UGC NET INTERNATIONAL ECONOMICS MATERIAL
THEORIES OF TRADE
1. Mercantilists'’ View on Trade
According to them, exports should be greater than the imports, which will further help the
nation become rich.
More gold and silver with the nation, implies more powerful and rich it will be. Government’s
role was limited to a. Facilitate exports and b. Restrict Imports
Mercantilists measured wealth of nations in terms of the stock of precious metals it possessed.
Mercantilists given importance to the concept of Nationalism whereby exports were
encouraged and imports were discouraged.
2. Absolute Advantage Theory (1776)
Given by Adam Smith. He in his book named “Wealth of Nations” stated that international
trade is beneficial only when the two nations have absolute differences in the cost of
production of the commodity in which they specialize
Important Assumptions:
1. Complete specialization
2. 2x2x1 model, that is, two nations, two goods and one factor of production
3. Constant returns to scale 4. No transportation cost
5. Perfect mobility of factors within the nation but not outside the nation
The theory of Absolute Advantage is based on the Labour Theory of Value.
Let us assume, U.S. produces 6 units of product A or 4 units of product B per one unit of labour.
On the other hand, U.K. produces 1 unit of product A or 5 units of product B per one unit of
labour (Table 1). This implies that U.S. specializes in the production of product A and hence has an
absolute advantage in producing that commodity while U.K. specializes in production of product
B and hence has an absolute advantage in producing that commodity.
Theory of Comparative Advantage (1817)
Given by David Ricardo in his “Principles of Political Economy and Taxation”.
The theory of Comparative Advantage states that “other things being equal, a country tends to
specialize in and export those commodities in the production of which it has maximum
comparative cost advantage or minimum comparative disadvantage.”
The country will import the goods which have a relatively less comparative cost advantage or
greater disadvantage.
Important Assumptions:
1. 2x2x1 model. Labour is the only factor of production
2. Labour is homogenous in terms of efficiency in a particular country.
3. Constant returns to scale 4. No transport cost.
5. Perfect mobility of factor within the nation and perfect immobility across the nations.
6. Included labour theory of value: Value of good is judged by labour input.
According to this theory, basis of trade will be the difference in labour productivity.
Opportunity Cost Theory (1936)
The theory was given by Haberler.
According to the theory, difference in opportunity cost leads to comparative advantage.
Important Assumptions:-
1. Straight line production possibility curve 2. Fixed supply of factors
3. Free trade between countries 4. Price = Marginal Money cost
5. Price of Factor = Marginal Productivity
According to this theory, cost of a commodity is the amount of the second commodity that
must be given up to release just enough resources to produce one additional unit of first
commodity.
The theory does not consider supply and demand differences but just the opportunity cost.
Modern Theory of Trade (Factor Proportion theory/ Factor Endowment theory)
The theory was given by Hecksher-Ohlin in the years 1919 and 1933 respectively.
The Hecksher- Ohlin Theory states that “countries which are rich in labor will export labor
intensive goods and countries which are rich in capital will export capital intensive
goods.”
According to this theory, the basis of trade is the supply of factor resources, that is,
difference in availability of resources.
Suppose: Nation 1 is labour abundant and nation 2 is capital abundant. Also, X is a labour
intensive commodity and Y is a capital intensive commodity.
Factor Intensity: (L/K)X > (L/K)Y
Factor abundance: (L/K)1 > (L/K)2
This implies, relative pricing of Labour in nation 1 will be less than that in nation 2 simply
because of its abundance in nation 1. Similarly, capital will be cheaper in nation 2.
The countries should export/produce the good which makes intensive use of the
abundant factor and import the good which makes intensive use of the cheap factor.
The theory comes to the following conclusions:
1. The basis of internal trade is the difference between the commodity prices in the two countries.
2. Difference in commodity prices is due to the difference in cost prices which is further due to the
difference in factor endowments in the two countries.
3. The country which is rich in capital produces and exports capital intensive product and the
country which is rich in labour produces and exports labour intensive product.
Criticisms of H-O Theory
Wijnhold’s criticism:
According to him, it is the commodity prices which determine the factor prices and not
the other way round
Haberler’s criticism:
According to him, the theory is based on partial equilibrium analysis. It does not provide
the general equilibrium solution.
Factor Price Equalization:
In 1970, Paul Samuelson has proved the factor-price equalization theorem, also known as
Hecksher-Ohlin-Samuelson theorem. According to this theorem, the relative and absolute
returns to factors after trade will be equalized. This implies that trade will lead to
convergence of factor.
Stolper-Samuelson Theorem:
The theorem talks about income distribution impact of trade. When trade takes place,
abundant factor will gain and scarce factor will lose. When tariffs are imposed, then
abundant factor will lose.
Factor Intensity Reversal:
The theory was empirically proved by Minhas in 1962. According to his theory, the
Hecksher-Ohlin Theory and Stolper-Samuelson theory will fail.
The reason was attributed
to very large difference in the elasticity of substitution between two nations.
Rybzinscky Theorem (1955):
According to this theory, the impact of increase in factor endowment on the output of the
good using that factor intensively will increase more than proportionately and output of
the other good will decline.
Metzler Effect/Paradox (1949):
According to this theory, the price of the importable good and the scarce factor will fall
leading to backward bending offer curves.
Leontief Paradox(1950s):
According to this theory, the Hecksher-Ohlin theory does not hold true. He empirically
proved it using the example of the U.S. economy saying that U.S. being a capital intensive
nation imported the capital intensive goods and exported labour intensive product.
The Theory of Reciprocal Demand
The term “Reciprocal Demand” was introduced by J.S.Mill to explain the determination of the
equilibrium terms of trade. Reciprocal demand helps in identifying a country’s demand of one
commodity in terms of quantities of other commodities which are to be given up in exchange.
The reciprocal demand helps in determining the terms of trade of a nation which further
determines the relative share of each country.
