UNIT- 4

• Exchange control
• Devaluation
• Free trade vs Protection

EXCHANGE CONTROL

Exchange control means that all foreign receipts and payments in the form of foreign
currencies are controlled by the government.
Prof. Haberler defines exchange control as “State regulation excluding the free play of
economic forces from the foreign exchange market.

Features of Exchange control:

1. It involves complete government control over the foreign exchange market.

2. All foreign currencies are required to be surrendered to the central bank.

3. The central bank sanctions and allocates all foreign payments in respect of different
currencies.

4. The central bank fixes the official exchange rate.

5. It regulates demand and supply so as to maintain the official exchange rate.

6. There is regulation of currency to be supplied to importers.

7. Exporters are required to surrender foreign currencies to the central bank.

8. Only specified banks and licensed dealers can deal in foreign exchange.

9. The central bank acts as a discriminating monopolist by charging low rates of exchange for
the purchase of essential imports and high rates for purchasing luxury imports.

Objectives of Exchange control:

1. Over-valuation: The currency is over-valued for three reasons:

A. The country is at war and needs large quantities of imports.

B. The country is engaged in the development process and needs raw materials and
capital equipment from abroad; and third, the country has to repay large foreign debt.
When the country overvalues its currency, its currency becomes dearer relative to
other currencies.
 2. Under-valuation: countries also exercise exchange control to keep their currency
undervalued. This is done to stimulate exports and reduce imports and to raise the general
price level of the country. But such a policy can succeed only in the case of a small country
whose participation in world trade is insignificant.

3. Stabilisation of exchange rates: Exchange control is adopted to stabilise the rate of

exchange. Fluctuating exchange rates harm commerce and industry.

4. Prevention of capital flight: Gold and capital funds cannot be exported without the
permission of the exchange control authority. The latter may totally ban such movements or
give foreign exchange in limited quantities to export capital for specific purpose.

5. Protection of domestic industries: Exchange control is resorted to giving protection to

domestic industries against foreign producers. The exchange control authority controls the
import of such commodities which compete with domestic producers and thus protects them
from for eign competition.

6. Checking Non- essential imports. Exchange control also aims at checking imports of
non-essential commodities. The exchange control authority restricts import of non-essential,
luxury and harmful commodities through foreign exchange control.

7. Help to the planning process. Exchange control helps the process of planning by
controlling the non-essential and wasteful expenditure on imports and encouraging the flow
of exports. The exchange control authority encourages the inflow of essential raw materials,
capital goods and technical know-how by allocating scarce foreign exchange resources. Such
imports are needed for the execution of plan projects.

8. Remedying Unfavourable Balance of Payments. Exchange control is introduced to

remedy adverse balance of payments. This is achieved by checking and regulating imports
and foreign exchange. With reduction in imports and control of foreign exchange, visible and
invisible imports are reduced. Consequently, adverse balance of payments are corrected.

9. Earning Revenue. Exchange control is also used to earn revenue by the government. The
central bank of the country, which is usually the exchange control authority, sells foreign
currencies to traders, businessmen and individuals at rates higher than at which it buys in the
international market. The difference between the selling and buying rates goes to the
government as revenue.

10. Repaying foreign debt. To earn and conserve foreign exchange for the purpose of
repaying the principle and interest charges on foreign debt.

11. Retaliation. Exchange control is used to secure bargaining power in trade with other
countries and also as a retaliatory device.
Exchange control gives monopoly power to a country which can get essential commodities at
favourable rates from the other country. It can, thus, be used to exploit the other country.
Under the circumstances, the other country can also adopt exchange control as a retaliatory
measure.

Methods of Exchange control:

Direct methods

The central bank of the country, which is the exchange control authority, adopts a number of
direct methods which restrict the use and quantity of foreign exchange.

1. Intervention: Intervention means that “a government may intervene in the foreign

exchange market to hold the value of its currency up or to hold it down.” This method
is known as “pegging exchange rates”.
If the government fixes the exchange rate of its currency at a higher level than
prevailing in the foreign exchange market, it is called “pegging up”.
On the other hand, fixing a lower exchange rate than prevailing in the foreign
exchange market is called “pegging down”.

When a country pegs up its currency, it means that the demand for its currency at the
higher exchange rate is less than its supply.
So the central bank must intervene to purchase local currency in exchange for foreign
currencies at the fixed rate. On the other hand, in the case of pegging down of its
currency, the central bank must sell the local currency in exchange for foreign currencies
at the fixed rate. This is because the demand for the local currency at the lower exchange
rate is more than its supply.

