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 ASSIGNMENT SOLUTIONS GUIDE (2017-2018)
M.E.C.-7
International Trade and Finance
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%
accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.
As these solutions and answers are prepared by the private Teacher/Tutor so the chances of error or mistake cannot be
denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample
Answers/Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date
and exact information, data and solution. Student should must read and refer the official study material provided by the
university.
Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in
about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each).
In the case of numerical questions word limits do not apply.
SECTION-A
Q. 1. Critically discuss the Ricardian theory of Comparative Advantage. How is it different from
Adam Smith’s theory of Absolute Advantage?
Ans. Ricardian Comparative Advantage and Opportunity Cost: David Ricardo explains how a country
can gain through International Trade even if the country does not have comparative advantage in any goods. In that
situation, he demonstrates in his comparative advantage theory how a country would benefit by comparative advantage.
To explain this theory, he has taken the example of England and Portugal. In Portugal it is possible to produce
both wine and cloth with less labour than it would take to produce the same quantities in England. So Portugal has
absolute advantage in the production of both wine and cloth. So how can England gain from trade with Portugal?
Both England and Portugal would gain from trade and one can understand through the concepts of the opportu-
nity costs manifested in comparative advantages.
For example, the cost conditions in the two countries are as given in the Table –1. So, Portugal has advantage
over both wine and cloth.
Table 1. Labour Cost and Opportunity Cost Comparisons

Country Labour cost of production (in hours) Opportunity cost of production

1 unit of cloth 1 unit of wine 1 unit of cloth 1 unit of wine
England 100 120 100/120 = 0.83 120/100 = 1.2
Portugal 90 80 90/80 = 1.12 80/90 = 0.89
If we calculate the opportunity costs, Portugal has lower opportunity costs (0.89) of the two countries in wine
production, while England has lower opportunity costs (0.83) in cloth production. So, Portugal has comparative
advantage over wine and England has over cloth and both the countries would gain if they export these respective
products to the other country.
Adam Smith’s theory of International Trade is based on the concept of absolute advantage, while Ricardo’s
theory is based on comparative advantage.
Adam Smith says two countries can gain through international trade if they have absolute advantage in producing
different goods. For instance, China can produce 500 parts of product X with 100 workers. Japan can produce 1000
parts of product X with 100 workers. On the other hand, China can produce 1000 parts of product Y with 100

