MBA Notes on International Business Economics

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306 International Business Economics LECTURE notes
Master of business admistration (Savitribai Phule Pune University)
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MBA– Semester III

Generic Courses (Electives)
INTERNATIONAL
BUSINESS ECONOMICS
306 COURSE NOTES

BY DR. RAKESH BHATI
Dr. Rakesh Bhati 306 – International Business Economics 1

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Generic Courses (Electives) – University Level – Semester III

306 – International Business Economics
2 Credits LTP: 2:0:0 Generic Elective – University Level
Course Outcomes: On successful completion of the course the learner will be able to CO#
COGNITIVE ABILITIES COURSE OUTCOMES
CO 306 .1 Remembering RECALL and ENUMERATE the economic aspects of international business.
CO 306 .2 Understanding DESCRIBE the outcomes of globalising and liberalising trade environment, trade policy
frameworks and macroeconomic linkages of the open economy.
CO 306 .3 Applying DISCUSS the mechanisms and working of the foreign exchange markets.
CO 306 .4 Analysing EXAMINE how a protectionist trade policy improves or diminishes the prospects of survival /
growth of business.
CO 306 .5 Evaluating APPRAISE the implications of trade related policies under different levels of product
market concentration?
1. International Trade: Trade Theories , Ricardo and Comparative advantage, Heckscher Ohlin
model of factor abundance , Krugman’s model of Intra-Industry Trade (5+1)
2. Trade policies: Unilateral and multilateral trade policies, Tariffs in competitive markets, WTO tariff
policy, Quota, Tariff and quota in monopolistic markets, Dumping and Antidumping Duty under
the WTO, Subsidies and Countervailing duties under the WTO, Export taxes, Export subsidies,
Economic Integration - Custom Unions and Free Trade Areas - Major Regional Trade
Agreements(5+1)
3. Currency and International Finance: Currency market and exchange rate, Spot and forward
markets, Types of Foreign Exchange Transactions – Reading Foreign Exchange Quotations –
Forward and Futures Market – ForeignCurrency Options – Arbitrage – Speculation and Exchange-
Market Stability, Currency market and basic Central Bank operation, Product market approach to
determination of exchange rate, Asset market approach to determination of exchange rate.
(5+1)
4. Exchange rate policies and macroeconomic management: Fixed and flexible rates – Central
Banks actions, Impact of changing exchange rates on exports and imports, Volatility
managements by the government and Exchange rate regimes, Open economy
macroeconomics, Monetary approach and asset market approach to predict future exchange
rate, 3 International Financial Crises models - Understanding the recent few crises, The Euro Crisis/
crisis in Venezuela, Economic risk indicators for FDI and FII (5+1)
5. International Banking: Reserves, Debt and Risk : Nature of International Reserves – Demand for
International Reserves – Supply of International Reserves – Gold Exchange Standard – Special
Drawing Rights – International Lending Risk – The Problem of International Debt – Financial Crisis
and the International Monetary Fund – Eurocurrency Market. (5+1)
Suggested Text Books:

1. International Economics Theory and Policy by Paul Krugman, Maurice Obstfeld, Pearson Education
2. International Economics by Robert Carbaugh, Thomson – South Western 3. International Business by John
Daniels, Lee Radebaugh, Daniel Sullivan and Prashant Salwan, Pearson
Suggested Reference Books:

1. International Economics by Thomas Pugel, McGraw-Hill-Irwin
2. The World is Flat by Friedman Thomas
3. International Economics by Edward Leamer, editor,
4. Jagdish N. Bhagwati, Arvind Panagariya, and T. N. Srinivasan, Lectures on International Trade
5. Rethinking International Trade by Paul R. Krugman
UNIT – 1

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International Trade: Trade Theories , Ricardo and Comparative advantage, Heckscher Ohlin
model of factor abundance , Krugman’s model of Intra-Industry Trade
INTERNATIONAL TRADE: TRADE THEORIES

We live in a global marketplace. The food on your table might include fresh fruit from Chile,
cheese from France, and bottled water from Scotland. Your wireless phone might have been
made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in
China.
The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever
ruined by trade.” Many economists would express their attitudes toward international trade in an
even more positive manner. The evidence that international trade confers overall benefits on
economies is pretty strong.
There are very few models of trade that include all five reasons for trade simultaneously.
The reason is that such a model is too complicated to work with. Economists simplify the world by
choosing a model that generally contains just one reason. This does not mean that economists
believe that one reason, or one model, is sufficient to explain all outcomes. Instead, one must try
to understand the world by looking at what a collection of different models tells us about the
same phenomenon.
In the real world, trade takes place because of a combination of all these different
reasons. Each single model provides only a glimpse of some of the effects that might arise.
Consequently, we should expect that a combination of the different outcomes that are
presented in different models is the true characterization of the real world. Unfortunately, because
of this, understanding the complexities of the real world is still more of an art than a science.
The five basic reasons why trade may take place are summarized below. The purpose of
each model is to establish a basis for trade and then to use that model to identify the expected
effects of trade on prices, profits, incomes, and individual welfare.
Reason for Trade
1. Differences in Technology : Advantageous trade can occur between countries if the
countries differ in their technological abilities to produce goods and services. Technology
refers to the techniques used to turn resources (labor, capital, land) into outputs (goods
and services). The basis for trade in the Ricardian model of comparative advantage in
"The Ricardian Theory of Comparative Advantage" is differences in technology.
2. Differences in Resource Endowments: Advantageous trade can occur between countries if
the countries differ in their endowments of resources. Resource endowments refer to the
skills and abilities of a country’s workforce, the natural resources available within its borders
(minerals, farmland, etc.), and the sophistication of its capital stock (machinery,
infrastructure, communications systems). The basis for trade in both the pure exchange
model in "The Pure Exchange Model of Trade" and the Heckscher-Ohlin model in “The
Heckscher-Ohlin (Factor Proportions) Model" is differences in resource endowments.
3. Differences in Demand: Advantageous trade can occur between countries if demands or
preferences differ between countries. Individuals in different countries may have different
preferences or demands for various products. For example, the Chinese are likely to
demand more rice than Americans, even if consumers face the same price. Canadians
may demand more beer, the Dutch more wooden shoes, and the Japanese more fish than
Americans would, even if they all faced the same prices. There is no formal trade model
with demand differences, although the monopolistic competition model in "Economies of
Scale and International Trade" does include a demand for variety that can be based on
differences in tastes between consumers.
4. Existence of Economies of Scale in Production: The existence of economies of scale in
production is sufficient to generate advantageous trade between two countries.
Economies of scale refer to a production process in which production costs fall as the scale
of production rises. This feature of production is also known as “increasing returns to scale.”

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5. Existence of Government Policies: Government tax and subsidy programs alter the prices
charged for goods and services. These changes can be sufficient to generate advantages
in production of certain products. In these circumstances, advantageous trade may arise
solely due to differences in government policies across countries. "Domestic Policies and
International Trade", "Production Subsidies as a Reason for Trade" and "Consumption Taxes
as a Reason for Trade" provide several examples in which domestic tax or subsidy policies
can induce international trade.
RICARDO AND COMPARATIVE ADVANTAGE

Ricardo used the theory of comparative advantage to argue against Great Britain’s
protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free
trade, the political economist stated that countries were better off specializing in what they enjoy
a comparative advantage in and importing the good in which they lack a comparative
advantage. He introduced this theory for the first time in his book “On the Principles of Political
Economy and Taxation”, 1817, using a simple numerical example concerning the trade between
Portugal and the England.
What is an Opportunity Cost?
To understand the theory behind a comparative advantage, it is crucial to understand the
idea of an opportunity cost. An opportunity cost is the foregone benefits from choosing one
alternative over others. For example, a laborer can use one hour of work to produce either 1 cloth
or 3 wines. We can think of opportunity cost as follows: What is the forgone benefit from choosing
to produce one cloth or one wine?
Therefore:
By producing one cloth, the opportunity cost is 3 wines.
By producing one wine, the opportunity cost is ⅓ cloth.
Let’s say the labour costs per unit of cloth (C) and wine (W) produced by England (E) and
Portugal (P) are as those seen in the adjacent figure. Even though Portugal has an absolute
advantage on wine and cloth production, England has a comparative advantage on cloth
production.
Ricardian Model Assumptions
1. The modern version of the Ricardian Model assumes that there are two countries,
producing two goods, using one factor of production, usually labor.
2. The model is a general equilibrium model in which all markets (i.e., goods and factors) are
perfectly competitive.
3. The goods produced are assumed to be homogeneous across countries and firms within
an industry.
4. Goods can be costlessly shipped between countries (i.e., there are no transportation costs).
5. Labor is homogeneous within a country but may have different productivities across
countries. This implies that the production technology is assumed to differ across countries. L
6. abor is costlessly mobile across industries within a country but is immobile across countries.
7. Full employment of labor is also assumed.
8. Consumers (the laborers) are assumed to maximize utility subject to an income constraint.
Practical Example: Comparative Advantage
Consider two countries (France and the United States) that use labor as an input to
produce two goods: wine and cloth.
In France, one hour of a worker’s labor can produce either 5 cloths or 10 wines.
In the US, one hour of a worker’s labor can produce either 20 cloths or 20 wines.
The information provided is illustrated as follows:
It is important to note that the United States enjoys an absolute advantage in the production of
cloth and wine. With one labor hour, a worker can produce either 20 cloths or 20 wines in the
United States compared to France’s 5 cloths or 10 wines.
The United States enjoys an absolute advantage in the production of cloth and wine.

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To determine the comparative advantages of France and the United States, we must first
determine the opportunity cost for each output:
France: The United States:
Opportunity cost of 1 cloth = 2 wine Opportunity cost of 1 cloth = 1 wine
Opportunity cost of 1 wine = ½ cloth Opportunity cost of 1 wine = 1 cloth
When comparing the opportunity cost of 1 cloth for both France and the United States, we
can see that the opportunity cost of cloth is lower in the United States. Therefore, the United States
enjoys a comparative advantage in the production of cloth.
Additionally, when comparing the opportunity cost of 1 wine for France and the United
States, we can see that the opportunity cost of wine is lower in France. Therefore, France enjoys a
comparative advantage in the production of wine.
Comparative Advantage and its Benefits in Free Trade
How does identifying each country’s comparative advantage aid in understanding its
benefits in free trade?
First, let’s assume that the maximum amount of labor hours is 100 hours.
In France:
If all labor hours went into wine, 1,000 barrels of wine could be produced.
If all labor hours went into cloth, 500 pieces of cloth could be produced.
In the United States:
If all labor hours went into wine, 2,000 barrels of wine could be produced.
If all labor hours went into cloth, 2,000 pieces of cloth could be produced.
Following Ricardo’s theory of comparative advantage in free trade, if each country
specializes in what they enjoy a comparative advantage in and imports the other good, they will
be better off. Recall that:
France enjoys a comparative advantage in wine.
The United States enjoys a comparative advantage in cloth.
In France, the country specializes in wine and produces 1,000 barrels. Recall that the
opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United
States would be open to accepting a trade of 1 wine for up to 1 piece of cloth.
The potential gains from trade for Europe by specializing in wine is represented by the arrow:
In the United States, the country specializes in cloth and produces

2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in
France is 2 barrels of wine. Therefore, France would be open to
accepting a trade of 1 cloth for up to 2 barrels of wine.
The potential gains from trade for the United States by specializing
in cloth is represented by the arrow:
Therefore, using the theory of comparative advantage, a country

that specializes in their comparative advantage in free trade is
able to realize higher output gains by exporting the good in
which they enjoy a comparative advantage and importing the
good in which they suffer a comparative disadvantage.
CRITICISMS OF COMPARATIVE ADVANTAGE

1. Cost of trade. To export goods to India imposes transport costs.
2. External costs of trade. Exporting goods leads to increased pollution from ‘air-freight’
and can contribute to environmental costs not included in models which only include
private costs and benefits.
3. Diminishing returns/diseconomies of scale. Specialisation means a country will increase
the output of one particular good. However, for some industries increasing output may
lead to diminishing returns. For example, if Portugal has a comparative advantage in
wine, it may run out of suitable land for growing grapes. A contemporary example is

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Mongolia. Mongolia was believed to have a comparative advantage in cattle farming.

However, according to Erik Reinert opening of markets to international competition in
1991 led to an increased size of animal herds, but this led to over-grazing and loss of
grazing land. [Reinert, E (2004) “Globalization and economic development: an
Alternative Perspective”, Edward Elgar pub. p 158.]
4. Static comparative advantage. A developing economy, in sub-Saharan-Africa, may
have a comparative advantage in producing primary products (metals, agriculture),
but these products have a low-income elasticity of demand, and it can hold back an
economy from diversifying into more profitable industries, such as manufacturing.
5. Dutch disease. Dutch disease is a phenomenon where countries specialise in producing
primary products (oil/natural gas) but doing this can harm the long-term performance
of the economy. In the 1970s, the Netherlands specialised in producing natural gas, but
this led to the neglect of manufacturing and when the gas industry declined, the
economy was left behind its near neighbours.
6. Trade – not a Pareto improvement. Trade can lead to an increase in net economic
welfare. However, it doesn’t mean that everyone will become better off. Some workers
in uncompetitive industries may lose out and struggle to gain employment in new
industries.
7. Gravity theory. Proposed by Jan Tinbergen, in 1962, this states that international trade is
influenced by two factors – the relative size of economies and economic distance. The
model suggests that countries of similar size will be attracted to trade with each other.
Economic distance depends on geographical distance and trade barriers. The
implication is that countries economically close and of similar size will engage in similar
levels of bilateral trade. It also suggests trade is more likely between countries which are
geographically close.
8. Complexity of global trade. Models of comparative advantage usually focus on two
countries and two goods, but in the real world, there are multiple goods and countries.
Increasingly there is growing demand for a variety of goods and choice – rather than
competing on simple price.
HECKSCHER OHLIN MODEL OF FACTOR ABUNDANCE

Eli Heckscher (1919) and Bertil Ohlin (1933) found the basis for crucial and substantial
theoretical developments of international trade by emphasizing the relationships between the
composition of countries’ factor endowments and commodity trade patterns. The Heckscher-
Ohlin (H-O) theory is the simplest explanation for why countries involve in trade of goods and
services with other countries. Heckscher-Ohlin model, which is the general equilibrium
mathematical model of international trade theory, is built on the Ricardian theory of comparative
advantage by making prediction on trade patterns and production of goods based on the factor
endowments of nations
Assumptions of the Heckscher- Ohlin Model
The following assumptions pertain to the 2*2 model of Heckscher-Ohlin.
1. It is assumed that there are only two nations (1 and 2) with two goods for trade (X and Y)
and two factors of production (capital and labour).
2. For producing the goods, both nations use the same technology and they use uniform
factors of production.
3. In both countries, good X is labour intensive and Y is capital intensive.
4. The tastes and preferences of both nations are the same (both countries can be
represented in the same indifference curve).
5. In both nations, the assumption of constant returns to scale is applicable for the production
of goods X and Y.
6. In both nations, specialization in production is not complete.
7. Goods and factor markets in both nations are perfectly competitive.
8. There exists perfect mobility of factors of production within each country though
international mobility is not possible.

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9. There are no restrictions or limitations to the free flow of international trade. That is, there
exist no transportation costs, tariffs, or like other obstructions either to control or to restrict
the exports or imports.
10. It is assumed that there exists full employment of all resources in both nations. That is, there
will not be any under employed resource in either nation.
11. The exports and imports between the nations are balanced. It means that the total value
of the exports will be equal to the total value of imports in both nations.
THE HECKSCHER-OHLIN MODEL
Heckscher-Ohlin model is generally described as two countries, two goods and two factors
model (2x2x2 model). This formulation of HO model was mathematically developed by Paul
Samuelson. The goal of the model is to predict the pattern of international trade in commodities
between the two countries on the basis of differences in factor endowments in both the countries.
Definition: A nation exports the commodities which are produced out of its relatively abundant
and cheap factors or resources and imports the commodity which is produced out of relatively
scarce factors or resources. In another words, relatively labour abundant country exports relatively
labour intensive commodity and imports the relatively capital-intensive commodity. Country 1
exports commodity X because X is the Labor (L) intensive commodity and L is relatively cheap
and abundant factor in country 1. Country 2 exports commodity Y because Y is the Capital (K)
intensive commodity and K is relatively cheap and abundant factor in country 2.
The theory implicates two things: first, different supply conditions in terms of resource
endowments explain comparative advantage and second, countries export goods that use
abundant and cheap factors of production and import goods that use scarce and expensive
factors.
According to Heckscher-Ohlin theory, international and interregional differences in
production costs occur due to the differences in the supply of factors of production. Under free
trade, countries export the commodities whose production requires intensive use of abundant
factors and import the commodities whose production requires the scarce factors. Hence,
international trade compensates for the uneven geographic distribution of factors of production.
The theory gives insight to the fact that commodities are the bundles of factors (land, labour and
capital). Thus, the exchange of commodities is indirect arbitrage of factors of production and the
transfer of services of otherwise immobile factors from regions where factors are abundant to
regions where they are scarce.
The H-O theorem identifies the basic reason for comparative advantage and international
trade as the different factor abundance or factor endowments among nations. Because of this
particular reason, the theory is known as factor proportions or factor endowment theory. The
theory postulates that the difference in relative factor endowment and prices is the main reason
for the difference in relative commodity prices between two countries.
The Price Criterion of Relative Factor Abundance:
According to the price criterion, a

country having capital relatively cheap and
labour relatively dear is regarded as relatively
capital-abundant, irrespective of its ratio of
total quantities of capital to labour in
comparison with the other country. In
symbolic terms, when:
(PK/PL) A < (PK/PL) B
Country A is relatively capital-abundant. (Here
P stands for factor price and К for capital, L for
labour, A and В for the two respective
countries.) Ohlin’s theorem may be verified
diagrammatically in Fig. 1.
Fig. 1 depicts xx and yy isoquants
(equal product curves) for two goods X and Y

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respectively. These two isoquants intersect only once so that the goods X and Y can be classified
unambiguously according to factor intensity.
It is easy to see that x is relatively capital- intensive, since the amount of capital is represented on
the vertical axis. Similarly, good Y is labour-intensive, since the amount of labour is represented on
the horizontal axis. If the isoquants intersect more than once, good X will not always be capital
intensive relatively to Y.
Let us assume that there are two countries A and В A is the relatively capital-abundant and В is
labour abundant. Now all possible factor combinations (of labour and capital) that can produce
the given amounts of two goods X and Y in each country can be read off from the two isoquants.
Economically, the most efficient factor combination, however, depends upon the relative factor
prices. To consider this, let us assume that the slope of the line P represents the relative factor
prices in country A, i.e., (PK/PL) A.
The line PA is tangent to yy isoquant at point Q. Similarly, xx isoquant is also tangential to PA at
point Z. Since we have assumed that (PK/PL) A < (PK/PL) B i.e., capital in A is relatively cheaper,
the slope of the line representing relative factor prices (PK/PL) in B must be less than that of PA.
Thus, line P’B is supposed to represent factor ratio in B. Line P’B is tangent to the isoquant yy at
point T. Now, the line RS is drawn parallel to P’B such that it becomes tangent to the isoquant xx at
point M. Line RS lies above the line P’B implying that OR intercept of RS on the capital axis is
greater than OP’, the intercept of P’B’ on the same axis.
Under these assumptions, it appears that the equilibrium factor proportions are OZ for good X and
OQ for Y in country A. That means, the cost of producing the given amount of X in country A is the
cost of using the quantities of two factors _ labour and capital_ indicated by OZ at relative factor
prices given by PA.
This is equal to the cost of using capital in the amount of OP (the point at which PA cuts the
capital axis). Similarly, the cost of producing the given amount of Y in country A is equal to the
cost of using capital in the same quantity (OP).
In country B, similarly, the equilibrium factor proportions are OM for X and OOT for good Y. The
relative factor prices are shown by P’B (or RS). And therefore, the costs of producing the given
amounts of X and Y (as assumed for country A) in this country are, in terms of capital, OR and OP
respectively. Evidently, in country В the given amount of goods X is more expensive than the given
amount of good Y.
Comparing the relative costs of the equal amounts of the two goods X and Y in the countries A
and B, we thus find good X is relatively cheaper in A and good Y is relatively cheaper in B. That
means, the capital-abundant country has a comparative cost advantage in producing a capital-
intensive good. So with the opening of trade with the other country, it must export such goods
only. Likewise, the labour abundant country must export labour-intensive goods.
This is how the Heckscher-Ohlin theorem confines to the position that: a country exports goods
produced relatively cheaper by using a relatively greater proportion of its relatively abundant
factor. Though this conclusion has been inferred without consideration of demand conditions or
factor endowments, it may be said that the data about relative factor prices do presuppose the
given demand conditions and factor endowments in the two countries, obviously because the
prices of factors are determined by the interaction of the supply of and demand for factors.
However, the demand for factors, being a derived demand, depends, along with the technical
conditions of production, on the demand for final commodities produced by them.
The Physical Criterion of Relative Factor Abundance:
Viewing the physical criteria, strictly implying relative factor endowments in physical quantities, a
country is relatively capital-abundant only if it possesses a greater proportion of capital to labour
as compared to the other country. To put it symbolically, then
(K/L)A > (K/L)B
Country A is relatively capital-abundant, whether or not the ratio of the prices of capital to labour
is lower than in country B.
Using the price criterion of relative factor abundance, Ohlin’s conclusion can be traced
immediately from the assumptions made above, without consideration of demand conditions or

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factor proportions. But if the physical criterion is viewed, demand conditions are to be considered
in order to establish the theorem.
Ohlin, it seems, chooses the former criterion of determining the relative factor abundance and
relative cheapness inter-changeably; but, he also lays down that the difference in factor prices is
due to the difference in the relative endowment of the factors between countries. He thus asserts
that once the relative physical quantities of each productive factor endowed in both the
countries are known, the relative factor-price structure for each country can be easily inferred.
Evidently, a country possessing relatively abundant capital will have a factor price structure such
that capital will be cheaper as compared to labour (relatively scarce factor). It follows, thus, that
a relatively cheaper factor in a country implies that it is relatively abundant.
Hence, considering physical quantities and scarcities rather than economic scarcities, Ohlin
assumes that the supply aspect has a greater significance than demand in determining the
relative factor prices in a country.
Ohlin, then, stresses the point that the factor-price structure will be different in two countries when
the factor endowments are in differing proportions. Comparative advantages thus arise when the
capital-abundant country (A) exports capital-intensive goods and imports labour- intensive goods
and the labour abundant country (B) exports labour intensive goods and imports capital- intensive
goods; because, (PK/PL)A < (PK/PL)B < (PK/PL)A.
If relative factor endowments are identical in two countries and commodity factor intensities are
also the same, there will be no comparative price differences (PK\PL)A = (PK/PL)B; there is no
comparative cost difference); hence no theoretical basis for international trade.
LIMITATIONS OF HECKSCHER OHLIN'S H-O THEORY

Heckscher Ohlin's Theory has been criticised on basis of following grounds :-
1. Unrealistic Assumptions : Besides the usual assumptions of two countries, two
commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative
difference in factors of production, identical production function, constant return to
scale, etc. All these assumptions makes the theory unrealistic one.
2. Restrictive : Ohlin's theory is not free from constrains. His theory includes only two
commodities, two countries and two factors. Thus it is a restrictive one.
3. One-Sided Theory : According to Ohlin's theory, supply plays a significant role than
demand in determining factor prices. But if demand forces are more significant, a
capital abundant country will export labour intensive good as the price of capital will
be high due to high demand for capital.
4. Static in Nature : Like Ricardian Theory the H-O Model is also static in nature. The theory
is based on a given state of economy and with a given production function and does
not accept any change.
5. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that determine
the costs and commodity prices but it is commodity prices that determine the factor
prices.
6. Consumers' Demand ignored : Ohlin forgot an important fact that commodity prices
are also influenced by the consumers' demand.
7. Haberler's Criticism : According to Haberler, Ohlin's theory is based on partial
equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.
8. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory
underU.S.A conditions. He found out that U.S.A exports labour intensive goods and
imports capital intensive goods, but U.S.A being a capital abundant country must
export capital intensive goods and import labour intensive goods than to produce them
at home. This situation is called Leontief Paradox which negates H-O Theory.
9. Other Factors Neglected : Factor endowment is not the sole factor influencing
commodity price and international trade. The H-O Theory neglects other factors like
technology, technique of production, natural factors, different qualities of labour, etc.,
which can also influence the international trade.

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KRUGMAN’S MODEL OF INTRA-INDUSTRY TRADE

This model uses economies of scale, differentiated products and heterogenous preferences
to explain intraindustry trade. The essence of the model is as follows:
- preferences are heterogeneous between and within countries
- production experiences economies of scale
- products are differentiated
Industries within a country will produce goods which are targeted for the majority of their home
consumers, thereby, exploiting economies of scale. However, not all consumers have the same
preferences. Some minority will have preferences for the styles etc. produced elsewhere.
Domestic firms find small production runs costly and forgo this segment of the market. This minority
then winds up buying imported goods. The converse is also true that some portion of foreign
consumers will have a greater preference for home country goods and home country winds up
exporting to foreign's minority's share of the market.
The implications for this model transcends a simple explanation of intra-industry trade. It lies at the
heart of the controversy of managed trade and industrial policy. With economies of scale there
are only a feasible small number of firms to satisfy world demand (aircraft, for example). Under
these conditions, the principle of first movers winning market share makes for compelling logic for
advocates of managed trade.
The model:
Preliminaries - Economies of scale can be modelled by the following total cost linear equation,
C = F + cX.
Total cost is equal to the sum of fixed costs (F) and variable costs cX. Note that the parameter c
is constant marginal cost.
Average cost are: AC = F/X + c
Monopolistically competitive firms face a downward sloping demand due to brand loyalty etc.
Profit maximization Marginal revenue = Marginal Cost, but unlike perfect competition, marginal
revenue no longer equals price.
Marginal Revenue (MR) - is the change in total revenue due to a change in quantity.
Assuming a linear demand curve given by:
X = A - BP,
then by simple algebra - A = X + BP.
The inverse linear demand curve is P = A/B - X/B. MR from this is MR = (A - 2X)/B. Substitute in for A,
MR = (X + BP- 2X)/B = (BP - X)/B, therefore
MR = P - X/B.
Assumptions of the model.

Demand facing typical monopolistically competitive firm:
X = S[1/n - b(P - Pavg)],
where X is the firm's sales, S is the total sales of the industry, n the number of firms in the industry, P
the price charged by the firm itself, and Pavg the average price charged by its competitors. The
following intuition follows from this equation: if all firms charge the same price then P = Pavg and
the firms equally share the market. A firm charging more than the industry average will have a
smaller market share and a firm less than the average will gain market share. A simplifying
assumption is that total industry sales, S, is unaffected by price. This means that price competition
simply rearranges market share without increasing the total.
Market equilibrium - first assume all firms are symmetric, the demand and cost functions are
the same for all firms even though they are producing differentiated products. In order to
determine the behavior of the firm we first need to describe the industry, that is to determine n
and Pavg. This is a 3 step process:
1) derive the relationship between the number of firms and the average cost of a typical firm.
This relationship is upward sloping. The greater the number of firms the lower each firms
output and with economies of scale the greater the average costs.
2) derive the relationship between the number of firms and the price that each firm charges
which must equal Pavg in equilibrium. This will be downward sloping, the greater the
number firms the greater the competition and consequently the lower the price charged
by each firm.

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3) with monopolistically competitive industry long profits equal zero. If price is greater than
average cost then the number of firms will increase, if less then the number decreases. Thus
the number of firms in the industry is determined by the relation of average costs and price
to n.
The number of firms and average cost. Since all firms are symmetric then in equilibrium P =
Pavg then the firm's demand curve devolves into:
X = S/n, that is all firms equally share the market. Using the average cost function derived
earlier,
AC = F/X + c = nF/S + c.
The more numerous the firms the higher the average cost, ceteris paribus.
The number of firms and the price. The price that the typical firm charges is also dependent on
the number of firms. Each firm takes Pavg as exogenous. We can rewrite the firm' demand curve
as: X = (S/n + SbPavg) - SbP
which is nothing more than a linear function with (S/n + SbPavg) being the intercept term and Sb
the slope. Going back to the earlier derivation of MR we can write the firm's marginal revenue
as: MR = P - X/Sb.
Profit maximization requires the equality of MR and MC, therefore: P - X/Sb = c,
which rearranged leads to : P = c + X/(Sb),
but with each firm charging the same price then X is an equal share of the market, S/n, thus:
P = c + 1/(bn).
Equilibrium number of firms.

The following diagram shows the equilibrium number of firms such that there are zero profits.
Equilibrium occurs at n2 where price is

equal to average cost, ie, zero economic
profits. This is a long run equilibrium.
Suppose that the number of firms was
equal to n1. Then price would be P1 and
average cost AC1. Under these conditions
economic profits would be positive
leading to entry increasing the number of
firms up to n2. Should the number of firms
be greater than n2 then the opposite
would occur.
International Trade
We can now use this model to derive some important implications for international trade.
With international trade the size of the market increases. This enters in the average cost equation
as S. An increase in S shifts the average cost curve downwards thus lowering the price of the good
while increasing the number of viable firms. The greater the number of firms the more the number
of differentiated products, thus international trade provides consumers with greater variety and
lower prices. The P line is independent of S and therefore does not shift. Note though that with a
non-horizontal P line the number of firms that will exist in the long run with trade is less than the sum
of the numbers across countries in autarky.

