ECONOMICS PRACTICE SHEETS BY- CA NITIN GURU

INTERNATIONAL TRADE
Practice Sheet

UNIT 4.1: THEORIES OF INTERNATIONAL TRADE

Question 1: [MTP March 2021]

What is Factor Price–Equalization Theorem of International Trade?

Solution 1:
The factor price equalisation theorem postulates that if the prices of the output of goods are equalized between
countries engaged in free trade, then the price of the input factor will also be equalised between countries. This implies
that the wages and rent will converge across the countries with free trade or in other words, trade in goods is a perfect
substitute for trade in factors.

Question 2: [MTP April 2021]

How is New Trade Policy (NTT) beneficial for development of Foreign Trade?

Solution 2:
New Trade Policy (NTT) is an economic theory and that was developed in the 1970’s as a way to understand
International Trade patterns. NTT helps in understanding why developed and big countries trade partners are when they
are trading similar goods and services. These Countries constitutes more than 50 % of the world trade. This is
particularly true in key economic sectors such as electronics, IT, food and automotive. Those countries with the
advantages will dominate the market and takes the form of monopolistic competition. According to NTT, two key
concepts give advantage to countries that import goods to compete with products from home country namely
economies of scale and network effects.

Question 3: [JULY 2021]

Briefly explain the advantages of two key concepts of New Trade theories to countries when importing goods to
compete with products from the home country.

Question 4. [JAN 2021]

You are given the following information:
Good M India Japan China
(Mobile Phones) (in $) (in $) (in $)
Average Cost 70.5 69.4 70.9
Price per unit for domestic sales 71.2 71.10 70.9
Price charged in Dubai 71.9 70.6 70.6
A. Which of the three exporters are engaged in anticompetitive act in the international market while pricing its export
of mobile phones to Dubai?
B. What would be the effect of such pricing on domestic producers of mobile phones?

Solution 4:
China and Japan are engaged in anti-competitive act in the international market while pricing its export of mobile
phones to Dubai. Both China and Japan are selling at a price which is less than price per unit for domestic sales.

The effect of such pricing will be having adverse effect on domestic industry as they will lose competitiveness in their
domestic market due to unfair practice of dumping. Dubai may prove damage to domestic industries and change anti-
dumping duties on goods imported from Japan and China so as to raise the price and making it at par with similar goods
produced by domestic firms.

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Question 5: [NOV 2020]

'The Heckscher Ohlin theory of Foreign Trade' can be stated in the form of two theorems. Explain those briefly.

Solution 5:
The ‘Heckscher-Ohlin theory of foreign trade ‘can be stated in the form of two theorems namely,
(a) Heckscher-Ohlin Trade Theorem and
(b) Factor-Price Equalization Theorem.

The Heckscher-Ohlin Trade Theorem establishes that a country’s exports depend on the endowment of resources it
has i.e. whether the country is capital-abundant or labour-abundant. If a country is a capital abundant one, it will
produce and export capital-intensive goods relatively more cheaply than other countries. Likewise, a labour-abundant
country will produce and export labour-intensive goods relatively more cheaply than another country.
Countries tend to specialize in the export of a commodity whose production requires intensive use of its abundant
resources and imports a commodity whose production requires intensive use of its scarce resources. The cause of
difference in the relative prices of goods is the difference the amount of factor endowments, like capital and labour,
between two countries.

The ‘Factor-Price Equalization’ Theorem postulates that if the prices of the output of goods are equalised between
countries engaged in free trade, then the price of the input factors will also be equalised between countries. In other
words, international trade eliminates the factor price differentials and tends to equalize the absolute and relative
returns to homogenous factors of production and their prices. Thus, the wages of homogeneous labour and returns to
homogeneous capital will be the same in all those nations which engage in trading.

Question 6: [Nov 2019]

Explain the key features of modem theory of international trade.

