SU1. Open Economy Free Trade and Protectionism Bop Exchange Rate Currency Convertibility

SU→1.
Open economy, Free trade

and Protectionism, BoP, Exchange
rate, Currency convertibility
HPAS MAINS HPAS PRELIMS MAINS UPSC
RELEVENCE
PRELIMS UPSC
TOPIC MOBLISATON OF RESOURCES
LECTURE NO. 2019-

2020
LECTURE NO. 2021-

1, 2, 3, 4, 5
2022
RELATIONSHIP
WITH GS 3
SOURCES SANJEEVE VERMA , YB
VAJIRAM FACULTY SHOBIT UNIYAL
OPEN ECONOMY/ EXTERNAL SECTOR

CLOSED ECONOMY (1→00:13)
BARRIER TO TRADE (1→00:20)
TARRIF BARRIERS
NON-TARIFF BARRIERS(1→00:38)
Commercial Policy (Trade Policy): Free Trade v/s Protectionism (1→1:23)
The Global Enabling Trade Report 2016
Arguments in favour of free trade(1→1:50)
Arguments in favour of protectionism(1→2:22)
BALANCE of PAYMENTs (BoP) (2→00:35)
Components of BoP (2→00:47)
1. CURRENT ACCOUTS
1.1 VISIBLE
1.1.1 EXPORT
1.1.2 IMPORT
1.2 INVISIBLE
SU→1. Open economy, Free trade and Protectionism, BoP, Exchange rate, Currency convertibility 1
1.2.1 SERVICE
1.2.2 INCOME
1.2.3 TRANSFER
2. CAPITAL ACCOUNTS(2→1:16)
2.1 INVESTMENT
2.2 LOANS
2.3 BANKING CAPITAL
3. FOREIGN EXCHANGE RESERVE
Current Account Deficit (CAD) is good or bad for the economy?(3→00:07)
Balance of Payments (BoP) Crisis
Importance of Foreign Exchange reserves(3→1:07)
BoP during 2020-21
Large Forex reserves : Problems / Concerns (4→00:00)
Foreign Exchange Rate(4→1:12)
Floating and Fixed Exchange Rate system
Currency Convertibility(4→2:08)(5→00:45)
Current Account convertibility
Capital Account convertibility of Rupee (5→00:58)
NEER and REER(5→1:48)
prelims and mains PYQ
handout 1
handout 2
handout 3
handout 4
handout 4 b
handout PYQ
OPEN ECONOMY/ EXTERNAL SECTOR

Is the economy that has no economic transactions with the outside world. There are no
imports, no exports and no flow of capital to or from the outside world. Thus a closed
economy is completely self-sufficient. In reality no nation can have a completely closed
economy (essential items like crude oil, pharmaceutical drugs etc. are imported even if
economy is largely a closed economy).
Freely engages in economic transactions with the outside world. ‘Freely’ here means without
any restriction.
No nation in the world has a completely open economy. Even the most open economies in the
world may impose a certain restrictions on the economic transactions with the outside world.
BARRIER TO TRADE (1→00:20)

The policy instruments which obstruct trade are called barriers to trade.
These are of the following two types:
A) Tariff Barriers
B) Non-Tariff Barriers
TARRIF BARRIERS
Tariff means the duty or tax imposed by the government on the import and export of goods.
The tariff on imports increases the price of the imported goods. This makes the imported
goods less competitive. As a result the imports are discouraged.
The tariff on exports makes the exported items costlier and hence less competitive in the
international market. This discourages the export. Usually export tariffs are raised for certain
items when the government wants to discourage their export in order to make those items
available in domestic market which otherwise may be exported.
Tariffs are also a source of government revenue.
NON-TARIFF BARRIERS(1→00:38)
These are the administrative measures, other than tariffs, imposed by a domestic
Government to discriminate against foreign goods in favour of domestic goods.
These are of following types:
1. Quotas: is a restriction on the amount of goods that is allowed to be imported into a

country. This is usually enforced by issuing import licences.
2. Subsidies: Subsidies like production subsidies and export subsidies given by the
government to the exporters helps in making the goods from the country competitive in
the international market. It is considered as a barrier to trade because it creates a non-
level playing field. Exporters from rich countries who receive such subsidies are at great
advantage in comparison to exporters from other poorer countries who cannot afford
such subsidies. Hence subsidies are also considered as Trade distortion.(more in WTO
chapter)
Production subsidies: are given by the government to the producers of exportable goods
and services. Example: raw materials at low cost, low interest credit, tax concessions etc.
Export subsidies: are given in the post-production stage of exportable goods. Example:
transportation subsidies.
3. Health, Sanitary and Safety regulations: A country can restrict imports by fixing very
high standards for the goods that are imported based on health, sanitary and safety
considerations. If the imported goods do not meet these standards the imports may be
rejected. For example the importing country can fix a maximum limit of pesticide
residue on food items that are imported. If pesticide residue is more than the set limit the
imports are rejected.
High packaging standards for imported goods will push up the prices and hence will act
like a barrier to trade. Example Indian Basmati exported to EU rejected because of
pesticides residue, rejection based on Packaging requirement, etc.
4. Local content requirement: The government can make it mandatory that a certain
percentage of the parts of the Product to be made domestically . eg. Like in 2014 India
mandated 25 % of solar panel to be made in India , against this US complain in WTO in
which US win . Similarly 11 US states made excess local requirement against which
India made complain in WTO in India win. ANB is not LCR it is just to attract Indian
entrepreneur.
QUESTION OF STUDENT (1→1:05)
1. SANCTIONS are very strong non-tariff barrier.
2. Reason for the barrier is to promote domestic industry.
Commercial Policy (Trade Policy): Free Trade v/s

