Ma Economics

INTERNATIONAL FINANCE
(ECO4 C12)
IV SEMESTER
MA ECONOMICS
2019 Admission onwards
UNIVERSITY OF CALICUT
School of Distance Education
Calicut University- P.O,
Malappuram - 673635, Kerala.
190313
UNIVERSITY OF CALICUT
Study Material
IV SEMESTER
MA ECONOMICS
CORE COURSE: ECO4 C12
INTERNATIONAL FINANCE
Prepared by:
Dr. SHIMA K.M,
Assistant Professor of Economics,
SDE, University of Calicut,
Scrutinized by:
Dr. RASEENA K.K,
Asst. Professor of Economics,
Sri. C. Achutha Menon Govt. College,
Thrissur.
DISCLAIMER
“The author shall be solely responsible for the
content and views expressed in this book”
International Finance 2
ECO4 C12 - INTERNATIONAL FINANCE

(Credit 3)
Module I: Balance of Payments
Balance of payments- Components- Equilibrium and
disequilibrium in BOP- Methods of correcting BOP deficit-
Adjustment Mechanisms-Automatic, price and income
adjustments- Elasticity approach- Marshall-Lerner
condition- Absorption Approach-Monetary approach- J
curve effect- Currency convertibility- Current and capital
account convertibility-The Indian experience-FEMA.
Module II: Exchange Rate and Theories of Exchange

Rate
Exchange rate-Nominal, Real, Effective, NEER, REER-
Exchange rate systems- Relative merits and demerits of
fixed and flexible exchange rates- Hybrid exchange rates-
Purchasing power parity theory-Monetary approach- Asset
market (portfolio balance) model- Exchange rate
overshooting - Exchange rate in India- Indian Rupee and its
fluctuations in international currency market.
Module III: Foreign Exchange Market

Foreign exchange market-Functions-Participants- Stability
of foreign exchange markets-Spot and forward market-
Currency futures and options- Swap market- Foreign
exchange risk- Hedging- Speculation- Stabilizing and de-
stabilizing- Currency arbitrage- Internal and external
balance-( Salvatore) Policy adjustments- Expenditure

changing and expenditure switching policies- Assignment
problem- Swan diagram- Mundell-Fleming model.
Module IV International Capital Flows

Portfolio investment and direct investments- Motives for
capital flows- Effects of international capital flows-
Multinational corporations- Advantages and disadvantages
of MNCs- Foreign investment in India since 1991.
Module V International Monetary System

International monetary system-The gold standard and its
breakdown-Bretton Woods system and its breakdown-
Present international monetary system- European monetary
union-Euro-Optimum currency areas- Currency boards-
Dollarization- Brexit.
ModuleI
Balance of Payments
1.1. Balance of Payments

The balance of payments (BOP), also known as balance of
international payments, summarizes all transactions that a
country’s individuals, companies, and government bodies
complete with individuals, companies, and government
bodies outside the country. These transactions consist of
imports and exports of goods, services, and capital, as well
as transfer payments, such as foreign aid and remittances. It
represents a summation of country’s current demand and
supply of the claims on foreign currencies and of foreign
claims on its currency. It also indicates whether the country
has a surplus or a deficit on trade. When exports exceed
imports, there is a trade surplus and when imports exceed
exports there is a trade deficit.
A country’s balance of payments and its net international
investment position together constitute its international
accounts. The sum of all transactions recorded in the
balance of payments must be zero, as long as the capital
account is defined broadly. The reason is that every credit
appearing in the current account has a corresponding debit
in the capital account, and vice-versa. If a country exports
an item (a current account transaction), it effectively
imports foreign capital when that item is paid for (a capital
account transaction).
Purposes of Calculation of Balance of Payments
 Reveals the financial and economic status of a

country.
 Can be used as an indicator to determine whether the
country’s currency value isappreciating or depreciating.
 Helps the Government to decide on fiscal and trade
policies.
 Provides important information to analyze and
understand the economic dealings of a country with other
countries
1.1.1. Components of Balance of Payments
The main components of balance of payments can be
discussed under following heads:
a) Current Account
Current account refers to an account which records all the
transactions relating to export and import of goods and
services and unilateral transfers during a given period of
time. Current account contains the receipts and payments
relating to all the transactions of visible items, invisible
items and unilateral transfers. The main components of
Current Account are:
i) Export and Import of Goods (Merchandise
Transactions or Visible Trade): A major part of transactions
in foreign trade is in the form of export and import of
goods (visible items). Payment for import of goods is
written on the negative side (debit items) and receipt from
exports is shown on the positive side (credit items). Balance
of these visible exports and imports is known as balance of

trade (or tradebalance).
ii) Export and Import of Services (Invisible Trade): It

includes a large variety of non- factor services (known as
invisible items) sold and purchased by the residents of a
country, to and from the rest of the world. Payments are
either received or made to the other countries for use of
these services. The services are generally of three kinds: a)
shipping b) Banking c) Insurance
iii) Unilateral or Unrequited Transfers to and from
abroad (One sided Transactions): Unilateral transfers
include gifts, donations, personal remittances and other
‘one-way’ transactions. These refer to those receipts and
payments, which take place without any service in return.
Receipt of unilateral transfers from rest of the world is
shown on the credit side and unilateral transfers to rest of the
world on the debit side.
iv) Income receipts and payments to and from abroad:
The Income receipts and payments to and from abroad
include investment income in the form of interest, rent and
profits.
b) Capital Account
Capital account of BOP records all those transactions,
between the residents of a country and the rest of the world,
which cause a change in the assets or liabilities of the
residents of the country or its government. It is related to
claims and liabilities of financial nature. The main
components of capital accounts are as follows:
i. Borrowing and lending to and from abroad: It
includes all transactions relating to borrowings from abroad

by private sector, government, etc. the receipts of such loans
and repayment of loans by foreigners are recorded on the
positive (credit) side. On the other hand the transactions of
lending to abroad by private sector and government. These
lending abroad and repayment of loans to abroad is recorded
as negative or debit item.
ii. Investments to and from abroad: It includes the
investments by rest of the world in shares of Indian
companies, real estate in India, etc. Such investments from
abroadare recorded on the positive (credit) side as they bring
in foreign exchange. On the other hand investments made by
Indian residents in shares of foreign companies, real estate
abroad, etc. are recorded on the negative (debit) side as they
lead to outflow of foreign exchange.
iii. Change in Foreign Exchange Reserves: The
foreign exchange reserves are the financial assets of the
government held in the central bank. A change in reserves
serves as the financing item in India’s BOP. So, any
withdrawal from the reserves is recorded on the positive
(credit) side and any addition to these reserves is
recorded on the negative (debit) side. It must be noted that
‘change in reserves’ is recorded in the BOP account and not
‘reserves’.
1.1.2. Components of Balance of Payments in

case of India
A. CURRENT ACCOUNT
1. Export, 2. Imports, 3. Trade Balance, 4. Invisibles
(net) a) Service , b) Income, c) Transfers 5. Goods and
Service Balance, 6. Current account balance
B. CAPITAL ACCOUNT
1. External Assistance (net), 2. External Commercial
Borrowings, 3. Short term Debt, 4. Banking Capital, 5.
Foreign Investment a) FDI (net) b) Portfolio (net), 6.
Other Flows (net).
C. CAPITAL ACCOUNT BALANCE :Errors and
Omissions
D. OVERALL BALANCE
E. RESERVE
1.2. Relative Importance of Current account
and Capital Account
Current Account records all the actual transactions of
goods and services which affect the income, output and
employment of a country. So, it shows the net income
generated in the foreign sector. In the current account,
receipts from export of goods, services and unilateral
receipts are entered as credit or positive items and payments
for import of goods, services and unilateral payments are
entered as debit or negative items. The net value of credit
and debit balances is the balance on current account. The
surplus in current account arises when credit items are more
than debit items. It indicates net inflow of foreign exchange.
On the other hand deficit in current account arises when
debit items are more than credit items. It indicates net
outflow of foreign exchange.
In case of capital account, the transactions, which lead
to inflow of foreign exchange like receipt of loan from
abroad, sale of assets or shares in foreign countries are
recorded on the credit or positive side of capital account.
Similarly, transactions, which lead to outflow of foreign

exchange like repayment of loans, purchase of assets or
shares in foreign countries, are recorded on the debit or
negative side. The net value of credit and debit balances is
the balance on capital account. The surplus in capital
account arises when credit items are more than debit items.
It indicates net inflow of capital. On the other hand, the
deficit in capital account arises when debit items are more
than credit items. It indicates net outflow of capital, further
current account and capital account, there is one more
element in BOP, known as ‘Errors and Omissions’. It is the
balancing item, which reflects the inability to record all
international transactions accurately.
1.2.1.Current Account Deficit

The current account records exports and imports in
goods and services and transfer payments. It represents a
country’s transactions with the rest of the world and, like the
capital account, is a component of a country’s Balance of
Payments (BOP). There is a deficit in Current Account if the
value of the goods and services imported exceeds the value
of those exported.
Major components are: Goods, Services, and Net

earnings on overseas investments (such as interests and
dividend) and net transfer of payments over a period of time,
such as remittances. It is measured as a percentage of Gross
Domestic Product (GDP). The formulae for calculating
Current Account Balance is:
Current Account Balance = Trade gap + Net current
transfers + Net income abroad. Trade gap = Exports –
Imports
A country with rising CAD shows that it has become

uncompetitive, and investors may not be willing to invest
there. In India, the Current Account Deficit could be
reduced by boosting exports and curbing non-essential
imports such as gold, mobiles, and electronics. Current
Account Deficit and Fiscal Deficit (also known as "budget
deficit" is a situation when a nation's expenditure exceeds its
revenues) are together known as twin deficits and both often
reinforce each other, i.e., a high fiscal deficit leads to higher
CAD and vice versa.
According to the data released by the Reserve Bank of
India (RBI), the Current Account Deficit (CAD) of the
country came down to 2% of GDP in the first quarter of the
April 2019- June 2019 from 2.3% of GDP, reported during
the same period in the previous year (2018). According to
the RBI, the CAD declined on a year-on-year basis, because
of a number offactors such as:
a) Invisible Account: Higher invisible receipts at
$31.9 billion as compared with $29.9 billion a year ago. For
e.g., rise in net earnings from travel, financial services, and
telecommunications, computer and information services.
b)Trade Visible: Trade deficit has been lower recently,

due to lower crude oil prices and also due to the declining
demand. C) Rising Private transfers (Remittances).
1.2.2. Capital Account Deficit

A capital account deficit is a very infrequent
occurrence. It implies that there is a net outflow of
investment capital, as domestic institutions and individuals
increase their holdings of assets valued in foreign exchange.
China, the world’s largest export, experienced a temporary
capital account deficit of US $71.4 billion in the first quarter

of 2012-13. This is largely because of investors pulling out
short-term funds amid the global economic downturn.
Earlier, China ran massive surpluses on both accounts. This
was possible due to a high level of government intervention.
The influx of foreign funds put pressure on the yuan to
appreciate. To combat this pressure, the People’s Bank of
China bought up most of the foreign currency that entered
the country, leading to a swelling of the nation’s foreign
exchange reserves. This allowed it to maintain a surplus in
its capital account.
1.3.Balance of Payment: India
 Strong BoP: The BoP is going to be strong on the back

of significant improvement in exports and a fall in
imports. The exports in July 2020 is at about 91%
export level of July 2019 figures. Imports are still at
about 70-71% level as of July 2019.
 Trade Surplus in June 2020: India’s trade has turned

surplus for the first time in 18 years as imports dropped
by 47.59% in June 2020 as compared to June 2019. The
country posted a trade surplus of USD 0.79 billion in
June 2020.
 Domestic Manufacturing Being Boosted: The

government is taking steps to support and promote
domestic manufacturing and industry. It has increased
curbs on imports of products and parts, especially from
China, as part of its ‘Atmanirbhar' Initiative. The
government also reviewed all Free-Trade Agreements
(FTA) done between 2009 and 2011 and found most of
them to be asymmetrical. FTAs done earlier have

permitted foreign goods to come easily into the country.
But Indian goods have not been allowed reciprocal
entry. E.g. European countries have opposed technical
standards imposed by India on import of tyres, even as
they have restricted export of tyres from India.
 Change in Mode of Manufacturing: The government has

also asked firms investing in the country to stop having
an “assembly workshop” approach that has typically
characterisedIndian manufacturing.
Preliminary data released by the government showed
that India's trade deficit in goods widened to USD 14.11
billion in March 2021 from USD 9.98 billion during
March 2020. Merchandise Exports: India’s merchandise
exports in March 2021 were USD 34.0 billion as
compared to USD
21.49 billion in March 2020, an increase of 58.23%. For
the first time ever in a month, Indian exports crossed
USD 34 billion in March 2021. Merchandise Imports:
India’s merchandise imports were USD 48.12 billion as
compared to USD 31.47 billion in March 2020, an
increase of52.89%. India is thus a net importer in March
2021, with a trade deficit of USD 14.11 billion. Reasons
for Increased Imports: Relaxation in lockdown policy
and start of economic activities are the main reasons for
increase in demand for the goods and the import. Also
the rise in global trade has made the global supply chain
active and the commerce is taking place. Oil import has
increased due to opening up of the transportation
sector.
1.4.Equilibrium and Disequilibrium of Balance of

Payments
It has already been stated about that the balance of
payments must always balance. It will be balanced only
when the total of credit items will exactly be equal to the
total of debit items which really happens. As such, there
must be either a deficit or a surplus in the current account.
The deficit or surplus so created is met by transferring to
capital account.
Equilibrium is that state of the balance of payment over the
relevant time period which makes it possible to sustain an
open economy without severe unemployment on a
continuing basis. Whether the Balance of Payments is in
equilibrium or not, it can be justified with this help of the
three following test:
(i) Decrease in Foreign Exchange: If gold continuously
flows from the country, it may be assumed that the balance
of payments is in disequilibrium. At present the decrease in
foreign exchange reserves of our country indicate such a
situation.
(ii) Increase in Foreign Debts and Loans: If the amount of
foreign debts and loans increase, that indicates the balance
of payment of the country is in disequilibrium i.e., exports
are less than imports,
(iii) Decrease in Foreign Exchange Rates: If the foreign
exchange rates of a country decrease, it may be said that the
country is suffering from the disequilibrium in the balance
of payments position.
1.4.1. Causes of Disequilibrium of Balance of Payments

Disequilibrium in the balance of payments is a result of
many factors, e.g. the prices of goods and services, national
incomes at home or abroad, the rate of interest, the supply
of money, the state of technology, tastes, the distribution of
incomes etc. Now, if any of the above factors change
without a corresponding change in other factors there must
be a case of disequilibrium in the balance of payment
position. We know that the exports and imports of a country
are influenced by a number of factors. It is hardly possible
that equilibrium in balance of trade of a country is possible
at fixed exchange rate over a long period of time. The
balance of payments is quite disturbed by the factors which
affect and change imports and exports continuously. The
reasons for the cause of disequilibrium in the balance of
payments are noted below:
(a) Domestic Inflation: The greater bulk of balance of

payments difficulties are the result of domestic inflation and
the same can be corrected by disinflation i.e., eliminating
the inflationary gap and reducing demand to the level of
full employment. It is possible by increasing exports and
reducing imports. Similarly halting of inflation and
correction of exchange rate may also help in this regard.
(b) Technological Changes: It is quite known that every

change in technology brings some comparative advantages
which the other country tries to adjust, but the adjustment
process itself brings a deficit in balance of payments. Thus,
the innovation, whatever form it is, invites disequilibrium.
So, a new equilibrium requires either to reduce exports or to
increase imports.
(c) Short Supply: Disequilibrium of balance of payment

arises due to a fall in supply. For example, due to industrial
strike the sugar production of India fall which affect the
supply and as a result there is a corresponding shortfall in
exports and consequently increases the amount of imports which
is the result of disequilibrium.
(d) Fall in Demand or Structural Disequilibrium:

Disequilibrium also arises out of a fall in demand of the
export product. For example, if the demand of the Indian
jute product decreases in the world due to a change in taste
or what so ever, the resources which are engaged in jute
production must be shifted to other lines of activity. In such
a situation, we are to restrict our imports and our resources
must be diverted into another export line product. If the
same is not possible, there must be a structural
disequilibrium in balance of payment position.
(e) The deficit in current account due to the loss of
service incomes creates disequilibrium position which may
arise through the bankruptcy of direct investment abroad or
nationalization etc.
1.4.2. Methods of Correcting Disequilibrium in Balance

of Payments
In order to maintain a country’s sound economic condition,
its disequilibrium in balance of payment position (if any)
must be corrected. Naturally, the reasons for creating such a
situation must be removed. Otherwise if the situation
continues for a long, the country will exhaust its foreign
exchange reserves. If such a situation arises the country
concerned will have to depreciate its currency below par.
We describe here, certain measures to correct or improve
the adverse balance of payments position.
(a) Stimulating exports or to check imports: If there

is a declining trend in exports, various steps must be taken
to improve it. In other words, the total cost of the product
must be brought down to encourage export which may
require cutting down of wages and rate of interest etc.
Exports may be also encouraged by granting bounties to
exporters and to manufacturers also. Similarly, imports
must be discouraged by:
(i) Imposing import duty,
(ii) Prohibiting the product totally or
(iii) Adopting quota system,
(iv) Manufacturing the equivalent product within the
country etc.
(b) Depreciate the External Exchange value: by
depreciate the external (exchange) value of the home
currency brings domestic goods cheaper to the foreigner. It
must be remembered in this respect that the rate of exchange
serves as an equilibrating factor between the balance of
payments positions.
(c) To deflate the Currency: If our currency contracts,

no doubt, prices will fall which will check imports and
stimulate exports, although the method of deflation is not
even free from snags. Because, if the prices of the product are
forced to come down while the cost of the same is rigid, these two
do not follow suit. As a result, the country concerned may have to
face a serious depression as well as unemployment.
(d) Exchange Control: Under exchange control, all the

exporters are directed to surrender their foreign exchange to
the central bank or to sell it at the official rate to the

government. Then it is rationed out among the licensed
importers i.e., the government will allocate the scarce
foreign exchange among the importers on the basis of some
non-price criteria. No importer is allowed to import goods
without a license. In this way, the balance of payment is to
some extent rectified byreducing the imports.
(e) Devaluation:
The effect of devaluation is almost same like depreciation.
In other words, when a currency is devalued its values are
decreased in terms of foreign currency. It means, the
foreigners can buy more goods than before with the same
amount of currency which no doubt, stimulates exports and
check imports.
Since the imports are discouraged and exports are
encouraged, a time will come when the adverse balance of
payment will be corrected and will turn in our favour. From
the decision made so far, we can draw a conclusion about
the correction of adverse balance of payment position on the
basis of the judicious combination of the following:
(i) Adjustment of exchange rate (i.e.
appreciation/depreciation of the home currency).
(ii) Movement of Capital (i.e., lending/borrowing abroad).
(iii) Fiscal and Monetary changes that affect prices and

incomes.
(iv) Trade restrictions (quotas/tariffs).
Thus, in order to correct the adverse balance of payments no
single method is found suitable. We should try to implement

all the methods stated above although the application of the
factor depends on the nature and type of disequilibrium in
balance of payments, (e.g., exchange rate will play a
significant role in structural disequilibrium).
1.5. Balance of Payments adjustments: Absorption and

Monetary Approaches
1.5.1. Absorption Approaches in adjustment of Balance
of Payments
Sidney S. Alexander pioneered the development of the
absorption to BOP adjustment in his article, “The effects of
Devaluation on the Trade Balance” which appeared in
I.M.F. Staff paper, in the year 1952. The absorption
approach lies in seeing the BOP, not as a relation between
the country’s debits and credits on international account, but
rather as an element in the relation between the aggregate
receipts and expenditures of the economy. The theory
states that if a country has a deficit in its balance of
payments, it means that people are ‘absorbing’ more than
they produce. It implies that domestic expenditure on
consumption and investment is greater than national income.
On the other hand if they have a surplus in the balance of
payments, they are absorbing less. Expenditure on
consumption and investment is less than national income.
The absorption approach stresses the supply side and
implicitly assumes an adequate demand for the nation’s
exports and import substitutes. Here the BOP is defined as
the difference between national income and domestic
expenditure. The analysis can be explained in the following
form
Y = C + Id + G + X-M -------- (1)

Where Y is national income, C is consumption expenditure,
Id total domestic investment, G is autonomous government
expenditure, X represents exports and M imports.
The sum of (C + Id + G) is the total absorption designated

as A, and the balance of payments (X
– M) is designated as B. Thus Equation (1) becomes
Y = A + B Or B = Y – A ------ (2)
It implies that BOP on current account is the difference

between national income (Y) and total absorption (A). BOP
can be improved by either increasing domestic income or
reducing the absorption. For this purpose, Alexander
advocates devaluation because it acts both ways. First,
devaluation increases exports and reduces imports, thereby
increasing the national income. The additional income so
generated will further increase income via the multiplier
effect. This will lead to an increase in domestic
consumption. Thus the net effect of the increase in national
income on the balance of payments is the difference
between the total increase in income and the induced
increase in absorption, i.e.,
∆B = ∆Y – ∆A ---------------- (3)
Total absorption (∆A) depends on the marginal propensity
to absorb when there is devaluation. This is expressed as ‘a’.
Devaluation also directly affects absorption through the
change in income which we write as D. Thus
∆A = a∆Y + ∆D ----------------- (4)
Substituting equation (4) in (3), we get

∆B = ∆Y – a∆Y – ∆D or ∆B = (1 -a) ∆Y-∆D -------------- (5)
The equation points toward three factors which explain the

effects of devaluation on BOP. They are: (i) the marginal
propensity to absorb ‘a’, (ii) change in income (∆Y), and
change in direct absorption (∆D). It may be noted that since
‘a’ is the marginal propensity (MP) to absorb, (1 – a) is the
propensity to hoard or save. These factors, in turn, are
influenced by the existence of unemployed or idle resources
and fully employed resources in the devaluing country.
A depreciation or a devaluation of the deficit nation’s
currency automatically reduces domestic absorption if it
redistributes income from wages to profits (since profits
earners usually have a higher marginal propensity to save
than wage earners). In addition, the increase in domestic
prices resulting from the depreciation reduces the value of
the real cash balances that the public wants to hold. To
restore the value of real cash balances, the public must
reduce consumption expenditures. Finally, rising domestic
prices push people into higher tax brackets and also reduce
consumption. Since we cannot be certain as to the speed and
size of these automatic effects, contractionary fiscal and
monetary policies may have to be used to cut domestic
absorption adequately.
1.5.2.Monetary Approach in the Adjustment of Balance

of Payment
The monetary approach to the balance of payments is
associated with the names of R. Mundell and H. Johnson.
The other writers who have made contribution to it include
R. Dornbusch, M. Mussa, D. Kemp and J. Frankel. The
basic premise of the approach is the recognition that the

BOP disequilibrium is fundamentally a monetary
phenomenon. It attempts to explain the BOP deficits or
surpluses through demand for and supply of money.
Assumptions of Monetary Approach: This approach rests
upon the following main assumptions:
(i) There is the existence of a single price for identical

products in different countries, after allowing the
transport costs.
(ii) The level of output in a given country is exogenously
determined.
(iii) There is full employment of resources in all the
countries.
(iv) There is no possibility of sterilization of currency
flows under a system of fixed exchange rates on
account of single price assumption.
(v) The demand for money is a direct function of income
and an inverse function of therate of interest.
(vi) The supply of money is determined by the high
powered money and moneymultiplier.
(vii) The demand for nominal money balances is stable.
The monetary approach, given the above assumptions,

holds that the excess of money supply over money demand
reflects the balance of payments deficit. The excessive
money holdings are utilised by the people in the purchase of
foreign goods and securities. The excess supply of money
may be offset by the central bank under a system of fixed
exchange rates through the sale of foreign exchange reserves

and the purchase of domestic currency. As the excess supply
conditions in the money market are removed, the balance of
payments equilibrium gets restored. On the opposite, if the
supply of money falls short of the demand for money, the
country will have a balance of payments surplus. In such a
situation, people try to acquire the domestic- currency
through the sale of goods and securities to the foreigners.
For meeting the shortage of domestic currency, the central
bank will buy excess foreign currency in addition to the
purchase of domestic securities. Such measures will remove
the BOP surplus and restore the BOP equilibrium.
The monetary approach to BOP can be expressed through
the following relations: The supply of money (Ms) consists
of domestic component of the nation’s monetary base (H)
and international or foreign component of the nation’s
monetary base (F).
Ms = H + F
The demand for money (MD) is a stable and direct function
of income and inverse function of the rate of interest. The
monetary equilibrium is determined by the equality between
the demand for money and the supply of money.
MS = MD H + F = MDF = MD -H
From this relation, it follows that the excess of money

demand over the domestic monetary base is offset by an
inflow of reserves from abroad or international monetary
base in the event of a BOP surplus. On the opposite, if there
is a BOP deficit reflected by the excess of money supply
over money demand, the adjustment can be possible through
an outflow of foreign reserves. The monetary approach also

explains that the BOP disequilibria, under a flexible
exchange system, are corrected immediately through
automatic changes in exchange rate without any
international flow of money or reserves. A deficit in the
BOP resulting from the excess of money supply over money
demand, causes an automatic depreciation in country’s
currency. This leads to a rise in domestic prices and also the
demand for money. As a result, there is an absorption of the
excess supply of money and the BOP deficit gets adjusted.
On the other hand, a surplus in the BOP, caused by the

excess of demand for money over its supply, results
automatically in the appreciation of nation’s currency. It
leads to a fall in domestic prices. As a consequence, the
excess money demand and the BOP surplus get offset. The
monetary approach to the BOP situation has an important
policy implications. It suggests that the policies like
devaluation can have effectiveness in the short period only if
the monetary authority does not increase the supply of
money to match exactly the increase in the demand for
money resulting from devaluation or other adjustment
policies.
The main criticism of monetary approach is as follows:

(i) Stability of Money Demand Functions: This
approach, assumes the demand function of money to
be stable. Such an assumption may be valid in the
long run. But there is a strong opinion among the
economists that money demand function is unstable in
the short period.
(ii) Assumption of Full Employment: In this approach, an

assumption has been taken that there is the existence of
full employment. This assumption does not hold valid
in actual life.
(iii) Invalidity of Single Price: The monetary approach to
BOP adjustment rests upon the assumption of single
price for identical products. Even this assumption is
not true. When the productive factors are diverted to
sectors producing non-traded commodities, the excess
demand for non-traded goods can spill over into the
reduced supply of traded goods. That can cause an
increase in imports. Consequently, the principle of
single price for all traded goods stands violated.
(iv) Neglect of other Influences on Money Demand: In this
approach, the demand function for money is related
only to income and rate of interest. In fact, the money
demand function is related to several other variables
connected with both domestic economy and foreign
trade and exchange.
(v) Possibility of Sterilization of Currency: The critics have

not accepted the validity of the assumption of
impossibility of sterilization of currency under a system
of fixed exchange rates. They have referred to
circumstances in which the sterilization of currency can
become possible. In their opinion, the currency flow can
become sterile, if the private sector is willing to adjust
the composition of its wealth portfolio with regard to the
relative importance of bonds and money balances.
Another situation in which sterilization of currency flow
can be possible occurs if the government is prepared to
have higher budget deficits whenever the country has to
deal with the problem of BOP deficit.

(vi) Market Imperfections: The principle of single price for
identical products is vitiated by the market
imperfections. The price differentials between different
trading countries do exist on account of market
imperfections and various restrictions or regulations
enforced by the governments on the domestic and
international trade.
(vii)Neglect of Monetary Lags: The monetary approach is

conceptually suited to long term balance of payments
adjustment. The prolonged monetary lags between the
recognition of the problem of BOP deficit and ultimate
BOP adjustment have been generally neglected in this
approach.
(viii) Neglect of Other Economic Policies: In this
approach, the emphasis is essentially upon the variation
in credit flows. The BOP equilibrium can be achieved
also through the alternative economic policies of
expenditure switching which can work through domestic
real and money flows as well as the government
budgetary variations.
Despite its weaknesses, the monetary approach is superior to
the traditional price-specie flow theory of D. Hume. That
theory had stressed upon the BOP adjustments through the
gold flows and consequent effects upon prices, international
trade and payments. The modern monetary approach, in
contrast, suggests the correction of BOP deficits or surpluses
through changes in domestic and international monetary
base and their effects upon production, income and
expenditure.
1.6. Automatic, price and income adjustments

Here we integrate the automatic price, income, and
monetary adjustments (i.e., provide a synthesis of automatic
adjustments) for a nation that faces unemployment and a
deficit in its balance of payments at the equilibrium level of
income. The income adjustment mechanism relies on
induced changes in the national income of the deficit and
surplus nations to bring about adjustment in the balance of
payments. To isolate the income adjustment mechanism, we
initially assume that the nation operates under a fixed
exchange rate system and that all prices, wages, and interest
rates are constant. We also begin by assuming that the
nation operates at less than full employment.
Under a freely flexible exchange rate system and a
stable foreign exchange market, the nation’s currency will
depreciate until the deficit is entirely eliminated. Under a
managed float, the nation’s monetary authorities usually do
not allow the full depreciation required to eliminate the
deficit completely. Under a fixed exchange rate system, the
exchange rate can depreciate only within the narrow limits
allowed so that most of the balance-of-payments adjustment
must come from elsewhere. A depreciation (to the extent
that it is allowed) stimulates production and income in the
deficit nation and induces imports to rise, thus reducing part
of the original improvement in the trade balance resulting
from the depreciation.
Under a freely flexible exchange rate system, this
simply means that the depreciation required to eliminate a
balance-of-payments deficit is larger than if these automatic
income changes were not present. Except under a freely
flexible exchange rate system, a balance-of- payments
deficit tends to reduce the nation’s money supply, thus

increasing its interest rates. This, in turn, reduces domestic
investment and income in the deficit nation, which induces
its imports to fall and thereby reduces the deficit. The
increase in interest rates also attracts foreign capital, which
helps the nation finance the deficit. The reduction in income
and in the money supply also causes prices in the deficit
nation to fall relative to prices in the surplus nation, thus
further improving the balance of trade of the deficit nation.
Under a fixed exchange rate system, most of the automatic
adjustment would have to come from the monetary
adjustments unless the nation devalues its currency. On the
other hand, under a freely flexible exchange rate system, the
national economy is to a large extent supposed to be
insulated from balance-of-payments disequilibria, and most
of the adjustment in the balance of payments is supposed to
take place through exchange rate variations. When all of
these automatic price, income, and monetary adjustments
are allowed to operate, the adjustment to balance-of-
payments disequilibria is likely to be more or less complete
even under a fixed exchange rate system. The problem is
that automatic adjustments frequently have serious
disadvantages, which nations often try to avoid by the use of
adjustment policies.
In the real world, income, prices, interest rates,
exchange rates, the current account, and other variables
change as a result of an autonomous disturbance (such as
an increase in expenditures) in one nation, and a
disturbance in one nation affects other nations, with
repercussions back to the first nation. It is very difficult to
trace all of these effects in the real world because of the very
intricate relationships that exist among these variables and
also because, over time, other changes and disturbances
occur, and nations also adopt various policies to achieve

domestic and international objectives. With the advent of
large computers, large-scale models of the economy have
been constructed, and they have been used to estimate
foreign trade multipliers and the net effect on income,
prices, interest rates, exchange rates, current account, and
other variables that would result from an autonomous
change in expenditures in one nation or in the rest of the
world.
1.6.1. Disadvantages of Automatic Adjustments

The disadvantages facing a freely flexible exchange
rate system may be overshooting and erratic fluctuations in
exchange rates. These interfere with the flow of
international trade and impose costly adjustment burdens
that might be entirely unnecessary in the long run. Under a
managed floating exchange rate system, erratic exchange
rate fluctuations can be avoided, but monetary authorities
may manage the exchange rate so as to keep the domestic
currency undervalued to stimulate the domestic economy at
the expense of other nations. Such competitive depreciations
or devaluations (beggar-thy-neighbor policies) proved very
disruptive and damaging to international trade in the period
between the two world wars . On the other hand, the
possibility of a devaluation under a fixed exchange rate
system can lead to destabilizing international capital flows,
which can also prove very disruptive.
A fixed exchange rate system also forces a nation to
rely primarily on monetary adjustments. Automatic income
changes can also have serious disadvantages. For example, a
nation facing an autonomous increase in its imports at the
expense of domestic production would have to allow its
national income to fall in order to reduce its trade deficit.