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workers and Japan can produce 500 parts of product Y with 100 workers. Here China has the absolute advantage
over Japan in producing product Y, while Japan has absolute advantage over China in producing product X. So, if
China exports product Y to Japan and gets X from Japan, both the countries will gain.
Ricardo says even if a country does not have absolute advantage, and a country has absolute advantage in all the
goods, they would gain if they have comparative advantage. To compare comparative advantage, we have to get the
opportunity costs of the products.
For example, India and Japan the cost conditions in the two countries are as given in following table. So, India has
advantage over both rice and sugar.
Table 2. Labour Cost and Opportunity Cost Comparisons
Country Labour cost of production (in hours) Opportunity cost of production
1 quintal of rice 1 quintal of sugar 1 quintal of rice 1 quintal of sugar
Japan 100 120 100/120 = 0.83 120/100 = 1.2
India 90 80 90/80 = 1.12 80/90 = 0.89
If we calculate the opportunity costs, India has lower opportunity costs (0.89) of the two countries in rice
production, while Japan has lower opportunity costs (0.83) in sugar production. So, India has comparative advantage
over rice and Japan has over sugar. So India would gain if it exports rice to Japan and Japan would gain if it exports
sugar to India.
Q. 2. Explain the various concepts of terms of trade. Critically examine the behavior of terms of trade
as explained by Prebisch.
Ans. Definitions of the Terms of Trade: Terms of trade is the commodity terms of trade between the South
and the North - the two regions. Terms of trade is (price exports)/(price imports) or the ratio of the prices of export
commodities to the prices of import commodities. For example, if the South exports 400 dollars worth of products and
imports 200 dollars worth of products, its terms of trade are 400/200 = 2. If multiplied by 100, these calculations can
be expressed as a percent (200%). If a country’s terms of trade fall from say 100% to 70% (from 1 to 0.7), it has
experienced a 30% fall in its terms of trade.
Terms of trade are sometimes used as a proxy for the relative social welfare of a country or region, but this
heuristic is technically questionable and should be used with extreme caution. The increase of the ratio means an
improvement in a nation’s terms of trade which is good for that country in the sense that it can buy more imports for
any given level of exports. The terms of trade is influenced by the exchange rate because a rise in the value of a
country’s currency lowers the domestic prices for its imports but does not directly affect the commodities it produces.
There are a number of concepts related to terms of trade. These concepts are two types: Those that relate to
exchange between productive resources and those that relate to exchange ratios between commodities.
1. Net Barter Terms of Trade (NBTT): This is the price of exports to the price of imports, namely Pc/Pm =
P, where Pc is the price of exports and Pm is imports.
2. Single Factorial Terms of Trade (SFTT): This is the net barter terms of trade adjusted for the changes in
productivity of exports. SFTT = P×Oc where Oc is output per person in a country. The change in SFTT measures the
change in living standard of an exporter in terms of imports. Suppose output rise but price declines and the total
changes is zero, i.e., 6P+6OC=0, then the SFTT index will remain unchanged.
The Consumer Price index (CPI) will be Pc1-aPma where a is share of imports in the consumption basket. If E is
money expenditure, then E/CPI is real expenditure when trade is balanced. So real expenditure will be:
Pc.Oc÷ Pc1-aPma = Qc(Pc/Pmm) a = Pa.Qc
As P fall, the real expenditure rose. But if there is no change in employment, there is a one to one relation
between an output index and a productivity index, and the index for real expenditure per employed person, P a.Qc, is
the Weighted Single Factorial Terms of Trade (WSFTT).
Double Factorial Terms of Trade (DFTT) is adjusted for both the productivity of imports and productivity of
exports. DFTT is calculated to know the relative change in living standards. Thus,
DFTT = (Pc/Pm)(Oc/Om) where Om is output per person in the North. This provides the relative value of the output
of workers and combines relative prices and relative productivity.

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 Change in relative living standards can be decomposed into employment, productivity and TT changes. If we
keep employment out of the picture then the remaining two factors of productivity and TT can be combined into the
DFTT. But the DFTT gives an accurate measure of changes in the relative size of consumption baskets only in
special cases (i) fraction of income spent on tradeable goods should be the same in the two regions (ii) the relative
price component is trendless.
For the DFTT, relative real income of the South relative to the North is (E/Pc(1-a) Pma) ÷ E*/Pm1-a Pca where E* is
the expenditure in the North. When trade is balanced E =. PcQc and E* = PmQ*m , and this expression becomes (Qc
/ Q*m ) P a+a*. Under constant employment assumption, this converts to k P a+a*(Qc / Qm ) where k is the constant ratio
of persons employed in the two countries. k drops out when we view the last expression as an index. So,
WDFIT = P a+a*(Qc /Qm )
The trade unweighted version corresponds to the case where a+a* = 1.
This condition is satisfied when the two countries have identical consumption patterns.
4. Income TT = (Pc /Pm ).Oc .Nc = V/Pm
Where Nc is employment in the production of commodity, so that V is value of primary production. The given
value of output measured in import prices. This is a useful measure as employment data to calculate Oc is often not
available.
5. Employment Corrected IT: As there is full employment in the North, in case of increased output in one sector,
there will be not be an increase in total income as income in other sectors falls.
But this will not be the case in the South where due to unemployment output foregone elsewhere is zero. To take
account of this, we can estimate the employment corrected DFTT, namely ECDFTT which equals:
 Pc  Oc 
ECDFTT =  P  O  Nc = P a+a*-1 V (PmOm)
 c  m 
Where V = PcOc Nc is index of output of exportables valued at current prices.
This extends the index to all three dimensions and also gets rid of troublesome O c , which can often not be
calculated because of lack of data.
6) Because of unemployment in the South, analysts take interest over employment corrected WSFlT.
ECWSFlT=
Pac Pac P a-1c
PaOcPc= P a .O c N c . = P a .Pc O c N c = P a .V
m m m