Protectionism (1→1:23)
The Commercial Policy (Trade policy or International trade policy) is the Government policy
which governs the trade and commerce with other countries. The commercial policy is
concerned with whether the country should adopt the policy of Free trade or of protection.
Free Trade: The policy of unrestricted international trade is known as the policy of Free
Trade. There are no barriers to trade and very minimal or no government intervention in
trade. Adam smith, also known as the father of economics, advocated the policy of free trade
way back in 18th century. David Ricardo is another classical economist who propagated this
policy in 19th century.
Laissez-faire is an economic theory that opposed any government intervention in business
affairs. It is a French term which in English translates to “leave alone”.
The Global Enabling Trade Report 2016
Co-published by the World Economic Forum and the Global Alliance for Trade
Facilitation, the Report features the Enabling Trade Index, which evaluates 136 economies
based on their capacity to facilitate the flow of goods over borders and to their destination. It
was first published in 2008.
The Enabling Trade Index measures the factors, policies and services that facilitate the trade
in goods across borders and to destination. It is made up of four sub-indexes:
1. Market access
2. Border administration
3. Transport and communications infrastructure
4. Business environment
The Enabling Trade Index Ranking for 2016

1 Singapore
2 Netherlands
3 Hong Kong SAR

4 Luxembourg
5 Sweden
22 USA
35 China
102.India
110 Brazil
111Russian Federation
136 Venezuela
Protectionism: It is a policy of creating trade barriers with an intention of protecting
nation’s vital economic interests like domestic industries, employment, commodities etc. It is
the opposite of free trade.
Commercial policy has been a topic of heated debate. Let us now discuss the arguments in
favour of free trade and protectionism.
Arguments in favour of free trade(1→1:50)

It would take the time to reap the favours. If these benefits of opening economy does not
achieved then they might act is issue in the economy.
1. Gains from Specialization: the countries should specialize in the production of those
goods in which it is relatively more efficient and export a part of them and in exchange
import those goods from other countries in production of which they are comparatively
more efficient. Specialization and trading in this way would achieve a more efficient
allocation of resources and a higher level of output and well being.
a. If it not work then
2. Gains from economies of scale: trade makes it possible for the producers to move
beyond the domestic market into the international market and produce at large scale and
take advantage of economies of scale by achieving lower cost per unit.
3.
4. Promotes competition: free trade increases competition in the economy as domestic

firms have to compete against foreign firms in order to survive. Domestic firms have to
increase their efficiency and are compelled to innovate and improve the quality of their
products. Consumers on the other hand get wide range of products at lower prices.
5. Transfer of Technology: Free trade leads to international diffusion of technology. A

technology developed by one country is improved by another country and so technology
goes on being improved successively.
6. Access to domestically unavailable goods and raw materials: free trade can make
available those goods to a country which it cannot produce or produce inefficiently. It
also makes available those raw materials which are not available in the country.
7. Improves international cooperation: Free trade makes nations economically dependent

on each other. The economic interdependence reduces the likelihood of hostilities
between countries. It provides powerful incentives for peaceful solution of disputes.
Arguments in favour of protectionism(1→2:22)

1. Infant industry argument: this argument advocates that infant industries should be
provided protection from the competition of low priced imports of the mature and well
established industries of the developed industrialised countries. The protected
environment will allow them to grow, become more efficient and over a period of time
they will be in a position to compete with the foreign firms. In the absence of protection
they will be wiped out by foreign competition.
This argument is explained well by the dictum-‘Nurse the baby, protect the child, and
free the adult.’
2. Employment argument: according to this argument protection would lead to an

increase in domestic employment or at least save the present domestic employment.
Instead of imports, the goods are manufactured domestically and this leads to an increase
in employment.
If imports are restricted exports can’t remain unaffected. Export industries will face
difficulties in procuring raw materials and capital goods and as a result exports would
fall and so would the employment in export industries.
Also when one country imposes restrictions on imports other countries also retaliate by
imposing restrictions on that country’s exports and this leads to fall in exports and fall in
employment in export industries.
(2→00:00)
3. National defense argument: This argument states that total dependence on foreign
goods that are essential for defense purpose or for consumption can be dangerous in
times of war or emergencies. By having manufacturing for defense items protected from
foreign competition, trade protectionism is necessary for a nation’s existence. Thus the
country must protect and develop its defense industry and farming industry even if this
means an economic loss to the country.
4. Anti-dumping argument: sometimes protection is required in order to protect the