A nation facing an autonomous increase in its exports
from a position of full employment would have to accept
domestic inflation to eliminate the trade surplus. Similarly,
for the automatic monetary adjustments to operate, the
nation must passively allow its money supply to change as a
result of balance-of-payments disequilibria and thus give up
its use of monetary policy to achieve the more important
objective of domestic full employment without inflation. For
all of these reasons, nations often will use adjustment
policies to correct balance-of-payments disequilibria instead
of relying on automatic mechanisms.
1.7. Mechanism of the Elasticity Approach to the

Balance of Payment Adjustment
1.7.1.Marshall-Lerner condition
The elasticity approach to BOP is associated with
the Marshall-Lerner condition which was worked out
independently by these two economists. It studies the
conditions under which exchange rate changes restore
equilibrium in BOP by devaluing a country’s currency. This
approach is related to the price effect of devaluation.
The Marshall-Lerner condition states that for a
devaluation of domestic currency to improve the balance of
payments, the sum of the price elasticities of demand for
exports and imports must be greater than one.
A fall in the exchange rate will increase the price of
imports in domestic currency which will lead to a decrease
in the quantity demanded. If the demand for imports is price
elastic, which means that the increase in the price will lead
to a larger proportionate decrease in the quantity demanded,

import expenditure will fall which will improve the balance
of trade. If the demand for imports is price inelastic, which
means that the increase in the price will lead to a smaller
proportionate decrease in the quantity demanded, import
expenditure will rise. However, this may not worsen the
balance of trade as export revenue will also rise. A fall in the
exchange rate will decrease the price of exports in foreign
currency which will lead to an increase in the quantity
demanded. As the price of exports in domestic currency will
not be affected by a fall in the exchange rate, an increase in
the quantity demanded will lead to an increase in export
revenue. Therefore, if the sum of the price elasticities of
demand for exports and imports is greater than one, which
means that the Marshall-Lerner condition holds, the increase
in export revenue will be greater than the increase in
import expenditure which will improve the balance of trade
resulting in an improvement in the current account and
hence the balance of payments, assuming export revenue is
equal to import expenditure initially. However, if the sum
of the price elasticities of demand for exports and imports is
less than one, which means that the Marshall-Lerner
condition does not hold, the increase in import expenditure
will be greater than the increase in export revenue which
will worsen the balance of trade resulting in a deterioration
in the current account and hence the balance of payments,
assuming export revenue is equal to import expenditure
initially.
1.7.2. The J-Curve Effect

The effects of devaluation on domestic prices and
demand for exports and imports will take time for
consumers and producers to adjust themselves to the new
situation. The short-run price elasticities of demand for

exports and imports are lower and they do not satisfy the
Marshall- Lerner condition. Therefore, to begin with,
devaluation makes the BOP worse in the short-run and then
improves it in the long-run. This traces a J-shaped curve
through time. This is known as the J-curve effect of
devaluation.
The J-Curve effect refers to a phenomenon wherein the
trade balance of a country worsens following the
depreciation of its currency before it improves. Generally,
any depreciation in the value of a currency is expected to
improve the economy’s overall trade balance by
encouraging exports and discouraging imports. However,
this may not happen immediately due to some other frictions
within the economy. Many importers and exporters in the
country, for instance, may be locked into binding
agreements that could force them to buy or sell a certain
number of goods despite the unfavourable exchange rate of
the currency.
The reason is that when the nation’s net trade balance
is plotted on the vertical axis and time is plotted on the
horizontal axis, the response of the trade balance to a
devaluation or depreciation looks like the curve of a J
(Figure 1.1). The figure assumes that the original trade
balance was zero. Time is taken on the horizontal axis and
deficit-surplus on the vertical axis. Starting from the origin
and a given trade balance, a devaluation or depreciation of
the nation’s currency will first result in a deterioration of the
nation’s trade balance before showing a net improvement
(after time A).
Figure 1.1: J-Curve Effect
1.8. Convertibility of currency

Prior to the First World War the whole world was
having gold standard under which the currency in circulation
was allowed to get converted either in gold or other
currencies based on the gold standard. But after the failure
of Bretton woods system in 1971 this system changed; the
various countries switched over to the floating foreign
exchange rate system. Under the floating or flexible
exchange rate system, exchange rates between different
national currencies are allowed to be determined through
market demand for and supply of the same. Presently
convertibility of money implies a system where a country’s
currency becomes convertible in foreign exchange and vice
versa.
Convertibility is an important factor in international

trade, where instruments valued in different currencies
must been changed. Currency convertibility refers to how
liquid a nation's currency is in terms of exchanging with
other global currencies. A convertible currency one that
can be easily traded on forex markets with little to no
restrictions. A convertible currency (e.g., U.S. dollar,
Euro, Japanese Yen, and the British pound) is seen as a
reliable store of value, meaning an investor will have no
trouble buying and selling the currency. Non-convertible
and blocked currencies (e.g. Cuban Pesos or North
Korean Won) are not easily exchanged for other monies
and are only used for domestic exchange with their
respective borders.
Advantages of Currency Convertibility

• Export promotion: An important advantage of currency
convertibility is that it encourages exports by increasing
their profitability. With convertibility profitability of
exports increases because market foreign exchange rate
is higher than the previous officially fixed exchange
rate. This implies that from given exports, exporters can
get more rupees against foreign exchange (e.g. US
dollars) earned from exports. Currency convertibility
especially encourages those exports which have low
import- intensity.
• Incentive to Import Substitution: Since free or market
determined exchange rate is higher than the previous
officially fixed exchange rate, imports become more
expensive after convertibility of a currency. This
discourages imports and gives boost to import
substitution.
• Incentive to send remittances from abroad: Thirdly,

rupee convertibility provided greater incentives to send
remittances of foreign exchange by Indian workers
living abroad and by NRI. Further, it makes illegal
remittance such ‘hawala money’ and smuggling of gold
less attractive.
• A self – Balancing Ability: Another important merit of
currency convertibility lies in its self-balancing
mechanism. When balance of payments is in deficit due
to overvalued exchange rate, under currency
convertibility, the currency of the country depreciates
which gives boost to exports by lowering their prices on
the one hand and discourages imports by raising their
prices on the other. In this way, deficit in balance of
payments get automatically corrected without
intervention by the Government or its Central bank.
The opposite happens when balance of payments is in
surplus due to the under-valued exchange rate.
• Integration of World Economy: Currency
convertibility gives the chance to any economy to
interact with the rest the world economy. As under
currency convertibility there is easy access to foreign
exchange, it greatly helps the growth of trade and
capital flows between the countries. The expansion in
trade and capital flows between countries will ensure
rapid economic growth in the economies of the world.
In fact, currency convertibility is said to be a
prerequisite for the success of Globalisation.
When looking at currency convertibility, there are three
different categories; fully convertible, partially convertible,
and non-convertible.
1.8.1. Fully Convertible

Currency that is fully or freely convertible can be traded
without any conditions or limits. Generally, fully convertible
currencies come from more stable or wealthy countries. All
major currencies (the US dollar, the euro, the Japanese yen,
pound sterling, and the Swiss franc), are fully convertible
currencies. In addition to the majors, there are a few minor
and exotic currencies that are freely convertible. The
Canadian dollar, Australian dollar, Danish krone, New
Zealand dollar, and Norwegian krone are all minor
currencies that are fully convertible. Examples of fully
convertible exotic currencies are; the Hong Kong dollar,
Indian rupee, and Bahraini dinar.
Merits of full currency convertibility

• The full currency convertibility will give the true
value of any currency against the foreign currencies.
If the market foreign exchange rate is higher than the
previous officially fixed exchange rate, the
profitability of domestic exports would increase.
• Higher market determined exchange rate would also
promote import substitution as imports would become
more expensive which would ultimately encourage
the domestic industries.
• Higher market determined exchange rate would
provide more incentives to the workers living abroad
and NRI to send remittances of foreign exchange. It
would make illegal remittances such as Hawala
money etc unattractive and the remittances would
take place through proper channel.
• Full currency convertibility provides a self balancing

mechanism. If a country is facing balance of payment
(BoP) deficit due to the overvalued exchange rate, full
currency convertibility would depreciate the exchange
rate which would ultimately boost exports and
discourage imports. This will allow the BoP to get
automatically corrected without the intervention of the
central bank. The opposite would happen in the case of
surplus BoP due to the undervalued exchange rate.
• It would lead to greater integration of the domestic
economy with the global economy. It would also allow
Indians to invest globally, and hold an internationally
diversified investment portfolio.
Demerits of full convertibility of rupee

• It leads to the appreciation of domestic currency which
can cause a reduction in the exports overseas.
Appreciation of rupee would also increase imports
which can have negative impacts on the balance of
payment deficit.
• It may also lead to the depreciation of domestic
currency which would ultimately increase the prices of
imports. Imports like oil etc cannot be substituted for
domestic production which could ultimately intensify
the inflationary pressures.
• It would lead to the exchange rate of domestic currency
being based on the market forces of demand and
supply. This can strengthen the speculative tendencies
in the market which could lead to instability in the
financial system.
1.8.2. Partially Convertible

A partially convertible currency is a currency that can be
traded only with restrictions and controls imposed by the
government that issues it. In general, partially convertible
currencies come from countries with less stable economies.
An increase in the price of foreign imports or a capital
flight on currency reserves could easily destabilize an
already fragile economy. Therefore, limits are imposed –
thus making a currency partially convertible. All partially
convertible currencies are exotic currencies. Some
examples include; the Chinese yuan, South African rand,
and Malaysian ringgit.
Rules to exchanging partially convertible currencies vary –

some countries impose restrictions on where you can take
the money (for example, Indonesian rupiahs must stay on-
shore), others can only be converted in-country (like
Philippine pesos). In many cases, documented proof is
required either to show foreign currency buying is for a
legitimate reason or have foreign exchange transactions
registered with the central bank. Other common restrictions
are limits on how much foreign currency you can have and
how much domestic currency you can take out of the
country.
1.8.3. Non-Convertible
Non-convertible currencies or “blocked currencies” are, as
the name suggests, not at all traded on the foreign exchange
market. Currency is blocked by the issuing government,
usually to protect the country’s extremely fragile economy.
The only way to exchange non-convertible currency is on
the black market, making business in countries with non-
convertible currency both risky and difficult. Often, non-

convertible currencies are exotic. An example of a blocked
currency is the Venezuelan bolívar.
1.9.Current Account and Capital Account Convertibility
1.9.1. Current Account Convertibility

Current account convertibility refers to the freedom in
payments and transfers in the current account international
transactions. Article VIII, section 2, section 3 and section 4
of the International Monetary Fund (IMF) puts an
obligation on the member countries for restoring the current
account convertibility of their currencies. It puts obligation
for removing the restrictions on current payments, avoiding
any kind of discriminatory currency practices such as
multiple exchange rates etc. However, capital account
restrictions are allowed.
Current account convertibility is the next phase for
attaining full convertibility of any currency. Current
account convertibility relates to the removal of restrictions
on payments relating to the international exchange of goals,
services and factor incomes, while capital account
convertibility refers to a similar liberalization of a country’s
capital transactions such as loans and investment, both
short term and long term. Current account convertibility
has been defined as the freedom to buy or sell foreign
exchange for the following international transactions:
2. All payments due in connection with foreign trade,
other current business, including services and normal
short term banking and credit facilities;
3. Payments due as interest on loans and as net income
from other investments;

4. Payments of moderate amount of amortization of
loans or for depreciation of direct investment; and
5. Moderate remittances for family living expenses.
1.9.2. Capital Account Convertibility

Capital account convertibility refers to a liberalization of
a country’s capital transactions such as loans and
investment, both short term and long term as well as
speculative capital flows.
In a way, capital account convertibility removes all the
restrains on international flows on countries capital account.
There is a basic difference between current account
convertibility and capital account convertibility. In the case
of current account convertibility, it is important to have a
transaction – importing and exporting of goods, buying and
selling of services, inward or outward remittances, etc.
involving payment or receipt of one currency against
another currency. In the case of capital account
convertibility, a currency can be converted into any other
currency without any transaction.
The Benefits of Capital Account Convertibility

The Tarapore Committee mentioned the following
benefits of capital account convertibility to India:
1. Availability of large funds to supplement domestic
resources and thereby promoteeconomic growth.
2. Improved access to international financial markets and

reduction in cost of capital.
3. Incentive for people to acquire and hold international

securities and assets, and
4. Improvement of the financial system in the context of
global competition.
5. Freedom to convert local financial assets into

foreign ones at market-determinedexchange rates
6. Leads to free exchange of currency at lower rates and
an unrestricted mobility of capital
1.9.2. Convertibility of Currency in India

In India, after the economic reforms of 1991, the rupee was
made partially convertible under the liberalised exchange
rate management scheme from March 1992 onwards. Under
this scheme, 60% of all receipts on current account was to
be freely converted into rupees whereas 40% was on the
basis of official exchange rate fixed by the RBI. India
acquired the article VIII status of IMF in 1994.
The 40% of fixed exchange rate convertibility was meant
for fulfilling the government's exclusive requirements for
the import of essential commodities. In March 1993, the
foreign exchange budget was abolished and the exchange
rate was unified, and transactions on the trade account were
made free from the exchange control. The exchange rate of
rupee was now left to be determined by the market forces of
demand and supply.
In August 1994 rupee was made fully convertible on the
current account. In January 1997, the RBI announced some
major relaxation in the currency exchange control. The RBI
removed the monetary ceilings prescribed for remittances of
foreign exchange for various purposes. The authorised

dealers could not allow remittances without having to take
prior clearance from the Reserve Bank of India.
Indian rupee is now fully convertible in any foreign
currency for the current account transactions. However,
some restrictions from the Foreign Exchange Management
Act, 1999 (FEMA) is still applicable. These restrictions
include non-convertibility for activities such as betting,
gambling and on prohibited items. Different limits have
been imposed on convertibility in the current account for
traveling to other countries, sending gifts, educational
purposes, employment, and medical treatment etc.
Capital account convertibility-India

Full capital account convertibility of Indian rupee was not
introduced because the prevailing conditions were not in its
favour as India was facing a large current account deficit.
The government wanted to ensure the availability of foreign
exchange at lower prices for the input of essential goods and
commodities. India adopted a cautious approach in the full
capital account convertibility of rupee in the view of the
Mexican crisis. The subsequent East Asian crisis justified
the approach of partial capital account convertibility. Earlier
also partial capital account convertibility was allowed under
certain conditions.
Complete capital account convertibility can increase the
inflow of capital in the country but if the conditions become
unfavourable there is a great risk of the outflow of capital
from the home country. This can lead to higher volatility in
the exchange rates and can even create a crisis like situation
as happened during the East Asian crisis.
Current Status of Capital Account Convertibility
 Capital account convertibility exists for foreign investors

and Non-Resident Indians (NRIs) for undertaking direct
and portfolio investment in India.
 Indian investment abroad up to US $ 4 million is eligible

for automatic approval by the RBI subject to certain
conditions.
 In September 1995, the RBI appointed a special

committee to process all applications involving Indian
direct foreign investment abroad beyond US $ 4 million
or those not qualifying for fast track clearance.
Tarapore committee on capital account convertibility

In 1997, RBI appointed a committee on the capital account
convertibility under the chairmanship of Mr. S.S. Tarapore,
the former Deputy Governor of The Reserve Bank of India.
As per the committee, capital account convertibility refers to
the freedom to convert the foreign financial assets with the
local financial assets and vice versa at the exchange rate
determined by the market forces of demand and supply. The
ultimate aim of capital account convertibility is to allow
foreign investors to easily move in and move out of the
Indian market and to make it clear to the foreign investors
that India has sufficient Foreign Exchange Reserves for
meeting any outflow of capital from India to any extent.
Full capital account convertibility would ensure availability
of large funds for promoting the economic growth of India.
It would provide the Indian economy easy access to the
international financial markets and can reduce the cost of
capital. It would incentivize the Indian investors for
acquiring the international assets and securities which would

ultimately improve India s position in the global
competition.
Conditions to be fulfilled before full capital account

convertibility
Tarapore committee gave the following conditions to be
fulfilled before adopting full capital account convertibility
in India.
 The government should reduce the fiscal deficit to 3.5

percent of the GDP. The committee recommended for
setting up the Consolidated Sinking Fund (CSF) for the
reduction of government debt.
 It recommended for mandated inflation targeting between

3% to 5%. The RBI was to be given full freedom for
using monetary policy tools for achieving this inflation
target.
 The committee recommended for strengthening the

financial sector by deregulating the interest rates,
reducing the non-performing assets to 5 , and the cash
reserve ratio to 3%. It recommended for either the
liquidation of weak banks or their merger with other
strongbanks.
 The current account deficit should be brought down to

manageable limits and the debt service ratio to be
reduced to 20 % from the present 25% of the export
earnings.
 The Reserve Bank of India should have the exchange rate

band of 5 of the real effective exchange rate. The RBI
should intervene in the exchange rate market only when

the real effective exchange rate is outside this band.
 To have adequate foreign exchange reserves in the range

between $22 billion and $32 billion for meeting the
import and debt service payments.
 The restrictions on the movement of gold need to be

removed completely by the government.
Features under full capital account convertibility

proposed by the Tarapore committee
 The Indian corporate sector to be allowed to issue the

foreign currency denominated bonds to the domestic
investors, to issue the Global depository receipts, to
invest in such securities and deposits, and to go for
external commercial borrowings with certain limitations
without the approval of the Reserve Bank of India.
 Allowing Indian residents to have foreign currency

denominated deposits with Indian banks, allowing capital
transfer to other countries with certain limitations etc.
 To allow the Indian banks to borrow from the foreign

markets for short term and long term within certain
limits, to accept and extend loans denominated in any
foreign currency, and allowing them to invest in the
foreign money markets etc.
 All India Financial Institutions which fulfill the specified

prudential and regulatory requirements would be allowed
to participate in the forex market with the authorized
dealers.
 The banks and financial Institutions which would be

allowed to participate in the international markets would
also be allowed to freely purchase and sell gold and offer
thegold denominated deposits and loans.
The committee had given a period of 3 years to achieve
targets like current account convertibility etc which was too
short to meet the preconditions and the macroeconomic
indicators. Further, thepolitical instability and the East Asian
financial crisis did not allow the recommendations of the
Tarapore committee to be implemented completely at that
time.
Second Tarapore committee

In 2006, the RBI constituted the second Tarapore committee
on the fuller capital account convertibility. The committee
submitted its report in September 2006 and had drawn
roadmap for 2011 for full capital convertibility of Indian
rupee. At that time, Indian economy was having certain
strong fundamentals such as forex reserves of $165 billion,
liberalised foreign exchange system, a prudent financial
system for dealing with external capital flows etc.
However, certain economic events such as the global
financial crisis of 2007-09 etc could not allow the RBI to
go for full capital account convertibility. The partial
capital account convertibility had helped India to cope up
with the extreme capital outflows which could have taken
place during 2008-09.
In 2015, former deputy governor of the RBI, HR Khan had
said that India is not yet ready for full capital account
convertibility of rupee. This is because the Indian economy
is expanding and it needs stability on the external front.
According to him, India needs an eclectic combination of

some capital account openness and some flexibility in the
exchange rate.
However, the former RBI governor Raghuram Rajan in
April 2015, had said that India may have full capital account
convertibility in a short number of years. Therefore, it is
expected that India would gradually move towards full
capital account convertibility depending upon the
macroeconomic indicators of the economy.
1.10. Foreign Exchange Management Act (FEMA), 1999

It is a set of regulations that empowers the Reserve Bank of
India to pass regulations and enables the Government of
India to pass rules relating to foreign exchange in tune with
the foreign trade policy of India. FEMA replaced an act
called Foreign Exchange Regulation Act (FERA). FERA
(Foreign Exchange Regulation Act) legislation was passed
in 1973. It came into effect on January 1, 1974. FERA was
passed to regulate the financial transactions concerning
foreign exchange and securities. FERA was introduced
when the Forex reserves of the country were very low.
FERA did not comply with the post-liberalization policies of
the Government. The main change brought in FEMA
compared to FERA is it made all the criminal offences as
civil offences.
The legal framework for the administration of foreign
exchange transactions in India is provided by the Foreign
Exchange Management Act, 1999. Under the FEMA, which
came into force with effect from 1st June 2000, all
transactions involving foreign exchange have been classified
eitheras capital or current account transactions.
 Current Account Transactions: All transactions

undertaken by a resident that do not alter his / her assets
or liabilities, including contingent liabilities, outside India
are current account transactions. Example: payment in
connection with foreign trade, expenses in connection
with foreign travel, education etc.
 Capital Account Transactions: It includes those

transactions which are undertaken by a resident of India
such that his/her assets or liabilities outside India are
altered (either increased or decreased). Example:
investment in foreign securities, acquisition of
immovable property outside India etc.
Resident Indians: A 'person resident in India' is defined in
Section 2(v) of FEMA, 1999 as : Barring few exceptions, a
person residing in India for more than 182 days during the
course of the preceding financial year. Any person or body
corporate registered or incorporated in India.
An office, branch or agency in India owned or controlled
by a person resident outside India. An office, branch or
agency outside India owned or controlled by a person
resident in India.
Main Features of Foreign Exchange Management Act, 1999
 It gives powers to the Central Government to regulate

the flow of payments to and from a person situated
outside the country.
 All financial transactions concerning foreign securities

or exchange cannot be carried out without the approval
of FEMA. All transactions must be carried out through
“Authorised Persons.”
 In the general interest of the public, the Government of

India can restrict an authorized individual from carrying
out foreign exchange deals within the current account.
 Empowers RBI to place restrictions on transactions from

capital Account even if it is carried out via an authorized
individual.
As per this act, Indians residing in India, have the
permission to conduct a foreign exchange, foreign
security transactions or the right to hold or own
immovable property in a foreign country in case
security, property, or currency was acquired, or owned
when the individual was based outside of the country, or
when they inherit the property from individual staying
outside the country.
Foreign Exchange Foreign Exchange

Regulation Act Management Act (FEMA)
(FERA)
Parliament of India Parliament of India enacted
passed the Foreign the Foreign Exchange
Exchange Regulation
Management Act (FEMA) on
Act in1973 29 December 1999 replacing
FERA.
FERA came into force FEMA came into force from
from January June 2000.
1, 1974.
FERA was repealed FEMA succeeded FERA
in 1998 by
Vajpayee Government
FERA has 81 sections FEMA has 49 sections
FERA was conceived FEMA was conceived with

with the notionthat the notion that Foreign
Foreign Exchange is a Exchange is an asset.
scarce resource.
FERA rules regulated FEMA focused on increasing
foreign payments. the foreign exchange reserves
of India, focused on
promoting foreign payments
and foreign trade.
The objective of The objective of FEMA is
FERA was Management of Foreign
conservation of Foreign Exchange
Exchange
The definition of The definition of “Authorized
“Authorized Person” Person” was widened
was narrow.
Banking units did not Banking units came under
come under the the definition of Authorized
definition of Authorized Person.
Person.
If there was a If there was a violation of
violation of FERA FEMA rules, then it is
rules, then it was considered as civil offence
considered asCriminal
offence.
A person accused of A person accused of FEMA
FERA violation was not violation will be provided
provided legal help. legal help.
There was no provision There is provision for Special
for Tribunal, the appeals Director (Appeals) and Special
were sent to High Courts Tribunal
For those guilty of For those guilty of violating

violating FERA rules, FEMA rules, they have to pay
there was provision for a fine, starting from the date of
direct punishment. conviction, if the penalty is
not paid within 90 days, then
the guilty will be imprisoned.
If there was a need for For External trade and

transferring of funds for remittances, there is no need
external operations, then for prior approval from the
prior approval of the Reserve Bank of India (RBI).
Reserve Bank of India
(RBI) is required.
There was no provision There is provision for IT

for IT
Module II
Exchange Rate and Theories of
Exchange Rate
2.1. Foreign Exchange Reserves

Foreign exchange reserves are the foreign currencies held
by a country’s central bank. They are also called foreign
currency reserves or foreign reserves. One of the most
important reasons for holding reserves is to manage the
currency’s value.
Foreign Exchange reserves consist of:
 Foreign Currency Assets
 Gold
 Special Drawing Rights (SDR) holdings of the government
 Reserve Tranche
Foreign Currency Assets (FCAs)
The currencies of various countries held in foreign
exchange reserve are called foreign currency assets. For
example, reserves held in US Dollars, Euro, Japanese Yen,
etc. Apart from currencies, it includes foreign bank
deposits, foreign treasury bills and short term and long term
foreign government securities. The deposit agreements with
IMF trust is also a part of FCAs and are readily available to
meet a BOP financing need.
Gold
The RBI uses its gold stock as a back up to issue currency
and meet the unexpected Balance of Payment problems.
Special Drawing Rights (SDRs)

The SDR is an international reserve asset, created by the
IMF in 1969 to supplement its member countries’ official
reserves, and help countries meet Balance of Payment
problem. The member countries contribute to this account to
avail this benefit. The contribution is in proportion of their
IMF quota (membership fee). SDRs can be exchanged for
freely usable currencies. The value of the SDR is based on a
basket of five major currencies – the US dollar, the euro, the
Chinese renminbi (RMB), the Japanese yen, and the British
pound sterling. The SDR is neither a currency, nor a claim
on the IMF. Rather, it is a potential claim on the freely
usable currencies of IMF members. Holders of SDRs can
obtain these currencies in exchange for their SDRs in two
ways:
1. Through the arrangement of voluntary exchanges between
members
2. By the IMF, designating members with strong external
positions, to purchase SDRs from members with weak
external positions.
Reserve Tranche
It is the proportion of the required quota of currency that
each IMF member country must provide to the IMF, but can
designate for its own use. The reserve tranche portion of the
quota can be accessed by the member nation at any time,
whereas the rest of the member’s quota is typically

inaccessible. If any money was lent over and above the
quota to the IMF’s General Resource Account, it becomes
part of Reserve Tranche.
2.2. Exchange Rate

The price of one currency in terms of the other is known as
the exchange rate. A currency’s exchange rate vis-a-vis
another currency reflects the relative demand among the
holders of the two currencies. For e.g. If the US dollar is
stronger than the rupee (implying value of dollar is higher
with respect to rupee), then it shows that the demand for
dollars (by those holding rupee) is more than the demand for
rupees (by those holding dollars). This demand in turn
depends on the relative demand for the goods and services
of the two countries. Foreign Exchange Rate is the amount
of domestic currency that must be paid in order to get a unit
of foreign currency. According to Purchasing Power Parity
theory, the foreign exchange rate is determined by the
relative purchasing powers of the two currencies. Example:
If a Mac Donald Burger costs $20 in the USA and Re 100 in
India, then the exchange rate between India and the USA
will be (100/20=5), 1 $ = 5 Re.
2.2.1. Forces Behind Exchange Rate Determination

Foreign Exchange is a price of one country’s currency in
relation to other country’s currency, which like the price of
any other commodity is determined by the demand and
supply factors. The demand and supply of the foreign
exchange rate come from the residents of the respective
countries.
Demand for Foreign Supply of Foreign

Exchange (Foreign Money Exchange (Foreign Money
goes out) Comes in)
Foreign Currency is needed The source of foreign

to carry out transactions in currency available to the
foreign countries or for the domestic country are
purchase of foreign goods foreigners purchasing our
and services (IMPORTS). goods and services
(Exports).
Foreign currency is needed Foreigners investing in

to invest in foreign country Indian Stock markets,
assets/shares/bonds etc. Assets, Bonds etc. (FPIs
and FDIs)
Foreign currency is needed Transfer payments.

to make transfer payments. Example: Indianworking
Example: Indian Parents in the USA, sending
sending Money to his/her money to his/her old aged
son/daughter studying in the parents.
USA.
Indians holding money in Foreigners holding assets in Indian

overseas Banks Banks.
Indians Travelling abroad for Foreigners travelling to

Tourism Purpose. India.
The DD curve represents the demand for foreign exchange

by India. The SS curve represents the supply of foreign
exchange to India. The point where both DD and SS curves
intersect is the point of equilibrium. At this point demand
for foreign exchange is exactly equal to the supply of
foreign exchange. At equilibrium point E0, the exchange
rate is 1 $ equal to 5 Re.
In normal day to day functioning of markets, the exchange
rate may fluctuate. If at any point in time, the exchange rate
is at E1(1$=15Re), then the demand for foreign exchange
falls short of supply of foreign exchange, as a result at this
point Indians are demanding less foreign currency due to
which Re will appreciate vis-a-vis foreign currency. The
appreciation mainly occurs due to a favourable balance of
payment situation (Surplus). Both the points, E1 and E2
(upward and downward movements) shown depreciation as
per the diagram.
By the same token at point E2, demand for foreign exchange

is greater than the supply of foreign exchange, at this point
Indians are demanding excess foreign exchange than what
the foreigners are willing to supply, as a result, at E2 Re will
depreciate vis-à-vis foreign currency. The depreciation
mainly occurs due to the unfavourable balance of payments
situation (Deficits).
2.2.2. Nominal Exchange Rate
 Nominal exchange rate means a rate by which you can

exchange your domestic currency with the foreign
currency at any financial institutions like banks, NBFCs
etc.
 It is the value of money which is received in an exchange

with another currency.
 So in short, the nominal exchange rate is the rate

which is presented by the financialinstitutions.
 If the Nominal exchange rate is high it will benefit

an economy a lot in the tradingactivities.
 If it is high, the goods and services get more foreign units
 If there is a change in the Exchange rate, Nominal

Exchange rate is less affected as compared to the Real
exchange rate.
2.2.3. Real Exchange Rate
 The real exchange rate is a rate which measures

how many times an item of goods purchased locally
can be purchased abroad.
 So, it indicates the ratio of items purchased in the

domestic market to the items purchased in the foreign
market.
 Real exchange rate actually determines the ratio of

price in the local market to the price in the foreign
market.
 So, it indicates the goods and services consumed as

compared to another country.
 It is complex and also a difficult method to calculate the

real exchange rate, thus it measures the purchasing
power of domestic currency to the foreign currency at a
prevailing time.
 Real exchange rate is highly affected by the change in

the exchange rate in the global market.
2.2.4. Effective Exchange Rate
 Effective exchange rates compare a country’s currency

to a basket of other countries’ currencies.
 The most common way to identify the basket of

currencies is to consider a country’s major trade
partners. In this case, the effective exchange rate is
called the trade-weighted index because the weights
attached to other countries’ currencies reflect the
relevance of the home country’s trade with these
countries.
 It measures the value of the domestic currency against

the weighted value of a basket of foreign currencies,
where the weights reflect the foreign countries’ share in
the domestic country’s trade. Therefore, you use the

effective exchange rate if you’re interested in the
domestic currency’s performance compared to the
country’s most important trade partners.
 It is usually expressed as an index number out of 100.

