Module 4

International trade leads to increase in world production, increase in

consumption and increase in economic welfare.
 -> Ricardo's principle of Comparative Cost
Advantage: absolute
• According to Ricardo it's not the absolute but the comparative difference in cost
that determines trade relations between the two countries. Production cost differ
in country because of geographical, D.O.L., and specialization in production due to
differences in climate natural resources, geographical situation and efficiency of
labour a country can produce commodity at a lower cost than the other.
• In this way each country Specializes in the production of commodity in which its
cost is less. Thus, when a country enters in a trade with some
• other country it will export those commodities in which the comparative cost is
less & those will import those commodities in which the comparative cost is more
This is the basis of international trade.
• According to Ricardo each country will specialize in production of those
commodities in which it has greater advantage or least comparative disadvantage.
• Comparative Cost Ratios (CCR)
• For Portugal
• in the case of wine:-
• 80/90= 0.89 C

• In the case of cloth :-

• 90/80 = 1.125 W

• For England
• in the case of wine:-
• 120/100=1.2C

• in the case of cloth:-

• = 100/120 = 0.83W
• After calculating comparative cost ratios it is found that for portugal the C. C. R.s are less in both the goods. So Portugal has a
greater C.C. Advantage over England in the production of both the goods. But the the cost of advantage is greater in the
production of wine then in the production of cloth because the ratio 80/90 < 90/80 (i.e. 1.125>0.89)
• At the same time for England though the comparative Cost Ratios are more, its "comparative cost disadvantage is lesser in the
production of cloth because 100/120 < 120/100

• Hence, Portugal would specialize in the production of wine & England in the production of cloth.

• -> Increase in World Production

• If there is no trade between them then,
• Portugal produces I unit of wine & 1 unit of cloth with 80+ 90=170 hrs. of labour & England will use 120+100=220 hrs. of labour.

• However, after specialization Portugal, would divert 170 hour of labour to produce wine only and England will divert 220 hrs of
labours to produce cloth only.
• Hence the output of wine in Portugal would be 170/80=2.125 units of Wine and output of cloth in England would be 220/100=2.2
units of cloth.
• Hence the same amount of Labour Produces a larger amount of commodities after specialization and international trade.
Heckscher-Ohlin theory OR 2x2x2 model
• The theory believes that different countries are endowed with varying proportions of different factors of production.

• Some countries have large population and large labour resource. The others have abundance of capital but short of labour resource.

• Capital abundant country presents a higher capital ratio than what a labour abundant county presents.

• Thus, a country with large labour force will be able to produce those goods at lower cost that involve labour intensive mode of production.

• Similarly the countries with large supply of capital will specialize in those goods that involve capital intensive mode of production.

• The former will export its labour intensive goods to the latter and import capital intensive goods there from.

• After the trade, both the countries will have both types of goods at the least cost.

• All this means that the theory holds good if the capital abundant country has a distinct preference for the labour-intensive goods and the labour
abundant country has a distinct preference for capital intensive goods. If it is not, the theory may not hold good.

• Again, the theory does not hold good if the labour abundant country is technologically advanced in capital intensive goods or if capital abundant
economy is technologically advanced in the production of labour intensive goods.

• Limitation: Leontief paradox: Leontief's paradox in economics is that a country with a higher capital per worker has a lower capital per labor
ratio in exports than in imports.

