Contents

Contents 3

List of Tables 5

List of Figures 7

1 Gains from Trade 9

1.1 Inter-regional and International Trade . . . . . . . . . . . . . . 9
1.2 Gains from International Trade . . . . . . . . . . . . . . . . . . 11
1.3 An Absolute Advantage Theory . . . . . . . . . . . . . . . . . . 15
1.3.1 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . 16
1.3.2 Output Maximisation . . . . . . . . . . . . . . . . . . . 16
1.4 The Comparative Cost Advantage Theory . . . . . . . . . . . . 20
1.4.1 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . 21
1.4.2 Output Maximisation . . . . . . . . . . . . . . . . . . . 22
1.4.3 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.5 Modern Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.6 Kravis’ Availability Theory . . . . . . . . . . . . . . . . . . . . 26
1.7 Volume of Trade Theory . . . . . . . . . . . . . . . . . . . . . . 28
1.8 Imitation Gap Theory . . . . . . . . . . . . . . . . . . . . . . . 30

2 Commercial Policy 35
2.1 Trade Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.2 Tariff Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.3 Effects of Barriers . . . . . . . . . . . . . . . . . . . . . . . . . 39

1
 2.4 Non-Tariff Barriers . . . . . . . . . . . . . . . . . . . . . . . . . 41

3 Economic Integration 45

4 Balance of Payments 49
4.1 Structure of Balance Payments . . . . . . . . . . . . . . . . . . 50
4.2 Disequilibrium in Balance of Payments . . . . . . . . . . . . . . 53
4.3 Causes of Disequilibrium . . . . . . . . . . . . . . . . . . . . . . 56
4.4 Measures to Correct the Deficit . . . . . . . . . . . . . . . . . . 57
4.5 India’s BoPs since 1991 . . . . . . . . . . . . . . . . . . . . . . 61

5 Foreign Exchange Market 65

5.1 Instruments of International Payments . . . . . . . . . . . . . . 66
5.2 Participants in Exchange Markets . . . . . . . . . . . . . . . . . 69
5.3 Functions of Foreign Exchange Market . . . . . . . . . . . . . . 71
5.4 Determination of Foreign Exchange Rate . . . . . . . . . . . . . 72
5.5 Fixed Exchange Rate System . . . . . . . . . . . . . . . . . . . 73
5.6 Breton Woods System . . . . . . . . . . . . . . . . . . . . . . . 74
5.7 Purchasing Parity Theory . . . . . . . . . . . . . . . . . . . . . 78
5.8 Clean Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
5.9 Managed Flexibility . . . . . . . . . . . . . . . . . . . . . . . . 85

6 RBI Intervention in Exchange Rate 91

6.1 Exchange Market Intervention . . . . . . . . . . . . . . . . . . . 91
6.2 India’s Exchange Rate System . . . . . . . . . . . . . . . . . . 93

2
List of Tables

1.1 Gain by Cost Differences . . . . . . . . . . . . . . . . . . . . . . 12

1.2 Gain from Increased Output . . . . . . . . . . . . . . . . . . . . 13
1.3 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.4 Gain from Increased Output . . . . . . . . . . . . . . . . . . . . 17
1.5 Absolute and Comparative Cost . . . . . . . . . . . . . . . . . 19
1.6 Cost Minimisation . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.7 Availability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

4.1 Structure of India’s Balance of Payments as per cent of GDP . 63

3
4
List of Figures

1.1 Increase in Consumption . . . . . . . . . . . . . . . . . . . . . . 14

1.2 Economies of Scale . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.3 Output Maximisation . . . . . . . . . . . . . . . . . . . . . . . 18
1.4 Comparative Advantage: Output Maximisation . . . . . . . . . 22
1.5 Modern Theory of International Trade . . . . . . . . . . . . . . 25
1.6 Volume of Trade Theory . . . . . . . . . . . . . . . . . . . . . . 30
1.7 Imitation Gap Theory . . . . . . . . . . . . . . . . . . . . . . . 32

2.1 Effects of Tariff Barriers . . . . . . . . . . . . . . . . . . . . . . 40

3.1 Levels of Economic Integration . . . . . . . . . . . . . . . . . . 46

5.1 Clean Float . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

5.2 Managed Float . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
5.3 Exchange Rate Band . . . . . . . . . . . . . . . . . . . . . . . . 87
5.4 Snake in Tunnel . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

5
6
Chapter 1

Gains from Trade

1.1 Inter-regional and International Trade

Trade is an exchange of goods or services between the parties. When it is
among nationals of the same country, it is internal or domestic trade and if it
is among nationals of different countries, it is international trade.

There is a lack of unanimity of opinion among economists whether differences

between domestic and international trade are enough to frame different theories
or the same theories of trade can explain the both. Classical economists held
that there are certain fundamental differences between them due to which
international trade deserve separate theories. But modern economists, like
Bertil Ohlin and Haberler, opined that the difference between inter-regional
and international trade is of a degree rather than a kind, therefore, there is no
need for separate theories of international trade.

Inter-regional v/s International Trade

Difference between domestic and international trade arises due to economic

environment. Different factors which are operational incase of inter-regional
trade disappear at inter-national level while few new arise there. It makes
international trade different from domestic trade.

7
1. Factor mobility: Factors of production are more mobile within the
country than between countries. Among the factors, the land is the
least mobile, and capital is the most mobile between countries. The
reasons for lower mobility of labour in international trade are differences
in languages, customs, occupational skills, and unwillingness to live in un-
familiar surroundings and family ties, high travelling expenses, political
uncertainty, restrictions imposed by a foreign country on labour immi-
gration. International mobility of capital is restricted not by transport
cost but by differences of legal redress, political uncertainty, ignorance
of prospect of investment, the imperfection of banking, instability of
foreign exchange rate etc.

2. Differences in natural resources: Different countries are endowed

with different types of natural resources. Hence they tend to specialise
in the production of those commodities in which abundant resources
are largely used and export those commodities to other countries. In
Australia land is in abundance but labour and capital are in short supply.
In the UK capital is abundant but the land is scarce. Therefore, capital
intensive commodities will be produced by the UK; land-intensive com-
modities will be produced by Australia and labour intensive commodities
by India. Such kinds of differences in natural resources availability are
less prominent in internal trade.

3. Human capabilities: Some people are more suitable in one line of pro-
duction than others, therefore, they tend to specialise in their respective
capabilities. Such capability differences are lesser within country and
more between countries. That is why products and costs differ more
between countries.

4. Geographical and climatic differences: Possible production varies

with variations in climate. A country produces only a set of commodities
for which climate is suitable while other countries will produce other
sets of commodities. For instance, Brazil has favourable conditions for
coffee, Bangladesh for jute etc. Within country climatic conditions and
therefore production differ lesser.

5. Different markets: International markets are separated by differences

8
 in languages, usages, habits, taste, fashion etc. Even systems of weights
and measures as well as pattern and styles in machinery and equipment
differ from country to country. It makes transactions in the international
market to differ from those in the domestic market.

6. Mobility of goods: There is also a difference in mobility of goods

between inter-regional and international markets. The mobility of goods
within the country is restricted only by geographical distances and
transport costs. But along with these restrictions, there are many tariff
and non-tariff barriers to the movement of goods between countries.

7. Different currencies: The principle difference between inter-regional

and international trade arises because of the involvement of more than
one currency in international trade. Because of the involvement of more
than one currency international trade turns multi transactional and give
rise to the balance of payments or international liquidity problem. It
arises due to a shortage of means of payment rather than purchasing
power problem and is perpetual in international trade. While inter-
regional trade has no such problem as it is a single currency transaction.

8. Different transportation cost: Trade between countries, in general,

involves longer distances and larger transportation costs compared with
inter-regional trade.

9. Different economic environment: Countries differ in their economic

environment like legal framework, institutional setup, monetary, fiscal
and commercial policies, etc. But domestic trade is in the same national
economic environment.

Therefore classical economist asserted that there are fundamental differences

between inter-regional international trades and advocated a separate theory of
international trade.

1.2 Gains from International Trade

Any trade is based on price differences likewise international trade is. Price
differences reflect differences in cost of production which are due to differences

9
in factor prices, factor combinations and production processes. Differences in
factor prices are because of natural abundance. Accordingly, every country
produces and exports those commodities which it can produce at a lower cost
than other countries. No economy can remain in isolation because international
trade confers various gains like economic development, employment, consumer’s
welfare, a boost to investment, healthy competition, efficiency, economies of
large scale, socio-political advantages.

1. Gain from cost differences: Assume that per unit production cost of
cotton and sugar in India and Pakistan in labour hours is as follows.

Table 1.1: Gain by Cost Differences

Before international trade During the international trade

Country Cotton Sugar Total Cotton Sugar Total

India 3 2 5 ... 4 4

Pakistan 2 3 5 4 ... 4

5 labourer/country 4 labourer/countrry

If two countries produced and consumed separately one unit of each

good, it will cost 5 labourers for each country. If two countries entered
international trade, by specialising in their lower cost commodity, India
will produce one unit of sugar for each country and Pakistan will produce
one unit of cotton for each of them. Each country will get 1 unit of each
good as before. But the cost of production will decrease to 4 labourers
only. Thus, by trading each country will save 1 labour unit of cost.

2. Increase in world production: Assume that production per labour

in India and Pakistan is as following

If both countries employed one labour in the production of each com-

modity, together they can produce 175 units of each commodity. If India
specialised in the production of sugar and Pakistan in the production of
cotton, they can produce 200 units of each commodity i.e. additional

10
 Table 1.2: Gain from Increased Output

Before international trade During the international trade

Country Cotton Sugar Cotton Sugar

India 75 100 ··· 200

Pakistan 100 75 200 ···

Output 175 175 200 200

175 unit/each cotton & sugar 200 unit/each cotton & sugar

25 unit of production of each commodity. Thus, world production will

increase with international trade.

3. Increase in Consumption: With an increase in world production

prices in the international market will come down, and real income will
increase. It will increase consumption and consumer’s welfare.

In the following diagram, domestic market prices in isolation are shown

by price line AA’ and B’B. Country A and B will consume at point a
and b respectively. After the introduction of international trade, the new
price line for both the countries will be AB and both the countries may
consume at point c on a higher indifference curve. Thus, countries will
become better off than before.

4. Economies of Large Scale: International trade provides an expanded

market for all commodities. Therefore, producers of such commodities
can produce in large quantities and can avail economies of large scale.

5. Increase in Investment: Expanding market and increasing production,

due to international trade, demand increase in investment. Expanding
international market, economies of scale ensure increase in marginal
efficiency of capita and better returns. Therefore, it will boost investment.

6. Employment Generation: Expanded market and will increase demand

11
 Y

B′
a
y1 c
y
b
y2
IC2
IC1
O x1 x x2 A ′ B X

Figure 1.1: Increase in Consumption

Cost

AC

O
Output

Figure 1.2: Economies of Scale

and production of many commodities which it can produce at competitive

prices. This will generate employment in the economy.

7. Economic Development: International trade through expanded mar-

ket, increased investment and employment causes economic development.

8. Healthy Competition: International trade increases number of partic-

ipants in the market of each commodity from both demand and supply
sides. This will give rise to healthy competition which always benefits
both consumers as well as producers.

12
1.3 An Absolute Advantage Theory
Adam Smith, the father of economics, in his book the Wealth of Nations,
attempted to explain the process by which market and production operate in
society. He attacked mercantilists assumption that trade is a zero-sum game.
He introduced two concepts that are fundamental to his trade theory: absolute
cost advantage and division of labour.

Absolute Advantage

Smith noted that some countries, owing to the skills of their labourers or the
quality of their natural resources, could produce the given commodities with
fewer labour hours. He termed this efficiency as an absolute cost advantage. In
other words, a country is said to have an absolute advantage if it produces the
given commodity comparatively with a lower quantity of resources or labour
than other countries.

Division of Labour

Smith observed that the division of labour and specialisation increase the
productivity of workers and industries. Smith extended this argument of
the division of labour across the countries. He argued that a country could
certainly gain by exchanging its absolute cost advantage commodity with other
countries for commodities that it can produce only at higher costs.

Just as a tailor does not make his shoes but exchange a suit for shoes, and hence
both the tailor as well as the shoemaker gain by trading. In the same manner,
each country and thereby the whole world gains by having trade relations with
each other. Each country should specialise in the commodities that it can
produce more efficiently than others i.e. a good in which it has an absolute
cost advantage. Efficiency suggests fewer inputs for a given output (Cost
Minimisation) or more output form is given inputs (Output Maximisation).
Smith basic argument is that a country should never produce those goods at
home that it can buy at a lower cost from other countries.

13
1.3.1 Cost Minimisation
Assume that India has an absolute cost advantage in sugar measured on the
X-axis and Pakistan in cotton measured on the Y-axis. An average labour
cost of production is given in the following table.

Table 1.3: Cost Minimisation

Before international trade During the international trade

Country Cotton Sugar Total Cotton Sugar Total

India 20 10 30 ... 20 20

Pakistan 10 20 30 20 ... 20

Cost 30 labourer/country 20 labourer/countrry

The table shows that the average production cost of sugar is 10 labour hours
in India and 20 labour hours in Pakistan. While the average production cost of
cotton is 20 labour hours in India and 10 labour hours in Pakistan. Thus, we
can say that India has an absolute cost advantage in sugar and Pakistan has
an absolute cost advantage in the production of cotton. The table shows that,
if both countries produced and consumed separately, to have one unit of each
commodity, it will cost 30 labour hours to each country. If they specialised in
the commodity of absolute cost advantage and exchanged the commodities
with each other at the exchange rate of 1X = 1Y , both countries will have one
unit of each commodity at the cost of 20 labour hours. Thus, both countries
will have the same consumption with lower labour cost.

1.3.2 Output Maximisation

Assume that in India a labourer while working for a labour day can produce
25 units of sugar or 10 units of cotton per day. While in Pakistan a labourer
working for a labour day can produce 15 units of sugar and 20 units of
cotton.

14
 Table 1.4: Gain from Increased Output

Before international trade During the international trade

Country Cotton Sugar Cotton Sugar

India 10 25 ··· 50

Pakistan 20 15 40 ···

Output 30 40 40 50

30 cotton & 40 sugar 40 cotton & 50 sugar

Also, assume that each country employees one labour in the production of each
product. The above table shows that before the trade both countries together
produce only 40 units of sugar and 30 units of cotton. If they specialised in the
production of commodity of their absolute cost advantage, India will produce
50 units of sugar and Pakistan 40 units of cotton with the same labour cost as
before. Thus, India produces extra 25 units of sugar at an opportunity cost
of 10 units of cotton. While Pakistan produces extra 20 units of cotton at
an opportunity cost of 15 units of sugar. Both the countries taken together
produce extra units of both commodities.

