,

transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign

countries, investments by residents to foreign countries, and official purchase of reserve

assets or gold from foreign countries and international agencies.



These credit and debit items are shown vertically in the balance of payments account

of a country according to the principle of double-entry book-keeping. Horizontally, they are

divided into three categories: the current account, the capital account, and the official

settlements account or the official reserve assets account.

The balance of payments account of a country is constructed in the following Table

5.1.

Table. 5.1 : The Balance of Payments Account

� Current Account:

The current account of a country consists of all transactions relating to trade in goods

and services and unilateral (or unrequited) transfers. Service transactions include costs of

travel and transportation, insurance, income and payments of foreign investments, etc.

Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable

donations etc. received from foreign individuals and governments to foreigners.

In the current account, merchandise exports and imports are the most important items.

Exports are shown as a positive item and are calculated f.o.b. (free on board) which means

that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown



as a negative item and are calculated c.i.f. which means that costs, insurance and freight are

included.

The difference between exports and imports of a country is its balance of visible trade

or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the

balance of trade is favourable. In the opposite case when imports exceed exports, it is

unfavourable.

It is, however, services and transfer payments or invisible items of the current account

that reflect the true picture of the balance of payments account. The balance of exports and

imports of services and transfer payments is called the balance of invisible trade. The

invisible items along with the visible items determine the actual current account position. If

exports of goods and services exceed imports of goods and services, the balance of payments

is said to be favourable. In the opposite case, it is unfavourable.

In the current account, the exports of goods and services and the receipts of transfer

payments (unrequited receipts) are entered as credits (+) because they represent receipts from

foreigners. On the other hand, the imports of goods and services and grant of transfer

payments to foreigners are entered as debits (-) because they represent payments to

foreigners. The net value of these visible and invisible trade balances is the balance on

current account.



Capital Account:

The capital account of a country consists of its transactions in financial assets in the

form of short-term and long-term lending’s and borrowings, and private and official

investments. In other words, the capital account shows international flow of loans and

investments, and represents a change in the country’s foreign assets and liabilities. Long-term

capital transactions relate to international capital movements with maturity of one year or

more and include direct investments like building of a foreign plant, portfolio investment like

the purchase of foreign bonds and stocks, and international loans. On the other hand, short-

term international capital transactions are for a period ranging between three month and less

than one year.

There are two types of transactions in the capital account private and government.

Private transactions include all types of investment: direct, portfolio and short-term.

Government transactions consist of loans to and from foreign official agencies. In the capital

account, borrowings from foreign countries and direct investment by foreign countries

represent capital inflows. They are positive items or credits because these are receipts from

foreigners. On the other hand, lending to foreign countries and direct investments in foreign

countries represent capital outflows. They are negative items or debits because they are

payments to foreigners. The net value of the balances of short-term and long-term direct and

portfolio investments is the balance on capital account.

Basic Balance. The sum of current account and capital account is known as the basic

balance.

� The Official Settlements Account:

The official settlements account or official reserve assets account is, in fact, a part of

the capital account. But the U.K. and U.S. balance of payments accounts show it as a separate

account. “The official settlements account measures the change in nation’s liquidity and non-

liquid liabilities to foreign official holders and the change in a nation’s official reserve assets

during the year. The official reserve assets of a country include its gold stock, holdings of its

convertible foreign currencies and SDRs, and its net position in the IMF.” It shows

transactions in a country’s net official reserve assets.

Errors and Omissions:



Errors and omissions is a balancing item so that total credits and debits of the three

accounts must equal in accordance with the principles of double entry book-keeping so that

the balance of payments of a country always balances in the accounting sense.

5.4. Equilibrium and Disequilibrium in Balance of Payments :

� Equilibrium in Balance of Payments :

Balance of payments always balances means that the algebraic sum of the net credit

and debit balances of current account, capital account and official settlements account must

equal zero. Balance of payments is written as

B=Rf - Pf

where, B represents balance of payments.

Rf Receipts from foreigners.

Pf payments made to foreigners.

When B = Rf - Pf = 0 the balance of payments is in equilibrium. When Rf - Pf>0 it

implies receipts from foreigners exceed payments made to foreigners and there is surplus in

the balance of payments. On the other hand, when Rf - Pf< 0 or Rf< Pf there is deficit in the

balance of payments as the payments made to foreigners exceed receipts from foreigners.

� Disequilibrium in Balance of Payments :

A disequilibrium in the BOP of a country may be either a deficit or a surplus. A

deficit or surplus in BOP of a country appears when its autonomous receipts (credits) do not

match its autonomous payments (debits). If autonomous credit receipts exceed autonomous

debit payments, there is a surplus in the BOP and the disequilibrium is said to be favourable.

On the other hand, if autonomous debit payments exceed autonomous credit receipts, there is

a deficit in the BOP and the disequilibrium is said to be unfourable or adverse.

5.5. Surplus in Balance of Payments :

If autonomous credit receipts exceed autonomous debit payments, there is a surplus in

the BOP and the disequilibrium is said to be favourable.