• This econometric finding was the result of Wassily W. Leontief's attempt to test the Heckscher–Ohlin theory ("H–O theory") empirically. In 1953, Leontief found
that the United States—the most capital-abundant country in the world—exported commodities that were more labor-intensive than capital-intensive, contrary to
H–O theory
Terms of Trade
• Terms of trade refer to the rate at which the goods of one country is exchanged for the goods of other country. It is measure of purchasing
power of exports of a country in terms of its imports when the exports prices of the country rise relatively compared to the price of imports,
its terms of trade the supposed to improve. the country benefits from 'gains from trade' if it can have larger quantity of imports in exchange
for a given quantity of exports. different concepts of terms of trade have been put forward by Jacob Viner, Gerald Meier and Dorrance and
Taussig.
1. Net Barter terms of trade (NBTT)=Px/Pm
Price of export, price of import
2. Gross Barter Terms of Trade (GBTT)=Qm/Qx
Quantity of import quantity of exports
3. Income terms of trade (ITT)= PxQx/Pm
4. Single factoral terms of trade (Ts)=Px/Pm*Fx
Fx is productivity of exports
5. Double factoral terms of trade (Td)=Px/Pm*Fx/Fm
Fm is productivity of imports
6. Real cost terms of trade (TR)=Px/Pm *Fx*Rx
Rx refers to the disutility of productive resources used in producing exports
7. Utility terms of trade(Tu)=Px/Pm*Fx*Rx*u
U stands for utility from imports
• Gains from trade (offer curve) Gains from Trade (offer curve)
• An offer curve is a locus of various combinations of the two commodities say X and Y which nation finds acceptable in trade. The offer
curve shows the bargaining position of the country that is how much it is willing to offer of its exports for different quantities of imports.
 Meaning and structure of Balance of Payment
• According to Charles Kindleberger, "the BoP of a country is systematic
recording of all Economic transaction between residents of that
country and the rest of world during a given period of time."
• If the receipts exceeds payment than a country is said to have
favourable BoP and vice versa.
• The BoP record is maintained in a standard double entry book keeping
method. International transaction enter into record as credit or debit.
The payments received from foreign countries enter as credit and
payments made to other countries as debit.
• The following table shows the elements of BoP
Balance of Payment- structure
• The BoP includes 3 types of accounts:
1) current account
a. Trade account
B. Service account
C. Unilateral transfers.

2) capital account

3) official reserves account

A. Foreign exchange
B. Gold
C. Special drawing rights.
 Components of current account
• The current account measures the flow of goods, service and income which occur across the
national borders it includes following item :
A. Balance of Trade
Which includes export and imports of goods. It is also called the balance of visible trade. Balance of
trade is the difference between export and import of goods. It is not necessary for balance of trade
to be always in balance. If a country's export is more than import there is a trade surplus hence the
country has a favourable BoP and vice versa.
B. Balance of invisible trade (services)
Which includes the export and import of service. The services includes the following, services refers to
receipts from tourism , transportation, engineering, business service fees (from lawyers or
management consulting and royalties from patents and copyrights)
C. Unilateral transfers
these transfers are one way transaction. As there is no claim involved so far as repayment is concerned.
Unilateral transfers includes gift, grant and personal remittances (salaries sent back to their families
in their country). Which are salary sent back into home country of a national working abroad
receipts from income-generating assets such as stocks (in the form of dividends) and also interest
payments on external debt.
• The capital account measures the outflow and inflow of capital into the economy the capital account
includes the following capital transaction.
• Long term movements of capital:
• this includes
1)portfolio investment: which refers to the purchase of long term securities by foreigners from the residence of
the domestic countries.
•
2) direct investment :
• Which refers to the foreign investment in plant and machinery in the country for doing business. In this
case the investor has controlling power.
• Short term movement of capital:
This includes purchase of short government and corporate securities with maturity period of less than 1 year.
For example commercial papers and treasury bills.
• Loan repayments
(Loan from IMF international agencies, etc)
All the capital inflow are recorded as positive entry in BoP and outflow as negative entry.
• 3) Official Reserve Account:
• A) foreign currency
• B) gold
• C) SDRs
• The position of international reserves account determine the foreign
exchange reserve which are available for settling the deficit in current
or capital account of the Country.
• Current Account + Capital Account = change in official reserve account
 Conclusion
• Autonomous and accommodating transaction
• Autonomous items refer to those international transactions which take
place due to some economic motive such as profit maximisation.
• Autonomous transaction are independent of other items in BoP
account for e.g. imports and exports.