If each country wished to maintain consumption of imported commodity as

before and exchanged with each other at the rate of 1X = 1Y . India will
consume 25 units of sugar instead of earlier 10 units and Pakistan will consume
45 units of cotton instead of earlier 20 units. Geometrically In the following
diagram BB’ and PP’ are production possibility curves in India and Pakistan
respectively. Production possibility curve BB’ is flatter to show that with a
given quantity of resources, India produces more units (20) of sugar, than
cotton (10 units). Production possibility curve PP’ is steeper to show that
with a given quantity of resources, Pakistan produces more units (25) of cotton,
than sugar (15 units).

Assume that in autarky India produces and consumes at point B with C1 of

cotton and S1 of sugar (12S, 4C). while Pakistan consumes at point K with

15
 Cotton

B2 (7.5, 14)
C2

B’
B1 (16.3, 7)
C1
B(7.5, 5.6)

O
S2 S1 P’ B Sugar

Figure 1.3: Output Maximisation

S of sugar and C of cotton(5S, 16C).

If both the countries specialised in the production of commodity of their

absolute advantage, India will produce only sugar at point B and Pakistan
will produce only cotton at point P . Thus, P B would be the new production
possibility curve.

Now India does not produce cotton, therefore, will have to depend on Pakistan
for cotton; while Pakistan does not produce sugar and will have to depend
upon India for sugar. Therefore, they will enter into international trade for
each other’s product. The combined production possibility of the two countries
would be P B. It would be flatter than P P ’ and steeper than BB’ possibility
curve, which means that the international market opportunity of cotton would
be more than that of cotton in Pakistan and lesser than that in India. It also
means that the international opportunity of sugar would be more than that of
sugar in India and lesser than that in Pakistan.

Suppose that India preferred to consume the same quantity of sugar S1 as

before in autarky. It means India can exchange its excess of sugar S1 B with
Pakistan for C2 quantity of cotton at the international price level. India’s new
consumption point would be B2 , while it produces at point B.

16
If India decided to consume the same quantity of cotton as before in autarky,
it can get it at the exchange of S2 B quantity of sugar with Pakistan at
international terms of trade. Thus, India can consume an increased quantity
of sugar S2 . India’s new consumption point would be B1 , while it produces at
point B.

India also may prefer to consume more of both sugar and cotton between point
B1 and B2 . Thus, we can say that with specialisation and international trade
Indian would be better off than before either by consuming more quantity
one commodity while consuming the same quantity of other commodity or by
consuming more of both the commodities than before. Consumption above
B2 point and below B1 point involves compensating variation.

Table 1.5: Absolute and Comparative Cost

Absolute Advantage Comparative Advantage

Some producers, owing to their Some producers, owing to their

skills or the quality of their natu-
ral resources, can produce a given
commodity with fewer resources
than other producers. Adam
Smith termed this efficiency as an
absolute cost advantage. In other
words, a producer is said to have
an absolute advantage in the given
commodity, if he produces it, with
a lower quantity of resources or
labour than other producers.
skills or inclination, can produce
given commodity with fewer re-
sources than other commodities.
A producer is said to have a com-
parative cost advantage in the pro-
duction of the given commodity if
it can produce that commodity at
lower opportunity cost than other
commodities.

The absolute cost denotes the pro- Comparative cost denotes the
ducer who is more efficient in pro- commodity in the production of
ducing the given commodity. which the given producer is more
efficient.

17
 Absolute advantage compares pro- Comparative advantage compares
duction efficiency of different pro- the production efficiency of the
ducers in the same good same producer in different goods.

Absolute advantage owes to the Comparative advantage owes to

producer. To find it, ask your-
self: Which producer of the given
commodity produces it cheaper?
(Answer is producers name)
the commodity. To find it, ask
yourself: Which commodity of the
given producer is being produced
cheaper? (Answer is the name of
a commodity)

It is determined by the absolute It is determined by ratios of the

numbers of real production cost. production cost of different com-
modities by the same producer.

1.4 The Comparative Cost Advantage Theory

Ricardo agreed with Smith that international trade would be of mutual advan-
tage if countries have an absolute cost advantage over each other in different
goods. But Ricardo further argued that any two countries can gain by trading,
even if one of the countries have an absolute cost advantage in both the
goods, provided the extent of absolute cost advantage is different in the two
commodities. It means that the comparative cost advantage in one commodity
should be greater than that in other commodities. In other words, it is not
an absolute cost but a comparative cost difference that determines the trade
relationship between countries.

A country is said to have a comparative* cost advantage in the production of

a commodity if it can produce that commodity at a cost lower than that of
other commodities or lower opportunity cost. If a country specialises in the
production of its comparative cost advantage commodity, then international
trade improves production and consumption with the same resources.

Due to the combined effect of many factors, a country may produce a com-
modity at a lower cost than other commodities, though it produces both the
commodities at a higher cost compared to other countries. In this way, each

18
country specialises in the production of comparative cost advantage commodity.
Therefore, when a country enters international trade with some other country,
it will export commodity of comparative costs advantage and will import
others.

Assumptions

1. There are only two countries, two commodities

2. Labour is homogeneous and the only factor of production with no change

in supply.

3. Law of constant returns to scale and unchanged technology.

4. Barter system

1.4.1 Cost Minimisation

Given these assumptions, Ricardo showed that trade between the two countries
depends, not on an absolute cost advantage but comparative cost advantage.
To illustrate consider Ricardo’s well-known example of trade between England
and Portugal. The labour cost of production of cloth and wine is as given in
the following table.

Table 1.6: Cost Minimisation

Before international trade During the international trade

Country England Portugal England Portugal

Wine 120 80 ... 160

Cloth 100 90 200 ...

Total 220 170 200 160

The above table shows that if both the countries produced and consumed both
commodities separately, to have one unit of each commodity it will cost 220

19
labour hours for England and 170 labour hour for Portugal. If they specialised
in the commodity of their comparative cost advantage and exchanged for each
other’s commodity at the exchange rate of 1 wine = 1 Cloth, England will
have one unit of each commodity at the cost of 200 labour hours thus saving
20 labour hours and Portugal will have one unit of each commodity at the
cost of 160 units saving 10 units of labour.

Thus, both countries will have the same consumption with lower labour
cost.

1.4.2 Output Maximisation

In the following diagram, the P P1 production possibility curve of Portugal
lies above that of England EE1 denoting that Portugal has an absolute cost
advantage in the production of both the commodities. P P1 is flatter, showing
that Portugal has a comparative cost advantage in wine, measured on the
horizontal axis, while EE1 is steeper and shows England’s comparative cost
advantage in the production of cloth, measured on the vertical axis. In autarky,
both the countries can produce and consume at any point on their production
possibility curve.

Cloth

P1

A2
C2
C1 A1

O
W2 W1 E’ I P Wine

Figure 1.4: Comparative Advantage: Output Maximisation

Assume that in isolation England produces and consumes at point A1 with

W1 of wine and C1 of cloth.

20
After the opening of international trade, England will produce only cloth - a
commodity of comparative cost advantage and will depend upon Portugal for
wine. While Portugal will produce only wine and will depend upon England for
cloth. If international trade is opened between these countries new production
possibility curve would be as EI, which shows international terms of trade.
The price of each commodity would be more than the price of that commodity
in the country in which it is a commodity of comparative cost advantage and
less than the price in other countries. Thus, international price line will be
steeper than P P1 and flatter than EE1 1 .

Assume that the consumption of cloth is kept constant at C1 by England. It

can exchange the rest quantity EC1 of cloth with Portugal for W2 quantity
of wine at international terms of trade BI. Or it can consume the same
quantity W1 of wine which it can get for exchange of EC2 of cloth and can
increase consumption of cloth to C2 . Or it can increase consumption of both
commodities between points A1 and A2 on international terms of trade. By
doing so, with the same resources England can consume the same quantity
of one commodity along with the increased quantity of others or increase the
quantity of both the commodities. Thus, there is again in international trade
for England.

Similarly, we can show the gain for Portugal too.

1.4.3 Criticism

1. Unrealistic assumptions of labour cost, similar tastes, fixed proportion,

constant cost, free trade, full employment, etc.

2. Ignores transportation cost, immobility of factors between countries, the

role of technology, etc.

3. Two-country, two-commodity model is unrealistic.

4. Only supply side is considered.

5. Complete specialisation is impractical.

1

21
 6. The theory explains how gain arises but does not explain how it will be
distributed.

1.5 Modern Theory

Bertin Ohlin in his book Inter-regional and International Trade 2 criticised
the classical theory of international trade and gave general equilibrium theory
also called factor endowment or factor abundance or factor proportion or
Heckscher-Ohlin or modern theory of international trade. According to him
the main reason which makes a country specialise in and export a particular
commodity is relative factor endowment.

The logic is that the factors which are abundant in the county would be cheaper
and if they are utilised proportionately more in the production it will reduce
cost. Therefore, it would be the natural choice of the country to specialise in
and export those commodities in which their abundant factor is used more. In
short, the labour abundant countries will export labour-intensive goods and
capital abundant countries will export capital intensive goods, land abundant
countries will export land-intensive goods etc.

To illustrate the theory let us assume,

1. There are only two factors, labour measured on X-axis and capital
measured on Y-axis.

2. There are only two countries A and B. Country A labour is abundant

and in B capital is abundant. Therefore, labour is cheaper in country
A than capital and in-country B capital is cheaper than labour. It is
shown by the flatter factor price line P A (P A′ ) in country A and the
steeper factor price line in country B. It means with a given amount of
money, one can buy more labour in country A than capital and more
capital in country B than labour.

3. There are only two goods, X -a labour-intensive and Y -a capital intensive.

It is shown by the iso-quant x closer to X-axis and iso-quant y closer to
Y-axis.
2

22
 4. Production technology is the same in both countries A and B. It is shown
with common iso-quants for both the countries. But factor combinations
would be different because of the difference in factor prices.

5. Now thinks how these two countries will produce in autarky and in what
commodity will they specialise in after entering international trade.
Capital

By
C1

P’

Ay
C2 Bx
C3 y

P
A’

Ax
C4 x
O
L1 L2 L3 P L4 A labour

Figure 1.5: Modern Theory of International Trade

Before trade factor prices in the country, B are shown by the price line P B
and in-country A by the price line P A(P ′ A′ ).

Production of good Y: Country B produces one unit of good Y at point

By with C1 of capital and L1 of labour, while country A at point Ay with C2
of capital and L3 of labour, where their factor price lines are tangential to
iso-quant y.

Production of good X: Country B produces one unit of good X at point

Bx with C3 of capital and L2 of labour, while country A at point Ax with C4
of capital and L4 of labour, where their factor price lines are tangential to
iso-quant y.

Here we can observe that labour abundant country A uses more labour than

23
country B and capital abundant country B uses more capital than country A
in the production of both goods. It is because more use of abundant factor
will reduce the cost of production.

When international trade will be opened between these countries, to minimise

cost, country A would like to export good X and country B good Y.

It means that capital abundant country will produce and export capital
intensive goods and labour abundant country will produce and export labour-
intensive goods.

1.6 Kravis’ Availability Theory

In 1956, Irving B Kravis questioned the assumption of the classical theory that
technology is the same in all trading countries. While testing the Heckscher-
Ohlin theory he wanted to find out whether labour-intensive exports were
produced by cheap labour. But he found that almost in every country exporting
industries paid the highest wage rates. It means that labour abundant country
does not export cheap labour product but costlier labour product.

According to him, a country produced and exported those goods which were
available. Thus, he propounded a theory that the commodity composition
of trade is determined primarily by availability. Availability means elastic
supply. Trade does not take place in only those goods which are ‘not available
at home.’ By this phrase he means;

• a country will imports those goods which are not available in the absolute
sense,

• export those goods which are available in a quantity greater than domestic
demand.

Kravis had explained four factors that influence availability. First, availability
of natural resources, second, availability of technical knowledge, third, prod-
uct differentiation which confers temporary monopoly of innovating country,
fourthly, importing country’s government policy influences the trade negatively.
Tariff policies, transport costs, cartelisation etc, tend to eliminate from trade,

24
those goods which are available through domestic production at a slightly
higher cost. Thus, Kravis availability is a result of natural resources, technical
knowledge, product differentiation and protectionist policies.

Availability theory can be explained with the help of an example. Suppose

that there are four countries A, B, C and D and two goods, food (F ) and
manufactures (M ). Both goods require labour and capital. But the production
of F also requires land and that of M technical knowhow. It is further assumed
that country A does not possess knowhow and country D does not possess
land. Hence country A produces only F and country D only M. But country
B and C can produce both F and M.

Table 1.7: Availability

Country A/F B/F & M C/F & M D/M

Domestic ptice ratio → 5:1 3:1

If IT T > 5F
1M (6F) F M M M

If 5F
1M > IT T > 3F
1M (4F) F F M M

If 3F
1M > IT T (2F) F F F M

Suppose that the marginal rate of transformation or marginal rate of technical

substitution (M RT SM F )3 is constant at 5F : 1M in country B and 3F : 1M in
country C. An equilibrium price ratio between F and M would be determined
by the world demand conditions and production possibilities.

Based on availability, country A will always export good F and country D

good M. But the trade pattern of country B and C would be governed by an
equilibrium price ratio. If the equilibrium price ratio is less than 3F : 1M
both B and C countries would export food F . If it is greater than 5F : 1M ,
both would export good M . If the price ratio is more than 3F : 1M but less
3 Marginal rate of technical transformation or marginal rate of technical substitution
is several units of one commodity that must surrender to produce one unit of another
commodity.

25
than 5F : 1M , say 4F : 1M , then country B would export F and country C
would export M .

To sum up, country A would export good F to country D and country D

would export good M to country A based on availability theory since each
country cannot produce imported goods domestically. However, trade between
B and C can be explained in terms of comparative cost theory since both
countries can produce both commodities.

1.7 Volume of Trade Theory

Linder makes a distinction between trade-in primary products and manufac-
tures. According to him while trade in primary products can be explained in
terms of an endowment of natural resources, while that in manufactures cannot
be explained so, because of many complexities such as quality, appearance,
technological superiority, managerial skills and economies of scale etc. which
cannot be in a precise and predictable pattern. He, therefore, does not explain
the precise composition of trade in manufactures; instead, he propounded a
theory concerning the volume of trade in manufactures as a proportion of the
national income of trading partners.

Linder argues that as per the level of P CI, the country will have its represen-
tative demand pattern. The higher is the P CI, the more would be demand for
high end (or high priced) goods and vice versa. The level of P CI causes more
demand for a specific quality4 of the product which can be called representative
demand. It leads to increased production of such goods and economies of
scale in that, fall in average cost and such manufacture become the country’s
new comparative cost advantage exports. In this way, the country exports its
representative demand product.