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UNIT – 2
Trade policies: Unilateral and multilateral trade policies, Tariffs in competitive markets, WTO
tariff policy, Quota, Tariff and quota in monopolistic markets, Dumping and Antidumping Duty
under the WTO, Subsidies and Countervailing duties under the WTO, Export taxes, Export
subsidies, Economic Integration - Custom Unions and Free Trade Areas - Major Regional Trade
Agreements
TRADE POLICIES: UNILATERAL AND MULTILATERAL TRADE POLICIES

Unilateral trade agreements
In a unilateral trade agreement, the agreement is imposed on one country, organization
or groups by another. So the action or decision is taken by one of the countries, groups or
organizations. Here, the unilateral agreement is benefited to one country, organization or group.
Trade restriction, minimizing of imports, imposing of higher import duty and taxes etc. are imposed
to such group, country or organization. So least developed countries (LDCs) are more alert on
such unilateral trade agreement against the imbalance of power by developed countries.
Multilateral trade agreements are made between two or more countries to strengthen
economy of member countries by exchanging of goods and services among them. The
multilateral trade agreement builds commercial relationship, trade facilitation and financial
investments among member countries of such multilateral trade agreement. Compared to
bilateral trade agreement, multilateral trade agreements are difficult in negotiation of
agreement, as more member countries are involved in multilateral trade agreements. Up to the
level of norms in multilateral trade agreement, the member countries are treated equally.
The multilateral trade agreements can be formed in regional basis also. There are many
multilateral trade agreements between countries worldwide regionally for the development of
economy of each member countries signed in each multilateral trade agreement. SAARC (South
Asian Association for Regional Cooperation), NAFTA (North American Free Trade Agreement) etc.
are some of the multilateral trade agreements constructed geographically. The multilateral trade
agreements are moved globally for public health, environment etc. also other than economic
development of each member country and in turn over all development of world nations.
The world trading system has witnessed an increasing number of integration initiatives in
recent years on the back of comparative advantages. For India too it became necessary to be
integrated into the global trade to attain its economic growth targets.
The ever-growing number of Free trade agreements and preferential trade arrangements is
a prominent feature of international trade in the world. The basic premise of such initiatives is to
liberalize trade among the members by granting tariff concessions for, or eliminations of selected
products. The integration initiatives can be of various types, depending on the degree of
integration.
These arrangements have various nomenclatures such as Preferential Trade
Agreement(PTA), Free Trade Area (FTA), Comprehensive Economic Cooperation Agreement
(CECA) and Comprehensive Economic Partnership Agreement (CEPA), Customs Union (CU),
Common Market (CM) And Economic Union (EU). India has, so far, signed 11 FTAs and 5 limited
Preferential Trade Agreements (PTAs) and still in the process of negotiating 17 FTAs/PTAs, including
expansion of the existing FTAs/PTAs.
Thus, Trade Agreements are arrangements between two or more countries or trading blocs
that primarily agree to reduce or eliminate customs tariff and non tariff barriers on substantial
trade between them. Trade Agreements, normally cover trade in goods (such as agricultural or
industrial products) or trade in services (such as banking, construction, trading etc.). Trade
Agreements can also cover other areas such as intellectual property rights (IPRs), investment,
government procurement and competition policy etc.
All the Trade agreements are typically of three types:
a. Multilateral Trade Agreements
b. Bilateral Trade Agreements
c. Unilateral Trade Agreements

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a. Multilateral Trade Agreements – These agreements are between three or more countries. These
agreements among three countries or more are the most difficult to negotiate. The greater the
number of participants, the more difficult the negotiations are. By nature, they are more
complex than bilateral agreements, as each country has its own needs and requests. Once
negotiated, multilateral agreements are very powerful. They cover a larger geographic area,
which confers a greater competitive advantage on the signatories. All countries also give each
other most-favored-nation status—granting the best mutual trade terms and lowest tariffs.
India has following Multilateral Trade Agreements:
Agreements Partners Year of

enforcement
Asia Pacific Trade Bangladesh, China, India, South Korea 2005
Agreement (APTA) and Sri Lanka
South Asia Free Trade Bangladehs, Bhutan, Maldives, Nepal, 2006
Agreement (SAFTA) Pakistan, Sri Lanka, Afghanistan
India-Mercosur PTA Brazil, Argentina, Uruguay, Paraguay 2009
ASEAN – India FTA Brunie, Combodia, Indonesia, Laos, 2010
Malasia, Myanmar, Philippines,
Singapore, Thailand, Vietnam
b. Bilateral Trade Agreements – These agreements involve two countries. Both countries agree to
loosen trade restrictions to expand business opportunities between them. They lower tariffs and
confer preferred trade status on each other. Following Bilateral Trade Agreements have been
entered into by India.
Agreements Year of Enforcement
India-Srilanka 2000
India-Nepal treaty 1999
Agreement of Cooperation with Nepal to 2002
control unauthorized trade
Treaty of transit between India and Nepal 2009
India Afghanistan PTA 2003
India Singapore CECA 2005
India Bhutan Trade Agreement 2006
India Chile PTA 2007
India Korea CEPA 2010
India Malaysia CECA 2011
India Japan CEPA 2011
India Finland Agreement for Economic 2009
Cooperation
c. Unilateral Trade Agreements – This is typically not an agreement. It occurs when a country
unilaterally gives certain benefits to the imports from other countries. Some of the countries to
whom India provides the unilateral benefits are Combodia, Bangladesh, Somalia, Haiti, Chad,
Rwanda, Tanzania, Mozambique etc. and many more.
Similarly, India also gets unilateral trade benefits from many developed countries. There are
various categories of trade agreements which have India have entered like FTA, Preferential Trade
Agreement (PTA), Comprehensive Economic Cooperation Agreement (CECA), Comprehensive
Economic Partnership Agreement (CEPA), Regional Trade Agreement (RTA), Customs Union,
Common Market, and Economic Union (EU). Before we delve into the complexities of trade

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agreements, it is important to understand these terms and as to why India has these agreements
with different countries.
 PTA – In a PTA, two or more partners agree to reduce tariffs on agreed number of tariff lines.
The list of products on which the partners agree to reduce duty is called positive list. India
MERCOSUR PTA is such an example. However, in general PTAs do not cover substantially all
trade.
 FTA – In FTAs, tariffs on items covering substantial bilateral trade are eliminated between the
partner countries; however each maintains individual tariff structure for non-members. India
Sri Lanka FTA is an example. The key difference between an FTA and a PTA is that while in a
PTA there is a positive list of products on which duty is to be reduced; in an FTA there is a
negative list on which duty is not reduced or eliminated. Thus, compared to a PTA, FTAs are
generally more ambitious in coverage of tariff lines (products) on which duty is to be
reduced.
 CEPA/CECA – These terms describe agreements which consist of an integrated package
on goods, services and investment along with other areas including IPR, competition etc.
The India Korea CEPA is one such example and it covers a broad range of other areas like
trade facilitation and customs cooperation, investment, competition, IPR etc.
 Customs Union – In a Customs union, partner countries may decide to trade at zero duty
among themselves, however they maintain common tariffs against rest of the world. An
example is Southern African Customs Union (SACU) amongst South Africa, Lesotho,
Namibia, Botswana and Swaziland. European Union is also an outstanding example
 Common market – Integration provided by a Common market is one step deeper than
that by a Customs Union. A common market is a Customs Union with provisions to facilitate
free movements of labour and capital, harmonize technical standards across members
etc. European Common Market is an example.
 Economic Union – Economic Union is a Common Market extended through further
harmonization of fiscal/monetary policies and shared executive, judicial & legislative
institutions. European Union (EU) is an example.
After entering into the agreements, the Indian government and reciprocally the other member
country/ies has to issue country specific notifications through which the benefits incorporated in
the agreements are effectuated in the home country.
Therefore, in case there are any exports or imports that take place with the countries with
which India has trade agreements, the exporters/importers should get a complete analysis of the
duty structure done as may be applicable. Further, there are many countries to whom India gives
the benefits unilaterally and also India gets benefits which the other developed countries of the
world provides to India unilaterally. Many people lose the benefits since they are unaware of the
benefits under the trade agreements. There are many conditions to be fulfilled and procedures to
be complied with in order to get the benefits under the trade agreements.
TARIFFS IN COMPETITIVE MARKETS,

Tariffs are a tax placed by the government on imports. They raise the price for consumers, lead to
a decline in imports, and can lead to retaliation by other countries.
• They could be a specific amount (e.g. £1 per unit.)
• Or they could be an ad valorem tax (e.g. 10% of the price)
Tariffs are an important barrier to free trade; they are often imposed to protect domestic industry
from cheap imports. However, it often leads to retaliation with other countries placing tariffs on
their exports.
In this case, the tariff is P1-P2.
• The tariff leads to a decline in imports.
Imports were Q4-Q1. After the tariff,
imports fall to Q3-Q2.
• Consumer surplus falls by 1+2+3+4
• Government raises tariff revenue of
area 3

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• Domestic suppliers gain an increase in producer surplus of area 1

• The net welfare loss is (1+2+3+4) – (1+3) = 2+4
Without any trade, the equilibrium price is £1.80 and a

quantity of 40 million
With a tariff of £0.40, the price of imports will be £1.60.
The quantity of imports at £1.60 is (50-30) = 20 million.
With free trade (no tariffs) the price would be £1.20
and quantity bought 60 million.
Government tariff revenue
Tariff revenue = tariff × q. of imports (£0.40 × 20 million)
= £ 8 million
Consumer surplus
This is the difference between the price consumers pay
and the price they are willing to pay; therefore we find
the area of the triangle between demand curve and
price
With no trade = (£3.20 – £1.80 × 40) /2 = (£1.40 ×40)/2 = £28 million
After tariff – (£3.20 – £1.60) × 50)/2 = £40 million
With no tariff (free trade)- £3.20 – £1.20 × 60)/2 = £60 million
Tariffs reduce consumer surplus by £20 million
Diagram showing the effect of tariffs on consumer surplus effect-tariffs-on-consumer-surplus
Tariffs lead to a decline in consumer surplus of 1+2+3+4.
Producer surplus
The difference between the price and the price firms are willing to supply at (supply curve
 With no trade (£1.80 – £0.5) × 40)/2 = £24 million
 With tariff (£1.10 × 30)/2 = £15 million 16.5
 With free trade and no tariff (£0.7 ×20)/2 = £6 million.
 Tariffs increase producer surplus by £9 million
Welfare effect of tariffs = gain in producer surplus (£9 m) + gain in tariff revenue (£8m) – loss of
consumer surplus £20m)
Therefore net welfare loss = £3 million
Reasons for imposing tariffs
 Raise revenue. If a country produces no oil, levying a tax on oil imports will raise money as
people have no alternative put to pay the import tariff.
 Environmental. A tariff could be placed on goods who may have negative externalities.
e.g.
 Protectionism. The most common reason for a tariff. Imposing import tariffs makes domestic
firms more competitive.
Reasons for removing tariffs
1. Trade liberalisation involves removing barriers to trade such as tariffs on imports.
2. Free trade areas will have no tariffs between member states, though they may have a
common external tariff if it is a customs union.
3. Lower prices for consumers
4. Increase specialisation and benefits from economies of scale.
5. Theory of comparative advantage states net welfare gain from free trade.
6. The reduction of tariffs leads to trade creation.
Winners and losers of tariffs

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C. Tariffs
Tax on a product when it crosses international boundaries
Could be on imports or exports .
1. Types of tariffs
a. Protective tariff - protect import-competing industries .
b. Revenue tariff - generate tax revenue , World average = 3.9 percent of government
revenue
U.S. = 1.3 percent.
c. Specific tariff - fixed monetary amount per unit of import Ex. - Brooms ($0.32)
Degree of protection varies inversely with changes in import prices
- More protection when prices fall, less protection when prices rise.
d. Ad valorem tariff - fixed percentage of the value of an import Ex. - Bicycles (5.5%)
Good when products have a wide range of grade (and value) variations
- Constant degree of protection as prices change
Valuation:
(1) Free-on-board (FOB) valuation - product's value as it leaves exporting country
(2) Cost-insurance-freight (CIF) valuation - product's value as it arrives at final destination.
c. Compound tariff - combination of specific and ad valorem tariffs Ex. - Electricity meters
($0.16 + 1.5%)
Specific portion compensates for cost disadvantage due to protection for domestic input
suppliers. Ad valorem portion is protection to finished goods industry.
2. Effective rate of protection
Amount that domestic prices can rise above foreign prices before being priced out of
market
 Nominal tariff rate - published tariff schedule
 Effective tariff rate - gives effective rate of protection
- Effective protection increases as value added decreases
- Tariff on imports used in production process reduces level of effective
protection
- If inputs enter a country under low tariffs and final imported product is
protected by high tariffs, effective protection rate is high
 Tariff escalation - greater protection to intermediate and finished goods than to
primary commodities
- Hurts development of processing in less developed countries
3. Dealing with tariffs
a. Outsourcing
 Different aspects of manufacturing process done in different countries
 Foreign assembly of domestic components reduces costs
 Offshore-assembly provision (OAP) - if U.S. components are assembled into a finished
product overseas and imported into the U.S., only the value added is subject to
import duties
 Gives incentives to buy U.S. components
 Encourages outsourcing of assembly
b. Postponing import duties
(1) Bonded warehouse

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 Buy imported products in bulk to reduce costs

 Duty-free if left in a bonded warehouse
 Tariff paid only when products taken out of warehouse to be used or sold
 No duty owed if products are exported
(2) Free trade zone (FTZ)
 Foreign products imported without tariffs
 Duties and taxes not paid unless product shipped to U.S. markets
 No duties if product is exported
4. Welfare effects
a. Surplus
b. Small-nation model
 Imports are a small portion of the world market supply
 Small nation is a price taker - constant world price for import commodity
(1) Impact of free trade
 Consumers benefit - price lower, more quantity consumed
 Profits, production down in domestic industry => job loss.
(2) Impact of tariff
 Consumer hurt - price increases, quantity consumed decreases
 Domestic production increases => jobs increase
 Imports decrease
National welfare impacted
(a) Revenue effect - government's collection of duties.
(b) Redistributive effect - transfer of consumer surplus to domestic producers.
(c) Protective effect - wasted resources because product produced at higher cost.
(d) Consumption effect - loss to consumer due to higher price and less consumption.
(e) Deadweight loss - sum of protective effect and consumption effect.
b. Large-nation model
Country large enough to affect world price
(a) Redistributive effect - transfer of consumer surplus to domestic producers .
(b) Deadweight loss - sum of protective effect and consumption effect
 Protective effect - wasted resources because product produced at higher
cost
 Consumption effect - loss to consumer due to higher price and less
consumption .
(c) Revenue effect - government's collection of duties
Domestic revenue effect - revenue shifted from domestic consumers to government
Terms-of-trade effect - redistribution from foreign nation to tariff-levying nation
because of new terms of trade .
5. Effects on exporters
Increases costs of inputs
Higher import prices => higher cost of living => higher wages for workers
Fewer imports => less export revenue in foreign countries => foreign countries less able to
import
Exporters don't protest because:
- Cost increases are subtle and invisible
- Some firms don't form because of increased costs - no basis to oppose policies.
6. Tariffs and the poor
 Welfare costs high
 Income distribution becomes more inequitable
 Tariffs high on cheap goods, lower on luxuries
 High burden on countries specializing in cheapest goods .
7. Arguments for trade restrictions
Argument for trade is lower prices and higher levels of output, income, and consumption.
a. Job protection
 Dominant factor in government imposition of trade restrictions

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 Ignores dual nature of trade - imports generate revenue for foreign countries, which
allow those countries to import from domestic country
 Studies show trade restrictions have no long term effect on jobs
 Need to consider the cost of saving domestic jobs
.b. Protection against cheap foreign labor
 Set tariff equal to wage differential
 Low wages alone don't guarantee low production costs - need to look at productivity too
 Low wage countries have an advantage when labor requirement is higher than other
factors
c. Fairness in trade (level playing field)
(1) Advantages for foreign firms
 Environmental regulations
 Workplace safety
 Low corporate taxes and government regulation
 High trade barriers (subsidies).
(2) Counter arguments
 Consumers benefit from these practices
 Could lead to retaliation.
d. Maintenance of domestic standard of living
 Encourage domestic spending => stimulates domestic economy
 Foreign economies hurt, could lead to retaliation.
e. Production cost equalization
 Foreign firms have advantage because of lower wages, tax breaks, or government
subsidies
 Levy a tariff to equalize costs
 Which costs should be used?
 Consumer would be subsidizing inefficient production.
f. Infant industry argument
 Countries should temporarily shield newly developing industries from foreign competition
 Lift barriers after industries have time to develop and become efficient
 Difficult to remove protective barriers
 Difficult to determine which industries will eventually be able to handle foreign competition
g. Non-economic arguments
(1) National security
 Problems during international crises if too dependent on foreign suppliers
 What is an essential industry?.
(2) Cultural and sociological considerations
 Protect against "cultural imperialism".
8 Political economy of protectionism
a. Supporters
 Import-competing companies, workers and unions, suppliers
 Highly concerned with protecting industries and jobs
 Impacts are concentrated and severe
 Import-competing industries can point to direct damage (sales, profits, jobs).
b. Opponents
 Exporting companies, consumers, suppliers
 Less organized
 Impacts are dispersed and small
 Damage to exporters is indirect (lower foreign income, retaliation).
c. Supply of protection by government depends on
 Cost to society (welfare loss)
- Higher cost => less likely to have protection
 Political importance of import-competing industry
- Industry more important => more likely to have protection
 Adjustment cost
- High adjustment cost => more likely to have protection

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 Public sympathy
- More public sympathy => more likely to have protection.
d. Demand for protection by domestic industries depends on:
 Comparative disadvantage
- Greater disadvantage => more likely to demand protection
 Import penetration
- Higher level of import penetration => more likely to demand protection
 Concentration of domestic production
- Higher concentration => more likely to demand protection
 Export dependence
- Foreign sales a large portion of total sales => less likely to demand protection
D. NONTARIFF TRADE BARRIERS

1. Absolute quotas
 Physical restriction on the quantity of goods that may be imported into a country
 Quotas on manufactured goods outlawed by WTO
 Used primarily by developed countries against agricultural producers
a. Implementation
(1) Import licenses required
- Could be based on historic share of imports - discriminates against new companies
- Pro-rata share of domestic market, auctioning also used.
(2) Global quota - specified amount of goods can be imported
- No specification of where goods can come from
- Leads to a rush by exporting countries to get products in before quota is filled
- Could lead to monopoly, favoritism.
(3) Selective quota - quotas allocated to specific countries
- Could have same problems as global quotas.
b. Welfare effects
 Quota less desirable than tariff, particularly when demand is growing
- Both increase price, but tariff doesn't restrict quantity
- Tariffs allow for some degree of competition
 WTO has sought to replace quotas with tariffs - "tariffication".
2. Tariff-rate quotas (two-tier tariff)
 A specified amount of imports can be imported at one tariff rate
 Imports above specified amount are allowed, but pay a much higher rate
 Must decide import-quota threshold, within-quota tariff, and over-quota tariff
a. Welfare effects
b. Implementation
 License on demand allocation
 First-come, first served
 Historical market share
 Auctions.
3. Export quotas
• Voluntary export restraint agreement - orderly marketing agreement
• More efficient countries voluntarily restrain level of exports
• Same impact as quotas
Ex. - 1980s - Steel, automobiles, textiles.
4. Domestic content requirements
• Minimum percentage of a product's total value must be produced domestically
• Increases demand for domestic inputs => higher input prices.
5. Subsidies
a. Domestic subsidy
 Given to import-competing manufacturers
 Cash distributions, tax breaks, insurance arrangements, loans at below market
interest

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 Reduces cost of production

b. Export subsidy
 Encourage exports by reducing price foreign consumers pay
 Terms-of-trade effect - terms of trade worsens as foreign price of exports drops
 Export-revenue effect - export revenue affected by lower prices but higher
export volume
6. Dumping
 Foreign buyers charged lower price than domestic buyers
 Also selling in foreign markets for a price below the cost of production
a. Forms of dumping
1) Sporadic dumping (distress dumping) - firm disposes of excess inventory on foreign
markets at lower prices than at home
2) Predatory dumping - producer temporarily reduces prices to drive foreign
competitors out of business
3) Persistent dumping - dumping goes on indefinitely.
b. International price discrimination
 Charge different prices in different countries for the same product
 Charge higher price when demand is inelastic (market power), lower price when
demand is inelastic (competition)
c. Antidumping regulations
 Antidumping duty levied when imports sold at less than fair value (LTFV) and such
sales cause material injury to a U.S. industry
 Should average variable cost be used?
 Doesn't take into account currency fluctuations
 Overused to provide protection
7. Other barriers
a. Government procurement policies
 Government gives preference to domestic suppliers in purchases - "buy-national"
policies
 Higher costs, welfare losses.
b. Social regulations
 Correct undesirable side effects in an economy
 Health, safety, environment
o Ex. - CAFE standards, hormones in beef.
c. Sea transport and freight restrictions
 Restrictions as to what can be done in transporting goods
Tariffs and Tariff Rate Quotas

Tariffs, which are taxes on imports of commodities into a country or region, are among the
oldest forms of government intervention in economic activity. They are implemented for two clear
economic purposes. First, they provide revenue for the government. Second, they improve
economic returns to firms and suppliers of resources to domestic industry that face competition
from foreign imports.
Tariffs are widely used to protect domestic producers’ incomes from foreign competition.
This protection comes at an economic cost to domestic consumers who pay higher prices for
import-competing goods, and to the economy as a whole through the inefficient allocation of
resources to the import competing domestic industry. Therefore, since 1948, when average tariffs
on manufactured goods exceeded 30 percent in most developed economies, those economies
have sought to reduce tariffs on manufactured goods through several rounds of negotiations
under the General Agreement on Tariffs Trade (GATT). Only in the most recent Uruguay Round of
negotiations were trade and tariff restrictions in agriculture addressed. In the past, and even
under GATT, tariffs levied on some agricultural commodities by some countries have been very
large. When coupled with other barriers to trade they have often constituted formidable barriers
to market access from foreign producers. In fact, tariffs that are set high enough can block all
trade and act just like import bans.

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A tariff-rate quota (TRQ) combines the idea of a tariff with that of a quota. The typical TRQ
will set a low tariff for imports of a fixed quantity and a higher tariff for any imports that exceed
that initial quantity. In a legal sense and at the WTO, countries are allowed to combine the use of
two tariffs in the form of a TRQ, even when they have agreed not to use strict import quotas. In the
United States, important TRQ schedules are set for beef, sugar, peanuts, and many dairy products.
In each case, the initial tariff rate is quite low, but the over-quota tariff is prohibitive or close to
prohibitive for most normal trade.
Explicit import quotas used to be quite common in agricultural trade. They allowed
governments to strictly limit the amount of imports of a commodity and thus to plan on a
particular import quantity in setting domestic commodity programs. Another common non-tariff
barrier (NTB) was the so-called "voluntary export restraint" (VER) under which exporting countries
would agree to limit shipments of a commodity to the importing country, although often only
under threat of some even more restrictive or onerous activity. In some cases, exporters were
willing to comply with a VER because they were able to capture economic benefits through
higher prices for their exports in the importing country’s market.
Issues
In the Uruguay round of the GATT/WTO negotiations, members agreed to drop the use of
import quotas and other non-tariff barriers in favor of tariff-rate quotas. Countries also
agreed to gradually lower each tariff rate and raise the quantity to which the low tariff
applied. Thus, over time, trade would be taxed at a lower rate and trade flows would
increase.
Given current U.S. commitments under the WTO on market access, options are limited for
U.S. policy innovations in the 2002 Farm Bill vis a vis tariffs on agricultural imports from other
countries. Providing higher prices to domestic producers by increasing tariffs on agricultural
imports is not permitted. In addition, particularly because the U.S. is a net exporter of many
agricultural commodities, successive U.S. governments have generally taken a strong
position within the WTO that tariff and TRQ barriers need to be reduced.
Non-Tariff Trade Barriers

Countries use many mechanisms to restrict imports. A critical objective of the Uruguay
Round of GATT negotiations, shared by the U.S., was the elimination of non-tariff barriers to
trade in agricultural commodities (including quotas) and, where necessary, to replace
them with tariffs -- a process called tarrification. Tarrification of agricultural commodities
was largely achieved and viewed as a major success of the 1994 GATT agreement. Thus, if
the U.S. honors its GATT commitments, the utilization of new non-tariff barriers to trade is not
really an option for the 2002 Farm Bill.
Domestic Content Requirements : Governments have used domestic content regulations to

restrict imports. The intent is usually to stimulate the development of domestic industries. Domestic
content regulations typically specify the percentage of a product’s total value that must be
produced domestically in order for the product to be sold in the domestic market. Several
developing countries have imposed domestic content requirements to foster agricultural,
automobile, and textile production. They are normally used in conjunction with a policy of import
substitution in which domestic production replaces imports.
Domestic content requirements have not been as prevalent in agriculture as in some other
industries, such as automobiles, but some agricultural examples illustrate their effects. Australia
used domestic content requirements to support leaf tobacco production. In order to pay a
relatively low import duty on imported tobacco, Australian cigarette manufacturers were required
to use 57 percent domestic leaf tobacco. Member countries of trade agreements also use
domestic content rules to ensure that nonmembers do not manipulate the agreements to
circumvent tariffs. For example, North American Free Trade Agreement (NAFTA) rules of origin
provisions stipulate that all single-strength citrus juice must be made from 100 percent NAFTA origin
fresh citrus fruit.

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Again, as is the case with other trade barriers, it seems unlikely that introducing domestic content
rules to enhance domestic demand for U.S. agricultural commodities is a viable option for the
2002 Farm Bill.
Import Licenses: Import licenses have proved to be effective mechanisms for restricting imports.
Under an import-licensing scheme, importers of a commodity are required to obtain a license for
each shipment they bring into the country. Without explicitly utilizing a quota mechanism, a
country can simply restrict imports on any basis it chooses through its allocation of import licenses.
Prior to the implementation of NAFTA, for example, Mexico required that wheat and other
agricultural commodity imports be permitted only under license. Elimination of import licenses for
agricultural commodities was a critical objective of the Uruguay Round of GATT negotiations and
thus the use of this mechanism to protect U.S. agricultural producers is unlikely an option for the
2002 Farm Bill.
Import State Trading Enterprises: Import State Trading Enterprises (STEs) are government owned or
sanctioned agencies that act as partial or pure single buyer importers of a commodity or set of
commodities in world markets. They also often enjoy a partial or pure domestic monopoly over the
sale of those commodities. Current important examples of import STEs in world agricultural
commodity markets include the Japanese Food Agency (barley, rice, and wheat), South Korea’s
Livestock Products Marketing Organization, and China’s National Cereals, Oil and Foodstuffs
Import and Export Commission (COFCO).
STEs can restrict imports in several ways. First, they can impose a set of implicit import tariffs by
purchasing imports at world prices and offering them for sale at much higher domestic prices. The
difference between the purchase price and the domestic sales price simply represents a hidden
tariff. Import STEs may also implement implicit general and targeted import quotas, or utilize
complex and costly implicit import rules that make importing into the market unprofitable.
In WTO negotiations, the United States targeted the trade restricting operations of import and
export STEs as a primary concern. A major problem with import STEs is that it is quite difficult to
estimate the impacts of their operations on trade, because those operations lack transparency.
STEs often refuse to provide the information needed to make such assessments, claiming that such
disclosure is not required because they are quasi-private companies. In spite of these difficulties,
the challenges provided by STEs will almost certainly continue to be addressed through bilateral
and multilateral trade negotiations rather than in the context of domestic legislation through the
2002 Farm Bill.
Technical Barriers to Trade: All countries impose technical rules about packaging, product
definitions, labeling, etc. In the context of international trade, such rules may also be used as non-
tariff trade barriers. For example, imagine if Korea were to require that oranges sold in the country
be less than two inches in diameter. Oranges grown in Korea happen to be much smaller than
Navel oranges grown in California, so this type of "technical" rule would effectively ban the sales
of California oranges and protect the market for Korean oranges. Such rules violate WTO
provisions that require countries to treat imports and domestic products equivalently and not to
advantage products from one source over another, even in indirect ways. Again, however, these
issues will likely be dealt with through bilateral and multilateral trade negotiations rather than
through domestic Farm Bill policy initiatives.
Exchange Rate Management Policies: Some countries may restrict agricultural imports through
managing their exchange rates. To some degree, countries can and have used exchange rate
policies to discourage imports and encourage exports of all commodities. The exchange rate
between two countries’ currencies is simply the price at which one currency trades for the other.
For example, if one U.S. dollar can be used to purchase 100 Japanese yen (and vice versa), the
exchange rate between the U.S. dollar and the Japanese yen is 100 yen per dollar. If the yen
depreciates in value relative to the U.S. dollar, then a dollar is able to purchase more yen. A 10

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percent depreciation or devaluation of the yen, for example, would mean that the price of one
U.S. dollar increased to 110 yen.
One effect of currency depreciation is to make all imports more expensive in the country
itself. If, for example, the yen depreciates by 10 percent from an initial value of 100 yen per dollar,
and the price of a ton of U.S. beef on world markets is $2,000, then the price of that ton of beef in
Japan would increase from 200,000 yen to 220,000 yen. A policy that deliberately lowers the
exchange rate of a country’s currency will, therefore, inhibit imports of agricultural commodities,
as well as imports of all other commodities. Thus, countries that pursue deliberate policies of
undervaluing their currency in international financial markets are not usually targeting agricultural
imports.
Some countries have targeted specific types of imports through implementing multiple
exchange rate policy under which importers were required to pay different exchange rates for
foreign currency depending on the commodities they were importing. The objectives of such
programs have been to reduce balance of payments problems and to raise revenues for the
government. Multiple exchange rate programs were rare in the 1990s, and generally have not
been utilized by developed economies.
Finally, exchange rate policies are usually not sector-specific. In the United States, they are
clearly under the purview of the Federal Reserve Board and, as such, will not likely be a major
issue for the 2002 Farm Bill. There have been many calls in recent congressional testimony,
however, to offset the negative impacts caused by a strengthening US dollar with counter-
cyclical payments to export dependent agricultural products.
The Precautionary Principle and Sanitary and Phytosanitary Barriers to Trade : The precautionary
principle, or foresight planning, has recently been frequently proposed as a justification for
government restrictions on trade in the context of environmental and health concerns, often
regardless of cost or scientific evidence. It was first proposed as a household management
technique in the 1930s in Germany, and included elements of prevention, cost effectiveness, and
ethical responsibility to maintain natural systems (O’Riordan and Cameron). In the context of
managing environmental uncertainty, the principle enjoyed a resurgence of popularity during a
meeting of the U.N. World Charter for Nature (of which the U.S. is only an observer) in 1982. Its use
was re-endorsed by the U.N. Convention on Bio-diversity in 1992, and again in Montreal, Canada
in January 2000.
The precautionary principle has been interpreted by some to mean that new chemicals
and technologies should be considered dangerous until proven otherwise. It therefore requires
those responsible for an activity or process to establish its harmlessness and to be liable if damage
occurs. Most recent attempts to invoke the principle have cited the use of toxic substances,
exploitation of natural resources, and environmental degradation. Concerns about species
extinction, high rates of birth defects, learning deficiencies, cancer, climate change, ozone
depletion, and contamination with toxic chemicals and nuclear materials have also been used to
justify trade and other government restrictions on the basis of the precautionary principle. Thus,
countries seeking more open trading regimes have been concerned that the precautionary
principle will simply be used to justify nontariff trade barriers. For example, rigid adherence to the
precautionary principle could lead to trade embargoes on products such as genetically modified
oil seeds with little or no reliance on scientific analysis to justify market closure.
Sometimes, restrictions on imports from certain places are fully consistent with protecting
consumers, the environment, or agriculture from harmful diseases or pests that may accompany
the imported product. The WTO Sanitary and Phytosanitary (SPS) provisions on technical trade
rules specifically recognize that all countries feel a responsibility to secure their borders against the
importation of unsafe products. Prior to 1994, however, such barriers were often simply used as
excuses to keep out a product for which there was no real evidence of any problem. These phony
technical barriers were just an excuse to keep out competitive products. The current WTO
agreement requires that whenever a technical barrier is challenged, a member country must

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show that the barrier has solid scientific justification and restricts trade as little as possible to
achieve its scientific objectives. This requirement has resulted in a number of barriers being relaxed
around the world. It should be emphasized that WTO rules do not require member countries to
harmonize rules or adopt international standards -- only that there must be some scientific basis for
the rules that are adopted. Thus, any options for sanitary and phytosanitary initiatives considered
in the 2002 Farm Bill must be based on sound science and they do not have to be harmonized
with the initiatives of other countries.
WTO TARIFF POLICY
The WTO provides quantitative information in relation to economic and trade policy issues. Its
data-bases and publications provide access to data on trade flows, tariffs, non-tariff measures
(NTMs) and trade in value added.
Visualize three types of tariff viz. Most Favored Nation (MFN), Bound Tariff (BND) and Effectively
Applied (AHS). Also explore Bound overhang for various countries.
 Most-Favored Nation Tariffs : In current usage, MFN tariffs are what countries promise to
impose on imports from other members of the WTO, unless the country is part of a
preferential trade agreement (such as a free trade area or customs union). This means that,
in practice, MFN rates are the highest (most restrictive) that WTO members charge one
another.
Some countries impose higher tariffs on countries that are not part of the WTO. In
some rare cases, WTO members/GATT contracting parties have invoked the "Non-
Application Clause" of WTO/GATT agreements and chosen not to extend MFN treatment to
certain other countries.
 Preferential Tariffs: Virtually all countries in the world joined at least one preferential trade
agreement, under which they promise to give another country's products lower tariffs than
their MFN rate. In a customs union (such as the Southern Africa Customs Union or the
European Community) or a free trade area (e.g., NAFTA), the preferential tariff rate is zero
on essentially all products. These agreements are reciprocal: all parties agree to give each
other the benefits of lower tariffs. Some agreements specify that members will receive a
percentage reduction from the MFN tariff, but not necessarily zero tariffs. Preferences
therefore differ between partners and agreements. Many countries, particularly the
wealthier ones, give developing countriesunilateral preferential treatment, rather than
through a reciprocal agreement. The largest of these programs is the Generalized System
of Preferences (GSP), which was initiated in the 1960s. The European Union, Japan, United
States offer multiple unilateral preference programs. The EU's Everything But Arms (EBA)
program is one example. Exporting countries may have access to several different
preference programs from a given importing partner and for a given product.
 Bound Tariffs: Bound tariffs are specific commitments made by individual WTO member
governments. The bound tariff is the maximum MFN tariff level for a given commodity line.
When countries join the WTO or when WTO members negotiate tariff levels with each other
during trade rounds, they make agreements about bound tariff rates, rather than actually
applied rates.
Bound tariffs are not necessarily the rate that a WTO member applies in practice to
other WTO members' products. Members have the flexibility increase or decrease their
tariffs (on a non-discriminatory basis) so long as they didn't raise them above their bound
levels. If one WTO member raises applied tariffs above their bound level, other WTO
members can take the country to dispute settlement. If the country did not reduced
applied tariffs below their bound levels, other countries could request compensation in the
form of higher tariffs of their own. In other words, the applied tariff is less than or equal to
the bound tariff in practice for any particular product.
The gap between the bound and applied MFN rates is called the binding
overhang. Trade economists argue that a large binding overhang makes a country's trade
policies less predictable. This gap tends to be small on average in industrial countries and
often fairly large in developing countries

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The binding coverage the share of tariff lines with WTO-bound rates also varies
across countries. Until the Uruguay Round of the GATT, which ended in 1994, countries
agreed to bind tariffs only on manufactured goods; trade in agricultural products was
excluded from the GATT when it was written in the late-1940s. Even within manufactured
products, countries were not obligated to bind all tariff lines. Reflecting their relative lack of
participation in previous trade rounds, developing countries tended to bind fewer tariff lines
than industrial countries. During the Uruguay Round, countries committed to bind tariffs on
all agricultural products. New members of the WTO have been asked to bind all
manufactured tariff lines as well.
The binding coverage varies by region. In Latin America, practically all countries
bind all tariff lines. In Asia, the binding coverage varies from less than 15 percent in
Bangladesh to 100 percent in Mongolia.
Comparing Types of Tariffs : The 3 types of tariffs may exist for the same commodity line. In general,
the bound rate is the highest tariff, the preferential the lowest one, and the MFN applied is
generally somewhere in between the other two. When analyzing the effects of preferential tariffs
on trade flows you will need to be careful with assumptions about which tariff rate is actually
applied to a particular import. The importing country will apply the MFN tariff if the product fails to
meet the country's rules that determine the product's country of origin. For example, some former
European colonies find it easier to satisfy the rules of origin under the Cotonou Agreement rather
than the Everything But Arms (EBA) program, even where preferential tariffs are lower under the
EBA.
QUOTA
A quota is a limit to the quantity coming into a country.
With no trade, equilibrium market price in the

country will exist at the price which equates
domestic demand and domestic supply, at P, and
with output at Q. However, the world price is likely
to be lower, at P1, than the price in a country that
does not trade. If the country is opened up to free
trade from the rest of the world, the world supply
curve will be perfectly elastic at the world price, P1.
The new equilibrium price is P1 and output is Q1.
The domestic share of output is now Q2, compared
with Q, the self-sufficient quantity. The amount
imported is the distance Q2 to Q1.
Imposing a quota
In an attempt to protect domestic producers, a
quota of Q2 to Q3 may be imposed on imports. This
enables the domestic share of output to rise to 0 to
Q2, plus Q3 to Q4.