• Accommodating transactions are those transactions that are

undertaken for the specific purpose of equalising the BoP from an
accountant's view. They are not motivated by profit.
 Causes of disequilibrium
• Any disequilibrium in BoP is the result of imbalance between receipts and payments for exports and
imports.
• Causes of increase in imports:
1) imports of essential goods and services
Countries which do not have enough supply of essential goods like food items (even oil, petroleum) or raw
materials or essential capital equipments are required to import them. Being essential items it is not
possible to reduce their imports.
2) Development Programme
Developing economies which have embarked upon planned Development programmes required to import
capital goods, raw materials which are not available at home and highly skilled and specialised manpower
unavailable at home. Since Development is continuous process, imports of these items continue for a long
time landing these in a BoP deficit.
3) population growth : most countries experiences an increase in population. In some like India and China, the
population is not only large but increase at a faster rate. To meet their needs imports become essential
and the quantity of imports may increases as population increases.
4) Demonstration effect : an increase in income coupled with the awareness of the higher standard of living of
foreigners. Such a behaviour is termed 'international demonstration effect'. When people become victims
of demonstration effect, their propensity to import increases.
 Other causes
1. Cyclical transmission business cycle affect international trade. Recession or
depression in one or more developed countries may affect the rest of world as
was the case during depression.
2. Capital Flight: When restrictions on the movement of capital are reduced or
eliminated there is a tendency among those who possess money capital to
transfer into those countries which yield higher returns.
• If economic and political troubles are sensed then capital is the first to run away
from the country.
• Hot Money
3. Structural Adjustments many countries especially those which were subject to
more control by the government or central authorities have in recent been
undergoing structural changes their economies are being liberalized, private
sectors have been given more freedom and responsibilities.
4. Globalization the world economy has been undergoing a change under the
world trade organization (WTO). There has been more liberal and open
atmosphere for international movement for goods, services and capital.
Monetary measures to correct disequilibrium in BoP
• Expenditure Switching and Expenditure Reducing
• The principle involved in the measures adopted to correct disequilibrium is to increase exports and earn
more than what we pay for our imports. For this purpose the measures aim at reducing imports while at
the same time promoting exports. To achieve this task a country is required to make export cheap and
import costly.
Measures adopted to correct disequilibrium are broadly discussed under A) monetary measures
a) devaluation
b) depreciation
c) deflation

a) Devaluation-Expenditure Switching
• It aims at influencing the prices of only traded goods and not the general price level as in case of
deflation. Devaluation refers to an official announcement or an act of monetary authority through which
the exchange rate is changed i. e. The value of domestic currency is reduced vis-a-vis foreign currency.
• For e.g. if the exchange rate is Rs. 50=$1, the decision to devalue currency by 20% will make new
exchange rate, Rs. 60= $1. Devaluation makes exports cheaper and imports costlier.

• Marshall and Lerner's condition: if sum of price elasticity of exports and price elasticity of
import is greater than 1, then devaluation will succeed in improving the BoP.
• Depreciation
• Like devaluation lowers the value of domestic currency or increase the value of
foreign currency. Depreciation of a currency takes place in free or competitive
foreign exchange market. Due to market forces.
• An existing rate say, Rs. 60 =$1 may depreciate to Rs. 65 or more.

•Devaluation and Depreciation

• Devaluation and Depreciation have the same effect on exchange rate, though the
former takes place under the fixed exchange rate. Devaluation usually is larger in
degree than depreciation.
•
• the above method results in expenditure Switching that is people switch or divert
the expenditure from imported goods to the goods of the country, Which devalued
its currency or whose currency is depreciated, as domestic goods are now cheaper
than the imported goods.
 Reduction in absorption- deflation expenditure
adjustment
• 1. Deflation refers to the process of decline in general price level. It
was adopted under Gold Standard. It leads to expenditure adjustment
i.e. people in that country spend money mainly on domestic goods and
service and less on imports .
• 2. Deflation measures of correcting disequilibrium is unpopular as it
has many negative Economic effect as less investment, more
unemployment, less income and consumption and finally less saving
leading to cumulative downward cyclical phase (recession).