• Foreign trade is only an extension of domestic trade. The pre-condition

for the export of manufactures is the presence of home demand. It is
mainly because foreign trade is riskier 5 than domestic trade. Therefore,
producers do not wish to depend on the foreign market alone. It follows
4 quality is a wide term it may mean substitute goods or different quality goods.
5

26
 that the domestic demand pattern determines the range of potential
exportable or t is domestic demand which gives manufacturers export
possibility.

• Potential trade between the two countries is limited to those goods for
which demand exist in both countries.

• The good for which domestic demand exists is determined by per capita
income.

• There are innovating centres in the existing industries.

According to Linder, a country will export its products more to those countries
whose income level and demand pattern are similar to its own, what he calls
‘preference similarity.’ Preference similarity leads to overlapping demands.
Linder argues that other things being equal, on average, low-income countries
will demand low-quality goods and high-income countries high-quality goods.
In general income distribution is unequal. That is why there are preference
similarities between countries and demand patterns overlap. This leads to the
existence of trade relations between countries and every country, after meeting
its domestic demand exports a variety of products.

Assume that there are two countries A and B. Country A with low per capita
income and B with high per capita income. Per capita income is taken on
the horizontal axis and the quality of the product on the vertical axis. If
there is an equal distribution of income there will be no trade between the
two countries because each country will produce only one standard quality
product demanded by the residents.

In reality, income distribution is uneven and each country demands, both lower
and higher quality products. Suppose in country A income distribution leads
to demand for the products in the range A1 A2 and in-country B in the range
of B1 B2 . The range of overlap demand in the two countries is LH. Since there
is overlapping demand, trade is possible between the two countries.

In-country A, demand for the low-quality product (L) is greater than the
demand for a high-quality product (H). While in country B, demand for a
high-quality product (H) is greater than a low-quality product. Producers in

27
 quality

B2 R

A2 D

H high end goods

L low end goods

C B1

A1

O
A B PCI

Figure 1.6: Volume of Trade Theory

high per capita income country B will find economies of scale in the production
of high-quality good H. This will reduce the average cost of production of good
H in country B. The demand for high-quality product H in low-income country
A would below. Producers will face a higher average fixed cost of production.
That is why instead of producing at home this high-quality product will be
imported in country A. On the other hand, for similar reasons, a low-quality
product will be imported in a higher P CI country B. The greater the overlap
in the product composition, the larger will be the volume of trade.

1.8 Imitation Gap Theory

The Ricardian and Heckscher-Ohlin theories are based on the assumption of the
same level of technology in all trading countries, therefore, do not analyse the
effects of technological changes on trade. M. V. Posner has analysed the effect
of technology on trade. Posner regards technology as a continuous process
that influences the pattern of international trade. Technological innovation in
the form of the production of a new product in one country leads to imitation
and the demand gap in the other country. The extent to which trade between

28
the two countries will take place depends on the net effect of demand lag and
the imitation gap.

Assume that there are two countries with similar factor endowments, demand
conditions and pre-trade factor prices and different technologies.

The imitation gap theory explains the sequence of product innovation by

a country and imitation by other countries. When a firm innovates a new
product, which becomes profitable in the domestic market, the firm and country
enjoy a temporary monopoly, as no other country produces it. It is called the
foreign reaction lag, which is the time taken by the innovating firm (exporting
country) to start the production of the new product.

As the innovating country exports the product, few countries may be able to
imitate and produce but inferior substitute or the same product at higher cost.
Thus, innovating the county’s monopoly turns into an absolute advantage in
the product. It is called a domestic reaction lags, i.e. time taken by domestic
producers (of importing country) to follow the production of a new product
for the domestic market.

After some time, the innovated product may be successfully imitated by

other countries, but by the time innovating country may have improved its
product and process. Thus, the product will turn into a comparative advantage
commodity, till the importing country learns the new process, changes the
plant, equipment etc. to produce it. This is the learning period, which is the
time taken by the importing countries’ producers to master the technique of
producing the new product and selling in the domestic market.

The three lags together i.e. foreign reaction lag, domestic reaction lag and
learning period form imitation gap. The imports of the innovated product in
importing country is possible for the full duration of the imitation gap.

But there is demand lag which is the time taken by the consumers in the
importing country to acquire the taste for the new product. Therefore, the
import of innovated product will not be to the full duration of imitation lag.
To obtain the import period, the demand lag must be subtracted from the
imitation lag.

29
 Import Period = Imitation Lag - Demand Lag

If producers in the importing country start producing innovated product

quickly and consumer in that country are slow to adopt the new product, the
import period will be shorter. On the contrary, if consumers are quick to
adopt the new product and producers imitate slow, the import period will
be longer. When the imitation gap equals the demand lag, there will be no
import of the innovated product. Thus, the pattern of trade between the two
countries depends on the length of the lags.

export

C1

T0
T1 T2 T3 T4 T5 PCI

import C4 C3 C2

Figure 1.7: Imitation Gap Theory

In the above diagram, time is measured along the X-axis and the trade balance
of the product innovating country A against imitating country B is taken on
the vertical axis. At the time T0 , country A innovates the new product. Up to
point T1 , there is no trade between the countries. Therefore, T0 T1 is called a
demand lag. If country B starts importing the new innovated product by the
time T1 , the export of country A starts.

The imitation lag will determine how long country B will import the innovated
commodity from innovator country A.

If demand lag in country B comes to an end by time T1 , country A’s export

to country B starts and will increase till it reaches the maximum level by time
T3 . If country B is not able to imitate the innovated product, the export of
country A will follow course C1 . Here period of import starts from T1 where

30
demand lag ends and would be infinite.

Suppose that country B imitated innovated product by time T4 , then export of

country A to country B falls along with the course C2 , to become zero by time
T5 . From T4 to T5 export of country A falls because country B can produce a
part of its demand. By the time T5 , country B can produce enough for the
domestic market and the export of country A to B falls to zero. Imitation gap
would be T0 T5 . Period of importation would be imitation gap minus demand
lag, T1 T5 .

If country B improved in the innovated product, so that it is even better than

A’s original product, country B will penetrate country A’s market. It means
country A will import the same commodity from country B. This has been
shown by the course arrow below the time axis.

If country B starts imitating the new product, earlier, say by time T3 , the
export of country A falls along course C3 . The imitation gap becomes shorter
and export from country A to B will fully stop by time T4 when a new
commodity is fully imitated and produced enough in country B.

Posner combines two concepts of innovation and imitation gap into a single
concept of ‘dynamism’, which he defined as a function of the rate at which
a country innovates and the speed with which foreign countries imitate. If
an innovating country has a higher degree of dynamism than importers, the
latter country will find its deficit in the balance of trade. Conversely, if the
importing country is more dynamic, the innovating country will turn into an
importing country.

The imitation gap theory is more realistic than the traditional theories because
it analyses the effect of technical changes on the pattern of international
trade.

31
32
Chapter 2

Commercial Policy

The commercial policy or trade policy of a country refers to the measures to

control or influence the magnitude and direction of its international trade. The
countries pursue their international trade policies independently. These policies
are broadly classified as free trade policy and protectionist policy.

Free Trade Policy: Under such trade policy import and export are free or
have minimum restrictions. According to Adam Smith, free trade makes no
distinctions between domestic goods and foreign goods. It is a policy that
doesn’t encourage domestic goods or discourage foreign goods. It is difficult
to have the practical importance of this kind of policy.

Protectionist Policy: Under such policy countries, through the tariff, protect
domestic industries from foreign sophisticated goods and simultaneously gives
some concessions, bounties, subsidies, tax holidays etc. to the domestic
industries. It is import substitution and export promotion. Nearly all countries
of the world follow such type of policy with smaller or bigger variations.

2.1 Trade Barriers

Free and fair international trade is ideal, theoretical, and impracticable, in
practice countries impose various types of barriers. Trade barriers are artificial

33
restrictions or artificial distortions by governments in international trade. Most
trade barriers work on the same principle: to increase the price of imports
and decrease the price of exports. Trade barriers are distortions because they
hamper free trade and are detrimental to overall economic efficiency.

A trade barrier is defined as, “any hurdle or impediment or roadblock that

hamper the smooth flow of goods, service and payment from one destination
to another.” They arise from rules and regulations governing trade, either from
the home country or the host country or an intermediary. Even though all
international organisations like WTO advocate reduction and elimination of
trade barriers, they continue in different forms. Broadly trade barriers are
classified as tariff barriers and non-tariff barriers (NTB).

2.2 Tariff Barriers

A tax imposed on imported goods and services is called a tariff. It is used to
restrict trade, by making import more expensive and making export cheaper.
Governments may impose tariffs to raise revenue or to protect domestic
industries from foreign competition.

The main causes of imposing trade barriers are as follows

1. to protect domestic employment, industries from foreign competition.

2. to promote economic growth and development.

3. to manage foreign exchange resources and balance of payments

4. to raise government revenue.

Types of Tariff Barriers: Tariffs are classified on a different basis:

1. based on origin and destination of goods

(a) Import Duties: An import duty is a levy imposed on foreign

commodities while entering the domestic market. The purpose of
import duty may be revenue making, protection to the domestic
industry, the balance of payments.

34
 (b) Export Duties: An export duty is a levy imposed on domestic
goods being exported.

(c) Transit Duties: A transit duty is a levy imposed by a country

upon goods passing through its territory while being exported by
one foreign country to another.

2. based on the Qualifications of tariff

(a) Specific Duties: A fixed levy imposed per unit of an imported

good is called a specific tariff. This tariff can vary according to the
type of goods imported. For example, Rs. 100/pair of shoes, Rs.
1000/computer.

(b) Ad-valorem Duty: Ad valorem (according to the value) duty is

levied as a percentage of good‘s value.

(c) Compound Duty: When a tariff is imposed as both specific and

ad-valorem duty, it is called a compound duty. In this case, a
certain minimum specific tariff is imposed on goods up to a certain
price and for the excess price above the fixed minimum ad valorem
duty is charged at a specific rate.

(d) Sliding Scale Duty: It changes with the price of goods imported.
It may be an ad-valorem or specific duty.

3. based on the purpose of the imposition of tariff

(a) Revenue Tariff : When the main purpose of the government in

imposing tariff is to obtain revenue, it is called as revenue tariff.
Such a type of tariff is higher on inelastic demand goods and lower
on elastic demand goods. Revenue duties are levied on luxurious
goods. Here, the duty is imposed on items of mass consumption
at such a rate that will not affect consumption. If it affected
consumption it turns to be a protective tariff.

(b) Protective Tariff : When tariffs imposed to restrict imports, to

protect the domestic industry, it is called a protective tariff. Pro-

35
 tective tariffs are usually high to reduce imports.

4. based on country-wise application

(a) Single column Tariff : A single columns or uni-linear tariff is

charged uniformly without discrimination based on the country of
origin.

(b) Double column Tariff : When two different tariff rates are charged
simultaneously, on same commodity, with a certain kind of discre-
tion it is called a double-column tariff. The double-column tariff
discriminates goods based on origin. Preferential rate is charged
on goods from certain countries and general or maximum rate is
charged from all rest countries.

(c) Multiple or Triple Column Tariff : Under this system, two

or more rates- general, intermediate and preferential are levied.
The general rate is maximum, the intermediate rate is average and
the preferential rate is a special rate for selected countries, which
is charged on goods from the countries with which country has
commercial agreements of such nature.

5. based on retaliation

(a) Retaliatory Duty: When another country imposes import duties

on the country’s export, the exporting country may retaliate by
imposing duties on the goods from that country. Such retaliatory
import duty is called retaliatory duty.

(b) Countervailing Duty: When the export price is reduced by

exporting country through an export subsidy the importing country
may impose import duty to restore price to avoid consequences.
Such duty is known as a countervailing duty or anti-dumping duty.

36
2.3 Effects of Barriers

Effects of the tariff may be analysed for the whole economy (general equilibrium)
or on particularly good or market (partial equilibrium). The tariff imposed
will bring changes in the economy in the form of prices, quantity imported
as well as produced domestically, consumption, government revenue, welfare
etc.

Assumptions

1. Tariff imposing country is small.

2. Demand and supply of given good are constant.

3. On-demand side taste, income, prices and supply-side cost conditions

are constant.

4. The world supply of the good is perfectly elastic.

5. The foreign price of the commodity remains unchanged.

6. Imported and domestically produced goods are perfect substitutes.

Kindleberger had given eight effects of the tariff as discussed with the help of
the following diagram.

In the following figure quantity of a good is measured on the X-axis and price
on the Y-axis. Curve DD is the domestic demand curve, SS is a domestic
supply curve. P are the international price of the good and P1 is the post
tariff price. PB is the supply curve of import which is perfectly elastic. Thus,
under free trade, market equilibrium is given by point B and total demand
for a good is Q3 of which domestic supply is Q. Suppose that due to a tariff
imported goods price increase to P ′ . Total demand for goods decreases to Q2
of which domestic supply is Q1 and import is Q1 Q2 .

Various effects of tariffs mentioned above can be better understood with the
help of the above figure and an explanation given below;

1. Price effect: The price effect refers to the price rise due to tariff imposed

37
price

S
D

M N
P′
Redistributive Effect Revenue Effect

B
P
A S T
D

S
Protective Consumption
Effect Effect
O
Q Q1 Q2 Q3 quantity

Figure 2.1: Effects of Tariff Barriers

i.e. P P ′

2. Revenue effect: Revenue effect refers the rise in revenue to the govern-
ment due to the imposition of the tariff. It is a price effect multiplied by
imported quantity i.e. M N T S.

3. Protection effect: It refers to an increase in sales of domestic output

due to imposition of tariff i.e. QQ1 .

4. Consumption effect: It refers to a decrease in consumption of good

due to price rise because of tariff imposed i.e. Q2 Q3 .

5. Redistribution effect: Redistribution effect refers to the redistribution

of real income among various stake holders as a result of the tariff. It is
equal to P P ′ N B. It can be divided as an additional producer’s surplus,
paid cost, revenue and deadweight loss.

• Additional producer’s surplus P P ′ M A: It is that part of the real

value which is transformed from consumer’s surplus to producer’s
surplus.

38
 • Paid cost AM S: It is that part of the real value which was consumer
surplus before tariff

• revenue effect M N T S and,

• dead loss effects N T B

6. Terms of trade effect: Tariff imposed increase price and decreases

demand. Therefore, the price in importing country increases and that
in exporting country decreases. A larger part of total tariff is borne
by importer country and a smaller amount by exporter country. Thus,
the terms of trade of tariff-imposing country improves due to cheaper
import.

7. Competition effect: The competitive effect of the tariff is protection

to the domestic industry. Due to tariff domestic industry can increase its
sales by QQ1 , and there is a decrease in demand. Together they reduce
competition.