Solution 6:
The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of Trade or Modern Theory of
Trade, emphasises the role of a country's factor endowments in explaining the basis for its trade. ‘Factor endowment’
refers to the overall availability of usable resources including both natural and man-made means of production.
If two countries have different factor endowments under identical production function and identical preferences, then
the difference in factor endowment results in two countries having different factor prices and different cost functions.
In this model a country's advantage in production arises solely from its relative factor abundance. Thus, comparative
advantage in cost of production is explained exclusively by the differences in factor endowments of the nations.
According to this theory, international trade is but a special case of inter-regional trade. Different regions have
different factor endowments, that is, some regions have abundance of labour, but scarcity of capital; whereas other
regions have abundance of capital, but scarcity of labour. Thus, each region is suitable for the production of those
goods for whose production it has relatively plentiful supply of the requisite factors. The theory states that a country’s
exports depend on its resources endowment i.e. whether the country is capital-abundant or labour- abundant. A
country which is capital-abundant will export capital-intensive goods. Likewise, the country which is labor-abundant
will export labour-intensive goods.
The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the export of a commodity whose
production requires intensive use of its abundant resources and imports a commodity whose production requires
intensive use of its scarce resources.
The Factor-Price Equalization Theorem which is a corollary to the Heckscher-Ohlin trade theory states that in the
absence of foreign trade, it is quite likely that factor prices are different in different countries. International trade
equalizes the absolute and relative returns to homogenous factors of production and their prices. This implies that the
wages and rents will converge across the countries with free trade, or in other words, trade in goods is a perfect
substitute for trade in factors. The Heckscher-Ohlin theorem thus postulates that foreign trade eliminates the factor
price differentials.

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Question 7: [RTP May 2021]

Briefly explain the New Trade Theory and its importance.

Solution 7:
New Trade Theory (NTT) is an economic theory that was developed in the 1970s as a way to understand international
trade patterns. NTT helps in understanding why developed and big countries are trade partners when they are trading
similar goods and services. These countries constitute more than 50% of world trade.
This is particularly true in key economic sectors such as electronics, IT, food, and automotive. We have cars made in the
India, yet we purchase many cars made in other countries.

These are usually products that come from large, global industries that directly impact international economies. The
mobile phones that we use are a good example. India produces them and also imports them. NTT argues that, because
of substantial economies of scale and network effects, it pays to export phones to sell in another country. Those
countries with the advantages will dominate the market, and the market takes the form of monopolistic competition.
Monopolistic competition tells us that the firms are producing a similar product that isn't exactly the same, but awfully
close. According to NTT, two key concepts give advantages to countries that import goods to compete with products
from the home country. These are:
Economies of Scale: As a firm produces more of a product, its cost per unit keeps going down. So if the firm serves
domestic as well as foreign market instead of just one, then it can reap the benefit of large scale of production
consequently the profits are likely to be higher.
Network effects refer to the way one person’s value for a good or service is affected by the value of that good or service
to others. The value of the product or service is enhanced as the number of individuals using it increases. This is also
referred to as the ‘bandwagon effect’. Consumers like more choices, but they also want products and services with high
utility, and the network effect increases utility obtained from these products over others. A good example will be
Mobile App such as what’s App and software like Microsoft Windows.

Question 8: [RTP Nov 2020]

Countries Rose Land and Daisy land have a total of 4000 hours each of labour available each day to produce shirts and
trousers. Both countries use equal number of hours on each good each day. Rose Land produces 800 shirts and 500
trousers per day. Daisy land produces 500 shirts and 250 trousers per day.
In the absence of trade:
(i) Which country has absolute advantage in producing shirts or trousers?
(ii) Which country has comparative advantage in producing shirts or trousers?

Solution 8:
Goods produced by each country
Country Shirts Trousers
Rose Land 800 500

Daisy Land 500 250

Each country has 4000 hours of labour and uses 2000 hours each for both the goods. Therefore, the number of hours
spent per unit on each good

Country Shirts Trousers

Rose Land 2.5 4
Daisy Land 4 8

Since Rose Land produces both goods in less time, it has absolute advantage in both shirts and trousers.
Comparative advantage; comparing the opportunity costs of both goods we have
Rose Land

Opportunity cost of Shirts 2.5/4 = 0.625

Opportunity cost of Trousers 4/2. 5 =1.6

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Daisy Land
Opportunity cost of Shirts 4/8 = 0.5

Opportunity cost of Trousers 8/4 =2

For producing shirts

Daisy Land has lower opportunity cost for producing shirts, therefore Daisy Land has comparative advantage
For producing Trousers

Rose Land has lower opportunity cost for producing Trousers, therefore Rose Land has comparative advantage.