• 3. Therefore, deflation as a measure to correct disequilibrium is given

up by almost all countries.
 Non-Monetary Measures
(Direct OR trade measures/ Direct controls)
• Intro: A deficit along with monetary measures may adopt the following non-
monetary measure too, which will either restrict imports or promote exports.
1. Tariffs: are broadly defined as scheduled of custom duties, which includes import
duties, export duties and transit duties. Tariffs are the duties (taxes) imposed on
imports. When tariffs are imposed the prices of imports would increase to the
extend of tariff. The increased prices will reduce the dd for imported goods and at
the same time, induce domestic producer to produce more of import substitutes.
Non-essential imports can ve drastically reduced by imposing a very high rate of
tariffs.
2. Import Quota Under this method, Government fixes quota of imports. To reduce
imports for correcting the deficit in BoP the Government may introduce restriction
on the quantity or volume of goods imported. Quotas may be of different types
A. The tariff or custom quota
B. The unilateral quota
C. The bilateral quota
D. Moving quota and import licensing.
3. Export promotion: As pointed out earlier the real solution for the deficit in the BoPs lies in
exporting more than imports. If the export sector is not strong, then special efforts are
required to devise special policy measures to promote exports. Some of important incentives
that the government usually offers are : subsidies, tax concessions, grants and other
monetary or Non-Monetary incentive .Exports may be encouraged by reducing or abolishing
exports duties, providing export subsidy, encouraging export production and export
marketing by offering monetary, fiscal, physical and institutional incentives and facilities.