The income terms of trade are POcNc, namely, they correspond to the case where a = 1, and so equal P.X where
X is quantity of exports, namely value of exports expressed in import prices.
If employment is not constant, then we calculate the ECWDFTT, employment corrected relative income double
factor TT, = P a+a* O (Nc /N)Om
The Behaviour of the TT
In a development context, Prebisch revived the likely evolution of the TT, a feature of classical analysis, was
resurrected. Scarcity of land in classical economics would results in a rise in primary prices and the terms of trade for
primary products would improve.
In consequence, industrial investment would be unprofitable and economic growth would get halted and the
economy would come to stationary state. This line of argument in more recent times has been adopted by various
environmentalists beginning with the Club of Rome analysis.
According to Prebisch, developing countries could not follow a development strategy on the basis of growth of
the agricultural sector and export of the resulting higher output. If they attempt to raise the growth rate of an
economy, they would need a higher investment ratio and larger imports of capital goods because these countries do
not have a large domestic capacity to manufacture capital goods. Export earnings would rise only slowly as terms of
trade would fall as more farm goods were exported. Export earnings in results would be insufficient to fund the
imports of capital goods, resulting in BoP problems and so efforts to increase the growth rate would not be effective.
In a detailed statistical analysis, Prebisch gave his contention that the terms of trade of developing countries were
deteriorating. As he could not find data for the terms of trade of developing countries, he estimated the TT of the UK
since the UK was an exporter of manufactured goods and an importer of intermediaries from developing countries.
Prebisch found that the TT of the UK had improved between 1870 and 1938 and thus he concluded that the TT of
developing countries had deteriorated.

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 This procedure followed by Prebisch was criticised on several grounds.
1. The UK’s TT does not represent the TT of developing counties since the UK’s NBTT is not representative of
industrial countries as a whole. Thus, it is invalid to use the inverse of the UK’s TT for studying TT of developing
countries.
2. The UK’s TT would not be correct data for study as the UK imported primary commodities from developed
countries.
3. There are other factors like transportation costs which are responsible for fall in prices of imported products.
In the UK may the prices of imports might have declined because of a fall in shipping costs since import prices include
freight charges. So the fall in import prices in the UK could occur without a decline in the prices of commodities
exported by developing countries.
4. The usual method of calculation of price indices may be biased as it does not take account of introduction of
new goods and quality differences.
Besides, economists did not find any evidence to support the view that the TT of the developing countries
deteriorated in 1960s.
In a detailed analysis, Sparos however concluded that the evidence of Britain’s NBTT (with regard to the
developing countries) was not misleading though it gave an exaggerated impression of the magnitude of the deterioration.
Sparos presented with evidence that the prices of agricultural products exported by developed countries increased.
This bolsters the argument that if the relative prices of primary products imported into the UK were falling this would
be because of a decline in prices of primary goods imported from developing countries. The evidence also does not
support the argument that freight rates fell more sharply than prices of agricultural products except in the period 1900-
08 and hence could not have caused an improvement in UK’s TT without causing a deterioration in TT of developing
countries.
Spraos attempted to improve on the indices estimated by Prebisch. Taking into account, various import and export
indices and changes in transport costs, he found that the basic conclusion of Prebisch – a decline in the TT of primary
commodities – is sustained even though the rate of fall is somewhat slower than what Prebisch had estimated.
According to Grilli and Yang, the terms of trade of developing countries did not deteriorate much despite the
decline in primary commodity prices. They argued that developing countries had diversified their export baskets and
the TT of developing countries would have deteriorated much more sharply if their development strategy had been
based on growth of the agricultural sector.
SECTION-B
Q. 3. Explain multilateral framework of international trade. Explain its main features.
Ans. A multilateral framework of international trade facilitates member countries import and export of goods and
services. It is definitely a suitable platform for developing countries to join with. By becoming a member of a multilateral
framework, a country will have opportunity to engage in import and export.
A multilateral framework also offers a better deal to a country than any bilateral agreement for trade can
provide. It also provides collective security to member countries. The platform gets mechanism for enforcement of
rights and obligations and dispute settlement system to protect against unilateral actions of other countries.
A member country gets the opportunity to learn from the experiences of other countries in the group and also
influence the process to some extent. A country staying away from the group will get an image of an odd man out. So
it is better to be a part of such a framework which has been in existence for nearly six decades now. WTO is an
example of a multilateral framework of international trade.
Governments undertake during the Multilateral Trade Negotiations (MTN) obligations not to raise tariffs on
specified products beyond specified limits. These tariffs are said to be “bound”. Countries can apply a tariff lower
than the bound level on that product. A country cannot generally go beyond the bound level, except as a temporary
measure on two situations. First, countries can go beyond bound level for providing “safeguard” to the domestic
industry against sudden surge of imports, and second, it if for tiding over the problem of the shortage of inflow and
reserve of foreign exchange, which is called the “Balance of Payment” (BoP) problem.
Safeguard: The country may put check on import either by raising import duty beyond the bound level or by
putting quantitative restrictions on the import when the domestic industry of a country suffers serious injury because
of increased imports or if there is even a threat of serious injury.
Safeguard measures are stipulated in Article XIX of GATT 1994 and Agreement on Safeguard. A country has to
undertake a transparent, objective and detailed investigation to determine whether there has been a surge in import
and whether there is serious injury to the domestic industry because of such surge in import.