8. Income and employment effect: Due to a tariff imposed total demand

for goods will decrease and sales of the domestic industry will increase.
This will increase the income level and employment in the country.

9. The balance of payment effect (BOP): Tariff has a favourable effect

on the balance of payments of the country. It reduces imports and
increases the export surplus. In the above figure, the BoPs effect is equal
to the protective effect plus the consumption effect.

2.4 Non-Tariff Barriers

Non-tariff barriers or measures to trade (NTBs or NTMs)" are trade barriers
that restrict imports or exports through a mechanism other than the simple
imposition of tariffs. Tariff imposition indeed brings about limitations on free
trade, but its success depends on the various variables and is not certain. This
leads to resorting to non-tariff barriers. Non-tariff barriers are administrative
distortions to international trade.

39
Types of Non-Tariff Barriers

1. Specific Limitations on Trade: It includes Quotas, Import Licensing

requirements, proportion restrictions of foreign to domestic goods (local
content requirements), Minimum import price limits,

(a) Licenses: The licence system is the most common requires barrier
applied by all countries. Under this, the state issues permit for
import and export for commodities included in the lists of licensed
merchandises. The main types of licenses are general license, one-
time license. General license permits unrestricted trade for a certain
period. One-time license mentions a product, quantity, cost and
origin of the good, custom point through which import (or export)
of goods should be carried out.

(b) Quotas: A quota is a limitation in value or physical terms, imposed

on the import and export of certain goods for a certain period. It
is direct administrative government regulation of foreign trade. It
limits the independence of enterprises to enter foreign trade and
thereby the range and number of goods permitted for import and
export. This type of trade barrier normally leads to increased costs
and a limited selection of goods for buyers.

(c) Voluntary Export Restraints (VERs): A Voluntary Export

Restraint (VERs) is an agreement between two countries wherein
exporting country admits to limit their export. It is voluntary in
the sense that they are implemented by the exporting country at
the insistence of the importing country. These are unconventional
because trade barriers are set up at exporting country’s border
instead of the importing country. The export limit may be in the
form of quantity, value or market share. Though VER is said to
be voluntary they are seldom like that. These are accepted by
exporting country under the threat of sanctions to limit the export
of certain goods to the importing country.

(d) Embargo: Embargoes are the outright prohibition of trade in

certain commodities. They may be good specific or country-specific

40
 or both i.e. embargoes may be imposed on imports or exports
of particular goods regardless of destination, in respect of certain
goods supplied to specific countries, or in respect of all goods
shipped to certain countries. Although an embargo may be imposed
for phytosanitary reasons, more often the reasons are political.
Embargoes are generally considered legal trade barriers, not to be
confused with blockades, which are often considered to be acts of
war.

2. Standards: Standards take a special place among Non-Tariff barriers.

Countries usually impose standards on classification, labelling and testing
of the products to be sold in domestic products, but also to ban the sales
in the pretext of protecting the safety and health of the local population
and the natural environment.

3. Customs and Administrative Entry Procedures: These are ad-

ministrative and bureaucratic delays at the border. It includes valuation
systems, anti-dumping practices, tariff classifications, documentation
requirements, and fees and so on. For example, even though Turkey
is in the European Customs Union, transport of Turkish goods to the
European Union is subject to extensive administrative overheads.

4. Charges on imports: It includes prior import deposit subsidies, admin-

istrative fees, special supplementary duties, import credit discrimination,
variable levies, border taxes etc. Import deposits is a form of deposit,
which the importer must pay the bank for a definite time (non-interest
bearing deposit) in an amount equal to all or part of the cost of imported
goods.

5. Foreign exchange restrictions: Foreign exchange restrictions and

foreign exchange controls occupy a special place among the non-tariff
regulatory instruments of foreign economic activity. Foreign exchange
restrictions constitute the regulation of transactions of residents and
non-residents with currency availability and currency values.

6. Local content: An importing country may require the prospective

exporter to include a degree of local participation in the product or

41
 service. Options include a designated importer, a joint-venture company
with the majority local control, the requirement for complete local
manufacture which may imply a transfer of intellectual property etc.
The WTO has not concluded the legitimacy of these measures.

7. Government Participation in Trade: It has government procurement

policies, export subsidies, Countervailing duties, Domestic assistance
programs.

42
Chapter 3

Economic Integration

Before 1947, countries were free to impose any tariffs on imports. However,
tariffs and countervailing tariffs resulted in protectionism, lower efficiency,
less trade and unemployment. Thus, in the post-war era efforts were made
to reduce trade barriers. The liberalisation of trade can be multilateral or
regional. Multilateral agreements seek to liberalise trade worldwide and
regional agreements seek to liberalise trade within a group of countries. An
economic arrangement between different regions, to reduce or eliminate trade
barriers and to promote coordination of monetary and fiscal policies is economic
integration. Economic integration aims to reduce costs, for both consumers
and producers, as well as to increase trade between the countries.

Levels of economic integration

Economic integration is a spectrum, wherein at one extreme is a truly global

economy and on the other extreme closed economies. Economic integration
is an evolutionary process in which some integrations are well developed and
others are lagging. Based on their level of integration economic unions can be
classified as the following.

1. Preferential Trade Area (or preferential trade agreement, PTA): It is

the loosest form of the trading bloc. Under this, a group of countries

43
 Political Union

Preferential Trade Area

Figure 3.1: Levels of Economic Integration

have a formal agreement to allow each other’s goods to be traded on a

preferential basis. This is done by reducing tariffs, but not by abolishing
them completely. A good example of a preferential trade agreement is
the Commonwealth Preference System established in 1932.

2. Free Trade Areas*: It is usually a permanent arrangement between

a group of countries. It allows tariff-free trade between the member
countries but retains their independent policies, such as tariff structure
with rest countries. In other words, each member is free to set any tariff,
quotas or other restriction that it chooses to trade with countries outside
the FTA. Sometimes FTA is formed only for certain classes of goods and
services. A good example of a free trade area is the European Free Trade
Area, the North American Free Trade Agreement, etc. An important
problem faced by FTA is that goods from the outside area may enter
high duty member countries through low duty member countries. They
also agree on rules of origin.

3. Custom Union*: The customs union is one step further. Like FTA,
members of a customs union dismantle barriers to trade among them-
selves; in addition to that custom, the union establishes a common trade
policy concerning non-members. This takes the form of common external
tariff, whereby import from non-member countries is subject to the same
tariff rate in all member countries. The tariff revenues are shared among

44
 members according to a pre-specified formula. A customs union is a
free trade area plus an agreement to establish common barriers to trade
with the rest of the world. A good example of a customs union is the
European Community formed by the Treaty of Rome in 1957, the South
African Customs Union

4. Common Market*: Common market is a customs union that also

has free movement of all factors among the member countries. Thus,
restrictions on immigration, emigration and cross border investment are
abolished. The common market countries, like custom union, abolish all
trade restrictions and also establish common external tariff. A common
market implies that the internal market is common to all the firms
trading within it. Trade-in goods may be obstructed by non-tariff
barriers such as differences in product standards, testing procedures,
customs formalities, transport restrictions etc. While the common market
enhances productivity but it is not clear that individual member country
will always benefit. Despite obvious benefits, members of the common
market must be prepared to cooperate closely in monetary, fiscal and
employment policies.

5. Economic Union*: An economic union is the most complete form

of economic integration. It involves a common market and also the
harmonisation of economic policies in the particular monetary union and
fiscal coordination. Monetary union implies there is a fixed exchange rate
system between member countries, or single currency and central control
over the interest rates and other instruments of monetary policy. Fiscal
coordination implies harmonisation of taxes, tax rates and government
budget deficit. The European Union is the best example. The formation
of economic union requires the nation to surrender a large measure of
national sovereignty to supranational authorities.

6. Political Union: The move towards economic union raises an issue of

how to make bureaucracy accountable to the citizens of member nations.
The answer is a political union, in which the central political apparatus
coordinates the economic, social, defence, foreign policy and judicial
cooperation of member states. The EU is on the road towards at least

45
partial political union. The European Parliament is directly elected by
citizens of the EU

46
Chapter 4

Balance of Payments

Most1 of the exports and imports involve receipts and payments in money. An
account of such receipts and payments is known as a balance of payments. The
balance of payments is a principal tool for analysis of the monetary aspects of
international trade. It may be defined as, “a systematic record of all economic
transactions between residents of a country and the residents of the rest of
the world during a given period, usually one year.” Balance of Payment is a
monetary summary of a country’s international transactions.

Double entry book keeping: The balance of payments accounting uses a

double-entry system of recording transactions i. e. debit and credit.

Not a balance sheet: This is because the balance sheet shows assets and
liabilities at a particular point of time, whereas the balance of payment account
shows transactions during a year.

1 If
two countries trade with each other and none of their currency is hard currency, both
countries may be reluctant to accept each other currency. As a convenience, they may
make an agreement through which they may decide to trade with each other without the
involvement of currency. By doing so, they can make better use of their foreign exchange.

47
4.1 Structure of Balance Payments
Balance of payments is composed of two sections current and capital account
consisting of real and financial transactions respectively. Current account or
real transactions are those which make the actual transfer of goods and services
and affect income directly. Capital transactions are financial transactions and
do not affect income directly. The balance of payments can be explained with
the help of the following table

1. Goods Account or Visible Account: It includes the value of the merchan-

dise or tangible goods exports and imports.

2. Balance of Trade: It includes all type of ‘quid pro quo’ transactions

in goods. It shows the market share or position of a country in the
international market.

3. Service or invisible Account: It records all the services imported and

exported. They are intangible or invisible in the sense that they cannot
be recorded and exist.

4. Unilateral Transfers: It includes all the gifts, grants, assistance, do-

nations given to and received by a country. These are also known as
‘unilateral transfers because they flow in only one direction with no au-
tomatic reverse flow or no repayment obligations or neutralising counter
obligation. These transactions may be government or private transaction.
Account Debit Credit Net

5. Balance of Payment on Current Account: It includes the sum of three

balances above. It is also known as a net foreign investment because it
represents the contribution of foreign trade to GNP. It does not include
transactions in financial assets and liabilities. A sometimes narrower
definition of the current account is adopted by some countries in which
all or a part of unilateral transactions are excluded.

6. Long Term Capital Account: It includes the amount of capital that

has moved in or out of the country in a given year but for one year or
more. The long term capital account includes foreign direct investment,
government loans etc.

48
Account Debit Credit Net

1. Goods A/C 400 300 -100

A. Balance of Trade (1) 400 300 -100

2. Service A/C 500 800 300.

3. Unilateral Transfers 50 50 000

B. BoPs on Current A/C(1 + 2 + 3) 950 1150 200

4. Long Term. Capital A/C 300 1000 700

C. Basic Balance (B+ 4) 1250 2150 900

5. Short Term Capital A/C 200 300 100

D. BoPs on Capital A/C(4 + 5) 500 1300 800

E. Overall BoPs (B + D) 1450 2450 1000

6. International Liquidity 1000 ......... 1000

F. BoPs in Accounting Sense(E + 6) 2450 2450 Nil

49
 7. Basic Balance*: It includes current account and long term capital account.
It consists of permanent or semipermanent transactions. The short
term capital account is not included for two reasons. Firstly, short
term capital movement is volatile and unpredictable, therefore, it would
be improper to treat them with current account transaction which is
extremely durable. Secondly, many countries do not have a separate
short term capital account and such transactions are included in errors
and omissions.

8. Short Term Capital Account: It includes short term payment and credit
arrangements. Short term capital falls due to demand in less than one
year. It is hard to keep a track of all the short term capital movements.
It includes financial assets in foreign countries, purchase of shares of a
foreign company, bonds issued by the foreign government, short term
borrowing etc.

9. Balance of Payment on Capital Account: It includes all the transactions

inviting inward and outward movement of capital and investment. The
broad trends and implications of capital account are that developed
countries are a net exporter of capital and developing countries are net
importers i.e. developed countries will experience deficit and developing
countries will experience surplus in the capital account.

10. Overall Balance of Payment: This is a sum of balances on current

and capital account put together. It is highly aggregative and cannot
be of much significance. Because it does not reveal the behaviour of
components.

11. International Liquidity Account: It simply records the net changes in

foreign reserve. Essentially this account lists internationally acceptable
means of settling international obligations. It may be in the form of gold,
foreign reserve and investment in other countries. Accounting Balance
of Payment: If the overall balance of payments shows net surplus or
deficit, it will enter into an international liquidity account as debit or
credit respectively. The rationale behind this entry of surplus in the
debit column is that surplus will be disposed of through the purchase
of gold, an addition to the stock of foreign exchange, extending short

50
 term loans to other countries. Therefore, all the balance of payments
must always be balanced in an accounting or book-keeping sense. This
is because for any surplus (or deficit) in the overall balance of payments
there must be a corresponding debit (or credit) entry of the equivalent
amount in the international liquidity account.

4.2 Disequilibrium in Balance of Payments

Balance of payment is always balanced in the accounting sense because of its
double-entry system of bookkeeping. But in the economic sense, it may or may
not be balanced or in equilibrium. If we define equilibrium as that position
or condition which will require no change for betterment and can be retained
for a longer period. Then, disequilibrium in the balance of payment can be
defined as that situation of international receipts and payments of a country
that cannot be retained for a longer period without any difficulty.

When we speak of the equilibrium in the balance of payments*, we signify not

the balance of payments as a whole but receipts and payments of autonomous
nature in international transactions. Hence, the usual approach to the balance
of payments is to consider it as a difference between the autonomous type of
receipts from and payments to foreign countries and exclude accommodating
transactions.

Balance of Payments = Autonomous Receipts – Autonomous Payments

1. Autonomous transactions: Autonomous transactions are those which

takes place on their own and regardless of other items in the balance
of payments. They are at the will of the party. They are causes of
the balance of payment situation. For example, the export of goods,
borrowings for infrastructure projects, repatriation of profits, unilateral
transfers are undertaken for their own sake under profit or utility motive.

2. Accommodating Transactions*: Accommodating transactions, on

the other hand, take place due to the balance of payment situation
of a country. They are a result of the balance of payment situation.
Any imbalance in the autonomous transactions is counterbalanced by

51
 a change in foreign exchange reserve or short term capital movement,
recognised as accommodating transactions. The distinction between
autonomous and accommodating transaction is made on whether the
transaction has caused the balance of payment or the transaction has
been caused by the balance of payments.

Disequilibrium in Balance of Payments: Balance of payment is said to

be in disequilibrium when autonomous receipts are either greater than or less
than autonomous payments.

