Balance of Payments (BOP) is a systematic record of all economic transactions

conducted between residents of one country and residents of the rest of the world over a specific
period, typically a year. It provides a comprehensive summary of a country's economic interactions
with other nations.

The BOP consists of three main components:

Current Account: The current account records transactions involving goods, services, income, and
current transfers. It includes the following sub-components:

a. Goods: It represents the export and import of physical goods such as machinery, vehicles, and
consumer products.

b. Services: It includes transactions related to services such as tourism, transportation, financial

services, and consulting.

c. Income: It comprises income earned by residents of a country from investments abroad (e.g.,
dividends, interest) and income earned by foreigners from investments within the country.

d. Current Transfers: It records unilateral transfers of money, such as foreign aid, remittances, and
grants.

Capital Account: The capital account tracks the transactions involving the purchase and sale of non-
financial assets and capital transfers. It includes:

a. Capital Transfers: It represents the transfer of ownership of fixed assets, inheritance, and other
capital transfers.

b. Acquisition and Disposal of Non-Financial Assets: It records the purchase or sale of non-financial
assets, including land, buildings, and intellectual property.

Financial Account: The financial account reflects transactions related to financial assets and liabilities
between residents and non-residents. It includes:

a. Direct Investment: It represents investments in companies and businesses that involve significant
ownership stakes and control.

b. Portfolio Investment: It includes investments in stocks, bonds, and other securities.

c. Other Investment: This category covers transactions related to loans, deposits, and other financial
assets that do not fall under direct or portfolio investment.

d. Reserve Assets: It tracks changes in a country's reserve holdings, such as foreign currency, gold,
and Special Drawing Rights (SDRs).

The balance of payments is summarized by calculating the overall balance, which represents the net
inflow or outflow of funds from the country. A positive balance indicates a surplus (more inflows than
outflows), while a negative balance indicates a deficit (more outflows than inflows). The BOP
provides insights into a country's economic health, its international trade position, and its ability to
meet its external obligations.
The Balance of Payments (BOP) is an important economic indicator that holds
several key significance:

Economic Performance: The BOP provides insights into a country's economic performance in
international trade and financial transactions. It helps assess whether a country is running a surplus
or deficit, indicating the competitiveness of its goods and services in global markets. A sustained
deficit in the BOP may signal structural issues in the economy, while a surplus can indicate a strong
export sector.

Exchange Rate Stability: The BOP plays a crucial role in determining exchange rates. If a country runs
a persistent deficit, it implies a higher demand for foreign currency to pay for imports, potentially
leading to a depreciation of the domestic currency. Conversely, a surplus may put upward pressure
on the currency. Exchange rate stability is essential for promoting trade, attracting foreign
investment, and maintaining macroeconomic stability.

Policy Formulation: BOP data helps policymakers formulate appropriate economic policies. A deficit
in the current account may highlight the need to boost exports or reduce imports through trade
policies, while a surplus might necessitate measures to encourage domestic consumption and
investment. BOP information assists policymakers in making informed decisions to maintain a
favorable balance and foster economic growth.

External Solvency and Debt Management: The BOP provides insights into a country's external
solvency and its ability to meet its international payment obligations. A sustained deficit can lead to a
growing external debt burden, which may pose risks to the country's financial stability. By monitoring
the BOP, policymakers can identify potential vulnerabilities and take measures to manage and reduce
external debt.

Investment Decisions: Investors use BOP data to assess the attractiveness and stability of a country
for investment purposes. A country with a favorable BOP position, indicating a surplus or improving
external accounts, may be seen as more stable and attractive for foreign investment. BOP
information helps investors evaluate risks associated with currency fluctuations, political stability,
and economic prospects.

Policy Coordination: BOP data facilitates international policy coordination and cooperation among
countries. It enables countries to monitor global imbalances, exchange rate misalignments, and
capital flows. BOP discussions and negotiations occur in forums such as the International Monetary
Fund (IMF) and World Trade Organization (WTO), helping countries coordinate policies to address
imbalances and promote stability in the global economy.

SURPLUS AND DEFICIT IN BOP

Deficit: A deficit occurs when a country's total payments to the rest of the world (outflows)
exceed its total receipts from the rest of the world (inflows). In other words, it indicates a
negative balance in the BOP.

A deficit means that a country is spending more on imports, paying more in foreign debts, or
experiencing more capital outflows than it is receiving from exports, foreign investments, or
capital inflows.
 A BOP deficit can lead to a decrease in foreign exchange reserves, currency depreciation,
and potential challenges in meeting international payment obligations.

Surplus: A surplus occurs when a country's total receipts from the rest of the world (inflows)
exceed its total payments to the rest of the world (outflows). It represents a positive balance
in the BOP.

A surplus indicates that a country is earning more from exports, receiving more foreign
investment, or experiencing more capital inflows than it is spending on imports, paying out
in foreign debts, or experiencing capital outflows.