2. Exchange restriction: Crowther defines a policy of exchange restriction as one

which involves “a compulsory reduction by the government of supply of its currency
coming into the market. Under it, all foreign currencies are pooled with the central
bank which, in turn, sanction and allocates them in accordance with the rules laid
down by the government.
a) Allocation according to priorities: As the foreign currencies available with the
central bank are always limited in quantities, it will allocate them to finance imports
and to make other foreign payments. It will do so in accordance with certain
principles or priorities. It was widely used in England.
The following are the defects:
- Allocating foreign exchange according to priorities is bound to be arbitrary because
that is decided by bureaucrats.
- The processing and sanctioning of applications involve much time and
administrative costs.
- This system leads to inequities.

b) Multiple exchange rates: When a country establishes different exchange rates for
each of several categories of imports, exports and capital transfers, it is known as the
method of multiple exchange rates. This system of exchange control is operated in
such a way that the foreign value of imports is reduced and the foreign value of
 exports is increased.
Aim: to achieve balance of payments equilibrium for the country by reducing imports
and increasing exports.
The central bank may fix a low buying rate for foreign currency for the import of
essential commodities and a much higher rate for the import of luxuries. On the
export side, it may subsidise exports by fixing higher exchange rates. But the rates
for invisibles, including capital transfers, are usually very high.

Merits:
(1) It encourages exports and discourages imports.
(2) It has the same effects as a subsidy on exports and a tax on imports.
(3) It helps in checking disequilibrium in the balance of payments of the country
adopting this method.
(4) It encourages the inflow and discourages the outflow of capital.
(5) This system is better than other methods of exchange control because it restricts
trade indirectly.
(6) The government earns additional revenue by buying foreign exchange from
exporters and selling it to importers at a high price.

Defects:
(1) It is highly discriminatory.
(2) It is a complex system which requires lot of understanding and knowledge on the
part of the controlling authority for an accurate fixation of exchange rates.
(3) It depends much on bureaucratic decisions which are likely to be arbitrary.
(4) It hinders the growth of world trade.

c) Blocked Accounts. Under this system of exchange control, payments for imports
are credited to blocked accounts in the name of the foreign exporters. Such accounts
may be kept in the central bank of the debtor country. The creditors are prohibited for
some time from drawing on them.

3. Exchange clearing agreements. Under this method of exchange control two trading
countries agree to establish an account in their respective central banks through which
all payments for exports and imports are cleared. This method is known as bilateral
clearing or clearing agreement or exchange clearing.
Under this system, if country A imports goods from country B, payments by
importers are required to be made in the clearing account with its central bank in its
own currency. Similarly, exporters of country A are paid in their own currency out of
the clearing account.
The same principle applies to the other trading partners. But it is not essential that
exports and imports may be equal in both the countries and the clearing accounts may
balance.
So to balance them, the banks supply their own currency at a fixed rate of exchange
against that of the other country up to a certain limit. This is known as 'swing'.
 Defects
1. Such agreements are based on agreed exchange rates between the two countries.
A strong country with relatively more bargaining strength may agree to a
favourable exchange rate for itself. This exchange rate may be fixed arbitrarily
and to the disadvantage of the weak partner.
2. The size of the 'swing' may have disastrous effects on the domestic economies of
the two countries. If the size of the 'swing' is too small, its limit may bereached
soon and trade between the two countries may come to an end because the country
may not like to lose its gold.
3. If a country has excess of imports over exports, more local currency will be
deposited by the importers in the clearing accounts. This will lead to a decline in
the monetary supply which will be deflationary. On the contrary, the excess of
exports over imports will be inflationary because more currency will flow to the
exporters out of the clearing account. Both situations are possible, if the clearing
account reaches the limit of the 'swing'.
4. It hinders multilateral trade.
5. The central banks are overburdened under this system.

4. Payment agreements. Payments agreements are another form of bilateral agreements but
they are wider in scope than clearing agreements. A payments agreement is usually made for
the repayment of the debt by one country to the other. Under this system of exchange control,
a certain percentage of payments for imports by the creditor country is passed on to its
clearing account for the repay ment of its debt.

(1) Such payment agreements always favour the strong partner.

(2) The balances can only be used for buying goods and services from the debtor
country.
(3) They can only be used for payment between partners.
(4) It adversely affects the balance of payments position of the debtor
country.