Balance of payment is said to be deficit if autonomous receipts are less than

autonomous payments. The deficit in the balance of payment is considered
undesirable but is not always bad because it is a sign of increasing earning
capacity as it is accompanied by a surplus in the capital account and increasing
investment. Its significance depends upon location and duration. If the deficit
in the balance of payment, regardless of its location, is temporary, it may not
be a cause of serious concern. But if it is persistent then it is bad and requires
corrective measures.

A surplus in the current account should be treated as favourable, but not

necessarily always a good sign because it indicates the lending capacity only, as
it is accompanied by a deficit in the capital account. Generally, it is believed
that current account deficits are bad and surpluses are good. It is easy to see
how deficits in the current account are bad. In the case of surpluses, we may
readily agree that temporary surpluses are good and especially when are used
to offset capital account deficits. On the other hand, if a country is incurring
continuous surplus in the current account not offset by capital account deficit,
it will be risky- accumulation of foreign exchange reserve will lead to inflation-
the exchange rate will appreciate making goods uncompetitive.

Broadly speaking, we can lay down that current account and capital account
with a similar sign are undesirable and aggravate problems of international
liquidity. The ultimate result will depend upon the country’s exchange rate
policy, monetary and fiscal policy.

Type of Disequilibrium

52
1. Short term disequilibrium: It is a disequilibrium that prevails for a year
or few years. Such a deficit occurs due to a sudden increase in demand
for foreign products, failure of crops, natural calamities, and political
disturbances. This disequilibrium is less serious and does not require
major policy decisions.

2. Long run disequilibrium: Secular or long-run disequilibrium in BoPs

prevails for a longer period. This is chronic and persistent. IMF terms
such disequilibrium as fundamental disequilibrium. To cure, it requires
policy measures. The main causes for fundamental disequilibrium may
be

(a) Excess of imports for planned economic development

(b) Continuous increase in population

(c) Domestic investment exceeding domestic savings

(d) Increase in prices of imports.

(e) Decline in demand for imports.

3. Cyclical Disequilibrium*: A disequilibrium that is caused by the fluctua-

tions in economic activity or trade cycles is called cyclical disequilibrium.
During prosperity due to increasing demand domestic prices and income
goes up. This causes a decrease in export and an increase in import.
Thus there will be a deficit in BoPs. Contrarily, during recession BoPs
tends to become favourable. In modern time countries are highly inter-
dependent. They are subject to international transmission of business
cycles. If an economically important country undergoes recession or
depression, it would discourage our exports and encourage imports due
to a fall in foreign products prices.

4. Structural disequilibrium*: It emerges on account of structural changes

at home or abroad which may alter the demand or supply relations.
Export of country may decline if in the rest of world demand is diverted
to other products. Demand for raw materials may decline due to a
change in technology or finding of substitutes.

53
4.3 Causes of Disequilibrium
Disequilibrium in the balance of payments means autonomous receipts are
either more or lesser than autonomous payments. Both are undesirable, but
the deficit is more ill at ease. That is why economic literature shows special
concerns to deficits rather than a surplus.

1. Imports of essentials: Countries which do not have enough production of

essential goods like food, the raw material are required to import them.
Being essential they are inelastic in demand and import bill mounts. if
thee is a price increase.

2. Development and investment programme: Developing economies which

have embarked upon planned development programme requires the
import of capital goods, raw materials, and highly skilled and specialised
manpower. Since development is a continuous process, imports of these
items may continue for the long period. Similarly export may decline in
such a situation; therefore, BoPs may turn unfavourable.

3. Increased income: Due to rapid economic development per capita income

increases. Increased income causes an increase in demand for domestic
as well as foreign goods. An increase in demand for domestic good has
nothing to do with BoPs but increased demand for foreign goods causes
an increase in BoPs deficit or decrease in surplus.

4. Population: Population growth in poor countries causes adverse effects

on the balance of payments. Increased population, increase in demand
for domestic as well as foreign goods thereby decrease in export and
increase in imports causes balance of payment hardships.

5. Elasticity of importable and exportable: In general, the price elasticity

of imported goods in a developing country is low, therefore, whenever
there are an increase in their prices, import bill increases. On the other
hand, these countries cannot earn larger foreign exchange by charging a
lower price for its exportable because they also are inelastic in demand.

6. Discovery of substitutes: Recent technological and scientific improve-

ments had found new substitutes for traditional products like jute and

54
 raw materials like the rubber of developing countries. This resulted in
lower export earnings and BoPs deficits for those countries.

7. Protectionist policy: Most of the developed countries advocate free trade

policies but follow hidden protectionist policy by providing domestic and
export subsidies. This makes their products more competitive leaving
developing countries’ products lesser competitive.

8. Business cycle: Contractions and expansions in the economy do not bring

symmetrical effects. Harms of contraction are more than the benefits of
similar expansions. The more harmful and lesser beneficial for developing
countries than in developed countries.

9. Capital flights: Capital flight in the time of political trouble, speculation

in the foreign exchange market may result in a balance of payments
problems.

10. Structural adjustment: Many economies are being liberalised and their
structure is changing. In a changed structure, their demand also changes.
This results in a change in exports and imports.

4.4 Measures to Correct the Deficit

As disequilibrium BoPs of any type, deficit or surplus, is not good, therefore,
it requires measures to correct them. A short run deficit or surplus in BoPs
can be corrected through adjustments in the capital account. Borrowing or
lending is the main sources that restore balance. But it is not useful for chronic
disequilibrium. The solution to such problems lies in earning more foreign
exchange through additional exports and reducing imports. Quantitative
change in export and import require policy changes in the form of monetary,
fiscal and direct measures.

1. Expenditure Changing Policy This policy brings changes in national

expenditure through national income changes. Hence, they are, some-
times called income adjustment policies. The logic behind this is that a
change in income will result in a change in expenditure which consists of
domestic as well as foreign goods. Therefore, every increase or decrease

55
is likely to change import and export and BoPs. Expenditure reducing
policy can be used to curb deficit and expenditure increasing policy to
correct surplus. It consists of both monetary and fiscal policies

(a) Monetary policy: Monetary policy consists of the policy of the

central bank of the country towards availability, uses and cost of
money. The availability is controlled through reserve requirements
(RR), open market operations (OMO), and use through direct
actions and cost through bank rate. Generally, the surplus balance
of payment is not a problem, as it can be removed easily but
the deficit is difficult to remove. The surplus can be removed by
expansionary monetary or easy or light monetary policy- low interest
rate, increase the money supply, investment, income, imports, net
capital outflow and ultimately decrease in BoP surplus. If there
is a deficit in BOPs it can be removed contractionary monetary
policy or tight monetary policy- higher rate of interest, decrease in
money supply, investment, income, imports, net capital inflow, and
ultimately decrease in the deficit.

The success of expenditure reducing policy depends upon

i. Flexibility of income and prices: both should respond to

the policy measures otherwise, they will bring the opposite
result.

ii. Elastic demand for imports and exports: For the success
of this policy demand for imports and exports should be fairly
elastic, so that slight increase in prices of importable and
decrease in income will result in a decrease in imports and a
decrease in prices of exportable will increase exports.

iii. Co-operation by other countries: Other countries which

get affected by the deflationary policy should cooperate and
should not react through deflation. The workability of deflation
assumes exchange rates are stable.

(b) Fiscal policy*: Expansionary fiscal policy involves tax, govern-

56
 ment expenditure and public debt. These measures will change
domestic production, income and imports. This is useful to remove
the surplus. Contractionary fiscal policy refers to a reduction in
government expenditure and an increase in taxes. These measures
will reduce domestic production, income and imports.

2. Expenditure Switching Policies Expenditure switching policies pri-

marily works by changing relative prices between the two countries
without changing domestic prices. These switch expenditure from for-
eign to domestic product and vice versa. It consists of devaluation or
depreciation of the currency.

(a) Devaluation*: Devaluation means lowering of the external ex-

change value of the domestic currency by an official act of monetary
authority. This may be either about the currencies of a few or all
the countries or in terms of gold. Devaluation aims at influencing
prices of only treaded goods and not the general price level. Due
to devaluation, domestic products will become cheaper in foreign
countries and foreign products costlier in the domestic market. This
can decrease the deficit in BOPs. In modern times countries resort
to devaluation when there is fundamental disequilibrium in BoPs.

The success of this method depends upon the number of

conditions

i. A fairly elastic demand for imports and exports will ease the
way of devaluation and inelastic demand will worsen the balance
of payments.

ii. If devaluating a country’s export consists of non-traditional

items it can gain by improving terms of trade by devaluation.

iii. Devaluation requires no change in internal value when the

external value of a currency is deliberately reduced.

iv. Devaluation will serve its purpose only if other countries do

not retaliate by resorting to simultaneous devaluation.

57
 (b) Depreciation*: Like devaluation, depreciation lowers the value of
the domestic currency and brings the same effects as devaluation.
Only thing is that devaluation is a deliberate and arbitrary action of
monetary authority and depreciation stands for automatic market
correction under a flexible exchange rate. Sometimes devaluation
means giving official recognition to de facto depreciation. Deprecia-
tion will be in a flexible exchange rate system and devaluation in
the fixed exchange rate system.

Marshall Lerner Condition*: If devaluation or depression will

lead to a rise in export earnings and reduction in import expenditure
depends on price elasticities of export and import of the country.
According to Marshall Lerner devaluation will suspend in improving
BoPs if the sum of price elasticity of imports and exports is greater
than one. i.e. ex + em > 1

(c) Exchange control: Deficit in BoPs is a result of excess demand

for foreign exchange oversupply. Under this system, the government
tries to have complete control over all dealings in foreign exchange.
All the exporters are directed to surrender their foreign exchange
earnings to the exchange control authority and it is rationed out
among the licensed importers. Thus, only licensed importers are
allowed to import. Exchange control deals with the balance of
payments disequilibrium by suppressing the deficit that is only a
symptom, not the basic trouble.

3. Direct Measures A deficit country along with monetary measures

may adopt the following non-monetary measures.

(a) Tariffs: Tariffs are the duties imposed on imports. When tariffs
are increased prices will increase by that extent reducing import
and import bill.

(b) Quotas: To reduce imports for correcting a deficit in the balance

of payments, the government may introduce restrictions on the
number of goods imported.

58
 (c) Export promotion: Real solution for the deficit in the balance of
payments lies in exporting more than imports. This can be done by
export promotion with subsidies, tax concession, grants and other
monetary incentives.

(d) Import substitution: Along with the increase in export, it is

necessary to reduce dependence on imports by producing importable
in ones’ country

4.5 India’s BoPs since 1991

The new economic reforms were initiated in 1991 and efforts were made a
push-up exports, so that the major portion of the import bill could be paid with
the export bill. Further to bring about technological up-gradation government
liberalised imports. Along with this, in place of debt creation inflow of capital,
non-debt creating inflows such as foreign direct investment as well as portfolio
investment was encouraged.

The decade of 1990s started with a serious problem in the balance of payments.
The Gulf crisis of 1990 led to an unprecedented crisis in BoPs. The crisis
reached its peak in summer 1991 when foreign currency reserve had fallen to
almost $ 1 billion, inflation had risen to 17 per cent, industrial production was
falling and the overall economic growth rate was 1.1 per cent in 1991-92. The
payment crisis became evident in 1991 when oil prices increased due to the
gulf war. This resulted in a worsening of the current account deficit to 17,367
crores. For the first time during the last 40 years, net Invisibles deteriorated to
-433 crores, on account of lower remittances and higher interest payments. The
foreign exchange reserve started to decline. The main factor responsible for the
sharp decline in reserve was a rise in imports of POL. However, the payment
crisis of 1991 was not simply due to the deterioration of trade account; it was
accompanied by a loss of confidence in the government’s ability to manage the
situation.

India’s commercial borrowings dried up as credit rating agencies downgraded

India. Simultaneously, there was an outflow of non-residents deposits. By
June 1991, the balance of payment crisis become overwhelmingly a crisis of

59
confidence. The new government led by Narsimharao acted swiftly and took
necessary measures.

During the Eighth Five Year Plan (1992-97) trade deficit was mounting, by
1996-97, it has reached Rs. 52,561crores from Rs. 16,934 crores in 1990-91.
For the 8th Plan period, Invisibles neutralised the trade deficit to the extent
of 58 per cent.

During 1997-98, the current account deficit reached Rs. 20,883 crores, declined
to Rs. 16789 crores in 1998-99 and increased to Rs. 20331 crores. This was
largely due to a much greater trade deficit of Rs. 77359 crores which could
not be neutralised by invisible.

During 2001-02, the trade deficit was 54955 crores but the current account
went surplus due to heavy invisible receipts of Rs. 71381 crores. During the
entire 9th Plan trade deficit was wiped out to the extent of 82 per cent by
invisible account surplus. During the first two years of the 10th Plan, the
current account balance was surplus which was mainly due to the invisible
account. However, in the latter part of the 10th Plan current account went
deficit. During the whole period of the 10th Plan, Invisibles wiped out the
trade deficit.

However situation worsened during the 11th Plan period in which surplus
invisible account was able to wipe out 67.9 percent of deficit trade balance.
2012-13/54.9, 2013-14/78.8 Structure of India’s Balance of Payments as
per cent of GDP;

1. Export has increased from 5.8 per cent in 1990-91 to 14 per cent in
2006-07 of GDP.

2. Imports always were more than exports and increased from 8.8 per cent
in 1990-91 to 21.7 per cent of GDP in 2006-07.

3. Trade balance was always a deficit and continuously increasing through-

out the period.

4. Invisibles which were negative in 1990-91 turned positive and increased.

60
 Table 4.1: Structure of India’s Balance of Payments as per cent of GDP

Items 1990-91 2006-07 2009-10 2010-11

Exports 5.8 14.0 13.2

Imports 8.8 20.9 21.7

Trade Balance -3.0 -6.9 -8.6 -7.8

Invisible -0.1 5.8 5.8

Current Account Balance -3.1 -1.1 -2.8 -2.7

Capital Account Balance 2.7 5.1 3.8 3.7

External debt 28.7 17.9 35.7

5. Current account balance improved because of the contribution of invisible.

6. Capital account has been positive throughout the period. NRI deposits
and foreign investment helped to a great extent.

7. External debt came down heavily from 29 per cent in 1990-91 to 18 per
cent in 2006-07.

Causes of Balance of Payment deficits:

1. The factor responsible for the larger inflow of imports was the policy of
import liberalisation.

2. Rise in imports has been higher than the rise in exports. Since we started
with a large volume of imports, even a smaller percentage of import
growth was enough to offset a larger growth rate of exports. The imports
have risen from nearly $ 28 billion to $ 91 billion. This is because India
adopted an inward-looking strategy which required large imports in the
initial stage.

3. Rise in the price and volume of POL imports.

61
4. There had been an increase in import intensity due to the pattern of
industrial development created demand by upper-income groups. The
shift in income distribution in favour of the new-rich classes resulted in
higher demand for durables.