Question 9: [RTP May 2020]

Even if one nation is less efficient than the other nation in the production of all commodities, there is still scope for
mutually beneficial trade. Explain in detail.

Solution 9:
Yes, there is still scope for mutually beneficial trade. The first step is that nation should specialize in the production and
export of the commodity in which its absolute disadvantage is smaller and import the commodity in which its absolute
disadvantage is greater. This can be explained with the help of an example (Theory of Comparative Advantage).

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UNIT 4.2: THE INSTRUMENTS OF TRADE POLICY

Question 10: [MTP April 2021]

What are the important barriers in International Trade ? How does its resolution help in development of international
Trade?

Solution 10:
Trade barriers create obstacles to trade, reduces the prospect of market access, make imported goods more expensive,
increase consumption of domestic goods, protect domestic Industries, and increase government revenues.
Technical barriers to trade are Standards and Technical Regulations that define the specific characteristics that a product
should have such as its size, shape, design, labelling/marking/packaging functionality or performance and production
methods, excluding measures covered by the SPS agreement. The resolution of trade barriers will definitely be helpful in
functioning of trade. There are different forum and trade agreements between countries for the resolution of the
obstacle.

Question 11: [July 2021]

Explain in brief any four effects of Tariffs on importing and exporting countries.

Question 12: [Nov 2020]

What is meant by 'Countervailing Duties'?

Solution 12:
Countervailing Duties
Countervailing duties are tariffs imposed by an importing country with the aim of off- setting the artificially low prices
charged by exporters who enjoy export subsidies and tax concessions offered by the governments in their home
country.
If a foreign country does not have a comparative advantage in a particular product and a government subsidy allows
the foreign firm to artificially reduce the export price and be an exporter of the product, then the subsidy generates a
distortion from the free-trade allocation of resources. In such cases, CVD is charged by an importing country to negate
such advantage that exporters get from subsidies. This is done to ensure fair and market-oriented pricing of imported
products and thereby protecting domestic industries and firms.

Question 13: [Nov 2019]

What is meant by ‘Bound tariff’?

Solution 13:
A bound tariff is a tariff which a WTO member binds itself with a legal commitment not to raise it above a certain level.
By binding a tariff, often during negotiations, the members agree to limit their right to set tariff levels beyond a certain
level. The bound rates are specific to individual products and represent the maximum level of import duty that can be
levied on a product imported by that member. A member is always free to impose a tariff that is lower than the bound
level. Once bound, a tariff rate becomes permanent and a member can only increase its level after negotiating with its
trading partners and compensating them for possible losses of trade. A bound tariff ensures transparency and
predictability in trade.

Question 14: [RTP Nov 2021]

How does non-tariff measures interfere with free trade?

Solution 14:
The non- tariff measures (NTM) which have come into greater prominence than the conventional tariff barriers,
constitute the hidden or 'invisible' measures that interfere with free trade. Non-tariff measures comprise all types of
measures which alter the conditions of international trade, including policies and regulations that restrict trade and
those that facilitate it. NTMs consist of mandatory requirements, rules, or regulations that are legally set by the
government of the exporting, importing, or transit country. NTMs are sometimes used as means to circumvent free-
trade rules and favour domestic industries at the expense of foreign competition.

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Question 15: [RTP May 2021]

Describe different technical barriers to trade (TBT) and their effects on trade?

Solution 15:
Technical Barriers to Trade (TBT) which cover both food and non-food traded products refer to mandatory ‘Standards
and Technical Regulations’ that define the specific characteristics that a product should have, such as its size, shape,
design, labeling / marking / packaging, functionality or performance and production methods, excluding measures
covered by the SPS Agreement. The specific procedures used to check whether a product is really conforming to these
requirements (conformity assessment procedures e.g. testing, inspection and certification) are also covered in TBT.
This involves compulsory quality, quantity and price control of goods before shipment from the exporting country.
Just as SPS, TBT measures are standards-based measures that countries use to protect their consumers and preserve
natural resources, but these can also be used effectively as obstacles to imports or to discriminate against imports and
protect domestic products. Altering products and production processes to comply with the diverse requirements in
export markets may be either impossible for the exporting country or would obviously raise costs, hurting the
competitiveness of the exporting country. Some examples of TBT are: food laws, quality standards, industrial
standards, organic certification, eco-labeling, and marketing and label requirements.