A BOP surplus can lead to an increase in foreign exchange reserves, currency appreciation,
and potential opportunities for investing abroad or paying off foreign debts.

Equilibrium, Disequilibrium

Equilibrium refers to a state in the balance of payments where the total inflows of funds
(receipts) from the rest of the world are equal to the total outflows of funds (payments) to
the rest of the world. In this state, there is a balance between a country's international
receipts and payments.

Disequilibrium, on the other hand, occurs when there is an imbalance between the inflows
and outflows of funds in the balance of payments. It means that the receipts and payments
are not equal, resulting in a deficit or surplus.

common methods used to correct disequilibrium include:

Exchange Rate Adjustment: Countries can allow their exchange rates to fluctuate in
response to market forces.

If a country has a deficit, a depreciation of its currency can make exports more competitive
and imports relatively more expensive, helping to reduce the deficit.

Conversely, if a country has a surplus, an appreciation of its currency can make imports
cheaper and exports relatively more expensive, helping to decrease the surplus.

Fiscal and Monetary Policies: Governments can implement fiscal and monetary policies to
influence the balance of payments.

For example, if a country has a deficit, it can reduce government spending, increase taxes, or
tighten monetary policy to reduce domestic demand and imports.

Conversely, if a country has a surplus, it can increase government spending, reduce taxes, or
adopt expansionary monetary policy to stimulate domestic demand and imports.

Trade Policies: Governments can implement trade policies to influence the balance of
payments.
For instance, a country with a deficit can impose import restrictions such as tariffs, quotas, or
import licenses to reduce imports.

Conversely, a country with a surplus can implement policies to promote exports, such as
export subsidies or trade agreements.

Capital Controls: Governments can impose restrictions on capital flows to control the
balance of payments.

Capital controls can include measures such as limits on foreign investments, restrictions on
capital outflows, or regulations on speculative capital inflows. By managing capital flows,
countries can influence their balance of payments position.

Structural Reforms: Countries can undertake structural reforms to enhance their

competitiveness and address underlying issues causing imbalances.

These reforms can include improving infrastructure, increasing productivity, promoting

innovation, reducing trade barriers, and enhancing the business environment.

Accounting Principles In BOP

Residence principle: This principle states that all economic transactions between residents
and non-residents of a country are recorded in the balance of payments.

Double entry principle: This principle states that for every transaction, there must be two
entries, one debit and one credit. This ensures that the balance of payments always balances.

Monetary unit principle: This principle states that all transactions in the balance of
payments must be recorded in the same currency. This currency is usually the national
currency of the country.

accrual principle: This principle states that all transactions in the balance of payments must
be recorded in the period in which they occur.

Matching principle: This principle states that expenses must be matched with the revenues
they generate. This ensures that the profits and losses of a country are accurately reflected in
the balance of payments.

Conservatism principle: This principle states that when there is uncertainty about the timing
or amount of a transaction, the more conservative estimate should be used. This ensures that
the balance of payments does not overstate the profits or assets of a country.

Materiality principle: This principle states that only transactions that are material to the
balance of payments should be recorded. This ensures that the balance of payments is not
cluttered with irrelevant information.

These accounting principles ensure that BOP accounts provide a comprehensive and
accurate representation of a country's international transactions.
 UNIT 6
The International Monetary Fund (IMF) is an international financial institution that was
created in 1944 to promote international monetary cooperation, exchange stability, and
orderly exchange arrangements. It is headquartered in Washington, D.C., and has 190
member countries.

The IMF's main functions are to:

Foster international monetary cooperation: The IMF works to promote international

monetary cooperation by providing a forum for member countries to discuss and agree on
policies that will help to stabilize the international monetary system.

Encourage the expansion of international trade: The IMF believes that trade is essential
for economic growth and development, and it works to encourage the expansion of
international trade by providing technical assistance and training to member countries.

Provide financial assistance to member countries: The IMF provides financial assistance to
member countries that are experiencing balance of payments difficulties. This assistance can
help countries to overcome short-term economic problems and to implement economic
reforms that will help to promote long-term growth.

Advise member countries on economic policies: The IMF provides economic advice to
member countries on a wide range of issues, including fiscal policy, monetary policy, and
financial sector regulation. This advice is designed to help countries to adopt sound
economic policies that will promote economic growth and stability.

IMPORTANCE OF IMF
Economic and Financial Stability: The IMF aims to promote global economic and financial
stability by providing member countries with policy advice, technical assistance, and financial
resources. It helps countries design and implement sound macroeconomic policies, manage
financial crises, and address vulnerabilities in their economies.

Financial Assistance: One of the primary functions of the IMF is to provide financial
assistance to member countries facing balance of payments problems. Through its lending
programs, such as Stand-By Arrangements and Extended Fund Facilities, the IMF offers
temporary financial support to countries in need, helping them stabilize their economies,
restore confidence, and implement necessary reforms.