An increase in the effective exchange rate indicates a
strengthening of the home currency with respect to
other currencies considered in its calculation.
Conversely, a decline in the effective exchange rate
means a weakening of the home currency.
2.2.5. NEER (Nominal Effective Exchange Rate)

The nominal effective exchange rate (NEER) is an
unadjusted weighted average rate at which one country’s
currency exchanges for a basket of multiple foreign
currencies. The nominal exchange rate is the amount of
domestic currency needed to purchase foreign currency.
In economics, the NEER is an indicator of a country’s
international competitiveness in terms of the foreign
exchange (forex) market. Forex traders sometimes refer to
the NEER as the trade- weighted currency index.
The NEER may be adjusted to compensate for the inflation
rate of the home country relative to the inflation rate of its
trading partners. The resulting figure is the real effective
exchange rate (REER). Unlike the relationships in a
nominal exchange rate, NEER is not determined for each
currency separately. Instead, one individual number,
typically an index, expresses how a domestic currency’s
value compares against multiple foreign currencies at once.
NEER = Domestic currency exchange rate in terms of
SDR/Foreign currency exchange rate in terms of SDR.
How to calculate NEER?

The Nominal Effective Exchange Rate can be calculated
from the following formula:
2.2.6. Real Effective Exchange Rate (REER)
 The real effective exchange rate (REER) is the weighted

average of a country’s currency in relation to an index
or basket of other major currencies, adjusted for the
effects of inflation. The weights are determined by
comparing the relative trade balance of a country’s
currency against each country within the index.
 This exchange rate is used to determine an individual

country’s currency value relative to the other major
currencies in the index.
 REER is determined from NEER after correcting it for

price change. „ REER = NEER × (Domestic Price
Index/Foreign Price Index).
The formula used for calculating REER is mentioned

below:
How to calculate REER?

A country’s REER can be derived by taking the average of
the bilateral exchange rates between itself and its trading
partners and then weighing it using the trade allocation of
each partner. The average of the exchange rates is
calculated after assigning the weightings for each rate. For
example, if a currency had a 60% weighting, the exchange
rate would be raised to the power by
0.60 and do the same for each exchange rate and its
respective weighting. Multiply each exchange rate in step 2
by each other and multiply the final result by 100 to create
the scale or index. Some calculations use bilateral exchange
rates while other models use real exchange rates, which
adjusts the exchange rate for inflation. Regardless of the
way in which REER is calculated, it is an average and
considered in equilibrium when it is overvalued in relation

to one trading partner and undervalued in relation to a
second partner.
2.3. Exchange Rate Regime

Exchange rate regime refers to the ‘way’ the value of the
domestic currency in terms of foreign currencies is
determined. It is closely related to monetary policy and the
two are generally dependent on many of the same factor.
Exchange rate regimes can broadly be categorized into two
extremes, namely fixed and floating. Foreign Exchange: It
refers to money denominated in a currency other than the
domestic currency. Exchange Rate: Like any other
commodity, foreign exchange has a price. The exchange
rate is the price of one currency in terms of another. For
example, if the exchange rate between the rupee and the US
dollar (USD) is Rs. 65, this means that Rs. 65 is required to
purchase 1 Dollar.
2.3.1. Fixed/Pegged Exchange Rate Regime

In a fixed exchange rate regime, the domestic currency
is tied to another foreign currency such as the U.S.
dollar, Euro, the Pound Sterling or a basket of
currencies.
In a fixed exchange rate system, the government
(or the central bank acting on the government’s behalf)
intervenes in the foreign exchange market to ensure that
the exchange rate stays close to a predetermined target.
Under this system, exchange rate stability is achieved,
but if the exchange rate is fixed at the wrong rate it may
be at the expense of domestic economic stability.
In a fixed exchange rate system, a rise in the exchange

rate of the domestic currency vis- à-vis another foreign
currency is called a devaluation. This means that in
order to buy 1 unit of a given foreign currency more of
the domestic currency is needed. On the other hand,
when the exchange rate falls it is termed as a
revaluation.
Fixed rates provide greater certainty for exporters and
importers as there are no or limited exchange rate risks.
However, a significant gap between the official rate and
that determined by the market can promote black
markets. In a black market, the bulk of foreign exchange
transactions are carried out outside the banking system.
This may force the government to draw down on
reserves to meet its obligations and cause scarcity of
foreign exchange.
The fixed or pegged rate of exchange can be shown

through Fig. (a) and (b), the amount of foreign
currency is measured along the horizontal scale and
the rate of exchange is measured along the vertical
scale. In Fig.(a), the equilibrium fixed official
rate of exchange is R0 determined by the intersection
between the demand and supply function D and S
respectively. If the demand for foreign currency
increases such that the demand function shifts from D
to D1, given the exchange rate, there is excess demand
gap which is likely to appreciate the exchange value of
foreign currency in terms of domestic currency to R1
or cause corresponding depreciation in the exchange
value of domestic currency.
It is possible for the government or monetary authority
of the home country to fill up the foreign exchange gap

AB in any of three possible ways:
Reduction in the foreign exchange reserves built
through BOP surplus in past years (which implies sale
of foreign exchange),
Borrowing of short-term funds externally as
accommodating transactions, and
Export of monetary gold.
The resort to any one of the measures will help
maintain the exchange rate at the official level rate of
exchange R0.
In Fig. (b), the fixed official rate of exchange is again R 0. If

there is an increase in the supply of foreign currency due to
BOP surplus, the supply curve shifts to the right from S to
S1. This creates an excess supply gap A1B1. Consequently,
the exchange value of foreign currency in terms of domestic
currency depreciates to R2 or there is a corresponding
appreciation in the exchange value of domestic currency.
In order to maintain the exchange rate at the official level

R0, the government or monetary authority will be obliged to
buy the foreign currency in the exchange market. Thus in a
system of fixed exchange rates, the pegging operations (sale
or purchase of foreign currency) can help maintain the
equilibrium rate of exchange at the official level.
Merits of Fixed Exchange Rate System

Fixed exchange rate prevents the member countries
from the economic fluctuation which can weaken the
economic policies.
It promotes capital movements. Fixed exchange rate
system attracts foreign capital because a stable
currency does not involve any uncertainties about
exchange rate that may cause capital loss.
Reduce the Uncertainty and Risk
Discourage Speculation
Prevention in Depreciation of Currency
Adoption of Responsible Macroeconomic Policies
Attraction of Foreign Investment
Anti-inflationary
Demerits of Fixed Exchange Rate System

It creates a barrier on achieving the objective of free
markets.
Under this system, countries with deficits in balance
of payment uses their stock of gold and foreign
currencies to solve the problem. This can further
create serious problem for them. They may be forced
to devalue their currency. On the other hand, countries
with surplus in balance of payments will face the
problem of inflation.
Speculation Encouraged
inadequacy of Foreign Exchange Reserves
Internal Objectives of Growth and Full Employment

Sacrificed
International Competitive Environment bypassed
2.3.2. Floating Exchange Rate System

It is an exchange rate system in which market’s
supply and demand of currencies determines the
exchange rate.
The exchange rate is allowed to vary to international

foreign exchange market influences. Thus, government
does not intervene.
Automatic variations in exchange rates consequent
upon a change in market forces are the essence of
freely fluctuating exchange rates.
A deficit in the BOP account means an excess supply

of the domestic currency in the world markets. As
price declines, imbalances are removed. In other
words, excess supply of domestic currency will
automatically cause a fall in the exchange rate and
BOP balance will be restored.
There is no pre-determined exchange rate target of the
government or the Central Bank.
The Central Bank (RBI) or government can indirectly

influence the exchange rate by managing the level and
volume of foreign and domestic currencies in the
banking system.
Under a floating exchange rate system, a rise in the
exchange rate of the domestic currency vis-a-vis
another foreign currency is called depreciation. This
means that more rupees are required to buy one unit
of foreign currency.
On the other hand, appreciation is the fall in the
exchange rate of the domestic currency vis-a-vis
another foreign currency. This means that fewer
rupees are required to buy one unit of foreign
currency.
In Figs. (a) and (b), the amount of foreign currency is

measured along the horizontal scale and rate of exchange is
measured along the vertical scale. In Fig. (a), given the
demand and supply functions of foreign currency D and S,
the initial equilibrium rate of exchange is R0. If demand
increases and demand function shifts to the right to D 1,
there is excess demand for foreign currency at R0 rate of
exchange. The excess demand pressure causes an
appreciation of foreign currency to R1 (depreciation of
home currency).
In Fig. (b), the original equilibrium rate of exchange is R0.

If there is an increase in supply of foreign currency, the
supply function shifts to the right to S1 causing depreciation
in foreign currency R1 (appreciation of home currency). On
the opposite, a decrease in supply causes a shift in the
supply function to the left to S2. There is shortage of the
foreign currency at the original rate. It leads to an
appreciation of foreign exchange upto R2 (depreciation of
home currency). With the change in economic conditions
underlying demand and supply, the exchange rate will
automatically change without any intervention by the
Government. That is why, it is called floating or variable
exchange rate system.
Merits of Flexible Exchange Rate System

It eliminates the problem of overvaluation or
undervaluation of currencies, Deficit or surplus in
balance of payments is automatically corrected under
this system.
It frees the government from problem of balance of
payments.
Promotes Growth of Multilateral Trade
Floating Exchange Rates does not necessarily show
large fluctuations:
Demerits of Flexible Exchange Rate System

It creates situations of instability and uncertainty. Wide
fluctuations in exchange rate are possible. This hampers
foreign trade and capital movements between countries.
The uncertainty caused by currency fluctuations can

discourage international trade and investments.
Widespread speculation with a de-stabilizing effect
Provides an inflationary bias to an economy
Relationship of Exchange Rate and Exports/Imports:

If a country has a high dependence on imports, e.g.,
India, more foreign currency leaves the country than
what enters. This puts downward pressure on the
exchange rate and can cause depreciation of the local
currency. When depreciation occurs, imported goods
will become more costly in the local currency. But
depreciation will benefit the exporters as they will get
more revenue in rupees when they exchange the dollars
they got by exporting their products. The reverse case
happens in the case of appreciation.
2.3.3.The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or
value, which is either fixed or periodically adjusted.
These are a hybrid of fixed and floating regimes. There
are three types of pegged float regimes:
 Crawling bands: The market value of a national
currency is permitted to fluctuate within a range
specified by a band of fluctuation. This band is
determined by international agreements or by unilateral
decision by a central bank. The bands are adjusted
periodically by the country’s central bank. Generally the
bands are adjusted in response to economic
circumstances and indicators.
 Crawling pegs: A crawling peg is an exchange rate

regime, usually seen as a part of fixed exchange rate
regimes, that allows gradual depreciation or
appreciation in an exchange rate. The system is a
method to fully utilize the peg under the fixed exchange
regimes, as well as the flexibility under the floating
exchange rate regime. The system is designed to peg at
a certain value but, at the same time, to “glide” in
response to external market uncertainties. In dealing
with external pressure to appreciate or depreciate the
exchange rate (such as interest rate differentials or
changes in foreign exchange reserves), the system can
meet frequent but moderate exchange rate changes to
ensure that the economic dislocation is minimized.
 Pegged with horizontal bands: This system is similar
to crawling bands, but the currency is allowed to
fluctuate within a larger band of greater than one
percent of the currency’s value.
2.3.4. Managed Floating Exchange Rate System

In between the two extreme exchange rate regimes,
there is the managed floating (semi- fixed exchange
rate) exchange rate system.
It is the mixture of fixed and floating exchange rate
system.
In this system, the exchange rate is given a specific
target and a central bank keeps the rate from deviating
too far from a target band or value.
Under this regime, the exchange rate is the main target

of economic policy making (interest rates are set to
meet the target).

Governments attempt to affect the exchange rate
directly by buying or selling foreign currencies, or
indirectly through monetary policy (e.g. by changing
interest rates on foreign currency bank accounts).
Most of the countries have shifted to this system of
exchange rate determination.
Managed floating exchange rate are :
Crawling peg system: Under this, the central bank
keeps on adjusting exchange rate based on the new
demand and supply conditions of the exchange rate
market. It follows a system of regular checks and
balances and the central bank undertakes small
devaluationsbased on the market conditions.
Clean floating: Under this, the exchange rate of

domestic currency is based on the market forces of
demand and supply without the government
intervention. This system is identical to the floating
exchange rate.
Adjusted peg system: Under this, the central bank tries

to hold the exchange rate of domestic currency until the
foreign exchange reserves of that country gets
exhausted. After this, the central bank goes for the
devaluation of the domestic currency to move to another
equilibrium of the exchange rate.
Dirty floating: Under this, the exchange rate is mainly
determined by the market forces of demand and supply
but the central banks occasionally intervened to remove
excessive fluctuations from the foreign exchange

markets.
2.4. Exchange Rate Regimes

Gold Standard (1870-1914)
Bretton Woods System (1946-1971)
Pegged regime(1971-1992):
Towards Managed Floating Exchange Rate: 1995

onwards
2.4.1. Fixed exchange rate system - Gold Standard

(1870-1914)
USA would issue $1 note, if only it has 14 grams of
gold in reserve, whereas England
would issue one pound note if only it has 73 grams of

gold in its reserve. Accordingly, their exchange rate will
be 1 Pound =73/14 = about 5 USD.
And, each Central Bank Governor has promised to
convert their currency into gold at a fixed amount. So,
a person could walk with paper currency and demand
the goldcoins or gold bars in return.
When the gold mining production declined, nations
gradually shifted to ‘bimetallism’. $1 promised with 14
gm gold or 210 gm of silver whichever available with
their Central Bank.
This system collapsed during the First World War
(WW1) because the nation’s currency printing capacity
was limited by their gold reserve, but their governments

where more eager to print more money to finance the
war (soldiers’ salaries, rifles, ammunition etc.)
2.4.2. Fixed exchange rate system -Bretton Woods

System (1946-1971)
Here, USA agreed to fix price of its $1 = (1/35) ounces
of gold. [1 ounce = 28 grams]. USA allowed free
convertibility of Dollar to Gold. So if a person walked
into the US Federal Reserve with $35, their chairman
(Governor) will give him one ounce of gold.
Then IMF fixed the exchange rate of every country’s
currency against USA. e.g.₹ 1=
$0.30 = about 0.24 grams of Gold. So, that implied
India can’t issue more currency if RBI does not have
proportionately sufficient gold reserve of its own. Still
if RBI issues more ₹ currency, International Monetary
Fund (IMF) will order India to devalue its rupee
exchange rate against dollar.
Robert Triffin (American Economist) claimed this
system will collapse eventually because gold is a finite
commodity and its price will continue to rise (from 1
ounce of gold = $35 to $40). So there is always danger
of people converting the local currency into dollars and
then converting dollars into gold at $35, then selling it
in open market at profit, then US Feds Chairman can’t
continue honouring his promise. It was called “Triffin
Dilemma”. He therefore suggested an alternative SDR
(Paper gold) system for IMF.
USA President Robert Nixon, in 1971 pulled out of
Bretton Woods gold convertibility system, mainly

because he wanted freedom to print more dollars to
finance the Cold War and arms race against the USSR.
Thus, USA shifted to “Floating Exchange System”.
Eventually most of the nations also shifted in that either
floating / managed-floating system.
Ecuador adopted Dollarization in 2000.e. it abandoned

the domestic currency and adopted the US dollar as
their official currency.
2.5.Devaluation of a currency
Under the fixed rate regime, the central bank or the
government decides the value of the currency with
respect to other foreign currencies. The central bank
or the government purchases or sells its currencies to
maintain the exchange rate. When the government or
the central bank reduces the value of its currency, then it
is known as the devaluation of the currency.
For instance, in 1966 when the India was following the
fixed exchange rate regime, the Indian Rupee was
devalued by 36 %.
Advantages of Currency Devaluation

To increase Exports: countries go for currency
devaluation to boost their exports in the international
market. Devaluation of currency makes its goods
cheaper compared to its International competitors.
Competitive devaluation (race to the bottom):if one
country devalues its currency other countries are also
incentivized to devalue their own currency to maintain

their competitiveness and the international export
market.
To reduce trade deficits: currency devaluation makes a
countries exports cheaper, while imports become more
expensive. This leads to an increase in exports and
decrease in imports. This situation favors the improved
balance of payment and reduces trade deficits.
To reduce the sovereign debt burden: If the debt

payments are fixed, devaluation of currency will make
the domestic currency weaker and will ultimately make
the payments less expensive over time.
Disadvantages of currency devaluation

Inflation: it can lead to increase in the inflation rate as
essential imports such as oil etc will become more
expensive. It can also lead to demand-pull inflation.
It reduces the purchasing power of the country’s citizens

and foreign goods and foreign tours become expensive
for them.
Large and quick devaluation of currency may reduce the

faith of international investors in the domestic
economy. Foreign investors would be less interested in
holding the government debt as devaluation reduces the
value of their holdings.
Devaluation of currency negatively impacts the
corporates and individuals who hold debt in the foreign
currency.
2.6.Depreciation of a currency
In the floating exchange rate regimes, the value of a
country’s currency is determined by the market forces
of demand and supply. The exchange rate of the
currency changes on daily basis as per the demand and
supply of that currency with respect to foreign
currencies. A currency depreciates with respect to
foreign currency when the supply of currency in the
market increases while its demand falls.
Reasons for Depreciation of Currency

Decline in exports: The decline in a country’s overall
exports leads to a decline in export revenues. This
reduces the demand for the country’s currency and
leads to its depreciation.
Large increase in imports: A large increase in the
demand for imported goods and services can lead to a
trade deficit. Increase in the current account deficit can
lead to a net outflow of the currency which can weaken
the exchange rate leading to currency depreciation.
Monetary policy of Central Bank: If the central bank
reduces its policy interest rates it can lead to the
outflow of hot money such as foreign portfolio
investment etc. This can lead to the depreciation of
domestic currency.
Open market operations of the central bank: If the
Central bank (in Indian case, RBI) undertakes open
market operations to buy foreign currency and gold etc.
it canlead to the depreciation of domestic currency.
Devaluation vs depreciation
Both devaluation and depreciation lead to the decline
in the value of domestic currency. However, there are
certain differences between them.
Devaluation Depreciation
Devaluation is the official Depreciation refers to an
reduction in the unofficial decline in
value of a currency. the currency’s value.
Devaluation is the Depreciation of a currency
phenomena associated is associated with the
with fixed exchange rate floating or managed
regime. floating exchange rate
regime
Devaluation of the The market forces of
currency is done purposely demand and supply are
by the central bank or the responsible for the
government depreciation of a currency.
The impact of currency The depreciation of
devaluation is for short currency can affect the
term, economy for a longer time.
Devaluation of currency is Depreciation and
done occasionally by the appreciation of currency
central bank. occur on a daily basis.
2.7.Revaluation
Revaluation refers to an upward adjustment to the
country’s official exchange rate the relative to either
price of gold or any other foreign currency.
Revaluation increases the value of the domestic
currency with respect to the foreigncurrency.
Revaluation is a feature of the fixed exchange rate

regime, where the exchange rate is determined by the
central bank or the government.
Revaluation is opposite to devaluation, which is a
downward adjustment.
Reasons for currency Revaluation

Current account surplus: the government can go for
currency revaluation for reducing the current account
surplus. This happens for economies where exports are
higher than imports.
To manage inflation: the government may go for
currency revaluation in order to manage that inflation
rate. Revaluation can lead to either higher inflation or
even lower inflation. Currency revaluation can make the
imports cheaper which can reduce the inflation rate in
the domestic economy.
Changes in the interest rates of other countries and

changes in the global economic environment can also
lead to currency revaluation in order to manage its
impact on the domestic economy.
2.8.Currency Appreciation
Currency appreciation refers to the increase in the value
of one currency with respect to other foreign currencies.
Currency appreciation is the unofficial increase in the
value of any currency.
It is a feature associated with floating or managed

floating exchange rate regimes.
Appreciation of a currency takes place when the supply

of the currency is lesser than its demand in the foreign
exchange market.
Causes of currency appreciation

Increase in the policy interest rate by the central bank: it
would make the investors attractive to invest in the
government bonds and domestic securities which can
lead to inflow of foreign investment in the form of hot
money.
Current account surplus: current account surplus can

cause an inflow of foreign exchange in the economy
leading to appreciation in the exchange rate of the
domestic currency.
Increase in exports: it increase the demand for the
domestic currency leading to its appreciation with
respect to foreign currencies.
Intervention by the central bank through open market
operations: buying of domestic currency from the
foreign exchange market by the central bank can lead to
an appreciation of the domestic currency.
Higher economic growth can increase foreign
investment in the economy which can cause appreciation
in the exchange rate.
2.9.Purchasing Power Parity Theory

Currencies are used for purchasing goods and services.
Value of a currency (money) depends upon the quantity
of goods and services that can be purchased by the
currency. Thus, value of money is its purchasing power.
Exchange rate can also be mentioned on the basis of this

purchasing power. Exchange rate is the expression of
one currency in terms of another currency
E.g. INR 60 = $ 1. Suppose by using Rs 60, we can
purchase one kilogram of orange, then the purchasing
power of Rupees can be expressed as Rs 60 = 1 kg
orange. Similarly for purchasing one kg orange, we have
to pay one dollar, then the purchasing power of dollar
can be expressed as $1 = 1 kg orange. Now it is possible
to state the exchange rates in terms of the value of
orange Rs 60 = 1kg orange = $ 1. Now it is possible to
express the exchange rate in terms of their purchasing
power as INR 60 = $1. This expression is on the basis of
the parity of purchasing power of the two currencies.
Purchasing power of currency changes due to inflation

or deflation. When there is inflation, price level
increases, quantity of goods that can be purchased by
one unit of currency declines, thus, the purchasing
power also decline and vice versa. Thus, inflation /
deflation affect the exchange rates. Purchasing power
parity theory explains the relationship between exchange
rate and inflation. This theory is based on “Law of one
price”. Law of one price states that any commodity
cannot command two different prices in two different
markets. If so profits can be taken by trading between
these two markets. Ultimately the difference will set off
the price differential and prices of the two markets
become equal.
PPP theory was proposed by David Ricardo, 19th
century, popularized by Gustav Cassel –in 1920s.
According to this theory, exchange rate of a commodity
is determined on the basis of the purchasing power of the

currency.
This theory considers foreign exchange as a commodity.
Under gold standard, the exchange rate can be stated in
terms of the price of “Mint parity of gold” . But in
flexible or floating exchange rate system in the era of
paper currencies, currencies are not backed up by gold
or gold exchange standard, currencies are not based on
their intrinsic worth in terms of gold. Thus, to determine
the exchange rate, purchasing power of the two
currencies can be considered. In other words, the
exchange rate of two currencies can be determined on
the basis of products of commodities that can be
purchased by the currencies. According to this theory
exchange rates are determined by what each unit of a
currency can buy in terms of real goods and services in
its own country.
The rate of exchange is the amount of currency which
would buy the equivalent basket of goods and services in
both the countries. As mentioned, to purchase one Kg of
orange, in India, we have to pay Rs. 50 and at the same
time to purchase the same quantity of orange in US, one
has to pay $1. in that case Exchange rate (E) = Price of
orange in India / Price of orange in US = 50/1 or 50:1.
Assumptions of law of one price and PPP theory

1. There exist perfect market conditions
2. Absence of transportation costs from one market to
another (country to another)
3. Free trade across the international market
4. No barriers or controls over international trade like

tariffs, taxes, incentives, promotions etc
5. No country is strong enough to influence the exchange
rate.
There are two versions to the PPP theory:

1. The absolute PPP (Positive version) and
2. The relative PPP (Comparative version)
2.9.1. The Absolute PPP Theory

In the olden days (1700 -1970) gold formed the basis for
determination of the exchange rate because it commanded
good demand all over the world. Today, gold is like any
other commodity. Thus, in the olden days PPP was based on
gold prices. According to the Jamaica Agreement in 1976
gold was demonetized. The PPP and the exchange rates are
not determined or governed by a single commodity like
gold. Now, it comprises of a basket of commodities in
which gold is only a commodity. Thus, for the purpose of
determining the exchange rate a basket of commodities
which have common utility among the natives will be
considered. The value of commodities in different places
may differ according to customs, traditions, culture, believes
etc. For determining the inflation rates, every country forms
a common basket of goods in proportionto their utility to the
people. Based on variations in prices inflationary
tendencies are determined.
Inflation influences exchange rates. Consider, Two countries
India and China. Inflation rate in India is 20% and that of
China is 0%; then the INR will depreciate when compared
to Chinese Yuan. Chinese Yuan will appreciate when

compared to INR .
Formerly the currencies were in equilibrium position and
were traded INR 5 = 2 Yuan on account of inflation the
position can be INR 6 = 2 Yuan. Now Chinese get more
INR for their Yuan and they can purchase more goods from
India by giving their Yuan. This will increase Chinese
import from India and or Indian export to China. Thereby
increasing demand for Indian Rupees from Chinese who pay
in term of their Yuan. Demand for INR leads to increase
exchange rate of INR and increased supply of Yuan tends to
reduce the price of Yuan. Thus, ultimately through the
interaction of market forces, the exchange rate reaches again
in equilibrium position.
Demerits 1. Assumes composition of common basket of

goods. Due to factors like culture, tradition, values believes
etc. common goods may not be the same 2. Assumes
identical utility – but utility is different 3. Quality of goods
may be different in different countries 4. Styling and
packing difference 5. Trade barriers 6. Transportation,
insurance cost etc 7. Non-tradable goods (service, human
resource) 8. Time lag : consequence of inflation may occur
in different time 9.Other factors affecting demand and
supply of currencies - interest, investment portfolio returns
etc
2.9.2. Relative Purchasing Power Parity Theory

This theory considers the impact of market imperfections
like transportation cost, tariffs, quotas, incentives etc.
Imperfections result in different prices for the same
commodities in different countries, even if measured in a
common currency. However, this theory argues that “the

rate of exchange in the prices of products will be somewhat
similar when measured in common currency, as long as the
transportation costs and trade barriers are unchanged. In
other words, “the change in the exchange rate over a period
of time should be proportional to the relative change in the
price levels in two countries over the same period”.
Example, Suppose:- t = 0 (base period or year), Pₒd = Price

of the commodity in domestic country during the base
period, Pₒf = Price of the commodity in foreign country
during the base period. Thus, exchange (spot) rate = Sₒ =
Pₒd/ Pₒf. Suppose if the prices changes due to inflation, after
one year the situation will be t = 1 (after one year) P₁d =
Price of the commodity in domestic country after one year,
P₁f = Price of the commodity in foreign country after one
year Thus, exchange (spot) rate = S₁ = P₁d/ P₁f. P₁d = Pₒd +
inflation in domestic country, P₁f = Pₒf + inflation in foreign
country.
If, Inflation in domestic country = Id, inflation in foreign

country = If. Thus, S₁ = Pₒd ( 1 + Id) / Pₒf (1 +If) .
Suppose the price of 1 kg orange in India is INR 50 and that

in USA is $1. The inflation rate in India is 20% and that of
USA is 10%. Determine the new exchange rate When t=o,
Sₒ = Sₒ = Pₒd
/ Pₒf = 50/1 = INR50: $1 t=1, inflation in India (Id), 20 % 0r

0.2 and inflation in USA (If) is 10% or 0.1 Present exchange
rate will be 50 x (1+0.2/1+0.1) = INR 54.45 : $ 1.
2.10. Monetary Approach to the Balance of Payments

and Exchange Rates
The monetary approach to the balance of payments was
started toward the end of the 1960s by Robert Mundell and
Harry Johnson and became fully developed during the
1970s. The monetary approach represents an extension of
domestic monetarism (stemming from the Chicago school)
to the international economy in that it views the balance of
payments as an essentially monetary phenomenon. That is,
money plays the crucial role in the long run both as a
disturbance and as an adjustment in the nation’s balance of
payments.
2.10.1. Monetary Approach under Fixed Exchange Rates

The monetary approach begins by postulating that the
demand for nominal money balances is positively related to
the level of nominal national income and is stable in the
long run. Thus, the equation for the demand for money can
be written as:
Md = kPY (2.1)
where Md = quantity demanded of nominal money balances
k = desired ratio of nominal money balances to nominal
national income P = domestic price level Y = real output.
In Equation (2.1), PY is the nominal national income. This
is assumed to be at or to tend toward full employment in the
long run. The symbol k is the desired ratio of nominal
money balances to nominal national income; k is also equal
to 1/V , where V is the velocity of circulation of money or
the number of times a dollar turns over in the economy
during a year.With V (and thus k) depending on institutional
factors and assumed to be constant, Md is a stable and

positive function of the domestic price level and real
national income. The demand for money is inversely related
to the interest rate (i) or opportunity cost of holding inactive
money balances rather than interest-bearing securities. Thus,
Md is directly related to PY and inversely related to i. The
nation’s supply of money is given by
Ms = m(D + F) (2.2).
where Ms = the nation’s total money supply m = money

multiplier, it is constant over time, D = domestic component
of the nation’s monetary base is the domestic credit created
by the nation’s monetary authorities or the domestic assets
backing the nation’s money supply. F = international or
foreign component of the nation’s monetary base refers to
the international reserves of the nation, which can be
increased or decreased through balance-of-payments
surpluses or deficits respectively. D + F is called the
monetary base of the nation, or high-powered money.
Starting from a condition of equilibrium where Md = Ms, an
increase in the demand for money can be satisfied either by
an increase in the nation’s domestic monetary base (D) or by
an inflow of international reserves, or balance-of-payments
surplus (F). If the nation’s monetary authorities do not
increase D, the excess demand for money will be satisfied
by an increase in F. On the other hand, an increase in the
domestic component of the nation’s monetary base (D) and
money supply (Ms), in the face of unchanged money
demand (Md ), flows out of the nation and leads to a fall in
F (a deficit in the nation’s balance of payments). Thus, a
surplus in the nation’s balance of payments results from an
excess in the stock of money demanded that is not satisfied
by an increase in the domestic component of the nation’s

monetary base. A deficit in the nation’s balance of payments
results from an excess in the stock of the money supply of
the nation that is not eliminated by the nation’s monetary
authorities but is corrected by an outflow of reserves. The
nation’s balance-of-payments surplus or deficit is temporary
and self-correcting in the long run; that is, after the excess
demand for or supply of money is eliminated through an
inflow or outflow of funds, the balance-of-payments surplus
or deficit is corrected and the international flow of money
dries up and comes to an end.
The nation has no control over its money supply under a
fixed exchange rate system in the long run. That is, the size
of the nation’s money supply will be the one that is
consistent with equilibrium in its balance of payments in the
long run. Only a reserve-currency country, such as the
United States, retains control over its money supply in the
long run under a fixed exchange rate system because
foreigners willingly hold dollars.
2.10.2. Monetary Approach under Flexible Exchange
Rates
Under a flexible exchange rate system, balance-of-payments
disequilibria are immediately corrected by automatic
changes in exchange rates without any international flow of
money or reserves. Thus, under a flexible exchange rate
system, the nation retains dominant control over its money
supply and monetary policy. Adjustment takes place as a
result of the change in domestic prices that accompanies the
change in the exchange rate. A deficit in the balance of
payments (resulting from an excess money supply) leads to
an automatic depreciation of the nation’s currency, which
causes prices and therefore the demand for money to rise

sufficiently to absorb the excess supply of money and
automatically eliminate the balance-of-payments deficit. On
the other hand, a surplus in the balance of payments
(resulting from an excess demand for money) automatically
leads to an appreciation of the nation’s currency, which
tends to reduce domestic prices, thus eliminating the excess
demand for money and the balance of payments surplus.
Under a flexible exchange rate system, a balance of
payments disequilibrium is immediately corrected by an
automatic change in exchange rates and without any
international flow of money or reserves (so that the nation
retains dominant control over its money supply and
domestic monetary policy). The actual exchange value of a
nation’s currency in terms of the currencies of other nations
is determined by the rate of growth of the money supply and
real income in the nation relative to the growth of the money
supply and real income in the other nations. Thus, according
to the monetary approach, a currency depreciation results
from excessive money growth in the nation over time, while
a currency appreciation results from inadequate money
growth in the nation. A nation facing greater inflationary
pressure than other nations (resulting from more rapid
growth of its money supply in relation to the growth in its
real income and demand for money) will find its exchange
rate rising (its currency depreciating). On the other hand, a
nation facing lower inflationary pressure than the rest of the
world will find its exchange rate falling (its currency
appreciating).
With flexible exchange rates, the rest of the world is to some
extent shielded from the monetary excesses of some nations.
The nations with excessive money growth and depreciating
currencies will now transmit inflationary pressures to the

rest of the world primarily through their increased imports
rather than directly through the export of money or reserves.
This will take some time to occur and will depend on how
much slack exists in the world economy and on structural
conditions abroad. Under a managed floating exchange rate
system of the type in operation today, the nation’s monetary
authorities intervene in foreign exchange markets and either
lose or accumulate international reserves to prevent an
“excessive” depreciation or appreciation of the nation’s
currency, respectively. Under such a system, part of a
balance-of-payments deficit is automatically corrected by a
depreciation of the nation’s currency, and part is corrected
by a loss of international reserves. As a result, the nation’s
money supply is affected by the balance-of- payments
deficit, and domestic monetary policy loses some of its
effectiveness. Under a managed float, the nation’s money
supply is similarly affected by excessive or inadequate
growth of the money supply in other nations, although to a
smaller extent than under a fixed exchange rate system.
2.10.3. Monetary Approach to Exchange Rate

