Chapter 5 INTERNATIONAL FINANCE

Exchange Control
 Exchange Control is one of the device to control international trade & payments.  It aims at equilibrium of foreign receipts & payments.  Exchange control is also being used as protective device in modern time – to ensure equilibrium of foreign receipts & payments.  However, the main objective of exchange control is to maintain the stability of the fixed exchange rate of a currency – BOP  Exchange rate determined by govt by fixing official exchange rate but not by determination of demand & supply forces.

 Exchange control may be complete or partial, if exchange control is complete when the govt has full control over the exchange market.  Infact under complete exchange control, full control is possible to govt on exchange market & no disequilibrium in the BOP.  The exchange control applies to all types of international transactions & the govt restricts the sale & purchase of all currencies.  Govt control partially controls the exchange market – specified banks & financial institutions.

Definition of Exchange Controls  Haberlar – exchange control refers to state regulation excluding the free play of economic forces in the foreign exchange market.  P.T. Ellsworth – exchange control dealing with BOP difficulties, disregards market forces & substitutes for them the arbitrary decision of govt officials.  G.D.H. Cole – “The essence of exchange control is that the possessor of the controlled currency has no right, without special leave to convert it into foreign currency”.

1. 2. 3. 4. 5. 6.

Features of exchange control Exchange control has full control over the foreign exchange market. Only specified banks & licensed dealers can deal in foreign exchange. All foreign currencies are required to be surrendered to the central bank. The central bank sanctions & allocates all foreign payments in respect of different currencies. The central bank fixes the Official Exchange Rate by the govt – not by market demand & supply forces. There is regulation on imports.

Objectives of exchange control 1. Over valuation 2. Under valuation 3. Stabilization of exchange rates 4. Prevention of capital flight 5. Protection to domestic industries 6. Checking non – essential imports 7. Help to the planning process 8. Remedying unfavorable BOP 9. Earning Revenues

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1. Overvaluation Some countries resort to exchange control to keep their currencies overvalued. Under this, the foreign exchange value of the currency is fixed at a higher level than the free market rate – overvaluation It is also known as pegging up – increases values of home currency to foreigners – reduces the prices of imports & raises the prices of exports. The currency is overvalued for three reasons – 1. At time of war – many countries leads large quantities of imports. 2. In the development process needs – raw material & capital equipment form abroad. 3. The repayment of large foreign debt.

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2. Under valuation Undervaluation refers to the fixing of the value of a currency at a rate lower than the free market rate. It is also known as ‘pegging down’. Reduced export price & increases prices of imports. This is done to stimulate exports & reduce imports & to raise the general price level of the country. But such a policy can succeed only in the case of a small country whose participation in world trade is insignificant.

 But if a large county were to adopt this policy, it will lead other countries to retaliate & follow this policy – highly dangerous. 3. Stabilisation of exchange rates  Foreign control is adopted to stabilise the rates of exchange.  Fluctuating exchange rates harms commerce & industry.  The govt, therefore, adopts exchange control measures to stabilise the exchange rates by fixation of official exchange rate.

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4. To check Flight of Capital Exchange control may be adopted to prevent the flight of capital from the country. Flight of capital refers to the action of the citizens of a country to convert their cash holding into foreign currencies. Flight of capital may be the result of speculative activities, economic fluctuations and political uncertainty. Flight of capital exhausts the country’s limited reserves of foreign exchange & de-stabilize the economy. Through exchange control, the govt imposes restrictions on the sale of foreign currencies & there by checks the flight of capital.

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5. Protection to domestic industries Exchange control may be restored to protect the home industry from foreign competition. For this purpose, the govt restricts the imports through foreign exchange controls & thus provides opportunity to the domestic industries to develop without any fear of international competition. 6. Checking non-essential imports Exchange control also aims at checking imports of non-essential commodities. The non-essential, luxury, harmful & socially undesirable commodities through foreign exchange control. Licenses are issued for imports of essential commodities.