5.6. Deficit in Balance of Payments :

If autonomous debit payments exceed autonomous credit receipts, there is a deficit in

the BOP and the disequilibrium is said to be unfourable or adverse.

5.7.Causes of Disequilibrium in Balance of Payments

Balance of Payment (BOP) is the accounting record of all monetary transactions

between a given country and the rest of the world. The transactions comprises of payments

for country's export and imports of goods and services. Disequilibrium in the Balance of

Payment may take place either in the form of deficit, that is, when the receipts from the

foreigners fall below a country's payment and surplus disequilibrium which arises when the

receipts of the country exceeds its payments, which is favourable. These forms of

disequilibrium may be caused by the following factors.

1. Political Conditions :

Political condition of a country is one of the important cause of disequilibrium in

BOP. Political instability in a country creates uncertainty among foreign investors which

leads to the outflow of capital and retards inflow. This causes disequilibrium in BOP of the

country.

2. Social Causes :

Some of the social causes like Changes in fashions, tastes and preferences of the

people bring disequilibrium in BOP by influencing imports and exports and High population

growth in poor countries adversely affects their BOP because it increases the needs of the

countries for imports and decreases their capacity to export.

3. Cyclical Fluctuations (or Disequilibrium) :

Cyclical fluctuations in business activity also lead to BOP disequilibrium. When

there is depression in a Country, volumes of both exports and imports fall drastically in

relation to other Countries. But the fall in exports may be more than that of imports due to

decline in domestic production. Therefore, there is an adverse BOP situation. On the other

hand, when there is boom in a country in relation to other countries, both exports and imports

may increase. But there can be either a surplus or deficit in BOP situation depending upon



whether the country exports more than imports OR Imports more than exports. In both the

cases, there will be disequilibrium in BOP.

4. Price Changes :

Inflation or deflation is another cause of disequilibrium in the balance of payments. If

there is inflation in the country, prices of exports increase. As a result, exports fall. At the

same time, the demand for imports Increase. Thus increase in export prices leading to decline

in exports and rise in imports results in adverse balance of payments.

5. Change in Demand:

Fall in demand for country’s goods in the foreign markets leads to fall in exports and it

adversely affects the balance of payments.

6. Changes in National Income:

Another cause is the change in the country’s national income. If the national income of

a country increases, it will lead to an increase in imports thereby creating a deficit in its

balance of payments, other things remaining the same. If the country is already at full

employment level, an increase in income will lead to inflationary rise in prices which may

increase its imports and thus bring disequilibrium in the balance of payments.

7. Stage of Economic Development:

A country’s balance of payments also depends on its stage of economic development.

If a country is developing it will have a deficit in its balance of payments because it imports

raw materials, machinery, capital equipment, and services associated with the development

process and exports primary products. The country has to pay more for costly imports and

gets less for its cheap exports. This leads to disequilibrium in its balance of payments

8. Changes in Exchange Rates:

Changes in foreign exchange rate in the form of overvaluation or undervaluation of

foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation

to other currencies, it is said to be overvalued. Opposite is the case of an undervalued

currency. Overvaluation of the domestic currency makes foreign goods cheaper and exports

dearer in foreign countries. As a result, the country imports more and exports less of goods.

There is also outflow of capital. This leads to unfavourable BOP. On the contrary,



undervaluation of the currency makes BOP favourable for the country by encouraging

exports and inflow of capital and reducing imports.

9. Scarcity of Capital:

Scarcity of Capital of a country is another cause of disequilibrium in BOP because it

imports capital intensive goods associated with the development process from developed

countries. This leads to disequilibrium in its balance of payments.

10. Structural Changes (or Disequilibrium):

Structural changes bring about disequilibrium in BOP over the long run. They may

result from the following factors:

� Technological changes in methods of production of products in domestic industries or

in the industries of other countries. They lead to changes in costs, prices and quality

of products.

� Import restrictions of all kinds bring about disequilibrium in BOP.

� Deficit in BOP also arises when a country suffers from deficiency of resources which

it is required to import from other countries.

� Disequilibrium in BOP may also be caused by changes in the supply or direction of

long-term capital flows. More and regular flow of long-term capital may lead to BOP

surplus, while an irregular and short supply of capital brings BOP deficit.

11. Natural Factor :

Natural calamities, such as droughts, floods, etc., adversely affect the production in

the country. As a result, the exports fall, the imports increase and the country experiences

deficit in its balance of payments.

12. Demonstration Effect :

According to Nurkse, the people in the less developed countries tend to follow the

consumption patterns of the developed countries. As a result of this demonstration effect, the



imports of the less developed countries will increase and create disequilibrium in the balance

of payments.

13. High population Growth :

A huge population and its high rate of growth in poor countries also have adversely

affected their BOP position. It is easy to see that an increase in population increases the need

for these countries for imports and decrease the capacity to export.

5.8. Methods of Correcting Disequilibrium in BOP

When there is a deficit in the balance of payments of a country , adjustment is brought

about by adopting certain policy measures like monetary and non monetary measures. We

study these as follows.

