SELF-LEARNING MATERIAL

INTERNATIONAL ECONOMICS

MODULE – 1: INTRODUCTION AND INTERNATIONAL TRADE THEORY 9L

Globalisation of World Economy – Introduction to International Finance – International Trade

Theory – Mercantilism – Absolute Advantage – Law of Comparative Advantage – Standard Theory
of International Trade – Demand and Supply, Offer Curves, and Terms of Trade – Factor CO-1
Endowments and Heckscher-Ohlin Theory – Factor-Price Equalisation and Income Distribution – BTL-1
Economies of Scale, Imperfect Competition, and International Trade – Economic Growth and
International Trade – Rybczynski Theorem – Small country and Large country cases

MODULE – 2: INTERNATIONAL TRADE POLICY 9L

Trade Restrictions: Tariffs – Partial Equilibrium Analysis of a Tariff – Theory of Tariff Structure –
Tariffs in Large and Small Countries – Optimum Tariff – Nontariff Trade Barriers – New
Protectionism – Cartels and Dumping – GATT and WTO – Multilateral Trade Negotiations – CO-2
Economic Integration: Customs Unions and Free Trade Areas – European Union – International BTL-2
Trade and Economic Development – International Resource Movements and Multinational
Corporations

MODULE – 3: BALANCE OF PAYMENTS, FOREIGN EXCHANGE MARKETS AND RATES 9L

Balance of Payments – Balance of Trade – Foreign Exchange Markets – Foreign Exchange Rates –
Spot and Forward Rates – Currency Swaps, Futures, and Options – Foreign Exchange Risks,
Hedging, Speculation – Interest Arbitrage: Case of Carry Trade – Eurocurrency and Offshore CO-3
Markets – Exchange Rate Determination – Purchasing-Power Parity Theory – Monetary Approach BTL-3
to Balance of Payments and Exchange Rates – Portfolio Balance Model and Exchange Rates –
Exchange Rate Dynamics

MODULE – 4: OPEN ECONOMY MACROECONOMICS 9L

Price Adjustment Mechanism with Flexible and Fixed Exchange Rates – Effect of Exchange Rate
on Domestic Prices and Terms of Trade – Stability of Foreign Exchange Markets – Elasticities in
Real World – Adjustments under Gold Standard – Income Adjustment Mechanism and Synthesis CO-4
of Automatic Adjustments – Adjustment Policies – Policy Mix and Price Changes – Direct
Controls – Prices and Output in Open Economy – Flexible vs. Fixed Exchange Rates – Impossible BTL-2
Trinity – Optimum Currency Areas, EMS, EMU – Currency Boards – Dollarisation – Exchange
Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Float – International Coordination

MODULE – 5: INTERNATIONAL MONETARY SYSTEM

9L

Gold Standard and Interwar Experience – Bretton Woods System: Evolution, Operation and
Collapse – Present System – Role of IMF – Problems with present Exchange Rate Arrangements – CO-5
Proposals for Reform – Financial Stability Issues in Advanced and Emerging Markets – Other
BTL-2
Current International Economic Problems – Case studies
REFERENCE BOOKS

1.
Dominick Salvatore, (2014), International Economics: Trade and Finance, Wiley Student Edition, 11th edition.
 MODULE- 1

What is international trade?

International trade is the process of exchange of goods and services between
countries. This includes both imports and exports and via any mode of transportation – air
and ocean freight. Import and export together fuel economic interactions and growth between
countries.
Export: Process of selling goods and services to other countries.
Import: Process of buying goods and services from other countries.

Importance of International trade

1. Make use of abundant raw materials
Some countries are naturally abundant in raw materials – oil (Qatar), metals, fish
(Iceland), Congo (diamonds) Butter (New Zealand). Without trade, these countries would not
benefit from the natural endowments of raw materials.
A theoretical model for this was developed by Eli Heckscher and Bertil Ohlin. Known as the
Heckscher–Ohlin model (H–O model) it states countries will specialise in producing and
exports goods which use abundant local factor endowments. Countries will import those
goods, where resources are scarce.
2. Comparative advantage
The theory of comparative advantage states that countries should specialise in those
goods where they have a relatively lower opportunity cost. Even if one country can produce
two goods at a lower absolute cost – doesn’t mean they should produce everything. India,
with lower labour costs, may have a comparative advantage in labour-intensive production
(e.g., call centres, clothing manufacture). Therefore, it would be efficient for India to export
these services and goods. While an economy like the UK may have a comparative advantage
in education and video game production. Trade allows countries to specialise. More details
on how comparative advantage can increase economic welfare. The theory of comparative
advantage has limitations, but it explains at least some aspects of international trade.
3. Greater choice for consumers
New trade theory places less emphasis on comparative advantage and relative input
costs. New trade theory states that in the real world, a driving factor behind the trade is giving
consumers greater choice of differentiated products. We import BMW cars from Germany,
not because they are the cheapest but because of the quality and brand image. Regarding
music and film, trade enables the widest choice of music and film to appeal to different tastes.
When the Beatles went on tour to the US in the 1960s, it was exporting British music –
relative labour costs were unimportant.
Perhaps the best example is with goods like clothing. Some clothing (e.g., value
clothes from Primark – price is very important and they are likely to be imported from low-
labour cost countries like Bangladesh. However, we also import fashion labels Gucci (Italy)
Chanel (France). Here consumers are benefitting from choice, rather than the lowest price.
Economists argue that international trade often fits the model of monopolistic competition. In
this model, the important aspect is brand differentiation. For many goods, we want to buy
goods with strong brands and reputations. e.g., the popularity of Coca-Cola, Nike, Addidas,
McDonalds etc.
4. Specialisation and economies of scale – greater efficiency
Another aspect of new trade theory is that it doesn’t really matter what countries
specialise in, the important thing is to pursue specialisation and this enables companies to
benefit from economies of scale which outweigh most other factors. Sometimes, countries
may specialise in particular industries for no over-riding reason – it may just be a historical
accident. But that specialisation enables improved efficiency. For high value-added products,
multinationals often split the production process into a global production system. For
example, Apple designs their computers in the US but contract the production to Asian
factories. Trade enables a product to have multiple country sources. With car production, the
productive process is often even more global with engines, tyres, design and marketing all
potentially coming from different countries.
5. Service sector trade
Trade tends to conjure images of physical goods import bananas, export cars. But
increasingly the service sector economy means more trade is of invisibles – services, such as
insurance, IT services and banking. Even in making this website, I sometimes outsource IT
services to developers in other countries. It may be for jobs as small as $50. Furthermore, I
may export a revision guide for £7.49 to countries all around the world. A global economy
with modern communications enables many micro trades, which wouldn’t have been as
possible in a pre-internet age.

Inter - regional and International Trade

Inter-regional trade or internal trade refers to the transaction of goods and services
between two regions within the geographical boundary of a country. International trade
means transaction of goods and services among different countries of the world.

DIFFERENCE BETWEEN INTERNAL VS INTERNATIONAL TRADE

1. Factor Immobility
The classical economists advocated a separate theory of international trade on the
ground that factors of production are freely mobile within each region as between places and
occupations and immobile between countries entering into international trade. Thus, labour
and capital are regarded as immobile between countries while they are perfectly mobile
within a country. There is complete adjustment to wage differences and factor-price
disparities within a country with quick and easy movement of labour and other factors from
low return to high sectors. But no such movements are possible internationally. Price changes
lead to movement of goods between countries rather than factors.
The reasons for international immobility of labor are-difference in languages,
customs, occupational skills, unwillingness to leave familiar surroundings, and family ties,
the high travelling expenses to the foreign country, and restrictions imposed by the foreign
country on labor immigration. The international mobility of capital is restricted not by
transport costs but by the difficulties of legal redress, political uncertainty, ignorance of the
prospects of investment in a foreign country, imperfections of the banking system, instability
of foreign currencies, mistrust of the foreigners, etc. Thus, widespread legal and other
restrictions exist in the movement of labour and capital between countries. But such problems
do not arise in the case of inter-regional trade.
2. Differences in Natural Resources
Different countries are endowed with d1fferent types of natural resources. Hence,
they tend to specialize in production of those commodities in which they are richly endowed
and trade them with others where such resources are scarce. In Australia, land is in
abundance but labour and capital are relatively scarce. On the contrary, capital is relatively
abundant and cheap in England while land is scarce and-dear there. Thus, 3 commodities
requiring more capital, such as manufactures, can be produced in England; while such
commodities as wool, mutton, wheat, etc. requiring more land can be produced m Australia.
Thus, both countries can trade each other's commodities on the basis of comparative cost
differences in the production of different commodities.
3. Geographical and Climatic Differences
Every country cannot produce all the commodities due to geographical and climatic
conditions, except at possibly prohibitive costs. For instance, Brazil has favorable climate
geographical conditions for the production of coffee; Bangladesh for jute; Cuba for beet
sugar; etc.
So, countries having climatic and geographical advantages specialize in the
production of particular commodities and trade them with others.
4. Different Markets
International markets are separated by difference in languages, usages, tastes, fashions
etc. Even the systems of weights and measures and pattern and styles in machinery and
equipment differ from country to country. For instance, British railway engines and freight
cars are basically different from those in France or in the United States. Thus, goods which
may be traded within regions may not be sold in other countries. That is why, in great many
cases, products to be sold in foreign countries are especially designed to confirm to the
national characteristics of that country. Similarly, in India right-hand drive cars are used
whereas in Europe and America left-hand driven cars are used.
5. Mobility of Goods
There is also the difference in the mobility of goods between inter-regional and
international markets. The mobility of goods within a country is restricted by only
geographical distances and transportation costs. But there are many tariff and non-tariff
barriers on the movement of goods between countries. Besides export 4 and import duties,
there. are quotas, VES, exchange controls, export subsidies, dumping, etc. which restrict the
mobility of goods at international plane.
6.Different Currencies
The principal difference between inter-regional and international trade lies m use of
different currencies in foreign trade, but the same currency in domestic trade. Rupee is
accepted throughout India from the North to the South and from the East to the west, but if
we cross over to Nepal or Pakistan, we must convert our rupee into their rupee to buy goods
and services there. It is not the differences in currencies alone that are important in
international trade, but changes in their relative values. Every time a change occurs in the
value of one currency in another, a number of economic problems arise. "Calculation and
execution of monetary exchange transactions incidental to international trading constitute
costs and risks of a kind that are not ordinarily in domestic trade.
Further, currencies of some countries like the Arnerican dollar, the British pound the
Euro and Japanese yen are more widely used in international trade actions, while othersers
are almost inconvertible. Such tendencies tend to create more economic problems at hte
international plane. Moreover, different countries follow different monetary and foreign
exchange policies which affect the supply of exports or the demand for imports. It is this
difference in policies rather than the existence of different national currencies which
distinguishes foreign trade from domestic trade," according to Kindleberger.
7. Problems of Balance of Payments
Another important point which distinguishes international trade from inter-regional
trade is the problem of balance of payments. The problem of balance of payments is perpetual
in international trade while regions within a country have no such problem. This is because
these is greater mobility of capital within regions 5 than between countries. Further, the
policies which a country chooses to correct its disequilibrium in the balance of payments may
give rise to a number of other problems. If it adopts deflation or devaluation or restrictions on
imports or the movement of currency, they create further problems. But such problems do not
arise in the case of inter-regional trade.
8. Different Transport Costs
Trade between countries involves high transport costs as against inter-regionally
within a country because of geographical distances between different countries.
9. Different Political Groups
A significant distinction between inter-regional and international trade is that all
regions within a country belong to one political unit while different countries have different
political units. Inter-regional trade is among people belonging to the same country even
though they may differ on the basis of castes, creeds, religions, tastes or customs. They have
a sense of belonging to one nation and their loyalty to the region is secondary. The
government is also interested more in the welfare of its nationals belonging to different
regions. But in international trade there is no cohension among nations and every country
trade with other countries in its own interests and often to the detriment of others. As
remarked by friedrich List, "Domestic trade is among us, international trade is between us
and them."
10. Different National Policies
Another difference between inter-regional and international trade arises from the fact
that policies relating to commerce, trade, taxation, etc. are the same within a country. But in
international trade there are artificial barriers in the form of quotas, import duties, tariffs,
exchange controls, etc. on the movement of goods and services from one country to another.
Sometimes, restrictions are more subtle. They take the form of elaborate custom procedures,
packing requirements, etc. Such restrictions are not found minter-regional 6 trade to impede
the flow of goods between regions. Under these circumstances, the internal economic policies
relating to taxation, commerce, money, incomes, etc. would be different from what they
would be under a policy of free trade.

Adam Smith’s theory of absolute cost advantage

Adam Smith’s theory of absolute cost advantage in international trade was
evolved as a strong reaction of the restrictive and protectionist mercantilist views on
international trade. He upheld in this theory the necessity of free trade as the only sound
guarantees for progressive expansion of trade and increased prosperity of nations. The
free trade, according to Smith, promotes international division of labour.
Every country tends to specialize in the production of that commodity which it
can produce most cheaply. Undoubtedly, the slogans of self- reliance and protectionism
have been raised from time to time, but the self-reliance has eluded all the countries even
up to the recent times. The free and unfettered international trade can make the countries
specialise in the production and exchange of such commodities in case of which they
command some absolute advantage, when compared with the other countries.
In this context, Adam Smith writes; “Whether the advantage which one country
has over another, be natural or acquired is in this respect of no consequence. As long as
one country has those advantages, and the other wants them, it will always be more
advantageous for the latter, rather to buy of the former than to make.”
 When countries specialise on the basis of absolute advantage in costs, they stand
to gain through international trade, just as a tailor does not make his own shoes and
shoemaker does not stitch his own suit and both gain by exchanging shoes and suits.
Suppose there are two countries A and B and they produce two commodities X
and Y. The cost of producing these commodities is measured in terms of labour involved
in their production. If each country has at its disposal 2 man-days and 1 man-day is
devoted to the production of each of the two commodities, the respective production in
two countries can be shown through the hypothetical Table 2.1.