domestic firms against the dumping of goods done by the foreign firms. Dumping is an
unfair trade practice in which the producers of a country sell goods in another country
at lower prices than those charged at home. The intention of the foreign firm in this case
is to drive the competitors out of the market.
5. Protection for conserving the natural resources: unchecked free trade can lead to
exhaustion of mineral resources which are very vital for the development of the country.
DISCUSSION-(2→00:18)
1. As a member of WTO and having large volume of trade it is not to adopt

protectionist policy , Moraly we are obligate to integrate with global economy
2. if we are taking the advantage of other country's liberal policy then we should also
stand open.
3. eg Carbon tax by EU is a kind of trade barrier, ANB is a kind of protectionist policy

but we will not say it is , RBI ban on master card to further issue card to localize
their data or to promote RUPAY card, Banning on Chinese app ,
4. Any intervention by government is protectionist move.
5. Most of the economy promote free trade , it is the benefits all section it bring
prosperity, protectionism not.
6. For short term it is good but for the long time it is not , In long term it harm
consumer by innovation deficit.
7. From US or the other open country's point of view we are not open as much as they
are. like high duty on the luxury good.
8. We are highly agrarian society so our farmer may not be able to face corporate
competition .
BALANCE of PAYMENTs (BoP) (2→00:35)
The Balance of Payments (BoP) is defined as a systematic record of all economic
transactions of a nation with the outside world in a given year. The Transactions here
means transactions of the government as well as private entities.
The Bop records are prepared by the central banks of every country as per the format
given in International Monetary Fund’s (IMF) BPM-6 manual. (RBI in case of India).
All the figures in BoP are expressed in USD (US dollar).
It is like a balance sheet, capital account tells about Asset and Liability part where as
current Account tells about Cash flows
Components of BoP (2→00:47)
1. CURRENT ACCOUTS
1.1 VISIBLE
NET EXPORT= EXPORT — IMPORT
1.1.1 EXPORT
1.1.2 IMPORT
1.2 INVISIBLE
NET INVISIBLE= Net Services + Net Income + Net Transfer
(Net = export —Import)
1.2.1 SERVICE
Software ⇒
BPO ⇒Business Process Outsourcing eg Data entry job given by US companies to
Indians, US companies outsource call center in India, outsourcing of some work.
⇒
Tourism Foreigner visited to India →Exports→ We are earning foreign exchange→
we are selling our tourism services to them.
Indian student studying abroad → Export .
Foreign student studying in India → Import.
Banking
Insurance
1.2.2 INCOME
Factor income from cross border investments
Profit
Interest
Dividend
1.2.3 TRANSFER
One sided payments/No quid-pro-quo/Unilateral eg. Subsidies
⇒
Remittances Money sent back to home by the migrant worker working in some other
country, India is the largest remittances receiving country(both values wise and number
wise)(80 billion dollars incoming and 5 billion dollar outgoing → 2018)
Donations ⇒
Gifts ⇒
2. CAPITAL ACCOUNTS(2→1:16)
Every economy or business require capital to grow and sometime domestic capital is not
enough, so external/international capital is require.
Capital is of 2 types .
⇒
1. Debt capital Loans or Bonds or borrowing and I have to give the Principal +
interest back after maturity period. eg Government borrowing from outside
⇒
2. Equity capital Selling ownership rights or Shareholding. I have to share profit with
the Investor. eg IPO, Listing on share/stock market, FPI, FDI,
2.1 INVESTMENT
Foreign Equity Investment - have 2 sub types (both get share holding on investment
⇒
FDI They want to establish business in India so they can become part of
management, they want to run the business , they can come in the form of wholly
owned subsidiary or in joint venture in different sector different FDI is allowed In
some sector only joint venture is allowed like insurance. Suzuki , Honda, Kawasaki,
Vodafone, etc come in the manufacturing sector when joint venture was allowed
only→ STABLE AND LONG TERM INVESTMENT/CAPITAL -
They bring in technology (TOT).
Tech environment improve n the country.
We get to learn about Best International Practices.
Jobs creation.
Improvement and addition in our exports basket .
Improve Infrastructure.
⇒
FPI They do not want to participate in the management of the company, they
just purchase the shares of the companies and sell it when share prices rose, they just
want capital gains . UNSTABLE AND SHORT TERM
INVESTMENT/CAPITAL→ VOLATILE IN NATURE → HOT MONEY
It help the domestic investor also by raising share prices.
2.2 LOANS
Two types
1. Loans taken up by the government (Net Loans = Loans given by our government —
Loans taken up by our government)
2. ECB→ External Commercial Borrowing, Loans taken up by the commercial companies

form outside banks etc
2.3 BANKING CAPITAL

NRI deposit in India (Interest rates are good in India as compare to developed country
like —ve interest rate in Japan, So this is also kind of liability or Debt capital because
this is going to create Liability on the Indian banks (Deposits are liability of the banks on
which they have to give interest back )
3. FOREIGN EXCHANGE RESERVE