I. Monetary Measures for Correcting the Balance of Payments

The monetary methods for correcting disequilibrium in the balance of payment are as

follows

1. Deflation :

Deflation means falling prices. Deflation has been used as a measure to correct deficit

disequilibrium. A country faces deficit when its imports exceeds exports. Deflation is brought

through monetary measures like bank rate policy, open market operations, etc. or through

fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would

make our items cheaper in foreign market resulting a rise in our exports. At the same time the

demands for imports fall due to higher taxation and reduced income. This would built a

favourable atmosphere in the balance of payment position.

2. Exchange Depreciation :

Exchange depreciation means decline in the rate of exchange of domestic currency in

terms of foreign currency. This device implies that a country has adopted a flexible exchange

rate policy. Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40.

If India experiences an adverse balance of payments with regard to U.S.A, the Indian demand

for US dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will

appreciate in external value and rupee will depreciate in external value. The new rate of



exchange may be say $1 = Rs. 50. This means 25% exchange depreciation of the Indian

currency. Exchange depreciation will stimulate exports and reduce imports because exports

will become cheaper and imports costlier. Hence, a favourable balance of payments would

emerge to pay off the deficit.

3. Devaluation :

Devaluation refers to deliberate attempt made by monetary authorities to bring down

the value of home currency against foreign currency. While depreciation is a spontaneous fall

due to interactions of market forces, devaluation is official act enforced by the monetary

authority. Generally the international monetary fund advocates the policy of devaluation as a

corrective measure of disequilibrium for the countries facing adverse balance of payment

position. When India's balance of payment worsened in 1991, IMF suggested devaluation.

Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various

currencies. The 1991 devaluation brought the desired effect. The very next year the import

declined while exports picked up. When devaluation is effected, the value of home currency

goes down against foreign currency, Let us suppose the exchange rate remains $1 = Rs. 10

before devaluation. Let us suppose, devaluation takes place which reduces the value of home

currency and now the exchange rate becomes $1 = Rs. 20. After such a change our goods

becomes cheap in foreign market. This is because, after devaluation, dollar is exchanged for

more Indian currencies which push up the demand for exports. At the same time, imports

become costlier as Indians have to pay more currencies to obtain one dollar. Thus demand for

imports is reduced. Generally devaluation is resorted to where there is serious adverse

balance of payment problem.

4. Exchange Control :

It is an extreme step taken by the monetary authority to enjoy complete control over

the exchange dealings. Under such a measure, the central bank directs all exporters to

surrender their foreign exchange to the central authority. Thus it leads to concentration of

exchange reserves in the hands of central authority. At the same time, the supply of foreign

exchange is restricted only for essential goods. It can only help controlling situation from

turning worse. In short it is only a temporary measure and not permanent remedy.



II. Non Monetary Measures for Correcting the Balance of Payment

A deficit country along with Monetary measures may adopt the following non-

monetary measures too which will either restrict imports or promote exports.

1. Tariffs:

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of

imports would increase to the extent of tariff. The increased prices will reduced the demand

for imported goods and at the same time induce domestic producers to produce more of

import substitutes. Non-essential imports can be drastically reduced by imposing a very high

rate of tariff.

2. Quotas:

Under the quota system, the government may fix and permit the maximum quantity or

value of a commodity to be imported during a given period. By restricting imports through

the quota system, the deficit is reduced and the balance of payments position is improved.

3. Export Promotion:

The government can adopt export promotion measures to correct disequilibrium in

the balance of payments. This includes substitutes, tax concessions to exporters, marketing

facilities, credit and incentives to exporters, etc.

The government may also help to promote export through exhibition, trade fairs;

conducting marketing research & by providing the required administrative and diplomatic

help to tap the potential markets.

4. Import Substitution:

A country may resort to import substitution to reduce the volume of imports and make

it self-reliant. Fiscal and monetary measures may be adopted to encourage industries

producing import substitutes. Industries which produce import substitutes require special

attention in the form of various concessions, which include tax concession, technical

assistance, subsidies, providing scarce inputs, etc.

Non-monetary methods are more effective than monetary methods and are normally

applicable in correcting an adverse balance of payments.



5.9. Devaluation

5.9.1. Meaning of Devaluation :

Devaluation refers to a reduction in the external value of a currency in terms of other

currencies.

A country with fundamental disequilibrium in its balance of payments may devalue

its currency in order to increase its exports and discourage imports. With devaluation, the

domestic price of imports in the devaluating country increases and the foreign price of its

exports falls. Consequently, the exportable commodities of the country become cheaper

abroad because the foreigners can buy more goods by paying less money than before

devaluation. This encourages exports. On the other hand, the goods which the country

imports become dearer than before. This discourages imports. Thus when exports increase

and imports fall with devaluation, the balance of payments of the country moves towards

equilibrium.

