Trade Restrictions: 1. Tariffs 2. Non-tariff

1. Tariffs:- Tax or duty on import or export- Ad valorem tariff is expressed as a % of the value of the traded commodity- Specific tariff is a fixed sum per unit- Compound tariff is a combination of ad valorem and specific tariff

- Due to tariff, domestic price of imported commodity rises by the full amount of the tariff, domestic consumption decreases, domestic production increases, import declines and government revenue increases.

- income redistributed from domestic consumers (who pay higher price for the commodity) to domestic producers (who receive a higher price).

Px ($) Sx

4E

3

2 J H SF + T T

1 SF Dx

10 20 50 70

- With free trade, Px = $1, Nation 2 consume 70X of which 10X is produced domestically and 60X imported.

- With 100% tax, Px is now $2, so Nation 2 consumes 50X, of which 20X produced domestically and 30X imported.

1

Px ($)

4

3

2 H SF + T REDUCTION IN CONS SURPLUS

1 SF Dx

x 50 70

- Reduction in CS = $60

Px ($) Sx

Increase in 4 Producer Surplus

3

2 J SF + T T

1 SF

X10 20

- Increase in PS is $15

2

Trade protection via Import Tax leads to inefficiency:

Px ($) Sx

4E DWL = $5

3 DWL = $10

2 J H SF + T Tax Revenue T

1 SF Dx

10 20 50 70

- Reduction in CS = $60, increase in PS = $15 - Increase in Government Rev = $30- So the Deadweight loss = $60 – $15 – $30 = $15- But why it is imposed? To protect domestic producers…

Measuring the Degree of protection:- Nation normally imposes lower (or zero) tariff on the importation of inputs

than on the importation of final products produced with the imported inputs in order to encourage domestic production and employment.

- Example: Import Duty on car components < import duty on (fully assembled) cars

- The rate of Effective Protection :

g = t – ai ti 1 – ai

where g = the rate of effective protection to producers of final commodityt = the nominal tariff rate on consumers of the final commodityai = the ratio of the cost of the imported input to the price of the final commodity in the absence of tariff.ti = the nominal tariff rate on the imported input

Example: - In the production of suit, the domestic factory uses $80 of imported wool.

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- The free trade price of the suit is $100, but the nation imposes 10% tariff on imported suit, thus the domestic price is $110.

- So of the total $110, $80 represents imported wool, $20 is domestic value added and $10 is the tariff.

- The $10 tax represents a 10% nominal tariff because nominal tariff is calculated on the price of the final commodity ($10/$100).

- But the same $10 actually represents 50 % effective tariff rate because the effective tariff rate is calculated based on the domestic value added (for producing suit) i.e. $10/$20 = 50 %

- Based on this example, t = 10% or 0.1, ai = $80/$100 = 0.8, and ti = 0So g = 0.1 – (0.8)(0) = 0.1 – 0 = 0.5 = 50%

1 – 0.8 0.2

- If 5% nominal tariff is imposed on the imported input (ti = 0.05), then g = 0.1-(0.8)(0.05) = 0.1 – 0.04 = 0.06 = 0.3 = 30%

1- 0.8 0.2 0.2

Note :Effective Rate of protection - Note: `The two rates are equal (g = t) when there is no imported inputs (ai = 0

or 100% domestic value added). In other words, Effective tariff is equal to nominal tariff if production is based totally on domestic resources because the tariff on intermediate goods is nonexistent or irrelevant.

- For given value of ai and ti , g is larger the greater the value of t (meaning: higher nominal tariff on final products implies higher protection for domestic producers)

- For given value of t and ti g is larger the greater is the value of ai (meaning: the larger the portion of imported inputs, the more benefit of protection the domestic producer can feel or enjoy.

- When aiti is larger than t, the rate of Effective protection is negative (meaning: very high import tax on imported inputs or very low nominal tax on imported final products is very disastrous to the local producers)

- g is normally higher than t in the industrial nations.

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Non-tariff Barriers

1) Import quota- most important nontariff trade barrier- It is a direct quantitative restriction on the amount of a commodity allowed to

be imported or exported.- Of two types: - 1) absolute quota - specified within a period and based on first come first

served, and normally it's set world wide. Example: USA restrict imports of sugar, textile product.

- 2) tariff rates quota - Allowing import of goods at a specified quantity at a reduced tariff rates during a specified quota period; Example: tuna, olives import to USA.

- Exporting Nations need to apply the quota prior to export.- The impact on consumption and production is quite similar to the import tariff

Comparison of Import Quota and Tariff- with import quota, increase in demand will result in a higher domestic price

and greater domestic production as compared to an equivalent import tariff.- With a given import tariff, increase in demand will leave the domestic price

and domestic production unchanged, but result in a higher consumption and imports than with an equivalent import quota.

PxSx

3 E2.5 J’ H’2 J H K1 C M N B

Dx D’x

X20 50 55

- With free trade, Px = $1, an import quota of 30X (JH), results Px = $2, cons of 50X of which 20X is produced domestically.

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- If import license is auctioned to the highest bidder, then revenue effect would be $30 (JHNM), same as 100% import tariff.

- With increase in demand from Dx to D’x, cons rises from 50X to 55X, of which 25X is domestically produced.

Other non-tariff trade Barriers

2) Voluntary Export Restraint- The importing nation induces or persuades the exporting nations to curb its

exports of a commodity voluntarily- Practised by USA, EU to reduce imports of textiles, steel, electronic products

etc from Japan since 1950- In May 1981, Japanese agreed to reduce export of car to USA, max of 1.85

millions, 1.85 mill in 1984 and 2.3 mill 1985.- VER caused prices of Japanese and domestic cars increased in USA

3) Technical, administrative and other Regulations:- Used to hamper exporters- Includes environmental issues (banning of tropical forest logging to protect

non-tropical timber price), safety, health, packaging, labuyng and so many other regulations

The case of Gasoline import regulation by EPA:- In Dec. 1993, EPA instituted import standards for both reformulated and

conventional gasoline in order to control emissions. - This EPA regulation is effectively less favorable to foreign refiners as

compared to domestic refiners- In March, 1995, Venezuela filed complained to WTO against EPA regulation

and WTO ruled in favor of VenezuelaUSA Meat import regulations:- To be eligible to export meat to USA, a country must have had no outbreaks

of any animal diseases such as cattle mouth and foot diseases and must have outlawed the vaccination for such diseases for one year.