Reserve assets maintained by the RBI, Largely it is composed of $ but there can be other
Hard currency which are in demand in international market
In terms of these 4 asset
1. FOREIGN CURRENCY ASSET ⇒

Largely it is composed of $ but there can be
other Hard currency which are high in demand in international market like yen,
Pound, Yuan. RBI can keep some part of these currency reserve can be also invest in
sovereign government bonds(US treasury bills) ,or can keep in central banks or
commercial banks, or in gold monetization scheme.
2. GOLD RESERVES
⇒
3. SDR Special drawing rights with the IMF to helps the country in BOP crisis by
converting it into dollars, Its a contribution by the member country , IMF allocate
these contribution according to the QOUTA of the country, it can be used for the
transaction with other country, Its like a Token. Voting rights are also given
according to quota .US has 16-17% voting rights.
4. RTP ⇒ Reserve trans position with the IMF , 25% f the Amount of contribution
with IMF, Can be used any time without any conditions and any interest.
DISCUSSION(2→2:05)
Balance of Trade (BoT)⇒ Exports- Imports (of only visible goods)

Current Account Balance (CAB)⇒ Net Visibles+ Net Invisibles
If CAB is +ve , we call it Current account Surplus. It is only in the (2021-2022) financial
year India has current account surplus.
If CAB is –ve, we call it Current account Deficit(CAD)
Capital Account Balance ⇒ Net Investments+ Net Loans+ Net Banking Capital
Overall Balance ⇒ Current A/C Balance+ Capital A/C Balance
If Overall balance is +ve, it increases the Forex Reserves
If Overall balance is –ve, it decreases the Forex Reserves
Current Account Deficit (CAD) is good or bad for the

economy?(3→00:07)
It depends upon
a) What constitutes your imports?
1. If large part of CAD is due to the import of capital goods(plant and machinery) and raw
materials then we don’t consider CAD as bad. As these capital goods and raw materials
would help in increasing the production and exports.
2. But when CAD is there due to the imports of consumptive products (eg Gold , luxury
items etc) then it is bad for the economy as it would not help in increasing the exports
even in future.
b) How do you finance your deficit?
If CAD is financed through borrowing, it is unsustainable because borrowing leads to

high interest payments in the future.
Also attracting capital flows in the form of FPI (hot money) to finance the deficit is
risky as when confidence falls, hot money flow dry up and further there may be
flight of capital away from the country leading to rapid depreciation of currency and
crisis of confidence.
If CAD is too high and capital inflows are insufficient to meet the deficit then Forex reserves
starts depleting and currency starts depreciating.
Thus moderate CAD (around 2% of GDP) financed mainly by stable foreign investments
(FDI) can be helpful in the long run.
Balance of Payments (BoP) Crisis

If persistent current account deficit (CAD ) prevails and capital inflows are not enough to
fund the CAD then Forex reserves starts depleting. A situation may then come when the
forex reserves fall to dangerously low levels. The country will then face difficulty in
importing even the essential items like crude oil and servicing the external loans. Such
economic situation is known as Balance of Payments (BoP) crisis.
Importance of Foreign Exchange reserves(3→1:07)

1. Forex reserves help in the import of essential items like crude oil when both current
account and capital account are in deficit.
2. Defend rupee if it starts depreciating rapidly. Depreciation is market led, Depreciation

makes import costlier (More rupee required to buy 1 $)RBI will sell the $ and buy the
rupee or RBI will soak the liquidity in the market, RBI will lower the supply of rupee
which is more then demand.
3. Servicing of external loans (paying back borrowed loan's principal and interest )
4. To enjoy favourable rating by sovereign credit rating agencies which helps in borrowing
cheap. (Standard and Poor, Moody, Fitch→ give credit worthy-ness of the country),
CIBIL score→ which analysis the credit worthy ness of individual, CRISIL.
Improved current account balance, robust capital inflows (FDI, FII) drove the forex
reserves to an all time high USD 608.99 billion during the week ended 25 June 2021.
In terms of projected imports for 2021-22, the current level of reserves provides cover
for less than 15 months (Import cover).
India is the 4th largest reserve holding country in the world after China1, Japan2,
Switzerland3 .
BoP during 2020-21

The current account balance recorded a surplus of 0.9 per cent of GDP in 2020-21 as
against a deficit of 0.9 per cent in 2019-20 on the back of a sharp contraction in the trade
deficit to US$ 102.2 billion from US$ 157.5 billion in 2019-20. (because our import fall
too much and export picks up, crude oil prices are also low and we have robust capital
inflows→ FDI and FPI).
Net invisible receipts were lower in 2020-21 due to increase in net outgo of overseas
investment income payments and lower net private transfer receipts, even though net
services receipts were higher than a year ago.
Net FDI inflows at US$ 44.0 billion in 2020-21 were higher than US$ 43.0 billion in
2019-20.
Net FPI increased by US$ 36.1 billion in 2020-21 as compared to US$ 1.4 billion a year
ago.
External commercial borrowings to India recorded inflow of US$ 0.2 billion as
compared with US$ 21.7 billion in 2019-20.
In 2020-21, there was an accretion of US$ 87.3 billion to foreign exchange reserves.
Large Forex reserves : Problems / Concerns (4→00:00)