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The quota creates a relative shortage and

drives the price up to P2, with total output falling to
Q4. The amount imported falls to the quota level. It
is this price rise that provides an incentive for less
efficient domestic firms to increase their output.
One of the key differences between a tariff

and a quota is that the welfare loss associated with
a quota may be greater because there is no tax
revenue earned by a government. Because of this,
quotas are less frequently used than tariffs.
TARIFF AND QUOTA IN MONOPOLISTIC MARKETS
The starting point for the “new” international economics was the empirical finding that
much of international trade involved the simultaneous exchange of similar goods, that is, intra-
industry trade rather than the inter-industry specialization and trade suggested by traditional
theories. Modeling international trade in a monopolistic-competition setting (that is, a large
number of producers making differentiated varieties of a product under conditions of free entry).
The literature on monopolistic competition reflects these origins insofar as many contributions are
intended to show the possibility of intra-industry trade, rather than to focus on trade policy.
Monopolistic competition is easier to model than oligopoly, because strategic interactions

among firms are negligible. Free entry leads to equilibrium in which each firm maximizes profits
(MC= MR) without making monopoly profits (price - AC). Product differentiation means that no
firm faces perfectly elastic demand for its product, so price is above marginal cost. The simple
message is that, compared to perfect competition, monopolistic competition introduces an
element of inefficiency; firms do not produce at the minimum point on their average cost curve,
and, at the margin, the social benefits from an extra unit exceed the social costs.
The 1990s have seen widespread tariffication for the members of GATT and later WTO. This
process of converting quotas, VERs, import licenses and other trade barriers into their tariff import-
equivalents has been endorsed 16 by governments and economists alike. In a world of
monopolistic competition, tariffication may cause a welfare reduction, depending on the method
of tariffication (ad valorem versus specific tariffs) and the nature of the initial trade protection
regime (sold versus shared quotas). The distinction into sold and shared quotas is driven by the
property rights to the quantiative restriction. In particular with clear property rights a quota can be
sold and entry be limited such that rents accrue. However, without clear property rights – shared
quotas – a quantitative restriction suffers from the ‘tragedy of the commons’ where excessive
market entry reduces the sales of each firm such that neither rents nor revenue can be harvested.
The model of Krugman (1980 and 1981). In a symmetric, two country, general equilibrium
model, the case of bilateral tariffication of a sold quota and a shared quota is addressed. All
results are obtained under the assumption of complete redistribution of all tariff revenues and
quota rents. The main results of this analysis are that, under the assumption of monopolistic
competition, sold and shared quotas and their import-equivalent tariffs can result in different
effects in terms of prices, the number of firms/product variants and the output per firm. In
particular, in the traded goods sector a sold quota (shared quota) results in higher (the same)

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prices, less (the same) output per firm, and an even higher (lower) number of firms than under free
trade. Enforcing the same amount of total imports via an ad valorem tariff results in the same
number of firms as the shared quota (hence, also the same output per firm), however prices are
higher than in the shared quota case. Enforcing the same amount of total imports via a specific
tariff results in exactly the same equilibrium as under the binding quota.
In terms of the effect on consumers’ utility, it is established that utility under specific
tariffication – though less than under free trade – is higher than under ad valorem tariffication; a
result that is opposed to existing findings in oligopoly or monopoly settings. Furthermore, utility
under ad valorem tariffication is identical to utility under a shared quota, whereas utility under
specific tariffication is identical to utility under a sold quota. This paper has thus established that
when evaluating the welfare impact of tariffication for industries that feature monopolistic
competition, it is important to distinguish between both the tariff tool used and the initial trade
regime. Nevertheless, despite the findings of this paper, ad valorem tariffs might be preferred to
specific tariffs on grounds of transparency, ease of administration, and fairness – issues left aside in
the present analysis. An undue reliance on ad valorem tariffication under the rules of WTO might
have an opportunity cost in terms of the lost number of product variants and could even be
welfare reducing.
DUMPING AND ANTIDUMPING DUTY UNDER THE WTO
Dumping is, in general, a situation of international price discrimination, where the price of a
product when sold in the importing country is less than the price of that product in the market of
the exporting country. Thus, in the simplest of cases, one identifies dumping simply by comparing
prices in two markets. However, the situation is rarely, if ever, that simple, and in most cases it is
necessary to undertake a series of complex analytical steps in order to determine the appropriate
price in the market of the exporting country (known as the “normal value”) and the appropriate
price in the market of the importing country (known as the “export price”) so as to be able to
undertake an appropriate comparison.
Article VI of GATT and the Anti-Dumping Agreement

The GATT 1994 sets forth a number of basic principles applicable in trade between
Members of the WTO, including the “most favoured nation” principle. It also requires that imported
products not be subject to internal taxes or other changes in excess of those imposed on
domestic goods, and that imported goods in other respects be accorded treatment no less
favourable than domestic goods under domestic laws and regulations, and establishes rules
regarding quantitative restrictions, fees and formalities related to importation, and customs
valuation. Members of the WTO also agreed to the establishment of schedules of bound tariff
rates. Article VI of GATT 1994, on the other hand, explicitly authorizes the imposition of a specific
anti-dumping duty on imports from a particular source, in excess of bound rates, in cases where
dumping causes or threatens injury to a domestic industry, or materially retards the establishment
of a domestic industry.
The Agreement on Implementation of Article VI of GATT 1994, commonly known as the Anti-
Dumping Agreement, provides further elaboration on the basic principles set forth in Article VI
itself, to govern the investigation, determination, and application, of anti-dumping duties.
SUBSIDIES AND COUNTERVAILING DUTIES UNDER THE WTO
Article 1: Definition of a Subsidy

1.1 For the purpose of this Agreement, a subsidy shall be deemed to exist if:
(a)(1) there is a financial contribution by a government or any public body within the territory of
a Member (referred to in this Agreement as “government”), i.e. where:

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(i) a government practice involves a direct transfer of funds (e.g. grants, loans, and
equity infusion), potential direct transfers of funds or liabilities (e.g. loan guarantees);
(ii) government revenue that is otherwise due is foregone or not collected (e.g. fiscal
incentives such as tax credits);
(iii) a government provides goods or services other than general infrastructure, or
purchases goods;
(iv) a government makes payments to a funding mechanism, or entrusts or directs a
private body to carry out one or more of the type of functions illustrated in (i) to (iii) above
which would normally be vested in the government and the practice, in no real sense,
differs from practices normally followed by governments;
There are four types of “specificity” within the meaning of the Uruguay Round Agreement on
Subsidies and Countervailing Measures [ASCM]:
 Enterprise-specificity. A government targets a particular company or companies for
subsidization;
 Industry-specificity. A government targets a particular sector or sectors for subsidization.
 Regional specificity. A government targets producers in specified parts of its territory for
subsidization.
 Prohibited subsidies. A government targets export goods or goods using domestic inputs for
subsidization
De Jure Specificity: Where a subsidy is explicitly limited sectorally or regionally, either by the
granting authority, or by legislation, it is de jure specific. On the other hand, where the authority, or
legislation, establish objective criteria or conditions governing the eligibility for, and amount of, a
subsidy, specificity shall not exist, provided that the eligibility is automatic and the criteria and
conditions are strictly adhered to.
De Facto Specificity: It is quite possible that a subsidy at face value is non-specific, but in fact is
operated in a specific manner. In the analysis, account must be taken of the extent of
diversification of economic activities within the jurisdiction as well as of the length of time during
which the subsidy programme has been in operation. The analysis may lead to a finding of de
facto specificity.
Prohibited Subsidies
Prohibited - red light – subsidies, as defined in Article 3, are by definition specific and therefore
countervailable.
Article 3 singles out two types of subsidies: export subsidies and import substitution subsidies.
 Export Subsidies : Export subsidies are subsidies contingent, in law or in fact, whether solely
or as one of several other conditions, upon export performance, including the programmes
enumerated in the Illustrative List of export subsidies in Annex I. de facto export subsidies
exist when the facts demonstrate that the granting of a subsidy, without having been
made legally contingent upon export performance, is in fact tied to actual or anticipated
exportation or export earnings; on the other hand, the fact that a subsidy is granted to
enterprises which export shall not for that reason alone be considered to be an export
subsidy. Virtually every country in the world has a duty drawback or exemption scheme.
The basic concept underlying such schemes is that import duties on imports of raw
materials are either not payable or refundable on the condition that such raw materials are
used in the manufacture of products, which are consequently exported. Duty drawback
schemes assume special importance in cases where import duties are still high, as is often
the case for developing countries.
 Import Substitution Subsidies This second category of prohibited subsidies is defined as

subsidies contingent whether solely or as one of several other conditions, upon the use of
domestic over imported goods. Often, these take the form of local content requirements.
However, Article 3.1(b) talks about ‘goods’ and as local content requirements often

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comprise not only goods, but also other costs items; the requirements themselves will need
to be scrutinized in detail.
There can be benefits to subsidies, which the WTO recognises. Subsidies can achieve important
objectives like correcting regional imbalances, providing seed funding for early-stage
technologies or providing pubic goods where the market would fail to do so. They can also be
crucial during big economic crises – the coronavirus pandemic has led most governments to
provide large subsidies to support businesses during the downturn, including some targeted on
specific industries (such as the fishing industry in the UK).
However, subsidies are often economically wasteful. Using state resource to prop up a failing
company could come at the expense of consumers who would benefit if another company
could provide a better service without the support of taxpayers’ money. Supporting failing
businesses also prevents workers and capital moving to other more productive activities, making
the economy less dynamic and less efficient. It can also be inefficient for the state to subsidise
something that would have attracted private investment anyway.
Non-Actionable Subsidies
First, non-specific subsidies are not actionable. Second, certain narrowly defined R&D,
environmental and regional subsidies are non-actionable (these expired on 31 December 1999),
on the condition that they are notified in advance to the Subsidies Committee. Non-actionable
subsidies are often referred to as green light subsidies.
 The World Trade Organization (WTO) allows countries to implement antisubsidy

legislation. The law allows a country to place a countervailing duty (CVD) on imports
when a foreign government subsidizes exports of the product, which in turn causes injury
to the import-competing firms. The countervailing duty is a tariff designed to “counter”
the effects of the foreign export subsidy
 An antisubsidy law, allowable under the WTO agreement, enables countries to
apply a countervailing duty (CVD)—that is, an import tariff—equal in value to the
export subsidy that is shown to be in place by the exporting country in a particular
product market.
 A CVD will cause the price of the product in both countries to revert to the free
trade price.
 A CVD will raise producer surplus and lower consumer surplus in the import country
relative to the equilibrium with just the export subsidy in place.
 The net effect of a CVD and the foreign export subsidy together is a transfer of
income from the export country’s government to the import country’s government.
A special duty levied for the purpose of offsetting any bounty or subsidy bestowed, directly,
or indirectly, upon the manufacture, production or export of any merchandise. No WTO member
may levy any countervailing duty on the importation of any product of the territory of another
unless it determines that the effect of the subsidization is such as to cause or threaten material
injury to an established domestic industry, or is such as to retard materially the establishment of a
domestic industry.
The following Articles of the ASCM contain important procedural provisions as far as CVD
action is concerned:
Article 11 Initiation and subsequent investigation, including the standing determination
Article 12 Evidence, including due process rights of interested parties
Article 13 Pre-initiation consultations
Article 17 Provisional measures
Article 18 Undertakings
Article 19 Imposition and collection of countervailing duties
Article 20 Retroactivity
Article 21 Duration and review of countervailing duties and undertakings
Article 22 Public notice and explanation of determinations, pertaining to initiation,
imposition of preliminary and final measures
Article 23 Judicial review

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The general tendency of Panels has been to interpret these provisions strictly and little deference
is given to national implementation shortcuts that do not do justice to their plain meaning
A countervailing duty case normally starts with the official submission of a written complaint by the
domestic industry to the importing country authorities Article 11 ASCM 28 Dispute Settlement that
injurious subsidization is taking place. This complaint is called the application in the ASCM.
EXPORT TAXES, EXPORT SUBSIDIES,
 An export tax will lower the domestic  An export subsidy will raise the
price and, in the case of a large country, domestic price and, in the case of a
raise the foreign price. large country, reduce the foreign
 An export tax will decrease the quantity price.
of exports.  An export subsidy will increase the
 The export tax will drive a price wedge, quantity of exports.
equal to the tax rate, between the  The export subsidy will drive a price
domestic price and the foreign price of wedge, equal to the subsidy value,
the product. between the foreign price and the
 With the export tax in place in a two- domestic price of the product.
country model, export supply at the  With the export subsidy in place in a
lower domestic price will equal import two-country model, export supply at
demand at the higher foreign price. the higher domestic price will equal
 An export tax raises consumer surplus import demand at the lower foreign
and lowers producer surplus in the price.
exporter market.  An export subsidy lowers consumer
 An export tax lowers producer surplus in surplus and raises producer surplus in
the export market and raises it in the the exporter market.
import country market.  An export subsidy raises producer
 National welfare may rise or fall when a surplus in the export market and
large country implements an export tax. lowers it in the import country market.
 For any country that is large in an export  National welfare falls when a large
product, there is a positive optimal country implements an export subsidy.
export tax.  National welfare in the importing
 National welfare in the importing country country rises when a large exporting
falls when a large exporting country country implements an export subsidy.
implements an export tax.  An export subsidy of any size will
 An export tax of any size will reduce reduce world production and
world production and consumption consumption efficiency and thus
efficiency and thus cause world welfare cause world welfare to fall.
to fall.
Economic Integration - Custom Unions and Free Trade Areas

A customs union is an agreement between two or more neighboring countries to remove
trade barriers, reduce or abolish customs duty, and eliminate quotas. Such unions were defined
by the General Agreement on Tariffs and Trade (GATT) and are the third stage of economic
integration.
Unlike in free trade agreements, a common external tariff is imposed on non-members of
the union. When countries outside the union trade with countries in the customs union, they need
to make a single payment (duty fee) for the goods that have crossed the border. Once inside the
union, they can trade freely with no added tariffs.

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The purpose of a customs union is to make it easier for member countries to trade freely
with each other. The union reduces the administrative and financial burden of barrier trading and
fosters economic cooperation among nations.
However, member countries do not enjoy the liberty to form their own trade deals. The
countries in the customs union usually restructure their domestic economy and economic policies
in order to maximize their gain from membership in the union. The European Union is the largest
customs union in the world in terms of the economic output of its members.
A customs union generates trade creation and diversion that helps with economic integration.
Below are the advantages and disadvantages of customs unions.
Advantages of Custom Unions
Customs unions offer the following benefits:
1. Increase in trade flows and economic integration : The main effect of a free-trade
agreement is that it increases trade between member countries. It helps improve the
allocation of scarce resources that satisfy the wants and needs of consumers and boosts
foreign direct investment (FDI). Customs unions lead to better economic integration and
political cooperation between nations and the creation of a common market, monetary
union, and fiscal union.
2. Trade creation and trade diversion: The effectiveness of a customs union is measured in
terms of trade creation and trade diversion. Trade creation occurs when the more efficient
members of the union sell to less efficient members, leading to a better allocation of
resources.
Trade diversion occurs when efficient non-member countries sell fewer goods to member
countries because of external tariffs. It gives less efficient countries in the union the
opportunity to capitalize on their position and sell more goods within the union. If the gains
from trade creation exceed the losses from trade diversion, that leads to increased
economic welfare among member countries.
3. Reduces trade deflection: One of the main reasons a customs union is favored over a
free trade agreement is because the former solves the problem of trade deflection. This
occurs when a non-member country sells its goods to a low-tariff FTA (free trade
agreement) country, which then resells to a high-tariff FTA country, leading to trade
distortions. The presence of a common external tariff in customs unions helps avoid
problems that arise from tariff differentials.
Disadvantages of Customs Unions
Along with the advantages, customs unions also come with a few drawbacks:
1. Loss of economic sovereignty: Members of a customs union are required to negotiate
with non-member countries and organizations such as the WTO. This is necessary to
maintain a customs union; however, it also means that individual member countries are not
free to negotiate their own deals.
If a country wants to protect an infant industry in its market, it is unable to do so by imposing
tariffs or other protective barriers due to the liberal trading policies. Similarly, if a country
wants to liberalize its trade outside the union, it is unable to do this due to the common
external tariff.
2. Distribution of tariff revenues: Some countries in the union do not receive a fair share of
tariff revenues. This is common among countries like the UK that trade relatively more with
countries outside the union. Around 20%-25% of the tariff revenue is retained by the
member who collects the revenue. It is estimated that the cost of collecting this revenue
exceeds the actual revenue collected.

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3. Complexity of setting the tariff rate: A common problem faced by customs unions is the
complexity of setting the applicable tariff rate. The process is very costly and time-
consuming. Member countries often find it hard to forgo the trade of certain goods or
services because another country in the union is producing it more efficiently. The problem
is usually faced by developing countries and is a major issue that the UK is dealing with
during Brexit.
FREE TRADE AREA

A free trade area (FTA) refers to a specific region wherein a group of countries within the
said region signs an agreement that seals the economic cooperation among them. The FTA’s
main aims are to bring down barriers in trading, specifically tariffs and import quotas, and
encourage the free trade of goods and services among its member countries
Free trade occurs when there are agreements between two or more countries to reduce barriers
to the import and export markets. These treaties usually involve a mutual reduction in duties, taxes,
and tariffs so that the economies of every country can benefit from the various trading
opportunities. One of the most well-known examples of this approach is the USMC Agreement,
which replaces NAFTA to govern free trade across North America.
Free trade agreements allow a country to have access to more markets throughout the
world. It can encourage local industries to improve their competition while relying less on subsidies
from the government. It is a process that can lead to the opening of new markets, and
improvement in GDP figures, and new investment opportunities.
When free trade involves a developed country and one that has yet to fully industrialize, then
there can be an exploitation of natural resources that occurs. Some households might see the
traditional livelihood fade away for modern jobs. It can even cause problems in the domestic
employment sector for all involved parties.
The advantages and disadvantages of free trade show us that any nation deciding to enter into
an agreement must take proactive steps to guard their resources and people against exploitation
without resorting to protectionism.
Advantages of Free Trade
1. Free trade creates economic growth opportunities: When countries can freely move products
across borders, then each nation gets to take advantage of the manufacturing, commercial, and
industrial strengths of every other economy in the agreement. That means there are lower cost
burdens to worry about with each transaction, prices stay lower, and there can be healthy
competition in the market.
2. There are more opportunities for foreign direct investment: When nations remove the barriers
that are in place for free trade, then more companies are willing to invest in other countries. There
are new investments, partnerships, and opportunities that develop because of this approach in
markets of any size. That means you can focus on creating deeper, more fulfilling relationships
with other governments who share the same perspective of the world today. Countries with
shared borders can promote a better standard of living because it is harder to go to war with
someone who is your economic partner.
3. It lowers the taxes that consumers and businesses pay: The inclusion of tax and investment
protection in free trade agreements make it possible to guard the interests of local business
owners more efficiently. When these safeguards disappear, then the result tends to favor the
consumer because more competition from global agencies can happen at the level of
consumption. This advantage reduces stagnation within markets, though at the risk of eliminating
smaller businesses from the equation. Lower assessments and fewer restrictions to entry can also
reduce pricing for customers.
4. Fewer government expenditures occur because of free trade: Several domestic industries
receive financial benefits from the government, including farming and other areas of agriculture.
This money goes from the taxpayer to the producer as a way to counter the impact that tariffs
have on the import and export markets.
By injecting new best practices and creating new competencies into the domestic delivery
systems, less government money is necessary to keep prices affordable at the local level. This

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advantage means that the tax revenues can go toward infrastructure needs, social programs,
defense, or other community requirements without keeping unprofitable business ventures afloat.
5. It creates better goods: When free trade occurs, then each market receives more access to
higher-quality goods at lower prices. Cheaper imports help to ease the pressure of inflation in the
United States because of the American relationships with China and Mexico. Prices are held down
by over 2% for every 1% share in the market of imports that come from countries with a lower
income level. That means the average U.S. household has more money to spend on other
products. The requirement of innovation here means that businesses are constantly finding ways
to solve problems for consumers.
6. Free trade involves more than just consumer goods: At least 50% of the imports to the United
States each year are not consumer goods. They are inputs for producers who are based in the U.S.
so that domestic production costs can go down. This advantage also promotes economic growth
because it diversifies the supply chain for an organization of any size. Even micro-businesses,
freelancers, and gig specialists can benefit from this advantage because the Internet provides
immediate access to cheaper goods, new research, and service expansion opportunities.
7. It helps the people who have the least amount of money to spend: Some people believe that
more wealth can only come when a country can export more of its goods or services to other
nations. The economic reality of free trade is that it is the total level of imports and exports that
accurately reflects prosperity. When the people at the lower tier of the national income levels
have more money to spend, then the entire economy benefits. That’s why the removal of tariffs is
such an integral part of this process.
Cheap sneakers that come from China might have an import as high as 60% some years in the
United States. If you were to purchase a part of Italian leather dress shoes, the tariff might be less
than 9%. Regular drinking glasses have a tariff of almost 30%, but crystal glasses have one at 3%.
When more Americans can buy cheap imports, then it encourages non-Americans to invest more
in the country.
8. Free trade creates more opportunities to solicit workers with expertise: Automakers sent jobs to
Mexico because of NAFTA, and then decided to import the vehicles back to the United States
because of the favorable tariff policies. Although this issue took some jobs from American laborers,
it also gave companies the chance to find workers from almost anywhere in the world with the
right levels of expertise. By looking to foreign markets for this help, the costs stay down for the
manufacturing process to maintain pricing at competitive levels.
This advantage also means that multiple economies around the world can benefit from this
approach. It is one of the reasons why India has one of the fastest-growing Middle Class sectors in
the world today.
9. Experts get to have access to the most resources with free trade: Free trade agreements
attempt to put the most opportunities into the hands of the people who can create successful
outcomes. There are no border restrictions to this advantage. That’s why anyone can become
whatever they want to be in life if they have access to an economy built on this principle. The
amount of competition that becomes available is the primary driver of what local populations
think is possible. Anyone can become what they want to be in life if they work hard enough to
reach their goals thanks to the fewer economic restrictions that exist with this opportunity.
Disadvantages of Free Trade
1. Free trade does not create more jobs: It is a myth to say that free trade encourages employers
to send their jobs overseas. It would also be incorrect to say that the increase in competition
would create more employment opportunities. It reduces the number of opportunities that are
available in inefficient industries. The positions that do remain will see a boost to their overall
wages and an improvement to the standard of living, but it doesn’t ship the unwanted jobs
overseas. It eliminates the policy of saving a job at any cost, even if opportunities are shrinking in
that industry.
Free trade is responsible for 20% of the job losses that occur in the world today. When these
agreements are made with highly capable countries or those with relatively few products, then
there might be zero job creation measures that develop over time.
2. It encourages more urbanization : When you look at a map of the United States, you will find an
interesting trend. The households who live in urban areas typically lean to the political left, while
those in the rural regions vote more toward the right. Free trade encourages families to move

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away from agricultural work because it is more efficient to let factory farms take care of the food
supply. That means more people move into the cities, encouraging urbanization so that there isn’t
any money saved from the efforts to keep trading lanes open.
3. There are more risks for currency manipulation: When China allegedly made an effort to
devalue its currency in response to U.S. tariff demands, the stock market had its worst day in 2019.
Then the reality of the situation set in for investors. Lower yuan values make Chinese goods
cheaper for American consumers. It counters the process of a tariff by creating lower prices
through monetary policy. That also means Chinese consumers purchasing American goods must
pay more for their items. When this disadvantage is considered, then one set of consumers always
win and the other always lose. Free trade attempts to regulate this process, but the agreements
cannot account for unanticipated manipulation that occurs outside of the system.
4. There can be fewer intellectual property protections because of free trade: IP rights are not
always taken as seriously by international governments or business rivals as they are in a firm’s
home nation. Patents, processes, and other inventions, including branding, graphic displays, and
imaging, are sometimes copied in the free trade environment. This disadvantage lessens a
company’s opportunities to bring new jobs at the local level while providing reasonable wages.
Even when there are IP rights protections in place because of a free trade agreement, there are
guarantees that foreign governments will enforce the laws with the same rigor as the local
government.
5. The developing world doesn’t always have worker safeguards in place: Developing countries
and emerging markets rarely have the same laws in place that protect employee wages or the
conditions in the workplace. Some nations even permit the hiring of children for factory jobs or
heavy labor needs that place them in dangerous, sub-standard conditions. Some workers in
Jordan that produce clothing for American retailers might work 20-hour days, not receive a
paycheck for months, and then face jail time or physical abuse from supervisors if they complain.
The reason for this disadvantage involves the competition requirement for free trade. The goal is
to create an overall lack of restrictions so that consumers can watch their spending. That means
compromises are possible, promoting poor working conditions that workers must endure if they
want to continue earning a living for their family.
6. Environmental protections are minimal in free trade: Free trade agreements rarely protect the
environment. The goal for businesses in developed nations is to exploit the natural resources in
other regions where restrictions or regulations may not be as stringent. Then the fastest, cheapest
methods of creating goods or performing services becomes the point of emphasis. Strip mining,
clearcut logging, and other problematic behaviors can increase global emissions, even though
the activities might not count on their domestic scoreboard.
The developing world often sells short-term gains for long-term problems. Money from the natural
resource trading can fund government operations or encourage corruption, allowing the wealthy
to benefit while the working poor struggles to survive. Unless new industries develop, the money
from this initial investment will eventually disappear.
7. There can be fewer revenue generation opportunities in free trade: Higher competition levels
can create lower revenue potential in the industries impacted by free trade the most. Some firms,
such as Walmart, are large enough to operate on a massive scale so that they can avoid this
disadvantage. Those razor-thin margins make it a challenge for small business owners to provide
meaningful services.
This disadvantage even applies to the gig economy. When a service provider in the United States
charges $30 for a service, someone in a developing country might get the same value from a $5
purchase. That cost difference makes it impossible for the one provider to stay competitive if the
quality of services is equal.
8. It can stiffen international competition for domestic economies: Free trade agreements only
guarantee that there are gains that occur because of enhanced activities in the import and
export markets. There is no way to determine who will benefit the most from an arrangement with
few, if any restrictions. Rising productivity in foreign countries might cause induced changes to
grow, which means the international competition in some industries can put additional pressure
on the overall market. Because free trade doesn’t assign specific industries to any particular
country, there is no way to determine in advance if a positive outcome is possible.

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9. Customers are left at the mercy of the largest providers: When companies grow larger, then
they can accrue more money. When there is additional wealth available to an agency, then
there is enough influence available to start shaping economic policies. Large multinational firms
have the power to offer lower prices, but many of them choose not to do so because there is no
need for that action to occur. Customers are forced into an economy of scale, purchasing items
from an oligarchy where price controls may be non-existent. That means your personal access to
affordable goods is entirely reliant on the generosity of the C-Suites of each agency for every
industry.
10. There can be opportunities for immigration outsourcing: When NAFTA first came about, the free
trade agreement made it easier for people in North America to travel or immigrate to all three
countries. If you had a specific skill set that was in demand, then your living situation could be
expedited. The current version of the USMCA allows for this to some extent as well. Companies
don’t always outsource jobs, but people can outsource themselves because of the loosening of
population movement restrictions in a free market.
Major Regional Trade Agreements
There exist different choices of instruments to alter the quantum of trade and trade direction
such as export subsidies, tariffs, non-tariff barriers viz import licensing, quota shares, product
specific quotas, labeling condition, product standards etc. Regional Trade Agreement (RTA) is
another type of instrument to influence trade pattern of an economy. According to WTO
Regional Trade Agreement (RTAs) are defined as reciprocal trade agreements amongst two
or more partners, including free trade agreements and custom unions. Free trade agreements
and partial scope agreements accounts for around 90% of the total RTAs, while customs
unions account for 10%. When it comes to the effects of regional trade agreements on trade
the empirical results are mixed for different RTAs.
Regional trade agreements in general exist in five types which are:
(a) In custom union, two or more nations who form a union eliminate tariffs and non-tariff barriers
among themselves but maintain and implement separate tariffs for outside nation and
simultaneously the member countries agree to maintain common external tariffs. Few
examples of custom union are East African community (EAC), European Union Custom Union
(EUCU), Southern African Custom Union SACU.
(b) Free trade agreement is almost similar to custom union but member countries do not maintain
common external tariffs. Some of free trade agreement includes North Area Free Trade Area
(NAFTA), AFTA, SAFTA, COMESA, and GAFTA.
(c) Common market is the platform where there is a free movement of capital and services but
major trade barrier remains. In general all tariff and quotas are eliminated for imported goods
traded within the members but non-tariff barrier remains. Major focus of common market is
economic convergence and the formation of integrated single market. ASEAN and
MERCOSUR are the example of common market.
(d) Economic union is another form of regional trade bloc which is an amalgamation of custom
union and common market where the members of the trading bloc practice common policies
on free movement of goods and services, factor of production and on product regulation and
also follow common external trade policies. Caribbean single market economy (CSME),
European Union (EU) is the RTAs which comes under economic union.
(e) Preferential trade agreement is another form of union where all the members of that union
lowers the trade barriers Regional trade Agreements though signed amongst nations to realize
mutual gains but it does not guarantee the same because of regional bias.
Welfare effects, which are expected from RTAs depend on whether the surge in trade is primarily
on the expense of non-members. Size of an economy has a vital role in deciding the nature and
objective of RTAs. If a country is small in GDP and area then it will seek to attain social, economic
and political security by forming a bloc with relatively larger economy. Nature and focus of
Regional Trade Agreement around the world differs from each other because of which wide
range of differences has to be taken into considerations while analysing the impact of RTAs.
Pros

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The pros of creating regional agreements include the following:

• Trade creation. These agreements create more opportunities for countries to trade with one
another by removing the barriers to trade and investment. Due to a reduction or removal
of tariffs, cooperation results in cheaper prices for consumers in the bloc countries. Studies
indicate that regional economic integration significantly contributes to the relatively high
growth rates in the less-developed countries.
• Employment opportunities. By removing restrictions on labor movement, economic
integration can help expand job opportunities.
• Consensus and cooperation. Member nations may find it easier to agree with smaller
numbers of countries. Regional understanding and similarities may also facilitate closer
political cooperation.
Cons
The cons involved in creating regional agreements include the following:
• Trade diversion. The flip side to trade creation is trade diversion. Member countries may
trade more with each other than with nonmember nations. This may mean increased trade
with a less efficient or more expensive producer because it is in a member country. In this
sense, weaker companies can be protected inadvertently with the bloc agreement acting
as a trade barrier. In essence, regional agreements have formed new trade barriers with
countries outside of the trading bloc.
• Employment shifts and reductions. Countries may move production to cheaper labor
markets in member countries. Similarly, workers may move to gain access to better jobs
and wages. Sudden shifts in employment can tax the resources of member countries.
• Loss of national sovereignty. With each new round of discussions and agreements within a
regional bloc, nations may find that they have to give up more of their political and
economic rights. In the opening case study, you learned how the economic crisis in
Greece is threatening not only the EU in general but also the rights of Greece and other
member nations to determine their own domestic economic policies.
THE MAJOR REGIONAL TRADE BLOCKS ARE, AS FOLLOWS:
1. ASEAN (Association of Southeast Asian Nations) Established on August 8, 1967, in

Bangkok/Thailand.
Member States: Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines,
Singapore, Thailand, and Vietnam.
Goals: (1) Accelerate economic growth, social progress and cultural development in the region
and (2) Promote regional peace and stability and adhere to United Nations Charter.
Important Indicators: Population 622 million; GDP US$2.6 trillion; and Total Trade US$1 trillion
ASEAN Economic Community (AEC): Learn more about ASEAN Leaders' vision to transform ASEAN
into a single market and production base that is highly competitive and fully integrated into the
global ecomony.
2. EU (European Union) Founded in 1951 by six neighboring states as the European Coal and Steel
Community (ECSC). Over time evolved into the European Economic Community, then the
European Community and, in 1992, was finally transformed into the European Union.
Regional block with the largest number of members states (28). These include Austria, Belgium,
Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece,
Hungary, Ireland,Italy, Latvia, Lithuania, Luxembourg, Malta, Poland, Portugal, Romania, Slovakia,
Slovenia, Spain, Sweden, The Netherlands, and the United Kingdom.
.Goals: Evolved from a regional free-trade association of states into a union of political, economic
and executive connections.
Population estimated at 515 million ; GDP (PPP) estimated at US$19.18 trillion (2016); and
Total Trade US$4.503 trillion (2014 est.) [All figures from CIA World Factbook]
EU-US Free Trade Alliance (TTIP): For updates on negotiations of the Transatlantic Trade and
Investment Partnership (TTIP) between the EU and the USA. BREXIT - All you need to know about
the UK leaving the EU: On 23 June 2016, the United Kingdom voted in a referendum to leave the
European Union after 43 years as a member state. The process was officially initiated on 29 March
2017, indicating that the UK is scheduled to leave the EU on 29 March 2019.