- Exporters must certification from veterinary unit followed by US food safety Inspection services with the cost borne by the exporting company

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4) International Cartel- Suppliers from different countries get together to restrict volume of output and

export- Example OPEC, caused to petroleum price to increase sharply (quadruple)

1973-74.- Can fail if members cheat on prices and quantity set, i.e. members export

larger volume that the specified ones and or sell at a lower price - Domestic cartel is illegal in USA and Europe, but international cartel is hard

to control.

5) Dumping- Export of a commodity at below cost or selling at a lower price abroad than

locally).a) Persistent dumping - international price discrimination to max profits- firms with market power use price discrimination between markets to increase

their total profits. - A firm will maximize profits by charging a lower price to foreign buyers if it

has greater monopoly power ( less competition) in its home market than abroad and if buyers in the home country cannot avoid the high home prices by buying the good abroad and importing it cheaply.

b) Predatory dumping - temporary sale at the lower price abroad in order to drive foreign producers

out of business. - The price set due to predatory dumping was so low that domestic competitors

could not cover variable costs at any level of production and would choose to leave market.

- Once the rivals are gone, the firm will use its monopoly power to raise prices and earn high profits.

c) Sporadic dumping or Cyclical dumping - occasional sale at below cost or lower price abroad to reduce domestic

surplus. - It is related to fluctuations in economic activities, whereby it occurs during

periods of recession. - During the part of the business cycle when demand is low, a firm makes

export sales that are lower than its average costs. If these low prices gain

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export sales, then the firm can use more of its production capacity and provide work for its labor.

d) “Seasonal dumping” - is intended to sell off excess inventories of a product, often without lowering

the price in the main market. - For instance, toward the end of a fashion season, US clothing companies may

decide to sell off remaining stock of swimsuits at very low prices in Canada- Prices in the major US market are kept more stable, with the Canadian market

absorbing the extra supply.

Trigger price mechanismNations impose high import duty on dumped commodity to increase the price.

Examples of Dumping cases: 1) Sony - the US government charged SONY of Japan for dumping their product in the

US market in 1970- Investigation showed that SONY was selling TV sets made in Japan for $180

while charging Japanese consumers $333 for the same model.

2) Cement- In August 1990, the US Department of Commerce ruled that cement suppliers

in Mexico were dumping their product in the US market. - Antidumping duties were then imposed to the suppliers from Mexico. The

duties were 57.96 per cent on products of Cemex S.A. Mexico’s largest cement producer, 53.26 per cent for Apasco S.A.de C. V.; and 57.65 per cent for all other Mexican suppliers.

3) DRAM - In June, 1999, The U.S. Commerce Department planned to impose a 13.11% DRAM tariff against Hyundai Electronics Industries Co. and a 10.67% penalty against LG Semicon Co. for dumping during the 12 months ended April 30, 1998.

6) Export subsidies- direct payments or tax relief or subsidized loans to the nations’ exporters and

low-interest loans to foreign buyers to stimulate nations exports.

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- Example: Under the 1985 Agricultural Export enhancing program (EEP), US exporters are paid subsidies when can export to certain countries where US sales has been nonexistent, displaced, reduced or threatened

- Budget for EEP was US$350 mill in 1996, US$500 mill in 1998, US$550 mill in 1999.

- Products included under EEP: Wheat, semolina, barley, vegetable oil, etc.

Example of Export subsidy (PALM OIL):20th March 2001

- Malaysia extend 10 million dollars in credit to Cuba to purchase its palmoil - provide the credit facility to a Cuban company, Empresa Cubana Importadora

de Alimentos,- This is under the palm oil credit payment arrangement (POCPA) arrangement,

whereby the Cuban firm will provide products to selected Malaysian companies to be sold in Malaysia or other countries in order to offset the credit.

- nine countries -- Pakistan, Algeria, Iran, Iraq, Myanmar, Bosnia-Herzegovina, Cuba, Sudan and Korea -- had signed POCPA agreements with Malaysia so far.

- government's total allocation is 500 million dollars, and only 227.4 million dollars have been used

- the scheme had proven effective in penetrating new and difficult markets. - PO price plunged from a high of 2,377 ringgit (626 dollars) a tonne in 1998 to

around 800 ringgit.

Political economy of protectionism- Fallacious Arguments:

1) to protect domestic labor against cheap foreign labor (fallacious because nation can lower domestic labor cost by increasing productivity or specialize in nonlabor intensive commodity and do the trade). 2) “scientific tariff” to mato the price of imported commodity equal to domestic price (fallacious because it will finally eliminate international price difference and eliminate trade altogether.

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- Questionable Arguments:1) To reduce domestic unemployment2) To cure trade deficit

Because these two measure can only be achieved at the cost of the neighbors.

- Qualified arguments: 1) Infant industry arguments, temporary protection to establish and protect domestic industry during its infancy until it can compete with foreign producers.

Most favoured nation principle: - Any tariff reduction agreement signed with a (favorite) nation is extended to all trade Partners- Disadvantage: freeloader nation (not directly involved in negotiations and not making any tariff concession of their own) also benefit.-Example: If Msia cut down its import tax on product X (imported from its favorite trade partner, Japan) from 50% to 25%, then any X imported from any other country would also deserve that rate of tariff)

The General Agreement on Tariff and Trade or GATT (1947 in Geneva, Switzerland)- To promote trade through multilateral trade negotiations- Based on 3 principles:

1) Nondiscrimination, based on most favored nation principle except for the cases of economic integrations such as European Union (meaning European member countries may reduce or eliminate tariff among them without having to reduce or eliminate tariff for the same goods imported from non-EU members.

2) Eliminations of nontariff trade barriers like quota except for agric products and nations in BoP difficulties

3) Consultation among nations in solving trade disputes within GATT framework.

- 124 nations were signatories during Uruguay Round 1993, excluding USSR and China.

- Through GATT, 35% world tariff were reduced during 1947-1962 after 5 trade negotiations.

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Major provisions fo the Uruguay Round (took effect July 1, 1995)- Tariff on industrial products be reduced from average of 4.7% to 3%, the

share of goods with zero tariff should be increase from 20-22% to 40-45%. Removing tariff on pharmaceutical, construction equipment, medical equipment, paper products and steel.

- Should replace quotas on agric and textile imports with less restrictive tariff over 10 year period.

- Tougher antidumping measures- Replacement of GATT secretariat with World Trade Organization (WTO).

Trade dispute can be settled by 2/3 or ¾ of the nation’s majority.

WTO

- The World Trade Organization was established in January, 1995 following the Uruguay Round of General Agreement on Tariffs and Trade (GATT) negotiations.