INDIRECT METHODS

1. Quantitative restrictions. Quantitative restrictions or commercial controls

include import restrictions, import embargoes, import quotas and buying
policies of state trading corporations. Quantitative import controls restrict the
amount (in value or quantity) of commodity to be imported. The aim is to
curtail the value of imports to correct disequilibrium in the balance of
payments.
The import quota is another device by which a specified quantity of a
commodity is imported free of any duty, while imports above that quantity are
levied on import duty.
The state trading corporation or authority is given a monopoly in the import
 of certain commodities. It regulates the amount of commodities to be imported
and distributes them within the country. The aim of these quantitative
restrictions is to make the rate of exchange in favour of the country imposing
them and to correct its adverse balance of payments.

2. Export bounties. A bounty on exports has the effect of raising the external
value of the country giving the bounty. But export bounties are limited by the
amount of funds with the government.
3. Raising interest rates. When the interest rate increases in a country, it attracts
capital funds from other countries and prevents the outflow of domestic funds
to other countries. Consequently, the demand for its currency rises which
raises its external value and making the foreign exchange rate favourable to it.

MERITS AND DEMERITS OF EXCHANGE CONTROL

Merits

1. Exchange control prevents the erratic outflow of capital.

2. By restricting imports, it helps in improving the balance of payments.

3. It makes possible the import of essential capital goods by ensuring the availability of
foreign exchange for them.

4. It prevents the import of non-essential consumption goods, thereby curbing conspicuous

consumption.

5. Exchange control prevents the spread of foreign companies beyond a limit, and regulates
their working in national interest.

6. It is an important device to protect domestic industries from foreign competition and start
import substitution and export promotion industries.

7. It helps in maintaining exchange rate stability by removing fluctuations in exchange rates.

8. With the help of exchange control, government is able to pursue an anti-deflationary

policy.

9. Government employs exchange control for controlling speculation in foreign exchange.

10. It enables the government to repay foreign loans.

11. It is a source of revenue for the government when it buys foreign exchange at a low price
and sells at a higher price.

12. Control over foreign exchange helps in conserving foreign exchange for strategic, defence
and planning needs of the country.
13. It is a good device to enable a country to have bilateral trade relations benefitting the two
countries.

14. If a country becomes hostile, the country can prevent the repatriation of funds by freezing
all its assets through exchange control.

Demerits

1. Exchange control tends to reduce the volume and value of international trade. When
one country restricts imports from other countries, the latter retaliate, and exports
from the former are also restricted. This leads to the diminution of world trade which
is harmful for all countries.
2. The exchange control system breeds inefficiency, red-tapism and corruption among
administrators and organisers connected with this.
3. It is a very expensive system because the exchange control authority needs large
number of persons to carry on the system efficiently.
4. Exchange control always creates a black market in foreign exchange. There is
smuggling of foreign exchange even in a very strict and efficient exchange control
system.
5. The criteria laid down for the various types of exchange control are arbitrary. They
depend upon the whims of the bureaucracy which may be in the interest of some and
against others.
6. The system of exchange control creates vested interests in the country for their
continuance.
7. The system of exchange control leads to inequities. Some importers profit more
because there are little restrictions on their imports while the imports of others are
curtailed by an import duty.
DEVALUATION AND ITS IMPACT ON THE INDIAN CURRENCY

DEVALUATION

Devaluation refers to a reduction in the external value of a currency in terms of other

currencies. Under it, there is no change in the internal purchasing power of the
currency. A country with fundamental disequilibrium in its balance of payments may
devalue its currency in order to increase its exports and discourage imports.

With devaluation, the domestic price of imports in the devaluating country increases
and the foreign price of its exports fall. Consequently, the exportable commodities of
the country become cheaper abroad because the foreigners can buy more goods by
paying less money than before devaluation. This encourages exports.

On the other hand, the goods which the country imports become dearer than before.
This discourages imports. Thus when exports increase and imports fall with
devaluation, the balance of payments of the country moves towards equilibrium.

EFFECT OF DEVALUATION ON EXPORTS

It is the extent of price elasticity of demand for the de valuing country's exports which
determines whether its export earnings increase, fall or remain unchanged.

1. Inelastic demand for exports: If the elasticity of foreign (U.S.) demand for
exports of the devaluing country (India) is perfectly inelastic, devaluation will
have an adverse effect on its balance of payments.

Dx = Inelastic demand for exports

Sx= Perfectly elastic supply curve for exports before devaluation
Demand and supply curve intersect at point E where exchange rate OR is determined.
OX = exports before devaluation.
After devaluation, the price of exports in terms of foreign currency ($) falls to OR1.
The supply curve for exports shifts downward to S1x and cuts the Dx curve at E1.
after devaluation, there is no effect on the value of exports, it is OX.
To measure the effect of devaluation on the balance of payments, the total value
received from exports before and after devaluation is compared. The total value of
exports before devaluation is OXER and OXER after devaluation. As is clear from the
figure, the total value of exports before devaluation (OXER) is greater than the total
value of exports after devaluation (OXE1R1): OXER > OXE1R1. It proves that
devaluation has an adverse effect on the balance of payments of the country
devaluating its currency because its export earnings have decreased.