In country A, I man-day of labour can produce 20 units of X but 10 units of Y. In

country B, on the other hand. I man-day of labour can produce 10 units of X but 20 units
of Y. It signifies that country A has an absolute advantage in producing X while country
B enjoys absolute advantage in producing commodity Y. Country A may be willing to
give up 1 unit of X for having 0.5 unit of Y. At the same time, the country B may be
willing to give up 2 units of Y to have I unit of X. If country A specialises in the
production and export of commodity X and country B specialises in the production and
export of commodity Y. both the countries stand to gain.
The absolute cost advantage of country A in the production of X and that of B in the
production of Y can also be expressed as below:

It is possible to explain the cost difference in two countries A and B concerning the
commodities X and Y geometrically through Fig. 2.1.
 In Fig. 2.1, AA 1 is the production possibility curve of country A. Given the
techniques and factor endowments, if all the resources are employed in the production of
X commodity, it can produce OA 1 quantity of X. On the contrary, if all resources are
used in the production of Y, country A can produce OA quantity of Y. BB 1 is the
production possibility curve of country B.
In case of this country, if all resources are employed in the production of X
commodity, OB 1 quantity can be produced. Alternatively, if all the resources are used in
the production of Y, it is possible to produce OB quantity of Y. The slope of production
possibility curve is measured by the ratio of labour productivity in X to labour
productivity in Y in each country.
Slope of AA1 = LXA/LYA
Slope of BB 1 = LXB/LYB
Since slope of AA 1 is less than the slope of BB 1, it signifies that country A has absolute
cost advantage in the production of X commodity, while country B has the absolute cost
advantage in the production of Y commodity.
Adam Smith also emphasised that specialisation on the basis of absolute cost advantage
would lead to maximisation of world production. The gains from trade for the two
trading countries can be shown through Table 2.2.

Before trade, Country A produces 20 units of X and 10 units of Y. After trade, as

it specialises in the production of X commodity, the total output of 40 units of X is
turned out by A and it produces no unit of Y. Country B produces 10 units of X and 20
units of Y before trade. After trade it specialises in Y and produces 40 units of Y and no
unit of X. The gain is production of X and Y commodity each is of 10 units. The gain
from trade for country A is +20 units of X and -10 units of Y so that net gain to it from
trade is +10 units of X. Similarly net gain to country B is +10 units of Y.
An interesting aspect of Smith’s analysis of trade has been his ‘Vent for Surplus’
doctrine. According to him, the surplus of production in a country over what can be
absorbed in the domestic market can be disposed of in the foreign markets. It was
basically this desire that led Mercantilists and subsequent theorists to place much
emphasis on the international trade.
The ‘Vent for Surplus’ doctrine implies that the international specialisation is not
reversible and that it is an integral part of the development process in any country. In
addition, this doctrine implies that the foreign trade results in the fullest utilisation of the
idle productive capacity that is likely to exist in the absence of trade. This implication
makes a clear departure from the assumption held in the comparative cost approach that
the resources are fully employed even before trade. What trade does is to bring about a
more efficient allocation of them.
Criticisms
Adam Smith, no doubt, provided a quite lucid explanation of the principle of
absolute cost advantage as the basis of international transactions, yet his theory has
certain weaknesses.
Firstly, this theory assumes that each exporting country has an absolute cast
advantage in the production of a specific commodity. This assumption may not hold true,
when a country has no specific line of production in which it has an absolute superiority.
In this context Ellsworth says “Smith’s argument is not very convincing as it
assumed without argument that international trade required a producer of exports to have
an absolute advantage, that is, an exporting country must be able to produce with a given
amount of capital and labour a larger output than any rival. But what if a country has no
line of production in which it was clearly superior.”
Most of the backward countries with inefficient labour and machinery may not be
enjoying absolute advantage in any line of activity. So, the principle of absolute cost
advantage cannot provide complete and satisfactory explanation of the basis on which
trade proceeds among the different countries.
Secondly, Adam Smith simply indicated the fundamental basis on which
international trade rests. The absolute cost advantage had failed to explore in any
comprehensive manner the factors influencing trade between two or more countries.
Thirdly, the ‘Vent for Surplus’ doctrine of Adam Smith is not completely
satisfactory. This doctrine can have serious adverse repercussions on the growth process
of the backward countries. These countries do not sell their surplus produce in foreign
markets but are constrained to export despite domestic shortages for the reasons of
neutralising their balance of payments deficit.
A more detailed and satisfactory explanation concerning the basis of international
trade has been provided by David Ricardo and J.S. Mill.
Recardo’s Theory of International Trade:
Comparative Cost Advantage theory

Comparative Cost Advantage Theory

The Comparative Cost Advantage Theory of Trade was developed by British political
economist, David Ricardo in his book “The Principles of Political Economy and Taxation”
published in 1817. According to Comparative Advantage Theory, a country has a
comparative advantage if it can produce a good at a lower opportunity cost than another
country. A lower opportunity cost means it has to forego less of other goods in order to
produce it.
Assumptions of the Theory
The theory of comparative cost advantage is based on several assumptions:
(a) Trade takes place between two countries only, say England and Portugal.
(b) They are trading with only two commodities, say, Cloth and Wine.
(c) The cost of production of these two goods in both the countries is expressed in
terms of labour only.
(d) The production of these two goods in both the countries taken place at constant
costs.
(e) There is no transport cost, or the transport cost, if any, is so small a part of product
prices that it is ignored.
Given the above assumptions, the theory of comparative Cost Advantage can be
explained with the following table as below:

The above Table showsthat the US has an absolute advantage in producing clothing
(5>4) and also aeroplanes(12>1). Brazil does not have an absolute advantage in anything.
However, that doesn’t mean the US should be the only producer. We should look at
comparative advantage based on opportunity cost.
 The above opportunity cost table shows that, the US has a comparative advantage in
producing aeroplanes. This is because the opportunity cost of producing aeroplanes
(5/12=0.41) is lower than that of Cloth (12/5=2.4) in US. Therefore, US should specialise in
producing aeroplanes even though it has absolute advantage in both cloth and aeroplanes.
In contrast, Brazil has a comparative advantage in producing Cloth. Brazil produces
clothing, the opportunity cost is 1/5 = 0.25 aeroplanes as the one shown in above table. This
is because the opportunity cost of producing cloth (¼=0.25) is lower than that of aeroplanes
(4/1=4) in Brazil. Therefore, Brazil should specialise in producing clothing even though it
doesn’t have an absolute advantage.
Therefore, we conclude that based on comparative cost advantage analysis, both US
and Brazil will be benefited by trading each other.
Criticisms of the Theory
As with many other economic ideas there are criticisms to be levelled at comparative
cost advantage theory:
(i) It is much more complicated in the real world in deciding in which goods countries
have a comparative cost advantage. This is so because there are a large number of goods and
many countries.
(ii) The theory ignores the effects of transport costs. However, once transport costs
are added any comparative advantage may be lost.
(iii) Modern theories, no longer based on Ricardo’s labour theory, have established
that the only necessary condition for the possibility of gains from trade is that price ratios
should differ between countries.
(iv) Ricardo ignored the role of demand completely and explained trade from supply
side.
(v) Ricardo’s analysis is based on the labour theory of value as costs are expressed in
terms of labour hours. However, the classical labour theory itself has lost its relevance.
(vi) The theory applied their principle in case of trade with two countries only and
with two commodities only.
 So, the principle has a limited scope of application in practice. It cannot explain multi-
lateral trade.
Heckscher-Ohlin’s Factor Endowment Theory
Heckscher-Ohlin’s Factor Endowment Theory also called Heckscher-Ohlin Model, H-
O Model, Factor Endowment Theory, and Factor Proportion Theory is an economic as well
as international trade theory that states that a nation should produce and export products for
which factors of production the country is rich.
Factor endowment refers to the richness, abundance, and easy availability of factors of
production (namely land, labour, and capital) to the country. This theory argues that a country
that has relatively large labour forces should concentrate on production through labour-
intensive means. And, a country that has relatively more capital should go for production
through capital-intensive means.
Swedish economists, Eli Heckscher in 1919 and Bertil Ohlin in 1933 put forward
different explanations of Ricardo’s comparative cost advantage theory. So, called the H-O
Model. The H-O model explains what causes differences in the comparative cost of different
countries.
The theory holds that factors in relative abundance are cheaper than factors in
relative scarcity. It explains the basis of international trade in terms of factor endowments.
Factor endowment refers to how many factors of production a country has been endowed
with by Mother Nature.
If labour, for example, were abundant in comparison to land and capital, labor costs
would be low relative to land and capital costs (i.e., rent and interests respectively). If labour
were scarce, labour costs would obviously be high against land and capital costs. These
relative factors costs would lead countries to excel (do better) in the production and also
exports, which have used their cheaper, abundant factors of production.
According to the H-O model, “variances in the supply of production components
produce international and interregional differences in production cost.” Comparative
advantage originates from variations in national factor endowments, according to Heckscher
and Ohlin, and while free trade is advantageous, the pattern of trade is regulated by
differences in factor endowments rather than productivity disparities.
According to factor endowment, countries export products requiring large amounts of
their abundant production factors and import products requiring large amounts of their scarce
production factors.
 By this H-O model, trade or international trade takes place because production costs
occur due to the differences in the supply of production factors. For example, China, India,
Nepal, Bangladesh, etc. can export labor-oriented products because labor resources are
abundant in these countries.
Countries like Japan, the USA, the UK, and Germany are exporting capital-oriented
products like machinery, high-value equipment, etc. as they pose the abundant (endowment)
of having high capital investment required for technology and other facilities.
Assumptions of the H-O Model
The main assumptions of the H-O model can be mentioned below.
 Different goods have different factor intensities – for example, textile and clothing are labor-
intensive goods and a semi-conductor is a capital-intensive product.
 Countries differ with respect to their factor endowments – for example, Nepal has an
abundant supply of labor goods relative to capital, whereas the USA has an abundant supply
of capital goods relative to labor.
 Two countries, two goods, and two factors of production.
 Perfect competition in commodities and factor markets.
 Constant returns to factors.
 Given technology is universally available.
 There are no transport costs, insurance premiums, or exchanges.
 No control of trade and exchange rates.
 Factors immobility between countries and factors endowments.
 Demand conditions are fixed.
Criticisms of Factor Endowment Theory
Factor endowment theory of international trade may be criticized in the following
points.
1. Static Nature of Inputs is Wrong
In terms of new technologies, the H-O model assumes a constant supply of factor
endowments. New technologies and breakthroughs, on the other hand, can be used to produce
endowments.
Superior technology and abilities that lower the cost of production could also be
drivers of trade. A practical and high-quality educational system can also improve the quality
of human resources.
2. Wrong Assumption of Homogeneous Products and Consumers’ Taste
For theory, factor endowment homogeneous products and the same tastes were the
assumptions. The difference in taste is also a basis of trade, where even the price factor is
neglected.
In the case of some products transportation charges, handling costs and tariffs
together are higher than the cost of the product itself. However, people are ready to pay such
costs because of taste preferences.
For example, Swiss Cottage Cheese, French wines and perfumes, German beer, etc.
are preferred in many parts of the world, and trades on these products take place not because
of price factors but because of differences in tastes.
3. Assumption of Non-Existence of Money and Absence of Transportation Costs
This theory assumes there is no existence of money and transportation costs. With the
introduction of money, traders could know if it was profitable to buy locally or to import by
the means of exchange rates, converting foreign currency to home currency.
Therefore, with the introduction of money and exchange rate traders could judge the
profitability.
4. Other Factors are Avoided
Economies of scale and the experience curve also affect international trade as these
permit a nation’s industry to become a low-cost producer without having an abundance of
certain factors.
When a plant grows, output increases and unit production cost decrease the fact that –
large and efficient equipment is used, it gets volume discounts on bulk procurement of inputs,
R&D and overhead cost decrease, and it also learns the technique to decrease the cost.
5. The Leontief Paradox
In short, the Leontief paradox means the actions against the principle of factor
endowment theory. As this theory states a nation’s abundance of labor should export labor-
intensive products and import capital-intensive ones. And, a nation’s abundance in capital
factors should export capital-intensive goods and import labor-intensive ones. But the
Leontief paradox is the just opposite of it.
Wassily Leontief, the US Economist, criticized the H-O Model when his study was
completed in 1953. It was well believed that the US has a relatively abundant capital supply
compared to labor in other countries. And the US would be an exporter of capital-intensive
goods and an importer of labor-intensive goods.
 He found the cases where the US was exporting highly labor and skill intensive
products in exchange for capital intensive products also. Therefore, the finding was at
variance with the philosophy of the H-O Model, and his finding was named “The Lenotief
Paradox”.
Because of the strong incentives for R&D developed countries like the US, Germany,
and Japan produced many innovative consumer products and also cost-saving processes.
They also exported many products all over the world. The majority of export products were
not capital-intensive products. On the other hand, these developed countries also imported or
exchanged many capital-intensive items like machinery, computers, etc. from Taiwan,
Poland, and China, etc.
Factor-Price Equalisation Theorem
The factor-price equalisation theorem is an important corollary derived from the
Heckscher-Ohlin factor-proportions analysis.
Having explained the meaning of comparative price advantages as the basis of
international trade, Ohlin proceeds to analyse the effects of international trade on factor
prices in a general equilibrium system.
The basic contention of the Heckscher-Ohlin theorem, as has been seen in the
previous sections, is that: factor- intensity difference in the production functions to two
goods, in conjunction with the differing factor endowments of the two countries, accounts for
the international difference in comparative costs, causing differences in the relative
commodity prices.
According to Ohlin, thus, trade takes place when relative prices of goods differ
between countries and continues until these relative differences (ignoring transport costs)
have been eliminated. In the absence of transport costs or other impediments (such as tariffs)
to trade, the most immediate effect of international trade is that it would equalise relative
commodity prices in all regions.
The commodity price equalisation tendency is inherent, because the opening of free
trade between two countries tends to eliminate the pre-trade differences in the comparative
costs. As the volume of trade increases, comparative costs difference between the two
countries diminishes, so that differences in relative prices become small.
Apparently, the relative commodity prices would become equal when the relative
factor prices are equalised. Thus, the most significant consequence of free trade is that it
tends to bring about equalisation of factor prices.
 The theorem of factor-price equalisation thus contends that: fundamentally,
international trade in commodities acts as a substitute of the mobility of factors between
countries. When the factors of production are completely immobile internationally, but goods
are freely exchanged between countries, then the prices of these factors tend to become equal
(both relatively and absolutely) in the countries concerned.
Ohlin realising this tendency argues that in practice when factors lack international
mobility in the physical sense, the same is implied in the exchange of goods produced by
these factors. When a country exports capital-intensive goods in exchange, it indirectly
exports its abundant/cheap capital and imports scarce/dear labour.
Under trade, thus, the factors concerned move in the form of goods. International
trade in commodities as such acts as a substitute for the mobility of factors between countries.
It therefore, follows that free commodity trade between countries has an effect similar to that
of free international mobility of factors of production, i. e., a tendency to make factor prices
equal internationally.
An Exposition
In specific terms, the tendency of factor price equalisation as a result of international
trade follows from the fact that export will raise the demand and thus the price of the
abundant and cheap factors, and import will reduce the demand and thus the price of the
scarce and expensive factors. To elucidate this point, let us take a very simple case of two
regions A and В and two factors, labour, and capital. Let us assume that capital is relatively
abundant and cheap in region A, while labour is relatively abundant and cheap in region B.
Thus, region В with an abundant supply of labour but a scant supply of capital finds it
advantageous to import goods requiring much capital. Since they can be more cheaply
produced ‘abroad’ in region A, and to export goods embodying much labour.
In region B, industries using great quantities of capital will be reduced or stopped;
hence, the demand for capital will decrease in this region. Thus price of the scarce factor will
fall (its supply being the same with the reduced demand).
On the other hand, in this region, industries that require a large amount of labour will expand,
so that the demand for labour will increase. With the increasing demand, this abundant factor
— labour will now become relatively scarce.
Thus, its price will rise. In short, as a result of international trade the scarcity of
capital is reduced and that of labour is increased; hence, the price of the former will fall and
that of the latter will rise in region B. Thus, the relative factor price (PK/PL) changes in
country B, so that capital will now be substituted for labour in both the industries, labour-
intensive and capital-intensive.
In region B, the opening up to trade, as such tends to reduce the disparity between the
returns to the factors of production that existed in the pre-trade situation, when trade results in
cheapening of the relatively expensive-scarce factor and an increase in the returns of the
relatively cheap-abundant factor. (For with a relative rise in the capital-labour ratio in country
B, (K/L) B the marginal product of labour rises, as does the return to labour, the relatively
cheap factor. Correspondingly, the return to capital, the relatively dear factor, falls.
Likewise, region A which has plenty of capital but scarce labour, will import goods
requiring much of labour and export goods embodying much of capital. Hence, its
concentration on industries using much capital means greater relative scarcity of capital and
less relatively scarcity of labour.
Evidently, in both the regions the factor that is relatively abundant becomes more in
demand as a result of international trade, whereas demand for the scarce factor falls and it
yields relatively a lower reward (price) than before. This reasoning holds good for a greater
number of factors also.
As Ohlin elucidated the point, let us assume that some of the factors (X 1, x2…x1) are
relatively abundant in A, thus, being cheaper here than in region B. Similarly, the rest of
factors (x1….xn) are relatively scarce and dearer in A but cheaper in B.
After opening up of trade, the demand for factors cheaper in region A than in В
increases; consequently, their prices rise in A but these very factor’s demand in region В
contracts and their price decreases. Similarly, factors that are relatively dearer in A than in В
become less in demand, so that their prices fall there, while the reverse happens in the case of
the same factors in B.
As a matter of fact, the relative scarcity of the productive factors is reduced in both
the regions on account of international trade, which leads to equalisation of factor prices,
implying that the real factor prices must be exactly the same in both the countries.
A Graphical Representation:
By using the geometrical device of the box diagram, we may illustrate the factor-price
equalisation theorem as in Fig. 2.