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8. To correct adverse BOP Exchange control is introduced to correct adverse BOPs. This is achieved by checking & regulating imports of foreign exchange. With reduction in imports & control of foreign exchange visible & invisible imports are reduced. Consequently, adverse BOP are corrected. 9. Sources of Income Exchange control is also used to earn revenue by the govt. Under the multiple exchange rate system, the govt fixes the selling rates higher than the buying rates and earns income equal to the difference between the two rates.

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10. To practices discrimination in trade Exchange control helps a country to follow a policy of discrimination in international trade. The govt fixes favourable rates of exchange for the countries with which it wants to strengthen its trade relation. 11. To check enemy nations Exchange control is also used by some countries to prevent the enemy countries from using their foreign assets. Regulations are adopted to freeze the assets held by the residents of the enemy country & they are not allowed to use transfer these assets.

Methods of Exchange Control  According to Prof. Paul Einzig there are 41 methods of exchange control.  But in reality only two methods of control adopted by various countries of the world.  Generally speaking, the methods of exchange control are classified under two head. 1. Direct Methods of exchange control – unilateral methods. 2. Indirect methods of exchange control – bilateral or multilateral methods.

Methods of Exchange Control

Direct Methods
1. Intervention or exchange Pegging 2. Rationing of foreign exchange 3. Blocked Accounts 4. Multiple Exchange Rates 5. Exchange Clearing Agreements 6. Payment Agreement 7. Gold Policy

Indirect Methods

1. Changes in interest rates 2. Quantitative Restrictions 3. Export Bounties/subsidies

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Direct methods of exchange control 1. Intervention or exchange Pegging Interventions means govt may intervene in the foreign exchange market and fixing exchange rate either above or below the normal market rate, this is know as exchange pegging. When the govt fixes the rate of exchange above the normal rate it is known as ‘Pegging up”. On the contrary, if the govt fixes the exchange rate below the normal market rate it is known as ‘Pegging Down”. Obviously, these ups & down of Pegging adopted by less developed countries (LDCs) to overcome pressure of BOP disequilibrium.

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2. Rationing of foreign exchange Under this method of exchange control the govt keeps the exchange value of its currency fixed by rationing the ability of its residents to acquire foreign exchange for spending abroad. The govt imposes restrictions on the use, sale & purchase of foreign exchange. All foreign exchange business is centralized either with the govt or with its agents. 3. Blocked Accounts – convertibility of accounts Blocked accounts imply restrictions on the transfer of foreign capital to home countries or transfer of funds by foreigners to their home countries. The central bank not allowed to convert foreign account into home account. Under this methods, the foreigners are not allowed to convert their deposits, securities & other assets into their currency.

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4. Multiple exchange rates When a country, instead of single exchange rate, fixes different exchange rates for the import & exports of different goods – it is known as multiple exchange rates. Even, different countries or different types of imports & exports – different exchange rates. This types of multiple exchange rates fixed on different goods & services, different countries & different types of imports & exports. Earning substantial foreign exchange.

5. Exchange Clearing Agreements Clearing agreements refers to a system under which agreement is made between two countries for settling their international trade account through their respective central bank. Kent in his words “Clearing Agreement is an agreement between the govt of the two countries for payments & receipts of import & exports. Under this system, the importers instead of making payment for the imported goods in foreign currency pay in home currency to their central bank. Similarly, the exporters, instead of receiving payment for goods exported in foreign currency receive it through the central bank in the home currency.

6. Payment Agreement The system of payment agreement solves two major problems experienced under the system of clearing agreement i.e.,
1. The centralisation of payment 2. The problem of waiting for exporters

The payment includes the trade transaction such as shipping charges, debt services, tourism etc which are reflected in the BOP

7. Gold Policy  Exchange control can also be affected by manipulating the buying & selling price of gold.  Such a policy affects exchange rates through its effect on the gold points.  For example, the Tripartite Agreement of 1936 between U.K., France & USA sought to control exchange rates by fixing the purchase & sale prices of gold at a level at which these parties proposed to fix up the exchange rates.