5. Import Control imports may be control by imposing or changing import duties, restricting
importing through import quotas and licensing and even by prohibiting altogether the import
of certain inessential items.
6. Import substitution: along with increase in exports, it is necessary to reduce the dependence
on imports. In a highly interdependent world which works under the concept of global
economy it is not possible to reduce imports to greater extent. Besides it is not possible for
every country to think of only exports and not of imports.
• Industries which produces import substitutes require special attention in for of various
concessions, technical assistance, subsidies providing scarce inputs, etc.
WTO Agreements
GATS
• The General Agreement on Trade in Services (GATS) is a treaty of
the World Trade Organization (WTO) which entered into force in January
1995 as a result of the Uruguay Round negotiations. The treaty was
created to extend the multilateral trading system to service sector. The
overall goal of GATS is to remove barriers to trade, members are free to
choose which sectors are to be progressively "liberalized" (i.e. marketized
and privatized).
TRIMs
• The Agreement on Trade-Related Investment Measures (TRIMs) are
rules that are applicable to the domestic regulations a country applies to
foreign investors, often as part of an industrial policy.
• In the late 1980s, there was a significant increase in foreign direct
investment across the world. However, some of the countries receiving
foreign investment imposed numerous restrictions on that investment
designed to protect and foster domestic industries, and to prevent the
outflow of foreign exchange reserves.
• But under this, members are required to liberalize restrictions on direct
investment in a range of areas. TRIMs are rules that restrict preference of
domestic firms and thereby enable international firms to operate more
easily within foreign markets. Policies such as local content requirements
and trade balancing rules that have traditionally been used to both
promote the interests of domestic industries and combat restrictive
business practices are now banned.
 INTRODUCTION AND CONCEPT OF FOREIGN
EXCHANGE RATE
• Domestic trade involves no question of foreign exchange and hence no question of foreign
exchange rate because trade remains within the geographical/political boundary of a
country and the trade is facilitated through the medium of national currency only.
• Unlike the domestic trade the international trade involves the participation of two or more
than two countries and hence two or more than two currencies are required. Therefore
there arises the problem of foreign exchange rate.
• CONCEPT:-
• The foreign exchange rate is defined as the rate at which the currencies of two countries
get exchanged against each other. It is the price of one country‘s currency in terms of
another country‘s currency. For example in U. S. A. Dollar is the domestic currency while in
India, Rupee is the domestic currency. When international trade takes place between
these two countries, it leads to payments and receipts. So as to facilitate payments and
receipts between these two countries, through the medium of foreign exchange rate it is
done. If $1 = Rs. 45. This foreign exchange rate gets established then it expresses the price
of one U.S. dollar in terms of Indian Rupees. i.e. one U.S. Dollar is equal to 45 Indian
Rupees.
DETERMINATION OF FOREIGN EXCHANGE RATE:
• Demand and supply forces determine the foreign exchange rate in the
foreign exchange market.
• Algebraically.
• F. E. R. = f (Df, Sf)
• F. E. R. stands for Foreign Exchange Rate.
• f stands for functional relationship.
• Df stands for Demand for foreign exchange
• Sf stands for Supply of foreign exchange
 Demand for foreign exchange
• Foreign exchange is demanded by the residents of the country for the
following reasons:-
• Import of goods and services
• Unilateral payments donations, gifts, reparations, etc are all one sided
payments without corresponding returns. Such payments create demand for
foreign exchange.
• Miscellaneous/export of Capital:- The miscellaneous items constitute
repayment of foreign debt, purchase of assets in foreign countries, direct
foreign investment etc. All these miscellaneous items also require the
demand for foreign exchange
• Note: The total demand is inversely related to the exchange rate and thus,
downward sloping curve.
 Supply of foreign exchange
• The supply of foreign exchange comes out of receipts due to excess of
exports over imports. The following are the main sources of supply of
foreign exchange:-
• Export of goods and services
• Unilateral receipts
• Miscellaneous / import of capital : foreign investment direct and
portfolio repayment of debt by the foreigners all increase the supply of
foreign exchange.
The supply curve slopes upward showing proportional
relationship between supply and exchange rate.
• The intersection between the demand for foreign exchange curve and the
supply of foreign exchange curve determine the equilibrium foreign
exchange rate.
 Purchasing Power Parity (PPP)
• The theory first propounded by WHEATLY in 1802 and developed by
Gustav Cassel, a Swedish Economist.PPP theory explains the
determination of exchange rate. After first world war, when many of
the western countries allowed their exchange rate to float, it was
observed that the changes in exchange rates were highly influenced by
the changes in domestic prices.PPP has 2 versions, 1 is based on strict
interpretation of above mentioned law of single price and is termed as
Absolute Purchasing Power Parity. The other is liberal interpretation
and called Relative PPP.
 1.APPP
• according to it, the identical baskets of goods in 2 different countries must
sale for the same price. When expressed in the same currency. Stating
differently the exchange rate between the currency of two different
countries is decided by their respective purchasing power for example if a
basket of goods cost of rupees 100 in India and the same basket of goods
cost $ 2 in USA. Then the exchange rate defined as Rs. Per $ will be:-
• R=P/P*
• Where R= rate of exchange defined as domestic currency units per unit of
foreign currency
• P= price of basket of goods measured in domestic currency i.e. Rupees
• P*= price of identical basket of goods in the foreign country expressed in
terms of foreign currency i.e. $
• For example R=Rs100/$2=Rs.50
 Relative Version of PPP
• The absolute PPP states that exchange rate equals relative price levels. According
to P.R. Krugman and M. Obstfeld, "the relative PPP states that the percentage
change in the exchange rate between two currencies over any period equals the
difference between the percentage changes in the National Price Level". The
relative Version of PPP theory argues that the exchange rate will adjust by the
amount of inflation differential between two countries. Algebraically, it can be
stated as:-
• R1= R0 *P1 /P2
• Where , R0 =Equilibrium rate of exchange in base year .
• R1 =Equilibrium rate of exchange in the current year .
• P1= change in the Price index of home country, say India.
• P2 = change in the Price index of foreign country, say USA.
• example : if the price index in India rises from Rs. Hundred to Rs. 300 and in USA
from $100 to $ 200 then the new exchange rate will be with $1=Rs. 40 as base
period exchange.R1= R0*P1/P2= 40*300/200=60.°. Rs. 60= $1, .°. $1=Rs. 60
Functions of Foreign Exchange Market
The foreign exchange market is over a counter (OTC) global marketplace that
determines the exchange rate for currencies around the world. This foreign exchange
market is also known as Forex, FX, or even the currency marke

