Effect of Monetary Policy on Foreign Trade

in India
INTRODUCTION
For decades of years now, the geometric acceleration of a long term sustainable
economic growth and development especially, through increase in export as one of
the major macroeconomic objectives has been the desired aim of every economy in
the world. The realization of this goal, undoubtedly, is not automatic. However, it
requires policy guidance which involves manipulation of policy instruments. Such
macroeconomic policies that could be used to actualize the above aim encompass
mutually monetary and fiscal policies. These policies are inextricable, apart from
instruments and implementing authorities. However, MONETARY POLICY
appears more effective in correcting short term macroeconomic maladjustments
due to its frequency in applying and altering policy tools, relative ease of its
decision process and sheer nature of the sector which propagates its effect to the
real economy. Hence, economists see monetary policy as an essential instrument
that every nation can install for the accurate maintenance of domestic price and
exchange rate stability, as a significant condition for the attainment of a sustainable
economic growth and development. Monetary policy as a macroeconomic tool is
widely used by central banks, RBI or other regulatory committees to control
quantity and rate of money supply in an economy, essentially affecting interest
rates. A country’s macro economy environment is affected by its monetary policy.
Financial system is the mechanism where a nation's financial authority, usually a
reserve bank, monitors the flow of money to the nation by imposing its power over
policy rate in order to retain stable growth and gain better wealth creation.
The FOREIGN TRADE is considered as lifeblood of an economy and is referred
to be a major contributor and determinant of its economic growth. The transfer and
exchange of goods as well as resources between the nations minimizes the chances
of having unintended surpluses and shortages. The countries can specialize in the
production of articles for which they have comparative advantage and then trade
with other nations. It is not possible for any nation to produce each and every
article by itself and then absorb by itself .The foreign trade also ensures the
efficient utilization of resources leading to the overall welfare being of individuals
in the society. There are many factors that may affect the trade activates between
two nations and the exchange rate is also considered as a major such contributing
factoring.
This paper studies the impact of monetary policy shocks on the exports
and foreign investment inflows. The call money interest rate (INT) would be acting
as a proxy for the monetary policy. In addition to these variables, GDP growth rate
(GDP) and inflation rate (CPI) have been included to study their impact on the
exports (EXP) and foreign investment inflows (FDI). Inclusion of GDP growth rate
is based on the premise that a higher GDP growth should encourage foreign
investment inflows indicating bright future prospects for the economy. This in turn
should be impacting the exports positively.

OBJECTIVE OF THE STUDY

The main objective of the study is to x-ray the effect of monetary policy on foreign
trade.
In other words, the specific objectives of the study are:
▪To examine the effect of Imports, Exports and Exchange rate in INDIA.
▪To examine the effect of foreign direct investment on foreign trade in INDIA.

SCOPE OF THE STUDY

PROFILE OF THE TOPIC
In today’s global economy, consumers are used to seeing products from every
corner of the world in their local grocery stores and retail shops. These overseas
products or imports provide more choices to consumers. And because they are
usually manufactured more cheaply than any domestically-produced equivalent,
imports help consumers manage their strained household budgets. When there are
too many imports coming into a country in relation to its exports which are
products shipped from that country to a foreign destination it can distort a
nation’s balance of trade and devalue its currency. The devaluation of a country's
currency can have a huge impact on the everyday life of a country's citizens
because the value of a currency is one of the biggest determinants of a nation’s
economic performance and its gross domestic product (GDP). Maintaining the
appropriate balance of imports and exports is crucial for a country. The importing
and exporting activity of a country can influence a country's GDP, its exchange
rate, and its level of inflation and interest rates.

Effect on Gross Domestic Product

Gross domestic product (GDP) is a broad measurement of a nation's overall
economic activity. Imports and exports are important components of
the expenditures method of calculating GDP. The calculation of a country’s GDP
encompasses all private and public consumption, government outlays,
investments, additions to private inventories, paid-in construction costs, and the
foreign balance of trade. (Exports are added to the value and imports are
subtracted). Of all the components that make up a country’s GDP, the foreign
balance of trade is especially important. The GDP of a country tends to increase
when the total value of goods and services that domestic producers sell to foreign
countries exceeds the total value of foreign goods and services that domestic
consumers buy. When this situation occurs, a country is said to have a trade
surplus. If the opposite situation occurs—if the amount that domestic consumers
spend on foreign products is greater than the total sum of what domestic producers
are able to sell to foreign consumers—it is called a trade deficit. In this situation,
the GDP of a country tends to decrease.
The formula for GDP is as follows:
In this equation, exports minus imports (X – M) equals net exports. When exports
exceed imports, the net exports figure is positive. This indicates that a country has
a trade surplus. When exports are less than imports, the net exports figure is
negative. This indicates that the nation has a trade deficit.
A trade surplus contributes to economic growth in a country. When there are more
exports, it means that there is a high level of output from a country's factories and
industrial facilities, as well as a greater number of people that are being employed
in order to keep these factories in operation. When a company is exporting a high
level of goods, this also equates to a flow of funds into the country, which
stimulates consumer spending and contributes to economic growth.