Important Points:-
The possible barter terms are given by the respective domestic terms of trade as set by the
comparative efficiency in each country.
The actual terms of trade would depend on each country’s demand for the other country’s
commodity production.
The barter terms will be stable at the point where exports offered by each country just suffice
to pay for the imports it desires.
Specific Factor Model of Trade
The theory was given by Jacob Viner and David Ricardo.
It first came in 1971 and in 1974 the theory’s graphical form was introduced by Michael
Mussan. However, the credit of the theory is given to Jacob Viner.
The theory is also associated with Paul Samuelson and Ronald Jones.
Important Assumptions:-
1. 2 goods: Food and manufacturing Goods
2. 3 factors of production: Land and Capital ( Specific factors) and Labour (Mobile Factor)
3. Production displays diminishing returns.
4. Concave production possibility curve that is, increasing opportunity cost because expansion of
one industry is possible only at the cost of other industry
According to this theory, the factor specific to export sector of each country will gain
while factor specific to import sector of each country will lose. Also trade will lead to
settling of prices between the original relative prices between the factors of production.
Intra-Industry trade
Economies of scale can either be external or internal. It is the product difference which
leads to imperfection in any industry. Exporting and importing the same commodity is
called intra-industry trade.
Differences:
Measure of Intra Industry Trade:-
The measure was given by Grusel and Lloyd in 1971.
Intra-Industry Trade (T) = 1 - |𝑿−𝑴| / 𝑿+𝑴
If there is only inter- industry trade then T = 0 and if there is only intra- industry trade the
T = 1. So the value of the index
Due to intra-industry trade, average cost would reduce, hence further reducing the
average price and increasing the number of firms in the market. As a result, the market
expands, price of the commodity falls and hence more variety for the consumers.
However, in case of external economies, pattern of trade is not predictable.
TECHNOLOGICAL GAP MODEL
This model was given by Posney in 1961. Under this, the trade is based on introduction of new
technique of production which gives the country a temporary monopoly for some time.
The theory also talked about lags which are of following types:
1. Imitation lag: It includes:
1. Foreign reaction lag: How foreign firms react to the new product.
2. Domestic reaction lag: Studies the impact of the new product on domestic firms.
3. Learning period lag: Over how much period of time, the other firms learn about new
technology.
2. Demand lag:
It is the time taken for the generation/creation of demand due to introduction of new
technology.
Net lag = Imitation lag – Demand lag
PRODUCT LIFE CYCLE MODEL
The product life cycle model was given by Vernon in 1966. The model is based on the concept of
standardisation. According to this theory, the comparative advantage shifts from the advanced
nation to the less developed or developing nations.
QUESTIONS FOR CLARIFICATION
1. Dutch disease refers to
A) A boom in a traded good sector leading to a boom in other traded good sector
B) A boom in a traded good sector leading to a decline in other traded good sector
C) A recession in a traded good sector leading to a recession in other traded good sector
D) A recession in a traded good sector leading to a boom in other traded good sector
2. Which of the following is an example of tragedy of commons?
A) Over fishing B) Smoking in a public place
C) Excessive rain D) Common use of public toilet
3. Dirty float refers to
A) Freely floating exchange rate system B) Fixed exchange rate system
C) Managed floating exchange rate system D) Gold standard system
4. Soft loan stands for
A) Loan with no rate of interest B) Loan to poor countries
C) Loan from international agencies D) Loan backed by no securities
5. The Organisation of Petroleum Exporting Countries (OPEC) is a ---------------- whose members
have agreed to limit output and fix prices
A) Duopoly B) Generalised system of tariff preferences
C) Cartel D) Free trade system
6. The terms of trade are defined as
A) The degree of competition existing in international trade
B) The differences between exports and imports
C) The differences in value between exports and imports
D) The rate at which exports exchange for imports
7. The product cycle theory of trade is essentially a
A) Static, short run trade theory B) Dynamic, long run trade theory
C) Zero sum theory of trade D) Negative sum theory of trade
8. If the international terms of trade settle at a level that is between each country’s opportunity
cost
A) There is no basis for gainful trade for either country
B) Both countries gain from the trade
C) Only one country gains from the trade
D) One country gains and the other country looses from the trade
Answers:-
1) B 2) A 3) C 4) A 5) C 6) D 7)B 8) B
TERMS OF TRADE
The concepts under the topic terms of trade are given below:
Based on Exchange Ratios
1. Net Barter Terms of Trade: The concept was given by Taussig in 1927. According to the
concept, the terms of trade are favourable when for given
exports we can import more.
Net Barter Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭 / 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭
2. Gross Barter Terms of Trade: The concept too was given by Taussig in 1927.
Gross Barter Terms of Trade = 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐢𝐦𝐩𝐨𝐫𝐭𝐞𝐝 / 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐞𝐱𝐩𝐨𝐫𝐭𝐞𝐝
3. Income Terms of Trade: The concept was given by Dorrance and Stanley in 1948.
Income Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭∗𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐞𝐱𝐩𝐨𝐫𝐭𝐞𝐝 /𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭
Based on Difference in Productivity of Factors
1. Single Factoral Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭 /𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐱
Where: Zx is the index adjusted for changes in productivity of factors
engaged in the country’s export sector.
The concept was given by Jacob Viner in 1937.
Double Factoral Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭/ 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐱 /𝐙𝐦
Where: Zm is the index adjusted for the changes in productivity of factors
engaged in the import sector
BALANCE OF PAYMENTS
Structure of Balance of Payment is as follows
1. Current account balance: It includes: 1. Balance of Visible trade: Trade in goods
2. Balance of invisible trade: Trade in services
3. Interest, dividends, profits and unilateral payments.
2. Capital account balance: It includes changes in capital assets or savings.
It has following heads: 1. Investments made in the economy.