In Fig. 2 OA represents resources diagonal of country A, showing that it is heavily

endowed with labour. OB represents the resources diagonal of country B, indicating that it is
capital rich. ОКНА is country A’s efficiency locus or the contract curve. Pre-trade
equilibrium of country A is at point H in view of its relative demand for goods X and Y.
Similarly, OGZB is country B’s efficiency locus and Z its pre-trade equilibrium
position. See that line OH is closer to the labour axis than line OG, implying thereby that
country A adopts more labour- intensive techniques in producing X than country B.
Likewise, AH is closer to the labour axis than BZ. So, in producing V also, country A resorts
to relatively more labour-intensive techniques than country B. Conversely, country В adopts
capital-intensive techniques.
When trade occurs between A and B, country A tends to move to К on its contract
curve. It may also be noticed that OK and OZ fall on the same straight line and depict the
same angle with labour and capital axis. This means now countries A and В have identical
production functions of X. Further, AK being parallel to BZ, it appears that A and В have
identical production of Y.
 Before, trade factor-intensities employed by A and В in producing X and Y were
different. A had labour- intensity and В had capital-intensity, as the former being labour-
abundant and the latter being capital- rich in factor endowments. This reflects factor prices
being different in the two countries, labour being cheaper in A and capital being cheaper in B.
After trade, however, when an equilibrium position is reached, factor intensities in
both the countries tend to be equal which obviously implies factor price equality.
Ohlin states that: “the mobility of goods to some extent compensates the lack of inter-
regional mobility of the factors. The tendency towards equalisation also of the prices of the
factors of production means a better use of them and thus a reduction of the advantages
arising from the unsuitable geographical distribution of the productive factors.”
Ohlin, however, frankly admits that, in reality, there is no complete factor price
equalisation. “It is not worthwhile to analyse in detail why full equalisation does not occur;
for, when the costs of transport and other impediments to trade have been introduced into the
reasoning, such an equalisation is in any case obviously impossible.”

Learner’s Illustration of Factor-Price Equalisation

Professor Learner has worked out a simple graphical method of illustrating factor
price equalisation. In this regard, he uses a single isoquant describing the production
functions of the two goods [See Fig. 2 (a)]. Such isoquants for the two goods are taken which
represent their relative prices or the quantities in which they are exchanged after trade is
established.
Under the assumption of linear homogeneous production functions, the shape of
successive isoquants indicating larger quantities is obviously identical. Hence, the expansion
path is a straight line denoting larger and larger outputs at a given factor price.
 Further assuming perfect competition and no transport cost, the units chosen express
commodity prices which are identical in both the countries after trade. As such, Fig. 2 panel
(a) is applicable to both the countries. (Here we have taken England and Portugal.)
From the figure, it follows that there can be only one factor price ratio, as represented
by the line or tangency (FP) to the two isoquants. Apparently, factor- price equalisation
theorem is established at this point.
If, however, the isoquants cut each other more than once as in Fig. 2, panel (b), the
theorem loses ground due to factor intensity reversal. Under this situation, a good scope for
factor substitution remains in at least one of the commodities, which would allow the same
commodity prices to prevail in those two countries at differing factor prices.
In Fig. 2 (b) the production function for wine is as in Fig. 2(a), but in the former, there
is enough scope for factor substitution in cloth. Under this situation, England with a high
capital/labour ratio may produce cloth with the factor proportions denoted by the ray from the
origin OQ, and wine with the proportions OM, fetching a factor price FP. Here cloth is
relatively capital-intensive.
In Portugal, however, labour is substituted for capital in producing cloth, and with
production at M and Q’, cloth is labour-intensive while wine is capital- intensive, so that
factor prices would differ. Moreover, it is also difficult to say from factor endowments which
country will export which goods.
Limitations of the Theorem: Assumption Underlying the Factor-Price Equalisation
Theorem:
It must be noted that under certain limited conditions only, this tendency towards factor-price
equalisation will be carried to the point where factor prices are fully equalised.
In other words, the factor-price equalisation theorem is based on the following
assumptions:
(i) There are quantitative differences of factors in different regions, no qualitative differences.
(ii) Production functions of different products are different, requiring different proportions of
different factors in producing different goods.
(iii) There is perfect competition in the commodity markets as well as in the factor markets in
all the regions.
(iv) There are no restrictions on trade, that is, free trade policy is followed by all the
countries.
(v) The consumer’s preferences as well as the demand patterns and positions are unchanged.
(vi) There are stable economic and fiscal policies in the participating nations.
(vii) The transport cost element is ignored.
(viii) Technological progress in different regions is identical.
(ix) There are constant returns to scales in each region.
(x) There is perfect mobility of factors.
(xi) There is tendency towards complete specialisation.
Under these assumptions only the theorem holds that free trade between countries tends to
reduce the original factor price inequality and a state of complete specialisation in effect leads
to complete factor price equality.

ECONOMIES OF SCALE AND IMPERFECT COMPETITION

Economies of scale and imperfect competition have important influences on
international trade. These effects include gains from trade, pattern and volume of trade,
changes in income distribution, agglomeration, and factor mobility. The importance of
economies of scale was realized as early as 1933 when Ohlin used economies of scale as an
explanation of foreign trade patterns. The interaction between economies of scale and
imperfect competition in trade was also noted. The literature on imperfect competition that
centers on Monopolistic Competition, by E. Chamberlin (1933), and Imperfect Competition,
by J. Robinson (1933), details its important implications for trade.
The relation between imperfect competition and international trade resurfaced in the
late 1960s and early 1970s, when economists were searching for an explanation for
postWorld War II development in international trade. A large volume of trade was flowing
between similar countries that could not be explained by the law of comparative advantage.
The growing trade in similar products was also drawing increasing attention. In order to
relate economies of scale, imperfect competition, and international trade, this article will
focus on the development of the concept of intra-industry trade, how it can coexist with inter-
industry trade, and its effects on the pattern, volume, and gains from trade. It will also explain
the absence of income-distribution effects, the emergence of agglomeration economics, and
the concept of economic geography.
Economies of Scale and Imperfect Competition Economies of scale means gains from
producing in large quantities. It is also referred to as increasing returns. Industries use
economies of scale because they become more efficient the larger the scale at which they
operate. More specifically, when there are economies of scale, doubling of inputs to an
industry will more than double the industry’s production.
 Table 1 shows that when inputs are increased from 4 to 8 units, output rises from 15 to
32 units and economies of scale are realized. These economies of scale can be of two types:
a) external economies of scale and b) internal economies of scale. If the increase in the
industry output is because each firm in the industry raises its output, this is internal
economies of scale. However, if the industry output increases without each firm raising its
output, this is external economies of scale.

The firm that does not increase its output level enjoys the benefit of a larger scale of
production in the industry without producing on a larger scale. It is important to understand
the distinction between these two types of economies of scale. Under external economies of
scale, a large number of firms can enter the industry to raise the industrial output originally
produced by the existing group. Each firm behaves like a perfectly competitive firm and can
thus be called a price taker. But when economies of scale are there because the firm itself
increases its scale of production (i.e. it realizes internal economies of scale) the market
structure becomes imperfectly competitive. Under an imperfectly competitive market
structure, a very large firm can behave like a monopolist or a few big firms can form an
oligopoly.
A monopolist, unlike the perfectly competitive firm, is free to set its price and output
at a level that will maximize its profit. However, unless there are barriers to entry, the
monopoly profits and incentives will be wiped out by the new entrants. Oligopolistic
behaviour, on the other hand, does not provide any clear-cut rule of operations. The outcome
depends on the strategies of a few big participants in the market. It is obvious that whether we
are dealing with monopolists or oligopolies, the handling of market structure becomes much
more difficult than the perfectly competitive market behaviour where price is given.
 This difficulty of dealing with the market structure may explain why internal
economies of scale were not used as an explanation for trade until the 1970s, even though
their importance in analysing economic behaviour was recognized earlier. To examine the
implications of imperfectly competitive market structure with internal economies of scale for
analysing international trade, our focus will be on monopolistic competition. Monopolistic
competition consists of a few very large firms, each of whose products are regarded as
differentiated products by the consumers (see Strategic Interaction, Trade Policy, and
National Welfare).
The Rybczynski Theorem
This theorem states that the increase in the supply of one of the factors of
production, other factors remaining the same, causes the output of the good using the
accumulating factor intensively to increase and the output of the other good to decrease
in absolute amount, provided that commodity and factor prices remain unchanged.
Suppose in a labour- surplus country, the supply of labour gets increased. It will lead to
an increased output of the labour- intensive commodity, say cloth, and reduced output of
the capital- intensive commodity, say steel.
Assumptions of the Rybczynski Theorem:
The Rybczynski theorem is based upon the following main assumptions:
(i) The trade takes place between two countries. The case of only one of the two
countries will be discussed here.
(ii) The given country is labour-abundant and capital-scarce.
(ii) This country produces two commodities— cloth and steel.
(iv) The production of these commodities requires two factors—labour and capital.
(v) Capital and labour are perfectly mobile, perfectly divisible and substitutable in some
degree.
(vi) Cloth is labour-intensive good and steel is a capital-intensive good.
(vii) There are the conditions of perfect competition in the product and factor markets.
(viii) The production functions related to both the commodities are homogenous of the
first degree. That implies constant returns to scale in production.
(ix) The factor and commodity prices are constant.
(x) The supply of the factor labour expands while that of capital remains the same.
It is now clear that Rybczynki makes departure from H-O theorem and factor-price
equalisation theorem in respect of his abandoning the assumption of fixed factor
supplies. He discusses the effect of an increased supply of the factor in which the
country is abundant upon production, factor and commodity prices and the terms of
trade. His theorem is explained through Fig. 8.12.

