Internationa Economics Module-1

International Economics
CHAPTER I
1. CHARACTERISTIC FEATURES OF INTERNATIONAL TRADE
CHAPTER OBJECTIVES
The objective of this chapter is to familiarize and acquaint students with the basic characteristic features of
international trade. After learning the contents in this chapter, students will be able to:
Explain the reasons why countries of the world make trade relations with each other.
Analyze how product price differentials between countries lead to international trade between
countries causing one as exporter of the product and the other as importer; identify the factors that
cause product price differentials.
Differentiate the static and dynamic gains from international trade; analyze the static (welfare gains)
from international trade using graphical models
Explain the difference between international trade and domestic trade in terms of differences in factor
mobility, product mobility, economic environment and monetary units.
1.1 Basis of International Trade
The basic question in international trade theory is to explain why nations trade with each other. Countries
trade with each other basically for the same reasons that individual people trade with each other. In today’s
world of unlimited wants, no nation by itself can produce all the goods and services which its citizens require
for their consumption. The following points explain why nations trade with each other.
i. Differences in factor endowments
Nature has distributed the factors of production unequally over the surface of the earth. Countries differ in
terms of natural resource endowments, climatic conditions, mineral resources and mines, labor, capital,
technological capabilities, entrepreneurial and management skills, and other variables that determine the
capacities of countries to produce goods and services. All these differences in production possibilities lead to
situations where some countries can produce some goods and services more efficiently than others; and no
country can produce all the goods and services in the most efficient manner ( at the lowest possible cost of
production). For example, Japan can produce automobiles or electronic goods more efficiently than any other
country in the world; Malaysia can produce rubber and palm oil more efficiently than other countries can do.
Their capacity to produce these goods is in excess of their capacity to consume them. Japan and Malaysia can,
therefore, export these goods to other countries at relatively lower prices. Brazil, Ethiopia or Thailand can
import these goods at a lower price from Japan and Malaysia and in return they can export coffee (Ethiopia)
and rice (Thailand). Because Brazil and Ethiopia can produce coffee at much lower production costs and
Thailand can produce rice at much lower cost than Japan and Malaysia.
ii. Division of labor (specialization)
Just as there is division of labor among individuals, there could be division of labor among countries of the
world. No individual is able to produce all the goods and services that he/she requires to consume and this
applies to countries as well. Just as individuals specialize in certain functions, countries specialize in the
production of certain goods and services in which they have production superiorities over the other countries.
Thus, a country specializes in the production and export of those goods and services over which they have
absolute or comparative advantage; and it imports other goods and services in the production of which it has an
absolute or a comparative disadvantage over the other countries of the world.
iii. Gains form exchange of goods and services
The basis of international trade is the gains or profits to be made from the exchange of goods and services. If
there are no gains to be made, there would be no such trade between countries.
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Department of Economics
iv. Price differentials
The immediate cause of international trade is the existence of differences in the prices of goods and services
between nations. Foreigners buy our goods because they find them cheaper than anywhere else in the world;
and we buy foreign goods because we find them cheaper. Price differences can arise due to either differences
in supply conditions or differences in demand conditions or due to differences in both.
a) differences in supply conditions (or production possibilities)
Such differences can arise due to several factors that determine the cost of producing goods and services.
These factors include natural endowments of economic resources, the degree of efficiency with which these
factors are employed, the level of technology used in production, labor skills, factor abundance, etc.
b) differences in demand conditions
Differences in demand conditions, which are largely a function of income levels and taste patterns, contribute
to international price differentials. Countries A and B may be producing the same commodity at the same
cost of production, but that does not guarantee the same price in both countries for that commodity. If country
A has a higher level of income matched by a stronger taste for that commodity, the commodity will sell for a
higher price in country A than in country B. In country B there may be lower level of demand for that product
due to lower level of income and/or taste. Hence, both income and tastes, in their capacity to affect demand,
would affect international trade, by causing international price differentials.
Let us consider a simple model of the world with two countries producing the same commodity in order to
explain the basis of international trade graphically. In all the following thee figures the price in the foreign
country (PF) is lower than the price in the home country (PH) for a given product that both countries produce.
This is due to:
• differences in supply conditions, where supply curve of the home country is less elastic than the
supply curve of the home country (figure 1.1).
• differences in demand condition, where the demand curve of the home country is more elastic than
the demand curve of the foreign country (figure 1.2).
• differences in both demand and supply conditions, where demand curve of the home country is more
elastic than the demand curve of the foreign country, but the supply curve of the home country is less
elastic than the supply curve of the foreign country (figure 1.3).
P P
S S
Foreign Home
country Foreign Country
S Home country
Exports PH S
Country
Exports PH
P
P
PF
Imports PF
Imports
D D
D D
Q Q Q Q
Figure 1.1 Identical demand conditions but different supply conditions Figure 1.2: Identical supply conditions but different demand conditions
P
Foreign S P
country Foreign S
country Home
S Country
Home
S Exports PH
Country
P
PH
PF
Imports
PF
D
D D D
Q Q
Q Q
Figure 1.3. Different demand and supply conditions
Figure 1.4. Identical demand and supply conditions
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This is in the absence of trade between the two countries. The price deferential (PH > PF) causes international
trade between the foreign country and the home country. Higher price in the home country attracts imports of
the good into this country from the foreign country where the price of that good is relatively lower. Once the
two countries brought into trade relationship with each other, the foreign country would emerge as exporter,
and the home country emerge as importer of that product. The trade between the two countries will continue
until the price deferential is wiped out (i.e. until PF = PH). When the prices in the home and foreign country are
equal there will not be any more incentive for trade to exist between the two countries (i.e. no imports and
exports) as indicated in figure1.4 above. At this stage the demand and supply conditions in the two countries
are identical i.e., the elasticity of the demand functions of the home and the foreign country are the same and
the elasticity of the supply functions too.
1.2 The difference between international trade and domestic trade
International trade (external trade or foreign trade) can be defined as the exchange of goods and services
between the residents of a given country with those of residents in the rest of the world. Domestic trade
(internal trade) is the exchange of goods and services among the residents of the same country. The difference
between domestic and foreign trade can be explained as follows:
i. Factor mobility
The distinction made by classical economists between domestic and international trade was grounded on the
notion of geographic mobility of factors of production. The assumption made was that within the nation, there
is free mobility of factors of production. If internal mobility were perfect, then all factors of production notably
labor and capital- would move into areas where they can receive highest rate of return for their services. Under
idealized perfect mobility there could not exist inter-regional differences in factor prices. The factors would
move away from the regions where their prices are relatively lower to regions where their prices are relatively
higher, until the factor price differences between the regions are completely wiped off. In such a case, the price
of any factor of production of a given type and quality must be the same throughout the entire country.
In international trade, however, the factor mobility is neither free nor perfect. First of all, there are restrictive
immigration laws which prevent free mobility of labor from one country to another. In respect of capital also,
there are restrictions on the inflow and outflow of capital and investment across national frontiers. In addition
to these legal barriers, there are other social, cultural and political barriers that restrict the mobility of factors
from one country to another. Differences in language, climate, social customs and practices, political and
educational systems, etc. do create additional barriers to factor mobility between nations. Within the nation,
such differences may not exist, or may not appear too formidable to be overcome by economic incentives. At
any rate factor mobility is relatively greater within country than between countries.
ii. Product mobility
Within the nation, the movement of goods and services from one region to another is free. The only internal
barriers to free movement of goods and services are the distance and cost of transportation – what may be
termed as natural barriers. But in the case of international trade, such a movement is not free, because in
addition to the natural barriers, are formidable man-made barriers. For instance, there are import and export
duties and quotas, exchange controls, non-tariff (hidden) barriers which put countless obstacles to the free
movement of goods and services between countries (we will discuss much about barriers to trade in chapter
four). Growing protectionism and spirits of nationalism have been making trade between countries more and
more difficult. Agricultural protectionism in the western industrialized countries and the policies of
industrialization through import-substitution in the developing countries are some of the examples of how
international trade in commodities is being deliberately reduced in today’s world.
iii. Economic environment
Within the nation, the economic environment is more or less the same in all the regions of the country. For
example, the legal framework or the laws governing consumption, production and exchange of goods and
services are the same throughout the country. The government polices with regard to interest rates, taxes,
wages or prices are the same within the country. Production techniques, factor proportions, factor prices,
infrastructure facilities and production functions or possibilities are nearly the same in the country. Similarly,
market structures-the degree of competition or monopoly in production-and consumer taste patterns and
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preferences are more or less the same throughout the country. All of them would add up to create a certain
economic environment or investment climate within the nation. But between nations, they could all differ very
significantly. This would make the character of international trade significantly different from that of domestic
trade.
iv. Monetary units
The difference between domestic and foreign trade is more obvious in international monetary or currency
differences. Within the nation, monetary laws and the financial system and arrangements are the same for all
regions in the country. Most significantly, there is a single currency used as a medium of exchange or a
measure of value which would make exchange very smooth as far as domestic trade is concerned.
This is not so between countries. We have dollars, euros, yens, pounds, marks franks, birr etc., and not all of
them are freely accepted in discharge of international monetary obligations. An Ethiopian importer must first
obtain US dollars before he can think of buying goods from the United States of America. But with the
domestic currency you can “import” and “export” goods from one region to another in any quantity you wish.
There are no currency complications or convertibility problems involved in carrying out domestic trade. In
respect of foreign trade, however, there are currency complications, problems of non-convertibility of
currencies, exchange controls and restrictions and many other obstacles. International monetary differences,
therefore, introduce complications and complexities in international transactions; and these are absent in
domestic trade and exchange.
1.3 Gains from international trade
International trade brings about improvement in production and promotes economic development in the
participating countries. It prevents monopolies. It is beneficial to consumers by providing them new and cheap
commodities. It also facilitates international payments. The gains from international trade can be broadly
classified into static and dynamic gains.
i. Static gains
Static gains arise from optimum use of the country’s factor endowments or human and physical resources, so
that the national output is maximized resulting in increase in social welfare.
Let us assume a simple model of international trade with two countries A and B both producing wheat and
cotton. The production possibility curves and indifference curves (used to measure utility or welfare) are
shown below in figures 1.5 and 1.6.
Figure 1.5 shows that, before the start of foreign Wheat

trade, country A would be in equilibrium at
point E where the price line PP1 is tangent to T
both production possibility curve (PPC) AB and G
indifference curve IC1. The slope of the price P
line shows the price ratio or cost ratio of the two E
A
commodities in country A. TT1 is the terms of
trade line whose slope shows the price ratio at IC2
which goods can be exchanged between country A’s
Import IC1
A and country B. The TT1 curve is tangent to s
K F
the PPC AB of country A at point F. Figure 1.5 A’s Exports
shows that at F, country A will produce more of
cloth (in which it has a comparative advantage) Pl
Tl
and less of wheat than at point E. Taking the
pattern of demand in country A, we have the O B Cloth
indifference curves IC1 and IC2 representing the
demand for the two commodities.
Figure 1.5: Country A’s gain from international
trade
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The terms of trade line TT1 is tangent to IC2 at point G which shows that the quantities of wheat and cloth
consumed by country A.
It can be seen that as a result of introduction of international trade, country A has moved from E on IC1 to G on
IC2, which represents a higher level of social welfare in terms of larger consumption of the two traded goods.
This is called static gain resulting from specialization brought about by the introduction of international trade.
It can also be seen that the quantities of the two goods produced are different from the quantities consumed.
The quantities produced are shown at F and the quantities consumed at G. The differences are accounted for by
exports and imports. Country A will be exporting KF quantity of cloth and importing KG quantities of wheat.
The gains to country B can be similarly explained using figure 1.6 below. Country B will fix its production and
consumption at point E before the introduction of international trade.
With the introduction of foreign trade,

country B will produce more of wheat in Wheat
which it has comparative advantage and less
of cloth in which it has comparative P
disadvantage. As a result, it will consume T
quantities of two goods as shown by point G C F
where the terms of trade line TT1 is tangent
to IC2 implying a higher welfare level than B’s
the situation before foreign trade. Country Exports
B will now export KF units of wheat and G

K
imports KG units of cloth. E
B’s Imports
Thus, both trading countries gain from

IC2
international trade through increased social
welfare that can be measured in terms of Pl IC1 Tl
increased consumption of the two O

D Cloth
commodities in both countries.
Figure 1.6: Country B’s gain from international trade
ii. Dynamic gains
Dynamic gains refer to those benefits, which promote economic growth and economic development of the
participating countries. International trade increases national income and facilitates saving and opens out new
channels of investment. Increase in saving and investment is found to promote economic growth. Exports earn
foreign exchange, which can be utilized in buying capital goods and know-how from abroad that can serve as
instruments of economic growth. The larger the national income and output the higher the rate of growth. The
higher level of output will enable a country to avoid the vicious circle of poverty and put the country in the
take off or self-sustaining growth. Production possibilities and cost of production in different countries differ
so widely that foreign trade brings to the participating countries tremendous gains in terms of national output
and income.
International trade promotes economic development in the following ways.
1) Developing countries can import capital goods in exchange for their exports that are mostly
agricultural exports. The capital goods then will increase the productive capacity of these countries
and promote the process of industrial development.
2) A country can also import technical know-how, technical skills, managerial talent and
entrepreneurship through foreign trade and collaboration.
3) International trade has brought about a tremendous movement of capital from developed countries to
developing countries. Thus, foreign trade facilitates the payment of interest or repatriation of capital.
The existence of large volume of foreign trade serves as a guarantee for the payment of interest and
the principal for lenders.
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CHAPTER SUMMARY
• In today’s world of unlimited wants, no nation by itself can produce all the goods and services which its
citizens require for their consumption
• Differences in factor endowments, division of labor or specialization in production, static and dynamic
gains from international trade, and the existence of price differences among countries are the reasons that
explain why nations of the world trade with each other.
• Differences in demand conditions, which are largely a function of income levels and taste patterns, as well
as difference in supply conditions, which are a function of factor endowments and hence cost of
production, contribute to international price differentials.
• The difference between domestic and foreign trade can be explained in terms of differences in degree of
product and factor motilities in domestic and foreign trade, differences in economic environment under
which domestic trade and foreign trade operate, and differences in monetary unit requirements for
domestic trade and foreign trade.
REVIEW QUESTIONS
1. Explain graphically how differences in demand and supply conditions between two hypothetical
countries that produce wheat and cloth will lead to trade between the countries.
2. Given that the demand for good X is more elastic in country A than country B while the supply
conditions are the same, answer the following questions.
a) Compare the before trade price of X in country A and B

b) Which country will be importer of X and which country will be exporter?
c) What will happen to the price of X in country A and country B during the process of
international trade?
d) What does the price change in country A result on quantity demand, quantity supply of
domestic producers, and supply?
e) What does the price change in country B result on quantity demand, quantity supply of
domestic producers, and demand?
Note: Answer all of the above questions based on graphical illustration.
3. Give examples of the dynamic gains from international trade.

4. Discuss the static gains from international trade using graphical illustration of how welfare
improvements are possible in two countries due to trade.
5. Give examples of barriers to factor mobility in case of domestic trade, factor mobility in case of
foreign trade and compare the degree of their effect on factor mobility.
6. What does it mean by an economic environment? How this makes foreign trade different from
domestic trade?
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CHAPTER II
2. THE CLASSICAL THEORY OF INTERNATIONAL TRADE
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the basic elements of the classical theory of
Explain the basic ideas of Adam Smith’s absolute cost advantage theory of international and David
Ricardo’s Comparative Advantage theory of international trade; compare the similarities and basic
differences of the two models of international trade theories..
Understand and analyze how terms of trade between trading countries are determined by demand and
supply forces as stated by John Stuart Mill’s theory of Reciprocal Demand using the offer curve
analysis.
Explain the factors that cause changes in terms of trade between countries and analyze using the offer
curve analysis technique.
Compare the Law of reciprocal demand with the theories of absolute and comparative advantages
Critically evaluate the validity of the classical theories of international trade to the real world trade
relations between countries.
2.1. Pre- Classical theory of International Trade (Mercantilism)
The economic philosophy that prevailed during the 17th and 18th centuries was that of the Mercantilism. The
main feature of the mercantilist doctrine was that a country could grow rich and prosperous by acquiring more
and more precious metals especially gold, and, therefore, all the efforts of the state should be directed to such
economic activities that help a country to acquire more and more precious metals. According to the
mercantilist school of economists, if international trade is not properly regulated then people might exchange
gold for commodities of daily use or require for a luxurious living. This would lead to the depletion of the
stock of precious metals within the nation. Thus, exports were viewed favorably so long as they brought in
gold but imports were looked at with apprehension as depriving the country of its true source of riches, i.e.,
precious metals.
Taxing imports was often justified as a way of creating jobs and income for the national population. Imports
were supposed to be bad because they had to be paid for, which might cause the nation to lose spices (gold or
silver) to foreigners if it imported a greater value of goods and services than it sold to foreigners. Imports were
also to be feared because those same foreign goods might not be available in time of war.
2.2. The classical theory of international trade
Adam Smith (1723 – 1790) provided the basic building block for the construction of the classical theory of
international trade. He enunciated the theory in terms of what is called Absolute Advantage model. Another
well known classiest, David Ricardo (1722 – 1823), articulated it and expanded it further into what is called
Comparative Advantages model. The models of Smith and Ricardo together constitute what is sometimes
referred to as the supply version of the classical theory of trade, because Smith and Ricardo paid almost
exclusive attention to considerations of supply or production costs in the determination of terms of trade and
the gains from trade. The modern version of the classical theory of trade, however, treats supply and demand
with equal weight. John Stuart Mill (1806 -1873), another renowned classical economist, was the first to
indicate that demand considerations must be incorporated into Comparative advantage model. But Mill was not
very clear or articulate. The vagueness in Mill’s principle of Reciprocal Demand was removed in the 19th
century, first by F.Y. Edgeworth and later by Alfred Marshall. Both Marshal and Edgeworth are credited with
originating and developing the theory of offer curves, which is a geometric technique of demonstrating the
theory of reciprocal demand. All these contributions of Smith, Ricardo, Mill, Edgeworth and Marshall, put
together, would constitute the modern version of the classical theory of comparative advantage, which is
the oldest and the most famous model of international trade.
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2.2.1 Adam Smith’s theory of absolute advantage
Adam smith challenged the mercantilists views on what constituted the wealth of Nations, and what
contributed to "nation building" or increasing the wealth and welfare of nations. Smith was the first economist
to show that goods, rather than gold (or treasure), were the true measure of the wealth of a nation. He argued
that the wealth of a nation would expand most rapidly if the government would abandon mercantilist controls
over foreign trade. Smith also exploded the mercantilist myth that in international trade one country gains at
the cost of other countries. He showed how all countries would gain from international trade through the
international division of labor.
Adam Smith, in his Wealth of nations (1776), argued that a country could certainly gain by trading with other
nations. Just as a tailor does not make his own shoes but exchanges a suit for shoes, and hence both the tailor
and the shoe maker gain by trading, in the same manner, Smith argued that a country as a whole would gain by
having trade relations with other countries. According to Smith, if one country has an absolute advantage over
another in one line of production, and the other country has an absolute advantage over the first country in
another line of production, then both countries would gain by trading. Let's discuss the Smiths model by taking
a simplistic world of two countries A and B both producing Rubber and Textile.
Assumptions
1. There are constant returns to scale in the production of both goods in the two countries (i.e. constant
marginal opportunity cost conditions).
2. The production possibilities are such that both countries can produce both the goods if they wish.
3. The countries are endowed with X amounts of factors of production such that:
a) With X factors of production country A can produce either 100 units of rubber or 50 units of
textile, or any other mix of rubber and textile, that satisfies the opportunity cost ratio of 2:1
b) With X factors of production country B can produce either 50 units of rubber or 100 units of textile,
or some other combinations of rubber and textile subject to the opportunity cost ratio of 1:2
From the above production possibilities (or supply conditions) it is quite clear that country A has an absolute
advantage in the production of rubber, and country B has an absolute advantage in the production of textile.
This means there is symmetrical factor distribution between the two countries so that there is scope for
specialization in production and also a scope for establishing mutually beneficial trade between the two
countries.
A. Autarky (closed economy) situation
The table to the right implies that

country A produces and consumes Table 1: Production and consumption levels under autarky situation
50 units of rubber and 25 units of Commodities in units Units of Opportunity
textile with the given production Country output cost ratio
technology and input supply. Rubber Textile (GDP ) (R:T)
The total production, GDP, is 75
units and this is the maximum
consumption level if we assume A 50 25 75 2:1
that saving is zero. Country B B 25 50 75 1:2
produces 25 units of rubber and 50
units of textile with its given World 75 75 150
technology and input supplies.
The total production of country B is 75 units and total consumption will also be 75 units if savings are assumed
to be zero. For our simple world of two countries, therefore, world production and consumption will be 150
units.
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B. The case of open economy
Opening trade provides the two countries an opportunity to specialize in production. It will lead to production
and consumption gains. These effects can be seen in the following table. Country A will specialize in the
production and export of rubber and B will specialize in the production and export of textile. Trade will enable
the countries to realize production and consumption gains.
After trade both countries become richer by 25 units Table 2: Production levels after international trade.
than their situation without trade and this is due to Country Commodities Total
production gain from international trade. The world in unit output or
GNP has also increased from 150 to 200 units. Rubber Textile GDP
Country A has specialized in the production of rubber
and country B has specialized in the production of A 100 0 100
textile. B 0 100 100
World 100 100 200
What about consumption gains? After trade, have the consumer in the two countries been happier as a result
of their countries becoming richer and more specialized in terms of production? This depends on how the
gains from production are distributed between the two countries. In other worlds consumption gains to the tow
countries depend up on the terms of trade (TOT) i.e. how many units of rubber exchanged for one unit of
textile between country A and B.
Case 1. Trade at TOT = 1:1
At this TOT country A agree with country B to exchange 1 unit of rubber for 1 unit of textile. Then depending
up an the taste pattern in the two countries and up on how much or how little they want to trade each other's
goods, the consumption gains can be determined.
• If the two countries want to consume all that they have produced, it mean that their consumers
have no taste for the product of the other country then, there will be no trade between countries.
• But if each country wants to consume some mix of both goods; then the countries will trade each
other’s goods. Country A could export, say; 40 units of rubber for 40 units of textile import from
country B (at terms of trade 1:1). The result of this trade can be depicted in table 3 below.
Country A, after trade, has produced 100 units of rubber (see table 2) consumers in country A want to consume
60 of rubber, which means that this country can export 40 units of rubber to country B in exchange for 40 units
textile imports.
As a result, their consumption will Table 3: Consumption shares after international trade at TOT=1:1
increase by a total of 25 units than Country Commodities Total Consumption
the case without trade (see table 1). in unit Consumpti Gains
Similarly, country B's consumption Rubber Textile on
level will also increase by 25 units
import
than the situation without trade A 60 40 100 25
import
However, if the terms of trade is B 40 60 100 25
equal to the cost ratio of country A, World 100 100 200 50
all the gains from trade will be Note: Import of country A is export of country B
attributed to country B.
Conversely, if the term of trade is equal to the cost ration of county B, all the gains from trade will be
attributed to country A. Any other terms of trade between the cost ratios of the two countries may lead to
unequal gains to country A and B. The country whose domestic cost ratio is larger by small amount than the
TOT will gain the smaller share and vice versa i.e. if TOT closer to the domestic opportunity cost ratio of
country A, country A will gain the smaller and B will gain larger.
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Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1
All the consumption gains from Table 4: Consumption shares after trade at TOT =2:1
international trade go to country B Country Commodities Total Consumption
because the TOT is equal to the domestic in unit Consumption Gains
opportunity cost ratio of country A. Rubber Textile
Thus such a TOT is favorable to country
import
B but does not bring any change in A 50 25 75 0
import
welfare level of A. B 50 75 125 50
World 100 100 200 50
Case 3: Trade at TOT =Domestic opportunity cost ratio of country B = 1:2
All the consumption gains from Table 5: Consumption shares after trade at TOT =1:2
international trade go to country Country Commodities Total Consumption
A because the TOT is equal to the in unit Consumption Gains
domestic opportunity cost ratio of Rubber Textile
country B. Thus such a TOT is
import
favorable to country A. It does A 75 50 125 50
Import
not bring any change in the B 25 50 75 0
consumption level of country B. World 100 100 200 50
The welfare of country B before and after trade remains constant.
Case 4: Trade at TOT = 2:3
Most of the consumption gains from Table 6: Consumption shares after trade at TOT =2:3
international trade go to country A Country Commodities Total Consumption
because the TOT is closer to the in unit Consumption Gains
country B than country A. Thus such a
import
TOT is more favorable to country A than A 60 60 120 45
import
country B. B 40 40 80 5
World 100 100 200 50
Case 5: Trade at TOT = 3:2
Most of the consumption gains from Table 7: Consumption shares after trade at TOT =3:2
international trade go to country B Country Commodities Total Consumption
because the TOT is closer to the in unit Consumption Gains
country A than country B. Thus such a
import
TOT is more favorable to country B than A 40 40 80 5
import
country A. B 60 60 120 45
World 100 100 200 50
It is important to note that production gains alone are not sufficient to determine the profitability of
international trade from the standpoint of an individual member country. The consumption gains (welfare
gains) are also equally important. How the consumption gains are determined is crucial in determining
whether the economic well being (standard of living measured by consumption gains) of a member country has
gone up as a result of international trade. International TOT, therefore, plays a very important part in
determine the welfare gains from trade. International trade would be beneficial and profitable for a country if
it results in consumption gains. Production gains alone do not bring profitable trade from the stand point of the
country concerned, but it may from world point of view.
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2.2.2 David Ricardo's comparative advantage model
Ricardo, in relation to Adam Smith’s absolute cost advantage model of international trade, went farther, and
argued that even if the countries did not have absolute advantage in any line of production over the others,
international trade would be beneficial; leading to gains from trade to all the participating countries. Ricardo’s
model is termed as comparative advantage model. Ricardo’s modal is a further refinement of Smiths’ model.
Assumption of Ricardo’s Model
1) A simple model of the world with two countries each producing two goods, rubber and textile.
2) Both countries can produce both goods if they wish ( i.e., dependence on each other is not mandatory)
3) Constant returns to scale in production of both goods in the two countries (constant marginal
opportunity cost condition)
4) One country’s comparative advantage is grater in one line of production and the other country’s
comparative disadvantage is smaller in the other line of production.
In simple example the countries are endowed with X amount of factors of production such that :
a) With x factors of production A can produce, say, 120 units of rubber or 120 units of textile or
any mix of rubber and textile conditioned by the opportunity cost ratio of 1:1. The cost of
producing a unit of either commodity is the same in this country.
b) With X factors of production B can produce either 40 units of rubber or 80 units of textile
or any mix of rubber and textile conditioned by the opportunity cost ratio of 1:2. Producing
rubber costs two times producing textile.
From the above production possibilities (or supply condition) it is quit clear that county A has an absolute
advantage over country B in both lines of production and country B has an absolute disadvantage over country
A in both lines of production. In terms of relative or comparative advantage, country A has a greater
comparative advantage in the production of rubber as compared with the production of textile. B's comparative
disadvantage is smaller in the production of textile compared with the first line of production (rubber). Using a
given quantity of factor inputs country A can produce 3 units of rubber whereas country B produces only 1 unit
of rubber using the same unit of factor input. In case of textile production country A can produce 1.5 times
what country B can produce using the same quantity of factor input.
In brief, one country's comparative advantage is greater in one line of production, and the other country's
comparative disadvantage is smaller in the other line of production. International trade would bring production
and consumption gains, when the two countries enter into trade with each other.
Let's see with the help of numerical models, Table 8: Production possibilities in county A and B
how international trade will benefit countries Commodities in units Opportunity
in a situation where countries differ in both Country cost ratio
absolute and comparative advantages. In other Rubber or Textile (R:T)
words, how countries will benefit from A 120 120 1:1
international trade in a situation where one
country has a larger comparative advantage in B 40 80 1:2
the production of one good and the other World 160 200
country has a smaller comparative
disadvantage in the production of the other
good
_____________________________________________________________________________________ 11
Absolute advantage
• Country A has absolute advantage in the production of both textile and rubber over country B.
• Country B has absolute disadvantage in the production of both goods over country A.
Relative (comparative) advantage
• Country A's comparative advantage over country B is greater in the production of Ruber (3:1) as
compared to Textile (1.5:1)
• Country B's comparative disadvantage, in relation to country A, is lower in the production of Textile
(1:1:5) as against Rubber (1:3)
In addition country B can produce rubber at a far higher cost of production than textile. For country B the cost
of producing 1 unit of rubber equals the cost of producing 2 units of textile. Hence country A would specialize
in product of rubber and country B in production of textile. The theory of comparative advantage suggests that
a country should specialize in the production and export of those goods in which either its comparative
advantage is greater or its comparative disadvantage is smaller. It should import those goods, in the production
of which its comparative advantage is smaller or its comparative disadvantage is greater there by a country
would be able to maximize its production (GNP) and consumption (economic welfare) gains from trade.
Case 1 Autarky Situation
Table 9 indicates that country a produces and Table 9: Production and consumption under autarky
consumes 80 units of rubber and 40 units of Country Commodities in unit Total output or
textile with the given production technology and Rubber Textile GDP
input supply. The total production, GDP, is 120
units and this is the maximum consumption A 80 40 120
level if we assume that saving is zero. B 20 40 60
World 100 80 180
Country B produces 20 units of rubber and 40 units of textile with its given technology and input supplies. The
total production of country B is 60 units and total consumption will also be 60 units if savings are assumed to
be zero. For our simple world of two countries, therefore, world production and consumption will be 180 units.
After trade country B becomes richer Table 10: Production levels after internal trade
by 20 units than the autarky situation Country Commodities in unit Total GDP and GNP
and the world GNP increases from Rubber Textile Consumption gains
180 units to 200 units. This is due to
the fact that trade enables country A A 120 0 120 0
to specialize in the production of B 0 80 80 20
Rubber, for which it has a greater World 120 80 200 20
comparative advantage, and country B has specialized in the production of textile for which it has a smaller
comparative disadvantage.
As in the case of Smith’s model, the distribution of production gains from international trade among trading
countries for consumption depends on the terms of trade. The following tables illustrate the distribution of
consumption gains at different terms of trade.
_____________________________________________________________________________________ 12
The gains are equally distributed to Table 11: Consumption levels after IT at TOT = 3:4
country A and B at TOT = 3:4. This TOT Country Commodities in Total Consumption
is exactly half way between internal cost unit Consumption Gains
ratios of country A (1:1) and country B Rubber Textile
(1:2). From table 10 and 11 we observe
import
that, although the production gains are A 90 40 130 10
import
obtained entirely by country B, the B 30 40 70 10
consumption gains are distributed equally World 120 80 200 20
between country A and B. This is due to
the equitable terms of trade.
All the gains in consumption are

appropriated by country B due to the Table 12: Consumption levels after IT at TOT =1:1=OCR of A
reason that TOT is equal to the internal Country Commodities in unit Total Consumption
opportunity cost ratio of country A. In Rubber Textile Consumption Gains
this situation, country A will not gain import
anything from international trade, A 80 40 120 0
import
because the cost of importing the good B 40 40 80 20
World 120 80 200 20
is the same as the cost of producing
that good domestically.
Table 13: Consumption levels after IT at TOT = 1:2 = OCR of B

All the gains in consumption are Country Commodities in unit Total Consumption
appropriated by country A due to the Rubber Textile Consumption Gains
reason that TOT is equal to the A 90 import
60 140 20
internal opportunity cost ration of B import
30 20 60 0
country B. World 120 80 200 20
2.2.3 Law of Reciprocal Demand Offer curve Analysis
The Principle of Reciprocal Demand was developed by J.S. Mill in 1848 when he wrote his book: Principles of
Political Economy. Later offer curve technique was developed by Edgeworth and Marshall. The offer curve
tries to show how the terms of trade are determined by the interaction of demand and supply. Their merit lies in
the fact that they resolve the problem of determining the exact terms of trade that emerge in trade equilibrium.
Assumptions
• Simple model of the world with two countries A and B,
• Country A specializes in the production of textile and B in the production of rubber.
The TOT, then according to the law of reciprocal demand, are determined by A’s demand for B’s product and
B’s demand for A’s product. In other words, the TOT are determined by the intensity of domestic demand for
foreign goods (offer curve of the country A) and of the foreign demand for domestic good (offer curve of the
other country B). The equilibrium TOT is determined at the point where the offer curves of the two countries
intersect.
Table 14 indicates that textile is country A’s Table 14: Schedule of Trade Propensity for country A
exportable product, and rubber is its importable Textile Rubber Potential
product. Country A has completely specialized (Exportable) (Importable) Terms of Trade ratios
in the production of textile, because it has an 25 5 5:1
absolute or comparative advantage in this line 40 10 4:1
of production. If consumers in country A want 60 20 3:1
to consume rubber, it can be fulfilled only by 80 40 2:1
importing it from country B, which has 100 100 1:1
achieved complete specialization in rubber 90 120 0.75:1
production.
_____________________________________________________________________________________ 13
Initially when country A does not have any rubber to consume at all, it is willing to export 25 units of textile
in exchange for 5 units of rubber implying trade takes place at 5:1 terms of trade.
This is the highest TOT in table 5 and as trade continues between A and B, the TOT declines. The reason is,
initially the marginal utility of rubber for country A is so high that it is willing to offer 5 units of textile
(export) in exchange for 1 unit of rubber (import). But as trade continues and country A consumes more and
more of the imported product (rubber), the marginal utility from additional consumption of rubber goes down.
This is explained by the decrease in the TOT ratios in column 3 of table 10 from 5:1 to 1:1.
This follows from the law of diminishing marginal utility where the consumer is willing to pay higher price per
unit of utility initially, but only lower and lower price for subsequent unit that he/she buys. In the same way
the price that a country is willing to pay per unit of imports decrease as the imports increase in quantity. The
TOT in column 3 of table 14 are potential terms of trade, which only indicate country A’s propensity to trade
more and more at different possible terms of trade. That is, as TOT decreases what country A want to export
and import will also increase as indicated in columns 1 and 2 of table 14. We can plot the information in table
10 and draw the offer curve of country A as shown below.
The continuous line which is drawn from