2. Borrowings and lending
3. Foreign exchange reserves: It shows the changes in reserves of foreign exchange
with the country. It shows the reserves which are held in the form
of foreign currencies like dollar, pound, etc and even Special
Drawing Rights (SDRs).
4. Errors and Omissions: All statistical discrepancies are included in this category.
Current Account Balance: The current account of balance of payment includes the export
and import of goods and services, receiving or paying of
interests, profits, dividends and unilateral receipts from and
unilateral payments to abroad
Trade account balance: Also known as ‘Balance of Visible Trade’ or ‘Balance of
Merchandise Trade’. It is the difference between the export and
import of goods, or more specifically the tangible items.
Capital Account Balance: It includes the difference between the receipt and payment
under capital account. It involves inflows and outflows of
investments; short term, medium term or long term borrowings
or lending.
Autonomous capital transactions:
The investments which are not concerned with the surplus or deficit in the current account of
the balance of payments are known as autonomous capital transactions. Due to autonomous
transactions, there may be net inflow or outflow in the foreign exchange of a country,
resulting to deficit or surplus in the balance of payments account.
Accommodating capital transactions:
The transactions which are made due to deficit or surplus in the balance of payments are
known as accommodating capital transactions.
Types of Balance of Payment Disequilibrium
Structural Disequilibrium:
It is due to structural changes in the economy. These are long term in nature and are also
known as fundamental or secular disequilibrium. It refers to a persistent deficit or surplus in
the balance of payments account of a country. Any permanent change in the supply and
demand conditions may lead the economy towards fundamental disequilibrium.
Cyclical Disequilibrium:
Disequilibrium, under this case, is caused due to changes in the trade cycles. Different phases
of trade cycles like depression, recovery, boom, and recession cause disequilibrium in the
balance of payments account.
Technological Disequilibrium:
Any technological advancements like inventions or innovations of new goods or technique of
production cause a disequilibrium in the balance of payments account
Balance of payments is always in balance but only in accounting sense.
In General, Balance of Payment Equilibrium: Receipt = Expenditure
Balance of Payment Disequilibrium: Receipt > Expenditure (Surplus)
Receipt < Expenditure (Deficit)
Correcting BoP Disequilibrium
BOP Deficit Depreciation or devalue the Currency Increase exports and decrease
Imports BOP Equilibrium
BOP Surplus Appreciation or Revalue the currency Exports decrease and imports
increase BOP Equilibrium
Marshall-Lerner Condition
Devaluation or depreciation of a currency can be successful depending on the elasticities of
foreign demand of exports (ex) and elasticity of domestic demand for imports (em).
If ex + em > 1, implies that devaluation is successful.
If ex + em = 1, implies devaluation will have no effect on the balance of payment.
If ex + em < 1, implies that devaluation will worsen the balance of payment.
If ex = 0, then em should be greater than one to improve the balance of payment situation
due to devaluation.
If em = 0, then ex should be greater than one to improve the balance of payment situation.
J-Curve
The concept of J-Curve was given by Harberger and Houthakker in 1960s.
They based the concept on empirical findings on efforts to improve trade balance.
Initial efforts to improve the trade balance by devaluation or depreciation will keep the
balance of payment in deficit for some time but later it will turn into surplus because import
prices move much faster than the export prices.
Reasons for the shape of J Curve
1. Pre-existing trade contracts have to be honoured.
2. Elasticities are not very responsive in short run
or insensitiveness of demand for exports and
imports.
3. Consumers and producers are also not able
to react immediately.
Currency Pass Through
It is the extent to which changing currency values lead to changes in import and export prices.
J-Curve analysis assumes that a given change in exchange rate brings about a proportionate
change in the import prices. This is known as a complete currency pass through.
Reasons for the shape of J Curve
1. Pre-existing trade contracts have to be honoured.
2. Elasticities are not very responsive in short run
or insensitiveness of demand for exports and
imports.
3. Consumers and producers are also not able
to react immediately.
Currency Pass Through
It is the extent to which changing currency values lead to changes in import and export prices.
J-Curve analysis assumes that a given change in exchange rate brings about a proportionate
change in the import prices. This is known as a complete currency pass through.
Currency Pass Through It is the extent to which changing currency values lead to changes in import and export prices.
J-Curve analysis assumes that a given change in exchange rate brings about a proportionate
change in the import prices. This is known as a complete currency pass through.
Immiserizing growth
The ‘Theory of Immiserizing Growth’ was given by Jagdish Bhagwati in 1958.
The theory states that a country, if focuses on economic growth, could lead it to in the fall in
terms of trade and making the country worse-off than before.
According to the theory, if the growth is heavily export biased, it will result into worsening of
the situation of the country.
However, such kind of growth is beneficial only when the country
can influence the world prices.
INCOME ABSORPTION APPROACH
The concept was given by Sidney Alexander in 1952. According to this theory, the trade
balance of a country can improve if the domestic absorption is reduced.
X-M = y – C+I
Where: X-M= Exports – Imports = Trade Balance, C+I = Consumption +
Investment = Absorption y = income
So, Trade balance = Income – Absorption
MONETARY APPROACH REGARDING BALANCE OF PAYMENT
The concept was given by Robert Mundell and Harey Johnson.
The concept was simply an extension of monetarism. According to them, balance of payment
is a monetary phenomenon and money plays a very important role in it.
The concept is explained in terms of both fixed and flexible exchange rates.
1. Fixed Exchange Rate:
According to this, disequilibrium will be settled by inflow and outflow of foreign exchange in
the economy.
We know, Demand for Money (Md) = kPy Supply of Money (Ms) = m(D+F)
Where: m is the money multiplier and D is the domestic component,
F is the foreign exchange.
Case 1: If Md > Ms; This implies excess demand for money which cannot be handled by the
authorities and hence this will lead to inflow of foreign reserves in the economy. As a result, there
will be surplus in the balance of payment.