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3. MERCOSUR (Mercado Comun del Cono Sul - Southern Cone Common Market)
Established on 26 March 1991 with the Treaty of Assunción.
Full members include Argentina, Bolivia, Brazil, Paraguay, Uruguay, and Venezuela. Associate
members includeChile, Colombia, Ecuador, and Peru. Associate members have access to
preferential trade but not to tariffbenefits of full members. Guyana and Suriname signed
Framework Agreements in 2013. Mexico, interested inbecoming a member of the region, has an
observer status.
Goals: Integration of member states for acceleration of sustained economic development based
on social justice, environmental protection, and combating poverty.
Population: 295 million people (2014 est.);
GDP (PPP): US$3.2 trillion (Summit of Heads of Member & Associated States, Brazil, July 17, 2015).
4. NAFTA (North American Free Trade Agreement)

Agreement signed on 1 January 1994.
Members: Canada, Mexico, and the United States of America.
Goals: Eliminate trade barriers among member states, promote conditions for free trade, increase
investment opportunities, and protect intellectual property rights.
Population of over 478 million ( The CIA Factbook).
GDP (PPP) US$21.818 trillion
Other regional trade blocks, regional economic partnerships and free trade associations include
the following:
1. ANDEAN (Andean Community Countries) – Bolivia, Colombia, Ecuador, and Peru.
Associate Members: Argentina, Brazil, Chile, Paraguay, and Uruguay.
Observer Countries: Mexico and Panama.
2. BSEC (Organization of the Black Sea Economic Cooperation) – Albania, Armenia,

Azerbaijan, Bulgaria, Georgia, Hellenic Republic, Moldova, Romania, Russian Federation,
Serbia, Turkey, and Ukraine.
3. CARICOM (Caribbean Community) – Antigua & Barbuda, The Bahamas, Barbados, Belize,
Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, Saint Kitts & Nevis, Saint Lucia, Saint
Vincent & The Grenadines, Surinam, and Trinidad & Tobago.
Associate Members: Anguilla, Bermuda, British Virgin Islands, Cayman Islands, and Turks &
Caicos Islands.
4. CIS (Commonwealth of Independent States) Armenia, Azerbaijan, Belarus, Kazakhstan,

Kyrgyz, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.
5. COMESA (Common Market for Eastern and Southern Africa)

Burundi, Comoros, Democratic Republic of the Congo, Djibouti, Egypt, Eritrea, Ethiopia, Kenya,
Libya, Madagascar, Malawi, Mauritius, Rwanda, Seychelles, Sudan, Swaziland, Uganda, Zambia,
Zimbabwe.
7. ECOWAS (Economic Community of West African States)

Benin, Burkina Faso, Cape Verde, The Gambia, Ghana, Guinea, Guinea Bissau, Ivory Coast,
Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, and Togo.
8. Eurasian Economic Union - Armenia, Belarus, Kazakhstan, Kyrgyz, and Russia.
9. EFTA (European Free Trade Association) – Iceland, Liechtenstein, Norway, and Switzerland.
10. GAFTA (Greater Arab Free Trade Area) - Algeria, Bahrain, Egypt, Iraq, Jordan, Kuwait,
Lebanon, Libya,Morocco, Oman, Palestine, Qatar, Saudi Arabia, Sudan, Syria, Tunisia, United
Arab Emirates (UAE), and Yemen. (No official Website found.)

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11. GCC (Gulf Cooperation Council for the Arab States of the Gulf) – Bahrain, Kuwait, Oman,
Qatar, Saudi Arabia, and the United Arab Emirates (UAE).
12. Pacific Community – comprised of the 22 Pacific island countries and territories of American
Samoa, Cook Islands, Fiji Islands, French Polynesia, Guam, Kiribati, Marshall Islands,
Micronesia, Nauru, New Caledonia, Niue, Northern Mariana Islands, Palau, Papua New Guinea,
Pitcairn Islands, Samoa, Solomon Islands, Tokelau, Tonga, Tuvalu, Vanuatu, Wallis and Futuna,
and the founding countries of Australia, France, New Zealand and the United States of America.
13. SAARC (South Asian Association for Regional Cooperation)

Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka.
14. SADC (Southern Africa Development Community)

Angola, Botswana, Democratic Republic of Congo, Lesotho, Madagascar, Malawi, Mauritius,
Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, and Zimbabwe.
15. The Shanghai Cooperation Organisation

China, Kazakhstan, Kyrgyz, Russia, Tajikistan, and Uzbekistan.
Unit 3
Currency and International Finance: Currency market and exchange rate, Spot
and forward markets, Types of Foreign Exchange Transactions – Reading Foreign
Exchange Quotations – Forward and Futures Market – Foreign-Currency Options –
Arbitrage – Speculation and Exchange-Market Stability, Currency market and
basic Central Bank operation, Product market approach to determination of
exchange rate, Asset market approach to determination of exchange rate.
CURRENCY AND INTERNATIONAL FINANCE:

The foreign exchange market is a global online network where traders buy and sell currencies. It
has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m. EST
on Friday because currencies are in high demand. It sets the exchange rates for currencies with
floating rates.
The Forex market has an estimated turnover of $6.6 trillion a day. It is the largest and most liquid
financial market in the world. Demand and supply determine the differences in exchange rates,
which in turn, determine traders’ profits.
This global market has two tiers. The first is the interbank market. It's where the biggest banks
exchange currencies with each other. Even though it only has a few members, the trades are
enormous. As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where companies and individuals
trade. OTC has become very popular since there are now many companies that offer online
trading platforms. New traders, starting with limited capital, need to know more about forex
trading. It’s risky because the forex industry is not highly regulated and provides substantial
leverage.

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The biggest geographic OTC trading center is in the United Kingdom. London dominates the
market. A currency’s quoted price is usually London’s market price.
Foreign exchange trading is a contract between two parties. There are three types of
trades. The spot market is for the currency price at the time of the trade. The forward market is an
agreement to exchange currencies at an agreed-upon price on a future date.
A swap trade involves both. Dealers buy a currency at today's price on the spot market
and sell the same amount in the forward market. This way, they have just limited their risk in the
future. No matter how much the currency falls, they will not lose more than the forward price.
Meanwhile, they can invest the currency they bought on the spot market.
Manipulation Scandal
In 2014, Citigroup, Barclays, JPMorgan Chase, and The Royal Bank of Scotland pled guilty
to illegal manipulation of currency prices. Here's how they did it.
Traders at the banks would collaborate in online chat rooms. One trader would agree to build a
huge position in a currency, then unload it at 4 p.m. London Time each day. That's when the
WM/Reuters fix price is set. That price is based on all the trades taking place in one minute. By
selling a currency during that minute, the trader could lower the fix price. That's the price used to
calculate benchmarks in mutual funds. Traders at the other banks would also profit because they
knew what the fix price would be.
These traders also lied to their clients about currency prices. One Barclays trader explained it as
the “worst price I can put on this where the customer’s decision to trade with me or give me future
business doesn’t change.”
History
For the past 300 years, there has been some form of a foreign exchange market. For most
of U.S. history, the only currency traders were multinational corporations that did business in many
countries. They used forex markets to hedge their exposure to overseas currencies. They could do
so because the U.S. dollar was fixed to the price of gold. According to the gold price history, gold
was the only metal the United States used to back up the value of the nation’s paper currency.
The foreign exchange market didn't take off until 1973. That's when President Nixon completely
untied the value of the dollar to the price of an ounce of gold. The so-called gold standard kept
the dollar at a stable value of 1/35 of an ounce of gold. The history of the gold standard explains
why gold was chosen to back up the dollar.
Once Nixon abolished the gold standard, the dollar's value quickly plummeted. The dollar index
was established to give companies the ability to hedge this risk. Someone created the U.S. Dollar
Index to give them a tradeable platform. Soon, banks, hedge funds, and some speculative
traders entered the market. They were more interested in chasing profit than in hedging risks.
CURRENCY MARKET AND EXCHANGE RATE,
Every country has some kind of money. Usually a country’s money, also referred to as its
currency, is called by its own unique name. For example, the United States has money called the
U.S. Dollar. Japan has money called the Japanese Yen. Germany has money called the Deutsche
Mark. Colombia has money called the Colombian Peso.
In most cases, it’s easy to trade one currency for another. Just as you can trade the goods
you own–that is, you can trade corn for rice or high-tech steel knives or computers–you can trade
one kind of money for another. All you have to do is find someone with whom to trade. Markets in
which you can trade one kind of money for another are called currency markets or foreign
exchange markets.
The price at which you trade one currency for another is called the exchange rate. If you
can trade $1 U.S. dollar for 20 MXN (Mexican Pesos) that means you can receive 20 MXN for each
U.S. dollar. Or, for each Mexican Peso, you can receive $.05. Thus, for each pair of currencies,
there are two ways to describe the exchange rate. In our example, the exchange rate is either
MXN 20/$1 or $.05/MXN1. The exchange rate is usually quoted in terms of U.S. dollars, so the
exchange rate is $.05 per Mexican Peso.
Currencies traded in markets–as they are presently for most countries–have prices that
change by the minute, depending on whatever people will buy or sell them at. Such exchange

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rates are called flexible or floating. Historically–up until the early 1970s–exchange rates were not
flexible market rates, but instead were set by governments. Government-set exchange rates are
called fixed.
For example, the government of Mexico could fix its exchange rate by simply declaring
that anyone who wants Mexican pesos can buy them for $.04 per peso, instead of $.05 per peso.
The Mexican central bank–a government-run bank such as the Federal Reserve in the United
States, which is the U.S. central bank–would guarantee the new fixed exchange rate by
guaranteeing that it will buy and sell pesos at $.04 each. Compared to the market rate, that
would be a great deal! Certainly, if I wanted to buy pesos, I would buy from the Mexican central
bank rather than the market.
In fact, you could make a lot of money buying pesos from the Mexican central bank at
$.04 each and selling them to people who couldn’t get there for $.05 each. That activity is an
example of what is called arbitrage, which means that if there are two different prices for the
same item, there is money that might be made by buying low and selling high so long as the
transportation or transactions costs don’t eat up the difference. The upshot is that the Mexican
central bank, because it is charging a rate lower than the market rate, would start accumulating
dollars. If it ran out of pesos, it would have to print more in order to maintain the government
guarantee.
Alternatively, were it to start to run out of pesos, the Mexican central bank could break its
promise and change the rate at which it is fixing the peso to $.05/peso–the market rate. People
would no longer clamor at its doorstep trying to arbitrage the peso and the government would no
longer be under pressure to print up more pesos. When a government changes a fixed exchange
rate, it is said to be devaluing or revaluing its currency, depending on whether the value of its
currency goes down or up. In our example, the Mexican government revalued the peso: its price
or value went up from $.04 each to $.05 each.
Another example of a fixed exchange rate system is the gold standard. Under a gold
standard, a government fixes not the price at which people can buy and sell currencies, but the
the price at which people can buy and sell gold. Doing this historically led to crises called
balance of payments crises, which happened when a government started to run out of the gold it
had to keep on hand to maintain its price guarantee.
Under a flexible exchange rate system, there can be no balance of payments crises; but
the exchange rate can fluctuate widely from day to day, making it hard to write long-term
contracts with foreigners. Both fixed and flexible exchange rate systems have pros and cons.
SPOT AND FORWARD MARKETS
There are different ways of classifying financial market and so, based on the time of
delivery, the financial market is classified as cash market and future market. Cash market, or
otherwise known as spot market is one where the delivery of the underlying asset takes place
immediately. On the other hand, future market is the market, wherein the delivery and payment
of the financial assets such as shares, debentures, etc. occurs at a future specified date.
A cash market is a place where financial instruments like securities and commodities, i.e.
precious metals or agricultural produce are bought and sold for immediate delivery (on a spot
date). It is also referred as a spot market. In the cash market, there are two sections, equities –
where equities like shares are traded and debts – where debts like government bonds and
mortgage bonds are traded.
The cash market may be an exchange or an OTC – Over The Counter. The exchange is a
place where the general public, government, firms, etc. can mutually by and sell their securities
and other financial instruments. It can be a Stock Exchange like BSE (Bombay Stock Exchange) or
NSE (National Stock Exchange) or a Commodity Exchange or a Foreign Exchange Market. Over
The Counter is a trading made between two parties without the help of exchange.
Future Market: Future Market is an exchange market where future contracts are bought
and sold. The term futures contract refers to a contract which is executed in the future. It is a
contract between two parties in which one party agrees to buy a certain quantity of a

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commodity or financial instrument at an agreed price, and delivery of the stuff is done at a later
date (pre-specified) in future.
The regulators of future market in India are SEBI (Securities Exchange Board of India) and
FMC (Forward Markets Commission). In India, the famous future exchange market is Bombay Stock
Exchange (BSE), National Stock Exchange (NSE), Bharat Diamond Bourse (BDB), Indian Energy
Exchange (IEX).
Comparison Chart
BASIS FOR
CASH MARKET FUTURE MARKET
COMPARISON
Meaning A place where dealing of financial A place where future

instruments is done for immediate contracts are dealt by people
delivery. and entities.
Time Horizon Normally, trade date + 2 or 3 days At a specific future date.

(as the case may be).
Regulation Exchanges and Over The Counter Exchanges.

(OTC).
TYPES OF FOREIGN EXCHANGE TRANSACTIONS
Foreign exchange transaction refers to purchase and sale of foreign currencies. The transactions
are done with an exchange of a specific country’s currency for another at an agreed exchange
rate on a specific date.
Foreign exchange transactions include all conversions of currencies which may be done by a
traveler on an airport kiosk or billion-dollar payments made by financial institutions and
governments. The growth in globalisation has led to a massive increase in a number of foreign
exchange transactions in the recent years.
The following are the types of foreign exchange transactions:

1. SPOT TRANSACTIONS : This method of transaction is the fastest way to exchange currencies.
Spot transaction refers to the exchange or settlement of the currencies by the buyer and
seller within two days of the deal without a signed contract. The Spot Exchange Rate is the
prevailing exchange rate in the market.
2. FORWARD TRANSACTIONS: Forward transactions are future transactions when the buyer
and seller enter into an agreement of purchase and sale of currency after 90 days. The
agreement is framed on the basis of a fixed exchange rate for a definite date in the future.
The rate at which the deal is fixed is termed as Forward Exchange Rate.
3. FUTURE TRANSACTION: The future transactions are also the forward transactions and deals
with the contracts in the same manner as that of normal forward transactions. But however,
the transactions made in a future contract differs from the transaction made in the forward
contract on the following grounds:
• The forward contracts can be customized on the client’s request, while the future
contracts are standardized such as the features, date, and the size of the
contracts is standardized.
• The future contracts can only be traded on the organized exchanges, while the
forward contracts can be traded anywhere depending on the client’s
convenience.
• No margin is required in case of the forward contracts, while the margins are
required of all the participants and an initial margin is kept as collateral so as to
establish the future position.
4. SWAP TRANSACTIONS: A simultaneous lending and borrowing of two different currencies
between two investors are referred to as swap transaction. One investor borrows a

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currency and repays in the form of a second currency to the second investor. Swap
transactions are done to pay off obligations without suffering a foreign exchange risk.
5. OPTION TRANSACTIONS: The exchange of currency from one denomination to another at
an agreed rate on a specific date is an option for an investor. Every investor owns the right
to convert the currency but is not obligated to do so. The foreign exchange option gives
an investor the right, but not the obligation to exchange the currency in one denomination
to another at an agreed exchange rate on a pre-defined date. An option to buy the
currency is called as a Call Option, while the option to sell the currency is called as a Put
Option.
READING FOREIGN EXCHANGE QUOTATIONS
1. Bid and Ask prices are from the perspective of the broker. Traders buy currency at the ask
price and sell at the bid price.
2. The base currency is the first currency in the pair and that the quote currency is the second
currency.
3. The smallest movement for non-JPY currency pairs is one pip (a single digit movement in
the fourth decimal place of the quoted price and a single digit movement in the second
decimal place for JPY pairs).
4. The spread is the initial hurdle (cost) that traders realize in a trade.
CURRENCY PAIRS
A forex quote always consists of two currencies, a currency pair consisting of a base
currency and a quote currency (sometimes called the "counter currency"). These pairs represent
the currencies you're trading. The first part of the pair is called the base currency, and the second
is called the quote currency.
Popular, often-used base currencies include EUR (Euros), GBP (British pounds) AUD
(Australian Dollars) and USD (US Dollars).
The quote currency may be any currency, including another of the common base currencies, as
in this example:
EUR/USD = 1.3600
Here, EUR is the base currency and USD is the quote currency. You would translate this pair to
mean that one Euro is worth 1.36 US Dollars.
No matter which currency is the base currency—whether USD, EUR or any base currency—the
base currency always equals 1. The quoted amount, 1.3600 is the amount of the quote currency,
USD, it takes to equal 1 unit of the base currency, EUR.
The forex convention is that when these two currencies are compared, EUR is always the
base. If instead, USD were the base currency, the quote would be:
USD/EUR = .7352
The meaning of this hypothetical quote is that 1 USD equals .7352 EUR. If you divide 1 by .7352 the
result is 1.36—the two results look different, but the relationship between the two currencies
remains the same.
BID AND ASK QUOTES
There are two parts to a forex quote, a bid and an ask. Here's another forex quote
that helps make clear the meaning of these terms in the forex market:
EUR/USD = 1.3600/05
Here the bid is 1.3600, and the ask is 1.3605. Since the difference between a bid and an ask
price in normal circumstances is a very small fraction—less than 1/100th of the currency unit—the
convention is that only the last two digits (05) of the four trailing digits are shown. If you spelled this
out, it would look like this:
EUR/USD = 1.3600/1.3605
Here the bid price is 1.3600, and the ask is 1.3605.

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Contrary to what you may think when you begin exploring the forex market, a bid price is
not the price you'll bid when you want to buy a currency pair.
Instead, the two terms are used from the perspective of the forex broker. From the broker's
perspective, when you're the potential buyer, the broker will ask for a little more than what he
might be willing to bid if you were selling. In the given example, since you're interested in buying
EUR, the base currency, you'll pay the ask, the broker's asking price, which is 3.3605.
If you were selling, you'd accept the broker's bid, which is 3.3600.
If you find these terms initially confusing, it helps to remember that the terms bid and ask
are from the broker's perspective, not yours. When you're buying, you'll pay what the broker's
asking for the currency; when you're selling, you'll need to accept what the broker's bidding.
The difference between the bid and the ask is called the spread. The spread is simply the broker's
commission on the trade.
SPREADS AND PIPS
One of the terms you'll often hear in forex contexts is the pip. A pip is a unit of measure, and it's
the smallest unit of value in a forex currency quote. So, in the example
EUR/USD = 1.3600/1.3605
the difference between the 1.3600 bid and the 1.3605 ask is 5 pips. The first number, 1.3600,
represents the bid price, while the 1.3605 represents the ask price. The spread is the difference of 5
pips.
FORWARD AND FUTURES MARKET

In stock market shares are traded in spot market as well as in forward market. In the spot
market, there is delivery of shares against payment. But in forward market an agreement is for
future payment and delivery. This may or may not materialize. But, the purpose of entering into
forward market is to prevent any fall in the price of shares which is an insurance against the risk of
fluctuating prices. This is called Hedge.
In financial market, risks arise due to the fluctuation in the price of securities or due to a
change in the interest rate on debt instruments. So, to protect these, the financial companies
undertake derivative contract in the forward or futures markets by which they protect themselves
from falling prices or interest rates.
A forward market is a contract entered into between a buyer and seller for future delivery
of stock or currency or commodity. The buyer in a forward contract gains if the price at which he
buys is less than the spot price and he will lose if the price is higher than the spot price.
What is the purpose of forward contract in a forward market?

The purpose of the forward contract is to protect the seller or buyer against any fluctuations
in the price. If the seller or the buyer incurs loss in a forward contract, they can compensate the
same by reversing the contract and selling or buying at lower or higher prices, according to their
positions. Thus, a forward market is a hedge against fluctuating prices. This applies to stock,
currency as well as goods.
Forward Market classification: Forward market can be classified as
• commodity forward, and
• financial forward.
In financial forward, we have currency contracts. There is also forward market on interest rate and
the agreement reached in the forward market for interest rate is called forward rate agreement.
Such agreements are entered into when traders expect an increase in demand for funds in the
next 3 or 4 months.
What is a futures market?

Futures market : Though futures market is similar to forward market, it comes under
regulated organizations in which members alone are permitted to transact. The futures market will
have its own rules and regulations and will also fix the minimum value for each transaction. Here

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again, the purpose is to smooth out the price fluctuation so that neither the buyer nor the seller
incurs heavy loss due to price fluctuations.
Futures market can be classified as commodity future, and financial future.

Benefits of Forward and Futures Markets
1. Forward and futures markets protect against price fluctuations:Any expectation in the price
increase or any decline in the same can be protected by entering into forward contracts
to buy or sell at a particular price.
2. Forward and futures markets provides the option of buying and selling: The buyer or seller
can exercise their option and if they are not keen to execute the contract they can opt
out by paying a nominal amount.
3. They enable the buyer or seller to make proper arrangements for finance: Since the
transactions are for future buying or selling, suitable financial arrangements could be done
by proper planning.
4. Investors can plan their future investments: Based on the forward or future market, investors
can plan their investments either by shifting it from the existing investment or by borrowing
and going in for new investments.
5. Cash crunch does not arise owing to these markets: As the transactions do not involve
payments in bulk and with buying and selling of securities or currencies, only marginal
amount is involved.
6. Forward and futures markets helps in large transactions: With more people entering the
market, volume of transactions increases along with frequent turnover of transactions.
7. Flexibility in forward and futures markets: They are very flexible contracts enabling the
buyer or seller to opt out by paying a small margin amount. The market provides flexibility,
as simultaneously a person can buy and sell in different markets due to the development of
Information Technology.
8. Forward and Futures markets reduce risks for financial companies: The forward and futures
market has improved financial services and financial companies are able to reduce their
risks. With various credit instruments available and resources made available from various
sources, the financial companies are in a position to earn good profits even with a very low
margin in their price. This is due to the higher volume of trade. The market is also attracting
funds from foreign countries. So, the financial companies with various financial products are
able to have better returns for their investment.
9. Portfolio investment: Mutual fund companies are able to have better portfolio investment
due to forward contracts and hedging against price fluctuations.
Comparison Chart
BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON
Meaning Forward Contract is an A contract in which the parties agree

agreement between parties to to exchange the asset for cash at a
buy and sell the underlying asset fixed price and at a future specified
at a specified date and agreed date, is known as future contract.
rate in future.
What is it? It is a tailor made contract. It is a standardized contract.
Traded on Over the counter, i.e. there is no Organized stock exchange.

secondary market.
Settlement On maturity date. On a daily basis.
Risk High Low
Default As they are private agreement, No such probability.


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BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON
the chances of default are

relatively high.
Size of Depends on the contract terms. Fixed

contract
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High
FOREIGN-CURRENCY OPTIONS
Currency options – or forex options – give the holder the right, but not the obligation, to buy
or sell a currency pair at a given price before or on a set expiry date.
To be granted this right, the buyer of the option pays a premium to the seller. When trading
options, it’s important to know that the buyer is often referred to as the ‘holder’, and the seller is
often referred to as the ‘writer’.
Types of currency options
There are two types of currency options – the put option and the call option . A put option
gives you the right but not the obligation to sell currency at a specific price on a certain date. The
above example of FancyTech that we have used is that of a put option. This kind of currency
option works best in a scenario where you expect the value of a currency like the INR to
strengthen vis-à-vis another currency.
The other type of currency option is the call option, which gives you the right to buy currency at a
certain rate. This works when you expect the value of the INR to weaken against another currency
like the dollar.
How to trade in currency options

Currency futures were first introduced in India in 2008, followed by options in 2010. Today,
the derivatives segment of the National Stock Exchange (NSE) offers trading services in derivative
instruments like currency futures on four currency pairs, cross-currency futures and options on three
currency pairs. You can purchase currency options on the Indian rupee against other currencies
like the euro, pound sterling and the US dollar.
You can purchase call and put options on the USD-INR pair through your stockbroker, or
using your online trading platform. The options are European, which means that you can exercise
it only on the expiration date. However, you can square off the transaction by selling the options
contract back in the market. The difference between the premiums paid for buying and selling
would be your net loss or gain.
How do currency options work?

There are two types of currency options: calls and puts. Buying a call option gives the
holder the right to buy a currency pair for the strike price on or before the expiry date, and buying
a put option gives the holder the right to sell a currency pair for the strike price on or before the
expiry date.
If the expiry arrives and the market price of a currency pair is above the strike price when
buying calls, or below the strike price when buying puts, a trader can choose to exercise it. This

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means they can buy or sell the currency for a better price than what is currently available in the
underlying market.
But if this doesn’t happen, a trader can let their option expire, and they’ll only lose the
value of the premium. As a result, buying call or put options means that a trader’s upside is
potentially unlimited, and their downside is capped at the premium.
On the other hand, traders can also sell call options and put options – which obliges them
to sell a currency pair in the case of a call, and to buy a currency pair in the case of a put. For
taking on this obligation, the seller of a call or put option will receive a premium.
If a trader is taking on the obligation to sell an options contract, their losses are potentially
unlimited – and profits are capped at the total value of the option premium. When selling options,
a trader is hoping that the price of a call option remains below the strike price, and the price of a
put option remains above the strike price.
ARBITRAGE
Arbitrage is the process of simultaneous buying and selling of an asset from different
platforms, exchanges or locations to cash in on the price difference (usually small in percentage
terms). While getting into an arbitrage trade, the quantity of the underlying asset bought and sold
should be the same. Only the price difference is captured as the net pay-off from the trade. The
pay-off should be large enough to cover the costs involved in executing the trades (i.e.
transaction costs). Else, it won’t make sense for the trader to initiate the trade in the first place.
Arbitrage is a widely used trading strategy, and probably one of the oldest trading
strategies to exist. Traders who engage in the strategy are called arbitrageurs.
The concept is closely related to the market efficiency theory. The theory states that for
markets to be perfectly efficient, there must be no arbitrage opportunities – all equivalent assets
should converge to the same price. The convergence of the prices in different markets measures
market efficiency.
Both the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory explain that
arbitrage opportunities occur due to the mispricing of assets. If the opportunities are fully explored,
the prices of equivalent assets should converge.
Description: Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion
market and at Rs 27,500 in the Mumbai bullion market. A trader may buy 10 gm of gold in Delhi
and sell it in Mumbai, making a profit of Rs 500 (Rs 27,500 - Rs 27,000). However, this trade will be
profitable only if the cost of transactions is less than Rs 500 per 10 gm of gold.
In the above example, assuming that the total transaction cost, of executing the trades
and physical delivery of gold, is Rs 200 for 10gm, then the net profit for the trader would reduce to
Rs 300.
If the price difference between the two bullion markets reduces to Rs 200 (or less than that)
per 10gm of gold, then the arbitrage opportunity between the two markets shall cease to exist, as
the transaction costs shall be equal to, or more than, the price difference between the two
markets.
In real life, arbitrage opportunities (if any) exist only for brief periods since most of the
arbitrage trading has been taken over by algorithm-based trading in matured markets. These
algorithms are quick to spot and capture arbitrage opportunity, making it easy for human traders
to keep track.
Types of Arbitrage
While arbitrage usually refers to trading opportunities in financial markets, there are also other
types of arbitrage opportunities covering other tradeable markets. Those include risk arbitrage,
retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage.
1. Risk arbitrage – This type of arbitrage is also called merger arbitrage, as it involves the
buying of stocks in the process of a merger & acquisition. Risk arbitrage is a popular
strategy among hedge funds, which buy the target’s stocks and short-sell the stocks of the
acquirer.

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2. Retail arbitrage – Just like on financial markets, arbitrage can also be performed with usual
retail products from your favourite supermarket. Take a look at eBay for example, and you’ll
find hundreds of products bought in China and sold online at a higher price on a different
market.
3. Convertible arbitrage – Another popular arbitrage strategy, convertible arbitrage involves
buying a convertible security and short-selling its underlying stock.
4. Negative arbitrage – Negative arbitrage refers to the opportunity lost when the interest rate
that a borrower pays on its debt (a bond issuer, for example) is higher than the interest rate
at which those funds are invested.
5. Statistical arbitrage – Also known as stat arb, is an arbitrage technique that involves
complex statistical models to find trading opportunities among financial instruments with
different market prices. Those models are usually based on mean-reverting strategies and
require significant computational power.
SPECULATION AND EXCHANGE- MARKET STABILITY

Role of speculation is stabilizing the economy against stochastic disturbances. Increased
speculation (i) stabilizes domestic income against disturbances in the domestic bond market and
forward exchange market; (ii) exacerbates the effect of foreign disturbances; and (iii) may
dampen or augment the effect of money market and output supply disturbances. Forward
market intervention does not provide monetary authorities additional leverage in stabilizing
income beyond unsterilized spot market intervention. Intervention rules based on reactions to both
the forward and the spot exchange rates, however, can outperform intervention policies
responding to the spot rate alone, regardless of the market in which intervention occur.
Currency speculation is the act of purchasing and holding foreign currency in the hopes of
selling that currency at an appreciated, or higher, rate in future. This is in contrast to those who
buy currencies to finance a foreign investment or to pay for an import.
Slightly in contrast to currency speculation, is currency trading. Both, to some extent or another,
facilitate international transactions. There is nothing preventing a trader from acting as a
speculator or a speculator from acting as a trader. A trader will purchase foreign currency from
importers/exporters and charge a transaction fee for doing so, but there is nothing stopping them
from holding on to that currency, in the hopes of selling it at an appreciated value in future (and
thereby engaging in speculation).
How Does It Work?

Take, for example, a maple syrup producer in India looking to export their product to
Europe. Let’s say the European importer is paying the bill in euros. The Canadian exporter would
then have to exchange those euros to Indian Rupees, in order to pay their suppliers and workers.
But the exporter needs someone to buy those euros. This is where the currency trader or
speculator comes in. For a transaction fee, the trader will purchase the euros from the exporter in
the currency that they need (in this case, Indian Rupee).
Were they to speculate on that transaction in future, they would wait for a time in which
the euro was unusually high compared to the Indian Rupee, or the dollar unusually low when held
up against the euro. They might also look at how other currencies are standing up against the
euro, and decide to make an investment there. If the market for speculation is not looking so
good for the euro, they could simply trade it to another importer looking for euros, and make their
money off of the transaction fees. While the potential for making money off of speculation is far
greater than the amount they might make off of charging fees doing trading, there is also a much
higher degree of risk involved.
Primary & Secondary Markets

An FDI, or Foreign Direct Investment, is another example of a situation in which currency
traders, or speculators, are required to facilitate transactions. In this scenario, a company looking
to purchase or establish a production facility in another country would need to exchange their

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domestic currency for the currency of the country they are expanding operations to. FDIs, as well
as imports/exports and all other transactions directly related to trade and investment and the
exchange of real goods and services, make up what is known as the “primary exchange market”.
The vast majority of currency transactions, however, take place on the secondary market. It is in
this market that currency speculation occurs. Former United States Secretary of the Treasury,
Robert Rubin, once stated that “the proper operations of secondary markets ensure liquidity in the
primary markets.”. Put simply, currency speculation is a necessary activity enabling imports,
exports and investment. Certainly, many financiers would agree with him. The more speculation
and exchange that goes on in the secondary market, the easier it is for investors and traders to
purchase and sell foreign currency, as with more speculators there is more currency being used in
transactions and less being held in reserves.
A Risky Business: The Ramifications Involved
While currency speculation is an important factor in the smooth operations of international

trade and investment, it has also been known to contribute to the disruption of that same trade,
leading to the stagnation of economic development and creation of economic crises. The most
challenging aspect of speculation is doing just that: speculating. Deciding upon when the right
time to buy and sell is. To be successful at it often requires a keen knowledge of economics and
finance, as well as an awareness of current political and economic events. But even with such
qualifications, what currency speculation boils down to is playing a “guessing game”, and as such
there is a great degree of risk involved.
To minimize that risk, speculators adopt strategies they hope will lead to greater accuracy
in their guesses. Following the actions of other, most often larger, speculators, is one such strategy.
Using forward exchange markets is another; as well, the gathering of information on what makes a
healthy economy (unemployment, inflation, and productivity growth, etc.). Unfortunately, this
information often comes from biased sources. For example, policies enacted by local
governments that reduce the short-term profitability of financial and industrial businesses will be
taken as signs to sell a currency, while policies expanding or opening profit opportunities are read
as reasons to buy a currency. The end result of all of these strategies is that they can at times
embrace self-fulfilling prophecies that condemn nations to financial upheaval and sometimes
ruin.
Heavy trading in a specific currency can create artificial demand, leading to an increase
in the price of goods beyond inflation-adjusted levels. This phenomenon has the potential to
make everyday necessities unaffordable for many people – especially if it takes place in a country
where a large segment of the population survive on lower incomes. What can be even more
dangerous, however, is when this artificial demand is made transparent and speculators begin to
sell their stock of that currency. It is in this scenario where financial ruin can occur, where the
collapse of the currency drives many people into poverty overnight.
Solutions to the Problem
While currency speculation is seldom the sole cause of these financial catastrophes, it has
has shown itself quite capable of turning relatively minor economic hiccoughs into far greater
problems. Examples of this can be found with the financial crises in Mexico in 1994, Southeast Asia
in 1997 and Argentina between 1998 and 2002. Fortunately, since that time, steps have been
taken to limit the market volatility caused by currency speculation and reign in the amount of
foreign currency trading taking place. The consolidation of much of Europe into the eurozone,
with a single currency (the euro), is one such example. Reducing the amount of currency
speculation by reducing the number of currencies in circulation.
Another, is the Tobin Tax, or Financial Transaction Tax. The concept remains controversial, as
it basically entails taxing every foreign exchange transaction. Implementation of such a tax has so
far been limited; taking place predominantly on a nation-by-nation basis. Indeed, the European
Union is the most significant example of an politico-economic entity pursuing such a policy. The EU
FTT has yet to be enacted, but if it proves successful, it could pave the way for similar taxes
elsewhere.
A fixed exchange rate will be the victim of speculation if:


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The currency is at the wrong market value. e.g. in 1990, the UK arguably joined at a rate
that was too high. (The economy was experiencing high inflation and an economic slowdown,
meaning the value of the currency was too high)
The Government doesn’t have sufficient reserves to protect the currency. In practice, government
reserves are only a fraction of the value traded on foreign exchange markets. The old saying is
‘you can’t buck the market’ If a country can rely on other Central Banks to intervene they have
more potential.
People have no confidence in the government intervention. For example, the day before
the UK left the ERM, the government increased interest rates to 15% in a desperate attempt to
prevent the value of the currency falling. Usually, high-interest rates increase the value of the
exchange rate. However, they were unsuccessful. Speculators correctly predicted that these
high-interest rates just couldn’t be maintained when the economy was in recession. Therefore it
was an empty move.
A floating exchange rate, means the government allow the value of the currency to be
determined by market forces. It could depreciate or appreciate depending on market sentiment.
The argument is that the market will correctly value the exchange rate so there is no speculative
attack because the currency is correctly valued.
A floating exchange rate can still have rapid appreciation and depreciation because the
situation of an economy can change frequently.
Suppose investors thought an economy like Iceland was weak (large current account deficit, high
inflation and external debt). Then speculators would sell the currency, in anticipation of its fall. This
speculation would cause the currency to fall.
CURRENCY MARKET AND BASIC CENTRAL BANK OPERATION,
The approach to liberalisation adopted by the Reserve Bank has been characterized by
greater transparency, data monitoring and information dissemination and to move away from
micro management of foreign exchange transactions to macro management of foreign
exchange flows.
The emphasis has been to ensure that procedural formalities are minimized so that
individuals are able to conduct hassle free current account transactions and exporters and other
users of the market are able to concentrate on their core activities rather than engage in
avoidable paper work. With a view to maintaining the integrity of the market, strong know your-
customer (KYC)/anti-money laundering (AML) guidelines have also been put in place.
When Do Central Banks Intervene in the Forex Market ?