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 The country has to impose on the import product as a whole and not against the import from a particular country.
If a country applies quantitative restriction, an annual limit of import will be fixed on the basis of the past imports.
There is a provision for deviation from this normal rule of quota division in very specific circumstances. For instance,
in case there is a fast rise in exports from a specific country.
A safeguard is a temporary measure. The maximum duration of application of a safeguard measure is generally
four years. It can be extended in certain circumstances, but the total maximum period should not be more than eight
years.
Countries applying a safeguard measure provide some compensatory benefit to countries that have substantial
interest in the export of that product. Otherwise, those countries can take retaliatory measures, generally in the form
of raising the tariffs on some products of that country.
The safeguard provision is an example of burden-sharing in the WTO system. When a country faces sudden rise
in imports, it is required to adjust to the emerging situation. In that situation, the safeguard situation ensures that the
burden is shared by all the countries, so that it does not fall on the country facing the surge in imports.
Balance of Payment (BoP) Provision: If a country faces the problem of the foreign exchange reserve and
flow, or a BoP problem, it is allowed to restrict its imports. WTO has two separate provisions in this regard–one is for
the general including both developed and developing and another only for the developing countries.
The rationale behind providing separate provision for the developing is that in course of their economic development
they may have to import a lot, while their export prospects are not high. This may lead to shortage of foreign exchange
which will curtail their option for further import. Thus, to provide them a break for recovery to a more comfortable
foreign exchange situation, they are allowed to restrict their imports. The measure will remain until the BoP problem
is there.
Before applying a BoP measure, the developing countries make consultations with the BoP Committee of the
WTO for a detailed scrutiny on its BoP situation and on its need to impose trade restrains for BoP reasons. During
such consultations, the International Monetary Fund (IMF) generally gives a report on the BoP situation of the
country.
The country resorting to BoP measures has to apply it equally for all exporting countries. There should not be any
discrimination in the restriction and has to be applied to the import of selected products from all countries.
General Exceptions: There is an exception that a country can stop import of a product from a particular
country under certain conditions such as protection of life and health of human beings, animals and plants, protection
of public morals and protection of environment. For example, it can put restriction on importing injurious food articles
or those with improper packaging or indecent books and magazines or relating to articles that may pollute water or air
while in use or during disposal.
For protection of life and health and for other environmental reasons, most of the time countries put restrictions in
imports. The Agreement on Technical Barriers to Trade (TBT) and the Agreement on the Application of Sanitary and
Phytosanitary (SPS) Measures further elaborate and clarify this provision. The agreements on TBT and SPS suggest
the formulation of global standards and provide pre-eminence to them.
Q. 4. What are the various forms of economic integration? How is trade diversion different from trade
creation? Elucidate.
Ans. Regional trading Blocs and trade Creation: Trade creation refers to formation of a regional trading
bloc or a Free Trade Area (FTA) through preferential tariff concessions. In such grouping, a more efficient producer
of the product supplies within the free trade area. Trade creation in all cases boosts a country’s welfare as imports
replace high-cost domestic production.
Trade diversion is diverting trade away from a more efficient supplier outside the FTA towards a less efficient
supplier within the FTA. Trade diversion may reduce a country’s national welfare. In certain cases despite the trade
diversion national welfare improves.
The key concepts of trade creation and trade diversion were introduced by Jacob Viner in his pioneering study of
the theory of customs unions. Viner demonstrated through a simple model that a customs union could have welfare-
increasing effects whereas it could have welfare-reducing effects in other circumstances.
Table 3: Production costs of homogeneous product of in A, B and C countries
Country A B C
Production cost 500 400 300