Surveillance and Policy Advice: The IMF conducts regular surveillance of the global
economy and member countries' economies. It assesses economic developments, identifies
risks, and provides policy recommendations to promote stability and sustainable growth. The
IMF's policy advice carries significant weight and helps guide economic policymaking at the
national and international levels.
Technical Assistance and Capacity Building: The IMF provides technical assistance and
capacity-building support to member countries, particularly in areas such as fiscal
management, monetary policy, financial sector regulation, and statistics. This assistance helps
countries strengthen their institutional frameworks, improve governance, and enhance their
economic management capabilities.

Global Cooperation and Coordination: The IMF serves as a platform for global cooperation
and coordination on economic and financial matters. It facilitates dialogue among member
countries, fosters consensus on policy issues, and helps address global challenges
collectively, such as global imbalances, exchange rate stability, and financial sector
vulnerabilities.

Poverty Reduction and Sustainable Development: The IMF recognizes the importance of
poverty reduction and supports member countries' efforts to achieve sustainable and
inclusive growth. It promotes policies that focus on poverty alleviation, social spending, and
inclusive economic development. The IMF also collaborates with other international
organizations to address global development challenges, including the United Nations'
Sustainable Development Goals (SDGs).
 UNIT 5
ADR stands for "American Depositary Receipt." It is a financial instrument that allows non-
U.S. companies to list their shares on U.S. stock exchanges and enable U.S. investors to invest
in foreign companies without directly purchasing the shares on foreign exchanges. ADRs are
issued by U.S. banks and represent ownership of underlying shares in a foreign company.

Here are some key points about ADRs:

Structure: ADRs are created when a U.S. bank purchases shares of a foreign company and
deposits them in a local custodian bank in the company's home country. The U.S. bank then
issues ADRs, which represent a specified number of underlying shares.

Types of ADRs: There are different types of ADRs based on the level of compliance with U.S.
Securities and Exchange Commission (SEC) regulations. The most common types include
Level 1 ADRs, Level 2 ADRs, and Level 3 ADRs. Each type has different reporting
requirements and levels of liquidity.

Trading and Pricing: ADRs are traded on U.S. stock exchanges like regular stocks, making
them easily accessible to U.S. investors. They are priced in U.S. dollars and may have different
trading hours than the foreign stock markets where the underlying shares are listed.

Dividends and Voting Rights: ADR holders are entitled to receive dividends in U.S. dollars if
the underlying company declares dividends. The ADR issuer handles the currency conversion
and distribution of dividends to ADR holders. However, ADR holders generally do not have
voting rights in the foreign company's shareholder meetings.

Benefits: ADRs provide several benefits to both foreign companies and U.S. investors. For
foreign companies, ADRs offer increased access to U.S. capital markets and exposure to a
broader investor base. For U.S. investors, ADRs provide a convenient way to invest in foreign
companies, eliminating the need for international trading accounts and currency conversions.

Risks: Investing in ADRs carries certain risks. These include foreign exchange risk, country-
specific risks, political and economic instability in the foreign company's home country, and
the potential for differences in accounting standards and regulations.

Disclosure and Regulation: ADRs are subject to U.S. securities laws and regulations, including
the reporting requirements of the SEC. This ensures that ADR issuers provide relevant
financial information and meet transparency standards, providing investors with information
necessary for informed decision-making.

Global Depositary Receipt (GDR):

GDR stands for Global Depository Receipt. It is a financial instrument used by companies to
raise capital from international investors. A GDR represents ownership in a company's shares
but is traded on foreign stock exchanges, typically in U.S. dollars or other major currencies.

Here are some key points about GDRs:

Purpose: GDRs are primarily used by companies to access international capital markets and
raise funds from global investors. They provide an avenue for companies to tap into a
broader investor base and attract foreign investment.

Structure: GDRs are issued by depositary banks, which purchase shares of the issuing
company and hold them on behalf of investors. These depositary banks issue GDRs to
investors, typically representing a certain number of underlying shares. GDRs are
denominated in a foreign currency and can be listed and traded on international stock
exchanges.

Types: There are two main types of GDRs: sponsored GDRs and unsponsored GDRs.
Sponsored GDRs are issued with the cooperation and support of the issuing company, which
is directly involved in the process. Unsponsored GDRs, on the other hand, are created by
financial institutions without the explicit involvement or endorsement of the issuing
company.

Benefits for Issuers: GDRs provide companies with several advantages. They allow companies
to diversify their investor base, gain exposure to international markets, and raise capital in
foreign currencies. GDR issuance can also enhance a company's visibility and reputation on
the global stage.

Benefits for Investors: GDRs offer international investors the opportunity to invest in
companies from different countries without the need to navigate local markets or comply
with domestic regulations. GDRs provide liquidity and facilitate easy trading of shares on
international exchanges.