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Indirect Methods of exchange control 1. Changes in interest rates The govt can influence the rate of exchange indirectly through changes in the rate of interest. The exchange rates can be reduced by lowering the interest rate & can be increased by rising the interest rates. 2. Quantitative restriction Another indirect method of exchange control is to restrict the imports of the country through measures like tariff, import quotas & other such quantitative restrictions. Import duties reduces imports & with it rises the value of home currency relative to foreign currency.

 Similarly, export duty restricts exports as a result, the value of home currency falls relative to foreign currencies.  In short, when import duties & quotas are imposed, the rate of exchange tends to go up in favour of the controlling country. 3. Export Bounties  Export bounties or subsidies increases to exports.  Export bounties refer to the financial assistance to industries producing exportable goods.  Export subsides increase exports as a consequence, the demand for home currency in the foreign exchange market increase, thus raising the rate of home currency in terms of foreign currencies.

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Meaning of Foreign exchange rate The foreign exchange rate or exchange rate is the rate at which one country is exchanged for another. The rate of exchange is the price of one currency stated in terms of another currency. If 1 US $ = 48 Indian rupees, then the rate of exchange is $1 = Rs. 48 or Re. 1 = 1/48 = 0.020 dollars. It means that what $1 can purchase in America, Rs. 48 can purchase in India.

 In other world, the rate of exchange expresses the external purchasing power of a home currency.  According to Crowther, the rate of exchange “measures the number of units of one currency which will exchange in the foreign exchange market for another”.  Anatol Murad “The ratio at which one country’s currency can be exchanged for another is the rate of exchange between these two currencies”.  According to Sayers “the prices of currencies in terms of each other are called foreign exchange rate”.

E X C H A N G E R A T E

1. Spot Rate 2. Forward Rate 3. Long Rate 4. Fixed Rate 5. Flexible Rate 6. Multiple Rate 7. Two Tier Rate System

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1. Spot Rate Spot rate of exchange is the rate at which foreign exchange is made available on the spot. It is also known as cable rate or telegraphic transfer rate. Spot rate is the day to day rate of exchange. The spot rate is quoted differently for buyers & sellers. For example $ 1 = Rs. 48.50 for buyers & $1 = Rs. 48.30 for the seller. This difference is due to the transport charges, insurance charges, dealer’s commission etc – these costs are to be bears by the buyers.

2. Forward Rate  Forward rate of exchange is the rate at which the future contract for currency is made.  The forward exchange rate is settled now but the actual sale & purchase of foreign exchange occurs in future. 3. Long Rate  The long rate of exchange is calculated by adding premium to the spot rate of exchange in the case of credit purchase of foreign exchange & deducting premium from the spot rate in the case of credit sale.

5. Flexible Rate  Flexible or floating of exchange rate refers to the system in which the rate of exchange is determined by the forces of demand & supply in the foreign exchange market.  It is free to fluctuate according to the changes in the demand & supply of foreign currency.
Y D S

ER S

E D M

O

X

6. Multiple Rate Multiple rates refer to a system in which a country adopts more than one rate of exchange for its currency. Different exchange rates are fixed for imports, exports & for different countries. 7. Two - tier Rate System Two tier exchange rate system is a form of multiple exchange rate system in which a country maintains two rates. Higher exchange rate for commercial transaction & a lower rate for capital transaction.

Determination of Exchange Rate  Rate of exchange is the price of one currency in terms of another currency.  Therefore, like other prices, the rate of exchange is also determined in accordance with the general theory of value i.e., interaction of demand & supply forces.
 Supply of foreign exchange  Demand for foreign exchange

1. Supply of foreign exchange
1. The domestic exporters who receive payments of foreign currency. 2. The foreigners who invest & lend in the home country. 3. Domestic residents who repatriate capital funds previously send abroad. 4. The domestic residents who receive gifts from abroad.

2. Demand for foreign exchange
1. The domestic residents to import goods & services from abroad. 2. The domestic residents investing & lending abroad 3. The foreign residents to repatriate funds previously invested in the home country. 4. Sending gifts to foreign countries.