2. Less elastic demand for exports.

The total export earnings before devaluation are greater than that after devaluation :
OXER > OX1E1R1. The total loss from export earnings is RR1DE (= OXER -
OXER). The effect on balance of payments has been adverse.

3. Elastic demand for exports.

If the foreign demand for exports is elastic or greater than unity, devaluation will
improve the balance of payments, as shown in Figure 3.
OX volume is exported before devaluation.
OX1 after devaluation.
With the fall in the exchange rate from OR to OR1, the total value of exports after
devaluation (OX1E1R1) is more than the total value of exports after devaluation
(OXER), i.e. OX1E1R1 > OXER. Thus given the perfectly elastic supply of exports,
if the demand for exports is greater than unity, devaluation has a favourable effect on
the balance of payments.

4. Unitary elastic demand for exports.

If the elasticity of demand for exports is unity, there is no effect on the balance of
payments with devaluation. This is because there is no change in the total value of
exports after devaluation.
the loss in export earnings RR1DE = the gain in export earnings XX1E1D after
devaluation.
Thus, the total value of exports before devaluation, OXER = OX1E1R1, the total
value of exports after devaluation.

EFFECT OF DEVALUATION ON IMPORTS

1. Inelastic demand for imports. Devaluation raises the price of imports in the
devaluing country which will import less goods than before. If the demand for
imports is perfectly inelastic, it cannot reduce its imports even when they have
become costlier. There will be loss instead of gain from devaluation when the
demand for imports is perfectly inelastic.

Dm= Perfectly inelastic demand curve

Sm= Perfectly elastic supply curve.
With devaluation, the supply curve shifts upwards to S1m because imports are
reduced with increase in import price from OR to OR1 . This makes the total
 value of imports (OR1E1M) after devaluation greater than the total value of
imports (OREM) before devaluation: OR1E1M > OREM.
Thus with the increase in the total value of imports after devaluation, the balance
of payments of the devaluing country has worsened with perfectly inelastic
demand for imports.

2. Less elastic demand for imports.

If the elasticity of demand for imports is less than unity, the balance of payments
worsens with devaluation.
The total value of imports (ORE1M1) after devaluation is greater than the total value
of imports (OXER) before devaluation : ORE1M1 > OREM.

3. Elastic Demand for Imports. If the elasticity of demand for imports is greater than
unity, the effect of devaluation on the balance of payments will be favourable. This is
shown in Fig. 7, where the total value of imports after devaluation
(OR1E1M1 ) is less than the total value of imports (OREM) before
devaluation : OR1E1M1 < OREM.

4. Unity Elasticity of Demand for Imports. If the elasticity of demand for imports is
equal to unity, the total value of imports before devaluation and after devaluation
remains the same and there is no effect of devaluation on the balance of payments.
The total value of imports before devaluation, OMER= OM1E1R, the total value of
imports after devaluation. The value of the Indian rupee was devalued on numerous
occasions in the past, and these actions eventually improved both the economy and
the value of the currency.

Devaluation of Indian rupee

Due to a lack of funds, the Indian government devalued the rupee in 1949, 1966,
during the war with china and Pakistan, and in 1991, during an economic downturn.

In 1991, the value of the rupee depreciated from ₹4.76 against the US dollar to ₹7.5.
Then, in 1991, India had another severe economic crisis as a result of its inability to
pay for imports and fulfill its obligations under its external debt. India was once more
on the point of default, which made it necessary to implement the urgent reforms that
opened the economy of the nation. According to reports, the Reserve Bank of India
sharply depreciated the rupee by 9% and 11%, respectively, to address the situation.
After the devaluation, the rupee's exchange rate to the US dollar was somewhere
about 26. The rupee has lost 75 % of its value in the last 75 years, going from 4
against the then-benchmark Pound sterling at the time of Independence to roughly 79
or 80 versus the US dollar today.

When the INR is devalued, foreign currencies gain value because it is incredibly
lucrative for foreign nations to import goods from India. Due to the fact that a certain
quantity of foreign money will now buy more items, foreign nations are more inclined
to purchase commodities at lower prices from India. Additionally, because Indian
exports are more accessible and typically cost less, more overseas clients choose to
purchase from India. The depreciation of the INR also enables Indian enterprises to
decrease their product pricing far more aggressively on the global market, making
them very appealing to overseas customers.