Regulation: GDRs are subject to regulatory frameworks, both in the country of issuance and
in the jurisdictions where they are listed. The regulatory requirements for GDRs may vary
depending on the country and exchange where they are traded.

Conversion: GDRs can typically be converted into underlying shares, either partially or in full,
at the request of investors. This conversion process allows investors to take ownership of the
company's shares listed on the domestic stock exchange
ADR

Certificates representing shares of a foreign Certificates representing shares of a foreign

company held by a U.S. depositary bank, company held by a depositary bank outside
traded on U.S. stock exchanges. the United States, traded on international
Definition stock exchanges.
 Enable international investors to invest in
Allow U.S. investors to invest in foreign foreign companies without directly buying
companies without directly buying their their shares on the home country's
Purpose shares on foreign exchanges. exchange.

Traded on international stock exchanges

Trading Traded on U.S. stock exchanges such as such as London Stock Exchange or
Market NYSE or NASDAQ. Luxembourg Stock Exchange.

Regulated by the U.S. Securities and Regulated by the securities laws and
Exchange Commission (SEC) and subject to regulations of the country where the GDR is
Regulation U.S. securities laws and regulations. listed.

Denominated in a currency chosen by the

issuing bank (usually U.S. dollars, euros, or
Currency Denominated in U.S. dollars. British pounds).

Generally accessible to international

Investment Widely accessible to U.S. investors and often investors but may have lower trading
Accessibility have higher trading volumes. volumes compared to ADRs.

International depositary bank holds the

Custodian U.S. depositary bank holds the foreign foreign company's shares on behalf of GDR
Bank company's shares on behalf of ADR holders. holders.

Sponsored ADRs: Supported and issued by Sponsored GDRs: Supported and issued by
the foreign company in collaboration with a the foreign company in collaboration with a
depositary bank. Unsponsored ADRs: Issued depositary bank. Unsponsored GDRs: Issued
Types without the company's involvement. without the company's involvement.
 International commercial paper (ICP) is a short-term, unsecured
debt instrument that is issued by a company or financial institution in one country
and sold to investors in another country. ICPs are typically denominated in the
currency of the country where they are sold, but they can also be denominated in
other currencies.
 ICPs are a popular way for companies to raise short-term capital. They are typically
issued with maturities of less than one year, and they can be used to finance a variety
of purposes, such as working capital needs, seasonal fluctuations in demand, or to
bridge the gap between long-term debt issuances.
 ICPs are typically sold through a network of banks and other financial institutions.
They are also traded on over-the-counter (OTC) markets.

**ICPs offer a number of advantages to investors, including:

 Liquidity: ICPs are typically more liquid than other types of debt instruments, such as
bonds. This means that investors can buy and sell them more easily.
 Yield: ICPs typically offer higher yields than other types of debt instruments, such as
government bonds. This is because they are considered to be riskier investments.
 Diversification: ICPs can be a good way to diversify a portfolio. This is because they
are exposed to different currencies and markets.

**ICPs also have some disadvantages, including:

 Risk: ICPs are considered to be riskier investments than other types of debt
instruments. This is because they are not backed by the full faith and credit of a
government.
 Foreign exchange risk: ICPs that are denominated in foreign currencies are exposed
to foreign exchange risk. This means that the value of the ICPs can fluctuate if the
exchange rate between the two currencies changes.
 Country risk: ICPs that are issued in countries with unstable economies are exposed
to country risk. This means that the value of the ICPs can fluctuate if the economy of
the country deteriorates.
 UNIT 1
International trade refers to the exchange of goods, services, and capital across national
borders. It plays a crucial role in the global economy and has several important implications.

IMPORTANCE

1. Economic Growth: International trade is a significant driver of economic growth. It allows

countries to specialize in producing goods and services in which they have a comparative
advantage, which leads to increased efficiency and productivity. By engaging in trade,
countries can access larger markets and benefit from economies of scale, leading to
higher output, employment, and income levels.
2. Increased Consumer Choice: International trade expands the range of products available
to consumers. Countries can import goods and services that are not domestically
produced or are available at lower costs from other countries. This variety of choices
enhances consumer welfare and satisfaction.
3. Resource Allocation: International trade enables efficient allocation of resources on a
global scale. Countries can focus on producing goods and services that they can produce
most efficiently and trade for those they are less efficient in producing. This specialization
and trade allow for optimal utilization of resources, leading to higher overall productivity
and economic welfare.
4. Access to Resources: Not all countries possess the same resources or have the capacity
to produce all goods and services. International trade provides access to resources that
are scarce or unavailable domestically. It allows countries to acquire inputs, raw materials,
and capital goods from other nations, enabling them to enhance production capabilities
and support economic development.
5. Competitive Advantage: Engaging in international trade encourages competition
among producers. Competition drives innovation, efficiency improvements, and
technological advancements as companies strive to offer better quality products at
competitive prices. This competition benefits consumers by providing them with
improved products and lower prices.
6. Foreign Exchange: International trade involves the exchange of currencies, which
facilitates international transactions and fosters economic cooperation. It generates
demand for foreign currencies and provides an avenue for countries to earn foreign
exchange through exports. Foreign exchange reserves are crucial for various economic
activities, including import payments, debt servicing, and investment.
7. Interconnectedness and Cooperation: International trade promotes economic
interdependence and fosters cooperation among nations. It creates a network of
economic relationships, trade agreements, and institutions that facilitate communication,
negotiation, and collaboration on various issues. This interconnectedness can lead to
greater political stability, diplomatic relations, and peaceful coexistence among nations.
8. Poverty Reduction: International trade can contribute to poverty reduction by
stimulating economic growth, creating employment opportunities, and raising living
standards. It allows developing countries to participate in the global economy, attract
foreign investment, and access international markets, providing avenues for economic
development and poverty alleviation.
LIMITATIONS
Trade Barriers: Countries often impose trade barriers such as tariffs, quotas, subsidies, and non-tariff
barriers (e.g., regulations, standards) to protect domestic industries, safeguard national security, or
address social and environmental concerns. These barriers can restrict market access, increase the
cost of trade, and hinder the flow of goods and services.