Y

D£ (= S$)
Excess supply D1 S1

S £ (= D$)

Exchange rate of pound ($ per £

R1

R

E Excess Demand

R2

S2

D2 D£ (= S$)

S £ (= D$)

O

M M1 Quantity of pounds

M2

X

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Equilibrium of Exchange rate Equilibrium rate of exchange is determined at the point where demand for foreign exchange becomes equal to the supply of foreign exchange. The demand schedule for pounds, i.e., D £ (S$) intersects the supply schedule for pounds i.e., S £ (D$) at point E. The equilibrium rate of exchange is OR & at this rate OM amounts of pounds are demanded as well as supplied. Any rate of exchange above or below OR will represents disequilibrium position & will be unstable.

 For example, At OR1 rate, there exist excess supply for foreign exchange i.e., the supply of rupees exceeds the demand for rupees (R1S1 > R1D1).  This will lead to a fall in the rupees rate of exchange & bring it down to the equilibrium level OR.  Similarly, OR2 rate represents a situation of excess demand i.e., the demand for pound exceeds the supply of pounds (R2D2 > R2S2).  This will push up the pound exchange rate to the equilibrium level OR.

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Balance of Payments (BOP) The balance of payment of a country system record of its monetary transactions with other countries of the world during a given period (in a year). Kinderberger defines BOP as a “systamatic record of all economic transactions between the residents of a country & the residents of rest of countries during a given period of time”. Bosodersten – the BOP is merely a way of listing receipts & payments in international transactions for a country. BOP expresses true economic position of a country in a given period whether the country is a creditor country or debtor country & whether its currency is rising or falling in its external value.

 A country exports & imports many items both visible & invisible goods as well as services Visible items – goods Invisible items - are services – shipping, insurance, banking etc. Capital transactions – lending & borrowing  BOP are also differences from Balance of Trade – the value of import & export of commodities including on visible items.  Where as BOP is more comprehensive in scope & it refers to the total debits & credits due to both visible items, export & import & capital movements.  A BOP statement is essential of a double – entry system of record of all economic transactions between the residents of a country & the rest of the world – specific period of time

1. 2. 3. 4.

5.

Features of Balance of Payment It is a systamatic record of all economic transactions between one country & the rest of the world. It includes all transaction – visible as well as invisible. It relates to a period of time. Generally, it is an annual statement. It adopts a double – entry book – keeping system Credit side – Receipts & Debit side – Payments. When receipts = payment – BOP is an equilibrium Receipts > payments – surplus BOP Payments > receipts – deficit BOP

Structure / kinds of Balance of Payments 1. Current Account 2. Capital Account 1. Current Account  Related to Short term transactions  It contains receipts & payments of account of exports of visible & invisible items.  Exports & imports of material goods are visible items.  Exports & imports of services are invisible items.

According to IMF the current accounts of BOP includes –
1. Merchandise imports & exports of visible items. 2. Travel – invisible account – education, health, international conventions or pleasures. 3. Transportation. 4. Insurance – premium & payments. 5. Investment income. 6. Government transactions. 7. Donation & gifts.

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Capital Account The capital account of BOP of a country deals with the financial transactions. It includes all types of short term & long term international movement of capital. If a country invests or lends abroad, it is a payment & will be recorded on the debt side. On the other hand, capital inflows in the form of borrowings from abroad or the foreign investments in the home country are entered on the credit side of the BOP account.

Capital accounts includes – 1. Private loans 2. Movements in Banking capital – inflow of banking capital & outflow of banking 3. Official capital transaction

Statement of Balance of Payments Receipts / Credits Payments / Debits
I Current Account I Current Account 1. Exports 1. Imports 2. Non – monetary gold movement (in) 2. Non – monetary gold movement (out) 3. Invisibles (Receipts) 3. Invisible (payments) II Capital Account II Capital Account 1. Private Receipts 1. Private payments 2. Government Receipts 2. Government Payments 3. Amortization Receipts 3. Amortization payments 4. Resale to IMF 4. Repurchase from IMF 5. Banking Capital Receipts 5. Banking capital payments 6. Errors & Omissions 6. Errors & Omissions III Settlement Account 1. Loans & Assistance from foreignIII Settlement Account countries 1. Loans & advance to foreign country 2. Loans & borrowings from IMF & SDRs 2. Repayments to IMF & SDRs. 3. Decline in Resources 3. Increase in Resources

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Balance of Payments – Balance In the accounting sense, the BOP of a country is always in equilibrium. The statement of BOP is prepared in terms of credits & debits – based on the system of double entry book keeping. Thus the sum of all credit equals the debit – import = export Equilibrium of BOP = import = export / debits = credit.