Textile
the point of origin connecting all the five
points, 1,2,3,4, and 5 is the offer curve of
country A. It is designated as OA. It has
a positive slope and it is non-linear. Its
5
positive slope derives from country A's 6
desire to trade more and more, though at 100
different terms of trade. Up to point 5 its

9080 3 4
slope continues to be positive. At point 5, OA
60
country A is willing to offer 100 units of
40 2
textiles in exchange for 100 units of
1
rubber imports. Beyond point 5, however, 20
the offer curve has a negative slope. This

indicates that at point 5 where country A 40
Rubber
20 60 80 100 120
exports 100 units, its desire or the
capacity to export more textiles is
Figure 2.1: Derivation of an offer curve
exhausted.
At point 6 in the diagram, country A is willing to accept or import 120 units of rubber at a price of only 90
units of textile exports. This will not be acceptable to country B; because, for country B it is better to sell 100
units of rubber and receive100 units of textiles at point 5 than trading at point 6. This means country A would
be willing to trade with country B even beyond point 5, but this will not be acceptable by country B.
Therefore, trade virtually cannot take place beyond point 5. Thus, we can have the following properties of
offer curve of a country.
i. The relevant portion of the offer curve is positively sloped
Only the positively sloping portion of the offer curve is relevant for trade equilibrium. The negative portion of
the other offer curve is an irrelevant range.
ii. The offer curve is not a straight line, it is a non-linear curve.
This property follows from the law of diminishing marginal utility for the purchased goods.
For a given unit of imported commodity, country A is willing to offer less and less price as it goes on
importing more and more quantity. The rays which are drawn from the point of origin across points 1, 2, 3, 4, 5
and 6 represent potentially acceptable terms of trade from the standpoint of country A. They all have different
slopes suggesting that the price of rubber, payable in terms of the number of units of textiles per unit of rubber
imported, goes on decreasing as country A imports lager and larger quantities of imports.
_____________________________________________________________________________________ 14
iii. The offer curve is a composite curve (both demand and supply)
Each point on the offer curve represents the demand of the country for imports and supply of the country
(exports).
The offer curve of a country has an affinity with the potential terms of trade. The question then is where the
actual terms of trade are? This cannot be known until the other country's offer curve is known. It is
unnecessary to repeat the whole explanation, because the same principles apply to country B's offer curve as
those of country A's offer curve.
The only point to emphasize for contrast would be that country A's importable product would be country B's
exportable. Once we know the offer curve of country A and country B, we can see where the actual terms of
trade are. Figure 2.2 demonstrates where the terms of trade are actually settled between the two countries.
OA and OB are the two offer curves Textile

OB e
of country A and country B. Both
1
intersect at point 1, country A is
a
willing to offer (export) Oa quantity C2
OA
of textiles in exchange for Ob quantity

of rubber imports. This perfectly
matches with country B's trading C3
2
a1 C1
propensity as well, because at point 1,
country B is willing to offer (export)
Ob quantity of rubber in exchange for C4
Oa quantity of textile imports. In other
words, A's demand for B's product O
b1 b
Rubber
exactly coincides with B's demand for

Figure 2.2: Determination of Terms of Trade
A's product at point 1.
The straight line starting from the point of origin and going through point 1 is the equilibrium terms of trade
line, Oe. The slope of this line represents the international terms of trade (i.e., the price of rubber in terms of
textile).
The two countries can trade as much or as little as they wish along the terms of trade line Oe, but beyond point
1 on the Oe line they will have no incentive to trade further. The equilibrium size of trade is represented by the
triangle Oal or Ob1 i.e., when Oa exports of country A (or bl imports of country B) are matched by al imports
of country a (or Ob exports of country B). Beyond point 1 there will be no incentive for trade between the two
countries. By the same token, an incentive to trade will not stop until the two countries reach point 1 on the Oe
line. Let us see why this is so. Take for instance a point such as point 2 on the terms of trade line Oe. At point 2
there is:
• Excess offer of C3C1 amount of rubber by country B to country A, and

• Excess offer of C2C4 amount of textiles by country A to country B.
Both the countries accept this excess offers and their trade volumes increase. This process of trade expansion
will go on until the excess offers by the two countries are eliminated. Such a point is reached when both
countries arrive at point 1, where country A's offer is exactly equal to what country B is asking for, and country
B's offer is also exactly equal to what country A is willing to accept. We say that at point 1 the reciprocal
demands of the two countries are in exact balance and trade equilibrium point is reached. This has taken place
at a point where the two offer curves intersect. The size of international trade corresponding to this equilibrium
position is Oa of textile exports plus b1 of rubber imports for country A that equals a1 textile imports plus Ob
rubber exports of country B at Oe terms of trade.
_____________________________________________________________________________________ 15
Changes in Terms of Trade
The offer curve of a country is both a demand curve and a supply curve. It is a demand curve to the
extent that it represents domestic demand for foreign goods. It is also a supply curve insofar as it
represents quantities of exportable goods offered in exchange for imported good. An offer curve of a
country, therefore, is a composite curve, representing demand for importable goods and supply of
exportable goods. This applies to offer curves of both (or all) the countries. When the offer curves of two
countries intersect at a point such as 1 in figure 2.2 we have equilibrium terms of trade in the static sense.
But the conditions underlying demand and supply in the home and the foreign country do not remain
static forever. Many dynamic changes are possible. For example, the domestic demand for foreign goods
may change due to changes in tastes, incomes, foreign prices of the goods etc. Similarly, the supplies of
exportable goods may change on account of changes in domestic cost conditions or demand conditions.
In the same way there could be changes affecting foreign country's offer curve as well.
Figure 2.3 demonstrates the Textile b

effects of such dynamic OB1
OB2 OA2
changes on the equilibrium 3
terms of trade and size of e
international trade. OA and OA1
OB are the offer curves of 1
countries A and B
respectively. Point 1 2
determines equilibrium size of
international trade in the static
sense; Oe line represents
static terms of trade. A
leftward shift in country B's
offer curve from OB1 to OB2
would shift the terms of trade O
Rubber
line from Oe to Ob.
Figure 2.3: Changes in Terms of Trade
This would shift the trade equilibrium position from point 1 to point 2 as shown in figure 2.3. Such a shift
causes terms of trade to improve for country B and worsen for country A. Country A is now able to import a
smaller quantity of rubber in exchange for a given quantity of textile exports. This is suggested by the fact that
the new terms of trade line, Ob, is steeper than the original terms of trade line Oe. As the terms of trade line
becomes steeper, and keeps moving closer to the vertical axis (where we measure country A's export product)
the terms of trade would go on worsening for country A and improving for country B.
A shift from point 1 to point 2 causing terms of trade deterioration for country A has, in this case come about
due to adverse changes in country B for country A's export product. This may have been the as a result of
several factors like:
• A drop in the taste in country B for the product of country A.
• Country B might have diverted its trade direction away from country A to some other country in the
world. This will reduce country B's demand for country A’s product.
• Country B might have launched a program of import substitution as a result of which it has started'
producing country A's product domestically within country B itself.
It is also possible for terms of trade to worsen for country A even though there are no adverse changes in
country B towards the product of country A. For instance, starting from point 1 we could end up at point
3 in figure 2.3. This will also shift the terms of trade line from Oe to Ob. Note, however, that this time the
worsening of terms of trade is a result of a leftward shift in country A's offer curve from OA1 to OA2.
Such a shift is due to changes that have taken place within country A itself. These internal changes could
be:
• Increase in export production in country A leading to fall in the price of export product.
• A technological revolution in the export production has considerably cut costs of producing
_____________________________________________________________________________________ 16
textiles in country A. This would mean that country A has become a more efficient producer and
exporter of its product to country B.
In this way it is possible to visualize number of changes in supply condition in country A that will have
the effect of shifting its offer curve from OA1 to OA2. Compare now the effects on terms of trade on
country A as a result of going from point 1 to point 2 and going from point 1 to point 3. In either case, of
course, there has been the same degree of deterioration in terms of trade affecting country A adversely.
But there are differences too. These differences are:
• Movement from point 1 to point 2 has resulted in contraction of the volume of world trade; but in
respect of the movement from point 1 to point 3 there has been an expansion in trade volume.
• Movement from point 1 to point 2 is the result of an adverse demand shift in the foreign country
(country B) causing terms of trade decline for country A. Country A may suffer trading losses on
account of such terms of trade deterioration. In the case of a movement from point 1 to point 3,
however, there is decline in terms of trade for country A; but this term of trade decline may not
amount to a trading loss as such. Because, this movement has resulted from favorable supply shifts
in the home country (country A) itself, such as for example technological progress or efficiency in
export production leading to reduced input costs. Country B, in this case benefits from such
technological progress in country A, because country A can now sell its product at a lower price to
country B. Country A can increase country B's welfare without suffering any loss of welfare itself.
In this way the benefits of progress in one country (country d A in this case) can be transmitted to
other countries (country B) in the form of reduced export prices.
The classical economists had these advantages of trade in their mind; they thought that international trade
would act as a "transmission belt" in which the benefits of growth, productivity and efficiency in one
country will be passed on to other countries through the mechanism of trade.
The reality of the world today may appear to be quite puzzling. Advanced industrial countries have
experienced remarkable progress in technology and productivity in the last several years, but this
does not seem to have resulted in reduced prices of their products to the developing countries.
Examples are not lacking. According to a United Nations' report, 25 tons of rubber exports could
earn enough foreign exchange for a less developed country to buy 6 tractors from an advanced
industrial country in 1960; but in 1975, the same 25 tons of rubber can buy only 2 tractors.
Technological breakthrough in rubber production has reflected in rubber price reduction by rubber
exporting countries (i.e. the LDCs), but the industrial countries have not reduced their tractor prices
in spite of a much more spectacular technological progress in all fields of industrial production. This
is quite contrary to what the classical economists had hoped about benevolent trade between
countries. Where have the productivity gains, resulting from technological progress in the industrial
countries, gone then? They have gone in the form of higher wages, profits and standards of living in
those countries themselves. The benefits of technological progress in the LDCs have gone to the
industrial countries in the form of reduced prices of primary goods, which the LDCs export to the
industrial countries. This would only suggest that trade is benefiting the rich countries and not the
poor countries. Productivity gains are going from the poor to the rich countries, while rich countries
themselves are retaining their productivity gains by improving their wage and profit levels. LDCs are
quite bitter about such kind of trade relationship existing in the world today.
Let us now take another Textile

OB
situation where the offer 3
curve of country B, rich OA3
country, is a straight line 2

OA2
and the offer curve of
country A, poor country, 1 OA1
not as shown in the

following figure 2.4.
Rubber
Figure 2.4: Trade between small and large country
_____________________________________________________________________________________ 17
To whatever direction the offer curve of country A shifts, the terms of trade remains constant and equal
to the offer curve of country B. From this it should be realized that a small country could exercise no
influence in changing the course of international terms of trade. A small country, like country A in this
case, is essentially price taker than a price-maker.
CHAPTER SUMMARY
• Mercantilists measure the welfare of a society in terms of the accumulation of precious metals like gold
and silver. Thus, they were against free tree trade in general and favor exports sol long as they brought in
gold but imports were looked with apprehension as depriving the country of its precious metals.
• According to smith’s theory of absolute cost advantage, the wealth of a nation is measured in terms of real
goods and services.
• According to the theory of absolute cost advantage, a country has to specialize in the production and
export of the good for which it has an absolute cost advantage over the other country and import the good
for which it has an absolute cost disadvantage over the other country. This will benefit both countries in
terms of production and consumption gains
• Ricardo’s theory of comparative advantage states that a country has to specialize in the production and
export of the good for which it has either a larger comparative advantage or smaller comparative
disadvantage over the other country. It has to import the good for which it has either a smaller
comparative advantage or a larger comparative disadvantage over the other country. Such a trade
relation will benefit both trading countries.
• The distribution of welfare (consumption) gain from international trade among the trading countries
depends on the international terms of trade. If the terms of trade is closer to the domestic opportunity cost
ratio of one country, most of the welfare gains will be attributed to the other country and vise versa.
• Both Smith’s and Ricardo’s theories of international trade are termed as supply version of the classical
theory of international trade. Both theories paid exclusive attention to production costs (supply factors) in
the determination terms of trade and gains from international trade.
• The law of reciprocal demand and the offer curve analysis resolve the problem of determining the exact
terms of trade that emerge in trade equilibrium. According to this law terms of trade are determined by
the forces of demand and supply.
• The offer curve is a composite curve in a sense that it represents both demand and supply. Each point on
the offer curve represents the demand for imports and the supply of exports of a country. All factors that
affect demand and supply of a product do have the same effect on the offer curve of a country and cause it
to shift. The shift of the offer curves will cause a change in terms of trade.
REVIEW QUESTIONS
1. Write the statements of the absolute cost advantage and the comparative advantage theories of
international trade; compare their differences and similarities.
2. Assuming a simple model of two countries A and B where A is exporter of coffee and B is exporter
of steel based on their absolute and comparative advantages answer the following questions.
a) If the offer curve of country A is constant but the offer curve of country B
shifts right ward due to increase in income of people in country B and
positive taste and preference to the product of country B, Coffee, what are
the effects of such change on:
_____________________________________________________________________________________ 18
• Equilibrium terms of trade ( which product will be cheaper than the
basic situation; show it graphically)
• Volume of world trade
• Country A and B
b) What factors cause the offer curve of country A to shift up showing increase
in supply of coffee and down rightwards showing a decrease in supply of
coffee at a given terms of trade.
3. Write the properties of the offer curve of a country.
4. What does the law of Reciprocal demand states about and how does it differ from the theories of
Smith and Ricardo?
5. Suppose that the following table shows the case of an open economy of comparative advantage
model of two countries Japan and China. Both countries can produce cloth and steel at different
internal domestic cost ratios. The production and consumption levels in the case of autarky for the
two countries are given in the following tables.
Table 1: Production schedule

Countries Commodities produced in units
Cloth Steel
Japan 240 or 240
China 80 or 160
World 320 or 400
Table 2: production and consumption under autarky

Countries Commodities produced and consumed in Total production
Unit and consumption
Cloth Steel Cloth + Steel
Japan 160 80 240
China 40 80 120
World 200 160 360
Based on the above information answer the questions a to d.

a) Compare the two countries in terms of both absolute and relative advantages
b) Calculate the internal opportunity cost ratios for each country and determine in which
production line each country should specialize according to the comparative advantage
theory.
c) What is level of the production gain due to specialization and trade
d) What will be the consumption gain between china and Japan if the international TOT = 1:1.
Based on the result give general statement on how TOT determines the distribution of
welfare gains from international trade among trading countries.
_____________________________________________________________________________________ 19
CHAPTER III
3. THE MODERN THEORY OF INTERNATIONAL TRADE
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the two main propositions of the modern theory of
Analyze the factor endowment theory (Heckscher-Ohlin theorem) and its predictions about the
structure of international trade based on the price and physical criteria of defining factor abundance..
Compare the validity of the H-O theorem under price and physical criteria.
Critically evaluate the validity of the H-O theorem based on the factor intensity reversal argument,
the demand reversal argument and the Leonthief’s paradox.
Analyze the basic principles and ideas of factor price equalization theorem base on the Edgeworth-
Box graphical analysis.
Critically evaluate the validity of the factor price equalization theorem by comparing its assumption
with the empirical world.
The two main propositions of the modern theory of international trade are the Factor-Endowment theory
(Heckscher-Ohlin theorem, hereafter named H-O theorem in this module) and the Factor-Price equalization
theorem.
The Factor-Endowment theory (H-O Theorem) states that a country has a comparative advantage in the
production and exports of that commodity which uses more intensively the country's relatively abundant factor
of production.
The Factor-Price Equalization Theorem states that the effect of trade is to equalize factor prices between
countries, thus serving as substitute for international factor mobility.
3.1 The H-O Theorem (Factor-Endowment theory) and its Assumptions
Recent contributions to the pure theory of international trade have relied heavily on the factor proportions
analysis developed by the two Swedish economists, Eli Heckscher (1919) and Bertil Ohlin (1933). According
to their theory, the immediate cause of international trade is, the differences in the relative prices of
commodities between the countries, and these differences in the commodity prices arise on account of the
differences in the factor supplies (endowments) in the two countries.
The H-O model is based upon the following assumptions:
• There are only two factors of production-labor and capital.
• There are only two countries and they are different in factor abundance, e.g. one country is capital
abundant but labor scarce and the other country is labor abundant but capital scarce. In other
words, the two countries differ in factor endowments.
• There are only two commodities. Both goods involve the use of both factors. The production
functions are such that the relative factor intensities are the same for ach good in the two countries.
In other words, regardless of what the factor proportions or factor prices are in the two countries,
one commodity is always capital intensive in both countries and the other commodity is labor
intensive in both countries.
On the basis of these assumptions, the H-O theorem predicted that the capital surplus country specializes in the
production and exports of capital intensive goods, and the labor surplus country specializes in the production
and exports of labor intensive goods. We will now proceed to demonstrate this well-known structure of trade
prediction of the H-O model. In order to demonstrate this prediction we need to define the term factor
abundance.
_____________________________________________________________________________________ 20
3.1.1 Factor Abundance
There are two alternative definitions that have been given for the term 'factor abundance base on the criterion
used to define the term. There are two criteria for defining the term factor abundance. These are price
criterion and physical criterion.
i. The Price Criterion
According to this "price criterion" a country in which capital is relatively cheap and labor is relatively more
expensive, is regarded as the capital abundant country, regardless of the physical quantities of capital and
labor available in this country compared with the other country; in the same way, a labor abundant country
would be defined as one where labor is relatively cheaper and capital is more expensive.
For the fact that price of a factor is the result of demand and supply forces in the factor market, this criterion
takes into account the supply and demand conditions for the two factors of production in the two countries.
ii. The Physical Criterion
Factor abundance can be defined in physical terms. According to the "physical criterion", a country is
relatively capital abundant if and only if it is endowed with a higher proportion of capital to labor than the
other country. In other words, if the capital to labor ratio of country A is larger than the capital to labor ratio of
country B, country A is a capital surplus country and country B is a labor surplus country. This criterion takes
into account only the supply (physical quantities) of factors as a base for defining factor abundance. It does not
take factor demand into account.
These two alternative definitions are not equivalent. The Heckscher-Ohlin prediction with regard to the
structure of trade would follow only if we use the price criterion but it does not necessarily hold well if we use
the physical criterion to define factor abundance. Ohlin himself defined relative factor abundance using the
price criterion. He thought that if capital is relatively cheap in one country, that country must be abundant in
capital supply; and if labor is relatively cheap in the other country, it must be a reflection of the labor abundance
in that country.
It now remains for us to show that one country, say country A, is capital abundant and it exports capital-
intensive good, and the other country, say country B, is labor abundant and, therefore, it will export labor
intensive good. We shall examine these Heckscher- Ohlin proposition about the structure of trade under each
definition of factor abundance separately.
3.1.1.1 Price Criterion of Factor Abundance and the Structure of trade
Starting from the definition of factor abundance in terms of factor prices, it is easy to establish the H-O
theorem. It is easily demonstrated in figure 3.1. The two factors-capital (K) and labour (L) are measured along
the vertical and horizontal axis, respectively. The set of factor price ratios (isocost curves) in country A, a
capital surplus country, are shown by the parallel isocost lines P0P0 and P0'P0'. The slope of the isocost curve
∆K PL
shows the factor price ratios in country A ( Slopeof Iso cos t curve = = ). The relative steepness of
∆L PK
these lines reflects the fact that capital is cheaper and labor is dearer in country A. Similarly, the lines P1P1 and
P1'P1' reflect the factor price ratios (isocost curves) in country B. The relative flatness of these lines shows that
labor is cheap and capital is expensive in country B, a labor surplus country.
_____________________________________________________________________________________ 21
Then we have the two isoquants labeled aa and bb, Capital

and the two isoquants cut each other only once, i.e. at
point Q. This indicates that there is no reversal of P
factor intensity, meaning that one commodity is P0 a
capital intensive in both the countries (K good b
represented by the isoquant aa) and other commodity

F J
(Good represented by the isoquant bb) is labor H
intensive in both countries. This is in conformity with

the H-O assumption that the production functions Q
P
are identical for each good in the two countries. P1
b K-Good
We can now see how the capital surplus country N
T
R
M
a L-Good
would export capital-intensive good, and labor Labor

O D E P0 P0 G P P1
surplus country would export labor intensive good.

Figure 3.1: Price Criterion of Factor Abundance
i. Cost of Production in Country A
The cost of producing one unit of K good is made up of HD amount of capital plus HF amount of labor,
because at point H there is a tangency between the isocost curve P0P0 and the isoquant for K good. The cost of
producing one unit of L good consists of OF=JE amount of capital (which is equal to the capital unit required
to produce the K-good) but more labor viz. OE amount of labor (as against OD amount needed to produce one
unit of K good). In other words, in country A, in order to produce one unit of L good, you need to use the same
amount of capital as in K good (viz. HD=JE = OF) but more labor (OE as against OD). In other words, the
isoquant curve of K-good is tangent at the lower isocost curve whreas the isoquant curve of L-good is tangent
to the upper isocost curve of country A. This implies producing K-good is cheaper than producing L-good in
country A. Hence the capital surplus country (country A) would specialize in the production and exports of
capital-intensive good (K good). K-good is capital intensive and L-good is labor intensive to both country A
and B due to a higher capital to labor ratio in K-good production than the L-good production as shown in
figure 3.1.
OF OF
( k − good ) > ( L − good ) for Country A and
OD OE .
ON OT
(K − good ) > ( L − good ) for country B
OG OG
ii. Cost of Production in Country B
The cost of producing one unit of L good is made up of OT = MG amount of capital plus OG amount of labor,
but the cost of producing one unit of K good consists of the same amount of labor but more amount of capital
i.e. ON = RG (as against OT=MG needed to produce one unit of K good). This means that country B can
produce L good at a relatively lower cost of production per unit. Therefore, country B (a labor surplus country)
would specialize in the production and exports of L good (a labor intensive good).
To sum up:
a) Factor price ratios in country A and B are different, which reflects that country A is capital-
abundant and country B is labor-abundant,
b) One commodity is capital intensive in both countries (viz. K good) and the other commodity is
labor intensive in both countries (L good).
Thus, starting from the definition of factor abundance in terms of factor prices, (or price criterion) it is
easy to establish the H-O theorem. Incidentally, we might also say that reverse of the theorem also holds
well, i.e. if a country exports capital intensive good, then capital must be its cheaper factor of production.
Likewise, if a country exports labor-intensive good, then labor must be a cheaper factor of production in
that country.
_____________________________________________________________________________________ 22
One could argue, however, that stating the theorem in terms of factor prices, is not very interesting,
because factor prices are themselves the result of a complicated interplay of economic forces- particularly
of demand for and supply of the factors of production. From the mere knowledge of factor endowments
alone it is not possible to say anything precisely about factor prices. Therefore, to state the H-O theorem
in terms' of factor prices (using the price-criterion) does not give, perhaps, the most interesting
explanation of the theorem. A more natural definition of factor abundance, it appears would run in terms
of physical amounts. We shall now turn to the physical criterion and see what the results would turn out to
be:
3.1.1.2 Physical criterion of factor abundance and the structure of trade
According to this criterion country A is capital abundant and B is labor abundant if the capital to labor ratio of
country A is greater than the capital to labor ration of country B.
KA KB
Symbolically: >
LA LB
Where KA and LA are the total amounts of capital and labor, respectively, in country A, and KB and LB are the
amounts of, capital and labor, respectively, in country B.
We will now show that country A, a capital abundant country by the physical criterion of abundance, has a bias
in favor of producing the capital-intensive good; and that country B, a labor abundant country will have a
production bias in favor of labor-intensive good production.
Figure 3.2 reflects the nature of these Steel

biases in the two countries in respect of
the two goods. The production
A P1
possibility curve of country A is AB
and that of country B is CD. We
assume that steel is the capital intensive P2 Q1
good and Cloth is the labor intensive C
P1
good. Suppose, the two countries Q2 P2
produce the goods in the same
proportion-along the ray OR- then
country A would produce at Q 1 and
country B at Q2 on their respective
production possibility curves. Note that
O B D Cloth
the slope of country A's production-
possibility curve at Q l is steeper than
Figure 3.2: Factor abundance defined in physical terms
the corresponding slope of country B at
Q2.
Similarly, the commodity price line P lP 1 is steeper than the line P2P2. All this implies that steel production
is cheaper in country A and cloth production is cheaper in country B, if the two countries are producing at Ql
and Q2 respectively. Country A would, therefore, tend to expand production of steel and country B would do
so for cloth. This means that country A has a bias in producing more steel than cloth and B has a bias in
producing more cloth than steel.
Does it follow from this that country A would export steel and country B would export cloth? The answer
depends very much upon the demand (consumption) factors in each country. This gives rise to two
possibilities:
• If the consumption bias and the production bias are towards the same direction, then country A would
import rather than export steel and country B would import rather than export cloth. The H-O
prediction would then be invalid,
• If the consumption and production biases are in the opposite direction, then the H-O prediction will
be valid, viz. country A would export steel and country B would export cloth. Let us illustrate these
two cases.
_____________________________________________________________________________________ 23
i. Production and Consumption biases in opposite direction
As depicted in figure 3.3 below, after the establishment of trade between the two countries, country A's
production shifts to point A (towards greater production of steel), and country B's production shifts to point B
(towards greater production of more cloth). This means that the capital surplus country (country A) specializes
in the production of the capital-intensive good (steel), and the labour surplus country (country B) specializes in
the production of the labor-intensive commodity (cloth). There is greater degree of specialization but by no
means complete specialization, in the two countries, because of the diminishing return to scale conditions in
the two countries in respect of both the goods.
Figure 3.3 shows that the line PP stands for the international terms of trade line, which is also the relative
factor price ratio line after trade is established between the two countries.
(Note incidentally that factor prices will be equalized as a result, of trade). We shall discuss this later under
factor price equalization theorem, which is the second proposition of the Modern theory of international trade).
If the demand biases in the two countries Steel

are in opposite direction such that we
have an indifference curve like IC in P
A
figure 3.3, the H-O theorem and its A
prediction about the structure of trade
R
will hold good. The two countries H ICA
produce at points A and B but consume
C
at point C. It is important that E
IC
consumption point, 'such as point C, C
T
must lie to the right of point A but to the ICB
left of point B (implying opposite D F B

direction in production and consumption
biases in each country) in order for H-O O D P
B
prediction to be valid. In this case, it has
Cloth
happened in figure 3.3. Country A
exports an amount of steel equal to the Figure 3.3: Consumption and production biases in opposite direction
size AE and imports cloth equal to the
size EC.
Country B exports DB units of cloth and imports CD units of steel. The capital surplus country, therefore, is
exporting capital intensive good and it is importing labor-intensive good. Similarly, the labor surplus country is
exporting labor-intensive good and it is importing capital-intensive good.
In this case, therefore, the H-O prediction would be valid. We emphasize that it is important that consumption
should take place to the right of where the production is taking place in country A, and to the left of where the
production is taking place in country B. Only then the two countries will specialize in the production as well as
export of the commodities which involve intensive use of their respectively abundant factors of production.
It is by no means necessary that the taste pattern in the two countries must be identical. In figure 3.3, we have
made that assumption in drawing a common indifference curve IC both for country A and country B, but it is
not necessary. One can feel free to assume that taste patterns in the two countries are different, if that sounds
more realistic. For instance, in the same figure, we have also drawn ICA and ICB which represent different
demand (or utility) patterns in country A and country B. This would only mean that country A is consuming at
point R while it produces at point A, and that country B is producing at point B and consuming at point T.
Nevertheless, country A exports steel (equal to AH amount) and imports cloth (equal to HR amount); and
country B exports FB amount of cloth and imports TF amount of steel. Therefore, as long as the consumption
points lie to the right of where production is taking place in country A and to the left of where the production is
taking place in country B, the H-O prediction concerning production specialization as well as commodity
composition of exports and imports by countries would perfectly hold good.
_____________________________________________________________________________________ 24
ii. Production and consumption biases in same direction
This case is illustrated in figure 3.4. The figure reproduces the same information as in figure 3.3, except that in
figure 3.4, the demand in country A is biased toward the capital-intensive good and that in country B the
demand is biased toward the labor-intensive good. Therefore, as a result, country A produces at point A,
specializing in the production of steel.
It consumes at point D, given the Steel

utility pattern represented by
P
indifference curve ICA, This means
D ICA
that country A exports EA amount of
cloth and imports ED amount of steel. A
Therefore, country A which is a capital E ICA1
surplus country is exporting labor- ICB1
intensive good (cloth) and importing
capital-intensive good (steel). This is in
B
direct conflict with the H-O prediction
concerning the commodity structure of G
trade. Likewise, country B specializes ICB
F
in the production of cloth; it produces
O P
at point B. But it consumes at point G
in response to its utility pattern Cloth
represented by the indifference curve
ICB. Figure 3.4: Consumption and production biases in same
direction
Therefore, it exports BF amount of steel and imports FG amount of cloth. Once again we notice that
country B, which is a labor-surplus country exports capital-intensive good (steel) and imports labor-
intensive good (cloth). The H-O prediction is overturned.
iii. Autarky Situation
If, on the other hand, the demand patterns are not identical that the indifference curve of country A is tangent at
point A (as shown by ICA1 in figure 3.4) and the indifference curve of country B is tangent at point B (also
shown by ICB1 in figure 3.4), then it would mean that
country A and B choose to consume where they produce. There will then be no trade, but a situation of autarky.
In such an event, the H-O prediction will still be valid but, only insofar as it related to production specialization
but not structure of trade. There, will, in fact, be no trade to speak of.
3.1.2 Critical evaluation of the H-O theorem
Although the factor proportions theorem developed by Heckscher and Ohlin provides a thorough and plausible
explanation of international trade as compared with the classical comparative advantage model, yet it is not
free from criticism. The H-O theorem has been criticized mainly along the following three lines of arguments.
• Factor intensity reversal argument

• Leontief’s Paradox, i.e. the results obtained by empirical tests conducted by Leontief and others on
the capital to labor ratios of exports and imports of developed countries like USA and Japan.
• Demand reversal argument. We have already seen how the H-O theorem will turn out-to be invalid
when the demand reversal takes place.
i. Factor intensity reversal argument
The H-O theorem was based on the assumption of no factor intensity reversal. That is, the production functions
are different for different goods but they are identical for each good in the two countries. This, in other words,
means that one good is capital intensive (with higher capital-labor ratio) and the other good is labor-intensive
_____________________________________________________________________________________ 25
(with lower capital-labor ratio); but the same good, which is capital-intensive in one country, must be capital
intensive in the other country also, and the labor intensive good remains labor intensive in both countries. This
assumption is guaranteed when the two production isoquants of the capital-intensive and the labor intensive
goods-cut each other only once but not more than once. In figure 3.1, this is shown to happen at point Q. The
demonstration in this figure is consistent with the H-O assumption of non-reversibility of factor intensities.
If factor intensity reversal takes place, then the

Capital
two isoquants would cut each –other at more
than once and the H-O theorem would turn out Cloth Steel
to be invalid. This case is demonstrated in

figure 3.5. The two production isoquants for
steel and cloth cut each other twice in figure 3.5
once at point A and the second time at point B. A
The factor price ratios in country A (capital P0 P’0
surplus country) are represented by the parallel

lines P0 and P’0 whereas P1 and P’1 represent B Steel
the factor price ratios in country B (labor P’1
Cloth
P1
surplus country).
Labor
Figure 3.5: Factor Intensity Reversal
In figure 3.5, note the following factors.