5. Devaluation: In 1991 Indian rupee was devaluated and in recent years

there was slow depreciation. This increased import bills. There was an
increase in export due to devaluation but not enough to outstrip imports.

6. Slow rise in export earnings: Even though export earnings rose they
were not enough to meet the rising imports.

7. Competition from other countries: India faces competition from devel-

oping countries like Taiwan and South Korea in manufactured items,
from the Philippines, Indonesia, Malaysia Latin American and African
countries in natural products.

8. Debt Service: Debt service of the Indian Government was very high.
Fortunately, debt service decreased from 35.3 per cent of current receipts
to 6.2 per cent in 2004-05.

62
Chapter 5

Foreign Exchange Market

When a country buys goods from another country, it needs foreign currency to
make payment to exporting country and if exporting county accepted importing
country’s currency, again it will have to convert it into domestic currency.
Thus, at least one country needs to exchange one currency for another. Or
importing country may make payment in a thirds country’s currency; in this
case, both the countries need to exchange currencies.

Concept of Foreign Exchange

The term foreign exchange* can be defined as the mechanism through which
payments between two or more countries are done. The term foreign exchange
is very broad includes not only foreign money but also near money instruments
denominated in foreign currency.

Foreign exchange refers to foreign money which includes paper currency notes,
cheques, bills of exchange, bank balances and deposits in foreign curren-
cies.

According to H. E. Evitt, “foreign exchange deals with the means and methods
by which rights to wealth in one country are converted into rights to wealth in
another country.” It involves an investigation of the methods through which

63
one currency is exchanged for another, the causes which render such exchange
necessary, the forms which such exchange may take place, and the ratios or
equivalent values at which such exchanges are effected.

5.1 Instruments of International Payments

1. Foreign Bill Exchange: A foreign bill of exchange is a negotiable
credit instrument. It is an unconditional order in writing drawn by a
drawer (exporter) addressed to the drawee to pay a sum of money on
demand to the payee or to the undersigned at a specified future date for
the volume of goods received. It arises out of a genuine trade transaction.
There are three parties to a foreign bill of exchange viz.

(a) The drawer of the foreign bill of exchange: The drawer of

the foreign bill of exchange is an exporter. Having exported the
goods he draws the foreign bill of exchange and sends the written
order to the drawee by signing at the right-hand side bottom of the
foreign bill of exchange.

(b) Drawee: The drawee is an importer. It is he who receives the writ-

ten order of the drawer. After receiving the order he acknowledges
his responsibility of making payment to the payee.

(c) Payee: A Payee is a person who receives the payment. When

the drawer orders the drawee to pay to MR. XYZ then Mr XYZ
becomes the payee. And if he orders the drawee to pay to the
undersigned then the undersigned drawer becomes the payee.

The working of the bill of exchange is very simple. The mechanism of

the foreign bill of exchange makes it necessary that every payment in
one direction is matched with equal payments in another direction.

Merchant A in Delhi imports machinery from person B in England and

Person C in England imports tea from Person D in Delhi. In such a
situation person B in England will draw the foreign bill of exchange on
person A in Delhi who accepts the bill and acknowledges his responsibility
of payment of the bill. However, Mr B in England sells his right to Mr

64
 C in England who has imported tea from merchant D in Delhi. Mr C
in his term sends that bill to Mr D in Delhi. He will collect the money
through his bank from Mr A in Delhi.

2. Bank Draft: A Bank draft is an order of a bank on its branch or on

another bank to pay a sum of money to the bearer of a bank draft on
demand. In international trade transactions a debtor who imports goods,
from the creditor or an exporter, approaches his bank, deposits adequate
money with the commission and obtains a bank draft. He sends that
bank draft to the creditor by registered post. On receipt of the bank
draft, the creditor presents it across the counter of the said branch of
the bank and gets it encased.

3. Mail Transfer: Just as funds are transferred from one bank account to
another bank account of the same bank at a different place through the
post office by mailing the postcard in the international trade transactions
are effected through airmail other things remaining the same.

4. Telegraphic Transfer: It is a telegraphic order of a bank to its branch or

to the correspondent bank to pay a sum of money to a person concerned.
Debtor deposits the money in his bank asking the bank to remit the sum
of money through telegraphic transfer to a person concerned through its
branch or a correspondent bank. It is a quicker mode of payment.

5. Letter Credit: A letter of credit is a document that guarantees the

buyer’s payment to the sellers. It is issued by a bank and ensures timely
and full payment to the seller. If the buyer is unable to make such a
payment, the bank covers the full or the remaining amount on behalf of
the buyer. It is a written commitment to pay, by a buyer’s or importer’s
bank (called the issuing bank) to the seller’s or exporter’s bank (called
the accepting bank, negotiating bank, or paying bank). A letter of
credit guarantees payment of a specified sum in a specified currency,
provided the seller meets precisely-defined conditions and submits the
prescribed documents within a fixed timeframe. These documents almost
always include a clean bill of lading or air waybill, commercial invoice,
and certificate of origin. To establish a letter of credit in favour of the
seller or exporter (called the beneficiary) the buyer (called the applicant

65
 or account party) either pays the specified sum (plus service charges)
upfront to the issuing bank or negotiates credit.

6. Travellers Cheque*: A traveller’s cheque authorises a person to draw

a cheque up to a specified amount of money on the bank or a branch of
the bank during a specified period. Here traveller approaches his bank,
deposits a sum of money along with a commission, asking the bank to
issue the traveller’s cheque to him. While doing so he has to specify the
direction of his travel. The bank informs all the branches of the bank in
that direction. Thus, on presentation of the traveller’s cheque, he can get
it encashed at any of the branches of the bank situated in that direction

The foreign exchange market is an organisational setting within which indi-

viduals business, Govt. and banks buy and sell foreign currencies. It is a
mechanism where various national currencies are sold and purchased like any
other commodity. The foreign exchange market can be completely free or
partially or completely restricted.

A foreign exchange market can‘t be designated by any geographical area or

location. They deal with each other through a telecommunication network.
With the advent of advanced technology like Renters Money 2000 – 2, it is
possible to access the trader in any corner of the world within a few seconds.
The deal can be done through electronic devices which allow bid and offer
rates to be matched through central computers

The foreign exchange market is broadly divided into the retail and wholesale
market. In the retail market travellers, tourist and people who are in the need
of foreign currency, exchange one currency for another. The wholesale market
is also called an inter-bank market. Commercial banks, business corporations
and central bank are the main participants in this market.

The foreign exchange market can be classified as a spot market and forward
market. In the spot market transactions are made at some point in time
and the forward market sale and purchase contract are made for a future
date.

66
5.2 Participants in Exchange Markets
The main participants or players in the foreign exchange markets are as
follows:

1. Customers: - Customers who participate in the foreign exchange market

mainly comprise the importers and exporters. They participate in the
foreign exchange market through bank services. The importer to make
payments utilises the services of a bank to convert its local currency into
exporting country‘s currency. The exporter converts the received foreign
currency into domestic currency through banks.

2. Commercial Banks: Commercial banks facilitate the conversion of one

currency into another. Commercial banks are the most active players
in the foreign exchange market. These banks have a wide network of
branches or correspondent banks all over the world because of which
they can transact foreign exchange business smoother, faster and effi-
ciently. Importers and exporters belong to different countries. These
banks act as intermediaries between importers and exporters. They buy
foreign exchange from the exporter and sell it to the importers. In India
commercial banks have to obtain a license from the Reserve Bank of
India under section 6 of the Foreign Exchange Regulation Act (FERA),
1973.

Commercial banks follow the following objectives:

(a) Profitability: Commercial banks buy foreign currency at a lower

rate and sells to the needy at a higher rate. The difference leads to
the accruing of profit to the commercial banks.

(b) Risk bearing: The foreign exchange business entails risk which
arises out of fluctuations in the foreign exchange rate. This risk is
shouldered by foreign exchange banks by entering into a forward
contract.

3. Central Banks As a custodian of foreign exchange reserve central bank

is the largest player. Its function is to maintain the external value of the

67
 domestic currency. There are two main types of foreign exchange rate
systems viz

(a) fixed exchange rate system and

(b) floating or fluctuating exchange rate system.

Under a fixed exchange rate system, the central bank has to maintain
the parity and under a floating exchange rate system, the central bank
has to intervene in the foreign exchange market to buy and sell foreign
exchange depending upon the situation. When the demand for foreign
exchange is more then it sells foreign exchange. Conversely, when the
supply of foreign exchange happens to be more it buys Thus, it tries to
maintain the external value of the domestic currency.

4. Bill Brokers: Bill brokers are the intermediaries between the buyers
and sellers of foreign exchange. They, by using their knowledge of the
foreign exchange market, make the best possible exchange rate available
for buyers and sellers. Their function is to bring both parties together to
settle the foreign exchange traction. For performing this function they
get their commission known as brokerage.

5. Discount Houses: The discount houses are specialised houses in the

business of discounting the foreign bill of exchange. The discount houses
discount the foreign bill of exchange put forwarded by exporters and
finances them before the maturity of foreigh bill of exchangethe foreign
bill of exchange at a discount. They retain the bill of exchange until
maturity and recover the full value of the foreign exchange bill. The
London discount house is an example.

6. Acceptance Houses: The Acceptance Houses are financially well to

do firms that have earned name and fame in the foreign exchange world.
When an importer, who is a drawee, receives the foreign bill of exchange
from the drawer will acknowledge the responsibility of payment. He is
an amateur he would like to put the weight of the acceptance house in
that foreign bill of exchange. The acceptance house lends its name and
acknowledges the responsibility to make payment of the bill of exchange

68
 to the payee on behalf of the drawee.

5.3 Functions of Foreign Exchange Market

1. Transfer of Purchasing Power: This function of foreign exchange
arises as a corollary of the store of value function of money. Currency
in hand is purchasing power but in the domestic economy. If one wants
to transfer such purchasing power to another country, he will have to
buy the currency of that country in which purchasing power is to be
transferred. The international clearing function performed by the foreign
exchange market plays a very important role in facilitating international
trade and international capital movements.

2. Credit Instruments: It is also one of the important functions of the

foreign exchange market. Just as domestic trade requires credit, likewise
international trade also requires credit to finance international trade
transactions. When the goods are imported it takes time for the actual
delivery of the goods because of the shipment and transportation of
goods. Therefore, it entails credit and credit instruments provided by
the foreign exchange market. The foreign exchange market gives loans to
needy participants. Exporters may get pre-shipment and post-shipment
credit. Credit facilities are also available for importers. The Euro-dollar
market has emerged as a major credit market.

3. Hedging: To hedge means to shoulder the risk. It provides a mechanism

for both the exporters and importers to guard themselves against the
future fluctuations in the foreign exchange rate and the consequent
lossless thereof. Hedgers are the agents who enter the foreign exchange
market to protect themselves against risks arising out of exchange rate
fluctuations. Let us assumed that Mr A decided to import 100 units of a
commodity priced $1 form the U.S when the exchange rate is $1= Rs. 50.
Thus, he will have to pay either $100 or its equivalent Rs. 5000. If he
gave the order today he will get consignment only after six months. The
exchange rate after six months is uncertain. If Rupee devalued, and the
new exchange rate is $1= Rs. 60 then he will have to pay Rs. 6000 as
against Rs. 5000, as an equivalent of $100. To avoid this excess payment

69
 of Rs. 1000 he can buy $ 100 in the forward exchange market to execute
deal only after six months at a predetermined rate and date. Suppose
that he entered into a deal in which he purchased $100 at an exchange
rate of $1= Rs. 50 where payment is to be made after six months at the
time of delivery of foreign currency. Thus excess payment of Rs. 1000
can be avoided. This practice of covering risk is known as hedging and
practiser is known as a hedger.

4. Swap Operations: Swap refers to an exchange of one financial instru-

ment for another between the parties. This exchange takes place at a
predetermined time, as specified in the contract. Swaps can be used to
hedge the risk of various kinds including interest rate risk and currency
risk. Currency swaps and interest rates swaps are the two most common
kinds of swaps traded in the market.

5. Arbitrage*: Arbitrage means the simultaneous buying and selling of

assets to make a profit. The profit accrues due to the difference in selling
and buying price. In the foreign exchange market, there are two kinds of
arbitrage currency arbitrage and interest arbitrage. In currency arbitrage
currency is bought in one foreign exchange market where it is cheaper to
sell in another foreign exchange market where it is costlier. In interest
arbitrage, arbitrager borrows fund from a lower interest rate financial
market to lend in a higher interest rate financial market. The arbitrage
leads to iron out the differences in the rates of exchange at different
places. It seems to be a move towards creating a single world market for
foreign exchange.

6. Speculations: Speculation means buying foreign currency to sell to

make income. The profit accrues due to the difference between exchange
rates prevailing at a different point in time.

5.4 Determination of Foreign Exchange Rate

International trade involves two or more than two currencies that need to be
sold and bought for one another. Like any other market there is determination
of price or foreign exchange rate.

70
The foreign exchange rate is defined as the rate at which currencies are
exchanged for one another. It is the price of one currency in terms of another
currency.

The exchange rate is expressed in two ways i.e. direct - the value of a domestic
currency is expressed in foreign currency and indirect the value of a foreign
currency is expressed in domestic currency.

Depending on time exchange rate is of two type i.e. spot and forward exchange
rate. The spot exchange rate is the current exchange rate, where delivery of
and payment for foreign currency is made immediately. In actual practice,
the settlement takes place in a few days. Where delivery of and payment for
foreign currency lies in the future exchange rate is called forward exchange
rate. The forward rate of exchange is determined at the time of contract of
buying and selling but delivery and payment of currencies will be in the future.
The forward exchange rate may be lower or higher than the spot exchange
rate at the time and palace of delivery and payment.

The foreign exchange market quotes the forward exchange rate a priory in two
ways i.e. either at a premium or discount as a percentage of the spot exchange
rate.

The exchange rate is determined by the demand and supply of respective

currencies.

5.5 Fixed Exchange Rate System

The fixed exchange rate system is also known as a stable exchange rate system
or a pegged exchange rate system. Under this system, monetary authority
decides the exchange rate and assures that at such a rate it will exchange
currencies. The Gold Standard is an example of a fixed exchange rate system.
It prevailed till the First World War period. The gold standard had its different
versions viz.

• Gold specie Standard: the currency in circulation was made up of gold

coins with fixed gold content.

71
 • Gold Bullion Standard: the currency in circulation was paper currency
but fully backed by gold and convertible into gold.

• Gold Exchange Standard: the currency is linked with the paper currency
of another country which is fully convertible into gold.