India’s gross domestic product (GDP), at current prices, stood at Rs. 51.23 lakh
crore (US$ 694.93 billion) in the first quarter of FY22, as per the provisional GDP
estimates for the first quarter of 2021-22. India’s trade and external sector had a
significant impact on the GDP growth as well as expansion in per capita income.
According to the Ministry of Commerce and Industry, India’s overall exports
between April 2021 and August 2021 were estimated at US$ 256.17 billion (a
44.04% YoY increase). Whereas overall imports between April 2021 and August
2021 were estimated at US$ 273.45 billion (a 64.18% YoY increase).
How Imports and Exports affect you?
When a country is importing goods, this represents an outflow of funds from that
country. Local companies are the importers and they make payments to overseas
entities, or the exporters. A high level of imports indicates robust domestic
demand and a growing economy. If these imports are mainly productive assets,
such as machinery and equipment, this is even more favorable for a country since
productive assets will improve the economy's productivity over the long run.
A healthy economy is one where both exports and imports are experiencing
growth. This typically indicates economic strength and a sustainable trade surplus
or deficit. If exports are growing, but imports have declined significantly, it may
indicate that foreign economies are in better shape than the domestic economy.
Conversely, if exports fall sharply but imports surge, this may indicate that the
domestic economy is faring better than overseas markets.
For example, the U.S. trade deficit tends to worsen when the economy is growing
strongly. This is the level at which U.S. imports exceed U.S. exports. However,
the U.S.’s chronic trade deficit has not impeded it from continuing to have one of
the most productive economies in the world.

However, in general, a rising level of imports and a growing trade deficit can have
a negative effect on one key economic variable, which is a country's exchange
rate, the level at which their domestic currency is valued versus foreign
currencies.

Exchange rate
Until 1991, India followed fixed exchange rate system and only occasionally
devalued the rupee with the permission of IMF. The policies of floating exchange
rate and increasing openness and globalization of the Indian economy, adopted
since 1991, have made the exchange rate of rupee quite volatile.
Exchange rate the price of a currency in terms of another currency is arguably the
single most important variable in determining the economic environment for trade
sectors. Appreciation or depreciation of currency affects the economic
performance of a country. Any government at any point in time seek the stability
of the exchange rate because it provides economic agents to plan ahead of varying
costs and prices of goods and services. An exchange rate depreciation can make a
country’s exports cheaper and imports more expensive. Exchange rates in India are
prone to high fluctuations, which are pegged against a strong currency, usually the
U.S. dollar .This study examines the impact of fluctuations of Indian currency on
foreign trading in India.
The changes in capital inflows and capital outflows and changes in demand for and
supply of foreign exchange, particularly US dollar, arising from the imports and
exports cause great fluctuations in the foreign exchange rate of rupee. In order to
prevent large depreciation and appreciation of foreign exchange rate Reserve Bank
has to take suitable monetary measures to ensure foreign exchange rate
stability.Owing to the fixed exchange rate system prior to 1991 the concern about
foreign exchange rate had not played a significant role in the formulation of
monetary policy.
Today, the exchange rate of rupee is determined by demand for and supply of
foreign exchange (say, US dollar). When there is mismatch between demand for
and supply of foreign exchange, external value of rupee changes.

Foreign Direct Investment

Foreign Direct Investment (FDI) leads to the long term growth of the economy. 
MNCs bring about technology transfer to the domestic companies. Organic growth
or expansion takes place in the companies. Employment too rises. FDI strengthens
the balance sheet as it raises the assets of the companies. Profits of the businesses
increase and labor productivity too increases. Per capita income increases and
consumption improves. Tax revenues increase and government spending rises.GDP
increases and there is also a lagged effect due to which subsequent years GDP too
increases. Furthermore investment has gestation period and returns increase after few
years. FDI puts the companies and hence the economy on higher growth mode and
the right process of FDI is selection of the strategic sectors in the economy that
generate highest ROI. Balanced and unbalanced growth theories of Development
economics too harp on this.FDI also acts as a solid complement to domestic stock of
investment which is low (about 32%) in India because of low savings. This
investment raises competitiveness among the businesses, breeds innovation and
efficiency and increases standard of living through better products and services in the
market. Exports get a fillip and balance of payments show surplus which causes
rupee to appreciate viz a viz the Dollar. Forex reserves rises significantly and this
causes RBI‘s assets to increase due to which money supply rises and thus inflation
too rises according to Quantity Theory of Money. So according to Mundell Fleming
model in the open economy context, bond prices go up, interest rates go down,
investment escalates further and growth rises.FDI is better than Foreign Institutional
Investment (FII) or hot money which is volatile in nature and moves to  the stock and
bond markets. Because of FDI, there is solid growth in the companies and hence
stock market rallies and attracts more capital which raises more funds for the
businesses. In FDI there is technology transfer or the movement of technical know
how to the domestic country due to which skill development takes place and together
with higher capital this raises productivity and profitability.