Question 16: [RTP May 2021]

Explain Export Duties.

Solution 16:
An export duty tax is a tax collected on exported goods and may be either specific or ad valorem. The effect of an
export tax is to raise the price of the good and to decrease exports. Since an export tax reduces exports and increases
domestic supply, it also reduces domestic prices and leads to higher domestic consumption.

Question 17: [RTP May 2020]

Explain how a tariff levied on an imported product affects both the country exporting a product and the country
importing that product.

Solution 17:
A tariff levied on an imported product affects both the country exporting a product and the country importing that
product. (i) Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of
international trade. The prospect of market access of the exporting country is worsened when an importing country
imposes a tariff. (ii) By making imported goods more expensive, tariffs discourage domestic consumers from consuming
imported foreign goods. Domestic consumers suffer a loss in consumer surplus because they must now pay a higher
price for the good and also because compared to free trade quantity, they now consume lesser quantity of the good. (iii)
Tariffs encourage consumption and production of the domestically produced import substitutes and thus protect
domestic industries. (iv)Producers in the importing country experience an increase in well-being as a result of imposition
of tariff. The price increase of their product in the domestic market increases producer surplus in the industry. They can
also charge higher prices than would be possible in the case of free trade because foreign competition has reduced. (v)
The price increase also induces an increase in the output of the existing firms and possibly addition of new firms due to
entry into the industry to take advantage of the new high profits and consequently an increase in employment in the
industry. (vi)Tariffs create trade distortions by disregarding comparative advantage and prevent countries from enjoying
gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in the rest of the
world and encourage inefficient production in the home country. (vii) Tariffs increase government revenues of the
importing country by the value of the total tariff it charges.

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UNIT 4.3: TRADE NEGOTIATIONS

Question 18: [MTP March 2021]

The developing countries will have disadvantage if they engage in liberal trade. Explain in detail.

Solution 18:
The developing countries find themselves disproportionately disadvantage and vulnerable with regard to adjustments
due to lack of human as well as physical capital, poor infrastructure, inadequate institutions, political instabilities etc.
Developing countries also complain that they face exceptionally high tariffs on selected products in many markets and
this obstructs their vital exports.

Question 19: [July 2021]

Mention any three key objectives of World Trade Organisation.

Question 20: [July 2021]

Explain the concept of ‘Voluntary Export Restraints’ . Under which circumstances exporters commit to voluntary
export restraint? Discuss.

Question 21: [Jan 2021]

Describe the purposes of Trade Barriers in international trade.

Solution 21:
Over the past decades significant transformation are happening in terms of growth as well as trends of flows and
pattern of global trade. The increasing importance of developing countries has been a salient feature of the shifting
global trade patterns. Fundamental changes are taking place in the way countries associate themselves for international
trade and investments. Trading through regional arrangements which foster closer trade and economic relations is
shaping the global trade landscape in an unprecedented way. Trade barriers create obstacles to trade, reduce the
prospect of market access, make imported goods more expensive, increase consumption of domestic goods, protect
domestic industries, and increase government revenue.

Question 22: [Nov 2020]

Discuss the guiding principle of WTO in relation to trade without discrimination.

Solution 22:
The guiding principle of WTO in relation to trade without discrimination
The two principles on non-discrimination namely, Most-favoured-Nation (MFN) and the National Treatment Principle
(NTP) relate to the rules of trade among member - nations. These are designed to secure fair conditions of trade.
a) Most-favoured-Nation (MFN) principle holds that the member countries cannot normally discriminate among
their trading partners. Each member treats all the other members equally as “most-favoured” trading
partners. If a country grants a special advantage, favour, privilege or immunity to one (such as lowering of
customs duty or opening up of market), it has to unconditionally extend the same treatment to all the other
WTO members.
b) The National Treatment Principle (NTP) mandates that when goods are imported, the imported goods and the
locally produced goods and services should be treated equally in respect of internal taxes and internal laws. A
member country should not discriminate between its own and foreign products, services or nationals. For
instance, once imported apples reach Indian market, they cannot be discriminated against and should be
treated at par in respect of marketing opportunities, product visibility or any other aspect with locally
produced apples.

Question 23: [Nov 2019]

How does the WTO agreement ensure market access?