Effect of Devaluation on Economy

• Exports cheaper – Devaluation of the currency will make exports more competitive
and cheaper to foreigners.

• Imports expensive – The petrol, food and raw material will become more expensive
as more Indian rupees will have to be paid for a foreign currency. This will reduce
demand for imports.
• Improvement in current account – Current account deficit is the difference of
exports and imports. Because of devaluation the imports are decreasing and exports
are increasing. These situations reduce the current account deficit.

• Impact on common man – There would be a higher burden on the common man
because of devaluation of currency. For example – the prices of fuel, imported goods
and fees of abroad universities etc. are increased and travel to foreign countries
becomes costlier.

• Impact on infrastructure – The devaluation of rupee has negative impact on the

infrastructure sector. It increases the cost of projects by increasing the cost of raw
materials like steel, cement and price of construction equipment’s.

• Impact on agriculture – Devaluation of rupee has positive impact on agriculture.

India is world’s largest producer of wheat. So fall in the value of rupee increase the
profit of Indian wheat exporters and similarly the export of sugar, rice, cotton and
edible oil etc. are increased.

• Impact on real estate – Devaluation of currency increases the cost of projects by

increasing the prices of raw material, transportation, import of construction
equipment, wages and salary of labour etc.

• Impact on foreign investors – Foreign investors bear a loss when the value of
currency is devalued.

• Impact on Economic growth – The devaluation of rupee can only increase the short
term economic growth. But it has negative impact on the long term economic growth.
Because of devaluation, there is a loss of confidence in International and domestic
investors. Long term economic growth is affected by reduction in investment.

• Impact on Inflation – Due to devaluation, the prices of goods are increased because
of imports are more expensive and exports are cheaper. So more money is pay for the
same products for which less money is paid before devaluation. So this situation
increased inflation.

• Impact on Foreign Direct Investment – After the devaluation of currency the inflow
of foreign direct investment is increased. As we seen in table after the devaluation of
rupee in 1991 the inflow of FDI is increased from 409 crores to 64,193 crores.
FREE TRADE versus PROTECTION

Free Trade
Free trade policy refers to a trade policy without any tariffs, quantitative restrictions and other
devices obstructing the movement of goods between countries.

Prof. Jagdish Bhagwati defines free trade policy, “as absence of tariffs, quotas, exchange
restrictions, taxes and subsidies on production, factor use and consumption”.

The policy of free trade means simply complete freedom of international trade without any
restrictions on the movement of goods between countries.

If the government levies a duty of 15 per cent on all imports, all foreign goods which enjoy a
cost and trade will continue as usual. But if even a simple foreign good enjoys a cost
advantage of less than 15 per cent, it means the end free trade and import duty is for
protection and not for revenue alone. Thus a country following the free trade policy levies
import duties which are lower than the cost advantage enjoyed by the lowest cost foreign
good.

The case for free trade

1. Maximisation of output: Under free trade a country specialises in the production of

those commodities which it is relatively best suited to produce and exports them in
exchange for those imports which it can obtain more cheaply. This maximises the
output of all the participating countries because all gain from trade which, in turn,
increases the real national income of the world economy. Free trade leads to the
maximisation of output income and employment.

2. Optimum utilisation of resources: Free trade leads to international specialisation

and geographical and territorial division of labour. Each country specialises in the
production of those goods for which it has abundant supply of natural resources.
International trade and division of labour leads to optimum utilisation of resources.

3. Optimisation of consumption: It benefits the consumers when they are able to buy a
variety of commodities from abroad at the minimum possible prices.

4. High factor incomes. There is perfect mobility of factor of production. They can
move from one place to another and between countries in order to earn more. Thus
such factor incomes as wages, interests, rents and profits are high under free trade.
 There is increase in the real income of the world economy and of its participant
countries.

5. Educative Value. According to Haberler, free trade has an educative value.

International competition encourages home producers to sacrifices leisure in order to
increase productivity. For this, they innovate and bring improvements in organisation and
methods of production.

6. Wide Markets. Free trade leads to wide extent of markets for goods. As the demand
for goods is not confined to one country but to a number of countries, the entire world
becomes the market for all types of goods. This leads to the production of quality goods
at low prices because of world competition.

7. Prevents Monopolies. Free trade prevents the establishment of monopolies. Under free
trade each country specialises in the production of a few commodities, and the firms or
industries are of the optimum size so that the cost of production of each commodity is the
minimum. Thus free trade ensures a lower price for exports as well as imports and the
price mechanism under perfect competition prevents the formation of monopolies.