Case 2: If Md < Ms; this implies excess supply of money which could not be handled by the
authorities and hence there will be outflow of foreign reserves in the economy, leading to deficit
in the balance of payment.
2. Flexible Exchange Rate:
Under this, the central authority has the control on the money supply in the economy.
Therefore, the changes in balance of payment will take place with changes in the exchange
rates and domestic prices.
Case 1: Excess supply of money :- Deficit in Balance of Payment Inflationary pressures in the
economy Depreciation of the currency Demand for
money increases Excess supply will be absorbed
Case 2: Excess demand for money :- Surplus in Balance of Payment Currency appreciates
Decrease in demand for money and decrease in
domestic prices as well Excess demand for money is absorbed
QUESTIONS FOR CLARIFICATION
1. Based on the balance of payment, which of the following terms constitute the current account?
A. Balance of invisible B. Balance of trade
C. Both A and B D. None of the above
2. The extent to which a change in exchange rate leads to changes in import and export prices is
known as
A) J curve effect B) Marshall – Lerner effect
C) Absorption effect D) Pass through effect
3. Duty or other charges levied on an item on the basis of its value and not on the
basis of its quantity, size or weight is:
A) Ad valorem tariff B) Compound tariff
C) Effective tariff D) None of the above
4. Under floating exchange rate system and perfect capital mobility
A) Only fiscal policy is effective
B) Both monetary and fiscal policies are effective
C) Only monetary policy is effective
D) Both monetary and fiscal policies are ineffective
5. SDR is the currency of
A) IBRD B) IMF C) WTO D) ADB
6. Balance of current account includes
A) Balance of Trade B) Balance of invisibles
C) Balance of unilateral D) All the above
7. The Stopler Samuelson theorem postulates that imposition of a tariff by a nation causes the
real income of the nation’s
A) Scarce factor to fall B) Abundant factor to rise
C) Scarce and abundant factors to rise D) Scarce factors to rise
8. The neo Chamberlain models of intra industry trade differ from neo Heksher
Ohlin model in that the goods in question are
A) Vertically differentiated B) Horizontally differentiated
C) Identical D) None of these
Answers:-
1) C 2) D 3) A 4) C 5) B 6) D 7) D 8) B
FOREIGN EXCHANGE
1. Nominal Exchange rate: Number of units of domestic currency required to purchase one unit
of foreign currency.
2. Real Exchange rate: Relative price of two currencies after adjusting for the price levels in those
two nations.
3. Nominal Effective Exchange Rate (NEER): The weighted average of nominal exchange rate
where weights are the share of trading partners in the foreign trade of a country.
4. Real Effective Exchange Rate (REER): The weighted average of Real Exchange rate where
weights are the shares of a country in foreign trade.
EXCHANGE RATE DETERMINATION
1. Fixed Exchange: Exchange rate is determined by the monetary authority of a nation
2. Flexible Exchange Rate: Exchange rate is determined by the market forces of demand and
supply
3. Managed Floating: Initially the exchange rate is determined by the market forces of demand
and supply. After a certain stage the central bank of the economy intervenes.
MUNDELL-FLEMING MODEL
Mundell-Fleming Model is also known as IS-LM-BP model and was given by Robert
Mundell in 1963 and Fleming in 1962.
Assumptions
1. Small open economy 2. Perfect capital mobility
3. Domestic and foreign bonds are perfect substitutes.
4. Tax rates are same everywhere. 5. Perfect equalisation of returns in different countries.
6. Foreign investors do not face political risks. 7. Fixed foreign or world interest rates.
In case of fixed exchange rate, expansionary fiscal policy leads to rightward shift in the IS
curve. As a result, there is a rise in price of dollars in terms of rupee, leading to inflow of
foreign currency. So to keep it constant, the central bank increases the money supply by
purchasing dollars and hence shifting the LM curve to the right and restoring the equality
between IS, LM and BOP curves. Therefore, Fiscal policy is more effective in case of fixed
exchange rate because there is an increase in income with no change in the interest rates and
exchange rates.
In case of expansionary monetary policy, the LM curve shifts towards the right. This makes the
domestic interest rate to fall below the world interest rate. As a result, money would flow
inside the economy. So to keep the money supply constant, the central bank would sell
dollars, thus reducing our currency circulation and hence shifting the LM curve back.
Therefore, monetary policy is not effective.
Under flexible exchange rate, the role of exports play a very important role.
If fiscal policy is applied in the flexible exchange rate scenario then,
Expansionary Fiscal Policy which shifts the IS curve upwards Currency
appreciates Imports increase and exports decrease IS curve shifts back
making the fiscal policy ineffective
Monetary policy is effective in the case of flexible exchange rate.
Expansionary Monetary Policy which shifts the LM curve Downwards implying increase in
the money supply Currency depreciates Imports decrease and exports increase IS
curve shifts upwards making the monetary policy effective by bringing a rise in the
income levels of the economy.
OFFER CURVES
The concept of offer curves was given by J.S. Mill.
The graphical interpretation of the same was given by Marshall and Edgeworth. The offer
curves are also known as “Reciprocal Demand Curves”.
The offer curves show that how much will a nation import or export at different relative prices.
In simple words, they tell us how much quantity of goods will be imported or exported at
different relative prices by two nations, engaging into trade.
The offer curve is bent towards the good which will be exported by the country
The equilibrium will exist at the point where the offer curves of the two nations intersect. The
line of equilibrium shows that the supply will always be equal to the demand at this line. Here,
we can derive the terms of trade between two countries.
Elasticity of Offer Curves
Elasticity of offer curves shows how responsive is the demand for imports to the change in the
relative prices.
Elasticities of Offer Curve
E < 1 Price changes are less than proportionate to quantity changes
E = 1 Any change in price will lead to proportionate change in quantity
E > 1 Total Revenue increases
There are three effects which determine the shape of offer curves.