• In country A, steel is labour-intensive and cloth is capital intensive. In order to produce one unit of either
steel or cloth, country A has to use the same amount of capital but more labor for steel than for cloth.
Cloth has a higher capital labor ratio and steel has a lower capital labor ratio. Therefore, a capital rich
country like country A would specialize in the production and exports of the capital intensive good, which
is cloth. It would import steel which is a labor intensive good.
• In country B, cloth is a labor intensive good and steel is a capital intensive good. Because, to produce one
unit of cloth, it takes a given amount of labor and smaller amount of capital as compared to steel. Steel
takes the same amount of labor but more capital per unit of output. In country B, therefore, steel has a
higher capital labor ratio than in cloth. Naturally, country B (which is a labor surplus country) would
choose to specialize in the production and exports of the labor-intensive good, viz. cloth. Country B,
therefore, would export cloth and import steel which is capital intensive.
In this case of factor intensity reversal, as we saw above, both the countries produce and export the same
commodity i.e. cloth. In the capital rich country, (country A) it is a capital-intensive product, and in the labor
rich country, (country B) it is a labor-intensive product. That means the same product (viz. cloth) is capital-
intensive in one country but labor-intensive in the other. The same thing applies to steel as well. Steel is a labor
intensive product in the capital rich country (country A), and it is a capital-intensive product in the labor rich
country (country B). This is a situation of factor intensity reversal. When this takes place, both countries end
up producing and exporting the same commodities (cloth) and importing the other commodity steel. This
would invalidate the H-O prediction regarding the structure of commodity trade.
ii. Leontief paradox
The first comprehensive and detailed examination of the H-O theorem was the one undertaken by Leontief.
You will recall that the theory of factor proportions predicted that the capital abundant country exported
capital-intensive goods and imported labor-intensive goods, and the labor surplus country did the opposite.
It is commonly agreed that the United States is a capital rich and labor scarce country. Therefore, one would
expect exports to consist of capital-intensive goods and imports to consist of labor-intensive goods. Leontief
made an extensive study of the US structure of trade and the results were startling. Contrary to what the H-
O theory had predicted, Leontiefs study showed that the US exports consisted of labor-intensive goods and
the imports, (or more precisely import competing products) consisted of capital-intensive goods. In
Leontiefs own words, "America's participation in division of labor in international trade is based on its
specialization in labor intensive rather than capital-intensive lines of production. In other words, the country
resorts to foreign trade in order to economize its capital and dispose of its surplus labor, rather than vice
versa”. Leontief’s findings are summarized in the following table:
_____________________________________________________________________________________ 26
Exports Imports Replacements

Capital (US $ in 1947 prices) 2550780 3091339
Labor (man years) 180313 170004
Capital Labor ratio (US $ per man hour) 13911 18185
From the, above table, it is obvious that the US exports had a lower capital-labor ratio than the import
replacements. Note carefully that these are import replacements produced in the United States as opposed to
the actually imported goods in that country.
iii. Demand reversal argument
As we have discussed in figure 3.4 above, if production and consumption biases operate in the same direction
in each country, a capital surplus country will go for specializing in the production of capital intensive good
but it will export a labor intensive good and a labor surplus country will go for exporting capital intensive good.
This structure of trade is contrary to the H-O prediction. Therefore, if demand reversal takes place in both
countries, the H-O prediction about the structure of trade will be invalid.
3.2 The factor-price equalization theorem
The factor-price equalization theorem states that the effect of trade is to equalize factor prices between
countries, thus serving as substitute for international factor mobility. This theorem has enjoyed far less
limelight than the H-O theorem. Nevertheless, it has attracted considerable attention from well-known
economists. Heckscher (1919) stated that free trade equalizes factor rewards completely. Ohlin (1933), on the
other hand argued that full factor-price equalization cannot occur in practice. Ohlin asserted that free trade
brings about only a tendency towards factor-price equalization, and only partial factor-price equalization is
possible. The later models by Stolper and Samuelson (1941) and Uzawa (1959) also support partial
equalization thesis. The later works of Samuelson (1948, 1949, and 1953) and of Lerner (1953) make out a
case for complete factor-price equalization.
Assumptions of the theorem
In order to demonstrate how the factor-price equalization takes place as a result of international trade, we
will use:
• A model of two countries (country A and B),
• Both countries produce commodities (goods X and Y) and
• There are two factors of production (capital K, and Labor, L) used in each country to produce
commodities X and Y.
• Before trade (i.e. in a situation of autarky) we have the following situations:
o In country A, a labor surplus country, labor is abundant and cheap and capital is scarce and
expensive. Therefore, the K/ L (or capital labor ratio) is rather low. And once the trade is
opened up, labor becomes relatively scarce and the price of labor will go up. Similarly,
capital becomes relatively abundant and hence the cost of capital will go down. This
follows directly from the H-O theorem that the labor surplus country will specialize in the
production and exports of labor-intensive goods. In other words, the abundant factor
becomes scarce and the scarce factor becomes abundant, relatively so that (after trade) the
K/ L will go up in country A.
o In the capital surplus country-country B-the pre-trade situation is such that capital is
abundant and cheap, and labor is scarce and therefore expensive. The K / L will be high
before trade. But after trade, this country will specialize in the production of capital-
intensive goods, so that the demand for capital will rise relative to that of labor. This will
result in capital becoming scarce and the cost of capital going up, and labor becoming
abundant and the cost of labor going down. The K / L will drop as a result.
In brief, we start with a low capital-labour ratio in country A and a high capital-labor ratio in country B.
_____________________________________________________________________________________ 27
This is before trade. But after trade capital ratio will rise in country A and fall in country B until the
capital ratios are equalized in the two countries. This is the process by which the factor prices (capital-
labor ratios) in the two countries are equalized as a result of trade. Note that this factor-price equalization
is brought about without the movement of factors of production between the two countries. What brings
about this factor price equalization, then, is the international trade mechanism. It is in this sense that we
can argue that international trade in goods and services, is a substitute for international labor and capital
movements (or factor mobility).
We shall now explore the

meaning and process of how this
factor-price equalization will, in
fact, be brought about. We will do
it with the help of Edgeworth- Labor
Good Y
D B
Bowley box diagrams.
Y1
The points of origin for Good X 3
X’0 X3
and Good Y are as shown in
figure 3.6. Capital and labor are Capital Y’0 N 2 Capital
measured along the horizontal Y3
1 X2
and vertical sides of the above T
box diagram. The base of the box X1 X0

is larger than the height
representing a labor surplus A C
Good X
country since it has more supply Labor
of labor than of capital.
Figure 3.6. Capital to Labor ratio in good X and good Y (Edgeworth-Box)
There are three possibilities with regard to the capital-labor ratio (K/ L) in the production of good X and Good
Y:
• A Straight Line Contract Curve: If the optimum-efficiency locus (or the contract curve) is a
linear straight line, such as AB, the capital-labor ratio in the two goods will be equal and remain
so regardless of whether more of X is produced or more of Y is produced. In other words,
whether we produce at point 1 or 2 or 3 on the line AB, the capital-labor ratio in good X will be
equal to the capital-labour ratio in good Y, which is shown by the equality of the
angles BAˆ C and ABˆ D .
K K
If the contract curve is straight line , in good X = in good Y
L L
K K
tan B Aˆ C = tan A Bˆ D , where tan B Aˆ C = in good X and tan A Bˆ D = in good Y
L L
• A non-linear contract curve representing difference in the capital to labor ratios of good X
and Y.
o If the contract curve is non-linear of the type represented by the line ANB in figure 3.6),
Good X will be a capital-intensive good and Good Y will be a labor-intensive good.
K K
Because , in good X > in good Y
L L
K K
tan N Aˆ C > tan N Bˆ D , where tan N Aˆ C = in good X and tan N Bˆ D = in good Y
L L
o Finally, if the contract curve is non-linearly shaped like the sagging line ATB in figure
3.6, we find that good X is labor-intensive and good Y is capital-intensive.
K K
Because , in good X < in good Y
L L
K K
tan T Aˆ C < tan T Bˆ D , where tan T Aˆ C = in good X and tan T Bˆ D = in good Y
L L
_____________________________________________________________________________________ 28
Throughout what follows, we will assume that the contract curve is of the type represented by the non-linear
line ATB so that good X is labor intensive and good Y is capital intensive.
Even if the country had more capital and less labor, good X will remain labor-intensive and good Y capital-
intensive, so long as we have a contract curve of the shape of ATB as shown in figure 3.6. This would mean
that in our model:
• country A is a labor surplus country and country B is capital-surplus country,

• Good X is labor-intensive and good Y is capital-intensive in both the countries, regardless of the
differences in factor proportions and factor prices in the two countries.
We shall now turn to the process of factor-price equalization between the two countries, as a result of the
opening of trade between them. We will first show what happens in the two countries, using separate graphs,
and later on put them together in one composite graph.
3.2.1 Labor Surplus Country Case
The Box ACBD shows total factor Good Y

supplies in a labor surplus country A. D Labor K-Good
B
The contract curve has the shape of ATB.
The production isoquants X0and X1 are
for good X; and Y0 and Y1 are for good
P1 X3
Y. Before trade, the country produces at
point T, where X0 is tangent to Y0 at Capital
factor price ratio represented by the line

P0
P0. At point T the capital-labor ratio in F Capital
good X is equal to tan TAˆ C , and the T X1

X0
capital-labor ratio in good Y is equal to. Y0
A C
tan TABˆ D . The size of angle TBD is Good X
more than the size of TAC, which shows L-Good Labor
that good Y is capital-intensive and good

X is labor intensive in country A. Figure 3.7. Increase in Capital to labor ratio in Labor-surplus country
Once trade is opened, this country will go for specializing in the production (and exports) of good X. This
would result in a rightward shift along the contract curve from, say, point T to point F. In. moving from point T
to F, there is an increase in the production of X and a decrease in the production of Y, which is indicated by an
upward movement of the X isoquant and a downward movement of the Y isoquant. In moving from point T to
F, there has been an increase in the capital-labor ratio in X production (from TAˆ C to FAˆ C ) as well as Y
production (from TBˆ D to FBˆ D ). You will, therefore, notice that in country A (a labor surplus country) the
capital-labor ratio in both goods production has gone up after the establishment of trade. This is indicated by
the change in the slope of factor price line (slope of P0 < Slope of P1). This change in slope of the price line
indicates that the factor price ratio in terms of PL/PK has increased as we move from point T to point F.
_____________________________________________________________________________________ 29
3.2.2 Capital Surplus Country Case
The box ACBD in figure 3.7 represents Labor

Good Y
K-Good
factor supplies in country B, a capital D
B
surplus country. Before trade country

B produces at point T. At this point,
P0
the capital-labor ratio in the production
of X was equal to the angle TAC, and
in the production of Y it was equal to
T
TBD. Trade results in specialization Capital
X0
Capital
towards increased production of Y (the

capital intensive good), and, therefore, P1 Y0
the point of production shifts from

point T to, say, point F. As a result of
F
this production-shift, we find that the Y1
X1
capital-labor ratios in the production of

C
both X and Y has decreased in this A
Good X
Labor
country. L-Good
Figure 3.7. Decrease in Capital to labor ratio in capital -surplus country
ˆC
In respect of X, the capital-labor ratio has decreased from tan TA to tan FAˆ C ; and in respect of Y; it has
decreased from tan TBˆ D to tan FBˆ D .
The change in capital-labor ratios in the production of both X and Y is indicated by the change in the slope of
the relative factor-price ratio line from P0 to P1 where slope of P0 > slope of P1.
Thus, in the capital surplus country-country B, the capital to labor ratio has decreased in the production of both
X and Y goods, as a result of trade. When this is combined with the increase in capital-labor ratio in the
production of the two goods in country A, a labor surplus country, we eventually get to a point where the
capital-labor ratios (or factor prices) are equalized in the two countries.
3.2.3 Factor price equalization: a composite graph
Figure 3.8 is a joint of figures 3.6 and Good Y

D
3.7. Under autarky, country A produced B
at point M and country B at point R. The

two countries' factor price ratios were
different, as measured by the slope of the
line P0 and P’0 in the two countries.
After the establishment of trade between Capital P’0 Labor Good
Y
the two countries, there is a shift in the G X0
P1
equilibrium production points. The Y0
F
equilibrium production point shifts from N
point M to N in country A, and from P0 X1
point F to T in country B. P1 factor price X1 M

Capital
P’1
ratio line in country A (at point N) has
the same slope as the P’1 line for country A
T Y0 X0
C
B (at point T), which shows that trade Good X Labor
has led to equalization of factor prices in
Figure 3.8. Factor price equalization
country A and B. The slope of the price
lines are the ratio of price of labor to
price of capital in each country.
_____________________________________________________________________________________ 30
Thus, we see that international trade brings about equalization of factor prices between countries even in the
absence of factor movements between the countries. It is in this sense that we argue that international trade in
goods and services, is a substitute for international movement of labor and capital. In other words,
international trade brings about equalization of both the product prices and the factor prices.
3.3 Critical evaluation of the factor price equalization theorem
The factor price equalization theorem is based on certain assumptions which are rather unwarranted in real
life. The following key points are worth taking note of, because they constitute obstacles to the equalization
of factor prices in the real world.
1. The theorem assumes complete free trade, i.e. the absence of tariff and non-tariff barriers to trade. It also
assumes that there are no transport costs in exporting and importing goods and services between nations.
In real world, we know that both exist. Their very existence, therefore, will prevent factor price
equalization that free trade could have otherwise brought about. Complete equalization of factor prices
could take place if, and only if, the factors of production were internationally perfectly mobile. In that
sense, international trade in goods and services is not perfect substitute for international factor mobility.
It is at best a close substitute.
2. International trade would only lead to partial or incomplete specialization, but by no means to complete
specialization in production. This will, therefore, rule out the possibility of complete factor price
equalization. At best, we can expect partial equalization of factor prices. This conclusion is based on the
premise that there are diminishing returns to scale conditions in the production of all goods in all
countries.
3. The theorem is based on the assumption of perfect competition and diminishing- returns to scale in
production. In the real world, however, there is imperfect or monopolistic competition on the one hand,
and on the other hand, there are increasing returns to scale in the production of some goods. This would
destroy the credibility of the factor price equalization theorem.
4. For complete factor price equalization to take place the number of factors should not exceed the number
of products. In a model of two countries, two factors and two goods, it is possible to show factor price
equalization. But, in a real world model, of many countries, many factors and many goods and services, it
is not possible to argue for a complete equalization of factor prices.
5. The theorem would collapse once we show that the production functions are not identical in all the
countries taking part in international trade. The theorem will not hold good if the factor intensity reversal
takes place, because in that event a capital rich country and a labor rich country will export the same
good by using different techniques of production suited to their factor endowments. Factor intensity
reversal creates obstacle to factor price equalization.
6. The theorem assumes that factor supplies remain fixed in every country. This is unrealistic, because we
do know that the supplies of labor and capital keep constantly changing over time, almost in every
country.
_____________________________________________________________________________________ 31
CHAPTER SUMMARY
• The modern theory of international trade is based on two propositions: the factor endowment theory (H-O
theorem) and the factor price equalization theorem.
• The factor endowment theory states that a country has to specialize in the production and export of the
good that uses most the country’s relatively abundant (cheap) factor of production and import the good
that uses most its relatively scarce ( expensive) factor of production.
• The H-O prediction about the structure of trade between countries that differ in factor endowment holds
true under the price criterion of defining factor abundance whereas it may or may not hold true under the
physical criterion. Under the physical criterion it holds true if production and consumption biases in each
country are in opposite direction and will not hold true otherwise (i.e. if demand reversal takes place).
• The H-O model is criticized base on three main lines of arguments called the factor intensity reversal
argument, the demand reversal argument and the empirical works by Leontief and his associates (i.e.,
Leontief’s paradox).
• According to the factor price equalization theorem, the objective of international trade in goods and
services is to equalize factor price differences between countries and hence serve as a substitute for
international factor mobility.
• In an Edgeworth-Box, a straight line contract curve represents no factor intensity difference between two
commodities in production whereas a non-linear contract curve below and above the main diagonal of the
box represent difference in factor intensity between the two commodities (i.e., if one is relatively capital
intensive the other good will be labor intensive).
• A contract curve is a line that joins the locus of points at which the isoquant curves of two commodities
are tangent to each other. At the tangency point, the slopes of the two contract curves are equal
representing that the marginal rate of technical substitution of labor for capital for the two goods are
equal.
REVIEW QUESTIONS
1. State the two main propositions of the modern theory of international trade.
2. Explain the two alternative criteria used to define factor abundance in the H-O theorem.
3. What does that H-O theorem predicts about the structure of trade between countries with different
factor endowments?
4. Explain H-O model under the price criterion using graphs and the basic assumptions.
5. Analyze the situation of demand reversal under the physical criterion of defining factor abundance
with the help of graph.
6. Explain graphically the factor intensity reversal argument.
7. Define the contract curve.
8. Show the three possibilities with regard to the capital-to-labor ratio in producing good X and good Y
using the Edgeworth-Box.
9. Explain how factor price equalization takes place between countries with different factor endowments
(one country as labor surplus and the other as capital surplice country) using composite graph of the
Edgeworth-Box.
10. Write the basic criticisms of the factor price equalization theorem.
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CHAPTER IV
4. INTERNATIONAL TRADE POLICY
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with theories of international trade policy and their impact
on trading countries. After learning the contents in this chapter, students will be able to:
Explain the arguments for and against free trade policy
Explain the arguments against protectionist policy of international trade.
Identify and explain the tariff and non-tariff barriers to free trade.
Identify the types of import and export tariffs on goods and services.
Explain graphically the price, consumption, production (import substitution), revenue, balance of
payment, welfare, terms of trade, and employment effects of import tariffs on the tariff imposing
country
Explain why nations often prefer non-tariff barriers to tariff barriers as international trade policy.
Identify the types of quota; explain the effects of quota on quota imposing country.
Explain the differences and similarities between import quota and import tariffs
Explain the effects of export subsidies on trading countries.
4.1 Free trade: Case for and against
A policy of no restrictions on the movement of goods between countries is known as the policy of Free Trade.
Restrictions placed with a view to safeguarding home industries constitute the policy of protection. In the
words of Adam Smith, the term 'free trade' has been used to denote "that system of commercial policy which
draws no distinction between domestic and foreign commodities and, therefore, neither imposes additional
burdens on the latter, nor grants any special favors to the former." Free trade, however, does not require the
removal of all duties on commodities. It only insists that they shall be imposed exclusively for revenue and not
at all for protection.
Adam Smith wrote: "If a foreign country can supply us with a commodity cheaper than we ourselves can
produce, better buy it from them with some part of the produce of our own industry, employed in a way in
which we have some advantage." Be continued further: "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." The only exception that Adam Smith would make was industries necessary for defense.
These might be protected since defense is more important than opulence, he said.
The doctrine of free trade is the extension of the doctrine of division of labor to the international field. In the
words of Adam Smith again, "Individuals find it for their interest to employ their industry in a way in which
they have some advantage over their neighbors." And he adds, "What is prudence in the conduct of every
private family can scarce be folly in that of great kingdom." In short, the free trade theory is that such a policy
enables every country to devote itself to those forms of production for which it is best suited on the basis of
comparative advantages.
4.1.1 Cases for free trade
For arguments in favor of free trade see advantages of foreign trade discussed in chapter I.
Gains from foreign trade:
• Static gains = to welfare gains in consumption and production
• Dynamic gains impact on economic growth and economic development
4.1.2 Cases against free trade: protectionism
The term 'protection' is used to denote a policy of encouraging the home industries by the use of bounties or by
the imposition of high customs duties on foreign products. The objective is to build up great national industries
_____________________________________________________________________________________ 33
even by sacrificing utilities on the part of existing consumers. The arguments for protection are stated below.
1. Infant Industry Argument.
This argument was put forward by Friedrich List, J. S. Mill, Alfred Marshal and Souderton.
Friedrich List
Friedrich List was a German economist, in 1840. In those days, Germany was making all-out efforts to
industrialize its economy. On the other hand, the U.K. had already built by that time, a sound industrial base.
Germany was then facing lot of difficulties in competing with the established British industry. List had strong
view that the development of industries is a pre-requisite of economic progress. Free trade was good for Britain
whose economic position was already well established. For young emerging German industry, however,
protection of a tariff wall was essential.
J. S. Mill
In the words of Mill, "The superiority of one country over another in a branch of production often arises only
from having started it sooner. There may be no inherent advantage on one part or disadvantage on the other,
but only a present- superiority of acquired skill and experience. Thus, J. S. 'Mill, one of the advocates of free
trade, accepted only one argument. In Mill’s words it ran thus: “A productive duty, continued for a reasonable
time, might sometimes be the least inconvenient mode in which a nation can tax itself for the support of such
an experiment (introducing new industries). But it is essential that protection should be confined to cases in
which there is good ground of assurance that the industry which it fosters will after a time be able to dispense
with it.
Alfred Marshall
This prominent English economist, too, conceded the force of the infant industry argument, although the
English economists by and large advocated free trade. However, for protection to produce social benefits, an
infant industry must first grow up. It must eventually be able to compete at world market prices. Not only has it
to grow up, for a protectionist policy to be profitable, according to Sodersten, it will have to be able to pay
back the losses due to protection during the infant industry period. Only then is there a clear-cut case for infant
industry protection.
This argument specially applies to countries that enter the industrial field at a later stage. Such countries
possess potential advantages which may not become effective unless- foreign competition is excluded for a
period of time. Unless an industry in its infancy is protected till it acquires strength and maturity, it will die in
the face of foreign competition.
The infant industry argument rests on the following grounds:
• Every country has its own potentialities for developing some industries in the form of labour skill,
raw materials and entrepreneurial talent. No country is completely devoid of productive elements
which may yet be latent.
• Every nation has the right to develop its potentialities or discover its latent productive powers. No
nation would like its efforts for economic development to be smothered before it has had a full
chance for trial and error.
• It takes time for the productive elements to be developed. Labour can be trained; raw materials can
be improved; and entrepreneurs can become competent by experience. But they should have enough
time to develop and discover themselves.
• Infant industries cannot be expected to withstand completion from old and well- entrenched
industries. It will be unfair to expose new industries.
• If infant industries are not duly protected against competition from strong and well-established'
industries, they are bound to die. This will mean waste of valuable national assets invested in the
industry and a serious setback to entrepreneurial venture in future.
In spite of these weaknesses, the argument has been widely accepted and many countries have industrialized
themselves through protection given on the basis of this argument, e.g., the U.S.A. and several members of the
British Commonwealth, including India. But it is recognized that protection should not be given on a
_____________________________________________________________________________________ 34
permanent basis. It should be given for a definite period considered sufficient for the industry to grow.
Moreover, it should not be given indiscriminately to all industries. The industries to be given protection should
be selected with proper care and discrimination so that scarce productive resources of the community are
properly allocated.
2. Diversification of Industry Argument
This argument was advanced, among other writers, by Friedrich List in Germany. According to List, a nation
should have a variety of sources of production and employment. Depending on one industry or on a few
industries is dangerous both politically and, economically. Politically it means too much dependence on
foreign trade which may be cut off during a war. Economically, a country depending on a few industries is
exposed to the danger of serious economic dislocation in case some adverse circum stances affect such an
industry.
But it must be understood that this argument cuts at the root of the principle of comparative cost according to
which each country must specialize in the production of certain articles. According to this argument a country
must produce even those articles in which it may not have comparative advantage.
3. Employment Argument
It is argued that industrial development through protection increases employment in a country. Conversely, if
protection is not given to old established industries; foreign competition may ruin them and create
unemployment in the country.
4. Conservation of National Resources Argument
Carey and Patten had argued that free trade resulted in the export of agricultural commodities from America
and thus led to the exhaustion of the soil. Jevons in England applied the same argument again", the export of
coal which exhausted coal fields. The same argument has also been applied the Union of South Africa
regarding gold mining and in India regarding the export of manganese.
The argument has some force. If a country exports its exhaustible materials in a raw-state, it loses
manufacturer's profits. It may also be seriously handicapped when such materials have been altogether
exhausted.
5. Defense Argument
Adam Smith remarked "Defense is better than opulence". It is said that essential to make a country militarily
strong though it may not be economically prosperous. Hitler preached to the German nation, "Gun! Better
than butter." According to this argument a country must actively encourage the development of those
industries which are essential from the point of view of defense, even though it may result uneconomic
distribution of the national resource. The advocates of free trade point out that this is politics and not
economics. On purely economic grounds, they say, free trade is the best.
6. Revenue Argument
Protection is also advocated for revenue purposes. When protective import duties are imposed, they certainly
bring in revenue to the government. But it may be pointed out that there is a certain degree of incompatibility
between the revenue and protection. If full protection is given, the government will not get any revenue,
because full protection will mean that domestic goods have driven foreign goods altogether. When foreign
goods not come in, there will be no revenue from import duty. On the other hand, if government wants
revenue then foreign goods must come in and compete with domestic goods. Then domestic industries do not
get any protection. This incompatibility, however, arises between maximum protection and maximum
revenue. But if the duties are moderate, they will yield revenue besides affording protection. It is, however,
much better to advocate protection for the sake of protecting industries rather than for raising revenues.
_____________________________________________________________________________________ 35
7. Key Industry Argument
If the industrial structure of a country is to be stable and sound, the country must develop 'key' or basic
industries; otherwise foundation of industries will have been laid on sand. The country may not have any
comparative advantage in such industries. But since they are of crucial importance and have to be developed,
protection must be granted to them.
8. Balance of Payments Argument
It may become necessary to check imports by means of tariff in order to rectify adverse balance payments. The
I.M.F. regulations permit member countries to impose temporary restriction trade to cure a balance of
payments deficit. Import restrictions on non -essential imports become necessary in the interest of accelerated
economic growth.
9. Patriotism Argument.
Protection is advocated on patriotic grounds also. It is the duty of every citizen to use home-made goods as far
as possible. W-f: must, therefore, develop our industries, through protection, if necessary, so that home-made
goods in the right quantity and of good quality are made available for use.
10. Self-sufficiency Argument
Another argument in favor of protection is that we should become self-sufficient and not depend on other
countries for our necessaries. Such dependence proves very dangerous during war when foreign trade is cut
off.
11. Avoid unfair competition
Protection also becomes necessary against unfair competition from abroad arising from dumping, depreciated
exchanges, bounties, etc.
12. For Economic Stability
Protection is also advocated to shut out the baneful influences trade cycles from abroad. It is expected to make
the domestic economy immune from the destabilizing effects of external disturbing factors. In the Macmillan
Committee (1931), the late Lord Keynes put forward the opinion that protection and not free trade was needed
to restore the much-needed economic stability for an economy which is out of gear.
4.1.3 Arguments against protection
1. Vested interests are created
Once certain industries are given protection, they claim it as a matter of right. It then becomes very difficult to
take away protection. The infants begin kicking if you touch them in any manner. Such infants refuse to admit
that they have grown into adults.
2. Protection produces lethargy and acts like an opiate
When foreign competition has been removed, it sends the home manufacturers to sleep, as it were. They do not
try to make any improvement, and technical progress comes to a standstill.
3. Then there is the danger of corruption
The industrialists bribe legislators so that protection is not taken away. This evil was rampant in the U.S.A. at
one time.
4. Protection creates monopolies
Tariff is said to be the mother of trusts. When foreign competition has been removed, the home manufacturers
_____________________________________________________________________________________ 36
are tempted to combine to reap monopoly profits.
5. Consumers and unprotected industries suffer
This is so because imposition of import duties invariably leads to the rising of prices.
6. The distribution of wealth becomes more unequal
Protection favors the rich capitalists who grow still richer. The gulf between the 'haves' and 'have-nots' is
thus widened still further.
7. Source of conflict
Protection leads to conflict, friction and retaliation in international dealings. It thus breeds the germs of
future wars.
8. Inefficiency in world resource allocation
The most important argument against protection on economic grounds is that it militates against optimum
utilization of resources. It hampers international division of labor so that labor, capital and other factors of
production do not find their most remunerative employment. Their distribution is not governed by natural
economic forces-, but they are artificially forced into certain channels. The result is that they do not make their
maximum possible contribution in the production of commodities. The world output is lower than it could be,
so that the standard of living is necessarily lowered. A natural movement towards world prosperity is hindered.
4.2 Barriers to Trade
The two broader categories of barrier to free trade between countries are natural barriers and man made
barriers. Natural barriers to trade: arise on account of the cost and the distance involved in moving goods
and services from one country to another. In short, it is the transport cost. Man made barriers is further
classified into tariff and non-tariff (hidden) barriers.
4.2.1 Tariff and Its Effects
What is tariff?
Tariffs are essentially the taxes or duties imposed on the imported or exported goods. Import duties are
more common than export duties, so much so that tariffs are often
identified with import duties. Tariffs are aimed at altering the import prices (or export prices) so as to
regulate the volume of imports (or of exports).
Types of Tariffs
1) Specific tariffs: are tariffs which are assessed on the basis of the physical weight of the product
which is imported or exported. The units are in terms of Birr/Kg, Birr/ tone. They can be levied
on goods like wheat, sugar, coffee, cattle, etc. Specific tariffs can not be levied on valuable
goods like diamond, modern art paintings, TV etc.
2) Ad valorem tariffs: are tariffs levied based on the value of the product. It is a percentage tax.
E.g. 10% of the value of diamond, TV etc. Ad valorem tariff is revenue elastic but specific tariff
is not.
3) Compound tariff: combines a specific duty with an ad valorem duty.
4) Discriminatory tariff calls for different rates of duties depending on the country of origin or
destination of the product
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5) Non-discriminatory tariffs: uniform tariffs rates imposed on goods and services regardless of
their source of origin or destination. Tariffs are said to be single column when they are non-
discriminatory and double-column when they are discriminatory.
6) Revenue tariffs: these are tariffs that are imposed primarily and produce revenue for the
government
7) Protective tariffs: are tariffs that are imposed primarily to protect the domestic industries from
foreign competitions
8) Retaliatory tariffs: when country A imposes (increases) duties against the products from
country B, it is possible that country B will retaliate and levy duties on goods imported from
country A. Thus, country B’s tariffs are then described as retaliatory tariffs.
9) Countervailing tariffs: Tariffs are said to be countervailing when a country imposes
(increases) import duties with a view to offset export subsiding in the country of origin.
4.2.1.1 Effects of import tariff on tariff imposing country
Tariff is an important tool of commercial policy. Although it is primarily a protectionist device yet it proves to
be a double-edged weapon. On the one hand, it limits consumers’ choice by forcing them to cut consumption
of the goods they like and, on the other; it shifts the use of resources from one use to another. The effect of
tariffs is to change relative prices of goods, services and factors of production.
Figure 4.1 shows the foreign country’s demand and supply for a given product on the left side of the graph and
to the right is the home (tariff imposing) country’s demand for and supply of same (homogeneous) product.
PH and PF are the pre-trade equilibrium prices in the home and foreign countries respectively. The price
deferential (PH – PF) induces trade between the two countries letting the home country importer and the
foreign country an exporter of the product.
When international price is