- By February 2002, it has 144 member states, (Moldova being the latest member) accounting for over 90% of world trade.

- The WTO’s overriding objective is to help trade flow smoothly, freely, fairly and predictably. The goal is to improve the welfare of the peoples of the member.

- The WTO transformed the GATT (which focused primarily on tariff and quota cuts), into a new global commerce agency with the same legal status as the United Nations.

- Unlike GATT, WTO is empowered to enforce global commerce rules with the imposition of economic sanction.

- The WTO's rules are also much broader, covering food and environmental standards, regulation of services such as insurance and transport, how the government can use tax dollars, copyright and patent law, farm policy, and more.

- The WTO expanded key aspects of the North American Free Trade Agreement (NAFTA), which had been signed the year before, to the entire world.

- WTO rules subject a broad array of non-trade-related local and national laws, regulatory structures, and policy approaches to challenge if they are claimed to pose barriers to trade and investment.

- Within 4 years, there have been 117 cases in which a country has challenged a law or practice of another country. Eighteen cases have led to binding WTO rulings, and another 18 are currently being considered at the WTO tribunals.

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- The WTO's tribunals conduct WTO challenge cases in secret. Even briefs from the public are only accepted by WTO panels if endorsed by a government. (NGOs cannot file briefs with the WTO unless a government is willing to submit the briefs.)

- Only national governments are allowed to participate, so a state attorney general could only assist with defense of a challenge against a state law if invited by the current administration.

- A government that has lost a WTO case has no recourse to appeal outside of the WTO's limited appellate process.

- Once a final WTO ruling is issued, losing countries have only three choices: 1) change their law to conform to the WTO requirements, 2) pay permanent compensation to the winning country, or 3) face trade sanctions.

Example of WTO rulings:- Related to import quota of sugar imposed by the USA, Under WTO rules, USA

must allow minimum of 1.256 million (Short Tones) of sugar annually- Related to Venezuela complaints on EPA regulation on import of gasoline, in

January, 1996, WTO ruled that USA was in violation of article III, of GATT, known as national treatment principle which requires equal treatment for imports and domestic products.

Economic Integration: Custom Unions and Free Trade AreasStages of economic Integration:1) Preferential trade arrangement 2) Free trade areas 3) Custom union 4) common markets 5) economic union

1) Preferential trade arrangement- Provide lower trade barriers among members as compared to nonmembers- Example: British Commonwealth Preference Scheme (1932), British and ex-

colonies

2) Free trade area- all trade barriers are removed among members and each members retains its

own barriers to trade with nonmembers- Example: 1) North American Free Trade Arrangement (NAFTA), formed by

USA, Canada and Mexico in 1993. 2) EFTA (UK, Austria, Denmark, Norway, Portugal, Sweden, Switzerland, 1961) 3) AFTA

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3) Custom Union- No trade barriers among members and setting common tariff rates towards the

rest of the world- Example: 1) European Union or European Common Market: West Germany,

France, Italy, Belgium, the Netherlands, and Luxembourg, 1957.

4) Common market - Similar to custom union but in addition allowing movement of labor and

capital among member nations.- Example: EU (achieved this status in 1993)

5) Economic Union- like custom union but in addition the monetary and fiscal policies of member

states are harmonized. Having the same currency.- Example: 1) USA 2) Benelux (Belgium, the Netherlands, Luxembourg)

3) European Union

Effects of forming custom unions:

Trade Creation- Occurs when volume of trading increase as domestic production in a union

member is replaced by lower-cost imports from another member nation. Specialization, overall production and welfare increase.

- It also increases the welfare of nonmembers as the increase in real income spills over into increased imports from the rest of the world.

Px ($) Nation 2Sx

3 E

2 J H S1 +T

1 C M N B S1

0 X 10 20 50 70

13

- Before trade union, Px = $2, Nation 2 consumes 50X (30X imported from nation 1). Nation 2 collect revenue of $30.

- As nation 2 and 1 form a custom union, nation 2 consumes 70X, (60X imported from nation 1). Nation 2 does not import from nation 3 because in nation 3 Px >$2.

- Nation 2 gains net $15 (JCM + HNB)

Trade Diversion- Occurs when lower-cost imports from outside the custom union are replaced

by higher cost imports from a union member- The preferential trade treatment has made importing from member country

cheaper- It reduces welfare because it shifts production from more efficient (outside

union) to less efficient producers (within union)- It worsen international allocation of resources and shifts production away

from comparative advantage.

Px ($) Sx

Nation 2 E S3 + T

2 J H S1 + T 1.5 C’ J’ H’ B’ S3

1 M N S1Dx

0 10 15 20 50 60 70

- S1 and S3 are the perfectly elastic supply curve of X for nation 1 and nation 3- Without union (whereby there is 100% nondiscriminatory tariff), Nation 2

imports 30X (JH) from nation 1 at Px = $2. Note: Without union price of X from nation 3 is $3.

- As nation 2 and 3 form a union, importing X from nation 3 would be cheaper (Px = $1.5)

- The welfare gain in nation 2 due to trade creation is $3.75 (JC’J’ + HH’B’).- The welfare loss due to trade diversion is $15 (J’MNH’)- So the net effect of this trade-diverting custom union is net welfare loss of

$11.25 for nation 2.

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Trade Deflection (Effects of forming Free trade block)- Trade deflection will occur if imports enter the FTA through the participating

country, which has the lowest tariff. - assuming that transportation costs and other costs related to imports do not

outweigh the difference in tariff rates. - the trade deflection effect will therefore limit the extent of trade diversion and

will have welfare-increasing effects in member countries. - Trade deflection will reduce both the terms of trade gain for member countries

and the terms of trade loss for the outside world, ceteris paribus.

AFTA

- The ASEAN Free Trade Area (AFTA) was initiated in 1993. - Reduce import tariffs on most products to 0-5 per cent by 2002 - later implementation dates for Cambodia, Vietnam, Burma and Laos- AFTA covers various manufactured and agricultural products and considering

the constraint of each member, some flexibility is allowed in terms of timetables for reducing tariffs and removing quantitative restrictions and other non-tariff barriers.

- Four types of lists i.e. fast-track tariff cuts, temporary, sensitive and permanent exclusions.