It may be understood with the help of an example. Before devaluation of the Indian

rupee on 6 June, 1966, the exchange rate between the Indian rupee and the U.S. dollar was

Re. 1= 21 cents. After devaluation, this rate became Re.1=13.3 cents. As a result, U.S.

imports became dearer for India. Before devaluation, India bought goods worth 21 cents in

exchange for Re. 1. But after devaluation, it could buy goods worth only 13.3 cents for Re. 1.

As a result, U.S. imports fell, having become dearer. On the other hand, Indian exports

Cheaper in America because the U.S. traders could buy goods worth Re.1 from India by

paying 13.3 cents instead of 21 cents. As a result, Indian exports increased. Thus with the

increase in exports and decrease in imports, the disequilibrium in the balance of payments is

reduced.

5.9.2. Effects of Devaluation:

Effects of Devaluation can be explained in the following ways:



1. Exports cheaper :

A devaluation of the exchange rate will make exports more competitive and

appear cheaper to foreigners. This will increase demand for exports. Also, after a

devaluation, UK assets become more attractive; for example, a devaluation in the rupee

can make Indian property appear cheaper to foreigners.

2. Imports more expensive :

A devaluation means imports, such as petrol, food and raw materials will become

more expensive. This will reduce demand for imports. It may also encourage Indian

tourists to take a holiday in the India, rather than US – which now appears more

expensive.

3. Increased aggregate demand (AD) :

A devaluation could cause higher economic growth. Part of AD is (X-M)

therefore higher exports and lower imports should increase AD (assuming demand is

relatively elastic). In normal circumstances, higher AD is likely to cause higher real GDP

and inflation.



4. Inflation is likely to occur following a Devaluation because:

�� Imports are more expensive – causing cost push inflation.

�� AD is increasing causing demand pull inflation

�� With exports becoming cheaper, manufacturers may have less incentive to cut costs and become more efficient. Therefore over time, costs may increase.

5. Improvement in the Current Account :

With exports more competitive and imports more expensive, we should see higher

exports and lower imports, which will reduce the current account deficit.

6. Falling Real Wages:

In a period of stagnant wage growth, devaluation can cause a fall in real wages. This

is because devaluation causes inflation, but if the inflation rate is higher than wage increases,

then real wages will fall.

5.9.3. Evaluation of a Devaluation :

The effect of a devaluation depends on:



1. Elasticity of Demand for Exports and Imports :

If demand is price inelastic, then a fall in the price of exports will lead to only a small

rise in quantity. Therefore, the value of exports may actually fall. An improvement in the

current account on the balance of payments depends upon the Marshall Lerner condition and

the elasticity of demand for exports and imports.

� If PEDx + PEDm > 1 then a devaluation will improve the current account

� The impact of a devaluation may take time to influence the economy. In the short

term, demand may be inelastic, but over time demand may become more price

elastic and have a bigger effect.

2. State of the Global Economy :

If the global economy is in recession, then a devaluation may be insufficient to boost

export demand. If growth is strong, then there will be a greater increase in demand. However,

in a boom, a devaluation is likely to exacerbate inflation.

� Inflation :

The effect on inflation will depend on other factors such as:

�� Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to

cause inflation.

�� Do firms pass increased import costs onto consumers? Firms may reduce their

profit margins, at least in the short run.

�� Import prices are not the only determinant of inflation. Other factors affecting

inflation such as wage increases may be important.

� It depends on why the currency is being devalued :

If it is due to a loss of competitiveness, then a devaluation can help to restore

competitiveness and economic growth. If the devaluation is aiming to meet a certain

exchange rate target, it may be inappropriate for the economy.



Winners and Losers from devaluation

Examples of Devaluation

�� Leaving the ERM in 1992

�� UK devaluation of 1967

�� Devaluation of Indian Rupee 1949, 1966 and 1991.

What are the differences between FERA and FEMA?

� What is FERA?

Foreign Exchange Regulation Act (also known as FERA), was introduced in the year

1973.The act came into force, to regulate inflow and outflow of foreign currency, foreign

payments, securities and purchase of fixed assets by the foreigners.

The FERA was promulgated in India at a time when it does not have good foreign

exchange reserve. It aimed at conserving foreign currency and its optimum utilisation for the

development of the economy.



� What is FEMA?

In the budget of 1997-98, the government had proposed to replace FERA-1973 by

FEMA (Foreign Exchange Management Act). It came into force on June 1, 2000. Under the

FEMA, provisions related to foreign exchange have been modified and liberalised so as to

simplify foreign trade and payments.

The important goal of FEMA is to amend and integrate all laws related to foreign

currency in India. In addition to this, FEMA aims to promote foreign payments, export of the

country and promote foreign capital and investment in the country to promote holistic

development of India. FEMA also encourages the maintenance and improvement of the

foreign exchange market in India. FEMA provides complete independence to a person living

in India that he/she can buy property outside India.

Let's know what are the differences between FERA and FEMA

Differences between FERA and FEMA

S.N. FERA FEMA

1. It was approved by the Parliament in 1973.

It was approved by the Parliament in 1999.