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 With an example we will see how trade creation and trade variation take place. In the Table 1. production cost of
a homogeneous product in three countries is given. If it is assumed that the price of the good is determined by the
production cost and tariffs remain as the only source of divergence between price and cost, understanding the effects
of preferential tariff liberalization under a customs union is possible.
If A levies a tariff of 100 per cent, imports from B will be available at 800, and imports from C will be 600. In such
a situation, A would not import the good.
Suppose A and B form a customs union and impose 100 per cent tariff on imports from C, consumers in A will get
indigenous products at a price of 500, imports from B at 400, and imports from C at 600. In such a situation, A would
import the good from B. This is called trade creation. It replaces relatively inefficient (high-cost) indigenous production
with efficient (low-cost) imports from the partner country. It leads to welfare gains.
Suppose prior to the formation of a customs union A imposes a tariff of 50 per cent, then domestic goods will be
available at a price of 500, imports from B at 600, and imports from C at 450. A would import the good from the
lowest-cost import source, that is country C. In this context, if A and B form a customs union, consumers in A will get
the indigenous products at 500 and imports from B at 400, imports from C at 450. A will switch imports from the
lowest-cost supplier, C to the higher-cost supplier, B. This is called trade diversion. Trade diversion occurs when a
country shifts its source of imports from a more efficient country to a less efficient country due to the tariff-preferences
in a customs union. It entails a less efficient allocation of resources and thus leads to a lowering of welfare.
It gets further complicated when under a Regional Trade Agreement (RTA) tariffs are not reduced to zero. In
such case the members of the RTA do not have necessarily zero tariffs among them, thus the calculations to get the
most-efficient supplier will differ. In the simplest form of the Vinerian model, thus trade creation is always welfare
increasing and trade diversion always leads to lowering of welfare. This argument is often used by those who points
out the limitations of RTA or a customs union.
However, if there is not assumption that demand is perfectly price inelastic then such a conclusion will be
erroneous. Trade creation and trade diversion occur due to the formation of the customs union leading to a fall in the
price of products consumers get in A. So, if demand is not perfectly inelastic then this decline in price could lead to a
rise in consumption, which is a source of welfare gain to consumers. In this context consumption gains boost the
welfare-increasing effects of trade creation. They can outweigh the welfare-reducing effects of trade diversion and
could create a situation wherein trade diversion leads to increase in welfare.
Trade Diversion: In Figure 1, it is presented how trade diversion could reduce welfare in a country that enters
into an FTA. D and S are the demand and supply curves for country X.
PY and PZ are the free trade supply prices of the product from countries Y and Z respectively.