Central Banks do not intervene often in the Forex market. In fact, the intervention by Central Banks
can be considered to be a sign of significant economic weakness in a currency. As a
result, Central Bank intervention usually only happens when the currency is under some sort of
crisis. This could be a genuine economic crisis like the 2008 crisis or the Euro crisis. Alternatively, it
could also be a speculative attack that a country is facing.
There are multiple ways in which Central Banks can intervene in the markets. Some of these
ways require more commitment than the others and are also more effective than the others.
1. Jawboning: Jawboning is one of the basic techniques used by Central Banks to manage
their Forex reserves. As the name suggests, the technique of Jawboning is more about
talking than about actually conducting action. While using this technique, Central Banks
start actively talking about their target currency levels and tell the media that an
intervention is possible from their end if the currency goes beyond a certain point.
The traders and other participants in the market are aware of the monetary might of
the Central Banks and therefore more often than not, the currency range declared by the
Central Bank becomes the range in which the currency automatically starts trading without
any Central Bank intervention.
Jawboning is essentially a technique where the threat of a Central Bank intervention
to reset the rates is used to reset the rates without the intervention ever taking place!

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Jawboning is particularly effective when Central Banks have the reputation for periodic
intervention into the open markets.
2. Operational Intervention: Another technique that is used by Central Banks to control their
currency’s exchange rates is called operational intervention. This is what we usually
understand when we use the term Central Bank intervention. Here, the Central Bank
actually steps into the market and starts buying and selling currency as per its objective to
drive the exchange rate to a particular point. Traders are concerned about Central Bank
intervention because the objective of a Central Bank is not to make money trading. They
are perfectly content with losing money as long as they can meet their objective!
Therefore, an operational intervention can also cause a significant dent in the Forex
reserves of the Central Banks. This is the reason, why it is recommended that this policy be
sparingly used.
3. Concerted Intervention: A concerted intervention is like a hybrid between jawboning and
operational intervention. Firstly, as the name suggests, concerted intervention requires the
concerted action of multiple central banks. Therefore, multiple Central Banks might start
jawboning particular currency rates in the market. Then, as a part of concerted action, one
of these Central Banks may actually start operational intervention to correct the currency
rates whereas the other banks may increase their jawboning activity. Thus the market
participants are under threat of action from several Central Banks at one go. If multiple
Central Banks were to actually simultaneously intervene, they could drastically alter the
exchange rates in the markets within a matter of minutes.
Concerted intervention only takes place when many Central Banks share the same
objective i.e. they want to control a particular exchange rate. Usually jawboning from all
Central Banks gets the desired results. One or two Central Banks may actually have to
intervene. However, only in the rarest of the rare cases do multiple Central Banks have to
conduct operational interventions to correct a currency rate.
4. Sterilized Intervention: A sterilized intervention is another form of operational intervention by
the Central Banks. The term “sterilization” is taken from medical sciences. In this context it
means that a Central Bank conducts operations which affect the currency rates in the
Forex market. However, at the same time it takes measures to ensure that none of its
activities in the market have any effect on trade and commerce within its home country.
Thus it effectively sterilizes the intervention as far as the home country is concerned.
Let’s understand this with the help of an example. Let’s say that the Fed is
concerned about the dollar depreciation against the Indian rupee and wants to take
action to change this. In this case, the Fed will sell Indian rupee in the market and buy
dollars from it. This will lead to two effects. Firstly, it will increase the supply of the rupee and
secondly it will decrease the supply of the dollars. The objective of the Fed in the Forex
market will be fulfilled.
However, there is also a side effect to this policy. The number of dollars in the United
States economy would suddenly increase as a result of this transaction. This could cause
inflation and other economic issues as well. Therefore, to counter the situation, the Fed
would sell United States denominated bonds in the market. As a result, it will remove dollars
from the domestic market (sterilizing the effect). The dollars will now be replaced with the
government obligation and therefore the inflation and other effects will be controlled.
PRODUCT MARKET APPROACH TO DETERMINATION OF EXCHANGE RATE,

The asset market model views currencies as an important element in finding the equilibrium
exchange rate. Asset prices are influenced mostly by people’s willingness to hold the existing
quantities of assets, which in turn depends on their expectations on the future worth of the assets.
The asset market model of exchange rate determination states that the exchange rate between
two currencies represents the price that just balances the relative supplies of, and demand for,
assets denominated in those currencies. These assets are not limited to consumables, such as
groceries or cars. They include investments, such as shares of stock that is denominated in the
currency, and debt denominated in the currency.

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6 - 16
Asset Models
of the Spot Exchange Rate
Asset Model Approach
perfect capital mobility
Monetary Approach Portfolio-Balance Approach

perfect capital substitutability imperfect capital substitutability
Monetarist Model Small Country Model
completely flexible Preferred Local

commodity prices Habitat Model
Overshooting Model Uniform Preference
sticky commodity prices Model
McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.
1. PURCHASING POWER PARITY (PPP)

The Purchasing Power Parity (PPP) model or else the “law of one price” estimates the adjustment
needed on the exchange rate between countries in order for the exchange to be equivalent to
each currency's purchasing power.
PPP Basic Assumptions
PPP assumes that if there are no barriers to free trade the price of the same commodities must be
the same everywhere in the world. Based on that assumption, the exchange rate between two
economies must fluctuate towards a long-term value that ensures the equilibrium of commodity
pricing.
Key Points regarding the PPP Analysis:
• PPP analysis is based on several assumptions, including homogeneous products and
absence of trade restrictions
• PPP analysis can be used only for tradeable goods and not for non-tradeable goods such
as services
• In reality, only the prices of internationally traded goods tend to balance out
• PPP analysis is useful for long-term currency valuation
• There can significant divergences between currency valuations and PPP, especially in the
short-term
• PPP analysis is particularly useful for corporations, carry traders, and other long-term thinkers
• PPP analysis is useless for short-term currency traders
Calculating the PPP

Basically, the price parity between two countries is formulated as:
■ e = Pd / Pf
This can be also expressed as:
■ Pd = e x Pf
where:
e = The PPP equilibrium exchange rate value
Pd = Domestic price level of a commodity
Pf = Foreign price level of a commodity
Actually, there are two different ways to calculate the Purchasing Power Parity (PPP):

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(a) Absolute PPP {equilibrium = Domestic Price Index / Foreign Price Index}
(b) Relative PPP {equilibrium = Domestic Price Index - Foreign Price Index}
Practically, in order to calculate PPP:
(i) Create a basket of traded goods and services in two countries
(ii) Price the two baskets
(iii) Compare the two baskets and identify an exchange rate that would make the pricing
of those two baskets identical
The Problems when using the PPP
PPP assumes that there are no barriers to trade. But actually, there are a lot of barriers and other
similar anomalies in international trade. Moreover, Forex currencies can remain overvalued for
long periods of time. For example, the Swiss Franc (CHF) remains overvalued, on a PPP basis, since
the 80s.
These are some factors disturbing PPP analysis:
• The traded goods are not perfectly homogeneous
• There are several barriers to international trade
• Restricting government policies (such as tariffs)
• Speculation in the prices of goods
• Transportation costs
• Transaction costs
• Multinational corporations usually delay the re-adjustment of prices across different markets
• PPP analysis may not hold for services and other non-tradable goods
• PPP analysis may not hold even for homogeneous commodities as the pricing between
economies depends on local market dynamics
THE PORTFOLIO BALANCE APPROACH

The Portfolio Balance approach is a modern theory based on the relationship between the
relative price of bonds and exchange rates.
The portfolio balance approach is an extension of the monetary exchange rate models focusing
on the impact of bonds. According to this approach, any change in the economic conditions of
a country will have a direct impact on the demand and supply for the domestic and the foreign
bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between
the domestic and foreign economies.
The key advantage of the portfolio approach when compared to traditional approaches is that
the financial assets tend to adjust considerably faster to news economic conditions than
tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is
not an accurate predictor of exchange rates.
The Assumptions of Portfolio Balance Approach

The portfolio balance approach is based on several assumptions:
1. The purchasing power parity (PPP) does not hold
2. The uncovered interest parity does not hold
3. The exchange rate is expected unchanged
4. Only three (3) assets are available for investment for each household: money, domestic bonds,
and foreign bonds
5. Bonds are not perfect substitutes
6. Assumes perfect capital mobility without capital controls and similar barriers to investment
7. Assumes narrow transaction costs and high completion in the money markets
Portfolio Balance Approach Key Points
• Emphasizes on the importance of global financial markets (especially as concerns the
bond markets)
• Assumes the existence of arbitrage between two economies
• Offers a realistic and simplistic analysis framework
• The portfolio balance approach, based on empirical evidence, hasn’t proven an accurate
predictor of exchange rates

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3. THE INTEREST RATE APPROACH & THE FISHER EFFECT

The connection between currency exchange rates and interest rate differentials appeared after
the end of the Bretton Woods agreement in 1970-1972
The interest-rate models assume that the global capital enjoys perfect mobility and that it will
immediately take advantage of any interest rate differentials. A situation which is known as
‘Covered Interest Rate Arbitrage’.
Covered Interest Rate Arbitrage

According to covered interest rate arbitrage theory, the interest-rate arbitrage is always active
and ensures the covered interest rate parity worldwide.
Interest Rate Parity (IRP)
Interest Rate Parity (IRP) assumes that the interest rate differential between two countries remains
always equal to the differential calculated by using the forward exchange rate and the spot
exchange rate. In other words, an exchange rate’s forward premium/discount equals its interest
rate differential:
■ Forward premium/discount (%) = interest rate differential (%)
This creates an equilibrium based on the relationship between exchange rates and interest rates.
Covered vs Uncovered Interest Rate Parity

Defining the covered and uncovered interest rate parity:
(1) Covered Interest Rate Parity (CIP)
Covered interest rate parity assumes that forward exchange rates are a function of current spot
rates and interest rates
(2) Uncovered Interest Rate Parity
Uncovered interest rate parity assumes that the expected future spot rate is a function of the
current spot rate and the interest rates of each currency (valid only in the absence of forward
contracts)
Empirical research has shown that the uncovered interest rate parity holds better than the
covered interest rate parity.
Formulating the Interest Rate Parity

The interest rate parity links interest rates, spot exchange, and forward exchange rates. The
exchange rates are adjusting to the changing financial conditions as follows:
■ Interest Rate Parity = (1 + id) = (S / F) x (1 + if)
Where:
id is the domestic interest rate (or the base currency)
if is the foreign interest rate (or the quoted currency)
F is the forward foreign exchange rate
S is the current spot foreign exchange rate
If we solve the equation for the Forward foreign exchange rate
■ Forward Foreign Exchange Rate = S x {(1 + if) / (1 + id)}
The Fisher Effect & the International Fisher Effect

The Fisher Effect
The Fisher effect theory suggests that differences in the nominal interest rates between two
economies equal the expected changes of inflation rates.
■ Interest rate differentials = Expected inflation rates differentials
According to the PPP principle, the exchange rates, and the inflation rates are linked.
The Fisher effect links exchange rates and inflation rates with interest rates.
The International Fisher Effect
The international Fisher effect (or Fisher's open hypothesis) is a hypothesis that suggests differences
in nominal interest rates between two economies equal the expected changes in the spot
exchange rates of those countries.
■ Interest rate differentials = Expected change in the spot exchange

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LINKING ALL THEORIES TOGETHER

By linking all theories together:
(i) Spot and forward rates differentials = interest rates differential (Interest rate parity theory)
(ii) Interest rates differential = expected inflation rates differential (Fisher effect)
(iii) Expected inflation rates differential = expected change in the spot exchange rate (Purchasing
Power Parity)
(iv) Interest rates differential = expected change in the spot exchange rate (International Fisher
effect)
Comparing Theory and Practice based on Empirical Evidence

Although the relationship between interest rates differential and the exchange rates seem logical,
in practice things are different. In practice, interest rate differentials and future spot exchange
rates are sometimes positively and some other times negatively correlated. These are some facts
based on empirical evidence:
90% of the aggregate market volume has speculative characteristics and that means that the key
market movers ignore the long-term effect of interest rate differentials
The Foreign Exchange market is aligned with interest rate differentials but it tends to anticipate the
movements of interest rates before they actually happen
The Foreign Exchange market focus on many other factors except interest rates differentials and
inflation rates. These factors include political stability, new legislation, new growth opportunities,
business conditions, etc.
The Interest Rate Parity and the two Fisher theories hold better for emerging economies.
Developed economies are in general more complicated than emerging economies.
4. THE MONETARY APPROACH

The Monetary Approach focuses on the monetary policies of two countries in order to determine
their currency exchange rate. The Monetary Approach uses two dynamics to determine an
exchange rate, the price dynamics and the interest rates dynamics.
A change in the domestic money supply leads to a change in the level of prices and a change in
the level of prices leads to a change in the exchange rate.
Monetary Approach Assumptions

The monetary model assumes:
(i) A freely-floating exchange rate regime (not a fixed exchange rate regime)
(ii) Minimal interventions by central banks
(iii) The aggregate supply curve is vertical
(iv) The prices of tradable goods are immediately adjusted to any change in the dynamics that
affect them
(v) The transmission mechanism through prices to the exchange rate is immediate
The Monetary Policies
In general, a monetary policy focuses on the money supply of an economy. The available money
supply is determined by:
(a) the amount of money in circulation, and
(b) the level of interest rates.
Countries that apply expansionary monetary policies in order to increase the amount of money in
circulation will face inflationary pressures. This usually leads to a devaluation of the currency
exchange rate. On the contrary, countries that apply tight monetary policies decrease the
amount of money in circulation and see their currencies appreciate.
Money Supply & Money Demand
■ Money supply is generally determined according to the central bank objectives. This is
happening by:
(a) adjusting the level of interest rates, and
(b) controlling the amount of printed money in circular.
■ Money demand is a more complex variable determined by:
(a) the available income
(b) the level of interest rates

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(c) the level of prices, and

(d) future income and price expectations
The Mundell–Fleming Model

The Mundell–Fleming model focuses on the short-run relationship between the exchange rate, the
interest rate, and the economic output. According to the Mundell–Fleming Model, certain
combinations of fiscal and monetary policies may lead to some changes in the balance of
payments relative to a new equilibrium level. Therefore, the exchange rate becomes a
transmission mechanism by which the equilibrium can be fully restored.
Comparing Theory and Practice based on Empirical Evidence

The Monetary Approach is neither an easy predictor nor an accurate predictor of exchange
rates. In reality, the transmission mechanism between the price and the exchange rates is
delayed.
The Monetary Approach is unable to make accurate short-term exchange rate forecast, it is more
reliable in the long-term. Depending on the market expectations, the reaction of investors to a
change in the level of interest rates can be unpredictable by a static economic model.
Furthermore, the monetary approach holds better when applied in emerging economies than in
developed economies.
What is the Balance of Payments?

The balance of payments is a general account that incorporates all the payments and receipts of
the residents of a country in their transactions with residents of foreign countries. This account
includes a great variety of transactions:
(i) Traded goods and services
(ii) Income from foreign investment
(iii) New investment
(iv) Foreign aid
(v) Capital flows between central banks and treasuries (cash or gold)
The annual payments and receipts of each country must be equal. Any inequality leads to a
deficit or a surplus in the balance of payments.
■ Payments > Receipts = Deficit
■ Payments < Receipts = Surplus
The Current Account and the Capital Account
The balance of payments account contains two sub-accounts: the current and the capital
accounts.
(i) The current account includes exports and imports of goods and services as well as unilateral
transfers.
(ii) The capital account includes payments of debts and claims (no matter the time period)
What is the Balance of Trade?
The balance of trade is a smaller account that includes only the traded goods and services. The
balance of trade is the difference between the value of the traded goods and services that are
imported and exported by a country.
■ Imports > Exports = Trade Deficit
■ Imports < Exports = Trade Surplus
The balance of trade includes two categories of trade balances: (i) the balance of merchandise
trade for tangible goods, and (ii) the balance of services
Calculating the Equilibrium

In theory, the national income minus the national expenditure of a country must be equal to the
difference between savings and investment and the difference between imports and exports.
■I−E=X–M=S−C
where:
I = Income | E = Expenditure | X = Exports | M = Imports | S = Savings | C = Investment
The Relationship between the National Income, the Current Account, and the Exchange Rate

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Assuming that the level of interest rate is stable, if the national income of a country is rising, the
demand for foreign goods is rising too. That stronger demand leads to an increased amount of
imports, and a new equilibrium in the current account balance. In that case, the exchange rate
of the country works as a transmission mechanism for restoring the balance of payments
equilibrium. Practically, the exchange rate of that country will depreciate in order to make imports
more expensive and thus to restore the balance between exports and imports.
On the other hand, if the national income is falling, the imports will shrink and the exchange rate
will appreciate restoring the equilibrium in the current account balance.
Adding the Effect of an Interest Rate Hike
If the national income of a country increases, the domestic central bank will be tempted to raise
the level of interest rates. The higher the real interest rates the lower the demand for consumption
and the lower the country's imports. Therefore, higher interest rates restore the balance of
payments equilibrium.
On the other hand, if the national income is falling, the interest rates will fall too in order to
stimulate the domestic demand and the equilibrium in the current account again is restored.
■ Summarizing the Transmission Mechanism:
(i) National Income Change > Change in Real Demand > Change in Current Account > Change
in the Interest Rates to achieve equilibrium
(ii) National Income Reverses > Reverse in Current Account > Reverse in the level of Interest Rates
> Balance of Payments new equilibrium
Foreign Exchange Rate Determination
Foreign Exchange Rate is the amount of domestic currency that must be paid in order to
get a unit of foreign currency. According to Purchasing Power Parity theory, the foreign exchange
rate is determined by the relative purchasing powers of the two currencies.
Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate
between India and the USA will be (100/20=5), 1 $ = 5 Re.
Forces Behind Exchange Rate Determination
Foreign Exchange is a price of one country currency in relation to other country currency,
which like the price of any other commodity is determined by the demand and supply factors.
The demand and supply of the foreign exchange rate come from the residents of the respective
countries.
Demand for Foreign Exchange (Foreign Supply of Foreign Exchange (Foreign Money
Money goes out) Comes in)
Foreign Currency is needed to carry out

The source of foreign currency available to
transactions in foreign countries or for the
the domestic country is foreigners purchasing
purchase of foreign goods and services
our goods and services (Exports).
(IMPORTS).
Foreign currency is needed to invest in Foreigners investing in Indian Stock markets,

foreign country assets/shares/bonds etc. Assets, Bonds etc. (FPIs and FDIs)
Foreign currency is needed to make transfer

Transfer payments. Example: Indian working
payments. Example: Indian Parents sending
in the USA, sending money to his/her old
Money to his/her son/daughter studying in
aged parents.
the USA.
Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.

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Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.
The DD curve represents the demand for foreign exchange by India. The SS curve represents the
supply of foreign exchange to India.
The point where both DD and SS curves intersect is the point of equilibrium. At this point
demand for foreign exchange is exactly equal to the supply of foreign exchange.
At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in
time, the exchange rate is at E1, then the demand for foreign exchange falls short of supply of
foreign exchange, as a result at this point Indians are demanding less foreign currency due to
which Re will appreciate vis-à-vis foreign currency. The appreciation mainly occurs due to a
favourable balance of payment situation (Surplus).
By the same token at point E2, demand for foreign exchange is greater than the supply of
foreign exchange, at this point Indians are demanding excess foreign exchange than what the
foreigners are willing to supply, as a result, at E2 Re will depreciate vis-à-vis foreign currency. The
depreciation mainly occurs due to the unfavourable balance of payments situation(Deficits).
Managed Floating Exchange rate

Manage Floating exchange rate lies in between of the two extremes of fixed and floating
exchange rate. Under such a system, the exchange is allowed to move freely and determined by
the forces of the market (Demand and Supply). But when a difficult situation arises, the central
banks of the country can intervene to stabilise the exchange rate.
There are mainly three sub categories under managed floating exchange rate:
 Adjusted Peg System: In this system, a country should try to hold on to a fixed exchange
rate system for as long as it can, i.e. until the country’s foreign exchange reserves got
exhausted. Once the country’s foreign exchange reserves got exhausted, the country
should undergo devaluation of currency and move to another equilibrium exchange rate.
 Crawling Peg System: In this system, a country keeps on adjusting its exchange rate to new
demand and supply conditions. The system requires that instead of devaluing currency at
the time of crisis, a country should follow regular checks at the exchange rate and when
require must undertake small devaluations.
 Clean Floating: In the clean float system, the exchange rate is determined by market forces
of demand and supply. The exchange rate appreciates or depreciates as per market
forces and with no government intervention. It is identical to floating exchange rate.
 Dirty Floating: In the dirty float system, the exchange rate is to a very large extent is
determined by the market forces of demand and supply (so far identical to clean floating),

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but occasionally the central banks of the countries intervene in foreign exchange markets
to smoothen or remove excessive fluctuations from the foreign exchange markets.
The Bretton Woods system of exchange rate which was in operation from 1944 till 1971, was one of
relative fixed exchange rate as opposed to rigid fixed exchange rate. As a matter of fact, rigid
fixed exchange rate as defined above, is never been used in history. Even under the system of
Gold Standard 1870-1941, the exchange was relatively fixed and not rigidly fixed.
EXCHANGE RATE MANAGEMENT IN INDIA

Over the last six decades since independence the exchange rate system in India has transited
from fixed exchange rate regime where the Indian Rupee was pegged to the UK Pound to a
basket of currencies during the 1970s and 1980s and eventually to the present form of market
determined exchange rate regime since 1993.
[1]. Par Value System (1974-1971): After Independence Indian followed the ‘Par Value System’
whereby the rupee’s external par value was fixed with gold and UK pound sterling. This
system was followed up to 1966 when the rupee was devalued by 36 percent.
[2]. Pegged Regime (1971-1992): India pegged its currency to the US dollar (1971-1991) and to
pound (1971-75). Following the breakdown of Breton Woods system, the value of pound
collapsed, and India witnessed misalignment of the rupee. To overcome the pressure of
devaluation India pegged its currency to a basket of currencies. During this period, the
exchange rate was officially determined by the RBI within a nominal band of +/- 5 percent
of the weighted average of a basket of currencies of India’s major trading partners.
[3]. The period since 1991: The transition to market-based exchange rate was in response to the
BOP crisis of 1991. As a first step towards transition, India introduces partial convertibility of
rupee in 1992-93 under LERMS.
[4]. Liberalised Exchange Rate Management System (LERMS): The LERMS involved partial
convertibility of rupee. Under this system, India followed a dual exchange rate policy,
where 40 percent of the exchange rate were to be converted at the official exchange
rate and the remaining 60 percent were to be converted at the market-based exchange
rate. The exchange rate converted at the official rate were to be used for essential imports
like crude, oil, fertilizers, life savings drugs etc. All other imports should be financed at the
market-based exchange rate.
[5]. Market-Based Exchange rate Regime (1993- till present): The LERMS was a transitional
mechanism to provide stability during the crisis period. Once the stability is achieved, India
transited from LERMS to a full flash market exchange rate system. As a result, since 1993,
exchange rate fluctuations are marker determined. In the 1994 budget, 60:40 ratio was
removed, and 100 percent conversion at market-based rate was allowed for all goods and
capital movements.
UNIT-4 Exchange rate policies and macroeconomic management: Fixed and flexible rates –
Central Banks actions, Impact of changing exchange rates on exports and imports,
Volatility managements by the government and Exchange rate regimes, Open
economy macroeconomics, Monetary approach and asset market approach to
predict future exchange rate, 3 International Financial Crises models - Understanding
the recent few crises, The Euro Crisis/ crisis in Venezuela, Economic risk indicators for
FDI and FII
EXCHANGE RATE POLICIES AND MACROECONOMIC MANAGEMENT

Changes in the external value of a currency can have important effects on a number of
macroeconomic outcomes and objectives
The Exchange Rate and Inflation:
The exchange rate affects the rate of inflation in a number of direct and indirect ways:
1. Changes in the prices of imported goods and services – this has a direct effect on the
consumer price index. For example, an appreciation of the exchange rate usually reduces
the price of imported consumer goods and durables, raw materials and capital goods.

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2. Commodity prices: Many commodities are priced in dollars – so a change in the sterling-
dollar exchange rate has a direct impact on the UK price of commodities such as oil and
foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.
3. Changes in the growth of exports: A higher exchange rate makes it harder to sell overseas
because of a rise in relative prices. If exports slowdown (price elasticity of demand is
important in determining the scale of any change in demand), then exporters may choose
to cut their prices, reduce output and cut-back employment levels.
Bank of England research for the UK economy suggests that 10% depreciation in the exchange
rate can add up to 3% to the level of consumer prices three years after the initial change in the
exchange rate. But the impact on inflation of a change in the exchange rate depends on what
else is going on in the economy.
The Exchange Rate and Unemployment
1. An exchange rate appreciation causes a slower growth of real GDP because of a fall in
net exports (reduced injection) and a rise in the demand for imports (an increased leakage
in the circular flow).
2. A reduction in demand and output may cause job losses as businesses seek to control
costs. Some job losses are temporary – reflecting short term changes in export demand and
import penetration. Others are permanent if imports take up a permanently higher share of
the domestic market. Thus a higher exchange rate can have a negative multiplier effect
on the economy.
3. Some industries are more exposed than others to currency fluctuations – e.g. sectors where
a high percentage of total output is exported and where demand is highly price sensitive
(price elastic)
What are some of the Macroeconomic Benefits of a Weaker Currency?
• A fall in a currency is an expansionary monetary policy and can be used as a counter-
cyclical measure to stimulate demand, profits, output and jobs when an economy is in
recession or slowdown
• It ought to bring about an improvement in the balance of trade and, through higher export
sales, drive an expansion of output in industries that serve export businesses – this is known
as the ‘supply-chain’ effect.
• Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has the
same effect on UK output as a 0.2 percentage-point cut in interest rates. On this basis, the
25% decline in sterling in 2008 was equivalent to a cut in interest rates of between 4 and 5%.
Without the depreciation in sterling at this time, the recession in the UK would have been
much deeper.
In brief, a cheaper currency provides a competitive boost to an economy and can lead to
positive multiplier and accelerator effects within the circular flow of income and spending.
Depreciation of also has the effect of increasing the value of profits and income for a
country’s businesses with investments overseas. And it is a boost to tourist and farming industries.
For farmers in Europe, CAP payments are made in Euros, so a lower sterling/Euro exchange
rate increases the sterling value of farm subsidies for farmers in Britain.
Some of the benefits of a weaker currency happen in the near term; but there are also some
potential gains in the medium term. For many years the UK economy has been criticized for over-
consumption and under-investment with the economy being unbalanced and too dependent on
borrowing.
What are the Limits of a Currency Depreciation to solve Economic Problems?
Not all of the effects of a cheaper currency are positive – here are some downsides and risks:
 A weak currency can make it harder for the government to finance a budget deficit if
overseas investors lose confidence. When investors take their money out, this is known as
capital flight
A weak currency also makes it harder to pay for a trade deficit that is owed to overseas creditors
 Depreciation increases the cost of imports – e.g. rising prices for essential foodstuffs, raw
materials and components and also imported technology. This can cause an inward shift of
SRAS (and has inflationary risks) and might also affect long-run productive potential.
 Weak global demand can dampen the beneficial effects of a lower currency – it is then
harder to export when key markets are in recession and overseas sales are falling

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 If the price elasticity of demand for exports and imports is low, a depreciation of the
exchange rate may initially cause a worsening of the balance of trade in goods and
services. This is known as the J-Curve Effect
Exchange rates and balance of payments adjustment - The ‘J-Curve’ effect
 In the short term depreciation may not improve the current account of the Balance of
Payments
 This is due to the low price elasticity of demand for imports and exports in the short term
 oInitially the quantity of imports will remain steady because contracts for imported goods
will have been signed. Export demand will be inelastic in response to the exchange rate
change
 Earnings from exports may be insufficient to compensate for higher spending on imports.
 The balance of trade may worsen and this is known as the ‘J-Curve’ effect
 Providing that the elasticity of demand for imports and exports are greater than one, then
the trade balance will improve over time. This is known as the Marshall-Lerner condition.
FIXED AND FLEXIBLE RATES – CENTRAL BANKS ACTIONS

Fixed exchange rate and flexible exchange rate are two exchange rate systems, differ in the
sense that when the exchange rate of the country is attached to the another currency or gold
prices, is called fixed exchange rate, whereas if it depends on the supply and demand of money
in the market is called flexible exchange rate.
An exchange rate regime, also known as the pegged exchange rate, wherein the
government and central bank attempts to keep the value of the currency is fixed against the
value of other currencies, is called fixed exchange rate. Under this system, the flexibility of
exchange rate (if any) is permitted, under IMF (International Monetary Fund) arrangement, but up
to a certain extent.
In India, when the currency price is fixed, an official price of its currency in reserve currency
is issued by the apex bank, i.e. Reserve Bank of India. After the determination of the rate, the RBI
undertakes to buy and sell foreign exchange, and the private purchases and sales are
postponed. The central bank makes changes in the exchange rate (if necessary).
A monetary system, wherein the exchange rate is set according to the demand and supply
forces, is known as flexible or floating exchange rate. The economic position of the country
determines the market demand and supply for its currency.
In this system, the currency price is market determined, concerning other currencies, i.e. the
higher the demand for a particular currency, the higher is its exchange rate and the lower the
demand, the lesser is the value of currency compared to other currencies. Therefore, the
exchange rate is not under the control of the government or central bank.
Basis for
Fixed Exchange Rate Flexible Exchange Rate
Comparison
Fixed exchange rate refers to a rate Flexible exchange rate is a rate
Meaning
which the government sets and that variate according to the

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maintains at the same level. market forces.