ABCD is the Edgeworth box concerning the given country. It shows that this
country is labour- abundant and capital-scarce. A is the origin of the commodity cloth
which is labour- intensive (L-good). C is the origin for the good steel which is capital-
intensive (K-good). AC is the non-linear contract curve sagging downwards. The
production takes place at R. The K-L ratio in cloth is measured by the slope of the line
AR and K-L ratio in steel is measured by the slope of the line RC.
It is now supposed that the supply of labour is increased by BE, capital stock
remaining the same, so that the new box diagram is AEFD. Now A and F are the points
of origin for the goods cloth and steel respectively. AF is the non-linear contract curve.
A is the origin for the L-good cloth and F is the origin for K-good steel. Production, in
this case, takes place at S. The K-L ratio in cloth is measured by the slope of the line AS
and the K-L ratio in steel is measured by the slope of the line SF.
The factor-intensity in the two commodities remains unchanged at the points R
and S. Since R and S lie on the same straight line AS, the K-L ratio in cloth remains
unchanged. On the other hand, the line RC is parallel to SF. Since the slope of RC and
SF are equal, there is no change also in the K-L ratio in the capital-intensive commodity
steel.
 When the factor- intensity in both the commodities remains the same, there will
be no change in the prices of the two factors. It shows that the Rybczynaski theorem
refutes the possibility of factor price equalisation. As the increase in the supply of labour
in the labour-abundant country and increase in capital stock in the capital-abundant
country leaves the prices of two factors unchanged, there can be no equalisation in the
factor prices.
When there is no change in the prices of the factors of production, the prices of
two commodities will also remain the same as before.
The most significant effect of an increase in the supply of factor will be upon the
volume of production. The distance of the point of production equilibrium from origin
measures the quantity produced of a commodity. In case of cloth, the original production
is measured by the distance AR. Subsequently, it is measured by the distance AS. Since
AS is greater than AR, it signifies an increase in the production of cloth after there is an
increase in the supply of labour.
In case of steel, the production at R was originally indicated by the distance RC
and subsequently it is measured by the distance SF. Since SF is shorter than RC, it
follows that the production of K-good steel decreases after there is an expansion in the
supply of labour in this country. Thus, the conclusion can be drawn that the increased
supply of one factor, keeping the other unchanged, will raise in absolute amount the
production of good intensive in the increasing factor, while the production of the other
good will get reduced in absolute amount.
The above analysis suggests that the commodity prices of the two commodities
remain constant. This can happen only if the prices of two factors remain constant. It
implies that the capital- labour ratio in the two industries remains constant. But how can
all this be possible when the quantity of one of the two factors goes on increasing.
In this connection, it may be stated that increase in the supply of labour will result
in the entire additional labour going into the labour-intensive industry. There will also be
diversion of labour from the capital- intensive industry (steel). Along with the diversion
of labour, some amount of capital will also be diverted from the steel industry to the
labour-intensive cloth industry.
Consequently, the production of cloth expands and that of steel contracts but the
K-L ratios in two industries, factor prices and commodity prices still remain unchanged.
If the labour force continues to expand indefinitely, the country will soon become
completely specialised in the production of cloth.
 The constancy of the commodity prices implies that the terms of trade will remain
unaffected. However, the equilibrium with constant prices, when supply of one factor has
been increasing, is not compatible with general equilibrium. It may be possible if one of
the two commodities, particularly the commodity intensive in the other factor (capital) is
inferior. But neither of the two commodities— cloth and steel, can be considered
inferior.
The general equilibrium in such a situation can be possible only if the price of the
commodity intensive in the expanding factor decreases. It means the terms of trade are
likely to become worse for the country in which one factor has been expanding. This is
explained through Fig. 8.13.
In Fig. 8.13, the labour-intensive commodity cloth is measured along the
horizontal scale and the capital-intensive commodity steel is measured along the vertical
scale. The production possibility curve AA 1 is derived from the box ABCD shown in
Fig. 8.12. The international terms of trade are denoted by the slope of P 0P0. The
production equilibrium is determined at R.
The expanded supply of labour along with diversion of labour and capital from
steel industry to cloth industry gives the new production possibility curve A 2A3 derived
from Box AEFD in Fig. 8.12. If the prices of two commodities remain the same, the
terms of trade line P 1P1 is parallel to P 0P0. The production equilibrium takes place now at
S where P1P1 is tangent to A2A3.
The point S shows a larger production of labour-intensive commodity cloth and
reduced output of the capital-intensive commodity steel. This can happen only if steel is
an inferior commodity. The expansion in labour force and shift in the production
possibility curve to the right imply an increase in national income.
In such a situation, barring the inferior goods, the demand for both the goods
must increase. Therefore, the new position of equilibrium must lie on that part of the
production possibility curve A 2A3 that lies between the lines RQ and RT. The slope of
this segment on the curve A 2A3 is less steep than the slope of AA 1 at R. It implies that
the price of cloth will be relatively lower and that of steel is relatively higher. A lower
price of exportable commodity cloth and a higher price of importable commodity steel
mean that there is deterioration of terms of trade subsequent to an increase in the supply
of labour.
 About the pattern of consumption, Rybczynski explained that the pattern of
consumption may remain unaltered, or change in favour of one good or the other despite
the change in the relative prices of the two commodities. If the marginal propensity to
consume of the product intensive in the accumulated factor is equal to or greater than the
average propensity to consume, the production and the consumption pattern will change
in the direction of the product intensive in that factor.
When the marginal propensity to consume falls short of the average propensity to
consume, the new production and consumption pattern may still change in favour of the
commodity using much of the factor increased, or may remain unchanged or move in the
direction of the other good. This depends upon the relative magnitudes of the average
and marginal propensities to consume.
From the above analysis, it is obvious that the Rybczynski theorem has several
implications related to production, factor and commodity prices, and terms of trade and
consumption pattern. However, its implication related to the factor price equalisation is
most clear-cut. When the supply of the abundant factor increases rapidly, the factor price
ratio may remain unchanged preventing the equalisation of factor prices among the
trading countries.
Criticisms of the Rybczynski Theorem
E.J. Mishan has raised two major objections against the theorem given by
Rybczynski. Firstly, if the increase in the supply of one factor (labour) is accompanied
by the increased supply of the other factor (capital), the results suggested by Rybczynski
are not likely to follow. Secondly, there is technical difficulty in extending Rybczynski’s
two- factor model to a multi-factor system.
 MODULE – 2
INTERNATIONAL TRADE POLICY
Tariff- Meaning
Tariff which is often referred to as customs duty is the tax levied on goods and
services involved in international trading, after they cross the national boundaries. These
taxes are usually imposed by the government of the importing country. There are many
reasons for the imposition of tariffs on goods and services, the primary reasons being
reduction of importation of goods and protection of domestic producers. Another reason for
imposing tariffs is to yield revenues. These tariffs can be interchangeable and have multiple
benefits, for example, a tariff which is imposed for protection can yield revenues while a
tariff imposed for yielding revenues may have a protective influence.
Tariff in Partial Equilibrium

Key:

P, Q Price and quantity of good

S, D Domestic supply and demand in importing country
F, T Equilibrium values under free trade and tariff
t Specific tariff
PW Price of good on world market
Explanation:

The diagram shows upward-sloping supply and downward-sloping demand for a good
inside a country. The world price, PW, is assumed to be below the country's autarky price, so
that it has excess demand at the world price and will import the good if it is free to do so. If
that were not the case, a tariff on imports would have no effect. Thus, with free trade, the
country supplies and demands the good in the amounts SF and DF respectively, as determined
by the supply and demand curves.
A tariff raises the domestic price above the world price by the amount of the tariff, so
long as the good continues to be imported. The effects on the domestic market depend on
whether the tariff induces any change in the world price. In the small-country case, the
country's imports are too small to matter for the world market and the world price remains
unchanged. If the importing country is large, however, its reduced demand for imports causes
the world price to fall by an amount that cannot be determined with this diagram alone. The
large-country case shown here simply assumes an arbitrary fall in the world price. Finally, if
the tariff is larger than the gap between the country's autarky price and the world price, then it
is "prohibitive," reducing imports of the good to zero.
Small-Country Case
In the small-country case, the world price remains unchanged, and therefore the
domestic price must rise by the full amount of the tariff. This rise in price causes
domestic supply to rise and domestic demand to fall, along the respective supply and
demand curves. Since the quantity of imports is the difference between demand and
supply, imports are reduced by both of these changes.
Effects on welfare within the country can be measured by various areas in the diagram.
The rise in price benefits suppliers, as measured by the increase in producer surplus,
which is the area to the left of the supply curve between the old and new prices. The
same price increase hurts demanders, as measured by the decrease in consumer surplus,
which is the analogous area to the left of the demand curve. In addition to these effects
on the market participants, the tariff-levying government also benefits in the form of
increased government revenue from the tariff, which is simply the rectangle
representing the tariff itself multiplied by the new level of imports. This tariff revenue
accrues directly to the government, but presumably indirectly to the domestic
 population as taxpayers.
The net of these three changes is necessarily a loss in the small country case, since the
gains to suppliers and government are both subsumed within the larger area of loss to
demanders. The net loss appears as two triangles, with height equal to the size of the
tariff and width equal to the amounts by which supply and demand have changed.
Together these triangles measure the deadweight loss from the tariff, and they exist only
to the extent that the tariff has induced changes in the behavior of the market
participants.
Large-Country Case
The small-country analysis also implies that a country of any size will demand less from
the world market, as a result of a tariff, for any given world price. This reduced demand
from the world market, if the country is large enough to matter at all, causes the world
price to fall. The size of this fall depends on properties of the world market that do not
appear here, although it is normally smaller than the tariff itself.
The fall in world price implies that the domestic price rises by less than the tariff.
Qualitatively, the rising domestic price has the same effects on domestic suppliers and
demanders as in the small-country case, but quantitatively both the gain to suppliers and
the loss to demanders are reduced, since the price increase is smaller. The tariff revenue,
on the other hand, is not reduced by the fall in world price. On the contrary, with a
specific tariff the tariff revenue is larger here, since the size of the tariff itself is the
same and the quantity of imports (which has fallen less) is larger. In the figure, the
rectangle of tariff revenue is no longer fully subsumed within the area of lost consumer
surplus, but instead extends below it
The net welfare effect of the tariff on a large tariff-levying country can therefore be
positive. This is the case, above, if the portion of tariff revenue shown by the upward-
sloping-cross-hatched rectangle below PW is larger than the sum of the two downward-
sloping-cross-hatched triangles of deadweight loss. If so, this is a case of an optimal
tariff that has successfully altered the importing country's terms of trade in its favor.
Indeed, the benefit depends entirely on being able to push down the world price, which
the country pays for its imports, and thus occurs at the expense of foreign exporters.
(The effect on welfare abroad does not appear in this figure.)
Welfare Effects of a Tariff: Small Country Consider a market in a small importing
country that faces an international or world price of PFT in free trade. The free trade
equilibrium is depicted in the adjoining diagram where PFT is the free trade equilibrium
price. At that price, domestic demand is given by DFT, domestic supply by SFT and imports
by the difference DFT - SFT (the blue line in the figure).