Surging reserves can be a double-edged sword as there is a cost to holding them.
Appreciation of the currency and rise in inflation :High reserves will obviously lead to
appreciation of the currency and rise in inflation, because capital inflows that result in
high reserves are used to buy domestic currency, thereby expanding the domestic
monetary base without a corresponding increase in production, and this causes a rise in
inflation.
High cost of Sterilization : In order to check inflation due to rising Forex reserves central
banks often undertake “sterilisation” of capital flows by squeezing the excess liquidity
out of the market through open market operations (OMO) i.e. by selling treasury bills
and government bonds in the open market.
But sterilisation may also raise the domestic interest rates and thus stimulate even greater
capital inflows. Open market operations also have a fiscal cost leading to increase in debt
and debtservicing charges.
To the extent that forex reserves are built up by external borrowings, the interest
payments add to the cost.
The sudden and sharp spike in India’s foreign exchange reserves in recent months is the
result of recessionary conditions and th0e speculative rush of investors riding on cheap
capital into Indian equity and debt markets in search of quick and high yields. It can
hardly be a cause for comfort as this implies that any increase in reserves resulting from
such inflows are borrowed reserves and not reserves earned, as through positive net
exports for example.
PROBLEMS/ASSOCIATED WITH LARGE FOREX RESERVE (3→1:44)(4→00:00)
These reserve are double edged sword,
These reserve can lead to APPRECIATION OF RUPEE
Appreciation means increase in the price of the currency relative to some other
currency.
Demand of rupee would increase for same level of supply-lead appreciation of

rupee, which makes the export costlier and makes export less competitive in
international market hence lower export.
What should RBI do → RBI should print new currency notes and release them in
the forex market and purchase $, which will increase money supply or liquidity in
the economy, which will moderate the prices of rupee. This process is called as
Sterlization (RBI negate the inflation causing tendency of forex reserve by
sterlization )
OMO→ Open Market Operation in which RBI buying and selling the government
securities in the open market. In the appreciation condition RBI sell the government
securities and soak the excess liquidity form the market.
What will be the effect of OMO? ⇒ These have Fiscal cost for the government is
bearing the pressure because RBI is just intermediary selling the G-sec on the behalf
of the government hence the cost is bear by the government, The proceeds locked by
the RBI not go to the government .
⇒
What will be side effect of these steps by RBI INFLATION → Persistent increase
in general level of prices of the goods and services in the economy or fall in the
purchasing power of currency.
WHAT FACTORS LEADING TO INFLATION (3→2:10)
1. DEMAND PULL FACTORS or demand side constraints ⇒ Demand increase for

the same level of supply
Demand is composed of 2 factor
1. Willingness to purchase ⇒
2. Ability to pay ⇒
eg. In corona period there has been fall in both willingness and ability which
demotivate the industries to reduce the manufacturing → In this situation
Government and RBI try to increase the money in the hands of the people /
purchasing power of the people by giving them subsidies, DBTs, etc.
RBI follows the Cheap money policy and Government follows the expansionary
policy.
When people demand increased without much corresponding increase in production
of goods and services→ But supply is not increased which would eventually lead to
inflation. In this situation we call too much money start chasing too few goods.
Happen when economy boom
⇒
2. COST PUSH FACTOR or supply side constraints Are those factor in which
supply fall for the same level of demand or the increase in the cost of
production/prices.eg poor infrastructure makes goods costlier, drought year or bad
monsoon can lead to decrease in production of food grains eventually increase the
prices, Crude oil prices gone up which increase cost of production, transportation,
DISCUSSION (3→2:40)
EARNED AND BORROWED RESERVE (4→1:04)
If large part of our reserve are from the current account surplus then we call them as
earned reserve then these reserve are good and If large part of our reserve are from the
capital account surplus then we call them as borrowed reserve these reserve are not good
because you are just custodian of the money which coming in the form of FDI or FPI or
LOANS . In case of china earned are much more then borrowed reserve where as in case
of India large part of reserve are borrowed we cannot invest like china in other country.
Chinese reserve are more earned then borrowed.
Foreign Exchange Rate(4→1:12)

Foreign exchange is the name given to any foreign currency. US dollars, Japanese Yen, Euro
etc are foreign exchange for India.
Foreign Exchange Rate is the price of a country’s currency in terms of another country’s
currency.
Eg. 1 USD= 74 INR
Foreign exchange market is a platform or market where currency are traded brought and sold
where central , commercial banks, financial institution, traders are the participants here.
HOW DO WE DETERMINATION OF FOREIGN EXCHANGE RATE
Floating and Fixed Exchange Rate system

Flexible exchange system/ Floating exchange system.
The system of exchange rate in which the value of a currency is allowed to adjust freely or to
float as determined by demand for and supply of foreign exchange is called a flexible
exchange system or the floating exchange system, central bank or government will not
intervene.
So the exchange rate is market determined and its value changes at every moment in time
depending on the demand and supply of currency in the market. E.g. USA , EU , Japan etc.
Advantage
1. Dependency on banks,central bank and government is not there for the determination of
the currency.
2. Requirement of huge foreign exchange reserve for the management of the currency is not
there.
3. Currency in this system is prone to volatality, because there is no central bank or

geovernment to intervene.
Fixed exchange rate system.