Prospects for the emerging industries

i) Trade Creation: The formation of AFTA is expected to further boost intra-ASEAN. In a way AFTA provide opportunities for the ASEAN companies to enjoy a bigger market of 510 million population and with the GNP capacity of US$820 billion.

ii) Specialization: On the production side, AFTA creates a larger ASEAN's internal market, which can deliver lower prices, attract investment and allow for specialisation of production and economies of scale. More importantly, the reduction of high tariffs can promote trade in intermediate products and encourage an international division of labour in industrial production within ASEAN.

iii) A more attractive place for FDI: Through AFTA, ASEAN can become more attractive to MNCs. Indeed, FDI should remain an important backbone for a more competitive and leading manufacturing activities and at the same time acting as a stimulant for the local emerging industries.

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Challenges of AFTA on the emerging industries

i) Not ready to compete: - There is sentiment of fear and worry that AFTA might cause distress to some

local industries. For example, Malaysia has asked for the postponement of automobile industry into the inclusion list in order to protect her national carmaker PROTON against competition from its own neighbor which has become a regional arm for world leader of auto industry from Japan, Europe and the USA.

ii) Individual versus Collective Regional gain: - Even within the current framework of AFTA, each nation seems to be taking

steps and measures that are more "individualistic" rather than "collaborative" or "complementary" types of moves.

iii) Trade Deflection:- non-collective planning and strategies among ASEAN members allows trade

deflection to take place- For example, Thailand has been busy with Japan, Europe and the USA for

collaboration in automobile industries - Singapore with Japan and New Zealand for various goods to be marketed in

the region approaching AFTA dateline.

How to Make AFTA successful and Beneficial to local ASEAN industries?

Identify Every Nation's Strength and Advantages: assigning the right duty based on each member's strength and weaknesses, and understanding the spirit of common gain and not individual gain

- Nations endowed with more labor, land and raw resources like Indonesia should concentrate on industries which are more labor intensive, resource based, upstream and low skilled industries.

- On the other hand, Singapore which is relatively capital abundant as compared to other ASEAN countries should engaged in industries which are capital and technology intensive, high skilled and downstream production activities.

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Formal Analysis:AFTA, Trade Deflection, gates of entrance and Custom Union

- The good and bad of AFTA for the local emerging industries may be analyzed using the following Figures (1, 2, and 3).

- Figure 1 shows a situation of pre-AFTA where each member imposes similar barriers to ASEAN and Non-ASEAN countries.

- For simplicity, we only assume six nations (N1, N2, N3, N4, N5 and N6) involved in the integration with their six new industries of specialization X1, X2, X3, X4, X5 and X6 respectively.

- Before free trade area (FTA) is formed, each nation imposes relatively higher barrier for products of their specialization, i.e. N1 imposes high tax barrier on X1, N2 on X2 and so forth in order to protect their relatively infant and emerging industries.

- When FTA is formed, as shown in Figure 2, trade barriers among members are lifted (as indicated by the disappearance of bolded lines between member countries) while barriers towards nonmembers are left NON-STANDARD (up to each individual member to decide).

- Thus, each member will set barriers towards non-members such that their welfare and benefits will be maximized.

- Unfortunately in doing so, they might or might not realize that members' welfare would be affected by some of their trade policies towards the non-members.

- Specifically, they might totally remove tariff on products that are of the specialization of the other member countries in the FTA.

- To the worse extent, a member might allow their countries to become a "gate of entrance" for the products (that will put pressure on local products) from a more advanced and established producers from outside the FTA.

- As shown in Figure 2, N1 produces X1 and at the same time welcomes industry X2 from a more established world producer to operates in her country.

- This will negatively affect the new and emerging industry X2 in nation N2. - To complete the story, N2 which produces X2 also welcomes industry X3

from a more established world producer to operate in her land targeting for the neighboring FTA markets and N2 action will negatively affect locally new industry in N3.

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- N3, N4, N5 and N6 are also involved in this unwise and non-strategic business collaborations with the rest of the world as shown in Figure 2 and all of them would as a matter of fact loose simultaneously.

- Most of the locally new or emerging industries would most likely be driven out of the industries as they are not able to compete with the world established and prominent producers.

- How to solve this problem? - They must have a common policies towards the non-members. - This can be achieved if they can transform AFTA into a more solid economic

integration i.e. a custom union which technically similar to free trade area but on top of that set common policies and barriers towards the rest of the world as illustrated in Figure 3.

- Members can collectively decide which industries or products should be imported and restrict the entry of industries or products that can weaken the local industries.

- It should be stressed that we are not promoting for permanent protection for the emerging industries.

- The main purpose is to temporarily protect and strengthen the new industries in the region and to come up with a more solid and strategic process of economic integration.

- ASEAN economic integration through AFTA is quite unique because most of the nations are still developing and new in various manufacturing industries.

- Without proper planning, they would not really benefit from the free trade arrangement. When some of the members are positioning themselves as "gates of entrance", bringing in products from other nonmember nations and market them to their neighbors at merely zero tax barrier, then, on paper it seems that intra-industry trade would increase but effectively more trade actually takes place between ASEAN and NON-ASEAN countries, and more dangerously, the local new and growing industries are being driven out"

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FIGURE 1: PRE-AFTA19

N1

X1 N6 N2

X6 X2

X5 X3

N5 N3X4

N4

FIGURE 2: AFTA WITHOUT CUSTOM UNION

X2

20

X1

X3X1

X6 N1 X2

N6 N2

N5 N3

X5 N4 X3

X4X4

X6 X5

FIGURE 3: AFTA WITH CUSTOM UNION21

Members can collectively decide which industries or products should be imported and restrict the entry of industries or products that will threaten the local industries.

Resource movement and Multinational corporations

(Non-direct Investment/Portfolio investment)- involving normally financial assets such as purchase of stocks and bonds

denominated in national currency.

Bonds- Investor lends capital and gets fixed payouts or a return at regular intervals

and then receives the face value of the bond at a prespecified date.

Stock- Investors purchase equity or claim on the net worth of a firm.

Foreign Direct Investment or FDI- Real investment in factories, capital goods, land and inventories where both

capital and management are involved and the investor retains control over use of the invested capital.

- Foreign Direct investment or FDI are normally undertaken by multinational corporations (MNCs) .

- United States Department of Commerce - "FDI should include all foreign business organizations owning an interest of at least 10 percent in the host country"

- IMF defines FDI as “ an investment that made to acquire a lasting interest in an enterprise operating in an economy and have an effective voice in the management of the enterprise.”