Determination
With the dollar ($) as the domestic currency and the euro (€)
as the foreign currency, the exchange rate (R) was defined
as the number of dollars per euro, or R = $/€. For example,
if R = $1/€1, this means that one dollar is required to
purchase one euro, or if R = $1.20/€1, it would take $1.20 to
get one euro. If markets are competitive and if there are no
tariffs, transportation costs, or other obstructions to
international trade, then according to the law of one price
postulated by the purchasing-power parity (PPP) theory, the
price of a commodity must be the same in the United States
as in the European Monetary Union (EMU). That is, PX ($)

= RPX (€).
The same is true for every other traded commodity and for
all commodities together (price indices). That is,
P = RP∗ and R = P /P∗ (2.3)

where R is the exchange rate of the dollar, P is the index of
dollar prices in the United States, and P∗ is the index of euro
prices in the EMU.
We can show how the exchange rate between the dollar and
the euro is determined according to the monetary approach
by starting with the nominal demand-for-money function of
the United States (Md) and for the EMU (M∗ d ):
Md = kPY and M∗ d = k∗P∗Y∗ (2.4)

where k is the desired ratio of nominal money balances to
nominal national income in the United States, P is the price
level in the United States, and Y is real output in the United
States, while the asterisked symbols have the same meaning
for the EMU.
In equilibrium, the quantity of money demanded is equal to
the quantity of money supplied. That is, Md = Ms and M∗d =
M∗s. Substituting Ms for Md and M∗s for M∗d in Equation
(2.4), and dividing the resulting EMU function by the U.S.
function, we get
M∗s/ Ms = k∗P∗Y∗ /kPY (2.5)
By then dividing both sides of Equation (2.5) by P∗/P and
M∗s/Ms we get
P/ P∗ = Msk∗Y∗/ M∗skY (2.6) But since R = P/P∗, we have

R = Msk∗Y∗/ M∗s kY (2.7)
Since k∗ and Y∗ in the EMU and k and Y in the United

States are assumed to be constant, R is constant as long as
Ms and M∗ s remain unchanged. Several important things
need to be noted with respect to Equation (2.7). First, it
depends on the purchasing-power parity (PPP) theory and
the law of one price. Second, Equation (2.7) was derived
from the demand for nominal money balances in the form of
Equation, which does not include the interest rate. Third, the
exchange rate adjusts to clear money markets in each
country without any flow or change in reserves. Thus, for a
small country (one that does not affect world prices by its
trading), the PPP theory determines the price level under
fixed exchange rates and the exchange rate under flexible
rates.
2.11. Portfolio Balance Model

The portfolio balance approach (also called the asset market
approach) differs from the monetary approach in that
domestic and foreign bonds are assumed to be imperfect
substitutes, and by postulating that the exchange rate is
determined in the process of equilibrating or balancing the
stock or total demand and supply of financial assets (of
which money is only one) in each country. Thus, the
portfolio balance approach can be regarded as a more
realistic and satisfactory version of the monetary approach.
The portfolio balance approach was developed since the
mid- 1970s, and many variants of the basic model have been
introduced.
In the simplest asset market model, individuals and firms

hold their financial wealth in some combination of domestic
money, a domestic bond, and a foreign bond denominated
in the foreign currency. The incentive to hold bonds
(domestic and foreign) results from the yield or interest that
they provide. However, they also carry the risk of default
and the risk arising from the variability of their market value
over time. Domestic and foreign bonds are not perfect
substitutes, and foreign bonds pose some additional risk
with respect to domestic bonds. Holding domestic money, on
the other hand, is riskless but provides no yield or interest.
Thus, the opportunity cost of holding domestic money is the
yield forgone on holding bonds. The higher the yield or
interest on bonds, the smaller is the quantity of money that
individuals and firms willwant to hold.
At any particular point in time, an individual will want to
hold part of his or her financial wealth in money and part in
bonds, depending on his or her particular set of preferences
and degree of risk aversion. Individuals and firms do want to
hold a portion of their wealth in the form of money (rather
than bonds) in order to make business payments (the
transaction demand for money). But the higher the interest
on bonds, the smaller is the amount of money that they will
want to hold (i.e., they will economize on the use of money).
The choice, however, is not only between holding domestic
money, on the one hand, and bonds in general, on the other,
but among holding domestic money, the domestic bond, and
the foreign bond. The foreign bond denominated in the
foreign currency carries the additional risk that the foreign
currency may depreciate, thereby imposing a capital loss in
terms of the holder’s domestic currency. But holding foreign
bonds also allows the individual to spread his or her risks
because disturbances that lower returns in one country are
not likely to occur at the same time in other countries. Thus,

a financial portfolio is likely to hold domestic money (to
carry out business transactions), the domestic bond (for the
return it yields), and the foreign bond (for the return and for
the spreadingof risks it provides).
Given the holder’s tastes and preferences, his or her wealth,
the level of domestic and foreign interest rates, his or her
expectations as to the future value of the foreign currency,
rates of inflation at home and abroad, and so on, he or she
will choose the portfolio that maximizes his or her
satisfaction (i.e., that best fits his or her tastes). A change in
any of the underlying factors (i.e., the holder’s preferences,
his or her wealth, domestic and foreign interest rates,
expectations, and so on) will prompt the holder to reshuffle
his or her portfolio until he or she achieves the new desired
(equilibrium) portfolio.
According to the portfolio balance approach, equilibrium in

each financial market occurs when the quantity demanded of
each financial asset equals its supply. It is because investors
hold diversified and balanced (from their individual point of
view) portfolios of financial assets that this model is called
the portfolio balance approach. If investors demand more of
the foreign bond either because the foreign interest rate rose
relative to the domestic interest rate or because their wealth
increased, the demand for the foreign currency increases and
this causes an increase in the exchange rate (i.e., depreciation
of the domestic currency). On the other hand, if investors
sell foreign bonds either because of a reduction in the
interest rate abroad relative to the domestic interest rate or
because of a reduction in their wealth, the supply of the
foreign currency increases and this causes a decrease in the
exchange rate (i.e., appreciation of the domestic currency).
Thus, we see that the exchange rate is determined in the

process of reaching equilibrium in each financial market.
2.12. Exchange Rate Overshooting

Overshooting was introduced to the world by Rüdiger
Dornbusch, a renowned German economist focusing on
international economics, including monetary policy,
macroeconomic development, growth, and international
trade. Dornbusch first introduced the model, now widely
known as the Dornbusch Overshooting Model, in the
famous paper "Expectations and Exchange Rate Dynamics,"
which was published in 1976 in the Journal of Political
Economy. Before Dornbusch, economists generally believed
that markets should, ideally, arrive at equilibrium and stay
there. Some economists had argued that volatility was
purely the result of speculators and inefficiencies in the
foreign exchange market, such as asymmetric information or
adjustment obstacles. Dornbusch rejected this view. Instead,
he argued that volatility was more fundamental to the market
than this, much closer to inherent in the market than to being
simply and exclusively the result of inefficiencies. More
basically, Dornbusch was arguing that in the short run,
equilibrium is reached in the financial markets, and in the
long run, the price of goods responds to these changes in the
financial markets.
The Overshooting Model

The overshooting model argues that the foreign exchange
rate will temporarily overreact to changes in monetary
policy to compensate for sticky prices of goods in the
economy. This means that, in the short run, the equilibrium
level will be reached through shifts in financial market
prices, rather than through shifts in the prices of goods

themselves. Gradually, as the prices of goods unstick and
adjust to the reality of these financial market prices, the
financial market, including the foreign exchange market,
also adjusts to this financial reality. So, initially, foreign
exchange markets overreact to changes in monetary policy,
which creates equilibrium in the short term. Then, as the
prices of goods gradually respond to these financial market
prices, the foreign exchange markets temper their reaction
and create long-term equilibrium. Thus, there will be more
volatility in the exchange rate due to overshooting and
subsequent corrections than would otherwise be expected.
Panel (a) shows that the U.S. money supply unexpectedly
increases by 10 percent from $100 to
$110 billion at time t 0. In panel (b) the increase in the U.S.

money supply immediately leads to a decline in the U.S.
interest rate from 10 percent to 9 percent. Panel (c) shows
that the U.S. price index rises by 10 percent from 100 to 110
only gradually over the long run. Panel (d) shows that the
exchange rate of the dollar (R) immediately rises (the dollar
depreciates) by 16 percent, from
$1/€1 to $1.16/€1, thus overshooting its long-run

equilibrium level of $1.10/€1, toward which it will then
gradually move by appreciating (R falling) in the long run.
As U.S. prices rise, the U.S. interest rate also gradually rises
back to its original level of 10 percent in the long run.
The immediate depreciation of the dollar will lead to a

gradual increase in the nation’s exports and reduction in the
nation’s imports, which will result (everything else being
equal) in an appreciation of the dollar over time. Since we
know from the PPP theory that the dollar must depreciate
by 10 percent in the long run, the only way to also expect
that the dollar will appreciate in the future is for the dollar
to immediately depreciate by more than 10 percent as a
result of the unexpected 10 percent increase in the U.S.
money supply. Of course, if other disturbances occur before
the exchange rate reaches its long-run equilibrium level, the
exchange rate will be continually fluctuating, always
moving toward its long-run equilibrium level but never
quite reaching it. This seems to conform well with the
recent real-world experience with exchange rates.
Specifically, since 1971, and especially since 1973,
exchange rates have been characterized by a great deal of
volatility, overshooting, and subsequent correction, but

always fluctuating in value.
2.13. Exchange Rate System in India

The exchange rate system in India has undergone a
systematic change since Independence. From the system of
the pegged exchange rate to the present form of market
determined exchange rate after liberalisation in 1993.
Objectives of Exchange Rate Management In India
 To ensure that the economic fundamentals of the

Indian economy are correctly reflected in the external
value of Indian rupee.
 To reduce the volatility in exchange rates for ensuring
that changes in the exchange rates take place in a
smooth and orderly manner.
 To maintain a sufficient level of foreign exchange
reserves to deal with any externalcurrency shocks.
 To help in the elimination of market constraints for
ensuring the growth of a healthy foreign exchange
market.
 To help in the prevention of the emergence of any
destabilizing and speculative activities in the foreign
exchange market.
Factors affecting the Exchange Rate of India
Intervention of The Reserve Bank of India:
During high volatility in the exchange rate, RBI
intervenes to prevent the exchange rate going out of
control.
For example, the RBI sells dollars when Indian rupee
depreciates too much, while it purchases dollars when the
Indian rupee appreciates beyond a certain level.
Inflation rate:
The increase in inflation rate can increase the demand for
foreign currency which can negatively impact the exchange
rate of the national currency.
For example, an increase in the inflation level of
petroleum oil can increase the demand for foreign currency
leading to the depreciation of Indian rupee.
Interest rate:
Interest rates on government securities and bonds,
corporate securities etc affect the outflow and inflow of
foreign currency.
If the interest rates on government bonds are higher
compared to other country forex markets, it can increase
the inflow of foreign currency, while lower interest rates
can lead to the outflow of foreign currency. This affects the
exchange rate ofIndian rupee,.
Exports and imports:
Exports and imports affect exchange rate as exports earn of
foreign currency while imports require payments in foreign
currency.
Thus, if the overall exports increases, the national currency
appreciates, while increases in imports leads to the
depreciation of the national currency.
Apart from above, the Indian foreign exchange market is
also affected by factors such as the receipts in the accounts

of exports in invisibles in the current account, inflow in the
capital account such as FDI, external commercial
borrowings, foreign institutional investments, NRI
deposits, tourism activities etc.
2.14. Exchange Rate Regime in India
Towards Fixed Exchange Rate
1860 Fixed Fiduciary System à i.e. British

onwards Indian Govt can issue Rs.10 crore notes
on fiduciary (“trust”) backed by G-
Sec. Beyond that every note must be
backed by gold / silver.
1935 Proportional Reserve à RBI must keep
onwards about 40% gold to the value of currency
issued. British govt fixed exchange rate.
1946 Bretton Woods / IMF system of fixed
onwards exchange rate à Wherein ₹ price was
fixed (pegged) against dollar, and dollar
price was fixed (pegged) against gold.
1956 While RBI could issue any amount of
onwards Indian currency but that has to be
balanced by the Assets of the issue
department (Remember M0). If RBI
printed too much currency backed by
only Indian G-sec but (without adequate
Gold / Forex Reserve, then IMF may
force devaluation of ₹ against Dollar).
So, we adopted “Minimum Reserve
System” i.e. RBI must keep ₹ 400 crore of
foreign currency/security + ₹ ‘specified’
crore worth gold.
Towards Managed Floating Exchange Rate: 1995

onwards
Post 1995 onwards, “Minimum Reserve System; is
continued but RBI is required to only keep ₹ ‘specified’
crores of gold. No compulsion for RBI to keep additional
400 crore worth foreign currency or foreign securities. RBI
can print as much currency it wants as long as its balanced
by the Assets of Issue Dept. (such as Indian G-sec, Foreign
Securities, Gold etc.)
Attracting Dollars: VRR and FAR
To prevent weakening of ₹, we have to attract more $ (and

other foreign currencies) in India. So, RBI taken following
notable measures:
Voluntary Retention Launched in 2019: If an FPI

Route(VRR) buys Indian Union/State
Governments’ G-Sec and Indian
Corporates’ Bonds through this
route → FPI will be given more
freedom in certain technical
regulations of RBI & SEBI.
 But, with condition FPI
must remain invested in India
for minimum 3 years. (Hot
Money)
 RBI decides quantitative
limits to how much money can
FPI invest through this route.

Fully Accessible  Budget-2020 had announced

Route(FAR) allowing non-resident investors
to invest in G-Sec, without any
restrictions.
 2020-March: RBI
announced this window, non-
resident individual investors
(who’re not FPI) can buy G-Sec.
No limits on amount of
investment.
Benefit – Investors will convert $ & other foreign currency
into ₹ currency to buy G-Sec. so more $ coming towards
India which will help keeping BoP and currency exchange
rate stable during crisis.
 Currency Exchange Rate in COVID-19 Crisis
Corona Virus Force Majeure àSENSEX dips

2020-Feb so FPIs Selling shares from Indian
companies= they got ₹₹ → converting them
into $ → running back to USA to invest in
(AAA rated) US treasury bonds which is
safest investment. So there is a great shortage
of dollars in the Indian market. If RBI does
not supply dollars → further weakening of
rupee ($1=₹75 → ₹80).
RBI starts Dollars Swap with Indian banks.
2020-March i.e. A bank shall buy US Dollars from the
Reserve Bank and simultaneously agree to
sell the same amount of US Dollars at the
end of the swap period (6 months). It is done
through auctioning, so, RBI to earn some %
of profit.
COVID-19 Dollar up-down movements, RBI signing

more swap agreements, Indian Government
borrowing more $$ from ADB, BRICS Bank
etc.
 After the collapse of Bretton Woods Exchange Rate
System, IMF was converted into a type of ‘deposit bank’,
where the members would deposit currencies in the
proportion of quotas allotted to them (depending on size of
their economy, openness etc).
 IMF will pay them a small interest rate for their

deposits. And IMF would lend this money to a member
facing balance of payment crisis. To operationalize this
mechanism, IMF would allot an artificial currency /
accounting unit called SDR to the members based on their
deposits.
 Initially the price of SDR was fixed against the
amount of gold but present mechanism:
Currency Basket Weightage

U.S. Dollar 41.73
Euro 30.93
Chinese Yuan (Renminbi *added in 2015) 10.92
Japanese Yen 8.33
Pound Sterling 8.09
 By applying a formula involving (weight *
exchange rate), IMF will obtain value of 1 SDR = how
many dollars?
 Presently, 1 SDR = $1.40 = ₹ 98 (assuming $1 is

trading at ₹ 70).

 SDR is called ‘Paper Gold’ because it’s merely an

accounting entry or artificial currency, without any gold
involved.
 SDR can be traded among the members, it can be
converted into members’ currencies as per above method &
be used to settle their Balance of Payment Transactions /
Crisis.
 If the BoP crisis is so big, that a country’s entire
SDR quota exhausts, then member country may borrow
more SDR from IMF (and then convert it into dollar etc. to
pay off the import bill), but eventually member will have to
repay this loan to IMF with interest.
2016-Reforms: The total quantity of SDR was increased,
and India’s quota was increased from 2.44% to about
2.75%, accordingly, we are allotted around 13 billion SDR
[25% of it is kept as reserve tranche position (RTP)]
India is 8th largest quota holder after USA (~18%), Japan
(~7%), China (~6%)…
 In IMF, a member’s voting power depends on his
SDR quota contribution.
 For India, this voting power is exercised by
India’s Finance Minister as the ex-officio Governor in
IMF’s Board of Governors.
 If Finance Minister absent, then RBI Governor can
vote as the Alternate Governor duringthe IMF’s meetings.
Presently, India has managed floating exchange rate system
wherein, currency exchange rate is determined by the

market forces of supply and demand, however, during high

level of volatility RBI will intervene to buy / sell ₹ or $ to
stabilize the exchange rate. But if people are allowed to
convert the local and foreign currency in an unrestricted
manner, this will led to so much volatility that RBI will not
be able to manage.
So, RBI puts certain restrictions on the convertibility of
Indian rupee to foreign currency using the powers conferred
under: Foreign Exchange Regulation Act, 1973 (FERA),
FERA was later replaced by Foreign Exchange Management
Act, 1999 (FEMA)
RBI Restriction On Convertibility Of Rupee:
1. CONVERTIBILITY OF RUPEE
o Convertibility on Capital Account Transactions
o Convertibility on Current account transactions
Convertibility on Capital Account Transactions:
RBI’s External Commercial Borrowing

(BoP → Capital Account → Borrowing
External →Commercial Borrowing
ECB) ceiling is up to $750 million (or
equivalent other currency) per year for
Indian Companies. That means even if
Bank of America was willing to lend
$1500 million to Reliance, it can’t bring
all those dollars (or its converted rupee
equivalent) in India. If he tries through
illegal

(ECB) methods like Hawala, then

Enforcement Directorate (ED)
willtake action for FEMA violation.
Foreign Portfolio An Foreign Portfolio Investors
Investors(FPI) (BoP → Capital Account →
Investment → FPI) can’t invest in
more than 5% of available
government securities in the Indian
market and more than 20% of the
available corporate bonds in the
Indian market.
So, even if Morgan Stanley or
Franklin Templeton investment
fund has billions of dollars they
can’t bring them all to India
because of above restrictions.
Foreign Direct Similar restrictions on Foreign
Investment (FDI) Direct Investment (FDI) as well.
Govt decides FDI policy and RBI
mandates the forex dealers
accordingly to convert or not
convert foreign currency into
Indian currency. E.g. Las Vegas’s
Flamingo Casino company can’t
convert $ into ₹ to invest in Goa’s
Casino (Because FDI prohibited in
Casino). If they manage to
‘smuggle’ rupees through Hawala /
Mafia boats then again ED will
take action for FEMA violation.

Thus, Indian rupee is not fully

Conclusion convertible on capital account
transactions.
Convertibility on Current account transactions
 During 2013 to 2014, RBI’s 80:20 norms mandated
min. 20% of the imported gold must be exported back.
 Until then Jeweller/bullion dealers will not get
permission to (convert their rupees into dollars/foreign
currency) to import next consignment of gold.
 However, if we disregard such few rare
examples/restriction, Indian rupee is considered fully
convertible on current account transactions (i.e. Import and
export, remittance, income transfer gift and donations)
since 1994.
FCRA 2010 violations:
 If NGO / Universities were allowed to accept
foreign donations in an unrestricted manner, they may
become puppets of ISI / Pakistan / China / CIA.
 So, Ministry of Home Affairs (MHA) requires
them to ‘register’ and furnish annual reports under Foreign
Contribution Regulation Act 2010 (FCRA). Those who
fail to comply with it, are prohibited from accepting
foreign donations.
 But this angle takes us towards the ‘National
security and sovereignty of India’. We need not confuse or
mix it up with ‘Economics concept’ of Rupee
convertibility under FEMA ACT.
Full convertibility of Rupee

Meaning – India should permit unrestricted conversion of

Indian ₹ to foreign currency for both current account and
capital account transactions. This will infuse more FDI
investment in India which will help in resolution of NPA
problem, new factories, jobs, GDP growth, rivers of honey
and milk will flow.
Anti-Arguments:
 Before 1997, East Asian “Tiger” economies –
(South Korea, Indonesia, Malaysia, Thailand, Vietnam
Philippines etc.) allowed full capital account convertibility
to attract FDI.
 But 1997: Their automobile & steel companies
filed bankruptcy. The foreign investors panicked, sold
their shares and bonds and got local currency to convert
into $ and ran away. The flight of this ‘Hot Money’
resulted into extreme depreciation of local currency $1 =
2000 Indonesian Rupiah → $1= 18,000 Indonesian
Rupiah. All developments resulted into heavy inflation of
petrol and diesel, social unrest, riots and political
instability. None of their central banks had enough forex
reserve to combat this crisis.
 So, in 1998, their GDP growth rates fell in
negative territory e.g. Indonesia (- 13.7%) Because of
their mistake of allowing full currency convertibility.
 Whereas India and China grew at 6-8% because
we had not allowed it.
S.S. Tarapore Committee (1997) on Convertibility of

Rupee
Committee suggested India to allow full Capital
Account Convertibility (CAC) only when the

fundamentals of our economy become strong enough, such
as:
1. RBI must have enough forex to sustain 6 months’
import
2. Fiscal deficit must not be more than 3.5% of GDP
3. Inflation must not be more than 3-5%
4. Banks’ NPA must not be more than 5% of their total
assets, and among others.
So, time is not yet ripe for allowing full CAC.
Rupee Convertibility and RBI reforms (2004-2019)
While RBI has not permitted full convertibility
of Indian rupee (on Capital Account), but over the years it
has liberalised the norms, such as:
Liberalised Remittance Scheme (LRS) for
each financial year, An Indian resident (incl.
minor) is allowed to take out upto $2,50,000
(or its equivalents in other currencies) from
India. He may use it for either current
account or capital account transaction as per
2004 his wish. (e.g. paying for college fees
abroad, buying shares, bonds, properties,
bank accounts abroad.)
Controversy à Panama papers allege certain
Bollywood celebrities used LRS window to
shift money from India in their shell
companies in tax havens. Later used those
shell companies for tax avoidance.

RBI began relaxing the norms for External

Commercial Borrowing (ECB), mainly to
2016
soften the NPA problem e.g. Software firms
onwards
can bring up to $200 million in ECB,
Micro-finance $500 mill, Infrastructure
companies $750 million etc.
2018-19 When ₹ started to depreciate heavily against
dollars ($1 → ₹ 63 → ₹ 74), RBI had to
encourage the flow of dollars into
Indian economy. So, aforementioned
sector- specific limits streamlined → all
eligible companies automatically allowed to
borrow upto $750 million via ECB route.
(Although prohibited in certain categories
e.g. purchase of farm house, tobacco,
betting, gambling, lottery etc.)
2019 RBI allowed ECB even for working capital
& repayment of rupee loans.
Twin Deficit – It’s the term used when both Current
Account Deficit and Fiscal Deficit are high.
CURRENCY WAR 2018

2015: Chinese authorities announced they don’t
manipulate/control Yuan exchange rate. They only
intervene if Yuan’s exchange rate varies more than +/- 4%
from previous day.
During 2018, People’s Bank of China pursued
‘Cheap (Dovish) Money Policy’ to injected more Yuan
(renminbi) in the system to makes loans cheaper in
domestic market and boost the consumption, demand,
growth.
But, on the other side, US Feds pursued Dear

(Hawkish) Money Policy, so dollar supply is shrinking, so
dollar is becoming more expensive against other
currencies.
Results à Increased supply of Yuan vs. reduced
supply of $: resulted in $1=6.20 Yuan weakening to
almost $1= 7 Yuan.
Trump alleges Yuan was deliberately weakened
(due to PCB increasing Yuan supply) to make Chinese
product more cheaper in global trade. He even accused
Russia and Japan of playing similar ‘Currency War’
against him.
Currency War and Fall of Indian ₹ in 2018

2018: Turkey was suffering from high Inflation, current
account deficit and political turmoil.
US Feds was pursuing Hawkish (Dear) monetary policy,
so dollar supply shrinking and resultantly dollar is
becoming more expensive against other currencies. In this
atmosphere, foreign investors feared Turkish companies
(who had previously borrowed lot of money from
American financial market) will not be able to repay their
loans in dollar currency.
So foreign investors began selling their shares and
bonds from Turkey’s market. They got Lira currency and
exchanged it to dollars and ran away from Turkey.
Because of this rush, demand of dollars

strengthened even further and resultantly, other currencies
became even weaker. (Including India: $1=₹ 63 in January

→ $1= ₹ 74 in Oct’18).
In 2019-20 also, India rupee continued to weaken
towards $1=75₹ because Corona Force Majure which
leads to dip in SENSEX. Foreign investors pulling out
money from India.
While such depreciation is good for our exporters
but bad for our importers. To combat this fall, Govt and
RBI initiated following steps:
1. FPI’s investment limits in Bond market was
relaxed. (So they feel encouraged to convert their Dollars
into Rupees and invest in Indian bond market)
2. External commercial borrowing (ECB) norms
were also relaxed.
3. RBI sold about 25 billion dollars from its forex
reserve to calm down the demand of dollars.
4. Further, to attract NRI’s dollar savings into India:
2013. RBI could announce more interest rates on

Foreign Currency (Non- Resident) Account (Banks)
[FCNR (B) Account] & then pay interest subsidy to Indian
Banks, like they had done in 2013.
2014. Govt could also tell RBI to issue NRI bonds to
attract their $ savings to India.
5. But, Urjit Patel avoided doing 4A and 4B
solutions because eventually such borrowed dollars have
to be returned back to NRI with interest, which could
result in exchange rate crisis in future.

6. RBI could also pursue Hawkish Monetary Policy

to reduce rupee supply in market (so that ₹ can also
become expensive just like dollars). But, because RBI act
mandates inflation control within 2-6% CPI, and by
December 2018 the CPI has been falling towards 2% so
RBI’s MPC had to actually reduce the policy rate (2019
Feb to August) to combat deflation.
2018-Oct The central banks of India and Japan

signed Currency Swap Agreement of $75
billions i.e. either party can use that much
dollar currency from other party’s forex
reserve during the crisis. Even in 2008 and
2013 too they had signed similar
agreement but lower amount was involved.
2019- March RBI’s $5 bn Currency Swap with Indian
banks → RBI gains dollar reserve to fight
future volatility in currency exchange rate,
whereas Indian banks got extra rupee
liquidity → (Hopefully) cheaper interest
rates to combat deflation.
2018-Dec India signed pact with Iran to pay crude oil
bill in rupee currency. National Iranian Oil
Co (NIOC) will open a bank account in
India’s UCO Bank (a PSB). Indian oil
companies will make payments there in ₹
currency. This will help curbing the
demand of dollars in India.
Budget – Nirmala S. announced various measures to
2019 attract more FPI and FDI investment in
India

2020-Feb Corona Virus Force Major dip in SENSEX

so FPIs Selling shares from Indian
companies they got ₹₹ → converting them
into $ → running back to USA to invest in
(AAA rated) US treasury bonds which is
safest investment. So there is a great
shortage of dollars in the Indian market. If
RBI does not supply dollars → further
weakening of rupee ($1=₹75 → ₹80).
2020-March RBI starts Dollars Swap with Indian banks.
i.e. A bank shall buy US Dollars from the
Reserve Bank and simultaneously agree to
sell the same amount of US Dollars at the
end of the swap period (6 months). It is
done through auctioning, so, RBI to earn
some % of profit.
Quantitative Easing and Federal Tapering
Subprime crisis in USA (2007-08 →

Quantitative Borrowers unable to repay the home
Easing loans → American Banks and NBFCs’
bad loans / NPA / toxic assets increased
→ to help them, US Federal Reserve
printed new dollars & used it to buy those
toxic assets → increased dollar supply in
the system. Known as “Quantitative
Easing”.
Fed Tapering 2013: US Federal Reserve gradually cut
down its toxic asset purchasing program
→ less new dollars issued → called “Fed
Tapering”

Result
shortage (perceived) of dollars in USA → Loans %
become more expensive in USA so American investors
began selling shares/bonds in other countries, and took
their dollars back to USA (to lend to local
businessmen).
This phenomenon was called “Taper Tantrum”. It

resulted into weakening of other currencies against
USD.
Helicopter Money & Zero interest rate regimes

Economist Milton Friedman (1969) introduced concept
of ‘Helicopter Money’ to combat recession, a central
bank should supply large amounts of money to the
public at near zero interest rate, as if the money was
being showered on them from a helicopter. It will
encourage consumption, demand which will result into
more factories, jobs and economic growth.
In the aftermath of sub-prime crisis and global financial
crisis, there was fall in consumption, demand and so the
deflation & recession scenario.
So, the Central Banks of Sweden, EU and Japan cut
their deposit interest rates into negative figures (-0.1%)
so if a commercial bank parked/deposited its surplus
money into the central bank (through a reverse repo like
mechanism), its money will be deducted in penalty
instead of earning deposit interest.
Results, Commercial banks will proactively try to give
away more loans to customers to boost demand in
economy.
Module: III
Foreign Exchange Market
3.1.Foreign Exchange Market:
The foreign exchange market is a decentralized worldwide

market. Foreign exchange market is the market in which
foreign currencies are bought and sold. The buyers and
sellers include individuals, firms, foreign exchange brokers,
commercial banks and the central bank. The transactions in
this market are not confined to only one or few foreign
currencies. In fact, there are a large number of foreign
currencies which are traded, converted and exchanged in
the foreign exchange market. Foreign exchange market is
also described as an OTC (Over the counter) market as
there is no physical place where the participants meet to
execute their deals. It is more an informal arrangement
among the banks and brokers operating in a financing
centre purchasing and selling currencies, connected to each
other by tele-communications like telex, telephone and a
satellite communication network.
The term foreign exchange market is used to refer to the

wholesale segment of the market, where the dealings take
place among the banks. The retail segment refers to the
dealings take place between banks and their customers. The
retail segment is situated at a large number of places. They
can be considered not as foreign exchange markets, but as
the counters of such markets. The central banks monitor
market movements and sentiments and intervene according

to government policy. The function of buying and selling

of foreign currencies in India is performed by authorized
dealers / moneychangers appointed by the RBI. The foreign
exchange department of the major banks are linked across
the world on a 24 hour basis. Major commercial centers are
London, Amsterdam, Frankfurt, Milan, Paris, New York,
Toronto, Bahrain, Tokyo, Hong Kong and Singapore.
3.1.1. Functions of a foreign exchange market:
Purchasing power is transferred across different

countries which will enhance the feasibility of
international trade and overseas investments
The foreign exchange market acts as a central
focal point wherein prices of various currencies are
discovered.
Enables the investors to hedge or minimize their risks
Enables the traders to arbitrage any inequalities
Provides an investment / trading avenue to entities
who are willing to expose themselvesto this risk
3.1.2. Foreign currency and foreign exchange :
In the context of India, any currency other than Indian

rupees is foreign currency. Foreign exchange includes
currency, drafts, bills, letters of credits and traveler cheques
which are denominated and ultimately payable in foreign
currency.