8. Encourages Inventions. Free competition and trade encourage nations to produce the
best and the cheapest products in order to gain more. It stimulates them to invent new
techniques and processes of production, to find new markets, new sources of raw
materials, etc.

9. Develops Transport and Communications. Free trade encourages the development of

the means of transport and communications not only within countries but also among
countries. Rail, road, sea and air transport systems expand with better and more cargo
facilities which move safely and quickly globally. The development of internet, E-Mail
and E-Commerce has been possible due to more freed trade globally.

10. Promotes International Co-operation. Free trade also promotes international co-
operation among nations. To solve bilateral and multilateral trade problems, different
countries come into contact with each other, hold trade talks with among each other.
International organisations like WTO are meant to solve trade problems and promote
international co-operation.

11. Best Policy for Economic Development. Haberler points out that “substantial free
trade with marginal, insubstantial corrections and deviations is the best policy from the
point of view of economic development.”

Defects

(a) it leads to the importation of capital goods, and raw materials;

(b) it instils new ideas, and brings technical knowhow, skills, managerial talents and
entrepreneurship to the developing countries;
(c) it facilitates the flow of foreign capital; and Lastly, it fosters healthy competition
and checks inefficient and exploitative monopolies.

The case against free trade:

1. Laissez Faire and perfect competition do not exist: Free trade presupposes the
existence of laissez-faire and the working of price mechanism under prefect
competition. But these conditions do not exist in the present day world.
Monopoly, monopsony, cartels, imperfect labour markets and tariffs led to the
abandonment of free trade.
2. One-sided development: Under the policy of free trade, some industries expand
in which the country possesses comparative advantage but other industries are not
developed. An agricultural country may develop only agriculture and neglect the
industrial sector.

3. Production of inferior and harmful goods: There being no restrictions on the

movement of goods under free trade, substandard and harmful commodities are likely
to be produced and traded. This leads to diminution of social welfare. Trade
restrictions on the import of such commodities become necessary.

4. Cut-throat Competition and Dumping. Countries with better factor endowments

are able to produce certain commodities cheaper than others. This led to cut-throat
competition in the world market under free trade. So certain countries like Japan
resorted to the policy of dumping whereby they would sell huge quantities of their
products at rock-bottom prices in the foreign markets. Naturally, this policy led to the
imposition of trade restrictions.

5. Emergence of Multinational Corporations and Monopolies. Free trade leads to

the emergence of international monopolies and local monopolies, according to
Haberler. Such monopolies developed with the spread of multinational corporation
under free trade which proved harmful to the other countries and the domestic
interests. This factor also led to the adoption of the policy of protection.

6. Exploitation and Colonisation of Countries. Economists do not agree with

Haberler that the free trade policy helps in the development of under-developed
countries. Rather, this policy led tothe exploitation and colonisation of countries
during the 19th and early 20th centuries.

7. Economic Dependence. Free trade leads to economic dependence which is

harmful for a backward country. Such a country has to depend on the imports of
varied types of consumers and capital goods, raw materials, etc.on developed
countries both in war and peace.

8. Trade Cycles. Free trade leads to international business fluctuations. Booms and
depressions spread among countries. But the danger of depression is more as was the
case of the Great Depression of the 1930s. Depression in America spread to the whole
world, except Russia which was a closed economy at that time.
PROTECTION

Protection refers to a policy whereby domestic industries are to be protected from

foreign competition.
The aim is to impose restrictions on the imports of low-priced products in order to
encourage domestic industries, may be protected by imposing import duties which
raise the price of foreign goods by more than the price of domestic goods.

CASE FOR PROTECTION

1. Terms of trade argument: It is argued that the imposition of a tariff on imports

improves the rate at which the country’s exports are exchanged for imports. This
means that a tariff improves its terms of trade because the foreign exporter is
forced to pay some part of the import duty. The extent to which a country can
improve its terms of trade by imposing import duty will depend upon the relative
demand and supply elasticities at home and abroad.
Large quantity importing country- less elastic demand , improved terms of trade
than those who imports small quantity.
-There are certain adverse effects on the tariff imposing country.

A. The term of trade may improve but the volume to trade of the tariff-imposing
country is reduced.
B. The imposition of tariff increases the price of the imported commodity to the
domestic consumer.
C. It may lead to retaliation by the other country. Thus too high a tariff leads to
reduction in consumers ‘satisfaction, malallocation of domestic resources with
the reduction in the volume of trade, and retaliatory tariffs harm the economies
of both the countries.