- FDI is the major channel for international private capital flows

Motives for Portfolio Investment- Yield (profit) maximization - risk diversification (this explains why there is two way international flows)

Motives for FDI- To exploit or utilize (abroad) some unique production knowledge or

managerial skill (Horizontal integration) over which corporation wants to retain direct control.Example: IBM owns unique technology to produce computer, so to serve the foreign market better but at the same time does not want to release its secret technology and patent to foreign producers, IBM has to involve in FDI. Other example: Xerox, Toyota, Nissan, Mercedes, Matsushita, etc.

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- To gain control over foreign source of required raw materials or foreign marketing outlets (Vertical Integration). Example: USA companies own mines in Canada, Venezuela etc.

- To avoid import tariff and other trade restrictions or tato advantage of production subsidy.

- To enter foreign oligopolistic market to share big profits.- To acquire foreign firm to avoid future competition or avoid loss of export

market.

Importance of Foreign Direct Investment

1) Employment - FDI creates job opportunities2) FDI can improve the balance of payments account through promoting import-

substitution and export oriented industries. 3) Foreign investors bring with them additional capital can lead to a higher level of

investment. Foreign investors can develop and finance certain investment projects that the host country may not be able to undertake.

4) Furthermore, MNCs normally come along with scarce productive factors such as technological knowledge and business experiences that could contribute to economic development. MNCs can sometimes be considered as “ reservoirs of technology” which can provide many times larger allocations for research and development (R&D).

5) FDI help the development of local supporting industries (SMEs), thereby promoting forward and backward linkages, which are crucial to sustain our high rate of industrial growth.

Disadvantages of FDI

1. Problems Encountered By Local Investor- pressure of competition- Local investor might not be able to compete due to lack of capital, and

experience. - Skill development and experiences are very low among local investor

compare to foreign investor. - Foreign investor willing to pay higher wages to attract domestic resident to

work with them and causing local investor losing workers.

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2. Dependency Onto Foreign Capital- In case of foreign investor withdrawals, the country will suffer and economic

growth distrupted. 3. Repatriation of Profits and earnings

- main reason for service account deficit in Malaysia BoP - worth around RM20 billions annually

4. Unbalanced Foreign Direct Investment Into Sectors - mainly in mobile industries, assembly type, low value added and labor

intensive- less in technology and capital intensive industries

MNCs - multinational corporations- main vehicle for FDI (MNCs involved in FDI activities)- largest MNCs in the world:

MNCs Annual Sale % Foreign sale IndustryUS$ bill

- General Motor 178.2 28.6 auto- Ford 153.6 31.3 auto- Mitsui 132.6 39.4 div- Shell 128 53.9 pet- Mitsubishi 120.4 34.5 div- Exxon 120.3 87.1 pet- Gen Electric 90.8 27 elect- Toyota 88.5 56.9 auto- IBM 78.5 62.3 comp- BP 71.3 51.2 pet- Daimler-Benze 69 66.8 auto- Volk- Mobil- Siemen- Matsushita- Phillips Morris- AT &T- Sony 51.1 78.9 elect- Fiat 50.6 39.9 auto

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Capital Flows and External Financing: The Five Asian Countries* (in US$ billion)

1994 1995 1996 1997e 1998fCurrent account balance

-24.6 -41.3 -54.9 -26.0 17.6

External Financing (net)47.4 80.9 92.8 15.2 15.2

Private flows (net) Equity Investment Direct equity Portfolio equity Private creditors Commercial banks Non-bank private creditors

40.512.24.77.6

28.224.0

4.2

77.415.54.910.6

61.849.512.4

93.019.17.012.1

74.055.518.4

-12.1-4.57.2

-11.6

-7.6-21.313.7

-9.47.99.8-1.9

-17.3-14.1-3.2

Offcial flows (net)

7.0 3.6 -0.2 27.2 24.6

Resident lending/other (net)** -17.5 -25.9 -19.6 -11.9 -5.9

Reserves excluding gold (- = increase) -5.4 -13.7 -18.3 22.7 -27.1

Source: Institute of International Finance, Inc, “Capital Flows to Emerging market economy”, January 29, 1998.e = estimate, f = forcast*Indonesia, Malaysia, Philippines, Thailand and South Korea**Including resident net lending, monetary gold, and errors and omissions

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Output and Welfare Effects of International Capital Transfers

F Nation 1 Nation 2 J

VMPK nation2VMPKNation1

M H

N E R T

C G

VMPK2 VMPK1

O O’ B A

Total Capital Stocks of nations 1 and 2 combinedVMPK = Value of Marginal Product of Capital

- Total capital stock is OO’. Nation 1 owns OA and its output is OFGA while Nation 2 owns O’A and its output is O’JMA

- Transfer of capital as much as AB from nation 1 to nation 2 equalizes the return on capital in the two nations at BE.

- As a result, world output increases as much as EGM of which EGR accrues to Nation 1 and ERM to nation 2.

- increase in domestic product in Nation 2 ABEM, of which ABER goes to foreign investors, leaving ERM as the net gain in domestic income in nation 2.

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Balance of Payments- summary statement of all the transactions of the residents of a nation with the

rest of the world.

Credit- transaction that involves the receipt of payments from foreigners- example: exports of goods and services, unilateral transfers from foreigners,

capital inflows- entered with positive (+) sign

Debit- transaction that involves payments to foreigners- example: imports of goods and services, unilateral transfers to foreigners,

capital outflows- entered with negative (-) sign

B of Payment Account comprises of:- Current Account- Capital Account

Current Account- Merchandise trade balance (balance of payments)- All goods exports or imports like agricultural products, machinery, autos,

petroleum, electronics, textile, etc - services balance (imbangan perkhidmatan)- Insurance, transportation, investment income- Unilateral transfer balance (imbangan pindahan)- Private transfer payments or government transfer payments (bantuan

kewangan atau good an pindahan yang diterima atau dipay oleh kerajaan atau pihak swasta)

Capital Account- Changes in the nation’s assets abroad and foreign assets in the country- The nation’s assets include real estates, corporate stocks and bonds,

government securities, and ordinary commercial bank deposits.- They include both long term and short term private and official sector

transactions

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- Reserves is not included because its changes reflects government policy rather than market forces

Official reserve account- Includes convertible foreign currencies, such as US$, UK £, Singapore $ etc;

reserve position in the international monetary fund (IMF); stock of gold reserves held by bank negara; and special drawing rights.