Determined by Government or central bank Demand and Supply forces
Changes in
Devaluation and Revaluation Depreciation and Appreciation
currency price
Takes place when there is rumor
Speculation Very common
about change in government policy.
Operates through variation in supply
Self-adjusting Operates to remove external
of money, domestic interest rate and
mechanism instability by change in forex rate.
price.
Central banks are mainly responsible for maintaining inflation in the interest of sustainable
economic growth while contributing to the overall stability of the financial system. When central
banks deem it necessary they will intervene in financial markets in line with the defined “Monetary
Policy Framework”. The implementation of such policy is highly monitored and anticipated by
forex traders seeking to take advantage of resulting currency movements.
In theory, within a flexible system, central banks should leave the process of determining
appropriate exchange rates to the currency markets. Supply and demand and the reactions of
currency traders to changes in the macroeconomic setting result in the free floating of exchange
rates. In practice, however, central banks have frequently intervened to “manage” the exchange
rates according to their goals and priorities.
THE MOTIVES FOR FX INTERVENTIONS

The motives of the central banks’ activities in the FX markets can be grouped as follows:
1. Leaning against the wind: According to the recent BIS survey of central banks, the most
common reason cited for emerging market central banks to intervene in foreign exchange
markets was to limit exchange rate volatility and smooth the trend path of the exchange rate.
2. Reducing exchange rate misalignment: Too high an exchange rate can reduce a country’s
competitiveness, and too low can lead to an unsustainable growth spurt and inflation.
Therefore, central banks step into the foreign exchange market if they see that the current
exchange rate appears to be either overvalued or undervalued.
3. Managing FX reserves: After the Asian financial crisis, many central banks accumulated
reserves. The crisis focused the spotlight on the precautionary motive for holding reserves, and
their insurance value in the face of currency pressures… Around 50% of central banks
intervening in foreign exchange markets during 2004-2010 were motivated at least in part by
the desire to accumulate reserves.
4. Ensuring liquidity: Owing to shallow foreign exchange markets, some central banks may
conduct intervention to ensure adequate liquidity in order to counter disorderly markets and
avoid financial stress. During the international financial crisis, more than half of participating
central banks intervened to provide liquidity.
Central banks have a choice of different types of interventions to make use of. These can
either be direct or indirect. Direct intervention, as the name suggests, has an immediate effect on
the forex market, while indirect intervention achieves the objectives of the central bank via less
invasive means. Below are examples of direct and indirect intervention:
TYPES OF INTERVENTION DIRECT OR INDIRECT
Jawboning Indirect
Operational Intervention Direct
Concerted Intervention Direct and indirect
Sterilized Intervention Direct
1. Operational Intervention: This is usually what people mean when they refer to central bank
intervention. It involves the central bank buying and selling both foreign and local currency
to drive the exchange rate to a targeted level. It is the pure size of these transactions that
move the market.

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2. Jawboning: this is an example of indirect FX intervention whereby a central bank mentions

that it may intervene in the market if the local currency reaches a certain undesirable level.
This method, as the name suggests, is more about talking than actual intervention. With the
central bank ready to intervene, traders take it upon themselves to collectively bring the
currency back to more acceptable levels.
3. Concerted Intervention: This is a combination of jawboning and operational intervention
and is most effective when multiple central banks voice the same concerns over exchange
rates. If a number of central banks increase their jawboning efforts, it is likely that one of
them actually conducts operational intervention to drive the exchange rate in the desired
direction.
4. Sterilized intervention: Sterilized intervention involves two actions from the central bank in
order to influence the exchange rate and at the same time, leave the monetary base
unchanged. This involves two steps: The sale or purchase of foreign currency, and an open
market operation (selling or buying government securities) of the same size as the first
transaction.
HOW CENTRAL BANKS IMPACT THE FOREX MARKET

Forex traders often assess the language used by the chairman of the central bank to look
for clues on whether the central bank is likely to increase or decrease interest rates. Language
that is interpreted to suggest an increase/decrease in rates is referred to as Hawkish/Dovish. These
subtle clues are referred to as “forward guidance” and have the potential to move the forex
market.
Traders that believe the central bank is about to embark on an interest rate hiking cycle will
place a long trade in favour of that currency, while traders anticipating a dovish stance from the
central bank will look to short the currency.
Movements in central bank interest rates present traders with opportunities to trade based
on the interest rate differential between two country’s currencies via a carry trade. Carry traders
look to receive overnight interest for trading a high yielding currency against a low yielding
currency.
IMPACT OF CHANGING EXCHANGE RATES ON EXPORTS AND IMPORTS,
The exchange rate is defined as "the rate at which one country's currency may be
converted into another. Typically, these rates fluctuate daily in response to the forces of supply
and demand for different countries’ currencies. India, for instance, is the world’s leading copper
exporter. If global demand for copper goes up, demand for the country’s currency, the Indian
Rupee, may also rise since companies may need Rupees to buy copper. That would increase the
Rupee value compared with dollars, pounds, and euros. If demand for copper falls, the Indian
Rupee value may also take a hit.
Other important factors that affect exchange rates include:
1. Inflation rates. Inflation is a major determinant of exchange rates. Countries with low
inflation usually see the value of their currency rise compared to others. Those with higher
inflation, meaning each unit of their currency buys fewer goods and services over time,
usually see their exchange rates fall.
2. Interest rates. Interest rates are also closely tied to foreign exchange and inflation rates. If
the rate a country pays when it borrows rises relative to other countries, more money
seeking higher returns will flock to that country, demand for its currency will rise and the
currency’s value will rise with it. Likewise, if interest rates fall, money will flee in search of
higher returns and the exchange rate will drop.
3. Current account. A country’s current account includes its balance of trade and earnings
on foreign investment. Its trade balance reflects its exports versus its imports and foreign
debt. A current account deficit may occur when a country imports more than it exports,
and this in turn can cause its currency to depreciate.
4. Government debt. When governments issue new debt, interest rates may rise to attract
bond buyers, leading to more demand for its currency. But if investors fear that the

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government has taken on too much debt and may default, they may sell whatever
government bonds they hold, undercutting demand for its currency and causing its
exchange rate to decline. This, in turn, may cause inflation to spike.
5. Political and economic stability. This is another important factor, since foreign capital will
gravitate towards countries where investments are secure and the business landscape
offers few surprises. Money flocks to countries where the business climate is predictable and
flees countries roiled by uncertainty. This favors the former’s exchange rate and undermines
the latter’s currency.
6. Speculation. Investors looking for profits through currency trading can also play a role,
especially when a turn of events is deemed likely to have an outsized impact on a
country’s currency. If that country is on the brink of a recession, for example, speculators
may see its currency as vulnerable and sell it short. This can amplify any decline in its value.
Ways Exchange Rates Affect Imports and Exports

A strengthening dollar can spell trouble for U.S. companies that export a lot of goods to
other countries. Since their products are priced in dollars, those exports become more expensive
for the foreign consumers and businesses that have to pay for them in other currencies. The value
of the profits they make on export sales falls, as well, when they convert overseas profits back to
dollars.
But the dollar’s favorable exchange rate can also hurt U.S. firms at home. That’s because
when the dollar is strong, American consumers are able to buy imported goods for fewer dollars,
making American-made products more costly in comparison.
While this makes it appear that U.S. businesses benefit when the dollar weakens, reality is
not so simple. When the dollar falls in value compared to other currencies, the price of imported
raw materials like steel go up in price and products like cars that are manufactured in the U.S. can
cost more to make.
Conversely, if the dollar rises and the cost of imported materials drops, American
manufacturers that hold their prices steady will see their margins increase. Alternatively, they have
the option of dropping their prices to grab a bigger chunk of the market, without surrendering any
of their profits. Moves like this can compensate for the loss of price competitiveness due to a
stronger dollar both at home and abroad.
VOLATILITY MANAGEMENTS BY THE GOVERNMENT AND EXCHANGE RATE REGIMES
Volatility in exchange rate refers to the amount of uncertainty or risk involved with the size
of changes in a currency’s exchange rate. Volatility in the rupee-dollar exchange rate during
various episodes of heightened volatility in the forex market in the past two decades have been
computed using standard deviations of daily forex market returns, which have been annualised.
The rupee-dollar exchange rate data for volatility computation have been sourced from
Bloomberg. An analysis of volatility in various phases of exchange rate pressures shows that
volatility in rupee-dollar exchange rate has exhibited mixed trends in the past two decades of
market determined exchange rate.
After the first major episode of volatility in 1995-96 in the wake of Mexican crisis when volatility
touched the level of around 13- 14 per cent, volatility remained relatively subdued, even during
the East Asian crisis of 1997-98. However, there has been a significant increase in exchange rate
volatility in the aftermath of the global financial crisis, signifying the greater influence of volatile
capital flows on exchange rate movements.
EMEs like India, which have large current account deficit, are particularly vulnerable to the
vagaries of international capital flows where a surge in capital flows in search of better yield is
invariably followed by reversals/sudden stops on sudden change in risk appetite of international
investors, thereby imparting significant volatility to the EME financial markets. Volatility has
increased significantly in the post May 22, 2013 phase after Chairman Bernanke’s testimony about
the possibility of QE tapering. Among various episodes of volatility, the annualized daily volatility
was maximum at around 17.14 per cent during the period from May 23 to September 4, 2013.
However, it declined to 9.15 per cent during the period September 4, 2013 to April 2, 2014.

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Indian foreign exchange market has gone through a process of gradual liberalization
during the past two decades. It has indeed come a long way since its inception in 1978 when
banks in India were allowed to undertake intra-day trade in foreign exchange. However, it was in
the 1990s that the Indian foreign exchange market witnessed far reaching changes along with the
shifts in the currency regime in India from pegged to floating.
The balance of payments crisis of 1991, which marked the beginning of the process of
economic reforms in India, led to introduction of Liberalized Exchange Rate Management System
(LERMS) in 1992, which was introduced as a transitional measure and entailed a dual exchange
rate system.
LERMS was abolished in March 1993 and floating exchange rate regime was adopted. With
the introduction of market-based exchange rate regime in 1993, adoption of current account
convertibility in 1994, and gradual liberalization of capital account over the years, essential
underpinnings were provided for the foreign exchange market to flourish in India.
Today, it constitutes a significant segment of the Indian financial markets with reasonable
degree of integration with money market, government securities market and capital market, and
plays an important role in the Indian economy.
In the aftermath of the global financial crisis and the Euro zone debt crisis, emerging market
economies (EMEs) have faced enhanced uncertainty. Capital flows to EMEs have become
extremely volatile with excessive capital inflows to EMEs in search of better yields followed by
sudden stops and reversals. Many major EM currencies, including the Indian rupee, witnessed
significant depreciation in the recent period owing to the ‘announcement effect’ of the likely
tapering of quantitative easing (QE) by the US Federal Reserve (Fed).
Post-Exchange Rate Unification Period (March 1993 to July 1995): Surge in Capital Flows
To maintain the external competitiveness of exports and stability of the rupee, which is a
prerequisite for capital inflows, RBI, under Governor Rangarajan, intervened in the spot market
and purchased dollars and, thereafter, conducted Open Market Operations to partly sterilize the
expansionary impact on domestic liquidity. The focus of exchange rate policy in 1993-94 was on
preserving the external competitiveness of the rupee at a time when the economy was
undergoing a structural transformation coupled with building up of the forex reserves.
Impact of Mexican Crisis (August 1995 to March 1996)
As the rupee was overvalued in REER terms, the RBI allowed the rupee to depreciate but
intervened in the market to ensure that the market corrections were calibrated and orderly. The
RBI intervened in the second fortnight of October 1995 to the tune of US$ 912.5 million. Further,
certain administrative measures were initiated to reduce the leads and lags in import payments
and export realization and to improve inflows. Some of the major administrative/monetary
measures taken by the RBI under Governor Rangarajan in October/November 1995, inter alia,
included:

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 Imposition of interest surcharge on import finance with effect from October 1995,
 Tightening of concessionality in export credit for longer periods,
 Easing of CRR requirements on domestic as well as nonresident deposits from 15.0 per cent
to 14.5 per cent in November 1995,
 Foreign currency denominated deposits like FCNR(B) and NR(NR)RD were exempted from
CRR requirements, and
 Interest rates on NRE deposits were increased.
January-March 1996: Renewed Volatility on Weak Sentiments
In order to curb the volatility in the spot as well as forward market, spot sales followed by
buy-sell swaps were undertaken on several occasions. In addition, direct forward sales were also
resorted to. As at the end of March 1996, the RBI’s cumulative forward sales obligations were to
the tune of US$ 2.3 billion, spread over the next six months. As a result of the RBI’s intervention
operations to contain volatility in the forex market, RBI’s foreign currency assets, which stood at
19.0 billion at end- August 1995, declined to US$ 15.9 billion by end-February 1996. Apart from the
intervention efforts, a number of administrative measures were also initiated on February 7, 1996 to
encourage faster realization of export proceeds and to prevent an acceleration of import
payments, i.e., to reduce the lags and leads.
The measures, inter alia, included:
 Increase in interest rate surcharge on import finance from 15 to 25 per cent,
 discontinuation of Post-Shipment Export Credit denominated in US dollars (PSCFC) with
effect from February 8, 1996,
 Weekly reporting to the RBI of cancellation of forward contracts booked by ADs for
amounts of US$ 1,00,000 and above.
 Other measures included relaxation in the inward remittance of GDR proceeds, relaxation
in the external commercial borrowing (ECB) norms, freeing of interest rate on postshipment
export rupee credit for over 90 days and upto 180 days, etc.
Impact of East Asian Crisis (August 1997 to August 1998)
In order to restore stability, the RBI intervened in the spot, forward and swap markets. In
September 1997 alone, RBI was net seller in the forex market to the tune of US$ 978 million, while
during the period November 1997 to July 1998, RBI was net seller to the tune of US$ 3.1 billion. As a
result of RBI’s intervention in the forward market to manage expectations and bring forward
premia down, RBI’s forward laibilities increased from US$ 40 million in August 1997 to a peak of US$
3.2 billion in January 1998 but came down subsequently as normalcy returned to the market.
Apart from intervention operations, the RBI also initiated stringent monetary and administrative
measures to stem the unidirectional expectation of a depreciating rupee and curb speculative
attacks on the currency. Some of the important measures taken by the RBI under Governor
Rangarajan (upto November 22, 1997) and subsequently under Governor Jalan during the period
from August 1997 to April 1998 are set out below:
 With a view to reducing arbitrage opportunities between forex market and the domestic
rupee markets, and thereby reducing the demand for dollars, the interest rate on fixed rate
‘repos’ was raised to 5 per cent from 4.5 per cent,
 The CRR requirement of scheduled commercial banks was raised by 0.5 percentage point.
 Incremental CRR of 10 per cent on NRERA and NR(NR) deposits were removed with effect
from the fortnight beginning December 6, 1997.
 The interest rate on post-shipment export credit in rupees for periods beyond 90 days and
up to six months was raised from 13 per cent to 15 per cent,
 In respect of overdue export bills, a minimum interest rate of 20 per cent per annum was
prescribed,
 An interest rate surcharge of 15 per cent on lending rate (excluding interest tax) on bank
credit for imports was introduced.
On Jan 6/16, 1998, more measures were taken, which included
 Raising of cash reserve ratio requirement for banks from 10 per cent to 10.5 per cent,
 Raising Bank Rate from 9 per cent to 11 per cent,

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 Raising interest rate on fixed rate repos from 7 per cent to 9 per cent,
 Reducing access of banks to export and general refinance facility from RBI and
 Prohibiting banks from taking any overnight currency position from January 6, 1998.
May-August 1998: Renewed Volatility due to Spread of Asian Crisis
Some important measures announced by the RBI during the period have been set out below:
 Export credit denominated in foreign currency was made cheaper and banks were
advised to charge a spread of not more than 1.5 per cent above LIBOR as against the
earlier norm of not exceeding 2-2.5 per cent over LIBOR.
 Exporters were also allowed to use their balances in EEFC accounts for all business related
payments in India and abroad at their discretion,
 Withdrawal of the facility of rebooking of cancelled forward contracts for trade related
transactions including imports, etc.
 As a measure of abundant precaution and also to send a signal to the world regarding the
intrinsic strength of the economy, India floated the Resurgent India Bonds (RIBs) in August
1998, which was very well received by the Non Resident Indians(NRIs)/ Persons of Indian
Origin (PIOs) and subscribed to the tune of US$ 4.2 billion.
The Pre Crisis Phase (September 1998 till August 2008)

I. Episode of Volatility in 2000: Higher imports and Reduced Capital Flows
Apart from intervention (net sales of US$ 1.9 billion during May-June 1998), the RBI under Governor
Jalan took a number of administrative measures to contain volatility in the forex market, which
had a salutary impact. The measures taken on May 25, 2000 included:
1] an interest rate surcharge of 50 per cent of the lending rate on import finance was
imposed with effect from May 26, 2000, as a temporary measure, on all non-essential
imports,
2] it was indicated that the Reserve Bank would meet, partially or fully, the Government debt
service payments directly as considered necessary;
3] arrangements would be made to meet, partially or fully, the foreign exchange
requirements for import of crude oil by the Indian Oil Corporation;
4] the Reserve Bank would continue to sell US dollars through State Bank of India in order to
augment supply in the market or intervene directly as considered necessary to meet any
temporary demand-supply imbalances;
5] banks would charge interest at 25 per cent per annum (minimum) from the date the bill fell
due for payment in respect of overdue export bills in order to discourage any delay in
realisation of export proceeds;
6] authorised dealers acting on behalf of FIIs could approach the Reserve Bank to procure
foreign exchange at the prevailing market rate and the Reserve Bank would, depending
on market conditions, either sell the foreign exchange directly or advise the concerned
bank to buy it in the market; and
7] banks were advised to enter into transactions in the forex market only on the basis of
genuine requirements and not for the purpose of building up speculative positions.
Subsequently, the exchange rate of the rupee, which was moving in a range of Rs. 44.67-44.73
per US dollar during the first half of July 2000 touched a low of Rs 45.07 per US dollar on July 21,
2000, the day on which RBI announced certain monetary measures, which have been set out
below:
 Raising of CRR by 0.5 percentage points to 8.5 per cent from 8.0 per cent;
 Raising of bank rate by one percentage point from 7 per cent to 8 per cent and
 Reduction of 50 per cent in refinance facilities including collateralised lending facility
available to the banks.
II. Episode of Volatility in 2001: September 11, 2001 Terrorist Attacks
The Reserve Bank tackled the situation through quick responses in terms of net sales in the forex
market to the tune of US$ 894 million in September 2001 and package of measures, which have
been set out below:
The measures taken by the Reserve bank under Governor Jalan included:

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 Reiteration by the Reserve Bank to keep interest rates stable with adequate liquidity;
 Assurance to sell foreign exchange to meet any unusual supply demand gap;
 Opening a purchase window for select Government securities on an auction basis;
 Relaxation in FII investment limits upto the sectoral cap/statutory ceiling;
 A special financial package for large value exports of six select products;
 Reduction in interest rates on export credit by one percentage point, etc.
The Global Financial Crisis (2008-09 To 2011-12)

I. Volatility in 2008-09: Collapse of Lehman Brothers
The robust macro-economic environment with GDP expanding at over 9 per cent during 2006-07
and 2007-08, CAD standing at 1.3 per cent of GDP in 2007-08 (1.0 per cent in 2006-07) and WPI
inflation standing at a comfortable 4.7 per cent during 2007-08 also facilitated strong capital
inflows. However, there was a sudden change in the external environment following the Lehman
Brothers’ failure in mid-September 2008. The global financial crisis and deleveraging led to reversal
and/ or modulation of capital flows, particularly FII flows, ECBs and trade credit. Large withdrawals
of funds from the equity markets by the FIIs, reflecting the credit squeeze and global
deleveraging, resulted in large capital outflows during September-October 2008, with
concomitant pressures in the foreign exchange market across the globe, including India.
After Lehman’s bankruptcy, the rupee depreciated sharply from around Rs. 48 levels, breaching
the level of Rs.50 per US dollar on October 27, 2008
The Reserve Bank under Governor Subbarao took a number of measures to control volatility,
which included:
 Announcement in mid-September 2008 by the Reserve Bank about its intentions to
continue selling foreign exchange (US dollar) through agent banks to augment supply in
the domestic foreign exchange market or intervene directly to meet any demand-supply
gaps.
 A rupee-dollar swap facility for Indian banks was introduced with effect from November 7,
2008 to give the Indian banks comfort in managing their short-term foreign funding
requirements. For funding the swaps, banks were also allowed to borrow under the LAF for
the corresponding tenor at the prevailing repo rate. The forex swap facility, which was
originally available till June 30, 2009, was extended up to March 31, 2010; however, this was
discontinued in October 2009.
 The Reserve Bank also continued with Special Market Operations (SMO) which were
instituted in June 2008 to meet the forex requirements of public sector oil marketing
companies (OMCs), taking into account the then prevailing extraordinary situation in the
money and foreign exchange markets; these operations were largely (Rupee) liquidity
neutral.
 Finally, measures to ease forex liquidity also included those aimed at encouraging capital
inflows, such as, an upward adjustment of the interest rate ceiling on foreign currency
deposits by non-resident Indians, substantially relaxing the ECB regime for corporates, and
allowing non-banking financial companies and housing finance companies to access
foreign borrowing.
Volatility in 2011-12: Deepening of Euro Zone Debt Crisis & Weak Fundamentals
After being largely range bound in the first four months of the financial year 2011-12, rupee
depreciated by about 17 per cent during August to mid-December of 2011, reflecting global
uncertainties and domestic macro-economic weakness.
Considering the excessive pressures in the currency markets, the Reserve Bank under Governor
Subbarao intervened in the foreign exchange market through dollar sale. It also took several
capital account measures to stabilise rupee that included:
 Deregulation of interest rates on rupee denominated NRI deposits and enhancing the all-in-
cost ceiling for ECBs with average maturity of 3-5 years.
 Ceilings for FIIs’ investment in government securities and corporate bonds were raised by
US$ 5 billion each to US$ 15 billion and US$ 45 billion, respectively.

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Additionally, the Reserve Bank initiated various administrative steps to curb speculation, which
included:
 Withdrawing the facility of cancellation and rebooking of contracts available under
contracted exposure to residents and FIIs;
 Reducing the limit under past performance facility for importers to 25 percent of the limit
available at that time;
 Making the past performance facility available to exporters and importers only on a
delivery basis, mandating that all cash/ tom/ spot transactions by ADs on behalf of clients
were to be undertaken for actual remittances/ delivery only and could not be cancelled/
cash settled;
 Reducing the net overnight open position limit (NOOPL) of ADs across the board;
 Mandating that the intra-day position/ daylight limit of ADs should not exceed the existing
NOOPL approved by the Reserve Bank.
 The taking of position by banks, in the currency futures segment, was also curbed, because
it was rampantly used for arbitrage between the OTC and the currency futures, which
exacerbated the volatility in the forex market.
Episode of Volatility Post Chairman Bernanke’s Testimony on May 22, 2013

In the aftermath of the global financial crisis and the Euro zone debt crisis, EMEs have faced
enhanced uncertainty. Capital flows to EMEs have become extremely volatile with excessive
capital inflows to EMEs in search of better yields, resulting from massive quantitative easing (QE)
undertaken by the advanced economies to pump prime their economies, followed by sudden
stops and reversals as witnessed in the post May 22, 2013 period on fears of tapering of the QE
programme. As a result of substantial slowdown in capital inflows, the rupee experienced
significant depreciating pressure from the second half of May 2013 with the rupee depreciating
sharply by around 19.4 per cent against the US dollar between May 22, 2013 when it stood at 55.4
per US dollar and August 28, 2013 when it touched historic low of 68.85 per US dollar on the back
of sharp reversals in capital inflows and unsustainable level of CAD (4.8 per cent of GDP in 2012-
13) coupled with weak macroeconomic environment in the form of sharp deceleration in GDP
growth rate (4.5 per cent in 2012-13 and 4.4 per cent in Q1 of 2013-14), high inflation (WPI inflation
of 7.4 per cent in 2012-13), large fiscal deficit (4.9 per cent of GDP in 2012-13), etc
MEASURES TAKEN BY THE RBI TO CONTAIN VOLATILITY

 Recalibration in MSF rate with immediate effect to 300 basis points above the repo rate,
i.e., the MSF rate was increased to 10.25 per cent from the earlier 8.25 per cent,
 Limiting overall allocation of funds under LAF to 1.0 per cent of NDTL of the banking system
reckoned at Rs. 75,000 crore with effect from July 17, 2013 and
 Announcement to conduct open market sales of government securities of Rs. 12,000 crore
on July 18, 2013.
The Reserve Bank also took a number of administrative/ other measures to ease pressure on the
rupee. Some of the key measures included:
 On July 8, 2013, banks were disallowed from carrying proprietary trading in currency
futures/exchange traded options
 To moderate the demand for gold for domestic use, measures were taken to restrict import
of gold by nominated agencies on consignment basis on May 13 and June 4, 2013. On July
22, revised guidelines regarding import of gold by nominated agencies was issued
according to which at least 20 per cent of every import of gold needs to be exclusively
made available for the purpose of export.
 Special dollar swap window was opened for the PSU oil Companies on August 28, 2013
 Norms relating to rebooking of cancelled forward exchange contracts for exporters and
importers were relaxed on September 4, 2013
 A separate concessional swap window for attracting FCNR(B) dollar funds was opened on
September 4, 2013
 Overseas borrowings limit was hiked from 50 per cent to 100 per cent of Tier I capital of the
banks and concessional swap facility with the Reserve Bank for borrowings mobilized under
the scheme was provided on September 4, 2013.

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OPEN ECONOMY MACROECONOMICS

An open economy is one that interacts freely with other economies around the world.
An open economy interacts with other countries in two ways.
 It buys and sells goods and services in world product markets.
 It buys and sells capital assets in world financial markets
International transactions are influenced by international prices. The two most important
international prices are the nominal exchange rate and the real exchange rate.
Nominal Exchange Rates
 The nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another.
 The nominal exchange rate is expressed in two ways:
 In units of foreign currency per one U.S. dollar. And in units of U.S. dollars per one unit of the
foreign currency.
 Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one
dollar.
One U.S. dollar trades for 80 yen. One yen trades for 1/80 (= 0.0125) of a dollar.
Appreciation refers to an increase in the value of a currency as measured by the amount
of foreign currency it can buy.
Depreciation refers to a decrease in the value of a currency as measured by the amount
of foreign currency it can buy.
 If a dollar buys more foreign currency, there is an appreciation of the dollar.
 If it buys less there is a depreciation of the dollar.
Real Exchange Rates
 The real exchange rate is the rate at which a person can trade the goods and services of
one country for the goods and services of another.
 The real exchange rate compares the prices of domestic goods and foreign goods in the
domestic economy.
 If a case of German beer is twice as expensive as American beer, the real exchange rate is
1/2 case of German beer per case of American beer.
 The real exchange rate depends on the nominal exchange rate and the prices of goods in
the two countries measured in local currencies.
 The real exchange rate is a key determinant of how much a country exports and imports.
 Real exchange rate = Nominal exchange rate X Domestic price
Foreign price
 A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become
cheaper relative to foreign goods.
 This encourages consumers both at home and abroad to buy more U.S. goods and fewer
goods from other countries.
 As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S. net
exports.
 Conversely, an appreciation in the U.S. real exchange rate means that U.S. goods have
become more expensive compared to foreign goods, so U.S. net exports fall.
MONETARY APPROACH AND ASSET MARKET APPROACH TO PREDICT FUTURE EXCHANGE RATE
Market determined exchange rates exhibit considerable volatility. A variety of studies shows
that the volatility of short-run exchange rate returns is indistinguishable from stock or bond
market volatility. Because of this similarity, most economists rely on asset market models to explain
short-run exchange rate behaviour. The chief characteristic of an asset market model is its
emphasis on forward-looking behaviour. Asset prices today are determined in large part on
expectations of the future performance of an asset. If people think an asset will rise in value in the
future, they will be willing to pay more for that asset today, and its price will tend to rise. The same
logic holds for foreign currencies.

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Foreign Exchange Market Equilibrium: Asset Market Approach

Foreign exchange market will be in equilibrium when interest parity condition holds. Foreign
exchange market is in equilibrium when deposits of all currencies offer the same expected rate of
returns. The condition that the expected returns on deposits of any two currencies are equal when
measured in the same currency is called the interest parity condition. Let us see why foreign
exchange market is in equilibrium when the interest parity condition holds. Suppose that the dollar
interest rate is 6 percent and euro interest rate is 10 percent but dollar is expected to appreciate
at 6 percent over a year. In this circumstance, the expected rate of returns on euro deposits
would be 2 percent lower than that on dollar deposits. This means that no one will be willing to
continue holding euro deposits and the holders of euro deposits will be trying to sell them for dollar
deposits. There will therefore be an excess supply of Euro deposits and an excess demand for
Dollar deposits in the foreign exchange market.
When all expected rates of returns are equal (that is, when interest parity holds), there is no excess
supply of certain type of deposit and no excess demand for another. Thus, the foreign exchange
market is in equilibrium when the following condition is met:
Expected rate of return on Dollar deposits = Expected rate of return on Euro deposits
Vertical schedule indicates the returns to dollar

deposits measured in dollars and the RR
schedule which represent the relation between
the expected return on euro deposits measured
in dollars and the current exchange rate.
Equilibrium occurs at point 1, where two
schedules intersect.
At point 2, the return on euro deposits exceeds

that on dollar deposits, so there is now an excess
supply of the latter. As unwilling holders of dollar
deposits bid for the more attractive euro deposits, the price of euro in terms of dollars tends to rise
that is, the Dollars tend to depreciate against the Euro. When the exchange rate has moved to E1,
rates of return are equalized across currencies and the market is in equilibrium.
The short run movements in the exchange rates are governed by asset market conditions,
the long run fluctuations in the exchange rates are anchored by goods market conditions. The
long run pattern is known as purchasing power parity. The notion of PPP is one of the oldest
concepts in economics. Purchasing Power Parity (PPP) theory is based on the ‘Law of One Price’.
MONETARY APPROACH TO EXCHANGE RATE DETERMINATION
The theory of PPP is a statement that exchange rates and domestic and foreign price levels
should move together in the long run. It says nothing about what causes any of these three
variables to move. To close the circle, we need to add elements to the model. This is done with a
theory of exchange rate behaviour known as monetary approach to exchange rate
determination. The monetary approach to exchange rate is the workhorse theory of long-run
exchange rate behaviour. It was developed in the 1970s by economists at University of Chicago
and has been widely studied over the past 40 years. The monetary approach to exchange rate
has two fundamental building blocks. The first is purchasing power parity. The second is the agents
in the two countries in question have well defined stable demands for real money balances as a
function of national income and interest rates. Imposing money market equilibrium and PPP, it is
straight forward to show that the theory predicts the following equation for the exchange rate:

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Money Market will be in equilibrium when the demand for money exactly matches the
supply of money. The money is demanded for three motives namely transaction motive,
precautionary motive and speculative motive by households, firms and governments. The
aggregate demand for money in turn is affected by three factors: (i) The interest rate: A rise in the
interest rate causes each individual in the economy to reduce their demand for money; (ii) The
price level: If the price level rises, agents will have to spend more than before to purchase the
same basket, they will therefore have to hold more money; and (iii) Real national income: An
increase in the real national income raises the demand for money, given the price level. If P is the
price level, r is the interest rate, and Y is real GNP, the aggregate demand for money, Md
The monetary approach makes the general prediction that the exchange rate, which is
the relative price of the US and the Euro area, is determined in the long run by the relative supplies
of those monies and the relative real demands for them. Shifts in interest rates and output levels
affect the exchange rate only through their influences on money demand.
In addition, the monetary approach makes a number of specific predictions about the long run
effects on the exchange rate of changes in money supplies, interest rates and output levels.
a) Money Supply: Other things equal, a permanent rise in US money supply causes a
proportional increase in the long run US price level. Under PPP, an increase in the U.S.
money supply causes a proportional long run depreciation of the dollar against the
euro. Predictions in part (a) should seem straightforward. In essence, they say that if
a country prints more of its own money (everything else held constant), it will
decrease in value in foreign exchange markets. This is because a rise in home
(foreign) money will introduce inflationary pressures in home (foreign) country.
b) Interest Rate: A rise in the interest rate on dollar denominated assets lowers real U.S.
money demand. The long run U.S. price level rises, and under PPP the dollar must
depreciate against the euro in proportion to this U.S. price level increase.
c) Output Level: A rise in the U.S. output raises real U.S. money demand , leads to a fall
in the long run U.S. price level . According to PPP, there is an appreciation of the
dollar against the euro.
Predictions (b) and (c) show how changes in variables that influence money demand (everything
else held constant) also can influence the exchange rate. In particular, growth in the home
(foreign) interest rate lowers money demand and raises home (foreign) prices. Working through
PPP, this depreciates (appreciates) the exchange rate. Growth in home (foreign) income raises
money demand and puts downward pressure on home (foreign) prices. Working through PPP, this
appreciates (depreciates) the exchange rate.
3 INTERNATIONAL FINANCIAL CRISES MODELS
Financial and monetary systems are designed to improve the efficiency of real activity and
resource allocation. In theory, financial institutions and markets enable the efficient transmission of
resources from savers to the best investment opportunities. In addition, they also provide risk
sharing possibilities so that investors can take more risk and advance the economy. Finally, they
enable aggregation of information that provides guidance for more efficient investment
decisions.
A financial crisis — marked, for example, by the failure of banks, the sharp decrease in credit and
trade, and/or the collapse of an exchange rate regime — causes extreme disruption of the
normal functions of financial and monetary systems, thereby hurting the efficiency of the
economy. Unfortunately, financial crises have happened frequently throughout history and,
despite constant attempts to eliminate them, it seems unlikely that they will disappear in the
future. The several types of financial crises in recent history: banking crises, credit and market
freezes, and currency crises
1. Banking Crises and Panics: Depository institutions are inherently unstable because they
have a mismatch in the maturity structure between their assets and liabilities. In particular,
they finance long-term investments with short-term deposits. This puts banks at risk of bank
runs because when many depositors demand their money in the short term, banks will have