5.6 Breton Woods System

World War I brought the gold standard to an end because the participating
countries couldn‘t observe the rules of the game of gold standard. The bitter
experience of war forced the countries to think of a free, stable and multilateral
monetary system that could help in the restoration of international trade. In
1944 an international monetary conference was held at Breton Woods according
to which the International Monetary Fund was established in 1946. This led
to an establishment of an exchange rate system which comes to be known as
the Breton Woods System. This system was followed by member countries
from 1946 to 1971. The main objectives of the system were as follows:-

1. to establish an international monetary system with stable exchange rates.

2. To eliminate existing exchange controls.

3. To bring about free convertibility of all currencies. The

Breton Woods system required the member countries to fix parities of their
currencies in terms of either gold or the U.S. Dollar. The countries were asked
to keep the fluctuations of their currencies within 1 per cent of their declared
parity. It was also agreed that without the approval of the Fund no change in
parity should be undertaken. USA agreed to fix the parity of the US Dollar
in terms of gold at $ 35 per ounce of gold and undertook to convert dollar
balances held by other countries at the fixed rate.

Under this system as the central banks were obliged to intervene in the foreign
exchange market to keep the exchange rate within 1 per cent of the declared
parity. It required maintaining foreign exchange reserves by the central banks.
If the reserves of foreign exchange with the central banks are not sufficient
then the central banks were allowed to switch over to special Drawing Rights

72
and other I. M. F. facilities.

The Breton Woods system collapsed because of a persistent deficit in the U.S.
balance of payments. It led to a flood of U.S. dollar in the international market.
The gold reserves of the USA were not sufficient to cover the massive supply
of dollar in the international market. This led to a loss of confidence in the
U.S. dollar and US capacity to convert US dollars into gold at a fixed rate i.e.
$35 per ounce of gold. On 15th August 1971 USA announced its inability to
convert U.S. dollars into gold at fixed parity which virtually brought to an
end the Bretton Woods System of the fixed exchange rate.

Fixed exchange rates have the following advantages:

1. Stability: Due to the fluctuating exchange rate, prices of domestic

goods in the foreign market and of foreign goods in the domestic market
were fluctuating. It created uncertainty in foreign trade. Under a fixed
exchange rate system such type of unsuitability can be avoided.

2. Encourage Long Term Capital Flows: Under a fixed exchange rate

system loss of capital due to the change in the exchange rate is avoided.
Therefore, it assures investors of uncertainty and risk resulting from
exchange rate fluctuations.

3. No Speculation: Speculative activities in the exchange market tend to

aggravate fluctuations in the economy. As monetary authority is prepared
to buy and sell foreign currency at a stipulated rate, speculative activities
are eliminated from the scene.

4. Disciplinary: Inflation will cause balance of payments deficits and

foreign currency reserve loss. Hence the authorities will have to take
counter-measures to stop inflation. The fixed exchange rate system
imposes ’discipline’ on governments and they need not pursue anti-
inflationary policies which are out of tune with the rest of the world.

5. Best for Small Countries: Trade as a proportion to the domestic

market in smaller countries is larger. Therefore, for smaller countries,
external stability is more important. A fixed exchange rate system
assures such stability more than alternative systems.

73
 6. Suitable for Common Currency Areas: This system is suitable for
common currency areas such as the Euro, Dollar, etc. where a fixed
exchange rate promotes the growth of world trade.

7. Promotes Money and Capital Markets: It promotes the develop-

ment of international money and capital markets and helps the flow of
capital among nations.

8. Multilateral Trade: This system is intended basically to encourage

multilateral trade among countries because there is no fear of fluctuations
in the exchange rate.

9. International Monetary Co-operation: The system of fixed ex-

change rate promotes international monetary co-operation and so helps
in the smooth working of the international monetary system under such
institutions as IMF, World Bank, Euro-Market.

CASE AGAINST FIXED EXCHANGE RATES

1. Sacrifice internal stability: The principal defect of the fixed exchange

rate system is that it is external sector-oriented and neglect stability of
the internal sector. The maintenance of a fixed exchange rate may result
in unemployment or inflation. When the balance of payment is surplus
there will be inflation and when it is deficit there will be unemployment.

2. Unexpected Disturbances: Under this system, a country may be

protected from the full consequences of domestic disturbances and policy
mistakes; it has to bear a share of the burden of the disturbances and
mistakes of others. For to the extent that excess demand ’leaks out’ of
the country where it was created, it ’leaks in’ (via a balance of payments
surplus) to that country’s trading partner.”

3. Heavy Burden of Exchange Reserve: Under this system, foreign

exchange reserves are required to maintain the exchange rate. Countries
with BoPs deficits, which lose foreign exchange, have to maintain reserves
to avoid devaluation.

4. Non-optimal allocation of Resources: This system requires exchange

74
 control which leads to non-optimal allocation of resources.

5. Complex system: This system is very complex and requires highly

skilled administrators to operate it. It is also time-consuming and may
lead to uncertain results.

6. Comparative Advantage Unclear: Under this system, the compara-

tive advantage of a country is not clear. For instance, the exchange rate
may be so low that a product may be very cheap to the other country.
Consequently, the country may export that commodity in which it has no
comparative advantage. On the contrary with a very high exchange rate,
the country may possess a comparative disadvantage in the product.

7. Fixed Exchange Rate not Always Possible: The exchange rate of a

currency vis-a-vis another currency cannot remain fixed for a sufficiently
long period. Balance of payments problems and fluctuations in inter-
national commodity prices often compel countries to bring changes in
exchange rates.

8. BoPs Disequilibrium Persists: This system fails to solve the problem

of balance of payments disequilibrium. It can be tackled only temporarily
because its permanent solution lies in monetary, fiscal and other measures.

9. Dependence on International Institutions: Under this system,

the country depends upon international institutions for borrowing and
lending foreign currencies so that it can intervene in the exchange market
successfully.

10. Problems of International Liquidity: To maintain a fixed exchange

rate, the country needs to have an exchange reserve. The excess interna-
tional liquidity to inflation.

A regime of fixed exchange rates presupposes the uniformity of domestic

policy objectives and the response of prices to fluctuations in demand. Such
a system would undoubtedly run into severe difficulties in the present-day
world. This is because there is a reluctance for being committed to the
harmonisation of domestic policy objectives; prices respond only in a limited
fashion of fluctuations in the pressures of demand, and elasticities of demand

75
in international trade have in general turned out to be quite low, at least in
the short run. For these reasons, a rigidly fixed exchange rate regime has
never been advanced as a serious possibility in any of the recent discussions of
reform of the international monetary system.

5.7 Purchasing Parity Theory

The limitations of the mint parity theory led to the breakdown of the gold
standard or mint parity and countries of the world switched over to the
adoption of the inconvertible paper currency standard and introduction of the
purchasing power parity theory.

The concept of purchasing power parity was originally enunciated by John

Wheatley and later on, it was modified and renewed by the Swedish economist,
Gustav Cassel in 1920 to determine the exchange rate between inconvertible
paper currencies. The theory states that the equilibrium exchange rate between
two inconvertible papers currencies is determined by purchasing power of the
currency in the domestic economy. The changes in purchasing power will
change the exchange rate.

Purchasing power parity has two versions i.e. absolute PPP to explain exchange
rate at a point of time and relative PPP to explain changes in the exchange
rate.

An absolute version of PPP

The purchasing power of a currency is the number of goods a unit currency

can buy in the market, at given a point in time. To be reliable, we need to
select a basket of goods representing consumption in both countries. If the
basket in both countries is identical then their prices in both countries must
be equivalent. Suppose such basket costs Rs 700 in India and $ 20 in the U.S;
then

Price of basket in US = price of basket in India

$ 20 = Rs. 500
Therefore, $1 = Rs. 25
Re.1 = $0.04

76
If the price levels in the two countries remain the same but the dollar ap-
preciated to $ 1 = Rs. 30 (or rupee depreciate). It will encourage export
and discourage import. Therefore, the supply of the dollar will increase and
demand will decrease. This will restore the initial price of the dollar. If there
is the devaluation of the dollar to $ 1 = 20 (or evaluation of rupee), this
will encourage imports and discourage exports by India. As a result, the
demand for the dollar will increase and supply will decrease. This process will
ultimately restore the initial equilibrium exchange rate of $ 1 = Rs. 20.

Relative version of PPP

An absolute version of PPP does not stand in changing prices. It expresses the
static exchange rate at a point in time. Due to monetary and fiscal policies
followed by countries, there is inflation in most of the countries. Therefore,
the price of such a basket and exchange rate between currencies will change.
A currency, of the country in which inflation is higher, will depreciate and
that of the country in which there is deflation or relatively lower inflation
will appreciate. This is the purchasing power parity which is a moving par
and not fixed par (as under the gold standard). When an absolute version of
purchasing power parity is altered to accommodate price changes, it becomes
a relative version of PPP.

Therefore, it is argued that a relative version of PPP can explain exchange

rate determination. The relative version of PPP theory explains how the
existing equilibrium exchange rate will be adjusted for the amount of inflation
differential between the two countries.

Suppose the base year price of an identical basket in the US is $ 20 and in

India |500. Then exchange rate of $ is

Price of basket in US = price of basket in India

$ 20 = Rs. 500
Therefore, $1 = Rs. 25

Thus, $ 1 = |25. is the base year equilibrium exchange rate of a currency ($)

77
in terms of other currency (|), i.e. $ 1 = |25. If there is change in price index
in both the countries and new price indices are I$ and I

I
New exchange rate of $ = Equilibrium exchange rate
I$

If the price indices in the US and India increased to 200 and 300 respectively.
Then new exchange rate (r).

300
r = 25 × = |37.5
200

Limitations of relative version

1. Difficulty to select appropriate base year: The theory attempts

to arrive at a new equilibrium exchange rate based on the base year
equilibrium exchange rate. But the selection of the base year is not easy,
as it should not abnormal or bumper year.

2. Selecting relevant index numbers: Another difficulty encountered

in calculating the new exchange rate is the selection of an appropriate
index number.

3. Identical goods: Theory does not consider qualitative differences in

goods and assume goods in both countries are identical.

4. Neglect transportation cost: The theory does not take into con-
sideration the cost of transportation, though they are significant in
international trade.

5. Trade restrictions: Absolute version does not take into consideration

various trade restrictions like tariff and non-tariff barriers.

6. Prices do not change at a uniform rate: The purchasing power

parity theory compares the general price level and not merely the price
level of goods entered in the international trade. It means it assumes
that all prices and cost rise or fall uniformly, but it is not true.

7. Limited application to large countries: This theory is relevant

78
 to small countries and countries with a dominant external sector. Its
applicability for larger countries, where international trade is not a
dominant sector, is limited.

8. According to Keynes theory does not take into consideration the elasticity
of reciprocal demand and ignore the influence of the capital movement.

9. No direct link between change in price and exchange rate: The

theory assumes that change in the price gets reflected in the exchange
rate. But there is no such a direct link and even after a change in prices
exchange rate may not change.

10. Impact of change in the exchange rate on price level is neglected:

The theory assumes that changes in price levels led to a change in the
exchange rate, but not vice versa. This is not true.

11. Capital transfer neglected: The theory takes into account trade in
merchandise but neglect capital and unilateral transfers which create
demand for and supply of foreign currencies.

12. Much emphasis on PPP: The theory places too much emphasis on
purchasing power as a determining factor of the rate of exchange. It
ignores factors such as reciprocal demand of the trading countries which
can influence the rate of exchange even with no change in price levels.

13. Do not consider speculations in the foreign exchange market:

PPP theory does not consider speculation in the foreign exchange market
which is in a large quantity.

5.8 Clean Float

Under this system, the exchange rate is determined by the free market forces
of demand and supply of foreign exchange. The exchange rate moves up and
down freely without any intervention by the monetary authority. Thus, it is
simply the system of a free-floating exchange rate.

Demand for foreign currency is inversely related to the exchange rate. It is

79
because the higher is the exchange rate the higher would be prices of import
and the lesser demand for them. This will require less amount of foreign
exchange. Therefore, foreign exchange demand slopes downward from left to
right. The nature of the demand curve depends upon the elasticity of demand
for imported goods.

Demand for currency arises from

1. Import of Goods and Services: Goods and services contribute a major

part of total imports. Consumer goods, raw materials, intermediate
goods, capital goods and services are imported from other countries.
Demand for foreign exchange for this purpose depends on the price and
elasticity of imports.

2. Unilateral Payments: Donations, gifts, reparations are all one-sided

payments without corresponding counter transactions. Such payments
create demand for foreign exchange.

3. Export of Capital: Purchase of assets in foreign countries, investment

in financial assets or direct investment is to be made in their domestic
currencies; therefore, they all require foreign currency.

4. Dividend, Interest and Profits Remittances: Foreign firms have

invested in various sectors in India. Therefore, there is an outflow of
foreign exchange on account of dividend and profits. Also, Indian firms
and Govt. have resorted to borrowings, which results in payment of
interest.

5. Lending Abroad: Financial institutions in India lend money abroad –

short term, medium-term and long term in the terms of foreign currency.
The higher the lending of funds, the higher is the demand for foreign
currency.

Supply of the foreign exchange arises from

Supply for foreign currency is directly related to its price or exchange rate.
It is because the higher is the exchange rate the higher would be prices of
exportable and the more supply. These will supply more amount of foreign

80
exchange. Therefore, foreign exchange demand slopes upward from left to
right.

1. Exports of Goods and Services: This constitutes a major source of

supply of foreign exchange. The supply of foreign currency depends on
foreign demand for India’s exportable. This also depends on the price
and elasticity of demand.

2. Unilateral Receipts: Payments received in the form of remittance

from domestics working abroad, donations and all types of one-sided
receipts form a part of foreign exchange supply.

3. Import of Capital: Foreign investment-direct and portfolio, repayment

of debts by the foreigners, all increase the supply of foreign exchange.

4. Dividend, Interest and Profits: Indian firms have invested in various

sectors in foreign countries. Therefore, there is an inflow of foreign
exchange on account of dividend and profits. Also, Indian institutions
have lent money abroad, which results in the receipt of interest.

5. Borrowings from Abroad: Govt. and corporate firms borrow money

from abroad – short-term, medium-term and long term. Higher the
borrowing of funds, higher is the supply of foreign currency

Determination of Exchange Rate

In the above diagram and are the original demand and supply curves of foreign
currency. e is the foreign exchange rate when the balance of payments is
in equilibrium. Suppose BoPs turns surplus, i.e. supply of foreign currency
increases too. The new equilibrium point will be A and the new exchange rate
will be. There is the depreciation of foreign currency and appreciation of the
domestic currency. This will increase import or demand for foreign currency
and decrease export or supply of foreign currency. Thus, demand and supply
curves will shift as and. The new equilibrium point would be B and the new
exchange rate. Still, foreign currency is at a depreciated rate, the import will
increase and export will decrease. The demand and supply curve will again
shift as and. Therefore, the equilibrium exchange rate will be reestablished at
E. Similar but opposite direction movements will be there if there is a deficit

81
 exchange rate

S S3 S2 S1

e2 b

e1 a
D D1 D2

O
Expenditure

Figure 5.1: Clean Float

in the balance of payments.