Political and Legal Barriers: Political instability, conflicts, and changes in government policies can
disrupt international trade. Inconsistent or unpredictable regulations, legal systems, and intellectual
property protection can create uncertainty and hinder cross-border trade activities.

Transportation and Logistics: The physical movement of goods across long distances involves
transportation costs, customs procedures, documentation requirements, and logistics management.
Infrastructure limitations, inadequate transport networks, customs delays, and inefficient supply
chains can increase costs and lead to delays in international trade.

Cultural and Language Barriers: Differences in cultural norms, preferences, and language can pose
challenges for international trade. Understanding consumer behavior, marketing strategies, and
communication with foreign partners require cultural sensitivity and adaptation.

Exchange Rate Fluctuations: Exchange rate volatility can impact international trade by affecting the
cost competitiveness of exports and imports. Sharp fluctuations in exchange rates can introduce
uncertainty, increase transaction costs, and impact profitability for businesses engaged in
international trade.

Economic Disparities: Wide disparities in economic development, income levels, and resource
endowments between countries can create challenges in international trade. Less developed
countries may face difficulties in competing with technologically advanced and more productive
economies, limiting their ability to benefit from trade.

Environmental and Social Concerns: Increasing awareness of environmental sustainability and social
responsibility has led to concerns about the impact of trade on the environment, labor rights, and
human rights. Regulations and consumer demands related to sustainability and ethical sourcing can
pose challenges for businesses engaged in international trade.

Dependency and Vulnerability: Heavy reliance on a few trading partners or a limited range of
exports can make countries vulnerable to external shocks, such as changes in market demand,
political disputes, or natural disasters. Economic dependency on a specific sector or commodity can
also pose risks to countries engaged in international trade.

Barriers to international trade are obstacles or restrictions that limit the flow of
goods, services, or investments across national borders. These barriers can be imposed by
governments, arise from economic factors, or result from other factors.

Here are some common barriers to international trade:

Tariffs: Tariffs are taxes or customs duties imposed on imported goods. They increase the cost of
imported products, making them less competitive compared to domestically produced goods.
Quotas: Quotas limit the quantity or volume of specific goods that can be imported or exported.
They restrict the amount of goods that can enter a country, which can lead to higher prices and
reduced availability.

Import/Export Licenses: Governments may require licenses or permits for importing or exporting
certain goods. Obtaining these licenses can be time-consuming, costly, or subject to bureaucratic
processes, creating barriers to trade.

Embargoes and Sanctions: Embargoes and sanctions are trade restrictions imposed by one country
on another. They prohibit or limit trade with a specific country, typically due to political, security, or
human rights concerns.

Technical Barriers: Technical barriers to trade include technical standards, regulations, and
certifications that products must meet to be imported into a country. These standards can vary
across nations, leading to additional costs and complexities for exporters.

Subsidies: Subsidies provided by governments to domestic industries can distort international trade
by giving an unfair advantage to domestic producers over foreign competitors. This can hinder the
ability of foreign companies to compete in the domestic market.

Intellectual Property Protection: Inadequate protection of intellectual property rights, such as

patents, copyrights, and trademarks, can discourage foreign companies from exporting their
products or investing in countries where intellectual property rights are not effectively enforced.

Currency Barriers: Currency fluctuations and exchange rate controls can affect trade by making
imported goods more expensive or reducing the competitiveness of exported goods.

Cultural and Social Barriers: Differences in cultural norms, languages, consumer preferences, and
business practices can create barriers to international trade. Lack of understanding or adaptation to
local customs can limit market access and hinder trade relationships.