Solution 23:
The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly and
predictably. The WTO agreement aims to increase world trade by enhancing market access by the following:

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(i) The agreement specifies the conduct of trade without discrimination. The Most- favoured-nation (MFN)
principle holds that if a country lowers a trade barrier or opens up a market, it has to do so for the same
goods or services from all other WTO members.
(ii) The National Treatment Principle requires that a country should not discriminate between its own and
foreign products, services or nationals. With respect to internal taxes, internal laws, etc. applied to imports,
treatment not less favourable than that which is accorded to like domestic products must be accorded to all
other members.
(iii) The principle of general prohibition of quantitative restrictions
(iv) By converting all non- tariff barriers into tariffs which are subject to country specific limits.
(v) The imposition of tariffs should be only legitimate measures for the protection of domestic industries, and
tariff rates for individual items are being gradually reduced through negotiations ‘on a reciprocal and
mutually advantageous’ basis.
(vi) In major multilateral agreements like the Agreement on Agriculture (AOA), specific targets have been
specified for ensuring market access.

Question 24: [RTP Nov 2020]

Describe the different types of agreements that take place during the negotiations of trade?

Solution 24:
Trade negotiations result in different types of agreements. These agreements are –

Unilateral trade agreements- under which an importing country offers trade incentives in order to encourage the
exporting country to engage in international economic activities.
E.g. Generalized System of Preferences.

Bilateral agreements- agreements which set rules of trade between two countries, two blocs or a bloc and a country.
These may be limited to certain goods and services or certain types of market entry barriers. E.g. EU-South Africa Free
Trade Agreement; ASEAN–India Free Trade Area.

Regional Preferential Trade Agreements- agreements that reduce trade barriers on a reciprocal and preferential basis for
only the members of the group. E.g. Global System of Trade Preferences among Developing Countries (GSTP).

Trading bloc- A group of countries that have a free trade agreement between themselves and may apply a common
external tariff to other countries. Example: Arab League (AL), European Free Trade Association (EFTA).

Free-trade area- is a group of countries that eliminate all tariff barriers on trade with each other and retains
independence in determining their tariffs with non-members. Example: NAFTA.

Customs union -A group of countries that eliminate all tariffs on trade among themselves but maintain a common
external tariff on trade with countries outside the union (thus technically violating MFN). E.g. EC, MERCOSUR.

Common market- A common market deepens a customs union by providing for the free flow of factors of production
(labor and capital) in addition to the free flow of outputs. The member countries attempt to harmonize some
institutional arrangements and commercial and financial laws and regulations among themselves. There are also
common barriers against non-members (E.g., EU, ASEAN).

In an Economic and Monetary Union- members share a common currency and macroeconomic policies. For E.g., the
European Union countries implement and adopt a single currency.

Question 25: [RTP Nov 2020]

What does the Agreement on Trade-Related Investment Measures (TRIMs) stipulate?

Solution 25:
Agreement on TRIMS establishes discipline governing investment measures in relation to cross-border investments by
stipulating that countries receiving foreign investments shall not impose investment measures such as requirements,
conditions and restrictions inconsistent with the provisions of the principle of national treatment and general
elimination of quantitative restrictions.

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Question 26: [RTP May 2020]

Why GATT lost its relevance by 1980?

Solution 26:
The GATT lost its relevance by 1980s because-
(i) It was obsolete to the fast evolving contemporary complex world trade scenario characterized by emerging
globalization.
(ii) International investments had expanded substantially.
(iii) Intellectual property rights and trade in services were not covered by GATT.
(iv) World merchandise trade increased by leaps and bounds and was beyond its scope.
(v) The ambiguities in the multilateral system could be heavily exploited.
(vi) Efforts at liberalizing agricultural trade were not successful.
(vii) There were inadequacies in institutional structure and dispute settlement system.
(viii) It was not a treaty and therefore terms of GATT were binding only insofar as they are not incoherent with a
nation’s domestic rules.

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UNIT 4.4: EXCHANGE RATE AND ITS ECONOMIC EFFECTS

Question 27: [MTP April 2021]

What are the major differences between Foreign Direct Investment and Foreign Portfolio Investment?