Foreign Country E Home (Tariff imposing) country
equalized at Pw (world price), the
foreign country’s exports (S0FD0F) Sd (Domestic Supply curve)
are equal to the home countries
F
imports (S0D0 = JM). The free PH
trade price is therefore Pw at Free trade Export
G H
Pt Domestic price with tariff
SF
which the home country’s Tariff a b c d
Pw Sd + Import
imports are JM. Transport costs J K L M
and tariffs are assumed to be zero. Dd
Now let us introduce tariffs. If the PF
rate of import tariff per unit of
imported product is equal to the B
distance between Pt and Pw, this DF
imposition of tariff by the home
country on the imported product S0F D0F O S0 S1 D1 D0
will cause the following effects Quantity

on the importing country.
Figure 4.1: Effect of Tariff on Home (Tariff imposing)
1. Price effect
The immediate effect of imposition of tariff is to raise the price of both the imported product and the
domestically produced product (import replacement product) in the home country. Figure 4.1 shows that due to
tariff the product prices increases from Pw to Pt. Thus, the import duty is paid as well as borne by the
importing country exclusively.
2. Consumption effect
When tariff is imposed, price of the commodity rises and domestic consumption is reduced from OD0 (free
_____________________________________________________________________________________ 38
trade consumption) to OD1 (consumption after tariff) following the law of demand. The reduction in
consumption due to tariff is equal to (D0D1 = ML). This is called the consumption effect.
3. Production (Import substitution), or protective effect
The domestic production will go up as a result of the tariff, except in a limiting case where the domestic supply
curve is perfectly inelastic. In figure 4.1, the domestic supply curve Sd is elastic so that when the tariff raises
the price from Pw to Pt, the domestic production of import replacement goods goes up from S0 to S1. The
amount by which domestic production goes up as a result of tariff can be described as the extent of import
substitution. In the figure the distance S0S1 = JK is a measure of this import substitution. Tariff reduces the
import competing goods thus affording protection to the domestic producer. Domestic production increased as
shown above as a result of the imposition of tariff.
4. Revenue Effect
The government derives revenue from the tariff which is measured by the quantity of the imports multiplied
by the rate of tariff. The total tariff revenue that government collected amounts to the size of the rectangle
(GHLK = c).
5. Balance of trade effect
This effect of tariff is the result of tariffs on the level of imports. At the free trade price Pw, the level of imports
was S0D0 = JM. The country was paying a foreign currency equivalent to area of the rectangle S0JMD0 = OPw
X S0D0 as an import payments. But after tariff, the import quantity has been reduced to S1D1 = KL and the
import payment has also been reduced to the area of the rectangle S1KLD1 = OPw X S1D1 from the free trade
import payment level. Thus this will lead to improvement in the balance of trade (i.e., either increasing trade
surplus or reducing trade deficits) of the tariff imposing country. Out of the total import cuts from S0D0 to S1D1,
the reduction amounting S0S1 = JK is due to production (import substitution or protective) effect of tariff and
the other D1D0 = LM is due to consumption effect of tariff.
6. Economic welfare effect
The welfare effect of tariffs is, perhaps, the most important effect. The economy of a country is composed of
three parties, namely, consumers, producers and the government. In considering the economic welfare effect of
tariffs on the imposing country, we need to find out whether the welfare of each of the groups in the economy
has gone up or down.
a. welfare effect of tariffs on consumers
Before tariffs were imposed (or at the free trade price Pw), the price paid by the consumers per unit of
product was OPw. At this price consumers buy OD0 quantity of the product. Since the demand curve Dd
is also the marginal utility curve for the product, under free trade equilibrium, consumers can derive a total
utility of OEMD0 and to derive this much of utility they need to pay OPwMD0 as consumption expenditure.
The difference, which is equal to the area of the triangle PwEM, is the net utility or consumers’ surplus
that consumers can derive at the free trade world price Pw. This consumers’ surplus is the measure of the
total welfare of consumers at the free trade price.
Imposing a tariff rate of PwPt per unit of imports will reduce the consumers’ surplus from the free trade
level to an area of the triangle PtEH. This implies that consumers will loss a welfare level equal to the area
PwPtHM = a + b + c + d. Thus, tariffs decrease the welfare level of consumers through increased prices and
decrease in quantity demand (consumed).
b. welfare effect of tariff on producers
At the free trade price Pw, the level of producers’ surplus that measures of the welfatre of domestic producers
is equal to the size of the triangle BPwJ. It is the difference between revenue (the area OPwJS0) and cost (the
area OBJS0) of domestic producers.
_____________________________________________________________________________________ 39
After tariff, the producers’ surplus increased to the size of the triangle BPtG. The net gain in producers’
surplice equals the area PwPtGJ = a. This gain in producers’ surplus is part of the loss in consumers’ surplus.
Moreovere, the gain in producers’ surplus is due to the protective (production or import substitution) effect of
tariff.
c. welfare effect of tariff on government
Before tariff, there is no revenue to the domestic government collected from import duties. The tariff rate of
PwPt multiplied by the amount of import quantity S1D1 = KL generates a tariff revenue of the size of the
rectangle KGHL = c to the tariff imposing country’s government. This revenue is also part of the welfare loss
by consumers.
d. Overall welfare effect of tariff
The imposition of tariff increases the price of the commodity and thus reduces the consumers' surplus. In this
way income is transferred from the consumers to producers and the government. This effect of distribution of
income is called the distributive effect. However, all the welfare loss by consumers is not redistributed to
other groups in the society. There is a dead weight loss, also termed as the cost of tariff. This loss equals the
area b + d. It is the net welfare loss to the economy due to tariff.
7. The Terms of Trade Effect.
Take the case that the foreign and the home countries with different factor endowments giving comparative
advantage to each production of a certain commodity. Tariff reduces the volume of trade and the terms of
trade will improve for the country imposing the tariff.
8. Effect on National Income.
If a country is facing unemployment problem, imposition of tariff increase employment and thus increases
income. This happens because with the imposition of tariff consumers’ demands are diverted to domestically
produced goods. To meet this increased demand for domestic products new production units will be set up.
As a result lot of employment will be created and national income increased.
4.2.2 Non-tariff barriers
Non-tariff barriers encompass a variety of measures. Some have insignificant trade consequences; for example,
labeling and packaging requirements can restrict trade, but generally only marginally. Other non-tariff barriers
significantly affect trade patterns; examples include import quotas, voluntary export restraints, subsidies and
domestic content requirements. These non-tariff barriers are intended to reduce imports and benefit domestic
producers. There are several reasons suggested for why countries use non-tariff barriers instead of tariff.
1. Political reason
Politicians may sometimes be reluctant to levy a tariff because it is an explicit tax on domestic consumers.
Although non-tariff barriers result similar consumers’ welfare loss like tariff, the non-tariff barriers’ effect
tends to be more remote and less visible. Politicians may therefore perceive non-tariff barriers as being more
acceptable to the voting public.
2. Certainty of restrictive impact of non-tariff barriers
The restrictive impact of non-tariff barriers is relatively more certain as a protection instrument than tariff. For
example it may be much easier to show that a quota of 5 million tons restricts food imports to 5 million tons
than to show conclusively that a tariff of Birr 20 per ton would result in imports of only 5 million tons of food
imports.
_____________________________________________________________________________________ 40
Moreover, a rise in an import tariff may encourage the exporting country to subsidize its exporting companies
to make them more price-competitive, thus offsetting the tariff’s restrictive impact. Such subsidies, however,
would not alter the restrictive impact of an import quota or other non-tariff barriers.
3. Non-tariff barriers are not covered by rule of WTO (former GATT)
Many nations have adopted non-tariff barriers because they are not covered by the main body of rules of
conduct in international trade, the General Agreement on Tariffs and Trade (GATT). Although GATT has
succeeded in liberalizing tariffs in the post-World War II era, nations have circumvented GATT rules by using
loopholes in the agreements and levying types of non-tariff barriers over which trade negotiations have failed.
4.2.2.1 Import quota
A Quota is a direct limitation of the physical quantity of exports and imports permitted in the country. We
will only discuss import quotas as they are more common than the export quotas. An import quota is a
physical restriction on the quantity of goods that may be imported during a specific time period; the quota
generally limits imports to a level below that which would occur under free-trade conditions. The effects of
quotas are similar to those of tariffs, but there are also substantive differences between the two which are
worth examining.
Types of Quotas
1) Unilateral quotas
Unilateral quotas can be global and has price advantage, or allocated. Import quotas are generally imposed
unilaterally by the home government, without prior negotiation or consultation with other nations. They are
levied and administered exclusively by the importing nation. Because of their unilateral nature, import quotas
may be resented by other nations and may lead to retaliatory quotas.
a. Global quota
One way of administering import limitations is through a global quota. This technique permits a specified
number of goods to be imported each year, but does not specify where the product is shipped from or who is
permitted to import. When the specified amount has been imported (the quota is filled), additional imports of
the product are prevented for the remainder of the year.
In practice, the global quota becomes unwieldy because of the rush of both domestic importers and foreign
exporters to get their goods shipped into the country before the quota is filled. Those who import early in the
year get their goods; those who import late in the year may not. Moreover, goods shipped from distant
locations tend to be discriminated against because of the longer transportation time. Smaller merchants,
without good trade connections, may also be disadvantaged relative to large merchants. Global quotas are thus
plagued by accusations of favoritism against merchants fortunate enough to be the first to capture a large
portion of the business. For these reasons, global quotas are relatively uncommon, especially among industrial
nations.
b. Selective ( allocated) quota
To avoid the problems of a global quota system, import quotas are usually allocated to specific countries; this
type of quota is known as a selective quota. For example, the
Ethiopia might impose a global quota of 10 million tons of canned food per year, of which 3 million must
come from the Kenya, 4 million from Germany, and 3 million from Saudi Arabia. Customs officials in the
importing nation monitor the quantity of a particular good that enters the country from each source; once the
quota for that source has been filled, no more goods are permitted to be imported.
2. Bilateral quotas
_____________________________________________________________________________________ 41
Bilateral quotas imply mutual agreement between countries through negotiations. They do not provoke
retaliation.
3. Mixing or indirect quotas
In this case the domestic producers are asked to use a fixed proportion of imported and domestic materials
used in producing their products. The quota is fixed not in absolute forms but in percentage forms.
4.2.1.1 Tariffs versus quotas
The effects of quotas are similar to those of tariffs, but there are also substantive differences between the two
which are worth examining.
a. Similarities
1) they both have the same objectives like protecting domestic industries, correcting BOP, and expand
domestic employment and economic activities
2) A tariff of a certain height cuts imports to a certain quantity. It has, therefore a quota equivalent effect.
At the same time a quota would limit imports to a certain quantity and therefore, raises the import price.
A quota has, thus, a tariff equivalent effect.
3) Since both quota and tariffs raise the import price and reduce the import quantity they produce similar
effects on consumption, production, trade balance, TOT, national income redistribution, factor
movements, economic growth and economic welfare.
b. differences
1. Tariffs bring revenue to the government whereas quotas do not. Under tariff same of consumers’ loss
goes to government in the form of revenue. But under quota it is ambiguous. It could go to government
if it charges a fee for selling import licenses and if not, some of consumers loss will be distribute to
importers and the imports welfare will increase further more. Tariff revenues can be used for investment
on social services, but the quota profits going to importers may not contribute to net social welfare.
2. Distribution of import licenses (associated with quota) may give rise to corruption and bribery on the
part of government. Import tariffs do not create such problems or even if they do the degree is small.
Quotas could be more

effective than tariffs Sd0 = Sd1 Sd0 + Import
Price
particularly when the
domestic demand and supply Import after Tariff
curves for the imported good

are inelastic. As figure 4.2 P1 D1
indicates the demand and
supply curves are perfectly Tariff
inelastic. A rise in the price R
P0 D0
of the commodity from P0
(free trade price) to P1 (price
after tariff) does not bring
Free trade import
any change in the quantity of
import. The import quantity
O Quantity
before and after tariff are
equal. Tariff may of course
Figure 4.2. Tariffs and inelastic supply and demand conditions
results in substantial
government revenue equal to
_____________________________________________________________________________________ 42
the area of rectangle R, but it has failed to bring protection effect. Import quotas, are therefore, more
effective in protecting domestic industries that produce products with inelastic demand and supply
behavior.
3. The TOT effects of tariffs are determined or predictable, but those resulting from quotas are
unpredictable.
Importable of B Importable of B
Exportable of A Exportable of A
OB1
OB2
OB
TOT0
TOT0
TOT1 C
OA1 Q0 OA
TOT1A
A
B
TOT1B
Q1 A B
Quota
O O Exportable of B, Importable of A
Exportable of B, Importable of A
Figure 4.3: Terms of trade effect of tariff Figure 4.4: Terms of trade effect of quota
4. There are several reasons why domestic producers, importers, and even governments may prefer quota
to tariffs (refer section 4.2.2).
4.2.2.2 Subsidies
National governments sometimes grant subsidies to domestic producers to help improve their trade position.
Such devices are an indirect form of protection provided to home businesses, whether they may be import-
competing producers or exporters. By providing domestic firms a cost advantage, a subsidy allows them to
market their products at prices lower than their actual cost or profit considerations warrant. Governments
wanting to see certain domestic industries expand may provide subsidies to encourage their development.
Government subsidies assume a variety of forms. In the simplest method, a government makes an outright cash
disbursement to a domestic exporter after the sale has been completed. The payment may be according to the
discrepancy between the exporter's actual costs and the price received or on the basis of a fixed amount for
each unit of a product sold. The overall result is to permit the producer a cost advantage that would not
otherwise exist. Such direct export subsidies when applied to manufactured goods have been prohibited by the
General Agreement on Tariffs and Trade.
Governments sometimes use indirect subsidies to achieve the same general result. For example, governments
may give their exporters special privileges, including tax concessions, insurance arrangements, and loans at
below market interest rates. Governments may also sell surplus materials (such as ships) to domestic exporters
at favorable prices. Governments may purchase a firm's product at a relatively high price and then dump it in
foreign markets at lower prices. This has traditionally been the technique used by the U.S. government in con-
junction with its farm-support programs. As with direct cash disbursements to domestic producers, indirect
subsidies are intended to encourage the expansion of a nation's exports by permitting them to be sold abroad at
lower prices.
For purposes of our discussion, two types of subsidy can be distinguished: a domestic subsidy, which is
sometimes granted to producers of import-competing goods, and an export subsidy, which is made to
producers of goods that are to be sold overseas. In both cases, the recipient producer views the subsidy as
_____________________________________________________________________________________ 43
tantamount to a negative tax: the government adds an amount to the price the purchaser pays rather than
subtracting from it. The net price actually received by the producer equals the price paid by the purchaser plus
the subsidy. The subsidized producer is thus able to supply a greater quantity at each consumer's price.
i. Domestic Subsidy
Figure 6.6 illustrates the trade and welfare effects of a subsidy granted to import-competing producers. Assume
that the initial domestic supply and demand for steel are depicted by curves SS0 and DD0 so that the market
equilibrium price is P0 per ton.
Assume also that, because the home

country is a small buyer of steel, changes
Price of steel
in its purchases do not affect the world
price of Pw per ton. Given a free-trade S0
price of Pw per ton, the home country
consumes Q3 tons of steel, produces Q0 S1
tons, and imports Q3-Q0 tons. To

partially insulate domestic producers
PD
from foreign competition, suppose the
home country’s government grants them Ps
B
Subsidy
A
a production subsidy of Ps-Pw per ton of Pw Sw
steel. The cost advantage made possible
by the subsidy results in a shift in the Dd
domestic supply curve from SS0 to SS1.

Domestic production expands from Q0
to Q1 tons, and imports fall from Q3-Q0 O Q0 Q1 Q3 Quantity of steel
to Q3-Q1 tons. These changes represent

Figure 6.4: Economic effect of domestic subsidy
the subsidy's trade effect.
The subsidy also affects the national welfare of the home country. According to Figure 6.6, the subsidy permits
home country output to rise from Q0 to Q1 tons. Note that, at this output, the net price to the steelmaker is Ps-
the sum of the price paid by the consumer Pw plus the subsidy Ps-Pw. To the home government, the total cost
of protecting its steelmakers equals the amount of the subsidy (Ps-Pw) times the amount of output to which it is
applied OQ1.
Where does this subsidy revenue go? Part of it is redistributed to the more efficient domestic producers in the
form of producer surplus. This amount is denoted by area a in the figure. There is also a protective effect,
whereby more costly domestic output is allowed to be sold in the market as a result of the subsidy. This is
denoted by area b in the figure. To the domestic economy as a whole, the protective effect represents a dead-
weight loss of welfare.
Attempting to encourage production by its Import-competing producers, a government might levy tariffs or
quotas on imports. But tariffs and quotas involve larger sacrifices in national welfare than would occur under
an equivalent subsidy. Unlike subsidies, tariffs and quotas distort choices for consumers (resulting in a
decrease in the domestic demand for imports), in addition to permitting less efficient home production to occur.
The result is the familiar consumption effect of protection, whereby a deadweight loss of consumer surplus is
borne by the home nation. This welfare loss is absent in the subsidy case. A subsidy tends to yield the same
result for domestic producers as does an equivalent tariff or quota, but at a lower cost in terms of national
welfare.
Subsidies are not free goods, however, for they must be financed by someone. The direct cost of the subsidy is
a burden that must be financed out of tax revenues paid by the public. Moreover, when a subsidy is given to an
industry, it is often in return for accepting government conditions on key matters (such as employee
compensation levels). The superiority of a subsidy over other types of commercial policies may thus be less
than the preceding analysis suggests.
_____________________________________________________________________________________ 44
ii. Export Subsidy
Besides attempting to protect import-competing industries, many national governments grant subsidies,
including special tax exemptions and the provision of capital at favored rates, to increase the volume of exports.
By providing a cost advantage to domestic producers, such subsidies are intended to encourage a nation's
exports by reducing the price paid by foreigners. Foreign consumers are favored over domestic consumers to
the extent that the foreign price of a subsidized export is less than the product's domestic price.
The granting of an export subsidy yields two direct effects for the home economy: a terms-of-trade effect and
an export revenue effect. Because subsidies tend to reduce the foreign price of home-nation exports, the home
nation's terms trade worsened. But lower foreign prices generally stimulate export volume. Should the foreign
demand for exports be relatively elastic, so that a given percentage drop in foreign price is more than offset by
die rise in export volume, the home nation's export revenues would increase.
Figure 6.7 illustrates the case of an

export subsidy applied to a
commodity in trade between home
Price
country and a foreign country.
Under free trade, market Sd0
equilibrium exists at 'point E,
Sd1
where the home country exports Q0
Subsidy
units of the commodity to the P0
G
foreign country at a price Pw. Pw E
Suppose the exporting country
P1
government, to encourage export F
sales, grants to its exporters a
subsidy of PsP1 per commodity.
The home country’s supply curve DF
will shifts from SS0 to SS1 and
market equilibrium moves to point
F. The terms of trade thus turns O Qw Q1 Quantity
against exporting country because

Figure 6.4: Economic effect of an export subsidy
its export price falls from Pw to P1
per commodity exported.
Whether the exporter country’s export revenue rises depends on how foreign country buyers respond to the
price decrease. If the percentage increase in the number of the commodity sold to the foreign country’s buyers
more than offsets the percentage decrease in price, home country’s export revenue will rise. This is the case in
Figure 6.7, which shows the exporter country’s export revenue rising from OPwEQ1 to OP1FQ1 units of
currency as the result of the decline in the price of its export good.
Although export subsidies may benefit industries and workers in a subsidized industry by increasing sales and
employment, the benefits may be offset by certain costs that fall on the society as a whole. Consumers in the
exporting nation suffer as the international terms of trade moves against them. This is because, given a fall in
export prices, a greater number of exports must be exchanged for a given dollar amount in imports. Domestic
consumers also find they must pay higher prices than foreigners for the goods they help subsidize. Furthermore,
to the extent that taxes are required to finance the export subsidy, domestic consumers find themselves poorer.
_____________________________________________________________________________________ 45
CHAPTER SUMMARY
• Free trade is a policy of no restriction on the movement of goods between countries whereas a policy used
to encourage domestic industries by the use of barriers like imposition of high custom duties on foreign
products is termed as a protection policy.
• Advocates of free trade, mostly the classical economists, argue for free trade based on the dynamic and
static gains that countries can get from international trade.
• There are a number of arguments in favor of protectionism. The arguments are based on the importance of
protection for infant industries, for diversification of industries, for increasing domestic employment, for
conserving natural resources, for developing key industries, for defense as source of government revenue,
to check balance of payment problem, to be self sufficient, to avoid unfair competition between foreign and
domestic producers, and to avoid economic instability due to external shocks.
• Barriers to trade are grouped as natural and man made barriers. The man made (artificial) barriers to
trade are further classified into tariffs and non-tariff barriers.
• Tariffs can be classified as specific, ad valorem, compound, discriminatory, non-discriminatory, revenue,
protective, retaliatory, and countervailing tariffs.
• The major effects of import tariff on the tariff imposing country are: increase in price of the product in the
domestic market, decrease in consumption level of domestic consumers, increase in domestic production
(import substitution effect), brings revenue to the government, reduction in import payments (BOP effect),
decrease in consumers welfare and increase in producers welfare (that leads to a net social welfare loss),
favorable terms of trade, and increase in employment and national income.
• Some of the reasons why nations often use non-tariff barriers like quota and subsidies and others than
tariffs as a trade policy include political reasons (to get vote from the public during election), certainty of
restrictive impact of non-tariff barriers (especially quota) compared top tariffs, and the fact that non-
tariff barriers are not covered by rules of the WTO (GATT).
• Both quota and tariff raise the import price and reduce import quantity. As a result, they produce similar
effects on consumption, production, trade balance, terms of trade, national income redistribution,
economic growth, and economic welfare.
• Tariff and quota are different in terms: revenue (tariff brings revenue to government but quota not),
degree of risk of corruption ( import quota licensing is more susceptible for risk of corruption than tariff),
quota could be more effective in protecting domestic producers that produce a product whose supply is
high or perfectly price inelastic, and the terms of trade effect of tariff is predictable but that of quota is
unpredictable.
• Governments may provide subsidies to domestic producers that produce import competing products as
domestic subsidy and to domestic producers that produce for export as exporter subsidies.
REVIEW QUESTIONS
1. Discuss the arguments against free trade.

2. Discuss the arguments against protectionism
3. Explain the effects of import tariff on the tariff imposing country with the help of graph.
4. Unilateral quotas can be global or allocated. Explain the basic features of global and allocated quotas.
5. Write the similarities and differences between import tariff and import quota.
6. Explain the economic effects of domestic subsidy given to import competing producers and export subsidy
using graphs.
__________________________________________________________________________________ 46
CHAPTER V
5. FOREIGN EXCHANGE RATE POLICY
CHAPTER OBJECTIVES
The objective of this chapter is to familiarize and acquaint students with the basics of foreign exchange policy.
After learning the contents in this chapter, students will be able to:
Analyze the market for foreign currency in terms of demand for and supply of foreign currency using
graphs.
Identify the three major factors that cause changes in demand and supply of foreign currency in a
foreign exchange market.
Identify the difference between nominal and real exchange rate and know how to calculate real
exchange rate.
Identify the long run determinants of real exchange rate
Explain the difference between fixed and flexible exchange rate systems.
Define the terms: devaluation, revaluation, depreciation and appreciation
Know what exchange control is as a policy; explain the objectives of exchange control; distinguish the
direct and indirect methods of exchange control.
5.1. Supply and Demand for Foreign Exchange
The value of a nation’s money, like most goods and services, can be analyzed by looking at its supply and
demand. For example an increase in the demand for the dollar will raise its price (cause an appreciation in its
value), while an increase in its supply will lower its price (cause a depreciation). These are only tendencies,
however, and depend on other factors remaining constant.
5.1.1 Supply, demand and market for foreign exchange
A) Demand for foreign exchange
Figure 5.1 shows the demand for US $ in Ethiopia.

The exchange rate is measured on the vertical axis Exchange rate in Birr/$ = R
and quantity of the foreign currency (US$) is
measured on the X-axis. The exchange rate R is a
measure of the price of the foreign currency
(US$) in terms of domestic currency (Ethiopia
Birr). An increase in R implies a decline in the
value of Birr and an increase in the value of US$.
In other words, a movement up on the vertical
axis represents an increase in the price of foreign
currency (which is equivalent to a fall in the price D
of Birr). For Ethiopians, American goods are less
expensive when the Dollar is cheaper and the Birr $
is stronger. Hence, at the depreciated values for
Quantity of foreign currency
the dollar, Ethiopians will switch from home
made or third-party supplies of goods and service Figure 5.1. Demand for foreign exchange
to American suppliers.
Before they can purchase goods made in USA, however, they must first exchange Birr for US$.
Consequently, the increased demand for US goods is simultaneously an increase in the quantity of US
$ demanded.
__________________________________________________________________________________ 47
B) Supply curve for foreign exchange
The supply curve of foreign currency slopes up because

foreign firms and consumers are willing to buy a greater Exchange rate in
quantity of domestic goods as the domestic currency
becomes cheaper. The supply of US$ will increase if US S
and/or foreign citizens are willing to buy a greater
quantity of Ethiopia’s goods as the Ethiopian currency
becomes cheaper (i.e. as the foreigners receive more birr
per USD). Before the foreign citizens can buy Ethiopia
goods, however, they must first convert Dollar into Birr,
so the increase in quantity of Ethiopian good demanded
is simultaneously an increase in the quantity of foreign $
currency supplied to the Ethiopian Economy. Quantity of foreign currency
Figure 5.2. Supply of foreign exchange
C) The market for foreign exchange
Figure 5.3 shows (combines) the supply and

Exchange rate in Birr/$ = R
demand curves of foreign currency. The
intersection of the curves in the Ethio-US
foreign exchange market determines the S
exchange rate R1 at which the quantity of
demand and supply of foreign currency to R1
the Ethiopian Economy are equal.
D
Q1 Quantity of foreign currency
Figure 5.3. Market for foreign exchange
5.1.2. Change in demand and supply of foreign exchange
There are three major reasons why people hold foreign currency rather than their own. These are:
• For reasons related to trade and direct investment ( like business cycle, inflation and
expectation of future economic growth)
• to take advantage of interest rate changes
• to speculate
Changes in one or more of these three motives for holding foreign currencies can lead to a shift in the
demand and supply curves of foreign currency indicating in change in demand and change in supply of
foreign currency. The following table is an illustrative example on the determinants of demand and supply
of USD in Ethiopia.
__________________________________________________________________________________ 48
Table 5.1. Major determinates of the supply and demand for foreign currency in Ethiopia.
Increase in Ethiopia’s demand Increases in the supply of
Factors for foreign currency foreign currency
1. Trade and direct
investment factor
a) the business cycle Ethiopians economic Expansion Foreign economic expansion
(more Ethiopians Imports) (more Ethiopians exports)
b) inflation Ethiopian inflation (foreign goods Foreign inflation (Ethiopians

relatively cheaper) goods relatively cheaper)
c) expectation of future Increased potential for foreign Increased potential for Ethiopians
growth growth (attracts outward Ethiopian growth (attracts foreign direct
direct investment) investment in Ethiopia
An increase in foreign interest An increase in Ethiopia interest

2. interest rate changes rates or decline in Ethiopian rates or a decline in the foreign
interest rates
Expectation of a future decline in
3. speculation Expectation of future decline in the the value of a foreign currency, or
value of Birr, or a future rise in the a future raise in the value of Birr
value of foreign currency
5.2 Nominal and Real Exchange Rates
From the point of view of tourists and business people who use foreign exchange, the key item of interest is
the purchasing power that they get when they convert their dollars, not the number of units of a foreign
currency.
An American importer trying to decide between Ethiopia and Kenyan textiles does not care if he or she gets
8.7 birr per dollar or 73.2 KES per dollar. The biggest concern is the volume of textiles that can be
purchased in Ethiopia with 8.7 Birr and in Kenya with 73.2 KES.
Real Exchange Rate is the market exchange rate (nominal exchange rate) adjusted for inflation.
Rr = Rn (PF/PH)----------------------------------------- (1)
Where Rr = real exchange rate

Rn = market (nominal) exchange rate
PH= home country price level
PF = foreign country’s price level
A base year is arbitrary chosen as a standard for comparison, and PL and PF are both equal to 100 at the
base year. Thus, the base year real exchange rate is:
Rr = Rn (100/100) = Rn ------------------------------(2)
Over time, if inflation is higher at home than in the foreign country, then PH rises more than PF, and Rr falls
if Rn is constant. This means:
• Domestic currency appreciates in real terms
• Foreign currency depreciates in real terms
__________________________________________________________________________________ 49
Example: The base year nominal or market exchange rate in the Ethio-US foreign exchange market is 8.7
birr per USD. After a year there has been 10% inflation in Ethiopia while the inflation in USA is zero
percent. Calculate the real exchange rate.
Rr = Rn (PF/PH)
= 8.7 (100/110)
= 7.91 Birr/USD
Tourists, investors, and business people can still trade birr and USD at the nominal rate (8.7B/USD) plus
what ever commissions they must pay to the sellers). After the price increase (inflation) in Ethiopia, the
real purchasing power of the Birr has risen in USA compared to what it buys at home. The real exchange
rate of 7.91 Birr/USD tells us that US goods are now 10 percent cheaper than Ethiopian goods that have
risen in price. As long as the nominal exchange rate remains unchanged, US goods remain less expensive
to both Ethiopian and American purchasers. In real terms the USD has depreciated and the Birr has
appreciated. The real exchange rate is useful for examining changes over time in the relative purchasing
power of foreign currencies.
5.3 Determinates of Exchange Rate in the Long-Run
Few tasks in economics are more difficult and riskier than trying to predict exchange rate. Currency
markets are as volatile as stock markets, and no one yet has been able to devise a system to consistently
forecast exchange rates. Nevertheless, there is substantial evidence that over the very long run (periods of a
decade or more), exchange rates are determined by two main factors.
• Purchasing Power Parity (PPP)

• Differences in productive growth between countries.
5.3.1 Purchasing power parity
Purchasing power parity also termed as law of one price, states that a currency should buy the same
quantity of goods when converted to another currency as it can buy at home. If a unit of home currency can
buy a certain quantity of market baskets of goods in the home market, the same unit of home currency
converted to its equivalent foreign currency must buy equal quantity of markets baskets of goods from the
foreign market. In other words, the exchange rate should be at a level that keeps the real purchasing power
of money constant when it is converted to another currency.
If the law of one price does not hold, a birr in Ethiopia buys a different (larger or smaller) bundle of goods
than it buys from USA when the Birr is converted into Dollar. If birr buys more in Ethiopia than its dollar
equivalent buys in USA, then business people could make profit buy shipping goods from Ethiopia where
they are relatively cheap and sell them in USA where they are relatively expensive. If a birr worth of dollar
buys more in USA, goods will flow in the opposite direction, from USA to Ethiopia.
The law of one price can be thought of as a long-run tendency for the real exchange rate to remain constant.
Since the real exchange rate equals the nominal rate times the relative price levels, the law of one price
essentially states that if foreign prices rise more than domestic prices (∆PF > ∆PH), then the nominal rate
decrease by the same percentage (Rn falls and it takes fewer Birr to buy a unit of foreign currency). These
forces can take highly variable and sometimes very long periods of time to materialize, however, so the law
of one price does not permit anyone to forecast tomorrow’s or next years Birr- dollar exchange rate. In
addition, even over the long-run, there can be substantial deviations in a nation’s currency from the law of
one price.
__________________________________________________________________________________ 50
5.3.2 Differences in productivity growth rates
Faster productivity growth is equivalent to a relative decline in prices and leads to a real appreciation in
currency values over the long run. Let us take a historical data on US – Japanese and US-German
exchange rate over the period 1980 – 1994 as shown in table 5.1. The higher productivity growth in Japan
and Germany relative to the US productivity growth over the period 1980 to 1994 resulted in an increase in
the market exchange rate in the US-Japan and US-Germany foreign exchange market. For example of the
4.9% increase in USD-Yen market exchange rate, 2.1% of the increase was due to higher productivity
growth in Japan relative to USA, 0.9% of the increase was due to higher inflation in USA relative to the
inflation in Japan over the indicated period. The remaining 1.9% increase was due to unexplained or
stochastic factors that may have effect on exchange rate.
Table 5.1 Determinants of long-run charges in exchange rate, US-Japan and US-Germany, 1980-1994
US – Japan US - Germany
(∆PH - ∆PF) in percent where PH is price in US and PF is 0.9% 1.9%
price level in foreign
Differences in productivity growth (foreign minus US) in 2.1% 1.1%
percent )
∆Rn, in percent +4.9% +3.2%
Unexplained portion 4.9-3.0=1.9% 3.2-3.0=0.2%
Source: Kenneth Kasa “Understanding Trends in foreign exchange rates’” FRBSF weekly letter, FRB of
San Francisco, h. 9, 1995.
5.4. Exchange Rate Systems
Exchange rate systems are the rules that nations attach to the movement of their exchange rates. There are a
number of different categories of sets or rules that nations may adopt, but they all are modifications of two
fundamental categories. These are:
• Fixed exchange rate system