2. Currently it is not in force. Currently it is not in force.

3. It had 81 sections. It had 49 sections.

4. It was implemented to regulate foreign payments and to ensure optimum use of foreign currency in India.

It aims to promote foreign trade, foreign payments and to increase size of foreign exchange reserve in the country.

5. Under FERA, only "citizenship" was a criterion to conclude the residential status of a person.

As per this law; a person who is living in India from last 6 months can be considered as an Indian.



6. The crime was kept in criminal offence category.

The crime was kept in Civil offence category.

7. If anyone found guilty of FERA violation; there was a provision of punishment directly.

Fine or imprisonment (if the person does not deposit the prescribed penalty within 90 days from the date of conviction).

8. The accused was considered guilty as soon as the lawsuit was filed and he had to prove that he is innocent.

In FEMA, the accused is not liable to prove his innocence but burden lies on the FEMA officer to prove him guilty.

9. A person has to obtain permission of RBI with regard to transfer of funds related to external operations.

There is no requirement of pre approval from RBI related to remittances & external trade.



QUESTION PAPERS OF LAST FIVE YEARS

Akkamahadevi Women’s University , Vijayapura

B.Com . IV Semester Degree Examination, May 2014

ECONOMICS

Paper- 4.3: International Economics

Time: 3 Hours. Max. Marks: 80

Instructions:

1. All Sections are compulsory

2. Answer to the sub-questions in each Section should be written continuously.

3. Diagram should be drawn, wherever necessary.

SECTION – A

Answer any ten of the following: . (2×10=20)

1. What is International Trade?

2. Who has given the comparative cost theory of International Trade ?

3. What are Quotas?

4. What are Terms of Trade?

5. What is Dumping?

6. Give the meaning of foreign exchange.

7. What is import substitution ?

8. What is meant by exchange control ?

9. Mention any four advantages of International Trade.

10.Give the meaning of disequilibrium in Balance of Payment.



11. What is Free Trade?

12. Give the meaning of Flexible Exchange Rate.

13. What are Tariffs?

14. Give the meaning of Devaluation.

15. What is meant by Balance of Trade?

SECTION-B

Answer any three of the following:(3×10=30)

1.Explain the functions of Foreign Exchange Market.

2. Bring Out the differences between internal trade and international trade

3. Discuss the various concepts of Terms of Trade.

4. Explain the arguments in favour and against free trade

5. Explain the advantages and disadvantages of fixed exchange rate.

SECTION-C

Answer any two of the following: (2×15=30)

1. Explain the Heckscher-Ohilin's theory of International Trade.

2. Describe the methods of correcting disequilibrium in Balance of Payments.

3. Discuss the methods of Protection Trade Policy.

4. Explain the purchasing power parity theory of exchange rate.




B.Com . IV Semester Degree Examination, May/June 2015

ECONOMICS



Instructions:




SECTION – A



2. Give the meaning of opportunity cost.

3. Who has given the Modern theory of International Trade ?

4. What are Terms of Trade ?

5. State any four differences between Internal Trade and International Trade.

6. What are Tariffs ?

7. Give the meaning of Dumping.

8. What is Free Trade ?

9. What is meant by Devaluation ?

10. What are Quotas?

11. Give the meaning of exchange control.



12. What do you mean by Balance of Trade?

13. What is Foreign Exchange Market?

14. Give the meaning of export promotion.

15. What is Flexible rate of exchange?

SECTION-B

Answer any three of the following:. (3×10=30)

16. Explain the advantages of International Trade.

17. Discuss the role of protection in Underdeveloped countries.

18. Bring out the causes of disequilibrium in balance of payments.

19. Describe the various concepts of Terms of Trade.

20. Explain the advantages and disadvantages of Fixed exchange rate..

SECTION-C


21. Critically analyse the comparative cost theory of International Trade.

22. Discuss the arguments in favour and against the protection policy.

23. Describe the methods of correcting disequilibrium in Balance of Payments.

24. Explain the purchasing power parity theory of exchange rate.




B.Com . IV Semester Degree Examination, May/June 2016

ECONOMICS



Instructions:




SECTION – A


1. State the meaning of international trade

2. What is opportunity cost ?

3. Mention four significance of international trade.

4. What is protection policy ?

5. Give the meaning of terms of trade

6. Who has given the comparative cost theory of international trade ?

7. State the meaning of infant industry.

8. Mention four assumptions of classical theory of international trade.

9.What is disequilibrium in balance of payment ?

10. Give the meaning of exchange control.

11. What is current account of balance of payment ?



12. State the meaning of foreign exchange.

13. Give the meaning of Quota.

14. What is Dumping ?

15. Give the meaning of mint parity rate.

SECTION-B

Answer any three of the following: (3×10=30)

16. Distinguish between Internal and international trade

17.Critically examine the modern theory of international trade

18. Discuss the advantages and disadvantages of flexible exchange rate

19. Explain the methods of exchange control.

20. What is tariff ? Analyse the effect of tariff

SECTION-C

Answer any two of the following:. (2×15=30)

21.Discuss the various concepts of terms of trade

22.Define free trade. Discuss the arguments in favour and against free trade.