Tariff Effects on: Importing Country Consumers - Consumers of the product in the
importing country are worse-off as a result of the tariff. The increase in the domestic price of
both imported goods and the domestic substitutes reduces consumer surplus in the market.
Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is
represented. Importing Country Producers - Producers in the importing country are better-off
as a result of the tariff. The increase in the price of their product increases producer surplus in
the industry. The price increases also induce an increase in output of existing firms (and
perhaps the addition of new firms), an increase in employment, and an increase in profit
and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the
change in producer surplus is represented. Importing Country Government - The government
receives tariff revenue as a result of the tariff. Who will benefit from the revenue depends on
how the government spends it.
These funds help support diverse government spending programs, therefore, someone
within the country will be the likely recipient of these benefits. Refer to the Table and Figure
to see how the magnitude of the tariff revenue is represented. Importing Country - The
aggregate welfare effect for the country is found by summing the gains and losses to
consumers, producers and the government. The net effect consists of two components: a
negative production efficiency loss (B), and a negative consumption efficiency loss (D). The
two losses together are typically referred to as "deadweight losses." Refer to the Table and
Figure to see how the magnitude of the change in national welfare is represented.
Welfare Effects of a Tariff: Large Country
Suppose for simplicity that there are only two trading countries, one importing and one
exporting country. The supply and demand curves for the two countries are shown in the
adjoining diagram. PFT is the free trade equilibrium price. At that price, the excess demand
by the importing country equals excess supply by the exporter.
Optimum Tariff- Meaning
Optimal tariffs are defined as welfare-maximizing tariffs without retaliation.
Non-Tariff Barriers to Trade

A non-tariff barrier is any measure, other than a customs tariff, that acts as a barrier to
international trade. These include: regulations: Any rules which dictate how a product can be
manufactured, handled, or advertised. rules of origin: Rules which require proof of which
country goods were produced in.
Non-Tariff Barriers (NTBs) refer to restrictions that result from prohibitions,
conditions, or specific market requirements that make importation or exportation of products
difficult and/or costly. NTBs also include unjustified and/or improper application of Non-
Tariff Measures (NTMs) such as sanitary and phytosanitary (SPS) measures and other
technical barriers to Trade (TBT).
NTBs arise from different measures taken by governments and authorities in the form
of government laws, regulations, policies, conditions, restrictions or specific requirements,
and private sector business practices, or prohibitions that protect the domestic industries from
foreign competition.

Examples of Non-Tariff Barriers

Non-Tariff Barriers to trade can arise from:


o Import bans
o General or product-specific quotas
o Complex/discriminatory Rules of Origin
o Quality conditions imposed by the importing country on the exporting
countries
o Unjustified Sanitary and Phyto-sanitary conditions
o Unreasonable/unjustified packaging, labelling, product standards
o Complex regulatory environment
o Determination of eligibility of an exporting country by the importing country
o Determination of eligibility of an exporting establishment (firm, company) by
the importing country.
o Additional trade documents like Certificate of Origin, Certificate of
Authenticity etc


o Occupational safety and health regulation

o Employment law
o Import licenses
o State subsidies, procurement, trading, state ownership
o Export subsidies
o Fixation of a minimum import price
o Product classification
o Quota shares
o Multiplicity and Controls of Foreign exchange market
o Inadequate infrastructure
o "Buy national" policy
o Over-valued currency
o Restrictive licenses
o Seasonal import regimes
o Corrupt and/or lengthy customs procedures
New protectionism
 In addition to tariffs and quotas, there are several other barriers that national
governments may use to limit imports or stimulate exports. Despite the relative success of
the WTO in encouraging multi-lateral negotiations to reduce tariff barriers, and to arbitrate
over disputes, barriers still exist, but are becoming harder to detect, and somewhat hidden
from view. Examples include the following:
Government favouring domestic firms
Countries can protect their domestic industries by employing public procurement
policies, where national governments favour local firms. For example, national or local
governments may purchase supplies of military or medical equipment from local firms.
While many WTO members have signed up to the GPA (Government Procurement
Agreement), the majority have not signed up to initiatives to make national public
procurement more open to overseas competition.
Domestic subsidies
Governments may also give subsidies to domestic firms, which can then be used to
help reduce price and deter imports. This financial support can also be in the form of
an export subsidy, providing an incentive for firms to export. Such subsidies may be in the
form of start-up or ‘launch’ aid, which may be given to larger projects, such as the EU with
its Airbus development, and the US with its support for Boeing.
Health and safety grounds
National governments can also use health and safety regulations to discriminate against
imported products, such as banning the import of a product on health or safety grounds, while
local producers do not have to pass such stringent tests.
Quality standards
In a similar way, governments can set tough quality standards that may be difficult for
overseas producers to meet.
Bureaucracy
Excessive bureaucracy associated with the process of importing and exporting may also
restrict trade. For example, goods may be deliberately held-up at ports and airports, and there
may be unnecessarily complex and lengthy paperwork associated with international
transactions.
Exchange rates
Monetary protection involves countries deliberately devaluing their exchange rate to
stimulate exports and deter imports.
GATT.
The General Agreement on Tariffs and Trade (GATT) is a legal
agreement between many countries, whose overall purpose was to promote international
trade by reducing or eliminating trade barriers such as tariffs or quotas. According to its
preamble, its purpose was the "substantial reduction of tariffs and other trade barriers and the
elimination of preferences, on a reciprocal and mutually advantageous basis.
The GATT was first discussed during the United Nations Conference on Trade and
Employment and was the outcome of the failure of negotiating governments to create
the International Trade Organization (ITO). It was signed by 23 nations in Geneva on 30
October 1947, and was applied on a provisional basis 1 January 1948. It remained in effect
until 1 January 1995, when the World Trade Organization (WTO) was established after
agreement by 123 nations in Marrakesh on 15 April 1994, as part of the Uruguay
Round Agreements. The WTO is the successor to the GATT, and the original GATT text
(GATT 1947) is still in effect under the WTO framework, subject to the modifications of
GATT 1994. Nations that were not party in 1995 to the GATT need to meet the minimum
conditions spelled out in specific documents before they can accede; in September 2019, the
list contained 36 nations.
The GATT, and its successor the WTO, have succeeded in reducing tariffs. The
average tariff levels for the major GATT participants were about 22% in 1947, but were 5%
after the Uruguay Round in 1999. Experts attribute part of these tariff changes to GATT and
the WTO.
GATT and the World Trade Organization

In 1993, the GATT was updated ('GATT 1994') to include new obligations upon its
signatories. One of the most significant changes was the creation of the World Trade
Organization (WTO). The 76 existing GATT members and the European
Communities became the founding members of the WTO on 1 January 1995. The other 51
GATT members rejoined the WTO in the following two years (the last being Congo in 1997).
Since the founding of the WTO, 33 new non-GATT members have joined and 22 are
currently negotiating membership. There are a total of 164 member countries in the WTO,
with Liberia and Afghanistan being the newest members as of 2018.
Of the original GATT members, Syria, Lebanon and the SFR Yugoslavia have not
rejoined the WTO. Since FR Yugoslavia (renamed as Serbia and Montenegro and with
membership negotiations later split in two), is not recognised as a direct SFRY successor
state; therefore, its application is considered a new (non-GATT) one. The General Council of
WTO, on 4 May 2010, agreed to establish a working party to examine the request of Syria for
WTO membership. The contracting parties who founded the WTO ended official agreement
of the "GATT 1947" terms on 31 December 1995. Montenegro became a member in 2012,
while Serbia is in the decision stage of the negotiations and is expected to become a member
of the WTO in the future.
Whilst GATT was a set of rules agreed upon by nations, the WTO is
an intergovernmental organisation with its own headquarters and staff, and its scope includes
both traded goods and trade within the service sector and intellectual property rights.
Although it was designed to serve multilateral agreements, during several rounds of GATT
negotiations (particularly the Tokyo Round) plurilateral agreements created selective trading
and caused fragmentation among members. WTO arrangements are generally a multilateral
agreement settlement mechanism of GATT.
Multilateral Agreement

A multilateral agreement is a trade agreement established between three or more

countries with the intention of reducing barriers to trade, such as tariffs, subsidies, and
embargoes, that limit a nation’s ability to import or export goods. They are considered the
best method of encouraging a truly global economy that opens markets to small and large
countries on an equitable basis.
In general, trade agreements between nations are either bilateral, involving only two
nations, or multilateral. By their very nature, requiring concessions by several countries that
have traditionally used trade barriers to protect certain industries or domestic goods,
multilateral agreements are much more difficult to negotiate than bilateral agreements.

Examples of Multilateral Agreements

Multilateral agreements are usually negotiated between countries that share a

geographic region, and some of the most well-known regional agreements are the North
American Free Trade Agreement (NAFTA) and the Central American-Dominican Republic
Free Trade Agreement (CAFTA). However, multilateral agreements can also be international
in nature, with perhaps the most successful international trade agreement being the General
Agreement on Trade and Tariffs (GATT), negotiated between 153 countries following the
end of World War II.
There is a debate as to their effectiveness. For instance, those in favor of multilateral
agreements point to the economic benefits they provide smaller countries with emerging
markets, while those against them claim that they provide multi-national companies increased
control over the individual sovereignty of nations.

Free Trade Area

A free trade area (FTA) occurs when a group of countries agrees to eliminate tariffs
among themselves but maintain their own external tariff on imports from the rest of the
world. The North American Free Trade Agreement (NAFTA) is an example of an FTA.
When NAFTA is fully implemented, tariffs of automobile imports between the United States
and Mexico will be zero. However, Mexico may continue to set a different tariff than the
United States on automobile imports from non-NAFTA countries. Because of the different
external tariffs, FTAs generally develop elaborate “rules of origin.” These rules are designed
to prevent goods from being imported into the FTA member country with the lowest tariff
and then transhipped to the country with higher tariffs. Of the thousands of pages of text that
make up NAFTA, most of them describe rules of origin.

Customs Union

A customs union occurs when a group of countries agrees to eliminate tariffs among
themselves and set a common external tariff on imports from the rest of the world. The
European Union (EU) represents such an arrangement. A customs union avoids the problem
of developing complicated rules of origin but introduces the problem of policy coordination.
With a customs union, all member countries must be able to agree on tariff rates across many
different import industries.

European Union
The European Union is a group of 27 countries that operate as a cohesive economic and
political block.

19 of these countries use EURO as their official currency. 8 EU members (Bulgaria,

Croatia, Czech Republic, Denmark, Hungary, Poland, Romania, Sweden) do not use the
euro.

The EU grew out of a desire to form a single European political entity to end centuries of
warfare among European countries that culminated with World War II and decimated much
of the continent.

The EU has developed an internal single market through a standardised system of laws that
apply in all member states in matters, where members have agreed to act as one.

What are the Objectives of the EU?

 Promote peace, values and the well-being of all citizens of EU.

 Offer freedom, security and justice without internal borders
 Sustainable development based on balanced economic growth and price
stability, a highly competitive market economy with full employment and social
progress, and environmental protection
 Combat social exclusion and discrimination
 Promote scientific and technological progress
 Enhance economic, social and territorial cohesion and solidarity among EU
countries
 Respect its rich cultural and linguistic diversity
 Establish an economic and monetary union whose currency is euro.

What led to the Formation of the EU?

 After World War II, European integration was seen as a cure to the excessive
nationalism which had devastated the continent.
 In 1946 at the University of Zurich, Switzerland, Winston Churchill went
further and advocated the emergence of a United States of Europe.
 In 1952, European Coal and Steel Community (ECSC) was founded
under Treaty of Paris (1951) by 6 countries called Six (Belgium, France,
 Germany, Italy, Luxembourg and the Netherlands) to renounce part of their
sovereignty by placing their coal and steel production in a common market,
under it.
International Trade and Economic Development
International Trade – According to Robertson, international trade is an engine of
growth. According to Haberler, International trade has made a tremendous contribution to the
development of less developed countries in 19th and 20th centuries. Role of International
trade – International trade plays an important role in increasing the production of any country.
... In countries where home market is limited it is necessary to sell product in other countries.
Some roles of international trade in Economic development are as follows:
1) Increase in investment international trade encourages the businessmen to increase
the investment to produce more goods. So, the rate of investment increases.
2)Foreign investment international trade provides incentives for the foreign investors,
besides local investment, to invest in those countries where there is a shortage of investment
Trade is central to ending global poverty. Open trade also benefits lower-income households
by offering consumers more affordable goods and services. Integrating with the world
economy through trade and global value chains helps drive economic growth and reduce
poverty—locally and globally.
3) Reduction of Poverty
4) Market expansion - International trade plays an important role in increasing the
production of any country. The foreign trade is remarkable factor in expanding the market
and encouraging the producers. In countries where home market is limited it is necessary to
sell product in other countries.
5) Foreign exchange earning foreign trade provides foreign exchange that is used to
remove the poverty and for other productive purposes.

6) Educative Effect of Trade: International trade can serve as a vehicle for the
dissemination of technological knowledge. A deficiency of knowledge can be a biggest
handicap in the development of a country and this deficiency can be effectively removed
through contact with more advanced economies i.e. by making possible through foreign trade
Thus help in bringing about technological and industrial revolution
 7) Healthy Competition: International trade also helps in economic development by
providing healthy competition and keeping in check inefficient monopolies. The more
competitive an economy is, the more efficient it will be.
8)Efficient Use of Means of Production: International trade, it is felt, provides better
ground for efficient use of various resources due to its comparative advantages.
9) Easy flow of capital: International trade facilitates international short term and
long-term flow of capital between countries.
10) Stabilization of prices international trade can deal with problem of internal
inflation or deflation.

MODULE 3

Balance Of Payment (BOP) is a statement that records all the monetary transactions
made between residents of a country and the rest of the world during any given period. This
statement includes all the transactions made by/to individuals, corporates and the government
and helps in monitoring the flow of funds to develop the economy.
Why is the Balance of Payment (BOP) vital for a country?

A country’s BOP is vital for the following reasons:

 The BOP of a country reveals its financial and economic status.
 A BOP statement can be used to determine whether the country’s currency value is
appreciating or depreciating.
 The BOP statement helps the government to decide on fiscal and trade policies.
 It provides important information to analyse and understand the economic dealings
with other countries.
By studying its BOP statement and its components closely, one would be able to identify
trends that may be beneficial or harmful to the county’s economy and, thus, then take
appropriate measures.
Elements of a Balance of Payment

There are three components of the balance of payment viz current account, capital
account, and financial account. The total of the current account must balance with the total of
capital and financial accounts in ideal situations.