(X – M) + S +E +U + C + G = 0

Current Account
X = Exports

Capital Account

of goods M = Imports of goods S = Net Services exported E = Net earning from foreign investments U = Net unilateral receipts C = Net capital inflow G = Net sale of gold

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Disequilibrium in BOP Normally, the BOP of a country should be in equilibrium – imports & exports of goods and services should be equal. But in reality disequilibrium generally arises in the BOP. BOP may be unfavorable when there is excess of imports over exports (Deficit BOP). The favorable BOP when there is excess of exports over imports (Surplus BOP)

Types of BOP 1. Cyclical disequilibrium – arises due to business cycle – prosperity recession, full employment & depression. 2. Secular disequilibrium – it is also known as long – term disequilibrium in BOP – stages. 3.Structural disequilibrium – structural changes in some sectors of the economy.
 Demand & supply forces influencing exports & imports.

4. Fundamental disequilibrium  The fundamental disequilibrium has been originally used by the IMF.  Fundamental disequilibrium is generally caused by dynamic factors & particularly lead to chronic deficit in the balance.  Main causes of fundamental disequilibrium are –
Excessive or inadequate internal demand for foreign goods. Excessive or inadequate competitive strength the world market. Excessive capital movement.

Causes of disequilibrium
1. 2. 3. 4. 5. 6. 7. 8. 9. Development scheme – huge investment Price-cost structure Changes in foreign exchange rates Fall in export demand Demonstration effect. International borrowing & lending Cyclical fluctuation Population explosion Natural factors.

Methods of correcting Disequilibrium 1. Deflation 2. Depreciation 3. Devaluation 4. Exchange control 5. Capital movement 6. Encouraging exports 7. Discouraging imports.

What is Inflation ?
 Inflation refers to a situation when there is a general rise in prices & a corresponding fall in the value of money.  Inflation is a persistent upward rise in the general price level at a substantial rate that continues for a prolonged period of time.  Inflations a sizeable and a rapid increase in the general price level.  Inflation is a monetary phenomenon direct relationship between money supply and price level and indirect relationship between money supply and value of money.

 Prof Crowther – inflation as a state in which the value of money is falling i.e., prices are rising.  Prof Hawtrey’s – inflation as the issue of too much currency.  Prof Kemmerer – inflation “as too much currency in relation to the physical volume of business being done”.  Prof Coulbourn – inflation is too much money chasing too few goods.  Prof Goldenwesser – inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods.

Characteristics of Inflation
1. Inflation is a long term operating dynamic process. 2. It is a process of persistently rising price level. 3. Inflation is a rising trend in the price level and not a cyclical movement. 4. Inflation is endogenous to the economic system. 5. Inflation in the real sense, is a post-full employment phenomenon. 6. Inflation is also monetary phenomenon. It is usually characterised by an overflow of money and credit.

Classification of Inflation

Rate of Inflation
Creeping Walking Running Hyper

Government Reaction

Conditions
War time

Open inflation

Post war time Close Inflation Peace time Inflation

Credit inflation Deficit inflation Causes of inflation scarcity inflation Profit inflation Foreign trade inflation Cost/wage inflation Demand inflation

On the basis of Rate of inflation 1. Creeping inflation When the price rise is very slow like the pace of snail or creeps it is called creeping inflation. The government has a sometimes to resort to creeping inflation to make the economy dynamic. This type of inflation serves as a tonic for a backward & under developed economy. Under this, the prices rise slowly – industry & trade receive stimulus and the country slowly and gradually develops economically. It has been pointed out that the price level rises approximately by 2% annually under creeping inflation.