Country X
P D S

PYT
Z
PT
Y m n r s
P u
P2

2 1 1 2 2
S S DD Q
Fig. 1.Trade Diversion

It is assumed that X has a specific tariff, tY = tZ = t* imposed on imports from countries Y and Z. The tariff
increases the domestic supply prices to PTY and PTZ, respectively. The size of the tariff is equal to PTY – PY = PTZ – PZ.
It is quite clear that country X will import the product from country Z and will not trade initially with country Y. Imports
would be to the order of D1 – S1.
After countries X and Y form an FTA, X would impose zero tariff on imports from country Y. Consequently, the
domestic prices on goods from countries Y and Z would be PY and PTZ, respectively. Since PY < PTZ, country X would
import only from country Y after the FTA. At the lower domestic price, PY, imports would rise to D2 – S2. Since the
initial price in country Z is lesser than the price in country Y, imports from Y are considered as diverted from a more
efficient supplier Z to a less efficient supplier Y.

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 Table 2. Welfare Effects of RTA: Trade Diversion
Effects on Country X
Consumer Surplus + (m + n + r + s)
Producer Surplus –m
Govt. Revenue – (r + u)
National Welfare + (n + s) – u
As you see in the Table 2, the net national welfare effect can be either positive or negative. Trade diversion is
generally considered to be welfare lowering as discussed earlier. However, in certain conditions the national welfare
change could be positive under the trade diversion scenario. If the free trade supply price (PY) offered by country Y
is lower and closer to country Z’s free trade supply price PZ, trade diversion still takes place after the FTA-formation.
The welfare effects will be the same as far as the direction is concerned. However, they differ in magnitude. The
consumer surplus gain becomes larger due to the larger fall in the domestic price. Hence, in such cases, formation of
an FTA that causes trade diversion could have a positive welfare effect. Thus, trade diversion need not necessarily be
welfare lowering.
Trade Creation: Trade creation under an FTA means products are imported from a more efficient producer in
the region, often involving a shift of imports away from the rest of the world.
Such a move is welfare enhancing for a member country of the FTA. In Figure 1. country X enters into a FTA
with the more efficient supplier country Z, there will be only trade creation and no diversion. Figure 15.2 presents
another example of trade creation and its effects where country X forms an FTA with country Y.
P Country X
D S
Y
PT
Z
PT X
P
Y
m nr
P
Pz

2 2
S D Q
Fig.2 Trade Creation

S and D represent the supply and demand curves for country X in the figure 2. The supply prices of the good from
countries Y and Z, respectively, are by PY and PZ. Assume that X has a specific tariff tY = tZ = t* imposed on imports
from both countries Y and Z. The tariff raises the domestic supply prices to PTY and PTZ respectively. The tariff size
will be t* = PTY - PY = PTZ – PZ. Including the tariffs, the pre-FTA price in country X (PX) is less than both PTY and
PTZ thus the product will not be imported. Country X will instead fulfil its domestic demand with its own supply at S1
= D1.
Suppose X and Y form an FTA and X fully eliminates the tariff on imports from country Y, the tY, becomes zero
but tZ remains at t*. The domestic prices of products from countries Y and Z become PY and PTZ respectively. As PY
< PX, country X would now import the product from country Y after the FTA. At the lower domestic price PY, imports
would increase to D2 – S2. Trade now is generated in the post-FTA scenario from an efficient source within the
region. This is trade creation.
Table: 3. Welfare Effects of RTA: Trade Creation

Effects on Country X
Consumer Surplus + (m + n + r)
Producer Surplus –m
Govt. Revenue 0
National Welfare + (n + r)