1. Substitution effect (S.E.) = When (Px/Py) increases, consumer in nation 1 shifts from
consumption of X to consumption of Y, that is, more of income is available for export. This
leads to upward sloping portion.
2. Production effect (P.E.) = If country 1 has an incentive to produce more of X and less of Y,
then price effect reinforces substitution effect and leads to greater availability of X and hence
an upward sloping offer curves.
3. Income effect/Terms of Trade effect (I.E.) = With increase in real income, due to higher price
of export goods, the nation will purchase more of both goods. In other words, there is greater
domestic purchase of X and less availability of X for exports.
Income effect works in the opposite direction to substitution effect and production effect
If S.E. + P.E. > I.E. Upward sloping offer curves
If S.E. + P.E. < I.E. Backward bending/ negative sloping offer curves
If S.E. + P.E. = I.E. Vertical offer curve
TARIFFS
Tariff is a tax levied on export and import of goods. These are the restrictions on free trade.
Types of tariffs
On the basis of Purpose
1. Revenue Tariff: The kind of tariff implemented specially to raise the revenue capacity of the
government is known as the revenue tariff.
2. Protective Tariff: The kind of tariff imposed especially to inflate the prices of imports and
protect the domestic industries from foreign competition is known as protective tariff.
On the basis of origin and Destination
1. Ad Valorem Duty: Ad Valorem duty is charged on the total value of the imported commodity.
It is a fixed proportion of total commodity imported.
2. Specific duty: It is a tariff charged on the specific amount of money which does not vary with
the price of the good. It is charged on the weight of the commodity or the number of units
imported of that commodity.
3. Compound Duty: It is a mixture of both ad valorem and specific duty.
Non-tariff barriers to trade
1. Quotas: It is the ceiling on the quantity to be imported or exported.
i) Tariff Quota: It is a mix of tariff and quota.
ii)
Unilateral Quota: It is imposed on one nation.
iii) Multilateral Quota: Certain proportion is decided to use domestic inputs.
2. Import licensing: Import is dependent on the licenses obtained.
3. Voluntary Export Restraints: Also known as Orderly Market arrangement.
Other regulations to trade
1. Administrative regulations
2. Anti-dumping duties/countervailing duties
3. Export subsidies
Differences between Quota and Tariff
Partial and General Equilibrium effects of Quota
1. Partial Equilibrium effects:
If a nation imposes quota: a. Consumption decreases (Consumption effect)
b. Production increases (Production effect)
c. Trade decreases (Trade effect)
d. Revenue decreases (Revenue effect)
Overall, the consumer surplus reduces and producer surplus increases
2. General Equilibrium effects:
a. In case of large nation:
• The volume of trade decreases.
• Terms of trade may possibly increase.
b. In case of a small nation:
• Overall prices are not affected.
• Volume of trade decreases.
• Terms of trade remains unaffected.
QUESTIONS FOR CLARIFICATIONS
1. When the foreign offer curve has an elasticity equal to unity, the optimum tariff will be
A) Unity B) Infinity
C) Zero D) Less than unity
2. To be considered a good candidate for an export cartel, a commodity should
A) Be a manufactured good B) Be a primary product
C) Have a high price elasticity of demand D) Have a low price elasticity of demand
3. If no imported inputs go into the domestic production of a final product, the
A) Nominal tariff rate on the final product equals the effective rate on the product
B) Nominal tariff rate on the final product is greater than the effective rate on the product
C) Nominal tariff rate on the final product is less than the effective rate on the product
D) None of the above
4. ---------------------- curve shows how much of its import commodity is required by a nation in
exchange for various quantities of its export commodity
A) Indifference curve B) Offer curve
C) Demand curve D) Production possibility curve
5. The Leontief paradox presented by Wassiley Leontief in 1951, found that USA exported ---------
----- and imported ---------------- in apparent contradiction with Hekscher-Ohlin theorem.
A) Labour intensive commodities, capital intensive commodities
B) Capital intensive commodities, labour intensive commodities
C) Capital intensive commodities, capital intensive commodities
D) Labour intensive commodities, labour intensive commodities
6. A hot money or refugee capital is
A) Earned by refugees
B) One which is transferred from one centre to another for greater safety
C) Deposited by refugees before taking refuge
D) None of these
Answers:-
1) C 2) D 3) A 4) B 5) A 6) B
FOREIGN EXCHANGE MARKETS
Foreign Exchange Market is a market which deals in foreign currency. It may or may not be
physically located.
Functions: 1. Transfer function: Implies foreign exchange market transfers the
purchasing power of people.
2. Credit function: Providing credit to exporters and importers.
3. Hedging: Protection against foreign exchange risk.
Spot transaction: Payment has to be made within two business days.
Forward or future transactions: Signing an agreement for payments on delivery in future.
Hedging: Protection against foreign exchange risks.
Types of risks:-
1. Transaction exposure: Arises due to fluctuations in rates of foreign exchange markets in
future markets.
2. Accounting translation exposure: Interprets accounts in terms of different currencies to
accommodate balance of payment.
3. Economic exposure: Estimate domestic currency value of future profitability of the firm.
2. Speculation/Speculators:
It is the opposite of hedging.
More in forward market.
The speculators are willing to take risk or take an open position.
Stabilising Speculation: Buy currency at a low price expecting that the price will be higher
in the near future and sell the currency when the price is higher
expecting that it will be lower in the near future.
Destabilizing Speculation: It is an exact opposite of the stabilizing activities. Buy currency at
a higher price expecting that prices are going to be higher in
near future and sell it when the price is lower expecting that
prices will get lower in the near future.
Arbitrage: It is a tool to equalise the price. Buying the currency from a country where price is
lower and immediately reselling it in a country where it is higher in order to earn
monetary profits.
Purchasing Power Parity (PPP)
The concept was given by Gustav Cassel in 1918.