3.1.3. Determinants of Exchange rate
 Purchasing power parity (Inflation) theorem:

Difference in inflation rates between two countries is
considered as the most important factor for variations
in exchange rates. If domestic inflation is high, it
means domestic goods are costlier than foreign
goods. This results in higher imports creating more
demand for foreign currency, making it costlier. (In
other words the value of domestic currency will
decline). If a basket of goods cost Rs470 in India and
$10 in US then it is quite natural that the exchange
rate should be Rs47/$1. PPP theory can be expressed
by the formula: PPPr = Spot rate (1+rh) (1+rf) where
rh is inflation rate at home; rf is the inflation rate of
foreign country.
Weakness of PPP theory : It is not only inflation,

which affects foreign currency movements. PPP
ignores substitution effects – i.e. instead of importing
goods might be substituted.
 Interest Rate Parity Theorem: The second most

important factor in determining exchange rates
after PPP theory. Money tends to move towards
country offering a higher interest rate thereby
resulting in more demand for the foreign country’s
currency. If interest rates in Japan are lower than
interest rates in US then Japanese investors would
prefer to invest in US which would result in more
demand for US $ in Japan (this will cause US$ to
appreciate in Japan). Interest rates provide the
basis for computing forward rates as under:
Forward rate = Spot rate x (1+If) (1+Ih)
 Balance of payments position : The BOP position has a

big impact on the value of a nation’s currency. A big or
consistent deficit would mount a pressure on the
currency of a nation as deficits require payments in
foreign currency. In the case of a fixed currency rate
scenario – the local currency would be devalued thereby
making imports costlier and exports cheaper. However
in the free rate scenario a big or consistent deficit would
be a forewarning for depreciation of a nations currency
 Government intervention : At times the government

would intervene by purchasing or selling foreign
exchange to control pressures on the nation’s currency.
 Market expectation : Market expectation as regards

interest rates, inflation, taxes, BOP positions etc would
affect the foreign exchange rates. Overseas investment :
E.g. if US investments in India increases there would be
dollar inflows putting downward pressure on dollar in
India.
 Speculation : Speculators including treasury managers of

banks, by virtue of their buying and selling, tend to
influence the rates.
3.1.4. Participants in Foreign Exchange Market

Foreign exchange market (Forex market) witnesses a lot
of market participants. However, all of these participants
have different motives. An understanding of these
motives is required to predict their behavior in the
markets. Also, some of these participants have deeper
pockets, better information and are more active than the
others. Therefore, here we discuss the different kinds of

participants that they are likely to come across when

they trade in this market. The participants have been
listed in descending order. This means that dealers are
the most active traders in the Forex markets, followed by
brokers and so on. It would also be fair to say that
dealers have the maximum information about the
market, followed by brokers and so on.
Forex Dealers
Forex dealers are one amongst the biggest
participants in the Forex market. They are also known
as broker dealers. Most Forex dealers in the world are
banks. It is for this reason that the market in which dealers
interact with one another is also known as the interbank
market. However, there are some notable non-bank
financial institutions also that deal in foreign exchange.
These dealers participate in the Forex markets by providing
bid-ask quotes for currency pairs at all times. All brokers do
not participate in all currency pairs. Rather, they may
specialize in a specific currency pair. Alternatively, a lot of
dealers also use their own capital to conduct proprietary
trading operations. When both these operations are
combined, Forex dealers have a significant participation in
the Forex market.
Brokers
The Forex market is largely devoid of brokers. This is
because a person need not deal with brokers necessarily. If
they have sufficient knowledge, they can directly call the
dealer and obtain a favorable rate. However, there are
brokers in the Forex market. These brokers exist because
they add value to their clients by helping them obtain the
best quote. For instance, they may help their clients obtain
the lowest buying price or the highest selling price by
making available quotes from several dealers. Another
major reason for using brokers is creating anonymity while
trading. Many big investors and even Forex dealers use the
services of brokers who act as henchmen for the trading
operations of these big players.
Hedgers
There are many businesses which end up creating an
asset or a liability priced in foreign currency in the
regular course of their business. For instance, importers
and exporters engaged in foreign trade may have open
positions in several foreign currencies. They may
therefore be impacted if there is a fluctuation in the
value of foreign currency. As a result, to protect
themselves against these losses, hedgers take opposite
positions in the market. Therefore if there is an
unfavorable movement in their original position, it is
offset by an opposite movement in their hedged
positions. Their profits and losses and therefore
nullified and they get stability in the operations of their
business.
Speculators
Speculators are a class of traders that have no genuine
requirement for foreign currency. They only buy and
sell these currencies with the hope of making a profit
from it. The number of speculators increases a lot when
the market sentiment is high and everyone seems to be
making money in the Forex markets. Speculators
usually do not maintain open positions in any currency

for a very long time. Their positions are transient and

are only meant to make a short term profit.
Arbitrageurs
Arbitrageurs are traders that take advantage of the
price discrepancy in different markets to make a profit.
Arbitrageurs serve an important function in the foreign
exchange market. It is their operations that ensure that
a market as large, as decentralized and as diffused as
the Forex market functions efficiently and provides
uniform price quotations all over the world. Whenever
arbitrageurs find a price discrepancy in the market,
they start buying in one place and selling in another till
the discrepancy disappears.
Central Banks
Central Banks of all countries participate in the Forex
market to some extent. Most of the times, this
participation is official. Although many times Central
Banks do participate in the market by covert means.
This is because every Central Bank has a target range
within which they would like to see their currency
fluctuate. If the currency falls out of the given range,
Central Banks conduct open market operations to bring
it back in range. Also, whenever the currency of a
given nation is under speculative attack, Central Banks
participate extensively in the market to defend their
currency.
Retail Market Participants

Retail market participants include tourists, students and even
patients who are travelling abroad. Then there are also a
variety of small businesses that indulge in foreign trade.

Most of the retail participants participate in the spot market
whereas people with long term interests operate in the
futures market. This is because these participants only
buy/sell currency when they have a personal/professional
requirement and dealing with foreign currencies is not a part
of their regular business.
3.2. Stability of Foreign Exchange Markets

In this section, we examine the meanings of and the
conditions for stability of the foreign exchange market. We
have a stable foreign exchange market when a disturbance
from the equilibrium exchange rate gives rise to automatic
forces that push the exchange rate back toward the
equilibrium level. We have an unstable foreign exchange
market when a disturbance from equilibrium pushes the
exchange rate further away from equilibrium.
3.2.1. A Stable and Unstable Foreign Exchange

Markets
A foreign exchange market is stable when the supply
curve of foreign exchange is positively sloped or, if
negatively sloped, is less elastic (steeper) than the demand
curve of foreign exchange. A foreign exchange market is
unstable if the supply curve is negatively sloped and more
elastic (flatter) than the demand curve of foreign
exchange.
These conditions are illustrated in Figure 3.1. With D€
and S€, the equilibrium exchange rate is R = $1.20/€1, at
which the quantity of euros demanded and the quantity
supplied are equal at €10 billion per year (point E in the
left panel of Figure 3.1). If, for whatever reason, the
exchange rate fell to R = $1/€1, there would be an excess

demand for euros (a deficit in the U.S. balance of
payments) of €4 billion (AB), which would automatically
push the exchange rate back up toward the equilibrium
rate of R = $1.20/€1. On the other hand, if the
exchange rate rose to R =
$1.40/€1, there would be an excess quantity supplied of
euros (a surplus in the U.S. balance of payments) of €3
billion (NR), which would automatically drive the
exchange rate back down toward the equilibrium rate of R
= $1.20/€1. Thus, the foreign exchange market shown in
the left panel of Figure 3.1 is stable.
The center panel of Figure 3.1 shows the same D€ as in

the left panel, but S€ is now negatively sloped but steeper
(less elastic) than D€. Once again, the equilibrium
exchange rate is R =
$1.20/€1 (point E). At the lower than equilibrium
exchange rate R = $1/€1, there is an excess demand for
euros (a deficit in the U.S. balance of payments) equal to
€1.5 billion, which automatically pushes the exchange rate
back up toward the equilibrium rate of R = $1.20/€1. At
the higher than equilibrium exchange rate of R = $1.40/€1,
there is an excess supply of euros (a surplus in the U.S.
balance of payments) of €1 billion, which automatically
pushes the exchange rate back down toward the
equilibrium rate of R = $1.20/€1. In this case also, the
foreign exchange market is stable.
The right panel of Figure 3.1 looks the same as the center
panel, but the labels of the demand and supply curves are
reversed, so that now S€ is negatively sloped and flatter

(more elastic) than D€. The equilibrium exchange rate is

still R = $1.20/€1 (point E). Now, however, at any
exchange rate lower than equilibrium, there is an excess
quantity supplied of euros, which automatically drives the
exchange rate even lower and farther away from the
equilibrium rate. For example, at R = $1/€1, there is an
excess quantity supplied of euros of €1.5 billion, which
pushes the exchange rate even lower and farther away
from R = $1.20/€1. On the other hand, at R = $1.40/€1,
there is an excess quantity demanded for euros of €1
billion, which automatically pushes the exchange rate even
higher and farther away from the equilibrium rate. Thus,
the foreign exchange market in the right panel is unstable.
Figure 3.1: Stable and Unstable Foreign Exchange

Markets
When the foreign exchange market is unstable, a flexible

exchange rate system increases rather than reduces a
balance-of-payments disequilibrium. Then a revaluation or
an appreciation rather than a devaluation of the deficit
nation’s currency is required to eliminate or reduce a

deficit, while a devaluation would be necessary to correct a

surplus. These policies are just the opposite of those
required under a stable foreign exchange market.
Determining whether the foreign exchange market is stable
or unstable is, therefore, crucial. Only after the foreign
exchange market has been determined to be stable will the
elasticity of D€ and S€ (and thus the feasibility of
correcting a balance-of-payments disequilibrium with a
depreciation or devaluation of the deficit nation’s currency)
become important.
3.2.2. The Marshall–Lerner Condition

The Marshall-Lerner condition, which states that a currency
devaluation will only lead to an improvement in the
balance of payments if the sum of demand elasticity for
imports and exports is greater than one, is named after
English economist Alfred Marshall (1842-1924) and the
Romanian born economist Abba Lerner (1905 – 1985).
This refers to the proposition that the devaluation of a
country’s currency will lead to an improvement in its
balance of trade with the rest of the world only if the sum
of the price elasticities of its exports and imports is greater
than one. For instance, if total export revenue falls due to
inelastic demand for a country’s exports and total import
expense rises due to inelastic demand for its imports, this
will lead to a further worsening of the country’s trade
deficit. So devaluing its currency may not always be the
best way forward for a country looking to reduce its trade
deficit.
Here we discuss the simplified version of Marshall- Learner
condition that is generally used. This is valid when the
supply curves of imports and exports (i.e., SM and SX ) are

both infinitely elastic, or horizontal. Then the Marshall–

Lerner condition indicates a stable foreign exchange market
if the sum of the price elasticities of the demand for imports
(DM) and the demand for exports (DX), in absolute terms, is
greater than 1. If the sum of the price elasticities of DM and
DX is less than 1, the foreign exchange market is unstable,
and if the sum of these two demand elasticities is equal to 1,
a change in the exchange rate will leave the balance of
payments unchanged.
3.3. Spot Market and Forward Market

Foreign exchange markets are sometimes classified into spot
market and forward market on the basis of the period of
transaction carried out. It is explained below:
(a) Spot Market:
If the operation is of daily nature, it is called spot market
or current market. It handles only spot transactions or
current transactions in foreign exchange. Transactions are
affected at prevailing rate of exchange at that point of time
and delivery of foreign exchange is affected instantly. The
most common type of foreign exchange transaction
involves the payment and receipt of the foreign exchange
within two bussiness days after the day the transaction is
agreed upon. The two-day period gives adequate time for
the parties to send instructions to debit and credit the
appropriate bank accounts at home and abroad. This type of
transaction is called a spot transaction, and the exchange
rate at which the transaction takes place is called the spot
rate. Theexchange rate R = $/₹ = 1 is a spot rate.
For instance, if one US dollar can be purchased for Rs 40
at the point of time in the foreign exchange market, it will
be called spot rate of foreign exchange. No doubt, spot rate

of foreign exchange is very useful for current transactions
but it is also necessary to find what the spot rate is. In
addition, it is also significant to find the strength of the
domestic currency with respect to all of home country’s
trading partners. Note that the measure of average relative
strength of a given currency is called Effective Exchange
Rate (EER).
(b) Forward Market:
A market in which foreign exchange is bought and sold for
future delivery is known as Forward Market. It deals with
transactions (sale and purchase of foreign exchange) which
are contracted today but implemented sometimes in future.
A forward transaction involves an agreement today to buy
or sell a specified amount of a foreign currency at a
specified future date at a rate agreed upon today (the
forward rate). For example, I could enter into an
agreement today to purchase ₹100 three months from
today at $1.01 = ₹1. Note that no currencies are paid out at
the time the contract is signed (except for the usual 10
percent security margin). After three months, I get the
₹100 for $101, regardless of what the spot rate is at that
time. The typical forward contract is for one month, three
months, or six months, with three months the most
common. Forward contracts for longer periods are not as
common because of the great uncertainties involved.
However, forward contracts can be renegotiated for one or
more periods when they become due. The equilibrium
forward rate is determined at the intersection of the market
demand and supply curves of foreign exchange for future
delivery. The demand for and supply of forward foreign
exchange arise in the course of hedging, from foreign
exchange speculation, and from covered interest arbitrage.

A forward contract is entered into for two reasons: To
minimise risk of lossdue to adverse change in exchange rate
(i.e., hedging) and to make a profit (i.e., speculation).
At any point in time, the forward rate can be equal to,
above, or below the corresponding spot rate. If the forward
rate is below the present spot rate, the foreign currency
is said to be at a forward discount with respect to the
domestic currency. However, if the forward rate is above
the present spot rate, the foreign currency is said to be at a
forward premium. For example, if the spot rate is $1 = ₹1
and the three-month forward rate is $0.99 = ₹1, we say that
the rupee is at a three-month forward discount of 1 percent
(or at a 4 percent forward discount per year) with respect to
the dollar. On the other hand, if the spot rate is still $1 = ₹1
but the three-month forward rate is instead $1.01 = ₹1, the
rupee is said to be at a forward premium of 1 percent for
three months, or 4 percent per year. Forward discounts
(FD) or premiums (FP) are usually expressed as
percentages per year.
3.4. Foreign Exchange Futures and Options

Currency futures and options are derivative contracts.
Depending on the selection of buying or selling the
numerator or denominator of a currency pair, the
derivative contracts are known as futures and options.
There are various ways to earn a profit from futures and
options, but the contract-holder is always obliged to certain
rules when they go into a contract. Currencies are always
traded in pairs. For example, the Euro and U.S. Dollar pair
is expressed as EUR/USD. When someone buys this pair,
they are said to be going long (buying) with the numerator,
or the base, currency, which is the Euro; and thereby selling

the denominator (quote) currency, which is the Dollar.
When someone sells the pair, it is selling the Euro and
buying the Dollar. When the long currency appreciates
against the short currency, people make money.
Foreign Exchange Options:

A foreign exchange option is a contract giving the purchaser
the right, but not the obligation, to buy (a call option) or to
sell (a put option) a standard amount of a traded currency on
a stated date or at any time before a stated date and at a
stated price (the strike or exercise price). If an investor
purchases the right to buy an asset at a specific price within
a given time frame, he has purchased a call option. On the
contrary, if he purchases the right to sell an asset at a given
price, he has purchased a put option. The seller has the
corresponding obligation to fulfill the transaction that is to
sell or buy if the buyer (owner) exercises the option. The
buyer pays a premium to the seller for this right. An option
that conveys to the owner the right to buy something at a
certain price is a "call option"; an option that conveys the
right of the owner to sell something at a certain price is a
"put option".
Options contracts were used for many centuries, however
both trading activity and academic interest increased when,
as from 1973, options were issued with standardized terms
and traded through a guaranteed clearing house at the
Chicago Board Options Exchange. Today many options are
created in a standardized form and traded through clearing
houses on regulated options exchanges, while other over-
the-counter options are written as bilateral, customized
contracts between a single buyer and seller, one or both of

which may be a dealer or market- maker. Options are part of

major category of financial instruments termed as derivative
products or simply derivatives.
Features of options:
 A fixed maturity date on which they expire (Expiry

date).
 The price at which the option is exercised is called the

exercise price or strike price.
 The person who writes the option and is the seller is

denoted as the "option writer", andwho holds the option
and is the buyer, is called "option holder".
 The premium is the price paid for the option by the

buyer to the seller.
 A clearing house is interposed between the seller and

the buyer which guaranteesperformance of the contract.
Foreign Exchange Futures:

An individual, firm, or bank can also purchase or sell
foreign exchange futures and options. Trading in foreign
exchange futures was initiated in 1972 by the International
Monetary Market (IMM) of the Chicago Mercantile
Exchange (CME). A foreign exchange futures is a forward
contract for standardized currency amounts and selected
calendar dates traded on an organized market (exchange).
The currencies traded on the IMM are the Japanese yen, the
Canadian dollar, the British pound, the Swiss franc, the
Australian dollar, the Mexican peso, and the euro. The IMM
imposes a daily limit on exchange rate fluctuations. Buyers

and sellers pay a brokerage commission and are required to

post a security deposit or margin (about 4 percent of the
value of the contract). the futures market only a few
currencies are traded; trades occur in standardized contracts
only, for a few specific delivery dates, and are subject to
daily limits on exchange rate fluctuations; and trading takes
place only in a few geographical locations, such as Chicago,
New York, London, Frankfurt, and Singapore. Futures
contracts are usually for smaller amounts and thus are more
useful to small firms than to large ones but are somewhat
more expensive. Futures contracts can also be sold at any
time up until maturity on an organized futures market. The
market for currency futures is small and it has grown very
rapidly, especially in recent years.
Foreign Exchange Swaps

Swap means to exchange one for another. A foreign
exchange swap refers to a spot sale of a currency combined
with a forward repurchase of the same currency—as part of
a single transaction. It means, where one leg's cash flows are
paid in one currency, while the other leg's cash flows are
paid in another currency. It can be either fixed for floating,
floating for floating, or fixed for fixed. In order to price
foreign exchange swap, first each leg is present valued in its
currency. For example, suppose that Citibank receives a $1
million payment today that it will need in three months, but
in the meantime it wants to invest this sum in euros.
Citibank would incur lower brokerage fees by swapping the
$1 million into euros with Frankfurt’s Deutsche Bank as
part of a single transaction or deal, instead of selling dollars
for euros in the spot market today and at the same time
repurchasing dollars for euros in the forward market for
delivery in three months—in two separate transactions. The
swap rate (usually expressed on a yearly basis) is the

difference between the spot and forward rates in the
currency swap. Most interbank trading involving the
purchase or sale of currencies for future delivery is done not
by forward exchange contracts alone but combined with
spot transactions in the form of foreign exchange swaps.
The foreign exchange market is dominated by the foreign
exchange swap and spot markets. Swaps were first
introduced to the public in 1981 when IBM and the World
Bank entered into a swap contract. Presently, swaps are
among the most heavily traded financial contracts around
the globe.
3.5. Foreign Exchange Risks, Hedging, and

Speculation
 Foreign Exchange Risks

Through time, a nation’s demand and supply curves for
foreign exchange shift, causing the spot (and the forward)
rate to vary frequently. A nation’s demand and supply
curves for foreign exchange shift over time as a result of
changes in tastes for domestic and foreign products in the
nation and abroad, different growth and inflation rates in
different nations, changes in relative rates of interest,
changing expectations, and so on. For example, if U.S.
tastes for EMU products increase, the U.S. demand for euros
increases (the demand curve shifts up), leading to a rise in
the exchange rate (i.e., a depreciation of the dollar). On the
other hand, a lower rate of inflation in the United States
than in the European Monetary Union leads to U.S. products
becoming cheaper for EMU residents. This tends to increase
the U.S. supply of euros (the supply curve shifts to the
right) and causes a decline in the exchange rate (i.e., an

appreciation of the dollar). Or simply the expectation of a

stronger dollar may lead to an appreciation of the dollar. In
short, in a dynamic and changing world, exchange rates
frequently vary, reflecting the constant change in the
numerous economic forces simultaneously at work. The
frequent and relatively large fluctuations in exchange rates
impose foreign exchange risks on all individuals, firms, and
banks that have to make or receive future payments
denominated in a foreign currency.
Whenever a future payment must be made or received in a
foreign currency, a foreign exchange risk, or a so-called
open position, is involved because spot exchange rates vary
over time. In general, businesspeople are risk averse and
they will want to avoid or insure themselves against their
foreign exchange risk. A foreign exchange risk arises not
only from transactions involving future payments and
receipts in a foreign currency (the transaction exposure) but
also from the need to value inventories and assets held
abroad in terms of the domestic currency for inclusion in the
firm’s consolidated balance sheet (the translation or
accounting exposure), and in estimating the domestic
currency value of the future profitability of the firm (the
economic exposure).
 Hedging
Hedging refers to the avoidance of a foreign exchange risk,
or the covering of an open position. It is a financial
technique that helps to reduce or mitigate the effects of
measurable type of risk from the future changes in the fair
value of commodities, cash flows, securities, currencies,
assets and liabilities. It is a kind of an insurance that do
not eliminate the risk completely but mitigate its effect. In

other words, it is a risk-reducing tool wherein the firm uses

the derivatives and other instruments to offset the future
changes in the value of securities, currencies, assets, etc.
The firm uses several derivatives or other instruments to
hedge against the exchange risk.
The following are the main advantages of risk management
through hedging:
 The financial risk management enables the managers to

hedge against the probable movement in the exchange rates
and interest rates. These are the factors that are beyond
management control and cannot be predicted with certainty.
Thus, it encourages the managers to direct their efforts
towards the improvement of the operations rather than
worrying about the factors that are not under their control.
 It helps to differentiate the effects of fluctuation in the

external factors viz. exchange rates and interest rates and
management performance. Even if the company hedges its
risk and suffers a huge loss, then it can be said that
management is bad.
Thus the primary objective of the risk management tool is to
reduce the risk, not to save cost or earn profits.
The cost of avoiding the foreign exchange risk equal to the
positive difference between the borrowing and deposit rates
of interest. Hedging usually takes place in the forward
market, where no borrowing or tying up of funds is required.
A foreign exchange risk can also be hedged and an open
position avoided in the futures or options markets. In a
world of foreign exchange uncertainty, the ability of traders
and investors to hedge greatly facilitates the international

flow of trade and investments. Without hedging there would

be smaller international capital flows, less trade and
specialization in production, and smaller benefits from trade.
Note that a large firm, such as a multinational corporation,
that has to make and receive a large number of payments in
the same foreign currency at the same time in the future
need only hedge its net open position. Similarly, a bank has
an open position only in the amount of its net balance on
contracted future payments and receipts in each foreign
currency at each future date. The bank closes as much of its
open positions as possible by dealing with other banks
(through foreign exchange brokers), and it may cover the
remainder in the spot, futures, or options markets.
Speculation
Speculation is the opposite of hedging. Whereas a hedger
seeks to cover a foreign exchange risk, a speculator accepts
and even seeks out a foreign exchange risk, or an open
position, in the hope of making a profit. If the speculator
correctly anticipates future changes in spot rates, he or she
makes a profit; otherwise, he or she incurs a loss. As in the
case of hedging, speculation can take place in the spot,
forward, futures, or options markets—usually in the forward
market. Speculation in foreign exchange is very risky and
can lead to huge losses.
We begin by examining speculation in the spot market. If a
speculator believes that the spot rate of a particular foreign
currency will rise, he or she can purchase the currency now
and hold it on deposit in a bank for resale later. If the
speculator is correct and the spot rate does indeed rise, he or
she earns a profit on each unit of the foreign currency equal
to the spread between the previous lower spot rate at which

he or she purchased the foreign currency and the higher

subsequent spot rate at which he or she resells it. If the
speculator is wrong and the spot rate falls instead, he or she
incurs a loss because the foreign currency must be resold at
a price lower than the purchase price. If, on the other hand,
the speculator believes that the spot rate will fall, he or she
borrows the foreign currency for three months, immediately
exchanges it for the domestic currency at the prevailing spot
rate, and deposits the domestic currency in a bank to earn
interest. After three months, if the spot rate on the foreign
currency is lower, as anticipated, the speculator earns a profit
by purchasing the currency (to repay the foreign exchange
loan) at the lower spot rate. If the spot rate in three months is
higher rather than lower, the speculator incurs a loss.
In both of the preceding examples, the speculator operated
in the spot market and either had to tie up his or her own
funds or had to borrow to speculate. It is to avoid this
serious shortcoming that speculation, like hedging, usually
takes place in the forward market. When a speculator buys a
foreign currency on the spot, forward, or futures market, or
buys an option to purchase a foreign currency in the
expectation of reselling it at a higher future spot rate, he or
she is said to take a long position in the currency. On the
other hand, when the speculator borrows or sells forward a
foreign currency in the expectation of buying it at a future
lower price to repay the foreign exchange loan or honor the
forward sale contract or option, the speculator is said to
take a short position (i.e., the speculator is now selling what
he or she does not have).
Speculation can be stabilizing or destabilizing. Stabilizing
speculation refers to the purchase of a foreign currency
when the domestic price of the foreign currency (i.e., the
exchange rate) falls or is low, in the expectation that it will

soon rise, thus leading to a profit. Or it refers to the sale of
the foreign currency when the exchange rate rises or is high,
in the expectation that it will soon fall. Stabilizing
speculation moderates fluctuations in exchange rates over
time and performs a useful function. On the other hand,
destabilizing speculation refers to the sale of a foreign
currency when the exchange rate falls or is low, in the
expectation that it will fall even lower in the future, or the
purchase of a foreign currency when the exchange rate is
rising or is high, in the expectation that it will rise even
higher in the future. Destabilizing speculation thus
magnifies exchange rate fluctuations over time and can
prove very disruptive to the international flow of trade and
investments. In general, it is believed that under “normal”
conditions speculation is stabilizing, and we assume so here.
Speculators are usually wealthy individuals or firms rather
than banks. However, anyone who has to make a payment
in a foreign currency in the future can speculate by speeding
up payment if he or she expects the exchange rate to rise and
delaying it if he or she expects the exchange rate to fall,
while anyone who has to receive a future payment in a
foreign currency can speculate by using the reverse tactics.
For example, if an importer expects the exchange rate to
rise soon, he or she can anticipate the placing of an order
and pay for imports right away. On the other hand, an
exporter who expects the exchange rate to rise will want to
delay deliveries and extend longer credit terms to delay
payment. These are known as leads and lags and are a form
of speculation.

3.6. Currency Arbitrage

The exchange rate between any two currencies is kept the
same in different monetary centers by arbitrage. This refers
to the purchase of a currency in the monetary center where it
is cheaper, for immediate resale in the monetary center
where it is more expensive, in order to make a profit.
Arbitrage refers to purchase of an asset in a low price
market and its sale in a higher price market. This process
leads to equalisation of price of an asset in all the segments
of the market. Arbitrageurs take advantage of the different
exchange rates prevailing in various foreign exchange
markets due to different interest rates. They purchase
foreign currency from the foreign exchange market with
lower exchange rate and sell the same in market with a
higher exchange rate. Arbitrage is also possible within the
country where two banks offer two different bids and asking
rate. When arbitrage involves only two currencies or two
countries, it is called two-point arbitrage. It increases the
supply of dearer currency.
For example, if the dollar price of the euro was $0.99 in
New York and $1.01 in Frankfurt, an arbitrageur (usually a
foreign exchange dealer of a commercial bank) would
purchase euros at $0.99 in New York and immediately
resell them in Frankfurt for $1.01, thus realizing a profit of
$0.02 per euro. While the profit per euro transferred seems
small, on €1 million the profit would be $20,000 for only a
few minutes work. From this profit must be deducted the
cost of the electronic transfer and the other costs associated
with arbitrage. Since these costs are very small.
As arbitrage takes place, however, the exchange rate

between the two currencies tends to be equalized in the two

monetary centers. Continuing our example, we see that

arbitrage increases the demand for euros in New York,
thereby exerting an upward pressure on the dollar price of
euros in New York. At the same time, the sale of euros in
Frankfurt increases the supply of euros there, thus exerting a
downward pressure on the dollar price of euros in Frankfurt.
This continues until the dollar price of the euro quickly
becomes equal in New York and Frankfurt (say at $1 = €1),
thus eliminating the profitability of further arbitrage.
When only two currencies and two monetary centers are
involved in arbitrage, as in the preceding example, we have
two-point arbitrage. When three currencies and three
monetary centers are involved, we have triangular, or three-
point, arbitrage. While triangular arbitrage is not very
common, it operates in the same manner to ensure consistent
indirect, or cross, exchange rates between the three
currencies in the three monetary centers.
As in the case of two-point arbitrage, triangular arbitrage
increases the demand for the currency in the monetary
center where the currency is cheaper, increases the supply of
the currency in the monetary center where the currency is
more expensive, and quickly eliminates inconsistent cross
rates and the profitability of further arbitrage. As a result,
arbitrage quickly equalizes exchange rates for each pair of
currencies and results in consistent cross rates among all
pairs of currencies, thus unifying all international monetary
centers into a single market.
3.7. Internal and External Balance with Expenditure-

Changing and Expenditure- Switching Policies
The adjustment policies are the policies that are used to

achieve full employment with price stability and equilibrium

in the balance of payments. The need for adjustment
policies arises because of the absence of automatic
adjustment mechanisms. The economist most responsible
for shifting the emphasis from automatic adjustment
mechanisms to adjustment policies was James Meade. The
most important economic goals or objectives of nations are
(1) internal balance, (2) external balance, a reasonable rate
of growth, (4) an equitable distribution of income, and (5)
adequate protection of the environment.
Internal balance refers to full employment or a rate of
unemployment of no more than, say, 4 to 5 percent per year
(the so-called frictional unemployment arising in the process
of changing jobs) and a rate of inflation of no more than 2 or
3 percent per year. External balance refers to equilibrium in
the balance of payments (or a desired temporary
disequilibrium such as a surplus that a nation may want in
order to replenish its depleted international reserves). In
general, nations place priority on internal over external
balance, but they are sometimes forced to switch their
priority when faced with large and persistent external
imbalances.
To achieve these objectives, nations have the following
policy instruments at their disposal: (1) expenditure-
changing, or demand, policies, (2) expenditure switching
policies, and (3) direct controls.
Expenditure-changing policies include both fiscal and
monetary policies. Fiscal policy refers to changes in
government expenditures, taxes, or both. Fiscal policy is
expansionary if government expenditures are increased
and/or taxes reduced. These actions lead to an expansion of

domestic production and income through a multiplier

process (just as in the case of an increase in domestic
investment or exports) and induce a rise in imports
(depending on the marginal propensity to import of the
nation). Contractionary fiscal policy refers to a reduction in
government expenditures and/or an increase in taxes, both of
which reduce domestic production and income and induce a
fall in imports.
The introduction of the government sector means that the
equilibrium condition of Equation 3.1 must be extended to
become Equation 3.2, where G refers to government
expenditures and T to taxes:
I + X = S + M (3.1)
I + X + G = S + M + T (3.2)
Government expenditures (G), just like investments (I)
and exports (X), are injections into the system, while taxes
(T), just like savings (S) and imports (M), are a leakage from
the system. Equation (3.2) can also be rearranged as
(G − T) = (S − I ) + (M − X) (3.3)
Which postulates that a government budget deficit (G>T)

must be financed by an excess of S over I and/ or an excess
of M over X. Expansionary fiscal policy refers to an
increase in (G −T), and this can be accomplished with an
increase in G, a reduction in T, or both. Contractionary fiscal
policy refers to the opposite.
Monetary policy involves a change in the nation’s money
supply that affects domestic interest rates. Monetary policy
is easy if the money supply is increased and interest rates

fall. This induces an increase in the level of investment and

income in the nation (through the multiplier process) and
induces imports to rise. At the same time, the reduction in
the interest rate induces a short-term capital outflow or
reduced inflow. On the other hand, tight monetary policy
refers to a reduction in the nation’s money supply and a rise
in the interest rate. This discourages investment, income,
and imports, and also leads to a short-term capital inflow or
reduced outflow.
Expenditure-switching policies refer to changes in the
exchange rate (i.e., a devaluation or revaluation). A
devaluation switches expenditures from foreign to domestic
commodities and can be used to correct a deficit in the
nation’s balance of payments. But it also increases domestic
production, and this induces a rise in imports, which
neutralizes a part of the original improvement in the trade
balance. A revaluation switches expenditures from
domestic to foreign products and can be used to correct a
surplus in the nation’s balance of payments. This also
reduces domestic production and, consequently, induces a
decline in imports, which neutralizes part of the effect of the
revaluation.
Direct controls consist of tariffs, quotas, and other
restrictions on the flow of international trade and capital.
These are also expenditure-switching policies, but they can
be aimed at specific balance-of-payments items (as opposed
to a devaluation or revaluation, which is a general policy and
applies to all items at the same time). Direct controls in the
form of price and wage controls can also be used to stem
domestic inflation when other policies fail. Faced with
multiple objectives and with several policy instruments at its
disposal, the nation must decide which policy to utilize to
achieve each of its objectives.