23. Explain the methods of correcting disequilibrium in the balance of payment

24 .Critically examine the purchasing power parity theory.




B.Com . IV Semester Degree Examination, May/June-2017

ECONOMICS



Instructions:




SECTION – A


1. What is international trade?

2. Who has developed modern theory of international trade ?

3. What do you mean by opportunity cost theory of international trade?

4 .What are quotas ?

5. Give the meaning of free trade.

6. Give the meaning of Dumping.


8. What are the terms of trade ?

9 .Give the meaning of devaluation.

10. What to import substitution?

11. State the meaning of flexible exchange rate.



12. What is meant by exchange control ?.

SECTION-B

Answer any three of the following: (3×10=30)

13. Explain the gains from international trade.

14. Bring out the difference between internal and international trade.

15. Discuss the purchasing power parity theory.

16. Analyse the merits and demerits of free trade policy.

17. Explain the functions of Foreign Exchange Market.

SECTION - C


18. Critically examine the comparative cost theory of international trade.

19. Discuss The various methods of correcting disequilibrium in balance of payments

20. Explain the advantages and disadvantages of flexible exchange rate

21. Discuss the various Concepts of terms of trade.




B.Com . IV Semester Degree Examination, May-2018

ECONOMICS


Time: 3 Hours. Max. Marks:

80

Instructions:




SECTION – A


1. Give the meaning of internal trade.

2. Mention four dis-advantages of international trade.

3.State the meaning of opportunity cost.

4. Who has developed comparative cost theory of international trade ?

5. What are terms of trade?

6. What is protection policy ?

7. What do you mean by tariffs ?

8. Give the meaning of quotas.

9. What is meant by balanced balance of payment?

10. State the meaning of foreign exchange.



11. What do you mean by foreign exchange market ?

12. Give the meaning of fixed exchange rate.

SECTION-B


13. Explain the significance of international trade.

14. Describe the various concepts of terms of trade.

15. Bring out the causes of disequilibrium in balance of Payments

16. Discuss the advantage and disadvantages if fixed exchange rate.

17. Critically discuss the purchasing power parity theory of exchange rate.

SECTION-C


18.Critically examine the modern theory of international trade.

19. Explain the arguments in favour and against the protection policy.

20.Discuss the various methods of correcting disequilibrium in balance of payment.

21. What is exchange control ? Explain the various methods of exchange control




B.A V. Semester Degree Examination, October/November, 2019

ECONOMICS

Paper- 5.3 : International Economics


Instructions:




SECTION – A



2. What is meant by free trade policy?

3. Give the meaning of Quotas.

4. Mention any four types of Tariffs.

5. What is meant by Dumping?

6. Give the meaning of Hedging facilities.

7. Expand FERA..


9.State the meaning of Foreign exchange control.

10. What is meant by Balance of Payments?



11. Give the meaning of Opportunity Cost.

12. What is Fixed and Flexible Exchange Rate?

SECTION-B


13. Explain the difference between Internal and International Trade.

14. Describe the concept of Terms of trade.

15. What are the main objectives of Foreign Exchange Control?

16. Explain the effects of Quotas.

17. Discuss the Significance of International Trade.

SECTION-C


18. Discuss the Purchasing Power Parity theory.

19. What are the causes of Dis equilibrium in Balance of payments and Discuss the

methods of correcting Dis equilibrium in BOP.

20. Critically examine the modern theory of international trade.

21.Discuss the arguments for and against Protection trade policy.



The Most important Questions and Answers of Two Marks

1. What do you mean by Trade?

Trade refers to the exchange of goods and services at a certain

price at a given time. Thus, trade involves sale and purchase of

commodity or services.

2. What is internal Trade?

Internal trade refers to the exchange of goods and services

within a country between individuals or regions or localities. Internal

trade is also known as home trade or inter- regional trade or Domestic

trade.

3. What is external Trade (International Trade)?

External trade refers to the exchange of goods and services

between two or more nations. It is also known as international trade or

foreign trade.

4. Who has given the Comparative Cost theory of International

Trade?

David Ricardo has given the comparative cost theory of international trade

5. What is the Basis of Trade according to David Ricardo?

According to David Ricardo Comparative differences in costs is the basis of

international trade.

6. Give the meaning of Opportunity Cost.

The opportunity cost of any goods is the next best alternative goods that is

sacrificed. or The next best choice sacrificed in the production of a commodity.

7. Who has given the theory of Opportunity Cost?

G.Haberlerhas given the theory of opportunity cost.



8. What is an increasing Opportunity Cost?

If more quantities of Y is required to be given up in order to have an additional

quantity of X, the production possibility curve would be concave to the Origin and it

would indicate increasing opportunity costs.

9. What is decreasing Opportunity Cost?

If in order to get an additional quantity of X, less quantity if Y is required to be

given Up, the production possibility curve would be convex to the origin, and it would

indicate diminishing opportunity costs.