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2. Walking inflation When prices rise moderately and the annual inflation is a single digit. The rate of the increase of the price level acquires greater speed and rapidly under walking inflation. Roughly speaking, the price level under walking inflation rises approximately by 5% annually. If proper control is not exercised over walking inflation in time, it can easily assume the form of running inflation.

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3. Running inflation When the prices rises rapidly like the running of a horse at a rate of speed 10 to 20% per annum. The rate of the increase of price level gets further accelerated under running inflation. The price level under this type of inflation rises approximately by 10% every year. If government fails to curb running inflation in time, it may easily develop into galloping inflation.

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4. Galloping inflation/hyper inflation When prices rise very fast at double or triple digit rates from more than 20 to 100% per annum. Infact, this is the most dangerous type of inflation. Under this type of inflation, the prices rise every minute and there is no upward limit to which the price level may rise in course of time. Lord J.M. Keynes has referred to this - beyond the full employment level is the true inflation.

Y D Hyper
Running
W al kin

C

Rate of inflation

B A

g pin ree C

g

O Years

2% 5% 10% 10 & above

X

Y

Hyp er in flati o

n

Percentage of price increases

un R

g in n

in

tio fla

n
alk W n gi in

n tio fla

Creep

io inflat in g

n

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Time period

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On the basis of scope or coverage 1. Comprehensive inflation When the prices of all commodities register a rise in the economy - comprehensive inflation The prices of almost all the commodities show an upward trend during a period of inflation spiral. 2. Sporadic inflation Under this type of inflation, the prices of all the commodities do not register a rise, only the prices of a few commodities show an upward trend. For example – the prices of food grains may show an upward rise on account of the failure of crops.

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On the basis of government reaction 1. Open inflation An inflation is said to be open when the government takes no steps to check the rise in the price level. Market mechanism is allowed to work itself out fully without restrictions being imposed by the government. 2. Closed/repressed inflation when the government actively intervenes to check the rise in the price level. The government may check the rising trend in the price level by resorting to price control & rationing of scarce items in the economy.

the nature of time period of occurrences

 War time inflation – during a period of war government makes lots of investment on defence expenditure, which is diverted from development expenditure.  Post war period – disposable income of the community increases, withdrawn taxation & repayment of public debt.  Peace time inflation – increasing prices of commodities due to government expenditure on various infrastructural and social overhead capital.  Such an inflation very often occurs during a period of planned economic development in backward and underdeveloped economies.

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Causes of rising prices Credit inflation – inflation which is caused by excessive expansion of bank credit or money supply is referred to as credit or money inflation. Deficit inflation – it is the inflation caused by deficit financing – creating new money. Scarcity inflation – whenever scarcity of real goods occurs or hoarding activities of unscrupulous traders and speculators which may result into black – marking, thereby causing prices to go up, such type of inflation may be described as scarcity inflation. Foreign trade induced inflation – export boom inflation and import price hike inflation

Demand pull inflation
 Demand inflation is caused by an increase in the aggregate effective demand for goods and services in the economy.  Aggregate effective demand higher than aggregate supply of goods and services.  Money supply is one of the most important element for demand pull inflation.  When money supply increases – rate of interest falls – investment increases – money income of factors of production increases – increases expenditure on consumption – investment increases.  Since the economy was already operating at the point of full employment – an increase in investment expenditure will naturally result in demand inflation.

Y D1 P2 P1 P

S D2

D F D S X D2 D1

Price level
O

Y Real output

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Cost push inflation Cost inflation is not due to excessive aggregate demand but is caused by an increase in production costs. The factors of production may deliberately raise the prices of their services through various types of collusive activities. Cost inflation is generally caused by three factors – An increase in wages of laborers An increase in the profit margins of entrepreneurs Imposition of heavy commodity taxes by government.