If the exchange rate instead of being determined by the demand for or supply of foreign
exchange is fixed by the Government or the central bank, it is called the fixed exchange rate
system. They “peg” the value of the foreign exchange rate to a fixed parity i.e. a certain
amount of rupees per dollar.
In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it
must also commit to defend that parity by being willing to buy (or sell) foreign reserves
whenever the market demand for foreign currency is greater (or smaller) than the supply of
foreign currency. Eg. China, Mexico, Russia etc. There is active involvement of government
and central bank in the determination of foreign exchange rate.
Advantage
1. This system is attractive to foreign investor because of the stabilty it offer.
Disadvantage
1. Government has to maintain huge foreign exchange reserve to maintain its value.
2. Very difficult to maintain, government and central bank have to work constantly, we
have to associate with more free market economy.
Managed Float system.

In India though the exchange rate is market-determined but it is not perfectly flexible or
perfect floating exchange rate system. The central bank (RBI) intervenes in the foreign
exchange market to prevent large fluctuations in exchange rate. This is also referred to as
‘dirty floating’. eg. algeria, argentina
The changes in exports and imports, capital outflow and capital inflows can bring in large
fluctuations in foreign exchange rate of rupee. These large fluctuations on either side i.e.
appreciation or depreciation can adversely affect the economy, especially the exports and
imports. In order to prevent large appreciation and depreciation of Indian rupee, RBI often
intervenes to ensure that exchange rate should remain within reasonable limits.
Thus when rupee is depreciating too much, RBI intervenes and sells dollars from its reserves
of foreign exchange. This increases the supply of dollars in the market and prevents the
depreciation of the rupee. Depreciation (market determined) of rupee makes the imports
costlier.
However through sale and purchase of foreign exchange by RBI has implications for
maintaining price stability. When RBI buys foreign exchange from the market it issues new
money (rupees) to pay for it.
When rupee is appreciating too much, RBI intervenes and purchases dollars from the market.
This reduces supply of dollars in foreign exchange market which prevents the appreciation of
exchange rate of rupee. Appreciation (market determined) of rupee makes the Indian exports
expensive and therefore discourages them.
This new money comes into circulation in the Indian economy and thus leads to the
expansion in money supply. If aggregate supply of goods remain the same or does not
increase much, this expansion in money supply will cause rise in general price levels
(Inflation) in the economy.
Advantage
1. This system reduces the risk of exchange rate volatality.
Disadvantage
1. Government has to maintain huge amount of foreign exchange reserve.
To check the inflation RBI can ‘Sterilize’ the impact of increasing the foreign exchange
inflows by selling government securities in the open market (Open Market Operations). The
banks will give cash to RBI against the purchase of these securities. In this way RBI soaks
the excess liquidity.
Appreciation and Depreciation is market determined like rupee can, yuan cannot.
Revaluation and Devaluation is government or central bank determined like yuan can, rupee
cannot.
Currency Convertibility(4→2:08)(5→00:45)
By convertibility of a currency we mean currency of a country can be freely converted into
foreign exchange and vice-versa at market determined rate of exchange.
For the rapid growth of world trade(current account) and capital flows(investment) between
the countries convertibility of currency is desirable.
Without free and unrestricted convertibility of currencies into foreign exchange trade and
capital flows between countries cannot take place smoothly.
Current Account convertibility

Current account convertibility refers to the freedom to convert domestic currency into foreign
currency and vice-versa for current account purposes like- exports, imports, remittances,
foreign travel etc.
Current account convertibility in India
As a part of new economic reforms initiated in 1991 Rupee was made partly convertible from
march 1992 under the “Liberalized Exchange Rate Management (LERM)” scheme.
In this scheme 60% of all receipts on current account could be converted freely into rupees at
market determined exchange rate while 40% was to be surrendered to RBI at the officially
fixed exchange rate. Thus partial convertibility of rupee on current account meant a dual
exchange rate system.
From march 1993 rupee was made convertible for all trade in merchandise.
From march 1994 rupee was made fully convertible even for invisible transactions. Thus
rupee became fully convertible on current account.
DISCUSSION (4→2:21)
which of the following can help in reducing current account deficit? (5→00:00)
1. devaluing the currency
2. reduction in the export subsidy
3. adopting suitable policies which attract greater FDI and more funds from FII
Ans. 1 and 3
1 becoz that why china continously devalue its currency.