According to Tinbergen (Nobel prize winner in economics
in 1969), the nation usually needs as many effective policy
instruments as the number of independent objectives it has.
If the nation has two objectives, it usually needs two policy
instruments to achieve the two objectives completely; if it
has three objectives, it requires three instruments, and so on.
Sometimes a policy instrument directed at a particular
objective also helps the nation move closer to another
objective. At other times, it pushes the nation even farther
away from the second objective. For example, expansionary
fiscal policy to eliminate domestic unemployment will also
reduce a balance-of-payments surplus, but it will increase a
deficit. Since each policy affects both the internal and
external balance of the nation, it is crucial that each policy
be paired with and used for the objective toward which it is
most effective, according to the principle of effective market
classification developed by Mundell.
Use of expenditure-changing and expenditure-switching

policies to achieve both internal and external balance
Here we examine how a nation can simultaneously attain
internal and external balance with expenditure-changing and
expenditure-switching policies. For simplicity we assume a
zero international capital flow (so that the balance of
payments is equal to the nation’s trade balance). We also
assume that prices remain constant until aggregate demand
begins to exceed the full- employment level of output.
In figure 3.2, the vertical axis measures the exchange rate
(R). An increase in R refers to a devaluation and a decrease
in R to a revaluation. The horizontal axis measures real

domestic expenditures, or absorption (D). Besides domestic

consumption and investments, D also includes government
expenditures (which can be manipulated in the pursuit of
fiscal policy). The EE curve shows the various combinations
of exchange rates and real domestic expenditures, or
absorption, that result in external balance. The EE curve is
positively inclined because a higher R (due to a devaluation)
improves the nation’s trade balance (if the Marshall–Lerner
condition is satisfied) and must be matched by an increase in
real domestic absorption (D) to induce imports to rise
sufficiently to keep the trade balance in equilibrium and
maintain external balance.
For example, starting from point F on EE, an increase in R
from R2 to R3 must be accompanied by an increase in D
from D2 to D3 for the nation to maintain external balance
(point J _ on EE). A smaller increase in D will lead to a
balance-of-trade surplus, while a larger increase in D will
lead to a balance-of-trade deficit. On the other hand, the YY
curve shows the various combinations of exchange rates (R)
and domestic absorption (D) that result in internal balance
(i.e., full employment with price stability). The YY curve is
negatively inclined because a lower R (due to a revaluation)
worsens the trade balance and must be matched with larger
domestic absorption (D) for the nation to remain in internal
balance. For example, starting from point F on YY , a
reduction in R from R2 to R1 must be accompanied by an
increase in D from D2 to D3 to maintain internal balance
(point J on YY ). A smaller increase in D will lead to
unemployment, while a larger increase in D will lead to
excess aggregate demand and (demand-pull) inflation.

In Figure 3.2, we see that only at point F (i.e., at R2 and

D2), defined as where the EE and YY curves intersect, will
the nation be simultaneously in external and internal
balance. With points above the EE curve referring to
external surpluses and points below referring to deficits,
and with points below the YY curve referring to
unemployment and points above referring to inflation, we
can define the following four zones of external and internal
imbalance:
 Zone I External surplus and internal unemployment

 Zone II External surplus and internal inflation
 Zone III External deficit and internal inflation
 Zone IV External deficit and internal unemployment
From the figure 3.2 we can now determine the combination

of expenditure-changing and expenditure-switching policies
required to reach point F. For example, starting from point
C (deficit and unemployment), both the exchange rate (R)
and domestic absorption (D) must be increased to reach

point F. By increasing R only, the nation can reach either

external balance (point C_ on the EE curve) or, with a larger
increase in R, internal balance (point C on the YY curve), but
it cannot reach both simultaneously. Similarly, by increasing
domestic absorption only, the nation can reach internal
balance (point J on the YY curve), but this leaves an external
deficit because the nation will be below the EE curve. Note
that although both point C and point H are in zone IV, point
C requires an increase in domestic absorption while point H
requires a decrease in domestic absorption to reach point F.
Even if the nation were already in internal balance, say, at
point J on YY , a devaluation alone could get the nation to
point J _ on EE, but then the nation would face inflation.
Thus, two policies are usually required to achieve two goals
simultaneously. Only if the nation happens to be directly
across from or directly above or below point F will the
nation be able to reach point F with a single policy
instrument. For example, from point N the nation will be
able to reach point F simply by increasing domestic
absorption from D1 to D2. The reason is that this increase in
domestic absorption induces imports to rise by the precise
amount required to eliminate the original surplus without
any change in the exchange rate. But this is unusual.
Figure 3.2. is called a Swan diagram in honor of Trevor
Swan, the Australian economist who introduced it. Under
the fixed exchange rate system that prevailed from the end
of World War II until 1971, industrial nations were
generally unwilling to devalue or revalue their currency
even when they were in fundamental disequilibrium.
Surplus nations enjoyed the prestige of the surplus and
the accumulation of reserves. Deficit nations regarded
devaluation as a sign of weakness and feared it might lead to

destabilizing international capital movements. As a result,

nations were left with only expenditure-changing policies to
achieve internal and external balance.
3.8. Mundell-Fleming Model
The Mundell–Fleming model is used to show how a nation
can use fiscal and monetary policies to achieve both
internal and external balance without any change in the
exchange rate. This model is relating to appropriate use of
monetary and fiscal policy in an open economy under fixed
exchange rates with capital mobility. Under floating
exchange rate there is limited scope for government
intervention to achieve internal and external balance. The
model differentiates the effect of monetary and fiscal policy
on the open economy.
The separation of monetary and fiscal policy was first
accomplished by Swan’s model to include capital flows as
well. ‘External balance’ or ‘balance of payments
equilibrium’ was thus redefined by Mundell to mean a zero
balance in the official financing accounts. In the Mundell
world, the attainment of the external balance target is
influenced by both monetary policy and fiscal policy. For
example, an expansionary monetary policy (in the term of
an decrease in the money supply) which reduces interest
rates will lead to a reduction in the short- term capital
inflows or an increase in short-term capital outflows and to
a BOP deficit.
An expansionary fiscal policy—in the term of an increase
in income and an increase in imports and also a BOP
deficit. Since either expansionary monetary policy or
expansionary fiscal policy is assumed to have an adverse
effect on the BOP, maintaining BOP equilibrium for a

given ex•change rate requires an opposite use of monetary

and fiscal policy in this model, i.e., expan•sionary fiscal
policy must be supported by centractionary monetary
policy, and vice versa.
There is an exactly similar type of policy relationship with
respect to the internal balance target. An increase in the
money supply leads to lower interest rates and tends to
stimulate realinvestment. This is likely to be expansionary
and/or inflationary. So an increase in investment has to be
offset by a decrease in government spending or by an
increase in taxes that will reduce consumption. Similarly,
maintenance of a given domestic internal balance target
indicates that any increase in government spending (or any
increase in consumption spending via a decrease in taxes)
must be offset by some monetary policy actions such as
raising interest rates by reducing the money supply so as to
prevent the generation of inflationary pressures within the
economy.
Figure 3.3:
Equilibrium in the Goods and Money Markets and in
the Balance of Payments

The IS, LM, and BP curves are shown in Figure 3.3. The IS
curve shows the various combinations of interest rates (i)
and national income (Y) that result in equilibrium in the
goods market. The goods market is in equilibrium
whenever the quantity of goods and services demanded
equals the quantity supplied, or when injections into the
system equal Leakages. The level of investment (I) is now
taken to be inversely related to the rate of interest (i). That
is, the lower the rate of interest (to borrow funds for
investment purposes), the higher is the level of investment
(and national income, through the multiplier process).
The IS curve is negatively inclined because at lower interest
rates, the level of investment is higher so that the level of
national income will also have to be higher to induce a
higher level of saving and imports to once again be equal to
the higher level of investment. At that point, the nation’s
goods market is once again in equilibrium. Exports,
government expenditures, and taxes are not affected by the
increase in the level of national income because they are
exogenous. Thus, equilibrium in the nation’s goods market
is reestablished when I = S + M.
The LM curve shows the various combinations of interest
rates (i) and national income (Y) at which the demand for
money is equal to the given and fixed supply of money, so
that the money market is in equilibrium. Money is
demanded for transactions and speculative purposes. The
transaction demand for money consists of the active
working balances held for the purpose of making business
payments as they become due. The transaction demand for
money is positively related to the level of national income.
That is, as the level of national income rises, the quantity
demanded of active money balances increases (usually in
the same proportion) because the volume of transactions is

greater. The speculative demand for money arises from the
desire to hold money balances instead of interest-bearing
securities. The reason for the preference for money
balances is to avoid the risk of falling security prices.
Furthermore, money balances will allow the holder to take
advantage of possible future (financial) investment
opportunities. However, the higher the rate of interest, the
smaller is the quantity of money demanded for speculative
or liquidity purposes because the cost (interest foregone) of
holding inactive money balances is greater.
The LM curve is positively inclined because the higher the
rate of interest (i ), the smaller the quantity of money
demanded for speculative purposes. The remaining larger
supply of money available for transaction purposes will be
held only at higher levels of national income. To be noted is
that the LM curve is derived on the assumption that the
monetary authorities keep the nation’s money supply fixed.
The BP curve shows the various combinations of interest
rates (i) and national income (Y) at which the nation’s
balance of payments is in equilibrium at a given exchange
rate. The balance of payments is in equilibrium when a
trade deficit is matched by an equal net capital inflow, a
trade surplus is matched by an equal net capital outflow, or
a zero trade balance is associated with a zero net
international capital flow. The BP curve is positively
inclined because higher rates of interest lead to greater
capital inflows (or smaller outflows) and must be balanced
with higher levels of national income and imports for the
balance of payments to remain in equilibrium.
To the left of the FE curve, the nation has a balance-of-

payments surplus and to the right a balance-of-payments

deficit. The more responsive international short-term capital
flows are to changes in interest rates, the flatter is the BP
curve. The BP curve is drawn on the assumption of a
constant exchange rate. A devaluation or depreciation of the
nation’s currency shifts the BP curve down since the
nation’s trade balance improves, and so a lower interest rate
and smaller capital inflows (or greater capital outflows) are
required to keep the balance of payments in equilibrium. On
the other hand, a revaluation or appreciation of the nation’s
currency shifts the BP curve upward. Since we are here
assuming that the exchange rate is fixed, the BP curve does
not shift.
In Figure 3.3, the only point at which the nation is
simultaneously in equilibrium in the goods market, in the
money market, and in the balance of payments is at point
E, where the IS , LM, and BP curves cross. Note that this
equilibrium point is associated with an income level of YE
= 1000, which is below the full-employment level of
national income of YF = 1500. Also to be noted is that the
BP curve need not cross at the IS−LM intersection. In that
case, the goods and money markets, but not the balance of
payments, would be in equilibrium. However, a point such
as E, where the nation is simultaneously in equilibrium in
all three markets, is a convenient starting point to examine
how the nation, by the appropriate combination of fiscal
and monetary policies, can reach the full-employment level
of national income (and remain in external balance) while
keeping the exchange rate fixed. Thus the Mundell-Fleming
model suggests that effective classification of policy
instruments and targets is, no doubt, a strategic issue. It is
an important element in the successful administration of
economic policy in an open economy under fixed exchange

rates.
3.9. The Assignment Problem:

Here we presents and evaluates the so-called assignment
problem, or how fiscal and monetary policies must be used
to achieve both internal and external balance. In Figure 3.4,
movements along the horizontal axis away from the origin
refer to expansionary fiscal policy (i.e., higher government
expenditures and/or lower taxes), while movements along
the vertical axis away from the origin refer to tight
monetary policy (i.e., reductions in the nation’s money
supply and increases in its interest rate).
Figure.3.4: Effective market classification and the policy

mix
The IB line in the figure shows the various combinations of

fiscal and monetary policies that result in internal balance

(i.e., full employment with price stability) in the nation. The
IB line is positively inclined because an expansionary fiscal
policy must be balanced by a tight monetary policy of a
sufficient intensity to maintain internal balance.
Starting at point F in Figure 18.10, an increase in
government expenditures that moves the nation to point A
leads to excess aggregate demand, or demand-pull inflation.
This can be corrected or avoided by the tight monetary
policy and higher interest rate that moves the nation to point
A’ on the IB line. A tight monetary policy that leaves the
nation’s interest rate below that indicated by point A’ does
not eliminate the excess aggregate demand entirely and
leaves some inflationary pressure in the nation. On the other
hand, a tighter monetary policy and higher interest rate that
moves the nation above point A’ not only eliminates the
inflation created by the increase in government
expenditures but leads to unemployment. Thus, to the right
of and below the IB line there is inflation, and to the left of
and above there is unemployment.
On the other hand, the EB line shows the various
combinations of fiscal and monetary policies that result in
external balance (i.e., equilibrium in the nation’s balance
of payments). Starting from a point of external balance on
the EB line, an expansionary fiscal policy stimulates
national income and causes the nation’s trade balance to
worsen. This must be balanced with a tight monetary policy
that increases the nation’s interest rate sufficiently to
increase capital inflows (or reduce capital outflows) for the
nation to remain in external balance.

For example, starting from point F on the EB line, an

expansionary fiscal policy that moves the nation to point A
leads to an external deficit, which can be corrected or
avoided by the tight monetary policy and higher interest
rate that moves the nation to point A” on the EB line. As a
result, the EB line is also positively inclined. A monetary
policy that moves the nation to a point below point A”
leaves an external deficit, while a tighter monetary policy
that moves the nation above point A” leads to an external
surplus.
Thus, to the right of and below the EB line there is an
external deficit, and to the left of and above there is an
external surplus. Only at point F, where the IB and EB lines
cross, will the nation be at the same time in internal and
external balance. The crossing of the IB and EB curves in
Figure 3.4 defines the four zones of internal and external
imbalance. Note that the EB line is flatter than the IB line.
This is always the case whenever short-term international
capital flows are responsive to international interest
differentials.
Expansionary fiscal policy raises national income and
increases the transaction demand for money in the nation.
If monetary authorities increase the money supply
sufficiently to satisfy this increased demand, the interest
rate will remain unchanged. Under these circumstances,
fiscal policy affects the level of national income but not the
nation’s interest rate. On the other hand, monetary policy
operates by changing the money supply and the nation’s
interest rate. The change in the nation’s interest rate affects
not only the level of investment and national income
(through the multiplier process) but also international
capital flows. As a result, monetary policy is more
effective than fiscal policy in achieving external balance,

and so the EB line is flatter than the IB line.
Following the principle of effective market classification,
monetary policy should be assigned to achieve external
balance and fiscal policy to achieve internal balance. If the
nation did the opposite, it would move farther and farther
away from internal and external balance. For example, if
from point C in Figure 3.4, indicating unemployment and a
deficit (zone IV), the nation used a contractionary fiscal
policy to eliminate the external deficit and moved to point
C’1 on the EB line, and then used an easy monetary policy
to eliminate unemployment and moved to point C’2 on the
IB line, the nation would move farther and farther away
from point F. On the other hand, if the nation appropriately
used an expansionary fiscal policy to reach point C1 on the
IB line, and then used a tight monetary policy to reach point
C2 on the EB line, the nation would move closer and closer
to point F.
In fact, the nation could move from point C to point F in a
single step by the appropriate mix of expansionary fiscal
and contractionary monetary policies. The nation could
similarly reach point F from any other point of internal and
external imbalance by the appropriate combination of
fiscal and monetary policies. The more responsive
international short-term capital flows are to interest rate
differentials across nations, the flatter is the EB line in
relation to the IB line. On the other hand, if short-term
capital flows did not respond at all to interest differentials,
the EB line would have the same slope as (and coincide
with) the IB line so that no useful purpose could be served
by separating fiscal and monetary policies as was done

above. In that case, the nation could not achieve internal

and external balance at the same time without also
changing its exchange rate.
Evaluation of the Policy Mix with Price Changes

The combination of fiscal policy to achieve internal balance
and monetary policy to achieve external balance with a
fixed exchange rate faces several criticisms. One of these is
that short- term international capital flows may not respond
as expected to international interest rate differentials, and
their response may be inadequate or even erratic and of a
once-and-for-all nature rather than continuous (as assumed
by Mundell). According to some economists, the use of
monetary policy merely allows the nation to finance its
deficit in the short run, unless the deficit nation continues
to tighten its monetary policy over time. Long-run
adjustment may very well require exchange rate changes.
Another criticism is that the government and monetary
authorities do not know precisely what the effects of fiscal
and monetary policies will be and that there are various
lags in recognition, policy selection, and implementation
before these policies begin to show results.
It is difficult to coordinate fiscal and monetary policies
because fiscal policy is conducted by one branch of the
government while monetary policy is determined by the
central Bank. However, the nation may still be able to
move closer and closer to internal and external balance on a
step- by-step basis (as indicated by the arrows from point if
fiscal authorities pursue only the objective of internal
balance and disregard the external imbalance, and if
monetary authorities can be persuaded to pursue only the

goal of external balance without regard to the effect that

monetary policies have on the internal imbalance.
Another difficulty arises when we relax the assumption that
prices remain constant until the full- employment level of
national income is reached. With price increases or
inflation occurring even at less than full employment, the
nation has at least three objectives: full employment, price
stability, and equilibrium in the balance of payments, thus
requiring three policies to achieve all three objectives
completely. The nation might then have to use fiscal policy
to achieve full employment, monetary policy to achieve
price stability, and exchange rate changes to achieve
external balance. In unusual circumstances, the government
may also impose direct controls to achieve one or more of
its objectives when other policies fail.
Modern nations also have as a fourth objective an
“adequate” rate of growth, which usually requires a low
long-term interest rate to achieve. The nation may then
attempt to “twist” the interest rate structure, keeping long-
term interest rates low and allowing higher short-term
interest rates. Monetary authorities may try to accomplish
this by open market sales of treasury bills and purchases of
long-term bonds .

Module IV
International Capital Flows
Capital, labor, and technology do move across national

boundaries. International trade and movements of
productive resources can be regarded as substitutes for one
another. For example, a relatively capital-abundant and
labor-scarce country, such as the United States, could either
export capital-intensive commodities or export capital itself,
and either import labor-intensive products or allow the
immigration of workers from countries with plentiful labor
supplies. As in the case of international trade, the
movement of productive resources from nations with
relative abundance and low remuneration to nations with
relative scarcity and high remuneration has a tendency to
equalize factor returns internationally and generally
increases welfare. International trade and movements of
productive factors, however, have very different economic
effects on the nations involved. Here we focus on the cost
and benefits of international resource movements. Since
multinational corporations are an important vehicle for the
international flows of capital, labor, and technology, we
also devote a great deal of attention to this relatively new
and crucial type of economic enterprise.
There are two main types of foreign investments: portfolio
investments and direct investments. Portfolio investments
are purely financial assets, such as bonds, denominated in a
national currency. With bonds, the investor simply lends
capital to get fixed payouts or a return at regular intervals
and then receives the face value of the bond at a pre-

specified date. Most foreign investments prior to World
War I were of this type and flowed primarily from the
United Kingdom to the “regions of recent settlement” for
railroad construction and the opening up of new lands and
sources of raw materials. Portfolio or financial investments
take place primarily through financial institutions such as
banks and investment funds. International portfolio
investments collapsed after World War I and have only
revived since the 1960s. Direct investments, on the other
hand, are real investments in factories, capital goods, land,
and inventories where both capital and management are
involved and the investor retains control over use of the
invested capital. Direct investment usually takes the form of
a firm starting a subsidiary or taking control of another firm
(for example, by purchasing a majority of the stock). In the
international context, direct investments are usually
undertaken by multinational corporations engaged in
manufacturing, resource extraction, or services. Direct
investments are now as important as portfolio investments
as forms or channels of international private capital flows.
4.1. International Capital Flows- FDI & FPI

FPI and FDI are both important sources of funding for most
economies. A Foreign Direct Investment (FDI) is an
investment made by a firm or individual in one country into
business interests located in another country. FDI lets an
investor purchase a direct business interest in a foreign
country. Example: Investors can make FDI in a number of
ways. Some common ones include establishing a subsidiary
in another country, acquiring or merging with an existing
foreign company, or starting a joint venture partnership
with a foreign company.
Generally, FDI is when a foreign entity acquires ownership

or controlling stake in the shares of a company in one
country, or establishes businesses there. It is different from
foreign portfolio investment where the foreign entity merely
buys equity shares of a company. In FDI, the foreign entity
has a say in the day-to-day operations of the company. FDI
is not just the inflow of money, but also the inflow of
technology, knowledge, skills and expertise/know-how. It
is a major source of non-debt financial resources for the
economic development of a country. FDI generally takes
place in an economy which has the prospect of growth and
also a skilled workforce. FDI has developed radically as a
major form of international capital transfer since the last
many years. The advantages of FDI are not evenly
distributed. It depends on the host country’s systems and
infrastructure. The determinants of FDI in host countries
are: Policy framework, Rules with respect to entry and
operations/functioning (mergers/acquisitions and
competition), Political, economic and social stability,
Treatment standards of foreign affiliates, International
agreements, Trade policy (tariff and non-tariff barriers),
Privatization policy
Foreign portfolio investment (FPI) consists of securities and
other financial assets passively held by foreign investors. It
does not provide the investor with direct ownership of
financial assets and is relatively liquid depending on the
volatility of the market. Examples of FPIs include stocks,
bonds, mutual funds, exchange traded funds, American
Depositary Receipts (ADRs), and Global Depositary
Receipts (GDRs). FPI is part of a country’s capital account
and is shown on its Balance of Payments (BOP). The BOP
measures the amount of money flowing from one country to
other countries over one monetary year. The brought new
FPI Regulations, 2019, replacing the erstwhile FPI

Regulations of 2014. FPI is often referred to as “hot
money” because of its tendency to flee at the first signs of
trouble in an economy. FPI is more liquid and less risky
than FDI.
Difference Between FDI and FPI

Parameters FDI FPI
Definition The investment Investing in the
made by foreign financial assets
investors to obtain a of a foreign
substantial interest country, such as
in the enterprise stocks or bonds
located in a available on an
different country exchange.
Role of investors Active investors Passive investors
Type Direct investment Indirect investment
Degree of control High control Very low control
Term Long term investment Short term
investment
Management ofEfficient Comparatively less
Projects efficient
Investment has Physical assets ofFinancial assets of
done on the foreign country the foreign
country
Entry and exit Difficult Relatively easy
Leads to Transfer of funds, Capital inflows to
technology, and other the foreigncountry
resources to the
foreign country
Risks involved Stable Volatile

4.2. Motives for International Capital Flows

Motives for International Portfolio Investments
The basic motive for international portfolio investments is
to earn higher returns abroad. Thus, residents of one
country purchase bonds of another country if the returns on
bonds are higher in the other country. This is the simple and
straight forward outcome of yield maximization and tends
to equalize returns internationally. Residents of one country
may also purchase stock in a corporation in another country
if they expect the future profitability of the foreign
corporation to be greater than that of domestic corporations.
The international portfolio investments occur to take

advantage of higher yields abroad is certainly correct as far
as it goes. It cannot account for observed two-way capital
flows. That is, if returns on securities are lower in one
nation than in another nation, this could explain the flow of
capital investments from the former nation to the latter but
is inconsistent with the simultaneous flow of capital in the
opposite direction, which is often observed in the real
world. To explain two-way international capital flows, the
element of risk must be introduced. That is, investors are
interested not only in the rate of return but also in the risk
associated with a particular investment. The risk with bonds
consists of bankruptcy and the variability in their market
value. With stocks, the risk consists of bankruptcy, even
greater variability in market value, and the possibility of
lower than anticipated returns. Thus, investors maximize
returns fora given level of risk and generally accept a higher
risk only if returns are higher.

Portfolio theory tells us that by investing in securities with

yields that are inversely related over time, a given yield can
be obtained at a smaller risk or a higher yield can be
obtained for the same level of risk for the portfolio as a
whole. Since yields on foreign securities (depending
primarily on the different economic conditions abroad) are
more likely to be inversely related to yields on domestic
securities, a portfolio including both domestic and foreign
securities can have a higher average yield and/or lower risk
than a portfolio containing only domestic securities. To
achieve such a balanced portfolio, a two-way capital flow
may be required.
Risk diversification can explain two-way international
portfolio investments. The investors must determine for
themselves (from their market knowledge and intuition)
what the average returns and variabilities are likely to be in
deciding which stocks to purchase. Since different
individuals can have different expectations for the same
stocks, it is possible that some investors in each nation think
that stocks in the other nation are a better buy. This
provides an additional explanation for two-way
international portfolio investments.
Motives for Direct Foreign Investments
The motives for direct investments abroad are generally the

same as for portfolio investments, that is, to earn higher
returns (possibly resulting from higher growth rates abroad,
more favorable tax treatment, or greater availability of
infrastructures) and to diversify risks. Indeed, it has been
found that firms with a strong international orientation,
either through exports or through foreign production and/or
sales facilities, are more profitable and have a much smaller

variability in profits than purely domestic firms. Many large

corporations (usually in monopolistic and oligopolistic
markets) often have some unique production knowledge or
managerial skill that could easily and profitably be utilized
abroad and over which the corporation wants to retain direct
control. In such a situation, the firm will make direct
investments abroad. This involves horizontal integration, or
the production abroad of a differentiated product that is
also producedat home.
Another important reason for direct foreign investments is
to obtain control of a needed raw material and thus ensure
an uninterrupted supply at the lowest possible cost. This is
referred to as vertical integration and is the form of most
direct foreign investments in developing countries and in
some mineral-rich developed countries. Vertical integration
involving multinational corporations can also go forward
into the ownership of sales or distribution networks abroad,
as is the case with most of the world’s major automobile
producers. Still other reasons for direct foreign investments
are to avoid tariffs and other restrictions that nations impose
on imports or to take advantage of various government
subsidies to encourage direct foreign investments. Other
possible reasons for direct foreign investments are to enter a
foreign oligopolistic market so as to share in the profits, to
purchase a promising foreign firm to avoid its future
competition and the possible loss of export markets, or
because only a large foreign multinational corporation can
obtain the necessary financing to enter the market.
Two-way direct foreign investments can then be explained
by some industries being more advanced in one nation
(such as the computer industry in the United States), while
other industries are more efficient in other nations (such as
the automobile industry in Japan). Direct foreign

investments have been greatly facilitated (in a sense made
possible) by the very rapid advances in transportation (i.e.,
jet travel) and communications (i.e., international telephone
linesand international data transmission and processing) that
have occurred since the end of World War II. These
advances permit the headquarters of multinational
corporations to exert immediate and direct control over the
operations of their subsidiaries around the world, thus
facilitating and encouraging direct investments abroad. The
regional distribution of foreign direct investments around
the world also seems to depend on geographical proximity
or established trade relations.
4.3. Welfare Effects of International Capital Flows

Here we examine the welfare effects of international capital
flows on the investing and host countries. In order to isolate
the effect of capital flows, we assume here that there is no
trade in goods.
Effects on the Investing and Host Countries
In Figure 4.1, we examine a world of only two nations
(Nation 1 and Nation 2) with a total combined capital stock
of OO . Of this total capital stock, OA belongs to Nation 1
and O A belongs to Nation 2. The VMPK1 and VMPK2
curves give the value of the marginal product of capital in
Nation 1 and Nation 2, respectively, for various levels of
investments. Under competitive conditions, the value of the
marginal product of capital represents the return, or yield,
on capital. In isolation, Nation 1 invests its entire capital
stock OA domestically at a yield of OC.