10. What is constant Opportunity Cost?

If the amount of Y required to be given up to get additional quantity of X remain

constant, the production possibility curve would be a straight line and it would indicate

constant opportunity costs.

11. Who has developed modern theory of international trade ?

B Ohlin has developed modern theory of international trade

12. Who has firstly formulated modern theory if international trade?

Swedish economist Eli Heckscher firstly formulated modern theory of international

trade

13. What is Leontief paradox?

American economist Dr. Wassily Leontief tested H-O theory under U.S.A

conditions. Prof.Leontief's empirical study of the Ohlin theorem , known as the

Leontief Paradox. He found out that U.S.A exports labour intensive goods and

imports capital intensive goods, even though it is a capital rich country. As being a

capital abundant country must export capital intensive goods and import labour

intensive goods than to produce them at home.

14. What is the main cause of international trade according to H.O.?

The main cause of trade between regions is the difference in prices of

commodities based on relative factor endowments and factor prices.



15. Give the meaning of Gains from Trade.

The gains from trade refer to a net benefits or increase in goods that a country

obtains by trading with other countries.

16. What are Terms of Trade?

The terms of trade refers to the rate at which the goods of one country

exchange for the goods of another country. It expressed as the relation between export

prices and import prices of its goods.

17. What is Net(Commodity) Barter Terms of Trade?

Net barter terms of trade is the ratio between the prices of a countries export

goods and import goods. Symbolically, it can be expressed as,

Tc=Px/Pm

18. What is Gross Barter Terms of Trade?

The gross barter terms of trade is the ratio between the quantities of a

countries imports and exports. Symbolically, it can be expressed as ,

Tg=Qm/Qx

19. Give the meaning of Income Terms of Trade?

The income terms of trade is the net barter terms of trade of a country

multiplied by its exports volume index. It can be expressed as

Ty = Tc.Qx = Px.Qx/Pm= Index of export prices×export quantity/Index of Import

Prices.

20. What is Trade Policy?

Trade policy refers to the regulations and agreements that control imports and

exports to foreign countries.

21. What is Free Trade?



Free trade is that policy of trade where there is complete freedom of

international trade without any restrictions on the movement of goods between

countries.

22. What is Protection?

The term protection refers to a policy where by domestic industries are to be

protected from foreign competition. The aim is to impose restrictions on the imports

of the low priced products in order to encourage domestic industries.

23. Mention any two devices (Methods)of Policy of Protection.

� Tariffs

� Quotas

24. What do you mean by Tariffs ?

Tariffs are the duties imposed on the goods coming into or going out of the

country. But as restrictive measure, import duties are more important than export

duties.

25. Give the meaning of Quotas.

Quotas are more popular and an old form of trade restriction . As. Protective

device, import quotas are more important. Import quotas refers to the fixed quantities

of goods , which is allowed to be imported into a country during a specified period.

26. What is Infant Industry Argument?

The infant industry argument, a classic theory in international trade, states

that new industries require protection from international competitors until they

become mature, stable, and are able to be competitive. The infant industry argument is

commonly used to justify domestic trade protectionism.

27. What is Dumping?

Dumping is an international price discrimination in which an exporter firm

sells a portion of its output in a foreign market at a very low price and the remaining

output at a high price in the home market



28. Define Foreign Exchange?

Foreign exchange is the system or process of converting one national currency

into another.


The foreign exchange market is the market in which different currencies are

bought and sold for one another. For example, dollars are traded for yens, yens for

pound, pound for rupees.

30. What do you mean by Foreign Exchange Rate?

The foreign exchange rate is the rate at which one currency is exchanged for

another currency. It is the price of the one currency in terms of another currency. The

exchange rate between the dollar and the pound refers to the number of dollars

required to purchase a pound

31. Give the meaning of Fixed Exchange Rate.

Fixed exchange rate is the rate at which is officially fixed by the government,

monetary authority and not determined by market forces.

32. Give the meaning of Flexible Exchange Rate.

Flexible Exchange rate is the rate which is determined by forces of supply and

demand in the foreign exchange market.

33. What do you mean by Dual Exchange Rate ?

In this type of system, the currency rate is maintained separately by two

values-one rates applicable for the foreign transactions and another for the domestic

transactions. Such systems are normally adopted by countries who are transitioning

from one system to another. This ensures a smooth changeover without causing much

disruption to the economy.

34. What is Exchange Control?

Exchange control means that all foreign receipts and payments in the form of

foreign currencies are controlled by the government.



35. Give the meaning of Pegging?

When domestic currency is tied to the value of foreign currency, it is known as

pegging

36. What do you mean by Pegging Operation?

To maintain stability in fixed exchange rate system, government buy foreign

currency when exchange rate appreciates and sell foreign currency when exchange

rate depreciate. This process is called pegging operation. (All efforts made by the

central bank to keep the rate of Exchange stable)

37. What is Devaluation of Currency?

Devaluation refers to decrease in the value of domestic currency in terms of

foreign currency by the government. It is a part of Fixed Exchange rate.