• The various functions of the Foreign Exchange Market are as follows:

• Transfer Function: The basic and the most obvious function of the foreign exchange market is
to transfer the funds or the foreign currencies from one country to another for settling their
payments. The market basically converts one’s currency to another.
• Credit Function: The FOREX provides short-term credit to the importers in order to facilitate
the smooth flow of goods and services from various countries. The importer can use his own
credit to finance foreign purchases.
• Hedging Function: The third function of a foreign exchange market is to hedge the foreign
exchange risks. The parties in the foreign exchange are often afraid of the fluctuations in the
exchange rates, which means the price of one currency in terms of another currency. This
might result in a gain or loss to the party concerned.
It is the day-to-day rate of exchange.
Speculators
• Speculators are agents who speculate, i. e. purchase and sell
foreign exchange with the intention of making a profit by taking the
advantage of changes in exchange rates. They participate in the
forward exchange market by entering into forward exchange deal.
They do so on the basis of their own calculation of the difference
between the forward rate and the spot rate that may prevail on a
future date. For example if a speculator enters to sell a dollar at
rupees 66.00 after three months with expectations of the dollar
becoming cheap and the spot rate after three months is rupees 65,
the speculator purchases the dollar for spot rate rupees 65=dollar 1
and sells for the agreed forward rate rupees 66, thus making a profit
of rupees 1. He may incur loss if the spot rate crosses rupees 67.
Arbitrage means the simultaneous buying and selling of foreign currencies with the intension of making profit.

Arbitrage takes place because of

Difference in bid and ask price at different banks, & • Example
Difference in exchange rate at different places
• Suppose the market for $ in the UK is:
£1 = $2.01
• and in Japan £1 = $2.01
• If there was a sudden increase in
demand for sterling in the UK. The £
would rise in the UK £1=$2.10. If
markets are not perfectly competitive
there may be a lag effect so that £ are
cheaper in Japan (stay at £1 = $2.01).
Therefore you could buy £in Japan and
then immediately sell them in UK
markets. This would give you a small
but guaranteed profit. As arbitrageurs
do this it will help bring the two
markets into line. The speed with which
markets are brought into line depends
upon how many people seek to do this.
An exchange rate system, also called a currency
system, establishes the way in which the exchange
rate is determined, i.e., the value of the domestic
currency with respect to other currencies
 Types of Floating rate system
• A floating (or flexible) exchange rate regime is one in which a country's exchange rate fluctuates in a wider range and the country's
monetary authority makes no attempt to fix it against any base currency. A movement in the exchange is either an appreciation or
depreciation.
1. Free float (Floating exchange rate)- Under a free float, also known as clean float, a currency's value is allowed to fluctuate in response
to foreign-exchange market mechanisms without government intervention.
2. Managed float (or dirty float)- Under a managed float, also known as dirty float, a government may intervene in the market exchange
rate in a variety of ways and degrees, in an attempt to make the exchange rate move in a direction conducive to the economic
development of the country, especially during an extreme appreciation or depreciation.
• A monetary authority may, for example, allow the exchange rate to float freely between an upper and lower bound, a price "ceiling" and
"floor".
❖ Intermediate rate regime
• The exchange rate regimes between the fixed ones and the floating ones.
1. Band (Target zone)- There is only a tiny variation around the fixed exchange rate against another currency, well within plus or minus 2%.
For example, Denmark has fixed its exchange rate against the euro, keeping it very close to 7.44 krone = 1 euro (0.134 euro = 1 krone).
2. Crawling peg- A crawling peg is when a currency steadily depreciates or appreciates at an almost constant rate against another currency,
with the exchange rate following a simple trend.
3. Crawling band- Some variation about the rate is allowed, and adjusted as above. For example, Colombia from 1996 to 2002, and Chile in
the 1990s.
4. Currency basket peg- A currency basket is a portfolio of selected currencies with different weightings. The currency basket peg is
commonly used to minimize the risk of currency fluctuations. For example, Kuwait shifted the peg based on a currency basket consists of
currencies of its major trade and financial partners.