2. Bargaining or retaliation arguments: It is argued that the imposition of tariffs is

necessary to bargain in trade negotiations with other countries. Since international
trade is based on reciprocal basis, tariff is used as a weapon to persuade or
dissuade the other country to lower its tariff wall. Thus the fear of retaliation may
induce countries to give reciprocal concessions to each other.

3. Anti-dumping argument: Dumping means selling a product in a foreign market

at a lower price than in the home market, after taking into account transport and
other costs of transfer. Dumping aims at flooding a foreign market with low-
priced commodities.

4. Diversification argument: It means that there should be a balanced growth of the

economy so that all the sectors of the economy develop side by side. For this
purpose, agriculture and manufacturing industries should be protected from
 foreign competition.

5. Infant industry argument: oldest and the most accepted argument for protection.
It was formulated by Alexander Hamilton in 1790 and was popularised by
Friedrich List in 1885.
Protection is also needed to facilitate the flow of resources into infant industries,
even though consumers have to bear the burden of higher prices temporarily.
Further, there may be “imperfection of the information flow” to infant industries
in the form of difficulty to borrow funds for investment, knowledge of
infrastructure facilities, labour market,etc. All these require government protection
to such industries.
The economic justification lies in that social benefit exceed private benefits from
investment in such industries. It means that the protection should be given to those
infant industries which generate large externalities than other industries not given
protection.
The case for infant industry protection is based on the argument that when a new
industry is started, it cannot reap the economies of scale and its cost of production
is high as compared with its foreign competitors. But if it is protected by
providing all types of facilities, such as subsidies, heavy import duties on foreign
goods. etc . it may expand and enjoy internal economies of scale. It may, in turn,
lead to external economies for all firms within the industry in the form of lower
costs of production through the availability of trained labour force, advance
production techniques, research facilities, etc. If infant industry protection is given
to several industries simultaneously, several external economies accrue in the
form of road, railway, power, technical and research facilities, etc. Moreover,
protection to infant industry, leads to its expansion and a lowering of costs an
prices which, in turn, benefits industries using the products of the protected
industry. But protection results in lowering of welfare because a tariff increases
production and consumption costs in the economy. Therefore, to increase social
welfare, the infant industry must be protected and pass what is called Mill’s test.
This test requires that it should be protected temporarily and must grow up and be
able to compete on equal terms at world market prices with foreign producers in
domestic and world markets. For protection to be profitable, it should be able to
pay back the losses incurred due to protection during the infancy period. After
that, protection should be withdrawn. But Bastable suggested another test called
Bastable’s test which an infant industry must also pass. This test requires that
the infant industry must be able to cover the costs of protection during its infancy
by lowering production costs.

Criticisms of infant industry argument:

i. Difficult Decision. It is difficult to decide which industry needs

protection because every industry is in its infancy to begin with. In
fact, it is difficult to select genuine infant industries because it
 requires “forecasting the potential cost structure of an industry, and
its established competition.”
ii. Lack of Reliable Criteria. Protection is given to an infant industry
with the promise that it would be withdrawn after a few years when
the industry attains adulthood and is able to face foreign competition.
But it is difficult to decide about this due to the lack of any reliable
criteria.
iii. Vested Interests. Once protection is granted to an industry,
vested interests are created which do not want the removal of duties.
Thus as pointed out by Haberler, “temporary infant-industry duties
are transformed into permanent duties to preserve the industries
they protect.”
iv. Difficult to Remove Duties. Even if a part of the industry is able
to stand upon its feet, a number of less efficient concerns are
established behind the shelter of tariffs which make it difficult to
remove the duties.
v. Monopoly Profits. Some of the industrialists who start making
monopoly profits under protection do not want the removal of duties.
They, therefore, bribe the legislators and corrupt the general politics
of the country.
vi. External Economies do not exist. Haberler does not agree with
the view that the development of infant industries leads to internal
and external economies of production. He has shown that alleged
possibilities of external economies under infant industry protection
are vague, muddled and doubtful “so that arguments for tariffs based
upon them belong to curiosa of theory rather than to a practical
economy theory.

6. Sunset industries argument: This argument implies that sun is setting on such
mature industries of Europe which should be granted temporary protection so that
they may be able “to re-equip and regain competitiveness”. In the absence of
protection, it will lead to displacement of labour and capital in such industries.
This has actually led to the imposition of import tariffs on textiles, clothing,
footwear and such products in the European Countries.

7. Socially important industries argument: Protection should be given to socially

important industries such as agriculture or strategically important industries as
iron and steel, heavy electricals, machine making, heavy chemicals, etc.