Current Account
The current account monitors the inflow and outflow of goods and services between
countries. This account covers all the receipts and payments made with respect to raw
materials and manufactured goods.
It also includes receipts from engineering, tourism, transportation, business services, stocks,
and royalties from patents and copyrights. When all the goods and services are combined,
they make up a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It
could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading
in goods between countries is referred to as visible items, and import/export of services
(banking, information technology etc.) are referred to as invisible items.
 Unilateral transfers refer to money sent as gifts or donations to residents of foreign
countries. This can also be personal transfers like – money sent by relatives to their family
located in another country.
Capital Account
All capital transactions between the countries are monitored through the capital
account. Capital transactions include purchasing and selling assets (non-financial) like land
and properties.
The capital account also includes the flow of taxes, purchase and sale of fixed assets
etc., by migrants moving out/into a different country. The deficit or surplus in the current
account is managed through the finance from the capital account and vice versa. There are
three major elements of a capital account:
 Loans and borrowings – It includes all types of loans from the private and public
sectors located in foreign countries.
 Investments – These are funds invested in corporate stocks by non-residents.
 Foreign exchange reserves – Foreign exchange reserves held by the country’s central
bank to monitor and control the exchange rate do impact the capital account.
Financial Account
The flow of funds from and to foreign countries through various investments in real
estate, business ventures, foreign direct investments etc., is monitored through the financial
account. This account measures the changes in the foreign ownership of domestic assets and
domestic ownership of foreign assets. Analysing these changes can be understood if the
country is selling or acquiring more assets (like gold, stocks, equity, etc.).
What Is the Balance of Trade (BOT)?

Balance of trade (BOT) is the difference between the value of a country's exports and
the value of a country's imports for a given period. Balance of trade is the largest component
of a country's balance of payments (BOP).
The foreign exchange markets
The foreign exchange market or the forex market, is the largest and most liquid
financial market in the world. It is where different currencies are bought and sold, with the
exchange rate determining the value of each currency relative to another. The forex market
plays a critical role in facilitating international trade and investment, as well as providing
opportunities for individuals and institutions to profit from fluctuations in currency values.
 The forex market operates 24 hours a day, 5 days a week, with trading volumes
exceeding $6 trillion per day. It is a highly decentralized market, with no single entity
controlling the exchange rates or setting the prices of currencies.
How does Foreign Exchange Market work?

The foreign exchange market works by facilitating the exchange of one currency for
another. Market participants buy and sell currencies to facilitate international trade and
investment and speculate on currency price movements. The exchange rate, which is the
value of one currency relative to another, is determined by supply and demand forces in the
market.
Currency values are influenced by a variety of factors, including economic indicators,
geopolitical events, and central bank policies. Transactions in the forex market can take place
over the counter or through electronic trading platforms, and the market operates 24 hours a
day, 5 days a week, across major financial centers around the world.

What are the Different Types of Foreign Exchange Markets?

There are three main types of foreign exchange markets:

1. Spot Forex Market
The spot forex market is where currencies are traded for immediate delivery. This
means that the exchange of currencies takes place at the current market price, which is
determined by supply and demand forces. The spot forex market is the most liquid and
actively traded market in the world, with trading taking place 24 hours a day across major
financial centres.

2. Forward Forex Market

The forward forex market is where contracts are used to buy or sell currencies at a
future date at a predetermined exchange rate. This allows participants to lock in a future
exchange rate, providing protection against currency fluctuations. The forward forex market
is used for hedging purposes and is not as actively traded as the spot market.
3. Futures Forex Market
 The futures forex market is a centralized exchange where standardized contracts are
traded for the future delivery of a specified currency at a predetermined price. Futures
contracts are used for hedging and speculative purposes and are traded on regulated
exchanges. The futures forex market is less liquid than the spot market and requires
participants to post margin.
Who are the Participants in a Foreign Exchange Market?

There are a wide range of participants in the foreign exchange market, including:
● Commercial banks: Banks are the most active participants in the forex market, trading
on behalf of their clients and for their own accounts.
● Central banks: Central banks participate in the market to manage their country's
monetary policy and stabilize currency values.
● Hedge funds and investment firms: These institutions trade in the forex market to
generate returns for their clients.
● Corporations: Multinational corporations use the forex market to manage their currency
risk, particularly when conducting international trade.
● Retail traders: Individual traders can participate in the forex market through online
brokers, seeking to profit from currency price movements.
● Governments: Governments participate in the forex market to manage their currency
values and maintain their country's economic stability.
What Causes Exchange Rates to Fall?

There are several factors that can cause exchange rates to fall:
● Decreased demand: If demand for a country's currency decreases relative to other
currencies, its exchange rate may fall.
● Economic factors: Economic indicators such as low inflation or slowing economic
growth can lead to a fall in a country's exchange rate.
● Political instability: Political instability, such as political protests or leadership changes,
can cause a country's exchange rate to fall.
● Central bank policies: If a country's central bank reduces interest rates or engages in
quantitative easing, its currency may weaken.
● Trade imbalances: Persistent trade deficits can cause a country's currency to depreciate
as demand for its currency weakens.
CURRENCY FUTURES
A Currency Futures Contract is a commitment to either take delivery or give delivery
of a certain amount of a foreign currency on a future date at a specified exchange rate.
Currency futures are conceptually similar to currency forward contracts. But they differ
widely in terms of operational process. For example, A needs • 1000 on a date sometime in
near future. So, instead of buying this amount now and keeping it idle, A buys a futures
contract maturing around the date when he needs • 1000. Suppose this particular futures
contract is quoting at Rs 56 per euro today. Once A enters into a contract to buy •1000 at Rs
56 per euro, he will have to pay neither more nor less than Rs 56 per euro irrespective of the
actual spot rate on the date of delivery of the •1000. The participants on currency futures
market may be traders, brokers or brokers traders.
CURRENCY OPTIONS
A currency option, as the name suggests, gives its holder a right and not an obligation
to buy or sell or not to buy or sell a currency at a predetermined rate on or before a specified
maturity date. Options are traded on the Over-the-Counter (OTC) market as well as on
organised exchanges. _There are different categories of market operators such as enterprisers
(known as hedgers) who use options to cover their exposures, banks that profit by speculating
and arbitrageurs who profit by taking advantage of price distortions on different markets.
Earlier, all currency options were OTC options, written by international banks and investment
banks.
CURRENCY SWAPS
Swaps are nothing but an exchange of two payment streams. Swaps can be arr anged
either directly between two parties or through a third party like a bank or a financial
institution. Swap market has been developing at a fast pace in the last two decades, A
currency swap enables the substitution of one debt denominated in one currency at a fixed or
floating rate to a debt denominated in another currency at a fixed or floating rate.
It enables both parties to draw benefit from the differences of interest rates existing on
segmented markets. Thus, currency swaps can be fixed-to-fixed type as well as fixed-to-
floating type. 55 Currency Futures, Options and swaps financial institutions play very
important role in swap deals.
Hedging, speculation and arbitrage in Foreign Exchange
Hedging, speculation, and arbitrage are three common strategies used in foreign
exchange trading. Hedging: Hedging is a strategy used to manage currency risk. Currency
risk arises from the fluctuation of exchange rates. Hedging involves taking a position that
offsets potential losses from an existing position.
For example, if a company has an upcoming payment to make in euros, it could enter
into a currency futures contract to buy euros at a fixed exchange rate to protect against
adverse movements in the exchange rate. In this way, the company can hedge against
potential losses due to the exchange rate moving against them.
Speculation: Speculation is a strategy used to profit from exchange rate movements.
Speculators take positions based on their predictions about the future direction of exchange
rates. If a speculator believes that the euro will appreciate against the dollar, they could buy
euros and sell dollars. If their prediction is correct, they will make a profit when they sell the
euros at a higher price.
Arbitrage: Arbitrage is a strategy used to profit from price discrepancies between
different markets. In foreign exchange, arbitrage opportunities arise when the exchange rates
quoted in different markets are not in sync. For example, if the exchange rate for the
EUR/USD currency pair is 1.10 in the spot market and 1.12 in the futures market, a trader
could buy euros in the spot market and sell euros in the futures market to lock in a profit.
Each of these strategies involves taking on risks, and traders must use appropriate risk
management techniques, such as stop-loss orders, to minimize their exposure. Additionally,
traders must have a deep understanding of the markets they are trading in, as well as the
economic and political factors that impact exchange rates, to execute these strategies
successfully.

Exchange Rate Determination

There are numerous methods of calculating the exchange rate of currencies. Some popular
methods are -
 Floating Exchange Rate
 Fixed Exchange Rate
 Flexible Exchange Rate.
Floating Exchange Rate
An exchange rate that is not fixed is called a flexible exchange rate. The flexible
exchange rate fluctuates from one value to another. The market determines whether the
exchange rate moves or not. The term "floating currency" is used to indicate any currency
subject to a floating regime.
For example, the US dollar is an example of a floating exchange currency.
Floating rates are notable and are very popular among economists. The believers in a
free market are of the mindset that markets should determine the currency value. The USD
values usually decline when crude oil prices rise, for example. So, the crude oil prices and
USD currency value are inversely related. Therefore, the USD value fluctuates freely
because oil prices fluctuate daily.
Economists are of the point of view that markets generally correct themselves
frequently. Most major economies are generally dependent on floating exchanges because of
little government intervention. These countries are popularly known as 'First World
Countries'.
Flexible Exchange Rate
The flexible exchange rate is called pegged exchange rate system because of
government intervention. The value of a currency is maintained either to certain currencies’
values–either collectively or individually–or to the reserves of gold and foreign currencies
available in the given country.
Fixed Exchange Rate
China is probably the most famous example of fixed exchange regimes. A fixed-rate
regime also used to exist under the former Soviet Union. It must be noted that the flexible
exchange rate is not solely determined by market forces. If the foreign exchange market
fluctuates widely, the central banks will have to sell or buy currency reserves.

Determination of Foreign Exchange Rate

The flexible exchange rate is determined by the forces of demand and supply of
foreign exchange in the market. Under this, the equilibrium is established at a point where
the quantity demanded is equal to the quantity supplied of foreign exchange, i.e., Demand
for foreign exchange is similar to the supply of foreign exchange. This can be shown in Fig
1.
Observations:
It is evident in the diagram (Fig 1) that the rate of foreign exchange is shown on the Y axis,
and the demand and supply of foreign exchange are shown on the X axis.
1. DD is a negatively sloped Demand curve, and SS is a positively sloped Supply
curve of foreign exchange that intersects each other at point E.
2. Point E shows the equilibrium between the demand and supply of foreign exchange.
3. Point E corresponds to the OR, which is the equilibrium rate of exchange
and OQ, which is the quantity of foreign exchange demanded and supplied.
But now the question arises what if the exchange rate is not the Equilibrium exchange
rate?
Case I: At the exchange rate higher than the equilibrium exchange rate, say OR2,
there will be excess supply, i.e., Q1Q2. This is so because there is a positive relationship
between the price of foreign exchange and the quantity supplied. Thus if the exchange rate
rises, the quantity supplied also increases. On the other hand, demand will fall to OQ2, as
there is a negative relationship between the price of foreign exchange and the quantity
demanded. Thus the excess supply with the fall in demand for foreign exchange will push
down the rate of foreign exchange (this indicates that the Indian Rupee will appreciate). It
will again lead to an increase in demand from OQ2 to OQ, and a decrease in supply
from OQ1 to OQ till it reaches equilibrium E.
Case II: Conversely, at the exchange rate lower than the equilibrium exchange rate
says OR1, there will be excess demand, i.e., Q1Q2. This is so because there is a negative
relationship between the price of foreign exchange and the quantity demanded. Thus, if the
exchange rate falls, the quantity demanded increases. On the other hand, supply will fall
to OQ2, as there is a positive relationship between the price of foreign exchange and the
quantity supplied. Thus, the excess demand with an increase in the demand for foreign
exchange will push up the rate of foreign exchange (this indicates that the Indian Rupee
will depreciate). It will again lead to a decrease in demand from OQ1 to OQ and an
increase in supply from OQ2 to OQ till it reaches equilibrium E.

What is Purchasing Power Parity?

Purchasing power parity (PPP) is a theory which states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each of the two countries.
This means that the exchange rate between two countries should equal the ratio of the two
countries' price level of a fixed basket of goods and services. When a country's domestic price level
is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in
order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other
transaction costs, competitive markets will equalize the price of an identical good in two countries
when the prices are expressed in the same currency. For example, a particular TV set that sells for
750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the
exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver
was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this
process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian
goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to
them. This process continues until the goods have again the same price. There are three caveats
with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and other
transaction costs, can be significant. (2) There must be competitive markets for the goods and
services in both countries. (3) The law of one price only applies to tradeable goods; immobile
goods such as houses, and many services that are local, are of course not traded between countries.
Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP.
Absolute PPP was described in the previous paragraph; it refers to the equalization of price levels
across countries. Put formally, the exchange rate between Canada and the United States E CAD/USD is
equal to the price level in Canada P CAN divided by the price level in the United States P USA. Assume
that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1 USD. If today's
exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD will appreciate (get
stronger) against the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states
that the rate of appreciation of a currency is equal to the difference in inflation rates between the
foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has
an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year.
This proposition holds well empirically especially when the inflation differences are large.

Does PPP determine exchange rates in the short term?