• Floating exchange rate system
Historically, fixed exchange rate systems have usually been a gold standard or a modified gold standard
and have been far more common than a floating exchange rate system. Both fixed and floating exchange
rate systems have advantages and disadvantages. The weight of economic opinion has probably tended to
favor floating exchange rates, although this is by no means unanimous.
5.4.1 The gold standard and fixed exchange rates
Gold standards are a form of fixed exchange rates. Under a pure gold standard, nations keep gold as their
international reserve. Gold is used to settle most international obligations, and nations must be prepared to
trade it for their own currency whenever foreigners attempt to "redeem" the home currency they earned
when they sold goods and services. In this sense, the nation's money is backed by gold.
There are essentially three rules that countries need to follow in order to maintain a gold exchange
standard.
Rule 1: Nations must fix the value of their currency unit in terms of gold.
Fixing the value of a nation’s currency in terms of gold fixes the exchange rate. For example, under the
modified gold standard of the Bretton Woods System (1947-1971) the U.S. dollar was fixed at $35 per
__________________________________________________________________________________ 51
ounce, and the British pound was set at £12.5 per ounce. The exchange rate was $35/£12.5, or $2.80 per
pound. If in Ethiopian case, government may fix Ethiopian Birr at Birr 120 per ounce of gold. Thus the
exchange rate for Birr to Dollar would be Birr 120/$35, or Birr 3.43 per USD.
Rule 2: Nations keep the supply of their domestic money fixed in some constant
proportion to their supply of gold.
This requirement or rule is an informal one, but it is necessary in order to insure that the domestic money
supply does not grow beyond the capacity of the gold supply to support it. Consider what would happen if a
country decided to print large quantities of money for which there was no gold backing. In the short run,
purchases of domestically produced goods would rise; in the medium to long run, domestic prices would
follow them up. As domestic prices rise, foreign goods become more attractive, since a fixed exchange rate
means that they have not increased in price. As imports in the home country increase, foreigners
accumulate an unwanted supply of the home country's currency. This is the point at which the gold
standard would begin to become unhinged.
Rule 3: Nations must be willing to redeem their own currency with payments in gold,
and they must freely allow gold to be imported and exported
If gold supplies are low in relation to the supply of domestic currency, gold reserves will run out when the
nation tries to redeem its currency from foreigners. This spells crisis and a possible end to the gold standard.
Note: Under any fixed exchange rate system, whether it is based on gold or not, the national supply
and demand for foreign currency may vary, but the nominal exchange rate does not. It is the
responsibility of the monetary authorities (i.e. the central bank or treasury department) to keep the
exchange rate fixed.
Figure 5.4 shows an increase in the Ethiopia’s

demand for US dollar. In the short run, a rise in Exchange D2
demand is caused by one of the factors listed in S1
D
S2
Table 5.1. These factors include, for example, R2
increased Ethiopia’s demand for US goods,
higher US interest rates, or the expectation that R2
the value of the Birr will fall against the dollar.
If R1 is the fixed Birr-USD exchange rate, then
Central Bank of Ethiopia must counter the
weakening Birr and prevent the rate from rising
to R2. (Remember, R2 represents more Birr per Q1 Q2 Quantity of foreign
currency
USD than Rl; therefore, the Birr is worth less.) Figure 5.4 Fixed Exchange rate and Changes in Demand
One option is to sell the Ethiopia’s reserves of USD. This shifts the supply curve out, from S1 to S2 and
keeps the exchange rate at RI.
Under a pure gold standard, nations hold gold as a reserve instead of foreign currencies and Ethiopia sells
its gold reserves in exchange for Birr. This action increases the demand for Birr and offsets the pressure on
the Birr to fall in value.
As Ethiopia sells its gold reserves, one of two things can happen. Either the demand for gold by people
supplying Birr is satisfied or the pressure on the Birr eases or Ethiopia begins to run out of gold. If the latter
happens, Ethiopia may be forced to devalue the Birr. Under a gold standard, devaluation is accomplished
__________________________________________________________________________________ 52
by changing the gold price of the Birr. If the Birr was set at Birr 120 per ounce of gold, devaluation would
shift the price of gold to something more than Birr 120, and each ounce of gold sold by Ethiopia buys back
a greater quantity of Birr.
Note: Devaluation and revaluation are equivalent to depreciation and appreciation, except that the first
group refers to changes in a currency's value under a fixed exchange rate system.
Devaluation is a decline in the value of a currency under a fixed exchange rate system, while depreciation
is a decline under a flexible system.
Revaluation is an increase in the value of currency under a fixed exchange rate system while an
appreciation is an increase in the value of currency under a flexible exchange rate.
5.4.2 Alternative exchange rate systems
Fixed exchange rates under a gold standard are one extreme in the spectrum of possible exchange rate
systems. At the other extreme are floating (or flexible) exchange rates. Under a floating exchange rate
system, the value of a nation's currency "floats" up and down in response to changes in its supply and
demand. When demand for domestic currency exceeds its supply, the domestic currency appreciates in
value (Rn, the nominal exchange rate falls), and when supply is greater than demand, the domestic currency
depreciates (Rn rises).
Between fixed and floating exchange rates, there are a number of other types of exchange rate systems. The
simplest way to categorize these systems is on a scale that measures the amount of flexibility each
allows.
• Freely floating rates: At one end are freely floating rates, which are the most flexible and
determined purely by the forces of demand and supply of the foreign exchange market.
• Managed floating rate: One step down the spectrum of flexibility is a managed floating rate.
The difference between a managed floating rate and a purely floating exchange rate is that the
national government occasionally intervenes in international currency markets in an attempt to
"manage" the direction of change. Intervention takes the form of buying the home currency in
order to increase its demand and prop up its value, or selling the home currency in order to en-
courage depreciation. Countries with floating exchange rates use these tactics whenever policy
makers think there is a need to nudge their currency up or down, or to stop an ongoing change.
Nearly all governments try to manage their exchange rate at some point in time. Consequently,
most of the nations that have adopted floating exchange rate systems are in fact using a managed
floating system.
• A target zone exchange rate system: this is similar to a managed floating system. The most
prominent example is the European Monetary System of the fifteen-member European Union,
prior to the single currency (Euro) of 1999. With a target zone, exchange rates are allowed to float
freely within some well-defined range, or band. The band defines a line of intervention; that is, it
is like a managed float except the limits of a currency's flexibility are precisely defined.
• Adjustable peg exchange rate: An adjustable peg is a fixed exchange rate that is adjusted
periodically. Developing nations often use an adjustable peg or something very similar as a way
to keep their exchange rate more or less fixed in real terms.
Given that Rr = Rn(PF/PH), regular adjustment to Rn keeps the real exchange rate, Rr, from
appreciating when domestic inflation is greater than the inflation rate of the country's trading partners.
5.5 Exchange Control
It should be noted at the very outset that, exchange controls, like currency devaluations, form a part of
expenditure-switching policy package. Because, they too, like devaluation, aim at directing domestic
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spending away from foreign supplies and investment. Exchange controls try to divert domestic spending
into consumption of domestically produced goods and services on the one hand and into domestic
investment on the other.
5.5.1 Objectives of exchange control
The object of controlling exchange is to fix it at a level different from what it would be if the economic
forces were permitted free interplay. The objectives of exchange control could be to:
• correct a serious imbalance in the economy of the country relatively to the outside world; or
• permit national economies and policy architects a broad freedom of action both in emergency
and normal economic situations and warranty the decision to pursue domestic policies of
economic growth and development; or
• correct a persistently adverse balance of payments; or
• prevent a flight of capital from the country; or
• conserve foreign exchange reserves for large payments abroad, i.e facilitate servicing of
foreign debt; or
• maintain stable exchange rate, or to ensure growth with stability, and so on.
In all these circumstances, a free exchange would be either embarrassing or prejudicial to the object in view,
and exchange control becomes an imperative necessity.
5.5.2 Methods of exchange control
Exchange controls may be broadly classified into two groups - direct and indirect exchange controls.
Among the direct methods mention may be made of intervention and regulation in matters concerning
exchange rates, foreign exchange restrictions, multiple exchange rate policies etc. Indirect methods of
exchange control include import tariffs, export subsidies, bilateral and multilateral clearing arrangements,
etc.
A. Direct methods of exchange control
1. Foreign exchange rate regulation through intervention
The government may intervene in the foreign exchange market with a view to raise or reduce the external
value of its home currency. This intervention takes the form of large-scale buying or selling of home
currency by the government in the foreign exchange market. The idea is to support or "peg" the external
value of the currency to a chosen rate of exchange. In the absence of such pegging or government support
through intervention, there is a risk that the free market rate of foreign exchange would diverge from the
pegged rate. Put simply, government will sell foreign exchange when the price of foreign exchange is rising
excessively on the foreign exchange market; and government will buy foreign exchange when the foreign
exchange rate is going down excessively causing appreciation of domestic currency in terms of foreign
currency. Since both depreciation and appreciation of currency are regarded as undesirable, there is need
for government intervention in keeping exchange rates relatively stable. Exchange rate stability is
necessary to facilitate and promote healthy growth of international trade and capital movements. Exchange
rate stability is threatened off and on by BOP deficit and surplus pressures on the one hand and by the
speculative buying and selling of foreign exchange of a destabilizing type, on the other. Hence, the need for
government intervention to "smoothen out" such ups and downs in the exchange rate movement from time
to time.
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It is relatively easier for a country to sell its home currency and buy excess amount of foreign exchange to
prevent depreciation of foreign exchange (or appreciation of its own currency), because every country has
unlimited supplies of its own currency. All that the governments have to do is to go to the printing press
and get more currency notes. On the other hand, the foreign exchange reserves at the disposal of a country
are rather strictly limited. Therefore, if the foreign exchange rate is appreciating due to scarcity of foreign
exchange (i.e. the domestic currency is depreciating against foreign currency), it would not be easy for
governments to sell unlimited quantities of foreign exchange to prevent a rise in the foreign exchange rate.
Government intervention, however, has to be of both the types pegging up or pegging down. The
complexity or the case with which they can be undertaken are, however, quite different.
2. Exchange restrictions
This is another, and perhaps more severe, form of exchange controls. In this case, all foreign exchange
earnings and receipts must be surrendered to the government and exchanged for home currency; and
foreign exchange can be purchased only from the government authorities. Non-compliance with currency
transactions and regulations laid down by the governments are a crime even punishable with death as in
Germany in 1931.
Government will acquire all foreign exchange coming into the country, and it will allocate or sell that
foreign exchange to buyers on the basis of predetermined national priorities. For example, foreign
exchange may not be made available for all kinds of foreign tour, travel or study or for non-essential import
of goods and services, and so forth. A country may practice a system of what is called as "blocked
accounts" i.e. not allowing the creditors of these blocked accounts to use their currency holdings in their
accounts. This was done during Hitler's Germany. Many Jews who fled to London as refugees could not
draw money from their accounts, though they had millions of marks in their German bank accounts,
because their accounts had been blocked by the German government. Similarly, government may not allow
capital transfers away from the home country. Foreign investment by nationals may not be permitted due to
shortage of foreign exchange. One can visualize any number of measures which governments may take to
cop serve scarce foreign exchange, and they all constitute foreign exchange restrictions as a form of
exchange controls.
3. Multiple exchange rate policies
Multiple exchange rates were first employed by Germany and later they were followed by other countries
like Argentina, Brazil, and Chile, Ecuador, Peru and many others. In the case of this policy, different
exchange rates are fixed for imports and exports of different goods. Even for different categories of imports,
different exchange rates are applied. Argentina maintained a higher complex system of multiple exchange
rates, because she was not a member of the IMF. The system was administered quite efficiently for a long
time.
The mechanism of multiple exchange rates is very simple. Suppose for example, the government
considered imports of some raw materials and capital goods as essential to the economic development of
the country; then the foreign exchange rate used in the case of such imports would be lower, say 1USD= 5
Birr rather than the standard exchange rate of, say 1 USD= 8.70 Birr. In terms of Birr (home currency) the
importer pays a lower price for obtaining a given amount of USD (foreign exchange). This would make
imports of such goods cheaper, because the Birr price of USD fixed for their imports is lower. On the other
hand, imports of non-essential luxury goods may be subjected to a higher foreign exchange rate, say 1USD
=15 Birr. This would raise value of USD in terms of Birr and make import of the luxury goods rather very
expensive. The same discriminatory exchange rate policy could be applied to export goods as well to
encourage exports of certain types of goods and services more than others.
The policy of multiple exchange rates is also called selective devaluation policy as opposed to general
devaluation policy. In the case of general devaluation policy, imports of all goods and services are made
expensive, regardless of whether they are essential or nonessential types of imports. Similarly, generally
devaluation would make all the exports attractive regardless of what the export commodity is. Multiple
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exchange rate policy undertakes selective devaluation i.e. it would make essential imports cheaper and non-
essential imports expensive, and it would make some exports attractive and other exports unattractive.
Multiple exchange rate policy will have different exchange rates not only for different goods (imported and
exported) but also for different countries with which the home country is trading.
The advantage of multiple exchange rate policy to the practicing country lies in the fact that it eliminates
the need for employing quantitative restrictions on imports (or exports) and licensing of imports (or
exports). To that extent, this system can eliminate inefficiency and corruption that usually go with import
licensing and quantitative restrictions on imports. This is perhaps the great merit of multiple exchange
rates vis-a-vis physical controls on imports. However, there are several shortcomings associated with the
multiple exchange rate systems. For example, the system introduces complexity and lot of confusion with
regard to the number of exchange rates applicable to number of commodities in relation to number of
countries. Sometimes, they can harm healthy economic development of a country.
B. Indirect methods of foreign exchange control
Among the indirect methods of exchange control to mention are: exchange clearing agreements, import
restrictions, tariffs and import quotas are the chief instruments of indirect methods of exchange control.
1. Exchange clearing agreements
Exchange clearing agreements can be bilateral or multilateral, private or official. The world has witnessed
all such different types of agreements over the past several years. Bilateral clearing arrangements lead to a
system of international trade and payments of a barter nature. Among the earliest forms of bilateral trade
were barter deals undertaken by private firms. If all exports and imports of a country are carried out in such
a bilateral barter fashion, there would be no BOP deficits or surpluses in any country. There would even be
no need to use money or foreign exchange in settling international trade and payment obligations. Such
bilateral clearing arrangements are employed by Communist countries in trading with one another.
One problem with such arrangements is that the exporter has to play the role of an importer as well, and
exporters may not be accustomed to playing such dual roles. Germany evolved a novel device of exchange
clearing which had the advantage of relieving the exporter from also performing the unaccustomed
functions of an importer. This led to a system of barter clearing agreements between governments i.e. the
central banks of the two trading nations.
Such arrangements of BOP settlement are strictly limited to commodity trade between countries. At best,
they can cover service transactions as well. But other kinds of payments, particularly capital flows, are
excluded from bilateral clearing arrangements. In any case, a clear disadvantage of these agreements,
whether they are limited to only merchandise trade or all trade and payments, is that they distort the pattern
of trade i.e. in the presence of such exchange control arrangements trade cannot conform to the dictates of
comparative advantage, which requires trade multilateralism.
2. Tariffs and quotas
Tariffs and quotas on imports are indirect exchange control methods insofar as they become necessary as
soon as direct exchange control methods are adopted in a country. To the extent that tariffs and quotas
succeed in cutting down import expenditures, without materially reducing export receipts, they will
contribute towards an improvement in the BOP balance of a country. As we have discussed the effects of
tariffs and quotas in an earlier chapter, we do not wish to repeat them here again. However, it is necessary
to emphasize that not all tariffs and quotas can be automatically considered as indirect forms of exchange
control. For instance, import duties levied for revenue consideration or to stimulate domestic
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industrialization, can be considered as indirect exchange control methods. Similarly, export subsidies with
a view to expand exports need not necessarily fall into the category of exchange controls. Only when the
objective of import duties or quotas or export duties or subsidies is explicitly to support the foreign
exchange rate or improve the BOP situation, can they be truly considered as indirect methods of exchanges
control. In reality, however, it is very difficult to identify whether a given important tariff or export
subsidy is introduced for considerations of revenue or foreign exchange earning (saving to improve BOP
situation). The same kind of difficulty extends also to non-tariff barriers which a country may impose.
Their objectives are so numerous that is almost impossible to identify with certainty that they are meant
solely to improve the BOP situation of a country.
CHAPTER SUMMARY
• The quantity demand for foreign currency is a function of foreign exchange rate (the price of foreign
currency in terms of domestic currency) and the functional relationship follows the law of demand.
• The quantity supply for foreign currency is a function of foreign exchange rate (the price of foreign
currency in terms of domestic currency) and the functional relationship follows the law of supply.
• The three major factors for a change in demand and a change in supply of foreign currency (depicted
by shifts in the demand and supply curves of foreign currency) are trade and direct investment related
factors (which include, business cycle, inflation and expectation of future economic growth in the home
and foreign country), changes in interest rates in the foreign and home country, and speculation
(particularly currency speculation).
• Devaluation is a decline in the value of a currency under a fixed exchange rate system, while
depreciation is a decline under a flexible system.
• Revaluation is an increase in the value of currency under a fixed exchange rate system while an
appreciation is an increase in the value of currency under a flexible exchange rate.
• Purchasing Power Parity (law of one price) and differences in productivity growth between countries
are the major determinants of changes in real exchange rate over the long run.
• Exchange rate systems are broadly categorized into fixed and flexible exchange rate systems. Flexible
exchange rate system can further be classified into freely floating rate, managed floating rare, a target
zone exchange rate system, and adjustable peg exchange rate system. As we go from purely floating
rate to adjustable peg exchange rate system the degree of flexibility decrease and there is an increase
in the degree of intervention by the monetary authority (Central Bank) in to the foreign exchange
market.
• The major objectives of exchange control as a policy by most developing countries is to correct
balance of payment problems, to allow policy makers and governments a freedom of action in policy
making and implementation, prevent illegal capital flight, conserve foreign exchange reserves for
large payments abroad, to facilitate debt servicing, and maintain stable exchange rate to encourage
growth with stability.
• The direct methods of exchange control include, foreign exchange regulation through intervention,
foreign exchange restrictions, and multiple exchange rate policies (selective devaluation). Exchange
clearing agreement, tariff on imports, import quotas, and import restrictions are the main instruments
that can be considered as indirect methods of exchange control.
REVIEW QUESTIONS
1. Explain the difference between a change in supply and a change in quantity supply of foreign
currency. (Hint: Use graphs; identify the factors that cause each of the changes).
2. Assuming that the market for foreign exchange in Ethiopia is governed by flexible exchange rate
policy and there is no exchange control, explain how each of the determinants of demand for and
supply of foreign currency causes decrease in demand for and decrease in supply of foreign
currency (let say USD) in Ethiopia using the following format.
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No Factors Decrease in Demand for USD in Decrease in Supply of USD in

Ethiopia Ethiopia
1
a
b
c
2
3
3. The base year nominal exchange rate in the Ethio-US foreign exchange market is Birr 9/USD.
After a year there has been 15% inflation in Ethiopia and a 5% deflation in USA. Calculate the
real Exchange rate.
4. Based on the answer in question 3, what will be the effect of the change in real exchange rate on
Ethiopia’s export and import market?
5. Explain how productivity growth differences between countries lead to a change in real exchange
rate over the long run.
6. Write the three rules that two countries need to follow in order to maintain a gold standard fixed
exchange rate between their currencies.
7. Does fixed exchange rate policy imply that the demand and supply of foreign currency in the
country remains fixed? Yes or No. Give reason for your answer.
8. Define the terms devaluation, revaluation, depreciation and appreciation and identify their
differences.
9. Explain the sub-categories of floating exchange rate system and mention the base of classification.
10. Write the objectives of exchange control
11. List the direct methods of exchange control and write the basic features of each method.
12. Write the indirect methods of exchange control and explain the basic difference between the
indirect and direct methods of exchange control.
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CHAPTER VI
6. BALANCE OF TRADE AND BALANCE OF PAYMENT
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the basic principles of balance of payments
accounting and economic implications of balance of payments deficit and surplus. After learning the
contents in this chapter, students will be able to:
Define balance of payment and balance of trade
Identify the different accounts and sub-accounts of the balance of payment and know which
international transactions have to be recorded in each of the sub-accounts of the balance of payment
Analyze the economic implications of balance of payment deficits and/or surplus
Calculate balances of sub accounts like trade account, current account, capital account, basic
account, and official settlement balance from international balance of payment transactions.
6.1 Balance of Payments
The balance of payments is a statistical record of all the economic transactions between residents of the
reporting country and residents of the rest of the world during a given time period. The usual reporting
period for all the statistics included in the accounts is a year. However, some of the statistics that make up
the balance of payments are published on a more regular monthly and quarterly basis. Without question the
balance of payments is one of the most important statistical statements for any country.
• It reveals how many goods and services the country has been exporting and importing, and
whether the country has been borrowing from or lending money to the rest of the world.
• In addition, whether or not the central monetary authority (usually the central bank) has added to
or reduced its reserves of foreign currency is reported in the statistics.
A key definition that needs to be resolved at the outset is that of a domestic and foreign resident. It is
important to note that citizenship and residency are not necessarily the same thing from the viewpoint of
the balance-of-payments statistics. The term resident comprises individuals, households, firms and the
public authorities, and there are some problems that arise with respect to the definition of a resident. These
problems include for example:
• Multinational corporations are by definition resident in more than one country. For the
purposes of balance-of-payments reporting, the subsidiaries of a multinational are treated as
being resident in the country in which they are located even if their shares are actually owned by
foreign residents.
• Another problem concerns the treatment of international organizations such as the International
Monetary Fund, the World Bank, United Nations and so forth. These institutions are treated as
being foreign residents even though they reside in USA
• Tourists are regarded as being foreign residents if they stay in the reporting country for less than
a year.
The criterion for a transaction to be included in the balance of payments is that it must involve dealings
between a resident of the reporting country and a resident from the rest of the world. Purchases and sales
between residents of the same country are excluded.
6.1.1 Balance of payments accounting and accounts
An important point about a country's balance-of-payments statistics is that in an accounting sense they
always balance. This is because they are based upon the principle of double-entry book-keeping. Each
transaction between a domestic and foreign resident has two sides to it, a receipt and a payment, and both
these sides are recorded in the balance-of-payments statistics.
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Each receipt of currency from residents of the rest of the world is recorded as a credit item (a plus in the
accounts) while each payment to residents of the rest of the world is recorded as a debit item (a minus in
the accounts).
Before considering some examples of how different types of economic transactions between domestic and
foreign residents get recorded in the balance of payments, we need to consider the various sub accounts that
make up the balance of payments. Traditionally, the statistics are divided into two main sections:
• The current account (items in this part refer to income flows)
• The capital account ( items in this part refer to records on changes in assets and liabilities of the
country)
Each part is further sub divided into sub-accounts.
A) Current account
The current account can be divided into two sub accounts: visible and invisible accounts. The visible sub-
account records the values of imported and exported goods where as the invisible sub-account records
values of imported and exported services; interests, profits and dividends received; interests, profits and
dividends paid; unilateral receipts and payments. The balance on the visible accounts of the current account
is termed as the trade balance whereas the sum of the visible trade balance and the invisible balance is
termed as the current account balance
Trade Balance = Receipts for exported goods – Payments on imported goods
The trade balance is sometimes referred to as the visible balance because it represents the difference
between receipts for exports of goods and expenditure on imports of goods which can be visibly seen
crossing frontiers. The receipts for exports are recorded as a credit in the balance of payments, while the
payment for imports is recorded as a debit. When the trade balance is in surplus this means that a country
has earned more from its exports of goods than it has paid for its imports of goods.
Current Account Balance = Trade balance + Invisible Balance
The current account balance is the sum of visible trade balance and the invisible balance. The invisible
balance shows the difference between revenue received for exports of services and payments made for
imports of services such as shipping, tourism, insurance and banking. In addition, receipts and payments of
interest, dividends and profits are recorded in the invisible balance because they represent the rewards for
investment in overseas companies, bonds and equity; while payments reflect the rewards to foreign
residents for their investment in the domestic economy. As such, they are receipts and payments for the
services of capital that earn and cost the country income just as do exports and imports.
Dear Students! note that there is an item referred to as unilateral transfer included in the invisible balance;
these are payments or receipts for which there is no corresponding quid pro quo (something given or
received for something else). Examples of such transactions are migrant workers' remittances to their
families back home, the payment of pensions to foreign residents, and foreign aid. Such receipts and
payments represent a redistribution of income between domestic and foreign residents. Unilateral payments
can be viewed as a fall in domestic income due to payments to foreigners and so are recorded as a debit;
while unilateral receipts can be viewed as an increase in income due to receipts from foreigners and
consequently are recorded as a credit.
B) Capital account
The capital account records transactions concerning the movement of financial capital into and out of the
country. Capital comes into the country by borrowing, sales of overseas assets, and investment in the
country by foreigners. These items are referred to as capital inflows and are recorded as credit items in the
balance of payments. Capital inflows are, in effect, a decrease in the country's holding of foreign assets or
increase in liabilities to foreigners. The fact that capital inflows are recorded as credits in the balance of
payments often presents students with difficulty.
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Capital Account Balance = Capital Inflows – Capital Out flows
Table 6.1. The balance of payments of a hypothetical country

Current Account
1) Exports of goods +150
2) Imports of goods -200
3) Trade Balance -50 = 1+2
4) Exports of services +120
5) Imports of services -160
6) Interest, profits and dividends received + 20
7) Interest, profits and dividends paid - 10
8) Unilateral receipts + 30
9) Unilateral payments - 20
10) Invisible Balance - 20 = 4+5+6+7+8+9

11) Current account balance - 70 = 3+10
Capital Account
12) Investment Abroad - 45
13) Short-term lending - 65
14) Medium- and long-term lending - 75
15) Repayment of borrowing from rest of the world -55
16) Inward Foreign investment +170
17) Short-term borrowing + 40
18) Medium- and long-term borrowing + 30
19) Repayments on loans received from rest of the world + 50
20) Capital account balance + 50 sum (12) to (19)

21)Statistical error +5 (Zero minus [11 + 20 + 25]
22)Official settlements balance -15 =11 + 20 + 21
23)Change in reserves rise (-), fall (+) +10
24)IMF borrowing from (+) repayments to (-) +5
25)Official financing balance +15 = 23 + 24
26) Overall balance of payments 0 = 22+25
Similarly investment by foreign residents is the export of equity or bonds, while sales of overseas
investments is an export of those investments to foreigners. Conversely, capital leaves the country due to
lending, buying of overseas assets, and purchases of domestic assets owned by foreign residents. These
items represent capital outflows and are recorded as debits in the capital account. Capital outflows are, in
effect, an increase in the country's holding of foreign assets or decrease in liabilities to foreigners. These
items are recorded as debits as they represent the purchase, the purchase of foreign bonds or equity, and the
purchase of investments in the foreign economy.
Items in the capital account are normally distinguished according to whether they originate from the private
or public sector, and whether they are of a short-term or long-term nature. The summation of the capital
inflows and outflows as recorded in the capital account gives the capital account balance.
C) Official settlements balance
Given the huge statistical problems involved in compiling the balance-of payments statistics there will
usually be a discrepancy between the sum of all the items recorded in the current account, capital account
and the balance of official financing (see table 6.1) which in theory should sum to zero. To ensure that the
credits and debits are equal it is necessary to incorporate a statistical discrepancy for any difference
between the sum of credits and debits. There are several possible sources of this error.
• One of the most important is that it is an impossible task to keep track of all the
transactions between domestic and foreign residents; many of the reported statistics are
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based on sampling estimates derived from separate sources, so that some error is
unavoidable.
• Another problem is that the desire to avoid taxes means that some of the transactions in
the capital account are underreported.
• Moreover some dishonest firms may deliberately under-invoice their exports and over-
invoice their imports to artificially deflate their profits.
• Another problem is that of 'leads and lags'. The balance of payments records receipts and
payments for a transaction between domestic and foreign residents, but it can happen that
a good is imported but the payment delayed. Since the import is recorded by the customs
authorities and the payment by the banks, the time discrepancy may mean that the two
sides of the transaction are not recorded in the same set of figures.
The summation of the current account balance, capital account balance and the statistical discrepancy gives
the official settlements balance. The balance on this account is important because it shows the money
available for adding to the country's official reserves or paying off the country's official borrowing. A
central bank normally holds a stock of reserves made up of foreign currency assets. Such reserves are held
primarily to enable the central bank to purchase its currency should it wish to prevent it depreciating. Any
official settlements deficit has to be covered by the authorities drawing on the reserves, or borrowing
money from foreign central banks or the IMF (recorded as a plus in the accounts). If, on the other hand,
there is an official settlements surplus then this can be reflected by the government increasing official
reserves or repaying debts to the IMF or other sources overseas (a minus since money leaves the country).
The fact that reserve increases are recorded as a minus, while reserve falls are recorded as a plus in the
balance-of-payments statistics is usually a source of confusion. It is most easily rationalized by thinking
that reserves increase when the authorities have been purchasing foreign currency because the domestic
currency is strong. This implies that the other items in the balance of payments are in surplus, so reserve
increases have to be recorded as a debit to ensure overall balance. Conversely, reserves fall when the
authorities have been supporting a currency that is weak; that is, all other items sum to a deficit so reserve
falls must be recorded as a plus to ensure overall balance.
6.1.2 Balance of Payments Surplus or Deficit
As we have seen in Table 6.1, the balance of payments always balances since each credit in the account has
a corresponding debit elsewhere. However, this does not mean that each of the individual accounts that
make up the balance of payments is necessarily in balance; for instance, the current account can be in
surplus while the capital account is in deficit. When talking about a balance-of-payments deficit or surplus
economists are really saying that a subset of items in the balance of payments is in surplus or deficit.
Economists make a distinction between autonomous (above the line items) and accommodating (below the
line) items. The former are transactions that take place independently of the balance of payments, whilst
accommodating items are those transactions which finance any difference between autonomous receipts or
payments. A surplus in the balance of payments is defined as a excess of autonomous receipts aver
autonomous payments. While a deficit is an excess of autonomous payments over autonomous receipts.
Autanomous receipts > autonomous payments = surplus

Autonomous receipts < autonomous payments = deficit
The issue that then arises is which specific items in the balance of payments should be classified as
autonomous and which as accommodating. Disagreement on which items qualify as autonomous leads to
alternative views on what constitutes a balance-of-payments surplus or deficit. The difficulty arises because
it is not easy to identify the motive underlying a transaction. For example, if there is a short-term capital
inflow in response to a higher domestic interest rate, it should be classified an autonomous item. If,
however, the item is an inflow to enable the financing of imports then it should be classified as an
__________________________________________________________________________________ 62
accommodating item. The difficulty of deciding which items should be classified as accommodating and
autonomous has led to several concepts of balance-of-payments disequilibrium. We shall now review some
of the most important of these concepts and consider their usefulness as economic indicators.
6.1.3 Alternative Concepts of Balance of Payments Surplus and Deficits
a) The trade account and current account
These two accounts derive much of their importance because estimates are published on a monthly basis by
most developed countries. Since the current account balance is concerned with visibles and invisibles, it is
generally considered to be the more important of the two accounts. What really makes a current account
surplus or deficit important is that a surplus means that the country as a whole is earning more that in it
spending vis-avis the rest of the world and hence is increasing its stock of claims on the rest of the world;
while a deficit means that the country is reducing its net claims on the rest of the world. Furthermore, the
current account can readily be incorporated into economic analysis of an open economy. More generally,
the current account is likely to quickly pick up changes in other economic variables such as changes in the
real exchange rate, domestic and foreign economic growth and relative price inflation
b) The basic balance
This is the current account balance plus the net balance on long-term capital flows. The basic balance was
considered to be particularly important during the 1950s and 1960s period of fixed exchange rates because
it was viewed as bringing together the stable elements in the balance of payments. It was argued that any
significant change in the basic balance must be a sign of a fundamental change in the direction of the
balance of payments. The more volatile elements such as short-term capital flows and changes in official
reserves were regarded as accommodating items.
Although a worsening of the basic balance is supposed to be a sign of a deteriorating economic situation,
having an overall basic balance deficit is not necessarily a bad thing. For example, a country may have a
current account deficit that is reinforced by a large long-term capital outflow so that the basic balance is in
a large deficit. However, the capital outflow will yield future profits, dividends and interest receipts that
will help to generate future surpluses on the current account. Conversely, a surplus in the basic balance is
not necessarily a good thing. A current account deficit which is more than covered by a net capital inflow
so that the basic is in surplus could be open to two interpretations. It might be argued that because the
country is able to borrow long run there is nothing to worry about since it regarded as viable by those
foreigners who are prepared to lend it money in the long run. Another interpretation could argue that the
basic balance surplus is a problem because the long-term borrowing will lead to future interest, profits and
dividend payments which will worsen the current account deficit.
A part from interpretation, the principal problem with the basic balance concerns the classification of short-
term and long-term capital flows. The usual means of classifying long-term loans or borrowing is that they
be of at least 12 months to maturity. However, many long-term capital flows can be easily converted into
short-term flows if need be. For example, the purchase of a five-year US treasury bond by a UK investor
would be classified as a long-term capital outflow in the UK balance of payments and long-term capital
inflow in the US balance of payments. However, the UK investor could very easily sell the bond back to
US investors any time before its maturity date. Similarly, many short-term items with less than 12 months
to maturity automatically get renewed so that they effectively become long-term assets. Another problem
that blurs the distinction between short-term and long-term capital flows is that transactions in financial
assets are classified in accordance with their original maturity date. Hence, if after four and a half years a
UK investor sells his five-year US treasury bill to a US citizen it will be classified as a long-term capital
flow even though the bond has only six months to maturity.
__________________________________________________________________________________ 63
c) The official settlements balance
The official settlements balance focuses on the operations that the monetary authorities have to undertake
to finance any imbalance in the current and capital accounts. With the settlements concept, the autonomous
items are all the current and capital account transactions including the statistical error, while the
accommodating items are those transactions that the monetary authorities have undertaken as indicated by
the balance of official financing. The current account and capital account items are all regarded as being
induced by independent households, firms, central and local government and are regarded as the
autonomous items. If the sum of the current and capital accounts is negative, the country can be regarded as
being in deficit as this has to be financed by the authorities drawing on their reserves of foreign currency,
borrowing from foreign monetary authorities or the International Monetary Fund.
A major point to note with the settlements concept is that countries whose currency is used as a reserve
asset can have a combined current and capital account deficit and yet maintain fixed parity for their
currency without running down their reserves or borrowing from the IMF. This can be the case if foreign
authorities eliminate the excess supply of the domestic currency by purchasing it and adding it to their
reserves. This is particularly important for the United States since the US dollar is the major reserve
currency. The United States can have a current account and capital account deficit which is financed by
increased foreign authorities' purchases of dollars and dollar treasury bills - in other words increased US
liabilities constituting foreign authorities' reserves. For this reason part of the official settlements balance
records 'changes in liabilities constituting foreign authorities' reserves.'
The official settlements concept of a surplus or deficit is not as relevant to countries that have floating
exchange rates as it is to those with fixed exchange rates. This is because if exchange rates are left to float
freely the official settlements balance will tend to zero because the central authorities neither purchase nor
sell their currency, and so there will be no changes in their reserves. If the sales of a currency exceed the
purchases then the currency will depreciate, and if sales are less than purchases the currency appreciates.
The settlements concept is, however, very important under fixed exchange rates because it shows the
amount of pressure on the authorities to devalue or revalue the currency. Under a fixed exchange-rate
system a country that is running an official settlements deficit will find that sales of its currency exceed
purchases, and to avert a devaluation of the currency authorities have to sell reserves of foreign currency to
purchase the home currency. On the other hand, under floating exchange rates and no intervention the
official settlements balance automatically tends to zero as the authorities do not buy or sell the home
currency since it is left to appreciate or depreciate.
Even in a fixed exchange-rate regime the settlements concept ignores the fact that the authorities have other
instruments available with which to defend the exchange rate, such as capital controls and interest rates.
Also, it does not reveal the real threat to the domestic currency and official reserves represented by the
liquid liabilities held by foreign residents who might switch suddenly out of the currency.
Although in 1973 the major industrialized countries switched from a fixed to floating exchange-rate system,
many developing countries continue to peg their exchange rate to the US dollar and consequently attach
much significance to the settlements balance. Indeed, to the extent that industrialized countries continue to
intervene in the foreign exchange market to influence the value of their currencies, the settlements balance
retains some significance and news about changes in the reserves of the authorities is of interest to foreign
exchange dealers as a guide to the amount of official intervention in the foreign exchange market.
__________________________________________________________________________________ 64
CHAPTER SUMMARY
• The balance of payments is a statistical record of all the economic transactions between residents of the
reporting country and residents of the rest of the world during a given time period.
• Citizenship and residency are not necessarily the same from the viewpoint of the balance of payments
statistics
• Each receipt of currency from residents of the rest of the world is recorded as a credit item (a plus in
the accounts) while each payment to residents of the rest of the world is recorded as a debit item (a
minus in the accounts).
• All debit items in the current account represent an outflow of income from the reporting country
whereas all the credit items in the current account represent an inflow of income to the reporting
country.
• All the debit items in the capital account represent either an increase in overseas asset holdings of the
country or a decrease in the liability of the country.
• All the credit items in the capital account represent either a decrease in overseas asset holdings of the
country or an increase in the liability of the country.
• Deficit in the official settlement balance implies that the sum of inflows of income and capital into the
country is less than the sum of the outflows of income and capital from the country and vise versa.
• A country will apply official financing sources (IMF borrowings from and repayments and changes in
reserves) provided that the country follows a fixed exchange rate policy.
• Positive balance in the official financing balance implies that there is a decrease in the reserve level of
the country and/or the country has borrowed money from IMF implying an increase in liabilities.
REVIEW QUESTIONS
1. Define the following terms:

• Balance of payment • Capital account balance
• Balance of trade • Basic balance
• Service balance • Statistical errors and omissions
• Current account balance
2. Based on the given international transactions answer the questions that follow.
Transaction Value in USD

Exported goods 500
Exported services 800
Imported goods 650
Imported services 300
Receipts of foreign aid 200
Receipts of private transfers 150
Payments of private transfers 75
Foreign direct investment inflow 350
Government borrowings from foreign sources 400
Government landings to foreign country 180
Short and medium term borrowings 50
Short and medium term landings 230
Interest payments 150
Dividend and profit payments 500
Interest receipts 200
Dividends and profit receipts 150
Investment abroad 675
Official settlement balance 30
__________________________________________________________________________________ 65
b) Calculate the sum of current and capital account

c) What is the sign and magnitude of the statistical errors and omissions?
d) What is the sign and value of official financing balance? What does it imply in terms of the
reserves of the country and its liabilities to IMF?
e) Calculate the trade and invisible balances.
f) How much is the balance on unilateral transfer account?
g) Calculate the basic balance. Does it show deficit or surplus?
__________________________________________________________________________________ 66
CHAPTER VII
7. THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the views and approaches of monetarists to
balance of payment problems. After learning the contents in this chapter, students will be able to:
Understand the link between balance of payment disequilibrium and the domestic money market
disequilibrium.
Examine how devaluation affects the balance of payment within the context of monetary model
Examine how the simple monetary model can be used to highlight some fundamentally different
implications of fixed and floating exchange rates on the balance of payments
Compare and contrast the effects of money supply, rise in domestic income and foreign price shocks
on balance of payment under fixed and floating rates
7.1 A Simple Monetary Model
There are three key assumptions that underlie the monetary model. These are:
• A stable money demand function,
• A vertical aggregate supply curve, and
• Purchasing power parity (PPP).
A) Stable money demand function
The most basic postulate of the monetary approach to the balance of payments is that there is a stable
demand for money function that is made up of only a few variables. The monetarists use the quantity theory
of money as the basis of the money demand function, which is written as:
Md = kPy , where k > 0 ---------------(1)

Where Md is the demand for nominal money balances,
P is the domestic price level,
y is real domestic income, and
k is a parameter that measures the sensitivity of money demand to changes
in nominal income.
The demand for money is a positive function of the domestic price level because it is a demand for real
money balances. A rise in the domestic price level will reduce real money balances (M/P) and accordingly
lead to an equiproportionate increase in the demand for money.
The money demand function forms the basis of the Price level
aggregate demand curve which is depicted in Figure

7.1 for a simple monetary model. From equation 1
if we hold the money supply (money demand) fixed P1
and assume that k is a fixed parameter, this means A
that an increase in Y from Y1 to Y2 requires an

equiproporrionate fall in the price level from P1 to P2. P2
Since P1Y1 = P2Y2 the aggregate demand curve is a AD2

rectangular hyperbola given by AD1. A fall in the AD1
price level from P1 to P2 given a fixed money supply

will create excess real money balances (M/P) and this Real income
Y1 Y2
leads to increased aggregate demand from Yl to Y2.
Figure 7.1: The aggregate demand curve
__________________________________________________________________________________ 67
An increase in the money supply has the effect of shifting the aggregate demand curve to the right from
AD1 to AD2. This is because at any given price level there is a rise in real money balances which leads to
increased aggregate demand.
B) vertical aggregate supply curve
The simple monetary model assumes that the labor market is sufficiently flexible that the economy is
continuously at the full employment level of output. In other words, wages are sufficiently flexible that
they are constantly at the level that equates the supply and demand for labor.
Furthermore, a rise in the domestic price level

does not lead to an increase in domestic output
because wages adjust immediately to the Price level
higher price level so that there is no advantage AS1 AS2
for domestic producers to take on more labor.
This means that the aggregate supply curve is
vertical at the full employment level of output
as depicted in figure 7.2.
Although the aggregate supply curve AS1 in

figure 7.2 is vertical at the full employment
level of output Y1, this does not mean that
output is always constrained to be fixed at Yl;
the aggregate supply curve may shift to the
right to say AS2 if there is an improvement in Y1 Y2
O
productivity due to technological progress, Real income
which means that full employment is
Figure 7.2: The aggregate supply curve
associated with a higher level of real output.
C) Purchasing power parity
The final assumption that underpins the monetary model is that of purchasing power parity (PPP). In its
simplified version the theory says that the exchange rate adjusts so as to keep the following equation in
equilibrium:
P
S= i.e. P = SP * -----------------------------------------(2)
P*
Where S is the exchange rate defined as domestic currency per unit of foreign currency,
so that a rise is depreciation and a fall isan appreciation of the domestic currency,
P is the domestic price level in the domestic currency, and
P* is the foreign price in the foreign currency.
In figure 7.3 we depict the PPP

relationship between the domestic Price level
PPP
price and the exchange rate. The PPP
curve shows combinations of the
Overvaluation
domestic price level and exchange rate
P1
which are compatible with PPP given
the foreign price level P*. Points to the
Undervaluation
left of the PPP curve depict an
overvaluation of the domestic currency
in relation to PPP, whereas points to
O S1 Exchange rate
the right depict undervaluation in
relation to PPP. Figure 7.3: The purchasing power parity (PPP) curve
__________________________________________________________________________________ 68
The simple monetary model invokes the three assumptions set out above and then proceeds with the use of
some accounting identities and behavioral assumptions to develop a theory of the balance of payments. The
domestic monetary supply in the economy is made up of two components:
Ms = D + R ------------------------------------------------------------- (3)
Where: Ms is the domestic money base, D the domestic bond holdings of the monetary authorities, and R
the reserves of foreign currencies valued in the domestic currency.
Equation 3 says that the domestic money base is made up of two components. This monetary base can
come into circulation in one of two ways:
1. The authorities may conduct an open market operation (OMO) which is a purchase of treasury
bonds held by private agents by the central bank. This increases the central bank's monetary
liabilities but increases its assets of domestic bond holdings which is the domestic component of
the monetary base as represented by D.
2. The authorities may conduct a foreign exchange operation (FXO) which is a purchase of foreign
currency assets (money or foreign treasury bonds) held by private agents by the central bank. This
again increases the central bank's monetary liabilities but increases its assets of foreign currency
and foreign bonds which are represented by R.
We can now rewrite equation 3 in its derivative form as:
dMs = dD + dR--------------------------------------------------(4)
Equation 4 states that any increase (decrease) in the domestic money supply can come about through either
an OMO as represented by dD, or a FXO as represented by dR. The relationship between the money supply
and reserves is depicted in Figure 7.4.
At point D1 all the domestic money

supply is made up entirely of the
domestic component since reserves are
zero. For convenience we set the Money supply MS2
exchange rate of domestic to foreign
MS1
currency equal to unity; this being the
C
case an increase of 1 unit of foreign M2
B
currency leads to an increase in the
M1
domestic money supply of 1 unit, so that A
when reserves are R1 the money s An D2
OMO will have the effect of shifting the
MS curve by the amount of the increase D1
in the central bank's domestic bond
holdings. An OMO which increases the
domestic component of the monetary
base from D1 to D2 shifts the money O R1 R2 Exchange rate
supply curve from MS1 to MS2, and the
total money supply rises from M1 to M2. Figure 7.4: The money supply and reserves
upply is M1 , where M1 = D1+ R1.
By contrast, an expansion of the money supply due to a purchase of foreign currencies, that is an FXO,
increases the country's foreign exchange reserves from R1to R2. This too has the effect of raising the money
stock from M1 to M2 and is represented by a movement along the money supply curve MS1 from point A to
point B.
__________________________________________________________________________________ 69
7.2 The Monetarist Concept of Balance of Payments Disequilibrium
The monetarists view balance of payments surpluses and deficits as monetary flows due to stock
disequilibrium in the money market. A deficit in the balance of payments is due to an excess of the stock of
money in relation to money demand, while a surplus is a monetary flow resulting from an excess demand for
money in relation to the stock of money supply.
Thus balance of payments disequilibrium is merely a reflection of disequilibrium in the money market. In this
sense the monetary flows are the 'autonomous' items in the balance of payments, while the purchases and sales
of goods/services and investments (long, medium and short-term) are viewed as the 'accommodating' items.
This is completely the reverse of the Keynesian approach which views the current account items as the
autonomous items and capital account and reserve changes as the accommodating items. This different way of
looking at the balance-of-payments statistics is sometimes contrasted by saying that Keynesians look at the
statistics from the 'top down' (that is, the current account), while the monetarists look from the 'bottom up' (the
change in reserves).
Monetarists observe that the overall balance of payments can be thought of as consisting of the current account
balance, the capital account balance, and change in the authorities' reserves. That is:
BP = CA + K + dR = 0 ----------------------------------------(5)
CA+K = -dR-------------------------------------------------------(6)
Where CA is the current account balance, K is the capital account balance, and dR is the change in the
authorities' reserves, BP is the monetarist balance of payment.
If the recorded dR in the balance-of-payments accounts is positive, this means that the combined current
account and capital accounts are in deficit. This implies that reserves have fallen as the authorities have
purchased the home currency with foreign currency reserves.
Equation 6 is a distinct way of viewing the balance of payments; increases in reserves due to purchases of
foreign currencies constitute a surplus in the balance-of-payments, while falls in reserves resulting from
purchases of the domestic currency represent a deficit in the balance of payments. If the authorities do not
intervene in the foreign exchange market, that is the currency is left to float, then reserves do not change and as
far as the monetary view is concerned the balance of payments is in equilibrium. Under a floating exchange-
rate regime a current account deficit must be financed by an equivalent capital inflow so the balance of
payments is in equilibrium.
Dear students! With this concept of a balance of payments surplus/deficit in mind we can proceed to an
analysis of the effects of various shocks under both fixed and floating exchange rates.
7.3 The Effects of a Devaluation
The monetary approach argues that devaluation can only have an affect on the balance of payments by
influencing the demand for money in relation to the supply of money. Figure 7.5 depicts the effects of
devaluation. The immediate effect of a devaluation of the exchange rate from S1 to S2 is to make domestic
goods competitive in relation to PPP at point A. As domestic goods become more competitive compared to
foreign goods there is an increase in the demand for the domestic currency as represented by a shift of the
money demand curve from Md1 to Md2. This means that money demand M2 exceeds the money supply Ml. The
competitive advantage of the devaluation means that the balance of payments moves into surplus as domestic
residents demand less foreign goods/services, while foreigners demand more domestic goods. To prevent the
domestic currency appreciating, the authorities have to purchase the foreign currency with new domestic
money base. This increases the reserves and leads to an expansion of the domestic money supply which in turn
raises aggregate demand for domestically-produced goods. The aggregate demand curve shifts to the right from
AD1 to AD2 and starts pushing up domestic prices until PPP is restored at price P2.
Once the domestic price level is at P2 and the money supply has increased to M2, real money balances will be
at their equilibrium level (M1/P1 = M2/P2) and the competitive advantage of the devaluation has been offset.
The balance of payments will be back in equilibrium as the money supply is once again equal to money
__________________________________________________________________________________ 70
demand. In the long run, the effect of X per cent devaluation is to lead to an X per cent rise in the domestic
price level, and X per cent increase in the domestic money stock. In other words, the surplus resulting from
devaluation is merely a transitory phenomenon.
Price level Price level Money supply
AS
PPP
Ms
P2 M2
P2 Md2
P1 AD2 Md1
A P1 M1
AD1
D1
S1 S2 Y1 R1 R2
Exchange rate Real income Reserve
(a) (b) (c)
Figure 7.5: Effect of devaluation on reserve, money supply and price level
The monetary approach emphasizes that devaluation will have a transitory beneficial effect on the balance of
payments only so long as the authorities do not simultaneously engage in an expansionary OMO. If the
authorities immediately increase the money stock to M2 via an
OMO, there would be an immediate rise in aggregate demand and domestic prices to P2 so that the competitive
advantage conferred by a devaluation is eliminated.
The important point derived from the monetary model concerning the effect of devaluation is that exchange
rate changes are viewed as incapable of bringing about a lasting change in the balance of payments. A
devaluation or revaluation operates strictly by causing disequilibrium in the money market, causing a deficit or
surplus in the balance of payments which continues only until equilibrium is restored in the money market via
reserve changes.
7.4 A Monetary Exchange-Rate Equation
Before we compare and contrast the effects of various shocks under fixed and floating exchange rates we need
to consider how the exchange rate is determined in the context of our simple monetary model.
As we have seen in equation 1 above, which is the demand for money in the home country is given by:
Md = kPy ----------------------------------------------------(7)
This being the case, we can postulate that the demand for money in the foreign economy is of a similar type
given below as:
Md* = k*P*y* --------------------------------------------------(8)

Where Md* denotes foreign money demand, k* the foreign nominal income elasticity of demand for money,
P* the foreign price level, and y* real foreign income.
__________________________________________________________________________________ 71
The exchange rate is determined by PPP so that
S = P/P*---------------------------------------------------------(9)
In equilibrium money demand is equal to the money supply in each country, so that:
Ms = Md and Ms* = Md* -----------------------------------(10)
This being the case we can denote the relative money supply functions as equation 7 divided by 8 replacing Md
and Md* with Ms and Ms* from equation 10:
Ms kPy
= −−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−11
Ms* k *P* y*
Since P /P* = S because of PPP, then we can rewrite equation 11 as:

Ms kSy
= −−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−12
Ms* k * y*
and solving the above equation for the exchange rate yields:
Ms Ms*
S = −−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−13
ky k* y*
Equation 13 says that the exchange rate is determined by the relative supply and demand for the different
national money stocks. An increase in the domestic money stock relative to the foreign money stock will lead
to a depreciation (rise) of the home currency, while an increase in domestic income relative to foreign income
leads to an appreciation (fall) in the exchange rate. The reason being that an increase in domestic income leads
to an increased transactions demand for the home currency leading to an appreciation. With this simple model
of exchange rate determination in mind we can proceed to analyze in more detail the effects of money supply,
income changes and changes in the foreign price level.
7.5 A Money Supply Expansion under Fixed Exchange Rates
If the exchange rate of a currency is fixed, this means that the authorities have to buy the currency when it is in
excess supply and sell it when it is in excess demand in the private market to avoid a currency depreciation or
appreciation. When the authorities sell the
domestic currency this leads to a rise in their reserves of foreign currency. If the authorities buy the domestic
currency they do so with foreign currency, and so their reserves fall.
Let us now consider what happens if there is an expansionary OMO under a fixed exchange rate which raises
the money supply by a central bank purchase of domestic treasury bonds.
Figure 7.6 depicts the effects of an expansionary open market operation. An expansionary OMO shifts the
money supply curve from MS1 to MS2 and increases the domestic money supply from M1 to M2, the domestic
component of the monetary base rising from D1 to D2. The immediate effect is that domestic residents have
excess real money balances (M2/P1 > M1/P1); that is, the money supply M2 exceeds money demand Ml. To
reduce their excess real balances residents increase aggregate demand for goods as represented by a shift of the
aggregate demand curve from AD1 to AD2, and this puts upward pressure on domestic goods whose prices rise
from P1 to P2. At price P2 and fixed exchange rate S1, the domestic economy is uncompetitive in relation to
PPP as it finds itself to the left of the PPP curve.
The uncompetitive nature of the economy moves the balance of payments into deficit. To prevent a devaluation
of the currency the authorities have to intervene to purchase the domestic currency and the authorities’
reserves start to decline below Rl. The purchase back of the domestic money supply starts to reduce the excess
__________________________________________________________________________________ 72
money balances and at the same time aggregate demand starts to shift back from AD2 towards ADl. As the
excess money balances are reduced this puts downward pressure on the domestic price level which falls back
to its original level P1 so as to arrive back at PPP. Once the money supply returns to M1 along the MS2 curve,
the excess supply of money is eliminated and the economy is restored to equilibrium.
AS
MS2
PPP MS1
P2 M2
P2
P1 AD2 Md
A P1 M1
D2
AD1
D1
S1 Y1 R2 R1
(a) (b) (c)
Figure 7.6: A monetary expansion under fixed exchange rates
In the long run the price level, output level and money stock return to their initial levels. Thus, an increase in
the domestic component of the monetary base from Dl to D2 will, because of the foreign exchange intervention
it necessitates to maintain a fixed exchange rate, lead to an equivalent fall in the reserves from Rl to R2. This
fall in the reserves due to purchases of the home currency leads to a return of the money stock to its original
level. The fact that the money supply has to return to its original level can be explained by reference to
equation 13. As the parameters S, Ms*, ky and k*y* are all fixed, any rise in Ms must eventually be reversed
for the equation to hold.
The monetary approach regards the balance of payments deficits resulting from the expansion in the money
stock to be merely a temporary and self correcting phenomenon. An expansion of the money supply causes a
temporary excess supply of money and a combined current and capital account deficit, which to maintain the
fixed exchange rate necessitates intervention in the foreign exchange market which eventually eliminates the
excess supply of the currency. .
There are two circumstances under which a balance of payments deficit or surplus can become more than a
transitory feature. One case is when the authorities practice sterilization of their foreign exchange
operations. When authorities intervene to purchase their currency to prevent it being devalued there is a
reduction of the monetary base. The authorities could try to offset these monetary-base implications by
conducting a further open market purchase of bonds from the public; however, as we have seen, such an open
market operation causes a balance of payments deficit, requiring a further foreign exchange intervention.
Hence, sterilization policies can cause a prolonged balance of payments deficit, and the pursuit of such
operations will be limited by the extent of a country's reserves.
Another factor that can lead to a continuous deficit would be if the surplus countries were prepared to
purchase the deficit country's currency and hold it in their reserves. In such circumstances the deficit
country will have its exchange rate fixed by foreign central bank intervention, and such a process can continue
so long as foreign central banks are prepared to accumulate the home country's currency in their reserves.
Although in this case reserve changes are zero, the deficit is reflected as an increase in liabilities to foreign
authorities.
__________________________________________________________________________________ 73
7.6 A Money Supply Expansion under Floating Exchange Rates
Under floating exchange rates the monetary approach maintains that there is no such thing as a balance-of-
payments deficit or surplus as the authorities do not intervene to purchase or sell the domestic currency. Since
there are no changes in international reserves, there is no balance-of payments surplus or deficit. Referring to
equation 6 as the change in reserves is zero any current account deficits (surplus) has to be offset by a net
capital inflow (outflow) of a like amount. Figure 7.7 depicts the effects of a monetary expansion under floating
exchange rates.
An expansionary OMO leads to a rise in the money stock from Ml to M2 and creates excess money balances.
The result is that the aggregate demand shifts from AD1 to AD2 with demand Y2 exceeding domestic output Yl.
The excess demand for goods translate into increased expenditure on foreign goods/services and foreign
investments leading to a depreciation of the exchange rate. As a result of the excess demand for goods the
domestic price level begins to rise and this leads to an increase in money demand as reflected by an upward
shift of the money demand function from Mdl towards Md2. As the domestic price level rises, this increases the
demand for money leading to a contraction of aggregate demand along the AD2 curve until the equilibrium
price level P2 is restored.
AS MS2
MS1
PPP
P2 M2
P2 Md2
P1 AD2 Md1
P1 M1
D2
AD1
D1
S1 S2 Y1 Y2 R1
(a) (b) (c)
Figure 7.7: A monetary expansion under floating exchange rates
In the long run, the effect of an x per cent increase in the money stock is an X per cent depreciation of the
exchange rate, and x per cent increase in the domestic price level. The rise in the price level induces a rise in
the demand for money so that the excess money balances created by the OMO are eliminated. With reference
to equation 13 we can see that with the parameters Ms*, ky and k*y* all fixed, any rise Ms leads to a rise in the
exchange rate S for the equation to hold.
The case of floating exchange rates provides a clear contrast with the fixed exchange-rate case. Under fixed
exchange rates an expansionary OMO leads to a disequilibrium in the money market which is resolved by
adjustment in the balance of payments and reserves held by the authorities. Under floating exchange rates an
expansion in the monetary base leads to a depreciation of the exchange rate and a rise in domestic prices.
Under fixed exchange rates the authorities can no longer retain independent control of the monetary supply,
and the quantity of money supply returns to its original level due to a gradual fall in the international reserves
held by the authorities. Whereas under floating exchange rates they can determine the amount of the money
__________________________________________________________________________________ 74
supply, and money market equilibrium is restored by changes in money demand brought about by changes in
the domestic price level and exchange rate. One of the arguments against fixed exchange rates is that the
authorities can no longer conduct independent monetary policies; while with floating exchange rates they are
free to expand and contract the money supply to their desired levels.
7.7 The Effects of an Increase in Income under Fixed Exchange Rates
Within the context of the monetary approach to the balance of payments, an increase in domestic income can
only have an effect on the balance of payments by influencing money demand in relation to the money supply.
Figure 7.8 depicts the effects of an increase in domestic income under fixed exchange rates.
AS1 AS2
Ms1
PPP
M2
Md2
P1 AD2 M1 Md1
P1
P2 P2 AD1
D1
S1 Y1 Y2 R1 R2
(a) (b) (c)
Figure 7.8: An increase in income under fixed exchange rate
The increase in real domestic income is represented by a rightward shift of the aggregate supply curve from
AS1 to AS2. As a result of this increase, the demand to hold money increases which shifts the money demand
function from Mdl to Md2. The result is that money demand M2 exceeds money supply Ml, and expenditure is
reduced on both domestic and foreign goods/services leading to a fall in the domestic price level from P1 to P2.
The fall in the domestic price level means that at the fixed exchange rate Sl the country gains a competitive
advantage, and the combined current and capital accounts move into surplus. To prevent an appreciation of the
currency the authorities have to purchase the foreign currency with newly created money base. As a result of
the intervention in the foreign exchange market there is a rise in the reserves and in the domestic money supply.
The increase in the money supply shifts the aggregate demand curve from ADl to AD2, which leads to a rise in
the domestic price level back towards its purchasing power parity value P1. Once the money stock has risen to
M2 the excess money balances are eliminated.
Notice that in the long run, while the price level has returned to its original level Pl, the money stock has risen
from Ml to M2 because of the transitory balance-of-payments surplus. This means that real money balances are
greater than before, that is M2/Pl is greater than Ml/P1. The reason why this is possible is that all the increased
money stock is willingly held as transactions balances due to the increase in domestic income. In terms of
equation 13, given that S, Ms* and k*y* are all fixed, the increase in domestic income is offset by the rise in
the domestic money supply.
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7.8 The Effects of an Increase in Income under Floating Exchange Rates
An increase in income under floating exchange rates has its impact on the exchange rate by influencing the
demand for money in relation to the supply of money, as depicted in Figure 7.9.
AS1 AS2
Ms1
PPP
P1 Md1
P1 M1
P2 P2 AD1
D1
S2 S1 Y1 Y2 R1
(a) (b) (c)
Figure 7.9: An increase in income under fixed exchange rate
An increase in income leads to an increase in the transactions demand for money and implies an excess supply
of goods (Y2 > Yl) at the existing price level P1. This means that there is a downward pressure on the domestic
price level which falls from P1 to P2 so as to equate aggregate demand and supply. As the price level falls, the
exchange rate appreciates to maintain PPP. Eventually, new equilibrium is obtained at a lower domestic price
level P2 and an exchange rate appreciation from S1 to S2.
In the long run, we note that there has been an increase in real money balances as Ml/P2 is greater than Ml/Pl.
Again, the reason for this is that the increase in real domestic income raises the demand for transaction
balances, so that the increased real money balances are willingly held. Overall, the money demand curve did
not shift because while the fall in domestic prices leads to less money demand, this is exactly offset by the rise
in money demand due to the increase in real income. In terms of equation 13 the fixed parameters are Ms, Ms*
and k*y*; a rise in ky due to an increase in income therefore implies an appreciation (fall) of the domestic
currency.
Under fixed exchange rates with an increase in domestic income, eventual adjustment was obtained via an
increase in the domestic money supply and reserves so as to satisfy the increased money demand. While under
a floating exchange rate equilibrium is obtained by an appreciation of the exchange rate and fall in the
domestic price level (to maintain PPP) with the domestic money supply unchanged.
7.9 An Increase in Foreign Prices under Fixed Exchange Rates
The effects of an increase in the foreign price level under fixed exchange rates are depicted in Figure 7.10. An
increase in the foreign price level means that the PPP line swivels upwards from PPP1 to PPP2. This is because
at the exchange rate S1, a rise in the foreign price level means that at price level P1 the domestic economy is
now more competitive than PPP. Accordingly, to maintain PPP at the exchange rate S1 requires a rise in the
domestic price level to say P2.
The initial effect of the rise in foreign prices is to make domestic goods at price P1 more competitive as
compared to foreign goods. This results in reduced consumption of foreign goods creating a balance of-
payments surplus and an increase in the demand for the domestic currency which is shown by a shift of the
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money demand curve from Mdl to Md2. To prevent an appreciation of the currency the authorities have to
purchase foreign currencies with newly created domestic money base. The reserves rise from Rl to R2 and the
money supply rises from Ml to M2. The increased money supply and undervaluation of the currency in relation
to PPP leads to a shift to the right of the aggregate demand curve from AD1 to AD2, which pushes up domestic
prices from P1 towards P2 where PPP is restored. Once PPP is restored the balance of payments surplus ceases.
AS1
PPP2
PPP1 Ms1
M2
P2 Md2
P2
P1 AD2 M1 Md1
P1
AD1
D1
S1 Y1 R1 R2
(a) (b) (c)
Figure 7.10: An increase in foreign prices under fixed exchange rate
An important point that emerges from this analysis is that by choosing to peg its exchange rate the country also
has to eventually accept that movements in its domestic price level will be determined by changes in the world
price level. A country that decides to peg its exchange rate therefore runs the risk of imported
inflation/deflation. If foreign inflation is determined by changes in the foreign money supply, the monetary
approach suggests that a country that opts to fix its exchange rate must change its money supply in line with
changes in the foreign money supply. Hence, countries that opt to fix their exchange rates give up their
monetary autonomy. As we shall see in section 7.10, this is not the case with floating exchange rates.
7.10 An Increase in the Foreign Price Level under Floating Exchange Rates
The effects of a rise in the foreign price level when the exchange rate is left to float freely are depicted in
Figure 7.11. A rise in the foreign price level leads to a swivel of the PPP line from PPP1 to PPP2. With a
floating exchange rate the competitive advantage to the domestic economy is offset by an appreciation of the
currency from S1 to S2 to maintain PPP at the existing domestic price level P1. Hence, with a floating exchange
rate, the domestic price level and aggregate demand and output are left unaffected by the foreign price shock.
The insulation of the domestic economy from the foreign price shock under floating exchange rates, given that
the authorities able to operate an independent monetary policy, stands in contrast to the imported inflation
experienced under fixed exchange rates. One of the most powerful arguments made by the proponents of
floating exchange rates is that it gives authorities the ability to avoid imported inflation/deflation. In effect, a
floating exchange rate enables them to pursue an independent monetary 'policy; the exchange rate will adjust
to offset an inflation differential and maintain PPP. Under fixed exchange rates the need to maintain PPP
means that an economy has to accept an inflation rate determined by the rate of growth of the foreign money
supply, and monetary independence is lost.
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AS1
PPP2
PPP1 Ms1
P1 P1 Md1
M1
AD1
D1
S2 S1 Y1 R1
(a) (b) (c)
Figure 7.11: A rise in foreign price level with floating exchange rates
7.11 Implications of the Monetary Approach
The distinctive feature of the monetary approach to the balance of payments is that money market
disequilibrium is seen as a crucial factor in provoking balance-of-payments disequilibrium. It is maintained
that the crucial decision of private agents concerns the level of their real money balances. With real output
fixed, aggregate expenditure is viewed as a function of real money balances rather than income. In the
monetary model agents decide firstly upon the amount of real balances they wish to hold and then spend
accordingly, and not the other way round. In this sense it is money decisions that matter and not the
expenditure ones.
The core of the monetary approach is that the demand for money function is a stable and predictable function
of a relatively few variables. The demand for money is a demand for real money balances and excess money
balances raise aggregate demand.
A major implication of the monetary approach is that in a fixed exchange-rate regime the authorities have to
accept a loss of control over their domestic monetary policy as the price of fixing the exchange rate. As we
have seen, any attempt to expand the domestic money supply under fixed exchange rates leads to a balance of
payments deficit and the need to purchase back the currency on the foreign exchange market. If foreign prices
rise, then so does the domestic money supply and domestic price level. Under fixed exchange rates the
authorities lose the ability to pursue an independent monetary policy. The only thing that the authorities can do
is to control the composition of the monetary base between its domestic and foreign components. With a fixed
exchange rate, an increase in the domestic component of the monetary base leads to an equivalent fall in the
foreign component.
A further implication of the monetarist approach is that from the viewpoint of the balance of payments it is
irrelevant whether the change in the money supply results from an OMO or a FXO. As far as monetarists are
concerned, both operations can bring about disequilibrium in the money market. An expansion of the domestic
monetary base under fixed exchange rates, whether arising from a purchase of domestic bonds or a purchase of
foreign currencies, causes an excess of real money balances. The result is a balance-of-payments deficit which
requires the authorities to intervene to support their currency; the reserves decline until the money supply is
brought back to its original level and excess balances are eliminated.
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The contrast between fixed and floating exchange rates in the monetary model is pronounced. Under fixed
exchange rates monetary policy is endogenously determined by the need to peg the exchange rate, while with a
floating exchange rate the country can exogenously determine its money supply because it is the exchange rate
and not monetary changes that restore equilibrium.
There is a split in the monetarist camp over the desirability of fixed as opposed to floating exchange rates.
Some monetarists argue that because balance-of-payments deficits and surpluses are necessarily transitory and
self-correcting, then countries should agree to permanently fix their exchange rates and enjoy the benefits of
their stability. On the other hand, Milton Friedman has long advocated that authorities should allow their
exchange rate to float so that countries are left free to determine their own rates of inflation and monetary
policies independently of other countries.
7.12 Criticisms of the Monetary Approach
Some argue that an increase in the domestic money supply might not be reflected exclusively in an equivalent
fall in the reserves under fixed exchange rates. For instance, if there is unemployment an expansionary
monetary policy may lead to some increase in output (reflected in a positive-sloping aggregate supply function),
which by raising money demand will reduce the devaluation pressures on the home currency. In this instance
reserves would not need to fall in exact proportion to the initial rise in the money supply as some of the
expansion would be willingly held as transactions balances.
Some critics have argued that to regard the balance of payments as a monetary phenomenon is only true in the
sense that the balance of payments measures monetary flows between domestic and foreign residents. They
argue that it is quite wrong to regard the balance-of-payments deficits and surpluses as exclusively due to
monetary decisions because the question of causation is an open issue. If suddenly, economic agents decide to
spend more on foreign goods/services and foreign investments under a fixed exchange-rate system, there will
be a transitory deficit in the balance of payments. The deficit then forces the authorities to buy the domestic
money base in the foreign exchange market. The cause of the deficit is the expenditure decision, not a decrease
in money demand which then leads to excess real money balances and a balance-of-payments deficit. In other
words, causation can easily lead from expenditure decisions to changes in money demand, rather than changes
in money demand inducing changes in expenditure behavior.
A survey of the monetary approach by Boughton (1988) has argued that nearly every assumption made by the
proponents is empirically open to question. There is ample evidence that money demand functions can be
highly unstable, economies are rarely at full employment, and purchasing power parity is useless as a guide to
exchange rate movements. Although these assumptions hold reasonably well in the longer run, they are very
rarely fulfilled in the short run. The empirical violation of these key assumptions must bring into question the
policy relevance of the monetary approach.
The proponents of the monetary approach argue that it provides an insight into the short-run disequilibrium in
the balance of payments. Yet its assumptions of full employment and purchasing power parity and a stable
money demand function are highly questionable in the short run. There is clearly something wrong with using
assumptions that may be valid in the long run to explain what is happening in the short run. In this sense, the
monetary model's conclusions about the long-run consequences of changes in economic policy are probably
more insightful than its postulates about the short-run consequences.
Another criticism of the monetary approach is that no attention is paid to the composition of a deficit and
surplus. If there is a large deficit in the current account which is financed by an offsetting surplus in the capital
account, the monetarists argue that this means there is no need for any policy concern with regard to the
balance of payments. Indeed, because any surplus or deficit is necessarily a transitory feature representing a
stock disequilibrium in the money market which is necessarily self-correcting, a policy with regard to the
balance of payments is unnecessary. Such an approach ignores the dangers of increasing indebtedness due to
current account deficits being financed by capital inflows. In the real world it is the increase in such
indebtedness, such as the Third World debt crisis in the 1980s and Asian financial crises in 1997/8 that causes
much concern for policy-makers of the countries concerned.
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CHAPTER SUMMARY
• The monetary approach provides a distinctive and clear analysis of the effects of a devaluation and
monetary expansion on the balance of payments.
• Its emphasis on disequilibrium in the balance of payments being a flow response to stock disequilibrium in
the money market represents an important contribution to the research on international economics.
• Another significant contribution of the monetary approach is that it provides a rich set of policy
recommendations.
o A country that opts to fix its exchange rate will lose its monetary autonomy, and a monetary
expansion can lead to temporary balance-of-payments deficits. Whereas a country that allows
its currency to float will have monetary autonomy but a monetary expansion then leads to a
depreciation of its currency.
o Hence, it provides a warning to policy-makers that reckless monetary expansion can lead to
balance-of-payments problems under fixed exchange rates, or a currency problem under
floating exchange rates.
• With regard to the effects of a devaluation of a currency, starting from a position of equilibrium, the
monetary approach suggests that there will be an unambiguous transitory surplus in the balance of
payments. This stands in contrast to the elasticity and absorption approaches, which suggest the effects are
ambiguous. It must be borne in mind, however, that the monetary model is referring to the combined
current and capital account whereas the latter two are concerned exclusively with the current account.
• Finally it needs to be remembered that the monetary approach does not specify precisely how temporary
the resulting surplus is, presumably this varies on a country-by-country basis.
REVIEW QUESTIONS
1. Explain the three assumptions of a simple monetary model.
2. Write the domestic money supply equation and explain the two possible operations that can be used to
make the monetary base to come into circulation.
3. Show graphically how OMO can lead to increase in money supply.
4. Explain in short the view of monetarists about balance of payment disequilibrium.