It is the law of one price. The situation occurs when all the opportunities of arbitrage are
exploited and we reach a single price. In the long run, law of one price prevails, that is, one
price for same good will prevail in all the nations.
OPTIMUM CURRENCY AREA
The theory of optimum currency area was developed by Mundell and Mc Kinnon (1963) in
1960s.
It refers to the group of countries whose currencies are permanently tied and will vary with
non-members.
It refers to an optimum geographical size within which means of payment is in a single
currency and exchange rates are pegged to one another with unlimited capital and current
transactions on the balance of payment but whose exchange rates fluctuate in unison against
the non-members.
Conditions in which it will be beneficial:
1. Greater mobility of resources among member nations
2. Greater structural similarities.
3. Countries should be more willing to co-ordinate their monetary and fiscal policies.
ECONOMIC INTEGRATION
There are five forms of Economic Integration;
1. Preferential Trade Agreements: It is a trading bloc which gives preferential access to certain
products from the participating countries. Reducing tariffs but not abolishing them complete
is the feature of these kind of agreements.
2. Free trade area: Group of nations having no trade restrictions among the members. The
countries in a free trade area can pursue independent tariff policy with non-members.
Example: NAFTA (North American Free Trade Association)
3. Custom Union: Freedom of trade and common tariff policy with non-members.
4. Common market: Has features of free trade area and custom union and also there is a free
movement of labour and capital. European Union became a common market in 1993.
5. Economic Union: It is the highest level of integration. There are no restrictions and there is a
free movement of labour and capital. The countries follow a common tariff policy and also
overall there are common policies for the economy. There is one central bank. This implies
that there is monetary and fiscal unification.
TRADE CREATION AND TRADE DIVERSION
The concept of Trade creation and Trade diversion were developed by Jacob Viner in 1950.
Trade Creation: It is the increase in volume of trade because of inclusion of a more
efficient producer in the union.
Trade Diversion: It is the loss of more efficient producer to a relatively less efficient
producer. It results from the non-inclusion of a more efficient producer in
a union.
OPTIMUM TARIFF
Optimum tariff is the rate at which the net gain will be maximised. It helps the country to reach its
maximum rate of satisfaction. In simple words, by applying optimum tariff, the country’s social
welfare is maximized.
The formula for calculating optimum tariff is: t* = 𝟏 /𝒆−𝟏
where: t* = optimum tariff , e= absolute value of elasticity of nation’s trading partner’s offer
curve. If e = ∞, then t= 0 and when e < ∞, then t > 0.
Lower value of t means greater curvature of the offer curve and greater value of optimum
tariff.
Optimum tariff is the rate of tariff that maximizes the net benefit resulting from the
improvement in the nation’s terms of trade against the negative effect resulting from the
reduction in the volume of trade.
In other words, optimum tariff is the rate which makes the nation reach its highest trade
indifference curve and this trade indifference curve is tangent to the trade partner’s offer
curve.
THEORY OF TARIFF STRUCTURE
Nominal Rate of Protection: It concerns the consumer because it impacts the real income.
It is calculated on the value of the final good and hence is
very important to the consumers as it tells by how much
price rises as a result of tariff.
Effective Rate of Protection:
The concept was developed by Corden in 1966. It tells us the
degree of protection provided to the domestic good from the
export good. Effective rate of protection is the percent increase
in the value added per unit and is calculated on the domestic
value added, that is, price of the final good minus cost of
imported inputs going into the production of the good.
Effective Rate of Protection can be founded by the formula,
g= t- ai*ti/1-ai
Where: g= rate of effective protection to the producer of final good. t= nominal tariff rate
on consumption of final good, ai= Ratio of cost of imported input to the price of final
good in absence of tariff ti= nominal tariff on imported inputs.
Important Points:-
If ti < t, then g > t Tariff on imported goods is less than tariff on final goods.
If ti > t, then g < t Nominal tariff on imported goods is greater than nominal tariff on final
goods or in other words, effective rate is less than nominal rate
If ti = t, then g = t Tariff on imported goods is equal to tariff on final good
If ai = 0 then g=t
For given values of ai and ti, g is larger for larger value of t.
For given values of t and ti, g is larger for larger values of ai.
If aiti > t, then g becomes negative.
BRETTON WOODS SYSTEM
UN Monetary and Financial Conference was held in 1944 amongst 44 nations’ representatives
who met at New Hampshire.
Reasons for holding a conference:
1. Due to the impact of Great Depression on the world economies.
2. World War II
Two plans were proposed:
1. Keynes Plan: The plan proposed to create a clearing house which will be entrusted with
powers to issue international reserve currency.
2. White Plan: The plan proposed to create an “International Fund” which will perform the
following functions: 1. Pool of international reserves.
2. Assist in removing the balance of payment deficits
3. Determine and maintain the exchange rates between currencies.
The White Plan was approved. As a result of this, three institutions were developed:
1. IMF (International Monetary Fund)
2. IBRD (International Bank for Reconstruction and Development)
3. ITO (International Trade Organisation) : It was later replaced by GATT
Exchange System
The system adopted a fixed exchange system, that is, Gold value was fixed in terms of dollars.
1 ounce of gold = $35
All other currencies were linked to dollars.
The collapse of Bretton Woods System
The process of collapse started in 1971. In 1973, the system was completely removed.
Reasons for the collapse of Bretton Woods follows;
1. Large current account deficit by U.S. As a result the U.S. $ started fluctuating.
Therefore, U.S.$ was unable to commit to the agreement of 1 ounce of gold = $35.
Moreover, there was shortage in supply of $ inside U.S. and excess supply outside U.S.
2. Vietnam War (1965-68): U.S. was supporting their military expenditure which led
to worsening the problem of deficit.
3. Two different markets of gold, private market and official market, which led to
instability in the supply demand equilibrium of gold.