Autonomous transactions- All transaction in the current and capital accounts (except the unilateral

transfers)- They tato place for business or profit motives and independently of B of P

considerations- Autonomous items are also called items above the line

Accommodating transaction- Transactions in the official reserve assets- Also called items below the line- They occur as a results of and for the purpose of balancing international

transactions

Statistical discrepancy- when statisticians sum credits and debits, many times the two total do not

match.- Since in principle total debits must equal total credits, statisticians insert

residual to mato them equal- This correcting entry is called statistical discrepancy or errors and omissions- It is treated as part of capital account because short term capital transactions

are generally the most frequent source of error.

How to obtain the overall balance of payments?- (1) Merchandise account balance (export minus import) plus (2) Service

account balance plus (3) net transfers plus (4) long term capital balance plus (5) net (short term) private capital plus (6) errors and omissions

note- (1) + (2) = Merchandise and service account balance = (A)- (A) + (3) = CA balance = (B)

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- (B) + (4) = basic balance = (C)- C + 5 + 6 = Overall BOP

Example: BoP in RM million

Item 1996 1997 1998

1. Current Account*Merchandise Balance ( Balance of payments) 10,088 10,273 69,008

-Exp 193,363 217,712 281,947-Imp 183,275 207,439 212,939

*Balance on Services -18,371 -22,748 -22,338 - (various sub-items)

Balance on Goods and services -8,283 12,475 46,670(Balance of payments & perkhidmatan)

*Transfers (pindahan) -2,943 -3,345 -9,876

Balance on current account -11,226 -15,820 36,794(Imbangan Akaun sgolda)

2. Capital Account*Official Long term capital 748 4,645 2,137 (Modal jangka panjang rasmi)

- (various sub-items)* Private Long term capital 12,777 14,450 8,490 Balance on long term capital 13,525 19,095 10,627

Basic Balance 2,299 3,275 47,421

*Private short term capital 10,317 -12,913 -20,633 *Errors and Omissions -6,371 -1,254 13,513

Overall balance 6,245 -10,892 40,301(Imbangan overall)

Net change in international reserves -6,245 10,892 -40,301(Perubahan bersih rizab antarabangsa)(-ve = increase, +ve = decrease)

Total reserves (held by BNM) 70,015 59,123 99,424

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Note: Why increase in reserves (-ve) while decrease in reserves (+ve)?

- 1) as BNM receive more reserve (foreign currencies), it has to pay or exchange with RM, thus BNM stock of RM declines, (thus -ve)

- 2) as people or public require more reserve (foreign currencies) from BNM, BNM has give up its stock of reserves and in exchange receive more RM from the public, thus BNM stock of RM increases, (thus +ve)

FOREIGN EXCHANGE MARKETS AND EXCHANGE RATEForeign exchange market

- market in which individuals, firms and banks buy and sell foreign currencies- Composed of several monetary centers like Zurich, Frankfurt, Singapore,

Hong Kong, Tokyo, New York, etc- Those centers are connected by telephone network and video screen.

3 Main Roles of FOREX market:- payment clearance- Credit facilities for export and import - Provide risk aversion facilities such as “hedging”

Why do we need foreign currencies?- To pay for import of good and services from other nations- To make investment abroad

Levels of transactors:- 1st level (at the bottom) such as tourists, importers, exporters, investors, etc.

They are the immediate users as well as suppliers of foreign currencies.- 2nd level such as commercial banks, acting as the clearing house between users

and earners of foreign exchange- 3rd level, foreign exchange brokers. The commercial banks even out their

foreign exchange inflows and outflows through the currency brokers.- 4th level, central bank, acting as the seller or buyer of the last resort when

nation’s total foreign exchange earnings and expenditures are not equal which ultimately will result in the increase or decrease of the level of the nation’s reserves.

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Central Bank

Brokers

Commercial Banks

Exporters, Importers, Tourists, Investors

Vehicle currency- When the currency is used for transaction without involving the nation of that

currency at all, for example when US$ is used by Brazilian importer to pay a Japanese exporter.

- US$ is currently the most dominant vehicle currency serving as a unit of account, medium of exchange, and store of value not only for domestic transaction but also for international private and official transactions.

- About 60 % of US$ is held abroad- In 1995, 41 % of total world foreign exchange trading was in US dollars (19

% in Deutsche mark, 12 % in Yen, 7 % in sterling)- The nation (of vehicle currency) benefit in terms of seignorage

Seignorage- Benefit accruing to a nation when its currency is used as an international

currency- For example, USA enjoys “interest-free” loan from foreigners on the amounts

of dollars held abroad.

Exchange Rate (US$ and UK£)- The number of dollars needed to purchase one pound or R = $/£. If R = 1.5, it

means $1.50 is required to purchase 1 pound

Exchange Rate Equilibrium- it is determined at the intersection of the nation’s aggregate demand and

supply curve for the foreign currency

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D£ D£’R=$/£ S£

2.0

1.5

40 Million £/day

- As the demand for pound increases the value of R increases- For example, when US import of goods from UK increases, the demand curve

for pound shifted upward, causing an increase in the R.Depreciation

- Increase in the domestic price of foreign currency- In the above example, the US$ depreciates since now it requires US$2 to buy

£1LECTURE 13

Appreciation- Decline in the domestic price of the foreign currency- In the above example, UK pound appreciates as now it requires 0.5 (1/2)

pound to buy US$ 1.00 (compared to 0.67 (1/1.5) before)

Arbitrage- Purchase of currency in the monetary center where it is cheaper and

immediately sell in the monetary center where it is more expensive in order to obtain profit.

- Due to arbitrage, any two currencies is kept the same in different monetary centers.

- For example (2 point arbitrage): dollar price of pounds were $1.99 in New York, $2.01 in London, an arbitrageur would purchase pounds at $1.99 in NY and sell them in London for $2.01.

- In triangular arbitrage: $1.96 = £1 in NY £0.2 = DM1 in London DM2.5 = $1 in Frankfurt

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- $1.96 = £1 in NY (Buy pound)

£0.2 = DM1 DM2.5 = $1 in London in Frankfurt(buy DM) (exchange the DM for $)

So the arbitrageur would buy pound at $1.96 in NY, use £1 to buy DM5 in London and exchange the DM5 for $2 in Frankfurt, thus realizing profit of $0.04 on each pound.

2 types of FOREX rates and transaction:

1) SPOT - based on spot rates- Delivery takes place immediately - Normally within 2 – 3 days

2) Forward- Delivery of the currency not immediately after purchase agreement- Rates of exchange is determined on the date of signing but delivery of the

currency is done later in the future (normally 1,3, atau 6 month)- The most common is 3 month - It can be used for risk protection against exchange rate uncertainties for

exporters or importers

(forward) premium- when forward rate is above the present spot rate, the foreign currency is said

to be at a forward premium- Example: SR: $2 = BP1, while the 3 month FR: $2.02 = BP1, the pound is

said to be at forward premium of 2 cents or 1 % for 3 month or 4 % per year.