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to liquidate long-term investments at a loss, leading to their failure. This can lead to a self-
fulfilling prophecy because depositors believe that they are better off withdrawing their
money if they believe others will do so as well, therefore the mere belief that a bank run will
occur causes a bank run to occur.
 Diamond-Dybvig economy
 Heterogeneous signals and unique equilibrium
 A basis for micro policy analysis
 Why debt contracts? The reasons behind bank fragility : demand-deposit contracts offered
by banks are not necessary for achieving the optimal allocation. Instead, this can be
achieved in a market, where patient agents and impatient agents trade after finding out
their types. In such a market solution, fragility does not arise. Hence, one can say that
demand deposit contracts and bank runs will only occur in a model with limitations on
trading. Such limitations on trading may be quite pertinent in the real world. Indeed, many
households stay away from financial markets for various reasons.
 Contagion and systemic risk: An important reason for concern with banking crises is that
they spread across banks, leading many to fail at the same time, and hence creating
systemic risk. The contagion arises due to bank inter-linkages. Banks facing idiosyncratic
liquidity needs insure each other and so provide efficient risk sharing. However, this creates
links across banks, leading to spillover of shocks and contagion of crises
2. Credit Frictions and Market Freezes : The models of financial-institution failure reviled that
the returns on assets and loans held by the bank were generally assumed to be exogenous,
and the focus was on the behavior of depositors or creditors of the banks. However,
problems in the financial sector often arise from the other side of the balance sheet. The
quality of loans provided by the banks is determined in equilibrium by the behavior of the
bank and the behavior of its borrowers. Moral hazard between the bank and its borrowers
and between the bank and its lenders affects the amount of bank lending and its return.
This can lead to frictions in the flow of credit in the economy. There are two key frictions.
The first one is moral hazard: if borrowers are charged a very high cost for credit, they lose
the incentive to increase the value of their projects, and are therefore less likely capable of
paying back. The second one is adverse selection: if interest rates are high, only borrowers
with bad projects will attempt to get loans, and again the bank is unlikely to get the money
back.
 Moral hazard : When an entrepreneur borrows money to finance a project, he can take
actions that reduce the value of the project and increase his own private benefits. Hence,
a lender needs to make sure that the entrepreneur has a large enough incentive to
preserve (or improve) the quality of the project, which will enable him to repay the loan. A
direct implication is that the entrepreneur has to have a large enough stake in the
investment or he has to be able to secure the loan with collateral. These considerations limit
the amount of credit available to firms. They can lead to amplification of shocks to
fundamentals and ultimately to financial crises.
The incentive of the entrepreneur to choose the good project will depend on how
much “skin in the game” he has. This means that the entrepreneur will need to keep
enough ownership of the project so that he has a monetary incentive to make the “right”
decision. A key implication is that it would be easier to provide external financing to
entrepreneurs with large assets A, since they are more likely to internalize the monetary
benefit and choose the good project rather than enjoying the non-pecuniary private
benefits of the bad project.
In case of aggregate uncertainty, the government can improve overall welfare by
issuing government debt and supplementing the supply of liquid securities in the economy.
Other models of government intervention to alleviate problems in the provision of credit are
based on externalities between lenders that might lead to a credit freeze. The network
externalities across firms imply that the profitability of providing credit by one bank depends
on the amount of credit provided by other banks. Then, a credit freeze might arise as a self-
fulfilling belief. The externalities originate from the endogenous value of collateral. On the
other hand, others have focused on periods of excessive lending or credit booms. They

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show that these can also be inefficient and might call for government intervention to tame
the boom
 Implications for macroeconomic models : In macroeconomic setups, showing how shocks
to asset values can be amplified and become persistent in equilibrium. In many cases, the
downside in macroeconomic models is that they do not provide rich micro foundations.
The first financial accelerator models in macroeconomics, emphasizing that financial
friction amplify adverse shocks and that they are persistent. That is, a temporary shock
depresses not only current but also future economic activity. The mechanism goes through
the agency problem between borrowers and lenders as described earlier. A negative
shock to the net worth of a borrower strengthens the agency problem between the
borrower and potential lenders, which reduces lending and investment in equilibrium, and
thus amplifies the initial shock. A different angle on the role of credit frictions in the macro
economy is with heterogeneous agents, where patient agents lend and impatient agents
borrow subject to a collateral constraint. If, for some reason, the collateral requirement
becomes tighter, impatient agents will have to go into a process of deleveraging, reducing
the aggregate demand. This excess saving leads to a reduction in the natural interest rate,
which might become negative. The nominal (policy) interest rate then hits the zero bound,
putting the economy into a liquidity trap. Consequently, traditional monetary policy
becomes impossible but fiscal policy regains some potency.
 Asymmetric information: Another key factor behind the breakdown of financial markets,
including credit markets, is adverse selection. A market where sellers have private
information about the quality of the assets that they are trying to sell. As a result, buyers are
reluctant to buy the assets from them because they realize that the sale represents
negative information about the asset. In extreme situations, when the only motivation to
trade is based on information, this leads to a complete market breakdown: no transactions
will happen in equilibrium. If there are other gains to trade between sellers and buyers,
trade may still occur. However, the increase in the magnitude of asymmetric information,
due to an increase in the share of informed agents or in the degree of underlying
uncertainty, might reduce trade (or the efficiency of trade). Adverse selection as a
potential reason for credit rationing when lenders do not know the quality of their
borrowers, increasing the interest rate will only attract bad borrowers. This means that the
interest rate cannot increase freely to clear the market, and we might get equilibrium with
credit rationing. A firm, which is better informed about the value of its assets, will have a
hard time raising equity for the purpose of financing new investment as outsiders will fear
that the firm is raising equity because the value of its assets in place is low. They go on to
show that debt may be a better security as it is less sensitive to the information about the
value of the assets, leading to the famous pecking order theory of capital structure. The
adverse selection problem was perceived to be a central issue in the freezing of financial
markets in the recent crisis, and so several government programs were designed to
alleviate adverse selection by, for example, removing toxic assets from the financial system
and restoring flows of trade and credit as a result. Other solutions to the adverse selection
problem may be in the form of market design. The presence of intermediation chains can
help alleviate adverse selection. The idea is that the asset being sold moves along the
chain of intermediaries between the seller and the buyer. While the adverse selection
between the seller and the buyer might be too large to support direct trade between
them, the fact that adverse selection is not too large between any two adjacent
participants in the chain implies that trade can be supported by the chain.
3. Currency Crises : Currency crises occur when the country is trying to maintain a fixed
exchange rate regime with capital mobility, but faces conflicting policy needs, such as
fiscal imbalances or a fragile financial sector, that need to be resolved by independent
monetary policy. This leads to a shift in the regime from the first solution of the trilemma to
the second one. The sudden depreciation in the exchange rate is often referred to as a
currency crisis. It often has implications for the financial system as a whole and for the real
economy, where agents were used to rely on a fixed exchange rate regime and often
have to adjust to the change abruptly and unexpectedly

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In general, currency crises originate from the attempt of governments to maintain

certain financial and monetary arrangements, most notably a fixed-exchange rate regime.
Their goal is to stabilize the economy. At times, these arrangements become unstable,
which leads to a speculative attack on a fixed exchange rate regime and from there to a
financial crisis. The best way to understand the origins of currency crises is to think about the
basic trilemma in international finance.
A trilemma is a situation in which someone faces a choice among three options,
each of which comes with some inevitable problems.
[1]. First, make the country’s economy open to international capital flows, because by
doing so they let investors diversify their portfolios overseas and achieve risk sharing.
They also benefit from the expertise brought to the country by foreign investors.
[2]. Second, use monetary policy as a tool to help stabilize inflation, output, and the
financial sector in the economy. This is achieved as the central bank can increase
the money supply and reduce interest rates when the economy is depressed, or
reduce money growth and raise interest rates when it is overheated. Moreover, it
can serve as a lender of last resort in case of financial panic.
[3]. Third, maintain stability in the exchange rate. This is because a volatile exchange
rate, at times driven by speculation, can be a source of broader financial volatility,
and makes it harder for households and businesses to trade in the world economy
and for investors to plan for the future.
The problem, however, is that a country can only achieve two of these three policy
goals. In order to maintain a fixed exchange rate and capital mobility, the central bank
loses its ability to control its policy instruments: the interest rate, or, equivalently, the
monetary base. This is because, under free capital mobility, the interest rate becomes
anchored to the world interest rate by the interest rate parity, and the monetary base is
automatically adjusted to the pre-determined money demand.
 First-generation models of currency crises: The first generation model was
developed in the late 1970’s and attributes crises to fundamental policy problems. It
motivated by a series of events in which fixed exchange rate regimes collapsed following
speculative attacks, for example, the early 1970s breakdown of the Bretton Woods global
system. a government that tries to maintain a fixed exchange rate regime but is subject to
a constant loss of reserves, due to the need to monetize persistent government budget
deficits. These two features of the policy are inconsistent with each other, and lead to an
eventual attack on the reserves of the central bank, that culminates in a collapse of the
fixed exchange rate regime. The model is based on the central bank’s balance sheet. The
asset-side of the central bank’s balance sheet at time t is composed of domestic assets
BH,t, and the domestic-currency value of foreign assets StBF,t, where St denotes the
exchange rate, that is, the value of foreign currency in terms of domestic currency. The
total assets have to equal the total liabilities of the central bank, which are, by definition,
the monetary base, denoted as Mt . In the model, the domestic assets grow in a fixed and
exogenous rate due to fiscal imbalances: BH,t − BH,t−1 / BH,t−1 = µ. The problem is that this
process cannot continue forever because the reserves of foreign currency have a lower
bound. Eventually, the central bank will have to abandon the current solution of the
trilemma — fixed exchange rate regime and perfect capital mobility — for another solution
— flexible exchange rate with flexible monetary policy (that is, flexible monetary base or
equivalently flexible domestic interest rate) and perfect capital mobility.
 Second-generation models of currency crises: The second generation model came into
being during the 80’s. In that model, the fundamentals of the economy are relatively fine
but a speculative attack may trigger a crisis. The collapse of the European Exchange Rate
Mechanism (ERM) in the early 1990s. The events in Europe at that time featured
governments actively making decisions between fighting the declining economic activity
level and remaining in the exchange rate management system. Hence, there was a need
for a model in which the government’s choice is endogenized, rather than the first-
generation models in which the exchange rate regime is essentially on ‘automatic pilot’.
This led to the development of the so-called ‘second generation model of currency
attacks,’ pioneered by Obstfeld [1994, 1996]. In this line of models, the government/central

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bank is setting the policy endogenously, trying to maximize a well-specified objective

function, without being able to fully commit to a given policy. An outcome of these models
is that there are usually self-fulfilling multiple equilibria, where the expectation of a collapse
of the fixed exchange rate regime leads to the government abandoning the regime. This
feature seemed to capture the fact that crises where often unexpected. Overall, when
deciding on the rate of depreciation, the government has to weigh the costs against the
benefit of depreciation. There is a cost in operating the economy under inflation and there
is a cost in deviating from the promise of a fixed exchange rate regime. The benefit in
depreciation is that it enables reduction in the deviations from the target level of output.
More precisely, creating inflation (which is equivalent to depreciation here) above the
expected level serves to boost output.
 Third-generation models of currency crises : The third generation model was developed in
response to the Asian financial crisis of 1997. Here too the fundamentals of the economy
are fine but the country cannot meet its short-term debt obligations. That is a liquidity crisis.
In the late 1990s, a wave of crises hit the emerging economies in Asia, including Thailand,
South Korea, Indonesia, Philippines, and Malaysia. A clear feature of these crises was the
combination of the collapse of fixed exchange rate regimes, capital flows, financial
institutions, and credit. There was a strong need to incorporate banking panics and credit
frictions into these models. This led to the interplay between currency crises and banking
crises, sometimes referred to as the twin crises, and between currency crises and credit
frictions. The firms suffer from a currency mismatch between their assets and liabilities: their
assets are denominated in domestic goods and their liabilities are denominated in foreign
goods. Then, a real exchange rate depreciation increases the value of liabilities relative to
assets, leading to deterioration in firms’ balance sheets. The weaknesses in the banking
sector increase doubts about the ability of governments to pay back their debt. This is
because governments will attempt to support banks in order to prevent their collapse but
on the way they might harm their own ability to pay back the debt, making the sovereign
debt crisis more severe. Similarly, as the sovereign-debt problems become more severe,
banks are also becoming weaker. This is because banks are holding a lot of government
bonds and rely on government guarantees. Hence, there is a feedback loop between
banking crises and sovereign debt crises in which they reinforce each other and make the
overall problem more severe. the European countries are in a monetary union plays a
crucial role. Without a monetary union, individual countries could use monetary policy to
address the problems but now they cannot. Given that other mechanisms for absorbing
shocks that are present in other monetary unions are not very strong in Europe — for
example, labor mobility, fiscal transfers, and a unified financial system — the existence of
the monetary union may be making the problems worse. Hence, over time, it seems
possible that some members of the European monetary union will leave the common
currency.
 Contagion of currency crises: contagion is an immediate reaction in one country to a crisis
in another country. there are several theories that link contagion to fundamental
explanations. The clearest one would be that there is common information about the
different countries, and so the collapse in one country leads investors to withdraw from
other countries. Models of the connections of portfolios across different countries also shed
light on such international contagion. If two countries compete in export markets, the
devaluation of one’s currency hurts the competitiveness of the other, leading it to devalue
the currency as well.
UNDERSTANDING THE RECENT FEW CRISES : THE EURO CRISIS/ CRISIS IN VENEZUELA
THE EURO CRISIS


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The core reality behind virtual every crisis is the rapid unwinding of economic imbalances. The size
and duration of the crisis typically depends upon the size of the initial imbalances, how the initial
shock gets magnified by a variety of ‘amplifiers’, and how rapidly and effectively policy responds.
In the case of the Eurozone crisis, the imbalances were extremely unoriginal. They were the
standard culprits that have been responsible for economic crises since time immemorial – namely,
too much public and private debt borrowed from abroad. Too much, that is to say, in relation to
the productive investment financed through the borrowing. From the euro’s launch and up until
the crisis, there were big capital flows from Eurozone core nations like Germany, France, and the
Netherland to Eurozone periphery nations like Ireland, Portugal, Spain and Greece. A major slice
of these were invested in non-traded sectors – housing and government services/consumption.
This meant assets were not being created to help pay off in the investment. It also tended to drive
up wages and costs in a way that harmed the competitiveness of the receivers’ export earnings,
thus encouraging further worsening of their current accounts.
According to the Organization for Economic Cooperation and Development, the eurozone
debt crisis was the world's greatest threat in 2011, and in 2012, things only got worse. The crisis
started in 2009 when the world first realized that Greece could default on its debt. In three years, it
escalated into the potential for sovereign debt defaults from Portugal, Italy, Ireland, and Spain.
The European Union, led by Germany and France, struggled to support these members. They
initiated bailouts from the European Central Bank (ECB) and the International Monetary Fund, but
these measures didn't keep many from questioning the viability of the euro itself.
After President Trump threatened to double tariffs on aluminum and steel imports from
Turkey in August 2018, the value of the Turkish lira lowered to a record low against the U.S. dollar—
renewing fears that the poor health of the Turkish economy could trigger another crisis in the
eurozone. Many European banks own stakes in Turkish lenders or made loans to Turkish
companies. As the lira plummets, it becomes less likely these borrowers can afford to pay back
these loans. The defaults could severely impact the European economy.
CAUSES THE EURO CRISIS
 First, there were no penalties for countries that violated the debt-to-GDP ratios set by the
EU's founding Maastricht Criteria. This is because France and Germany also were spending
above the limit, and it would be hypocritical to sanction others until they got their own
houses in order. There were no teeth in any sanctions except expulsion from the eurozone,
a harsh penalty which would weaken the power of the euro itself. The EU wanted to
strengthen the euro's power.
 Second, eurozone countries benefited from the euro's power. They enjoyed the low-interest
rates and increased investment capital. Most of this flow of capital was from Germany and
France to the southern nations, and this increased liquidity raised wages and prices—
making their exports less competitive. Countries using the euro couldn't do what most
countries do to cool inflation: raise interest rates or print less currency. During the recession,
tax revenues fell, but public spending rose to pay for unemployment and other benefits.
 Third, austerity measures slowed economic growth by being too restrictive. They increased
unemployment, cut back consumer spending, and reduced the capital needed for
lending. Greek voters were fed up with the recession and shut down the Greek
government by giving an equal number of votes to the "no austerity” Syriza party. Rather
than leave the eurozone, though, the new government worked to continue with austerity.
In the long-term, austerity measures will alleviate the Greek debt crisis.
THE SOLUTION OF EURO CRISIS
In May 2012, German Chancellor Angela Merkel developed a 7-point plan, which went against
newly-elected French President Francois Hollande's proposal to create Eurobonds. He also
wanted to cut back on austerity measures and create more economic stimulus. Merkel's plan
would:
 Launch quick-start programs to help business startups
 Relax protections against wrongful dismissal

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 Introduce "mini-jobs" with lower taxes

 Combine apprenticeships with vocational education targeted toward youth
unemployment
 Create special funds and tax benefits to privatize state-owned businesses
 Establish special economic zones like those in China
 Invest in renewable energy
Merkel found this worked to integrate East Germany, and saw how austerity measures could boost
the competitiveness of the entire eurozone. The 7-point plan followed an intergovernmental treaty
approved on December 9, 2011, where EU leaders agreed to create a fiscal unity parallel to the
monetary union that already exists.
AFFECTS OF THE TREATY THE EURO CRISIS

The treaty did three things. First, it enforced the budget restrictions of the Maastricht Treaty.
Second, it reassured lenders that the EU would stand behind its members' sovereign debt. Third, it
allowed the EU to act as a more integrated unit. Specifically, the treaty would create five
changes:
[1]. Eurozone member countries would legally give some budgetary power to centralized EU
control.
[2]. Members that exceeded the 3% deficit-to-GDP ratio would face financial sanctions, and
any plans to issue sovereign debt must be reported in advance.
[3]. The European Financial Stability Facility was replaced by a permanent bailout fund. The
European Stability Mechanism became effective in July 2012, and the permanent fund
assured lenders that the EU would stand behind its members—lowering the risk of default.
[4]. Voting rules in the ESM would allow emergency decisions to be passed with an 85%
qualified majority, allowing the EU to act faster.
[5]. Eurozone countries would lend another 200 billion euros to the IMF from their central banks.
This followed a bailout in May 2010, where EU leaders and the International Monetary Fund
pledged 720 billion euros (about $920 billion) to prevent the debt crisis from triggering another
Wall Street flash crash. The bailout restored faith in the euro, which slid to a 14-month low against
the dollar.
The Libor rose as banks started to panic like in 2008. Only this time, banks were avoiding
each other’s toxic Greek debt instead of mortgage-backed securities.
CONSEQUENCES THE EURO CRISIS
 First, the United Kingdom and several other EU countries that aren't part of the eurozone
balked at Merkel's treaty. They worried the treaty would lead to a "two-tier" EU. Eurozone
countries could create preferential treaties for their members only and exclude EU
countries that don't have the euro.
 Second, eurozone countries must agree to cutbacks in spending, which could slow their
economic growth, as it has in Greece. These austerity measures have been politically
unpopular. Voters could bring in new leaders who might leave the eurozone or the EU itself.
 Third, a new form of financing, the eurobond, has become available. The ESM is funded by
700 billion euros in eurobonds, and these are fully guaranteed by the eurozone countries.
Like U.S. Treasurys, these bonds could be bought and sold on a secondary market. By
competing with Treasurys, the Eurobonds could lead to- higher interest rates in the U.S.
How the Euro-Crisis Could've Turned Out

If those countries had defaulted, it would have been worse than the 2008 financial crisis.
Banks, the primary holders of sovereign debt, would face huge losses, and smaller ones would
have collapsed. In a panic, they'd cut back on lending to each other, and the Libor rate would
skyrocket like it did in 2008.
The ECB held a lot of sovereign debt; default would have jeopardized its future, and
threatened the survival of the EU itself, as uncontrolled sovereign debt could result in a recession
or global depression. It could have been worse than the 1998 sovereign debt crisis. When Russia

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defaulted, other emerging market countries did too, but not developed markets. This time, it's
wasn't the emerging markets but the developed markets that were in danger of default.
Germany, France, and the U.S., the major backers of the IMF, are themselves highly indebted.
There would be little political appetite to add to that debt to fund the massive bailouts needed.
Features of the Eurozone Crisis:

1. Eurozone is divided into an economically healthy “core” in the North (Germany) and a crisis-
ridden “periphery” in the South (Greece, Italy, Portugal and Spain; GIPS).
2. The crisis countries (now) have unsustainable private and public debts (as % of GDP).
They face trade deficit (their imports exceed exports). Governments face great difficulties
financing their budgets and deficits. These problems became unmanageable after the U.S.
financial crisis destabilized financial markets and created
a global recession (2008-2010).
3. A key issue is that the core and the periphery share the same currency (€) and have a
common central bank (ECB, located in Frankfurt). This means that (a) intra-Eurozone trade is in the
same currency (no exchange rate); devaluation of the exchange rate in response to a trade
deficit is not possible; and (b) interest rate policy is not a national policy instrument.
4. Fiscal problems in the GIPS countries are not at the root of the Euro crisis. Actually, Spain’s Debt-
GDP ratio was lower than that of Germany; public deficits in Italy, Portugal and Spain were not
high. Nor are weak banking systems the cause of the crisis in the periphery. The Italian and
Portuguese banking systems were in better shape than their French or German counterparts when
the global financial crisis struck in 2008-9.
The Eurozone suffers from serious imbalances:
(i) the core countries have a trade surplus (exports>imports), the periphery countries
have a trade deficit (exports<imports);
(ii) the core countries are still growing, the periphery suffers from negative growth and
rising unemployment;
(iii) the core countries are “fiscally” healthy (their public debts and deficits are
manageable), the periphery is “fiscally” sick (high public debts and
unmanageable public deficits).
VENEZUELAN CRISIS
The Venezuelan Crisis in Venezuela during the Bolivarian Revolution is an ongoing socioeconomic
and political crisis that began in Venezuela on 2 June 2010. Venezuela experiences the worst
economic crisis in its history, with an inflation rate of over 400 percent and a volatile exchange
rate. Heavily in debt and with inflation soaring, its people continue to take to the streets in protest.
It wasn’t that long ago that Venezuela, which possesses the world’s largest crude oil reserves, was
a relatively stable democracy with one of Latin America’s fastest-rising economies. It was a nation
so awash in petroleum revenues that the socialist government of the late former President Hugo
Chavez spent huge amounts on social programs and, at one point, even provided free heating oil
for impoverished Americans.
But starting in 2014, the South American nation began suffering a startling collapse. With
Venezuela’s gross domestic product plummeting even more than the United States during the
Great Depression, many of its nearly 32 million inhabitants became unable to afford food, and
resource-starved hospitals did not have enough soap and antibiotics.
Meanwhile, Venezuela’s political system spiraled into turmoil. President Nicolás Maduro, whose
2018 reelection was tainted by accusations of irregularities and voter intimidation, faced massive
street protests and survived a spring 2019 military uprising instigated by opposition politician Juan
Guaido, leader of the elected National Assembly whose legislative powers were taken away by
Maduro’s regime in 2017.
ECONOMIC RISK INDICATORS FOR FDI AND FII

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According to UNCTAD's 2020 World Investment Report, FDI inflows hit an all-time high of USD 51
billion in 2019, an increase of 20% if compared to 2018. FDI stock reached USD 427 billion in 2019.
India has relaxed administrative regulations for foreign investors in some industrial sectors by
abolishing the requirement for approval by the Reserve Bank of India under certain conditions.
Invest India, India's investment promotion agency, seeks to promote and facilitate inward (and
outward) direct investment and provide policy inputs into FDI settings. Invest India also works with
Indian states to advise them how to refine their areas of competitive strength when seeking
foreign investors.
Most FDI applications are now made via a single window portal run by the Department of
Industrial Policy and Promotion and subject to compulsory approval provisions. Restrictions such as
foreign equity caps, divestment conditions and lock-in-periods are being scaled back across
sectors.
Despite these improvements, real challenges remain in converting potential FDI in India into
investment on the ground, and into the sectors in which it is needed. The three most limiting
factors are:
 India's challenging business environment which produces a shortage of projects with
commercial appeal, even in those sectors that are completely open to investment. This is
compounded by unpredictable government intervention.
 Equity, screening and personnel restrictions on foreign investors.
 Complete closure of some sectors to FDI, such as legal and accounting services.
India has allowed foreign institutional investment in Indian shares and debentures since 1992.
Foreign investors are now able to invest directly in India's listed companies and the Securities and
Exchange Board of India (SEBI) has relaxed approval norms for registered foreign portfolio
investors in India. Foreign portfolio investors are prevented from investing more than USD51 billion
in Indian corporate debt by a hard FPI investment cap (which has been fully taken up). In 2016,
requirements for foreign portfolio investors to purchase bonds through Indian brokers were also
relaxed, reducing transaction costs. Given the need to boost domestic investment and facilitate
hedging, a gradual further expansion of FPI caps would seem a logical policy outcome. In 2017,
Masala bonds (rupee-denominated overseas bonds) were removed from India's FPI corporate
debt investment cap, making an additional USD6.79 billion in domestic corporate debt available
to offshore investors
Advantages for FDI in India:

 Deep-rooted and highly effective democratic regime, which ensures a calm and stable
political environment
 Well-developed administration and an independent judicial system, along with a vast
geography, making the country a repository of resources
 Work force is educated, hard-working and skilled (engineers, management staff,
accountants and lawyers).
 India hosts an ever-growing consumer base, making it one of the world's largest markets for
manufactured goods and services.
 Proximity to key manufacturing sites, key suppliers and low development costs. These
factors make it an effective base from which multi-national companies can export to other
high-growth emerging markets.
 Transparency International gave Indian companies the top ranking among emerging
market multinationals in terms of transparency and compliance.
Disadvantages for FDI in India:
 Persistent uncertainties regarding Kashmir province
 A glaring lack of infrastructure that slows the development of this country-continent
 Cumbersome and slow administrative procedures at the federal level make it difficult to
carry out any economic reform
 The vastness of its territory makes India a country vulnerable to natural disasters which can
at any time paralyse an entire part of the national economy.

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 Problems related to corruption (especially at the federal level) and political pressures,
depending on the party in power, both at regional and national level
 Labour regulations remain rigid and among the most complex in the world.
The Global Crisis and its high economic costs have revived the academic and policy interest in
‘early warning indicators’ to provide timely alert of economic risks
Economic risk centers on macroeconomic circumstances that may result in significant loss for a
business. These conditions include inflation, exchange rates, new government regulations and
other decisions that may adversely affect profits.
When it comes to global supply chains risks, economic risk is particularly challenging to anticipate
and predict. Without an economic risk management strategy, you put your business, its current
profitability and its potential growth at risk.
For the most effective economic risk management strategy, you must first understand the variety
of economic threats to your business.
Common Types of Economic Risk
There are many types of economic risk that businesses need to identify and manage to best
defend against global supply chain risks.
1. Interest rates. As with any loan, increasing interest rates can lead to reduced profits.
Researching the interest rate environment of a country is a crucial step for
comprehensive economic risk management.
2. Minimum Wage. If minimum wage is increased, the cost of production is increased.
Often, labor costs can increase but market price remains stable, leading to decreased
profits.
3. Market Prices. A country’s economy greatly influences market prices. When market
prices decrease but production costs stay the same, profitability can be significantly
reduced.
4. Taxes. New types of taxes can threaten a business’ profits. When a government
introduces new taxes, it can negatively impact a business’ financial performance.
5. Duty Rates. Similar to taxes, an increase on import/export duties can decrease
profitability.
6. The Cost of Materials. An increased cost of materials is one of the economic risk factors
that manufacturing businesses need to identify and manage. When the market is
competitive and these costs increase, consumers still expect to pay the consistent
prices, leading to a possible loss in profits.
7. Other common types of economic risk to be aware of include exchange rates,
hyperinflation and general government regulations that can affect investments.
Businesses need to proactively identify and monitor all these conditions to support a
robust economic risk management strategy.
Vulnerability indicators can be a valuable input for monitoring economic risks. Vulnerability
indicators should be complemented with other monitoring tools and in-depths assessments,
including expert judgement, to provide a holistic assessment of country risks. A bird’s eye view of
the areas covered by the indicators grouped into six areas: financial sector imbalances; non-
financial sector imbalances; asset market imbalances; public sector imbalances; external sector
imbalances; and spillovers, contagion, and global risks.

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Financial sector imbalances: These include indicators in three main categories.

 The first category refers to leverage and excessive risk taking of the financial sector. It
includes indicators such as leverage, capital ratios, and lending standards.
 A second category aims at capturing liquidity and currency mismatches which increase
liquidity risk. It includes indicators of ratios of liquid assets to short-term liabilities, loan-to-
deposit ratios, and the net open foreign currency position of the financial sector.
 The final category includes information on common exposures of banks to, for example,
sovereigns or the housing market.
Non-financial sector imbalances: The focus is mainly on vulnerabilities stemming from balance
sheet imbalances of households and non-financial corporations that may result in financial
instability. The indicators cover different measures of credit and credit growth to households and
non-financial corporations as well as measures of liabilities for households and non-financial
corporations (e.g. gross financial, foreign currency denominated, and short-term liabilities).
Asset market imbalances: Indicators of asset market imbalances mainly relate to housing market
and equity market misalignments. Indicators include real house prices and ratios of house prices
to disposable income and rents, as well as real stock prices. Besides interlink ages with private
sector balance sheets, house price booms can affect the real economy if they are associated
with booms in residential investment, as experienced in several European countries prior to the
Crisis. To capture this housing market-real economy nexus, the dataset includes the share of
residential investment in GDP and the share of employment in construction.
Public sector imbalances: The indicators of public sector imbalances mainly relate to sovereign
solvency risk, including basic fiscal solvency, long-term fiscal solvency indicators, and government
debt composition indicators. Indicators measuring basic solvency risk include the primary budget
balance, the general government debt and the differential between the sovereign bond yield
and potential GDP growth rate differential. Long-term fiscal solvency indicators include future
public spending in pensions and health, as well as the projected age dependency ratio.
External imbalances
The external imbalances indicators include the current-account balance, external debt, FDI
liabilities, currency mismatch, external reserves, and the real effective exchange rate.

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International spillovers, contagion, and global risks: A key insight from the 2008/09 Crisis was that
even countries without significant domestic imbalances were affected by the Crisis through
international spillovers and contagion. Indicators of trade and financial openness are included to
account for vulnerabilities to international spillovers. Indicators of global risks are also included.
They are constructed as GDP-weighted averages of country-specific imbalances.
Vulnerabilities in each of the five domestic areas should not be taken in isolation. Indeed, in the
boom phase of the business cycle many of the imbalances interact and can reinforce each
other. In the bust phase, the unwinding of one imbalance can trigger the unwinding of others. The
simultaneous unwinding of several imbalances will often exacerbate the downturn and deepen
the crisis. Conversely, if policymakers tackle one imbalance, they are also likely to reduce
vulnerabilities in other sectors.
FINANCIAL RISK : banks began tightening lending standards, borrowers became more delinquent
paying back loans and financial stress while still low, began to increase. Financial stress indicators
from the RBI Reserve are extremely valuable for compositing various financial risks. They measure
foreign exchange rates, real estate, interest rates, yield spreads, volatility indexes, liquidity, yield
curve, market indexes, and inflation.
Government Measures to Motivate or Restrict FDI

The Government of India provides tax and non-tax investment incentives in specific sectors (e.g.
electronics) and regions (Northeast region, Jammu & Kashmir, Himachal Pradesh and
Uttarakhand). It has also created incentives for manufacturing companies to set up in Special
Economic Zones (SEZ), National Investment & Manufacturing Zones (NIMZ) and Export Oriented
Units (EOUs). In addition, each state government has its own policy, providing additional
investment incentives, including subsidised land prices, attractive interest rates on loans, reduced
tariffs on electric power supply, tax concessions, etc. The central government development banks
and state industrial development banks offer medium to long-term loans for new projects.
The Government has recently relaxed FDI policy in a variety of sectors by such measures as raising
the foreign investment limit, easing conditions for investment and putting many sectors on the
‘automatic route’ (as opposed to the ‘Government route’, which requires approval from the
Foreign Investment Promotion Board). Reforms to clean up the banking system have been
implemented, but they take time and may impact the supply of credit. On the other hand, while
the fiscal deficit and public debt remain large, the government has taken steps to reduce them.
The most notable of these initiatives is the introduction of the GST (Good and Services Tax), which
aims to boost tax revenues and make the economy more competitive in the long run. Sectors that
have benefited from the expansion include real estate, private banking, defence, civil aviation,
single-brand retail and television news. For more information, consult the website of Invest India,
the official Investment Promotion and Facilitation Agency of the Government of India.
UNIT – 5
International Banking: Reserves, Debt and Risk : Nature of International Reserves – Demand for
International Reserves – Supply of International Reserves – Gold Exchange Standard – Special
Drawing Rights – International Lending Risk – The Problem of International Debt – Financial
Crisis and the International Monetary Fund – Eurocurrency Market.