Solution 27:
Major differences between FDI and Foreign Portfolio Investment are as follows
Foreign Direct Investment Foreign Portfolio Investment
Investment involves creation of physical assets Investment is only in financial assets.
Has a long-term interest and therefore invested Only short-term interest and generally remain
for long invested in short periods.
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology transfer Not accompanied by technology transfer.
Direct impact on employment of labour and wages. No direct impact on employment of labour and
wages.
Enduring interest in management and control No abiding interest in management and Control.

Question 28: [MTP April 2021]

Under Floating Rate Regime how exchange rate is determined?

Solution 28:
An exchange rate regime is the system by which a country manages its currency with respect to foreign currencies.
There are two major types of exchange rate regimes namely floating exchange rate regime and fixed exchange rate
regime.
A floating exchange rate allows a government to pursue its own independent monetary policy and there is no need
for market intervention or maintenance of reserves. However, volatile exchange rates generate a lot of uncertainties
with regard to international transaction.

Question 29: [July 2021]

Compare and contrast between devaluation and depreciation in the context of exchange rate.

Question 30: [July 2021]

Mention any four sectors in which foreign direct investment is prohibited.

Question 31: [July 2021]

Briefly describe any two advantages of fixed exchange rate regime in the context of open economy.

Question 32: [July 2021]

Distinguish between horizontal, vertical and conglomerate type of foreign investments.

Question 33: [July 2021]

Mention any four arguments made in favour of Foreign Direct Investment to developing economy like India.

Question 34: [Jan 2021]

Distinguish between 'direct quote' and ‘indirect quote’ with reference to express nominal exchange rate between two
currencies.

Solution 34:
Exchange rate is the rate at which the currency of one country is exchanged for the currency of another country. There
are two ways to express nominal exchange rate between two currencies namely direct quote and indirect quote. A

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direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency. The price of 1
dollar may be quoted in terms of how much rupees it takes to buy one dollar.
An indirect quote is the number of units of a foreign currency exchangeable for one unit of local currency. A quotation in
direct form can easily be converted into a quotation in indirect form and vice versa. This is done by taking the reciprocal
of the given rate.

Question 35: [Jan 2021]

Describe the advantages of Floating Exchange Rate.

Solution 35:
Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is market
determined i.e., the demand for and supply of currency relative to other currencies determine the exchange rate. A
floating exchange rate has many advantages:
(a) A floating exchange rate has the greatest advantage of allowing a Central bank and /or government to
pursue its own monetary policy.
(b) Floating exchange rate regime allows exchange rate to be used as a policy tool: for example, policy
makers can adjust the nominal exchange rate to influence the competitiveness of the tradable goods
sector.
(c) As there is no obligation or necessary to intervene in the currency markets, the Central bank is not
required to maintain a huge foreign exchange reserves.
On the contrary a floating rate has greater policy flexibility but less stability.

Question 36: [Jan 2021]

Describe the benefits and costs of FDI to the host country.

Solution 36:
Benefit of Foreign Direct Investment:
 Entry of foreign enterprises fosters competition and generates a competitive environment in the host country.
 International capital allows countries to finance more investment than can be supported by domestic savings.
 FDI can accelerate growth by providing much needed capital, technological know-how and management skill.
 Competition for FDI among national government promotes political and structural reforms.
 FDI also help in creating direct employment opportunities.
 It also promotes relatively higher wages for skilled jobs.
 FDI generally entails people to people relations and is usually considered as a promoter of bilateral and
international relations.
 Foreign investment projects also would act as a source of new tax revenue which can be used for development
projects.

Cost of Foreign Direct Investment:

 FDI are likely to concentrate on capital intensive methods of production and services so they need to hire few
workers.
 FDI flows has tendency to move towards regions which is well endowed in natural resources and infrastructure
so accentuate regional disparity.
 If foreign corporations are able to secure incentives in the form of tax holidays or similar provisions, the host
country loses tax revenue.
 FDI is also held responsible by many for ruthless exploitation of natural resources and the possible
environmental damage.
 With substantial FDI in developing countries there is strong possibility of emergence of a dual economy with a
developed foreign sector and an underdeveloped domestic sector.
 Foreign entities are usually accused of being anti-ethical as they frequently resort to methods like aggregate
advertising and anticompetitive practices which would induce market distortions.