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forward discount- when forward rate is below the present spot rate, the foreign currency is said

to be at a forward discountexample: Spot rate : $2 = BP1 and 3 month FR: $1.98 = BP1, the pound is at 3 month forward discount of 2 cents or 1 % or at 4 % Forward discount per year.

LECTURE 14

Calculating FD or FP

- Forward discount or forward premium are usually expressed as percentages per year from the corresponding spot rate and can be calculated as:

FD or FP = ((FR – SR)/SR ) x (12/M) x 100

FR = Forward rateSR = Spot rate (written usually as R)M = number of month for the forward rate (1, 3 or 6 month)

Example 1: Given the following information

SR: RM6.00 / BP1.00FR3month : RM6.30 / BP1.00

What is the annual (forward) premium for the BP ?FP = [(6.30 - 6.00) / 6.00 ] x 12/3 x 100% = 20 %

What is the (forward) premium for BP for 3 month period?= 20 % x 3/12 = 5%

What is the (forward) premium for BP for 9 month period?= 20 % x 9/12 = 15%

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Example 2: SR : Yen 250 / RM1.00FR(6 month) : Yen 240 / RM 1.00

What is the discount rate for RM for the period of 3 month?

(240 -250) / 250 x 12/6 x 100% x 3/12 = 2%

What determines Forward Rate?- Average Expectation (consensus forecast) of what will happen to the spot rate- Example: FR 1month ($1.56) < SR ($1.60) if the public expect that pound’s spot

rate will depreciate by 4 cents by next 1 month.- Or If the public expect pound to appreciate, then FR ($1.65) > SR ($1.60)

Hedging- Avoidance of foreign exchange risk (for future payment (import) or received

payment (export))- Any future payment in foreign currency needs to be hedged if there is

possibility that the future spot rate would be higher (domestic currency depreciates)

- Siam Cement’s profit during 1994-97 was wiped out by the loss in foreign exchange because the company had $4.2 billion foreign borrowing that was not hedged.

Example: SR: RM 5.80 / BP 1.00

Problem: malaysian importer needs to pay RM580,000 (BP 100,000) after 3 month.

There would be no problem if on the 90th day, spot exchange rate stays at SR: RM 5.80 / BP 1.00

But if after 3 month:

SR: RM 6.40 / BP 1.00

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This implies, additional of RM60,000 or (640,000 - 580,000) is needed to pay the import from UK after 3month . So to avoid that risk, Malaysian importer needs to do hedging:

Now, there are two ways to do:

1. Deposit BP 100,000 in bank and after 3 month, withdraw the money to pay

PROBLEM with this method: capital is stuck in the bank for 3 month and cannot be used for rolling.

What is the better way?

2) Buy BP in future market (3 month).

Sign agreement today, buy BP 100,000 but delivery is after 3 month.

If BP is at 3 month forward rates is at 4 % per annum premium, then Malaysian importer only need to pay an extra of?

Given 3 month forward premium for BP is 4% per annum , so the 3 month premium 3/12 x 4% = 1%

So the hedging cost is 1% x 580,000 = RM 5800

2) US Importer. Assume current spot rate is ($2.00/£1.00)

- US importer who needs to pay in BP after 3 month can buy £ in future market (3 month).

- Sign the purchase contract today, buy £100,000, but delivery is made after 3 month.

- If £ is at 3 month forward rates premium of 4% per annum, then US importer needs to pay extra of only $2000 to buy in 3 month £100,000.

- ($202,000 exchange with £100,000) that is ($2.02/£1.00)

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hedging cost is only $2000, that is 1% from 200,000 for 3 month.

3) US Exporter. Assume current spot rate is ($2.00/£1.00)

- US exporter who will receive £100,000 can do “hedging” if he is afraid that the value of (£) will decrease in 3 month time.

- He can sell £ in future market (3 month).

- If £ is at discount 4% per annum for the 3 month forward rate, then he will receive $198,000 ( “hedging” cost is = $2000). Rf(3B) ($1.98/£1.00).

Interest and exchange rate Arbitrage

Malaysia & U.K. RM vs £

Investment in Malaysia will obtaain a return of: (1 + rm)

Where rm = interest rate di Malaysia

If want to invest in U.K.

Return (U.K.) =

Where: S(RM/£) = Spot exchange rates RM for £.

F(RM/£) = Future rates RM for £.

RUK = annual interest rate in U.K.

1. If investor will borrow from UK and invest in

Malaysia.

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2. If investor will borrow from Malaysia and invest in

U.K.

3. If can invest any where.

Example:

If (RM/£) = S(RM/£)

Rm = 0.08, rUK = 0.06

Return in Malaysia = 1.08 > return in U.K. 1.06

Investor invest in Malaysia.

F = 6.15, S = 6.00

> 1.08 UK >

Speculation

Activities of buying currencies with the hope that the currencies value will increase or selling currencies with the hope that the value will fall

Example:

Rf (3B) $2.02/£1.00

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- If a speculator expect that Rs after 3 month is $1.98/£1.00)

- Today, He “sell” £ in future market (using 3 month F Rate i.e. $2.02/£1.00)

- On the 90th day, he will buy £ at the expected spot rate i.e. $1.98/£1.00 and on the same day sell or deliver the pound as agreed in the future market at the $2.02/£1.00 (profit of 4 cents per £).

- Note: Speculator in the above case gain because his expectation prediction for the spot rate on the 90th day was correct

- What will happen if the spot rate on the 90th day is $2.08/£1.00)? Then he would lose 5 cents per pound.

Should speculators be shot?- “Entire regions can be bankrupted by just a few speculators whose only

objective is to enrich themselves and their wealthy clients”. “Currency trading, beyond the level necessary to finance trade, is unnecessary, unproductive, and immoral, and that speculators should be shot!”

- Speculators blame the politicians for mismanaging the economy.

True fact:- 90 % of nowadays foreign exchange transaction is undertaken by foreign

currency traders and speculators- By 1995, currency trading was about 50 times the value of world trade,

implying that much currency trading occurs for the reasons other than to provide liquidity for world trade.

- Speculators are able to mobilize between US$600 billion to US$1 trillion to bet against currencies, for example selling a currency forward in the hope that they can buy it back later at a cheaper rate.