Y AS2 E2 AS1 P2

Price level

P1

E1

AD X

O

Y2

Y1

Aggregate Output

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International Debt Problem The international debt problem is actually related to the less developed countries of the world. Most of LDCs being poor countries, their rates of domestic savings and investment are low. They are also facing problem of economic & social overhead capital & basic & key industries. To accelerate the rate of economic development, they borrow to import capital goods, components, raw materials, technical knowhow etc.

 These LDCs borrowing from commercial banks abroad, international financial institutions like IMF, IBRD, IFC, IDA, ADB etc.  They also borrowing money from various external sources such as international govt & private firms.  Besides, they also borrow to finance consumer goods to meet the requirements of the growing population.  Their exports being limited to a few primary products they borrow to supplement and increase their domestic resources.

 These lead to huge current account balance of payments deficits.  The oil shocks of the 1970s & the reactions of the developed countries to them led to a major debt crisis in LDCs.  To repay these debts in the form of interest & capital caused serious problems in such economies.  The problem had become very severe by the early 1980s which led to increase in debt – service payments from 18 billion dollars in 1973 to 140 billion dollars in 1990.

International comparison of external debt - 2002
Total Debt Short term debt external Debt to GNP service to total external debt (US (ratio %) (ratio %) debt %) billion $) Concessional debt to total debt %

Countries

Brazil China Russia Mexico Argentina Indonesia Turkey India Poland Philippines

227.9 168.3 147.5 141.3 132.2 132.2 131.6 104.4 69.5 59.5

52.5 13.4 43.3 22.6 138.6 80.3 72.7 20.7 37.2 71.4

68.9 8.2 11.3 23.2 18.3 25.0 46.8 14.9 22.5 20.2

10.3 28.5 11.1 7.0 11.2 17.6 11.5 4.4 12.8 9.4

1.4 17.8 0.4 0.9 0.9 24.0 3.5 38.4 9.5 21.1

Causes of the Debt Crisis 1. Oil Price Shocks 2. Bad Macro – economic Management 3. Large – scale lending by western banks to the LDCs 4. Rising interest rates 5. Trade policies 6. Immediate cause

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1. Oil Price Shocks The principal cause of the international debt crisis of the 1970s & 1980s was the increase in oil prices in 1970s & 1980s The first oil crisis was found in 1973 – 1979 fourfold increases the oil prices. This results cost of imports values becomes higher than net export values. The second crisis was found during 1980s to 1990s – three fold increases the oil prices.

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2. Bad macro – economic management Bad macro – economic management was the second reasons for the LDCs – debt trap. This problem are also leads to BOP deficits. The fiscal & monetary expansion method also enormous borrowing from abroad. This resulted in inflation & also increasing external debt.

3. Large – scale lending by western banks to the LDCs  Large scale lending by western bank to LDCs was another reasons for international debt.  The enormous increase in oil prices increases the revenues of oil exporting countries.  The oil exporting countries could not absorb the increased revenues in their economies & they deposited large volumes of Petro – Dollars in the commercial bank of LDCs.

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4. Rising interest rates Increase in interest rate also added to the debt crisis. During the first oil price hike, the real interest rates were low & even negative in the developed countries. But the second oil shock increased both money & real interest rate of between 1979-82. The rise in oil prices led to inflation in the developed countries.

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5. Trade Policies Trade related policies of both LDCs & developed countries also led to the growth of external debt of LDCs. The LDCs followed the inward oriented importsubstitution industrializations till the 1970s. 6. Immediate cause After 1979, many LDCs had accumulated huge external debt which they found it difficult to repay in the form of interest & principal. This led to the international debt crisis of the 1980s. The crisis emerged in August 1982 when the Mexican Central Bank announced that it had run out of foreign exchange reserves.

Measure to solve the Debt crisis  LDCs countries receiving loan from the official world agencies like the IMF & world bank.  Bilateral & multilateral basis.  Further, they restructured monetary & fiscal policies –

Measure to solve the Debt crisis 1. Twin-Track IMF Strategy 2. Debt rescheduling by commercial bank 3. The Banker Plan 4. The Brady Plan 5. Debt Swaps 6. Rescheduling of official loans 7. Toronto Terms 8. The Houston Terms 9. Enhanced Toronto Term.

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