On August 15, 1971; US President Nixon, stopped backing the dollars with gold, hence known
as Nixon shock. He took some restrictive steps.
1. U.S. would no longer sell gold to foreign central bank for conversion.
2. On all imports to U.S., 10% tax was imposed and will remain effective until all
American partners revalue their currencies.
3. Did not meet the requirements of exchange $35 for 1 ounce of gold.
EUROPEAN MONETARY SYSTEM
In 1969, steps were taken towards European Currency Reform initiatives. Major
Developments are:
1. Eliminate the intra-exchange rate movements.
2. Centralising monetary policy decisions.
3. Lowering the remaining trade barriers.
4. Transform it into large unified market.
Wenner report was adopted in 1971. Its task was to recommend suggestions to make
a union and fixing the exchange rates among themselves.
European Monetary System
In 1989, Delors Committee, chaired by Jacques Delors, was formed and it presented its
report. The report suggested steps to convert European market into European Union.
The steps were:
Step 1: All countries that are a part of European Monetary System (EMS) should adopt a specific
exchange rate mechanism. Bands were set which were Exchange rate ± 2.25. A greater degree of
co- operation among central banks of the member nations should be there and also there should
be convergence of macro-economic policies.
Step 2: Development of European System of Central Bank (ESCB) and exchange rate margins were
to be narrowed.
Step 3: There will be irrevocable fixing of exchange rates and a unified monetary policy would be
taken care of by the newly created European System of Central Bank.
QUESTIONS FOR CLARIFICATIONS
1. If depreciation is to improve the country’s BoP, the Marshall Lerner condition requires that the
sum of elasticities of demand for imports and demand for exports should be
A) Smaller than unity B) Greater than unity
C) Equal to unity D) Equal to 0
2. Which of the following items is within the total of BoP?
A) The merchandise balances B) The basic balance
C) The current account balance D) All of these
3. The OLI paradigm (ownership advantages, locational considerations and international gains)
as an explanation for FDI has been put forward by
A) Emmanuel B) Dunning
C) Kindle Berger D) Hymer
4.Under fixed exchange rate system, an expansionary monetary policy always leads to ------------
in BoP, while a contractionary monetary policy always leads to --------------- in the BoP.
A) Deterioration, improvement B) Improvement, deterioration
C) Deterioration, deterioration D) Improvement, improvement
5. The essence of -------------------- is that the importing country negotiates with its foreign
suppliers on quantitative restrictions on the amount of exports they will supply to the domestic
market.
A) Voluntary Export Restraints B) Import Tariff
C) Export tariff D) None of these
Answers:-
1) B 2) D 3) B 4) A 5) A
EURO-CURRENCY MARKET
Euro-Currency market is also known as Off-Shore Market. It is an international financial
market which specialises in borrowing and lending of US $ and other European currencies
outside their respective countries of issue.
Features of Euro-Currency Market
1. Wholesale Market
2. Inter-Bank transactions: Largest proportion of transactions.
3. Euro banks are concerned with short term lending, essentially short term in nature.
4. Highly competitive market
5. Involves greater risk
Development of Euro-currency market started in 1950s.
Reasons for development in 1960s and 70s are:
1. Advantage of the London money market
2. Flow of economic and military aid from U.S. to the West European countries
3. Decline in the importance of pound
4. Regulation Q was a restriction imposed by U.S. Federal Bank in 1960s, where
in a ceiling was imposed on the interest rate payable on time deposits with the
U.S. Banks.
5. In 1963, there was imposition of interest equalisation tax that raised the cost
of borrowing in U.S.
6. Inflationary pressures in U.S. monetary controls.
7. Expand the borrowing needs.
Negative impact of Euro-Currency Market is that monetary policy cannot be made by the
country
European Union
European Union was formed on November 1, 1993. Euro was formed on January 1, 1999 but
was started using as a currency in 2002.
Headquarters: Belgium
Euro Zone: Group of countries in European Union that have started using Euro as their
currency.
Euro Group: Group of finance ministers of European Union member states who have adopted
the euro.
ESCB: European Central Bank plus the national/Central banks of European Union,
whether or not they have adopted euro.
Euro System: European central bank plus the central banks of nations in the European Union
who have adopted Euro.
GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)
It was formed in the year 1944.
Important Objectives:-
1. Formed to provide a code of conduct to countries for trade.
2. Liberalisation of trade, that is, reducing the restrictions on trade.
3. Restrictions on unilateral action
Main convention of GATT was that no country can take a one sided action.
Principles of GATT
1. Non-Discrimination: MFN and National treatment
2. Reciprocity
3. Transparency
GATT Rounds:
Last round: Uruguay Round (1986), talked about trade in services, Intellectual Property
Rights (IPRs) and promoted the participation of developing countries
WORLD TRADE ORGANISATION (WTO)
WTO was brought into effect on January 1, 1995.
Principles: 1. Non-Discrimination
2. Free trade or market based liberalism
3. Safety Values/Domestic Safeguards: Trading partners have an option to opt out
of those commitments temporarily.
4. Reciprocity
5. Binding and Enforceable commitments.
Structure of WTO
1. Ministerial Council (MC): Topmost in the hierarchy. It meets once in every two years.
2. General Council (GC): It is functioning at all times when Ministerial Council doesn’t meet.
Functions:
1) As a Dispute Settlement Body: Settles disputes regarding trade.
2) As a Trade Policy Review Body: Reviews the trade policy of members.
TRIPS (Trade Related Intellectual Property Rights): Related to patents, copyrights, etc.
There are 9 categories under intellectual properties and gives protection to countries having
intellectual properties.
TRIMS (Trade Related Investment Measures): Under this, the foreign domestic investment
issues and conditions/requirements are taken care of.
GATS (General Agreement on Trade and Services): Service trade is protected and included
in WTO.