No. Exchange rate movements in the short term are news-driven. Announcements about interest
rate changes, changes in perception of the growth path of economies and the like are all factors that
drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour of
exchange rates. The economic forces behind PPP will eventually equalize the purchasing power of
currencies. This can take many years, however. A time horizon of 4-10 years would be typical.

How is PPP calculated?

The simplest way to calculate purchasing power parity between two countries is to compare the
price of a "standard" good that is in fact identical across countries. Every year The
Economist magazine publishes a light-hearted version of PPP: its "Hamburger Index" that
compares the price of a McDonald's hamburger around the world. More sophisticated versions of
PPP look at a large number of goods and services. One of the key problems is that people in
different countries consumer very different sets of goods and services, making it difficult to
compare the purchasing power between countries.

Monetary Approach to Balance of Payments Adjustment

The monetary approach to the balance of payments is associated with the names
of R. Mundell and H. Johnson. The other writers who have made contribution to it
include R. Dornbusch, M. Mussa, D. Kemp and J. Frankel. The basic premise of the
approach is the recognition that the BOP disequilibrium is fundamentally a monetary
phenomenon. It attempts to explain the BOP deficits or surpluses through demand for
and supply of money.
Assumptions of Monetary Approach:
This approach rests upon the following main assumptions:
(i) There is the existence of a single price for identical products in different countries,
after allowing the transport costs.
(ii) The level of output in a given country is exogenously determined.
(iii) There is full employment of resources in all the countries.
(iv) There is no possibility of sterilisation of currency flows under a system of fixed
exchange rates on account of single price assumption.
(v) The demand for money is a direct function of income and an inverse function of the
rate of interest.
(vi) The supply of money is determined by the high-powered money and money
multiplier.
(vii) The demand for nominal money balances is stable.
The monetary approach, given the above assumptions, holds that the excess of money
supply over money demand reflects the balance of payments deficit. The excessive
money holdings are utilised by the people in the purchase of foreign goods and
securities.
The excess supply of money may be offset by the central bank under a system of fixed
exchange rates through the sale of foreign exchange reserves and the purchase of
domestic currency. As the excess supply conditions in the money market are removed,
the balance of payments equilibrium gets restored.
On the opposite, if the supply of money falls short of the demand for money, the country
will have a balance of payments surplus. In such a situation, people try to acquire the
domestic- currency through the sale of goods and securities to the foreigners. For
meeting the shortage of domestic currency, the central bank will buy excess foreign
currency in addition to the purchase of domestic securities. Such measures will remove
the BOP surplus and restore the BOP equilibrium.
The monetary approach to BOP can be expressed through the following relations:
The supply of money (M s) consists of domestic component of the nation’s monetary base
(H) and international or foreign component of the nation’s monetary base (F).
Ms = H + F
The demand for money (M D) is a stable and direct function of income and inverse
function of the rate of interest. The monetary equilibrium is determined by the equality
between the demand for money and the supply of money.
MS = MD
H + F = MD
F = MD -H
From this relation, it follows that the excess of money demand over the domestic
monetary base is offset by an inflow of reserves from abroad or international monetary
base in the event of a BOP surplus. On the opposite, if there is a BOP deficit reflected by
the excess of money supply over money demand, the adjustment can be possible through
an outflow of foreign reserves.
The monetary approach also explains that the BOP disequilibria, under a flexible
exchange system, are corrected immediately through automatic changes in exchange rate
without any international flow of money or reserves. A deficit in the BOP resulting from
the excess of money supply over money demand, causes an automatic depreciation in
country’s currency. This leads to a rise in domestic prices and also the demand for
money.
As a consequence, there is an absorption of the excess supply of money and the
BOP deficit gets adjusted.

On the opposite, a surplus in the BOP, caused by the excess of demand for money
over its supply, results automatically in the appreciation of nation’s currency. It leads to
a fall in domestic prices. As a consequence, the excess money demand and the BOP
surplus get offset.
The monetary approach to the BOP situation has an important policy implication.
It suggests that the policies like devaluation can have effectiveness in the short period
only if the monetary authority does not increase the supply of money to match exactly
the increase in the demand for money resulting from devaluation or other adjustment
policies.

MODULE 4
STABILITY OF EXCHANGE RATES
At a basic level, a currency is stable when the international currency exchange
rates do not fluctuate too much as against the Consumer Price Index (CPI). Exchange
rates express the value of one country's currency in relation to the value of another
country's currency. The rates play an important part in economics, affecting the
balance of trade between nations and influencing investment strategies.
Determinants of Stability in Exchange Rates
1. Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During
the last half of the 20th century, the countries with low inflation included Japan,
Germany, and Switzerland, while the U.S. and Canada achieved low inflation only
later. Those countries with higher inflation typically see depreciation in their currency
about the currencies of their trading partners. This is also usually accompanied by
higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency values.
Higher interest rates offer lenders in an economy a higher return relative to other
countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to
drive the currency down. The opposite relationship exists for decreasing interest rates
– that is, lower interest rates tend to decrease exchange rates.
3. Current Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest, and
dividends. A deficit in the current account shows the country is spending more on
foreign trade than it is earning, and that it is borrowing capital from foreign sources to
make up the deficit.
In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to foreign
investors. The reason being, a large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst-case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through domestic
means (selling domestic bonds, increasing the money supply), then it must increase
the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a
large debt may prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own securities
denominated in that currency if the risk of default is great. For this reason, the
country's debt rating (as determined by Moody's or Standard & Poor's, for example) is
a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports rises
by a greater rate than that of its imports, its terms of trade have favourably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes
will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of
confidence in a currency and a movement of capital to the currencies of more stable
countries.
Automatic Price Adjustment under Gold Standard
Under the international gold standard which operated between 1880-1914, the
currency in use was made of gold or was convertible into gold at a fixed rate. The
central bank of the country was always ready to buy and sell gold at the specified
price.
The rate at which the standard money of the country was convertible into gold
was called the mint price of gold. This rate was called the mint parity or mint par of
exchange because it was based on the mint price of gold. But the actual rate of
exchange could vary above and below the mint parity by the cost of shipping gold
between the two countries.
To illustrate this, suppose the US had a deficit in its balance of payments with
Britain. The difference between the value of imports and exports would have to be
paid in gold by US importers because the demand for pounds exceeded the supply of
pounds.
But the transhipment of gold involved transportation cost and other handling charges,
insurance, etc. Suppose the shipping cost of gold from the US to Britain was 3 cents.
So the US importers would have to spend $ 6.03 ($ 6 + .03c) for getting £ 1.
This could be the exchange rate which was the US gold export point or upper
specie point. No US importer would pay more than $ 6.03 to obtain £ 1 because he
could buy $ 6 worth of gold from the US treasury and ship it to Britain at a cost of 3
cents per ounce.
Similarly, the exchange rate of the pound could not fall below $ 5.97 in the
case of a surplus in the US balance of payments. Thus, the exchange rate of $ 5.97to a
pound was the US gold import point or lower specie point.

The exchange rate under the gold standard was determined by the forces of
demand and supply between the gold points and was prevented from moving outside
the gold points by shipments of gold. The main objective was to keep bop in
equilibrium.
A deficit or surplus in bop under the gold standard was automatically adjusted
by the price-specie-flow mechanism. For instance, a bop deficit of a country meant a
fall in its foreign exchange reserves due to an outflow of its gold to a surplus country.
 This reduced the country’s money supply thereby bringing a fall in the general
price level. This, in turn, would increase its exports and reduce its imports. This
adjustment process in bop was supplemented by a rise in interest rates as a result of
reduction in money supply. This led to the inflow of short-term capital from the
surplus country. Thus, the inflow of short-term capital from the surplus to the deficit
country helped in restoring bop equilibrium.
Optimum Currency Areas
The optimum currency area theory is a relatively recent area of study. The
pioneering work in this field was done by J.E. Meade and T. Scitovsky in 1957-
58. The main credit for developing this analysis, however, goes to Mundell (1961)
and McKinnon (1963).
According to Mundell, optimum currency area is a region which leads
automatically to a complete elimination of unemployment and the BOP
disequilibrium. In a currency area, either there is a common currency or the
currencies of a group of countries are linked through a permanently fixed
exchange rate.
The currencies of the member countries of a union could then float jointly
with respect to the currencies of the non-member countries. Mundell pointed that
there would be an automatic achievement of internal and external equilibria in the
countries of a currency area without either the policy of flexible exchange rates or
the government intervention through monetary and fiscal policies, provided there
were free mobility of labour and capital through the currency area.

McKinnon, in contrast to Mundell’s emphasis upon cost-price adjustments,

laid stress upon the internal price stability as the objective of the currency area.
McKinnon believed that the currency area is best suited to open economies rather
than closed economies. Higher is the ratio of traded to non-traded goods or higher
the ratio of foreign trade to GNP, more beneficial it is to form a currency area.
According to him, the open economies should rely upon the monetary and
fiscal policy changes rather than the exchange rate changes to achieve internal and
external balances. A closed economy, on the other hand, should rely upon
exchange rate changes rather than monetary and fiscal policies to realize the goal
of internal and external stability.

What Is a Currency Board?

A currency board is an extreme form of a pegged exchange rate. Management

of the exchange rate and the money supply are taken away from the nation's central
bank, if it has one. In addition to a fixed exchange rate, a currency board is also
generally required to maintain reserves of the underlying foreign currency.
 A currency board is an extreme form of a pegged exchange rate.
 Often, this monetary authority has direct instructions to back all units of
domestic currency in circulation with foreign currency.
 Currency boards offer stable exchange rates, which promote trade and
investment.
 In a crisis, a currency board can cause substantial damage by restricting
monetary policy.
What is Dollarization?
Dollarization is the term for when the U.S. dollar is used in addition to or
instead of the domestic currency of another country. It is an example of currency
substitution. Dollarization usually happens when a country's own currency loses its
usefulness as a medium of exchange, due to hyperinflation or instability.

What Is Currency Band?

A currency band is a monetary regulation imposed by a government or central

bank that specifies both a price floor and ceiling for its national currency in relation
to other currencies.
 A currency band is a range of upper and lower acceptable exchange rates for a
national currency to fluctuate between.
 A currency band allows the currency to float between these two specified
prices, but upon reaching those limits the currency price will switch to a fixed rate.
 A currency band allows the currency to float between these two specified
prices, but upon reaching those limits the currency price will switch to a fixed rate.
 Basically, a currency band can be understood as a managed exchange rate
system that is a hybrid of a fixed exchange rate and a floating exchange rate. A
country fixes a range of values at which its currency can float or move within, and
the limits where it will revert to a fixed exchange rate. This allows for
some revaluation, but usually stabilizes the currency's price back within the band.
 For instance, the central bank can bring the currency back to the mid-point rate
of the established band. However, if this move is too difficult or challenging to do,
the bank will realign the band to create a new target exchange rate.
 A currency band helps to impose discipline on monetary policy, but still
provides flexibility if the country is hit by big capital inflows or outflows. The
monetary policy of a country with a currency band is dependent on the behavior of its
reference foreign currency because the central bank must make decisions that cause
the value of the local currency to change in a way that approximates changes in the
value of the reference currency.
 The band is used by a government to stabilize its currency during times of
exchange rate volatility.

What is an Adjustable Peg?

An adjustable peg is an exchange rate policy in which a currency is pegged or

fixed to a major currency such as the U.S. dollar or euro, but which can be readjusted
to account for changing market conditions or macroeconomic trends. An example
of managed currency or "dirty float", these periodic adjustments are usually intended
to improve the country's competitive position in the export market and world
financial stage.

A crawling peg is a system of exchange rate adjustments in which a currency with

a fixed exchange rate is allowed to fluctuate within a narrow band of rates.
 An adjustable peg describes a currency regime where a country allows its
currency's value to float on the market, but only within a narrow band before the
central bank intervenes to restore the peg.
 Typically, the currency is allowed to fluctuate within a narrow band before the
peg is restored; however, the peg itself can be reviewed and adjusted according to
economic conditions and macro trends.
 The adjustable peg is a hybrid system seeking to take advantage of the benefits
from both a fixed peg and freely floating currency.
An adjustable peg can float on the market according to economic conditions,
but typically has only a 2% percent degree of flexibility against a specified base level
or peg. If the exchange rate moves by more than the agreed-upon level, the central
bank intervenes to keep the target exchange rate at the peg. Over time, the peg itself
can be re-evaluated and changed to reflect changing conditions and trends. The
ability of countries to revalue their peg to reassert their competitiveness is at the crux
of the adjustable peg system.