Of the total capital stock of OO , Nation 1 holds OA and its

total output is OFGA, while Nation 2 holds O’A and its total
output is O’JMA. The transfer of AB of capital from Nation
1 to Nation 2 equalizes the return on capital in the two
nations at BE. This increases world output by EGM (the
shaded area), of which EGR accrues to Nation 1 and ERM
to Nation 2. Of the increase in total domestic product of
ABEM in Nation 2, ABER goes to foreign investors,
leaving ERM as the net gain in domestic income in Nation
2.
Other Effects on the Investing and Host Countries

Assuming two factors of production, capital and labor, both
fully employed before and after the capital transfer, that the
total and average return on capital increases, whereas the
total and average return to labor decreases in the investing
country. Thus, while the investing country as a whole gains
from investing abroad, there is a redistribution of domestic

income from labor to capital. On the other hand, while the

host country also gains from receiving foreign investments,
these investments lead to a redistribution of domestic
income from capital to labor. If we allow for less than full
employment, foreign investments tend to depress the level
of employment in the investing country and increase it in the
host country and, once again, can be expected to be opposed
by labor in the former and to benefit labor in the latter.
International capital transfers also affect the balance of
payments of the investing and host countries. A nation’s
balance of payments measures its total receipts from and
total expenditures in the rest of the world. In the year in
which the foreign investment takes place, the foreign
expenditures of the investing country increase and cause a
balance-of-payments deficit (an excess of expenditures
abroad over foreign receipts). The counterpart to the
worsening in the investing nation’s balance of payments is
the improvement in the host nation’s balance of payments
in the year in which it receives the foreign investment. The
initial capital transfer and increased expenditures abroad of
the investing country are likely to be mitigated by increased
exports of capital goods, spare parts, and other products of
the investing country, and by the subsequent flow of profits
to the investing country. It has been estimated that the
“payback” period for the initial capital transfer is between
five and ten years on average.
Another effect to consider in the long run is whether foreign
investments will lead to the replacement of the investing
country’s exports and even to imports of commodities
previously exported. Thus, while the immediate effect on
the balance of payments is negative in the investing country
and positive in the host country, the long-run effects are less
certain. Since foreign investments for most developed

countries are two-way; these short-run and long-run
balance-of-payments effects are mostly neutralized.
Another important welfare effect of foreign investments on
both the investing and host countries results from different
rates of taxation and foreign earnings in various countries.
Foreign investments, by affecting output and the volume of

trade of both investing and host countries, are also likely to
affect the terms of trade. However, the way the terms of
trade will change depends on conditions in both nations,
and not much can be said a priori. Foreign investments may
also affect the investing nation’s technological lead and the
host country’s control over its economy and ability to
conduct its own independent economic policy. Since these
and other effects of international capital transfers usually
result from the operations of multinational corporations.
4.4. Multinational Corporations

One of the most significant international economic
developments of the postwar period is the proliferation of
multinational corporations (MNCs). These are firms that
own, control, or manage production facilities in several
countries. A multinational corporation is a company
incorporated in its home country (country of origin) but it
carries out business operations beyond that country in many
other foreign countries, we call the host countries. Its head
office will be in the home country.
Reasons for the Existence of Multinational

Corporations
The basic reason for the existence of MNCs is the
competitive advantage of a global network of production

and distribution. This competitive advantage arises in part
from vertical and horizontal integration with foreign
affiliates. By vertical integration, most MNCs can ensure
their supply of foreign raw materials and intermediate
products and circumvent (with more efficient intra-firm
trade) the imperfections often found in foreign markets.
They can also provide better distribution and service
networks. By horizontal integration through foreign
affiliates, MNCs can better protect and exploit their
monopoly power, adapt their products to local conditions
and tastes, and ensure consistent product quality. The
competitive advantage of MNCs is also based on economies
of scale in production, financing, research and development
(R&D), and the gathering of market information. The large
output of MNCs allows them to carry division of labor and
specialization in production much further than smaller
national firms. Product components requiring only unskilled
labor can be produced in low-wage nations and shipped
elsewhere for assembly. Furthermore, MNCs and their
affiliates usually have greater access, at better terms, to
international capital markets than do purely national firms,
and this puts MNCs in a better position to finance large
projects. They can also concentrate R&D in one or a few
advanced nations best suited for these purposes because of
the greater availability of technical personnel and facilities.
Finally, foreign affiliates funnel information from around
the world to the parent firm, placing it in a better position
than national firms to evaluate, anticipate, and take
advantage of changes in comparative costs, consumers’
tastes, and market conditions generally.
The large corporation invests abroad when expected profits
on additional investments in its industry are higher abroad.
Since the corporation usually has a competitive advantage

in and knows its industry best, it does not usually consider
the possibility of higher returns in every other domestic
industry before it decides to invest abroad. That is,
differences in expected rates of profits domestically and
abroad in the particular industry are of crucial importance in
a large corporation’s decision to invest abroad. This
explains, for example, Toyota automotive investments in
the United States and IBM computer investments in Japan.
Indeed, it also explains investments of several Japanese
electronics MNCs in the United States as an attempt to
invade the latter’s computer market. All of this information
implies that MNCs are oligopolists selling for the most part
differentiated products, often developed as described by the
technological gap and product cycle models, and produced
under strong economies of scale. Examples of the products
sold by MNCs are motor vehicles, petroleum products,
electronics, metals, office equipment, chemicals, and food.
Multinational corporations are also in a much better
position to control or change to their advantage the
environment in which they operate than are purely national
firms. For example, in determining where to set up a
plant to produce a component, an MNC can and usually
does “shop around” for the low-wage nation that offers the
most incentives in the form of tax holidays, subsidies, and
other tax and trade benefits. The sheer size of most MNCs
in relation to most host nations also means the MNCs are
in a better position than purely national firms to influence
the policies of local governments and extract benefits.
Furthermore, MNCs can buy up promising local firms to
avoid future competition and are in a much better position
than purely domestic firms to engage in other practices that
restrict local trade and increase their profits. MNCs, through
greater diversification, also face lower risks and generally

earn higher profits than purely national firms.
Finally, by artificially overpricing components shipped to
an affiliate in a higher-tax nation and under-pricing
products shipped from the affiliate in the high-tax nation,
an MNC can minimize its tax bill. This is called transfer
pricing and can arise in intra-firm trade as opposed to trade
among independent firms or conducted at “arm’s length.” In
the final analysis, it is a combination of all or most of these
factors that gives MNCs their competitive advantage vis-a-
vis purely national firms and explains the proliferation and `
great importance of MNCs today. That is, by vertical and
horizontal integration with foreign affiliates, by taking
advantage of economies of scale, and by being in a better
position than purely national firms to control the
environment in which they operate, MNCs have grown to
become the most prominent form of private international
economic organization in the world.
Problems Created by Multinational Corporations

in the Home Country
While MNCs, by efficiently organizing production and
distribution on a world-wide basis, can increase world
output and welfare, they can also create serious problems in
both the home and host countries. The most controversial of
the alleged harmful effects of MNCs on the home nation is
the loss of domestic jobs resulting from foreign direct
investments. These are likely to be unskilled and
semiskilled production jobs in which the home nation has a
comparative disadvantage. However, some clerical,
managerial, and technical jobs are also likely to be created
in the headquarters of the MNC in the home nation as a

result of direct foreign investments. Even if the number of

jobs lost exceeds the number created, it may be that the
home nation would have lost these jobs anyway to foreign
competitors and would have had no jobs created at home
without the direct foreign investment.
A related problem is the export of advanced technology to
be combined with other cheaper foreign factors to
maximize corporate profits. It is claimed that this may
undermine the technological superiority and future of the
home nation. However, against this possible harmful effect
is the tendency of MNCs to concentrate their R&D in the
home nation, thus allowing it to maintain its technological
lead.
Another possible harmful effect of MNCs on the home
country can result from transfer pricing and similar
practices, and from shifting their operations to lower-tax
nations, which reduces tax revenues and erodes the tax
base of the home country. This results from common
international taxing practice. Specifically, the host country
taxes the subsidiary’s profits first. To avoid double taxation
of foreign subsidiaries, the home country then usually
taxes only repatriated profits (if its tax rate is higher than in
the host country), and only by the difference in the tax rates.
Finally, because of their access to international capital

markets, MNCs can circumvent domestic monetary policies
and make government control over the economy in the
home nation more difficult. These alleged harmful effects
of MNCs are of crucial importance to the United States,
since it is home for about one-third of the largest MNCs. In
general, home nations do impose some restrictions on the
activities of MNCs, either for balance-of-payments reasons

or, more recently, for employment reasons.
Problems Created by Multinational Corporations

in the Host Country
Host countries have even more serious complaints against
MNCs. First and foremost is the allegation that MNCs
dominate their economies. Foreign domination is felt in
many different ways in host countries, including (1) the
unwillingness of a local affiliate of an MNC to export to a
nation deemed unfriendly to the home nation or the
requirement to comply with a home-nation law prohibiting
such exports; (2) the borrowing of funds abroad to
circumvent tight domestic credit conditions and the lending
of funds abroad when interest rates are low at home; and (3)
the effect on national tastes of large-scale advertising for
such products as Coca-Cola, jeans, and so on. Another
alleged harmful effect of MNCs on the host country is the
siphoning off of R&D funds to the home nation. While this
may be more efficient for the MNC and the world as a
whole, it also keeps the host country technologically
dependent. This is especially true and serious for
developing nations. Also, MNCs may absorb local savings
and entrepreneurial talent, thus preventing them from being
used to establish domestic enterprises that might be more
important for national growth and development.
Multinational corporations may also extract from host
nations most of the benefits resulting from their
investments, either through tax and tariff benefits or
through tax avoidance. In developing nations, foreign direct
investments by MNCs in mineral and raw material
production have often given rise to complaints of foreign
exploitation in the form of low prices paid to host nations,
the use of highly capital-intensive production techniques
inappropriate for labor-abundant developing nations, lack of

training of local labor, overexploitation of natural resources,
and creating highly dualistic “enclave” economies.
Most of these complaints are to some extent true,
particularly in the case of developing host countries, and
they have led many host nations to regulate foreign
investments in order to mitigate the harmful effects and
increase the possible benefits. India specified the sectors in
which direct foreign investments are allowed and set rules
to regulate their operation. Some developing nations allow
only joint ventures (i.e., local equity participation) and set
rules for the transfer of technology and the training of
domestic labor, impose limits on the use of imported inputs
and the remission of profits, set environmental regulations,
and so on. In the extreme, the host nation can nationalize
foreign production facilities. However, this is likely to
seriously reduce the future flow of direct foreign
investments to the nation.
Efforts are currently in progress within the EU, OECD, the
UN, and UNCTAD to devise an international code of
conduct for MNCs. However, since the interests of home
and host countries are generally in conflict, it is virtually
impossible for such an international code to be very
specific. As a result, it is unlikely to succeed in severely
restricting most of the abuses of and problems created by
MNCs in home and host countries. The Uruguay Round
eliminated only some of the domestic restrictions and
regulations on FDI.
4.5. FDI in India

The investment climate in India has improved tremendously

since 1991 when the government opened up the economy

and initiated the LPG strategies. The improvement in this
regard is commonly attributed to the easing of FDI norms.
Many sectors have opened up for foreign investment
partially or wholly since the economic liberalization of the
country. Currently, India ranks in the list of the top 100
countries in ease of doing business. In 2019, India was
among the top ten receivers of FDI, totalling $49 billion
inflows, as per a UN report. This is a 16% increase from
2018. In February 2020, the DPIIT notifies policy to allow
100% FDI in insurance intermediaries. In April 2020, the
DPIIT came out with a new rule, which stated that the
entityof nay company that shares a land border with India or
where the beneficial owner of investment into India is
situated in or is a citizen of such a country can invest only
under the Government route. In other words, such entities
can only invest following the approval of the Government
of India. In early 2020, the government decided to sell a
100% stake in the national airline’s Air India. From April to
August 2020, total Foreign Direct Investment inflow of
USD 35.73 billion was received. It is the highest ever for
the first 5 months of a financial year. FDI inflow has
increased despite Gross Domestic Product (GDP) growth
contracted 23.9% in the first quarter (April-June 2020). FDI
received in the first 5 months of 2020-21 (USD 35.73
billion) is 13% higher as compared to the first five months
of 2019-20 (USD 31.60 billion.
Gross inflows/ gross investment is same as “total FDI
inflow”. The gross inflow consists of (i) direct investment
to India and (ii) repatriation/disinvestment. The
disaggregation shows that direct investment to India has
declined by 2.4%. Hence, an increase of 47% in
repatriation/disinvestment entirely accounts for the rise in
the gross inflows. In other words, there is a wide gap

between gross FDI inflow and direct investment to India.
Repatriation- significance : FDI inflow increasingly consists
of private equity funds, which are usually disinvested after
3•5 years to book profits (per its business model). In
principle, private equity funds do not make long• term
Greenfield investment. Similarly, measured on a net basis
(that is, “direct investment to India” net of “FDI by India”
or, outward FDI from India), direct investment to India has
barely risen (0.8%) in 2020•21 over the last year. It is
almost entirely on account of “Net Portfolio Investment”,
shooting up from $1.4 billion in 2019-20 to $36.8 billion in
the next year. That is a whopping 2,526% rise. Further,
within the net portfolio investment, foreign institutional
investment (FIIs) has boomed by an as founding 6,800% to
$38 billion in 2020•21, from a mere half a billion dollars in
the previous year. So, the mystery of the surge in gross FDI
inflows is solved. It is entirely on account of net foreign
portfolio investment.
FDI has three components, viz., equity capital, reinvested
earnings and intra-company loans. Equity capital is the
foreign direct investor’s purchase of shares of an enterprise
in a country other than its own. Reinvested earnings
comprise the direct investors’ share (in proportion to direct
equity participation) of earnings not distributed as dividends
by affiliates, or earnings not remitted to the direct investor.
Such retained profits by affiliates are reinvested. Intra-
company loans or intra-company debt transactions refer to
short- or long-term borrowing and lending of funds between
direct investors (or enterprises) and affiliate enterprises.

FDI Routes in India

There are three routes through which FDI flows into India.
They are described in the following table:
Category 1 Category 2 Category 3
100% FDI Up to 100% Up to 100% FDI

permitted through FDI permitted permitted through
AutomaticRoute through Automatic +
Government Government
Route Route
Automatic Route FDI: In the automatic route, the foreign

entity does not require the prior approval of the government
or the RBI.
Examples:
 Medical devices: up to 100%
 Thermal power: up to 100%
 Services under Civil Aviation Services such as
Maintenance & Repair Organizations
 Insurance: up to 49%
 Infrastructure company in the securities market: up to
49%
 Ports and shipping
 Railway infrastructure

 Pension: up to 49%
 Power exchanges: up to 49%
 Petroleum Refining (By PSUs): up to 49%
Government Route FDI

Under the government route, the foreign entity should
compulsorily take the approval of the government. It should
file an application through the Foreign Investment
Facilitation Portal, which facilitates single-window
clearance. This application is then forwarded to the
respective ministry or department, which then approves or
rejects the application after consultation withthe DPIIT.
Examples:
 Broadcasting Content Services: 49%
 Banking & Public sector: 20%
 Food Products Retail Trading: 100%

 Core Investment Company: 100%
 Multi-Brand Retail Trading: 51%
 Mining & Minerals separations of titanium bearing
minerals and ores: 100%
 Print Media (publications/printing of scientific and

technical magazines/speciality journals/periodicals and a
facsimile edition of foreign newspapers): 100%
 Satellite (Establishment and operations): 100%

 Print Media (publishing of newspaper, periodicals

and Indian editions of foreign magazines dealing with news
& current affairs): 26%
Sectors where FDI is prohibited

There are some sectors where any FDI is completely
prohibited. They are:
 Agricultural or Plantation Activities (although there
are many exceptions like horticulture, fisheries, tea
plantations, Pisciculture, animal husbandry, etc.)
 Atomic Energy Generation
 Nidhi Company
 Lotteries (online, private, government, etc.)
 Investment in Chit Funds
 Trading in TDR’s
 Any Gambling or Betting businesses
 Cigars, Cigarettes, or any related tobacco industry
 Housing and Real Estate (except townships,

commercial projects, etc.)
New FDI Policy

According to the new FDI policy, an entity of a country,
which shares a land border with India or where the
beneficial owner of investment into India is situated in or is
a citizen of any such country, can invest only under the
Government route. A transfer of ownership in an FDI deal
that benefits any country that shares a border with India will
also need government approval. Investors from countries
not covered by the new policy only have to inform the RBI
after a transaction rather than asking for prior permission
from the relevant government department.
The earlier FDI policy was limited to allowing only
Bangladesh and Pakistan via the government route in all
sectors. The revised rule has now brought companies from
China under the government route filter.
Benefits of FDI
FDI brings in many advantages to the country. Some of
them are discussed below.
1. Brings in financial resources for economic
development.
2. Brings in new technologies, skills, knowledge, etc.

3. Generates more employment opportunities for the
people.
4. Brings in a more competitive business environment in
the country.
5. Improves the quality of products and services in
sectors.
Disadvantages of FDI
However, there are also some disadvantages associated with
foreign direct investment. Some of them are:
1. It can affect domestic investment, and domestic

companies adversely.
2. Small companies in a country may not be able to
withstand the onslaught of MNCs in their sector. There is
the risk of many domestic firms shutting shop as a result of
increased FDI.
3. FDI may also adversely affect the exchange rates of a
country.
Government Measures to increase FDI in India

1. Government schemes like production-linked incentive
(PLI) scheme in 2020 for electronics manufacturing, have
been notified to attract foreign investments.
2. In 2019, the amendment of FDI Policy 2017 by
the government, to permit 100% FDI under automatic route
in coal mining activities enhanced FDI inflow.
3. FDI in manufacturing was already under the 100%
automatic route, however, in 2019, the government clarified
that investments in Indian entities engaged in contract
manufacturing is also permitted under the 100% automatic
route provided it is undertakenthrough a legitimate contract.
4. Further, the government permitted 26% FDI in
digital sectors. The sector has particularly high return
capabilities in India as favourable demographics, substantial
mobile and internet penetration, massive consumption along
technology uptake provides great market opportunity for a
foreign investor.
5. Foreign Investment Facilitation Portal (FIFP) is the
online single point interface of the Government of India

with investors to facilitate FDI. It is administered by the

Department for Promotion of Industry and Internal Trade,
Ministry of Commerce and Industry.
6. FDI inflow is further expected to increase –

 as foreign investors have shown interest in the
government’s moves to allow private train operations and
bid out airports.
 Valuable sectors such as defence manufacturing
where the government enhanced the FDI limit under the
automatic route from 49% to 74% in May 2020, is also
expected to attract large investments going forward.
Regulatory Framework for FDI in India

In India, there are several laws regulating FDI inflows.
They are:
 Companies Act
 Securities and Exchange Board of India Act, 1992 and
SEBI Regulations
 Foreign Exchange Management Act (FEMA)
 Foreign Trade (Development and Regulation) Act,

1992
 Civil Procedure Code, 1908
 Indian Contract Act, 1872
 Arbitration and Conciliation Act, 1996

 Competition Act, 2002
 Income Tax Act, 1961

 Foreign Direct Investment Policy (FDI Policy)
Important Government Authorities in India concerning

FDI
 Foreign Investment Promotion Board (FIPB)
 Department for Promotion of Industry and Internal
Trade (DPIIT)
 Reserve Bank of India (RBI)
 Directorate General of Foreign Trade (DGFT)
 Ministry of Corporate Affairs, Government of India
 Securities and Exchange Board of India (SEBI)

 Income Tax Department
 Several Ministries of the GOI such as Power,
Information & Communication, Energy, etc.
Way Forward with FDI

1. FDI is a major driver of economic growth and an
important source of non-debt finance for the economic
development of India. A robust and easily accessible FDI
regime, thus, should be ensured.
2. Economic growth in the post-pandemic period
and India’s large market shall continue to attract market-
seeking investments to the country.

Module V
International Monetary System
5.1. International Monetary System: Evolution and

gold standard International Monetary System: An
Overview
International monetary system is defined as a set of
procedures, mechanisms, processes, and
institutions that establish a rate at which exchange rate is
determined in respect to other currency. To understand the
complex procedure of international trading practices, it is
pertinent to have a look at the historical perspective of the
financial and monetary system. The whole story of
monetary and financial system revolves around 'Exchange
Rate' i.e. the rate at which currency is exchanged among
different countries for settlement of payments arising from
trading of goods and services. To have an understanding of
historical perspectives of international monetary system,
firstly one must have a knowledge of exchange rate
regimes. Various exchange rate regimes found from 1880 to
till date at the international level are described briefly as
follows:
5.1.1. Monetary System Before First World War:

(1880-1914 Era of Gold Standard)
The oldest system of exchange rate was known as "Gold
Species Standard" in which actual currency contained a
fixed content of gold. The other version called "Gold
Bullion Standard", where the basis of money remained
fixed gold but the authorities were ready to convert, at a

fixed rate, the paper currency issued by them into paper
currency of another country which is operating in Gold. The
exchange rate between pair of two currencies was
determined by respective exchange rates against 'Gold'
which was called 'Mint Parity'.
Three rules were followed with respect to this conversion:
• The authorities must fix some once-for-all conversion
rate of paper money issued by theminto gold.
• There must be free flow of Gold between countries on
Gold Standard.
• The money supply should be tied with the amount of
Gold reserves kept by authorities.
The gold standard was very rigid and during 'great
depression' (1929-32) it vanished completely. In modern
times some economists and policy makers advocate this
standard to continue because of its ability to control
excessive money supply.
5.1.2. The Gold Exchange Standard (1925-1931)

With the failure of gold standard during First World War, a
much refined form of exchange regime was initiated in
1925 in which US and England could hold gold reserve and
other nations could hold both gold and dollars/sterling as
reserves. In 1931, England took its foot back which resulted
in abolition of this regime. Also to maintain trade
competitiveness, the countries started devaluing their
currencies in order to increase exports and de-motivate
imports. This was termed as "beggar-thy-neighbour "

policy. This practice led to great depression which was a

threat to war ravaged world after the second world war.
Allied nations held a conference in New Hampshire, the
outcome of which gave birth to two new institutions namely
the International Monetary Fund (IMF) and the World
Bank, (WB) and the system was known as Bretton Woods
System which prevailed during (1946-1971) (Bretton
Woods, the place in New Hampshire, where more than 40
nations met to hold a conference).
5.1.3. The Bretton Woods Era (1946 to 1971)

To streamline and revamp the war ravaged world economy
& monetary system, allied powers held a conference in
'Bretton Woods', which gave birth to two super institutions
– IMF (International Monetary Fund) and the World Bank
(WB). In Bretton Woods modified form of Gold Exchange
Standard was set up with the following characteristics :
• One US dollar conversion rate was fixed by the USA as
one dollar = 35 ounce of Gold
• Other members agreed to fix the parities of their
currencies vis-a-vis dollar with respect to permissible central
parity with one per cent (± 1%) fluctuation on either side.
In case of crossing the limits, the authorities were free hand
to intervene to bring back the exchange rate within limits.
The mechanism of Bretton Woods can be understood with
the help of the following illustration: Suppose there is a
supply curve SS and demand curve DD for Dollars. On Y-
axis, let us draw price of Dollar with respect to Rupees (See
fig.)

Suppose Indian residents start demanding American goods

& services. Naturally demand of US Dollar will rise; And
suppose US residents develop an interest in buying goods
and services from India, it will increase supply of dollars
from America. Assume a parity rate of exchange is Rs.
10.00 per dollar. The ± 1% limits are therefore Rs. 10.10
(Upper support and Rs. 9.90 lower support). As long as the
demand and supply curve intersect within the permissible
range; Indian authorities will not intervene. Suppose
demand curve shifts towards right due to a shift in
preference of Indians towards buying American goods and
the market determined exchange rate would fall outside the
band, in this situation, Indian authorities will intervene and
buy rupees and supply dollars to bring back the demand
curve within permissible band. The vice-versa can also
happen. There can be two consequences of this intervention.
Firstly, the domestic money supply, price, G.N.P. etc. can
be effected. Secondly, excessive supply of dollars from

reserves may lead to exhaustion or depletion of forex

reserves, thereby preventing all possibilities to borrow
dollars from other countries or IMF.
During Bretton Woods regime American dollar became
international money while other countries needed to hold
dollar reserves. US could buy goods and services from her
own money. The confidence of countries in US dollars
started shaking in 1960s with chronological events which
were political and economic and on August 15, 1971
American abandoned their commitment to convert dollars
into gold at fixed price of $35 per ounce, the currencies
went on float rather than fixed. Though "Smithsonian
Agreement" also failed to resolve the crisis yet by 1973, the
world moved to a system of floating rates. (Note :
Smithsonian Agreement made an attempt to resurrect the
system by increasing the price of gold and widening the
band of permissible variations around the central parity).
The immediate cause of the collapse of the Bretton Woods
system was the huge balance-of-payments deficit of the
United States in 1970 and the expectation of an even larger
deficit in 1971. This led to massive destabilizing
speculation against the dollar, suspension of the
convertibility of the dollar into gold on August 15, 1971,
and a realignment of currencies in December 1971. The
fundamental cause of the collapse of the Bretton Woods
system is to be found in the lack of an adequate adjustment
mechanism. The persistence of U.S. balance-of-payments
deficits provided for the system’s liquidity but also led to
loss of confidence in the dollar. The dollar was devalued
again in February 1973. In March 1973, in the face of
continued speculation against the dollar, the major
currencies were allowed to fluctuate either independently or
jointly.
5.1.4. Post Bretton Woods Period (1971-1991)

Two major events took place in 1973-74 when oil prices
were quadrupled by the Organisational of Petroleum
Exporting Countries (OPEC). The result was seen in
expended oils bills, inflation and economic dislocation;
thereby the monetary policies of the countries were being
overhauled. Since March 1973, the world has operated
under a managed float (formally recognized in the Jamaica
Accords, which took effect in April 1978). From 1977 to
1985, US dollar observed fluctuations in the oil prices
which imposed on the countries to adopt a much flexible
regime i.e. a hybrid between fixed and floating regimes. A
group of European Nations entered into European
Monetary System (EMS) which was an arrangement of
pegging their currencies within themselves. In March 1979,
the European Monetary System was formed, in October
1988, the European Central Bank was created, the euro was
introduced on January 1, 1999, and began circulating on
January 1, 2002, as the single currency of the European
Monetary Union. Borrowing at the IMF has been relaxed,
and significant new credit facilities have been created.
The most significant monetary problems facing the world
today are the excessive fluctuations and large
misalignments in exchange rates. Target zones and greater
international macroeconomic policy coordination have been
advocated to overcome them. During the past decade, there
were a series of financial and economic crises in Mexico,
Southeast Asia, Russia, Brazil, Turkey, and Argentina, and
in 2008–2009 in the United States and most other advanced
economies. Proposed solutions by the G-20 include
strengthening financial supervision and regulation, fostering
international policy coordination, reforming the IMF, and
maintaining open markets.

Other serious international economic problems are
(1) slow growth and high unemployment in advanced

economies after the “great recession,” (2) trade
protectionism in advanced countries in the context of a
rapidly globalizing world, (3) large structural imbalances in
the United States, slow growth in Europe and Japan, and
insufficient restructuring in transition economies of Central
and Eastern Europe,
(4) deep poverty in many developing economies, and
(5) resource scarcity, environmental degradation, and

climate change that endanger growth and sustainable world
development.
5.1.5. Flexible exchange rate regime

The flexible exchange rate regime that replaced the Bretton
Woods system was ratified by the Jamaica Agreement.
Following a spectacular rise and fall of the US dollar in the
1980s, major industrial countries agreed to cooperate to
achieve greater exchange rate stability. The Louvre Accord
of 1987 marked the inception of the managed-float system
under which the G-7 countries would jointly intervene in the
foreign exchange market to correct over- or undervaluation
of currencies. On January 1,1999, eleven European
countries including France and Germany adopted a
common currency called the euro. The advent of a single
European currency, which may eventually rival the US
dollar as a global vehicle currency, will have major
implications for the European as well as world economy.

Flexible exchange rate regimes were rare before the late

twentieth century. Prior to World War II, governments
used to purchase and sell foreign and domestic currency in
order to maintain a desirable exchange rate, especially in
accordance with each country’s trade policy. After a few
experiences with flexible exchange rates during the 1920s,
most countries came back to the gold standard. In 1930,
before a new wave of flexible rate regimes started, prior to
the war, over 50 countries were on the gold standard.
However, most countries would abandon it just before
World War II started. In 1944, with the war almost over,
international policy coordination was starting to make sense
in everybody’s mind. Along with other international
organisations created during those years, the Bretton Woods
agreement was signed, putting in place a new pegging
system: currencies were pegged to the dollar, which in turn
was pegged to gold. It was not until 1973, when Bretton
Woods completely collapsed, that countries started to
implement flexible exchange rate regimes.
Flexible exchange rates can be defined as exchange rates
determined by global supply and demand of currency. In
other words, they are prices of foreign exchange determined
by the market, that can rapidly change due to supply and
demand, and are not pegged nor controlled by central
banks. The opposite scenario, where central banks intervene
in the market with purchases and sales of foreign and
domestic currency in order to keep the exchange rate within
limits, also known as bands, is called fixed exchange rate.
Within this pure definition of flexible exchange rate, we can
find two types of flexible exchange rates: pure floating
regimes and managed floating regimes. On the one hand,
pure floating regimes exist when, in a flexible exchange rate
regime, there are absolutely no official purchases or sales of
currency. On the other hand, managed (also called dirty)

floating regimes, are those flexible exchange rate regimes
where at least some official intervention happens. This
system would reduce Economic volatility and facilitates
free trade. Floating rates offset the differences in inflation
rates so that other elements such as : wages, employment,
output etc., need not be adjusted. Earlier experience
revealed that the fixed rates did not efficiently work for
longer periods
Criticism: Critics state that the system leads to uncertainty
which discourages free trade. Floating system encourages
speculation. As Per IMF Survey On Floating Regime:
Exchange rate volatility since early 1970s does not impede
world trade. Instead world exports increased for 8 years.
The statement of critics that uncertainty in the exchange
rates, drives the investors in to speculation, is also not valid.
Actually, fixed exchange system is having more chances of
promoting speculation. Both fixed and floating regime has
the same fault of speculation. But fixed regime is having
more fault than floating regime. Keeping in view
inflationary trends, a number of economists have called for
a return to fixed regime. Although history never offers a
convincing model for a system that will lead to long term
exchange rate stability, it points outs 2 (two) basic
requirement: Credible system must have price stability
build into its very core. Without price stability the system
will not be credible.
5.2. The Exchange Rate Arrangements

IMF (International Monetary Fund) categories different
exchange rate mechanism as follows:

 Exchange arrangement with no separate legal tender:

The members of a currency union share a common
currency. Economic and Monetary Unit (EMU) who have
adopted common currency and countries which have
adopted currency of other country.
 Currency Board Agreement

In this regime, there is a legislative commitment to
exchange domestic currency against a specified currency at a
fixed rate. As of 1999, eight members had adopted this
regime.
 Conventional fixed peg arrangement

This regime is equivalent to Bretton Woods in the sense
that a country pegs its currencyto another, or to a basket of
currencies with a band variation not exceeding ± 1% around
the central parity.
 Pegged Exchange Rates

Within Horizontal Bands In this regime, the variation
around a central parity is permitted within a wider band. It
is a middle way between a fixed peg and floating peg.
 Crawling Peg
A currency is pegged to another currency or a basket of
currencies but the peg is adjusted periodically which may be
pre-announced or discretion based or well specified
criterion.
 Crawling bands

The currency is maintained within a certain margins around

a central parity which 'crawls' in response to certain
indicators.
 Managed float
In this regime, central bank interferes in the foreign
exchange market by buying and selling foreign currencies
against home currencies without any commitment or
pronouncement.
 Independently floating
Here exchange rate is determined by market forces and
central bank only act as a catalyst to prevent excessive
supply of foreign exchange and not to drive it to a particular
level.
Now-a-days a wide variety of arrangements exist and
countries adopt the monetary system according to their own
whims and fancies. That's why some analysts are calling is
a monetary "non-system".
5.3. Economic And Monetary Union

Economic and Monetary Union (EMU) represents a major
step in the integration of EU economies. It involves the
coordination of economic and fiscal policies, a common
monetary policy, and a common currency, the euro. The
European Monetary System (EMS) was the pioneer of
Economic and Monetary Union(EMU), which led to the
establishment of the Euro. It was a way of creating an area
of currency stability throughout the European Community
by encouraging countries to co-ordinate their monetary
policies. The decision to form an Economic and Monetary

Union was taken by the European Council in to be the

Dutch city of Maastricht in December 1991. The Treaty of
Maastricht laid down a set of criteria met by member states
if they were to qualify for the EMU. Its main criteria was
Curbing inflation, GDP, Limiting public Cutting interest
rates, Reducing budget deficits to a maximum of 3% of
borrowing, Stabilizing the currency‘s exchange rate. The
Maastricht Treaty laid down the three-stage process: First
stage (1st Jul 1990), Second stage(1st Jan 1994), Third
stage(1st Jan 1999)) in which EMU was established.
Stage One Of EMU
 Complete freedom for capital transactions

 Increased co-operation between central banks
 Free use of the ECU (European Currency Unit)
 Improvement of economic convergence
Second Stage Of EMU
 (EMI) Establishment of the European Monetary
Institute
 Ban on the granting of central bank credit
 Increased co-ordination of monetary policies
 Strengthening of economic convergence
 Process leading to the independence of the
national central banks to be completed at the latest by the
date of establishment of the European System of Central
Banks;

Third Stage Of EMU
 Irrevocable fixing of conversion rates
 Introduction of the euro
 Conduct of the single monetary policy by the

European System of Central Banks
 Entry into effect of the intra-EU exchange rate

mechanism (ERM II)
 Entry into force of the Stability and Growth Pact

The management of Economic and Monetary Union
involves many actors with different responsibilities. As well
as the governments and central banks of the Member States,
the Council, the European Commission, the European
Parliament and the European Central Bank all have roles to
fulfill. The management of EMU involves three main areas
of macroeconomic policy-making: monetary policy, fiscal
policy and economic policy coordination.
5.4. European Monetary Union

The European Monetary Union is a group of 28 countries
that operate as a cohesive economic and political block. 19
of these countries use EURO as their official currency. 9
EU members (Bulgaria, Croatia, Czech Republic,
Denmark, Hungary, Poland, Romania, Sweden, and the
United Kingdom) do not use the euro. The EU grew out of a
desire to form a single European political entity to end
centuries of warfare among European countries that
culminated with World War II and decimated much of the
continent. The EU has developed an internal single market

through a standardised system of laws that apply in all

member states in matters, where members have agreed to
act as one. Evolution of EU has roots in looking for an
integration of divided Europe because of excessive
nationalism over a long period of time which also witnessed
two world wars. It has played an important role in
improving economic conditions and raising living standard
of people in weaker members of group.
Goals
 Promote peace, values and the well-being of all
citizens of EU.
 Offer freedom, security and justice without internal
borders
 Sustainable development based on balanced economic
growth and price stability, a highly competitive market
economy with full employment and social progress, and
environmental protection
 Combat social exclusion and discrimination
 Promote scientific and technological progress
 Enhance economic, social and territorial cohesion and
solidarity among EU countries
 Respect its rich cultural and linguistic diversity
 Establish an economic and monetary union whose
currency is euro.