5. Based on graphs, discuss the effect of devaluation on the balance of payment of a country. Is the
effect transitory or persistent?
6. Derive the monetary exchange rate equation from the stable money demand equation.
7. Explain the effect of the following shocks on the balance of payments and reserve level of a country
under the condition where the country follows a fixed exchange rate and a floating exchange rate
separately. Compare the effects under the two foreign exchange policies.
a) Increase in money supply through OMO

b) Increase in real income of the country
c) Increase in the rice level of the foreign country with which the domestic country has trade
relations.
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CHAPTER VIII
8. INTERNATIONAL DEBT CRISIS
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the basic developments in international debt crisis.
After learning the contents in this chapter, students will be able to:
Have an overview on the historical development of debt crisis as an international policy agenda since
the early 1980s.
Understand the basic characteristic features of middle income developing countries in terms of the
structure of financial markets, foreign exchange policy, exchange control, degree of economic
diversification, and inflation in relation to developed countries.
Analyze the economic rationale why developing nations are interested in borrowing from developed
nations and vise versa.
Identify the different sources of finance or capital inflows to developing countries
Be familiar with the most popular statistics used to assess country risk or used as measures of
indebtedness.
Understand the roles and view points of commercial banks, governments of developed countries, the
world bank and international Monetary Fund (IMF), and debtor developing countries in international
debt crisis.
8.1 Introduction
On 12 August 1982, the Mexican government announced that it could not meet its forthcoming debt
repayments on its $80 billion of outstanding debt to international banks. This was the first sign of the
international debt crisis. Soon after the Mexican announcement a number of other less developed countries
(LDCs) announced that they too were facing severe difficulties in meeting forthcoming repayments.
Throughout the 1980s and 1990s the problems faced by the LDCs in servicing their debts has been one of the
major international policy issues.
The debt crisis encompassed a wide set of countries from low-income developing nations to middle-income
countries. According to the World Bank’s 1996 World Debt Table, the world indebted countries were
classified into four categories.
• Severely Indebted Middle income developing countries (SIMILDCs)

• Moderately Indebted Middle Income developing countries (MIMILDCs)
• Severely Indebted Low income developing countries (SILILDCs)
• Moderately Indebted Low Income developing countries (MILILDCs
To be classified as a SIMILDCs a country must be a middle-income country (an annual income of between
$750 and $8955 per capita) and have one of two key ratios above certain critical levels. These ratios are the
present value of debt to GNP (80 per cent), and the present value of debt to exports of goods and services (220
per cent).
Although they are both severely indebted there are considerable contrasts between the SIMILDCs and the
SILILDCs. The 15 SIMILDCs are especially concentrated in Latin America, and in 1994 their combined
external debt amounted to $587.4 billion, the majority of which was owed to private sources made up primarily
of commercial banks. By contrast, the majority of the 35 SILILDCs are to be found in sub-Saharan Africa, and
in 1994 their combined external debt amounted to $223.6 billion with the vast majority owed to governments
and official agencies and the remainder to private sources.
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8.2 The Low- and Middle-Income Less- Developed Countries
The less-developed countries are traditionally distinguished from the developed economies by their lower per
capita GNP, although developed and less-developed countries are far from homogenous groups. LDCs can be
placed into two categories:
1. Low-income LDCs - typically with incomes of less than $725 per capita at 1994 prices, these include
most of sub-Saharan Africa, India and China.
2. Middle-income LDCs - this group comprises a very wide range of countries with incomes ranging
from $725 to $8955 per capita at 1994 prices. Some of this group can be classified as low-middle-
income developing countries, which includes most countries in Latin America - Argentina ($8065),
Brazil ($3370), Mexico ($4014) and Venezuela ($2761) and many richer African countries.
8.3 Characteristics of Typical Middle-Income LDCs
Since the debt crisis has been predominately confined to less-developed countries, especially those in the low-
middle-income group, some discussion of the main features of such LDCs is necessary. Although it is difficult
to generalize, the following represents a list of the main differences between developed and middle-income
less-developed economies.
a) Financial markets
The financial markets in less-developed countries tend to have a relatively limited range of investment
opportunities for savers and are normally subject to a high degree of government control. Unlike developed
countries that tend to have well-developed stock markets, LDCs stock markets can be fairly rudimentary in
nature, and companies have traditionally been heavily reliant on banks for funding. Banks are usually either
state-owned or subject to heavy government control aimed at maintaining low real interest rates designed to
stimulate investment. A major problem that results from these low real interest-rate policies is that they tend to
further discourage saving which is already low because of low income levels. Low savings combined with low
real interest rates lead to an excess demand for funds requiring credit rationing under which the decisions as to
which industries can borrow and how much is largely determined by the government of the day. In addition,
the low interest rates stimulate expenditure on imports contributing to balance-of-payments problems.
b) Exchange-Rate Pegging and Exchange Controls
The exchange rates of LDCs are frequently pegged to the US dollar, Euro or the special drawing right (SDR),
often on a 'crawling peg' basis. The SDR is not a currency; it is a unit of account by which member states of
International Monetary Fund (IMF) can exchange with one another in order to settle international accounts
Since LDCs tend to have relatively high inflation rates, pegging their currencies against foreign currencies
which have lower inflation rates would be impractical as they would quickly lose competitiveness. For this
reason they frequently devalue the central rate against the currencies to which they are pegged. One of the
problems with such crawling peg arrangements is that if the currency to which they are pegged appreciates,
such as the strong dollar appreciation between 1980 and 1985, this can prove to be disastrous for the LDC's
exports. For this reason, some LDCs prefer to peg to a basket of currencies such as the SDR which will tend
not appreciate or depreciate as much as an individual currency.
In addition to pegging their exchange rates, many LDCs make extensive use of capital controls with the central
bank applying various restrictions on the purchases and sales of foreign currencies. These restrictions serve
several purposes as far as the LDC governments are concerned. By restricting the ability of its residents to
invest their savings abroad, the controls enable the government to borrow funds from its residents at a lower
rate of interest than would otherwise be the case. Controls are usually heavily biased against capital outflows,
restricting sales of the home currency and reducing the strain on foreign currency reserves which would
otherwise be required to defend a pegged exchange rate.
The exchange controls normally require that home residents obtain government permission to purchase foreign
__________________________________________________________________________________ 82
currencies, and often the authorities combine the controls with multiple exchange-rate systems. This means
that the authorities may offer a different rate of exchange depending upon the nature of the particular
transaction. For instance, if the foreign currency is required to pay for imports of capital equipment or essential
items, the authorities will usually offer a more favorable rate of exchange than if it is required to pay for the
import of luxury consumption goods. This is because capital imports and cheap prices for essentials are
considered more favorable to economic development.
c) Low Degree of Diversification
The output of less-developed economies is usually far less diversified than that of developed countries.
Agricultural output can represent a fairly high proportion of GDP and their exports are usually made up of
relatively few commodities, such as raw materials, and agricultural exports. This means their economic
performance can be subject to a wide degree of fluctuation due to bad harvests or changes in the value of their
principal exports. The prices of primary products produced and exported by LDCs tend to fluctuate far more
than the manufactured products of developed economies. This price variability means that the incomes and
trade performances of LDCs can be subject to large year-to-year fluctuations. Recessions in industrialized
countries are especially harmful to LDCs as they experience both a fall in the price of their primary products,
and a decline in their export volumes meaning large reductions in their export revenues.
d) Inflationary Environment
The LDCs tend to have persistent problems with controlling their inflation rates. Government budget deficits
are frequently financed by the government resorting to money creation, partly because the financial markets
are too rudimentary to raise the required borrowing from domestic sources and partly because governments
find taxing their citizens to be politically unpopular and often easily evaded. The resulting inflation reduces the
real value of money held by domestic residents constituting an 'inflation tax' and reduces the real value of
outstanding government debt.
To protect workers' wages from the effects of the inflationary environment there is usually a high degree of
wage indexation so that wages rise in line with prices. Wage indexation makes it very difficult for the
authorities to bring inflation under control because at the same time the authorities take measures to slow down
future inflation, wages are being adjusted upwards on the basis of previous inflation. Indexation also means
that real wages are difficult to reduce should an economic shock such as deterioration in the country's terms of
trade require such a fall. Consequently, such shocks normally lead to increased unemployment. A rapidly
growing workforce leads to a continuous upward pressure on government expenditure to provide employment
in state enterprises.
8.4 The Economics of LDC Borrowing
Key question relating to the debt problem is why were developing countries eager to borrow and the
commercial banks and developed countries so willing to supply the funds in the first place?
From the perspective of the LDCs their combinations of low incomes and poorly developed capital markets
mean that there is insufficient domestic savings to provide the finance for domestic investment. Their relatively
low capital stock means that there are plenty of opportunities for profitable investment and a low capital-to-
Labor ratio means that the marginal productivity of capital is high. By borrowing funds from abroad they can
raise domestic investment above domestic savings which in turn leads to a higher rate of economic growth than
in the absence of such borrowing. The fact that investment then exceeds domestic savings implies that the
country is running a current account deficit, the counterpart of which is the capital inflow on the capital
account. Later on, the LDC will have to repay the principal and interest on the loans extended to it. The hope is
that the state of the economy will be such that repayments should present no problems.
As for the developed economies, their relatively high incomes and sophisticated financial markets lead to
relatively high savings ratios while their relatively high capital-to-Labor ratios mean that the marginal
productivity of capital is relatively low, restricting the amount of profitable investment opportunities. This
means that there is an excess of savings looking for appropriate investment opportunities. Such opportunities
exist in abundance in LDCs who in turn lack the required funds. Hence, there is the potential for profitable
exchange between the developed and developing countries. The LDCs can utilize the excess savings of the
__________________________________________________________________________________ 83
developed countries for investment, while the lending developed countries have higher prospective returns
from investing in the LDCs than domestic investments.
8.5 Different Types of Capital Inflows into LDCs
There are a variety of means available for LDCs to attract capital inflows from the developed economies to
finance new investment. These include, bond finance, bank loans, foreign direct investment (FDI), and official
finance. They can be grouped into equity finance (FDI) and debt finance (bond, bank loans and official
finance)
a) Bond Finance
The LDC governments can issue bonds to foreign investors with a guaranteed rate of interest depending upon
the maturity date of the bond and whether or not it is denominated in the domestic or foreign currency. If the
bond is issued in the domestic currency it is subject to 'inflation risk' because there is a danger that higher
than expected inflation in the issuing country could undermine the real redemption value of the bond. Alter-
natively, if the bond is issued in a foreign currency it is subject to 'default risk', that is the danger that the
LDC will not be able to redeem the bond.
b) Bank Loans
The LDCs can borrow money from the commercial banks of the developed countries. Such loans are usually
made either at fixed or floating rates of interest and may be of a short-term or long-term nature. During the
1970s and 1980s this was the major source of finance for the Latin American countries. The loans extended
were predominately 'syndicated loans', that is loans made by syndicates of international banks, and were
generally made in US dollars at floating rates of interest where the repayments could be adjusted upwards or
downwards in line with changes in international interest rates. The key rate of interest for such loans was the
dollar London Inter-Bank Offer Rate (LIBOR), the rate of interest at which banks in London lend dollars to
one another. Loans to LDCs are normally expressed as a margin over dollar LIBOR.
c) Foreign Direct Investment (FDI)
Another means by which LDCs can raise foreign finance is by attracting foreign direct investment into their
countries. Such investment can take many forms; it could involve a foreign multinational acquiring equity in a
domestically-owned business, a multinational expanding an existing subsidiary, or foreign investors setting up
a completely new enterprise in the LDC. Such direct investment is a popular method of multinationals
investing in LDCs since it gives them both ownership and control over the businesses that they set up and
acquire. In addition, it is regarded as a qualitatively different type of capital inflow representing a long-term
investment and a vote of confidence in the developing country.
d) Official Finance
In addition to private sources of foreign investment, the LDCs are also able to raise money for developmental
purposes directly from foreign governments and international institutions. Loans from foreign governments are
often made at below market rates of interest to developing countries as part of their foreign aid programs.
Loans from the World Bank come at favorable rates of interest because its top credit rating enables it to raise
large sums of capital from private markets at a lower rate of interest than is possible for an individual LDC.
Overall, a clear distinction needs to be made between debt finance and equity finance. Debt finance, of which
bond, bank and official finance are examples, requires the debtor to repay the principal and the rate of interest
attached to the loan whatever the economic situation in the debtor nation. If the country faces a worsening of
its economic circumstances, it must repay the principal and interest on its outstanding debt regardless. This
contrasts with equity finance whereby the foreign investors either own shares or have direct control of LDC
companies. In these cases, the repayment for their investment in the form of profits and dividends and changes
in the market value of the companies is directly related to the performance of the companies and the LDC
concerned. If the LDC faces adverse economic conditions it will lead to less repayment to foreigners in the
form of reduced profits and dividends. Conversely economic prosperity in the LDC will lead to larger profits
and dividend payments to foreign investors.
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8.6 Measures of Indebtedness
When deciding whether to extend a new loan or to make provisions against existing loans, or even whether to
write off parts of their outstanding loans, private banks will want to know the probability of the existing debt or
new loan being repaid. This will enable them to balance the risk-and-return elements of the loan. The problem
is that there is no unique indicator or measure of the burden imposed on a country by its external indebtedness.
In order to assess the risks, banks will have to arrive at a view of the economic and political state of a country
relying on a range of indicators many of which are reported by the World Bank in its World Debt Tables.
Some of the most popular statistics employed to assess country risk are:
a) External debt as a percentage of exports of goods and services
This expresses the country's external debt, both private public and publicly guaranteed as a ratio of its export
earnings. The idea is that the export earnings are the means by which the country earns foreign currency to
payoff its debt. Problems with this ratio are that exports may be subject to a high degree of fluctuation from
year to year, and there are alternative measures a country can employ to payoff its external debt other than
increasing its export revenues. For example, cutting down import expenditure or running down reserves.
b) Reserves as a percentage of total external debt
This is a measure showing the reserves that the central bank of the debtor nation could in theory use to payoff
its external debt.
c) External debt as a percentage of gross domestic products
This is a measure that gives an ideal of the total debt burden in relation to the GDP of the country. However, it
says nothing about the annual burden imposed on the country, the amount of repayments falling due, or which
section of the community the burden will fall upon.
d) Total debt service as a percentage of exports of goods and services
This measures the public and publicly guaranteed principal and interest repayments that the country has to
make as a percentage of it exports of goods and services. This gives an indication of the annual burden facing a
debtor in relation to its export earnings. The major problem is the effect of variations in export earnings, and
this measure only gives the burden for the particular year under consideration.
e) Total debt service as a percentage of gross domestic product
This figure measures the public and publicly guaranteed principal and interest repayments that the country has
to make as a percentage of its GDP.
Of course other statistics such as the evolution of the current account, unemployment rates and the rate of
growth of GDP are usually taken into account when assessing the risk of lending to a given country. Other
noneconomic variables which rely upon judgment are also used, which include the likelihood of internal
conflict, degree of religious conflict, wealth disparity measures and so forth. It is apparent that no individual
indicator can provide an adequate measure of the complexity of a Country's debt problem.
Even when used in combination, the various measures do not necessarily provide an accurate picture of the
creditworthiness of different countries. They neglect factors such as the differing degrees of vulnerability to'
external shocks, differing capacities to increase export' earnings, and differing future economic prospects of the
economies. In addition, there may be a difference between the ability of a country to service its external
obligations and its willingness to do so, although the two are usually positively correlated. An understanding of
country risk assessment is an essential background to the study of the debt crisis because part of the blame for
the crisis is attributable to the inadequacies of the measures used by banks when extending loans to the debtor
nations in the first instance.
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8.7 The Dimensions of the Debt Crisis
As a result of the Mexican moratorium, international banks began to realize that many other countries were
facing similar difficulties in servicing their debt. Table 8.1 shows the rapid growth of external debt for the big
four debtors.
Table 8.1: Total External Debt of the Big-Four Debtors, 1972-1982 (US$ millions)
Year Argentina Brazil Mexico Venezuela
1972 6028 10165 7028 1712
1973 6429 12939 8999 1891
1974 6789 19416 11946 1784
1975 6874 23737 15609 1494
1976 8258 29031 20520 3311
1977 11445 41397 31189 10727
1978 13276 53614 35732 16568
1979 20950 60419 42828 23896
1980 27157 70838 57378 29310
1981 35657 80643 78215 32093
1982 43634 92221 86019 32094
Source: World Debt Tables 1989-90, p.59.
The real fear of both the banks and the authorities in the industrialized countries was that if Mexico went into
default it would be quickly followed by other major debtors. Many US banks had more loans outstanding in
Latin America than the value of their equity. A default by any of the big four debtor nations could easily have
set off a chain reaction of banking failures and provoked a collapse of the banking systems in the developed
countries. Not surprisingly, both the banks and authorities of the industrialized countries were determined to
avert such a scenario.
Precisely how the banks got so heavily exposed with their LDC lending is not easy to explain. In retrospect
there were clear flaws in their credit rating procedures and they got somewhat carried away with syndicated
loans. As Graham Bird explains the most simple and convincing explanation was that the banks made major
mistakes:
8.8 The Role and Viewpoints of the Actors in the Debt Crisis
There were very divergent views on the nature and extent of the debt crisis and these differences led to
differing perspectives on how to best manage the crisis. The viewpoint adopted towards the crisis was partly
colored by the differing interests of the four major actors involved. These were the international banks that lent
the funds, the authorities of the developed nations, international institutions notably the World Bank and the
IMF and the debtor nations. We shall briefly overview their perspectives and roles in the crisis although we
need to be wary of treating these actors as homogeneous groups. For example, the international banks that lent
the money had differing degrees of exposure, faced differing regulatory and tax regimes, and often had diverse
views on the appropriate policy response. Likewise the debtor nations had differing degrees of indebtedness,
differing repayment burdens and prospects with regard to debt repayment. As for the national authorities, their
economies have varying degrees of trading links and different historical and strategic relationships with the
debtors.
a) The Commercial Banks
The immediate reaction of international banks to the emergence of the debt problem was to view it as primarily
a 'liquidity crisis'. Bankers believed that high interest rates and a large amount of principal repayments falling
due combined with adverse economic conditions had meant that the debtor nations were finding themselves in
only short-term difficulties. To support this viewpoint it was argued that the debt profile of the debtors was
primarily of a short-term horizon and that nations do not go bankrupt. As such, the banks early on sought
solutions based upon restructuring debtors' repayments to give debtors more time to pay. Banks initially
preferred rescheduling debt repayments, and at the same time sought to ensure that additional interest was paid
on the postponed principal repayments. Following the onset of the crisis the banks were very reluctant to
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extend new funds to the debtors given the precarious position of their outstanding loans. Many bankers took
the view that extending new loans to the debtors was 'throwing good money after bad'. Despite this, the banks
realized that without new loans the incentives for the debtors to default rise, and so some further lending was
an essential part of restructuring packages designed to avert default by the debtors.
Bankers were opposed to granting any debt forgiveness for a number of reasons. They argued that doing so for
one country would lead other debtors to seek similar relief. Also debt relief might discourage the debtors from
taking the measures necessary to improve their economic performance to ensure they qualify for debt relief. In
addition, bankers argued that granting a country a degree of debt relief branded it as un creditworthy so that
new loans to the country would dry up. In sum, the view of the banking community was that granting debt
relief was too costly for banks to contemplate and ultimately harmful to the debtor nations themselves. Banks
argued that any new lending to the Latin American countries should be carried out by the national authorities
of the industrialized countries and international institutions. The banks were also keen to treat each debtor on a
'case-by-case' approach. This was motivated not only by a belief that the circumstances facing each debtor
were different, but also because the different creditor banks had varying degrees of exposure to each debtor
making a uniform solution impracticable.
b) National Authorities
The national authorities of the industrialized countries were primarily concerned to avoid a calamitous
collapse of their banking systems which could result from a default by one of the major debtors. However, they
were also extremely wary of utilizing public funds to ease the debtors' plight. Authorities did not wish to be
seen to be bailing-out the commercial banks whose lending had gone bad. In addition, any significant
assistance would be extremely costly and be at the expense of reduced public expenditure or increased taxes. A
general feeling was that further loans by the authorities would not help when the problem of the debtors was
having too much debt already.
Nevertheless, the authorities (especially the US administration) had strategic and economic interests in the
Latin American debtors, making it impossible for them to be indifferent to the debtors' plight. Rather than get
involved in lending new money to the LDCs, most authorities were prepared to allow some tax concessions for
provisions banks made against possible losses on their lending to LDCs. In addition, authorities were prepared
to increase the amount of capital available to the World Bank and the IMF for lending to LDCs. Channeling
funds via these institutions was considered useful because both the World Bank and IMF could ensure the
LDCs undertook appropriate measures to reform their economies and LDCs nearly always ensure repayment of
funds to these institutions.
c) The IMF and the World Bank
The two main international institutions involved in the debt crisis played somewhat differing and at times
conflicting roles, although in the later stages there was a more coherent policy stance. The World Bank was
very much concerned about the sheer size and extent of the debt crisis and particularly the costs in terms of
slower development that debt repayments impose upon the debtor nations. On the other hand, the IMF saw its
main role as ensuring that the debtor nations that came to it for assistance adopted the tough economic
measures required for improving their longer-term ability to service their debts. Another role played by the
IMF was to ensure that creditor banks continued sufficient new lending to the debtor nations to make it
worthwhile for the debtor nations to accept an IMF sponsored adjustment package.
From time to time the two institutions came into conflict over the handling of the debt crisis; the World Bank
criticizing the IMF for setting too severe economic adjustment programs and to some extent infringing upon
the Bank's traditional domain. Overall, the direct financial impact that the two organizations could make was
very much limited by the amount of finance they had available.
d) The Debtors
The debtors to a large extent viewed the crisis that they found themselves in as not of their making but as due
to a combination of external factors beyond their control. As such, they felt that the creditor banks should
allow some degree of debt forgiveness in the form of reducing the stock of debt owed by the debtors and/or
reduced interest-rate repayments below market rates. Surprisingly, attempts to form a debtors' cartel to improve
their bargaining positions vis-a-vis the creditor banks did not come to anything. This was partly because the
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debtors had differing debt problems and so were unable to agree on the way they could best be helped. In
addition, they were in competition with one another for whatever new lending was available, and creditor
banks were careful to treat them on a case-by-case basis rather than as a group. The debtors consistently argued
that they needed some debt forgiveness as an incentive to make economic adjustments in their economies.
Without such relief they have little incentive to adjust as all the improved economic performance goes to
creditors to payoff their debts.
CHAPTER SUMMARY
• Although it is difficult to generalize, the main differences between developed and middle-income less-
developed economies can be explained in terms of the differences in the structure of financial markets,
exchange rate policy and exchange control, degree of economic diversification and inflation.
• The marginal productivity of capital in developing countries is relatively higher than the marginal
productivity of capital in the developed countries. This is due to the low capital to labor ratio in the
developing countries than the developed countries. As a result, developing countries have a demand for
capital that tend them to borrow from developed countries whereas developed countries have the
willingness to supply.
• Bond finance, bank loans and official finance are debt finance through which capital can flow from
developed countries to developing countries. Foreign direct investment is and equity finance for the inflow
of capital to developing countries.
• The different actors in international debt crisis have different views and roles concerning international debt
crisis.
REVIEW QUESTIONS
1. Explain the basic differences between developed countries and middle income LDCs.
2. Explain why developing countries have the demand for borrowing and why do developed countries
also supply loans to developing countries. Give only the economic reason.
3. Discuss the view role and view points of IMF and the World Bank in international debt crisis.
4. List the popular statistics used to assess the friskiness of extending loan to developing country.
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CHAPTER IX
9. INTERNATIONAL ECONOMIC COOPERATIONS AND ORGANIZATIONS
CHAPTER OBJECTIVES
The objective of this chapter is to acquaint students with the merits and demerits of international economic
cooperation and the functions of international organizations like the world Bank, International Monetary Fund
and World Trade Organization.. After learning the contents in this chapter, students will be able to:
Understand the basic reason or advantages of international and regional economic cooperation
between countries.
Identify the different forms of international economic cooperation and differentiate them according to
their scope.
Be familiarized with the history and basic functions of international organizations like the World Bank,
International Monetary Fund(IMF), and the World Trade Organization (WTO).
9.1 Why International Economic Co-operations?
International economic relations imply a mutual economic influence between countries. Exports of goods,
international capital flows or changes in one country's economic policy will always influence another country
to a greater or lesser degree.
International economic cooperation is prompted mainly by this mutual influence which countries have via their
economic policy and subsequently through their international transactions. The 'spill-over' of one country's
economic policy on the economies of other countries is usually an unintentional side effect. In welfare theory it
is called an external effect. The consequence of such an external effect is that, from the point of view of total
world welfare, the country pursuing this economic policy is not applying the correct dose, because it is
concerned only with the costs and benefits which it will itself derive from that policy. These determine the
exact form and extent of the policy devised. The ensuing costs and benefits in another country are ignored. If
the policy makers were to take these into account as well, then they would have undoubtedly devised a
different optimum policy as being the optimum policy.
The aim of international economic cooperation is that national economic policy decisions should also take
account of their effects on other countries' economies. This seldom if ever seems to happen spontaneously.
National governments obviously focus mainly on their own country. That is what they are for, because that is
the location of the electorate who will ultimately decide whether to re-elect the policy makers. .
9.2 Forms of international economic cooperation
The forms of international economic cooperation can be categorized into four based on the degree of closeness
of countries making the economic cooperation. These are cooperation for exchange of information,
international economic policy coordination, international policy harmonization, and economic unification or
integration.
a) Exchange of information
There has been some degree of international economic cooperation for hundreds of years. Often it was in a
very moderate form, namely the exchange of information on the state of the countries' own economies and on
their plans for future national economic policy. It was not until this century that international economic
cooperation became more or less permanent. At the end of the Second World War it actually gained
momentum.
Since the Second World War the exchange of information on national economic policy has been incorporated
in the work of the Organization for Economic Cooperation and Development (OECD), which has its secretariat
in Paris. Government representatives regularly meet there to exchange ideas on the economic situation in their
country and forthcoming economic policy. With the information thus obtained, a country's government is in a
better position, when preparing its policy, to take account of the expected policy in other countries and the
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influence which that is likely to have on the economy of the home country. For example, if it is apparent that
Germany is preparing for an expansionary policy, the governments of countries such as Belgium and the
Netherlands can react by moderating any plans which they have for expansion. They can expect that via the
increased German demand for imports, stronger growth in Germany will have an expansionary influence on
their economies, which traditionally send a substantial percentage of their exports to Germany.
b) International policy coordination
A closer form of international cooperation is policy coordination. All countries involved in the coordination
have their own preferences as regards the future values of their economic policy objectives. They are aware of
the mutual influence exerted by national economic policy. The ultimate aim of policy coordination is that
individual countries should adjust their policy instruments in the best interests of all the economic objectives of
the countries concerned. In theoretical form: the econometric model containing all the countries concerned
includes all national economic objectives and economic policy instruments; there is also an objective function
comprising all countries and containing all national objectives, each in relation to the target value for that
objective, with a specific weighting which expresses the importance of the objective concerned. The aim is to
maximize the objective function under the condition of the econometric model. This process yields the
optimum value of each of the national policy instruments, in the best interests of the group of countries
concerned - although it cannot be precluded that the result of this optimization is that some countries' welfare
declines.
Since the mid 1970s, international policy coordination has taken place mainly in the G-7. This is the group of
seven leading industrial countries: the US, Japan, Germany, United Kingdom (UK), France, Italy and Canada.
Since 1976 these G-7 members have held annual meetings of the heads of state or government leaders of the
participating countries. The agreements made at these meetings are general in character, aiming, for instance,
to reduce the American budget deficit, cut-taxes in Japan and produce a more expansive government policy in
Germany. There is no retrospective monitoring or evaluation. The agreed policy often fails to be implemented
because, according to the country concerned, new developments during the year necessitated interim
adjustments of their policy intentions.
Various other groups of countries have developed in addition to the G- 7. These also aim at coordination, but in
regard to a specific aspect of economic policy. Thus, the G-I0 has been in existence since 1962. It consists of
the G- 7 countries plus the Netherlands, Belgium and Sweden, with the addition of Switzerland in 1964 this
group became involved in the IMF's liquidity position on the initiative of the US; Since 1972 there has also
been a G-24 comprising a large group of developing countries. The number of members rapidly grew to far
more than 24. This group discusses international monetary issues and tries to arrive at common positions
before the annual meeting of the IMF, so that the developing countries can speak with one voice and thus have
more say at that meeting. There have been periods in which a G-5 looked likely to develop as a permanent
consultation agency. This group consisted of the G-7 without Italy and Canada. However, the G-5 now seems
to have had its day. Instead there is a tendency to establish a G-3 consisting of the US, Japan and Germany, or
a variant in which Germany is replaced by the European Union (EU). The G-7 coordination meetings could
then become a matter for the G-3.
c) International policy harmonization
Another form of international economic cooperation is international policy harmonization. We usually talk
of harmonize at ion if the object of cooperation is to achieve a degree of convergence in policy intervention in
the various countries. Thus, harmonization does not so much concern macro-economic policy but rather
policy intervention which influences the international competitive position of national enterprise, e.g. the
setting of rates of tax - particularly indirect taxes such as VAT rates - and government regulations aimed at
protecting the safety and health of consumers. This has been attempted in the EC, in particular, in recent years.
As regards VAT, so much progress has been made that all countries impose their indirect taxation on the
basis of VAT and a minimum level has been set for both the low and high rates of VAT. This system combats
price advantages which are not based on low production costs but on something else than comparative
advantage such as favorable rates of tax.
d) Unification/integration of economic policy
The most radical form of international economic cooperation is total integration or unification of economic
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policy in the countries concerned. Obviously, such an economic policy is supranational in practice. This
means the existence of economic control at a higher than national level, mapping out and implementing
economic policy for the countries involved in the unification. Another form of supranational decision-making
is majority decisions by participating countries. This form of cooperation combines well with democratic
decision-making, though this requires a supranational parliament. The plans for an Economic and Monetary
Union (EMU) in the EU clearly contain supranational elements and thus' constitute an example.
The above four forms of international economic cooperation were put in ascending order of closeness, these
are: exchange of information as the least radical form, coordination, harmonization and unification as
undoubtedly the closest form of international economic cooperation. For each of these a further distinction
can be made according to the scope of the cooperation, which ranges from strictly sectoral (e.g. international
cooperation on trade policy for the textile sector only, in the form of the Multi-Fibre Arrangement) to fully
integrated economic policy. There is also a geographical differentiation in scope: from small-scale, regional
cooperation (e.g. by Belgium, the Netherlands and Luxembourg in the Benelux) to truly global cooperation
(as in the IMF).
Advantages of international economic cooperation
As stated in section 9.1, the advantage of international economic cooperation is undeniably that the effects on
other countries' economies are taken into account in determining national policy.
Disadvantages of international economic cooperation
However, in economics there are no advantages without disadvantages; it remains a science based on
weighing up costs and benefits, and international economic cooperation is no exception to that. The
disadvantages of international cooperation can be divided into: the sacrifice of national autonomy in policy-
making; the complexity of implementation; the risk of cheating; and free riders. These four disadvantages
will now be explained in more detail.
a) Loss of national autonomy in policy making
Loss of national autonomy in the implementation of economic policy is often in itself a psychological
disadvantage for a national government. Independence and autonomy are usually regarded as positive
attributes. But optimum international economic cooperation ought to lead to maximum economic welfare for
the whole co-operating region. However, one cannot rule out the possibility that part of the region, e.g. one of
the co-operating countries, will nevertheless suffer a loss of welfare or gain hardly anything at all. Much
depends on the weightings given to that country's economic objectives in the overall economic welfare
function. Those weightings will be small if the country in question is of minor importance in the overall co-
operative framework. In economic terms, it is the largest countries which have the power. They have very little
interest in cooperation since their economy is relatively little influenced by other countries. For small countries
the exact opposite applies. As a result, the large countries will be able to impose the most demands, and they
will do so.
b) Complexity of implementation
International economic cooperation in the form of policy coordination is difficult to implement. It is in fact
even more difficult to implement than national economic policy. In formal terms, ascertaining the outcome of
optimum international policy coordination demands knowledge of a number of elements, which are
particularly difficult to quantify. One is the combined welfare function for the countries taking part in the
coordination. Another is the composition of national models considered to give a good quantitative description
of the participating economies. At national level this information is already hard to come by, and people
continue to disagree on the correct form. Where several countries are concerned, the level of disagreement can
clearly increase significantly. One complication here is that simulation results of econometric models for
policy coordination indicate that use of a model which, on closer examination, proves to be incorrect or
unsatisfactory as a reflection of the economy involved, can easily more than negate the positive result of
coordination.
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c) The risk of cheating or behaving as free riders
The last issue in connection with policy coordination concerns the fact that (potential) participants withdraw
from the agreements or from the cooperation as a whole. In this case, the cooperation is undermined by
participants cheating or behaving as free riders. Once the form in which the coordinated economic policy is to
be implemented has been decided by mutual consultation, it can be to the advantage of a participating country
to fail to carry out its own part. The other countries' policy will in itself make a positive contribution to the
desired economic development of the country in question. One reason for trying to avoid participating in the
implementation of the policy may be that the country's own intended contribution to the coordinated policy
entails costs for that country: One example is the implementation of an expansive fiscal policy which has to be
financed on the capital market by issuing government bonds. Failure to meet obligations, or cheating, cannot
be avoided altogether; at best the risk can be reduced. In this connection, retrospective legal action serves no
practical purpose, because there are no legal rules for this type of international agreement, although failure to
comply with agreements will be less attractive if such policy coordination is not an isolated instance but
continues from year to year. Cheating in anyone year then entails costs for the country concerned, in that it is
bound to be excluded from the policy coordination in subsequent years - and hence also from the important
phase of devising the common policy! The risk of cheating can be further reduced if the policy for countries
taking part in the cooperation is laid down in an agreement and if an organization is set up to supervise
compliance with the rules.
The free rider issue concerns the fact that a country can withdraw not only from implementing the coordinated
policy but also from devising it. In short, the country remains totally outside the international economic
cooperation. Such an attitude combined with the expectation that the country will actually benefit from the
common policy of the remaining group of countries - in the form of an improvement in economic development
- makes the country into a free rider. Nothing can be done about this problem apart from bringing political
pressure to be~ on the free rider. A single free rider will not block international policy coordination. However,
if a number of mainly larger countries thus stay out of range, this can mean the end of the attempt at
coordination.
9.3 Regional integration
Ever since the creation of the European Economic Community (EEC), in 1958, regional groupings, have
despite the reservations of many economists, become ever more popular. In fact, one has the impression that
the world is turning into a mass of regional groupings. These may take any of the following forms, a co-
operation agreement, a free trade agreement, a customs union, a common market and/or an economic and
monetary union, customs union, a common market and/or an economic and monetary union (EMU).
It is generally accepted that countries at a particular level of economic and trade development will choose one
particular form of regional integration rather than another. However, there may be political considerations of a
sometimes longer-term nature which may persuade some countries to pay a short- or medium-term economic
and financial price in exchange for longer-term benefits. Thus, for example, last century, when the German-
speaking states united to create Germany, Prussia allowed the smaller states to enjoy benefits knowing that in
the long run Prussia would dominate Germany. Similarly, at the present time, in the European Union, Germany,
albeit grudgingly, makes very large financial contributions to the Community budget because she knows that
she enjoys a captive market inside the union.
Despite the existence of such examples, economists, ever since the publication of Viner's pathbreaking book in
1950, "The Customs Union Issue''', have been puzzled as to why countries should, for example, join a customs
union rather than orgasms non-preferential multilateral trade agreements. At the two extremes, EI-Agaa,
writing in 19892, lists clear reasons why such regional groupings may appear to be advantageous to countries.
These include the following:
• Enhanced efficiency as the result of specialization
• Increased production levels as a result of the exploitation of economies of scale
• Improved international bargaining positions as a result of increased size (and a long run improvement
in the terms of trade)
• Enforced efficiency gains as a result of increased competition, and
• Increased rate of growth as a result of technological advances.
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9.4 The World Bank, International Monetary Fund and World Trade Organization
9.4.1 The World Bank
The World Bank is like a cooperative, where its 184 member countries are shareholders. The shareholders are
represented by a Board of Governors, who are the ultimate policy makers at the World Bank. Generally, the
governors are member countries' ministers of finance or ministers of development.
Conceived during World War II at Bretton Woods, New Hampshire, the World Bank initially helped rebuild
Europe after the war. Its first loan of $250 million was to France in 1947 for post-war reconstruction.
Reconstruction has remained an important focus of the Bank's work, given the natural disasters, humanitarian
emergencies, and post conflict rehabilitation needs that affect developing and transition economies.
Nowadays the Bank, however, has sharpened its focus on poverty reduction as the overarching goal of all its
work. It once had a homogeneous staff of engineers and financial analysts, based solely in Washington, D.C.
Today, it has a multidisciplinary and diverse staff including economists, public policy experts, sectoral experts,
and social scientists. 40 percent of staff is now based in country offices.
The Bank itself is bigger, broader, and far more complex. It has become a Group, encompassing five closely
associated development institutions:
• the International Bank for Reconstruction and Development (IBRD),