38. What is Revaluation of Currency?

Revaluation refers to increase in the value of domestic currency by the

government. It is a part of Fixed exchange rate.

39. Give the meaning of Parity Value.

In the context of exchange rate in foreign exchange market, parity value refers

to the value of one currency in terms of the other for a given basket of goods and

services. If a U.S. dollar buys 50 times the goods and services in India, compared to a

rupee, the parity value of a US dollar should be 50:1. Accordingly, the exchange rate

between rupee and a US dollar ought to be Rs. 50: 1$. Any change in the parity value

would imply a Corresponding change in exchange rate.

40. Give the meaning of Balance of Payments.

The balance of payments of a country is a systematic record of all its

economic transactions with the outside world in a given year.

41. What is Balance of Trade?

The difference between export and import of goods, i.e. only the visible items

of economic transactions is termed as Balance of Trade. Balance of Trade = Export of

Goods - Import of Goods. Balance of Trade does not include the export and import of

invisible items (services) or capital transfers.



42. Give the meaning of Disequilibrium in Balance of Payments.

BOP is said to be in state of Disequilibrium when there is either surplus or deficit

in BOP.

43. Give the meaning of Equilibrium in Balance of Payments.

When B = Rf - Pf = 0 the balance of payments is in equilibrium. Where, B

represents balance of payments. Rf Receipts from foreigners.Pf payments made to

foreigners.

44. What is Surplus in BOP?

If autonomous credit receipts exceed autonomous debit payments, there is a

surplus in the BOP and the disequilibrium is said to be favourable.

45. What is Deficit in BOP?

If autonomous debit payments exceed autonomous credit receipts, there is a

deficit in the BOP and the disequilibrium is said to be unfourable or adverse.

46. What is Devaluation?

Devaluation refers to a reduction in the external value of a currency in terms

of other currencies.

47. What is Import Substitution ?

Import substitution is an economic and trade policy which advocates replacing

foreign goods with domestic goods.

48. Give the meaning of Export Promotion.

Export promotion means total activities of the government and state

institutions, which have a positive impact on the export performance of the economy.

49. What does Deficit in Balance of Trade indicate ?

A deficit in Balance of Trade indicates that the value of exports of goods are

less than the imports of goods for a country.

50. Name two invisible items of the Balance of Payments.

� Banking Services � Insurance Services



51. What do you mean by Hedging function?

Hedging function pertains to protecting against foreign exchange risks, where

hedging is an activity which is designed to minimize the risk of loss.

52. Expand FERA.

FERA : Foreign Exchange Regulation Act.

53. What is the full form of FEMA?

FEMA : Foreign Exchange Management Act.

54. Mention any four types of Tariffs.

Following are the important types of Tariffs.

a) Revenue Tariff

b) Protective Tariff

c) Specific Tariff

d) And Valorem Tariff



The Most Important Questions of Ten or Fifteen Marks

1. Bring out the difference between internal and international trade.

2. Explain the advantages of International Trade

3. Discuss the significance or importance of international trade.

4. Critically examine the comparative cost theory of international trade.

5. Discuss the theory of opportunity cost.

6. Explain the Heckscher-Ohilin’s theory of International Trade.

7. Discuss the various concepts of terms of trade.

8. Explain the various factors which determines (Effects) terms of trade.

9. Discuss the reasons for unfavourable terms of trade for developing countries.

10. Discuss the arguments in favour and against free trade. (Advantages and Dis

Advantages free trade policy)

11. Discuss the arguments in favour and against policy of protection. (Advantages &

Disadvantages of policy of protection).

12. Explain the role of protection in developing countries?

13. Discuss the methods of protection trade policy.

14. What is tariff ? Analyse the effect of tariff

15. Explain the effects of Quotas.

16. Explain the functions of Foreign Exchange Market.

17. Discuss the advantage and disadvantages of fixed exchange rate.

18. Explain the advantages and disadvantages of flexible exchange rate.

19. Critically discuss the purchasing power parity theory.



20. Write a note on Exchange control.

21. What is exchange control ? Explain the various methods of exchange control.

22. Bring out the causes of disequilibrium in balance of Payments.

23. .Discuss the various methods of correcting disequilibrium in balance of payment

24. Discuss the various components of balance of payments (Structure of Balance of

Payments Account).

25. Write a note on Devaluation.



References

1. Jingan, M.L., International Economics,Vrinda Publications, New Delhi , 2012.

2. Krishnamurthy, H.R, Basic Economic Theory, Sapna book House (P) Ltd, Bangalore,

2009.

3. kalyan-city.blogspot.in.

4. wikipedia.org

5. www.preserve article.

6. www.shareyouressays.com.

7. www.yourarticlelibrary.com.

8. www.microeconomicsnotes.com.

9. Pratiyogita Darpan, Indian Economy (General Studies) Extra Issue , 2019.

International Economics Corrected...INTERNATIONAL ECONOMICS iii Ideal International E- Publication...

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