8. Employment argument: The imposition of a tariff reduces imports and

encourages employment directly in import competing industries. This, in turn,
generates employment in other industries dependent upon this import-competing
industry and may even spread to import-substitution industries.
9. Balance of payments arguments. Tariffs help in restricting the imports of
unnecessary goods and try to reduce the balance of payments deficit. They assist
in conserving foreign exchange which can be used for importing essential goods
and services for import-substitution industries and for the export sector. The
expansion of the import-substitution and export sectors, in turn, raises
employment and income in the country. And the increase in income increases
savings and the supply of loanable funds which reduce the interest rate and
encourage investment.

10. Factor income redistribution argument: There is a large labour-intensive sector

with low incomes and a small capital-intensive sector with high incomes. The
latter sector is mainly dependent on imports. It is argued that the imposition of
tariffs on the imports of this sector will encourage the production of the labour-
intensive sector where real incomes will rise. Factors of production will move
from the former to the latter sector in the long run.

11. Revenue argument: Tariffs are levied to generate revenue for the government
and to protect domestic industries from foreign competition. In LDCs, revenue
collection is considered the main objective of import and export tariffs.
In LDCs, revenue collection is considered the main objective of import and export
tariffs. This is not a correct view because raising revenue is a by-product of
protection to domestic industries. However, if such governments depend more on
tariffs as a source of revenue, it may lead to some negative side-effects. If the
demand for imported goods is fairly inelastic, tariffs may bring more revenue. On
the contrary, in the case of highly elastic demand, tariffs may stop trade altogether
and reduce the government revenue. Similarly, taxes (duties) on exports reduce
the sales of exports and foreign earnings, thereby creating balance of payments
difficulties. Despite these demerits, LDCs prefer tariffs for raising revenue
because they are easy to levy and less expensive to collect than other direct and
indirect taxes. But the tariff rates should not be so high as to become prohibitive
and harmful for the country. So far as the burden of import tariffs on domestic
importers and foreign exporters is concerned, it depends on the price elasticities of
demand and supply for the goods. If the demand for imports is relatively elastic
and the supply exports are relatively inelastic, the main burden of the tariffs will
fall on the foreign exporters. In case the demand for imports is relatively inelastic
and the supply of exports is relatively elastic, the major burden will be borne by
the domestic importers.

12. Strategic trade policy argument: The strategic trade policy argument is based on
the development of high-technology industries in developed countries which need
protection against foreign competition.
13. Conservation of national resources argument. Conservation of National
Resources Argument. Countries which export minerals and raw materials always
fear that there exports would ultimately exhaust them.
14. Conservation of national resources argument. Conservation of National
Resources Argument. Countries which export minerals and raw materials always
fear that thereexports would ultimately exhaust them.

Non- Economic arguments

1. Defence Argument. A country should adopt the policy of protecting it
industries from the standpoint of national defence. If a country is dependent o
other countries for its requirements of agricultural and industrial products, it will
be very harmful for its national interest in times of war. The argument runs that it
is no use amassing wealth and becoming richer, if the country is not in a
position to defend its freedom. As aptly put by Adam Smith, “Defence is better
than opulence.” Therefore, a country should be self-sufficient as far as possible
even if it involves an economic loss in the production of certain commodities,
which are needed for national defence. In particular, protection for national
defence refers to self-sufficiency in arms and ammunitions and other related
industries. But complete self-sufficiency as an argument for national defence does
not carry much force for it will lead to inefficiency in domestic industries and loss
of the gains from international trade. Thus industries which are directly ad
indirectly needed for the manufacture of arms and ammunitions and other war
materials should be developed under protection.

2. Preservation Argument. Protection is advocated to preserve the special ethos

of the nation and certain classes of the population or certain occupations. It is
argued that these would tend to disappear under free trade and their preservation is
desired on political and social grounds. This argument is put forth to safeguard the
interests of the agriculturists. The imposition of agricultural duties on import of
farm products is beneficial for the farmers who would be assured fair prices for
their products. They would thus become prosperous. The prosperity of the
peasantry is essential for it forms the backbone of every nation. As pointed out by
Haberler “Agriculture is the wellspring from which the human race is physically
and mentally regenerated. Therefore, agriculture should be protected from foreign
competition at all costs to preserve the special ethos of the nation.”

3. Patriotism or Nationalism Argument. To arouse patriotism or nationalism

among the people, imports of foreign goods are restricted through high import
duties so that they consume the goods manufactured within the country. This is
what Gandhiji advocated in his swadeshi movements. For the success of such a
policy, it is essential that goods produced within the country should be of high
quality and available in sufficient quantities.