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 For the country X, the net welfare effect is the total of gains and losses to consumers and producers. There are
two positive dimensions: a positive consumption efficiency gain (r) and a positive production efficiency gain (n). An
FTA that leads to trade creation implies net welfare gains. Thus, the gain would be even larger if country X entered
into the FTA with the more efficient supplier country Z.
Trade creation and trade diversion analysis can be extended to cover many markets and multiple countries of an
FTA. The aggregate effects of an FTA can be obtained by totalling the effects across markets and across countries.
The net welfare effects are measured by taking both trade creation and trade diversion into account. If the positive
effects from trade creation outweigh the negative effects from trade diversion, the FTA under consideration is said to
be welfare improving. Thus, both trade creation and trade diversion effects need to be added to assess the welfare-
increasing effects of a customs union or RTA.
Q. 5. Describe the evolution of international monetary system. Examine the trends in the international
monetary and financial systems.
Ans. Evolution of International Monetary System and Its Present Status: International monetary system
is part of the international financial system which is defined as a set of global financial markets, global financial
institutions, official lenders such as the IMF, and global regulatory arrangements. These institutions facilitate cross
border transactions in financial instruments.
International monetary system is interdependent in the sense that balances of payment are connected together. If
one country has a balance of payments surplus, the rest of the world has a balance of payments deficit and vice
versa. If one country has a balance of trade surplus, the rest of the world has a balance of trade deficit. This
influences the exchange rate system. In a world of n countries with n currencies, there are n-1 independent exchange
rates. No country can fix exchange rates on its own.
As we learnt that the problem of what is widely known as the “impossible trinity” will be there with the prevalence
of cross-border capital flows. It is impossible to achieve simultaneously the objectives of a fixed exchange rate, an
open capital account and a monetary policy dedicated to domestic economic goals.
The fixed exchange rate system in various countries was dropped as an objective worth pursuing. The IMF had
managed the anchored dollar system of fixed exchange rates. Since 1971 and especially after1973, the year the
international monetary system moved towards flexible exchange rates, the IMF lost its role as a guardian of the
international monetary system. The IMF was then shifted from its role at the centre of the international monetary
system to a new role of ad hoc macroeconomic consultant and debt monitor.
When the gold exchange standard broke down as a price-stabilization mechanism through the inter-dependence
of the currency system, there was inflationary pressure witnessed worldwide. In results, the Articles of Agreement of
the IMF were amended in 1978 with a focus how on price stabilisation as imbibed in the amended Article IV. In 1971,
the US decided to de-link the dollar from gold. Regarding role of the Fund, it is amply clear that the international
monetary system was being run by industrialized countries. The Fund had no coherent system for monetary stabilisation
to offer.
In the strict sense, an international monetary system does not currently exist. Every nation has its own monetary
system. The functioning of the IMF has been severely criticised. Its credentials have also been questioned with
regard several issues including IMF-supported programmes that impose austerity on countries in financial crisis.
There are various trends prevailing at present in the international monetary system. They are fragmented and
there is no one-umbrella institution, which is said to be offering an international monetary and financial architecture.
Some of the trends are summarised below:
l Deregulation and opening of domestic financial markets.
l Globalization of domestic financial markets and institutions.
l Firms and financial institutions raising funds through international capital markets.
l Investors collecting funds from abroad.
l Foreign corporations and financial institutions are allowed to issue bonds and stocks denominated in different
currencies. They are also allowed to buy domestic securities.
l Emergence of international financial centers in Europe and Asia.
l Growth of offshore money and capital markets
l Globalization of insurance, banking and other intermediation businesses.