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Question 37: [Nov 2020]

Following exchange rate quotations are available for different periods:
1. The spot exchange rate changes from ₹ 65 per $ to ₹ 68 per $.
2. The spot exchange rate changes from $ 0.0125 per rupee to $ 0.01625 per rupee.
Answer:
A. Identify the nature of rate quotations in (1) and (2) above.
B. Identify the base currency and counter currency in (1) and (2) above.
C. What are possible consequences on exports and imports of (1) and (2) above.

Solution 37:
(A) The nature of rate quotations in (1) and (2)
In an exchange rate, two currencies are involved. There are two ways to express nominal exchange rate between two
currencies (here US $ and Indian Rupee) namely direct quote and indirect quote.
The nature of rate quotation in [(1) ₹ 65/per $] is direct quote, (also called European Currency Quotation). The
exchange rate is quoted in terms of the number of units of a local currency exchangeable for one unit of a foreign
currency. For example, 65/US$ means that an amount of 65 is needed to buy one US dollar or 65 will be received while
selling one US dollar.
An indirect quote is presented in [(2) $ 0.0125 per Rupee] of the question. In an indirect quote, (also known as
American Currency Quotation), the exchange rate is quoted in terms of the number of units of a foreign currency
exchangeable for one unit of local currency; for example: $ 0.0125 per rupee. In an indirect quote, domestic currency
is the commodity which is being bought and sold.

(B) The base currency and counter currency in (1) and (2)
An exchange rate has two currency components; a ‘base currency’ and a ‘counter currency’. The currency in the
numerator always states ‘how much of that currency is required for one unit of the base currency’.
 In a direct quotation [in (1) ₹ 65/per $], the foreign currency is the base currency and the domestic currency is the
counter currency. So in the given question, US dollar is the base currency and Indian Rupee is the counter currency.
 In an indirect quotation, [in (2) $ 0.0125 per Rupee], the domestic currency is the base currency and the foreign
currency is the counter currency. So in the given question, Indian Rupee is the base currency and US dollar is the
counter currency.

(C) The possible consequences on exports and imports of (1) and (2)
When the spot exchange rate changes from ₹ 65/per $ to ₹ 68/ per $, it indicates that a person has to exchange a
greater amount of Indian Rupees (68) to get the same 1 unit of US dollar. The rupee has become less valuable with
respect to the U.S. dollar or Indian Rupee has depreciated in its value. Simultaneously, the dollar has appreciated.

Consequence on exports and imports of (1)

Other things remaining the same, when a country’s currency depreciates, foreigners find that its exports are cheaper
and the quantity demanded of its export goods will increase. For example a foreigner who spends ten dollars on
buying Indian goods will, get goods worth ₹ 680 /- instead of ₹ 650/- prior to depreciation.
On the other hand, the domestic residents find that imports from abroad are more expensive. A resident of India, who
wants to import goods worth $1 will have to pay ₹ 68/- instead of ₹ 65/- prior to depreciation. Imports will be
discouraged as importers will have to pay more rupees per dollar for importing products.
In short, depreciation of domestic currency lowers the relative price of a country’s exports and raises the relative price
of its imports.

Consequence on exports and imports of (2)

In this case, Rupee has appreciated and dollar has depreciated. Earlier, $ 1.25 would fetch export goods worth ₹ 100/-
from India; but after the change $16.25 would be necessary to buy the same amount of goods.
Other things remaining the same, when a country’s currency appreciates, it raises the relative price of its exports and
lowers the relative price of its imports. In other words, foreigners find their imports from that country (exports from
India in the above case) costlier. Therefore quantity demanded of export goods would decrease.
On the other hand, the domestic residents find that imports from abroad are cheaper. Therefore, we may expect an
increase in the quantity of imports.

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Question 38: [Nov 2020]

Explain the concept of soft peg and hard peg exchange rate policies.

Solution 38:
The concept of soft peg and hard peg exchange rate policies
A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a
foreign currency or basket of currencies. Pegging a currency stabilizes the exchange rate between countries.
A soft peg refers to an exchange rate policy under which the exchange rate is generally determined by the market, but
in case the exchange rate tends to move speedily in one direction, the central bank will intervene in the market.
With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. Both
soft peg and hard peg policy require that the central bank intervenes in the foreign exchange market.

Question 39: NOV 2020

In which sectors Foreign Investment is prohibited in India?