3 becoz it will help in boosting export in future otherwise FDI and FII are part of capital
account.
TECHNIQUE:- Elimination
If another lobal financial crisis happens in the near future which of the following actions or
the policies are most likely to give some immunity to India? (5→00:37)
1. not depending on short term foreign borrowings
2. opening up to more foreign banks(transacting more with foreign bank)
3. maintaining full capital account convertibilty
Ans. 1
2 will make you more vulnerable to exteral shock they are not under RBI
TECHNIQUE :- Elimination
Capital Account convertibility of Rupee (5→00:58)
The Reserve Bank of India [RBI] in 1997 appointed the committee on capital account
convertibility with Mr. S.S. Tarapore (former deputy governor of RBI) as its chairman.
The Tarapore committee defined capital account convertibility as the freedom to convert
local financial assets into foreign financial assets and vice-versa at market determined rate
of exchange.
In simple words capital account convertibility means converting domestic currency into
foreign exchange and vice-versa for capital account purposes [e.g. foreign investments (FPI,
FII) , external loans (ECB) etc.], freely and at market determined rate of exchange.
The purpose of capital account convertibility is to give foreign investors an easy market to
move in and move out and to send a strong message that Indian economy is strong enough
and that India has sufficient FOREX reserves to meet any flight of capital from the country.
Benefits of Capital Account Convertibility→given by Tarapore committee
1. Availability of large funds to supplement domestic resources and thereby promote

economic growth.
2. Improved access to international financial markets and reduction in cost of capital. (like
low interst rate in the US)
3. Incentive for Indians to acquire and hold international securities and assets.
4. Improvement of the financial system in the context of global competition.
Preconditions for Capital Account Convertibility`→ Reccomendation of Tarapore

committee
1. Fiscal deficit should be reduced to 3.5% of GDP.
2. The government should fix annual inflation target between 3-5%. This was called
mandated inflation target. RBI should be given full freedom to use monetary weapons to
achieve the inflation target.
3. Indian financial sector should be strengthened – interest rates should be fully

deregulated, gross NPA should be reduced to 5 %, weak banks should either be
liquidated or be merged with other strong banks
Because of Asian financial crisis [1997] and political instability during those years these
recommendations could not be implemented.
Second Tarapore committee was set up in 2006 and it gave a roadmap for adopting full
capital account convertibility by 2011. Because of global financial crisis of 2007-09 the
recommendations could not be implemented.
At present rupee is fully convertible on the current account but is only partially convertible
on the capital account.
It means if indian company want to raise money in $ from abroad then they have to take
permission of the government or central bank like for the ECB private company has to take
permission from RBI, ECB are part of the capital account.
We have restriction(means thier are limit on the amount which can be raised from abroad) on
ECB means have to take permission from RBI like for the infrastructure their are lesser
restriction .
Their are 2 routes for the ECB
Automatic route ⇒loans can be taken from external source without RBI permision but
there is capping eg. 750 million $ worth of loans can be taken.
Approval route ⇒ loans can be taken from external source only prior permission of RBI
and there is capping.
These restriction are more on the indians entities, indivizuals, company then the foreign
investor to attract them like for the FDI and FII we have very less restrictions
Sooner or later we are going to become fully convertible on capital account. means
government is now enough confident
WHY WE HAVE RESTRICTION ON THE CAPITAL ACCOUNT

CONVERTIBILITY (5→1:08)
Concerns related to full capital account convertibility
1. If currency convertibility is not properly managed and monitored, market exchange rate
may lead to depreciation of domestic currency. If currency depreciates heavily the
confidence in it is shaken and no one will accept it in its transactions.
2. Convertibility of currency sometimes makes it highly volatile and unstable. It shakes the
confidence and capital flight from the country can take place as it happened in Asian
financial crisis 1997 in countries like Thailand, Malaysia, Indonesia, and Singapore etc.
(called as asian tiger in 1997, newly opened )
3. Full capital convetibility can make economy vulenerable to panic selling , large scale
devastation of the economy.
NEER and REER(5→1:48)

Nominal Exchange Rate (NER): Foreign exchange rate is generally quoted as the number
of units of a domestic currency required to purchase one unit of a foreign currency. For
example 1 USD= 73 INR means that 73 Rupees would be needed to buy 1 US dollar in
foreign exchange market. Likewise there is a foreign exchange rate between Rupee and Euro,
between rupee and Yen and so on. This exchange rate of rupees per dollar or per euro etc is
called Nominal Exchange Rate (NER).
Nominal Effective Exchange Rate (NEER): NEER is the weighted average of nominal
exchange rates where the weights used are the shares of the trading partners in the foreign
trade of a country.
Suppose USA accounts for 60 percent total trade with India and UK accounts for 40 percent
of trade with India then the NEER is given by
NEER=( NER with USA x Weight of USA)+ ( NER with UK x Weight of UK)
=(73x 0.6) + (103x 0.4)= 85
Real Exchange Rate (RER): measures the relative price of two currencies after adjusting for
price levels prevailing within two countries. Real Exchange Rate between Rupee and US
Dollar is defined as the rupee price of a basket of goods in India relative to the Dollar price of
the same basket of goods in USA.
RER= NERx (Price in USA/ Price in India)
Thus while the NER measures the rate at which currencies of two countries are exchanged,
RER measures the rate at which domestic goods can be exchanged for foreign goods.
Suppose Rs. 73 are required to buy 1 US Dollar (NER). If the basket of goods costs Rs. 200
in India and the same basket of goods costs USD 20 in USA , then RER= 73 x (20/200) = 7.3
Thus 7.3 is the Real Exchange Rate (RER) of Indian Rupee. This means that 7.3 units of
Indian goods are needed to buy one unit of US goods. RER is used as a measure of
International Competitiveness.
A rise in RER indicates that foreign goods (in this example USA goods) have become more
expensive relative to domestic goods of a country. This means competitiveness of our goods
has increased relative to that of the USA.
Real Effective Exchange Rate (REER): REER is the weighted average of Real Exchange
Rate (RER) with its trade partners, the shares of different countries in its total trade are used
as weights.
DISCUSSION(5→2:22)
prelims and mains PYQ