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 These trends make the international capital market as one market. International capital flows has been growing
steadily in recent decades. However, this has negative effects on countries dependent on such flows. These countries
became increasingly vulnerable to crises of confidence. Besides, the spreading of crises from one country to another
has become a part of reality. This was evident in various financial crisis including the Asian crisis of 1997, Latin
America and Russia in 1998 and the 2008 crisis.
Various trends are prevailing in the international monetary and financial system. Some of them are give below:
l Globalization of financial markets and institutions: Financial markets and institutions are setting up their
branches all parts of the world. There is no border or territorial barriers now.
l Firms and financial institutions raising funds through foreign capital markets: MNCs and financial
institutions are going overseas to sell their financial instruments to raise funds. Foreign corporations and
financial institutions are also now allowed to issue bonds and stocks denominated in different currencies. They
are also allowed to buy domestic securities.
l Emergence of international financial centers in Europe and Asia: A number of financial centres have
opened in Western countries.
l Growth of offshore money and capital markets: Example is markets for Eurobonds.
l Globalisation of insurance, banking and other intermediation businesses: Banks and insurance firms
have opened branches all over the world.
Q. 6. Discuss the various instruments of trade protection. Differentiate between quotas and tariffs.
Ans. The instruments of trade protection can be divided into two types: (i) tariffs and price-related measures and
(ii) Non-Tariff Barriers (NTBs) or non-price related.
Tariffs: A tariff is a tax on imported products. This is called import duty. Tariff is imposed on both final and
intermediate goods. It changes the prices of imported goods and domestic goods. Tariff are two types - specific or ad
valorem. Specific tariffs are fixed amount levied on a product, for example, Rs. 500 on 100kg of rice. Ad valorem are
fixed per centage of the total value of the goods, for example, 10% tax on imported vegetables.
Non-Tariff Barriers: Non-tariff barriers are trade barriers that restrict imports. They are different from a tariff.
Some common examples of NTBs are import quotas and export restrictions. Some of the NTBs are discussed below:
Quotas: An import quota is a type of protectionist trade restriction that sets a physical limit on the quantity of a
good that can be imported into a country in a given period of time. Quotas are applied through a system of import
licenses. Firms which have license are permitted to import specified quantities of the imported good into the domestic
market. With a quota the domestic price of an imported good will always be higher than its world market price. Firms
buy the product at world price and sell them at higher price in the domestic market.
Other Non Tariff Barriers: Some of the NTBs commonly used by countries across the world are foreign
exchange restrictions, import deposit scheme, health and safety standard, customs valuation procedure and local
content requirements.
Q. 7. Critically examine the relative merits and demerits of the fixed and flexible exchange rates.
Ans. Some of the merits and demerits of the fixed and floating rates systems are mentioned below:
(i) Under the floating rate regime, all the countries have the same opportunity to influence its exchange rate
against foreign currencies. This was not the case in Bretton Woods regime as the US was able to set world
monetary conditions all by itself.
(ii) Under the flexible rate regime, the Central Banks have the freedom to fix their exchange rates and thus
might engage in inflationary policies. This is not the case under fixed exchange rate regime.
(iii) In the case of floating rate regime, there is always tremendous instability in foreign exchange market,
affecting internal and external balance of countries. This is not the case in fixed rate system.
(iv) Under floating rate regime, countries adopt competitive currency policies without taking into account the
position of other countries. Floating exchange rate fuels higher uncertainty in the economy than the fixed
exchange rate.
Relatives Merits and Demerits of Fixed and Flexible Exchange Rates
On the basis of the experiences on the Bretton Woods system and the managed or dirty floating rate system since
1973, we will see the merits and demerits of the fixed and floating rates systems.

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 Monetary Policy Autonomy: The Central Banks under fixed exchange rate system are obliged to intervene in
the foreign exchange market to keep the rate fixed. Such obligation is not there under floating rate regime. Thus, the
government uses monetary policy to get internal and external balance.
Symmetry: The US was able to set world monetary conditions all by itself under Bretton Woods regime. Under
floating rate system, it is different. All the countries have the same opportunity to influence its exchange rate against
foreign currencies.
Exchange rates as automatic stabilisers: For any rate alignment, there used to be long periods of speculation
under Bretton Woods system. Under floating rate system, policy-induced exchange rates were sought to stabilise the
economies. Under floating rate, no long-period speculation is needed.
Discipline: Under the floating rate system, the Central Banks might engage in inflationary policies as they have
the freedom to fix their exchange rates. This is not possible under fixed exchange rate regime.
Speculation: Speculation in change is rate under floating rate system may result in tremendous instability in
foreign exchange market, effecting internal and external balance of countries.
International Trade and Investment: The exchange rate under floating rate regime make internal prices more
unpredictable and thus hit international trade and investment.
Uncoordinated Economic policies: There will be competitive currency practices under floating rate system.
This may harm the world economy. Countries may adopt policies without taking into account the position of other
countries.
Uncertainty: In floating rate, the exchange rate volatility increases.Floating exchange rate fuels greater
uncertainty in the economy than the fixed exchange rate.
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