History
 After World War II, European integration was seen
as a cure to the excessive nationalism which had
devastated the continent.
 In 1946 at the University of Zurich, Switzerland,

Winston Churchill went further and advocated the
emergence of a United States of Europe.
 In 1952, European Coal and Steel Community (ECSC)
was founded under Treaty of Paris (1951) by 6 countries
called Six (Belgium, France, Germany, Italy, Luxembourg
and the Netherlands) to renounce part of their sovereignty
by placing their coal and steel production in a common
market, under it. European Court of Justice (called "Court
of Justice of the European Communities" until 2009) was
also established in 1952 under Paris Treaty.
 European Atomic Energy Community (EAEC or
Euratom) is an international organisation established by the
Euratom Treaty (1957) with the original purpose of creating
a specialist market for nuclear power in Europe, by
developing nuclear energy and distributing it to its member
states while selling the surplus to non-member states. It has
same members as the European Union and is governed by
the European Commission (EC) and Council, operating
under the jurisdiction of the European Court of Justice.
 European Economic Community (EEC) was created
by the Treaty of Rome (1957). The Community's initial aim
was to bring about economic integration, including a
common market and customs union, among its founding
members (Six). It ceased to exist by Lisbon Treaty-2007 and
its activities were incorporated in EU.
 Merger Treaty (1965, Brussels) in which an agreement

was reached to merge the three communities (ECSC,
EAEC, and EEC) under a single set of institutions,
creating the European Communities (ECs). The
Commission and Council of the EEC were to take over the
responsibilities of its counterparts (ECSC, EAEC) in other
organisations.
 The ECs initially expanded in 1973 when Denmark,
Ireland, the United Kingdom became members. Greece
joined in 1981, Portugal and Spain following in 1986.
 Schengen Agreement (1985) paved the way for the

creation of open borders without passport controls between
most member states. It was effective in 1995.
 Single European Act (1986): enacted by the European
Community that committed its member countries to a
timetable for their economic merger and the establishment
of a single European currency and common foreign and
domestic policies.
 The Maastricht Treaty-1992 (also called the Treaty on
European Union) was signed on 7 February 1992 by the
members of the European Community in Maastricht,
Netherlands to further European integration. It received a
great push with the end of the Cold War.
o European Communities (ECSC, EAEC, and EEC)

incorporated as European Union.
o European citizenship was created, allowing
citizens to reside in and move freely between Member
States.

o A common foreign and security policy was

established.
o Closer cooperation between police and the
judiciary in criminal matters was agreed.
o It paved the way for the creation of a single

European currency – the euro. It was the culmination of
several decades of debate on increasing economic
cooperation in Europe.
o It established the European Central Bank (ECB).
o It enabled people to run for local office and for
European Parliament elections in the EU country they lived
in.
 A monetary union was established in 1999 and came

into full force in 2002 and is composed of 19 EU member
states which use the euro currency. These are Austria,
Belgium, Cyprus, Estonia, Finland, France, Germany,
Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg,
Malta, Netherlands, Portugal, Slovakia, Slovenia, and
Spain.
 In 2002, Treaty of Paris (1951) expired & ECSC

ceased to exist and its activities fully absorbed by the
European Community (EEC).
 The Treaty of Lisbon 2007:
o European Community (now composed only of
EEC, EAEC, as ECSC already ceased in 2002) was ceased
and its activities incorporated in EU.
o EAEC is only remaining community organization
legally distinct from the European Union (EU), but has the
same membership, and is governed by many of the EU's
institutions.
 Euro Crisis: The EU and the European Central Bank
(ECB) have struggled with high sovereign debt and
collapsing growth in Portugal, Ireland, Greece and Spain
since the global financial market collapse of 2008. Greece
and Ireland received financial bailouts from the community
in 2009, which were accompanied by fiscal austerity.
Portugal followed in 2011, along with a second Greek
bailout.
o Multiple rounds of interest rate cuts and economic
stimulus failed to resolve the problem.
o Northern countries such as Germany, the United
Kingdom and the Netherlands increasingly resent the
financial drain from the south.
 In 2012, the EU received the Nobel Peace Prize for
having contributed to the advancement of peace and
reconciliation, democracy, and human rights in Europe.
 Brexit: In 2016, a referendum (called Brexit) was held
by U.K. government, and the nation voted to leave the EU.
Now the process is under UK Parliament for formal
withdrawal from EU.
Challenges & Reforms

 It is no longer self-evident that all old member states
will stay in the Union. The Treaty of Lisbon gave the
members the right to leave the EU. The financial crisis has
hit Greece so hard that many people have predicted for a

long time that the country will exit from the Union.
 Layoffs, redundancies and migration of jobs to
countries where labour is cheap affect the daily lives of
European citizens. The EU is expected to find solutions to
economic problems and employment.
 There is also demand for standard labour agreements
on terms of employment and working conditions that would
apply across Europe and even worldwide. As a member of
the World Trade Organisation, the European Union is in a
position to influence developments worldwide.
 EU is a global leader in the development of Key
Enabling Technologies (KETs). However, EU’s record in
translating this knowledge advantage into marketable
products and services doesn't match this. KETs-related
manufacturing is decreasing in the EU and patents are
increasingly being exploited outside the EU.
 Europe is experiencing a renaissance of national
sovereignty supported by a nationalistic turn of public
opinion and represented by parties on both ends of the
political spectrum. Popular disaffection toward EU
membership is fuelled by the contemporaneous occurrence
of two shocks, the economic and the migration crises.
 USA, by withdrawing from the Paris climate change
deal, by pulling out of the Joint Comprehensive Plan of
Action (JCPOA) on Iran’s nuclear programme, and by
attacking the integrity of the international trading system
through the unilateral imposition of tariffs, has called into
question Europeans’ formerly unshakeable faith in
diplomacy as a way to resolve disagreements and to protect
Europe.
 European leaders now fear that the transatlantic

security guarantee will centre not on alliances and common
interests but purchases of American technology and
materiel.
 Like the United States, the EU has been forced to
reconsider its relationship with a more assertive Russia
with implications for European security and stability. The
EU has sought to support Ukraine's political transition,
condemned Russia's annexation of Crimea in March 2014,
and strongly urged Russia to stop backing separatist forces
in eastern Ukraine.
o Democratic regression in Ukraine combined with a
hardening attitude in Moscow imposes constraints on the
Ukrainian government’s freedom of maneuver in pursuing
its European Union membership.
 Brexit: EU has imposed too many rules on business
and charged billions of pounds a year in membership fees
for little in return.
o The EU added eight eastern European countries in
2004, triggering a wave of immigration that strained public
services. In England and Wales, the share of foreign- born
residents had swelled to 13.4 percent of the population by
2011, roughly double the level in 1991.
o Brexit supporters wanted Britain to take back full
control of its borders and reduce the number of people
coming here to live and/or work.
o They argued that the EU is morphing into a super-
state that increasingly impinges on national sovereignty.
Britain has global clout without the bloc, they said, and can
negotiate better trade treaties on its own.

o Withdrawal from the EU is governed by Article 50
of the Treaty on European Union.
o A deal between UK & EU that gives it control over
immigration and also preferential access to the EU’s tariff-
free single market of 500 million people (UK), the
economic backbone of the world’s largest trading bloc is
rejected by Germany & other EU leaders.
EU & India
 The EU works closely with India to promote peace,
create jobs, boost economic growth and enhance sustainable
development across the country.
 As India graduated from low to medium income

country (OECD 2014), the EU-India cooperation also
evolved from a traditional financial assistance type
towards a partnership with a focus on common priorities.
 At the 2017 EU-India Summit, leaders reiterated their
intention to strengthen cooperation on the implementation of
the 2030 Agenda for Sustainable Development and agreed
to explore the continuation of the EU-India Development
Dialogue.
 The EU is India's largest trading partner, accounting
for €85 billion (95 billion USD) worth of trade in goods in
2017 or 13.1% of total India trade, ahead of China (11.4%)
and the USA(9.5%).
 The EU's share in foreign investment inflows to India
has more than doubled from 8% to 18% in the last decade,

making the EU the first foreign investor in India.

 EU foreign direct investment stocks in India amounted
to €73 billion in 2016, which is significant but way below
EU foreign investment stocks in China (€178 billion).
 INDIA-EU Bilateral Trade and Investment Agreement

(BTIA): It is a Free Trade Agreement between India and EU,
which was initiated in 2007. Even after a decade of
negotiations, India and EU have failed to resolve certain
issues which have led to a deadlock.
o "Data Secure" status not granted by EU affecting
prospects of India’s IT-enabled exports.
o Presence of non-tariff barriers on Indian
agricultural products in the form of sanitary and phyto-
sanitary(SPS) measures which are too stringent and enable
the EU to bar many Indian agricultural products from
entering its markets.
o EU wants India to liberalise accountancy and legal

services. India denies on the ground of already shortage of
jobs.
o EU demands tax reduction on wines and spirits but

in India these are regarded as ‘sin goods’ and the states
which derive huge revenue from liquor sales would be
reluctant to cut taxes.
o Reduction of taxes on automobiles not acceptable
to India as its own automobile industry would not be able to
match the competition from EU automobiles.
o India has rejected an informal attempt by the

European Union (EU) to work towards a global investment

agreement at the World Trade Organisation (WTO)-level
that would incorporate a contentious Investor-State Dispute
Settlement (ISDS) mechanism which will allow
corporations to take sovereign governments to international
arbitration. The ISDS mechanism permits companies to
drag governments to international arbitration without
exhausting the local remedies and claim huge amounts as
compensation citing losses they suffered due to reasons,
including policy changes.
o The non-tariff barriers in pharmaceuticals that EU
has imposed include requirement of WTO—Good
Manufacturing Practice certification, import bans,
antidumping measures and pre-shipment inspection among
others.
o India has cancelled most individual bilateral
investment agreements with EU member states on grounds
that they were outdated. By doing this India is putting
pressure on EUto sign BTIA on favouring terms.
5.5. Optimum Currency Areas

The theory of optimum currency areas was developed by
Robert Mundell and Ronald McKinnon during the 1960s.
An optimum currency area or bloc refers to a group of
nations whose national currencies are linked through
permanently fixed exchange rates and the conditions that
would make such an area optimum. The currencies of
member nations could then float jointly with respect to the
currencies of nonmember nations. Obviously, regions of
the same nation, sharing as they do the same currency, are
optimum currency areas. The formation of an optimum

currency area eliminates the uncertainty that arises when

exchange rates are not permanently fixed, thus stimulating
specialization in production and the flow of trade and
investments among member regions or nations. The
formation of an optimum currency area also encourages
producers to view the entire area as a single market and to
benefit from greater economies of scale in production.
With permanently fixed exchange rates, an optimum
currency area is likely to experience greater price stability
than if exchange rates could change between the various
member nations. The greater price stability arises because
random shocks in different regions or nations within the
area tend to cancel each other out, and whatever disturbance
may remain is relatively smaller when the area is increased.
This greater price stability encourages the use of money as a
store of value and as a medium of exchange, and
discourages inefficient barter deals arising under more
inflationary circumstances. An optimum currency area also
saves the cost of official interventions in foreign exchange
markets involving the currencies of member nations, the
cost of hedging, and the cost of exchanging one currency
for another to pay for imports of goods and services and
when citizens travel between member nations (if the
optimum currency area also adopts a common currency).
Perhaps the greatest disadvantage of an optimum currency
area is that each member nation cannot pursue its own
independent stabilization and growth policies attuned to its
particular preferences and circumstances. For example, a
depressed region or nation within an optimum currency area
might require expansionary fiscal and monetary policies to
reduce an excessive unemployment rate, while the more
prosperous region or nation might require contractionary
policies to curb inflationary pressures. To some extent, this

cost of an optimum currency area is compensated by the
ability of workers to emigrate from the poorer to the richer
members and by greater capital inflows into the poorer
members. Despite the fact that national differences are
likely to persist, few would suggest that poorer nations or
regions would do better by not entering into or seceding
from an optimum currency area or nation. Furthermore,
poorer nations or regions usually receive investment
incentives and other special aid from richer members or
areas.
The formation of an optimum currency area is more likely
to be beneficial on balance under the following conditions:
(1) the greater the mobility of resources among the various
member nations, (2) the greater their structural similarities,
and (3) the more willing they are too closely coordinate
their fiscal, monetary, and other policies. An optimum
currency area should aim at maximizing the benefits from
permanently fixed exchange rates and minimizing the costs.
It is not easy, however, to actually measure the net benefits
accruing to each member nation or region from joining an
optimum currency area.
Some of the benefits provided by the formation of an
optimum currency area can also be obtained under the
looser form of economic relationship provided by fixed
exchange rates. Thus, the case for the formation of an
optimum currency area is to some extent also a case for
fixed as opposed to flexible exchange rates. The theory of
optimum currency areas can be regarded as the special
branch of the theory of customs unions that deals with
monetary factors.

5.6. Currency Board Agreements (CBAs)

A currency board is an exchange rate regime based on the
full convertibility of a local currency into a reserve one, by
a fixed exchange rate and 100 percent coverage of the
monetary supply backed up with foreign currency reserves.
Therefore, in the currency board system there can be no
fiduciary issuing of money. As defined by the IMF, a
currency board agreement is “a monetary regime based on
an explicit legislative commitment to exchange domestic
currency for a specific foreign currency at a fixed exchange
rate, combined with restrictions on the issuing authority”.
For currency boards to work properly, there has to be a
long-term commitment to the system and automatic
currency convertibility. This includes, but is not limited to,
a limitation on printing new money, since this would affect
the exchange rate. The key conditions for the successful
operation of CBAs (besides those generally required for the
successful operation of a fixed exchange rate system) are a
sound banking system (since the central bank cannot be the
“lender of last resort” or extend credit to banks
experiencing difficulties) and a prudent fiscal policy (since
the central bank cannot lend to the government).
Under CBAs, the nation rigidly fixes (often by law) the
exchange rate of its currency to a foreign currency, SDR, or
composite, and its central bank ceases to operate as such.
CBAs are similar to the gold standard in that they require
100 percent international-reserve backing of the nation’s
money supply. Thus, the nation gives up control over its
money supply, and its central bank abdicates its function of
conducting an independent monetary policy. With a CBA,
the nation’s money supply increases or decreases,
respectively, only in response to a balance-of-payments
surplus and inflow of international reserves or to a balance-

of-payments deficit and outflow of international reserves.
As a result, the nation’s inflation and interest rates are
determined, for the most part, by conditions in the country
against whose currency the nation pegged or fixed its
currency.
The first currency boards appeared during the nineteenth
century in Britain and France’s colonies. Since for locals of
those colonies using the metropolitan currency was risky
(loss or destruction of notes and coins, resources being
permanently locked into the currency), the implementation
of currency boards in the colonies made sense. The
principle of the currency board was thus created in 1844 by
the British Bank Charter Act.
The main advantage of CBAs is the credibility of the

economic policy regime (since the nation is committed
politically and often by law to stick with it), which results
in lower interest rates and lower inflation in the nation. The
cost of CBAs is the inability of the nation’s central bank to
(1) conduct its own monetary policy, (2) act as a lender of

last resort, and (3) collect seignorage from independently
issuing its own currency. Examples include the Bulgarian
Lev against the Euro, or the Hong Kong dollar against the
U.S. dollar.
The following figure shows the different regimes according
to four different variables: exchange rate flexibility, loss of
monetary policy independence, anti-inflation effect and
credibility of the exchange rate commitment:

5.7. Dollarization
Dollarization refers to the economic phenomenon wherein
people turn to the U.S. dollar as an alternative to their own
local currency. Dollarization happens mainly because of the
widespread belief that the value of the U.S. dollar is more
stable than other currencies. The dollar thus offers an abode
for people looking to safeguard their savings. Sometimes, a
country’s government may choose to link the supply of its
own currency to the dollar in order to boost confidence
among people in its long-term value. It is usually countries
that have suffered hyperinflation often resort to
dollarization as a means to regain economic confidence.
Dollarization occurs when residents of a country
extensively use foreign currency alongside or instead of the
domestic currency. It can occur unofficially, without formal
legal approval, or it can be official, as when a country
ceases to issue a domestic currency and uses only foreign
currency. Unofficial dollarization occurs when individuals
hold foreign-currency bank deposits or notes (paper money)
to protect against high inflation in the domestic currency.

Official dollarization occurs when a government adopts

foreign currency as the predominant or exclusive legal
tender.
Dollarization has three main varieties: unofficial
dollarization; semiofficial dollarization; and official
dollarization.
 Unofficial dollarization:
Unofficial dollarization occurs when people hold much of
their financial wealth in foreign assets even though foreign
currency is not legal tender. (Legal tender means that a
currency is legally acceptable as payment for all debts,
unless perhaps the parties to the payment have specified
payment in another currency. Legal tender differs from
forced tender, which means that people must accept a
currency in payment even if they would prefer to specify
another currency.) The term "unofficial dollarization"
covers both cases where holding foreign assets is legal and
cases where it is illegal. In some countries it is legal to hold
some kinds of foreign assets, such as dollar accounts with a
domestic bank, but illegal to hold other kinds of foreign
assets, such as bank accounts abroad, unless special
permission has been granted. Unofficial dollarization can
include holding any of the following:
 foreign bonds and other nonmonetary assets,

generally held abroad
 foreign-currency deposits abroad;
 foreign-currency deposits in the domestic banking

system;

 foreign notes (paper money) in wallets and

mattresses.
 Semiofficial dollarization: More than a dozen

countries have what might be called semiofficial
dollarization or officially bi-monetary systems. Under
semiofficial dollarization, foreign currency is legal tender
and may even dominate bank deposits, but plays a
secondary role to domestic currency in paying wages, taxes,
and everyday expenses such as grocery and electric bills.
Unlike officially dollarized countries, semiofficially
dollarized ones retain a domestic central bank or other
monetary authority and have corresponding latitude to
conduct their own monetary policy. Table 1 lists
semiofficially dollarized countries.
 Official dollarization: Official dollarization, also

called full dollarization, occurs when foreign currency has
exclusive or predominant status as full legal tender. That
means not only is foreign currency legal for use in contracts
between private parties, but the government uses it in
payments. If domestic currency exists, it is confined to a
secondary role, such as being issued only in the form of
coins having small value.
Officially dollarized countries vary concerning the number
of foreign currencies they allow to be full legal tender and
concerning the relationship between domestic currency--if it
exists--and foreign currency. Official dollarization need not
mean that just one or two foreign currencies are the only
full legal tenders; freedom of choice can provide some
protection from being stuck using a foreign currency that
becomes unstable. Most officially dollarized countries give
only one foreign currency status as full legal tender. In most
dollarized countries, private parties are permitted to make

contracts in any mutually agreeable currency.
Besides the Commonwealth of Puerto Rico and the U.S.
Virgin Islands, Panama has had full or official dollarization
since 1904. Ecuador fully dollarized in 2000 and El
Salvador in 2001. Since 2001, Nicaragua has nearly fully
dollarized and Costa Rica has considered it.
India and Dollarization

India is among the most dollarized countries as far as
invoicing is concerned, and by all these measures of
internationalization, the dollar is largely ahead of other
currencies with euro as a distant second. While international
reserves are held in dollars, dollar is a vehicle currency on
the foreign exchange market. The U.S. gets seigniorage as
people from different countries use dollars, she said, adding
that India was one of the most dollarized countries in the
world, following Brazil, Pakistan and Indonesia, in the share
of imports and exports invoiced in dollars.
Euro is the closest substitute to dollar, as the euro area is
comparable to the U.S. in terms of economic size and in
international trade, but the incomplete architecture of the of
the euro area with 19 finance ministries backing the
currency, and the absence of a euro area wide safe assets
inhibits the internationalization of the euro. The crypto
currency and the private or public digital currency were
alternate options, but would not play an important role in
the international monetary system.
The Benefits of Dollarization

The benefits of dollarization arise from the nation
 Avoiding the cost of exchanging the domestic

currency for dollars and the need to hedge foreign exchange
risks;
 Facing a rate of inflation similar to that of the
United States as a result of commodity arbitrage, and
interest rates tending to fall to the U.S. level, except for any
remaining country risk (i.e., political factors that affect
security and property rights in the nation);
 Avoiding foreign exchange crises and the need for

foreign exchange and trade controls, fostering budgetary
discipline; and
 Encouraging more rapid and full international
financial integration.
Costs of Dollarization
Dollarization also imposes some costs on the dollarizing
country:
 The cost of replacing the domestic currency with
the dollar (estimated to be about 4 to 5 percent of GDP for
the average Latin American country);
 The loss of independence of monetary and
exchange rate policies (the country will face the same
monetary policy of the United States, regardless of its
cyclical situation); and
 The loss of its central bank as a lender of last
resort to bail out domestic banks and other financial
institutions facing a crisis.

Good candidates for dollarization are small open economies

for which the United States is the dominant economic
partner and which have a history of poor monetary
performance, and hence very little economic-policy
credibility. Most of the small countries of Latin America,
especially those in Central America, as well as the
Caribbean nations, fit this description very well. Once we
move from small to large countries, however, it becomes
more difficult to come up with clear-cut answers as to
whether dollarization would provide a net benefit to the
nation.
5.8. Brexit
The United Kingdom (U.K.) finally left the European Union
(EU) on 31st January 2020. It was a long-awaited historical
move which will bring an important change in the policies
and politics of the remaining 27 European Union members
states and the U.K. mainly. It becomes important to see how
this will shift the policymaking process and what are the
ways in which nations are going to tackle it.
The UK faced a lot of challenges in materializing this move

finally. It is a notable change for the UK although nothing
will change immediately because of the 11-month transition
period negotiated as part of an EU-UK exit deal, 2019. The
UK will be able to work in and trade freely with EU nations
and vice versa until December 31, 2020. However, it will
no longer be represented in the EU's institutions. From
2021, the UK and EU will enter a new relationship possibly
underpinned by a free trade deal.
European Union: The EU is an economic and political
union involving 28 European countries. It allows free trade,

which means goods can move between member countries

without any checks or extra charges. The EU also allows
free movement of people, to live and work in whichever
country they choose. The UK joined in 1973 (when it was
known as the European Economic Community) and it will
be the first member state to withdraw.
EU-UK Exit Deal
This agreement sets out the exact terms of the UK and EU
relationship immediately after exit but it is not clear, on
what terms the UK and EU’s future relationship will be. A
key part of the withdrawal agreement was, there would be a
transition period, until the end of 2020. The transitional
arrangement is designed to make the separation process
smoother and it covers subjects like trade, law, and
immigration. It will give them more time to iron out all the
details of their future relationship including a possible free
trade deal. During the transition, the UK will be officially
out of the EU and not be represented on EU bodies but
would still have the same obligations as an EU member.
That includes remaining in the EU customs union and the
single market, contributing to the EU’s budget and
following EU law.
Withdrawal Agreement:
 Under this, a transition period of 11 months has

finalised until December 2020. However, it might get
delayed until 2022 or 2023.
 During this period, the U.K. will continue to

participate in the EU’s Customs Union and in the Single
Market.

 The U.K. will apply EU law even if it is no longer

a Member State and will also continue to abide by the
international agreements of the EU.
 The transition period makes sure that there is not

a sudden shock but a degree of continuity and allows both
parties to secure an orderly Brexit, minimising disruption
for the citizens, businesses, public administrations, as well
as for the international partners.
Causes of Brexit
So far, there seem to be three theories for what drove so
many people to vote Brexit:
 Immigrants: Faced with rising immigration locals

worried about their jobs and the erosion of the English way
of life wanted their government to clamp down on
immigration. This was a revolt against unrestricted
immigration from poorer Eastern European states, Syrian
refugees residing in the EU and millions of Turks about to
join the EU.
 Elites: Faced with decades of economic malaise,

stagnant real wages and economic destitution in former
industrial heartlands ever since the rise of “Thaterchism”
and the embrace of Neoliberal policies by Tony Blair’s
New Labour the non-Londoners have decided to revolt
against the elite. This isn’t just about being against the EU
as it stands, and its free market and free movement of
peoples.
 Bureaucracy: Faced with Brussel’s asphyxiating

amount of red tape the English people decide to “take back
control” of their country’s bureaucracy.
Impact on the U.K. and the EU
 By leaving the EU, the U.K. automatically,

mechanically, legally, leaves hundreds of international
agreements concluded by or on behalf of the EU, to the
benefit of its Member States, on topics as different as trade,
aviation, fisheries or civil nuclear cooperation.
 However, with just 11 months to negotiate, there are

only chances of very basic and minimal deals covering
trade, fisheries and security.
 In that case, at the end of 2020, differing aspirations
for the trade talks might raise the prospect of a new no-deal
scenario.
 In the absence of a deal, the earlier accord on citizens’
rights, money and the Irish border will remain intact.
 Both of them will have to be ready for the economic

shift in trading on World Trade Organization (WTO) terms.
 The first priority is the trade deal to ensure the tariff

and quota-free flow of goods between the EU and U.K.
 However, the EU will only agree to zero tariffs and
zero quotas if the U.K. pledges zero dumping – that is, not
lowering social and environmental standards to outcompete
the EU.
 Negotiations will clash over the EU’s refusal to bring

services into the trade deal.

 The EU seeks to link goods trade to maintaining

the status quo on access to British waters which is
considered to be a matter of concern for the U.K., so it
might give rise to clashes.
 Even the non-trade subjects will be full of

political troubles because the EU Member States will have
to change their policies according to the new deals and the
regulations.
Impact on India
 India has had strong historical ties with the U.K.

and currently, it is one of India’s most important trading
partners. In the last four years alone, the number of Indian
companies investing in the U.K. has quadrupled.
 Similarly, the U.K. is one of the largest investors

in India, among the G20 countries. Hence, it is important to
see how India and the U.K. can manoeuvre through Brexit
and enter into new trade agreements that are mutually
beneficial to both economies.
 Brexit will directly impact not only the Indian

stock market but the global market in totality, including the
emerging markets in the world. This is because of the high
volatility in the pound.
 Both the U.K. and EU account for 23.7% of

Rupee’s effective exchange rate. With Brexit, foreign
portfolio investments will outflow and will lead to the
weakening of the rupee.
 India’s businesses based in the U.K. will be

hampered as till now they had border-free access to the rest
of Europe.
 The investors are concerned as India invests more

in the United Kingdom than the rest of Europe combined.
Impact on the World
 Brexit will weaken the EU economically and

politically. The U.K. was the EU’s second- biggest
economy (after Germany) a major net budget contributor,
key military force and one of the bloc’s two nuclear powers
(another one is France) and permanent UN security council
members.
 The U.K.’s departure has distracted attention from

a number of other big and urgent problems, including the
climate crisis.
 In the longer term of balancing of global powers,

a smaller Europe can be a weaker Europe in the face of an
ambitious China and an increasingly protectionist US.
The Way Forward

The EU and the U.K. are bound by history, geography,
culture, shared values and a strong belief in rules-based
multilateralism which will be reflected in its future
partnership as well. The EU and the U.K. will have to focus
on building a new partnership. The process will start as soon
as the 27 Member States will approve the negotiating
mandate, proposed by the European Commission. The
mandate sets out terms and ambitions for achieving the
closest possible partnership between the EU and the U.K.
Both of them will have to work together, beyond these
historical and trade links, on security and defence areas in
which the U.K. has experiences and assets. These will be

used the best as part of a common effort to tackle the
global challenges and changes such as climate change,
cybercrime, terrorism, inequality etc. These challenges
require collective responses and the more the U.K. is able to
cooperate with the EU and other partners around the world,
the greater are the chances of addressing these challenges
effectively. The EU and the U.K. need to consult each other
and cooperate bilaterally while working with the regional
and global institutions such as the United Nations, the
World Trade Organization, the North Atlantic Treaty
Organization (NATO) and the G20. The EU will need to be
significantly tougher, with a centralised foreign policy and
stronger rules ensuring European companies can compete
with overseas rivals like China and the US. Brexit makes
that imperative even more urgent.
The EU’s core idea is that the member nations are stronger
together and pooling the resources and initiatives is the best
way of achieving common goals. Even if the U.K. has
moved out of it, it will continue to move forward as 27.
Meanwhile, other nations of the world will have to
accommodate themselves according to the shifting balance
of power and politics.
*****

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INTERNATIONAL FINANCE

ECO4 C12 - INTERNATIONAL FINANCE

Module II: Exchange Rate and Theories of Exchange

Module III: Foreign Exchange Market

balance-( Salvatore) Policy adjustments- Expenditure

Module IV International Capital Flows

Module V International Monetary System

1.1. Balance of Payments

Purposes of Calculation of Balance of Payments

 Reveals the financial and economic status of a

of these visible exports and imports is known as balance of

ii) Export and Import of Services (Invisible Trade): It

includes all transactions relating to borrowings from abroad

1.1.2. Components of Balance of Payments in

Similarly, transactions, which lead to outflow of foreign

1.2.1.Current Account Deficit

Major components are: Goods, Services, and Net

A country with rising CAD shows that it has become

b)Trade Visible: Trade deficit has been lower recently,

1.2.2. Capital Account Deficit

capital account deficit of US $71.4 billion in the first quarter

1.3.Balance of Payment: India

 Strong BoP: The BoP is going to be strong on the back

 Trade Surplus in June 2020: India’s trade has turned

 Domestic Manufacturing Being Boosted: The

them to be asymmetrical. FTAs done earlier have

 Change in Mode of Manufacturing: The government has

1.4.Equilibrium and Disequilibrium of Balance of

1.4.1. Causes of Disequilibrium of Balance of Payments

(a) Domestic Inflation: The greater bulk of balance of

(b) Technological Changes: It is quite known that every

(c) Short Supply: Disequilibrium of balance of payment

(d) Fall in Demand or Structural Disequilibrium:

1.4.2. Methods of Correcting Disequilibrium in Balance

(a) Stimulating exports or to check imports: If there

(c) To deflate the Currency: If our currency contracts,

(d) Exchange Control: Under exchange control, all the

the central bank or to sell it at the official rate to the

(iii) Fiscal and Monetary changes that affect prices and

single method is found suitable. We should try to implement

1.5. Balance of Payments adjustments: Absorption and

Y = C + Id + G + X-M -------- (1)

The sum of (C + Id + G) is the total absorption designated

It implies that BOP on current account is the difference

Substituting equation (4) in (3), we get

The equation points toward three factors which explain the

1.5.2.Monetary Approach in the Adjustment of Balance

basic premise of the approach is the recognition that the

(i) There is the existence of a single price for identical

The monetary approach, given the above assumptions,

exchange rates through the sale of foreign exchange reserves

From this relation, it follows that the excess of money

an outflow of foreign reserves. The monetary approach also

On the other hand, a surplus in the BOP, caused by the

The main criticism of monetary approach is as follows:

(ii) Assumption of Full Employment: In this approach, an

(v) Possibility of Sterilization of Currency: The critics have

deal with the problem of BOP deficit.

(vii)Neglect of Monetary Lags: The monetary approach is

1.6. Automatic, price and income adjustments

deficit tends to reduce the nation’s money supply, thus

occur, and nations also adopt various policies to achieve

1.6.1. Disadvantages of Automatic Adjustments