Solution 39:
Sectors in which foreign investment is prohibited in India
In India, foreign investment is prohibited in the following sectors:
(a) Lottery business including Government / private lottery, online lotteries, etc.
(b) Gambling and betting including casinos etc.
(c) Chit funds
(d) Nidhi company
(e) Trading in Transferable Development Rights (TD₹)
(f) Real Estate Business or Construction of Farmhouses
(g) Manufacturing of cigars, cheroots, cigarillos, and cigarettes, of tobacco or of tobacco substitutes
(h) Activities / sectors not open to private sector investment e.g., atomic energy and railway operations (other than
permitted activities).
Foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management
contract is also prohibited for lottery business and gambling and betting activities.

Question 40: [Nov 2019]

Explain the term 'Real Exchange Rate'.

Solution 40:
The Real Exchange Rate (RER) compares the relative price of the consumption baskets of two countries, i.e. it describes
‘how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a foreign country.
Unlike nominal exchange rate which assumes constant prices of goods and services, the real exchange rate incorporates
changes in prices. The real exchange rate therefore is the exchange rate times the relative prices of a market basket of
goods in the two countries and is calculated as:
Real Exchange Rate = Nominal exchange rate x Domestic Price Index
Foreign Price Index

Question 41: [RTP Nov 2021]

What are the problems associated with foreign Direct Investment?

Solution 41:
Potential problems of foreign direct investment include use of inappropriate capital - intensive methods in a labour-
abundant country, increase in regional disparity, crowding-out of domestic investments, diversion of capital resulting in
distorted pattern of production and investment, instability in the balance of payments and exchange rate and
indiscriminate repatriation of the profits.
FDIs are also likely to indulge in anti-ethical market distortions, off shoring or shifting of jobs, overexploitation of natural
resources causing environmental damage, exercising monopoly power, decrease in competitiveness of domestic
companies, potentially jeopardizing national security and sovereignty, worsening commodity terms of trade, and
causing emergence of a dual economy.

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Question 42: [RTP Nov 2021]

How does arbitrage prevents the risk arising out of the fluctuations in the exchange rate?

Solution 42:
Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an asset at
different dealing places. On account of arbitrage, regardless of physical location, at any given moment, all markets tend
to have the same exchange rate for a given currency. When price differences occur in different markets, participants
purchase foreign exchange in a low-priced market for resale in a high-priced market and makes profit in this process.
Due to the operation of price mechanism, the price is driven up in the low-priced market and pushed down in the high-
priced market. This activity will continue until the prices in the two markets are equalized, or until they differ only by
the amount of transaction costs involved in the operation. Since forex markets are efficient, any profit spread on a given
currency is quickly arbitraged away.

Question 43: [RTP May 2021]

What is Arbitrage? What is the outcome of Arbitrage?

Solution 43:
Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an asset at
different dealing places. On account of arbitrage, regardless of physical location, at any given moment, all markets tend
to have the same exchange rate for a given currency.

Question 44: [RTP May 2021]

Mention the types of transactions in the forex market?

Solution 44:
There are two types of transactions in a forex market; current transactions which are carried out in the spot market and
future transactions involving contracts to buy or sell currencies for future delivery which are carried out in forward and
futures markets.

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UNIT 4.5: INTERNATIONAL CAPITAL MOVEMENTS

Question 45: [RTP Nov 2020]

Into how many parts are FDIs categorized according to the nature of foreign investment? Describe them.

Solution 45:
Based on the nature of foreign investments, FDI may be categorized into three parts as horizontal, vertical or
conglomerate.
(i) A horizontal direct investment is said to take place when the investor establishes the same type of business
operation in a foreign country as it operates in its home country, for example, a cell phone service provider based in
the United States moving to India to provide the same service.
(ii) A vertical investment is one under which the investor establishes or acquires a business activity in a foreign country
which is different from the investor’s main business activity yet in some way supplements its major activity. For
example; an automobile manufacturing company may acquire an interest in a foreign company that supplies parts
or raw materials required for the company.
(iii) A conglomerate type of foreign direct investment is one where an investor makes a foreign investment in a
business that is unrelated to its existing business in its home country. This is often in the form of a joint venture
with a foreign firm already operating in the industry as the investor has no previous experience.

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