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US$Currency Trading volume 8,000

Foreign Exchange Trading 6,000

4,000

2,000 World Trade

73 83 85 89 92 95

Who is likely to be the victim of currency speculators?- Normally they attack currencies of the nations with economic imbalances that

offer them profitable opportunities.- Generally they would not attack currencies that are underlain by credible

economic policies- In the recent 1997 currency crisis event, speculators successfully attacked the

Thai, Indonesia, Malaysia, The Philippines and Korea currencies- Speculators were not very successful in trying to attack Hong Kong currency

as Hong Kong possesses very strong reserves.

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WORLD EXCHANGE RATE SYSTEM

1) Fixed (pegged)

ER fixed by government.

By selling and buying back mechanism influence S and D of curr in the FOREX market.

Weakness: expensive to “maintain”

Note: Currently Malaysia is practising currency peg system (to the US $). To ensure the success of the peg, Malaysia introduced "international demonetization of ringgit" since sept, 1998, which implies that selling and buying of RM can only be done and valid within Malaysian border. The demonetization policy has been quite successful in stabilizing the RM and without any substantial cost in terms of reserve. Prior to that, Malaysia practised managed floating system.

2) Adjustable pegged AP

It is like fixed system but not necessary can not be changed

Nation will change the ER especially when there is BOP disequilibrium.

It's changed to BOP , employment , growth , inflation.

Weakness: can lead to destabilizing speculation.

Crawling Peg system is meant to overcome weaknesses in AP. It is like AP but par values are changed by small amounts at frequent specified intervals

3) Managed Floating

There is no routine intervention by the government except the rate becomes very high or very low.

The system might require a large amount of reserves.

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4) Independent Floating

Free of government intervention.

Rates are determined merely by the market supply and demand of the currencies.

2 benefits:

Can solve the problems of currency overvalue or undervalue automatically through S and D of the currency

Can solve the BOP problem automatically because it can increase or decrease the export and import prices of the commodities and services. When deficit occurs, currency drops, import more expensive, export price cheaper, thus less import and more export, so BOP improves

3 weaknesses:

Exchange rate risks for Exporter or importer.

Can worsen nation's terms of trade (it will fall when Ex. Rate falls).

Can weaken the economy especially when Ex Rate , leads to difficulty to export, factories might close down, and in unemployment.

5) Gold Standard

exchange gold with money at the predetermined rate.

Example: 1 oz gold = A$20.00

1 oz gold = £4.00

So ¼ oz gold = £1 : A$5.00

Gold bought and sold to the public

Advantage : Exchange rate is stable.

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Dolar point of export for gold

Per pound Dt USA St

$5.02

$5.00

$4.98 point of import for gold

0 quantity (Pound)System of Gold Standard

1 oz = $20.00 US

= £4

Assume : £1 = AS$5.00

export cost for gold = 0.02 for ¼ oz.

If ER is US$5.03 : 1 £, then US importers will pay import with gold. Say cost of good = $5.00 US. Send gold to England with the cost of $0.02 US. Can save $0.01 US.

(5.03) – (5.00 + 0.02)

If ER is US$4.97 = 1 £, then importer from England will pay import with gold.

Say cost for the good is $5.00 US; so, buy gold = 1 £ ($4.97 US$). Send gold to US

with cost $0.02 US. So, total cost = $4.97 + 0.02 (thus, pay only $4.99 US).

Note:

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The auto adjustment mechanism under gold standard is called "price-specie-flow mechanism

The ER between two nations is based on the ratio of "amount or content" of pure gold in a physical unit of nation's currency

For example: I BP contained 113.0016 of pure gold while 1 US$ contained 23.22 grains of pure gold, thus the ER ($/BP) is 4.87

This ER is called "Mint Parity" If the price of shipping 1BP worth of gold between NY and London is 3 cents,

Then the ER will normally not fluctuate by more than the shipment price (3 cents)

Gold Standard operated from about 1880 to outbreak of WW1 in 1914. The fixed ER of Bretton Wood system (BWS) or Gold Exchange Standard,

operated from the end of WWII (1947-1971) BWS was initially based initially based on the gold exchange standard with the

USA played major role by maintaining the price of gold at about $35 per ounce and be ready to exchange on demand $ for gold at that price without any limitation

The system collapsed in 1971 due to the global expectation for US$ major devaluation in the light of US huge BOP deficit.

Huge capital flight took place from USA. Then world rely on floating system of ER.

Effects of Currency Devaluation:1. Flow of goods and services: import (), export ().2. International price for exported domestic goods and services ().3. Domestic costs for goods and services ().4. Demanded quantity for foreign reserves ().5. Supplied quantity for foreign reserves (not sure).6. Terms of trade (not sure).7. Balance of Payments:

Depends on Marshall-Lerner Condition:

1) If (elasticity of demand for import + export elasticity) > 1, then devaluation will improve balance of payments

2) If (elasticity of demand for import + export elasticity) < 1, then devaluation will worsen balance of payments problem

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3) If (elasticity of demand for import + export elasticity) = 1, then devaluation will have no effect on balance of payments

Balance of Payment Improvement

2 ways: 1. Cost Approach2. Income Approach

Cost Approach:2 ways:a. Manipulating the Exchange rate (in “Flexible Exchange Rate System”)b. Manipulating the price level (Inflation or Deflation)

(in “Fixed Exchange Rate System” or (Gold Standard)

Income Approach

When demand for export , (deficit will occur) then output, employment, income of export sector . Then the overall economy i.e. overall output, employment, income of non-export sector .

When of demand (good an services) for import (deficit will occur), implying reduction in demand for import substitute, then output, employment, income import substitution sector . Then the Overall output , employment, income .

When there is BOP surplus due to increase in export, then output, employment and export sector income . As income , saving, and Domestic spending as well as import will , (export - import) Thus BOP surplus will automatically.

Relationship between Income and BOP

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X – M = S – I (1)

(BOP (Net saving)

(+) (S - I0) Net Expenditure (S-I1) 0 Y0 Y1 Y2 Y

B Income A

(-) (X – M)

When Y , (S – I)

When Y , (X – M)

Initially, equilibrium is at Y0,

when (X – M) = (S – Io) [BOP is balanced]If I , (S - I0) shifts to the right (downward) to (S – I1), Y to Y1, thus there is

deficit (Y1B).

Deficit can be rectified:

1. X or M, shifting (X – M) to the right, S or I, shifting (S – I1) to the left and

intersect at Y1.

2. X or M, letting S and I intersect at Y2.

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