***************

MODULE – 5

Gold standard, until 1914 (fixed rates under UK dominance): throughout most of the
19th century and up to 1914 (outbreak of WW1), the world was on a gold standard.
Especially, the period of 1879-1913 was called the Classical Gold Standard (or International
Gold Standard) because all major countries participated in it. Trade was liberalized and
capital was mobile.
Interwar period: after WW1, the world powers tried to return to the gold standard at
prewar parities (i.e., at the previous exchange rates), but the attempt to restore gold
convertibility did not succeed, except momentarily. The 1920s-30s were characterized by
recessions, banking crises, the Great Depression and the rise of fascism. Exchange rates were
mostly floating and protectionism increased. There was a hegemonic power shift from the
UK to the US.
The Classical Gold Standard, 1879-1914
The 19th century was the century of British economic and military dominance. The
UK adopted the gold standard in 1821, after the inflation associated with the Napoleonic
Wars stabilized. But the other countries remained on bimetallism (both gold and silver were
used, with a fluctuating conversion ratio between them).
During the 1870s, most European countries joined the gold standard. In 1879, the US
returned to the gold standard when price stability was restored after the Civil War. In this
way, from 1879 until the sudden outbreak of WW1 in July 1914, all major countries in
Europe and North America were on the gold standard. This meant that their economies were
closely linked and operating under the same financial mechanism orchestrated by
the City (London financial market). The Classical Gold Standard was truly international.
Salient features of the Classical Gold Standard were as follows.
(1) Goods market integration under free trade
International price linkage was strong, and the world experienced common price
movements and business cycles. The law of one price (the same products bear the same price
in different locations) held in many commodities, and this fact can also be confirmed by
econometric studies. However, one problem was the absence of the nominal anchor (see
below).
This means that no country, organization or mechanism played the role of stabilizing
the global price level. As a result, there was globally common price fluctuations in the
medium and long run.
(2) Financial integration under free capital mobility
The private sector could issue, sell or buy foreign stocks and bonds freely. US railroad
bonds were particularly popular as a means to convert British saving into American
investment. Free capital movement resulted in strong interest rate linkage.
Short-term interest rates were volatile while long-term interest rates were extremely
stable, and these interest movements were internationally synchronized. British interest rates
always provided the floor (i.e., they were lowest) for the rates of other countries, because
British securities had highest liquidity and lowest risk premium, and because London was the
financial center of the world. Another interesting point was that current account "imbalances"
were huge relative to (estimated) GDP. This means that some countries lent while others
borrowed according to their saving-investment balances. And this was not a disequilibrium.
Furthermore, banking crises tended to occur simultaneously across countries.
(3) Fixed exchange rates
 For 35 years, there was no realignment of major exchange rates. In those days, the
exchange rate was called the "gold parity" which was the conversion ratio between the home
currency and an ounce (31.10 grams) of gold. The cross rates between two currencies could
be calculated as the ratio of two gold parities.
(4) Macroeconomic fundamentals were not stable
Although integrated in trade and finance, the world economy was far from stable,
from the viewpoint of macroeconomy. There were booms and busts, and severe recessions
were experienced. Financial crises and bank runs were common.
Bretton Woods Agreement
What is the Bretton Woods Agreement?

The Bretton Woods Agreement was reached in a 1944 summit held in New
Hampshire, USA on a site by the same name. The agreement was reached by 730 delegates,
who were the representatives of the 44 allied nations that attended the summit. The delegates,
within the agreement, used the gold standard to create a fixed currency exchange rate.

The agreement also facilitated the creation of immensely important structures in the
financial world: the International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (IBRD), which is known today as the World Bank.
History and Functionality of the Bretton Woods Agreement
As mentioned above, 44 allied nations met in Bretton Woods, NH in 1944 for the
United Nations Monetary and Financial Conference. At that time, the world economy was
very shaky, and the allied nations sought to meet to discuss and find a solution for the
prevailing issues that plagued currency exchange.
The summit was also looking for policies and regulations that would maximize the
potential benefits and profits that could be derived from the global trading system. What
resulted from the conference were the Bretton Woods Agreement and the Bretton Woods
System.
The Bretton Woods System is a set of unified rules and policies that provided the
framework necessary to create fixed international currency exchange rates. Essentially, the
agreement called for the newly created IMF to determine the fixed rate of exchange for
currencies around the world.
 Every represented country assumed the responsibility of upholding the exchange rate,
with incredibly narrow margins above and below. Countries struggling to stay within the
window of the fixed exchange rate could petition the IMF for a rate adjustment, which all
allied countries would then be responsible for following.
The system was depended on and was used heavily until the beginning of the 1970s.
The Collapse of the Bretton Woods System
Backing currency by the gold standard started to become a serious problem
throughout the late 1960s. By 1971, the issue was so bad that US President Richard Nixon
gave notification that the ability to convert the dollar to gold was being suspended
“temporarily.” The move was inevitably the final straw for the system and the agreement that
outlined it.
Still, there were several attempts by representatives, financial leaders, and
governmental bodies to revive the system and keep the currency exchange rate fixed.
However, by 1973, nearly all major currencies had begun to float relatively toward one
another, and the entire system eventually collapsed.

International Monetary Fund (IMF)

The formation of the IMF was initiated in 1944 at the Bretton Woods Conference.
IMF came into operation on 27th December 1945 and is today an international organization
that consists of 189 member countries. Headquartered in Washington, D.C., IMF focuses on
fostering global monetary cooperation, securing financial stability, facilitating and promoting
international trade, employment, and economic growth around the world. The IMF is a
specialized agency of the United Nations.
Formation of IMF
The breakdown of international monetary cooperation during the Great Depression
led to the development of the IMF, which aimed at improving economic growth and reducing
poverty around the world. The International Monetary Fund (IMF) was initially formed at the
Bretton Woods Conference in 1944. 45 government representatives were present at the
Conference to discuss a framework for postwar international economic cooperation.
The IMF became operational on 27th December 1945 with 29 member countries that
agreed to bound to this treaty. It began its financial operations on 1st March 1947. Currently,
the IMF consists of 189 member countries.
 The IMF is regarded as a key organisation in the international economic system which
focuses on rebuilding the international capital along with maximizing the national economic
sovereignty and human welfare.
Objectives of the IMF

IMF was developed as an initiative to promote international monetary cooperation,

enable international trade, achieve financial stability, stimulate high employment, diminish
poverty in the world, and sustain economic growth. Initially, there were 29 countries with a
goal of redoing the global payment system. Today, the organization has 189 members.
The main objectives of the International Monetary Fund (IMF) are mentioned below:
1. To improve and promote global monetary cooperation of the world.
2. To secure financial stability by eliminating or minimizing the exchange rate stability.
3. To facilitate a balanced international trade.
4. To promote high employment through economic assistance and sustainable economic
growth.
5. To reduce poverty around the world.

What are the functions of the IMF?

IMF mainly focuses on supervising the international monetary system along with providing
credits to the member countries. The functions of the International Monetary Fund can be
categorized into three types:
1. Regulatory functions: IMF functions as a regulatory body and as per the rules of the
Articles of Agreement, it also focuses on administering a code of conduct for exchange rate
policies and restrictions on payments for current account transactions.
2. Financial functions: IMF provides financial support and resources to the member
countries to meet short term and medium-term Balance of Payments (BOP) disequilibrium.
3. Consultative functions: IMF is a centre for international cooperation for the member
countries. It also acts as a source of counsel and technical assistance.

Financial Stability Issues in Advanced and Emerging Markets

Emerging market and developing economies (EMDEs) comprise a large and diverse
group whose financial systems have grown in importance over the last decade. Based on the
classification of countries used by the IMF in its World Economic Outlook (WEO), 150
economies are classified as EMDEs, including 10 members of the G20. They differ
substantially in terms of economic size, level of development, legal and institutional
frameworks, and other factors that affect financial systems. Over the last 10 years, financial
systems in EMDEs have grown significantly vis-à-vis those in advanced economies (AEs).
Although they proved resilient during the global financial crisis, they are now facing
important new challenges.
Five key financial stability issues in EMDEs:
 Application of international financial standards.
Most EMDEs have strengthened banking supervision and the quality of securities
regulation and insurance supervision over the past decade, helping them withstand the effects
of the global financial crisis. The principal challenges in this area relate to supervisory
capacity constraints, incomplete legal frameworks, the ability to adequately regulate and
supervise financial and mixed-activity conglomerates, as well as adopting international
standards at a pace consistent with the level of those countries ‘financial development and
supervisory capacity.

 Promoting cross-border supervisory cooperation.

In countries where foreign banks play a significant role, the inherent conflicts of
interest between the home and host jurisdictions can prevent adequate supervisory
cooperation and information sharing and complicate risk assessments and cross-border
resolution. In response, many EMDEs and some AEs require foreign banks to enter as
subsidiaries and sometimes apply additional prudential measures (‗ring-fencing ‘) to
safeguard the interests of local stakeholders.
 Expanding the regulatory and supervisory perimeter.
In many EMDEs, small-scale nonbank lending and deposit-taking institutions play an
increasingly important role. As it has expanded, this sector has become increasingly complex
and interconnected with the rest of the financial system. The rapid pace of growth, sometimes
combined with deteriorating asset quality, may potentially have adverse consequences to
financial stability in some EMDEs. Several factors contribute to this situation, including an
inadequate regulatory framework and limited supervisory resources and capacity.
 Management of foreign exchange risks.
 With the growing reliance on flexible exchange regimes in many EMDEs, the
nominal exchange rate is often more volatile, especially during shifts in the global economic
environment. While this flexibility provides important benefits, the resulting volatility—
which can be compounded by sizeable capital flows—can also present risks.
These risks are especially prominent in EMDEs with thin domestic financial markets,
significant financial dollarization, or limited markets to hedge currency mismatches. As a
result, banks may be exposed to foreign exchange risk either directly via net open positions
that cannot be efficiently hedged, or indirectly as a result of lending to borrowers whose
asset-liability profiles and revenue sources expose them to exchange rate fluctuations.
 Developing domestic capital markets.
Compared to AEs, capital markets in EMDEs are shallower and more susceptible to
sudden price movements and greater disruption that may undermine confidence in their
integrity. When faced with negative investor sentiment, liquidity in those markets can erode
quickly, causing panic sales and contagion effects resulting in disorderly markets and
financial instability, as evidenced by a number of crises affecting EMDEs in the past two
decades. The development of the domestic investor base, measures to address market
illiquidity, and improvements in market infrastructure are important building blocks to
address some of the related financial stability issues.
Classification of Exchange Rate Arrangements
This classification system is based on members' actual, de facto, arrangements as
identified by IMF staff, which may differ from their officially announced arrangements. The
scheme ranks exchange rate arrangements on the basis of their degree of flexibility and the
existence of formal or informal commitments to exchange rate paths.
Exchange Rate Regimes
Exchange Arrangements with No Separate Legal Tender
The currency of another country circulates as the sole legal tender (formal
dollarization), or the member belongs to a monetary or currency union in which the same
legal tender is shared by the members of the union. Adopting such regimes implies the
complete surrender of the monetary authorities' independent control over domestic monetary
policy.
Currency Board Arrangements
A monetary regime based on an explicit legislative commitment to exchange domestic
currency for a specified foreign currency at a fixed exchange rate, combined with restrictions
on the issuing authority to ensure the fulfillment of its legal obligation. This implies that
domestic currency will be issued only against foreign exchange and that it remains fully
backed by foreign assets, eliminating traditional central bank functions, such as monetary
control and lender-of-last-resort, and leaving little scope for discretionary monetary policy.
Some flexibility may still be afforded, depending on how strict the banking rules of the
currency board arrangement are.
Other Conventional Fixed Peg Arrangements
The country (formally or de facto) pegs its currency at a fixed rate to another currency
or a basket of currencies, where the basket is formed from the currencies of major trading or
financial partners and weights reflect the geographical distribution of trade, services, or
capital flows. The currency composites can also be standardized, as in the case of the SDR.
There is no commitment to keep the parity irrevocably.
The exchange rate may fluctuate within narrow margins of less than ±1 percent
around a central rate-or the maximum and minimum value of the exchange rate may remain
within a narrow margin of 2 percent-for at least three months. The monetary authority stands
ready to maintain the fixed parity through direct intervention (i.e., via sale/purchase of
foreign exchange in the market) or indirect intervention (e.g., via aggressive use of interest
rate policy, imposition of foreign exchange regulations, exercise of moral suasion that
constrains foreign exchange activity, or through intervention by other public institutions).
Flexibility of monetary policy, though limited, is greater than in the case of exchange
arrangements with no separate legal tender and currency boards because traditional central
banking functions are still possible, and the monetary authority can adjust the level of the
exchange rate, although relatively infrequently.
Pegged Exchange Rates within Horizontal Bands
The value of the currency is maintained within certain margins of fluctuation of at
least ±1 percent around a fixed central rate or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent. It also includes arrangements of
countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS)
that was replaced with the ERM II on January 1, 1999. There is a limited degree of monetary
policy discretion, depending on the band width.
Crawling Pegs
The currency is adjusted periodically in small amounts at a fixed rate or in response to
changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major
trading partners, differentials between the inflation target and expected inflation in major
trading partners, and so forth. The rate of crawl can be set to generate inflation-adjusted
changes in the exchange rate (backward looking), or set at a preannounced fixed rate and/or
below the projected inflation differentials (forward looking). Maintaining a crawling peg
imposes constraints on monetary policy in a manner similar to a fixed peg system.
Exchange Rates within Crawling Bands
The currency is maintained within certain fluctuation margins of at least ±1 percent
around a central rate-or the margin between the maximum and minimum value of the
exchange rate exceeds 2 percent-and the central rate or margins are adjusted periodically at a
fixed rate or in response to changes in selective quantitative indicators. The degree of
exchange rate flexibility is a function of the band width. Bands are either symmetric around a
crawling central parity or widen gradually with an asymmetric choice of the crawl of upper
and lower bands (in the latter case, there may be no preannounced central rate). The
commitment to maintain the exchange rate within the band imposes constraints on monetary
policy, with the degree of policy independence being a function of the band width.

Managed Floating with No Predetermined Path for the Exchange Rate

The monetary authority attempts to influence the exchange rate without having a specific
exchange rate path or target. Indicators for managing the rate are broadly judgmental (e.g.,
balance of payments position, international reserves, parallel market developments), and
adjustments may not be automatic. Intervention may be direct or indirect.
Independently Floating
The exchange rate is market-determined, with any official foreign exchange market
intervention aimed at moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it.

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