Topic: Macro Economy - Current Account, Capital Account, Balance of Payments, Trade
Balance
2015 Craze for gold in Indians have led to a surge in import of gold in recent years and
put pressure on balance of payments and external value of rupee. In view of this,
examine the merits of Gold Monetization Scheme. 200 12.5
2003 Point out the measures undertaken towards flexibility in capital account
transactions during the recent past. 150 10
PYQ PRELIMS OF ECONOMY-2020 CHAPTER 11 EXTERNAL SECTOR IN INDIA
Q A
Topic: Macro Economy - Current Account, Capital Account, Balance of Payments, Trade
Balance
2015 Craze for gold in Indians have led to a surge in import of gold in recent years and
put pressure on balance of payments and external value of rupee. In view of this,
examine the merits of Gold Monetization Scheme. 200 12.5
2003 Point out the measures undertaken towards flexibility in capital account
transactions during the recent past. 150 10
PYQ PRELIMS OF ECONOMY-2020 CHAPTER 11 EXTERNAL SECTOR IN INDIA
A
handout 1
handout 2
handout 3
handout 4
handout 4 b
handout PYQ

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Open economy, Free trade

TOPIC MOBLISATON OF RESOURCES

LECTURE NO. 2019-

LECTURE NO. 2021-

SOURCES SANJEEVE VERMA , YB

VAJIRAM FACULTY SHOBIT UNIYAL

OPEN ECONOMY/ EXTERNAL SECTOR

OPEN ECONOMY/ EXTERNAL SECTOR

CLOSED ECONOMY (1→00:17)

BARRIER TO TRADE (1→00:20)

These are of the following two types:

Tariffs are also a source of government revenue.

These are of following types:

1. Quotas: is a restriction on the amount of goods that is allowed to be imported into a

QUESTION OF STUDENT (1→1:05)

1. SANCTIONS are very strong non-tariff barrier.

2. Reason for the barrier is to promote domestic industry.

Commercial Policy (Trade Policy): Free Trade v/s

3. Transport and communications infrastructure

The Enabling Trade Index Ranking for 2016

3 Hong Kong SAR

Arguments in favour of free trade(1→1:50)

a. If it not work then

4. Promotes competition: free trade increases competition in the economy as domestic

5. Transfer of Technology: Free trade leads to international diffusion of technology. A

7. Improves international cooperation: Free trade makes nations economically dependent

Arguments in favour of protectionism(1→2:22)

2. Employment argument: according to this argument protection would lead to an

4. Anti-dumping argument: sometimes protection is required in order to protect the

1. As a member of WTO and having large volume of trade it is not to adopt

3. eg Carbon tax by EU is a kind of trade barrier, ANB is a kind of protectionist policy

4. Any intervention by government is protectionist move.

All the figures in BoP are expressed in USD (US dollar).

Components of BoP (2→00:47)

(Net = export —Import)

Foreign student studying in India → Import.

They bring in technology (TOT).

Tech environment improve n the country.

We get to learn about Best International Practices.

Improvement and addition in our exports basket .

It help the domestic investor also by raising share prices.

2. ECB→ External Commercial Borrowing, Loans taken up by the commercial companies

2.3 BANKING CAPITAL

3. FOREIGN EXCHANGE RESERVE

In terms of these 4 asset

1. FOREIGN CURRENCY ASSET ⇒

Balance of Trade (BoT)⇒ Exports- Imports (of only visible goods)

Current Account Deficit (CAD) is good or bad for the

b) How do you finance your deficit?

If CAD is financed through borrowing, it is unsustainable because borrowing leads to

Balance of Payments (BoP) Crisis

Importance of Foreign Exchange reserves(3→1:07)

2. Defend rupee if it starts depreciating rapidly. Depreciation is market led, Depreciation

BoP during 2020-21

Large Forex reserves : Problems / Concerns (4→00:00)

PROBLEMS/ASSOCIATED WITH LARGE FOREX RESERVE (3→1:44)(4→00:00)