• the International Development Association (IDA),
• the International Finance Corporation (IFC),
• the Multilateral Investment Guarantee Agency (MIGA), and
• the International Centre for Settlement of Investment Disputes (ICSID).
The World Bank's two closely affiliated entities—the International Bank for Reconstruction and Development
(IBRD) and the International Development Association (IDA)—provide low or no interest loans and grants to
countries that have unfavorable or no interest loans and grants to countries that have unfavorable or no access
to international credit markets
Fund Generation
IBRD lending to developing countries is primarily financed by selling bonds in the world's financial markets.
While IBRD earns a small margin on this lending, the greater proportion of its income comes from lending out
its own capital. This capital consists of reserves built up over the years and money paid in from the bank's 184
member country shareholders. IBRD’s income also pays for World Bank operating expenses and has
contributed to IDA and debt relief.
IDA, the world's largest source of interest-free loans and grant assistance to the poorest countries, is
replenished every three years by 40 donor countries. Additional funds are regenerated through repayments of
loan principal on 35-to-40-year, no-interest loans, which are then available for re-lending.
Loans
Through the IBRD and IDA, the bank offers two basic types of loans and credits.
• Investment loans: Investment loans are made to countries for goods, works and services in support of
economic and social development projects in a broad range of economic and social sectors.
• Development policy loans: Development policy loans (formerly known as adjustment loans) provide
quick-disbursing financing to support countries’ policy and institutional reforms
•
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Grants
Grants are designed to facilitate development projects by encouraging innovation, co-operation between
organizations and local stakeholders’ participation in projects. For example in recent years, IDA grants—which
are either funded directly or managed through partnerships—have been used to:
• Relieve the debt burden of heavily indebted poor countries

• Improve sanitation and water supplies
• Support vaccination and immunization programs to reduce the incidence of communicable diseases
like malaria
• Support vaccination and immunization programs to reduce the incidence of communicable diseases
like malaria
• Combat the HIV/AIDS pandemic
• Support civil society organizations
• Create initiatives to cut the emission of greenhouse gasses
Analytic and Advisory Services
While the bank is best known as a financier, another of its roles is to provide analysis, advice and information
to member countries so they can deliver the lasting economic and social improvements their people need. The
bank does this in several ways: through economic research on broad issues such as the environment, poverty,
trade and globalization and through country-specific economic and sector work, where the bank evaluates a
country's economic prospects by examining its banking systems and financial markets, as well as trade,
infrastructure, poverty and social safety net issues, for example.
Capacity building
Another core bank function is to increase the capabilities of its staff, partners and the people in developing
countries—to help them acquire the knowledge and skills they need to provide technical assistance, improve
government performance and delivery of services, promote economic growth and sustain poverty reduction
programs. Linkages to knowledge-sharing networks such as these have been set up by the bank to address the
vast needs for information and dialogue about development.
9.4.2 International Monetary Fund (IMF)
The IMF was born at the end of World War II, out of the Bretton Woods Conference in 1945. The Fund was
created out of a need to prevent economic crises like the Great Depression. The main purposes for which the
I.M.F. was set up were to provide exchange stability, temporary assistance to countries falling short of foreign
exchange and international sponsoring of measures for curing fundamental causes of disequilibrium in balance
of payments. The I.M.F. is a pool of central -bank reserves and national currencies which are available to its
members under certain conditions. It can be regarded as an extension of the central bank reserves of the
member countries.
The IMF works to the creation of financial markets worldwide and to the growth of developing countries. With
its sister organization, the World Bank, the IMF is the largest public lender of funds in the world. It is a
specialized agency of the United Nations and is run by its 184 member states. Membership is open to any
country that conducts foreign policy and accepts the statutes of the Fund.
Objectives of IMF
According to Article I of the Fund, the main purposes of the Fund are:
1. To promote international monetary cooperation through a permanent institution.
2. To facilitate the expansion and balanced growth of international trade, and to contribute thereby to
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the promotion and maintenance of high, levels of employment of the member-countries.
3. To promote exchange stability, to maintain orderly exchange arrangements among members, and to
avoid competitive exchange deprecia1ion.
4. To assist in the establishment of a multilateral system of payments in respect of current'
transaction between members and in the elimination of foreign exchange restrictions. .
5. To give confidence to members by making the Fund's resources available to them under adequate
safeguards, thus providing them with opportunity to correct maladjustments in their balance of
payments without resorting to measures destructive of national or international prosperity (e.g.,
deflationary policies).
6. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of members.
The IMF is responsible for the creation and maintenance of the international monetary system, the system by
which international payments among countries take place. It thus strives to provide a systematic mechanism for
foreign exchange transactions in order to foster investment and promote balanced global economic trade.
How Does It Work?
The IMF gets its money from quota subscriptions paid by member states. The size of each quota is determined
by how much each government can pay according to the size of its economy. The quota in turn determines the
weight each country has within the IMF - and hence its voting rights - as well as how much financing it can
receive from the IMF.
Twenty-five percent of each country's quota is paid in the form of special drawing rights (SDRs), which are a
claim on the freely usable currencies of IMF members. Before SDRs, the Bretton Woods system had been
based on a fixed exchange rate, and it was feared that there would not be enough reserves to finance global
economic growth. Therefore, in 1968, the IMF created the SDRs, which is a kind of international reserve asset.
It was created to supplement the international reserves of the time, which were gold and the U.S. dollar. The
SDR is not a currency; it is a unit of account by which member states can exchange with one another in order
to settle international accounts. The SDR can also be used in exchange for other freely-traded currencies of
IMF members. A country may do this when it has a deficit and needs more foreign currency to pay its
international obligations.
The SDR's value lies in the fact that member states commit to honor their obligations to use and accept SDRs.
Each member country is assigned a certain amount of SDRs based on how much the country contributes to the
Fund (which is based on the size of the country's economy). However, the need for SDRs lessened when major
economies dropped the fixed exchange rate and opted for floating rates instead. The IMF does all of its
accounting in SDRs, and commercial banks accept SDR denominated accounts. The value of the SDR is
adjusted daily against a basket of currencies, which currently includes the U.S. dollar, the Japanese yen, the
euro, and the British pound.
The larger the country, the larger its contribution; thus the U.S. contributes about 18% of total quotas while the
Seychelles Islands contribute a modest 0.004%. If called upon by the IMF, a country can pay the rest of its
quota in its local currency. The IMF may also borrow funds, if necessary, under two separate agreements with
member countries. In total, it has SDR 212 billion (USD 290 billion) in quotas and SDR 34 billion (USD 46
billion) available to borrow.
Functions of the IMF
The IMF performs five major functions:

1. It serves as a short-term credit institution. If any country is in a temporary difficulty in liquidating an
adverse balance of payments, the Fund will come to its aid. It does not, however, undertaken to supply
all the foreign exchange that a country may need. All countries are supposed to have their separate
monetary and foreign exchange reserves to meet their normal requirements. The Fund is not intended to
supplant them but to provide only a second line of defence in case of emergency. The borrowing country
has to pay interest and maintain its quota intact. Should a country borrow unnecessarily, the rate of
interest rise~ as the amount of loan increases. Lower rates are charged if a loan is taken for a short period.
__________________________________________________________________________________ 95
If the amount of the loan and its duration are such as to raise the rate of interest to 5 per cent, the Fund
can then raise the rate to any level by way of penalty, for this is regarded as an abuse of the privilege of
membership.
Thus; it is clear that the credit operations of the Fund are not only conducted on sound business principle but
they also ensure that the object of the Fund, viz., to provide short-term loan only, is not defeated.
2. The Fund provides a mechanism for improving short-term balance of payments position. For this purpose,
its rules provide for orderly adjustment of, exchange. No member-country can indulge in irresponsible and
competitive exchange depreciation thus introducing the law of the jungle in international monetary
relations. Whenever a country feels, that its rate of exchange is out of line with its economy, the rate can
be altered but only after due deliberation between the authorities and'1ne authorities of the Fund. There is
thus provision for the careful determination of the initial rate and its orderly adjustment subsequently. This
procedure at once reconciles the claims to internal stability and full employment on the one hand and to
international stability and high level of world trade on the other. Every country must now rely on its own
productive efficiency rather than on artificial stimulus of exchange depreciation to hold its own in the
world markets.
3. The Fund provides machinery for international consultations. It brings together representatives of the
principal countries of the world and affords an excellent opportunity for reconciling their conflicting
claims. This constructive approach and the measure of international co-operation have had not only a
stabilizing influence on world economy but they have also led to the expansion and balanced
development of world trade and world production. The Fund has thus contributed to the promotion and
maintenance of high levels of employment and real income and to the development of the productive
resources of the member countries. For this purpose, the Fund is engaged in constant study and research
relating to the important and urgent economic problems of the world.
4. It provides a reservoir of the currencies of the member-countries and enables members to borrow one
another's currency.
5. It promotes orderly adjustment of exchange rates to promote exchange stability.
9.4.3 World Trade Organization (WTO)
The World Trade Organization (WTO) is an international, multinational organization, which sets the rules
for the global trading system and resolves disputes between its member states; all of whom are signatories to
its approximately 30 agreements.
The Bretton Woods Conference of 1944 proposed the creation of an International Trade Organization (ITO) to
establish rules and regulations for trade between countries. Members of the UN Conference on Trade and
Employment in Havana agreed to the ITO charter in March 1948, but ratification was blocked by the U.S.
Senate (WTO, 2004b). Some historians have argued that the failure may have resulted from fears within the
American business community that the International Trade Organization could be used to regulate (rather than
liberate) big business (Lisa Wilkins, 1997; Helen Milner 1993).
Only one element of the ITO survived: the General Agreement on Tariffs and Trade (GATT). Seven rounds of
negotiations occurred under the GATT before the eighth round - known as the Uruguay Round - which began
in 1984 and concluded in 1995 with the establishment of the WTO. The GATT principles and agreements were
adopted by the
WTO, which was charged with administering and extending them and approximately 30 other agreements and
resolving trade disputes between member countries. Unlike the GATT, the WTO has a substantial institutional
structure.
The WTO aims to increase international trade by promoting lower trade barriers and providing a platform for
the negotiation of trade and to their business.
__________________________________________________________________________________ 96
Principles of the trading system
The WTO discussions follow the following fundamental principles of trading.
1. A trading system should be free of discrimination in the sense that one country cannot privilege a
particular trading partner above others within the system, nor can it discriminate against foreign
products and services.
2. A trading system should tend toward more freedom, that is, toward fewer trade barriers (tariffs and
non-tariff barriers).
3. A trading system should be predictable, with foreign companies and governments reassured that trade
barriers will not be raised arbitrarily and that markets will remain open.
4. A trading system should tend toward greater competition.
5. A trading system should be more accommodating for less developed countries, giving them more
time to adjust, greater flexibility, and more privileges
The WTO has 149 members (76 members at its foundation and a further 73 members joined over the following
ten years). The 25 states of the European Union are represented also as the European Communities. Some non-
sovereign autonomous entities of member states are included as separate members.
A number of non-members, around 31 countries including Ethiopia, have been observers at the WTO and are
currently negotiating their membership. The WTO oversees about 30 different agreements which have the
status of international legal texts. Member countries must sign and ratify all WTO agreements on accession.
The following are some of the most important agreements of WTO.
1) Agreement on Agriculture (AoA)
The AoA came into effect with the establishment of the WTO at the beginning of 1995. The AoA has three
central concepts, or "pillars": domestic support, market access and export subsidies.
Criticism: The AoA is criticized for reducing tariff protections for small farmers – a key source of income for
developing countries – while allowing rich countries to continue to pay their farmers massive subsidies which
developing countries cannot afford.
2) General Agreement on Trade in Services (GATS)

3) Trade-Related Aspects of Intellectual Property Rights (TRIPs) Agreement
4) Sanitary and Phyto-Sanitary (SPS) Agreement
The Agreement on the Application of Sanitary and Phytosanitary Measures - also known as the SPS
Agreement was negotiated during the Uruguay Round of the General Agreement on Tariffs and Trade, and
entered into force with the establishment of the WTO at the beginning of 1995.
Under the SPS agreement, the WTO sets constraints on member-states' policies relating to food safety
(bacterial contaminants, pesticides, inspection and labelling) as well as animal and plant health (imported pests
and diseases).
SPS & Genetically Modified Organisms (GMOs)
In 2003, the USA challenged a number of EU laws restricting the importation of Genetically Modified
Organisms (GMOs), arguing they are “unjustifiable” and illegal under SPS agreement. In May 2006, the
WTO's dispute resolution panel issued a complex ruling which took issue with some aspect's of the EU's
regulation of GMOs, but dismissed many of the claims made by the USA.
__________________________________________________________________________________ 97
Criticism
Quarantine policies plays an important role in ensuring the protection of human, animal and plant health. Yet
under the SPS agreement, quarantine barriers can be a ‘technical trade barrier’ used to keep out foreign
competitors.
The SPS agreement gives the WTO the power to override a country's use of the precautionary principle – a
principle which allows them to act on the side of caution if there is no scientific certainty about potential
threats to human health and the environment. Under SPS rules, the burden of proof is on countries to
demonstrate scientifically that something is dangerous before it can be regulated, even though scientists agree
that it is impossible to predict all forms of damage posed by insects or pest plants.
5) Agreement on Technical Barriers to Trade (TBT)
The Agreement on Technical Barriers to Trade - also known as the TBT Agreement is an international
treaty of the World Trade Organization. It was negotiated during the Uruguay Round of the General
Agreement on Tariffs and Trade, and entered into force with the establishment of the WTO at the beginning of
1995.
The object of the TBT Agreement is to "to ensure that technical negotiations and standards, as well as testing
and certification procedures, do not create unnecessary obstacles to trade.
CHAPTER SUMMARY
• The aim of international economic cooperation is that national economic policy decisions should also take
account of their effects on other countries’ economies.
• The different forms of international economic cooperation in ascending order of closeness between the
countries are: exchange of information, coordination, harmonization, and unification.
• The disadvantages of international economic cooperation can be grouped into: the sacrifice of national
autonomy in policy making; the complexity of implementation; and the risk of cheating and free riders.
The reasons why countries for regional integrations or groupings are countries get: enhanced efficiency as
the result of specialization; increased production levels as a result of the exploitation of economies of
scale; improved international bargaining positions as a result of increased size (and a long run
improvement in the terms of trade); enforced efficiency gains as a result of increased competition; and
Increased rate of growth as a result of technological advances.
• The World Bank encompasses five closely associated development institutions. These are: IBRD, IDA,
IFC, MIGA and ICSID.
• The World Bank uses the funds it generates to provide investment loans and development policy loans to
its member countries through IBRD and IDA. It also provide grants to facilitate development projects by
encouraging innovations and cooperation between organizations and local stakeholders’ participation in
projects
• The IMF is responsible for the creation and maintenance of the international monetary system, the system
by which international payments among countries take place. It thus strives to provide a systematic
mechanism for foreign exchange transactions in order to foster investment and promote balanced global
economic trade.
• The World Trade Organization is an international, multinational, organization, which sets the rules for the
global trading system and resolves disputes between its member states; all of whom are signatories to its
approximately 30 agreements.
__________________________________________________________________________________ 98
REVIEW QUESTIONS
1. Discuss why countries need international economic cooperation.

2. Explain the different forms of international economic cooperation.
3. List and discuss the disadvantages of international economic cooperation.
4. Write the reasons why countries form regional groupings or integrations.
5. List the five development institutions of the World Bank group.
6. What are the two basic types of loans and credits of the World Bank that are extended to member
countries through IBRD and IDA?
7. Give examples of IDA grants.
8. Write the objectives of IMF
9. Discuss the major functions of IMF.
10. Write the five principles of trading system followed by the WTO discussions.
11. List the five fundamental agreements of WTO and write the three central concepts of AoA.
REFERENCES
1. B. Sodersten, International economics 2nd ed., London, Macmillan press, 1980
2. Charles P.Kindleberger, International Economics, 5th ed., Home Wood III, Irwin, 1973.
3. Charles P.Kindleberger, Foreign Trade and National Economy, New Hoven, Yale university press, 1962
4. Coffey,P., Dodds, J.C., Lazacano, E., and Riley, R., NAFTA- Past Present and Future: International
Handbook on Economic Integration, Kluwer Academic Publisher,1999.
5. Gerald M.Meir, The International Economics of Development, New York, Harper and Raw 1968
6. H.G. Mannur, International Economics theory and Policy Issues, Delhi, vikas publishing house 1983
7. H. Lindert, Peter, International Economics, 8th ed. Richard D. Irwin, INC, New Delhi, 1998
8. J. Carbaugh, Robert, International Economics, 5th ed. South College Publishing Co., USA, 1995.
9. Jepma, CJ, Jager, H., Kampluis, E., Introduction to International Economics, Heerlen, Open University of
the Netherlands, 1996
10. KEITH PILBEAM, International Finance, 2nd ed., City University, London, 1992.
11. K.K., Dewett and Adarsh Chand, Modern Economic Theory, 21st ed. S. Chand and Company LTD., New
Delhi, 2001.
12. Salvatore Dominidik, International Economics, 7th ed John Willy & Sons, New York, 2001.
__________________________________________________________________________________ 99
TABLE OF CONTENTS
1. CHARACTERISTIC FEATURES OF INTERNATIONAL TRADE ..............................................................1

CHAPTER OBJECTIVES .....................................................................................................................................1
1.1 Basis of International Trade ...............................................................................................................1
1.2 The difference between international trade and domestic trade .........................................................3
1.3 Gains from international trade ...........................................................................................................4
CHAPTER SUMMARY .........................................................................................................................................6
REVIEW QUESTIONS ..........................................................................................................................................6
2. THE CLASSICAL THEORY OF INTERNATIONAL TRADE ......................................................................7
CHAPTER OBJECTIVES .....................................................................................................................................7
2.1. Pre- Classical theory of International Trade (Mercantilism)..............................................................7
2.2. The classical theory of international trade .........................................................................................7
2.2.1 Adam Smith’s theory of absolute advantage .................................................................................8
2.2.2 David Ricardo's comparative advantage model .......................................................................... 11
2.2.3 Law of Reciprocal Demand Offer curve Analysis ...................................................................... 13
2.2.3.1 Changes in Terms of Trade................................................................................................ 16
CHAPTER SUMMARY ....................................................................................................................................... 18
REVIEW QUESTIONS ........................................................................................................................................ 18
3. THE MODERN THEORY OF INTERNATIONAL TRADE ....................................................................... 20
CHAPTER OBJECTIVES ................................................................................................................................... 20
3.1 The H-O Theorem (Factor-Endowment theory) and its Assumptions ............................................. 20
3.1.1 Factor Abundance ....................................................................................................................... 21
3.1.1.1 Price Criterion of Factor Abundance and the Structure of trade ........................................ 21
3.1.1.2 Physical criterion of factor abundance and the structure of trade ...................................... 23
3.1.2 Critical evaluation of the H-O theorem ....................................................................................... 25
3.2 The factor-price equalization theorem ............................................................................................. 27
3.2.1 Labor Surplus Country Case ....................................................................................................... 29
3.2.2 Capital Surplus Country Case ..................................................................................................... 30
3.2.3 Factor price equalization: a composite graph .............................................................................. 30
3.3 Critical evaluation of the factor price equalization theorem ............................................................ 31
CHAPTER SUMMARY ....................................................................................................................................... 32
4. INTERNATIONAL TRADE POLICY ......................................................................................................... 33
4.1 Free trade: Case for and against ....................................................................................................... 33
4.1.1 Cases for free trade...................................................................................................................... 33
4.1.2 Cases against free trade: protectionism ....................................................................................... 33
4.1.3 Arguments against protection...................................................................................................... 36
__________________________________________________________________________________ 100
4.2 Barriers to Trade .............................................................................................................................. 37
4.2.1 Tariff and Its Effects ................................................................................................................... 37
4.2.1.1 Effects of import tariff on tariff imposing country ............................................................ 38
4.2.2 Non-tariff barriers ....................................................................................................................... 40
4.2.2.1 Import quota ...................................................................................................................... 41
4.2.1.1 Tariffs versus quotas ............................................................................................................ 42
4.2.2.2 Subsidies ............................................................................................................................ 43
CHAPTER SUMMARY ....................................................................................................................................... 46
5. FOREIGN EXCHANGE RATE POLICY......................................................................................................... 47
5.1. Supply and Demand for Foreign Exchange ............................................................................................. 47
5.1.1 Supply, demand and market for foreign exchange ........................................................................... 47
5.1.2. Change in demand and supply of foreign exchange ........................................................................ 48
5.2 Nominal and Real Exchange Rates .......................................................................................................... 49
5.3 Determinates of Exchange Rate in the Long-Run .................................................................................... 50
5.3.1 Purchasing power parity ................................................................................................................... 50
5.3.2 Differences in productivity growth rates .......................................................................................... 51
5.4. Exchange Rate Systems........................................................................................................................... 51
5.4.1 The gold standard and fixed exchange rates ..................................................................................... 51
5.4.2 Alternative exchange rate systems.................................................................................................... 53
5.5 Exchange Control ..................................................................................................................................... 53
5.5.1 Objectives of exchange control ........................................................................................................ 54
5.5.2 Methods of exchange control............................................................................................................ 54
CHAPTER SUMMARY ....................................................................................................................................... 57
6. BALANCE OF TRADE AND BALANCE OF PAYMENT................................................................................ 59
6.1 Balance of Payments ................................................................................................................................ 59
6.1.1 Balance of payments accounting and accounts ................................................................................. 59
6.1.2 Balance of Payments Surplus or Deficit ........................................................................................... 62
6.1.3 Alternative Concepts of Balance of Payments Surplus and Deficits ................................................ 63
CHAPTER SUMMARY ....................................................................................................................................... 65
7. THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS .......................................................... 67
7.1 A Simple Monetary Model ....................................................................................................................... 67
7.2 The Monetarist Concept of Balance of Payments Disequilibrium ........................................................... 70
7.3 The Effects of a Devaluation .................................................................................................................... 70
7.4 A Monetary Exchange-Rate Equation ...................................................................................................... 71
7.5 A Money Supply Expansion under Fixed Exchange Rates ...................................................................... 72
7.6 A Money Supply Expansion under Floating Exchange Rates .................................................................. 74
7.7 The Effects of an Increase in Income under Fixed Exchange Rates......................................................... 75
7.8 The Effects of an Increase in Income under Floating Exchange Rates .................................................... 76
7.9 An Increase in Foreign Prices under Fixed Exchange Rates .................................................................... 76
__________________________________________________________________________________ 101
7.10 An Increase in the Foreign Price Level under Floating Exchange Rates ............................................... 77
7.11 Implications of the Monetary Approach ................................................................................................. 78
7.12 Criticisms of the Monetary Approach .................................................................................................... 79
CHAPTER SUMMARY ....................................................................................................................................... 80
8. INTERNATIONAL DEBT CRISIS ................................................................................................................... 81
8.1 Introduction .............................................................................................................................................. 81
8.2 The Low- and Middle-Income Less- Developed Countries ..................................................................... 82
8.3 Characteristics of Typical Middle-Income LDCs..................................................................................... 82
8.4 The Economics of LDC Borrowing ......................................................................................................... 83
8.5 Different Types of Capital Inflows into LDCs ......................................................................................... 84
8.6 Measures of Indebtedness ........................................................................................................................ 85
8.7 The Dimensions of the Debt Crisis .......................................................................................................... 86
8.8 The Role and Viewpoints of the Actors in the Debt Crisis ...................................................................... 86
CHAPTER SUMMARY ....................................................................................................................................... 88
9. INTERNATIONAL ECONOMIC COOPERATIONS AND ORGANIZATIONS ............................................... 89
9.1 Why International Economic Co-operations? .......................................................................................... 89
9.2 Forms of international economic cooperation .......................................................................................... 89
9.3 Regional integration ................................................................................................................................. 92
9.4 The World Bank, International Monetary Fund and World Trade Organization ..................................... 93
9.4.1 The World Bank ............................................................................................................................... 93
9.4.2 International Monetary Fund (IMF) ................................................................................................. 94
9.4.3 World Trade Organization (WTO) ................................................................................................... 96
Criticism ............................................................................................................................................... 98
CHAPTER SUMMARY ....................................................................................................................................... 98
REFERENCES .................................................................................................................................................... 99
__________________________________________________________________________________ 102

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International Economics

1.1 Basis of International Trade

i. Differences in factor endowments

ii. Division of labor (specialization)

iii. Gains form exchange of goods and services

a) differences in supply conditions (or production possibilities)

b) differences in demand conditions

This is due to:

1.2 The difference between international trade and domestic trade

ii. Product mobility

iii. Economic environment

iv. Monetary units

1.3 Gains from international trade

Figure 1.5 shows that, before the start of foreign Wheat

With the introduction of foreign trade,

B will now export KF units of wheat and G

Thus, both trading countries gain from

increased consumption of the two O

ii. Dynamic gains

International trade promotes economic development in the following ways.

a) Compare the before trade price of X in country A and B

Note: Answer all of the above questions based on graphical illustration.

3. Give examples of the dynamic gains from international trade.

2.1. Pre- Classical theory of International Trade (Mercantilism)

2.2. The classical theory of international trade

2.2.1 Adam Smith’s theory of absolute advantage

A. Autarky (closed economy) situation

The table to the right implies that

B. The case of open economy

Case 1. Trade at TOT = 1:1

Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1

Case 3: Trade at TOT =Domestic opportunity cost ratio of country B = 1:2

The welfare of country B before and after trade remains constant.

Case 4: Trade at TOT = 2:3

Case 5: Trade at TOT = 3:2

Assumption of Ricardo’s Model

Relative (comparative) advantage

Case 1 Autarky Situation

All the gains in consumption are

Table 13: Consumption levels after IT at TOT = 1:2 = OCR of B

2.2.3 Law of Reciprocal Demand Offer curve Analysis

The continuous line which is drawn from

different terms of trade. Up to point 5 its

the offer curve has a negative slope. This

i. The relevant portion of the offer curve is positively sloped

ii. The offer curve is not a straight line, it is a non-linear curve.

OA and OB are the two offer curves Textile

of textiles in exchange for Ob quantity

exactly coincides with B's demand for

• Excess offer of C3C1 amount of rubber by country B to country A, and

Figure 2.3 demonstrates the Textile b

Let us now take another Textile

country, is a straight line 2

not as shown in the

Figure 2.4: Trade between small and large country

Table 1: Production schedule

Table 2: production and consumption under autarky

Based on the above information answer the questions a to d.

3.1 The H-O Theorem (Factor-Endowment theory) and its Assumptions

The H-O model is based upon the following assumptions:

• There are only two factors of production-labor and capital.

i. The Price Criterion

ii. The Physical Criterion

3.1.1.1 Price Criterion of Factor Abundance and the Structure of trade