Heckscher-Ohlin theory (Factor Proportions theory)

The theories founded by Smith and Ricardo were not efficient enough for the
countries, as they could not help the countries determine which of the
products would benefit the country. The theory of Absolute Advantage and
Comparative Advantage supported the idea of how a free and open market
would help countries determine which products could be efficiently produced
by the country. However, the theory proposed by Heckscher and Ohlin dealt
with the concept of comparative advantage that a country can gain by
producing products that make use of the factors that are present in
abundance in the country. The main basis of their theory is on a country’s
production factors like land, labour, capital, etc. They proposed that the
approximate cost of any factor of resource is directly related to its demand
and supply. Factors which are present in abundance as compared to demand
will be available at a cheaper cost, and factors which are in great demand
and less availability will be expensive. They proposed that countries produce
goods and export the ones for which the resources required in their
production are available in a much greater quantity. Contrary to this,
countries will import goods whose raw materials are in shorter supply in their
own country as compared to the one from which they are importing.

For example, India has a large number of labourers, so foreign countries

establish industries that are labour-intensive in India. Examples of such
industries are the garment and textile industries.

Comparative advantage
The theory of comparative advantage flourished in the 19th century and was
propounded by David Ricardo. This theory strengthened the understanding of
the nature of trade and acknowledges its benefits. The theory suggests that
it is better if a country exports goods in which its relative cost advantage is
greater than its absolute cost advantage when compared with other
countries. For instance, let’s take the examples of Malaysia and Indonesia.
Let’s say Indonesia can produce both electrical appliances and rubber
products more efficiently than Malaysia. The production of electrical
appliances is twice as much as that of Malaysia, and for rubber products, it is
five times more than that of Malaysia. In such a condition, Indonesia has an
absolute productive advantage in both goods but a relative advantage in the
case of rubber products. In such a case, it would be more mutually beneficial
if Indonesia exported rubber products to Malaysia and imported electrical
appliances from them, even if Indonesia could efficiently produce electrical
appliances too.

What Ricardo proposed is that even though a country may efficiently produce
goods, it may still import them from another country if a relative advantage
lies therein. Similar is the case with export, even if a country is not very
efficient in certain goods from other countries, it may still export that product
to other countries. This theory basically encourages trade that is mutually
beneficial

Absolute Advantage Theory:

The Absolute Advantage Theory, also associated with Adam Smith, asserts
that countries should specialize in producing goods or services in which they
have an absolute advantage over other countries. This theory focuses on a
country's ability to produce a good more efficiently or with fewer resources
than another country, irrespective of relative efficiency.
The theory of comparative cost advantage is indeed considered an
improvement over the theory of absolute cost advantage. Here's an
explanation of why:

Consideration of Opportunity Cost: The theory of comparative cost advantage takes into account the
concept of opportunity cost, which is the cost of forgoing the production of one good in favor of
another.

It recognizes that countries should specialize in producing goods and services in which they have a
lower opportunity cost compared to other countries. In contrast, the theory of absolute cost
advantage focuses solely on which country can produce a good more efficiently without considering
the alternative goods that could be produced.

Flexibility and Range of Specialization: Comparative cost advantage allows for a broader range of
specialization possibilities.

It recognizes that even if a country has an absolute disadvantage in producing all goods, it can still
benefit from trade by specializing in the goods for which it has a comparative advantage. This
flexibility allows countries to exploit their relative strengths and trade for goods they would
otherwise produce at a higher opportunity cost.

Consideration of Trade-offs: Comparative cost advantage theory acknowledges that there are trade-
offs in production decisions.

It recognizes that a country may have an absolute advantage in producing multiple goods, but it may
not be efficient or optimal to produce all those goods domestically. By considering the opportunity
cost and focusing on goods with comparative advantages, countries can allocate their resources
more efficiently and achieve higher overall productivity.

Dynamic Perspective: Comparative cost advantage theory provides a dynamic perspective on trade.

It recognizes that countries can improve their productivity and competitiveness over time through
learning, technological advancements, and economies of scale. By specializing in goods with
comparative advantages, countries can enhance their efficiency, stimulate innovation, and drive
economic growth.

Applicability to Real-World Trade: The theory of comparative cost advantage aligns more closely
with observed patterns of international trade in the real world. Countries tend to specialize in
producing and exporting goods and services in which they have a comparative advantage, leveraging
the benefits of global trade and interdependence.
Overall, the theory of comparative cost advantage builds upon the theory of absolute cost advantage
by considering opportunity costs, providing flexibility in specialization, recognizing trade-offs, offering
a dynamic perspective, and aligning with real-world trade patterns. It provides a more
comprehensive framework for understanding the benefits and dynamics of international trade.
 Aspect Comparative Cost Advantage Theory Absolute Cost Advantage Theory

Countries specialize based on comparative Countries specialize based on absolute

Key Concept cost advantage. cost advantage.

Does not consider opportunity cost;

Opportunity Focuses on the opportunity cost of instead, focuses on overall production
Cost producing one good in terms of another. efficiency.