Factors responsible for the change in the equilibrium exchange rate:

1. Inflation: If the rate of inflation in the domestic economy is higher than

in a foreign country, domestic goods will become costlier and export
will decrease. This will result in a decrease in foreign exchange earnings
and depreciation of the domestic currency. Conversely, if demand is an
inelastic appreciation of the home currency.

2. Interest rate: If the interest rate in the country is higher than in foreign
countries, it will attract foreign money increasing the supply of foreign
currency and will cause an appreciation of the domestic currency.

3. Economic Growth: Higher economic growth rate is preceded by higher

demand and a higher exchange rate of foreign currency; while during
economic growth and later it attracts foreign capital, export increases
followed by a decrease in foreign currency’s exchange rate.

4. Capital movements: Short-term and long-term capital movements

also influence the exchange rate.

82
 5. Influence of banks: Banks also affects exchange rate by the sale and
purchase of bank drafts, letter of credit, arbitrage, bills of exchange etc.

6. Speculations in the market: Speculative motive transactions in the

foreign exchange market are expected to normalise fluctuations but
sometimes they can escalate.

5.9 Managed Flexibility

Hybrid Exchange Rate System: Fixed as well as floating exchange rate systems
have their advantages and disadvantages. Therefore, it is not wise to stick to a
single exchange rate system rigidly. That is why Hybrid exchange rate systems
have evolved. They allow fluctuation in exchange rate without completely
exposing the currency to the flexibility of a free float.

Managed flexibility means the system of controlled flexibility. In managed

flexibility, the monetary authority has a key role. Under managed flexibility,
the foreign exchange rate is allowed to fluctuate but within the limit. Hence it
is also called controlled flexibility. When the foreign exchange rate moves away
from the equilibrium exchange rate, the central bank intervenes in the foreign
exchange market to restore it. When there is an appreciation of domestic
currency or depreciation of the foreign currency, the monetary authority buys
a foreign currency. Contrarily, if the domestic currency depreciates or foreign
currency appreciates monetary authority will sell foreign currency. Thus, the
central bank tries to keep fluctuations within the limit. The managed flexibility
is of three types.

1. Adjustable Peg System* This is pegged or fixed exchange rate system

but when a deficit or surplus of BoPs becomes substantial, the exchange
rate is changed. The monetary authority tries to maintain a fixed
exchange rate, but when there is a substantial fall in the exchange
reserve, the currency is re-pegged at a new suitable exchange rate. It
means if disequilibrium in BOP persists, the currency will be re-pegged.

In the above diagram foreign currency US $ is measured on the horizontal

axis and exchange rate (rupee/dollar) on the vertical axis. D and S are the

83
 exchange rate

e2 S

e1
D7
e
D3 D6
D D1
O
Expenditure

Figure 5.2: Managed Float

original demand and supply curves that determine the pegged exchange
rate E at point A. If the demand for foreign exchange increases, the
demand curve shifts from D to and, but the exchange rate remains pegged
at E. This is because the monetary authority sells its foreign exchange
reserves to meet the increased demand and support this exchange rate.
The supply curve moves horizontally from point A to B and C i.e.
perfectly elastic supply. This will reduce the foreign exchange reserve of
the monetary authority; therefore, it can’t support this pegged exchange
rate E when demand for foreign exchange further rises from D2 to D3.

In such a case monetary authority will devalue its currency and re-peg the
exchange rate at E1. The supply curve is vertical or perfectly inelastic
from C to F.

If the demand for hold constant by using the country’s foreign exchange
reserves and the supply curve moves horizontally from point F to G and
to H. If the demand for foreign exchange increases beyond, there will
be another devaluation of the currency and the exchange rate will be
re-pegged at another higher level. The supply curve will rise vertically
from I to J. Thus, the supply curve under an adjustable peg system will

84
 e

eU
e
eL

Foreign exchange

Figure 5.3: Exchange Rate Band

be zig-zag shaped.

2. Joint Float: A fixed exchange rate assures the stability of the external
sector but maintaining a fixed exchange rate requires foreign exchange
reserve. Therefore, the country may decide to have a stable exchange
rate at least with few important currencies. Under this system, a group
of countries have an adjustable peg system between their currencies, but
they have joint float against other currencies. This system is used in the
European Monetary System.

3. Exchange Rate Band: In this system, the currency is allowed to

fluctuate between an upper and lower exchange rate about the established
par value. But it is not allowed to move outside this band. Suppose the
par value of the exchange rate is fixed at $ 1= Rs. 70 by the monetary
authority. It also sets a lower limit $ 1 = Rs.68 and an upper limit $
= Rs. 72 within which it is allowed to fluctuate freely. These limits
represent the exchange rate band. So long as the exchange rate moves
within the band, the monetary authority does not intervene. It is only
when the exchange rate hits the ceiling or the floor of the band that it
intervenes.

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 e

+4%
+2.25
e

−2.25

−4%

O
Foreign exchange

Figure 5.4: Snake in Tunnel

4. Pegged within a Band: A currency is said to be pegged within a

band when the central bank specifies a central exchange rate concerning
a single currency, and it also specifies a percentage deviation allowed on
both sides. Depending on the bandwidth, the central bank has discretion
in carrying out its monetary policy.

The band itself may be a crawling one, which implies that the central
rate is adjusted periodically. Bands may be symmetrically maintained
around a crawling central parity (with the band moving in the same
direction as this parity does). Alternatively, the band may be allowed to
widen gradually without any pre-announced central rate

5. Snake in the Tunnel The six original EEC member countries started
an exchange rate system similar to joint float in 1972 known as a snake in
the tunnel. Under this, there was a band within the band. They allowed
their currencies to fluctuate within the 2.25 per cent band relative to one
another and 4.5 per cent relative to other currencies of the world. So
fluctuations of exchange rate among their currencies appeared like the
movement of a snake within a tunnel. This arrangement is categorised
as exchange rate co-operation.

6. Multiple Exchange Rates: It is a system under which a country

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 adopts multiple exchange rates for the import and export of different
commodities. A country may adopt a controlled exchange rate with some
countries and free exchange rates with others. The exchange rates may
be fixed with few currencies and completely with others. The objectives
of multiple exchange rates are to obtain the maximum foreign exchange
by maximising exports and minimising imports to correct the balance of
payments deficit.

7. Basket of Currencies: Countries often have several important trading

partners or are apprehensive of a particular currency being too volatile
over an extended period. They can choose to peg their currency to a
weighted average of several currencies (also known as a currency basket).
The country creating this system would need to maintain reserves in one
or more of these currencies to intervene in the foreign exchange market.

8. Currency Boards: A currency board or ’linked exchange rate system"

effectively replaces the central bank through legislation to fix the currency
to that of another country. The domestic currency remains perpetually
exchangeable for the reserve currency at the fixed exchange rate. As
the anchor currency is now the basis for movements of the domestic
currency, the interest rates and inflation in the domestic economy would
be greatly influenced by those of the foreign economy to which the
domestic currency is tied. The currency board needs to ensure the
maintenance of adequate reserves of the anchor currency. It is a step
away from officially adopting the anchor currency.

9. Currency Substitution: This is the most extreme and rigid manner

of fixing exchange rates as it entails adopting the currency of another
country in place of its own. The most prominent example is the Euro-
zone, where 19 European Union (EU) member states have adopted the
euro (€) as their common currency (euroisation). Their exchange rates
are effectively fixed to each other. There are similar examples of coun-
tries adopting the U.S. dollar as their domestic currency (dollarisation):
British Virgin Islands, Caribbean Netherlands, East Timor, Ecuador,
El Salvador, Marshall Islands, Federated States of Micronesia, Palau,
Panama, Turks and Caicos Islands and Zimbabwe.

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10. Monetary Co-operation: Monetary co-operation is the mechanism in
which two or more monetary policies or exchange rates are linked. The
monetary co-operation does not necessarily need to be voluntary, as it
is also possible for a country to link its currency to another countries
currency without any consent of the other country. Various forms of
monetary co-operations exist, which range from fixed parity systems to
monetary unions. Also, numerous institutions have been established to
enforce monetary co-operation and to stabilise exchange rates, including
the European Monetary Cooperation Fund (EMCF) in 1973 and the
International Monetary Fund (IMF)

Monetary co-operation is formed to promote balanced economic growth

and monetary stability, but can also work counter-effectively if the mem-
ber countries have different levels of economic development. Especially
European and Asian countries have a history of monetary and exchange
rate co-operation, however, the European monetary co-operation and
economic integration eventually resulted in a European monetary union.

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Chapter 6

RBI Intervention in Exchange

Rate

6.1 Exchange Market Intervention

According to classical economists, the exchange rate is determined by the

demand for and supply of foreign currency. But the frequent changes in demand
and supply bring about fluctuations in the exchange rate. Such changes lead
to instability in the economy. Hence, it is essential to control or regulate the
exchange rate. Even if the exchange rate is not fluctuating it may be stable
where it is not suitable for the economy.

It is because the undervalued domestic currency will increase export by making

domestic goods cheaper in foreign countries. But it will increase the prices
of import. In case the country’s imports are inelastic the country will lose
the foreign exchange. Repayment of foreign debt would be costlier. While
overvalued domestic currency will decrease export and will increase import
creating a balance of payment problem.

Therefore, there is a trade-off and the country has to intervene to change the
exchange rate accordingly. This practice of changing the exchange rate is

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intervention is known as exchange market intervention. These changes can be
done by the biggest participant in the exchange market i.e. central bank of
the country. Therefore, the central bank intervenes in the foreign exchange
market.

Exchange market intervention refers to the control of the exchange rate by the
central bank of the country. The exchange market intervention is very useful
in the case of developing countries to promote desired goals. Exchange market
intervention is defined as the sale and purchase of foreign currency to change
the exchange rate of their currency vis-à-vis one or more currencies.

The process of exchange market intervention: Intervention is done to change

the exchange rate in upward and downward direction i.e. evaluation and
devaluation.

1. Evaluation: When evaluation of domestic currency is desired, there is

a need to make a shortage of domestic currency and to make plenty of
foreign currency. This can be done by the central bank by selling foreign
currency in the foreign exchange market.

2. Devaluation: When devaluation of domestic currency is required, there

is a need to make plenty of domestic currency and shortage of foreign
currency. This can be done by the central bank by purchasing foreign
currency in the exchange market.

The important reasons for exchange market interventions are:

1. Ability to produce a more appropriate exchange rate: If the

present exchange rate is not suitable, the central bank can change it
accordingly. Thus to establish an appropriate exchange rate, there is a
need for market intervention.

2. To mitigate the cost of overvalued or undervalued exchange

rate: The exchange rate which deviates from the real exchange rate leads
to distortion in resource allocation between the domestic and external
sectors of an economy. Undervaluation leads to inflation and overvalua-
tion unemployment. To avoid all these exchanges, rate intervention is
required.

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 3. To smooth the economic adjustment process: A persistence surplus
or deficit in the balance of payments need changes in the exchange rate
to correct disequilibrium. To remove deficit in the balance of payment
devaluation is required and to remove surplus evaluation is required

4. Economic development of the country: Exchange intervention can

be used to bring about the planned economic development of a country.
Foreign exchange resources should be allocated for different purposes
in such a manner that things required for development are imported in
adequate quantity.

5. To secure imports of essential goods on reasonable terms: Eval-

uation of domestic currency by market intervention ensures import of
essential goods and services on reasonable terms from abroad.

6. To encourage exports: Exports can be increased by the devaluation

of domestic currency through exchange market intervention.

7. To make the balance of payment position favourable: If there is

a balance of payment deficit it can be removed by the devaluation of the
domestic currency.

8. Protection of domestic industry: By the devaluation, domestic

production can be made cheaper in foreign countries to protect

6.2 India’s Exchange Rate System

Over the last century, the exchange rate system in India had transited from a
fixed exchange rate system where the rupee was pegged to pound sterling on
account of India’s historic link with Briton to basket peg during the 1970s and
1980s and eventually to the present form of the market-determined exchange
rate. In the British India exchange rate of rupee was established in 1929 at
6 s and 2d per rupee. This link with the pound sterling was continued even
after independence.

1. Par value system (1947-71): After the independence, India followed

the par value system of the IMF whereby the rupees external par value

91
 was fixed at 4.15 grains of gold i.e. Rs. 4.76 per US dollars and 13.33 per
pound sterling in September 1949. The sterling was devalued in 1949
and along with the rupee and many other currencies of commonwealth
countries too were devalued. This remained unchanged up to 1966 when
the rupee was devalued by 36.5 per cent to Rs. 7.5 per US dollars and
Rs. 21 per pound sterling. This exchange rate remained till 1971 when
Breton Woods System collapsed with the suspension of convertibility of
dollars’ by the USA.

2. Pegged regime (1971-92): India pegged its currency to the US dollars

from August 19971 to December 1971 and the pound sterling from
December 1971 to September 1975. Following the breakdown of the
Breton Woods System, there was downward pressure on the pound
sterling vis-a-vis major international currencies. Being pegged to the
pound sterling, this led to the misalignment of the rupee vis-a-vis other
currencies. Moreover, the importance of the UK in India’s trade had
declined over the years. To overcome weakness associated with a single
peg Indian rupee was delinked from the pound sterling and pegged to
the undisclosed basket of currencies of major trading partners from 1975
to 1992.

3. Liberalised Exchange Rate Management System (LERMS):

In 1992, the RBI introduced LERMS a dual exchange rate was fixed.
Under this system 40 per cent of foreign exchange earnings were to be
surrendered to RBI at the official exchange rate and 60 per cent were to
be converted into an Indian rupee at a market-determined exchange rate.
In 1993, a unified market-determined exchange rate was introduced for
all transactions in the current account. RBI intervened in the foreign
exchange market on a selective basis both in spot and forward markets.
The foreign exchange market was also influenced by the RBI through
monetary measures like bank rate, change in cash reserve ratio (CRR),
and repo rate. Besides these measures, changes in export credit rate and
interest were also used for the purpose.

Under the policy of liberalisation, India allowed free convertibility of

rupee, at first on trade account and subsequently on the current account.

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A full float on both current and capital account was seriously considered
by the government in 1993. However, the Mexican crisis and subsequently
the East – Asian crisis have made India ponder over the problems and
confine itself to the current account convertibility.

We now have a system of managed flexible exchange rate wherein, as

discussed earlier; the RBI selectively intervenes in the market to prevent
wide fluctuation.

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