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INTERNATIONAL BANKING
International banking is just like any other banking service, but it takes place across different
nations or internationally. To put in another way, international banking is an arrangement of
financial service by a residential bank of one country to the residents of another country. Mostly
multinational companies and individuals use this banking facility for transacting
Features and Benefits of International Banking
 Flexibility: International banking facility provides flexibility to the multinational companies to
deal in multiple currencies. The major currencies that multinational companies or individuals
can deal with include euro, dollar, pounds, sterling, and rupee. The companies having
headquarters in other countries can manage their bank accounts and avail financial
services in other countries through international banking without any hassle.
 Accessibility; International banking provides accessibility and ease of doing business to the
companies from different countries. An individual or MNC can use their money anywhere
around the world. This gives them a freedom to transact and use their money to meet any
requirement of funds in any part of the world.
 International Transactions; International banking allows the business to make international
bill payments. The currency conversion facility allows the companies to pay and receive
money easily. Also, the benefits like overdraft facility, loans, deposits, etc. are available
every time for overseas transactions.
 Accounts Maintenance: A multinational company can maintain the records of global
accounts in a fair manner with the help of international banking. All the transactions of the
company are recorded in the books of the banks across the globe. By compiling the data
and figures, the accounts of the company can be maintained.
NATURE OF INTERNATIONAL RESERVES

International reserves (or reserve assets in the balance of payments) are those external
assets that are readily available to and controlled by a country’s monetary authorities. According
to the International Monetary Fund (IMF), international reserves comprise foreign currencies, other
assets denominated in foreign currencies, gold reserves, special drawing rights (SDRs) and IMF
reserve positions. These reserves may be used for direct financing of international payments
imbalances, or for indirect regulation of the magnitude of such imbalances via intervention in
foreign exchange markets in order to affect the exchange rate of the country’s currency. A
narrower definition for international reserves only includes foreign currency deposits and bonds.
These assets held by the country’s monetary authorities are usually denominated in different
reserve currencies, mostly the U.S. dollar (USD), the Euro (EUR), the Japanese yen (JPY) and the
British pound (GBP)
International reserves are any kind of reserve funds, which central banks can pass among
themselves, internationally. International reserves remain an acceptable form of payment among
these banks. Reserves themselves can either be gold or a specific currency, such as the dollar or
euro.
Many countries also use international reserves to back liabilities, including local currency, as well
as bank deposits.
Examples of International Reserves: Gold as a reserve asset
 Gold was originally used as currency, but it began to be replaced by paper money and
bank deposits
 Post-World War I inflation prompted many nations to return to a gold standard, where all
currency in circulation was backed by gold
 Gold standard collapsed during the Great Depression, to be replaced by a gold exchange
standard after World War II

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 The US dollar was set to be convertible to gold at a fixed rate, and the dollar became a
key reserve asset
 Stresses from persistent US payments deficits brought an end to the gold exchange
standard by 1973, and in 1975 gold was removed as an international reserve asset
Examples of International Reserves: Special Drawing Rights (SDR)
Special drawing rights (SDR) are another form of international reserves. The International
Monetary Fund (IMF) created SDRs in 1969 in response to concerns about the limitations of gold
and dollars as the only means of settling international accounts. SDRs can enhance international
liquidity by supplementing standard reserve currencies. Member countries' governments back
SDRs with their full faith and credit.
A SDR is essentially an artificial currency. Some describe SDRs as baskets of national
currencies. IMF member states holding SDRs can exchange them for freely usable currencies (such
as USD or Japanese Yen), either by agreeing among themselves or via voluntary swaps. In
addition the IMF may instruct countries with stronger economies or larger foreign currency reserves
to buy SDRs from its less-endowed members. IMF member countries are able to borrow SDRs from
IMF reserves at good interest rates. (They generally use these to adjust their balance of payments
to become more favorable.)
The IMF also uses SDRs for internal accounting purposes as the SDR is the unit of account of
the IMF, in addition to acting as an auxiliary reserve asset. SDRs’ value, which the IMF sums up in
U.S. dollars, is calculated from a weighted basket of major currencies: Japanese yen, U.S. dollars,
Sterling and the Euro.
Facilities for borrowing reserves
• IMF drawings - members may purchase foreign currency with their own currency, with
limits and sometimes conditions
• General Arrangements to Borrow - major industrial nations agreed to make further
reserves available to the IMF if needed
• Swap arrangements - major industrial nations agree to swap currencies with each other;
can be done more quickly and less visibly than Fund drawings
• Special financing facilities - to compensate mostly developing countries which face
hardships which are transient or beyond their control: Compensatory Financing Facility,
Oil Facility, Buffer Stock Facility
• Commercial bank lending
International lending risk
• Credit risk - potential for financial default
• Country risk - whether government policies will help or hinder the servicing of the loan
• Currency risk - whether devaluations or exchange controls will interfere with the
repayment of the loan
International debt problems
• Many developing nations borrowed heavily on easier terms in the 1970s because major
banks were flush with deposits from oil producing states
• In the 1980s, rising interest rates caused payments on the variable rate international
loans to increase, and the ability of many of these major debtor nations to service their
loans came into question
• Most loans were denominated in dollars, meaning that these nations had to run current
account surpluses to earn foreign exchange with which to make loan payments - just as
the industrial nations went into a recession
• Measures used to gauge debt burden: debt-to-export ratio; debt service/export ratio
Options for debt-service problems

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• Nations can stop making payments - but there are severe consequences
• Service debt at any cost - but may be politically impossible
• Reschedule the debt - stretch out repayment schedule (but pay more overall)
• Obtain emergency loans from the IMF - but conditionality may be hard to stomach
Reducing bank exposure to developing-country debt
• Loan sales in secondary market
• Debt buybacks or debt-for-debt swaps
• Debt-for-equity swaps
• Debt reduction and forgiveness
Nature of International Reserves –
 Reserves of foreign currency and other suitable assets are used to finance payments
imbalances
 Reserves allow a nation to take more time to correct BOP disequilibrium (but may also
delay needed action)
 Demand for reserves depends on the monetary value of international transactions and the
size of payments imbalances
DEMAND FOR INTERNATIONAL RESERVES –
 Main factor in demand for reserves is the nature of the adjustment mechanisms to correct
BOP imbalances
 Exchange rate flexibility is a crucial element of the adjustment process
 Key use for reserves is to intervene in currency markets to defend an exchange rate
 The more a nation is willing to let its currency float, the less it will need sizable reserves
 Other factors affecting demand for reserves:
 Automatic adjustment mechanisms that respond to payments imbalances
 Economic policies used to correct payments imbalances
 International coordination of economic policies
 Level of world prices and income
SUPPLY OF INTERNATIONAL RESERVES
International reserves may be owned by nations or may be borrowed if reserves on hand prove
insufficient
 Owned reserves:
 Reserve currencies (US dollar, Japanese yen, etc,)
 Gold - once central, now rarely used
 Special drawing rights
 Borrowed reserves can come from the IMF and other official arrangements, or can be
borrowed from major commercial banks
GOLD EXCHANGE STANDARD

In the simplest terms, the gold standard is a system used to understand currency value and
it means that a currency is compared against how much it is worth in gold and at what rate it can
be exchanged for gold.
Historically, gold has been one of the most popular exchange mediums that have been extremely
effective in being an asset that stores value. In the modern world, gold is much less likely to be
seen than paper and coin currency. However, the gold standard is still considered important by
investors and financial analysts. A gold exchange standard is a mixed system consisting of a cross
between a reserve currency standard and a gold standard. In general it includes the following
rules.

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First, a reserve currency is chosen. All non-reserve countries agree to fix their exchange rates to the
reserve at some announced rate. To maintain the fixity, these non-reserve countries will hold a
stockpile of reserve currency assets.
Second, the reserve currency country agrees to fix its currency value to a weight in gold. Finally,
the reserve country agrees to exchange gold for its own currency with other central banks within
the system, upon demand.
One key difference in this system from a gold standard is that the reserve country does not agree
to exchange gold for currency with the general public, only with other central banks.
The system works exactly like a reserve currency system from the perspective of the non-
reserve countries. However, if over time the non-reserve countries accumulate the reserve
currency they can demand exchange for gold from the reserve country central bank. In this case
gold reserves will flow away from the reserve currency country.
The fixed exchange rate system set up after World War II was a gold-exchange standard,
as was the system that prevailed between 1920 and the early 1930s. The post-WWII system was
agreed to by the allied countries at a conference in Bretton-Woods New Hampshire in the US in
June 1944. As a result, the exchange rate system after the war also became know as the Bretton-
Woods system.
Also proposed at Bretton-Woods was the establishment of an international institution to
help regulate the fixed exchange rate system. This institution was the International Monetary Fund
(IMF). The IMF’s main mission was to help maintain the stability of the Bretton-Woods fixed
exchange rate system.
The international gold standard prevailed from 1875 to 1914. In a gold standard system,
gold alone is assured of unrestricted coinage. There was a two-way convertibility between gold
and national currencies at a stable ratio. No restrictions were in place for the export and import of
gold. The exchange rate between two currencies was determined by their gold content.
The gold standard ended in 1914 during World War I. Great Britain, France, Germany, and
many other countries imposed embargoes on gold exports and suspended redemption of bank
notes in gold. The interwar period was between World War I and World War II (1915-1944). During
this period the United States replaced Britain as the dominant financial power of the world. The
United States returned to a gold standard in 1919. During the intermittent period, many countries
followed a policy of sterilization of gold by matching inflows and outflows of gold with changes in
domestic money and credit.
The Bretton Woods System was established after World War II and was in existence during
the period 1945-1972. In 1944, representatives of 44 nations met at Bretton Woods, New
Hampshire, and designed a new postwar international monetary system. This system advocated
the adoption of an exchange standard that included both gold and foreign exchanges. Under
this system, each country established a par value in relation to the US dollar, which was pegged to
gold at $35 per ounce. Under this system, the reserve currency country would aim to run a
balance of payments (BOPs) deficit to supply reserves. If such deficits turned out to be very large
then the reserve currency itself would witness crisis. This condition was often coined the Triffin
paradox.
Eventually in the early 1970s, the gold exchange standard system collapsed because of
these reasons. From 1950 onward, the United States started facing trade deficit problems. With
development of the euro markets, there was a huge outflow of dollars. The US government took
several dollar defense measures, including the imposition of the Interest Equalization Tax (IET) on
US purchases of foreign stock to prevent the outflow of dollars. The international monetary fund
created a new reserve asset called special drawing rights (SDRs) to ease the pressure on the
dollar, which was the central reserve currency. Initially, the SDR were modeled to be the weighted

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average of 16 currencies of such countries whose shares in the world exports were more than 1%.
In 1981, the SDR were restructured to constitute only five major currencies: the US dollar, German
mark, Japanese yen, British pound, and French franc. The SDR were also being used as a
denomination currency for international transactions. But the dollar-based gold exchange
standard could not be sustained in the context of rising inflation and monetary expansion. In 1971
the Smithsonian Agreement signed by the Group of Ten major countries made changes to the
gold exchange standard. The price of gold was raised to $38 per ounce. Other countries revalued
their currency by up to 10%. The band for exchange rate fluctuation was increased to 2.25% from
1%. But the Smithsonian agreement also proved to be ineffective and the Bretton Woods System
collapsed.
SPECIAL DRAWING RIGHTS –
The SDR is an international reserve asset, created by the IMF in 1969 to supplement its
member countries’ official reserves.
The value of the SDR is based on a basket of five currencies—the U.S. dollar, the euro, the Chinese
renminbi, the Japanese yen, and the British pound sterling.
So far SDR 204.2 billion (equivalent to about US$281 billion) have been allocated to members,
including SDR 182.6 billion allocated in 2009 in the wake of the global financial crisis.
The role of the SDR:
The SDR was created as a supplementary international reserve asset in the context of the Bretton
Woods fixed exchange rate system.
1. The SDR serves as the unit of account of the IMF and some other international organizations.
2. The SDR is neither a currency nor a claim on the IMF.Rather, it is a potential claim on the freely
usable currencies of IMF members.
3. SDRs can be exchanged for these currencies.
4. The SDR basket is reviewed every five years or earlier if warranted, to ensure that the
basket reflects the relative importance of currencies in the world’s trading and financial
systems.
What is SDR?
1. The SDR is an interest-bearing international reserve asset created by the IMF in 1969 to
supplement other reserve assets of member countries.
2. To participate in this system, a country was required to have official reserves.
3. This consisted of a central bank or government reserves of gold and globally accepted foreign
currencies that could be used to buy the local currency.
4. It is based on a basket of international currencies comprising the U.S. dollar, Japanese yen,
euro, pound sterling and Chinese Renminbi.
5. It is not a currency, nor a claim on the IMF, but is potentially a claim on freely usable currencies
of IMF members.
6. The value of the SDR is not directly determined by supply and demand in the market but is set
daily by the IMF on the basis of market exchange rates between the currencies included in the
SDR basket.
Who can hold SDRs?
1. SDRs can be held and used by member countries, the IMF, and certain designated official
entities called “prescribed holders”.
2. It cannot be held, for example, by private entities or individuals.
3. Its status as a reserve asset derives from the commitments of members to hold, accept, and
honour obligations denominated in SDR.
4. The SDR also serves as the unit of account of the IMF and some other international
organizations.
General allocation of SDRs
1. An SDR allocation is a low-cost way of adding to members’ international reserves, allowing
members to reduce their reliance on more expensive domestic or external debt for building
reserves.

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2. The IMF has the authority under its Articles of Agreement to create unconditional liquidity
through “general allocations” of SDRs to participants in its SDR Department (currently, all
members of the IMF) in proportion to their quotas in the IMF.
The SDR Interest Rate
1. The interest rate on SDRs, or the SDRi, provides the basis for calculating the interest rate that is
charged to member countries when they borrow from the IMF and paid to members for their
remunerated creditor positions in the IMF.
2. It is also the interest paid to member countries on their own SDR holdings and charged on their
SDR allocation.
3. The SDRi is determined weekly based on a weighted average of representative interest rates
on short-term government debt instruments in the money markets of the SDR basket
currencies, with a floor of five basis points.
How many SDRs have been allocated so far?
1. The general SDR allocation of August 28, 2009 is by far the biggest allocation to date:
2. SDR 9.3 billion was allocated in yearly installments in 1970–72.
3. SDR 12.1 billion was allocated in yearly installments in 1979–81.
4. SDR 161.2 billion was allocated on August 28, 2009.
What happens to the SDRs once they are allocated?
1. The IMF’s SDR Department keeps records of members’ SDR allocations and holdings; the SDR
Department is also the channel through which all transactions and operations involving SDRs
are conducted.
2. Once allocated, members can hold their SDRs as part of their international reserves or sell part
or all of their SDR allocations.
3. Members can exchange SDRs for freely usable currencies among themselves and with
prescribed holders; such exchange can take place under a voluntary arrangement or under
designation by the Fund.
4. IMF members can also use SDRs in operations and transactions involving the IMF, such as the
payment of interest on and repayment of loans, or payment for future quota increases.
Issues with new allocations
1. New reserves are allocated according to members’ quotas — or shares in the IMF.
2. A great deal of the benefit in 2009 went to advanced economies that didn’t need help in
accessing markets or financing fiscal deficits.
3. If the same system is being used now, only 40 per cent of the total would be given to the
emerging economies. That is not good enough.
Other reasons
1. The possible extraneous purposes FM could be referring to maybe misuse of resources for terror
funding or some such purpose by neighbours.
2. This may seem far-fetched to some, but is par for the course for the government.
3. The other possibility is that India is merely trying to prove its loyalty to the Trump administration.
4. India has already requested to access the US Fed’s currency swaps.
Recently, the Finance Minister of India opposed a general allocation of new Special Drawing
Rights (SDR) by the International Monetary Fund (IMF) because it might not be effective in
easing Covid-19 driven financial pressures.
 The Finance Minister was concerned that such a major liquidity injection could produce
potentially costly side-effects if countries used the funds for irrelevant purposes.
 The new SDR allocation will provide all 189 members with new foreign exchange reserves
with no conditions.
Key Points
 The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the
freely usable currencies of IMF members. SDRs can be exchanged for these currencies.
 The SDR serves as the unit of account of the IMF and some other international
organizations.
 The currency value of the SDR is determined by summing the values in U.S. dollars, based
on market exchange rates, of a SDR basket of currencies.

lOMoARcPSD|22015297
 The SDR basket of currencies includes the U.S. dollar, Euro, Japanese yen, pound sterling
and the Chinese renminbi (included in 2016).
 The SDR currency value is calculated daily (except on IMF holidays or whenever the IMF is
closed for business) and the valuation basket is reviewed and adjusted every five years.
 Quota (the amount contributed to the IMF) of a country is denominated (expressed) in
SDRs.
o Members’ voting power is related directly to their quotas.
 India's Foreign exchange reserves also incorporate SDR.
INTERNATIONAL LENDING RISK
Lending involves a number of risks. In addition to risks related to the creditworthiness of the
borrower, there are others including funding risk, interest rate risk, clearing risk, and foreign
exchange risk. International lending also involves country risk.
• credit risk - probability that interest or principal will not be repaid larger risk results in higher
interest rate assessing credit risk on international loans more difficult
• country risk - probability that political developments will impact international investment
• currency risk – economic risk associated with currency appreciation or depreciation;
increased if hedging not possible or exchange controls exist
THE PROBLEM OF INTERNATIONAL DEBT

concern that volume of lending insufficient particularly with respect to developing nations
excessive international lending created repayment problems during global recession in early
1980s debt service/export ratio – interest and principal payments as a percentage of export
earnings indicating: interest rate nation pays on its debt growth in exports of goods & services
Debt Servicing Difficulties
Reasons for difficulties:
 improper macroeconomic policies
 leading to balance of payments
 deficit excessive borrowing or unfavorable terms uncontrollable economic events
Options:
 cease repayment
 service debt at all costs
 debt rescheduling
 emergency loans from IMF with conditionality
Reducing Exposure to Developing Nation Debt
 loan sales – sell to other banks in secondary market for less than face value
 debt buyback – government of debtor nation buys loan from bank at discount
 debt for debt swaps – bank exchanges loans for securities issued by debtor nation’s
government at discount
 debt/equity swaps – bank sells loans at discount to debtor nation’s government for local
currency used to finance equity investment
Debt Reduction & Forgiveness
debt reduction –
 voluntary agreement reducing portion of debtor nation’s debt service
 negotiating modification in terms and conditions of contract
 debt/equity swaps or debt buybacks
debt forgiveness –
 creditor’s elimination of contractual obligations of debtor nation
 write-offs of debt
 abrogation of interest obligations
 advocates argue elimination of debt service will lead to growth in developing nations
FINANCIAL CRISIS AND THE INTERNATIONAL MONETARY FUND

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History will record the globalization of trade and financial markets as among the most
important economic developments of the late 20th century. In 1996 net international capital flows
to developing countries amounted to $235 billion—an impressive 0.8 percent of world GDP, and
more than two percent of developing country GDP. And since international portfolio
diversification is far from complete, the scale of international financial flows is bound to continue
increasing for some time. While the long-term benefits of financial liberalization and globalization
are not in doubt, the increased volume and volatility of capital flows have exposed vulnerabilities
in recipient developing countries that have led to major financial crises.
To avoid crises, a country needs both sound macroeconomic policies and a strong
financial system. A sound macroeconomic policy framework is one that promotes growth by
keeping inflation low, the budget deficit small, and the current account sustainable. As a formal
matter of debt dynamics, the sustainability of the current account depends on the economy’s
growth rate and the real interest rate at which the country can borrow. But sustainability has
another sense, of the ability to withstand shocks, and that is less susceptible to formal analysis. In
any case, large current account deficits—depending on the growth rate of the economy, in the
range of 5-8 percent of GDP, and certainly any higher—should be cause for concern. Current
account deficits financed by longer-term borrowing and in particular by foreign direct investment
are more sustainable; sizable deficits financed in large part by short-term capital flows are a
cause for alarm.
It is sometimes difficult to deal with short-term capital inflows that are a response to high
domestic interest rates, particularly in a context in which policy limits exchange rate flexibility. This
is the famous capital inflows problem that so many countries seeking to stabilize from moderate
rates of inflation have faced. There is no easy answer to this problem, but a tightening of fiscal
policy is the first line of defense. A second response is to increase the flexibility of the exchange
rate
The Fund's purposes are as follows:
1. To facilitate the expansion and balanced growth of international trade, and to contribute to
the promotion and maintenance of high levels of employment and real income and to the
development of the productive resources of all members as primary objectives of economic
policy;
2. To give confidence to members by making the general resources of the Fund temporarily
available to them … thus providing them with opportunity to correct maladjustments in their
balance of payments without resorting to measures destructive of national and international
prosperity;
3. When the Fund unduly emphasizes the reduction of aggregate demand and acts pro-
cyclically, it pursues "beggar thyself policies".
The Role of the IMF
1. The IMF plays its role in stabilizing the international financial system through crisis prevention
and crisis mitigation. IMF surveillance, technical assistance, and information provision,
contribute to the prevention of crises. IMF lending in support of a country’s adjustment
program contributes to the mitigation of crises.
2. Since the Mexican crisis, the IMF has placed increased emphasis on timely surveillance of
market developments. Surveillance takes the form of regular reporting to the Executive Board
of the IMF, and through the Board to member countries, on the state of each country’s
economy, and particularly of any emerging problems.
3. In addition to its surveillance activities, the IMF provides technical assistance to member
countries seeking to strengthen various aspects of their economies, such as the financial

lOMoARcPSD|22015297
system, the tax system, monetary policy, and the exchange rate system. Through extensive
publication of statistics, including through the Data Standards Bulletin Board, we strengthen the
capacity of the markets to operate efficiently.
4. It is reasonable to expect that Fund surveillance will work well in future. But it would be a
mistake to imagine that Fund or any other surveillance could ever be made perfect. We will
surely miss the warning signs of some future crisis, and just as surely will predict some crises that
do not happen. The international system cannot be built on the assumption that improved
surveillance, or the increased provision of information to markets, will prevent all future crises,
even though they should reduce the frequency of crises. Crises will happen.
5. In a crisis, private sector financing evaporates, and countries are forced to take painful
adjustment measures. One of the purposes of the IMF set out in the first Article of Agreement is
"To give confidence to members by making the general resources of the Fund temporarily
available to them under appropriate safeguards, thus providing them with opportunity to
correct maladjustments in their balance of payments without resorting to measures destructive
of national or international prosperity". The Fund—that is the international community—has
shown its willingness to act in this way in many crises. The Fund will continue to act in
accordance with its purposes, and to provide financing, with the conditionality that provides
the safeguards referred to in Article I (v), to countries faced with the need to take actions to
stem the destructive effects of an external crisis. It is for these reasons that the Fund’s Board of
Governors voted, at our recent September 1997 meetings in Hong Kong, to increase Fund
quotas, which constitute our capital base, by 45 percent.
6. At the Hong Kong meeting, the Board of Governors also approved moving ahead to develop
an amendment of the IMF Articles of Agreement to make the liberalization of international
capital flows one of the purposes of the Fund. The Mexican and Thai crises, and the proposed
amendment of the Articles of Agreement, raise two important interrelated questions about
Fund lending. The first is whether we should expect a change in the scale of international
financial crises; the second is whether the Fund’s willingness to lend in a crisis contributes to
moral hazard. The answer to both questions is yes. As the efficiency of the international capital
markets improves, it is reasonable to expect that there will be fewer crises requiring official
funding in future, but it is also likely that they will be on a larger scale than typical in the past.
7. As in the case of any insurance, the possibility of IMF lending to countries in trouble creates a
moral hazard. The hazard is not that the availability of IMF financing in emergencies
encourages countries to behave recklessly, for Fund conditionality is such that governments in
trouble are usually too slow rather than too fast to come to the Fund. Instead the hazard is that
the private sector may be too willing to lend, because it knows that a country in trouble will go
to the Fund rather than default. Spreads in some markets are so low as to support this view, but
they are also consistent with the view that the private sector is too willing to lend to some
borrowers. Spreads in some domestic markets support the second view.
8. The international community has struggled with the question of how to reduce this moral
hazard. The potential moral hazard is easier to deal with in the case of lending to the private
sector, for in those circumstances some private companies and financial institutions in the crisis
country are likely to be closed or forced to restructure, and some of the losses will be borne by
foreign lenders. Severe legal complications could follow for any government seeking to
impose a moratorium, and no international organization has, or is likely to have, the authority
to overrule domestic law by authorizing a moratorium. Nonetheless, the international system
needs to find a solution to the moral hazard problem posed by private sector international
lending to governments, a solution that ensures that the private sector shares in the financial
costs of dealing with crises.

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EUROCURRENCY MARKET.
An important innovation in international banking occurred during the Bretton Woods era when
commercial banks in several countries began to accept deposits and to extend loans in
currencies other than their own national currency. As currencies other than the dollar became
more central to its operation this became known as the “Eurocurrency market,” or merely as
“offshore banking.”
The Euro-currency market is an international financial market, which specialises in the
borrowing and lending of the U.S. dollars and other European currencies, outside their respective
countries of issue. The main centres of Euro-currency transactions include London, Paris, Frankfurt,
Zurich and Amsterdam. Since the U.S. dollar was predominantly transacted in these centres, the
market was called as Euro-dollar market for a long time.
The prefix ‘Euro’ too has become a misnomer because of the following reasons.
Firstly, a number of financial centres dealing in Dollar, European and other currencies have
appeared in the countries outside Europe. These include Tokyo, Hong Kong, Singapore, Panama,
Bahamas, Bahrain, Beirut etc.
Secondly, the Euro-currency market does not deal only in the European currencies.
The U.S. dollar continues to remain the dominant currency in the European and other
centres. But other currencies also account for a substantial part of total deposits of the
international banking institutions. Thirdly, the name ‘Euro’ has been given to the common
currency of the countries of European Union (EU).
Organisation: The largest and fastest growing part of these markets is the inter-bank transactions.
About one-third of the total Euro-currency transactions consist of the non-bank sources and uses
of funds through these markets.
Origin: The origin of the Euro-currency market can be traced back to the period of First World
War, when the banks in most of the European countries accepted deposits in every other
European country. The British pound sterling was the predominant currency and the interest rate
earned on any other currency was determined primarily by the rate payable on sterling deposits,
in conjunction with the spot and forward exchange rates of sterling.
During 1950’s, the U.S. dollar assumed the position of predominant international currency. The
emergence of Euro-dollar or Euro-currency market occurred on account of some major
developments in the late 1950’s.
Firstly, towards the close of 1958, the currencies of major West European countries were made
convertible for non-residents. That enabled the banks in those countries to buy and sell dollars
freely and to use dollar in the financing of international trade.
Secondly, subsequent to the sterling crisis in 1959, the tight controls on non-resident borrowings or
lendings were imposed on the British banks by the government. This made the banks to turn
towards dollars as a substitute for sterling.
Thirdly, the countries of erstwhile Soviet block and East European countries too had a hand in the
origin of Euro-dollar market.
They did not want to retain their deposits of dollars with the U.S. banks. They preferred to keep their
dollar balances in Paris and London rather than New York. By 1961, the Euro-dollars accounted for
at least 90 percent of all Euro-currencies and sterling perhaps accounted for only 5 percent of the
aggregate currency deposits with the banks in London and Paris.
Features of Eurocurrency Market:
The main features of the Euro-currency or Euro-dollar market are as below:
I. Wholesale Market: The Euro-currency market is essentially a wholesale market. The
transactions include, on the one hand, large banks extensive international operations and,
on the other hand, governments, large government agencies or private corporations. The
average size of transactions, lending or borrowing, is quite large. On account of the
extensive scale of operations, the overhead expenses of Euro-banks are quite low.
II. Inter-Bank Transactions: An outstanding feature of the Euro-currency market is that the
inter-bank transactions constitute the largest proportion of its transactions. In this context, it
may be pointed out that Euro-banks are against other banks. As the inter-bank transactions

lOMoARcPSD|22015297
are generally concerned with a short period, the lending and borrowing operations of Euro-
banks are essentially short term in nature.
III. Highly Competitive Market: The Euro-currency market is a highly competitive market. The
new banking institutions have almost unrestricted entry. As a result of greater extent of
competition, the margin between interest rates on deposits has sometimes made the Euro-
banks to take greater risk in the matters of choice of borrowers, security of loan and the
maturity of loan. In the recent years, however, the Euro-banks have become more cautious
about the element of risk.
IV. Distinct from Domestic Money Market: Although in many respects the Euro-currency market
is similar to the domestic money market, yet it is distinct from the latter in a significant
respect. The Euro-banks have no central monetary authority and they are free from central
monetary and exchange restrictions.
V. Greater Extent of Risk: The transactions in the Euro-currency market involve a greater
degree of risk than that existing in the case of domestic banking. Apart from the normal risk
associated with a given transaction in a given currency, there is additional risk on account
of possibility of imposition of new banking regulations or exchange controls by the
government of the country in which the transactions are affected.
Role of Euro-Currency Market in International Financial System:

During the last few decades, the Euro-currency or Euro-dollar market has played a highly
significant role in the international financial system. Although the prime function of this market is to
borrow and lend the U.S. dollars and other principal currencies, yet it confers several benefits
including the increasing mobility of international capital, improvement in asset portfolios of banks,
extension of services to the non-bank private sector, attraction of large scale capital flows,
imparting of flexibility in the financial market and reduction in the interest rate structures related to
deposits and loans.
The Euro-currency market has brought about a closer integration in the international
capital market. The central banks, government treasuries, commercial banks, international banks
like the Bank of International Settlements (BIS) and the transnational corporations act as borrowers
and lenders in this market. Their mutual interdependence leads to a greater measure of co-
operation and closer co-ordination.
The expansion of Euro-currency market has greatly increased the international mobility of
capital. The interest rate differentials between the different financial centres bring out large scale
transfer of short-term and medium-term funds throughout the world. The funds flow out from low
interest financial centre to high interest centre. The Euro-currency market has played a crucial role
in recycling of funds generated through steep rise in petroleum prices.
Similarly the Euro-currency Market has been effectively recycling funds from countries
having balance of payments surplus to those having balance of payments deficit. In brief, the
Euro-currency market has imparted greater mobility to the international capital and thereby
improved the economic efficiency and reduced the interest rate differentials among the various
financial centres and countries.
If a country has the objective of controlling the international capital movements, the
Euro-currency market can render useful assistance in this direction. Suppose there is transfer of
deposits from a U.S. bank to a Euro-bank, there will be reduction of U.S. surplus or increase in its
deficit on account of capital outflow. On the contrary, an inflow of funds from a Euro-bank to the
U.S. bank will reduce the U.S. payment deficit or increase its surplus.

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306 International Business Economics LECTURE notes

Master of business admistration (Savitribai Phule Pune University)

Studocu is not sponsored or endorsed by any college or university

MBA– Semester III

306 COURSE NOTES

Dr. Rakesh Bhati 306 – International Business Economics 1

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Generic Courses (Electives) – University Level – Semester III

Suggested Text Books:

Suggested Reference Books:

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INTERNATIONAL TRADE: TRADE THEORIES

Dr. Rakesh Bhati 306 – International Business Economics 3

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RICARDO AND COMPARATIVE ADVANTAGE

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In the United States, the country specializes in cloth and produces

Therefore, using the theory of comparative advantage, a country

CRITICISMS OF COMPARATIVE ADVANTAGE

Dr. Rakesh Bhati 306 – International Business Economics 5

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Mongolia. Mongolia was believed to have a comparative advantage in cattle farming.

HECKSCHER OHLIN MODEL OF FACTOR ABUNDANCE

Dr. Rakesh Bhati 306 – International Business Economics 6

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The Price Criterion of Relative Factor Abundance:

According to the price criterion, a

Dr. Rakesh Bhati 306 – International Business Economics 7

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The Physical Criterion of Relative Factor Abundance:

Dr. Rakesh Bhati 306 – International Business Economics 8

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LIMITATIONS OF HECKSCHER OHLIN'S H-O THEORY

Dr. Rakesh Bhati 306 – International Business Economics 9

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KRUGMAN’S MODEL OF INTRA-INDUSTRY TRADE

Assumptions of the model.

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Equilibrium number of firms.

Equilibrium occurs at n2 where price is

Dr. Rakesh Bhati 306 – International Business Economics 11

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TRADE POLICIES: UNILATERAL AND MULTILATERAL TRADE POLICIES

Dr. Rakesh Bhati 306 – International Business Economics 12

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Agreements Partners Year of

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TARIFFS IN COMPETITIVE MARKETS,

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• Domestic suppliers gain an increase in producer surplus of area 1

Without any trade, the equilibrium price is £1.80 and a

Dr. Rakesh Bhati 306 – International Business Economics 15

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 Buy imported products in bulk to reduce costs

Dr. Rakesh Bhati 306 – International Business Economics 17

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D. NONTARIFF TRADE BARRIERS