Trade occurs due to differences in Trade occurs based on absolute cost

comparative costs (opportunity costs) differences in production between
Basis of Trade between countries. countries.

Countries specialize in producing goods

Countries specialize in producing goods in which they have an absolute
with lower opportunity costs compared to advantage (higher efficiency) over other
Specialization other countries. countries.

Countries trade goods in which they have Countries trade goods in which they
Trade Patterns a comparative cost advantage. have an absolute cost advantage.

Trade is mutually beneficial, even if one Trade is mutually beneficial as long as

country is more efficient in producing all there is a difference in production
Mutual Benefit goods. efficiency between countries.

Country A produces wheat more Country A produces wheat more

efficiently (lower opportunity cost) and efficiently (absolute advantage) and
trades with Country B, which produces trades with Country B, which produces
cloth more efficiently (lower opportunity cloth more efficiently (absolute
Example cost). advantage).
 UNIT 4
An exchange rate is a relative price of one currency expressed in terms of another currency (or group
of currencies)

Gold Standard

Under the gold standard, the value of a currency is directly linked to the price of gold.
This means that the government or central bank guarantees that it will exchange a
certain amount of currency for a certain amount of gold. This system provides a fixed
exchange rate between currencies, which can help to promote trade and investment.

Under the Gold Standard:

Fixed Exchange Rates: The Gold Standard entailed fixed exchange rates between currencies.
Each currency had a specific gold parity, which determined its value in terms of a fixed
amount of gold. The exchange rate between two currencies was determined by their
respective gold parities.

Gold Convertibility: Under the Gold Standard, currencies were directly convertible into gold
at the specified exchange rate. This convertibility provided a link between currencies and
gold, ensuring their stability and anchoring the exchange rate system.

Gold Flows and Balance of Payments: The flow of gold played a crucial role in determining
exchange rates under the Gold Standard. If a country had a trade surplus, it would receive
gold payments from countries with trade deficits. Gold flows acted as an automatic
adjustment mechanism, signaling imbalances in the balance of payments. Persistent trade
deficits would lead to gold outflows, which reduced the money supply, deflated prices, and
eventually improved the trade balance.

coin Flow Mechanism: The gold flows and the need to maintain gold convertibility acted as
constraints on monetary policies. If a country pursued expansionary monetary policies,
leading to inflation, it would experience gold outflows, depleting its gold reserves. To
stabilize the currency and maintain the fixed exchange rate, the country would need to
implement contractionary measures.

Paper Standard
Under the paper standard, the value of a currency is not directly linked to the price of
gold. Instead, the value of the currency is determined by the government or central
bank. This system gives the government or central bank more flexibility in managing the
economy, but it also makes the value of the currency more volatile.

Under the Paper Standard (Fiat Currency System):

Floating Exchange Rates: In the Fiat Currency System, exchange rates are primarily
determined by market forces of supply and demand in the foreign exchange market.
Currencies fluctuate freely based on various factors, such as economic indicators, interest
rates, inflation rates, geopolitical events, and market sentiment.
Central Bank Interventions: Central banks may intervene in the foreign exchange market to
influence exchange rates. They can buy or sell their currencies, known as foreign exchange
market interventions, to stabilize or manipulate the exchange rates. Central bank
interventions are typically employed to address excessive exchange rate volatility or to
manage economic imbalances.

Monetary Policies: Monetary policies, including changes in interest rates and open market
operations, indirectly affect exchange rates under the Fiat Currency System. Higher interest
rates tend to attract foreign investors, increasing demand for the currency and potentially
strengthening its value. Conversely, lower interest rates may weaken the currency.

Capital Flows: Capital flows, such as foreign direct investment and portfolio investment, can
influence exchange rates in the Fiat Currency System. If a country attracts significant capital
inflows, its currency may appreciate, while capital outflows can lead to currency depreciation.

Market Sentiment and Speculation: Exchange rates under the Fiat Currency System can be
influenced by market sentiment and speculative activity. Traders and investors make
decisions based on their expectations of future exchange rate movements, which can lead to
short-term fluctuations and volatility.

Several factors influence the determination of exchange

rates in the foreign exchange market. The following are some key factors that can affect
exchange rates:

1. Interest Rates: Differences in interest rates between countries can impact exchange rates.
Higher interest rates attract foreign investors seeking higher returns, leading to an
increased demand for the currency of the country with higher interest rates and
potentially strengthening its value.
2. Inflation Rates: Inflation rates also play a role in exchange rate determination. Countries
with lower inflation rates generally experience an appreciation in their currency value, as
the purchasing power of their currency increases. Conversely, countries with higher
inflation rates may see a depreciation in their currency value.
3. Economic Performance: The overall economic performance and indicators of a country,
such as GDP growth, employment levels, trade balance, and productivity, can influence
exchange rates. Strong economic performance is typically associated with a stronger
currency, as it signals a stable and attractive investment environment.
4. Political Stability: Political stability and the absence of geopolitical risks are important
considerations for foreign investors. Countries with stable political systems and low
political risks tend to attract more foreign investment, leading to increased demand for
their currency and potentially strengthening its value.
5. Current Account Balance: The current account balance, which includes trade in goods
and services, income from investments, and transfers, can impact exchange rates. A
country with a current account surplus (exports exceeding imports) may experience an
appreciation of its currency, while a country with a current account deficit may experience
a depreciation of its currency.
 6. Government Intervention: Central banks and governments can influence exchange rates
through intervention in the foreign exchange market. They may buy or sell their currency
to stabilize or manipulate its value. Such interventions are typically employed to address
excessive exchange rate volatility or to manage economic imbalances.
7. Market Sentiment and Speculation: Exchange rates can be influenced by market
sentiment and speculative activities. Traders and investors make decisions based on their
expectations of future exchange rate movements, which can lead to short-term
fluctuations and volatility.
8. Capital Flows: Capital flows, including foreign direct investment, portfolio investment,
and loans, can significantly impact exchange rates. Countries that attract substantial
capital inflows may experience currency appreciation, while capital outflows may lead to
currency depreciation.
9. Market Supply and Demand: The basic principles of supply and demand apply to the
foreign exchange market as well. If there is a higher demand for a currency compared to
its supply, its value is likely to increase, and vice versa.

The Purchasing Power Parity (PPP) theory

Purchasing power parity (PPP) theory is a theory of exchange rate determination. It states that the
exchange rate between two currencies will adjust in the long run so that the prices of a basket of
goods and services are the same in both countries. This means that a dollar will buy the same
amount of goods and services in both countries.

The PPP theory is based on the law of one price, which states that the same good should have the
same price in all markets. If this is not the case, there will be arbitrage opportunities, where people
can buy the good in one market and sell it in another market at a profit. This will drive the prices of
the good towards equality in all markets.

The key principles of the Purchasing Power Parity theory are as follows:
Law of One Price: According to the Law of One Price, in a perfectly competitive market, identical
goods should have the same price in different countries when expressed in a common currency. This
principle assumes that there are no trade barriers, transportation costs, or other impediments to
international trade.

Absolute Purchasing Power Parity: The Absolute Purchasing Power Parity suggests that the exchange
rate between two currencies should be equal to the ratio of the price levels of a basket of goods in
each country. In other words, the exchange rate should adjust to ensure that the cost of the same
basket of goods is the same in different countries when converted into a common currency.

Relative Purchasing Power Parity: The Relative Purchasing Power Parity extends the concept of
Absolute Purchasing Power Parity by considering changes in the price levels over time. It suggests
that the exchange rate between two currencies should adjust to offset differences in the inflation
rates between countries. If the inflation rate is higher in one country compared to another, the
currency of the country with higher inflation should depreciate to maintain purchasing power parity.
The implications of the Purchasing Power Parity theory are as follows :

If a currency is overvalued (its exchange rate is higher than what the theory suggests), it implies that
the currency is relatively stronger than it should be based on its purchasing power. This situation may
lead to a decrease in exports and an increase in imports, which could eventually correct the
exchange rate.

If a currency is undervalued (its exchange rate is lower than what the theory suggests), it implies that
the currency is relatively weaker than it should be based on its purchasing power. This situation may
lead to an increase in exports and a decrease in imports, which could eventually correct the
exchange rate.

The Purchasing Power Parity theory is based on long-term equilibrium and may not hold in the short
run due to factors such as market imperfections, trade barriers, transportation costs, and differences
in non-tradable goods and services.

Exchange control is a system of government regulations that restrict

the flow of foreign exchange. These regulations can be used to achieve a variety
of objectives, such as:
Controlling the balance of payments: Exchange control can be used to prevent a
country's currency from depreciating or appreciating too much. This can help to
stabilize the economy and prevent financial crises.
Protecting domestic industries: Exchange control can be used to protect domestic
industries from foreign competition. This can be done by restricting the import of
goods and services from other countries.
Raising revenue: Exchange control can be used to raise revenue for the
government. This can be done by imposing taxes on foreign exchange transactions.
Preventing capital flight: Exchange control can be used to prevent capital from
flowing out of a country. This can be done by restricting the amount of foreign
exchange that individuals and businesses can hold.

Exchange control can have a number of negative consequences,

such as:
Distorted prices: Exchange control can distort prices in the domestic market. This is
because the government is artificially controlling the supply and demand for foreign
exchange.
Reduced efficiency: Exchange control can reduce the efficiency of the economy.
This is because it makes it more difficult for businesses to import and export goods
and services.
Increased corruption: Exchange control can increase corruption. This is because it
creates opportunities for people to profit from the black market for foreign exchange.
It should only be used as a last resort, and it should be carefully designed to
minimize the negative effects.