AOA (Agreement on Agriculture): It is specifically related to agriculture and its policies.
INTERNATIONAL MONETARY FUND (IMF)
IMF was established officially on December 29, 1945.
India holds 8th position and its share in IMF is 2.76%.
Objectives:
1. Short term lending institution to countries to solve their balance of payment disequilibria.
2. Maintains exchange rate stability. 3. Remove foreign exchange restrictions.
4. Promote international monetary co-operation. 5. Balanced growth of trade.
6. Establish multi-lateral system of payments.
7. Provides consultation and also works as a research institute. It is involved in data collection
Functions of IMF
1. Exchange arrangements: IMF assists in all matters related to the exchange rates between
various countries.
2. Surveillance: IMF performs surveillance function to keep a check on members.
3. It keeps a check on countries to avoid any restrictions on the current account.
4. IMF provides consultation and technical assistance.
5. IMF lends for BOP difficulties.
Membership in IMF
Members of IMF have to pay: 25% of their quota in the form of gold and 75% of the quota in
its own currency. Quota is decided on the basis of international
standing and U.S. has the maximum quota.
Borrowing Limits:
1. Gold Tranche: First 25% of the borrowing limit without restrictions.
2. Credit Tranche: Borrowing with restrictions
Quota determines the subscription of funds, drawing rights, voting power, borrowing capacity
and share of a nation in the allocation of Special Drawing Rights (SDRs).
Special Drawing Rights (SDRs):
They were formed in 1969. It is a unit of account for IMF members and each member is given
SDRs in proportion to their quotas.
Initially value of 1SDR was decided to be U.S.$ 1 which was further defined in terms of gold.
Now valuation of SDRs takes place in every 5 years.
SDRs are in the form of book-keeping entry form.
Lending Facilities of IMF
1. Supplementary Reserve Facility (SRF): It is the loan given to countries having extreme
BOP crisis.
2. Contingent Credit Lines: It is for vulnerable countries who may suffer from BOP Crisis in
near future.
3. Contemporary Financing Facility: It is for short term or temporary fall in export earnings.
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (IBRD)
IBRD was formed in 1945.
Its main function is to help poor countries and developing countries by providing loans which
are long term in nature. Help is also extended to the countries affected or destroyed in wars.
It extends loan where private capital is not available and finances projects of economic
development.
Members of IMF are eligible to become members of World Bank.
Functions of IBRD
1. Assist in reconstruction and development of territories of its member countries.
2. Promote private foreign investments by giving guarantees on loans.
3. Arrange for the loans, made or guaranteed.
4. Promote long term balanced growth of international trade and maintain the equilibrium
Lending Facilities
1. Structural Adjustment Facility: It was introduced in 1985. The main objective is to maintain a
sustainable balance of payment for the countries.
2. Enhanced Structural Adjustment Facility: It was introduced in 1987. The main objective was
to increase the availability of concessional resources to
low income member countries.
3. Special Action Programme: It was introduced in 1983. The main objective was to strengthen
IBRD’s ability to assist member countries in adjusting to the
current economic environment.
Under IBRD, loans extended are either medium term of long term.
Total Subscription
1. 2% in the form of gold or U.S. dollar and is available for lending.
2. 18% is payable in nation’s own currency and is available for lending on consent
of the country involved.
3. 80% is not available for lending and is subject to call as and when required to
meet the banks’ obligation.
Associates of IBRD:-
1.
International Finance Corporation (IFC):
It was formed in 1956. It is pertaining to private investors and provides finance to them.
Rate of interest is negotiable and it does not seek government guarantee for repayment of
any of its investments.
2. International Development Association (IDA):
It was formed in 1960. It is considered to be the bank for poorest of the poor. It provides
them the loans at even zero rate of interest or very low interest rates.
Its main objective is to reduce poverty and providing funds for human and economic
development projects.
3. International council for Settlement of Investment Disputes (ICSID)
It was formed in 1966 and helps in settling the disputes.
4. Multilateral Investment Guarantee Agency (MIGA):
It was formed in 1988 and its main function is to guarantee investment of member nations.
GLOBALISATION
Globalization means the integration of different markets in the global economy.
Reasons for the growth of globalisation
1. Developments in the ICT, transport and communications sectors of the economies.
2. Increase in the capital mobility.
3. Development of various different kinds of financial products, like derivatives, etc.
4. Free trade amongst nations, and participation of institutions like WTO, IMF, etc. has
facilitated the process of globalisation.
5. Growth of MNCs have contributed a lot in the process of globalisation.
QUESTIONS FOR CLARIFICATIONS
1. The Stopler Samuelson theorem postulates that imposition of a tariff by a nation causes the
real income of the nation’s
A) Scarce factor to fall
B) Abundant factor to rise
C) Scarce and abundant factors to rise
D) Scarce factors to rise
2. Factor intensity Reversal refers to a situation where
A) The same commodity is more labour intensive in one nation than in the other
B) One commodity is the labour intensive commodity in one nation and the capital intensive
commodity in the other nation.
C) Both commodities are more labour intensive in one nation than in the other nation.
D) None of the above.
3. The foundation of all WTO and GATT agreements is the principle of
A) Preferential treatment B) Discrimination
C) Non discrimination D) None of these
4. Economic integration with common market plus substantial harmonization of
economic policies including possibly a common currency is
A) Partial trade area B) Free trade area
C) Customs union D) Economic union
5. -------------- considers levels of protection on intermediate inputs as well as the
nominal tariff levied on the protected good
A) Nominal rate of protection B) Absolute rate of protection
C) Effective rate of protection D) Comparative rate of protection
6. A numerical limit on the volume of imports is
A) Tariff B) Quotas
C) Duty D) None of these
7. SDRs were created by IMF in
A) 1973 B) 1972 C) 1969 D) 1981
Answers:-
1) D 2) B 3) C 4) D 5) C 6) B 7) C
